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201461_1993.txt

201461_1993

1993

201461

ITEM 1. BUSINESS City National Corporation (the Corporation) was organized in Delaware in 1968 to acquire the outstanding capital stock of City National Bank (the Bank). Because the Bank comprises substantially all of the business of the Corporation, references to the "Company" reflect the consolidated activities of the Corporation and the Bank. The Corporation owns all the outstanding shares of the Bank. The Bank, which was founded in 1953, conducts business in Southern California and operates 19 banking offices in Los Angeles County, two in Orange County, and one in San Diego County. In November 1993, the Bank closed one office in Los Angeles County and announced a consolidation plan to improve efficiency and operational productivity in its branch network. The streamlining will involve closures of five additional branches in Los Angeles County and one branch in Orange County, while also designating four of the remaining locations as regional lending centers. The Bank expects to complete the closures in early 1994. The Bank primarily serves middle-market companies, professional and business borrowers and associated individuals with commercial banking and fiduciary needs. The Bank provides revolving lines of credit, term loans, asset based loans, real estate secured loans, trade facilities, and deposit, cash management and other business services. Real estate construction lending has been substantially curtailed since late 1990. The Bank also operates an Investment Management and Trust Services Division offering personal, employee benefit and corporate trust and estate services, and deals in money market and other investments for its own account and for its customers. The Bank offers mutual funds and residential home mortgages in association with other companies. Effective January 1, 1991, the Bank entered into an agreement to subcontract with Systematics, Inc. (now Systematics Financial Services, Inc.) for applications software, computer operations and integration services. In December 1992, the Bank entered into an agreement to sell its data processing business, City National Information Services (CNIS), to Systematics, Inc. for $12.0 million. A pretax gain of $10.8 million, which is net of certain software licensing payments and programming expenses shared with Systematics, Inc. was recognized at closing, June 1, 1993. Effective January 1, 1993, the Bank sold its merchant credit card processing business and customer contracts to NOVA Information Systems, Inc., for $1.9 million. Competition The banking business is highly competitive. The Bank competes with domestic and foreign banks for deposits, loans and other banking business. In addition, other financial intermediaries, such as savings and loans, money market mutual funds, credit unions and other financial services companies, compete with the Bank. Non-depository institutions can be expected to increase the extent to which they act as financial intermediaries. Large institutional users and sources of credit may also increase the extent to which they interact directly, meeting business credit needs outside the banking system. Furthermore, the geographic constraints on portions of the financial services industry can be expected to continue to erode. Monetary Policy The earnings of the Bank are affected not only by general economic conditions, but also by the policies of various governmental regulatory authorities in the U.S. and abroad. In particular, the Board of Governors of the Federal Reserve System (Federal Reserve Board) exerts a substantial influence on interest rates and credit conditions, primarily through open market operations in U.S. government securities, varying the discount rate on member bank borrowings and setting reserve requirements against deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of financial institutions in the past and are expected to continue to do so in the future. SUPERVISION AND REGULATION Bank holding companies, banks and their non-bank affiliates are extensively regulated under both federal and state law. The following is not intended to be an exhaustive description of the statutes and regulations applicable to the Corporation's or the Bank's business. The description of statutory and regulatory provisions is qualified in its entirety by reference to the particular statutory or regulatory provisions. Moreover, major new legislation and other regulatory changes affecting the Corporation, the Bank, banking and the financial services industry in general have occurred in the last several years and can be expected to occur in the future. The nature, timing and impact of new and amended laws and regulations cannot be accurately predicted. Bank Holding Companies Bank holding companies are regulated under the Bank Holding Company Act (BHC Act) and are supervised by the Federal Reserve Board. Under the BHC Act, the Corporation files reports of its operations with the Federal Reserve Board and is subject to examination by it. The BHC Act requires, among other things, the Federal Reserve Board's prior approval whenever a bank holding company proposes to (i) acquire all or substantially all the assets of a bank, (ii) acquire direct or indirect ownership or control of more than 5% of the voting shares of a bank, or (iii) merge or consolidate with another bank holding company. The Federal Reserve Board may not approve an acquisition, merger or consolidation that would result in or further a monopoly, or may substantially lessen competition in any section of the country, or in any other manner would be in restraint of trade, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the convenience and needs of the community. The BHC Act prohibits the Federal Reserve Board from approving a bank holding company's application to acquire a bank or bank holding company located outside the state where its banking subsidiaries' operations are principally conducted, unless such acquisition is specifically authorized by statute of the state where the bank or bank holding company to be acquired is located. California law permits bank holding companies in other states to acquire California banks and bank holding companies, provided the acquiring company's home state has enacted "reciprocal" legislation that expressly authorizes California bank holding companies to acquire banks or bank holding companies in that state on terms and conditions substantially no more restrictive than those applicable to such an acquisition in California by a bank holding company from the other state. The BHC Act also prohibits a bank holding company, with certain exceptions, from acquiring more than 5% of the voting shares of any company that is not a bank and from engaging in any activities without the Federal Reserve Board's prior approval other than (1) managing or controlling banks and other subsidiaries authorized by the BHC Act, or (2) furnishing services to, or performing services for, its subsidiaries. The BHC Act authorizes the Federal Reserve Board to approve the ownership of shares in any company, the activities of which have been determined to be so closely related to banking or to managing or controlling banks as to be a proper incident thereto. The Federal Reserve Board has by regulation determined that certain activities are closely related to banking within the meaning of the BHC Act. Consistent with its "source of strength" policy (see "Capital Adequacy Requirements," below), the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company generally should not pay cash dividends unless its net income available to common shareholders has been sufficient to fund fully the dividends, and the prospective rate of earnings retention appears consistent with the company's capital needs, asset quality and overall financial condition. The Corporation ceased paying dividends in the third quarter of 1991. Dividend payments are expected to resume, based on achieved earnings, and when the Board of Directors determines that such payments are consistent with the long-term objectives of the Corporation. A bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit. The Federal Reserve Board may, among other things, issue cease-and-desist orders with respect to activities of bank holding companies and nonbanking subsidiaries that represent unsafe or unsound practices or violate a law, administrative order or written agreement with a federal banking regulator. The Federal Reserve Board can also assess civil money penalties against companies or individuals who violate the BHC Act or other federal laws or regulations, order termination of nonbanking activities by nonbanking subsidiaries of bank holding companies and order termination of ownership and control of a nonbanking subsidiary by a bank holding company. National Banks The Bank is a national bank and, as such, is subject to supervision and examination by the Office of the Comptroller of the Currency (OCC) and requirements and restrictions under federal and state law, including 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, and limitations on the types of investments that may be made and services that may be offered. Various consumer laws and regulations also affect the Bank's operations. These laws primarily protect depositors and other customers of the Bank, rather than the Corporation and its shareholders. The laws and regulations affecting the Bank were significantly altered and augmented by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). "Brokered deposits" are deposits obtained by a bank from a "deposit broker" or that pay above-market rates of interest. Under FDICIA, only a well capitalized depository institution may accept brokered deposits without the prior approval of the Federal Deposit Insurance Corporation (FDIC). Banks that are not at least adequately capitalized cannot obtain such approval. For purposes of this provision, the capital category definitions are similar, but not identical, to the OCC's definitions of those categories for the purpose of requiring prompt corrective action. See "Capital Adequacy Requirements," below. Although the Bank sought, and received, the permission of the FDIC to accept brokered deposits in 1993, no such deposits have in fact been accepted. The Corporation's principal asset is its investment in, and its loans and advances to, the Bank. Bank dividends are one of the Corporation's principal sources of liquidity. The Bank's ability to pay dividends is limited by certain statutes and regulations. OCC approval is required for a national bank to pay a dividend if the total of all dividends declared in any calendar year exceeds the total of the bank's net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years, less any required transfer to surplus. A national bank may not pay any dividend that exceeds its net profits then on hand after deducting its loan losses and bad debts, as defined by the OCC. The OCC and the Federal Reserve Board have also issued banking circulars emphasizing that the level of cash dividends should bear a direct correlation to the level of a national bank's current and expected earnings stream, the bank's need to maintain an adequate capital base and other factors. National banks that are not in compliance with regulatory capital requirements generally are not permitted to pay dividends. The OCC also can prohibit a national bank from engaging in an unsafe or unsound practice in its business. Depending on the bank's financial condition, payment of dividends could be deemed to constitute an unsafe or unsound practice. Under FDICIA, a bank may not, except under certain circumstances and with prior regulatory approval, pay a dividend if, after so doing, it would be undercapitalized. The Bank's ability to pay dividends in the future is, and could be further, influenced by regulatory policies or agreements and by capital guidelines. The Bank ceased paying dividends in the second quarter of 1991. Dividend payments were also restricted in 1993 by the terms of the Bank's Agreement with the OCC, which was terminated on January 21, 1994. See "Regulatory Agreements," below. Dividend payments are expected to resume, based on achieved earnings, and when the Board of Directors of the Bank determine that such payments are consistent with the long-term objectives of the Bank. The Bank's ability to make funds available to the Corporation is also subject to restrictions imposed by federal law on the Bank's ability to extend credit to the Corporation to purchase assets from it, to issue a guarantee, acceptance or letter of credit on its behalf (including an endorsement or standby letter of credit), to invest in its stock or securities, or to take such stock or securities as collateral for loans to any borrower. Such extensions of credit and issuances generally must be secured and are generally limited, with respect to the Corporation, to 10% of the Bank's capital stock and surplus. The Bank is insured by the FDIC and therefore is subject to its regulations. Among other things, FDICIA provided authority for special assessments against insured deposits and required the FDIC to develop a general risk-based assessment system. The insurance assessment is set forth in a schedule issued by the FDIC that specifies, at semiannual intervals, target reserve ratios for the Bank Insurance Fund designed to increase to at least 1.25% of estimated insured deposits in 15 years. During 1992, the assessment rate for all banks was 0.23% of the average assessment base. However, in October 1992, the FDIC adopted a risk-based assessment system under which insured institutions will be assigned to one of nine categories, based on capital levels and degree of supervisory concern. Depending on its category (which may not be disclosed without the permission of the FDIC), a bank's assessment now ranges from 0.23% to 0.31% of the base, effective January 1, 1993. Due to declines in total deposits, the increases in FDIC insurance assessment rates that became effective in July 1, 1992 and January 1, 1993 did not result in an increase in FDIC insurance assessment expense. FDICIA also contains numerous other regulatory requirements. Annual examinations are required for all insured depository institutions by the appropriate federal banking agency, with some exceptions. In December 1992, the Federal Reserve Board issued regulations under FDICIA requiring institutions to adopt policies limiting their exposure to correspondent institutions in relation to the correspondent's financial condition and, in particular, to limit exposure to any correspondent that is not adequately capitalized, as defined, to not more than 25% of the exposed institution's total capital. FDICIA also requires the banking agencies to review and, under certain circumstances, prescribe more stringent accounting and reporting standards than required by generally accepted accounting principles. In addition, FDICIA contains a number of consumer banking provisions, including disclosure requirements and substantive contractual limitations with respect to deposit accounts. Under FDICIA, institutions other than small institutions must prepare a management report stating management's responsibility for preparing the institution's annual financial statements, complying with designated safety and soundness laws and regulations and other related matters. The report also must contain an assessment by management of the effectiveness of internal controls over financial reporting and of the institution's compliance with designated laws and regulations. The institution's independent public accountant must examine, attest to, and report separately on, the assertions of management concerning internal controls over financial reporting and must apply procedures agreed to by the FDIC to test compliance by the institution with designated laws and regulations concerning loans to insiders and dividend restrictions. Banks and bank holding companies are also subject to the Community Reinvestment Act of 1977, as amended (CRA). CRA requires the Bank to ascertain and meet the credit needs of the communities it serves, including low- and moderate-income neighborhoods. The Bank's compliance with CRA is reviewed and evaluated by the OCC, which assigns the Bank a publicly available CRA rating at the conclusion of the examination. Further, an assessment of CRA compliance is also required in connection with applications for OCC approval of certain activities, including establishing or relocating a branch office that accepts deposits or merging or consolidating with, or acquiring the assets or assuming the liabilities of, a federally regulated financial institution. An unfavorable rating may be the basis for OCC denial of such an application, or approval may be conditioned upon improvement of the applicant's CRA record. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve Board will assess the CRA record of each subsidiary bank of the applicant, and such records may be the basis for denying the application. In the most recent completed examination, conducted in 1993, the OCC assigned the Bank a rating of "Satisfactory," the second highest of four possible ratings. From time to time, banking legislation has been proposed that would require consideration of the Bank's CRA rating in connection with applications by the Corporation or the Bank to the Federal Reserve Board or the OCC for permission to engage in additional lines of business. The Corporation cannot predict whether such legislation will be adopted, or its effect upon the Bank and the Corporation if adopted. The federal regulatory agencies recently issued proposed revisions to the rules governing CRA compliance. The proposed rules are intended to simplify CRA compliance evaluations by establishing performance-based criteria. The regulatory agencies have extended the time for comment on, and consideration of, the proposed rules, and management is unable to predict when, or in what form, such rules will be adopted, or the effect of the rules on the Bank's CRA rating. The OCC has enforcement powers with respect to national banks for violations of federal laws or regulations that are similar to the powers of the Federal Reserve Board with respect to bank holding companies and nonbanking subsidiaries. See "Bank Holding Companies," above. On December 21, 1993, an interagency policy statement was issued on the allowance for loan and lease losses (the Policy Statement). The Policy Statement requires that federally-insured depository institutions maintain an allowance for loan and lease losses (ALLL) adequate to absorb credit losses associated with the loan and lease portfolio, including all binding commitments to lend. The Policy Statement defines an adequate ALLL as a level that is no less than the sum of the following items, given the appropriate facts and circumstances as of the evaluation date: (1) For loans and leases classified as substandard or doubtful, all credit losses over the remaining effective lives of those loans. (2) For those loans that are not classified, all estimated credit losses forecast for the upcoming twelve months. (3) Amounts for estimated losses from transfer risk on international loans. Additionally, the Policy Statement provides that an adequate level of ALLL should reflect an additional margin for imprecision inherent in most estimates of expected credit losses. The Policy Statement also provides guidance to examiners in evaluating the adequacy of a bank's ALLL. Among other things, the Policy Statement directs examiners to check the reasonableness of ALLL methodology by comparing the reported ALLL against the sum of the following amounts: (a) 50 percent of the portfolio that is classified doubtful. (b) 15 percent of the portfolio that is classified substandard; and (c) For the portions of the portfolio that have not been classified (including those loans designated special mention), estimated credit losses over the upcoming twelve months given the facts and circumstances as of the evaluation date (based on the institutions's average annual rate of net charge-offs experienced over the previous two or three years on similar loans, adjusted for current conditions and trends). The Policy Statement specifies that the amount of ALLL determined by the sum of the amounts above is neither a floor nor a "safe harbor" level for an institution's ALLL. However, it is expected that examiners will review a shortfall relative to this amount as indicating a need to more closely review management's analysis to determine whether it is reasonable, supported by the weight of reliable evidence and that all relevant factors have been appropriately considered. The Company has reviewed the Policy Statement and believes that it will not have a material impact on the level of the Company's allowances for loan losses. Capital Adequacy Requirements Both the Federal Reserve Board and the OCC have adopted similar, but not identical, "risk-based" and "leverage" capital adequacy guidelines for bank holding companies and national banks, respectively. Under the risk-based capital guidelines, different categories of assets are assigned different risk weights, ranging from zero percent for risk-free assets (e.g., cash) to 100% for relatively high-risk assets (e.g., commercial loans). These risk weights are multiplied by corresponding asset balances to determine a risk-adjusted asset base. Certain off-balance sheet items (e.g., standby letters of credit) are added to the risk-adjusted asset base. The minimum required ratio of total capital to risk-weighted assets for both bank holding companies and national banks is presently 8%. At least half of the total capital is required to be "Tier 1 capital," consisting principally of common shareholders' equity, a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder (Tier 2 capital) may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, preferred stock and a limited amount of the general loan-loss allowance. As of December 31, 1993, the Corporation had a ratio of Tier 1 capital to risk-weighted assets (Tier 1 risk-based capital ratio) of 15.75% and a ratio of total capital to risk-weighted assets (total risk-based capital ratio) of 17.06%, while the Bank had a Tier 1 risk-based capital ratio of 14.78% and a total risk-based capital ratio of 16.09%. The minimum Tier 1 leverage ratio, consisting of Tier 1 capital to average adjusted total assets, is 3% for bank holding companies and national banks that have the highest regulatory examination rating and are not contemplating significant growth or expansion. All other bank holding companies and national banks are expected to maintain a ratio of at least 1% to 2% or more above the stated minimum. As of December 31, 1993, the Corporation had a Tier 1 leverage ratio of 9.95%, and the Bank's Tier 1 leverage ratio was 9.38%. The OCC has adopted regulations under FDICIA establishing capital categories for national banks and prompt corrective actions for undercapitalized institutions. The regulations create five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The following table shows the minimum total risk-based capital, Tier 1 risk- based capital and Tier 1 leverage ratios, all of which must be satisfied for a bank to be classified as well capitalized, adequately capitalized or undercapitalized, respectively, together with the Bank's ratios at December 31, 1993: (1) A bank may not be classified as well capitalized if it is subject to a specific agreement with the OCC to meet and maintain a specified level of capital. (2) 3% for institutions having a composite rating of "1" in the most recent OCC examination. If any one or more of a bank's ratios are below the minimum ratios required to be classified as undercapitalized, it will be classified as substantially undercapitalized or, if in addition its ratio of tangible equity to total assets is 2% or less, it will be classified as critically undercapitalized. A bank may be reclassified by the OCC to the next level below that determined by the criteria described above if the OCC finds that it is in an unsafe or unsound condition or if it has received a less-than-satisfactory rating for any of the categories of asset quality, management, earnings or liquidity in its most recent examination and the deficiency has not been corrected, except that a bank cannot be reclassified as critically undercapitalized for such reasons. Under FDICIA and its implementing regulations, the OCC may subject national banks to a broad range of restrictions and regulatory requirements. A national bank may not pay management fees to any person having control of the institution, nor, except under certain circumstances and with prior regulatory approval, make any capital distribution if, after doing so, it would be undercapitalized. Undercapitalized banks are subject to increased monitoring by the OCC, are restricted in their asset growth, must obtain regulatory approval for certain corporate activities, such as acquisitions, new branches and new lines of business, and, in most cases, must submit to the OCC a plan to bring their capital levels to the minimum required in order to be classified as adequately capitalized. The OCC may not approve a capital restoration plan unless the bank's holding company guarantees that the bank will comply with it. Significantly and critically undercapitalized banks are subject to additional mandatory and discretionary restrictions and, in the case of critically undercapitalized institutions, must be placed into conservatorship or receivership unless the OCC and the FDIC agree otherwise. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to its subsidiary banks and to commit resources to support each such bank. In addition, a bank holding company is required to guarantee that its subsidiary bank will comply with any capital restoration plan required under FDICIA. The amount of such a guarantee is limited to the lesser of (i) 5% of the bank's total assets at the time it became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all applicable capital standards as of the time the bank fails to comply with the capital restoration plan. A guaranty by the Corporation of a capital restoration plan for the Bank would result in a priority claim to the Corporation's assets ahead of the Corporation's other unsecured creditors and shareholders that would be enforceable even in the event of the Corporation's bankruptcy or the Bank's insolvency. Regulatory Agreements On November 18, 1992, the Bank entered into a written agreement with the OCC (the Agreement) with respect to capital and other matters described below, which replaced a memorandum of understanding dated June 26, 1991, between the Bank and the OCC. The Agreement required the Bank to generate through internal and external sources a minimum of $65 million in Tier 1 capital by June 30, 1993, so as to maintain a Tier 1 risk-based capital ratio of at least 10% and a Tier 1 leverage ratio of at least 7%. In June 1993, the Corporation completed an offering and sale of 12.7 million shares of common stock (the Offering) at a price of $6.375 per share. The gross proceeds of the Offering were $81.1 million before expenses of the issuance of $4.6 million. Upon completion of the Offering, the Corporation contributed $65 million in capital to the Bank to comply with the $65 million capital - raising requirement in the Agreement with the OCC. The Agreement also required the Bank to develop a three-year capital plan and a three-year business plan and continue to improve its policies and procedures in the lending and credit administration areas. Each of these requirements was successfully met prior to December 31, 1993. As a result, on January 21, 1994, the OCC lifted the Agreement. On February 24, 1993, the Corporation entered into a memorandum of understanding with the Federal Reserve Bank of San Francisco. The memorandum of understanding required the Corporation to submit to the Federal Reserve Bank a summary of measures to improve the Bank's financial condition and ensure the Bank's compliance with the Agreement, a plan to ensure the Corporation's maintenance of adequate consolidated capital levels commensurate with its risk profile, and quarterly progress reports. Under the memorandum of understanding, the Corporation was required to give prior notice to the Federal Reserve Bank of the declaration of any cash dividends or the incurrence of debt, other than operating expenses, and the Corporation was not permitted to repurchase any of its outstanding stock without the Federal Reserve Bank's prior approval. In February 1994, the Federal Reserve Bank of San Francisco notified the Corporation that the memorandum of understanding was lifted. ITEM 2. ITEM 2. PROPERTIES The Company has its principal offices in the City National Bank Building, 400 North Roxbury Drive, Beverly Hills, California 90210, which the Bank owns and occupies. As of December 31, 1993, the Bank and its subsidiaries actively maintained premises composed of 22 banking offices, a computer center, a regional data capture center, a warehouse, and certain other properties. Since 1967, the Bank's Pershing Square Regional Office and a number of Bank departments have been the major tenant of the office building located at 600 South Olive Street in downtown Los Angeles. The building was originally developed and built by a partnership between a wholly-owned subsidiary of the Bank, Citinational Bancorporation, and Buckeye Construction Co. and Buckeye Realty and Management Corporation (two corporations then affiliated with Mr. Bram Goldsmith, Chairman of the Board and Chief Executive Officer of the Corporation and the Bank); since its completion, the building has been owned by Citinational-Buckeye Building Co., a limited partnership of which Citinational Bancorporation and Olive-Sixth Buckeye Co. are the only general partners, each with a 29% partnership interest. Citinational Bancorporation has an additional 3% interest as a limited partner of Citinational-Buckeye Building Co.; the remainder is held by other, unaffiliated limited partners. Olive-Sixth Buckeye Co. is a limited partnership of which Mr. Goldsmith is a 49% general partner; therefore, Mr. Goldsmith has an indirect 14% ownership interest in Citinational-Buckeye Building Co. The remaining general partner and all limited partners of Olive-Sixth Buckeye Co. are not affiliated with the Corporation. Since 1990, Citinational-Buckeye Building Co. has managed the building, which is expected to require capital investment of approximately $2.2 million over the next four years, the source of which is uncertain. The major encumbrance on real properties owned directly by the Bank or its subsidiaries is a deed of trust on the 600 South Olive Street building, securing a note in favor of City National Bank on which the unpaid balance at December 31, 1993, was $16,650,842. The Bank's subsidiary, Citinational Bancorporation, also owns two buildings located on Olympic Boulevard in downtown Los Angeles, approximately 80,000 square feet of which is subject to a lease between Citinational Bancorporation and Systematics Financial Services, Inc., that expires on December 31, 2000. Twenty additional branch locations throughout Southern California are leased by the Bank at annual rentals (exclusive of operating charges and real property taxes) of approximately $4,500,000, with expiration dates ranging from 1994 to 2016, exclusive of renewal options. The Northridge earthquake of January 17, 1994, resulted in damage to several of the Bank's facilities, of which two remain closed. Of these, one will be closed permanently as part of the Bank's branch restructuring, and the Bank is negotiating for alternate facilities to replace the other. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Corporation and its subsidiaries are defendants in various pending lawsuits claiming substantial amounts. Based on present knowledge, management and in-house counsel are of the opinion that the final outcome of such lawsuits will not have a material adverse effect upon the financial position or the future results of its operations. The Company is not aware of any material proceedings to which any director, officer or affiliate of the Company, any owner of record or beneficially of more than 5% of the voting securities of the Company, or any associate of any such director, officer or security holder is a party adverse to the Company or any of its subsidiaries or has a material interest adverse to the Company or any of its subsidiaries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There was no submission of matters to a vote of security holders during the fourth quarter of the year ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Shown below are names and ages of all executive officers of the Corporation and officers of the Bank who may be deemed to be executive officers of the Corporation, with indication of all positions and offices with the Corporation and the Bank. There was no family relationship among the executive officers. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information regarding the market for the Corporation's Common Stock and related stockholder matters appearing under the caption "Market Data on Shares of Common Stock" on page 33 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference in this Annual Report on Form 10-K. Information regarding restrictions on the Corporation's payment of dividends appearing under "Capital" and Note 12 to the consolidated financial statements of the Company and its subsidiaries, appearing on pages 20 and 49 respectively of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, are hereby incorporated by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data for the five years ended December 31, 1993, appearing under "Selected Financial Information" on page 7 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference in this Annual Report on Form 10-K. The Corporation's dividend payout ratio for 1990 and 1989 was 47.4% and 31.0%, respectively. Due to the Corporation's loss in 1991, the dividend payout ratio for 1991 is not meaningful. The Corporation did not pay any dividends in 1993 or 1992. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item appearing on pages 8 through 33 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference in this Annual Report on Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Corporation and its subsidiaries and the notes thereto, and the condensed financial statements of the registrant (the Corporation), together with the report thereon of KPMG Peat Marwick dated January 21, 1994, appearing on pages 35 through 53, and the supplementary data under "1993 Quarterly Operating Results" and "1992 Quarterly Operating Results" on page 34 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, together with the report of Price Waterhouse dated January 13, 1993, are incorporated by reference in this Annual Report on Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The information required by this item appearing in Item 4 of the Registrant's Form 8-K/A dated August 25, 1993 is incorporated by reference in this Annual Report on Form 10-K. There were no disagreements with accountants on accounting and financial disclosure matters. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT To the extent not provided above, the information required by this item appearing under the captions "Election of Directors" and "Compliance With Section 16(a) of Securities Exchange Act of 1934" on pages 4 through 6 and 22 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. See "Executive Officers of the Registrant," above. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item regarding executive compensation appearing under the caption "Compensation of Directors and Executive Officers" on pages 7 through 18 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item appearing under the captions "Record Date and Number of Shares Outstanding; Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" on pages 2, 3 and 19 through 21 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item appearing under the captions "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions with Management and Others" on page 14, 21 and 22 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. 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: 3. Exhibits (listed by numbers corresponding to Exhibit Table of Item 601 in Regulation S-K) (b) During the calendar quarter ended December 31, 1993, the registrant did not file any 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 has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. City National Corporation ------------------------- (Registrant) March 23, 1994 By /s/ Bram Goldsmith ------------------------ Bram Goldsmith, 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. INDEX TO EXHIBITS

757011_1993.txt

757011_1993

1993

757011

ITEM 1. BUSINESS (A) GENERAL DEVELOPMENT OF BUSINESS United States Gypsum Company ("U.S. GYPSUM") was incorporated in 1901. USG Corporation (together with its subsidiaries, called "USG" or the "CORPORATION") was incorporated in Delaware on October 22, 1984. By a vote of stockholders at a special meeting on December 19, 1984, U.S. Gypsum became a wholly owned subsidiary of the Corporation and the stockholders of U.S. Gypsum became the stockholders of the Corporation, all effective January 1, 1985. In July 1988, the Corporation consummated a plan of recapitalization (the "1988 RECAPITALIZATION") in part in response to an unsolicited takeover attempt. Approximately $2.5 billion in new debt was incurred by the Corporation to finance the 1988 Recapitalization, pay related costs and repay certain debt existing at that time. The 1988 Recapitalization immediately changed the Corporation's capital structure to one that was highly leveraged. At the time of the 1988 Recapitalization, the Corporation projected that it would have sufficient cash flows to meet its debt service obligations in a timely manner. However, the Corporation was adversely affected by a cyclical downturn in its construction-based markets which resulted in the Corporation's inability to achieve projected operating results and service certain debt obligations in a timely manner. On May 6, 1993, the Corporation completed a comprehensive restructuring of its debt (the "RESTRUCTURING") through implementation of a "prepackaged" plan of reorganization (the "PREPACKAGED PLAN"). The provisions of the Prepackaged Plan were agreed upon in principle with all committees and certain institutions representing debt subject to the Restructuring in January 1993. The Corporation's Registration Statement (Registration No. 33-40136), which included a Disclosure Statement and Proxy Statement - Prospectus, was declared effective by the Securities and Exchange Commission (the "SEC") in February 1993. The solicitation process for approvals of the Prepackaged Plan was completed on March 15, 1993. The Corporation commenced a prepackaged Chapter 11 bankruptcy case in Delaware (IN RE: USG CORPORATION, Case No. 93-300) on March 17, 1993 and received the U.S. Bankruptcy Court's confirmation of the Prepackaged Plan on April 23, 1993. None of the subsidiaries of the Corporation were part of this proceeding and there was no impact on trade creditors of the Corporation's subsidiaries. Under the Prepackaged Plan, all previously existing defaults on debt obligations were waived or cured. The Corporation accounted for the Restructuring using the principles of fresh start accounting as required by AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code". Pursuant to such principles, individual assets and liabilities were adjusted to fair market value and reorganization value in excess of identifiable assets ("EXCESS REORGANIZATION VALUE") was established. Post-bankruptcy accounting rules require separate reporting of financial results for the restructured company and the predecessor company. As such, the Corporation's financial statements effective May 7, 1993 are presented under "Restructured Company" in Part II, Item 8. "Financial Statements and Supplementary Data," while financial statements for periods prior to that date are presented under "Predecessor Company." Due to the Restructuring and implementation of fresh start accounting, financial statements for the Restructured Company are not comparable to those for the Predecessor Company. However, in order to facilitate a meaningful comparison of the Corporation's operating performance, certain 1993 financial information is presented in the following Part I narratives on an annual basis. See Part II, Item 8. "Financial Statements and Supplementary Data - Predecessor Company - Notes to Financial Statements - Financial Restructuring and Fresh Start Accounting" notes for additional information on the Restructuring and implementation of fresh start accounting. On January 7, 1994, the Corporation filed a Registration Statement (Registration No. 33-51845), as amended on February 16, 1994, pertaining to its planned public offering of 6,000,000 new shares of its common stock ("COMMON STOCK") to be sold by the Corporation (the "OFFERING") and 4,000,000 shares of Common Stock to be sold by Water Street Corporate Recovery Fund I, L.P. ("WATER STREET"). The Offering is part of a refinancing strategy which also includes (i) the placement of $150 million principal amount of new senior notes due 2001 with certain institutional investors (the "NOTE PLACEMENT") and (ii) certain amendments (the "CREDIT AGREEMENT AMENDMENTS" and, together with the Offering and the Note Placement, the "TRANSACTIONS") to the Credit Agreement. The Credit Agreement Amendments will, among other things, increase the size of the Corporation's revolving credit facility (the "REVOLVING CREDIT FACILITY") by $70 million, amend existing mandatory Bank Term Loan prepayment provisions to allow the Corporation, upon the achievement of certain financial tests, to retain additional free cash flow for capital expenditures and for the purchase of its public debt. Certain Credit Agreement Amendments are contingent on the consummation of the Offering. See Part II, Item 8. "Financial Statements and Supplementary Data - Restructured Company - Notes to Financial Statements - Subsequent Event" note for more information on the Transactions. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Corporation participates in three industry segments: Gypsum Products, Interior Systems and Building Products Distribution. Selected financial information for each of the Corporation's industry segments is presented below under "(c) Narrative Description of Business." See Part II, Item 8. "Financial Statements and Supplementary Data - Notes to Financial Statements - Geographic and Industry Segments" notes for both the Restructured Company and the Predecessor Company for additional financial information and other related disclosures about the Corporation's industry and geographic segments. (C) NARRATIVE DESCRIPTION OF BUSINESS Through its subsidiaries, USG is a leading manufacturer of building materials in North America which produces a wide range of products for use in residential and nonresidential construction, repair and remodeling, as well as products used in certain industrial processes. U.S. Gypsum is the largest producer of gypsum wallboard in the United States and accounted for approximately one-third of total domestic gypsum wallboard sales in 1993. USG Interiors, Inc. ("USG INTERIORS") is a leading supplier of interior ceiling, wall and floor products used primarily in commercial applications. In 1993, USG Interiors was the largest producer of ceiling grid and the second largest producer of ceiling tile in the United States, accounting for over one-half and approximately one-third of total domestic sales of such products, respectively. L&W Supply Corporation ("L&W SUPPLY") is the largest distributor of wallboard and related products in the United States and in 1993 distributed approximately 22% of U.S. Gypsum's wallboard production. In addition to its United States operations, the Corporation's 76% owned subsidiary, CGC Inc. ("CGC"), is the largest manufacturer of gypsum products in Eastern Canada and the Corporation's USG International, Ltd. ("USG INTERNATIONAL") unit supplies interior systems and gypsum wallboard products in the Pacific, Europe and Latin America. In the year ended December 31, 1993, the Corporation had net sales of $1,916 million and generated EBITDA of $218 million. U.S. INDUSTRY OVERVIEW USG's consolidated financial performance is largely influenced by changes in the three major components of the construction industry in the United States: new residential construction, new nonresidential construction, and repair and remodel activity. In recent years, structural changes in residential construction activity combined with growth in the repair and remodel component have partially mitigated the impact of the cyclical demand of the overall new construction components. NEW RESIDENTIAL AND NONRESIDENTIAL CONSTRUCTION Demand for the Corporation's products has historically been influenced primarily by new residential (single and multi-family homes) and nonresidential (offices, schools, stores, and other institutions) construction. Construction activity is directly influenced by a variety of economic variables. In the short term, the new residential segment is characterized by fluctuating activity levels as builders and buyers respond to changes in funding costs, new home prices, and the availability of new construction financing. Over the medium to long term, new residential construction activity reflects the demand generated by household formations, the home ownership rate, removals of housing stock, and the growth of personal income. Although new residential construction remains the largest single source of demand for gypsum wallboard in the United States, it has declined significantly as a percentage of gypsum wallboard demand since 1986 (a year in which total gypsum wallboard shipments were comparable to 1993 levels). Residential construction has a nominal impact on demand for Interiors Systems products. The following table sets forth demand for gypsum wallboard in the United States by end-use segment as estimated by U.S. Gypsum based on publicly available data, internal surveys and data from the Gypsum Association, an industry trade group. Management estimates that the distribution of U.S. Gypsum's sales volume to these four end-use segments is generally proportional to industry demand. Over recent economic cycles, demand for gypsum wallboard has been favorably impacted by a shift toward more single family housing within the new residential construction segment and an increase in the average single family home size. New single family homes, which typically require twice as much wallboard as multi-family homes, accounted for 87% of total housing starts in 1993, as compared to 65% in 1986. Additionally, the size of the average single family home in the United States increased approximately 15% to 2,095 square feet in 1992 from 1,825 square feet in 1986. Largely as a result of these factors, United States industry shipments of gypsum wallboard were a record 21.6 billion square feet in 1993, as compared to 21.3 billion in 1986, despite an approximate 28% decline in the number of housing starts from 1.8 million units in 1986 to 1.3 million units in 1993, as depicted in the following chart. GYPSUM WALLBOARD INDUSTRY SHIPMENTS AND TOTAL HOUSING STARTS SOURCES: HOUSING STARTS ARE BASED ON DATA PUBLISHED BY THE U.S. BUREAU OF THE CENSUS. GYPSUM WALLBOARD INDUSTRY SHIPMENTS ARE BASED ON DATA PUBLISHED BY THE GYPSUM ASSOCIATION. Nonresidential construction responds less quickly to changes in interest rates than residential construction because long-term financing is normally arranged in advance of the commencement of major building projects. In the longer term, nonresidential construction activity levels are also affected by the general rate of economic growth, the rate of new job formation and population shifts. Continued weakness in the nonresidential construction segment has negatively impacted demand for the products manufactured by both U.S. Gypsum and USG Interiors. Demand for USG Interiors' products is particularly dependent on new nonresidential construction activity. Management estimates that approximately one-half of USG Interiors' 1993 sales were in the new nonresidential construction segment as compared to approximately two-thirds in 1986. In recent years, nonresidential construction demand has accounted for approximately 10% of gypsum wallboard industry demand in the United States. REPAIR AND REMODEL Based on data published by the U.S. Bureau of The Census, the size of the total residential repair and remodel market grew to $104 billion in 1992 from $91 billion in 1986 and $46 billion in 1980. Although data on nonresidential repair and remodel activity is not readily available, management believes that this segment grew significantly during the 1980s. The growth of the repair and remodel market is primarily due to the aging of housing stock, remodeling of existing buildings and tenant turnover in commercial space. The median age of housing stock was 27 years in 1990, and the National Association of Homebuilders forecasts that the median age will increase to 32 years by 2000. Management believes that the continued aging of housing stock will contribute to further growth in the repair and remodel segment. In addition, management believes that the increase in the number of commercial buildings over the last decade will provide a greater base for nonresidential repair and remodel activity in the future, as building owners or tenants replace ceiling, wall and floor systems as part of the tenant turnover process. Demand in the repair and remodel component tends to be more stable than in new construction, although it does fluctuate somewhat in response to general economic conditions. Management estimates that repair and remodel demand for gypsum wallboard has increased more than 22% since 1986 and, in 1993, accounted for 36% of total demand for gypsum wallboard in the United States. Management estimates that approximately one-half of USG Interiors' 1993 sales were to the nonresidential repair and remodel segment. GYPSUM PRODUCTS BUSINESS The Gypsum Products segment consists primarily of the gypsum operations of U.S. Gypsum in the United States, CGC in Canada and USG International in Mexico. CGC is the largest manufacturer of gypsum wallboard in Eastern Canada. Management estimates that industry sales in Eastern Canada, including the Toronto and Montreal metropolitan areas, represent approximately two-thirds of total Canadian sales volume. In 1993, CGC accounted for approximately 45% of industry sales in Eastern Canada. PRODUCTS The Gypsum Products segment manufactures and markets building and industrial products used in a variety of applications. Gypsum panel products are used to finish the interior walls and ceilings in residential, commercial and mobile home construction. These products provide aesthetic as well as sound and fire retarding value. The majority of these products are sold under the "SHEETROCK" brand name. Also sold under the "SHEETROCK" brand name is a line of joint compounds used for finishing wallboard joints. The "DUROCK" line of cement board and accessories is produced to provide fire-resistant and water damage resistant assemblies for both interior and exterior construction. The Corporation also produces a variety of plaster products used to provide a custom finish for residential and commercial interiors. Like "SHEETROCK" brand wallboard, these products provide aesthetic and sound and fire retarding value. Plaster products are sold under the trade names of "RED TOP," "IMPERIAL" and "DIAMOND." The Corporation also produces gypsum-based products sold to agricultural and industrial customers for use in a number of applications, including soil conditioning, road repair, fireproofing and ceramics. FINANCIAL PERFORMANCE Summary financial results of the Gypsum Products segment are outlined in the table below. Such results are not adjusted for intersegment sales eliminations and corporate expenses. Operating profit in 1993 for the Gypsum Products segment is not comparable to prior years due to $51 million of non-cash amortization of Excess Reorganization Value. For additional information on the Corporation's results by industry segment, including intersegment sales eliminations and corporate expenses, see Part II, Item 8. "Financial Statements and Supplementary Data - Notes to Financial Statements - Geographic and Industry Segments" notes for both the Restructured and Predecessor Companies. MANUFACTURING Gypsum and related products are produced by the Corporation at 42 plants located throughout the United States, Eastern Canada and in central Mexico. The Corporation believes several factors contribute to its low delivered cost, including (i) the vertical integration of its key raw materials (gypsum and paper); (ii) the technical expertise provided by its extensive research and development efforts and its experienced employees and (iii) the proximity of its plants to major metropolitan areas. USG's vertically integrated gypsum and paper operations provide several cost and quality advantages. Since the Corporation obtains substantially all of its gypsum requirements from its own quarries and mines, it controls the cost, quality and continuity of its supply. These factors are vital to producing wallboard of a consistently high quality at a low cost. The Corporation's geologists estimate that recoverable rock reserves are sufficient for more than 30 years of operation based on the Corporation's average annual production of crude gypsum during the past five years. Proven reserves contain approximately 243 million tons, of which approximately 69% are located in the United States and 31% in Canada. Additional reserves of approximately 153 million tons exist on three properties not in operation. The Corporation's total average annual production of crude gypsum in the United States and Canada during the past five years was 9.4 million tons. USG owns and operates seven modern paper mills located across the United States for efficient distribution of paper to virtually all of its wallboard plants. These mills have sufficient capacity to satisfy virtually all of the Corporation's expected paper needs for the foreseeable future. All these mills presently are designed to produce paper utilizing 100% recycled waste paper fiber as opposed to more costly virgin pulp. Vertical integration in paper ensures a continuous supply of high quality paper that is tailored to the specific needs of USG's wallboard production processes. As the leading producer of gypsum products for over 90 years, USG has developed extensive knowledge of gypsum and the processes used in making its products. Combined with USG's experienced work force, USG's technical expertise provides significant cost efficiencies in the production of existing products and development of new ones. USG maintains the largest research and development facility in the gypsum industry in Libertyville, Illinois which conducts fire and structural testing and product and process development. Research and development activities involve technology related to gypsum, cellulosic fiber and cement as the primary raw materials on which panel products and systems, such as gypsum board and cement board, are based. Related technologies are those pertaining to joint compounds and textures for wallboard finishing, specialty plaster products for both construction and industrial applications, coatings and latex polymers. The number and location of the Corporation's gypsum plants enhance its cost position by minimizing the distance and the transportation costs to major metropolitan areas. Transportation costs can be a significant part of total delivered cost of gypsum products. MARKETING AND DISTRIBUTION Distribution is carried out through L&W Supply's 131 distribution centers located in 34 states, as well as mass merchandisers and other retailers, building material dealers, contractors and distributors. Sales of gypsum products are seasonal to the extent that sales are generally greater from spring through the middle of autumn than during the remaining part of the year. COMPETITION The Corporation competes in North America as the largest of 18 producers of gypsum wallboard products and, in 1993, accounted for approximately one-third of total gypsum wallboard sales in the United States. In 1993, U.S. Gypsum's shipments of gypsum wallboard totaled 7.3 billion square feet, the highest in the Corporation's history, compared with total domestic industry shipments of 21.6 billion square feet which is also a record level. Principal competitors in the United States are: National Gypsum Company, which emerged from Chapter 11 bankruptcy in July 1993, The Celotex Corporation, which has operated under Chapter 11 of the Bankruptcy Code since 1990, Domtar, Inc., Georgia-Pacific Corporation and several smaller, regional competitors. Major competitors of CGC in Eastern Canada include Domtar, Inc. and Westroc Industries Ltd. INTERIOR SYSTEMS BUSINESS The Interior Systems segment consists of USG Interiors in the United States, USG International in Europe, the Pacific and Latin America and CGC in Canada. The Corporation has increased its emphasis on the interior systems business since 1986 when Donn Inc. ("DONN"), a manufacturer of ceiling suspension systems ("grid") and other interior products, was acquired. Already second behind Armstrong World Industries, Inc. in the ceiling tile market, the acquisition of Donn positioned the Corporation as the worldwide leader in ceiling suspension systems and the only company to offer complete pre-designed, pre-engineered and fully integrated ceiling systems. With the acquisition of Donn, USG Interiors was established as a separate subsidiary to combine the operations of Donn and USG Acoustical Products Company, formerly part of U.S. Gypsum and a leading producer of mineral fiber ceiling products. USG's international position was enhanced in late 1987 when it began to export ceiling tile to Europe to complement Donn's established grid business and to capitalize on the strength of its existing distribution channels. By combining ceiling tile and grid as a system for distributors and contractors, USG has used its leading position in grid to advance sales of ceiling tile. As a result, management estimates that USG's share of the European ceiling tile market has grown to approximately 8%. International sales are managed through USG International on a regional basis consisting of Europe, the Pacific and Latin America. CGC manufactures and markets ceiling products and wall and floor systems and accounted for over one-half of Canadian grid sales in 1993. CGC is the second largest marketer of ceiling tile in Canada, behind Armstrong World Industries, Inc., and accounted for approximately 30% of Canadian sales of such products in 1993. CGC markets ceiling tile produced by USG Interiors. PRODUCTS The Interior Systems segment manufactures and markets ceiling grid and ceiling tile, access floor systems, wall systems and mineral wool insulation and soundproofing products. USG's integrated line of ceiling products provides qualities such as sound absorption, fire retardation, and convenient access to the space above the ceiling for electrical and mechanical systems, air distribution and maintenance. The Corporation believes its ability to provide custom-designed and specially fabricated ceiling solutions to meet specific job design installation conditions is increasingly attractive to architects, designers and building owners. USG Interiors' significant trade names include the "ACOUSTONE" and "AURATONE" brands of ceiling tile and the "DX," "FINELINE," "CENTRICITEE" and "DONN" brands of ceiling grid. USG's wall systems provide the versatility of an open floor plan with the privacy of floor-to-ceiling partitions which are compatible with leading office equipment and furniture systems. Wall systems are designed to be installed quickly and reconfigured easily. In addition, USG manufactures a line of access floor systems that permit easy access to wires and cables for repairs, modifications, and upgrading of electrical and communication networks as well as convenient movement of furniture and equipment. FINANCIAL PERFORMANCE Summary financial results for the Interior Systems segment are outlined in the table below. Such results are not adjusted for intersegment sales eliminations and corporate expenses. Operating profit/(loss) in 1993 for the Interior Systems segment is not comparable to prior years due to $60 million of non-cash amortization of Excess Reorganization Value. For additional information on the Corporation's results by industry segment, including intersegment sales eliminations and corporate expenses, see Part II, Item 8. "Financial Statements and Supplementary Data - Notes to Financial Statements - Geographic and Industry Segments" notes for both the Restructured and Predecessor Companies. MANUFACTURING Interior Systems products are manufactured at 16 plants throughout North America, including 5 ceiling tile plants and 4 ceiling grid plants. The remaining plants produce other interior products and raw materials for ceiling tile and grid. Principal raw materials used in the production of Interior Systems products include mineral fiber, steel, aluminum extrusions and high-pressure laminates. Certain of these raw materials are produced internally, while others are obtained from various outside suppliers. Shortages of raw materials used in this segment are not expected. USG Interiors maintains its own research and development facility in Avon, Ohio, which provides product design, engineering and testing services in addition to manufacturing development, primarily in metal forming, with tool and machine design and construction services. Additional research and development is carried out at the Corporation's research and development center in Libertyville, Illinois and at its "Solutions Center" -sm- in Chicago. MARKETING AND DISTRIBUTION Interiors Systems products are sold primarily in markets related to the new construction and renovation of commercial buildings as well as the retail market for small commercial contractors. Marketing and distribution to large commercial users is conducted through a network of distributors and installation contractors as well as through L&W Supply and is oriented toward providing integrated interior systems at competitive price levels. The Corporation emphasizes educational and promotional materials designed to influence decision makers who play a significant role in choosing material suppliers, such as interior designers, contractors and facility managers. To this end, USG Interiors maintains the "Solutions Center"-sm- located adjacent to Chicago's Merchandise Mart which is used for product displays, educational seminars on products and new product design and development. In recent years, the Corporation has increased its emphasis on the retail market and as a result now sells its products to seven of the ten largest building products retailers in the United States. COMPETITION The Corporation estimates that it is the world's largest manufacturer of ceiling suspension systems with approximately 40% of worldwide sales of such products. USG's most significant competitor is Chicago Metallic Corporation, which participates in the U.S. and European markets. Other competitors in ceiling grid include W.A.V.E. (a joint venture of Armstrong World Industries, Inc. and National Rolling Mills). The Corporation estimates that it accounts for approximately one-third of sales of acoustical ceiling tile to the U.S. market. Principal global competitors include Armstrong World Industries, Inc. (the largest manufacturer), Odenwald of West Germany and the Celotex Corporation. BUILDING PRODUCTS DISTRIBUTION BUSINESS The Building Products Distribution segment consists of the operations of the Corporation's L&W Supply subsidiary. L&W Supply is the largest distributor of gypsum wallboard and related building products for residential and nonresidential construction in the United States. L&W Supply distributes approximately 9% of all gypsum wallboard in the United States (including approximately 22% of U.S. Gypsum's wallboard production). Wallboard accounts for approximately 47% of L&W Supply's total net sales. Although L&W Supply specializes in distribution of gypsum wallboard, joint compound and other products manufactured primarily by U.S. Gypsum, it also distributes USG Interiors' products such as acoustical ceiling tile and ceiling grid and products of other manufacturers, including drywall metal, insulation, roofing products and accessories. L&W Supply was founded in 1971 by U.S. Gypsum to address what management perceived as a growing demand in the construction industry for a specialized delivery service for construction materials, especially gypsum wallboard. U.S. Gypsum management believed the construction industry could benefit from a service-oriented organization that would deliver less than truckload quantities of construction materials to a job site and place them in the areas where the work was being done, thereby reducing or eliminating the need for handling by contractors. To perform this service, U.S. Gypsum established a number of distribution centers that could stock construction materials and be able to deliver relatively large quantities with short lead times. L&W Supply has grown significantly over the past 23 years and now has 131 distribution centers located in 34 states. FINANCIAL PERFORMANCE Summary financial results for the Building Products Distribution segment are outlined in the table below. Such results are not adjusted for corporate expenses and there are no intersegment sales eliminations for this segment. Operating profit in 1993 for the Building Products Distribution segment is not comparable to prior years due to $2 million of non-cash amortization of Excess Reorganization Value. For additional information on the Corporation's results by industry segment, including intersegment sales eliminations and corporate expenses, see Part II, Item 8. "Financial Statements and Supplementary Data - Notes to Financial Statements - Geographic and Industry Segments" notes for both the Restructured and Predecessor Companies. DISTRIBUTION CENTERS L&W Supply leases approximately 80% of its facilities from third parties, which management believes provides it with the flexibility to enter and exit fluctuating market areas. Usually, initial leases are from three to five years with a five-year renewal option. Facilities are located in virtually every major metropolitan area in the United States. A typical L&W Supply facility has approximately 12,000 square feet of warehouse space, 1,500 square feet of office space and is located on 1.5 paved acres of land in prime industrial areas with good interstate highway access. Each center is equipped with at least one flatbed truck, a boom truck and, in some cases, a towable forklift. Boom trucks are standard flatbed trucks with telescoping hydraulic booms installed on the front of the truckbed. By using either the telescoping boom or the towable forklift, L&W Supply employees are able to place wallboard, joint compound and other materials in various locations on a job site. COMPETITION L&W Supply's closest competitor, Gypsum Management Supply, is an independent distributor with approximately 70 locations in the southern, central and western United States. There are several regional competitors, such as Gypsum Drywall Management Association in the southern United States and Strober Building Supply in the northeastern United States. L&W Supply's many local competitors include lumber dealers, hardware stores, mass merchandisers, home improvement centers, acoustical tile distributors and manufacturers. Sales are seasonal to the extent that sales are generally greater from the middle of spring through the middle of autumn than during the remaining part of the year. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES See Part II, Item 8. "Financial Statements and Supplementary Data - Notes to Financial Statements - Geographic and Industry Segments" notes for both the Restructured and Predecessor Companies. ITEM 2. ITEM 2. PROPERTIES The Corporation's plants, mines, transport ships, quarries and other facilities are located in North America, Europe, Australia, New Zealand, and Malaysia. Many of these facilities are operating at or near full capacity. All facilities and equipment are in good operating condition and, in management's judgment, sufficient expenditures have been made annually to maintain them. The locations of the production properties of the Corporation's subsidiaries, grouped by industry segment, are as follows (plants are owned unless otherwise indicated): GYPSUM PRODUCTS GYPSUM BOARD AND OTHER GYPSUM PRODUCTS Gypsum plants utilize locally mined or quarried gypsum rock unless noted as follows: * These plants use rock from quarry operations at Alabaster (Tawas City), Michigan; Empire, Nevada; Plaster City, California; Little Narrows and/or Windsor, Nova Scotia; or Harbour Head, Jamaica, an outside source. ** These plants purchase synthetic gypsum from outside sources. *** This plant purchases all gypsum rock from outside sources. JOINT COMPOUND Surface preparation and joint treatment products are produced in plants located at Chamblee, Georgia; Dallas, Texas; East Chicago, Indiana; Fort Dodge, Iowa; Gypsum, Ohio; Jacksonville, Florida; Port Reading, New Jersey (leased); Sigurd, Utah; Tacoma, Washington (leased); Torrance, California; Hagersville, Ontario, Canada; Montreal, Quebec, Canada; Puebla, Mexico; and Selangor, Malaysia (leased). PAPER Paper for gypsum board is manufactured at Clark, New Jersey; Galena Park, Texas; Gypsum, Ohio; Jacksonville, Florida; North Kansas City, Missouri; Oakfield, New York; and South Gate, California. OCEAN VESSELS Gypsum Transportation Limited, a wholly owned subsidiary of the Corporation, headquartered in Bermuda, owns and operates a fleet of three self-unloading ocean vessels. Under contract of affreightment, these vessels haul gypsum rock from Nova Scotia to the East Coast and Gulf port plants of U.S. Gypsum. Excess ship time, when available, is offered for charter on the open market. MISCELLANEOUS A mica-processing plant is located at Spruce Pine, North Carolina; perlite ore is produced at Grants, New Mexico. Metal lath, plaster and drywall accessories and light gauge steel framing products are manufactured at Puebla, Mexico. Metal safety grating products are manufactured at Burlington, Ontario, Canada (leased); and Delta, British Columbia, Canada (leased). Various other products are manufactured at La Mirada, California (adhesives); and New Orleans, Louisiana (lime products). INTERIOR SYSTEMS CEILING TILE Acoustical ceiling tile and panels are manufactured at Cloquet, Minnesota; Greenville, Mississippi; Gypsum, Ohio; Walworth, Wisconsin; San Juan Ixhautepec, Mexico; and Aubange, Belgium. CEILING GRID Ceiling grid products are manufactured at Cartersville, Georgia; Stockton, California; Westlake, Ohio; Auckland, New Zealand (leased); Dreux, France; Oakville, Ontario, Canada; Peterlee, England (leased); Selangor, Malaysia (leased); and Viersen, Germany. A coil coater and slitter plant used in the production of ceiling grid is also located in Westlake, Ohio. ACCESS FLOOR SYSTEMS Access floor systems products are manufactured at Red Lion, Pennsylvania; Dreux, France; Peterlee, England (leased); and Selangor, Malaysia (leased). MINERAL WOOL Mineral wool products are manufactured at Birmingham, Alabama; Gypsum, Ohio; Red Wing, Minnesota; Tacoma, Washington; Wabash, Indiana; Walworth, Wisconsin; and Weston, Ontario, Canada. WALL SYSTEMS Wall system products are manufactured at Medina, Ohio (leased). ITEM 3. ITEM 3. LEGAL PROCEEDINGS See Part II, Item 8. "Financial Statements and Supplementary Data - Notes to Financial Statements - Litigation" for information on 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 the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS (a) See Item 8. "Financial Statements and Supplementary Data - Selected Quarterly Financial Data" for information with respect to the principal market on which the Corporation's Common Stock is traded and the range of high and low closing market prices. (b) As of January 31, 1994, there were 14,702 stockholders of record of the Corporation's Common Stock. (c) There have been no dividends declared since the third quarter of 1988. The Credit Agreement and certain other debt instruments prohibit the payment of cash dividends for the foreseeable future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA USG CORPORATION COMPARATIVE FIVE-YEAR SUMMARY (A) (UNAUDITED) (DOLLARS IN MILLIONS,EXCEPT PER SHARE DATA) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS On May 6, 1993, the Corporation completed the Restructuring. Due to the Restructuring and implementation of fresh start accounting, the Corporation's financial statements effective May 7, 1993 are not comparable to financial statements for periods prior to that date. See Item 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ALL OTHER SCHEDULES HAVE BEEN OMITTED BECAUSE THEY ARE NOT APPLICABLE, ARE NOT REQUIRED, OR THE INFORMATION IS INCLUDED IN THE FINANCIAL STATEMENTS OR NOTES THERETO. USG CORPORATION (RESTRUCTURED COMPANY) CONSOLIDATED STATEMENT OF EARNINGS (DOLLARS IN MILLIONS EXCEPT PER SHARE DATA) THE NOTES TO FINANCIAL STATEMENTS ON PAGES 29 THROUGH 52 ARE AN INTEGRAL PART OF THIS STATEMENT. USG CORPORATION (RESTRUCTURED COMPANY) CONSOLIDATED BALANCE SHEET (DOLLARS IN MILLIONS) THE NOTES TO FINANCIAL STATEMENTS ON PAGES 29 THROUGH 52 ARE AN INTEGRAL PART OF THIS STATEMENT. USG CORPORATION (RESTRUCTURED COMPANY) CONSOLIDATED STATEMENT OF CASH FLOWS (DOLLARS IN MILLIONS) THE NOTES TO FINANCIAL STATEMENTS ON PAGER 29 THROUGH 52 ARE AN INTEGRAL PART OF THIS STATEMENT. USG CORPORATION (RESTRUCTURED COMPANY) NOTES TO FINANCIAL STATEMENTS (TERMS IN INITIAL CAPITAL LETTERS ARE DEFINED ELSEWHERE IN THIS FORM 10-K) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Corporation and its subsidiaries after elimination of intercompany accounts and transactions. Revenue is recognized upon the shipment of products. Net currency translation gains or losses on foreign subsidiaries are included in deferred currency translation, a component of stockholders' equity. Excess Reorganization Value, which was recorded as a result of the implementation of fresh start accounting, is being amortized through April 1998. The Corporation continues to evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of Excess Reorganization Value may warrant revision or that the remaining balances may not be recoverable. The Corporation uses an estimate of its undiscounted cash flows over the remaining life of the Excess Reorganization Value in measuring whether the asset is recoverable. See "Financial Restructuring" note below for more information on the implementation of fresh start accounting. For purposes of the Consolidated Balance Sheet and Consolidated Statement of Cash Flows, all highly liquid investments with a maturity of three months or less at the time of purchase are considered to be cash equivalents. FINANCIAL RESTRUCTURING On May 6, 1993, the Corporation completed a comprehensive restructuring of its debt (the "RESTRUCTURING") through implementation of a "prepackaged" plan of reorganization under federal bankruptcy laws (the "PREPACKAGED PLAN") which was confirmed on April 23, 1993 by the Bankruptcy Court. In the Restructuring, the Corporation (i) converted approximately $1.4 billion of subordinated debt and accrued interest into Common Stock and warrants to purchase Common Stock, (ii) converted approximately $340 million of its bank obligations into 10 1/4% Senior Notes due 2002 ("SENIOR 2002 NOTES") and (iii) extended the maturities of its remaining Bank Debt and certain public debt. Upon consummation of the Restructuring, all previously existing defaults upon senior securities were waived or cured. None of the subsidiaries of the Corporation were part of this proceeding and there was no impact on trade creditors of the Corporation's subsidiaries. The Corporation accounted for the Restructuring using the principles of fresh start accounting as required by AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). Pursuant to such principles, individual assets and liabilities were adjusted to fair market value as of May 6, 1993. See "Predecessor Company - Notes to Financial Statements - Financial Restructuring and Fresh Start Accounting" notes for information on the terms and implementation of the Prepackaged Plan and fresh start accounting. PRO FORMA CONSOLIDATED STATEMENT OF EARNINGS The following unaudited Pro Forma Condensed Consolidated Statement of Earnings for the year ended December 31, 1993 has been prepared giving effect to the consummation of the Restructuring, including the implementation of fresh start accounting, as if the consummation had occurred on January 1, 1993. Due to the Restructuring and implementation of fresh start accounting, financial statements effective May 7, 1993 for the restructured company are not comparable to financial statements prior to that date for the predecessor company. However, for presentation of this statement, total results for 1993 are shown under the caption "Total Before Adjustments." The adjustments set forth under the caption "Pro Forma Adjustments" reflect the implementation of the Prepackaged Plan and the adoption of fresh start accounting as if they had occurred on January 1, 1993. USG CORPORATION PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF EARNINGS YEAR ENDED DECEMBER 31, 1993 (UNAUDITED) (DOLLARS IN MILLIONS) EXTRAORDINARY LOSS In December 1993, the Corporation recorded an extraordinary loss of $21 million, net of related income tax benefit of $11 million, reflecting the write- off of the reorganization discount associated with debt issues expected to be prepaid, redeemed or purchased in 1994 in connection with the Corporation's planned public offering of Common Stock and issuance of new senior notes. See "Subsequent Event" note for more information on the planned public offering of stock and issuance of new senior notes. RESEARCH AND DEVELOPMENT Research and development expenditures are charged to earnings as incurred and amounted to $10 million in the period of May 7 through December 31, 1993. TAXES ON INCOME AND DEFERRED INCOME TAXES Loss before taxes on income and extraordinary loss consisted of the following (dollars in millions): Taxes on income consisted of the following (dollars in millions): The difference between the statutory U.S. Federal income tax/(benefit) rate and the Corporation's effective income tax rate is summarized as follows: Temporary differences and carryforwards which give rise to current and long-term deferred tax (assets)/liabilities as of December 31, 1993 were as follows (dollars in millions): A valuation allowance has been provided for deferred tax assets relating to pension and retiree medical benefits due to the long-term nature of their realization. Because of the uncertainty regarding the application of the Internal Revenue Code (the "CODE") to the Corporation's NOL Carryforwards as a result of the Prepackaged Plan, no deferred tax asset is recorded. Under fresh start accounting rules, any benefit realized from utilizing predecessor company NOL Carryforwards will not impact net earnings. The Corporation has NOL Carryforwards of $90 million remaining from 1992 after using approximately $23 million to offset U.S. taxable income in 1993 and a reduction due to cancellation of indebtedness from the Prepackaged Plan. These NOL Carryforwards may be used to offset U.S. taxable income through 2007. The Code will limit the Corporation's annual use of its NOL Carryforwards to the lesser of its taxable income or approximately $30 million plus any unused limit from prior years. Furthermore, due to the uncertainty regarding the application of the Code to the exchange of stock for debt, the Corporation's NOL Carryforwards could be further reduced or eliminated. The Corporation has a $4 million minimum tax credit which may be used to offset U.S. regular tax liability in future years. The Corporation does not provide for U.S. Federal income taxes on the portion of undistributed earnings of foreign subsidiaries which are intended to be permanently reinvested. The cumulative amount of such undistributed earnings totaled approximately $79 million as of December 31, 1993. Any future repatriation of undistributed earnings would not, in the opinion of management, result in significant additional taxes. INVENTORIES In accordance with the implementation of fresh start accounting, inventories were stated at fair market value as of May 6, 1993. Most of the Corporation's domestic inventories are valued under the last-in, first-out ("LIFO") method. As of December 31, 1993, the LIFO values of these inventories were $103 million and would have been the same if they were valued under the first-in, first-out ("FIFO") and average production cost methods. The remaining inventories are stated at the lower of cost or market, under the FIFO or average production cost methods. Inventories include material, labor and applicable factory overhead costs. Inventory classifications were as follows (dollars in millions): The LIFO value of U.S. domestic inventories under fresh start accounting exceeded that computed for U.S. Federal income tax purposes by $25 million as of December 31, 1993. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment were stated at fair market value as of May 6, 1993 in accordance with fresh start accounting. Provisions for depreciation are determined principally on a straight-line basis over the expected average useful lives of composite asset groups. Depletion is computed on a basis calculated to spread the cost of gypsum and other applicable resources over the estimated quantities of material recoverable. Interest during construction is capitalized on major property additions. Property, plant and equipment classifications were as follows (dollars in millions): LEASES The Corporation leases certain of its offices, buildings, machinery and equipment, and autos under noncancellable operating leases. These leases have various terms and renewal options. Lease expense amounted to $22 million in the period of May 7 through December 31, 1993. Future minimum lease payments, by year and in the aggregate, under operating leases with initial or remaining noncancellable terms in excess of one year as of December 31, 1993 were as follows (dollars in millions): INDEBTEDNESS Total debt, including currently maturing debt, consisted of the following (dollars in millions): As of December 31, 1993, the Corporation and its subsidiaries had $1,531 million total principal amount of debt (before unamortized reorganization discount) on a consolidated basis. Of such total debt, $105 million represented direct borrowings by the subsidiaries, including $38 million of industrial revenue bonds, $36 million of 7 7/8% sinking fund debentures issued by U.S. Gypsum in 1974 and subsequently assumed by the Corporation on a joint and several basis in 1985, $27 million of debt (primarily project financing) incurred by the Corporation's foreign subsidiaries other than CGC, $2 million of working capital borrowings by CGC, and $2 million of other long-term borrowings by CGC. The Credit Agreement includes a cash sweep mechanism under which excess cash as of the end of any year, calculated in accordance with the Credit Agreement, must be used to pay debt within the following year. As of December 31, 1993, such excess cash amounted to $158 million. Accordingly, $158 million of long term debt was reclassified to currently maturing long- term debt. On August 10, 1993, the Corporation issued $138 million of Senior 2002 Notes in exchange for $92 million of Bank Term Loans due 1994 through 1996 and $46 million of Capitalized Interest Notes due 2000. The Corporation did not receive any cash proceeds from the issuance of these securities. In connection with this transaction, the Credit Agreement was modified, providing for the following changes: (i) scheduled Bank Term Loan amortization payments of $95 million due in 1994, 1995 and 1996 were eliminated ($3 million was added to the final maturity of the Bank Term Loan due in 2000); (ii) USG Interiors paid $9 million of Capitalized Interest Notes due in 1998; and (iii) the cash sweep mechanism was modified to permit the use of up to $165 million of cash otherwise subject to mandatory Bank Term Loan prepayments in 1994, 1995 and 1996 for payment or purchase of senior debt with maturities prior to January 1, 1999, or for the prepayment of Bank Term Loans, at the discretion of the Corporation. The Bank Term Loan and most other senior debt are secured by a pledge of all of the shares of the Corporation's major domestic subsidiaries and 65% of the shares of certain of its foreign subsidiaries including CGC, pursuant to a collateral trust arrangement controlled primarily by holders of the Bank Term Loan. The rights of the Corporation and its creditors to the assets of any subsidiary upon the latter's liquidation or reorganization will be subject to the prior claims of such subsidiary's creditors, except to the extent that the Corporation may itself be a creditor with enforceable claims against such subsidiary. The average rate of interest on the Bank Term Loan was 5.3% in the period of May 7 through December 31, 1993. The "Other Secured Debt" category shown in the table above primarily includes short-term and long-term borrowings from several foreign banks by USG International used principally to finance construction of the Aubange, Belgium ceiling tile plant. This debt is secured by a lien on the assets of the Aubange plant and has restrictive covenants that restrict, among other things, the payment of dividends. Foreign borrowings made by the Corporation's international operations are generally allowed, within certain limits, under provisions of the Credit Agreement. In general, the Credit Agreement restricts, among other things, the incurrence of additional indebtedness, mergers, asset dispositions, investments, prepayment of other debt, dealings with affiliates, capital expenditures, payment of dividends and lease commitments. The Credit Agreement, as amended in accordance with the Prepackaged Plan, also requires the Corporation, beginning January 1, 1995, to satisfy certain financial covenants. The fair market value of debt as of December 31, 1993 was $1,481 million, based on indicative bond prices as of that date, excluding other secured debt, primarily representing financing for construction of the Aubange plant, which was not practicable to estimate. Aggregate, presently scheduled maturities of long-term debt, after the assumed effect of prepayments pursuant to the aforementioned cash sweep mechanism and excluding other amounts classified as current liabilities, are $9 million, $20 million, $148 million and $153 million in the years 1995 through 1998, respectively. PENSION PLANS The Corporation and most of its subsidiaries have defined benefit retirement plans for all eligible employees. Benefits of the plans are generally based on years of service and employees' compensation during the last years of employment. The Corporation's contributions are made in accordance with independent actuarial reports which, for most plans, required minimal funding in the period of May 7 through December 31, 1993. Net pension expense included the following components (dollars in millions): The pension plan assets, which consist primarily of publicly traded common stocks and debt securities, had an estimated fair market value that was lower than the projected benefit obligation as of December 31, 1993. The following table presents a reconciliation of the total assets of the pension plans to the projected benefit obligation (dollars in millions): The projected benefit obligation in excess of assets consisted of an unrecognized net loss due to changes in assumptions and differences between actual and estimated experience. The expected long-term rate of return on plan assets was 9% for the period of May 7 through December 31, 1993. The assumed weighted average discount rate used in determining the accumulated benefit obligation was 7% and the rate of increases in projected future compensation levels was 5%. POSTRETIREMENT BENEFITS The Corporation maintains plans that provide retiree health care and life insurance benefits for all eligible employees. Employees generally become eligible for the retiree benefit plans when they meet minimum retirement age and service requirements. The cost of providing most of these benefits is shared with retirees. The following table summarizes the components of net periodic postretirement benefit cost for the period of May 7 through December 31, 1993 (dollars in millions): The status of the Corporation's accrued postretirement benefit cost as of December 31, 1993 was as follows (dollars in millions): The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 11% as of December 31, 1993 with a gradually declining rate to 5% by the year 2000 and remaining at that level 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 $22 million and increase the net periodic postretirement benefit cost for the period of May 7 through December 31, 1993 by $2 million. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7%. COMMITMENTS AND CONTINGENCIES The Corporation employs a variety of off-balance sheet financial instruments to reduce its exposure to fluctuations in interest rates, foreign currency exchange rates and energy costs. These instruments consists primarily of interest rate caps and swaps, foreign currency forward exchange contracts and energy price swaps and option agreements. The Corporation designates interest rate swaps as hedges of LIBOR-based bank debt, and accrues as interest expense the differential to be paid or received under the agreements as rates change over the life of the contracts. Gains and losses arising from foreign currency forward contracts offset gains and losses resulting from the underlying hedged transactions. Upon settlement of energy price contracts, the resulting gain or loss is included in related manufacturing cost. The Corporation continually monitors its positions with, and the credit quality of, the financial institutions which are counterparties to its off-balance sheet financial instruments and does not anticipate non-performance by the counterparties. As of December 31, 1993, the Corporation had approximately $500 million (notional amount) of interest rate contracts outstanding, extending up to three years, and approximately $50 million (combined notional amount) of foreign currency and energy price contracts outstanding, extending one year or less. The difference in the value of all of the aforementioned contracts and the December 31, 1993 market value was not material. MANAGEMENT PERFORMANCE PLAN On May 6, 1993, all outstanding stock options were cancelled without consideration and certain shares of restricted and deferred stock were cashed-out pursuant to "change in control" provisions contained in the Management Performance Plan (the "PERFORMANCE PLAN"). As of December 31, 1993, restricted stock and awards for deferred stock yet to be issued (totaling 25,259 shares) remained outstanding as a consequence of certain waivers of the change in control event by senior members of management. As permitted by the Prepackaged Plan, 2,788,350 common shares were reserved for future issuance in conjunction with stock options, all of which remained in reserve as of December 31,1993. Options for 1,673,000 common shares were granted on June 1, 1993, leaving an additional 1,115,350 common shares available for future grants. The options granted on June 1, 1993 become exercisable in the years 1994 through 1996 at an exercise price of $10.3125 per share. PREFERRED SHARE PURCHASE RIGHTS On June 6, 1988, the Corporation adopted a Preferred Share Purchase Rights Plan and pursuant to its provisions declared, subject to the consummation of the 1988 Recapitalization, a distribution of one right (the "RIGHTS") upon each new share of Common Stock issued in the 1988 Recapitalization. The 1988 Recapitalization became effective July 13, 1988 and the distribution occurred immediately thereafter. The Rights contain provisions which are intended to protect stockholders in the event of an unsolicited attempt to acquire the Corporation. The Preferred Share Purchase Rights Plan was terminated in connection with the implementation of the Prepackaged Plan. On May 6, 1993, a new rights plan (the "RIGHTS AGREEMENT") was adopted with provisions substantially similar to the old rights agreement except that: (i) the purchase price of the Rights was reset; (ii) the expiration of the Rights was extended; (iii) a so-called "flip-in" feature and exchange feature were added; (iv) certain exemptions were added permitting certain acquisition and the continued holding of common shares by Water Street and its affiliates in excess of the otherwise specified thresholds; (v) the redemption price was reduced; and (vi) the amendment provision was liberalized. Under the terms of the Rights Agreement, and subject to certain exceptions for Water Street and its affiliates, generally the Rights become exercisable (i) 10 days following the date of a public announcement that a person or group of affiliated or associated persons (an "ACQUIRING PERSON"), other than the Corporation, any employee benefit plan of the Corporation, any entity holding Common Stock for or pursuant to the terms of any such plan, has beneficial ownership (as defined in the Rights Agreement) of 20% or more of the then outstanding Common Stock, (ii) 10 days following the date of a public announcement that a person or group of affiliated or associated persons (an "ADVERSE PERSON") has beneficial ownership of 10% or more of the then outstanding Common Stock, the acquisition of which has been determined by the Board to present an actual threat of an acquisition of the Corporation that would not be in the best interest of the Corporation's stockholders or (iii) 10 days following the date of commencement of, or public announcement of, a tender offer or exchange offer for 30% or more of the Common Stock. When exercisable, each of the Rights entitles the registered holder to purchase one-hundredth of a share of a junior participating preferred stock, series C, $1.00 par value per share, at a price of $35.00 per one-hundredth of a preferred share, subject to adjustments. In the event that the Corporation is the surviving corporation in a merger or other business combination involving an Acquiring Person or an Adverse Person and the Common Stock remains outstanding and unchanged or in the event that an Acquiring Person or an Adverse Person engages in one of a number of self-dealing transactions specified in the Rights Agreement, proper provision will be made so that each holder of a Right, other than Rights that are or were beneficially owned (as defined in the Rights Agreement) by the Acquiring Person or the Adverse Person, as the case may be, on the earliest of the Distribution Date, the date the Acquiring Person acquires 20% or more of the outstanding Common Stock or the date the Adverse Person becomes such (which will thereafter be void), will thereafter have the right to receive upon exercise thereof that number of shares of Common Stock having a market value at the time of such transaction of two times the exercise price of the Right. In addition, under certain circumstances the Board has the option of exchanging all or part of the Rights (excluding void Rights) for Common Stock in the manner described in the Rights Agreement. The Rights Agreement also contains a so-called "flip-in" feature which provides that if any person or group of affiliated or associated persons becomes an Adverse Person, then the provisions of the preceding two sentences shall apply. WARRANTS On May 6, 1993, a total of 2,602,566 warrants, each to purchase a share of Common Stock at an exercise price of $16.14 per share (the "WARRANTS"), were issued to holders of the Old Junior Subordinated Debentures in addition to the shares of Common Stock issued to such holders, all as provided by the Prepackaged Plan. Upon issuance, each of the Warrants entitled the holder to purchase one share of Common Stock at a purchase price of $16.14 per share, subject to adjustment under certain events. The Warrants are exercisable, subject to applicable securities laws, at any time prior to May 6, 1998. Each share of Common Stock issued upon exercise of a Warrant prior to the Distribution Date (as defined in the Rights Agreement) and prior to the redemption or expiration of the Rights will be accompanied by an attached Right issued under the terms and subject to the conditions of the Rights Agreement as it may then be in effect. As of December 31, 1993, 2,601,619 Warrants were outstanding. STOCKHOLDERS' EQUITY Changes in stockholders' equity are summarized as follows (dollars in millions): As of December 31, 1993, there were 27,876 shares of $0.10 par value Common Stock held in treasury, which were acquired through the forfeiture of restricted stock. LITIGATION One of the Corporation's subsidiaries, U.S. Gypsum, is among numerous defendants in lawsuits arising out of the manufacture and sale of asbestos- containing building materials. U.S. Gypsum sold certain asbestos-containing products beginning in the 1930's; in most cases the products were discontinued or asbestos was removed from the product formula by 1972, and no asbestos- containing products were sold after 1977. Some of these lawsuits seek to recover compensatory and in many cases punitive damages for costs associated with maintenance or removal and replacement of products containing asbestos (the "PROPERTY DAMAGE CASES"). Others of these suits (the "PERSONAL INJURY CASES") seek to recover compensatory and in many cases punitive damages for personal injury allegedly resulting from exposure to asbestos and asbestos-containing products. It is anticipated that additional personal injury and property damage cases containing similar allegations will be filed. As discussed below, U.S. Gypsum has substantial personal injury and property damage insurance for the years involved in the asbestos litigation. Prior to 1985, when an asbestos exclusion was added to U.S. Gypsum's policies, U.S. Gypsum purchased comprehensive general liability insurance policies covering personal injury and property damage in an aggregate face amount of approximately $850 million. Insurers that issued approximately $106 million of these policies are presently insolvent. After deducting insolvencies and exhaustion of policies, approximately $625 million of insurance remains potentially available. Because U.S. Gypsum's insurance carriers initially responded to its claims for defense and indemnification with various theories denying or limiting coverage and the applicability of their policies, U.S. Gypsum filed a declaratory judgment action against them in the Circuit Court of Cook County, Illinois on December 29, 1983. (U.S. GYPSUM CO. V. ADMIRAL INSURANCE CO., ET AL.) (the "COVERAGE ACTION"). U.S. Gypsum alleges in the Coverage Action that the carriers are obligated to provide indemnification for settlements and judgments and, in some cases, defense costs incurred by U.S. Gypsum in property damage and personal injury claims in which it is a defendant. The current defendants are ten insurance carriers that provided comprehensive general liability insurance coverage to U.S. Gypsum between the 1940's and 1984. As discussed below, several carriers have settled all or a portion of the claims in the Coverage Action. U.S. Gypsum's aggregate expenditures for all asbestos-related matters, including property damage, personal injury, insurance coverage litigation and related expenses, exceeded aggregate insurance payments by $10.9 million in 1991, $25.8 million in 1992, and $8.2 million in 1993. PROPERTY DAMAGE CASES The Property Damage Cases have been brought against U.S. Gypsum by a variety of plaintiffs, including school districts, state and local governments, colleges and universities, hospitals and private property owners. U.S. Gypsum is one of many defendants in four cases that have been certified as class actions and others that request such certification. One class action suit is brought on behalf of owners and operators of all elementary and secondary schools in the United States that contain or contained friable asbestos- containing material. (IN RE ASBESTOS SCHOOL LITIGATION, U.S.D.C., E.D. Pa.) Approximately 1,350 school districts opted out of the class, some of which have filed or may file separate lawsuits or are participants in a state court class action involving approximately 333 school districts in Michigan. (BOARD OF EDUCATION OF THE CITY OF DETROIT, ET AL. V. THE CELOTEX CORP., ET AL., Circuit Court for Wayne County, Mich.) On April 10, 1992, a state court in Philadelphia certified a class consisting of all owners of buildings leased to the federal government. (PRINCE GEORGE CENTER, INC. V. U.S. GYPSUM CO., ET AL., Court of Common Pleas, Philadelphia, Pa.) On September 4, 1992, a Federal district court in South Carolina conditionally certified a class comprised of all colleges and universities in the United States, which certification is presently limited to the resolution of certain allegedly "common" liability issues. (CENTRAL WESLEYAN COLLEGE V. W.R. GRACE & CO., ET AL., U.S.D.C. S.C.). On December 23, 1992, a case was filed in state court in South Carolina purporting to be a "voluntary" class action on behalf of owners of all buildings containing certain types of asbestos-containing products manufactured by the nine named defendants, including U.S. Gypsum, other than buildings owned by the federal or state governments, single family residences, or buildings at issue in the four above-described class actions (ANDERSON COUNTY HOSPITAL V. W.R. GRACE & CO., ET AL., Court of Common Pleas, Hampton Co., S.C. (the "ANDERSON CASE"). On January 14, 1993, the plaintiff filed an amended complaint that added a number of claims and defendants, including USG Corporation. The amended complaint alleges, among other things, that the guarantees executed by U.S. Gypsum in connection with the 1988 Recapitalization, as well as subsequent distributions of cash from U.S. Gypsum to the Corporation, rendered U.S. Gypsum insolvent and constitute a fraudulent conveyance. The suit seeks to set aside the guarantees and recover the value of the cash flow "diverted" from U.S. Gypsum to the Corporation in an amount to be determined. This case has not been certified as a class action and no other threshold issues, including whether the South Carolina Courts have personal jurisdiction over the Corporation, have been decided. The damages claimed against U.S. Gypsum in the class action cases are unspecified. U.S. Gypsum has denied the substantive allegations of each of the Property Damage Cases and intends to defend them vigorously except when advantageous settlements are possible. As of December 31, 1993, 61 Property Damage Cases were pending against U.S. Gypsum; however, the number of buildings involved is greater than the number of cases because many of these cases, including the class actions referred to above, involve multiple buildings. In addition, approximately 42 property damage claims have been threatened against U.S. Gypsum. In total, U.S. Gypsum has settled property damage claims of approximately 191 plaintiffs involved in approximately 75 cases. Twenty-five cases have been tried to verdict, 16 of which were won by U.S. Gypsum and 6 lost; two other cases, one won at the trial level and one lost, were settled during appeals. Another case that was lost at the trial court level has been reversed on appeal and a new trial ordered. Appeals are pending in 5 of the tried cases. In the cases lost, compensatory damage awards against U.S. Gypsum have totaled $11.5 million. Punitive damages totalling $5.5 million were entered against U.S. Gypsum in four trials. Two of the punitive damage awards, totalling $1.45 million, were paid after appeals were exhausted; a third was settled after the verdict was reversed on appeal. The remaining punitive damage award is on appeal. In 1991, 13 new Property Damage Cases were filed against U.S. Gypsum, 11 were dismissed before trial, 8 were settled, 2 were closed following trial or appeal, and 100 were pending at year-end. U.S. Gypsum expended $22.2 million for the defense and resolution of Property Damage Cases and received insurance payments of $13.8 million in 1991. During 1992, 7 new Property Damage Cases were filed against U.S. Gypsum, 10 were dismissed before trial, 18 were settled, 3 were closed following trial or appeal, and 76 were pending at year-end. U.S. Gypsum expended $34.9 million for the defense and resolution of Property Damage Cases and received insurance payments of $10.2 million in 1992. In 1993, 5 new Property Damage Cases were filed against U.S. Gypsum, 7 were dismissed before trial, 11 were settled, 1 was closed following trial or appeal, 2 were consolidated into 1, and 61 were pending at year-end. U.S. Gypsum expended $13.9 million for the defense and resolution of Property Damage Cases and received insurance payments of $7.6 million in 1993. In the Property Damage Cases litigated to date, a defendant's liability for compensatory damages, if any, has been limited to damages associated with the presence and quantity of asbestos-containing products manufactured by that defendant which are identified in the buildings at issue, although plaintiffs in some cases have argued that principles of joint and several liability should apply. Because of the unique factors inherent in each of the Property Damage Cases, including the lack of reliable information as to product identification and the amount of damages claimed against U.S. Gypsum in many cases, including the class actions described above, management is unable to make a reasonable estimate of the cost of disposing of pending Property Damage Cases. PERSONAL INJURY CASES U.S. Gypsum was among numerous defendants in asbestos personal injury suits and administrative claims involving approximately 59,000 claimants pending as of December 31, 1993. All asbestos bodily injury claims pending in the federal courts, including approximately one-third of the Personal Injury Cases pending against U.S. Gypsum, have been consolidated in the United States District Court for the Eastern District of Pennsylvania. U.S. Gypsum is a member, together with 19 other former producers of asbestos-containing products, of the Center for Claims Resolution (the "CENTER"). The Center has assumed the handling, including the defense and settlement, of all Personal Injury Cases pending against U.S. Gypsum and the other members of the Center. Each member of the Center is assessed a portion of the liability and defense costs of the Center for the Personal Injury Cases handled by the Center, according to predetermined allocation formulas. Five of U.S. Gypsum's insurance carriers that in 1985 signed an Agreement Concerning Asbestos-Related Claims (the "WELLINGTON AGREEMENT") are supporting insurers (the "SUPPORTING INSURERS") of the Center. The Supporting Insurers are obligated to provide coverage for the defense and indemnity costs of the Center's members pursuant to the coverage provisions in the Wellington Agreement. Claims for punitive damages are defended but not paid by the Center; if punitive damages are recovered, insurance coverage may be available under the Wellington Agreement depending on the terms of particular policies and applicable state law. Punitive damages have not been awarded against U.S. Gypsum in any of the Personal Injury Cases. Virtually all of U.S. Gypsum's personal injury liability and defense costs are paid by those of its insurance carriers that are Supporting Insurers. The Supporting Insurers provided approximately $350 million of the total coverage referred to above, of which approximately $262 million remains unexhausted. On January 15, 1993, U.S. Gypsum and the other members of the Center were named as defendants in a class action filed in the U.S. District Court for the Eastern District of Pennsylvania (GEORGINE ET AL. V. AMCHEM PRODUCTS INC., ET AL., Case No. 93-CV-0215) (hereinafter "GEORGINE," formerly known as "CARLOUGH"). The complaint generally defines the class of plaintiffs as all persons who have been occupationally exposed to asbestos-containing products manufactured by the defendants and who had not filed an asbestos personal injury suit as of the date of the filing of the class action. Simultaneously with the filing of the class action, the parties filed a settlement agreement in which the named plaintiffs, proposed class counsel, and the defendants agreed to settle and compromise the claims of the proposed class. The settlement, if approved by the court, will implement for all future Personal Injury Cases, except as noted below, an administrative compensation system to replace judicial claims against the defendants, and will provide fair and adequate compensation to future claimants who can demonstrate exposure to asbestos-containing products manufactured by the defendants and the presence of an asbestos-related disease. Class members will be given the opportunity to "opt out," or elect to be excluded from the settlement, although the defendants reserve the right to withdraw from the settlement if the number of opt outs is, in their sole judgment, excessive. In addition, in each year a limited number of claimants will have certain rights to prosecute their claims for compensatory (but not punitive) damages in court in the event they reject the compensation offered by the administrative processing of their claim. The Center members, including U.S. Gypsum, have instituted proceedings against those of their insurance carriers that had not consented to support the settlement, seeking a declaratory judgment that the settlement is reasonable and, therefore, that the carriers are obligated to fund their portion of it. Consummation of the settlement is contingent upon, among other things, court approval of the settlement and a favorable ruling in the declaratory judgment proceedings against the non-consenting insurers. It is anticipated that appeals will follow the district court's ruling on the fairness and reasonableness of the settlement. Each of the defendants has committed to fund a defined portion of the settlement, up to a stated maximum amount, over the initial ten year period of the agreement (which is automatically extended unless terminated by the defendants). Taking into account the provisions of the settlement agreement concerning the maximum number of claims that must be processed in each year and the total amount to be made available to the claimants, the Center estimates that U.S. Gypsum will be obligated to fund a maximum of approximately $125 million of the class action settlement, exclusive of expenses, with a maximum payment of less than $18 million in any single year; of the total amount of U.S. Gypsum's obligation, all but approximately $7 million is expected to be paid by U.S. Gypsum's insurance carriers. During 1991, approximately 13,100 Personal Injury Cases were filed against U.S. Gypsum and approximately 6,300 were settled or dismissed. U.S. Gypsum incurred expenses of $15.1 million in 1991 with respect to Personal Injury Cases of which $15.0 million was paid by insurance. During 1992, approximately 20,100 Personal Injury Cases were filed against U.S. Gypsum and approximately 10,600 were settled or dismissed. U.S. Gypsum incurred expenses of $21.6 million in 1992 with respect to Personal Injury Cases of which $21.5 million was paid by insurance. During 1993, approximately 26,900 Personal Injury Cases were filed against U.S. Gypsum and approximately 22,900 were settled or dismissed. U.S. Gypsum incurred expenses of $34.9 million in 1993 with respect to Personal Injury Cases of which $34.0 million was paid by insurance. As of December 31, 1993, 1992, and 1991, approximately 59,000, 54,000, and 43,000 Personal Injury Cases were outstanding against U.S. Gypsum, respectively. U.S. Gypsum's average settlement cost for Personal Injury Cases over the past three years has been approximately $1,600 per claim, exclusive of defense costs. Management anticipates that its average settlement cost is likely to increase due to such factors as the possible insolvency of co- defendants, although this increase may be offset to some extent by other factors, including the possibility for block settlements of large numbers of cases and the apparent increase in the percentage of asbestos personal injury cases that appear to have been brought by individuals with little or no physical impairment. Through the Center, U.S. Gypsum has reached settlements on approximately 26,700 pending Personal Injury Cases for an amount estimated at approximately $32 million. These settlements will be consummated and the cases closed over a three year period. In management's opinion, based primarily upon U.S. Gypsum's experience in the Personal Injury Cases disposed of to date and taking into consideration a number of uncertainties, it is probable that all asbestos-related Personal Injury Cases pending against U.S. Gypsum as of December 31, 1993, can be disposed of for a total amount, including both indemnity costs and legal fees and expenses, estimated to be between $100 million and $120 million (of which all but $2 million or $5 million, respectively, is expected to be paid by insurance). The estimated cost of resolving pending claims takes into account, among other factors, (i) an increase in the number of pending claims; (ii) the settlements of certain large blocks of claims for higher per-case averages than have historically been paid; (iii) the committed but unconsummated settlements described above; and (iv) a small increase in U.S. Gypsum's historical settlement average. Assuming that the Georgine class action settlement referred to above is approved substantially in its current form, management estimates, based on assumptions supplied by the Center, U.S. Gypsum's maximum total exposure in Personal Injury Cases during the next ten years (the initial term of the agreement), including liability for pending claims and claims resolved as part of the class action settlement, as well as defense costs and other expenses, at approximately $262 million, of which approximately $250 million is expected to be paid by insurance. U.S. Gypsum's additional exposure for claims filed by persons who have opted out of Georgine would depend on the number of such claims that are filed, which cannot presently be determined. COVERAGE ACTION As indicated above, all of U.S. Gypsum's carriers initially denied coverage for the Property Damage Cases and the Personal Injury Cases, and U.S. Gypsum initiated the Coverage Action to establish its right to such coverage. U.S. Gypsum has voluntarily dismissed the Supporting Insurers referred to above from the personal injury portion of the Coverage Action because they are committed to providing personal injury coverage in accordance with the Wellington Agreement. U.S. Gypsum's claims against the remaining carriers for coverage for the Personal Injury Cases have been stayed since 1984. On January 7, 1991, the trial court in the Coverage Action ruled on the applicability of U.S. Gypsum's insurance policies to settlements and one adverse judgment in eight Property Damage Cases. The court ruled that the eight cases were generally covered, and imposed coverage obligations on particular policy years based upon the dates when the presence of asbestos-containing material was "first discovered" by the plaintiff in each case. The court awarded reimbursement of approximately $6.2 million spent by U.S. Gypsum to resolve the eight cases. U.S. Gypsum has appealed the court's ruling with respect to the policy years available to cover particular claims, and the carriers have appealed most other aspects of the court's ruling. The appeal process is likely to take up to a year or more from the date of this report. U.S. Gypsum's experience in the Property Damage Cases suggests that "first discovery" dates in the eight cases referred to above (1978 through 1985) are likely to be typical of most pending cases. U.S. Gypsum's total insurance coverage for the years 1978 through 1984 is approximately $350 million (after subtracting insolvencies and discounts given to settling carriers). However, some pending cases, as well as some cases filed in the future, may be found to have first discovery dates later than August 1, 1984, after which U.S. Gypsum's insurance policies did not provide coverage for asbestos-related claims. In addition, as described below, the first layer excess carrier for the years 1980 through 1984 is insolvent and U.S. Gypsum may be required to pay amounts otherwise covered by those and other insolvent policies. Accordingly, if the court's ruling is affirmed, U.S. Gypsum will likely be required to bear a portion of the cost of the property damage litigation. Eight carriers, including two of the Supporting Insurers, have settled U.S. Gypsum's claims for both property damage and personal injury coverage and have been dismissed from the Coverage Action entirely. Four of these carriers have agreed to pay all or a substantial portion of their policy limits to U.S. Gypsum beginning in 1991 and continuing over the next four years. Three other excess carriers, including the two settling Supporting Insurers, have agreed to provide coverage for the Property Damage Cases and the Personal Injury Cases subject to certain limitations and conditions, when and if underlying primary and excess coverage is exhausted. It cannot presently be determined when such coverage might be reached. Taking into account the above settlements, including participation of certain of the settling carriers in the Wellington Agreement, and consumption through December 31, 1993, carriers providing a total of approximately $90 million of unexhausted insurance have agreed, subject to the terms of the various settlement agreements, to cover both Personal Injury Cases and Property Damage Cases. Carriers providing an additional $250 million of coverage that was unexhausted as of December 31, 1993 have agreed to cover Personal Injury Cases under the Wellington Agreement, but continue to contest coverage for Property Damage Cases and remain defendants in the Coverage Action. U.S. Gypsum will continue to seek negotiated resolutions with its carriers in order to minimize the expense and delays of litigation. Insolvency proceedings have been instituted against four of U.S. Gypsum's insurance carriers. Midland Insurance Company, declared insolvent in 1986, provided excess insurance ($4 million excess of $1 million excess of $500,000 primary in each policy year) from February 15, 1975 to February 15, 1978; Transit Casualty Company, declared insolvent in 1985, provided excess insurance ($15 million excess of $1 million primary in each policy year) from August 1, 1980 to December 31, 1985; Integrity Insurance Company, declared insolvent in 1986, provided excess insurance ($10 million quota share of $25 million excess of $90 million) from August 1, 1983 to July 31, 1984; and American Mutual Insurance Company, declared insolvent in 1989, provided the primary layer of insurance ($500,000 per year) from February 1, 1963 to April 15, 1971. It is possible that U.S. Gypsum will be required to pay a presently indeterminable portion of the costs that would otherwise have been covered by these policies. In addition, portions of various policies issued by Lloyd's and other London market companies between 1966 and 1979 have also become insolvent; under the Wellington Agreement, U.S. Gypsum must pay these amounts, which total approximately $12 million. It is not possible to predict the number of additional lawsuits alleging asbestos-related claims that may be filed against U.S. Gypsum. The number of Personal Injury Cases pending against U.S. Gypsum has increased in each of the last several years. In addition, many Property Damage Cases are still at an early stage and the potential liability therefrom is consequently uncertain. In view of the limited insurance funding currently available for the Property Damage Cases resulting from the continued resistance by a number of U.S. Gypsum's insurers to providing coverage, the effect of the asbestos litigation on the Corporation will depend upon a variety of factors, including the damages sought in the Property Damage Cases that reach trial prior to the completion of the Coverage Action, U.S. Gypsum's ability to successfully defend or settle such cases, and the resolution of the Coverage Action. As a result, management is unable to determine whether an adverse outcome in the asbestos litigation will have a material adverse effect on the results of operations or the consolidated financial position of the Corporation. ACCOUNTING CHANGE Effective January 1, 1994, the Corporation will adopt the requirements of Financial Accounting Standards Board Interpretation No. 39. In accordance with Interpretation No. 39, U.S. Gypsum will record an accrual for its liabilities for asbestos-related matters which are deemed probable and can be reasonably estimated, and will separately record an asset equal to the amount of such liabilities that is expected to be paid by uncontested insurance. Due to management's inability to reasonably estimate U.S. Gypsum's liability for Property Damage Cases and (until the implementation of Georgine is deemed probable) future Personal Injury Cases, it is presently anticipated that the liabilities and assets to be recorded in 1994 will relate only to pending Personal Injury Cases. This implementation of Interpretation No. 39 is not expected to have a material impact on reported earnings or net assets. ENVIRONMENTAL LITIGATION The Corporation and certain of its subsidiaries have been notified by state and federal environmental protection agencies of possible involvement as one of numerous "potentially responsible parties" in a number of so-called "Superfund" sites in the United States. In substantially all of these sites, the involvement of the Corporation or its Subsidiaries is expected to be minimal. The Corporation believes that appropriate reserves have been established for its potential liability in connection with all Superfund sites but is continuing to review its accruals as additional information becomes available. Such reserves take into account all known or estimable costs associated with these sites including site investigations and feasibility costs, site cleanup and remediation, legal costs, and fines and penalties, if any. In addition, environmental costs connected with site cleanups on USG-owned property are also covered by reserves established in accordance with the foregoing. The Corporation believes that neither these matters nor any other known governmental proceeding regarding environmental matters will have a material adverse effect upon its earnings or consolidated financial position. SUBSEQUENT EVENT On January 7, 1994, the Corporation filed a Registration Statement (Registration No. 33-51845), as amended on February 16, 1994, pertaining to its planned public offering (the "OFFERING") of 6,000,000 new shares of Common Stock to be sold by the Corporation and 4,000,000 shares of Common Stock to be sold by Water Street Corporate Recovery Fund I, L.P. The Offering is part of a refinancing strategy which also includes (i) the placement (the "NOTE PLACEMENT") of $150 million principal amount of Senior 2001 Notes with certain institutional investors and (ii) certain amendments to the Corporation's Credit Agreement (the "CREDIT AGREEMENT AMENDMENTS" and, together with the Offering and Note Placement, the "TRANSACTIONS"). The Credit Agreement Amendments will, among other things, increase the size of the Corporation's revolving credit facility by $70 million and amend existing mandatory Bank Term Loan prepayment provisions to allow the Corporation, upon the achievement of certain financial tests, to retain additional free cash flow for capital expenditures and the purchase of its public debt. Certain Credit Agreement Amendments are contingent on the consummation of the Offering. The Corporation expects to use a portion of the net proceeds from the Offering and the Note Placement, together with approximately $158 million of existing cash generated from operations to pay $140 million of Bank Term Loans and to redeem or purchase approximately $260 million aggregate principal amount of certain other senior debt issues. The remainder of the net proceeds, approximately $92 million, will be available for general corporate purposes, including capital expenditures for cost reduction, capacity improvement and future growth opportunities. The following is an unaudited Pro Forma Condensed Consolidated Balance Sheet as of December 31, 1993 illustrating the effect of the Transactions as if they had occurred on that date: GEOGRAPHIC AND INDUSTRY SEGMENTS Transactions between geographic areas are accounted for on an "arm's-length" basis. No single customer accounted for 4% or more of consolidated net sales. Export sales to foreign unaffiliated customers represent less than 10% of consolidated net sales. Intrasegment and intersegment eliminations largely reflect intercompany sales from U.S. Gypsum to L&W Supply. Segment operating profit/(loss) includes all costs and expenses directly related to the segment involved and an allocation of expenses which benefit more than one segment. Operating profit/(loss) in the period of May 7 through December 31, 1993 reflects the non-cash amortization of Excess Reorganization Value which had the impact of reducing the operating profit of domestic Gypsum Products by $51 million, domestic Interior Systems by $60 million and Building Products Distribution by $2 million. To assist the reader in evaluating the profitability of each geographic and industry segment, EBITDA is shown separately in the following tables. EBITDA represents earnings before interest, taxes, depreciation, depletion and amortization. For the period of May 7 through December 31, 1993, the Corporation also added back non-cash postretirement charges and an extraordinary loss. The Corporation believes EBITDA is helpful in understanding cash flow generated from operations that is available for taxes, debt service and capital expenditures. In addition, EBITDA facilitates the monitoring of covenants related to certain long-term debt and other agreements entered into in conjunction with the Restructuring. EBITDA should not be considered by investors as an alternative to net earnings as an indicator of the Corporation's operating performance or to cash flows as a measure of its overall liquidity. SUBSIDIARY DEBT GUARANTEES The Corporation issued $340 million aggregate principal amount of Senior 2002 Notes in May 1993 and an additional $138 million aggregate principal amount of similar notes in August 1993. Each of U.S. Gypsum, USG Industries, Inc., USG Interiors, USG Foreign Investments, Ltd., L&W Supply, Westbank Planting Company, USG Interiors International, Inc., American Metals Corporation and La Mirada Products Co., Inc. (together, the "COMBINED GUARANTORS") guaranteed, in the manner described below, both the obligations of the Corporation under the Credit Agreement and the Senior 2002 Notes. The Combined Guarantors are jointly and severally liable under the Subsidiary Guarantees. Holders of the Bank Debt have the right to (i) determine whether, when and to what extent the guarantees will be enforced (provided that each guarantee payment will be applied to the Bank Term Loan, Revolving Credit Facility, Capitalized Interest Notes and Senior 2002 Notes pro rata based on the respective amounts owed thereon) and (ii) amend or eliminate the guarantees. The guarantees will terminate when the Bank Term Loan, the Revolving Credit Facility and the Capitalized Interest Notes are retired regardless of whether any Senior 2002 Notes remain unpaid. The liability of each of the Combined Guarantors on its guarantee is limited to the greater of (i) 95% of the lowest amount, calculated as of July 13, 1988, sufficient to render the guarantor insolvent, leave the guarantor with unreasonably small capital or leave the guarantor unable to pay its debts as they become due (each as defined under applicable law) and (ii) the same amount, calculated as of the date any demand for payment under such guarantee is made, in each case plus collection costs. The guarantees are senior obligations of the applicable guarantor and rank PARI PASSU with all unsubordinated obligations of the guarantor. There are 43 Non-Guarantors (the "COMBINED NON-GUARANTORS"), substantially all of which are subsidiaries of Guarantors. The Combined Non-Guarantors primarily include CGC, Gypsum Transportation Limited, USG Canadian Mining Ltd. and the Corporation's Mexican, European and Pacific subsidiaries. The long-term debt of the Combined Non-Guarantors of $24 million as of December 31, 1993 has restrictive covenants that restrict, among other things, the payment of dividends. The following condensed consolidating information presents: (i) Condensed financial statements as of December 31, 1993 and for the period of May 7 through December 31, 1993 of: (a) the Corporation on a parent company only basis (the "PARENT COMPANY," which was the only entity of the Corporation included in the bankruptcy proceeding); (b) the Combined Guarantors; (c) the Combined Non-Guarantors; and (d) the Corporation on a consolidated basis. Due to the Restructuring and implementation of fresh start accounting, the financial statements for the restructured company (periods after May 6, 1993) are not comparable to those of the predecessor company. Except for the following condensed financial statements, separate financial information with respect to the Combined Guarantors is omitted as such separate financial information is not deemed material to investors. (ii) The Parent Company and Combined Guarantors shown with their investments in their subsidiaries accounted for on the equity method. (iii) Elimination entries necessary to consolidate the Parent Company and its subsidiaries. USG CORPORATION (RESTRUCTURED COMPANY) CONDENSED CONSOLIDATING STATEMENT OF EARNINGS MAY 7 THROUGH DECEMBER 31, 1993 (DOLLARS IN MILLIONS) USG CORPORATION (RESTRUCTURED COMPANY) CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 1993 (DOLLARS IN MILLIONS) USG CORPORATION (RESTRUCTURED COMPANY) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS MAY 7 THROUGH DECEMBER 31, 1993 (DOLLARS IN MILLIONS) USG CORPORATION MANAGEMENT REPORT Management is responsible for the preparation and integrity of the financial statements and related notes included herein. These statements have been prepared in accordance with generally accepted accounting principles and, of necessity, include some amounts that are based on management's best estimates and judgments. The Corporation's accounting systems include internal controls designed to provide reasonable assurance of the reliability of its financial records and the proper safeguarding and use of its assets. Such controls are based on established policies and procedures, are implemented by trained personnel, and are monitored through an internal audit program. The Corporation's policies and procedures prescribe that the Corporation and its subsidiaries are to maintain ethical standards and that its business practices are to be consistent with those standards. The Audit Committee of the Board, consisting solely of outside Directors of the Corporation, maintains an ongoing appraisal, on behalf of the stockholders, of the effectiveness of the independent auditors and management with respect to the preparation of financial statements, the adequacy of internal controls and the Corporation's accounting policies. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of USG Corporation: We have audited the accompanying consolidated balance sheet of USG Corporation (Restructured Company), a Delaware corporation, and subsidiaries as of December 31, 1993 and the related consolidated statements of earnings and cash flows for the period of May 7 through 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 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 discussed in Notes to Financial Statements - "Financial Restructuring" note, on May 6, 1993, the Corporation completed a comprehensive financial restructuring through the implementation of a prepackaged plan of reorganization under Chapter 11 of the United States Bankruptcy Code and applied fresh start accounting. As such, results of operations through May 6, 1993 (Predecessor Company) are not comparable with results of operations subsequent to that date. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of USG Corporation and subsidiaries as of December 31, 1993, and the results of their operations and their cash flows for the period of May 7 through December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes to Financial Statements - "Litigation" note, in view of the limited insurance funding currently available for property damage cases resulting from the continued resistance by a number of U.S. Gypsum's insurers to providing coverage, the effect of the asbestos litigation on the Corporation will depend upon a variety of factors, including the damages sought in property damage cases that reach trial prior to the completion of the coverage action, U.S. Gypsum's ability to successfully defend or settle such cases, and the resolution of the coverage action. As a result, management is unable to determine whether an adverse outcome in the asbestos litigation will have a material adverse effect on the consolidated results of operations or the consolidated financial position of the Corporation. ARTHUR ANDERSEN & CO. Chicago, Illinois January 31, 1994 USG CORPORATION (RESTRUCTURED COMPANY) SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN MILLIONS) In accordance with fresh start accounting, the Corporation adjusted its property, plant and equipment accounts as of May 6, 1993 to fair market value. Detailed information regarding additions and deductions is omitted as neither total additions nor total deductions during the period shown above exceeded 10% of the balance at the end of the period. Total additions were $29 million, total deductions were $8 million and other adjustments increased property, plant and equipment by $2 million in the period of May 7 through December 31, 1993. Total deductions include the effect of foreign currency translation which increased total deductions by $5 million in the period of May 7 through December 31, 1993. Upon retirement or other disposition of property, the applicable cost and accumulated depreciation and depletion are removed from the accounts. Any gains and losses are included in earnings. USG CORPORATION (RESTRUCTURED COMPANY) SCHEDULE VI ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN MILLIONS) In accordance with fresh start accounting, the Corporation adjusted its property, plant and equipment accounts as of May 6, 1993 to fair market value. Consequently, there were no reserves for depreciation and depletion as of May 7, 1993. Detailed information regarding additions and deductions is omitted as neither total additions nor total deductions of property, plant and equipment (see Schedule V) during the period shown above exceeded 10% of the balance of property, plant and equipment at the end of the period. Total provisions for depreciation and depletion were $34 million, total deductions were $1 million and other adjustments increased reserves by $3 million in the period of May 7 through December 31, 1993. Upon retirement or other disposition of property, the applicable cost and accumulated depreciation and depletion are removed from the accounts. Any gains and losses are included in earnings. USG CORPORATION (Restructured Company) SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (Dollars in millions) USG CORPORATION (Restructured Company) SCHEDULE IX SHORT-TERM BORROWINGS (Dollars in millions) USG CORPORATION (Restructured Company) SCHEDULE X SUPPLEMENTAL STATEMENT OF EARNINGS INFORMATION (Dollars in millions) The following amounts were charged to costs and expenses: Maintenance and repairs are recorded as costs or expenses when incurred. Taxes (excluding payroll and income taxes), rents, royalties and advertising costs are not shown above, as individually they do not exceed one percent of net sales in the period shown. USG CORPORATION (Restructured Company) SUPPLEMENTAL NOTE ON FINANCIAL INFORMATION FOR UNITED STATES GYPSUM COMPANY (A SUBSIDIARY OF USG CORPORATION) USG Corporation, a holding company, owns several operating subsidiaries, including U.S. Gypsum. On January 1, 1985, all of the issued and outstanding shares of stock of U.S. Gypsum were converted into shares of USG Corporation and the holding company became a joint and several obligor for certain debentures originally issued by U.S. Gypsum. As of December 31, 1993, debentures totaling $36 million were recorded on the holding company's books of account. Financial results for U.S. Gypsum are presented below in accordance with disclosure requirements of the SEC (dollars in millions): SUMMARY STATEMENT OF EARNINGS SUMMARY BALANCE SHEET REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS WITH RESPECT TO SUPPLEMENTAL NOTE AND FINANCIAL STATEMENT SCHEDULES We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of USG Corporation (Restructured Company) included in this Form 10-K, and have issued our report thereon dated January 31, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the asbestos litigation as discussed in Notes to Financial Statements - "Litigation" note. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental note and financial statement schedules on pages 54 through 59 are the responsibility of the Corporation'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. The supplemental note and financial statement 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. Chicago, Illinois January 31, 1994 USG CORPORATION (PREDECESSOR COMPANY) CONSOLIDATED STATEMENT OF EARNINGS (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONSOLIDATED BALANCE SHEET (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONSOLIDATED STATEMENT OF CASH FLOWS (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) NOTES TO FINANCIAL STATEMENTS (TERMS IN INITIAL CAPITAL LETTERS ARE DEFINED ELSEWHERE IN THIS FORM 10-K) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Corporation and its subsidiaries after elimination of intercompany accounts and transactions. Revenue is recognized upon the shipment of products. Net currency translation gains or losses on foreign subsidiaries are included in deferred currency translation, a component of stockholders' equity, except for the years ended December 31, 1992 and 1991, for which Mexican currency translation losses were charged to earnings. Purchased goodwill, which was written off in accordance with the implementation of fresh start accounting, was previously being amortized over a period of 40 years. See "Fresh Start Accounting" note below for more information on the implementation of fresh start accounting. For purposes of the Consolidated Balance Sheet and Consolidated Statement of Cash Flows, all highly liquid investments with a maturity of three months or less at the time of purchase are considered to be cash equivalents. FINANCIAL RESTRUCTURING On May 6, 1993, the Corporation completed a comprehensive restructuring of its debt (the "RESTRUCTURING") through implementation of a "prepackaged" plan of reorganization (the "PREPACKAGED PLAN"). The provisions of the Prepackaged Plan were agreed upon in principle with all committees and certain institutions representing debt subject to the Restructuring in January 1993. The Corporation's Registration Statement (Registration No. 33-40136), which included a Disclosure Statement and Proxy Statement - Prospectus, was declared effective by the SEC in February 1993. The solicitation process for approvals of the Prepackaged Plan was completed on March 15, 1993. The Corporation commenced a prepackaged Chapter 11 bankruptcy case in Delaware (IN RE: USG CORPORATION, Case No. 93-300) on March 17, 1993 and received the U.S. Bankruptcy Court's confirmation of the Prepackaged Plan on April 23, 1993. None of the subsidiaries of the Corporation were part of this proceeding and there was no impact on trade creditors of the Corporation's subsidiaries. Under the Prepackaged Plan, all previously existing defaults were waived or cured. The following summary of the major provisions of the Prepackaged Plan is qualified in its entirety by reference to the more detailed information appearing in the Disclosure Statement. (a) The Prepackaged Plan provided for a one-for-50 reverse stock split (the "REVERSE STOCK SPLIT") which was effected immediately prior to the distribution of new common stock (the "NEW COMMON STOCK") pursuant to the Prepackaged Plan. On May 6, 1993, after giving effect to the Reverse Stock Split, the following distributions were made to holders of the following securities of the Corporation: (i) For each $1,000 principal amount of 13 1/4% senior subordinated debentures due 2000 (the "OLD SENIOR SUBORDINATED DEBENTURES") (excluding accrued interest thereon, which was cancelled), the holder received 50.81 shares of New Common Stock. As of May 6, 1993, the total principal amount of the Old Senior Subordinated Debentures was $600 million. (ii) For each $1,000 principal amount of 16% junior subordinated debentures due 2008 (the "OLD JUNIOR SUBORDINATED DEBENTURES") (excluding accrued interest thereon, which was cancelled), the holder received 11.61 shares of New Common Stock and 5.42 Warrants. As of May 6, 1993, the total principal amount of Old Junior Subordinated Debentures was $533 million, of which $480 million was subject to the distribution. Stockholders existing prior to the distribution of New Common Stock retained their shares of Common Stock, subject to the Reverse Stock Split. After giving effect to the Reverse Stock Split and distribution of New Common Stock, there were 37,157,458 shares of Common Stock outstanding on May 6, 1993, of which the shares held by stockholders existing prior to such distribution represented 3% of the total number of outstanding shares. If all Warrants were exercised, the aggregate holdings of Old Senior Subordinated Debenture holders, Old Junior Subordinated Debenture holders and previously existing stockholders would represent 76.7%, 20.6% and 2.7%, respectively, of the total number of outstanding shares. (b) For each $1,000 principal amount of 7 3/8% senior notes due 1991 (the "OLD SENIOR 1991 NOTES"), the holder received $750 principal amount of 8% senior notes due 1995 (the "SENIOR 1995 NOTES") and $250 principal amount of 9% senior notes due 1998 (the "SENIOR 1998 NOTES"). As of May 6, 1993, the total principal amount of the Old Senior 1991 Notes was $100 million. In addition, the Corporation issued $10 million principal amount of Senior 1998 Notes to two institutional holders of existing 8% senior notes due 1996 (the "SENIOR 1996 NOTES") in exchange for an equal principal amount thereof. The Senior 1995 and 1998 Notes are secured, with certain other indebtedness of the Corporation and subject to a collateral trust arrangement controlled primarily by holders of the Banks' claims, by first priority security interests in the capital stock of certain subsidiaries of the Corporation. (c) Pursuant to the Prepackaged Plan, modifications were made to a credit agreement dated as of July 1, 1988 (the "OLD CREDIT AGREEMENT") with the Bank Group. The modifications, reflected in the Credit Agreement, are summarized as follows: (i) issuance of $340 million of Senior 2002 Notes in exchange for $300 million principal amount of Bank Term Loans, $24 million of accrued but unpaid interest on the Bank Term Loan and $16 million owed in connection with certain interest rate swap contracts; (ii) extension of the final maturity of the remaining principal outstanding on the Bank Term Loan ($540 million) from 1996 to 2000 and deferral of any scheduled principal payments until December 1994; (iii) issuance of $56 million of Capitalized Interest Notes bearing annual interest at LIBOR plus 2 1/4% (or Citibank's base rate plus 1 1/4%) in exchange for $51 million of accrued but unpaid interest on the Bank Debt and $5 million in additional amounts owed in connection with interest rate swap contracts; (iv) making available (at the Corporation's option but subject to certain limitations on the availability of LIBOR) an annual interest rate applicable to the Bank Term Loan and an extended revolving credit facility of LIBOR plus 1 7/8% (or Citibank's base rate plus 7/8%), with the option to issue additional Capitalized Interest Notes for the amount of such interest in excess of LIBOR plus 1% per annum; (v) provision for an excess cash flow sweep that will take into account certain liquidity thresholds; (vi) suspension of all financial covenants through January 1, 1995 and providing for new covenants thereafter; and (vii) extension to 1998 of the maturity date of and establishment of a maximum borrowing capacity of $175 million under the Revolving Credit Facility, including a $110 million letter of credit subfacility. Capitalized Interest Notes of $47 million were allocated as term capitalized interest notes maturing in 2000, being direct obligations of the Corporation, and $9 million of the Capitalized Interest Notes were allocated as revolver capitalized interest notes maturing in 1998, being direct obligations of USG Interiors. The Corporation deferred certain principal and interest payments in order to maintain adequate liquidity during the Restructuring process. These payment deferrals constituted defaults under the applicable loan agreements and indentures, which were waived or cured on May 6, 1993. FRESH START ACCOUNTING The Corporation accounted for the Restructuring using the principles of fresh start accounting as required by SOP 90-7. Pursuant to such principles, in general, the Corporation's assets and liabilities were revalued. Total assets were stated at the reorganization value of the Corporation following the Restructuring. The Corporation primarily used "net present value" and "comparable companies" approaches to determine reorganization value (the "REORGANIZATION VALUE"). In the net present value approach, projected, unleveraged after-tax cash flows of the Subsidiaries and corporate operations through 1995 were discounted at rates approximating the Corporation's adjusted weighted average cost of capital. Terminal value was determined by capitalizing the 1995 projected results. Liabilities were stated at fair market value. The difference between the Reorganization Value of the assets and the fair market value of the liabilities was recorded as stockholders' equity with retained earnings restated to zero. In accordance with SOP 90-7, individual assets and liabilities were adjusted to fair market value as of May 6, 1993. The portion of the Reorganization Value not attributable to specific assets ("EXCESS REORGANIZATION VALUE") will be amortized over a five year period. Adjustments were made to the historical balances of inventory, property, plant and equipment, purchased goodwill, long- term debt, various accrued liabilities and other long-term liabilities. The following balance sheet details the adjustments that were made as of May 6, 1993 to record the Restructuring and implement fresh start accounting: USG CORPORATION (PREDECESSOR COMPANY) CONSOLIDATED BALANCE SHEET AS OF MAY 6, 1993 (DOLLARS IN MILLIONS) REORGANIZATION ITEMS In connection with the Restructuring, the Corporation recorded a one-time reorganization items gain of $709 million in the period of January 1 through May 6, 1993. The (income)/expense components of this gain are as follows (dollars in millions): EXTRAORDINARY GAIN Also in connection with the Restructuring, the Corporation recorded a one- time after-tax extraordinary gain of $944 million in the period of January 1 through May 6, 1993. The income/(expense) components of this gain are as follows (dollars in millions): CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES A one-time after-tax charge of $150 million was recorded in the first quarter of 1993 representing the adoption of Statement of Financial Accounting Standard ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," - $180 million, partially offset by the adoption of SFAS No. 109, "Accounting for Income Taxes," - $30 million. See "Postretirement Benefits" and "Taxes on Income and Deferred Taxes" notes for information on the adoption of these standards. Neither of these standards impact cash flow. DISCONTINUED OPERATIONS Results for DAP are set forth separately as discontinued operations in the accompanying consolidated financial statements and supplementary data schedules up to September 20, 1991, the completion date of the sale of the business and substantially all of the assets. Operating results for DAP in 1991 included net sales of $128 million, taxes on income of $1 million and breakeven net earnings. In the second quarter of 1991, the Corporation absorbed an expense provision of $20 million related to the disposition of DAP, net of related income tax expense of $8 million. An expense provision of $41 million, net of a related income tax benefit of $2 million, was previously recorded in the fourth quarter of 1990. Net proceeds from the transaction amounted to approximately $84 million. In connection with the execution of the DAP sale agreement, the Banks consented to the sale as required under the Old Credit Agreement subject to an agreement by the Corporation and DAP to deposit the proceeds in a bank account to be held exclusively for use in the Restructuring. As a result, these funds, and interest earned on these funds, were maintained on an interim basis in a restricted bank account and were classified as restricted cash in the Consolidated Balance Sheet until their release in connection with the Restructuring. RESEARCH AND DEVELOPMENT Research and development expenditures are charged to earnings as incurred and amounted to $4 million, $14 million and $12 million in the period of January 1 through May 6, 1993 and in the years ended December 31, 1992 and 1991, respectively. TAXES ON INCOME AND DEFERRED INCOME TAXES Effective January 1, 1993, the Corporation adopted SFAS No. 109, "Accounting for Income Taxes." The cumulative effect as of January 1, 1993 of adopting SFAS No. 109 was a one-time benefit to first quarter 1993 net earnings of $30 million, primarily due to adjusting deferred taxes from historical to current tax rates. Financial statements for periods prior to January 1, 1993 have not been restated to reflect the adoption of this standard. Earnings/(loss) from continuing operations before taxes on income, extraordinary gain and changes in accounting principles consisted of the following (dollars in millions): Taxes on income/(income tax benefit) consisted of the following (dollars in millions): The difference between the statutory U.S. Federal income tax/(benefit) rate and the Corporation's effective income tax/(benefit) rate is summarized as follows: Temporary differences and carryforwards which give rise to current and long- term deferred tax (assets)/liabilities as of May 6, 1993 were as follows (dollars in millions): A valuation allowance has been provided for deferred tax assets relating to pension and retiree medical benefits due to the long-term nature of their realization. Because of the uncertainty regarding the application of the Code to the Corporation's NOL Carryforwards as a result of the Prepackaged Plan, no deferred tax asset is recorded. The Corporation has NOL Carryforwards of $113 million remaining from 1992 after a reduction due to cancellation of indebtedness from the Prepackaged Plan. These NOL Carryforwards may be used to offset U.S. taxable income through 2007. The Code will limit the Corporation's annual use of its NOL Carryforwards to the lesser of its taxable income or approximately $30 million plus any unused limit from prior years. Furthermore, due to the uncertainty regarding the application of the Code to the exchange of stock for debt, the Corporation's NOL Carryforwards could be further reduced or eliminated. The Corporation has a $3 million minimum tax credit which may be used to offset U.S. regular tax liability in future years. During 1991 and 1992, deferred income taxes resulted from certain items being treated differently for financial reporting purposes than for income tax purposes. The tax effect of such differences is summarized as follows (dollars in millions): The Corporation does not provide for U.S. Federal income taxes on the portion of undistributed earnings of foreign subsidiaries which are intended to be permanently reinvested. The cumulative amount of such undistributed earnings totaled approximately $75 million as of May 6, 1993. Any future repatriation of undistributed earnings would not, in the opinion of management, result in significant additional taxes. INVENTORIES In accordance with the implementation of fresh start accounting, inventories were stated at fair market value as of May 6, 1993. Most of the Corporation's domestic and Mexican inventories are valued under the LIFO method. As of May 6, 1993, the LIFO values of these inventories were $103 million and would have been the same if they were valued under the FIFO and average production cost methods. Inventories valued under the LIFO method totaled $72 million as of December 31, 1992 and would have been $25 million higher if they were valued under the FIFO and average production cost methods. The remaining inventories as of December 31, 1992 were stated at the lower of cost or market, under the FIFO or average production cost methods. Inventories include material, labor and applicable factory overhead costs. Inventory classifications were as follows (dollars in millions): The LIFO value of U.S. domestic inventories under fresh start accounting exceeded that computed for U.S. Federal income tax purposes by $26 million as of May 6, 1993. As of December 31, 1992, the LIFO value of USG Interiors' inventories acquired under the purchase method exceeded that computed for U.S. Federal income tax purposes by $6 million. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment were stated at fair market value as of May 6, 1993 in accordance with fresh start accounting and at cost as of December 31, 1992. Provisions for depreciation are determined principally on a straight-line basis over the expected average useful lives of composite asset groups. Depletion is computed on a basis calculated to spread the cost of gypsum and other applicable resources over the estimated quantities of material recoverable. Interest during construction is capitalized on major property additions. Property, plant and equipment classifications were as follows (dollars in millions): LEASES The Corporation leases certain of its offices, buildings, machinery and equipment, and autos under noncancellable operating leases. These leases have various terms and renewal options. Lease expense amounted to $11 million, $31 million and $26 million in the period of January 1 through May 6, 1993 and in the years ended December 31, 1992 and 1991, respectively. INDEBTEDNESS Total debt, including currently maturing debt, consisted of the following (dollars in millions): As of May 6, 1993, the Corporation and its subsidiaries had $1,556 million total principal amount of debt (before unamortized reorganization discount) on a consolidated basis. Of such total debt, $118 million represented direct borrowings by the subsidiaries, including $38 million of industrial revenue bonds, $41 million of 7 7/8% sinking fund debentures issued by U.S. Gypsum in 1974 and subsequently assumed by the Corporation on a joint and several basis in 1985, $33 million of debt (primarily project financing) incurred by the Corporation's foreign subsidiaries other than CGC, $4 million of working capital borrowings by CGC, and $3 million of other long-term borrowings by CGC. Throughout the Restructuring process (from December 31, 1990 through May 6, 1993), most long-term debt issues were included in current liabilities due to various defaults upon certain of the debt issues which allowed for the possible triggering of acceleration and cross-acceleration provisions. Upon consummation of the Prepackaged Plan, all previously existing defaults were waived or cured and long-term debt included in current liabilities was treated in accordance with the Prepackaged Plan as described in "Financial Restructuring" note above. The Bank Debt and most other senior debt are secured by a pledge of all of the shares of the Corporation's major domestic subsidiaries and 65% of the shares of certain of its foreign subsidiaries, including CGC, pursuant to a collateral trust arrangement controlled primarily by holders of the Bank Debt. The rights of the Corporation and its creditors to the assets of any subsidiary upon the latter's liquidation or reorganization will be subject to the prior claims of such subsidiary's creditors, except to the extent that the Corporation may itself be a creditor with enforceable claims against such subsidiary. The average rate of interest on the Bank Term Loan, excluding default interest which was cured or waived in accordance with the Prepackaged Plan, was 6.5% in the period of January 1 through May 6, 1993. The rate of interest on the Capitalized Interest Notes issued on May 6, 1993 in connection with the provisions of the Prepackaged Plan was 5.4% based on LIBOR plus 2 1/4%. The "Other Secured Debt" category shown in the table above primarily includes short-term and long-term borrowings from several foreign banks by USG International used principally to finance construction of the Aubange, Belgium ceiling tile plant. This debt is secured by a lien on the assets of the Aubange plant and has restrictive covenants that restrict, among other things, the payment of dividends. Foreign borrowings made by the Corporation's international operations are generally allowed, within certain limits, under provisions of the Credit Agreement. In general, the Credit Agreement restricts, among other things, the incurrence of additional indebtedness, mergers, asset dispositions, investments, prepayment of other debt, dealings with affiliates, capital expenditures, payment of dividends and lease commitments. The fair market value of debt as of May 6, 1993 was $1,421 million, based on estimates of fair market value calculated in connection with implementation of fresh start accounting, excluding other secured debt, primarily representing financing for construction of the Aubange plant that is secured by a direct lien on its assets, which was not practicable to estimate. As of December 31, 1992, the fair market value of debt amounted to $679 million, based on indicative bond prices as of that date excluding the following items which were not practicable to estimate: (i) the bank debt for which there was no active market; (ii) the 7 7/8% senior debentures due 2004 virtually all of which were owned by a single investment group; and (iii) the other secured debt which primarily represented financing for construction of the Aubange plant as described above. PENSION PLANS The Corporation and most of its subsidiaries have defined benefit retirement plans for all eligible employees. Benefits of the plans are generally based on years of service and employees' compensation during the last years of employment. The Corporation's contributions are made in accordance with independent actuarial reports which, for most plans, required minimal funding in the period of January 1 through May 6, 1993 and the years ended December 31, 1992 and 1991. Net pension expense/(benefit) included the following components (dollars in millions): The pension plan assets, which consist primarily of publicly traded common stocks and debt securities, had an estimated fair market value that equaled the projected benefit obligation as of May 6, 1993 and exceeded the projected benefit obligation as of December 31, 1992. The following table presents a reconciliation of the total assets of the pension plans to the projected benefit obligation (dollars in millions): Assets in excess of projected benefit obligation consisted of the following (dollars in millions): The expected long-term rate of return on plan assets was 9% for both the period of January 1 through May 6, 1993 and the year ended December 31, 1992. The assumed weighted average discount rate used in determining the accumulated benefit obligation was 8% and 9% as of May 6, 1993 and December 31, 1992, respectively. The rate of increases in projected future compensation levels was 5.5% for the period of January 1 through May 6, 1993 and the year ended December 31, 1992. The unrecognized cost of retroactive benefits granted by plan amendments was being amortized over 13 years as of December 31, 1992. POSTRETIREMENT BENEFITS The Corporation maintains plans that provide retiree health care and life insurance benefits for all eligible employees. Employees generally become eligible for the retiree benefit plans when they meet minimum retirement age and service requirements. The cost of providing most of these benefits is shared with retirees. Effective January 1, 1993, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," for its retiree benefit plans. Under this accounting standard, the Corporation is required to accrue the estimated cost of retiree benefit payments during employees' active service period. The Corporation elected to recognize this change in accounting principles on the immediate recognition basis. The cumulative effect as of January 1, 1993 of adopting SFAS No. 106 was a one-time after-tax charge to first quarter 1993 net earnings of $180 million. The Corporation previously expensed the cost of these benefits, which principally relate to health care, as claims were incurred. These costs were $8 million and $7 million in the years ended December 31, 1992 and 1991, respectively. The following table summarizes the components of net periodic postretirement benefit cost for the period of January 1 through May 6, 1993 (dollars in millions): The status of the Corporation's accrued postretirement benefit cost as of May 6, 1993 was as follows (dollars in millions): The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 13% as of May 6, 1993 with a gradually declining rate to 6% by the year 2000 and remaining at that level 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 May 6, 1993 by $18 million and increase the net periodic postretirement benefit cost for the period of January 1 through May 6, 1993 by $1 million. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 8%. MANAGEMENT PERFORMANCE PLAN The Performance Plan reserved 8,600,000 shares of Common Stock for issuance in connection with grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, deferred stock, performance shares and performance units. In accordance with the Prepackaged Plan, all outstanding stock options (for 3,786,575 shares) were cancelled without consideration, 1,016,090 shares of restricted and deferred stock were cashed-out pursuant to "change in control" provisions contained in the Performance Plan, and 25,580 shares (after giving effect to the Reverse Stock Split) of restricted stock and awards for deferred stock yet to be issued remained outstanding as a consequence of certain waivers of the change in control event by senior members of management. Limitations on the Performance Plan in accordance with the Prepackaged Plan provide that: (i) options to purchase a number of shares not to exceed 7.5% of the number of shares of New Common Stock outstanding immediately after giving effect to the Reverse Stock Split and all distributions of New Common Stock under the Prepackaged Plan will be reserved for management incentives (2,788,350 shares); (ii) a portion of such options (not to exceed 4.5% of such number of outstanding shares) may be granted immediately upon consummation of the Prepackaged Plan; (iii) prior to June 22, 1997, the Corporation will not issue, award or grant, for compensatory purposes, any stock (including restricted and deferred stock grants and awards), stock options, stock appreciation rights or other stock-based awards, except for the options described above or as may otherwise be approved by the Corporation's stockholders; and (iv) reference to the year "1988" is deleted from the name of the Performance Plan. PREFERRED SHARE PURCHASE RIGHTS On June 6, 1988, the Corporation adopted a Preferred Share Purchase Rights Plan and pursuant to its provisions declared, subject to the consummation of the 1988 Recapitalization, the distribution of one Right upon each new share of Common Stock issued in the 1988 Recapitalization. The 1988 Recapitalization became effective July 13, 1988 and the distribution occurred immediately thereafter. The Rights contain provisions which are intended to protect stockholders in the event of an unsolicited attempt to acquire the Corporation. The Preferred Share Purchase Rights Plan was terminated in connection with implementation of the Prepackaged Plan. On May 6, 1993, the Rights Agreement was adopted with provisions substantially similar to the old rights except that: (i) the purchase price of the Rights was reset; (ii) the expiration of the Rights was extended; (iii) a so-called "flip-in" feature and exchange feature was added; (iv) certain exemptions were added permitting certain acquisitions and the continued holding of common shares by Water Street and its affiliates in excess of the otherwise specified thresholds; (v) the redemption price was reduced; and (vi) the amendment provision was liberalized. Under the terms of the Rights Agreement and subject to certain exceptions for Water Street and its affiliates, generally the Rights become exercisable (i) 10 days following the date of a public announcement that a person or group of affiliated or associated persons (an "ACQUIRING PERSON"), other than the Corporation, any employee benefit plan of the Corporation, any entity holding Common Stock for or pursuant to the terms of any such plan has beneficial ownership (as defined in the Rights Agreement) of 20% or more of the then outstanding Common Stock, (ii) 10 days following the date of a public announcement that a person or group of affiliated or associated persons (an "ADVERSE PERSON") has beneficial ownership of 10% or more of the then outstanding Common Stock, the acquisition of which has been determined by the Board to present an actual threat of an acquisition of the Corporation that would not be in the best interest of the Corporation's stockholders or (iii) 10 days following the date of commencement of, or public announcement of, a tender offer or exchange offer for 30% or more of the Common Stock. When exercisable, each of the Rights entitles the registered holder to purchase one-hundredth of a share of a junior participating preferred stock, series C, $1.00 par value per share, at a price of $35.00 per one-hundredth of a preferred share, subject to adjustment. In the event that the Corporation is the surviving corporation in a merger or other business combination involving an Acquiring Person or an Adverse Person and the Common Stock remains outstanding and unchanged or in the event that an Acquiring Person or an Adverse Person engages in one of a number of self-dealing transactions specified in the Rights Agreement, proper provision will be made so that each holder of a Right, other than Rights that are or were beneficially owned (as defined in the Rights Agreement) by the Acquiring Person or the Adverse Person, as the case may be, on the earliest of the Distribution Date, the date the Acquiring Person acquires 20% or more of the outstanding Common Stock or the date the Adverse Person becomes such (which will thereafter be void), will thereafter have the right to receive upon exercise thereof that number of shares of Common Stock having a market value at the time of such transaction of two times the exercise price of the Right. In addition, under certain circumstances the Board has the option of exchanging all or part of the Rights (excluding void Rights) for Common Stock in the manner described in the Rights Agreement. The Rights Agreement also contains a so-called "flip-in" feature which provides that if any person or group of affiliated or associated persons becomes an Adverse Person, then the provisions of the preceding two sentences shall apply. WARRANTS On May 6, 1993, a total of 2,602,566 Warrants were issued to holders of the Old Junior Subordinated Debentures in addition to the shares of Common Stock issued to such holders, all as provided by the Prepackaged Plan. Upon issuance, each of the Warrants entitled the holder to purchase one share of Common Stock at a purchase price of $16.14 per share, subject to adjustment under certain events. The Warrants are exercisable, subject to applicable securities laws, at any time prior to May 6, 1998. Each share of Common Stock issued upon exercise of a Warrant prior to the Distribution Date (as defined in the Rights Agreement) and prior to the redemption or expiration of the Rights will be accompanied by an attached Right issued under the terms and subject to the conditions of the Rights Agreement as it may then be in effect. STOCKHOLDERS' EQUITY Changes in stockholders' equity are summarized as follows (dollars in millions): The Corporation is authorized to issue 36,000,000 shares of $1 par value preferred stock, however, none were outstanding as of May 6, 1993 or December 31, 1992. As of May 6, 1993, the number of authorized shares of Common Stock, $0.10 par value, was 200,000,000 shares, reduced from 300,000,000 shares in accordance with the Prepackaged Plan. After giving effect to the Reverse Stock Split and distribution of New Common Stock pursuant to the Prepackaged Plan, there were 37,157,458 shares of Common Stock outstanding, excluding 27,556 shares held in treasury, as of May 6, 1993. As of December 31, 1992, there were 55,757,394 shares of Common Stock outstanding, after deducting 368,409 shares held in treasury. The treasury shares were acquired through the forfeiture of restricted stock. LITIGATION One of the Corporation's subsidiaries, U.S. Gypsum, is among numerous defendants in lawsuits arising out of the manufacture and sale of asbestos- containing building materials. U.S. Gypsum sold certain asbestos-containing products beginning in the 1930's; in most cases the products were discontinued or asbestos was removed from the product formula by 1972, and no asbestos- containing products were sold after 1977. Some of these lawsuits seek to recover compensatory and in many cases punitive damages for costs associated with maintenance or removal and replacement of products containing asbestos (the "PROPERTY DAMAGE CASES"). Others of these suits (the "PERSONAL INJURY CASES") seek to recover compensatory and in many cases punitive damages for personal injury allegedly resulting from exposure to asbestos and asbestos-containing products. It is anticipated that additional personal injury and property damage cases containing similar allegations will be filed. As discussed below, U.S. Gypsum has substantial personal injury and property damage insurance for the years involved in the asbestos litigation. Prior to 1985, when an asbestos exclusion was added to U.S. Gypsum's policies, U.S. Gypsum purchased comprehensive general liability insurance policies covering personal injury and property damage in an aggregate face amount of approximately $850 million. Insurers that issued approximately $100 million of these policies are presently insolvent. Because U.S. Gypsum's insurance carriers initially responded to its claims for defense and indemnification with various theories denying or limiting coverage and the applicability of their policies, U.S. Gypsum filed a declaratory judgment action against them in the Circuit Court of Cook County, Illinois on December 29, 1983. (U.S. GYPSUM CO. V. ADMIRAL INSURANCE CO., ET AL.) (the "COVERAGE ACTION"). U.S. Gypsum alleges in the Coverage Action that the carriers are obligated to provide indemnification for settlements and judgments and, in some cases, defense costs incurred by U.S. Gypsum in personal injury and property damage cases in which it is a defendant. The current defendants are ten insurance carriers that provided comprehensive general liability insurance coverage to U.S. Gypsum between the 1940's and 1984. As discussed below, several carriers have settled all or a portion of the claims in the Coverage Action. U.S. Gypsum's aggregate expenditures for all asbestos-related matters, including property damage, personal injury, insurance coverage litigation and related expenses, exceeded aggregate insurance payments by $10.9 million and $25.8 million in the years ended December 31, 1991 and 1992, respectively, and by $3.8 million in the period of January 1 through May 6, 1993. PROPERTY DAMAGE CASES The Property Damage Cases have been brought against U.S. Gypsum by a variety of plaintiffs, including school districts, state and local governments, colleges and universities, hospitals, and private property owners. U.S. Gypsum is one of many defendants in four cases that have been certified as class actions and others that request such certification. One class action suit is brought on behalf of owners and operators of all elementary and secondary schools in the United States that contain or contained friable asbestos-containing material. (IN RE ASBESTOS SCHOOL LITIGATION, U.S.D.C., E.D. Pa.) Approximately 1,350 school districts opted out of the class, some of which have filed or may file separate lawsuits or are participants in a state court class action involving approximately 333 school districts in Michigan. (BOARD OF EDUCATION OF THE CITY OF DETROIT, ET AL. V. THE CELOTEX CORP., ET AL., Cir. Ct. for Wayne County, Mich.) On April 10, 1992, a state court in Philadelphia certified a class consisting of all owners of buildings leased to the federal government. (PRINCE GEORGE CENTER, INC. V. U.S. GYPSUM CO., ET AL., Ct. of Common Pleas, Philadelphia, Pa.) On September 4, 1992, a Federal district court in South Carolina conditionally certified a class comprised of all colleges and universities in the United States, which certification is presently limited to the resolution of certain allegedly "common" liability issues. (CENTRAL WESLEYAN COLLEGE, V. W.R. GRACE & CO., ET AL., U.S.D.C., S.C.). On December 23, 1992, a case was filed in state court in South Carolina purporting to be a "voluntary" class action on behalf of owners of all buildings containing certain types of asbestos-containing products manufactured by the nine named defendants, including U.S. Gypsum, other than buildings owned by the federal or state governments, single family residences, or buildings at issue in the four above described class actions (ANDERSON COUNTY HOSPITAL V. W.R. GRACE & CO., ET AL., Court of Common Pleas, Hampton Co., S.C. (the "ANDERSON CASE"). On January 14, 1993, the plaintiff filed an amended complaint that added a number of defendants, including the Corporation. The amended complaint alleges, among other things, that the guarantees executed by U.S. Gypsum in connection with the 1988 Recapitalization, as well as subsequent distributions of cash from U.S. Gypsum to the Corporation, rendered U.S. Gypsum insolvent and constitute a fraudulent conveyance. The suit seeks to set aside the guarantees and recover the value of the cash flow "diverted" from U.S. Gypsum to the Corporation in an amount to be determined. This case has not been certified as a class action and no other threshold issues, including whether the South Carolina Courts have personal jurisdiction over the Corporation, have been decided. The damages claimed against U.S. Gypsum in the class action cases are unspecified. U.S. Gypsum has denied the substantive allegations of each of the Property Damage Cases and intends to defend them vigorously except when advantageous settlements are possible. As of May 6, 1993, 67 Property Damage Cases were pending against U.S. Gypsum; however, the number of buildings involved is greater than the number of cases because many of these cases, including the class actions referred to above, involve multiple buildings. Approximately 40 property damage claims have been threatened against U.S. Gypsum. In total, U.S. Gypsum has settled property damage claims of approximately 187 plaintiffs involved in approximately 71 cases. Twenty-two cases have been tried to verdict, 13 of which were won by U.S. Gypsum and 7 lost; two other cases, one won at the trial level and one lost, were settled after appeals. Appeals are pending in 4 of the tried cases. In the cases lost, compensatory damage awards against U.S. Gypsum have totaled $12.5 million. Punitive damages totaling $5.5 million were entered against U.S. Gypsum in four trials. Two of the punitive damage awards, totaling $1.45 million, were paid after appeals were exhausted; a third was settled after the verdict was reversed on appeal. The remaining punitive award is on appeal. In 1991, 13 new Property Damage Cases were filed against U.S. Gypsum, 11 were dismissed before trial, 8 were settled, 2 were closed following trial or appeal, and 100 were pending at year end; U.S. Gypsum expended $22.2 million for the defense and resolution of Property Damage Cases and received insurance payments of $13.8 million in 1991. In 1992, 7 new Property Damage Cases were filed against U.S. Gypsum, 10 were dismissed before trial, 18 were settled, 3 were closed following trial or appeal, and 76 were pending at year end. U.S. Gypsum expended $34.9 million for the defense and resolution of Property Damage Cases and received insurance payments of $10.2 million in 1992. In the period of January 1 through May 6, 1993, no new Property Damage Cases were filed against U.S. Gypsum, 2 were dismissed before trial, 7 were settled, and 67 were pending at the end of the period. U.S. Gypsum expended $7.0 million for the defense and resolution of Property Damage Cases and received insurance payments of $3.7 million in the period. In the Property Damage Cases litigated to date, a defendant's liability for compensatory damages, if any, has been limited to damages associated with the presence and quantity of asbestos- containing products manufactured by that defendant which are identified in the buildings at issue, although plaintiffs in some cases have argued that principles of joint and several liability should apply. Because of the unique factors inherent in each of the Property Damage Cases, including the lack of reliable information as to product identification and the amount of damages claimed against U.S. Gypsum in many cases, including the class actions described above, management is unable to make a reasonable estimate of the cost of disposing of pending Property Damage Cases. PERSONAL INJURY CASES U.S. Gypsum was among numerous defendants in asbestos personal injury suits and administrative claims involving 57,645 claimants pending as of May 6, 1993. All asbestos bodily injury claims pending in the federal courts, including approximately one-third of the Personal Injury Cases pending against U.S.Gypsum, have been consolidated in the United States District Court for the Eastern District of Pennsylvania. U.S. Gypsum is a member, together with 19 other former producers of asbestos- containing products, of the Center for Claims Resolution (the "CENTER"). The Center has assumed the handling, including the defense and settlement, of all Personal Injury Cases pending against U.S. Gypsum and the other members of the Center. Each member of the Center is assessed a portion of the liability and defense costs of the Center for the Personal Injury Cases handled by the Center, according to predetermined allocation formulas. Five of U.S. Gypsum's insurance carriers that in 1985 signed an Agreement Concerning Asbestos-Related Claims (the "WELLINGTON AGREEMENT") are supporting insurers (the "SUPPORTING INSURERS") of the Center. The Supporting Insurers are obligated to provide coverage for the defense and indemnity costs of the Center's members pursuant to the coverage provisions in the Wellington Agreement. Claims for punitive damages are defended but not paid by the Center; if punitive damages are recovered, insurance coverage may be available under the Wellington Agreement depending on the terms of particular policies and applicable state law. Punitive damages have not been awarded against U.S. Gypsum in any of the Personal Injury Cases. Virtually all of U.S. Gypsum's personal injury liability and defense costs are paid by those of its insurance carriers that are Supporting Insurers. The Supporting Insurers provided approximately $350 million of the total coverage referred to above. On January 15, 1993, U.S. Gypsum and the other members of the Center were named as defendants in a class action filed in the U.S. District Court for the Eastern District Pennsylvania (GEORGINE ET AL. V. AMCHEM PRODUCTS INC., ET AL., Case No. 93-CV-0215) (hereinafter "GEORGINE," formerly known as "CARLOUGH"). The complaint generally defines the class of plaintiffs as all persons who have been occupationally exposed to asbestos-containing products manufactured by the defendants and who had not filed an asbestos personal injury suit as of the date of the filing of the class action. Simultaneously with the filing of the class action, the parties filed a settlement agreement in which the named plaintiffs, proposed class counsel, and the defendants agreed to settle and compromise the claims of the proposed class. The settlement, if approved by the court, will implement for all future Personal Injury Cases, except as noted below, an administrative compensation system to replace judicial claims against the defendants, and will provide fair and adequate compensation to future claimants who can demonstrate exposure to asbestos-containing products manufactured by the defendants and the presence of an asbestos-related disease. Class members will be given the opportunity to "opt out," or elect to be excluded from the settlement, although the defendants reserve the right to withdraw from the settlement if the number of opt outs is, in their sole judgment, excessive. In addition, in each year a limited number of claimants will have certain rights to prosecute their claims for compensatory (but not punitive) damages in court in the event they reject compensation offered by the administrative processing of their claim. The Center members, including U.S. Gypsum, have instituted proceedings against those of their insurance carriers that had not consented to support the settlement, seeking a declaratory judgment that the settlement is reasonable and, therefore, that the carriers are obligated to fund their portion of it. Consummation of the settlement is contingent upon, among other things, court approval of the settlement and a favorable ruling in the declaratory judgment proceedings against the non-consenting insurers. It is anticipated that appeals will follow the district court's ruling on the fairness and reasonableness of the settlement. Each of the defendants has committed to fund a defined portion of the settlement, up to a stated maximum amount, over the initial ten-year period of the agreement (which is automatically extended unless terminated by the defendants). Taking into account the provisions of the settlement agreement concerning the maximum number of claims that must be processed in each year and the total amount to be made available to the claimants, the Center estimates that U.S. Gypsum will be obligated to fund a maximum of approximately $125 million of the class action settlement, exclusive of expenses, with a maximum payment of less than $18 million in any single year; of the total amount of U.S. Gypsum's obligation, all but approximately $13 million or less is expected to be paid by U.S. Gypsum's insurance carriers. During 1991, approximately 13,100 Personal Injury Cases were filed against U.S. Gypsum and approximately 6,300 were settled or dismissed. U.S. Gypsum incurred expenses of $15.1 million in 1991 with respect to Personal Injury Cases, of which $15.0 million was paid by insurance. During 1992, approximately 20,100 Personal Injury Cases were filed against U.S. Gypsum and approximately 10,600 were settled or dismissed. U.S. Gypsum incurred expenses of $21.6 million in 1992 with respect to Personal Injury Cases of which $21.5 million was paid by insurance. In the period of January 1 through May 6, 1993, approximately 8,700 Personal Injury Cases were filed against U.S. Gypsum and approximately 5,300 were settled or dismissed. U.S. Gypsum incurred expenses of $10.9 million in the period with respect to Personal Injury Cases of which $10.8 million was paid by insurance. As of May 6, 1993, December 31, 1992 and December 31, 1991, approximately 58,000, 54,000 and 43,000 Personal Injury Cases were outstanding against U.S. Gypsum, respectively. U.S. Gypsum's average settlement cost for Personal Injury Cases over the past three years has been approximately $1,350 per claim, exclusive of defense costs. Management anticipates that its average settlement cost is likely to increase due to such factors as the possible insolvency of co-defendants, although this increase may be offset to some extent by other factors, including the possibility for block settlements of large numbers of cases and the apparent increase in the percentage of asbestos personal injury cases that appear to have been brought by individuals with little or no physical impairment. In management's opinion, based primarily upon U.S. Gypsum's experience in the Personal Injury Cases disposed of to date and taking into consideration a number of uncertainties, it is probable that asbestos-related Personal Injury Cases pending against U.S. Gypsum as of December 31, 1992, can be disposed of for an amount estimated to be between $80 million and $100 million, including both indemnity costs and legal fees and expenses. The estimated cost of resolving pending claims takes into account, among other factors, (i) an increase in the number of pending claims; (ii) the settlements of certain large blocks of claims for higher per-case averages than have historically been paid; and (iii) a slight increase in U.S. Gypsum's historical settlement average. No accrual has been recorded for this amount because, pursuant to the Wellington Agreement, U.S. Gypsum's Supporting Insurers are obligated to pay these costs. Assuming that the Georgine class action settlement referred to above is approved substantially in its current form, management estimates, based on assumptions supplied by the Center, U.S. Gypsum's maximum total exposure in Personal Injury Cases during the next ten years (the initial term of the agreement), including liability for pending claims, claims resolved as part of the class action settlement, and opt out claims, as well as defense costs and other expenses, at approximately $271 million, of which at least $254 million is expected to be paid by insurance. U.S. Gypsum's additional exposure for claims filed by persons who have opted out of Georgine would depend on the number of such claims that are filed, which cannot presently be determined. COVERAGE ACTION As indicated above, all of U.S. Gypsum's carriers initially denied coverage for the Property Damage Cases and the Personal Injury Cases, and U.S. Gypsum initiated the Coverage Action to establish its right to such coverage. U.S. Gypsum has voluntarily dismissed the Supporting Insurers referred to above from the personal injury portion of the Coverage Action because they are committed to providing personal injury coverage in accordance with the Wellington Agreement. U.S. Gypsum's claims against the remaining carriers for coverage for the Personal Injury Cases have been stayed since 1984. On January 7, 1991, the trial court in the Coverage Action ruled on the applicability of U.S. Gypsum's insurance policies to settlements and one adverse judgment in eight Property Damage Cases. The court ruled that the eight cases were generally covered, and imposed coverage obligations on particular policy years based upon the dates when the presence of asbestos-containing material was "first discovered" by the plaintiff in each case. The court awarded reimbursement of approximately $6.2 million spent by U.S. Gypsum to resolve the eight cases. U.S. Gypsum has appealed the court's ruling with respect to the policy years available to cover particular claims, and the carriers have appealed most other aspects of the court's ruling. These appeals are likely to take a year or more. U.S. Gypsum's experience in the Property Damage Cases suggests that "first discovery" dates in the eight cases referred to above (1978 through 1985) are likely to be typical of most pending cases. U.S. Gypsum's total insurance coverage for the years 1978 through 1984 totals approximately $350 million (after subtracting insolvencies and discounts given to settling carriers). However, some pending cases, as well as some cases filed in the future, may be found to have first discovery dates later than August 1, 1984, after which U.S. Gypsum's insurance policies did not provide coverage for asbestos-related claims. In addition, as described below, the first layer excess carrier for the years 1980 through 1984 is insolvent and U.S. Gypsum may be required to pay amounts otherwise covered by those and other insolvent policies. Accordingly, if the court's ruling is affirmed, U.S. Gypsum will likely be required to bear a portion of the cost of the property damage litigation. Eight carriers, including two of the Supporting Insurers, have settled U.S. Gypsum's claims for both property damage and personal injury coverage and have been dismissed from the Coverage Action entirely. Four of these carriers have agreed to pay all or a substantial portion of their policy limits to U.S. Gypsum beginning in 1991 and continuing over the next four years. Three other excess carriers, including the two settling Supporting Insurers, have agreed to provide coverage for the Property Damage Cases and the Personal Injury Cases subject to certain limitations and conditions, when and if underlying primary and excess coverage is exhausted. It cannot presently be determined when such coverage might be reached. Taking into account the above settlements, including participation of certain of the settling carriers in the Wellington Agreement, and consumption through December 31, 1992, carriers providing a total of approximately $97 million of unexhausted insurance have agreed, subject to the terms of the various settlement agreements, to cover both Personal Injury Cases and Property Damage Cases. Carriers providing an additional $276 million of coverage that was unexhausted as of December 31, 1992 have agreed to cover Personal Injury Cases under the Wellington Agreement, but continue to contest coverage for Property Damage Cases and remain defendants in the Coverage Action. U.S. Gypsum will continue to seek negotiated resolutions with its carriers in order to minimize the expense and delays of litigation. Insolvency proceedings have been instituted against four of U.S. Gypsum's insurance carriers. Midland Insurance Company, declared insolvent in 1986, provided excess insurance ($4 million excess of $1 million excess of $500,000 primary in each policy year) from February 15, 1975 to February 15, 1978; Transit Casualty Company, declared insolvent in 1985, provided excess insurance ($15 million excess of $1 million primary in each policy year) from August 1, 1980 to December 31, 1985; Integrity Insurance Company, declared insolvent in 1986, provided excess insurance ($10 million quota share of $25 million excess of $90 million) from August 1, 1983 to July 31, 1984; and American Mutual Insurance Company, declared insolvent in 1989, provided the primary layer of insurance ($500,000 per year) from February 1, 1963 to April 15, 1971. It is possible that U.S. Gypsum will be required to pay a presently indeterminable portion of the costs that would otherwise have been covered by these policies. It is not possible to predict the number of additional lawsuits alleging asbestos-related claims that may be filed against U.S. Gypsum. The number of Personal Injury Claims pending against U.S. Gypsum has increased in each of the last several years. In addition, many Property Damage Cases are still at an early stage and the potential liability therefrom is consequently uncertain. In view of the limited insurance funding currently available for the Property Damage Cases resulting from the continued resistance by a number of U.S. Gypsum's insurers to providing coverage, the effect of the asbestos litigation on the Corporation will depend upon a variety of factors, including the damages sought in the Property Damage Cases that reach trial prior to the completion of the Coverage Action, U.S. Gypsum's ability to successfully defend or settle such cases, and the resolution of the Coverage Action. As a result, management is unable to determine whether an adverse outcome in the asbestos litigation will have a material adverse effect on the results of operations or the consolidated financial position of the Corporation. ENVIRONMENTAL LITIGATION The Corporation and certain of its subsidiaries have been notified by state and federal environmental protection agencies of possible involvement as one of numerous "potentially responsible parties" in a number of so-called "Superfund" sites in the United States. In substantially all of these sites, the involvement of the Corporation or its subsidiaries is expected to be minimal. The Corporation believes that appropriate reserves have been established for its potential liability in connection with all Superfund sites but is continuing to review its accruals as additional information becomes available. Such reserves take into account all known or estimable costs associated with these sites including site investigations and feasibility costs, site cleanup and remediation, legal costs, and fines and penalties, if any. In addition, environmental costs connected with site cleanups on USG-owned property are also covered by reserves established in accordance with the foregoing. The Corporation believes that neither these matters nor any other known governmental proceeding regarding environmental matters will have a material adverse effect upon its earnings or consolidated financial position. GEOGRAPHIC AND INDUSTRY SEGMENTS Transactions between geographic areas are accounted for on an "arm's-length" basis. No single customer accounted for 4% or more of consolidated net sales. Export sales to foreign unaffiliated customers represent less than 10% of consolidated net sales. Intrasegment and intersegment eliminations largely reflect intercompany sales from U.S. Gypsum to L&W Supply. Segment operating profit/(loss) includes all costs and expenses directly related to the segment involved and an allocation of expenses which benefit more than one segment. Geographic and industry segment data for 1991 exclude discontinued operations. To assist the reader in evaluating the profitability of each geographic and industry segment, EBITDA is shown separately in the following tables. EBITDA represents earnings before interest, taxes, depreciation, depletion and amortization. For the period of January 1 through May 6, 1993, the Corporation also added back non-cash postretirement charges, reorganization items, an extraordinary gain and the cumulative impact of changes in accounting principles. The Corporation believes EBITDA is helpful in understanding cash flow generated from operations that is available for taxes, debt service and capital expenditures. In addition, EBITDA facilitates the monitoring of covenants related to certain long-term debt and other agreements entered into in conjunction with the Restructuring. EBITDA should not be considered by investors as an alternative to net earnings as an indicator of the Corporation's operating performance or to cash flows as a measure of its overall liquidity. Certain amounts for 1992 and 1991 have been reclassified to conform to the current period presentation. Variations in the levels of corporate identifiable assets primarily reflect fluctuations in the levels of cash and cash equivalents. Restricted cash of $88 million and $84 million, which represents the proceeds from the sale of DAP, are included in corporate identifiable assets for 1992 and 1991, respectively. SUBSIDIARY DEBT GUARANTEES In May 1993, the Corporation issued $340 million aggregate principal amount of Senior 2002 Notes. Each of U.S. Gypsum, USG Industries, Inc., USG Interiors, USG Foreign Investments, Ltd., L&W Supply, Westbank Planting Company, USG Interiors International, Inc., American Metals Corporation and La Mirada Products Co., Inc. (together, the "COMBINED GUARANTORS") guaranteed, in the manner described below, both the obligations of the Corporation under the Credit Agreement and the Senior 2002 Notes. The Combined Guarantors are jointly and severally liable under the Subsidiary Guarantees. Holders of the Bank Debt have the right to (i) determine whether, when and to what extent the guarantees will be enforced (provided that each guarantee payment will be applied to the Bank Term Loan, Revolving Credit Facility, Capitalized Interest Notes and Senior 2002 Notes pro rata based on the respective amounts owed thereon) and (ii) amend or eliminate the guarantees. The guarantees will terminate when the Bank Term Loan, the Revolving Credit Facility and the Capitalized Interest Notes are retired regardless of whether any Senior 2002 Notes remain unpaid. The liability of each of the Combined Guarantors on its guarantee is limited to the greater of (i) 95% of the lowest amount, calculated as of July 13, 1988, sufficient to render the guarantor insolvent, leave the guarantor with unreasonably small capital or leave the guarantor unable to pay its debts as they become due (each as defined under applicable law) and (ii) the same amount, calculated as of the date any demand for payment under such guarantee is made, in each case plus collection costs. The guarantees are senior obligations of the applicable guarantor and rank PARI PASSU with all unsubordinated obligations of the guarantor. There are 43 Non-Guarantors (the "COMBINED NON-GUARANTORS"), substantially all of which are subsidiaries of Guarantors. The Combined Non-Guarantors primarily include CGC, Gypsum Transportation Limited, USG Canadian Mining Ltd. and the Corporation's Mexican, European and Pacific subsidiaries. The long-term debt of the Combined Non-Guarantors of $28 million as of May 6, 1993 has restrictive covenants that restrict, among other things, the payment of dividends. The following condensed consolidating information presents: (i) Condensed financial statements as of May 6, 1993 and December 31, 1992 and for the period of January 1 through May 6, 1993, and the years ended December 31, 1992 and 1991 of: (a) the Corporation on a parent company only basis (the "PARENT COMPANY," which was the only entity of the Corporation included in the bankruptcy proceeding); (b) the Combined Guarantors; (c) the Combined Non-Guarantors; and (d) the Corporation on a consolidated basis. Due to the Restructuring and implementation of fresh start accounting, the financial statements for the restructured company (periods after May 6, 1993) are not comparable to those of the predecessor company. Except for the following condensed financial statements, separate financial information with respect to the Combined Guarantors is omitted as such separate financial information is not deemed material to investors. (ii) The Parent Company and Combined Guarantors shown with their investments in their subsidiaries accounted for on the equity method. (iii) Elimination entries necessary to consolidate the Parent Company and its subsidiaries. USG CORPORATION (PREDECESSOR COMPANY) CONDENSED CONSOLIDATING STATEMENT OF EARNINGS YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONDENSED CONSOLIDATING STATEMENT OF EARNINGS YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONDENSED CONSOLIDATING BALANCE SHEET AS OF MAY 6, 1993 (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 1992 (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS JANUARY 1 THROUGH MAY 6, 1993 (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) USG CORPORATION MANAGEMENT REPORT Management is responsible for the preparation and integrity of the financial statements and related notes included herein. These statements have been prepared in accordance with generally accepted accounting principles and, of necessity, include some amounts that are based on management's best estimates and judgments. The Corporation's accounting systems include internal controls designed to provide reasonable assurance of the reliability of its financial records and the proper safeguarding and use of its assets. Such controls are based on established policies and procedures, are implemented by trained personnel, and are monitored through an internal audit program. The Corporation's policies and procedures prescribe that the Corporation and its subsidiaries are to maintain ethical standards and that its business practices are to be consistent with those standards. The Audit Committee of the Board, consisting solely of outside Directors of the Corporation, maintains an ongoing appraisal, on behalf of the stockholders, of the effectiveness of the independent auditors and management with respect to the preparation of financial statements, the adequacy of internal controls and the Corporation's accounting policies. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of USG Corporation: We have audited the accompanying consolidated balance sheet of USG Corporation (Predecessor Company), a Delaware corporation, and subsidiaries as of May 6, 1993 and December 31, 1992 and the related consolidated statements of earnings and cash flows for the period of January 1 through May 6, 1993 and for the years ended December 31, 1992 and 1991. 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. As discussed in Notes to Financial Statements - "Financial Restructuring" and "Fresh Start Accounting" notes, on May 6, 1993, the Corporation completed a comprehensive financial restructuring through the implementation of a prepackaged plan of reorganization under Chapter 11 of the United States Bankruptcy Code and applied fresh start accounting. The restructuring resulted in an extraordinary gain of $944 million, primarily from the exchange of debt, and fresh start accounting resulted in a $709 million gain, primarily from revaluing assets and liabilities to reflect reorganization value. These one- time credits to income were recorded as of May 6, 1993 by the Predecessor Company. As such, results of operations through May 6, 1993 (Predecessor Company) are not comparable with results of operations subsequent to that date. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of USG Corporation and subsidiaries as of May 6, 1993 and December 31, 1992, and the results of their operations and their cash flows for the period of January 1 through May 6, 1993 and for the years ended December 31, 1992 and 1991, in conformity with generally accepted accounting principles. As discussed in Notes to Financial Statements - "Litigation" note, in view of the limited insurance funding currently available for property damage cases resulting from the continued resistance by a number of U.S. Gypsum's insurers to providing coverage, the effect of the asbestos litigation on the Corporation will depend upon a variety of factors, including the damages sought in property damage cases that reach trial prior to the completion of the coverage action, U.S. Gypsum's ability to successfully defend or settle such cases, and the resolution of the coverage action. As a result, management is unable to determine whether an adverse outcome in the asbestos litigation will have a material adverse effect on the consolidated results of operations or the consolidated financial position of the Corporation. As discussed in Notes to Financial Statements - "Cumulative Effect of Changes in Accounting Principles" note, on January 1, 1993 the Corporation changed its method of accounting for postretirement benefits other than pensions and accounting for income taxes. ARTHUR ANDERSEN & CO. Chicago, Illinois January 31, 1994 USG CORPORATION (PREDECESSOR COMPANY) SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN MILLIONS) In accordance with fresh start accounting, the Corporation adjusted its property, plant and equipment accounts as of May 6, 1993 to fair market value. Detailed information regarding additions and deductions other than those associated with fresh start accounting is omitted as neither total additions nor total deductions during each of the periods shown above exceeded 10% of the balance at the end of the period. Excluding fresh start adjustments, total additions were $12 million in the period of January 1 through May 6, 1993 and $49 million in each of the years ended December 31, 1992 and 1991. Total deductions excluding fresh start adjustments were $12 million in the period of January 1 through May 6, 1993 and $38 million and $6 million in the years ended December 31, 1992 and 1991, respectively. Total deductions include the effect of foreign currency translation which increased total deductions by $1 million in the period of January 1 through May 6, 1993 and by $18 million in the year ended December 31, 1992. In 1991, foreign currency translation adjustments decreased total deductions by $1 million. Upon retirement of other disposition of property, the applicable cost and accumulated depreciation and depletion are removed from the accounts. Any gains and losses are included in earnings. USG CORPORATION (PREDECESSOR COMPANY) SCHEDULE VI ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN MILLIONS) In accordance with fresh start accounting, the Corporation adjusted its property, plant and equipment accounts as of May 6, 1993 to fair market value. Consequently, there were no reserves for depreciation and depletion as of that date. Detailed information regarding additions and deductions other than those associated with fresh start accounting is omitted as neither total additions nor total deductions of property, plant and equipment (see Schedule V) during each of the periods shown above exceeded 10% of the balance of property, plant and equipment at the end of the related period. Total provisions for depreciation and depletion were $20 million in the period of January 1 through May 6, 1993 and $58 million and $57 million in the years ended December 31, 1992 and 1991, respectively. Total deductions, excluding fresh start adjustments, were $12 million in the period of January 1 through May 6, 1993 and $28 million and $8 million in the years ended December 31, 1992 and 1991, respectively. Total deductions include the effect of foreign currency translation which increased total deductions by $2 million in the period of January 1 through May 6, 1993 and by $10 million in the year ended December 31, 1992 and decreased total deductions by $1 million in the year ended December 31, 1991. Upon retirement or other disposition of property, the applicable cost and accumulated depreciation and depletion are removed from the accounts. Any gains and losses are included in earnings. USG CORPORATION (PREDECESSOR COMPANY) SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) SCHEDULE IX SHORT-TERM BORROWINGS (DOLLARS IN MILLIONS) USG CORPORATION (PREDECESSOR COMPANY) SCHEDULE X SUPPLEMENTAL STATEMENT OF EARNINGS INFORMATION (DOLLARS IN MILLIONS) The following amounts were charged to costs and expenses: Maintenance and repairs are recorded as costs or expenses when incurred. Taxes (excluding payroll and income taxes), rents, royalties and advertising costs are not shown above, as individually they do not exceed one percent of net sales in any of the periods shown. USG CORPORATION (PREDECESSOR COMPANY) SUPPLEMENTAL NOTE ON FINANCIAL INFORMATION FOR UNITED STATES GYPSUM COMPANY (A SUBSIDIARY OF USG CORPORATION) USG Corporation, a holding company, owns several operating subsidiaries, including U.S. Gypsum. On January 1, 1985, all of the issued and outstanding shares of stock of U.S. Gypsum were converted into shares of USG Corporation and the holding company became a joint and several obligor for certain debentures originally issued by U.S. Gypsum. As of May 6, 1993, debentures totaling $41 million were recorded on the holding company's books of account equal to the amount recorded as of December 31, 1992. Financial results for U.S. Gypsum are presented below in accordance with disclosure requirements of the SEC (dollars in millions): SUMMARY STATEMENT OF EARNINGS SUMMARY BALANCE SHEET REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS WITH RESPECT TO SUPPLEMENTAL NOTE AND FINANCIAL STATEMENT SCHEDULES We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of USG Corporation (Predecessor Company) included in this Form 10-K, and have issued our report thereon dated January 31, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the asbestos litigation as discussed in Notes to the Financial Statements - "Litigation" note. Our report on the consolidated financial statements also includes an explanatory paragraph with respect to the changes in the methods of accounting for postretirement benefits other than pensions and accounting for income taxes as discussed in Notes to Financial Statements - "Cumulative Effect of Changes in Accounting Principles" note. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental note and financial statement schedules on pages 97 through 102 are the responsibility of the Corporation'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. The supplemental note and financial statement 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 January 31, 1994 USG CORPORATION SELECTED QUARTERLY FINANCIAL DATA (A) (UNAUDITED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE A Form 8-K reporting a change of accountants has not been filed within 24 months prior to the date of the most recent financial statements. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT In connection with the consummation of the Prepackaged Plan, the number of persons comprising the Board was increased by five effective May 6, 1993 which, after the May 1993 retirement of one director whose position was eliminated, brought the total Board membership to 15. Of the five New Directors (the "NEW DIRECTORS"), two, Messrs. Crutcher and Lesser, were nominated by a committee representing holders of the Corporation's senior subordinated debentures which were converted into Common Stock under the Prepackaged Plan (each a "SENIOR SUBORDINATED DIRECTOR"); two, Messrs. Fetzer and Zubrow, were nominated by Water Street (each a "WATER STREET DIRECTOR"); and one, Mr. Brown, was nominated by a committee representing holders of the Corporation's junior subordinated debentures which were converted into Common Stock and Warrants to purchase Common Stock under the Prepackaged Plan (a "JUNIOR SUBORDINATED DIRECTOR"). As the respective terms of office of the New Directors expire, the Prepackaged Plan provides that each such New Director will be renominated. If a New Director declines or is unable to accept such nomination, or in the event a New Director resigns during his term or otherwise becomes unable to continue his duties as a director, such New Director or, in the case of a Water Street Director, Water Street, shall recommend his successor to the Committee on Directors of the Board. In the event of the death or incapacity of a New Director, his successor shall be recommended, in the case of a Water Street Director, by Water Street, in the case of a Senior Subordinated Director, by the remaining Senior Subordinated Director, and in the case of a Junior Subordinated Director, by the remaining New Directors. Any such nominee shall be subject to approval by the Board's Committee on Directors and the Board, which approval shall not be unreasonably withheld. Until June 22, 1997, the time at which the director nomination and selection procedures established by the Prepackaged Plan terminate, no more than two employee directors may serve simultaneously on the Board. An "employee director" is defined for this purpose as any officer or employee of the Corporation or any direct or indirect subsidiary, or any director of any such subsidiary who is not also a director of the Corporation. On February 9, 1994, William C. Foote was elected a director of the Corporation (in the class with a term expiring in 1995) to become effective March 1, 1994 following the retirement of Mr. Falvo. See "Executive Officers of the Registrant" below for Mr. Foote's age, present position and employment within the past five years. He will be a member of the Executive Committee. EXECUTIVE OFFICERS OF THE REGISTRANT (WHO ARE NOT DIRECTORS) ITEM 11. ITEM 11. EXECUTIVE COMPENSATION EXECUTIVE COMPENSATION AND BENEFITS The discussion that follows has been prepared based on the actual compensation paid and benefits provided by the Corporation to the five most highly compensated executive officers of the Corporation (collectively, the "NAMED EXECUTIVES"), for services performed during 1993 and the other periods indicated. This historical data is not necessarily indicative of the compensation and benefits that may be provided to such persons in the future. In general, the Prepackaged Plan provided for the continuation by the Corporation of the existing employment, compensation and benefit arrangements. The Prepackaged Plan resulted in a substantial reduction on May 6, 1993 in the amounts otherwise potentially payable to the Named Executives in 1994 under the Corporation's three-year Incentive Recovery Program (the "IRP") and the concurrent cash settlement of such reduced awards. Although no further awards will be made to the Named Executives under the IRP, the Named Executives were eligible for incentive awards under the Corporation's 1993 Annual Management Incentive Program. SUMMARY COMPENSATION TABLE The following table summarizes for the years indicated the compensation awarded to, earned by or paid to the Named Executives for services rendered in all capacities to the Corporation and its subsidiaries. OPTION/SAR GRANTS IN LAST FISCAL YEAR (A) AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES EMPLOYMENT AGREEMENTS In order to assure continued availability of services of the Named Executives, the Corporation (or, in the case of Mr. Roller, U.S. Gypsum) entered into employment agreements (the "EMPLOYMENT AGREEMENTS") with the Named Executives in 1993 which superseded substantially identical agreements entered into on various dates prior to 1993. The Employment Agreements, which do not by their terms provide for renewal or extension, terminate on December 31, 1996. The Employment Agreements provide for minimum annual salaries at the then current rate to be paid at normal pay periods and at normal intervals to Messrs. Connolly ($585,000), Falvo ($455,000), O'Bryan ($280,000), Roller ($280,000), and Pendexter ($255,000), with the minimum annual salaries deemed increased concurrently with salary increases authorized by the Compensation and Organization Committee of the Board of Directors. The Employment Agreements require that each Named Executive devote his full attention and best efforts during the term of such agreement to the performance of assigned duties. If a Named Executive is discharged without cause by the Corporation during the term of his Employment Agreement, he may elect to be treated as a continuing employee under such agreement, with salary continuing at the minimum rate specified in such agreement or at the rate in effect at the time of discharge, if greater, for the balance of the term of the Employment Agreement or for a period of two years, whichever is greater. In the event of any such salary continuation, certain benefits will be continued at corresponding levels and for the same period of time. If a Named Executive becomes disabled during the term of his Employment Agreement, his compensation continues for the unexpired term of the Employment Agreement at the rate in effect at the inception of the disability. In the event of a Named Executive's death during the term of his Employment Agreement, one-half of the full rate of compensation in effect at the time of his death will be paid to his beneficiary for the remainder of the unexpired term of the Employment Agreement. Each of the Named Executives has undertaken, during the term of his Employment Agreement and for a period of three years thereafter, not to participate, directly or indirectly, in any enterprise which competes with the Corporation or any of its subsidiaries in any line of products in any region of the United States. Each Named Executive has also agreed not to, at any time, use for his benefit or the benefit of others or disclose to others any of the Corporation's confidential information except as required by the performance of his duties under his Employment Agreement. TERMINATION COMPENSATION AGREEMENTS The Corporation is a party to termination compensation agreements with the Named Executives, each of such agreement which will terminate at the earlier of the close of business on December 31, 1995, or upon the Named Executive attaining age 65. The agreements provide certain benefits in the event of a "change in control" and termination of employment within three years thereafter or prior to the Named Executive attaining age 65, whichever is earlier, but only if such termination occurs under one of several sets of identified circumstances. Such circumstances include termination by the Corporation other than for "cause" and termination by the Named Executive for "good reason". Each "change in control" will begin a new three-year period for the foregoing purposes. For purposes of the agreements: (i) a "change in control" is deemed to have occurred, in general, if any person or group of persons acquires beneficial ownership of 20% or more of the combined voting power of the Corporation's then outstanding voting securities, if there is a change in a majority of the members of the Board within a two year period and in certain other events; (ii) the term "cause" is defined as, in general, the willful and continued failure by the Named Executive substantially to perform his duties after a demand for substantial performance has been delivered or the willful engaging of the Named Executive in misconduct which is materially injurious to the Corporation; and (iii) "good reason" for termination by a Named Executive means, in general, termination subsequent to a change in control based on specified changes in the Named Executive's duties, responsibilities, titles, offices or office location, compensation levels and benefit levels or participation. The benefits include payment of full base salary through the date of termination at the rate in effect at the time of notice of termination, payment of any unpaid bonus for a past fiscal year and pro rata payment of bonus for the then current fiscal year, and continuation through the date of termination of all stock ownership, purchase and option plans and insurance and other benefit plans. In the event of a termination giving rise to benefits under the agreements, the applicable Named Executive will be entitled to payment of a lump sum amount equal to 2.99 times the sum of (i) his then annual base salary, computed at 12 times his then current monthly pay and (ii) his full year position par bonus for the then current fiscal year, subject to all applicable federal and state income taxes, together with payment of a gross-up amount to provide for applicable federal excise taxes in the event such lump sum and all other benefits payable to the Named Executive constitute an "excess parachute payment" under the Internal Revenue Code. The Corporation is required to maintain in full force and effect until the earlier of (i) two years after the date of any termination which gives rise to benefits under any of the agreements and (ii) commencement by the Named Executive of full-time employment with a new employer, all insurance plans and arrangements in which the Named Executive was entitled to participate immediately prior to his termination in a manner which would give rise to benefits under his agreement, provided that if such participation is barred, the Corporation will be obligated to provide substantially similar benefits. In the event of any termination giving rise to benefits under the agreements, the Corporation is required to credit the applicable Named Executive with three years of benefit and credited service in addition to the total number of years of benefit and credited service the Named Executive accrued under the USG Corporation Retirement Plan. See "Retirement Plans" below. If the Named Executive has a total of less than five years of credited service following such crediting, he nonetheless will be treated as if he were fully vested under that Plan, but with benefits calculated solely on the basis of such total benefit service. The Corporation is obligated to pay to each Named Executive all legal fees and expenses incurred by him as a result of a termination which gives rise to benefits under his agreement, including all fees and expenses incurred in contesting or disputing any such termination or in seeking to obtain or enforce any right or benefit provided under such agreement. No amounts are payable under such agreements if the Named Executive's employment is terminated by the Corporation for "cause" or if the Named Executive terminates his employment and "good reason" does not exist. Although Water Street's ownership of more than 20% of the Corporation's voting securities as a result of the Restructuring constituted a "change in control" under the agreements, each of the Named Executives agreed to waive this occurrence. Such waivers do not constitute a waiver of any other occurrence of a change in control. The Corporation has established a so-called "rabbi trust" to provide a source of payment for benefits payable under such agreements. Immediately upon any change in control, the Corporation may deposit with the trustee under such trust an amount reasonably estimated to be potentially payable under all such agreements, taking into account any previous deposits. The Corporation did not make any such deposit to the trust as a result of Water Street's ownership. In the event that the assets of such trust in fact prove insufficient to provide for benefits payable under all such agreements, the shortfall would be paid directly by the Corporation from its general assets. RETIREMENT PLANS The following table shows the annual pension benefits on a straight-life annuity basis for retirement at normal retirement age under the terms of the Corporation's contributory retirement plan (the "RETIREMENT PLAN"), before the applicable offset of one-half of the primary social security benefits at time of retirement. The table has been prepared for various compensation classifications and representative years of credited service under the Plan. Each participating employee contributes towards the cost of his or her retirement benefit. Retirement benefits are based on the average rate of annual covered compensation during the three consecutive years of highest annual compensation in the ten years of employment immediately preceding retirement. Participants become fully vested after five years of continuous credited service. The Named Executives participate in the Retirement Plan. The Named Executives' full years of continuous credited service at December 31, 1993 were as follows: Mr. Connolly, 35; Mr. Falvo, 38; Mr. O'Bryan, 35; Mr. Roller, 33; and Mr. Pendexter, 36. Compensation under the Retirement Plan includes salary and incentive compensation (bonus and IRP payments) for the year in which payments are made. Pursuant to a supplemental retirement plan, the Corporation has undertaken to pay any retirement benefits otherwise payable to certain individuals, including the Named Executives, under the terms of the Corporation's contributory Retirement Plan but for provisions of the Internal Revenue Code limiting amounts payable under tax-qualified retirement plans in certain circumstances. The Corporation has established a so-called "rabbi trust" to provide a source of payment for benefits under this supplemental plan. Amounts are deposited in this trust from time to time to provide a source of payments to participants as they retire as well as for periodic payments to certain other retirees. In addition, the Corporation has authorized establishment by certain individuals, including the Named Executives, of special retirement accounts with independent financial institutions as an additional means of funding the Corporation's obligations to make such supplemental payments. DIRECTOR COMPENSATION Directors who are not employees of the Corporation are currently entitled to receive a retainer of $6,000 per quarter plus a fee of $900 for each Board or Board committee meeting attended, together with reimbursement for out-of-pocket expenses incurred in connection with attendance at meetings. A non-employee director serving as chairman of a committee is entitled to receive an additional retainer of $1,000 per quarter for each such chairmanship. Additional fees for pre-meeting consultations may be paid as applicable to non-employee directors, the amount of such fees to bear a reasonable relationship to the regular meeting fee of $900 and the customary length of a meeting of the Board committee involved. No director of the Corporation has received any compensation of any kind for serving as a director while also serving as an officer or other employee of the Corporation or any of its subsidiaries. In the past, the Corporation has entered into consulting agreements with retiring non-employee directors who had specified minimum periods of service on the Board. Those agreements continued the annualized retainer which was in effect in each instance at the time of retirement from the Board in return for an undertaking to serve in an advisory capacity and to refrain from any activity in conflict or in competition with the Corporation. The Board has determined to continue to offer such agreements on a case-by-case basis but also has determined to limit any such agreement to a term not to exceed five years. 1994 Stock Option Grants Options for 933,000 shares of Common Stock were granted on February 9, 1994 to 76 officers and key managers, none of whom is a Named Executive, at the exercise price of $32.5625 per share, which was the average of the high and low sales prices for a share of Common Stock as reported on the NYSE Composite Tape for such date. These options become exercisable at the rate of one-third of the aggregate grant on each of the first three anniversaries of the date of grant and expire on the tenth anniversary of the date of grant, except in the case of retirement, death or disability, in which case they expire on the earlier of the fifth anniversary of such event or the expiration of the original option term. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 5% HOLDERS OF COMMON STOCK The following persons are known by the Corporation to be a beneficial owner of more than five percent of the outstanding Common Stock: DIRECTORS AND EXECUTIVE OFFICERS The following table sets forth information as of January 1, 1994 regarding the beneficial ownership of Common Stock by each current director and Named Executive and by all current directors and executive officers of the Corporation as a group (31 persons). Such information is derived from the filings made with the SEC by such persons under Section 16(a) of the Exchange Act. The totals include any shares allocated to the accounts of those individuals through December 31, 1993 under the USG Corporation Investment Plan. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AGREEMENT WITH WATER STREET ENTITIES On February 25, 1993, the Corporation entered into an agreement with Water Street (the "WATER STREET AGREEMENT"). The Water Street Agreement, among other things, (i) restricts Water Steet and its affiliates Goldman, Sachs & Co. and The Goldman Sachs Group, L.P. (collectively the "WATER STREET ENTITIES") from purchasing, or offering or agreeing to purchase, any shares of Common Stock or other voting securities of the Corporation, except for Permitted Acquisitions (as defined in the Water Street Agreement) and acquisitions by any Water Street Entity other than Water Street of up to an aggregate of 10% of the then outstanding shares of Common Stock in the ordinary course of its business; (ii) requires (a) Water Street to vote all shares of Common Stock and other voting securities of the Corporation beneficially owned by it and (b) the other Water Street Entities to vote all shares of Common Stock beneficially owned by them in excess of 10% of the then outstanding shares of Common Stock, in each case, in the same proportion as the votes cast by all other holders of Common Stock and other voting securities of the Corporation, subject to certain exceptions described below; (iii) places restrictions on the ability of the Water Street Entities to transfer shares of Common Stock to any person, except for (a) sales consistent with Rule 144 of the Securities Act of 1993, (b) underwritten public offerings, (c) persons not known to be 5% holders, (d) pledgees who agree to be bound by certain provisions of the Water Street Agreement, (e) in the case of Water Street, distributions to Water Street's partners in accordance with the governing partnership agreement, (f) pursuant to certain tender or exchange offers for shares of Common Stock and (g) pursuant to transactions approved by the Board; (iv) provides Water Street with certain rights to nominate directors to the Board and Finance Committee (as described below); (v) requires the maintenance of directors' and officers' liability insurance and indemnification rights; (vi) requires that the Corporation's shareholder rights plan provide temporary exemptions for ownership of Common Stock by the Water Street Entities; (vii) provides Water Street with four demand registrations and unlimited piggyback registrations, subject to certain limitations described below; and (viii) provides for indemnification by the Corporation of Water Street, its underwriters and related parties for securities law claims related to any demand or piggyback registration contemplated in clause (vii) above. In connection with the Restructuring, Water Street nominated two New Directors to the Board, Wade Fetzer III and Barry L. Zubrow. See Item 10, "Directors and Executive Officers of the Registrant". In the event that the Water Street Directors are removed from office without the consent of Water Street, then the restrictions on the Water Street Entities relating to (i) the purchases of voting securities of the Corporation other than Permitted Acquisitions, (ii) the voting of securities of the Corporation and (iii) the transfer of shares of Common Stock, as described above, shall terminate. These restrictions shall also terminate upon the earliest to occur of: (i) the consummation of a merger, consolidation or other business combination to which the Corporation is a constituent corporation, if the stockholders of the Corporation immediately before such merger, consolidation or combination do not own more than 50% of the combined voting power of the then outstanding voting securities of the surviving corporation, (ii) the Board consisting of a majority of directors not approved by a vote of the directors serving at the time the Water Street Agreement was executed, and (iii) the tenth anniversary of the Water Street Agreement. In addition, the restrictions on purchases of voting securities and transfers of Common Stock shall also terminate upon the Water Street Entities owning less than 5% of the then outstanding shares of Common Stock. Furthermore, the Water Street Entities will not be subject to the voting restrictions contained in the Water Street Agreement if, among other things: (i) the Corporation defaults on the payment of principal or interest required to be paid pursuant to any indebtedness if the aggregate amount of such indebtedness is $25 million or more; (ii) the principal of any of the Corporation's indebtedness is declared due and payable prior to the date on which it would otherwise become due and payable if the aggregate amount of such indebtedness is $25 million or more; (iii) any person other than Water Street becomes the beneficial owner of more than 10% of the then outstanding shares of Common Stock; or (iv) the Corporation fails to comply with (x) the following financial covenants: a minimum senior interest coverage ratio, a minimum total interest coverage ratio, a minimum fixed charge coverage ratio, a minimum adjusted cumulative net worth, and a maximum leverage ratio or (y) a minimum total interest coverage ratio of 0.63 for a specified coverage period in 1993 and for the first quarter of 1994, 0.84 for the second quarter of 1994, 0.97 for the third quarter of 1994 and 1.14 for the fourth quarter of 1994, provided that (a) such financial covenants shall be calculated based only on domestic revenues unless the Corporation's non-domestic consolidated revenues exceed 35% of its total consolidated revenues, and (b) the Corporation shall not be deemed out of compliance in the event of a breach, after 1994 and prior to 1998, of the senior interest coverage ratio or the total interest coverage ratio unless there shall also exist at such time a breach of the fixed charge coverage ratio or in the event of a breach, after 1994 and prior to 1998, of the fixed charge coverage ratio unless there shall also exist at such time a breach of either the senior interest coverage ratio or the total interest coverage ratio. See "Description of Credit Agreement". If the Corporation complies with the financial covenants within the two fiscal quarters following the first failure to comply, the voting restrictions shall apply again. However, if the Corporation thereafter fails to comply with any of the financial covenants, the voting restrictions shall terminate. The provision of registration rights to Water Street is subject to certain limitations, including but not limited to the following: (i) of Water Street's four demand registrations, the Corporation shall pay the registration expenses (other than commissions and discounts of underwriters) for two registrations, and the Corporation and Water Street shall each pay one-half of the registration expenses (other than commissions and discounts of underwriters) for two registrations; and (ii) other than in connection with the Offering, Water Street (and any Water Street Entity that receives a distribution of Common Stock from Water Street and owns 5% or more of the then outstanding shares of Common Stock) shall not request a demand registration of Common Stock during any period in which the Corporation is actively engaged in a registered distribution of Common Stock until 90 days after the effective date of the registration statement relating to such distribution. With respect to the Offering, Water Street (and, if it distributes Common Stock to its partners, those partners) shall not request a demand registration of Common Stock during the 120-day period after the effective date of the Offering. In addition, during such 120-day period, Water Street and Goldman, Sachs & Co. shall not sell or otherwise dispose of any shares of Common Stock or Warrants, except that, at any time after 90 days after the effective date of the Offering, Water Street may distribute all or any portion of its shares of Common Stock or Warrants to its partners in accordance with its governing partnership agreement. In the event of any such distribution by Water Street, the partners (other than Goldman, Sachs & Co.) would not be subject to the restriction on selling shares of Common Stock or Warrants during the remainder of the 120-day period referred to above. Except in the case of the Offering, the Corporation and Water Street have mutual piggyback rights on registrations initiated by either, generally on a 50-50 basis. The Water Street Agreement originally provided, subject to certain exceptions, that, in connection with the first underwritten public offering of Common Stock after the Restructuring, the Corporation would have the right to sell, without participation of Water Street, up to such number of shares of Common Stock as would yield an aggregate price to the public of $100,000,000 and that, if a greater number of shares were to be sold in that offering, Water Street and the Corporation would each have the right to sell 50% of such greater number of shares. In addition, in connection with such offering, subject to certain exceptions, the Water Street Agreement originally provided that Water Street (and, if it distributes Common Stock to its partners, those partners) would not request or demand registration of Common Stock during the 180-day period after the effective date of such offering, rather than the 120-day period that applies to the Offering. In connection with the Offering, the Corporation and Water Street have mutually determined that they would sell in the Offering 4,000,000 shares of Common Stock, without regard to such $100,000,000 limitation, and that such 120-day period would apply in lieu of such 180-day period. NOTE PLACEMENT Fidelity Management & Research Company and Fidelity Management Trust Company may beneficially own in excess of 5% of the outstanding shares of Common Stock. See Item 12. "Security Ownership of Certain Beneficial Owners and Management." In connection with the Note Placement, certain funds and accounts managed or advised by Fidelity Management & Research Company and Fidelity Management Trust Company purchased $150 million in aggregate principal amount of Senior Notes due 2001. Such purchasers exchanged approximately $30 million aggregate principal amount of the Corporaton's outstanding Senior Notes due 1996 and approximately $35 million aggregate principal amount of the Corporation's outstanding Senior Notes due 1997 and paid the $85 million balance of the purchase price in cash. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K EXHIBIT INDEX (A) 1. & 2. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL FINANCIAL STATEMENT SCHEDULES See Part II, Item 8. "Financial Statements and Supplementary Data" for an index of the Corporation's consolidated financial statements and supplementary data schedules. 3. EXHIBITS (REG. S-K, ITEM 601): Exhibits followed by an (*) constitute management contracts or compensatory plans or arrangements. EXHIBIT NO. Page ---- 3 Articles of incorporation and by-laws: (a) Restated Certificate of Incorporation of USG Corporation (incorporated by reference to Exhibit 3.1 of USG Corporation's Form 8-K, dated May 7, 1993.) (b) Amended and Restated By-Laws of USG Corporation, dated as of May 12, 1993 (incorporated by reference to Exhibit 3(b) of Amendment No. 1 to USG Corporation's Registration Statement No. 33-61162 on Form S-1, dated June 16, 1993). 4 Instruments defining the rights of security holders, including indentures: (a) Indenture dated as of October 1, 1986 between USG Corporation and Harris Trust and Savings Bank, Trustee (incorporated by reference to Exhibit 4(a) of USG Corporation's Registration Statement No. 33-9294 on Form S-3, dated October 7, 1986). (b) Resolutions dated December 16, 1986 of a Special Committee created by the Board of Directors of USG Corporation. (c) Resolutions dated March 5, 1987 of a Special Committee created by the Board of Directors of USG Corporation. (d) Resolutions dated March 6, 1987 of a Special Committee created by the Board of Directors of USG Corporation. (e) Resolutions dated April 26, 1993 of a Special Committee created by the Board of Directors of USG Corporation relating to USG Corporation's 8% Senior Notes due 1995 and 9% Senior Notes due 1998 (incorporated by reference to Exhibit 4.1 of USG Corporation's Form 8-K, dated May 7, 1993). (f) Consent Resolutions adopted by a Special Committee created by the Board of Directors of USG Corporation relating to USG Corporation's 9-1/4% Senior Notes due 2001. (g) Indenture dated as of April 26, 1993 among USG Corporation, certain guarantors and State Street Bank and Trust Company, as Trustees, relating to USG Corporation's 10-1/4% Senior Notes due 2002 (incorporated by reference to Exhibit 4.2 of USG Corporation's Form 8-K, dated May 7, 1993). (h) Indenture dated as of August 10, 1993 among USG Corporation, certain guarantors and State Street Bank and Trust Company, as Trustee, relating to USG Corporation's 10-1/4% Senior Notes due 2002, Series B (incorporated by reference to Exhibit 4(f) of USG Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 dated August 12, 1993. (i) Warrant Agreement dated May 6, 1993 between USG Corporation and Harris Trust and Savings Bank, as Warrant Agent, relating to USG Corporation's Warrants (incorporated by reference to Exhibit 4.3 of USG Corporation's Form 8-K, dated May 7, 1993). (j) Form of Warrant Certificate (incorporated by reference to Exhibit 4(g) of Amendment No. 4 to USG Corporation's Registration Statement No. 33-40136 on Form S-4, dated November 12, 1992). (k) Rights Agreement dated May 6, 1993 between USG Corporation and Harris Trust and Savings Bank, as Rights Agent (incorporated by reference to Exhibit 10.1 of USG Corporation's Form 8-K, dated May 7, 1993). (l) Form of Common Stock certificate (incorporated by reference to Exhibit 4.4 to USG Corporation's Form 8-K, dated May 7, 1993). The Corporation and certain of its consolidated subsidiaries are parties to long-term debt instruments under which the total amount of securities authorized does not exceed 10% of the total assets of the Corporation and its subsidiaries on a consolidated basis. Pursuant to paragraph (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Corporation agrees to furnish a copy of such instruments to the Securities and Exchange Commission upon request. 10 Material contracts: (a) Management Performance Plan of USG Corporation (incorporated by reference to Annex C of Amendment No. 8 to USG Corporation's Registration Statement No. 33-40136 on Form S-4, dated February 3, 1993).* (b) 1991-1993 Management Incentive Compensation Program -- USG Corporation, as amended (incorporated by reference to Exhibit 10(b) of USG Corporation's 1991 Annual Report on Form 10-K, dated March 5, 1992).* (c) Amendment and Restatement of USG Corporation Supplemental Retirement Plan, effective as of July 1, 1993 and dated November 30, 1993 (incorporated by reference to Exhibit 10(c) of USG Corporation's Registration No. 33-51845 on Form S-1).* (d) First Amendment of USG Corporation Supplemental Retirement Plan, effective as of November 15, 1993 and dated December 2, 1993 (incorporated by reference to Exhibit 10(d) of USG Corporation's Registration No. 33-51845 on Form S-1).* (e) Termination Compensation Agreements (incorporated by reference to Exhibit 10(h) of USG Corporation's 1991 Annual Report on Form 10-K, dated March 5, 1992).* (f) USG Corporation Severance Plan for Key Managers, dated May 15, 1991 (incorporated by reference to Exhibit 10(i) of USG Corporation's 1991 Annual Report on Form 10-K, dated March 5, 1992).* (g) Indemnification Agreements (incorporated by reference to Exhibit 10(g) of Amendment No. 1 to USG Corporation's Registration No. 33-51845 on Form S-1).* (h) Form of Change of Control Waiver (incorporated by reference to Exhibit 10(t) of USG Corporation's 1992 Annual Report on Form 10-K dated March 26, 1993).* (i) Incentive Recovery Program -- Waiver of Full Payment (incorporated by reference to Exhibit 10(u) of USG Corporation's 1992 Annual Report on Form 10-K, dated March 26, 1993).* (j) Rights Agreement dated May 6, 1993 between USG Corporation and Harris Trust and Savings Bank, as Rights Agent (incorporated by reference to Exhibit 10.1 of Form 8-K filed by USG Corporation on May 7, 1993). (k) Warrant Agreement dated May 6, 1993 between USG Corporation and Harris Trust and Savings Bank, as Warrant Agent, relating to USG Corporation's Warrants (incorporated by reference to Exhibit 4.3 of Form 8-K filed by USG Corporation on May 7, 1993). (l) Amended and Restated Credit Agreement dated as of May 6, 1993 among USG Corporation and USG Interiors, Inc., as borrowers; the Financial Institutions listed on the signature pages thereof, as Senior Lenders; Bankers Trust Company, Chemical Bank and Citibank, N.A., as Agents; and Citibank, N.A., as Administrative Agent (incorporated by reference to Exhibit 10.2 of Form 8-K filed by USG Corporation on May 7, 1993). (m) First Amendment to Amended and Restated Credit Agreement between USG Corporation and USG Interiors, Inc. as borrowers; the Financial Institutions listed on the signature pages thereof, as Senior Lenders; Bankers Trust Company, Chemical Bank and Citibank, N.A., as Agents; and Citibank, N.A., as Administrative Agent (incorporated by reference to Exhibit 4M of USG Corporation's Registration Statement No. 35-65804 on Form S- 1, dated July 9, 1993). (n) Second Amendment to Amended and Restated Credit Agreement between USG Corporation and USG Interiors, Inc. as borrowers; the Financial Institutions listed on the signature pages thereof, as Senior Lenders; Bankers Trust Company, Chemical Bank and Citibank, N.A., as Agents; and Citibank, N.A., as Administrative Agent (incorporated by reference to 10(n) of Amendment No. 1 to USG Corporation's Registration No. 33-51845 on Form S-1). (o) Letter of Credit Issuance and Reimbursement Agreement dated as of May 6, 1993 between USG Interiors, Inc. and Chemical Bank (incorporated by reference to Exhibit 10.12 of Form 8-K filed by USG Corporation on May 7, 1993). (p) Amended and Restated Collateral Trust Agreement dated as of May 6, 1993 among USG Corporation, USG Interiors, Inc. and USG Foreign Investments, Ltd., as grantors, and Wilmington Trust Company and William J. Wade, as Trustees (incorporated by reference to Exhibit 10.6 of Form 8-K filed by USG Corporation on May 7, 1993). (q) Amended and Restated Company Pledge Agreement dated as of May 6, 1993 among USG Corporation, Wilmington Trust Company and William J. Wade (incorporated by reference to Exhibit 10.7 of Form 8-K filed by USG Corporation on May 7, 1993). (r) Amended and Restated Subsidiary Pledge Agreement dated as of May 6, 1993 among USG Interiors, Inc., Wilmington Trust Company and William J. Wade (incorporated by reference to Exhibit 10.8 of Form 8-K filed by USG Corporation on May 7, 1993). (s) Amended and Restated Subsidiary Pledge Agreement dated as of May 6, 1993 among USG Foreign Investments, Ltd., Wilmington Trust Company and William J. Wade (incorporated by reference to Exhibit 10.9 of Form 8-K filed by USG Corporation on May 7, 1993). (t) Amended and Restated Share Pledge Agreement dated as of May 6, 1993 among USG Foreign Investments, Ltd., Wilmington Trust Company and William J. Wade (incorporated by reference to Exhibit 10.10 of Form 8-K filed by USG Corporation on May 7, 1993). (u) Amended and Restated Deed of Charge dated as of May 6, 1993 among USG Foreign Investments, Ltd., Wilmington Trust Company and William J. Wade (incorporated by reference to Exhibit 10.11 of Form 8-K filed by USG Corporation on May 7, 1993). (v) Amended and Restated Company Guaranty dated as of May 6, 1993 made by USG Corporation (incorporated by reference to Exhibit 10.3 of Form 8-K filed by USG Corporation on May 7, 1993). (w) Amended and Restated Subsidiary Guaranty dated as of May 6, 1993 made by USG Interiors, Inc. (incorporated by reference to Exhibit 10.1 of Form 8-K filed by USG Corporation on May 7, 1993). (x) Form of Amended and Restated Subsidiary Guaranty dated as of May 6, 1993 made by each of United States Gypsum Company, USG Foreign Investments, Ltd., L&W Supply Corporation, USG Interiors International, Inc., La Mirada Products Co., Inc., Westbank Planting Company, American Metals Corporation and USG Industries, Inc. (incorporated by reference to Exhibit 10.5 of Form 8-K filed by USG Corporation on May 7, 1993). (y) Consent and Agreement dated as of August 22, 1991 with respect to the Old Credit Agreement dated as of July 1, 1988 (incorporated by reference to Exhibit 10(ai) of USG Corporation's Form 8-K, dated August 23, 1991). (z) First Amendment dated as of March 12, 1993 with respect to the Consent and Agreement dated as of August 22, 1991 (incorporated by reference to Exhibit 10(ap) of USG Corporation's 1992 Annual Report on Form 10-K, dated March 26, 1993). (aa) Deposit Agreement dated as of September 19, 1991 (incorporated by reference to Exhibit 10(aq) of USG Corporation's 1992 Annual Report on Form 10-K, dated March 26, 1993). (ab) First Amendment dated as of March 12, 1993 to the Deposit Agreement (incorporated by reference to Exhibit 10(ar) of USG Corporation's 1992 Annual Report on Form 10-K, dated March 26, 1993). (ac) Agreement, dated August 31, 1992, among USG Corporation and the Ad Hoc Committee of Holders of 13 1/4% Senior Subordinated Debentures of USG Corporation due 2000 (incorporated by reference to Exhibit 10(aq) of Amendment No. 4 to USG Corporation's Registration Statement No. 33-40136 on Form S-4). (ad) Letter Agreement dated February 25, 1993 among USG Corporation, Water Street Corporate Recovery Fund, L.P., the Goldman Sachs Group, L.P. and Goldman, Sachs & Co. (incorporated by reference to Exhibit 10(au) of USG Corporation's 1992 Annual Report on Form 10-K, dated March 26, 1993). (ae) Bankruptcy Court Order issued April 23, 1993 confirming USG Corporation's Prepackaged Plan of Reorganization (incorporated by reference to Exhibit 28.1 of Form 8-K filed by USG Corporation on May 7, 1993). (af) Consulting Agreement dated July 1, 1990, as amended March 23, 1992, between USG Corporation and William L. Weiss (incorporated by reference to Exhibit 10(au) of Amendment No. 4 to USG Corporation's Registration Statement No. 33-40136 on Form S-4). (ag) Consulting Agreement dated May 6, 1993 between USG Corporation and Jack D. Sparks (incorporated by reference to Exhibit 10(av) in USG Corporation's Registration Statement 33-51845 on Form S-1). Page ---- (ah) Consulting Agreement dated August 11, 1993 between USG Corporation and James W. Cozad (incorporated by reference to Exhibit 10(aw) in USG Corporation's Registration Statement 33-51845, on Form S-1). (ai) 1993 Annual Management Incentive Program -- USG Corporation (incorporated by reference to Exhibit 10(b) of Amendment No. 1 to USG Corporation's Registration Statement No. 33-61152 on Form S-1). (aj) Form of Employment Agreement dated May 12, 1993 (incorporated by reference to Exhibit 10(h) of Amendment No. 1 to USG Corporation's Registration Statement No. 33-61152 on Form S-1). (ak) Amendment of Termination Compensation Agreements (incorporated by reference to Exhibit 10(j) of Amendment No. 1 to USG Corporation's Registration Statement No. 33-61152 on Form S-1). (al) Form of Nonqualified Stock Option Agreement effective June 1, 1993 (incorporated by reference to Exhibit 10(l) of Amendment No. 1 on USG Corporation's Registration Statement No. 33-61152 on Form S-1). (am) Form of Nonqualified Stock Option Agreement with Anthony J. Falvo, Jr. effective June 1, 1993 (incorporated by reference to Exhibit 10(m) of Amendment No. 1 to USG Corporation's Registration Statement No. 33-61152 on Form S-1). (an) Form of First Amendment to Amended and Restated Collateral Trust Agreement (incorporated by reference to Exhibit 10(w) of Amendment No. 1 to USG Corporation's Registration Statement No. 33-61152 on Form S-1). (ao) Form of First Amendment to Amended and Restated Subsidiary Guaranty (incorporated by reference to Exhibit 10(ae) of Amendment No. 2 to USG Corporation's Registration Statement No. 33-61152 on Form S-1). (ap) Form of First Amendment to Amended and Restated Subsidiary Guaranty (incorporated by reference to Exhibit 10(ae) of Amendment No. 2 to USG Corporation's Registration Statement No. 33-61152 on Form S-1). (aq) First Amendment to Management Performance Plan, effective November 15, 1993 and dated February 1, 1994 (incorporated by reference to Exhibit 10(aq) of USG Corporation's Registration Statement No. 33-51845 on Form S-1). (ar) Modification letter dated February 1, 1994 to Nonqualified Stock Option Agreement dated June 1, 1993 between USG Corporation and Eugene B. Connolly (incorporated by reference to Exhibit 10(ar) of USG Corporation's Registration Statement No. 33-51845 on Form S-1). (as) Form of Nonqualified Stock Option Agreement effective February 9, 1994 (incorporated by reference to Exhibit 10(as) of USG Corporation's Registration Statement No. 33-51845 on Form S-1). (at) Executive Consulting Agreement effective March 1, 1994 between USG Corporation and Anthony J. Falvo, Jr. (incorporated by reference to Exhibit 10(at) of USG Corporation's Registration Statement No. 33-51845 on Form S-1). 11 Computation of Earnings/(Loss) Per Common Share 21 Subsidiaries 23 Consents of Experts and Counsel (a) Consent of Arthur Andersen & Co. 24 Power of Attorney (B) REPORTS ON FORM 8-K: 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. USG CORPORATION February 24, 1994 By: /s/ Richard H. Fleming ------------------------------------ Richard H. Fleming 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 date indicated. /s/ Eugene B. Connolly February 24, 1994 - --------------------------------- EUGENE B. CONNOLLY Chairman of the Board, Chief Executive Officer and Director (Principal Executive Officer) /s/ Richard H. Fleming February 24, 1994 - --------------------------------- RICHARD H. FLEMING Vice President and Chief Financial Officer (Principal Financial Officer) /s/ Raymond T. Belz February 24, 1994 - --------------------------------- RAYMOND T. BELZ Vice President and Controller (Principal Accounting Officer) ROBERT L. BARNETT, KEITH A. BROWN, ) By: /s/ Richard H. Fleming W. H. CLARK, JAMES C. COTTING, ) --------------------------- LAWRENCE M. CRUTCHER, ANTHONY J. ) Richard H. Fleming FALVO, JR., WADE FETZER III, DAVID W. FOX, ) Attorney-in-fact PHILIP C. JACKSON, JR., MARVIN E. LESSER, ) Pursuant to Power of Attorney ALAN G. TURNER, BARRY L.ZUBROW ) (Exhibit 24 hereto) Directors ) February 24, 1994 APPENDIX TO FORM 10-K The following graphic has been omitted from the EDGAR submission of USG Corporation's form 10-K: Page 7: A line graph depicting United States Gypsum wallboard industry shipments and United States total housing starts for the years 1982 through 1993 was replaced with a table providing such data.

784977_1993.txt

784977_1993

1993

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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):

88205_1993.txt

88205_1993

1993

88205

ITEM 1. BUSINESS SPX Corporation ("SPX" or the "company") is a global leader in the design, manufacture and marketing of products for the motor vehicle industry. Its operations are focused on the markets for specialty service tools and equipment used in vehicular repair and maintenance, and original equipment components for the manufacture and repair of motor vehicles. The company was organized in 1911 under the laws of Michigan, and reincorporated in Delaware in 1968. It was known as The Piston Ring Company until 1931, when it changed its name to Sealed Power Corporation. The name was changed again in 1988, when it became SPX Corporation. Today, SPX Corporation is a multi-national corporation with operations in 14 nations. The corporate headquarters is located in Muskegon, Michigan. Recent Developments During 1993 the company completed several significant transactions that are designed to increase its focus upon two primary core markets, specialty service tools and original equipment components for the motor vehicle industry. -- On June 10, 1993, the company purchased the Allen Testproducts division and its related leasing company, Allen Group Leasing, from The Allen Group, Inc. These businesses are being merged with the company's Bear Automotive division to create the Automotive Diagnostics division to enhance the company's engine diagnostics, emissions testing and wheel service equipment capabilities. Allen Group Leasing was renamed SPX Credit Corporation and was combined with the company's existing leasing operation and provides customers with a leasing option when purchasing higher dollar specialty service equipment. -- On October 22, 1993, the company divested its Sealed Power Replacement division, which markets and distributes replacement engine and under vehicle parts. -- On November 5, 1993, the company divested its Truth division, which designs and manufactures window and door hardware products. -- Effective December 31, 1993, the company acquired Riken Corporation's 49% ownership interest in Sealed Power Technologies Limited Partnership ("SPT"). SPT represents substantially all of the company's original equipment components segment. -- Sealed Power Technologies Limited Partnership Europe ("SP Europe"), which has not previously been consolidated in the financial statements of SPX, has been consolidated as of December 31, 1993. While SPX now owns 70% of SP Europe, the partnership had not previously been consolidated due to a pending participation of a 20% ownership interest by Riken. The Riken participation was not consummated. SP Europe is managed by the Sealed Power division of SPT. The remaining 30% interest in SP Europe is held by Mahle Gmbh, a German corporation. Refinancing Late in the fourth quarter of 1993, the company determined that virtually all existing SPX and SPT debt should be refinanced in connection with the purchase of Riken's 49% interest in SPT, due to favorable prevailing interest rates, scheduled and accelerated existing debt maturities, and to maintain the flexibility of the company to grow through internal investments and through acquisitions. The plan of refinancing (the "Refinancing") includes two elements, a new $225 million revolving bank credit facility and the issuance of $260 million of senior subordinated notes. The Refinancing is expected to be completed by the end of the second quarter of 1994. In March, the first portion of the Refinancing was completed when the company closed a $250 million revolving credit facility with The First National Bank of Chicago, as agent for a syndication of banks. This revolving credit facility bears interest at LIBOR plus 1.0% or the prime rate (at the company's option) and expires in 1999. Upon completion of the senior subordinated note offering, this revolving credit facility will be reduced to $225 million of maximum availability. Proceeds from this revolving credit facility were used to extinguish approximately $205 million of SPX debt, much of which was technically in default of covenant provisions. At December 31, 1993, SPT was in compliance with its debt covenants. By June 30, 1994, the company expects to have completed its $260 million offering of senior subordinated notes. These notes are anticipated to bear interest at a rate of approximately 10% and will be due in or after the year 2002. The proceeds from the notes will be used to retire existing SPT borrowings which totaled $210.2 million at December 31, 1993. Excess proceeds will be used to pay down the company's revolving credit facility. If the company does not issue the senior subordinated notes, provisions have been made so that the revolving credit facility will remain at $250 million and the rate of interest would become LIBOR plus 1.5% or the prime rate plus .5% (at the company's option) and the facility would be secured by substantially all of SPX's assets. The existing SPT debt would remain outstanding in its current form, including security interests in SPT's assets. BUSINESS SEGMENTS The result of these transactions is to increase the company's focus upon two primary business segments, Specialty Service Tools and Original Equipment Components. Additionally, a lease financing segment supports the Specialty Service Tool segment. The following unaudited pro forma information summarizes the company's revenues as if the above transactions had occurred as of the beginning of 1991. Please refer to footnote 7 to the consolidated financial statements for further explanation of the 1993 pro forma results. SPECIALTY SERVICE TOOLS This segment includes six operating divisions that design, manufacture and market a wide range of specialty service tools and diagnostic equipment primarily to the worldwide motor vehicle industry. Approximately one-fourth of sales are to customers outside of North America. The company competes with numerous companies which specialize in certain lines of its Specialty Service Tools. The company believes it is the world leader in offering specialty tool programs for motor vehicle original equipment manufacturers' franchised dealer networks. The company is a major producer of electronic engine diagnostic equipment, emission testing equipment and wheel service equipment in North America and Europe. The key competitive factors influencing the sale of Specialty Service Tools are design expertise, timeliness of delivery, quality, service and price. Sales of specialty service tools essential to franchised dealers tend to vary with changes in vehicle design and the number of dealerships and are not directly dependent on the volume of vehicles that are produced by the original equipment manufacturers. Design of specialty service tools is critical to their functionality and generally requires close coordination with either the motor vehicle original equipment manufacturers or with the ultimate users of the tools or instruments. These products are marketed as solutions to service problems and as aids to performance improvements. After the design is completed, the company manufactures, assembles or outsources these products. The company also markets a broad line of equipment of other manufacturers through franchised dealer equipment programs coordinated with certain motor vehicle original equipment manufacturers. Automotive Diagnostics -- This division is the combination of the company's Bear Automotive unit and Allen Testproducts, which was acquired in June of 1993. The division manufactures and markets performance test, emission test, and wheel service equipment, including related software, to the global automotive service industry. Products are marketed under both the Bear and Allen Testproducts brand names. These products are marketed to both the dealership and aftermarket channels through a direct sales force, OEM distribution and through independent distributorships, primarily in foreign countries. In North America, sales are supported by a network of company owned distribution and service centers. The division has operations located in Australia, Canada, the United Kingdom, Switzerland, Germany, Italy, France and the United States. Dealer Equipment and Services (formerly Kent-Moore Tool & Equipment). -- This division administers dealer equipment programs in North America and Europe for fourteen motor vehicle manufacturers, including General Motors, Saturn, Opel, Nissan, Toyota and Hyundai. Under the motor vehicle manufacturer's identity, the division supplies service equipment and support material to franchised dealers, develops and distributes equipment catalogues, and helps franchised dealers assess and meet their service equipment needs. The division's operations, which consist primarily of distribution of purchased products to customers, are located in the United States and Canada, the United Kingdom, Switzerland, Germany and Spain. Kent-Moore -- This division designs and markets specialty service tools and hand-held diagnostic products for the world's motor vehicle manufacturers. Franchised dealers use its products to do essential warranty and service work. Examples of products include specialty hand-held mechanical tools and specialty hand-held electronic diagnostic instruments. The division's technical product development and sales staffs work closely with the original equipment manufacturers to design tools to meet the exacting needs of specialty repair work. Products are sold to franchised dealerships under both essential and general programs. Essential programs are those in which the OEM requires its franchised dealers to purchase and maintain the tools for warranty and service work. The division has manufacturing operations in the United States and Spain. Sales and marketing operations exist in the United States, Switzerland, the United Kingdom, Australia, Spain, and Brazil. The division also manages the company's 50% interest in JATEK, a Japanese company that markets specialty service tools and equipment in the Asia Pacific Rim. OTC -- The division designs, manufactures and markets a variety of specialty service tools and equipment that range from gear pullers to complex, hand held diagnostic equipment. These products are based on customer needs and are marketed globally through automotive, agricultural, and construction equipment manufacturers to their franchised dealers. The division also has a strong aftermarket distribution system around the world. Products are marketed under brand names including OTC, V.L. Churchill, Lowener, and Miller Special Tools. The division's technical product development and sales staff works closely with original equipment manufacturers to design tools that meet the exacting needs of specialty repair and maintenance work. Products are sold to franchised dealerships under both essential and general programs. Essential programs are those in which the OEM requires its franchised dealers to purchase and maintain the tools for warranty and service work. The division's aftermarket distribution is primarily through warehouse distributors and jobbers who are supported by an in-house sales and technical support staff. The division has manufacturing operations located in the United States and sales and marketing operations located in the United States, the United Kingdom, Germany, and Australia. Power Team -- The division is a world leader in producing and marketing precision quality high-pressure hydraulic pumps, rams, valves, pullers and other equipment. The division markets these products through industrial distributors, its own sales force and independent agents. The sales and marketing effort is supported by a strong technical support staff as products must be designed to exacting specifications to meet the multitude of applications for these products. Approximately three-fourths of the division's sales are related to the motor vehicle service industry, while the balance of sales are made in non-transportation markets such as construction, aerospace and industrial maintenance. The division has sales, marketing and manufacturing operations in the United States. Additionally, sales and marketing offices are located in Australia, The Netherlands, and Singapore. The company is one of two major producers in this marketplace, which is also supplied by many niche companies. Robinair -- The division is a global leader in the design, manufacture, and marketing of specialty tools and equipment for the service of stationary and mobile air conditioning and refrigeration systems. These specialty tools range from mechanical hand-held tools, vacuum pumps and recharging equipment and leak detection equipment to refrigerant recovery and recycling equipment. The division also manufactures and markets engine coolant recycling systems. Approximately one-third of the division's sales are to the stationary, or non-transportation, market which includes appliance, refrigeration, and non-vehicular air conditioning repair. The division's manufacturing facilities are located in the United States. Sales and marketing operations exist in the United States, Canada, the United Kingdom, Switzerland, Spain, and Australia. ORIGINAL EQUIPMENT COMPONENTS This segment includes five operating divisions that design, manufacture and market component parts for light and heavy duty vehicle markets. The component parts for the light and heavy duty vehicle market are composed of two primary sectors: (i) the OEM sector and (ii) the vehicle maintenance and repair sector, the so-called replacement market or aftermarket. The U.S. -- Canadian -- European OEM sector is composed primarily of four classes of customers: (a) U.S. manufacturers, dominated by General Motors, Ford and Chrysler, but including other vehicle manufacturers such as Navistar International and Mack Trucks; (b) foreign companies producing vehicles in North America and Europe ("transplants"); (c) European vehicle manufacturers, sometimes sourcing the company's products through assemblies; and (d) vehicle manufacturers producing vehicles outside the U.S., Canada and Europe. Aftermarket customers include the service organizations of OEMs, automotive parts manufacturers and distributors, private brand distributors, and export customers. OEM contracts typically are from one to five years in length with the one year contracts typically being renewed or renegotiated, depending on part changes, in the ordinary course of business and the longer term contracts typically containing material cost pass-through and productivity improvement clauses. Sales of products to OEMs are affected, to a large extent, by vehicle production which, in turn, is dependent on general economic conditions. Historically, global vehicle production has been cyclical. Aftermarket sales are tied to the age of vehicles in service and the need for replacement parts. Sales of products to the aftermarket historically have been less adversely affected by general economic conditions since vehicle owners are more likely to repair vehicles than purchase new ones during recessionary periods. In its main product areas, the company competes with a small number of principal competitors (including the OEMs in certain product categories), some of which are larger in size and have greater financial resources than the company. Competitive factors influencing sales include quality, technology, service and price. Acutex -- This division produces solenoid valves and related assemblies for major vehicle and transmission manufacturers around the world. Acutex's proprietary solenoid valve products are devices that interface between the electronic signals of a vehicle's on-board computer and the vehicle's hydraulic systems. The company is using this technology in designing and manufacturing solenoid valves for electronically controlled automatic transmissions. The continued growth of electronically controlled automatic transmissions should increase the company's sales of solenoid valves. This division is also responsible for managing the company's 50% investment in RSV, a Japanese company that utilizes the company's technology to develop and manufacture solenoid valves for the Asia Pacific Rim. Contech -- This division produces precision aluminum, magnesium, and zinc die cast parts for automotive steering and air conditioning systems, and other assorted automotive/light truck uses. Primary products in this area include steering column parts, rack-and-pinion components and other castings such as components for air conditioning compressors, fuel systems, clutches, and transmissions. Approximately one half of the castings are machined by the division prior to delivery to customers. Products are sold almost exclusively to automotive OEMs through the division's marketing and sales personnel who are assisted by an outside sales organization. The market is driven primarily by major OEM model and assembly programs. The division has recently completed a major investment in magnesium die casting. The benefits of magnesium, including less weight and higher strength-to-weight ratio, will increase the division's proportion of future sales that are magnesium die castings. Filtran -- This division is a leading global producer of automatic transmission filters and other filter products and has a leading position in the U.S. and Canadian OEM market and aftermarket. A typical transmission filter product consists of a composite plastic/metal or all metal housing which contains a highly specialized needled felt, polymesh, or metal filter element designed to capture foreign particles. The division sells filters directly to the worldwide OEM market and aftermarket. Approximately two thirds of sales are to the aftermarket which includes the OEM parts and service organizations as well as private brand manufacturers and assorted transmission rebuilders, repackagers, and "quick lube" shops. The division participates in the worldwide OEM market in two different methods. In Europe, the company's 50% owned joint venture, IBS Filtran, manufactures and distributes filters to OEM customers. In the Asia Pacific Rim, the division exports filters to OEM manufacturers in Japan, Korea and Australia. Hy-Lift -- This division is a major domestic supplier of a variety of valve train components, including tappets, lash adjusters and roller rocker arms. Sales are made to both the domestic OEM market and the domestic aftermarket. Sales to the aftermarket, comprising approximately one third of total sales, are made through several channels, including direct sales to the OEM parts and service organizations and sales to private brand and export customers. Sealed Power Division -- The division is the leading North American producer of automotive piston rings and among the largest independent producers of cylinder sleeves for automotive and heavy duty engines. The division also produces sealing rings for automatic transmissions. There is a continuing trend in the automotive industry to reduce the weight of vehicles, which increases gas mileage. This trend has resulted in the development of aluminum engine blocks which require cast iron cylinder sleeves. Engine blocks made of cast iron do not require a cylinder sleeve. The division has been successful in obtaining contracts from the OEMs for these high volume automotive cylinder sleeve applications. The division's products are purchased by both automotive/light truck and heavy duty engine OEMs. The division utilizes a technical sales force that works with OEM engine and transmission designers to provide high-quality rings and cylinder sleeves. Approximately one-fourth of the division's sales are to the aftermarket. In addition to OEM parts and service organizations, the division supplies the aftermarket through two main distribution channels: private brand organizations, which sell the products under their own labels and a special export sales organization. Sealed Power Technologies (Europe) Limited Partnership ("SP Europe"), like its North American counterpart, Sealed Power division, is a leading designer, producer and distributor of automotive piston rings and cylinder sleeves. Its sales are predominately to European OEMs and to the European aftermarket. SP Europe's primary European customers are VW, Federal Mogul, Mahle, Kolbenschmidt, Alcan, Avdi, Volvo and Mercedes Benz. SP Europe was created in June of 1991 after acquiring the European piston ring and cylinder sleeve manufacturing business of TRW, Inc. In October of 1992, Mahle GmbH contributed its Spanish piston ring operation to SP Europe in exchange for a 30% ownership interest in SP Europe. The Sealed Power division has managed SP Europe since its inception. The division manages a 50% owned investment in Allied Ring Corporation, a U.S. joint venture with Riken, which manufactures and distributes piston rings to foreign companies producing vehicles in North America ("transplants"). The division is also responsible for managing the company's 40% equity investment in Promec, a Mexican company that manufactures and distributes rings and sleeves in Mexico. SPX CREDIT CORPORATION This unit was created through the acquisition of Allen Group Leasing from the Allen Group in June of 1993. This business provides U.S. and Canadian customers, primarily of the Automotive Diagnostics division, with lease financing as an alternative for purchasing electronic diagnostic, emissions testing and wheel service equipment. Essentially all of the direct financing leases are with companies or individuals operating within the automotive repair industry and leases are five years in length or less. INTERNATIONAL OPERATIONS The company has wholly owned operations located in Australia, Brazil, Canada, France, Germany, Italy, The Netherlands, Singapore, Spain, Switzerland and the United Kingdom. The company also has a 70% ownership in SP Europe, located in France, Germany and Spain. Additionally, the company has the following non U.S. equity investments: JATEK (50%). A Japanese company that sells various products into the Asia Pacific Rim market, including many of the company's service products. RSV (50%). A Japanese company that utilizes the company's technology to develop and manufacture solenoid valves for the Asia Pacific Rim. Promec (40%). A Mexican company which, through its subsidiaries, manufactures and distributes piston ring and cylinder sleeve products in Mexico. IBS Filtran (50%). A German company that manufactures and distributes automotive transmission filters to the European market. The company licenses its piston ring technology to a Brazilian automotive parts manufacturer and has a cross-licensing agreement for piston rings with Riken Corporation. The company's international operations are subject to the risk of possible currency devaluation and blockage, nationalization or restrictive legislation regulating foreign investments and other risks attendant to the countries in which they are located. The company's total export sales (for the three year period ending December 31, 1993), to both affiliated and unaffiliated customers, from the United States, were as follows (historical basis): SPT's export sales have historically been less than 10% of its total sales. RESEARCH AND DEVELOPMENT The company is actively engaged in research and development programs designed to improve existing products and manufacturing methods and to develop new products. These engineering efforts encompass all of the company's products with divisional engineering teams coordinating their resources. Particular emphasis has been placed on the development of new products that are compatible with, and build upon, the manufacturing and marketing capabilities of the company. To assist the company in meeting customer requirements, computer aided design (CAD) systems, that provide rapid integration of computers in mechanical design, model testing and manufacturing control, are used extensively. The company expended approximately $17.6 million on research activities relating to the development and improvement of its products in 1993, $14.7 million in 1992 and $13.1 million in 1991. There was no customer sponsored research activity in these years. With the addition of SPT, research and development expenditures will increase. SPT's research and development expenditures were $3.4 million in 1993, $3.8 million in 1992 and $3.6 million in 1991. PATENTS/TRADEMARKS The company owns numerous domestic and foreign patents covering a variety of its products and methods of manufacture and also owns a number of registered trademarks. Although in the aggregate its patents and trademarks are of considerable importance in the operation of its businesses, the company does not consider any single patent or trademark to be of such material importance that its absence would adversely affect the company's ability to conduct its businesses as presently constituted. RAW MATERIALS The company's manufactured products are made predominately from iron, steel, zinc, aluminum, magnesium, plastics and electronic components. These raw materials are generally purchased from multiple sources of supply and the company has not experienced any significant disruptions in its businesses due to shortages. OTHER MATTERS At the end of 1993, the company's employment was 8600 persons, which includes the employees of SPT and SP Europe. Approximately one-third of the company's 5000 production and maintenance employees are covered by collective bargaining agreements with various unions. The company has collective bargaining agreements with Locals 637, 221, and 1071, International Union, United Automobile, Aerospace and Agricultural Implement Workers of America (UAW); Shopmen's Local Union No. 473 of the International Association of Bridge, Structural and Ornamental Iron Workers; District No. 9, International Association of Machinists and Aerospace Workers (MAW); International Molders and Allied Workers Union, AFL-CIO, Local No. 120; Local 7629 of the United Paper International Union; Local 2492 International Association of Machinists & Aerospace Workers (MAW); and Local 2074 of the International Brotherhood of Electrical Workers. The collective bargaining agreements with UAW Locals 637, 221, and 1071 will expire on July 24, 1998, August 15, 1997, and March 3, 1995, respectively. The collective bargaining agreement with MAW District 9 will expire on May 13, 1995; the Molders Local 120 on May 15, 1995; the Shopmen's Local 473 on April 30, 1996. The collective bargaining agreement with Local 7629 of the United Paper International Union expires July 1, 1996. The collective bargaining agreement with Local 2492 of MAW expires September 13, 1996. The collective bargaining agreement with Local 2074 of the International Brotherhood of Electrical Workers expires May 4, 1995. Management believes it has generally good relations with its employees and anticipates that all of its collective bargaining agreements will be extended or renegotiated in the ordinary course of business. Certain contracts with OEM customers require the company to stockpile critical components prior to the expiration of collective bargaining agreements. Approximately 9% in 1993, 13% in 1992 and 9% in 1991 of the company's consolidated sales were made to General Motors Corporation and its various divisions, dealers and distributors. No other customer or group of customers under common control accounted for more than 10% of consolidated sales for any of these years. With the effect of the consolidation of SPT, the percentage sales to General Motors will increase in the future. SPT's sales to General Motors were 25% in 1993, 27% in 1992 and 31% in 1991. SPT's sales to Ford Motor Company and its various divisions, dealers and distributors were 23% in 1993, 20% in 1992 and 15% in 1991. With the consolidation of SPT, sales to Ford should exceed 10% of consolidated sales in the future. The company does not believe that order backlog is a significant factor in the specialty service tools and equipment sector. Within the original equipment components sector, long term contracts and the related level of new vehicle production are significant to future sales. All of the company's businesses are required to maintain sufficient levels of working capital to support customer requirements, particularly inventory. Sales terms and payment terms are in line with the practices of the industries in which they compete, none of which are unusual. The majority of the company's businesses tend to be nonseasonal and closely follow changes in vehicle design, vehicle production, and general economic conditions. However, specific markets such as air conditioning service and repair follow the seasonal trends associated with the weather (sales are typically higher in spring and summer). Government regulations, such as the Clean Air Act, can also impact the timing and level of certain specialty service tool sales. ITEM 2. ITEM 2. PROPERTIES UNITED STATES -- The principal properties used by the company for manufacturing, administration and warehousing consist of 42 separate facilities totaling approximately 3.8 million square feet. These facilities are located in Georgia, Illinois, Indiana, Kentucky, Michigan, Minnesota, Missouri, Ohio, and Pennsylvania. All facilities are owned, except for 11, which are leased (all non manufacturing). These leased facilities aggregate 442,000 square feet and have an average lease term of 6 years. The company also has 33 distribution and service centers located throughout the United States for distribution and servicing of its Specialty Service Tools. These distribution and service centers aggregate 190,000 square feet and all are leased. No single distribution and service center is of material significance to the company's business. INTERNATIONAL -- The company owns approximately 150,000 square feet and leases approximately 600,000 square feet of manufacturing, administration and distribution facilities in Australia, Brazil, Canada, France, Germany, Italy, The Netherlands, Singapore, Spain, Switzerland and the United Kingdom. The company's properties used for manufacturing, administration and warehousing are adequate to meet its needs as of December 31, 1993. The company configures and maintains these facilities as required by their business use. At December 31, 1993, the company does not have significant excess capacity at any of its major utilized facilities, and utilized its manufacturing facilities, taken as a whole, at approximately 75% of three shift capacity in 1993. A vacated manufacturing facility in Arkansas was sold in early 1994. A vacated administrative facility in Wisconsin (with three years remaining on its lease), is currently being marketed for a sub-lease. Plans were announced during the fourth quarter to close a small casting facility in Michigan. Products manufactured at this facility will be produced in other facilities or outsourced. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Certain claims, including environmental matters, suits and complaints arising in the ordinary course of business, have been filed or are pending against the company. In the opinion of management, all such matters are without merit or are of such kind, or involve such amounts, as would not have a significant effect on the financial position or results of operations of the company if disposed of unfavorably. Additionally, the company has insurance to minimize its exposures of this nature. The company's operations and products are subject to federal, state and local regulatory requirements relating to environmental protection. It is the company's policy to comply fully with all such applicable requirements. As part of its effort to comply, management has established an ongoing internal compliance auditing program which has been in place since 1989. Based on current information, management believes that the company's operations are in substantial compliance with applicable environmental laws and regulations and the company is not aware of any violation that could have a material adverse effect on the business, financial condition or results of operations of the company. There can be no assurance, however, that currently unknown matters, new laws and regulations, or stricter interpretations of existing laws and regulations will not materially affect the company's business or operations in the future. In addition, it is the company's practice to reduce use of environmentally sensitive materials as much as possible. First, it reduces the risk to the environment in that such use could result in adverse environmental effects either from operations or utilization of the end product. Second, a reduction in environmentally sensitive materials reduces the ongoing burden and resulting cost of handling, controlling emissions, and disposing of wastes that may be generated from such materials. The company is also subject to potential liability for the costs of environmental remediation. This liability may be based upon the ownership or operation of industrial facilities where contamination may be found as well as contribution to contamination existing at offsite, non-owned facilities. These offsite remediation costs cannot be quantified with any degree of certainty. At this time, management can estimate the environmental remediation costs only in terms of possibilities and probabilities based on available information. The company is involved as a potentially responsible party ("PRP") under the Comprehensive, Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), as amended, or similar state superfund statutes in eight active proceedings involving off-site waste disposal facilities. At three of these sites it has been established that the company is a de minimis contributor. A determination has not been made with respect to the remaining five sites, but the company believes that it will be found to be a de minimis contributor at three of them. Based on information available to the Company, which in most cases includes estimates from PRPs and/or federal or state regulatory agencies for the investigation, clean up costs at those sites, data related to the quantities and characteristics of materials generated at or shipped to each site, the company believes that the costs for each site are not material and in total the anticipated clean up costs of current PRP actions would not have a material adverse effect on the Company's financial condition or operations. In the case of contamination existing upon properties owned or controlled by the company, the company has established reserves which it deems adequate to meet its current remediation obligations. There can be no assurance that the company will not be required to pay environmental compliance costs or incur liabilities that may be material in amount due to matters which arise in the future or are not currently known to the company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM -- EXECUTIVE OFFICERS OF REGISTRANT The following table sets forth with respect to each executive officer or other significant employee of the company, his name, age, all positions and offices with the company held by him, the term during which he has been an officer of the company and, if he has been an officer of the company for less than five years, his business experience during the past five years. - --------------- See page 59 for a complete list of all executive compensation plans and arrangements. (1) Effective October 1991, Mr. Atkisson was elected President, Chief Operating Officer. From May 1989 through September 1991, Mr. Atkisson was President, Chief Executive Officer of SPT. Prior to 1989, Mr. Atkisson was a Group Vice President of the company. (2) Effective February 1994, Mr. Zagotta was elected Executive Vice President. From October 1991 through February 1994, he served as President and Chief Executive Officer of SPT. Prior to October 1991, he served as Vice President, General Manager of the Sealed Power division. (3) Effective February 1994, Mr. Huff was elected Treasurer. From April 1989 through February of 1994, he was Vice President, Finance of SPT. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The company's common stock is traded on the New York Stock Exchange and Pacific Stock Exchange under the symbol "SPW". Set forth below are the high and low sales prices for the company's common stock as reported on the New York Stock Exchange composite transaction reporting system and dividends paid per share for each quarterly period during the past two years: The approximate number of record holders of the company's Common Stock as of December 31, 1993 was 7,500. The company is subject to a number of restrictive covenants under various debt agreements. Please see Note 19 to the consolidated financial statements for further discussion. Future dividends will depend upon the earnings and financial condition of the company and other relevant factors. The new revolving credit agreement includes a covenant that limits dividends. Please see Note 23 to the consolidated financial statements for further explanation. The company has no present intention to discontinue its dividend policy and believes that dividends will continue at current levels during 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - --------------- (1) Includes restructuring charge of $27.5 million, $18.5 million aftertax and $1.47 per share. Refer to Note 9 to the consolidated financial statements for explanation. (2) Refer to Note 2 to the consolidated financial statements for explanation. (3) Refer to Note 8 to the consolidated financial statements for explanation. (4) Includes special charge of $18.2 million, $14.7 million aftertax and $1.06 per share. Refer to Note 9 to the consolidated financial statements for explanation. (5) Represents gain on sale of five small non-core businesses. (6) Includes a $50.7 million gain, net of income taxes, from the contribution of operations to SPT. (7) Includes special dividend of $13.00 per share. 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 company's consolidated financial statements and the related footnotes. OVERVIEW Strategic Change -- The company completed several major transactions in 1993 which were designed to increase its focus upon two primary core markets, specialty service tools and original equipment components for the motor vehicle industry. These transactions were as follows: -- Acquired the Allen Testproducts division and its related leasing subsidiary, Allen Group Leasing, from The Allen Group in June. -- Acquired Riken's 49% interest in SPT. SPT represents substantially all of the company's Original Equipment Component segment. -- Divested two divisions, SPR and Truth, that are no longer strategic to the company's core markets. As a result of these changes, the company's business is categorized into two primary segments, Specialty Service Tools and Original Equipment Components. Additionally, a lease financing segment, SPX Credit Corporation, supports the Specialty Service Tools segment. Specialty Service Tools -- Over the past 11 years, the company has made significant investments in the specialty service tool market. The company acquired Kent-Moore and Robinair in 1982, acquired OTC and Power Team in 1985, acquired V.L. Churchill (United Kingdom) in 1985, acquired Bear Automotive in 1988, created Dealer Equipment and Services in 1989, acquired Miller Special Tools in 1991 and acquired Allen Testproducts and Lowener (Germany) in 1993. The specialty service tool market continues to be a source of opportunity as customers' needs for products and services continue to expand due to the increasing complexity of repairing motor vehicles. The company's acquisition of Allen Testproducts has enhanced its offering of electronic diagnostic products. Closely related to Specialty Service Tools, particularly electronic diagnostic and wheel service equipment, the company also acquired Allen Group Leasing in June. Now named SPX Credit Corporation, this lease financing operation provides customers with a leasing option when purchasing higher dollar specialty service equipment. Revenues of Specialty Service Tools were $503.6 million in 1993, which included seven months of Allen Testproducts. The 1993 operating loss of $11.7 million for Specialty Service Tools was significantly affected by the third quarter $27.5 million pretax restructuring charge associated with the acquisition of Allen Testproducts. The integration of Bear Automotive and Allen Testproducts began with the acquisition in June and was approximately 75% complete as of year-end 1993. In addition to the restructuring charge, which covered facility and work force reduction expenses, other incremental costs have been incurred during this transitional period. Management believes the annualized cost savings will be in excess of $20 million once the integration is completed by mid-1994. Original Equipment Components -- During 1993, the company determined to focus its position as an original equipment component supplier. As of December 31, 1993, the purchase of the other half of SPT enabled the company to increase its focus on original equipment components. Combined with the company's majority stake in SP Europe and its Acutex division, the company has a broad range of products for both original equipment manufacturers and aftermarket customers. Each of the Original Equipment Component segment's operating divisions have achieved various OEM customer quality awards. Pro forma 1993 sales of this segment are $458.8 million. Current U.S. motor vehicle manufacturers' production forecasts for the next few years show increased volumes, and signs of some economic recovery in Europe are encouraging. Finally, the continued growth of electronically controlled automatic transmissions should increase the company's sales of solenoid valves. Pro forma operating income for the Original Equipment Components segment was $18.1 million in 1993. In addition, it should be noted that in 1993; (a) a $4.5 million charge for the closure of a manufacturing plant and the write down of equipment was recorded; (b) substantial work force reductions and efficiency improvements were completed at SP Europe; (c) negotiations were completed limiting a significant portion of retirement health care costs; and (d) volume increases at the solenoid valve facility improved fixed cost recovery at that plant. Management believes that these actions will benefit future results of operations. SPX Credit Corporation -- Formed as a part of the acquisition of Allen Group Leasing in June, this lease financing operation provides leasing alternatives primarily to Automotive Diagnostics' customers. Pro forma 1993 leasing revenues were $15.7 million and operating income was $9.7 million. Management believes that SPX Credit Corporation will continue to be a positive factor in the sale of its electronic diagnostic and wheel service equipment. Divestitures and Refinancing Plan -- The divestitures of the SPR and Truth divisions were based on the belief that these operations were not strategically related to either the Specialty Service Tools or Original Equipment Components segments. The sale of these units provided proceeds of approximately $189 million, net of tax. The company also established a new revolving credit facility of $250 million in March 1994 with a syndicate of banks. The bank credit facility, coupled with the planned $260 million offering of senior subordinated notes during the second quarter of 1994, will provide the company with a more favorable debt maturity schedule. Management believes this debt capacity will provide flexibility for future acquisitions and internal growth opportunities. RESULTS OF OPERATIONS FISCAL YEAR ENDED DECEMBER 31, 1993 AS COMPARED TO FISCAL YEAR ENDED DECEMBER 31, 1992 Revenues The following are revenues by business segment: Total revenues for 1993 were lower than 1992 due primarily to lower Specialty Service Tools revenues and reduced revenues from businesses which were sold in the fourth quarter of 1993. These declines in revenues were offset by increased revenues in the Original Equipment Components segment and the inclusion of lease financing revenues since June 1993 when the SPX Credit Corporation was formed. Revenues of Specialty Service Tools were down $36.0 million principally from reduced sales of refrigerant recovery and recycling systems. In 1992, revenues benefited from approximately $60.0 million of incremental sales of HFC134a refrigerant recovery and recycling systems to franchised automotive dealerships as many original equipment manufacturers required their dealerships to purchase this equipment. The balance of Specialty Service Tools revenues was up in 1993 due to higher essential tool programs, improved general U.S. economic conditions, increased sales of electronic hand-held diagnostic equipment and the June 1993 acquisition of Allen Testproducts. Revenues of Original Equipment Components were up significantly from 1992 as more automatic transmissions incorporated the company's electronic solenoid valve. Management believes that revenues from these valves will continue to increase as more automatic transmissions begin to incorporate these valves. Beginning in 1994, revenues of SPT and SP Europe will be included in this segment. Gross Profit Gross profit was $248.1 million, or 32.8% of revenues, in 1993 compared to $268.0 million, or 33.5% of revenues, in 1992. The decrease in gross margin in 1993 relates to the reduction in higher margin refrigerant recovery and recycling equipment sales and the related higher manufacturing volumes, certain costs and redundancies incurred during the integration of Bear Automotive and Allen Testproducts and increased sales of solenoid valves which carry a lower gross margin. Inclusion of lease financing revenues increased the gross margin in 1993, as such revenues do not have a related cost of sales. In 1992, the effect of inventory reductions resulted in a $1.8 million decrease in costs related to LIFO inventory liquidations compared to $0.5 million in 1993. Selling, General and Administrative Expense Selling, general and administrative expense ("SG&A") was $207.6 million, or 27.5% of revenues, in 1993 compared to $209.9 million, or 26.2% of revenues, in 1992. In 1993, expense was down from 1992 primarily due to the divestitures of SPR and Truth in the fourth quarter and the impact of the new ESOP accounting method. In 1993, the interest on the ESOP debt was classified as "interest expense, net" ($3.9 million), whereas, in 1992, the majority of this amount was included in SG&A. Offsetting these reductions was the acquisition of Allen Testproducts in June, a business with relatively high SG&A as a percentage of revenues. Operating Income (Loss) The following is operating income (loss) by business segment: Overall operating income (loss) was significantly reduced by the $27.5 million restructuring charge recorded in 1993. Excluding this restructuring charge, 1993 operating loss would have been $15.4 million compared to $49.1 million of income in 1992. This decrease is associated with lower sales of refrigerant recovery and recycling systems and integration costs at Automotive Diagnostics and SPT and SP Europe equity losses. Specialty Service Tools incurred an $11.7 million loss in 1993, which includes a $27.5 million restructuring charge for the combination of Bear Automotive and Allen Testproducts into the new Automotive Diagnostics division (see following paragraph). Excluding the restructuring charge, 1993 operating income would have been $15.8 million compared to $51.7 million of income in 1992. This decrease is associated with lower sales of refrigerant recovery and recycling systems and other integration costs at Automotive Diagnostics. The $27.5 million restructuring charge to combine the businesses into the Automotive Diagnostics division was recorded in the third quarter of 1993. Of the $27.5 million restructuring charge, approximately $16.0 million relates to work force reductions and associated costs. The combined businesses started with approximately 2,200 employees. That number was reduced to 1,800 at December 31, 1993 and will be at approximately 1,700 by the end of the second quarter of 1994. The charge also included $9.3 million of facility duplication and shutdown costs, including the write down of excess assets of $4.2 million (non-cash). The balance of the reserves at December 31, 1993 was approximately $14.5 million, which is principally required for remaining work force reduction and facility closing costs. Original Equipment Components' 1993 operating loss includes SPT equity losses of $26.9 million and SP Europe equity losses of $21.5 million. Offsetting these losses, to some extent, were the improved results of the Company's electronic solenoid valve operation. Interest Expense, net Interest expense, net, was $17.8 million in 1993 compared to $15.1 million in 1992. Interest costs have been decreasing since 1991 due to favorable rates and overall lower average borrowing levels. In 1993, interest expense increased by $3.9 million when compared to 1992 and 1991 levels as new accounting for the company's ESOP now recognizes the interest element on the ESOP debt. Prior to 1993, this expense was classified as administrative expense. The interest element on ESOP debt in 1992 and 1991, which was included in administrative expense, was $4.1 million and $4.0 million, respectively. Gain on Sale of Businesses A $105.4 million pretax gain on the sales of the Sealed Power Replacement division ($52.4 million) and the Truth division ($53 million) was recorded during the fourth quarter. The operating results of these units were included through their dates of divestiture, October 22, 1993 for SPR and November 5, 1993 for Truth. The combined aftertax gain was $64.2 million or $5.09 per share. Provision (Benefit) for Income Taxes The company's 1993 effective income tax rate for 1993 was 66% compared to 39.5% in 1992. The primary item affecting the 1993 rate was the inability to tax benefit the $21.5 million of SP Europe's equity losses as its foreign subsidiaries are in net operating loss carryforward positions. Also affecting the 1993 rate were certain items within the Automotive Diagnostics restructuring charge not being tax benefited and the cumulative effect of adjusting net deferred tax liabilities for the 1993 change in the U.S. federal income tax rate from 34% to 35%. The 1992 rate reflects a normal effective income tax rate. Cumulative Effect of Change in Accounting Methods, net of Taxes In 1993 and 1992, the company adopted three new accounting methods relating to its ESOP, postretirement benefits other than pensions, and income taxes. See Note 2 to the consolidated financial statements for a detailed explanation of these changes. Extraordinary Loss, net of Taxes During the fourth quarter of 1993, the company determined to refinance both SPX and SPT debt. As a result, the company recorded an extraordinary charge of $37.0 million ($24.0 million aftertax) for costs associated with the early retirement of $415.0 million (principal amount) of debt expected to be refinanced. The aggregate amount to retire this indebtedness, including existing unamortized debt placement fees, will be $452.0 million. FISCAL YEAR ENDED DECEMBER 31, 1992 AS COMPARED TO FISCAL YEAR ENDED DECEMBER 31, 1991 Revenues The following are revenues by business segment: Overall revenues increased principally from increases within the Specialty Service Tools segment. Specialty Service Tools revenues increased over 1991 due to an increase of approximately $100 million in sales of refrigerant recovery and recycling systems. The segment also benefited from higher sales to franchised vehicle dealerships, the result of new model vehicle introductions and improved general economic conditions. Revenues of Original Equipment Components were up significantly from 1991 as more automatic transmissions incorporated the company's electronic solenoid valve. Gross Profit Gross profit was $268.0 million, or 33.5% of revenues, in 1992 compared to $211.8 million, or 31.5% of revenues, in 1991. This improvement as a percentage of revenues was primarily attributable to higher production activity and related cost absorption, previous cost reduction programs (including the closure of a plant in Arkansas), and general sales mix shift towards higher margin products than in 1991. In 1992, the effect of inventory reductions resulted in a $1.8 million decrease in costs related to LIFO inventory liquidation. Selling, General and Administrative Expense Selling, general and administrative expense was $209.9 million, or 26.2% of revenues, in 1992 compared to $194.0 million, or 28.8% of revenues, in 1991. The primary reason for the increase was the variable selling costs associated with the higher revenues. However, several other factors also contributed to the increase, including increases in health care costs, costs associated with an unsuccessful acquisition effort and the higher current year costs associated with adoption of SFAS No. 106 -- "Employers' Accounting for Postretirement Benefits Other Than Pensions." Operating Income (Loss) The following is operating income (loss) by business segment: Operating losses in 1991 were impacted by a $18.2 million special charge (discussed below). Excluding this special charge, 1991 operating income would have been $6.3 million compared to $49.1 million in 1992. The significant increase was principally due to income related to the incremental sales of refrigerant recovery and recycling systems as well as generally improved sales of specialty service tools. Specialty Service Tools' 1991 operating income was impacted by a special charge of $12.5 million related to organizational and facility consolidation of two operating units and the writeoff of certain capitalized computer software development costs due to conceptual changes in future product offerings. Without the special charge, 1991 operating income would have been $15.9 million compared to $51.7 million in 1992. In 1992, operating income increased primarily from approximately $100 million of incremental sales of refrigerant recovery and recycling systems as well as generally improved sales of specialty service tools. Original Equipment Components' operating losses decreased due to improvements at the company's solenoid valve operation and due to reduced SPT equity losses (a $2.4 million loss in 1992 compared to an $8.5 million loss in 1991). Also, 1991 operating losses included a $2.6 million special charge for the start-up related reduced value of RSV, a joint venture with Riken, which produces solenoid valves for the Asia Pacific Rim market. General corporate expenses in 1991 included a $3.0 million special charge related to losses on certain project development investments and notes receivable related to previous business unit sales. Interest Expense, net Interest expense, net, was $15.1 million in 1992 and $16.8 million in 1991 due primarily to lower short-term interest rates. Provision (Benefit) for Income Taxes The company's 1992 effective income tax rate was 39.5% compared to a 25.0% benefit in 1991. The 1992 rate represents a normal effective income tax rate. The 1991 rate of benefit was the result of the company not recognizing a deferred tax benefit on some cost elements included in the special charge recorded that year, as future tax realization was uncertain. Cumulative Effect of Change in Accounting Methods, net of Taxes In 1992, the company adopted two new accounting methods relating to postretirement benefits other than pensions, and income taxes. See Note 2 to the consolidated financial statements for a detailed explanation of these changes. LIQUIDITY AND FINANCIAL CONDITION The company's liquidity needs arise primarily from capital investment in new equipment, funding working capital requirements and meeting interest costs. As a result of the company's acquisition activity in 1993, the company will be more leveraged than in the past. This financial leverage will require management to focus on cash flows to meet higher interest costs and to maintain dividends. Management believes that operations and the credit arrangements established will be sufficient to supply the future funds needed by the company. Management also believes that improvements in operations accomplished in 1993, coupled with completion of other cost reduction activities begun in 1993, will improve the cash flows of the company. Cash Flow Operating cash flow was significantly lower in 1993 than in 1992 due to lower operating earnings, the cash utilization of the Automotive Diagnostics division restructuring reserve, higher tax payments and increases in the amount of lease receivables. Cash flows from investing activities in 1993 reflected the net proceeds from the divestiture of SPR and Truth of approximately $189 million and the purchase of Allen Testproducts and Allen Group Leasing for approximately $102 million. In addition, 1993 included $19.9 million of advances to SP Europe prior to it being consolidated into the company's balance sheet compared to $3.1 million in 1992. In 1991, the $12.1 million purchase of Miller Special Tools and $5.0 million invested in SPT were included. Cash flows from financing activities reflected $37.7 million of debt reduction in 1992 compared to $44.0 million of additional borrowings in 1993. In 1991 a $24.2 million debt reduction was achieved. The resulting $108.1 million in 1993 cash flow was reflected in the year-end cash and temporary cash investment balance. A significant portion of this cash balance was utilized during the first quarter of 1994 to complete the acquisition of SPT and to refinance certain SPX debt. Capitalization At December 31, 1993, the company's total debt was composed of existing SPX debt of $220.0 million and of SPT debt of $210.2 million. In March 1994, the company extinguished approximately $205 million of the SPX debt by utilizing its existing cash balance and a portion of the new $250 million revolving credit facility. As of March 1994, the SPT debt remains outstanding. In March 1994, the company initiated the process to issue $260 million in senior subordinated notes. The issuance is expected to be completed before the end of the second quarter of 1994. At that time, the outstanding SPT debt will be extinguished using the proceeds from this offering. The December 31, 1993 unaudited pro forma presentation that follows assumes that both the revolving credit facility and the senior subordinated notes were available (in millions): On an unaudited pro forma basis, the following summarizes the debt outstanding and unused credit availability: After completion of this refinancing, management believes that the additional availability of borrowings is sufficient to meet operational cash requirements, working capital requirements and capital expenditures planned for 1994. If the notes are not issued, the revolving credit facility commitment will remain at $250 million and be secured by the company's assets (excluding SPT) and the SPT debt will remain outstanding. The combination of the unused SPX revolver availability of $85 million and SPT unused credit availability of $46 million at December 31, 1993, would be sufficient to cover the company's 1994 operational cash requirements, working capital requirements and capital expenditures. Capital Expenditures Capital expenditures were $15.1 million in 1993, $20.4 million in 1992 and $19.4 million in 1991. Management expects to continue to incur incremental capital expenditures to develop new products, improve product and service quality, and expand the business. With the consummation of the purchase of SPT, capital expenditures will increase due to SPT's capital intensity. SPT's capital expenditures, net were $17.8 million in 1993, $12.9 million in 1992 and $13.1 million in 1991. Capital expenditures planned in 1994 for the company (including SPT) are approximately $45 million. Significant projects include expanded cylinder sleeve manufacturing capabilities, an additional solenoid valve production line and a facility expansion at a major manufacturing plant. Management estimates that annual capital expenditures of approximately $15 million are required to maintain the company's (including SPT) current operations. Acquisitions and Divestitures After the acquisition and divestiture activity in 1993, management does not foresee any significant acquisitions or divestitures. Flexibility is available under the company's new revolving credit agreement to allow for strategically oriented acquisitions that directly complement the company's existing businesses. SEASONALITY, WORKING CAPITAL AND CYCLICALITY The majority of the company's revenues are not subject to seasonal variation. Revenues of the Original Equipment Components segment are predominantly dependent upon domestic and foreign vehicle production which is cyclical and dependent on general economic conditions and other factors. Revenues of the Specialty Service Tools segment are dependent upon the frequency of new vehicle introductions and the general economic status of vehicle dealerships and aftermarket maintenance facilities. These factors can, therefore, affect the company's working capital requirements. However, because the company receives production forecasts and new vehicle introduction information from original equipment manufacturers, the company is able to anticipate and manage these requirements. IMPACT OF INFLATION The company believes that inflation has not had a significant impact on operations during the period 1991 through 1993 in any of the countries in which the company operates. OTHER MATTERS Accounting Pronouncements -- As of the beginning of 1994, the company must adopt Statement of Financial Accounting Standards, No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires that the cost of benefits provided to former or inactive employees be recognized on the accrual basis of accounting. The company does not anticipate that this standard will materially impact its financial position or results of operations upon adoption. Automotive Diagnostics -- At December 31, 1993, $74 million of goodwill relates to the Automotive Diagnostics division (which is composed of Bear Automotive and Allen Testproducts, which was acquired in 1993). This division has incurred significant operating losses in 1993 and in prior years. The company projects that, in the near future, the cost savings, market synergies and other factors which, in part, will be realized from the Bear Automotive and Allen Testproducts combination will result in non-discounted operating income sufficient to exceed goodwill amortization. However, should such projections require downward revision based on changed events or circumstances, this division's goodwill may require writedown. Although having no cash flow impact, the resulting charge, if any, could materially reduce the company's future reported results of operations and shareholders' equity. At this time, based upon present information, projections and strategic plans, the company has concluded that there has been no permanent impairment of the Automotive Diagnostic division's tangible or intangible assets. Tax Settlement -- During the fourth quarter of 1993, the company settled a dispute with the Internal Revenue Service regarding the company's tax deferred treatment of the 1989 transaction in which several operating units were contributed to SPT. The settlement of approximately $5 million in tax eliminates the IRS contention that one-half of the 1989 transaction was currently taxable. The settlement and interest will be paid during the second quarter of 1994 and is adequately provided for in the company's deferred income tax accounts. Actuarial Discount Rate -- At year-end 1993, the company (and SPT) reduced the discount rate used for computation of pension and other postretirement benefits to 7.5% from the previous 8.25%. This assumption change had no effect on 1993 results of operations, but will increase expense in the future. The company does not expect the increase to be material as certain other actuarial assumptions, including salary growth and medical trend rates, were also modified to reflect current experience. The future discount rate is subject to change as long-term interest rates and other such factors warrant. Environmental -- The company's operations and products are subject to federal, state and local regulatory requirements relating to environmental protection. It is the company's policy to comply fully with all such applicable requirements. As part of its effort to comply, management has established an ongoing internal compliance auditing program which has been in place since 1989. Based on current information, management believes that the company's operations are in substantial compliance with applicable environmental laws and regulations and the company is not aware of any violation that could have a material adverse effect on the business, financial condition or results of operations of the company. There can be no assurance, however, that currently unknown matters, new laws and regulations, or stricter interpretations of existing laws and regulations will not materially affect the company's business or operations in the future. See Note 18 to the consolidated financial statements for further discussion. Foreign Net Operating Loss Carryforwards -- The company has foreign net operating loss carryforwards ("NOLs") of approximately $32.5 million as of December 31, 1993. These NOLs are available to offset applicable future foreign taxable income and, for the most part, expire in years after 1996. These NOLs have been fully reserved through the valuation allowance due to uncertainty regarding the ability to realize these tax assets. SPX CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of SPX Corporation: We have audited the accompanying consolidated balance sheets of SPX CORPORATION (a Delaware 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 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 SPX 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 Note 2 to the consolidated financial statements, effective January 1, 1993, the company changed its method of accounting for its Employee Stock Ownership Plan and Sealed Power Technologies Limited Partnership changed its method of accounting for postretirement benefits other than pensions and effective January 1, 1992, the company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. ARTHUR ANDERSEN & CO. Chicago, Illinois, March 25, 1994. SPX CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these statements. SPX CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of these statements. SPX CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these statements. SPX CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these statements. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (1) BASIS OF PRESENTATION AND SUMMARY OF ACCOUNTING POLICIES The accounting and financial policies which affect significant elements of the consolidated financial statements of SPX Corporation (the "company") and which are not apparent on the face of the statements, or in other notes to the consolidated financial statements, are described below. Restatement -- As a result of the company's purchase of Riken Corporation's interest in Sealed Power Technologies Limited Partnership ("SPT") as of December 31, 1993, prior years' consolidated financial statements have been restated to reflect the company's 49% share of SPT's earnings or losses for prior years (see Note 5). Consolidation -- The consolidated financial statements include the accounts of the company and all of its majority-owned subsidiaries after the elimination of all significant intercompany accounts and transactions. Foreign Currency Translation -- Translation of significant subsidiaries results in unrealized translation adjustments being reflected as cumulative translation adjustment in shareholders' equity. Lease Finance Income Recognition -- The company's lease financing operation, SPX Credit Corporation, uses the direct financing method of accounting for leases. Under this method, the excess of future lease payments and estimated residual value over the cost of equipment leased is recorded as unearned income and is recognized over the life of the lease by the effective interest method. Deferred Service Revenue -- Revenue from service contracts and long-term maintenance arrangements has been deferred and will be recognized as revenue on a pro rata basis over the agreement periods. Research and Development Costs -- The company expenses currently all costs for development of products. Research and developments costs were $17.6 million in 1993, $14.7 million in 1992, and $13.1 million in 1991. Earnings Per Share -- Primary earnings per share is computed by dividing net income by the weighted average number of common shares outstanding. Common shares outstanding includes issued shares less shares held in treasury and, in 1993, unallocated and uncommitted shares held by the ESOP trust. The exclusion of unallocated and uncommitted shares held by the ESOP trust in 1993 is due to the company's adoption of Statement of Position 93-6 (see Note 2). Prior to 1993, unallocated and uncommitted shares held by the ESOP trust were included in weighted average number of common shares outstanding used for calculating earnings per share. Average weighted unallocated and uncommitted shares in the ESOP trust were 1,361,000 shares at the end of 1992 and 1,476,000 shares at the end of 1991. The potential dilutive effect from the exercise of stock options is not material. (2) CHANGES IN ACCOUNTING METHODS In 1993 and 1992, the company adopted three new accounting methods relating to its Employee Stock Ownership Plan ("ESOP"), postretirement benefits, and income taxes. The effect of the change to these new accounting methods has been reflected in the consolidated statements of income as "Cumulative effect of change in accounting methods, net of taxes." Effective January 1, 1993, the company elected to adopt new accounting for its ESOP in accordance with Statement of Position 93-6 of the Accounting Standards Division of the American Institute of Certified Public Accountants, issued in November of 1993. As part of this change, the company recorded a one time cumulative charge of $5.1 million pretax, or $3.3 million aftertax. This charge recognizes the cumulative difference of expense since the inception of the ESOP until January 1, 1993 to reflect the shares allocated SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 method of accounting for ESOPs. As the company adopted this accounting change in the fourth quarter of 1993, previously reported 1993 quarterly information has been restated to reflect the change effective January 1, 1993. See Note 10 for further discussion of the effect of this change. Effective January 1, 1993, SPT adopted Statement of Financial Accounting Standards (SFAS) No. 106 -- "Employers' Accounting for Postretirement Benefits Other Than Pensions", using the immediate recognition transition option. SFAS No. 106 requires recognition, during the employees' service with the company, of the cost of their retiree health and life insurance benefits. At that date, the full accumulated postretirement benefit obligation was $89.5 million pretax. The company recorded its 49% share of this transition obligation, $28.5 million, net of deferred taxes of $15.4 million in the first quarter. Effective January 1, 1992, the company adopted SFAS No. 106 using the immediate recognition transition option. At January 1, 1992, the accumulated postretirement benefit obligation was $16.8 million and was recorded as a pretax transition obligation. The decrease in net earnings and shareholders' equity was $10.7 million after a deferred tax benefit of $6.1 million. Effective January 1, 1992, the company adopted Statement of Financial Accounting Standards (SFAS) No. 109 -- "Accounting for Income Taxes." Under SFAS No. 109, deferred tax balances are stated at tax rates expected to be in effect when taxes are actually paid or recovered. The cumulative effect of adoption as of January 1, 1992 was a $5.0 million aftertax benefit. As of the beginning of 1994, the company must adopt Statement of Financial Accounting Standards, No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires that the cost of benefits provided to former or inactive employees be recognized on the accrual basis of accounting. The company does not anticipate that this standard will materially impact its financial position or results of operations upon adoption. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (3) SEGMENT AND GEOGRAPHIC INFORMATION The company is comprised of three business segments. Specialty Service Tools includes operations that design, manufacture and market a wide range of specialty service tools and diagnostic equipment primarily to the global motor vehicle industry. Original Equipment Components includes operations that design, manufacture and market component parts for light and heavy duty vehicle markets. SPX Credit Corporation, a lease financing operation, provides Specialty Service Tools customers with a leasing option for purchasing more expensive diagnostic testing, emission testing, and wheel service equipment. SPX Credit Corporation was created with the purchase of Allen Group Leasing in June of 1993. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 - --------------- (a) 1993 includes a $27.5 million restructuring charge to merge Allen Testproducts and Bear Automotive into Automotive Diagnostics. (b) 1993 includes $26.9 million of SPT equity losses and $21.5 million of SP Europe equity losses. (c) Increase in 1993 was primarily the additional $108.1 million in cash resulting from the SPR and Truth divestitures. Revenues by business segment represent sales to unconsolidated customers. Intercompany sales between segments are not significant. Operating income (loss) by segment does not include general unallocated corporate expense, interest expense, income taxes and extraordinary items. Identifiable assets by business segment are those used in company operations in each segment. General corporate assets are principally cash, deferred tax assets, prepaid pension and prepaid health care expenses. Information about the company's operations in different geographic areas is as follows: SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 - --------------- (a) Included in the United States revenues are export sales to unconsolidated customers of $74.4 million in 1993, $64.0 million in 1992 and $55.4 million in 1991. (b) 1993 includes a $27.5 million restructuring charge to merge Allen Testproducts and Bear Automotive into Automotive Diagnostics and $26.9 million of SPT equity losses. (c) 1993 includes $21.5 million of SP Europe equity losses. (d) 1993 includes assets resulting from the consolidation of SP Europe and assets acquired in the Lowener purchase during the third quarter. Approximately 9% in 1993, 13% in 1992 and 9% in 1991 of the company's consolidated sales were made to General Motors Corporation and its various divisions, dealers and distributors. No other customer or group of customers under common control accounted for more than 10% of consolidated sales for any of these years. With the effect of the consolidation of SPT, the percentage sales to General Motors will increase in the future. SPT's sales to General Motors were 25% in 1993, 27% in 1992 and 31% in 1991. SPT's sales to Ford Motor Company and its various divisions, dealers and distributors were 23% in 1993, 20% in 1992 and 15% in 1991. With the consolidation of SPT, sales to Ford should exceed 10% of consolidated sales in the future. (4) ACQUISITION -- ALLEN TESTPRODUCTS AND ALLEN GROUP LEASING On June 10, 1993, the company acquired the Allen Testproducts division ("ATP") and its related leasing company, Allen Group Leasing ("AGL"), from the Allen Group, Inc. for $102 million. ATP is a manufacturer and marketer of vehicular test and service equipment. This acquisition has been recorded using the purchase method of accounting, and the results of ATP and AGL have been included in the company's consolidated statement of income since June 10, 1993. The purchase price has been allocated to the fair values of the net assets of ATP and AGL. The purchase price allocations recorded are based upon estimates available and may be revised at a later date. The excess of the purchase price over the estimated fair value of the net assets acquired of $16.3 million has been recorded as costs in excess of net assets acquired and is being amortized over the remaining life of goodwill from the 1988 acquisition of Bear Automotive (approximately 35 years). The purchase price allocation was as follows (in millions of dollars): Financing was obtained by a $50 million note with two banks, a $19.7 million, three year, 8%, note from the seller and the balance by utilizing the company's existing revolving credit line. The acquired businesses have been combined with the company's Bear Automotive division to form a single business unit called Automotive Diagnostics. In the third quarter of 1993, the company recorded a pretax $27.5 million restructuring charge to provide for substantial reduction in work force and facilities related to the combination. The restructuring charge was $18.5 million aftertax. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (5) ACQUISITION -- SEALED POWER TECHNOLOGIES LIMITED PARTNERSHIP ("SPT") Effective December 31, 1993, the company acquired Riken Corporation's 49% interest in SPT for $39 million. Additionally, SPT will redeem the 2% management interest in SPT for $2.7 million. The company previously owned 49% of SPT. Accordingly, the net assets of SPT have been included in the accompanying consolidated balance sheet as of December 31, 1993. Prior to this acquisition, the company accounted for its investment using the equity method. Beginning in the first quarter of 1994, the results of operations of SPT will be reflected in the company's consolidated statements of income and cash flows. SPT designs and manufactures engine parts, castings and filters for the automotive and heavy duty original equipment manufacturers ("OEM") and the aftermarket. SPT was created in 1989 when the company contributed the Sealed Power, Contech, Filtran and Hy-Lift divisions to the newly created limited partnership. SPT obtained nonrecourse financing through a combination of bank debt and a public offering of subordinated debentures. In exchange for the net assets of the divisions contributed, the company received $245 million in cash from the partnership and a 49% interest in the partnership. As the debt incurred by SPT to fund this transaction was nonrecourse to the company, the company previously recorded a pretax $91 million gain in 1989, in accordance with guidance prescribed in Emerging Issues Task Force pronouncement 89-7. The cash distribution to the company resulted in an initial partnership capital deficit. SPT has had cumulative losses since its inception and, up to December 31, 1993, the company had carried its investment in SPT at zero. Because the SPT debt was nonrecourse, the company properly did not reflect its share of the equity losses of SPT and did not amortize the difference between its investment balance and its share of SPT's initial partnership capital deficit in its previously reported financial statements. As a result of the acquisition of the remaining 51% of SPT, as of December 31, 1993, the company accounted for this transaction as follows: 1. The company recorded this acquisition using step acquisition accounting. Step acquisition accounting requires that when the company previously did not record its share of SPT's losses because the company's investment was zero and now, as a result of additional ownership, consolidates SPT, the company must retroactively reflect its share of SPT losses not previously recorded. Accordingly, the financial statements for the 1993 quarters and prior years were restated to record the company's previous 49% share of SPT's income or losses, the effect of amortizing the difference between its investment balance and its share of SPT's initial partnership capital deficit and an adjustment required to record the company's previous investment in SPT at historical cost. 2. The 51% of SPT's net assets acquired has been included in the accompanying consolidated balance sheet at December 31, 1993 at estimated fair value based upon preliminary information which may be revised at a later date. The excess of the purchase price (including the acquired equity deficit of $87.9 million) over the estimated fair values of the net assets acquired was $97.1 million and has been recorded as costs in excess of net assets acquired and will be amortized over 40 years. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 A summary of the purchase price allocation is as follows (in millions of dollars): - --------------- * Represents the cumulative restatement of equity losses, including the company's 49% share of the 1993 SPT adoption of SFAS No. 106, recorded by the company prior to the consolidation of the net assets of SPT at December 31, 1993. (6) DIVESTITURES During 1993, the company sold its Sealed Power Replacement and Truth divisions. Sealed Power Replacement ("SPR") -- On October 22, 1993, the company sold SPR to Federal-Mogul Corporation for approximately $141 million in cash. SPR distributes engine and undervehicle parts into the U.S. and Canadian aftermarket. Net proceeds, after income taxes, were approximately $117.5 million. The company recorded a pretax gain of $52.4 million after transaction and facility reduction expenses, or $32.4 million aftertax. The proceeds were used to reduce a portion of the company's debt and the excess invested in short term investments. Truth -- On November 5, 1993, the company sold Truth to Danks America Corporation, an affiliate of FKI Industries, Inc. for approximately $92.5 million in cash. In addition, the company will receive an annual royalty ranging from 1.0% to 1.5% of Truth's annual sales for a five year period following the closing (cumulatively not to exceed $7.5 million) which will be recorded as income as received. Truth manufactures and markets window and door hardware primarily in the U.S. and Canada. Net proceeds, after income taxes, were approximately $71.6 million. The company recorded a pretax gain of $53.0 million after transaction expenses, or $31.8 million aftertax. The proceeds were invested in short term investments. The final proceeds for these divestitures are based upon the closing balance sheet of each business. Any changes in proceeds as a result of adjustments to the closing balance sheets are not expected to be material. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (7) PRO FORMA RESULTS OF OPERATIONS (UNAUDITED) The accompanying consolidated statements of income include the results of operations of Allen Testproducts ("ATP") and Allen Group Leasing ("AGL") from the date of acquisition, June 10, 1993, the results of the Sealed Power Replacement ("SPR") division through the date of disposition, October 22, 1993, the results of the Truth division through the date of disposition, November 5, 1993, the company's 49% share of the earnings or losses of SPT, and the equity losses of SP Europe. The following 1993 unaudited pro forma selected financial data reflects the acquisition of ATP and AGL and related restructuring, the divestiture of the SPR and Truth divisions, the acquisition of 51% of SPT, and the consolidation of SP Europe as if they had occurred as of January 1, 1993. Pro forma adjustments are described below. The 1992 pro forma assumes that these transactions occurred as of January 1, 1992 and comparable pro forma adjustments were made. - --------------- (a) Historical results of ATP and AGL through June 10, 1993, the date of acquisition. Pro forma adjustments include a $6.8 million reduction in cost of products sold resulting from primarily work force reductions; a $10.2 million reduction in SG&A resulting from primarily work force reductions: and $0.3 million of additional goodwill amortization. (b) SPR and Truth were divested during the fourth quarter of 1993. This represents the results of operations through the date of divestiture. (c) SP Europe was consolidated as of December 31, 1993. This pro forma adds the results of operations for the full year. Pro forma adjustments include reflecting the minority owner's share of losses, $4.3 million, and $21.5 million to reverse the company's share of equity losses as SP Europe is consolidated in the pro forma. (d) SPT was consolidated as of December 31, 1993. This pro forma adds the results of operations for the full year. Pro forma adjustments include $2.0 million of additional depreciation expense resulting from purchase accounting; $26.9 million to reverse the company's share of equity losses as SPT is consolidated in the pro forma; and $2.4 million to reflect goodwill amortization resulting from purchase accounting. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (e) Adjustment to interest expense, net to reflect the financing to purchase ATP and AGL and 51% of SPT and to reflect the net proceeds from the sale of SPR and Truth. Proceeds in excess of expenditures are assumed to have reduced outstanding revolving credit, short-term notes and notes payable to The Allen Group. Any excess was then assumed to be invested in short-term investments. (f) Reversal of gain on the sale of the SPR and Truth divisions. (g) Adjustment to income tax expense to reflect a consolidated effective rate of 39%, which was then adjusted for the inability to tax benefit SP Europe losses and the effect of the change in U.S. federal income tax rate to 35% from 34% on deferred tax assets and liabilities. (h) Income (loss) excludes cumulative effect of changes in accounting methods for ESOP accounting and SPT's 1993 SFAS No. 106 adoption and the 1993 extraordinary loss recorded for the early retirement of indebtedness. The unaudited pro forma selected results of operations does not purport to represent what the company's results of operations would actually have been had the above transactions in fact occurred as of January 1, 1993, or January 1, 1992 or project the results of operations for any future date or period. (8) EXTRAORDINARY LOSS During the fourth quarter of 1993, the company determined to refinance both SPX and SPT debt. As a result, the company recorded an extraordinary charge of $37.0 million ($24.0 million after taxes) for extinguishment costs associated with the early retirement of $415 million (principal amount) of debt expected to be refinanced. The aggregate amount to retire this debt, including existing unamortized debt placement fees, will be $452 million. See Note 23 for further discussion of the refinancing. (9) RESTRUCTURING AND SPECIAL CHARGES 1993 -- During 1993, the company recorded a $27.5 million restructuring charge for the costs required to merge the Bear Automotive division with Allen Testproducts, acquired in June of 1993. This charge was recorded in the third quarter. Of the $27.5 million restructuring charge, approximately $16 million relates to work force reductions and associated costs. The combined businesses started with approximately 2,200 employees. That number was reduced to approximately 1,800 employees at December 31, 1993 and will be at approximately 1,700 employees by the end of the second quarter of 1994. The charge also included $9.3 million of facility duplication and shutdown costs, including the write down of excess assets of $4.2 million (non-cash). The balance of the reserves at December 31, 1993 is approximately $14.5 million, which is principally required for remaining work force reduction and facility closing costs. 1991 -- In the third quarter of 1991, the company recorded a pretax special charge of $18.2 million which included; a $6.0 million charge associated with organizational and facility consolidation of two operating units which included employment reductions and facility closings; a $6.5 million charge-off of certain capitalized computer software development costs due to conceptual changes in future product offerings whereby these costs are more appropriately characterized as general software development; a $1.4 million net charge associated with consummation of two transactions with an overseas partner that relate to further globalization of the company's automotive original equipment affiliated businesses; and a $4.3 million charge for losses, resulting principally from recessionary conditions, on certain project development investments and notes receivable related to previous sales of certain business units. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (10) EMPLOYEE BENEFIT PLANS DEFINED BENEFIT PENSION PLANS The company has defined benefit pension plans which cover substantially all domestic employees. These plans provide pension benefits that are principally based on the employees' years of credited service and levels of earnings. Contributions in excess of pension expense are considered prepayments for financial accounting purposes. The company has determined that foreign defined pension plans are immaterial to the consolidated financial statements. Net periodic pension cost (benefit) included the following components: Plan assets principally consist of equity and fixed income security investments. The following table sets forth the plans' funded status and amounts recognized in the company's consolidated balance sheets as Other Assets for its U.S. pension plans (in thousands): The significant increase in pension benefit obligations, assets and prepaid pension cost was due to the consolidation of SPT as of December 31, 1993. As part of the divestitures of the SPR and Truth divisions, the company recorded curtailment gains of $4.1 million. These gains have been included in the gain recognized on the sale of these divisions. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE Prior to 1992, postretirement health care and life insurance benefits were recognized as expense when claims or premiums were paid. In 1992, the company adopted SFAS No. 106. These costs totaled $958,000 in 1991. The following summarizes the 1993 and 1992 expense for postretirement health and life insurance (in thousands): The accumulated postretirement benefit obligation was actuarially determined based on assumptions regarding the discount rate and health care trend rates. The health care trend assumption applies to postretirement medical and dental benefits. Different trend rates are used for pre-age 65 and post-age 65 medical claims and for expected dental claims. The trend rate used for the medical plan was 15% initially, grading to a 6% ultimate rate by 1% each year for pre-65 claims; and 10.5% grading to 6% by .5% each year for post-age 65 claims. The trend rate for the dental plan was 6% each year. The liability was discounted using a 7.5% interest rate. Increasing the health care trend rate by one percentage point would increase the accumulated postretirement benefit obligation by $.7 million and would increase the 1993 postretirement benefit cost by $.1 million. The following table summarizes the accumulated benefit obligation (in thousands): The significant increase in accumulated postretirement benefits obligation was due to the consolidation of SPT as of December 31, 1993. SPT adopted SFAS No. 106 in 1993. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 EMPLOYEE STOCK OWNERSHIP PLAN ("ESOP") In June 1989, the company established an ESOP, which includes substantially all domestic employees not covered by collective bargaining agreements. The ESOP borrowed $50 million, which is guaranteed by the company, and used the proceeds to purchase 1,746,725 shares of common stock issued directly by the company. Employees vest in these shares based upon a predetermined formula. Employees may vote allocated shares directly, while the ESOP trustee will vote the unallocated shares proportionally on the same basis as the allocated shares were voted. During 1993, 1992 and 1991, 114,588, 114,735 and 114,870 shares were allocated to the employees, leaving 1,246,346 unallocated shares in the ESOP trust at December 31, 1993. The fair market value of these unallocated shares was $22.1 million at December 31, 1993. The company's contributions to the ESOP trust were as follows (in thousands of dollars): With the change in ESOP accounting in 1993, compensation expense is now measured using the fair market value when the shares are committed to the employee. Interest expense represents the actual interest paid by the ESOP trust and any dividends paid on unallocated shares in the trust are recorded as direct debt principal payments rather than as dividends. OTHER The company provides defined contribution pension plans for substantially all employees not covered by defined benefit pension plans. Collectively, the company's contributions to these plans were $683,000 in 1993, $848,000 in 1992 and $580,000 in 1991. The company provides a Retirement Savings Plan for eligible employees. Employees can contribute up to 15% of their earnings with the company matching a portion of the amount up to 6% of their earnings. The company's contribution to this plan was $875,000 in 1993, $715,000 in 1992 and $725,000 in 1991. Starting in 1994, the company matching contribution will consist of unallocated ESOP shares. (11) RELATED PARTY TRANSACTIONS Since the creation of SPT on May 30, 1989, the company has continued to provide certain administrative and insurance services to SPT. The costs associated with these services are identified and recovered from the partnership. In addition, the company's former Sealed Power Replacement division purchased replacement engine parts, principally piston rings, cylinder sleeves and valve lifters from SPT at arm's-length prices. Purchases from the partnership during 1993 through October 22 (date of sale of SPR), 1992 and 1991 were $21.5 million, $27.8 million and $27.0 million, respectively. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (12) RECEIVABLES Changes in the reserve for losses on receivables were as follows: The company has a three year agreement, expiring in April 1994, with a financial institution whereby the company agreed to sell undivided fractional interests in designated pools of domestic trade accounts receivable, in an amount not to exceed $30 million. In order to maintain the balance in the designated pools of trade accounts receivable sold, the company sells participating interests in new receivables as existing receivables are collected. At December 31, 1993 and 1992, the company had sold $25.9 million and $30 million of trade accounts receivable under this program. Under the terms of this agreement, the company is obligated to pay fees which approximate the purchasers' cost of issuing a like amount in commercial paper plus certain administrative costs. The amount of such fees in 1993 and 1992 were $1,215,000 and $1,465,000 respectively. These fees are included in other expense, net. (13) INVENTORIES Domestic inventories, amounting to $122.6 and $141.3 million at December 31, 1993 and 1992, respectively, are based on the last-in, first-out (LIFO) method. Such inventories, if priced on the first-in, first-out (FIFO) method, would have been approximately $17.7 and $34.8 million greater at December 31, 1993 and 1992, respectively. During 1993 and 1992, certain inventory quantities were reduced resulting in liquidations of LIFO inventory quantities carried at lower costs prevailing in prior years. The effect was to increase net income in 1993 by $455,000 and in 1992 by $1.8 million. Foreign inventories are valued at FIFO costs. None of the inventories exceed realizable values. The components of inventory at year-end were as follows: SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (14) INCOME TAXES The provision (benefit) for income taxes consists of the following (in thousands): A reconciliation of the effective rate for income taxes shown in the consolidated statements of income with the U.S. statutory rate of 35% in 1993 and 34% in 1992 and 1991 is shown below: No provision has been made for income and withholding taxes which would become payable upon distribution of the undistributed earnings of foreign subsidiaries and affiliates. It is the company's present intention to permanently reinvest these earnings in its foreign operations. The amount of undistributed earnings which have been reinvested in foreign subsidiaries and affiliates at December 31, 1993, was $26.7 million. It is not practical to determine the hypothetical U.S. federal income tax liability if all such earnings were remitted, but distribution as dividends at the end of 1993 would have resulted in payment of withholding taxes of approximately $1.4 million. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 The following summarizes the detail of the deferred income tax provision (benefit) for 1991, which has not been restated in accordance with SFAS No. 109: The components of the net deferred income tax assets (liabilities) were as follows: Included on the consolidated balance sheets are U.S. federal income tax refunds of $5.6 million in 1993 and $3.0 million in 1992. At December 31, 1993, the company has net operating loss carryforwards attributable to foreign operations of approximately $32.5 million that are available to offset future taxable income. These loss SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 carryforwards expire as follows: $.6 million in 1994, $0 in 1995, $0 in 1996, $2.4 million in 1997, $1.5 million in 1998 and $28.0 million thereafter. During 1993, the company utilized $2.8 million of net operating loss carryforwards attributable to foreign operations, resulting in tax benefits of $1.2 million. The deferred tax asset related to the net operating loss carryforwards have been reserved in the valuation allowance. During the fourth quarter of 1993, the company settled a dispute with the Internal Revenue Service regarding the company's tax deferred treatment of the 1989 transaction in which several operating units were contributed to SPT. The settlement of approximately $5 million in tax eliminates the IRS contention that one half of the 1989 transaction was currently taxable. The settlement and interest will be paid during the second quarter of 1994 and is adequately provided for in the company's deferred income tax accounts. (15) INVESTMENTS As of December 31, 1993, investments, as shown on the consolidated balance sheet, include equity investments in non-majority owned subsidiaries. These investments include the company's 50% owned interest in a U.S. joint venture, two 50% owned interests in joint ventures in Japan, a 40% interest in a Mexican company and a 50% interest in a German company. All of these investments are accounted for using the equity method. These investments, both individually and collectively, are not material to the company's consolidated financial statements. Until December 31, 1993, the company held a 49% interest in SPT. The pro rata share of earnings or losses and the amortization of the company's investment in SPT is reflected as "SPT equity losses" on the consolidated statements of income (see Note 5). Until December 31, 1993, the company reported that it held a 50% interest in SP Europe. As of December 31, 1993, Riken's pending 20% participation in SP Europe reverted to the company in connection with the transaction to acquire Riken's 49% interest in SPT. SP Europe had not been previously consolidated due to the company's deemed temporary control and because nonrecourse (to the partners) financing was being pursued. Up to December 31, 1993, the company carried its investment in SP Europe at zero. Due to the resulting 70% ownership, the company is recording its share of cumulative losses since the partnership formation in mid-1991 of $21.5 million. As of December 31, 1993, the balance sheet of this partnership is included in the consolidated financial statements, reflecting the company's 70% ownership and Mahle GmbH's 30% minority interest. Beginning in the first quarter of 1994, results of operations of SP Europe will be reflected in the consolidated statements of income and cash flows. (16) PROPERTY, PLANT, AND EQUIPMENT AND RELATED ACCUMULATED DEPRECIATION The company uses principally the straight line method for computing depreciation expense over the useful lives of the property, plant and equipment. For income tax purposes, the company uses accelerated methods where permitted. Asset additions and improvements are added to the property accounts while maintenance and repairs, which do not renew or extend the lives of the respective assets, are expensed currently. Upon sale or retirement of depreciable properties, the related cost and accumulated depreciation are removed from the property accounts. The net gain or loss on disposition of property is reflected in income. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Changes in property, plant, and equipment accounts and in related accumulated depreciation for the three years ended December 31, 1993 were as follows: SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (17) COSTS IN EXCESS OF NET ASSETS OF BUSINESSES ACQUIRED At December 31, 1993 and 1992, total costs in excess of net assets of businesses acquired were $223.3 and $113.2 million, respectively, and accumulated amortization of costs in excess of net assets of businesses acquired was $19.2 and $18.3 million, respectively. The increase is attributable to the acquisition of ATP and AGL, $16.3 million, and the acquisition of 51% of SPT, $97.1 million. Amortization was $3.4 million in 1993, $3.4 million in 1992 and $3.1 million in 1991. The company amortizes costs in excess of the net assets of businesses ("goodwill") acquired on a straight-line method over the estimated periods benefitted, not to exceed 40 years. After an acquisition, the company periodically reviews whether subsequent events and circumstances have occurred that indicate the remaining estimated useful life of goodwill may warrant revision or that the remaining balance of goodwill may not be recoverable. If events and circumstances indicate that goodwill related to a particular business should be reviewed for possible impairment, the company uses projections to assess whether future operating income on a non-discounted basis (before goodwill amortization) of the unit is likely to exceed the goodwill amortization over the remaining life of the goodwill, to determine whether a write down of goodwill to recoverable value is appropriate. At December 31, 1993, $74 million of goodwill relates to the Automotive Diagnostics division (which is composed of Bear Automotive and Allen Testproducts, which was acquired in 1993). This division has incurred significant operating losses in 1993 and in prior years. The company projects that, in the near future, the cost savings, market synergies and other factors which, in part, will be realized from the Bear Automotive and Allen Testproducts combination will result in non-discounted operating income sufficient to exceed goodwill amortization. However, should such projections require downward revision based on changed events or circumstances, this division's goodwill may require writedown. Although having no cash flow impact, the resulting charge, if any, could materially reduce the company's future reported results of operations and shareholders' equity. At this time, based upon present information, projections and strategic plans, the company has concluded that there has been no permanent impairment of the Automotive Diagnostics division's tangible or intangible assets. (18) COMMITMENTS AND CONTINGENT LIABILITIES The company leases certain offices, warehouses and equipment under lease agreements which expire at various dates through 2006. Future minimum rental commitments under non-cancelable operating leases are $10.9 million for 1994, $8.8 million for 1995, $6.3 million for 1996, $4.0 million for 1997, $2.9 million for 1998 and aggregate $14.5 million thereafter. Rentals on these leases were approximately $12.9 million in 1993, $9.3 million in 1992 and $10.8 million in 1991. Certain claims, including environmental matters, suits and complaints arising in the ordinary course of business, have been filed or are pending against the company. In the opinion of management, all such matters are without merit or are of such kind, or involve such amounts, as would not have a significant effect on the financial position or results of operations of the company if disposed of unfavorably. Additionally, the company has insurance to minimize its exposures of this nature. The company's operations and products are subject to federal, state and local regulatory requirements relating to environmental protection. It is the company's policy to comply fully with all such applicable requirements. As part of its effort to comply, management has established an ongoing internal compliance auditing program which has been in place since 1989. Based on current information, management believes that the company's operations are in substantial compliance with applicable environmental laws and regulations and the company is not aware of any violation that could have a material adverse effect on the business, financial condition or results of operations of the company. There can be no assurance, however, that SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 currently unknown matters, new laws and regulations, or stricter interpretations of existing laws and regulations will not materially affect the company's business or operations in the future. The company is also subject to potential liability for the costs of environmental remediation. This liability may be based upon the ownership or operation of industrial facilities where contamination may be found as well as contribution to contamination existing at offsite, non-owned facilities. These offsite remediation costs cannot be quantified with any degree of certainty. At this time, management can estimate the environmental remediation costs only in terms of possibilities and probabilities based on available information. The company is involved as a potentially responsible party ("PRP") under the Comprehensive, Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), as amended, or similar state superfund statutes in eight active proceedings involving off-site waste disposal facilities. At three of these sites it has been established that the company is a de minimis contributor. A determination has not been made with respect to the remaining five sites, but the company believes that it will be found to be a de minimis contributor at three of them. Based on information available to the company, which in most cases includes estimates from PRPs and/or federal or state regulatory agencies for the investigation, clean up costs at these sites, data related to the quantities and characteristics of materials generated at or shipped to each site, the company believes that the costs for each site are not material and in total the anticipated clean up costs of current PRP actions would not have a material adverse effect on the company's financial condition or operations. In the case of contamination existing upon properties owned or controlled by the company, the company has established reserves which it deems adequate to meet its current remediation obligations. There can be no assurance that the company will not be required to pay environmental compliance costs or incur liabilities that may be material in amount due to matters which arise in the future or are not currently known to the company. During 1988, the company's Board of Directors adopted executive severance agreements which create certain liabilities in the event of the termination of the covered executives following a change of control of the company. The aggregate commitment under these executive severance agreements should all 7 covered employees be terminated is approximately $10 million. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (19) NOTES PAYABLE AND DEBT The following table summarizes the company's current and long-term debt obligations as they existed at December 31, 1993 and 1992. During the first quarter of 1994, the company significantly restructured this debt. Refer to Note 23 for further explanation of this subsequent refinancing. Aggregate maturities of total debt are as follows before the debt refinancing described in Note 23: SPX Revolving credit loans, under revolving credit agreements dated July 1, 1991 as amended, aggregating $75 million with five banks, have terms of one year. During the period of the revolving credit loans, the borrowings will bear interest at negotiated rates not to exceed prime. The company has agreed to pay the SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 banks commitment fees of 3/8% per annum of the unused portion of the credit commitments. The credit agreements do not require the company to maintain any additional balances at the participating banks, and the agreements can be reduced in amount or terminated at any time at the option of the company. At December 31, 1993, the company had unused lines of revolving credit of $75 million. This facility was replaced by a new revolving credit agreement dated March 1994 (see Note 23). The company has guaranteed a note purchase agreement with certain insurance companies under its ESOP. This loan bears interest at 9.04%. Principal is payable in fifteen annual installments commencing June 1990. The company's semiannual contributions to the ESOP trust enable the trust to make interest and principal payments. Additionally, dividends on the ESOP's unallocated shares are used to make interest and principal payments and are deductible for income tax purposes. Dividends on unallocated shares were $545,000 in 1993, $590,000 in 1992 and $1,113,000 in 1991. Beginning in 1993, as a result of new ESOP accounting, these dividends are no longer reflected as dividends in the consolidated financial statements and are accounted for as direct principal payments. This facility will be terminated by the end of March 1994 and will be replaced by the new revolving credit agreement. The company is subject to a number of restrictive covenants under the various debt agreements. At December 31, 1993 without consideration of the availability of the new revolving credit agreement, the company is in default on the following restrictive covenants due to the consolidation of SP Europe and the purchase of Riken's 49% ownership interest in SPT; (a) the company is required to maintain a consolidated fixed charge ratio of 1.5 to 1.0, at December 31, 1993 it is .54 to 1.0, (b) the company is required to maintain consolidated net tangible assets of at least 160% of consolidated funded indebtedness, at December 31, 1993 it is 122%, (c) the company will not declare dividends that exceed the sum of $40 million plus cumulative consolidated net income since May 31, 1989, at December 31, 1993, cumulative dividends exceeded the limitation by $32 million, and (d) the company is required to maintain consolidated current assets of at least 150% of current liabilities, at December 31, 1993 it was 130%. These restrictive covenant defaults pertain to the $53 million of senior notes, the $22 million of senior notes, the $75 million revolving credit line, the $19.7 million note to the Allen Group, Inc. and the guaranteed $42.1 million ESOP note and make the debt payable on demand should the conditions of default continue after notification. However, in March 1994, the company obtained a new revolving credit facility of $250 million and will utilize this facility to repay this defaulted debt (see Note 23). As the new credit facility expires in 1999, the debt existing at December 31, 1993 has been classified as long-term. Included in interest expense, net, was $1.5 million in 1993, $0.5 million in 1992 and $0.5 million in 1991 of interest income. SPT The Term Bank Loan and the Revolving Credit Loans are provided by a syndicate of ten banks. SPT has unused available credit of up to $25 million on the revolving credit agreement as of December 31, 1993, subject to receivable and inventory balances. Additionally, $16 million of financing is available through the Deferred Term Loan Facility under the Bank Credit Agreement to make payments on borrowings under the Term Loan Facility should funds not be sufficient to make scheduled amortization payments due under the Term Loan Facility. SPT also has $5 million available on a swingline loan facility used to manage daily cash receipts and disbursements. Loans under this facility are payable in 5 days. Management believes the facilities are adequate to cover the 1994 financing requirements of SPT. SPT has entered into hedging arrangements which fix the interest rate of approximately $70 million of the bank borrowings at 11 1/2% for a period ranging from one to three years. The unhedged bank loans bear interest at 1 1/4% over the prime rate or 2 1/4% over the LIBOR rate. The rates are set, at SPT's option, for various SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 periods up to one year in length. Substantially all of SPT's assets are pledged as collateral for loans under the Bank Credit Agreement. SPT is subject to a number of restrictive covenants under the Bank Credit Agreement, as amended, and the Indenture related to the subordinated debentures. Under the most restrictive of these covenants as of year-end, SPT must: (a) meet a fixed charge coverage ratio of 1.10 to 1; (b) meet a cash interest expense coverage ratio of 1.90 to 1; (c) meet a current ratio of 1.5 to 1; and (d) limit capital expenditures for the year ended December 31, 1993 to $18 million. At year-end, SPT's actual fixed charge ratio was 1.12 to 1; its cash interest expense coverage ratio was 2.04 to 1; its current ratio was 1.5 to 1 and net capital expenditures were approximately $17.8 million. The cash interest expense coverage ratio becomes more restrictive in future periods. The covenants also restrict distributions to the partners. Financing costs incurred by SPT were being amortized over the life of the respective borrowings. Amortization of $1.2 million was recorded in 1993, 1992 and 1991 with the remaining $3.9 million written off as part of the debt extinguishment charge (see Note 8). At December 31, 1993, substantially all of SPT's assets are pledged as collateral under SPT's bank credit agreements. The distribution of these assets, as well as partnership distributions, to the company from SPT are restricted. The company's planned second quarter issuance of $260 million of senior subordinated notes and concurrent payment of the SPT lenders will remove this restriction. Should the notes not be issued, the SPT indebtedness will remain in place, including the restrictions. (20) CAPITAL STOCK Authorized shares of common stock (par value $10.00) total 50,000,000 shares. Common shares issued and outstanding are summarized in the table below. The company's treasury stock was purchased in the last half of 1989 at an average cost of $30 5/8 per share using $50 million of proceeds from the creation of the company's leveraged ESOP. The company has 3,000,000 shares of preferred stock, no par value, authorized, but no shares have been issued. In June 1989, the company established an employee stock ownership plan (ESOP). 1,746,725 shares of common stock were issued to the ESOP trust in exchange for $50 million. These shares were issued at market value ($28 5/8 per share) and the appropriate amounts are included in common stock and paid in capital. The company restated, amended and renamed its 1982 Stock Option Plan to the 1992 Stock Compensation Plan, effective December 15, 1992. Under the new Stock Compensation Plan, up to 700,000 shares of the company's common stock may be granted to key employees with those shares still available for use under the 1982 Stock Option Plan being carried forward and forming a part of the 700,000 shares. Awards of incentive stock options, nonqualified stock options, stock appreciation rights (SAR's), performance units and restricted SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 stock may be made under the Plan although no more than 200,000 shares may be granted in the form of restricted stock. The Plan also authorizes the granting of stock options to directors. Stock options may be granted to key employees in the form of incentive stock options or nonqualified stock options at an option price per share of no less than the fair market value of the common stock of the company on the date of grant. The options become exercisable six months after the date of the grant and expire no later than 10 years from the date of grant (or 10 years and 1 day with respect to nonqualified stock options). SAR's may be granted to key employees either in conjunction with the awarding of nonqualified stock options or on a stand-alone basis. The SAR's entitle the holder to receive a cash payment equal to the excess of the fair market value of a share of common stock of the company over the exercise price of the right at the date of exercise of the right. Performance units, which are equivalent to a share of common stock, may be granted to key employees and may be earned, in whole or in part, dependent upon the attainment of performance goals established at the time of grant. Restricted stock may be granted to key individuals to recognize or foster extraordinary performance, promotion, recruitment or retention. At the time of the grant, restrictions are placed on ownership of the shares for a stated period of time during which a participant will not be able to dispose of the restricted shares. Upon lapse of the restriction period, complete ownership is vested in the participant and the shares become freely transferable. A summary of common stock options, SAR's, and restricted stock issued under the company's Stock Compensation Plan is as follows: Preferred stock is issuable in series with the Board of Directors having the authority to determine, among other things, the stated value of each series, dividend rate, conversion rights and preferences in liquidation or redemption. On June 25, 1986, the company entered into a Rights Agreement which was amended and restated as of October 20, 1988. Pursuant to the Rights Agreement, in July 1986, the company issued a dividend of one SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 preferred stock purchase right on each outstanding share of common stock. Each right entitles the holder, upon the occurrence of certain events, to purchase one one-hundredth of a share of a new series of junior participating preferred stock for $100. Furthermore, if the company is involved in a merger or other business combination at any time after the rights become exercisable, the rights will entitle the holder to buy the number of shares of common stock of the acquiring company having a market value of twice the then current exercise price of each right. Alternatively, if a 20% or more shareholder acquires the company by means of a reverse merger in which the company and its stock survive, or engages in self-dealing transactions with the company, or if any person acquires 20% or more of the company's common stock, then each right not owned by a 20% or more shareholder will become exercisable for the number of shares of common stock of the company having a market value of twice the then current exercise price of each right. The rights, which do not have voting rights, expire on July 15, 1996, and may be redeemed by the company at a price of $.05 per right at any time prior to their expiration. (21) SPX CREDIT CORPORATION In June of 1993, the company acquired Allen Group Leasing from The Allen Group, Inc. (see Note 4). The company's SP Financial division was merged with this lease financing unit and has been renamed SPX Credit Corporation ("SPX CC"). SPX CC provides direct financing leasing alternatives to primarily electronic diagnostic, emissions testing, and wheel service equipment customers in the United States and Canada. SPX CC purchases equipment for lease to others from the company's Specialty Service Tools divisions, its sole supplier, at prices comparable to those to third parties. The aggregate cost of equipment purchased from Specialty Service Tool divisions amounted to approximately $16.0 million in 1993. The company's Specialty Service Tools divisions charge a commission representing an origination fee for providing leases and for the cost of services provided to SPX CC with respect to the negotiation and consummation of new leases in the amount of $521,000 for 1993 (since the acquisition). SPX CC has an agreement with Specialty Service Tools divisions for the repurchase of repossessed equipment at amounts determined to approximate realizable value by the Specialty Service Tools division. In 1993 (since the acquisition), approximately $5.8 million of equipment was repurchased under this agreement. Information regarding lease receivables included in the consolidated balance sheets is as follows (amounts in thousands): The aggregate maturities of direct financing lease receivables as of December 31, 1993 were $36.7 million in 1994, $28.4 million in 1995, $18.0 million in 1996, $10.3 million in 1997 and $3.5 million in 1998. Essentially all of SPX CC's direct financing lease receivables are with companies or individuals operating within the automotive repair industry, including automotive dealerships, garages and similar repair and inspection facilities, and approximately one-third of lease receivables are with lessees located in the state of California. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 The company has a program whereby certain lease receivables are sold to financial institutions with limited recourse. In the event of default by a lessee, the financial institution has recourse equal to their net lease receivable. In return, the company receives the collateralized lease equipment. In 1993, 1992 and 1991, $5,613,000, $21,390,000 and $18,705,000 of gross lease receivables were sold to financial institutions generating revenues of $846,000, $1,386,000 and $2,936,000. At December 31, 1993 and 1992, financial institutions held lease receivables, which are subject to limited recourse, of $42,766,000 and $49,235,000. Correspondingly, allowances for recourse liabilities, net of recoverable value, were $3,743,000 and $2,225,000 at December 31, 1993 and 1992. (22) CASH FLOWS FROM OPERATING ACTIVITIES The following provides supplementary information comprising the company's cash flows from operating activities: (23) SUBSEQUENT EVENT -- REFINANCING Late in the fourth quarter of 1993, the company determined that virtually all existing SPX and SPT debt should be refinanced in anticipation of the purchase of Riken's 49% interest in SPT, due to favorable prevailing interest rates, scheduled and accelerated debt maturities, and to maintain the flexibility of the company to grow through internal investments and acquisitions. The plan of refinancing (the "Refinancing") includes two elements, a new $225 million revolving bank facility and the issuance of $260 million of senior subordinated notes. The Refinancing is expected to be completed by the end of the second quarter of 1994. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 In March of 1994, the first portion of the Refinancing was completed when the company closed a $250 million revolving credit facility with First National Bank of Chicago, as agent for a syndicate of banks. This revolving credit facility bears interest at LIBOR plus 1.0% or the prime rate (at the company's option) and expires in 1999. Upon completion of the senior subordinated note offering, this revolving credit facility is to be reduced to $225 million of maximum availability. Proceeds from this revolving credit facility will be used to extinguish SPX debt as follows: Senior Notes aggregating $75 million, the $19.7 million note to the Allen Group, the company's ESOP trust's note of $42.1 million and $68 million of miscellaneous debt, much of which was technically in default of covenant provisions. Also, $15.2 million of letters of credit securing the Industrial Revenue Bonds were renegotiated. By June 30, 1994, the company expects to have completed its $260 million offering of senior subordinated notes. These notes are anticipated to bear interest at a rate of approximately 10% and will be due in or after the year 2002. At that time, the proceeds will be used to retire existing SPT borrowings, including the $100 million of 14.5% senior subordinated debentures, the Term Bank Loan, and the Revolving Credit Loans. Excess proceeds will be used to pay down the company's new revolving credit facility at that time. The revolving credit agreement contains covenants, the most restrictive of which are as follows: (a) maintain a leverage ratio of 78% in 1994, declining on a graduated scale to 65% in 1999, (b) maintain an interest expense coverage ratio of 2.0 to 1.0 in 1994 rising on a graduated scale to 3.5 to 1.0 in 1998 and thereafter, (c) maintenance of a fixed charge coverage ratio, as defined in the revolving credit agreement, of 1.75 to 1.0 in 1994 and 1995, and 2.0 to 1.0 thereafter, and (d) dividends are limited to $8 million for the five quarters starting with the first quarter of 1994, and are limited to 10% of operating income plus depreciation and amortization (EBITDA) thereafter. The revolving credit agreement also limits capital expenditures, investments, and transactions with affiliates. If the company does not issue senior subordinated notes, provisions have been made so that the revolving credit facility will remain at $250 million and the rate of interest would become LIBOR plus 1.5% or the prime rate plus .5% (at the company's option) and the facility would be secured by substantially all of SPX's assets. Also, the existing SPT debt would remain outstanding in its current form, including security interests in SPT's assets. The financial covenants, the most restrictive of which, will require the company (excluding SPT) to: (a) maintain a leverage ratio of 55% in 1994 and 1995, and 50% thereafter, (b) maintain an interest expense coverage ratio of 3.0 to 1.0 in 1994, 4.0 to 1.0 in 1995 and 5.0 to 1.0 thereafter, (c) maintenance of a fixed charge coverage ratio, as defined in the revolving credit agreement, of 2.0 to 1.0 in 1994, 1995 and 1996 and 2.25 to 1.0 thereafter, and (d) dividends declared before March 31, 1995 and paid before June 30, 1995 are limited to $8 million, and thereafter are limited to 10% of operating income plus depreciation and amortization (EBITDA) during the preceding twelve months. The revolving credit agreement also limits capital expenditures, investments, transactions with affiliates, and transactions with SPT. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (24) SEALED POWER TECHNOLOGIES -- SELECTED FINANCIAL INFORMATION As discussed in Note 5, the company consolidated SPT's balance sheet at December 31, 1993. The company's 49% share of SPT's results of operations has been recognized on the equity method of accounting. Selected historical financial information on SPT is as follows: - --------------- * In 1993, SPT adopted SFAS No. 106, "Employers Accounting for Postretirement Benefits other than Pensions." (25) FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosure about Fair Value of Financial Instruments" requires disclosure of an estimate of the fair value of certain financial instruments. The following methods and assumptions were used by the company in estimating its fair value disclosures: Cash and temporary cash investments: The carrying amount reported on the consolidated balance sheet approximates its fair value. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Lease Finance Receivables: The carrying amount, which is net of deferred future lease finance income and reserves for credit losses, approximates fair value. Notes payable and current maturities of long-term debt and long-term debt: The fair value of the company's debt either approximates its carrying value or represents the carrying value plus the early extinguishment costs to be paid in the first quarter of 1994 or to be paid during the second quarter of 1994. Interest rate swaps: The fair value represents the early extinguishment costs required to terminate the arrangement in 1994. Letters of Credit: The company utilizes letters of credit to back certain financing instruments and insurance policies. The Letters of Credit reflect fair value as a condition of their underlying purpose and are subject to fees competitively determined in the marketplace. The carrying amounts and fair values of the company's financial instruments at December 31, 1993 are as follows (amounts in thousands): SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 (26) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The first three quarters of 1993 and each quarter of the years 1992 and 1991 have been restated to reflect the company's previous 49% share of SPT income or losses and the effect of amortizing the difference between its investment balance and its share of SPT's initial partnership capital deficit. The first three quarters of 1993 have also been restated to reflect new accounting for the company's ESOP. - --------------- * Includes a pretax restructuring charge of $27.5 million, $18.5 million aftertax and $1.47 per share. ** Includes SP Europe equity losses, $21.5 million after tax and $1.71 per share. Also includes a pretax gain on the sale of businesses of $105.4 million, $64.2 million aftertax and $5.07 per share. SPX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 - --------------- * Includes a pretax special charge of $18.2 million, $14.7 million aftertax and $1.06 per share. (27) SUPPLEMENTARY FINANCIAL INFORMATION PROFIT AND LOSS BALANCE SHEET 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 (a) Directors of the company. See the company's Proxy Statement, incorporated by reference as Part III of this Form 10-K, under the caption "Election of Directors". (b) Executive Officers of the company. See Part I of this Form 10-K at page 10. ITEM 11. ITEM 11. MANAGEMENT REMUNERATION AND TRANSACTIONS See the company's Proxy Statement, incorporated by reference as Part III of this Form 10-K, under the headings "Compensation of Executive Officers" and "Directors' Compensation". ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See the company's Proxy Statement, incorporated by reference as Part III of this Form 10-K, under the caption "Stock Ownership of Management and Certain Beneficial Owners". ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Peter H. Merlin, a Director of the company, is a Partner and Chairman -- International Department of the law firm of Gardner, Carton & Douglas which the company has retained in 1993 and many prior years and anticipates retaining in 1994 and thereafter. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed, or incorporated by reference, as part of this Form 10-K: 1. All financial statements. See Index to Consolidated Financial Statements on page 22 of this Form 10-K. 2. Financial Statement Schedules. None required. See page 22 of this Form 10-K. 3. Exhibits (b) Reports on Form 8-K. The company, on October 26, 1993, filed Form 8-K which provided the information regarding the divestiture of its Sealed Power Replacement division. The company, on November 5, 1993, filed Form 8-K which provided the information regarding the divestiture of its Truth division. SIGNATURES Pursuant to the requirements of the Securities and 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 the capacities indicated on the 25th day of March, 1994. EXHIBIT INDEX

868635_1993.txt

868635_1993

1993

868635

ITEM 1. BUSINESS -------- THE COMPANY Robertson-Ceco Corporation (the "Company") was formed on November 8, 1990 by the merger (the "Combination") of H. H. Robertson ("Robertson") and Ceco Industries, Inc. ("Ceco Industries") with and into The Ceco Corporation ("Ceco"), a wholly-owned subsidiary of Ceco Industries, with Ceco continuing as the surviving corporation under the name Robertson-Ceco Corporation. The Combination was accounted for using the purchase method, with Robertson deemed the acquiror. Accordingly, the assets, liabilities and results of operations of Ceco Industries are included in the Company's consolidated financial statements only for periods subsequent to November 1, 1990. The Company and its subsidiaries operate in three segments: (1) the Metal Buildings Group, which is engaged in the manufacture, sale and installation of pre-engineered metal buildings for commercial and industrial users; (2) the Building Products Group, which provides construction services and at certain locations is engaged in the manufacture, sale and installation of non- residential building components, including wall, roof and floor systems; and (3) the Concrete Construction Group, which is engaged in the provision of subcontracting services for forming poured-in-place, reinforced concrete buildings. Most of the products and services which the Company manufactures and sells are used in the construction of buildings, including commercial and industrial buildings, schools, offices, hospitals and multi-family dwellings. The Company considers all aspects of its business to be highly competitive. The Company's business is both seasonal and cyclical in nature and, as a consequence, has certain working capital needs which are characteristic of the industry in which the Company conducts its business. At a time of increased construction activity, the Company has a need for increased working capital which traditionally has been funded principally by short-term bank borrowings and letters of credit. When construction activity declines on a temporary basis, the Company tends to increase its liquidity position and reduce its accounts receivable, inventories and accounts payable. As a result of the significant, negative impact on operations and liquidity caused by the severe recession in the worldwide non-residential construction markets, and the unlikelihood that a turnaround in the economy would occur in the near future, during the third quarter of 1991, the Company began to develop a restructuring plan designed to improve its operational and financial performance. In connection with this restructuring plan, during the first quarter of 1992, the Company sold (a) certain of its domestic building products and construction businesses, including the operations of the Ceco Door Products, the Ceco Entry Systems and the Ceco/Windsor Door operating units of the Company (collectively, the "Door Business"), acquired as part of the Combination, and the portion of the Company's H. H. Robertson Company (USA) operating unit engaged in the design, fabrication, marketing, sale and erection of industrial and architectural wall, roof and other building products systems (the "X-1 Business") for approximately $135 million, (b) its floor and deck business (the "Floor Business") for $2.4 million and (c) its subsidiary located in South Africa (the "South African Subsidiary") and, together with the X-1 Business and the Floor Business, the "Sold Businesses") for $5.3 million. The Company's 1990 results of operations were reclassified to reflect the Door Business as a discontinued operation. The X-1 Business, the Floor Business and the South African Subsidiary, which were recorded as held for sale at December 31, 1991, represent a portion of a segment and operated as part of the Company's Building Products Group. In November of 1993, the Company sold its subsidiary located in the United Kingdom (the "U.K. Subsidiary") which also operated as part of the Company's Building Products Group. In addition to the sale of the Door Business, the Sold Businesses and the U.K. Subsidiary discussed above, a series of other operational restructuring actions were taken in 1991, 1992 and 1993. Operational restructuring actions which have taken place include downsizing the corporate headquarters, closing excess plants and redistributing manufacturing operations and equipment from closed operations, consolidating and improving capacity and cost effectiveness at remaining plants, closing sales and district offices, relocating certain product lines, reducing work force levels and consolidating certain financial and administrative functions. The Company is continuing to pursue a variety of further operational restructuring options, including further consolidation and redistribution of operations and equipment and withdrawal from unprofitable and nonstrategic businesses through sale or closure. The significant financial restructuring actions which were completed during 1993 include: the completion of the Company's exchange offer for the Company's 15.5% Discount Subordinated Debentures due 2000 for new debt and common stock and the exchange of the Company's outstanding cumulative convertible preferred stock for common stock; replacement of the Company's domestic credit facility; significant reductions in outstanding letters of credit; renegotiation and settlement of certain operating leases in connection with the Company's downsizing activities; retirement of a $4.0 million facility fee note through the issuance of 1,374,292 shares of common stock; and the sale of 3,333,333 newly issued shares of the Company's common stock and the transfer of all assets, claims and rights under a foreign project to an outside investor which is indirectly controlled by a director of the Company for $10.0 million. METAL BUILDINGS The Company owns and operates three pre-engineered metal building companies: Ceco Building Systems, Star Building Systems, and H. H. Robertson Building Systems (Canada). Pre-engineered metal buildings have traditionally accounted for a significant portion of the market for commercial and industrial buildings under 150,000 sq. ft. in size that are built in North America. Historically aimed at the one-story small to medium building market, the use of the product is expanding to large (up to 1 million sq. ft.), more complex, and multi-story (up to 4 floors) buildings. The product provides the customer with a custom designed building at generally a lower cost than conventional construction and is generally faster to job completion from concept. The Company's pre-engineered metal buildings are designed and manufactured at plants in California, Iowa, Mississippi, North Carolina, and in Ontario, Canada. The buildings are sold through builder/dealers located throughout the U.S. and Canada. In addition to sales in North America, in recent years the Company has been selling its buildings to a growing Asian market. Sales to these markets are made both through local unaffiliated dealers and by Company salespersons. The principal materials used in the manufactured buildings are hot and cold rolled steel products that are readily available from many sources. The buildings consist of four components: primary structural steel, secondary structural steel, cladding, and accessories (doors, windows, flashing, etc.). The buildings are erected by the dealer network supplemented by subcontractors and, in certain cases, by Company erection crews. The Company believes it is an important manufacturer of pre-engineered buildings, although it faces competition from other manufacturers. Price and service are the primary competitive features in this market. The Metal Buildings Group accounted for 31%, 47% and 57% of the Company's revenue (before intersegment eliminations) in 1991, 1992 and 1993, respectively. BUILDING PRODUCTS The Building Products Group provides construction services and at certain locations, manufactures products, and provides construction services with respect to, (a) insulated and non-insulated roofing, siding and exterior wall panels; (b) fluted steel roofs and decks and fluted and cellular steel floor and deck and related supplies and accessories; (c) louvers and ventilators; and (d) architectural wall systems. In connection with an agreement pursuant to which the Company sold the Door Business and the X-1 Business, the Company (a) sold its United States building products businesses, other than its architectural wall operations located at its Cupples Products Division ("Cupples") in St. Louis, Missouri, and (b) agreed not to compete in the United States with respect to the building products businesses which were sold. Cupples continues to design, engineer and manufacture architectural wall systems. The principal materials used by the Company in the manufacture of its building products are coiled steel (both galvanized and prepainted), coiled and sheet aluminum, ingot aluminum, glass synthetic resins and metal fastening devices. These materials are readily available from multiple sources. Cupples markets and sells its products both in the United States and throughout the rest of the world. The principal geographic areas in which the Company's other building products are sold are Continental Europe, Australia, Canada, New Zealand and Southeast Asia. The Company's building products compete on a worldwide basis with a number of manufacturers of metal building products which are similar to those fabricated by the Company. Further competition comes from manufacturers using other materials such as concrete, brick, gypsum products, glass and reinforced plastics. Price, service, warranty and product and installation performance each affect competition for the Company's building products. The Building Products Group accounted for 56%, 36% and 26% of the Company's revenues (before intersegment eliminations) in 1991, 1992 and 1993, respectively. CONCRETE CONSTRUCTION The Concrete Construction Group provides a subcontracting service for forming poured-in-place, reinforced concrete buildings. The forms are used to mold the site-case concrete floors, roofs, walls and other miscellaneous parts of buildings, and generally are removed for repeated use on the same structure or on other buildings. After the forms are in place, other parties provide material and labor for reinforcement and concrete. In selected markets, the Company provides additional services which may include material and labor for concrete and reinforcing steel, as well as project management for construction of the entire concrete structural frame or skeleton of a building. The Company's primary market is the non-residential building segment of the U.S. construction market, including commercial, industrial and institutional buildings, as well as water storage and treatment plants, and other similar public programs. The Concrete Construction Group maintains storage facilities for its forming and other equipment at locations throughout the United States. The yards are located regionally to reduce transportation costs in servicing of construction markets located throughout the country. In addition, the Company currently operates two remanufacturing facilities which are equipped to recondition forms, as required for repeated use. Construction services are provided by the Company's own employees or by subcontractors. Although the number of workers employed in this business varies because of the cyclical and seasonal nature of construction activity, the supply of labor is considered to be adequate. Concrete forming services are sold to general building contractors and others through the regional sales offices. At December 31, 1993, there were concrete construction sales offices in 21 cities throughout the continental United States. The Company believes that it is the largest organization performing such services in the United States; however, there are a number of local and regional general building contractors, concrete subcontractors and forming subcontractors offering competitive services, often with lower transportation costs and overhead than the Company. The Company competes with these firms through a regional marketing network, preconstruction services (such as design consulting and project scheduling) and national name-recognition. The Company's experience and volume allow it to maintain cost advantages with respect to certain aspects of the services offered. The Concrete Construction Group accounted for 13%, 17% and 17% of the Company's revenues (before intersegment eliminations) in 1991, 1992 and 1993, respectively. CUSTOMERS The Company serves a wide variety of customers, virtually all of which are in the construction industry, and there is no dependence upon a single customer, group of related customers or a few large customers. INVENTORY AND BACKLOG Virtually all sales of pre-engineered metal buildings and building products are for specific projects, and the Company maintains a minimum inventory of finished products. Shipments of pre-engineered metal buildings and building products are generally made directly from the manufacturing plant to the building sites. Raw materials are largely comprised of steel-related materials which are susceptible to price increases, especially during periods of strong economic expansion. Historically, the Company and the related industries with which it competes have been successful in passing on such price increases to purchasers. Due to the wide availability of the necessary raw materials and the generally short delivery lead times, the Company generally has been able to minimize its risk with respect to price increases in the raw materials used to make its products. To the extent that the Company has quoted a fixed-price sales contract and has not locked in the related cost of the raw materials, the Company is at risk for price increases in such raw materials. An inventory of reusable forms for concrete construction in standard sizes and shapes is maintained at locations throughout the United States. Special sizes and shapes may be required for specific jobs and are scrapped after use. The Company believes that it has an adequate supply of standard forms to meet current and foreseeable demand and that any specialized forms are readily available from multiple sources. For material, backlog is determined primarily based upon receipt of a letter of intent or purchase order from the customer and with respect to erection work, backlog is determined based primarily on receipt of the customer contract or letter of intent. The Company reduces its backlog upon recognition of the related revenue. At December 31, 1993, the backlog of unfilled orders believed to be firm for the Company's ongoing businesses was approximately $151 million. On a comparable basis, adjusted for the sale of the U.K. Subsidiary, which had at December 31, 1992 backlog of approximately $26 million, the order backlog was approximately $143 million at December 31, 1992. Approximately $10 million of the December 31, 1993 backlog is expected to be performed after 1994. FACILITIES During 1993, the Company's facilities for manufacturing pre-engineered metal buildings generally operated on a two-shift work schedule five days each week, while the Company's facilities for manufacturing building products generally operated on a one-shift work schedule five days each week. Should the need to fill additional orders for its products occur, the Company believes it could institute additional working shifts or work days. The majority of the Company's pre-engineered metal buildings and building products are manufactured for specific projects, and its forms for concrete construction are often standard shapes and sizes which can be reused. Quantitative determination of total production capacity and of utilization thereof is therefore not meaningful. The Company believes its existing manufacturing facilities and labor force are adequate to serve the present and reasonably foreseeable future needs of its business. PATENTS The Company owns a number of patents with varying expiration dates extending beyond the year 2000. None of these patents is believed to be a major factor in the competitive position of the Company. The Company has entered into various licensing arrangements relating to the Company's patents, trademarks and 'know-how,' but the revenues received from these arrangements, in the aggregate, are not significant. RESEARCH AND DEVELOPMENT The Company conducts limited research activities for the purpose of developing new products and improvements to, and new applications for, existing products. Research and development expenditures were approximately $2.0 million in 1991, $.7 million in 1992, and $.5 million in 1993. The decline in research and development expenditures is primarily a result of the exclusion of businesses which have been sold. ENVIRONMENTAL CONTROLS The Company's manufacturing activities have generated and continue to generate materials classified as hazardous wastes. The Company devotes considerable resources to compliance with legal and regulatory requirements relating to (a) the use of these materials, (b) the proper disposal of such materials classified as hazardous wastes and (c) the protection of the environment. These requirements include clean-ups at various sites. The Company's policy is to accrue environmental and clean-up related costs of a non-capital nature when it is probable that a liability has been incurred and such liability can be reasonably estimated. Based upon currently available information, including the reports of third parties, management does not believe that the reasonable possible loss in excess of the amounts accrued in the Company's consolidated financial statements would be material. However, no assurance can be given that any future discovery of new facts and the retroactive application of the Company's legal and regulatory requirements to those facts would not be material and would not change the Company's estimate of costs it could be required to pay in any particular situation. EMPLOYEES At December 31, 1993, the Company employed approximately 3,103 persons worldwide and was a party to collective bargaining agreements with various labor unions covering approximately 785 U.S. employees and 119 foreign employees. Work stoppages are generally a possibility in connection with the negotiation of collective bargaining agreements, although the Company believes that its employee relations are generally satisfactory. FOREIGN OPERATIONS As described above, the Company owns subsidiaries or directly conducts operations in several foreign countries. For the year ended December 31, 1993, foreign operations accounted for 25% of the Company's revenues before inter-area eliminations, and at December 31, 1993, foreign operations accounted for 22% of the Company's total assets (before adjustments and eliminations). The Company's foreign investments and businesses result in several risks to the Company's financial condition and results of operations, including potential losses through currency exchange rate fluctuations, expropriation of assets, restrictions upon the repatriation of capital and profits, and foreign governmental regulations discriminating against non-domestic companies. The Company intends to comply with United States laws and Treasury Department and Commerce Department regulations concerning boycotts, which compliance could adversely affect the Company's business in countries which impose boycott requirements. ITEM 2. ITEM 2. PROPERTIES ---------- The Company maintains and operates manufacturing plants world-wide to produce the products and materials required by its business activities. The listing below identifies those manufacturing facilities which are currently used in the Company's business and identifies the business segments that use the properties. Facilities not indicated as "leased" are owned in fee by the Company. Substantially all of the Company's domestic manufacturing facilities are pledged as collateral in connection with the Company's domestic credit facility. MANUFACTURING PLANT BUSINESS SEGMENT - - ------------------- ---------------- Monticello, Iowa Metal Buildings Lockeford, California Metal Buildings Mt. Pleasant, Iowa Metal Buildings Rocky Mount, North Carolina Metal Buildings Columbus, Mississippi Metal Buildings Hamilton, Ontario, Canada Metal Buildings St. Louis, Missouri (leased) Building Products Granollers, Spain Building Products Broenderslev, Denmark Building Products Revesby, N.S.W., Australia Building Products Each of the Company's manufacturing plants is an operating facility, designed to produce particular items. The productive capacities of these plants are adequate to serve the Company's business needs at a volume at least equal to that achieved in 1993. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- LAWSUITS Three related lawsuits were filed by or against the Company in 1990 and and are pending in the Supreme Court of the State of New York (Cupples Product Division of H. H. Robertson Company v. Morgan Guaranty Trust Company of New York, et al; Ace Contracting Company, a Division of Cell-San Construction Company, Inc. v. Morgan Guaranty Trust Company of New York, et al; H. Sand & Co., Inc. v. Morgan Guaranty Trust Company of New York). The lawsuits arise out of the construction of new headquarters for Morgan Guaranty Trust Company of New York ("Morgan") at 60 Wall Street, New York, New York. Cupples acted as a subcontractor for the provision and erection of custom curtainwall for the building. Morgan and Tishman Construction Company of New York ("Tishman"), the general contractors for the project, have claimed that the Company and Federal Insurance Company ("Federal"), as issuer of a performance bond in connection with the Company's work, are liable for $29.9 million in excess completion costs and delay damages due to the Company's alleged failure to perform its obligations under its subcontract. The Company has taken action to enforce a $5.0 million mechanic's lien against the building and seeks to recover more than $10.0 million in costs and damages caused by Tishman's breach of the subcontract with the Company. The Company and Federal believes there are meritorious defenses to those claims against them and are vigorously defending and prosecuting these actions. In February 1994, the Company filed suit in state court in Iowa against Alaska Industrial Development and Export Authority ("AIDEA"), Olympic Pacific Builders, Inc. ("OPB") and Strand Hunt Corp. ("Strand Hunt") and others alleging breach of contract, tortious interference with contractual relations, negligence and misrepresentation, and seeking payment of amounts owed to the Company and other damages in connection with a pre-engineered metal building in Anchorage, Alaska. The Company fabricated the building for OPB, which in turn supplied the building to Strand Hunt, as general contractor for AIDEA. In March 1994, Strand Hunt filed suit in the Superior Court for the State of Alaska against a number of parties, including the Company and its surety. Strand Hunt has alleged against the Company breach of contract, breach of implied warranties, misrepresentation and negligence in connection with the fabrication of the building and seeks damages in excess of $10 million. The Company believes that it is entitled to payment and that it has meritorious defenses against the claims of Strand Hunt. Two separate, but related lawsuits have been filed by or against the Company in connection with a $2.4 million subcontract performed by Cupples for the supply and erection of custom curtainwall on a commercial office building project known as the 3DI Tower in Houston, Texas. On January 29, 1991, Harvey Construction Company ("Harvey"), the general contractor, filed suit in federal court in Houston asserting claims for the owner/developer of the project as well as attempting to enforce a $4.0 million state court judgment against Cupples by virtue of the indemnity provisions in the subcontract (Harvey Construction Co. v. Robertson Ceco Corp.). On January 30, 1991, without knowledge of the action filed by Harvey the previous day, Cupples filed an action in federal court in St. Louis seeking a declaratory judgment that it is not liable under the indemnity provisions or for any of the owner/developer's claims that were assigned to Harvey (Cupples Products Division of Robertson Ceco Corp. v. Harvey Construction Co.). Harvey has filed a counterclaim in the St. Louis action, seeking to enforce the state court judgment as well as the assigned claims. Other than demanding indemnity for the $4.0 million state court judgment, Harvey's counterclaims seek unspecified damages. The Company believes it has meritorious defenses to Harvey's claims against Cupples and is vigorously defending and prosecuting these actions. There are various other proceedings pending against or involving the Company which are ordinary or routine given the nature of the Company's business. While the outcome of the Company's legal proceedings cannot at this time be predicted with certainty, management does not expect that these matters will have a material adverse effect upon the consolidated financial condition or results of operations of the Company. During 1993 and through February 1994, the Company resolved and settled certain litigation relating to matters of alleged employment discrimination and alleged breaches of real estate leases by the Company. These settlements did not have a material adverse effect on the Company's 1993 Consolidated Statement of Operations. ENVIRONMENTAL MATTERS The Company has completed its investigation with respect to the remediation of two owned disposal sites formerly used by Robertson to dispose of plant wastes from the Company's former Ambridge, Pennsylvania, manufacturing facility. The Company has submitted its reports of findings to the Pennsylvania Department of Environmental Resources ("PDER") and it is now in the process of submitting work plans for remedial activities for both sites to the PDER for its consideration and approval. The Company also is in the process of negotiating a Consent Order and Agreement to memorialize the agreed upon approach to remediate these sites. In another matter, the Company has submitted a proposal to the Illinois Environmental Protection Agency ("IEPA) regarding an appropriate modified closure plan for a hazardous waste storage facility for electric arc furnace dust at Ceco's former Lemont, Illinois, steel mill facility. Environmental closure at this site is substantially complete. A closure unit has been constructed and a post-closure groundwater monitoring well system has been installed and is currently in operation. The Company has entered into discussions with the IEPA regarding what further conditions they will require to secure final closure. The Company has recorded reserves in amounts which it considers to be adequate to cover the probable and reasonably estimable costs which may be incurred in relation to these matters. However, no guarantee can be made that the relevant governmental authorities will accept the remediation plans or actions proposed by the Company or the position taken by the Company as to its legal responsibilities and therefore that more costly remediation efforts will not be required. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- During the fourth quarter of the fiscal year covered by this report no matter was submitted to a vote of security holders. ITEM 4.1. EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ Mr. Andrew G. C. Sage, II is Chairman (since July 1993) of the Company. Mr. Sage also served as President (from November 1992 until July 1993) and Chief Executive Officer (from November 1992 until December 1993) of the Company. Mr. Sage is also President of Sage Capital Corporation ("Sage Capital"), a general business and financial management corporation specializing in business restructuring and problem solving. Prior to the formation of Sage Capital in 1989, Mr. Sage was a consultant to and a director of RJR Nabisco, Heico, Inc., Pettibone Corporation and USIF Real Estate. Mr. Sage is a director of Computervision Corporation, Fluid Conditioning Products, Heico, Inc. and Pettibone Corporation. Mr. Heisley is Chief Executive Officer and Vice Chairman (since December 1993) of the Company. Mr. Heisley is Chairman of the following companies: Heico, Inc. (since 1978), a diversified manufacturing company; Pettibone Corporation (since 1988), a manufacturer of heavy equipment; Davis Wire Corporation (since 1991), a manufacturer of steel wire; Steelastic Company (since 1991), a manufacturer of tire making equipment; Tom's Foods, Inc. (since 1993), a manufacturer and distributor of snack foods; Newbury Industries, Inc. (since 1993), a manufacturer of injection molding equipment for the plastics industry, and Nutri/System, Inc. (since 1993), a national weight maintenance company. He is also a director of Envirodyne, Inc. (since 1994). Mr. Maiorani is President (since July 1993) of the Company. Prior to being elected President, Mr. Maiorani served in various senior management positions with the Company including Executive Vice President and Chief Administrative Officer (from November 1992 until July 1993), Chief Financial Officer (from March 1992 until July 1993) and Senior Vice President (from March 1992 until November 1992). Prior to joining the Company, Mr. Maiorani was Senior Vice President and Chief Financial Officer (1988-1992) of M/A-COM, Inc., a manufacturer of electronic semi-conductors, components and subsystems. Mr. Baker is Vice President of Financial Planning (since March 1993) of the Company. Previously, Mr. Baker was Director of Financial Planning (from April 1992 until March 1993) of the Company. From 1990 to 1992, Mr. Baker was Vice President of Sixx Holdings, Incorporated, an investment corporation. From 1988 to 1990, Mr. Baker was Vice President of The Thompson Company, an investment company. Mr. Bishop is Vice President and Treasurer (since August 1992) of the Company. Prior to that date, Mr. Bishop was Assistant Treasurer (1983-1992) of General Cinema Corporation (now known as Harcourt General). Mr. Gernert is Corporate Senior Vice President (since July 1993) of the Company and President, Cupples Products Division (since January 1993). Mr. Gernert also served as Senior Vice President, Corporate Planning and Development (from March 1992 until July 1993). Prior to that time, Mr. Gernert was Founder and Managing Director (1991) of Counterpoint Management, a management consulting business. From 1989 to 1990, Mr. Gernert was Vice President and Assistant to the President and, from 1988-1989, was Vice President-Corporate Development of HMK Enterprises, a diversified holding company. Mr. Pultz is Vice President, General Counsel and Secretary (since January 1993) of the Company. Previously, Mr. Pultz was Assistant General Counsel and Assistant Secretary (1990-1993) and Assistant Corporate Counsel (1985-1990) of M/A-COM Inc. In addition, Mr. Pultz served as director (1988-1990) of Meteor Message Corporation, a start-up global positioning and messaging services provider. Mr. Pultz was also Clerk (1989-1993) of Filcom Microwave Inc., a microwave filter assembly maker. Mr. Rodriguez is Corporate Vice President and President, Building Products - - - Europe (since March 1993) of the Company. Prior to that date, Mr. Rodriguez was a private consultant (1990 to 1993) for various companies in the engineering, pharmaceutical and food industries in the United Kingdom, France and Spain. From 1988 to 1990, Mr. Rodriguez was Vice President, in London, England, of International Nabisco Brands, Inc. Mr. Schuster is Vice President of the Company and President of Robertson-Ceco Concrete Construction Group (since January 1993). Prior to that time, Mr. Schuster held various senior level positions with the Company, including Regional Manager, Northern Region (1991-1992), Regional Manager, North Central Region (1990-1991), and District Manager/Operations Manager, Chicago (1988-1990). Mr. Sills is Vice President and Controller (since May 1992) of the Company. Previously, Mr. Sills was an independent consultant to a commercial bank and was a Senior Audit Manager (1981-1991) at Price Waterhouse, a public accounting firm. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS -------------------------------------------------------------------- COMMON STOCK The Company's Common Stock is listed for trading on the New York Stock Exchange ("NYSE") under the symbol "RHH". The following table sets forth the high and low sale prices per share of the Common Stock as reported on the NYSE Composite Transaction Reporting System during the calendar periods indicated. Under the terms of the Company's domestic credit facility, the Company is restricted from paying cash dividends on its Common Stock. The Company did not pay cash dividends on the Common Stock during the periods set forth below. There were approximately 2,844 holders of record of the Company's Common Stock as of March 14, 1994. Included in the number of stockholders of record are stockholders who held shares in "nominee" or "street" name. The closing price per share of the Company's Common Stock as of March 14, 1994, as reported under the NYSE Composite Transaction Reporting System was $3.125. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Set forth below are historical financial data concerning the Company at December 31, 1989, 1990, 1991, 1992 and 1993 and for each of the five years in the period ended December 31, 1993. These data have been derived from the audited consolidated financial statements of the Company for such periods, some of which are presented elsewhere herein. The following information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's consolidated financial statements and the notes thereto appearing elsewhere in this Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ----------------------------------------------------------- AND RESULTS OF OPERATIONS ------------------------- RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1993 COMPARED WITH YEAR ENDED DECEMBER 31, 1992 During the past several years, the Company has been adversely affected by the worldwide recession in the construction industry and as a result has incurred significant operating losses and has experienced severe liquidity problems. To address these problems, the Company has developed and either implemented or is in the process of implementing a number of operational and financial restructuring plans for the Company, including reducing operating costs to meet current and expected levels of demand, liquidating or divesting of operations which do not meet the Company's strategic direction or where the amount of cash required to restructure the business exceeds the expected return within a reasonable period of time, and investing in remaining businesses, where appropriate, to realize their potential. The significant operational restructuring actions which were completed during 1992 and 1993 include: staff reductions at Corporate; closure of three high-cost manufacturing plants and consolidation and rationalization at the remaining manufacturing plants at the Metal Buildings Group; sales and closure of certain businesses; exiting markets and manufacturing operations at certain locations and other reductions in fixed costs primarily through headcount reductions at the Building Products Group and closure of unprofitable sales offices; closure of equipment yards and reconditioning centers; closure of the forms manufacturing facility and reductions in operating and administrative personnel at the Concrete Construction Group. In addition, there are currently a number of restructuring programs which are ongoing and under consideration, including further reductions in work force levels and rationalization through sales, redistribution or closure of unprofitable businesses and facilities. The significant financial restructuring actions which were completed during 1993 include: the completion of the Company's exchange offer for the Company's 15.5% Discount Subordinated Debentures due 2000 (the "15.5% Subordinated Debentures") for new debt and common stock and the exchange of the Company's outstanding cumulative convertible preferred stock (the "Preferred Stock") for common stock (together with the exchange of the 15.5% Subordinated Debentures, the "Exchange Offer"); replacement of the Company's domestic credit facility; significant reductions in outstanding letters of credit; renegotiation and settlement of certain operating leases in connection with the Company's downsizing activities; retirement of a $4.0 million facility fee note through the issuance of 1,374,292 shares of common stock; and the sale of 3,333,333 newly issued shares of the Company's common stock and the transfer of all assets, claims and rights under a foreign construction project to an outside investor indirectly controlled by a director of the Company for $10.0 million. The operating results and financial condition of the sold U.K. Subsidiary are excluded from the Company's financial statements for all periods subsequent to September 30, 1993, which was determined to be the effective date of the sale. On July 23, 1993, a 1 for 16.5 reverse split of the Company's common stock became effective. All common stock share amounts and per share data are restated to reflect the reverse split. OVERVIEW OF RESULTS OF OPERATIONS. Revenue for the year ended December 31, 1993 of $379.9 million decreased $21.0 million or 5.2% compared to 1992. Excluding the effect of the sold U.K. Subsidiary, revenues declined $10.4 million or 2.8%. The remaining decrease reflects lower sales at the Company's Building Products and Concrete Construction Groups offset in part by higher sales volumes at the Company's Metal Buildings Group. The Company's gross margin percentage was approximately 14.8% in 1993 compared with 12.0% in 1992 with each of the Company's business segments reporting improvements over 1992. The increase reflects primarily restructuring activities at the Company's Building Products Group and Concrete Construction Group and higher sales levels at the Company's Metal Buildings Group. Selling, general and administrative expenses decreased by $20.0 million in 1993 compared with 1992. Excluding the effect of the sold U.K. Subsidiary, selling, general and administrative expenses decreased $18.5 million. The remaining decline represents primarily reductions in operating expenses in the Building Products Group and Concrete Construction Group resulting from restructuring actions, reductions in consulting, legal and other professional fees at Corporate, offset in part by higher selling and advertising costs at the Company's Metal Buildings Group. Additionally, amounts for 1993 include a credit to selling, general and administrative expense of $2.8 million as a result of favorable settlements of certain litigation, and results for 1992 include a charge of $3.5 million relating to environmental matters and a charge of $1.3 million relating to severances. For the year ended December 31, 1993 losses from continuing operations were $22.6 million compared with $67.3 million during the same period in 1992. Losses from continuing operations for 1993 include a $9.7 million loss from the sale of businesses and losses from continuing operations for 1992 include losses from the sale of businesses of $1.1 million and restructuring charges of $11.9 million. Exclusive of the 1993 and 1992 losses from sold businesses, the 1992 restructuring charges and the effect of the operating results of the sold U.K. Subsidiary which recorded a loss of $4.4 million in 1993 compared with a loss of $13.2 million in 1992, the Company's loss from continuing operations decreased by $32.6 million. As further discussed below, results for the year ended December 31, 1993 include a charge for discontinued operations of $2.5 million, an extraordinary gain of $5.4 million from the Company's Exchange Offer and a charge of $1.2 million for the cumulative effect of an accounting change. The following sections highlight the Company's operating income (loss) on a segment basis and provide information on non-operating income and expenses. METAL BUILDINGS GROUP. For the year end December 31, 1993, Metal Buildings Group revenues increased by $30.9 million or 16.5% compared to 1992. The increase in 1993 reflects primarily improved market conditions in the United States. For the year ended December 31, 1993 operating income was $7.2 million compared with $4.2 million in 1992. The improved operating results are primarily attributable to higher levels of sales offset, in part, by higher per unit material costs and higher selling and advertising expenditures associated with the development of international markets. BUILDING PRODUCTS GROUP. For the year ended December 31, 1993, Building Product Group revenues decreased by $47.1 million or 32.6%. Excluding the effect of the sold U.K. Subsidiary, Building Products Group revenues decreased $36.5 million or 33%. The decline reflects weak market conditions and pressures on selling prices at both the Company's U.S. and foreign operations. For the year ended December 31, 1993, the Building Products Group reported an operating loss of $6.7 million compared with $18.1 million in 1992. The 1993 and 1992 operating losses include operating losses before restructuring charges of $3.9 million and $7.6 million, respectively, from the sold U.K. Subsidiary. The 1992 operating losses also include restructuring charges of $7.6 million. Exclusive of these items, the operating results for the Building Products Group were losses of $2.8 million in 1993 compared with losses of $2.9 million in 1992. The decrease in operating losses is primarily a result of downsizing and restructuring actions which have decreased operating and fixed costs, offset, in part, by a significant decline in revenues. CONCRETE CONSTRUCTION GROUP. For the year ended December 31, 1993, Concrete Construction Group revenues decreased by $4.8 million or 7.0% compared to 1992. The decline reflects decreases resulting from the closure of unprofitable sales offices and from weaknesses in the U.S. non-residential construction markets. For the year ended December 31, 1993, the Concrete Construction Group reported operating income of $4.5 million compared with an operating loss of $4.7 million in 1992. The operating loss for 1992 includes a restructuring charge of $2.7 million. The improvement in the operating results reflects better job executions, savings from restructuring activities and other reductions in operating costs, including reductions in worker's compensation and other insurance costs. At December 31, 1993, the backlog of unfilled orders believed to be firm for the Company's ongoing businesses was approximately $151 million. On a comparable basis, adjusted for the sale of the U.K. Subsidiary, which had at December 31, 1992 backlog of approximately $26 million, the order backlog was approximately $143 million at December 31, 1992. Approximately $10 million of the December 31, 1993 backlog is expected to be performed after 1994. OTHER INCOME (EXPENSES). Interest expense for the year ended December 31, 1992 and 1993 totalled $15.3 million and $10.8 million, respectively. The decrease in interest expense of $4.5 million for 1993 compared with 1992 is primarily due to the completion of the Exchange Offer which became effective July 14, 1993. On a proforma basis, assuming that the Exchange Offer had occurred on January 1 of 1992 and 1993, reported interest expense for the years ended 1992 and 1993 would have been reduced by $10.7 million and $6.5 million, respectively. On November 9, 1993, the Company sold its U.K. Subsidiary and in connection with the sale recorded a charge of $9.7 million in the third quarter of 1993. The Company's decision to sell the U.K. Subsidiary was based on the current negative economic outlook for the entity's operation which was not expected to improve in the foreseeable future and the estimated cost to continue to support and to further restructure and downsize the business. Other income (expense)-net for the year ended December 31, 1993, totalled $.8 million compared to $(6.8) million for 1992. The 1992 expense includes charges of approximately $6.2 million associated with operating losses and the writedown of an equity investment and foreign exchange losses of $1.1 million. INCOME TAXES. The Exchange Offer has resulted in a "Change in Ownership", as defined by Section 382 of the Internal Revenue Code. The effect of this transaction is to limit the Company's ability to utilize its unused U.S. tax loss carryforwards which existed prior to the Change in Ownership. At December 31, 1993, the Company has worldwide net operating loss carryforwards of $38.2 million for tax reporting purposes which are available to offset future income without limitation. Approximately $17.8 million of the tax net operating loss carryforwards relate to domestic operations and are available for use until expiration in the year 2009. The foreign net operating loss carryforwards at December 31, 1993 were $20.4 million and expire at various dates in the years 1995 through 2004. Should another "Change in Control" occur, the Company's current domestic loss carryforwards would be further limited. DISCONTINUED OPERATIONS. During the year ended December 31, 1993, the Company recorded a charge of $2.5 million reflecting primarily provisions for costs associated with the settlement of claims and disputes associated with the Company's discontinued custom curtainwall operations which were discontinued in 1988. ACCOUNTING CHANGES. Effective January 1, 1993, the Company adopted SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" for its U.S. plans and SFAS No. 109 "Accounting for Income Taxes". The adoption of these statements did not have a material impact on the Company's Consolidated Balance Sheets or Statements of Operations and the financial statements of prior periods have not been restated. Also, in the fourth quarter of 1993, the Company adopted the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits". The cumulative effect of the adoption of SFAS No. 112 was a charge of $1.2 million and has been recorded in the 1993 Consolidated Statement of Operations as a cumulative effect of accounting change. The Company believes that the adoption of the above accounting standards, exclusive of the cumulative effect associated with the adoption of SFAS No. 112, would not have a material effect on reported operating results for 1991, 1992 and 1993. OTHER ACCOUNTING PRONOUNCEMENTS. In May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". SFAS No. 114 and No. 115 are effective for fiscal years beginning after December 15, 1994 and December 15, 1993, respectively. The Company will implement these statements as required. The future adoption of these standards is not expected to have a material effect on the Company's Consolidated Balance Sheet or Statement of Operations. The Company is also required to adopt the provisions of SFAS No. 106 with respect to its foreign postretirement benefit plans for fiscal years beginning after December 15, 1994. The Company plans to adopt this standard as required, and is currently evaluating its impact. LITIGATION. Several contracts related to the Company's discontinued custom curtainwall operations continue to be the subject of litigation. In one of the actions, the owner and the general contractor for the project have claimed the Company and Federal Insurance Company, as issuer of a performance bond in connection with the Company's work, are liable for $29.9 million in excess completion costs and delay damages due to the Company's alleged failure to perform its obligations under its subcontract. The Company has taken action to enforce a $5.0 million mechanic's lien against the building and seeks to recover more than $10.0 million in costs and damages caused by the general contractor's breach of the subcontract with the Company. The Company filed suit in state court in Iowa against the owner, general contractor and a subcontractor seeking payment of amounts owed to the Company and other damages in connection with a pre-engineered metal building project in Anchorage, Alaska. The general contractor subsequently filed suit in state court in Alaska against a number of parties, including the Company and its surety, alleging against the Company breach of contract, breach of implied warranties, misrepresentation and negligence in connection with the fabrication of the building and seeking damages in excess of $10.0 million. The Company believes that it is entitled to payment under its contract and that it has meritorious defenses against the claims of the general contractor. Two separate, but related lawsuits have been filed against the Company in connection with a $2.4 million subcontract performed by the Company to supply custom curtainwall on a commercial office building. On January 29, 1991, the general contractor filed suit in federal court in Houston, Texas, asserting claims for the owner/developer of the project as well as attempting to enforce indemnification for a $4.0 million state court judgement against the general contractor by virtue of the indemnity provisions in the subcontract. The Company has filed an action in the federal court in St. Louis, Missouri, seeking a declaratory judgement that it is not liable under the indemnity provision or for any of the owner/developer's claims. The general contractor has filed a counterclaim, seeking to enforce its indemnification claim as well as the assigned claims. The general contractor's counterclaim seeks indemnity of $4.0 million and unspecified damages. There are various other proceedings pending against or involving the Company which are ordinary or routine given the nature of the Company's business. The Company has recorded a liability related to litigation where it is both probable that a loss has been incurred and the amount of the loss can be reasonably estimated. While the outcome of the Company's legal proceedings cannot at this time be predicted with certainty, management does not expect that these matters will have a material adverse effect on the Consolidated Balance Sheets or Statement of Operations of the Company. During 1993 and through February 1994, the Company resolved and settled certain litigation relating to matters of alleged employment discrimination and alleged breaches of real estate leases by the Company. These settlements did not have a material adverse effect on the Company's 1993 Consolidated Statement of Operations. ENVIRONMENTAL MATTERS. The Company has been identified as a potentially responsible party by various federal and state authorities for clean-up at various waste disposal sites. While it is often extremely difficult to reasonably quantify future environmental related expenditures, the Company has engaged various third parties to perform feasibility studies and assist in estimating the cost of investigation and remediation. 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 that the amount can be reasonably estimated. Based upon currently available information, including the reports of third parties, management does not believe that the reasonably possible loss in excess of the amounts accrued would be material to the consolidated financial statements. YEAR ENDED DECEMBER 31, 1992 COMPARED WITH YEAR ENDED DECEMBER 31, 1991 In connection with the Company's operational restructuring plans, on February 3, 1992, the Company sold certain of its domestic building products and construction businesses including the Company's door businesses (the "Door Businesses") and certain of the Company's U.S. building products businesses (the "X-1 Businesses") for $135 million (the "Disposition"). Additionally, during the first quarter of 1992, the Company sold its U.S. floor and deck businesses (the "Floor Business") and its subsidiary located in South Africa (the "South African Subsidiary") for $2.4 million and $5.3 million, respectively. As the Door Business represented a segment of the Company, the results of operations for the year ended December 31, 1991, have been reclassified to reflect the Door Business as a discontinued operation. The X-1 Businesses, the Floor Business and the South African Subsidiary (collectively, the "Sold Businesses"), which were held for sale at December 31, 1991 represent a portion of a business segment. Accordingly, the results of operations for the year ended December 31, 1991, include the Sold Businesses while results of operations for the year ended December 31, 1992 exclude the Sold Businesses. The net assets of the Door Business and the Sold Businesses were reflected as net assets held for sale (current) at December 31, 1991. OVERVIEW OF RESULTS OF OPERATIONS. During fiscal 1992, each of the Company's businesses continued to be adversely effected by the weak worldwide conditions in most major nonresidential construction markets. For the year ended December 31, 1992, revenues were $401.0 million, a decrease of $250.5 million or 38% compared to the same period in 1991. Approximately $157.3 million or 24% represents 1991 revenues associated with the Sold Businesses. The remaining decrease of 14% reflects primarily lower sales volumes resulting from continued weak conditions experienced in most major non-residential construction markets and competitive market pressures on selling prices. The Company's gross margin percentage was approximately 12.0% in 1992 compared with 11.4% in 1991. The slight improvement was a result of the exclusion of the Sold Businesses which had a gross margin in 1991 of approximately 8.3% offset by declining margins in the Company's Building Products Group and Concrete Construction Group resulting primarily from market pressures on selling prices and unabsorbed fixed costs. The Company's Metal Buildings Group gross margin percentage was unchanged from 1991 to 1992. Selling, general and administrative expenses decreased by $21.4 million in 1992 compared with 1991. Approximately $19.7 million of the decline resulted from the exclusion of Sold Businesses. The remaining decline represents reductions in costs at the operating units resulting from the restructuring actions offset by higher expenses at the Corporate Group related primarily to environmental matters, consulting, legal and other professional fees, severances and other costs. For the year ended December 31, 1992, losses from continuing operations were $67.3 million compared with $109.0 million during the same period in 1991. Operating results for the year ended December 31, 1992 include restructuring expense of $11.9 million compared with restructuring expense of $34.8 million in 1991. Exclusive of the 1992 and 1991 restructuring expenses, the losses recorded on the sale of businesses, and the effect of the Sold Businesses, which recorded a loss from operations of $7.8 million, net of a $1.9 million restructuring charge in 1991, the Company's loss from continuing operations increased $13.2 million. The continued operating losses were primarily a result of unabsorbed fixed costs at the Company's operations which have been affected by significant declines in revenue during 1992 and 1991 and certain non-operating expenses incurred in 1992 which are further described in the Other Income (Expenses) section below. The Company did not anticipate that there would be a significant improvement in most of the existing markets for the Company's products and services during 1993. As a result, the Company took restructuring actions to appropriately size its unprofitable operations to meet existing and expected levels of demand and sought to expand products and markets, as appropriate. The following sections highlight the Company's operating income (loss) on a segment basis and provide information on non-operating income and expenses and discontinued operations. METAL BUILDINGS GROUP. Metal Buildings Group revenues declined by $12.6 million or 6% for the year ended December 31, 1992, compared to 1991. The decline in revenues was primarily due to the soft U.S. and Canadian markets for the group's products, and to consolidation and restructuring activities which resulted in temporary delays in shipments during the reorganization. For the year ended December 31, 1992, operating income was $4.2 million, compared to a $5.7 million operating loss in 1991. The improved operating results, despite the decline in revenues were primarily attributable to restructuring actions implemented during the first quarter of 1992 which resulted in plant closures and cost reductions attributable to redistributing manufacturing operations and equipment from closed operations and improved capacity and cost effectiveness at remaining operations. BUILDING PRODUCTS GROUP. For the year ended December 31, 1992, Building Products Group revenues decreased by $223.7 million or 61% compared to 1991. Approximately $157.3 million or 43% represents the 1991 revenues of the Sold Businesses. The remaining decline reflected lower activity at the Company's operations, primarily in the United Kingdom, United States and Canada, due to overall market weaknesses. For the year ended December 31, 1992, the Building Products Group recorded an operating loss of $18.1 million compared with an operating loss of $36.0 million in 1991. The 1992 loss included a restructuring provision of $7.6 million related to charges taken to recognize impairment of asset values and costs to restructure the foreign subsidiaries. The 1991 operating loss included restructuring expenses of $18.4 million. Exclusive of the 1992 and 1991 restructuring expense and the effect of the Sold Businesses which recorded an operating loss of $7.8 million in 1991, the operating loss of the Building Products Group increased by $.7 million during the year ended December 31, 1992, compared to 1991. The 1992 operating losses were primarily due to unabsorbed fixed costs attributable to lower revenue levels and project losses at the Company's subsidiaries in the United Kingdom, Canada and Australia. CONCRETE CONSTRUCTION GROUP. For the year ended December 31, 1992, Concrete Construction Group revenues declined $15.9 million or 19% compared to 1991. The decline in revenues reflected the continued weakness in the U.S. non- residential construction markets, pressure on sales prices and management's selectivity in accepting projects. For the year ended December 31, 1992, the operating loss was $4.7 million compared with an operating loss of $.7 million in 1991. The 1992 and 1991 operating losses included restructuring charges of $2.7 million and $1.6 million, respectively. Exclusive of the effect of the restructuring charges recorded in 1992 and 1991, operating losses for this group increased $2.9 million for the year ended December 31, 1992 compared to 1991. The 1992 increase in operating losses reflected lower levels of revenue and competitive pricing pressures, partially offset by cost reductions resulting from restructuring activities which have included closures of sales offices, consolidations in regional facilities and reductions in work force levels. As a result of the continued weakness in the U.S. non residential building market, the Company took actions to further size operations to forecasted demand and in connection therewith, recorded a $2.7 million restructuring charge during the fourth quarter of 1992. OTHER INCOME (EXPENSES). Interest expense for the year ended December 31, 1992 totaled $15.3 million, compared to $20.9 million for 1991. The decrease in interest expense was primarily due to the Company's repayment of debt with proceeds from the Disposition. The Company recorded charges associated with trailing liabilities of the Sold Businesses of $1.1 million for the year ended December 31, 1992. Other income (expense)-net for the year ended December 31, 1992 totaled $(6.8) million, compared to $(2.0) million for 1991. Interest income increased from $.9 million in 1991 to $1.7 million in 1992 as a result of higher levels of short-term investments, due to proceeds from the Disposition. The remaining increase in other expense in 1992 was primarily attributable to 1992 charges reflecting operating losses and write-offs aggregating $6.2 million relating to the Company's equity investment and to foreign exchange losses of $1.1 million. INCOME TAXES. Income tax expense represents primarily taxes on foreign earnings which could not be offset by loss carryforwards. DISCONTINUED OPERATIONS. During the year ended December 31, 1992, the Company recorded a charge of $3.9 million reflecting primarily provisions for the settlement of contract disputes and litigation, and the write-off of related accounts receivable determined to be uncollectible associated with the Company's discontinued custom curtainwall operation. LIQUIDITY AND CAPITAL RESOURCES The Company has incurred significant losses from continuing operations during the past several years, including the first three quarters of 1993. The combination of these operating losses, along with the funding required for restructuring activities, trailing liabilities associated with sold and discontinued businesses and substantial financing expenses have placed a strain on the Company's liquidity. To respond to this situation, the Company has taken a number of operational and financial restructuring actions which are designed to improve the Company's profitability and liquidity. The status of the Company's financial activities, as well as the Company's liquidity and capital resources is summarized below. During the year ended December 31, 1993, the Company used approximately $20.2 million of cash, including amounts which were previously restricted, to fund its operating activities. Of this amount approximately $14.5 million was used for restructuring related activities, $2.8 million was paid in connection with the new domestic credit facility and the Exchange Offer, and $1.7 million was used to fund the operating activities of the sold U.K. Subsidiary. Funding of this operating deficit was provided primarily through cash which was previously restricted under the Company's former domestic credit facility. In addition, during the year the Company spent approximately $5.5 million on capital expenditures, most of which were directed toward upgrading and improving manufacturing equipment and data processing systems at the Company's Metal Buildings Group and manufacturing operations at the Building Products Group . Funding of investing activities was largely offset by proceeds received from sales of property and equipment and assets held for sale which aggregated $4.5 million for the year. Cash provided by financing activities during the year consisted of borrowings of $5.0 million provided under the Company's new domestic credit facility and $7.0 million which was provided through the sale of common stock. Also during the year, the Company paid down approximately $2.3 million of long-term debt which consisted primarily of industrial revenue bonds and an outstanding real estate mortgage. As a result, primarily of the financing activities discussed above, unrestricted cash and cash equivalents at December 31, 1993 increased by $8.4 million over December 31, 1992. At December 31, 1993, the Company had $15.7 million of unrestricted cash and cash equivalents which consisted of $2.9 million of cash and short-term investments located at foreign subsidiaries which is available to fund local working capital requirements and $12.8 million of cash located in the U.S. which was available for general business purposes. On April 12, 1993, the Company entered into a new credit agreement (the "Credit Facility") with Foothill Capital Corporation ("Foothill"). Under the terms of the Credit Facility, Foothill agreed to provide the Company with a term loan and a revolving line of credit of up to a maximum amount of $35.0 million. The initial funding of the Credit Facility occurred on May 3, 1993 (the "Closing Date"). Under the terms of the Credit Facility, the revolving line of credit is determined based on a percentage of eligible (as defined and subject to certain restrictions) accounts receivable and inventory, plus an amount equal to $10.0 million (which is reduced by $166,667 per month commencing six months after the Closing Date), plus the amount provided by the Company as cash collateral, if any, less the amount of $5.0 million required to be outstanding under the term loan (each together the "Borrowing Base"). The Credit Facility requires that the Company borrow $5.0 million under the term loan and provides for additional borrowings and or issuances of commercial or standby letters of credit or guarantees of payment with respect to such letters of credit in an aggregate amount not to exceed $30.0 million, based upon availability under the Borrowing Base. At December 31, 1993, the amount of the Borrowing Base was approximately $30.0 million and was used to support outstanding letters of credit of $29.4 million. The Credit Facility required payment on the Closing Date of a facility note in an amount equal to $4.0 million (the "Facility Note"). On November 30, 1993 the Company paid in full the Facility Note, plus accrued interest, and in settlement thereof, issued 1,374,292 shares of the Company's common stock to Foothill. In addition to the Credit Facility, borrowing arrangements are in place at certain international locations to assist in supporting local working capital requirements. The outstanding balance of such short-term loans payable at December 31, 1993 was $1.1 million. At December 31, 1993 the Company had in place at its international locations unused lines of credit of $1.0 million and letter of credit and guarantee facilities of $8.9 million of which $4.4 million was outstanding. In connection with the Company's financial restructuring plan, during 1993, the Company reduced its letter of credit guarantees which were outstanding at December 31, 1992 under its domestic credit facilities by $12.6 million. On July 14, 1993 the Company consummated its Exchange Offer. Pursuant to the Exchange Offer, $63.7 million principal amount of the Company's 15.5% Subordinated Debentures plus accrued but unpaid interest of approximately $17.1 million were exchanged for an aggregate of $17.9 million principal amount of the Company's 10%-12% Senior Subordinated Notes due 1999 and 10,041,812 shares of the Company's common stock, and all 500,000 outstanding shares of the Company's Preferred Stock were exchanged for an aggregate of 137,030 shares of the Company's common stock. Interest on the 10%-12% Senior Subordinated Notes is payable semi-annually on May 31 and November 30 of each year. Interest accruing on the 10%-12% Senior Subordinated Notes through and including May 31, 1995 may, at the Company's option, be paid in cash or additional 10%-12% Senior Subordinated Notes, and thereafter will be paid in cash. Interest accrues on the 10%-12% Senior Subordinated Notes from May 31, 1993 through and including November 30, 1994 at the rate of 10% per annum if paid in cash and 12% per annum if paid in additional 10%-12% Senior Subordinated Notes, and thereafter accrues at 12% per annum. The November 30, 1993 interest payment was paid by the Company in additional 10%-12% Senior Subordinated Notes. At December 31, 1993, the 15.5% Subordinated Debentures consisted of principal of $5.2 million and unamortized discount of $.4 million. The 15.5% Subordinated Debentures, which accrete in value at the rate of 17.4% per annum, began to accrue cash interest December 9, 1991. The Company did not make its scheduled interest payments on its 15.5% Subordinated Debentures which were due on May 31, 1992, November 30, 1992, May 31, 1993 and November 30, 1993, and consequently was in default under the indenture. On February 15, 1994, the Company paid all past due interest, including interest on past due interest, which in the aggregate approximated $1.8 million, thereby curing the event of default under the indenture. The payment of this interest payment was largely offset by the receipt of a $1.7 million settlement payment in February of 1994 for an old backcharge claim related to a job completed in 1989. On December 9, 1993, the Company entered into an agreement with an investor, indirectly controlled by a member of the Company's board of directors, which provided the Company with an additional $10.0 million of liquidity. In consideration for the $10.0 million, the Company agreed to issue to the investor 3,333,333 shares of the Company's common stock and to transfer all assets, claims and rights under a foreign construction project under which the developer has been placed in insolvency. OUTLOOK. Operating profits, along with bookings and backlog at the Company's Metal Buildings Group, Concrete Construction Group and certain of the Company's Building Products businesses, in particular, the Company's Asia/Australia operations, have shown significant improvements throughout 1993, and in the fourth quarter of 1993 the Company recorded income from continuing operations of $662,000. The Company's North American and European Building Products operations continue to be adversely affected by weak market conditions and severe competition and as a result are continuing to experience declines in revenue and incur operating losses. In November of 1993 the Company sold its U.K. subsidiary which had accounted for a significant portion of the Company's Building Product Group's operating losses and cash flow deficit during 1993. At each of the remaining Building Products businesses which continue to operate unprofitably, the Company is evaluating various alternatives and has been and is continuing to implement restructuring and other actions. The Company expects that demands on its liquidity and credit resources will continue to be significant throughout most of 1994 as a result of the anticipated funding required for seasonal operating losses during the first quarter of 1994, expected requirements for working capital in connection with business growth and bonding requirements, and funding requirements for restructuring programs, nonrecurring cash obligations and trailing liabilities associated with sold and discontinued businesses. The Company expects to meet these requirements through a number of sources, including available cash which was $15.7 million at December 31, 1993, reductions in letter of credit requirements for certain obligations, availability under domestic and foreign credit facilities, and to a lesser extent, through proceeds from asset sales and settlements of certain outstanding claims. To further assist in funding anticipated working capital growth requirements, on March 30, 1994, the Company received a commitment letter from Foothill Capital Corporation, the current lender under the Company's domestic credit facility, which under its terms, would amend the Company's existing domestic credit facility by temporarily increasing the Company's maximum availability under the facility by $10 million from the current level of $35 million to $45 million through June 30, 1994 and would expand the definition of the borrowing base (upon which availability is determined) to include certain assets of the Company's Canadian operations. Under the Foothill Capital Corporation proposal, the Company would have a one time option of extending the increase in the maximum availability to $45 million through November 30, 1994 and to $40 million through December 31, 1994. The Company is currently negotiating with an outside commercial bank to participate with Foothill Capital Corporation in the credit facility and to extend the maximum availability to $45 million through the entire term of the credit facility. Based upon the Company's current assumptions, the Company believes that available liquidity and credit will be sufficient to meet its needs at least through the end of the year. In the event that the Company's business growth exceeds expectations, improvements in operating cash flow do not meet anticipated levels, or anticipated sources of liquidity and credit as described above do not meet expectations, the Company may be required to restrict such growth and/or may seek to raise additional capital through the sale of businesses, through further expansion of existing credit facilities or through new credit facilities, through a possible debt or equity offering or a combination of the above. See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. See Notes to Consolidated Financial Statements. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1991, 1992 AND 1993 1. SUMMARY OF ACCOUNTING POLICIES Basis of presentation The consolidated financial statements include the accounts of Robertson- Ceco Corporation (the "Company") and all majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Investments in affiliates owned 20% to 50% are accounted for under the equity method. Certain previously reported amounts have been reclassified to conform to the 1993 presentation. Foreign currency translation Asset and liability accounts of foreign subsidiaries and affiliates are translated into U.S. dollars at current exchange rates. Income and expense accounts are translated at average rates. Any unrealized gains or losses arising from the translation are charged or credited to the foreign currency translation adjustments account included in stockholders' equity (deficiency). Foreign currency gains and losses resulting from transactions, except for intercompany debt of a long-term investment nature, are included in other income (expense)-net and amounted to $(320,000), $(1,088,000), and $(382,000) respectively, for the years ended December 31, 1991, 1992 and 1993. Inventories Inventories are valued at the lower of cost or market. Cost is determined using the last-in, first-out ("LIFO") method for certain inventories and the first- in, first-out ("FIFO") method for other inventories. Property Property is stated at cost. Depreciation is computed for financial statement purposes by applying the straight-line method over the estimated lives of the property. For federal income tax purposes, assets are generally depreciated using accelerated methods. Amortization of assets under capital leases is included with depreciation expense. Estimated useful lives used in computing depreciation for financial statement purposes are as follows: Land improvements . . . . . . . . . . . 10-25 years Buildings and building equipment. . . . 25-33 years Machinery and equipment . . . . . . . . 3-16 years Income taxes The provision for income taxes is based on earnings reported in the financial statements. Deferred tax assets, when considered realizable, and deferred tax liabilities are recorded to reflect temporary differences between the tax bases of assets and liabilities for financial reporting and tax purposes. Revenue Revenue from product sales is recognized generally upon passage of title, acceptance at a job site, or when affixed to a building. Revenue from construction services is recognized generally using the percentage-of-completion method which recognizes income ratably over the period during which contract costs are incurred. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued A provision for loss on construction services in progress is made at the time a loss is determinable. Insurance Liabilities The Company is self-insured in the U.S. for certain health insurance, worker's compensation, general liability and automotive liability, subject to specific retention levels. Insurance liabilities consist of liabilities incurred but not yet paid for such amounts. Deferred Revenues Billings in excess of revenues earned on construction contracts are reflected in other accrued liabilities as deferred revenues. Revenues earned in excess of billings are included in accounts receivable as unbilled receivables. Excess of Cost Over Net Assets of Acquired Businesses The excess of cost over the net assets of acquired businesses relates to the Company's acquisitions of metal building businesses. Such costs are being amortized on a straight-line basis over a period of 40 years. Cash and cash equivalents As used in the consolidated statements of cash flows, cash equivalents represent those short-term investments that can be easily converted into cash and that have original maturities of three months or less. Earnings (Loss) per Common Share Earnings (loss) per common share is based on the weighted average number of common shares and common share equivalents outstanding during each period. Warrants to purchase common stock, outstanding stock options and restricted stock are included in earnings (loss) per share computations if the effect is not antidilutive. Earnings (loss) used in the computation, is earnings (loss), plus dividends paid or payable on preferred stock. On July 23, 1993, a 1 for 16.5 reverse split (the "Reverse Split") of the Company's common stock became effective. All common stock share amounts and per share data presented herein are restated to reflect the Reverse Split. Recent Accounting Pronouncements In May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". SFAS No. 114 and SFAS No. are effective for fiscal years beginning after December 15, 1994 and December 15, 1993, respectively. The Company will implement these statements as required. The future adoption of these standards is not expected to have a material effect on the Company's consolidated financial position or results of operations. 2. RESTRUCTURING ACTIONS During the past several years, the Company has been adversely affected by the worldwide recession in the construction industry and as a result has incurred significant operating losses and has experienced severe liquidity problems. The Company's defaults under its loan and capital lease agreements at December 31, 1992, and its inability to generate adequate unrestricted cash to meet its current and anticipated operating requirements, along with the Company's recurring losses from operations, negative working capital, and stockholders' deficiency raised ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued substantial doubt at December 31, 1992 about the Company's ability to continue as a going concern. To address these problems, the Company has developed and either implemented or is in the process of implementing a number of operational and financial restructuring plans for the Company, including reducing operating costs to meet current and expected levels of demand, liquidating or divesting of operations which do not meet the Company's strategic direction or where the amount of cash required to restructure the business exceeds the expected return within a reasonable period of time, and investing in remaining businesses, where appropriate, to realize their potential. In connection with these restructuring plans, the Company recorded restructuring charges of $34,776,000 or $39.60 per share and $11,858,000 or $13.47 per share in 1991 and 1992, respectively. The significant operational restructuring actions which were completed during 1992 and 1993 include: staff reductions at Corporate; closure of three high- cost manufacturing plants and consolidation and rationalization at the remaining manufacturing plants at the Metal Buildings Group; sales and closure of certain businesses; exiting markets and manufacturing operations at certain locations and other reductions in fixed costs primarily through headcount reductions at the Building Products Group and closure of unprofitable sales offices; closure of equipment yards and reconditioning centers; closure of the forms manufacturing facility and reductions in operating and administrative personnel at the Concrete Construction Group. In addition, there are currently a number of restructuring programs which are ongoing and under consideration, including further reductions in work force levels and rationalization through sales, redistribution or closure of unprofitable businesses and facilities. The significant financial restructuring actions which were completed during 1993 include: the completion of the Company's exchange offer for the Company's 15.5% Discount Subordinated Debentures due 2000 (the "15.5% Subordinated Debentures") for new debt and common stock and the exchange of the Company's outstanding cumulative convertible preferred stock (the "Preferred Stock") for common stock (together with the exchange of the 15.5% Subordinated Debentures, the "Exchange Offer"); replacement of the Company's domestic credit facility (the initial funding of the credit facility occurred on May 3, 1993); significant reductions in outstanding letters of credit; renegotiation and settlement of certain operating leases in connection with the Company's downsizing activities; retirement of a $4,000,000 facility fee note through issuance of 1,374,292 shares of the Company's common stock; and the sale of 3,333,333 shares of the Company's common stock and the transfer of all assets, claims and rights under a foreign construction project to an outside investor indirectly controlled by a director of the Company for $10,000,000. Outlook Operating profits, along with bookings and backlog at the Company's Metal Buildings Group, Concrete Construction Group and certain of the Company's Building Products businesses, in particular, the Company's Asia/Australia operations, have shown significant improvements throughout 1993, and in the fourth quarter of the Company recorded income from continuing operations of $662,000. The Company's North American and European Building Products operations continue to be adversely affected by weak market conditions and severe competition and as a result are continuing to experience declines in revenue and incur operating losses. As discussed more fully in Note 3, in November of 1993 the Company sold its U.K. subsidiary which had accounted for a significant portion of the Company's Building Product Group's operating losses and cash flow deficit during 1993. At each of the remaining Building Products businesses which continue to operate unprofitably, the Company is evaluating various alternatives and has been and is continuing to ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued implement restructuring and other actions. The Company expects that demands on its liquidity and credit resources will continue to be significant throughout most of 1994 as a result of the anticipated funding required for seasonal operating losses during the first quarter of 1994, expected requirements for working capital in connection with business growth and bonding requirements, and funding requirements for restructuring programs, nonrecurring cash obligations and trailing liabilities associated with sold and discontinued businesses. The Company expects to meet these requirements through a number of sources, including available cash which was $15,666,000 at December 31, 1993, reductions in letter of credit requirements for certain obligations, availability under domestic and foreign credit facilities, and to a lesser extent, through proceeds from asset sales and settlements of certain outstanding claims. To further assist in funding anticipated working capital growth requirements, on March 30, 1994, the Company received a commitment letter from Foothill Capital Corporation, the current lender under the Company's domestic credit facility (Note 10), which under its terms, would amend the Company's existing domestic credit facility by temporarily increasing the Company's maximum availability under the facility by $10 million from the current level of $35 million to $45 million through June 30, 1994 and would expand the definition of the borrowing base (upon which availability is determined) to include certain assets of the Company's Canadian operations. Under the Foothill Capital Corporation proposal, the Company would have a one time option of extending the increase in the maximum availability to $45 million through November 30, 1994 and to $40 million through December 31, 1994. The Company is currently negotiating with an outside commercial bank to participate with Foothill Capital Corporation in the credit facility and to extend the maximum availability to $45 million through the entire term of the credit facility. Based upon the Company's current assumptions, the Company believes that available liquidity and credit will be sufficient to meet its needs at least through the end of the year. In the event that the Company's business growth exceeds expectations, improvements in operating cash flow do not meet anticipated levels, or anticipated sources of liquidity and credit as described above do not meet expectations, the Company may be required to restrict such growth and/or may seek to raise additional capital through the sale of businesses, through further expansion of existing credit facilities or through new credit facilities, through a possible debt or equity offering or a combination of the above. 3. ACQUISITIONS AND DIVESTITURES On November 8, 1990, H.H. Robertson Company ("Robertson") and Ceco Industries, Inc. ("Ceco Industries") merged into The Ceco Corporation ("Ceco"), a wholly- owned subsidiary of Ceco Industries, hereinafter referred to as the "Combination," with Ceco continuing as the surviving corporation under the name Robertson-Ceco Corporation (the "Company"). The Combination was accounted for using the purchase method of accounting, with Robertson deemed to be the acquiror. On February 3, 1992, the Company sold its door businesses (the "Door Business"), acquired as part of the Combination discussed above, and certain of its U.S. domestic building products and construction businesses (the "X-1 Business") for $135,000,000 (the "Disposition"). Additionally, during the first quarter of 1992, the Company sold its floor and deck business and its South African Subsidiary for $2,400,000 and $5,300,000, respectively. The loss on the sale of the Door Business is reflected as a discontinued operation and the sale of the X-1 Business, the floor and deck business and the Company's South African Subsidiary (collectively the "Sold Businesses") are reflected as disposals of portions of a segment of a business. Revenue of the Door Business was $158,000,000 for 1991. Revenue associated with the Sold Businesses was $157,311,000 in 1991 and loss from operations was $(9,701,000) in 1991. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In the fourth quarter of 1993, the Company settled in a noncash transaction certain purchase price calculation disputes arising out of the Disposition. In connection therewith, the Company transferred to the purchaser certain real estate previously recorded as assets held for sale which had an approximate fair value of $1,900,000. This transaction had no effect on the 1993 Consolidated Statement of Operations. On November 9, 1993, the Company sold, for no cash consideration, its subsidiary located in the United Kingdom (the "U.K. Subsidiary") which operated as part of the Company's Building Products Group. In connection with the sale, the Company recorded a charge of $9,700,000 in the quarter ended September 30, 1993. The operating results and cash flows of the U.K. Subsidiary are included in the accompanying financial statements for 1991 and 1992 and for the period January 1, 1993 through September 30, 1993, which was determined to be the effective date of the sale. After completion of the sale of the U.K. Subsidiary, the Company remains contingently liable under a $1,800,000 letter of credit guarantee which secures the former subsidiary's banking line; under an equipment lease which had an outstanding balance of $1,900,000 at December 31, 1993; and under certain performance guarantees which arose prior to the sale. During 1991, 1992 and the nine month period ended September 30, 1993, the U.K. Subsidiary recorded revenues of $63,600,000, $33,700,000 and $23,100,000, respectively, and losses from continuing operations of $12,000,000, $13,200,000 and $4,400,000, respectively. The components of the $9,700,000 charge include the write-off of the net assets noted above, provisions and expenses related to the sale of $1,500,000 and a charge of $4,579,000 reflecting the write-off of the cumulative foreign currency translation adjustment which previously was recorded as a component of stockholders' equity in accordance with SFAS No. 52. During 1988, the Company adopted a formal plan to discontinue its fixed- price custom curtainwall operations. During 1989, the existing contracts related to the discontinued operation were substantially physically completed; however, several of the contracts are the subject of various disputes and litigation relating to performance, scope of work and other contract issues. The charges recorded in 1991, 1992 and 1993 relate to costs incurred to provide for the settlement of contract disputes, litigation and rectification costs and to write-off related accounts receivable determined to be uncollectible. Such provisions are made when it is probable that a loss has been incurred and the amount of the loss can be estimated. As discussed in Note 14, the Company continues to be involved in litigation related to certain of these discontinued operations. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued The transactions described above are included in the Consolidated Statements of Operations as follows: The following unaudited proforma financial information shows the results of operations of the Company assuming that the sale of the Sold Businesses, sale of the U.K. Subsidiary and the Exchange Offer (see Notes 2 and 10) had occurred at the beginning of the periods presented. These results are not necessarily indicative of what results would have been if such transactions had occurred at the beginning of the periods presented and are not necessarily indicative of the financial condition or results of operations for any future date or period. 4. EQUITY INVESTMENT The Company had a 40% equity interest in Spectrum Glass Products, Inc. ("Spectrum") which was accounted for under the equity method. On February 25, 1993, Spectrum filed a petition under Chapter 11 of the United States Bankruptcy Code and on March 19, 1993, the Bankruptcy Court approved the sale of substantially all of Spectrum's assets to an unrelated third party. At December 31, 1993, the Company is contingently liable for approximately $881,000 under a guarantee relating to an equipment lease which was previously held by Spectrum which was assumed by the new owner. In connection with this guarantee, the Company has pledged a mortgage interest in certain of the Company's real estate. Operating results and writedowns recognized by the Company related to its investment in Spectrum were $20,000 in and $(6,161,000) in 1992 and are included in other income (expense)-net in the accompanying Consolidated Statements of Operations. There was no income (expense) related to Spectrum recognized in 1993. 5. CASH AND RELATED MATTERS At December 31, 1993, restricted cash of $459,000 was pledged primarily to support various borrowing agreements and guarantees and $2,679,000 related to the Disposition was held in escrow (see Note 10). 6. ACCOUNTS RECEIVABLE The Company grants credit to its customers, substantially all of which are involved in the construction industry. At December 31, 1992 and 1993 the Company's accounts receivable due from customers located outside of the United States totalled $32,594,000, and $20,599,000, respectively. Accounts receivable included unbilled ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued retainages and unbilled accounts receivable relating to construction contracts of $6,582,000 and $1,404,000, respectively, at December 31, 1992 and $3,624,000 and $1,463,000, respectively, at December 31, 1993. At December 31, 1992 other non- current assets included $1,175,000 of retainages due beyond one year. There were no retainages due beyond one year at December 31, 1993. 7. INVENTORIES At December 31, 1992 and 1993, approximately 22% and 75%, respectively, of inventories were valued on the LIFO method. The LIFO value for those inventories approximates their FIFO value at December 31, 1992 and 1993. 8. ASSETS HELD FOR SALE Assets held for sale consists principally of land, buildings and equipment which are held for sale as a result of restructuring actions and other operating decisions. Such assets are recorded at their estimated net realizable value. 9. OTHER ACCRUED LIABILITIES ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued 10. DEBT The aggregate maturities of long-term debt at December 31, 1993 were as follows: As described below, in connection with the Exchange Offer, all future interest payments on the Company's 10%-12% Senior Subordinated Notes have been capitalized. For purposes of determining the debt maturities of the 10%-12% Senior Subordinated Notes, the table above assumes that interest will be paid in additional notes through May 31, 1995 and subsequent interest payments are considered maturities of long-term debt when currently due. On April 12, 1993, the Company entered into a new domestic credit facility (the ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued "Credit Facility") with Foothill Capital Corporation ("Foothill"). Under the terms of the Credit Facility, Foothill agreed to provide the Company with a term loan and a revolving line of credit of up to a maximum amount of $35.0 million. The initial funding of the Credit Facility occurred on May 3, 1993 (the "Closing Date"). Prior to entering into the Credit Facility, the Company had in place a domestic borrowing facility with Wells Fargo (the "Old Credit Agreement"). The Company was in default of certain financial covenants of the Old Credit Agreement from March 31, 1992 through the Closing Date of the Credit Facility. Under the terms of the Credit Facility, the revolving line of credit is determined based on a percentage of eligible (as defined and subject to certain restrictions) accounts receivable and inventory, plus an amount equal to $10,000,000 (which is reduced by $166,667 per month commencing six months after the Closing Date), plus the amount provided by the Company as cash collateral, if any, less the amount of $5,000,000 required to be outstanding under the term loan (each together the "Borrowing Base"). At December 31, 1993, the amount of the Borrowing Base was $30,000,000 and was used to support outstanding letters of credit of $29,400,000. The Credit Facility requires that the Company borrow $5,000,000 under the term loan and provides for additional borrowings and or issuances of commercial or standby letters of credit or guarantees of payment with respect to such letters of credit in an aggregate amount not to exceed $30,000,000, based upon availability under the Borrowing Base. The term loan is evidenced by a term loan note that bears interest which is payable monthly at a rate equal to twenty-four percentage points above the reference rate (the reference rate is equivalent to the prime rate at designated institutions). All other obligations, excluding undrawn letters of credit and letter of credit guarantees (for which there is no interest charge), bear interest at the higher of three percent above the reference rate or nine percent per annum. The Credit Facility matures five years from the Closing Date. The Credit Facility required payment of a $350,000 commitment fee, and required on the Closing Date that the Company deliver a facility note in an amount equal to $4,000,000 (the "Facility Note"). The Facility Note was originally payable on October 31, 1993 with interest payable at the higher of the reference rate or six percent. The Company had a one time option of discharging its obligations under the Facility Note, in cash, in common stock having an equivalent fair market value at the maturity date equal to the Facility Note plus accrued interest, or any combination of cash and common stock. The original settlement date was subsequently extended to November 30, 1993, at which time, the Facility Note, plus accrued interest which combined were $4,123,000 were paid in full in a noncash transaction through the issuance of 1,374,292 shares of the Company's common stock to Foothill. As collateral for its obligations under the Credit Facility, the Company granted to Foothill a continuing security interest in and lien on substantially all of the Company's assets. The Credit Facility contains certain financial covenants with respect to the Company's tangible net worth and current ratio. In addition, there are covenants which prohibit the Company from paying dividends on or acquiring any of its capital stock and which either restrict or limit the Company's ability with respect to actions involving other indebtedness, liens, mergers, acquisitions, consolidations, dispositions, investments, capital expenditures, guarantees, prepayment of debt, transactions with affiliates and other matters. In addition to the Credit Facility, borrowing arrangements are in place at certain international locations to assist in supporting local working capital requirements. These arrangements are generally reviewed annually with the local banks and do not require significant commitment fees. The outstanding balance of such short-term loans payable and the weighted average interest rate at December 31, was $8,024,000 and 8.77% in 1992 and $1,054,000 and 13.07% in 1993. At December 31, 1993, the Company had in place at its international locations unused lines of credit of $961,000 and letter of credit and guarantee facilities of $8,851,000 of which $4,355,000 was outstanding. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued At December 31, 1993 the Company had outstanding combined letters of credit and bank guarantees of $33,736,000 and performance guarantees of $4,577,000. Of these amounts, approximately $25,384,000 support reported liabilities and $12,929,000 relate to contingent liabilities. In connection with the Disposition, the Company entered into a Letter of Credit and Reimbursement Agreement and an Escrow Agreement, whereby the purchaser provided the Company with a letter of credit to guarantee certain of the Company's worker's compensation and general insurance liabilities and the Company placed certain funds in escrow. At December 31, 1993, the amount of the outstanding letter of credit which was put in place by the purchaser was $4,171,000 and the amount held in escrow by the Company was $2,679,000. Under the terms of the current agreement with the purchaser, the Company will have access to certain of the escrow cash based upon certain conditions, including reductions in the face amount of the letter of credit either through replacement of the letter of credit by the Company or reductions in the letter of credit requirements which will occur through reduction of the underlying obligations. On February 2, 1994, based upon the Company's partial reduction and replacement of $1,171,000 of the face amount of the purchaser's letter of credit, the Company was granted access to $1,080,000 of cash which was recorded as restricted at December 31, 1993. On July 14, 1993, the Company consummated its Exchange Offer. Under the terms of the Exchange Offer, the 15.5% Subordinated Debenture holders other than Sage RHH (see Note 16) who tendered their bonds each received $407.57 in principal amount of the Company's 10%-12% Senior Subordinated Notes due 1999, plus 111.4 shares of the Company's common stock for each $1,000 aggregate principal amount of 15.5% Subordinated Debentures. Sage RHH, an investor which controlled approximately 29% of the 15.5% Subordinated Debentures and 33.8% of the Company's common stock received approximately 260.4 shares of the Company's common stock for each $1,000 aggregate principal amount of 15.5% Subordinated Debentures tendered. The Company's Preferred Stock holder received 54.8 shares of common stock for each 200 shares of Preferred Stock plus accrued but unpaid dividends, which in the aggregate totaled $281,250 for all of the Preferred Stock. Pursuant to the Exchange Offer, $63,734,000 principal amount of 15.5% Subordinated Debentures plus accrued but unpaid interest of $17,128,000 were exchanged for an aggregate of $17,850,000 principal amount of the Company's 10%-12% Senior Subordinated Notes and 10,041,812 shares of the Company's common stock, and all 500,000 outstanding shares of the Preferred Stock were exchanged for an aggregate of 137,030 shares of the Company's common stock. Interest on the 10%-12% Senior Subordinated Notes is payable semi- annually on May 31 and November 30 of each year. Interest accruing on the 10%-12% Senior Subordinated Notes through and including May 31, 1995 may, at the Company's option, be paid in cash or additional 10%-12% Senior Subordinated Notes, and thereafter will be paid in cash. Interest accrues on the 10%-12% Senior Subordinated Notes from May 31, 1993 through and including November 30, 1994 at the rate of 10% per annum if paid in cash and 12% per annum if paid in additional 10%-12% Senior Subordinated Notes, and thereafter accrues at 12% per annum. The November 30, 1993 interest payment was paid by the Company in additional 10%-12% Senior Subordinated Notes. The 10%-12% Senior Subordinated Notes will mature November 30, 1999, and are redeemable at the Company's option, at any time in whole or from time to time in part, at the principal amount thereof plus accrued interest to the redemption date. Indebtedness under the 10%-12% Senior Subordinated Notes is senior to the Company's 15.5% Subordinated Debentures, and subordinate to the extent provided in the indenture to all indebtedness under the Company's Credit Facility with Foothill and any other indebtedness which by its terms provides that it shall be senior to the 10%-12% Senior Subordinated Notes. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued During the third quarter of 1993, the Company recorded an extraordinary gain from the exchange of the 15.5% Subordinated Debentures of $5,367,000. In accordance with SFAS No. 15, all future interest payments which are due on the 10%-12% Senior Subordinated Notes have been recorded as part of long-term debt, and, as a result, the Company has deferred the related economic gain and will not record any future interest expense related to the 10%-12% Senior Subordinated Notes. On a proforma basis, assuming that the Exchange Offer occurred at the beginning of the period, interest expense for the years ended December 31, 1991, 1992 and 1993 would have been reduced by $8,545,000, $10,733,000 and $6,491,000, respectively. The effect of the Exchange Offer, which was a noncash transaction, on the assets, liabilities and stockholders' equity of the Company, was recorded in the 1993 Consolidated Balance Sheet as of the date of the Exchange Offer, and is summarized as follows: At December 31, 1993, the 15.5% Subordinated Debentures consisted of principal of $5,194,000 and unamortized discount of $382,000. The 15.5% Subordinated Debentures, which accrete in value at the rate of 17.4% per annum, began to accrue cash interest December 9, 1991. The Company did not make its scheduled interest payments on its 15.5% Subordinated Debentures which were due on May 31, 1992, November 30, 1992, May 31, 1993 and November 30, 1993, and consequently was in default under the indenture. On February 15, 1994, the Company paid all past due interest, including interest on past due interest which in the aggregate approximated $1,829,000, thereby curing the event of default under the indenture. At December 31, 1992, the 15.5% Subordinated Debentures were classified as currently due and at December 31, 1993, as a result of the curing of the event of default, are classified as long-term in the Consolidated Balance Sheets. 11. RENTAL AND LEASE INFORMATION The Company leases certain facilities and equipment under operating leases. Total rental expense charged to the Consolidated Statements of Operations for continuing operations on operating leases was $9,031,000, $7,104,000 and $4,063,000 for 1991, 1992 and 1993, respectively. In addition, sublease rental income of $202,000, $218,000 and $140,000 respectively, was netted against rental expense in 1991, 1992, and 1993, respectively. During the years ended December 31, 1991, and 1993, the Company charged $906,000, $2,293,000 and $4,529,000 respectively, to previously established restructuring reserves related to rentals and lease settlements associated with properties which were no longer used in operations. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Future minimum rental commitments under operating leases at December 31, 1993 were as follows: (Thousands) 1994. . . . . . . . . . . . . . . $3,740 1995. . . . . . . . . . . . . . . 2,986 1996. . . . . . . . . . . . . . . 2,249 1997. . . . . . . . . . . . . . . 1,190 1998. . . . . . . . . . . . . . . 727 1999 and later. . . . . . . . . . 122 ------- Total . . . . . . . . . . . . $11,014 ======= Minimum rental commitments have not been reduced by minimum sublease rentals of $2,963,000 at December 31, 1993 which are due in the future under noncancellable subleases. The above amounts do not include rent payable under escalation clauses as the amounts are not determinable. 12. FINANCIAL INSTRUMENTS In December 1991, the Financial Accounting Standards Board issued SFAS No. 107, "Disclosures about Fair Value of Financial Instruments". This statement requires the Company to disclose estimated fair values for its financial instruments, as well as the underlying methods and assumptions used in estimating fair value. The Company enters into various types of financial instruments in the normal course of business. The estimated fair value of amounts have been determined \ based on available market information and based in certain cases on assumptions concerning the amount and timing of estimated future cash flows and assumed discount rates reflecting varying degrees of perceived risk. Accordingly, the fair values may not represent actual values of the financial instruments that could have been realized as of year end or that will be realized in the future. Fair values for cash and cash equivalents, restricted cash, and loans payable approximate carrying value at December 31, 1993 due to the relatively short maturity of these financial instruments. The fair value of long-term debt, including the current portion of long-term debt at December 31, 1993 was estimated to be $25,900,000 compared to a carrying value of $45,474,000. 13. TAXES ON INCOME Effective January 1, 1993, the Company changed its method of accounting for income taxes to the method required by SFAS No. 109, "Accounting for Income Taxes". As permitted under the new standard, the Company has not restated the prior years' financial statements which had been reported using SFAS No. 96, "Accounting for Income Taxes". The adoption of SFAS No. 109 did not have a material impact on the Company's Consolidated Balance Sheets or Statements of Operations. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Income (loss) from continuing operations before provision (credit) for taxes on income from continuing operations consisted of the following: A reconciliation between taxes computed at the U.S. statutory federal income tax rate and the provision for taxes on income from continuing operations reported in the Consolidated Statements of Operations follows: ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued At December 31, 1993, the Company has worldwide net operating loss carryforwards of $38,180,000 for tax reporting purposes which are available to offset future income without limitation. Approximately $17,758,000 of the net operating loss carryforwards relate to domestic operations and are available for use until expiration in the year 2009. The foreign net operating loss carryforwards at December 31, 1993 were $20,422,000 and expire at various dates in the years 1995 through 2004. In addition to the above, the Company has tax net operating loss carryforwards of $134,244,000, as well as a general business credit carryforward of $1,000,000, that existed as of the date of the Exchange Offer, whose use has been limited due to a "Change in Ownership", as defined in Section 382 of the Internal Revenue Code. The Company's ability to utilize such carryforwards and credits is restricted to an aggregate potential availability of $3,375,000, with an annual limitation of approximately $225,000 through the year 2008. Additionally, these carryforwards can be used to offset income generated by the sale of certain assets to the extent the gain existed at the time of the exchange. This amount and the Company's unlimited, domestic net operating loss carryforwards could be further limited should another "Change in Ownership" occur. Undistributed earnings of consolidated foreign subsidiaries at December 31, 1993, amounted to approximately $3,520,000. No provision for income taxes has been made because the Company intends to invest such earnings permanently. If the Company were to repatriate all undistributed earnings, withholding taxes assessed in the local country would not be material to the Consolidated Financial Statements at December 31, 1993. 14. CONTINGENT LIABILITIES Several contracts related to the discontinued custom curtainwall operations continue to be the subject of litigation. In one of the actions, the owner and the general contractor for the project have claimed the Company and Federal Insurance ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Company, as issuer of a performance bond in connection with the Company's work, are liable for $29.9 million in excess completion costs and delay damages due to the Company's alleged failure to perform its obligations under its subcontract. The Company has taken action to enforce a $5.0 million mechanic's lien against the building and seeks to recover more than $10.0 million in costs and damages caused by the general contractor's breach of the subcontract with the Company. The Company filed suit in state court in Iowa against the owner, general contractor and a subcontractor seeking payment of amounts owed to the Company and other damages in connection with a pre-engineered metal building project in Anchorage, Alaska. The general contractor subsequently filed suit in state court in Alaska against a number of parties, including the Company and its surety, alleging against the Company breach of contract, breach of implied warranties, misrepresentation and negligence in connection with the fabrication of the building and seeking damages in excess of $10.0 million. The Company believes that it is entitled to payment under its contract and that it has meritorious defenses against the claims of the general contractor. Two separate, but related lawsuits have been filed against the Company in connection with a $2.4 million subcontract performed by the Company to supply custom curtainwall on a commercial office building. On January 29, 1991, the general contractor filed suit in federal court in Houston, Texas, asserting claims for the owner/developer of the project as well as attempting to enforce indemnification for a $4.0 million state court judgement against the general contractor by virtue of the indemnity provisions in the subcontract. The Company has filed an action in the federal court in St. Louis, Missouri, seeking a declaratory judgement that it is not liable under the indemnity provision or for any of the owner/developer's claims. The general contractor has filed a counterclaim, seeking to enforce its indemnification claim as well as the assigned claims. The general contractor's counterclaim seeks indemnity of $4.0 million and unspecified damages. There are various other proceedings pending against or involving the Company which are ordinary or routine given the nature of the Company's business. The Company has recorded a liability related to litigation where it is both probable that a loss will be incurred and the amount of the loss can be reasonably estimated. While the outcome of the Company's legal proceedings cannot at this time be predicted with certainty, management does not expect that these matters will have a material adverse effect on the consolidated financial condition or results of operations of the Company. During 1993 and through February 1994, the Company resolved and settled certain litigation relating to matters of alleged employment discrimination and alleged breaches of real estate leases by the Company. These settlements did not have a material adverse effect on the Company's 1993 Consolidated Statement of Operations. The Company has been identified as a potentially responsible party by various federal and state authorities for clean-up at various waste disposal sites. While it is often extremely difficult to reasonably quantify future environmental related expenditures, the Company has engaged various third parties to perform feasibility studies and assist in estimating the cost of investigation and remediation. 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 that the amount can be reasonably estimated. Based upon currently available information, including the reports of third parties, management does not believe that the reasonably possible loss in excess of the amounts accrued would be material to the Consolidated Financial Statements. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued 15. INCENTIVE PLANS, STOCK OPTIONS, WARRANTS 1986 Stock Option Plan and 1976 Stock Option Plan Options to purchase common stock of the Company have been granted under the Company's 1986 Stock Option Plan (the "1986 Plan") and the 1976 Stock Option Plan (the "1976 Plan"). The 1986 Plan terminated by its terms effective May 6, 1991, and the 1976 Plan terminated by its terms effective December 31, 1986. No more options may be granted under the 1986 Plan or the 1976 Plan. Stock options, including stock options with stock appreciation rights granted in conjunction therewith, which were outstanding on the respective termination dates of the 1986 Plan and the 1976 Plan, continue in effect in accordance with their terms. There were no stock appreciation rights on stock options outstanding at December 31, 1993. All options granted under the plans are at prices which were not less than 100% of the fair value of the Company's common stock on the date the options were granted. Stock options outstanding at December 31, 1993 expire at various dates from 1995 to 1999. Long-Term Incentive Plan The Company's 1991 Long-Term Incentive Plan, (the "Long Term Incentive Plan"), as amended and restated in 1993, provides for the grant of both cash-based and stock-based awards to eligible employees of, and persons or entities providing services to the Company and its subsidiaries and provides for one-time, automatic stock awards to non-employee members of the Board of Directors. Under the Long-Term Incentive Plan, the Company may provide awards in the form of stock options, stock appreciation rights, restricted shares, performance awards, and other stock based awards. Currently up to 1,400,000 shares of common stock are issuable under the Long-Term Incentive Plan, subject to appropriate adjustment in certain events. Shares issued pursuant to the Long-Term Incentive Plan may be authorized and unissued shares, or shares held in treasury. Awards may be granted under the Long- Term Incentive Plan through March 19, 2001, unless the plan is terminated earlier by action of the Board of Directors. At December 31, 1993, there were 829,146 shares under the Long-Term Incentive Plan which were available for grant. On December 22, 1993, the Company granted awards (the "1993 Awards") of 564,000 restricted shares of the Company's common stock to certain executive officers and key employees. The awards are designed to incentivize management in a manner which ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued would enhance shareholder value by tying vesting provisions to achievement of performance targets representing increases in the average market value of the Company's common stock. In summary, the accelerated vesting provisions include comparison of future share prices to a pre-determined base price, each measured on a 60-day average basis , cumulative market value appreciation targets over a three year period, and a requirement of continued employment with the Company except in certain specific circumstances. The base price for the 1993 Awards is $3.41 per share. The 1993 Awards also provide that if performance targets are not achieved by August 10, 1996, all unvested shares not forfeited will vest automatically on August 10, 2003, provided the holder is still an employee of the Company as defined in the plan. The 1993 Awards also provide for immediate vesting if a change in the control of the Company occurs, as defined, and under certain circumstances, upon the termination of one of the Company's executive officers. The fair market value of the restricted shares, based on the market price at the date of the grant, is recorded as deferred compensation, as a component of stockholders' equity and deferred compensation expense is amortized over the period benefited. Warrants In connection with the Combination, the Company assumed 1,470,000 of outstanding warrants of Ceco Industries. Each warrant, which is exercisable on or before December 9, 1996, provides for the right to purchase one stock unit at a price of $6.02 per unit, a unit being a fraction (as determined under the warrants) of a share. The warrants currently provide the holders with the right to acquire an aggregate of 90,249 shares of the Company's common stock at an exercise price of $98.11 per share. The Company has reserved 90,249 shares of its common stock for issuance upon exercise of the warrants. These warrants are reflected in the accompanying Consolidated Balance Sheets at their fair value at the date of acquisition. 16. RELATED PARTY TRANSACTIONS On September 15, 1992, Mulligan Partnership ("Mulligan") sold 297,655 shares of the Company's common stock, representing approximately 33.8% of the Company's then outstanding common stock, and $19,831,000 aggregate principal amount of the Company's 15.5% Subordinated Debentures, representing approximately 29% of the outstanding principal amount of such 15.5% Subordinated Debentures, to Sage Capital Corporation ("Sage Capital"), a Wyoming corporation. The rights of Frontera S.A., ("Frontera") an affiliate of Mulligan, under the Stockholders Agreement dated as of June 8, 1990 among the Company, Frontera and certain other stockholders, including the right to nominate certain members of the Company's Board of Directors, terminated upon the sale by Mulligan to Sage Capital. Mulligan has assigned to Sage Capital, Mulligan's rights under the terms of a registration rights agreement dated as of November 8, 1990 between the Company and Frontera. On November 18, 1992, the Company elected the President of Sage Capital as President and Chief Executive Officer and as a Director, and the Managing Director of Sage Capital as a Director. On December 30, 1992, Sage Capital transferred its shares of common stock and the 15.5% Subordinated Debentures to Sage RHH, a partnership, with Sage Capital retaining an 80% ownership in Sage RHH. As described in Note 10, Sage RHH tendered all of its 15.5% Subordinated Debentures in connection with the Exchange Offer. On December 2, 1993, the Company and its wholly owned subsidiary Robertson ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Espanola, S.A. entered into an agreement (the "Agreement") with RC Holdings, Inc. ("RC Holdings") (formerly Heico Acquisitions, Inc.) which is indirectly controlled by a member of the Company's Board of Directors. Pursuant to the Agreement, RC Holdings, through an affiliate entity acquired 3,333,333 newly issued shares of the Company's common stock and certain inventory and interests related to the project in Madrid, Spain known as Puerta de Europa, for which the Company had been providing the curtainwall system and the owner had been placed in insolvency. The shares issued represented approximately 21.4% of the then outstanding shares of the Company after issuance of such shares. The Company received an aggregate of $10 million in cash for the shares and assets. The Agreement also provides that, if RC Holdings is able to realize any proceeds in connection with the Puerta de Europa project, all receipts in excess of $5 million plus expenses incurred for completion and collection, will be split equally between RC Holdings and the Company. The Agreement provides that, until the earlier of (i) December 2, 1998, (ii) the date on which RC Holdings and its affiliates no longer hold 10% of the Company's outstanding common stock or (iii) the date on which the current President of RC Holdings ceases to be a controlling person with respect to RC Holdings and its affiliates, the Board of Directors of the Company shall not elect a chief executive officer without the prior written consent of RC Holdings. On December 9, 1993, the Board of Directors appointed the President and sole stockholder of RC Holdings as its chief executive officer and vice chairman of the Board of Directors. The Company has employment agreements and severance payment plans with respect to certain of its executive officers and certain other management personnel. These agreements generally provide for salary continuation for a specified number of months under certain circumstances. Certain of the agreements provide the employees with certain additional rights after a change of control of the Company, as defined, occurs. 17. INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION The Company's operations are classified into three business segments: the Metal Buildings Group, the Building Products Group, and the Concrete Construction Group. The Metal Buildings Group designs and manufactures complete pre-engineered metal buildings for commercial and industrial users. The Building Products Group provides construction services and at certain locations fabricates, sells and erects the components for roof, walls and floors of non-residential buildings. The Concrete Construction Group provides a subcontracting service for forming poured-in-place, reinforced concrete buildings. Summarized financial information for each of the Company's business segments and geographic areas of operations for the years ended December 31, 1991, 1992, and 1993 is presented below. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Information on Segments 1991 1992 1993 ---- ---- ---- (Thousands) Revenue: Metal Buildings Group. . . . .$200,017 $187,465 $218,338 Building Products Group . . . 368,085 144,426 97,319 Concrete Construction Group . 84,943 69,062 64,249 Intersegment eliminations. . . (1,592) - - -------- -------- -------- Total. . . . . . . . .$651,453 $400,953 $379,906 ======== ======== ======== Operating income (loss): Metal Buildings Group. . . . .$ (5,672) $ 4,179 $ 7,212 Building Products Group . . . (36,012) (18,146) (6,685) Concrete Construction Group . (692) (4,702) 4,518 Corporate. . . . . . . . . . . (20,358) (24,240) (7,948) -------- -------- -------- Total. . . . . . . . .$(62,734) $(42,909) $ (2,903) ======== ======== ======== Identifiable assets: Metal Buildings Group. . . . .$ 98,732 $ 84,448 $ 96,665 Building Products Group . . . 142,460 90,705 42,839 Concrete Construction Group . 30,776 22,055 22,736 Businesses held for sale . . . 143,812 - - Corporate. . . . . . . . . . . 23,686 38,462 25,934 Adjustments and eliminations . (16,529) (3,300) (6,351) -------- -------- -------- Total. . . . . . . . .$422,937 $232,370 $181,823 ======== ======== ======== Capital expenditures: Metal Buildings Group. . . . .$ 1,143 $ 948 $ 2,955 Building Products Group . . . 5,906 1,371 1,614 Concrete Construction Group . 945 649 899 Corporate. . . . . . . . . . . 224 253 35 -------- -------- -------- Total. . . . . . . . .$ 8,218 $ 3,221 $ 5,503 ======== ======== ======== Depreciation: Metal Buildings Group. . . . .$ 3,305 $ 2,510 $ 2,419 Building Products Group . . . 5,654 3,106 2,348 Concrete Construction Group . 979 963 1,004 Corporate. . . . . . . . . . . 454 63 94 -------- -------- -------- Total. . . . . . . . .$ 10,392 $ 6,642 $ 5,865 ======== ======== ======== ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Information on Geographic Areas 1991 1992 1993 ---- ---- ---- (Thousands) Revenue: United States. . . . . . . . .$434,504 $274,027 $287,802 Canada . . . . . . . . . . . . 47,053 29,099 22,063 Europe . . . . . . . . . . . . 130,292 86,939 52,498 Other. . . . . . . . . . . . . 55,444 24,843 21,681 Inter-area eliminations. . . . (15,840) (13,955) (4,138) -------- -------- -------- Total. . . . . . . . .$651,453 $400,953 $379,906 ======== ======== ======== Operating income (loss): United States. . . . . . . . .$(20,196) $ (3,601) $ 7,347 Canada . . . . . . . . . . . . (14,449) (2,829) 1,099 Europe . . . . . . . . . . . . (11,914) (11,131) (5,054) Other. . . . . . . . . . . . . 4,183 (1,108) 1,653 Corporate. . . . . . . . . . . (20,358) (24,240) (7,948) -------- -------- -------- Total. . . . . . . . .$(62,734) $(42,909) $ (2,903) ======== ======== ======== Identifiable assets: United States. . . . . . . . .$146,315 $127,786 $125,689 Canada . . . . . . . . . . . . 24,407 16,716 15,013 Europe . . . . . . . . . . . . 84,670 52,896 13,088 Other. . . . . . . . . . . . . 16,684 12,104 13,431 Businesses held for sale . . . 143,812 - - Corporate. . . . . . . . . . . 23,686 38,462 25,934 Adjustments and eliminations . (16,637) (15,594) (11,332) -------- -------- -------- Total. . . . . . . . .$422,937 $232,370 $181,823 ======== ======== ======== Identifiable assets in each segment or geographic area include the assets used in the Company's operations and the excess of the purchase price over the fair value of assets acquired. Corporate assets consist primarily of cash and cash equivalents, income tax refunds receivable, restricted cash, property and equipment, assets held for sale and deferred costs related to the Credit Facility. Inter-area sales are generally recorded at prices which are intended to approximate prices charged to unaffiliated customers. 18. RETIREMENT BENEFITS The Company and its subsidiaries have various defined contribution and defined benefit pension plans covering substantially all of its U.S. employees and employees in certain foreign countries. In connection with the Company's restructuring plan, the Company merged certain of its U.S. defined benefit plans effective June 1, into an existing pension plan of the Company which was amended to provide future retirement benefits to all of the Company's U.S. eligible salary and hourly employees. Certain U.S. employees are covered by a defined contribution plan which provides for contributions based primarily on compensation levels. The Company also participates in numerous multi-employer plans which are administered by unions and provide defined benefits to employees covered under industry collective bargaining agreements. Benefits provided under the Company's defined benefit pension plans are primarily based on years of service and the employee's compensation. The Company's funding policy is to contribute an amount annually based upon actuarial and economic assumptions designed to achieve adequate funding of projected benefit obligations. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Plan assets are invested in broadly diversified portfolios of government obligations, mutual funds, stocks, bonds and fixed income and equity securities. The Company funds its contributions to the defined contribution plan as accrued. Plan assets are invested in mutual funds. Contributions under the various union- sponsored, multi-employer plans are determined in accordance with the provisions of negotiated labor contracts and generally are based on the number of hours worked. Such contributions are charged against operations as incurred. U.S. and Canadian Defined Benefit Plans The following table sets forth the aggregate funded status of the U.S. and Canadian defined benefit plans: ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Other Foreign Defined Benefit Plans The amounts reported below relating to other foreign defined benefit plans exclude in 1993 the plan of the sold U.K. Subsidiary. ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued For the purposes of measuring the December 31, 1993 accumulated postretirement benefit obligation, the per capita cost of covered health care benefits was assumed to increase at 12.25% from 1993 to 1994 for retirees not in the Company's fixed cost plan. The rate was assumed to decrease gradually down to 4.75% by 2002 and remain at that level thereafter. Because the health care cost trend rate assumption affects relatively few participants, there is no significant effect on the amounts reported. Increasing assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued December 31, 1993 by $468,000, or 2.2%. The weighted average discount rate used in determining the accumulated postretirement benefit obligation at December 31, 1993 was 7.25%. For purposes of measuring the 1993 net periodic postretirement benefit cost, the per capita cost of covered health care benefits was assumed to increase at 13.5% from 1993 to 1994 for retirees not in the fixed cost plans. The rate was assumed to decrease gradually down to 6.0% by 2002 and remain level thereafter. Because the health care cost trend rate assumption affects relatively few participants, increasing assumed health care cost trend rates by one percentage point each year would increase the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for fiscal 1993 by $22,000, or 0.7%. The weighted average discount rate used in determining the 1993 expense was 8.5%. In the fourth quarter of 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits". This statement requires an accrual method of recognizing postemployment benefits. The cumulative effect of adopting SFAS No. 112 was $1,200,000. Prior to the adoption of SFAS No. 112, the Company expensed the net cost of providing these benefits on a pay-as-you-go basis. Amounts recognized in prior years Statements of Operations were not material. 20. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) ROBERTSON-CECO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued (a) In the third quarter of 1993, the Company recorded a charge of $9,700,000 for the sale of the Company's U.K. Subsidiary (Note 3) and an extraordinary gain of $5,367,000 resulting from the completion of the Company's Exchange Offer (Note 10). In the fourth quarter of 1993, the Company recorded a charge for discontinued operations of $2,500,000 (Note 3) and a charge of $1,200,000 for the cumulative effect of an accounting change (Note 19). As discussed in Note 3, fourth quarter results for 1993 exclude the operations of the sold U.K. Subsidiary. (b) As discussed in Note 2, during 1992, the Company took certain actions with respect to the operational and financial restructuring of the Company. As a result of the restructuring plan, the Company was required to provide for the estimated costs associated with the restructuring, as well as losses on businesses held for sale. These estimates resulted in charges (credits) to the first, second, third and fourth quarters of 1992 as follows: $20,502,000, $3,000,000, $(9,932,000), and $3,108,000, respectively. In the second quarter of 1992, the Company provided $3,500,000 for various environmental matters and in the third quarter of 1992, the Company provided $4,167,000 to write-off its equity investment (Note 4) and $3,900,000 to recognize a loss from discontinued operations (Note 3). The second quarter's sales and cost of sales reflect a reclassification resulting from the Company's decision, in the third quarter, to retain certain foreign businesses. Such reclassifications had no effect on loss from continuing operations or on net loss. Independent Auditors' Report To the Board of Directors and Stockholders of Robertson-Ceco Corporation In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, stockholders' equity (deficiency) and cash flows present fairly, in all material respects, the financial position of Robertson-Ceco Corporation and its subsidiaries (the "Company") at December 31, 1993, and the results of their operations and their cash flows for the year then ended 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 audit. We conducted our audit 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 audit provides a reasonable basis for the opinion expressed above. The financial statements of Robertson-Ceco Corporation for the years ended December 31, 1992 and 1991 were audited by other independent accountants whose report dated February 25, 1993 (May 3, 1993 as to Note 2) expressed an unqualified opinion on those statements and included an explanatory paragraph that described the substantial doubt about the Company's ability to continue as a going concern. As discussed in Note 19 to the financial statements, the Company changed its method of accounting for postemployment benefits in 1993 by adopting Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits". In addition, as discussed in Note 13 to the financial statements, the Company changed its method of accounting for income taxes in 1993 by adopting Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". /s/ Price Waterhouse PRICE WATERHOUSE Boston, Massachusetts March 30, 1994 Independent Auditors' Report To the Stockholders of Robertson-Ceco Corporation: We have audited the accompanying consolidated balance sheet of Robertson-Ceco Corporation and its subsidiaries as of December 31, 1992 and the related consolidated statements of operations, stockholders' equity (deficiency), and cash flows for each of the two years in the period ended December 31, 1992. Our audits also included the financial statement schedules as of December 31, 1992 and for each of the two years in the period ended December 31, 1992 listed in 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 Robertson-Ceco Corporation and its subsidiaries at 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. 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. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company's defaults under its loan and capital lease agreements and its inability to generate adequate unrestricted cash to meet its current and anticipated operating requirements, along with the Company's recurring losses from operations, negative working capital, and stockholders' deficiency raise substantial doubt about its ability to continue as a going concern. Management's plans concerning these matters are also discussed in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Deloitte & Touche DELOITTE & TOUCHE Boston, Massachusetts February 25, 1993 (May 3, 1993 as to Note 2) ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- On September 14, 1993, the Board of Directors of Robertson Ceco Corporation, acting upon the recommendation of its Audit Committee, authorized the engagement of the firm of Price Waterhouse as its independent accountants to audit the financial statements of the Company for the fiscal year ending December 31, 1993. Price Waterhouse replaced the firm of Deloitte & Touche, whose engagement as independent accountants of the Company terminated September 14, 1993. The reports of Deloitte & Touche on the Company's financial statements for the years ended December 31, 1991 and 1992, except as noted below, did not contain an adverse opinion or a disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principles. The report of Deloitte & Touche on the Company's financial statements for the year ended December 31, 1992 contained an explanatory paragraph with respect to a substantial doubt about the ability of the Company to continue as a going concern. During the years ended December 31, 1991 and 1992 and in the period from January 1, 1993 through September 14, 1993, there were no disagreements with Deloitte & Touche on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure which, if not resolved to the satisfaction of Deloitte & Touche, would have caused Deloitte & Touche to make reference to the matter in connection with its reports on the Company's financial statements with respect to such periods. Also, during the years ended December 31, 1991 and 1992 and in the period from January 1, 1993 through September 14, 1993, there were no "reportable events" as defined in subparagraph (a)(1)(v) of Item 304 of Regulation S-K. During the years ended December 31, 1991 and 1992 and in the period from January 1, 1993 through September 14, 1993, which was prior to the engagement of Price Waterhouse, neither the Company nor anyone else on its behalf consulted Price Waterhouse regarding either (i) the application of accounting principles to a specified transaction, either completed or proposed, or (ii) the type of audit opinion that might be rendered on the Company's financial statements. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------------------------------------------------- (a) Information concerning the Registrant's directors is incorporated by reference to the section entitled "Election of Directors" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. (b) Information concerning executive officers of the Registrant is set forth in Item 4.1 of Part I at pages 11 to 12 of this Report under the heading "EXECUTIVE OFFICERS OF THE REGISTRANT". ITEM 11. EXECUTIVE COMPENSATION ---------------------- Information concerning executive compensation is incorporated by reference to the section entitled "Executive Compensation" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -------------------------------------------------------------- Information concerning security ownership of certain beneficial owners and management is incorporated by reference to the section entitled "Security Ownership" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- Information concerning certain relationships and related transactions is incorporated by reference to the section entitled "Certain Relationships and Related Transactions" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, --------------------------------------- AND REPORTS ON FORM 8-K ----------------------- PAGE NO. The following documents are filed as part of this Report: (a)1. Consolidated Financial Statements of Robertson- Ceco Corporation. Consolidated Statements of Operations for the three years ended December 31, 1993. 26 Consolidated Balance Sheets at December 31, 1992 and 1993. 27 Consolidated Statements of Cash Flows for the three years ended December 31, 1993. 29 Consolidated Statements of Stockholders' Equity (Deficiency) for the three years ended December 31, 1993. 30 Notes to Consolidated Financial Statements, including Selected Quarterly Financial Data as required by Item 302 of Regulation S-K. 31 Independent Auditors' Reports. Price Waterhouse 58 Deloitte & Touche 59 (a)2.Financial Statement Schedules for the Three Years Ended December 31, 1993. SCHEDULE VIII - Valuation and Qualifying Accounts 65 SCHEDULE IX - Short Term Borrowings 67 SCHEDULE X - Supplementary Income Statement 68 Information All other schedules are omitted because they are not applicable or not required. Report of Independent Accountants on Financial Schedules Price Waterhouse - as of and for the year ended December 31, 1993 69 (a)3.List of Exhibits. Exhibits filed or incorporated by reference in connection with this Report are listed in the Exhibit Index starting on page 70. (b) Reports on Form 8-K On November 22, 1993 the Company filed a Form 8-K reporting the sale of all of the common stock of H.H. Robertson (U.K.) Limited on November 9, 1993 in a noncash transaction to Capella Investments Limited. The U.K. Subsidiary had operated as part of the Company's Building Products Group. On December 22, 1993 the Company filed a Form 8-K reporting the completion of an investment transaction with RC Holdings, Inc. on December 14, 1993. RC Holdings, Inc. is owned by Michael E. Heisley, a director of Robertson-Ceco Corporation since July 1993. The Company also reported that, on December 9, 1993, the Board of Directors of the Company appointed Michael E. Heisley as Chief Executive Officer, replacing Andrew G.C. Sage II who continues as Chairman of the Board. Mr. Heisley was also elected as Vice Chairman of the Board. SIGNATURES Pursuant to the requirements of Section 10 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 Boston, The Commonwealth of Massachusetts, on this 31st day of March, 1994. ROBERTSON-CECO CORPORATION By /s/ John C. Sills ------------------------------ Vice President and Controller (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and as of the 31st day of March, 1994. Each person whose signature appears below hereby authorizes each of Andrew G. C. Sage, II, Denis N. Maiorani and George S. Pultz and appoints each of them singly his or her attorney-in-fact, each with full power of substitution, to execute in his name, place and stead, in any and all capacities, any or all further amendments to this Report and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, making such further changes in this Report as the Company deems appropriate. SIGNATURE /s/ Michael E. Heisley /s/ Andrew G. C. Sage, II - - ---------------------------------- ------------------------------- Chief Executive Officer Andrew G. C. Sage, II and Director Chairman (Principal Executive Officer) /s/ Denis N. Maiorani /s/ John C. Sills - - ---------------------------------- ------------------------------- Denis N. Maiorani John C. Sills President and Director Vice President and Controller (Principal Financial Officer) (Principal Accounting Officer) /s/ Frank A. Benevento /s/ Stanley G. Berman - - ---------------------------------- ------------------------------- Frank A. Benevento Stanley G. Berman Director Director /s/ Mary Heidi Hall Jones /s/ Kevin E. Lewis - - ---------------------------------- ------------------------------- Mary Heidi Hall Jones Kevin E. Lewis Director Director /s/ Leonids Rudins /s/ Gregg C. Sage - - ---------------------------------- ------------------------------- Leonids Rudins Gregg C. Sage Director Director NOTE - Other items have not been shown either because they have been included in the Consolidated Financial Statements or because the individual amounts do not exceed 1% of total revenues from continuing operations. Report of Independent Accountants on Financial Statement Schedules To the Board of Directors of Robertson-Ceco Corporation Our audit of the consolidated financial statements referred to in our report dated March 30, 1994 appearing on page 58 of the 1993 Annual Report on Form 10-K of Robertson-Ceco Corporation also included an audit of the Financial Statement Schedules which are as of and for the year ended December 31, 1993 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 March 30, 1994 Exhibit Index Exhibit Sequential No. Description Page No. 3.1 Registrant's Second Restated Certificate of Incorporation, effective July 23, 1993, filed as Exhibit 3 to Registrant's report on Form 8-K dated July 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . 3.2 Bylaws of Registrant, effective November 8, 1990, and as Amended on November 12, 1991, August 27, 1992 and December 16, 1993 . . . . . . . . . 77 4.1 Registrant's Second Restated Certificate of Incorporation, effective July 23, 1993 referred to in Exhibit 3.1 above . 4.2 Bylaws of Registrant, effective November 8, 1990, and as Amended on November 12, 1991, August 27, 1992 and December 16, 1993 referred to in Exhibit 3.2 above . . . . 4.3 Indenture, dated December 9, 1986, by and between M C Co. (a predecessor of Registrant) and Mellon Bank, N.A. relating to Ceco Industries, Inc. 15.5% Discount Subordinated Debentures Due 2000 filed as Exhibit 4(b) to Ceco Industries, Inc.'s report on Form 10-K for the year ended December 31, 1986 (File No. 33-10181), and incorporated herein by reference thereto . . . . 4.4 First Supplemental Indenture, dated as of December 9, 1986 between M C Co. (a predecessor of Registrant) and Mellon Bank, N.A. filed as Exhibit 4.5 to Registration Statement of The Ceco Corporation on Form S-4, Registration No. 33- 37020, and incorporated herein by reference thereto . . 4.5 Second Supplemental Indenture, dated November 8, 1990, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) filed as Exhibit 4.6 to Registrant's report on Form 8-K dated as of November 8, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . . . 4.6 Third Supplemental Indenture, dated July 14, 1993, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) filed as Exhibit 2 to Registrant's report on Form 8-K (File No. 1-10659) dated July 14, 1993, and incorporated herein by reference thereto . 4.7 Amended and Restated Stockholders Agreement dated as of July 12, 1990 by and among the principal stockholders of Ceco Industries, Inc., H.H. Robertson Company and Registrant (formerly known as The Ceco Corporation) filed as Exhibit 4.2 to Registration Statement of The Ceco Corporation on Form S-4, Registration Statement No. 33 -37020, and incorporated herein by reference thereto . . 4.8 Stock Purchase Agreement and related Registration Rights Agreement dated as of June 8, 1990 by and among H.H. Robertson Company, Ceco Industries, Inc. and Frontera S.A. filed as Exhibit 10(a) to Ceco Industries, Inc.'s report on Form 8-K (File No. 33-10181), dated as of June 5, 1990, and incorporated herein by reference thereto . . . . 4.9 Agreement, dated as of June 8, 1990, by and among Frontera S.A., First City Financial Corporation Ltd., Hornby Trading Inc., Frill Trading Inc., the principal stockholders of Ceco Industries, Inc. and H.H. Robertson Company and related letter agreement dated as of June 8, 1990, among the principal stockholders of Ceco Industries, Inc., and Frontera S.A. filed as Exhibit 28(b) to Ceco Industries, Inc.'s report on Form 8-K (File No. 33-10181), dated as of June 5, 1990, and incorporated herein by reference thereto . . . . . . . . 4.10 Warrant Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc. (a predecessor of Registrant) and Continental Illinois National Bank and Trust Company of Chicago (now known as Continental Bank N.A.), filed as Exhibit 4(c) to Ceco Industries, Inc.'s Form 10-K (File No. 33-10181), for the year ended December 31, 1986, and incorporated herein by reference thereto together with Supplement to Warrant Agreement dated as of November 8, 1990 between Registrant and Continental Bank, N.A. filed as Exhibit 4.6 to Registrant's report on Form SE (File No. 1-10659), dated November 16, 1990, and incorporated herein by reference thereto . . . . . . 4.11 Registration Rights Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc., and the Purchasers listed on the Signature Pages of the Purchase Agreement dated December 9, 1986, between the Ceco Corporation, Ceco Industries, Inc., and the Purchasers of the Subordinated Notes of The Ceco Corporation and the Warrants of Ceco Industries, Inc. filed as Exhibit 4(d) to Ceco Industries, Inc.'s Form 10-K (File No. 33-10181), for the year ended December 31, 1986, and incorporated herein by reference thereto . . . . . . . . . 4.12 Registration Rights Agreement dated May 17, 1993 by and among the Registrant and Sage RHH filed as Exhibit 10.27 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . 4.13 Registration Rights Agreement dated November 23, 1993 by and among the Registrant and Foothill Capital Corporation . 92 4.14 Registration Rights Agreement dated December 14, 1993 by and among the Registrant and Heico Acquisitions, Inc. . . 102 4.15 Indenture dated as of July 14, 1993 among the Registrant and IBJ Schroder Bank and Trust Company, Trustee, relating to the Registrant's 10-12% Senior Subordinated Notes due 1999 together with specimen certificate therefor filed as Exhibit 1 to the Registrant's report on Form 8-K (File No. 1-10659), dated July 14, 1993, and incorporated herein by reference thereto . . . . . . . . 4.16 Specimen certificate for Common Stock, par value $.01 per share, of Registrant filed as Exhibit 4.9 to the Registration Statement of The Ceco Corporation on Form S-4, Registration No. 33-37020, and incorporated herein by reference thereto . . . . . . . . 10.1 Borrower Security Agreement dated as of November 8, 1990 by Registrant in favor of Wells Fargo Bank, N.A., as Agent, filed as Exhibit 10.6 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . 10.2 Subsidiary Security Agreement dated as of November 8, 1990 among Ceco Dallas Co., Ceco Houston Co., Ceco San Antonio Co., M C Durham Co., M C Wathena Co., M C Windsor Co., Meyerland Co., R.P.M. Erectors, Inc. and Quantum Constructors, Inc. in favor of Wells Fargo Bank, N.A., as Agent, filed as Exhibit 10.7 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1- 10659), and incorporated herein by reference thereto . . 10.3 Subsidiary Guarantee dated as of November 8, 1990 among Ceco Dallas Co., Ceco Houston Co., Ceco San Antonio Co., M C Durham Co., M C Wathena Co., M C Windsor Co., Meyerland Co., R.P.M. Erectors and Quantum Constructors, Inc. in favor of Wells Fargo Bank, N.A. as Agent, filed as Exhibit 10.8 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . 10.4 Underwriting and Continuing Indemnity Agreement dated November 8, 1990 among the Registrant, R.P.M. Erectors, Inc., Quantum Constructors, Inc., H.H. Robertson (U.K.) Limited and Reliance Insurance Company, United Pacific Insurance Company and Planet Insurance Company, filed as Exhibit 10.20 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . 10.5 Intercreditor Agreement dated as of November 8, 1990 between Wells Fargo Bank, N.A., as Agent and Reliance Insurance Company, filed as Exhibit 10.19 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . . . . 10.6 1976 Option Plan of H.H. Robertson Company (a predecessor of Registrant), as adopted and approved by H.H. Robertson Company's shareholders on May 2, 1978 and on May 6, 1980 and as further amended by H.H. Robertson Company's Board of Directors on August 11, 1981, February 9, 1982 and September 14, 1982, filed as Exhibit 10.5 to the report of H.H. Robertson Company on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1-5697), and incorporated herein by reference thereto . . . . . . 10.7 1986 Stock Option Plan of H.H. Robertson Company (a predecessor of Registrant), as adopted and approved by H.H. Robertson Company's shareholders on May 6, 1986, as amended by H.H. Robertson Company's Board of Directors on March 24, 1987 and as further amended by H.H. Robertson Company's Board of Directors on February 22, 1989, filed as Exhibit 19 to the report of H.H. Robertson Company on Form 10-Q of H.H. Robertson Company for the quarter ended September 30,1989, (File No. 1-5697), and incorporated herein by reference thereto . . . . . . . . 10.8 Text of Executive Separation Plan of H.H. Robertson Company (a predecessor of Registrant) effective May 1, 1989, filed as Exhibit 19 to H.H. Robertson Company's report on Form 10-Q for the quarter ended June 30, 1989 (File No. 1-5697), and incorporated herein by reference thereto . . . 10.9 Agreement and Purchase of Sale of Assets by and between United Dominion Industries, Inc., and Robertson-Ceco Corporation dated December 20, 1991, with letter amendment dated January 24, 1992, filed as Exhibit 2.1 to Registrant's report on Form 8-K dated as of February 3, 1992 (File No. 1-10659), and incorporated herein by reference thereto . 10.10 Loan and Security Agreement dated as of April 12, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.15 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . 10.11 Amendment No. 1 to Loan and Security Agreement dated April 30, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.16 to Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . 10.12 Consulting and Services Agreement dated as of September 15, 1992 between Registrant and Sage Capital Corporation, filed as Exhibit 10.17 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1- 10659), and incorporated herein by reference thereto . . 10.13 Amended and Restated Consulting and Services Agreement dated as of July 15, 1993 between Registrant and Sage Capital Corporation . . . . . . . 113 10.14 Continuing Guaranty dated as of April 30, 1993 between M C Durham Co. & Foothill Capital Corporation, filed as Exhibit 10.19 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto. . . . . . . 10.15 Continuing Guaranty dated as of April 30, 1993 between Ceco-San Antonio Co. and Foothill Capital Corporation, filed as Exhibit 10.20 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . 10.16 Continuing Guaranty dated as of April 30, 1993 between Meyerland Co. and Foothill Capital Corporation, filed as Exhibit 10.21 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . 10.17 Security Agreement - Stock Pledge (Domestic Subsidiaries) dated as of April 30, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.22 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . 10.18 Security Agreement - Stock Pledge (Foreign Subsidiaries) dated as of April 30, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.23 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . 10.19 Intercreditor Agreement dated as of April 30, 1993 among the Registrant, Foothill Capital Corporation and Wells Fargo Bank, N.A., filed as Exhibit 10.24 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . 10.20 Intercreditor Agreement dated as of April 30, 1993 among Foothill Capital Corporation, Reliance Insurance Co., United Pacific Insurance Company, Planet Insurance Company and the Registrant, filed as Exhibit 10.25 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . . 10.21 Asset Purchase and Stock Subscription Agreement among Heico Acquisitions, Inc., Registrant and Robertson Espanola, S.A. dated December 2, 1993, filed as Exhibit 28 to Registrant's report on Form 8-K dated December 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . 10.22 Employment Agreement between Registrant and Denis N. Maiorani dated July 15, 1993 . . . . . . 115 10.23 Employment Agreement between Registrant and Andrew G. C. Sage, II dated July 15, 1993 . . . . . . 122 10.24 Agreement Regarding Debtor in Possession Financing and Use of Cash Collateral dated as of April 30, 1993 among the Registrant, Foothill Capital Corporation and Wells Fargo Bank, N.A., filed as Exhibit 10.28 to Registrant's report on Form 8-K dated December 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . . 10.25 Letter of Credit by and among Registrant, Wells Fargo Bank, N.A. and Foothill Capital Corporation dated as of April 30, 1993, filed as Exhibit 10.29 to Registrant's report on Form 8-K dated December 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . . 10.26 Amended and Restated 1991 Long Term Incentive Plan, filed as Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 33-51665 dated December 22, 1993, and incorporated herein by reference thereto . . . . 10.27 Agreement by and among Registrant, Capella Investments Limited and H. H. Robertson (U.K.) Limited dated November 9, 1993, filed as Exhibit 2.1 to the Registrant's report on Form 8-K dated November 22, 1993, and incorporated herein by reference thereto. . . . . . . . 10.28 Indenture, dated December 9, 1986, by and between M C Co. (a predecessor of Registrant) and Mellon Bank, N.A. relating to Ceco Industries, Inc. 15.5% Discount Subordinated Debentures Due 2000 referred to in Exhibit 4.3 above . . . . . . . . . . 10.29 First Supplemental Indenture, dated as of December 9, 1986 between M C Co. (a predecessor Registrant) and Mellon Bank, N.A. referred to in Exhibit 4.4 above . . . . 10.30 Second Supplemental Indenture, dated November 8, 1990, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) referred to in Exhibit 4.5 above . . . . . . . . 10.31 Third Supplemental Indenture, dated July 14, 1993, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) referred to in Exhibit 4.6 above . . . . . . . . . . 10.32 Amended and Restated Stockholders Agreement dated as of July 12, 1990 by and among the principal stockholders of Ceco Industries, Inc., H.H. Robertson Company and Registrant (formerly known as The Ceco Corporation) referred to in Exhibit 4.7 above . . . . . . . . 10.33 Stock Purchase Agreement and related Registration Rights Agreement dated as of June 8, 1990 by and among H.H. Robertson Company, Ceco Industries, Inc. and Frontera S.A. referred to in Exhibit 4.8 above . . . . . 10.34 Agreement, dated as of June 8, 1990, by and among Frontera S.A., First City Financial Corporation Ltd., Hornby Trading Inc., Frill Trading Inc., the principal stockholders of Ceco Industries, Inc. and H.H. Robertson Company and related letter agreement dated as of June 8, 1990, among the principal stockholders of Ceco Industries, Inc., and Frontera S.A. referred to in Exhibit 4.9 above . . . 10.35 Warrant Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc. (a predecessor of Registrant) and Continental Illinois National Bank and Trust Company of Chicago (now known as Continental Bank N.A.) referred to in Exhibit 4.10 above . . . . . . . 10.36 Supplement dated as of November 8, 1990 to Warrant Agreement referred to in Item 4.5 above between Registrant and Continental Bank, N.A. referred to in Exhibit 4.10 above . . . . . . . . . . 10.37 Registration Rights Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc., and the Purchasers listed on the Signature Pages of the Purchase Agreement dated December 9, 1986, between the Ceco Corporation, Ceco Industries, Inc., and the Purchasers of the Subordinated Notes of The Ceco Corporation and the Warrants of Ceco Industries, Inc. referred to in Exhibit 4.11 above . . 10.38 Registration Rights Agreement dated May 17, 1993 by and among the Registrant and Sage RHH referred to in Exhibit 4.12 above . . . . . . . . . 10.39 Registration Rights Agreement dated November 23, 1993 by and among the Registrant and Foothill Capital Corporation referred to in Exhibit 4.13 above . . . . . 10.40 Registration Rights Agreement dated December 14, 1993 by and among the Registrant and Heico Acquisitions, Inc. referred to in Exhibit 4.14 above . . . . . 10.41 Indenture dated as of July 14, 1993 among the Registrant and IBJ Schroder Bank and Trust Company, Trustee, relating to the Registrant's 10-12% Senior Subordinated Notes due 1999 together with specimen certificate therefor referred to in Exhibit 4.15 above . . . . . . . 10.42 Specimen certificate for Common Stock, par value $.01 per share, of Registrant referred to in Exhibit 4.16 above . 11 Statement re Computation of Earnings (Loss) Per Common Share . . . . . . . . . . 129 16 Letter dated September 20, 1993 from Deloitte & Touche to the Securities and Exchange Commission filed as Exhibit 16 to Registrant's report on Form 8-K dated September 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . . . . 21 List of subsidiaries of Registrant . . . . . 131 23.1 Consent of Deloitte & Touche . . . . . . 132 23.2 Consent of Price Waterhouse . . . . . . 133 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- On September 14, 1993, the Board of Directors of Robertson Ceco Corporation, acting upon the recommendation of its Audit Committee, authorized the engagement of the firm of Price Waterhouse as its independent accountants to audit the financial statements of the Company for the fiscal year ending December 31, 1993. Price Waterhouse replaced the firm of Deloitte & Touche, whose engagement as independent accountants of the Company terminated September 14, 1993. The reports of Deloitte & Touche on the Company's financial statements for the years ended December 31, 1991 and 1992, except as noted below, did not contain an adverse opinion or a disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principles. The report of Deloitte & Touche on the Company's financial statements for the year ended December 31, 1992 contained an explanatory paragraph with respect to a substantial doubt about the ability of the Company to continue as a going concern. During the years ended December 31, 1991 and 1992 and in the period from January 1, 1993 through September 14, 1993, there were no disagreements with Deloitte & Touche on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure which, if not resolved to the satisfaction of Deloitte & Touche, would have caused Deloitte & Touche to make reference to the matter in connection with its reports on the Company's financial statements with respect to such periods. Also, during the years ended December 31, 1991 and 1992 and in the period from January 1, 1993 through September 14, 1993, there were no "reportable events" as defined in subparagraph (a)(1)(v) of Item 304 of Regulation S-K. During the years ended December 31, 1991 and 1992 and in the period from January 1, 1993 through September 14, 1993, which was prior to the engagement of Price Waterhouse, neither the Company nor anyone else on its behalf consulted Price Waterhouse regarding either (i) the application of accounting principles to a specified transaction, either completed or proposed, or (ii) the type of audit opinion that might be rendered on the Company's financial statements. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------------------------------------------------- (a) Information concerning the Registrant's directors is incorporated by reference to the section entitled "Election of Directors" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. (b) Information concerning executive officers of the Registrant is set forth in Item 4.1 of Part I at pages 11 to 12 of this Report under the heading "EXECUTIVE OFFICERS OF THE REGISTRANT". ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ---------------------- Information concerning executive compensation is incorporated by reference to the section entitled "Executive Compensation" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. 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 to the section entitled "Security Ownership" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- Information concerning certain relationships and related transactions is incorporated by reference to the section entitled "Certain Relationships and Related Transactions" in the registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 3, 1994, to be filed pursuant to Regulation 14A. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, --------------------------------------- AND REPORTS ON FORM 8-K ----------------------- PAGE NO. The following documents are filed as part of this Report: (a)1. Consolidated Financial Statements of Robertson- Ceco Corporation. Consolidated Statements of Operations for the three years ended December 31, 1993. 26 Consolidated Balance Sheets at December 31, 1992 and 1993. 27 Consolidated Statements of Cash Flows for the three years ended December 31, 1993. 29 Consolidated Statements of Stockholders' Equity (Deficiency) for the three years ended December 31, 1993. 30 Notes to Consolidated Financial Statements, including Selected Quarterly Financial Data as required by Item 302 of Regulation S-K. 31 Independent Auditors' Reports. Price Waterhouse 58 Deloitte & Touche 59 (a)2.Financial Statement Schedules for the Three Years Ended December 31, 1993. SCHEDULE VIII - Valuation and Qualifying Accounts 65 SCHEDULE IX - Short Term Borrowings 67 SCHEDULE X - Supplementary Income Statement 68 Information All other schedules are omitted because they are not applicable or not required. Report of Independent Accountants on Financial Schedules Price Waterhouse - as of and for the year ended December 31, 1993 69 (a)3.List of Exhibits. Exhibits filed or incorporated by reference in connection with this Report are listed in the Exhibit Index starting on page 70. (b) Reports on Form 8-K On November 22, 1993 the Company filed a Form 8-K reporting the sale of all of the common stock of H.H. Robertson (U.K.) Limited on November 9, 1993 in a noncash transaction to Capella Investments Limited. The U.K. Subsidiary had operated as part of the Company's Building Products Group. On December 22, 1993 the Company filed a Form 8-K reporting the completion of an investment transaction with RC Holdings, Inc. on December 14, 1993. RC Holdings, Inc. is owned by Michael E. Heisley, a director of Robertson-Ceco Corporation since July 1993. The Company also reported that, on December 9, 1993, the Board of Directors of the Company appointed Michael E. Heisley as Chief Executive Officer, replacing Andrew G.C. Sage II who continues as Chairman of the Board. Mr. Heisley was also elected as Vice Chairman of the Board. SIGNATURES Pursuant to the requirements of Section 10 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 Boston, The Commonwealth of Massachusetts, on this 31st day of March, 1994. ROBERTSON-CECO CORPORATION By /s/ John C. Sills ------------------------------ Vice President and Controller (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and as of the 31st day of March, 1994. Each person whose signature appears below hereby authorizes each of Andrew G. C. Sage, II, Denis N. Maiorani and George S. Pultz and appoints each of them singly his or her attorney-in-fact, each with full power of substitution, to execute in his name, place and stead, in any and all capacities, any or all further amendments to this Report and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, making such further changes in this Report as the Company deems appropriate. SIGNATURE /s/ Michael E. Heisley /s/ Andrew G. C. Sage, II - - ---------------------------------- ------------------------------- Chief Executive Officer Andrew G. C. Sage, II and Director Chairman (Principal Executive Officer) /s/ Denis N. Maiorani /s/ John C. Sills - - ---------------------------------- ------------------------------- Denis N. Maiorani John C. Sills President and Director Vice President and Controller (Principal Financial Officer) (Principal Accounting Officer) /s/ Frank A. Benevento /s/ Stanley G. Berman - - ---------------------------------- ------------------------------- Frank A. Benevento Stanley G. Berman Director Director /s/ Mary Heidi Hall Jones /s/ Kevin E. Lewis - - ---------------------------------- ------------------------------- Mary Heidi Hall Jones Kevin E. Lewis Director Director /s/ Leonids Rudins /s/ Gregg C. Sage - - ---------------------------------- ------------------------------- Leonids Rudins Gregg C. Sage Director Director NOTE - Other items have not been shown either because they have been included in the Consolidated Financial Statements or because the individual amounts do not exceed 1% of total revenues from continuing operations. Report of Independent Accountants on Financial Statement Schedules To the Board of Directors of Robertson-Ceco Corporation Our audit of the consolidated financial statements referred to in our report dated March 30, 1994 appearing on page 58 of the 1993 Annual Report on Form 10-K of Robertson-Ceco Corporation also included an audit of the Financial Statement Schedules which are as of and for the year ended December 31, 1993 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 March 30, 1994 Exhibit Index Exhibit Sequential No. Description Page No. 3.1 Registrant's Second Restated Certificate of Incorporation, effective July 23, 1993, filed as Exhibit 3 to Registrant's report on Form 8-K dated July 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . 3.2 Bylaws of Registrant, effective November 8, 1990, and as Amended on November 12, 1991, August 27, 1992 and December 16, 1993 . . . . . . . . . 77 4.1 Registrant's Second Restated Certificate of Incorporation, effective July 23, 1993 referred to in Exhibit 3.1 above . 4.2 Bylaws of Registrant, effective November 8, 1990, and as Amended on November 12, 1991, August 27, 1992 and December 16, 1993 referred to in Exhibit 3.2 above . . . . 4.3 Indenture, dated December 9, 1986, by and between M C Co. (a predecessor of Registrant) and Mellon Bank, N.A. relating to Ceco Industries, Inc. 15.5% Discount Subordinated Debentures Due 2000 filed as Exhibit 4(b) to Ceco Industries, Inc.'s report on Form 10-K for the year ended December 31, 1986 (File No. 33-10181), and incorporated herein by reference thereto . . . . 4.4 First Supplemental Indenture, dated as of December 9, 1986 between M C Co. (a predecessor of Registrant) and Mellon Bank, N.A. filed as Exhibit 4.5 to Registration Statement of The Ceco Corporation on Form S-4, Registration No. 33- 37020, and incorporated herein by reference thereto . . 4.5 Second Supplemental Indenture, dated November 8, 1990, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) filed as Exhibit 4.6 to Registrant's report on Form 8-K dated as of November 8, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . . . 4.6 Third Supplemental Indenture, dated July 14, 1993, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) filed as Exhibit 2 to Registrant's report on Form 8-K (File No. 1-10659) dated July 14, 1993, and incorporated herein by reference thereto . 4.7 Amended and Restated Stockholders Agreement dated as of July 12, 1990 by and among the principal stockholders of Ceco Industries, Inc., H.H. Robertson Company and Registrant (formerly known as The Ceco Corporation) filed as Exhibit 4.2 to Registration Statement of The Ceco Corporation on Form S-4, Registration Statement No. 33 -37020, and incorporated herein by reference thereto . . 4.8 Stock Purchase Agreement and related Registration Rights Agreement dated as of June 8, 1990 by and among H.H. Robertson Company, Ceco Industries, Inc. and Frontera S.A. filed as Exhibit 10(a) to Ceco Industries, Inc.'s report on Form 8-K (File No. 33-10181), dated as of June 5, 1990, and incorporated herein by reference thereto . . . . 4.9 Agreement, dated as of June 8, 1990, by and among Frontera S.A., First City Financial Corporation Ltd., Hornby Trading Inc., Frill Trading Inc., the principal stockholders of Ceco Industries, Inc. and H.H. Robertson Company and related letter agreement dated as of June 8, 1990, among the principal stockholders of Ceco Industries, Inc., and Frontera S.A. filed as Exhibit 28(b) to Ceco Industries, Inc.'s report on Form 8-K (File No. 33-10181), dated as of June 5, 1990, and incorporated herein by reference thereto . . . . . . . . 4.10 Warrant Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc. (a predecessor of Registrant) and Continental Illinois National Bank and Trust Company of Chicago (now known as Continental Bank N.A.), filed as Exhibit 4(c) to Ceco Industries, Inc.'s Form 10-K (File No. 33-10181), for the year ended December 31, 1986, and incorporated herein by reference thereto together with Supplement to Warrant Agreement dated as of November 8, 1990 between Registrant and Continental Bank, N.A. filed as Exhibit 4.6 to Registrant's report on Form SE (File No. 1-10659), dated November 16, 1990, and incorporated herein by reference thereto . . . . . . 4.11 Registration Rights Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc., and the Purchasers listed on the Signature Pages of the Purchase Agreement dated December 9, 1986, between the Ceco Corporation, Ceco Industries, Inc., and the Purchasers of the Subordinated Notes of The Ceco Corporation and the Warrants of Ceco Industries, Inc. filed as Exhibit 4(d) to Ceco Industries, Inc.'s Form 10-K (File No. 33-10181), for the year ended December 31, 1986, and incorporated herein by reference thereto . . . . . . . . . 4.12 Registration Rights Agreement dated May 17, 1993 by and among the Registrant and Sage RHH filed as Exhibit 10.27 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . 4.13 Registration Rights Agreement dated November 23, 1993 by and among the Registrant and Foothill Capital Corporation . 92 4.14 Registration Rights Agreement dated December 14, 1993 by and among the Registrant and Heico Acquisitions, Inc. . . 102 4.15 Indenture dated as of July 14, 1993 among the Registrant and IBJ Schroder Bank and Trust Company, Trustee, relating to the Registrant's 10-12% Senior Subordinated Notes due 1999 together with specimen certificate therefor filed as Exhibit 1 to the Registrant's report on Form 8-K (File No. 1-10659), dated July 14, 1993, and incorporated herein by reference thereto . . . . . . . . 4.16 Specimen certificate for Common Stock, par value $.01 per share, of Registrant filed as Exhibit 4.9 to the Registration Statement of The Ceco Corporation on Form S-4, Registration No. 33-37020, and incorporated herein by reference thereto . . . . . . . . 10.1 Borrower Security Agreement dated as of November 8, 1990 by Registrant in favor of Wells Fargo Bank, N.A., as Agent, filed as Exhibit 10.6 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . 10.2 Subsidiary Security Agreement dated as of November 8, 1990 among Ceco Dallas Co., Ceco Houston Co., Ceco San Antonio Co., M C Durham Co., M C Wathena Co., M C Windsor Co., Meyerland Co., R.P.M. Erectors, Inc. and Quantum Constructors, Inc. in favor of Wells Fargo Bank, N.A., as Agent, filed as Exhibit 10.7 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1- 10659), and incorporated herein by reference thereto . . 10.3 Subsidiary Guarantee dated as of November 8, 1990 among Ceco Dallas Co., Ceco Houston Co., Ceco San Antonio Co., M C Durham Co., M C Wathena Co., M C Windsor Co., Meyerland Co., R.P.M. Erectors and Quantum Constructors, Inc. in favor of Wells Fargo Bank, N.A. as Agent, filed as Exhibit 10.8 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . 10.4 Underwriting and Continuing Indemnity Agreement dated November 8, 1990 among the Registrant, R.P.M. Erectors, Inc., Quantum Constructors, Inc., H.H. Robertson (U.K.) Limited and Reliance Insurance Company, United Pacific Insurance Company and Planet Insurance Company, filed as Exhibit 10.20 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . 10.5 Intercreditor Agreement dated as of November 8, 1990 between Wells Fargo Bank, N.A., as Agent and Reliance Insurance Company, filed as Exhibit 10.19 to Registrant's report on Form 10-K for the year ended December 31, 1990 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . . . . 10.6 1976 Option Plan of H.H. Robertson Company (a predecessor of Registrant), as adopted and approved by H.H. Robertson Company's shareholders on May 2, 1978 and on May 6, 1980 and as further amended by H.H. Robertson Company's Board of Directors on August 11, 1981, February 9, 1982 and September 14, 1982, filed as Exhibit 10.5 to the report of H.H. Robertson Company on Form 10-K for the fiscal year ended December 31, 1987 (File No. 1-5697), and incorporated herein by reference thereto . . . . . . 10.7 1986 Stock Option Plan of H.H. Robertson Company (a predecessor of Registrant), as adopted and approved by H.H. Robertson Company's shareholders on May 6, 1986, as amended by H.H. Robertson Company's Board of Directors on March 24, 1987 and as further amended by H.H. Robertson Company's Board of Directors on February 22, 1989, filed as Exhibit 19 to the report of H.H. Robertson Company on Form 10-Q of H.H. Robertson Company for the quarter ended September 30,1989, (File No. 1-5697), and incorporated herein by reference thereto . . . . . . . . 10.8 Text of Executive Separation Plan of H.H. Robertson Company (a predecessor of Registrant) effective May 1, 1989, filed as Exhibit 19 to H.H. Robertson Company's report on Form 10-Q for the quarter ended June 30, 1989 (File No. 1-5697), and incorporated herein by reference thereto . . . 10.9 Agreement and Purchase of Sale of Assets by and between United Dominion Industries, Inc., and Robertson-Ceco Corporation dated December 20, 1991, with letter amendment dated January 24, 1992, filed as Exhibit 2.1 to Registrant's report on Form 8-K dated as of February 3, 1992 (File No. 1-10659), and incorporated herein by reference thereto . 10.10 Loan and Security Agreement dated as of April 12, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.15 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . 10.11 Amendment No. 1 to Loan and Security Agreement dated April 30, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.16 to Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . 10.12 Consulting and Services Agreement dated as of September 15, 1992 between Registrant and Sage Capital Corporation, filed as Exhibit 10.17 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1- 10659), and incorporated herein by reference thereto . . 10.13 Amended and Restated Consulting and Services Agreement dated as of July 15, 1993 between Registrant and Sage Capital Corporation . . . . . . . 113 10.14 Continuing Guaranty dated as of April 30, 1993 between M C Durham Co. & Foothill Capital Corporation, filed as Exhibit 10.19 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto. . . . . . . 10.15 Continuing Guaranty dated as of April 30, 1993 between Ceco-San Antonio Co. and Foothill Capital Corporation, filed as Exhibit 10.20 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . 10.16 Continuing Guaranty dated as of April 30, 1993 between Meyerland Co. and Foothill Capital Corporation, filed as Exhibit 10.21 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . 10.17 Security Agreement - Stock Pledge (Domestic Subsidiaries) dated as of April 30, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.22 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . 10.18 Security Agreement - Stock Pledge (Foreign Subsidiaries) dated as of April 30, 1993 between the Registrant and Foothill Capital Corporation, filed as Exhibit 10.23 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . 10.19 Intercreditor Agreement dated as of April 30, 1993 among the Registrant, Foothill Capital Corporation and Wells Fargo Bank, N.A., filed as Exhibit 10.24 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . 10.20 Intercreditor Agreement dated as of April 30, 1993 among Foothill Capital Corporation, Reliance Insurance Co., United Pacific Insurance Company, Planet Insurance Company and the Registrant, filed as Exhibit 10.25 to the Registrant's Registration Statement on Form S-4, Registration Statement No. 33-58818, and incorporated herein by reference thereto . . . . . . . 10.21 Asset Purchase and Stock Subscription Agreement among Heico Acquisitions, Inc., Registrant and Robertson Espanola, S.A. dated December 2, 1993, filed as Exhibit 28 to Registrant's report on Form 8-K dated December 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . 10.22 Employment Agreement between Registrant and Denis N. Maiorani dated July 15, 1993 . . . . . . 115 10.23 Employment Agreement between Registrant and Andrew G. C. Sage, II dated July 15, 1993 . . . . . . 122 10.24 Agreement Regarding Debtor in Possession Financing and Use of Cash Collateral dated as of April 30, 1993 among the Registrant, Foothill Capital Corporation and Wells Fargo Bank, N.A., filed as Exhibit 10.28 to Registrant's report on Form 8-K dated December 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . . 10.25 Letter of Credit by and among Registrant, Wells Fargo Bank, N.A. and Foothill Capital Corporation dated as of April 30, 1993, filed as Exhibit 10.29 to Registrant's report on Form 8-K dated December 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . . 10.26 Amended and Restated 1991 Long Term Incentive Plan, filed as Exhibit 4.1 to Registrant's Form S-8 Registration Statement No. 33-51665 dated December 22, 1993, and incorporated herein by reference thereto . . . . 10.27 Agreement by and among Registrant, Capella Investments Limited and H. H. Robertson (U.K.) Limited dated November 9, 1993, filed as Exhibit 2.1 to the Registrant's report on Form 8-K dated November 22, 1993, and incorporated herein by reference thereto. . . . . . . . 10.28 Indenture, dated December 9, 1986, by and between M C Co. (a predecessor of Registrant) and Mellon Bank, N.A. relating to Ceco Industries, Inc. 15.5% Discount Subordinated Debentures Due 2000 referred to in Exhibit 4.3 above . . . . . . . . . . 10.29 First Supplemental Indenture, dated as of December 9, 1986 between M C Co. (a predecessor Registrant) and Mellon Bank, N.A. referred to in Exhibit 4.4 above . . . . 10.30 Second Supplemental Indenture, dated November 8, 1990, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) referred to in Exhibit 4.5 above . . . . . . . . 10.31 Third Supplemental Indenture, dated July 14, 1993, between Registrant and Bank One, Columbus, N.A. (as successor Trustee to Mellon Bank, N.A.) referred to in Exhibit 4.6 above . . . . . . . . . . 10.32 Amended and Restated Stockholders Agreement dated as of July 12, 1990 by and among the principal stockholders of Ceco Industries, Inc., H.H. Robertson Company and Registrant (formerly known as The Ceco Corporation) referred to in Exhibit 4.7 above . . . . . . . . 10.33 Stock Purchase Agreement and related Registration Rights Agreement dated as of June 8, 1990 by and among H.H. Robertson Company, Ceco Industries, Inc. and Frontera S.A. referred to in Exhibit 4.8 above . . . . . 10.34 Agreement, dated as of June 8, 1990, by and among Frontera S.A., First City Financial Corporation Ltd., Hornby Trading Inc., Frill Trading Inc., the principal stockholders of Ceco Industries, Inc. and H.H. Robertson Company and related letter agreement dated as of June 8, 1990, among the principal stockholders of Ceco Industries, Inc., and Frontera S.A. referred to in Exhibit 4.9 above . . . 10.35 Warrant Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc. (a predecessor of Registrant) and Continental Illinois National Bank and Trust Company of Chicago (now known as Continental Bank N.A.) referred to in Exhibit 4.10 above . . . . . . . 10.36 Supplement dated as of November 8, 1990 to Warrant Agreement referred to in Item 4.5 above between Registrant and Continental Bank, N.A. referred to in Exhibit 4.10 above . . . . . . . . . . 10.37 Registration Rights Agreement, dated December 9, 1986, by and among Registrant (formerly known as The Ceco Corporation), Ceco Industries, Inc., and the Purchasers listed on the Signature Pages of the Purchase Agreement dated December 9, 1986, between the Ceco Corporation, Ceco Industries, Inc., and the Purchasers of the Subordinated Notes of The Ceco Corporation and the Warrants of Ceco Industries, Inc. referred to in Exhibit 4.11 above . . 10.38 Registration Rights Agreement dated May 17, 1993 by and among the Registrant and Sage RHH referred to in Exhibit 4.12 above . . . . . . . . . 10.39 Registration Rights Agreement dated November 23, 1993 by and among the Registrant and Foothill Capital Corporation referred to in Exhibit 4.13 above . . . . . 10.40 Registration Rights Agreement dated December 14, 1993 by and among the Registrant and Heico Acquisitions, Inc. referred to in Exhibit 4.14 above . . . . . 10.41 Indenture dated as of July 14, 1993 among the Registrant and IBJ Schroder Bank and Trust Company, Trustee, relating to the Registrant's 10-12% Senior Subordinated Notes due 1999 together with specimen certificate therefor referred to in Exhibit 4.15 above . . . . . . . 10.42 Specimen certificate for Common Stock, par value $.01 per share, of Registrant referred to in Exhibit 4.16 above . 11 Statement re Computation of Earnings (Loss) Per Common Share . . . . . . . . . . 129 16 Letter dated September 20, 1993 from Deloitte & Touche to the Securities and Exchange Commission filed as Exhibit 16 to Registrant's report on Form 8-K dated September 14, 1993 (File No. 1-10659), and incorporated herein by reference thereto . . . . . . . . . 21 List of subsidiaries of Registrant . . . . . 131 23.1 Consent of Deloitte & Touche . . . . . . 132 23.2 Consent of Price Waterhouse . . . . . . 133

66029_1993.txt

66029_1993

1993

66029

ITEM 1. BUSINESS -------- (A) GENERAL ------- Midland Enterprises Inc. (the "Registrant"), incorporated under the laws of the State of Delaware in 1961, is a wholly-owned subsidiary of Eastern Enterprises ("Eastern") of Weston, Massachusetts. The Registrant is primarily engaged through wholly-owned subsidiaries in the operation of a fleet of towboats, tugboats and barges, principally on the Ohio and Mississippi Rivers and their tributaries and the Gulf Intracoastal Waterway and in the Gulf of Mexico. The Registrant's barge line subsidiaries transport bulk commodities, a major portion of which is coal. In December, 1993, the Company sold its liquid barges and in conjunction, Chotin, a subsidiary, sold its liquid contract and trade name. The Registrant, through other subsidiaries, also performs repair work on marine equipment and operates two coal dumping terminals, a phosphate rock and phosphate chemical fertilizer terminal, a marine fuel supply facility and a barge construction facility. In January 1994, the Company indefinitely suspended the construction of barges at this facility. Substantially all of the barges, towboats and tugboats operated by the Registrant's barge line subsidiaries are owned by and chartered from the Registrant. A substantial portion of this equipment is mortgaged or leased and the payments under related charter agreements with its subsidiaries are pledged to secure long-term debt or to meet lease payments. The Registrant's barge line subsidiaries are The Ohio River Company ("ORCO"), Orgulf Transport Co. ("Orgulf"), Red Circle Transport Co. ("Red Circle"), and Chotin Transportation, Inc. ("Chotin"). The Registrant's other principal subsidiaries, all of whose outstanding stock is owned by the Registrant, are Eastern Associated Terminals Company ("EATCO"), Port Allen Marine Service, Inc. ("Port Allen"), Hartley Marine Corp. ("Hartley"), The Ohio River Terminals Company ("ORTCO") and West Virginia Terminals Inc. (B) INDUSTRY SEGMENTS ----------------- Registrant's only reportable industry segment is barge transportation. (C) (1) (I) PRINCIPAL SERVICES AND MARKETS ------------------------------ ORCO is the largest of the Registrant's subsidiaries, accounting for 63% of the Registrant's total 1993 tonnage transported. ORCO operates principally on the Ohio River and certain of its tributaries. Approximately 97% of the tonnage transported by ORCO in 1993 was transported in movements not regulated by the Interstate Commerce Commission ("ICC"). The balance of ORCO's tonnage was transported in movements pursuant to a Contract Carrier Permit issued by the ICC. For an explanation of regulated and non-regulated barge transportation see "Franchises". The principal commodity transported by ORCO is coal, primarily for electric utilities. Grain, stone, sand, gravel, iron, steel, scrap, and coke are the other groups of commodities which ORCO carries in significant amounts. Orgulf operates principally on the Mississippi and Ohio Rivers, and the Illinois, Arkansas-Verdigris, Tennessee-Tombigbee, and Gulf Intracoastal Waterways, transporting principally coal, grain and ores. Approximately 93% of the tonnage transported by Orgulf in 1993 was transported in movements not regulated by the Interstate Commerce Commission ("ICC"). The balance of Orgulf's tonnage was transported in movements pursuant to a Contract Carrier Permit issued by the ICC. Chotin operated principally on the Mississippi, Ohio and Warrior Rivers, and on the Illinois, Tennessee-Tombigbee and Gulf Intracoastal Waterways, transporting refined petroleum products and dry commodities including coal, grain, and ores. Chotin operated without ICC authority by limiting itself to transporting bulk commodities which are exempt from regulation by the ICC. Red Circle is engaged primarily in the transportation of phosphate rock in the Gulf of Mexico and grain to Puerto Rico and, because these commodities are exempt from regulation, operates without authority from the ICC. EATCO owns and operates a terminal on leased land at Tampa, Florida. Port Allen operates shipyard facilities in the vicinity of Baton Rouge, Louisiana. Hartley operates shipyard facilities at Paducah, Kentucky, sells fuel at Point Pleasant, West Virginia, and provides towing services principally on the Ohio River and its tributaries. ORTCO owns and operates a coal dumping facility in Huntington, West Virginia. West Virginia Terminals Inc. operates a coal dumping facility in Kenova, West Virginia. The record tonnage in 1993 increased slightly over 1992 with reduced tonnage in coal, grain and phosphate more than offset by increased tonnage in all other commodities. The tonnage in 1992 was up 3% from 1991, primarily reflecting increases in spot coal, iron, scrap and steel, and grain volumes. Ton miles are the product of tons and distance transported. The slight decrease in ton miles in 1993 reflected lower ton miles from coal, grain and phosphate mostly offset by higher ton miles in all other commodities. The record ton miles in 1992 reflected increased ton miles from grain, aggregates and ores, somewhat offset by lower coal affreightment ton miles as higher tonnages were more than offset by shorter average trip lengths. In addition to changes in ton miles transported, Registrant's revenues and net income are affected by other factors such as competitive conditions, weather and the segment of the river system traveled. See "Seasonal Aspect." (C) (1) (II) STATUS OF PRODUCT OR SEGMENT ---------------------------- No significant new product, service or segment requiring a material amount of assets was developed. (C) (1) (III) RAW MATERIALS ------------- The only significant raw material required by the Registrant is the diesel fuel to operate towboats. Diesel fuel is purchased from a variety of sources and the Registrant regards the availability of diesel fuel as adequate for presently planned operations. (C) (1) (IV) FRANCHISES ---------- The Interstate Commerce Act, as amended in December 1973, exempts from regulation water transportation of dry commodities which were transported in bulk as of June 1, 1939 (including coal, phosphate rock, stone, sand and gravel, grain, and ores). In addition, the Interstate Commerce Act exempts from regulation water transportation of liquid cargoes in bulk in certified liquid barges. Approximately 96% of the 1993 tonnage was exempt from regulation by the ICC. Regulated commodities include iron and steel products, other manufactured products, packaged goods and scrap. ORCO holds a certificate of Public Convenience and Necessity issued by the ICC authorizing service as a common carrier on the Ohio River and certain of its tributaries, the Mississippi River, the Illinois Waterway, the Arkansas-Verdigris Waterway and the Missouri River, the Warrior System, and the Gulf Intracoastal Waterway, and for regulated movements to and from Tampa, Florida. ORCO also holds a Contract Carrier Permit issued by the ICC, authorizing contract carriage of regulated commodities on the same waterways. Orgulf also holds such a Contract Carrier Permit. Red Circle and Chotin do not hold or require ICC authority since they provide transportation only in non-regulated movements. (C) (1) (V) SEASONAL ASPECT --------------- Due to the freezing of some northern rivers and waterways during winter months, and increased coal consumption by electric utilities during the summer months, average winter month revenues tend to be lower than revenues for the remainder of the year. (C) (1) (VI) WORKING CAPITAL --------------- No unusual working capital requirements are normally encountered. (C) (1) (VII) CUSTOMERS --------- No customer, or group of customers under common control, accounted for 10% or more of the total revenues in 1993. On the basis of past experience and its competitive position, the Registrant considers that the loss of several of its subsidiaries' largest customers simultaneously, while possible, is unlikely to happen. The Registrant's subsidiaries have long-term transportation and terminaling contracts which expire at various dates from January 1995 through December 2007. During 1993, approximately 41% of the Registrant's consolidated revenues resulted from these contracts. A substantial portion of the contracts provide for rate adjustments based on changes in various costs, including diesel fuel costs, and, additionally, contain "force majeure" clauses which excuse performance by the parties to the contracts when performance is prevented by circumstances beyond their reasonable control. Many of these contracts have provisions for termination for specified causes, such as material breach of the contract, environmental restrictions on the burning of coal, or loss by the customer of an underlying commodity supply contract. Penalties for termination for such causes are not generally specified. However, some contracts provide that in the event of an uncured material breach by Registrant's subsidiary which results in termination of the contract, Registrant's subsidiary would be responsible for reimbursing its customer for the differential between the contract price and the cost of substituted performance. Due to the capital-intensive, high fixed cost nature of the Registrant's business, the negotiation of long-term contracts which facilitate steady and efficient utilization of equipment is important to profitable operations. (C) (1) (VIII) BACKLOG ------- The 1993 revenue backlog (which is based on contracts that extend beyond December 31, 1994) is shown at prices current as of December 31, 1993 which are subject to escalation/de-escalation provisions. Since services under many of the long-term contracts are based on customer requirements, Midland has estimated its backlog based on its forecast of the requirements of these long-term contract customers. About 50% of the decrease in the tonnage backlog is due to the sale of the liquid barge business and its contract. About 40% of the revenue backlog at December 31, 1993 is associated with a disputed contract with Gulf Power Company, for which shipments have been curtailed. (C) (1) (IX) GOVERNMENT CONTRACTS -------------------- The Registrant has no material portion of business subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government. (C) (1) (X) COMPETITIVE CONDITIONS ---------------------- Improvements in operating efficiencies have permitted barge operators to maintain relatively low rate structures. Consequently, the barge industry has generally been able to retain its competitive position with alternate methods of transportation for bulk commodities when the origin and destination of such movements are contiguous to navigable waterways. Primary competitors of the Registrant's barge line subsidiaries include other barge lines and railroads (including one integrated rail-barge carrier). There are a number of companies offering transportation services on the waterways served by the Registrant, including carriers holding operating authority issued by the ICC and carriers not so regulated. Competition among major barge line competitors is intense due to a continuing imbalance between barge supply and demand, and most recently by weak grain and coal exports. This in turn has led to revenue and margin erosion, cost and productivity improvements, and some industry consolidation. Many railroads operating in areas served by the inland waterways compete for cargoes carried by river barges. In many cases, these railroads offer unit train service (pursuant to which an entire train is committed to the customer) and dedicated equipment service (pursuant to which equipment is set aside for the exclusive use of a particular customer) for coal, grain and other bulk commodities. In addition, rates charged by both railroads and river barge operators are sometimes designed to reflect special circumstances and requirements of the individual shippers. As a result, it is difficult to compare rates charged for movements of the various commodities between specific points. Modern diesel powered towboats such as those which comprise the Registrant's towboat fleet are, however, capable of moving in one tow approximately 22,500 tons (equivalent to 225 one hundred-ton capacity railroad cars) on the Ohio River and on the Upper Mississippi River and approximately 60,000 tons (equivalent to 600 one hundred-ton capacity railroad cars) on the Lower Mississippi River, where there are no locks to transit, at average rates per ton mile which are generally below those charged by Class 1 railroads. (C) (1) (XI) RESEARCH -------- No significant amount was spent during the last fiscal year on research to improve existing services or develop new services. The task of improving and developing services is a continuing assignment of various operating departments of Registrant's subsidiaries, but such efforts are not segregated and would not generally be regarded as research activities. (C) (1) (XII) COMPLIANCE WITH ENVIRONMENTAL STATUTES -------------------------------------- The Registrant and/or its subsidiaries are subject to the provisions of the Federal Water Pollution Control Act, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, the Superfund Amendment and Reauthorization Act, the Resource Conservation and Recovery Act of 1976, and the Oil Pollution Act of 1990, which permit the Coast Guard and the Environmental Protection Agency to assess penalties and clean-up costs for oil, hazardous substance, and hazardous waste discharges. Some of these acts also allow third parties to seek damages for losses caused by such discharges. Compliance with these acts has had no material effect on the Registrant's capital expenditures, earnings, or competitive position; and no such effect is anticipated. (C) (1) (XIII) EMPLOYEES --------- As of December 31, 1993, Registrant and its subsidiaries employed approximately 1,500 persons, of whom approximately 28% are represented by labor unions. (D) FOREIGN OPERATIONS ------------------ Registrant does not engage in material operations in foreign countries, and no material portion of Registrant's revenues is derived from customers in foreign countries. ITEM 2. ITEM 2. PROPERTIES ---------- (A) AS OF DECEMBER 31, 1993, THE REGISTRANT'S FLOATING EQUIPMENT CONSISTED OF 2,461 BARGES AND 91 BOATS. West Virginia Terminals Inc. leases a coal dumping facility in Kenova, West Virginia. Orco leases office facilities in Cincinnati, Ohio. EATCO owns terminal facilities on leased land in Tampa, Florida. Chotin owns approximately 738 acres of land in West Baton Rouge Parish, Louisiana; and Port Allen owns shipyard facilities located on that land. ORTCO owns coal dumping facilities in Huntington, West Virginia. Hartley owns shipyard facilities in Paducah, Kentucky. Capital expenditures for the Registrant in 1993 totalled approximately $14,191,000. These expenditures were made principally for replacement of the barge fleet and for renewal of equipment. (B) NOT APPLICABLE. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- On August 30, 1993, ORCO and Orgulf filed suit in the United States District Court for the Southern District of Ohio, Western Division, against Gulf Power Company and its affiliate Southern Company Services, Inc., claiming damages for breach of a long-term coal transportation contract. See Item 1(c)(1)(viii) above and Item 7 below. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- Not required PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER --------------------------------------------------------------------- MATTERS ------ The Registrant's common stock is held solely by Eastern and is not traded in any market. Dividends were declared in the amount of $10,087,000 in 1993 and $36,837,000 in 1992. The payment of dividends is subject to the restrictions described in Note 4 to the Consolidated Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ----------------------- Not required. Reference Management Narrative Analysis following Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1993 COMPARED TO 1992 - --------------------- Midland's 1993 tonnage and tonmile production was unchanged from 1992 despite several significant events that negatively affected the river towing industry and Midland specifically. Coal tonnage declined 6% from 1992 primarily reflecting reduced shipments to electric utilities due to the United Mine Worker's (UMW) strike (resolved in December), disruption in river traffic caused by record flooding on the Mississippi River system, and the cessation of coal shipments under a long-term contract. Regarding the latter, in July 1993, Midland was advised by Gulf Power Company, a major customer that it was considering termination of a long-term contract for transportation of coal. This contract, initially executed in 1971 and extended through 2007, generated revenues of $17,200,000 and $9,122,000 in the prior year and 1993, respectively. Midland believes the customer's actions to be a breach of the contract, and has filed suit in U.S. District Court. Presently, the customer has renewed shipments of coal under the contract, although at significantly reduced volumes. Non-coal tonnage increased 13% over 1992, despite a 23% reduction in grain tonnage, and served to offset the lower coal volume, although at lower margins. The aforementioned flooding on the Mississippi River system and a poor export market impacted grain tonnage. Increased shipments of alumina, scrap and stone tonnage and towing of non-affiliated barges contributed to the increase in non-coal commodities. Operating results of Midland's terminaling and shipyard repair facilities were mixed, with improved results for coal terminaling and shipyards being offset by lower phosphate product terminaling, as export markets continued to be depressed in 1993. As a result of the reduced coal affreightment tonnage and lower phosphate terminaling, consolidated revenues declined 3% as compared to 1992. Operating earnings declined nearly 14% as compared to 1992 with all of the shortfall occurring in the second half of 1993. The reduction in coal tonnage as described above, as well as the UMW strikes' related impact on traffic patterns and operating costs, combined with the record flooding on the Upper Mississippi River system were the significant negative factors. The Upper Mississippi River flooding closed or severely restricted operations on that river segment during the third and fourth quarters which: idled equipment, significantly increased operating costs, and shifted business to less profitable markets. Depreciation expense was slightly higher than 1992 due to recent capital spending for fleet renewal, while administrative costs were 10% below 1992 due to lower employment and consulting costs, as well as gains on the purchase of pension annuities for retirees. On December 21, 1993 Midland terminated its participation in the liquid barge affreightment business by the sale of its tank barges, affreightment contract, and "Chotin" trade name. The transaction resulted in a pre-tax gain of $7,988,000. In addition, the Company closed its barge construction facility in Port Allen, Louisiana, and recorded a $3,500,000 pre-tax charge to reflect costs associated with the final disposition of the facility. These transactions resulted in a net gain of $4,488,000 included in "Other Income." In addition to the above changes in operating earnings and other income, Midland's 1993 after tax earnings were impacted by the increase in the statutory Federal income tax rate from 34% to 35% (See Note 5 of Notes to Financial Statements), which resulted in an increase to the 1993 tax provision of approximately $1,812,000. Midland's net earnings for 1992 included a one-time benefit of $12,156,000 on the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") recorded as of January 1, 1992. 1992 COMPARED TO 1991 - --------------------- Midland's consolidated ton miles transported during 1992 increased 1% from 1991 despite reduced utility coal demand from the mild winter and summer temperatures and the lingering effects of the recession. Total affreightment tonnage increased 3% from 1991. While coal tonnage increased nearly 2% from 1991 levels, principally from increased industrial coal and spot coal shipments, ton miles generated from coal affreightment declined nearly 3% due to shorter hauls. Ton miles generated from other commodities, including grain, aggregates, ores, etc., increased nearly 7% as Midland obtained replacement tonnages to offset the weakness of the coal market. Activity levels at Midland's support operations were generally lower than 1991. Phosphate product terminalling was down substantially from 1991 due to weak export demand. Partially offsetting was coal terminalling activity which was much improved over 1991 results. Shipyard repair activity was also lower in 1992. Consolidated revenues declined 1% from 1991 with slightly reduced revenues from nearly all segments. Affreightment rate levels were essentially unchanged from those in 1991, with lower volumes mainly from support operations accounting for the majority of the slight revenue decline. Operating conditions for river transportation were generally good in 1992 and improved slightly over 1991. Diesel fuel costs were basically stable, with 1992 costs averaging below 1991 levels. Depreciation expense from fleet renewal and administrative overhead costs were higher than 1991. As a result of the lower phosphate terminalling, reduced shipyard activity and higher depreciation charges, Midland's operating earnings declined 5% as compared to 1991. Midland's net earnings before accounting changes declined 18% from 1991, reflecting the lower operating earnings formerly discussed and higher interest charges associated with Midland's capital expenditure program. Lower earnings in 1992 also reflected an increase in the effective tax rate from 29% to 35%, due to the adoption of Statement of Financial Accounting Standards SFAS No. 109. (See Note 5 of Notes to Financial Statements.) The Company chose to reflect the cumulative effect of adopting SFAS No. 109 as a change in accounting principle at the beginning of fiscal 1992 and recorded a tax credit of $12,156,000 which represents the net decrease to the deferred tax liability as of that date. In 1991, Midland elected early adoption of SFAS No. 106 "Employers Accounting for Post-Retirement Benefits Other Than Pensions". The Company chose to reflect the cumulative effect of adopting this statement as a change in accounting principle at as of January 1, 1991 with a charge to earnings of $5,906,000. This non-cash charge reflected the actuarially computed value of accrued non-pension benefits of active and retired employees as of December 31, 1990. Net earnings after the accounting change was $15,005,000. After the cumulative effect of the accounting change, net earnings increased $14,259,000 over 1991. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- Debt payments, dividends to Parent and capital expenditures of $14,191,000 were funded from cash provided by operating activities in 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- Information with respect to this item appears on page of this report. Such information 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 -------------------------------------------------- Not required. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ---------------------- Not required. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -------------------------------------------------------------- Not required. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- Not required. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K ---------------------------------------------------------------- (A) (1) AND (2) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. Information with respect to these items appears on page of this report. Such information is incorporated herein by reference. (3) LIST OF EXHIBITS ---------------- 3.1 Certificate of Incorporation of Midland Enterprises Inc. (filed as Exhibit 3.1 to Registration Statement of Midland Enterprises Inc. on Form S-1 (Registration No. 2-39895, as filed May 5, 1971).1 3.2 By-Laws of Midland Enterprises Inc. (filed as Exhibit 3.2 to Annual Report of Midland Enterprises Inc. on Form 10-K for the year ended December 31, 1984).1 4.1 Ship financing agreement dated December 27, 1984.2 4.2 Promissory note of Midland Enterprises Inc. to Chemical Bank dated January 4, 1985.2 ________________________ 1 Not filed herewith. In accordance with Rule 12-b-32 of the General Rules and Regulations under the Securities Act of 1934, reference is made to the document previously filed with the Commission. 2 Not filed herewith. Private placements that are less than 10% of the total assets of Registrant and its subsidiaries on a consolidated basis. 4.3 Indenture between Midland Enterprises Inc. and Shawmut Bank, N.A. dated as of April 1, 1988 (filed as Exhibit 4.2 to Registration Statement No. 33-20789).1 4.4 Indenture between Midland Enterprises Inc. and The First National Bank of Boston dated as of April 2, 1990 (filed as Exhibit 4.2 to Registration Statement No. 33-32120).1 (NOTE: The Registrant agrees to furnish to the Securities and Exchange Commission upon request a copy of any instrument with respect to any long-term debt of the Registrant.) 24.1 Consent of Independent Public Accountants. (B) REPORTS ON FORM 8-K ------------------- There were no reports on Form 8-K filed in the fourth quarter of 1993. __________________________ 1 Not filed herewith. In accordance with Rule 12-b-32 of the General Rules and Regulations under the Securities Act of 1934, reference is made to the document previously filed with the Commission. 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. MIDLAND ENTERPRISES INC. (Registrant) BY /s/ R. L. DOETTLING ---------------------------- R. L. DOETTLING SENIOR VICE PRESIDENT, FINANCE AND ADMINISTRATION (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) DATE MARCH 16, 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 16th day of March, 1994. BY: /s/ F. C. RASKIN BY: /s/ R. L. DOETTLING ----------------------------- ----------------------------- F. C. RASKIN R. L. DOETTLING PRESIDENT; DIRECTOR SENIOR VICE PRESIDENT, FINANCE (PRINCIPAL EXECUTIVE OFFICER) AND ADMINISTRATION; DIRECTOR; (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) BY: /s/ P. E. HUBBARD BY: /s/ S. A. FRASHER ----------------------------- ----------------------------- P. E. HUBBARD S. A. FRASHER SENIOR VICE PRESIDENT, SALES VICE PRESIDENT, OPERATIONS; AND MARKETING; DIRECTOR DIRECTOR Supplemental information to be Furnished With Reports Filed Pursuant to Section 15 (3) of the Act by Registrants Which Have Not Registered Securities Pursuant to Section 12 of the Act. No annual reports to security holders covering the Registrant's last fiscal year nor any proxy materials have been sent to the Registrant's security holders. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To Midland Enterprises Inc.: We have audited the accompanying consolidated balance sheets of MIDLAND ENTERPRISES INC. (a Delaware corporation and a wholly-owned subsidiary of Eastern Enterprises) and subsidiaries 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. 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 financial statements referred to above present fairly, in all material respects, the financial position of Midland Enterprises 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 Note 5 to the Consolidated Financial Statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. As discussed in Note 3 to the Consolidated Financial Statements, effective January 1, 1991, the Company changed its method of accounting for post-retirement benefits other than pensions. 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 Consolidated Financial Statements and Schedules 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 our 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. Cincinnati, Ohio, February 4, 1994. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) SIGNIFICANT ACCOUNTING POLICIES Midland Enterprises Inc. (the "Company") is a wholly-owned subsidiary of Eastern Enterprises ("Eastern") of Weston, Massachusetts. The consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany balances and transactions have been eliminated. The significant accounting policies followed by the Company and its subsidiaries are described below: Note 2 - Retirement and employee benefit plans Note 3 - Post-retirement benefits other than pensions Note 5 - Income taxes Note 6 - Property and equipment (a) The Company's principal business is barge transportation with its principal commodity being coal, substantially all of which is transported to electric utilities in the eastern half of the United States. (b) Cash Equivalents - Cash equivalents are comprised of highly liquid instruments with original maturities of three months or less. (c) Transactions with Parent - Parent receivables represent advances to Eastern which bear interest at the prime rate, 6% at December 31, 1993, 6% at December 31, 1992 and 6 1/2% at December 31, 1991. The Company was also charged a corporate overhead allocation from its parent computed on several factors including direct corporate management time, revenues, capitalization and employees, which management believes is a reasonable method of allocation. (d) Materials, Supplies and Fuel - Materials, supplies and fuel are stated at the lower of cost (first-in, first-out or average) or market. (e) Unamortized Debt Expense - Unamortized debt expense represents fees and discounts incurred in obtaining long-term debt. Such costs are being amortized over the terms of the respective bond issues. (f) Accounting for Income on Tows in Progress - The Company recognizes income on tows in progress on the percentage of completion method by relating the number of miles completed to date to the total miles to be traveled. (g) Reserve for Insurance Claims - The Company is self-insured for personal injury and property claims, certain of which are insured above a deductible amount per occurrence. The Company's estimate of liability for the self-insured claims is included in the "Reserve for Insurance Claims" in the Consolidated Balance Sheets and is net of amounts expected to be recovered from its insurance carriers. Payments made for losses incurred are netted against the related liability for the loss. (h) Reclassifications - Certain reclassifications of previously reported amounts have been made to conform with current classifications. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) RETIREMENT AND EMPLOYEE BENEFIT PLANS The Company and its subsidiaries, through various Company-administered plans and union-administered plans, provide retirement benefits for substantially all of their employees. Normal retirement age is 65, but provision is made for earlier retirement. Benefits under non-union plans are based on salary or wages and years of service, while benefits under union plans are based on negotiated amounts and years of service. The funding of retirement and employee benefit plans is in accordance with the requirements of the plans and collective bargaining agreements and, where applicable, is in sufficient amount to satisfy the "Minimum Funding Standards" of the Employee Retirement Income Security Act of 1974. During 1993 the Company settled portions of its defined benefit pension obligation through the purchase of annuity contracts from insurance companies. In compliance with the provisions of Statement of Financial Accounting Standards No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans," the Company recognized a pre-tax gain of $603,267 in 1993. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) RETIREMENT AND EMPLOYEE BENEFIT PLANS (CONTINUED) Certain of the Company's subsidiaries participate in one or more multi-employer pension plans, and contribute to such plans in amounts required by the applicable union contracts. Contribution levels are negotiated between the subsidiaries and the unions. A subsidiary would be required under the Federal law to compute its liability for, and accelerate its funding of, its proportionate share of a multi-employer plan's unfunded vested benefits (if any) upon its withdrawal from, or the termination of, such a plan. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (3) POST-RETIREMENT BENEFITS OTHER THAN PENSIONS The Company and its subsidiaries, through various Company-administered plans and other union retirement and welfare plans under collective bargaining agreements, provide certain health care and life insurance benefits for retired employees. The Company's employees, who are participants in the pension plans, become eligible for these benefits if they reach retirement age while working for the Company. Effective January 1, 1991, Statement of Financial Accounting Standards No. 106 ("SFAS 106"), "Employers' Accounting for Post-Retirement Benefits Other Than Pensions" was adopted by immediately recognizing the cumulative effect of the accounting change. SFAS 106 requires that the expected cost of post-retirement benefits other than pensions be charged to expense during the period that the employee renders service. In prior years, expense was recognized when claims were paid. At the date of adoption, the cumulative effect of the accounting change ("transition obligation") was $8,949,000. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (3) POST-RETIREMENT BENEFITS OTHER THAN PENSIONS (CONTINUED) The weighted average discount rate used in determining the accumulated benefit obligation was 7.5%. A 12% and 14% increase in cost of covered health care benefits has been assumed for 1993 and 1992, respectively. This rate of increase is assumed to drop gradually to 5% after 7 years. A one percentage point increase in the assumed health care cost trend would have increased the net periodic post-retirement benefit cost by $48,000 in 1993 and $75,000 in 1992 and the accumulated post-retirement benefit obligation by $561,000 in 1993 and $644,000 in 1992. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) LONG-TERM OBLIGATIONS AND CREDIT AGREEMENTS (CONTINUED) (a) Summary of Long-Term Debt (Continued) The First Preferred Ship Mortgage Bonds, Ship Financing Bond, and obligations under capital leases are secured by a substantial portion of the Company's towboats and barges and by assignment of rentals for that equipment payable to the company by its subsidiaries. $25,000,000 and $17,000,000 of First Preferred Ship Mortgage Medium-Term Notes were issued in 1992 and 1991, respectively. Under the most restrictive of the mortgage indentures, the Company, (a) may not pay dividends, reacquire its common stock or make any advances or loans to its stockholder or subsidiaries of its stockholder except to the extent of the sum of (i) Consolidated Net Earnings after December 31, 1988, (ii) the net proceeds of the sale of stock of the Company after December 31, 1988, and (iii) the amount of $50,000,000 with respect to any advances or loans to its stockholder or to subsidiaries of its stockholder, (b) is required to maintain Consolidated Net Current Assets at least equal to $1,250,000, and (c) may not incur or permit any of its subsidiaries to incur additional Senior Unsecured Funded Debt except for refunding unless immediately thereafter Consolidated Net Tangible Assets will aggregate at least 150% of (i) Consolidated Senior Unsecured Funded Debt (excluding therefrom unsecured loans or advances to the company from its stockholder) plus (ii) Consolidated Senior Secured Funded Debt (all terms as defined in the applicable indenture). Under these agreements, $18,197,000 of retained earnings at December 31, 1993 are available for additional dividends to Eastern. Included in obligations under capital leases is $35,804,000 of barge lease obligations having a weighted average interest rate of 9.8%. Minimum lease payments under these agreements are due in installments through 2003; principal payments due for the next five years amount to $3,070,000 in 1994, $3,378,000 in 1995, $3,719,000 in 1996, $4,095,000 in 1997, and $4,509,000 in 1998. (b) Credit Agreements Eastern maintains a credit agreement with a group of banks which provides for the borrowing by Eastern and certain subsidiaries of up to $60,000,000 at any time through December 31, 1994, with borrowing thereunder maturing not later than December 31, 1995. The Company's maximum available borrowings under the credit agreement are $35,000,000. In addition, Eastern and certain subsidiaries maintain lines of credit totaling $50,000,000, under which the Company can borrow up to $10,000,000. The agreement and lines require facility or commitment fees, which average 1/5 of 1% of the unused portion. During 1993 and at December 31, 1993, the Company had no borrowings outstanding under these agreements. The interest rate for borrowings is the agent bank's prime rate or, at Eastern's option, various alternatives. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) LONG-TERM OBLIGATIONS AND CREDIT AGREEMENTS (CONTINUED) (b) Credit Agreements (continued) Eastern also maintains a $10,000,000 line of credit available to the Company, which provides for interest at the prime rate or, at Eastern's option, rates tied to Eurodollar, certificate of deposit or money market quotes. During 1993 and at December 31, 1993, the Company had no borrowings outstanding under this line of credit. (c) Consolidated Five Year Sinking Funds and Maturities The aggregate annual sinking fund requirements and current maturities of long-term debt, including capital leases, for the next five years amount to $5,871,000 in 1994, $4,360,000 in 1995, $3,905,000 in 1996, $4,095,000 in 1997, and $4,509,000 in 1998. (d) Deposited Monies Monies on deposit with trustee are netted against long-term debt. In accordance with the provision of certain bond indentures, these amounts represent deposits with the bond trustee for the equipment mortgaged under the bond indenture and subsequently sold. It is the Company's intention to repurchase its own bonds with these funds to be used for sinking fund requirements. (5) INCOME TAXES The Company and its subsidiaries are members of an affiliated group of Companies which files a consolidated Federal Income Tax return with Eastern. The Companies follow the policy, established for the group, of providing for Federal Income Taxes which would be payable on a separate company basis. For financial reporting purposes, investment tax credits were deferred and are being amortized to income over the book life of the related property and equipment. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (5) INCOME TAXES (CONTINUED) Effective January 1, 1992, Midland adopted the Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes". SFAS 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 tax returns. Under this method, deferred tax assets and liabilities 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. At the date of adoption, Midland recorded a tax credit of approximately $12,156,000 which represents the net decrease to the deferred tax liabilities as of that date. This amount has been reflected in the consolidated statement of earnings as the cumulative effect of an accounting change. The 1991 tax provision was reduced by $1,755,000 of credits no longer applicable under SFAS 109. The Revenue Reconciliation Act of 1993, increased the statutory Federal income tax rate from 34% to 35%, effective January 1, 1993. The provision for income tax in 1993 includes approximately $240,000 for the impact of the rate change in the current earnings, and approximately $1,572,000 to reflect the additional deferred tax requirements as of January 1, 1993, in accordance with SFAS 109. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (5) INCOME TAXES (CONTINUED) (6) PROPERTY AND EQUIPMENT (a) Depreciation and Amortization - Depreciation and amortization are provided using the straight-line method over the estimated useful lives of property and equipment. Depreciation and amortization as a percentage of average depreciable assets was 4.2%, 4.1%, and 3.9% in 1993, 1992 and 1991, respectively. (b) Maintenance & Repairs - The costs of routine maintenance and repairs are charged to expense as incurred. Major renovations and renewals, which benefit future periods or extend the life of the asset, are capitalized and amortized over their estimated useful lives. (c) Interest During Construction - The Company reflects as an element of cost in all major construction projects the estimated cost of borrowed funds employed during the period of construction. Capitalized interest is amortized over the estimated useful life of the property or equipment. (7) COMMITMENTS The Company and its subsidiaries lease certain facilities, vessels and equipment under long-term leases which expire on various dates through 2008. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Short-term charter rents, which represent amounts paid for the charter of towboat equipment on a day-to-day, "fully-found" (i.e., fully equipped and crew included, with all operating costs included in the charter fee) basis, as well as the costs of chartering barges on a day-to-day basis, have been excluded from the above rentals. Such amounts are not included above since, (1) they are considered to be essentially an "outside towing" or barge "per diem" expense, (2) they involve no continuing commitments on the part of the Company and its subsidiaries, and (3) the rental amounts contain little or no interest factor. Amortization of intangibles, royalties, advertising costs and research and development costs have been omitted as the information is not applicable or not significant. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (9) SIGNIFICANT CUSTOMERS None of the subsidiaries' customers accounted for more than 10% of the Company's total consolidated operating revenues in 1993, 1992 and 1991. (10) FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value disclosures for financial instruments: Cash, trade receivables and accounts payable: The carrying amounts approximates fair value because of the short maturity of these instruments. Long-term debt: The fair value of long-term debt is estimated using discounted cash flow analyses based on the current incremental borrowing rates for similar types of borrowing arrangements. MIDLAND ENTERPRISES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

96289_1993.txt

96289_1993

1993

96289

ITEM 1. BUSINESS. GENERAL The Company engages in the retail sale of consumer electronics including personal computers primarily in the United States. The Company's retail operations include the Radio Shack, McDuff Electronics, VideoConcepts, The Edge in Electronics, Computer City and Incredible Universe store chains as well as some new concepts which it is testing. These new test concepts are Famous Brand Electronics Warehouse, Energy Express Plus and Audio Video & Computers. Radio Shack. Radio Shack is the Company's largest operating division. At December 31, 1993, Radio Shack had 4,553 company-owned stores located throughout the United States. These stores average approximately 2,370 square feet in area and are located in major malls, strip centers and individual store fronts, primarily in metropolitan markets. To provide service to smaller communities, Radio Shack had on the same date a network of 2,002 dealer/franchise stores. The dealers are generally engaged in other retail operations and augment their sales with Radio Shack products. In addition, Radio Shack had 65 international dealers at December 31, 1993. The 4,553 company-owned stores carry a broad assortment of electronic parts and accessories, audio/video equipment, cellular and conventional telephones as well as specialized products such as scanners, electronic toys and personal computers. The personal computers offered through these consumer stores primarily target entry level users seeking computers for home, individual and small business use. Tandy Name Brand Retail Group. The Tandy Name Brand Retail Group is comprised of VideoConcepts, McDuff Electronics and The Edge in Electronics retail outlets. At December 31, 1993, this group operated a total of 322 stores which sell name brand televisions, audio equipment, personal computers and other electronic products and appliances. The Tandy Name Brand Retail Group operates two distinctly different types of store formats -- mall stores and supercenters. The 231 mall stores average 3,100 square feet in size while the 75 supercenters, which are located in stand-alone or strip center locations, average 12,200 square feet. Mall stores sell primarily electronic, audio and video products. The supercenter product offerings also include major appliances. The Company closed approximately 110 Tandy Name Brand Retail Group stores in the first quarter of 1993. See "Management's Discussion and Analysis of Results of Operations and Financial Condition" found in Item 7 and Note 4 of the Notes to Consolidated Financial Statements for more information. "The Edge in Electronics" began operating in 1990. This chain of electronic boutique stores is designed for mall customers interested in fashionable personal and portable name brand electronics. As of December 31, 1993, these 16 stores were located in major malls and averaged approximately 1,100 square feet. Computer City. As of December 31, 1993, the Company had 40 Computer City stores open, three of which were in Europe. The Computer City chain operates as a supercenter format featuring many name brand computers, software and related products, including U. S. Logic, Tandy, IBM, Apple, Sony, Lotus, Borland, Microsoft, Packard-Bell, Compaq, AST and Hewlett-Packard. These stores average about 23,500 square feet and carry more than 5,000 products. The Company has opened two new stores since December 31, 1993 and plans to open an additional 22 stores later in 1994. Incredible Universe. In August 1993 Incredible Universe became a separate division of Tandy. At December 31, 1993, Tandy operated three Incredible Universe stores: one in Portland, Oregon; a second in Arlington, Texas; and a third store located in northeast Dallas, Texas. These 160,000 to 200,000 square foot stores offer a broad selection of consumer electronics and appliances. The Company recently opened its fourth store in Miami, Florida, and announced plans to open stores in Tempe, Arizona; Columbus, Ohio; Sacramento, California and Hollywood, Florida. In addition, more Incredible Universe stores are currently planned for 1994 and 1995. Supporting the retail operations is an extensive infrastructure that includes: A&A International, Inc. - This wholly owned subsidiary of the Company serves the wide-ranging international import/export, sourcing, evaluation, logistics and quality control needs of the Company. InterTAN Inc. is the largest outside customer of the Company. Most of A&A's activity for InterTAN originates from manufacturers in the Far East. For more discussion on InterTAN see Note 21 of the Notes to Consolidated Financial Statements. Tandy Service Centers - The Company maintains a large service and support network in the consumer electronics retail industry. These centers repair name brand and private label products sold through all of the Company's retail distribution channels. Over one million parts are stocked in the Tandy Service division which includes 116 service centers throughout the nation. Regional Distribution Centers - The 14 distribution centers ship over one million cartons each month to both Radio Shack and the Tandy Name Brand Retail Group operations. This group will also be instrumental in supporting the new Radio Shack Gift Express service. Tandy Information Services - TIS collects information from the retail stores nationwide and updates a large database with sales information. This database is a sophisticated marketing tool benefiting every phase of the Company's operations. TIS also processes the inventory, accounting, payroll, telecommunications and operating information for all of the Company's operations. In addition, specialized information is tracked for the Company's distribution and corporate activities. Tandy Credit Corporation - This operation, a wholly owned subsidiary of the Company, helps support sales of the Company's retail operations and provides retail divisions additional marketing flexibility through the utilization of credit promotions. This group maintains and manages Tandy's various private label credit cards. Tandy Transportation, Inc. - A large fleet of tractors and trailers transports much of the merchandise from the ports of entry to the Company's regional distribution centers and local distribution facilities for delivery to Radio Shack and Tandy Name Brand Retail Group stores. Consumer Electronics Manufacturing - The Company also engages in the manufacturing business with 11 manufacturing facilities in the United States and three overseas manufacturing operations in China, Hong Kong and Taiwan. The China operation is a joint venture. These 14 manufacturing facilities cover a total of 1,674,000 square feet and employ over 4,700 workers and professionals as of December 31, 1993, excluding those persons working at facilities included in discontinued operations. The Company continues to manufacture a variety of products for use in its consumer electronics retailing operations. The products include audio, video, telephony, antennas, wire and cable products and a wide variety of hard to find parts for consumer electronic products. Most of the Company's manufacturing output is sold through the Radio Shack store chain. In addition, the Company has previously operated several related marketing businesses that manufacture and sell consumer electronics and computers to retailers and end users, see "Discontinued Operations" below for further information. DISCONTINUED OPERATIONS On June 25, 1993, the Board of Directors of Tandy adopted a formal plan of divestiture under which it would sell its computer manufacturing and marketing businesses, the O'Sullivan Industries, Inc. ready-to-assemble furniture manufacturing and related marketing business, the Memtek Products division and the Lika printed circuit board business. The divestiture plan replaced the Company's plan to spin off all of the Company's manufacturing and marketing businesses as described in Tandy's Transition Report on Form 10-K/A-4 for the six-month period ended December 31, 1992. In connection with the plan of divestiture the Company accounted for the divestiture of these businesses as discontinued operations. Prior year results of operations have been reclassified to reflect the discontinued operations treatment. Computer Manufacturing. In furtherance of the divestiture plan, the Company closed the sale of the computer manufacturing and marketing businesses to AST Research, Inc. ("AST") on July 13, 1993. In accordance with the terms of the definitive agreement between Tandy and AST, Tandy received $15,000,000 upon closing of the sale. The balance of the purchase price of $90,000,000 (as adjusted post-closing based on the results of an audit of the assets and liabilities conveyed) is payable by a promissory note. The promissory note is payable in three years and interest is accrued and paid annually. The interest rate on the promissory note is currently 3.75% per annum and is adjusted annually, not to exceed 5% per annum. The terms of the promissory note stipulate that the outstanding principal balance may be paid at maturity at AST's option in cash or the common stock of AST. However, at Tandy's option not more than 50% of the initial principal balance may be paid in common stock of AST. The promissory note is supported by a standby letter of credit in the amount of the lesser of $100,000,000 or 70% of the outstanding principal amount of the promissory note. At December 31, 1993, the standby letter of credit approximated $67,704,000. Accounts receivable relating to the computer operations, approximating $83,000,000 at June 30, 1993, inured to the benefit of Tandy upon collection. At December 31, 1993, the balance of the remaining accounts receivable, net of allowance for doubtful accounts, was $7,700,000. Tandy also retained certain inventory which it intends to liquidate before June 30, 1994. At December 31, 1993, this inventory amounted to approximately $3,700,000. In October 1993, the Company sold its computer marketing operations in France to AST, together with certain other multimedia assets and additional Swedish inventory, for an aggregate of approximately $6,700,000, which was evidenced by an increase in the amount of the promissory note described above to $96,700,000. The Company has discounted this note by $2,000,000 and the discount will be recognized as interest using the effective interest rate method over the life of the note. Memtek Products. On November 10, 1993, the Company executed a definitive agreement with Hanny Magnetics (B.V.I.) Limited, a British Virgin Islands corporation ("Hanny") to purchase certain assets of the Company's Memtek Products operations, including the license agreement with Memorex Telex, N.V. for the use of the Memorex trademark on licensed consumer electronics products. This sale closed on December 16, 1993. As of December 31, 1993, Tandy has received payments of $62,500,000, recorded a $7,102,000 receivable from Hanny for the remaining purchase price and retained approximately $61,000,000 in accounts receivable and certain other assets for liquidation. Hanny is a subsidiary of Hanny Magnetics (Holdings) Limited, a Bermuda corporation, listed on the Hong Kong Stock Exchange. At December 31, 1993, accounts receivable, net of related allowance for doubtful accounts, retained by Tandy approximated $40,100,000. O'Sullivan Industries. On November 23, 1993, the Company announced that it would sell the common stock of O'Sullivan Industries, Inc. ("O'Sullivan") in an initial public offering. On January 27, 1994 the Company announced that it had reached an agreement with the underwriters to sell O'Sullivan Industries Holdings, Inc., the parent company of O'Sullivan, common stock to the public at $22 per share. The net proceeds realized by Tandy in the initial public offering, together with the $40,000,000 cash dividend from O'Sullivan Industries, Inc., approximated $350,000,000. The initial public offering closed on February 2, 1994. Pursuant to a Tax Sharing and Tax Benefit Reimbursement Agreement between Tandy and O'Sullivan Industries Holdings, Inc. the Company will receive payments from O'Sullivan resulting from an increased tax basis of O'Sullivan's assets thereby increasing tax deductions and accordingly, reducing income taxes payable by O'Sullivan. The amount to be received by the Company each year will approximate the federal tax benefit expected to be realized with respect to the increased tax basis. These payments will be made over a 15-year time period. The Company will recognize these payments as additional sale proceeds and gain in the year in which the payments become due and payable to the Company. Lika. On January 24, 1994, the Company announced that it had signed a definitive agreement to sell its manufacturing facilities which make Lika printed circuit boards. This divestiture is expected to close by June 1994 and is expected to yield approximately $17,000,000 in proceeds, including cash, a note and the liquidation of certain retained assets. In connection with the computer manufacturing sale and the Memtek Products sale, the Company agreed to retain certain liabilities primarily relating to warranty obligations on products sold prior to the sale. Management believes that accrued reserves, as reflected on its December 31, 1993 balance sheet, are adequate to cover estimated future warranty obligations for the products and for any remaining costs to dispose of these operations. With the closing of the Lika transaction, the divestiture program announced in June 1993 will be complete. The proceeds from the divestitures are being used to reduce short-term debt and for the expansion of the Incredible Universe and Computer City store operations. See "Management's Discussion and Analysis of Results of Operations and Financial Condition" and Note 3 of the Notes to Consolidated Financial Statements for further information. SALE OF JOINT VENTURE INTEREST During the quarter ended September 30, 1993, the Company entered into definitive agreements with Nokia Corporation ("Nokia") to sell the Company's interests in two cellular telephone manufacturing joint ventures with Nokia, TMC Company Ltd. located in Masan, Korea, and TNC Company located in Fort Worth, Texas. Pursuant to the terms of the definitive agreements, the Company received an aggregate of approximately $31,700,000 for its interests in these joint ventures. The Company also entered into a three-year Preferred Supplier Agreement pursuant to which it has agreed to purchase from Nokia substantially all of Radio Shack's requirements for cellular telephones at prevailing competitive market prices at the time of the purchase. These operations were not part of the overall divestment plan adopted in June 1993 by the Company's Board of Directors; therefore, the gain from the sale and their results of operations are not included in discontinued operations. SEASONALITY As is the case with other retail businesses, the Company's net sales and other revenues are greater during the Christmas season than during other periods of the year. There is a corresponding pre-seasonal inventory build-up requiring working capital associated with this increased sales volume. For additional information, see Note 22 of the Notes to Consolidated Financial Statements. PATENTS AND TRADEMARKS Tandy owns or is licensed to use many trademarks related to its business in the United States and in foreign countries. Radio Shack, Computer City, Incredible Universe, McDuff Electronics, VideoConcepts, Realistic, Tandy and Optimus are some of the registered marks most widely used by the Company. Tandy believes that the Radio Shack, Computer City and Incredible Universe names and marks are well-recognized and associated with a high-quality service provider by consumers. The Company's products are sold primarily under the Radio Shack, Optimus, Tandy and Realistic trademarks which are registered in the U.S. and many foreign countries. The Company believes that the loss of the Radio Shack name or mark would be material to its business, but does not believe that the loss of any one trademark registration would be material. Tandy also owns, and is in the process of applying for, various patents relating to retail and support functions. SUPPLIERS The Company obtains merchandise from a large number of suppliers from various parts of the world. Alternative sources of supply exist for most merchandise purchased by the Company. As the Company's product line is diverse, the Company would not expect a lack of availability of any single product to have a material impact on its operations. BACKLOG ORDERS The Company has no material backlog of orders for the products it sells. COMPETITION The consumer electronics retail business is highly competitive. The Company competes in the sale of its products with department stores, mail order houses, discount stores, general merchants, home appliance stores and gift stores which sell comparable products manufactured by others. Competitors range in size from local drug and hardware stores to large chains and department stores. Computer store chains and franchise groups as well as independent computer stores and several major retailers compete with the Company in the retail personal computer marketplace. Consumer electronic and computer mail-order companies also compete with the Company. The products which compete with those sold by the Company are manufactured by numerous domestic and foreign manufacturers. Many of these products carry nationally recognized brand names or private labels and are sold in markets common to the Company. Some of the Company's competitors have financial resources equal to or greater than the Company's resources. Management believes that among the factors that are important to its competitive position are price, quality, service and the broad selection of electronic products and computers carried at conveniently located retail outlets. The Company's utilization of trained personnel and its ability to use national and local advertising media are important to the Company's ability to compete in the consumer electronics marketplace. Management of the Company believes it is a strong competitor in each of the factors referenced above. Given the highly competitive nature of the consumer electronics retail business, no assurance can be given that the Company will continue to compete successfully in all of the factors referenced above. However, the Company would be adversely affected if its competitors were to offer their products at significantly lower prices, introduce innovative or technologically superior products not yet available to the Company or if the Company were unable to obtain products in a timely manner for an extended period of time. The Company focuses on various types of store formats to address the marketplace. Each of the Company's retailing formats uses a distinct but complementary path to the marketplace, based on its unique customer appeal, marketing strengths and margin structure. Radio Shack. Radio Shack stores offer the shopping convenience of approximately 6,555 outlets, high-quality private label products, unique selection, knowledgeable personnel and excellent customer service. Radio Shack has strong sales in approximately 3,200 different items in such consumer-demand product categories as speakers, batteries, communications equipment, tape decks, antennas, electronic components and accessories. Computer City. Computer City stores offer approximately 5,000 different name-brand items, competitive prices and excellent customer service on computers, computer software and accessories. Tandy Name Brand Retail Group. This group sells name brand consumer electronics and appliances in three distinctly different types of store formats. VideoConcepts and McDuff Electronics mall stores average approximately 3,100 square feet in size. McDuff SuperCenters average approximately 12,200 square feet and are located in many secondary markets. The Edge in Electronics stores average approximately 1,100 square feet in size, carry approximately 1,000 different name brand personal and portable consumer electronics products and are located in major markets. Incredible Universe. A new concept in the retailing of name brand consumer electronics are 160,000 to 200,000 square foot stores which provide the customer with a "universe" of choices. These stores carry over 85,000 different stock-keeping units. The Company has faced intense competition in its consumer electronics retailing businesses. Competition is driven by technology and product cycles, as well as the economy. In the consumer electronics retailing business, competitive factors include price, product quality, manufacturing and distribution capability and brand reputation. The Company believes that its retailing formats compete effectively in their respective marketplaces. RESEARCH AND DEVELOPMENT Research and development expenditures are not significant. EMPLOYEES As of December 31, 1993, the Company had approximately 42,000 employees, excluding 2,000 full time employees associated with discontinued operations at O'Sullivan and Lika. The number also excludes temporary retail employees remaining from the Christmas selling season. Management of the Company considers the relationship between the Company and its employees to be good. It does not anticipate any work stoppage due to labor difficulties. ITEM 2. ITEM 2. PROPERTIES. Information on the Company's properties is in "Management's Discussion and Analysis of Results of Operations and Financial Condition" and the financial statements included in this Form 10-K and is incorporated herein by reference. The following items are discussed further on the following pages: Page Retail Outlets . . . . . . . . . 16 Property, Plant and Equipment. . 43 Leases . . . . . . . . . . . . . 47 The Company leases rather than owns most of its retail facilities. However, the land and buildings of most of the Incredible Universe stores are owned rather than leased. The Radio Shack, Tandy Name Brand Retail Group and Computer City stores are located primarily in major shopping malls, stand-alone buildings or shopping centers owned by other companies. The Company owns most of the property on which its executive offices are located in Fort Worth, Texas as well as five distribution facilities and most of its manufacturing facilities and land located throughout the United States. Existing warehouse and office facilities are deemed adequate to meet the Company's needs in the foreseeable future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In July 1985, Pan American Electronics, Inc., a Radio Shack dealer in Mission, Texas ("Pan Am"), filed suit against the Company in the 92nd Judicial District Court in Hidalgo County, Texas. The Plaintiff's complaint alleged breach of contract and fraud based upon the allegations that the Company made certain misrepresentations and acted beyond the scope of its authority under the dealer agreement, with the alleged result that the plaintiff was forced out of the computer mail order business in 1984. In November 1993, Pan Am and Tandy resolved the pending litigation and the lawsuit was dismissed in December 1993. Although the terms of the settlement are confidential, the resolution of this legal action did not have a materially adverse impact on the Company's financial position or results of operation. There are various other claims, lawsuits, disputes with third parties, investigations and pending actions involving allegations of negligence, product defects, discrimination, patent infringement, tax deficiencies and breach of contract against the Company and its subsidiaries incident to the operation of its business. The liability, if any, associated with these matters was not determinable at December 31, 1993. While certain of these matters involve substantial amounts, and although occasional adverse settlements or resolutions may occur and negatively impact earnings in the year of settlement, it is the opinion of management that their ultimate resolution will not have a materially adverse effect on Tandy's financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. At the Annual Meeting of Stockholders held October 15, 1993, the Company elected directors to serve for the ensuing year and voted to adopt the Tandy Corporation 1993 Incentive Stock Plan. Out of the 80,915,627 eligible votes, 63,361,775 votes were cast at the meeting either by proxies solicited in accordance with Schedule 14A or by security holders voting in person. There were 9,890,351 broker non-votes which are not included in the following table as they were not treated as being present at the meeting. In the case of directors, abstentions are treated as votes withheld and are included in the table. No other matters were voted on at the meeting. The tabulation of votes for each nominee is set forth below under Item No. 1 and the vote on the Tandy Corporation 1993 Incentive Stock Plan is set forth under Item No. 2 below: Nominees for Directors ______________________ Item No. 1 __________ VOTES VOTES DIRECTORS FOR WITHHELD _________ _____ ________ James I. Cash, Jr. 62,626,072 735,703 Caroline R. Hunt 62,588,534 773,241 Lewis F. Kornfeld, Jr. 62,507,688 854,087 Jack L. Messman 62,848,102 513,673 William G. Morton, Jr. 62,606,784 754,991 Thomas G. Plaskett 62,216,712 1,145,063 John V. Roach 62,391,582 970,193 William T. Smith 62,598,399 763,376 Alfred J. Stein 62,569,000 792,775 William E. Tucker 62,627,905 733,870 Jesse L. Upchurch 62,792,385 569,390 John A. Wilson 62,679,493 682,282 1993 Incentive Stock Plan _________________________ Item No. 2 __________ FOR AGAINST ABSTAIN ___ _______ _______ 52,196,098 10,338,869 826,808 EXECUTIVE OFFICERS OF THE REGISTRANT (SEE ITEM 10 OF PART III). The following is a list of Tandy Corporation's executive officers, their ages, positions and length of service with the Company as of March 30, 1994 Position (Date Elected Years with Name to Current Position) Age Company ____ ____________________ ___ __________ John V. Roach Chairman of the Board, 55 26 Chief Executive Officer and President (July 1982) William C. Bousquette Executive Vice President 57 3 (1) and Chief Financial Officer (January 1994) Herschel C. Winn Senior Vice President and 62 25 Secretary (November 1979) Robert M. McClure Senior Vice President 58 21 (2) (January 1994) Lou Ann Blaylock Vice President - 55 23 (3) Corporate Relations (January 1993) Dwain H. Hughes Vice President and 46 14 (4) Treasurer (June 1991) Ronald L. Parrish Vice President - 51 7 Corporate Development (April 1987) Richard L. Ramsey Vice President and 48 27 Controller (January 1986) Frederick W. Padden Vice President - Law 61 3 (5) and Assistant Secretary (January 1994) Leonard H. Roberts President of Radio Shack 45 (6) (July 1993) David M. Thirion Vice President - 46 17 (7) Retail Services (January 1993-August 1993) James B. Sheets Vice President - Legal 42 17 (8) (January 1993-December 1993) and Assistant Secretary (November 1986-December 1993) Bernie S. Appel Senior Vice President, 61 33 (9) Tandy Corporation and Chairman, Radio Shack Division (January 1992- March 1993) There are no family relationships among the executive officers listed and there are no arrangements or understandings pursuant to which any of them were appointed as executive officers. All executive officers of Tandy Corporation are elected by the Board of Directors annually to serve for the ensuing year, or until their successors are elected. All of the executive officers listed above have served the Company in various capacities over the past five years, except for Mr. Bousquette, Mr. Padden and Mr. Roberts. (1) Mr. Bousquette previously served as Executive Vice President and Chief Financial Officer of the Company from November 1990 until January 1993 when he was elected as Chief Executive Officer of TE Electronics Inc. Prior to joining Tandy, he served as Executive Vice President and Chief Financial Officer of Emerson Electric Company from March 1984 until November 1990. (2) Mr. McClure served as President of the Tandy Electronics Division from August 1987 until January 1993 when he was elected as Chief Operating Officer and President of TE Electronics Inc. (3) Mrs. Blaylock was Director of Corporate Relations from January 1986 until she was elected Vice President - Corporate Relations in January 1993. (4) Mr. Hughes was elected Vice President and Treasurer of the Company in June 1991. From June 1989 until June 1991, Mr. Hughes was Assistant Treasurer of the Company; and, from 1984 until June 1989, he was Director of the Company's Internal Audit Department. (5) Mr. Padden has been Vice President, General Counsel and Secretary of TE Electronics Inc. since January 1993. From January 1991 to January 1993 he was the Deputy General Counsel - Intellectual Property for Tandy Corporation. Prior to joining Tandy he was a General Attorney at AT&T-Bell Laboratories from 1984 to January 1991. (6) Mr. Roberts became President of the Radio Shack Division on July 7, 1993. Prior to joining Tandy he served as the Chairman and Chief Executive Officer of Shoney's Inc. from 1990 to 1993 and as President and Chief Executive Officer of Arby's, Inc. from 1985 to 1990. (7) Mr. Thirion resigned as the Vice President - Retail Services in August 1993 to become the Senior Vice President and General Manager of the Tandy Name Brand Retail Group Division. Mr. Thirion was Vice President of the Radio Shack Division from January 1989 until January 1993. (8) Mr. Sheets served as Assistant Secretary of the Company, a position he was elected to in November 1986. Mr. Sheets also served as Deputy General Counsel - Corporate from November 1986 until he was elected Vice President - Legal in January 1993. Mr. Sheets resigned effective December 31, 1993. (9) Mr. Appel was President of the Radio Shack Division from June 1984 until January 1992. In January 1992 Mr Appel was appointed as the Senior Vice President of Tandy Corporation and Chairman of the Radio Shack division. Mr. Appel resigned as an executive officer of the Company on March 1, 1993 and retired as an employee of Tandy on June 30, 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. MARKET FOR COMMON STOCK The Company's common stock is listed on the New York Stock Exchange and trades under the symbol "TAN". The following table presents the high and low sale prices for the Company's common stock for each quarter of the two and one-half years ended December 31, 1993. Dividends Quarter Ended: High Low Close Declared ____ ___ _____ _________ December 31, 1993 $50 3/4 $35 3/8 $49 1/2 $.15 September 30,1993 37 3/8 28 1/8 36 7/8 .15 June 30, 1993 32 3/8 28 3/8 30 .15 March 31, 1993 32 1/8 24 5/8 29 5/8 .15 December 31, 1992 31 3/4 24 5/8 29 3/4 .15 September 30,1992 27 3/4 22 1/4 27 1/8 .15 June 30, 1992 29 5/8 23 7/8 24 1/2 .15 March 31, 1992 31 1/4 23 7/8 29 3/4 .15 December 31, 1991 30 1/8 24 3/8 28 7/8 .15 September 30, 1991 28 3/4 23 3/8 28 3/8 .15 HOLDERS OF RECORD At March 22, 1994 there were 35,227 holders of record of the Company's common stock. DIVIDENDS The Board of Directors periodically reviews the Company's dividend policy. The quarterly dividend rate is currently $.15. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SELECTED SUPPLEMENTAL FINANCIAL DATA (UNAUDITED) TANDY CORPORATION AND SUBSIDIARIES (1) The Company changed its fiscal year end from a June 30 to a December 31 year end effective with the six month transition period ended December 31, 1992. (2) See Note 2 of the Notes to Consolidated Financial Statements for a discussion of the change in accounting principles. (3) Income (loss) per share amounts and average common and common equivalent share amounts for the six months ending December 31, 1992 and fiscal 1992 have been retroactively restated to reflect the assumption that the Series C PERCS would convert into 12,457,100 common shares in lieu of the previously used conversion amount of 15,000,000 common shares based upon the Company's December 31, 1993 closing price of its common stock of $49.50 per share. See Note 2 of the Notes to Consolidated Financial Statements. (4) Computed using income from continuing operations. (5) Includes investment in discontinued operations. (6) At December 31, 1993, December 31, 1992 and June 30, 1992, computed assuming the Series C PERCS will convertinto 12,457,100 shares of common stock. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION. Tandy Corporation ("Tandy" or the "Company") changed its fiscal year end from June 30 to December 31 effective December 31, 1992. The following Management's Discussion and Analysis of Results of Operations and Financial Condition compares the full calendar year ended December 31, 1993 with the full fiscal years ended June 30, 1992 and 1991. Although these twelve-month periods end at different times, management believes that the seasonality of the retail business relating to Christmas is so significant that it would distort trends and related percentage comparisons to sales for the readers if a full year's results were compared to the six-month transition period ended December 31, 1992. NET SALES AND OPERATING REVENUES For the year ending December 31, 1993, overall sales grew 12% to $4,102,551,000 as compared to $3,649,284,000 for the fiscal year ending June 30, 1992. This increase was primarily due to the opening of three Incredible Universe stores and the expansion of the Computer City chain. On a comparable store basis, Radio Shack's sales increased slightly during the year ended December 31, 1993 as compared to the fiscal year ended June 30, 1992. A moderate increase in sales of Radio Shack's core business (i.e., consumer electronics and accessories) was offset by a decline in sales of personal computers through the Radio Shack division. The decrease in Radio Shack's computer business reflects the impact of sharply lower pricing in response to competitive pressures in the marketplace. The changing dynamics of the personal computer business has had a significant impact on Radio Shack's performance during fiscal years 1993, 1992 and 1991. A combination of shifts in retail distribution to super stores and telemarketing combined with rapidly declining prices has taken the computer category from approximately 17.0% of Radio Shack's sales with a gross profit of 29.0% in the year ended June 30, 1992 to approximately 14.2% of sales and a gross profit of 15.2% for the year ended December 31, 1993. Radio Shack's extensive assortment of electronic parts, accessories and specialty items differentiates it from other consumer electronics retailers in the marketplace. The table below shows the breakdown by major category of Radio Shack sales. The decline in Radio Shack's computer sales has been offset by sales of the Computer City chain. The Computer City chain opened its 40th supercenter in December 1993, approximately two years after its initial launching of eight stores. Computer City's sales increases were the result of 25 additional stores since June 30, 1992 and comparable store sales gains at old stores in excess of 30% for the year ended December 31, 1993. The Name Brand Retail Group experienced a sales decrease in calendar 1993 as compared to the June 1992 fiscal year. This decrease was primarily a result of the closing of 110 McDuff and VideoConcepts stores in February 1993. This decline was offset in part by the addition of three Incredible Universe stores. The first two Incredible Universe stores were opened in the fall of 1992 with the third having been added in the fall of 1993. Shipments to InterTAN Inc. decreased for calendar year 1993 as compared to the fiscal year ended June 30, 1992. See the discussion in the "InterTAN Update" found on page 23. For the six-month period ending December 31, 1992, net sales and operating revenues increased 6.4% to $2,161,149,000. This increase was primarily due to the opening of two Incredible Universe stores and expansion of the Computer City chain. Comparable store sales were essentially even with the six-month period ended December 31, 1991. The change in the Company's sales in the fiscal years ended June 30, 1992 and 1991 reflected a continued adverse product cycle in consumer electronics, a weak economy and widespread price cutting in the personal computer market. Sales through all retail stores increased 3.2% in the fiscal year ended June 30, 1992 as compared with fiscal 1991. The increase in sales in the fiscal year ended June 30, 1992 was primarily due to new store expansions. During fiscal 1992, 15 Computer City stores, 34 McDuff and VideoConcepts stores and seven of The Edge in Electronics stores were opened. On a company-wide basis, comparable store sales declined 1% in fiscal 1992 following a similar decline in the prior year. Comparable store sales increased slightly at Radio Shack in fiscal 1992 due to the continued strengthening of its electronics parts, accessories and specialty items business. This increase more than offset a decline in Radio Shack's computer business which was impacted significantly by extensive price cutting in the marketplace. Comparable store sales of the McDuff and VideoConcepts stores were down 10% in fiscal 1992 as compared to fiscal 1991, reflecting intense competitive pressures in name brand electronics retailing. To address the pricing and distribution shifts in computer retailing, the Computer City chain of super stores was launched in October 1991 (fiscal year ended June 30, 1992). The Computer City format is designed to sell high volumes of well known name brand personal computers and related products at discount prices. Though in operation for only the last seven months of fiscal 1992, Computer City's sales more than offset the decline in the Company's U.S. computer sales through Radio Shack and direct sales. As of June 30, 1992, 15 Computer City stores were in operation, 13 in the U.S. and two in Europe. GROSS PROFIT Gross profit as a percent of sales and operating revenues for the year ended December 31, 1993 was 41.9% as compared to 43.5% for the six months ended December 31, 1992, 47.2% for the fiscal year ended June 30, 1992 and 48.7% for the fiscal year ended June 30, 1991. The decline, in part, reflects the faster growth of new high-volume formats such as Computer City and Incredible Universe with inherently lower gross margins than Radio Shack stores. The Company expects this trend to continue as sales at Incredible Universe and Computer City increase. Combined Computer City and Incredible Universe sales contributed 18.6%, 8.9% and 2.6% to consolidated sales in the fiscal year ended December 31, 1993, the six months ended December 31, 1992 and the fiscal year ended June 30, 1992, respectively. The 5.3% decline in gross profit percent from fiscal 1992 reflects the growth of the newer retail businesses. Management expects the long-term impact of accelerated growth for its new businesses to result in a lower consolidated gross margin as a percent of sales and operating revenues. In addition to the increasing effect of the lower gross margin businesses, Radio Shack's gross margin has trended down during the fiscal years ended December 31, 1993 and June 30, 1992 and 1991 because of a decline in computer margins resulting from more competitive pricing. In the absence of any additional major decreases in computer retail prices in the industry, management believes this decline in Radio Shack's gross margin will diminish during 1994. Partially offsetting the decline were increased sales of high-margin electronic parts, accessories and specialty items sold through Radio Shack. In management's opinion, new concepts which could increase Radio Shack gross margins include introducing the Radio Shack Gift Express program, creating new store formats and the launching of The Repair Shop at Radio Shack, a name brand out-of-warranty repair program. Competitive pressures in name brand electronics retailing decreased McDuff's and VideoConcepts' gross margins in each of the three fiscal years ended December 31, 1993 and June 30, 1992 and 1991. Additionally, gross margins were impacted in the McDuff and VideoConcepts units by the increasing percentage of sales related to the lower margin computer category. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses ("SG&A") as a percent of sales and operating revenues for the year ended December 31, 1993 declined from the year ended June 30, 1992 and declined for the six months ended December 31, 1992 from the six months ended December 31, 1991. The accompanying table summarizes the breakdown of various components of SG&A and their related percentage of sales and operating revenues. The lower SG&A percent reflects the lower costs, relative to net sales and operating revenues associated with the Company's newer retail formats, as well as the lower operating costs achieved through cost reduction programs and the further streamlining of operations in the new retail formats. SG&A expenses as a percent of sales and operating revenues declined in the fiscal year ended June 30, 1992 as compared with fiscal 1991. The benefits of actions taken to streamline operations and reduce costs are reflected in most expense categories in fiscal 1992. Year-to-year comparisons are impacted by the $18,987,000 gain which includes a foreign currency gain of $6,894,000 in fiscal year 1992 from the sale of a Japanese subsidiary, the assets of which were primarily real estate, and the remaining foreign currency gain of $3,748,000 recognized in 1992 as opposed to a foreign currency gain of only $762,000 in 1993. The Company's exposure to foreign currency fluctuations has decreased significantly with the disposal of the Company's computer manufacturing and marketing operations as well as the disposal of Memtek Products. Both of these operations had significant European operations. Advertising costs have decreased in dollars and as a percent of sales and operating revenues in the fiscal year ended December 31, 1993 as compared to the fiscal years ended June 30, 1992 and 1991. Management has focused its efforts on more efficient advertising methods in Radio Shack utilizing the Company's data base of customer activity to reduce costs while maintaining market awareness. Rent expense has declined slightly in dollars and more significantly as a percent of sales during the year ended December 31, 1993 as compared to fiscal 1992. This percentage decrease results primarily from the fact that the Company owns most of the Incredible Universe locations and is additionally impacted by Computer City's low rent to sales ratio. The Company's credit operations have been successful in supporting sales of the retail operations. Private label credit cards represented 34% of credit sales for the year ended December 31, 1993, 36% for the six months ended December 31, 1992, 43% in fiscal 1992 and 44% in fiscal 1991. This decline in the percentage results from increased sales through the Computer City and Incredible Universe stores which have a lower percentage of private label card usage. A decrease in bad debt expense relates to tighter credit controls and a 4% decline from fiscal 1992 in overall private label credit card sales. Expenses associated with the credit card operations which are included in SG&A expense have decreased. PROVISION FOR BUSINESS RESTRUCTURING The Company adopted a plan resulting in business restructuring charges during the six months ended December 31, 1992 designed to improve the Company's competitiveness and future profitability. The pre-tax charge of $48,000,000 related primarily to the closing of approximately 110 of the 432 Tandy Name Brand Retail Group stores, mainly McDuff Supercenters in major market areas and, to a lesser extent, the elimination of certain product lines. Some product lines were reduced or eliminated after consideration of competitive factors and market trends. In the fourth quarter of fiscal year 1991, the Company recorded a business restructuring charge of $8,531,000. The charge covered anticipated costs associated with Radio Shack computer centers which were being closed, relocated or converted to other store formats or sales offices. These costs included the estimated lease obligations for store closings and relocations as well as estimated fixed asset write-offs for all affected stores. DEPRECIATION AND AMORTIZATION Depreciation and amortization expense as a percentage of sales and operating revenues decreased slightly in the year ended December 31, 1993 as compared with the year ended June 30, 1992. The dollar amount of depreciation and amortization expense for the year ended December 31, 1993 increased 7% over the dollar amount for the year ended June 30, 1992, due to additional capital expenditures related to the three Incredible Universe stores and the addition of 25 new Computer City stores. The dollar amount of depreciation and amortization expense for the year ended June 30, 1992 increased 5% over the prior fiscal year due to increased capital expenditures related to the new Tandy Name Brand Retail Group and Computer City super stores and the remodeling of Radio Shack stores. Net interest income of $25,831,000 for the year ended December 31, 1993 and $24,245,000 for the fiscal year ended June 30, 1992 was attributable primarily to interest income earned by the credit operations. The decrease in interest income of the credit company in the year ended December 31, 1993 as compared to the fiscal year ended June 30, 1992 resulted from a decrease in the average credit card receivables outstanding during the period. This decline results from increased payments from credit customers reflecting the overall improvement in the economy and a desire by consumers to shift debt to lower interest rate instruments. The increase in interest income of the credit company in the six months ended December 31, 1992 as compared to December 31, 1991 resulted from growth of consumer credit card receivables. The decrease in interest income of the credit company in the fiscal year ended June 30, 1992 as compared with fiscal year 1991 resulted from the securitization of private label receivables in June 1991. Interest income, exclusive of Tandy Credit Corporation's income, represented primarily interest on short-term investments. The increase in interest income for the year ended December 31, 1993 compared to the fiscal year ended June 30, 1992 was due to the increase in short-term investments as proceeds from the divestiture of discontinued operations were received and to the recognition of interest income on the AST and InterTAN notes receivable. Interest income as it relates to InterTAN notes receivable will increase in fiscal 1994 as the Company will commence recording the accretion of discount relating thereto. See further discussion on notes receivable in the "InterTAN Update". The decrease in interest expense for the year ended December 31, 1993 as compared to the year ended June 30, 1992 is due to the decrease of total debt and lower U.S. interest rates. Overall interest expense should decline in fiscal 1994 as the Company receives cash proceeds from the disposal of its discontinued operations and applies a significant portion of such proceeds against short-term debt and toward the retirement of its 10% subordinated debentures. Partially offsetting the decline in expected interest expense in 1994 will be higher interest rates resulting from the Federal Reserve Bank's move to keep inflation low in the overall U.S. economy. The decrease in interest expense in the fiscal year ended June 30, 1992 reflected the reduced debt attributable to the securitization of private label credit card receivables and lower interest rates. PROVISION FOR INCOME TAXES The effective tax rate for the year ended December 31, 1993 was 37.1%. The higher effective tax rate for the year ended December 31, 1993 as compared to 36.2% for the year ended June 30, 1992 and 36.0% for the year ended June 30, 1991 reflects the impact of the increase of the federal tax rate to 35% from 34%. The effective tax rate for the six-month period ended December 31, 1992 was 34.2%. This lower effective rate reflects the successful resolution of certain IRS examinations during the period. The requirements of Financial Accounting Standard No. 109, "Accounting for Income Taxes", which the Company adopted January 1, 1993, are discussed in Note 12 of the Notes to Consolidated Financial Statements. DISCONTINUED OPERATIONS On June 25, 1993, the Board of Directors of Tandy adopted a formal plan of divestiture under which it would sell its computer manufacturing and marketing businesses, the O'Sullivan Industries, Inc. ready-to-assemble furniture manufacturing and related marketing business, the Memtek Products division and the Lika printed circuit board business. The divestiture plan replaced the Company's plan to spin off all of the Company's manufacturing and marketing businesses as described in Tandy's Transition Report on Form 10-K/A-4 for the six-month period ended December 31, 1992. In connection with the plan of divestiture the Company accounted for the divestiture of these businesses as discontinued operations and recognized an after-tax charge of $70,000,000 in its quarter ended June 30, 1993. This charge was subsequently reduced by approximately $15,822,000 in the quarter ended December 31, 1993. The reduction of the reserve previously taken resulted from the better than anticipated sales price received for O'Sullivan Industries Holdings, Inc. partially offset by additional foreign currency translation losses and below plan operating results of the divested companies during the divestment period, net of related income tax adjustments. Prior year results of operations have been reclassified to reflect the discontinued operations treatment. Computer Manufacturing. In furtherance of the divestiture plan, the Company closed the sale of the computer manufacturing and marketing businesses to AST Research, Inc. ("AST") on July 13, 1993. In accordance with the terms of the definitive agreement between Tandy and AST, Tandy received $15,000,000 upon closing of the sale. The balance of the purchase price of $90,000,000 (as adjusted post-closing based on the results of an audit of the assets and liabilities conveyed) is payable by a promissory note. The promissory note is payable in three years and interest is accrued and paid annually. The interest rate on the promissory note is currently 3.75% per annum and is adjusted annually, not to exceed 5% per annum. The terms of the promissory note stipulate that the outstanding principal balance may be paid at maturity at AST's option in cash or the common stock of AST. However, at Tandy's option not more than 50% of the initial principal balance may be paid in common stock of AST. The promissory note is supported by a standby letter of credit in the amount of the lesser of $100,000,000 or 70% of the outstanding principal amount of the promissory note. At December 31, 1993, the standby letter of credit approximated $67,704,000. Accounts receivable relating to the computer operations, approximating $83,000,000 at June 30, 1993, inured to the benefit of Tandy upon collection. At December 31, 1993, the balance of the remaining accounts receivable, net of allowance for doubtful accounts, was $7,700,000. Tandy also retained certain inventory which it intends to liquidate before June 30, 1994. At December 31, 1993, this inventory amounted to approximately $3,700,000. In October 1993, the Company sold its computer marketing operations in France to AST, together with certain other multimedia assets and additional Swedish inventory, for an aggregate of approximately $6,700,000, which was evidenced by an increase in the amount of the promissory note described above to $96,700,000. The Company has discounted this note by $2,000,000 and the discount will be recognized as income using the effective interest rate method over the life of the note. Memtek Products. On November 10, 1993, the Company executed a definitive agreement with Hanny Magnetics (B.V.I.) Limited, a British Virgin Islands corporation ("Hanny") to purchase certain assets of the Company's Memtek Products operations, including the license agreement with Memorex Telex, N.V. for the use of the Memorex trademark on licensed consumer electronics products. This sale closed on December 16, 1993. As of December 31, 1993, Tandy has received payments of $62,500,000, recorded a $7,102,000 receivable from Hanny for the remaining purchase price and retained approximately $61,000,000 in accounts receivable and certain other assets for liquidation. Hanny is a subsidiary of Hanny Magnetics (Holdings) Limited, a Bermuda corporation, listed on the Hong Kong Stock Exchange. At December 31, 1993, accounts receivable, net of related allowance for doubtful accounts, retained by Tandy approximated $40,100,000. O'Sullivan Industries. On November 23, 1993, the Company announced that it would sell the common stock of O'Sullivan Industries, Inc. ("O'Sullivan") in an initial public offering. On January 27, 1994 the Company announced that it had reached an agreement with the underwriters to sell O'Sullivan Industries Holdings, Inc., the parent company of O'Sullivan, common stock to the public at $22 per share. The net proceeds realized by Tandy in the initial public offering, together with the $40,000,000 cash dividend from O'Sullivan, approximated $350,000,000. The initial public offering closed on February 2, 1994. Pursuant to a Tax Sharing and Tax Benefit Reimbursement Agreement between Tandy and O'Sullivan Industries Holdings, Inc., the Company will receive payments from O'Sullivan resulting from an increased tax basis of O'Sullivan's assets thereby increasing tax deductions and accordingly, reducing income taxes payable by O'Sullivan. The amount to be received by the Company each year will approximate the federal tax benefit expected to be realized with respect to the increased tax basis. These payments will be made over a 15-year time period. The Company will recognize these payments as additional sale proceeds and gain in the year in which the payments become due and payable to the Company. Lika. On January 24, 1994, the Company announced that it had signed a definitive agreement to sell its manufacturing facilities which make Lika printed circuit boards. This divestiture is expected to close by June 1994 and is expected to yield approximately $17,000,000 in proceeds, including cash, a note and the liquidation of certain retained assets. In connection with the computer manufacturing sale and the Memtek Products sale, the Company agreed to retain certain liabilities primarily relating to warranty obligations on products sold prior to the sale. Management believes that accrued reserves, as reflected on its December 31, 1993 balance sheet, are adequate to cover estimated future warranty obligations for the products and for any remaining costs to dispose of these operations. With the closing of the Lika transaction, the divestiture program announced in June 1993 will be complete. Proceeds from the formal divestiture plan should total approximately $715,000,000 including net income tax benefits of $16,600,000 and notes receivable of approximately $100,000,000 that mature by the end of 1996. The proceeds from the divestitures are being used to reduce short-term debt and for the expansion of the Incredible Universe and Computer City store operations. Tandy's cash flow and liquidity, in management's opinion, remains strong. During the year ended December 31, 1993, cash provided by operations was $322,294,000 as compared to $146,782,000 for the fiscal year ended June 30, 1992. The increased cash flow from operations in calendar 1993 compared to fiscal year ended June 30, 1992 was due partially to receivables which provided $30,133,000 in cash in 1993 but used $121,719,000 in 1992. The decline in accounts receivable in 1993 versus 1992 is due to the liquidation of receivables related to the divested operations and lower consumer receivables related to the Company's private label credit card portfolio. The latter reason reflects consumers' desires to liquidate debt with higher interest rates and the overall improved economy. Inventory required less cash in calendar 1993 than in fiscal 1992. The increase in inventory during 1993 related to new store openings and the expansion of Radio Shack's core product lines. Investing activities involved capital expenditures, net of retirements, primarily for retail expansion of $129,287,000 for the year ended December 31, 1993 compared to $127,495,000 for the fiscal year ended June 30, 1992. Proceeds received from the sale of divested operations totaled $111,988,000 during the year ended December 31, 1993. Investing activities in 1993 also included $31,663,000 for the purchase of InterTAN's bank debt and the extension/funding of a working capital line of credit. See "InterTAN Update" for further information. Short-term debt of $46,885,000 and long-term debt of $62,195,000 were retired during 1993. Future store expansions and refurbishments and other capital expenditures are expected to approximate $150,000,000 to $180,000,000 per year over the next two years and will be funded primarily from available cash, proceeds from divestiture of discontinued operations, cash flow from operations and proceeds from possible sale/leaseback arrangements of Incredible Universe stores. Operating cash flow in the fiscal year ended June 30, 1992 was $146,782,000 compared to $617,353,000 for the fiscal year ended June 30, 1991. This decreased cash flow was partially due to the $89,441,000 increase in inventories for the Tandy Name Brand Retail Group and Computer City store expansions in fiscal 1992 compared to a $151,339,000 decrease in inventories in 1991. Operating cash flow was also higher in 1991 due to the cash proceeds from the securitization of $350,000,000 of credit card receivables. The Company's investing activities were generally for capital expenditures in fiscal 1992 which totaled $127,495,000. The capital expenditures were used principally for Radio Shack's store remodeling program, expansion of the Computer City store chain and initial construction of two Incredible Universe stores. Financing activities in the fiscal year ended June 30, 1992 included the sale of Depositary Shares of PERCS for $430,000,000 and the subsequent purchase of common stock with the proceeds of this preferred stock issue. Long-term and short-term debt of $20,098,000 was retired in the year ended June 30, 1992 compared to fiscal 1991 retirements of $441,577,000. Following are the current credit ratings for Tandy Corporation: Standard Category Moody's and Poor's ________ _______ __________ Senior Unsecured Baa2 A- Subordinated Baa3 BBB Medium Term Notes Baa2 A- Preferred Stock Baa3 BBB ESOP Senior Notes Baa2 A- Commercial Paper P-2 A-2 The above ratings are investment grade ratings. Management does not believe that a downgrade in 1993 by Moody's has had or will have a materially adverse effect on the Company's ability to borrow funds although the borrowings may be slightly more costly. CAPITAL STRUCTURE AND FINANCIAL CONDITION The Company's balance sheet and financial condition continue to be strong. The Company's available borrowing facilities as of December 31, 1993 are detailed in Note 9 of the Notes to Consolidated Financial Statements and are incorporated herein by reference. Proceeds from the sale of divested operations totaled $111,988,000 through December 31, 1993. The net assets associated with discontinued operations remaining to be divested were $405,664,000 at December 31, 1993 and related primarily to O'Sullivan which was disposed of in February 1994 and Lika whose sale is pending. Other information related to discontinued operations are discussed in "Discontinued Operations". In the fiscal year ended June 30, 1992, the Company issued 150,000 PERCS shares and used the proceeds of this offering to purchase $430,000,000 of the Company's common stock for treasury. Each PERCS share has an annual dividend rate of $214.00 and is automatically convertible on April 15, 1995 into 100 shares of common stock, par value $1 per share, subject to possible adjustment based upon the market value of the common stock on the conversion date or the occurrence of certain other events. Based upon the market price of the Company's common stock at December 31, 1993, each PERCS share would have converted into 83 shares. At any time prior to April 15, 1995, the Company may call the PERCS. The PERCS are discussed further in Note 18 of the Notes to Consolidated Financial Statements. The Company's issue of 10% subordinated debentures due June 30, 1994 was called by the Company on February 23, 1994 for redemption on April 1, 1994. The redemption will be at the price of 100% of face value or approximately $32,000,000. In fiscal 1991, the Company filed a shelf registration for $500,000,000, of which $400,000,000 was designated for medium-term notes, and Tandy Credit Corporation increased its medium-term note program by $200,000,000. During fiscal 1991, short-term debt was refinanced by the issuance of $155,500,000 in medium-term notes. In the fourth quarter of fiscal 1991, Tandy Credit Corporation completed an asset securitization to increase financial flexibility. Credit card receivables were sold to the Tandy Master Trust which issued $350,000,000 of participating 8.25% Class A Asset Backed Certificates, Series A. Proceeds were primarily used to retire short-term debt. Tandy established an employee stock ownership plan ("TESOP") in 1990. This plan issued $100,000,000 of debt in July 1990 to purchase preferred stock from the Company for funding of the plan. The Company has guaranteed the repayment of the TESOP notes and, as a result, the indebtedness of the TESOP has been recognized as a long-term obligation on the Company's consolidated balance sheet. Dividend payments and contributions by the Company will be used to repay the indebtedness. The debt-to-capitalization ratio was 22.8%, 27.3%, 23.4% and 24.8% at December 31, 1993, December 31, 1992, June 30, 1992 and June 30, 1991, respectively. This debt-to-capitalization ratio should improve further in fiscal 1994 due to the cash proceeds from divestitures being used to retire debt. The Company's available borrowing facilities as of December 31, 1993 are detailed in Note 9 of the Notes to Consolidated Financial Statements. Management believes that the Company's present borrowing capacity is greater than the established credit lines and long-term debt in place. Management believes that the Company's cash flow from operations, cash and short-term investments, expected proceeds from divestitures and its available borrowing facilities are more than adequate to fund planned store expansion, growth in the Company's private label credit accounts, retirement of the 10% subordinated debentures and to meet debt service and preferred dividend requirements. Inflation has not significantly impacted the Company over the past three years. Management does not expect inflation to have a significant impact on operations in the foreseeable future unless global situations substantially affect the world economy. The American Institute of Certified Public Accountants issued Statement of Position 93-7, "Reporting on Advertising Costs" in December 1993. The statement generally requires all advertising costs to be expensed in the period in which the costs are incurred or the first time the advertising takes place and is effective for years beginning after June 15, 1994. The statement is not anticipated to have any material effect on the results of operation or financial condition of the Company. SALE OF JOINT VENTURE INTEREST During the quarter ended September 30, 1993, the Company entered into definitive agreements with Nokia Corporation ("Nokia") to sell the Company's interests in two cellular telephone manufacturing joint ventures with Nokia, TMC Company Ltd. located in Masan, Korea, and TNC Company located in Fort Worth, Texas. Pursuant to the terms of the definitive agreements, the Company received an aggregate of approximately $31,700,000 for its interests in these joint ventures. The Company also entered into a three-year Preferred Supplier Agreement pursuant to which it has agreed to purchase from Nokia substantially all of Radio Shack's requirements for cellular telephones at prevailing competitive market prices at the time of the purchase. These operations were not part of the overall divestment plan adopted in June 1993 by the Company's Board of Directors; therefore, the gain on the sale and their results of operations are not included in discontinued operations. INTERTAN UPDATE InterTAN Inc. ("InterTAN"), the former foreign retail operations of Tandy, was spun off to Tandy stockholders as a tax-free dividend in fiscal 1987. Under the merchandise purchase terms of the original distribution agreement, InterTAN could purchase on payment terms from Tandy, at negotiated prices, new and replacement models of products that Tandy had in its Radio Shack U.S. catalog or which Tandy may reasonably secure. A&A International ("A&A"), a subsidiary of Tandy, was the exclusive purchasing agent for products originating in the Far East for InterTAN. On July 16, 1993 InterTAN had an account payable to Tandy of approximately $17,000,000 of which $7,600,000 was in default. InterTAN's outstanding purchase orders for merchandise placed under the distribution agreement with Tandy, but not yet shipped, totaled approximately $44,000,000. Because InterTAN had defaulted, on July 16 Tandy terminated the merchandise purchase terms of the distribution agreement and the license agreements. Tandy offered InterTAN interim license agreements which expired July 22, 1993, unless extended. These were extended on July 23, 1993. On July 30, 1993 Trans World Electronics, Inc. ("Trans World"), a subsidiary of Tandy, reached agreement with InterTAN's banking syndicate to buy approximately $42,000,000 of InterTAN's debt at a negotiated, discounted price. The closing of this purchase occurred on August 5, 1993, at which time Tandy resumed limited shipments to InterTAN and granted a series of short-term, interim licenses pending the execution of new license and merchandise agreements. The debt purchased from the banks has been restructured into a seven-year note with interest of 8.64% due semiannually beginning February 25, 1994 and semiannual principal payments beginning February 25, 1995 (the "Series A" note). Trans World also provided approximately $10,000,000 in working capital and trade credit to InterTAN. Interest on the working capital loan (the "Series B" note) of 8.11% is due semiannually beginning February 25, 1994 with the principal due in full on August 25, 1996. Trans World also has received warrants with a five-year term exercisable for approximately 1,450,000 shares of InterTAN common stock at an exercise price of $6.62 per share. As required by an agreement with Trans World, InterTAN filed a registration statement on January 21, 1994 seeking to register the warrants under the Securities Act of 1933. In addition to the bank debt purchased by Trans World and the working capital loan, InterTAN's obligations to Trans World included two additional notes for approximately $23,665,000 (the "Series C" note) and $24,037,000 (the "Series D" note) with interest rates of 7.5% and 8%, respectively. The notes represent the restructuring of InterTAN accounts payable for merchandise already shipped and require monthly interest payments. Also, InterTAN had obligations for purchase orders outstanding for merchandise ordered by A&A for InterTAN but not yet shipped totaling approximately $31,262,000 at December 31, 1993. All principal and interest on the Series C note was paid in full by December 31, 1993. As merchandise under existing outstanding purchase orders is shipped, A&A will invoice InterTAN and amounts owed will be assigned to Trans World and will increase the amount of the Series D note. The balance of the Series D note as of December 31, 1993 was approximately $7,500,000. All of Tandy's debt from InterTAN is secured by a first priority lien on substantially all of InterTAN's assets. A new merchandise agreement was reached with InterTAN in October 1993 which requires future purchase orders be backed by letters of credit posted by InterTAN. New license agreements have been negotiated which provide for a future royalty to Tandy. As required by the various agreements now existing between Tandy and InterTAN, InterTAN has obtained a bank revolving credit facility for Canadian $30,000,000 (U.S. $22,662,000 equivalent at December 31, 1993). Tandy has agreed with InterTAN's new banking agent, that in case of InterTAN's default on the bank credit line, Tandy will, at the option of the bank, purchase InterTAN's inventory and related accounts receivable at 50% of their net book value, up to the amount of outstanding bank loans, but not to exceed Canadian $60,000,000 (U.S. $45,324,000 equivalent at December 31, 1993). In that event, Tandy could foreclose on its first priority lien on InterTAN's assets. If Tandy fails to purchase the inventory and related accounts receivable of InterTAN from the bank, InterTAN's banking agent, upon notice to Tandy and expiration of time, can foreclose upon InterTAN's assets ahead of Tandy. At December 31, 1993, InterTAN had no borrowings under this revolving credit facility. As of December 31,1993 InterTAN owed Tandy an aggregate of $63,511,000. The current portion of the obligation approximates $11,650,000 and the non-current portion approximates $51,861,000. In 1993 Tandy has not recognized any accretion of discount on the note receivable from InterTAN resulting from the purchase of the bank debt at a discounted price but will commence accretion of such discount in 1994 due to InterTAN's financial results and payment history as of December 31, 1993. Accretion of this discount will be based on the effective interest rate method and will approximate $3,856,000 in 1994. During the year ended December 31, 1993, Tandy recognized approximately $93,315,000 of sales to InterTAN and interest income of $3,085,000. Tandy's sales to InterTAN totaled $90,130,000 during the six months ended December 31, 1992, $171,126,000 during fiscal 1992, and $160,024,000 during fiscal 1991. A&A will continue as the exclusive purchasing agent for InterTAN in the Far East on a commission basis. Commencing in March 1994 only the purchasing agent commission and sales by Tandy manufacturing plants to InterTAN will be recorded as sales. InterTAN purchases from third parties through A&A will no longer be recorded as sales reflecting the arrangement under the new merchandise agreement. Accordingly, management expects that reported sales by Tandy to InterTAN in 1994 will be considerably lower than in prior years, however, the earned income relating thereto will not be materially different. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Index to Consolidated Financial Statements and Financial Statement Schedules is found on page 29. The Company's Financial Statements, Notes to Consolidated Financial Statements and Financial Statement Schedules follow the index. 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 Tandy will file a definitive proxy statement with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K pursuant to Regulation 14A. The information called for by this Item with respect to directors has been omitted pursuant to General Instruction G(3). This information is incorporated by reference from the Proxy Statement for the 1994 Annual Meeting. For information relating to the Executive Officers of the Company, see Part I of this report. The Section 16(A) reporting information is incorporated by reference from the Proxy Statement for the 1994 Annual Meeting. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Tandy will file a definitive proxy statement with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K pursuant to Regulation 14A. The information called for by this Item with respect to executive compensation has been omitted pursuant to General Instruction G(3). This information is incorporated by reference from the Proxy Statement for the 1994 Annual Meeting. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Tandy will file a definitive proxy statement with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K pursuant to Regulation 14A. The information called for by this Item with respect to security ownership of certain beneficial owners and management has been omitted pursuant to General Instruction G(3). This information is incorporated by reference from the Proxy Statement for the 1994 Annual Meeting. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Tandy will file a definitive proxy statement with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K pursuant to Regulation 14A. The information called for by this Item with respect to certain relationships and transactions with management and others has been omitted pursuant to General Instruction G(3). This information is incorporated by reference from the Proxy Statement for the 1994 Annual Meeting. 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 2. Financial Statement Schedules The financial statements and financial statement schedules filed as a part of this report are listed in the "Index to Consolidated Financial Statements and Financial Statement Schedules" on page 29. The index, statements and schedules are incorporated herein by reference. 3. Exhibits required by Item 601 of Regulation S-K A list of the exhibits required by Item 601 of Regulation S-K and filed as part of this report is set forth in the Index to Exhibits on page 63, which immediately precedes such exhibits. Certain instruments defining the rights of holders of long-term debt of the Company and its consolidated subsidiaries are not filed as exhibits to this report because the total amount of securities authorized thereunder does not exceed ten percent of the total assets of the Company on a consolidated basis. The Company hereby agrees to furnish the Securities and Exchange Commission copies of such instruments upon request. (b) Reports on Form 8-K. No reports on Form 8-K were filed for the three months ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Tandy Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TANDY CORPORATION March 30, 1994 /s/ John V. Roach ______________________ John V. Roach Chairman of the Board, Chief Executive Officer and President Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Tandy Corporation has duly caused this report to be signed on its behalf by the following persons in the capacities indicated on this 30th day of March, 1994. Signature Title /s/ John V. Roach Chairman of the Board, Chief ___________________________ John V. Roach Executive Officer and President (Chief Executive Officer) /s/ William C. Bousquette Executive Vice President and ___________________________ William C. Bousquette Chief Financial Officer (Principal Financial Officer) /s/ Richard L. Ramsey Vice President and Controller ___________________________ Richard L. Ramsey (Principal Accounting Officer) /s/ James I. Cash, Jr. Director ___________________________ James I. Cash, Jr. /s/ Caroline R. Hunt Director ___________________________ Caroline R. Hunt /s/ Lewis F. Kornfeld, Jr. Director ___________________________ Lewis F. Kornfeld, Jr. /s/ Jack L. Messman Director ___________________________ Jack L. Messman /s/ William G. Morton Director ___________________________ William G. Morton /s/ Thomas G. Plaskett Director ___________________________ Thomas G. Plaskett /s/ William T. Smith Director ___________________________ William T. Smith /s/ Alfred J. Stein Director ___________________________ Alfred J. Stein /s/ William E.Tucker Director ___________________________ William E. Tucker /s/ Jesse L. Upchurch Director ___________________________ Jesse L. Upchurch /s/ John A. Wilson Director ___________________________ John A. Wilson TANDY CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page Report of Independent Accountants. . . . . . . . . . 30 Consolidated Statements of Income for the year ended December 31, 1993, the six months ended December 31, 1992 and each of the two years ended June 30, 1992. . . . . . . . . . . . . . . . . . . 31 Consolidated Balance Sheets at December 31, 1993 and December 31, 1992. . . . . . . . . . . . . . . 32 Consolidated Statements of Cash Flows for the year ended December 31, 1993, the six months ended December 31, 1992 and each of the two years ended June 30, 1992. . . . . . . . . . . . . . . . . . . 33 Consolidated Statements of Stockholders' Equity for the year ended December 31, 1993, the six months ended December 31, 1992 and the two years ended June 30, 1992 . . . . . . . . . . . . . . . . . . 34-35 Notes to Consolidated Financial Statements . . . . . 36-60 Financial Statement Schedules: V-Property, Plant and Equipment. . . . . . . . . . 61 VI-Accumulated Depreciation and Amortization of Property, Plant and Equipment . . . . . . . . . . 62 X-Supplementary Income Statement Information . . . 62 Separate financial statements of Tandy Corporation have been omitted because Tandy is primarily an operating company and the amount of restricted net assets of consolidated and unconsolidated subsidiaries and Tandy's equity in undistributed earnings of 50% or less-owned companies accounted for by the equity method are not significant. All subsidiaries of Tandy Corporation are included in the consolidated financial statements. Financial statements of 50% or less-owned companies have been omitted because they do not, considered individually or in the aggregate, constitute a significant subsidiary. The financial statement schedules should be read in conjunction with the consolidated financial statements. All other schedules have been omitted because they are not applicable, not required or the information is included in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Tandy Corporation In our opinion, the consolidated financial statements listed in the accompanying index on page 29 present fairly, in all material respects, the financial position of Tandy Corporation and its subsidiaries (the "Company") at December 31, 1993 and 1992, and the results of their operations and their cash flows for the year ended December 31, 1993, the six months ended December 31, 1992, and for each of the two years in the period ended June 30, 1992 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 2 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 and for extended warranty and service contracts in fiscal 1991. /s/ Price Waterhouse____________________ PRICE WATERHOUSE Fort Worth, Texas February 22, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Tandy Corporation and Subsidiaries NOTE 1-DESCRIPTION OF BUSINESS Tandy Corporation ("Tandy" or the "Company") is engaged in consumer electronics retailing including the retail sale of personal computers. Radio Shack is the largest of Tandy's retail store systems with company-owned stores and dealer/franchise outlets. The Tandy Name Brand Retail Group includes McDuff Electronics mall stores and Supercenters, VideoConcepts mall stores and The Edge in Electronics stores. Tandy also operates the Computer City and Incredible Universe store chains. Additionally, Tandy continues to operate certain related retail support groups and consumer electronics manufacturing businesses. NOTE 2-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of Tandy and its wholly owned subsidiaries, including its credit and insurance subsidiaries. Investments in 20% to 50% owned companies are accounted for on the equity method. The manufacturing and marketing operations included in the divestment plan have been accounted for as discontinued operations. See Note 3 for further information relating to discontinued operations. Significant intercompany transactions are eliminated in consolidation. CHANGE IN FISCAL YEAR: On January 10, 1993, the Board of Directors authorized the fiscal year of Tandy to be changed from June 30 to December 31 and as of December 31, 1992 this change was made. The fiscal periods of certain foreign operations end one month earlier than the Company's year end to facilitate their inclusion in the consolidated financial statements. FOREIGN CURRENCY TRANSLATION: In accordance with the Financial Accounting Standards Board (the "FASB") Statement No. 52, "Foreign Currency Translation," balance sheet accounts of the Company's foreign operations are translated from foreign currencies into U.S. dollars at year end or historical rates while income and expenses are translated at the weighted average sales exchange rates for the year. Translation gains or losses related to net assets located outside the United States are shown as a separate component of stockholders' equity. Losses aggregating $19,803,000, net of tax, relating to discontinued operations were transferred from equity and charged to loss on disposal of discontinued operations during 1993. Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's functional currency) are included in net income. Such foreign currency transaction gains approximated $762,000 for the year ended December 31, 1993, $3,065,000 for the six months ended December 31, 1992 and $10,642,000 and $13,051,000 for fiscal years 1992 and 1991, respectively. CHANGE IN ACCOUNTING PRINCIPLE-PROVISION FOR INCOME TAXES: In January 1993, the Company adopted Statement of Financial Accounting Standards ("FAS") No. 109, "Accounting for Income Taxes" ("FAS 109") and applied the provisions prospectively. The adoption of FAS 109 changes the Company's method of accounting for income taxes from the deferred method ("APB 11") to an asset and liability approach. Previously, the Company deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The adjustments to the January 1, 1993 balance sheet to adopt FAS 109 totaled $13,014,000. Approximately $9,786,000 of this adjustment related to continuing operations and the remaining $3,228,000 was from discontinued operations. The aggregate amount of $13,014,000 is reflected in the accompanying 1993 Consolidated Statements of Income as the cumulative effect of change in accounting principle. It primarily represents the impact of adjusting deferred taxes to reflect the then current tax rate of 34% as opposed to the higher tax rates that were in effect when the deferred taxes originated. See Note 12 for further discussion of income taxes. CHANGE IN ACCOUNTING PRINCIPLE-EXTENDED WARRANTY AND SERVICE CONTRACTS: Tandy's retail operations offer extended warranty and service contracts on products sold. These contracts generally provide extended warranty coverage for periods of 12 to 48 months. The FASB issued Technical Bulletin No. 90-1, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts" in December 1990. This bulletin requires revenues from sales of extended warranty and service contracts to be recognized ratably over the lives of the contracts. Costs directly related to sales of such contracts are to be deferred and charged to expense proportionately as the revenues are recognized. A loss is recognized on extended warranty and service contracts if the sum of the expected costs of providing services under the contracts exceeds related unearned revenue. During the fourth quarter of fiscal 1991, the Company elected to adopt this technical bulletin on a retroactive basis to the beginning of fiscal 1991 by restating the previously reported three quarters. The method of adoption included the application of this accounting change to all existing contracts outstanding at July 1, 1990 and to all contracts entered into during fiscal 1991. Prior to the adoption of this technical bulletin, the Company had recognized a portion of the extended warranty and service contract revenues immediately, deferred the remaining revenues which were recognized ratably over their contract lives and expensed associated costs as incurred. The effect of this change for fiscal 1991 was to decrease income before the cumulative effect of the change in accounting by $3,708,000 ($.05 per share). The cumulative effect of the change on years prior to 1991, net of income taxes of $5,471,000, was to decrease 1991 net income by $10,619,000 ($.14 per share). CASH AND SHORT-TERM INVESTMENTS: Cash on hand in stores, deposits in banks and short-term investments with original maturities of three months or less are considered cash and cash equivalents. Short-term investments are carried at cost, which approximates market value. ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS: CREDIT OPERATIONS-The customer receivables of the credit operations are classified as current assets, including amounts which are contractually due after one year. This is consistent with retail industry practices. Finance charges, late charges and returned check fees arising from the Company's private label credit cards are recognized when earned, as interest income. The Company's policy is to write off accounts after 210 days past the initial billing date without payment of the amount due or whenever deemed uncollectible by management, whichever is sooner. Collection efforts continue subsequent to write-off. The Company is charged a fee by an outside accounts receivable processing service for establishing new accounts. These initial direct costs are capitalized and amortized on a straight-line basis over a period of 84 months, the estimated life over which the account will be used by a customer. These costs are shown in the accompanying consolidated balance sheets as a part of the related accounts receivable. Amortization of these loan origination costs are included as a reduction of interest income in the accompanying consolidated statements of income. Costs to process accounts on an ongoing basis are expensed as incurred. OTHER CUSTOMER RECEIVABLES-An allowance for doubtful accounts is provided when accounts are determined to be uncollectible. Concentrations of credit risk with respect to customer receivables are limited due to the large number of customers comprising the Company's base and their location in many different geographic areas of the country. INVENTORIES: Inventories are stated at the lower of cost (principally based on average cost) or market value. PROPERTY AND EQUIPMENT: For financial reporting purposes, depreciation and amortization are primarily calculated using the straight-line method, which amortizes the cost of the assets over their estimated useful lives. The ranges of estimated useful lives are: _____________________________________________________________ Buildings. . . . . . . . . . . . . . . . . . . .10-40 years Equipment. . . . . . . . . . . . . . . . . . . . 2-15 years Leasehold improvements . . . . . . . . . . . . .the shorter of the life of the improvements or the term of the related lease and certain renewal periods _____________________________________________________________ When depreciable assets are sold or retired, the related cost and accumulated depreciation are removed from the accounts. Any gains or losses are included in selling, general and administrative expenses. Major additions and betterments are capitalized. Maintenance and repairs which do not materially improve or extend the lives of the respective assets are charged to operating expenses as incurred. AMORTIZATION OF EXCESS PURCHASE PRICE OVER NET TANGIBLE ASSETS OF BUSINESSES ACQUIRED: The excess purchase price is generally amortized over a 40-year period using the straight-line method and is classified as a non-current asset. FAIR VALUE OF FINANCIAL INSTRUMENTS: The fair value of financial instruments is determined by reference to various market data and other valuation techniques as appropriate. Unless otherwise disclosed, the fair values of financial instruments approximate their recorded values. REVENUES: Retail sales are recorded on the accrual basis. Credit service charges are recorded monthly on the basis of customer account balances. PRE-STORE OPENING EXPENSES: Direct incremental expenses associated with the openings of new stores are deferred and amortized over a twelve-month period from the date of the store opening. NET INCOME PER AVERAGE COMMON AND COMMON EQUIVALENT SHARE: Net income per average common and common equivalent share is computed by dividing net income less the Series B convertible stock dividends, net of taxes, by the weighted average common and common equivalent shares outstanding during the period. Current year weighted average share calculations include 12,457,000 common shares relating to the Preferred Equity Redemption Convertible Preferred Stock ("PERCS"). Per share amounts and the weighted average number of shares outstanding for the six-month period ended December 31, 1992 and for the fiscal year ended June 30, 1992, have been retroactively restated to reflect the assumption that the PERCS would convert into 12,457,000 common shares in lieu of the maximum number of common shares of 15,000,000. The reduction is based upon Tandy's common stock price at December 31, 1993 being in excess of the conversion strike price thereby reducing the number of common shares that would be issued to PERCS shareholders upon conversion. Earnings per share amounts previously reported by the Company for the six months ended December 31, 1992 and the fiscal year ended June 30, 1992 were $0.84 and $2.58 for income from continuing operations, respectively, and $0.02 and $2.24 for net income, respectively. Fiscal 1991 and 1990 were not effected as the PERCS were not outstanding during these years. The Series B convertible stock dividends, net of taxes, were $7,136,000 for the fiscal year ended December 31, 1993, $2,419,000 for the six months ended December 31, 1992, $4,911,000 in fiscal 1992 and $4,538,000 in fiscal 1991. The taxes netted against these amounts were $0, $1,246,000, $2,530,000 and $2,337,000, respectively. Upon adoption of FAS 109 as of January 1, 1993 and in accordance with EITF 92-3, preferred dividends utilized in the earnings per share calculation can no longer be reduced for associated tax benefits paid on unallocated preferred stock held by an employee stock ownership plan. As the Series C PERCS mandatorily convert into common stock, they are considered outstanding common stock and the dividends are not deducted from net income for purposes of calculating net income per average common and common equivalent share. Dividends on the Series C PERCS, which were issued in February 1992, were $32,100,000 for the year ended December 31, 1993, $16,050,000 for the six months ended December 31, 1992 and $12,573,000 for the year ended June 30, 1992. Fully diluted earnings per common and common equivalent share are not presented since dilution is less than 3%. NOTE 3-DISCONTINUED OPERATIONS On June 25, 1993, the Board of Directors of Tandy adopted a formal plan of divestiture under which it would sell its computer manufacturing and marketing businesses, the O'Sullivan Industries, Inc. ready-to-assemble furniture manufacturing and related marketing business, the Memtek Products division and the Lika printed circuit board business. The divestiture plan replaced the Company's plan to spin off all of the Company's manufacturing and marketing businesses as described in Tandy's Transition Report on Form 10-K/A-4 for the six-month period ended December 31, 1992. In connection with the plan of divestiture the Company accounted for the divestiture of these businesses as discontinued operations and recognized an after-tax charge of $70,000,000 in its quarter ended June 30, 1993. This charge was subsequently reduced by approximately $15,822,000 in the quarter ended December 31, 1993. The reduction of the reserve previously taken resulted from the better than anticipated sales price received for O'Sullivan Industries Holdings, Inc. partially offset by additional foreign currency translation losses and below plan operating results of the divested companies during the divestment period, net of related income tax adjustments. Prior year results of operations have been reclassified to reflect the discontinued operations treatment. Computer Manufacturing. In furtherance of the divestiture plan, the Company closed the sale of the computer manufacturing and marketing businesses to AST Research, Inc. ("AST") on July 13, 1993. In accordance with the terms of the definitive agreement between Tandy and AST, Tandy received $15,000,000 upon closing of the sale. The balance of the purchase price of $90,000,000 (as adjusted post-closing based on the results of an audit of the assets and liabilities conveyed) is payable by a promissory note. The promissory note is payable in three years and interest is accrued and paid annually. The interest rate on the promissory note is currently 3.75% per annum and is adjusted annually, not to exceed 5% per annum. The terms of the promissory note stipulate that the outstanding principal balance may be paid at maturity at AST's option in cash or the common stock of AST. However, at Tandy's option not more than 50% of the initial principal balance may be paid in common stock of AST. The promissory note is supported by a standby letter of credit in the amount of the lesser of $100,000,000 or 70% of the outstanding principal amount of the promissory note. At December 31, 1993, the standby letter of credit approximated $67,704,000. Accounts receivable relating to the computer operations, approximating $83,000,000 at June 30, 1993, inured to the benefit of Tandy upon collection. At December 31, 1993, the balance of the remaining accounts receivable, net of allowance for doubtful accounts, was $7,700,000. Tandy also retained certain inventory which it intends to liquidate before June 30, 1994. At December 31, 1993, this inventory amounted to approximately $3,700,000. In October 1993, the Company sold its computer marketing operations in France to AST, together with certain other multimedia assets and additional Swedish inventory, for an aggregate of approximately $6,700,000, which was evidenced by an increase in the amount of the promissory note described above to $96,700,000. The Company has discounted this note by $2,000,000 and the discount will be recognized as income using the effective interest rate method over the life of the note. Memtek Products. On November 10, 1993, the Company executed a definitive agreement with Hanny Magnetics (B.V.I.) Limited, a British Virgin Islands corporation ("Hanny") to purchase certain assets of the Company's Memtek Products operations, including the license agreement with Memorex Telex, N.V. for the use of the Memorex trademark on licensed consumer electronics products. This sale closed on December 16, 1993. As of December 31, 1993, Tandy has received payments of $62,500,000, recorded a $7,102,000 receivable from Hanny for the remaining purchase price and retained approximately $61,000,000 in accounts receivable and certain other assets for liquidation. Hanny is a subsidiary of Hanny Magnetics (Holdings) Limited, a Bermuda corporation, listed on the Hong Kong Stock Exchange. At December 31, 1993, accounts receivable, net of related allowance for doubtful accounts, retained by Tandy approximated $40,100,000. O'Sullivan Industries. On November 23, 1993, the Company announced that it would sell the common stock of O'Sullivan Industries, Inc. ("O'Sullivan") in an initial public offering. On January 27, 1994 the Company announced that it had reached an agreement with the underwriters to sell O'Sullivan Industries Holdings, Inc., the parent company of O'Sullivan, common stock to the public at $22 per share. The net proceeds realized by Tandy in the initial public offering, together with the $40,000,000 cash dividend from O'Sullivan, approximated $350,000,000. The initial public offering closed on February 2, 1994. Pursuant to a Tax Sharing and Tax Benefit Reimbursement Agreement between Tandy and O'Sullivan Industries Holdings, Inc., the Company will receive payments from O'Sullivan resulting from an increased tax basis of O'Sullivan's assets thereby increasing tax deductions and accordingly, reducing income taxes payable by O'Sullivan. The amount to be received by the Company each year will approximate the federal tax benefit expected to be realized with respect to the increased tax basis. These payments will be made over a 15-year time period. The Company will recognize these payments as additional sale proceeds and gain in the year in which the payments become due and payable to the Company. Lika. On January 24, 1994, the Company announced that it had signed a definitive agreement to sell its manufacturing facilities which make Lika printed circuit boards. This divestiture is expected to close by June 1994 and is expected to yield approximately $17,000,000 in proceeds, including cash, a note and the liquidation of certain retained assets. In connection with the computer manufacturing sale and the Memtek Products sale, the Company agreed to retain certain liabilities primarily relating to warranty obligations on products sold prior to the sale. Management believes that accrued reserves, as reflected on its December 31, 1993 balance sheet, are adequate to cover estimated future warranty obligations for the products and for any remaining costs to dispose of these operations. With the closing of the Lika transaction, the divestiture program announced in June 1993 will be complete. Proceeds from the formal divestiture plan should total approximately $715,000,000 including net income tax benefits of $16,600,000 and notes receivable of approximately $100,000,000 that mature by the end of 1996. The proceeds from the divestitures are being used to reduce short-term debt and for the expansion of the Incredible Universe and Computer City store operations. The losses from discontinued operations prior to the measurement date are outlined in the table below. A loss from the sale of the Company's computer manufacturing operations to AST, inclusive of losses from operations during the phase out period, is offset by the gains from the sale of Memtek Products, O'Sullivan and Lika, also inclusive of results of operations during the phase out period. Interest expense of $4,608,000 allocated through the measurement date of June 30, 1993 and $5,170,000 for the six months ended December 31, 1992, have been allocated to discontinued operations based on the percentage of the net assets of discontinued operations to total net assets. At December 31, 1993 net assets of discontinued operations consist primarily of inventories, accounts receivable and property, plant and equipment, primarily relating to O'Sullivan and Lika operations. NOTE 4-RESTRUCTURING AND OTHER CHARGES The Company adopted a plan resulting in business restructuring charges during the six months ended December 31, 1992 designed to improve the Company's competitiveness and future profitability. The pre-tax charge of $48,000,000 related primarily to the closing of approximately 110 of the 432 Tandy Name Brand Retail Group stores, mainly McDuff Supercenters in major market areas and, to a lesser extent, the elimination of certain product lines. Some product lines were reduced or eliminated after consideration of competitive factors and market trends. Additional restructuring charges of $39,500,000 related to discontinued operations were recognized in the six months ending December 31, 1992 and primarily related to the write-off of goodwill, the rationalization of certain product lines and the closure of certain operations. This restructuring charge is included in the operating loss from discontinued operations. In fiscal 1991 an $8,531,000 charge was incurred for restructuring. The charges consisted principally of costs associated with closings of Radio Shack computer centers. Restructuring charges relating to continuing operations are presented in the accompanying income statements as a separate line item. NOTE 5-SHORT-TERM INVESTMENTS The weighted average interest rate was 3.2% at December 31, 1993 for short-term investments totaling $153,839,000. The weighted average interest rate was 3.5% at December 31, 1992 for short-term investments totaling $40,913,000. NOTE 6-ACCOUNTS AND NOTES RECEIVABLE Accounts and Notes Receivable Effective May 1, 1991, the Company transferred $573,500,000 of its customer receivables to a trust which, in turn, on June 18, 1991, sold $350,000,000 of certificates representing undivided interests in the trust in a public offering. Net proceeds from the sale of receivables approximated $346,000,000 and the Company recognized a gain of approximately $3,900,000 related to the transaction. At December 31, 1993 and 1992, all $350,000,000 of the certificates were outstanding and, accordingly, were not reflected in the Company's accounts receivable balances. The fair value of the certificates at December 31, 1993 was approximately $367,815,000. At December 31, 1993, the balance of the receivables in the trust approximated $651,700,000. The Company owns the remaining undivided interest in the trust not represented by the certificates and will continue to service the receivables for the trust. Cash flows generated from the receivables in the trust are dedicated to the payment of interest on the certificates which have an annual fixed interest rate of 8.25%, absorption of defaulted accounts in the trust and payment of servicing fees to the Company with any remaining cash flows remitted to the Company. In the event that such excess cash flows are not sufficient to absorb defaulted accounts, the Company is contingently liable up to a maximum amount of $136,100,000. Under this agreement the trust may issue additional series of certificates from time to time. Terms of any future series will be determined at the time of issuance. NOTE 7-PROPERTY, PLANT AND EQUIPMENT December 31, ____________________ (In thousands) 1993 1992 _____________________________________________________________ Land . . . . . . . . . . . . . . . . . . $ 32,346 $ 20,942 Buildings. . . . . . . . . . . . . . . . 174,126 156,783 Furniture, fixtures and equipment . . . 394,242 393,886 Leasehold improvements . . . . . . . . . 314,424 310,509 ________ ________ 915,138 882,120 Less accumulated depreciation. . . . . . 451,400 437,180 ________ ________ Property, plant and equipment related to continuing operations. . . . . . . . . 463,738 444,940 Property, plant and equipment related to discontinued operations, net . . . . . -- 101,645 ________ ________ $463,738 $546,585 ________ ________ ________ ________ NOTE 8-OTHER ASSETS Other assets includes the excess purchase price over net tangible assets of businesses acquired for continuing operations of $18,207,000 at December 31, 1993 and $18,728,000 at December 31, 1992. These amounts are net of accumulated amortization of $4,485,000, and $3,964,000, respectively. The balance at December 31, 1993 includes long-term receivables relating to InterTAN and AST of $126,384,000, net of discount of $22,198,000. See Notes 3 and 21 for a further description of the terms of the AST and InterTAN notes receivable. The balance at December 31, 1992 includes other assets relating to discontinued operations of approximately $207,864,000. NOTE 9-INDEBTEDNESS AND BORROWING FACILITIES Borrowings payable within one year are summarized in the accompanying short-term debt table on page 45. The short-term debt caption includes primarily domestic seasonal borrowings. The current portion of long-term debt at December 31, 1993 includes $82,701,000 of medium-term notes and other loans compared to $48,696,000 at December 31, 1992. The short-term debt additionally includes $31,739,000 of 10% subordinated debentures due June 30, 1994. This subordinated debenture has been called by the Company for redemption on April 1, 1994. Tandy's short-term credit facilities, including revolving credit lines, are summarized in the accompanying short-term borrowing facilities table found on page 46. A commercial paper program was established during fiscal 1991 for Tandy. The Company has a $400,000,000 committed facility in place for the commercial paper program. This facility is to be used only if maturing commercial paper cannot be repaid due to an inability to sell new paper. This facility is composed of two tranches of $200,000,000 each expiring in June 1994 with annual commitment fees for the tranches of 1/10 of 1% per annum and 3/20 of 1% per annum, respectively, whether used or unused. The commercial paper facility limits the amount of commercial paper that may be outstanding to a maximum of $400,000,000. Long-term debt at December 31, 1993 and December 31, 1992 totaled $186,638,000 and $322,778,000, respectively. Included in both years are $45,000,000 of 8.69% senior notes due January 15, 1995. These senior notes have been outstanding since February 7, 1990. Tandy completed a $500,000,000 shelf registration in January 1991 of which $400,000,000 was designated for medium-term notes. Tandy Credit's $400,000,000 shelf registration was amended in October 1990 to add a $200,000,000 Series B medium-term note program. At December 31, 1993 available borrowing capacity under Tandy's and Tandy Credit's medium-term note programs aggregated $429,200,000. Medium-term notes outstanding at December 31, 1993 totaled $125,479,00 compared 6to $148,900,000 at December 31, 1992. The weighted average coupon rates of medium-term notes outstanding at both of these dates was 8.7%. The Company established an employee stock ownership trust in June 1990. Further information on the trust and its related indebtedness, which is guaranteed by the Company, is detailed in the discussion of the Tandy Employees Stock Ownership Plan in Note 14. Long-term borrowings outstanding at December 31, 1993 mature as follows: (In thousands) _____________________________________________________________ 1994 . . . . . . . . . . . . . . . . . . . $124,490 1995 . . . . . . . . . . . . . . . . . . . 61,008 1996 . . . . . . . . . . . . . . . . . . . 22,678 1997 . . . . . . . . . . . . . . . . . . . 40,921 1998 . . . . . . . . . . . . . . . . . . . 37,331 1999 and thereafter. . . . . . . . . . . . 24,700 _____________________________________________________________ The fair value of the Company's long-term debt of $311,128,000 (including current portion) is approximately $328,516,000 at December 31, 1993. Consolidated interest expense was $39,707,000 for the year ended December 31, 1993, $20,532,000 for the six months ended December 31, 1992 and $43,154,000, and $70,313,000 for the years ended June 30, 1992 and 1991. Interest income, primarily related to the Company's credit card operations, totaled $65,538,000 for the year ended December 31, 1993, $33,290,000 for the six months ended December 31, 1992 and $67,399,000 and $98,872,000 for the years ended June 30, 1992 and 1991. NOTE 10-LEASES Tandy leases rather than owns most of its facilities. The Radio Shack stores comprise the largest portion of Tandy's leased facilities. The Radio Shack, Tandy Name Brand Retail Group and Computer City stores are located primarily in major shopping malls, shopping centers or freestanding facilities owned by other companies. The Company owns most of the Incredible Universe stores. The store leases are generally based on a minimum rental plus a percentage of the store's sales in excess of a stipulated base figure. Radio Shack store leases average approximately 10 years, generally with renewal options. Tandy also leases distribution centers and office space. Capital leases are not material as the Company's operations are basically structured in a manner that precludes the need for significant financing or capital leases. Future minimum rent commitments at December 31, 1993 for all long-term noncancelable leases (net of immaterial amounts of sublease rent income) are in the following table. (In thousands) ------------------------------------------------------------- 1994 . . . . . . . . . . . . . . . . . . . $144,102 1995 . . . . . . . . . . . . . . . . . . . 140,105 1996 . . . . . . . . . . . . . . . . . . . 126,148 1997 . . . . . . . . . . . . . . . . . . . 109,907 1998 . . . . . . . . . . . . . . . . . . . 93,541 1999 and thereafter. . . . . . . . . . . . 305,763 ------------------------------------------------------------- NOTE 12-INCOME TAXES The components of the provision for income taxes and a reconciliation of the U.S. statutory tax rate to the Company's effective income tax rate are given in the accompanying tables. As of December 31, 1993, the Company has tax net operating loss carryforwards of approximately $20,659,000 which are available to offset future taxable income. These carryforwards which are expected to be fully utilized, expire beginning in the year ending December 31, 2006. Accordingly, the Company has recognized a deferred tax asset relating to these carryforwards. In January 1993, the Company adopted FAS No. 109. The adoption of FAS 109 changes the Company's method of accounting for income taxes from the deferred method ("APB 11") to an asset and liability approach. Previously, the Company deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The adjustments to the January 1, 1993 balance sheet to adopt FAS 109 totaled $13,014,000. Approximately $9,786,000 of this adjustment related to continuing operations and the remaining $3,228,000 was from discontinued operations. The aggregate amount of $13,014,000 is reflected in 1993 net income as the cumulative effect of change in accounting principle. It primarily represents the impact of adjusting deferred taxes to reflect the then current tax rate of 34% as opposed to the higher tax rates that were in effect when the deferred taxes originated. The Company subsequently increased its U.S. deferred tax asset in 1993 as a result of legislation enacted during 1993 which increased the corporate tax rate from 34% to 35%. Deferred tax assets and liabilities as of December 31, 1993 for continuing operations were comprised of the following: Deferred Tax Assets ___________________ (In thousands) December 31, 1993 _________________ Bad debt reserve $14,268 Intercompany profit elimination 6,654 Deferred service contract income 41,290 Restructuring reserves 3,362 Insurance reserves 5,607 Loss carryforwards and carrybacks 7,231 Foreign tax credits 4,396 _______ 82,808 Valuation allowance (4,396) _______ Total deferred tax assets 78,412 _______ Deferred Tax Liabilities ________________________ Inventory adjustments, net 8,445 Depreciation and amortization 8,322 Credit card origination costs 3,221 Deferred taxes on foreign operations 4,275 Other 4,269 _______ Total deferred tax liabilities 28,532 _______ Net Deferred Tax Assets $49,880 _______ _______ NOTE 13-STOCK PURCHASE AND SAVINGS PLANS Stock purchase and savings plans are offered by Tandy Corporation to its employees. These plans are designed to provide employees with a consistent investment program which provides for their retirement and an opportunity to participate in the Company's growth. TANDY CORPORATION STOCK PURCHASE PROGRAM. The Program is available to most employees who have been employed at least six months. Each participant may contribute 1% to 10% of annual compensation, except that the President of the Company may limit the maximum contribution for employees of certain divisions or subsidiaries to a percentage less than 10%. The Company matches 40%, 60% or 80% of the employee's contribution depending on the length of the employee's participation in the program. The Company periodically purchases common stock on the open market and then sells the number of shares required by the program each month at a price equal to the average of the daily closing prices for that month. The stock purchased by each participant is distributed annually after December 31. In the event of a tender offer (other than an issuer tender offer) or a change in control, as defined in the program, all stock credited to participants' accounts will be distributed to the participants. If the Company elects, treasury shares or authorized but unissued shares may be used. Tandy's contributions to the stock purchase program were $18,955,000 for the year ended December 31, 1993 and $8,756,000 for the six months ended December 31, 1992. For fiscal 1992 and 1991 the Company's contributions were $20,253,000 and $19,614,000, respectively. TANDY EMPLOYEES DEFERRED SALARY AND INVESTMENT PLAN. The Plan became effective on July 1, 1982. An eligible employee electing to participate in this plan may defer 5% of annual compensation, subject to certain limitations established by the Tax Reform Act of 1986. The Company pays this amount into the plan as a deferred salary contribution for the account of the employee. The employee's 5% contribution is considered deferred compensation and is not taxed to the employee as long as it remains in the plan. Prior to October 1, 1990, the Company matched 80% of the employee's deferred salary contribution. This matching contribution ceased on September 30, 1990. Beginning October 1990, the Company began making contributions to the newly formed employee stock ownership plan described in Note 14 in lieu of the matching contributions to the deferred salary and investment plan. To participate in the employee stock ownership plan, employees must continue to make deferred salary contributions to the Tandy Employees Deferred Salary and Investment Plan. The plan is available to most employees who have been employed at least one year. The contributions made by the Company until the employee stock ownership plan became effective October 1, 1990 were fully vested upon payment to the trustee. In June 1992, the Company received a determination letter ruling that the Tandy Employees Deferred Salary and Investment Plan is a qualified 401(k) plan. An administrative committee appointed by the Board of Directors invests the plan's assets. A substantial majority of the plan's assets are invested in Tandy securities. The Company's contribution to the investment plan from July 1, 1990 through September 30, 1990 was $3,401,000. NOTE 14-TANDY EMPLOYEES STOCK OWNERSHIP PLAN As a continuation of the Company's programs to encourage employee ownership of Tandy stock, the Company formed the Tandy Employees Stock Ownership Plan and trust (the "TESOP") on June 28, 1990. On July 31, 1990, the TESOP trustee borrowed $100,000,000 at an interest rate of 9.34% with varying semi-annual principal payments through June 30, 2000. Dividend payments and contributions from Tandy will be used to repay the indebtedness. Because Tandy has guaranteed the repayment of these notes, the indebtedness of the TESOP is recognized as a long-term obligation in the accompanying consolidated balance sheet. An offsetting charge has been made in the stockholders' equity section of the accompanying consolidated balance sheet to reflect unearned compensation related to the TESOP. The TESOP trustee used the proceeds from the issuance of the notes to purchase 100,000 shares of Series B TESOP Convertible Preferred Stock (the "TESOP Preferred Stock") from Tandy at a price of $1,000 per share. Each share of such stock is convertible into 21.768 shares of Tandy common stock. The number of shares of Company common stock into which each share of the TESOP Preferred Stock is convertible ("the Conversion Price") is subject to anti-dilution adjustment upon the occurrence of a number of corporate events. The annual cumulative dividend on TESOP Preferred Stock is $75.00 per share, payable semi-annually. This series of stock has certain liquidation preferences and may be redeemed by Tandy after July 1, 1994 at specified premiums. The TESOP Preferred Stock will be held by the trustee until redemption or conversion and may not be sold or distributed outside the TESOP except for resale to Tandy. The TESOP requires that shares of TESOP Preferred Stock not yet allocated to any participant's account, as well as allocated shares for which no voting instructions are received, be voted by the trustee in proportion to the votes cast with respect to allocated shares of TESOP Preferred Stock. Participants in the Tandy Employees Deferred Salary and Investment Plan became eligible to participate in the TESOP effective October 1, 1990. At that time the Company began making payments to the TESOP in lieu of its matching contributions to the Tandy Employees Deferred Salary and Investment Plan. During the term of the TESOP, the TESOP Preferred Stock will be allocated to the participants semi-annually based on the principal payments made on the indebtedness. The allocations to the individual participants' accounts are determined according to the terms of the TESOP. As vested participants withdraw from the TESOP, payments are made in cash or Tandy common stock. The preferred stock has a face value of $1,000 per share and the Company is obligated to redeem the preferred stock at the higher of the appraised value or $1,000 per share in the event of a participant's withdrawal. The Company has the option to redeem the preferred stock in either cash or common stock. Participants in the TESOP that were hired prior to October 1, 1990 became immediately vested in all allocations made to their accounts. Employees hired after September 30, 1990 who become TESOP participants will become vested in amounts allocated to their accounts upon the earlier of three years of participation in the TESOP or the completion of five years of employment with the Company. Forfeited shares are returned to the TESOP and allocated to the accounts of other participants. In June 1992 the Company received a determination letter ruling from the IRS that the TESOP was a qualified employee stock ownership plan. In fiscal 1991 Tandy recorded, as a component of stockholders' equity, $100,000,000 of unearned compensation to reflect the value of the TESOP Preferred Stock sold to the TESOP. As shares of the TESOP Preferred Stock are allocated to the TESOP participants, compensation expense is recorded and unearned compensation is reduced. Interest expense on the TESOP notes is also recognized as a cost of the TESOP. The compensation component of the TESOP expense is reduced by the amount of dividends accrued on the TESOP Preferred Stock with any dividends in excess of the compensation expense reflected as a reduction of interest expense. During the year ended December 31, 1993, the compensation and interest costs related to the TESOP before the reduction for the allocation of dividends were $9,605,000 and $7,195,000, respectively. During the six months ended December 31, 1992, the compensation and interest costs related to the TESOP before the reduction for the allocation of dividends were $4,266,000 and $3,969,000, respectively. Such amounts for fiscal 1992 were $8,233,000 and $8,526,000, respectively. For the fiscal year ended June 30, 1991, these amounts were $5,967,000 and $8,488,000, respectively. Contributions from Tandy to the TESOP for the year ended December 31, 1993 and the six months ended December 31, 1992 totaled $17,895,000 and $9,269,000, respectively, including the $7,135,000 and $3,665,000 of dividends paid on the TESOP Preferred Stock. Contributions for the year ended June 30, 1992 totaled $16,926,000, including the $7,441,000 of dividends paid on the TESOP Preferred Stock. The fiscal 1991 cash contributions were $15,108,000, including $6,875,000 of dividends paid on the TESOP Preferred Stock. At September 30, 1993, 25,620 shares of TESOP Preferred Stock had been released and allocated to participants' accounts in the TESOP (including 6,093 shares which had been withdrawn by participants). During the six months ended December 31, 1993, 5,400 shares of TESOP Preferred Stock were released for allocation to participants at March 31, 1994. At December 31, 1993, 68,980 shares of TESOP Preferred Stock were available for later release and allocation to participants over the remaining life of the TESOP. Under the terms of Tandy's guarantee of the notes, Tandy is obligated to make annual contributions to the TESOP to enable it to pay principal and interest on the debt securities. Tandy has fully and unconditionally guaranteed the TESOP's payment obligations, whether at maturity, upon redemption, upon declaration of acceleration or otherwise. The holders of the notes have no recourse against the assets of the TESOP except in the event that the TESOP defaults on payments due and then only to the extent that the TESOP holds cash payments made by Tandy to the TESOP to enable it to meet its obligations under the notes and any earnings attributable to such contributions. No amounts were in default as of December 31, 1993. The TESOP fiscal year ends on March 31. At March 31, 1993, the TESOP held as assets $97,725,000 of TESOP Preferred Stock and $4,511,000 of receivables and had liabilities comprised of the remaining principal on the notes of $79,680,000 and accrued interest payable on the notes of $1,861,000, resulting in net assets of $20,695,000. NOTE 15-STOCK OPTIONS AND PERFORMANCE AWARDS 1985 Stock Option Plan ______________________ Under the 1985 Stock Option Plan, as amended, options to acquire up to 2,000,000 shares of Tandy's common stock may be granted to officers and key management employees of the Company. The shares authorized for issuance under the Plan upon the exercising of an option have been registered with the Securities and Exchange Commission. The Organization and Compensation Committee (the "Committee") has sole discretion in determining whether to grant options, who shall receive them, the number of options granted to any individual and whether an option will be an incentive stock option or a nonstatutory stock option. The term of incentive stock options may not exceed 10 years and the term of nonstatutory stock options may not exceed a term of 10 years plus one month. No option may be exercised within one year of the date of grant and then may be exercised in specified installments only after stated intervals of time. The maximum amount that may be exercised at the expiration of each of the first through fifth anniversaries of the nonstatutory stock options is 20%. On each of the first three anniversaries of the date of grant of the incentive stock options, one-third of each individual's options become exercisable. Upon termination of employment, the optionee must exercise all currently vested options by the earlier of the option expiration date(s) or three months from the date of termination of employment or forfeit such options, except that upon retirement at age 55 or older the three months is extended to 12 months in the case of nonstatutory stock options only. Notwithstanding the grant of options initially exercisable in installments, upon the termination of employment as a result of death or total disability of an optionee, all options then held shall for a period of 12 months, subject to earlier termination at the fixed expiration date, become immediately exercisable without regard to dates at which the installments are exercisable. Upon the retirement of an optionee at age 55 or older, the Committee may in its discretion accelerate the dates at which remaining installments of options may be exercised to the date of retirement. In the event of a change in control, all outstanding options become immediately exercisable for the full number of shares subject to options. The option price was determined by the Committee at the time the option is granted, but the option price will not be less than 100% of the fair market value of the stock on the date of grant. Since the option prices have been fixed at the market price on the date of grant, no compensation has been charged against earnings by the Company. Authorized and unissued shares or treasury stock may be issued to participants when options are exercised. The 1985 Stock Option Plan provides for adjustments to be made to options outstanding under the plan in order to prevent dilution of options upon the occurrence of a number of events, including the distribution of shares of a subsidiary of the Company to its stockholders. Tandy assumed an option plan which had been created by GRiD prior to its acquisition. All unexercised GRiD options expired June 30, 1993. Under the 1985 Stock Option Plan there were 1,268,205 vested options which could have been exercised for a total price of $44,710,134 at December 31, 1993. Shares available for additional grants under the 1985 Stock Option Plan were 138,599 at December 31, 1993. 1993 Incentive Stock Plan _________________________ During March 1993, the Board adopted the Tandy Corporation 1993 Incentive Stock Plan (the "1993 Plan"). The 1993 Plan was approved by stockholders in October 1993. Certain provisions of the 1993 Plan were amended by the Board on October 15, 1993. The 1993 Plan is administered by the Organization and Compensation Committee (the "Committee") of the Board. A total of 3,000,000 shares of the Company's common stock were reserved for issuance under the 1993 Plan and have been registered with the Securities and Exchange Commission. The 1993 Plan permits the grant of incentive stock options ("ISOs"), nonstatutory stock options (options which are not ISOs) ("NSOs"), stock appreciation rights ("SARs"), restricted stock, performance units or performance shares. Grants of options under the 1993 Plan shall be for terms specified by the Committee, except that the term shall not exceed 10 years (5 years if granted to a 10% or more stockholder of the Company's common stock). Subject to the discretion of the Committee, options become exercisable in such installments and at such times payments for shares issuable upon exercise of an option may be made in cash, common stock, or a combination of both. The amount payable upon exercise of a SAR may be made at the discretion of the Committee either in cash or common stock or in a combination of cash and common stock. Provisions of the 1993 Plan generally provide that in the event of a change in control all options become immediately and fully exercisable and all restrictions lapse on restricted stock. As part of the 1993 Plan, each non-employee director of the Company receives a grant of NSOs for 3,000 shares of the Company's common stock on the first business day of September of each year ("Director Options"). Director Options have an exercise price of 100% of the fair market value of the Company's common stock on the trading day prior to the date of grant, vest as to one-third of the shares annually on the first three anniversary dates of the date of grant and expire 10 years after the date of grant. The first grant of the Director Options was made on September 1, 1993. The exercise price of an option (other than a Director Option) is determined by the Committee, provided that the exercise price shall not be less than 100% of the fair market value of a share of the Company's common stock on the date of grant. At December 31, 1993 there were no vested options which could have been exercised and 2,650,050 shares available for additional grants under the 1993 Plan. The 1993 Plan shall terminate on the tenth anniversary of the day preceding the date of its adoption by the Board and no option or award shall be granted under the 1993 Plan thereafter. Stock option activity from June 30, 1990 through December 31, 1993, including the exercise of GRiD options, is summarized in the accompanying chart. NOTE 16-PREFERRED SHARE PURCHASE RIGHTS In August 1986 the Board of Directors adopted a stockholder rights plan and declared a dividend of one right for each outstanding share of Tandy common stock. The Board amended the rights plan in June 1988 and amended and restated the rights plan in June 1990. The rights, which will expire on June 22, 2000, are currently represented by the common stock certificates and when they become exercisable will entitle holders to purchase one one-thousandth of a share of Tandy Series A Junior Participating Preferred Stock for an exercise price of $140 (subject to adjustment). The rights will become exercisable and will trade separately from the common stock only upon the date of public announcement that a person, entity or group ("Person") has acquired 15% or more of Tandy's outstanding common stock without the prior consent or approval of the disinterested directors ("Acquiring Person") or ten days after the commencement or public announcement of a tender or exchange offer which would result in any person becoming an Acquiring Person. In the event that any person becomes an Acquiring Person, the rights will be exercisable for 60 days thereafter for Tandy common stock with a prior market value (as determined under the rights plan) equal to twice the exercise price. In the event that, after any person becomes an Acquiring Person, the Company engages in certain mergers, consolidations, or sales of assets representing 50% or more of its assets or earning power with an Acquiring Person (or persons acting on behalf of or in concert with an Acquiring Person) or in which all holders of common stock are not treated alike, the rights will be exercisable for common stock of the acquiring or surviving company with a prior market value (as determined under the rights plan) equal to twice the exercise price. The rights will not be exercisable by any Acquiring Person. The rights are redeemable at a price of $.05 per right prior to any person becoming an Acquiring Person or, under certain circumstances, after the expiration of the 60-day period described above, but the rights may not be redeemed or the rights plan amended for 180 days following a change in a majority of the members of the Board (or if certain agreements are entered into during such 180-day period). NOTE 17-TERMINATION PROTECTION PLANS In August 1990, the Board of Directors of the Company approved termination protection plans and amendments to various other benefit plans including the stock purchase program and deferred salary and investment plan described in Note 13. These plans provide for defined termination benefits to be paid to eligible employees of the Company who have been terminated, without cause, following a change in control of the Company (as defined). In addition, for a certain period of time following employee termination, the Company, at its expense, must continue to provide on behalf of the terminated employee certain employment benefits. In general, during the twelve months following a change in control, the Company may not terminate or change existing employee benefit plans in any way which will affect accrued benefits or decrease the rate of the Company's contribution to the plans. NOTE 18-ISSUANCE OF SERIES C PERCS AND TENDER OFFER In February 1992, the Company issued 15,000,000 depositary shares of Series C Conversion Preferred Stock ("Series C PERCS") at $29.50 per depositary share (equivalent to $2,950.00 for each Series C PERCS). Each of the depositary shares represents ownership of 1/100th of a share of Series C PERCS. The annual dividend for each depositary share is $2.14 (based on the annual dividend rate for each Series C PERCS of $214.00). On April 15, 1995, each of the depositary shares will automatically convert into (i) one share of Tandy common stock (equivalent to 100 shares for each Series C PERCS) subject to adjustment in certain events and (ii) the right to receive on such date an amount in cash equal to all accrued and unpaid dividends thereon. Conversion of the outstanding depositary shares (and the Series C PERCS) is also required upon certain mergers or consolidations of the Company or in connection with certain other events. The Company has reserved 15,000,000 shares of its common stock for the potential conversion of the Series C PERCS. At any time and from time to time prior to the mandatory conversion date, the Company may call the outstanding Series C PERCS (and thereby the depositary shares), in whole or in part, for redemption. Upon any such redemption, each owner of depositary shares will receive, in exchange for each depositary share so called, shares of Tandy common stock having a market value initially equal to $43.87 (equivalent to $4,387.00 for each Series C PERCS), declining by $.004085 (equivalent to $.408500 for each Series C PERCS) on each day following the date of issue of the Series C PERCS to $39.50 (equivalent to $3,950.00 for each Series C PERCS) on February 15, 1995, and equal to $39.25 (equivalent to $3,925.00 for each Series C PERCS) thereafter, plus an amount in cash equal to all proportionate accrued and unpaid dividends thereon. The liquidation preference for each depositary share is $29.50 (equivalent to $2,950 for each Series C PERCS) plus any accrued and unpaid dividends. The holders of the Series C PERCS have the right, voting together with the common stockholders as one class, to vote in the election of directors and upon such other matters coming before any meeting of the stockholders and are entitled to cast 100 common stock votes for each Series C PERCS (or one common stock vote for each depositary share). Using a substantial portion of the proceeds from the issuance of the Series C PERCS, the Company purchased 13,500,000 shares of its common stock at $32.00 per share in a "Dutch Auction" self tender offer that expired on March 26, 1992. NOTE 19-SUPPLEMENTAL CASH FLOW INFORMATION The effects of changes in foreign exchange rates on cash balances have not been material. Cash flows from operating activities included cash payments as follows: During the fiscal year ended June 30, 1991, the Company incurred non-cash financing activities which included the guarantee of TESOP indebtedness and increase in unearned deferred compensation of $100,000,000 and treasury stock issued under an earn-out program of $13,807,000. NOTE 20-LITIGATION In July 1985, Pan American Electronics, Inc., a Radio Shack dealer in Mission, Texas ("Pan Am"), filed suit against the Company in the 92nd Judicial District Court in Hidalgo County, Texas. The Plaintiff's complaint alleged breach of contract and fraud based upon the allegations that the Company made certain misrepresentations and acted beyond the scope of its authority under the dealer agreement, with the alleged result that the plaintiff was forced out of the computer mail order business in 1984. In November 1993, Pan Am and Tandy resolved the pending litigation and the lawsuit was dismissed in December 1993. Although the terms of the settlement are confidential, the resolution of this legal action did not have a materially adverse impact on the Company's financial position or results of operation. There are various other claims, lawsuits, disputes with third parties, investigations and pending actions involving allegations of negligence, product defects, discrimination, patent infringement, tax deficiencies and breach of contract against the Company and its subsidiaries incident to the operation of its business. The liability, if any, associated with these matters was not determinable at December 31, 1993. While certain of these matters involve substantial amounts, and although occasional adverse settlements or resolutions may occur and negatively impact earnings in the year of settlement, it is the opinion of management that their ultimate resolution will not have a materially adverse effect on Tandy's financial position. NOTE 21-RELATIONS WITH INTERTAN InterTAN Inc. ("InterTAN"), the former foreign retail operations of Tandy, was spun off to Tandy stockholders as a tax-free dividend in fiscal 1987. Under the merchandise purchase terms of the original distribution agreement, InterTAN could purchase on payment terms from Tandy, at negotiated prices, new and replacement models of products that Tandy had in its Radio Shack U.S. catalog or which Tandy may reasonably secure. A&A International ("A&A"), a subsidiary of Tandy, was the exclusive purchasing agent for products originating in the Far East for InterTAN. On July 16, 1993 InterTAN had an account payable to Tandy of approximately $17,000,000 of which $7,600,000 was in default. InterTAN's outstanding purchase orders for merchandise placed under the distribution agreement with Tandy, but not yet shipped, totaled approximately $44,000,000. Because InterTAN had defaulted, on July 16 Tandy terminated the merchandise purchase terms of the distribution agreement and the license agreements. Tandy offered InterTAN interim license agreements which expired July 22, 1993, unless extended. These were extended on July 23, 1993. On July 30, 1993 Trans World Electronics, Inc. ("Trans World"), a subsidiary of Tandy, reached agreement with InterTAN's banking syndicate to buy approximately $42,000,000 of InterTAN's debt at a negotiated, discounted price. The closing of this purchase occurred on August 5, 1993, at which time Tandy resumed limited shipments to InterTAN and granted a series of short-term, interim licenses pending the execution of new license and merchandise agreements. The debt purchased from the banks has been restructured into a seven-year note with interest of 8.64% due semiannually beginning February 25, 1994 and semiannual principal payments beginning February 25, 1995 (the "Series A" note). Trans World has provided approximately $10,000,000 in working capital and trade credit to InterTAN. Interest on the working capital loan (the "Series B" note) of 8.11% is due semiannually beginning February 25, 1994 with the principal due in full on August 25, 1996. Trans World also has received warrants with a five-year term exercisable for approximately 1,450,000 shares of InterTAN common stock at an exercise price of $6.62 per share. As required by an agreement with Trans World, InterTAN filed a registration statement on January 21, 1994 seeking to register the warrants under the Securities Act of 1933. In addition to the bank debt purchased by Trans World and the working capital loan, InterTAN's obligations to Trans World included two additional notes for approximately $23,665,000 (the "Series C" note) and $24,037,000, (the "Series D" note) with interest rates of 7.5% and 8%, respectively. The notes represent the restructuring of InterTAN accounts payable for merchandise already shipped and require monthly interest payments. Also, InterTAN had obligations for purchase orders outstanding for merchandise ordered by A&A for InterTAN but not yet shipped totaling approximately $31,262,000 at December 31, 1993. All principal and interest on the Series C note was paid in full by December 31, 1993. As merchandise under existing outstanding purchase orders is shipped, A&A will invoice InterTAN and amounts owed will be assigned to Trans World and will increase the amount of the Series D note. The balance of the Series D note as of December 31, 1993 was approximately $7,500,000. All of Tandy's debt from InterTAN is secured by a first priority lien on substantially all of InterTAN's assets. A new merchandise agreement was reached with InterTAN in October 1993 which requires future purchase orders be backed by letters of credit posted by InterTAN. New license agreements have been negotiated which provide for a future royalty to Tandy. As required by the various agreements now existing between Tandy and InterTAN, InterTAN has obtained a bank revolving credit facility for Canadian $30,000,000 (U.S. $22,662,000 equivalent at December 31, 1993). Tandy has agreed with InterTAN's new banking agent, that in case of InterTAN's default on the bank credit line, Tandy will, at the option of the bank, purchase InterTAN's inventory and related accounts receivable at 50% of their net book value, up to the amount of outstanding bank loans, but not to exceed Canadian $60,000,000 (U.S. $45,324,000 equivalent at December 31, 1993). In that event, Tandy could foreclose on its first priority lien on InterTAN's assets. If Tandy fails to purchase the inventory and related accounts receivable of InterTAN from the bank, InterTAN's banking agent, upon notice to Tandy and expiration of time, can foreclose upon InterTAN's assets ahead of Tandy. As of December 31,1993 InterTAN owed Tandy an aggregate of $63,511,000. The current portion of the obligation approximates $11,650,000 and the non-current portion approximates $51,861,000. In 1993 Tandy has not recognized any accretion of discount on the note receivable from InterTAN resulting from the purchase of the bank debt at a discounted price but will commence accretion of such discount in 1994 due to InterTAN's financial results and payment history as of December 31, 1993. Accretion of this discount will be based on the effective interest rate method and will approximate $3,856,000 in 1994. During the year ended December 31, 1993, Tandy recognized approximately $93,315,000 of sales to InterTAN and interest income of $3,085,000. Tandy's sales to InterTAN totaled $90,130,000 during the six months ended December 31, 1992, $171,126,000 during fiscal 1992, and $160,024,000 during fiscal 1991. A&A will continue as the exclusive purchasing agent for InterTAN in the Far East on a commission basis. Commencing in March 1994 only the purchasing agent commission and sales by Tandy manufacturing plants to InterTAN will be recorded as sales. InterTAN purchases from third parties through A&A will no longer be recorded as sales reflecting the arrangement under the new merchandise agreement. Accordingly, management expects that reported sales by Tandy to InterTAN in 1994 will be considerably lower than in prior years, however, the earned income relating thereto will not be materially different. NOTE 22-QUARTERLY DATA (UNAUDITED) As the Company's operations are predominantly retail oriented, its business is subject to seasonal fluctuations with the December 31 quarter being the most significant in terms of sales and profits because of the Christmas selling season. During the quarter ended December 31, 1993, the Company recognized a gain, net of tax, from discontinued operations of approximately $15,822,000. This gain partially offsets the after-tax charge of $70,000,000 previously taken in the June 1993 quarter and reduces the loss on disposal of discontinued operations to approximately $54,178,000. The gain resulted from the better than anticipated sales price received for O'Sullivan partially offset by additional foreign currency translation losses and below plan operating results of the divested companies during the divestment period, net of related income tax adjustments. See Note 3 for further information on discontinued operations. During the quarter ended March 31, 1993, the Company adopted FAS 109 which changes the Company's method of accounting for income taxes from the deferred method to an asset and liability approach. The adjustments to the January 1, 1993 balance sheet to adopt FAS 109 totaled $13,014,000. This amount is reflected in 1993 net income as the cumulative effect of a change in accounting principle. See Note 2 for further information on Change in Accounting Principle - Provision for Income Taxes. During the quarter ended December 31, 1992, the Company provided pre-tax reserves of $48,000,000 and $39,500,000 for business restructuring relating to continuing and discontinued operations, respectively. See Note 4 for further information on restructuring and other charges. During the quarter ended June 30, 1992, the Company completed the sale of a Japanese subsidiary, the assets of which were primarily real estate. The pre-tax gain from this sale, including recognition of foreign currency translation adjustments, was $18,987,000. As discussed in detail in Note 2, income per share amounts and the weighted average of common and common equivalent shares outstanding for all quarters commencing with the quarter ending March 31, 1992 (date of issuance) through September 30, 1993 have been retroactively restated for the assumption that the PERCS will convert into 12,457,133 shares in lieu of the previously used 15,000,000 common shares based upon the Company's stock price at December 31, 1993. (1) FAS No. 52, "Foreign Currency Translation," requires that foreign fixed assets and related accumulated depreciation be translated into U.S. dollars at the rates in effect at the date of the balance sheet. The amounts shown in the "Other" column reflect the changes in currency values between the balance sheet dates. (1) FAS No. 52, "Foreign Currency Translation," requires that foreign fixed assets and related accumulated depreciation be translated into U.S. dollars at the rates in effect at the date of the balance sheet. The amounts shown in the "Other" column reflect the changes in currency values between the balance sheet dates. TANDY CORPORATION INDEX TO EXHIBITS Exhibit Number Description 2a Agreement for Purchase and Sale of Assets dated as of June 30, 1993 between AST Research, Inc., as Purchaser and Tandy Corporation, TE Electronics Inc., and GRiD Systems Corporation, as Sellers (without exhibits) (filed as Exhibit 2 to Tandy's July 13, 1993 Form 8-K filed on July 27, 1993, Accession No. 0000096289-93-000004 and incorporated herein be reference). 2b Amended and Restated Stock Exchange Agreement dated February 1, 1994 by and among O'Sullivan Industries Holdings, Inc., and TE Electronics Inc. 2c U.S. Purchase Agreement dated January 26, 1994 by and among O'Sullivan Industries Holdings, Inc., TE Electronics Inc. and the U.S. Underwriters which included Merrill Lynch & Co., Wheat First Butcher & Singer, The Chicago Dearborn Company and Rauscher Pierce Refsnes, Inc. 2d International Purchase Agreement dated January 26, 1994 by and among O'Sullivan Industries Holdings, Inc., TE Electronics Inc. and the U.S. Underwriters which included Merrill Lynch International Limited and UBS Limited. 3a(i) Restated Certificate of Incorporation of Tandy dated December 10, 1982 (filed as Exhibit 4A to Tandy's 1993 Form S-8 for the Tandy Corporation Incentive Stock Plan, Reg. No. 33-51603, filed on November 12, 1993, Accession No. 0000096289-93-000017 and incorporated herein by reference). 3a(ii) Certificate of Amendment of Certificate of Incorporation of Tandy Corporation dated November 13, 1986 (filed as Exhibit 4A to Tandy's 1993 Form S-8 for the Tandy Corporation Incentive Stock Plan, Reg. No. 33-51603, filed on November 12, 1993, Accession No. 0000096289-93-000017 and incorporated herein by reference). 3a(iii) Certificate of Amendment of Certificate of Incorporation, amending and restating the Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock dated June 22, 1990 (filed as Exhibit 4A to Tandy's 1993 Form S-8 for the Tandy Corporation Incentive Stock Plan, Reg. No. 33-51603, filed on November 12, 1993, Accession No. 0000096289-93-000017 and incorporated herein by reference). 3a(iv) Certificate of Designations of Series B TESOP Convertible Preferred dated June 29, 1990 (filed as Exhibit 4A to Tandy's 1993 Form S-8 for the Tandy Corporation Incentive Stock Plan, Reg. No. 33-51603, filed on November 12, 1993, Accession No. 0000096289-93-000017 and incorporated herein by reference). 3a(v) Certificate of Designation, Series C Conversion Preferred Stock dated February 13, 1992 (filed as Exhibit 4A to Tandy's 1993 Form S-8 for the Tandy Corporation Incentive Stock Plan, Reg. No. 33-51603, filed on November 12, 1993, Accession No. 0000096289-93-000017 and incorporated herein by reference). 3b Tandy Corporation Bylaws, restated as of August 4, 1993 (filed as Exhibit 4B to Tandy's Form S-8 for the Tandy Corporation Incentive Stock Plan, Reg. No. 33-51603, filed on November 12, 1993, Accession No. 0000096289-93-000017 and incorporated herein by reference). 4a Indenture, dated June 30, 1974, for 10% Subordinated Debentures due 1994. 4b Amended and restated Rights Agreement with the First National Bank of Boston dated June 22, 1990 for Preferred Share Purchase Rights. 4c(i) Revolving Credit Agreement between Tandy Credit Corporation, Tandy Corporation and Texas Commerce Bank, individually and as Agent for eleven other banks, dated as of June 17, 1991. 4c(ii) First Amendment to Revolving Credit Agreement between Tandy Credit Corporation, Tandy Corporation and Texas Commerce Bank, individually and as agent for eleven other banks, dated June 11, 1992. 4c(iii) Second Amendment to Revolving Credit Agreement between Tandy Credit Corporation, Tandy Corporation and Texas Commerce Bank National Association, individually and as agent for eleven other banks, dated June 8, 1993 (filed as Exhibit 4c(iii) to Tandy's Form 10-Q filed on November 16, 1993, Accession No. 0000096289-93-000018 and incorporated herein by reference). 4d Continuing Guaranty dated June 18, 1991 by Tandy of obligations of the Company in favor of the banks participating in the Revolving Credit Agreement. 4e Continuing Guaranty dated as of June 18, 1991 by Tandy Corporation in favor of holders of indebtedness issued by Tandy Credit Corporation that is or may be publicly traded and is rated by at least one nationally recognized rating agency. 10a* Salary Continuation Plan for Executive Employees of Tandy Corporation and Subsidiaries including amendment dated June 14, 1984 with respect to participation by certain executive employees, as restated October 4, 1990. 10b* Form of Executive Pay Plan Letters 10c* Post Retirement Death Benefit Plan for Selected Executive Employees of Tandy Corporation and Subsidiaries as restated June 10, 1991.10d 10d* Tandy Corporation Officers Deferred Compensation Plan as restated July 10, 1992. 10e* Special Compensation Plan No. 1 for Tandy Corporation Executive Officers, adopted in 1993. 10f* Special Compensation Plan No. 2 for Tandy Corporation Executive Officers, adopted in 1993. 10g* Special Compensation Plan for Directors of Tandy Corporation dated November 13, 1986. 10h* Director Fee Resolution. 10i* Tandy Corporation 1985 Stock Option Plan as restated effective August 1990. 10j* Tandy Corporation 1993 Incentive Stock Plan as restated October 14, 1993 (filed as Exhibit 4B to Tandy's Form S-8 for Tandy Corporation Incentive Stock Plan, Reg. No. 33-51603, filed on November 12, 1993, Accession No. 0000096289-93-000017 and incorporated herein by reference). 10k* Tandy Corporation Officers Life Insurance Plan as amended and restated effective August 22, 1990. 10l* Restated Trust Agreement Tandy Employees Supplemental Stock Program through Amendment No. III dated March 29, 199 (filed as Exhibit 10H to Tandy's Form 10-K/A-4 filed on September 3, 1993, Accession No. 0000096289-93-000011 and incorporated herein by reference). 10m* Forms of Termination Protection Agreements for (i) Corporate Executives, (ii) Division Executives, and iii) Subsidiary Executives. 10n* Tandy Corporation Termination Protection Plans for Executive Employees of Tandy Corporation and its Subsidiaries (i) the Level I and (ii) Level II Plans. 10o* Forms of Bonus Guarantee Letter Agreements with certain Executive Employees of Tandy Corporation and its Subsidiaries i) Formula, ii) Discretionary, and iii) Pay Plan. 10p* Form of Indemnity Agreement with Directors, Corporate Officers and two Division Officers of Tandy Corporation. 11 Statement of Computation of Earnings per Share 12 Statement of Computation of Ratios of Earnings to Fixed Charges 22 Subsidiaries 23 Consent of Independent Accountants _______________________ * Each of these exhibits is a "management contract or compensatory plan, contract, or arrangement".

732780_1993.txt

732780_1993

1993

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ITEM 3. LEGAL PROCEEDINGS OMI and its subsidiaries are not parties to any material pending legal proceedings for damages, or a related group of such proceedings, other than ordinary routine litigation incidental to the business. OMI is a party, as plaintiff or defendant, in a variety of lawsuits for damages arising principally from personal injuries or other casualties in the ordinary course of the maritime business. All such personal injury and casualty claims against OMI are fully covered by insurance (subject to deductibles which are not material). ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders of the Company during the fourth quarter of 1993. EXECUTIVE OFFICERS OF OMI Set forth below are the names, ages, position and office, term and year appointed of all of the Company's executive officers (including OMI Bulk Management Co., a division of the Company) as of March 22, 1994. There is no family relationship by blood, marriage or adoption (not more remote than first cousins) between any of the above individuals and any other executive officer or any OMI director. The term of office of each officer is until the first meeting of directors after the annual stockholders' meeting next succeeding his election and until his respective successor is chosen and qualified. There are no arrangements or understandings between any of the above officers and any other person pursuant to which any of the above was selected as an officer. Mr. Klebanoff has served as Chairman of the Board of the Company since 1983. The following are descriptions of other occupations or positions that the other executive officers of the Company have held during the last five years: Jack Goldstein was appointed President and Chief Executive Officer of the Company in April 1986. Chaim Barash was elected Senior Vice President/Operations of the Company in November 1986 and President of OMI Bulk Management Co. in October 1992. Vincent de Sostoa was elected Senior Vice President/Finance of the Company in January 1989. Fredric S. London was elected Senior Vice President of the Company in December 1991. He was elected Vice President of the Company in December 1988. Craig H. Stevenson was elected Senior Vice President/Chartering of the Company in August 1993. For five years prior thereto he was President of Ocean Specialty Tankers Corp., a marketing manager for several of the Company's chemical tankers. Enrico Fenzi was elected Vice President of the Company in September 1990. He was elected Assistant Vice President of the Company in January 1988. Kathleen C. Haines was elected Vice President of the Company in January 1994. She was elected Assistant Vice President and Controller in December 1992. Prior thereto, Ms. Haines was Assistant Controller. Richard Halluska was elected Vice President of the Company in July 1993. He was elected Assistant Vice President of the Company in December 1989. William A.G. Hogg was elected Vice President of the Company in January 1994. He was elected Assistant Vice President of the Company in June 1987. William Osmer was elected Vice President of the Company in January 1994. He was elected Assistant Vice President of the Company in December 1986. Anthony Naccarato was elected Vice President/Labor Relations of the Company in June 1987. Kenneth Rogers was elected Vice President of the Company in January 1994. He was elected Assistant Vice President of the Company in December 1990. Prior thereto, Mr. Rogers was Ship Manager. PART II ITEM 5. ITEM 5. MARKET FOR OMI CORP.'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS COMMON STOCK The Company listed for trading on the New York Stock Exchange all of its common stock on March 13, 1992 (NYSE-OMM). Previously, the Company's common stock initially traded on the over-the-counter market on January 4, 1984, began trading on the NASDAQ National Market System on February 18, 1986, and on January 27, 1989 was listed for trading on the American Stock Exchange. As of March 22, 1994, the number of holders of OMI common stock was approximately 5,533. PAYMENT OF DIVIDENDS TO SHAREHOLDERS On May 2, 1990, the Board of Directors of OMI voted to initiate a semi-annual dividend of $.05 per share of common stock. At the Company's annual meeting of shareholders on June 19, 1991, the Board approved an increase in its semi-annual dividend from $.05 to $.07 per share of common stock. The dividends were paid in 1990 at $.05 and 1991 and 1992 at $.07. On July 23, 1992, dividends were paid to shareholders of record on June 26, 1992, and subsequently, on January 21, 1993, to shareholders of record on December 28, 1992. On June 15, 1993, the Board voted to declare special dividends rather than adhere to a regular dividend policy. For the year ended December 31, 1993, there were no dividends declared. 1993 QUARTER 1st 2nd 3rd 4th High 5 5/8 6 1/4 7 7 Low 3 7/8 4 3/4 5 5/8 6 1/8 1992 QUARTER 1st 2nd 3rd 4th High 8 5/8 6 1/4 5 7/8 5 1/4 Low 5 3/4 4 1/4 3 5/8 3 3/8 Semi-annual dividends declared $0.07 $0.07 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA OMI CORP. AND SUBSIDIARIES ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OMI Corp. ("OMI" or the "Company"), is a highly diversified bulk shipping company active in both the U.S. flag and international markets. OMI also has interests in lightering services in the Gulf of Mexico through OMI Petrolink Corp. ("Petrolink"), in offshore drilling through an 8.8 percent interest in Chiles Offshore Corporation ("COC"), and in the workboat market, via a two percent interest in Seacor Holdings, Inc. Results of operations of OMI include operating activities of the Company's domestic and foreign flag wholly-owned vessels, leased vessels and vessels chartered-in. Revenues are derived from five principal markets: crude oil, refined petroleum, dry bulk, LPG and combination carrier. FISCAL YEARS 1993, 1992 AND 1991 NET VOYAGE REVENUES The Company's vessels are operating under a variety of charters and contracts. The nature of these arrangements is such that, without a material variation in net voyage revenues (voyage revenues less vessel and voyage expenses), the revenues and expenses attributable to a vessel deployed under one type of charter or contract can differ substantially from those attributable to the same vessel if deployed under a different type of charter or contract. Accordingly, depending on the mix of charters or contracts in place during a particular accounting period, the Company's voyage revenues and vessel and voyage expenses can fluctuate substantially from one period to another even if the number of vessels deployed, the number of voyages completed, the amount of cargo carried and the net voyage revenues derived from the vessels were to remain relatively constant. As a result, fluctuations in voyage revenues and expenses are not necessarily indicative of trends in profitability. The discussion below addresses variations in net voyage revenues. In the period between mid-1988 and the beginning of 1991, the majority of OMI's vessels operated under time charter agreements. Since 1991, however, rates for time charters have declined, and vessels completing long-term time charters in 1992 were shifted to the spot market rather than being committed to long-term charters at unfavorable rates. Under a time charter, the charterer assumes certain operating expenses, such as bunkers and port charges. The length of time charters usually ranges for a period of one to five years, which, if rates are satisfactory, gives the company a predictable revenue stream and reduces its exposure to the volatility of the rates in the spot market. Under a voyage ("spot") charter, most expenses are for the owner's account and the charters are generally short-term. Revenues may be higher in the spot market as the owner has to cover more costs. If rates in the spot market are not adequate, the Company may elect to lay the vessel up until rates improve. As a result of weak worldwide economic conditions and a lower demand for petroleum products beginning after the Persian Gulf war of 1991, spot rates have fluctuated. While market pressures have reduced revenues, operating costs have increased, partially due to regulatory changes and new environmental laws. A direct impact on OMI, as a result of the Oil Pollution Act of 1990, was a substantial increase in insurance costs in 1992, which have leveled off in 1993. The Company currently participates with seven of its American flag tanker and dry bulk vessels in a number of federal programs for the distribution of agricultural products. These programs were enacted and are controlled by Congress as an extension of U.S. foreign policy. If these programs were discontinued or modified, six American flag vessels, eligible for Operating-Differential Subsidy from the U.S. Government, would operate in international trades. The Company's voyage revenues include charter hire from the Military Sealift Command ("MSC") in the amounts of $192,000, $23,942,000 and $42,061,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company currently has only one vessel on a voyage charter to MSC due to cutbacks in military spending. Vessels, previously chartered by MSC, are operating in the commercial market with subsidy or in federal programs. Net voyage revenues decreased $10,299,000 or 16 percent for the year ended December 31, 1993 from the prior year. The net decrease resulted primarily from increased idle time between voyages for five domestic vessels (aggregating approximately 541 more offhire days in 1993 than in 1992) while continuing to incur port expenses and other daily expenses. The net decrease is also attributable to three domestic vessels operating in a profit sharing pool, four vessels operating on time charters were offhire a total of 144 days for drydocking, loss of revenue for two vessels disposed of, and reduced revenue from Petrolink resulting from reduced volume of its lightering operations in 1993 and the sale of seven workboats. Although the federal programs that the American flag tankers and dry bulk vessels participated in were successful during 1993, in 1994 these programs have been cut back by the U.S. Government. These vessels will operate in the spot market and will likely experience sporadic offhire days during 1994. The OMI Columbia began the first quarter with spot charters in the Alaskan North Slope trade and the Company anticipates further employment in late 1994. Two other vessels operating in the spot market in 1993 will continue operating in the spot market in 1994 at approximately the same rates. The majority of the foreign flag vessels are currently operating on time charters, five of which expire in 1994. Management expects that three of these vessels will be able to operate in the spot market at competitive rates for the balance of 1994. Two vessels were added to the foreign fleet in December 1993, which are operating under bareboat charters. During March 1994, OMI contracted to purchase a vessel for approx- imately $12,050,000, which will operate in the spot market. Net voyage revenues decreased $41,569,000 or 39 percent for the year ended December 31, 1992 from the prior year. The following factors were the primary cause of this decrease: thirteen vessels, for which time charters expired during the year, were placed in the spot market because replacement time charters were not available at acceptable rates; two vessels, which operated in the spot market in both 1992 and 1991, earned lower rates in 1992 than in the previous year; two domestic vessels were laid up during a portion of the year; market conditions affecting the workboat operations of Petrolink weakened; and insurance costs increased, in part, from regulatory and environmental law changes. Net voyage revenues increased $23,827,000 or 28 percent for the year ended December 31, 1991 over 1990. Net increases during 1991 resulted primarily because of the acquisition of the remaining 50.1 percent interest in a joint venture, on March 13, 1990, whose operations were consolidated with those of OMI for a full year during 1991 compared with nine months in 1990. Additionally, increased rates on time charters continuing from 1990 and revenues from a domestic vessel acquired in 1991 contributed to 1991 revenue increases. YEAR ENDED DECEMBER 31, 1993 VERSUS DECEMBER 31, 1992 VOYAGE REVENUES AND VESSEL AND VOYAGE EXPENSES Voyage revenues increased $5,936,000 or two percent, with net increases in domestic revenues of $2,223,000 and foreign revenues of $3,713,000 for the year ended December 31, 1993 compared to the year ended December 31, 1992. Domestic revenues increased primarily from improvement in spot rates earned for two vessels in 1993 over 1992, three vessels which incurred less offhire days in 1993 than in 1992 and the purchase of a new vessel in June 1993 which operates in the spot market, primarily in grain trades. Domestic revenue increases were offset by decreased volume and reduced rates in Petrolink's lightering operations due to increased competition in 1993, an accident which caused the loss of a vessel which had been operating on a time charter since December 1992, the scrapping of a vessel in October 1993, and decreases in revenues of two vessels, including the Company's largest domestic vessel, the OMI Columbia, which were idle during 1993 for an aggregate of approximately 330 days. The OMI Columbia's operating results had a significantly adverse effect on the Company's earnings for 1993. However, while there can be no assurance, the Company believes that conditions have stabilized and, early in 1994, several spot charters were obtained for this vessel at satisfactory charter rates. During 1991, the last year in which the vessel was fully employed, it generated approximately $14.7 million of revenue and $3.1 million of pre-tax income. In the two years prior thereto, revenues were approximately $15.2 million and $14.5 million, respectively, and pre-tax income was approximately $4.8 million in each period. In 1992 and 1993, the vessel generated approximately $9.3 million and $4.0 million of revenue and a pre-tax loss of $1.1 million and $1.3 million, respectively. The pre-tax income effect of the vessel's sporadic trading as against full employment has historically been about $5.0-$7.0 million per year. Foreign revenues increased primarily because three vessels, which operated on time charters for a portion of 1992 began operating in the spot market and received higher revenues in 1993. Revenues also increased because two vessels were chartered-in during the last quarter of 1993. Foreign increases were partially offset by decreases from three vessels which incurred 110 idle days due to drydocking. The three vessels were on time charters in 1993 and 1992. Vessel and voyage expenses increased by $16,235,000 or eight percent consisting of net increases in domestic expenses of $13,832,000 and foreign expenses of $2,403,000 for the year ended December 31, 1993 over the comparable year in 1992. Vessel and voyage expenses increased largely due to the change in charter status for four domestic vessels and four foreign vessels from time charters in 1992 to spot charters in 1993. Other increases in expenses relate to expenses for the domestic vessel acquired May 1993, 78 more operating days in 1993 for a vessel which was operating in the spot market in both 1993 and 1992, and lease payments on a vessel which was sold and leased back in November 1992. Increases in expenses were partially offset by decreases in expenses for three vessels which were operating in the spot market in 1992 and began time charters in 1993, decreased expenses from workboat operations of Petrolink due to the workboat sales, and decline in volume of approximately 11 percent in Petrolink's lightering operations. OTHER INCOME Other income consists primarily of management fees received from affiliates and/or other parties. During the year ended December 31, 1993, other income decreased $986,000, or 17 percent, for the year as compared to 1992. The decrease in 1993 resulted primarily from a payment of $1,000,000 from Wilomi, Inc. ("Wilomi") during the first quarter of 1992, which was paid in accordance with a contractual agreement relating to the construction contract of a vessel delivered, offset by increases from the U.S. Government for the management of vessels in the Ready Reserve Fleet under a contract renewed for 10 vessels in 1993. OTHER OPERATING EXPENSES The Company's operating expenses, other than vessel and voyage expenses, consist of depreciation and amortization, operating lease expense and general and administrative expenses. For the year ended December 31, 1993 these expenses had a net decrease of $992,000 or two percent, as compared to the year ended December 31, 1992. The primary causes of the decrease in 1993 in general and administrative expenses were a change in health insurance coverage for employees, a decrease in other employee benefits and a reduction in legal fees for transactions during 1993 in comparison to 1992. OTHER INCOME (EXPENSE) Other income (expense) consists of gain/loss on disposal of assets - - net, provision for writedown of investments, interest expense, interest income, and minority interest. For the year ended December 31, 1993, net other expense decreased $21,633,000, or 55 percent, over 1992. The net decrease resulted primarily from the writedown of $13,094,000 on COC stock during 1992. In addition, decreases during 1993 also resulted from the $2,190,000 gain from the sale of seven workboats of Petrolink, gain on sale of COC stock of $4,086,000 previously written down in 1992 and the decrease in interest expense resulting from both lower interest rates and a decrease in the outstanding principal balance of debt during the year prior to issuing $170,000,000 in Senior Notes in November 1993, offset in part by losses on the sale of a 50 percent owned joint venture and 25 percent equity investment aggregating approximately $1,554,000. (BENEFIT) PROVISION FOR INCOME TAXES The benefit for income taxes of $1,730,000 for the year ended December 31, 1993 varied from statutory rates in 1993 by excluding the tax effect on the equity in operations of joint ventures other than Amazon Transport, Inc. ("Amazon"), as management considers it to be permanently invested, and included the effect of the change in the Federal tax rate. On August 2, 1993, Congress passed the Omnibus Budget Reconciliation Act of 1993 (the "Act"). The major component of the Act affecting OMI is the retroactive increase in the marginal corporate tax rate from 34 percent to 35 percent, increasing the provision for deferred taxes payable by $3,044,000 to comply with the provisions of the Act. EQUITY IN OPERATIONS OF JOINT VENTURES Equity in operations of joint ventures of $5,544,000 was $3,515,000 or 39 percent lower in 1993 than in 1992. Joint venture equity was less in 1993 primarily due to a gain on sale of a vessel owned by Wilomi in April 1992, which increased OMI's equity by approximately $4,826,000. This decline, along with a decline in profits for the vessel owned by Amazon, resulting from the termination of its time charter in 1993 and lower profits being earned in the spot market, were offset by decreases in operating losses in 1993 compared to 1992 incurred by a partnership, Ecomarine USA, which was wrapping up during 1993, and increased equity in the operating results of White Sea Holdings Ltd., a joint venture formed during December 1992. YEAR ENDED DECEMBER 31, 1992 VERSUS DECEMBER 31, 1991 VOYAGE REVENUES AND VESSEL AND VOYAGE EXPENSE Voyage revenues decreased $20,958,000 or seven percent, with net decreases of $7,924,000 and $13,034,000 in the domestic and foreign fleets, respectively, for the year ended December 31, 1992 compared to the year ended December 31, 1991. The net decrease in domestic revenues consisted of an aggregate decrease of $16,404,000 offset by increases of $8,480,000. The decreases resulted from reduced revenues from Petrolink's workboat operations, the lay-up of two vessels and the sale of a vessel in May 1992. Increases in revenues resulted primarily from two vessels which were on time charters in both 1992 and 1991, one of which continued the charter through 1992 at an increased rate and one of which operated for 52 more days in 1992 as a result of offhire incurred for repairs in 1991. Increases in domestic revenues also resulted from three vessels that began operating in the spot market in 1992 which were on time charters in 1991. Also, three vessels managed by a joint venture received additional revenues in 1992 as a result of increased profit sharing. In the foreign fleet, the net decrease in voyage revenues resulted primarily from the expiration of three time charters which were replaced with both voyage and short-term time charters with less favorable rates throughout the year, reduction in rates for a vessel which was operating in the spot market since 1991, and two vessels chartered-in during 1991 which were not part of OMI's fleet during 1992. Vessel and voyage expenses increased $20,611,000 or 12 percent consisting of a $16,473,000 increase in expenses of domestic operations and a $4,138,000 net increase in foreign operations for the year ended December 31, 1992 over the comparable 1991 period. The increase in domestic vessel and voyage expenses resulted primarily from increased voyage expenses of four vessels, two of which were operating in the spot market in both 1992 and 1991, and two vessels which began operating in the spot market in 1992 that were previously on time charters. Other increases in expenses were incurred on four vessels continuing time charters from 1991 with overall increases in stores, crew and insurance costs. The net increase in foreign vessel and voyage expenses consisted of an aggregate increase of $9,825,000 offset by decreases of $5,687,000. The increases resulted primarily from five vessels previously on time charters in 1991, which began operating in the spot market in 1992, and similar to the domestic operations, increased vessel expenses on two vessels continuing time charters from 1991. Decreases in vessel and voyage expenses were attributable to the return of the chartered-in vessels. OTHER INCOME During the year ended December 31, 1992, other income increased $1,729,000, or 44 percent, over 1991. The increase in 1992 resulted primarily from a contractual payment of $1,000,000 from Wilomi relating to a vessel delivered in the first quarter of 1992. The remaining increase in 1992 relates to increases in management fees from the U.S. Government for management of the Ready Reserve Fleet. OTHER OPERATING EXPENSES Other operating expenses increased $2,678,000, or five percent, over 1991. The primary increases in 1992 resulted in increased general and administrative expense of $1,859,000 from the change in the ESOP calculation in the third quarter of 1991 and the addition of a London marketing office in January 1992. Additionally, depreciation and amortization increased $795,000 during 1992 resulting primarily from the acquisition during the fourth quarter of a previously leased vessel and capital improvements on existing vessels. OTHER INCOME (EXPENSE) For the year ended December 31, 1992, net other expense increased $12,067,000, or 44 percent, over 1991. During 1992 OMI deemed its investment in COC shares to have an other than temporary decline in its market value and provided for a writedown of $13,094,000, in addition to a $1,982,000 writedown of a partnership investment to the realizable value of the company's assets. Net loss of $1,146,000 resulted primarily from the loss on the sale of a domestic vessel and disposal of other property of $1,394,000 offset by net gains from the sale of investments and amortization of gain on sale from the sale/leaseback of a vessel. Additionally, during 1992, interest expense decreased $5,544,000 resulting from the decline in interest rates and refinancing of debt. EQUITY IN OPERATIONS OF JOINT VENTURES Equity in operations of joint ventures was $3,200,000, or 26 percent, lower during 1992 than in 1991. The net decrease for the year, excluding the gain on sale of vessels of $4,826,000 in 1992 and $5,940,000 in 1991, primarily resulted from lower rates and higher expenses on vessels which operated under voyage charters in 1992. Additionally, two vessels, which were under construction in 1991, were delivered to a 49 percent joint venture during March and August of 1992. These vessels operated on voyage charters while incurring some offhire days between charters. Additionally, income for the second half of 1992 declined by approximately $2,500,000 due to the drop in the spot market rates for five vessels operating in the spot market or on backhaul voyages to reposition the vessels. The average decline in rates for each of the vessels was approximately $2,800 per day, reflecting a cyclical decline in spot market rates. Moreover, OMI owned a 25 percent interest in an offshore drilling rig whose charter expired in 1991 and for which no revenues were derived in 1992. This accounted for 38 percent of the total decrease in equity for 1992. LIQUIDITY AND CAPITAL RESOURCES The Company's working capital at December 31, 1993 was $32,957,000 versus a working capital deficit of $21,133,000 at December 31, 1992. Cash and cash equivalents of $45,321,000 at December 31, 1993 increased $28,471,000 or 169 percent over the balance of $16,850,000 at December 31, 1992. In 1993, the source of the Company's liquidity was issuance of debt, including use of lines of credit, and cash generated by operations. For the year ended December 31, 1993, net cash provided by operating activities was $18,300,000, which was an increase of $6,314,000 or 53 percent from $11,986,000 provided in 1992. Net cash used by investing activities was $8,778,000 in 1993 versus $13,624,000 in 1992. The Company received dividends aggregating $11,823,000 in 1993 from certain joint ventures. Most joint venture earnings are considered to be permanently invested and are not available for distribution, and there is no certainty that the joint venture, the earnings of which are not considered to be permanently invested, will have sufficient earnings to pay dividends in the future. Therefore, the Company cannot rely on dividends or loans from its joint ventures to improve its liquidity. The Company operates in a capital intensive industry and augments cash generated by operating activities with debt in order to purchase ships. On November 3, 1993, the Company completed a public sale of $170,000,000, 10.25 percent Senior Notes due November 1, 2003 ("the Notes"). The Notes are unsecured obligations of the Company. The net proceeds of approximately $163,781,000, after deducting fees and expenses, were used to prepay outstanding indebtedness of approximately $98,000,000 and the balance is being used for general corporate purposes, including the acquisition of vessels. The consummation of the offering of the Notes gives the Company greater financial flexibility. The Company has improved its liquidity and financial position by (1) extending the average life of its indebtedness so that the average life more closely approximates the useful life of its vessels, (2) prepaying a portion of its long-term debt scheduled to come due between 1994 and 1998, (3) enhancing the Company's ability to benefit from improvements in industry conditions, and (4) positioning the Company to finance the acquisition of replacement and additional vessels. The Company believes that, based upon current levels of operations and anticipated improvements in charter market conditions, cash flow from operations together with other available sources of funds, including lines of credit aggregating $45,500,000, should be adequate to make required payments of principal and interest on the Company's debt, including the Notes, to permit anticipated capital expenditures and to fund working capital requirements. In addition to cash provided by operating activities and issuance of the Notes, OMI received cash from the following significant activities: *During 1993, Petrolink sold seven workboats and other property and received $3,750,000 in cash proceeds from the sale; the remaining proceeds were received in the form of stock and a note payable through March 1996. *OMI received cash proceeds of $68,153,000 from drawdowns on its lines of credit and $7,000,000 in mortgage notes during the year ended December 31, 1993. *OMI was reimbursed $5,734,000 by a joint venture, White Sea Holdings Ltd., formed during December 1992 for a vessel OMI had purchased on behalf of the venture. *The Company received $5,552,000 from the sale of 1,173,000 shares of COC stock, and $1,363,000 on the sale of its investment in Mundogas Orinoco Ltd. *The Company received insurance proceeds of approximately $7,000,000 for the loss of the OMI Charger. *OMI received $1,480,000 in proceeds from the scrapping of a vessel. During the year ended December 31, 1993, OMI made the following disbursements other than from operating activities: *Cash payments of $81,653,000 on short-term lines of credit, $6,910,000 on notes with joint ventures and approximately $135,718,000 payments on mortgage notes on vessels as of December 31, 1993. *Capital expenditures of $36,548,000 for the purchase of one domestic vessel in May 1993, the purchase of two foreign flag vessels in December 1993, improvements to vessels and other property, and the purchase of a workboat. *Cash dividends of $2,140,000 paid on OMI common stock. *Cash payments of $3,724,000 in the form of contributions to existing joint venture/partnership investments. COMMITMENTS On January 28, 1994, a vessel built in Japan for a joint venture was delivered for an aggregate purchase price of $38,479,000. OMI has committed, with a joint venture partner, to construct another vessel to be built in the Peoples Republic of China for a cost of approximately $54,400,000. The vessel is scheduled to be delivered in the second quarter of 1996. OMI acts as a guarantor for a portion of the debt incurred by joint ventures with affiliates of two of its joint venture partners. Such debt was approximately $102,869,000 at December 31, 1993 with OMI's share of such guarantees being approximately $49,594,000. OMI also is a guarantor for one of its joint venture's revolving line of credit of $4,000,000, with a guarantee to OMI from its joint venture partner of $2,000,000. The Company and its joint venture partners have committed to fund any working capital deficiencies which may be incurred by their joint venture investments. At December 31, 1993, no such deficiencies have been funded. EFFECTS OF INFLATION The Company does not consider inflation to be a significant risk to the cost of doing business in the current and foreseeable future. The Company has experienced some additions to the costs of operating the vessels due to price level increases, however, in some cases, the effect has been offset by charter escalation clauses. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA OMI CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Three Years Ended December 31, 1993 (All tabular amounts are in thousands of dollars) Note 1 - Summary of Significant Accounting Policies PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include all domestic and foreign subsidiaries which are more than 50 percent owned by OMI Corp. ("OMI" or the "Company"). All significant intercompany accounts and transactions have been eliminated in consolidation. Investments in joint ventures, in which the Company's interest is 50 percent or less and where it is deemed that the Company's ownership gives it significant influence over operating and financial policies, are accounted for by the equity method. Accordingly, net income includes OMI's share of the earnings of these companies. OPERATING REVENUES AND EXPENSES - Voyage revenues and expenses are recognized on the percentage of completion method of accounting based on voyage costs incurred to date to estimated total voyage costs. Estimated losses on voyages are provided for in full at the time such losses become evident. Special survey and drydock expenses are accrued and charged to operating expenses over the survey cycle, which is generally a two to three year period. FOREIGN CURRENCY TRANSLATION - Foreign currency translation adjustments were related to assets and liabilities of two wholly-owned subsidiaries, whose functional currency was Yen. In August 1990, the functional currency of these subsidiaries was changed to U.S. dollars. The cumulative translation adjustment at that time was $(4,912,000), net of deferred income taxes of $(2,530,000) and will remain at this amount until such assets are sold or disposed of. ACCOUNTING FOR INVESTMENTS IN EQUITY SECURITIES - The Company has elected early adoption of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115") as of December 31, 1993. As a result of the adoption of SFAS 115, the Company recorded an unrealized gain of $9,709,000, net of deferred taxes of $5,228,000, which is presented as a separate component of stockholders' equity. Adjustments are made to net income for any impairment in value that is deemed to be other than temporary. Prior to adoption of SFAS 115, equity securities were carried at the lower of cost or market. MARKETABLE SECURITIES - Marketable securities comprise the current portion of available-for-sale securities. Available-for-sale securities, both current and long-term, are carried at market value. Net unrealized gains or losses are reported as a separate component of stockholders' equity until realized. Realized gains and losses on the sales of securities are recognized in net income on the specific identification basis. CAPITAL CONSTRUCTION AND OTHER RESTRICTED FUNDS - The Capital construction fund is restricted to provide for replacement vessels, additional vessels or reconstruction of vessels built in the United States. The other restricted funds are to be used to pay certain of the Company's debt. These funds can be used at the discretion of the Company upon receipt of written approval from the Maritime Administration. VESSELS AND OTHER PROPERTY - Vessels and other property are recorded at cost. Depreciation for financial reporting purposes is provided principally on the straight-line method based on the estimated useful lives of the assets up to the assets' estimated salvage value. Salvage value is based upon a vessel's light weight tonnage multiplied by a scrap rate. Leasehold improvements are amortized on the straight-line method over the terms of the leases or the estimated useful lives of the improvements as appropriate. The Company periodically reviews the book value of its vessels and its ability to recover the remaining book value of the vessels using undiscounted cash flows over the remaining life of each vessel. GOODWILL - Goodwill, recognized in business combinations accounted for as purchases, of $17,868,000 before accumulated amortization of $2,559,000 and $1,858,000 at December 31, 1993 and 1992, respectively, is being amortized over 25 years. NET (LOSS) INCOME PER COMMON SHARE - Net (loss) income per common share is determined by dividing net (loss) income by the weighted average number of common shares outstanding during the period. Shares issuable upon the exercise of stock options (see Note 8) have not been included in the computation because they would not have a material effect on net (loss) income per common share. INCOME TAXES - OMI files a consolidated Federal income tax return which includes all its domestic subsidiary companies. Deferred income taxes are consistent with the provisions of the Financial Accounting Standards Board ("FASB") Statement No. 109, "Accounting for Income Taxes", which was adopted by the Company in 1992 (see Note 5). POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS - In December 1990, the FASB issued Statement No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", effective for fiscal years beginning after December 15, 1992. Adoption of this statement has not affected the Company's financial position or results of operations as the Company provides no postretirement benefits. During November 1992, the FASB issued Statement No. 112, "Employers' Accounting for Postemployment Benefits", effective for fiscal years beginning after December 15, 1993. Adoption of this statement is not expected to have any material effect on the Company's financial position or results of operations. CASH FLOWS - During the years ended December 31, 1993, 1992 and 1991, interest paid totalled approximately $20,647,000, $25,429,000 and $28,679,000, respectively. For the years ended December 31, 1993, 1992 and 1991, income taxes paid were approximately $6,413,000, $7,628,000 and $10,964,000, respectively. Cash equivalents represent liquid investments which mature within 90 days. The carrying amount approximates fair market value. For the years ended December 31, 1993, 1992 and 1991, noncash transactions, which have been excluded from the Consolidated Statements of Cash Flows, include the amortization of the receivable from ESOP of $361,000, $1,141,000 and $2,105,000, respectively (see Note 7), and accruals for capital expenditures of $115,000, $2,525,000 and $2,676,000, respectively. RECLASSIFICATION - Certain reclassifications have been made to the 1992 and 1991 financial statements to conform to the 1993 presentations. NOTE 2--INVESTMENTS IN JOINT VENTURES OMI's investments in joint ventures are accounted for using the equity method, under which the Company's share of earnings of these affiliates is reflected in income as earned and dividends are credited against the investment in joint ventures when received. The operating results of the joint ventures have been included in the accompanying consolidated financial statements on the following basis: OMI has entered into management service agreements with certain of its joint ventures, wherein the Company acts as technical and/or commercial manager for certain of the ventures' vessels. Management fees relating to services rendered to joint ventures aggregated $699,000, $567,000 and $589,000 for the years ended December 31, 1993, 1992 and 1991, respectively. During 1992, OMI received a $1,000,000 payment from Wilomi, which is included in other income. At December 31, 1993, Mosaic owned 893,800 shares of OMI common stock at an aggregate cost of $4,595,000, acquired on the open market between 1990 and 1992 at prices ranging from $3.56 to $7.34. During February 1994, Mosaic sold 300,000 shares of OMI stock at $7.19 per share. During 1993, 1992 and 1991, OMI chartered three vessels for $24,269,000, three vessels for $27,260,000 and four vessels for $29,964,000, respectively, to OSTC. These amounts are included in the revenue of OMI as the operations of OSTC are not consolidated with OMI. Summarized combined financial information pertaining to all affiliated companies accounted for by the equity method is as follows: During the fourth quarter of 1993, OMI recognized a $1,625,000 writedown of its investment in Ecomarine USA, which represents OMI's remaining interest in the partnership. In 1992, OMI wrote this investment down by $1,982,000. At December 31, 1992, OMI had receivables from affiliates of $13,775,000 consisting of $4,655,000 in dividends receivable from Amazon, $2,500,000 in dividends receivable from Wilomi, and $6,620,000 receivable for the purchase of a vessel on behalf of White Sea. These receivables were collected in 1993, with the exception of $886,000 from White Sea, which was contributed to the venture. The Company received dividends from Amazon of $4,410,000 and $258,000 from Aurora in 1993. Certain of the loan agreements to which the Company's joint ventures are party contain restrictive covenants requiring minimum levels of cash or cash equivalents, working capital and net worth, maintenance of specified financial ratios and collateral values, and restrict the ability of the joint ventures to pay dividends to the Company. The loan agreements described above also contain various provisions restricting the right of the joint ventures to make certain investments, to place additional liens on their property, to incur additional long-term debt, to make certain payments (including in certain instances, dividends), to merge or to undergo a similar corporate reorganization, and to enter into transactions with affiliated companies. NOTE 3--LONG-TERM DEBT AND CREDIT ARRANGEMENTS Long-term debt consisted of the following: In November 1993, the Company issued $170,000,000 in unsecured Senior Notes due November 1, 2003. The notes are not redeemable prior to November 1, 1998; thereafter, the notes are redeemable at the option of the Company at a premium until November 1, 2000 when the notes will be redeemable at face value, plus accrued interest. Bonds of domestic subsidiaries of OMI aggregating $36,390,000 and $48,176,000 at December 31, 1993 and 1992, including the amounts due within one year, are collateralized by mortgages on specific vessels and are guaranteed as to the principal and interest by the U.S. Government under the Title XI program. These security arrangements restrict these subsidiaries from, among other things, the withdrawal of capital, the payment of common stock dividends and the extending of loans to affiliated parties. At December 31, 1993, vessels with a net book value of $269,349,000, investments of $13,786,000 (included in Capital construction and other restricted funds in the accompanying balance sheets) and shares of a subsidiary and a joint venture with an aggregate carrying value of $22,420,000 have been pledged as collateral on available lines of credit with banks and long-term debt issues. Certain of the loan agreements of the Company's subsidiaries contain restrictive covenants requiring minimum levels of cash or cash equivalents, working capital and net worth, maintenance of specified financial ratios and collateral values, and restrict the ability of the Company's subsidiaries to pay dividends to the Company. The loan agreements described above also contain various provisions restricting the right of OMI and/or its subsidiaries to make certain investments, to place additional liens on the property of certain of OMI's subsidiaries, to incur additional long-term debt, to make certain payments, to merge or to undergo a similar corporate reorganization, and to enter into transactions with affiliated companies. As dividend payments are limited to 50 percent of net income earned subsequent to issuance of the Notes, none of the retained earnings at December 31, 1993 were available for payment of dividends. The maturities of the long-term debt for the five years following December 31, 1993 are as follows: 1994 $ 15,302 1995 19,131 1996 16,838 1997 14,608 1998 16,901 Thereafter 214,847 Total $297,627 At December 31, 1993, OMI had available and unused a total of $45,500,000 in five short-term lines of credit with banks at variable rates, based on LIBOR. OMI has entered into interest rate SWAP agreements to manage interest costs and the risk associated with changing interest rates. At December 31, 1993 and 1992, the Company had outstanding four and seven, respectively, interest rate SWAP agreements with commercial banks. These agreements effectively change the Company's interest rate exposure on floating rate loans to fixed rates ranging from 5.29 percent to 9.02 percent. The interest rate SWAP agreements have various maturity dates from December 1994 to February 1999. The changes in the notional principal amounts are as follows: Interest expense on interest rate SWAPS for the three years ended December 31, 1993, 1992 and 1991 was $2,914,000, $4,332,000 and $2,412,000, respectively. Gains on termination of SWAP agreements totalled $217,000 for the year ended December 31, 1993. There were no gains on terminations in 1992 or 1991. The Company is exposed to credit loss in the event of non-performance by other parties to the interest rate SWAP agreements. However, OMI does not anticipate non-performance by the counter-parties. NOTE 4--FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Company's financial instruments at December 31, are as follows: 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 the Company for debt of the same remaining maturities. The fair value of interest rate SWAPS (used for hedging purposes) is the estimated amount the Company would receive or pay to terminate SWAP agreements at the reporting date, taking into account current interest rates and the current credit-worthiness of the SWAP counter-parties. Securities available-for-sale included in Marketable securities, Capital construction and other restricted funds, and Long-term investments consisted of the following components: Excluded from the above schedule are 125,000 shares of Seacor Holdings, Inc., with a carrying value of $1,875,000, which are restricted from sale until February 1995, and in accordance with SFAS 115, are not included in securities available-for- sale. In 1992, OMI recognized a $13,094,000 loss provision as a charge against operations pertaining to the COC investment. The unrealized loss of $5,948,000, net of deferred taxes of $3,295,000, reflected in stockholders' equity in 1991, pertained to this investment. NOTE 5--INCOME TAXES A summary of the components of the (benefit) provision for income taxes is as follows: The (benefit) provision for income taxes varied from the statutory rates due to the following: The components of deferred income taxes payable - net relate to the tax effects of temporary differences as follows: In 1992, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes". There was no cumulative effect on the Company's financial position or results of operations from this change. Prior year's financial statements had not been restated for deferred income taxes and benefits which had been provided in accordance with the provisions of FASB Statement No. 96. The Company has not provided deferred taxes on its equity in the undistributed earnings of foreign corporate joint ventures accounted for under the equity method other than Amazon. These earnings are considered by management to be permanently invested in the business. If the earnings were not considered permanently invested, approximately $10,347,000 of additional deferred tax liabilities would have been provided at December 31, 1993. On August 2, 1993, Congress passed the Omnibus Budget Reconciliation Act of 1993, (the "Act"). The major component of the Act affecting OMI was the retroactive increase in the marginal corporate tax rate from 34 percent to 35 percent, increasing deferred taxes payable by $3,044,000 to comply with the provisions of the Act. NOTE 6--TREASURY STOCK During 1992, OMI purchased 639,000 shares of the Company's common stock at an aggregate price of $2,658,000. In addition, 666,000 shares were added to treasury from the ESOP (see Note 7) and 1,291,000 shares were retired. NOTE 7--EMPLOYEE STOCK OWNERSHIP PLAN In November 1987, OMI established an Employee Stock Ownership Plan ("ESOP"), effective January 1, 1987, for all eligible employees and approved a contribution of $400,000 toward the funding of the ESOP trust. In November 1987, the ESOP trust borrowed $9,600,000 from a bank, pursuant to a loan agreement guaranteed by OMI, which provided for 28 quarterly payments. OMI agreed to make annual contributions to the ESOP as necessary to repay the principal and interest on the ESOP's debt. The ESOP purchased 2,666,666 shares of common stock, at the same date, from OMI for $10,000,000. In February 1990, OMI expanded its 1987 ESOP Plan by purchasing 737,366 shares of OMI common stock for an aggregate purchase price of $7,558,000. OMI funded this purchase by amending the November 1987 loan agreement, providing for 24 quarterly installments at a rate of Prime plus .53 percent, with a final payment due November 1995. OMI's contribution to the ESOP had been used to make loan principal and interest payments. With each loan payment, a portion of the common stock had been released from the pledge to the bank and allocated annually to participating employees to the extent allowable by the Internal Revenue Code. On December 23, 1992, OMI repurchased 666,000 shares of OMI common stock from the ESOP trust at an aggregate cost of $6,825,000 and, correspondingly, reduced the receivable from ESOP by the same amount. During 1992, OMI reduced ESOP debt by scheduled payments of $1,141,000, and in July 1992 paid the remaining ESOP loan balance of $9,345,000. NOTE 8--STOCK OPTION AND RESTRICTED STOCK PLANS The Incentive Stock Option Plan ("ISO") of 1984 provides for the granting of options to acquire up to 600,000 shares of the Company's common stock. Options under this Plan are exercisable at the rate of 33 1/3 percent a year, commencing one year from the date of grant and expiring ten years after the date of grant. The Non-Qualified Stock Option Plan of 1986 provides for the granting of up to 500,000 shares at a price not less than fair market value at the date of grant. Options are exercisable at the rate of 20 percent per year, commencing one year from the date of grant, and expiring ten years after the date of grant. Stock Appreciation Rights ("SARs") have been granted in tandem with all options under this plan. Such rights offer recipients the alternative of electing to cancel the related stock option, and to receive instead an amount in cash, stock or a combination of cash and stock equal to the difference between the option price and the market price of the Company's stock on the date at which the SAR is exercised. Proceeds received from the exercise of the options are credited to the capital accounts. Compensation expense is recorded for options based on the difference between market price on the day exercised and option prices. Compensation expense relating to SARs is recorded with respect to the rights based upon the quoted market value of the shares and exercise provisions. Charges (benefits) to net income relating to SARs and/or options in 1993, 1992 and 1991 were $96,000, $(126,000) and $426,000, respectively. On June 12, 1990, the Board of Directors of OMI adopted, with shareholders' approval, the 1990 Equity Incentive Plan (the "1990 Plan"). The total number of shares of OMI common stock that may be optioned or issued as stock under this plan is 1,000,000 shares. The maximum number of issuable common stock is 300,000 shares, of which OMI awarded 15,000 shares and 254,000 shares in 1991 and 1990, respectively, to eligible key employees under this Plan. On January 27, 1993 and December 18, 1990, OMI granted 131,000 and 606,000 options, respectively, that are not intended to qualify as incentive stock options which are exercisable at a rate of 33 1/3 percent per year commencing one year from the date of grant, and expiring ten years after the date of grant. Upon issuance of restricted common stock under the 1990 Plan, unearned compensation, equivalent to the market value at the date of grant, is charged to stockholders' equity and subsequently amortized over the life of the award. A summary of the changes in shares under option for all plans is as follows: Number of Options Option Price Outstanding at January 1, 1991 1,162,833 $2.8125 to 9.875 Exercised (137,154) 2.8125 to 4.6875 Cancelled (108,000) 4.6875 to 5.125 Outstanding at December 31, 1991 917,679 2.8125 to 9.875 Exercised (6,000) 5.125 Forfeited (4,267) 4.6875 Outstanding at December 31, 1992 907,412 2.8125 to 9.875 Granted 131,000 4.50 Exercised (47,623) 2.8125 to 5.125 Forfeited (14,300) 5.125 to 9.875 Outstanding at December 31, 1993 976,489 $4.25 to 9.875 NOTE 9--RETIREMENT BENEFITS AND DEFERRED COMPENSATION In June 1993, the Company terminated its non-contributory defined benefit Pension Plan (the "Plan"). This termination resulted in a loss of $1,017,000, which the Company recognized in 1993. All participants of the Plan were fully vested as of the termination date. The settlement of the accumulated benefit obligation, through the purchase of annuity contracts for or lump-sum payments to participants by the Company, will be completed in 1994. In determining the actuarial present value of the projected benefit obligation as of December 31, 1993 and 1992, the weighted average discount used was 4.2 percent in 1993 (which approximates the rate expected to be used in settlement of these obligations in 1994) and 8.5 percent in 1992, and the rate of increase in future compensation expense was 5 percent in 1992. The expected long-term rate of return on Pension Plan assets was 8 percent in 1993 and 1992. Assets of the Plan primarily consist of Chase Domestic Liquidity Funds. The following table sets forth the Plan's funded status and amounts recognized by OMI at December 31: NOTE 11--ASSETS HELD FOR SALE In December 1992, OMI Petrolink Corp. ("Petrolink"), a subsidiary of the Company, entered into a contract to sell seven workboats for $7,500,000 for delivery in 1993. Petrolink received $3,750,000 in cash, notes receivable of $1,875,000 payable through March 31, 1996 and $1,875,000 in restricted stock of the purchaser. Gain on the sale was approximately $2,190,000. NOTE 12--DISPOSAL OF ASSETS In 1992, the Company entered into a sale/leaseback transaction on a vessel. The Company received $11,500,000 in cash, of which $3,500,000 was used to pay the mortgage on the vessel, a $2,000,000 secured note receivable due December 31, 1995, and a six-year lease at the current market rate. The gain of approximately $2,001,000 is being amortized over the term of the lease. The net gain (loss) for the year ended December 31, on disposal of assets consists of the following: During 1991, OMI sold marketable securities and other assets with a cost of $7,319,000, resulting in a net gain of $105,000. In October 1993, the Company's vessel, OMI Charger, which was at anchor without cargo outside Galveston, Texas, suffered explosions which caused the deaths of three persons and resulted in the total loss of the vessel. No environmental damage occurred. The Company's insurance covered the loss of the vessel and its protection and indemnity coverage is expected to cover property and personal injury claims. NOTE 13--FINANCIAL INFORMATION RELATING TO DOMESTIC AND FOREIGN OPERATIONS Presented below is certain information relating to OMI's operations: Investments in and net receivables from foreign subsidiaries amounting to $395,988,000, $274,109,000 and $287,343,000 at December 31, 1993, 1992 and 1991, respectively, have been excluded from domestic assets as they have been eliminated in consolidation. Voyage revenues included income from major customers as follows: NOTE 14--COMMITMENTS AND CONTINGENCIES OMI and certain subsidiaries are defendants in various actions arising from shipping operations. Such actions are covered by insurance or, in the opinion of management, after review with counsel, are of such nature that the ultimate liability, if any, would not have a material adverse effect on the consolidated financial statements. In September 1988, the Board of Directors adopted a Separation Allowance Program providing for severance benefits to all non-union employees other than non-resident aliens, leased employees, directors who are not employees of the Company or employees with individual severance plans in the event there is a change of control in OMI and such employees are thereafter terminated without cause or transferred or their position is significantly changed. Severance benefits include a lump-sum payment equal to the employee's average monthly wages immediately prior to the date of termination times the lesser of 24 or one for each year of full-time employment by the Company (but not less than six). The Company has employment agreements with five key officers. Each of the employment agreements provide that if the employee is terminated without cause, voluntarily terminates his employment within 90 days of a relocation or reduction in compensation or responsibilities, dies or is disabled, such employee will continue to receive base salary (plus a portion of his incentive bonus for the year in which termination occurs) and other benefits until December 31, 1994 or twelve months from the date of termination, whichever is later. In addition, if any such employee is terminated without cause (other than for reasons of disability) within three years of a Change of Control (as defined in the Company's Separation Allowance Program), the Company will pay such employee an amount equal to three times the sum of his then current base salary and his maximum incentive bonus. The aggregate commitment for future salaries, excluding bonuses, under these employment agreements is approximately $1,328,000 at December 31, 1993. The maximum contingent liability for salary and incentive compensation in the event of a change in control is approximately $3,574,000 at December 31, 1993. The Company is in the process of revising its employment agreements and contracts with additional key employees. OMI has committed, with a joint venture partner, to construct a vessel to be built in the Peoples Republic of China for a cost of approximately $54,400,000. The vessel is scheduled to be delivered in the second quarter of 1996. OMI acts as a guarantor for a portion of the debt incurred by joint ventures with affiliates of two of its joint venture partners. Such debt was approximately $102,869,000 at December 31, 1993 with OMI's share of such guarantees being approximately $49,594,000. OMI also is a guarantor for one of its joint venture's revolving line of credit of $4,000,000, with a guarantee to OMI from its joint venture partner of $2,000,000. The Company and its joint venture partners have committed to fund any working capital deficiencies which may be incurred by their joint venture investments. At December 31, 1993, no such deficiencies have been funded. NOTE 15--SUBSEQUENT EVENT On January 28, 1994, a vessel built in Japan for a joint venture was delivered for an aggregate purchase price of $38,479,000. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of OMI Corp.: We have audited the accompanying consolidated balance sheets of OMI Corp. and its subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, 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 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 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 the 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. 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 New York, New York February 18, 1994 ITEM 8. SUPPLEMENTARY DATA QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) ITEM 8. FINANCIAL SCHEDULES OMI CORP. AND SUBSIDIARIES SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES (OTHER THAN RELATED PARTIES) DECEMBER 31, 1993 (IN THOUSANDS) Balance at Balance at Beginning End Affiliate of Year Additions Deletions of Year Amazon Transport, Inc. $ 4,655 $ -0- $ 4,655 $ -0- Wilomi, Inc. 2,500 -0- 2,500 -0- White Sea Holdings Ltd. 6,620 -0- 6,620 -0- Total $ 13,775 $ -0- $ 13,775 $ -0- [FN] The Company received $5,734 from White Sea Holdings, Inc. during 1993 and the remaining balance was recorded as a capital contribution. SCHEDULE III SCHEDULE III SCHEDULE III OMI CORP. NOTES TO CONDENSED FINANCIAL STATEMENTS 1. The condensed financial statements, hereto reflect OMI Corp. ("OMI") parent only, balance sheets, statements of operations and statements of cash flows. All domestic and foreign subsidiaries which are more than 20% owned and investments in joint ventures are accounted for by the equity method. See Notes to Consolidated Financial Statements on pages 35 through 53 of OMI's 1993 Form 10K. Certain reclassifications have been made to the 1992 financial statements to conform to the 1993 presentations. 2. Long-Term Debt Long-term debt as of December 31, 1993 and 1992 consisted of the following: In November 1993, the Company issued $170,000,000 in unsecured Senior Notes due November 1, 2003. The notes are not redeemable prior to November 1, 1998; thereafter, the notes are redeemable at the option of the Company at a premium until November 1, 2000 when the notes will be redeemable at face value, plus accrued interest. 3. Lines of Credit At December 31, 1992, the Company had $7,000,000 in short-term notes payable to banks representing borrowings against lines of credit established with a bank. At December 31, 1993, the Company had available and unused $35,500,000 in four lines of credit at variable rates, based on LIBOR. SCHEDULE X OMI CORP. AND SUBSIDIARIES SUPPLEMENTAL INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) CHARGED TO EXPENSE: Item 1993 1992 1991 Maintenance & Repair $21,410 $14,010 $16,962 WILOMI, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 NOTES 1993 1992 ASSETS CURRENT ASSETS: Cash (including cash equivalents of $2,400,000 in 1993 and $1,500,000 in 1992) 2 $ 7,013,960 $ 3,342,896 Advances to masters 89,026 63,823 Accounts receivable 925,328 1,032,323 Other receivables 352,930 704,988 Notes due from affiliate 4 2,755,102 2,500,000 Prepaid expenses 922,827 972,533 Total current assets 12,059,173 8,616,563 RECEIVABLES FROM AFFILIATES 4 225,192 VESSELS (net of accumulated depreciation of $10,069,152 in 1993 and $5,259,704 in 1992) 2,3 120,682,447 125,438,232 NOTES DUE FROM AFFILIATES 4 16,409,898 19,165,000 OTHER ASSETS 1,098,586 763,753 TOTAL ASSETS $150,475,296 $153,983,548 See notes to consolidated financial statements. NOTES 1993 1992 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 408,002 $ 339,083 Accrued expenses 2,261,056 1,225,868 Accrued interest payable 1,562,057 1,339,786 Due to affiliate 4 2,500,000 Current portion of long-term debt 6,064,000 5,887,000 Total current liabilities 10,295,115 11,291,737 PAYABLES TO AFFILIATES 4 2,168,126 ADVANCE TIME CHARTER REVENUES AND OTHER LIABILITIES 500,656 458,029 LONG-TERM DEBT 5 90,283,000 96,347,000 STOCKHOLDERS' EQUITY: Common stock - $1.00 par value; 10,000 shares authorized and outstanding 10,000 10,000 Capital surplus 1,080,577 1,080,577 Retained earnings 48,305,948 42,628,079 Total stockholders' equity 49,396,525 43,718,656 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $150,475,296 $153,983,548 WILOMI, INC. AND SUBSIDIARIES WILOMI, INC. AND SUBSIDIARIES WILOMI, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. COMPANY Wilomi, Inc. and subsidiaries (the "Company" or "Wilomi") are jointly-owned by Universal Bulk Carriers, Inc. ("UBC"), a wholly- owned subsidiary of OMI Corp. ("OMI"), and K/S Wilhelmsen Transport and Trading A/S ("Wilhelmsen") with interests of 49 and 51 percent respectively. On August 9, 1992, OMI transferred its 49 percent investment in Wilomi to its wholly-owned subsidiary, UBC. The joint venture, incorporated on May 15, 1987, owns and operates commercial vessels. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION - The consolidated financial statements include all subsidiaries of the Company. All significant intercompany accounts and transactions have been eliminated in consolidation. OPERATING REVENUES AND EXPENSES - Voyage revenues and expenses are recognized on the percentage-of-completion method of accounting based on voyage costs incurred to date to estimated total voyage costs. Estimated losses on voyages are provided in full at the time such losses become evident. Special survey and drydock expenses are accrued and charged to operating expenses over the survey cycle, which is generally a three year period. VESSELS AND VESSELS UNDER CONSTRUCTION - Vessels are recorded at cost; including interest on funds borrowed to finance the construction of new vessels. Interest of $594,893 and $2,088,081 was capitalized during the years ended December 31, 1992 and 1991, respectively. Depreciation is provided on the straight-line method based on the estimated useful lives of the vessels, up to the vessel's estimated salvage value. Salvage value is based upon the vessel's light weight tonnage, multiplied by a scrap rate. The Company periodically reviews the book value of its vessels and its ability to recover the remaining book value of the vessels using undiscounted cash flow over the remaining life of each vessel. FEDERAL INCOME TAXES - No provision has been made for Federal income taxes. The income of the Company is not generally subject to tax as a result of various provisions of the Internal Revenue Code. Additionally, the country in which the Company is incorporated exempts shipping and maritime operations from taxation. CASH FLOWS - Cash equivalents represent liquid investments that equal fair market value and mature within 90 days. During the years ended December 31, 1993, 1992 and 1991, the Company paid interest of $4,605,435, $4,097,261 and $5,178,645, respectively. The Company paid no taxes in 1993, 1992 or 1991. 3. VESSELS AND VESSELS UNDER CONSTRUCTION In November 1993, the Company entered into an agreement to construct a new vessel at an approximate cost of $54,000,000. The vessel is expected to be delivered in 1996. During 1992, the Company took delivery of three vessels which had been under construction in 1991. One vessel, with total costs of $37,681,683, was sold in April, 1992 at a gain of $9,848,317. In July 1991, a vessel with total construction costs of $36,858,043 was delivered to the Company. This vessel was sold in September 1991 for a gain of $12,050,416. 4. RELATED PARTY TRANSACTIONS OMI acted as technical and commercial manager for two vessels owned during 1993 and three vessels owned during 1992 and 1991. Management fees to OMI relating to years ended December 31, 1993, 1992 and 1991 were $288,000, $255,827 and $277,034, respectively. Wilhelmsen acted as manager for one vessel owned during 1993. Management fees to Wilhelmsen for the year ended December 31, 1993 were $144,000. The Company declared dividends of $5,102,041 and $1,000,000 in 1992. Notes due from affiliates in 1993 of $19,165,000 bear interest at 6.5 percent. During 1992, notes due from affiliates of $19,165,000 and $2,500,000 accrued interest at 6.5 percent and 6.3 percent, respectively. In 1992, the Company forgave $2,602,041 of the note due from Wilhelmsen in lieu of payment of the dividend. Notes due from affiliates of $5,500,000 in 1991 bear interest at 6.3 percent. Interest income on these notes amounted to $1,263,000, $836,000 and $25,000 for the years ended December 31, 1993, 1992 and 1991, respectively. In accordance with an agreement between UBC and Wilhelmsen, UBC is entitled to receive $1,000,000 upon delivery of each vessel that was contracted for or under construction at the time the joint venture was formed. In 1992, Wilomi took delivery on a new building subject to this agreement. Accordingly, Wilomi paid a dividend of $1,000,000 to UBC in 1992. 5. LONG-TERM DEBT Long term debt at December 31, 1993 and 1992 consisted of the following: The maturities of the mortgage notes payable, for each of the five years following December 31, 1993, are as follows: 1994 $ 6,064,000 1995 6,446,000 1996 6,654,000 1997 6,879,000 1998 7,122,000 Thereafter 63,182,000 Total $ 96,347,000 At December 31, 1993, the Company had available $10,000,000 in a short-term line of credit with a bank at a variable rate based on LIBOR. The fair market value of long-term debt at December 31, 1993 is equal to its carrying value. During 1992, credit line draw-downs on two vessels which were under construction during 1991 were refinanced with bank loans totaling $83,960,000. Additionally, a mortgage note on a vessel was refinanced in the amount of $19,300,000. 6. COMMITMENTS AND CONTINGENCIES The Company acts as a guarantor on debt incurred by an affiliated company. Such debt was $4,000,000 at December 31, 1993. INDEPENDENT AUDITORS' REPORT To the Shareholders of Wilomi, Inc. and Subsidiaries: We have audited the accompanying consolidated balance sheets of Wilomi, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related statements of consolidated income and retained earnings 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 Companies' 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 financial statements present fairly, in all material respects, the financial position of the 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. Deloitte & Touche New York, New York February 18, 1994 AMAZON TRANSPORT, INC. BALANCE SHEETS DECEMBER 31, 1993 and 1992 NOTES 1993 1992 ASSETS CURRENT ASSETS: 2 Cash and cash equivalents $ 7,873,324 $11,155,370 Advances to masters 31,971 137,417 Receivables: Traffic 530,721 Other 107,258 331,606 Prepaid expenses and other current assets 497,579 279,184 Total current assets 9,040,853 11,903,577 VESSEL AT COST: 2 Vessel 21,394,270 21,272,767 Less accumulated depreciation 4,906,994 4,293,358 Vessel - net 16,487,276 16,979,409 RECEIVABLE FROM AFFILIATE 3 4,410,000 OTHER ASSETS 5,866 73,712 TOTAL ASSETS $25,533,995 $33,366,698 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES - Accounts payable and accrued liabilities $ 2,113,435 $ 833,033 PAYABLE TO AFFILIATES 3 14,707 4,695,025 ADVANCED TIME CHARTER REVENUE 511,897 STOCKHOLDERS' EQUITY: Common stock - $5.00 par value; authorized 5,000 shares, outstanding 180 shares 900 900 Capital surplus 21,194,085 21,194,085 Retained earnings 2,210,868 6,131,758 Total stockholders' equity 23,405,853 27,326,743 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $25,533,995 $33,366,698 See notes to financial statements. AMAZON TRANSPORT, INC. AMAZON TRANSPORT, INC. AMAZON TRANSPORT, INC. NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. ORGANIZATION Amazon Transport, Inc. (the "Company" or "Amazon") is jointly owned by Universal Bulk Carriers, Inc. ("UBC"), a wholly-owned subsidiary of OMI Corp. ("OMI"), and Bergesen d.y. A/S ("Bergesen") with interests of 49 and 51 percent, respectively. The Company began operating as a joint venture on December 3, 1988 for the purpose of owning and chartering commercial vessels. The Company owned and operated one vessel, the Settebello, for all periods presented. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Operating Revenues and Expenses - Voyage revenues and expenses are recognized on the percentage-of-completion method of accounting. Estimated losses are provided in full at the time such losses become evident. Vessel - The vessel is recorded at cost. Depreciation is provided on the straight-line method based on the estimated useful life of the vessel up to the estimated salvage value. Salvage value is based upon the scrap value of the vessel's light weight tonnage. The Company periodically reviews the book value of its vessel and its ability to recover the remaining book value of the vessel using undiscounted cash flows over the remaining life of the vessel. Federal Income Taxes - No provision has been made for Federal income taxes. The income of the Company is not generally subject to tax as a result of various provisions of the Internal Revenue Code. Additionally, the country in which the Company is incorporated exempts shipping and maritime operations from taxation. Cash Flows - Cash equivalents represent liquid investments which mature within 90 days. The Company paid no interest or taxes in 1993, 1992 and 1991. 3. RELATED PARTY TRANSACTIONS The Company has entered into management service agreements with OMI and Bergesen, who act as technical and commercial managers of the Settebello. The Company paid OMI and Bergesen management fees of $200,000 for each of the years ended December 31, 1993, 1992, and 1991. The following table summarizes balances receivable from or due to affiliated companies at December 31: 1993 1992 Receivable from affiliate: OMI $4,410,000 Payable to affiliates: OMI $ 14,646 $ 29,281 UBC 61 4,657,572 Bergesen 8,172 $ 14,707 $4,695,025 During 1992, the Company issued 6.5 percent notes in the amounts of $4,410,000 and $4,590,000 to OMI and Bergesen, respectively. Interest earned on these notes aggregated $391,068. On December 31, 1992, the Company forgave the $4,590,000 note due from Bergesen and $199,443 of related interest in lieu of payment of a portion of the dividend. (See Note 4). 4. DIVIDENDS During 1993, the Company declared and paid a $9,000,000 dividend. The Company also paid $4,655,000 of 1992 dividends during the year. During 1992, the Company declared dividends of $9,500,000 of which $55,557 was paid. During 1991, the Company paid dividends of $12,000,000 to UBC and Bergesen. INDEPENDENT AUDITORS' REPORT To the Shareholders of Amazon Transport, Inc.: We have audited the accompanying balance sheets of Amazon Transport, Inc. as of December 31, 1993 and 1992 and the related statements of operations and retained earnings 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 accompanying 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. Deloitte & Touche New York, New York February 18, 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 OMI Pursuant to General Instruction G(3) the information regarding directors called for by this item is hereby incorporated by reference from OMI's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. Certain information relating to Executive Officers of the Company appears at the end of Part I of this Form 10-K Annual Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G(3) the information called for by this item is hereby incorporated by reference from OMI's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G(3) the information called for by this item is hereby incorporated by reference from OMI's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G(3) the information called for by this item is hereby incorporated by reference from OMI's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. PART IV ITEM 14. ITEM 14. FINANCIAL STATEMENT SCHEDULES, EXHIBITS, REPORTS ON FORM 8-K AND FINANCIAL STATEMENTS OF AFFILIATES (a) Financial Statements and Financial Statement Schedules 1. Financial Statements: OMI Corp. and Subsidiaries Consolidated Statements of Operations for the three years ended December 31, 1993. OMI Corp and Subsidiaries Consolidated Balance Sheets at December 31, 1993 and 1992. OMI Corp. and Subsidiaries Consolidated Statements of Cash Flows for the three years ended December 31, 1993. OMI Corp. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity for the three years ended December 31, 1993. OMI Corp. and Subsidiaries Notes to Consolidated Financial Statements for the three years ended December 31, 1993. OMI Corp. and Subsidiaries Quarterly Results of Operations for 1993 and 1992. 2. Financial Statement Schedules: II -- OMI Corp. and Subsidiaries Amounts Receivable from Related Parties and Underwriters, Promotors and Employees (Other than Related Parties) at December 31, 1993. III -- OMI Corp. (Parent only) Condensed financial information as to financial position as of December 31, 1993 and 1992, and statements of cash flows and results of operations for the years ended December 31, 1993, 1992 and 1991. V -- OMI Corp. and Subsidiaries Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991. VI -- OMI Corp. and Subsidiaries Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991. X -- OMI Corp. and Subsidiaries Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991. 3. Exhibits (b) Reports on Form 8-K. None. (d) Financial Statements of Affiliates: Wilomi Inc. and Subsidiaries Consolidated Balance Sheets at December 31, 1993 and 1992, and Related Statements of Consolidated Income and Retained Earnings, and Cash Flows for each of the three years in the period ended December 31, 1993 and Independent Auditors' Report. Amazon Transport, Inc. Balance Sheets at December 31, 1993 and 1992 and Related Statements of Operations and Retained Earnings, and Cash Flows for each of the three years in the period ended December 31, 1993 and Independent Auditors' 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. OMI CORP. By /s/ Jack Goldstein JACK GOLDSTEIN President, Chief Executive 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 dates indicated. SIGNATURE TITLE /s/ Michael Klebanoff Chairman of the Board March 22, 1994 MICHAEL KLEBANOFF and Director President, Chief March 22, 1994 /s/ Jack Goldstein Executive Officer, JACK GOLDSTEIN and Director /s/ Chaim Barash Senior Vice President March 22, 1994 CHAIM BARASH and Director /s/ Livio Borghese Director March 22, 1994 LIVIO BORGHESE /s/ C.G. Caras Director March 22, 1994 C.G. CARAS /s/ Steven D. Jellinek Director March 22, 1994 STEVEN D. JELLINEK /s/ Emanuel L. Rouvelas Director March 22, 1994 EMANUEL L. ROUVELAS /s/ Franklin W.L. Tsao Director March 22, 1994 FRANKLIN W.L. TSAO /s/ George W. Vlandis Director March 22, 1994 GEORGE W. VLANDIS Senior Vice President, March 22, 1994 /s/ Vincent J. de Sostoa Treasurer and Chief VINCENT J. DE SOSTOA Financial Officer

9548_1993.txt

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9548

ITEM 3 LEGAL PROCEEDINGS - ------ ----------------- See "Financial Difficulties of Significant Customer" above and Note 9 to the Company's Financial Statements, which are incorporated herein by reference, for a discussion of bankruptcy proceedings relating to a large customer of the Company. See Note 9 to the Company's Financial Statements for a discussion of potential liabilities under the Comprehensive Environmental Response, Compensation, and Liability Act. 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 - ------ --------------------------------------------------- As of December 31, 1993, there were 7,511 holders of record of the Company's common stock. The Company's common stock is traded on the New York Stock Exchange ("NYSE") under the symbol "BGR". The following table sets forth the high and low prices for the Common Stock as reported by the NYSE. The prices shown do not include commissions. Dividends are declared quarterly. DIVIDENDS DECLARED FISCAL PERIOD HIGH LOW PER SHARE - ------------- ------ ------- --------- - ---- First Quarter................ $18 1/8 $17 1/4 $.33 Second Quarter............... 18 1/4 17 1/4 .33 Third Quarter................ 19 7/8 17 3/4 .33 Fourth Quarter............... 20 1/4 18 1/4 .33 - ---- First Quarter................ $24 1/8 $17 7/8 $.33 Second Quarter............... 23 5/8 19 5/8 .33 Third Quarter................ 23 1/8 20 7/8 .33 Fourth Quarter............... 21 3/8 18 1/8 .33 - ---- First Quarter (through March 21, 1994)... $19 $16 3/4 $.33 NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION The Consolidated Financial Statements of Bangor Hydro-Electric Company (the "Company") include its wholly owned subsidiaries, Penobscot Hydro Co., Inc. ("PHC"), and Bangor Var Co., Inc. ("BVC"). The operations of PHC consist solely of a 50% interest in Bangor-Pacific Hydro Associates ("BPHA"), the owner and operator of the redeveloped West Enfield hydroelectric station. PHC accounts for its investment in BPHA under the equity method. BVC was incorporated in 1990 to own the Company's 50% interest in a partnership which owns certain facilities used in the Hydro-Quebec Phase II transmission project in which the Company is a participant. BVC accounts for its investment in the partnership under the equity method. All significant intercompany balances and transactions have been eliminated. The accounts of the Company are maintained in accordance with the Uniform System of Accounts prescribed by the regulatory bodies having jurisdiction. EQUITY METHOD OF ACCOUNTING The Company accounts for its investments in the common stock of Maine Yankee Atomic Power Company ("Maine Yankee") and Maine Electric Power Company, Inc. ("MEPCO") under the equity method of accounting, and records its proportionate share of the net earnings of these companies (substantially all of these earnings are paid out in dividends) as a reduction of purchased power capacity costs. See Note 7 for additional information with respect to these investments. ELECTRIC OPERATING REVENUE Electric Operating Revenue consists primarily of amounts charged for electricity delivered to customers during the period. The Company records unbilled revenue, based on estimates of electric service rendered and not billed at the end of an accounting period, in order to match revenue with related costs. The Federal Energy Regulatory Commission ("FERC") requires utilities to reclassify to operating revenue sales transactions related to power pool and interconnection agreements and resales of purchased power previously netted within fuel and purchased power expense. The reclassification increased total operating fuel revenue by $15.3 million in 1993, $13.8 million in 1992 and $15.7 million in 1991, while increasing fuel and purchased power expense by the same amounts. DEFERRED FUEL AND PURCHASED POWER CAPACITY ACCOUNTING The Company utilizes deferred fuel accounting. Under this accounting method, retail fuel costs are expensed when recovered through rates and recognized as revenue. Retail fuel costs not yet expensed are classified on the Consolidated Balance Sheets ("Balance Sheets") as deferred fuel costs. The fuel cost adjustment rate in- cludes a factor calculated to reimburse the Company or its customers, as appropriate, for the carrying cost of funds used to finance under- or over-collected fuel costs, respectively. Under the Maine Public Utilities Commission ("MPUC") fuel cost adjustment regulations effective through December 31, 1993, the Company is allowed to recover its fuel costs on a current basis. The fuel charge is based on the Company's projected cost of fuel for a twelve-month period. Under- or over-collections resulting from differences between estimated and actual fuel costs for a period are included in the computation of the estimated fuel costs of the succeeding fuel adjustment period. Commencing January 1, 1988, in accordance with an agreement approved by the MPUC, the Company began to phase-in increased fuel costs (primarily the cost of power purchased from small power producers see Note 7). The fuel rates are being designed so that all fuel costs incurred during that period will be billed in 1994. Prior to 1992, the MPUC allowed the Company to defer for future collection from, or payback to, customers the difference between actual purchased power costs incurred and those costs billed. As with fuel, the deferred purchased power capacity amounts were, for these years, considered when setting the fuel cost adjustment rate for the forthcoming year. The portion of purchased power capacity costs which is included in fuel revenue is classified as purchased power capacity expense in the Statements of Income. Effective November 15, 1992, the collection of the remaining balance of deferred purchased power costs is being recorded on the Statements of Income as fuel expense. The base rates, which became effective on January 1, 1992, excluded all purchased power capacity costs from this deferral process. DEPRECIATION OF ELECTRIC PLANT AND MAINTENANCE POLICY Depreciation of electric plant is provided using the straight-line method at rates designed to allocate the original cost of the properties over their estimated service lives. The composite depreciation rate, expressed as a percentage of average depreciable plant in service, and considering the amortization of the over-accrued depreciation which is discussed below, was approximately 2.1% in 1993, 1992 and 1991. A study conducted in 1989 by an independent firm determined that, as a group, the actual lives of the Company's property, plant and equipment are longer than the lives represented by the depreciation rates that the Company had been using to compute its depreciation expense for accounting purposes. In addition, the study also determined that the reserve for depreciation was over-accumulated. The agreement on base rates which became effective on October 1, 1990, contained a provision to amortize the remaining balance of the over-accumulated reserve for depreciation account ($11.4 million at October 1) over a six-year period and adopted the longer depreciable lives as determined by the aforementioned study. The Company follows the practice of charging to maintenance the cost of repairs, replacements and renewals of minor items considered to be less than a unit of property. Costs of additions, replacements and renewals of items considered to be units of property are charged to the utility plant accounts, and any items retired are removed from such accounts. The original costs of units of property retired and removal costs, less salvage, are charged to the reserve for depreciation. Depreciation, local property taxes and other taxes not based on income, which were charged to operating expenses, are stated separately in the Statements of Income. Rents and advertising costs are not significant. No royalty or research and development expenses were incurred. Maintenance expense was $6.5 million in 1993, $5.6 million in 1992 and $6.4 million in 1991. EQUITY RESERVE FOR LICENSED HYDRO PROJECTS The FERC requires that a reserve be maintained equal to one-half of the earnings in excess of a prescribed rate of return on the Company's investment in licensed hydro property, beginning with the twenty-first year of the project operation under license. The required reserve for licensed hydro projects is classified in retained earnings and has a balance of $584,942 at December 31, 1993. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION ("AFDC") In accordance with regulatory requirements of the MPUC, the Company capitalizes as AFDC financing costs related to portions of its construction work in progress at a rate equal to its weighted cost of capital and is capitalized into utility plant with offsetting credits to other income and interest. This cost is not an item of current cash income, but is recovered over the service life of plant in the form of increased revenue collected as a result of higher depreciation expense. In addition, carrying costs on certain regulatory assets are also capitalized and included in AFDC in the Statements of Income. The average AFDC (and carrying cost) rates computed by the Company were 10.0% in 1993, 10.6% for 1991 and 11.1% 1991. CASH AND CASH EQUIVALENTS The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be temporary cash investments. RECLASSIFICATIONS Prior year amounts have been reclassified to conform with the presentation used in the 1993 Consolidated Financial Statements. SIGNIFICANT CUSTOMER The Company has one industrial customer, LCP Chemicals ("LCP"), that accounted for 4.8%, 4.9% and 5.4% of total revenue (excluding AR 14 reclassifications) in 1993, 1992 and 1991, respectively. In 1988, with approval of the MPUC, the Company entered into an agreement with this customer by which its base rates for services were reduced and a "revenue-sharing" plan was instituted. Under the revenue-sharing plan, the amounts billed to this customer were adjusted up or down to reflect changes in the customer's per unit product price and electricity costs. The revenue-sharing rate continued for part of 1992 when it was replaced by a new rate that had a higher contribution to base revenue. In June 1993, LCP returned to the revenue-sharing rate. The Company recorded, as other income, approximately $513,000 in 1993, 206,000 in 1992, and $1.8 million in 1991 pursuant to the revenue-sharing rate. NOTE 2. INCOME TAXES The Company adopted Financial Accounting Standard Board Statement No. 109 "Accounting for Income Taxes" ("FAS 109") effective January 1, 1993. FAS 109 required a change in the accounting for income taxes from the deferred method to an asset and liability approach, which requires the recognition of deferred tax liabilities and assets for the future tax effects of temporary differences between the tax basis and carrying amounts of assets and liabilites. In accordance with FAS 109, the Company recorded net additional deferred income tax liabilities of approximately $23.1 million as of December 31, 1993. These additional deferred income tax liabilities have resulted from the accrual of deferred taxes on temporary differences on which deferred taxes had not been previously accrued ($32.5 million), offset by the effect of the 1987 change to lower income tax rates (reduced by the 1% increase in the federal income tax rate in 1993) that will be refunded to customers over time ($8.1 million) and the establishment of deferred tax assets on unamortized investment tax credits ($1.3 million). These latter amounts have been recorded as deferred regulatory liabilities at December 31, 1993. The accrual of the additional amount of deferred tax liabilities has been offset by a regulatory asset which represents the customers' future payment of these income taxes when the taxes are, in fact, expensed. As a result of this accounting, the consolidated statement of income for the year ended December 31, 1993 is not affected by the implementation of FAS 109. The rate-making practices followed by the MPUC permit the Company to recover federal and state income taxes payable currently, and to recover some, but not all, deferred taxes that would otherwise be recorded in accordance with FAS 109 in the absence of regulatory accounting. The individual components of other accumulated deferred income taxes are as follows at December 31, 1993: Deferred income tax liabilities: Excess book over tax basis of electric plant in service $43,023,222 Costs to terminate purchased power contract 4,553,166 Deferred FERC licensing costs 3,431,075 Deferred fuel, purchased power and interest costs 1,616,491 Deferred demand-side management program costs 1,055,030 Prepaid pension costs 1,028,179 Investment in jointly-owned companies 790,881 Other 2,434,532 ----------- $57,932,576 ----------- Deferred income tax assets: Deferred taxes provided on alternative minimum tax ($3,175,718) Provision for Basin Mills investment (3,137,895) Deferred state income tax benefit (1,561,137) Unamortized investment tax credit (1,286,156) Reserve for bad debts (797,696) Other (973,195) ------------- ($10,931,797) ------------- Total other accumulated deferred income taxes $ 47,000,779 ============= The individual components of federal and state income taxes reflected in the Consolidated Statements of Income for 1993, 1992 and 1991 are as stated in the table below. Year Ended December 31, ---------------------------------------- 1993 1992 1991 ---------------------------------------- Current: Federal $ - $6,274,554 $1,064,754 State - 2,739,089 485,586 ----------------------------------------- $ - $9,013,643 $1,550,340 ----------------------------------------- Deferred - Short-Term: Federal $ 114,674 $4,330,124 (1,803,480) State 68,216 213,745 (93,018) ------------------------------------------ $ 182,890 $4,543,869 (1,896,498) ------------------------------------------ Deferred - Long-Term: Federal - Other $ 2,512,026 $(5,741,329) $4,360,251 State - Other (21,507) (1,806,238) 418,052 Federal - Seabrook (341,917) (653,060) (705,036) State - Seabrook (72,730) (139,336) (150,297) ----------------------------------------- $2,075,872 $(8,339,963) $3,922,970 ----------------------------------------- Investment Tax Credits, Net $ (178,176) $ 672,798 $ 214,345 ----------------------------------------- Total Provision $2,080,586 $ 5,890,347 $3,791,157 Allocated to Other Income 2,682,359 (288,575) (940,793) ----------------------------------------- Charged to Operating Expense $4,762,945 $ 5,601,772 $2,850,364 ========================================= The table below reconciles an income tax provision, calculated by multiplying income before federal income taxes (as reported on the Statements of Income) by the statutory federal income tax rate to the federal income tax expense reported on the Statements of Income. The difference is represented by the temporary differences for which deferred taxes are not provided. 1993 1992 1991 ---- ---- ---- Amount % Amount % Amount % ------------------------------------------- (Dollars in Thousands) Federal income tax provisions at statutory rate $2,522 34% $5,489 34% $4,077 34% Less (Plus) temporary reductions in tax expense resulting from statutory exclusions from taxable income: Dividend received deduction related to earnings of associated companies 133 2 142 1 179 2 Equity component of AFDC 496 6 306 2 277 2 Amortization of equity component of AFDC on recoverable Seabrook investment (155) (2) (187) (2) (191) (2) Other (24) - 4 - (34) - ------ ---- ------ ---- ------ ---- Federal income tax provision before effect of temporary differences $2,072 28% $5,224 33% $3,846 32% Less (Plus) timing differences that are flowed through for ratemaking and accounting purposes: Amortization of debt component of AFDC and capitalized overheads on recoverable Seabrook investment (146) (2)% (193) (2)% (196) (2)% Book depreciation greater than tax depreciation on assets acquired before 1971 (292) (4) (293) (2) - - State income tax liability deducted for federal income tax purposes 116 2 467 4 351 3 Reversal of excess deferred income taxes 34 - 221 2 284 3 Life insurance flow-through in prior years - - - - 178 2 Other 253 4 139 1 98 1 ------- ---- ------ ---- ------ --- Federal income tax provision $2,107 28% $4,883 30% $3,131 25% ======= ==== ====== ==== ====== === The differences between the federal and state income tax expense reported on the Consolidated Statements of Income, and the federal and state income tax liability as reflected on the Company's tax returns, are caused by temporary differences on which deferred taxes are provided and recovered through rates. The table below shows the components of deferred tax expense as reported in the Statements of Income. 1993 1992 1991 ----------- ----------- ------------ Costs to terminate purchased power contract $4,553,166 $ - $ - Provision for Basin Mills (3,137,895) - - Seabrook Nuclear Project (414,647) (792,396) (855,333) Tax depreciation in excess of book depreciation 852,187 3,787,047 5,958,182 Deferred fuel and purchased power costs 163,665 (8,443,906) (2,843,764) State taxes provided for rate- making purposes but not paid (124,217) 146,702 (932,197) Deferred taxes provided on the AMT - 268,254 (551,503) Deferred interest costs 59,214 (209,149) (52,476) Costs of removal 84,203 227,649 204,179 Deferred demand-side management costs 97,672 284,297 198,677 FERC licensing costs 277,574 835,487 912,903 Other (152,160) 99,921 (12,196) ----------- ------------ ----------- Total deferred income tax expense (benefit) $2,258,762 $(3,796,094) $2,026,472 =========== ============ =========== Under the federal income tax laws, the Company received investment tax credits on qualified property additions through 1986. Investment tax credits utilized were deferred and are being amortized over the life of the related property. Investment tax credits available of about $4.8 million ($2.5 million of which is attributable to PHC and $900,000 to BVC) have not been utilized or recorded and, subject to review by the Internal Revenue Service ("IRS"), may be used prior to their expiration, which occurs between 1996 and 2005. At December 31, 1993, the Company had, for income tax purposes, alternative minimum tax credits ("AMT") of approximately $3.2 million for the reduction of future tax liabilities. At December 31, 1993, the Company had, for income tax reporting purposes, approximately $21 million of net operating loss carryforwards that expire in 2008. NOTE 3. COMMON AND PREFERRED STOCK COMMON STOCK In June of 1993 the Company issued and sold for cash 745,000 common shares (for proceeds of $14.8 million). The proceeds were utilized to finance construction expenditures, reduce short-term debt, and fund a portion of the buyout of the power purchase agreement with the Beaver Wood Joint Venture, which is more fully described in Note 7. The Company issued and sold for cash 920,000 common shares (for proceeds of approximately $13.1 million) in June of 1991. The proceeds were used to reduce outstanding short-term debt. Prior to 1992, stockholders had been able to invest their dividends and optional cash payments in common stock of the Company acquired by an independent agent in the open market through the Company's Dividend Reinvestment and Common Stock Purchase Plan ("the Plan"). In 1992 the Company amended the Plan to enable it to issue original shares in return for the reinvested dividends and optional cash payments. The common stock has general voting rights of one vote per twelve shares owned. PREFERRED STOCK Authorized preferred stock consists of 400,000 shares, par value $100 per share, of which there are 197,340 shares outstanding. The remaining 202,660 authorized but unissued shares (plus additional shares equal in number to such presently outstanding shares as may be retired) may be issued with such preferences, restrictions or qualifications as the Board of Directors may determine. Any new shares so issued will be required to be issued with per share voting rights no greater than that of the common stock. The callable preferred stock may be called in whole or in part upon any dividend date by appropriate resolution of the Board of Directors. Except for the holders of the 8.76% issue, which does not carry general voting rights, the currently outstanding preferred stock has general voting rights of one vote per share. With regard to payment of dividends or assets available in the event of liquidation, preferred stock ranks prior to common stock. REDEEMABLE PREFERRED SHARES Call premiums on preferred stock redeemed in 1986 and 1987 were deferred and were being amortized to earnings over a ten-year period. In compliance with an audit by FERC, the remaining balance of these deferred call premiums ($449,700 at December 31, 1990) were charged directly to retained earnings in 1991. On December 27, 1989, the Company issued to an institutional investor $15 million of non-voting preferred stock carrying a dividend rate of 8.76%. These shares have a maturity of fifteen years with a mandatory sinking fund of $1.5 million per year starting in 1995. The agreement to issue this series of preferred stock contains a provision whereby, if the Copany pays a dividend that is considered a return of capital for federal income tax purposes, the Company is required to make a payment to the stockholder in order to restore the stockholder's after-tax yield to the level it would have been had the dividend not been considered a return of capital. Since 100% of the dividends paid in 1990 and 1993, pending any review by the IRS, are to be considered a return of capital, the Company has become obligated to pay this stockholder approximately $969,000 at the time the stock is either sold or redeemed. This obligation is being recognized over the remaining life of the issue through a direct charge to retained earnings of $72,862 per year. NOTE 4. LONG-TERM DEBT Under the provisions of the first mortgage bond indenture, substantially all of the Company's plant and property has been mortgaged to secure the Company's first mortgage bonds. Sinking fund requirements and current maturities of the first mortgage bonds for the five years subsequent to December 31, 1993 aggregate $10,536,507 as follows: Sinking Fund Current Requirements Maturities Total 1994 $1,297,448 $ - $ 1,297,448 1995 1,461,253 - 1,461,253 1996 1,645,737 - 1,645,737 1997 1,853,515 - 1,853,515 1998 1,778,554 2,500,000 4,278,554 ----------- ----------- ----------- $8,036,507 $2,500,000 $10,536,507 =========== =========== =========== In 1993 the Company issued $15 million of 7.3% first mortgage bonds to an institutional investor for a period of 10 years. Also in 1993, in connection with the termination of the purchased power contract (which is discussed in Note 7), the Company issued $14.3 million of 12.25% mortgage bonds to the holders of Beaver Wood's debt in substitution for the Beaver Wood's pre- viously outstanding 12.25% secured notes. In September 1993 the Company redeemed the 8.25%, 8.6%, and 9.25% series of first mortgage bonds. The redemptions of these issues resulted in call premiums of $29,563, and $31,011, respectively. The Company completed two first mortgage bond financings during 1992. The first was issued in April for $20 million at an interest rate of 8.98% for a period of 20 years. The second was issued in October for $20 million at an interest rate of 7.38% for a period of 10 years. In 1992, the Company redeemed the 10.5%, 10.25% and the 17.35% series of first mortgage bonds. The redemption of these issues resulted in call premiums of $88,200, $170,765 and $88,000, respectively. The call premiums in 1993 and 1992 were deferred and have been included in the Company's current base rate filing on which a final decision was reached in February 1994. The Company is allowed to amortize these costs over a ten-year period with the unamortized balance included in the rate base. NOTE 5. SHORT-TERM BORROWINGS The Company has an unsecured revolving credit agreement ("Credit Agreement") with a group of four banks providing for loans of up to $25 million. The Credit Agreement expires on May 26, 1994 but may be extended through May 26, 1995 with unanimous consent of the participating banks. The Credit Agreement has a term loan arrangement whereby the loan balance at the date of termination can be paid in equal quarterly installments over a two-year period. The Company may borrow at rates, as defined within the Credit Agreement, based on certificate of deposit loan rates, Eurodollar loan rates or the agent bank's reference rate. A commitment fee of 1/4 of 1% per annum is required on the amount not borrowed under any of these borrowing options. A fourth borrowing option under the Credit Agreement is in the form of "bid loans" whereby the Company can borrow at "money market" rates independently set by each of the four banks participating in the Credit Agreement. This form of borrowing does not reduce the commitment fee but does reduce the credit available under the Credit Agreement. The Credit Agreement allows the Company to incur an additional $30 million in unsecured debt outside of the agreement. The Company maintains lines of credit with banks which it utilizes when the borrowing costs under the lines of credit are more favorable than those under the Credit Agreement. Certain of these lines of credit have commitment fees ranging from 1/8 of 1% to 1/4 of 1% of the line while others have no commitment fees. Certain information related to total short-term borrowings under the Credit Agreement and the lines of credit is as follows: 1993 1992 1991 - ---------------------------------------------------------------------------- Total credit available at end of period $55,000,000 $55,000,000 $42,000,000 Unused credit at end of period $19,000,000 $40,000,000 $13,500,000 Borrowings outstanding at end of period $36,000,000 $15,000,000 $28,500,000 Effective interest rate (exclusive of fees) on borrowings out- standing at end of period 3.7% 4.4% 5.4% Average daily outstanding bor- rowings for the period $22,754,205 $22,448,087 $23,297,260 Weighted daily average annual interest rate 3.7% 4.5% 6.6% Highest level of borrowings outstanding at any month- end during the period $36,000,000 $31,000,000 $28,500,000 The average daily borrowings outstanding for the period represent the sum of daily borrowings outstanding, divided by the number of days in the period. The weighted daily average annual interest rate is determined by dividing the annual interest expense by the average daily borrowings outstanding for the period. Commitment and agent fees for the revolving credit agreement of $40,000, $68,000 and $27,000 were paid in 1993, 1992 and 1991, respectively, and are excluded from the calculation of the weighted daily average annual interest rate. NOTE 6. PENSION AND OTHER POST-EMPLOYMENT BENEFITS The Company has noncontributory pension plans covering substantially all of its employees. On July 17, 1987, the Company created separate union and nonunion plans from an original plan. Benefits under the plans are generally based on the employee's years of service and compensation during the years preceding retirement. The Company's general policy is to contribute to the funds the amounts deductible for federal income tax purposes. The Company recorded pension income of $12,000, $348,214 and $263,700 for 1993, 1992 and 1991, respectively. The tables below and on the following page detail the components of pension income for 1993, 1992 and 1991, the funded status of the plans, the amounts recognized in the Company's Financial Statements and the major assumptions used to determine these amounts. The plan's assets are composed of fixed income securities, equity securities and cash equivalents. Total pension income included the following components: 1993 1992 1991 - ----------------------------------------------------------------------------- Service cost - benefits earned during the period $ 1,085,419 $ 1,037,419 $ 982,180 Interest cost on projected benefit obligation 2,244,706 1,996,491 1,605,246 Actual return on plan assets (4,633,435) (2,366,341) (6,595,692) Total of amortized obligations and the net gain (loss) deferred $ 1,291,310 $(1,015,783) $ 3,744,566 ------------ ------------ ------------ Total pension (income) $ (12,000) $ (348,214) $ (263,700) ============ ============ ============ Significant assumptions used were - Discount rate 7.0% 8.0% 8.0% Rate of increase in future compensation levels 5.0% 6.0% 6.0% Expected long-term rate of return on plan assets 9.0% 9.0% 8.0% The following table sets forth the plans' funded status and amounts recognized in the Balance Sheets at December 31, 1993 and 1992: 1993 1992 ------------- ------------ Actuarial present value of accumulated benefit obligation Vested $ 22,730,655 $ 16,294,432 Non-vested 2,669,955 1,686,977 ------------- ------------ Total $ 25,400,610 $ 17,981,409 ------------- ------------ Projected benefit obligation $(32,484,893) $(28,182,601) Plan assets at fair value 37,810,748 35,081,512 ------------- ------------ Excess of plan assets over projected benefit obligation $ 5,325,855 $ 6,898,911 Items not yet recognized in earnings - Net (asset) at transition (6,916,450) (7,848,775) Prior service cost 4,597,483 4,206,141 Unrecognized net gain from past experience and changes in assumptions (608,390) (869,779) ------------- ------------ Net pension asset recognized $ 2,398,498 2,386,498 ============= ============ In addition to pension benefits, the Company provides certain health care and life insurance benefits to its retired employees. Substantially all of the Company's employees may become eligible for retiree benefits if they reach normal retirement age while working for the Company. The Company has adopted Financial Accounting Standards Board Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106") as of January 1, 1993. This standard requires the accrual of postretirement benefits, including medical and life insurance coverage, during the years an employee provides services to the Company. Prior to 1993, the cost of health care benefits were expensed as benefits were paid. The MPUC issued a final accounting rule in connection with FAS 106 which adopted this pronouncement for ratemaking purposes and provides the Company with the accounting and regulatory framework required to defer the excess ($604,529, which is net of capitalized amounts at December 31, 1993) of the net periodic postretirement benefit cost recognized under FAS 106 over the pay-as-you-go amount in 1993 and to record such excess as a regulatory asset pending inclusion in future rates, subject to the same level of review for prudence and reasonableness as are all other utility expenses. The Company, in accordance with the ruling and FAS 106, is amortizing the unrecognized transition obligation of $10,023,200 over a 20-year period. The Company will begin recovering the deferred FAS 106 costs with the implementation of new base rates on March 1, 1994 and amortize the deferred balance over a ten-year period. In accordance with the provisions of FAS 106, the actuarially determined net periodic postretirement benefit cost for 1993 and the major assumptions used to determine these amounts are shown below. Net periodic postretirement benefit cost for 1993 includes the following components: Service cost of benefits earned $ 359,600 Interest cost on accumulated post- retirement benefit obligation 683,200 Amortization of unrecognized transition obligation over 20 years 501,200 ---------- Net periodic postretirement benefit cost $1,544,000 Expense on a pay-as-you-go basis (534,900) Amounts capitalized into construction work in progress (404,571) ---------- Regulatory asset recorded at December 31, 1993 $ 604,529 ========== The following table sets forth the benefit plan's unfunded status and amounts recognized in the Company's Balance Sheet at December 31, 1993: Accumulated postretirement benefit obligation: Retirees $ 5,640,000 Fully eligible active plan participants 773,000 Other active participants 4,196,000 ------------ $10,609,000 Unrecognized net transition obligation (9,522,000) Unrecognized net loss 457,000 ------------ Accrued postretirement benefit cost 1,544,000 Less: Expense recognized on a pay-as-you-go basis 534,900 ------------ Net liability recorded at December 31, 1993 (included in Other Reserves) $ 1,009,100 =========== For measuring the expected postretirement benefit obligation, a 12.4% annual rate of increase in the per capita claims cost ("trend rate") for participants who have not reached the age of 65 was assumed for 1992. This rate was assumed to decrease annually to 6% in 2050 and remain at that level thereafter. For those participants who are 65 or older, the trend rate was assumed to be 8.3% in 1992, 9.7% in 1993 and then decrease until 2050 when it is assumed to be 5.8%. If the health care cost trend rate was increased one percent, the accumulated postretirement benefit obligation as of January 1, 1993 would have increased by 11%. The effect of such change on the aggregate of service and interest cost for 1993 would be an increase of 12%. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1993. In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"). The Company is required to adopt this standard no later than January 1, 1994. FAS 112 applies to postemployment benefits provided to former or inactive employees, their beneficiaries, and covered dependents after employment but before retirement. FAS 112 will change the current methods of accounting for postemployment benefits from recognizing costs as benefits are paid, to accruing the expected costs of providing these benefits if certain conditions are met. Management is currently evaluating the financial impact of this accounting standard. However, the effect of FAS 112 on the Company's results of operations and financial position is not expected to be significant. NOTE 7. JOINTLY OWNED FACILITIES AND POWER SUPPLY COMMITMENTS MAINE YANKEE The Company owns 7% of the common stock of Maine Yankee which owns and operates a nuclear power plant in Wiscasset, Maine. Under purchased power arrangements, the Company is entitled to purchase an amount approximately equal to its ownership share of the output of Maine Yankee, an entitlement of approximately 62 MW. The Company is obligated to pay its pro rata share of Maine Yankee's operating expenses, fuel costs, capital costs and decommissioning costs. MEPCO The Company owns 14.2% of the common stock of MEPCO. MEPCO owns and operates electric transmission facilities from Wiscasset, Maine to the Maine-New Brunswick border. Several New England utilities, including the Company and MEPCO's other stockholders (two other Maine utiities), are parties to a transmission support agreement pursuant to which such utilities have agreed to pay MEPCO's costs, based on their relative system peaks, if MEPCO's revenues from transmission services are not sufficient to meet its expenses. Information relating to the operations and financial position of Maine Yankee and MEPCO appears at the bottom of page 40. WYMAN 4 The Company owns 8.33% (50 MW) of the oil-fired 600 MW Wyman No. 4 unit. The Company's proportionate share of the direct expenses of this unit is included in the corresponding operating expenses in the Statements of Income. Included in the Company's utility plant are the following amounts with respect to this unit: 1993 1992 1991 ----------- ----------- ----------- Electric plant in service $16,767,909 $16,760,816 $16,642,989 Accumulated depreciation (7,539,591) (7,025,278) (6,512,562) ----------- ----------- ----------- $ 9,228,318 $ 9,735,538 $10,130,427 =========== =========== =========== NEPOOL/HYDRO-QUEBEC PROJECT The Company is a 1.6% participant in the NEPOOL/Hydro-Quebec Phase 1 project ("Phase 1"), a 690 MW DC intertie between the New England utilities and Hydro-Quebec constructed by a subsidiary of another New England utility at a cost of about $140 million. The participants receive their respective share of savings from energy transactions with Hydro-Quebec, and are obliged to pay for their respective shares of the costs of ownership and operation whether or not any savings are realized. The Company is also a 1.5% participant in the NEPOOL/Hydro-Quebec Phase 2 project ("Phase 2"), which involves an increase to the capacity of the Phase 1 intertie to 2,000 MW. As in the Phase 1 project, the Company receives a share of the anticipated energy cost savings derived from purchases from Hydro-Quebec and capacity benefits provided by the intertie and is required to pay its share of the costs of ownership and operation whether or not any savings are obtained. MAINE YANKEE (Dollars in Thousands) -------------------------------------------------------- 1993 1992 1991 ---- ---- ---- OPERATIONS: As reported by investee - Operating Revenue $193,102 $187,259 $166,471 ---------------------------- Depreciation $ 25,458 $ 24,462 $ 23,729 Interest and Preferred Dividends 14,407 14,092 16,015 Other expenses, net 145,861 140,311 118,358 ---------------------------- Operating expenses $185,726 $178,865 $158,102 ---------------------------- Earnings Applicable to Common Stock $ 7,376 $ 8,394 $ 8,369 ============================ Amounts Reported by the Company - Purchased power costs $ 11,265 $10,830 $ 9,416 Equity in net income (542) (592) (581) ---------------------------- Net purchased power expense $ 10,723 $10,238 $ 8,835 ============================ FINANCIAL POSITION: As reported by investee - Plant in service $396,133 $384,664 $368,952 Accumulated depreciation (175,996) (163,887) (149,625) Other assets 314,680 300,416 267,554 ---------------------------- Total assets $534,817 $521,193 $486,881 Less - Preferred stock 19,800 21,000 6,600 Long-term debt 115,333 110,390 124,633 Other liabilities and deferred credits 332,030 322,900 287,734 ---------------------------- Net assets $ 67,654 $ 67,503 $ 67,914 ============================ Company's reported equity - Equity in net assets $ 4,736 $ 4,725 $ 4,754 Adjust Company's estimate to actual 20 11 (16) ---------------------------- Equity in net assets as reported $ 4,756 $ 4,736 $ 4,738 ============================ MEPCO (Dollars in Thousands) -------------------------------------------------------- 1993 1992 1991 ---- ---- ---- OPERATIONS: As reported by investee - Operating Revenue $ 12,809 $ 11,608 $ 14,918 ---------------------------- Depreciation $ 1,395 1,250 1,231 Interest and Preferred Dividends 124 186 336 Other expenses, net 11,185 10,067 13,246 ---------------------------- Operating expenses $ 12,704 $ 11,503 $ 14,813 ---------------------------- Earnings Applicable to Common Stock $ 105 $ 105 $ 105 ============================= Amounts Reported by the Company - Purchased power costs $ - $ - $ - Equity in net income (15) (15) (15) ---------------------------- Net purchased power expense $ (15) (15) (15) ============================= FINANCIAL POSITION: As reported by investee - Plant in service $ 23,123 $ 22,915 $ 22,775 Accumulated depreciation (19,174) (17,891) (16,841) Other assets 2,414 1,815 4,281 ----------------------------- Total assets $ 6,363 6,839 10,215 Less - Preferred stock - - - Long-term debt 2,590 3,450 4,310 Other liabilities and deferred credits 2,895 2,511 5,026 ----------------------------- Net assets $ 878 $ 878 $ 879 ============================= Company's reported equity - Equity in net assets $ 125 $ 125 $ 125 Adjust Company's estimate to actual - - - ----------------------------- Equity in net assets $ 125 $ 125 $ 125 as reported ============================= In 1990, the Company formed Bangor Var Co., Inc. whose sole function is to be a 50% general partner in the Chester SVC Partnership ("Chester"), a partnership which owns the static var compensator ("SVC"), which is electrical equipment that supports the Phase 2 transmission line. A wholly-owned subsidiary of Central Maine Power Company owns the other 50% interest in Chester. Chester has financed the acquisition and construction of the SVC through the issuance of $33 million in principal amount of 10.48% senior notes due 2020, and up to $3.25 million principal amount of additional notes due 2020 (collectively, the "SVC Notes"). The holders of the SVC Notes are without recourse against the partners or their parent companies and may only look to Chester and to the collateral for payment. The New England utilities which participate in Phase 2 have agreed under a FERC-approved contract to bear the cost of Chester, on a cost of service basis, which includes a return on and of all capital costs. SMALL POWER PRODUCTION FACILITIES As of the beginning of 1993, the Company had contracts with ten independent, non-utility power producers known as "small power production facilities." The West Enfield Project, described below, is one such facility. There are five other relatively small hydroelectic facilities. The remainder are larger (15-25 MW) facilities, three fueled by biomass (primarily wood chips) and one by municipal solid waste. The cost of power from the small power production facilities is more than the Company would incur if it were not obligated under these contracts, and, in the case of the biomass and solid waste plants, substantially more. The prices were negotiated at a time when oil prices were much higher than at present, and when forecasts for the costs of the Company's long-term power supply were higher than current forecasts. In the Company's 1987 rate proceeding, the MPUC investigated the events surrounding the contract negotiations but reached no conclusion about the Company's prudence in entering into these contracts. The fuel cost adjustment approved by the MPUC effective November 1, 1993 includes projected costs for small power production facilities. In order to lower the overall cost of power to its customers, the Company negotiated an agreement to cancel its long-term purchased power agreement with one of the biomass plants, the Beaver Wood Joint Venture ("Beaver Wood"), in June 1993. In connection with the cancellation the Company paid Beaver Wood $24 million in cash and issued a new series of 12.25% First Mortgage Bonds due July 15, 2001 to the holders of Beaver Wood's debt in the amount of $14.3 million in substitution for Beaver Wood's previously outstanding 12.25% Secured Notes. Also, in connection with the cancellation agreement, a reconstituted Beaver Wood partnership paid the Company $1 million at the time of settling the transaction and has agreed to pay the Company $1 million annually for the next six years in return for retaining the ownership and the option of operating the plant. The payments are secured by a mortgage on the property of the Beaver Wood facility. The Company believes this contract buyout transaction will result in significant savings to its customers compared to the continuation of payments under the purchased power contract. In May 1993 the Company received an accounting order from the MPUC related to the purchased power contract buyout. The order stipulated that the Company may seek recovery of the costs associated with the buyout in a future base rate case, and could also record carrying costs on the deferred balance. Consequently, a regulatory asset of $40.3 million has been recorded as of December 31, 1993. Effective with the implementation of new base rates on March 1, 1994, the Company will begin recovering over a nine-year period the deferred balance, net of the $6 million anticipated from Beaver Wood. The agreements with the other two biomass plants, located in the Company's service territory in West Enfield and Jonesboro, are also long-term (30-year) contracts. The West Enfield and Jonesboro facilities, plants of 24.5 MW each constructed by the same developer, commenced operation in November 1987. The Company has contracted to resell a portion of the capacity from these two projects to another utility. The cost to the Company of these contracts (net of revenues from the foregoing resale) is approximately $26 million annually. The Company also has a 30-year contract with the municipal solid waste facility, a 20 MW waste-to-energy plant in the Company's service territory in Orrington, completed in 1988. The Company has also contracted to resell a portion of the capacity for fifteen years from this facility to the other utility referred to earlier. The cost to the Company of the power delivered by this facility (net of revenues from the foregoing resale) is projected to be $14 million annally. WEST ENFIELD PROJECT In 1986, the Company entered into a joint venture with a development subsidiary of Pacific Lighting Corporation for the purpose of financing and constructing the redevelopment of an old 3.8 MW hydroelectric plant which the Company owned on the Penobscot River in Enfield and Howland, Maine, into a 13 MW facility (the "West Enfield Project") for the purpose of operating the facility once it was completed. Commercial operation of the redeveloped project began in April 1988. A wholly-owned corporate subsidiary, Penobscot Hydro Co., Inc. ("PHC") was formed to own the Company's 50% interest in the joint venture, Bangor-Pacific Hydro Associates ("Bangor Pacific"). Bangor-Pacific financed the $45 million estimated cost of the redevelopment through the issuance in a privately placed transaction of $40 million of fixed rate term notes and a commitment for up to $5 million of floating rate notes. The notes are secured by a mortgage on the project and a security interest in a 50-year purchased power contract, and the revenues expected thereunder, between the Company and Bangor-Pacific. Except as described below, the holders of the notes issued by Bangor-Pacific are without recourse to the joint venture partners or their parent companies. In the event Bangor-Pacific fails to pay when due amounts payable pursuant to the loan agreement, each partner has agreed to make capital contributions to Bangor-Pacific in an amount equal to 50% of such amounts due and payable, but not exceeding an amount equal to distributions from Bangor-Pacific received by such partner in the preceding twelve-month period. The Company is obliged to provide funds necessary to support the foregoing limited financial commitment to the project undertaken by PHC as the partner. Under the purchased power contract, if the project operates as anticipated, payments by the Company to Bangor-Pacific are estimated to be about $7.5 million annually (without consideration of any distributions by the joint venture to the partners). It is possible that the Company would be required to make payments under the contract regardless of whether any power is delivered, in an amount of approximately $4 million per year. However, the Company has the right to terminate the contract if the failure to deliver power continues for a period of 12 consecutive months. The fuel cost adjustment approved by the MPUC effective November 1, 1993, includes projected costs for power delivered to the Company by Bangor Pacific. BASIN MILLS AND VEAZIE PROJECTS As a result of increased uncertainty (discussed below) about the recoverability of amounts invested through 1993 in licensing activities for proposed additional hydroelectric facilities, the Company established a reserve against those investments in the amount of $8.7 million as of December 31, 1993. Further, the Company plans to expense all future amounts related to these licensing activities. The projects for which the reserve has been established are a proposed 38 megawatt generating facility located at the so-called Basin Mills site on the Penobscot River at Orono and Bradley, Maine and an 8 megawatt addition to the Company's existing dam and power station on the Penobscot River in Veazie and Eddington, Maine. The projects would require a total investment of $140 million. The Company has been pursuing the permitting of these facilities since the early 1980's. In November 1993 the Maine Board of Environmental Protection ("BEP") approved the projects under State environmental laws and issued the water quality certificate required by the Federal Clean Water Act. The BEP's order is subject to a number of conditions, some of which could prove to be costly if the projects are developed. The BEP's decision is being appealed by the projects' opponents, and the Company cannot predict the outcome of these proceedings. If the projects continue, further significant licensing activities can be expected at the FERC, the U.S. Army Corps of Engineers, the MPUC, the BEP and possibly other agencies. The Company cannot predict the outcome of the licensing and permitting activities that are required in order for these projects to be constructed. In addition to the Company's inability to predict the outcome of the requisite licensing activities, other uncertainties have arisen as a result of changes that have developed and are continuing to develop in the electric utility industry. In general, these changes are occurring as a result of the infusion of competition into the industry. As a consequence, even if these projects continue to be the least-cost alternatives for power supply, the increasing concern about the impact of competition raises uncertainty about the timely recovery of the investment required to construct the projects. Accordingly, although the projects are not being abandoned and licensing activities are continuing, there is now less certainty that they will be constructed or that the costs for the completed projects could be recovered. The Company also believes that the recoverability of the costs incurred to date is subject to increasing uncertainty. Under Maine law and regulation, the MPUC can authorize the recovery of prudently incurred utility investment in abandoned or cancelled projects. However, under current MPUC policy, recovery of plant investment cannot begin until either it becomes operational or it is abandoned or cancelled. Since neither of these events has occurred and since the Company cannot predict when either of them might occur, it is impossible to forecast when a final regulatory decision on the recoverability of these costs might be made. Moreover, given the concerns about competitiveness described above, at the time when recovery of those costs might be requested, the Company would likely take into consideration the impact of the inclusion of those costs in its rates, and could conclude that it would not be in the Company's best interests to pursue cost recovery. NOTE 8. RECOVERY OF SEABROOK INVESTMENT AND SALE OF SEABROOK INTEREST The Company was a participant in he Seabrook nuclear project in Seabrook, New Hampshire. On December 31, 1984, the Company had almost $87 million invested in Seabrook, but because the uncertainties arising out of the Seabrook Project were having an adverse impact on the Company's financial condition, an agreement for the sale of Seabrook was reached in mid-1985 and was finally consummated in November 1986. During 1985, a comprehensive agreement was negotiated among the Company, the MPUC staff, and the Maine Public Advocate addressing the recovery through rates of the Company's investment in Seabrook (the "Seabrook Stipulation"). This negotiated agreement was approved by the MPUC in late 1985. Although the implementation of the Seabrook Stipulation significantly improved the Company's financial condition, substantial write-offs were required as a result of the determination that a portion of the Company's investment in Seabrook would not be recovered. In addition to the disallowance of certain Seabrook costs, the Seabrook Stipulation also provided for the recovery through customer rates of 70% of the Company's year-end 1984 investment in Seabrook Unit 1 over 30 years, and 60% of the Company's investment in Unit 2 over seven years, with base rate treatment of the unamortized balances. As of December 31, 1992, the Company's investment in Seabrook Unit 2 was fully amortized. NOTE 9. CONTINGENCIES BANKRUPTCY OF LARGEST CUSTOMER LCP filed for protection under Chapter 11 of the bankruptcy law in July 1991. At the time of the bankruptcy filing, LCP owed $719,642 for electric service, for which the Company has a general, unsecured claim. In addition, LCP is seeking to recover from the Company certain payments for electric service made prior to the filing as preference payments under the bankruptcy law. Since the filing, pursuant to arrangements approved by the Bankruptcy Court, LCP must pay for service weekly in arrears and the Company may curtail deliveries of power three days after the presentation of a weekly bill. Furthermore, the Company has been permitted to collect a deposit to secure the value of approximately one week of service. As a result, the LCP account for service rendered after the date for bankruptcy filing is current. ENVIRONMENTAL MATTERS The Company has received a notice of potential liability under the Comprehensive Environmental Response, Compensation, and Liability Act as a generator of hazardous substances that the United States Environmental Protection Agency alleges may have been disposed of at a waste disposal facility in Connecticut. The Company is only one of several hundreds of potentially responsible parties at the site. The Company has received a notice from the Maine Department of Environmental Protection under similar Maine legislation relating to several facilities in Maine. The Company is not yet aware of the extent of potential clean-up necessary or the number of potentially responsible parties involved. In management's opinion, the resolution of these matters are not expected to have a material adverse impact on the Company's financial condition. NOTE 10. UNAUDITED QUARTERLY FINANCIAL DATA Unaudited quarterly financial data pertaining to the results of operations are shown below: Quarter Ended --------- --------- --------- -------- March 31 June 30 Sept. 30 Dec.31 --------- --------- --------- ------- (Dollars in thousands except per share amounts) ---- Electric Operating Revenue $46,679 $40,548 $43,476 $ 44,269 Operating Income 4,779 4,486 4,396 3,138 Net Income (Loss) 2,908 2,766 3,244 (3,582)* Earnings (Loss) Per Share of Common Stock $ .46 $ .42 $ .46 $(.64)* ======= ======== ======== ======== ---- Electric Operating Revenue $48,013 $39,722 $41,877 $ 47,177 Operating Income 4,472 4,370 5,050 4,624 Net Income 2,555 2,224 2,885 2,591 Earnings Per Share of Common Stock $ .40 $ .34 $ .46 $ .40 ======== ======== ======== ========= ---- Electric Operating Revenue $44,142 $35,256 $37,966 $44,879 Operating Income 4,526 3,500 4,119 4,300 Net Income 2,275 1,462 2,068 2,394 Earnings Per Share of Common Stock $ .42 $ .23 $ .31 $ .37 ========= ======== ======== ======== * Includes the provision for Basin Mills of $5.7 million after-tax or $.95 per common share. NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value at December 31, 1993 of each class of financial instruments for which it is practical to estimate the value: Cash and cash equivalents: The carrying amount of $2,387,156 approximates fair value. The fair values of mandatory redeemable cumulative preferred stock, first mortgage bonds and pollution control revenue bonds at December 31, 1993 based upon similar issues of comparable companies are as follows: In Thousands ------------------- Carrying Fair Amount Value ------------------- Mandatory redeemable cumulative preferred stock $ 15,168 $ 16,022 First Mortgage Bonds 116,223 137,735 Pollution Control Revenue Bonds 4,200 4,200 =================== REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Stockholders and Directors of Bangor Hydro-Electric Company: We have audited the accompanying consolidated balance sheets and statements of capitalization of Bangor Hydro-Electric Company and subsidiaries (the "Company") 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 responsiblity 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 the 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. As discussed in Note 2 to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes. Coopers & Lybrand Portland, Maine February 17, 1994 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH AUDIT FIRMS ON FINANCIAL DISCLOSURE - ------ ------------------------------------------------ There have been no changes in or disagreements with audit firms on financial disclosure. PART III - -------- ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------- -------------------------------------------------- See Part I above, and see the information under "Election of Directors" in the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. ITEM 11 EXECUTIVE COMPENSATION - ------- ---------------------- See the information under "Executive Compensation" in the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------- ----------------------------------------------- (a) Security Ownership of Certain Beneficial Owners See the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. (b) Security Ownership of Management See the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. (c) Changes in Control Not applicable. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------- ---------------------------------------------- See the information under "Election of Directors" in the Company's definitive proxy statement for the annual meeting of stockholders to be held on May 18, 1994, which information is incorporated herein by reference. PART IV - ------- ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ------- ---------------------------------------------------- (a) Consolidated Financial Statements of the Company (See Item 8) Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and Consolidated Statements of Retained Earnings for the Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization - December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants (b) Schedules Report of Independent Accountants Schedule V - Property, Plant and Equipment and and Construction in Progress Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Reserves for Doubtful Accounts and Insurance All other schedules are omitted as the required information is inapplicable or the information is presented in the Company's consolidated financial statements or related notes. (c) Exhibits See Exhibit Index, page (d) Reports on Form 8-K A Current Report on Form 8-K dated December 15, 1993 was filed in the fourth quarter of 1993, regarding the establishment of a reserve against investments in certain hydroelectric facilities. 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. Robert S. Briggs ------------------------- Robert S. Briggs President and Chairman of the Board (Chief Executive Officer) 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. Robert S. Briggs Helen Sloane Dudman - ------------------------ ------------------------ Robert S. Briggs Helen Sloane Dudman President and Director Chairman of the Board G. Clifton Eames - ------------------------ ------------------------ William C. Bullock, Jr. G. Clifton Eames Director Director Jane J. Bush Robert H. Foster - ------------------------ ------------------------ Jane J. Bush Robert H. Foster Director Director David M. Carlisle Carroll R. Lee - ------------------------ ------------------------ David M. Carlisle Carroll R. Lee Director Director, Vice President- Operations John P. O'Sullivan - ------------------------ ------------------------ Alton E. Cianchette John P. O'Sullivan Director Director, Vice President- Finance & Administration (Chief Financial Officer) David R. Black ----------------------- David R. Black Controller (Chief Accounting Officer) Each of the above signatures is affixed as of March 23, 1994. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors Bangor Hydro-Electric Company: Our report on the financial statements of Bangor Hydro-Electric Company is included Item 8

30163_1993.txt

30163_1993

1993

30163

ITEM 1. BUSINESS - ------ -------- General - ------- The Dreyfus Corporation ("Corporation") is one of the nation's oldest and largest mutual fund management companies. Based upon assets under management at December 31, 1993, the Corporation is the sixth largest mutual fund organization in the United States, the second largest manager of tax-exempt bond funds, the third largest manager of tax-exempt money market funds, and the third largest manager of taxable money market funds. As of December 31, 1993, the Corporation managed, advised or administered assets totalling $77.6 billion. As of December 31, 1993, the Corporation managed or administered 136 different mutual fund portfolios, including money market funds (taxable and tax-exempt), tax-exempt bond funds, equity funds and taxable fixed income funds, with approximately 1.9 million shareholder accounts. The Corporation serves primarily as a manager of mutual funds, providing both investment advisory and administrative services. The Corporation provides investment advisory services to the Dreyfus family of funds pursuant to agreements with each of those funds, in accordance with which the Corporation manages each fund's portfolio of investments, by making investment decisions and formulating and executing the fund's investment strategy, subject to supervision by the fund's board of directors and in accordance with the fund's fundamental investment objectives and policies. Administrative services generally consist of internal accounting and legal services, including preparing and distributing communications to shareholders, preparing government filings and tax returns, certain bookkeeping and accounting functions and other related services. The Corporation's wholly-owned subsidiary, Dreyfus Service Corporation ("Service Corporation"), markets, sells and distributes shares of the Dreyfus family of funds. Service Corporation is a registered broker-dealer under the Securities Exchange Act of 1934 and is a member of the National Association of Securities Dealers, Inc. Another wholly-owned subsidiary, Dreyfus Management, Inc., provides investment advisory and administrative services to various pension plans, institutions and individuals (such accounts and certain accounts of the trust company described below are collectively referred to herein as "separately advised accounts"). The Corporation and Dreyfus Management, Inc. are each registered under the Investment Advisers Act of 1940. The Corporation also owns a Federal savings bank, a New York trust company, a real estate investment advisory company and an insurance company. For the year ended December 31, 1993, the Corporation generated over 84% of its and its subsidiaries' total revenues. On December 5, 1993, the Corporation entered into an Agreement and Plan of Merger providing for the merger of the Corporation with a subsidiary of Mellon Bank Corporation ("Mellon"). Under the terms of the agreement, the Corporation's stockholders will be entitled to receive .88017 shares of Mellon common stock for each share of the Corporation's common stock, in a tax-free exchange. Following the merger, it is planned that the Corporation will be a direct subsidiary of Mellon Bank, N.A., a direct subsidiary of Mellon. Closing of the merger is subject to a number of contingencies, including the receipt of certain regulatory approvals, the approvals of the stockholders of the Corporation and of Mellon, and approvals of the boards of directors and shareholders of mutual funds advised or administered by the Corporation. The merger is expected to occur in mid-1994, but could occur later in 1994. ITEM 1. BUSINESS-CONTINUED - ------ -------- Mutual Funds and Other Assets Under Management - ---------------------------------------------- At December 31, 1993, the Corporation managed, advised or administered 23 taxable money market fund portfolios, 43 tax-exempt bond fund portfolios, 36 equity fund portfolios, 19 tax-exempt money market fund portfolios, and 15 fixed income fund portfolios. Some funds offer more than one investment portfolio and, with respect to some portfolios, the Corporation shared advisory or administrative responsibilities with other parties. The Corporation's taxable money market fund portfolios seek to provide high current income, to the extent consistent with the preservation of capital, through investment in short-term corporate debt, bank deposits and government obligations. The tax-exempt funds include a broad variety of portfolios for investors seeking tax-exempt income. The Corporation's tax-free bond fund portfolios include state-specific funds targeted toward investors in Arizona, California, Connecticut, Florida, Georgia, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Texas and Virginia. The Corporation's tax-exempt money market fund portfolios invest in short-term municipal obligations to provide income free of federal (and for some funds, state and local) income taxes. The equity fund portfolios seek to provide capital growth primarily through investment in U.S. or foreign common stocks or to provide both income and capital appreciation through investment in a varying combination of equity and debt instruments. The objective of the fixed-income fund portfolios is to produce income through investment in corporate debt, U.S. or foreign government obligations or combinations thereof. The following table sets forth certain information with respect to the net assets managed, advised or administered by the Corporation by fund category, at the dates shown (in billions): At December 31, --------------------------------- 1993 1992 ------------ ---------- Taxable money market funds. . . . . . . . $31.2 $38.0 Tax-exempt bond funds . . . . . . . . . . 21.3 17.9 Equity funds. . . . . . . . . . . . . . . 8.3 7.0 Tax-exempt money market funds . . . . . . 7.6 7.6 Fixed income funds. . . . . . . . . . . . 4.8 3.9 Funds jointly advised/administered. . . . 3.2 3.8 Separately advised accounts . . . . . . . 1.2 1.3 ----------- ----------- Total $77.6 $79.5 =========== =========== Mutual Fund Developments in 1993 - -------------------------------- During 1993, the Corporation continued to introduce funds which offer the public a range of investment options with greater diversity. During the first quarter of 1993, Dreyfus Strategic Investing and funds in the Premier Family of Funds began offering multiple classes of shares. The multiple classes consist of Class A shares, which are sold with a sales charge imposed at the time of purchase, and Class B shares, which are subject to a contingent deferred sales charge imposed on redemptions made within a specified period and operate pursuant to a distribution plan adopted in accordance with Rule 12b-1 under the Investment Company Act of 1940 (the "1940 Act"). These funds offer alternative classes of shares ITEM 1. BUSINESS-CONTINUED - ------ -------- so that an investor may choose the method of purchase deemed most desirable given the amount of the purchase, the length of time the investor expects to hold the shares and other relevant circumstances. Also during the first quarter of 1993, First Prairie U.S. Government Income Fund commenced operations. Its objective is to provide as high a level of current income as is consistent with the preservation of capital. The Corporation provides administrative services for the fund and Service Corporation serves as the fund's distributor. The First National Bank of Chicago is the fund's investment adviser. During the second quarter of 1993, the Registration Statement for Dreyfus International Equity Fund, Inc. was declared effective and the fund commenced operations. The fund's objective is capital growth. The Corporation serves as the fund's investment adviser and Service Corporation as its distributor; M&G Investment Management Limited is the fund's sub-investment adviser. Also during the second quarter, the Capital Appreciation Portfolio of Dreyfus Variable Investment Fund commenced operations. The Capital Appreciation Portfolio's primary goal is to provide long-term capital growth consistent with the preservation of capital; current income is a secondary goal. The fund, which consists of six separate portfolios, was designed as a funding vehicle for variable annuity contracts and variable life insurance policies offered by the separate accounts of various life insurance companies. Pursuant to stockholder vote, on May 7, 1993, Dreyfus Index Fund merged into Peoples Index Fund, Inc. and on September 17, 1993, The Dreyfus Convertible Securities Fund, Inc. merged into Dreyfus Growth and Income Fund, Inc. in a tax-free exchange. During the third quarter of 1993, the Registration Statement for Dreyfus Asset Allocation Fund, Inc. was declared effective and the fund commenced operations. The fund's objective is to maximize total return, consisting of capital appreciation and current income. Premier Growth Fund, Inc. ("Premier Growth") and Premier California Insured Municipal Bond Fund ("Premier California Insured"), the latest additions to the Premier Family of Funds, commenced operations during the third quarter of 1993. Premier Growth's primary goal is to provide long- term capital growth consistent with the preservation of capital; current income is a secondary goal. Premier California Insured seeks to maximize current income exempt from Federal and State of California personal income taxes to the extent consistent with the preservation of capital. Pursuant to stockholder vote, on September 24, 1993, all of the assets and liabilities of McDonald Money Market Fund, Inc. and McDonald U.S. Government Money Market Fund, Inc., for which the Corporation had served as sub-investment adviser and administrator, were transferred into Gradison-McDonald U.S. Government Reserves which the Corporation does not advise or administer. Additionally, McDonald Tax Exempt Money Market Fund, Inc., for which the Corporation had served as sub-investment adviser and administrator, was liquidated on September 27, 1993. During the fourth quarter of 1993, Dreyfus Pennsylvania Intermediate Municipal Bond Fund commenced operations. The goal of this fund is to provide as high a level of current income exempt from Federal and Pennsylvania income taxes as is consistent with the preservation of capital. ITEM 1. BUSINESS-CONTINUED - ------ -------- During the fourth quarter, Dreyfus Institutional Short Term Treasury Fund commenced operations. Its objective is to provide investors with a high level of current income with minimum fluctuation of principal value. Also during the fourth quarter, Dreyfus Florida Municipal Money Market Fund commenced operations. In the fourth quarter, The Dreyfus Socially Responsible Growth Fund, Inc. commenced operations. The fund's primary goal is to provide capital growth; current income is a secondary goal. The fund is intended to be a funding vehicle for variable annuity contracts and variable life insurance policies to be offered by the separate accounts of various life insurance companies. During the fourth quarter, Dreyfus Global Investing (A Premier Fund) began operating under the name Premier Global Investing. The Corporation is continuing to consider the development of additional funds to serve the diverse investment interests of various segments of the public. Marketing - ------------ The Corporation has achieved its position in the marketplace by concentrating substantial resources in sales and investor support activities and uses a variety of distribution channels to market shares in its funds. The Corporation markets load and no-load mutual fund products to its retail customers directly and through institutional clients such as banks, securities dealers and financial institutions. The Corporation also markets mutual fund products directly to those institutions for their own accounts and the accounts of their customers. Finally, the Corporation markets its funds to and through various employee benefit plans. The Corporation's largest marketing channel is its retail services division which engages in direct marketing, primarily of no-load funds, to retail customers through mail and media advertising. At December 31, 1993, the Corporation operated 16 Financial Centers that conduct sales and customer service activities in 12 major cities across the United States. All direct sales to the Corporation's customers, including those originated by mail and media advertising and those originated through the Financial Centers, are made through Service Corporation. The Corporation also has developed, through its Institutional Services Division, a number of arrangements to market products to the customer bases of other institutions and has sales or servicing agreements in place with over 1,700 broker-dealer firms and more than 300 banks and bank-affiliated broker-dealers. The Corporation's Institutional Services Division provides training support, legal information, marketing expertise and other services to these institutions to support their sales efforts. These banks and broker-dealers also market and sell investment products that compete with Dreyfus' products, including, in some cases, products sponsored by those institutions themselves. Sales representatives at these banks and broker-dealers may be offered compensation incentives to sell their own firm's investment products, or may choose to recommend to their customers investment products offered by firms other than the Corporation. In addition, the Corporation has arrangements with a number of banks jointly to manage, administer or distribute funds advised by those banks. The Dreyfus Group Retirement Plans Division markets the Corporation's funds to various employee benefit plans, and provides related services such as processing group defined contribution plan transactions and providing client enrollment and servicing functions. ITEM 1. BUSINESS-CONTINUED - ------ -------- Fee Revenues - ------------ The majority of the Corporation's revenues are derived from management, investment advisory and administrative fees (collectively, "fee revenues"). The Corporation had total net revenues for the fiscal years ended December 31, 1993 and December 31, 1992 of $386 million and $342.4 million, respectively, of which $297.5 million (77.1% of revenues) and $273.6 million (79.9% of revenues), respectively, represented fee revenues. Fee revenues from each fund are based on a percentage of the value of the average net assets of that fund. The fee rate varies according to the type of fund and the services provided. The following table sets forth certain information with respect to the Corporation's fee revenues for the periods shown: (Years prior to 1993 have been reclassified to conform to the current year's presentation.) ITEM 1. BUSINESS-CONTINUED - ------ -------- The increase in management, investment advisory and administrative fees during 1993, as shown in the preceding table, was principally due to a reduction of management fees waived and reflects a change in the mix of the average net assets under management during the year. Although the average net assets of sponsored taxable money market funds declined during 1993, there has been substantial growth in tax-exempt bond and equity funds during the same period. Management fee rates charged to tax-exempt bond and equity funds are generally higher than the rates charged to taxable money market funds. During 1992, the increase in management, investment advisory and administrative fees was principally due to an increase in the average net assets of sponsored taxable money market funds for which a management fee was charged. From time to time for competitive reasons, the Corporation agrees with a particular fund to waive certain management fees and/or to reimburse certain fund expenses, either for a specified or an unspecified period of time, in order to increase the fund's rate of return to investors and thereby promote the growth of the fund's assets. In the future, the Corporation may continue to follow such practices; however, it is not possible to predict what effect, if any, the imposition of management fees and/or the discontinuance of fund expense reimbursements may have on the future level of certain fund assets under management. Furthermore, the Corporation presently is unable to determine to what extent, if any, it may impose management fees on funds where fee waivers presently exist, or to what extent fund expense reimbursements may be reduced in the future. As required by the 1940 Act, the management contracts of each of the funds managed by the Corporation provide that those contracts are subject to annual approval by (i) the Board of Directors of the fund or (ii) vote of a majority of the outstanding voting securities of the fund, provided that in either event the continuance is also approved by a majority of the directors who are not "interested persons" (as defined in the Investment Company Act) of the fund or the manager, by vote cast in person at a meeting called for the purpose of voting such approval. These statutory requirements are also applicable to the sub-investment advisory contracts of the Corporation. The contracts are subject to termination by either party without penalty on 60 days' notice as required by the 1940 Act. They are also automatically terminated in the event of any assignment of the contracts. "Assignment" is defined in the 1940 Act as including any direct or indirect transfer of a controlling block of voting stock. The ownership of more than 25% of the voting stock of a company creates a presumption of control. Control is also defined as the power to exercise a controlling influence over the management or policies of a company. Similar requirements are applicable to the underwriting and distribution agreements between Service Corporation, as principal underwriter, and the Dreyfus family of funds. The Corporation's proposed merger with Mellon would constitute an "assignment" for these purposes, and for that reason the conditions to the merger include the approvals of the boards of directors and stockholders of the funds advised by the Corporation. Certain administrative contracts of the Corporation will also terminate in the event of such "assignment" and the Corporation will therefore seek the approvals of the Boards of Directors of the applicable funds. Under the terms of the management contracts with the funds, the Corporation supervises and assists in the management of their investment portfolios, subject to the approval of the funds' directors, and furnishes statistical and research data. The Corporation also provides office facilities and a research library for the funds, supplies accounting services and clerical, secretarial and administrative personnel, arranges for fidelity and other insurance as appropriate, and generally supplies all investment and administrative services and facilities. The Corporation pays the salaries of officers and employees of the funds. The funds pay their own corporate expenses such as outside legal and auditing fees, corporate reporting and meeting costs, Securities and Exchange Commission ITEM 1. BUSINESS-CONTINUED - ------ -------- ("SEC") registration fees, transfer agency, dividend disbursing and custodial expenses and taxes and, in addition, pay brokerage commissions and any interest charges on borrowings. In the case of funds sold with a sales charge, Blue Sky (state securities law) registration fees and prospectus printing costs are paid by the sponsor and/or underwriter. In the case of funds sold without a sales charge, the Blue Sky fees are paid by the funds as well as the cost of printing prospectuses for shareholders and regulatory agencies. In addition, certain of these funds bear investor servicing costs allocated to them by the Corporation. The Mutual Fund Industry and Competition - ---------------------------------------- The mutual fund industry has grown dramatically over the past several years and is highly competitive. Total assets managed by the industry grew from approximately $810 billion at December 31, 1988 to over $2 trillion at December 31, 1993. There are presently almost 600 mutual fund management companies in the United States, managing over 4,500 mutual funds of varying sizes and investment policies. The Corporation and the mutual fund industry are in competition with insurance companies, banking organizations, securities dealers and other financial institutions that provide investors with competing mutual funds and alternatives to mutual funds. This competition has increased over the past several years, in part as a result of a number of rulings and interpretations issued by Federal bank regulatory agencies that have expanded significantly the range of mutual fund activities in which banks and bank holding companies may engage. Competition is based upon investment performance in terms of attaining the stated objectives of particular funds, advertising and sales promotional efforts, available distribution channels (such as banks and broker dealers) and the type and quality of services offered to investors. With respect to open-end tax-exempt bond funds, there are over 1,000 funds currently offering their shares to the public. At December 31, 1993, based upon assets under management, Dreyfus Municipal Bond Fund was one of the largest of these funds. Competition in this area is keen not only among the various tax-exempt bond funds but also with respect to municipal bond investment trusts sponsored largely by major securities firms, which have for a number of years actively solicited investments in these fixed trusts by the public and are continuing to do so. Dreyfus Municipal Money Market Fund, Inc. also meets competition from over 300 municipal money market funds. With respect to money market funds, such as Dreyfus Liquid Assets and Dreyfus Worldwide Dollar Money Market Fund, there are over 700 such funds, many of which have been sponsored by major securities firms. Money market funds generally fall into three categories: (i) those primarily soliciting the general public, particularly the small or average individual investor, (ii) those formed by securities brokerage firms primarily for their customers, and (iii) those offering their shares primarily to institutional investors, such as bank trust departments, pension funds and investment advisers. Dreyfus Liquid Assets and Dreyfus Worldwide Dollar Money Market Fund, offering their shares to the general public, are among the larger money market funds of that type. Money market funds such as Dreyfus Treasury Prime Cash Management, Dreyfus Cash Management, Dreyfus Government Cash Management, and Dreyfus Treasury Cash Management are designed primarily for institutions. Particularly when interest rates are low, competition significantly limits the amounts of fees which can be charged to money market funds because those fees materially affect the yield offered to investors. Extended periods of declining or increasing interest rates may, in different ways, affect the various types of mutual funds sponsored by the Corporation. ITEM 1. BUSINESS-CONTINUED - ------ -------- The ability of a mutual fund complex to provide competitive services to fund investors is, in part, dependent upon the type and quality of transfer agency and related services being provided to the funds. Factors which can materially affect the nature of such transfer agency services include: the size of the fund complex, the cost of the services, and the experience and economic resources of the provider(s) of such services, as well as their technological, staffing and managerial capabilities. Consumer Financial Services - --------------------------- The Dreyfus Security Savings Bank, F.S.B. (the "Savings Bank"), an indirect wholly-owned subsidiary of the Corporation, is a Federally- chartered savings bank and a member of the Federal Deposit Insurance Corporation. The Savings Bank offers various bank products and services, (including, but not limited to certificates of deposits, residential mortgage loans, and secured personal loans) to the investors in the mutual funds sponsored by the Corporation and to the general public. During 1993 the Savings Bank, with its principal office located in Paramus, New Jersey, opened a branch office in San Francisco, California. It also received conditional approval from The Office of Thrift Supervision to open additional branch offices in six other states. Investments - ----------- The Corporation invests its assets in U.S. and foreign government obligations, equity securities, including public utilities and other dividend-paying, widely-held common stocks of major corporations, non- readily marketable limited partnerships and other non-readily marketable securities, options to purchase certain securities and in funds sponsored by the Corporation. From time to time, the Corporation makes investments in special situations. Investments maintained by the Corporation are used as a resource to provide funds to sponsor, promote and market shares of the Dreyfus family of funds and to sponsor and promote new business activities. Other Operations - ---------------- Dreyfus Personal Management, Inc., a wholly-owned subsidiary of the Corporation that provided personalized portfolio management to a limited number of individual clients, discontinued operations as of June 30, 1993. Dreyfus Precious Metals, Inc., a wholly-owned subsidiary of the Corporation, purchases and sells precious metals and coins for investors. Operating results to date from this subsidiary have not been significant to the Corporation. During 1993, the Corporation sold Dreyfus Life Insurance Company, an insurance company subsidiary, for $11.7 million. Personnel - --------- The Corporation and its subsidiaries had over 2,100 employees at December 31, 1993, most of whom were employed in New York. ITEM 2. ITEM 2. PROPERTIES - ------ ---------- On September 25, 1989 the Corporation entered into an amended and restated lease to consolidate its corporate headquarters at 200 Park Avenue in New York City. The lease provides for the rental of an aggregate of 228,883 square feet and expires in 2005. The Corporation has an option to extend the term of the lease for three successive five-year periods. On May 19, 1993 the Corporation leased an additional 11,000 square feet at 200 Park Avenue which expires in 2005. On October 1, 1993, the Corporation subleased 38,000 square feet at 200 Park Avenue which expires in 1997. The Corporation has an option to extend the term of this lease for a five-year period. The Corporation also leases approximately 10,500 square feet at 150 Varick Street, which expires on May 31, 1994. Service Corporation owns approximately 26,733 square feet of office space in Jersey City, N.J. In January, 1990, Service Corporation subleased 94,695 square feet in Uniondale (Long Island), N.Y., pursuant to a sublease which expires in 2005. In March and October, 1993 Service Corporation leased an additional 31,565 square feet which expires in 2005. Service Corporation also leases office space in twelve other cities. See Note 9 to the consolidated financial statements (listed in Item 8 below) for further information with respect to the Corporation's leases. The Corporation believes that the above-described premises are suitable and adequate for the Corporation's current needs in all material respects. All such premises are being fully utilized for the conduct of the Corporation's business or that of its subsidiaries. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - ------ ----------------- CLASS ACTIONS. On December 6, 1993, the Corporation and Mellon issued a joint press release announcing the merger described in Item 1 above (the "Merger"). Subsequently, six purported class action suits brought by six public shareholders of the Corporation were filed in December 1993 in the Supreme Court of the State of New York, County of New York, naming the Corporation, Mellon and the individual directors of the Corporation as defendants. Three of these complaints have been served. Defendants' time to move, answer or otherwise respond to these complaints has not yet expired. In these complaints, plaintiffs allege, among other things, that the Corporation and its Directors breached their fiduciary duties to the public shareholders of the Corporation by agreeing to the sale of the Corporation at a price which does not maximize shareholder value; failing to include a collar, or other form of price protection, for the Exchange Ratio; placing the defendants' interests above those of the Corporation's shareholders; including in the Merger Agreement a $50 million termination fee; and failing to create the conditions for an open and vigorous auction of the Corporation. The complaint seeks injunctive relief as well as compensatory and punitive damages. The Corporation believes that these complaints lack merit and intends to defend them vigorously. OTHER CLASS ACTION. On March 23, 1994, two stockholders of Dreyfus Liquid Assets, Inc. ("Dreyfus Liquid Assets") and Dreyfus Growth Opportunity Fund, Inc. ("Dreyfus Growth") filed a complaint in the Supreme Court of the State of New York, County of Queens, naming the Corporation and Service Corporation as defendants, and Dreyfus Liquid Assets and Dreyfus Growth, individually, and as representatives of the management investment companies for which the Corporation serves as investment adviser under the 1940 Act, as nominal defendants. The ITEM 3. LEGAL PROCEEDINGS-CONTINUED - ------ ----------------- complaint is brought derivatively on behalf of Dreyfus Liquid Assets and Dreyfus Growth, individually, and as representatives of the Dreyfus family of funds. In the complaint, the plaintiffs allege, among other things, that the Corporation and Service Corporation violated their fiduciary duties by receiving pecuniary benefits from the sale of their "trust offices" in connection with the Merger. The plaintiffs further allege that the Corporation and Service Corporation breached their respective fiduciary duties by charging the Dreyfus family of funds excessive fees, of at least $55 million, in order to maximize profits earned from the sale of the "trust offices," and by acting solely to maximize their own profits through the proposed sale of the "trust offices" to Mellon, in violation of Section 15(f) of the 1940 Act. Finally, the plaintiffs allege that the Merger will impose an "unfair burden" on the Dreyfus family of funds. The action seeks, among other things, to enjoin the Corporation and Service Corporation from selling the profits from the "trust offices" to Mellon, or, in the event the Merger is consummated, a rescission of such sale, or an accounting and disgorgement of all profits earned by the Corporation and Service Corporation as a result of the sale of the "trust offices," unspecified compensatory damages, costs and disbursements. Defendants' time to move, answer or otherwise respond to the complaint has not yet expired. The Corporation believes that the complaint lacks merit and intends to defend the suit vigorously. APPLICATION FILED WITH SEC. On December 22, 1993, six shareholders of mutual funds of which the Corporation is the adviser filed an application with the SEC for a statutory determination that the "independent" directors of the individual Corporation-managed mutual funds are "interested" directors within the meaning of the 1940 Act, thereby prohibiting them from voting on each of the fund's advisory contracts and other related matters in connection with the Merger (the "Application"). In the Application, the applicants allege, among other things, that (i) many of the "independent" directors serve on multiple boards of funds within the Corporation-managed mutual funds, (ii) as a result of such service, such directors earn material sums of money for very limited services, (iii) such directors have material business or professional relationships with the investment adviser, the Corporation, and (iv) these directors are, therefore, "interested." The Application further claims that common service on multiple boards with "interested" directors who are employees of the Corporation renders the "independent" directors "interested." The applicants also allege that since the "independent" directors of the Corporation-managed mutual funds are "interested," the directors are not qualified to make decisions on behalf of the funds. Applicants further note that as a result of the Merger, the Corporation's advisory contracts with various funds will terminate. Applicants contend that truly independent directors might well be in a position to bargain for possibly more advantageous terms in the investment advisory contracts from Mellon than had been negotiated with the Corporation. In the Application, applicants are seeking (i) a hearing before the SEC to consider their application, (ii) discovery from the Corporation and Mellon prior to such hearing, as such is permitted under the Administrative Procedure Act, and (iii) an order to the Corporation to cease and desist any efforts to obtain approval by the shareholders or the Boards of Directors of the Corporation-managed mutual funds of the proposed Merger or new contracts for advisory services arising from such Merger pending the hearing and a final ruling on the application by the SEC. ITEM 3. LEGAL PROCEEDINGS-CONTINUED - ------ ----------------- The "independent" directors have opposed the Application on the grounds that (i) the Directors are not interested persons within Section 2(a)(19) of the 1940 Act, and (ii) the legislative history, court and SEC decisions, and industry practice all recognize that service on multiple boards within a mutual fund complex does not render a director "interested" within the meaning of the 1940 Act. Counsel for the "independent" directors have advised the Corporation that the Application lacks merit. OTHER. The Corporation also is involved in ordinary routine litigation incidental to its business. Other than as described above, there are no pending legal proceedings or contingent liabilities affecting the Corporation that are expected to have a material adverse impact on the Corporation's financial position and results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------ --------------------------------------------------- No matters were submitted to a vote of the stockholders of the Corporation during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED - ------ ----------------------------------------------------- STOCKHOLDER MATTERS ------------------- Common Stock Market Prices and Dividends on page 17 of the annual stockholders report for the year ended December 31, 1993 are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - ------ ----------------------- Selected Consolidated Financial Data on page 3 of the annual stockholders report for the year ended December 31, 1993 are 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 on pages 4 through 6 of the annual stockholders report for the year ended December 31, 1993 are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------ ------------------------------------------- The following consolidated financial statements of the registrant and its subsidiaries are submitted in a separate section of this report: Consolidated statements of income--years ended December 31, 1993, 1992 and 1991 Consolidated balance sheets--December 31, 1993 and 1992 Consolidated statements of changes in Stockholders' 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 Selected Quarterly Consolidated Financial Data, on page 3 of the annual stockholders report for the year ended December 31, 1993, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------ --------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- No events requiring disclosure under this item have occurred. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------- -------------------------------------------------- Identification of Directors - --------------------------- The following table lists the names, ages (at December 31, 1993), and principal occupation and employment during the past five years of each Director of the Corporation, as well as the period he or she has served as a Director. Directors are elected to serve until the next annual meeting of the Corporation and until their successors shall have been duly chosen and shall have qualified. Principal Occupation Director Name Age or Employment Since - ---- --- ------------------- --------- Mandell L. Berman 76 Real Estate Consultant and Private 1970 Investor. Mr. Berman is also Immediate Past Chairman of the Board of Trustees of the Skillman Foundation, a member of the Board of Vintners International, and serves as a member of the Executive Investment Committee of the Corporation's Board of Directors. Joseph S. DiMartino 50 President and Chief Operating Officer 1982 of the Corporation since October 1982, formerly Executive Vice President since October 1981, and prior thereto Senior Vice President of the Corporation; Executive Vice President and a Director of Service Corporation; an officer and/or director or trustee of various investment companies advised or administered by the Corporation. Mr. DiMartino is also a Director of Noel Group, Inc., a Director and Corporate Member of the Muscular Dystrophy Association, and a Trustee of Bucknell University. Alvin E. Friedman 74 Senior Adviser to Dillon, Read & Co. 1984 Inc., an investment banking firm, since February 1986, formerly a Director since May 1984; prior thereto, managing director of Lehman Brothers Kuhn Loeb Incorporated. Mr. Friedman is a Director and member of various Board committees of Avnet, Inc. He also serves as a member of the Audit/ Compensation and Executive Investment Committees of the Corporation's Board of Directors. Lawrence M. Greene 82 Legal Consultant to the Corporation 1965 since January 1982, formerly Vice President-Legal of the Corporation; Executive Vice President and Director of Service Corporation; an officer and/or director or trustee of various investment companies managed by the Corporation; an officer and/or director of various subsidiaries of the Corporation. Mr. Greene also serves as a member of the Audit/Compensation Committee of the Corporation's Board of Directors. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - continued - ------- -------------------------------------------------- Abigail Q. McCarthy 78 Author, lecturer, columnist, 1970 educational consultant. Mrs. McCarthy was Founding President of the Washington Clearing House on Women's Issues and is on The Advisory Board of the Washington Independent Writers. Julian M. Smerling 65 Vice Chairman of the Board of the 1980 Corporation since October 1981, formerly Senior Vice President of the Corporation; Executive Vice President and a Director of Service Corporation. Mr. Smerling also serves as a member of the Executive Investment Committee of the Corporation's Board of Directors. Howard Stein 67 Chairman of the Board and Chief 1965 Executive Officer of the Corporation; Chairman of the Board of Service Corporation; an officer and/or director, trustee or managing general partner of various of the investment companies managed by the Corporation. Mr. Stein is a Director of Avnet, Inc. and a Trustee of Corporate Property Investors. He also serves as a member of the Executive Investment Committee of the Corporation's Board of Directors. David B. Truman 80 Educational Consultant; past President 1965 of the Russell Sage Foundation, a social science research organization; President of Mount Holyoke College from July 1969 to June 1978. Mr. Truman is also a member of the Audit/Compensation Committee of the Corporation's Board of Directors. Identification of Executive Officers - ------------------------------------ The following table lists the names, ages (at December 31, 1993), dates first elected as officers of the Corporation in the positions stated, and principal occupations and employment during the past five years of each of the Corporation's executive officers. All officers are elected to terms of office for one year. Name Age Principal Occupation or Employment - ---- --- ---------------------------------- Howard Stein 67 Chairman of the Board and Chief Executive Officer since December 1970; President from January 1980 to October 1982; Chairman of the Board of Service Corporation since February 1983 and Director since February 1968; Chairman of the Board of The Dreyfus Fund since February 1970, Director since May 1965, President from May 1965 to June 1984 and Investment Officer since 1960; also, an officer, director, trustee and/or managing general partner of various other companies sponsored by, or affiliated with, the Corporation. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - continued - ------- -------------------------------------------------- Julian M. Smerling 65 Vice Chairman of the Board since October 1981; Director since January 1980; Senior Vice President from December 1975 to October 1981; Director of Service Corporation since February 1968; Executive Vice President of Service Corporation; also, an officer and/or director of other companies affiliated with the Corporation. Joseph S. DiMartino 50 President and Chief Operating Officer since October 1982 and Director since June 1982; Executive Vice President from October 1981 to October 1982; Senior Vice President from September 1979 to October 1981; Director of Service Corporation since April 1973; Executive Vice President of Service Corporation; President, Director and Investment Officer of Dreyfus Liquid Assets and other money market mutual funds; also, an officer, director and/or trustee of various other companies sponsored by, or affiliated with, the Corporation. David W. Burke 57 Vice President and Chief Administrative Officer since October 1990; Vice President and Director of The Dreyfus Trust Co. (N.Y.); President of CBS News, a division of CBS, Inc., from August 1988 to September 1990; Executive Vice President of ABC News, a division of Capital Cities/ABC, from May 1986 to August 1988, and Vice President-Planning and Assistant to the President of ABC News from August 1977 to May 1986. Alan M. Eisner 54 Vice President and Chief Financial Officer since April 1981; an officer and/or director of other companies affiliated with the Corporation. Daniel C. Maclean 51 Vice President since December 1982 and General Counsel since March 1978; Secretary from October 1977 to December 1982; Secretary of Service Corporation since October 1977; also, an officer and/or director of other companies sponsored by, or affiliated with, the Corporation. Robert F. Dubuss 58 Vice President since March 1983; Assistant Vice President from July 1973 to March 1983; Treasurer of Service Corporation since September 1979; Assistant Treasurer of The Dreyfus Fund, Inc. since April 1969; also, an officer and/or director of other companies affiliated with the Corporation. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - continued - ------- -------------------------------------------------- Elie M. Genadry 49 Vice President - Institutional Sales since June, 1989; President of the Institutional Services Division of Service Corporation since February 1987 and Executive Vice President of Service Corporation since September 1983; Vice President-Institutional Operations of Service Corporation from October 1979 to September 1983; Interim President of the Group Retirement Plans Division of Service Corporation from November 1991 to August 1992 and President since August 1992; and Interim President of the Broker/Dealer Division of Service Corporation from January 1992 to May 1992 and President since May 1992. Also, an officer of other investment companies advised or administered by the Corporation. Jeffrey N. Nachman 43 Vice President - Mutual Fund Accounting since June 1989; Co-Manager of the Corporation's Mutual Fund Operations Department from November 1987 through June 1989 and Assistant Manager of the Mutual Fund Operations Department from July 1973 through November 1987. Also, an officer of other investment companies advised or administered by the Corporation. Peter A. Santoriello 46 Vice President since December 1982; Director and President of Dreyfus Management, Inc. since December 1977; President and Director of Dreyfus Balanced Fund, Inc. since June 1992. Robert H. Schmidt* 57 Vice President since January 1991; President and Director of Service Corporation and of Seven Six Seven Agency, Inc. since January 1991; Chairman and Chief Executive Officer of Levine, Huntley, Schmidt & Beaver, an advertising agency, from March 1972 to December 1990. Kirk V. Stumpp 39 Vice President-New Product Development since July 1993; Senior Vice President and Director of Marketing for Service Corporation since 1986; and Marketing Manager of Retail Products from 1982-1987. Philip L. Toia 60 Vice President since August 1986; Director of Fixed Income Research of the Corporation since January 1991; an officer and/or director of other companies affiliated with the Corporation; Senior Vice President of The Chase Manhattan Bank, N.A. and the Chase Manhattan Capital Markets Corporation from 1979 to July 1986. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - continued - ------- -------------------------------------------------- Mark N. Jacobs 47 Secretary since December 1982; Deputy General Counsel since January 1992, Associate General Counsel from February 1983 to December 1991 and Assistant General Counsel from June 1977 to February 1983; also, an officer of other companies sponsored by, or affiliated with, the Corporation. John J. Pyburn 58 Assistant Vice President since December 1983; Manager of the Corporation's Mutual Fund Operations Department from 1974 to June 1989; also, an officer of other companies sponsored by the Corporation. Katherine C. Wickham 44 Assistant Vice President-Human Resources since November 1989; Project Manager from September 1983 to October 1989; also, Vice President of Dreyfus Consumer Life Insurance Company since May 1984. Maurice Bendrihem 42 Controller since July 1986; also, an officer of other companies affiliated with the Corporation. Christine Pavalos 61 Assistant Secretary since March 1972; Assistant Secretary of Service Corporation since February 1968; Assistant Secretary of the Dreyfus Fund since March 1973; also, an officer of other companies affiliated with the Corporation. * Mr. Schmidt and the Corporation are currently discussing an arrangement pursuant to which Mr. Schmidt would cease to be an executive officer on or prior to June 30, 1994 but would continue as a consultant through October 31, 1994. Business Experience - ------------------- Included above under "Principal Occupation or Employment." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - ------- ---------------------- The information given below sets forth the annual and long-term compensation for services to the Corporation during the indicated fiscal years of those person who were, as of December 31, 1993, (i) the Chief Executive Officer, and (ii) the other four most highly compensated officers of the Corporation. 1. The amount shown for Mr. Stein represents his exercise, during 1992, of options granted to him in 1982, and reflects the increase in the Corporation's book value per share during the ten year period between the grant and the exercise of such options. ITEM 11. EXECUTIVE COMPENSATION - continued - ------- ---------------------- 2. The amounts shown in the "All Other Compensation" column for 1993 represent amounts paid to or accrued for the named individuals in accordance with the Corporation's Retirement Profit-Sharing Plan ("RPSP"), Deferred Compensation Plan ("DCP"), and/or Optional Incentive Payment Plan ("OIPP"), as follows: Howard Stein - $30,000 RPSP, $408,762 DCP, and $609,928 OIPP; Joseph S. DiMartino - $30,000 RPSP, $282,759 DCP, and $609,928 OIPP; Julian M. Smerling - $30,000 RPSP, $281,437 DCP, and $653,176 OIPP; Robert H. Schmidt - $30,000 RPSP and $120,000 DCP; and David W. Burke - $30,000 RPSP and $145,000 DCP. An amount of $36,905 is also included for Mr. DiMartino, representing the dollar value of the benefit to him of the premium paid by the Corporation during 1993 for the non-term portion of a split-dollar life insurance policy covering Mr. DiMartino and his wife. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR END OPTION VALUES The information presented below relates to options previously granted pursuant to either: (1) the Corporation's Incentive Stock Option Plan, which was approved by stockholders in 1982 and expired as to the grant of new options in 1992; or (2) the Corporation's 1989 Non-Qualified Stock Option Plan, approved by stockholders in 1989. There were no options granted to or exercised by the executive officers named below during 1993. ITEM 11. EXECUTIVE COMPENSATION - continued - ------- ---------------------- PENSION PLAN TABLE Years of Service ---------------------------------------------------------- Remuneration 15 20 25 30 35 - ------------ -- -- -- -- -- $125,000 $17,493 $23,325 $29,156 $34,987 $40,818 150,000 20,992 27,990 34,988 41,985 48,983 175,000 24,491 32,655 40,818 48,983 57,146 200,000 27,990 37,320 46,650 55,980 65,310 225,000 31,489 41,985 52,481 62,977 73,473 250,000 33,005 44,007 55,010 66,012 77,014 The above table shows the estimated annual pension benefits payable under the Pension Plan at the normal retirement age of 65, subject to limitations, if any, under the Internal Revenue Code, assuming payments made on the normal straight life annuity basis and not under any of the various survivor options. The benefits under the Pension Plan are not reduced for Social Security or other benefits received by participants. Remuneration covered by the plan consists of an employee's base salary (limited by the Internal Revenue Code during 1993 to a maximum of $235,840), and benefits are payable based on the average salary over the final ten years of employment. The years of credited service to date of the individuals listed in the Summary Compensation Table and their current compensation covered by the Pension Plan are: Howard Stein - 39 years, $235,840, Julian M. Smerling - 37 years, $163,942, Joseph S. DiMartino - 23 years, $169,231, Robert H. Schmidt - 3 years, $235,840, and David W. Burke - 3 years, $235,840. Compensation of Directors - ------------------------- Directors who are also officers of the Corporation receive no remuneration for their service as a Director or for their attendance at Board Meetings. Each Director who is not an officer of the Corporation receives a per annum fee of $20,000 in addition to a fee of $500 (increased to $1,000 effective October 14, 1993) for each Board Meeting attended. Non-officer members of the Audit/Compensation and Executive Investment Committees of the Board of Directors receive an attendance fee of $500 for each Audit/Compensation or Executive Investment Committee meeting attended. Mr. Greene serves as a consultant to the Corporation principally with respect to legal matters. He receives $75,000 on an annual basis under his consulting agreement with the Corporation. ITEM 11. EXECUTIVE COMPENSATION - continued - ------- ---------------------- Termination of Employment and Change-In-Control Arrangements - ------------------------------------------------------------ Contingent Benefit Plan - In 1984, the stockholders approved a Contingent Benefit Plan (the "Plan") adopted in order to provide for specified benefit payments to designated key employees of the Corporation in the event of termination of their employment after a change of control of the Corporation (defined as the acquisition of more than 25% of the voting stock of the Corporation). Under the Plan, the Board of Directors may grant the key employees a maximum aggregate of 1,500,000 Units, each representing the difference between the book value of one share of common stock of the Corporation and its market price, as defined. Each Unit represents the obligation of the Corporation to pay its value, in cash, in the event of termination of employment of the key employee, including voluntary termination but excluding termination for cause, within a period of two years following the change of control. As of December 31, 1993, the individuals named in the Summary Compensation Table had been granted the following numbers of Units pursuant to the Plan: Howard Stein - 165,000 Units, Joseph S. DiMartino - 165,000 Units, and Julian M. Smerling - - 165,000 Units. Supplemental Retirement Benefits - Pursuant to an agreement with the Corporation, Julian M. Smerling will receive supplemental retirement benefits of $500,000 per year, with a ten year certain payout. The agreement provides for a lump-sum payment of the entire remaining amount of such retirement benefits in the event of a change of control (as defined) of the Corporation. See also Item 10 - "Directors and Executive Officers of the Registrant." Compensation Committee Interlocks and Insider Participation - ----------------------------------------------------------- The members of the Audit/Compensation Committee of the Board of Directors are Alvin E. Friedman, Lawrence M. Greene and David B. Truman. Mr. Greene was formerly an officer of the Corporation, and is currently an officer of various subsidiaries of the Corporation, including Executive Vice President of Service Corporation. Messrs. Friedman and Truman are the sole members of the Executive Compensation Sub-Committee of the Audit/Compensation Committee. Merger Agreement - ---------------- The Agreement and Plan of Merger between the Corporation and Mellon described in Item 1 above contains provisions pursuant to which, if the merger with Mellon is consummated, changes in and additions to the Corporation's various employee benefits plans, agreements and programs will be implemented. Certain of the Corporation's directors and executive officers are participants in these plans, agreements and programs. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------- -------------------------------------------------------------- The following stockholders owned beneficially more than 5% of the Corporation's common stock issued and outstanding, according to filings made with the SEC: Name and Address Number of Shares Percentage ---------------- ---------------- ---------- Michael F. Price 1,894,900 as of 5.2% Heine Securities Corporation December 14, 1993 51 John F. Kennedy Parkway Short Hills, New Jersey The Equitable Companies 2,097,900 as of 5.7% Incorporated December 31, 1993 787 Seventh Avenue New York, New York The shares shown above for Michael F. Price and Heine Securities Corporation ("HSC") are held by HSC, a registered investment adviser, on behalf of its clients. Mr. Price is also listed as a beneficial owner of such shares since as President of HSC he exercises voting control and dispositive power over the securities held by HSC. The shares shown above for The Equitable Companies Incorporated were acquired for investment purposes by various of its subsidiaries, either directly or on behalf of client discretionary investment advisory accounts. The Depository Trust Company, central depository for the securities industry, held of record 33,070,272 shares or 90.5% of the Corporation's common stock issued and outstanding as of January 31, 1994. The beneficial ownership of such shares is not readily determinable. The following table represents shares of the Corporation's common stock beneficially owned by the Directors, other named executive officers, and all officers and Directors as a group, as of January 31, 1994. Name Number of Shares(1) Percent of Total Outstanding - ---- ---------------- ---------------------------- Mandell L. Berman 481,314 1.3% Joseph S. DiMartino 158,441 .4% Alvin E. Friedman 600 - Lawrence M. Greene 35,000 .1% Abigail Q. McCarthy 337 - Julian M. Smerling 116,347 .3% Howard Stein 1,204,661 3.3% David B. Truman 1,000 - Robert H. Schmidt 14,912 - David W. Burke 39,729 .1% All Directors and Officers as a group 2,664,030 7.3% - ---------------------- 1. The shares shown above include those held for the benefit of participants in the Corporation's Retirement Profit-Sharing Plan. It is estimated that Messrs. DiMartino, Smerling, Stein, Schmidt and Burke, and all officers of the Corporation as a group, had a beneficial interest in ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND - ------- --------------------------------------------------- MANAGEMENT - continued ---------- 33,441, 66,347, 178,361, 1,412, 2,226 and 603,557 of such shares, respectively, as of January 31, 1994. The shares shown above for the following individuals and group also includes those shares with respect to which there exists the right to acquire beneficial ownership pursuant to vested options, as follows: Joseph S. DiMartino - 125,000 shares, Julian M. Smerling - 50,000 shares, Howard Stein - 65,900 shares, Robert H. Schmidt - 12,500 shares, David W. Burke - 37,500 shares, and all Directors and officers as a group - 525,575 shares. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------- ---------------------------------------------- Loans to Officers - Two officers of the Corporation received mortgage loans from the Savings Bank during 1993, and a third officer remained as guarantor for such a loan made to a relative in 1992. Such loans were made in the ordinary course of business, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and did not include more than the normal risk of collectibility or present other unfavorable features. In addition, the loans to the two officers were subsequently sold in the secondary market, so that thereafter no indebtedness existed, or exists, between such officers and the Savings Bank. See also Item 10 - "Directors and Executive Officers of the Registrant." 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. (3)--Listing of Exhibits: 2 Agreement and Plan of Merger with Mellon Bank Corporation, Mellon Bank, N.A. and XYZ Sub Corporation, a subsidiary of Mellon Bank.* 3.(i)(a) Articles of Incorporation, as amended, are incorporated by reference to Exhibit 3(a) filed as a part of the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1983. 3.(i)(b) Certificate of Amendment to Articles of Incorporation effective as of June 16, 1986, is incorporated by reference to Exhibit 3(a)(ii) filed as part of the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 3.(i)(c) Certificate of Amendment to Articles of Incorporation effective as of June 16, 1987 is incorporated by reference to Exhibit 3(a)(ii) filed as part of The Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. 3.(i)(d) Certificate of Amendment to Articles of Incorporation effective as of June 27, 1988 is incorporated by reference to Exhibit 3(a)(ii) filed as part of the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. 3.(ii)(a) By-laws, as amended, are incorporated by reference to Exhibit 3(b) filed as a part of the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1984. 3.(ii)(b) Amendments to By-laws occurring from July 25, 1984 through March 3, 1988 are incorporated by reference to Exhibit 3(b)(ii) filed as a part of the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. *Omitted from filing of this Report and filed separately with the Securities and Exchange Commission. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM - ------- ----------------------------------------------------------- 8-K --Continued --- 10. Material Contracts 10.(iii)(A)(a) Agreement with respect to supplemental retirement benefits is incorporated by reference to Exhibit 10(ii)(A) filed as a part of the Corporations' Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 10.(iii)(A)(b) Amended Deferred Compensation Plan is incorporated by reference to Exhibit 10(iii)(A) filed as a part of the Corporations' Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10.(iii)(A)(c) An Incentive Stock Option Plan approved by shareholders in 1982 is incorporated by reference to the Corporation's proxy material for its 1982 Annual Meeting. 10.(iii)(A)(d) A Contingent Benefit Plan approved by shareholders in 1984 is incorporated by reference to the Corporation's proxy material for its 1984 Annual Meeting. 10.(iii)(A)(e) Optional Incentive Payment Plan is incorporated by reference to Exhibit 10(iii)(A) filed as a part of the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 10.(iii)(A)(f) 1989 Non-Qualified Stock Option Plan approved by shareholders in 1989 is incorporated by reference to the Corporation's proxy material for its 1989 Annual Meeting. 10.(iii)(A)(g) Agreement relating to split-dollar life insurance policy covering Joseph S. DiMartino and his wife.** 10.(iii)(A)(h) Consulting Agreement with Lawrence M. Greene.** 11. Computation of Earnings Per Share of Common Stock. 13. Annual Report to Stockholders for the year ended December 31, 1993. 21. Subsidiaries of the Registrant. 23. Consent of Independent Auditors. (b) Reports on Form 8-K filed in the fourth quarter of 1993: On December 7, 1993 the Corporation filed a Report on Form 8-K describing the Corporation's announcement of its execution of an Agreement and Plan of Merger with Mellon Bank Corporation. **Included in filing with the Securities and Exchange Commission only. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND - ------- ------------------------------------------- REPORTS ON FORM 8-K ------------------- (c) Exhibits EXHIBIT 11 -- COMPUTATION OF EARNINGS PER SHARE -- THE DREYFUS CORPORATION AND SUBSIDIARY COMPANIES ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND - ---------------------------------------------------- REPORTS ON FORM 8-K-- --------------------- (c) Exhibits EXHIBIT 11 -- COMPUTATION OF EARNINGS PER SHARE -- THE DREYFUS CORPORATION AND SUBSIDIARY COMPANIES (CONTINUED) ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM - ------- ----------------------------------------------------------- 8-K--Continued --- Exhibit 13 - Annual Report to Stockholders for the year ended December 31, 1993. (Pages 54 through 73) ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM - ------- ----------------------------------------------------------- 8-K--Continued --- (c) Exhibits--Continued Exhibit 21--Subsidiaries of the Registrant State of Date of Incorporation Incorporation ------------- ------------- The Dreyfus Corporation New York 1947 Subsidiaries of The Dreyfus Corporation(1) --------------------------------------- Dreyfus Service Corporation New York 1968 Dreyfus Management, Inc. New York 1970 Dreyfus Personal Management, Inc.(2) New York 1983 Dreyfus Consumer Life Insurance Company Connecticut 1981 The Dreyfus Security Savings Bank, F.S.B.(3) New Jersey 1970 Dreyfus Thrift & Commerce(4) Utah 1987 Dreyfus Realty Advisors, Inc.(5) Delaware 1986 The Dreyfus Trust Company(6) New York 1984 The Dreyfus Consumer Credit Corporation Delaware 1983 Lion Management, Inc.(7) Delaware 1988 Dreyfus Acquisition Corporation New York 1974 (1) The names of certain subsidiaries of the Corporation have been omitted because, considered in the aggregate as a single subsidiary, they would not constitute a significant subsidiary. Except as noted, all of the above listed subsidiaries are wholly-owned by the Corporation, except for directors' qualifying shares. (2) This subsidiary discontinued operations as of June 30, 1993. (3) The stock of this subsidiary is held as the sole asset of a separate, wholly-owned subsidiary of the Corporation, Dreyfus-Lincoln, Inc., which was incorporated in New Jersey in 1983. (4) The stock of this subsidiary is held as an asset of a separate, wholly-owned subsidiary of the Corporation, The Dreyfus Holding Corporation, which was incorporated in Delaware in 1982. (5) The stock of this subsidiary is held as an asset of a separate, wholly-owned subsidiary of the Corporation, Dreyfus Service Organization, Inc., which was incorporated in Delaware in 1971. (6) The stock of this subsidiary is held as an asset of a separate, wholly-owned subsidiary of the Corporation, Dreyfus Garden City, Inc., which was incorporated in Delaware in 1984. (7) The stock of this subsidiary is held as an asset of Service Corporation. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM - ------- ----------------------------------------------------------- 8-K--Continued --- (c) Exhibits--Continued Exhibit 23--Consent of Independent Auditors CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in Pre-Effective Amendment No. 4 to Registration Statement No. 33-37606 on Form S-3 dated August 30, 1991, Post-Effective Amendment No. 15 to Registration Statement No. 2-41530 on Form S-8 dated April 30, 1984, Post-Effective Amendment No. 12 to Registration Statement No. 2-47970 on Form S-3 dated April 30, 1984, Post-Effective Amendment No. 14 to Registration Statement No. 2-42821 on Form S-3 dated April 30, 1984, and in Post-Effective Amendment No. 11 to Registration Statement No. 2-50996 on Form S-3 dated April 30, 1984 of our report dated January 27, 1994, with respect to the consolidated financial statements and schedules of The Dreyfus Corporation, included in the Annual Report (Form 10-K) for the year ended December 31, 1993. /s/ ERNST & YOUNG New York, New York March 25, 1994 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM - ------- ----------------------------------------------------------- 8-K--Continued --- (d) Financial Statement Schedules--The response to this portion of Item 14 is submitted as a separate section 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 on Form 10-K for the fiscal year ended December 31, 1993, to be signed on its behalf by the undersigned, thereunto duly authorized. THE DREYFUS CORPORATION ----------------------- Principal Executive Officer --------------------------- /s/ Howard Stein ---------------------------- Howard Stein Principal Financial Officer --------------------------- /s/ Alan M. Eisner ---------------------------- Alan M. Eisner Principal Accounting Officer ---------------------------- /s/ Maurice Bendrihem ---------------------------- Maurice Bendrihem Dated: March 30, 1994 SIGNATURES OF DIRECTORS ----------------------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report on Form 10-K for the fiscal year ended December 31, 1993, to be signed on its behalf by the undersigned as Directors of the Registrant. /s/ Mandell L. Berman /s/ Abigail McCarthy -------------------------- ------------------------- Mandell L. Berman Abigail McCarthy /s/ Joseph S. DiMartino /s/ Julian Smerling -------------------------- ------------------------- Joseph S. DiMartino Julian Smerling /s/ Alvin E. Friedman /s/ Howard Stein -------------------------- -------------------------- Alvin E. Friedman Howard Stein /s/ Lawrence M. Greene /s/ David B. Truman -------------------------- -------------------------- Lawrence M. Greene David B. Truman Dated: March 30, 1994 ANNUAL REPORT ON FORM 10-K ITEM 14(a) (1) AND (2) AND ITEM 14(d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 THE DREYFUS CORPORATION AND SUBSIDIARY COMPANIES The following consolidated financial statements of The Dreyfus Corporation and subsidiary companies are included in Item 8: Page In Form 10-K ------------- Report of Independent Auditors . . . . . . . . . . . . . . . . . . . . . 38 Consolidated statements of income--years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . 39 Consolidated balance sheets--December 31, 1993 and December 31, 1992. . . . . . . . . . . . . . . . . . . . . . . . . . . 40-41 Consolidated statements of changes in Stockholders' Equity-- years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . 42 Consolidated statements of cash flows--years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . . . . . . 43 Notes to consolidated financial statements . . . . . . . . . . . . . . . 44-49 The following consolidated financial statement schedules of The Dreyfus Corporation and subsidiary companies are included in Item 14(d): Page In Form 10-K --------- Schedule I -- Marketable securities--other investments. . . . . . . . 50-52 Schedule X -- Supplementary income statement information. . . . . . . 53 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. Financial statements of subsidiaries not consolidated and 50% or less owned persons accounted for by the equity method have been omitted because they do not meet the requirements of Rule 3-09(a) of Regulation S-X. Report of Independent Auditors Stockholders and Board of Directors The Dreyfus Corporation We have audited the accompanying consolidated balance sheets of The Dreyfus Corporation and Subsidiary Companies 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. 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 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Dreyfus Corporation and Subsidiary Companies 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. /s/ ERNST & YOUNG New York, New York January 27, 1994, except for Note 14, as to which the date is March 23, 1994 Page> The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED STATEMENTS OF INCOME See notes to consolidated financial statements. The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Nature of Business: The Dreyfus Corporation ("Corporation") and Subsidiary Companies comprise a financial service organization whose primary business consists of providing investment management services as the investment adviser, manager and distributer for sponsored investment companies and as an investment adviser to other accounts. In addition, the Corporation is the sub-investment adviser and/or admistrator of several investment companies sponsored by others. Principles of Consolidation: The consolidated financial statements include the accounts of the Corporation and its subsidiaries. All significant intercompany accounts and transactions were eliminated in consolidation. Income Recognition: Management, investment advisory and administrative fees are reported net of expense reimbursements to certain funds. Transactions in investment securities are recorded on a trade date basis. Net realized gains or losses resulting from the sale of investments are recorded on the identified cost basis and included in operations. Declines in value of investments which are accounted for as "other than temporary" are charged to operations. Certain prior year amounts have been reclassified to conform to the current year's presentation. Fair Value of Financial Instruments: The following methods and assumptions were used by the Corporation in estimating its fair value disclosures for financial instruments: Cash and cash equivalents: The carrying amount reported in the balance sheet for cash and cash equivalents approximates fair value. Marketable securities: The fair value of the Corporation's marketable securities portfolios are based on quoted market prices or dealer quotes. Other investments: The fair value of certain limited partnerships engaged in securities trading, which are accounted for at cost, is based on quoted market prices of the respective partnerships' underlying securities portfolios. Financial instruments with off-balance sheet risk: The fair value of the Corporation's financial instruments with off-balance sheet risk is based on quoted market prices or dealer quotes. Banking customer deposits: The fair value of fixed-maturity certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently offered for deposits of similar remaining maturities to a schedule of aggregated expected monthly maturities on time deposits. The fair value for demand deposits, savings accounts and money market bank accounts are equal to the amounts payable on demand at the reporting date. NOTE 2 -- INVESTMENTS: Marketable Equity Securities: The Corporation, excluding Dreyfus Service Corporation ("Service Corporation"), carries its marketable equity securities portfolio at cost (long positions) or proceeds (short positions) if the portfolio has an aggregate net unrealized gain, or at market if the portfolio has an aggregate net unrealized loss. It is the Corporation's policy to charge aggregate net unrealized losses on the marketable equity securities portfolio to Stockholders' Equity; aggregate net unrealized gains on the marketable equity securities portfolio are not recognized, except to the extent of aggregate net unrealized losses previously recognized. The Corporation engages in short selling which obligates the Corporation to replace the security borrowed by purchasing the identical security at its then current market value. Service Corporation, a wholly-owned broker-dealer subsidiary of the Corporation, carries its securities at market value, in accordance with the practice in the brokerage industry. At December 31, 1993, the Corporation's marketable equity securities portfolio had an aggregate net unrealized gain amounting to $6,060,000. Gross unrealized gains and losses on such securities amounted to $10,820,000 and $4,760,000, respectively. The Corporation's aggregate long positions in the marketable equity securities portfolio were carried at cost of $183,968,000 (fair value - $190,138,000) and the aggregate short positions in the marketable equity securities portfolio were carried at proceeds of $7,915,000 (fair value - -$8,025,000). At December 31, 1992, the Corporation's aggregate long positions in the marketable equity securities portfolio were carried at market of $269,707,000 (cost - $280,908,000) and the aggregate short positions in the marketable equity securities portfolio were carried at market of $1,441,000 (proceeds - -$1,187,000). In 1993, the Corporation charged operations for $10.8 million in connection with "other than temporary" declines in the value of marketable equity securities. Other Marketable Securities: The Corporation (excluding Service Corporation) carries its other marketable securities, consisting primarily of Municipal and U.S. Government obligations, at cost. In addition, the Corporation carries its investments in options to purchase certain securities, designated as trading securities, at market; net unrealized gains and losses thereon are included in operations. Other Investments: Other investments consist of investments in non-readily marketable limited partnerships and non-readily marketable securities. In 1993 and 1992, the Corporation recorded a charge to operations of $4.1 million and $8 million, respectively, in connection with "other than temporary" declines in the value of such investments. Financial Instruments with Off-Balance Sheet Risk: The Corporation is a party to financial instruments with off-balance sheet risk. These financial instruments include futures contracts, forward contracts and options written. The Corporation enters into these transactions as part of its trading activities, as well as to reduce its own exposure to market risk in connection with its positions in certain sponsored index funds. Off-balance sheet financial instruments and commodity futures contracts involve varying degrees of market and credit risk that exceed the amounts recognized on the balance sheet. The estimated fair values for such financial instruments and commodity futures contracts with contract or notional principal amounts that exceed the amount of credit risk at December 31, 1993 are summarized below (000's omitted): Futures and forward contracts represent future commitments to purchase or sell a specified instrument at a specified price and date. Futures contracts are standardized and are traded on regulated exchanges, while forward contracts are traded in over-the-counter markets and generally do not have standardized terms. The Corporation uses futures and forward contracts in connection with its trading activities. For instruments that are traded on a regulated exchange, the exchange assumes the credit risk that a counter party will not settle and generally requires a margin deposit of cash or securities as collateral to minimize potential credit risk. Credit risk associated with futures and forward contracts is limited to the estimated aggregate replacement cost of those futures and forward contracts in a gain position and was not material at December 31, 1993. Credit risk related to futures contracts is substantially mitigated by daily cash settlements with the exchanges for the net change in futures contract value. Market risk arises from movements in securities values, foreign exchange rates and interest rates. Option contracts grant the contract "purchaser" the right, but not the obligation, to purchase or sell a specified amount of a financial instrument during a specified period at a predetermined price. The Corporation acts as both "purchaser" and "seller" of option contracts, which are used in reducing exposure to market risk in connection with its positions in certain sponsored index funds. Market risk arises from changes in market value of contractual positions due to movements in underlying securities or stock indices. The Corporation limits its exposure to market risk by entering into hedge positions. Credit risk relates to the ability of the Corporation's counter party to meet its settlement obligations under the contract and generally is limited to the estimated aggregate replacement cost of those contracts in a gain position and was not material at December 31, 1993. Accounting for Certain Investments in Debt and Equity Securities: 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", which is effective for investments held as of or acquired after January 1, 1994. In the first quarter of 1994, the Corporation intends to adopt the provisions of the new standard, which are not expected to have a material impact on the results of operations or financial condition of the Corporation. NOTE 3 -- FIXED ASSETS: The Corporation and its subsidiaries provide for depreciation on fixed assets (including licensed and certain internally developed computer software) based on the estimated useful life of the assets, using the straight line method. Amortization of leasehold improvements is computed over the respective terms of the leases. The major classifications of fixed assets are as follows (000's omitted): NOTE 4 -- DEFERRED SALES COMMISSIONS: During 1993, certain funds sponsored by the Corporation began offering multiple classes of shares. These funds offer Class A shares, which are sold with a sales charge imposed at the time of purchase, and Class B shares which are subject to a contingent deferred sales charge imposed on redemptions made within a specified period. Class B shares are also subject to an annual distribution fee payable to Service Corporation pursuant to a distribution plan adopted in accordance with Rule 12b-1 under the Investment Company Act of 1940 ("Rule 12b-1 Plan"). Sales commissions paid by Service Corporation to broker/dealers for selling Class B shares are capitalized by Service Corporation and amortized to operations over six years. This amortization period approximates the period of time during which the sales commissions paid to broker/ dealers are expected to be recovered from the funds through the payments made pursuant to the funds' Rule 12b-1 Plans. Contingent deferred sales charges, when received by Service Corporation, reduce unamortized deferred sales commissions. At December 31, 1993, deferred sales commissions included in Other assets amounted to $14.2 million (net of amortization of $1.2 million, included in Underwriting and other fees). NOTE 5 -- STOCKHOLDERS' EQUITY: At December 31, 1993, Additional paid-in capital and Retained earnings were not available for payment of dividends to the extent of $196.6 million, substantially representing the cost of treasury stock and required capital for the Corporation's regulated subsidiaries. Pursuant to the merger agreement (see Note 11), the Corporation may not declare dividends, other than the regular quarterly dividend of $.19 per share, and may not purchase any additional treasury shares. On January 19, 1994, the Board of Directors of the Corporation declared a first quarter dividend of $.19 per share, payable on February 16, 1994 to stockholders of record at the close of business on February 7, 1994. NOTE 6 -- STOCK PLANS AND CONTINGENT BENEFIT PLAN: 1989 Non-Qualified Stock Option Plan: In 1989, the stockholders of the Corporation approved the 1989 Non-Qualified Stock Option Plan (the "Plan") of the Corporation. The Plan authorizes the Corporation to grant Options to purchase up to 1,750,000 shares of common stock to key employees and key consultants who render services to the Corporation, at a price of not less than 95% of the price of the Corporation's common stock on the New York Stock Exchange on the day the Option is granted. The Plan provides generally that no Option shall be exercisable within two years nor more than ten years from the date of grant. Shares acquired upon exercise of Options will be registered under the Securities Act of 1933 and may be resold pursuant to such registration. The following table summarizes the 1989 Non-Qualified Stock Option Plan activity (000's omitted): Such options may be exercised at prices ranging from $24.06 to $41.63. At December 31, 1993, 603,000 of such Options were exercisable. The remaining options are exercisable as follows: 344,500 in 1994, 332,000 in 1995, 119,500 in 1996 and 12,500 in 1997 and 1998. Incentive Stock Option Plan: In 1982, the stockholders of the Corporation approved a plan under which Incentive Stock Options may be granted to the Corporation's key executives allowing them to purchase up to 1,500,000 shares of common stock of the Corporation. Under the plan, Options were granted for the purchase of either Book Value Shares or Market Shares. The plan provides that no Option shall be exercisable within one year, nor more than ten years, from the date of grant. The plan expired in 1992, and no new Options may be granted under the plan, although existing unexercised Options will continue in accordance with their terms. No Market Shares are outstanding. Book Value Shares must be acquired from and sold back to the Corporation at the book value (as defined in the plan) of the Corporation's Common Stock. The plan also provides for compensation (included in Accrued Compensation and Benefits) to recipients of Options in amounts equal to any cash dividends declared by the Corporation during the period following the grant of an Option up to the date of its exercise. Additional information with respect to Incentive Stock Options is as follows (000's omitted): In connection with the exercise of the Options, the Corporation received interest bearing notes payable over a maximum of 15 years. The balance of such notes at December 31, 1993 was $148,000. During 1993 and 1992, the Corporation repurchased 29,000 and 67,000 shares, respectively, issued under the plan, for an aggregate of $500,000 and $1,310,000, respectively. At December 31, 1993 Options to purchase 186,000 Book Value Shares were exercisable. The remaining Options to purchase Book Value Shares are exercisable as follows: 26,700 per year from 1994 to 1997 and 19,000 in each of 1998 and 1999. Such Options to purchase Book Value Shares may be exercised at prices ranging from $4.22 to $15.69. If the Corporation had been obligated to repurchase the Book Value Shares issued and outstanding and also the Book Value Shares related to exercisable Options under the plan at December 31, 1993, the net amount payable would have been approximately $3.4 million. Optional Incentive Payment Plan: In 1986, the Corporation's Board of Directors approved an Optional Incentive Payment Plan (the "Plan") pursuant to which individuals who have previously exercised Stock Purchase Rights ("Rights") and Incentive Stock Options ("Options") (see above) could sell the shares related to such rights and Options back to the Corporation pursuant to the provisions of those respective plans, and in turn receive an equal number of units. Pursuant to the terms of the Plan, quarterly payments are made on each unit held in amounts equal to the quarterly after tax earnings per share of the Corporation and such amounts are charged to operations. The activity in Plan units was as follows (000's omitted): Contingent Benefit Plan: In 1984 a Contingent Benefit Plan (the "Plan") was approved which provides for specified benefit payments to designated key employees of the Corporation in the event of a change of control of the Corporation, as defined in the Plan, and should their employment terminate during a specified period after such change of control (see Note 11). NOTE 7 -- EMPLOYEES' BENEFIT PLANS: The employees of the Corporation and certain of its subsidiaries are covered by a Retirement Profit-Sharing Plan and a related Deferred Compensation Plan. In general, the Retirement Profit-Sharing Plan provides for the payment of death, disability and retirement benefits to employees or their beneficiaries in amounts equal to the value of their proportionate interests in the plan. The aggregate contribution by the Corporation is based on consolidated net income (as defined in the plans) or compensation of eligible employees. Amounts charged to operations under the plans amounted to $9,321,000 in 1993, $9,304,000 in 1992 and $7,082,000 in 1991. The Corporation has a defined benefit pension plan which covers employees of the Corporation and certain of its subsidiaries. The costs to the Corporation and the pension plan assets and liabilities are not material. NOTE 8 -- FEDERAL, STATE AND LOCAL INCOME TAXES: The provisions for Federal and state and local taxes based on income include current tax expense of $59,911,000 in 1993, $51,969,000 in 1992, and $30,448,000 in 1991. Deferred tax provision (credits) were ($1,011,000) in 1993, ($3,469,000) in 1992 and $3,252,000 in 1991. The difference between total tax expense and the amount computed by applying the statutory Federal income tax rate to pre-tax income is as follows (000's omitted): NOTE 9 -- LEASES: Future minimum payments, by year and in the aggregate, under noncancelable operating leases (premises) with initial or remaining terms of one or more years, were as follows at December 31, 1993 (000's omitted): Approximate net rental expense for operating leases amounted to $21,953,000 in 1993, $20,299,000 in 1992 and $18,397,000 in 1991. NOTE 10 -- OTHER REVENUES (NET): In September 1989, a Noncompetition Agreement was entered into with The Bank of New York (Delaware) ("BONY") pursuant to which it was agreed that Dreyfus entities will not compete with BONY in the unsecured credit card business for six years after closing. In consideration for such covenants not to compete, BONY agreed to make six annual payments of $8 million each, commencing in 1990. These payments are being recognized annually over the period of the agreement and are included in Other revenues (net). NOTE 11 -- MERGER WITH MELLON BANK CORPORATION: On December 5, 1993, the Corporation entered into an Agreement and Plan of Merger providing for the merger of the Corporation with a subsidiary of Mellon Bank Corporation ("Mellon"). Under the terms of the agreement, the Corporation's stockholders will be entitled to receive .88017 shares of Mellon Common Stock for each share of the Corporation's Common Stock, in a tax-free exchange. Following the merger, it is planned that the Corporation will be a direct subsidiary of Mellon Bank, N.A. Closing of the merger is subject to a number of contingencies, including the receipt of certain regulatory approvals, the approvals of the stockholders of the Corporation and Mellon, and approvals of the Boards of Directors and shareholders of the mutual funds advised or administered by the Corporation. The merger is expected to occur in mid-1994, but could occur later. The merger agreement provides for the Corporation to pay Mellon $50,000,000, should the Corporation, among other matters, engage in certain business combination transactions specified in the agreement, with any person other than Mellon, or under certain other defined circumstances. Costs incurred in connection with the merger, including payments related to the Contingent Benefit Plan (see Note 6), will be charged against operations of the merged entities. NOTE 12 -- LITIGATION Subsequent to the announcement of the proposed merger with Mellon (see Note 11), public shareholders of the Corporation commenced six purported class action suits in the Supreme Court of the State of New York, County of New York, naming the Corporation, Mellon and the individual directors of the Corporation as defendants, with respect to the transactions contemplated by the Agreement and Plan of Merger with Mellon. The Corporation believes that these complaints lack merit and intends to defend them vigorously. On December 22, 1993, six shareholders of mutual funds of which the Corporation is the adviser ("Dreyfus-managed mutual funds") filed an application with the U.S. Securities and Exchange Commission (the "SEC") for a statutory determination that the "non-interested" directors of the individual Dreyfus-managed mutual funds are "interested" directors within the meaning of the Investment Company Act of 1940, thereby prohibiting them from voting on each of the fund's advisory contracts and other related matters in connection with the merger with Mellon (the "Application"). The non-interested directors have opposed the Application. Counsel for the non-interested directors has advised the Corporation that the Application lacks merit. NOTE 13 -- OTHER MATTERS: A) The Corporation earned revenues (management fees) from Dreyfus Liquid Assets, Inc., in excess of 10% of total revenues in the amount of $32,017,000 during 1991. No individual fund fees were in excess of 10% of total revenues during 1993 or 1992. B) The Corporation reimbursed certain fund expenses aggregating $8.9 million, $6.7 million, and $5.4 million, in 1993, 1992 and 1991 respectively, to promote the growth of fund assets. Such fund expense reimbursements are netted against management fees in the accompanying financial statements. C) Salaries and Other selling, general and administrative expenses of the Corporation have been reduced by reimbursements from certain sponsored investment companies for shareholder servicing costs incurred by the Corporation on their behalf. Such amounts aggregated $29.2 million in 1993, $21.8 million in 1992 and $9.3 million in 1991. NOTE 14 -- SUBSEQUENT EVENT: On March 23, 1994, two stockholders of Dreyfus Liquid Assets, Inc. ("Dreyfus Liquid Assets") and Dreyfus Growth Opportunity Fund, Inc. ("Dreyfus Growth") filed a complaint in the Supreme Court of the State of New York, County of Queens, naming the Corporation and Service Corporation as defendants, and Dreyfus Liquid Assets and Dreyfus Growth, individually, and as representatives of the management investment companies for which the Corporation serves as investment adviser under the 1940 Act, as nominal defendants. The complaint is brought derivatively on behalf of Dreyfus Liquid Assets and Dreyfus Growth, individually, and as representatives of the Dreyfus family of funds. In the complaint, the plaintiffs allege, among other things, that the Corporation and Service Corporation violated their fiduciary duties by receiving pecuniary benefits from the sale of their "trust offices" in connection with the Merger (see Notes 11 and 12). The plaintiffs further allege that the Corporation and Service Corporation breached their respective fiduciary duties by charging the Dreyfus family of funds excessive fees of at least $55 million, in order to maximize profits earned from the sale of the "trust offices," and by acting solely to maximize their own profits through the proposed sale of the "trust offices" to Mellon, in violation of Section 15(f) of the 1940 Act. Finally, the plaintiffs allege that the Merger will impose an "unfair burden" on the Dreyfus family of funds. The action seeks, among other things, to enjoin the Corporation and Service Corporation from selling the profits from the "trust offices" to Mellon, or, in the event that the Merger is consummated, a rescission of such sale or an accounting and disgorgement of all profits earned by the Corporation and Service Corporation as a result of the sale of the "trust offices," unspecified compensatory damages, costs and disbursements. Defendants' time to move, answer or otherwise respond to the complaint has not yet expired. The Corporation believes that the complaint lacks merit and intends to defend the suit vigorously. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THE DREYFUS CORPORATION AND SUBSIDIARY COMPANIES Column B Column A -- Item Charged to expenses - ----------------- ------------------------------------------ Year ended December 31, ------------------------------------------ 1993 1992 1991 ----------- ----------- ----------- Advertising, promotional literature, fulfillment and related mailing costs $54,279,000 $50,353,000 $45,306,000 =========== =========== =========== Note: (a)Amounts for taxes, other than payroll and income taxes, maintenance and repairs and depreciation and amortization of intangible assets are not presented since such amounts are less than 1% of total sales and revenues for 1993, 1992 and 1991. THE DREYFUS CORPORATION ANNUAL REPORT 1993 THE DREYFUS CORPORATION ANNUAL REPORT 1993 DIRECTORS HOWARD STEIN Chairman of the Board and Chief Executive Officer MANDELL L. BERMAN Real Estate Consultant and Private Investor JOSEPH S. DIMARTINO President and Chief Operating Officer ALVIN E. FRIEDMAN Senior Advisor to Dillon, Read & Co., Inc. LAWRENCE M. GREENE Legal Consultant ABIGAIL Q. MCCARTHY Author, Lecturer, Columnist and Educational Consultant JULIAN M. SMERLING Vice Chairman of the Board DAVID B. TRUMAN Educational Consultant OFFICERS* HOWARD STEIN Chairman of the Board and Chief Executive Officer JULIAN M. SMERLING Vice Chairman of the Board JOSEPH S. DIMARTINO President and Chief Operating Officer DAVID W. BURKE Chief Administrative Officer and Vice President ALAN M. EISNER Chief Financial Officer and Vice President DANIEL C. MACLEAN III General Counsel and Vice President ROBERT F. DUBUSS Vice President ELIE M. GENADRY Vice President-- Institutional Sales JEFFREY N. NACHMAN Vice President-- Mutual Fund Accounting PETER A. SANTORIELLO Vice President ROBERT H. SCHMIDT Vice President KIRK V. STUMPP Vice President-- New Product Development PHILIP L. TOIA Vice President JOHN J. PYBURN Assistant Vice President KATHERINE C. WICKHAM Assistant Vice President-- Human Resources MAURICE BENDRIHEM Controller MARK N. JACOBS Secretary and Deputy General Counsel CHRISTINE PAVALOS Assistant Secretary *The officers of the Corporation are also officers and/or directors of one or more affiliated companies and/or sponsored investment companies. MANAGERS OF SPONSORED INVESTMENT COMPANIES HOWARD STEIN JOSEPH S. DIMARTINO PATRICIA CUDDY A. PAUL DISDIER THOMAS A. FRANK KAREN M. HAND RICHARD B. HOEY BARBARA L. KENWORTHY STEPHEN KRIS PATRICIA A. LARKIN KELLY MCDERMOTT RICHARD J. MOYNIHAN PETER A. SANTORIELLO JILL SHAFFRO RICHARD SHIELDS L. LAWRENCE TROUTMAN SAMUEL WEINSTOCK MONICA S. WIEBOLDT ERNEST G. WIGGINS JR. WOLODYMYR WRONSKYJ SUBSIDIARIES** DREYFUS SERVICE CORPORATION Robert H. Schmidt, President DREYFUS MANAGEMENT, INC. Peter A. Santoriello, President THE DREYFUS SECURITY SAVINGS BANK, F.S.B. William V. Healey President DREYFUS CONSUMER LIFE INSURANCE COMPANY Howard Stein, President DREYFUS PRECIOUS METALS, INC. DREYFUS REALTY ADVISORS, INC. Francis X. Tansey, President THE TROTWOOD CORPORATION Herbert Sturz, President **Partial list. TRANSFER AGENT & REGISTRAR THE BANK OF NEW YORK 101 Barclay Street, New York, NY 10286 [D-LION LOGO] The lion designs in this report are service marks of the Dreyfus Service Corporation. THE DREYFUS CORPORATION ANNUAL REPORT 1993 DEAR SHAREHOLDER: For a Corporation that has always sought to be on the edge of change in the financial service industry, this annual report marks, we believe, a new beginning that should be welcomed by all. On December 6, 1993, in a widely heralded statement, The Dreyfus Corporation and Mellon Bank Corporation announced a definitive agreement to merge their companies. It is hoped that the necessary regulatory and stockholder approvals enabling this transaction to be consummated will be obtained in the next few months, although it is possible that it may take longer. As we approach this event, your Corporation at year-end was managing or administering approximately $77 billion of assets for nearly two million accounts. These funds were being managed in more than 130 different portfolios, offering investors opportunities to invest their money in a variety of ways: stocks, bonds, tax-exempt securities, money market instruments, foreign as well as domestic issues and retirement accounts; and an investor can even buy gold and silver bullion. Revenues for the 1993 fiscal year totalled $386,028,000, a gain of 12.7% over the 1992 revenues of $342,447,000. Net income after taxes for 1993 was $99,411,000 or $2.70 per share vs. $91,171,000 and $2.40 per share in 1992. That represented a gain of 9% in net income and 12.5% in earnings per share. Gratifying as these results may be, they pale in our view, when compared with the opportunities that await a stronger and more versatile Dreyfus organization fully participating in the rapidly changing world of financial services. In announcing our decision to move forward with Mellon we stated that this event signaled more than the joining of two major American business organizations; it was a melding of people, financial strengths and names that over time have consistently been associated with integrity, innovation and dedication to fiduciary care and deep personal trust. Noting the growing complexity of the marketplace, the explosive growth in numbers of mutual funds available to the public through innovative channels of distribution, and the realization in the public's mind of the distinction between the act of saving and the act of investing, we recognized the future of financial services as we saw it--and acted upon it. That recognition, simply stated, was that two organizations that had played so prominent a role in our nation's financial history--Mellon and Dreyfus--would be uniquely positioned to meet the public's growing desire for an array of high quality financial products delivered by a source committed to impeccable standards. It was clear to us at Dreyfus, to our colleagues at Mellon and to expert observers of the field, that in the financial world significant change was in the air, and it required innovation and real leadership to react appropriately. Dreyfus has, over the course of forty years, prided itself on anticipating economic change; considered itself adept in meeting new demands from its customers; and, mindful of its obligations to its shareholders, always sought to attain long-term growth by taking prudent and sensible risks in that direction. It is our belief today that this special Dreyfus tradition not only continues but also formed the basis for the historic financial transaction arrived at with the like-minded people of Mellon. The ancients have taught us that "to everything there is a season and there is a time for every purpose." There was a time, shortly after World War II, for the rejuvenation of mutual funds in this country--and under the leadership of Jack Dreyfus, the name Dreyfus became synonymous with the goals of prudence and integrity in the personal financial arena. There was a time for broader public awareness and education about mutual funds so that the financial opportunities once reserved for the few could be made available to the many--and the Dreyfus Lion and its innovative advertising campaigns led the industry for decades. This, coupled with breakthroughs in educational literature, Prospectus presentation, and new forms of direct customer services caused our business, our funds and our reputation to grow. And there was a time in the '70s of rising taxes, incomes, and interest rates, that caused us to spearhead the effort in Washington to allow corporate mutual funds to pass through to fund shareholders the tax exemptions of municipal securities--giving Dreyfus a leadership position in tax-free funds, all to the great benefit of our shareholders. But perhaps the most signal event in the mutual fund world was the creation of money market funds--with Dreyfus in the lead to once again grant to the many the level of yields on cash reserves that until then were available only to very large investors. Dreyfus Liquid Assets, Dreyfus Worldwide Dollar and many other Dreyfus money market funds became household names. It was the attractiveness and growth of these funds and their impact on America's banks that brought about personal financial industry realignments of such magnitude that the joining of savings organizations with the traditional investment industry reached the point of inevitability. And so it is that a vital corporation that time and again met every purpose and demand of its customers was prepared for the major change of its era. If "to everything there is a season," it was incumbent upon us at Dreyfus to recognize the vast changes that were occurring and to react as before in a prudent and sensible way for the benefit of our shareholders. The world had changed completely now that the public had recognized that the distinction between the act of saving and investment had come to an end. And it was apparent to those with the courage to see that the future would belong to whoever could meet the customers' demand for comprehensive planning and financial management services from a trusted and highly regarded core advisor. No longer just a provider of mutual funds, no longer just a bank, but an amalgam that would set the standard for personalized financial services as we enter the new century. For Dreyfus then, if we were to move to the future as we saw it, the only remaining question was who existed in the financial community who held the same values, had the same proud history and reputation for integrity, shared the understanding of this new era, and had proven themselves to be builders of sufficient strength--strong enough to entrust the vision? When Mellon approached us, the answer became apparent. Mellon, we judged, was an institution that in combination with Dreyfus would enable both of us to do the exciting and rewarding things together that we could not have readily done alone. As a merged entity the eventual result will be an entirely new organization in the field of financial services. We plan for the new organization to offer lifetime investment service to the public--not just new products, not just periodic transactions, not just another mutual fund, but a lifetime of service and financial care. We will try once again to bring to the many what was once reserved for the few--the sense of dedication and service that was the hallmark of a bank's trust department. This letter would not be complete without a tribute to those who have helped The Dreyfus Corporation reach this point in its history. First and foremost is our founder, Jack Dreyfus, who set the course and standards so many years ago. Then there are the men and women of the staff who literally have built this company with their intelligence, their energy and their devotion. We are very proud of our approximately 2,100 staff members, 34 of whom have been with the Company for more than 20 years. Our Board of Directors has also been of invaluable assistance in helping to guide the growth of The Dreyfus Corporation over the years and, most recently, in connection with the Mellon merger. To one and all who have helped nourish the Dreyfus Lion over the years, past employees, retirees and present staff and Directors, we extend the heartfelt thanks of a grateful Corporation. Sincerely, /s/ Howard Stein /s/ Joseph S. DiMartino - ------------------------- -------------------------------------- Howard Stein Joseph S. DiMartino Chairman of the Board and President and Chief Operating Officer Chief Executive Officer New York, N.Y. February 10, 1994 DESCRIPTION OF BUSINESS The Dreyfus Corporation ("Corporation") serves primarily as an investment adviser and manager of mutual funds and, through a wholly-owned subsidiary, Dreyfus Service Corporation ("Service Corporation"), as a distributor of shares of the Dreyfus Group of Mutual Funds. In addition, the Corporation provides investment advisory and administrative services, directly and through a wholly-owned subsidiary, Dreyfus Management, Inc., to various pension plans, institutions and individuals. Based upon assets under management at December 31, 1993, the Corporation, one of the largest mutual fund organizations in the country, managed or administered 136 mutual fund portfolios with approximately 1.9 million shareholder accounts. The following table sets forth certain information with respect to net assets managed, advised or administered by the Corporation by fund category, at the dates shown (in billions): ------------------------ SELECTED CONSOLIDATED FINANCIAL DATA (000's omitted, except per share amounts) SELECTED QUARTERLY CONSOLIDATED FINANCIAL DATA (000's omitted, except per share amounts) MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS I. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES For the three years ended December 31, 1993, the Stockholders' Equity of the Corporation increased $147.6 million, from $677 million to $824.6 million. This increase was primarily attributable to earnings applicable to investment management services and elimination of the aggregate net unrealized loss on the marketable equity securities portfolio (see Note 2 to Consolidated Financial Statements). The increase was reduced by treasury stock purchases ($67.7 million) and dividends paid to stockholders ($71.4 million). The Corporation generally has maintained a substantial degree of liquidity and believes that cash and cash flows from operations are adequate to meet current and potential business demands and opportunities. In addition to the liquidity provided by cash and cash equivalents of $301.3 million at December 31, 1993, the Corporation maintains a significant investment in marketable securities. The resources of the Corporation have been utilized to sponsor, promote and market shares of the Dreyfus Group of Mutual Funds and to sponsor and promote new business activities. At December 31, 1993, the Corporation had investments in marketable securities and certain other investments, consisting of limited partnerships engaged in securities trading, with an aggregate cost and market value of $450 million and $498.8 million, respectively. In determining the appropriate carrying amounts of these investments, the Corporation considered whether any declines in market value below carrying values were "other than temporary." In 1993, the Corporation charged to operations $14.9 million for "other than temporary" declines (See Note 2 to Consolidated Financial Statements). II. RESULTS OF OPERATIONS The following table sets forth certain information with respect to the Corporation's fee revenue for the periods shown (000's omitted): Revenues of the Corporation are primarily fees from mutual funds sponsored by the Corporation. These fees are at various rates and are based on the average net assets of each respective fund. The increase in Management, investment advisory and administrative fees during 1993, as shown in the preceding table, was principally due to a reduction of management fees waived and reflects a change in the mix of the average net assets under management during the year. Although the average net assets of sponsored taxable money market funds declined during 1993, there has been substantial growth in tax exempt bond and equity funds during the same period. Management fee rates charged to tax exempt bond and equity funds are generally higher than the rates charged to taxable money market funds. During 1992, the increase in Management, investment advisory and administrative fees was principally due to an increase in the average net assets of sponsored taxable money market funds for which a management fee was charged. From time to time, for competitive reasons, the Corporation agrees to waive certain management fees and/or reimburse certain fund expenses, either for a specified or an unspecified period of time to increase the fund's rate of return to investors and thereby promote the growth of fund assets. In the future, the Corporation may continue to follow such practices; however, it is not possible to predict what effect, if any, the imposition of management fees and/or the discontinuance of fund expense reimbursements may have on the future level of certain fund assets under management. Furthermore, the Corporation presently is unable to determine to what extent, if any, it may impose management fees on funds where fee waivers presently exist, or to what extent fund expense reimbursements may be reduced in the future. 1993 Compared to 1992 During 1993, the average net assets of sponsored funds was $78.1 billion, approximately the same as in 1992. Average net assets of sponsored taxable money market funds declined $6.7 billion, which was substantially offset by an increase in the average net assets of sponsored tax exempt funds ($4.1 billion), equity funds ($1.2 billion) and fixed income funds ($1 billion). Management fees waived decreased $18.3 million during 1993 as compared to 1992, primarily applicable to certain sponsored taxable money market funds. Fund expense reimbursements (netted against management fee revenues) increased during 1993 as compared to 1992, primarily attributable to certain taxable money market, municipal bond and fixed income funds. Interest and dividends decreased from $30.6 million during 1992 to $24.2 million during 1993, primarily as a result of reduced investment yields and, to a lesser extent, reduced amounts invested following the Corporation's purchase of treasury stock during the third quarter of 1992 and the first half of 1993. Underwriting and other fees increased $6.5 million during 1993 as compared to 1992, primarily due to an increase in the amount of service fees ($5.7 million) and, to a lesser extent, fees earned in connection with variable annuity products. Under various service plans adopted pursuant to Rule 12b-1 under the Investment Company Act of 1940, the Corporation receives fees (based on respective average daily net assets) from funds advised and/or administered by the Corporation to distribute and promote the sale of these funds. Such service fees are net of payments to service agents for administration, for servicing fund shareholders who are also their clients and/or for distribution. Other revenues increased $1.5 million during 1993 as compared to 1992, primarily due to an increase in fees earned from bank collective investment fund servicing fees and a gain recognized from the sale of Dreyfus Life Insurance Company, a subsidiary of the Corporation. Salaries increased in 1993 as compared to 1992 primarily due to an increase in staff in the Sales and Group Benefit areas. Advertising and direct selling expenses increased from $56.1 million in 1992 to $62.5 million in 1993, primarily as the result of an increase in television and newspaper advertising. Other selling, general and administrative expenses increased primarily as a result of an increase in occupancy and communication costs related to the Sales and Group Benefits areas and systems development costs. Interest expense decreased during 1993 as compared to 1992, primarily due to a decrease in banking customer deposits and the interest rates paid on such deposits. The increase in the Corporation's effective tax rate from 34.7% in 1992 to 37.2% in 1993, was primarily due to an increase in the Federal statutory tax rate from 34% to 35% and a decrease in the proportion of tax-exempt interest and dividend income to total pre-tax income. 1992 Compared to 1991 The average net assets of sponsored funds increased $11.4 billion from an average of $67.1 billion in 1991 to an average of $78.5 billion in 1992. This increase resulted principally from the growth of sponsored taxable money market funds ($6.5 billion) and, to a lesser extent, tax-exempt bond funds ($2.9 billion). Management fees waived decreased $20.8 million during 1992 as compared to 1991, primarily attributable to certain sponsored taxable money market funds. Fund expense reimbursements (netted against management fee revenues) increased during 1992 as compared to 1991, primarily related to certain municipal bond, taxable money market and fixed income funds. Interest and dividends decreased from $41.3 million in 1991 to $30.6 million in 1992, primarily as a result of reduced investment yields and, to a lesser extent, the Corporation's purchase of treasury stock during the third quarter of 1992. Underwriting and other fees (net) increased $7.6 million during 1992 as compared to 1991, principally due to an increase in underwriting commissions as a result of an increase in the sale of funds sold with a sales charge. Other revenues increased $3.3 million during 1992, primarily due to an increase in mortgage revenue from the Corporation's banking affiliates. Mortgage revenue amounted to $3.4 million in 1992 as compared to $1.3 million in 1991. Salaries increased $8.3 million in 1992 compared to 1991, largely related to the expansion of the Corporation's Sales and Group Benefit Plan operations. Advertising and other direct selling expenses increased $6.3 million in 1992 attributable to an increase in television and newspaper advertising. Other selling, general and administrative expenses increased $9.3 million during 1992, due to an increase in occupancy and communications costs, employee benefits and expenses related to the mortgage program of the Corporation's banking affiliates. Interest expense decreased during 1992 as compared to 1991, primarily due to a decrease in interest rates paid on banking customer deposits and a decrease in the balance of such deposits. The increase in the Corporation's effective tax rate from 33.2% in 1991 to 34.7% in 1992 was primarily due to a decrease in the proportion of tax-exempt interest and dividend income to total pre-tax income. Merger with Mellon Bank Corporation On December 5, 1993, the Corporation entered into an Agreement and Plan of Merger providing for the merger of the Corporation with a subsidiary of Mellon Bank Corporation ("Mellon"). Following the merger, it is planned that the Corporation will be a direct subsidiary of Mellon Bank, N.A. Closing of the merger is subject to a number of contingencies, including the receipt of certain regulatory approvals, the approvals of the stockholders of the Corporation and of Mellon, and approvals of the boards of directors and shareholders of mutual funds advised or administered by the Corporation. The merger is expected to occur in mid-1994, but could occur later (see Note 11 to the Consolidated Financial Statements). Matters Relating to Competition The mutual fund industry has grown dramatically over the past several years and is highly competitive. Total assets managed by the industry grew from approximately $810 billion at December 31, 1988 to over $2 trillion at December 31, 1993. There are presently almost 600 mutual fund management companies in the United States, managing over 4,500 mutual funds of varying sizes and investment policies. Dreyfus and the mutual fund industry are in competition with insurance companies, banking organizations, securities dealers and other financial institutions that provide investors with competing mutual funds and alternatives to mutual funds. This competition has increased over the past several years, in part as a result of a number of rulings and interpretations issued by Federal bank regulatory agencies that have expanded significantly the range of mutual fund activities in which banks and bank holding companies may engage. Competition is based upon investment performance in terms of attaining the stated objectives of particular funds, advertising and sales promotional efforts, available distribution channels (such as banks and broker dealers), the levels of fees and expenses charged to particular mutual funds and the type and quality of services offered to investors. Recent Mutual Fund Developments During 1993, the Corporation continued to introduce funds which offer the public a range of investment options with greater diversity. During the first quarter of 1993, Dreyfus Strategic Investing and funds in the Premier Family of Funds began offering multiple classes of shares. The multiple classes consist of Class A shares, which are sold with a sales charge imposed at the time of purchase, and Class B shares, which are subject to a contingent deferred sales charge imposed on redemptions made within a specified period and operate pursuant to a distribution plan adopted in accordance with Rule 12b-1 under the Investment Company Act of 1940. These funds offer alternative classes of shares so that an investor may choose the method of purchase deemed most desirable given the amount of the purchase, the length of time the investor expects to hold the shares and other relevant circumstances. Also during the first quarter of 1993, First Prairie U.S. Government Income Fund commenced operations. Its objective is to provide as high a level of current income as is consistent with the preservation of capital. The Corporation provides administrative services for the fund and Dreyfus Service Corporation serves as the fund's distributor. The First National Bank of Chicago is the fund's investment adviser. During the second quarter of 1993, the Registration Statement for Dreyfus International Equity Fund, Inc. was declared effective and the fund commenced operations. The fund's objective is capital growth. The Corporation serves as the fund's investment adviser and Dreyfus Service Corporation as its distributor; M&G Investment Management Limited is the fund's sub-investment adviser. Also during the second quarter, the Capital Appreciation Portfolio of Dreyfus Variable Investment Fund commenced operations. The Capital Appreciation Portfolio's primary goal is to provide long-term capital growth consistent with the preservation of capital; current income is a secondary goal. The fund, which consists of six separate portfolios, was designed as a funding vehicle for variable annuity contracts and variable life insurance policies offered by the separate accounts of various life insurance companies. Pursuant to shareholder vote, on May 7, 1993, Dreyfus Index Fund merged into Peoples Index Fund, Inc. and on September 17, 1993, The Dreyfus Convertible Securities Fund, Inc. merged into Dreyfus Growth and Income Fund, Inc. in a tax-free exchange. During the third quarter of 1993, the Registration Statement for Dreyfus Asset Allocation Fund, Inc. was declared effective and the fund commenced operations. The fund's objective is to maximize total return, consisting of capital appreciation and current income. Premier Growth Fund, Inc. ("Premier Growth") and Premier California Insured Municipal Bond Fund ("Premier California Insured"), the latest additions to the Premier Family of Funds, commenced operations during the third quarter of 1993. Premier Growth's primary goal is to provide long-term capital growth consistent with the preservation of capital; current income is a secondary goal. Premier California Insured seeks to maximize current income exempt from Federal and State of California personal income taxes to the extent consistent with the preservation of capital. Pursuant to stockholder vote, on September 24, 1993, all of the assets and liabilities of McDonald Money Market Fund, Inc. and McDonald U.S. Government Money Market Fund, Inc., for which the Corporation had served as sub-investment adviser and administrator, were transferred into Gradison-McDonald U.S. Government Reserves which the Corporation does not advise or administer. Additionally, McDonald Tax Exempt Money Market Fund, Inc., for which the Corporation had served as sub-investment adviser and administrator, was liquidated on September 27, 1993. During the fourth quarter of 1993, Dreyfus Pennsylvania Intermediate Municipal Bond Fund commenced operations. The goal of this fund is to provide as high a level of current income exempt from Federal and Pennsylvania income taxes as is consistent with the preservation of capital. Also during the fourth quarter, Dreyfus Institutional Short Term Treasury Fund commenced operations. Its objective is to provide investors with a high level of current income with minimum fluctuation of principal value. In the fourth quarter, The Dreyfus Socially Responsible Growth Fund, Inc. commenced operations. The fund's primary goal is to provide capital growth; current income is a secondary goal. The fund is intended to be a funding vehicle for variable annuity contracts and variable life insurance policies to be offered by the separate accounts of various life insurance companies. During the fourth quarter, Dreyfus Global Investing (A Premier Fund) began operating under the name Premier Global Investing. The Corporation is continuing to consider the development of additional funds to serve the diverse investment interests of various segments of the public. Consumer Financial Services The Dreyfus Security Savings Bank, F.S.B. (the "Savings Bank"), an indirect wholly-owned subsidiary of the Corporation, is a Federally-chartered savings bank and a member of the Federal Deposit Insurance Corporation (the "FDIC"). The Savings Bank offers various bank products and services (including, but not limited to, certificates of deposit, residential mortgage loans and secured personal loans) to investors in the mutual funds sponsored by the Corporation and to the general public. During 1993 the Savings Bank, with its principal office located in Paramus, New Jersey, opened a branch office in San Francisco, California. It also received conditional approval from the Office of Thrift Supervision to open additional branch offices in six other states. III. IMPACT OF INFLATION As noted above, revenues of the Corporation are principally derived from management fees earned from funds sponsored by the Corporation. The fee rates charged to the funds have not been raised except for an increase in July 1977 in the management fee rate charged to The Dreyfus Fund (in the case of The Dreyfus Fund, the fee had not been changed since the inception of the fund over 25 years before that date). In the case of all other Dreyfus funds, no increase in fee rates has been requested. Inflation, of course, has affected the cost of operations and may continue to do so in the future. During 1993, the Consumer Price Index increased approximately 2.7%. The Corporation is not able to predict what effect inflation will have on interest rates and on the continued attractiveness to the investing public of money market funds and other funds managed by the Corporation. - ------------------------------------------------------------------ The results of operations for 1993 and prior years are not necessarily indicative of future results. In evaluating the future operating results of the Corporation and subsidiary companies, several factors should be considered, including: inflation and interest rates, competition, the effects of the economy, the international situation, public attitude toward mutual funds, the securities market and government regulations. The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED STATEMENTS OF INCOME See notes to consolidated financial statements. The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY The Dreyfus Corporation and Subsidiary Companies CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Nature of Business: The Dreyfus Corporation ("Corporation") and Subsidiary Companies comprise a financial service organization whose primary business consists of providing investment management services as the investment adviser, manager and distributer for sponsored investment companies and as an investment adviser to other accounts. In addition, the Corporation is the sub-investment adviser and/or admistrator of several investment companies sponsored by others. Principles of Consolidation: The consolidated financial statements include the accounts of the Corporation and its subsidiaries. All significant intercompany accounts and transactions were eliminated in consolidation. Income Recognition: Management, investment advisory and administrative fees are reported net of expense reimbursements to certain funds. Transactions in investment securities are recorded on a trade date basis. Net realized gains or losses resulting from the sale of investments are recorded on the identified cost basis and included in operations. Declines in value of investments which are accounted for as "other than temporary" are charged to operations. Certain prior year amounts have been reclassified to conform to the current year's presentation. Fair Value of Financial Instruments: The following methods and assumptions were used by the Corporation in estimating its fair value disclosures for financial instruments: Cash and cash equivalents: The carrying amount reported in the balance sheet for cash and cash equivalents approximates fair value. Marketable securities: The fair value of the Corporation's marketable securities portfolios are based on quoted market prices or dealer quotes. Other investments: The fair value of certain limited partnerships engaged in securities trading, which are accounted for at cost, is based on quoted market prices of the respective partnerships' underlying securities portfolios. Financial instruments with off-balance sheet risk: The fair value of the Corporation's financial instruments with off-balance sheet risk is based on quoted market prices or dealer quotes. Banking customer deposits: The fair value of fixed-maturity certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently offered for deposits of similar remaining maturities to a schedule of aggregated expected monthly maturities on time deposits. The fair value for demand deposits, savings accounts and money market bank accounts are equal to the amounts payable on demand at the reporting date. NOTE 2 -- INVESTMENTS: Marketable Equity Securities: The Corporation, excluding Dreyfus Service Corporation ("Service Corporation"), carries its marketable equity securities portfolio at cost (long positions) or proceeds (short positions) if the portfolio has an aggregate net unrealized gain, or at market if the portfolio has an aggregate net unrealized loss. It is the Corporation's policy to charge aggregate net unrealized losses on the marketable equity securities portfolio to Stockholders' Equity; aggregate net unrealized gains on the marketable equity securities portfolio are not recognized, except to the extent of aggregate net unrealized losses previously recognized. The Corporation engages in short selling which obligates the Corporation to replace the security borrowed by purchasing the identical security at its then current market value. Service Corporation, a wholly-owned broker-dealer subsidiary of the Corporation, carries its securities at market value, in accordance with the practice in the brokerage industry. At December 31, 1993, the Corporation's marketable equity securities portfolio had an aggregate net unrealized gain amounting to $6,060,000. Gross unrealized gains and losses on such securities amounted to $10,820,000 and $4,760,000, respectively. The Corporation's aggregate long positions in the marketable equity securities portfolio were carried at cost of $183,968,000 (fair value - $190,138,000) and the aggregate short positions in the marketable equity securities portfolio were carried at proceeds of $7,915,000 (fair value - -$8,025,000). At December 31, 1992, the Corporation's aggregate long positions in the marketable equity securities portfolio were carried at market of $269,707,000 (cost - $280,908,000) and the aggregate short positions in the marketable equity securities portfolio were carried at market of $1,441,000 (proceeds - -$1,187,000). In 1993, the Corporation charged operations for $10.8 million in connection with "other than temporary" declines in the value of marketable equity securities. Other Marketable Securities: The Corporation (excluding Service Corporation) carries its other marketable securities, consisting primarily of Municipal and U.S. Government obligations, at cost. In addition, the Corporation carries its investments in options to purchase certain securities, designated as trading securities, at market; net unrealized gains and losses thereon are included in operations. Other Investments: Other investments consist of investments in non-readily marketable limited partnerships and non-readily marketable securities. In 1993 and 1992, the Corporation recorded a charge to operations of $4.1 million and $8 million, respectively, in connection with "other than temporary" declines in the value of such investments. Financial Instruments with Off-Balance Sheet Risk: The Corporation is a party to financial instruments with off-balance sheet risk. These financial instruments include futures contracts, forward contracts and options written. The Corporation enters into these transactions as part of its trading activities, as well as to reduce its own exposure to market risk in connection with its positions in certain sponsored index funds. Off-balance sheet financial instruments and commodity futures contracts involve varying degrees of market and credit risk that exceed the amounts recognized on the balance sheet. The estimated fair values for such financial instruments and commodity futures contracts with contract or notional principal amounts that exceed the amount of credit risk at December 31, 1993 are summarized below (000's omitted): Futures and forward contracts represent future commitments to purchase or sell a specified instrument at a specified price and date. Futures contracts are standardized and are traded on regulated exchanges, while forward contracts are traded in over-the-counter markets and generally do not have standardized terms. The Corporation uses futures and forward contracts in connection with its trading activities. For instruments that are traded on a regulated exchange, the exchange assumes the credit risk that a counter party will not settle and generally requires a margin deposit of cash or securities as collateral to minimize potential credit risk. Credit risk associated with futures and forward contracts is limited to the estimated aggregate replacement cost of those futures and forward contracts in a gain position and was not material at December 31, 1993. Credit risk related to futures contracts is substantially mitigated by daily cash settlements with the exchanges for the net change in futures contract value. Market risk arises from movements in securities values, foreign exchange rates and interest rates. Option contracts grant the contract "purchaser" the right, but not the obligation, to purchase or sell a specified amount of a financial instrument during a specified period at a predetermined price. The Corporation acts as both "purchaser" and "seller" of option contracts, which are used in reducing exposure to market risk in connection with its positions in certain sponsored index funds. Market risk arises from changes in market value of contractual positions due to movements in underlying securities or stock indices. The Corporation limits its exposure to market risk by entering into hedge positions. Credit risk relates to the ability of the Corporation's counter party to meet its settlement obligations under the contract and generally is limited to the estimated aggregate replacement cost of those contracts in a gain position and was not material at December 31, 1993. Accounting for Certain Investments in Debt and Equity Securities: 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", which is effective for investments held as of or acquired after January 1, 1994. In the first quarter of 1994, the Corporation intends to adopt the provisions of the new standard, which are not expected to have a material impact on the results of operations or financial condition of the Corporation. NOTE 3 -- FIXED ASSETS: The Corporation and its subsidiaries provide for depreciation on fixed assets (including licensed and certain internally developed computer software) based on the estimated useful life of the assets, using the straight line method. Amortization of leasehold improvements is computed over the respective terms of the leases. The major classifications of fixed assets are as follows (000's omitted): NOTE 4 -- DEFERRED SALES COMMISSIONS: During 1993, certain funds sponsored by the Corporation began offering multiple classes of shares. These funds offer Class A shares, which are sold with a sales charge imposed at the time of purchase, and Class B shares which are subject to a contingent deferred sales charge imposed on redemptions made within a specified period. Class B shares are also subject to an annual distribution fee payable to Service Corporation pursuant to a distribution plan adopted in accordance with Rule 12b-1 under the Investment Company Act of 1940 ("Rule 12b-1 Plan"). Sales commissions paid by Service Corporation to broker/dealers for selling Class B shares are capitalized by Service Corporation and amortized to operations over six years. This amortization period approximates the period of time during which the sales commissions paid to broker/ dealers are expected to be recovered from the funds through the payments made pursuant to the funds' Rule 12b-1 Plans. Contingent deferred sales charges, when received by Service Corporation, reduce unamortized deferred sales commissions. At December 31, 1993, deferred sales commissions included in Other assets amounted to $14.2 million (net of amortization of $1.2 million, included in Underwriting and other fees). NOTE 5 -- STOCKHOLDERS' EQUITY: At December 31, 1993, Additional paid-in capital and Retained earnings were not available for payment of dividends to the extent of $196.6 million, substantially representing the cost of treasury stock and required capital for the Corporation's regulated subsidiaries. Pursuant to the merger agreement (see Note 11), the Corporation may not declare dividends, other than the regular quarterly dividend of $.19 per share, and may not purchase any additional treasury shares. On January 19, 1994, the Board of Directors of the Corporation declared a first quarter dividend of $.19 per share, payable on February 16, 1994 to stockholders of record at the close of business on February 7, 1994. NOTE 6 -- STOCK PLANS AND CONTINGENT BENEFIT PLAN: 1989 Non-Qualified Stock Option Plan: In 1989, the stockholders of the Corporation approved the 1989 Non-Qualified Stock Option Plan (the "Plan") of the Corporation. The Plan authorizes the Corporation to grant Options to purchase up to 1,750,000 shares of common stock to key employees and key consultants who render services to the Corporation, at a price of not less than 95% of the price of the Corporation's common stock on the New York Stock Exchange on the day the Option is granted. The Plan provides generally that no Option shall be exercisable within two years nor more than ten years from the date of grant. Shares acquired upon exercise of Options will be registered under the Securities Act of 1933 and may be resold pursuant to such registration. The following table summarizes the 1989 Non-Qualified Stock Option Plan activity (000's omitted): Such options may be exercised at prices ranging from $24.06 to $41.63. At December 31, 1993, 603,000 of such Options were exercisable. The remaining options are exercisable as follows: 344,500 in 1994, 332,000 in 1995, 119,500 in 1996 and 12,500 in 1997 and 1998. Incentive Stock Option Plan: In 1982, the stockholders of the Corporation approved a plan under which Incentive Stock Options may be granted to the Corporation's key executives allowing them to purchase up to 1,500,000 shares of common stock of the Corporation. Under the plan, Options were granted for the purchase of either Book Value Shares or Market Shares. The plan provides that no Option shall be exercisable within one year, nor more than ten years, from the date of grant. The plan expired in 1992, and no new Options may be granted under the plan, although existing unexercised Options will continue in accordance with their terms. No Market Shares are outstanding. Book Value Shares must be acquired from and sold back to the Corporation at the book value (as defined in the plan) of the Corporation's Common Stock. The plan also provides for compensation (included in Accrued Compensation and Benefits) to recipients of Options in amounts equal to any cash dividends declared by the Corporation during the period following the grant of an Option up to the date of its exercise. Additional information with respect to Incentive Stock Options is as follows (000's omitted): In connection with the exercise of the Options, the Corporation received interest bearing notes payable over a maximum of 15 years. The balance of such notes at December 31, 1993 was $148,000. During 1993 and 1992, the Corporation repurchased 29,000 and 67,000 shares, respectively, issued under the plan, for an aggregate of $500,000 and $1,310,000, respectively. At December 31, 1993 Options to purchase 186,000 Book Value Shares were exercisable. The remaining Options to purchase Book Value Shares are exercisable as follows: 26,700 per year from 1994 to 1997 and 19,000 in each of 1998 and 1999. Such Options to purchase Book Value Shares may be exercised at prices ranging from $4.22 to $15.69. If the Corporation had been obligated to repurchase the Book Value Shares issued and outstanding and also the Book Value Shares related to exercisable Options under the plan at December 31, 1993, the net amount payable would have been approximately $3.4 million. Optional Incentive Payment Plan: In 1986, the Corporation's Board of Directors approved an Optional Incentive Payment Plan (the "Plan") pursuant to which individuals who have previously exercised Stock Purchase Rights ("Rights") and Incentive Stock Options ("Options") (see above) could sell the shares related to such rights and Options back to the Corporation pursuant to the provisions of those respective plans, and in turn receive an equal number of units. Pursuant to the terms of the Plan, quarterly payments are made on each unit held in amounts equal to the quarterly after tax earnings per share of the Corporation and such amounts are charged to operations. The activity in Plan units was as follows (000's omitted): Contingent Benefit Plan: In 1984 a Contingent Benefit Plan (the "Plan") was approved which provides for specified benefit payments to designated key employees of the Corporation in the event of a change of control of the Corporation, as defined in the Plan, and should their employment terminate during a specified period after such change of control (see Note 11). NOTE 7 -- EMPLOYEES' BENEFIT PLANS: The employees of the Corporation and certain of its subsidiaries are covered by a Retirement Profit-Sharing Plan and a related Deferred Compensation Plan. In general, the Retirement Profit-Sharing Plan provides for the payment of death, disability and retirement benefits to employees or their beneficiaries in amounts equal to the value of their proportionate interests in the plan. The aggregate contribution by the Corporation is based on consolidated net income (as defined in the plans) or compensation of eligible employees. Amounts charged to operations under the plans amounted to $9,321,000 in 1993, $9,304,000 in 1992 and $7,082,000 in 1991. The Corporation has a defined benefit pension plan which covers employees of the Corporation and certain of its subsidiaries. The costs to the Corporation and the pension plan assets and liabilities are not material. NOTE 8 -- FEDERAL, STATE AND LOCAL INCOME TAXES: The provisions for Federal and state and local taxes based on income include current tax expense of $59,911,000 in 1993, $51,969,000 in 1992, and $30,448,000 in 1991. Deferred tax provision (credits) were ($1,011,000) in 1993, ($3,469,000) in 1992 and $3,252,000 in 1991. The difference between total tax expense and the amount computed by applying the statutory Federal income tax rate to pre-tax income is as follows (000's omitted): NOTE 9 -- LEASES: Future minimum payments, by year and in the aggregate, under noncancelable operating leases (premises) with initial or remaining terms of one or more years, were as follows at December 31, 1993 (000's omitted): Approximate net rental expense for operating leases amounted to $21,953,000 in 1993, $20,299,000 in 1992 and $18,397,000 in 1991. NOTE 10 -- OTHER REVENUES (NET): In September 1989, a Noncompetition Agreement was entered into with The Bank of New York (Delaware) ("BONY") pursuant to which it was agreed that Dreyfus entities will not compete with BONY in the unsecured credit card business for six years after closing. In consideration for such covenants not to compete, BONY agreed to make six annual payments of $8 million each, commencing in 1990. These payments are being recognized annually over the period of the agreement and are included in Other revenues (net). NOTE 11 -- MERGER WITH MELLON BANK CORPORATION: On December 5, 1993, the Corporation entered into an Agreement and Plan of Merger providing for the merger of the Corporation with a subsidiary of Mellon Bank Corporation ("Mellon"). Under the terms of the agreement, the Corporation's stockholders will be entitled to receive .88017 shares of Mellon Common Stock for each share of the Corporation's Common Stock, in a tax-free exchange. Following the merger, it is planned that the Corporation will be a direct subsidiary of Mellon Bank, N.A. Closing of the merger is subject to a number of contingencies, including the receipt of certain regulatory approvals, the approvals of the stockholders of the Corporation and Mellon, and approvals of the Boards of Directors and shareholders of the mutual funds advised or administered by the Corporation. The merger is expected to occur in mid-1994, but could occur later. The merger agreement provides for the Corporation to pay Mellon $50,000,000, should the Corporation, among other matters, engage in certain business combination transactions specified in the agreement, with any person other than Mellon, or under certain other defined circumstances. Costs incurred in connection with the merger, including payments related to the Contingent Benefit Plan (see Note 6), will be charged against operations of the merged entities. NOTE 12 -- LITIGATION Subsequent to the announcement of the proposed merger with Mellon (see Note 11), public shareholders of the Corporation commenced six purported class action suits in the Supreme Court of the State of New York, County of New York, naming the Corporation, Mellon and the individual directors of the Corporation as defendants, with respect to the transactions contemplated by the Agreement and Plan of Merger with Mellon. The Corporation believes that these complaints lack merit and intends to defend them vigorously. On December 22, 1993, six shareholders of mutual funds of which the Corporation is the adviser ("Dreyfus-managed mutual funds") filed an application with the U.S. Securities and Exchange Commission (the "SEC") for a statutory determination that the "non-interested" directors of the individual Dreyfus-managed mutual funds are "interested" directors within the meaning of the Investment Company Act of 1940, thereby prohibiting them from voting on each of the fund's advisory contracts and other related matters in connection with the merger with Mellon (the "Application"). The non-interested directors have opposed the Application. Counsel for the non-interested directors has advised the Corporation that the Application lacks merit. NOTE 13 -- OTHER MATTERS: A) The Corporation earned revenues (management fees) from Dreyfus Liquid Assets, Inc., in excess of 10% of total revenues in the amount of $32,017,000 during 1991. No individual fund fees were in excess of 10% of total revenues during 1993 or 1992. B) The Corporation reimbursed certain fund expenses aggregating $8.9 million, $6.7 million, and $5.4 million, in 1993, 1992 and 1991 respectively, to promote the growth of fund assets. Such fund expense reimbursements are netted against management fees in the accompanying financial statements. C) Salaries and Other selling, general and administrative expenses of the Corporation have been reduced by reimbursements from certain sponsored investment companies for shareholder servicing costs incurred by the Corporation on their behalf. Such amounts aggregated $29.2 million in 1993, $21.8 million in 1992 and $9.3 million in 1991. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS Stockholders and Board of Directors The Dreyfus Corporation We have audited the accompanying consolidated balance sheets of The Dreyfus Corporation and Subsidiary Companies 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 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Dreyfus Corporation and Subsidiary Companies 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. /s/ Ernst & Young New York, New York January 27, 1994 COMMON STOCK MARKET PRICES AND DIVIDENDS The Corporation's Common Stock (DRY) is traded on the New York Stock Exchange (NYSE) and the Pacific Stock Exchange (PSE). There were approximately 1,900 holders of record of the Corporation's Common Stock at December 31, 1993. For 1993 and 1992 the high and low stock prices of the Corporation's Common Stock as traded on the NYSE Composite Tape, and dividends declared by the Corporation were as follows: MARKET PRICE OF COMMON STOCK OF THE CORPORATION CASH DIVIDENDS DECLARED BY THE CORPORATION (PER SHARE) The Corporation expects to continue its policy of paying regular cash dividends, although there is no assurance as to future dividends because dividends are dependent on future earnings, capital requirements and financial condition. Pursuant to the Corporation's merger agreement with Mellon, the Corporation is restricted from declaring dividends in excess of the regular quarterly dividend of $.19 per share (see Note 5 to the Consolidated Financial Statements). - -------------------------------------------------------------------------------- STOCKHOLDERS MAY OBTAIN A COPY OF THE DREYFUS CORPORATION'S FORM 10-K FOR 1993, AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION, WITHOUT CHARGE, BY WRITING TO CONTROLLER, THE DREYFUS CORPORATION, 200 PARK AVENUE, NEW YORK, NEW YORK 10166 The Dreyfus Corporation For close to 30 years, together we have cared for and watched over his growth alone. Now is the time - and he is ready - to seek out new challenges and opportunities in the company of others. [See Appendix A] Total Appreciation: 3,950%. Price of The Dreyfus Corporation stock since it went public on October 27, 1965. (*Restated for stock splits 3-for-1 Feb. 1981; 2-for-1 Oct. 1983; 3-for-1 Jul. 1986) TABLE FOR LINE GRAPH PRICE OF THE DREYFUS CORPORATION STOCK* APPENDIX A: |-------------------------| | |The Dreyfus | | |Corporation | |December 31,|stock price*| |------------|------------| | 1966 | $0.77 | | 1967 | 1.92 | | 1968 | 2.47 | | 1969 | 1.69 | | 1970 | 1.46 | | 1971 | 1.52 | | 1972 | 0.83 | | 1973 | 0.34 | | 1974 | 0.20 | | 1975 | 0.34 | | 1976 | 0.46 | | 1977 | 0.56 | | 1978 | 0.63 | | 1979 | 1.06 | | 1980 | 2.49 | | 1981 | 5.58 | | 1982 | 6.29 | | 1983 | 7.83 | | 1984 | 12.58 | | 1985 | 28.83 | | 1986 | 29.00 | | 1987 | 24.75 | | 1988 | 25.00 | | 1989 | 35.63 | | 1990 | 27.63 | | 1991 | 49.25 | | 1992 | 40.50 | | 1993 | 45.00 | |-------------------------| (*Restated for stock splits 3-for-1 Feb. 1981; 2-for-1 Oct. 1983; 3-for-1 Jul. 1986.) EXHIBITS -------- 10.(iii)(A)(g) Agreement relating to split-dollar life insurance policy covering Joseph S. DiMartino and his wife. 10.(iii)(A)(h) Consulting Agreement between Lawrence M. Greene and The Dreyfus Corporation. [This Agreement has been extended, by resolution of the Board of Directors of the Corporation adopted on December 7, 1984, for an indefinite period subject to termination upon sixty days' notice by either party.]

50548_1993.txt

50548_1993

1993

50548

ITEM 1. BUSINESS. Inland Steel Company (the "Company"), a Delaware corporation and a wholly owned subsidiary of Inland Steel Industries, Inc. ("Industries"), is a fully integrated domestic steel company. The Company produces and sells a wide range of steels, of which approximately 99% consists of carbon and high-strength low-alloy steel grades. It is also a participant in certain steel-finishing joint ventures. The Company has a single business segment, which is comprised of the operating companies and divisions involved in the manufacturing of basic steel products and in related raw materials operations. OPERATIONS General The Company is directly engaged in the production and sale of steel and related products and the transportation of iron ore, limestone and certain other commodities (primarily for its own use) on the Great Lakes. Certain subsidiaries and associated companies of the Company are engaged in the mining and pelletizing of iron ore and in the operation of a cold-rolling mill and two steel galvanizing lines. All raw steel made by the Company is produced at its Indiana Harbor Works located in East Chicago, Indiana, which also has facilities for converting the steel produced into semi-finished and finished steel products. In August 1988, the Company realigned its operations into two divisions -- the Inland Steel Flat Products Company division and the Inland Steel Bar Company division. The purpose of the realignment was to allow management to better focus on the distinctive competitive factors and customer requirements in the markets for the products manufactured by each division. The Flat Products division manages the Company's iron ore operations, conducts its ironmaking operations, and produces the major portion of its raw steel. This division also manufactures and sells steel sheet, strip and plate and certain related semi-finished products for the automotive, appliance, office furniture, steel service center and electrical motor markets. The Bar division manufactures and sells special quality bars and certain related semi-finished products for forgers, steel service centers, heavy equipment manufacturers, cold finishers and the transportation industry. The Bar division closed its 28-inch structural mill in early 1991, completing the Company's withdrawal from the structural steel manufacturing business. The Company and Nippon Steel Corporation ("NSC") are participants, through subsidiaries, in two joint ventures that operate steel-finishing facilities near New Carlisle, Indiana. The total cost of these two facilities was approximately $1.1 billion. I/N Tek, owned 60% by a wholly owned subsidiary of the Company and 40% by an indirect wholly owned subsidiary of NSC, operates a cold-rolling mill that began shipping commercial product in 1990 and reached its design capability in 1992. I/N Kote, owned equally by wholly owned subsidiaries of the Company and NSC (indirect in the case of NSC), operates two galvanizing lines which began start-up production in late 1991, became fully operational in the third quarter of 1992, and were operating near design capacity by August 1993. The Company is also a participant, through a subsidiary, in another galvanizing joint venture located near Walbridge, Ohio. Raw Steel Production and Mill Shipments The following table shows, for the five years indicated, the Company's production of raw steel and, based upon American Iron and Steel Institute data, its share of total domestic raw steel production: - --------------- * Net tons of 2,000 pounds. ** Based on preliminary data from the American Iron and Steel Institute. The annual raw steelmaking capacity of the Company was reduced to 6.0 million net tons from 6.5 million net tons effective September 1, 1991, as the Company ceased making ingots. The basic oxygen process accounted for 94% of raw steel production of the Company in 1993 and 1992. The remainder of such production was accounted for by electric furnaces. The total tonnage of steel mill products shipped by the Company for each of the five years 1989 through 1993 was 4.8 million tons in 1993; 4.3 million tons in 1992; 4.2 million tons in 1991; 4.7 million tons in 1990; and 4.9 million tons in 1989. In 1993, sheet, strip, plate and certain related semi-finished products accounted for 88% of the total tonnage of steel mill products shipped from the Indiana Harbor Works, and bar and certain related semi-finished products accounted for 12%. In 1993 and 1992, approximately 93% of the shipments of the Flat Products division and 92% of the shipments of the Bar division were to customers in 20 mid-American states. Approximately 75% of the shipments of the Flat Products division and 83% of the shipments of the Bar division in 1993 were to customers in a five-state area comprised of Illinois, Indiana, Ohio, Michigan and Wisconsin, compared to 72% and 83% in 1992. Both divisions compete in these geographical areas, principally on the basis of price, service and quality, with the nation's largest producers of raw steel as well as with foreign producers and with many smaller domestic mills. According to data from the American Iron and Steel Institute, steel imports to the United States in 1993 totaled an estimated 19.5 million tons, compared with 17.1 million tons imported in 1992. Steel imports constituted approximately 18.8% of apparent domestic supply in 1993, compared with approximately 17.9% of apparent domestic supply in 1992. During 1984, the peak year for steel imports into the U.S., such imports accounted for 26.4% of apparent domestic supply. In addition to the importation of steel mill products, the U.S. steel industry has faced indirect imports of steel. Data from the American Iron and Steel Institute show that imports of steel contained in manufactured goods exceeded exports by an estimated 16 million tons in 1993. Many foreign steel producers are owned, controlled or subsidized by their governments. In 1992, Industries and certain domestic steel producers filed unfair trade petitions against foreign producers of certain bar, rod and flat-rolled products. During 1993, the International Trade Commission ("ITC") upheld final subsidy and dumping margins on essentially all of the bar and rod products and about half of the flat-rolled products, in each case based on the tonnage of the products against which claims were brought. Industries and certain domestic producers have filed formal appeals of the adverse ITC decisions in the U.S. Court of International Trade or similar jurisdiction bodies, and foreign producers have appealed certain of the findings against them. These appeals are pending and decisions are not expected before September 1994 in the bar and rod product cases, and mid-1995 in the flat-rolled product cases. It is not certain how the ITC actions and the appeals will impact imports of steel products into the United States or the price of such steel products. On December 15, 1993, President Clinton notified the U.S. Congress of his intent to enter into agreements resulting from the Uruguay Round of multilateral trade negotiations under the General Agreement on Tariffs and Trade. The key provisions applicable to domestic steel producers include an agreement to eliminate steel tariffs in major industrial markets, including the United States, over a period of 10 years commencing July 1995, and agreements regarding various subsidy and dumping practices as well as dispute settlement procedures. Legislation must be enacted in order to implement the Uruguay Round agreements. Until that process is completed, it will not be possible to assess the extent to which existing U.S. laws against unfair trade practices may be weakened. Primarily as a result of the influx of foreign steel imports and the depressed demand for domestic steel products that began in the early 1980s, certain facilities at the Indiana Harbor Works were permanently closed during the second half of the 1980s and the early 1990s and others were shut down for temporary periods. The 28-inch structural mill was closed in early 1991, reflecting a decision to withdraw from the structural steel markets. In late 1991 the mold foundry, No. 8 Coke Oven Battery, and selected other facilities were closed either as part of a program to permanently reduce costs through the closure of uneconomic facilities or for environmental reasons. Provisions with respect to the shut-down of the structural mill were taken in 1987. Provisions for estimated costs incurred in connection with the closure of the mold foundry, No. 8 Coke Oven Battery, and selected other facilities were made in 1991. Included in such provisions were costs associated with Inland Steel Company's closure of its No. 11 Coke Oven Battery in June 1992. All remaining coke batteries were closed by year-end 1993, a year earlier than previously anticipated. An additional provision was required with respect to those closures. (See "Environment" below.) For the five years indicated, shipments by market classification of steel mill products produced by the Company at its Indiana Harbor Works, including shipments to affiliates of the Company, are set forth below. The table confirms that a substantial portion of shipments by the Flat Products division was to steel service centers and transportation-related markets. The Bar division shipped more than 70% of its products to the steel converters/processors market over the five-year period shown in the table. The increase in 1993 of sales to the automotive market and the decline in sales to the steel converters/processors market are indicative of the Company's efforts to maximize its sales of value-added and higher margin products. Some value-added steel processing operations that the Company does not have the capability to perform are performed by outside processors prior to shipment of certain products to the Company's customers. In 1993, approximately 16% of the products produced by the Company were processed further through value-added services such as electrogalvanizing, painting and slitting. Approximately 64% of the total tonnage of shipments by the Company during 1993 from the Indiana Harbor Works was transported by truck, with the remainder transported primarily by rail. A wholly owned truck transport subsidiary of the Company was responsible for shipment of approximately 15% of the total tonnage of products transported by truck from the Indiana Harbor Works in 1993. Substantially all of the steel mill products produced by the Flat Products division are marketed through its own selling organization, with offices located in Chicago; Southfield, Michigan; St. Louis; and Nashville, Tennessee. Substantially all of the steel mill products produced by the Bar division are marketed through its sales office in East Chicago, Indiana. See "Product Classes" below for information relating to the percentage of consolidated net sales accounted for by certain classes of similar products of integrated steel operations. Raw Materials The Company obtains iron ore pellets primarily from three iron ore properties, located in the United States and Canada, in which subsidiaries of the Company have varying interests -- the Empire Mine in Michigan, the Minorca Mine in Minnesota and the Wabush Mine in Labrador and Quebec, Canada. In recent years the Company has closed or terminated certain less cost-efficient iron ore mining operations. See "Properties Relating to Integrated Steel Segment -- Raw Materials Properties and Interests" in Item 2 ITEM 2. PROPERTIES. PROPERTIES RELATING TO OPERATIONS Steel Production All raw steel made by the Company is produced at its Indiana Harbor Works located in East Chicago, Indiana. The property on which this plant is located, consisting of approximately 1,900 acres, is held by the Company in fee. The basic production facilities of the Company at its Indiana Harbor Works consist of furnaces for making iron; basic oxygen and electric furnaces for making steel; a continuous billet caster, a continuous combination slab/bloom caster and two continuous slab casters; and a variety of rolling mills and processing lines which turn out finished steel mill products. Certain of these production facilities, including a continuous anneal line and the No. 2 BOF Shop Caster Facility ("Caster"), are held by the Company under leasing arrangements. The Company purchased the equity interest of the lessor of the Caster in March 1994 and currently intends to terminate the lease and prepay or formally assume the applicable debt in the first half of 1994. Substantially all of the remaining property, plant and equipment at the Indiana Harbor Works is subject to the lien of the First Mortgage of the Company dated April 1, 1928, as amended and supplemented. See "Operations -- Raw Steel Production and Mill Shipments" in Item 1 above for further information relating to capacity and utilization of the Company's properties. The Company's properties are adequate to serve its present and anticipated needs, taking into account those issues discussed in "Capital Expenditures and Investments in Joint Ventures" in Item 1 above. I/N Tek, a partnership in which a subsidiary of the Company owns a 60% interest, has constructed a 1,500,000-ton annual capacity cold-rolling mill on approximately 200 acres of land, which it owns in fee, located near New Carlisle, Indiana. Substantially all the property, plant and equipment owned by I/N Tek at this location is subject to a lien securing related indebtedness. The I/N Tek facility is adequate to serve the present and anticipated needs of the Company planned for such facility. I/N Kote, a partnership in which a subsidiary of the Company owns a 50% interest, has constructed a 900,000-ton annual capacity steel galvanizing facility on approximately 25 acres of land, which it owns in fee, located adjacent to the I/N Tek site. Substantially all the property, plant and equipment owned by I/N Kote is subject to a lien securing related indebtedness. The I/N Kote facility is adequate to serve the present and anticipated needs of the Company planned for such facility. PCI Associates, a partnership in which a subsidiary of the Company owns a 50% interest, has constructed a pulverized coal injection facility on land located within the Inland Harbor Works. The Company leases PCI Associates the land upon which the facility is located. Substantially all the property, plant and equipment owned by PCI Associates is subject to a lien securing related indebtedness. Upon achieving operation at design capacity, the PCI Associates facility will be adequate to serve the anticipated needs of the Company planned for such facility. The Company owns three vessels for the transportation of iron ore and limestone on the Great Lakes, and a subsidiary of the Company owns a fleet of 404 coal hopper cars (100-ton capacity each) used in unit trains to move coal to the Indiana Harbor Works. See "Operations -- Raw Materials" in Item 1 above for further information relating to utilization of the Company's transportation equipment. Such equipment is adequate, when combined with purchases of transportation services from independent sources, to meet the Company's present and anticipated transportation needs. The Company also owns and maintains research and development laboratories in East Chicago, Indiana, which facilities are adequate to serve its present and anticipated needs. Raw Materials Properties and Interests Certain information relating to raw materials properties and interests of the Company and its subsidiaries is set forth below. See "Operations -- Raw Materials" in Item 1 above for further information relating to capacity and utilization of such properties and interests. Iron Ore The operating iron ore properties of the Company's subsidiaries and of the iron ore ventures in which the Company has an interest are as follows: The Empire Mine is operated by the Empire Iron Mining Partnership, in which the Company has a 40% interest. The Company, through a subsidiary, is the sole owner and operator of the Minorca Mine. The Wabush Mine is a taconite project in which the Company owns a 13.75% interest. The Company also owns a 38% interest in the Butler Taconite project (permanently closed in 1985) in Nashwauk, Minnesota. The reserves at the Empire Mine, the Minorca Mine and the Wabush Mine are held under leases expiring, or expected at current production rates to expire, between 2012 and 2040. Substantially all of the reserves at Butler Taconite are held under leases. The Company's share of the production capacity of its interests in such iron ore properties is sufficient to provide the majority of its present and anticipated iron ore pellet requirements. Any remaining requirements have been and are expected to continue to be readily available from independent sources. During 1992, the Minorca Mine's original ore body was depleted and production shifted to a new major iron ore body, the Laurentian Reserve, acquired by lease in 1990. Limestone and Dolomite The limestone and dolomite properties of the Company located near the town of Gulliver in the Upper Peninsula of Michigan were permanently closed on December 29, 1989 and sold in 1990. Coal The Company's sole remaining coal property, the Lancashire No. 25 Property, located near Barnesboro, Pennsylvania, is permanently closed. All Company coal requirements for the past several years have been and are expected to continue to be met through contract purchases and other purchases from independent sources. OTHER PROPERTIES The Company and certain of its subsidiaries lease, under a long-term arrangement, approximately 12% of the space in the Inland Steel Building located at 30 West Monroe Street, Chicago, Illinois (where the Company's principal executive offices are located), which property interest is adequate to serve the Company's present and anticipated needs. Certain subsidiaries of the Company hold in fee at various locations an aggregate of approximately 355 acres of land, all of which is for sale. The Company also holds in fee approximately 300 acres of land adjacent to the I/N Tek and I/N Kote sites, which land is available for future development. Approximately 1,060 acres of rural land, which are held in fee at various locations in the north-central United States by various raw materials ventures, are also for sale. I R Construction Products Company, Inc. (formerly Inryco, Inc.), a subsidiary of the Company and the Company's former Construction Products business segment, owns, in fee, a combination office building and warehouse in Hoffman Estates (IL), which is for sale. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. On August 12, 1992, Inland Steel Administrative Service Company ("ISAS"), a wholly owned subsidiary of the Company, filed a lawsuit in the Court of Common Pleas in Lorain County, Ohio against Western Steel Group, Inc. ("Western") to collect the unpaid balance of its account for steel products sold to Western by the Company in the amount of $5.7 million. On October 15, 1992, Western filed a counterclaim against ISAS and a third-party complaint against the Company for $40 million actual damages and $100 million punitive damages, alleging, among other things, breach of contract and wrongful interference with contractual relations in connection with a refusal by the Company to continue selling steel products to Western and defamation of Western and a patent held by Western in connection with discussions with third parties. All claims were settled between the parties in February 1994 and the settlement was approved by the court. Under the terms of the settlement, ISAS has received $3.4 million and all counterclaims against the Company and ISAS have been released. On June 10, 1993, the U.S. District Court for the Northern District of Indiana entered a consent decree that resolved all matters raised by the lawsuit filed by the EPA in 1990. The consent decree includes a $3.5 million cash fine, environmentally beneficial projects at the Indiana Harbor Works through 1997 costing approximately $7 million, and sediment remediation of portions of the Indiana Harbor Ship Canal and Indiana Harbor Turning Basin estimated to cost approximately $19 million over the next several years. The fine and estimated remediation costs were provided for in 1991 and 1992. After payment of the fine, the Company's reserve for environmental liabilities totalled $19 million. The consent decree also defines procedures for corrective action at the Company's Indiana Harbor Works. The procedures defined establish essentially a three-step process, each step of which requires agreement of the EPA before progressing to the next step in the process, consisting of: assessment of the site, evaluation of corrective measures for remediating the site, and implementation of the remediation plan according to the agreed-upon procedures. The Company is presently assessing the extent of environmental contamination. The Company anticipates that this assessment will cost approximately $1 million to $2 million per year and take another three to five years to complete. Because neither the nature and extent of the contamination nor the corrective actions can be determined until the assessment of environmental contamination and evaluation of corrective measures is completed, the Company cannot presently reasonably estimate the costs of or the time required to complete such corrective actions. Such corrective actions may, however, require significant expenditures over the next several years that may be material to the results of operations or financial position of the Company. Insurance coverage with respect to such corrective actions is not significant. On March 22, 1985, the EPA issued an administrative order to the Company's former Inland Steel Container Company Division ("Division") naming the former Division and various other unrelated companies as responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") in connection with the cleanup of a waste disposal facility operated by Duane Marine Salvage Corporation at Perth Amboy, New Jersey. The administrative order alleged that certain of the former Division's wastes were transported to, and disposed of at, that facility and required the Company to join with other named parties in taking certain actions relating to the facility. The Company and the other administrative order recipients have completed the work required by the order. In unrelated matters, the EPA also advised the former Division and various other unrelated parties of other sites located in New Jersey at which the EPA expects to spend public funds on any investigative and corrective measures that may be necessary to control any releases or threatened releases of hazardous substances, pollutants and contaminants pursuant to the applicable provisions of CERCLA. The notice also indicated that the EPA believes the Company may be a responsible party under CERCLA. The extent of the Company's involvement and participation in these matters has not yet been determined. While it is not possible at this time to predict the amount of the Company's potential liability, none of these matters is expected to materially affect the Company's financial position. The EPA has adopted a national policy of seeking substantial civil penalties against owners and operators of sources for noncompliance with air and water pollution control statutes and regulations under certain circumstances. It is not possible to predict whether further proceedings will be instituted against the Company or any of its subsidiaries pursuant to such policy, nor is it possible to predict the amount of any such penalties that might be assessed in any such proceeding. The Indiana Department of Environmental Management ("IDEM") from time to time advises various parties of alleged violations of air pollution regulations by issuing Notices of Violation so as to initiate discussions concerning corrective measures. The Company has three currently outstanding unresolved Notices of Violation at its Indiana Harbor Works. The Company is presently in discussions with the staff of IDEM with respect to these matters and cannot currently estimate the time period within which these matters will be resolved. While it is not possible at this time to predict the amount of the Company's potential liability, none of these matters is expected to materially affect the Company's financial position. The Company received a Notice of Violation from IDEM dated March 3, 1989 alleging violations of the Company's National Pollution Discharge Elimination System permit regarding water discharges. The Company is presently in discussions with the staff of IDEM with respect to these matters and cannot currently estimate the time period within which these matters will be resolved. While it is not possible at this time to predict the amount of the Company's potential liability, this matter is not expected to materially affect the Company's financial position. The Company received a Special Notice of Potential Liability ("Special Notice") from IDEM on February 18, 1992 relating to the Four County Landfill Site, Fulton County, Indiana (the "Facility"). The Special Notice stated that IDEM has documented the release of hazardous substances, pollutants and contaminants at the Facility and was planning to spend public funds to undertake an investigation and control the release or threatened release at the Facility unless IDEM determined that a potentially responsible party ("PRP") will properly and promptly perform such action. The Special Notice further stated that the Company may be a PRP and that the Company, as a PRP, may have potential liability with respect to the Facility. In August 1993, the Company, along with other PRPs, entered into an Agreed Order with IDEM pursuant to which the PRPs agreed to perform a Remedial Investigation/Feasibility Study ("RI/FS") for the Facility and pay certain past and future IDEM costs. In addition, the PRPs agreed to provide funds for operation and maintenance necessary for stabilization of the Facility. The costs which the Company has agreed to assume under the Agreed Order are not currently anticipated to exceed $154,000. The cost of the final remedies which will be determined to be required with respect to the Facility cannot be reasonably estimated until, at a minimum, the RI/FS is completed. The Company is therefore unable to determine the extent of its potential liability, if any, relating to the Facility or whether this matter could materially affect the Company's financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company is a wholly owned subsidiary of Inland Steel Industries, Inc. thus, market, stockholder and dividend information otherwise called for by this Item is omitted. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The Company meets the conditions set forth in General Instruction J(2)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 7. ITEM 7. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS. The Company's 1993 net loss of $59.7 million was significantly less than the 1992 net loss of $781.3 million. Included in the 1992 loss is $609.6 million related to one-time charges to recognize the cumulative effect of adopting the following new accounting standards: Financial Accounting Standards Board ("FASB") Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and FASB Statement No. 109, "Accounting for Income Taxes." Even excluding the one-time 1992 charges, 1993 results were significantly improved from the 1992 loss of $171.7 million. The following table summarizes selected earnings and other data: With I/N Tek and I/N Kote having reached the end of their learning curves and completion of major upgrades at the steelmaking operations, the Company's modernization program is complete. In addition, a new six-year labor contract at the Company is in place. These factors, coupled with the Company's turnaround strategy launched in 1991 to improve performance by increasing revenues, reducing costs and enhancing asset utilization, are anticipated to provide the basis for continued improvement in 1994 operating results. The 1993 financial results were negatively affected by approximately $30 million due to the unfavorable impact on steel operations of the scheduled outage of the largest blast furnace at the Indiana Harbor Works for a mini-reline. In addition, there was a $22.3 million charge taken for the early closure of the Company's remaining cokemaking facilities due to their inability to meet environmental regulations and deteriorating operating performance. Partially offsetting these unfavorable items was a $24 million LIFO profit recognition due to inventory reductions. Net sales increased 14 percent in 1993 to $2.17 billion due almost entirely to an increase in shipments to 4.8 million tons. The average selling price for 1993 was virtually unchanged from 1992. The Company operated at 83 percent of its raw steelmaking capability in 1993, compared with 79 percent in 1992. In 1992, a slower-than-expected shift in galvanized products to I/N Kote, as well as the initial recognition of interest and depreciation expense associated with the I/N Kote facility, added approximately $40 million to operating losses. Also, an outage of the No. 7 Blast Furnace reduced production by 140,000 tons, which increased the operating loss by nearly $30 million. These 1992 problems, coupled with an addition of $12 million to a reserve for environmental matters, more than offset the benefits of reduced costs and a $23 million gain on the sale of half of Inland's 25 percent interest in Walbridge Coatings. The Company embarked in 1991 on a three-year turnaround program to significantly reduce its underlying cost base by year-end 1994. The 1991 restructuring charge of $205 million provided for the write-off of facilities, an environmental reserve and the cost of an estimated 25 percent reduction in the workforce. Employment has been reduced by approximately 2,300 people from the end of 1991 through year-end 1993, and an additional 1,200 jobs are expected to be eliminated by the end of 1994. The 1993 effect of this program represents a savings of approximately $140 million in employment costs and $10 million in decreased depreciation expense. However, the savings from reduced employment was partially offset by increased wages under the Company's labor agreements and increased medical benefit costs as the Company began to accrue in 1992 for postretirement medical benefits. By year-end 1992 and throughout 1993, I/N Tek was operating near capacity and producing consistently high-quality steels. In August 1993, I/N Kote was operating near design capacity and, by year-end 1993, had achieved product qualification at all major customers. Under the I/N Kote partnership agreement, the Company supplies all of the steel for the joint venture and, with certain limited exceptions, is required to set the price of that steel to assure that I/N Kote's expenditures do not exceed its revenues. During 1993, the Company's sales price approximated its cost of production, but was still significantly less than the market value for cold-rolled steel. Beginning in 1993, I/N Kote expenditures included principal payments and provision for return on equity to the partners. Therefore, the Company's ability to realize a satisfactory price on its sales to I/N Kote depends on the facility achieving near capacity operations and obtaining appropriate pricing for its products. The Company's remaining cokemaking facilities were closed by year-end 1993. The Company determined that it was uneconomical to repair the coke batteries sufficiently to continue cost-effective operations that would comply with current environmental laws. To replace the Company-produced coke, the Company entered into a long-term contract and other arrangements to purchase coke. In addition, the Company and NIPSCO, a local utility, formed a joint venture which constructed and is operating a pulverized coal injection facility at the Indiana Harbor Works. This facility injects coal directly into the blast furnaces and is expected to reduce coke requirements by approximately 30 percent, or 600,000 tons a year, when fully operational. The joint venture commenced operations in the third quarter of 1993. FASB Statement No. 106 requires that the cost of retiree medical and life insurance benefits be accrued during the working years of each employee. Previously, retiree medical benefits were expensed as incurred after an employee's retirement. Adoption of this standard in 1992 did not and will not affect cash flow as liabilities for health care and life insurance benefits are not pre-funded and cash payments will continue to be made as claims are submitted. The net present value of the unfunded benefits liability as of December 31, 1993, calculated in accordance with that Statement was approximately $943 million. The expense provision for these benefits for 1993 was $86 million, which was $39 million more than the cash benefit payments for the year. The unfunded liability will continue to grow, since accrual-basis costs are expected to exceed cash benefit payments for several more years. The reported year-end benefits liability and postretirement benefits cost for the year reflect changes made during the year incorporating the favorable effects of the new United Steelworkers of America labor contract and revised actuarial assumptions incorporating more current information regarding claim costs and census data, partially offset by a reduction in the discount rate used to calculate the benefits liability. (See Note 6 to the consolidated financial statements for further details.) FASB Statement No. 109 requires the recognition of deferred 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. Without the change, the Company would not have been able to reduce its 1993 and 1992 losses by credits for deferred tax benefits of $30 million and $418 million, respectively. At December 31, 1993, the Company had a net deferred tax asset of $417 million of which $396 million relates to the temporary difference arising from the adoption of FASB Statement No. 106. While the Company believes it is more likely than not that taxable income generated through future profitable operations will be sufficient to realize all deferred tax assets, a secondary source of future taxable income could result from tax planning strategies, including the Company's option of changing from the LIFO method of accounting for inventories to the FIFO method (such change would have resulted in approximately $240 million of additional taxable income as of year-end 1993 which would serve to offset approximately $85 million of deferred tax assets) and selection of different tax depreciation methods. After assuming such change in accounting for inventories, the Company would need to recognize approximately $900 million of taxable income over the 15-year net operating loss carryforward period and the period in which the temporary difference related to the FASB Statement No. 106 obligation will reverse, in order to fully realize its net deferred tax asset. Additionally, in accordance with the Industries tax sharing agreement, if the Company is unable to use all of its allocated tax attributes (net operating loss carryforwards and tax credit carryforwards) in a given year but other companies in the Industries group are able to utilize them, then the Company will be paid for the use of its attributes. The Company believes that it is more likely than not that it will achieve such taxable income level. (See Note 7 to the consolidated financial statements for further details regarding this net deferred tax asset.) ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements (including the financial statement schedules listed under Item 14(a)2 of this report) of the Company called for by this Item, together with the Report of Independent Accountants dated February 23, 1994, are set forth on pages to, inclusive, of this Report on Form 10-K, and are hereby incorporated by reference into this Item. Financial statement schedules not included in this Report on Form 10-K have been omitted because they are not applicable or because the information called for is shown in the consolidated financial statements or notes thereto. Consolidated quarterly sales and earnings information for 1993 and 1992 is set forth in Note 13 of Notes to Consolidated Financial Statements (contained herein), which is hereby incorporated by reference into this Item. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by this Item. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Company meets the conditions set forth in General Instruction J(1)(a) and (b) of Form 10-K and is therefore omitting, pursuant to General Instruction J(2), the information called for by 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. CONSOLIDATED FINANCIAL STATEMENTS. The consolidated financial statements listed below are set forth on pages to, inclusive, of this Report and are incorporated by reference in Item 8 of this Annual Report on Form 10-K. Report of Independent Accountants. Consolidated Statements of Operations and Reinvested Earnings for the three years ended December 31, 1993. Consolidated Statement of Cash Flows for the three years ended December 31, 1993. Consolidated Balance Sheet at December 31, 1993 and 1992. Schedules to Consolidated Financial Statements at December 31, 1993 and 1992, relating to: Property, Plant and Equipment. Long-Term Debt. Statement of Accounting and Financial Policies. Notes to Consolidated Financial Statements. Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: Schedule V -- Property, Plant and Equipment. Schedule VI -- Reserve for Depreciation, Amortization and Depletion of Property, Plant and Equipment. Schedule VIII -- Reserves. Schedule IX -- Short-Term Borrowings. Schedule X -- Supplementary Profit and Loss Information. 2. EXHIBITS. The exhibits required to be filed by Item 601 of Regulation S-K are listed under the caption "Exhibits" below. (B) REPORTS ON FORM 8-K. No reports on Form 8-K were filed by the Company during the quarter ended December 31, 1993. (C) EXHIBITS. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. INLAND STEEL COMPANY By: /S/ ROBERT J. DARNALL Robert J. Darnall Chairman and Chief Executive 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 Company and in the capacities and on the dates indicated. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) REPORT OF INDEPENDENT ACCOUNTANTS TO THE BOARD OF DIRECTORS AND STOCKHOLDER OF INLAND STEEL COMPANY In our opinion, the consolidated financial statements listed in the index appearing on page present fairly, in all material respects, the financial position of Inland Steel Company (a wholly owned subsidiary of Inland Steel Industries, Inc.) 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 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 6 and 7 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and for income taxes. PRICE WATERHOUSE Chicago, Illinois February 23, 1994 INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) CONSOLIDATED STATEMENTS OF OPERATIONS AND REINVESTED EARNINGS DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) CONSOLIDATED STATEMENT OF CASH FLOWS DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) CONSOLIDATED BALANCE SHEET DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULES TO CONSOLIDATED FINANCIAL STATEMENTS DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) STATEMENT OF ACCOUNTING AND FINANCIAL POLICIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The following briefly describes the Company's principal accounting and financial policies. ACCOUNTING FOR EQUITY INVESTMENTS The Company's investments in 20% or more but less than majority-owned companies, joint ventures and partnerships, and the Company's majority interest in the I/N Tek partnership, are accounted for under the equity method. INVENTORY VALUATION Inventories are valued at cost which is not in excess of market. Cost is determined by the last-in, first-out method except for supply inventories, which are determined by the average cost or first-in, first-out methods. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is depreciated for financial reporting purposes over the estimated useful lives of the assets. Steelmaking machinery and equipment, a significant class of assets, is depreciated on a production-variable method, which adjusts straight-line depreciation to reflect production levels at the steel plant. The adjustment is limited to not more than a 25% increase or decrease from straight-line depreciation. Blast furnace relining expenditures are capitalized and amortized on a unit-of-production method over the life of the lining. All other assets are depreciated on a straight-line method. Expenditures for normal repairs and maintenance are charged to income as incurred. Gains or losses from significant abnormal disposals or retirements of properties are credited or charged to income. The cost of other retired assets less any sales proceeds is charged to accumulated depreciation. BENEFITS FOR RETIRED EMPLOYEES Pension benefits are provided by the Company to substantially all employees under a trusteed non-contributory plan of Inland Steel Industries, Inc. Life insurance and certain medical benefits are provided for retired employees. The estimated costs of pension, medical, and life insurance benefits are determined annually by consulting actuaries. With the adoption of Financial Accounting Standards Board ("FASB") Statement No. 106, "Employers' Accounting For Postretirement Benefits Other Than Pensions," effective January 1, 1992, the cost of health care benefits for retirees, previously recognized as incurred, is now being accrued during their term of employment (see Note 6). Pensions are funded in accordance with ERISA requirements in a trust established under the plan. Costs for retired employee medical benefits and life insurance are funded when claims are submitted. CASH EQUIVALENTS Cash equivalents reflected in the Statement of Cash Flows are highly liquid, short-term investments with maturities of three months or less. Cash management activities are performed by the Company's parent, Inland Steel Industries, Inc., and periodic cash transfers are made, thereby minimizing the level of cash maintained by the Company. INCOME TAXES Effective January 1, 1992, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes" (see Note 7). - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTE 1/INVENTORIES Inventories were classified on December 31 as follows: During 1993, various inventory quantities were reduced, resulting in liquidations of LIFO inventory quantities carried at lower costs prevailing in prior years as compared with the current year costs. The effect of these liquidations on continuing operations was to decrease cost of goods sold by $24 million in 1993. The effect on cost of goods sold of LIFO liquidations in 1992 and 1991 was not material. Replacement costs for the LIFO inventories exceeded LIFO values by approximately $241 million and $280 million on December 31, 1993 and 1992, respectively. NOTE 2/BORROWING ARRANGEMENTS Inland Steel Administrative Service Company, a wholly owned subsidiary of the Company established to provide a supplemental source of short-term funds to the Company, has a $100 million revolving credit facility with a group of banks which extends to November 30, 1995. Under this arrangement the Company has agreed to sell substantially all of its receivables to Inland Steel Administrative Service Company to secure this facility. The facility requires the maintenance of various financial ratios including minimum net worth and leverage ratios. NOTE 3/LONG-TERM DEBT The outstanding First Mortgage Bonds of Inland Steel Company are the obligation solely of the Company and have not been guaranteed or assumed by, or otherwise become the obligation of, Inland Steel Industries, Inc. ("Industries") or any of its other subsidiaries. Each series of First Mortgage Bonds issued by the Company is limited to the principal amount outstanding and, with the exception of the Pollution Control Series 1982 Bonds, the Pollution Control Series 1993 Bonds, and the Series T First Mortgage Bonds described below, is subject to a sinking fund. Substantially all the property, plant and equipment owned by the Company at its Indiana Harbor Works is subject to the lien of the First Mortgage. This property had a net book value of approximately $1.0 billion on December 31, 1993. In June 1993, the Company refinanced $40 million of pollution control revenue bonds at an interest rate of 6.8 percent. The weighted average percentage rate of the refunded bonds was 9.9 percent. At year-end 1993 all remaining outstanding Series O, P, and Q First Mortgage Bonds were called to be redeemed on January 28, 1994. Accordingly, the outstanding principal amount of $75.1 million at December 31, 1993 has been classified as a current liability. Prior to the redemption of the Series O, P and Q First Mortgage Bonds, under terms of the First Mortgage, the Company was prohibited, when its reinvested earnings were less than - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- $187.1 million, from paying dividends on its common stock (other than stock dividends). At year-end 1993, the accumulated deficit of the Company was $1.0 billion. In December 1991, the Company issued $125 million principal amount of First Mortgage 12% Bonds, Series T, due December 1, 1998. Net proceeds of the offering were added to the general funds of the Company and used for general corporate purposes, allowing its special-purpose subsidiary to repay its short-term bank borrowing. The amended and supplemented Mortgage under which the Series T Bonds were issued contains covenants limiting, among other things, the creation of additional indebtedness; the declaration and payment of dividends and distributions on the Company's capital stock; and the acquisition or retirement of any debt of the Company that is subordinate to the Series T Bonds. Maturities of long-term debt and capitalized lease obligations due within five years are: $86.2 million in 1994, $15.9 million in 1995, $18.1 million in 1996, $18.2 million in 1997, and $145.4 million in 1998. See Note 10 regarding commitments and contingencies for other scheduled payments. Interest cost incurred by the Company totaled $63.3 million in 1993, $63.4 million in 1992, and $71.1 million in 1991. Included in these totals is capitalized interest of $2.9 million in 1993, $10.2 million in 1992, and $13.1 million in 1991. The estimated fair value of the Company's long-term debt (including current portions thereof) using quoted market prices of Company debt securities recently traded and market-based prices of similar securities for those securities not recently traded was $583 million, as compared with the carrying value of $562 million included in the balance sheet, at year-end 1993. NOTE 4/CAPITAL STOCK In December 1991, the Company sold 1,500,000 shares of Series C Preferred Stock to Industries for $150 million. Aside from this issuance, there were no changes in the Company's preferred or common stock during the year ended December 31, 1991. The Company's other preferred stock consisted of 295,094 shares of Series A Preferred Stock with a stated value of $.6 million and 1,497,500 shares of Series B Preferred Stock with a stated value of $74.9 million. In the fourth quarter of 1992, the Board of Directors authorized: (i) a reduction in the number of Company shares authorized, issued and outstanding and (ii) a change from no par to $1.00 par value stock. One share of $1.00 par value stock was issued for each 30,000 shares of the no par stock, rounded to the nearest whole share. As a result, capital in excess of par increased and corresponding capital accounts decreased by $674.5 million. Summarized below is the effect of these actions on the shares of Company stock: Information provided below for each preferred issue is presented on an after-change basis, which reflects the current status of each such issue. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Cash dividends on Series A Preferred Stock are cumulative and payable quarterly at an annual rate of $72,000 per share. The shares are convertible into common stock at the rate of one share of common stock for each share of Series A Preferred Stock and are redeemable, at the Company's option, for $1,320,000 per share plus any accrued and unpaid dividends. Cash dividends on Series B Preferred Stock are cumulative and payable quarterly at an annual rate of $142,500 per share. The shares are convertible into common stock at a conversion price of $1,128,750 per share, or 1.33 common shares for each preferred share, and have a liquidation value of $1,500,000 per share plus any accrued and unpaid dividends. The shares are redeemable at the Company's option, for $1,500,000 per share plus any accrued and unpaid dividends. Cash dividends on Series C Preferred Stock are cumulative and payable quarterly at an annual rate of $360,000 per share. The shares have a liquidation value of $3,000,000 per share plus any accrued and unpaid dividends. The shares are redeemable at the Company's option at a price (plus accrued and unpaid dividends) declining from $3,324,000 for the one-year period commencing December 1, 1993 to $3,000,000 beginning December 1, 2011. The Series C Preferred Stock is also exchangeable at the Company's option on any dividend payment date for the Company's 12% subordinated debentures due December 1, 2016, at a rate of $3,000,000 principal amount of debentures for each share of Series C Preferred Stock. NOTE 5/PROVISIONS FOR FACILITIES SHUTDOWN In 1993, the Company recorded a facility shutdown provision of $22.3 million which covered costs associated with the earlier than planned closure of the Company's cokemaking facilities. Of the amount provided, $7.7 million relates to the write-off of assets with the remainder provided for various expenditures associated with the shutdown of the facility, including personnel costs. In 1991, the Company recorded restructuring provisions aggregating $205 million which pertained to the Indiana Harbor steelmaking complex. The provisions cover writedowns of uneconomic facilities, principally cokemaking batteries, the ingot mold foundry, and selected older facilities expected to be shut down, as well as provisions for environmental matters and workforce reductions (consisting principally of added pension and other employee benefit costs). In 1992, as the specific identification of the continuing status of pension liabilities associated with the shutdown provisions is not feasible, these liabilities were transferred from the restructuring reserve to the general pension liabilities of the Company. At December 31, 1993, the Company had restructuring reserves, excluding pension-related liabilities, totaling $149.7 million. Comparable reserves at December 31, 1992 and 1991 were $140.7 million and $134.3 million, respectively. NOTE 6/RETIREMENT BENEFITS Pensions The Inland Steel Industries Pension Plan and Pension Trust, which covers certain employees of the Company, also covers certain employees of Industries and of certain of Industries' other subsidiaries. The plan is a non-contributory defined benefit plan with pensions based on final pay and years of service for all salaried employees and certain wage employees, and years of service and a fixed rate (in most instances based on frozen pay or on job class) for all other wage employees, including members of the United Steelworkers union. Because the fair value of pension plan assets pertains to all participants in the plan, no separate determination of the fair value of such assets is made solely with respect to the Company. At year-end 1993 and 1992, the - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- actuarial present value of benefits for service rendered to date and the fair value of plan assets available for benefits for the Industries consolidated group were as follows: In 1993, Industries recorded an additional minimum pension liability of $122.1 million representing the excess of the unfunded Accumulated Benefit Obligation over previously accrued pension costs. A corresponding intangible asset was recorded as an offset to this additional liability as prescribed. A weighted average discount (settlement) rate of 7.25% in 1993 and 8.6% in 1992 was used in the determination of the actuarial present value of benefits. Pension cost for the Company for 1993 was a credit of $5.6 million compared with a credit of $9.5 million in 1992 and an expense of $87.9 million in 1991. Included in the 1991 pension cost is a pension provision for workforce reductions of $106.3 million. Benefits Other Than Pension Substantially all of the Company's employees are covered under postretirement life insurance and medical benefit plans that involve deductible and co-insurance requirements. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on applicable annual earnings at retirement for salaried employees and specific amounts for hourly employees. The Company did not prefund any of these postretirement benefits in 1993. Effective January 1, 1994, a Voluntary Employee Benefit Association Trust was established for payment of health care benefits made to United Steelworkers of America ("USWA") retirees. Funding of the Trust will be made as claims are submitted for payment. The Company has adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective January 1, 1992. FASB Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. The Company must be fully accrued for these postretirement benefits by the date each employee attains full eligibility for such benefits. In conjunction with the adoption of FASB Statement No. 106, the Company elected to immediately recognize the accumulated postretirement benefit obligation for current and future retirees (the "transition obligation"). Prior to the adoption of FASB Statement No. 106, the cost of medical benefits for retired employees was expensed as incurred. For 1993 and 1992, the accrued expense for benefits other than pensions recorded in accordance with FASB Statement No. 106 exceeded the expense that would have been recorded under the prior accounting methods by $39 million ($25 million after tax) and $53 million ($33 million after tax), respectively. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The amount of net periodic postretirement benefit cost for 1993 and 1992 is composed of the following: The following table sets forth components of the accumulated postretirement benefit obligation: Any net gain or loss in excess of 10 percent of the accumulated post retirement benefit obligation will be amortized over the remaining service period of active plan participants. In 1993, in connection with the Company's new labor agreement with the USWA, the postretirement medical benefit plan covering union employees was amended, effective August 1, 1993, to provide for employee co-payments and increased deductibles. As a result of these plan amendments, the Company remeasured its postretirement benefit obligation under FASB Statement No. 106, as of August 1, 1993. This remeasurement incorporated the effect of the union contract changes as well as the effects of changes in actuarial assumptions to reflect more current information regarding claim costs, census data and interest rate factors. The assumptions used to determine the plan's accumulated postretirement benefit obligation are as follows: A one percentage point increase in the assumed health care cost trend rates for each future year increases annual net periodic postretirement benefit cost and the accumulated postretirement benefit obligation as of December 31, 1993 by $12 million and $118 million, respectively. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Postemployment Benefits In November 1992, the FASB issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." Adoption of the new Standard, which is required by the first quarter of 1994, is not anticipated to have a material impact on results of operations or the financial position of the Company. NOTE 7/INCOME TAXES The Company adopted FASB Statement No. 109, "Accounting for Income Taxes," effective January 1, 1992. As a result of adopting Statement No. 109, the Company recorded a $31.3 million charge reflecting the cumulative effect of the change on prior years. The Company is now required to record deferred tax assets and liabilities on its balance sheet as compared with the Company's past practice under APB Opinion No. 11 and Industries' former tax-sharing agreement under which no such recording was required. Pursuant to the former tax-sharing agreement with Industries, the Company paid Industries a charge in lieu of Federal income taxes only in those years in which the Company had regular taxable income or alternative minimum taxable income and the Industries group incurred a current Federal income tax liability. In addition, for purposes of determining the charge in lieu of Federal income taxes to the Company, the tax-sharing agreement recognized that the Company was entitled to utilize the full benefits of the NOL carryforwards and general business and other credit carryforwards that existed as of May 1, 1986 (the date of formation of Industries as a holding company for the Company and its subsidiaries). In 1991, the Company was credited $.3 million due entirely to its share of Industries' AMT liability. To comply with the provisions of FASB Statement No. 109, a new tax-sharing agreement was adopted under which current and deferred income tax provisions are determined for each company in the Industries group on a stand-alone basis. Companies with taxable losses record current income tax credits not to exceed current income tax charges recorded by profitable companies. NOL and tax credit carryforwards are allocated to each company in accordance with applicable tax regulations as if a company were to leave the consolidated group. The elements of the provisions for income taxes for each of the three years indicated below were as follows: - --------------- Cr. = Credit In accordance with FASB Statement No. 109, the Company adjusted its deferred tax assets and liabilities for the effect of the change in the corporate Federal income tax rate from 34 to 35 percent, effective January 1, 1993. A credit to income of $9 million, which includes the effect of the rate change on deferred tax asset and liability balances as of January 1, 1993 as well as the effect on 1993 tax benefits recorded by the Company prior to the enactment date of August 10, 1993, was recorded in the third quarter of 1993. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The components of the deferred income tax assets and liabilities arising under FASB Statement No. 109 were as follows: For tax purposes, the Company had available, at December 31, 1993, net operating loss ("NOL") carryforwards for regular Federal income tax purposes of approximately $837 million which will expire as follows: $72 million in year 2000, $114 million in year 2005, $288 million in year 2006, $258 million in year 2007, and $105 million in 2008. The Company also had investment tax credit and other general business credit carryforwards for tax purposes of approximately $18 million, which expire during the years 1994 through 2006. A valuation allowance of $9 million has been established for those tax credits which are not expected to be realized. Additionally, in conjunction with the Alternative Minimum Tax ("AMT") rules, the Company had available minimum tax credit carryforwards for tax purposes of approximately $13 million, which may be used indefinitely to reduce regular Federal income taxes. The Company believes that it is more likely than not that the $837 million of NOL carryforwards will be utilized prior to their expiration. This belief is based upon the factors discussed below. The NOL carryforwards and existing deductible temporary differences (excluding those relating to FASB Statement No. 106) are substantially offset by existing taxable temporary differences reversing within the carryforward period. Furthermore, any such recorded tax benefits which would not be so offset are expected to be realized by achieving future profitable operations based on the following: First, the Company launched a turnaround strategy to improve performance by implementing a cost reduction program and enhancing asset utilization. This resulted in a $205 million restructuring provision in 1991 to write off uneconomic facilities and provide for future workforce reductions at the Company. Second, in 1992 the Company completed a major plant and equipment investment program that amounted to approximately $1.3 billion since 1988. This included the joint ventures of I/N Tek and I/N Kote and major upgrades to facilities in the flat products and bar business. As expected, these facility upgrades - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- resulted in significant start-up costs and disruptions to operations that negatively impacted financial results. By year-end 1993, all facilities except the 12-inch Bar Mill reached their design capabilities. This major investment program also shifts the product mix to higher value-added products which historically have not experienced significant price volatility. Consequently, the Company is now positioned with modern facilities that will enhance its ability to generate taxable profits. Finally, the Company operates in a highly cyclical industry and consequently has had a history of generating and then fully utilizing significant amounts of NOL carryforwards. Subsequent to the adoption of FASB Statement No. 109, the Company adopted FASB Statement No. 106 and recognized the entire transition obligation at January 1, 1992 as a cumulative effect charge in 1992 (Note 6). This adoption resulted in a $366 million deferred tax asset at December 31, 1992, and future annual charges under FASB Statement No. 106 are expected to continue to exceed deductible amounts for many years. Thereafter, even if the Company should have a tax loss in any year in which the deductible amount would exceed the financial statement expense, the tax law provides for a 15-year carryforward period of that loss. Because of the extremely long period that is available to realize these future tax benefits, a valuation allowance for this deferred tax asset is not necessary. While not affecting the determination of deferred income taxes for financial reporting purposes, at December 31, 1993, the Company had available for AMT purposes approximately $270 million of NOL carryforwards which will expire as follows: $113 million in 2006 and $157 million in 2007. Total income taxes reflected in the Consolidated Statement of Operations differ from the amounts computed by applying the Federal corporate tax rate as follows: - --------------- Cr. = Credit Due to the existence of the former tax-sharing agreement, such reconciliation does not provide meaningful information for 1991 and has therefore been omitted. NOTE 8/TRANSACTIONS WITH NIPPON STEEL CORPORATION On December 18, 1989, Industries sold 185,000 shares of its Series F Exchangeable Preferred Stock to NS Finance III, Inc., an indirectly wholly owned subsidiary of Nippon Steel Corporation ("NSC"), for $1,000 per share. With respect to Industries stockholder voting, such preferred stock entitles the holder to - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 30.604 votes per share, which number may be adjusted from time to time upon the occurrence of certain events. The following is a summary of the Company's relationships with NSC. I/N Tek, a general partnership formed for a joint venture between the Company and NSC, owns and operates a cold-rolling facility that commenced operations in early 1990. I/N Tek is 60% owned by a wholly owned subsidiary of the Company and 40% owned by an indirect wholly owned subsidiary of NSC. The cost of the facility was $525 million, of which $111.6 million was contributed by the subsidiary of the Company and $74.4 million by the subsidiary of NSC, with the balance borrowed by I/N Tek from three Japanese trading companies. The Company has exclusive rights to the productive capacity of the facility, except in certain limited circumstances, and, under a tolling arrangement with I/N Tek, has an obligation to use the facility for the production of cold-rolled steel. Under the tolling arrangement, the Company was charged $141.2 million, $122.6 million and $95.0 million in 1993, 1992 and 1991, respectively, for such tolling services. NSC has the right to purchase up to 400,000 tons of cold-rolled steel from the Company in each year at market-based negotiated prices, up to half of which may be steel processed by I/N Tek. Purchases of Company products by a subsidiary of NSC aggregated $157.8 million, $123.0 million and $100.6 million during 1993, 1992 and 1991, respectively. At year-end 1993 and 1992, a subsidiary of NSC owed the Company $8.2 million and $7.1 million, respectively, related to these purchases. The Company and NSC also own and operate another joint venture which consists of a 400,000 ton electrogalvanizing line and a 500,000 ton hot-dip galvanizing line adjacent to the I/N Tek facility. I/N Kote, the general partnership formed for this joint venture, is owned 50% by a wholly owned subsidiary of the Company and 50% by an indirect wholly owned subsidiary of NSC. The facility commenced operations in the fourth quarter of 1991 and became fully operational in the third quarter of 1992, with the cost of the project being $554 million. Permanent financing for the project, as well as for capitalized interest and a portion of the working capital, was provided by third-party long-term financing, by capital contributions of the two partners of $60 million each and by subordinated partner loans of $30 million each. The Company and NSC each have guaranteed the share of long-term financing attributable to their respective subsidiary's interest in the partnership. I/N Kote had $516 million outstanding under its long-term financing agreement at December 31, 1993. Additional working capital requirements were met by partner loans and by third-party credit arrangements. I/N Kote is required to buy all of its cold-rolled steel from the Company, which is required to furnish such cold-rolled steel at a price that results in an annual return on equity to the partners of I/N Kote, depending upon operating levels, of up to 10 percent after operating and financing costs; this price is subject to an upward adjustment if the Company's return on sales is less than I/N Kote's return on sales. Purchases of Company cold-rolled steel by I/N Kote aggregated $191.7 million in 1993 and $99.3 million in 1992. At year-end 1993, I/N Kote owed the Company $35.5 million related to these purchases. Prices of cold-rolled steel sold by the Company to I/N Kote are determined pursuant to the terms of the joint venture agreement and are based, in part, on operating costs of the partnership. During 1993, the Company sold cold-rolled steel to I/N Kote at a price that approximated its cost of production compared with 1992 when such sales were at less than its cost of production. I/N Kote also provides tolling services to the Company for which it was charged $29.1 million in 1993. The Company sells all I/N Kote products that are distributed in North America. The Company and NSC have entered into various agreements pursuant to which NSC has provided technical services and licenses of proprietary steel technology with respect to specific Company research and engineering projects. Pursuant to such agreements, the Company incurred costs of $3.7 million, $4.1 million and $7.0 million for technical services and related administrative costs for services provided during 1993, 1992 and 1991, respectively. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTE 9/INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES The Company's investments in unconsolidated joint ventures accounted for by the equity method consist primarily of its 60% interest in I/N Tek, 50% interest in I/N Kote, 50% interest in PCI Associates, 40% interest in the Empire Iron Mining Partnership, 12 1/2% interest (25% interest in 1991) in Walbridge Electrogalvanizing Company and 13 3/4% interest in Wabush Mines. I/N Tek and I/N Kote are joint ventures with NSC (see Note 8). The Company does not exercise control over I/N Tek, as all significant management decisions of the joint venture require agreement by both of the partners. Due to this lack of control by the Company, the Company accounts for its investment in I/N Tek under the equity method. PCI Associates is a joint venture which operates a pulverized coal injection facility at the Indiana Harbor Works. Empire and Wabush are iron ore mining and pelletizing ventures owned in various percentages primarily by U.S. and Canadian steel companies. On June 30, 1992, the Company sold one-half of its interest in Walbridge, resulting in a $22.5 million pre-tax gain. Walbridge is a venture that coats cold-rolled steel in which Inland has the right to 25% of the productive capacity (50% at year-end 1991). Following is a summary of combined financial information of the Company's unconsolidated joint ventures: NOTE 10/COMMITMENTS AND CONTINGENCIES The Company guarantees payment of principal and interest on its 40% share of the long-term debt of Empire Iron Mining Partnership requiring principal payments of approximately $7.6 million annually through 1996. At year-end 1993, the Company also guaranteed $34.5 million of long-term debt attributable to a subsidiary's interest in PCI Associates. As part of the agreement covering the 1990 sale of the Inland Lime & Stone Company division assets, the Company agreed, subject to certain exceptions, to purchase, at prices which approximate market, the full amount of its annual limestone needs or one million gross tons minimum, whichever is greater, through 2002. The Company and its subsidiaries have various operating leases for which minimum lease payments are estimated to total $288.3 million through 2018, including approximately $45.0 million in 1994, $40.5 million in 1995, $37.4 million in 1996, $36.0 million in 1997, and $32.7 million in 1998. Included in the above amounts is a total of $154 million, approximately $20 million per year, related to the lease of a caster facility that the Company plans to buy-out in 1994. Upon completion of the transaction, the total and five year estimates provided should be reduced accordingly. The Company will also record additional long-term debt of - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- approximately $63 million as part of the transaction, the interest and principal of which will be paid on through 2001. It is anticipated that the Company will make expenditures of $20 million in 1994, $13 million in 1995, and $5 million to $10 million annually in each of the three years thereafter for the construction, and have ongoing annual expenditures of $40 million to $50 million for the operation, of air and water pollution control facilities to comply with current Federal, state and local laws and regulations. The Company is involved in various environmental and other administrative or judicial actions initiated by governmental agencies. While it is not possible to predict the results of these matters, the Company does not expect environmental expenditures, excluding amounts that may be required in connection with the consent decree in the 1990 EPA lawsuit, to materially affect the Company's results of operations or financial position. Corrective actions relating to the EPA consent decree may require significant expenditures over the next several years that may be material to the results of operations or financial position of the Company. At December 31, 1993, the Company's reserves for environmental liabilities totaled $19 million related to the sediment remediation under the 1993 EPA consent decree. The total amount of firm commitments of the Company and its subsidiaries to contractors and suppliers, primarily in connection with additions to property, plant and equipment, approximated $12 million at year-end 1993. NOTE 11/RELATED PARTY TRANSACTIONS Industries has established procedures for charging its administrative expenses to the operating companies owned by it. These charges are for management, financial and legal services provided to those companies. Charges from Industries for 1993, 1992 and 1991 totaled $24.2 million, $25.4 million and $25.2 million, respectively. There are also established procedures to charge interest on all intercompany loans within the Industries group of companies. Such loans currently bear interest at the prime rate. For 1993, 1992 and 1991, the Company's net interest expense to companies within the Industries group totaled $8.0 million, $5.1 million and $18.6 million, respectively. The Company sells to and purchases products from other companies within the Industries group of companies at prevailing market prices. These transactions for the indicated years are summarized as follows: NOTE 12/CONCENTRATION OF CREDIT RISK The Company produces and sells a wide range of steels, of which approximately 99% consists of carbon and high-strength low-alloy steel grades. Approximately 76% of the sales were to customers in five mid-American states, and 93% were to customers in 20 mid-American states. Over half the sales are to the steel service center and transportation (including automotive) markets. Sales to General Motors Corporation approximated 12% of consolidated net sales in 1993 and 1992, and 11% in 1991. No other customer accounted for more than 10% of the consolidated net sales of the Company during any of these years. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTE 13/CONSOLIDATED QUARTERLY SALES AND EARNINGS (UNAUDITED) - --------------- * Includes facility shutdown provision of $22.3 million, $14.7 million after tax. ** Includes cumulative effect of changes in accounting principles of $(609.6) million. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) Reflects the change in book value of rolls, annealing covers and convector plates. (B) Transfer between property, plant and equipment and other assets and other miscellaneous adjustments. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE VI - RESERVE FOR DEPRECIATION, AMORTIZATION AND DEPLETION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) Reclassification among indicated reserve accounts and other miscellaneous adjustments. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE VIII--RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) Bad debts written off during year. (B) Allowances granted during year. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE IX--SHORT-TERM BORROWINGS FOR YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (A) The average outstanding amount was computed by aggregating the daily balances of short-term debt outstanding and dividing the aggregate by the number of days in the year. (B) The weighted average interest rate during the year was computed by dividing interest expense on short-term debt by the average short-term debt outstanding during the year. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INLAND STEEL COMPANY AND SUBSIDIARY COMPANIES (A WHOLLY OWNED SUBSIDIARY OF INLAND STEEL INDUSTRIES, INC.) SCHEDULE X--SUPPLEMENTARY PROFIT AND LOSS INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 DOLLARS IN MILLIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INDEX TO EXHIBITS

59255_1993.txt

59255_1993

1993

59255

ITEM 1. BUSINESS GENERAL: Valhi, Inc., based in Dallas, Texas, is a diversified industrial management company. Information regarding Valhi's consolidated business segments and unconsolidated affiliates which Valhi may be deemed to control, and the companies conducting such operations, is set forth below. Business and geographic segment financial information is included in Note 2 to the Company's Consolidated Financial Statements, which information is incorporated herein by reference. - 1 - Valhi, a Delaware corporation, is the successor of the 1987 merger of The Amalgamated Sugar Company and LLC Corporation. Contran Corporation holds, directly or through subsidiaries, approximately 90% of Valhi's outstanding common stock. All of Contran's outstanding voting stock is held by trusts established for the benefit of the children and grandchildren of Harold C. Simmons, of which Mr. Simmons is the sole trustee. Mr. Simmons is Chairman of the Board and Chief Executive Officer of Contran, Valhi and Valcor, Chairman of the Board of NL and a director of Tremont, and may be deemed to control each of such companies. A summary corporate organization chart for the Company is set forth below. Valcor, Inc. is an intermediate parent company formed in 1993 to segregate certain subsidiaries and enable the Company to obtain lower-cost, long-term debt. {Summary corporate organization chart showing Valhi's 100% ownership of Valcor and Amalgamated, Valcor's 100% ownership of Medite, Sybra and National Cabinet Lock, Medite's 100% ownership of Medite of Europe (Ireland) and National Cabinet Lock's 100% ownership of Waterloo Furniture Components (Canada). Chart also shows Valhi's ownership of NL (49%) and Tremont (48%) along with Tremont's 18% ownership of NL. Footnote to the chart discloses Valhi's 3% ownership of Dresser Industries, Inc. common stock.} - 2 - REFINED SUGAR: Products and operations. Amalgamated, headquartered in Ogden, Utah, is the second-largest U.S. beet sugar producer with approximately 10% of United States annual sugar production. Refined sugar accounts for approximately 90% of Amalgamated's annual sales. Animal feed in the forms of beet pulp and molasses, by-products of sugarbeet processing, accounts for most of its remaining sales. Each spring, Amalgamated contracts with approximately 1,700 individual farmers to plant a specified number of acres of sugarbeets and to deliver the sugarbeets to Amalgamated upon harvest in the fall. Amalgamated's sugarbeet processing, which consists of extracting sugar from the sugarbeets and refining the sugar, begins upon harvest and usually lasts until February. Approximately one-fourth of the sugarbeet crop is initially processed into a thick syrup, which is stored in Amalgamated's facilities and subsequently processed into refined sugar. Refined sugar is sold throughout the year while by-products are sold primarily in the first and fourth calendar quarters. Amalgamated's profitability is determined primarily by the quantity and quality of the sugarbeets processed, Amalgamated's efficiency in extracting and refining sugar, and the sales price of refined sugar. Amalgamated's four factories operate at approximately full capacity during the annual sugarbeet processing campaigns, and sugar production from the past five crops has averaged over 1.4 billion pounds per year. Due principally to record-high sugar content of the beets, sugar production from the crop harvested in the fall of 1993 is expected to establish a new record for the fourth consecutive year. The price paid to growers for sugarbeets is a function of Amalgamated's average sales price for refined sugar during the contract settlement year, which runs from October through September, and of the sugar content of the sugarbeets. The cost of transporting sugarbeets to Amalgamated's factories generally limits the geographic area from which sugarbeets are purchased. The anticipated price of sugar and the price of competing crops influence the number of acres of sugarbeets planted. The available sugarbeet acreage in Amalgamated's geographic area of operations exceeds Amalgamated's processing capacity. Amalgamated sells sugar primarily in the North Central and Intermountain Northwest regions of the United States. Approximately 80% of sugar sales are to industrial sugar users and approximately 20% are to wholesalers or retailers in consumer-sized packages. As is customary in the sugar industry, Amalgamated sells sugar to its customers under contract for future delivery, generally within one to six months. Amalgamated does not otherwise engage in the purchase or sale of sugar futures contracts. Beet pulp and molasses, by-products of the sugar extraction process, constitute approximately 10% of Amalgamated's sales and are sold primarily to animal feeders in the U.S. Intermountain Northwest region and Japan. The quantity of by-products available for sale is determined principally by the size of the sugarbeet crop. By-product sales prices are influenced by the prices of competing animal feeds and have no direct relation to refined sugar prices. - 3 - Strategy. Amalgamated's primary strategic focus is to improve its efficiency in extracting and refining sugar in order to increase sugar production, to reduce unit production costs and to maintain market share. Amalgamated's recent capital investments, and those planned for the next several years, have emphasized extraction and other productivity improvement projects. Competitors and competition. Sugar production in the United States has increased slightly in recent years, and the U.S. sugar industry currently produces over 80% of the country's sugar needs from domestically-grown sugarbeets and sugarcane. The remainder of the country's sugar supply is imported, principally as raw sugar that is processed into refined sugar by coastal refiners. There is no difference between domestically-produced sugar, either from sugarbeets or sugarcane, and that produced from imported raw sugar. Amalgamated competes with virtually all processors of either domestically-grown sugar crops or imported raw sugar. Major competitors in Amalgamated's geographic sales area include the C&H, Domino, Imperial Holly, Savannah Foods, Spreckels, United Sugar and Western sugar companies. Because refined sugar is a commodity product, Amalgamated has little ability to independently establish selling prices. Total domestic sugar consumption has increased slightly during the past few years after declining during the early 1980's as a result of increased consumption of high fructose corn syrup and non-caloric sweeteners such as aspartame. According to published sources, the percentage of total United States caloric sweetener use attributable to refined sugar has averaged about 45% during the last five years and per capita consumption of refined sugar in 1993 is estimated at 65 pounds, as compared to actual consumption of 64.5 pounds in 1990, 63.4 pounds in 1985 and 83.6 pounds in 1980. Amalgamated does not believe it is dependent upon one or a few customers; however, major food processors are substantial customers and represent an important portion of sales. Amalgamated's ten largest customers accounted for slightly more than one-third of its sales in each of the past three years, with the largest customer accounting for 5% to 8% of sales in each year. Governmental sugar price support program. The Food, Agriculture, Conservation and Trade Act of 1990 (the "1990 Farm Bill"), as amended by the Omnibus Budget Reconciliation Act of 1993, continues, through the 1997 crop year ending in September 1998, the sugar price support program for domestically-grown sugarcane and sugarbeets established by the Agriculture and Food Act of 1981. Under such program, Amalgamated is able to obtain, from the federal government, nonrecourse loans on its refined sugar inventories at loan rates based upon a raw sugar support price of no less than 18 cents per pound. The effective net government loan rate applicable to Amalgamated's 1993 crop sugar is 20.75 cents per pound. The 1990 Farm Bill also implemented marketing assessments on domestically-produced refined beet sugar and domestically-produced raw cane sugar. The marketing assessment cost is shared by the processors and the growers, and results in a net cost to Amalgamated of about 0.077 cents per pound, or approximately $1 million per year. The 1990 Farm Bill continues the provision that the sugar price support loan program is to be operated at no cost to the federal government, which requires the government to take actions to maintain the market prices of raw and refined sugar above the price support loan levels in order to prevent defaults on the - 4 - nonrecourse loans extended under the program. Currently, the government imposes quotas and duties on imported sugar to restrict supply and to help maintain domestic market prices. The 1990 Farm Bill guarantees a minimum annual import quota of 1.25 million short tons (1.1 million metric tons) of raw sugar. In addition, the United States Department of Agriculture can impose marketing allotments on domestic sugarcane and sugarbeet processors to limit the amount of raw and refined sugar which each domestic processor may market. For the first time in over 20 years, marketing allotments were imposed effective June 30, 1993 for the crop year ended September 30, 1993. Amalgamated's allotment equated to approximately 95% of its production from that crop. See also Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations." Research and development. Amalgamated maintains research and development programs emphasizing processing technology and its annual research and development expense has been slightly under $600,000 in each of the past three years. Amalgamated has developed various proprietary technologies related to sugar processing and employs these process improvements to reduce its operating costs. Some of these techniques apply to fructose and cane refinery operations as well as sugarbeet operations. Amalgamated presently holds nine domestic patents on certain of its proprietary technology, which patents have an average remaining term of approximately four years. The loss of any of such patents would not have a material adverse effect on Amalgamated. Employees. Amalgamated employs approximately 2,200 persons at the height of the production season, of which approximately 1,400 are year-round employees. Amalgamated's three-year labor agreement with the American Federation of Grain Millers, which represents production employees through local unions, expires July 1996. Amalgamated believes its labor relations are satisfactory. Energy. Amalgamated's primary fuel is coal, but it can utilize other fuels. The supply of coal is provided under a long-term contract expiring February 1998, subject to extension at Amalgamated's option for three five-year periods. Energy is an important element in the processing of sugarbeets, and the use of coal has historically resulted in lower production costs than if oil, natural gas or electricity were Amalgamated's primary energy source. Properties. Amalgamated owns four sugar processing factories, located in Paul, Twin Falls and Nampa, Idaho and Nyssa, Oregon, and also owns its general office facilities in Ogden, Utah, four distribution terminals in four states, and six storage facilities in two states. Environmental matters. Amalgamated believes that it is currently in substantial compliance with existing permits relating to its facilities; however, federal and state environmental compliance requirements are becoming more stringent in certain respects and are expected to result in expenditures in excess of the relatively nominal amounts spent in recent years. Amalgamated's capital budget for 1994 includes over $5 million in the area of environmental protection and improvement, principally related to air and water treatment facilities at certain of its factories. - 5 - FOREST PRODUCTS: Products, operations and properties. Medite, headquartered in Medford, Oregon, produces MDF (an engineered wood product) at three plants in the United States and Republic or Ireland. Medite owns 167,000 acres of timberland in Oregon and also produces solid wood products, including logs, lumber, veneer and wood chips. MDF is a reconstituted wood panel product that serves as a lower-cost alternative to solid wood in a variety of applications, including furniture, cabinetry and joinery and architectural applications. Lumber is used in residential and commercial construction, veneer is used in the production of plywood and laminated veneer lumber ("LVL"), and wood chips are a basic raw material for the paper and MDF industries. Certain sizes and species of logs harvested by Medite that are not used in its manufacturing operations are sold to other mills in Southern Oregon. Medite, with annual MDF production capacity of 490,000 cubic meters, is the world's second-largest producer of MDF. Medite's MDF production was about 95% of its aggregate capacity in each of 1993 and 1992, up from about 90% in 1991. Medite has commenced an expansion of its Irish MDF production facilities which will increase its Irish production capacity by about 75% and its worldwide capacity by about 25%. Medite sells MDF principally under the trademarks of Medite and Medex. Development of new products focused on meeting customer needs has expanded the Company's MDF product line to include the following items: The Company believes Medite is the world's best known trademark for MDF, that Medex is the world's only current exterior grade MDF, and that Medite is the leading producer of Class 1 flame retardant MDF. Medex is designed primarily for outdoor applications that take a heavy environmental toll on standard wood products; Medite 313 is designed for use in high-humidity interior environments such as kitchens; Medite FR was developed specifically for use where a Class 1 flame retardant board is required under building regulations; and Medite II is used in areas with zero formaldehyde tolerance, such as hospitals and schools. Medite owns and operates MDF plants in Medford, Oregon and Las Vegas, New Mexico; its MDF plant in Clonmel, Republic of Ireland, is owned and operated by Medite of Europe Limited, a wholly-owned subsidiary of Medite. Medite's access to adequate and reliable wood fiber raw material supplies is a key aspect of its MDF operations. Medite/Europe has a long-term timber contract with the Irish State Forestry Company that provides for sufficient logs to supply the wood fiber needs of the Clonmel MDF plant, although Medite/Europe - 6 - also currently utilizes lower-cost sawmill residues from local Irish suppliers for a portion of its fiber requirements. Wood chips, shavings and sawdust used as raw materials in the Oregon MDF plant have been provided principally by Medite's solid wood plants but are also generally available from other sources. Wood chips for the New Mexico MDF plant have historically been available from several sources within a 150-mile radius of the plant, although, due to decreased production by certain suppliers, Medite has continued to expand its supplier base to encompass a wider area. Other raw materials for MDF, principally resins and glues, are available from a variety of suppliers. Medite conducts substantial logging operations and owns approximately 167,000 acres of timberland, including 77,000 acres added since Medite was acquired by Valhi in 1984. Medite's timberlands contain approximately 645 million board feet ("MMBF") of generally second-growth merchantable timber, with the dominant species being Douglas Fir. The average annual timber growth rate is approximately 4%. Medite's timber holdings are within close proximity to its Oregon production facilities and are in relatively accessible terrain. Based on reported U.S. Government sales of comparable timber, the Company believes that Medite's timber and timberlands have a fair market value substantially in excess of their December 31, 1993 carrying value of $52 million. In June 1992, a fire destroyed Medite's veneer and chipping plant in Rogue River, Oregon. Replacement chipping operations resumed in July 1993 and replacement veneer operations resumed in January 1994. The new Rogue River facilities are designed to process the smaller second-growth timber expected to be available from company-owned timberlands on a longer-term basis. Veneer from this plant will serve the LVL industry as well as traditional plywood customers. Medite also owns and operates a stud lumber mill in White City, Oregon, which primarily produces 2x4 studs. As a result of the closure of its plywood operations in January 1993, Medite has a 105 acre site in Medford, Oregon which is held for sale. Strategy. Medite's primary strategic focus is to continue expansion in the growing market for MDF with particular emphasis on higher margin specialty products and to increase its presence in Europe and Mexico. Expanded MDF production capabilities will generally be directed to those regions providing attractive long-term availability of wood fiber. As discussed above, Medite has commenced an expansion of its Irish MDF plant. Medite also is placing emphasis on greater penetration of the growing market for MDF in Mexico, which readily can be served by Medite's plant in Las Vegas, New Mexico. In the U.S., where Medite anticipates further escalation of the cost of traditional sources of wood fiber, Medite is introducing alternative sources such as hardwoods and recycled wood products. Medite actively manages its fee timberlands in Oregon, which are a valuable resource as the shortage of Pacific Northwest public timber available for harvest is expected to continue for the foreseeable future. In this regard, Medite has adjusted its solid wood manufacturing operations to more closely parallel the timber available from company-owned lands on a longer-term basis, has increased its emphasis on the sale of logs, closed marginal manufacturing operations and has adopted a more sustained yield approach to harvesting timber from company-owned lands. - 7 - Distribution and sale of products. MDF produced in Ireland by Medite/Europe is sold primarily to wholesalers and distributors of building products in European Union ("EU") countries, with the largest market being the United Kingdom. U.S.-produced products are sold primarily to wholesalers of building materials and are concentrated primarily in western states, with U.S. exports principally to Pacific Rim countries and Mexico. Logs are sold primarily to other Oregon mills. Medite's operations are not dependent upon one or a few customers, the loss of which would have a material adverse effect on this business segment. Medite's ten largest customers accounted for about one-fourth of its sales in each of the past three years. In 1993, the ten largest customers included eight companies in the U.S., one in Europe and one in the Far East. Five of the ten largest customers in 1993 were primarily MDF customers. Logging operations are seasonal due to inclement weather conditions during winter and spring months, however the production and sale of products is not particularly seasonal in nature. Markets for engineered wood products such as MDF are broader, more varied and less cyclical than those for traditional solid wood forest products. Sales of traditional forest products in the U.S. are largely dependent upon the strength of the housing industry, which historically has been cyclical in nature. Competition. The forest products industry is highly competitive, with price being a principal competitive factor. Transportation costs are also significant and generally limit the geographic market in which products are sold. Medite's MDF operations compete in the U.S. principally with a number of producers of MDF and other composite board products, and in the Pacific Rim with Australian, New Zealand and other U.S. manufacturers. Principal MDF competitors in the U.S. include Plum Creek, Sierra Pine, Louisiana Pacific Corp. and Wilamette Industries. In Europe, Medite competes principally with other EU producers, including the world's largest MDF producer, the Glunz Group. The cost of shipping products is significant and Medite may operate at a competitive disadvantage to certain other producers who are located closer to certain key Northern European markets. In addition, some of Medite's competitors may possess greater financial resources, including in some cases the financial support of the governments of the countries in which such competitors are located. Due to periodic declines in the value of the U.S. dollar relative to other currencies, Medite's Irish operations have also experienced periodic increases in competition from U.S. producers. According to industry sources, demand for MDF has increased at an average annual rate of about 15% over the last five years, with estimated worldwide consumption in 1993 double that of 1988. Medite believes demand will continue to grow at slightly lower rates in the foreseeable future and that demand for specialty MDF products will grow at a faster rate than for standard MDF products. Medite continues to emphasize marketing of its higher margin specialty MDF products, which accounted for approximately 20% of Medite's MDF sales dollars in 1993. Medite's solid wood operations compete primarily with numerous other producers in the Pacific Northwest. The Pacific Northwest forest products industry experiences competition from Canadian imports and, to a lesser extent, from producers in southern states. - 8 - Environmental matters. Medite conducts an extensive forest management program with respect to company-owned timberlands, including selective harvest, reforestation and fertilization activities. Medite believes that its operations are in substantial compliance with existing permits relating to its facilities and does not anticipate spending significant amounts for facilities-related environmental matters in the near future. Trademarks and patents. Patents held for MDF products and production processes are believed to be important to Medite's MDF business activities. The Company's major MDF trademarks, Medite and Medex, are protected by registration in the United States and certain other countries with respect to the manufacture and sale of its products. Medite also has a non-exclusive world-wide license relating to application of resins in the manufacture of Medex. Employees. As of December 31, 1993, Medite employed approximately 670 persons, including 490 in the U.S. and 180 in Europe. Approximately one-fourth of U.S. employees and two-thirds of non-U.S. employees are represented by various labor unions. Employees of Medite's Oregon MDF plant are covered by a five-year collective bargaining agreement through September 1997, and employees at the Rogue River facility are covered under a three-year agreement through May 1996. Employees of Medite's Irish plant are covered by a collective bargaining agreement through March 1994. Negotiations are underway for a new three-year agreement and Medite believes it will be able to enter into a satisfactory new labor agreement with the union at the Irish plant. Medite believes that its labor relations are satisfactory. Governmental regulation. Medite's timber operations are subject to a variety of Oregon and, in some cases, federal laws and regulations dealing with timber harvesting, reforestation, endangered species, and air and water quality. These regulations generally require Medite to obtain operating permits and, in some cases, to file timber harvesting plans that must be approved by the Oregon Department of Forestry prior to the harvesting of timber. Medite does not expect that compliance with such existing laws and regulations will have a material adverse effect on Medite's timber harvesting practices. The U.S. Fish and Wildlife Service has designated the Northern Spotted Owl as a threatened species under the Endangered Species Act ("ESA"). Generally, habitat for Northern Spotted Owls is found in old-growth timber stands, compared to Medite's generally second-growth timber. Consequently, Medite believes the designation of the Northern Spotted Owl under the ESA will not have a material adverse effect on its timber harvesting practices. There can be no assurance, however, that future legislation, governmental regulations or judicial or administrative decisions will not adversely affect Medite or its ability to harvest and sell logs or timber in the manner currently contemplated. The Federal Timber Contract Payment Modification Act of 1986 contains certain restrictions on the volume of timber that may be offered for sale pursuant to government contracts, and the volume of timber being offered for competitive bidding in Medite's area of operations has been significantly limited due to current government forest management plans, including the effect of court-imposed restrictions resulting from application of the ESA and litigation initiated by environmental groups. - 9 - Risk of loss from fire or other casualties. Medite assumes substantially all risks of loss from fire and other casualties on its timberlands, as do the owners of most other timber tracts in the United States. Medite is a participant with state agencies and other timberland owners in cooperative fire fighting and aerial fire surveillance programs. The extensive roads on Medite's acreage also serve as fire breaks and facilitate implementation of fire control techniques and utilization of fire fighting equipment. Medite's various timber tracts are also somewhat geographically dispersed, which also reduces the possibility of significant fire damage. The only forest fire on Medite's timberlands of any significance during the past five years occurred in July 1992 and resulted in damage to approximately 1,200 acres, which were salvaged with minimal loss. Consistent with the past practices of Medite and the owners of most other timber tracts in the United States, Medite does not intend to maintain fire insurance in respect of standing timber. FAST FOOD: Products and operations. Sybra, based in Atlanta, Georgia, operates approximately 160 Arby's restaurants clustered in four regions pursuant to licenses with Arby's, Inc. According to information provided by Arby's, Sybra is the second-largest franchisee in the Arby's restaurant system based upon the number of restaurants operated and gross sales. Arby's is a well-established fast food restaurant chain and features a menu that highlights roast beef sandwiches along with a variety of chicken and deli sandwiches, potato products and soft drinks. Arby's represents a niche segment of the fast food restaurant industry. Arby's recent national advertising campaign slogans include "Arby's is Different(C)" and "Different is Good(C)". New product development is important to the continued success of a restaurant system, and Sybra has introduced several new menu items in recent years including chicken, submarine and alternative roast beef sandwiches, curly fried potatoes and ice cream desserts. Total sandwich category items accounted for over 60% of Sybra's total sales during the past few years, and roast beef sandwiches currently account for approximately two-thirds of Sybra's sandwich sales. During the past three years, substantially all of the new restaurants opened were free-standing stores as will be all of the new stores planned for 1994. Sybra also continuously evaluates its individual stores and closes unprofitable stores when considered appropriate. Sybra's 160 Arby's restaurants at the end of 1993 represent a net increase of 101 stores from the 59 Arby's restaurants Sybra operated when it was acquired in 1979 by a predecessor of Valhi. Sybra has also remodeled over 40 stores during the past five years. Sybra currently expects a net increase in restaurants operated of two to five stores in 1994, as it plans to open six to ten new restaurants within its existing regions and to close four or five stores. The first new restaurant in 1994 opened in late February, and four existing stores were closed in January. - 10 - Strategy. Given the extremely competitive environment in which Sybra operates, Sybra will (i) continue its strong emphasis on operational details; (ii) routinely review the profit contribution of each restaurant with a view toward closing those stores which do not meet expectations; and, (iii) continue to follow its "clustering" concept in opening new stores in order to capitalize on the economies of scale realized in management and advertising as a result of geographic proximity. Sybra's exclusive Arby's development rights in the Dallas/Ft. Worth, Texas and Tampa, Florida areas, discussed below, provide future growth opportunities consistent with Sybra's store clustering concept. New stores are likely to be free-standing restaurants of Sybra's smaller design, which the Company has found generally to yield a greater rate of return. Sybra also plans to continue to increase market share in the fast food industry in its geographic markets through periodic promotions including the introduction of innovative menu items to complement its main product offerings. Properties. The following table summarizes by region the number of Arby's restaurants operated by Sybra at the end of the last three years. Of the 160 stores operated at the end of 1993, 115 were free-standing stores and the remaining 45 are located within regional shopping malls or strip shopping centers. Sybra leases 116 locations and owns the remainder. Lease terms vary with most leases being on a long-term basis and providing for contingent rents based on sales in addition to base monthly rents. At the end of 1993, the remaining term of individual store leases averaged six years and ranged up to 16 years. Approximately 90% of the leases of free-standing locations contain purchase and/or various renewal options at fair market values. Approximately 90% of the mall locations operate under leases which expire in the next five years and do not provide for renewal options. In most cases, Sybra expects that in the normal course of business leases can be renewed or replaced by other leases. The four stores closed in January 1994 were leased mall units. Contingent rentals based upon various percentages of gross sales of individual restaurants were less than 10% of Sybra's total rent expense in each of the past three years. Sybra also leases corporate and regional office space in five states. - 11 - Sybra has a Consolidated Development Agreement ("CDA") with Arby's, Inc., which replaced several prior Area Development Agreements. Under the CDA, Sybra has exclusive development rights within certain counties in the Dallas/Fort Worth and Tampa areas and is required to open an aggregate of 31 stores in its existing markets during the five year term (1993 - 1997) of the CDA. At December 31, 1993, Sybra had opened three stores pursuant to the CDA. Sybra currently anticipates that its expansion program will enable it to retain its exclusive Dallas/Ft. Worth and Tampa development rights over the term of the CDA. Sybra does not have any other territorial or development agreements which would prohibit others from operating an Arby's restaurant in the general geographic markets in which Sybra now operates. Food products and supplies. Sybra and other Arby's franchisees are members of ARCOP, Inc., a non-profit cooperative purchasing organization. ARCOP facilitates negotiations of national contracts for food and distribution, taking advantage of the larger purchasing requirements of the member franchisees. Since Arby's franchisees are not required to purchase any food products or supplies from Arby's, Inc., ARCOP facilitates control over food and supplies costs and avoids franchisor conflicts of interest. License terms and royalty fees. The 27-year relationship between Sybra and Arby's, Inc. is governed principally by licenses relating to each restaurant location. Generally, such franchise agreements require that Sybra comply with certain requirements as to business operations and facility maintenance. Currently, Sybra pays an initial franchise fee of $25,000 and a royalty rate of 4% of sales for a standard 20-year license. Because some of Sybra's licenses were issued at times when license terms were perpetual and lower royalty rates were in effect, 45% of Sybra's franchise agreements have no fixed termination date and royalties for all locations aggregated 2.6% to 2.7% of sales in each of the past three years. Sybra's average royalty rate is expected to increase over time as new stores are opened or existing 20-year licenses are renewed at then-prevailing royalty rates. The first of Sybra's 20-year licenses expires in 2003. In 1993, an investment group purchased a controlling interest in Triarc Company (formerly DWG Corporation), the parent company of Arby's, Inc. Sybra believes that the change in ownership of Triarc is a positive development for the Arby's system. Advertising and marketing. For the past several years, Sybra has directed about 7 1/2% of its total restaurant sales toward marketing. All franchisees of Arby's, Inc. must belong to AFA Service Corporation ("AFA"), a non-profit association of Arby's restaurant operators, and must contribute a specified portion (up to 1.2%) of their gross revenues as dues to AFA. In return, AFA provides franchisees creative materials such as television and radio commercials, ad mats for newspapers, point-of-purchase graphics and other advertising materials. Although Arby's, Inc., as an operator of Arby's restaurants, is a member of AFA, the direction and management of AFA is principally controlled by the member franchisees. Sybra and other franchisees currently contribute .7% of their gross revenues to AFA. In addition to the AFA contribution, Sybra devotes approximately 3% of its restaurant sales to coupon sales promotions, including the direct cost of discounted food, and newspaper and direct mail inserts, and approximately 3 1/2% of its restaurant sales to local advertising, including outdoor advertising and electronic media. - 12 - Competition and seasonality. The fast food industry is extremely competitive and subject to pressures from major business cycles and competition from many established and new restaurant concepts. According to industry data, there is a significant disparity in the revenues and number of restaurants operated by the largest restaurant systems and the Arby's system. As a result, some organizations and franchised restaurant systems have significantly greater resources for advertising and marketing than the Arby's restaurant system or Sybra, which is an important competitive factor. Sybra's response to these competitive factors has been to cluster its stores in certain geographic areas where it can achieve economies of scale in advertising and other activities. Operating results of Sybra's restaurants have historically been affected by both retail shopping patterns and weather conditions. Accordingly, Sybra historically has experienced its most favorable results during the fourth calendar quarter (which includes the holiday shopping season) and its least favorable results during the first calendar quarter (which includes winter weather, which can be adverse in certain markets). Employees. As of December 31, 1993, Sybra had approximately 4,000 employees, of which 3,400 were part-time employees. Approximately 3,900 employees work in Sybra's restaurants and the remainder work in its corporate or regional offices. Sybra's employees are not covered by collective bargaining agreements, and Sybra believes that its relationship with its employees is satisfactory. Governmental regulation. Various federal, state and local laws affect Sybra's restaurant business, including laws and regulations relating to health, sanitation, employment and safety standards and local zoning ordinances. Sybra has not experienced and does not anticipate unusual difficulties in complying with these regulations. Sybra does not expect that remedial costs, if any, related to compliance with the Americans with Disabilities Act will be material. Sybra is subject to the Federal Fair Labor Standards Act, which governs minimum wages, overtime and other working conditions. A significant portion of Sybra's restaurant employees work on a part-time basis and are paid at rates related to the minimum wage rate. Further increases in the minimum wage rate (last increased in April 1991) and any mandatory medical insurance benefits to part-time employees, both of which are favored by the Clinton Administration, would increase Sybra's labor costs. Although Sybra's competitors would probably experience similar increases, there can be no assurance that Sybra will be able to increase sales prices to offset future increases, if any, in these costs. HARDWARE PRODUCTS: Products, operations and properties. National Cabinet Lock, headquartered in Mauldin, South Carolina, manufactures low and medium- security locks, drawer slides, computer keyboard support arms and other components for furniture and a variety of other applications. Lock products accounted for approximately 40% of National Cabinet Lock's sales in 1993 with the other products constituting approximately 60%. National Cabinet Lock believes its products compete in relatively well-defined niche markets. The Company also believes that it is the second- largest U.S. cabinet lock producer, that it is the largest Canadian producer of drawer slides and that it is the largest supplier of computer keyboard support arms to the North American office furniture manufacturing market. - 13 - Locks are manufactured, assembled and packaged by National Cabinet Lock in Mauldin, South Carolina, and by a subsidiary in Mississauga, Ontario, Canada. Waterloo Furniture Components Limited, another Canadian subsidiary, produces drawer slides and computer keyboard support arms for distributor and industrial markets at a plant located in Kitchener, Ontario, Canada. The Kitchener and Mauldin plants are owned, and the Mississauga facility is leased through 1997. National Cabinet Lock markets its products primarily through its own sales organization as well as select manufacturers' representatives. Purchased components, including zinc castings, are the principal raw materials used in the manufacture of latching and security products. Strip steel is the major raw material used in the manufacture of hardware and stamped metal products. These raw materials are purchased from several suppliers and are readily available. Strategy. National Cabinet Lock will seek to maintain its relatively high margins through improved manufacturing efficiency and through development of specialty, higher margin products engineered to customer specification and to capitalize on future opportunities that may emerge to enter into longer-term contracts with niche original equipment manufacturers. National Cabinet Lock will also seek to expand its established market positions by emphasizing customer service, promoting its distribution programs and seeking greater penetration of the replacement lock market. Competition and customer base. Competition in National Cabinet Lock's markets is based on product features, customer service, quality, distribution channels and consumer brand preferences. Approximately 30% of National Cabinet Lock's lock sales are made through its STOCK LOCKS distribution program, a program the Company believes offers a competitive advantage because delivery generally is made within 72 hours. Most of National Cabinet Lock's remaining sales are to original equipment manufacturers' specifications. The Company's major competitors include Chicago Lock, Hudson Lock and Fort Lock (locks), Accuride and Hettich/Grant (drawer slides) and Weber Knapp and Jacmorr (computer keyboard support arms). National Cabinet Lock also competes with a large number of other manufacturers, and the variety of relatively small competitors generally makes significant price increases difficult. National Cabinet Lock does not believe it is dependent upon one or a few customers, however, select furniture manufacturers and a government agency lock purchaser are important customers. National Cabinet Lock's ten largest customers accounted for about one-third of its sales in each of the past three years, with the largest customer less than 10% in each year. In 1993, seven of the ten largest customers were located in the U.S. with three in Canada. Of such customers, nine were primarily purchasers of Canadian-produced products and one was a U.S. lock customer. Patents and trademarks. National Cabinet Lock holds a number of patents relating to its hardware products operations, none of which by itself is considered significant, and owns a number of trademarks, including National Cabinet Lock and STOCK LOCKS, which the Company believes are well recognized in the hardware products industry. - 14 - Employees. As of December 31, 1993, National Cabinet Lock employed approximately 600 persons, of which 230 were in the United States and 370 were in Canada. Approximately 60% of Canadian employees are covered by a three-year collective bargaining agreement expiring in February 1997. National Cabinet Lock believes that its labor relations are satisfactory. Environmental matters. National Cabinet Lock's operations are subject to various federal, state, provincial and local provisions regulating the discharge of materials into the environment and otherwise relating to the protection of the environment. National Cabinet Lock does not believe future expenditures to comply with these regulations will be material. OTHER: Foreign operations. The Company has substantial operations and assets located outside the United States, primarily in Canada (National Cabinet Lock) and Ireland (Medite). Foreign operations are subject to, among other things, currency exchange rate fluctuations and the Company's results of operations have in the past been both favorably and unfavorably affected by fluctuations in currency exchange rates. Medite/Europe maintains a multi-currency revolving credit agreement to mitigate exchange rate risk on receivables and has also entered into certain forward contracts to mitigate exchange rate risk on certain equipment purchase commitments related to the expansion of its MDF plant. See Note 20 to the Company's Consolidated Financial Statements. The Company's unconsolidated affiliates also have substantial foreign operations, as discussed elsewhere herein. Environmental matters. The Company has been subject to environmental regulatory enforcement or litigation under various statues, including the Comprehensive Environmental Response, Compensation and Liability Act, as amended by the Superfund Amendments and Reauthorization Act ("CERCLA"), arising out of past disposal practices. In some cases the Company has voluntarily undertaken cleanup activities at various sites, while in some cases the Company has been named as a potentially responsible party ("PRP") pursuant to CERCLA or state counterparts to CERCLA. Typically these proceedings seek cleanup costs, damages for personal injury or property damage, or both. While the Company may be jointly and severally liable for such costs, in most cases the Company is only one of a number of PRPs who are also jointly and severally liable. The extent of CERCLA or other similar liability cannot be determined until a remedial investigation and feasibility study is complete, the applicable environmental authority issues a record of decision and costs are allocated among PRPs. The Company has been named as a PRP pursuant to CERCLA at one Superfund site in Indiana and has also undertaken a voluntary cleanup program approved by state authorities at another Indiana site, both of which involve operations no longer conducted by the Company. The total estimated cost for cleanup and remediation at the Indiana Superfund site is $43.5 million, of which the Company's share is currently estimated to be approximately $2 million. The Company's estimated cost to complete the voluntary cleanup program at the other Indiana site, which involves both surface and groundwater remediation, is relatively nominal. The Company believes it has adequately provided accruals for reasonably estimable costs for CERCLA matters and other environmental liabilities. At December 31, - 15 - 1993, the Company had accrued $2.3 million in respect of such matters, which accrual does not reflect any amounts which the Company could recover from insurers or other third parties and is near the Company's estimate of the upper end of range of possible costs. No assurance can be given that actual costs will not exceed accrued amounts or the upper end of the range. The imposition of more stringent standards or requirements under environmental laws or regulations, new developments or changes respecting site cleanup costs or allocation of such costs among PRPs or a determination that the Company is potentially responsible for the release of hazardous substances at other sites could result in expenditures in excess of amounts currently estimated by the Company to be required for such matters. Furthermore, there can be no assurance that additional environmental matters related to current or former operations will not arise in the future. Other environmental matters relating to the Company's consolidated business segments and to its unconsolidated affiliates are discussed in the respective business sections elsewhere herein. Acquisition and restructuring activities. The Company routinely compares its liquidity requirements and alternative uses of capital against the estimated future cash flows to be received from its subsidiaries and unconsolidated affiliates, and the estimated sales value of those units. As a result of this process, the Company has in the past and may in the future seek to raise additional capital, refinance or restructure indebtedness, modify its dividend policy, consider the sale of interests in subsidiaries or unconsolidated affiliates, business units, marketable securities or other assets, or take a combination of such steps or other steps, to increase liquidity, reduce indebtedness and fund future activities. Such activities have in the past and may in the future involve related companies. From time to time, the Company also evaluates the restructuring of ownership interests among its subsidiaries and related companies and expects to continue this activity in the future. The Company and other entities that may be deemed to be controlled by or affiliated with Mr. Harold C. Simmons routinely evaluate acquisitions of interests in, or combinations with, companies, including related companies, perceived by management to be undervalued in the marketplace. These companies may or may not be engaged in businesses related to the Company's current businesses. In a number of instances, the Company has actively managed the businesses acquired with a focus on maximizing return-on-investment through cost reductions, capital expenditures, improved operating efficiencies, selective marketing to address market niches, disposition of marginal operations, use of leverage, and redeployment of capital to more productive assets. In other instances, the Company has disposed of the acquired interest in a company prior to gaining control. The Company intends to consider such activities in the future and may, in connection with such activities, consider issuing additional equity securities and increasing the indebtedness of Valhi, its subsidiaries and related companies. Other. Through June 1989, Valmont Insurance Company, a wholly-owned captive insurance subsidiary of Valhi, reinsured workers' compensation and employers' liability, auto liability, and comprehensive general liability risks of Valhi and certain affiliates. Through April 1989, Valmont assumed certain third-party reinsurance business, primarily property, marine and casualty risks from insurance subsidiaries of other industrial firms, and a small amount of U.S. quota share property and casualty risks. Valmont currently writes certain - 16 - miscellaneous direct coverages of Valhi and affiliates. All of Valmont's third-party reinsurance risks are on a runoff basis. The Company, through a general partnership, has an interest in certain medical-related research and development activities pursuant to sponsored research agreements. See Note 19 to the Company's Consolidated Financial Statements. UNCONSOLIDATED AFFILIATES - NL INDUSTRIES, INC. AND TREMONT CORPORATION: NL and Tremont file periodic reports with the Securities and Exchange Commission (the "Commission") pursuant to the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The following information with respect to NL (Commission file number 1-640) and Tremont (Commission file number 1-10126) has been summarized from such reports, which contain more detailed information concerning the respective businesses, results of operations and financial condition of NL and Tremont. At the end of 1993, the net carrying value of the Company's investment in NL was $60 million ($2.43 per share) and in Tremont was $15 million ($4.17 per share). NL INDUSTRIES General. NL, headquartered in Houston, Texas, is an international producer and marketer of titanium dioxide pigments ("TiO2") through its wholly-owned subsidiary, Kronos, Inc. NL also produces specialty chemicals, primarily rheological additives, through its wholly-owned subsidiary, Rheox, Inc. Kronos is the world's fourth-largest TiO2 producer, with an estimated 11% share of the worldwide market. Approximately one-half of Kronos' 1993 sales volume was in Europe, where Kronos is the second-largest producer of TiO2. In 1993, Kronos accounted for 87% of NL's sales and 58% of its operating income. TiO2 products and operations. Titanium dioxide pigments are chemical products used for imparting whiteness, brightness and opacity to a wide range of products, including paints, paper, plastics, fibers and ceramics. TiO2 is considered to be a "quality-of-life" product with demand affected by the gross domestic product in various regions of the world. Demand, supply and pricing of TiO2 have historically been cyclical and the last cyclical peak for TiO2 prices occurred in early 1990. While TiO2 prices are currently approximately one-third below those of the last cyclical peak, NL believes the TiO2 industry has significant long-term potential. However, NL expects that the TiO2 industry will continue to operate at lower capacity utilization levels over the next few years relative to the high utilization levels prevalent during the late 1980's, primarily because of the slow recovery from the worldwide recession and the impact of capacity additions since the late 1980's. The economic recovery has been particularly slow in Europe, where a significant portion of Kronos' TiO2 manufacturing facilities are located. Kronos has an estimated 17% share of European TiO2 sales and an estimated 9% share of the U.S. market. Consumption per capita in the United States and Western Europe far exceeds that in other areas of the world and these regions are expected to continue to be the largest geographic markets for pigment consumption. However, if the economies in Eastern Europe, the Far East and China continue to develop, a significant market for TiO2 - 17 - could emerge in those countries. Kronos believes it is well positioned to participate in the Eastern European market. NL currently produces over 40 different TiO2 grades, sold under the Kronos and Titanox trademarks, which provide a variety of performance properties to meet customers' specific requirements. Major TiO2 customers include international paint, paper and plastics manufacturers. NL believes that there are no effective substitutes for TiO2. However, extenders such as kaolin clays, calcium carbonate and polymeric opacifiers are used in a number of Kronos' markets. Generally, extenders are used to reduce to some extent the utilization of higher cost TiO2. The use of extenders has not significantly affected TiO2 consumption over the past decade because extenders generally have, to date, failed to match the performance characteristics of TiO2. NL believes that the use of extenders will not materially alter the growth of the TiO2 business in the foreseeable future. Kronos and its predecessors have produced and marketed TiO2 in North America and Europe for over 70 years. As a result, Kronos believes that it has developed considerable expertise and efficiency in the manufacture, sale, shipment and service of its products in domestic and international markets. By volume, about one-half of Kronos' 1993 TiO2 sales were to Europe, with approximately two-fifths to North America and the balance to export markets. Kronos' international operations are conducted through Kronos International, Inc. ("KII"), a German-based holding company NL formed in 1989 to manage and coordinate NL's manufacturing operations in Europe and Canada and its sales and marketing activities in over 100 countries. NL believes the KII structure allows it to capitalize on expertise and technology developed in Germany over a 60-year period. Kronos is also engaged in the mining and sale of ilmenite ores (a raw material used in the sulfate pigment production process), and the manufacture and sale of iron-based water treatment chemicals (derived from co-products of the pigment production processes). Water treatment chemicals are used as treatment and conditioning agents for industrial effluents and municipal wastewater and in the manufacture of iron pigments. TiO2 manufacturing process, properties and raw materials. TiO2 is manufactured by Kronos using either the chloride and sulfate pigment production processes. Although most end-use applications can use pigments produced by either process, chloride process pigments are generally preferred in certain segments of the coatings and plastics applications, and sulfate process pigments are generally preferred for paper, fibers and ceramics applications. Due to environmental factors and customer considerations, the proportion of TiO2 industry sales represented by the chloride process pigments has increased relative to sulfate process pigments. About two-thirds of Kronos' current production capacity is based on an efficient chloride process technology. Kronos currently has four TiO2 plants in Europe (Leverkusen and Nordenham, Germany; Langerbrugge, Belgium; and Fredrikstad, Norway), a plant in Varennes, Quebec, Canada and, through the manufacturing joint venture discussed below, a one-half interest in a plant in Lake Charles, Louisiana which commenced production in 1992. Prior to October 1993, Kronos owned all of the Louisiana plant. Kronos' principal German operating subsidiary leases the land under its Leverkusen production facility pursuant to a lease expiring in 2050. The Leverkusen plant, with approximately one-third of Kronos' current TiO2 production - 18 - capacity, is located within the lessor's extensive manufacturing complex, and Kronos is the only unrelated party so situated. Under a separate supplies and services agreement, which expired in 1991 and to which an extension through 2011 has been agreed to in principle, the lessor provides some raw materials, auxiliary and operating materials and utilities services necessary to operate the Leverkusen plant. Both the lease and supplies and services agreement restrict NL's ability to transfer ownership or use of the Leverkusen plant. Kronos also has a governmental concession through 2007 to operate its ilmenite mine in Norway. Kronos produced approximately 352,000 metric tons of TiO2 in 1993, compared to 358,000 metric tons in 1992 and 293,000 metric tons in 1991. The increase in production during 1992 was primarily at Kronos' chloride process plants, including Lake Charles, and Kronos achieved record production levels of chloride process pigments in 1992 through improved operational efficiencies. In response to weakened demand, production rates were reduced in late 1992 and during 1993 in order to reduce inventory levels. Kronos believes its annual attainable production capacity is approximately 380,000 metric tons, including its one-half interest in the Louisiana plant. NL believes such capacity is sufficient to provide Kronos with the capability to meet current market requirements and continue its worldwide presence in future years. The primary raw materials used in the TiO2 chloride production process are chlorine, coke and titanium-containing feedstock derived from beach sand ilmenite and rutile. Chlorine and coke are available from a number of suppliers. Titanium-containing feedstock suitable for use in the chloride process is available from a limited number of suppliers around the world, principally in Australia, Africa, India and the United States. Kronos purchases slag refined from beach sand ilmenite from Richards Bay Iron and Titanium (Proprietary) Ltd. (South Africa), approximately 50% of which is owned by Q.I.T. Fer et Titane Inc. ("QIT"), an indirect subsidiary of RTZ Corp. Natural rutile ore is purchased from a number of sources. The primary raw materials used in the TiO2 sulfate production process are sulfuric acid and titanium-containing feedstock derived primarily from rock and beach sand ilmenite. Sulfuric acid is available from a number of suppliers. Titanium-containing feedstock suitable for use in the sulfate process is available from a limited number of suppliers around the world. Currently, the principal active sources are located in Norway, Canada, Australia, India and South Africa. As one of the few vertically-integrated producers of sulfate process pigments, Kronos operates a rock ilmenite mine near Hauge i Dalane, Norway, which provided all of Kronos' feedstock for its European sulfate process pigment plants in 1993. Kronos' mine is also a major commercial source of rock ilmenite for other sulfate process producers in Europe, and NL believes the mine supplies almost 40% of aggregate European demand, including NL, for sulfate feedstock. Kronos also purchases sulfate grade ilmenite slag under contracts negotiated annually with QIT and Tinfos Titanium and Iron K/S. Kronos believes the availability of titanium-containing feedstock for both the chloride and sulfate processes is adequate in the near- term; however tightening supplies for the chlorine process may be encountered in the late 1990's. Kronos does not anticipate experiencing any interruptions of its raw material supplies. - 19 - TiO2 manufacturing joint venture. In October 1993, Kronos formed a manufacturing joint venture with Tioxide Group, Ltd., a wholly- owned subsidiary of Imperial Chemicals Industries PLC. The joint venture, which is equally owned by subsidiaries of Kronos and Tioxide, owns and operates the Louisiana chloride process TiO2 plant formerly owned by Kronos. Under the terms of the joint venture and related agreements, Kronos contributed the plant to the joint venture, Tioxide paid an aggregate of approximately $205 million, including its tranche of the joint venture debt, and Kronos and certain of its subsidiaries exchanged proprietary chloride process and product technologies with Tioxide and certain of its affiliates. Production from the plant is being shared equally by Kronos and Tioxide pursuant to separate offtake agreements. The manufacturing joint venture is intended to be operated on a break-even basis, and accordingly Kronos' transfer price for its share of the TiO2 produced is equal to its share of the joint venture's operating expenses (fixed and variable costs of production and interest expense). Kronos' share of the fixed and variable production costs are reported as cost of sales as the related TiO2 acquired from the joint venture is sold, and its share of the joint venture's interest expense is reported as a component of NL's consolidated interest expense. A supervisory committee, composed of two members appointed by each partner, directs the business and affairs of the joint venture, including production and output decisions. Two general managers, one appointed and compensated by each partner, manage the day-to-day operations of the joint venture acting under the direction of the supervisory committee. Specialty chemicals operations. Rheological additives produced by Rheox control the flow and levelling characteristics of a variety of products, including paints, inks, lubricants, sealants, adhesives and cosmetics. Organoclay rheological additives are clays which have been chemically reacted with organic chemicals and compounds. Rheox produces rheological additives for both solvent-based and water-based systems. Rheox believes that it is the world's largest producer of rheological additives for solvent-based systems, supplying approximately 40% of the worldwide market, and is also a supplier for rheological additives used in water-based systems. Rheological additives for solvent-based systems accounted for approximately 90% of Rheox's sales in 1993, with the remainder principally rheological additives for water-based systems. Rheox has introduced a number of new products during the past three years, many of which are for water-based systems, which currently represent a larger portion of the market than solvent-based systems and which Rheox believes, in the long term, will account for an increasing portion of the market. Rheox also focused on product development for environmental applications with new products introduced for de-inking recycled paper and soil stabilization at contaminated sites. Rheox's plants are in Charleston, West Virginia, Newberry Springs, California, St. Louis, Missouri, Livingston, Scotland and Nordenham, Germany. The primary raw materials utilized in the production of rheological additives are bentonite clays, hectorite clays, quaternary amines, polyethylene waxes and castor oil derivatives. Bentonite clays are currently purchased under a three-year contract, renewable through 2004, with a subsidiary of Dresser, which has significant bentonite reserves in Wyoming. This contract assures Rheox the right to purchase its anticipated requirements of bentonite clays for the foreseeable future and Dresser's reserves are believed to be sufficient for such purpose. Hectorite clays are mined from company-owned reserves in Newberry Springs, California, which NL believes are adequate to supply its needs for the - 20 - foreseeable future. The Newberry Springs ore body contains the largest known commercial deposit of hectorite clays in the world. Quaternary amines are purchased primarily from a joint venture company 50%-owned by Rheox and are also generally available on the open market from a number of suppliers. Castor oil-based rheological additives are purchased from sources in the United States and abroad. Rheox has a supply contract with a manufacturer of these products, which may not be terminated without 180 days notice by either party. Competition. The TiO2 industry is highly competitive. During the late 1980's worldwide demand approximated available supply and the major producers, including Kronos, were operating at or near available capacity. In the past few years, supply has exceeded demand, in part due to new chloride process capacity coming on-stream. Relative supply/demand relationships, which had a favorable impact on industry-wide prices during the late 1980's, have had a negative impact since prices peaked in early 1990. Worldwide capacity additions in the TiO2 market are slow to develop because of the significant capital expenditures and substantial lead time (typically three to five years in NL's experience) for, among other things, planning, obtaining environmental approvals and construction. Kronos competes primarily on the basis of price, product quality and technical service, and the availability of high performance pigment grades. Although certain TiO2 grades are considered specialty pigments, the majority of grades and substantially all of Kronos' production are considered commodity pigments with price generally being a most significant competitive factor. Kronos has an estimated worldwide TiO2 market share of 11% (17% in Europe and 9% in the U.S), and believes that it is the leading marketer of TiO2 in a number of countries, including Germany and Canada. Kronos' principal competitors are E.I. du Pont de Nemours & Co.; Tioxide; Hanson PLC (SCM Chemicals); Kemira Oy; Bayer AG and Ishihara Sangyo Kaisha, Ltd. These six competitors have estimated individual worldwide market shares ranging from 5% to 21%, and an aggregate estimated 65% share. Du Pont has over one-half of total U.S. TiO2 production capacity and is Kronos' principal North American competitor. Kronos has substantially completed a major environmental protection and improvement program commenced in the early 1980's to replace or modify its European TiO2 production facilities for compliance with various environmental laws by the respective effective dates. All of Kronos' European plants now use either the low-waste yielding chloride process, or the sulfate process with reprocessing or neutralization of waste acid. Kronos has commenced construction of a $25 million waste acid neutralization/synthetic gypsum manufacturing facility for its Canadian sulfate process TiO2 plant, which is expected to be completed in mid-1994. Although these upgrades increased operating costs, they are expected to reduce future capital expenditures that Kronos would otherwise need to incur as environmental standards are increased. NL believes that certain competitors have not upgraded their facilities and are expected to do so in the future or be forced to curtail production due to lack of environmental compliance. Competition in the specialty chemicals industry is generally concentrated in the areas of product uniqueness, quality and availability, technical service, knowledge of end-use applications and price. Rheox's principal competitors for rheological additives for solvent-based systems are LaPorte PLC, Sud Chemie AG and Akzo NV. Principal competitors for water-based systems are Rohm and Haas - 21 - Company, Hercules Incorporated, The Dow Chemical Company and Union Carbide Corporation. Research and development. NL's annual expenditures for research and development and technical support programs have averaged approximately $10 million during the past three years, with Kronos accounting for about three-fourths of the annual totals. Research and development activities related to TiO2 are conducted principally at the Leverkusen, Germany facility. Such activities are directed primarily towards improving both the chloride and sulfate production processes, improving product quality and strengthening Kronos' competitive position by developing new pigment applications. Activities relating to rheological additives are conducted primarily in the United States and directed towards the development of new products for water-based systems, environmental applications and new end-use applications for existing product lines. Patents and trademarks. Patents held for products and production processes are believed to be important to NL and contribute to the continuing business activities of Kronos and Rheox. NL continually seeks patent protection for its technical developments, principally in the United States, Canada and Europe, and from time to time enters into licensing arrangements with third parties. In connection with the formation of the manufacturing joint venture with Tioxide, Kronos and certain of its subsidiaries exchanged proprietary chloride process and product technologies with Tioxide and certain of its affiliates. Use by each recipient of the other's technology in Europe is restricted until October 1996. NL's major trademarks, including Kronos, Titanox and Rheox, are protected by registration in the United States and elsewhere with respect to those products it manufactures and sells. Foreign operations. NL's chemical businesses have operated in international markets since the 1920's. Most of Kronos' current production capacity is located in Europe and Canada and about one-third of Rheox's sales in the past three years have been attributable to European production. Approximately three-quarters of NL's 1993 consolidated sales were attributable to non-U.S. customers, including over 10% attributable to customers in areas other than Europe and Canada. Political and economic uncertainties in certain of the countries in which NL operates may expose NL to risk of loss. NL does not believe that there is currently any likelihood of material loss through political or economic instability, seizure, nationalization or similar event. NL cannot predict, however, whether events of this type in the future could have a material effect on its operations. NL's manufacturing and mining operations are also subject to extensive and diverse environmental regulation in each of the foreign countries in which they operate. See "Regulatory and environmental matters." Customer base and seasonality. NL believes that neither its aggregate sales nor those of any of its principal product groups are concentrated in or materially dependent upon any single customer or small group of customers. Neither NL's business as a whole nor that of any of its principal product groups is seasonal to any significant extent. Due in part to the increase in paint production in the spring to meet spring and summer painting season demand, TiO2 sales are generally higher in the second and third calendar quarters than in the first and fourth calendar quarters. Sales of rheological additives are - 22 - influenced by the worldwide industrial protective coatings industry, where second calendar quarter sales are generally the strongest. Employees. As of December 31, 1993, NL employed approximately 3,200 persons (excluding the joint venture employees), with 400 employees in the United States and 2,800 at sites outside the United States. Hourly employees in production facilities worldwide are represented by a variety of labor unions, with labor agreements having various expiration dates. NL believes its labor relations are satisfactory. Regulatory and environmental matters. Certain of NL's businesses are and have been engaged in the handling, manufacture or use of substances or compounds that may be considered toxic or hazardous within the meaning of applicable environmental laws. As with other companies engaged in similar businesses, certain past and current operations and products of NL have the potential to cause environmental or other damage. NL has implemented and continues to implement various policies and programs in an effort to minimize these risks. NL's policy is to achieve compliance with applicable environmental laws and regulations at all of its facilities and to strive to improve environmental performance. It is possible that future developments, such as stricter requirements of environmental laws and enforcement policies thereunder, could affect NL's production, handling, use, storage, transportation, sale or disposal of such substances. NL's U.S. manufacturing operations are governed by federal environmental and worker health and safety laws and regulations, principally the Resource Conservation and Recovery Act, the Occupational Safety and Health Act, the Clean Air Act, the Clean Water Act, the Safe Drinking Water Act, the Toxic Substances Control Act, and CERCLA, as well as the state counterparts of these statutes. NL believes that all of its U.S. plants and the Louisiana plant owned and operated by the joint venture are in substantial compliance with applicable requirements of these laws. From time to time, NL facilities may be subject to environmental regulatory enforcement under such statutes. Resolution of such matters typically involves the establishment of compliance programs. Occasionally, resolution may result in the payment of penalties, but to date such penalties have not involved amounts having a material adverse effect on NL's consolidated financial position, results of operations or liquidity. NL's European and Canadian production facilities operate in an environmental regulatory framework in which governmental authorities typically are granted broad discretionary powers which allow them to issue operating permits required for the plants to operate. NL believes all of its European plants are in substantial compliance with applicable environmental laws. While the laws regulating operations of industrial facilities in Europe vary from country to country, a common regulatory denominator is provided by the EU. Germany, Belgium and the United Kingdom, members of the EU, follow the initiatives of the EU; Norway, although not a member, generally patterns its environmental regulatory actions after the EU. Kronos believes it is in substantial compliance with agreements reached with European environmental authorities and with an EU directive to control the effluents produced by TiO2 production facilities. Rheox believes it is in substantial compliance with environmental regulations in Germany and the United Kingdom. - 23 - In order to reduce sulfur dioxide emissions into the atmosphere, Kronos is installing off-gas desulfurization systems at its German plants at an estimated cost of approximately $24 million. The manufacturing joint venture is installing an off-gas desulfurization system at its Louisiana plant at an estimated cost of $15 million. The German systems are expected to be completed in 1996 and the Louisiana system is scheduled for completion in 1995. Kronos' ilmenite mine near Hauge i Dalane had a permit for the offshore disposal of tailings through February 1994. In February 1994, Kronos completed a $15 million onshore disposal system to replace the offshore disposal of tailings. Onshore disposal will result in a modest increase in the mine's operating costs. The Quebec provincial government is an environmental regulatory body with authority over Kronos' Canadian TiO2 production facilities, which currently consist of plants utilizing both the chloride and sulfate process technologies. The provincial government regulates discharges into the St. Lawrence River. In May 1992, the Quebec provincial government extended Kronos' right to discharge effluents from its Canadian sulfate process TiO2 plant into the St. Lawrence River until June 1994, at which time Kronos' new $25 million waste acid neutralization facility is expected to be completed. In January 1993, the Quebec provincial government granted a permit to Kronos to construct the facility and established the future permit parameters, which Kronos will be required to meet upon completion of the facility. Notwithstanding the above-described agreement, in March 1993 Kronos' Canadian subsidiary and two of its directors were charged by the Canadian federal government with five violations of the Canadian Fisheries Act relating to discharges into the St. Lawrence River from the Varennes sulfate TiO2 production facility. The penalty for these violations, if proven, could be up to Canadian $15 million. Additional charges, if brought, could involve additional penalties. NL has moved to dismiss the case on constitutional grounds, and believes that this charge is inconsistent with the extension granted by provincial authorities referred to above. NL's future capital expenditures related to its ongoing environmental protection and improvement programs, including those described above, are currently expected to be approximately $75 million, including $30 million in 1994. NL has been named as a defendant, PRP, or both, pursuant to CERCLA and similar state laws in approximately 80 governmental enforcement and private actions associated with waste disposal sites and facilities currently or previously owned, operated or used by NL, many of which are on the U.S. Environmental Protection Agency's Superfund National Priority List or similar state lists. These proceedings seek cleanup costs, damages for personal injury or property damage, or both. Certain of these proceedings involve claims for substantial amounts. Although NL may be jointly and severally liable for such costs, in most cases, it is only one of a number of PRPs who are also jointly and severally liable. In addition to the matters noted above, certain current and former facilities of NL, including several divested secondary lead smelter and former mining locations, are the subject of environmental investigations or litigation arising out of industrial waste disposal practices and mining activities. - 24 - The extent of NL's CERCLA liability cannot be determined until the Remedial Investigation and Feasibility Study is complete, the U.S. EPA issues a record of decision and costs are allocated among PRPs. The extent of liability under analogous state cleanup statutes and for common law equivalents are subject to similar uncertainties. NL believes it has provided adequate accruals for reasonably estimable costs of such matters. At December 31, 1993, NL had accrued $70 million in respect of those environmental matters which are reasonably estimable. NL determines the amount of accrual on a quarterly basis by analyzing and estimating the range of possible costs to NL. Such costs include, among other things, remedial investigations, monitoring, studies, clean-up, removal and remediation. It is not possible to estimate the range of costs for certain sites. NL has estimated that the upper end of the range of reasonably possible costs to NL for sites for which it is possible to estimate costs is approximately $105 million. No assurance can be given that actual costs will not exceed accrued amounts or the upper end of the range for sites for which estimates have been made, and no assurance can be given that costs will not be incurred with respect to sites as to which no estimate presently can be made. The imposition of more stringent standards or requirements under environmental laws or regulations, new developments or changes respecting site cleanup costs or allocation of such costs among PRPs, or a determination that NL is potentially responsible for the release of hazardous substances at other sites could result in expenditures in excess of amounts currently estimated by NL to be required for such matters. Further, there can be no assurance that additional environmental matters will not arise in the future. NL was formerly involved in the manufacture of lead pigments for use in paint and lead-based paint. NL has been named as a defendant or third party defendant in various legal proceedings alleging that NL and other manufacturers are responsible for personal injury and property damage allegedly associated with the use of lead pigments. NL is vigorously defending such litigation. Considering NL's previous involvement in the lead pigment and lead-based paint business, there can be no assurance that additional similar litigation will not be filed. In addition, various legislation and administrative regulations have, from time to time, been enacted or proposed at the state, local and federal levels that seek to (i) impose various obligations on present and former manufacturers of lead pigment and lead-based paint with respect to asserted health concerns associated with the use of such products and (ii) effectively overturn court decisions in which NL and other pigment manufacturers have been successful. One such bill that would subject lead pigment manufacturers to civil liability for damages caused by lead- based paint on the basis of market share, and extends certain statutes of limitations, passed the Massachusetts House of Representatives in 1993. The same bill has been re-introduced in the Massachusetts legislature in 1994. No legislation or regulations have been enacted to date which are expected to have a material adverse effect on NL's consolidated financial position, results of operations or liquidity. NL has not accrued any amounts for the pending lead pigment litigation. Although no assurance can be given that NL will not incur future liability in respect of this litigation, based on, among other things, the results of such litigation to date, NL believes that the pending lead pigment litigation is without merit. Any liability that may result is not reasonably capable of estimation by NL. NL has filed declaratory judgment actions against various insurance carriers seeking costs of defense and indemnity coverage for certain of its environmental and lead pigment litigation. To date, one court has granted NL's motion for - 25 - summary judgment and ordered an insurance carrier to pay to NL the reasonable costs of defending certain of NL's lead pigment cases. The courts have not made any rulings on defense costs or indemnity coverage with respect to NL's pending environmental litigation or on indemnity coverage in the lead pigment litigation. No trial dates have been set. Other than the rulings to date, the issue of whether insurance coverage for defense costs or indemnity, or both, will be found to exist depends upon a variety of factors, and there can be no assurance that such insurance coverage will exist in other cases. NL has not included amounts in any accruals in anticipation of insurance coverage for lead pigment or environmental litigation. TREMONT CORPORATION General. Tremont, based in Denver, Colorado, conducts its titanium metals operations through its 75%-owned subsidiary, Titanium Metals Corporation ("TIMET"), an integrated producer of titanium metal products. TIMET is presently one of the four major U.S producers of titanium metal products and has an estimated one-third share of the U.S. market. Tremont also holds 9.1 million NL shares, or 18% of NL's outstanding common stock, and reports its interest in NL by the equity method. Products, operations, and properties. Titanium has a unique combination of strength, light weight, stability at high temperatures and resistance to corrosion, which makes it highly desirable for certain applications. The aerospace industry (including airframe and engine construction) has historically accounted for approximately three-fourths of U.S. titanium mill products consumption. Consequently, the activity in the highly cyclical aerospace industry has a significant effect on the overall sales and profitability of the titanium industry. The titanium metals business continues to be significantly and adversely affected by, among other things, weak demand within the military and commercial aerospace markets and excess worldwide production capacity. Adverse selling price pressures have been exacerbated by the increasing availability of relatively inexpensive titanium scrap, sponge and mill products principally from Russia and other countries of the former Soviet Union (the Commonwealth of Independent States or "CIS"). Tremont expects that TIMET's and the industry's production levels and shipments over the next few years will remain substantially lower than the peak levels of the late 1980's and 1990. TIMET's titanium products are used in a wide variety of commercial and industrial applications, including commercial and military aircraft, chemical processing equipment, power generation facilities, medical applications and sports equipment. Titanium sponge, so called because of its appearance, is the elemental form of titanium metal used in processed titanium products and is produced by TIMET at its Nevada plant, described below. Titanium ingot results from melting sponge and/or scrap, often with various other alloying elements, while titanium wrought products are forged, rolled and/or extruded from ingot and/or cast slab. TIMET sends certain products to outside vendors for further processing, including hot rolling of titanium strip. Over 90% of TIMET's sales in the past three years were generated from the sale of titanium ingot and wrought products. - 26 - TIMET owns and operates a 22 million pound (10,000 metric ton) annual rated capacity vacuum distillation process ("VDP") titanium sponge production facility in Henderson, Nevada. The VDP plant commenced production in early 1993 and has received substantially all necessary aerospace qualifications. TIMET expects to operate the VDP plant at approximately 60% of capacity during 1994. In December 1993, Union Titanium Sponge Corporation ("UTSC"), a consortium of Japanese companies that provided the advanced technology and a majority of the financing for the VDP plant, converted its $75 million of TIMET debentures into 25% of TIMET's outstanding voting common stock. UTSC has the right to acquire up to approximately 20% of TIMET's annual production capacity of VDP sponge at agreed-upon and formula-determined prices. TIMET also has a 32 million pound (14,500 metric ton) annual capacity titanium sponge plant at its Henderson site which utilizes the older Kroll-leach production process. TIMET expects to temporarily close this plant in 1994 and expects that it will remain closed until market conditions significantly improve. The titanium sponge produced at Henderson is used as the basic raw material for a 28 million pound (12,700 metric ton) annual capacity ingot facility also at the Nevada plant. Titanium wrought products are produced at TIMET's forging and rolling facility in Toronto, Ohio, which receives titanium ingots from the Nevada plant and titanium slab from 50%-owned Titanium Hearth Technologies ("THT"). Wrought products are also produced at TIMET's finishing facility in Morristown, Tennessee. TIMET has operated below production capacity during the past three years in response to lower demand levels. In 1993, the Nevada plant operated at about 50% of capacity, down from about 80% of capacity in 1992, while the Ohio and Tennessee facilities operated at 70% and 60%, respectively, of capacity in 1993, which approximated 1992 levels. THT, a TIMET and Axel Johnson Metals, Inc. joint venture formed in 1992, owns and operates a 12 million pound (5,400 metric ton) annual capacity cold hearth melting furnace formerly owned by Axel Johnson. TIMET has committed to have THT perform a substantial percentage of TIMET's requirements for melting certain titanium products. THT also provides melting services to unrelated parties. In March 1993, TIMET and Compagnie Europeenne du Zirconium ("CEZUS"), a French company, executed a series of agreements by which, following a transition period of approximately two years, TIMET expects to acquire CEZUS' titanium business and CEZUS would become an exclusive TIMET subcontractor, primarily for titanium melting and forging, pursuant to a long-term agreement. Any such acquisition is subject to, among other things, approval of the French Ministry of Finance. As part of the agreements, TIMET will generally be entitled to receive, or be obligated to pay (subject to certain limitations), 50% of the net income or loss of CEZUS's titanium business in 1994. TIMET has three service centers in the U.S. and two in Europe which maintain supplies of mill products for customer sales in their respective regions. Most of these service centers are located near major customers and have secondary shearing, cutting and machining capabilities to tailor mill products to meet customers' specifications. TIMET believes its service center network provides a competitive advantage. - 27 - Raw materials. The primary raw materials used in the production of titanium sponge are titanium-containing rutile ore, chlorine, magnesium and coke. Chlorine, magnesium and coke are generally available from a number of suppliers. Titanium-containing rutile ore is currently available from a limited number of suppliers around the world, and substantially all of TIMET's rutile ore is currently purchased from Australian suppliers. While TIMET believes the availability of titanium-containing rutile ore is adequate in the near-term, tightening supplies may be encountered in the late 1990's. TIMET does not anticipate experiencing any interruptions of its raw material supplies. Various alloying elements used in the production of titanium ingot are available from a number of suppliers. Market and customer base. A majority of TIMET's sales in 1993 were to customers in the aerospace industry. TIMET expects that a majority of its 1994 sales will be to this sector but that industrial markets will represent an increasing portion of its sales over the next few years. TIMET's long-term goal is to transition from a dependence on aerospace markets to a closer balance between aerospace and industrial markets, in part because TIMET does not expect a return in government defense aerospace spending to prior levels and does not expect commercial aerospace spending to increase substantially over the next few years. TIMET does, however, expect a long-term increase in demand for new commercial aircraft, a significant portion of which is expected to be met by wide-body aircraft which use more titanium than narrow-body aircraft. Sales to industrial markets of titanium plate, strip and tube, which currently account for approximately 45% of TIMET's sales, are improving as the utility, desalination, and certain other industries increase capital spending. TIMET's five largest customers accounted for an aggregate of approximately 20% to 25% of its sales in each of the past three years. Competition. The worldwide titanium metals industry is highly competitive. TIMET competes primarily on the basis of price, quality of products, technical support and the availability of products to meet customers' delivery schedules. TIMET believes that the trademark TIMET, which is protected by registration in the U.S. and other countries, is significant to its business. Over 70% of TIMET's sales in the past three years were to customers in the U.S. where its principal competitors are Oregon Metallurgical Corporation ("Oremet"), RMI Titanium Company and Teledyne Allvac. TIMET estimates its share of U.S. sponge production capacity at the end of 1993 approximated 75%, including 40% related to its older Kroll-leach process plant. TIMET, Oremet, RMI and Teledyne Allvac represent an estimated aggregate 80% of U.S. sales of titanium mill products, and TIMET believes it has the largest share of these producers. TIMET competes with a number of non-integrated producers that produce titanium products from sponge, ingot and slab purchased from outside vendors (including TIMET and THT), and to a lesser extent with foreign integrated producers located primarily in Japan and Europe. While the mill product production of Japanese and European titanium producers is approximately one-half that of the U.S. titanium producers, they are significant competitors in international markets. Until recently, imports of foreign titanium products into the U.S. have not been significant, however, imports of titanium sponge and scrap, principally from the CIS, increased during 1991 and 1992 and substantially increased in 1993. TIMET purchased a considerable volume of CIS sponge in 1993 for use in producing certain industrial products. - 28 - Historically, Russia and other members of the CIS have not been significant competitors as their titanium products were largely consumed internally. However, TIMET believes these producers are likely to become more significant competitors in the future. Although accurate information regarding the CIS's titanium industry is not readily available, TIMET believes the CIS's sponge production capacity and actual 1993 production may be as much as one-half of aggregate worldwide levels. The CIS is also known to have significant melting and wrought product production capacity. Although imports of CIS sponge have increased in recent years, TIMET believes the majority of the sponge produced in the CIS continues to be consumed internally. In September 1993, President Clinton issued an Executive Proclamation granting to Russia the status of "beneficiary developing country" under the U.S. trade laws. This had the effect of eliminating or reducing the tariffs on many products imported from Russia, including the elimination of tariffs on most wrought titanium products (excluding titanium ingot, slab and billet). A petition filed by a group of U.S. titanium producers (including TIMET) to reverse this action is currently pending. At present, there is no duty on titanium scrap from Russia, while titanium sponge from Russia (as well as from the other CIS sponge-exporting states, Ukraine and Kazakhstan) carries both regular and antidumping duties. TIMET understands the Ukraine sponge plant was temporarily closed in late 1993. The level of this antidumping duty is currently under review by the Department of Commerce at the request of TIMET and the other integrated U.S. titanium producer. Entry as an integrated titanium producer would require significant capital investment and substantial technical expertise. However, producers of other metal products, such as steel and aluminum, maintain forging, rolling and finishing facilities which could be modified to produce titanium products. Titanium mill products also compete with certain stainless steels and nickel alloy mill products in industrial applications. Research and development. TIMET's annual research and development expenditures have averaged $2 million during the past three years and are directed primarily towards improving process technology, developing new alloys, enhancing the performance of TIMET's products in current applications and searching for new uses of titanium products. Employees. At December 31, 1993, TIMET employed approximately 1,050 persons in the U.S. (down from 1,150 at the end of 1992) and 20 persons in Europe. Substantially all of TIMET's production and maintenance workers at its facilities in Nevada and Ohio are represented by the United Steel Workers of America. A strike of approximately 400 union workers at the Nevada facility commenced in October 1993 at the expiration of their contract. TIMET has unilaterally implemented its last contract proposal that includes modest wage increases, enhanced profit sharing opportunities and pension improvements over the life of the contract along with changes in TIMET's medical program and work rules. The union work stoppage has not materially impacted TIMET's production activities, as production is continuing during the strike utilizing salaried personnel and outside contract labor. The Ohio union contract, as extended in January 1994, expires in July 1994. During this period TIMET and the union will negotiate towards a new agreement and evaluate possible relocations of certain work and/or equipment to other TIMET locations or outside vendors. - 29 - Regulatory and environmental matters. Tremont's operations conducted through TIMET are governed by environmental and worker safety laws and regulations. TIMET maintains procedures designed to ensure compliance with such laws, including those relating to raw material and product storage, atmospheric emissions, effluent discharge, waste disposal and environmental reporting and recordkeeping. In the area of environmental protection and compliance, TIMET's annual capital expenditures averaged over $1 million during the past three years, and its 1994 capital budget provides for such capital expenditures of less than $1 million. TIMET is and has been engaged in the handling, manufacture or use of substances or compounds that may be considered toxic or hazardous within the meaning of environmental and worker safety laws and regulations. In addition, in connection with TIMET's operation in Nevada, it handles substantial quantities of a material regulated as an extremely hazardous substance under the emergency planning and community right- to-know requirements of CERCLA. Although TIMET's policy is to comply with all such applicable laws, some risk of environmental and other damage is inherent in TIMET's operations and products, as it is with other companies engaged in similar businesses. Moreover, it is possible that future developments, such as implementation of stricter requirements under the environmental laws, worker safety laws, and enforcement policies thereunder, could bring into question the production, handling, use, storage, transportation, sale or disposal of TIMET's products and their by-products. Such developments could result in additional, presently unquantifiable, costs or liabilities to TIMET. TIMET's foreign operations are similarly subject to foreign laws respecting environmental and worker safety matters, which laws are generally less stringent than their U.S. counterparts and which have not had, and are not presently expected to have, a material adverse effect on TIMET. TIMET holds 32% of the outstanding common stock of Basic Investments, Inc. ("BII"). BII and its subsidiaries, including Basic Management, Inc. ("BMI"), provide utility services to, and owns property adjacent to, TIMET's plant at Henderson, Nevada (the "BMI Complex"). The other principal owners of BII, including Kerr McGee Chemical Corporation, Chemstar Lime Company and Pioneer Chlor Alkali Company, Inc., also operate facilities in the BMI Complex. Each of such companies, along with certain other companies that previously operated facilities in the BMI Complex, have executed an agreement with the Nevada Division of Environmental Protection ("NDEP") providing for a phased assessment of the environmental condition of the BMI Complex and each of the individual company sites. Phase I reports have been submitted to the NDEP. Negotiations between the NDEP and the BMI Complex companies over the scope of any necessary sampling and analysis, and the allocation of the costs therefor, are ongoing at this time. TIMET has accrued anticipated expenses in connection with the ongoing investigation. While no determination has been made with respect to the need for, or scope of, any environmental remediation at this site, there can be no assurance that TIMET will not incur some liability for any remediation costs which may result. - 30 - In 1993, Tremont entered into a settlement agreement with the Arkansas Division of Pollution Control and Ecology in connection with certain alleged water discharge permit violations at an abandoned barite mining property in Arkansas. The settlement agreement, among other things, requires Tremont to undertake a remediation/reclamation program during 1994 at an approximate cost of $1 million. In 1993, TIMET discovered an anomaly in certain alloyed titanium material manufactured by TIMET for shipment to a jet engine manufacturer, resulting from tungsten-contaminated master alloy sold to TIMET by a third-party vendor and used as a alloying addition to its titanium material. The engine manufacturer has taken the precaution of requiring the inspection, and, in certain cases, the remelting, reprocessing and reinspection, of all titanium material that might have been manufactured using potentially contaminated master alloy from this vendor (which also includes titanium produced by another major U.S. titanium manufacturer that purchased master alloy from the same supplier). TIMET has accrued its estimate of out-of-pocket expenses in connection with this on-going investigation. TIMET believes that any liability for costs or damages incurred by TIMET and/or its customers in this matter should ultimately rest with the supplier of the defective master alloy. TIMET maintains substantial general liability insurance coverage against claims of this nature that it currently believes would cover most of any such claims in the event it were unable to recover from the master alloy supplier. Other. BII is actively engaged in efforts to develop for commercial, industrial and residential purposes approximately 3,000 acres of land surrounding the BMI Complex in Henderson, a suburb of Las Vegas. Any such development by BII would be in conjunction with TIMET and the other BII stockholders who hold water rights necessary for any development of such lands. The use of the water rights for this purpose is subject to governmental approval, which approval Tremont understands BII expects to receive during the first half of 1994. TIMET is also pursuing the possible commercial development of approximately 80 acres of unused land surrounding its Nevada plant, either independently or as a part of BII's land development activities. Indirect wholly-owned captive insurance subsidiaries of Tremont (collectively, "TRE Insurance") reinsured certain comprehensive general liability, auto liability, workers' compensation and employers' liability risks of NL (which then included both Tremont and Baroid) through June 1988, and also participated in various third party reinsurance treaties through December 1988. TRE Insurance's reinsurance business is on a runoff basis. NL, Baroid (now a Dresser subsidiary) and TRE Insurance are parties to insurance sharing agreements whereby NL and Baroid will reimburse TRE Insurance with respect to certain loss payments and reserves established by TRE Insurance that (i) arise out of claims against NL and Baroid and (ii) are subject to payment by TRE Insurance under certain reinsurance contracts. Also, TRE Insurance will credit NL and Baroid with respect to certain underwriting profits or recoveries, if any, that TRE Insurance receives from independent reinsurers that relate to NL and Baroid. - 31 - ITEM 2. ITEM 2. PROPERTIES Valhi leases approximately 34,000 square feet of office space for its principal executive offices in a building located at 5430 LBJ Freeway, Dallas, Texas, 75240-2697. The principal properties used in the operations of the Company, NL and Tremont are described in the applicable business sections of Item 1 - "Business." The Company, NL and Tremont believe that their facilities are adequate and suitable for their respective uses. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company, NL and Tremont are involved in various legal proceedings. Information called for by this Item, except for information regarding certain of NL's and Tremont's legal proceedings that has been summarized, is included in Note 20 to the Company's Consolidated Financial Statements, which information is incorporated herein by reference. Information called for by this Item regarding NL's legal proceedings that has been summarized in Note 20 to the Company's Consolidated Financial Statements is included in Item 3 of NL's Annual Report on Form 10-K for the year ended December 31, 1993 included as Exhibit 99.1 of this Annual Report on Form 10-K, and is incorporated herein by reference. Information called for by this Item regarding certain of Tremont's legal proceedings that has been summarized in Note 20 to the Company's Consolidated Financial Statements is included in Note 17 (Legal proceedings - Tremont and consolidated subsidiaries) to Tremont's Consolidated Financial Statements included in Item 8 of Tremont's Annual Report on Form 10-K for the year ended December 31, 1993 included as Exhibit 99.2 of this Annual Report on Form 10-K, and is incorporated herein by reference. 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 quarter ended December 31, 1993. - 32 - PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Valhi's common stock is listed and traded on the New York and Pacific Stock Exchanges (symbol: VHI). As of February 28, 1994, there were approximately 6,500 holders of record of Valhi common stock. The following table sets forth the high and low sales prices for Valhi common stock for the years indicated, according to the New York Stock Exchange Composite Tape, and dividends paid during such periods. On February 28, 1994 the closing price of Valhi common stock according to the NYSE Composite Tape was $6. On March 10, 1994, the Company declared a cash dividend of $.02 per common share, payable March 31, 1994 to holders of record on March 24, 1994, and adopted a policy which provides for regular quarterly dividends of $.02 per common share. However, declaration and payment of dividends and the amount thereof will be dependent upon the Company's results of operations, financial condition, cash requirements for its businesses, contractual requirements and restrictions and other factors deemed relevant by the Board of Directors. There are currently no contractual restrictions on the ability of Valhi to declare or pay dividends. - 33 - ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with the Company's Consolidated Financial Statements and Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS: GENERAL The results of operations of the Company's consolidated business segments, general corporate and other items, as well as the Company's equity in losses of NL and Tremont, are discussed below. Consolidated operating income and margins increased in both 1992 and 1993, and interest expense declined in each of the past two years as both average borrowing levels and interest rates were reduced. The following table expresses income of consolidated companies before income taxes as a percentage of total sales. Segment operating income is expressed as a percentage of the respective segment's sales. The Company's results for the past three years were also impacted by significant nonoperating transactions. The Company reported significant losses attributable to NL and Tremont in each of the past three years, including impairment charges for other than temporary declines in the market value of Tremont stock ($22 million in 1992) and NL stock ($84 million in 1993). In 1991, the Company reported a $64 million gain from securities transactions as a result of its sale of Baroid common stock, and both 1992 and 1993 included extraordinary losses related to prepayments of indebtedness. - 35 - Changes in accounting methods by the Company, NL and Tremont for postretirement benefits other than pensions ("OPEB") and income taxes in 1992 resulted in a $70 million charge to earnings, of which about $64 million related to NL and Tremont. In 1993, a change in accounting for marketable securities resulted in a $42 million increase in stockholders' equity, substantially all of which related to the Company's remaining Baroid (now Dresser) common stock, and which was recorded as a direct credit to equity. The Company's business plan for 1994 reflects profitable operations for its consolidated companies, and reflects continuing but reduced losses attributable to its equity in NL and Tremont. During 1993, average refined sugar selling prices declined for the third year in a row, principally as a result of an oversupply of sugar resulting from increases in allowable imports and increases in domestic production. Sugar sales volume in 1993 was lower than in 1992 in large part as a result of marketing allotments imposed by the United States Department of Agriculture on domestic sugarcane and sugarbeet processors, which allotments limited the amount of sugar which each processor could market for the crop year ended September 30, 1993. Amalgamated's allotment equated to approximately 95% of its production from the 1992 crop and, accordingly, resulted in a larger than normal carryover of refined sugar inventory into the new crop year. The marketing allotments, imposed in June, had a positive impact on prices in the third quarter of 1993. Prices weakened during the fourth quarter following expiration of the allotments. The Company believes that sugar import quota levels are too high for current domestic production levels. As a result, absent import quota reductions or imposition of marketing allotments on domestic producers, the pressure on selling prices will likely continue. Due primarily to a projected record high sugar content of the beets, Amalgamated's sugar production from the crop harvested in the fall of 1993 is currently expected to establish a new record for the fourth consecutive year. Refined sugar inventories were significantly higher at December 31, 1993 than one year ago due to the carryover effects of the 1993 marketing allotments, as well as the size of this year's crop. Absent any marketing allotment restrictions, - 36 - these combined factors are expected to result in an increase in 1994 refined sugar sales volume over 1993 levels. Amalgamated currently expects contracted acreage for the 1994 crop will approximate that harvested in 1993. Refined sugar historically represents approximately 90% of Amalgamated's annual sales. Fluctuations in the volume of by-products sold, generally sold principally in the first and fourth calendar quarters, approximate those of refined sugar. The selling prices of by-products are affected by the prices of competing animal feeds and are, therefore, independent of the price of sugar. Average selling prices of dried pulp, the principal by-product, were 11% lower in 1993 than in 1992. Sugarbeet purchase cost is the largest cost component of producing refined sugar and the price Amalgamated pays for sugarbeets is, under the terms of its contracts with sugarbeet growers, a function of the average selling price of Amalgamated's refined sugar. As a result, changes in sugar selling prices impact sugarbeet purchase costs as well as revenues. Processing costs per hundredweight of refined sugar were higher in 1992 than in either 1991 or 1993 due in part to relatively adverse weather conditions during the sugarbeet processing campaign. Processing costs per hundredweight for the current crop are expected to be slightly higher than last year in part due to a new three-year labor contract which extends through July 1996. This labor contract provides for wage increases averaging approximately 3% per year and for increased employee deductibles and co-payments for medical insurance. The largest component of Amalgamated's selling, general and administrative expenses is the freight cost of sugar and by-products delivered to customers. Consequently, such expenses vary significantly with the volume of refined sugar and by-products sold. Amalgamated's cost of sales is determined under the last-in, first-out accounting method. In periods of declining sugar prices, such as during much of the past three years, LIFO operating income will be higher than on a FIFO basis. Supplemental information comparing refined sugar segment operating income and margins computed on a LIFO basis and on a FIFO basis is presented below. - 37 - FOREST PRODUCTS Medite's operations are grouped into two components: MDF (an engineered wood product) and solid wood (logs, lumber and other wood products). Medium density fiberboard. Medite's worldwide MDF sales volume increased 3% in 1993, setting a new volume record for the second consecutive year. Volume in the second half of 1993 was stronger than in the first half of the year while in 1992 the reverse was true. The improvements in volume reflect, in Medite's opinion, increased demand for engineered wood products. Sales of specialty MDF products have continued to increase, with these higher-margin sales representing 20% of MDF sales dollars (12% of MDF volume) in 1993 compared to 14% and 7%, respectively, in 1992 and 12% and 6%, respectively, in 1991. Overall MDF average selling prices, in billing currency terms, were favorably impacted in 1993 by product price increases and the higher percentage of specialty product sales. These increases were more than offset by adverse effects of currency fluctuations and, in U.S. dollar terms, worldwide average selling prices were 2% lower than in 1992. The improvements in MDF sales and operating income in 1992 resulted from an 8% increase in volume and higher average selling prices. Fluctuations in the value of the U.S. dollar relative to other currencies had a generally positive impact on 1992 average selling prices, in U.S. dollar terms, although a significant decline in the value of the pound sterling had a negative impact late in the year. Sales of higher- margin specialty grades of MDF increased, as noted above. Volume comparisons in 1992 were aided by the extremely low volume in the first quarter of 1991, in part as a result of the Persian Gulf War, and sales resulting from the reduction of inventories during 1992 which were higher than normal in Europe at the end of 1991. Medite had determined to build inventories during the later part of 1991 in anticipation of improved demand and pricing in 1992. MDF operating income was also favorably impacted in 1992 by increased production volume and improved operational efficiency at the New Mexico MDF plant. - 38 - Medite is operating at a high rate of capacity and while its total MDF volume is not expected to increase significantly prior to completion of the Irish plant expansion in 1995, Medite plans to continue to pursue further penetration of higher-margin specialty MDF markets in 1994. Solid wood products. Solid wood operations for the past three years are not, in certain respects, directly comparable due to the closure of Medite's plywood operations in January 1993 and the destruction by fire of its Rogue River, Oregon chipping and veneer plant in June 1992, as discussed below. Excluding plywood and veneer operations, solid wood sales increased 48% in 1993 compared to 1992. Medite's solid wood products are principally commodity-type products with selling prices significantly influenced by relative industry supply and demand factors. Average selling prices of solid wood products increased significantly in 1993 over 1992 levels (lumber up 29%; logs up 46%) due primarily to the combined effects of the continuing Pacific Northwest timber shortage, closure of certain competitor operations and increased demand for building products. These factors also increased Medite's timber costs, as discussed below. The increase in average selling prices of logs in 1993, as well as a significant increase in log volume, was also impacted by Medite's decision to sell higher-quality logs rather than using such logs in plywood manufacturing operations, which were closed in January 1993. Solid wood sales declined slightly in 1992 compared to 1991 due to the net effects of increases in product line average selling prices of 12% to 19%, an 18% decrease in total volume and changes in product mix, including lower wood chip sales. The Rogue River fire contributed to the volume decline and product mix changes in 1992. The average unit cost of logs used in Medite's solid wood operations increased about 25% in 1993 following a 28% increase in 1992. These cost increases were due primarily to increases in the cost of timber from government and other sources, offset in part by the favorable impact of planned reductions in LIFO log and other inventory levels, which were being reduced as a result of the closure of the plywood operations. The favorable impact on operating income from the reduction of LIFO inventories was $.8 million in 1991, $1.9 million in 1992 and $.5 million in 1993. The current Pacific Northwest timber shortage, and the resulting high cost of public and other purchased timber, is expected to continue for the foreseeable future. In response, Medite has reduced its longer-term need for government timber by closing marginal production facilities (including its plywood operations), increasing its emphasis on the direct sale of logs, reducing the rate of harvest of its fee timber and adopting a more sustained yield approach to harvesting timber from company-owned lands. Medite believes that, over the longer term, approximately 40% of the log requirements for its solid wood operations will be obtained from its own lands. The percentage of logs obtained from company-owned lands in 1993 (20%), and expected in 1994 (10%), is unusually low due to the harvest of timber under government contracts that expire in 1994. The combined net effects of this relatively low percentage of lower-cost fee timber and a substantial reduction in the volume of logs sold is expected to negatively impact solid wood operating income comparisons in 1994. - 39 - Medite's Rogue River veneer operations contributed about $19 million to 1991 solid wood sales and $10 million to 1992 sales before the fire. Replacement chipping operations resumed in July 1993 and new veneer operations resumed in January 1994. The new veneer operations are designed to process the smaller, second-growth timber expected to be available from company-owned timberlands on a longer-term sustainable basis. Recognition of business interruption insurance helped, to some extent, to offset the loss of Rogue River earnings in late 1992 and part of 1993. Business interruption insurance, received in 1992 and recognized as a component of operating income from July 1992 through August 1993 ($3.7 million in 1992 and $1.9 million in 1993), was allocated to each month that the various operations were originally expected to be down based upon estimates of the expected operating profit of the Rogue River operations during such periods. Such estimates of lost operating earnings were based upon selling prices in effect at the time they were prepared in 1992 and the expected reconstruction schedule at that time. Medite believes that business interruption insurance did not fully compensate for the aggregate dollar amount of operating earnings that Rogue River would have generated had it been operating because industry price levels were higher than those inherent in the insurance estimates and because operations did not resume as soon as originally expected. Inclusion of business interruption insurance in the results of operations did, however, have a significant favorable, non-recurring effect on the aggregate solid wood operating income margins during the July 1992 - August 1993 period as this income had no associated cost. Medite closed its plywood operations principally as a result of increased wood costs (the full effect of which could not be passed through in increased selling prices) and the relative shortage of public timber to supply the large diameter logs required to match the plywood plant's manufacturing capabilities. Plywood operations accounted for approximately $2 million of solid wood sales in 1993 before the closure compared to $36 million in 1992 and $31 million in 1991. As a result of improvement in market conditions late in the year, Medite's plywood operations were approximately break-even during 1992 after losing approximately $2 million in 1991. Reductions in overhead and administrative costs due to the reduced scale of manufacturing operations and overall cost containment programs also favorably impacted 1993 solid wood operating income. Costs in 1991 were, in certain respects, not directly comparable to 1992 and 1993 as a result of adopting SFAS Nos. 109 (income taxes) and 106 (OPEB), which increased costs due primarily to additional depreciation and depletion resulting from adjustment of assets acquired in prior business combinations originally recorded net-of-tax, and an offsetting cost decrease in depletion resulting from lower depletion rates on company-owned timber, as depletion rates were revised due to a change in estimate of remaining standing timber based upon a cruise of Medite's timber holdings. - 40 - FAST FOOD Sales in 1993 established a new record for Sybra, and operating income was a near-record, as comparable store sales increased 6%. Customer traffic increased in part due to certain promotional sandwiches positioned as limited-time only products in certain regions and marketed to price-driven consumers with various levels of advertising support. Improving general economic conditions also contributed to the increase in comparable store sales in 1993. Extensive menu-price discounting caused by the continued high level of competition in the fast food industry and weak economic conditions impacted Sybra's results during much of 1991 and 1992. As a result of a 4% increase in comparable store sales during the fourth quarter, comparable store sales for 1992 were only nominally below 1991 levels. Stable food product costs and higher average transactions contributed to the improvement in operating income in 1992. As a result of the strengthening in sales beginning in September 1992, and the resulting 16 consecutive months of increases in comparable store sales through December 1993 following declines in 18 of the previous 20 months going back to the beginning of 1991, comparative increases may not be as favorable during 1994 as those of 1993. In addition, winter weather in certain of Sybra's markets during early 1994 was much more severe than in the comparable period of 1993. Sybra continues to seek opportunities to broaden its menu and expand high volume service hours. HARDWARE PRODUCTS Hardware products reported record sales and operating income in 1993. Sales, operating income and margins improved in both 1993 and 1992 due primarily to increased volumes in the three major product lines. In 1993, lock sales dollars were up 24%, drawer slides were up 10% and computer keyboard support arms were up 38% following increases of 33%, 21% and 16%, respectively, in 1992. A - 41 - lock contract with a U.S. Government agency obtained in 1992 and extended through much of 1993, along with a new contract with the same agency covering May 1993 through 1994 at higher than prior contract volume levels, contributed significantly to the lock volume increase. The operations acquired in June 1992 from a Canadian competitor, which complemented the existing drawer slide and lock product lines, also contributed to volume increases in both 1992 and 1993. Almost two-thirds of National Cabinet Lock's sales are generated by its Canadian operations. About 60% of the Canadian-produced sales are denominated in U.S. dollars while substantially all of the related costs are incurred in Canadian dollars. As a result, fluctuations in the value of the U.S. dollar relative to the Canadian dollar favorably impacted operating results in both 1993 and 1992 compared to the respective prior year. National Cabinet Lock currently expects more modest growth in 1994 than in the prior two years in part due to production capacity considerations. Capital spending in 1994 emphasizes capacity increases. BUSINESS UNIT DISPOSITIONS See Note 4 to the Company's Consolidated Financial Statements. GENERAL CORPORATE Securities transactions - Securities transactions in 1991 relate principally to the sale of Baroid common stock and in 1992 and 1993 relate to U.S. Treasury securities. As described in Note 1 to the Company's Consolidated Financial Statements, the Company adopted the accounting for certain marketable debt and equity securities prescribed by SFAS No. 115 effective December 31, 1993. Accordingly, timing of recognition of gains and losses related to marketable securities beginning in 1994 will, in certain respects, be different than in prior years. Other general corporate income (expense) Interest and dividend income fluctuates based on levels of investments and yields thereon. The average balance of funds available for temporary investment was higher in 1992 than in either 1991 or 1993 while yields generally declined in both 1992 and 1993. The increase in general corporate expenses in 1993 resulted in large part from lower net charges to affiliates. Other, net in 1991 includes $3.3 million of income related to the Company's equity in undistributed earnings of Baroid prior to May 1991. A $1.5 million provision for additional environmental remediation expenses relating to certain operations no longer conducted by the Company was a principal reason for the increase in other expenses, net in 1993. - 42 - INTEREST EXPENSE Interest expense declined $20.7 million (29%) in 1992 and further declined $12.9 million (25%) in 1993 as a result of lower average indebtedness levels and lower interest rates. The lower average interest rates resulted in part from the prepayment of Valhi 12 1/2% Senior Subordinated Notes from the proceeds of lower-rate borrowings. At December 31, 1993, about one-half of the Company's aggregate long-term debt and credit facilities, including unused amounts, have variable interest rates and the remainder (principally Valhi's 9.25% LYONs, Valcor's 9 5/8% Senior Notes and a portion of Medite's Timber Credit Agreement term loan) have fixed rates. No periodic interest payments are required on the deferred coupon LYONs, resulting in cash interest payments lower than accrual basis interest expense. PROVISION FOR INCOME TAXES The principal reasons for the difference between the Company's effective income tax rates and the U.S. federal statutory income tax rates are explained in Note 14 to the Company's Consolidated Financial Statements. The Company's provision for income tax benefits in both 1992 and 1993 includes deferred tax benefits in excess of taxes currently payable. At December 31, 1993, the Company had net deferred tax assets of approximately $24 million resulting primarily from amounts related to the excess of tax basis over book basis of investments in subsidiaries and affiliates that are not members of the Company's consolidated tax group. The Company has, among other things, significant appreciated assets and the ability to generate significant taxable capital gains should it need to offset any capital losses reported for tax purposes. EXTRAORDINARY ITEMS AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES See Notes 16 and 18, respectively, to the Company's Consolidated Financial Statements. - 43 - UNCONSOLIDATED AFFILIATES - NL AND TREMONT The Company's interests in NL and Tremont are reported by the equity method. The information included below related to the financial position, results of operations and liquidity and capital resources of NL and Tremont has been summarized from the reports filed with the Commission by NL and Tremont, which reports contain more detailed information concerning such companies, including complete financial statements prepared on their historical bases of accounting. Valhi's equity in earnings (losses) of NL and Tremont is different than its percentage ownership in their separately-reported earnings due to amortization of basis differences arising from purchase accounting adjustments made by the Company in conjunction with the acquisition of its interests in NL and Tremont. Amortization of such basis differences generally reduces earnings, or increases losses, attributable to affiliates, as reported by Valhi. In 1993, aggregate basis difference amortization expense was reduced by approximately $7 million as a result of enacted changes in certain income tax rates, principally a reduction in German rates. Substantially all of such favorable impact, which is not of a normal recurring nature, relates to NL. The Company periodically evaluates the net carrying value of its long-term assets, including its investments in NL and Tremont, to determine if there has been any decline in value below their respective net carrying values that is considered to be other than temporary and would, therefore, require a write-down accounted for as a realized loss. As a result of this process, Valhi recorded a $22 million writedown of its investment in Tremont in 1992 and each of Valhi and Tremont recorded writedowns of their respective investments in NL in 1993, resulting in an $84 million pre-tax charge to Valhi. While the accounting rules may require an investment in a security accounted for by the equity method to be written down if the market value of that security declines, they do not permit a writeup if the market value subsequently recovers. The Company's per share net carrying value of NL at December 31, 1993 was $2.43, compared to quoted market values of $4.50 at that date and $8.875 at February 28, 1994. The Company's per share net carrying value of Tremont at December 31, 1993 was $4.17, compared to quoted market values of $6.875 at that date and $7.875 at February 28, 1994. - 44 - NL Industries. NL's chemical operations are conducted through its wholly-owned subsidiaries Kronos, Inc. (TiO2) and Rheox, Inc. (specialty chemicals). NL is highly leveraged and has reported significant losses in the past three years. The future profitability of NL is dependent upon, among other things, improved pricing for TiO2, NL's principal product. Selling prices for TiO2 are significantly influenced by industry supply and demand. In the fourth quarter of 1993, TiO2 prices increased slightly in certain markets. Based on, among other things, NL's current near-term outlook for its TiO2 business, NL expects its results for 1994, while improved from 1993, will still result in a net loss for the year. Accordingly, Valhi expects to report a loss attributable to its equity in NL in 1994. (*) Excludes Valhi's $84 million impairment provision for an other than temporary decline in the market value of NL common stock in 1993. Such impairment provision is separately disclosed in Note 2 to the Company's Consolidated Financial Statements. - 45 - The worldwide TiO2 industry continues to be adversely affected by, among other things, production capacity in excess of current demand. Largely as a result thereof, TiO2 selling prices continued to decline during most of 1993 and Kronos' operating income and margins significantly declined. Recessionary economic conditions in Europe and changes in the relative values of European currencies were principal additional factors influencing current demand and pricing levels during 1993. In billing currency terms, Kronos' 1993 average TiO2 selling prices were approximately 8% lower than in 1992 and were 6% lower in 1992 than in 1991. A significant amount of sales are denominated in currencies other than the U.S. dollar, and fluctuations in the value of the U.S. dollar relative to other currencies further decreased 1993 sales by $45 million compared to 1992 and increased 1992 sales by $22 million compared to 1991. Average TiO2 prices at the end of 1993 were approximately 5% below year-end 1992 levels and approximately one-third below those of the last cyclical peak in early 1990. While TiO2 prices are significantly below prior year levels, most of the 1993 decline occurred in the first half of the year as average prices declined only slightly during the third quarter and increased slightly during the fourth quarter. TiO2 sales volume of 346,000 metric tons in 1993 increased 3% compared to 1992, as increases in North American sales volume more than offset weakened demand in Europe. In response to weakened demand, and in order to reduce inventories, Kronos made further reductions in its TiO2 production rates during 1993. TiO2 sales volume increased 11% in 1992, primarily in U.S. and European markets. Approximately one-half of Kronos' 1993 TiO2 sales, by volume, were attributable to markets in Europe with about two-fifths attributable to North America and the balance to export markets. As a result of continued cost reduction and containment efforts, Kronos' raw material and production costs increased only slightly in 1993 compared to year-ago levels. Start-up costs at the chloride process plant in Lake Charles, Louisiana, which commenced production during the first half of 1992, unfavorably impacted operating income in 1992. Kronos' 1992 operating income was also impacted by slightly lower unit production costs resulting from its continued emphasis on costs reduction efforts and increased production volumes. Kronos' water treatment chemicals business, which utilizes TiO2 co-products, contributed more to operating income in 1992 than in either 1991 or 1993. Demand, supply and pricing of TiO2 have historically been cyclical and, as noted above, the last cyclical peak for TiO2 prices occurred in early 1990. Kronos believes that its operating income and margins for 1994 will be higher than in 1993 due principally to slightly higher sales and production volumes and the favorable effect of the joint venture with Tioxide, discussed below. However, NL expects that the TiO2 industry will continue to operate at lower capacity utilization levels over the next few years relative to the high utilization levels prevalent during the late 1980's, primarily because of the slow recovery from worldwide recession and the impact of capacity additions since the late 1980's. The economic recovery has been particularly slow in Europe, where a significant portion of Kronos' TiO2 manufacturing facilities are located. - 46 - During the current period of depressed TiO2 prices, NL has operated with a strategy to maintain its competitive position. During the past three years, Kronos has increased its estimated worldwide market share from 10% to 11%. Kronos has implemented a cost reduction and control program which favorably impacted Kronos' operating results, and Kronos has continued its environmental improvement efforts. In October 1993, NL formed a manufacturing joint venture with Tioxide and refinanced certain debt which, among other things, increased NL's liquidity, reduced its aggregate debt level and extended its debt maturities. See also "Liquidity and Capital Resources." The manufacturing joint venture, which is equally owned by subsidiaries of Kronos and Tioxide, owns and operates the Louisiana chloride process TiO2 plant formerly owned by Kronos. Under the terms of the joint venture and related agreements, Kronos contributed the plant to the joint venture, Tioxide paid an aggregate of approximately $205 million, including its tranche of the joint venture debt, and Kronos and certain subsidiaries exchanged proprietary chloride process and product technologies with Tioxide and certain of its affiliates. Of the total consideration paid by Tioxide, $30 million was attributable to the exchange of technologies and is being reported as a component of operating income ratably over three years from October 1993. Production from the plant is being shared equally by Kronos and Tioxide pursuant to separate offtake agreements. The formation of the joint venture resulted in a 12% decrease in Kronos' total TiO2 production capacity, however Kronos' remaining capacity is about 10% higher than Kronos' 1993 sales volume. Rheox's aggregate operating results have been relatively consistent during the past three years. Changes in currency exchange rates had a negative effect in 1993 and a positive effect in 1992 compared to the respective prior year, and operating costs generally increased during both years. NL has substantial operations and assets located outside the United States. Foreign operations are subject to currency exchange rate fluctuations and NL's results of operations have in the past been both favorably and unfavorably affected by the fluctuations in currency exchange rates. To the extent NL both manufactures and sells in a given country, the impact of currency exchange rate fluctuations is to some extent mitigated. NL's interest and dividend income fluctuates based upon the amount of funds invested and yields thereon. Amounts available for investment and the yield thereon in 1993 were lower than in 1992 and 1991. After unsuccessful attempts to gain representation on the board of directors of Lockheed Corporation, NL disposed of its interest in Lockheed in 1991, and the significant loss from securities transactions in 1991 relates principally to that disposition. In February 1994, NL settled its lawsuit against Lockheed and Lockheed's directors, and Lockheed made a cash payment to NL. See Note 20 to the Company's Consolidated Financial Statements. Securities transactions in 1992 and 1993 relate principally to U.S. Treasury securities. NL does not anticipate acquiring marketable securities (other than U.S. Treasury or similar securities) in the foreseeable future. - 47 - NL's corporate expenses, net have decreased slightly during each of the past two years. In 1992, reductions in certain proxy solicitation and litigation settlement expenses of $5 million and $9 million, respectively, compared to 1991 were partially offset by an $11 million increase in environmental remediation costs. Environmental remediation costs were $4 million higher in 1993 than in 1992. Lower average levels of indebtedness in 1993 and lower DM interest rates reduced NL's interest expense in 1993 compared to 1992. In addition, 1992 interest expense reflected the benefit of $9 million of capitalized interest related principally to the Louisiana plant completed in March 1992. Interest expense increased from 1991 to 1992 due to the net effects of lower average levels of indebtedness, a $17 million decline in capitalized interest and a $9 million reduction in NL's accrual for income tax related interest in 1991. Overall, NL expects its October 1993 reduction and refinancing of certain indebtedness will result in a modest decrease in NL's interest expense. NL's operations are conducted on a worldwide basis and the geographic mix of income can significantly impact NL's effective income tax rate. In both 1992 and 1993, the geographic mix, including losses in certain jurisdictions for which no current refund was available and in which recognition of a deferred tax asset is not currently considered appropriate, contributed significantly to its effective tax rate varying from a normally expected rate. In 1991, realization of the available capital loss carryback of NL's securities transactions at a relatively low rate due to the alternative minimum tax rates in prior years also significantly impacted NL's effective tax rate. NL reported an extraordinary loss of approximately $28 million in 1993 related to the settlement of certain interest rate swaps in conjunction with prepaying the existing Louisiana plant borrowings and from the write-off of deferred financing costs related to prepayment of such Louisiana plant indebtedness and a portion of Kronos' Deutsche mark denominated bank credit facility. - 48 - Tremont Corporation - Tremont's consolidated operations consist of one industry segment, titanium metals operations conducted through its now 75%-owned TIMET subsidiary. Tremont also holds approximately 18% of NL's outstanding common stock and reports its interest in NL by the equity method. Discontinued operations represent Tremont's former bentonite mining operations, which were sold to Baroid in July 1993. As discussed below, the titanium metals business has been adversely affected by, among other things, excess worldwide production capacity and changes in market conditions. Tremont has reported significant losses during the past two years and expects to report a net loss for 1994. Accordingly, Valhi expects to report a loss attributable to its equity in Tremont for 1994. (*) Excludes (i) Valhi's $22 million impairment provision for an other than temporary decline in the market value of Tremont common stock in 1992 and (ii) Valhi's $14 million share of Tremont's 1993 impairment provision for an other than temporary decline in the market value of NL common stock, which equity is included as a component of Valhi's impairment charge related to NL. Such impairment provisions are separately disclosed in Note 2 to the Company's Consolidated Financial Statements. - 49 - TIMET's 1993 operating results reflect an 14% decrease in pounds shipped compared to 1992, partially offset by changes in product mix. The volume decline occurred in the last half of 1993 (TIMET reported comparative volume increases for the first half of the year), and reflected several significant customer order cancellations and delays. Start-up costs related to TIMET's new VDP titanium sponge facility and other production variances also adversely impacted operating income comparisons. TIMET's 1993 operating loss included a $4.7 million restructuring charge related to cost reduction measures, including closing certain service centers in 1993 and severance costs associated with workforce reductions expected to occur principally in 1994. Sales volume in 1992 increased approximately 32% compared to pounds shipped in 1991 reflecting, in part, an increase in TIMET's market share. TIMET's average selling prices in 1992 were approximately 15% lower than in 1991 and changes in product mix also adversely affected operating income. The titanium metals industry continues to be adversely affected by, among other things, weak demand within the military and commercial aerospace markets and excess worldwide production capacity. Selling price pressures are being exacerbated by the increasing availability of relatively inexpensive titanium scrap, sponge and other mill products principally from Russia and other CIS countries. Sales of titanium for industrial markets, which currently account for approximately 45% of TIMET's sales, are improving as the utility, desalination, and certain other industries increase capital spending. Tremont expects that TIMET's and the industry's production levels and shipments over the next few years will remain substantially lower than the peak levels of the late 1980's and 1990. TIMET also expects industry conditions will continue to result in adverse selling price pressures. TIMET's efforts to return to profitability are focused on improving manufacturing processes, reducing overall costs and developing new markets for titanium products. TIMET expects its new VDP titanium sponge facility in Nevada to operate at approximately 60% of capacity during 1994. TIMET also expects to temporarily close its older Kroll-leach titanium sponge production plant in 1994 until market conditions substantially improve. Union workers at TIMET's Nevada facility commenced a work stoppage in October following expiration of their contract. TIMET has unilaterally implemented its last contract proposal, which includes modest wage increases, enhanced profit sharing opportunities and pension improvements over the life of the contract along with changes in TIMET's medical program and work rules. The union work stoppage has not materially impacted TIMET's production activities as production is continuing during the strike utilizing salaried personnel and outside contract labor. The Ohio union contract, as extended in January 1994, expires in July 1994. During this period, TIMET and the union will negotiate towards a new agreement and evaluate possible relocation of certain operations to other TIMET locations or outside vendors. UTSC converted its $75 million of debentures into a 25% equity interest in TIMET in December 1993. In addition to its minority interest in TIMET, UTSC has the right to acquire up to approximately 20% of TIMET's annual production capacity of VDP sponge at agreed-upon and formula-determined prices. - 50 - General corporate items, net include (i) a $5.5 million gain in 1993 from the sale of Tremont's 50% interest in a gold mining venture and (ii) losses aggregating $3.4 million in 1991 and $5.9 million in 1992 resulting from changes in estimated net realizable value of certain properties and other assets held for sale. Average outstanding borrowings increased in each of the past three years. Capitalized interest, related primarily to the VDP sponge facility, was $1.5 million in 1991, $4.9 million in 1992 and $3.1 million in 1993. Interest expense in 1994 is expected to be slightly higher than in 1993. Valhi may be deemed to control each of NL and Tremont and, accordingly, Tremont reports its 18% interest in NL by the equity method. Similarly to Valhi, Tremont's amortization of basis differences generally reduces earnings, or increases losses, attributable to NL, as reported by Tremont compared to the amount that would be expected by applying its ownership interest to NL's separately-reported earnings. Tremont's income tax benefit in both 1992 and 1993 varies from a normally expected rate due primarily to losses, including losses related to NL, resulting in temporary differences between book and taxable income for which recognition of a deferred tax asset is not currently considered appropriate. In 1991, Tremont's equity in losses of affiliates for which no tax benefit was provided also impacted its effective tax rate. - 51 - LIQUIDITY AND CAPITAL RESOURCES: CONSOLIDATED CASH FLOWS Operating activities. Depreciation, depletion and amortization for each business segment is presented in Note 2 to the Company's Consolidated Financial Statements. The lower volume of fee timber harvested by Medite was a principal reason for the declines in depreciation, depletion and amortization. Noncash interest expense consists principally of amortization of original issue discount ("OID") on Valhi's 12 1/2% Notes and, beginning in the fourth quarter of 1992, on Valhi's LYONs. The net deferred tax benefits in 1992 and 1993 relate principally to equity in losses of NL and Tremont. Both NL and Tremont suspended payment of dividends in 1992. - 52 - Changes in assets and liabilities relate to the relative timing of sales, production and purchases, including, among other things, significant seasonal fluctuations related to refined sugar operations. Other, net includes items, such as the gain on selling Baroid stock in 1991 and losses related to prepaying 12 1/2% Notes in 1992 and 1993, that are included in the determination of net income but are excluded from the determination of cash flow from operating activities. Cash provided by operating activities is summarized below. Approximately 80% of the aggregate net change in assets and liabilities during the last three years relates to Amalgamated as year-to-year fluctuations in the size of the sugarbeet crop can have a material impact on working capital levels. Investing activities. Capital expenditures during the past three years for each business segment are presented in Note 2 to the Company's Consolidated Financial Statements and discussed in the individual segment sections below. At December 31, 1993, the estimated cost to complete capital projects in process approximated $36 million ($26 million in firm purchase commitments), most of which relates to the expansion of Medite's Irish MDF production facility discussed below. The Company's total capital expenditures for 1994 are estimated at approximately $70 million, including $22 million related to the Irish expansion and $6 million related to environmental protection and improvement programs, principally air and water facilities at certain of Amalgamated's factories. Capital expenditures in 1994 are expected to be financed primarily from the respective unit's operations or existing credit facilities. Net sales of securities in 1993 include sales of U.S. Treasury securities made in conjunction with the redemptions of 12 1/2% Notes. On a net basis, cash was used to purchase Treasury securities in both 1991 and 1992. The purchase of such securities in 1991 was more than offset from the proceeds of Baroid stock sold, the sale of NL shares pursuant to NL's "Dutch Auction" self-tender offer and the sale of NL shares to Tremont, which transactions are described in Note 3 to the Company's Consolidated Financial Statements. Net cash used from business unit dispositions in 1993 relates to Medite's plywood plant. Net cash provided in 1992 includes $11 million of insurance proceeds related to the fire at Medite's Rogue River plant, and in 1991 relates to a Medite unit sold in 1990. - 53 - Financing activities. Net repayments of indebtedness in 1993 relate principally to (i) Valhi's redemptions of $235 million principal amount of 12 1/2% Notes, (ii) Valcor's issuance of $100 million of 9 5/8% Senior Notes Due 2003, and (iii) net new borrowings of approximately $39 million under Medite's Timber Credit Agreement. Net borrowings in 1992 include $94 million of net proceeds from the issuance of the LYONs and $59 million expended to repurchase 12 1/2% Notes in market transactions. Net borrowing transactions in 1991 include Valhi's repayment of $252 million of parent company bank debt, principally from the proceeds of Baroid and NL stock sold. At December 31, 1993, the Company had aggregate unused borrowing availability of $93 million under subsidiary credit facilities. See Note 11 to the Company's Consolidated Financial Statements. REFINED SUGAR Amalgamated's cash requirements are seasonal in that a major portion of the total payments for sugarbeets is made, and the costs of processing the sugarbeets are incurred, in the fall and winter of each year. Accordingly, Amalgamated's operating activities provide significant cash flow in the second and third calendar quarters and use significant amounts of cash in the first and fourth calendar quarters of each year. To meet its seasonal cash needs, Amalgamated obtains short-term borrowings, primarily pursuant to the Government's sugar price support loan program and bank credit facilities. Amalgamated expects to meet its seasonal cash needs for the remainder of the 1993 crop year and for the 1994 crop through borrowings from such sources and from internally-generated funds. The effective net Government loan rate available to Amalgamated for refined sugar from the 1993 crop is approximately 20.7 cents per pound, up from 20.47 cents per pound for the 1992 crop. Borrowings under the Government loan program are secured by refined sugar inventory and are otherwise nonrecourse to Amalgamated. At December 31, 1993, approximately 3.6 million hundredweight of refined sugar inventory with a LIFO carrying value of approximately $67 million (18.42 cents per pound) was the sole collateral for nonrecourse Government loans of $76 million. Amalgamated's capital expenditures in the past three years, which emphasized equipment to improve productivity, aggregated $38 million and were financed principally from operations and $18 million of term loan borrowings. Estimated 1994 capital expenditures approximate $25 million, including $15 million for sugar extraction enhancing equipment and $5 million for environmental protection and improvement programs, principally air and water treatment facilities. Capital expenditures in 1995 are also currently expected to exceed the averages of the past few years and aggregate over $20 million. In view of, among other things, the level of capital expenditures expected during the next few years, Amalgamated is exploring additional financing alternatives. At December 31, 1993, Amalgamated had $24 million of borrowing availability under the government loan program and bank credit facilities. The Company believes the recently enacted North American Free Trade Agreement will not adversely impact the U.S. sugar industry, and that the new General Agreement on Tariffs and Trade, finalized in late 1993 but not yet enacted by Congress, can be supported by the industry. - 54 - FOREST PRODUCTS Medite's primary strategic focus is to continue its expansion in the growing market for MDF with particular emphasis on higher-margin specialty products and to increase its presence in Europe and Mexico. Medite's present access to adequate and reliable wood fiber raw materials represents a significant aspect of its MDF operations, and expanded MDF production capabilities will generally be directed to those regions providing attractive long-term availability of wood fiber. Medite also actively manages its fee timberlands, which are a valuable resource as the existing shortage of Pacific Northwest public timber available for harvest is expected to continue for the foreseeable future. In this regard, and as a result of the uncertain supply and increased cost of government timber, Medite has closed marginal production facilities, reduced the rate of harvest of its fee timber and adopted a more sustained yield approach to managing its fee timber holdings. Medite has commenced an expansion of its Clonmel, Republic of Ireland MDF plant, which will increase its Irish MDF production capacity by approximately 75% and increase its worldwide MDF capacity by approximately 25%. This expansion is expected to be completed in 1995, cost approximately $33 million and will be financed in part by a $26 million multi-currency bank term loan. In connection with the expansion, Medite obtained approximately $4 million of grants from the Irish government, approximately $2 million of which will reduce bank borrowings. Medite's fee timberlands in Southern Oregon contain approximately 645 MMBF of generally second-growth merchantable timber. The average annual timber growth rate is approximately 4%. Medite's new Rogue River chipping facility began operations in July 1993 and its new veneer operations resumed in January 1994. These facilities, as well as Medite's Oregon stud lumber mill, are designed to process the smaller, second-growth timber expected to be available from company-owned timberlands on a longer-term basis. At December 31, 1993, Medite had contracts to acquire approximately 20 MMBF of timber from Government sources in 1994. The Federal Timber Contract Payment Modification Act of 1986 contains certain restrictions on the volume of Government timber that may be offered for sale, and Medite does not anticipate acquiring any significant amount of new Government timber contracts in the foreseeable future. As discussed above, Medite has adjusted its manufacturing operations in response to the expected timber supply and expects to meet its longer-term timber needs from its own lands and other private sources. Medite's capital expenditures in the past three years totaled $35 million and included an aggregate of $11 million in 1992 and 1993 related to the replacement of the Rogue River facilities, $6 million in 1993 related to the Irish expansion and over $4 million during the three-year period for additions to timber and timberland and reforestation activities. Capital expenditures in 1994 are estimated at $32 million, including $22 million related to the Irish MDF plant expansion. At December 31, 1993, amounts available for borrowing under Medite's existing U.S. and non-U.S. bank credit agreements were $29 million and $26 million, respectively. As a result of the closure of its plywood operations, Medite has a 105 acre site in Medford, Oregon which is believed to have alternative development possibilities and is held for sale. - 55 - FAST FOOD Sybra, like most restaurant businesses, is able to operate with nominal working capital because sales are for cash, inventory turnover is rapid, and payments to trade suppliers are generally not due for 30 days. During the past three years, Sybra has opened 14 new Arby's restaurants. Sybra currently plans to open six to ten new Arby's restaurants during 1994, and the first new store opened in late February. Sybra's 1994 capital expenditures are estimated at $11 million, approximately 75% of which are for new restaurants, and the remainder for Sybra's continuing program to remodel and update existing stores. Approximately 40% of Sybra's capital expenditures in the past three years related to remodeling older stores. Sybra continually evaluates the profitability of its individual restaurants and intends to continue to close unprofitable stores when appropriate. In this regard, Sybra closed eight stores during the past three years, closed another four stores in January 1994 and may close one or two additional stores later in 1994. Sybra's Consolidated Development Agreement with Arby's, Inc. requires it to open 31 new stores during 1993-1997 in its existing markets, of which three units had been opened through December 31, 1993. The aggregate cost of this expansion during the remaining four years of the CDA is estimated at approximately $23 million, including $8 million in 1994, and is expected to be financed with a combination of new mortgage and capital lease financing and internally generated funds. Sybra currently anticipates that its planned expansion program will enable it to retain its exclusive Dallas/Fort Worth and Tampa development rights over the term of the CDA. At December 31, 1993, Sybra had $8 million of borrowing availability under its existing unsecured revolving credit agreements. HARDWARE PRODUCTS In early 1993, National Cabinet Lock completed the relocation of the Canadian manufacturing operations acquired in June 1992, certain of which operations were integrated into existing facilities. In late 1993, National Cabinet Lock completed an expansion of its South Carolina lock facility and terminated certain low-margin furniture component product lines previously manufactured in Canada. Capital expenditures for 1994 are estimated at $4 million and are directed principally at capacity-related projects. At December 31, 1993, National Cabinet Lock's Canadian subsidiary had $6 million of borrowing availability under its existing revolving credit agreements. - 56 - GENERAL CORPORATE Valhi's operations are conducted through its wholly-owned subsidiaries (Amalgamated and Valcor) and through NL and Tremont, publicly- held affiliates which Valhi may be deemed to control. Valcor is an intermediate parent company with its operations conducted through wholly- owned subsidiaries (Medite, Sybra and National Cabinet Lock). Accordingly, Valhi's and Valcor's long-term ability to meet their respective parent company level obligations is dependent in large measure on the receipt of dividends or other distributions from their respective subsidiaries, the realization of their investments through the sale of interests in such entities and investment income. Various credit agreements to which subsidiaries are parties contain customary limitations on the payment of dividends, typically a percentage of net income or cash flow; however, such restrictions have not significantly impacted the Company's ability to service parent company level obligations. Valhi has not guaranteed any indebtedness of its direct and indirect wholly-owned subsidiaries or of NL or Tremont. Valcor. Valcor was formed in 1993 to hold three of the Company's core operating businesses and enable the Company to obtain lower cost borrowings than could have been obtained through a similar-sized issue of Valhi notes. In the fourth quarter of 1993, Valcor issued $100 million of 9 5/8% Senior Notes Due 2003 and dividended $75 million of the proceeds to Valhi. The Company believes that distributions from Valcor's operating subsidiaries (Medite, Sybra and National Cabinet Lock) will be sufficient to enable Valcor to meet its obligations, which consist principally of the 9 5/8% Notes. In addition, a portion of the net proceeds from the Valcor Note issue were retained within the Valcor group for general corporate purposes, including maintenance of a liquidity cushion and temporary reduction of subsidiary revolving borrowings. Valcor has not guaranteed any indebtedness of its subsidiaries. Future Valcor dividends to Valhi are generally limited to 50% of Valcor's consolidated net income, as defined, after 1993. Valhi. At December 31, 1993, Valhi's parent company debt consists solely of the LYONs, which do not require current cash debt service. The Company believes that distributions from Amalgamated and Valcor will be more than sufficient to enable Valhi to satisfy its net parent level expenses. In addition, Valhi had cash, cash equivalents and trading securities of $39 million at year-end 1993. Valhi owns 5.5 million shares of Dresser common stock, which shares are held in escrow for the benefit of holders of the LYONs. The LYONs are exchangeable, at the option of the holder, for the Dresser shares owned by Valhi. Prior to the January 1994 merger of Dresser and Baroid, the LYONs were exchangeable for Baroid common stock held by the Company. Exchanges of LYONs for Dresser stock would result in the Company reporting income related to the disposition of the Dresser stock for both financial reporting and income tax purposes, although no cash proceeds would be generated by such exchanges. As of February 28, 1994, the market value of the Dresser stock held by Valhi was $124 million, or approximately $14 million in excess of the LYONs obligation at that date and equal to the accreted value of the LYONs through June 1995. Valhi continues to receive regular quarterly Dresser dividends (recently increased to $.17 per quarter) on the escrowed shares. At such rate, dividends from Dresser in 1994 would be 36% higher than those received from Baroid in 1993. - 57 - The Company routinely compares its liquidity requirements and alternative uses of capital against the estimated future cash flows to be received from its subsidiaries and unconsolidated affiliates, and the estimated sales value of those units. As a result of this process, the Company has in the past and may in the future seek to raise additional capital, refinance or restructure indebtedness, modify its dividend policy, consider the sale of interests in subsidiaries or unconsolidated affiliates, business units, marketable securities or other assets, or take a combination of such steps or other steps, to increase liquidity, reduce indebtedness and fund future activities. Such activities have in the past and may in the future involve related companies. From time to time, the Company also evaluates the restructuring of ownership interests among its subsidiaries and related companies. The Company routinely evaluates acquisitions of interests in, or combinations with, companies, including related companies, perceived by management to be undervalued in the marketplace. These companies may or may not be engaged in businesses related to the Company's current businesses. The Company intends to consider such acquisition activities in the future and, in connection with this activity, may consider issuing additional equity securities and increasing the indebtedness of the Company, its subsidiaries and related companies. - 58 - UNCONSOLIDATED AFFILIATES - NL AND TREMONT Summarized historical balance sheet and cash flow information of NL and Tremont is presented below. - 59 - NL Industries. During 1993, NL's operations continued to use significant amounts of cash. TiO2 production rates were reduced in late 1992 and during 1993 in order to reduce inventory levels. The $30 million received from Tioxide in October 1993 related to the exchange of technologies, which is being recognized as a component of operating income over three years, favorably impacted 1993 cash flow from operating activities. Other relative changes in working capital items, which result principally from the timing of purchases, production and sales, also contributed to the comparative decrease in NL's cash used by operating activities in 1993. The significant deterioration in NL's cash flow from operating activities from 1991 to 1992 resulted primarily from the decline in earnings and the relative change in NL's receivables, inventories and payables. Cash provided by investing activities relates primarily to net sales of marketable securities in each period to fund debt repayments, capital expenditures and operations, and in 1993 includes $161 million net cash generated related to the formation of the Tioxide manufacturing joint venture. NL's capital expenditures during the past three years include an aggregate of $204 million related to the completion of the Louisiana chloride process TiO2 plant and an aggregate of $57 million ($30 million in 1993) for NL's ongoing environmental protection and compliance programs, including a Canadian waste acid neutralization facility, a Norwegian onshore tailings disposal system and off-gas desulfurization systems at various operating facilities. NL's estimated 1994 capital expenditures are $44 million and include $30 million in the area of environmental protection and compliance, primarily related to the Canadian waste acid neutralization facility and the German off-gas desulfurization systems. Net repayments of indebtedness in 1993 included payments on the DM bank credit facility of DM 552 million ($342 million when paid), a $110 million net reduction in indebtedness related to the Louisiana TiO2 plant and $350 million proceeds from NL's October 1993 public offering of debt, all as discussed below. Net repayments of indebtedness in 1992 included payments on the DM term loan aggregating DM 350 million ($225 million when paid) and $61 million drawn under Kronos' Louisiana plant credit facilities. Net borrowings in 1991 included a $115 million Rheox term loan, a $52 million increase in the Louisiana plant term construction loan and a DM 150 million ($87 million when paid) reduction in the DM term loan. NL and Kronos have agreed, under certain conditions, to provide Kronos' principal international subsidiary with up to an additional DM 125 million through January 1, 2001. In October 1993, NL (i) completed the formation of the manufacturing joint venture with Tioxide, including related refinancing of Louisiana plant indebtedness, (ii) completed a public offering of $250 million of 11.75% Senior Secured Notes Due 2003 and $100 million proceeds ($188 million principal amount at maturity) of 13% Senior Secured Discount Notes Due 2005 (collectively, the "NL Notes"), (iii) prepaid DM 552 million ($342 million when paid) of the DM bank credit facility and amended the DM loan agreement, and (iv) redeemed the remaining $10 million of NL's 7 1/2% sinking fund debentures. The DM bank credit facility, as amended, consists of a DM 448 million term loan and a DM 250 million revolving credit facility. At December 31, 1993, DM 150 million was available for future borrowings under the revolving facility. The final maturities of the term and revolving portion of the DM credit facility were extended to 1999 and 2000, respectively, with the first payment of the term loan due in 1997. - 60 - Upon formation, the joint venture obtained $216 million in new financing consisting of two equal tranches, one attributable to each partner, which is serviced through the purchase of the plant's TiO2 output in equal quantities by the partners. Each partner is required to make capital contributions to the joint venture to pay principal on their respective portion of the joint venture indebtedness. Kronos' pro rata share of the joint venture debt is reflected as outstanding consolidated indebtedness of NL because Kronos has guaranteed the purchase obligation relative to the debt service of its tranche. Formation of the joint venture and related refinancing, issuance of the NL Notes and prepayment of a portion of the DM bank credit facility significantly improved NL's liquidity and financial flexibility by (i) increasing cash and cash equivalents by approximately $75 million, (ii) reducing total outstanding indebtedness by approximately $109 million, (iii) providing for approximately DM 150 million of borrowing availability under the revolving portion of the amended DM bank credit facility, (iv) eliminating the near-term principal amortization requirements and extending the remaining principal amortization schedule of the DM bank credit facility, and (v) replacing approximately $100 million of outstanding debt with the Senior Secured Discount Notes which do not require cash interest payments for five years. The NL Notes are intended to be serviced from the cash flow generated by Kronos' international subsidiaries, principally through a series of intercompany notes whose terms mirror those of the NL Notes. Financing activities include treasury stock purchases, including $181 million expended in 1991 in connection with NL's "Dutch Auction" self-tender offer. Dividends paid were $35 million in 1991 and $18 million in 1992. NL suspended dividend payments in October 1992. At December 31, 1993, approximately one-fourth of NL's cash, cash equivalents and current securities were held by non-U.S. subsidiaries. NL's subsidiaries had $14 million and $117 million available for borrowing at December 31, 1993 under existing U.S and non-U.S. credit facilities, respectively. NL has taken and continues to take measures to manage its near-term and long-term liquidity requirements, including cost reduction and containment efforts, tightening of controls over working capital, deferral and reduction of capital expenditures, discontinuance of unrelated business acquisition activities, suspension of dividends, formation of the manufacturing joint venture and the refinancing discussed above. NL currently expects to have sufficient liquidity to meet its near-term obligations including operations, capital expenditures and debt service. A prolonged period of depressed TiO2 selling prices and continued use of cash by operations would, however, over the long term, have an adverse effect on NL's liquidity and financial condition. Certain of NL's income tax returns in various U.S. and non-U.S. jurisdictions, including Germany, are being examined and tax authorities have proposed or may propose tax deficiencies. In June 1993, German tax authorities issued assessment reports in connection with examinations of NL's German income tax returns disallowing NL's claims for refunds, primarily for 1989 and 1990, aggregating DM 160 million ($92 million at year-end exchange rates), and proposing additional taxes of approximately DM 100 million ($58 million). NL has applied for administrative relief from collection procedures and may grant a lien on certain German assets while NL contests the proposed adjustments. Although NL believes that it will ultimately prevail, in June 1993 NL reclassified the DM 160 million of refundable income tax claims disallowed by the German tax authorities from current assets to noncurrent assets due to the uncertain timing - 61 - of a resolution. NL believes that it has adequately provided accruals for additional income taxes and related interest expense which may ultimately result from all such examinations and believes that the ultimate disposition of all such examinations should not have a material adverse effect on NL's consolidated financial position, results of operations or liquidity. Pursuant to the amended DM bank credit facility, any receipt of the refundable German income taxes will be applied ratably to prepay installments of the term portion of the DM bank credit facility, with any remaining proceeds of the tax refund used to permanently reduce the revolving credit portion. At December 31, 1993, NL had recorded net deferred tax liabilities of $139 million. NL operates in several tax jurisdictions, in certain of which it has temporary differences that net to deferred tax assets (before valuation allowance). NL has provided a deferred tax valuation allowance of $133 million, principally related to the U.S. and Germany, for deferred tax assets which NL believes may not currently meet the "more likely than not" realization criteria for asset recognition. NL has been named as a defendant, PRP, or both, in a number of legal proceedings associated with environmental matters, including waste disposal sites currently or formerly owned, operated or used by NL, many of which disposal sites or facilities are on the U.S. Environmental Protection Agency's Superfund National Priorities List or similar state lists. On a regular basis, NL evaluates the potential range of its liability at sites where it has been named as a PRP or a defendant. NL believes it has provided adequate accruals ($70 million at December 31, 1993) for reasonably estimable costs of such matters, but NL's ultimate liability may be affected by a number of factors, including changes in remedial alternatives and costs and the allocation of such costs among PRPs. NL is also a defendant in a number of legal proceedings seeking damages for personal injury and property damage arising out of the sale of lead pigments and lead-based paints. NL has not accrued any amounts for the pending lead pigment litigation. Although no assurance can be given that NL will not incur future liability in respect of this litigation, based on, among other things, the results of such litigation to date, NL believes that the pending lead pigment litigation is without merit. Any liability that may result is not reasonably capable of estimation by NL. NL currently believes the disposition of all claims and disputes, individually and in the aggregate, should not have a material adverse effect on NL's consolidated financial position, results of operations or liquidity. There can be no assurance that additional matters of these types will not arise in the future. NL periodically evaluates its liquidity requirements, capital needs and availability of resources in view of, among other things, its debt service requirements and estimated future operating cash flows. As a result of this process, NL has in the past and may in the future seek to refinance or restructure indebtedness, raise additional capital, restructure ownership interests, sell interests in subsidiaries, marketable securities or other assets, or take a combination of such steps or other steps to increase or manage its liquidity and capital resources. Such activities have in the past and may in the future involve related companies. - 62 - Tremont Corporation. Tremont's cash flow from operations improved in 1993, despite higher operating losses, in large part as a result of relative changes in operating assets and liabilities, including TIMET's restructuring charge accrual. TIMET's new VDP titanium sponge facility accounted for over two-thirds of aggregate capital expenditures during the past three calendar years (90% in 1993). Capital expenditures for 1994 are currently estimated at about $3 million, significantly lower than in recent years due principally to the completion of the VDP plant. Investing activities in 1993 included aggregate proceeds of approximately $26 million from the sale of Tremont's interest in a gold mining venture and the sale of its bentonite mining business, and included purchases of NL common stock of $92 million in 1991 and $10 million in 1992. Average outstanding borrowings increased in each of the past three years due to relative operating needs and funding of TIMET's capital expenditures. Net borrowings in 1991 and 1992 included $61 million of TIMET subordinated debentures issued to UTSC, which increased the debentures outstanding to $75 million at the end of 1992. Dividends paid were $4 million in 1991 and $5 million in 1992. Tremont suspended payment of dividends in 1992. In December 1993, UTSC converted its $75 million of debentures into 25% of TIMET's outstanding voting common stock. Such conversion (i) decreased Tremont's ownership of TIMET to 75%, resulting in recognition of minority interest of $27 million, (ii) eliminated $75 million of long-term debt from Tremont's consolidated balance sheet, and (iii) increased Tremont's consolidated stockholders' equity by about $31 million, net of related deferred income taxes. During the past several years, TIMET's combined operations, capital expenditures and debt service have consumed significant amounts of cash. TIMET has taken and continues to take measures to manage its near-term and long-term liquidity requirements including, among other things, continued cost reduction efforts, deferral and reduction of capital expenditures, sale of certain assets, deferral of certain payments and other efforts to reduce the level of working capital, including reducing production rates and closing certain facilities. At December 31, 1993, TIMET had outstanding borrowings and letters of credit of approximately $29 million under the $30 million revolving portion of its bank credit agreement. TIMET is pursuing additional sources of liquidity. UTSC has allowed TIMET to defer interest payments aggregating approximately $6 million originally due prior to July 1993 until June 1994, and TIMET is currently negotiating for a further deferral. TIMET believes these measures, if successful, will provide it with the liquidity to meet its near-term obligations including operations, capital expenditures and debt service. However, the continued consumption of cash would have a further adverse effect on TIMET's liquidity and financial condition. Neither Tremont or UTSC have guaranteed any indebtedness of TIMET nor are they obligated to provide additional funds to TIMET. Tremont, with its 75% equity interest in TIMET and 18% equity interest in NL, is principally a holding company. At December 31, 1993, Tremont had parent level cash, equivalents and securities of approximately $13 million. Tremont has suspended both its regular quarterly dividend and its unrelated business acquisition activities. Tremont believes it will have sufficient liquidity to meet its existing near-term parent company level obligations. - 63 - Tremont loaned $25 million to TIMET over the past two years, a portion of which was contributed to TIMET's capital in 1993. TIMET's repayment of the remaining $19 million of such loans and related accrued interest, and the payment of dividends by TIMET, is subject to TIMET achieving certain financial targets under its bank credit agreement and are not currently permitted. Approximately one-half of Tremont's consolidated accrued OPEB costs relate to TIMET's plans, with substantially all of the remainder relating to retirees of former units from periods prior to the 1990 separation of Tremont and Baroid for which Tremont retained the obligation. Tremont periodically evaluates its liquidity requirements, capital needs and availability of resources in view of, among other things, its debt service requirements and estimated future operating cash flows. As a result of this process, Tremont may seek to raise additional capital, restructure ownership interests, refinance or restructure indebtedness, sell interests in subsidiaries, marketable securities or other assets, or take a combination of such steps or other steps to increase or manage its liquidity and capital resources. Such activities have in the past and may in the future involve related companies. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this Item is contained in a separate section of this Annual Report. See "Index of Financial Statements and Schedules" on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. - 64 - PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item is incorporated by reference to Valhi's definitive Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this report (the "Valhi Proxy Statement"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the Valhi 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 Valhi Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the Valhi Proxy Statement. See also Note 19 to the Company's Consolidated Financial Statements. - 65 - PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) and (d) Financial Statements and Schedules The Registrant The consolidated financial statements and schedules listed on the accompanying Index of Financial Statements and Schedules (see page) are filed as part of this Annual Report. 50 percent-or-less owned persons Consolidated financial statements of NL Industries, Inc. (49%-owned), with independent auditors report thereon, pages through inclusive of NL's Annual Report on Form 10-K for the year ended December 31, 1993 (Commission File No. 1-640) included herein as Exhibit 99.1, are filed as part of this Annual Report. Consolidated financial statements of Tremont Corporation (48%-owned), with independent auditors report thereon, pages through inclusive of Tremont's Annual Report on Form 10-K for the year ended December 31, 1993 (Commission File No. 1-10126) included herein as Exhibit 99.2, are filed as part of this Annual Report. (b) Reports on Form 8-K Reports on Form 8-K filed for the quarter ended December 31, 1993 and the months of January and February 1994: October 29, 1993 - Reported Items 5 and 7. November 8, 1993 - Reported Items 5 and 7. February 11, 1994 - Reported Items 5 and 7. (c) Exhibits Included as exhibits are the items listed in the Exhibit Index. Valhi will furnish a copy of any of the exhibits listed below upon payment of $4.00 per exhibit to cover the costs to Valhi of furnishing the exhibits. Instruments defining the rights of holders of long-term debt issues which do not exceed 10% of consolidated total assets will be furnished to the Commission upon request. - 66 - - 67 - - 68 - - 69 - 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. VALHI, INC. (Registrant) By: /s/ MICHAEL A. SNETZER Michael A. Snetzer, March 10, 1994 (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: /s/ ARTHUR H. BILGER /s/ HAROLD C. SIMMONS Arthur H. Bilger, March 10, 1994 Harold C. Simmons, March 10, 1994 (Director) (Chairman of the Board and Chief Executive Officer) /s/ NORMAN S. EDELCUP /s/ GLENN R. SIMMONS Norman S. Edelcup, March 10, 1994 Glenn R. Simmons, March 10, 1994 (Director) (Vice Chairman of the Board) /s/ ROBERT J. FRAME /s/ MICHAEL A. SNETZER Robert J. Frame, March 10, 1994 Michael A. Snetzer, March 10, 1994 (Director) (Director and President) /s/ J. WALTER TUCKER, JR. /s/ WILLIAM C. TIMM J. Walter Tucker, Jr., March 10, 1994 William C. Timm, March 10, 1994 (Director) (Vice President-Finance and Administration, Treasurer and Chief Financial Officer) /s/ J. THOMAS MONTGOMERY, JR. J. Thomas Montgomery, Jr., March 10, 1994 (Vice President, Controller and Chief Accounting Officer) - 70 - ANNUAL REPORT ON FORM 10-K ITEMS 8, 14(A) AND 14(D) INDEX OF FINANCIAL STATEMENTS AND SCHEDULES All other schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto. {THIS PAGE INTENTIONALLY LEFT BLANK.} REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Valhi, Inc.: We have audited the accompanying consolidated balance sheets of Valhi, Inc. and Subsidiaries as of December 31, 1992 and 1993, and the related consolidated statements of operations, cash flows and stockholders' 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 the refined sugar (The Amalgamated Sugar Company) and forest products (Medite Corporation) subsidiaries constituting approximately 48% and 59% of consolidated assets as of December 31, 1992 and 1993, respectively, and approximately 81%, 81% and 77% of consolidated net sales for the years ended December 31, 1991, 1992 and 1993, respectively. These statements were audited by other auditors whose reports thereon have been furnished to us, and our opinion, insofar as it relates to amounts included for such subsidiaries, is based solely upon their reports. 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 reports of other auditors provide a reasonable basis for our opinion. In our opinion, based upon our audits and the reports of other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Valhi, Inc. and Subsidiaries as of December 31, 1992 and 1993, 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 Notes 1 and 18 to the consolidated financial statements, in 1993 the Company changed its method of accounting for certain investments in debt and equity securities in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115 and in 1992 changed its method of accounting for postretirement benefits other than pensions and income taxes in accordance with SFAS Nos. 106 and 109, respectively. COOPERS & LYBRAND Dallas, Texas February 25, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholder of The Amalgamated Sugar Company: We have audited the consolidated balance sheets of The Amalgamated Sugar Company as of December 31, 1992 and 1993, and the related consolidated statements of income and shareholder's equity and cash flows for each of the three years in the period ended December 31, 1993 (not presented separately herein). 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 (not presented separately herein) referred to above present fairly, in all material respects, the consolidated financial position of The Amalgamated Sugar Company at December 31, 1992 and 1993, 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. As discussed in Note 10 to the consolidated financial statements (not presented separately herein), in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes in accordance with Statements of Financial Accounting Standards Nos. 106 and 109, respectively. KPMG PEAT MARWICK Salt Lake City, Utah January 28, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholder of Medite Corporation: We have audited the consolidated balance sheets of Medite Corporation as of December 31, 1992 and 1993, 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 (not presented separately herein). 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 (not presented separately herein) referred to above present fairly, in all material respects, the consolidated financial position of Medite Corporation as of December 31, 1992 and 1993, 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. As discussed in Note 8 to the consolidated financial statements (not presented separately herein), in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes in accordance with Statements of Financial Accounting Standards Nos. 106 and 109, respectively. ARTHUR ANDERSEN & CO. Portland, Oregon, January 28, 1994 VALHI, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1992 AND 1993 (IN THOUSANDS, EXCEPT PER SHARE DATA) VALHI, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) DECEMBER 31, 1992 AND 1993 (IN THOUSANDS, EXCEPT PER SHARE DATA) Commitments and contingencies (Note 20) See accompanying notes to consolidated financial statements. VALHI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS, EXCEPT PER SHARE DATA) VALHI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED) YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS, EXCEPT PER SHARE DATA) See accompanying notes to consolidated financial statements. VALHI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) VALHI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) VALHI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) See accompanying notes to consolidated financial statements. VALHI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) See accompanying notes to consolidated financial statements. VALHI, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Organization Valhi, Inc. is a subsidiary of Contran Corporation which holds, directly or through subsidiaries, approximately 90% of Valhi's outstanding common stock. All of Contran's outstanding voting stock is held by trusts established for the benefit of the children and grandchildren of Harold C. Simmons, of which Mr. Simmons is sole trustee. Mr. Simmons, the Chairman of the Board and Chief Executive Officer of Valhi and Contran, may be deemed to control each of Contran and Valhi. Principles of consolidation The accompanying consolidated financial statements include the accounts of Valhi and its majority-owned subsidiaries (collectively, the "Company"). All material intercompany accounts and balances have been eliminated. Translation of foreign currencies Assets and liabilities of subsidiaries whose functional currency is deemed to be other than the U.S. dollar are translated at year-end rates of exchange and revenues and expenses are translated at average exchange rates prevailing during the year. Resulting translation adjustments, and the Company's equity in translation adjustments of less than majority-owned affiliates, are accumulated in the currency translation adjustments component of stockholders' equity, net of related deferred income taxes. Currency transaction gains and losses are recognized in income currently. Cash and cash equivalents Cash equivalents include bank time deposits and government and commercial notes and bills with original maturities of three months or less. Marketable securities and securities transactions The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities" effective December 31, 1993. See Notes 5 and 18. Under SFAS No. 115, the Company's portfolio of marketable debt and equity securities is carried at market. Unrealized gains and losses on trading securities are recognized in income currently. Unrealized gains and losses on available-for-sale securities, and the Company's equity in unrealized gain and loss adjustments of less than majority-owned affiliates, are accumulated in the marketable securities adjustment component of stockholders' equity, net of related deferred income taxes. Realized gains and losses are based upon the specific identification of the securities sold. SFAS No. 115 superseded SFAS No. 12 under which marketable securities were generally carried at the lower of aggregate market or amortized cost and unrealized net gains were not recognized. Net sales Refined sugar, forest products and hardware products sales are recorded when products are shipped. Fast food sales are recorded at the time of retail sale. Inventories and cost of sales Inventories are stated at the lower of cost or market. The last-in, first-out method is used to determine the cost of substantially all inventories, except supplies. Supplies and other inventory costs are generally based on average cost. Under the terms of its contracts with sugarbeet growers, the Company's cost of sugarbeets is based on average sugar sales prices during the beet crop purchase contract year, which begins in October and ends the following September. Any differences between the sugarbeet cost estimated at the end of the fiscal year and the amount ultimately paid is an element of cost of sales in the succeeding year. Investment in affiliates Investments in more than 20%-owned but less than majority-owned companies are accounted for by the equity method. Differences between the cost of each investment and the Company's pro rata share of the affiliate's separately-reported net assets are allocated among the assets and liabilities of the affiliate based upon estimated relative fair values. Such differences are charged or credited to income as the affiliates depreciate, amortize or dispose of the related net assets. At December 31, 1993, the unamortized net difference was $158 million, of which $80 million is goodwill being amortized over 40 years with substantially all of the remainder attributable to the affiliates' property and equipment. The remaining unamortized net basis difference is greater than the Company's $75 million aggregate net carrying value of its investment in NL Industries, Inc. and Tremont Corporation because NL reports a shareholders' deficit on its separate historical basis of accounting. Timber and timberlands and depletion Timber and timberlands are stated at cost less accumulated depletion. Depletion is computed by the unit-of-production method. Intangible assets and amortization Goodwill, representing the excess of cost over fair value of individual net assets acquired in business combinations accounted for by the purchase method, is amortized by the straight-line method over 40 years. Fast food restaurant franchise fees and other intangible assets are amortized by the straight-line method over the periods (10 to 20 years) expected to be benefitted. Property, equipment and depreciation Property and equipment are stated at cost. Maintenance, repairs and minor renewals are expensed; major improvements are capitalized. Interest costs related to major long-term capital projects capitalized as a component of construction costs were $172,000 in 1991, $342,000 in 1992 and $420,000 in 1993. Depreciation is computed principally by the straight-line and unit-of-production methods over the estimated useful lives of eight to 40 years for buildings and three to 20 years for equipment. Long-term debt Long-term debt is stated net of unamortized original issue discount ("OID"). OID and deferred financing costs are amortized over the life of the applicable issue by the interest method. Capital lease obligations are stated net of imputed interest. Employee benefit plans Accounting and funding policies for retirement plans and postretirement benefits other than pensions ("OPEB") are described in Note 17. Research and development Research and development expense was $706,000 in 1991, $901,000 in 1992 and $854,000 in 1993. Income taxes Valhi and its qualifying subsidiaries are members of Contran's consolidated United States federal income tax group (the "Contran Tax Group"). The policy for intercompany allocation of federal income taxes provides that subsidiaries included in the Contran Tax Group compute the provision for income taxes on a separate company basis. Subsidiaries make payments to or receive payments from Contran in the amounts they would have paid to or received from the Internal Revenue Service had they not been members of the Contran Tax Group. The separate company provisions and payments are computed using the tax elections made by Contran. NL and Tremont are separate U.S. taxpayers and are not members of the Contran Tax Group. Payable to affiliates at December 31, 1992 includes income taxes payable to Contran of $1,612,000; receivable from affiliates at December 31, 1993 includes income taxes receivable from Contran of $44,000. Deferred income tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the income tax and financial reporting carrying amounts of assets and liabilities, including investments in subsidiaries and affiliates not included in the Contran Tax Group. Income (loss) per share of common stock Income (loss) per share is based upon the weighted average number of common shares outstanding. Common stock equivalents are excluded from the computation because the dilutive effect is either antidilutive or not material. NOTE 2 - BUSINESS AND GEOGRAPHIC SEGMENTS: * Tremont holds an additional 18% of NL. Capital expenditures include additions to property and equipment and timber and timberlands, excluding amounts attributable to business units acquired in business combinations accounted for by the purchase method. Corporate assets consist principally of cash, cash equivalents and marketable securities. Valhi has a wholly-owned captive insurance company ("Valmont") registered in Vermont. Valmont's operations, which are not significant, are included in general corporate expenses. At December 31, 1993, the net assets of non-U.S. subsidiaries included in consolidated net assets approximated $36.4 million. NOTE 3 - BUSINESS COMBINATIONS AND RESTRUCTURINGS: NL Industries, Inc. At December 31, 1990, the Company held 68% of NL's outstanding common stock. Valhi's ownership of NL increased to 69% by July 1991 as a result of NL's purchases of its common stock in market transactions. In September 1991, NL purchased 11.3 million shares of its common stock at a price of $16 per share pursuant to a "Dutch Auction" self-tender offer. Valhi sold 10.9 million shares to NL pursuant to the offer and thereby reduced its interest in NL to 63%. In December 1991, to complete the Company's plan to reduce its direct ownership of NL to less than 50% and thereby achieve certain income tax savings, Valhi sold 7.8 million NL shares to Tremont at a price of $11.75 per share in a privately-negotiated transaction and further reduced its direct interest in NL to 48%. The Company recognized a $.8 million pre-tax loss on the aggregate reduction in its direct interest in NL from 69% to 48%. During 1992, Valhi's direct interest in NL increased to 49% as a result of additional NL purchases of its common stock in market transactions. For comparative purposes, Valhi's interest in NL is reported by the equity method for all periods presented. Valhi may be deemed to control each of NL and Tremont and, accordingly, Tremont reports its 18% interest in NL by the equity method. Tremont Corporation. At December 31, 1990, the Company held 44% of Tremont's outstanding common stock and in 1992 purchased additional Tremont shares for $4.9 million, increasing its interest in Tremont to 48%. Baroid Corporation. At December 31, 1990, the Company held 42% of Baroid's outstanding common stock. In May 1991, the Company sold 17.25 million shares of Baroid common stock in an underwritten secondary offering at a price to the public of $6.25 per share, which reduced the Company's interest in Baroid to less than 20%. As a result of this sale and the Company's intent to hold its remaining interest in Baroid solely as an investment and not for the purposes of directing the policies, management or control of Baroid, the Company ceased accounting for Baroid by the equity method effective in May 1991. The Company's $3.3 million equity in undistributed Baroid earnings in 1991, for the period prior to May, is included in other income. In January 1994, Baroid merged with Dresser Industries, Inc. and the Company now holds approximately 3% of Dresser's outstanding common stock. See Note 5. Other. In June 1992, National Cabinet Lock purchased certain assets of a competitor for $1.2 million. NOTE 4 - BUSINESS UNIT DISPOSITIONS: The insurance gain relates to Medite's veneer and chipping plant in Rogue River, Oregon, as insurance proceeds exceeded the net carrying value of the assets destroyed and cleanup costs. The aggregate insurance proceeds of $16.5 million included $5.6 million attributable to business interruption insurance which was recognized as a component of operating income through August 1993. The amount attributable to business interruption insurance was based upon estimates, negotiated with the insurance carrier, of the expected operating profit of the Rogue River operations during each month that the various operations were originally expected to be down. Medite deemed such estimates to be reasonable based upon selling prices in effect at the time in 1992 when the estimates were made and the expected construction schedule at that time. In 1992, Medite accrued a loss on its plywood business and related facilities permanently closed in January 1993, most of which related to the net carrying value of property and equipment in excess of estimated net realizable sales value. In 1993, Medite changed its estimate of the aggregate loss primarily because the auction sale proceeds of certain equipment exceeded the previously estimated net realizable value. NOTE 5 - MARKETABLE SECURITIES AND SECURITIES TRANSACTIONS: Upon adoption of SFAS No. 115 as of December 31, 1993, the Company classified its portfolio of U.S. Treasury securities as trading securities and its Baroid common stock as securities available-for-sale. Cost of the treasury securities at December 31, 1993 was approximately $28.6 million. At December 31, 1993, Valhi held 13.7 million Baroid shares (cost - $44.3 million) with a quoted market price of $8.25 per share, or an aggregate of $112.8 million. However, because the Baroid common stock is exchangeable for the Company's LYONs at the option of the LYONs holder (see Note 11), the carrying value of the Baroid stock is limited to the accreted LYONs obligation. In January 1994, Baroid and Dresser merged and each share of Baroid common stock was exchanged for .4 shares of Dresser common stock. As a result, the LYONs became exchangeable for the 5.5 million Dresser shares now held by the Company. At December 31, 1992, the treasury securities were carried at market value, which was slightly less than their aggregate cost of $127.9 million. Market value of the Baroid common stock was $76.9 million at December 31, 1992. Net gains from securities transactions in 1991 include $63.7 million on the sale of 19.5 million Baroid shares, of which $8.1 million related to 2.3 million shares sold to Contran at the current market price. NOTE 6 - ACCOUNTS AND NOTES RECEIVABLE: NOTE 7 - INVENTORIES: The current cost of LIFO inventories exceeded the net carrying value of such inventories by approximately $45 million and $43 million at December 31, 1992 and 1993, respectively. The effect of reductions in certain LIFO inventory quantities increased consolidated operating income by $.8 million in 1991, $1.9 million in 1992 and $.5 million in 1993. NOTE 8 - INVESTMENT IN AFFILIATES: The Company holds approximately 24.8 million shares of NL common stock and 3.5 million shares of Tremont common stock. The quoted per share market prices of NL and Tremont common stock at December 31, 1993 were $4.50 and $6.875, respectively, or an aggregate quoted market value of $135.8 million. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Annual Report on Form 10-K for summarized information relating to the results of operations, financial position and cash flows of each of NL and Tremont. The carrying value of NL is stated net of a $10.3 million elimination for Valhi common stock held by NL classified by the Company as common stock reacquired. See Note 13. NOTE 9 - OTHER NONCURRENT ASSETS: Property held for sale is carried at the lower of cost or estimated net realizable value under current market conditions. NOTE 10 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES: NOTE 11 - NOTES PAYABLE AND LONG-TERM DEBT: Valhi The zero coupon Senior Secured LYONs, $379 million principal amount at maturity in October 2007, were issued with significant OID to represent a yield to maturity of 9.25%. No periodic interest payments are required. Each $1,000 in principal amount at maturity of the LYONs is exchangeable, at any time, for 14.4308 shares of Dresser common stock held by Valhi. Prior to the Baroid/Dresser merger in January 1994, the LYONs were exchangeable for Baroid common stock (see Note 5). The LYONs are redeemable at the option of the holder in October 1997 or October 2002 at $404.84 or $636.27, respectively, per $1,000 principal amount (the issue price plus accrued OID through such purchase dates). Such redemptions may be paid, at Valhi's option, in cash, Dresser common stock, or a combination thereof. The LYONs are not redeemable at Valhi's option prior to October 1997 unless the market price of Dresser common stock exceeds $35.70 per share for specified time periods. At December 31, 1992 and 1993, the net carrying value of the LYONs per $1,000 principal amount at maturity was $262.22 and $287.04, respectively, and the quoted market price was $253 and $330, respectively. The LYONs are secured by the 5.5 million shares of Dresser common stock held by Valhi, which shares are held in escrow for the benefit of holders of the LYONs. Valhi receives the regular quarterly dividend on the escrowed Dresser shares. Amalgamated The United States Government loans are made under the sugar price support loan program, which program extends through the 1997 crop year ending September 30, 1998. These short-term nonrecourse loans are collateralized by refined sugar inventories and are payable at the earlier of the date the refined sugar is sold or upon maturity. The weighted average interest rate on Government loans was 3.4% at December 31, 1993. Amalgamated's principal bank credit agreement (the "Sugar Credit Agreement") provides for a revolving credit facility in varying amounts up to $75 million, with advances based upon formula-determined amounts of accounts receivable and inventories, and a $21 million term loan. Borrowings under the revolving credit facility bear interest, at Amalgamated's option, at the prime rate or LIBOR plus 1.25% and mature not later than September 30, 1995. The term loan bears interest, at Amalgamated's option, at the prime rate plus .25% or LIBOR plus 1.5% and matures in July 1996. The Sugar Credit Agreement may be terminated by the lenders in the event the sugar price support loan program is abolished or materially and adversely modified, and borrowings are collateralized by substantially all of Amalgamated's assets. Amalgamated also has a $5 million unsecured line of credit with the agent bank for the Sugar Credit Agreement. At December 31, 1993, the weighted average interest rate on Amalgamated's outstanding bank borrowings was 4.9%. At December 31, 1993, unused credit available to Amalgamated under its bank credit agreements and the sugar price support loan program aggregated approximately $24 million. Valcor Valcor's unsecured 9 5/8% Senior Notes Due November 2003 are redeemable at the Company's option beginning November 1998, initially at 104.813% of principal amount declining to 100% after November 2000. In the event of a Change of Control, as defined, Valcor would be required to make an offer to purchase the Valcor Notes at 101% of principal amount. At December 31, 1993, the quoted market price of the Valcor Senior Notes was $100.75. Medite Medite's U.S. bank credit agreement (the "Timber Credit Agreement") provides for (i) $75 million of term loan financing due in annual installments of $8 million beginning September 1994 with the balance due September 2000, and (ii) a $15 million revolving working capital facility through September 1995. Borrowings generally bear interest at rates 1.75% to 2% over LIBOR, are collateralized by Medite's timber and timberlands, and borrowings under the working capital facility are also collateralized by Medite's U.S. receivables and inventories. The term loan consists of two tranches - a $50 million term loan (Tranche A) and a $25 million reducing revolving facility (Tranche B). Medite has entered into interest rate swaps for $26 million of the Tranche A term loan that results in a weighted average interest rate of 7.6% for such borrowings. At December 31, 1993, the fair value of the swap agreements, which mature in 1998 through 2000, is estimated to be a $.1 million liability, which amount represents the estimated cost to the Company if it were to terminate the swap agreements at that date. The Company is exposed to interest rate risk in the event of nonperformance by the other parties to the swap agreements, however, it does not anticipate nonperformance by such parties. Medite's Irish subsidiary, Medite of Europe Limited, has bank credit agreements providing for (i) a $26 million multi-currency term construction loan repayable in installments from 1995 through 2000 and (ii) a $12 million multi-currency revolving credit facility through January 1995. Borrowings under both facilities bear interest at rates based upon LIBOR and are collateralized by substantially all of Medite/Europe's assets. At December 31, 1993, the weighted average interest rates on Medite's outstanding U.S. and non-U.S. bank borrowings, including the effect of the interest rate swaps discussed above, were 6.3% and 6.7%, respectively, and amounts available for borrowing under the existing bank credit facilities aggregated approximately $55 million. The State of Oregon term loan matures in monthly installments through March 2008, bears interest at 6.9% and is collateralized by certain of Medite's property and equipment. Sybra Sybra's revolving bank credit agreements provide for unsecured credit facilities aggregating $21 million with interest generally at LIBOR plus 1.25%. Borrowings under these agreements mature July 1995, subject to renewal by the parties through July 1997. At December 31, 1993, the weighted average interest rate on outstanding revolving borrowings was 4.7% and amounts available for borrowing aggregated approximately $8 million. Future minimum payments under capital lease obligations at December 31, 1993, including amounts representing interest, are approximately $1.5 million in each of the next five years and an aggregate of $4.6 million thereafter. Capital lease obligations incurred on sale/leaseback and financing transactions were $3.5 million in 1991. National Cabinet Lock National Cabinet Lock's Canadian subsidiary has a bank credit agreement which provides for a $3.3 million term facility due through 2001 and a $3 million revolving facility through April 1994. Borrowings may be in U.S. or Canadian dollars, bear interest generally at LIBOR plus .5% and are collateralized by substantially all of this subsidiary's assets. At December 31, 1993, the full amount of these facilities was available for borrowing. Other The quoted market prices of the Valhi LYONs and Valcor Senior Notes are disclosed above. Substantially all other notes payable and long-term debt of subsidiaries either reprice with changes in market interest rates or bear interest at recently fixed market rates, and the book value of such indebtedness is deemed to approximate market value. The Indenture governing the Valcor Senior Notes, among other things, limits Valcor dividends and additional indebtedness and prohibits Valcor from co-investing with affiliates. Other credit agreements of subsidiaries typically require the respective subsidiary to maintain minimum levels of equity, require the maintenance of certain financial ratios, limit dividends and additional indebtedness and contain other provisions and restrictive covenants customary in lending transactions of this type. At December 31, 1993, the restricted net assets of consolidated subsidiaries approximated $14 million. Aggregate maturities of long-term debt at December 31, 1993 The LYONs are reflected in the above table as due October 1997, the first of the two dates they are redeemable at the option of the holder, at the aggregate redemption price on such date of $153.5 million ($404.84 per $1,000 principal amount at maturity in October 2007). NOTE 12 - OTHER NONCURRENT LIABILITIES: NOTE 13 - STOCKHOLDERS' EQUITY: Common stock Common stock issued includes 14,800 shares in 1991, 15,500 shares in 1992 and 47,800 in 1993 to pay accrued employee benefits of $74,000, $87,000 and $239,000, respectively. Consolidated common stock reacquired at December 31, 1993 includes 679,000 shares representing the Company's proportional interest in shares of Valhi common stock held by NL. Under Delaware Corporation Law, all shares held by a less than 50%-owned company are considered to be outstanding. As a result, shares outstanding for financial reporting purposes differ from those outstanding for legal purposes. Options and restricted stock The Valhi, Inc. 1987 Incentive Stock Option - Stock Appreciation Rights Plan, as amended, (the "1987 Option Plan") provides for the discretionary grant of stock options, restricted stock and stock appreciation rights. Valhi's Board of Directors has increased, subject to stockholder approval, the number of shares of Valhi common stock that may be issued pursuant to the 1987 Option Plan from six million to nine million shares. The 1987 Option Plan provides for the grant of options that qualify as incentive options and for options which are not so qualified. Options are granted at a price not less than 85% of fair market value on the date of grant, vest ratably over a five-year period beginning one year from the date of grant and expire 10 years from the date of grant. The exercise price of certain options increases annually based upon an interest factor less Valhi dividends per share paid during the year. Restricted stock, forfeitable unless certain periods of employment are completed, is held in escrow in the name of the grantee until the restriction period expires. At December 31, 1993, 296,400 shares restricted for periods up to 30 months are included in outstanding shares. No stock appreciation rights have been granted. Pursuant to the Valhi, Inc. 1990 Non-Employee Director Stock Option Plan, options to purchase 2,000 shares of Valhi common stock are automatically granted once a year to each non-employee director of Valhi. Options are granted at a price equal to the fair market value on the date of grant, vest one year from the date of grant and expire five years from the date of grant. Up to 50,000 shares of Valhi common stock may be issued pursuant to this plan. Changes in outstanding options are summarized in the table below. At December 31, 1993, options to purchase 3,095,000 Valhi shares were exercisable (20,000 shares exercisable at prices lower than the December 31, 1993 quoted market price of $4.875 per share) and options to purchase 506,000 shares become exercisable in 1994. At December 31, 1993, an aggregate of 711,000 shares were available for future grants. NOTE 14 - INCOME TAXES: Summarized below are (i) the components of income (loss) before income taxes, extraordinary items and cumulative effect of changes in accounting principles ("pretax income"), (ii) the difference between income tax benefit (expense) attributable to pretax income and the amounts that would be expected using the U.S. federal statutory income tax rate of 34% in 1991 and 1992 and 35% in 1993, (iii) the components of income tax benefit (expense) attributable to pretax income, and (iv) the components of the comprehensive tax benefit (expense). Changes in deferred income taxes related to adoption of new accounting standards is disclosed in Note 18. The components of the net deferred tax liability are summarized below. The components of the provision for deferred income taxes for 1991 (a disclosure not required after adopting SFAS No. 109 in 1992) is summarized below. NOTE 15 - INTEREST AND OTHER INCOME: NOTE 16 - EXTRAORDINARY ITEMS: Funds for the prepayment of $235 million principal amount of Valhi 12 1/2% Senior Subordinated Notes during 1992 and 1993 were provided in part from net proceeds of the LYONs ($95 million), Medite's Timber Credit Agreement ($60 million) and Valcor's Senior Notes ($50 million). Utilization of tax loss and credit carryforwards are not classified as extraordinary items subsequent to the adoption of SFAS No. 109. NOTE 17 - EMPLOYEE BENEFIT PLANS: Company-sponsored pension plans Valhi and its subsidiaries maintain various defined benefit and defined contribution plans and about 40% of the Company's worldwide full and part-time employees (over 80% of full-time employees) participate in one or more of such company-sponsored plans. Defined pension benefits are generally based on years of service and compensation under fixed dollar, final pay or career average formulas and the related expenses are based on independent actuarial valuations. The funding policies for U.S. defined benefit plans are to contribute amounts satisfying funding requirements of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). Non-U.S. defined benefit plans are funded in accordance with applicable statutory requirements. Defined contribution plans. Approximately 90% of full-time U.S. employees are eligible to participate in contributory savings plans with Company contributions based on matching or other formulas, and certain of such employees also participate in Valhi's noncontributory unleveraged Employee Stock Ownership Plan. At December 31, 1993, 186,000 shares of Valhi common stock were held by the ESOP, all of which were allocated to participants. The Company's expense related to the savings plans and the ESOP approximated $2 million in 1991, $2.4 million in 1992 and $2.6 million in 1993. Defined benefit plans. Approximately 65% of the Company's worldwide full-time employees are covered by defined benefit plans. The funded status of the Company's defined benefit pension plans and the components of net periodic defined benefit pension cost are set forth below. The rates used in determining the actuarial present value of benefit obligations at December 31, 1993 were (i) discount rate - 7.5% (1992 - 8% to 8.5%), and (ii) rate of increase in future compensation levels - 4% to 5%. The expected long-term rates of return on assets used ranged from 7.5% to 10% (1992 - 7.5% to 12%). Approximately one-half of the aggregate plan assets at December 31, 1993 consist of units in a combined investment fund for employee benefit plans sponsored by Valhi and its affiliates, including Contran and certain Contran affiliates. Other plan assets are primarily mutual funds. Assets of the combined investment fund are primarily investments in corporate equity and debt securities, short-term cash investments and notes collateralized by residential and commercial real estate. The 1992 loss related to the permanent closure of the Company's plywood operations (see Note 4) includes a pension curtailment loss of $.6 million. The pension liabilities component of stockholders' equity relates to the Company's equity in amounts recorded by NL and Tremont, net of related deferred income taxes. Multiemployer pension plans A small minority of the Company's employees are covered by union-sponsored, collectively-bargained multiemployer pension plans. Contributions to multiemployer plans based upon collectively-bargained agreements were $128,000 in 1991, $95,000 in 1992, and $53,000 in 1993. Based upon information provided by the multiemployer plans' administrators, the Company's share of such plans' unfunded vested benefits is not significant. Postretirement benefits other than pensions Certain subsidiaries currently provide certain health care and life insurance benefits for eligible retired employees. Under plans currently in effect, some currently active employees of Amalgamated and Medite may become eligible for postretirement health care benefits if they reach retirement age while working for the applicable subsidiary. Substantially all retirees are required to contribute a portion of the cost of their benefits and certain current and all future retirees either cease to be eligible for health care benefits at age 65 or are thereafter eligible only for limited benefits. The components of the periodic OPEB cost and accumulated OPEB obligation are set forth below. The rates used in determining the actuarial present value of the accumulated OPEB obligations at December 31, 1993, were (i) discount rate - 7.5% (1992 - 7.75%), (ii) rate of increase in future compensation levels - - 4% to 4.5% (1992 - 4% to 5%) and (iii) rate of increase in future health care costs - 13.5% in 1994, gradually declining to approximately 6% in 2017 and thereafter. If the health care cost trend rate was increased by one percentage point for each year, OPEB expense would have increased $210,000 in 1993, and the actuarial present value of accumulated OPEB obligations at December 31, 1993 would have increased $1.7 million. Pay-as-you-go OPEB expense, prior to adoption of SFAS No. 106, was approximately $1 million in 1991. NOTE 18 - CHANGES IN ACCOUNTING PRINCIPLES: Marketable securities (SFAS No. 115). The Company, NL and Tremont each elected early compliance with SFAS No. 115 effective December 31, 1993. The cumulative effect of this change in accounting principle is shown in the table below. The amounts attributable to the Company's investment in NL and Tremont consist of the Company's equity in the respective amounts reported by NL and Tremont. OPEB (SFAS No. 106) and income taxes (SFAS No. 109). The Company, NL and Tremont each elected (i) early compliance with both SFAS No. 106 and SFAS No. 109 as of January 1, 1992; (ii) to apply SFAS No. 109 prospectively and not restate prior years; and (iii) immediate recognition of the OPEB transition obligation. The cumulative effect of changes in accounting principles adjustment is shown in the table below. The amounts attributable to the Company's investments in NL and Tremont consist of the Company's equity in the respective historical amounts reported by NL and Tremont and applicable adjustment of the Company's purchase accounting basis differences originally recorded net-of- tax at rates differing from current rates. NOTE 19 - RELATED PARTY TRANSACTIONS: The Company may be deemed to be controlled by Harold C. Simmons. Corporations that may be deemed to be controlled by or affiliated with Mr. Simmons sometimes engage in (a) intercorporate transactions such as guarantees, management and expense sharing arrangements, shared fee arrangements, joint ventures, partnerships, loans, options, advances of funds on open account, and sales, leases and exchanges of assets, including securities issued by both related and unrelated parties and (b) common investment and acquisition strategies, business combinations, reorganizations, recapitalizations, securities repurchases, and purchases and sales (and other acquisitions and dispositions) of subsidiaries, divisions or other business units, which transactions have involved both related and unrelated parties and have included transactions which resulted in the acquisition by one related party of a publicly-held minority equity interest in another related party. While no transactions of the type described above are planned or proposed with respect to the Company (except as otherwise set forth in this Annual Report on Form 10-K), the Company continuously considers, reviews and evaluates, and understands that Contran and related entities consider, review and evaluate such transactions. Depending upon the business, tax and other objectives then relevant, it is possible that the Company might be a party to one or more such transactions in the future. It is the policy of the Company to engage in transactions with related parties on terms, in the opinion of the Company, no less favorable to the Company than could be obtained from unrelated parties. Loans are made between the Company and various related parties, including Contran, pursuant to term and demand notes, principally for cash management purposes. Related party loans generally bear interest at rates related to credit agreements with unrelated parties. Interest income on loans to related parties was $1,694,000 in 1991, $405,000 in 1992, and $73,000 in 1993 and related party interest expense was $625,000 in 1991, nil in 1992 and $39,000 in 1993. Contran has an $18 million bank credit agreement which includes a $10 million letter of credit facility. Pursuant to such agreement, Contran may authorize the banks to issue letters of credit on behalf of Valmont ($2.3 million outstanding at December 31, 1993). Obligations under this Contran credit agreement are collateralized by certain securities held by Contran. Under the terms of Intercorporate Services Agreements ("ISAs") with Contran, Contran provides certain management, administrative and aircraft maintenance services to the Company, and the Company provides various administrative and other services to Contran, on a fee basis. The net ISA fees charged to the Company were approximately $1.2 million in each of the past three years. Charges from corporate related parties for services provided in the ordinary course of business were less than $250,000 in each of the past three years. Such charges are principally pass-through in nature and, in the Company's opinion, are not materially different from those that would have been incurred on a stand-alone basis. The Company has established a policy whereby the Board of Directors will consider the payment of additional management fees to Contran for certain financial advisory and other services provided by Contran beyond the scope of the ISAs. No such payments were made in the past three years. NL and Tremont are parties to ISAs with Valhi whereby Valhi provides certain management, financial and administrative services to NL and Tremont on a fee basis. Baroid and Valhi were parties to a similar agreement terminated in May 1991. Fees charged to affiliates pursuant to these agreements aggregated $2.1 million in 1991, $1.8 million in 1992 and $1.0 million in 1993. In June 1991, Valhi sold 2.3 million Baroid shares to Contran for cash at the then-current market price of $6.375 per share. See Note 5. The Company's December 1991 sale of NL common stock to Tremont is described in Note 3. In conjunction with the issuance of the LYONs in October 1992, Valhi purchased 1.7 million shares of Baroid common stock from Contran at the then-current market price of $6.375 per share. COAM Company is a partnership, formed prior to 1991, which has sponsored research agreements with the University of Texas Southwestern Medical Center at Dallas (the "University") to develop and commercially market a safe and effective treatment for arthritis (the "Arthritis Research Agreement") and to develop and commercially market patents and technology resulting from a cancer research program (the "Cancer Research Agreement"). At December 31, 1993, COAM partners are Contran, Valhi and another Contran subsidiary. Harold C. Simmons is the manager of COAM. The Arthritis Research Agreement, as amended, provides for payments by COAM of up to $8.4 million over the next 11 years and the Cancer Research Agreement, as amended, provides for funds of up to $19.7 million over the next 17 years. Funding requirements pursuant to the Arthritis and Cancer Research Agreements are without recourse to the COAM partners and the partnership agreement provides that no partner shall be required to make capital contributions. The Company's contributions to COAM were approximately $1.1 million in 1991, $1.7 million in 1992 and $2 million in 1993. NOTE 20 - COMMITMENTS AND CONTINGENCIES: Legal proceedings Valhi and consolidated subsidiaries In November 1987, a complaint was filed in the United States District Court for the District of Utah against Valhi, Amalgamated, the Amalgamated Retirement Plan Committee and Harold C. Simmons (Holland, et al. v. Valhi, Inc., et al., No. 87-C-968G). The complaint, a class action on behalf of certain retired salaried employees of Amalgamated, alleges, among other things, that the defendants breached their fiduciary duties under ERISA by amending certain provisions of a retirement plan for salaried employees maintained by Amalgamated to permit the reversion of excess plan assets to Amalgamated in 1986. The complaint seeks a variety of remedies, including, among other things, orders requiring a return of all reverted funds (alleged to be in excess of $4 million) and a distribution of such funds to retirees and their beneficiaries, an award of punitive damages, and costs and expenses, including attorneys' fees. The punitive damage claim was dismissed in April 1989, Valhi was dismissed as a defendant in the suit and trial was held in July 1991. In January 1992, the court issued Findings of Fact and Conclusions of Law which held, among other things, that Harold C. Simmons was not liable for any violation of law, that the acts which are the subject of the complaint fall outside of Mr. Simmons' fiduciary function, that Amalgamated was entitled to a reversion of excess plan assets but that Amalgamated and the Plan Committee had breached their fiduciary duties under ERISA by calculating the plan participants' share of the reversion in accordance with regulations issued by the Pension Benefit Guaranty Corporation ("PBGC") where application of those regulations resulted in what the court deemed an inequitable distribution to plan participants. The court held that Amalgamated and the Plan Committee had a fiduciary duty under ERISA to consider alternative methods for calculating the plan participants' share of the reversion and, if necessary, to seek approval from the PBGC to utilize such an alternative method. Pursuant to a method of calculation that the court found to result in a more equitable distribution, the plaintiff class was awarded approximately $915,000 plus interest from July 1, 1986, costs and reasonable attorneys' fees. In April 1992, defendants Amalgamated and the Plan Committee filed a notice of appeal, and shortly thereafter, the plaintiffs cross-appealed certain issues resolved in favor of defendants. In November 1992, plaintiffs' appealed the amount of attorneys' fees the court awarded on behalf of plaintiffs. In September 1993 the United States Court of Appeals for the Tenth Circuit heard oral arguments. Amalgamated and the Plan Committee continue to believe the action is without merit, believe the court erred as to certain of its findings and conclusions, and intend to continue to appeal vigorously the court's decision. In November 1992, a complaint was filed in the United States District Court for the District of Utah against Valhi, Amalgamated and the Amalgamated Retirement Plan Committee (American Federation of Grain Millers International, et al. v. Valhi, Inc. et al., No. 29-NC-129J). The complaint, a purported class action on behalf of certain current and retired hourly employees of Amalgamated, alleges, among other things, that the defendants breached their fiduciary duties under ERISA by amending certain provisions of a retirement plan for hourly employees maintained by Amalgamated to permit the reversion of excess plan assets to Amalgamated in 1986. The complaint seeks a variety of remedies, including, among other things, orders requiring a return of all reverted funds (alleged to be in excess of $8 million) and any profits earned thereon, a distribution of such funds to the plan participants, retirees and their beneficiaries and enhancement of the benefits under the plan, and an award of costs and expenses, including attorney fees. The hearing on the Company's motion to dismiss and/or for partial summary judgment has been continued. The Company and the Plan Committee believe the action is without merit and intend to defend the action vigorously. In November 1991, a purported derivative complaint was filed in the Court of Chancery of the State of Delaware, New Castle County (Alan Russell Kahn v. Tremont Corporation, et al., No. 12339), in connection with Tremont's agreement to purchase 7.8 million NL common shares from Valhi. In addition to Tremont, the complaint names as defendants the members of Tremont's board of directors and Valhi. The complaint alleges, among other things, that Tremont's purchase of the NL shares constitutes a waste of Tremont's assets and that Tremont's board of directors breached their fiduciary duties to Tremont's public stockholders and seeks, among other things, to rescind Tremont's consummation of the purchase of the NL shares and award damages to Tremont for injuries allegedly suffered as a result of the defendants' wrongful conduct. Valhi believes, and understands that Tremont and the other defendants believe, that the action is without merit. Valhi has denied, and understands that Tremont and the other defendants have denied, all allegations of wrongdoing and liability and intends to defend the action vigorously. The defendants have moved to dismiss the complaint on the ground that the plaintiff lacks standing to pursue this action, and oral arguments are scheduled for Spring 1994. The court has granted the plaintiff limited discovery with respect to the motion to dismiss. The Company is also involved in various other environmental, contractual, product liability and other claims and disputes incidental to its business. The Company currently believes that the disposition of all claims and disputes, individually or in the aggregate, should not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. NL Industries Lead pigment litigation. Since 1987, NL, other past manufacturers of lead pigments for use in paint and lead-based paint and the Lead Industries Association have been named as defendants in various legal proceedings seeking damages for personal injury and property damage allegedly caused by the use of lead-based paints. Certain of these actions have been filed by or on behalf of large United States cities or their public housing authorities. These legal proceedings seek recovery under a variety of theories, including negligent product design, failure to warn, breach of warranty, conspiracy/concert of action, enterprise liability, market share liability, intentional tort, and fraud and misrepresentation. The plaintiffs in these actions generally seek to impose on the defendants responsibility for lead paint abatement and asserted health concerns associated with the use of lead-based paints, which was permitted for interior residential use in the United States until 1973, including damages for personal injury, contribution and/or indemnification for medical expenses, medical monitoring expenses, and costs for educational programs. Most of these legal proceedings are in various pre-trial stages; several are on appeal. NL is vigorously defending the pending lead pigment litigation and has not accrued any amounts for such litigation. Although no assurance can be given that NL will not incur future liability in respect of this litigation, based on, among other things, results of such litigation to date, NL believes that the pending lead pigment litigation is without merit. Considering NL's previous involvement in the lead and lead pigment businesses, there can be no assurance that additional litigation similar to that currently pending will not be filed. Environmental matters and litigation. Some of NL's current and former facilities, including several divested secondary lead smelters and former mining locations, are the subject of civil litigation, administrative proceedings or of investigations arising under federal and state environmental laws. Additionally, in connection with past disposal practices, NL has been named a potentially responsible party ("PRP") pursuant to CERCLA in approximately 80 governmental enforcement and private actions associated with hazardous waste sites and former mining locations, some of which are on the U.S. EPA's Superfund National Priority List. These actions seek cleanup costs and/or damages for personal injury or property damage. While NL may be jointly and severally liable for such costs, in most cases, it is only one of a number of PRPs who are also jointly and severally liable. In addition, NL is a party to a number of lawsuits filed in various jurisdictions alleging CERCLA or other environmental claims. At December 31, 1993, NL had accrued $70 million in respect of those environmental matters which are reasonably estimable. It is not possible to estimate the range of costs for certain sites. The upper end of range of reasonably possible costs to NL for sites for which it is possible to estimate costs is approximately $105 million. No assurance can be given that actual costs will not exceed accrued amounts or the upper end of the range for sites for which estimates have been made, and no assurance can be given that costs will not be incurred with respect to sites as to which no estimate presently can be made. The imposition of more stringent standards or requirements under environmental laws or regulations, new developments or changes respecting site cleanup costs or allocation of such costs among PRPs, or a determination that NL is potentially responsible for the release of hazardous substances at other sites, could result in expenditures in excess of amounts currently estimated by NL to be required for such matters. Further, there can be no assurance that additional environmental matters will not arise in the future. Other litigation. On February 24, 1994, NL settled its lawsuit against Lockheed Corporation and its directors. The litigation arose out of NL's claims, among other things, that Lockheed had violated the federal securities laws by making false and misleading statements about its ESOP that impacted the value of the Lockheed stock formerly owned by NL. The jury concluded in a December 1992 verdict that Lockheed violated the anti-fraud provisions of the federal securities laws and awarded NL $30 million, which gain contingency was not recorded as income by NL at that time. Both companies appealed. In connection with the settlement, NL and Lockheed agreed to dismiss the pending proceedings and to release all claims that each may have against the other. Under terms of the 1994 settlement, Lockheed made a $27 million cash payment to NL, resulting in net proceeds to NL of approximately $20 million. NL will recognize the resolution of this gain contingency in 1994. In January 1990, an action was filed in the United States District Court for the Southern District of Ohio against NLO, Inc., a subsidiary of NL, and NL on behalf of a putative class of former NLO employees and their families and former frequenters and invitees of the Feed Materials Production Center ("FMPC") in Ohio (Day, et al. v. NLO, Inc., et al., No. C-1-90-067). The FMPC is owned by the United States Department of Energy (the "DOE") and was formerly managed under contract by NLO. The complaint seeks damages for, among other things, emotional distress and damage to personal property allegedly caused by exposure to radioactive and/or hazardous materials at the FMPC and punitive damages. A trial was held separately on the defendants' defense that the statute of limitations barred the plaintiffs' claims. In November 1991, the jury returned a verdict against six of the ten named plaintiffs, finding that their claims were time barred. Without denying the plaintiffs' motion to vacate the verdict, the court certified this action as a class action. A merits trial is expected to be held in late 1994. Although no assurance can be given, the Company understands that NL believes that, consistent with a July 1987 DOE contracting officer's decision, the DOE will indemnify NLO in the event of an adverse decision just as it did when two previous cases relating to NLO's management of the FMPC were settled; therefore, the resolution of the Day matter is not expected to have a material adverse effect on NL. In the 1987 decision, the contracting officer affirmed NLO's entitlement to indemnification under its contract for the operation of the FMPC for all liability, including the cost of defense, arising out of those two previous cases. Tremont Corporation Titanium Metals Corporation ("TIMET"), a 75%-owned Tremont subsidiary, along with others, including the airline and the engine manufacturers, has been named in a number of lawsuits arising out of the July 1989 crash of a DC-10 aircraft in Iowa. The majority of the cases naming TIMET have been settled without payment by TIMET to date, although the possibility of a future claim for contribution by one or more other defendants exists with respect to certain of such cases. In addition, TIMET was granted summary judgment in approximately 15 other cases and approximately 25 cases were dismissed in 1993 but have been refiled by the plaintiffs. The Company understands TIMET maintains substantial general liability insurance coverage against claims of this nature and TIMET's insurance carrier has assumed TIMET's defense in the litigation. The Company understands that TIMET, based upon the information which TIMET has obtained to date, does not believe that its ultimate liability in this matter, if any, will exceed its applicable insurance coverage or otherwise have a material adverse effect on TIMET's consolidated financial position, results of operations or liquidity. See also the third paragraph under "Valhi and consolidated subsidiaries" above (Kahn v. Tremont, et al.). In addition to the litigation described above, NL and Tremont are involved in various environmental, contractual, product liability and other claims and disputes incidental to their respective present and former businesses. The Company understands that each of NL and Tremont currently believe the disposition of all claims and disputes, individually or in the aggregate, should not have a material adverse effect on its respective consolidated financial position, results of operations or liquidity. Environmental matters Valhi and consolidated subsidiaries. The Company's operations are governed by various federal, state, local and foreign environmental laws and regulations. The Company's policy is to comply with environmental laws and regulations at all of its plants and to continually strive to improve environmental performance in association with applicable industry initiatives and believes that its operations are in substantial compliance with applicable requirements of environmental laws. From time to time, the Company may be subject to environmental regulatory enforcement under various statutes, resolution of which typically involves the establishment of compliance programs. At December 31, 1993, the Company has accrued approximately $2 million in respect of environmental cleanup matters, principally related to one Superfund site in Indiana where the Company, as a result of former operations, has been named as a PRP. Such accrual does not reflect any amounts which the Company could potentially recover from insurers or other third parties and is near the upper end of the range of the Company's estimate of reasonably possible costs for such matters. The imposition of more strict standards or requirements under environmental laws or regulations, new developments or changes in site cleanup costs or allocations of such costs could result in expenditures in excess of amounts currently estimated to be required for such matters. NL and Tremont. In addition to litigation referred to above, certain other information relating to regulatory and environmental matters pertaining to NL and Tremont is included in Item 1 - "Business - Unconsolidated Affiliates - - NL and Tremont" of this Annual Report on Form 10- K. Concentrations of credit risk Amalgamated sells refined sugar primarily in the North Central and Intermountain Northwest regions of the United States. Amalgamated does not believe it is dependent upon one or a few customers; however, major food processors are substantial customers and represent an important portion of refined sugar segment sales. Amalgamated's ten largest customers accounted for about one-third of its sales in each of the past three years. Medite's sales are made primarily to wholesalers of building materials located principally in the western United States, the Pacific Rim, Europe and Mexico. In each of the past three years, Medite's ten largest customers accounted for approximately one-fourth of its sales with eight of such customers in each year located in the U.S. Sybra's approximately 160 Arby's restaurants are clustered in four regions, principally Texas, Michigan, Pennsylvania and Florida. All fast food sales are for cash. National Cabinet Lock's sales are primarily in the U.S. and Canada. In each of the past three years, National Cabinet Lock's ten largest customers accounted for approximately one-third of its sales with at least seven of such customers in each year located in the U.S. Operating leases The Company leases various fast food retail and other facilities and equipment. Most of the leases contain purchase and/or various term renewal options at fair market values. In most cases the Company expects that, in the normal course of business, leases will be renewed or replaced by other leases. Net rent expense was $5.6 million in 1991, $5.7 million in 1992 and $5.8 million in 1993. Contingent rentals based upon gross sales of individual fast food restaurants were less than 10% of total rent expense in each of the past three years. At December 31, 1993, substantially all future minimum payments under noncancellable operating leases having an initial or remaining term of more than one year relate to fast food restaurant facilities. Capital expenditures At December 31, 1993, the estimated cost to complete capital projects in process approximated $36 million, including $23.5 millon related to an expansion of Medite/Europe's medium density fiberboard plant. Medite/Europe has entered into certain forward currency contracts to hedge exchange rate risk on the equivalent of approximately $4 million of equipment purchase commitments related to its plant expansion. At December 31, 1993, the fair value of such currency contracts approximated the contract amount. Timber cutting contracts Deposits are made on timber cutting contracts with public and private sources from which Medite obtains a portion of its timber requirements. Medite records only the cash deposits and advances on these contracts because it does not obtain title to the timber until it has been harvested. At December 31, 1993, timber and log purchase obligations aggregated approximately $13.5 million under agreements expiring principally in 1994. Royalties Royalty expense, substantially all of which relates to fast food operations, was $3.6 million in 1991, $4.2 million in 1992 and $4.5 million in 1993. Fast food royalties are paid to the franchisor based upon a percentage of gross sales, as specified in the franchise agreement related to each individual store. Income taxes The Company is undergoing examinations of certain of its income tax returns, and tax authorities have or may propose tax deficiencies. The Company believes that it has adequately provided accruals for additional income taxes and related interest expense which may ultimately result from such examinations and believes that the ultimate disposition of all such examinations should not have a material adverse effect on its consolidated financial position, results of operations or liquidity. NL is undergoing examinations of certain of its income tax returns in various U.S. and non-U.S. jurisdictions, including Germany, and tax authorities have or may propose tax deficiencies. The Company understands that NL believes that it has adequately provided accruals for additional income taxes and related interest expense which may ultimately result from such examinations and believes that the ultimate disposition of all such examinations should not have a material adverse effect on its consolidated financial position, results of operations or liquidity. NOTE 21 - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED): {THIS PAGE INTENTIONALLY LEFT BLANK.} REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and Board of Directors of Valhi, Inc.: Our report on the consolidated financial statements of Valhi, Inc. and Subsidiaries as of December 31, 1992 and 1993 and for each of the three years in the period ended December 31, 1993 is herein included on this Annual Report on Form 10-K. As discussed in Notes 1 and 18 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes in accordance with Statements of Financial Accounting Standards ("SFAS") Nos. 106 and 109, respectively, and in 1993 changed its method of accounting for certain investments in debt and equity securities in accordance with SFAS No. 115. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page of this Annual Report on Form 10-K. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. We did not audit the financial statements of the refined sugar (The Amalgamated Sugar Company) and forest products (Medite Corporation) subsidiaries constituting approximately 48% and 59% of consolidated assets as of December 31, 1992 and 1993, respectively, and approximately 81%, 81% and 77% of consolidated net sales for the years ended December 31, 1991, 1992 and 1993, respectively. These statements were audited by other auditors whose reports thereon were furnished to us and our opinion expressed herein, insofar as it relates to amounts included for such subsidiaries, is based solely upon their reports. In our opinion, based upon our audits and the reports of other auditors, 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 Dallas, Texas February 25, 1994 S-1 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholder of The Amalgamated Sugar Company: Under date of January 28, 1994, we reported on the consolidated balance sheets of The Amalgamated Sugar Company as of December 31, 1992 and 1993, and the related consolidated statements of income and shareholder's equity and cash flows for each of the three years in the period ended December 31, 1993 (not presented separately herein). In connection with our audits of the aforementioned consolidated financial statements, we also audited consolidated financial statement schedules V, VI, VIII, IX and X (not presented separately herein). These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such 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 Salt Lake City, Utah January 28, 1994 S-2 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholder of Medite Corporation: We have audited in accordance with generally accepted auditing standards the consolidated financial statements (not presented separately herein) of Medite Corporation as of December 31, 1992 and 1993 and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 28, 1994. As discussed in Note 8 to the consolidated financial statements (not presented separately herein), in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes in accordance with Statements of Financial Accounting Standards Nos. 106 and 109, respectively. Our audits of the financial statements were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules V, VI, VIII and X (not presented separately herein) 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 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. Portland, Oregon, January 28, 1994 S-3 VALHI, INC. AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES (1) DECEMBER 31, 1993 (IN THOUSANDS) (1) The Company adopted SFAS No. 115 effective December 31, 1993. (2) Valhi's Liquid Yield Option Notes are exchangeable for the Company's Baroid common stock at the option of the LYONs holders. The carrying value of the Baroid common stock is therefore limited to the accreted value of the LYONs obligation. S-4 VALHI, INC. AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (IN THOUSANDS) This schedule omits income tax accruals and payments resulting from inclusion of the Registrant and its qualifying subsidiaries in Contran's consolidated U.S. federal income tax return and other amounts arising in the ordinary course of business. S-5 VALHI, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS DECEMBER 31, 1992 AND 1993 (IN THOUSANDS) S-6 VALHI, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) CONDENSED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) S-7 VALHI, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) CONDENSED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) S-8 VALHI, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) CONDENSED STATEMENTS OF CASH FLOWS (CONTINUED) YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) S-9 VALHI, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) NOTES TO CONDENSED FINANCIAL INFORMATION NOTE 1 - BASIS OF PRESENTATION: The Consolidated Financial Statements of Valhi, Inc. and Subsidiaries are incorporated herein by reference. Condensed financial information for all periods presented is classified based on the Company's organizational structure as of December 31, 1993, and certain prior year amounts have been reclassified to conform with the 1993 presentation. NOTE 2 - MARKETABLE SECURITIES: The Company adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" as of December 31, 1993 and classified its portfolio of U.S. Treasury securities as trading securities, and its Baroid common stock as securities available-for-sale. Cost of the U.S. Treasury securities at December 31, 1993 was approximately $28.6 million. At December 31, 1993, Valhi held 13.7 million Baroid shares (cost - $44.3 million) with a quoted market price of $8.25 per share, or an aggregate of $112.8 million. However, because the Baroid common stock is exchangeable for the Company's LYONs at the option of the LYONs holder (see Note 3), the carrying value of the Baroid stock is limited to the accreted LYONs obligation. In January 1994, Baroid and Dresser merged and each share of Baroid common stock was exchanged for .4 shares of Dresser common stock. As a result, the LYONS became exchangeable for the 5.5 million Dresser shares now held by the Company, which shares represent approximately 3% of Dresser's outstanding common stock. S-10 NOTE 3 - LONG-TERM DEBT: The zero coupon Senior Secured LYONs, $379 million principal amount at maturity in October 2007, were issued with significant original issue discount ("OID") to represent a yield to maturity of 9.25%. No periodic interest payments are required. Each $1,000 in principal amount at maturity of the LYONs is exchangeable, at any time, for 14.4308 shares of Dresser common stock held by the Company (see Note 2). The LYONs are redeemable at the option of the holder in October 1997 or October 2002 at the issue price plus accrued OID through such purchase date. Such redemptions may be paid, at Valhi's option, in cash, Dresser common stock, or a combination thereof. The LYONs are not redeemable at Valhi's option prior to October 1997 unless the market price of Dresser common stock exceeds $35.70 per share for specified time periods. The LYONs are secured by the 5.5 million shares of Dresser common stock held by Valhi, which shares are held in escrow for the benefit of holders of the LYONs. Valhi receives the regular quarterly dividend (currently $.17 per quarter) on the escrowed Dresser shares. Aggregate maturities of long-term debt at December 31, 1993 The LYONs are reflected in the above table as due in October 1997, the first of the two dates they are redeemable at the option of the holder, at the redemption price on such date of $404.84 per $1,000 principal amount at maturity. S-11 NOTE 4 - INVESTMENT IN AND ACCOUNTS WITH SUBSIDIARIES AND AFFILIATES: NOTE 5 - EQUITY IN EARNINGS OF SUBSIDIARIES AND IN LOSSES OF AFFILIATES: S-12 NOTE 6 - DIVIDENDS FROM SUBSIDIARIES AND AFFILIATES: Dividends from Valcor in 1993 include (1) $60 million from the proceeds of new borrowings under Medite's Timber Credit Agreement and (ii) $75 million from the proceeds of Valcor's Senior Notes Due 2003. NL and Tremont each suspended dividends during 1992. NOTE 7 - CASH RECEIVED FOR INCOME TAXES: NL and Tremont are separate U.S. taxpayers and are not members of the Contran Tax Group. S-13 NOTE 8 - INCOME TAXES: The components of the provision for income tax benefit (expense) attributable to income (loss) before extraordinary items and cumulative effect of changes in accounting principles are presented below. The components of the net deferred tax asset at December 31, 1992 and 1993 are summarized below. S-14 NOTE 9 - CHANGES IN ACCOUNTING PRINCIPLES: Marketable securities (SFAS No. 115). The Company, NL and Tremont each elected early compliance with SFAS No. 115 effective December 31, 1993. The cumulative effect of this change in accounting principle is shown in the table below. The amounts attributable to the Company's investment in NL and Tremont consist of the Company's equity in the respective amounts reported by NL and Tremont. OPEB (SFAS No. 106) and income taxes (SFAS No. 109). The Company, NL and Tremont each elected (i) early compliance with both SFAS No. 106 and SFAS No. 109 as of January 1, 1992; (ii) to apply SFAS No. 109 prospectively and not restate prior years; and (iii) immediate recognition of the OPEB transition obligation. The cumulative effect of these changes in accounting principles adjustment is shown in the table below. The amounts attributable to the Company's investments in NL and Tremont consist of the Company's equity in the respective historical amounts reported by NL and Tremont and, pursuant to SFAS No. 109, applicable adjustment of certain of the Company's purchase accounting basis differences originally recorded net-of-tax at rates differing from current rates. S-15 VALHI, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY AND EQUIPMENT (IN THOUSANDS) (a) Adjustment of carrying value resulting from adoption of SFAS No. 109. (b) A 1992 business combination accounted for by the purchase method, and reclassifications. S-16 VALHI, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY AND EQUIPMENT (CONTINUED) (IN THOUSANDS) (a) Adjustment of carrying value resulting from adoption of SFAS No. 109. S-17 VALHI, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT (IN THOUSANDS) (a) Reclassifications. S-18 VALHI, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) S-19 VALHI, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (IN MILLIONS, EXCEPT PERCENTAGES) (a) Based upon average daily balances. (b) Computed using actual interest charges as a percent of the average amount outstanding during the year. S-20 VALHI, INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (IN THOUSANDS) S-21

705752_1993.txt

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1993

705752

ITEM 1. BUSINESS. Century Properties Fund XIX (hereinafter referred to either as "Fund", "Partnership" or "Registrant") was organized in August 1982, as a California limited partnership under the Uniform Limited Partnership Act of the California Corporations Code. Fox Partners II, a California general partnership, is the general partner of the Fund. The general partners of Fox Partners II are Fox Capital Management Corporation ("Fox"), a California corporation, Fox Realty Investors ("FRI"), a California general partnership, and Fox Partners 83, a California general partnership. The Fund's Registration Statement, filed pursuant to the Securities Act of 1933 (No. 2-79007), was declared effective by the Securities and Exchange Commission on September 20, 1983. Registrant marketed its securities pursuant to its Prospectus dated September 20, 1983, which was amended on June 13, 1984, and thereafter supplemented (hereinafter the "Prospectus"). This Prospectus was filed with the Securities and Exchange Commission pursuant to Rule 424(b) of the Securities Act of 1933. The principal business of the Fund is and has been to acquire, hold for investment and ultimately sell income-producing multi-family residential properties. The Fund is a "closed" limited partnership real estate syndicate formed to acquire multi-family residential properties. Beginning in September 1983 through October 1984, the Fund offered $90,000,000 in Limited Partnership Units and sold $89,292,000. The net proceeds of this offering were used to acquire thirteen income-producing real properties. The Fund's original property portfolio was geographically diversified with properties acquired in seven states. The Fund's acquisition activities were completed in June 1985 and since then the principal activity of the Fund has been managing its portfolio. One property was sold in each of the years, 1988, 1992 and 1993 and in February 1994. In addition one property was foreclosed on in 1993. See Item 2 ITEM 2. PROPERTIES. A description of the multi-family residential properties in which the Fund has or has had an ownership interest is as follows: All Registrant's properties are or were owned in fee. See the financial statements in Item 8 for information regarding any encumbrances to which the properties of the Fund are subject. An occupancy summary is set forth on the chart following: CENTURY PROPERTIES FUND XIX OCCUPANCY SUMMARY AVERAGE OCCUPANCY RATE(%) FOR THE YEAR ENDED DECEMBER 31, 1993 1992 1991 Wood Lake Apartments . . . . . . . . . 91 92 89 Greenspoint Apartments . . . . . . . . 97 94 93 Sandspoint Apartments . . . . . . . . . 90 91 91 Wood Ridge Apartments . . . . . . . . . 94 92 90 Plantation Crossing Apartments . . . . 97 97 96 Plantation Forest Apartments . . . 94 95 95 Sunrunner Apartments . . . . . . . . . 91 92 92 McMillan Place Apartments . . . . . . . 93 93 93 Misty Woods Apartments . . . . . . . . 93 95 93 Parkside Village Apartments . . . 95 95 95 The Cove Apartments . . . . . . . - - 88 Property was sold in May 1993. 1993 average occupancy rate covers the periods from January 1993 through May 1993. Placed into receivership in 1992 and acquired by lender through foreclosure in July 1993. Property was sold in February 1994. NET PROJECT OPERATIONS INTRODUCTION The Net Project Operations tables reflect the components of net project operations for each property in which the Fund had an ownership interest that was included in the Fund's Consolidated Financial Statements for the years then ended. Net project operations should not be considered as an alternative to net loss (as presented in the consolidated financial statements) as an indicator of the Fund's operating performance or to cash flows as a measure of liquidity. The tables present: Project operations are the rental revenues less operating expenses (subtotal) less the related debt service (principal and interest on an accrual basis, excluding deferred interest). Net project operations are the amounts that were included in the consolidated statements of operations in Item 8, except that net project operations are net of principal reductions (exclusive of balloon payments). To determine net project operations, project operations may have been adjusted for the following items: Decreased for amortization of notes payable discount. Decreased for deferred interest recognized as an interest expense in the Consolidated Statements of Operations. A reconciliation of Net Project Operations to Loss Before Extraordinary Item is included. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Fund is a party or to which any of its assets are 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 period covered by this Report. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S EQUITY AND RELATED SECURITY HOLDER MATTERS. The Limited Partnership Unit holders are entitled to certain distributions as provided in the Partnership Agreement. No market for Limited Partnership Units exists, nor is expected to develop. For Unit Holders, distributions from operations to date have been approximately $25 for each $1,000 of original investment. As of December 31, 1993, the approximate number of holders of Limited Partnership Units was as follows: NUMBER OF RECORD TITLE OF CLASS HOLDERS* Limited Partnership Units 9,395 *Number of Investments. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following represents selected financial data for the Fund for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. The data should be read in conjunction with the consolidated financial statements included elsewhere herein. This data is not covered by the independent auditors' report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This Item should be read in conjunction with Consolidated Financial Statements and other Items contained elsewhere in this Report. RESULTS OF OPERATIONS In 1993, some of the Fund's properties experienced an improvement in operations as a result of slight increases in the rental and lease rates due, in part, to improvements in the local economies in which the properties operate. However, the operating results of certain of the Fund's properties continue to be affected by highly competitive market conditions combined with the continued sluggish economy. Markets in some areas remained depressed due, in part, to overbuilding which continued to depress rental rates at some of the Fund's properties. Markets in which the Fund's properties are located are discussed below: Phoenix The Phoenix economy remains stable. It is anticipated that several companies will be relocating to the area causing increased economic growth. Construction continues to decline, allowing absorption of vacant apartment units and rental rate increases. Occupancy increased and rental revenue improved at Greenspoint Apartments due to selective rental rate increases. Occupancy and revenue remained stable at Sandspoint Apartments. St. Petersburg/Tampa The recession still lingers within the St. Petersburg/Tampa economy. The defense cutbacks and the partial closing of MacDill Airforce Base have kept job growth to a minimum. However, job growth is expected to come from corporate relocations to the area due to lower rents and cost of living. The apartment market is competitive, resulting in stable occupancy and operations at Sunrunner Apartments. Dallas The Dallas economy is relatively diversified; however, the recession still lingers where continued defense cutbacks have slowed the growth in employment. These job losses were partially offset by major corporations relocating to the area near the Dallas/Fort Worth International Airport causing a recent increase in economic growth in certain submarkets. The apartment market remains competitive due to affordability of new single family homes and recent job losses as described above. Occupancy at McMillan Place Apartments remained stable and selective rental rate increases were implemented during the year due, in part, to a strong submarket. Atlanta Atlanta's economy appears to be recovering although it remains very weak. Relocating corporations, the 1996 Summer Olympic Games, health services and the Fighter contract awarded to Lockheed are expected to be major sources of job growth. In addition, UPS has relocated its headquarters to Atlanta. The apartment market remains competitive due to oversupply of available rental units. However, curtailment of apartment construction and continued corporate migration combined with a decline in single family home construction are expected to increase occupancy in the next year. The Partnership's properties operate in competitive submarkets. However, occupancy and rental revenue were relatively stable at Wood Lake, Plantation Forest, Plantation Crossing and Wood Ridge Apartments. Charlotte The economy is slowly recovering due to job losses in the dominant manufacturing industry. However, these job losses were offset, in part, by job growth in health care and financial services industries as Charlotte continues its transition from a manufacturing economy to a service economy. Abatement of construction in some areas has allowed occupancy to stabilize. However, the market remains competitive and rental concessions are common. Occupancy and operations at Misty Woods Apartments have remained stable. 1993 Compared to 1992 Loss before extraordinary item decreased $5,624,000 in 1993 compared to 1992 primarily due to the $3,846,000 provision for impairment of value and loss on sale recognized in 1992 and to a decrease in interest, operating and depreciation expenses, offset, in part, by decreased rental revenues, due to the sale of Parkside Village Apartments and the foreclosure of The Cove Apartments in 1993, and the sale of the Shadow Lake Apartments in December 1992. The decrease in rental revenue was offset, in part, by the increased rental revenue at certain of the Fund's properties due to increased occupancy. In addition, the decrease in interest expense is also due to lower interest rates obtained from the replacement financing of the Sandspoint and Greenspoint Apartments in June 1992 and Wood Lake, Wood Ridge and Plantation Crossing Apartments in June 1993 which is offset, in part, by the prepayment penalties paid in connection with the Wood Lake, Wood Ridge and Plantation Crossing Apartments refinancing. General and administrative expenses increased due to financing costs incurred in 1993 on refinancings which were not finalized. The gain on sale of property of $576,000 relates to the sale of Parkside Village Apartments and the loss on sale of $44,000 relates to the foreclosure of The Cove Apartments. 1992 Compared to 1991 Loss before extraordinary item increased $3,053,000 in 1992 compared to 1991 primarily due to the $1,694,000 and $1,895,000 provisions for impairment of value recognized in 1992 on The Cove Apartments and Parkside Village Apartments, respectively, and the $257,000 loss on sale of Shadow Lake Apartments recognized in 1992. Rental revenues, operating expenses and interest expenses decreased, in part, as a result of cessation of recording the operating results of Shadow Lake and The Cove Apartments since these properties were placed into receivership in 1992; however, operating expenses increased at most of the remaining properties. Depreciation expense decreased due to depreciation no longer being recorded on Shadow Lake and The Cove Apartments when a receiver was placed on the properties. Interest and other income decreased due to a decrease in interest rates and cash available for investments. The $7,022,000 extraordinary item - gain on extinguishment of debt recognized in 1992 relates to the debt -forgiveness by the lenders from the sale of Shadow Lake Apartments and the refinancing on Sandspoint and Greenspoint Apartments in 1992. FUND LIQUIDITY AND CAPITAL RESOURCES Introduction The results of project operations are determined by rental revenues less operating expenses (exclusive of depreciation and amortization) and debt service (see Item 2, Properties). Seven of the Fund's ten properties operating during all or part of 1993 generated positive project operations while Parkside Village, McMillan Place and Misty Woods Apartments experienced negative project operations. The Fund, after taking into account results of project operations, interest and other income and general and administrative expenses, incurred negative results from operations for the period, as defined herein. Negative results are also anticipated to occur in 1994. Cash distributions from operations were suspended since 1987. It is anticipated that cash distributions will remain suspended in 1994. Net project operations should not be considered as an alternative to net loss (as presented in the consolidated financial statements) as an indicator of the Fund's operating performance or to cash flows as a measure of liquidity. As presented in the Consolidated Statement of Cash Flows, cash was used by operating activities. Cash was provided by investing activities from proceeds from sale of rental property and used for additions and improvements to rental properties, an increase in restricted cash and cost of sale of rental property. Cash was used by financing activities primarily for notes payable principal payments and repayments of notes payable to affiliate of the general partner and provided primarily by notes payable proceeds on the refinancing of Wood Lake, Wood Ridge and Plantation Crossing Apartments. As a result of scheduled pay rate increases in 1990 in accordance with the Greenspoint and Sandspoint Apartments debt modification agreements, the Fund approached the lender on these notes requesting further debt relief or a discounted prepayment on the loans. The Fund received approval from the lender for discounted prepayments. The discounted prepayments were contingent upon receiving proceeds from replacement financing on the properties, which the Fund obtained in June 1992, as discussed in Note 7 to the consolidated financial statements. The Fund had been negotiating debt modification or a discounted payoff with the lender of the loan on Shadow Lake Apartments but was unsuccessful. In an effort to obtain debt modification, the Fund did not make the June 1992 debt service payment. The lender issued a notice of default and placed a receiver on the property on July 31, 1992. As discussed in Note 7 to the consolidated financial statements, the property was sold in December 1992. The net loss on sale was $257,000. The total consideration for the property was $11,724,000, including mortgage financing of $8,000,000 when acquired in November 1983. The Fund approached the lender on McMillan Place Apartments requesting an extension of the modification agreement which expired in October 1991 and, as discussed in Note 4 to the consolidated financial statements, finalized an agreement in July 1992. The Fund borrowed an additional $291,000 in 1993 from an affiliate of the general partner to provide cash for working capital needs. The Fund repaid $1,309,000 in principal and $86,000 in interest to an affiliate of the general partner in 1993. As of December 31, 1993 the Partnership had outstanding borrowings of $370,000 from an affiliate of the general partner as discussed in Note 5 to the consolidated financial statements. The Fund had been attempting to refinance the Wood Lake, Wood Ridge and Plantation Crossing Apartments loans in the amount of $6,850,000, $6,371,000 and $4,361,000, respectively, due in 1993 and 1994. As discussed in Note 4 to the consolidated financial statements, the Fund finalized an agreement with a new lender for replacement financing in June 1993. The new financing has a variable interest rate and matures in 1998. A wholly owned subsidiary was formed in October 1992 into which the properties were transferred in June 1993 as a condition of the refinancing. The Fund had not made the debt service payments since July 1992 on The Cove Apartments note payable. Consequently, the lender issued a notice of default and placed a receiver on the property on September 1, 1992. As discussed in Note 8 to the consolidated financial statements, the property was acquired through foreclosure by the first lender in July 1993. The net loss on property disposition after the $1,694,000 provision for impairment of value recognized in 1992 was $44,000. The total consideration for the property was $23,732,000, including mortgage financing of $14,546,000 when acquired in December 1984. The Fund placed Parkside Village Apartments, located in Aurora, Colorado, on the market for sale due to working capital needs for the Fund and continued improvement in the Denver market. As a result, as discussed in Note 8 to the consolidated financial statements, the Fund sold the property in May 1993 for $11,259,000. Net gain on the sale after the provision for impairment of value of $1,895,000 recognized in 1992 was $576,000. A substantial portion of the proceeds received from this sale was used to replenish working capital reserves, pay down the notes due to an affiliate of the general partner and pay down $500,000 on the Sunrunner Apartments note payable which was a condition of the sale of Parkside Village Apartments. The total consideration for the Parkside Village Apartments was $17,262,000, including mortgage financing of $10,000,000 when acquired in November 1983. The two remaining letters of credit on Misty Woods Apartments were scheduled to expire in June 1993. However, the Fund obtained a one year extension to June 1994. Upon expiration the lender will re-evaluate the requirements for such letters of credit, but could determine that all or part of these amounts be drawn to pay down the loan. As discussed in Note 3 to the consolidated financial statements, the Fund has cash reserved for this purpose should payment be required by the lender. The Fund approached the lender of the $5,804,000 first loan on Misty Woods Apartments for debt modification and an extension of the May 1996 maturity date. The lender is currently reviewing the proposal. The Fund has a balloon payment on McMillan Place Apartments of $10,800,000 due in December 1994. To meet this obligation, the Fund is currently negotiating with the lender for debt modification. In October 1993, Greenspoint Apartments sustained flood damage as a result of heavy rainfall. The Fund incurred $45,000 in damage, which was paid for by the Fund's insurance carrier. As discussed in Note 9 to the consolidated financial statements, in February 1994 the Fund sold Plantation Forest Apartments for $2,450,000. The estimated loss on the sale was $149,000 which will be recognized in the first quarter of 1994. Total consideration paid for the property was $3,429,000 including mortgage financing of $1,760,000 when acquired in June 1984. Net proceeds realized from the sale were, in part, used to fully repay the demand notes held by an affiliate of the general partner. In 1993, the Fund spent $658,000 on additions and improvements to properties, the majority of which was spent at Sandspoint, Sunrunner and Wood Ridge Apartments. In 1994, the Fund anticipates spending approximately $781,000 on property additions and improvements, the majority of which will be spent at Sandspoint, Wood Lake, Wood Ridge and McMillan Place Apartments. However, due to the limited cash available only improvements necessary to maintain occupancy or to meet safety requirements will be made in 1994. Conclusion At this time, it appears that the investment objective of capital growth will not be attained and that a significant portion of invested capital will not be returned to investors. The extent to which invested capital is returned to investors is dependent upon the success of the Fund's strategy as set forth herein, as well as upon significant improvement in the performance of the Fund's remaining properties and the markets in which such properties are located and on the sales price of the remaining properties. In this regard, the remaining properties will be held longer than originally expected. The ability to hold and operate these properties is dependent on the Fund's ability to obtain additional financing, refinancing, or debt restructuring as required. Since January 1991, the Fund's working capital reserves have been depleted and insufficient funds have been available to meet ongoing operating requirements. Subsequently, after periodically notifying the general partner of the Fund's need for capital to maintain operations, short-term loans have been obtained from an affiliate of the general partner. A substantial portion of the proceeds received from the sale of Parkside Village Apartments was used to pay down these borrowings. In order to meet capital and operating requirements and to hold and operate its properties, the Fund sold Parkside Village Apartments in May 1993 and Plantation Forest in February 1994 and obtained refinancing on the Wood Lake, Wood Ridge and Plantation Crossing Apartments. Proceeds received from the sale were used to replenish working capital reserves, pay off the notes payable to an affiliate of the general partner and pay down the Sunrunner Apartments note payable. If the Fund is unable to obtain additional debt modification or refinancing, the Fund may be required to dispose of additional properties now operating at a deficit or with significant balloon payments, through sale or transfer to lenders. The Fund believes this strategy, combined with cash generated from the Fund's properties with positive operations, will allow the Partnership to meet its capital and operating requirements. Although inflation impacts the Fund's expenses, the Fund has the ability to attempt to offset expense increases through rent increases. It is impossible to predict the future impact of inflation on the operations of the Fund's properties, the Fund's ability to successfully pass increased costs through to tenants or the impact of inflation on the ultimate sales price of remaining properties. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. CENTURY PROPERTIES FUND XIX (A LIMITED PARTNERSHIP) PAGE Independent Auditors' Report 15 Consolidated Financial Statements: Balance Sheets at December 31, 1993 and 1992 16 Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 17 Statements of Partners' Equity (Deficiency) for the Years Ended December 31, 1993, 1992 and 1991 18 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 19 Notes to Consolidated Financial Statements 20 Financial Statement Schedules: Schedule X - Consolidated Statements of Operations Information for the Years Ended December 31, 1993, 1992 and 1991 26 Schedule XI - Real Estate and Accumulated Depreciation at December 31, 1993 27 Consolidated financial statements and financial statement schedules not included have been omitted because of the absence of conditions under which they are required or because the information is included elsewhere in the consolidated financial statements. INDEPENDENT AUDITORS' REPORT Century Properties Fund XIX: We have audited the consolidated financial statements of Century Properties Fund XIX (a limited partnership) ("Partnership") and its wholly- owned subsidiaries listed in the accompanying table of contents. Our audits also included the financial statement schedules of the Partnership listed in the accompanying table of contents. These financial statements and financial statement schedules are the responsibility of the Partnership'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 the Partnership 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 shown therein. The accompanying consolidated financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Partnership has experienced negative cash flow from operations and has a balloon payment of $10,800,000 due in December 1994, which raises substantial doubt about the Partnership's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. DELOITTE & TOUCHE San Francisco, California March 18, 1994 CENTURY PROPERTIES FUND XIX (A LIMITED PARTNERSHIP) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization - Century Properties Fund XIX ("Partnership") is a limited partnership organized under the laws of the State of California to acquire, hold for investment, and ultimately sell income-producing real estate. The general partner of the Partnership is Fox Partners II, a California general partnership. The general partners of Fox Partners II are Fox Capital Management Corporation ("Fox", formerly known as Fox & Carskadon Financial Corporation), a California corporation, Fox Realty Investors ("FRI") (formerly known as Century Partners), a California general partnership, and Fox Partners 83, a California general partnership. The capital contributions of $89,292,000 ($1,000 per unit) were made by the limited partners, including 100 Limited Partnership Units purchased by Fox. On December 6, 1993, NPI Equity Investments II, Inc. ("NPI Equity II") became the managing partner of FRI and acquired voting control and assumed operational control over Fox. As a result, NPI Equity II became responsible for the operation and management of the business and affairs of the Partnership. Basis of Presentation and Operating Strategy - The accompanying consolidated financial statements have been prepared on a going concern basis which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Partnership, after taking into account accrued but unpaid interest on certain notes payable for which the Partnership had suspended debt service payments, has experienced cash flow deficiencies during recent years. At December 31, 1993, the Partnership had borrowed a total of $370,000 from affiliates of the general partner for working capital needs. The Partnership holds investments in and operates properties in real estate markets that are experiencing unfavorable economic conditions. Many of the Partnership's properties are or were located in oil industry related and other weakened markets and have experienced operating difficulties. In addition, markets in some areas remained depressed due in part to overbuilding which continued to depress residential rental rates. The level of sales of existing properties have been affected by the limited availability of financing in real estate markets. As disclosed in Note 4, the Partnership has a balloon payment of $10,800,000 on McMillan Place Apartments due in December 1994. To meet this obligation the Partnership is negotiating with the lender for an extension and modification of the loan. The Partnership's ability to hold and operate its remaining properties is dependent on obtaining refinancing or debt restructuring as required. If the Partnership is unable to obtain debt modification or refinancing, it is likely that dispositions of properties now operating at a deficit or with significant balloon payments will occur through sale, foreclosure or transfer to the lenders. The Partnership sold Plantation Forest in February 1994 and with the proceeds from the sale paid off the remaining loans from an affiliate of the general partner. The Partnership believes this strategy, combined with cash generated from the Partnership's properties with positive operations are expected to allow the Partnership to meet its capital and operating requirements. The outcome of these uncertainties cannot presently be determined. The consolidated financial statements do not include any adjustments that might result from the ultimate outcome of these uncertainties. Distributions - Cash distributions have been suspended since 1987. It is anticipated that cash distributions will remain suspended in 1994. Consolidation - The consolidated financial statements include the statements of the Partnership and its wholly owned subsidiaries, one of which was formed in April 1992 into which Sandspoint and Greenspoint Apartments were transferred. Another subsidiary was formed in October 1992 into which Wood Lake, Wood Ridge and Plantation Crossing Apartments were transferred in June 1993. An additional subsidiary was formed in May 1993 into which Sunrunner Apartments was transferred. All significant intercompany transactions and balances have been eliminated. New Accounting Pronouncements - In December 1991, the Financial Accounting Standards Board (FASB) issued Statement No. 107, "Disclosures About Fair Value of Financial Instruments". This Statement will not affect the financial position or results of operations of the Partnership but will require additional disclosure on the fair value of certain financial instruments for which it is practicable to estimate fair value. Disclosures under this statement will be required in the 1995 financial statements. Cash and Cash Equivalents - The Partnership considers cash investments, principally commercial paper, with an original maturity date of three months or less at the time of purchase to be cash equivalents. Rental Properties - Rental properties are stated at cost. A provision for impairment of value is recorded when a decline in value of property is determined to be other than temporary as a result of one or more of the following: (1) a property is offered for sale at a price below its current carrying value, (2) a property has significant balloon payments due within the foreseeable future for which the Partnership does not have the resources to meet, anticipates it will be unable to obtain replacement financing or debt modification sufficient to allow a continued hold of the property over a reasonable period of time, (3) a property has been, and is expected to continue, generating significant operating deficits and the Partnership is unable or unwilling to sustain such deficit results of operations, and has been unable to, or anticipates it will be unable to, obtain debt modification, financing or refinancing sufficient to allow a continued hold of the property for a reasonable period of time or, (4) a property's value has declined based on management's expectations with respect to projected future operational cash flows and prevailing economic conditions. An impairment loss is indicated when the undiscounted sum of estimated future cash flows from an asset, including estimated sales proceeds, and assuming a reasonable period of ownership up to five years, is less than the carrying amount of the asset. The impairment loss is measured as the difference between the estimated fair value and the carrying amount of the asset. In the absence of the above circumstances, rental properties and improvements are stated at cost. Depreciation - Depreciation is computed by the straight-line method over estimated useful lives of 30 years for buildings and improvements and six years for furnishings. Properties for which a provision for impairment of value has been recorded and are expected to be disposed of within the next year are not depreciated. Properties in Receivership - When a property has been placed in receivership and the Partnership does not expect to regain control of such property, the Partnership no longer records operating revenues and expenses, depreciation or other non cash expenses subsequent to the date of receivership. In addition, interest is no longer accrued on such property's notes payable as the Partnership does not expect to pay such interest. Deferred Financing Costs - Financing costs are deferred and amortized over the lives as interest expense of the related loans, which range from three to ten years, or expensed if financing is not obtained. Net Loss Per Limited Partnership Unit - The net loss per limited partnership unit is computed by dividing the net loss allocated to the limited partners by 89,292 units outstanding. Income Taxes - No provision for Federal and state income taxes has been made in the consolidated financial statements because income taxes are the obligation of the partners. Reclassification - Certain amounts have been reclassified to conform to the 1993 presentation. 2. TRANSACTIONS WITH THE GENERAL PARTNER AND AFFILIATES In accordance with the Partnership Agreement, the Partnership may be charged by the general partners and affiliates for services provided to the Partnership. From March 1988 to December 1992 such amounts were assigned pursuant to a services agreement by the general partner and affiliates to Metric Realty Services, L.P., which performed partnership management and other services for the Partnership. On January 1, 1993, Metric Management, Inc., a company which is not affiliated with the general partner, commenced providing certain property and portfolio management services to the Partnership under a new services agreement. As provided in the new services agreement effective January 1, 1993, no reimbursements were made to the general partner and affiliates during 1993. Subsequent to December 31, 1992, reimbursements were made to Metric Management, Inc. On December 16, 1993, the services agreement with Metric Management, Inc. was modified and, as a result thereof, the Partnership's general partner assumed responsibility for cash management of the Partnership as of December 23, 1993 and assumed responsibility for day-to-day management of the Partnership's affairs, including portfolio management, accounting and investor relations services as of April 1, 1994. In addition, interest was charged on borrowings from affiliates of the general partner to the Partnership. Related party expenses are as follows: 1993 1992 1991 Property management fees $ - $ 886,000 $ 878,000 Reimbursement of operational expenses: Accounting - 269,000 269,000 Investor services - 66,000 41,000 Professional services - 39,000 44,000 ------ ---------- ---------- Total $ - $1,260,000 $1,232,000 ====== ========== ========== Interest expense $57,000 $69,000 $26,000 ======= ======= ======= In accordance with the Partnership Agreement, the general partner received a Partnership management incentive allocation equal to ten percent of net and taxable income (losses) before gains on property dispositions. The general partner was also allocated its two percent continuing interest in the Partnership's net and taxable income (loss) after the preceding allocation. The general partner is also allocated gain on property dispositions to the extent it is entitled to receive distributions and then 12 percent of remaining gain. 3. RESTRICTED CASH Restricted cash at December 31, 1993 represents $160,000 in restricted tenant security deposits, $700,000 required to be maintained in accordance with the new financing agreement on Wood Lake, Wood Ridge and Plantation Crossing Apartments in order to meet future capital requirements, and $656,000 security for letters of credit totalling $600,000 which the Partnership provided the lender in connection with the purchase of Misty Woods Apartments. These letters of credit may be drawn upon by the lender under certain conditions. They are subject to annual review and renewal by the lender, and will be released upon satisfaction of the conditions per the agreement, principally the attainment of certain rental income levels at the property. The letters of credit were due June 15, 1993. However, the Partnership obtained an extension for an additional year to June 1994. Upon expiration the lender will re-evaluate the requirements for such letters of credit, but could determine that all or part of these amounts be drawn on to pay down the loan. Restricted cash of $656,000 has been invested in commercial paper and matured in January 1994 at an interest rate of 3.35 percent per annum. 4. NOTES PAYABLE Individual rental properties are pledged as collateral for the related notes payable. Interest rates range from 7.6 percent to 10.9 percent at December 31, 1993. Generally, the difference between the pay rates and contract rates was accrued and bore interest at the contract rate. The notes are generally payable monthly, mature between 1994 and 1998 and require balloon payments. Plantation Forest Apartments was sold in February 1994 and the related note payable was paid at sale. See Note 9. After reflecting the property sale as discussed above, principal payments at December 31, 1993 are required as follows: 1994 $13,562,000 1995 17,611,000 1996 6,083,000 1997 3,536,000 1998 19,077,000 ----------- Total $59,869,000 =========== Amortization of the deferred financing costs totalled $349,000, $256,000 and $213,000 for 1993, 1992 and 1991, respectively. The Fund approached the lender on McMillan Place Apartments requesting an extension of the current modification agreement which expired in October 1991 and finalized an agreement in July 1992. Monthly interest only payments will be made at 9.625 percent per annum from October 1, 1991 through November 1992, 10.250 percent from December 1992 through November 1993 and 10.875 percent from December 1993 through the loan's maturity date of December 1, 1994. The difference between the contract rate of 10.875 percent per annum and the modified pay rate is deferred and accrues interest at the contract rate. The Fund has a balloon payment on McMillan Place Apartments of $10,800,000 due in December 1994. To meet this obligation, the Fund is negotiating with the lender for debt modification and an extension of the loan. In June 1993 the Partnership finalized an agreement for replacement financing on Wood Lake, Wood Ridge and Plantation Crossing Apartments. The existing notes of $6,850,000, $6,371,000 and $4,361,000, respectively, with contract interest rates ranging from 11.75 percent to 13.98 percent and scheduled to mature in 1993 and 1994, were prepaid. The new loan in the amount of $20,375,000 with a variable interest rate of 4.125 percent over a 90 day LIBOR rate not to exceed 11.50 percent in the first three years, is due in June 1998. The loan interest rate was 7.6 percent at December 31, 1993. The note requires a minimum pay rate ranging from 8.5 percent to 9.5 percent. The difference between the loan interest rate and the minimum pay rate is credited to principal. The new financing agreement requires a $700,000 working capital reserve to be maintained by the Partnership. In connection with this refinancing, the Partnership was required to pay $540,000 in related costs, in addition to $199,000 in prepayment penalties. The agreement also required the Partnership to transfer the properties into a separate wholly owned subsidiary and to cross-collateralize the properties as security for the loan. Prepaid financing costs of $523,000 were refunded in 1993 when the original lender rejected the loan. In connection with the Parkside Village Apartments sale, the note payable on Sunrunner Apartments was paid down by $500,000. 5. NOTES PAYABLE TO AFFILIATE OF THE GENERAL PARTNER The Partnership borrowed an additional $291,000 in 1993 from an affiliate of the general partner to provide cash for working capital needs. The Partnership repaid $1,309,000 in principal and $86,000 in interest to an affiliate of the general partner in 1993. As of December 31, 1993 the Partnership had outstanding borrowings of $370,000 from an affiliate of the general partner to provide cash for working capital needs. These remaining notes bear interest at the prime rate plus one percent (prime rate was six percent at December 31, 1993) and are payable upon demand. Accrued interest payable to an affiliate of the general partner was $65,000 as of December 31, 1993. In February 1994 the Partnership paid off all remaining and outstanding borrowings owed to an affiliate of the general partner. Interest charged on the notes was $57,000, $69,000 and $26,000 for the year ended December 31, 1993, 1992 and 1991, respectively. 6. PROVISION FOR IMPAIRMENT OF VALUE AND LOSS ON SALE In 1992, the Partnership determined that it would allow The Cove Apartments, located in Tampa, Florida to be acquired by the lender through foreclosure. Accordingly, a provision for impairment of value of $1,694,000 was recognized in 1992 to reduce the carrying value of the property based on the estimated economic loss to the Partnership. Carrying value includes the cost of the property less accumulated depreciation and unamortized deferred financing costs. The Partnership had placed Parkside Village Apartments, located in Aurora, Colorado on the market for sale at a price less than its current carrying value. Accordingly, a provision for impairment of value of $1,895,000 was recognized in 1992 to reduce the carrying value based on the estimated economic loss to the Partnership. Carrying value includes cost of the property less accumulation depreciation and unamortized deferred financing costs. In July 1993, the Partnership disposed of The Cove Apartments through foreclosure, as discussed in Note 8, and recognized a $44,000 loss on disposition in 1993. 7. EXTRAORDINARY ITEM - GAIN ON EXTINGUISHMENT OF DEBT In June 1992, the Partnership obtained replacement financing on the Sandspoint and Greenspoint Apartments. The existing notes of $11,750,000 and $10,000,000 with an interest rate of 10 percent at June 30, 1992, which had been due in 1995, were prepaid at a discounted amount totalling $17,721,000. The replacement financing on the Sandspoint and Greenspoint Apartments totalled $9,820,000 and $8,430,000, respectively. In connection with the financing, the Partnership paid $727,000 in refinancing costs. The new financing agreement provides for a variable interest rate at 4.50 percent over a 90 day LIBOR interest rate. The current interest rate is 7.75 percent with a minimum pay rate of 10 percent. The notes will mature in 1995 with an option to extend the maturity date an additional two years. The agreement also required the Fund to transfer the properties into a separate wholly owned subsidiary and to cross-collateralize the properties as security for the loans. The discount amount of $4,029,000 plus accrued interest of $886,000 forgiven by the lender upon prepayment of the original financing, net of unamortized loan fees of $113,000 was recognized by the Partnership as extraordinary item - gain on extinguishment of debt in the 1992 consolidated financial statements. The Partnership had been negotiating debt modification or a discounted payoff with the lender of the loan on Shadow Lake Apartments but was unsuccessful. In an effort to obtain debt modification, the Partnership did not make the June 1992 debt service payment. The lender issued a notice of default and placed a receiver on the property on July 31, 1992. In December 1992, the Partnership sold Shadow Lake Apartments, located in Little Rock, Arkansas for $6,443,000. As part of the sale, a portion of the existing loan in the amount of $6,300,000 was repaid at the time of the sale. The lender forgave the remaining principal balance and accrued interest of $2,330,000. In connection with the property disposition, the Partnership incurred closing costs of $10,000. The net loss on sale was $257,000 which was recognized in 1992. The $2,330,000 amount forgiven by the lender net of unamortized financing costs of $110,000, was recognized as extraordinary item - gain on extinguishment of debt in the 1992 consolidated financial statements. 8. DISPOSITION OF RENTAL PROPERTIES In May 1993, the Partnership sold Parkside Village Apartments, located in Aurora, Colorado for $11,259,000. After payment of the existing loan of $7,667,000 and costs of the sale of $728,000 (including $281,000 real estate commission paid to an outside broker and $400,000 prepayment penalty on the existing loan), the net proceeds to the Partnership were $2,864,000. The carrying value of the property at the time of sale, net of the $1,895,000 provision for impairment of value recognized in 1992, was $9,955,000. The net gain on the sale was $576,000. In July 1993, the Partnership allowed The Cove Apartments, located in Tampa, Florida, to be acquired through foreclosure by the holder of the first loan. Accordingly, the Partnership was relieved of the first note payable of $16,000,000 (which had been due September 1994), $18,000 in accrued property taxes and $619,000 of accrued and unpaid interest. In addition, the expenses of disposition were $52,000. The carrying value of the property at the time of foreclosure, net of the $1,694,000 provision for impairment of value recognized in 1992, was $16,629,000. The net loss on disposition was $44,000 and was recognized in 1993. See Note 6. 9. SUBSEQUENT EVENT - SALE OF RENTAL PROPERTY In February 1994 the Partnership sold Plantation Forest Apartments, located in Atlanta, Georgia for $2,450,000. After payment of the existing loan of $1,965,000 and expenses of sale of $3,000, the proceeds to the Partnership were $482,000. The estimated loss on the sale of $149,000 will be recognized in the first quarter of 1994. A portion of the proceeds was used to fully repay the remaining and outstanding borrowings owed to an affiliate of the general partner. 10. RECONCILIATION TO INCOME TAX METHOD OF ACCOUNTING The differences between the accrual method of accounting for income tax reporting and the accrual method of accounting used in the consolidated financial statements are as follows: As to items omitted, amounts did not exceed one percent of total revenues. 1. COLUMN A - Description 2. COLUMN B - Encumbrances 3. COLUMN C - Initial cost to Partnership - Land 4. COLUMN C - Initial cost to Partnership - Buildings and Improvements 5. COLUMN D - Cost Capitalized Subsequent to Acquisition - Improvements 6. COLUMN D - Cost Capitalized Subsequent to Acquisition - Carrying Costs 7. COLUMN E - Gross Amount at Which Carried at Close of Period - Land 8. COLUMN E - Gross Amount at Which Carried at Close of Period - Buildings and Improvements 9. COLUMN E - Gross Amount at Which Carried at Close of Period - Total 10. COLUMN F - Accumulated Depreciation 11. COLUMN G - Year of Construction 12. COLUMN H - Date of Acquisition SCHEDULE XI CENTURY PROPERTIES FUND XIX (A LIMITED PARTNERSHIP) REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 NOTES: The aggregate cost for Federal income tax purposes is $91,986,000. Depreciation is computed on lives ranging from six to 30 years. Balance, January 1, 1991 $146,079,000 Improvements capitalized subsequent to acquisition 654,000 ------------ Balance, December 31, 1991 146,733,000 Improvements capitalized subsequent to acquisition 557,000 Cost of rental property disposed of (9,462,000) ------------ Balance, December 31, 1992 137,828,000 Improvements capitalized subsequent to acquisition 658,000 Cost of rental property disposed of (41,050,000) ------------ Balance, December 31, 1993 $ 97,436,000 ============ Balance, January 1, 1991 $ 32,499,000 Additions charged to expense 4,535,000 ------------ Balance, December 31, 1991 37,034,000 Additions charged to expense 3,784,000 Provision for impairment of value 3,589,000 Accumulated depreciation on rental property disposed of (2,772,000) ------------ Balance, December 31, 1992 41,635,000 Additions charged to expense 2,840,000 Accumulated depreciation on rental property disposed of (11,012,000) Allowance for impairment of value on rental properties disposed of (3,589,000) ------------ Balance, December 31, 1993 $29,874,000 =========== 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 Fund has no directors or executive officers. The following are the names and additional information relating to the directors and executive officers of NPI Equity II. On December 6, 1993, NPI Equity II became managing partner of FRI and acquired voting control and assumed operational control of Fox, thereby obtaining management and control of the general partner. By virtue of their positions with NPI Equity II, the listed individuals control the business affairs of the Fund. FRI, Fox and their affiliates, including NPI, serve directly or indirectly as general partner of 30 public partnerships. MICHAEL L. ASHNER (age 41) has been President and a Director of NPI since 1984, President and a Director of NPI Equity II since 1993 and President and a Director of Fox since December 6, 1993. Since 1991, Mr. Ashner has also served as a Director and President of NPI Equity Investments, Inc. ("NPI Equity I"), an affiliate of NPI Equity II, which serves as the general partner of the seven public NPI real estate limited partnerships. In addition, since 1981 Mr. Ashner has been President and sole shareholder of Exeter Capital Corporation, a firm which has organized and administered real estate limited partnerships. He received his A.B. degree cum laude from Cornell University and received a J.D. degree magna cum laude from the University of Miami School of Law, where he was an editor of the law review. Mr. Ashner is a member of the New Jersey, New York and Florida bar associations and is a member of the Executive Council of the Board of Directors of the National Multi Housing Council. MARTIN LIFTON (age 61) has been the Chairman and a Director of NPI since 1991 and NPI Equity II since 1993 and the Chairman and a Director of Fox since December 6, 1993. In addition, since 1991, Mr. Lifton has served as the Chairman and a Director of NPI Equity I. Mr. Lifton is also Chairman and President of Lifton Company, a real estate investment firm. Since entering the real estate business 35 years ago, Mr. Lifton has engaged in a wide range of real estate activities, including the purchase and construction of apartment complexes in the New York metropolitan area and in the southeastern and midwestern United States. Mr. Lifton was also one of the founders of the Bank of Great Neck of which he is Chairman and a major stockholder. Mr. Lifton received his B.S. degree from the New York University School of Commerce where he majored in real estate. ARTHUR N. QUELER (age 47) was a co-founder of NPI, of which he has been Executive Vice President and a Director since 1984. Mr. Queler has also been Executive Vice President and a Director of NPI Equity II since 1993 and of Fox since December 6, 1993. Since 1991, Mr. Queler has been Executive Vice President and a Director of NPI Equity I. In addition, since 1983 Mr. Queler has been President of ANQ Securities, Inc., a NASD registered broker-dealer firm which has been responsible for supervision of licensed brokers and coordination with a nationwide broker-dealer network for the marketing of NPI investment programs. Prior to 1983, Mr. Queler was a managing general partner of Berg Harquel Associates, a real estate syndication firm, in which capacity he was involved in the acquisition, syndication and management of 23 properties. Mr. Queler is a certified public accountant. He received B.B.A. and M.B.A. degrees from the City College of New York. Messrs. Ashner, Lifton and Queler currently are the beneficial owners of all of the outstanding stock of NPI. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Fund does not pay or employ any directors or officers. Compensation to the directors and officers of Fox, the managing general partner of the general partner, and to the partners of FRI, a general partner of the general partner, is paid directly by Fox and FRI, as the case may be. The Fund has not established any plans pursuant to which plan or non-plan compensation has been paid or distributed during the last fiscal year or is proposed to be paid or distributed in the future, nor has the Fund issued or established any options or rights relating to the acquisition of its securities or any plans relating to such options or rights. However, the general partner of the Fund has received and is expected to receive certain allocations, distributions and other amounts pursuant to the Fund's limited partnership agreement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. There is no person known to the Fund who owns beneficially or of record more than five percent of the voting securities of the Fund. Other than the 100 Limited Partnership Units which Fox purchased at or prior to the closing date, the Fund's general partners have not contributed any capital to the Fund. With respect to the ownership of 100 Limited Partnership Units, Fox has the same rights and entitlement as all other limited partners. However, the general partner has discretionary control over most of the decisions made by or for the Fund pursuant to the terms of the Fund's limited partnership agreement. The Fund has no directors or officers. The directors and executive officers of Fox and the partners of FRI, as a group, own less than one percent of the Fund's voting securities. There are no arrangements known to the Fund, the operation of which may, at a subsequent date, result in a change in control of the Fund. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Fund borrowed an additional $291,000 in 1993 from an affiliate of the general partner to provide cash for working capital needs. The Fund repaid $1,309,000 in principal and $86,000 in interest to an affiliate of the general partner in 1993. On December 6, 1993 an affiliate of NPI Equity II purchased the remaining and outstanding loans owed to an affiliate of the general partner. As of December 31, 1993 the Partnership had outstanding borrowings of $370,000 from an affiliate of the general partner to provide cash for working capital needs. These remaining notes bear interest at the prime rate plus one percent (prime rate was six percent at December 31, 1993) and are payable upon demand. In February 1994 the Partnership paid off all remaining and outstanding borrowings owed to an affiliate of the general partner. Interest charged on the notes was $57,000, $69,000 and $26,000 for the year ended December 31, 1993, 1992 and 1991, respectively. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1., 2. and 3. See Item 8 of this Form 10-K for the Financial Statements of the Fund, Notes thereto, and Financial Statement Schedules. (A table of contents to Consolidated Financial Statements and Financial Statement Schedules is included in Item 8 and incorporated herein by reference.) (b) The following report on Form 8-K was required to be filed during the last quarter covered by this Report: DATE OF ITEM MONTH SUCH NUMBERS FILED REPORT REPORTED DESCRIPTION December 12/6/93 1 Changes in Control of Registrant (c) Financial Statement Schedules, if required by Regulation S-K, are included in Item 8. 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. CENTURY PROPERTIES FUND XIX By: FOX PARTNERS II Its General Partner By: FOX CAPITAL MANAGEMENT CORPORATION A General Partner ("FOX") By: /s/ Michael L. Ashner ------------------------ Michael L. Ashner President Date: March 18, 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. By: /s/ Michael L. Ashner By: /s/ Arthur N. Queler ---------------------- ---------------------- Michael L. Ashner Arthur N. Queler President and Director of Executive Vice President (Principal FOX Financial and Accounting Officer) and Director of FOX By: /s/ Martin Lifton -------------------- Martin Lifton Chairman and Director of FOX Date: March 18, 1994

857775_1993.txt

857775_1993

1993

857775

Item 1. Business - ----------------- GENERAL Ford Holdings, Inc. (the "Company" or "Ford Holdings") was incorporated on September 1, 1989 for the principal purpose of acquiring, owning and managing certain assets of Ford Motor Company ("Ford"). The Company's primary activities consist of consumer and commercial financing operations, insurance underwriting and equipment leasing. These activities are conducted through the Company's wholly owned subsidiaries, Associates First Capital Corporation and its subsidiaries ("The Associates"), The American Road Insurance Company and its subsidiaries ("American Road"), USL Capital Corporation (formerly United States Leasing International, Inc.) and its subsidiaries ("USL Capital"), Ford Motor Land Development Corporation and its subsidiaries ("Ford Land") and Ford Leasing Development Company and its subsidiaries ("Ford Leasing"). The Associates, formerly a subsidiary of Paramount Communications Inc., was acquired by the Company on October 31, 1989. The Associates' primary business activities are consumer finance, commercial finance and insurance underwriting. The Associates conducts its operations primarily through its principal operating subsidiary, Associates Corporation of North America ("ACONA"). American Road is principally engaged in underwriting insurance with respect to coverages for physical damage on vehicles financed through Ford Motor Credit Company ("Ford Credit"), a wholly owned subsidiary of Ford, credit life and credit disability insurance in connection with retail vehicle financing, and extended service plan products covering vehicle repairs on retail contracts. In addition, Ford Life Insurance Company ("Ford Life"), a wholly owned subsidiary of American Road, offers single premium deferred annuities. The principal business of USL Capital is the leasing and financing of office and other business and commercial equipment, the leasing and management of rail cars and commercial auto fleets, the leasing and financing of commercial aircraft, industrial and energy facilities, and equipment financing for state and local governments. Ford Land's principal business is real estate development and Ford Leasing's principal business is the leasing of dealership facilities to franchised Ford vehicle dealers. All the outstanding Common Stock of the Company, representing 75% of the combined voting power of all classes of capital stock of the Company, is owned, directly or indirectly, by Ford. The balance of the capital stock, consisting of shares of Flexible Rate Auction Preferred Stock (Exchange), Series A Cumulative Preferred Stock, Series B Cumulative Preferred Stock and Series C Cumulative Preferred Stock, accounts for the remaining 25% of the total voting power; none of the preferred stock is held, directly or indirectly, by Ford. The principal executive offices of the Company are located at The American Road, Dearborn, Michigan 48121, and its telephone number is (313) 322-3000. Item 1. Business (Continued) - ----------------------------- BUSINESS OF THE COMPANY As indicated above, the Company is a holding company and conducts its operations through its subsidiaries. The Company, through its subsidiaries, operates in three business segments: consumer finance, commercial finance and insurance underwriting. The consumer finance segment (which includes certain operations of The Associates) is principally engaged in making and investing in residential real estate-secured receivables, making secured and unsecured installment loans to individuals, purchasing consumer retail installment obligations, investing in credit card receivables, financing manufactured housing purchases and providing other consumer financial services. The commercial finance segment (which includes the operations of USL Capital, Ford Land and Ford Leasing and certain operations of The Associates) is principally engaged in financing sales of transportation and industrial equipment, real estate development and leasing, and providing other financial services, including automobile club and relocation services. The insurance segment (which includes the operations of American Road and certain operations of The Associates) is engaged in, among other things, underwriting property, casualty, credit life and disability insurance products, and offering single premium deferred annuities. The business of each of the Company's principal subsidiaries is presented separately below. Segment information for the Company is set forth in Note 18 of Notes to Financial Statements, included on pages FH-19 and FH-20 of this Report. THE ASSOCIATES The Associates' foreign subsidiaries and Associates Federal Savings and Loan Association (sometimes referred to herein, collectively, as the "transferred operations") were transferred out of The Associates prior to, and not included in, the acquisition of The Associates by the Company. To provide comparative data for periods prior to the transfer of these operations, certain information included under this Item 1. "Business-The Associates" has been reclassified with respect to the transferred operations. The Associates has approximately 1,390 branch offices in the United States and, as of December 31, 1993, employed approximately 12,400 persons. The Associates' primary business activities are consumer finance, commercial finance and insurance underwriting. The Associates conducts its operations primarily through ACONA, its principal operating subsidiary. Item 1. Business (Continued) - ---------------------------- Selected Financial Data. The following table sets forth selected financial information of The Associates (in millions): (a) Excludes the results of the transferred operations, except as noted; the Consolidated Statement of Income for the year ended December 31, 1989 is unaudited. (b) Includes net charge of $10 million representing the cumulative effects of changes in accounting principles. (c) Includes the after-tax operating results of the transferred operations through October 30, 1989. Item 1. Business (Continued) Segment Data. The following table sets forth information by business segment of The Associates for the years ended December 31 (in millions): - ----------------- (a) Included in 1993 are $182 million of gross residential real estate-secured and installment finance receivables attributable to the Allied Finance Company acquisition and $216 million of credit card receivables purchased from Great Western Financial Corporation. Included in 1992 are $305 million of gross residential real estate-secured and installment finance receivables purchased from Signal Financial Corporation and $795 million of gross residential real estate-secured and installment finance receivables attributable to the acquisition of First Family Financial Services H.C., Inc. Included in 1991 are $2.7 billion of gross residential real estate-secured finance receivables and contracts for the purchase of manufactured housing purchased from Ford Credit and $337 million of gross installment finance receivables attributable to the acquisition of Kentucky Finance Co., Inc. Included in 1990 are $606 million in gross residential real estate-secured receivables and installment finance receivables attributable to the acquisition of Mellon Financial Services Corporation. (b) Included in 1993 are $597 million of gross heavy-duty truck and truck trailer finance receivables purchased from Mack Financial Corp. Included in 1992 are $57 million of gross industrial equipment finance receivables attributable to the acquisition of Trans-National Leasing, Inc. Included in 1991 are $931 million of gross industrial equipment finance receivables attributable to the acquisition of Chase Manhattan Leasing Company (Michigan), Inc. (renamed "Clark Credit"). Item 1. Business (Continued) - --------------------------- ____________ (a) Excludes wholesale receivables During 1993, 23% of the total gross volume of consumer loans, excluding credit card receivables, was made to current creditworthy customers that requested additional funds. The average balance prior to making an additional advance was $9,115 and the average additional advance was $3,112. Finance Receivables. The following tables set forth the amounts of gross finance receivables by major categories and average size and number of accounts (dollar amounts in millions): Item 1. Business (Continued) - ---------------------------- The ten largest accounts at December 31, 1993, other than accounts with affiliates, represented less than 8/10 of one percent of the total gross finance receivables outstanding. Of such ten accounts, five were secured by heavy-duty trucks or truck trailers, two were secured by construction equipment, two were secured by a manufacturer's endorsement and related to communications equipment and one was secured by auto leasing arrangements. At December 31, 1993, the largest gross balance outstanding in such accounts was $31 million and the average gross balance was $25 million. Item 1. Business (Continued) - ---------------------------- Credit Loss and Delinquency Experience. The credit loss experience, net of recoveries, of the finance business is set forth in the following table (dollar amounts in millions): An analysis of The Associates' allowance for losses on finance receivables is as follows (in millions): The allowance for losses on finance receivables is based on percentages of net finance receivables established by management for each major category of receivables based on historical loss experience, plus an amount for possible adverse deviation from historical experience. Additions to the allowance are charged to the provision for losses on finance receivables. Item 1. Business (Continued) - ---------------------------- Finance receivables are charged to the allowance for losses when they are deemed to be uncollectible. Additionally, The Associates' policy provides for charge-off of various types of accounts as follows: consumer direct installment receivables, except those collateralized by residential real estate, are charged to the allowance for losses when no cash payment has been received for six months; credit card receivables are charged to the allowance for losses when the receivable becomes contractually six months delinquent; all other finance receivables are charged to the allowance for losses when any of the following conditions occur: (i) the related security has been converted or destroyed; (ii) the related security has been repossessed and sold or held for sale for one year; or (iii) the related security has not been repossessed and the receivable has become contractually one year delinquent. Recoveries on losses previously charged to the allowance are credited to the allowance at the time the recovery is collected. Delinquency on consumer residential real estate-secured and direct installment and credit card receivables is determined by the date of the last cash payment received from the customer (recency of payment basis), a delinquent loan being one on which the customer has paid no cash whatsoever for a period of time. It is not The Associates' policy to accept token payments on delinquent accounts. A delinquent account on all types of receivables, other than consumer residential real estate-secured and direct installment and credit card receivables, is one on which the customer has not made payments as contractually agreed (contractual payment basis). Extensions are granted on receivables from customers with satisfactory credit and with prior approval of management. The following tables show (i) the gross account balances delinquent 60 through 89 days, 90 days and more, and total gross balances delinquent 60 days and more; and (ii) total gross balances delinquent 60 days and more by type of business (dollar amounts in millions): Item 1. Business (Continued) - ---------------------------- Insurance Underwriting. The Associates is engaged in the property and casualty and accidental death and dismemberment insurance business through Associates Insurance Company ("AIC") and in the credit life, credit accident and health insurance business through Associates Financial Life Insurance Company ("AFLIC"), principally for customers of the finance operations of The Associates. At December 31, 1993, AIC was licensed to do business in 50 states, the District of Columbia and Canada, and AFLIC was licensed to do business in 49 states and the District of Columbia. In addition, The Associates receives compensation for certain insurance programs underwritten by other companies through marketing arrangements in a number of states. The operating income produced by the finance operations' sale of insurance products is included in the respective finance operations' operating income. The following table sets forth the net property and casualty insurance premiums written by major lines of business (in millions): Item 1. Business (Continued) - ---------------------------- The following table sets forth the aggregate premium income relating to credit life, credit accident and health and accidental death and dismemberment insurance for the years indicated, and the life insurance in force (in millions): The following table summarizes the revenue of the insurance operation (in millions): - ------------------ (a) Includes compensation for insurance programs underwritten by other companies through marketing arrangements. Competition and Regulation. The interest rates charged for the various classes of receivables of The Associates' finance business vary with the type of risk and maturity of the receivable and generally are affected by competition, current interest rates and, in some cases, governmental regulation. In addition to competition with finance companies, competition exists with, among others, commercial banks, thrift institutions, credit unions and retailers. Consumer finance operations are subject to detailed supervision by state authorities under legislation and regulations which generally require finance companies to be licensed and which, in many states, govern interest rates and charges, maximum amounts and maturities of credit and other terms and conditions of consumer finance transactions, including disclosure to a debtor of certain terms of each transaction. Licenses may be subject to revocation for violations of such laws and regulations. In some states, the commercial finance operations are subject to similar laws and regulations. Customers may seek damages for violations of state and Federal statutes and regulations governing lending practices, interest rates and other charges. Federal legislation preempts state interest rate ceilings on first mortgage loans and state laws which restrict various types of alternative residential real estate-secured receivables, except Item 1. Business (Continued) - ---------------------------- in those states which have specifically opted out of such preemption. Certain Federal and state statutes and regulations, among other things, require disclosure of the finance charges in terms of an annual percentage rate, make credit discrimination unlawful on a number of bases, require disclosure of a maximum rate of interest on variable or adjustable rate mortgage loans, and limit the types of security that may be taken in connection with non-purchase money consumer loans. Federal and state legislation, in addition to that mentioned above, has been, and from time to time may be, introduced which seeks to regulate the maximum interest rate and/or other charges on consumer finance receivables, including credit cards. Associates National Bank (Delaware) ("ANB") is under the supervision of, and subject to examination by, the Office of the Comptroller of the Currency. In addition, ANB is subject to the rules and regulations of the Federal Reserve Board and the Federal Deposit Insurance Corporation ("FDIC"). Associates Investment Corporation is regulated by the FDIC and the Utah Department of Financial Institutions. Areas subject to regulation by these agencies include capital adequacy, loans, deposits, consumer protection, the payment of dividends and other aspects of operations. The insurance business is subject to detailed regulation, and premiums charged on certain lines of insurance are subject to limitation by state authorities. Most states in which insurance subsidiaries of The Associates are authorized to conduct business have enacted insurance holding company legislation pertaining to insurance companies and their affiliates. Generally, such laws provide, among other things, limitations on the amount of dividends payable by any insurance company and guidelines and standards with respect to dealings between insurance companies and affiliates. It is not possible to forecast the nature or the effect on future earnings or otherwise of present and future legislation, regulations and decisions with respect to the foregoing, or other related matters. AMERICAN ROAD American Road was incorporated as a wholly owned subsidiary of Ford Credit in 1959 and was transferred to Ford Holdings in 1989. It is licensed in 50 states and the District of Columbia and in most provinces of Canada. The operations of American Road consist primarily of underwriting floor plan insurance related to substantially all new vehicle inventories of dealers financed at wholesale by Ford Credit in the United States and Canada, credit life and disability insurance in connection with retail vehicle financing, and insurance related to retail contracts sold by automobile dealers to cover vehicle repairs. In addition, Ford Life, a wholly owned subsidiary of American Road, offers single premium deferred annuities which are sold primarily through banks and brokerage firms. The obligations of Ford Life, including annuities, are guaranteed by American Road. In the second quarter of 1992, Ford Credit discontinued purchasing collateral protection insurance ("CPI") from American Road for vehicles financed at retail by Ford Credit. This action continued to have a negative effect on Item 1. Business (Continued) - ---------------------------- 1993 earnings. The principal subsidiaries of American Road are Ford Life and Vista Life Insurance Company ("Vista Life"). Ford Life primarily offers annuities, credit life and disability insurance on vehicles and equipment financed at retail and Vista Life writes group credit life insurance and credit disability insurance on vehicles financed at retail. Vista Life Insurance Company of Texas, a subsidiary of American Road, was dissolved in April 1993. Total premiums written by American Road and its subsidiaries during the last five years were as follows (in millions): 1993: $309; 1992: $235; 1991: $379; 1990: $437; and 1989: $913. The decrease in premiums written after 1989 resulted primarily from (1) the conversion in October 1989 of a significant portion of the Extended Service Plan from an American Road insurance product to a Ford service contract and (2) the discontinuance in the second quarter of 1992 of Ford Credit's purchase of CPI insurance from American Road. The 1993 increase in premiums written resulted primarily from higher vehicle sales and higher premium rates for floor plan insurance products. ______________ (a) Includes increase of $16 million resulting from cumulative effect of adopting new accounting rules on income taxes. The detail of premiums earned by American Road was as follows (in millions): The insurance industry is highly regulated by the states with respect to premium rates, policy terms, dividends, investments and many other aspects of the insurance business. American Road competes with many insurance companies and is not a significant factor in car and truck insurance underwriting. The principal competitors of Ford Life and Vista Life are life insurance companies that specialize in credit life and credit disability insurance and insurance companies that offer single premium deferred annuities. Item 1. Business (Continued) - ---------------------------- USL CAPITAL USL Capital, a diversified commercial leasing and financing organization, originally incorporated in 1956, was acquired by Ford in 1987 and was transferred to Ford Holdings in 1989. In November 1993, the corporation's name was changed from United States Leasing International, Inc. to USL Capital Corporation. USL Capital provides financing to commercial and governmental entities principally in the United States, including: (i) leasing and financing of office, manufacturing, and other general-purpose business equipment; (ii) leasing and management of commercial fleets of automobiles, vans, and trucks; (iii) leasing and financing of large-balance transportation equipment (principally commercial aircraft, rail and marine equipment); (iv) acting as owner-trustee for certain leveraged leases for other investors; (v) first-mortgage, intermediate-term financing of commercial properties; (vi) financing of essential-use equipment for state and local governments; and (vii) purchase of industrial development, private activity and housing bonds and investment in publicly traded and privately placed preferred stocks and senior and subordinated debt of public and private companies. Certain of these financing transactions are carried on the books of Ford affiliates. At December 31, 1993, USL Capital had 682 full-time employees. Key Data. The following table sets forth certain data with respect to USL Capital's business for the periods ending on and as of the dates indicated (dollar amounts in millions): - ---------------- (a) Principally businesses sold prior to December 31, 1990. (b) Includes reduction of $3 million resulting from cumulative effect of adopting the new accounting standard on health care costs. (c) Includes foreign operations of USL Capital (transferred to Ford subsidiaries in October 1989) through September 30, 1989. Item 1. Business (Continued) - ---------------------------- Credit Loss Experience. The management of credit exposure is an important element of USL Capital's business. USL Capital reviews the credit of all prospective customers, and manages concentration exposure by customer, collateral type and geographic distribution. It establishes appropriate loss allowances based on the credit characteristics and the loss experience for each type of business, and also establishes additional reserves for specific transactions if it believes this action is warranted. Delinquent receivables are reviewed by management monthly, and are generally written down to expected realizable value when, in the opinion of management, they become uncollectible or when they become more than 180 days past due. Collection activities continue on accounts written off when management believes such action is warranted. The table below summarizes certain information on USL Capital's allowance for doubtful accounts at December 31 of the years indicated (dollar amounts in millions): Additions to the allowance for doubtful accounts for 1993 increased by $6 million from 1992, primarily as a result of the increase in earning assets as well as management's evaluation of the adequacy of the loss reserve. In addition, deductions in 1993 increased $1 million from 1992, the largest single transaction being less than $3 million. Item 1. Business (Continued) - ---------------------------- Total balances of accounts receivable over 90 days past due at year end 1993 decreased $5 million over 1992 primarily because of improved collection and workout activities as well as the write- down of several receivables which were delinquent at December 31, 1992, and which management has since deemed to be uncollectible. Residual Policy. The establishment and realization of residual values on both finance and operating leases are important elements of USL Capital's business. In general, finance leases are non-cancelable leases in which the lease payments over the term exceed the cost of the leased equipment plus financing and other expenses. Operating leases are usually of a shorter term and the lease payments by themselves are not sufficient to cover such cost and expenses. Full recovery of equipment cost is dependent upon selling or re-leasing the equipment. Residual values are established upon acquisition of the equipment based upon the estimated value of the equipment at the time USL Capital expects to dispose of the equipment under finance leases, and at the end of the equipment's expected useful life under operating leases. Periodically, USL Capital reviews its residual values, and if it determines there has been an other than temporary impairment in value, adjustments are made which result in an immediate charge to income and/or a reduction in earnings over the remaining term of the lease. Proceeds as a percentage of the adjusted residual values for finance leases were 215% in 1993, 129% in 1992, and 148% in 1991. Proceeds as a percentage of the adjusted residual values for operating leases were 115% in 1993, 1992 and 1991. Competition. In all of its financing programs, USL Capital competes with other leasing and finance companies, banks, lease brokers and investment banking firms who arrange for the financing and leasing of equipment, and manufacturers and vendors who sell, finance and lease their own products to customers. FORD LAND Ford Land was formed by Ford in 1970 to implement a master plan for the development of 2,360 acres of vacant land in Dearborn, Michigan. Since then, Ford Land has expanded its activities to include non-automotive real estate development, management and development of land and facilities related to Ford operations. See Item 2. Item 2. "Properties" for a description of Ford Land's real estate holdings. The assets employed in, and revenues derived from, Ford Land are not significant in relation to the Company's consolidated operations. Item 1. Business (Continued) - ---------------------------- FORD LEASING Ford Leasing, which was incorporated by Ford in 1960, acquires real property by purchase or lease and constructs facilities on such property for lease to franchised Ford car and truck dealers where private capital funding is unavailable. Ford Leasing provides dealers with facilities in key markets at affordable rental rates. It sells certain of those dealership facilities to the dealers, and sells to third parties property and facilities which are no longer needed for automobile dealerships. The assets employed in, and revenues derived from, Ford Leasing are not significant in relation to the Company's consolidated operations. Item 2. Properties - ------------------- The furniture, equipment and other physical property owned by the Company and its subsidiaries are not significant in relation to total assets. Ford Land and its wholly owned subsidiaries own or lease real property consisting of 3,745 acres of land and 6.4 million square feet of improvements having a net book value of $476 million. Of the real property owned or leased by Ford Land and its subsidiaries, 872 acres of land and 3.7 million square feet of improvements are located within the Fairlane Development, a commercial, residential and recreational community being developed by Ford Land in Dearborn and Allen Park, Michigan. The balance of the properties are located in California, Colorado, New Jersey, Massachusetts, Ohio and Virginia. The finance operations of the Company's subsidiaries generally are conducted on leased premises under short-term operating leases normally not exceeding five years. Item 3. Item 3. Legal Proceedings - -------------------------- Because the finance and insurance businesses involve the collection of numerous accounts, the validity and priority of liens, and loss or damage claims under many types of insurance policies, the finance and insurance subsidiaries of the Company are plaintiffs and defendants in numerous legal proceedings, including class action lawsuits. Neither the Company nor any of its subsidiaries is a party to, nor is the property thereof the subject of, any pending legal proceedings other than (i) ordinary routine litigation or (ii) litigation which should not have a material adverse impact on the consolidated financial position of the Company. There are no proceedings pending or, to the Company's knowledge, threatened by or on behalf of any administrative board or regulatory body which would materially affect or impair the right of the Company or any of its subsidiaries to carry on any of their respective businesses. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ At the Annual Meeting of Stockholders of the Company held on November 23, 1993 (the "Annual Meeting"), the holders of the outstanding shares of the Company's Common Stock elected the following nominees as directors of the Company: Wayland F. Blood, Malcolm S. Macdonald, Terrence F. Marrs, David N. McCammon, Stanley A. Seneker and Kenneth Whipple. Each such person received 1,099 votes; no votes were cast against or withheld from the election of such directors and there were no broker nonvotes. Also at the Annual Meeting, the holders of the outstanding shares of the Company's Flexible Rate Auction Preferred Stock (Exchange), Series A Cumulative Preferred Stock, Series B Cumulative Preferred Stock and Series C Cumulative Preferred Stock elected the following nominees as directors of the Company by the following votes: Also at the Annual Meeting, the holders of the Company's Common Stock, Flexible Rate Auction Preferred Stock (Exchange), Series A Cumulative Preferred Stock, Series B Cumulative Preferred Stock and Series C Cumulative Preferred Stock ratified the selection of Cooper's & Lybrand to audit the Company's books of account and other corporate records for the year 1993 by the following votes: ______________ (a) Holders of the outstanding shares of Common Stock had 75% of the combined voting power of all classes of capital stock. (b) Holders of the outstanding shares of the Flexible Rate Auction Preferred Stock (Exchange), Series A Cumulative Preferred Stock, Series B Cumulative Preferred Stock and Series C Cumulative Preferred Stock together had the remaining 25% of the combined voting power of all classes of capital stock. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters - ---------------------------------------------------------- All of the outstanding Common Stock of the Company is owned directly or indirectly by Ford as of March 1, 1994. There is no market for the Company's Common Stock. Dividends on the Common Stock will be paid when declared by the Board of Directors. No dividends have been paid to date. Item 6. Item 6. Selected Financial Data - -------------------------------- The following table sets forth selected consolidated financial information regarding the operating results and financial position of the Company and its subsidiaries. The amounts shown for the years ended December 31, 1989 through 1993 represent the consolidated operating results and financial position of the subsidiaries of the Company then owned, directly or indirectly, by Ford. The reorganizations of these subsidiaries, which occurred in October 1989, have been accounted for at historical cost in a manner similar to a pooling-of-interests combination. This table includes The Associates' results for the two-month period ended December 31, 1989 and the full-years ended December 31, 1990 through 1993. The unaudited pro forma adjustments for 1989 reflect the estimated interest expense, net of related income taxes, that the Company would have incurred on the zero-coupon note issued in connection with the transfer from Ford to the Company of USL Capital's domestic operations as if such transfer had occurred on November 1, 1987, the date USL Capital was acquired by Ford. The unaudited pro forma net income for 1989 does not purport to represent what the Company's net income actually would have been had the zero coupon note in fact been issued on November 1, 1987. The information should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited consolidated financial statements and accompanying notes to financial statements included in this Report. Item 6. Selected Financial Data (Continued) - -------------------------------------------- Each of the above-named persons has held the position with the Company set forth opposite his name since October 1989, except that Mr. T. F. Marrs has held his position since March 1990, Mr. W. F. Blood has held his position as Vice President since November 1992 and was elected a director effective May 1, 1993 and Mr. J. M. Rintamaki has held his position since July 1993. Except for Messrs. Toffey and Richardson, all of the above officers and directors have been employed by Ford or its subsidiaries in one or more executive capacities during the past five years. H. J. Toffey, Jr. was a Managing Director of First Boston, Inc. until his retirement in 1986. Mr. Toffey also serves as a director of Sterling Energy Corp. D. E. Richardson was the Chairman of the Board of Directors of Manufacturers National Corporation from October 1973 until his retirement in April 1990. Mr. Richardson serves as a director of Comerica Incorporated, The Detroit Edison Company, Tecumseh Products Company and the Automobile Club of Michigan. Mr. Seneker serves as a director of Ford. Mr. Whipple serves as a director of CMS Energy Corporation; Consumers Power Company; First Nationwide Bank, A Federal Savings Bank; First Nationwide Financial Corporation; Ford Credit; and USL Capital. Mr. Blood serves as a director of First Nationwide Bank, A Federal Savings Bank and First Nationwide Financial Corporation. Mr. Macdonald serves as a director of The Hertz Corporation. Mr. Marrs serves as a director of USL Capital and The Hertz Corporation. Mr. McCammon serves as a director of Ford Credit and The Hertz Corporation. Based on Company records and other information, the Company believes that all SEC filing requirements applicable to its directors and officers with respect to the Company's fiscal year ended December 31, 1993 were complied with except that Mr. D. E. Richardson had one late report of one transaction. Item 11. Item 11. Executive Compensation - -------------------------------- The directors and executive officers of the Company do not and will not receive any compensation from the Company except that directors of the Company who are not otherwise employed by Ford or another affiliate of the Company will be entitled to director fees in amounts established from time to time by the Board. Currently, each director who is not an employee of Ford or another affiliate of the Company is paid an annual fee of $15,000. Thus in 1993, Messrs. Richardson and Toffee each received annual fees of $15,000. None of the other directors received an annual fee in 1993. All directors and officers are reimbursed for expenses reasonably incurred in connection with their services on behalf of the Company. None of the directors and executive officers of the Company receives or will receive any additional compensation from Ford or any of its affiliates for services rendered on behalf of the Company. The Company compensates Ford for the time during which any salaried officer or employee of Ford performs services for the Company. See Item 13. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------ (a) Security ownership of certain beneficial owners. (b) Security ownership of management. None of the Company's or any of its parents or subsidiaries equity securities is beneficially owned by the Company's directors (and nominees) or officers, except as shown below: _________________ (*) Amount owned is less than 0.1% of class. (a) Mr. Richardson owns 4,000 Depositary Shares, each representing 1/4,000 of a share of Series A Cumulative Preferred Stock. Item 12. Security Ownership of Certain Beneficial Owners and Management (Continued) - --------------------------------------------------------- ______________ (*) Amount owned is less than 0.1% of class. (a) Indicates the number of shares listed with respect to which such person(s) has the right to acquire beneficial ownership within 60 days. (b) Mr. Macdonald owns 1,000 Depositary Shares, each representing 1/1,000 of a share at Ford Motor Company Series A Cumulative Convertible Preferred Stock. Each Depositary Share is convertible into 1.6327 shares of Ford Motor Company Common Stock. Item 13. Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- Ford is the direct or indirect beneficial owner of all of the outstanding shares of Common Stock of the Company, which represent 75% of the total voting power of the outstanding capital stock of the Company. As majority stockholder, Ford is in a position to cause the election of a majority of the Board of Directors of the Company and to control the Company's affairs. The Company, Ford and Ford Credit also maintain a number of financial and administrative arrangements and regularly engage in transactions with each other. These arrangements include management services agreements between the Company and Ford and the Company and Ford Credit ("Management Services Agreements") pursuant to which, upon the reasonable request of the Company, certain employees of Ford and Ford Credit work on the affairs of the Company and its subsidiaries, so as to enable the Company to continue to conduct and operate the business and affairs of the Company and to provide other services required by the Company. The services provided for under the Management Services Agreements include, but are not necessarily limited to, accounting, bookkeeping, finance, treasury, systems, credit, personnel (including administration of pension and other benefit plans), purchasing, engineering, legal, tax, and other technical and professional support, including Ford employees who serve as executive officers of the Company and/or its subsidiaries. Under the Management Services Agreements, the Company reimburses Ford or Ford Credit, as appropriate, for the costs of the services provided to the Company or its subsidiaries by Ford or Ford Credit, as the case may be. Presently, such costs include an allocation of the total compensation (including benefits) and overhead charges related to such employees, based on the time spent in rendering services under the Management Services Agreements, and in cases where the services are provided for purposes other than to enable the Company to provide, in turn, a service to Ford or Ford Credit, a reasonable markup on such costs. Out-of-pocket expenses incurred by Ford or Ford Credit under the Management Services Agreements also are reimbursed by the Company. The Associates also has similar services agreements with the various Ford subsidiaries that acquired The Associates' former foreign subsidiaries. Certain of the arrangements and agreements between the Company (and/or its subsidiaries) and Ford (and its subsidiaries) were established by Ford prior to the Company's formation and thus were not the result of direct negotiations between Ford and the Company. The Company believes, however, that all such arrangements and agreements are fair and reasonable. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------------------------------------------------------------------------- (a) 1. Financial Statements Ford Holdings, Inc. and Subsidiaries ------------------------------------ Report of Independent Accountants. Consolidated Statement of Income, for the years ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheet, December 31, 1993 and 1992. Consolidated Statement of Cash Flows, for the years ended December 31, 1993, 1992 and 1991. Consolidated Statement of Stockholders' Equity, for the years ended December 31, 1993, 1992 and 1991. Notes to Financial Statements. The Report of Independent Accountants, Financial Statements and Notes to Financial Statements listed above are filed as part of this Report and are as set forth on pages FH-1 through FH-20 immediately following the signature pages of this Report. (a) 2. Financial Statement Schedules Designation Description - ----------- ------------ Schedule III Condensed Financial Information of the Registrant (Parent Company) Schedule IV Indebtedness of and to Related Parties Schedule IX Short-Term Borrowings The Financial Statement Schedules listed above are filed as part of this Report and are as set forth on pages FSS-1 through FSS-4 immediately following page FH-20. The schedules not filed are omitted because the information required to be contained therein is disclosed elsewhere in the financial statements or the amounts involved are not sufficient to require submission. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (Continued) - ----------------------------------------------------------------- (a) 3. Exhibits - ---------------- Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (Continued) - -------------------------------------------------------------- Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (Continued) - ----------------------------------------------------------------- * Incorporated by reference as an exhibit hereto. (b) Reports on Form 8-K The Registrant did not file any Current Reports on Form 8-K during the quarter ended December 31, 1993. 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. FORD HOLDINGS, INC. By: /s/Terrence F. Marrs* (Terrence F. Marrs) Vice President-Controller Date: March 28, 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. J:\10K\FHI93.be Coopers & Lybrand Certified Public Accountants REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders Ford Holdings, Inc. We have audited the consolidated balance sheet of Ford Holdings, Inc. and Subsidiaries at 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, and the financial statement schedules 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 Ford Holdings, Inc. 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. 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 10 and 12 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1992. /s/Coopers & Lybrand Coopers & Lybrand 400 Renaissance Center Detroit, Michigan 48243 313-446-7100 February 1, 1994 FH-1 The accompanying notes are part of the financial statements. FH-2 The accompanying notes are part of the financial statements. FH-3 The accompanying notes are part of the financial statements. Certain amounts for 1992 and 1991 have been reclassified to conform with presentations adopted in 1993. FH-4 - - - - - - *Less than $50,000 The accompanying notes are part of the financial statements. FH-5 Ford Holdings, Inc. and Subsidiaries Notes to Financial Statements NOTE 1. Accounting Policies - ---------------------------- Principles of Consolidation - --------------------------- The consolidated financial statements include the accounts of Ford Holdings and all majority-owned subsidiaries (the "company"). On September 1, 1989, Ford Holdings, Inc. ("Ford Holdings") was formed as a wholly-owned subsidiary of Ford Motor Company ("Ford"). The company's wholly-owned subsidiaries include Associates First Capital Corporation and its subsidiaries ("The Associates"), The American Road Insurance Company and its subsidiaries ("American Road"), USL Capital Corporation (formerly United States Leasing International, Inc.) and its subsidiaries ("USL Capital"), Ford Motor Land Development Corporation and its subsidiaries ("Ford Land") and Ford Leasing Development Company and its subsidiaries ("Ford Leasing"). Investments in certain partnerships and affiliates that are 50% or less owned are included in the consolidated financial statements on an equity basis. Revenue Recognition - ------------------- Finance revenues on loans and direct financing leases are recognized in income over the term of the related contract using the interest method. Rental income on operating leases is recognized ratably over the lease term. Insurance premiums are recorded as unearned premiums when written and are subsequently recognized in income over the term of the related insurance contracts. The methods of recognizing premium revenue are related to amounts at risk and include historical loss experience, pro rata, and sum-of-the-digits bases. Goodwill - -------- Goodwill, arising primarily from the acquisitions of The Associates by Ford Holdings and of USL Capital by Ford, is being amortized using the straight-line method over 40 years. Insurance Claims - ---------------- A liability is provided for reported claims and for claims that have been incurred but not reported. The estimate of the liability for claims that have been incurred but not reported is based on prior experience and insurance in-force. Annuity Contracts - ----------------- The liability for annuity contracts reflects deposits received and interest credited, less related withdrawals. The weighted- average interest rate on annuity contracts outstanding at December 31, 1993 and 1992 was 6.2% and 7.3%, respectively. Interest rates offered are initially guaranteed for periods of either one or five years. Interest credited to annuity account balances is recognized as expense; surrender charges are recognized as a reduction of interest credited to annuitants. The fair value of annuity contracts at December 31, 1993 and 1992 approximated book value because the contractual interest rate due holders is reset annually for more than 97% of contracts outstanding. Cash Equivalents - ---------------- The company considers all highly-liquid investments purchased with a maturity of three months or less to be cash equivalents. The book value of these investments approximates fair value because of the short maturity. FH-6 NOTE 2. Investment and Other Income - ------------------------------------ Investment and other income consisted of the following (in millions): NOTE 3. Reinsurance Activity - ----------------------------- A portion of the physical damage and credit life and disability insurance business of the company relates to reinsurance agreements with unaffiliated insurance companies. Amounts added to or deducted from accounts in connection with insurance assumed or ceded were as follows (in millions): The company remains contingently liable with respect to insurance ceded should the reinsurer be unable to meet the obligation assumed under the reinsurance agreement. Amounts recoverable from reinsurers were $7 million in 1993 and $8 million in 1992. NOTE 4. Investments in Securities - ---------------------------------- Investments in debt securities are recorded at amortized cost because of the ability to hold such securities until maturity and the intent to hold them for the foreseeable future. If market conditions change, however, certain of these securities may be sold prior to maturity with the realized gain or loss included in investment and other income. The cost of investments sold generally is determined on a specific security basis. Marketable equity securities are recorded at fair value with unrealized gains or losses, net of applicable income taxes, recorded directly to stockholders' equity; realized gains and losses are included in investment and other income. The cost of investments sold generally is determined on a first-in, first-out basis. FH-7 NOTE 4. Investments in Securities (Cont'd) - ---------------------------------- Investments in debt securities at December 31 were as follows (in millions): The fair value of most securities was estimated based on quoted market prices for those securities. For those securities for which there were no quoted market prices, the estimate of fair value was based on similar types of securities that are traded in the market. The book value and fair value of investments in debt securities at December 31, by contractual maturity, are shown below (in millions). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalty. Proceeds from sales of investments in debt securities were $11.1 billion in 1993, $9.9 billion in 1992, and $11.2 billion in 1991. In 1993, gross gains of $112 million and gross losses of $20 million were realized on those sales; gross gains of $90 million and gross losses of $28 million were realized in 1992, and gross gains of $75 million and gross losses of $17 million were realized in 1991. The cost of marketable equity securities at December 31, 1993 and 1992 was $160 million and $262 million, respectively. In 1993, gross unrealized gains totaled $66 million and gross unrealized losses totaled $5 million; in 1992, gross unrealized gains and gross unrealized losses totaled $82 million and $11 million, respectively. FH-8 NOTE 5. Finance Receivables - ---------------------------- Finance receivables at December 31 were as follows (in millions): The estimated maturities of finance receivables outstanding at December 31, 1993 were as follows (in millions): Estimated maturities were based on contractual terms and do not give effect to possible prepayments or renewals. The fair value of most receivables was estimated by discounting future cash flows using an estimated discount rate which reflected the credit, interest rate and prepayment risks associated with similar types of instruments. For receivables with short maturities, the book value approximated fair value. Acquisitions - ------------ During 1993, 1992 and 1991, the company made acquisitions of finance businesses and finance receivables, the most significant of which were as follows: In September 1993, The Associates acquired the credit card portfolio of Great Western Financial Corporation. The outstanding balances totaled $216 million. In September 1993, The Associates purchased the assets of Mack Financial Corporation, the financing division of Mack Trucks, Inc., consisting of $552 million of net commercial finance receivables, principally secured by heavy-duty trucks and truck trailers. The fair value of assets acquired and liabilities assumed was $587 million and $380 million, respectively. The transaction was accounted for as a purchase. In April 1993, The Associates purchased the stock of Allied Finance Company, with assets primarily consisting of $146 million of net consumer finance receivables, principally comprised of residential real estate-secured, direct installment and indirect installment receivables. The fair value of assets acquired and liabilities assumed was $197 million and $112 million, respectively. The transaction was accounted for as a purchase. FH-9 NOTE 5. Finance Receivables (Cont'd) - ---------------------------- In December 1992, The Associates purchased the stock of Trans- National Leasing, Inc. Approximately $48 million of net commercial finance receivables relating to the financing of fleet vehicles was acquired in the transaction. The fair value of assets acquired and liabilities assumed was $52 million and $45 million, respectively. The transaction was accounted for as a purchase. In November 1992, The Associates purchased substantially all of the assets of First Family Financial Services H. C., Inc., including $546 million of net consumer finance receivables, principally residential real estate-secured and direct installment receivables. The fair value of assets acquired and liabilities assumed was $697 million and $543 million, respectively. The transaction was accounted for as a purchase. In April 1992, The Associates purchased from Signal Financial Corporation $290 million of net consumer finance receivables, consisting primarily of direct installment and residential real estate-secured receivables. The fair value of assets acquired and liabilities assumed was $303 million and $2 million, respectively. The transaction was accounted for as a purchase. In the third quarter of 1991, The Associates acquired Kentucky Finance Co., Inc. and Chase Manhattan Leasing Company (Michigan), Inc. in separate transactions. The transactions involved approximately $1,076 million of net consumer and commercial finance receivables. The fair values of assets acquired and liabilities assumed in the aggregate were $1,184 million and $294 million, respectively. Both transactions were accounted for as purchases. In January 1991, The Associates acquired from Ford Credit approximately $2.2 billion of net consumer finance receivables for a like amount of cash. The purchase price represented the net book value of the receivables, which also approximated fair value. The Associates funded the purchase through the issuance of short-term debt. NOTE 6. Investments in Direct Financing Leases - ----------------------------------------------- Minimum direct financing lease rentals are as follows (in millions): 1994 - $1,375; 1995 - $1,054; 1996 - $703; 1997 - $460; thereafter - $1,554. The estimated residual values represent proceeds expected to be received from the sale of equipment leased under direct financing leases. FH-10 NOTE 7. Investments in Operating Leases - ---------------------------------------- Minimum equipment operating lease rentals are as follows (in millions): 1994 - $95; 1995 - $67; 1996 - $27; 1997 - $15; thereafter - $51. Revenues from equipment operating leases, included in financing revenues, were as follows (in millions): 1993 - $189; 1992 - $168; 1991 - $202. The cost of equipment under operating leases is capitalized and depreciated over the lease term, primarily on a straight-line basis. Depreciation expense on these operating leases was as follows (in millions): 1993 - $131; 1992 - $159; 1991- $178. Investments in real estate operating leases at December 31 were as follows (in millions): NOTE 9. Deferred Policy Acquisition Costs - ------------------------------------------ Certain costs of acquiring insurance contracts are deferred and amortized over the terms of the related contracts on the same bases on which the premiums are earned. Changes in deferred policy acquisition costs were as follows (in millions): NOTE 10. Income Taxes - ---------------------- The provision for income taxes was as follows (in millions): - - - - - - *Excludes cumulative effects of changes in accounting principles The company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes," as of January 1, 1992. The cumulative effect of this change in accounting principle increased 1992 net income by $51 million. Financial statements for prior years were not restated to apply the provisions of SFAS 109. The adoption of SFAS 109 changes the method of accounting for income taxes from the deferred method using Accounting Principles Board Opinion No. 11 ("APB 11") to an asset and liability approach. Under SFAS 109, deferred income taxes reflect the estimated tax effect of temporary differences between assets and liabilities for financial reporting purposes and those amounts as measured by tax laws and regulations. FH-12 NOTE 10. Income Taxes (Cont'd) - ---------------------- The components of deferred income tax assets and liabilities at December 31 were as follows (in millions): Deferred income taxes for 1991 were derived using the guidelines in APB 11. Under APB 11, deferred income taxes result from timing differences in the recognition of revenues and expenses between financial statements and tax returns. The principal sources of these differences and the related effect of each on the provision for income taxes were as follows (in millions): A reconciliation of the provision for income taxes compared with the amounts at the U.S. statutory tax rate is shown below (in millions): FH-13 NOTE 11. Debt - -------------- Debt at December 31 was as follows (in millions): The fair value of debt was estimated based on quoted market prices or current rates for similar debt with the same remaining maturities. The average remaining term of commercial paper was 24 days and 32 days at December 31, 1993 and 1992, respectively. Long-term debt at December 31, 1993, including amounts payable within one year, matures as follows (in millions): 1994 - $2,609; 1995 - $2,479; 1996 - $2,955; 1997 - $3,069; 1998 - $1,513; thereafter - $5,752. The interest portion of capital lease obligations was $1 million at December 31, 1993. Secured indebtedness is collateralized by mortgages on land and buildings of approximately $99 million and by rentals receivable and rental equipment of approximately $7 million, which are included in investments in leases. At December 31, 1993, warrants were outstanding to purchase $155 million aggregate principal amount of senior notes at specified dates between 1994 and 1999. At December 31, 1993, Ford guaranteed all of Ford Holdings' debt held by nonaffiliated persons, totaling $1,862 million, and $46 million of Ford Leasing's debt. At December 31, 1993, the company had contractually committed revolving credit facilities with banks of $5.3 billion. These facilities were unused at December 31, 1993. Maturity dates for these facilities ranged from February 1994 through September 1998. Also, at December 31, 1993, the company had contractually committed lines of credit with banks of $3.1 billion, none of which were utilized. In addition, the company had $1.2 billion of contractually committed receivables sale facilities, of which about 14% were in use at December 31, 1993. Some of these agreements contain certain provisions related to the continuation of Ford's direct or indirect ownership in the company. FH-14 NOTE 12. Employee Retirement Benefits - -------------------------------------- Employee Retirement Plans - ------------------------- The Associates sponsors various defined benefit pension plans, which together cover substantially all permanent employees who meet certain eligibility requirements. The Associates' pension expense reflected the following (in millions): The status of these plans for The Associates at December 31 was as follows (in millions): USL Capital sponsors a defined contribution retirement plan which covers substantially all of its employees. Under the profit sharing part, contributions are determined as a percent (6.9%) of each covered participant's salary, minus the Old Age, Survivors, and Disability Insurance portion of social security taxes paid for the participant by USL Capital. Profit sharing cost represents contributions minus the unvested amounts of terminated participants. Under the deferred compensation part, contributions (cost) are determined as 75 cents per dollar for the first 3% and 25 cents per dollar on the next 3% of deferred compensation up to a maximum of 6% of a participant's compensa- tion. The amount charged to operating expenses related to USL Capital's retirement plan was as follows (in millions): 1993 - $4; 1992 - $4; 1991 - $4. Other subsidiaries of the company do not have employees but purchase technical and administrative services from Ford, the cost of which includes retirement benefits. Retirement costs included in such service fee billings from Ford were not sig- nificant. Postretirement Health Care and Life Insurance Benefits - ------------------------------------------------------ The Associates sponsors unfunded plans that provide selected health care and life insurance benefits to substantially all retired employees who have met certain eligibility requirements; however, the benefits of the plan may be modified or terminated at the discretion of The Associates. FH-15 NOTE 12. Employee Retirement Benefits (Cont'd) - -------------------------------------- USL Capital sponsors unfunded plans that provide selected health care and life insurance benefits to retired employees, the cost of which is shared between USL Capital and the retiree. The accounting for the health care plan anticipates future cost- sharing changes that are consistent with USL Capital's past practice. USL Capital defines a maximum amount (or "cap") that it will contribute toward the health benefits of each retiree. This cap is determined annually and is based on the individual retiree's number of dependents. Over the last six years the aggregate increase in the cap approximates the average increase in the underlying premium costs of the program. This valuation assumed that in future years USL Capital will continue to increase the cap at the average rate of increase of the underlying cost of the retiree benefit program. Benefits and eligibility rules, however, may be modified by USL Capital from time to time. Prior to 1992, the expense recognized for postretirement health care benefits was based on actual expenditures for the year. Beginning in 1992, the estimated cost of postretirement health care benefits is accrued on an actuarially determined basis, in accordance with the requirements of Statement of Financial Accounting Standards No. 106 ("SFAS 106"), "Employer's Accounting for Postretirement Benefits Other Than Pensions". Implementation of SFAS 106 has not increased the company's cash expenditures for postretirement benefits. As of January 1, 1992, The Associates recorded a one-time charge to net income of $40 million, which represented the estimated accumulated postretirement benefit obligation of $65 million, net of deferred income taxes of $21 million and amounts recorded as purchase accounting adjustments of $4 million. In addition, the unamortized amount ($19 million) of the postretirement benefit liability recorded by Ford Holdings at the time The Associates was acquired was reversed with the adoption of the new standard by The Associates. As of January 1, 1992, USL Capital recorded a one-time charge to net income of $3 million, which represented the estimated accumulated postretirement benefit obligation of $5 million, net of deferred income taxes of $2 million. These amounts have been reflected in the Consolidated Statement of Income as a component of the cumulative effects of changes in accounting principles. The combined amount paid by The Associates and USL Capital for postretirement benefits in 1993, 1992 and 1991 was $2 million, $2 million and $1 million, respectively. The combined net postretirement benefit expense for The Associates and USL Capital included the following (in millions): For measurement purposes, The Associates assumed 12.5% and 13.32% weighted average annual rates of increase in per capita cost of covered health care benefits for 1993 and 1992, respectively, decreasing gradually to 5.5% by 2009. FH-16 NOTE 12. Employee Retirement Benefits (Cont'd) - -------------------------------------- For measurement purposes, USL Capital assumed 12% and 8% annual rates of increase in per capita cost of postretirement medical benefits for 1993 for the under age 65 indemnity and HMO and over age 65 indemnity plans, respectively; the rates were assumed to decrease gradually to 5.5% by 2006 and remain at that level thereafter. The comparable rates assumed for 1992 were 14% and 9% for the under age 65 indemnity and HMO and over age 65 indemnity plans, respectively. Changing the assumed health care cost trend rate by one percentage point would change the aggregate of the service and interest cost components of net periodic postretirement benefit cost of The Associates and USL Capital, on a combined basis, for 1993 and 1992 by $1 million each year, and the accumulated postretirement benefit obligation at December 31, 1993 and 1992 by $7 million and $6 million, respectively. NOTE 13. Capital Stock - ----------------------- The authorized capital stock of Ford Holdings consists of Common Stock and Preferred Stock. Holders of Preferred Stock generally are entitled to elect not less than 25 percent of the directors of the company. On all matters other than the election of directors as to which stockholders generally have a vote, holders of Common Stock, as a class, are entitled to 75%, and holders of Preferred Stock, as a class, are entitled to 25%, of the total number of votes of all the capital stock of Ford Holdings. At December 31, 1993, the Preferred Stock consisted of $800 million of Cumulative Flexible Rate Auction Preferred Stock (Exchange) ("Flex-APS"); $285 million of fixed-rate Series A Cumulative Preferred Stock; $173 million of fixed-rate Series B Cumulative Preferred Stock; and $200 million of fixed-rate Series C Cumulative Preferred Stock. Dividends on the Flex-APS generally are determined through auction procedures. The maximum applicable dividend rate is a function of the 60-day "AA" Composite Commercial Paper rate or the applicable reference rate. The average dividend rate in effect on the Flex-APS in 1993 was 4.38%; the weighted average dividend rate was 4.43% on December 31, 1993. Accumulated and unpaid dividends on the Flex-APS amounted to $4 million at December 31, 1993. The fixed-rate Series A Cumulative Preferred Stock dividend rate is 8% ($2.00 per depository share) per year; accumulated and unpaid dividends were $2 million at December 31, 1993. The fixed-rate Series B Cumulative Preferred Stock dividend rate is 8% ($2.00 per depository share) per year; accumulated and unpaid dividends were $1 million at December 31, 1993. The fixed-rate Series C Cumulative Preferred Stock dividend rate is 7.12% ($1.78 per depository share) per year; accumulated and unpaid dividends were $1 million at December 31, 1993. NOTE 14. Dividend Restrictions - ------------------------------- Payment of dividends by American Road is restricted by insurance regulatory requirements of the State of Michigan. Based on these restrictions at December 31, 1993, management has determined the maximum dividend that may be paid in 1994 to Ford Holdings without regulatory approval is approximately $11 million. Payment of dividends by certain subsidiaries of The Associates is restricted under the provisions of certain debt and revolving credit agreements. At December 31, 1993, $222 million was available for the payment of dividends. FH-17 NOTE 15. Litigation and Claims - ------------------------------- Various legal actions, governmental investigations and proceedings, and claims are pending or may be instituted or asserted in the future against Ford Holdings and its subsidiaries. Certain of the pending legal actions are, or purport to be, class actions. Some of the foregoing matters involve or may involve compensatory, punitive, or antitrust or other treble damage claims in very large amounts, sanctions, or other relief which, if granted, would require very large expenditures. Litigation is subject to many uncertainties, the outcome of individual litigated matters is not predictable with assurance, and it is reasonably possible that some of the foregoing matters could be decided unfavorably to Ford Holdings or the subsidiary involved. Although the amount of the ultimate liability at December 31, 1993 with respect to these matters cannot be ascertained, the company believes that any resulting liability should not materially affect the consolidated financial position of the company at December 31, 1993. NOTE 16. Transactions With Affiliated Companies - ------------------------------------------------ The company receives technical and administrative advice and services from Ford and utilizes data processing facilities maintained by Ford. The cost of these services is allocated to the company based on actual costs incurred by Ford in performing these services. The company believes this allocation is a reasonable approximation of the costs it would have incurred on a stand-alone basis. Payments to Ford for such services were as follows (in millions): 1993 - $31; 1992 - $41; 1991 - $48. The company provides insurance and other services to Ford and other affiliated companies. Amounts included in revenues for these services were as follows (in millions): Net interest income under various financing arrangements between the company and Ford was as follows (in millions): 1993 - $16; 1992 - $33; 1991 - $37. In 1991, Ford Holdings received a capital contribution from Ford Credit of $216 million in the form of cash and stock of certain consumer finance subsidiaries formerly owned by Ford Credit in exchange for additional shares of Ford Holdings' Common Stock. The cash and stock of the consumer finance subsidiaries were then contributed by Ford Holdings to The Associates. NOTE 17. Commitments and Contingencies - --------------------------------------- The company has entered into foreign exchange agreements to manage exposure to foreign exchange rate fluctuations. These exchange agreements hedge primarily debt, firm commitments and dividends that are denominated in foreign currencies. Agreements entered into to manage these exposures are comprised primarily of foreign currency swaps. Gains or losses on the various agreements are either recognized during the period or included in the bases of the related transactions. FH-18 NOTE 17. Commitments and Contingencies (Cont'd) - --------------------------------------- The fair value of these foreign exchange agreements generally was estimated using current market prices provided by outside quotation services. The fair value was estimated to be net receivable of $12 million at December 31, 1993 and a net payable of $47 million at December 31, 1992. In the unlikely event that a counterparty fails to meet the terms of a foreign exchange agreement, the company's market risk is limited to the currency rate differential. In the case of currency swaps, the company's market risk also may include an interest rate differential. At December 31, 1993 and 1992, the total amount of the company's foreign currency swaps outstanding was $281 million and $398 million, respectively, maturing primarily through 1996. The company has entered into arrangements to manage exposure to fluctuations in interest rates. These arrangements are comprised primarily of interest-rate swap agreements. The differential paid or received on interest-rate swap agreements is recognized as an adjustment to interest expense. The fair value of interest-rate swaps is the estimated amount the company would receive or pay to terminate the swap agreement. The fair value is calculated using information provided by outside quotation services, taking into account current interest rates and the current credit-worthiness of the swap counterparties. The fair value was estimated to be a net receivable of $7 million at December 31, 1993 and a net payable of $7 million at December 31, 1992. In the unlikely event that a counterparty fails to meet the terms of an interest-rate swap agreement, the company's exposure is limited to the interest rate differential. The underlying principal amounts on which the company has interest-rate swap agreements and futures contracts outstanding aggregated $2.1 billion at December 31, 1993 and $1.9 billion at December 31, 1992. Certain Ford Holdings' subsidiaries make credit lines available to holders of their credit cards. At December 31, 1993 and 1992, the unused portion of available credit was approximately $9.6 billion and $5.5 billion, respectively, and is revocable under specified conditions. The fair value of unused credit lines and the potential risk of loss was not considered to be significant. In addition, the company has entered into a variety of other financial agreements which contain potential risk of loss. These agreements include financial guarantees and interest rate caps and floors. The fair value of these agreements and the potential risk of loss was not considered to be significant. NOTE 18. Segment Information - ----------------------------- The company operates in three business segments: consumer finance, commercial finance, and insurance. The consumer finance segment is engaged primarily in making and investing in direct installment and revolving credit receivables, including credit card receivables, purchasing consumer-related installment obligations, and providing other consumer financial services. The commercial finance segment is engaged primarily in financing sales of transportation and industrial equipment, leasing of equipment either through equipment vendors or directly to end users, and the construction and operation of commercial real estate developments. The insurance segment is engaged primarily in the issuance of single premium deferred annuities, property and casualty insurance relating to extended service plan contracts, credit life and credit disability insurance, and physical damage insurance. These insurance products are provided primarily to purchasers of vehicles financed by Ford subsidiaries and to customers of the finance operations of The Associates. Corporate expenses consist primarily of interest on acquisition- related debt. Acquisition-related goodwill has been allocated to the operating segments. FH-19 NOTE 18. Segment Information (Cont'd) - ----------------------------- (a) Primarily an increase in Ford Land notes receivable from Ford (b) Primarily an increase in receivables at American Road for insurance premiums collected by Ford Credit (c) Primarily higher payables at Ford Land and an increase in State taxes payable at Ford Holdings (d) Primarily interest accrual on Ford Holdings zero-coupon note to Ford and increase in American Road accounts payable to Ford (e) Primarily increases in accounts payables at USL Capital and The Associates with Ford Credit FSS-3 Schedule IX FORD HOLDINGS, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS --------------------- For the Years Ended December 31, 1993, 1992 and 1991 (dollar amounts in millions) - ------------------------- (a) The average amount outstanding during the period was computed using the amounts outstanding at the end of each month, including the amount at the beginning of the period. (b) The weighted average interest rate during the period was computed by dividing actual interest expense on short-term borrowings by the average short-term debt outstanding during the period. (c) The increase in debt in 1993, 1992 and 1991 resulted principally from the growth in receivables at The Associates. FSS-4 EXHIBIT INDEX (continued) ------------------------- EXHIBIT INDEX (continued) ------------------------- j:\10k\exindfh.93

727742_1993.txt

727742_1993

1993

727742

ITEM 1. BUSINESS SUMMARY OF SIGNIFICANT TRANSACTIONS Jefferson Smurfit Corporation ("JSC") was incorporated in 1976 under the laws of the State of Delaware. JSC is a wholly-owned subsidiary of SIBV/MS Holdings, Inc. ("Holdings"), a corporation formed in connection with the 1989 Transaction (as defined below), 50% of the voting stock of which is owned by Smurfit Packaging Corporation ("Smurfit Packaging") and Smurfit Holdings B.V. ("Smurfit Holdings"). The remaining 50% is owned by The Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"). Holdings has no operations other than its investment in JSC. MSLEF II is an investment fund formed by Morgan Stanley & Co. Incorporated ("MS&CO."). Smurfit Packaging and Smurfit Holdings are wholly- owned subsidiaries of Smurfit International B.V. ("SIBV"), which is an indirect wholly-owned subsidiary of Jefferson Smurfit Group plc, a corporation organized under the laws of the Republic of Ireland ("JS Group"). Container Corporation of America ("CCA") was incorporated in 1968 under the laws of the State of Delaware. On September 30, 1986, JSC acquired a 50% equity interest in CCA. Prior to September 30, 1986, CCA was a wholly-owned subsidiary of Mobil Corporation. In December 1989, (i) Holdings acquired the entire equity interest in JSC, (ii) JSC acquired the entire equity interest in CCA, (iii) The Morgan Stanley Leveraged Equity Fund, L.P., a Delaware limited partnership ("MSLEF I"), and certain other private investors, including MS&Co. and certain limited partners of MSLEF I investing in their individual capacities (collectively, the "MSLEF I Group") received $500 million in respect of their shares of CCA common stock and (iv) SIBV received $41.75 per share, or an aggregate of approximately $1.25 billion, in respect of its shares of JSC stock, and the public stockholders received $43 per share of JSC stock. Certain assets of JSC and CCA were also transferred to SIBV or one of its affiliates. Holdings' acquisition of all of the outstanding JSC common stock and CCA's acquisition of the 50% of its common equity owned by the MSLEF I Group are referred to hereafter as the "1989 Transaction". Financing for the 1989 Transaction was provided through borrowings under bank credit facilities, the sale of various debt securities, including $850.0 million of subordinated notes (the "Subordinated Debt") and debentures (the "Secured Notes") sold by CCA which are unconditionally guaranteed by JSC, equity contributions by Holdings and available cash of JSC and CCA. In August 1992, proceeds from a $231.8 million capital contribution by Holdings and a new $400 million senior secured term loan (the "1992 Credit Agreement") were used to prepay $400 million of the 1989 term loan facility (the "1989 Credit Agreement"), retire $193.5 million accreted value of the Junior Accrual Debentures and prepay $19.1 million aggregate principal amount of the subordinated note due in 1993. The proceeds from the capital contribution and the 1992 Credit Agreement and the prepayments of the 1989 Credit Agreement and the subordinated debt are referred to hereafter as the "1992 Transaction". The 1989 Credit Agreement and the 1992 Credit Agreement are collectively referred to herein as the "Old Bank Facilities". Holdings is implementing a recapitalization plan (the "Recapitalization Plan") to repay or refinance a substantial portion of its indebtedness in order to improve operating and financial flexibility by (i) reducing the level and overall cost of debt, (ii) extending maturities of indebtedness, (iii) increasing stockholders' equity and (iv) increasing its access to capital markets. In the first quarter of 1994, Holdings filed a registration statement with the Securities and Exchange Commission (the "SEC") for an offering of 17,250,000 shares of common stock (the "Equity Offerings"). In addition, CCA filed a registration statement with the SEC for an offering of $300 million aggregate principal amount of Series A Senior Notes due 2004 (the "Series A Senior Notes") and $100 million aggregate principal amount of Series B Senior Notes due 2002 (the "Series B Senior Notes"). The Series A Senior Notes and the Series B Senior Notes are referred to herein as the "Senior Notes" or the "Debt Offerings". The Equity Offerings and the Debt Offerings are collectively referred to herein as the "Offerings". The Recapitalization Plan includes, among other things, (i) the Offerings, (ii) the sale of $100 million of Common Stock to SIBV (or a corporate affiliate) (the "SIBV Investment") and (iii) a new credit agreement by JSC and CCA (the "New Credit Agreement") consisting of a $450 million revolving credit facility (the "New Revolving Credit Facility"), a $300 million term loan (the "Initial Term Loan") and a $900 million delayed term loan (the "Delayed Term Loan" and, together with the Initial Term Loan, the "New Term Loans"). Proceeds of the Recapitalization Plan, exclusive of the Delayed Term Loan, will be used to refinance all of the Company's indebtedness under the 1989 and 1992 Credit Agreements and the Secured Notes. The applications of borrowings under the Delayed Term Loan shall be used to redeem or repurchase the Subordinated Debt on approximately December 1, 1994 (the "Subordinated Debt Refinancing"). Prior to the date on which the Registration Statements are declared effective by the SEC, Holdings intends to change its name to "Jefferson Smurfit Corporation" and JSC intends to change its name to "Jefferson Smurfit Corporation (U.S.)". All references in this 10-K to the "Company" or to "JSC" refer to the corporation currently named Jefferson Smurfit Corporation and, when the context requires, its consolidated subsidiaries. All references in this 10-K to "Holdings" refer to the corporation currently named SIBV/MS Holdings, Inc. GENERAL The predecessor to the Company was founded in 1974 when JS Group, a worldwide leader in the packaging products industry, commenced operations in the United States by acquiring 40% of a small paperboard and packaging products company. The remaining 60% of that company was acquired by JS Group in 1977, and in 1978 net sales were $42.9 million. The Company implemented a strategy to build a fully integrated, broadly based, national packaging business, primarily through acquisitions, including Alton Box Board Company in 1979, the paperboard and packaging divisions of Diamond International Corporation in 1982, 80% of Smurfit Newsprint Corporation ("SNC") in 1986 and 50% of CCA in 1986. The Company financed its acquisitions by using leverage and, in several cases, utilized joint venture financing whereby the Company eventually obtained control of the acquired company. While no major acquisition has been made since 1986, the Company has made 18 smaller acquisitions and started up five new facilities which had combined sales in 1993 of $280.3 million. JSC was formed in 1983 to consolidate the operations of the Company, and today the Company ranks among the industry leaders in its two business segments, Paperboard/Packaging Products and Newsprint. In 1993, the Company had net sales of $2.9 billion, achieving a compound annual sales growth rate of 32.6% for the period since 1978. The Company believes it is one of the nation's largest producers of paperboard and packaging products and is the largest producer of recycled paperboard and recycled packaging products. In 1993, the Company's system of 16 paperboard mills produced 1,840,000 tons of virgin and recycled containerboard, 829,000 tons of coated and uncoated recycled boxboard and solid bleached sulfate ("SBS") and 206,000 tons of recycled cylinderboard, which were sold to the Company's own converting operations or to third parties. The Company's converting operations consist of 52 corrugated container plants, 18 folding carton plants, and 16 industrial packaging plants located across the country, with three plants located outside the U.S. In 1993, the Company's container plants converted 1,942,000 tons of containerboard, an amount equal to approximately 105.5% of the amount it produced, its folding carton plants converted 542,000 tons of SBS, recycled boxboard and coated natural kraft, an amount equal to approximately 65.4% of the amount it produced, and its industrial packaging plants converted 123,000 tons of recycled cylinderboard, an amount equal to approximately 59.7% of the amount it produced. The Company's Paperboard/Packaging Products segment contributed 91.6% of the Company's net sales in 1993. The Company's paperboard operations are supported by its reclamation division, which processed or brokered 3.9 million tons of wastepaper in 1993, and by its timber division which manages approximately one million acres of owned or leased timberland located in close proximity to its virgin fibre mills. The paperboard/packaging products operations also include 14 consumer packaging plants. In addition, the Company believes it is one of the nation's largest producers of recycled newsprint. The Company's Newsprint segment includes two newsprint mills in Oregon, which produced 615,000 tons of recycled newsprint in 1993, and two facilities that produce Cladwood, a construction material produced from newsprint and wood by-products. The Company's newsprint mills are also supported by the Company's reclamation division. PRODUCTS PAPERBOARD/PACKAGING PRODUCTS SEGMENT CONTAINERBOARD AND CORRUGATED SHIPPING CONTAINERS The Company's containerboard operations are highly integrated. Tons of containerboard produced and converted for the last three years were: The Company's mills produce a full line of containerboard, including unbleached kraft linerboard, mottled white linerboard and recycled medium. The Company believes it is the nation's largest producer of mottled white linerboard, the largest producer of recycled medium and the fifth largest producer of containerboard. Unbleached kraft linerboard is produced at the Company's mills located in Fernandina Beach and Jacksonville, Florida and mottled white linerboard is produced at its Brewton, Alabama mill. Recycled medium is produced at the Company's mills located in Alton, Illinois, Carthage, Indiana, Circleville, Ohio and Los Angeles, California. In 1993, the Company produced 1,018,000, 315,000 and 507,000 tons of unbleached kraft linerboard, mottled white linerboard and recycled medium, respectively. Large capital investment is required to sustain the Company's containerboard mills, which employ state of the art computer controlled machinery in their manufacturing processes. During the last five years, the Company has invested approximately $246 million to enhance product quality, reduce costs, expand capacity and increase production efficiency, as well as make required improvements to stay in compliance with environmental regulations. Major capital projects completed in the last five years include (i) a rebuild of Jacksonville's linerboard machine to produce high performance, lighter weight grades now experiencing higher demand, (ii) modifications to Brewton's mottled white machine to increase run speed by 100 tons per day and (iii) a project to reduce sulfur emissions from the Fernandina Beach linerboard mill. A key strategy for the next few years will be to reduce wood cost at its virgin fibre mills by modifying methods of woodchip production and handling, utilizing random length roundwood forms and continuing to pursue forest management practices designed to enhance timberland productivity. The Company's sales of containerboard in 1993 were $670.6 million (including $384.1 million of intracompany sales). Sales of containerboard to its 52 container plants are reflected at prices based upon those published by Official Board Markets which are generally higher than those paid by third parties except in exchange contracts. The Company believes it is the third largest producer of corrugated shipping containers in the U.S. Corrugated shipping containers, manufactured from containerboard in converting plants, are used to ship such diverse products as home appliances, electric motors, small machinery, grocery products, produce, books, tobacco and furniture, and for many other applications, including point of purchase displays. The Company stresses the value added aspects of its corrugated containers, such as labeling and multi-color graphics, to differentiate its products and respond to customer requirements. The Company's container plants serve local customers and large national accounts and are located nationwide, generally in or near large metropolitan areas. The Company's total sales of corrugated shipping containers in 1993 were $1,175.7 million (including $81.1 million of intracompany sales). Corrugated shipping container sales volumes for 1991, 1992 and 1993 were 25,178, 26,593 and 27,268 million square feet, respectively. RECYCLED BOXBOARD, SBS AND FOLDING CARTONS The Company's recycled boxboard, SBS and folding carton operations are also integrated. Tons of recycled boxboard and SBS produced and converted for the last three years were: The Company's recycled cylinderboard mills are located in: Tacoma, Washington, Monroe, Michigan (2 mills), Lafayette, Indiana, and Cedartown, Georgia. In 1993, total sales of recycled cylinderboard were $61.8 million (including $17.9 million of intracompany sales). The Company's 16 industrial packaging plants convert recycled cylinderboard, including a portion of the recycled cylinderboard produced by the Company, into papertubes and cores. Papertubes and cores are used primarily for paper, film and foil, yarn carriers and other textile products and furniture components. The Company also produces solid fibre partitions for the pharmaceutical, electronics, cosmetics and plastics industries. In addition, the Company produces a patented self-locking partition especially suited for automated packaging and product protection. The Company believes it is the nation's third largest producer of tubes and cores. The Company's industrial packaging sales in 1993 were $88.1 million (including $1.6 million in intracompany sales). CONSUMER PACKAGING The Company manufactures a wide variety of consumer packaging products. These products include flexible packaging, printed paper labels, foil labels, and labels that are heat transferred to plastic containers for a wide range of industrial and consumer product applications. The contract packaging plants provide cartoning, bagging, liquid- or powder-filling, high-speed overwrapping and fragranced advertising products. The Company produces high-quality rotogravure cylinders and has a full-service organization experienced in the production of color separations and lithographic film for the commercial printing, advertising and packaging industries. The Company also designs, manufactures and sells custom machinery including specialized machines that apply labels to customers' packaging. The Company currently has 14 facilities including the engineering service center referred to below and has improved their competitiveness by installing state- of-the-art production equipment. In addition, the Company has an engineering services center, specializing in automated production systems and highly specialized machinery, providing expert consultation, design and equipment fabrication for consumer and industrial products manufacturers, primarily from the food, beverage and medical products industries. Total sales of consumer packaging products and services were $179.8 million (including $15.1 million of intracompany sales). RECLAMATION OPERATIONS; FIBRE RESOURCES AND TIMBER PRODUCTS The raw materials essential to the Company's business are reclaimed fibre from wastepaper and wood, in the form of logs or chips. The Brewton, Circleville, Jacksonville and Fernandina mills use primarily wood fibres, while the other paperboard mills use reclaimed fibre exclusively. The newsprint mills use approximately 45% wood fibre and 55% reclaimed fibre. The Company believes it is the nation's largest processor of wastepaper. The use of recycled products in the Company's operations begins with its reclamation division which operates 26 facilities that collect, sort, grade and bale wastepaper, as well as collect aluminum and glass. The reclamation division provides valuable fibre resources to both the paperboard and newsprint segments of the Company as well as to other producers. Many of the reclamation facilities are located in close proximity to the Company's recycled paperboard and newsprint mills, assuring availability of supply, when needed, with minimal shipping costs. In 1993, the Company processed 3.9 million tons of wastepaper, which the Company believes is approximately twice the amount of wastepaper processed by its closest competitor. The amount of wastepaper collected and the proportions sold internally and externally by the Company's reclamation division for the last three years were: The reclamation division also operates a nationwide brokerage system whereby it purchases and resells wastepaper (including wastepaper for use in its recycled fibre mills) on a regional and national contract basis. Such contracts provide bulk purchasing, resulting in lower prices and cleaner wastepaper. Total sales of recycled materials for 1993 were $242.9 million (including $120.8 million of intracompany sales). During 1993, the wastepaper which was reclaimed by the Company's reclamation plants and brokerage operations satisfied all of the Company's mill requirements for reclaimed fibre. The Company's timber division manages approximately one million acres of owned and leased timberland. In 1993, approximately 53% of the timber harvested by the Company was used in its Jacksonville, Fernandina and Brewton Mills. The Company harvested 808,000 cords of timber which would satisfy approximately 32% of the Company's requirements for woodfibres. The Company's woodfibre requirements not satisfied internally are purchased on the open market or under long-term contracts. In the past, the Company has not experienced difficulty obtaining an adequate supply of wood through its own operations or open market purchases. The Company is not aware of any circumstances that would adversely affect its ability to satisfy its wood requirements in the foreseeable future. In recent years, a shortage of wood fibre in the spotted owl regions in the Northwest has resulted in increases in the cost of virgin wood fibre. However, the Company's use of reclaimed fibre in its newsprint mills has mitigated the effect of this in significant part. In 1993, the Company's total sales of timber products were $227.8 million (including $185.1 million of intracompany sales). NEWSPRINT SEGMENT NEWSPRINT MILLS The Company believes it is one of the largest producer of recycled newsprint and the fourth largest producer overall of newsprint in the United States. The Company's newsprint mills are located in Newberg and Oregon City, Oregon. During 1991, 1992 and 1993, the Company produced 614,000, 615,000 and 615,000 tons of newsprint, respectively. In 1993, total sales of newsprint were $219.5 million (none of which were intracompany sales). For the past three years, an average of approximately 56% of the Company's newsprint production has been sold to The Times Mirror Company ("Times Mirror") pursuant to a long-term newsprint agreement (the "Newsprint Agreement") entered into in connection with the Company's acquisition of SNC stock in February 1986. Under the terms of the Newsprint Agreement, the Company supplies newsprint to Times Mirror generally at prevailing West Coast market prices. Sales of newsprint to Times Mirror in 1993 amounted to $115.2 million. CLADWOOD Cladwood is a wood composite panel used by the housing industry, manufactured from sawmill shavings and other wood residuals and overlayed with recycled newsprint. The Company has two Cladwood plants located in Oregon. Total sales for Cladwood in 1993 were $29.1 million ($.5 million of which were intracompany sales). MARKETING The marketing strategy for the Company's mills is to maximize sales of products to manufacturers located within an economical shipping area. The strategy in the converting plants focuses on both specialty products tailored to fit customers' needs and high volume sales of commodity products. The Company also seeks to broaden the customer base for each of its segments rather than to concentrate on only a few accounts for each plant. These objectives have led to decentralization of marketing efforts, such that each plant has its own sales force, and many have product design engineers, who are in close contact with customers to respond to their specific needs. National sales offices are also maintained for customers who purchase through a centralized purchasing office. National account business may be allocated to more than one plant because of production capacity and equipment requirements. COMPETITION The paperboard and packaging products markets are highly competitive and are comprised of many participants. Although no single company is dominant, the Company does face significant competitors in each of its businesses. The Company's competitors include large vertically integrated companies as well as numerous smaller companies. The industries in which the Company competes are particularly sensitive to price fluctuations as well as other competitive factors including design, quality and service, with varying emphasis on these factors depending on product line. The market for the Newsprint segment is also highly competitive. BACKLOG Demand for the Company's major product lines is relatively constant throughout the year and seasonal fluctuations in marketing, production, shipments and inventories are not significant. The Company does not have a significant backlog of orders, as most orders are placed for delivery within 30 days. RESEARCH AND DEVELOPMENT The Company's research and development center works with its manufacturing and sales operations, providing state-of-the-art technology, from raw materials supply through finished packaging performance. Research programs have provided improvements in coatings and barriers, stiffeners, inks and printing. The technical staff conducts basic, applied and diagnostic research, develops processes and products and provides a wide range of other technical services. The Company actively pursues applications for patents on new inventions and designs and attempts to protect its patents against infringement. Nevertheless, the Company believes that its success and growth are dependent on the quality of its products and its relationships with its customers, rather than on the extent of its patent protection. The Company holds or is licensed to use certain patents, but does not consider that the successful continuation of any important phase of its business is dependent upon such patents. EMPLOYEES Subsequent to closure in early 1994 of three container plants, two folding carton plants and one recycled boxboard mill, the Company had approximately 16,600 employees at March 1, 1994, of which approximately 11,300 employees (68%), are represented by collective bargaining units. The expiration date of union contracts for the Company's major facilities are as follows: the Alton mill, expiring June 1994; the Newberg mill, expiring March 1995; the Oregon City mill, expiring March 1997; the Brewton mill, expiring October 1997; the Fernandina mill, expiring June 1998; a group of 12 properties, including 4 paper mills and 8 corrugated container plants, expiring June 1998; and the Jacksonville mill, expiring June 1999. The Company believes that its employee relations are generally good and is currently in the process of bargaining with unions representing production employees at a number of its other operations. ITEM 2. ITEM 2. PROPERTIES The Company's properties at December 31, 1993 are summarized in the table below. The table reflects the previously mentioned closure in early 1994 of three container plants, two folding carton plants and one recycled boxboard mill, but does not reflect the additional closures contemplated by the Restructuring Program. Approximately 62% of the Company's investment in property, plant and equipment is represented by its paperboard and newsprint mills. In addition to its manufacturing facilities, the Company owns and leases approximately 758,000 acres and 226,000 acres of timberland, respectively, and also operates wood harvesting facilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Litigation In May 1993, CCA received a notice of default on behalf of Otis B. Ingram, as executor of the estate of Naomi M. Ingram, and Ingram- LeGrand Lumber Company with respect to certain timber purchase agreements and timber management agreements between CCA and such parties dated November 22, 1967 pertaining to approximately 30,000 acres of property in Georgia (the "Agreements"). In June 1993, CCA filed suit against such parties in the United States District Court, Middle District of Georgia, seeking declaratory and injunctive relief and damages in excess of $3 million arising out of the defendants' alleged breach and anticipatory repudiation of the Agreements. The defendants have filed an answer and counterclaim seeking damages in excess of $14 million based on allegations that CCA breached the Agreements and failed to pay for timber allegedly stolen or otherwise removed from the property by CCA or third parties. The alleged thefts of timber are being investigated by the Georgia Bureau of Investigation, which has advised CCA that it is not presently a target of this investigation. CCA has filed a third-party complaint against Keadle Lumber Enterprises, Inc. seeking indemnification with respect to such alleged thefts and has filed a reply to the defendants' counterclaims denying the allegations and any liability to the defendants. Management does not believe that the outcome of this litigation will have a material adverse effect on the Company's financial condition or operations. The Company is a defendant in a number of other lawsuits which have arisen in the normal course of business. While any litigation has an element of uncertainty, the management of the Company believes that the outcome of such suits will not have a material adverse effect on its financial condition or operations. Environmental Matters Federal, state and local environmental requirements, particularly relating to air and water quality, are a significant factor in the Company's business. The Company employs processes in the manufacture of pulp, paperboard and other products, resulting in various discharges and emissions that are subject to numerous federal, state and local environmental control statutes, regulations and ordinances. The Company operates and expects to operate under permits and similar authorizations from various governmental authorities that regulate such discharges and emissions. Occasional violations of permit terms have occurred from time to time at the Company's facilities, resulting in administrative actions, legal proceedings or consent decrees and similar arrangements. Pending proceedings include the following: In March 1992, JSC entered into an administrative consent order with the Florida Department of Environmental Regulation to carry out any necessary assessment and remediation of JSC-owned property in Duval County, Florida that was formerly the site of a sawmill that dipped lumber into a chemical solution. Assessment is on-going, but initial data indicates soil and groundwater contamination that may require nonroutine remediation. Management believes that the probable costs of this site, taken alone or with potential costs at other Company-owned properties where some contamination has been found, will not have a material adverse effect on its financial condition or operations. In February 1994, JSC entered into a consent decree with the State of Ohio in full satisfaction of all liability for alleged violations of applicable standards for particulate and opacity emissions with respect to two coal-fired boilers at its Lockland, Ohio recycled boxboard mill (which has been permanently closed as part of the Company's restructuring program), and is required to pay $122,000 in penalties and enforcement costs pursuant to such consent decree. The United States Environmental Protection Agency has also issued a notice of violation with respect to such emissions, but has informally advised JSC's counsel that no Federal enforcement is likely to commenced in light of the settlement with the State of Ohio. The Company also faces potential liability as a result of releases, or threatened releases, of hazardous substances into the environment from various sites owned and operated by third parties at which Company-generated wastes have allegedly been deposited. Generators of hazardous substances sent to off-site disposal locations at which environmental problems exist, as well as the owners of those sites and certain other classes of persons (generally referred to as "potentially responsible parties" or "PRPs"), are, in most instances, subject to joint and several liability for response costs for the investigation and remediation of such sites under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") and analogous state laws, regardless of fault or the legality of the original disposal. The Company has received notice that it is or may be a PRP at a number of federal and/or state sites where remedial action may be required, and as a result may have joint and several liability for cleanup costs at such sites. However, liability of CERCLA sites is typically shared with the other PRPs and costs are commonly allocated according to relative amounts of waste deposited. Because the Company's relative percentage of waste deposited at the majority of these sites is quite small, management of the Company believes that its probable liability under CERCLA, taken on a case by case basis or in the aggregate, will not have a material adverse effect on its financial condition or operations. Pending CERCLA proceedings include the following: In January 1990, CCA filed a motion for leave to intervene and for modification of the consent decree in United States v. General Refuse Services, a case pending in the United States District Court for the Southern District of Ohio. CCA contends that it should be allowed to participate in the proposed consent decree, which provides for remediation of alleged releases or threatened releases of hazardous substances at a site in Miami County, near Troy, Ohio, according to a plan approved by the United States Environmental Protection Agency, Region V (the "Agency"). The Court granted CCA's motion to intervene in this litigation, but denied CCA's motion for an order denying entry of the consent decree. Consequently, the consent decree has been entered without CCA's being included as a party to the decree, meaning that CCA may have some exposure to potential claims for contribution to remediation costs incurred by other participants and for non-reimbursed response costs incurred by the Agency, which costs are reported by the Agency as $3.4 million as of February 1994. CCA's appeal of the Court's decision to the Sixth Circuit Court of Appeals is pending. In December 1991, the United States filed a civil action against CCA in United States District Court, Southern District of Ohio, to recover its unreimbursed costs at the Miami County site, and CCA subsequently filed a third-party complaint against certain entities that had joined the original consent decree. In October 1993, the United States filed an additional suit against CCA in the same court seeking injunctive relief and damages up to $25,000 per day from March 27, 1989 to the present, based on CCA's alleged failure to properly respond to the Agency's document and information requests in connection with this site. In July 1993, counsel for CCA was advised by the Office of the United Stated Attorney, Northern District of Illinois that a criminal inquiry is also underway relating to CCA's responses to the Agency's document and information requests. CCA is investigating the circumstances regarding its responses, and is pursuing settlement with respect to all matters relating to the Miami County Site. CCA has paid approximately $768,000 pursuant to two partial consent decrees entered into in 1990 and 1991 with respect to clean-up obligations at the Operating Industries site in Monterey Park, California. It is anticipated that there will be further remedial measures beyond those covered by these partial settlements. In addition to other Federal and State laws regarding hazardous substance contamination at sites owned or operated by the Company, the New Jersey Industrial Site Recovery Act ("ISRA") requires that a "Negative Declaration" or a "Cleanup Plan" be filed and approved by the New Jersey Department of Environmental Protection and Energy ("DEPE") as a precondition to the "transfer" of an "industrial establishment". The ISRA regulations provide that a transferor may close a transaction prior to the DEPE's approval of a negative declaration if the transferor enters into an administrative consent order with the DEPE. The Company is currently a signatory to administrative consent orders with respect to two formerly leased or owned industrial establishments and has recently closed a facility and received a negative declaration with respect thereto. Management believes that any requirements that may be imposed by the DEPE with respect to these sites will not have a materially adverse effect on the financial condition or operations of the Company. The Company's paperboard and newsprint mills are large consumers of energy, using either natural gas or coal. Approximately 67% of the Company's total paperboard tonnage is produced by mills which have coal-fired boilers. The cost of energy is dependent, in part, on environmental regulations concerning sulfur dioxide and particulate emissions. Because various pollution control standards are subject to change, it is not possible at this time to predict the amount of capital expenditures that will ultimately be required to comply with future standards. In particular, the United States Environmental Protection Agency has proposed a comprehensive rule governing the pulp, paper and paperboard industry, which could require substantial compliance expenditures on the part of the Company. For the past three years, the Company has spent an average of approximately $10 million annually on capital expenditures for environmental purposes. Further sums may be required in the future, although, in the opinion of management, such expenditures will not have a material effect on its financial condition or results of operations. The amount budgeted for such expenditures for fiscal 1994 is approximately $10 million. Since the Company's competitors are, or will be, subject to comparable pollution control standards, including the proposed rule discussed above, if implemented, management is of the opinion that compliance with future pollution standards will not adversely affect the Company's competitive position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of the registrant during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION CCA is an indirect wholly-owned subsidiary of JSC. All of the outstanding common stock of JSC ("JSC Common Stock") is owned by Holdings. As a result, there is no established public market for either the JSC Common Stock or the common stock of CCA ("CCA Common Stock"). DIVIDENDS In connection with the 1989 Transaction, the number of outstanding shares of JSC Common Stock was reduced from 38,557,721 to 1,000. There have been no dividends on the JSC Common Stock or the CCA Common Stock since the date of the 1989 Transaction. Following the consummation of the Offerings, the Senior Notes and the 9.75% Senior Unsecured Notes due 2003 (the "1993 Notes") will allow each of JSC and CCA to pay dividends such that the Company would be able, and permitted thereunder, to pay dividends. However, the New Credit Agreement and, unless and until the Subordinated Debt Refinancing is consummated, the indentures governing the Subordinated Debt, will prohibit the payment of any dividends by JSC or CCA for the foreseeable future. Delaware law generally requires that dividends are payable only out of a company's surplus or current net profits in accordance with the General Corporation Law of Delaware. Such Delaware law limitations apply to the payment of dividends by JSC and CCA. Any determination to pay cash dividends in the future will be at the discretion of the Board of Directors and will be dependent upon the Company's results of operations, financial condition, contractual restrictions and other factors deemed relevant at the time by the Board of Directors. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (In millions, except statistical data) ITEM 6. SELECTED FINANCIAL DATA (cont'd) (In millions, except statistical data) [FN] Data for the year ended December 31, 1989, includes CCA's results of operations as if CCA were consolidated with JSC as of January 1, 1989. Equity in earnings (loss) of affiliates in 1991 includes after-tax charges of $29.3 million and $6.7 million for the write-off of the Company's equity investments in Temboard and Company Company Limited Partnership, Inc., and PCL Industries Limited, respectively. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Industry Conditions Sales of containerboard and corrugated shipping containers, two of the Company's most important products, are generally subject to changes in industry capacity and cyclical changes in the economy, both of which can significantly impact selling prices and the Company's profitability. Operating rates in the industry during 1992 and 1991 were at high levels relative to demand, which was lower due to the sluggish U.S. economy and a decline in export markets. This imbalance resulted in excess inventories in the industry and lower prices for the Company's containerboard and corrugated shipping container products, which began early in 1991 and continued throughout 1992 and most of 1993. From the first quarter of 1991 through the third quarter of 1993 industry linerboard prices fell from $347 per ton to $295 per ton. During 1993, industry operating rates were lower as many containerboard producers, including the Company, took downtime at containerboard mills to reduce the excess inventories. By the end of the third quarter of 1993, inventory levels had decreased significantly. The lower level of inventories and the stronger U.S. economy provided what the Company believes were improved market conditions late in 1993, enabling the Company and other producers to implement a $25 per ton price increase for linerboard. A further linerboard increase of $30 per ton was implemented by all major integrated containerboard producers, including the Company, effective March 1, 1994. Newsprint prices have fallen substantially since 1990 due to supply and demand imbalances. During 1991 and 1992, new capacity of approximately 2.0 million tons annually came on line, representing an approximate 12% increase in supply. At the same time, U.S. consumption of newsprint fell, due to declines in readership and ad linage. As prices fell, certain high cost, virgin paper machines, primarily in Canada, representing approximately 1.2 million tons of annual production capacity, were shut down and remained idle during 1993. While supply was diminished, a price increase announced for 1993 was unsuccessful. Although market demand has improved in the fourth quarter of 1993, the Company does not expect significant improvement in prices before the second quarter of 1994. In addition, prices for many of the Company's other products, including solid bleached sulfate, recycled boxboard, folding cartons and reclaimed fibre weakened in 1993 and 1992. While the effect of the reclaimed fibre price decreases is unfavorable to the reclamation products division, it is favorable to the Company overall because of the reduction in fibre cost to the Company's paper mills that use reclaimed fibre. The Company has taken various steps to extend its business into less cyclical product lines, such as industrial packaging and consumer packaging. As a result of these industry conditions, the Company's gross margin declined from 18.1% in 1991 to 16.6% in 1992 and 12.7% in 1993. The Company's sales and profitability have historically been more sensitive to price changes than changes in volume. There can be no assurance that announced price increases for the Company's products can be implemented, or that prices for the Company's products will not decline from current levels. Cost Reduction Initiatives The recent cyclical downturn in the Paperboard/Packaging Products segment has led management to undertake several major cost reduction initiatives. In 1991, the Company implemented an austerity program to freeze staff levels, defer certain discretionary spending programs and more aggressively manage capital expenditures and working capital in order to conserve cash and reduce interest expense. While these measures successfully reduced expenses and increased cash flow, the length and extent of the industry downturn led the Company, in 1993, to initiate a new six year plan to reduce costs, increase volume and improve product mix (the "Plan"). The Plan is a systematic Company-wide effort designed to improve the cost competitiveness of all the Company's operating facilities and staff functions. In addition to increases in volume and improvements in product mix resulting from a focus on less commodity oriented business at its converting operations, the program will focus on opportunities to reduce costs and other measures, including (i) productivity improvements, (ii) capital projects which provide high returns and quick paybacks, (iii) reductions in fibre cost, (iv) reductions in the purchase cost of materials, (v) reductions in personnel costs and (vi) reductions in waste cost. Restructuring Program To further counteract the downturn in the industries in which the Company operates, management examined its cost and operating structure and developed a restructuring program (the "Restructuring Program") to improve its long-term position. As a result of management's review, in September 1993, the Company recorded a pre- tax charge of $96 million including a provision for direct expenses associated with (i) plant closures (consisting primarily of employee severance and termination benefits, lease termination costs and environmental costs); (ii) asset write-downs (consisting primarily of write-off of machinery no longer used in production and nonperforming machine upgrades); (iii) employee severance and termination benefits for the elimination of salaried and hourly personnel in operating and management realignment; and (iv) relocation of employees and consolidation of plant operations. Management anticipates that it will take approximately two to three years to complete the Restructuring Program due to ongoing customer demands. The Restructuring Program is expected to reduce production costs, employee expenses and depreciation charges. As part of the Restructuring Program, the Company closed certain high cost operating facilities, including a coated recycled boxboard mill and five converting plants, in January 1994. While future benefits of the Restructuring Program are uncertain, the operating losses in 1993 for the plants shut down in January 1994 and those contemplated in the future were $31 million. While the Company believes that it would have realized financial benefits in 1993 had these plants been shut down at the beginning of the year, and that it will realize such benefits in future periods, no assurances can be given in this regard and, in particular, no assurances can be given as to what portion of such loss would not have been realized in 1993 had such plants been shut down for the entire year. The $96 million charge consists of approximately $43 million for the write-down of assets at closed facilities and certain other nonproductive assets and $53 million of future cash expenditures. Significant anticipated cash expenditures reflected in the above amount include $33 million of plant closure costs, $5 million of employee severance and termination benefits and $7 million of consolidation and relocation of plant employees and equipment, a substantial portion of which will be paid in 1994, 1995 and 1996. Environmental Matters The Company recorded a provision of $54 million of which $39 million relates to environmental matters, representing asbestos and PCB removal, solid waste cleanup at existing and former operating sites, and expenses for response costs at various sites where the Company has received notice that it is a potentially responsible party ("PRP"). The Company, as well as other companies in the industry, faces potential environmental liability related to various sites at which wastes have allegedly been deposited. The Company has received notice that it is or may be a PRP at a number of federal and state sites (the "Sites") where remedial action may be required. Because the laws that govern the clean up of waste disposal sites have been construed to authorize joint and several liability, government agencies or other parties could seek to recover all response costs for any Site from any one of the PRPs for such Site, including the Company, despite the involvement of other PRPs. Although the Company is unable to estimate the aggregate response costs in connection with the remediation of all Sites, if the Company were held jointly and severally liable for all response costs at some or all of the Sites, it would have a material adverse effect on the financial condition and results of operations of the Company. However, joint and several liability generally has not in the past been imposed on PRPs, and, based on such past practice, the Company's past experience and the financial conditions of other PRPs with respect to the Sites, the Company does not expect to be held jointly and severally liable for all response costs at any Site. Liability at waste disposal sites is typically shared with other PRPs and costs generally are allocated according to relative volumes of waste deposited. At most Sites, the waste attributed to the Company is a very small portion of the total waste deposited at the Site (generally significantly less than 1%). There are approximately ten Sites where final settlement has not been reached and where the Company's potential liability is expected to exceed de minimis levels. Accordingly, the Company believes that its estimated total probable liability for response costs at the Sites was adequately reserved at December 31, 1993. Further, the estimate takes into consideration the number of other PRPs at each site, the identity, and financial position of such parties, in light of the joint and several nature of the liability, but does not take into account possible insurance coverage or other similar reimbursement. Results of Operations The following tables present net sales on a segment basis for the years ended December 31, 1993, 1992 and 1991 and an analysis of period-to-period increases (decreases) in net sales (in millions): 1993 Compared to 1992 The Company's net sales for 1993 decreased 1.7% to $2.95 billion compared to $3.0 billion in 1992. Net sales decreased 1.9% in the Paperboard/Packaging Products segment and increased 0.3% in the Newsprint segment. The decrease in Paperboard/Packaging Products segment sales for 1993 was due primarily to lower prices and changes in product mix for containerboard, corrugated shipping containers and folding cartons. This decrease was partially offset by an increase in sales volume primarily of corrugated shipping containers, which set a record in 1993. A newly constructed corrugated container facility and several minor acquisitions in 1992 caused net sales to increase $34.9 million for 1993. The net sales increase in the Newsprint segment was a result of an increase in sales volume in 1993 compared to 1992, partially offset by a decline in sales prices. Cost of goods sold as a percent of net sales for 1993 and 1992 were 85.9% and 81.9%, respectively, for the Paperboard/Packaging Products segment and 102.8% and 99.0%, respectively, for the Newsprint segment. The increase in cost of goods sold as a percent of net sales for the Paperboard/Packaging Products segment was due primarily to the aforementioned changes in pricing and product mix. The increase in the cost of goods sold as a percent of net sales for the Newsprint segment was due primarily to the higher cost of energy and fibre and decreases in sales price. In 1993, the Company changed the estimated depreciable lives of its paper machines and major converting equipment. These changes were made to better reflect the estimated periods during which the assets will remain in service and were based upon the Company's historical experience and comparable industry practice. These changes were made effective January 1, 1993 and had the effect of reducing depreciation expense by $17.8 million and decreasing the 1993 net loss by $11.0 million. Selling and administrative expenses increased to $239.2 million (3.4%) for 1993 compared to $231.4 million for 1992. The increase was due primarily to higher provisions for retirement costs, acquisitions, new facilities and other costs. In order to minimize significant year-to-year fluctuations in pension cost caused by financial market volatility, the Company changed, effective January 1, 1993, the method of accounting for the recognition of fluctuations in the market value of pension assets. The effect of this change on 1993 results of operations, including the cumulative effect of prior years, was not material. See Note 8 to the Company's consolidated financial statements. The Company reduced its weighted average discount rate in measuring its pension obligations from 8.75% to 7.6% and its rate of increase in compensation levels from 5.5% to 4.0% at December 31, 1993. The net effect of changing these assumptions was the primary reason for the increase in the projected benefit obligations and the changes are expected to increase pension cost by approximately $3.4 million in 1994. As a result of the $96 million restructuring charge, $54 million environmental and other charges, and the lower margins, primarily for newsprint and containerboard products, the Company had a loss from operations of $14.7 million for 1993, compared to $267.7 million income from operations for 1992. Interest expense for 1993 declined $45.9 million due to lower effective interest rates and the lower level of subordinated debt outstanding resulting primarily from the 1992 Transaction. The benefit from income taxes for 1993 was $83.0 million compared to a tax provision of $10.0 million in 1992. The significant difference in the income tax provision from 1993 to 1992 results from the use of the liability method of accounting which restored deferred income taxes and increased the related asset values for tax effects previously recorded as a reduction of the carrying amount of the related assets under prior business combinations. The Company's effective tax rate for 1993 was lower than the Federal statutory tax rate due to the nondeductibility of goodwill amortization and a $5.7 million provision to adjust deferred tax assets and liabilities in 1993 due to the enacted Federal income tax rate change from 34% to 35%. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The cumulative effect of adopting SFAS No. 109 was to increase net income for 1993 by approximately $20.5 million. The cumulative effect of adopting SFAS No. 106 was to decrease net income for 1993 by approximately $37 million. The Company will adopt SFAS No. 112 "Employers' Accounting for Postemployment Benefits" in 1994, the effect of which is not expected to be material. The loss before extraordinary item and cumulative effect of accounting changes for 1993 was $174.6 million, compared to $34.0 million for the comparable period in 1992. The Company recorded an extraordinary loss of $37.8 million (net of income tax benefits of $21.7 million) for the early extinguishment of debt associated with the issuance of the 1993 Notes. 1992 Compared to 1991 Net sales for 1992 increased to $3.0 billion (2.0%) compared to $2.94 billion in 1991. Net sales increased 3.7% in the Paperboard/Packaging Products segment and decreased 13.6% in the Newsprint segment. The increase in Paperboard/Packaging Products segment sales was due primarily to a 5.6% increase in sales volume for corrugated shipping containers. Segment sales were also positively affected by increases in sales volumes for papertubes and partitions and to a lesser extent for folding cartons and reclamation products. Prices of containerboard products improved over 1991 but did not increase sufficiently to cover cost increases, causing margins to be somewhat lower in 1992. Prices for most of the Company's other packaging products have declined compared to 1991. A minor acquisition in 1992 and the operation of new facilities in the Paperboard/Packaging Products segment resulted in an increase in net sales of $9.8 million, while plant closings caused net sales to decrease by $2.2 million. The net sales decrease in the Newsprint segment was a result of the lower sales prices as discussed above. Newsprint sales volume for 1992 was virtually the same as 1991. The Company continued to benefit from certain austerity measures first implemented during 1991 to help offset the impact of the recession. These measures had a positive effect on cost of goods sold and selling and administrative expenses. Cost of goods sold as a percent of net sales for 1992 and 1991 were 81.9% and 81.8%, respectively, for the Paperboard/Packaging Products segment and 99.0% and 83.1% respectively, for the Newsprint segment. The increase in the Newsprint segment was due primarily to the aforementioned decrease in sales price. Selling and administrative expense as a percent of net sales for 1992 was 7.7%, unchanged from 1991. The Company continued to benefit from certain cost containment measures implemented in 1991 to reduce expenses to help offset the impact of the recession and inflation. Income from operations for 1992 decreased 12.4% to $267.7 million as a result of the low average selling prices for newsprint and packaging products discussed above. Interest expense for 1992 was lower by $35.1 million, due to lower effective interest rates and the lower level of debt outstanding as a result of the 1992 Transaction. During 1992, the Company replaced $425.0 million of mature swaps with $400.0 million of the new two-year fixed interest rate swaps at an annual savings of approximately 3.8% on such amount (equivalent to an annual savings of approximately $15.1 million). The Company recorded a $10.0 million income tax provision to both 1992 and 1991 on income before income taxes, equity in earnings (loss) of affiliates and extraordinary item of $27.2 million and $24.3 million, respectively. The tax provisions for 1992 and 1991 were higher than the Federal statutory tax rate due to several factors, the most significant of which was the impact of permanent differences from applying purchase accounting. Equity in loss of affiliates for 1991 included a write-down of $36.0 million with respect to the Company's equity investments in Temboard and Company Limited Partnership and PCL Industries Limited. See Note 3 to the Company's consolidated financial statements. For 1992 the Company had an extraordinary loss of $49.8 million (net of income tax benefits of $25.8 million) for the early extinguishment of debt associated with the 1992 Transaction. Impact of Inflation and Changing Prices The Company uses the LIFO method of accounting for approximately 81% of its inventories. Under this method, the cost of products sold reported in the financial statements approximates current cost and thus reduces the distortion in reported income due to increasing costs. In recent years, inflation has not had a material effect on the financial position or results of operations of the Company. Liquidity and Capital Resources The Company's primary uses of cash for the next several years will be principal and interest payments on its indebtedness and capital expenditures. In April 1993, the Company issued $500 million aggregate principal amount of the 1993 Notes. Proceeds of the 1993 Notes were used to refinance a substantial portion of indebtedness in order to improve operating and financial flexibility by extending maturities of indebtedness and improving liquidity. As a result of the issuance of the 1993 Notes, there are no significant scheduled payments due on bank term loans until June 1996 (assuming the refinancing of the Company's indebtedness under 1989 and 1992 Credit Agreements and the Secured Notes is not consummated). In connection with the issuance of the 1993 Notes, SIBV committed to purchase up to $200 million aggregate principal amount of 11 1/2% Junior Subordinated Notes maturing 2005, the proceeds of which must be used to repurchase or otherwise retire Subordinated Debt. The above commitment will be terminated upon the consummation of the Offerings. Holdings and the Company are implementing the Recapitalization Plan to repay or refinance a substantial portion of their indebtedness in order to improve operating and financial flexibility by (i) reducing the level and overall cost of their debt, (ii) extending maturities of indebtedness, (iii) increasing stockholders' equity and (iv) increasing their access to capital markets. The Recapitalization Plan includes (i) the Debt Offerings, (ii) the Equity Offerings, (iii) the SIBV Investment, and (iv) the New Credit Agreement consisting of the New Revolving Credit Facility and the New Term Loans. Proceeds of the Recapitalization Plan, exclusive of funds used to effect the Subordinated Debt Refinancing (including the remaining borrowings under the Delayed Term Loan and available proceeds of the Debt Offerings), will be used to refinance all of the Company's indebtedness under the 1989 and 1992 Credit Agreements and the Secured Notes. Available proceeds of the Debt Offerings, remaining borrowings under the Delayed Term Loan and, to the extent required, borrowings under the New Revolving Credit Facility or available cash shall be used to redeem or repurchase the Subordinated Debt on approximately December 1, 1994. It is anticipated that immediately following the Offerings, borrowings of $65 million and letters of credit of approximately $90 million will be outstanding under the New Revolving Credit Facility. After giving effect to the Recapitalization Plan on a pro forma basis, at December 31, 1993 the Company would have had approximately $2,371.1 million of total long-term debt outstanding, all of which would have been senior debt, as compared to $2,619.1 million of long-term debt actually outstanding. After completion of the Recapitalization Plan there will be no significant scheduled payments due on bank debt (other than required payments out of "excess cash", if any) until 18 months following consummation of the Offerings, at which time approximately $46.0 million will be payable. Assuming consummation of the Recapitalization Plan (whether including or excluding the Subordinated Debt Refinancing), the Company does not currently anticipate that it will experience any liquidity problems which would cause it to fail to make any scheduled payment on its bank debt. As discussed below, the Company expects that liquidity will be provided by its operations and through the utilization of unused borrowing capacity under the New Credit Agreement and the Securitization (defined below). The Company's earnings are significantly affected by the amount of interest on its indebtedness. At December 31, 1993, the Company had $215 million of variable rate debt which had been swapped to a weighted average fixed rate of approximately 9.1%. The Company also had interest rate swap agreements related to the Accounts Receivable Securitization Program (the "Securitization") that effectively converted $95 million of fixed rate borrowings to a variable rate of 5.6% (at December 31, 1993) and converted $80 million of variable rate borrowings to a fixed rate of 7.2% through January 1996. In addition, the Company is party to interest rate swap agreements related to the 1993 Notes which convert $500 million of fixed rate borrowings to a variable rate of 8.6% (at December 31, 1993). Capital expenditures consist of property and timberland additions and acquisitions of businesses. Capital expenditures for 1993, 1992 and 1991 were $117.4 million, $97.9 million and $118.9 million, respectively. Financing arrangements entered into in connection with the 1989 Transaction impose an annual limit on future capital expenditures, as defined in the financing arrangements, of approximately $125.0 million. The capital spending limit is subject to increase in any year if the prior year's spending was less than the maximum amount allowed. For 1993, such carryover from 1992 was $75 million. Because the Company has invested heavily in its core businesses over the last several years, management believes the annual limitation on capital expenditures should not impair its plans for maintenance, expansion and continued modernization of its facilities. It is expected that the New Credit Agreement will contain limitations on capital expenditures substantially similar to those contained in the financing arrangements entered into in connection with the 1989 Transaction. The Company anticipates making capital expenditures of approximately $140 million in 1994. Under the terms of the Old Bank Facilities, the Company is required to comply with certain financial covenants, including maintenance of quarterly and annual interest coverage ratios and earnings, as defined. In anticipation of violating these financial covenants at September 30, 1993, the Company requested and received waivers from its lender group, and in December, 1993 amended the Old Bank Facilities to modify financial covenants. The Company was in compliance with the amended covenants at December 31, 1993. The Company expects to have similar covenants in the New Credit Agreement. Operating activities have historically been the major source of cash for the Company's working capital needs, capital expenditures and debt payments. For 1993 and 1992, net cash provided by operating activities was $78.2 million and $145.7 million, respectively. At December 31, 1993, the Company had $112.1 million in unused borrowing capacity under the Revolving Credit Facility. Following the Offerings, the Company anticipates having $295.0 million of unused borrowing capacity under the New Revolving Credit Facility under the New Credit Agreement. The Company has borrowing capacity of $230.0 million under the Securitization subject to the Company's level of eligible accounts receivable. At December 31, 1993, the Company had borrowed $182.3 million under the Securitization and the level of eligible receivables did not permit any additional borrowings under the Securitization at the date. The Securitization matures in April 1996, at which time the Company expects to refinance it. Although the Company believes that it will be able to do so, no assurance can be given in this regard. The Company's existing indebtedness imposes restrictions on its ability to incur additional indebtedness. Such restrictions, together with the highly leveraged position of the Company, could restrict corporate activities, including the Company's ability to respond to market conditions, to provide for unanticipated capital expenditures or to take advantage of business opportunities. However, the Company believes that cash provided by operations and available financing sources will be sufficient to meet the Company's cash requirements for the next several years. This page is intentionally left blank. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page No. The following consolidated financial statements of Jefferson Smurfit Corporation are included in this report: Consolidated balance sheets - December 31, 1993 and 1992 . . . . . 30 For the years ended December 31, 1993, 1992 and 1991: Consolidated statements of operations . . . . . . . . . . . . 32 Consolidated statements of stockholder's deficit. . . . . . . . . 33 Consolidated statements of cash flows . . . . . . . . . . . . . . 34 Notes to consolidated financial statements. . . . . . . . . . . . . 35 The following consolidated financial statement schedules of Jefferson Smurfit Corporation are included in Item 14(a): II: Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other than Related Parties. . . . . . 79 V: Property, Plant and Equipment . . . . . . . . . . . . . . . . 80 VI: Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . . . . . . . . . . . . . . . . 82 VIII: Valuation and Qualifying Accounts . . . . . . . . . . . . . . 84 X: Supplementary Income Statement Information. . . . . . . . . . 85 All other schedules specified under Regulation S-X for Jefferson Smurfit Corporation have been omitted because they are either not applicable, not required or because the information required is included in the financial statements or notes thereto. MANAGEMENT'S STATEMENT OF RESPONSIBILITY The management of the Company is responsible for the information contained in the consolidated financial statements and in other parts of this report. The consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include certain amounts based on management's best estimate and judgment. The Company maintains a system of internal accounting control, which it believes is sufficient to provide reasonable assurance that in all material respects transactions are properly authorized and recorded, financial reporting responsibilities are met and accountability for assets is maintained. In establishing and maintaining any system of internal control, judgment is required to assess and balance the relative costs and expected benefits. Management believes that through the careful selection of employees, the division of responsibilities and the application of formal policies and procedures, the Company has an effective and responsive system of internal accounting controls. The system is monitored by the Company's staff of internal auditors, who evaluate and report to management on the effectiveness of the system. The Audit Committee of the Board of Directors is composed of two directors who meet with the independent auditors, internal auditors and management to discuss specific accounting, reporting and internal control matters. Both the independent auditors and internal auditors have full and free access to the Audit Committee. James E. Terrill President, Chief Executive Officer John R. Funke Vice President and Chief Financial Officer (Principal Accounting Officer) REPORT OF INDEPENDENT AUDITORS Board of Directors JEFFERSON SMURFIT CORPORATION We have audited the accompanying consolidated balance sheets of Jefferson Smurfit Corporation as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's deficit 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Jefferson Smurfit 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 described in Note 6 and Note 7 to the financial statements, in 1993, the Company changed its method of accounting for income taxes and postretirement benefits. Ernst & Young St. Louis, Missouri January 28, 1994 except as to Note 15, as to which the date is February 23, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. JEFFERSON SMURFIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (Tabular amounts in millions) 1. -- Basis of Presentation Jefferson Smurfit Corporation ("JSC" or the "Company") is a wholly-owned subsidiary of SIBV/MS Holdings, Inc. ("Holdings"). Fifty percent of the voting stock of Holdings is owned by Smurfit Packaging Corporation ("SPC") and Smurfit Holdings B.V. ("SHBV"), indirect wholly-owned subsidiaries of Jefferson Smurfit Group plc ("JS Group"), a public corporation organized under the laws of the Republic of Ireland. The remaining 50% is owned by The Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"). Holdings has no operations other than its investment in JSC. In December 1989, pursuant to a series of transactions referred to hereafter as the "1989 Recapitalization", Holdings acquired the entire equity interest in JSC. Concurrently with Holdings' acquisition of JSC, Container Corporation of America ("CCA") acquired its common equity interest not owned by JSC. Prior to the 1989 Recapitalization, Smurfit International B.V. ("SIBV"), an indirect wholly-owned subsidiary of JS Group, owned 78% of JSC's outstanding common equity, the public owned the remaining common equity of JSC and JSC indirectly owned 50% of the common stock and 100% of the preferred stock of CCA. The remaining 50% of the common stock of CCA was owned by The Morgan Stanley Leveraged Equity Fund, L.P. and other investors ("MSLEF I Group"). Both MSLEF II and MSLEF I Group are affiliates of Morgan Stanley & Co. Incorporated ("MS & Co."). For financial accounting purposes, the 1989 acquisition by CCA of its common equity owned by MSLEF I Group and the purchase of the JSC common equity owned by SIBV were accounted for as purchases of treasury stock, resulting in a deficit balance in stockholder's equity in the accompanying consolidated financial statements. The acquisition of JSC's minority interest, representing approximately 22% of JSC's common equity, was accounted for as a purchase. 2. -- Significant Accounting Policies Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. Significant intercompany accounts and transactions are eliminated in consolidation. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. At December 31, 1993 cash and cash equivalents of $42.9 million are maintained as collateral for obligations under the accounts receivable securitization program (see Note 5). Revenue Recognition: Revenue is recognized at the time products are shipped. Inventories: Inventories are valued at the lower of cost or market, principally under the last-in, first-out ("LIFO") method except for $50.6 million in 1993 and $51.9 million in 1992 which are valued at the lower of average cost or market. First-in, first-out costs (which approximate replacement costs) exceed the LIFO value by $44.7 million and $46.3 million at December 31, 1993 and 1992, respectively. 2. -- Significant Accounting Policies (cont) Property, Plant and Equipment: Property, plant and equipment are carried at cost. Provisions for depreciation and amortization are made using straight-line rates over the estimated useful lives of the related assets and the terms of the applicable leases for leasehold improvements. Effective January 1, 1993, the Company changed its estimate of the useful lives of certain machinery and equipment. Based upon historical experience and comparable industry practice, the depreciable lives of the papermill machines that previously ranged from 16 to 20 years were increased to an average of 23 years, while major converting equipment and folding carton presses that previously averaged 12 years were increased to an average of 20 years. These changes were made to better reflect the estimated periods during which such assets will remain in service. These changes had the effect of reducing depreciation expense by $17.8 million and decreasing net loss by $11.0 million in 1993. Timberland: The portion of the costs of timberland attributed to standing timber is charged against income as timber is cut, at rates determined annually, based on the relationship of unamortized timber costs to the estimated volume of recoverable timber. The costs of seedlings and reforestation of timberland are capitalized. Deferred Debt Issuance Costs: Deferred debt issuance costs are amortized over the terms of the respective debt obligations using the interest method. Goodwill: The excess of cost over the fair value assigned to the net assets acquired is recorded as goodwill and is being amortized using the straight-line method over 40 years. Income Taxes: The taxable income of the Company is included in the consolidated federal income tax return filed by Holdings. The Company's income tax provisions are computed on a separate return basis. JSC's state income tax returns are filed on a separate return basis. Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" (see Note 6). Interest Rate Swap Agreements: The Company enters into interest rate swap agreements which involve the exchange of fixed and floating rate interest payments without the exchange of the underlying principal amount. The differential to be paid or received is accrued as interest rates change and is recognized over the life of the agreements as an adjustment to interest expense. Reclassifications: Certain reclassifications of prior year presentations have been made to conform to the 1993 presentation. 3. -- Investments Equity in loss of affiliates of $39.9 million in 1991, which is net of deferred income tax benefits of $18.5 million, includes the Company's (i) write-off of its equity investment in Temboard, Inc., formerly Temboard and Company Limited Partnership ("Temboard"), totaling $29.3 million, (ii) write-off of its remaining equity investment in PCL Industries Limited ("PCL") totaling $6.7 million, and (iii) proportionate share of the net loss of equity affiliates, including PCL prior to the write-off of that investment, totaling $3.9 million. 4. -- Related Party Transactions Transactions with JS Group Transactions with JS Group, its subsidiaries and affiliates were as follows: Product sales to and purchases from JS Group, its subsidiaries, and affiliates are consummated on terms generally similar to those prevailing with unrelated parties. The Company provides certain subsidiaries and affiliates of JS Group with general management and elective management services under separate Management Services Agreements. In consideration for general management services, the Company is paid a fee up to 2% of the subsidiaries' or affiliate's gross sales. In consideration for elective services, the Company is reimbursed for its direct cost of providing such services. In October 1991 an affiliate of JS Group completed a rebuild of the No. 2 paperboard machine owned by the affiliate that is located in CCA's Fernandina Beach, Florida paperboard mill (the "Fernandina Mill"). Pursuant to an operating agreement between CCA and the affiliate, the affiliate engaged CCA to operate and manage the No. 2 paperboard machine. As compensation to CCA for its services the affiliate reimburses CCA for production and manufacturing costs directly attributable to the No. 2 paperboard machine and pays CCA a portion of the indirect manufacturing, selling and administrative costs incurred by CCA for the entire Fernandina Mill. The compensation is determined by applying various formulas and agreed upon amounts to the subject costs. The amounts reimbursed to CCA are reflected as reductions of cost of goods sold and selling and administrative expenses in the accompanying consolidated statements of operations. 4. -- Related Party Transactions (cont) Transactions with Times Mirror Under the terms of a long-term agreement, Smurfit Newsprint Corporation ("SNC"), a majority-owned subsidiary of the Company, supplies newsprint to Times Mirror, a minority shareholder of SNC, at amounts which approximate prevailing market prices. The obligations of the Company and Times Mirror to supply and purchase newsprint, respectively, are wholly or partially terminable upon the occurrence of certain defined events. Sales to Times Mirror for 1993, 1992 and 1991 were $115.2 million, $114.0 million and $150.6 million, respectively. 5. -- Long-Term Debt Aggregate annual maturities of long-term debt at December 31, 1993, for the next five years are $10.3 million in 1994, $220.6 million in 1995, $379.8 million in 1996, $431.5 million in 1997, and $273.0 million in 1998. In addition, approximately $77.7 million in accrued interest related to the Junior Subordinated Accrual Debentures (the "Junior Accrual Debentures") becomes due in 1994. Accrued interest of approximately $58.9 million is classified as long-term debt in the accompanying financial statements because it is the Company's intention to refinance the Junior Accrual Debentures in December 1994 with the proceeds from the Equity and Debt Offerings and the new bank facility described in Note 15 or from its $200 million commitment from SIBV described below. 5. -- Long-Term Debt (cont) 1992 Term Loan In August 1992, the Company repurchased $193.5 million of Junior Accrual Debentures, and repaid $19.1 million of the Subordinated Note and $400 million of the 1989 term loan facility ("1989 Term Loan"). The proceeds from a $231.8 million capital contribution by Holdings and a $400 million senior secured term loan ("1992 Term Loan") were used to repurchase the Junior Accrual Debentures and repay the loans. Premiums paid in connection with this transaction, the write-off of related deferred debt issuance costs, and losses on interest rate swap agreements, totaling $49.8 million (net of income tax benefits of $25.8 million), are reflected in the accompanying 1992 consolidated statement of operations as an extraordinary loss. Outstanding loans under the 1992 Term Loan bear interest primarily at rates for which Eurodollar deposits are offered plus 3% (6.375% at December 31, 1993). The 1992 Term Loan, which matures on December 31, 1997, may require principal prepayments before then as defined in the 1992 Term Loan. 1989 Term Loan and Revolving Credit Facility The 1989 Amended and Restated Credit Agreement ("1989 Credit Agreement") consists of the 1989 Term Loan and a $400.0 million revolving credit facility (which expires in 1995) of which up to $125.0 million may consist of letters of credit. The 1989 Term Loan, which expires in 1997, requires minimum annual principal reductions, subject to additional reductions if the Company has excess cash flows or excess cash balances, as defined, or receives proceeds from certain sales of assets, issuance of equity securities, permitted indebtedness or any pension fund termination. Outstanding loans under the 1989 Credit Agreement bear interest primarily at rates for which Eurodollar deposits are offered plus 2.25%. The weighted average interest rate at December 31, 1993 on outstanding Credit Agreement borrowings was 5.95%. A commitment fee of 1/2 of 1% per annum is assessed on the unused portion of the revolving credit facility. At December 31, 1993, the unused portion of the revolving credit facility, after giving consideration to outstanding letters of credit, was $112.1 million. Senior Secured Notes The Senior Secured Notes due in 1998 may be prepaid at any time. Mandatory prepayment is required from a pro rata portion of net cash proceeds of certain sales of assets or additional borrowings. The Senior Secured Notes bear interest at rates for which three month Eurodollar deposits are offered plus 2.75% (6.25% at December 31, 1993). Obligations under the 1992 Term Loan, the 1989 Credit Agreement, and the Senior Secured Notes Agreement share pro rata in certain mandatory prepayments and the collateral and guarantees that secure these obligations. These obligations are secured by the common stock of JSC and CCA and substantially all of their assets, with the exception of cash and cash equivalents and trade receivables, and are guaranteed by Holdings. These agreements contain various business and financial covenants including, among other things, (i) limitations on the incurrence of indebtedness; (ii) limitations on capital expenditures; (iii) restrictions on paying dividends, except for dividends paid by SNC; (iv) maintenance of minimum interest coverage ratios; and (v) maintenance of quarterly and annual cash flows, as defined. 5. -- Long-Term Debt (cont) In anticipation of violation of certain financial covenants at September 30, 1993, in connection with its 1992 Term Loan, 1989 Credit Agreement and the Senior Secured Notes, the Company requested and received waivers from its lender group. In addition, the Company's credit facilities were amended in December 1993, to modify financial covenants that have become too restrictive due to continued pricing weakness in the paper industry. The Company complied with the amended covenants at December 31, 1993. Accounts Receivable Securitization Program Loans The $230.0 million accounts receivable securitization program ("Securitization Program") provides for the sale of certain of the Company's trade receivables to a wholly-owned, bankruptcy remote, limited purpose subsidiary, Jefferson Smurfit Finance Corporation ("JS Finance"), which finances its purchases of the receivables, through borrowings from a limited purpose finance company (the "Issuer") unaffiliated with the Company. The Issuer, which is restricted to making loans to JS Finance, issued $95.0 million in fixed rate term notes, issued $13.8 million under a subordinated loan, and may issue up to $121.2 million in trade receivables backed commercial paper or obtain up to $121.2 million under a revolving liquidity facility to fund loans to JS Finance. At December 31, 1993, $47.1 million was available for additional borrowing. Borrowings under the Securitization Program, which expires April 1996, have been classified as long-term debt because of the Company's intent to refinance this debt on a long-term basis and the availability of such financing under the terms of the program. At December 31, 1993, all assets of JS Finance, principally cash and cash equivalents of $42.9 million and trade receivables of $173.8 million, are pledged as collateral for obligations of JS Finance to the Issuer. Interest rates on borrowings under this program are at a fixed rate of 9.56% for $95.0 million of the borrowings and at a variable rate on the remainder (3.94% at December 31, 1993). Senior Unsecured Notes In April 1993, CCA issued $500.0 million of 9.75% Senior Unsecured Notes due 2003 which are unconditionally guaranteed by JSC. Net proceeds from the offering were used to repay: $100.0 million outstanding under the revolving credit facility, $196.5 million outstanding under the 1989 Term Loan, and $191.0 million outstanding under the 1992 Term Loan. The write-off of related deferred debt issuance costs and losses on interest rate swap agreements, totalling $37.8 million (net of income tax benefits of $21.7 million), are reflected in the accompanying 1993 consolidated statement of operations as an extraordinary item. In connection with the issuance of the Senior Unsecured Notes, the Company entered into an agreement with SIBV whereby SIBV committed to purchase up to $200 million of 11.5% Junior Subordinated Notes to be issued by the Company maturing December 1, 2005. From time to time until December 31, 1994, the Company, at their option, may issue the Junior Subordinated Notes, the proceeds of which must be used to repurchase or otherwise retire subordinated debt. The Company is obligated to pay SIBV for letter of credit fees incurred by SIBV in connection with this commitment in addition to an annual commitment fee of 1.375% on the undrawn principal amount (See Note 4). 5. -- Long-Term Debt (cont) The Senior Unsecured Notes due April 1, 2003, which are not redeemable prior to maturity, rank pari passu with the 1992 Term Loan, the 1989 Credit Agreement and the Senior Secured Notes. The Senior Unsecured Note Agreement contains business and financial covenants which are substantially less restrictive than those contained in the 1992 Term Loan, 1989 Credit Agreement and the Senior Secured Notes Agreement. Other Non-subordinated Debt Other non-subordinated long-term debt at December 31, 1993, is payable in varying installments through the year 2004. Interest rates on these obligations averaged approximately 9.76% at December 31, 1993. Subordinated Debt The Senior Subordinated Notes, Subordinated Debentures and Junior Accrual Debentures are unsecured obligations of CCA and are unconditionally guaranteed on a senior subordinated, subordinated and junior subordinated basis, respectively, by JSC. Semi-annual interest payments are required on the Senior Subordinated Notes, and Subordinated Debentures. Interest on the Junior Accrual Debentures accrues and compounds on a semi-annual basis until December 1, 1994 at which time accrued interest is payable. Thereafter, interest on the Junior Accrual Debentures will be payable semi-annually. The Senior Subordinated Notes are redeemable at CCA's option beginning December 1, 1994 with premiums of 6.75% and 3.375% of the principal amount if redeemed during the 12-month periods commencing December 1, 1994 and 1995, respectively. The payment of principal and interest is subordinated to the prior payment, when due, of all senior indebtedness, as defined. The Subordinated Debentures are redeemable at CCA's option beginning December 1, 1994 with premiums of 7% and 3.5% of the principal amount if redeemed during the 12-month periods commencing December 1, 1994 and 1995, respectively. The payment of principal and interest is subordinated to the prior payment, when due, of all senior indebtedness, as defined, and the Senior Subordinated Notes. Sinking fund payments to retire 33-1/3% of the original aggregate principal amount of the Subordinated Debentures are required on each of December 15, 1999 and 2000. The Junior Accrual Debentures are redeemable at CCA's option beginning December 1, 1994 at 100% of the principal amount. The payment of principal and interest is subordinated to the prior payment, when due, of all senior indebtedness, as defined, the Senior Subordinated Notes and the Subordinated Debentures. Sinking fund payments to retire 33- 1/3% of the original aggregate principal amount of the Junior Accrual Debentures are required on each of December 1, 2002 and 2003. Holders of the Senior Subordinated Notes, Subordinated Debentures, and Junior Accrual Debentures have the right, subject to certain limitations, to require the Company to repurchase their securities at 101% of the principal amount plus accrued and unpaid interest, upon the occurrence of a change of control or in certain events from proceeds of major asset sales, as defined. The Senior Subordinated Notes, Subordinated Debentures and Junior Accrual Debentures contain various business and financial covenants which are less restrictive than those contained in the 1992 Term Loan, the 1989 Credit Agreement and the Senior Secured Notes Agreement. 5. -- Long-Term Debt (cont) Interest Rate Swaps At December 31, 1993, the Company has interest rate swap and other hedging agreements with commercial banks which effectively fix (for remaining periods up to 3 years) the Company's interest rate on $215 million of variable rate borrowings at average all-in rates of approximately 9.1%. At December 31, 1993, the Company had $435 million of swap commitments outstanding which were marked to market in April 1993. The Company also has outstanding interest rate swap agreements related to the Securitization Program that effectively convert $95.0 million of fixed rate borrowings to a variable rate (5.6% at December 31, 1993) through December 1995, and convert $80.0 million of variable rate borrowings to a fixed rate of 7.2% through January 1996. In addition, the Company is party to interest rate swap agreements related to the Senior Unsecured Notes which effectively converts $500.0 million of fixed rate borrowings to a variable rate (8.6% at December 31, 1993) maturing at various dates through May 1995. 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 non-performance by the counter parties. Interest costs capitalized on construction projects in 1993, 1992 and 1991 totalled $3.4 million, $4.2 million and $2.4 million, respectively. Interest payments on all debt instruments for 1993, 1992 and 1991 were $226.2 million, $257.6 million and $273.1 million, respectively. 6. -- Income Taxes Effective January 1, 1993, 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". As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting SFAS No. 109 as of January 1, 1993 was to increase net income by $20.5 million. For 1993, application of SFAS No. 109 increased the pretax loss by $14.5 million because of increased depreciation expense as a result of the requirement to report assets acquired in prior business combinations at pretax amounts. In adopting this new accounting principle, the Company (i) adjusted assets acquired and liabilities assumed in prior business combinations from their net-of-tax amounts to their pretax amounts and recognized the related deferred tax assets and liabilities for those temporary differences, (ii) adjusted deferred income tax assets and liabilities to statutory income tax rates and for previously unrecognized tax benefits related to certain state net operating loss carryforwards and, (iii) adjusted asset and liability accounts arising from the 1986 acquisition of CCA and the 1989 Recapitalization to recognize potential tax liabilities related to those transactions. The net effect of these adjustments on assets and liabilities was to increase inventory $23.0 million, increase property, plant and equipment and timberlands $196.5 million, increase goodwill $42.0 million, increase liabilities by $12.6 million, and increase deferred income taxes by $228.4 million. 6. -- Income Taxes (cont) At December 31, 1993, the Company has net operating loss carryforwards for federal income tax purposes of approximately $308.6 million (expiring in the years 2005 through 2008), none of which are available for utilization against alternative minimum taxes. Significant components of the Company's deferred tax assets and liabilities at December 31, 1993 are as follows: Provisions for (benefit from) income taxes before extraordinary item and cumulative effect of accounting changes were as follows: The Company increased its deferred tax assets and liabilities in 1993 as a result of legislation enacted during 1993 increasing the corporate federal statutory tax rate from 34% to 35% effective January 1, 1993. 6. -- Income Taxes (cont) The Internal Revenue Service completed the examination of the Company's consolidated federal income tax returns for 1987 and 1988. The provision for current taxes includes settlement of the additional tax liabilities. The components of the provision for (benefit from) deferred taxes were as follows: A reconciliation of the difference between the statutory Federal income tax rate and the effective income tax rate as a percentage of loss before income taxes, equity in earnings (loss) of affiliates, extraordinary item, and cumulative effect of accounting changes is as follows: The Company made income tax payments of $33.0 million, $6.6 million, and $5.9 million in 1993, 1992, and 1991, respectively. 7. -- Employee Benefit Plans Pension Plans The Company sponsors noncontributory defined benefit pension plans covering substantially all employees not covered by multi-employer plans. Plans that cover salaried and management employees provide pension benefits that are based on the employee's five highest consecutive calendar years' compensation during the last ten years of service. Plans covering non-salaried employees generally provide benefits of stated amounts for each year of service. These plans provide reduced benefits for early retirement. The Company's funding policy is to make minimum annual contributions required by applicable regulations. The Company also participates in several multi-employer pension plans, which provide defined benefits to certain union employees. In order to minimize significant year-to-year fluctuations in pension cost caused by financial market volatility, the Company changed, effective as of January 1, 1993 the method of accounting used for determining the market-related value of plan assets. The method changed from a fair market value to a calculated value that recognizes all changes in a systematic manner over a period of four years and eliminates the use of a corridor approach for amortizing gains and losses. The effect of this change on 1993 results of operations, including the cumulative effect of prior years, was not material. Assumptions used in the accounting for the defined benefit plans were: The components of net pension income for the defined benefit plans and the total contributions charged to pension expense for the multi- employer plans follows: 7. -- Employee Benefit Plans (cont) The following table sets forth the funded status and amounts recognized in the consolidated balance sheets at December 31 for the Company's and its subsidiaries' defined benefit pension plans: Approximately 44% of plan assets at December 31, 1993 are invested in cash equivalents or debt securities and 56% are invested in equity securities, including common stock of JS Group having a market value of $87.7 million. Postretirement Health Care and Life Insurance Benefits The Company provides certain health care and life insurance benefits for all salaried and certain hourly employees. The Company has various plans under which the cost may be borne either by the Company, the employee or partially by each party. The Company does not currently fund these plans. These benefits are discretionary and are not a commitment to long-term benefit payments. The plans were amended effective January 1, 1993 to allow employees who retire on or after January 1, 1994 to become eligible for these benefits only if they retire after age 60 while working for the Company. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions", which requires companies to accrue the expected cost of retiree benefit payments, other than pensions, during employees' active service period. The Company elected to immediately recognize the accumulated liability, measured as of January 1, 1993. The cumulative effect of this change in accounting principle resulted in a charge of $37.0 million (net of income tax benefits of $21.9 million). The Company had previously recorded an obligation of $36.0 million in connection with prior business combinations. The net periodic postretirement benefit cost for 1993 was $9.8 million. In 1992 and 1991, the cost of the postretirement benefits was recognized as claims were paid and was $6.4 million and $5.3 million, respectively. 7. -- Employee Benefit Plans (cont) The following table sets forth the accumulated postretirement benefit obligation ("APBO") with respect to these benefits as of December 31, 1993: Net periodic postretirement benefit cost for 1993 included the following components: A weighted-average discount rate of 7.6% was used in determining the APBO at December 31, 1993. The weighted-average annual assumed rate of increase in the per capita cost of covered benefits ("healthcare cost trend rate") was 11%, with an annual decline of 1% until the rate reaches 5%. The effect of a 1% increase in the assumed healthcare cost trend rate would increase both the APBO as of December 31, 1993 by $5.7 million and the annual net periodic postretirement benefit cost for 1993 by $.8 million. 1992 Stock Option Plan Effective August 26, 1992, Holdings adopted the Holdings 1992 Stock Option Plan (the "Plan") which replaced the 1990 Long-Term Management Incentive Plan. Under the Plan, selected employees of JSC and its affiliates and subsidiaries are granted non-qualified stock options, up to a maximum of 603,656 shares, to acquire shares of common stock of Holdings. The stock options are exercisable at a price equal to the fair market value, as defined, of Holdings' common stock on the date of grant. The options vest pursuant to the schedule set forth for each option and expire upon the earlier of twelve years from the date of grant or termination of employment. The stock options become exercisable upon the earlier of the occurrence of certain trigger dates, as defined, or eleven years from the date of grant. Options for 494,215 and 502,645 shares, were outstanding at December 31, 1993 and 1992, respectively at an exercise price of $100.00, none of which were exercisable. 8. -- Leases The Company leases certain facilities and equipment for production, selling and administrative purposes under operating leases. Future minimum lease payments at December 31, 1993, required under operating leases that have initial or remaining noncancelable lease terms in excess of one year are $30.3 million in 1994, $22.5 million in 1995, $15.5 million in 1996, $11.3 million in 1997, $8.3 million in 1998 and $19.1 million thereafter. Net rental expense was $45.0 million, $42.2 million, and $38.7 million for 1993, 1992 and 1991, respectively. 9. -- Fair Value of Financial Instruments The estimated fair values of the Company's financial instruments are as follows: The carrying amount of cash equivalents approximates fair value because of the short maturity of those instruments. The fair value of the Company'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 Company for debt of the same remaining maturities. The fair value of the interest rate swap agreements is the estimated amount the Company would pay, net of accrued interest expense, to terminate the agreements at December 31, 1993, taking into account current interest rates and the current credit worthiness of the swap counterparties. 10. -- Restructuring Charge During 1993, the Company recorded a pretax charge of $96.0 million to recognize the effects of a restructuring program designed to improve the Company's long-term competitive position. The charge includes a provision for direct expenses associated with plant closures, reductions in workforce, realignment and consolidation of various manufacturing operations and write-downs of nonproductive assets. 11. -- Contingencies During 1993, the Company recorded a pretax charge of $54.0 million of which $39.0 million represents asbestos and PCB removal, solid waste cleanup at existing and former operating sites, and expenses for response costs at various sites where the company has received notice that it is a potentially responsible party. The Company is a defendant in a number of lawsuits and claims arising out of the conduct of its business, including those related to environmental matters. While the ultimate results of such suits or other proceedings against the Company cannot be predicted with certainty, the management of the Company believes that the resolution of these matters will not have a material adverse effect on its consolidated financial condition or results of operation. 12. -- Business Segment Information The Company's business segments are paperboard/packaging products and newsprint. Substantially all the Company's operations are in the United States. The Company's customers represent a diverse range of industries including paperboard and paperboard packaging, consumer products, wholesale trade, retailing, agri-business, and newspaper publishing located throughout the United States. Credit is extended based on an evaluation of the customer's financial condition. The paperboard/packaging products segment includes the manufacture and distribution of containerboard, boxboard and cylinderboard, corrugated containers, folding cartons, fibre partitions, spiral cores and tubes, labels and flexible packaging. A summary by business segment of net sales, operating profit, identifiable assets, capital expenditures and depreciation, depletion and amortization follows: Sales and transfers between segments are not material. Export sales are less than 10% of total sales. Corporate assets consist principally of cash and cash equivalents, refundable and deferred income taxes, investments in affiliates, deferred debt issuance costs and other assets which are not specific to a segment. 13. -- Summarized Financial Information of CCA Summarized below is financial information for CCA which is the issuer of the Senior Subordinated Notes, Senior Unsecured Notes, Subordinated Debentures and Junior Accrual Debentures. 13. -- Summarized Financial Information of CCA (cont) Intercompany loans to the Company made in connection with the 1989 Recapitalization ($1,262.0 million at December 31, 1993) are classified as long-term by CCA and are evidenced by a demand note which bears interest at 12.65%, which was the weighted average interest rate applicable to the bank credit facilities and the various debt securities sold in connection with the 1989 Recapitalization. Term loans to the Company under the Securitization Program ($262.5 million at December 31, 1993) are included in CCA's current assets and bear interest at the average borrowing rate under the Securitization Program (6.56% at December 31, 1993). Other amounts advanced to or from the Company are non-interest bearing. 14. -- Quarterly Results (Unaudited) The following is a summary of the unaudited quarterly results of operations: 15. -- Subsequent Events Holdings has filed with the Securities and Exchange Commission ("SEC") a Registration Statement on Form S-1 relating to the offering of 25,551,786 shares of common stock. JSC has filed with the SEC a Registration Statement on Form S-2 relating to the offering of $300 million of Senior Notes due 2004 and $100 million of Senior notes due 2002. In addition, JSC has obtained a new $1.65 billion bank facility. The proceeds from the debt and equity offerings and the new bank facility will be used to repay the 1992 Term Loan, the 1989 Term Loan and revolving credit facility, the Senior Secured Notes and the subordinated debentures and related premiums. 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 The following table sets forth the names and ages of the directors of each of JSC and CCA. The Board of Directors is currently comprised of six directors, three of whom, the Class B Directors, were nominees of MSLEF II and three of whom, the Class A Directors, were nominees of Smurfit Packaging as provided in the Organization Agreement. Name Age Michael W.J. Smurfit 57 Howard E. Kilroy 58 James E. Terrill 60 Donald P. Brennan 53 Alan E. Goldberg 39 David R. Ramsay 30 Following completion of the Offerings and pursuant to the Stockholders Agreement (as described below), the Company intends to expand its Board of Directors to include two additional directors, one of whom will be designated by, but not affiliated with SIBV and, one of whom will be designated by, but not affiliated with MSLEF II. Upon consummation of the Offerings, the current Board of Directors of each of JSC and CCA will be divided into three classes of directors serving staggered three-year terms. The terms of office of Messrs. Terrill and Ramsay expire in 1995, of Messrs. Kilroy and Goldberg expire in 1996 and of Messrs. Smurfit and Brennan expire in 1997. The terms of office of the additional unaffiliated directors who are to be designated by MSLEF II and SIBV as described above shall expire in 1995 and 1996, respectively. Executive Officers The following table sets forth the names and ages of the executive officers of each of JSC and CCA and the positions they will hold immediately prior to the consummation of the Offerings. Name Age Position Michael W.J. Smurfit 57 Chairman of the Board and Director James E. Terrill 60 President, Chief Executive Officer and Director Howard E. Kilroy 58 Senior Vice President and Director Richard W. Graham 59 Senior Vice President and General Manager - Folding Carton and Boxboard Mill Division C. Larry Bradford 57 Vice President - Sales and Marketing Raymond G. Duffy 52 Vice President - Planning Name Age Position Michael C. Farrar 53 Vice President - Environmental and Governmental Affairs John R. Funke 52 Vice President and Chief Financial Officer Richard J. Golden 52 Vice President - Purchasing Michael F. Harrington 53 Vice President - Personnel and Human Resources Alan W. Larson 55 Vice President and General Manager - Consumer Packaging Division Edward F. McCallum 59 Vice President and General Manager - Container Division Lyle L. Meyer 57 Vice President Patrick J. Moore 39 Vice President and Treasurer David C. Stevens 59 Vice President and General Manager - Smurfit Recycling Company Truman L. Sturdevant 59 President of SNC Michael E. Tierney 45 Vice President and General Counsel and Secretary Richard K. Volland 55 Vice President - Physical Distribution William N. Wandmacher 51 Vice President and General Manager - Containerboard Mill Division Gary L. West 51 Vice President and General Manager - Industrial Packaging Division Biographies C. Larry Bradford has been Vice President - Sales and Marketing since January 1993. He served as Vice President and General Manager - Container Division from February 1991 until October 1992. Prior to that time, he was Vice President and General Manager of the Folding Carton and Boxboard Mill Division from January 1983 to February 1991. Donald P. Brennan joined MS&Co. in 1982 and has been a Managing Director since 1984. He is responsible for MS&Co.'s Merchant Banking Division and is Chairman and President of Morgan Stanley Leveraged Equity Fund II, Inc. ("MSLEF II, Inc.") and Chairman of Morgan Stanley Capital Partners III, Inc. ("MSCP III, Inc."). Mr. Brennan serves as Director of Agricultural Minerals and Chemicals, Inc., Agricultural Minerals Corporation, Coltec Industries Inc, Fort Howard Corporation, Hamilton Services Limited, PSF Finance Holdings, Inc., Shuttleway, A/S Bulkhandling and Stanklav Holdings, Inc. Mr. Brennan is also Deputy Chairman and Director of Waterford Wedgwood plc. Raymond G. Duffy has been Vice President - Planning since July 1983 and served as Director of Corporate Planning from 1980 to 1983. Michael C. Farrar was appointed Vice President - Environmental and Governmental Affairs in March 1992. Prior to Joining JSC, he was Vice President of the American Paper Institute and the National Forest Products Association for more than 5 years. John R. Funke has been Vice President and Chief Financial Officer since April 1989 and was Corporate Controller and Secretary from 1982 to April 1989. Richard J. Golden has been Vice President - Purchasing since January 1985 and was Director of Corporate Purchasing from October 1981 to January 1985. In January 1994, he was assigned responsibility for world-wide purchasing for JS Group. Alan E. Goldberg has been a member of MS&Co.'s Merchant Banking Division since its formation in 1985 and a Managing Director of MS&Co. since 1988. Mr. Goldberg is a member of the Finance Committee of MS&Co. Mr. Goldberg is Chairman and President of Morgan Stanley Leveraged Equity Fund I, Inc., a Delaware corporation and is a Director of MSLEF II, Inc. and is a Vice Chairman and a Director of MSCP III, Inc. Mr. Goldberg also serves as Director of Agricultural Minerals and Chemicals, Inc., Agricultural Minerals Corporation, Amerin Guaranty Corporation, CIMIC Holdings Limited, Centre Cat Limited and Hamilton Services Limited. Richard W. Graham was appointed Senior Vice President and General Manager - Folding Carton and Boxboard Mill Division in February 1994. He served as Vice President and General Manager - Folding Carton and Boxboard Mill Division from February 1991 to January 1994. Mr. Graham was Vice President and General Manager - Folding Carton Division from October 1986 to February 1991. Mr. Graham joined CCA in 1959 and has served in various management positions, becoming Group Vice President of Administration for CCA in 1984. Michael F. Harrington was appointed Vice President - Personnel and Human Resources in January 1992. Prior to Joining JSC, he was Corporate Director of Labor Relations/Safety and Health with Boise Cascade Corporation for more than 5 years. Howard E. Kilroy has been Chief Operations Director of JS Group since 1978 and President of JS Group since October 1986. Mr. Kilroy was a member of the Supervisory Board of SIBV from January 1978 to January 1992. He has been a Director of JSC since 1979 and Senior Vice President for over 5 years. In addition, he is Governor (Chairman) of Bank of Ireland and a Director of Aran Energy plc. Alan W. Larson has been Vice President and General Manager - Consumer Packaging Division since October 1988. Prior to joining JSC in 1988, he was Executive Vice President of The Black and Decker Corporation. Edward F. McCallum has been Vice President and General Manager - Container Division since October 1992. He served as Vice President and General Manager of the Industrial Packaging Division from January 1991 to October 1992. Prior to that time, he served in various positions in the Container Division since joining JSC in 1971. Lyle L. Meyer has been Vice President since April 1989. He has also been President of Smurfit Pension and Insurance Services Company since 1982. Patrick J. Moore has been Vice President and Treasurer since February 1993. He was Treasurer from October 1990 to February 1993. Prior to joining JSC in 1987 as Assistant Treasurer, Mr. Moore was with Continental Bank in Chicago where he served in various corporate lending, international banking and administrative capacities. David R. Ramsay is a Vice President of MS&Co.'s Merchant Banking Division where he has worked since his graduation from business school in 1989. Mr. Ramsay also serves as a Director of Agricultural Minerals and Chemicals, Inc., Agricultural Minerals Corporation, ARM Financial Group Inc., Hamilton Services Limited and Stanklav Holdings, Inc. and is President and a Director of PSF Finance Holdings, Inc. Michael W.J. Smurfit has been Chairman and Chief Executive Officer of JS Group since 1977. Dr. Smurfit has been a Director of JSC since 1979 and Chairman of the Board since September 1983. He was Chief Executive Officer from September 1983 to July 1990. David C. Stevens has been Vice President and General Manager - Smurfit Recycling Company since January 1993. He joined JSC in 1987 as General Sales Manager and was named Vice President later that year. He held various management positions with International Paper and was President of Mead Container Division prior to joining JSC. Truman L. Sturdevant has been President of SNC since February 1993. He was Vice President and General Manager of SNC from August 1990 to February 1993. Mr. Sturdevant joined the Company in 1984 as Vice President and General Manager of the Oregon City newsprint mill. James E. Terrill was named a Director and President and Chief Executive Officer in February 1994. He served as Executive Vice President - Operations from August 1990 to February 1994. He also served as Executive Vice President of SNC from February 1993 to February 1994. He was President of SNC from February 1986 to February 1993. He served as Vice President and General Manager - Industrial Packaging Division of JSC from 1979 to February 1986. Michael E. Tierney has been Vice President and General Counsel and Secretary since January 1993. He served as Senior Counsel and Assistant Secretary since joining JSC in 1987. Richard K. Volland has been Vice President - Physical Distribution since 1978. William N. Wandmacher has been Vice President and General Manager - Containerboard Mill Division since January 1993. He served as Division Vice President - Medium Mills from October 1986 to January 1993. Since joining the Company in 1966, he has held increasingly responsible positions in production, plant management and planning, both domestic and foreign. Gary L. West has been Vice President and General Manager - Industrial Packaging Division since October 1992. He served as Vice President - Converting and Marketing for the Industrial Packaging Division from January 1991 to October 1992. Prior to that time, he held various management positions in the Container and Consumer Packaging divisions since joining JSC in 1980. Provisions of Stockholders Agreement Pertaining to Management The Stockholders Agreement will provide that SIBV and MS Holders (as defined in the Stockholders Agreement and which term includes the MSLEF II Associated Entities and, with respect to certain of their shares, includes the Direct Investors (as defined below)) shall vote their shares of Holdings Common Stock, or grant an irrevocable proxy to MSLEF II to vote their shares of Common Stock, to elect as directors of Holdings (a) four individuals selected by SIBV (each, an "SIBV Nominee") one of whom shall be the Chief Executive Officer and one of whom shall not be affiliated with SIBV, Holdings, JSC or CCA (an "SIBV Unaffiliated Director") and (b) four individuals selected by MSLEF II (each, a "MSLEF II Nominee"), one of whom shall not be affiliated with MSLEF II, Holdings, JSC or CCA (a "MSLEF II Unaffiliated Director"), if (i) the MS Holders collectively own more than 10% of the outstanding Holdings Common Stock or SIBV owns less than 25% of the outstanding Holdings Common Stock and the MS Holders shall not have received the Initial Return (as defined below) ("Tier 1") or (ii) the MS Holders collectively own 30% or more of the outstanding Holdings Common Stock or the MS Holders collectively own a greater number of voting shares than SIBV and the MS Holders shall have collectively received the Initial Return ("Tier 2"); provided however, that in the event that the MS Holders collectively own 7 1/2% or more and less than 30% of the outstanding Holdings Common Stock and have collectively received the Initial Return, then SIBV shall not be required to have one of its nominees be an SIBV Unaffiliated Director and the four MSLEF II Nominees shall include two MSLEF II Unaffiliated Directors; provided, further, that in the event that the MS Holders collectively own 6% or more but less than 7 1/2% of the outstanding Holdings Common Stock and have collectively received the Initial Return, then SIBV shall nominate four SIBV Nominees (one of whom shall be the Chief Executive Officer), MSLEF II shall nominate two MSLEF II Nominees and Holdings' Board of Directors shall nominate two persons to the Board of Directors who shall be reasonably acceptable to MSLEF II and SIBV. Unless MSLEF II determines otherwise, MSLEF II, except MSLEF II Unaffiliated Directors, Nominees shall be Managing Directors, Principals or Vice Presidents of MS&Co. The Stockholders Agreement defines "Initial Return" to mean the receipt, as dividends or as a result of sales of shares of Holdings Common Stock, of $400 million in cash or certain other property (or a combination thereof) collectively by the MS Holders. For purposes of calculating the Initial Return, shares which MSLEF II or Equity Investors (as defined below) distributes to its partners will be deemed to have been sold at the closing sales price per share as of the date such distribution is declared. Calculations made for purposes of the foregoing shall not give effect to shares of Holdings Common Stock purchased after the date of the closing of the Offerings (other than shares of Common Stock purchased by SIBV pursuant to the preemptive rights set forth in the Stockholders Agreement). In addition, notwithstanding the termination of the Stockholders Agreement upon the MS Holders ceasing to own six percent or more of the Holdings Common Stock, so long as MSLEF II or MSLEF II, Inc. and its affiliates own Holdings Common Stock with a market value of at least $25 million, MSLEF II shall be entitled to designate, and SIBV shall vote its shares of Holdings Common Stock for the election of, one nominee to the Board of Directors of Holdings (who need not be a MSLEF II Unaffiliated Director). Pursuant to the terms of the Stockholders Agreement, SIBV and MSLEF II will each be entitled to designate four nominees to Holdings' Board of Directors upon the consummation of the Recapitalization Plan (excluding the Subordinated Debt Refinancing). Such designees include, in the case of SIBV, Michael W.J. Smurfit, Howard E. Kilroy, James E. Terrill and, in the case of MSLEF II, Donald P. Brennan, Alan E. Goldberg and David R. Ramsay. The MSLEF II Unaffiliated Director and the SIBV Unaffiliated Director will be named following completion of the Offerings. See "--Directors". Pursuant to the Stockholders Agreement, SIBV and MSLEF II have agreed to ensure the election of only eight directors (unless they otherwise agree). In addition, the MS Holders and SIBV have agreed pursuant to the Stockholders Agreement to use their best efforts to cause their respective nominees to resign from the Holdings' Board of Directors and to cause the remaining Directors, subject to their fiduciary duties, to fill the resulting vacancies, if and to the extent changes in directors are necessary in order to reflect the Board representation contemplated by the Stockholders Agreement. Pursuant to the Stockholders Agreement, the Board of Directors of Holdings shall have all powers and duties and the full discretion to manage and conduct the business and affairs of Holdings as may be conferred or imposed upon a board of directors pursuant to Section 141 of the Delaware General Corporation Law; provided, however, that if the MS Holders' collective ownership of Holdings Common Stock shall be in Tier 1 or Tier 2, approval of certain specified actions shall require approval of (a) the sum of one and a majority of the entire Board of Directors of the Company present at a meeting of the Board of Directors and (b) two directors who are SIBV Nominees and two directors who are MSLEF II Nominees (the "Required Majority"). Without limiting the foregoing, unless the MS Holders collectively own 6% or more but less than 7 1/2% of the Holdings Common Stock during any period when Holdings' Board of Directors does not consist of eight members (or such greater number of members as may be agreed to by SIBV, MSLEF II and Holdings) then all actions of the Board of Directors shall require approval of at least one director who is a SIBV Nominee and one director who is a MSLEF II Nominee. The specified corporate actions that must be approved by a Required Majority include the amendment of the certificate of incorporation or by-laws of Holdings or any of its subsidiaries; the issuance, sale, purchase or redemption of securities of Holdings or any of its subsidiaries; the establishment of and appointments to the Audit Committee of Holdings' Board of Directors; certain sales of assets or investments in, or certain transactions with, JS Group or its affiliates in excess of a specified amount or any other person in excess of other specified amounts; certain mergers, consolidations, dissolutions or liquidations of Holdings or any of its subsidiaries; the filing of a petition in bankruptcy; the setting aside or making of any payment or distribution by way of dividend or otherwise to the stockholders of Holdings or any of its subsidiaries; the incurrence of new indebtedness, the creation of liens or guarantees, the institution, termination or settlement of material litigation, the surrender of property or rights, making certain investments, commitments, capital expenditures or donations, in each case in excess of certain specified amounts; entering into any lease (other than a capitalized lease) of any assets of Holdings located in any one place having a book value in excess of a specified amount; the entering into any agreement or material transaction between Holdings and a director or officer of Holdings, JSC, JS Group, CCA, SIBV or MSLEF II or their affiliates; the replacement of the independent accountants for Holdings or any of its subsidiaries or modification of significant accounting methods; the amendment or termination of Holdings' 1992 Stock Option Plan; except as provided in the Stockholders Agreement, the election or removal of directors and officers of each of JSC and CCA; and any decision regarding registration, except as provided in the Registration Rights Agreement. Pursuant to the Stockholders Agreement, SIBV and MSLEF II shall use their best efforts to cause their respective designees to Holdings' Board of Directors to elect directors to the Boards of Directors of JSC and CCA in an analogous manner. It is currently anticipated that the directors of Holdings, JSC and CCA will be the same individuals. Committees Following consummation of the Offerings, there will be four committees of the Boards of Directors of each of Holdings, JSC and CCA; the Executive Committee, the Compensation Committee, the Audit Committee and the Appointment Committee, which committee shall, among other things, select, replace or remove officers. The Stockholders Agreement provides that SIBV and MSLEF II will use their best efforts to cause their respective designees on the Holdings Board of Directors, subject to their fiduciary duties, to (i) insure that MSLEF II Nominees constitute a majority of the members on the Compensation Committee and any other committees which administer any option or incentive plan of Holdings and the Company and (ii) subject to certain limitations (including limitations based on the percentage stock ownership of the MS Holders and/or SIBV), insure that (a) SIBV Nominees constitute a majority of the members, and a MSLEF II Nominee is a member, of the Appointment Committee and (b) nominees of the SIBV Nominees for officers of Holdings, JSC and CCA (other than Chief Financial Officer), and a nominee of the MSLEF II Nominee for Chief Financial Officer of Holdings, JSC and CCA, are appointed or elected to such positions, whether by the Appointment Committee or the Board of Directors. In addition, SIBV and MSLEF II shall use their best efforts to cause their respective designees on Holdings' Board of Directors, subject to their fiduciary duties, to cause the officers of Holdings to be the respective officers of each of JSC and CCA, unless SIBV and MSLEF II otherwise agree. Appointments to the committees listed above will be made following consummation of the Offerings. Director Compensation Prior to the completion of the Offerings, no directors of Holdings, JSC and CCA received any fees for their services as directors; however, the directors were reimbursed for their travel expenses in connection with their attendance at board meetings. Following the completion of the Offerings, each of Holdings, JSC and CCA intends to reimburse all its directors for their travel expenses in connection with their attendance at board meetings and to pay all its directors who are not officers an annual fee of $35,000 plus $2,000 for attendance at each meeting which is in excess of four meetings per year. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Summary Compensation Table The following table sets forth the cash and noncash compensation for each of the last three fiscal years awarded to or earned by the Chief Executive Officer and the four other most highly compensated executive officers of the Company (the "Named Executive Officers") during 1993. Prior to consummation of the Offerings, the Company intends to pay aggregate cash bonuses of $7.62 million to a number of its and its affiliates' officers, including approximately $1,964,000, $347,000, $87,000, $231,000 and $1,386,000 to Messrs. Smurfit, Terrill, Larson, Bradford and Malloy, respectively, and $1.77 million to officers of JS Group and its affiliates (other than Michael W.J. Smurfit). In addition, the Company paid approximately $2.9 million of bonuses to other employees of the Company in 1992. 1994 Long-Term Incentive Plan Prior to consummation of the Equity Offerings, JSC intends to adopt the Jefferson Smurfit Corporation (U.S.) 1994 Long-Term Incentive Plan (the "Incentive Plan"). Pursuant to the Plan, participants will be granted awards, payable in cash on June 30, 1997 (the "Payment Date") (or earlier in the event of death or disability) if and to the extent vested. A participant's award will vest on the Payment Date if he is still employed by JSC or any of its subsidiaries at such time; provided that such award shall vest in full if the participant dies or becomes disabled and shall vest 20% on June 30, 1995, and an additional 20% on June 30, 1996 if the participant is employed on such date and is thereafter terminated, prior to June 30, 1997, by the Company without cause. Notwithstanding the foregoing, no amounts shall be paid under the Incentive Plan unless the Equity Offerings are consummated. The aggregate amount of awards under the Incentive Plan is $5 million. The awards expected to be granted to Messrs. Terrill, Larson and Bradford are $1,000,000, $200,000 and $75,000, respectively. Aggregate and individual awards will be increased by earnings accrued thereon (by virtue of the actual or deemed investment thereof, as determined by the Compensation Committee) during the period beginning as soon as practicable after the consummation of the Equity Offerings and ending on the Payment Date or earlier date of payment. 1992 Stock Option Plan Option Plan Under Holdings' 1992 Stock Option Plan, the Named Executive Officers and certain other eligible employees have been granted options to purchase shares of stock of Holdings. The options become vested over a ten year period and vest in their entirety upon the death, disability or retirement of the optionee. Non- vested options are forfeited upon any other termination of employment. Options may not be exercised unless they are both exercisable and vested. Upon the earliest to occur of (i) MSLEF II's transfer of all of its Holdings Common Stock or, if MSLEF II distributes its Holdings Common Stock to its partners pursuant to its dissolution, the transfer by such partners of at least 50% of the aggregate Holdings Common Stock received from MSLEF II pursuant to its dissolution, (ii) the 11th anniversary of the grant date of the options, and (iii) a public offering of Holdings common stock (including the Equity Offerings), all vested options shall become exercisable and all options which vest subsequently shall become exercisable upon vesting; provided, however, that if a public offering occurs prior to the Threshold Date (defined below) all vested options and all options which vest subsequent to the public offering but prior to the Threshold Date shall be exercisable in an amount (as of periodic determination dates) equal to the product of (a) the number of shares of Holdings Common Stock vested pursuant to the option (whether previously exercised or not) and (b) the Morgan Percentage (as defined below) as of such date; provided further that in any event a holder's options shall become exercisable from time to time in an amount equal to the percentage that the number of shares sold or distributed to its partners by MSLEF II represents of its aggregate ownership of shares (with vested options becoming exercisable up to such number before any non-vested options become so exercisable) less the number of options, if any, which have become exercisable on January 1, 1995 as set forth below. The Threshold Date is the earlier of (x) the date the members of the MSLEF II Group (as defined in the 1992 Stock Option Plan) shall have received collectively $200,000,000 in cash and/or other property as a return of their investment in Holdings (as a result of sales of shares of Holdings' common equity) and (y) the date that the members of the MSLEF II Group shall have transferred an aggregate of at least 30% of Holdings' common equity owned by the MSLEF II Group as of August 26, 1992. The Morgan Percentage as of any date is the percentage determined from the quotient of (a) the number of shares of Holdings' common equity held as of August 26, 1992, that were transferred by the MSLEF II Group as of the determination date and (b) the number of shares of Holdings' common equity outstanding as of such date. The Plan Committee, with the consent of the Board of Directors of Holdings, may accelerate the exercisability of options at such times and circumstances as it deems appropriate in its discretion. The option exercise price is not adjustable other than pursuant to an antidilution provision. Ten percent of stock options granted prior to 1993 vest and become exercisable on January 1, 1995 so long as the Equity Offerings have been consummated. Already owned shares and shares otherwise issuable upon exercise may be used to pay the exercise price of options and any tax withholding liability. The foregoing describes the terms of the 1992 Stock Option Plan, as intended to be amended prior to the consummation of the Equity Offerings. Option Grants No option grants were made during 1993 to any Named Executive Officers. Effective as of February 15, 1994 options with an exercise price of $20 per share were granted to a number of officers and employees including Messrs. Terrill and Larson who were granted options of 319,000, and 5,000 shares of Holdings Common Stock, respectively (such dollar amount and numbers have been adjusted to reflect the ten-for-one stock split contemplated by the Reclassification). Such options vest over the period ending on December 31, 1999. Option Exercises and Year-End Value Table The following table summarizes the exercise of options relating to shares of Holdings Common Stock by the Named Executive Officers during 1993 and the value of options held by such officers as of the end of 1993. No stock appreciation rights have been granted to any Named Executive Officers. In addition, options to purchase 755,000 shares (as adjusted for the ten-to-one stock split) have been granted to officers and employees of JS Group and its affiliates (other than Michael W.J. Smurfit). Pension Plans Salaried Employees' Pension Plan and Supplemental Income Pension Plans The Company and its subsidiaries maintain a non-contributory pension plan for salaried employees (the "Pension Plan") and non- contributory supplemental income pension plans (the "SIP Plans") for certain key executive officers. The Pension Plan provides monthly benefits at age 65 equal to 1.5% of a participant's final average earnings minus 1.2% of such participant's primary social security benefit, multiplied by the number of years of credited service. Final average earnings equals the average of the highest five consecutive years of the participant's last 10 years of service, including overtime and certain bonuses, but excluding bonus payments under the Management Incentive Plan, deferred or acquisition bonuses, fringe benefits and certain other compensation. Employees' pension rights vest after five years of service. Benefits are also available under the Pension Plan upon early or deferred retirement. The pension benefits for the Named Executive Officers can be calculated pursuant to the following table, which shows the total estimated single life annuity payments that would be payable to the Named Executive Officers participating in the Pension Plan and one of the SIP Plans after various years of service at selected compensation levels. A limit of 20 and 22.5 years of service can be credited for SIP I and SIP II, respectively. Payments under the SIP Plans are an unsecured liability of the Company. In order to participate in the SIP Plans, an executive must be selected by the Board of Directors. SIP Plan I provides annual benefits at normal retirement age (65) equal to 2.5% of a participants' final average earnings multiplied by the number of years of credited service (with a limit of 20 years or 50% of final average earnings), less such participants' regular Pension Plan benefit and a certain portion of the social security benefit, whereas SIP Plan II uses a 2% multiplier (with a limit of 22.5 years or 45% of final average earnings). Final average earnings equals the participant's average earnings, including bonus payments made under the Management Incentive Plan, for the five consecutive highest-paid calendar years out of the last 10 years of service. Participants may elect to receive benefits in the form of either a life annuity, a life annuity with ten years certain or a designated survivor annuity. Dr. Smurfit and Mr. Malloy participate in SIP Plan I and have 21 and 15 years of credited service, respectively. SIP Plan II became effective January 1, 1993, and Mr. Terrill, Mr. Larson and Mr. Bradford participate in such plan and have 22, 5 and 11 years of credited service, respectively. Estimated final average earnings for each of the Named Executive Officers are as follows: Mr. Malloy ($1,185,000); Dr. Smurfit ($1,040,000); Mr. Terrill ($532,000); Mr. Larson ($366,000); and Mr. Bradford ($461,000). Employment Contracts and Termination, Severance and Change of Control Arrangements The Company and its subsidiaries maintain a severance pay plan for all salaried employees who have at least one year of credited service (the "Severance Plan"). Upon a covered termination, the Severance Plan provides for the payment of one week's salary for each full year of service, payable in accordance with payroll practices. Mr. Malloy has a deferred compensation agreement with JSC pursuant to which JSC intends to pay to him, upon his retirement, lifetime payments of $70,000 annually in addition to his accrued benefits under SIP Plan I. Deferred Compensation Capital Enhancement Plan The Company's Deferred Compensation Capital Enhancement Plan (the "DCC") allows for the deferral of compensation of key full-time salaried employees of the Company and its subsidiaries. Participants may defer a portion of their compensation and their employer may defer discretionary bonuses (together the "Deferred Compensation Amount"). Deferrals occur in 18 month cycles. A participant becomes vested with respect to amounts deferred during a particular cycle if he continues to be employed by the Company or its subsidiaries for seven years from the beginning of the cycle, retires at age 65 or leaves employment for reasons of death or disability. Upon Normal Retirement (as defined in the DCC) benefits are distributed under the DCC. Certain participants will receive pre-retirement distributions from the DCC, beginning in the eighth year of each cycle. The amounts distributed upon Normal Retirement for each cycle are determined with reference to the age of the participant at the beginning of the cycle and the participant's Deferred Compensation Amount with respect to the cycle. If a participant is younger than 45 years old at the beginning of a cycle, he will receive upon Normal Retirement a total of fifteen annual payments, each totalling one and one-half times his Deferred Compensation Amount. If at the beginning of a cycle a participant is between the ages of 45 and 55 years old, at Normal Retirement he will receive a total of fifteen annual payments that, in the aggregate, equal his Deferred Compensation Amount with respect to the cycle plus appreciation credited annually at 100% of the Moody's Rate (as defined in the DCC). If at the beginning of a cycle a participant is at least 55 years old, his Normal Retirement benefit will be a total of fifteen annual payments that, in the aggregate, equal his Deferred Compensation Amount with respect to the cycle plus appreciation credited annually at 150% of the Moody's Rate . If at the beginning of a cycle a participant is age 65 or older, the number of such annual payments shall be five. If a participant dies prior to retirement, the value of his death benefit may be more or less than his Normal Retirement benefits, depending on his age at the beginning of the cycle. Benefits may be reduced by the employer if a former participant is engaged in a competing business within two years of termination from the Company or its subsidiaries. Participants may receive early distributions in the event that they experience unforeseen financial emergencies. Benefits otherwise payable to the participant are then actuarially reduced to reflect such early distributions. The benefits payable under the DCC are funded by the Company through life insurance policies. There have been no deferrals under the DCC since 1986. Deferrals made by the Named Executive Officers during 1985 and 1986 and their ages at the time of such deferrals were: Mr. Malloy ($30,000 at 57, $50,000 at 58), Dr. Smurfit ($30,000 at 48), Mr. Terrill ($15,000 at 51, $25,000 at 52), Mr. Bradford ($15,000 at 49, $25,000 at 50) and Mr. Larson ($0). In 1993, the Company made the first preretirement distribution to certain participants totaling $195,000. Compensation Committee Interlocks and Insider Participation The Company has not heretofore maintained a formal compensation committee. Dr. Smurfit, Mr. Malloy and Mr. Kilroy, executive officers of the Company, participated in deliberations of the Board of Directors on executive compensation matters during 1993. Following consummation of the Offerings, the Company will maintain a Compensation Committee of the Board of Directors. Dr. Smurfit and Mr. Kilroy are both directors and executive officers of JS Group, Holdings, JSC and CCA, and Mr. Malloy is a director of JS Group and a former director and executive officer of Holdings, JSC and CCA. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the outstanding JSC Common Stock is owned by Holdings. The outstanding voting stock of Holdings is owned equally by (i) Smurfit Packaging, 8182 Maryland Avenue, St. Louis, Missouri 63105 and Smurfit Holdings, 92/96 Rokin, Amsterdam 1012KZ, The Netherlands, and (ii) MSLEF II, 1251 Avenue of the Americas, New York, New York 10020. The Old Bank Facilities and Senior Secured Notes are secured by, among other things, the CCA Common Stock and the JSC Common Stock. If an Event of Default occurs under the Old Bank Facilities or the Senior Secured Notes, the banks or the holders of the Senior Secured Notes will have the right to foreclose upon such stock. The Organization Agreement (as defined in Item 13 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Set forth below is a summary of certain agreements and arrangements entered into by the Company and related parties in connection with the 1989 Transaction and the 1992 Transaction, as well as other transactions between the Company and related parties which have taken place during 1993. General As a result of certain transactions which occurred in December 1989 (the "1989 Transaction"), JSC became a wholly-owned subsidiary of Holdings and CCA became an indirect wholly-owned subsidiary of JSC. As part of the 1989 Transaction, Holdings issued (i) 1,510,000 shares of Holdings Class A common stock ("Class A Stock") and 500,000 shares of Holdings Class D common stock ("Class D Stock") to SIBV for $150 million and $50 million, respectively, (ii) 1,510,000 shares of Holdings Class B common stock ("Class B Stock") to MSLEF II for $150 million, (iii) 100,000 shares of Holdings Class C common stock ("Class C Stock") to MSLEF II, Inc. (the general partner of MSLEF II) and 400,000 shares of Class C Stock to the Direct Investors (as defined below) for $10 million and $40 million, respectively (the Direct Investors also purchased Junior Accrual Debentures and Subordinated Debentures in aggregate principal amounts of $129.2 million and $30.8 million, respectively), and (iv) its preferred stock ("Old Preferred Stock") to SIBV for $100 million. SIBV subsequently transferred all of such common and preferred stock to Smurfit Packaging. In addition to the issuances of capital stock by Holdings described above, the financing for the 1989 Transaction was provided by (i) the issuance by CCA of the Secured Notes and the Subordinated Debt, and (ii) the incurrence of term debt and revolving credit indebtedness pursuant to the 1989 Credit Agreement. As a result of the 1992 Transaction, (i) MSLEF II acquired an additional 330,000 and 1,212,788 shares of Class B Stock and Class C Stock, respectively, and certain holders of Class C Stock acquired 457,212 additional shares of Class C Stock, for an aggregate of $200 million, (ii) Smurfit Holdings, B.V., a subsidiary of SIBV, acquired 330,000 shares of Class A Stock for $33 million, (iii) Smurfit Packaging agreed that its Old Preferred Stock (including shares issued since the 1989 Transaction as a dividend) would convert into 1,670,000 shares of Class D Stock on December 31, 1993, (iv) proceeds from the issuances of shares described in clauses (i) and (ii) above were used to acquire, at a purchase price of $1,100 per $1,000 accreted value, an aggregate of $129.2 million principal amount ($193.5 million accreted value) of Junior Accrual Debentures from the Direct Investors, (v) CCA borrowed approximately $400 million under the 1992 Credit Agreement, and used the proceeds to prepay approximately $400 million of scheduled installments relating to term loan indebtedness under the 1989 Credit Agreement, (vi) various provisions of the 1989 Credit Agreement and the Secured Note Purchase Agreement were amended and restated, and (vii) MSLEF II and SIBV amended a number of the provisions contained in the Organization Agreement, agreed to the terms of a Stockholders Agreement (which will replace the Organization Agreement upon the closing of the Equity Offerings) and entered into the Registration Rights Agreement. Currently Smurfit Packaging and Smurfit Holdings, through their ownership of all of the outstanding Class A Stock, and MSLEF II, through its ownership of all of the outstanding Class B Stock, each own 50% of the voting common stock of Holdings. MSLEF II, MSLEF II, Inc., a Delaware Corporation that is a wholly-owned subsidiary of Morgan Stanley Group Inc. ("Morgan Stanley Group") and the general partner of MSLEF II, SIBV/MS Equity Investors, L.P., a Delaware limited partnership the general partner of which is a wholly-owned subsidiary of Morgan Stanley Group ("Equity Investors" and, together with MSLEF II and MSLEF II, Inc., the "MSLEF II Associated Entities"), First Plaza Group Trust, as trustee for certain pension plans ("First Plaza"), Leeway & Co., as nominee for State Street Bank and Trust Co., as trustee for a master pension trust ("Leeway" and, together with First Plaza, the "Direct Investors"), certain other investors and Smurfit Packaging own all of the non-voting stock of Holdings. On December 31, 1993, all of the Old Preferred Stock owned by Smurfit Packaging was converted into 1,670,000 shares of Class D Stock. Since such conversion of Old Preferred Stock, Smurfit Packaging, on the one hand, and the MSLEF II Associated Entities, the Direct Investors and such other investors, on the other, own, through their ownership of Class D Stock and Class C Stock, respectively, 50% of the non-voting common stock of Holdings. Holdings' capital stock currently consists of Class A Stock, Class B Stock, Class C Stock, Class D Stock and Class E common stock (the "Class E Stock" and, together with the Class A, Class B, Class C and Class D Stock, the "Old Common Stock"). The classes of stock comprising the Old Common Stock are identical in all respects except with respect to certain voting rights, and certain exchange provisions that do not affect the percentage of Holdings owned by SIBV and MSLEF II. Holdings' Class E Stock is non-voting stock reserved for issuance pursuant to the 1992 Stock Option Plan. In the Reclassification, the Old Common Stock, which consists of five classes of stock, will be converted into one class, on a basis of ten shares of Common Stock for each share of the Old Common Stock. Following the Reclassification, Holdings' only class of common stock will be Holdings Common Stock. Immediately prior to the consummation of the Equity Offerings, 80,200,000 shares of Holdings Common Stock will be outstanding and such stock will be owned by the Holdings' stockholders in proportion to their ownership of the Old Common Stock as described in the two preceding paragraphs. Substantially concurrently with the consummation of the Equity Offerings, SIBV (or a corporate affiliate of SIBV) will purchase 5,714,286 shares of Holdings Common Stock from Holdings pursuant to the SIBV Investment. Accordingly, following the consummation of the Equity Offerings and the SIBV Investment, MSLEF II Associated Entities and SIBV through its subsidiaries will beneficially own 30.8% and 44.4%, respectively, of the shares of Holdings Common Stock then outstanding. The relationships among JSC, CCA, Holdings and its stockholders are set forth in a number of agreements described below. The summary descriptions herein of the terms of such agreements do not purport to be complete and are subject to, and are qualified in their entirety by reference to, all of the provisions of such agreements, which have been filed as exhibits to the Registration Statement filed February 18, 1994. Capitalized terms not otherwise defined below or elsewhere in the document have the meanings given to them in such agreements. Any reference to either SIBV or MSLEF II in the following descriptions of the Organization Agreement and the Stockholders Agreement or in references to the terms of those agreements set forth in this document shall be deemed to include their permitted transferees, unless the context indicates otherwise. The Organization Agreement Since the 1989 Transaction, the Company has been operated pursuant to the terms of the Organization Agreement, which has been amended on various occasions. The Organization Agreement, among other things, provides generally for the election of directors, the selection of officers and the day-to-day management of the Company. The Organization Agreement provides that one-half of the directors of each of Holdings, CCA and JSC be elected by the holders of the Class A Stock (Smurfit Holdings and Smurfit Packaging) and one-half by the holders of the Class B Stock (MSLEF II) and that officers of such companies be designated by the designees of Smurfit Holdings and Smurfit Packaging on the respective boards, except that the Chief Financial Officer of the Company be designated by the holders of the Class B Stock (MSLEF II). The Organization Agreement also contains certain tag along rights, rights of first refusal and call and put provisions and provisions relating to a sale of Holdings as an entirety, as well as provisions relating to transactions between Holdings, the Company and its affiliates, on the one hand, and SIBV or MSLEF II, as the case may be, and their respective affiliates, on the other. These latter provisions are similar to those contained in the Stockholders Agreement described below. In connection with the Recapitalization Plan, the Organization Agreement will be terminated upon the closing of the Offerings and, at such time, the Stockholders Agreement shall become effective among the Company, SIBV, the MSLEF II Associated Entities and certain other entities. The Organization Agreement also contains provisions whereby each of SIBV, MSLEF II, MSLEF II, Inc., Holdings, JSC, CCA and the holders of Class C Stock indemnify each other and related parties with respect to certain matters arising under the Organization Agreement or the transactions contemplated thereby, including losses resulting from a breach of the Organization Agreement. In addition, Holdings, JSC and CCA have also agreed to indemnify SIBV, MSLEF II, MSLEF II, Inc. and the holders of Class C Stock and related parties against losses arising out of (i) the conduct and operation of the business of Holdings, JSC or CCA, (ii) any action or failure to act by Holdings, JSC or CCA, (iii) the 1989 Transaction and the 1992 Transaction or (iv) the financing for the 1989 Transaction. Further, SIBV has agreed to indemnify Holdings, JSC, CCA and each of their subsidiaries against all liability for taxes, charges, fees, levies or other assessments imposed on such entities as a result of their not having withheld tax upon the issuance or payment of a specified note to SIBV and the transfer of certain assets to SIBV in connection with the 1989 Transaction. The foregoing indemnification provisions survive a termination of the Organization Agreement, including a termination in connection with the Recapitalization Plan. Stockholders Agreement The Stockholders Agreement will be entered into at or prior to the consummation of the Offerings by Holdings, SIBV, the MSLEF II Associated Entities and certain other entities. Directors and Management For a description of certain provisions of the Stockholders Agreement which relate to the management of the Company (including the election of directors of the Company), see Item 10. Directors and Executives Officers of the Registrant -Provisions of Stockholders Agreement Pertaining to Management. Transactions with Affiliates; Other Businesses The Stockholders Agreement specifically permits SIBV and MSLEF II (and their affiliates) to engage in transactions with Holdings, JSC and CCA in addition to certain specific transactions contemplated by the Stockholders Agreement, provided such transactions (except for (i) transactions between any of Holdings, JSC and CCA, (ii) the transactions contemplated by the Stockholders Agreement or by the Organization Agreement, (iii) the transactions contemplated by the Operating Agreement, dated as of April 30, 1992, between CCA and Smurfit Paperboard, Inc. ("SPI"), or in the Rights Agreement, dated as of April 30, 1992, between CCA, SPI and Bankers Trust Company, (iv) the transactions contemplated by the Registration Rights Agreement, (v) the provision of services pursuant to the Financial Advisory Services Agreement, dated as of September 12, 1989, by and among MS&Co., SIBV and Holdings, and (vi) the provisions of certain other specified agreements) are fully and fairly disclosed, have fair and equitable terms, are reasonably necessary and are treated as a commercial arms-length transaction with an unrelated third party. Neither SIBV nor MSLEF II (or their affiliates) is prohibited from owning, operating or investing in any business, regardless of whether such business is competitive with Holdings, JSC or CCA, nor is either SIBV or MSLEF II required to disclose its intention to make any such investment to the other or to advise Holdings, JSC or CCA of the opportunity presented by any such prospective investment. Transfer of Ownership In general, transfers of Holdings Common Stock to entities affiliated with SIBV or any MS Holder are not restricted. The Stockholders Agreement provides MS Holders the right to "tag along" pro rata upon the transfer by SIBV of any Holdings Common Stock, other than transfers to affiliates and sales pursuant to a public offering registered under the Securities Act or pursuant to Rule 144 under the Securities Act. No MS Holder may, without SIBV's prior written consent, transfer shares of Holdings Common Stock to any non-affiliated person or group which, when taken together with all other shares of Holdings Common Stock then owned by such person or group, represent more than ten percent of the Holdings Common Stock then outstanding. Transfers by MS Holders of ten percent or less in the aggregate of the outstanding Holdings Common Stock are subject to certain rights of first offer and rights of first refusal on the part of SIBV. Such transfers by MS Holders which are subject to SIBV's right of first refusal may not be made to any competitor of SIBV or the Company. SIBV and its affiliates have the right, exercisable on or after August 26, 2002, to purchase all, but not less than all, of the Holdings Common Stock then owned by the MS Holders at a price equal to the Fair Market Value (as defined in the Stockholders Agreement). The terms of the Stockholders Agreement do not restrict the ability of MSLEF II or Equity Investors to distribute, upon dissolution or otherwise, shares of Common Stock to their respective partners. Following any such distribution the partners of MSLEF II or Equity Investors, as the case may be (other than MSLEF II, Inc., its affiliates and, in respect of shares owned other than as a result of any such distribution, the Direct Investors) will not be subject to the Stockholders Agreement. In addition, following any such distribution, MSLEF II may, on behalf of its partners or the partners of Equity Investors, include shares in a registration rquested by it under the Registration Rights Agreement of Common Stock which have been distributed to its partners. See "-- Registration Rights Agreement". In general, if JS Group either does not, directly or indirectly, own a majority of the voting stock of SIBV, or directly or indirectly, have the right to appoint a majority of the directors and officers of SIBV, then all of the obligations of MSLEF II may, at its option, terminate the Stockholders Agreement. Termination The Stockholders Agreement shall terminate either upon mutual agreement of SIBV and MSLEF II, or at the option of SIBV or MSLEF II, as the case may be, upon either the MS Holders collectively or SIBV, respectively, ceasing to own six percent or more of the outstanding Holdings Common Stock. Registration Rights Agreement Pursuant to the Registration Rights Agreement, each of MSLEF II and SIBV have certain rights, upon giving a notice as provided in the Registration Rights Agreement, to cause Holdings to use its best efforts to register under the Securities Act the shares of Holdings Common Stock owned by MSLEF II (including its partners) and certain other entities and certain shares of Holdings Common Stock owned by SIBV. See "--Stockholders Agreement -- Transfer of Ownership". Upon consummation of the Recapitalization Plan (other than the Subordinated Debt Refinancing), MSLEF II will be entitled to effect up to four such demand registrations pursuant to the Registration Rights Agreement. SIBV will be entitled to effect up to two such demand registrations pursuant to the Registration Rights Agreement; provided, however, that SIBV may not exercise such rights until the earlier of (i) such time as MSLEF II shall have effected two such demand registrations and (ii) October 31, 1996. Neither MSLEF II nor SIBV may, however, exercise a demand right (i) until the conclusion of any Holdings Registration Process, MSLEF II Registration Process or SIBV Registration Process (each, as defined in the Registration Rights Agreement), or (ii) in certain other limited situations. In addition, MSLEF II (including its partners) and certain other entities and, under certain circumstances, SIBV are entitled, subject to certain limitations, to register their shares of Holdings Common Stock in connection with a registration statement prepared by Holdings to register Holdings Common Stock or any equity securities exercisable for, convertible into, or exchangeable for Holdings Common Stock. In the event that there is a public trading market for the Holdings Common Stock, MSLEF II and certain other entities may not effect a sale of Holdings Common Stock pursuant to the demand registration rights granted in the Registration Rights Agreement without first offering the shares proposed to be sold to SIBV for purchase. Under the terms of the Registration Rights Agreement, Holdings may not effect a common stock registration for its own account until the earlier of (i) such time as MSLEF II shall have effected two demand registrations and (ii) July 31, 1996. In addition, Holdings is generally prohibited from "piggybacking" and selling stock for its own account in demand registrations except in the case of any registration requested by SIBV and any registration requested by MSLEF II after the second completed registration for MSLEF II, in which event SIBV or MSLEF II, as the case may be may require that any such securities which are "piggybacked" be offered and sold on the same terms as the securities offered by SIBV or MSLEF II, as the case may be. Holdings will pay all registration expenses (other than underwriting discounts and commissions) in connection with MSLEF II's first two completed demand registrations, SIBV's first completed demand registrations and all registrations made in connection with a Holdings registration. The Registration Rights Agreement also contains customary terms and provisions with respect to, among other things, registration procedures and certain rights to indemnification and contribution granted by parties thereunder in connection with the registration of Holdings Common Stock subject to such agreement. Financial Advisory Services Agreement Under a financial advisory services agreement (the "Financial Advisory Services Agreement"), MS&Co. agreed to act as Holdings' and the Company's financial advisor and provided certain services and earned certain fees in connection with its roles in the 1989 Transaction, with an expectation that for the term of the Stockholders Agreement, the Company would retain MS&Co. to render it investment banking services at market rates to be negotiated. Other Transactions In connection with the issuance of the 1993 Notes, the Company entered into an agreement with SIBV whereby SIBV committed to purchase up to $200 million aggregate principal amount of 11 1/2% Junior Subordinated Notes maturing 2005 to be issued by the Company. From time to time until December 31, 1994, the Company, at its option, may issue the Junior Subordinated Notes, the proceeds of which must be used to repurchase or otherwise retire Subordinated Debt. The Company is obligated to pay SIBV for letter of credit fees incurred by SIBV in connection with the commitment in addition to an annual commitment fee of 1.375% on the undrawn principal amount. The amount payable for such commitment for 1993 was $2.9 million. The above commitments will be terminated upon the consummation of the Offerings. The Company has agreed to pay certain costs of SIBV associated with such commitments and the termination thereof up to a maximum of $900,000. Net sales by JSC to JS Group, its subsidiaries and affiliates were $18.4 million in 1993. Net sales by JS Group, its subsidiaries and affiliates to JSC were $49.3 million in 1993. Product sales to and purchases from JS Group, its subsidiaries and affiliates were consummated on terms generally similar to those prevailing with unrelated parties. JSC provides certain subsidiaries and affiliates of JS Group with general management and elective management services under separate management services agreements. The services provided include, but are not limited to, management information services, accounting, tax and internal auditing services, financial management and treasury services, manufacturing and engineering services, research and development services, employee benefit plan and management services, purchasing services, transportation services and marketing services. In consideration of general management services, JSC is paid a fee up to 2% of the subsidiaries' or affiliates' gross sales, which fee amounted to $2.3 million for 1993. In consideration for elective services, JSC received approximately $3.5 million in 1993 for its cost of providing such services. In addition, JSC paid JS Group and its affiliates $0.4 million in 1993, for management services and certain other services. In October 1991, an affiliate of JS Group completed a rebuild of the No. 2 paperboard machine owned by it, located in CCA's Fernandina Beach, Florida paperboard mill (the "Fernandina Mill"). Pursuant to the Fernandina Operating Agreement, CCA operates and manages the machine, which is owned by a subsidiary of SIBV. As compensation to CCA for its services, the affiliate of JS Group agreed to reimburse CCA for production and manufacturing costs directly attributable to the No. 2 paperboard machine and to pay CCA a portion of the indirect manufacturing, selling and administrative costs incurred by CCA for the entire Fernandina Mill. The compensation is determined by applying various formulas and agreed upon amounts to the subject costs. The amounts reimbursed to CCA totaled $62.2 million in 1993. CCA, JS Group and MSLEF II have had discussions from time to time regarding the purchase of the No. 2 paperboard machine in the Fernandina Mill by the Company from JS Group in exchange for cash or Holdings Common Stock. No agreement has been reached as to any such transaction. The Company expects, however, that it may in the future reach an agreement with regard to such acquisition from JS Group but cannot predict when and on what terms such acquisition would be consummated. Such acquisition will occur only if it is approved by the Board of Directors of the Company and is determined by the Board of Directors to be on terms no less favorable than a sale made to a third party in an arm's length transaction. The Company has agreed to reimburse SIBV for legal fees and other out-of-pocket expenses incurred by SIBV in connection with the Recapitalization Plan. On February 21, 1986, JSC purchased from Times Mirror 80% of the issued and outstanding capital stock of SNC for approximately $132 million, including a promissory note to National Westminister Bank plc in the amount of $42 million (the "Subordinated Note"). The Subordinated Note was guaranteed by JS Group. In the 1992 Transaction, the Company prepaid $19.1 million aggregate principal amount on the Subordinated Note. The remaining amount of $22.9 million was due and paid on February 22, 1993. In connection with the purchase of the SNC capital stock, JSC and Times Mirror entered into a shareholders agreement dated as of February 21, 1986. 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 this item are included in Item 8 on page 27. (3) Exhibits. The Company agrees to furnish a copy of any long-term debt instrument wherein the securities authorized do not exceed 10 percent of the registrant's total assets on a consolidated basis upon the request of the Securities and Exchange Commission. 3.1 Restated Certificate of Incorporation of CCA. (i) 3.2 Restated Certificate of Incorporation of JSC. (i) 3.3 By-laws of CCA. (i) 3.4 By-laws of JSC. (i) 4.1 Form of Indenture for the Senior Subordinated Notes. (ii) 4.2 Form of Indenture for the Subordinated Debentures. (ii) 4.3 Form of Indenture for the Junior Accrual Debentures. (ii) 4.4 Form of Indenture for the 1993 Notes. (ii) 10.1 Second Amended and Restated Organization Agreement dated as of August 26, 1992 among the parties thereto. (iii) 10.2 Second Amended and Restated Credit Agreement dated as of November 9, 1989 among the parties thereto. (iii) 10.3(a) Financial Advisory Services Agreement, dated September 12, 1989, among Morgan Stanley & Co. Incorporated, Holdings and SIBV. (iv) 10.3(b) Financial Advisory Services Agreement Amendment dated as of October 19, 1989 among Morgan Stanley & Co. Incorporated, Holdings and SIBV. (iv) 10.4 Stock Purchase Agreement, dated as of January 15, 1986, between JSC and The Times Mirror Company. (v) 10.5 Shareholders Agreement, dated as of February 21, 1986, between JSC and The Times Mirror Company. (v) 10.6 Deferred Compensation Agreement, dated January 1, 1979, between JSC and James B. Malloy, as amended and effective November 10, 1983. (vi) 10.7(a) JSC Deferred Compensation Capital Enhancement Plan. (vii) 10.7(b) Amendment No. 1 to the Deferred Compensation Capital Enhancement Plan. (viii) 10.8 Letter Agreement, dated November 24, 1982, between C. Larry Bradford and Alton Packaging Corporation. (vi) 10.9 Form of Agreement for Indemnification of Directors and Officers of JSC and CCA. (ix) 10.10 Amended and Restated Note Purchase Agreement dated as of December 14, 1989, as amended and restated as of August 26, 1992, among the parties thereto. (iii) 10.11(a) JSC Deferred Director's Fee Plan. (viii) 10.11(b) Amendment No. 1 to JSC Deferred Director's Fee Plan. (viii) See Page 77 for footnotes. 10.12 Restated Newsprint Agreement, dated January 1, 1990, by and between Smurfit Newsprint Corporation and The Times Mirror Company. Portions of this exhibit have been excluded pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended. (i) 10.13 Operating Agreement, dated as of April 30, 1992, by and between CCA and Smurfit Paperboard, Inc. (x) 10.14 Rights Agreement, dated as of April 30, 1992, between CCA, Smurfit Paperboard, Inc. and Bankers Trust Company, as collateral trustee. (x) 10.15 Loan and Note Purchase Agreement dated as of August 26, 1992 among the parties thereto. (iii) 10.16 1992 SIBV/MS Holdings, Inc. Stock Option Plan. (iii) 10.17 Form of Indenture for the Junior Subordinated Notes. (xi) 10.18 Form of Purchase Agreement relating to the Junior Subordinated Notes. (xi) 10.19 Amendment No. 3 to Second Amended and Restated Credit Agreement and Amendment No. 3 to Amended and Restated Note Purchase Agreement. 10.20 JSC Management Incentive Plan 1994. (ii) 12.1 Calculation of Historical Ratios of Earnings to Fixed Charges. (xii) 18.1 Letter regarding change in accounting for pension plans. (xiii) 21.1 Subsidiaries of JSC (ii) 24.1 Powers of Attorney for Directors of JSC and CCA. b) Form 8-K, regarding the adoption of a company-wide restructuring program, was filed with the Securities and Exchange Commission on October 14, 1993. The Company did not file any other reports on Form 8-K during the three months ended December 31, 1993. See page 77 for footnotes. Footnotes to Exhibit List (i) Previously filed as an exhibit to JSC's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, and incorporated by this reference. (ii) Previously filed as an exhibit to Holdings' Registration Statement on Form S-1, which was initially filed on February 18, 1994 (file No. 33-75520), and incorporated by this reference. (iii) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, and incorporated by this reference. (iv) Previously filed as an exhibit to JSC/CCA's Registration Statement on Form S-1 which was initially filed on September 22, 1989 (file No. 33-31212), and incorporated by this reference. (v) Previously filed as an exhibit to JSC's Current Report on Form 8-K dated February 21, 1986 and incorporated by this reference. (vi) Previously filed as an exhibit to JSC's final Prospectus dated November 10, 1983, contained in the Registration Statement on Form S-1 (file No. 2-86554), as amended and effective November 10, 1983, and incorporated by this reference. (vii) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1985, and incorporated by this reference. (viii) Previously filed as an exhibit to JSC's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, and incorporated by this reference. (ix) Previously filed as an exhibit to JSC's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, and incorporated by this reference. (x) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated by this reference. (xi) Previously filed as an exhibit to JSC/CCA's Registration Statement on Form S-2, which was initially filed on February 12, 1993 (file No. 33-58348), and incorporated by this reference. (xii) Previously filed as an exhibit to JSC/CCA's Registration Statement on form S-2, which was initially filed on February 23, 1994 (file No. 33-52383), and incorporated by this reference. (xiii) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, and incorporated by this reference. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DATE March 31, 1994 JEFFERSON SMURFIT CORPORATION (Registrant) BY /s/ John R. Funke John R. Funke 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 in the capacities and on the date indicated. SIGNATURE TITLE DATE * Chairman of the Board Michael W. J. Smurfit and Director * President, Chief Executive Officer James E. Terrill and Director (Principal Executive Officer) /s/ John R. Funke Vice-President and Chief Financial John R. Funke Officer (Principal Accounting Officer) * Director Howard E. Kilroy * Director Donald P. Brennan * Director Alan E. Goldberg * Director David R. Ramsay * By /s/ John R. Funke , pursuant to Powers of Attorney John R. Funke filed as a part of the Form 10-K. As Attorney in Fact The annual provisions for depreciation have been computed principally in accordance with the following estimated lives: Buildings and leasehold improvements - 20 to 50 years Machinery, fixtures and equipment - 3 to 30 years Amounts for (i) depreciation and amortization of intangible assets, pre-operating costs and similar deferrals, (ii) taxes, other than payroll and income taxes, (iii) royalties and (iv) advertising costs are not presented as such amounts are less than 1% of total sales and revenue in all periods.

88255_1993.txt

88255_1993

1993

88255

Item 1. Business. Sears Roebuck Acceptance Corp. ("SRAC") is a wholly-owned subsidiary of Sears, Roebuck and Co. ("Sears"). SRAC raises funds through short-term borrowing programs, primarily the direct placement of commercial paper with corporate and institutional investors, and uses borrowing proceeds to acquire short-term notes of Sears and purchase outstanding customer receivable balances from Sears. Sears uses the funds obtained from SRAC for general funding purposes. SRAC's income is derived primarily from the earnings on its investment in the notes and receivable balances of Sears. The interest rate on Sears notes is calculated so that SRAC maintains an earnings to fixed charge ratio of at least 1.25 times. The yield on the investment in Sears notes is related to SRAC's borrowing costs and, as a result, SRAC's earnings fluctuate in response to movements in interest rates and changes in Sears short-term borrowing requirements. In late 1992, Sears announced a strategic repositioning with three main goals: to release shareholder value by allowing the financial markets to directly value the various components of the company, to strengthen the balance sheet by reducing debt, and to focus on the core retail and insurance operations. During 1993, Sears successfully executed the repositioning which included Dean Witter, Discover & Co.'s ("Dean Witter") sale of approximately 20 percent of its stock (completed in March) and the spin-off of Sears 80 percent interest in Dean Witter through a special tax-free dividend to Sears shareholders (June); The Allstate Corporation's sale of approximately 20 percent of its stock (June); and the completion of the sale of the Coldwell Banker Residential businesses (November). Sears also successfully restructured its Merchandise Group (which included closing the traditional U.S. catalog operations, paring costs, and closing 113 retail and specialty stores), and recapitalized Allstate Insurance Company, a subsidiary of The Allstate Corporation (after its capital base was severely impacted by Hurricane Andrew). The results of the strategic repositioning exceeded expectations. Of the $4.2 billion in gross proceeds, Sears used $3 billion to pay down debt, and left nearly $500 million at Allstate to improve its capital position and nearly $300 million at Dean Witter, Discover & Co. to strengthen its balance sheet. Sears also posted record earnings for 1993 of $2.37 billion, and achieved a total return on common equity of 19% on continuing businesses. Because of the pay down in debt, Sears debt-to-equity ratio declined from 3.4:1 to 1.8:1. The repositioning significantly impacted SRAC as well. In combination with the proceeds from the initial public offerings of Dean Witter and Allstate, Sears received another $3.0 billion as payment for the assumption of Dean Witter intercompany debt. Since proceeds from the strategic repositioning were used primarily to pay down commercial paper (temporarily leaving Sears with a higher amount of longer term fixed-rate funding), SRAC's total commercial paper outstandings declined from $8.5 billion at the beginning of the year to $2.5 billion at the close of 1993. In the last half of 1993, SRAC took steps to bring its liquidity support and capital resources into alignment with projected funding requirements. SRAC's credit facilities, which totalled $10.8 billion at the end of 1992, were replaced with two syndicated credit agreements totalling $4.0 billion, and $200 million of uniform credit agreements with individual banks. In December 1993, SRAC reduced its equity base by $2.0 billion through a reduction in SRAC's investment in Sears notes. SRAC continues to be a very strongly capitalized company, with an equity position of over $1.1 billion. The company's debt-to-equity ratio improved to 2.6:1 at the end of 1993 (from 3.0:1 at the end of 1992), further enhancing SRAC's financial flexibility given Sears stated intention to refinance a significant percentage of its fixed rate maturities with floating rate instruments, including commercial paper. In March 1993, Duff & Phelps reaffirmed SRAC's rating at Duff 1. SRAC's other ratings are A-2 from Standard & Poor's and P-2 from Moody's Investors Service. Pursuant to the syndicated credit agreements between SRAC and various banks (detailed below in Item 8 "Notes to Financial Statements, note 5"), the agreement between SRAC and Sears concerning SRAC's investment in Sears notes may not be amended, waived, terminated or modified (except that SRAC's fixed charge coverage ratio may be reduced to 1.15) without the approval of such banks. SRAC acts as placement agent for Sears Credit Corp. A, Sears Credit Corp. B, Sears Credit Corp. I and Sears Credit Corp. II (collectively "SCC"), which are wholly-owned subsidiaries of Sears that issue asset-backed commercial paper ("ABCP"). The ABCP is secured by investor certificates acquired by SCC, which represent undivided interests in a trust. The trust holds receivables arising in selected accounts under Sears open-end credit plans, all payments received on the receivables including related finance charges, and deposits in certain accounts of the trust. The ABCP is rated A-1+ or A-1 by Standard & Poor's and P-1 by Moody's Investors Service, has maturities of 180 days or less and is sold only to qualified investors in denominations of $100,000 or more. At February 28, 1994, SRAC had 14 employees. Item 2. Item 2. Properties. None. Item 3. Item 3. Legal Proceedings. None. 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. There is no established public trading market for SRAC's common stock. As of February 28, 1994, Sears owned all outstanding shares of SRAC's common stock. The Board of Directors of SRAC declared a $1.7 billion dividend on December 20, 1993 to Sears, payable on December 30, 1993. The Board also approved payment to Sears on December 30, 1993 of $330.2 million out of capital in excess of par value; such payment is characterized as a dividend under the Delaware General Corporation Law. Payments for these transactions were effected by reducing SRAC's investment in the notes of Sears by approximately $2.0 billion. SRAC does not intend to pay any cash or other dividends on its common stock in the foreseeable future. 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. Financial Condition SRAC's investment in Sears notes of $3.4 billion at year-end 1993 decreased $7.1 billion from $10.5 billion at the end of 1992, due to the reduction in Sears funding through the successful completion of its strategic repositioning and the payment of a dividend and return of capital to Sears. Total commercial paper outstandings declined from $8.5 billion at the beginning of the year to $2.5 billion at the close of 1993. SRAC reduced its equity base by $2.0 billion through a $1.7 billion dividend and $330.2 million return of capital in excess of par value, through a reduction in SRAC's investment in Sears notes. At the end of 1993, SRAC maintained a very strong equity position of over $1.1 billion, with a debt-to-equity ratio of 2.6:1. SRAC had investments in highly liquid short-term securities of $650.7 million at the end of 1993, as part of its liability management program. In the last half of 1993, SRAC took steps to bring its liquidity support into alignment with projected funding requirements. SRAC's credit facilities, which totalled $10.8 billion at the end of 1992, were replaced with two syndicated credit agreements totalling $4.0 billion, and $200 million in uniform credit agreements with individual banks. Results of Operations Under an agreement with Sears, SRAC is guaranteed a rate on the notes of Sears providing a ratio of earnings to fixed charges of at least 1.25 times. Primarily due to a reduction in Sears notes during 1993, SRAC's total revenues of $337.5 million declined $359.0 million, or 52%, compared to $696.5 million in 1992. In 1993, SRAC's average cost of short-term funds declined twenty-nine basis points to 3.67% from 3.96% in 1992. Coupled with the 57% decrease in average outstanding short-term debt during 1993, this decline resulted in a $246.7 million, or 51%, decrease in interest and related expenses to $236.1 million in 1993 from $482.8 million in 1992. The provision for credit losses decreased in 1993 due to lower average receivable balances and the sale of $847.6 million of receivables back to Sears in December 1993. As a result, total expenses of $276.7 million decreased $255.6 million, or 48%, from $532.3 million in 1992 and SRAC's 1993 net income of $39.5 million decreased $68.6 million, or 63%, from net income of $108.1 million in 1992. In 1992, SRAC's net income decreased 21% from $136.4 million in 1991, primarily due to a reduction in the interest rates on the Sears notes. The financial information appearing in this annual report on Form 10-K is presented in historical dollars which do not reflect the decline in purchasing power that results from inflation. As is the case for most financial companies, substantially all of SRAC's assets and liabilities are monetary in nature. Interest rates on SRAC's combined investment in Sears notes (set to provide a fixed charge coverage of at least 1.25 times) and customer receivable balances help insulate SRAC from the effects of inflation-based interest rate increases. Item 8. Item 8. Financial Statements and Supplementary Data. SEARS ROEBUCK ACCEPTANCE CORP. STATEMENTS OF INCOME Year Ended December 31, millions 1993 1992 1991 ------- ------- ------- Revenues - -------- Earnings on notes of Sears $209.1 $508.4 $972.3 Earnings on receivable balances purchased from Sears (Note 3) 105.4 125.3 70.5 Earnings on invested cash 22.6 61.9 56.7 Other revenues 0.4 0.9 1.3 ------- ------- ------- Total revenues 337.5 696.5 1,100.8 Expenses - -------- Interest and amortization of debt discount and expense 236.1 482.8 825.9 Provision for credit losses 33.8 44.9 63.6 Operating expenses 6.8 4.6 4.6 ------- ------- ------- Total expenses 276.7 532.3 894.1 ------- ------- ------- Income before income taxes 60.8 164.2 206.7 Income taxes (Note 2) 21.3 56.1 70.3 ------- ------- ------- Net Income $39.5 $108.1 $136.4 ------- ------- ------- Ratio of earnings to fixed charges 1.26 1.34 1.25 See notes to financial statements. SEARS ROEBUCK ACCEPTANCE CORP. STATEMENTS OF FINANCIAL POSITION December 31, millions 1993 1992 -------- --------- Assets - ------ Notes of Sears $3,403.9 $10,493.6 Customer receivable balances purchased from Sears (Note 3) 88.0 963.4 Cash and invested cash 650.7 946.5 Other assets 3.2 11.7 -------- --------- Total assets $4,145.8 $12,415.2 -------- --------- Liabilities - ----------- Commercial paper (net of unamortized discount of $5.1 and $32.2) $2,475.0 $8,515.3 Agreements with bank trust departments 139.8 397.9 Zero coupon note 379.8 332.1 Accrued interest and other liabilities 10.7 31.6 Deferred federal income taxes 3.0 10.1 -------- --------- Total liabilities 3,008.3 9,287.0 -------- --------- Stockholder's Equity - -------------------- Capital stock, par value $100 per share 500,000 shares authorized 350,000 shares issued and outstanding 35.0 35.0 Capital in excess of par value - 330.2 Retained income 1,102.5 2,763.0 -------- --------- Total stockholder's equity 1,137.5 3,128.2 -------- --------- Total liabilities and stockholder's equity $4,145.8 $12,415.2 -------- --------- See notes to financial statements. SEARS ROEBUCK ACCEPTANCE CORP. STATEMENTS OF STOCKHOLDER'S EQUITY Year Ended December 31, millions 1993 1992 1991 -------- -------- -------- Capital stock $35.0 $35.0 $35.0 --------- -------- -------- Capital in excess of par value Beginning of year $330.2 $330.2 $330.2 Return of capital paid to Sears* (330.2) - - --------- -------- -------- End of year $- $330.2 $330.2 --------- -------- -------- Retained income Beginning of year $2,763.0 $2,654.9 $2,518.5 Net income 39.5 108.1 136.4 Dividend paid to Sears (1,700.0) - - --------- -------- -------- End of year $1,102.5 $2,763.0 $2,654.9 --------- -------- -------- Total stockholder's equity $1,137.5 $3,128.2 $3,020.1 --------- -------- -------- * characterized as a dividend under Delaware General Corporation Law. See notes to financial statements. SEARS ROEBUCK ACCEPTANCE CORP. STATEMENTS OF CASH FLOWS Year Ended December 31, millions 1993 1992 1991 --------- --------- --------- Cash Flows From Operating Activities - ------------------------------------ Net income $39.5 $108.1 $136.4 Adjustments to reconcile net income to net cash provided by operating activities Earnings amortization on Retail Customer Receivable Balances discount (125.9) (149.2) (72.5) Provision for credit losses 33.8 44.9 63.6 Depreciation, amortization and other noncash items 58.7 55.3 94.7 Decrease in deferred federal income taxes (7.1) (5.9) (11.7) Increase in other assets (2.5) (1.0) (16.7) Decrease in other liabilities (20.9) (5.4) (6.2) --------- --------- --------- Net cash (used in) provided by operating activities (24.4) 46.8 187.6 Cash Flows From Investing Activities - ------------------------------------ Decrease in notes of Sears 5,059.5 1,720.9 1,713.7 Decrease (increase) in receivable balances purchased from Sears 967.5 183.7 (1,033.9) --------- --------- --------- Net cash provided by investing activities 6,027.0 1,904.6 679.8 Cash Flows From Financing Activities - ------------------------------------ Decrease in commercial paper, primarily 90 days or less (6,040.3) (1,690.5) (125.2) Decrease in agreements with bank trust departments (258.1) (112.2) (61.8) Payments for redemption of zero coupon and variable interest notes - (604.0) (71.0) --------- --------- --------- Net cash used in financing activities (6,298.4) (2,406.7) (258.0) --------- --------- --------- Net (decrease) increase in cash and invested cash (295.8) (455.3) 609.4 Cash and invested cash, beginning of year 946.5 1,401.8 792.4 --------- --------- --------- Cash and invested cash, end of year $650.7 $946.5 $1,401.8 --------- --------- --------- Supplemental Disclosure of Cash Flow Information Cash paid during the year Interest $200.5 $444.1 $742.8 Income taxes 37.1 61.0 84.7 See notes to financial statements. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Sears Roebuck Acceptance Corp. ("SRAC"), a wholly-owned subsidiary of Sears, Roebuck and Co. ("Sears"), is principally engaged in the business of acquiring short-term notes of Sears and purchasing outstanding customer receivable balances from Sears, using proceeds from its short-term borrowing programs (primarily the direct placement of commercial paper). Under the letter agreement between SRAC and Sears, the interest rate on the Sears notes is calculated so that SRAC maintains an earnings to fixed charge ratio of at least 1.25 times. Cash and invested cash is defined to include all highly liquid investments with maturities of three months or less. The $2.0 billion dividend and return of capital paid to Sears was effected through a reduction in SRAC's investment in Sears notes, a noncash transaction. Customer receivables purchased from Sears are either purchased at a discount and then amortized using the interest method, or purchased at par and are interest-bearing. The zero coupon note issued to Sears Overseas Finance N.V. ("SOFNV"), a wholly-owned international finance subsidiary of Sears, is amortized using the interest method. Other debt discount and issue expenses are amortized on a straight-line basis over the terms of the related obligation. The results of operations of SRAC are included in the consolidated federal income tax return of Sears. Tax liabilities and benefits are allocated as generated by SRAC, whether or not such benefits would be currently available on a separate return basis. Certain reclassifications have been made in the 1992 and 1991 financial statements to conform to current accounting classifications. Effective January 1, 1992, SRAC adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The adoption of the standards did not have a material impact on the financial statements of SRAC, and will have no effect on the future cash flows of the Company. 2. FEDERAL INCOME TAXES Year Ended December 31, millions 1993 1992 1991 ------- ------- ------- Current $28.4 $62.0 $82.0 Deferred (7.1) (5.9) (11.7) ------- ------- ------- Financial statement income tax provision $21.3 $56.1 $70.3 ------- ------- ------- Effective income tax rates 35% 34% 34% 3. CUSTOMER RECEIVABLE BALANCES SRAC purchased two types of customer receivable balances from Sears, retail ("RCRB") and merchant ("MCRB"). RCRB (excluding related finance charges) were purchased without recourse and at a discount (which included an allowance for uncollectible accounts). MCRB are purchased with recourse at par, with SRAC earning interest on the receivables. RCRB were made up of accounts under Sears open-end credit plans related to the purchase of goods and services at Sears. MCRB are made up of credit accounts Sears has established with merchants and contractors for bulk purchases from Sears. The MCRB's are predominately paid within 30 days. In December 1993, SRAC sold to Sears the entire outstanding RCRB at net book value of $847.6 million. At the end of 1993, SRAC owned $88.0 million of MCRB. SRAC received the collections and accepted the net charge-offs (collectively referred to as liquidations) related to the RCRB and paid Sears a fee for administering the accounts. Sears utilized procedures with respect to collections, charge-offs and other matters identical to those employed in administering account balances which had not been purchased by SRAC. Each month SRAC purchases the balance increases in the MCRB accounts attributable to additional credit sales and receives the collections related to the previously purchased balances. Sears will pay interest to SRAC on the balances in these accounts at a rate equivalent to the prime rate. Earnings on the purchased RCRB represent the amortization of discount, net of administration fees of $20.5 million for 1993 and $23.9 million for 1992. A summary is presented below: millions 1993 1992 --------- --------- Account balances at January 1 $1,176.5 $1,249.5 Purchases 710.0 942.8 Liquidations (1,038.9) (1,015.8) Sale of RCRB to Sears (847.6) - --------- --------- Account balances at December 31 - 1,176.5 Unearned discount - (151.6) Allowance for uncollectible accounts - (61.5) --------- --------- Account balances (net) at December 31 $- $963.4 --------- --------- Unearned Allowance for Discount Uncollectibles 1993 1992 1993 1992 ------- ------- ------- ------- Account balances at January 1 $151.6 $146.3 $ 61.5 $ 60.4 Additional purchase discount 82.6 109.7 33.8 44.8 Amortization/charge-offs (88.0) (104.4) (41.5) (43.7) Sale of RCRB to Sears (146.2) - (53.8) - ------- ------- ------- ------- Account balances at December 31 $- $151.6 $- $ 61.5 The fair value of the net RCRB account balance at December 31, 1992 was $1,000.1 million. 4. BORROWINGS SRAC obtains funds through the direct placement of commercial paper (issued in maturities of one to 270 days) and borrowings under agreements with bank trust departments. Selected details of SRAC's borrowings are shown below. Weighted interest rates are based on the actual number of days in the year and borrowings net of unamortized discount. The short-term nature of substantially all of SRAC's financial instruments (both assets and liabilities) causes their carrying value to approximate fair value. The terms of the loan agreement with SOFNV was negotiated between related parties, accordingly, the fair value of this instrument is not provided. December 31, millions 1993 1992 -------- -------- Commercial paper outstanding $2,480.1 $8,547.5 Less: Unamortized discount 5.1 32.2 -------- -------- Commercial paper outstanding (net) 2,475.0 8,515.3 Agreements with bank trust departments 139.8 397.9 Zero coupon, $400 million face value loan agreement with SOFNV due May 26, 1994 379.8 332.1 -------- -------- Total borrowings $2,994.6 $9,245.3 -------- -------- Commercial Paper and Agreements with Bank Trust Departments Average and Maximum Balances During the Year 1993 1992 ------------------- ------------------- Maximum Maximum millions Average (month-end) Average (month-end) ------------------- ------------------- Commercial paper $3,812.1 $ 7,271.1 $9,327.6 $10,582.4 Agreements with bank trust dept. 401.8 499.1 746.7 900.5 ------------------- ------------------- Weighted Interest Rates 1993 1992 ------------------- ------------------- millions Average Year-End Average Year-End ------------------- ------------------- Commercial paper 3.64% 3.51% 3.97% 4.08% Agreements with bank trust dept. 3.38% 3.30% 3.80% 3.76% ------------------- ------------------- Under the terms of a 1986 agreement, Sears agrees to make all payments required to be made by SRAC to SOFNV in accordance with certain loan agreements between SRAC and SOFNV (excluding the zero coupon $400 million loan due May, 1994, listed in the table above). SRAC remains liable to SOFNV for such loan agreements, which total $267 million as of December 31, 1993. 5. CREDIT FACILITIES AS OF DECEMBER 31, 1993 Contractual Credit Facilities Expires (millions) -------------------------- Credit Agreement dated as of August 25, 1993 August 1997 $3,000 Credit Agreement dated as of August 25, 1993 August 1994 1,000 Credit Agreements dated as of October 1, 1993 September 1994 200 ------ Total compensated credit facilities $4,200 ------ Commitment fees are paid on the unused portions of the above credit facilities. The annualized fees at December 31, 1993 on these lines were $8.6 million. 6. LETTER OF CREDIT COMMITMENTS SRAC issues letters of credit at Sears request to facilitate Sears purchase of goods from foreign suppliers. At December 31, 1993, letters of credit totaling $114.0 million were outstanding. SRAC has no liabilities with respect to this program other than the obligation to pay drafts under the letters of credit which, if not reimbursed by Sears on the day of the disbursement, are automatically converted into demand borrowings by Sears from SRAC. To date, all SRAC disbursements have been reimbursed on a same-day basis. SRAC issues standby letters of credit on behalf of its affiliate, Western Auto Supply Company ("Western Auto"), which are used by Western Auto to secure its obligation to repurchase any defaulted accounts receivable sold to a financial institution. At December 31, 1993, a $45.0 million standby letter of credit was outstanding. 7. QUARTERLY FINANCIAL DATA (UNAUDITED) For the quarter ended March 31, June 30, September 30, December 31, 1993 1992 1993 1992 1993 1992 1993 1992 ------------- ------------ ------------- ------------ Operating Results (millions) Combined earnings from Sears notes and RCRB $123.7 $195.9 $73.6 $146.7 $63.4 $140.1 $87.6 $151.0 Total Revenues 133.2 216.8 79.0 170.7 67.0 150.9 92.1 158.1 Interest & related expenses 96.7 150.6 54.7 123.3 44.9 102.0 39.8 106.9 Total expenses 107.7 163.2 65.0 134.9 55.7 113.7 48.3 120.5 Income before income taxes 25.5 53.6 14.0 35.8 11.3 37.2 10.0 37.6 Net income 16.8 35.4 9.3 23.6 6.6 24.6 6.8 24.5 Ratio of earnings to fixed charges 1.26 1.36 1.26 1.29 1.25 1.36 1.25 1.35 Averages (billions) Earning assets* $11.3 $14.7 $7.4 $13.6 $6.2 $12.7 $6.6 $13.3 Short-term debt 7.8 11.0 3.9 10.2 2.6 9.3 3.0 9.8 Cost of short-term debt 3.98% 4.51% 3.57% 4.13% 3.31% 3.55% 3.33% 3.56% * Notes and receivable balances of Sears and invested cash. Certain reclassifications have been made to the quarterly data from the classification used in reporting such data in Form 10-Q, which primarily relate to the presentation of the provision for credit losses. 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. Not applicable. Item 11. Item 11. Executive Compensation. Not applicable. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Not applicable. Item 13. Item 13. Certain Relationships and Related Transactions. Not applicable. 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. An "Index to Financial Statements" has been filed as a part of this report on page S-1 hereof. 2. No financial statement schedules are included herein because they are not required or because the information is contained in the financial statements and notes thereto, as noted in the "Index to Financial Statements" filed as part of this report. 3. An "Exhibit Index" has been filed as part of this report beginning on page E-1 hereof. (b) Reports on Form 8-K: A report on Form 8-K was filed by the Registrant dated December 20, 1993 (Item 5 and Item 7). 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. SEARS ROEBUCK ACCEPTANCE CORP. (Registrant) By Keith E. Trost* Vice President, Finance and Administration and Assistant Secretary 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 date indicated. Signature Title Date Michael W. Phillips* Director, President and ) Chief Executive Officer ) (Principal Executive ) Officer) ) ) ) Keith E. Trost* Vice President- ) March 30, 1994 Finance and Administration ) and Assistant Secretary ) (Principal Financial and ) Accounting Officer) ) ) ) James A. Blanda* Director ) ) ) James D. Constantine* Director ) ) ) Edward M. Liddy* Director ) ) ) Alice M. Peterson* Director ) ) ) Larry R. Raymond* Director ) ) ) George F. Slook* Director ) *By \s\ Keith E. Trost Individually and as Attorney-in-Fact ------------------ Keith E. Trost SEARS ROEBUCK ACCEPTANCE CORP. YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 PAGE STATEMENTS OF INCOME 6 STATEMENTS OF FINANCIAL POSITION 7 STATEMENTS OF STOCKHOLDER'S EQUITY 8 STATEMENTS OF CASH FLOWS 9 NOTES TO FINANCIAL STATEMENTS 10-15 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS S-2 S-1 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Stockholder and Board of Directors of Sears Roebuck Acceptance Corp.: We have audited the accompanying Statements of Financial Position of Sears Roebuck Acceptance Corp. (a wholly-owned subsidiary of Sears, Roebuck and Co.) as of December 31, 1993 and 1992, and the related Statements of Income, 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 financial statements present fairly, in all material respects, the financial position of Sears Roebuck Acceptance Corp. 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. Deloitte & Touche Philadelphia, Pennsylvania February 11, 1994 S-2 EXHIBIT INDEX 3(a) Certificate of Incorporation of the Registrant, as in effect at November 13, 1987 [Incorporated by reference to Exhibit 28(c) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987*]. 3(b) By-laws of the Registrant, as in effect at October 8, 1993 [Incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993*] 4(a)(1) Form of Series A-B Note [Incorporated by reference to Exhibit 4(a)(1) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982*]. 4(a)(2) Form of letter agreement relating to Series A-B Note [Incorporated by reference to Exhibit 4(a)(2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982*]. 4(b) $3,000,000,000 Credit Agreement dated as of August 25, 1993, among SRAC, the Banks listed therein and Morgan Guaranty Trust Company of New York, as Agent [Incorporated by reference to Exhibit 4(a) to Quarterly Report on Form 10-Q of the Registrant for the quarter ended September 30, 1993*] 4(c) $1,000,000,000 Credit Agreement dated as of August 25, 1993, among SRAC, the Banks listed therein and Morgan Guaranty Trust Company of New York, as Agent [Incorporated by reference to Exhibit 4(b) to Quarterly Report on Form 10-Q of the Registrant for the quarter ended September 30, 1993*] 4(d) Form of Sears Roebuck Acceptance Corp. Investment Note Agreement. [Incorporated by reference to Exhibit 4(c) to Annual Report on Form 10-K of the Registrant for the year ended December 31, 1992*] 4(e) The Registrant hereby agrees to furnish the Commission, upon request, with each instrument defining the rights of holders of long-term debt of the Registrant with respect to which the total amount of securities authorized does not exceed 10% of the total assets of the Registrant. _______________________________ * SEC File No. 1-4040. ** Filed herewith E-1 10(a) Letter Agreement dated as of October 17, 1991 between Sears Roebuck Acceptance Corp. and Sears, Roebuck and Co. [Incorporated by reference to Exhibit 10 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991*]. 10(b) Letter Agreement dated as of September 2, 1986 between Sears Roebuck Acceptance Corp. and Sears, Roebuck and Co. [Incorporated by reference to Exhibit 10 to the Registrant's Current Report on Form 8-K dated September 2, 1986*]. 10(c)(1) Agreement to Issue Letters of Credit dated December 3, 1985 between Sears, Roebuck and Co. and Sears Roebuck Acceptance Corp. [Incorporated by reference to Exhibit 10(i)(1) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1987*]. 10(c)(2) Letter Agreement dated March 11, 1986 amending Agreement to issue Letters of Credit dated December 3, 1985 [Incorporated by reference to Exhibit 10(i)(2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1987*]. 10(c)(3) Letter Agreement dated November 26, 1986 amending Agreement to Issue Letters of Credit dated December 3, 1985 [Incorporated by reference to Exhibit 10(i)(3) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1987*]. 12 Calculation of ratio of earnings to fixed charges.** 24 Power of attorney.** ________________________________ * SEC File No. 1-4040. ** Filed herewith. E-2 Exhibit 12 SEARS ROEBUCK ACCEPTANCE CORP. CALCULATION OF RATIO OF EARNINGS TO FIXED CHARGES Year Ended December 31, 1993 1992 1991 (dollars in millions) INCOME BEFORE INCOME TAXES $ 60.8 $ 164.2 $ 206.7 PLUS FIXED CHARGES: Interest 177.6 427.6 731.4 Amortization of debt discount and expense 58.5 55.2 94.5 _______ _______ _________ 236.1 482.8 825.9 ------- ------- --------- EARNINGS BEFORE INCOME TAXES AND FIXED CHARGES $ 296.9 $ 647.0 $ 1,032.6 ======= ======= ========= RATIO OF EARNINGS TO FIXED CHARGES 1.26 1.34 1.25

706270_1993.txt

706270_1993

1993

706270

Item 1. Business. ------ -------- Overview. -------- America West Airlines, Inc. ("America West" or the "Company"), a Delaware corporation, began operations in 1983. The Company is a full- service passenger airline which serves 43 destinations in the continental United States and Mexico City, including its hubs in Phoenix, Arizona and Las Vegas, Nevada and a mini-hub in Columbus, Ohio. In 1992, the Company established a code sharing relationship with Mesa Airlines, Inc. for commuter service, operating under the name "America West Express", permitting the Company to serve an additional 23 destinations as of December 31, 1993. On June 27, 1991, America West filed a voluntary petition in the United States Bankruptcy Court for the District of Arizona (the "Bankruptcy Court") to reorganize under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code"). The Company is currently operating as a debtor- in-possession ("D.I.P.") under the supervision of the Bankruptcy Court. The Company is authorized to operate its business but may not engage in transactions outside the ordinary course of business without the approval of the Bankruptcy Court. Bankruptcy And Reorganization Events. ------------------------------------ Since June 27, 1991, the date America West filed the voluntary petition with the Bankruptcy Court to reorganize, the Company has obtained D.I.P. financing, reduced expenses and overhead and restructured its routes and aircraft fleet. On February 24, 1994, America West selected an investment proposal pursuant to which it intends to develop a plan of reorganization. Bankruptcy Events. As a result of the Chapter 11 filing, the ----------------- prosecution of all actions and claims against America West was automatically stayed pursuant to Section 362 of the Bankruptcy Code. America West promptly obtained from the Bankruptcy Court a series of Orders ("First Day Orders") authorizing America West to pay certain critical vendors and suppliers, and also authorizing the payment of employee wages and benefits, as necessary to ensure that America West's passenger flight operations were not disrupted and that the Company's ongoing enterprise value would be preserved. Approximately $55 million of what otherwise would have been pre-petition unsecured debt was authorized by the Bankruptcy Court to be paid pursuant to the First Day Orders. In addition, certain stipulations between the Company and providers of aircraft and aircraft-related equipment were negotiated and approved by the Bankruptcy Court pursuant to Section 1110 and Section 365 of the Bankruptcy Code. These stipulations resulted in America West receiving certain deferrals, concessions and other payment term modifications in return for the assumption and/or conversion of the debts arising from the agreements to post-petition administrative expense priority status under Section 503 and Section 507 of the Bankruptcy Code. For further information on the effect of the stipulations, and subsequent events relating thereto, see Bankruptcy And Reorganization Events -- Route Structure and Aircraft Fleet Reductions, below. Subsequent to the case being filed, the United States Trustee for the District of Arizona appointed an Official Committee of Unsecured Creditors (the "Creditors' Committee") and an Official Committee of Equity Security Holders (the "Equity Committee") as provided by Section 1102 of the Bankruptcy Code. Each of these committees has certain rights and obligations provided for by the Bankruptcy Code and other applicable law, and have continued as active participants in the bankruptcy case since their appointment. Each of the committees has retained professional advisors to assist them in the bankruptcy proceedings, including attorneys and accountants, as well as financial and industry advisors. The expenses associated with the committees and their advisors, as allowed by the Bankruptcy Court, must be paid by the Company as administrative expenses pursuant to certain orders of the Bankruptcy Court providing for the payment of professional fees and expenses. The Company anticipates that each of the committees will continue to be actively involved in the bankruptcy proceedings on behalf of their respective constituents, particularly with respect to the development, negotiation and confirmation of a plan of reorganization for the Company. The Company anticipates that the reorganization process will result in the restructuring, cancellation and/or replacement of the interests of its existing common and preferred stockholders. Because of the "absolute priority rule" of Section 1129 of the Bankruptcy Code, which requires that the Company's creditors be paid in full (or otherwise consent) before equity holders can receive any value under a plan of reorganization, the Company previously disclosed that it anticipated that the reorganization process would result in the elimination of the Company's existing equity interests. However, due to recent events, including sustained improvement in the Company's operating results as a result of the general improvement in the condition of the United States' economy and airline industry, some form of distribution to the equity interests pursuant to Section 1129 may occur. However, there can be no assurances in this regard. On February 24, 1994, the Company selected an investment proposal as the basis for developing the Company's plan of reorganization, which proposal might result in a potential distribution to the Company's current equity holders as part of a plan of reorganization, however, there can be no assurances in this regard. See also Bankruptcy and Reorganization Events -- Plan of Reorganization, below. The Company has incurred and will continue to incur significant costs associated with the reorganization. The amount of these costs, which are being expensed as incurred, has affected and is expected to continue to affect the results of operations. Debtor-in-Possession Financing. In 1991, affiliates of Guinness Peat ------------------------------ Aviation ("GPA"), Northwest Airlines, Inc. ("Northwest") and Kawasaki Leasing International Inc. ("Kawasaki") provided $78 million of D.I.P. financing to the Company. In September 1992, America West received an additional $53 million in D.I.P. financing, bringing the total outstanding D.I.P. financing at December 31, 1992, to $110.8 million which consisted of $69.8 million from GPA, $23 million from Kawasaki, $10 million from Ansett Worldwide Aviation Services ("Ansett") and $8 million from several Arizona- based entities. The D.I.P. financing is collateralized by substantially all of the Company's assets. The financing provided by Northwest was repaid in full at the time of the September 1992 D.I.P. financing. America West also reconstituted its board of directors concurrent with the September 1992 D.I.P. financing. In September 1993, the D.I.P. lenders extended the maturity date of the D.I.P. financing from September 30, 1993 to June 30, 1994. At the time of the September 1993 extension, the financing provided by Ansett was repaid in full. Interest on all funds advanced under the D.I.P. facility accrues at 3.5 percent over the 90-day London Interbank Offered Rate ("LIBOR") and is payable quarterly. Principal repayments in the amount of $5.54 million were made on March 1993 and June 1993. As a result of the September 1993 extension of the D.I.P. financing maturity date, the Company is required to repay $5 million of principal on March 31, 1994. The remaining outstanding balance will be due upon the earlier of June 30, 1994, or upon the effective date of a confirmed Chapter 11 plan of reorganization (the "Reorganization Date"). The amended terms of the D.I.P. financing require the Company to notify the D.I.P. lenders if the unrestricted cash balance of the Company exceeds $125 million. Upon receipt of such notice, the D.I.P. lenders may require the Company to prepay the D.I.P. financing by the amount of such excess. During the first quarter of 1994, the Company notified the D.I.P. lenders that the Company's unrestricted cash exceeded $125 million; however, to date, the D.I.P. lenders have not exercised their prepayment rights. As a condition to extending the maturity date of the D.I.P. financing in September 1993, the Company also agreed to pay a facility fee of $627,000 to the D.I.P. lenders on September 30, 1993 and to pay an additional facility fee equal to 1/4 percent of the then outstanding balance of the D.I.P. financing on March 31, 1994. As of December 31, 1993, the outstanding amount due under the D.I.P. financing was approximately $83.6 million. Presently, the Company does not possess sufficient liquidity to satisfy the D.I.P. financing nor does it appear that new equity capital will be obtained and a plan of reorganization confirmed prior to June 30, 1994. Consequently, the Company will be required to obtain alternative repayment terms from its current D.I.P. lenders. Although there can be no assurance that alternative repayment terms will be obtained, the Company believes that any required extension of the D.I.P. financing would be for a short period of time and would be concurrent with the implementation of a plan of reorganization. In connection with the D.I.P. financing provided by Kawasaki, the Company agreed to convert advanced cash credits for 24 Airbus A320 aircraft (the "Kawasaki Aircraft") previously advanced by Kawasaki into an unsecured priority term loan (the "Kawasaki Term Loan"). At December 31, 1993, the amount of the Kawasaki Term Loan was $68.4 million, including accrued interest of $21.9 million. Until the Reorganization Date, the Kawasaki Term Loan will accrue interest at 12 percent per annum and such interest will be added to principal. On the Reorganization Date, 85 percent of the Kawasaki Term Loan will be converted into an eight-year term loan which will accrue interest at 2 percent over 90-day LIBOR and will be secured by substantially all the assets of the Company if the D.I.P. financing is fully repaid. Principal on such loan will be due and payable in equal quarterly installments, plus interest, commencing after the Reorganization Date. The Company has the right to prepay the Kawasaki Term Loan if the D.I.P. financing is fully repaid. The remaining 15 percent of the Kawasaki Term Loan will be treated as a general unsecured claim without priority status under the Company's plan of reorganization. In the first quarter of 1994, the Company received information that the Kawasaki Term Loan was purchased by a third party. Route Structure and Aircraft Fleet Reductions. Since its bankruptcy --------------------------------------------- filing, the Company has reviewed its route structure and flight schedules and the resulting requirements for aircraft. In September 1991, America West reduced the size of its fleet from 123 to 101 aircraft. The Company further reduced its fleet in September 1992 and, as of December 1993, the Company operated 85 aircraft. In connection with such fleet reductions, the Company renegotiated many of its aircraft lease and loan agreements. The Company returned aircraft to those providers whose aircraft were not consistent with the Company's revised business strategy and to those providers who were unwilling or unable to accept the revised terms proposed by the Company. Aircraft providers whose aircraft were returned to them in connection with the Company's fleet reduction and restructuring efforts may be entitled to unsecured pre-petition claims and/or administrative claims in the bankruptcy case for damages arising from the return of the aircraft. See Bankruptcy And Reorganization Events -- Claims, below. In general, the Company received rent deferrals in 1991 and further rent deferrals and rent reductions in 1992 from many of its aircraft providers. The rent reductions in 1992 reduced the rents on the affected aircraft to better reflect what the Company believed to be the fair market rent of the affected aircraft at the time of the reduction. In order to induce the lessors to accept rent reductions, the Company agreed that the rent on certain Boeing 737-300 and 757-200 aircraft would be readjusted to the current market rent effective August 1, 1994 and, if elected by the lessor, would be readjusted at two other times during the remaining term of the lease; however, such readjustments may not occur within two years of one another. The Company also agreed in certain cases that lessors could call the aircraft upon 180 days notice if the lessor had a better lease proposal from another party which the Company was unwilling to match. During the period August 1, 1994 through July 31, 1995, certain of these lessors may call their aircraft without first giving the Company the right to match any competing offer. Call rights with a right of first refusal affect 16 aircraft and call rights without a right of first refusal affect 10 aircraft. In addition, in order to induce several lessors to extend the lease terms of their aircraft, the Company agreed that the aircraft could be called by the lessors at the end of the original lease term. One lessor of 11 aircraft has the right to terminate each lease at the end of the original lease term of each aircraft. Such lessor also has the right to call its aircraft on 90 days notice at any time prior to the end of the amended lease term. America West has no right of first refusal with respect to such aircraft. To date, no lessor has exercised its call rights. Principal payments on certain loans secured by aircraft were deferred for the period August 1, 1992 through January 31, 1993 and will be repaid over the remaining terms of five to nine years. Interest payments due in July and August 1992, on such loans were deferred until the first quarter of 1993 and were repaid in three equal monthly installments without interest. A more comprehensive description of the rent deferrals and reductions as well as the loan deferrals is set forth herein in Item 7. ------ Management's Discussion and Analysis of Financial Condition and Results of Operations and in Item 8. Financial Statements and Supplementary Data - ------ Note 1 of Notes to Financial Statements. Claims. The reorganization process is expected to result in the ------ cancellation and/or restructuring of substantial debt obligations of the Company. Under the Bankruptcy Code, the Company's pre-petition liabilities are subject to settlement under a plan of reorganization. The Bankruptcy Code also requires that all administrative claims be paid on the effective date of a plan of reorganization unless the respective claimants agree to different treatment. There are differences between the amounts at which claims liabilities are recorded in the financial statements and the amounts claimed by the Company's creditors and such differences are material. Significant litigation may be required to resolve any disputes. The Bankruptcy Court set February 28, 1992, as the last date for the filing of proofs of claim under the Bankruptcy Code and the Company's creditors have submitted claims for liabilities not paid and for damages incurred. Claims for administrative expenses (administrative claims) were not required to be filed by that date. Due to the uncertain nature of many of the potential claims, America West is unable to project the magnitude of such claims with any degree of certainty. However, the claims (pre-petition claims and administrative claims) that have been filed against the Company are in excess of $2 billion. Such aggregate amount, includes claims of all character, including, but not limited to, unsecured claims, secured claims, claims that have been scheduled but not filed, duplicative claims, tax claims, claims for leases that were assumed, and claims which the Company believes to be without merit; however, claims filed for which an amount was not stated, are not reflected in such amount. The Company is unable to estimate the potential amount of such unstated claims; however, the amount of such claims could be material. The Company is in the process of reviewing the general unsecured claims asserted against the Company. In many instances, such review process will include the commencement of Bankruptcy Court proceedings in order to determine the amount at which such claims should be allowed. The Company has accrued its estimate of claims that will be allowed or the minimum amount at which it believes the asserted general unsecured claims will be allowed if there is no better estimate within the range of possible outcomes. However, the ultimate amount of allowed claims will be different and such differences could be material. The Company is unable to estimate the amount of such difference with any reasonable degree of certainty at this time. The Bankruptcy Code requires that all administrative claims be paid on the effective date of a plan of reorganization unless the respective claimants agree to different treatment. Consequently, depending on the ultimate amount of administrative claims allowed by the Bankruptcy Court, the Company may be unable to obtain confirmation of a plan of reorganization. The Company is actively negotiating with claimants to achieve mutually acceptable dispositions of these claims. Since the commencement of the bankruptcy proceeding, claims alleging administrative expense priority totaling more than $153 million have been filed and an additional claim of $14 million has been alleged. As of February 28, 1994, $115 million of the filed claims have been allowed and settled for $50.2 million in the aggregate. The Company is currently negotiating the resolution of the remaining $38 million filed administrative expense claim (which relates to a rejected lease of a Boeing 737-300 aircraft) and the $14 million alleged administrative expense claim (which relates to a rejected lease of a Boeing 757-200 aircraft). Claims have been or may be asserted against the Company for alleged administrative rent and/or breach of return conditions (i.e. maintenance standards), guarantees and tax indemnity agreements related to aircraft or engines abandoned or rejected during the bankruptcy proceedings. Additional claims may be asserted against the Company and allowed by the Bankruptcy Court. The amount of such unidentified administrative claims may be material. As part of its claims administration procedure, the Company is reviewing potential claims that could arise as a result of the Company's rejection of executory contracts. The Company's plan of reorganization will provide for the status of any executory contract not theretofore assumed by either affirming or rejecting such contracts. The assumption or rejection of certain executory contracts could result in additional claims against the Company. Plan of Reorganization. Under the Bankruptcy Code, the Company's pre- ---------------------- petition liabilities are subject to settlement under a plan of reorganization. Pursuant to an extension granted by the Bankruptcy Court on February 2, 1994, the Company has the partially exclusive right, until June 10, 1994 (unless extended by the Bankruptcy Court), to file a plan of reorganization. Each of the official committees has also been approved to submit a plan of reorganization. The exclusivity period may be extended by the Bankruptcy Court upon a showing of cause after notice has been given and a hearing has been held, although no assurance can be given that any additional extensions will be granted if requested by the Company. The Company has agreed not to seek additional extensions of the exclusivity period without the advance consent of the Creditors' Committee and the Equity Committee. On December 8, 1993 and February 16, 1994, the Bankruptcy Court entered certain orders which provided for a procedure pursuant to which interested parties could submit proposals to participate in a plan of reorganization for America West. The Bankruptcy Court also set February 24, 1994 as the date for America West to select a "Lead Plan Proposal" from the proposals submitted. On February 24, 1994, America West selected as its Lead Plan Proposal an investment proposal submitted by AmWest Partners, L.P., a limited partnership ("AmWest"), which includes Air Partners II, L.P., Continental Airlines, Inc., Mesa Airlines, Inc. and Fidelity Management Trust Company. On March 11, 1994, the Company and AmWest entered into a revised investment agreement which substantially incorporates the terms of the AmWest investment proposal (the "Investment Agreement"). The Investment Agreement provides that AmWest will purchase from America West equity securities representing a 37.5 percent ownership interest in the Company for $120 million and $100 million in new senior unsecured debt securities. The Investment Agreement also provides that, in addition to the 37.5 percent ownership interest in the Company, AmWest would also obtain 72.9 percent of the total voting interest in America West after the Company is reorganized. The terms of the Investment Agreement will be incorporated into a plan of reorganization to be filed with the Bankruptcy Court; however, modifications to the Investment Agreement may occur prior to the submission of a plan of reorganization and such modifications may be material. There can be no assurance that a plan of reorganization based upon the Investment Agreement will be accepted by the parties entitled to vote thereon or confirmed by the Bankruptcy Court. In addition to the interest in the reorganized America West that would be acquired by AmWest pursuant to the Investment Agreement, the Investment Agreement also provides for the following: 1. The D.I.P. financing would be repaid in full with cash on the Reorganization Date. 2. On the Reorganization Date, unsecured creditors would receive 45 percent of the new common equity in the reorganized Company, with the potential to receive up to 55 percent of such equity if within one year after the Reorganization Date, the value of the securities distributed to them has not provided them with a full recovery under the Bankruptcy Code. In addition, unsecured creditors would have the right to elect to receive cash at $8.889 per share up to an aggregate maximum amount of $100 million, through a repurchase by AmWest of a portion of the shares to be issued to unsecured creditors under a plan of reorganization. 3. Holders of equity interests would have the right to receive up to 10 percent of the new common equity of the Company, depending on certain conditions principally involving a determination as to whether the unsecured creditors had received a full recovery on account of their claims. In addition, holders of equity interests would have the right to purchase up to $15 million of the new common equity in the Company for $8.296 per share from AmWest, and would also receive warrants entitling them to purchase, together with AmWest, up to five percent of the reorganized Company's common stock, at a price to be set so that the warrants would have value only after the unsecured creditors receive full recovery on their claims. 4. In exchange for certain concessions principally arising from cancellation of the right of GPA affiliates to put to America West 10 Airbus A320 aircraft at fixed rates, GPA, or certain affiliates thereof, would receive (i) 7.5 percent of the new common equity in the reorganized Company, (ii) warrants to purchase up to 2.5 percent of the reorganized Company's common stock on the same terms as the AmWest warrant, (iii) $3 million in new senior unsecured debt securities, and (iv) the right to require the Company to lease up to eight aircraft of types operated by the Company from GPA prior to June 30, 1999 on terms which the Company believes to be more favorable those currently applicable to the put aircraft. For an additional discussion of the put rights, see Item 2. Item 2. Properties. ------ ---------- Facilities. ---------- In February 1988, the Company opened its maintenance and technical support facility at Phoenix Sky Harbor International Airport. The 660,000 square foot facility is comprised of four hangar bays, hangar shops, a flight simulator building as well as warehouse and commissary facilities. The Company owns the 68,000 square foot America West Corporate Center at 222 South Mill Avenue in Tempe, Arizona. At December 31, 1993, the Company leased approximately 650,000 square feet of general office and other space in Phoenix and Tempe, Arizona. As a result of the reduction in aircraft fleet size in 1991 and 1992, a portion of the leased space became surplus to the Company's operational requirements. Negotiations with lessors occurred during 1993 with the assistance of a consulting firm in an effort to develop a consolidation plan. Such plan was completed at the end of 1993 and its implementation commenced in the first quarter of 1994. The consolidation plan generally provides for a reduction in leased space by approximately 150,000 square feet. In 1990, the Company's Phoenix passenger service facilities were relocated to Terminal 4 of Phoenix Sky Harbor International Airport, where the Company leases approximately 258,200 square feet at December 31, 1993. The Company presently has 28 gates with 27 of such gates having enclosed passenger loading bridges at its two concourse facilities located in Terminal 4. The Company also leases approximately 25,000 square feet of other space at the airport for administrative offices and pilot training. At December 31, 1993, the Company leased approximately 106,000 square feet of space at McCarran International Airport in Las Vegas, Nevada. Included in this property at Terminal B are 13 gates (all equipped with enclosed passenger boarding bridges) and adjoining holding room areas. In February 1993, the Company vacated approximately 26,000 square feet at Terminal B, including six gates. At the Company's Columbus, Ohio mini-hub, the Company leased approximately 30,000 square feet of space at December 31, 1993. The Company also leased two gates from the Columbus airport authority and has the ability to sublease additional gates from other airlines as the need arises. Space for ticket counters, gates and back offices has also been obtained at each of the other airports served by the Company, either by lease from the airport operator or by sublease from another airline. Some of the Company's airport sublease agreements include requirements that the Company purchase various ground services at the airport from the lessor airline at rates in excess of what it would cost the Company to provide those services itself. Aircraft. -------- At December 31, 1993, the Company's 85 aircraft fleet consisted of three types of aircraft (56 Boeing 737s, 18 Airbus A320s and 11 Boeing 757s). America West's fleet has an average aircraft age of 8.1 years. The table below sets forth certain information regarding the Company's aircraft fleet at December 31, 1993: Each of the aircraft that is designated as owned serves as collateral for a loan pursuant to which the aircraft was acquired by the Company or serves as collateral for a non-purchase money loan. At December 31, 1993, the Company had on order a total of 93 aircraft of the types currently comprising the Company's fleet, of which 51 are firm and 42 are options. The table below details such deliveries. The current estimated aggregate cost for these firm commitments and options is approximately $5.2 billion. Future aircraft deliveries are planned in some instances for incremental additions to the Company's existing aircraft fleet and in other instances as replacements for aircraft with lease terminations occurring during this period. The purchase agreement to acquire 24 Boeing 737-300 aircraft had been affirmed in the Company's bankruptcy proceeding. With timely notice to the manufacturer, all or some of these deliveries may be converted to Boeing 737-400 aircraft. As of December 31, 1993, eight Boeing 737 delivery positions had been eliminated due to the lack of a required reconfirmation notice by the Company to Boeing resulting in the 16 Boeing 737-300 aircraft total reflected in the table above. The failure to reconfirm these delivery positions exposes the Company to loss of pre-delivery deposits and other claims which may be asserted by Boeing in the Bankruptcy proceeding. The purchase agreements for the remaining aircraft types have not been assumed and, the Company has not yet determined which of the other aircraft purchase agreements, if any, will be affirmed or rejected. As part of the Kawasaki Term Loan, the Company terminated an agreement to lease 24 Airbus A320 aircraft from Kawasaki, and ultimately replaced it with a put agreement to lease up to four such aircraft. Kawasaki is under no obligation to lease such aircraft to the Company and has the right to remarket these aircraft to other parties. Prior to its bankruptcy filing, the Company also entered into a similar arrangement with GPA, whereby the Company terminated its agreement to lease 10 Airbus A320 aircraft from GPA and replaced it with a put agreement to lease up to 10 Airbus A320 aircraft from GPA. The put agreement with Kawasaki requires Kawasaki to notify the Company prior to July 1, 1994 if it intends to require the Company to lease any of its put aircraft. GPA's put agreement requires 180 days prior notice of the delivery of a put aircraft. The agreement also provides that GPA may not put more than five aircraft to the Company in any one calendar year. No more than nine put aircraft (GPA and Kawasaki combined) may be put to the Company in one calendar year. GPA's put right expires on December 31, 1996. The Kawasaki and the GPA put aircraft are reflected in the "Firm Order" section of the table above. The Investment Agreement provides that as partial consideration for the cancellation of the GPA put rights, GPA will receive the right to require the Company to lease up to eight aircraft of types operated by the Company from GPA prior to June 30, 1999. See Item 1. Business -- Bankruptcy And ------ Reorganization Events -- Plan of Reorganization. The Company does not have firm lease or debt financing commitments with respect to the future scheduled aircraft deliveries (other than for the Kawasaki put aircraft and the GPA put aircraft referred to above). In addition to the aircraft set forth in the chart above, the Company also has a pre-petition executory contract under which the Company holds delivery positions for four Boeing 747-400 aircraft under firm orders and another four under options. The contract allows the Company, with the giving of adequate notice, to substitute other Boeing aircraft types for the Boeing 747-400 in these delivery positions. As a result, the Company is still evaluating its future fleet needs and is currently unable to determine if it will substitute other aircraft types or reject this agreement. Over the next four years, leases are scheduled to terminate on eight aircraft (six Boeing 737-200s and two Boeing 757-200s). In addition, leases for two Airbus A320-200s are scheduled to terminate during 1994; however, the Company has extended one lease for an additional twelve months. The other Airbus A320 aircraft will be returned to the lessor at the end of the lease term during 1994 and will be replaced by a Boeing 757 aircraft which has been leased for a term of three years. In addition, certain of the aircraft lessors have the right to call their respective aircraft upon (in most cases) 180 days prior notice to the Company. The Company, in turn (with some exceptions), may retain such aircraft via a right of first refusal by agreeing to the bona fide terms offered by a third party interested in leasing or purchasing the aircraft. See also Item 1. Business -- Bankruptcy And Reorganization Events -- Route Structure ------ and Fleet Reductions. Item 3. Item 3. Legal Proceedings. ------ ----------------- On June 27, 1991, the Company filed a voluntary petition in the United States Bankruptcy Court for the District of Arizona to reorganize under Chapter 11 of Title 11 of the United States Bankruptcy Code. Since the Bankruptcy filing, several entities have filed administrative claims requesting that the Bankruptcy Court order the Company to reimburse or compensate such entities for goods, taxes and services they allege that the Company has received or collected, but for which they claim the Company has not paid. Entities which have or may file administrative claims, include aircraft maintenance organizations, municipal airports and certain financial or governmental institutions. In addition, aircraft providers whose aircraft were returned to them in connection with the Company's fleet reduction and restructuring efforts in September 1991 and September 1992 may be entitled to general unsecured pre-petition claims and/or administrative claims in the Bankruptcy case for damages arising from the return of the aircraft. See also Item 1. Business -- Bankruptcy And ------ Reorganization Events. In August 1991, the Securities and Exchange Commission ("SEC") informally requested that the Company provide the SEC with certain information and documentation underlying disclosures made by the Company in annual and quarterly reports filed with the SEC by the Company in 1991. The Company has cooperated with the SEC's informal inquiry. On March 29, 1994, the Company's Board of Directors approved the submission of an offer of settlement for the purpose of resolving the inquiry through the entry of a consent decree pursuant to which the Company would, while neither admitting nor denying any violation of the securities laws, agree to comply with its future reporting obligations under Section 13 of the Securities Exchange Act of 1934. The SEC has not yet acted on the Company's offer of settlement and there can be no assurance that such offer of settlement will be accepted by the SEC. If the settlement is not accepted by the SEC, the offer will be of no force and effect. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. ------ --------------------------------------------------- No matter was submitted to a vote of the stockholders during the fourth quarter of the fiscal year ended December 31, 1993, through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder ------ ------------------------------------------------------------- Matters. ------- The Company's Common Stock has been publicly traded since February 25, 1983 and is currently listed on the National Association of Securities Dealers Automated Quotation System ("NASDAQ") under the symbol AWAQC. The Common Stock has also been listed on the Pacific Stock Exchange since December 20, 1988 under the symbol AWA. From February 14, 1984 to January 17, 1992, the Common Stock was listed on NASDAQ/National Market System ("NASDAQ/NMS"). Due to the bankruptcy filing and the Company's inability to satisfy certain NASDAQ/NMS listing requirements, the Common Stock listing was moved from NASDAQ/NMS to NASDAQ on January 20, 1992. The following table sets forth the high and low bid quotations for the years 1992 and 1993 as reported by NASDAQ. The number of record holders of the Company's Common Stock at December 31, 1993 was approximately 18,728. Cash dividends have never been paid on the Company's Common Stock. Various credit agreements between the Company and its lenders restrict the ability of the Company to pay cash dividends. In April 1986, the Company redeemed all outstanding shares of its Series A Preferred Stock. In September 1993, the holder of all the Company's Series B Preferred Stock converted such stock into 1,164,596 shares of Common Stock. The Company's Series C Preferred Stock is the only remaining outstanding class of preferred stock of the Company. A discussion of the Company's Preferred Stock is contained on pages 14 through 16 of the Company's Form S-3 Registration Statement No. 33-27416, incorporated herein by this reference. There is no public trading market for the Preferred Stock. The Company filed a motion with the Bankruptcy Court on February 10, 1994 to prohibit the sale or other transfers of any general unsecured claims, the convertible subordinated debentures or shares of any class of stock. The motion attempted to preserve the Company's tax assets as such sales and transfers in sufficient numbers and amounts could, under current tax law, jeopardize the preservation of the Company's net operating loss and general business tax credit carryforwards. At the request of the official committees, the Company withdrew its motion without prejudice on February 16, 1994. On March 11, 1994, the Company again filed a motion with the Bankruptcy Court to prohibit the sale or other transfer of shares of any class of the Company's stock to or from five percent or more shareholders. This motion is more limited in scope than the motion filed on February 10, 1994 in that it seeks only to restrict transfers of stock which could have an adverse effect on the Company's ability to fully utilize its NOL carryforwards. On March 15, 1994, the Bankruptcy Court ordered that this motion be converted to an adversary proceeding under the Bankruptcy rules. As of March 29, 1994, no hearing on such proceeding has been held. There can be no assurance that the Company will continue to pursue this matter and, if the Company continues to pursue this matter, that it will be successful. See Item 7. Management's Discussion and ------ Analysis of Financial Condition and Results of Operations -- Overview and Item 8. Financial Statements and Supplementary Data -- Note 5 of Notes to ------ Financial Statements. Item 6. Item 6. Selected Financial Data. ------ ----------------------- SELECTED FINANCIAL DATA (In thousands except per share amounts and ratio of earnings to fixed charges) The information set forth below should be read in conjunction with the Financial Statements and related Notes to Financial Statements included elsewhere herein. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and ------ --------------------------------------------------------------- Results of Operations. --------------------- Overview -------- On June 27, 1991 the Company filed a voluntary petition in the United States Bankruptcy Court for the District of Arizona (the "Bankruptcy Court") to reorganize under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code"). The Company is currently operating as a debtor- in-possession ("D.I.P.") under the supervision of the Bankruptcy Court. As a debtor-in-possession, the Company is authorized to operate its business but may not engage in transactions outside its ordinary course of business without approval of the Bankruptcy Court. The accompanying financial statements have been prepared on a going concern basis which assumes continuity of operations and realization of assets and liquidation of liabilities in the ordinary course of business. As a result of the reorganization proceedings, there are uncertainties relating to the ability of the Company to continue as a going concern. The financial statements do not include any adjustments that might be necessary as a result of the outcome of the uncertainties discussed herein including the effects of any plan of reorganization. Due to the bankruptcy proceedings, current economic conditions and the competitive nature of the airline industry, no measure of comparability can be drawn from past results in order to measure those that may occur in the future. Among the uncertainties which might adversely impact the Company's future operations are: economic recession; changes in the cost of fuel, labor, capital and other operating items; increased level of competition resulting in significant discounting of fares; changes in capacity, load factors and yields; or reduced levels of passenger traffic due to war or terrorist activities. In addition, the following significant bankruptcy related events occurred during 1993. D.I.P. Loan. The Bankruptcy Court approved an amendment to the D.I.P. ----------- loan agreement extending the maturity date of the loan from September 30, 1993 to June 30, 1994. Concurrent with the extension of the maturity date, $8.3 million of the principal balance was repaid to one of the participants who did not agree to the amendment. The amended D.I.P. loan agreement requires the payment of a facility fee of $627,000 and defers all principal payments to June 30, 1994 with the exception of $5 million that will be due on March 31, 1994. An additional facility fee equal to 1/4 percent of the then outstanding D.I.P. loan is required to be paid on March 31, 1994. The amended terms of the D.I.P. financing require the Company to notify the D.I.P. lenders if the unrestricted cash balance of the Company exceeds $125 million. Upon receipt of such notice, the D.I.P. lenders may require the Company to prepay the D.I.P. financing by the amount of such excess. During the first quarter of 1994, the Company notified the D.I.P. lenders that the Company's unrestricted cash exceeded $125 million; however, to date, the D.I.P. lenders have not exercised their prepayment rights. See Item 8. Item 8. Financial Statements and Supplementary Data -- Note 5 of Notes to ------ Financial Statements. Results of Operations --------------------- The Company realized net income of $37.2 million ($1.50 per common share) for 1993 compared to net losses of $131.8 million ($5.58 per common share) and $222 million ($10.39 per common share) for 1992 and 1991, respectively. The results for 1993 include reorganization expenses of $25 million and losses aggregating $4.6 million primarily resulting from the disposition of surplus spare aircraft parts and equipment. During 1992, the Company recorded restructuring charges of $31.3 million, reorganization expenses of $16.2 million and a gain of $15 million from the sale of its Honolulu to Nagoya, Japan route, while the 1991 results were affected by reorganization expenses of $58.4 million. The Company was only one of two major U.S. airlines to report a profit in each quarter of 1993. The Company began to realize significant improvement in its operating results commencing the fourth quarter of 1992. During 1993, the level of operating income improved each quarter as shown in the table below. The improvement in operating results for 1993 compared to 1992 and 1991 is attributable to several factors, the most significant of which are noted below. * A gradually improving economic climate, and a more stable environment relative to fare competition within the airline industry. * The reduction in fleet size from 123 aircraft in July 1991 to the current fleet of 85 aircraft has facilitated a better matching of capacity to demand. In addition, the consolidation of the fleet from five to three aircraft types has enabled the Company to further reduce its level of costs including those related to maintenance, training and inventories of parts. * In addition to reducing or eliminating certain routes as part of the aircraft fleet downsizing, the Company implemented certain enhancements to its revenue management system in an effort to optimize the level of passenger revenues generated on each flight. Such enhancements enable the Company to more effectively allocate seats within various fare categories. * The implementation of numerous cost reduction programs since 1991 including a Company-wide pay reduction in August of 1991 and reductions of aircraft lease rentals to fair market rates in the fall of 1992. * The elimination of the Company's commuter operation and the introduction of three code sharing agreements have enabled the Company to expand its scope of service and attract a broader passenger base. The effect of these programs and the other factors described above resulted in operating income of $121.1 million for 1993 compared to operating losses of $74.8 million and $104.7 million for 1992 and 1991, respectively. Total operating revenues were $1.3 billion in 1993, an increase of 2.4 percent compared to the prior year and 6.3 percent less than 1991 primarily due to the significant reduction in capacity. On April 1, 1993, the Company ceased service to Hawaii. Passenger revenues for 1993, 1992 and 1991 were $1.2 billion, $1.2 billion and $1.3 billion, respectively. Summarized below are certain capacity and traffic statistics for the years ended December 31, 1993, 1992 and 1991. In spite of the significant decline in capacity in 1993 compared to the two previous years, passenger revenues per available seat mile improved by 15.1 percent and 12.2 percent compared to 1992 and 1991, respectively. This improvement was primarily attributable to the combination of the following factors. * An improved climate relative to the economy and industry fare competition. * The reduction in aircraft fleet size in conjunction with the implementation of enhancements to the Company's revenue management systems. * The elimination of "fare simplification" in 1993 and 50 percent-off sales that occurred on an industry-wide basis in the second and third quarters of 1992. * The 50 percent-off sale conducted by the Company on a system-wide basis in February 1991. Revenues from sources other than passenger fares decreased during 1993 to $78.8 million compared to $79.3 million and $81.7 million for 1992 and 1991, respectively. Freight and mail revenues comprised 51.0 percent, or $40.2 million, of other revenues for 1993. This represents a decrease of 4.6 percent compared to 1992 and 8.0 percent compared to 1991. For the years 1993, 1992 and 1991, the Company carried 110.7 million, 116.4 million and 119.8 million pounds of freight and mail, respectively. The decline in freight and mail revenues during the last three years is a direct result of capacity reductions, the most significant of which relate to the cessation of service to Hawaii and Nagoya, Japan. The balance of other revenues includes revenues generated from: pilot training; contract services provided to other airlines for maintenance and ground handling; reduced rate fares; alcoholic beverage and headset sales; and service charges assessed for refunds, reissues and prepaid ticket advices. In spite of the significant reductions in capacity which have occurred since the filing of protection under Chapter 11, operating expense per available seat mile has declined to 7.01 cents for 1993 from 7.10 cents for 1992 and 7.36 cents for 1991. The table below sets forth the major categories of operating expense per available seat mile for 1993, 1992 an 1991: The changes in the components of operating expense per available seat mile should be considered in relation to the decline in available seat miles of 10.8 percent and 16.7 percent from 1992 and 1991, respectively, and are explained as follows: * The 6.0 percent increase in salaries and related costs compared to 1992 is a result of the decline in capacity as well as the implementation of a transition pay program in the second quarter of 1993. The transition pay program was designed to restore a portion of the 10 percent wage reduction that was effected company-wide on August 1, 1991 (officers and other management personnel received wage reductions of 10 percent to 25 percent commencing in February 1991). All wages have been frozen at such levels since 1991. The program, which is to be in effect for the earlier of four fiscal quarters or until the confirmation of a plan of reorganization, provides for the following payments on a quarterly basis to all active employees during the quarter. a. Commencing the second quarter of 1993, performance award distributions have been made based upon the Company meeting or exceeding its operating income target for a given quarter as incorporated in its business plan. The aggregate award for 1993 amounted to approximately $6.5 million including applicable payroll taxes. b. Commencing the third quarter of 1993, employment award distributions have been made based on the greater of .5 percent of an employee's annual base wage, or $125, which ever is higher, on a quarterly basis. The aggregate award for 1993 amounted to approximately $2.6 million including applicable payroll taxes. The favorable variance compared to the 1991 level was primarily attributable to the reduction in payroll costs related to the decline in capacity as well as overhead and the Company-wide wage reduction instituted in August 1991. * Rentals and landing fees decreased due to the reduction in fleet size to 85 aircraft as well as the reduction in rental rates to fair market for certain aircraft commencing in August 1992 for a period of two years. * Aircraft fuel decreased due to the decline in the average price per gallon to 61.05 cents from 62.70 cents for 1992 and 67.10 cents for 1991. * The increase in the level of agency commission expense is primarily due to the significant increase in passenger revenue per available seat mile from 6.30 cents and 6.46 cents for 1992 and 1991, respectively, to 7.25 cents for 1993. * The decrease in aircraft maintenance materials and repairs is primarily due to the change in the composition of the aircraft fleet. * Restructuring charges incurred in 1992 consisted of the following: The restructuring charges were necessitated by aircraft fleet reductions and other operational changes. The Company reduced its fleet to 87 aircraft at the end of 1992 as well as eliminated two of five aircraft types it operated. Additionally, employee headcount was reduced by approximately 1,500 employees and service was terminated to ten cities through the end of 1992. * The increase in depreciation and amortization is primarily attributable to increased heavy engine overhauls. * Other operating expenses increased 3.8 percent compared to 1992 but was lower by 3.5 percent compared to 1991. The increase compared to the prior year is primarily attributable to the 10.8 percent decline in capacity. Non-operating expenses (net of non-operating income) for 1993, 1992 and 1991 were $83.1 million, $56.9 million and $117.4 million, respectively. Interest expense decreased to $54.2 million in 1993 from $55.8 million in 1992 and $61.9 million in 1991. In conformity with Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code", issued by the American Institute of Certified Public Accountants, the Company has ceased accruing and paying interest on unsecured pre-petition long-term debt. Had the Company continued to accrue interest on such debt, interest expense for 1993, 1992 and 1991 would have been $73.0 million, $73.9 million and $79.3 million, respectively. See Item 8. Financial Statements and Supplementary Data -- Notes 3a and 4 of ------ Notes to Financial Statements. The Company incurred expenses of $25 million in 1993, $16.2 million in 1992 and $58.4 million in 1991 in connection with its efforts to reorganize under Chapter 11. Such expenses for 1993 include net charges aggregating $18.2 million in accruals for unsecured claims and settlements of administrative claims primarily relating to leased aircraft which were returned to the lessors. Reorganization related expenses are expected to significantly affect future results and to continue until such time as the Company has obtained approval for its plan of reorganization. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 Accounting for Income Taxes, (SFAS 109). --------------------------- Since there was no cumulative effect of this change in accounting, prior year financial statements have not been restated. Additionally, Statements of Financial Accounting Standards No. 106 Post ---- Retirement Benefits Other Than Pensions, (SFAS 106) became effective --------------------------------------- January 1, 1993. The Company does not provide any post retirement benefits, thus, the standard has no impact. Statement of Financial Accounting Standard No. 112, Employer's Accounting for Post Employment ----------------------------------------- Benefits, (SFAS 112) becomes effective January 1, 1994. This statement -------- requires that post employment benefits be treated as part of compensation provided to an employee in exchange for service. Previously, most employers expensed the cost of these benefits as the benefits were provided. The Company is still reviewing the impact of SFAS 112, but does not believe it will have a material effect. Liquidity And Capital Resources ------------------------------- At December 31, 1993, the Company had a working capital deficiency of $124.4 million and net shareholders' deficiency of $254.3 million. The 1993 working capital deficiency decreased from the 1992 deficiency of $201.6 million primarily as result of principal repayments on obligations and significantly improved operating results. Cash and cash equivalents amounted to $99.6 million at December 31, 1993 compared to $74.4 million at December 31, 1992. Net cash provided by operating activities increased to $153.4 million for 1993 compared to $76.7 million for 1992 and $19.9 million for 1991. During 1993, the Company incurred capital expenditures of $54.3 million compared to $69.2 million in 1992. The capital expenditures for 1993 consisted largely of aircraft modifications and heavy airframe and engine overhauls. The Company's transition pay program which was implemented in the second quarter of 1993 is scheduled to terminate in the second quarter of 1994. The Company announced certain amendments to its compensation program on March 24, 1994. Effective April 1, 1994, employee base wages will be increased between two percent to eight percent depending on the employee's length of service with the Company. Generally, each employee whose anniversary date occurs between April and December 1994 will also receive an additional increase on such date approximating 4% with certain exceptions. The Chairman of the Board and the President will not participate in the salary increase program. Due to the current collective bargaining process with the representatives of the pilots, increases in pilots' salaries will not be paid but will be accrued. The distribution of such amounts will be determined through the collective bargaining discussions. The Company is currently in the process of revising its entire compensation program and anticipates implementing such program effective January 1, 1995. The Company has also announced that, effective April 1, 1994, matching contributions by the Company under the America West 401(k) plan will be increased from 25 percent to 50 percent of the first six percent contributed by the employees, subject to certain limitations. This change restores the Company's matching contribution to the level that existed prior to the Chapter 11 filing. The Company estimates that the implementation of the increases in pay and the 401(k) matching contributions will result in increased costs of approximately $18 million during the last nine months of 1994. Under Delaware law, as well as the Company's D.I.P. loan agreement and the bankruptcy process, the Company is precluded from paying dividends on its outstanding preferred stock until such time as the total shareholders' deficiency is eliminated. During 1993 the Series B 10.5 percent convertible preferred stock (291,149 shares) with a liquidation preference of $15 million was converted into 1,164,596 shares of common stock of the Company. In 1991, affiliates of Guinness Peat Aviation ("GPA"), Northwest Airlines, Inc. ("Northwest") and Kawasaki Leasing International Inc. ("Kawasaki") provided $78 million in D.I.P. financing to the Company. In September 1992, America West received an additional $53 million in D.I.P. financing, bringing the total outstanding D.I.P. financing at December 31, 1992, to $110.8 million which consisted of $69.8 million from GPA, $23 million from Kawasaki, $10 million from Ansett Worldwide Aviation Services ("Ansett") and $8 million from several Arizona-based entities. The D.I.P. financing is collateralized by substantially all of the Company's assets. The financing provided by Northwest was repaid in full at the time of the September 1992 D.I.P. financing. America West also reconstituted its board of directors concurrent with the September 1992 D.I.P. financing. In September 1993, the D.I.P. lenders extended the maturity date of the D.I.P. financing from September 30, 1993 to June 30, 1994. At the time of the September 1993 extension, the financing provided by Ansett was repaid in full. The principal terms of the September 1993 extension are discussed below. Interest on all funds advanced under the D.I.P. financing accrues at 3.5 percent over the 90-day London Interbank Offered Rate ("LIBOR") and is payable quarterly. Principal repayments in the amount of $5.54 million were made on March 1993 and June 1993. As a result of the September 1993 extension of the D.I.P. financing maturity date, the Company is required to repay $5 million of the D.I.P. financing on March 31, 1994. The remaining outstanding balance will be due upon the earlier of June 30, 1994 or upon the effective date of a confirmed Chapter 11 plan of reorganization (the "Reorganization Date"). As a condition to extending the maturity date of the D.I.P. financing in September 1993, the Company also agreed to pay a facility fee of $627,000 to the D.I.P. lenders on September 30, 1993 and to pay an additional facility fee equal to 1/4 percent of the then outstanding balance of the D.I.P. financing on March 31, 1994. As of December 31, 1993, the outstanding amount due under the D.I.P. financing was approximately $83.6 million. Presently, the Company does not possess sufficient liquidity to satisfy the D.I.P. financing nor does it appear that new equity capital will be obtained and a plan of reorganization confirmed prior to June 30, 1994. Consequently, the Company will be required to obtain alternative repayment terms from its current D.I.P. lenders. Although there can be no assurance that alternative repayment terms will be obtained, the Company believes that any required extension of the D.I.P. financing would be for a short period of time and would be concurrent with the implementation of a plan of reorganization. During the first quarter of 1994, the Company notified the D.I.P. lenders that the Company's unrestricted cash exceeded $125 million; however, to date, the D.I.P. lenders have not exercised their prepayment rights. As a condition to the closing of the September 1992 D.I.P. financing, the Company was required to reduce its aircraft fleet to 86 aircraft and the number of aircraft types from five to three. Consequently, the Company reached certain agreements with third parties, which included the following: 1. With the exception of four lessors (two of which participated in the September 1992 D.I.P. financing), aircraft lessors whose aircraft were retained in the fleet and whose payments were deferred during July and August 1992, were required to waive any default which occurred as a result of such non-payments and to defer these payments without interest until the first calendar quarter of 1993. In addition, effective August 1, 1992, the rental rates on these retained aircraft were reduced to fair market rental rates for a period of two years or longer. The August 1992 payments were deferred at the reduced interest rates. Of the remaining two lessors, one accepted rental payment reductions and the other agreed to a deferral of the rents from July through October 1992. Repayment of this deferral is monthly over seven years beginning November 1992 at level principal and interest at 90 day LIBOR plus 3.5 percent. 2. The aircraft lessors who accepted rent reductions and agreed to waive any administrative claims arising from the reductions stipulated that, if prior to July 31, 1994, the Company defaults on any of these leases and the aircraft are repossessed, the lessors are entitled to fixed damages ranging from $500,000 to $2,000,000 (depending on the type of aircraft) as well as any other damages that can be claimed for breach of their leases, all of which will be afforded priority as administrative claims. Lessors of 12 aircraft have the option, beginning August 1, 1994, to reset the rents to the then current fair market rental rates (additionally, certain of these leases call for multiple resets subsequent to the August 1, 1994 reset date). In February 1994, the Company commenced negotiations with certain lessors with respect to determining the requisite reset rates. Lessors of 16 aircraft have call rights which generally provide for the acceleration of the lease termination to the 180th day after receipt by the Company of notice from the lessor that the lessor has a bona fide written offer to lease the aircraft to an unrelated third party. The Company in turn has a ten day right of first refusal after receipt of such notice to match the written offer. Lessors of 10 of aircraft also have the right to call their aircraft during specified periods without having received a bona fide offer to lease their aircraft and without offering the Company a right of first refusal. The lessor of 11 aircraft has the right to call its aircraft on 90 days notice after to the end of the original lease term of the aircraft. If a lessor exercises its call option, and 1991 deferred rents are still outstanding under the terminated lease, repayment of this deferral is not accelerated. Such deferral will continue to amortize over its original term; however, at a reduced interest rate of 90 day LIBOR plus 3.5 percent. See also Item 1. Business -- Bankruptcy And ------ Reorganization Events -- Route Structure and Aircraft Fleet Reductions. 3. Certain principal and interest payments on owned aircraft due in July 1992 were deferred without interest and were repaid by March 31, 1993. Additionally, certain other principal and interest payments due from August 1992 through January 1993 were deferred and are being repaid beginning February 1993 over terms of five to nine years with interest at approximately 10.25 percent. In lieu of payment deferrals, two aircraft lenders agreed to interest rate reductions of approximately three percent on their outstanding aircraft loans to the Company, resulting in interest rates of approximately 7.25 percent. 4. Two of the current D.I.P. lenders, amended their existing rights to put up to ten aircraft each to the Company such that a total of fourteen aircraft may be put to the Company beginning in 1994 through 1996. Such aircraft would be put to the Company under prearranged lease agreements. As of February 28, 1994, the Company has not received any notification from the parties exercising any of their put rights. In September 1993, the D.I.P. loan agreement was amended and the maturity date was extended from September 30, 1993 to June 30, 1994. The principal financial terms of the amended D.I.P. loan agreement include the following: 1. The repayment of $8.3 million to the loan participant who did not agree to the maturity date extension. 2. The outstanding principal balance at September 30, 1993 becomes due on June 30, 1994 or the confirmation of a plan of reorganization, whichever occurs earlier, with the exception of a principal repayment of $5 million on March 31, 1994. 3. The amended terms of the D.I.P. financing require the Company to notify the D.I.P. lenders if the unrestricted cash balance of the Company exceeds $125 million. Upon receipt of such notice, the D.I.P. lenders may require the Company to prepay the D.I.P. financing by the amount of such excess. During the first quarter of 1994, the Company notified the D.I.P. lenders that the Company's unrestricted cash exceeded $125 million; however, to date, the D.I.P. lenders have not exercised their prepayment rights. 4. Certain of the financial covenants were revised which the Company believes provide it with increased flexibility. In general, such covenants relate to operating results, liquidity, capital expenditures, collateral values and lease payments. 5. A facility fee of 3/4 percent of the outstanding balance, or $627,000, was paid to the participants on September 30, 1993. In addition, an additional 1/4 percent of the then outstanding balance must be paid on March 31, 1994. Presently, the Company does not possess sufficient liquidity to satisfy its D.I.P. loan obligation nor does it appear that a plan of reorganization could be confirmed prior to June 30, 1994. Consequently, the Company will be required to obtain alternative repayment terms from its current D.I.P. lenders, but there can be no assurances that such alternative repayment terms will be agreed to by the D.I.P. lenders. During 1993, the Company repaid approximately $18.4 million of scheduled aircraft lease payments which were deferred in 1991 and 1992 as well as $27.2 million of principal repayment related to the D.I.P. loan. As a condition of the D.I.P. financing, the Company obtained from most of its aircraft providers rent or principal and interest deferrals in excess of $100 million for the six-month period of June through November 1991. In general, the deferred amounts accrue interest at 10.5 percent. In December 1991, the Company began repaying such deferred amounts. See Item 8. Financial Statements and Supplementary Data -- Note 11 of Notes to ------ Financial Statements. Under the terms of the D.I.P. financing, Northwest acquired the Company's Honolulu to Nagoya, Japan route for $15 million in 1992. Upon the completion of the sale of the Nagoya route, $10 million of the proceeds from the sale were paid to Northwest to reduce the Company's obligation to Northwest under the D.I.P. financing. The balance of the proceeds from the sale of the Nagoya route were added to the Company's working capital. In connection with the D.I.P. financing provided by Kawasaki, the Company agreed to convert advanced cash credits for 24 Airbus A320 aircraft (the "Kawasaki Aircraft") previously advanced by Kawasaki into an unsecured priority term loan (the "Kawasaki Term Loan"). At December 31, 1993, the amount of the Kawasaki Term Loan was $68.4 million, including accrued interest of $21.9 million. Until the Reorganization Date, the Kawasaki Term Loan will accrue interest at 12 percent per annum and such interest will be added to principal. On the Reorganization Date, 85 percent of the Kawasaki Term Loan will be converted into an eight-year term loan which will accrue interest at 2 percent over 90-day LIBOR and will be secured by substantially all the assets of the Company if the D.I.P. financing is fully repaid. Principal on such loan will be due and payable in equal quarterly installments, plus interest commencing after the Reorganization Date. The Company has the right to prepay the Kawasaki Term Loan if the D.I.P. financing is fully repaid. The remaining 15 percent of the Kawasaki Term Loan will be treated as a general unsecured claim without priority status under the Company's plan of reorganization. In the first quarter of 1994, the Company received information that the Kawasaki Term Loan was purchased by a third party. As part of the Kawasaki Term Loan, the Company terminated an agreement to lease 24 Airbus A320 aircraft from Kawasaki, and ultimately replaced it with a put agreement to lease up to four such aircraft. Kawasaki is under no obligation to lease such aircraft to the Company and has the right to remarket these aircraft to other parties. Prior to its bankruptcy filing, the Company also entered into a similar arrangement with GPA, whereby the Company terminated its agreement to lease 10 Airbus A320 aircraft from GPA and replaced it with a put agreement to lease up to 10 Airbus A320 aircraft from GPA. The put agreement with Kawasaki requires Kawasaki to notify the Company prior to July 1, 1994 if it intends to require the Company to lease any of its put aircraft. GPA's put agreement requires 180 days prior notice of the delivery of a put aircraft. The agreement also provides that GPA may not put more than five aircraft to the Company in any one calendar year. No more than nine put aircraft (GPA and Kawasaki combined) may be put to the Company in one calendar year. GPA's put right expires on December 31, 1996. The Investment Agreement provides that as partial consideration for the cancellation of the GPA put rights, GPA will receive the right to require the Company to lease up to eight aircraft of types operated by the Company from GPA prior to June 30, 1999. The reorganization process is expected to result in the cancellation and/or restructuring of substantial debt obligations of the Company. Under the Bankruptcy Code, the Company's pre-petition liabilities are subject to settlement under a plan of reorganization. The Bankruptcy Code also requires that all administrative claims be paid on the effective date of a plan of reorganization unless the respective claimants agree to different treatment. There are differences between the amounts at which claims liabilities are recorded in the financial statements and the amounts claimed by the Company's creditors and such differences are material. Significant litigation may be required to resolve any disputes. Due to the uncertain nature of many of the potential claims, America West is unable to project the magnitude of such claims with any degree of certainty. However, the claims (pre-petition claims and administrative claims) that have been filed against the Company are in excess of $2 billion. Such aggregate amount, includes claims of all character, including, but not limited to, unsecured claims, secured claims, claims that have been scheduled but not filed, duplicative claims, tax claims, claims for leases that were assumed, and claims which the Company believes to be without merit; however, claims filed for which an amount was not stated, are not reflected in such amount. The Company is unable to estimate the potential amount of such unstated claims; however, the amount of such claims could be material. The Company is in the process of reviewing the general unsecured claims asserted against the Company. In many instances, such review process will include the commencement of Bankruptcy Court proceedings in order to determine the amount at which such claims should be allowed. The Company has accrued its estimate of claims that will be allowed or the minimum amount at which it believes the asserted general unsecured claims will be allowed if there is no better estimate within the range of possible outcome. However, the ultimate amount of allowed claims will be different and such differences could be material. The Company is unable to estimate the amount of such difference with any reasonable degree of certainty at this time. The Bankruptcy Code requires that all administrative claims be paid on the effective date of a plan of reorganization unless the respective claimants agree to different treatment. Consequently, depending on the ultimate amount of administrative claims allowed by the Bankruptcy Court, the Company may be unable to obtain confirmation of a plan of reorganization. The Company is actively negotiating with claimants to achieve mutually acceptable dispositions of these claims. Since the commencement of the bankruptcy proceeding, claims alleging administrative expense priority totaling more than $153 million have been filed and an additional claim of $14 million has been alleged. As of February 28, 1994, $115 million of the filed claims have been allowed and settled for $50.2 million in the aggregate. The Company is currently negotiating the resolution of the remaining $38 million filed administrative expense claim (which relates to a rejected lease of a Boeing 737-300 aircraft) and the $14 million alleged administrative expense claim (which relates to a rejected lease of a Boeing 757-200 aircraft). Claims have been or may be asserted against the Company for alleged administrative rent and/or breach of return conditions (i.e. maintenance standards), guarantees and tax indemnity agreements related to aircraft or engines abandoned or rejected during the bankruptcy proceedings. Additional claims may be asserted against the Company and allowed by the Bankruptcy Court. The amount of such unidentified administrative claims may be material. As part of its claims administration procedure, the Company is reviewing potential claims that could arise as a result of the Company's rejection of executory contracts. The Company's plan of reorganization will provide for the status of any executory contract not theretofore assumed by either affirming or rejecting such contracts. The assumption or rejection of certain executory contracts could result in additional claims against the Company. At December 31, 1993, the Company had a total of 93 aircraft on order, of which 51 are firm and 42 are options. The current estimated aggregate cost for these firm commitments and options is approximately $5.2 billion. Future aircraft deliveries are planned in some instances for incremental additions to the Company's existing aircraft fleet and in other instances as replacements for aircraft with lease terminations occurring during this period. The purchase agreement to acquire 24 Boeing 737-300 aircraft had been affirmed in the Company's bankruptcy proceeding. With timely notice to the manufacturer, all or some of these deliveries may be converted to Boeing 737-400 aircraft. As of December 31, 1993, eight Boeing 737 delivery positions had been eliminated due to the lack of a required reconfirmation notice by the Company to Boeing. The failure to reconfirm these delivery positions exposes the Company to loss of pre-delivery deposits and other claims which may be asserted by Boeing in the Bankruptcy proceeding. The purchase agreements for the remaining aircraft types have not been assumed and, the Company has not yet determined which of the other aircraft purchase agreements, if any, will be affirmed or rejected. The Company also has a pre-petition executory contract under which the Company holds delivery positions for four Boeing 747-400 aircraft under firm orders and another four under options. The contract allows the Company, with the giving of adequate notice, to substitute other Boeing aircraft types for the Boeing 747-400 in these delivery positions. As a result, the Company is still evaluating its future fleet needs and is currently unable to determine if it will substitute other aircraft types or reject this agreement. The Company believes it will be successful in negotiating new aircraft purchase agreements that will meet its needs. However, there can be no assurances that the Company will enter into such agreements. As of December 31, 1993, the Company had deposits on aircraft orders of approximately $52 million of which approximately $21 million were financed. During 1994, leases relating to four Boeing 737-200 aircraft, two Airbus A320 aircraft and two Boeing 757 aircraft are scheduled to expire. The Company has negotiated extensions of the leases for all but one of the Airbus A320 aircraft for terms ranging from one to three years. The Airbus A320 aircraft to be returned to the lessor will be replaced by a Boeing 757 aircraft which has been leased for a term of three years. In addition, up to nine Airbus A320 aircraft may be put to the Company should GPA and/or Kawasaki elect to exercise its put options. As of February 28, 1994, none of the put options have been exercised. Lease agreements have been arranged for such put aircraft for terms of five to eighteen years at specified monthly lease rate factors. Item 8. Financial Statements and Supplementary Data. ------ ------------------------------------------- Financial statements of the Company as of December 31, 1993 and 1992, and for each of the years in the three-year period ended December 31, 1993, together with the related notes and the Report of KPMG Peat Marwick, independent certified public accountants, are set forth on the following pages. Other required financial information and schedules are set forth herein, as more fully described in Item 14 hereof. Independent Auditors' Report ---------------------------- The Board of Directors and Stockholders America West Airlines, Inc., D.I.P.: We have audited the accompanying balance sheets of America West Airlines, Inc., D.I.P. (the Company) as of December 31, 1993 and 1992, and the related statements of operations, cash flows and stockholders' equity (deficiency) for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the financial statements, we also have audited the financial statement schedules V, VI, VIII and X for each of the years in the three-year period ended December 31, 1993. 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 America West Airlines, Inc., D.I.P. 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 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. The accompanying financial statements and financial statement schedules have been prepared assuming that the Company will continue as a going concern. As discussed in note 1 to the financial statements, on June 27, 1991 the Company filed a voluntary petition seeking to reorganize under Chapter 11 of the federal bankruptcy laws. This event and circumstances relating to this event, including the Company's significant losses, accumulated deficit and highly leveraged capital structure, raise substantial doubt about its ability to continue as a going concern. Although the Company is currently operating as debtor-in-possession under the jurisdiction of the Bankruptcy Court, the continuation of the business as a going concern is contingent upon, among other things, the ability to (1) file a Plan of Reorganization which will gain approval of the creditors and stockholders and confirmation by the Bankruptcy Court, (2) maintain compliance with all debt covenants under the debtor-in-possession financing agreements, (3) achieve satisfactory levels of future operating results and cash flows and (4) obtain additional debt and equity. Also, as discussed in note 1 to the financial statements, as part of the Company's bankruptcy proceeding there is uncertainty as to the amount of claims that will be allowed and as to a number of disputed claims which are materially in excess of amounts reflected in the accompanying financial statements. The accompanying financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. KPMG PEAT MARWICK Phoenix, Arizona March 18, 1994 AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements December 31, 1993, 1992 and 1991 (1) Reorganization Under Chapter 11, Liquidity, Financial Condition and ------------------------------------------------------------------- Subsequent Events ----------------- On June 27, 1991, America West Airlines, Inc., D.I.P. (the "Company" or "America West") filed a voluntary petition in the United States Bankruptcy Court for the District of Arizona (the "Bankruptcy Court") to reorganize under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code"). The Company is currently operating as a debtor-in-possession ("D.I.P.") under the supervision of the Bankruptcy Court. As a debtor-in-possession, the Company is authorized to operate its business but may not engage in transactions outside its ordinary course of business without the approval of the Bankruptcy Court. Subject to certain exceptions under the Bankruptcy Code, the Company's filing for reorganization automatically enjoined the continuation of any judicial or administrative proceedings against the Company. Any creditor actions to obtain possession of property from the Company or to create, perfect or enforce any lien against the property of the Company are also enjoined. As a result, the creditors of the Company are precluded from collecting pre-petition debts without the approval of the Bankruptcy Court. The Company had the exclusive right for 120 days after the Chapter 11 filing on June 27, 1991 to file a plan of reorganization and 60 additional days to obtain necessary acceptances of such plan. Such periods may be extended at the discretion of the Bankruptcy Court, but only on a showing of good cause, and extensions have been obtained such that the Company has until June 10, 1994 to file its plan of reorganization with the Court or obtain an additional extension. Subject to certain exceptions set forth in the Bankruptcy Code, acceptance of a plan of reorganization requires approval of the Bankruptcy Court and the affirmative vote (i.e. 50% of the number and 66- 2/3% of the dollar amount) of each class of creditors and equity holders whose claims are impaired by the plan. Certain pre-petition liabilities have been paid after obtaining the approval of the Bankruptcy Court, including certain wages and benefits of employees, insurance costs, obligations to foreign vendors and governmental agencies, travel agent commissions and ticket refunds. The Company has also been allowed to honor all tickets sold prior to the date it filed for reorganization. In addition, the Company is authorized to pay pre-petition liabilities to essential suppliers of fuel, food and beverages and to other vendors providing critical goods and services. Subsequent to filing and with the approval of the Bankruptcy Court, the Company assumed certain executory contracts of essential suppliers. Parties to executory contracts may, under certain circumstances, file motions with the Bankruptcy Court to require the Company to assume or reject such contracts. Unless otherwise agreed, the assumption of a contract will require the Company to cure all prior defaults under the related contract, including all pre-petition liabilities unless terms can be negotiated. Unless otherwise agreed, the rejection of a contract is deemed to constitute a breach of the agreement as of the moment immediately preceding Chapter 11 filing, giving the other party to the contract a right to assert a general unsecured claim for damages arising out of the breach. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements February 28, 1992 was set as the last date for the filing of proof of claims under the Bankruptcy Code and the Company's creditors have submitted claims for liabilities not paid and for damages incurred. There may be differences between the amounts at which any such liabilities are recorded in the financial statements and the amount claimed by the Company's creditors. Significant litigation may be required to resolve any such disputes. The Company has incurred and will continue to incur significant costs associated with the reorganization. The amount of these costs, which are being expensed as incurred, is expected to significantly affect results of operations. As a result of its filing for protection under Chapter 11 of the Bankruptcy Code, the Company is in default of substantially all of its debt agreements. All outstanding pre-petition unsecured debt of the Company has been presented in these financial statements within the caption Estimated Liabilities Subject to Chapter 11 Proceedings. Additional liabilities subject to the proceedings may arise in the future as a result of the rejection of executory contracts, including leases, and from the determination by the Bankruptcy Court (or agreement by parties in interest) of allowed claims for contingencies and other disputed amounts. Conversely, the assumption of executory contracts and unexpired leases may convert liabilities shown as subject to Chapter 11 proceedings to post-petition liabilities. Substantially all of the aircraft, engines and spare parts in the Company's fleet are subject to lease or secured financing agreements that entitle the Company's aircraft lessors and secured creditors to rights under Section 1110 of the Bankruptcy Code. Pursuant to Section 1110, the Company had 60 days from the date of its Chapter 11 filing, or until August 26, 1991, to bring its obligations to these aircraft lessors and secured creditors current and/or reach other mu- tually satisfactory negotiated arrangements. In September 1991, as a condition to the borrowings under the initial $55 million D.I.P. facility, the Company arranged for rent, principal and interest payment deferrals from a majority of its aircraft providers as a condition to the assumption of the related lease or secured borrowing by the Company. As a result of these arrangements, the Company was able to assume the executory contracts associated with 83 aircraft in its fleet without having to bring its obligations to these aircraft providers current. In addition, as part of the initial D.I.P. facility, the Company assumed and brought current lease agreements for 16 Airbus A320 aircraft, three CFM engines, a Boeing 757-200 and a Boeing 737-300. Twenty-two aircraft were deemed surplus to the Company's needs and the associated executory contracts were rejected. Included in 1991 reorganization costs is $35.2 million in write-offs of leasehold improvements, security deposits, accrued maintenance, accrued rents and other costs to return the aircraft which were subject to the rejected aircraft agreements. In certain cases, final agreements were reached with such aircraft providers and no further claims by such providers will be pursued as a result of the rejections. In other instances, the aircraft providers have filed claims in the normal course of the bankruptcy and as of December 31, 1993 significant claims for rejected aircraft have not yet been settled. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements Due to the uncertain nature of many of the potential claims, the Company is unable to project the magnitude of such claims with any degree of certainty. However, the claims (pre-petition claims and administrative claims) that have been filed against the Company are in excess of $2 billion. Such aggregate amount includes claims of all character, including, but not limited to, unsecured claims, secured claims, claims that have been scheduled but not filed, duplicative claims, tax claims, claims for leases that were assumed, and claims which the Company believes to be without merit; however, claims filed for which an amount was not stated, are not reflected in such amount. The Company is unable to estimate the potential amount of such unstated claims; however, the amount of such claims could be material. The Company is in the process of reviewing the general unsecured claims asserted against the Company. In many instances, such review process will include the commencement of Bankruptcy Court proceedings in order to determine the amount at which such claims should be allowed. The Company has accrued its estimate of claims that will be allowed or the minimum amount at which it believes the asserted general unsecured claims will be allowed if there is no better estimate within the range of possible outcomes. However, the ultimate amount of allowed claims will be different and such differences could be material. The Company is unable to estimate the amount of such differences with any reasonable degree of certainty at this time. The Bankruptcy Code requires that all administrative claims be paid on the effective date of a plan of reorganization unless the respective claimants agreed to different treatment. Consequently, depending on the ultimate amount of administrative claims allowed by the Bankruptcy Court, the Company may be unable to obtain confirmation of a plan of reorganization. The Company is actively negotiating with claimants to achieve mutually acceptable dispositions of these claims. Since the commencement of the bankruptcy proceeding, claims alleging administrative expense priority totaling more than $153 million have been filed and an additional claim of $14 million has been alleged. As of February 28, 1994, $115 million of the filed claims have been allowed and settled for $50.2 million in the aggregate. The Company is currently negotiating the resolution of the remaining $38 million filed administrative expense claim (which relates to a rejected lease of a Boeing 737-300 aircraft) and the alleged $14 million administrative claim (which relates to a rejected lease of a Boeing 757-200 aircraft). Claims have been or may be asserted against the Company for alleged administrative rent and/or breach of return conditions (i.e. maintenance standards), guarantees and tax indemnity agreements related to aircraft or engines abandoned or rejected during the bankruptcy proceedings. Additional claims may be asserted against the Company and allowed by the Bankruptcy Court. The amount of such unidentified administrative claims may be material. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements Plan of Reorganization ---------------------- Under the Bankruptcy Code, the Company's pre-petition liabilities are subject to settlement under a plan of reorganization. Pursuant to an extension granted by the Bankruptcy Court on February 2, 1994, the Company has the partially exclusive right, until June 10, 1994 (unless extended by the Bankruptcy Court), to file a plan of reorganization. Each of the official committees has also been approved to submit a plan of reorganization. The exclusivity period may be extended by the Bankruptcy Court upon a showing of cause after notice has been given and a hearing has been held, although no assurance can be given that any additional extensions will be granted if requested by the Company. The Company has agreed not to seek additional extensions of the exclusivity period without the advance consent of the Creditors' Committee and the Equity Committee. On December 8, 1993 and February 16, 1994, the Bankruptcy Court entered certain orders which provided for a procedure pursuant to which interested parties could submit proposals to participate in a plan of reorganization for America West. The Bankruptcy Court also set February 24, 1994 as the date for America West to select a "Lead Plan Proposal" from the proposals submitted. On February 24, 1994, America West selected as its Lead Plan Proposal an investment proposal submitted by AmWest Partners, L.P., a limited partnership ("AmWest"), which includes Air Partners II, L.P., Continental Airlines, Inc., Mesa Airlines, Inc. and Fidelity Management Trust Company. On March 11, 1994, the Company and AmWest entered into a revised investment agreement which substantially incorporates the terms of the AmWest investment proposal (the "Investment Agreement"). The Investment Agreement provides that AmWest will purchase from America West equity securities representing a 37.5% ownership interest in the Company for $120 million and $100 million in new senior unsecured debt securities. The Investment Agreement also provides that, in addition to the 37.5% ownership interest in the Company, AmWest would also obtain 72.9% of the total voting interest in America West after the Company is reorganized. The terms of the Investment Agreement will be incorporated into a plan of reorganization to be filed with the Bankruptcy Court; however, modifications to the Investment Agreement may occur prior to the submission of a plan of reorganization and such modifications may be material. There can be no assurance that a plan of reorganization based upon the Investment Agreement will be accepted by the parties entitled to vote thereon or confirmed by the Bankruptcy Court. In addition to the interest in the reorganized America West that would be acquired by AmWest pursuant to the Investment Agreement, the Investment Agreement also provides for the following: 1. The D.I.P. financing would be repaid in full with cash on the date a plan of reorganization is confirmed ("Reorganization Date"). (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements 2. On the Reorganization Date, unsecured creditors would receive 45% of the new common equity in the reorganized Company, with the potential to receive up to 55% of such equity if within one year after the Reorganization Date, the value of the securities dis- tributed to them has not provided them with a full recovery under the Bankruptcy Code. In addition, unsecured creditors would have the right to elect to receive cash at $8.889 per share up to an aggregate maximum amount of $100 million, through a repurchase by AmWest of a portion of the shares to be issued to unsecured creditors under a plan of reorganization. 3. Holders of equity interests would have the right to receive up to 10% of the new common equity of the Company, depending on certain conditions principally involving a determination as to whether the unsecured creditors had received a full recovery on account of their claims. In addition, holders of equity interests would have the right to purchase up to $15 million of the new common equity in the Company for $8.296 per share from AmWest, and would also receive warrants entitling them to purchase, together with AmWest, up to 5% of the reorganized Company's common stock, at a price to be set so that the warrants would have value only after the unsecured creditors would have received full recovery on their claims. 4. In exchange for certain concessions principally arising from cancellation of the right of Guinness Peat Aviation ("GPA") affiliates to put to America West 10 Airbus A320 aircraft at fixed rates, GPA, or certain affiliates thereof, would receive (i) 7.5% of the new common equity in the reorganized Company, (ii) warrants to purchase up to 2.5% of the reorganized Company's common stock on the same terms as the AmWest warrants, (iii) $3 million in new senior unsecured debt securities, and (iv) the right to require the Company to lease up to eight aircraft of types operated by the Company from GPA prior to June 30, 1999 on terms which the Company believes to be more favorable than those currently applicable to the put aircraft. See note 11 for an additional discussion of the put rights. 5. Continental Airlines, Inc., Mesa Airlines, Inc. and America West would enter into certain alliance agreements which would include code-sharing, schedule coordination and certain other relationships and agreements. A condition to proceeding with a plan of reorganization based upon the Investment Agreement would be that these agreements be in form and substance satisfactory to America West, including the Company's reasonable satisfaction that such alliance agreements when fully implemented will result in an increase in pre-tax income of not less than $40 million per year. 6. The expansion of the Company's board of directors to 15 members. Nine members would be designated by AmWest and other members reasonably acceptable to AmWest would include four members designated by representatives of the Company, the Equity Committee and the Creditors' Committee and two members designated by GPA. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements 7. The Investment Agreement also provides for many other matters, including the disposition of the various types of claims asserted against the Company, the adherence to the Company's aircraft lease agreements, the amendment of the Company's aircraft pur- chase agreements and release of the Company's employees from all currently existing obligations arising under the Company's stock purchase plan in consideration for the cancellation of the shares of Company stock securing such obligations. The Company has also entered into a Revised Interim Procedures Agreement (the "Procedures Agreement") with AmWest. The Procedures Agreement is subject to the approval of the Bankrupty Court and sets forth terms and conditions upon which the Company must operate prior to the effective date of a confirmed plan of reorganization based upon the terms of the Investment Agreement. The Procedures Agreement provides for the reimbursement of AmWest's expenses (up to a maximum of $3.6 million) as well as a termination fee of up to $8 million under certain conditions. The Procedures Agreement has not yet been approved by the Bankruptcy Court. The Company is currently developing with AmWest a plan of reorganization based upon the foregoing terms. The Equity Committee has agreed to support the plan. The Creditors' Committee has indicated that it does not support the current terms of the Investment Agreement. Another group interested in developing a plan of reorganization with the Company has proposed to invest $155 million in equity securities and $65 million in new senior unsecured debt securities. The proponent of this proposal would receive a 33.5% ownership interest in the reorganized Company, current equity holders would receive a 4% ownership interest in the reorganized Company and the unsecured creditors would receive a 62.5% ownership interest in the reorganized company. Any plan of reorganization must be approved by the Bankruptcy Court and by specified majorities of each class of creditors and equity holders whose claims are impaired by the plan. Alternatively, absent the requisite approvals, the Company may seek Bankruptcy Court approval of its reorganization plan under Section 1129(b) of the Bankruptcy Code, assuming certain tests are met. The Company cannot predict whether any plan submitted by it will be approved. The Company is currently unable to predict when it may file a plan of reorganization based upon the Investment Agreement, but intends to do so as soon as practicable. Once a plan with a disclosure statement is filed by any party, the Bankruptcy Court will hold a hearing to determine the adequacy of the information contained in such disclosure statement. Only upon receiving an order from the Bankruptcy Court providing that the disclosure statement accompanying any such plan contains adequate information as required by Section 1125 of the Bankruptcy Code, may a party solicit acceptances or rejections of any such plan of reorganization. Following entry of an order approving the disclosure statement, the plan will be sent to creditors and equity holders for voting pursuant to both the Bankruptcy Code and orders that will be entered by the Bankruptcy Court. Following submission of the plan to holders of claims and equity interests, the Bankruptcy Court will hold a hearing to consider confirmation of the plan pursuant to Section 1129 of the Bankruptcy Code. Although the Bankruptcy Code provides for certain minimum time periods for these events, the Company is unable to reasonably estimate when a plan based on the Investment Agreement might be submitted for voting and confirmation. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements If at any time the Creditors' Committee, the Equity Committee or any creditor of the Company or equity holder of the Company believes that the Company is or will not be in a position to sustain operations, such party can move in the Bankruptcy Court to compel a liquidation of the Company's estate by conversion to Chapter 7 bankruptcy proceedings or otherwise. In the event that the Company is forced to sell its assets and liquidate, it is unlikely that unsecured creditors or equity holders will receive any value for their claims or interests. The Company anticipates that the reorganization process will result in the restructuring, cancellation and/or replacement of the interest of its existing common and preferred stockholders. Because of the "absolute priority rule" of Section 1129 of the Bankruptcy Code, which requires that the Company's creditors be paid in full (or otherwise consent) before equity holders can receive any value under a plan of reorganization, the Company previously disclosed that it anticipated that the reorganization process would result in the elimination of the Company's existing equity interests. Due to recent events, including sustained improvement in the Company's operating results as well as general improvement in the condition of the United States' economy and airline industry, some form of distribution to the equity interests pursuant to Section 1129 may occur. However, there can be no assurances in this regard. The accompanying financial statements have been prepared on a going concern basis which assumes continuity of operations and realization of assets and liquidation of liabilities in the ordinary course of business. As a result of the reorganization proceedings, there are significant uncertainties relating to the ability of the Company to continue as a going concern. The financial statements do not include any adjustments that might be necessary as a result of the outcome of the uncertainties discussed herein including the effects of any plan of reorganization. (2) Estimated Liabilities Subject to Chapter 11 Proceedings and ----------------------------------------------------------- Reorganization Expense ---------------------- Under Chapter 11, certain claims against the Company in existence prior to the filing of the petitions for relief under the Code are stayed while the Company continues business operations as debtor-in- possession. These pre-petition liabilities are expected to be settled as part of the plan of reorganization and are classified as "Estimated liabilities subject to Chapter 11 proceedings." Estimated liabilities subject to Chapter 11 proceedings as of December 31, 1993 and 1992 consists of the following: (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements The debt balance included above consists of unsecured and secured obligations and other obligations that have not been affirmed by the Company through the Bankruptcy Court (note 4). Reorganization expense is comprised of items of income, expense, gain or loss that were realized or incurred by the Company as a result of reorganization under Chapter 11 of the Federal Bankruptcy Code. Such items consists of the following: (3) Summary of Significant Accounting Policies ------------------------------------------ (a) Financial Reporting for Bankruptcy Proceedings ---------------------------------------------- On November 19, 1990, the American Institute of Certified Public Accountants issued Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"). SOP 90-7 provides guidance for financial reporting by entities that have filed petitions with the Bankruptcy Court and expect to reorganize under Chapter 11 of the Code. SOP 90-7 recommends that all such entities report consistently while reorganizing under Chapter 11, with the objective of reflecting their financial evolution. To achieve such objectives, their financial statements should distinguish transactions and events that are directly associated with the reorganization from those of the operations of the ongoing business as it evolves. SOP 90-7 became effective for financial statements of enterprises that filed petitions under the Code after December 31, 1990, although earlier application was encouraged. The Company has implemented the guidance provided by SOP 90-7 in the accompanying financial statements. Pursuant to SOP 90-7, pre-petition liabilities are reported on the basis of the expected amounts of such allowed claims, as opposed to the amounts for which those allowed claims may be settled. Under an approved final plan of reorganization, those claims may be settled at amounts substantially less than their allowed amounts. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (b) Cash Equivalents ---------------- Cash equivalents consist of all highly liquid debt instruments purchased with original maturities of three months or less and are carried at cost which approximates market. (c) Restricted Cash --------------- Restricted cash includes cash held in Company accounts, but pledged to an institution which processes credit card sales transactions and cash deposits securing certain letters of credit. (d) Expendable Spare Parts and Supplies ----------------------------------- Flight equipment expendable spare parts and supplies are valued at average cost. Allowances for obsolescence are provided, over the estimated useful life of the related aircraft and engines, for spare parts expected to be on hand at the date the aircraft are retired from service. (e) Property and Equipment ---------------------- Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Interest capitalized on advance payments for aircraft acquisitions and on expenditures for aircraft improvements is part of the cost. Property and equipment is depreciated and amortized to residual values over the estimated useful lives or the lease term using the straight-line method. The Company discontinued capitalizing interest on June 27, 1991 due to the Chapter 11 filing. The estimated useful lives for the Company's property and equip- ment range from three to twelve years for owned property and equipment and to thirty years for the reservation and training center and technical support facilities. The estimated useful lives of the Company's owned aircraft, jet engines, flight equipment and rotable parts range from eleven to twenty-two years. Leasehold improvements relating to flight equipment and other property on operating leases are amortized over the life of the lease or the life of the asset, whichever is shorter. Routine maintenance and repairs are charged to expense as incurred. The cost of major scheduled airframe, engine and certain component overhauls are capitalized and amortized over the periods benefited and included in depreciation and amortization expense. Additionally, a provision for the estimated cost of scheduled airframe and engine overhauls required to be performed on leased aircraft prior to their return to the lessors has been provided. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (f) Revenue Recognition ------------------- Passenger revenue is recognized when the transportation is provided. Ticket sales for transportation which has not yet been provided are reflected in the financial statements as air traffic liability. (g) Passenger Traffic Commissions and Related Fees ---------------------------------------------- Passenger traffic commissions and related fees are expensed when the transportation is provided and the related revenue is recognized. Passenger traffic commissions and related fees not yet recognized are included as a prepaid expense. (h) Income Taxes ------------ Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. As more fully discussed at note 5, adoption of the new standard changes the Company's method of accounting for income taxes from the deferred approach to an asset and liability approach. As with the prior standard, the Company continues to account for its investment tax credits and general business credits by use of the flow-through method. (i) Per Share Data -------------- Primary earnings (loss) per share is based upon the weighted average number of shares of common stock outstanding and dilutive common stock equivalents (stock options and warrants). Primary earnings per share reflect net income adjusted for interest on borrowings effectively reduced by the proceeds from the assumed conversion of common stock equivalents. Fully diluted earnings per share in 1993 is based on the average number of shares of common stock and dilutive common stock equivalents outstanding adjusted for conversion of outstanding convertible preferred stock and convertible debentures. Fully diluted earnings per share reflects net income adjusted for interest on borrowings effectively reduced by the proceeds from the assumed conversion of common stock equivalents. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (j) Frequent Flyer Awards --------------------- The Company maintains a frequent travel award program known as "FlightFund" that provides a variety of awards to program members based on accumulated mileage. The estimated cost of providing the free travel, using the incremental cost method as adjusted for estimated redemption rates, is recognized as a liability and charged to operations as program members accumulate mileage. (k) Manufacturers' and Deferred Credits ----------------------------------- In connection with the acquisition of certain aircraft and engines, the Company receives various credits. Such manufacturers' credits are deferred until the aircraft and engines are delivered, at which time they are either applied as a reduction of the cost of acquiring owned aircraft and engines, resulting in a reduction of future depreciation expense, or amortized as a reduction of rent expense for leased aircraft and engines. (l) Fair Value of Financial Instruments ----------------------------------- The fair value estimates and assumptions used in developing the estimates of the Company's financial instruments are as follows: Cash and Cash Equivalents ------------------------- The carrying amount approximates fair value because of the short maturity of those instruments. Accounts Receivable and Accounts Payable ---------------------------------------- The carrying amount of accounts receivable and accounts payable approximates fair value as they are expected to be collected or paid within 90 days of year-end. Long-term Debt and Estimated Liabilities Subject to Chapter 11 -------------------------------------------------------------- Proceedings ----------- The fair value of long-term debt and estimated liabilities subject to Chapter 11 proceedings cannot readily be estimated as quoted market prices are not available. Additionally, future cash flows cannot be estimated as the repayment of these in- struments is subject to disposition within the bankruptcy proceedings. (m) Reclassifications ----------------- Certain prior year reclassifications have been made to conform to the current year presentation. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (4) Long-term Debt -------------- Long-term debt consists of the following: (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements Long-term debt included in estimated liabilities subject to Chapter 11 proceedings consists of the following: As part of the Chapter 11 reorganization process, the Company is required to notify all known or potential claimants for the purpose of identifying all pre-petition claims against the Company. Additional bankruptcy claims and pre-petition liabilities may arise by termina- tion of various contractual obligations and as certain contingent and/or potentially disputed bankruptcy claims are allowed for amounts which may differ from those shown on the balance sheet. As discussed in note 1, payment of these liabilities, including maturity of debt obligations, is stayed while the debtor continues to operate as a debtor-in-possession. As a result, contractual terms have been suspended with respect to debt subject to the Chapter 11 proceedings. The following paragraphs include discussion of the original contractual terms of the long-term debt; however, the maturity and terms of the long-term debt subsequent to the petition date may differ as a result of negotiations that take place as part of the plan of reorganization. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements No principal or interest may be paid on pre-petition debt without the approval of the Bankruptcy Court. The Company has continued to accrue and pay interest on its long-term debt related to D.I.P. financing, affirmed long-term debt and secured debt included in estimated liabilities subject to Chapter 11 proceedings only to the extent that, in the Company's opinion, the value of underlying collateral exceeds the principal amount of the secured claim. The Company believes it is probable such interest will be an allowed secured claim as part of the bankruptcy proceeding. Except as otherwise stated above, the Company ceased accruing interest on pre-petition debt as of June 27, 1991, due to uncertainties relating to a final plan of reorganization. (a) In September 1991, the Company completed arrangements for a $55 million D.I.P. credit facility. The D.I.P. credit facility is secured by a first priority lien senior to all other liens on substantially all existing assets of the Company, except that such lien is junior in priority to Permitted First Liens (as such term is defined in the D.I.P. credit facility documents) with respect to the property encumbered thereby. In December 1991, the Company completed arrangements for an additional $23 million of D.I.P. financing under terms and conditions substantially the same as those associated with the $55 million D.I.P. credit facility. Quarterly interest payments for the D.I.P. financings commenced in the quarter ending December 31, 1991 at the 90-day London Interbank Offered Rate (LIBOR) plus 3.5% and quarterly principal repayments of $3.9 million were to commence in September 1992 with the balance due in September 1993, or earlier upon confirmation of an approved plan of reorganization. In connection with the $23 million of D.I.P. financing, the Company agreed to convert advanced cash credits for 24 Airbus A320 aircraft previously provided to the Company into an unsecured priority term loan. At December 31, 1993, the amount of the term loan was $68.4 million including accrued interest of $21.9 million. Until the Reorganization Date, the term loan will accrue interest at 12% per annum and such interest will be added to the principal balance. On the Reorganization Date, 85% of the outstanding balance will be converted into an eight-year term loan which will accrue interest at 2% over 90-day LIBOR and will be secured by substantially all the assets of the Company if the D.I.P. financing is fully repaid. Principal payments will be made in equal quarterly installments, plus interest, commencing after the Reorganization Date. The Company has the right to prepay the loan if the D.I.P. financing is fully repaid. The remaining 15% of the term loan will be treated as a general unsecured claim without priority status under the Company's plan of reorganization. In the first quarter of 1994, the Company received information that the term loan was purchased by a third party. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements In connection with the D.I.P. financing, a D.I.P. lender agreed to acquire the Company's Honolulu to Nagoya, Japan route for $15 million. The Nagoya route sale was finalized in March 1992, resulting in a gain of $15 million, which is included in other non-operating income in the accompanying statement of operations. Upon the completion of the sale of the Nagoya route, $10 million of the proceeds from the sale were paid to the lender to reduce the Company's obligation to the lender under the D.I.P. fi- nancing. The balance of the proceeds from the sale of the Nagoya route were added to the Company's working capital. The remaining D.I.P. balance was paid to this lender in connection with the September 1992 D.I.P. Facility. In September 1992, the Company completed arrangements to expand its existing D.I.P. financing by an additional $53 million (the "September 1992 D.I.P. Facility"). As a condition to the closing of the September 1992 D.I.P. Facility, the Company was required to reduce its aircraft fleet and the number of aircraft types from five to three pursuant to certain agreements with third parties, including the following: 1. With the exception of four lessors (two of which participated in the September 1992 D.I.P. Facility and did not defer or reduce their lease payments), aircraft lessors whose aircraft were retained in the fleet and who agreed to payment deferrals during July and August 1992, were required to waive any default which occurred as a result of such non- payments and to defer these payments without interest until the first calendar quarter of 1993. In addition, effective August 1, 1992, the rental rates on these retained aircraft were reduced to fair market lease rates for a two-year period. The rental rates adjust to market rates effective August 1, 1994. Of the remaining two lessors, one accepted rental payment reductions and the other agreed to a deferral of the rents from July through October 1992. Repayment of this deferral is monthly over seven years beginning November 1992 at level principal and interest at 90-day LIBOR plus 3.5%. 2. The aircraft lessors who accepted rent reductions and agreed to waive any administrative claims arising from the reductions stipulated that, if prior to July 31, 1994, the Company defaults on any of these leases and the aircraft are repossessed, the lessors are entitled to fixed damages which will be afforded priority as administrative claims. Lessors of 11 aircraft have the option, beginning August 1, 1994, to reset the rents to the current fair market rental rates and, if elected by the lessor, to readjust at two other two-year intervals during the remaining term of the lease. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements The Company also agreed in certain cases that lessors could call the aircraft upon 180 days notice if the lessor had a better lease proposal from another party which the Company was unwilling to match. During the period August 1, 1994 through July 31, 1995, certain of these lessors may call their aircraft without first giving the Company the right to match any competing offer. Call rights with a right of first refusal affect 16 aircraft and call rights without a right of first refusal affect 10 aircraft. In addition, in order to induce several lessors to extend the lease terms of their aircraft, the Company agreed that the aircraft could be called by the lessors at the end of the original lease term. One lessor of 11 aircraft has the right to terminate each lease at the end of the original lease term of each aircraft. Such lessor also has the right to call its aircraft on 90 days notice at any time prior to the end of the amended lease term. America West has no right of first refusal with respect to such aircraft. To date, no lessor has exercised its call rights. 3. Certain principal and interest payments relating to owned aircraft due in July 1992 were deferred without interest and were repaid by March 31, 1993. Additionally, certain other principal and interest payments due from August 1992 through January 1993 were deferred and repaid beginning February 1993 over five to nine years with interest at approximately 10.25%. In lieu of payment deferrals, two of the aircraft lenders agreed to adjust the interest rates based on 90-day LIBOR plus 3.5% per annum. In September 1993, the Bankruptcy Court approved an amendment to the D.I.P. loan agreement extending the maturity date of the loan from September 30, 1993 to June 30, 1994. Concurrent with the extension of the maturity date, $8.3 million of the principal balance was repaid to one of the participants who did not agree with the amendment. Interest on all funds advanced under the D.I.P. facility accrues at 3.5% per annum, over 90-day LIBOR and is payable quarterly. The amended D.I.P. loan agreement defers all principal payments to the earlier of June 30, 1994 or the effective date of a confirmed Chapter 11 plan of reorganization with the exception of $5 million that will be due on March 31, 1994. The amended terms of the D.I.P. financing require the Company to notify the D.I.P. lenders if the unrestricted cash balance of the Company exceeds $125 million. Upon receipt of such notice, the D.I.P. lenders may require the Company to prepay the D.I.P. financing by the amount of such excess. Subsequent to December 31, 1993, the Company notified the D.I.P. lenders that the Company's unrestricted cash exceeded $125 million; however, the D.I.P. lenders have not exercised their prepayment rights. The D.I.P. financings contain a minimum unencumbered cash balance requirement of $55 million at December 31, 1993 and other financial covenants. At December 31, 1993, the Company was in compliance with these covenants. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements As a condition to extending the maturity date of the D.I.P. financing in September 1993, the Company also agreed to pay a facility fee of $627,000 to the D.I.P. lenders on September 30, 1993 and to pay an additional facility fee equal to 1/4% of the then outstanding balance of the D.I.P. financing on March 31, 1994. Consequently, the outstanding balance of $83.6 million is classified as a current liability as of December 31, 1993. Presently, the Company does not possess sufficient liquidity to satisfy the D.I.P. financing nor does it appear likely that new equity capital will be obtained and a plan of reorganization confirmed prior to June 30, 1994. Consequently, the Company will be required to obtain alternative repayment terms from the D.I.P. lenders. There can be no assurance that alternative repayment terms will be obtained. The Company believes that any extension of the D.I.P. financing will be for a short period of time and would be concurrent with the implementation of a plan of reorganization. The D.I.P. financings contain a minimum unencumbered cash balance requirement of $55 million at December 31, 1993 and other financial covenants. At December 31, 1993, the Company was in compliance with these covenants. (b) These notes from financial institutions, secured by seventeen aircraft with a net book value of $327.6 million, are payable in semi-monthly, monthly, quarterly and semi-annual installments ranging from $75,000 to $1,637,000 plus interest at 30-day LIBOR plus 3.5% (6.88% at December 31, 1993) to 10.79%, with maturities ranging from 1999 to 2008. Approximately $105.3 million of these secured notes have provisions providing for the reset of interest rates at various future dates based on fluctuations in indices such as the Eurodollar rate. Additionally, interest rates and principal payments for certain of these notes were modified, as discussed above, in connection with the September 1992 D.I.P. Facility. (c) The Company has a $40 million line of credit that extends to December 31, 1997 for which no borrowing can occur after December 31, 1994. The purpose of the line is to provide for the initial provisioning of spare parts for Airbus A320 aircraft. The loan is repaid quarterly with level principal payments of $970,000 each and interest at LIBOR plus 4%. At December 31, 1993 and 1992, the Company had borrowings outstanding of $15.5 million and $20.4 million, respectively, under this credit facility. However, the lender will not make the unused credit of $24.5 million available at December 31, 1993 as a result of the Chapter 11 filing. This loan was affirmed in December 1991 by the Bankruptcy Court under Section 1110 of the Bankruptcy Code. The Company also has a $25 million line of credit that extends to September 1997 under which no borrowing could occur after September 1992. The credit line was used for spare engine parts and has an interest rate of LIBOR plus 4%. At December 31, 1993 and 1992, the Company had borrowings outstanding of $3.1 million and $4.6 million, respectively, under this credit facility. In connection with the financing by this same lender of two aircraft flight simulators in October 1992 (see (e)), this loan was affirmed in the bankruptcy proceeding. Consequently, the outstanding balance at December 31, 1993 is included in long-term debt. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (d) This note from an aircraft engine manufacturer was originally made for $30 million in September 1990. The note is secured by two aircraft, spare engine parts and other equipment. Interest on the note began to accrue at its inception at 90-day LIBOR plus 2.0%, compounded quarterly, until September 1993 when all such accrued interest, or approximately $6 million, was paid. Interest is currently paid quarterly at the same interest rate. In October 1992, this lender financed two new flight simulators which were securing this note (see (e)), and this loan was reduced by the amount of such financing, or approximately $22.8 million. Repayment of the balance of this loan is dependent on the future delivery of certain firm ordered aircraft scheduled to begin in November 1996 (however, the related aircraft purchase agreement has been neither affirmed nor rejected at December 31, 1993). In connection with the above financing of the two flight simulators, this note was affirmed in the bankruptcy proceedings, and the outstanding balances at December 31, 1993 and 1992 are included in long-term debt. (e) In October 1992, the Company acquired two flight simulators and executed two notes secured by the simulators. The notes are payable in 84 equal monthly principal installments, plus accrued interest at LIBOR plus 2%. However, the Company has the right, upon the giving of notice to the lender, to fix the interest rate at the greater of the then current LIBOR plus 2% or 6.375%. In connection with this financing, the Company affirmed in the bankruptcy proceedings the agreements for a certain note payable (see (d) above) and a line of credit (see (c) above). (f) In 1993, the Company settled three administrative claims with three four-year promissory notes totaling $9.6 million with quarterly principal payments and interest at 6%. At December 31, 1993, the outstanding balance of these promissory notes was $8.7 million. Also in 1993, the Company renegotiated a note for certain ground equipment for $2 million as part of an administrative claim settlement which takes effect upon the confirmation of a plan of reorganization. The Company is required to make adequate protection payments of $8,000 per month from the settlement date until plan confirmation, at which time, the note term is 5 years with interest at 6%. (g) The Company's 7-3/4% convertible subordinated debentures are convertible into common stock at $13.50 per share. The debentures are redeemable at prices ranging from 101.55% of the principal amount at December 31, 1993 to 100% of the principal amount in 1995 and thereafter. Annual sinking fund payments of $1.5 million are required beginning in 1995. (h) The Company's 7-1/2% convertible subordinated debentures are convertible into common stock at $14.00 per share. The debentures are redeemable at prices ranging from 102.25% of the principal amount at December 31, 1993 to 100% of the principal amount in 1996 and thereafter. Annual sinking fund payments of $1.6 million are required beginning in 1996. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (i) The Company's 11-1/2% convertible subordinated debentures are convertible into common stock at $10.50 per share. The debentures are redeemable at prices ranging from 105.75% of the principal amount from January 1, 1994 to 100% of the principal amount in 1999 and thereafter. Annual sinking fund payments of $5.8 million are required beginning in 1999. During 1991, certain bondholders converted $22.1 million of the 11-1/2% convertible subordinated debentures into common stock. The conversion of the 11-1/2% subordinated debentures resulted in a charge to other non-operating expense of $875,000 for incremental shares issued upon conversion. Certain bondholders converted $1.4 million of the 7-1/2% convertible subordinated debentures and $4.4 million of the 7-3/4% convertible subordinated debentures into common stock. During 1992, certain bondholders converted $95,000 of the 7-1/2% convertible subordinated debentures, $100,000 of the 7-3/4% convertible subordinated debentures and $3.5 million of the 11-1/2% convertible subordinated debentures into common stock. During 1993, certain bondholders converted $360,000 of the 7-1/2% convertible subordinated debentures, $275,000 of the 7-3/4% convertible subordinated debentures and $1.3 million of the 11-1/2% convertible subordinated debentures into common stock. All of the convertible subordinated debenture interests will be subject to settlement of their stated amounts in a plan of reorganization, thereby eliminating the need for continued deferral of the debt issuance costs. Therefore, the unamortized debt issuance costs of $2.8 million for these convertible subordinated debentures were charged to operations as reorganization expense in 1991. The Company ceased accruing interest on all of these debentures as of June 27, 1991 in accordance with SOP 90-7. (j) This note from an aircraft manufacturer for deferred pre-delivery payments was required under a purchase agreement entered into in 1990. The deferred pre-delivery payments will accrue interest at one year LIBOR plus 4% with both principal and interest due upon delivery of the aircraft. The Company has ceased accruing interest on the outstanding balance in accordance with SOP 90-7. The acquisition of the aircraft associated with these deferred pre-delivery payments is subject to the affirmation or rejection of the respective aircraft purchase agreement by the Company in the reorganization proceeding. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (k) The Company has a $20 million secured revolving credit facility with a group of financial institutions that expired on April 17, 1993. Borrowings under this credit facility were either made i) at the federal funds rate plus 1%, ii) based on a CD rate or iii) 90-day LIBOR two business days prior to the first day of the interest period. The borrowings are secured by certain assets. The Company is obligated to pay a commitment fee equal to 1/4% per annum on the average daily amount by which the aggregate commitments exceed the applicable borrowing base and 1/2% per annum on the average daily amount by which the lower of the aggregate commitments or applicable borrowing base exceeds the aggregate principal amount on all outstanding loans. At December 31, 1993 and 1992, the Company had an outstanding balance of $9.9 million and $11 million, respectively, under the revolving credit agreement. Proceeds from sales of assets securing the loan were used to prepay the loan during 1993. The Company ceased accruing interest on the outstanding balance as of June 27, 1991 in accordance with SOP 90-7. (l) The holders of industrial development revenue bonds have the right to put the bonds back to the Company at various times. If such a put occurs, the Company has an agreement with the underwriters to remarket the bonds. Any bonds not remarketed will be retired utilizing a letter of credit. Any funding under the letter of credit will be in the form of a two-year term loan at prime plus 2%. During the first quarter of 1991, the Company redeemed $14.5 million of the $44 million of industrial develop- ment revenue bonds issued and outstanding and agreed to a seven- year amortization schedule for the redemption of the remaining balance. In July and August 1991, $29.5 million in the aggregate was drawn against the letter of credit facility that supported these bonds. The Company intends to remarket the bonds in the future. Such draws were made on behalf of holders of such bonds who exercised their right to put the bonds back to the Company for purchase. The bonds are currently held in trust for the benefit of the Company. These bonds were issued in connection with the Company's technical support facility. (m) These draws on a letter of credit from a financial institution, secured by spare rotable parts with a net book value of $35.8 million, are payable in quarterly installments of $1.3 million plus interest at prime plus 4.5%. The Company has ceased accruing interest as of June 27, 1991 on the outstanding balance in accordance with SOP 90-7. Maturities of long-term debt, excluding $225 million included in estimated liabilities subject to Chapter 11 proceedings, for the years ending December 31 are as follows: (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (5) Income Taxes ------------ Adoption of New Accounting Standard ----------------------------------- As of January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). SFAS 109 is a fundamental change in the manner used to account for income taxes in that the deferred method has been replaced with an asset and liability approach. Under SFAS 109, deferred tax assets (subject to a possible valuation allowance) and liabilities are recognized for the expected future tax consequences of events that are reflected in the Company's financial statements or tax returns. In the year of adoption, SFAS 109 permits an enterprise to record in its current year financial statements, the cumulative effect (if any) of the change in accounting principle. Upon adoption, the Company did not need to record a cumulative effect adjustment. Income Tax Expense ------------------ For the year ended December 31, 1993, the Company recorded income tax expense as follows: For the year ended December 31, 1993, income tax expense is solely attributable to income from continuing operations. The difference in income taxes at the federal statutory rate ("expected taxes") to those reflected in the financial statements (the "effective rate") results from the effect of the benefit of net operating loss carryforwards of $12.6 million and state income tax expense, net of federal tax benefit of $55,000, for an effective tax rate of 2%. In 1992 and 1991, the tax benefits at the federal statutory rate of 34% were offset by the generation of net operating loss carryforwards. At December 31, 1993, the Company has available net operating loss, business tax credit and alternative minimum tax credit carryforwards for federal income tax purposes of $530.3 million, $12.7 million and $700,000, respectively. The net operating loss carryforwards expire during the years 1999 through 2007 while the business credit carryforwards expire during the years 1997 through 2006. However, such carryforwards are not fully available to offset federal (and, in certain circumstances, state) alternative minimum taxable income. Accordingly, income tax expense recognized for the year ended December 31, 1993, is attributable to the Company's expected net current liability for federal and various state alternative minimum taxes. The alternative minimum tax credit carryforward does not expire and is available to reduce future income tax payable. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements As of December 31, 1993, to the best of the Company's knowledge, it has not undergone a statutory "ownership change" (as defined in Section 382 of the Internal Revenue Code) that would result in any material limitation of the Company's ability to use its net operating loss and business tax credit carryforwards in future tax years. Should an "ownership change" occur prior to confirmation of a plan of reor- ganization, the Company's ability to utilize said carryforwards would be significantly restricted. Further, the net operating loss and business tax credit carryforwards may be limited as a result of the Company's reorganization under the United States Bankruptcy Code. Composition of Deferred Tax Items --------------------------------- The Company has not recognized any net deferred tax items for the year ended December 31, 1993. 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 assets and liabilities as of December 31, 1993 are a result of the temporary differences related to the items described as follows: SFAS 109 requires a "more likely than not" criterion be applied when evaluating the realizability of a deferred tax asset. Given the Company's history of losses for income tax purposes, the volatility of the industry within which the Company operates and certain other factors, the Company has established a valuation allowance for the portion of its net operating loss carryforwards that may not be available due to expirations after considering the net reversals of future taxable and deductible differences occurring in the same periods. In this context, the Company has taken into account prudent and feasible tax planning strategies. After application of the valuation allowance, the Company's net deferred tax assets and liabilities are zero. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (6) Employee Stock Purchase Plans and Other Employee Benefit Programs ----------------------------------------------------------------- The Company has a stock purchase plan covering its directors, officers and employees and certain other persons providing service to the Company, as well as a separate plan covering its California resident employees. At December 31, 1993, the number of shares authorized under the plans is 10,450,000. Each participating employee is required to purchase a number of shares having an aggregate purchase price equivalent to 20% of such employee's annual base wage or salary on the date of purchase. Each participating employee has the option of simultaneously purchasing additional shares having an aggregate purchase price not exceeding 20% of such wage or salary. California resident employees electing to participate in the plan may purchase a number of shares having an aggregate purchase price not exceeding 40% of their annual base wage or salary on the date of purchase at a specified price. Participating employees can elect to finance their purchase through the Company for up to 20% of their annual base wage or salary over a five-year period at an interest rate of 9.5%. Employee notes receivable of $17.6 million existed at December 31, 1993 and were classified in the stockholders' deficiency section. Shares issued under the plans cannot be sold, transferred, assigned, pledged or encumbered in any way for a period of two years from the date such shares are paid for and delivered to participating employees. The employees' purchase price is 85% of the market price on the date of purchase. The difference between the employees' purchase price and the market price is recorded as deferred compensation and is amortized over five years. The plans provide for the purchase of additional shares of common stock up to 10% of the employee's annual base wage during the first year of employment and 20% of the employee's annual base wage during each subsequent calendar year. Such purchases may be financed through the Company at the same terms as indicated above, as long as total outstanding amounts previously financed do not exceed 10% of the employee's annual base compensation. Effective August 1, 1991, the Company suspended the mandatory portion of the Employee Stock Purchase Plan for 60 days. Subsequent to the expiration of the 60-day period, the Company indefinitely suspended the Employee Stock Purchase Plan. The Company also suspended payroll deductions related to the Employee Stock Purchase Plan as a result of a 10% across the board reduction in wages which commenced August 1, 1991 for all employees whose wages had not been previously reduced. The unpaid employee stock purchase notes continue to accrue interest. The Company anticipates that the reorganization process will result in the restructuring, cancellation and/or replacement of the interests of its existing common and preferred stockholders. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements The Bankruptcy process has caused the suspension of the Company's profit sharing plan which covers all personnel. The plan provided for the distribution of 15% of annual pre-tax profits to employees based on each individual's base wage. The Company made no distributions under the plan in 1993, 1992 or 1991. The Company implemented a 401(k) defined contribution plan on January 1, 1989, covering essentially all employees of the Company. Participants may contribute from 1% to 10% of their pre-tax earnings to a maximum of $8,994. The Company will match 25% of a participant's contributions up to 6% of the participant's annual pre-tax earnings. The Company's contribution expense to the plan totaled $2.1 million, $2 million and $4.9 million in 1993, 1992 and 1991, respectively. The Company provides no post-retirement benefits to its former employees other than the continuation of flight benefits on a stand- by, non-revenue basis; the cost of which is not material. Additionally, no material post-employment benefits are provided. (7) Convertible Preferred Stock --------------------------- Annual dividends of $5.41 per share are payable quarterly on the 291,149 shares of voting Series B 10.5% convertible preferred stock. Each preferred share is entitled to four votes and may be converted into four shares of common stock subject to certain anti-dilution provisions. The preferred shares are redeemable at the Company's election, if the price of common stock is at least $19.32 per share, at $51.52 per share plus unpaid accrued dividends plus a redemption premium starting at 3% during 1991 and decreasing 1% per year to zero during and after 1994. During 1993, the Series B convertible preferred stock was converted into 1,164,596 shares of common stock. Annual dividends of $1.33 per share are payable quarterly on the 73,099 shares of voting Series C 9.75% convertible preferred stock. Such shares may be converted into an equal number of shares of common stock subject to certain anti-dilution provisions. The preferred shares are redeemable at the Company's election at $13.68 per share plus unpaid accrued dividends plus a redemption premium starting at 4% during 1991 and decreasing 1% per year to zero during and after 1995. Under Delaware law, the Company is precluded from paying dividends on its outstanding preferred stock until such time as the Company's stockholder deficiency has been eliminated. At December 31, 1993, the Company was delinquent in the payment of its sixth consecutive dividends on the Preferred Stock. See note 1 for a discussion of the potential effects of the Company's reorganization upon preferred stock. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (8) Common Stock ------------ Certain "Rights" have been distributed to certain shareholders of record on August 25, 1986. The Rights, which entitle the holder to purchase one one-hundredth (1/100th) of a share of Series D Participating Preferred Stock at a price of $200, are not exercisable unless certain conditions relating to a possible attempt to acquire the Company are met. In the event of an acquisition or merger, the Rights will entitle the holder of a Right to purchase that number of common shares of the acquiring or surviving entity having twice the market value of the exercise price of each Right. The Rights expire on August 24, 1996 and are redeemable at a price of $.03 per Right under certain conditions. The Board of Directors has authorized the purchase of up to 700,000 shares of the Company's common stock from time to time in open market transactions. The Company has purchased and retired 348,410 shares as of December 31, 1993 at an average per share price of $8.31. (9) Stock Options and Warrants -------------------------- The Company has an Incentive Stock Option Plan and has reserved 13,225,000 shares of common stock for issuance upon the exercise of stock options granted under the plan. Of the total shares reserved, 10,350,000 shares are restricted for issuance to employees other than certain management employees. Options are granted at fair market value on the date of grant and generally become exercisable over a five-year period, and ultimately lapse if unexercised at the end of ten years. Activity under the Incentive Stock Option Plan is as follows: (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements At December 31, 1993, options to purchase 3,731,608 shares were exercisable at prices ranging from $0.94 to $13.06 per share under the Incentive Stock Option Plan. Effective March 13, 1992, additional grants under the Plan were suspended. The Company has a Nonstatutory Stock Option Plan under which options to purchase 3,785,880 shares of common stock at prices ranging from $5.06 to $10.25 per share (fair market value on date of grant) have been granted, of which 1,961,410 stock options are outstanding as of December 31, 1993. During 1991, 40,000 options were granted at $6.00 per share. During 1993, 1992 and 1991, no options were exercised. At December 31, 1993, all options were exercisable. Options expire 10 years from date of grant. The Company had granted warrants and options to purchase 227,500 shares of common stock to members of the Board of Directors who are not employees of the Company. At December 31, 1993, 110,000 options are outstanding and exercisable through February 4, 1996 at prices of $6.00 to $9.00 per share (fair market value at date of grant). No warrants or options were granted or exercised during 1993, 1992 or 1991. The Company has adopted a Restricted Stock Plan and has reserved 250,000 shares of common stock for issuance at no cost to key employees. Grants that are issued will vest over a three to five-year period. As of December 31, 1993, the Company granted 93,870 shares and the related unamortized deferred compensation was $5,320. In 1991, the operation of the Restricted Stock Plan was suspended due to the Company's reorganization. (10) Supplemental Information to Statements of Cash Flows ---------------------------------------------------- Cash paid for interest, net of amounts capitalized, during the years ended December 31, 1993, 1992 and 1991 was approximately $44 million, $46 million and $33 million, respectively. Cash paid for income taxes during the year ended December 31, 1993 was $537,000. Cash flows from reorganization items in connection with the Chapter 11 proceedings during the years ended December 31, 1993, 1992 and 1991 were as follows: (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements In addition, during the years ended December 31, 1993, 1992 and 1991, the Company had the following non-cash financing and investing activities: (11) Commitments and Contingencies ----------------------------- (a) Leases ------ During 1991, the Company restructured its lease commitment for Airbus A320 aircraft with the lessors. As a result of the restructuring, the Company's obligation to lease ten A320 aircraft was canceled and the basic rental rate for twelve aircraft was revised to provide for the repayment to the lessor over a ten-year period of certain advanced credits received by the Company which relate to the ten canceled aircraft. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements In the third quarter of 1991, the Company requested a deferral of rent and other periodic payments from its aircraft providers. The deferral was requested in an effort to conserve cash and improve the Company's liquidity position. As a condition of securing the $78 million D.I.P. financing, the Company was required to obtain from most aircraft providers rent, principal and interest payment deferrals in excess of $100 million covering the six-month period of June through November 1991. These deferrals will generally be repaid with interest at 10.5% over the remaining term of the lease or secured borrowing with repayment commencing December 1991. At December 31, 1993 and 1992, the remaining unpaid deferrals are reported as follows: In the third quarter of 1992, the Company requested an additional deferral of rent and other periodic payments from its aircraft providers. The deferral was requested to assure sufficient liquidity to sustain operations while additional debtor-in- possession financing was obtained (note 4). The 1992 deferrals will generally be repaid either without interest during the first quarter of 1993 or with interest over a period of seven years. At December 31, 1993 and 1992, the remaining unpaid deferrals are reported as follows: (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements As of December 31, 1993, the Company had 66 aircraft under operating leases with remaining terms ranging from four months to 20 years. The Company has options to purchase most of the aircraft at fair market value at the end of the lease term. Certain of the agreements require security deposits and maintenance reserve payments. The Company also leases certain terminal space, ground facilities and computer and other equipment under noncancelable operating leases. Future minimum rental payments for years ending December 31 under noncancelable operating leases with initial terms of more than one year are as follows: Collectively, the operating lease agreements require security de- posits with lessors of $8.1 million and bank letters of credit of $17.7 million. The letters of credit are collateralized by certain spare rotable parts with a net book value of $35.8 million and $17.6 million in restricted cash. Rent expense (excluding landing fees) was approximately $245 million in 1993, $307 million in 1992 and $319 million in 1991. (b) Revenue Bonds ------------- Special facility revenue bonds have been issued by a municipality used for leasehold improvements at the airport which have been leased by the Company. Under the operating lease agreements, which commenced in 1990, the Company is required to make rental payments sufficient to pay principal and interest when due on the bonds. The Company ceased rental payments in June 1991. The principal amount of such bonds outstanding at December 31, 1992 and 1991 was $40.7 million. In October 1993, the Company and the bondholder agreed to reduce the outstanding balance of the bonds to $22.5 million and adjust the related operating lease payments sufficient to pay principal and interest on the reduced amount effective upon the confirmation of a plan of reorganization. The remaining principal balance of $18.2 million will be accorded the same treatment under the plan of reorganization as a pre-petition unsecured claim. The Company also agreed to make adequate protection payments in the amount of $150,000 per month from August 1993 to plan confirmation. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (c) Aircraft Acquisitions --------------------- At December 31, 1993, the Company had on order a total of 93 aircraft of the types currently comprising the Company's fleet, of which 51 are firm and 42 are options. The table below details such deliveries. The current estimated aggregate cost for these firm commitments and options is approximately $5.2 billion. Future aircraft deliveries are planned in some instances for incremental additions to the Company's existing aircraft fleet and in other instances as replacements for aircraft with lease terminations occurring during this period. The purchase agreements to acquire 24 Boeing 737-300 aircraft had been affirmed in the Company's bankruptcy proceeding. With timely notice to the manufacturer, all or some of these deliveries may be converted to Boeing 737-400 aircraft. At December 31, 1993, eight Boeing 737 delivery positions had been eliminated due to the lack of a required reconfirmation notice by the Company to Boeing leaving 16 delivery positions as reflected above. The failure to reconfirm such delivery positions exposes the Company to loss of pre-delivery deposits and other claims which may be asserted by Boeing in the bankruptcy proceeding. The purchase agreements for the remaining aircraft types have not been assumed, and the Company has not yet determined which of the other aircraft pur- chase agreements, if any, will be affirmed or rejected. As part of the $68.4 million term loan (see note 4(a)), the Company terminated an agreement to lease 24 Airbus A320 aircraft and ultimately replaced it with a put agreement to lease up to four such aircraft. The lessor is under no obligation to lease such aircraft to the Company and has the right to remarket these aircraft to other parties. Prior to its bankruptcy filing, the Company also entered into a similar arrangement with another lessor, whereby the Company terminated its agreement to lease 10 Airbus A320 aircraft and replaced it with a put agreement to lease up to 10 Airbus A320 aircraft. The put agreement related to the term loan requires the lessor to notify the Company prior to July 1, 1994 if it intends to require the Company to lease any of its put aircraft. The other put agreement requires 180 days prior notice of the delivery of a put aircraft. The agreement also provides that the lessor may not put more than five aircraft to the Company in any one calendar year. This put right expires on December 31, 1996. No more than nine put aircraft (from both lessors combined) may be put to the Company in one calendar year. The put aircraft are reflected in the "Firm Orders" section of the table above. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements The Investment Agreement provides that as partial consideration for the cancellation of certain put rights, the lessor will receive the right to require the Company to lease up to eight aircraft prior to June 30, 1999. The Company does not have firm lease or debt financing commitments with respect to the future scheduled aircraft deliveries (other than for the put aircraft referred to above). In addition to the aircraft set forth in the chart above, the Company also has a pre-petition executory contract under which the Company holds delivery positions for four Boeing 747-400 aircraft under firm orders and another four under options. The contract allows the Company, with the giving of adequate notice, to substitute other Boeing aircraft types for the Boeing 747-400 in these delivery positions. As a result, the Company is still evaluating its future fleet needs and is currently unable to determine if it will substitute other aircraft types or reject this agreement. (d) Concentration of Credit Risk ---------------------------- The Company does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, approximately 82% of the Company's receivables related to tickets sold to individual passengers through the use of major credit cards or to tickets sold by other airlines and used by passengers on America West. These receivables are short-term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (12) Related Party Transactions -------------------------- During 1989, the Company sold 486,219 shares of common stock at $6.31 and $9.79 to the stockholder that purchased 3,029,235 shares of common stock at $10.50 in 1987 and $1 million of the Series C preferred stock in 1985. This stockholder has the right to maintain a 20% voting interest through the purchase of common stock from the Company at a price per share which is the average market price per share for the preceding six months. In 1990, the stockholder made direct purchases on the open market to maintain its 20% voting interest. On February 15, 1991, the stockholder purchased 253,422 shares of common stock from the Company at $5.50 per share. No such purchases occurred in 1993 or 1992. The Company has entered into various aircraft acquisition and leasing agreements with this stockholder at terms comparable to those obtained from third parties for similar transactions. The Company leases 11 aircraft from this stockholder and the rental payments for such leases amounted to $33.7 million in 1993, $33.8 million in 1992 and $18.1 million in 1991. At December 31, 1993, the Company was obligated to pay $232 million under these leases through August 2003 unless terminated earlier at the stockholder's option. In 1991, the stockholder drew upon a $7.5 million letter of credit which had been issued in its favor in lieu of a cash reserve for periodic heavy maintenance overhauls. This cash deposit is included in other assets at December 31, 1993 and 1992. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements In addition, the stockholder participated as a lender in the September 1992 D.I.P. Facility and advanced $10 million of the $53 million in total D.I.P. financing. In September 1993, the stockholder was repaid the then outstanding balance of $8.3 million as a result of not participating in the extension of the maturity date of the debt financing. In order to assist the Chairman of the Board with certain costs associated with his service as chairman, the Company pays an office overhead allowance of $4,167 per month to a company owned by the chairman. During 1993 and 1992, such payments totaled approximately $50,000 and $16,000, respectively. Additionally, a former member of the Board of Directors provided consulting services to the Company during 1993 and 1992 for which he received fees of approximately $39,000 and $47,000, respectively. (13) Restructuring Charges --------------------- Restructuring charges consist of the following: The restructuring charges were necessitated by aircraft fleet reductions and other operational changes. The Company has reduced its fleet to 85 aircraft and has reduced the number of aircraft types in the fleet from five to three. (Continued) AMERICA WEST AIRLINES, INC., D.I.P. Notes to Financial Statements (14) Quarterly Financial Data (Unaudited) ------------------------------------ Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands of dollars except per share amounts): (a) During the third quarter of 1992, restructuring charges for employee separation costs, losses related to returning aircraft to lessors, write-off of assets related to the restructuring and a loss provision related to spare parts expected to be sold amounting to $31.3 million was recorded. (b) During the first quarter of 1992, a gain of $15 million was recorded for the transfer of the Honolulu/Nagoya route to another carrier. Item 9 Item 9 Changes in and Disagreements with Accountants on Accounting and ------ --------------------------------------------------------------- Financial Disclosure. -------------------- During the last two fiscal years, the Company has not filed a Form 8-K to report a change in accountants because of a disagreement over accounting principles or procedures, financial statement disclosure, or otherwise. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. ------- -------------------------------------------------- Information respecting the names, ages, terms, positions with the Company and business experience of the executive officers and the directors of the Company as of February 28, 1994, is set forth below. Each director has served continuously with the Company since his first election. William A. Franke was named Chairman of the Board of Directors in ----------------- September 1992. On December 31, 1993, Mr. Franke was elected to also serve as the Company's Chief Executive Officer. In addition to his responsibilities at America West, Mr. Franke serves as president of the financial services firm, Franke & Co., a company he has owned since May 1987. From November 1989 until June 1990, Mr. Franke served as the Chairman of Circle K Corporation's executive committee with the responsibility for Circle K Corporations's restructure. In May 1990, the Circle K Corporation filed a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code. From June 1990 until August 1993, Mr. Franke served as the chairman of a special committee of directors overseeing the reorganization of the Circle K Corporation. Mr. Franke has also served in various other capacities at Circle K Corporation since 1990. Mr. Franke was also involved in the restructuring of the Valley National Bank of Arizona (now Bank One Arizona). Mr. Franke also serves as a director of Phelps Dodge Corp. and Central Newspapers Inc. A. Maurice Myers was named president and chief operating officer on ---------------- December 31, 1993 and was named to the Board of Director in 1994. Prior to joining America West, Mr. Myers was the president and chief executive officer of Aloha Airgroup, Inc. an aviation services corporation which owns and operates Aloha Airlines and Aloha IslandAir. Mr. Myers joined Aloha in 1983 as vice president of marketing and became its president and chief executive officer in June 1985. Mr. Myers is a member of the boards of directors of Air Transport Association of America and Hawaiian Electric Industries. Thomas P. Burns has served as Senior Vice President-Sales and Marketing --------------- since August 1987. Mr. Burns joined the Company in April 1985 as Vice President-Sales. Mr. Burns was employed for 25 years by Continental Airlines in various sales and passenger service positions. From 1982 to 1983, he was employed as North American Manager of Sales for UTA, a French airline. Mr. Burns returned to Continental from 1983 through March 1985, where he served as Director of International Sales prior to joining the Company. Alphonse E. Frei has been Senior Vice President-Finance and Chief ---------------- Financial Officer since April 1985. He joined the Company in April 1983 as Vice President-Controller. Prior to that time he had 23 years of experience at Continental Airlines where he held a variety of management positions in finance and data processing. Mr. Frei served as a member of the Company's Board of Directors from 1986 to 1992. Mr. Frei is also a member of the board of directors of Swift Transportation Co., Inc. Martin J. Whalen has been Senior Vice President-Administration and ---------------- General Counsel of the Company since July 1986. From 1980 until July 1986, Mr. Whalen was employed by McDonnell Douglas Helicopter Company and its predecessors, most recently as Vice President of Administration. He also held positions in labor relations, personnel and legal affairs at Hughes Airwest and Eastern Airlines. Frederick W. Bradley, Jr. has served as a member of the Board of ------------------------- Directors since September 1992. Immediately prior to joining the Board of Directors, Mr. Bradley was a senior advisor with Simat, Helliesen & Eichner, Inc. Mr. Bradley formerly served as senior vice president of Citibank/Citicorp's Global Airline and Aerospace business. Mr. Bradley joined Citibank/Citicorp in 1958. In addition, Mr. Bradley serves as a member of the board of directors of Shuttle, Inc. (USAir Shuttle) and the Institute of Air Transport, Paris, France. Mr. Bradley also serves as chairman of the board of directors of Aircraft Lease Portfolio Securitization 92-1 Ltd. and as President of IATA's International Airline Training Fund of the United States. O. Mark De Michele has served as a member of the Board of Directors ------------------ since 1986 and is president, chief executive officer and a director of Arizona Public Service Company. Mr. De Michele joined Arizona Public Service Company in 1978 as vice president of corporate relations, and also served as its chief operating officer and an executive vice president. Mr. De Michele is also a member of the board of directors of the Pinnacle West Capital Corporation. Samuel L. Eichenfield has served as a member of the Board of Directors --------------------- since September 1992 and is chairman of the board of directors and chief executive officer of GFC Financial Corporation. Mr. Eichenfield has also served as chief executive officer of Greyhound Financial Corporation, a subsidiary of GFC Financial Corporation, since joining GFC in 1987. Richard C. Kraemer has served as a member of the Board of Directors ------------------ since September 1992 and is president and chief operating officer of UDC Homes, Inc. Mr. Kraemer is also a member of the UDC Homes, Inc. board of directors. Prior to joining UDC Homes, Inc. in 1975, Mr. Kraemer held a variety of positions at American Cyanamid Company. James T. McMillan has served as a member of the Board of Directors since ----------------- December 1993. Mr. McMillan joined McDonnell Douglas Finance Corporation as its president in 1968 and retired as its chairman of the board in 1991. Mr. McMillan also served in various capacities for the McDonnell Douglas Corporation from August 1954 until August 1990, most recently as a Senior Vice President and Group Executive. John R. Norton III has served as a member of the Board of Directors ------------------ since September 1992 and was former Deputy Secretary of the United States Department of Agriculture from 1985 to 1986. Mr. Norton is currently a principal of J.R. Norton Company, an agricultural and real estate. Mr. Norton is also a member of the board of directors of Aztar Corp., Pinnacle West Capital Corporation, Arizona Public Service Company and Terra Industries, Inc. John F. Tierney has served as a member of the Board of Directors since --------------- December 1993. Mr. Tierney is the Assistant Chief Executive and Finance Director of GPA Group plc, an Irish aircraft leasing concern, and has served GPA Group plc in various such capacity since 1981. See Certain Relationships and Related Transactions. Declan Treacy has served as a member of the Board of Directors since ------------- December 1993. Mr. Tierney is the General Manager - Corporate Finance of GPA Group plc, an Irish aircraft leasing concern, and has served GPA Group plc in various such capacity since 1988. See Certain Relationships and Related Transactions. In February 1993, the Company and its debtor-in -possession lenders amended the terms of D.I.P. financing and in connection therewith the Company and certain of such lenders entered into an Amended and Restated Management Letter Agreement pursuant to which such lenders shall have a right to approve the membership of the Company's Board of Directors. Under the terms of such letter agreement GPA has the right to appoint two members to the Board of Directors, the remaining D.I.P. lenders (except Kawasaki) have the right to appoint five members to the Board of Directors, one member of the Board must be a member of America West management and two members must be independent. The Compensation Committee of the Board of Directors, which met ten times during 1993 reviews all aspects of compensation of executive officers of the Company and makes recommendations on such matters to the full Board of Directors. In addition, the Compensation Committee reviews and approves all compensation and employee benefit plans, the Company's organizational structure and plans for the development of successors to corporate officers and other key members of management. The Audit Committee, which met nine times during 1993, makes recommendations to the Board concerning the selection of outside auditors, reviews the financial statements of the Company and considers such other matters in relation to the internal and external audit of the financial affairs of the Company as may be necessary or appropriate in order to facilitate accurate and timely financial reporting. The Company does not maintain a standing nominating committee or other committee performing similar functions. During the fiscal year ended December 31, 1993, the Board of Directors of the Company met on twenty-nine occasions. During the period in which he served as director, each of the directors attended 75 percent or more of the meetings of the Board of Directors and of the meetings held by committees of the Board on which he served. Item 11. Item 11. Executive Compensation. ------- ---------------------- The table below sets forth information concerning the annual and long- term compensation for services in all capacities to the corporation for the fiscal years ended December 31, 1993, 1992 and 1991, of those persons who were, at December 31, 1993 (i) the chief executive officer and (ii) the other four most highly compensated executive officers of the Corporation (the "Named Officers"): Option Plan Information ----------------------- During the fiscal year ended December 31, 1993, none of the Named Officers exercised any options. All options held by the Named Officers have exercise prices greater than the fair market value of the Common Stock on December 31, 1993. The following table sets forth information with respect to the Company's Restated Nonstatutory Stock Option Plan ("NSOP") and Incentive Stock Option Plan ("ISO") as of the fiscal year ended December 31, 1993 with respect to the Named Officers. Termination of Employment Arrangements -------------------------------------- The Company has made certain Termination of Employment Arrangements in keeping with its practice under its July 26, 1991 Termination of Employment Guidelines, as amended: In connection with the termination of employment of Mr. Michael J. Conway as an officer of the Company, the Company agreed to pay Mr. Conway $503,000 in termination allowances, payable as an initial severance payment in the amount of $304,200, an additional $163,800 in six monthly installments of $27,300 each, and a $35,000 transition expense allowance. The Company also agreed to continue the payment until December 31, 1994, of premiums aggregating about $33,000 on certain life insurance policies owned by Mr. Conway. The foregoing payments were in addition to continuation of medical insurance benefits and certain other fringe benefit arrangements. In connection with the termination of employment of Mr. Don Monteath as an officer of the Company, the Company agreed to pay Mr. Monteath a severance payment of $168,862. This payment was in addition to continuation of medical insurance benefits and certain other fringe benefit arrangements. Director Compensation --------------------- Each non-employee director at December 31, 1993, is compensated as follows: an annual retainer of $25,000 plus $1,000 for each Board meeting attended, $1,000 for each committee meeting attended and reimbursement for expenses incurred in attending the meetings. Directors are also entitled to certain air travel benefits. Other Agreements ---------------- Mr. Franke, Chairman of the Board of Directors, is also the president of the financial services firm, Franke & Co. In order to assist Mr. Franke with certain costs associated with his service as Chairman and Chief Executive Officer, the Company pays Franke & Co. an office overhead allowance of $4,167 per month. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. ------- -------------------------------------------------------------- The following table sets forth information, as of March 15, 1994, concerning the capital stock beneficially owned by each director of the Company, by each of the named executive officers, by the directors and executive officers of the Company as a group, and by each Stockholder known by the Company to be the beneficial owner of more than five percent of the Common Stock or Preferred Stock. Item 13. Item 13. Certain Relationships and Related Transactions. ------- ---------------------------------------------- Transpacific Enterprises, Inc., an affiliate of Ansett Airlines of Australia ("Ansett Airlines"), holds all the Company's Series C Preferred Stock and certain shares of Common Stock. Pursuant to the terms of an agreement between the Company and Transpacific, Transpacific has the right to maintain a 20 percent voting interest in the Company through the purchase of Common Stock from the Company. See Item 12. Security Ownership ------- of Certain Beneficial Owners and Management. The Company presently leases or subleases a total of eleven Boeing 737 aircraft from Ansett Airlines or its affiliates for terms expiring at various dates through August 2003 (unless terminated earlier at Ansett's option). All of these leases were renegotiated in 1992 resulting in reduced rents and extended terms (Ansett may upon 90 days notice to the Company terminate any lease during the extension periods). As of December 31, 1993, the Company was obligated to pay approximately $232 million over the respective terms of these aircraft leases. Ansett Worldwide Aviation U.S.A. ("Ansett"), an affiliate of Transpacific and Ansett, provided the Company with $10 million of the September 1992 D.I.P. financing. In connection with such loan, Ansett received the right to designate one member to the Company's Board of Directors. Ansett was repaid in full in September 1993 and Tibor Sallay, Ansett's designated director, resigned from the Company's Board of Directors concurrent with such repayment. Affiliates of GPA Group, plc ("GPA") have loaned the Company approximately $70 million of D.I.P. financing. Under the terms of the D.I.P. financing documents, GPA has the right to designate two members to the Company's board of directors. John F. Tierney and Declan Treacy currently serve as GPA's designated directors. The Company presently leases or subleases a total of sixteen Airbus A320 aircraft from GPA or its affiliates for terms expiring at various dates through July 2013. As of December 31, 1993, the Company was obligated to pay approximately $1.136 billion over the respective terms of these aircraft leases. Effective January 1, 1994, Mr. A. Maurice Myers left his position as President and Chief Executive Officer of Aloha Airlines, Inc. to join the Company as President and Chief Operating Officer. The Employment Agreement between the Company and Mr. Myers provides an initial two year term at a base salary of $375,000 per year. Mr. Myers also received a $100,000 transition allowance. The Company has agreed to assist Mr. Myers in purchasing a residence in Phoenix, Arizona by a loan of up to $200,000 and to loan to Myers up to $500,000 if he elects to exercise options to acquire stock of Aloha Airlines, Inc. The loans would be nonrecourse to Mr. Myers but would be secured by such residence and stock. Upon confirmation of a plan of reorganization during the term of Mr. Myers' employment, the Company has agreed to seek Bankruptcy Court approval of payment to Mr. Myers of a reorganization success bonus, and grant, pursuant to the plan of reorganization, options to acquire shares of common stock in the reorganized Company. The Company has also agreed to provide to Mr. Myers certain retirement benefits, reduced for vested accrued benefits payable under plans maintained by his former employer. If Mr. Myers' employment with the Company is terminated or his responsibilities are materially altered following a change in control, he is entitled to receive a severance payment equal to 200% of his base salary and, for a period of 12 months, medical and life insurance coverages as provided immediately prior to such termination. Mr. Myers is entitled to participate in any incentive plans or other fringe benefits provided by the Company to other key employees. The Board of Directors has discussed and continues to discuss change of control severance arrangements and a reorganization success bonus with Mr. William A. Franke. It also has discussed and continues to discuss reorganization success bonuses for other key employees of the Company. It is the policy of the Company that transactions with affiliates be on terms no less favorable to the Company than those obtainable from unaffiliated third parties. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. ------- --------------------------------------------------------------- (a) Financial Statements. -------------------- (1) Report of KPMG Peat Marwick (2) Financial Statements and Notes to Financial Statements of the Company, including Balance Sheets as of December 31, 1993 and 1992 and related Statements of Operations, Cash Flows and Stockholders' Equity (Deficiency) for each of the years in the three-year period ended December 31, 1993 (b) Financial Statement Schedules. ----------------------------- (1) Schedule V. Property, Plant and Equipment (2) Schedule VI. Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment (3) Schedule VIII. Valuation and Qualifying Accounts (4) Schedule X. Supplementary Income Statement Information Schedules not listed above and columns within certain Schedules have been omitted because of the absence of conditions under which they are required or because the required material information is included in the Financial Statements or Notes to the Financial Statements included herein. (c) Exhibits -------- Exhibit Number Description and Method of Filing ------ -------------------------------- 3-A(1) Restated Certificate of Incorporation of the Company, dated May 19, 1988 - Incorporated by reference to Exhibit 3-A to the Company's Schedule 13E-4 Issuer Tender Offer Statement (SEC File No. 5-34444 ("13E-4") 3-A(2) Amendment to Restated Certificate of Incorporation of the Company - Incorporated by reference to Exhibit 3-A(2) to the Company's Report on Form 10-K for the year ended December 31, 1989 (the "1989 10-K") 3-B Restated Bylaws of the Company, as amended through December 31, 1993 - Filed herewith -------------- 4-A(1) Certificate of Designation, Voting Powers, Preferences and Rights of the Series of Preferred Stock of the Company, Designated Series B Convertible Preferred Stock, dated March 15, 1984 - Incorporated by reference to Exhibit 3-D of the Company's Form S-1 Registration Statement (SEC File No. 2-89212) 4-B(1) Certificate of Designation, Voting Powers, Preferences and Rights of the Series of Preferred Stock of the Company Designated Series C 9.75% Convertible Preferred Stock, dated October 8, 1985 - Incorporated by reference to Exhibit 3-E(1) of the Company's Form S-1 Registration Statement (SEC File No. 33-3800) ("S-1 No. 33-3800") 4-B(2) Series C 9.75% Convertible Preferred Stock Certificate No. 1 for 73,099 Shares issued to Transpacific Enterprises, Inc., dated October 9, 1985 - Incorporated by reference to Exhibit 3-E(2) to S-1 No. 33-3800 4-C Form of Certificate of Designation, Voting Powers, Preferences and Rights of the Series of Preferred Stock of the Company's Designated Series D Participating Preferred Stock, dated July 23, 1986 - Incorporated by reference to Exhibit 1 of the Company's Form 8-A Registration Statement (SEC File No. 0-12337) ("Form 8-A No. 0-12337") 4-D Indenture dated as of August 1, 1985, between the Company and First Interstate Bank of Arizona, N.A., as Trustee, including form of 7 3/4% Convertible Subordinated Debenture due 2010 - Incorporated by reference to Exhibit 4 to the Company's Form S-1 Registration Statement (SEC File No. 2-99206) Exhibit Number Description and Method of Filing ------ -------------------------------- 4-E Form of Indenture dated as of March 15, 1986, between the Company and First Interstate Bank of Arizona, N.A., as Trustee, including form of 7-1/2% Convertible Subordinated Debenture due 2011 - Incorporated by reference to Exhibit 4-B to S-1 No. 33-3800 4-F Form of Indenture, dated as of December 15, 1988, between the Company and First Interstate Bank of Arizona, N.A., as Trustee, including form of 11 1/2% Convertible Subordinated Debenture due 2009 - Incorporated by reference to Exhibit T3C to the Company's Form T-3 Application for Qualification of Indenture Under Trust Indenture Act of 1939 (SEC File No. 22-19024) 4-G Amended and Restated Rights Agreement, effective as of July 23, 1986 and dated as of June 17, 1988, between the Company and First Interstate Bank of Arizona, N.A., as Rights Agent - Incorporated by reference to Exhibit 2 to Amendment No. 1 to Form 8-A filed on Form 8 (SEC File No. 0-12337) 10-A(1)* America West Airlines, Inc. Stock Purchase Plan, as amended through February 26, 1991 - Incorporated by reference to Exhibit 10-A(1) to the Company's Report on Form 10-K for the year ended December 31, 1990 (the "1990 10-K") 10-A(2)* America West Airlines, Inc. Stock Purchase Plan for California and Alberta Resident Employees, as amended through February 26, 1991 - Incorporated by reference to Exhibit 10-A(2) to the 1990 Form 10-K 10-A(3)* America West Airlines, Inc. Incentive Stock Option Plan, as amended through February 27, 1990 - Incorporated by reference to Exhibit 10-A(3) to the 1989 Form 10-K 10-A(4)* Restated Nonstatutory Stock Option Plan, as of February 27, 1990 - Incorporated by reference to Exhibit 10-A(4) to the 1989 Form 10-K 10-A(5)* Non-Employee Directors Stock Option Plan, as of June 27, 1989 - Incorporated by reference to Exhibit 10-A(5) to the 1989 Form 10-K 10-A(6)* Restricted Stock Plan - Incorporated by reference to Exhibit 10-A(6) to the 1989 Form 10-K 10-A(7)* 1991 Incentive Stock Option Plan - Incorporated by reference to Exhibit 10-A(7) to the 1990 Form 10-K 10-C(1)* Stock Purchase and Sale Agreement dated October 9, 1985, between the Company and Transpacific Enterprises, Inc. - Incorporated by reference to Exhibit 10-H to S-1 No. 33-3800 Exhibit Number Description and Method of Filing ------- -------------------------------- 10-C(2)* Stock Purchase and Sale Agreement dated July 31, 1987, between the Company and Transpacific Enterprises, Inc. - Incorporated by reference to Exhibit 10-E(2) to the Company's Annual Report on Form 10-K for the year ended December 31, 1987 10-D(1) Second Restated and Amended Letter of Credit Reimbursement Agreement, dated as of April 27, 1990 among the Company, the Industrial Bank of Japan, Participating Banks and Bank of America National Trust and Savings Association - Incorporated by reference to Exhibit 10-D(3) to the 1990 Form 10-K 10-D(2) Third Amendment to Second Restated and Amended Letter of Credit Reimbursement Agreement - Incorporated by reference to Exhibit 10-D(4) to the 1990 Form 10-K 10-E Official Statement dated August 11, 1986 for the $54,000,000 Variable Rate Airport Facility Revenue Bonds - Incorporated by reference to Exhibit 10.e to the Company's Report on Form 10-Q for the quarter ended September 30, 1986 10-F(1) Trust Indenture dated July 1, 1989 between The Industrial Development Authority of the City of Phoenix, Arizona and First Interstate Bank of Arizona, N.A. - Incorporated by Reference to Exhibit 10-D(8) to 1989 Form 10-K 10-F(2) Airport Use Agreement dated as of July 1, 1989 among the City of Phoenix, The Industrial Development Authority of the City of Phoenix, Arizona and the Company - Incorporated by reference to Exhibit 10-D(9) to 1989 Form 10-K 10-F(3) First Amendment dated as of August 1, 1990 to Airport Use Agreement dated as of July 1, 1989 among the City of Phoenix and the Industrial Development Authority of the City of Phoenix, Arizona and the Company - Incorporated by reference to Exhibit 10-(D)(9) to the Company's Report on Form 10-Q for the quarter ended September 30, 1990 (the "9/30/90 10-Q") 10-G(1) Revolving Loan Agreement dated as of April 17, 1990, by and among the Company, the Bank signatories thereto, and Bank of America National Trust and Savings Association, as Agent for the Banks (the "Revolving Loan Agreement") - Incorporated by reference to Exhibit 10-1 to Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990 10-G(2) First Amendment dated as of April 17, 1990 to Revolving Loan Agreement - Incorporated by reference to Exhibit 10-(D)(10) to the 9/30/90 10-Q Exhibit Number Description and Method of Filing ------- -------------------------------- 10-G(3) Second Amendment dated as of September 28, 1990 to Revolving Loan Agreement - Incorporated by reference to Exhibit 10-(D)(11) to the 9/30/90 10-Q 10-G(4) Third Amendment dated as of January 14, 1991 to Revolving Loan Agreement - Incorporated by reference to Exhibit 10-D(13) to the 1990 Form 10-K 10-H Airbus A320 Purchase Agreement (including exhibits thereto), dated as of September 28, 1990 between AVSA, S.A.R.L. ("AVSA") and the Company, together with Letter Agreement Nos. 1-10, inclusive - Incorporated by reference to Exhibit 10-(D)(1) to the 9/30/90 10-Q 10-I Loan Agreement, dated as of September 28, 1990, among the Company, AVSA and AVSA, as agent - Incorporated by reference to Exhibit 10-(D)(2) to the 9/30/90 10-Q 10-J V2500 Support Contract Between the Company and IAE International Aero Engines AG ("IAE"), dated as of September 28, 1990, together with Side Letters Nos. 1-4, inclusive - Incorporated by reference to Exhibit 10-(D)(3) to the 9/30/90 10-Q 10-K Spares Credit Agreement, dated as of September 28, 1990, Between the Company and IAE - Incorporated by reference to Exhibit 10-(D)(4) to the 9/30/90 10-Q 10-L Master Credit Modification Agreement, dated as of October 1, 1992, among the Company, IAE International Aero Engines AG, Intlaero (Phoenix A320) Inc., Intlaero (Phoenix B737) Inc., CAE Electronics Ltd., and Hughes Rediffusion Simulation Limited - Incorporated by reference to Exhibit 10-L to the Company's Report on Form 10-K for the year ended December 31, 1992 (the "1992 10-K") 10-M(1) Credit Agreement, dated as of September 28, 1990 Between the Company and IAE - Incorporated by reference to Exhibit 10-(D)(5) to the 9/30/90 10-Q 10-M(2) Amendment No. 1 to Credit Agreement, dated March 1, 1991 - Incorporated by reference to Exhibit 10-M(2) to the Company's 1992 10-K 10-M(3) Amendment No. 2 to Credit Agreement, dated May 15, 1991 - Incorporated by reference to Exhibit 10-M(3) to the Company's 1992 10-K 10-M(4) Amendment No. 3 to Credit Agreement, dated October 1, 1992 - Incorporated by reference to Exhibit 10-M(4) to the Company's 1992 10-K Exhibit Number Description and Method of Filing ------- -------------------------------- 10-N(1) Form of Third Amended and Restated Credit Agreement dated as of September 30, 1993, among the Company, various lenders, and BT Commercial Corp. as Administrative Agent (without exhibits) - Filed herewith -------------- 10-N(2) Form of Amended and Restated Management Letter Agreement, dated as of September 30, 1993 from the Company to the Lenders - Filed herewith -------------- 10-N(3) Form of Amendment to Amended and Restated Management Letter Agreement; Consent to Amendment of Bylaws dated February 8, 1994 from the Company to the Lenders - Filed herewith -------------- 10-0(1) Cash Management Agreement, dated September 28, 1991, among the Company, BT and First Interstate of Arizona, N.A. - Incorporated by reference to Exhibit 10-D(21) to the 1991 10-K 10-O(2) First Amendment to Cash Management Agreement, dated December 1, 1991, among the Company, BT and First Interstate of Arizona, N.A. - Incorporated by reference to Exhibit 10-D(22) to the 1991 10-K 10-O(3) Second Amendment to Cash Management Agreement, dated September 1, 1992, among the Company, BT, and First Interstate Bank of Arizona, N.A. - Incorporated by reference to Exhibit 10-O(3) to the Company's 1992 10-K 10-P Loan Restructuring Agreement, dated as of December 1, 1991 between the Company and Kawasaki - Incorporated by reference to Exhibit 10-D(23) to the 1991 10-K 10-Q Restructuring Agreement, dated as of December 1, 1991 between the Company and Kawasaki - Incorporated by reference to Exhibit 10- D(24) to the 1991 10-K 10-R(1) A320 Put Agreement, dated as of December 1, 1991 between the Company and Kawasaki - Incorporated by reference to Exhibit 10- D(25) to the 1991 10-K 10-R(2) First Amendment to A320 Put Agreement, dated September 1, 1992 - Incorporated by reference to Exhibit 10-R(2) to the Company's 1992 10-K 10-S(1) A320 Put Agreement, dated as of June 25, 1991 between the Company and GPA Group plc - Incorporated by reference to Exhibit 10-D(26) to the 1991 10-K 10-S(2) First Amendment to Put Agreement, dated as of September 1, 1992 - Incorporated by reference to Exhibit 10-S(2) to the Company's 1992 10-K Exhibit Number Description and Method of Filing ------- -------------------------------- 10-T Restructuring Agreement, dated as of June 25, 1991 among GPA Group, plc, GPA Leasing USA I, Inc., GPA Leasing USA Sub I, Inc. and the Company - Incorporated by reference to Exhibit 10-D(27) to the 1991 10-K 10-U Form of Interim Procedures Agreement dated as of March 11, 1994 between America West Airlines and AmWest Partners, L.P. - Filed herewith -------------- 10-V For of Investment Agreement dated as of March 11, 1994 between America West Airlines and AmWest Partners, L.P. - Filed herewith -------------- 11 Statement re: computation of net income (loss) per common share - Filed herewith -------------- 12 Statement re: computation of ratio of earnings to fixed charges - Filed herewith -------------- 23 Consent of KPMG Peat Marwick (regarding Form S-8 Registration Statements) - Filed herewith -------------- 24 Powers of Attorney - See Signature Page - ---------------- * Indicates management contract or compensatory plan or arrangement required to be filed as an exhibit to this form. (d) Reports on Form 8-K ------------------- 1. The Company filed with the Securities and Exchange Commission a Form 8-K dated October 6, 1993 reporting information concerning the extension of the D.I.P Financing to June 30, 1994 and the resignation of board members. 2. On October 26, 1993, the Company filed with the Securities and Exchange Commission a Form 8-K reporting information that the pilots voted in favor of being represented by the Air Line Pilots Associations (ALPA). 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. AMERICA WEST AIRLINES, INC. Date: March 30, 1994 By /s/ A. E. Frei --------------------------------------- Alphonse E. Frei Senior Vice President - Finance POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints William A. Franke, A. Maurice Myers and Alphonse E. Frei, and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Form 10-K Annual Report, and to file the same, with all exhibits thereto, and other documents in connection therewith with the Securities and Exchange Commission, 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 and to all intents and purposes as he might or could do in person hereby ratifying and confirming all that said attorneys-in-fact and agents, 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 Company and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ William A. Franke Chairman of the Board of March 30, 1994 --------------------------- Director and Chief William A. Franke Executive Officer /s/ A. Maurice Myers President, Chief March 30, 1994 --------------------------- Operating Officer and A. Maurice Myers Director Signature Title Date --------- ----- ---- /s/ A. E. Frei Senior Vice President-- March 30, 1994 --------------------------- Finance (Principal Alphonse E. Frei Financial and Accounting Officer) /s/ O. Mark De Michele Director March 30, 1994 --------------------------- O. Mark De Michele /s/ Frederick W. Bradley Director March 30, 1994 --------------------------- Frederick W. Bradley /s/ Samuel L. Eichenfield Director March 30, 1994 --------------------------- Samuel L. Eichenfield /s/ Richard C. Kraemer Director March 30, 1994 --------------------------- Richard C. Kraemer /s/ James T. McMillan Director March 30, 1994 --------------------------- James T. McMillan /s/ John R. Norton Director March 30, 1994 --------------------------- John R. Norton /s/ John F. Tierney Director March 30, 1994 --------------------------- John F. Tierney /s/ Declan Treacy Director March 30, 1994 --------------------------- Declan Treacy

311871_1993.txt

311871_1993

1993

311871

Item 1. Business INTRODUCTION AND DEVELOPMENTS IN 1993 Pope & Talbot is engaged principally in the wood products and pulp and paper businesses. The Company's wood products business involves the manufacture and sale of standardized and specialty lumber and wood chips. In its pulp and paper business, the Company manufactures and sells a full line of private label consumer tissue and disposable diaper products, bleached kraft pulp for newsprint and writing paper, and brokers wood chips. During 1993, wood products accounted for approximately 48 percent of the Company's revenues, consumer tissue accounted for 17 percent, disposable diapers 27 percent and bleached kraft pulp and brokered wood chips 8 percent. The Company, a Delaware corporation, was originally incorporated as a California corporation in 1940. It is the successor to a partnership formed in San Francisco, California in 1849 that acquired its first timberlands and opened a lumber mill in the Seattle, Washington area in 1853. Subsequently, the Company developed a lumber business based on timberland and facilities in the U.S. Pacific Northwest, British Columbia, Canada, and the Black Hills region of South Dakota and Wyoming. Since the mid-1980s, the Company has reduced its dependency on timber from the Pacific Northwest, where environmental concerns about the preservation of old-growth forests have sharply restricted the availability and increased the cost of public timber. At the same time, the Company has increased its operations in regions of more stable timber supplies, particularly in British Columbia and the Black Hills region of South Dakota and Wyoming. In 1985, the Company distributed its timber and land development properties in the State of Washington to its stockholders through interests in a newly formed master limited partnership. In 1990, the Company sold its Oregon sawmill, and the Company has since sold its remaining Oregon timberlands. In 1992, the Company acquired a 225 million board feet capacity sawmill and related timber cutting rights in Castlegar, British Columbia. The Company currently operates six sawmills with an estimated annual capacity of 785 million board feet, of which approximately 80% is located in British Columbia and the Black Hills. In order to expand and broaden its sources of revenue, the Company acquired its pulp, consumer tissue and disposable diaper businesses in the late 1970s and 1980s. The Halsey, Oregon pulp mill produces bleached kraft pulp which is sold in the open market and to newsprint and writing paper manufacturers in the Pacific Northwest. The Company's private label tissue business manufactures towels, napkins, bathroom tissue and facial tissue from recycled paper at two mills in the U.S. Disposable diapers are produced by the Company at four mills in the U.S. The Company sells its tissue and diaper products under private labels to supermarkets, drugstores, mass merchandisers and food and drug distribution companies. In 1992, the Company commenced a program to reduce costs and improve operating efficiencies in these businesses, resulting in the consolidation of one tissue mill and one diaper plant. The Company is also presently in the process of making significant product and cost improvements to its pulp mill. The businesses in which the Company is engaged are extremely competitive, and a number of the Company's competitors are substantially larger than the Company with correspondingly greater resources. In particular, competition in the tissue products and disposable diaper markets is extremely strong, both in terms of price and product innovation. See "Pulp and Paper Products Business - Paper Products." Environmental regulations to which the Company is subject require the Company from time to time to incur significant expenditures. In addition, as discussed herein, environmental concerns have in the past materially affected the availability and cost of raw materials used in the Company's business. See "Wood Products Business." WOOD PRODUCTS BUSINESS The Company's wood products business involves the manufacture and sale of standardized and specialty lumber and wood chips. The Company's principal wood product categories and the sales generated by each over the past three years are set forth in the following table: In 1993, lumber revenues increased $80.3 million, or 45 percent, compared with 1992. These increased revenues in 1993 were due mainly to higher lumber sales prices, but also to greater lumber sales volumes due to operating the Castlegar, British Columbia sawmill throughout 1993. In 1992, lumber revenues increased $56.2 million, or 47 percent, compared with 1991. These increased revenues were due to higher lumber sales volume, primarily from the second quarter acquisition of the Castlegar, British Columbia sawmill, combined with higher lumber sales prices. The Company's lumber products consist principally of boards and dimension lumber, some of which are specialty, value-added items, such as stress-rated lumber. Wood chips and other similar materials are obtained as a by-product of the Company's lumber operations. Wood chips are also obtained from direct chipping of whole logs. The principal sources of raw material for the Company's wood products operations are timber obtained through long-term cutting licenses on public lands, logs purchased in open log markets, timber offered for sale via competitive bidding by federal and state agencies and private sources, and timber purchased under long-term contracts to cut timber on private and public lands. Approximately 80% of the Company's current lumber capacity is located in regions of relatively stable timber supply, namely Canada and the Black Hills region of South Dakota and Wyoming. In Canada, timber requirements are obtained primarily from the Provincial Government of British Columbia under long-term timber harvesting licenses which allow the Company to remove timber from defined areas annually on a sustained yield basis. Approximately 15 percent of the Company's Canadian log requirements are satisfied through open market log purchases. In the Black Hills, the Company obtains its timber from various public and private sources under long-term timber harvesting contracts in addition to buying logs on open markets. Under these licenses and contracts, prices are subject to periodic adjustment based upon formulas set forth therein. Additionally, the Provincial Government of British Columbia has the authority to modify prices and harvest volumes at any time. In the Northwest, the Company obtains its timber primarily via competitive bidding on timber offered by federal and state agencies and private sources. Decreased availability of federal timber caused primarily by pressures from environmental groups to curtail harvests from public lands, thereby protecting old-growth forests, combined with strong export demand for logs, has resulted in reduced wood supplies in Oregon and Washington, particularly affecting the Company's Port Gamble sawmill. The Northwest's highly competitive log supply environment caused the Company to reduce production at its Port Gamble sawmill to 74% of capacity in 1993. Although no assurances can be given, the Company believes that purchases from public agencies and private sources, in addition to its existing long-term cutting rights, will be adequate to sustain current lumber production levels at the Company's sawmills, with the exception of Port Gamble which will continue to operate based upon log availability. Marketing and Distribution. The Company's lumber products are sold primarily to wholesalers. Wood chips produced by the Company's sawmills are sold to manufacturers of pulp and paper in the U.S. and Canada. Sales of logs are made to other domestic forest products companies and to international trading companies. Marketing of the Company's wood products is centralized in its Portland, Oregon offices. The Company does not have distribution facilities at the wholesale or retail level. The Company sold wood products to numerous customers during 1993, the ten largest of which accounted for approximately 32% of total wood products sales. No wood products customer accounted for more than 10% of the Company's revenues in 1993. Backlog. The Company maintains a minimal finished goods inventory of wood products. At December 31, 1993, orders were approximately $11.2 million, compared with approximately $8.9 million at December 31, 1992. This was an average order file for the Company and generally would be shipped in two weeks to one month. The increase from 1992 to 1993 reflects increased lumber sales prices. Competition. The wood products industry is highly competitive, with a large number of companies producing products that are reasonably standardized. There are numerous competitors of the Company that are of comparable size or larger, none of which is believed to be dominant. With the 1992 Castlegar sawmill acquisition, the Company believes it is one of the larger lumber producers in North America. The principal means of competition in the Company's wood products business are pricing and an ability to satisfy customer demands for various types and grades of lumber and other finished products. For further information regarding amounts of revenue, operating profit and loss and identifiable assets attributable to the wood products industry segment, see Note 11 of "Notes to Consolidated Financial Statements" in the Company's 1993 Annual Report to Shareholders. PULP AND PAPER PRODUCTS BUSINESS The Company's principal pulp and paper products categories and the sales generated by each over the last three years are set forth in the following table: Pulp and paper revenues were essentially unchanged from 1992 to 1993 as increased disposable diaper revenues were offset by lower tissue and pulp revenues. The improved diaper revenues resulted from a 21 percent increase in sales volume. Tissue and pulp volumes were off approximately 8 percent and 28 percent, respectively, from 1992 to 1993, while tissue prices dropped 1 percent and pulp prices fell 12 percent during this same period. Pulp and paper revenues decreased $19.1 million, or 5 percent, from 1991 to 1992, due mainly to tissue and pulp volume and price reductions. From 1991 to 1992, tissue and pulp volumes fell approximately 12 percent and 8 percent, respectively, while prices dropped 6 percent for tissue and 9 percent for pulp. Diaper improvements from 1991 to 1992 only partially offset the tissue and pulp reductions as diaper volumes and average prices increased 10 percent and 6 percent, respectively. 1. PAPER PRODUCTS The Company produces a full line of private label consumer tissue products including towels, napkins, bathroom tissue, and facial tissue. The Company also produces disposable diapers. All of these products are sold under private and controlled labels. The raw material for the Company's tissue mills is wastepaper purchased from wastepaper dealers located in the upper Midwest, mid- Atlantic and, to a lesser extent, on the East Coast. The principal raw material for disposable diapers is fluff pulp, which is produced by pulp and paper manufacturers throughout the United States. The Company believes that there will continue to be an adequate supply of wastepaper and fluff pulp in the foreseeable future. Marketing and Distribution. The Company utilizes its own sales force and some retail consumer products brokers to sell its products to supermarkets, drugstores, mass merchandisers and food and drug distribution companies. The Company's products enjoy national distribution; however, the majority are sold east of the Rocky Mountains. Sales to the Company's ten largest paper products customers represented 54 percent of tissue products and diaper sales in 1993. No single paper products customer accounted for 10 percent or more of total Company revenues in 1993. Backlog. The Company carries a minimal finished goods inventory in tissue products and disposable diapers. At the end of 1993 the order file was approximately $13.3 million compared to a backlog of approximately $7.9 million at December 31, 1992. The higher order backlog at year-end 1993 than year-end 1992 relates to timing of order receipts and is not indicative of a business trend. This backlog is generally shipped in less than one month. Competition. The tissue market is extremely competitive, with approximately 10 major producers. Of these, James River Corporation, Scott Paper Company, Procter & Gamble Corporation and Fort Howard Paper Company are dominant and account for approximately 64 percent of the market. Within the tissue market, the Company estimates that the private label tissue segment accounts for approximately 9 percent to 22 percent of the total, depending on the product. In the tissue business, continued low industry operating rates resulting from industry capacity increases in recent years which have exceeded demand growth, coupled with aggressive pricing by tissue producers, has resulted in an extremely competitive tissue pricing environment. The Company's tissue mills operated at 97 percent of capacity in 1993. Overall, prices for the Company's tissue have fallen an average 13 percent from 1989 when tissue prices first began to decline. This 13 percent price reduction includes decreases of 6 percent in 1992 and 1 percent in 1993. Of the disposable diaper market, the Company estimates that approximately 82 percent is in branded products, with the remaining 18 percent relating to private label products. There are four major producers in the disposable diaper business. Procter & Gamble and Kimberly- Clark are dominant with a combined 76 percent of the market, all of which is in branded products. Paragon Trade Brands, Inc. is the largest producer in the private label market segment, followed by the Company with approximately 4 percent of the disposable diaper market. National branded manufacturers have introduced numerous and frequent product innovations that have resulted in major improvements in infant disposable diaper absorbency, leakage prevention and fit. The national branded manufacturers have substantially larger research and development budgets than the Company and are able to develop product innovations more rapidly than the Company and may thereby gain market share at the Company's expense. While in recent years the Company has been able to introduce product enhancements comparable to those introduced by the national branded manufacturers, there can be no assurance that the Company will be able to continue to introduce comparable product innovations on a profitable basis or that the Company will continue to be able to introduce such product innovations at the pace required to remain competitive with the national branded manufacturers. The Company believes that its national distribution capabilities, its full product line and its reputation as a private label supplier enhance its market efforts. 2. PULP PRODUCTS The Company owns a pulp mill and supporting facilities at Halsey, Oregon. This mill produces bleached kraft pulp which is sold in various forms in the open market and to newsprint and writing paper manufacturers in the Pacific Northwest. The mill also produces a flash dried pulp which is sold in the open market. In conjunction with the fiber acquisition program for the pulp mill, the Company brokers pulp chips for sale primarily into the export market. The total annual capacity of the mill is 180,000 air dry metric tons; 109,000 metric tons were produced in 1993 and 152,000 metric tons were produced in 1992. The Company's pulp business was affected in 1992 and to a greater extent in 1993 by high wood chip costs, weak demand, and declining pulp prices. During 1992 construction began at Halsey on a $24 million oxygen delignification project to reduce both the use of chlorine in the bleaching process and dioxin discharges. This multi-year project, which was necessary to comply with an agreement entered into with the Oregon Department of Environmental Quality on meeting target emission levels, was completed in late 1993. Since 1985 the Company has had a pulp supply contract with James River Corporation ("James River") to supply pulp in slush form to a tissue facility owned by James River adjacent to the Company's pulp mill. James River began production of its own recycled pulp at Halsey in 1992, and correspondingly reduced its consumption of pulp from the Company's pulp mill in 1992 and completely phased out of its Halsey pulp consumption in 1993. Approximately 10,000 metric tons were sold to James River in early 1993 compared to 31,000 in 1992. As a result of depressed world pulp prices, selective downtime was taken in lieu of selling pulp in the open market to replace the lost James River tonnage. Because of the lost James River volume and the related decision to take selective downtime, the Halsey pulp mill operated at 60 percent of capacity in 1993. Weyerhaeuser Company ("Weyerhaeuser") presently owns a pulp mill, which it has announced it intends to upgrade and expand, located adjacent to the North Pacific Paper Company ("Norpac") newspaper manufacturing facility in Longview, Washington. Weyerhaeuser is a part owner of Norpac. The Company believes that completion of the upgrade and expansion project by Weyerhaeuser at its pulp mill will occur in 1995 or later. At that time, there is a significant possibility that Norpac will begin to satisfy a portion of its pulp needs from the Weyerhaeuser mill, and at the same time substantially reduce the quantity of pulp it purchases from the Company at the Halsey mill. In 1993, Norpac purchased approximately 46,000 metric tons of pulp from the Company. In order to provide additional sales flexibility and attempt to improve margins through higher value products, the Company initiated mill modifications in 1993 totaling $41 million, which will be completed in early 1994 to improve pulp quality and expand pulp drying capabilities. These modifications are in addition to the $24 million oxygen delignification project. These mill improvements will allow the Company to expand its pulp product offerings and to dry its total pulp production, thus providing greater access to new pulp markets within and outside the Pacific Northwest, which has historically been the Company's primary pulp market region. Given these mill improvements, management does not anticipate that elimination of the James River sales volume will have a material adverse effect on the Company's pulp business. The pulp mill modifications mentioned previously made it possible for the Company to enter into a significant pulp supply agreement in the third quarter of 1993. Under this agreement, late in the fourth quarter of 1993 the Company began supplying pulp to a writing grade paper mill which reopened in January 1994. The paper mill was recently purchased from its former owners by a group of private investors. All output from the paper mill will be sold to one customer. It has been anticipated that ultimately the paper mill would purchase pulp from the Company in significant quantities, depending on sales by the paper mill to its customer. However, to date pulp purchases have not been at this level. In the event that the paper mill's sales to its customer are adversely impacted for any reason, sales of the Company's pulp may be adversely impacted. It is also anticipated that a portion of the pulp sold to the paper mill will be produced from sawdust and hardwood chips, which have historically been less expensive than softwood chips, which has been the primary raw material for the pulp mill. Pricing for this pulp will be computed using a formula based on prices for white paper. Based on prices in effect for white paper at the end of 1993, the price that pulp would be sold under this agreement would be 8 percent higher than the average pulp price the Company obtained for its pulp at the end of 1993. Substantially all of the Company's wood chip and sawdust requirements for the Halsey pulp mill are satisfied through purchases by the Company from third parties. The Company has long-term chip supply contracts with sawmills in the Pacific Northwest. Environmental concerns over timber harvests, which have caused high log costs for the Company's Port Gamble sawmill, have also caused higher chip costs and reduced chip availability from historic sources at the Halsey pulp mill over the last three years. In order to maintain an adequate supply of wood fiber for the mill, the Company has expanded its geographic base from which it obtains the softwood chips normally used as the primary raw material for the pulp mill. The Company has also expanded the capability of using sawdust and hardwood chips, which historically have been less expensive than softwood chips, as raw materials for a portion of the production. In order to maintain an adequate supply of chips for the anticipated 60 percent of the pulp mill's production which will remain based on softwood chips, the Company will continue to use an expanded geographic base to obtain chips, adding to their cost. Unless environmental restrictions on timber harvests are relaxed, chip prices likely will remain high, and sawdust and hardwood chip prices may also increase. The Company believes that these third-party chip purchases, in addition to its whole-log chipping capabilities, will be adequate for the Halsey pulp mill in the foreseeable future. Marketing and Distribution. The Company utilizes its own sales force and pulp brokers to sell its pulp products. Substantially all of the Company's pulp products are sold in the Northwest. In 1993, sales to Norpac represented 46 percent of the Company's pulp revenues, sales to James River represented 7 percent of the Company's pulp revenues, and the remaining eight largest customers accounted for an additional 37 percent of pulp revenues. No single pulp customer accounted for 10 percent or more of total Company revenues in 1993. Backlog. The Company's pulp customers typically enter into one- to three-year contracts and provide the Company with annual estimates of their requirements. More definite orders are placed by these customers on a quarterly basis. As of December 31, 1993, the Company's backlog of orders for pulp products for delivery during the first quarter of 1994 was $19 million, compared to a backlog of approximately $15 million at December 31, 1992. This increase was due primarily to scheduled pulp sales volume resulting from the third quarter 1993 pulp supply agreement mentioned previously. Competition. The pulp industry is highly competitive, with a substantial number of competitors having extensive financial resources, manufacturing expertise and sales and distribution organizations, most of which are larger than the Company, but none of which is believed to be dominant. The principal methods of competition in the pulp market are price, quality, volume, reliability of supply and customer service. For further information regarding amounts of revenue, operating profit and loss and identifiable assets attributable to the pulp and paper products industry segment, see Note 11 of "Notes to Consolidated Financial Statements" in the Company's 1993 Annual Report to Shareholders. ENVIRONMENTAL MATTERS The Company's wood products and pulp and paper businesses are subject to federal, state and Canadian pollution control regulations that have required, and are expected to continue to require, significant expenditures. During the fiscal year ended December 31, 1993, the Company's capital expenditures for environmental control amounted to approximately $23.4 million. Additionally, expenditures for such purposes are expected to be $2 million and $4 million for the years ending December 31, 1994 and 1995, respectively. The expenditures in 1993 represent primarily the costs necessary to complete the oxygen delignification project at the Halsey, Oregon pulp mill. $16 million of the oxygen delignification project was financed by a note payable to the State of Oregon under the State's Small Scale Energy Loan Program (SELP). In response to environmental concerns in Western Oregon and Western Washington, specifically the preservation of old-growth forests, substantial amounts of federal timberlands have been set aside as wilderness areas. This has affected and may continue to affect the amount and cost of timber obtainable from public agencies in this region. Currently, the Company's exposure in this region is the Port Gamble, Washington sawmill and the Halsey, Oregon pulp mill. The carrying value of the Port Gamble sawmill was written down in 1990 as a result of its inability to obtain adequate timber supply; the sawmill now operates based upon log availability. The Halsey pulp mill is also affected by the decrease in timber availability, since its primary raw materials, wood chips and to a greater extent beginning in 1994, sawdust and hardwood chips, are by-products of the lumber manufacturing process. It is management's opinion that, based on existing wood chip and sawdust availability both within the Willamette Valley region of Oregon and from other sources discussed previously, wood chip and sawdust resources will be adequate for the Company's requirements at the Halsey pulp mill in the foreseeable future. It is also management's opinion that the reduced availability of public timber in Western Washington will have little, if any, additional impact on the Company's Port Gamble operations. In 1992, the Company was contacted by the local governmental owner of a vacant industrial site in Oregon on which Pope & Talbot previously conducted business. The owner informed the Company that the site has been identified as one containing creosote and coal tar, and that it plans to undertake a voluntary clean-up effort of the site. The owner has requested that the Company participate in the cost of the cleanup. The Company, in conjunction with an environmental consultant, performed in 1993 a preliminary assessment of soil contamination on the site. The results of this study indicate there is some soil contamination present from creosote and coal tar as well as pollutants from other sources, and that the responsibility for the contamination is not clear. The estimated cost of cleaning up this site and the Company's liability, if any, has yet to be determined. EMPLOYEES The Company currently employs approximately 3,100 employees of whom 2,600 are paid hourly and a majority of which are members of various labor unions. Approximately 47 percent of the Company's employees are associated with the Company's wood products business, 51 percent are associated with the Company's pulp and paper business and 2 percent are corporate management and administration personnel. FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES The Company's foreign manufacturing operations consist of three lumber mills located in Canada. The Company's primary exports are disposable diapers sold to Canada and brokered wood chips sold to Japan. The Company's export sales from the United States were $29.1 million for 1993, $19.3 million for 1992 and $19.4 million for 1991. Of the 1993 export sales, 56 percent were to Canada and 32 percent were to Japan. Financial information regarding the Company's domestic and foreign operations is included in Note 11 of "Notes to Consolidated Financial State-ments" on page 32 of the Company's 1993 Annual Report to Shareholders. Item 2. Item 2. Properties WOOD PRODUCTS PROPERTIES 1. Mills and Plants The following tabulation briefly states the location, character, capacity and 1993 production of the Company's primary wood products manufacturing facilities: ________________________________________________________________________ (1) Based on normal industry practice of operating two shifts, five days per week for lumber mills except for the Newcastle, Wyoming mill which is based upon one shift, five days per week. Assumes two shifts, five days per week for the alder chip facility. (2) Wood chips are also produced as a result of the operation of the Company's lumber mills. It is estimated that the aggregate annual capacity for such production is 440,000 bone dry units. In 1993, 396,000 bone dry units were produced. The Company believes that its wood products manufacturing facilities are adequate and suitable for current operations. Nevertheless, the Company is committed to continually improving its manufacturing facilities as evidenced by the Castlegar lumber mill modernization completed in 1993. The Company owns all of its wood products manufacturing facilities except that it leases the ground on which the Port Gamble facilities are located from Pope Resources, A Delaware Limited Partnership, pursuant to a 20-year lease entered into in December 1985. 2. Timber and Timberland Restructuring activities in 1992 resulted in the sale of approximately 21,800 acres of primarily immature timber in Oregon. The Company no longer owns any timberland in the Pacific Northwest. PULP AND PAPER PROPERTIES 1. Tissue and Diaper Mills The following table briefly states the location, character, capacity and 1993 production of the Company's tissue and diaper products manufacturing facilities: _____________________________________________________________________ (1) Based on normal industry practice of operating three shifts per day, seven days per week, less scheduled downtime. The Company believes that its tissue and diaper manufacturing facilities are adequate and suitable for current operations. The Company completed installation of equipment in 1993 to produce diaper training pants at its Shenandoah, Georgia diaper facilities. The Company owns all of its tissue and diaper production facilities, except that it leases the building which contains the Shenandoah diaper and incontinent production facilities. 2. Pulp Mill The Company owns a bleached kraft pulp mill near Halsey, Oregon. In 1993, 109,000 air dry metric tons of pulp were produced, compared with an estimated annual capacity of 180,000 metric tons. During 1993 the Company (1) began installation of a conventional Flakt pulp dryer costing approximately $37 million which will be completed in the first quarter of 1994 and will allow the mill to produce market pulp in a form suitable for shipping to markets outside the Pacific Northwest, (2) completed the installation of an oxygen delignification system which, in addition to permitting the Company to meet the Oregon State Department of Environmental Quality dioxin discharge limitations, will improve pulp quality and slightly improve brightness, and (3) made certain modifications to its bleach plant at the Halsey mill which will also result in pulp quality and brightness improvements. The Flakt pulp dryer will require additional 1994 spending of approximately $13 million. With the completion of the above mentioned capital projects, the Company believes that its pulp facility is adequate and suitable for current operations. Item 3. Item 3. Legal Proceedings In 1985, stockholders of the Company approved a Plan of Distribution pursuant to which all of the Company's timber properties and development properties and related assets and liabilities in the State of Washington were transferred to newly-formed Pope Resources, A Delaware Limited Partnership, with interests in the partnership distributed to the Company's stockholders on a pro rata basis. The Company assigned to the assets transferred a distribution value for federal income tax purposes based upon the public trading price of the partnership interests at the time of distribution. The Internal Revenue Service has asserted that the Company owes additional federal income tax in the amount of approximately $14 million (plus applicable interest) in connection with this transaction and the Company has disputed this asserted tax liability. The issue is scheduled to be heard in U.S. Tax Court during the third quarter 1994. The Company will vigorously contest the assessed tax liability through independent tax counsel. It is management's opinion, based upon consultation with independent tax counsel, that the additional tax due in this matter, if any, will ultimately be significantly less than the assessed amount and will not have a material adverse effect on the Company's financial position. The final tax settlement, if any, will be recognized as a reduction in equity with respect to the partnership transaction. In September 1992, Kimberly-Clark sued in the U.S. District Court for the Western District of Washington, alleging that diapers manufactured by the Company infringe a U.S. patent that has been assigned to Kimberly-Clark. The Company is vigorously defending the litigation, on the basis that the patent is invalid and unenforceable. The Company is also defending on the basis that its products do not infringe the patent (even if it is determined to be valid and enforceable). The Company has significant arguments to defend its position of non-infringement, and has already prevailed on a motion for partial summary judgment that substantially narrowed the scope of the asserted patent. If the patent is found to be both valid and infringed, damages could consist of a reasonable royalty on the sales of infringing products and/or profits lost by Kimberly-Clark as a result of infringement. Kimberly-Clark has also requested an injunction to prohibit future sales of any products ultimately found to infringe the patent if the Company declines to accept Kimberly-Clark's offer to license the patent. The impact of any such injunction could be limited by accepting a patent license from Kimberly-Clark. The Company does not expect that the ultimate resolution of this matter will have a material adverse impact on the financial position or results of operations of the Company. Kimberly-Clark has also threatened additional litigation with respect to a related patent, which may issue from the U.S. Patent & Trademark Office. The patent that is the basis for the threatened litigation has not yet been issued and its scope has not yet been determined. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT WHO ARE NOT DIRECTORS In addition to the executive officers who are also directors of the Company, there are the following executive officers who are not directors. CARLOS M. LAMADRID, 58, Senior Vice President - Finance, Secretary, Treasurer and Chief Financial Officer since August 1987. MICHAEL FLANNERY, 50, Group Vice President - Wood Products Division since August 1987. WILLIAM G. FROHNMAYER, 55, Group Vice President - Fiber Products since August 1987. ROBERT L. VANDERSELT, 47, Group Vice President - Consumer Products Division since September 1991; August 1990 to September 1991 President, CKI Consulting (a management consulting firm); September 1988 to August 1990 President, Scott Worldwide Food Service, Scott Paper Company (a diversified consumer paper company). RICHARD N. MOFFITT, 46, Vice President - Human Resources since June 1987. All officers hold office at the pleasure of the Board of Directors. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS Pope & Talbot, Inc. common stock is traded on the New York and Pacific stock exchanges under the symbol POP. The number of shareholders at year-end 1993 and 1992 were 1,398 and 1,576, respectively. The high and low sales prices for the common stock on the New York Stock Exchange and the dividends paid per common share for each quarter in the last two fiscal years are shown below: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information required by Item 6 of Part II is presented in the table entitled "Five Year Summary of Selected Financial Data" on page 14 of the Company's 1993 Annual Report to Shareholders. Such information is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview An exceptionally strong lumber market and record earnings in diapers more than offset losses in tissue and pulp to return Pope & Talbot to profitability in 1993, after two years of losses. Pope & Talbot's earnings for 1993 were $21.0 million, or $1.80 per share ($1.67 on a fully diluted basis), up from 1992's loss of $2.3 million, or $.19 per share. Operations contributed $21.6 million, or $1.85 per share in 1993; however, also included was a net charge of $562,000, or $.05 per share, reflecting the cumulative effect of accounting changes adopted in 1993. See Note 1 of Notes to Consolidated Financial Statements for an explanation of the accounting changes. Widely divergent business environments affected Pope & Talbot's businesses during 1993. An improving housing industry, combined with sharply curtailed timber harvests in the Pacific Northwest as a result of environmental pressures, produced lumber prices that were 34 percent higher on average in 1993 than 1992, resulting in the best wood products earnings in the Company's history. Demand for the Company's disposable diapers remained strong in 1993 and, combined with only minor price reductions as a result of competitors' price reduction efforts, resulted in record profits for the diaper business. Conversely, tissue produced a loss for the second year in a row, as extremely competitive conditions in the tissue industry continued, and world pulp markets remained poor, resulting in losses from our pulp business for the third consecutive year. Revenues reached a record $628.9 million in 1993, a 16 percent increase from $544.3 million in 1992. Higher lumber sales prices in wood products was the most significant factor impacting the revenue increase. In pulp and paper, revenue gains from higher diaper sales volumes were largely offset by poor pricing and demand for tissue and pulp. Liquidity and Capital Resources Capital spending, largely to expand drying capabilities, improve pulp quality and to meet environmental requirements at the Company's Halsey, Oregon pulp mill, increased the debt-to-total-capitalization ratio to 42 percent at year-end 1993, from 34 percent at the end of 1992. The Company continues to have available $95 million under existing credit agreements, of which $11 million was borrowed at December 31, 1993. The Company's primary sources of internally generated cash are operating income plus depreciation; the principal external source of cash is debt financing. Cash generated from operations was $36.9 million in 1993. Additionally, during 1993 the Company completed an offering of $75 million of 8 3/8 percent, 20-year debentures, and received $16 million at 6.55 percent from the State of Oregon under the State's Small Scale Energy Loan Program. See Note 4 of Notes to Consolidated Financial Statements for further long-term debt information and subsequent years' debt repayment schedules. These cash resources were used to finance $82.6 million of capital expenditures, $8.9 million for the payment of dividends, and to reduce borrowings on the Company's lines of credit including repayment of $45.0 million on the Company's unsecured revolving-credit agreement. Scheduled long-term debt repayments were $500,000 in 1993 and are anticipated to be $901,000 in 1994. The most significant capital improvement projects included $47 million to improve pulp quality, expand drying capabilities and reduce both the use of chlorine in the bleaching process and the discharge of dioxins from the Halsey pulp mill. The project to reduce chlorine usage and dioxin discharges is necessary to comply with an agreement entered into with the Oregon Department of Environmental Quality on meeting target dioxin emission levels. Other significant projects during 1993 included completion of the first phase of a project to improve raw material utilization at the Castlegar, B.C. sawmill, installation of equipment to produce diaper training pants and other cost reduction and product improvement projects for the Company's diaper business. At December 31, 1993, the Company had numerous capital projects in process at its facilities. It is expected that $25 million will be required to complete approved projects, including those in progress at year-end. The principal projects included in this amount are for completion of the pulp drying improvements at Halsey and the completion of diaper cost reduction projects. In addition, the Company anticipates that additional capital projects will be undertaken during 1994, primarily to sustain existing operations. Projected 1994 capital spending is expected to be funded with internally generated cash, supplemented with borrowings on the Company's lines of credit. The December 31, 1993 current ratio remained essentially unchanged from year-end 1992 at 1.7 to 1. Significant changes in the components of working capital included increases in accounts receivable, inventories, and income taxes payable. Accounts receivable increased primarily due to a $6.1 million United States income tax refund receivable. Inventories increased approximately $21.6 million. Significant changes in inventory balances include a change in accounting for supplies inventories and higher log volumes from taking advantage of buying opportunities. Income taxes payable increased approximately $9.2 million reflecting higher current income taxes payable on higher earnings in Canada. The impact of fluctuations in foreign currency exchange rates have not had, and are not expected to have, a significant effect on the Company's liquidity or results of operations. Results of Operations Wood Products The Company's wood products business, which in 1993 comprised 48 percent of consolidated revenues, generated operating profit of $62.1 million in 1993, a sharp increase over earnings of $15.3 million in 1992, and a loss of $1.1 million in 1991. The 1993 earnings were more than double the previous best wood products earnings of $29.9 million reported in 1979. Housing starts, which historically have been a significant factor in the profitability of the wood products business, have improved in conjunction with the general economy and lower interest rates. Housing starts have increased from 1.0 million in 1991 to 1.2 million in 1992 and 1.28 million in 1993. Although these improvements in the housing market were a factor in the improved lumber sales prices, this alone was not adequate to generate the sales price increases and earnings improvements realized in 1993. A more significant factor continues to be the significantly curtailed harvest levels for timber from federal lands in the Pacific Northwest as a result of continuing environmental pressures to reduce timber harvests. During 1991, log costs increased as a result of constricting supply from federal lands. During 1992, lumber sales prices increased to offset these log cost increases and returned the relationship of log costs to sales prices to more historic levels. As log supplies, and consequently lumber supplies, tightened further in 1993, sales prices rose substantially. During 1993, log costs for the Company's United States sawmills increased generally with the increase in lumber sales prices. The Company has shifted much of its timber dependency out of Western Washington and Western Oregon where the environmental concerns over timber harvests have sharply restricted the volume of public timber available, and increased the cost of remaining timber, into regions of more stable timber supplies such as the Black Hills region of South Dakota and Wyoming and British Columbia. Currently, 80 percent of the Company's lumber capacity is in the Black Hills and British Columbia, with the remaining 20 percent representing the Company's Port Gamble, Washington sawmill. In the second quarter of this year, a Presidential Commission issued a proposal for resolving the timber supply situation in the Pacific Northwest. The proposal has been criticized by various environmental and industry groups. At this point, it is uncertain whether the proposal will be adopted. Until a solution is adopted, it is likely that timber supplies will remain restricted in the Pacific Northwest. When an agreement ultimately is reached, it is likely that the ultimately agreed upon harvest levels will be less than historic levels, but more than is currently available. During 1992, the United States government imposed a 6.51 percent tariff on Canadian lumber sold in the United States. During 1993, the Company paid approximately $9.2 million under this tariff resulting in higher costs for the approximately 425 million board feet of Canadian lumber sold in the United States. In December 1993, a bi-national commission ruled that there is no basis for this duty. However, this decision may be appealed by the United States Government. At this time, it is unknown if the United States Government will make such an appeal, or if any adjustment to the tariff would be made, either upward or downward, and if any such adjustment would be made retroactive to March 1992, when the tariff was first imposed. Lumber sales volume increased to 726 million board feet in 1993, up 9 percent from 669 million board feet in 1992 and 496 million board feet in 1991. The increased lumber volume over the three-year period was due primarily to the mid 1992 acquisition of the 225 million board-feet-per-year Castlegar, B.C. sawmill. With the acquisition of this sawmill, lumber capacity for the Company is now approximately 785 million board feet. The Company's sawmills operated essentially at capacity for 1993, except for the Port Gamble sawmill, which reduced production during the year as a result of lack of acceptably priced timber in relation to end-product prices. Port Gamble is the only Company sawmill in the high-priced timber regions of the Pacific Northwest and the Company, recognizing the limitation on acquiring adequate, acceptably priced timber supplies for the mill, has previously reduced its carrying value to its estimated recoverable value. Wood Products revenues climbed to a record $300 million in 1993 from $214.2 million in 1992 and $153 million in 1991. Both 1992 and 1993 revenue increases were a combination of volume increases and higher sales prices. Sales volumes were up 35 percent in 1992 and 9 percent in 1993 primarily from having the Castlegar sawmill for part of 1992, and for a full year in 1993. Lumber sales prices were up an average of 40 percent for the Company's Canadian sawmills and Port Gamble. These mills, which comprised approximately 80 percent of the Company's total lumber production, compete primarily in the home construction markets which have seen the greatest lumber supply reductions from the Pacific Northwest timber harvest restrictions. The remaining 20 percent of the Company's lumber production comes from two mills located in the Black Hills region of South Dakota and Wyoming. Lumber from these mills goes principally into remodeling markets and competes less directly with Pacific Northwest lumber. Prices for these products rose an average of 17 percent during 1993. Overall, sales prices were up an average of 34 percent in 1993 and 13 percent in 1992. Pulp and Paper Products The pulp and paper segment, which produces private label tissue and disposable diapers as well as market pulp, generated 52 percent of 1993 revenues. Operating profits from pulp and paper have declined from $6.2 million in 1991 to losses of $4.6 million in 1992 and $9.8 million in 1993. Disposable diapers have been increasingly profitable from 1991 through 1993; however, losses in tissue products and market pulp in 1992 and 1993 more than offset diaper profits. Pulp and paper revenues have remained essentially flat over the last three years, with 1993 sales of $328.9 million, 1992 sales of $330.2 million and 1991 sales of $349.3 million. Tissue products and market pulp revenues declined in 1992 and again in 1993 on lower pricing and volumes. Diaper sales volume and selling prices improved in 1992 and in 1993 volume again improved while prices declined slightly. Losses in the Company's market pulp business were the most significant factor in the pulp and paper segment's 1993 loss. A combination of an extremely depressed pulp market and the high cost of wood chips, the primary raw material for pulp, resulted in the increasing losses for 1991 through 1993. As a result of the weak markets, many pulp mills in the industry experienced significantly curtailed production rates during 1993. The Company's pulp mill at Halsey operated at 60 percent of capacity in 1993 and 83 percent of capacity in 1992. Historically, the Company had sold pulp to an adjacent tissue facility owned by James River Corporation. Beginning in 1992, James River began producing recycled pulp at Halsey and began phasing out of purchases of the Company's pulp. By mid 1993, James River no longer was purchasing any of the Company's pulp. As a result of depressed world pulp prices, selective downtime was taken in lieu of selling pulp in the open market to replace this lost tonnage. Consistent with world pulp pricing, the Company's sales prices in 1993 were approximately 12 percent below 1992's already depressed prices. Overall, pulp revenues decreased 36 percent to $40.3 million in 1993. Of this decline, approximately $17 million was due to volume reductions, and approximately $6 million was due to price declines. Based on a long-term pulp supply arrangement entered into in 1993, the Company began supplying, in December 1993, pulp to a printing and writing grade paper mill which opened at the beginning of 1994. The mill was purchased recently from its former owners by a group of private investors. The total output of this paper mill will be sold to one customer who will re-market the paper to outside customers. It has been anticipated that ultimately the paper mill would purchase pulp from the Company in significant quantities, depending on sales by the paper mill to its customer. However, to date pulp purchases have not been at this level. In the event that the paper mill's sales to its customer are adversely impacted for any reason, sales of the Company's pulp may be adversely impacted. Pricing for this pulp will be computed using a formula based on prices for white paper. Based on the prices in effect for white paper at the end of 1993, the price that pulp would be sold under this agreement would be 8 percent higher than the average pulp price the Company obtained for its pulp at the end of 1993. Environmental concerns over timber harvests, which have caused high log costs for the Company's Port Gamble sawmill, have also caused higher chip costs and reduced chip availability from historic sources at the Halsey pulp mill over the last three years. In order to maintain an adequate supply of wood fiber to the mill, the Company has expanded its geographic base from which it obtains softwood chips and has developed the capability of using sawdust and hardwood chips as raw materials for a portion of the production, which historically have been less expensive than the softwood chips normally used as the primary raw material for the pulp mill. It is anticipated that a portion of the pulp sold to the paper mill will be produced from sawdust and hardwood chips. In order to maintain an adequate supply of chips for the anticipated 60 percent of the pulp mill's production which will remain based on these softwood chips, the Company will continue to use an expanded geographic base to obtain chips, adding to their cost. Unless environmental restrictions on timber harvests are relaxed, chip prices likely will remain high, and sawdust and hardwood chip prices may also increase. In the tissue business, continued low industry operating rates resulting from industry capacity increases in recent years which have exceeded demand growth, coupled with aggressive pricing by tissue producers, resulted in a second consecutive loss year for the Company's tissue business. Overall, tissue operated at approximately 97 percent of capacity in 1993. Prices for the Company's tissue products declined in 1992 an average of 6 percent from the already depressed 1991 levels and declined by another 1 percent in 1993. Overall, prices for the Company's tissue have declined an average 13 percent from 1989, when tissue prices first began to decline. During 1992, the Company permanently closed one high-cost tissue facility and instituted cost reduction measures which reduced tissue operating costs in 1993; however, these savings were partially offset by increases in prices paid for wastepaper, the primary raw material for the Company's tissue products. Diaper earnings improved substantially in 1993 over already strong earnings in 1992 and 1991. Diaper sales volumes in 1992 were 10 percent greater than 1991. This sales growth continued in 1993, with sales volumes 21 percent ahead of 1992 at a record 1.1 billion diapers. Based on the existing mix of diaper sales, the Company's diaper business operated essentially at capacity in 1993. During 1992, Procter & Gamble, a significant producer of branded disposable diapers, instituted an everyday low price program intended to reduce the shelf package prices to the consumer. Private label disposable diapers, including the Company's, are priced under the pricing umbrella of branded products; however, the Company was generally able to maintain its diaper sales prices in 1993 at 1992 levels, which were on average 6 percent above 1991 levels. In November 1992, the Company closed one of its five diaper facilities and transferred the diaper machines to the remaining facilities. This eliminated the overhead of operating one additional facility while leaving diaper capacity essentially unchanged. Other Matters In 1993, the Company adopted Financial Accounting Standards Board Statement No. 109 on accounting for income taxes. The charge to earnings for adopting this new standard was $2.3 million ($.20 per share) and is reflected as part of the cumulative effect of accounting changes in the Consolidated Statements of Income. In 1993, expendable supplies on hand, which previously were charged to expense as purchased, were included in supplies inventories as of January 1, 1993. The cumulative effect of this change in accounting method amounted to $1.8 million ($.15 per share), net of tax, and is reflected as part of the cumulative effect of accounting changes in the Consolidated Statements of Income. In November 1992, the Financial Accounting Standards Board issued a pronouncement on Employers' Accounting for Postemployment Benefits. This statement must be adopted by the Company no later than 1994. The Company will adopt the new standard in the first quarter of 1994. The Company has reviewed the pronouncement and does not expect its implementation to have a material effect on the Company's financial position or results of operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 of Part II is presented on pages 20 through 33 of the Company's 1993 Annual Report to Shareholders. Such information is incorporated herein by reference. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The information required by Item 10 of Part III is presented on page 13 as a separate item entitled "Executive Officers of the Registrant Who are Not Directors" in Part I of this Report on Form 10-K and on pages 2-5 (under the item entitled "Certain Information Regarding Directors and Officers") of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such information is incorporated herein by reference. ITEM 11. ITEM 11. MANAGEMENT REMUNERATION The information required by Item 11 of Part III is presented on pages 5-13 of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 of Part III is presented on pages 2-4 and on page 6 (beginning just after the title "Beneficial Ownership of Over Five Percent of Pope & Talbot Common Stock" on page 6) of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 of Part III is presented on page 14 (beginning just after the title "Certain Relationships and Related Transactions" on page 14) of the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders on April 25, 1994. Such 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 -------------------- The financial statements listed in the accompanying Index to Financial Statements and Financial Statement Schedules are filed as part of this annual report. (a) (2) Schedules --------- The financial statement schedules listed in the accompanying Index to Financial Statements and Financial Statement schedules are filed as part of this annual report. (a) (3) Exhibits -------- The following exhibits are filed as part of this annual report. Exhibit No. - ----------- (3) (a) Certificate of Incorporation, as amended. (Incorporated herein by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (b) Bylaws. (Incorporated herein by reference to Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (4) (a) Indenture dated June 2, 1993, between the Company and Chemical Trust Company of California as Trustee with respect to the Company's 8-3/8% Debentures due 2013. (Incorporated herein by reference to Exhibit 4.1 to the Company's registration statement on Form S-3 filed April 6, 1993.) (b) A Revolving Credit Agreement with United States National Bank of Oregon dated July 18, 1990. (Incorporated herein by reference to Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990.) (c) A Revolving Credit Agreement dated May 6, 1992 with United States National Bank of Oregon; CIBC, Inc.; ABN AMRO Bank N.V.; Continental Bank N.A.; and Wachovia Bank of Georgia, National Association. (Incorporated herein by reference to Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992.) (d) Indenture dated March 1, 1987 between the Company and the Bank of California, National Association as Trustee with respect to the Company's 6% Convertible Subordinated Debentures due March 1, 2012. (Incorporated herein by reference to Exhibit 4(d) to the Company's registration statement on Form S-3 filed February 23, 1987.) (e) Instrument of Resignation, Appointment and Acceptance dated July 5, 1989 appointing Manufacturers Hanover Trust Company of California as successor trustee with respect to the Company's 6% Convertible Subordinated Debentures due March 1, 2012. (Incorporated herein by reference to Exhibit 4(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) (f) Rights Agreement between Pope & Talbot, Inc. and The Bank of California, as rights agent, dated as of April 13, 1988. (Incorporated herein by reference to Exhibit 4(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (10) Executive Compensation Plans and Arrangements --------------------------------------------- (a) Stock Option and Appreciation Plan. (Incorporated herein by reference to Exhibit 10(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (b) Executive Incentive Plan. (Incorporated herein by reference to Exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (c) Restricted Stock Bonus Plan. (Incorporated herein by reference to Exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (d) Deferral Election Plan. (Incorporated herein by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (e) Supplemental Executive Retirement Income Plan. (Incorporated herein by reference to Exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (f) Form of Severance Pay Agreement between the Corporation and certain of its executive officers. (Incorporated herein by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) ______________________________ (g) Lease agreement with Pope Resources dated December 20, 1985 for Port Gamble, Washington sawmill site. (Incorporated herein by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (h) Lease agreement with Shenandoah Development Group, Ltd. dated March 14, 1988 for Atlanta diaper mill site as amended September 1, 1988 and August 30, 1989. (Incorporated herein by reference to Exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (i) Lease agreement with Shenandoah Development Group, Ltd. dated July 31, 1989 for additional facilities at Atlanta diaper mill as amended August 30, 1989 and February 1990. (Incorporated herein by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) (j) Grays Harbor Industrial, Inc. Pulp Sales Supply Contract. (Incorporated herein by reference to Exhibit 10(j) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993.) (11) Statement showing computation of per share earnings. (13) Portions of the annual report to shareholders for the year ended December 31, 1993 which have been incorporated by reference in this report. (18) Letter re change in accounting principles. (Incorporated herein by reference to Exhibit 18 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993.) (22) Listing of parents and subsidiaries. (Incorporated herein by reference to Exhibit 22 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) (b) Reports on Form 8-K ------------------- No reports on Form 8-K were filed during the three months ended December 31, 1993. 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 financial statements and notes thereto. The consolidated financial statements listed in the above index which are included in the Annual Report to Shareholders of Pope & Talbot, Inc. for the year ended December 31, 1993 are hereby incorporated by reference. With the exception of the pages listed in the above index and the items referred to in Items 1, 6 and 8, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Stockholders of Pope & Talbot, Inc.: We have audited in accordance with generally accepted auditing standards the consolidated financial statements included in the Pope & Talbot, Inc. and subsidiaries' annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 20, 1994 (except with respect to the matter discussed in Note 12, as to which the date is January 24, 1994). 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 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 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. Portland, Oregon, January 20, 1994 POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE V - CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Years ended December 31, 1991, 1992 and 1993 (Thousands) NOTES: (a) Includes $14.9 million for new converting facilities at and modernization of Ransom, Pennsylvania tissue mill. (b) Includes $23.8 million for Flakt pulp dryer and $19.1 million for oxygen delignification project at the Halsey, Oregon pulp mill. Also includes $6.4 million for Castlegar, British Columbia sawmill modernization. (c) Includes $13.4 million related to the sale of the Ladysmith, Wisconsin tissue facilities. DEPRECIATION AND AMORTIZATION: The annual provisions for depreciation have been computed principally in accordance with the following ranges of rates applied on the straight-line method: POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE VI - CONSOLIDATED ACCUMULATED DEPRECIATION OF PLANT AND EQUIPMENT Years ended December 31, 1991, 1992 and 1993 (Thousands) Notes: (a) Amount relates to write-down of tissue machines removed from production and building held for sale. (b) Amount relates to write-down of the Company's Ladysmith, Wisconsin tissue plant and Maryville, Missouri diaper plant. (c) Includes $10.7 million related to the sale of the Ladysmith, Wisconsin tissue facilities. POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE IX - CONSOLIDATED SHORT-TERM BORROWINGS Years ended December 31, 1991, 1992 and 1993 Notes payable to banks: The Company has available from a bank a short-term line of credit totaling $20,000,000 with interest based on a negotiated rate. As of December 31, 1993, there was $11,000,000 outstanding on this line. Notes: (a) The average amount outstanding during the period is computed by dividing the total of daily outstanding principal balances by 365. (b) The weighted average interest rate during the period was computed by dividing the average amount of short-term debt outstanding during the period into the actual interest expense on short-term borrowings. POPE & TALBOT, INC. AND SUBSIDIARIES SCHEDULE X - CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 (Thousands) 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: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or 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 1933 Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of the 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 on the Form S-8's identified below, 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 1933 Act and will be governed by the final adjudication of such issue. The preceding undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 No. 33-34996 (filed May 21, 1990) and No. 33-64764 (filed June 21, 1993). CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K into the Company's previously filed Registration Statement No. 33-34996 on Form S-8, Registration Statement No. 33-64764 on Form S-8 and Registration Statement No. 33-52305 on Form S-3. ARTHUR ANDERSEN & CO. Portland, Oregon March 29, 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 Portland, State of Oregon, on this 29th day of March, 1993. POPE & TALBOT, INC. BY: \s\ Peter T. Pope ------------------------------ Peter T. Pope 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

1077141_1993.txt

1077141_1993

1993

1077141

ITEM 1. Business. The trust fund relating to Pooling and Servicing Agreement dated as of July 1, 1993 (the "Pooling and Servicing Agreement") between First Boston Mortgage Securities Corp., depositor (the "Depositor"), Countrywide Funding Corporation as master servicer (the "Master Servicer") and Bankers Trust Company of California, N.A. as trustee (the "Trustee"). The Conduit Mortgage Pass-Through Certificates, Series 1993-5 (the "Certificates") will be comprised of Interest-Only Class X, Principal Only Class P, Classes A-1 through A-15, Class A-R, Class M-1, Class M-2, Class B-1, Class B-2, and the Subordinated Class B-3, Class B-4 and Class B-5 Certificates (collectively with the Class B-1 and Class B-2 Certificates, the "Class B Certificates"). It is a condition to their issuance that the Class X, Class P, Class A-1 through Class A-15 and Class A-R (collectively, the "Class A Certificates") and Class M-1 Certificates be rated "AAA" by Fitch Investors Service, Inc. ("Fitch") and "Aaa" by Moody's Investors Service, Inc. ("Moody's"), that the Class M-2 Certificates be rated "AA" by Fitch, that the Class B-1 Certificates be rated "A" by Fitch and that the Class B-2 Certificates be rated "BBB" by Fitch. Accordingly, the Class B-1 and Class B-2 Certificates will not constitute "mortgage related securities" for purposes of the Secondary Mortgage Market Enhancement Act of 1984, as amended. The Certificates evidence beneficial ownership interests in a trust fund (the "Trust Fund") to be created by First Boston Mortgage Securities Corp. (the "Depositor"), which will consist primarily of a pool of conventional 30-year, fully-amortizing, fixed-rate mortgage loans (the "Mortgage Loans") secured by first liens on one- to four- family, residential real properties. The Mortgage Loans were originated by or acquired by Countrywide Funding Corporation ("Countrywide") and will be purchased by the Depositor from First Boston Mortgage Capital Corp., an affiliate of the Depositor. The Mortgage Loans are more fully described under "Description of the Mortgage Pool and the Underlying Mortgaged Properties" in the Prospectus Supplement dated July 22, 1993. Information with respect to the business of the Trust would not be meaningful because the only "business" of the Trust is the collection on the Mortgage Loans and distribution of payments on the Certificates to Certificateholders. This information is accurately summarized in the Monthly Reports to Certificateholders, which are filed on Form 8-K. There is no additional relevant information to report in response to Item 101 of Regulation S-K. ITEM 2. ITEM 2. Properties. The Depositor owns no property. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1993-5, in the aggregate, represent the beneficial ownership in a Trust consisting primarily of the Mortgage Loans. The Trust will acquire title to real estate only upon default of the mortgagors under the Mortgage Loan. Therefore, this item is inapplicable. 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 Certificateholders during the fiscal year covered by this report. PART II ITEM 5. ITEM 5. Market for Depositor's Common Equity and Related Stockholder Matters. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1993-5 represent, in the aggregate, the beneficial ownership in a trust fund consisting primarily of the Mortgage Loans. The Certificates are owned by Certificateholders as trust beneficiaries. Strictly speaking, Depositor has no "common equity," but for purposes of this Item only, Depositor's Conduit Mortgage Pass-Through Certificates are treated as "common equity." (a) Market Information. There is no established public trading market for Depositor's Notes. Depositor believes the Notes are traded primarily in intra-dealer markets and non-centralized inter-dealer markets. (b) Holders. The number of registered holders of all classes of Certificates on (for dates see ITEM 12(a)) was 29. (c) Dividends. Not applicable. The information regarding dividend required by sub-paragraph (c) of Item 201 of Regulation S-K is inapplicable because the Trust does not pay dividends. However, information as to distribution to Certificateholders is provided in the Monthly Reports to Certificateholders for each month of the fiscal year in which a distribution to Certificateholders was made. ITEM 6. ITEM 6. Selected Financial Data. Not Applicable. Because of the limited activities of the Trust, the Selected Financial Data required by Item 301 of Regulation S-K does not add relevant information to that provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Not Applicable. The information required by Item 303 of Regulation S-K is inapplicable because the Trust does not have management per se, but rather the Trust has a Trustee who causes the preparation of the Monthly Reports to Certificateholders. The information provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K, does provide the relevant financial information regarding the financial status of the Trust. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. Monthly Remittance Statement to the Certificateholders as to distributions made on August 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 26, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Annual Statement of Compliance by the Master Servicer is not currently available and will be subsequently filed on Form 8. Independent Accountant's Report on Servicer's will be subsequently filed on Form 8. 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 Depositor. Not Applicable. The Trust does not have officers or directors. Therefore, the information required by items 401 and 405 of Regulation S-K are inapplicable. ITEM 11. ITEM 11. Executive Compensation. Not Applicable. The Trust does not have officers or directors to whom compensation needs to be paid. Therefore, the information required by item 402 of regulation S-K is inapplicable. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. (a) Security ownership of certain beneficial owners. Under the Pooling and Servicing Agreement governing the Trust, the holders of the Certificates generally do not have the right to vote and are prohibited from taking part in management of the Trust. For purposes of this Item and Item 13 ITEM 13. Certain Relationships and Related Transactions. (a) Transactions with management and others. Depositor knows of no transaction or series of transactions during the fiscal year ended December 31, 1993, or any currently proposed transaction or series of transactions, in an amount exceeding $60,000 involving the Depositor in which the Certificateholders identified in Item 12(a) had or will have a direct or indirect material interest. There are no persons of the types described in Item 404(a)(1),(2) and (4) of Regulation S-K, however, the information required by Item 404(a)(3) of Regulation S-K is hereby incorporated by reference in Item 12 herein. (b) Certain business relationships. None. (c) Indebtedness of management. Not Applicable. The Trust does not have management consisting of any officers or directors. Therefore, the information required by item 404 of Regulation S-K is inapplicable. (d) Transactions with promoters. Not Applicable. The Trust does not use promoters. Therefore, the information required by item 404 of Regulation S-K is inapplicable. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following is a list of documents filed as part of this report: EXHIBITS Monthly Remittance Statement to the Certificateholders as to distributions made on August 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 26, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. (c) The exhibits required to be filed by Depositor pursuant to Item 601 of Regulation S-K are listed above and in the Exhibit Index that immediately follows the signature page hereof. (d) Not Applicable. The Trust does not have any subsidiaries or affiliates. Therefore, no financial statements are filed with respect to subsidiaries or affiliates. Supplemental information to be furnished with reports filed pursuant to Section 15(d) by Depositors which have not registered securities pursuant to Section 12 of the Act. No annual report, proxy statement, form of proxy or other soliciting material has been sent to Certificateholders, and the Depositor does not contemplate sending any such materials subsequent to the filing of this report. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Depositor has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: Bankers Trust Company of California, N.A. not in its individual capacity but solely as a duly authorized agent of the Registrant pursuant to the Pooling and Servicing Agreement, dated as of July 1, 1993. By: /s/Judy L. Gomez Judy L. Gomez Assistant Vice President Date: March 4, 1999 EXHIBIT INDEX Exhibit Document 1.1. Monthly Remittance Statement to the Certificateholders as to distributions made on August 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.2 Monthly Remittance Statement to the Certificateholders as to distributions made on September 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.3 Monthly Remittance Statement to the Certificateholders as to distributions made on October 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.4 Monthly Remittance Statement to the Certificateholders as to distributions made on November 26, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.5 Monthly Remittance Statement to the Certificateholders as to distributions made on December 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.6 The Pooling and Servicing Agreement of the Registrant dated as of July 1, 1993 (hereby incorporated herein by reference and filed as part of the Registrant's Current Report on Form 8-K filed with Securities and Exchange Commission on February , 1999.

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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 --

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Item 1. BUSINESS. Introduction General. Central Maine Power Company (the "Company") is an investor-owned Maine public utility incorporated in 1905. The Company is engaged in the business of generating, purchasing, transmitting, distributing and selling electric energy for the benefit of retail customers in southern and central Maine and wholesale customers, principally other utilities. Its principal executive offices are located at 83 Edison Drive, Augusta, Maine 04336, where its general telephone number is (207) 623-3521. The Company has more customers and greater revenues than any other electric utility in Maine, serving approximately 500,000 customers in its 11,000 square-mile service area in southern and central Maine and having $894 million in consolidated electric operating revenues in 1993 (reflecting consolidation of financial statements with a majority-owned subsidiary, Maine Electric Power Company, Inc. ("MEPCO")). The Company's service area contains the bulk of Maine's industrial and commercial centers, including Portland (the state's largest city), South Portland, Westbrook, Lewiston, Auburn, Rumford, Bath, Biddeford, Saco, Sanford, Kittery, Augusta (the state's capital), Waterville, Fairfield, Skowhegan and Rockland, and approximately 936,000 people, representing about 77 percent of the total population of the state. The Company's industrial and commercial customers include major producers of pulp and paper products, producers of chemicals, plastics, electronic components, processed food, and footwear, and shipbuilders. Large pulp-and-paper industry customers account for approximately 66 percent of the Company's industrial sales and approximately 27 percent of total service- area sales. Cost Reduction and Restructuring. Overall demand for energy from the Company's system increased at a rate of 0.4 percent in 1993, after an increase of 0.8 percent in 1992. The low rate of increase can be attributed to continued weakness in the Maine economy, significant competition from alternative fuel sources, the effects of the Company's demand-side management programs and other factors. The Company's earnings per share declined from $1.85 in 1992 to $1.65 in 1993. The rate of return on common equity for 1993 was 9.77 percent compared with 11.25 percent earned in 1992. The reduced earnings level for 1993 is attributable to higher costs, weak sales and cost disallowances associated with two proceedings before the Maine Public Utilities Commission ("Maine PUC", "MPUC" or "PUC") during 1993. For a discussion of those proceedings, see "Base Rates" and "MPUC NUG Contracts Investigation" under "Regulation and Rates", below. The combination of weak sales due to economic and competitive pressures and the disappointing and inadequate base- rate-case decision in December 1993 offers the Company no reasonable opportunity to achieve a level of 1994 earnings near the 1993 level or the current allowed rate of return of 10.05 percent on common equity. Moreover, the unfavorable outlook for the Company's near-term earnings capacity takes into account the significant reductions in previously planned 1994 operations, maintenance, and capital expenditures being implemented by the Company as part of its broad cost-reduction program. As a result of such factors, the Company's credit ratings came under significant pressure during 1993 and early 1994 when its senior secured debt was downgraded by all three agencies that rate the Company's securities, one of which lowered the rating to below investment grade. The Company's junior securities came under even more pressure late in the year, being assigned, in most cases, non-investment-grade ratings. The decline in the Company's credit ratings will impair its access to the capital markets, make the terms and conditions of borrowing more stringent, and increase its cost of capital, and has already substantially reduced, if not eliminated, the Company's access to the commercial-paper markets. The credit-rating agencies cited the stagnant economy, inadequate rate relief and pricing flexibility, increased competition, and uncertainty of recovery of non-utility purchased-power costs as reasons for the credit downgrades. For a more detailed discussion of the downgrades, see "Financing and Related Considerations" - "Rating Agency Actions", below. After review of the Company's overall financial position and outlook, including the impacts associated with the MPUC's rate- case order and the expected near-term revenue impacts of weak sales, the Company's Board of Directors voted on December 15, 1993, to reduce the quarterly common-stock dividend from 39 cents to 22.5 cents per share. The dividend reduction is part of a broad-based cost-reduction and restructuring program designed to stabilize the Company's rates and enhance its financial condition. The program is composed of three major initiatives: (1) reduce the Company's operating costs while maintaining appropriate levels of service; (2) reduce the Company's largest external expense, non-utility power costs; and (3) work with regulators on innovative, competitive new pricing and service options. The first step in implementing the cost-reduction strategy was to restructure the Company's organization along functional lines and eliminate 225 full-time-equivalent jobs, or approximately 10 percent of the Company's work-force, which was accomplished in March 1994. In addition, the Company's operating budget for 1994 was cut $22 million, or 12 percent, from previously planned levels, and the 1994 capital budget for plant, equipment, and conservation programs by $14 million, or 19 percent, from previously planned levels. The second component of the plan, reducing the cost of non- utility power, stresses continued efforts to renegotiate, buy out or terminate high-cost purchased power contracts. It also includes support for Maine legislative action on bills that could have the effect of reducing such costs. The final segment includes continuing efforts to achieve changes in regulation that would redefine the basis for overall price changes and provide flexibility in setting specific prices and in the acquisition and use of resources. As detailed below under "Regulation and Rates" - "Rate Stability Plan", the Company has indicated interest in pursuing a modified price-cap approach to the regulation of its electric rates and, consistent with the terms of the PUC's December 1993 order in the base-rate case, has been engaged in discussions with rate-case intervenors as to the structure of such a plan. The Company expects to file a rate- stability plan with the PUC sometime in the first half of 1994. The Company is committed to its cost-reduction and restructuring program. It believes that its ability to restore earnings to competitive levels and improve its overall financial health is closely tied to the success of the program. The following topics are discussed under the general heading of Business. Where applicable, the discussions make reference to the various other Items of this Report. In addition, for further discussion of information required to be furnished in response to this Item, see pages 1 through 49 of Exhibit 13-1 hereto (the Company's Annual Report to Shareholders for the year ended December 31, 1993), which pages are hereby incorporated herein by reference. Non-utility Generation The Company has been an industry leader in developing supplies of energy from non-utility generators, including cogeneration plants and small power producers. These sources supplied 4.0 billion kilowatt-hours of electricity to the Company in 1993, representing 40.2 percent of total generation, an increase from 38.2 percent in 1992. The Company expects to obtain approximately 44 percent of its energy from this source in 1994. The Company's contracts with non-utility generators, however, which were entered into pursuant to 1978 federal legislation and vigorous state implementation thereof, have contributed the largest part of the Company's increased costs in recent years. This has caused the Company to pursue re- negotiations or buyouts of such contracts wherever practicable. For further discussion of independent power production, see Item 2, Properties, "Non-utility Generation". For a discussion of a regulatory proceeding involving the Company's management of its contracts with non-utility generators, see "Regulation and Rates" - "MPUC NUG Contracts Investigation", below. Maine Yankee Atomic Power Company The Company owns a 38 percent stock interest in Maine Yankee Atomic Power Company ("Maine Yankee"), which owns and operates a nuclear generating plant in Wiscasset, Maine (the "Maine Yankee Plant"). The Maine Yankee Plant has been in commercial operation since 1972 and has consistently produced power at a cost among the lowest in the country for nuclear plants. In 1993 the Maine Yankee Plant produced 5.7 billion kilowatt-hours of electric power, the highest total ever for a year that included a scheduled refueling and maintenance shutdown, at an average cost of 3.4 cents per kilowatt-hour. The average capacity factor for the Maine Yankee plant in 1993 was 76 percent. For further discussion of Maine Yankee, see "Regulation and Rates", below, and Item 2, Properties, "Existing Facilities". Competition In October 1992 the United States Congress enacted the Energy Policy Act of 1992 (the "Policy Act"). The Policy Act was designed to encourage competition among electric utility companies, improve energy resource planning by utility companies, and encourage the development of alternative fuels and sources of energy. The Policy Act provides for, among other things, (1) enhanced access to electric transmission to promote competition for wholesale purchasers and sellers, (2) statutory reforms to encourage utility participation in the formation of exempt wholesale generators, (3) tax credits for electricity generation from renewable energy sources, (4) tax incentives for the use of alternative fuels, and (5) required fleet vehicle conversion to alternative fuels. The Policy Act has been a significant factor in creating new areas of competition for the Company. The Company is facing competition in several areas of its traditional business and anticipates that the new competition will continue to place pressure on both sales and the price the Company can charge for its product. Alternative fuels and pre- Policy Act regulation that had restricted competition from outside of the Company's service territory have expanded customers' energy options. As a result, the Company has been involved in a number of negotiations with certain of its customers and will continue to pursue retention of its customer base. This increasingly competitive environment has resulted in the Company's entering into contracts with two of its wholesale customers, as well as with certain of its industrial and commercial customers, to provide their energy needs at prices and margins lower than the current averages. For a discussion of the potential loss of the largest wholesale customer of the Company to an out-of-state supplier, see "Regulation and Rates" - "Potential Loss of Wholesale Customer", below. In addition to negotiating a number of special agreements with large customers, the Company is also pursuing with the MPUC alternative pricing mechanisms that would allow the Company the flexibility to modify the price of its product in certain instances, when the competitive alternatives could result in the loss of a significant end use of electricity. In its preliminary discussions, the MPUC has indicated there may be instances in which the ability of the Company to adjust its price in response to competitive pressures is advisable. In February 1994, the MPUC approved a specific competitive-pricing plan under which the Company will operate with respect to residential water-heating customers. The Company believes it may be granted the authority to develop additional market-responsive rates in certain circumstances in the future. For a discussion of relevant PUC orders, see "Regulation and Rates" - "Rate Design", below. Regulation and Rates The Company is subject to the regulatory authority of the PUC as to retail rates, accounting, service standards, territory served, the issuance of securities maturing more than one year after the date of issuance, certification of generation and transmission projects and various other matters. The Company is also subject as to some phases of its business, including licensing of its hydroelectric stations, accounting, rates relating to wholesale sales (which constitute less than one percent of operating revenues) and to interstate transmission and sales of energy and certain other matters, to the jurisdiction of the Federal Energy Regulatory Commission ("FERC") under Parts I, II and III of the Federal Power Act. Other activities of the Company from time to time are subject to the jurisdiction of various other state and federal regulatory agencies. The Maine Yankee Plant and the other nuclear facilities in which the Company has an interest are subject to extensive regulation by the federal Nuclear Regulatory Commission ("NRC"). The NRC is empowered to authorize the siting, construction and operation of nuclear reactors after consideration of public health, safety, environmental and antitrust matters. Under its continuing jurisdiction, the NRC may, after appropriate proceedings, require modification of units for which construction permits or operating licenses have already been issued, or impose new conditions on such permits or licenses, and may require that the operation of a unit cease or that the level of operation of a unit be temporarily or permanently reduced. The United States Environmental Protection Agency ("EPA") administers programs which affect all of the Company's thermal generating facilities as well as the nuclear facilities in which it has an interest. The EPA has broad authority in administering these programs, including the ability to require installation of pollution-control and mitigation devices. The Company is also subject to regulation by various state and local authorities with regard to environmental matters and land use. For further discussion of environmental considerations as they affect the Company, see "Environmental Matters", below. Under the Federal Power Act, the Company's hydroelectric projects (including storage reservoirs) on navigable waters of the United States are required to be licensed by the FERC. The Company is a licensee, either by itself or in some cases with other parties, for 27 FERC-licensed projects, some of which include more than one generating unit. Thirteen licenses were scheduled to expire in 1993, one in 1997, and thirteen after 2000. The Company filed all applications for relicensing the projects whose licenses were scheduled to expire in 1993 and has been authorized to continue to operate those projects pending action on relicensing by the FERC. New licenses may contain conditions that reduce operating flexibility and require substantial additional investment by the Company. The United States has the right upon or after expiration of a license to take over and thereafter maintain and operate a project upon payment to the licensee of the lesser of its "net investment" or the fair value of the property taken, and any severance damages, less certain amounts earned by the licensee in excess of specified rates of return. If the United States does not exercise its statutory right, the FERC is authorized to issue a new license to the original licensee, or to a new licensee upon payment to the original licensee of the amount the United States would have been obligated to pay had it taken over the project. The United States has not asserted such a right with respect to any of the Company's licensed projects. Base Rates. On March 1, 1993, the Company filed a request with the MPUC for a $95-million increase in base rates. The major components of the request were (1) compensating for lower-than-forecasted sales, (2) increased operation and maintenance expenses, (3) increased operating costs of the four operating nuclear plants in which the Company owns interests, (4) property additions and transmission, distribution and other improvements, (5) energy-management program costs and, (6) the expiration of the flow-through of certain tax benefits. Ultimately, the Company reduced the amount of its base-rate request from $95 million to $83 million. The decrease was the result of lower estimates of 1994 operation and maintenance expenses, further reductions in the Company's cost of capital, a decrease in the level of anticipated expenditures for energy management programs and the change in the federal income-tax rate from 34 percent to 35 percent. On December 14, 1993, the MPUC issued its order in the proceeding. The MPUC's analysis indicated a need for additional revenues of $51.5 million, yet found the Company to be entitled to a net revenue increase of only $26.2 million. The Commission found a total cost of capital of 8.52 percent and a cost of equity of 10.05 percent, after deducting a one-half percent (.5%) return-on-equity penalty established by the MPUC in a 1993 investigation of the Company's management of certain independent power-producer contracts. See "MPUC NUG Contracts Investigation" below, for further discussion of this investigation. To arrive at its revenue-requirement conclusion, the MPUC deducted $25.3 million "to adjust for management inefficiency" after finding the Company's performance in the areas of management efficiency and cost-cutting to have been "inadequate", based largely on the recommendations contained in a management audit of the Company conducted by a consultant retained by the MPUC. The Company strongly disagrees with the MPUC's management-inefficiency finding and with the resulting deduction of nearly one-half the revenue increase to which the Commission itself found the Company to be otherwise entitled using traditional ratemaking principles. The Company filed an appeal of the base-rate order with the Maine Supreme Judicial Court. The Company cannot, however, predict the result of that appeal. Rate-Stability Plan. In connection with the base-rate proceeding, on July 21, 1993, the Company filed an alternative rate proposal designed to promote stability in the Company's rates. The proposal consisted of a combination of pricing and regulatory changes that would, among other things, limit future rate increases to annual changes based on the rate of inflation and mandated costs, and revise existing regulatory rules and policies to allow the Company to adjust prices more rapidly in response to customer needs and competitive factors. In its December 14, 1993, base-rate order, the MPUC ordered that a follow-up proceeding be held to implement by mid-1994 a rate-stability plan along the lines discussed in the order. The MPUC encouraged the Company and the parties wishing to participate in the proceeding to work together to develop a plan containing price-cap, profit-sharing, and pricing-flexibility components. The MPUC also directed that the initial plan have a duration of five years, subject to a brief annual proceeding to implement any applicable rate changes, and a detailed review at the end of the fourth year to evaluate the performance of the plan and initiate necessary changes. Participants in the rate-stability plan proceeding have prepared price-cap proposals in response to the MPUC's order and regular discussions are being held. The Company cannot predict the outcome of this process or the MPUC's ultimate decision on a rate-stability plan. Fuel Clause Adjustment. The Company's electric sales are subject to a fuel adjustment clause that enables the Company to recover from its customers both fuel costs and the increasing amounts of the fuel component of purchased-power costs, including non-utility generation. The Company also collects carrying costs on unbilled fuel and pays interest on fuel-related over- collections. In accordance with a January 1993 ratemaking stipulation, the MPUC approved, as part of the $40 million July 1993 revenue increase, $17 million to reduce deferred fuel-clause balances. Earlier, in July 1992, the MPUC issued an order authorizing an increase, effective September 1, 1992, in the Company's fuel cost adjustment of $13.2 million of the $38.7 million requested by the Company, along with the Electric Revenue Adjustment Mechanism ("ERAM") and demand-side-management incentives discussed below under "Incentive Regulation". The orders extended the smoothing approach that had begun in 1988, resulting in unrecovered fuel and purchased-power costs being deferred for future recovery. Rate Design. Effective in December 1991, the Company implemented a rate-design order from the PUC that was intended to realign customer class revenues and specific rate components more closely with marginal costs. These rate design changes, which raised or lowered some customers' rates by as much as eight percent, were intended to reallocate revenues from customer classes, but not to produce any change in aggregate revenues for the Company. In February 1992, the Company filed a request with the PUC to re-examine several rate-design changes in response to concerns regarding the impact of such changes on some classes of residential customers. After considering a number of proposals by the Company and other parties, the PUC reduced the highest winter time-of-use rates by a small percentage from the prior winter's rates, effective in December 1992. The increases in on- peak rates in December 1991 resulting in part from the rate- design changes have caused a significant number of the Company's residential electric heating customers and water heating customers to convert to other fuel sources. On February 18, 1994, the PUC issued its order in an investigation of the Company's resource planning, rate structure, and avoided cost that was initiated in December 1992. The primary purpose of the investigation was to examine the Company's "long-term costs and their relationships to usage and prices, and to specify any implications for CMP's resource planning activities and general rate structure policies." In its order the PUC found, among other things, (1) "no reason to encourage electric utilities to pursue broad promotion of load growth . . . absent a clear and convincing demonstration that ratepayers as a group would benefit from such efforts"; (2) "that CMP's proposed strategy of encouraging marginal usage through broad adoption of declining block rates is not cost-justified . . ." but the PUC said it would "continue to encourage proposals for targeted, short-term rates that are carefully designed to retain movable load"; and (3) the PUC reaffirmed its "existing policy of encouraging narrowly-focused economic incentive rates for particular kinds of customers, when it can be shown that other ratepayers will not be harmed". The PUC also indicated that it would initiate a rulemaking proceeding to determine how "special rates for customers with competitive alternatives should best reflect the utility's obligation to serve, particularly with respect to backup and maintenance rates . . .." The Company cannot predict what changes it will ultimately be permitted to implement in the areas of resource planning, rate structure, and avoided cost. MPUC NUG Contracts Investigation. On October 28, 1993, in connection with an investigation of the Company's management of independent power-producer contracts, the MPUC issued an order finding that the Company had been unreasonable and imprudent in its management of two independent power-producer contracts and indicated that it would reduce the Company's allowed rate of return on equity by 0.5 percent in the then-pending base-rate case (approximately $4 million, before income taxes, over a 12-month period) and also directed the Company to charge against deferred fuel-cost balances approximately $4.1 million of payments from power providers that had previously been credited against purchased-power capacity costs, unless the Company could demonstrate that the crediting was proper. The Company recorded a reserve totalling $4.1 million during the third quarter of 1993, reflecting the impact of the order. Finally, the MPUC announced that it would review in the future the Company's administration and management of certain power-purchase contracts for purchases of ten megawatts or more. On December 20, 1993, the Chief Justice of the Maine Supreme Judicial Court (the "Court"), acting on the Company's request, issued an order staying the effectiveness of the 0.5-percent return-on-equity penalty pending final resolution of the Company's appeal of the October 28, 1993, MPUC order to the Court. In addition, the Court ordered that if the Company should not prevail on its appeal, it would be required to refund any revenues collected as a result of the stay order, with interest. Finally, the Court ordered an expedited hearing on the appeal, scheduling oral argument before the Court for March 1994. On February 3, 1994, the MPUC filed a motion to dismiss with the Court, stating that by order dated February 3, 1994, the Commission had reopened and reconsidered its October 28, 1993 decision. As a result of its reconsideration, the MPUC decided to vacate the return-on-equity penalty conditioned on either the Company's acquiescence in the MPUC's jurisdiction or a finding by the Court that the MPUC had retained jurisdiction, and to consider alternative remedies. The MPUC argued that because of its February 3 order the Company's appeal of the return-on-equity penalty should be dismissed as moot. The Chief Justice declined to dismiss the appeal and added the jurisdictional question to the issues to be determined by the Court. The MPUC, in its February 3, 1994 order, indicated that an alternative under consideration by the MPUC "appears to present an opportunity to insulate ratepayers sufficiently from CMP's imprudence...," yet also noted, "We do not decide at this time that such a remedy . . . will be adopted." The order indicated an intent to seek additional information on the issue of annual differences between the contract rates and avoided costs. The case was argued on March 17 and a decision is expected by early summer 1994. The Company cannot predict the outcome of the appeal on either the issue of jurisdiction or the merits of the return-on-equity penalty, or the outcome if remanded to the PUC, including any subsequent appeal of any alternative remedy. Incentive Regulation. In May 1991 the MPUC ordered a three-year trial of the ERAM, which was a fundamental change in the way the Company's revenues were treated and set new incentives for effective utility-sponsored energy management. In July 1992 the MPUC issued an order authorizing the Company to begin collecting $7.8 million, which was only a portion of the $26.2 million of ERAM revenues accrued in its first year, and an energy-management incentive of $1.5 million, beginning in September 1992. Approximately $18.4 million of ERAM revenues accrued in the 12 months beginning in March 1991 were therefore carried over to the 1993 ERAM filing. In January 1993, the MPUC approved a stipulation that resolved several outstanding issues, including those in the Company's ERAM proceeding. The stipulation permitted recovery of accrued ERAM balances in accordance with the terms of a Financial Accounting Standards Board Emerging Issues Task Force consensus. The stipulation also authorized recovery of the costs associated with buy-outs by the Company of certain purchased-power contracts and requested the MPUC to grant an increase in the Company's fuel-cost adjustment. The stipulation also approved an accounting order permitting the Company to accelerate the flow-back of $5.9 million of certain deferred taxes associated with prior losses on reacquired debt. For 1992, the stipulation placed a limit of 11.25 percent on the Company's allowed rate of return on equity. Earnings in excess of the limit, up to approximately $10 million (the revenue requirement of the tax benefits), were applied on a monthly basis to reduce 1993 ERAM accruals. In addition, approximately $317,000 of income, net of income taxes, in excess of the $10 million, was used to fund a portion of 1993 operation-and-maintenance expenses. The January 1993 stipulation also reduced the amount of ERAM accruals from January 1993 through November 1993 by $591,000 per month. The ERAM program continued until December 1, 1993, which was the effective date of the new base rates resulting from the Company's 1993 base-rate proceeding. As contemplated by the terms of the stipulation, the MPUC subsequently approved a revenue increase of $40 million, effective July 1, 1993, which included, among other things, $21.2 million toward recovery of deferred ERAM revenues. As of December 31, 1993, the Company had collected approximately $19.2 million of the ERAM revenues; the unbilled ERAM balance at that time was approximately $50.5 million. Potential Loss of Wholesale Customer. On July 28, 1993, the Town of Madison Electric Works (Madison), a wholesale customer of the Company, announced that it had selected a competitive bid from Northeast Utilities (NU) and was entering negotiations for NU to become its wholesale electric supplier for a period of up to ten years. The Company's bid was rejected by Madison for being submitted after the ten-day bidding period. NU, a Connecticut-based holding company with substantial excess generating capacity, had submitted a bid to provide up to 45 megawatts of capacity at a rate that would initially be well below the Company's existing rates. Substantially all of the 45 megawatts would supply a large paper-making facility in Madison's service territory that has been served directly by the Company under a special service agreement with Madison during the last 12 years. The Company understands that Madison intends to start taking power from NU in late 1994 for that portion required to serve the paper-making facility and in late 1996 for its remaining requirements. Losing Madison as a wholesale customer would reduce the Company's non-fuel revenues by approximately $11 million annually when fully in effect, based on current rates and 1993 sales, minus any amounts paid to the Company for transmission of the NU power from the New Hampshire border. The Company intervened in opposition to Madison's petition to the MPUC for approval of its contract with NU, but cannot predict what action the MPUC will take on the petition. The Company has also filed with the FERC for approval of a contract to provide transmission service for Madison over the Company's system. The filing seeks recovery of the full cost of providing transmission service as well as compensation for any "stranded investment" of the Company in facilities that would no longer be needed to serve the Madison area. FERC Power Contracts Settlement Agreement. In August 1991, the FERC issued an order requiring the Company to revise its rates to a level reflecting the filed cost of service associated with each of 14 contracts for non-territorial sales, rather than the negotiated market-based levels. In 1991 the Company established a $4.5 million reserve to reflect refunds associated with some of the contracts. In 1992 the Company reversed approximately $1.9 million of that reserve as a result of a settlement agreement that required the Company to refund approximately $2.6 million related to that issue. After rejection by the FERC of the Company's continuing claims of disparate treatment based on its having been ordered to make refunds while several similarly situated utilities were not, on September 29, 1993, the FERC rescinded the Company's obligation to make refunds. In making its decision, the FERC invoked its "equitable discretion" and agreed that, based on its having granted a general amnesty from refunds to other utilities, circumstances had changed so dramatically since its approval of the Company's 1992 refund settlement that it would be "unfair to continue to single out Central Maine for refunds." The FERC order allowed the utilities that had shared the $2.6 million in refunds to repay the Company, with interest, over a 24-month period. The utility that received the major share of the amount refunded by the Company requested reconsideration of the FERC rescission order. The Company recorded approximately $3.0 million of income during the third quarter of 1993, reflecting the refund including interest. On March 22, 1994, the parties submitted to the FERC a settlement agreement which, if approved, would require the Company to deliver a combination of cash and power sales having an aggregate value of up to $1.2 million. Financing and Related Considerations During 1993, the Company met its capital requirements (including the refunding of several outstanding securities issues) from a variety of sources, including the issuance of additional General and Refunding Mortgage Bonds, utilization of its unsecured Medium-Term Note Program and its Dividend Reinvestment and Common Stock Purchase Plan, short-term unsecured debt borrowings, including commercial paper, and internally generated funds. Financings. During 1993, the Company continued its program of refinancing its outstanding debt to take advantage of lower interest rates. The Company issued $75 million of Series Q 7.05% Due 2008 General and Refunding Mortgage Bonds in March, $50 million of Series R Bonds, 7 7/8% Due 2023 in May, $60 million of Series S Bonds, 6.03% Due 1998 in August, and $75 million of Series T Bonds, 6.25% Due 1998 in November. None of those series has a sinking fund, and the Series S and Series T Bonds are not callable at the option of the Company. The Series Q and Series R Bonds are not callable at the option of the Company prior to March 1, 1998, and June 1, 2003, respectively, except under limited circumstances. The Company redeemed its $100-million Series I Bonds, 9 1/4% Due 2016 in the second quarter of 1993, $50 million of its Series M Bonds, 9.18% Due 1995 in the third quarter of 1993, and $27.5 million of its Series N Bonds, 8.50% Due 2001 in the fourth quarter of 1993. Premiums paid on redemptions totalled $9.6 million. These financing and refinancing transactions reduced the annual cost of the Company's mortgage debt to 7.1 percent at December 31, 1993, from 8.5 percent at December 31, 1992. During the year, the Company also raised approximately $25.5 million of additional capital through its Dividend Reinvestment and Common Stock Purchase Plan, resulting in the issuance of 1.2 million new shares of common stock. Effective in January 1994, however, the Company elected to authorize an agent to purchase outstanding shares for this plan on the open market, rather than issue new shares. As a result, the Company's current plans call for no additional shares of common stock to be issued for the next several years. In 1993, the Company issued $48 million of notes under its $150-million medium-term note program at an average interest rate of 4.8 percent and an average life of 2.9 years. Notes in the amount of $26.5 million matured during the year, increasing the total outstanding medium-term notes at year-end 1993 to $146.0 million from $124.5 million at year-end 1992. The proceeds from the debt and equity issuances were used for general corporate purposes, which included financing construction and energy-management projects, retiring or refunding outstanding securities, repaying short-term debt, and buying out purchased-power contracts. Rating Agency Actions. Beginning in late August 1993, three major securities-rating agencies lowered their ratings on the Company's outstanding debt and preferred stock on a number of occasions. In October 1993, Duff & Phelps Credit Rating Co. lowered the Company's fixed income ratings as follows: General and Refunding Mortgage Bonds from "BBB+" to "BBB-"; unsecured notes from "BBB" to "BB+"; and preferred stock from "BBB" to "BB-." Standard & Poor's Corp. ("S&P") announced in late October 1993, the application of more stringent financial-risk standards to the investor-owned utility industry to reflect S&P's view of mounting business risk. S&P stated that it believed the industry's "credit profile" was being "threatened chiefly by intensifying competitive pressures but also by sluggish demand expectations, slow earnings growth prospects, high common dividend payout, environmental cost pressures, and nuclear operating cost and decommissioning challenges." As a result, S&P revised rating outlooks for about one-third of the industry and placed the Company and several other utilities on "CreditWatch with negative implications." On January 5, 1994, S&P removed the Company's ratings from "CreditWatch" and lowered them again as follows: senior secured debt to "BB+" from "BBB-"; senior unsecured debt to "BB-" from "BB+"; preferred stock to "B+" from "BB"; and commercial paper to "B" from "A-3." In addition, S&P assigned its preliminary "BB+" senior-secured-debt rating to the Company's $150-million General and Refunding Mortgage Bonds previously registered with the Securities and Exchange Commission as a "shelf" registration. On January 13, 1994, Moody's Investors Service ("Moody's") lowered its rating on the Company's preferred stock to "ba2" from "baa3" and its short-term debt rating for the Company's commercial paper to "Prime-3" from "Prime-2." At the same time, Moody's confirmed its ratings on the Company's General and Refunding Mortgage Bonds at "Baa2", unsecured medium-term notes and pollution control revenue bonds at "Baa3", and the Company's Securities and Exchange Commission "shelf" registration for $150,000,000 of General and Refunding Mortgage Bonds to "(P)Baa2." The rating agencies explained that the downgrades primarily reflected the MPUC's "unsupportive" base-rate decision, which in their opinion will not allow the Company's financial parameters, adjusted for off-balance-sheet obligations, to remain at acceptable levels for a utility with a "below-average" business position. In addition, the rating agencies expressed the belief that the Company's business position also reflected a depressed Maine economy, a large industrial-customer base, difficulty in materially reducing its significant purchased-power obligations, relatively high production costs, increasing rate pressures, and a high dividend payout. Deferred Costs. Over the past few years, the amount of the Company's deferred charges and regulatory assets has increased under the regulatory policies of the MPUC. The Securities and Exchange Commission has periodically considered issues regarding the proper accounting treatment of charges deferred by regulatory policy. As a result, the Company has regularly requested the MPUC to issue accounting and ratemaking orders to provide appropriate authority to comply with changing accounting requirements and to allow the Company to appropriately reflect the amounts as deferred charges and regulatory assets. In recent years, the Company received such orders with respect to issues in the 1991 Early Retirement Incentive Program, ERAM, purchased-power contract buy-outs, environmental-site cleanup costs, taxes on losses on reacquired debt, and accounting for postretirement benefits and income taxes pursuant to the newly issued accounting standards. The Company will monitor situations that result in deferred charges and regulatory assets and will seek appropriate regulatory approvals. For further discussion of financing considerations affecting the Company, see the information incorporated by reference in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data (Notes 4 and 7 of Notes to Financial Statements), below. Environmental Matters In connection with the operation and construction of its facilities, various federal, state and local authorities regulate the Company regarding air and water quality, hazardous wastes, land use, and other environmental considerations. Such regulation sometimes requires review, certification or issuance of permits by various regulatory authorities. In addition, implementation of measures to achieve environmental standards may hinder the ability of the Company to conduct day-to-day operations, or prevent or substantially increase the cost of construction of generating plants, and may require substantial investment in new equipment at existing generating plants. Although no substantial investment is presently necessary, the Company is unable to predict whether such investment may be required in the future. Water Quality Control. The federal Clean Water Act provides that every "point source" discharger of pollutants into navigable waters must obtain a National Pollutant Discharge Elimination System ("NPDES") permit specifying the allowable quantity and characteristics of its effluent. Maine law contains similar permit requirements and authorizes the state to impose more stringent requirements. The Company holds all permits required for its plants by the Clean Water Act, but such permits may be reopened at any time to reflect more stringent requirements promulgated by the EPA or the Maine Department of Environmental Protection ("DEP"). Compliance with NPDES and state requirements has necessitated substantial expenditures and may require further substantial expenditures in the future. Air Quality Control. Under the federal Clean Air Act, as amended, the EPA has promulgated national ambient air quality standards for certain air pollutants, including sulfur oxides, particulate matter and nitrogen oxides. The EPA has approved a Maine implementation plan prepared by the DEP for the achievement and maintenance of these standards. The Company believes that it is in compliance with the requirements of the Maine plan. The Clean Air Act also imposes stringent emission standards on new and modified sources of air pollutants. Maintaining compliance with more stringent standards, if they should be adopted, could require substantial expenditures by the Company. Although 1990 amendments to the Clean Air Act require, among other things, an aggregate reduction of sulfur dioxide emissions by United States electric utilities by the year 2000, the Company believes that the amendments will not have a material adverse effect on the Company's operations. In addition, a state regulation restricts the sulfur content of the fuel oil burned in Maine to 2.0 percent. However, all oil burned at William F. Wyman Unit No. 4 in Yarmouth, Maine, is required by license to have a sulfur content not exceeding 0.7 percent, and the other three units at Wyman Station are required to have a sulfur content not exceeding 1.5 percent when Wyman Unit No. 4 is in operation. The Company believes that it will continue to be able to obtain a sufficient supply of oil with the required sulfur contents, subject to unforeseen events and the factors influencing the availability of oil discussed under Item 2, Properties, "Fuel Supply", below. The operation of the Company's present fuel adjustment clause permits it to recover any additional cost of such fuel from its customers upon review by the MPUC. Hazardous Waste Regulations. Under the federal Resource Conservation and Recovery Act of 1976, as amended ("RCRA"), the generation, transportation, treatment, storage and disposal of hazardous wastes are subject to EPA regulations. Maine has adopted state regulations that parallel RCRA regulations, but in some cases are more stringent. The notifications and applications required by the present regulations have been made. The procedures by which the Company handles, stores, treats, and disposes of hazardous waste products have been revised, where necessary, to comply with these regulations and with more stringent requirements on hazardous waste handling imposed by amendments to RCRA enacted in 1984. For a discussion of a matter in which the Company has been named a potentially responsible party by the EPA with respect to the disposal of certain toxic substances, see Item 3, Legal Proceedings, under the caption "PCB Disposal", below. Electromagnetic Fields. Public concern has arisen in recent years as to whether electromagnetic fields associated with electric transmission and distribution facilities and appliances and wiring in buildings ("EMF") contribute to certain public health problems. This concern has resulted in some areas in opposition to existing or proposed utility facilities, requests for new legislative and regulatory standards, and litigation. On the basis of the scientific studies to date, the Company believes that no persuasive evidence exists that would prove a causal relationship or justify substantial capital outlays to mitigate the perceived risks. Although the Company has suffered no material effect as a result of this concern, the Company supports further research on this subject and since 1988 has been compiling and disseminating through a regular periodic publication information on all related studies and published materials as a central clearing house for such information, as well as providing such information to its customers. The Company intends to continue to monitor all significant developments in this field. Capital Expenditures. The Company estimates that its capital expenditures for environmental purposes for the five years from 1989 through 1993 totaled approximately $22.9 million. The Company cannot presently predict the amount of such expenditures in the future, as such estimates are subject to change in accordance with changes in applicable environmental regulations. Employee Information A local union affiliated with the International Brotherhood of Electrical Workers (AFL-CIO) represents operating and maintenance employees in each of the Company's operating divisions, and certain office and clerical employees. At December 31, 1993, the Company had 2,103 full-time employees, of whom approximately 46 percent are represented by the union. At the end of 1990 the Company had 2,322 full-time employees. The reduction in the number of full-time employees from 1991 through 1993 was due largely to the implementation of an early retirement program and other efficiency measures in 1991 and 1992. In the first quarter of 1994 the Company further reduced its staffing in connection with its restructuring and cost-reduction program described above under "Introduction" - "Cost Reduction and Restructuring". In 1989 the Company and its employees represented by the union agreed to a three-year contract, which was to expire on May 1, 1992. In November 1991, however, the Company and the union agreed to a three-year extension of the contract providing for annual wage increases of 3 percent, 3 percent, and 3.5 percent, respectively, for each of the three years ending on May 1, 1995, respectively. Item 2. Item 2. PROPERTIES. Existing Facilities The electric properties of the Company form a single integrated system which is connected at 345 kilovolts and 115 kilovolts with the lines of Public Service Company of New Hampshire at the southerly end and at 115 kilovolts with Bangor Hydro-Electric Company at the northerly end of the Company's system. The Company's system is also connected with the system of The New Brunswick Power Corporation and with Bangor Hydro-Electric Company, in each case through the 345-kilovolt interconnection constructed by MEPCO, a 78 percent-owned subsidiary of the Company. At December 31, 1993, the Company had approximately 2,273 circuit-miles of overhead transmission lines, 18,605 pole-miles of overhead distribution lines and 1,182 miles of underground and submarine cable. The maximum one-hour firm system net peak load experienced by the Company during the winter of 1993-1994 was approximately 1,337 megawatts on January 27, 1994. At the time of the peak, the Company's net capability was 1,977 megawatts. The maximum such peak load experienced by the Company during the preceding three winters was approximately 1,456 megawatts on January 8, 1991, at which time the Company's net capability was 2,069 megawatts. The New England Power Pool ("NEPOOL"), of which the Company is a member, had sufficient installed capacity and firm purchases to meet the NEPOOL four- year peak load of 19,742 megawatts experienced on July 19, 1991, and its 1993-1994 winter peak load of 19,534 megawatts on January 19, 1994. See "NEPOOL", below. The Company operates 28 hydroelectric generating stations with an estimated net capability of 368 megawatts and purchases an additional 91 megawatts of hydroelectric generation in Maine. It is currently re-evaluating some of its older hydroelectric plants in conjunction with efforts to obtain new federal operating licenses, with the objective of increasing their output and extending their usefulness. The Company also operates one oil-fired steam-electric generating station, William F. Wyman Station in Yarmouth, Maine, after de-activating its Mason Station in Wiscasset, Maine, in 1991. The Company's share of William F. Wyman Station has an estimated net capability of 592 megawatts. The oil-fired station is located on tidewater, permitting waterborne delivery of fuel. The Company also has three internal combustion generating facilities with an estimated aggregate net capability of 41 megawatts. The Company has ownership interests in five nuclear generating plants in New England. The largest is a 38-percent interest in Maine Yankee, which generates power at its plant in Wiscasset, Maine. In addition, the Company owns a 9.5 percent interest in Yankee Atomic Electric Company ("Yankee Atomic"), which has permanently shut down its plant located in Rowe, Massachusetts, a 6 percent interest in Connecticut Yankee Atomic Power Company ("Connecticut Yankee"), with a plant in Haddam, Connecticut, and a 4 percent interest in Vermont Yankee Nuclear Power Corporation ("Vermont Yankee"), which owns a plant located in Vernon, Vermont (collectively, with Maine Yankee, the "Yankee Companies"). In addition, pursuant to a joint ownership agreement, the Company has a 2.5 percent direct ownership interest in the Millstone 3 nuclear unit ("Millstone 3") in Waterford, Connecticut. In February 1992, the Board of Directors of Yankee Atomic, after concluding that it would be uneconomic to continue to operate, decided to permanently discontinue power operation at the Yankee Atomic plant and to decommission that facility. The Company had relied on Yankee Atomic for less than one percent of the Company's system capacity. Its 9.5-percent equity investment in Yankee Atomic is approximately $2.3 million. Currently, purchased-power costs billed to the Company, which include the estimated cost of the ultimate decommissioning of the unit, are collected by the Company from its customers through the Company's base-rate structure. On March 18, 1993, the FERC approved a settlement agreement regarding the decommissioning plan, recovery of plant investment, and all issues with respect to prudence of the decision to discontinue operation. The Company has estimated its remaining share of the cost of Yankee Atomic's continued compliance with regulatory requirements, recovery of its plant investments, decommissioning and closing the plant, to be approximately $32.8 million. This estimate, which is subject to ongoing review and revision, has been recorded by the Company as a regulatory asset and a liability on the Company's balance sheet. As part of the MPUC's decision in the Company's recent base-rate case, the Company's share of costs related to the deactivation of Yankee Atomic is being recovered through rates based on the most recent projections of costs. The Company's share of the capacity of the four operating nuclear generating plants amounted to the following: The Company is obligated to pay its proportionate share of the operating expenses, including depreciation and a return on invested capital, of each of the Yankee Companies referred to above for periods expiring at various dates to 2012. Pursuant to the joint ownership agreement for Millstone 3, the Company is similarly obligated to pay its proportionate share of the operating costs of Millstone 3. The Company is also required to pay its share of the estimated decommissioning costs of each of the Yankee Companies and Millstone 3. The estimated decommissioning costs are paid as a cost of energy in the amounts allowed in rates by the FERC. MEPCO owns and operates a 345-kilovolt transmission interconnection, completed in 1971, extending from the Company's substation at Wiscasset to the Canadian border where it connects with a line of The New Brunswick Power Corporation ("NB Power") under a 25-year interconnection agreement. MEPCO transmits power between NB Power and various New England utilities under separate agreements. In 1990 MEPCO transferred to a newly formed partnership, of which a subsidiary of the Company is a 50-percent general partner, approximately $29 million of construction work in progress and an equal amount of deferred credits related to the construction of certain static var compensator facilities used for stabilization purposes in connection with the NEPOOL Hydro-Quebec purchase discussed in the succeeding paragraph. NEPOOL, of which the Company is a member, contracted in connection with its Hydro-Quebec projects to purchase power from Hydro-Quebec. The contracts entitle the Company to 85.9 megawatts of capacity credit in the winter and 127.25 megawatts of capacity credit during the summer. The Company also entered into facilities-support agreements for its share of the related transmission facilities, with its share of the support responsibility and of associated benefits being approximately 7 percent of the totals. The Company is making facilities-support payments on approximately $33.2 million, its share of the construction cost for the transmission facilities incurred through December 31, 1993. Maine Yankee Decommissioning. Effective in 1988 Maine Yankee began collecting $9.1 million annually for decommissioning based on a FERC-approved funding level of $167 million. In January 1994, Maine Yankee filed a notice of tariff change with the FERC to increase its annual collection to $14.9 million and to reduce its return on common equity to 10.65 percent, for a total net increase in rates of approximately $3.4 million. The increase in decommissioning collection is based on the estimated cost of decommissioning the Maine Yankee Plant, assuming dismantlement and removal, of $317 million (in 1993 dollars) based on a 1993 external engineering study. The estimated cost of decommissioning nuclear plants is subject to change due to the evolving technology of decommissioning and the possibility of new legal requirements. Maine Yankee's accumulated decommissioning funds were $93.8 million as of December 31, 1993. Maine Yankee Low-Level Waste Disposal. The federal Low- Level Radioactive Waste Policy Amendments Act (the "Waste Act"), enacted in 1986, required operating disposal facilities to accept low-level nuclear waste from other states until December 31, 1992. The Waste Act also set limits on the volume of waste each disposal facility must accept from each state, established milestones for the nonsited states to establish facilities within their states or regions (pursuant to regional compacts) and authorized increasing surcharges on waste disposal until 1992. After 1992 the states in which there are operating disposal sites are permitted to refuse to accept waste generated outside their states or compact regions. In 1987 the Maine Legislature created the Maine Low-Level Radioactive Waste Authority (the "Maine Authority") to provide for such a facility if Maine is unable to secure continued access to out-of-state facilities after 1992, and the Maine Authority engaged in a search for a qualified disposal site in Maine. Maine Yankee volunteered its site at the Plant for that purpose, but progress toward establishing a definitive site in Maine, as in other states, was difficult because of the complex technical nature of the search process and the political sensitivities associated with it. As a result, Maine did not satisfy its milestone obligation under the Waste Act requiring submission of a site license application by the end of 1991, and is therefore subject to surcharges on its waste and has not had access to regulated disposal facilities since the end of 1992. Thus, Maine Yankee now stores all waste generated at an on-site storage facility. At the same time, the State of Maine was pursuing discussions with the State of Texas concerning participation in a compact with that state and Vermont. In May 1993, the Texas Legislature approved a compact with the states of Maine and Vermont. The Maine Legislature in June 1993 ratified the compact and submitted it to ratification by Maine voters in a referendum held on November 2, 1993, in which the compact was ratified by a margin of approximately 73% to 27%. It must now be presented to the United States Congress for final ratification. The compact provides for Texas to take Maine's low-level waste over a 30-year period for disposal at a planned facility in west Texas. In return Maine would be required to pay $25 million, assessed to Maine Yankee by the State of Maine, payable in two equal installments, the first after ratification by Congress and the second upon commencement of operation of the Texas facility. In addition, Maine Yankee would be assessed a total of $2.5 million for the benefit of the Texas county in which the facility would be located and would also be responsible for its pro-rata share of the Texas governing commission's operating expenses. Pending the ratification votes, the Maine Authority suspended its search for a suitable disposal site in Maine. In the event the required ratification by Congress is not obtained, subject to continued NRC approval, Maine Yankee can continue to utilize its capacity to store approximately ten to twelve years' production of low-level waste in its facility at the Maine Yankee Plant site, which it started in January 1993. Subject to obtaining necessary regulatory approval, Maine Yankee could also build a second facility on the Plant site. Maine Yankee believes it is probable that it will have adequate storage capacity for such low-level waste available on-site, if needed, through the licensed operating life of the Maine Yankee Plant. On January 26, 1993, the NRC published for public comment a proposed rulemaking that, if adopted, would require a licensee such as Maine Yankee, as a condition of its license, to document that it had exhausted other reasonable waste management options in order to be permitted to store low-level waste on-site beyond January 1, 1996. Such options include taking all reasonable steps to contract, either directly or through the state, for disposal of the low-level waste. On February 9, 1994, the NRC, after affirming its preference for disposal of waste over storage, announced its decision to withdraw the proposed rulemaking. Maine Yankee has informed the Company that it expects the NRC to issue its formal notice of withdrawal in the spring of 1994. The Company cannot predict whether the final required ratification of the Texas compact or other regulatory approvals required for on-site storage will be obtained, but Maine Yankee has stated that it intends to utilize its on-site storage facility in the interim and continue to cooperate with the State of Maine in pursuing all appropriate options. Nuclear Insurance. The Price-Anderson Act is a federal statute providing, among other things, a limit on the maximum liability for damages resulting from a nuclear incident. Coverage for the liability is provided for by existing private insurance and retrospective assessments for costs in excess of those covered by insurance, up to $75.5 million for each reactor owned, with a maximum assessment of $10 million per reactor in any year. Based on the Company's stock ownership in four nuclear generating facilities and its 2.5 percent direct ownership interest in the Millstone 3 nuclear plant, the Company's retrospective premium could be as high as $6 million in any year, for a cumulative total of $45.3 million, exclusive of the effect of inflation indexing and a 5-percent surcharge in the event that total public liability claims from a nuclear incident should exceed the funds available to pay such claims. In addition to the insurance required by the Price-Anderson Act, the nuclear generating facilities mentioned above carry additional nuclear property-damage insurance. This additional insurance is provided from commercial sources and from the nuclear electric utility industry's mutual insurance company through a combination of current premiums and retrospective premium adjustments. Based on current premiums and the Company's indirect and direct ownership in nuclear generating facilities, this adjustment could range up to approximately $6.3 million annually. For a discussion of issues relating to Maine Yankee's spent nuclear fuel disposal, see "Fuel Supply" - "Nuclear", below. Non-utility Generation In the Public Utility Regulatory Policies Act of 1978 ("PURPA") the United States Congress provided substantial economic incentives to non-utility power producers by allowing cogenerators and small power producers to sell their entire electrical output to an electric utility at the utility's avoided-cost rate and purchase their entire electric energy requirement at the utility's established rate for that customer class. The Maine Legislature enacted a companion measure in 1979. The Company has entered into a number of long-term, noncancellable contracts for the purchase of capacity and energy from non-utility generators. The agreements generally have terms of five to 30 years and require the Company to purchase the energy at specified prices per kilowatt-hour. As of December 31, 1993, facilities having 596 megawatts of capacity covered by these contracts were in service, and another 15 megawatts is expected to be added by the end of 1994. The costs of purchases under all of these contracts amounted to $360.7 million in 1993, $341.5 million in 1992 and $332.4 million in 1991. Such costs are recoverable through the Company's fuel clause, after review and approval by the PUC. In connection with the Company's 1992 fuel cost adjustment proceeding, the MPUC announced it would review the prudence of administration and management of these contracts, as well as the terms and conditions of recent contracts. For a discussion of an imprudence finding by the MPUC in connection with its review, see Item 1, "Business", "Regulation and Rates" - "MPUC NUG Contracts Investigation", above. In an effort to control the price pressure related to purchases from non-utility generators, the Company negotiated long term contract buy-outs or restructuring with three non-utility generators in 1992, four in 1993, eleven in early 1994, and continues to renegotiate other contracts. The Company incurred buy-out costs of approximately $11.4 million in 1993 and $19 million in 1992. The 1994 renegotiation of prices and contract terms did not require cash payments. Total buy-outs, restructuring, and terminations made to date are expected to save the Company's customers more than $170 million in fuel costs during the next five years. Construction Program The Company's plans for improvements and expansion of generating, transmission and distribution facilities and power- supply sources are under continuing review. Actual construction expenditures depend on the availability of capital and other resources, load forecasts, customer growth, and general business conditions. Recent economic and regulatory considerations have led the Company to hold its planned 1994 capital investment outlays, including deferred demand-side management expenditures, to a level below that of 1993. During the five-year period ended December 31, 1993, the Company's construction and acquisition expenditures amounted to $425.1 million (including investment in jointly-owned projects and excluding MEPCO), including an Allowance for Funds Used During Construction ("AFC") of $13.6 million. The program is currently estimated at approximately $60 million for 1994 and $256 million for 1995 through 1998, including AFC estimated for the period 1994 through 1998 at $3 million, and including an estimated $35 million for conservation and energy management programs for the 1994 through 1998 period. The following table sets forth the Company's estimated capital expenditures as discussed above: Demand-side Management The Company's demand-side-management efforts have included programs aimed at residential, commercial and industrial customers. Among the residential efforts have been programs that offer energy audits, low-cost insulation and weatherization packages, water heater wraps, energy-efficient light bulbs, and water heater cycling credits. Among the commercial and industrial efforts have been programs that offer rebates for efficient lighting systems and motors, energy management loans, grants to customers who make efficiency improvements, and shared savings arrangements with customers who undertake qualifying conservation and load management programs. Under the Company's "Power Partners" program, customers or energy service companies may submit energy management project bids in response to requests for proposals issued by the Company for specific blocks of power. Power Partners was the first program in the United States to allow energy management proposals to compete on an equal basis with cogeneration and small power production facilities in a bidding process for capacity and energy. The Company anticipates incurring expenses of approximately $17.5 million in 1994 in connection with conservation and load-management programs and expects the costs of all of these programs to be recoverable through rates. Actual expenditures depend on such factors as availability of capital and other resources, load forecasts, customer growth, and general business conditions. Because of budget constraints, the Company is seeking to concentrate its efforts where the need and cost- effectiveness are the greatest, while continuing to honor contractual commitments. NEPOOL The Company is a member of NEPOOL, which is open to all investor-owned, municipal and cooperative electric utilities in New England under an agreement in effect since 1971 that provides for coordinated planning and operation of approximately 99 percent of the electric power production, purchases and transmission in New England. The NEPOOL Agreement imposes obligations concerning generating capacity reserve and the use of major transmission lines, and provides for central dispatch of the region's facilities. Fuel Supply The Company's total kilowatt-hour production by energy source for each of the last two years and as estimated for 1994 is shown below: The 1994 estimated kilowatt-hour output from oil and purchased power may vary depending upon the relative costs of Company-generated power and power purchased through NEPOOL and independent producers. Oil. The Company's William F. Wyman Station in Yarmouth, Maine, and its internal combustion electric generating units are oil-fired. A one-year contract for the supply of the Company's fuel oil requirements at market prices expired on June 30, 1993. Since then the Company has been purchasing its fuel oil requirements on the open market. The average cost per barrel of fuel oil purchased by the Company during the five calendar years commencing with 1989 was $17.07, $17.33, $12.87, $14.02 and $13.12, respectively. A substantial portion of the fuel oil burned by the Company and the other member utilities of NEPOOL is imported. The availability and cost of oil to the Company, both under contract and in the open market, could be adversely affected by policies and events in oil-producing nations and other factors affecting world supplies and domestic governmental action. Nuclear. As described above, the Company has interests in a number of nuclear generating units. The cycle of production and utilization of nuclear fuel for such units consists of (1) the mining and milling of uranium ore, (2) the conversion of the resulting concentrate to uranium hexafluoride, (3) the enrichment of the uranium hexafluoride, (4) the fabrication of fuel assemblies, (5) the utilization of the nuclear fuel, and (6) the disposal of spent fuel. Maine Yankee has entered into a contract with the United States Department of Energy ("DOE") for disposal of its spent nuclear fuel, as required by the Nuclear Waste Policy Act of 1982, pursuant to which a fee of one dollar per megawatt-hour is currently assessed against net generation of electricity and paid to the DOE quarterly. Under this Act, the DOE has assumed the responsibility for disposal of spent nuclear fuel produced in private nuclear reactors. In addition, Maine Yankee is obligated to make a payment with respect to generation prior to April 7, 1983 (the date current DOE assessments began). Maine Yankee has elected under terms of this contract to make a single payment of this obligation prior to the first delivery of spent fuel to DOE, scheduled to begin no earlier than 1998. The payment will consist of $50.4 million (all of which Maine Yankee has previously collected from its customers, but for which a reserve was not funded), which is the approximate one-time fee charge, plus interest accrued at the 13-week Treasury Bill rate compounded on a quarterly basis from April 7, 1983, through the date of the actual payment. Current costs incurred by Maine Yankee under this contract are recoverable under the terms of its Power Contracts with its sponsoring utilities, including the Company. Maine Yankee has accrued and billed $53.1 million of interest cost for the period April 7, 1983, through December 31, 1993. Maine Yankee has formed a trust to provide for payment of its long-term spent fuel obligation, and is funding the trust with deposits at least semiannually which began in 1985, with currently projected semiannual deposits of approximately $0.6 million through December 1997. Deposits are expected to total approximately $62.8 million, with the total liability, including interest due at the time of disposal, estimated to be approximately $115.9 million at January 31, 1998. Maine Yankee estimates that trust fund deposits plus estimated earnings will meet this total liability if funding continues without material changes. Under the terms of a license amendment approved by the NRC in 1984, the present storage capacity of the spent fuel pool at the Maine Yankee Plant will be reached in 1999 and after 1996 the available capacity of the pool will not accommodate a full-core removal. After consideration of available technologies, Maine Yankee elected to provide additional capacity by replacing the fuel racks in the spent fuel pool at the Maine Yankee Plant for more compact storage and, on January 25, 1993, filed with the NRC seeking authorization to implement the plan. On March 15, 1994, the NRC granted the authorization. Maine Yankee believes that the replacement of the fuel racks will provide adequate storage capacity through the Maine Yankee Plant's licensed operating life. Maine Yankee has stated that it cannot predict with certainty whether or to what extent the storage capacity limitation at the plant will affect the operation of the plant or the future cost of disposal. Federal legislation enacted in December 1987 directed the DOE to proceed with the studies necessary to develop and operate a permanent high-level waste (spent fuel) disposal site at Yucca Mountain, Nevada. The legislation also provides for the possible development of a Monitored Retrievable Storage ("MRS") facility and abandons plans to identify and select a second permanent disposal site. An MRS facility would provide temporary storage for high-level waste prior to eventual permanent disposal. In late 1989 the DOE announced that the permanent disposal site is not expected to open before 2010, although originally scheduled to open in 1998. Additional delays due to political and technical problems are probable. The Company has been advised by the companies operating nuclear generating stations in which the Company has an interest that each of those companies has contracted for certain segments of the nuclear fuel production and utilization cycle through various dates. Contracts for other segments of the fuel cycle will be required in the future, but their availability, prices and terms cannot now be predicted. Those companies have also advised the Company that they are assessing options generally similar to those described above with respect to Maine Yankee in connection with disposal of spent nuclear fuel. Item 3. Item 3. LEGAL PROCEEDINGS. Material proceedings before the Maine PUC involving the Company are discussed above in Item 1, Business. PCB Disposal The Company is a party in legal and administrative proceedings that arise in the normal course of business. In connection with one such proceeding, the Company has been named as a potentially responsible party and has been incurring costs to determine the best method of cleaning up an Augusta, Maine, site formerly owned by a salvage company and identified by the EPA as containing soil contaminated by polychlorinated biphenyls (PCBs) from equipment originally owned by the Company. In 1990, the Company and the EPA signed a negotiated consent agreement, which was entered as an order by the United States District Court for the District of Maine in 1991. The agreement provides for studies, development of work plans, additional EPA review, and eventual cleanup of the site by the Company over a period of years, using the method and level of cleanup selected by the EPA. The Company has been investigating other courses of action that might result in lower costs and, in March 1992, acquired title to the site to pursue the possibility of developing it in a manner that would not require the same method and level of cleanup currently provided in the agreement. The Company also initiated a lawsuit against the original owners of the site and Westinghouse Electric Corp. (Westinghouse), which arranged for the equipment disposal, seeking contributions toward past and future cleanup costs. On November 8, 1993, the United States District Court for the District of Maine rendered its decision in the suit, holding that Westinghouse was responsible for 41 percent of the necessary past and future cleanup costs and the former owners 12.5 percent, other than a small amount (less than 5 percent) of such costs not attributable to PCBs, for which Westinghouse was held not responsible and the former owners were held responsible for 33 percent. The Court further concluded that the Company had incurred approximately $3.3 million to that point in costs subject to sharing among the parties. At the same time, the Company has been actively pursuing recovery of its costs through its insurance carriers and has reached agreement with one for recovering a portion of those costs. It has also filed lawsuits seeking such recovery from other carriers. In August 1991, the Company requested permission from the MPUC to defer its cleanup-related costs, with accrued carrying costs, on the basis that such costs are allowable costs of service and should be recoverable in rates. In August 1992, the MPUC issued an order authorizing the Company to defer direct costs associated with the site incurred after August 9, 1991, with accrued carrying costs. Such costs incurred prior to the request were charged to a $3-million reserve established in 1985. Initial tests on the site have been completed and more complex technological studies are still in progress. Based on results to date and on the most likely cleanup method, the Company believes that its remaining costs of the cleanup will total between $7 million and $11 million, depending on the level of cleanup ultimately required and other variable factors. Such estimate is net of the agreed insurance recovery and considers any contributions from Westinghouse and the former owners, but excludes contributions from the insurance carriers the Company has sued, or any other third parties. As a result, in the fourth quarter of 1993, the Company decreased the liability recorded on its books from $14 million, the estimated liability prior to the November 1993 court ruling, to $7 million and recorded an equal reduction in a regulatory asset established to reflect the anticipated ratemaking recovery of such costs when ultimately paid. Approximately $1 million of costs incurred to date has been charged against the liability. The Company cannot predict the level and timing of the cleanup costs, the extent to which they will be covered by insurance, or the ratemaking treatment of such costs, but believes it should recover substantially all of such costs through insurance and rates. The Company also believes that the ultimate resolution of the legal and environmental proceedings in which it is currently involved will not have a material adverse effect on its financial condition. Power Purchase Contract Suit. As previously reported, the Company and Caithness King of Maine Limited Partnership ("Caithness") engaged in a lawsuit in the United States District Court for the District of Maine over the Company's termination of a contract for the purchase of approximately 80 megawatts of electric power from a cogeneration project proposed for construction by Caithness at the Topsham, Maine. In the suit Caithness denied the validity of the termination and sought damages estimated by Caithness to be in excess of $100 million for breach of contract or, in the alternative, reformation of the contract, and other legal relief. Also as previously reported, on January 14, 1994, the Company and Caithness entered into a Termination and Settlement Agreement under which the Company paid Caithness a total of $5 million, and the parties agreed to the termination of the power- purchase contract and to dismiss the suit and counterclaims. The contract would have required payments by the Company over the life of the contract that were projected to be significantly higher than the Company's estimated avoided costs and was therefore inconsistent with the Company's program of pursuing terminations or other restructurings of high-cost power-purchase contracts. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. Item 4.1. EXECUTIVE OFFICERS OF THE REGISTRANT. The following are the present executive officers of the Company with all positions and offices held. There are no family relationships between any of them, nor are there any arrangements or understandings pursuant to which any were selected as officers. Each of the executive officers, except Mr. Mildner, has for the past five years been an officer or employee of the Company. Curtis A. Mildner joined the Company as Vice President, Marketing, on February 7, 1994. Prior to his employment by the Company, he had been employed since 1987 by Hussey Seating Company of Berwick, Maine, as Vice President, Marketing, and in related capacities. Mr. Hunter has announced that he plans to retire effective May 1, 1994. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is traded on the New York Stock Exchange. As of March 21, 1994, there were 35,146 holders of record of the Company's common stock. Under the most restrictive terms of the indenture securing the Company's General and Refunding Mortgage Bonds and of the Company's Articles of Incorporation, no dividend may be paid on the common stock of the Company if such dividend would reduce retained earnings below $29.6 million. At December 31, 1993, $87.5 million of retained earnings was not so restricted. Future dividend decisions will be subject to future earnings levels and the financial condition of the Company and will reflect the evaluation by the Company's Board of Directors of then existing circumstances. Item 6. Item 6. SELECTED FINANCIAL DATA. The following table sets forth selected consolidated financial data of the Company for the five years ended December 31, 1989 through 1993. This information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and related notes thereto included elsewhere herein. The selected consolidated financial data for the years ended December 31, 1989 through 1993 are derived from the audited financial statements of the Company. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required to be furnished in response to this Item is submitted as pages 1 to 15 of Exhibit 13-1 hereto (the Company's Annual Report to Shareholders for the year ended December 31, 1993), which pages are hereby incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required to be furnished in response to this Item is submitted as pages 15 through 48 of Exhibit 13-1 hereto (the Company's Annual Report to Shareholders for the year ended December 31, 1993), which pages are hereby incorporated herein by reference. For ease of reference, the following is a listing of financial information incorporated by reference to Exhibit 13-1 hereto, which shows the page number or numbers of said Exhibit on which such information is presented. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The information required to be furnished in response to this Item is submitted on page 49 of Exhibit 13-1 hereto (the Company's Annual Report to Shareholders for the year ended December 31, 1993), which page is hereby incorporated by reference. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. See the information under the heading "Election of Directors" in the registrant's definitive proxy material for its annual meeting of shareholders to be held on May 25, 1994, and Item 4.1, Executive Officers of the Registrant, above, both of which are hereby incorporated herein by reference. Item 11. Item 11. EXECUTIVE COMPENSATION. See the information under the heading "Board Committees, Meetings and Compensation" and the heading "Executive Compensation" in the registrant's definitive proxy material for its annual meeting of shareholders to be held on May 25, 1994, which is hereby incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. See the information under the heading "Security Ownership" in the registrant's definitive proxy material for its annual meeting of shareholders to be held on May 25, 1994, which is hereby incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. See the information under the heading, "Board Committees, Meetings and Compensation" in the registrant's definitive proxy material for its annual meeting of shareholders to be held on May 28, 1994, which is hereby incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Listing of Exhibits. The exhibits which are filed with this Form 10-K or are incorporated herein by reference are set forth in the Exhibit Index, which immediately precedes the exhibits to this report. (b) Reports on Form 8-K. The Company filed the following reports on Form 8-K during the last quarter of 1993 and thereafter to date: Date of Report Items Reported October 27, 1993 Item 5 Lowering of debt and preferred stock ratings. On October 27, 1993, Duff & Phelps Credit Rating Co. announced that it was lowering the ratings of the Company's debt and preferred stock. Date of Report Items Reported October 28, 1993 Item 5 (a) Debt and preferred stock ratings. On October 29, 1993, Moody's Investors Service ("Moody's") lowered the ratings on the Company's long-term debt and preferred stock, citing concerns about the Company's "ability to safeguard its competitive position and to gain the regulatory support needed to avoid further pressure on cash flow and debt-protection measurements". (b) Base-rate case. The Company reported on positions taken by certain parties in the Company's base-rate case before the PUC. (c) PUC order on independent power producer contracts. On October 28, 1993, the PUC issued its written order incorporating the conclusions of its October 5, 1993, deliberations. Date of Report Items Reported November 30, 1993 Item 5 Public Utilities Commission order in base-rate case and securities downgrading. On November 30, 1993, the MPUC issued its basic revenue requirements order finding the Company entitled to an annual revenue increase of $26.2 million in the Company's $83 million base-rate case. On December 1, 1993, Standard & Poor's Corp. ("S&P") further lowered its ratings of the Company's securities. Date of Report Items Reported December 15, 1993 Item 5 Common stock dividend reduction. On December 15, 1993, the Company's Board of Directors reduced the quarterly dividend on the Company's common stock from 39 cents to 22.5 cents per share. Date of Report Items Reported December 16, 1993 Item 5 (a) On December 16, 1993, the Company announced that David T. Flanagan had been elected President, Chief Executive Officer and a director, effective January 1, 1994, succeeding Matthew Hunter, who planned to retire May 1, 1994. (b) The Company reported that effective December 27, 1993, the Company's 450,000 shares of outstanding Flexible Money Market Preferred Stock, Series A, would no longer be subject to the restriction that it be conveyed only in Units of 1,000 shares. (c) On December 20, 1993, the Chief Justice of the Maine Supreme Judicial Court issued an order temporarily staying the .5% return-on-equity penalty that had been imposed on the Company by the MPUC on October 28, 1993, in its independent power producer contracts investigation. Date of Report Items Reported January 5, 1994 Item 5 On January 5, 1994, S&P further lowered its ratings on the Company's securities, including the senior secured debt rating to "BB+" from BBB-". Date of Report Items Reported January 13, 1994 Items 4 and 5 Item 4. On January 19, 1994, the Company's Board of Directors voted to engage Coopers & Lybrand as the Company's principal accountants in 1994. The Item also contained information on a disagreement in 1991 with the Company's predecessor accountants. (This item amended by Form 8-K/A, Amendment No. 1, also dated January 13, 1994. Item 5. (a) On January 13, 1994, Moody's lowered its ratings on the Company's preferred stock and commercial paper, while confirming its rating on the Company's General and Refunding Mortgage Bonds at "Baa2". (b) On January 14, 1994, the Company and Caithness King of Maine Limited Partnership entered into a Termination and Settlement Agreement terminating power-contract litigation. Date of Report (Form 8-K/A) Items Reported January 13, 1994 Item 4 The Company amended its January 13, 1994, Form 8-K to provide further information on its change of principal accountants and a 1991 disagreement with the Company's predecessor accountants. Date of Report Items Reported February 3, 1994 Item 5 On February 4, 1993, the Chief Justice of the Maine Supreme Judicial Court denied the MPUC's motion to dismiss the Company's approval of the MPUC's October 28, 1993, return-on-equity penalty. The MPUC had contended that it had reconsidered its order imposing the penalty and was considering alternative remedies. 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 Augusta, and State of Maine on the 30th day of March, 1994. CENTRAL MAINE POWER COMPANY By David E. Marsh Vice President, Corporate Services 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 in the capacities and on the dates indicated. The following report and consent and financial schedules of Central Maine Power Company are filed herewith and included in response to Item 14(d). Any and all other schedules are omitted because the required information is inapplicable or the information is presented in the financial statements or related notes. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Central Maine Power Company: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in Central Maine Power Company's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 4, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed on the accompanying index of schedules included in reports to Item 14(a) in 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 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. Boston, Massachusetts February 4, 1994 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports included and incorporated by references in this Form 10-K, into the Company's previously filed Registration Statements File No. 33-44944, File No. 33-44754, File No. 33-51611, File No. 33-39826 and File No. 33-36679. ARTHUR ANDERSEN & CO. Boston, Massachusetts, March 28, 1994 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 CENTRAL MAINE POWER COMPANY File No. 1-5139 (Exact name of Registrant as specified in charter) EXHIBITS

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ITEM 1 BUSINESS (a) General Development of Business Fischer & Porter Company was founded in 1937 and originally incorporated in Pennsylvania in 1942. It was re-incorporated in Delaware in 1987 and re- incorporated in Pennsylvania in 1990. The Company re-incorporated from Pennsylvania to Delaware in 1987 to make available to the Company the then more modern and less restrictive financial provisions of the Delaware Corporation Law. In 1988, Pennsylvania enacted the Business Corporation Law of 1988 ("1988 BCL"). Since the Company's executive offices and virtually all of its domestic operations are in Pennsylvania, and the "1988 BCL" appeared to meet all the objections motivating the 1987 move to Delaware, the Company re-incorporated in Pennsylvania. There has been no significant change in the general development of the Company's business during the past five years. The Company has continued to conduct its business on a worldwide basis through its United States operations and its Subsidiaries throughout the world. (b) Financial Information About Industry Segments The Company operates principally in one industry: process control instrumentation. The process control instrumentation industry designs, engineers, manufactures and sells instruments, systems, maintenance services and replacement parts for the measurement, recording and control of various processes. The Company's products are sold to such diverse markets as municipal and industrial water and wastewater treatment plants, chemical plants, pulp and paper mills, food and beverage processing facilities, pharmaceutical plants, metal refineries and mines. (c) Narrative Description of Business General A high degree of technological competence and innovation is involved in most of the products and services provided. The line of products includes a multiplicity of items, of which the major ones are flowmeters, transmitters, process controllers, micro-computers, disinfection equipment and systems, distributed control systems, and analytical instruments. In the design and manufacture of special process control systems, the Company purchases from outside sources advanced computer products modified to Company specifications. There are a number of suppliers of these computer products and there have not been any constraints as to their availability. Markets The Company's customers include manufacturers who process raw materials; municipalities and industries requiring water and wastewater treatment and control. Among the customers which use the Company's products are those in the chemical, water and waste, and pulp and paper fields. The Company also serves customers in the food, metal, mining, and pharmaceutical industries. Distribution During the twelve months ended 31 December 1993, approximately 32% of total sales were made to customers in the United States and the balance to markets outside the United States. The Company has sales engineering offices in 10 principal cities in the United States, employing 152 field engineers. A distribution center is also maintained in Warminster, Pa. Sales in countries other than the United States are made through field sales engineers of Fischer & Porter Subsidiaries and sales engineering representatives. Competition The business in which the Company is engaged is highly competitive both in the United States and in other countries where the Company does business. There are many other companies which manufacture products that compete with all portions of the product lines of the Company. The principal factors of competition are product performance and price. Some of these competitors are substantially larger than the Company. Reliable figures as to the volume and relative ranking of the business done by competitors are not available. Backlog The backlog of unfilled orders at 31 December 1993 was $55,500,000, compared to the $58,000,000 backlog at the beginning of the year. Incoming orders in 1993 amounted to $219,000,000, 5% lower than in 1992. Approximately 95% of the orders in the backlog at 31 December 1993 are anticipated to be shipped during 1994. Patents and Trademarks The Company owns or controls a number of patents in the United States and foreign countries. Although, in the aggregate, its patents are of considerable importance in the operation of its business, it is the opinion of the Company that there is no one patent or group of patents the loss of which would materially affect the overall operation of the Company. The duration of patents applicable to the Company's business varies, as the Company continually seeks to obtain patents on its inventions (and licenses on the patents of others.) At this time, the Company does not believe there is any point in time at which the expiration of its patents (or the licenses it holds under the patents of others,) will be of material importance. The Company uses a number of trademarks with respect to its products; the important trademarks are registered in the United States and, where deemed appropriate, in other countries. Research and Development The Company maintains an active research and development program for the design and development of new products and the adaptation of existing products for new applications. Total Company sponsored research and development expenditures during 1993, 1992 and 1991 were $10,973,000, $12,396,000, and $12,835,000, respectively. The research and development program employed 150 people during 1993, 156 people during 1992 and 161 people during 1991 . Employee Relations As of 31 December 1993, 2,112 persons were employed on a worldwide basis and relations with these employees are, and have been, satisfactory. The Company and its Subsidiaries provide group life insurance, sick pay, hospitalization, and surgical and medical benefits for its employees. There are also pension plans, which are described in Note 7 of the Notes to Consolidated Financial Statements. The Company is party to one collective bargaining agreement in the United States and three in its International operations. Environmental Matters 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 not had a material effect upon the capital expenditures, earnings or competitive position of the Company. (d) Foreign Operations Financial information relating to foreign and domestic operations for the three years ended 31 December 1993 is presented in Note 12 (Segments of Business) of the Notes to the Consolidated Financial Statements. While the Company is subject to certain risks by operating in foreign countries (political, currency, export and import regulations), the Company believes the risks involved are no greater than the normal risks of doing business. The economic, tariff and trade policies in the countries in which the Company operates are generally not restrictive such that the Company's ability to do business is impaired. Tax policies in these countries vary somewhat compared to the United States and each other, although none of them are overly onerous or restrictive. Cash flow among the countries within which the Company operates is not restricted. Currency exchange rate fluctuations can impact the financial statements via translation of Subsidiary balance sheets and settlement of foreign currency transactions (mostly intercompany in nature). Periodically, hedging techniques are used, but not as a general rule. ITEM 2 ITEM 2 PROPERTIES The Company conducts administrative, sales and manufacturing operations at the following premises: Premises Owned Approximate Area Location (Square Feet) Warminster, Pennsylvania 500,000 Vineland, New Jersey 29,000 Toronto, Canada 78,000 Goettingen, Germany 202,000 Milan, Italy 79,000 Antwerp, Belgium 18,000 Mexico City, Mexico 16,000 Workington, England 48,000 Refer to Note 3 (Long-Term Debt and Restrictions) of the Notes to the Consolidated Financial Statements regarding security interests in certain of these properties. Premises Leased Location Approximate Area Lease (Square Feet) Expiration Dates Madrid, Spain 22,000 1996 Melbourne, Australia 45,000 1999 Stockholm, Sweden 2,000 1996 Gorinchem, Netherlands 8,000 1995 Helsinki, Finland 6,000 1996 Clermont-Ferrand, France 100,000 1994 Wiener Neudorf, Austria 3,000 1994 The Company also leases sales offices in 10 U.S. cities which have expiration dates ranging from 1 to 5 years. See, also, Note 5 (Leases) of the Notes to the Consolidated Financial Statements. The Company believes that the facilities utilized by it are adequate and suitable for the purposes they serve. ITEM 3 ITEM 3 LEGAL PROCEEDINGS In December of 1991, a class action and shareholders' derivative action was filed against the Company and certain current and former officers and directors in the U.S. District Court for the Eastern District of Pennsylvania, [Weiner, et al. vs. Tolson, et al., (No:91-7822)]. The alleged wrongdoings have been denied. In March 1993, the parties stipulated to the dismissal of all class action claims and the dismissal of one of the plaintiffs, Howard Weiner from the action. A tentative agreement was reached by the parties in June 1993 to settle the derivative action, which was the only remaining claim in the lawsuit. However, in August 1993 when the matter was submitted to the Court for approval, the Court failed to approve the proposed settlement. In February 1994, a new agreement was reached to settle the matter, which the Company believes should satisfy all the requirements of the Court. The new Settlement Agreement has been submitted for Court approval, but has not yet been approved. The Company's results of operations or financial condition would not be materially impacted under the terms of the new Settlement Agreement. In October of 1993,a class action suit was filed on behalf of the Company's shareholders against the Company, Jay H. Tolson and E. Joseph Hochreiter (the Company's two former Class B Stockholders, who are also directors and executive officers). The suit was filed in the court of Common Pleas of Bucks County, Pennsylvania, under the caption, Roger Copland vs. Jay H. Tolson, et al., (No. 93008366). The suit challenged the validity of the warrants issued to the two named individuals in connection with their conversion of Class B Stock into Common Stock. The Plaintiff sought to enjoin the exercise of the warrants, to rescind the warrants and to award attorneys' fees and costs to Plaintiff's counsel. In March of 1994, the Company was informed that the Plaintiff will file an Amended Complaint asserting a class action and a derivative claim against the individual defendants. The Company will be named only as a Nominal Defendant on the derivative claims and no claim will be asserted against the Company for any of the wrongdoings alleged in this action. The Company's results of operations or financial condition would not be materially impacted by the outcome of this action, either as currently filed or under the Amended Complaint. Refer, also, to Note 10 (Commitments and Contingencies) of the Notes to 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 quarter ended 31 December 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K, the following list is included as an un-numbered Item in Part I of this Report. Business Experience Name, Age and Position During Past 5 Years Jay H. Tolson, 58 Appointed Chairman of the Board of Chairman of the Board of Directors in 1971 and Chief Executive Directors and Chief Officer in 1983. Was also President Executive Officer from 1974 to 1983 and from 1986 to 1991. Responsible for the formation of overall Corporate policy. E. Joseph Hochreiter, 47 Appointed President and Chief Operating President and Chief Operating Officer in 1991. He was a principal and Officer founder of HMA, Investments, Inc., a private investment firm, from 1987 to 1991; prior thereto he was Executive Vice President of Penn Central Telecommunications Co. from 1984 to 1987 and held various other senior management positions with the Penn Central Corporation from 1972 to 1984. In addition to serving on the Board of Fischer & Porter Company, he is a director of Pennsylvania Pressed Metals, Inc., and is the Chairman of the Board of Superior Air Parts, Inc. Laurence P. Finnegan, Jr., 56 Appointed Chief Financial Officer and Senior Vice President, Treasurer in 1986. Responsible Chief Financial Officer and primarily for all the Company's Treasurer financial, accounting, treasury and information systems functions. Previously was President of HMH Design Group (design and manufacture of electronic assembly equipment) from 1984 to 1986. Joseph P. Garay, 44 Appointed in 1989; Chief Legal Officer Vice President, Secretary and and Secretary responsible for all legal General Counsel matters worldwide, including patents and trademarks; also responsible for share- holders, investors and community relations. Previously was a partner in the corporate department of the law firm of Clark, Ladner, Fortenbaugh & Young of Philadelphia, Pa., specializing in corporate finance, acquisitions/ divestitures and general corporate matters. Nathan T. Schelle, 48 Appointed in 1987; Corporate Controller/ Vice President-Controller Chief Accounting Officer; and Assistant Secretary responsible for worldwide financial reporting and accounting policies and procedures. Previously was Assistant Treasurer with essentially the same duties and responsibilities. PART II ITEM 5 ITEM 5 MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS Principal Market Principal market on which Fischer & Porter's Common stock is traded: American Stock Exchange Market Price for the Common stock and Dividend Information 1993 1992 High Low High Low First quarter $10 1/2 $ 8 5/8 $ 8 3/8 $6 1/2 Second quarter $ 9 5/8 $ 8 $ 9 $7 3/8 Third quarter $ 9 1/4 $ 7 5/8 $ 8 5/8 $7 Fourth quarter $17 7/8 $ 11 $11 1/2 $7 1/8 No cash dividends were paid in 1993 or 1992. A revolving credit agreement contains certain covenants which, among other things, set limitations on the payment of cash dividends on Common Stock. As of 31 December 1993, no cash dividends can be paid on Common Stock. See Notes 3 and 6 of the Notes to the Consolidated Financial Statements. At 31 December 1993, approximately $32,000,000 of retained earnings of International Subsidiaries has not been distributed. Of this amount, $8,200,000 is not currently available for distribution due to local restrictions. See Note 3 of the Notes to the Consolidated Financial Statements with respect to restrictions on dividends and other related payments. Approximate Number of Holders of Common Stock The number of holders of record of Fischer & Porter's Common stock as of 28 February 1994: 2,920 ITEM 6 ITEM 6 SELECTED FINANCIAL DATA Fischer & Porter Company and Subsidiaries (dollar amounts in thousands except per share data) Year Ended 31 December 1993 1992 1991 1990 1989 Summary of Operations Net sales $221,644 $231,317 $236,976 $237,955 $225,324 Income (loss) from operations 4,223 9,117 (14,817) (1,567) 11,680 Interest expense, net 2,608 2,901 3,189 4,170 1,952 Foreign exchange loss (gain) 366 468 289 (1,250) 38 Other income (2) - - - 2,124 - Income (loss) before taxes and accounting change 1,249 5,748 (18,295) (2,363) 9,690 Income taxes 143 4,006 4,236 5,775 6,183 Income (loss) before accounting change 1,106 1,742 (22,531) (8,138) 3,507 Accounting change (1) - - 2,821 - - Net income (loss) (2) 1,106 1,742 (25,352) (8,138) 3,507 Depreciation 6,302 6,878 7,082 7,350 5,924 Capital expenditures 4,517 6,997 6,356 9,155 23,079 Year-End Position Current assets 87,452 86,178 107,329 123,706 125,319 Current liabilities 41,712 40,174 63,668 47,931 50,370 Working capital 45,740 46,004 43,661 75,775 74,949 Current ratio 2.10 2.15 1.69 2.58 2.49 Property, plant and equipment, net 36,638 39,963 42,039 43,958 46,109 Total assets 131,993 132,969 153,901 174,967 178,604 Asset turnover rate 1.68 1.74 1.54 1.36 1.26 Long-term debt 17,266 19,176 12,297 26,897 26,943 Total debt 28,840 25,697 30,734 31,961 33,963 Preferred stock - 710 1,425 2,140 3,427 Shareholders' equity 38,169 41,986 45,359 71,566 75,328 Total capitalization 67,009 68,393 77,518 105,667 112,718 Debt to shareholders' equity ratio .76 .61 .68 .45 .45 Debt to total capitalization ratio .43 .38 .40 .30 .30 Per Share Data (1) (2) Earnings(loss) before accounting change .19 .31 (4.36) (1.61) .62 Earnings (loss) per share .19 .31 (4.90) (1.61) .62 Dividends - - - 5% Stock 5% Stock Shareholders' equity 7.21 8.04 8.69 13.74 14.54 Other Data Number of employees 2,112 2,207 2,413 2,637 2,675 Number of shareholders 2,971 3,438 3,518 3,577 3,770 Average number of common shares for primary earnings (in thousands) 5,484 5,231 5,217 5,209 5,161 Total common shares outstanding (in thousands) 5,295 5,221 5,221 5,209 5,179 Net sales per employee $104.9 $104.8 $98.2 $90.2 $84.3 (1) In 1991, the Company adopted FASB #106 "Accounting for Postretirement Benefits other than Pensions." (2) In 1991, there was an aftertax charge of $17,704,000 for a major restructuring; in 1990, there was an aftertax charge of $6,000,000 for personnel reductions and additional inventory reserves and an aftertax gain of $2,124,000 on the sale of a facility. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Summary - 1993 Sales in 1993 were $9.7 million less than the previous year. Pretax income declined $4.5 million; however, net income was only $.6 million lower. There were a number of contrasts and offsetting activities which occurred during the year: Sales in the United States were down from 1992 while International sales (excluding currency effects) increased slightly; orders were up in the United States, yet orders for International units (particularly Europe) were down; improvement in gross profit margins in the U.S. was negated by lower margins by International. Economic conditions in Europe continued to be a major drag on meaningful improvement. The French Subsidiary had a $3.0 million net loss in 1993 due to difficulties in the transition from being a manufacturing operation. The U.S. Company generated $1.2 million in cash and income through the sale of a small research operation. The implementation of FASB #109 (Accounting for Income Taxes) resulted in deferred tax benefits being recognized. Consolidated cash flow from operations was slightly negative and International short term debt increased due to generally negative operating results compared to the prior year. Results of Operations 1993 Compared to 1992 United States Orders received in the United States in 1993 were $85.1 million, or $8.0 million more than in 1992; excluding the specialty glass business which was sold in 1992, the increase in orders was $10.8 million. Orders for systems increased $7.9 million while instruments were up by $2.9 million. Sales in the United States were $75.2 million. The decline of $8.4 million from 1992 levels was $2.6 million in specialty glass sales (business sold in 1992), $3.6 million in systems and $2.2 million in instruments. The backlog entering 1994 is $26.3 million compared to $16.4 million at 31 December 1992. Gross profit margins in the United States increased approximately four percentage points in 1993 compared to the previous year, mainly due to cost control and manufacturing improvements. In the third quarter of 1993, the Company sold a small research operation for cash and the net proceeds of $1.2 million were offset against research and development expenses. Operating expenses in the United States, including research and development, were 1.9% higher than in 1992, without the effect of the sale; reported operating expenses were 1.5% less than the previous year. Income from operations in the United States was down slightly from 1992. International Orders received by International units declined from the previous year's levels by $18.5 million to $133.9 million. Approximately $13.2 million results from different currency exchange rates used to translate local currency orders into dollars in each year. The comparatively stronger U.S. dollar in 1993 has the effect of producing a lower dollar value for orders which, in local currency, might be unchanged or even increased. The decline in orders on a more comparable basis was approximately $5.3 million, principally in the distributed control system business in Europe. Orders for other instrumentation, as well, were adversely affected by the European economic situation. Sales of $146.5 million by International units were $1.3 million lower than in 1992. As with orders, currency exchange rates impact comparability. On a comparable basis, sales increased approximately $14.6 million but different exchange rates reduced reported sales by $15.9 million. The higher sales volume was primarily in the systems business, driven to a great degree by the level of orders received in 1992 for the new distributed control system introduced in that year. Gross profit margins for International units were approximately four and one half percentage points lower than in 1992. The principal causes were severe pricing pressures in order to maintain market share and a higher portion of systems which tend to have lower margins than instrument sales. The French Subsidiary incurred an operating loss of $1.6 million in 1993 due to difficulties in the transition from manufacturing. Operating expenses, including research and development were approximately 3.0% less than the previous year, although at comparable exchange rates, operating expenses would have increased approximately 5.0%. Income from operations, as reported, reflects a decline of $4.6 million, mainly as a consequence of lower gross profit margins. Currency exchange rate changes reduced sales but also reduced costs and expenses. Consequently, the impact of currency exchange rate changes on comparability of International income from operations with 1992 is less than $.5 million. Consolidated Consolidated net interest expense in 1993 was slightly lower than in 1992. Interest expense in the United States was not significantly different since rates and debt levels were fairly consistent. International interest expense was higher due to debt levels but offset somewhat by reduced rates. Interest income was modestly higher. Foreign exchange losses are primarily a function of the U.S. dollar compared to other currencies when transactions (mainly intercompany) are settled. In 1993, the U.S. dollar was strong relative to other currencies for most of the year. In 1993, the effective tax rate of 11.5% is unusually low which is due to a number of factors as shown in the reconciliation table in Note 4 to the Consolidated Financial Statements. The absolute amount of difference between the expected and the actual tax provision is not that significant; however, the difference in relative percentages is substantial. The alternative minimum tax in 1993 is largely a one-time result (cost) of certain U.S. tax planning activities. The Company adopted FASB #109 (Accounting for Income Taxes) in 1993. In the fourth quarter, a deferred tax benefit of $1.0 million was recorded in the U.S. It was not until the fourth quarter that Management was able to conclude that it was more likely than not that sufficient taxable income will be available to realize the deferred benefit. There was insufficient evidence to conclude otherwise prior to the fourth quarter. The U.S. Company has approximately $21.0 million of deductible temporary differences at the end of 1993 for which no tax benefit has been reported. Certain U.S. tax planning techniques have already been implemented whereby taxable income has been or will be sufficient to allow for realization of the tax benefit recorded on approximately $3.0 million of deductible temporary differences. Summary - 1992 The Company reported net income of $1.7 million in 1992 on sales of $231.3 million. Sales were 2.4% lower than in 1991, however, there was a substantial improvement in earnings. The results for 1991 included $20.5 million of special charges for restructuring and an accounting change. Exclusive of these charges, there was an increase of $6.6 million in net income between 1992 and 1991. The worldwide economic situation continued to be a major obstacle to achievement of meaningful or significant increases in the level of business. In the United States and Canada, competition was very intense from both domestic and foreign businesses. In Europe, the recession has struck very hard and the situation has been further complicated by the turmoil in currency exchange rates during the latter part of the year. In general, inflation was not a significant factor in 1992 but there were increases in costs. In light of the circumstances, the Company has followed the course of managing for cash and continuing to cut costs wherever possible. Personnel levels have been reduced by over 8% in each of the past two years. New, lower cost medical plans have been put in place in the United States. Manufacturing inventories in the U.S. were reduced by $3.0 million. Total Company debt was reduced by $5.0 million in 1992 of which $3.0 was in the United States. The restructuring activities which were planned in 1991 were essentially completed in 1992. The French manufacturing Subsidiary has been downsized to a sales and service company and certain other European sales and service companies have been reduced to focus on fewer and more profitable products. The specialty glass business in the U.S. was sold in the fourth quarter of 1992. The Company also has scaled back its participation in certain U.S. environmental markets. There are additional personnel still to leave the payrolls in 1993 due to the restructuring, however, the associated costs were previously accrued in 1991. Results of Operations 1992 Compared to 1991 United States Orders received in the United States in 1992 were $77.1 million which was the same as in 1991. Orders for instruments declined $1.7 million while orders for systems increased the same amount. The increase in systems reflects the Company's objective to obtain smaller systems orders in specific markets while the decline in instrument orders mainly reflects economic conditions. Sales in the United States of $83.6 million were $4.7 million less than the previous year, all in the systems business. This reflects the decline in orders, primarily in the Environmental sector, that was experienced in 1991. Gross profit margins increased approximately four percentage points in 1992 compared to the previous year, mainly as a result of cost savings and the impact of less systems business in the Environmental sector. Operating expenses, including research and development, were essentially unchanged. Excluding the special charge in 1991, income from operations improved by $2.1 million in 1992. (Please refer to Note 12 to the Consolidated Financial Statements.) International Orders received by International Subsidiaries in 1992 were $152.4 million compared to $147.9 million in the previous year. While the recession in Europe adversely affected business in general, orders for the new distributed control system and other new products, as well, compensated somewhat for the stagnant conditions experienced in most other products. Sales of $147.7 million were basically unchanged from the sales levels in 1991. Gross profit margins improved slightly on a comparable basis with 1991. However, excluding the impact of restructured operations, gross profit margins increased by approximately three percentage points. Operating expenses, including research and development, were 2.2% higher in 1992. Income from operations was $ 9.7 million in 1992 while in 1991, excluding special charges, income from operations was $5.7 million. (Please refer to Note 12 to the Consolidated Financial Statements.) Consolidated Consolidated interest expense decreased $.3 million compared to 1991. In the United States interest was $.6 million lower due to rates and generally lower debt levels. International was $.3 million higher due to generally higher debt levels. Foreign exchange losses are primarily a function of the U.S. dollar compared to other currencies when transactions (mainly intercompany) are settled. In 1992 and 1991, the U.S. dollar was strong relative to other currencies for part of the year and weak for part of the year. The unusually high effective tax rate results, primarily, from an absence of tax benefits on losses in the United States and tax rates in other countries being generally higher than in the United States. (Please refer to Note 4 to the Consolidated Financial Statements.) Cash Flow In 1993 and 1992, cash was used to satisfy severance and other obligations stemming from the 1991 restructuring plan. Exclusive of the cash used for these activities, net cash provided from operating activities was essentially "break- even" in 1993 compared to $13.3 million in 1992. The principal areas of substantial change between years were lower net income and receivables. At the end of 1992, receivables were unusually low as a result of exceptional collections in the last month of that year. Also in 1992, $3.5 million of receivables were sold by the French Subsidiary in a non-recourse factoring arrangement; no similar transaction occurred in 1993. Consolidated days sales outstanding, on average for the year, were actually one day less in 1993. Capital expenditures were strictly controlled in 1993. The Company generated $1.2 million of cash through the sale of a small research operation in September of 1993. Liquidity and Capital Resources (See Notes 2, 3 and 7 to the Consolidated Financial Statements) In September 1993, the Company announced that its Board of Directors had engaged an investment banker to advise the Company on possible alternatives to increase shareholder value, including sale of the Company. Since that time, potential buyers have met with Management and conducted their due diligence activities. In March 1994, a definitive merger agreement was reached with Moorco International Inc. (Moorco). The agreement provides for Moorco to acquire all of the shares of the Company's common stock, on a fully-diluted basis, for approximately $150.0 million, or $23.25 per share. The transaction is conditional upon, among other things, the approval of the Company's shareholders; it is expected the process will be completed by mid-1994. Also in September 1993, the Company entered into an agreement with the holders of its outstanding Class B Capital stock, for the conversion of all of the Class B shares into shares of Common stock. In exchange for the conversion, the Class B shareholders were granted warrants, exercisable on or before 31 March 1995, to purchase 1,128,994 shares of Common stock at $8.625 per share, the closing price of the stock on the American Stock Exchange on 29 September 1994. At 31 December 1993, the available credit under the U.S. revolver was $7.6 million of which $6.3 million was outstanding; at 29 March 1994, the available credit was $13.4 million and the outstanding borrowings were $9.6 million. In January 1994, an amendment to the agreement was made to revise certain financial covenants and to modify the asset-based formula to provide for additional borrowing availability. The additional amount of availability can be up to $5,000,000, subject to support by the appropriate levels of assets. It was obtained to have additional financial resources available on an interim basis until the Company is sold. The additional borrowing capacity is available until the earlier of (1) the sale of the Company occurs, (2) the Company is no longer for sale, or (3) 31 December 1994. In exchange, the lender is entitled to a fee of $750,000 which is payable no later than 31 December 1994. At 31 December 1993, the U.S. Company has an unfunded accrued pension cost of $3.4 million and an additional minimum liability of $8.4 million for its defined benefit pension plan. In 1993, equity was reduced by $3.3 million resulting, mainly, from a reduction in the discount rate used to determine the projected benefit obligation. Annual funding requirements vary with interest rates and asset growth. Contributions are typically in the range of $1.5 million to $2.0 million which is not substantially different than the annual expense. The Company's largest and most profitable Subsidiary has an unfunded pension liability of approximately $14.3 million at 31 December 1993. It is not a trusteed plan and there are no legal funding requirements. Payment of pensions from this plan in the foreseeable future will not have a significant impact on overall liquidity since there are very few retirees or employees nearing retirement age. Foreign Currency Translation In 1991, the U.S. dollar strengthened slightly at yearend compared to the beginning of the year which resulted in a modest decrease in shareholders' equity. In 1992, there was a more significant strengthening of the dollar at yearend, which accounted for the substantial reduction in equity. The same pattern continued into 1993. "Cumulative translation adjustments" have affected shareholders' equity, as follows: Increase (Decrease) in Thousands 1993 1992 1991 Europe $(2,096) $(4,139) $(723) Other (223) (848) (50) $(2,319) $(4,987) $(773) Since 1 January 1981, the date of adoption of FASB #52, the "Cumulative Translation Adjustments" is a decrease of $2.5 million in shareholders' equity. Recent FASB Pronouncements In November 1992, the FASB issued its Standard #112 (effective in 1994) concerning the accounting for postemployment benefits (e.g. severance, salary continuation, job counseling, etc.). The Company already complies with the requirements of this standard. In May 1993, the FASB issued its Standard #115 (effective in 1994) concerning the accounting for investments in debt and equity securities. The Company typically does not have such investments and does not anticipate having such in the future. Other In December of 1991, a class action and shareholders' derivative action was filed against the Company and certain current and former officers and directors in the U.S. District Court for the Eastern District of Pennsylvania, [Weiner, et al. vs. Tolson, et al., (No:91-7822)]. The alleged wrongdoings have been denied. In March 1993, the parties stipulated to the dismissal of all class action claims and the dismissal of one of the plaintiffs, Howard Weiner from the action. A tentative agreement was reached by the parties in June 1993 to settle the derivative action, which was the only remaining claim in the lawsuit. However, in August 1993 when the matter was submitted to the Court for approval, the Court failed to approve the proposed settlement. In February 1994, a new agreement was reached to settle the matter, which the Company believes should satisfy all the requirements of the Court. The new Settlement Agreement has been submitted for Court approval, but has not yet been approved. The Company's results of operations or financial condition would not be materially impacted under the terms of the new Settlement Agreement. In October of 1993,a class action suit was filed on behalf of the Company's shareholders against the Company, Jay H. Tolson and E. Joseph Hochreiter (the Company's two former Class B Stockholders, who are also directors and executive officers). The suit was filed in the court of Common Pleas of Bucks County, Pennsylvania, under the caption, Roger Copland vs. Jay H. Tolson, et al., (No. 93008366). The suit challenged the validity of the warrants issued to the two named individuals in connection with their conversion of Class B Stock into Common Stock. The Plaintiff sought to enjoin the exercise of the warrants, to rescind the warrants and to award attorneys' fees and costs to Plaintiff's counsel. In March of 1994, the Company was informed that the Plaintiff will file an Amended Complaint asserting a class action and a derivative claim against the individual defendants. The Company will be named only as a Nominal Defendant on the derivative claims and no claim will be asserted against the Company for any of the wrongdoings alleged in this action. The Company's results of operations or financial condition would not be materially impacted by the outcome of this action, either as currently filed or under the Amended Complaint. ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED STATEMENTS OF INCOME Fischer & Porter Company and Subsidiaries (in thousands of dollars except per share data) Year Ended 31 December 1993 1992 1991 Net sales $221,644 $231,317 $236,976 Costs and expenses: Cost of sales 140,177 142,596 154,399 Research and development (Note 1) 10,973 12,396 12,835 Selling, general & administrative expenses 66,271 67,208 66,680 Restructuring charge (Note 9) - - 17,879 217,421 222,200 251,793 Income (loss) from operations 4,223 9,117 (14,817) Interest expense, net of interest income of $828 in 1993, $551 in 1992 and $612 in 1991 2,608 2,901 3,189 Foreign exchange losses (Note 1) 366 468 289 Income (loss) before provision for income taxes and accounting change 1,249 5,748 (18,295) Provision for income taxes (Note 4) 143 4,006 4,236 Income (loss) before accounting change 1,106 1,742 (22,531) Accounting change (Note 7) - - 2,821 Net income (loss) $1,106 $1,742 $(25,352) Earnings (loss) per share (Notes 1 and 9): Earnings (loss) before accounting change $.19 $.31 $(4.36) Accounting change - $.31 (.54) Earnings (loss) per share $.19 $.31 $(4.90) (See Notes to Consolidated Financial Statements) CONSOLIDATED BALANCE SHEETS Fischer & Porter Company and Subsidiaries (in thousands of dollars except share data) 31 December 1993 1992 1991 Assets Current assets: Cash and cash equivalents $5,565 $6,565 $12,585 Receivables, less reserves of $2,359 in 1993, $2,259 in 1992 and $2,268 in 1991 42,114 37,737 51,543 Inventories, at lower of cost (principally first-in, first-out) or market 37,666 40,109 41,186 Prepaid expenses 2,107 1,767 2,015 Total current assets 87,452 86,178 107,329 Property, plant and equipment, at cost: Land and land improvements 2,242 2,290 2,435 Buildings 37,760 38,706 39,031 Machinery and equipment 64,428 66,734 65,376 Construction in progress 1,348 972 1,494 105,778 108,702 108,336 Less-accumulated depreciation 69,140 68,739 66,297 36,638 39,963 42,039 Other assets (Notes 7 and 11) 7,903 6,828 4,533 $131,993 $132,969 $153,901 Liabilities and Shareholders' Equity Current liabilities: Current portion of long-term debt (Note 3) $1,779 $1,456 $1,345 Notes payable (Note 2) 9,795 5,065 17,092 Accounts payable 12,355 10,764 14,479 Accrued salaries and wages 13,674 16,891 19,681 Other accrued expenses 5,053 6,127 8,990 Accrued taxes on income (Note 4) (944) (129) 2,081 Total current liabilities 41,712 40,174 63,668 Long-term debt (Note 3) 17,266 19,176 12,297 Other noncurrent liabilities (Notes 1, 7 & 11) 34,846 30,923 31,152 Commitments and contingencies (Notes 5 & 10) - - - 9% Convertible, Exchangeable Preferred Stock, $100 par, authorized 50,000 shares; issued and outstanding 1993 - none; 1992- 7,100 shares; 1991 - 14,250 shares (Note 6) - 710 1,425 Shareholders' equity (Notes 1, 3 and 6): Series preference stock, $1 par, authorized 1,000,000 shares - - - Common stock, $1 par, authorized 8,000,000 shares; issued 1993 - 5,295,000 shares; 1992 - 4,657,000 shares; 1991 - 4,657,000 shares 5,295 4,657 4,657 Class B Capital stock, $1 par, authorized 700,000 shares; issued and outstanding 1993 - none; 1992 - 564,000 shares; 1991 - 564,000 shares - 564 564 Paid-in surplus 61,935 61,233 61,233 Accumulated deficit (23,217) (24,260) (25,874) Pension liability adjustment (3,317) - - Cumulative translation adjustments (2,527) (208) 4,779 Total shareholders' equity 38,169 41,986 45,359 $131,993 $132,969 $153,901 (See Notes to Consolidated Financial Statements) Consolidated Statements of Shareholders' Equity Fischer & Porter Company and Subsidiaries (in thousands of dollars) Year Ended 31 December 1993 1992 1991 Common stock Balance, beginning of year $4,657 $4,657 $4,645 Issuance of shares under stock option plans 7 - 12 Conversion of Class B Capital stock 564 - - Conversion of preferred stock (Note 6) 67 - - Balance, end of year 5,295 4,657 4,657 Class B Capital stock Balance, beginning of year 564 564 564 Conversion to common stock (564) - - Balance, end of year - 564 564 Paid-in surplus Balance, beginning of year 61,233 61,233 61,135 Issuance of shares under stock option plans 59 - 98 Conversion of preferred stock (Note 6) 643 - - Balance, end of year 61,935 61,233 61,233 Accumulated deficit Balance, beginning of year (24,260) (25,874) (330) Net income (loss) 1,106 1,742 (25,352) Preferred stock dividend (63) (128) (192) Balance, end of year (23,217) (24,260) (25,874) Pension liability adjustment Balance, beginning of year - - - Minimum liability adjustment (3,317) - - Balance, end of year (3,317) - - Cumulative translation adjustments Balance, beginning of year (208) 4,779 5,552 Currency translation adjustment (2,319) (4,987) (773) Balance, end of year (2,527) (208) 4,779 Total shareholders' equity $ 38,169 $41,986 $45,359 (See Notes to Consolidated Financial Statements) Consolidated Statements of Cash Flows Fischer & Porter Company and Subsidiaries (in thousands of dollars) Year Ended 31 December 1993 1992 1991 Operating Activities: Net income (loss) $1,106 $1,742 $(25,352) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 6,302 6,878 7,082 Amortization 359 203 49 Deferred income taxes (2,125) (322) 290 Provision for accounts receivable reserves 371 197 390 Provision for inventory reserves 1,667 2,033 3,744 Provision for retirement plans 2,714 2,592 2,148 Restructuring charge (Note 9) - - 17,879 Cash used for restructuring activity (1,392) (6,531) - Accounting change (Note 7) - - 2,821 Changes in assets and liabilities: (Increase) decrease in receivables (7,216) 9,394 (405) (Increase) decrease in inventories (1,133) (2,153) 9,232 (Increase) decrease in prepaid expenses (119) 155 (286) (Decrease) in accounts payable & accrued expenses (741) (3,996) (6,512) (Decrease) increase in income taxes payable (Note 11) (813) (1,965) 289 Increase (decrease) in noncurrent liabilities 181 (905) (375) (Increase) in other assets (533) (566) (297) Net cash (used for) provided by operating activities (1,372) 6,756 11,138 Investing Activities: Capital expenditures (4,517) (6,997) (6,356) Cash received from property dispositions 252 669 65 Net cash (used for) investing activities (4,265) (6,328) (6,291) Financing Activities: Sale of common stock 66 - 110 Cash dividend on preferred stock (63) (128) (192) Sinking fund payment on preferred stock - (1,287) (286) Long-term debt borrowings 240 8,760 3,655 Reduction in long-term debt (1,557) (1,355) (7,332) Net short-term borrowings 6,294 (11,352) 2,506 Net cash provided by (used for) financing activities 4,980 (5,362) (1,539) Effect of exchange rate changes on cash (343) (1,086) 632 Net (decrease) increase in cash and cash equivalents (1,000) (6,020) 3,940 Cash and cash equivalents, beginning of year 6,565 12,585 8,645 Cash and cash equivalents, end of year $5,565 $6,565 $12,585 (See Notes to Consolidated Financial Statements) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 Summary of Significant Accounting Policies The Company On 30 September 1993, the Company announced that its Board of Directors had engaged an investment banker to advise the Company on possible alternatives to increase shareholder value, including sale of the Company. Since that time, potential buyers have met with Management and conducted their due diligence activities. In March 1994, a definitive merger agreement was reached with Moorco International Inc. (Moorco). The agreement provides for Moorco to acquire all of the shares of the Company's common stock, on a fully-diluted basis, for approximately $150.0 million, or $23.25 per share. The transaction is conditional upon, among other things, the approval of the Company's shareholders; it is expected the process will be completed by mid-1994. Also in September 1993, the Company entered into an agreement with the holders of its outstanding Class B Capital stock, for the conversion of all of the Class B shares into shares of Common stock. In exchange for the conversion, the Class B shareholders were granted warrants, exercisable on or before 31 March 1995, to purchase 1,128,994 shares of Common stock at $8.625 per share, the closing price of the stock on the American Stock Exchange on 29 September 1993. The consolidated financial statements include the accounts of Fischer & Porter Company (the Company) and all of its Subsidiaries. All significant intercompany transactions have been eliminated. Foreign Currency Translation The assets and liabilities of International Subsidiaries are translated into U.S. dollars at the year-end exchange rate; income and expense items are translated at the average exchange rate for the period. Translation adjustments are charged or credited to a separate component of shareholders' equity. Gains and losses on foreign currency transactions are included in the consolidated statements of income. Depreciation Depreciation of plant and equipment is provided using, principally, the straight-line method based on the estimated useful lives of the assets, which for buildings, range from 15 to 50 years and for machinery and equipment from 3 to 20 years. Maintenance and repair costs ($4,062,000, $5,362,000 and $4,321,000 in 1993, 1992 and 1991 respectively) are charged to expense as incurred, and major renewals and betterments are capitalized. When assets are retired or disposed of, the asset cost and related reserves are eliminated from the accounts and any resultant gain or loss is included in net income. Income Taxes In January 1993, the Company changed from FASB #96 to FASB #109 for its accounting for income taxes. Deferred income taxes arise as a result of differences between amounts reported in the financial statements and their bases or timing of recognition for income tax purposes. These are referred to as temporary differences. The principal temporary differences are related to valuation reserves and accrued liabilities not currently deductible for tax purposes and tax depreciation in excess of depreciation recognized for financial reporting purposes. Deferred taxes can also arise from tax loss and tax credit carryforwards. The Company's policy is to provide additional estimated U.S. income taxes with respect to earnings of International Subsidiaries which are expected to be repatriated. As of 31 December 1993, U.S. income taxes have not been provided on undistributed earnings of $32,000,000 since they are considered to be permanently invested. No U.S. income taxes are payable until these earnings are distributed to the Company. It is not practicable to determine the amount of unrecognized deferred tax liability associated with these unremitted earnings; however, foreign tax credits would be available, upon distribution, to eliminate essentially all additional taxes. Earnings Per Share Primary earnings per Common and Class B share are based on the monthly weighted average number of shares of Common stock, Common stock equivalents, and Class B Capital stock outstanding during the respective years. Common stock equivalents are not considered in the calculation of primary loss per Common and Class B share since they would be antidilutive. The monthly weighted average number of shares was 5,484,000, 5,231,000 and 5,217,000 for primary earnings per share in 1993, 1992, and 1991, respectively and 5,710,000, 5,368,000, and 5,351,000 for fully diluted. Primary earnings per share are based on earnings after payment of the 9% dividend on Preferred stock. Fully diluted earnings per share assume conversion of Preferred stock and exercise of stock options as of the beginning of the period. For 1993, warrants to purchase common stock are assumed exercised from the date of issuance - 30 September 1993 (see Note 6). Primary and fully diluted earnings per share are the same for all years presented. Revenue Recognition Revenue is recognized when products are shipped or services are rendered. On longer-term systems contracts, revenue and the related cost of sales are recognized upon shipment and/or completion of specific services. Cash Equivalents The Company considers cash equivalents to be all highly liquid investments that are readily convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Research and Development All research and development costs are expensed, as incurred. In 1993, the Company sold a small research operation to a third party. The net proceeds of $1,234,000 have been offset against research and development costs in the consolidated statement of income. Note 2 Lines of Credit At 31 December 1993, the International Subsidiaries had $18,600,000 in total bank lines of credit of which $9,795,000 was utilized. The weighted average interest rate of bank borrowings outstanding at 31 December 1993 was 9.5% (10.5% at 31 December 1992 and 12.5% at 31 December 1991). The maximum amount of month-end bank borrowings during 1993 was $10,900,000 ($9,800,000 and $6,100,000 in 1992 and 1991, respectively). Based on month-end balances, the average amount of bank borrowings in 1993, 1992 and 1991 was $9,200,000, $6,600,000 and $5,100,000 at weighted average interest rates of 10%, 11% and 13%, respectively. At 31 December 1991, the U.S. revolving credit was classified as Notes payable (see Note 3). The weighted average interest rate at 31 December 1991 was 8.5%; the maximum outstanding at any month-end in 1991 was $15,100,000; and, the average outstanding during 1991 was $13,800,000. Note 3 Long-Term Debt and Restrictions At 31 December, long-term debt consisted of the following: 1993 1992 1991 Revolving credit $ 6,316,000 $ 6,116,000 $ - Mortgage 7,102,000 7,640,000 8,125,000 Term loan 1,917,000 2,417,000 - Other 3,710,000 4,459,000 5,517,000 19,045,000 20,632,000 13,642,000 Less current portion 1,779,000 1,456,000 1,345,000 $17,266,000 $19,176,000 $12,297,000 The total revolving credit outstanding at 31 December 1991 was $10,974,000. Subsequent to 31 December 1991, the revolving credit agreement was amended by converting the obligation to a demand basis. Consequently, at 31 December 1991, the revolving credit balance was classified as a current liability (see Note 2). In the third quarter of 1992, the Company replaced the revolving credit agreement with a three year, $17,500,000 financing facility which consists of a $15,000,000 revolving credit and a $2,500,000 term loan. The revolving credit is an asset-based formula facility with an interest rate of prime plus 1-1/2%; the term loan bears interest at prime plus 1-3/4%. A commitment fee of 1/2% is also charged on the revolving credit facility based on the average daily unused balance. The term loan is repayable in monthly installments of $42,000 with a final installment of $1,000,000 due in September of 1995. The total facility is secured by essentially all of the Company's assets. The agreement contains certain financial covenants which, among other things, provide for maintenance of specified levels of net worth and cash flows, limitations on indebtedness and payment of dividends. At 31 December 1993, the available revolving credit was $7,600,000 of which $6,316,000 was outstanding. In January 1994, an amendment to the agreement was made to revise certain financial covenants and to modify the asset-based formula to provide for additional borrowing availability. The additional amount of availability can be up to $5,000,000, subject to support by the appropriate levels of assets. It was obtained to have additional financial resources available on an interim basis until the Company is sold. The additional borrowing capacity is available until the earlier of (1) the sale of the Company occurs, (2) the Company is no longer for sale, or (3) 31 December 1994. In exchange, the lender is entitled to a fee of $750,000 which is payable no later than 31 December 1994. The mortgage matures in May 2004 and is repayable over fifteen years at an interest rate of 10% until May 1994. Thereafter, interest will be based on market rates. The Company may, at its option, repay the mortgage after May 1994 without penalty. An International Subsidiary's bank loan of $3,142,000, which was due to be repaid in June of 1993, was converted to a five-year term loan subsequent to 31 December 1992 and, therefore, included in Other long-term debt. Repayment in equal, annual installments commences in 1994. At 31 December 1993, retained earnings of International Subsidiaries of approximately $8,200,000 are not available for distribution due to local restrictions. The aggregate maturities of long-term debt during each of the five years subsequent to 31 December 1993 follow: 1994 - $1,779,000; 1995 - $8,934,000; 1996 - $1,148,000; 1997 - $1,164,000; 1988 - $1,207,000. Note 4 Income Taxes Effective 1 January 1993, FASB #109 (Accounting for Income Taxes) was adopted. Previous years financial statements have not been restated. The cumulative effect on retained earnings of adoption of the new principle at 31 December 1992 was an increase in net income of $94,000 in 1993 and related entirely to International. Pretax income (loss) and the related income tax provisions follow: Year Ended 31 December 1993 1992 1991 Income (loss) before taxes and accounting change: United States $ 298,000 $(2,307,000) $(11,029,000) International 951,000 8,055,000 (7,266,000) Total $1,249,000 $ 5,748,000 $(18,295,000) Provision (benefit) for income taxes: Current United States $ 501,000 $ 182,000 $ (69,000) International 1,767,000 4,146,000 4,015,000 Deferred United States (1,020,000) - - International (1,105,000) (322,000) 290,000 Total $ 143,000 $4,006,000 $4,236,000 The significant components of deferred tax liabilities and assets at 31 December 1993 are as follows: Deferred tax liabilities: Tax vs. book depreciation $3,169,000 Employee retirement plans 586,000 Other 826,000 $4,581,000 Deferred tax assets: Postretirement benefits $1,056,000 Employee benefit and retirement plans 2,392,000 Valuation reserves 2,414,000 Net operating loss carryforwards 6,007,000 Tax credit carryforwards 2,118,000 Other 3,337,000 17,324,000 Valuation allowance (15,328,000) $1,996,000 Net deferred tax liabilities $2,585,000 In 1993, the valuation allowance was reduced $4,782,000 from the amount established as of 1 January 1993 and gross deferred tax assets were reduced $3,782,000. Approximately $400,000 of the deferred tax benefit in 1993 was due to a reduction in tax rates for several International Subsidiaries. The majority of deferred tax assets have been reduced by a valuation allowance. The net deferred tax assets are considered to be realizable due to a history of earnings or sufficient future taxable income at the appropriate companies. The U.S. Company has recorded net deferred tax assets of $1,020,000 at 31 December 1993 since Management considers it more likely than not that sufficient taxable income will be available to realize the benefits. At 31 December 1993, approximately $21,000,000 of deductible temporary differences are available in the U.S. and have not been given any deferred tax benefit. Year Ended 31 December 1993 1992 1991 Reconciliation: Expected U.S. Federal provision (benefit) $425,000 $1,954,000 $(6,220,000) Alternative minimum tax 879,000 - - Absence of tax benefit in the U.S. - 966,000 3,681,000 Absence of tax benefit (provision) at International Subsidiaries 983,000 (77,000) 5,350,000 Absence of U.S. tax benefit on dividend withholding tax 172,000 318,000 455,000 Difference between U.S. and International tax rates (591,000) 845,000 957,000 Adjustment of tax accruals (604,000) - - Utilization of NOL carryforward (101,000) - - Deferred tax benefit in the U.S. (1,020,000) - - Other - - 13,000 Actual provision $143,000 $4,006,000 $4,236,000 Certain International Subsidiaries have net operating losses of approximately $18,000,000 available to reduce future taxable income, which expire in various years through 1998. The Company has AMT credit carryforwards of $1,100,000 and general business credits of $930,000 of which $620,000 expire between 1995 and 2001; the balance expire between 2002 and 2006. The accounting change implemented in 1991 (See Note 7) does not reflect any tax benefit. Note 5 Leases Substantially all leases are operating leases. Rental expense was $5,538,000, $6,346,000, and $5,856,000 in 1993, 1992 and 1991, respectively. Certain of the leases contain renewal options for periods from one to five years. No leases have contingent rentals nor do any leases impose restrictions on dividends, additional leasing or additional debt. Minimum net rental commitments under noncancellable leases (principally for plant, office space, and equipment) outstanding at 31 December 1993 amounted to approximately $9,400,000 including annual payments of $3,900,000 due in 1994, $2,600,000 in 1995, $1,400,000 in 1996, $900,000 in 1997 and $200,000 in 1998. Assets recorded under capital leases as well as any related debt obligations and future minimum rentals are not significant. Note 6 Shareholders' Equity and Preferred Stock Common shareholders are entitled to one vote per share and holders of Class B Capital Stock are entitled to ten votes per share. No cash dividends may be paid on the Class B shares. Class B shares are convertible at the holder's option, on a share-for-share basis, into Common shares. In September 1993, the holders of all of the Class B Capital Stock converted their stock into Common shares. The same shareholders were granted warrants to purchase 1,128,994 shares of Common at $8.625 per share which was the market price on the date of the transaction. The warrants expire on 31 March 1995. Annual dividends of 9% on the Convertible, Exchangeable Preferred Stock were cumulative and payable quarterly. This stock was convertible into Common stock at a price of $10.66 per Common share. The Preferred stock had a liquidation value of $100 per share and required an annual sinking fund payment of $715,000. Subsequent to 31 December 1990, $143,000 of the sinking fund requirement for 1990 was paid. In January 1992, $572,000 of the sinking fund requirement for 1991 was paid. In December 1993, the outstanding Preferred Stock was converted to Common stock. Under one of the Company's nonqualified stock option plans, certain employees can be granted options to purchase Common stock at prices equal to at least 80% of market value at the time of grant. These options become exercisable as the Board of Directors may determine. Additional options for 9,952 shares may be granted until 1 June 1996. Unexercised options expire ten years after the date of grant. The Company's Incentive Stock Option Plan provides that certain employees may be granted options to purchase Common stock at market value on the date of grant. Options become exercisable from six months to one year after they are granted. For certain individuals they are exercisable in cumulative groups of 20% each year. Unexercised options expire ten years after the date of grant. As of 1 May 1992, no additional options may be granted under this Plan. The "Non-Qualified Stock Option Plan (1991)" provides that certain employees may be granted options to purchase Common stock at a price not less than the market value on the date of grant. A total of 230,000 shares were initially authorized. This plan was amended in February 1992 to increase to 750,000 the total number of shares authorized to be issued under the plan. As a result of the conversion of Class B Capital Stock into Common shares, any stock options related to the "Non-Qualified Stock Option Plan (1991)" which were not exercisable by their terms became exercisable as of 30 September 1993. Activity for shares under options: 1993 1992 Non- Non- Non- Qualified Non- Qualified Incentive Qualified Stock Incentive Qualified Stock Stock Stock Options Stock Stock Options Options Options (1991) Options Options (1991) Balance at 1 January 62,687 31,834 441,410 60,687 13,039 152,910 Options granted - - 203,500 2,000 23,900 288,500 Options exercised 5,965 1,341 500 - - - Options canceled/ expired 10,410 - - - 5,105 - Balance at 31 December 46,312 30,493 644,410 62,687 31,834 441,410 Exercisable at 31 December 44,712 11,373 644,410 60,687 7,934 30,582 Average price of exercisable options $11.05 $9.86 $8.93 $10.50 $10.99 $11.00 As of 31 December 1993, there were 2,110,000 Common shares reserved for issuance under stock option plans and for warrants. Note 7 Retirement Plans and Benefits The Company has a noncontributory, defined benefit pension plan (Pension Plan) for all U.S. employees and three contributory, defined contribution retirement plans for U.S. employees who meet certain eligibility requirements. The annual retirement benefits of the Pension Plan are based on the number of years of credited service. Beginning in 1993, the pension benefits earned by salaried employees will be accumulated in a Cash Account Plan and based on a percent of salary. The Company funds its contribution annually based on an actuarial determination. The net periodic pension cost for 1993, 1992 and 1991 included the following components: 1993 1992 1991 Service cost $ 607,000 $562,000 $ 520,000 Interest cost 3,204,000 3,032,000 2,846,000 Actual return on assets (3,974,000) (2,240,000) (4,939,000) Amortization and deferral 1,723,000 20,000 3,108,000 $1,560,000 $1,374,000 $1,535,000 The Company also has a Supplemental Retirement (defined benefit) Plan for key executives. The annual retirement benefit is based upon an average of the last five years' salaries before normal retirement at age 65. The periodic pension cost related to this Plan was $394,000 in 1993, $364,000 in 1992, and $314,000 in 1991. The assets of the Pension Plan are held by a Trustee and consist of both equity and fixed income securities. The following table sets forth the funded status of the U.S. defined benefit plans and amounts included in the consolidated balance sheets at 31 December 1993, 1992 and 1991: Actuarial present value of benefit obligations (in 000's of dollars): 1993 1992 1991 Pension Supp. Pension Supp. Pension Supp. Plan Plan Plan Plan Plan Plan Vested $44,220 $2,176 $37,900 $1,898 $35,044 $1,755 Non-vested 184 269 134 199 139 172 Total accumulated benefit obligation $44,404 $2,445 $38,124 $2,097 $35,183 $1,927 Projected benefit obligation $44,404 $2,992 $38,124 $2,482 $35,183 $2,216 Fair value of Plan assets (32,555) - (30,197) - (28,596) - Projected benefit obliga- tion in excess of Plan assets 11,849 2,992 7,927 2,482 6,587 2,216 Unrecognized cumulative net (loss) gain (3,318) (82) 42 204 1,558 265 Unrecognized implemen- tation pension liability (2,581) (81) (2,897) (92) (3,212) (102) Prior service cost not yet recognized (2,548) (468) (2,069) (535) (1,422) (602) Unfunded accrued pension cost 3,402 2,361 3,003 2,059 3,511 1,777 Additional minimum liability 8,447 84 4,924 38 3,076 150 Net pension liability $11,849 $2,445 $7,927 $2,097 $6,587 $1,927 The discount rates used in determining the actuarial present value of the projected benefit obligations were 7.35% in 1993, 8.35% in 1992 and 8.5% in 1991. The assumed long-term rate of return on assets was 9.5% in all three years presented. The defined contribution plans are 401K plans which are available to essentially all the employees of the Company. Employee contributions are matched by the Company up to 2% or 3% of the employee's salary. The cost of these plans was $664,000 in 1993, $519,000 in 1992, and $515,000 in 1991. Certain of the International Subsidiaries participate in government mandated retirement programs requiring employee and employer contributions. Total pension expense for all International Subsidiaries was $3,281,000, $3,549,000, $3,046,000 in 1993, 1992 and 1991, respectively. Accrued pension expense for the International Subsidiaries is included in noncurrent liabilities. The Company's International pension plans are not required to report to governmental agencies and do not otherwise determine the actuarial value of accumulated benefits or net assets, except as discussed below. The Company follows FASB #87 for those International Subsidiaries which have defined benefit pension plans. Annual retirement benefits are based on years of service and salary. Some of the plans are funded on a current basis based on actuarial calculations. The net periodic pension cost in 1993, 1992 and 1991 for these Subsidiaries included the following components: 1993 1992 1991 Service cost $1,118,000 $1,007,000 $793,000 Interest cost 1,816,000 1,821,000 1,637,000 Actual return on assets (2,395,000) (1,583,000) (1,212,000) Amortization and deferral 1,549,000 712,000 332,000 $2,088,000 $1,957,000 $1,550,000 The assets of funded plans are held by Trustees. The following table sets forth the funded status of the Plans and the amounts included in noncurrent liabilities at 31 December 1993, 1992 and 1991. Actuarial present value of benefit obligations (in thousands of dollars): 1993 1992 1991 Funded Unfunded Funded Unfunded Funded Unfunded Plans Plans Plans Plans Plans Plans Vested $7,202 $12,524 $6,210 $10,881 $5,184 $9,309 Non-vested - 1,554 - 1,298 - 1,062 Total accumulated benefit obligations $7,202 $14,078 $6,210 $12,179 $5,184 $10,371 Projected benefit obligations $8,466 $17,258 $7,616 $15,375 $7,625 $13,187 Fair value of Plans' assets (11,944) - (9,887) - (10,238) - Projected benefit obligations (less than) in excess of Plans' assets (3,478) 17,258 (2,271) 15,375 (2,613) 13,187 Unrecognized cumulative net gain (loss) 1,560 (2,128) 260 (565) 177 1,369 Prior service cost not yet recognized (597) (94) (686) (113) (928) (184) Unrecognized implementation asset (liability) 1,124 (768) 1,287 (886) 1,688 (1,013) (Prepaid) accrued pension cost $(1,391) $14,268 $(1,410) $13,811 $(1,676) $13,359 The discount rates used in determining the actuarial present value of the projected benefit obligations range from 7.0% to 9.0% in 1993, 7.5% to 9.5% in 1992 and 8.5% to 10.5% in 1991. The assumed long-term rates of return on assets range from 8.0% to 9.0%, 8.0% to 9.5% and 9.5% to 10.5% in 1993, 1992 and 1991, respectively while salary assumptions range from 2.5% to 7.5%, 3.5% to 8.0% and 3.75% to 9.0%, respectively. In 1991, the Company adopted FASB #106 for a life insurance program for U.S. employees who retire from the Company. This is the only such postretirement plan other than pensions and it provides a flat death benefit regardless of years of service, final pay, etc. In previous years, the Company accounted for this cost on a pay-as-you-go-basis. The Company chose immediate recognition of the accumulated postretirement benefit obligation (the plan is not separately funded) and reported $2,821,000 as the cumulative effect of a change in accounting principle (accounting change) in the consolidated statement of income. The net periodic postretirement benefit cost in 1993 was $281,000, including $20,000 for service and $261,000 for interest; in 1992, the cost was $300,000 of which $39,000 was for service and $261,000 was for interest and, in 1991 the cost was $267,000 ($34,000 for service and $233,000 for interest). At 31 December, the accumulated postretirement benefit obligation status was as follows: 1993 1992 1991 Accumulated postretirement benefit obligation: Retirees $2,556,000 $2,135,000 $1,989,000 Actives 966,000 1,038,000 832,000 $3,522,000 $3,173,000 $2,821,000 There was an unrecognized loss of $417,000 at 31 December 1993 and $237,000 at 31 December 1992 but no unrecognized prior service cost or unrecognized net transition obligation at 31 December 1993, 1992 or 1991. The assumed discount rate used was 7.35% in 1993, 8.35% in 1992, and 8.75% in 1991. Note 8 Quarterly Data (Unaudited) Summarized quarterly unaudited financial data for 1993 and 1992 is presented below, in thousands of dollars, except per share data: 4th 3rd 2nd 1st Year Quarter Quarter Quarter Quarter Net sales $221,644 $ 54,612 $53,995 $59,229 $ 53,808 Gross profit 81,467 18,158 20,716 21,991 20,602 Net income (loss) 1,106 (319) 617 734 74 Earnings (loss) per share .19 (.07) .11 .14 .01 4th 3rd 2nd 1st Year Quarter Quarter Quarter Quarter Net sales $231,317 $ 56,865 $64,663 $56,415 $ 53,374 Gross profit 88,721 22,209 23,302 21,799 21,411 Net income 1,742 475 611 383 273 Earnings per share .31 .09 .11 .06 .05 Fully diluted earnings per share are the same as primary for all periods presented. The third quarter of 1993 includes net proceeds of $1,234,000 from the sale of a small research operation. The fourth quarter of 1993 includes $422,000 of deferred tax benefits for changes in tax rates in certain countries and $1,020,000 of deferred tax benefits in the United States. Note 9 Restructuring Charge In 1991, the Company recorded a pretax charge of $17,879,000. The charge related primarily to restructuring activities in certain European subsidiaries and in the United States, increased inventory reserves resulting from a narrowing of the Company's focus in certain U.S. environmental markets and the estimated loss resulting from a decision to dispose of an unrelated specialty glass business in the U.S. In 1992, the majority of the restructuring activities were concluded and the specialty glass business was sold. The reserves established in 1991 were utilized to absorb the impact of these activities. Note 10 Commitments and Contingencies In December of 1991, a class action and shareholders' derivative action was filed against the Company and certain current and former officers and directors in the U.S. District Court for the Eastern District of Pennsylvania, [Weiner, et al. vs. Tolson, et al., (No:91-7822)]. The alleged wrongdoings have been denied. In March 1993, the parties stipulated to the dismissal of all class action claims and the dismissal of one of the plaintiffs, Howard Weiner from the action. A tentative agreement was reached by the parties in June 1993 to settle the derivative action, which was the only remaining claim in the lawsuit. However, in August 1993 when the matter was submitted to the Court for approval, the Court failed to approve the proposed settlement. In February 1994, a new agreement was reached to settle the matter, which the Company believes should satisfy all the requirements of the Court. The new Settlement Agreement has been submitted for Court approval, but has not yet been approved. The Company's results of operations or financial condition would not be materially impacted under the terms of the new Settlement Agreement. In October of 1993, a class action suit was filed on behalf of the Company's shareholders against the Company, Jay H. Tolson and E. Joseph Hochreiter (the Company's two former Class B Stockholders, who are also directors and executive officers). The suit was filed in the court of Common Pleas of Bucks County, Pennsylvania, under the caption, Roger Copland vs. Jay H. Tolson, et al., (No. 93008366). The suit challenged the validity of the warrants issued to the two named individuals in connection with their conversion of Class B Stock into Common Stock. The Plaintiff sought to enjoin the exercise of the warrants, to rescind the warrants and to award attorneys' fees and costs to Plaintiff's counsel. In March of 1994, the Company was informed that the Plaintiff will file an Amended Complaint asserting a class action and a derivative claim against the individual defendants. The Company will be named only as a Nominal Defendant on the derivative claims and no claim will be asserted against the Company for any of the wrongdoings alleged in this action. The Company's results of operations or financial condition would not be materially impacted by the outcome of this action, either as currently filed or under the Amended Complaint. The Company is party to certain other claims and litigation arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the outcome of such matters will not materially affect the Company's financial position or the results of its operations. The Company has agreements with nine executives and certain other key employees which provide for separation pay and other related expenses if there is a change in control of the Company and the individual is terminated or duties are changed materially within two years after such a change. If all parties were compensated under these arrangements, payments would be required in the range of $5.0 to $5.5 million. Note 11 Supplementary Financial Information 1993 1992 1991 The following amounts were paid during the years indicated: Interest $3,429,000 $3,724,000 $4,067,000 Income taxes $3,127,000 $6,216,000 $3,142,000 Other noncurrent liabilities consist of the following: Deferred income taxes $3,826,000 $4,981,000 $5,536,000 Unfunded accrued postretirement benefits 3,105,000 2,936,000 2,821,000 Noncurrent pensions and other liabilities 27,915,000 23,006,000 22,795,000 Total $34,846,000 $30,923,000 $31,152,000 Other assets consist of the following: Pension intangible asset $5,214,000 $4,962,000 $3,226,000 Deferred debt expense 354,000 488,000 136,000 Deferred income taxes 962,000 - - Other 1,373,000 1,378,000 1,171,000 Total $7,903,000 $6,828,000 $4,533,000 Advertising expense $2,771,000 $2,961,000 $2,368,000 Note 12 Segments of Business The Company operates principally in one industry, process control instrumentation. The process control instrumentation industry designs, manufactures and sells process control instruments, equipment and systems. Income from operations represents total revenue less operating expenses. In computing income from operations, none of the following items has been added or deducted: interest expense, foreign exchange and income taxes. In 1991, income from operations includes a restructuring charge of $17,879,000 ($6,079,000 U.S., $10,842,000 Europe, $958,000 Other). Transfers between geographic areas are accounted for principally at current market value adjusted for quantity and operating efficiencies. Identifiable assets are those assets that are used in the Company's operations in each geographic area. Geographic Areas (in thousands of dollars) Year Ended 31 December 1993 1992 1991 Sales to Unaffiliated Customers United States $75,178 $83,590 $88,257 Europe 127,419 129,369 128,766 Other International 19,047 18,358 19,953 Consolidated $221,644 $231,317 $236,976 Transfers Between Geographic Areas United States $16,988 $17,784 $15,996 Europe 4,901 5,546 4,806 Other International 449 811 939 Consolidated $22,338 $24,141 $21,741 Net Sales United States $92,166 $101,374 $104,253 Europe 132,320 134,915 133,572 Other International 19,496 19,169 20,892 Eliminations (22,338) (24,141) (21,741) Consolidated $221,644 $231,317 $236,976 Income (Loss) From Operations United States $(902) $(616) $(8,760) Europe 5,514 10,217 (5,366) Other International (389) (484) (691) Consolidated 4,223 9,117 (14,817) Interest Expense, net (2,608) (2,901) (3,189) Foreign Exchange (366) (468) (289) Consolidated Income (Loss) Before Income Taxes and Accounting Change $1,249 $5,748 $(18,295) Identifiable Assets United States $50,594 $48,891 $52,080 Europe 71,107 74,201 91,465 Other International 15,802 15,055 15,624 Corporate 6,371 6,211 4,177 Eliminations (11,881) (11,389) (9,445) Consolidated $131,993 $132,969 $153,901 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Shareholders and The Board of Directors, Fischer & Porter Company: We have audited the accompanying consolidated balance sheets of Fischer & Porter Company (a Pennsylvania corporation) and subsidiaries as of 31 December 1993, 1992 and 1991, and the related consolidated statements of income, shareholders' equity and cash flows for the years then ended. 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 Fischer & Porter Company and subsidiaries as of 31 December 1993, 1992 and 1991, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. As discussed in Notes 1 and 4 to the consolidated financial statements, effective 1 January 1993, the Company changed its method of accounting for income taxes. Also, as discussed in Note 7, effective 1 January 1991, the Company changed its method of accounting for postretirement benefits other than pensions. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14(a)2 of the 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 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. /S/ Arthur Andersen & Co. Philadelphia, Pa., 25 March 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 (a) Directors of the Registrant The required information with respect to each director will be included as an amendment to this Form 10-K Annual Report under cover of Form 8 to be filed on or before 30 April 1994. (b) Executive Officers of the Registrant The required information with respect to each executive officer is contained at the end of Part I of this Form 10-K. (c) Family Relationships There are no family relationships between any of the directors or executive officers of the Company. (d) Other There have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions material to the evaluation of the ability and integrity of any director or executive officer during the past five years. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION The required information with respect to executive compensation will be included as an amendment to this Form 10-K Annual Report under cover of Form 8 to be filed on or before 30 April 1994. ITEM 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The required information with respect to security ownership of certain beneficial owners and Management will be included as an amendment to this Form 10-K Annual Report under cover of Form 8 to be filed on or before 30 April 1994. ITEM 13 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The required information with respect to certain relationships and related transactions will be included as an amendment to this Form 10-K Annual Report under cover of Form 8 to be filed on or before 30 April 1994. PART IV ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements Page Number Herein Consolidated Statements of Income 12 for the years ended 31 December 1993, 1992 and 1991 Consolidated Balance Sheets at 13 31 December 1993, 1992 and 1991 Consolidated Statements of Share- 14 holders' Equity for the years ended 31 December 1993, 1992 and 1991 Consolidated Statements of Cash Flows 15 for the years ended 31 December 1993, 1992 and 1991 Notes to Consolidated Financial 16-25 Statements Report of Independent Public 26 Accountants (a) 2. Financial Statement Schedules Consent of Independent Public 33 Accountants Schedule for years ended 31 December 1993, 1992 and 1991: II - Amounts Receivable from 34 Related Parties V - Property, Plant and Equipment 35 VI - Accumulated Depreciation of 36 Property, Plant and Equipment VIII - Valuation and Qualifying 37 Accounts and Reserves 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 Exhibits identified below by an asterisk (*) are Management Contracts and Compensatory Plans and Arrangements. Page Exhibit Number No. Herein 2.1 Agreement and Plan of Merger (incorporated by reference to Exhibit 2.01 to Form 8-K dated 2 July 1990). 3.1 Articles of Incorporation (incorporated by reference to Exhibit 3.01 to Form 8-K dated 2 July 1990). 3.2 By-Laws (incorporated by reference to Exhibit 3.02 to Form 8-K dated 2 July 1990). 4.1 Not applicable. 4.1.1.1 $10,000,000 mortgage note payable to Continental Bank (incorporated by reference to Exhibit 4.1.5 to Form 10-Q for first quarter 1989). 4.1.1.2 First mortgage issued to Continental Bank (incorporated by reference to Exhibit 4.1.6 to Form 10-Q for first quarter 1989). 4.2 The Company hereby agrees to fur- nish to the Securities and Exchange Commission, upon request, copies of other instruments defining the rights of holders of long-term debt of the Company and its subsidiaries. 10.1 *Supplemental Executive Benefit Agreement with Jay H. Tolson dated 1 January 1989. (In addition to Mr. Tolson, Messrs. Hochreiter, Finnegan and one other key employee have received essentially the same benefits provided and described in the aforementioned agreement with Jay H. Tolson). Page Exhibit Number No. Herein 10.1.1 *Change in Control Agreement Form (incorporated by reference to Exhibit 10.4.1 to Form 10-Q for third quarter 1991). 10.1.2 *Employment Agreement, dated 23 October 1991, with E. Joseph Hochreiter (incorporated by reference to Exhibit 10.4.2 to Form 10-Q for third quarter 1991). 10.2 Not applicable. 10.3 *Nonqualified Stock Option Plan (incorporated by reference to Post-Effective Amendment No. 1 to Form S-8 Registration Statement No. 2-73222, sequentially- numbered pages 12 to 18). 10.3.1 *Nonqualified Stock Option Plan (1991) (incorporated by reference to Exhibit 10.5.1 to Form 10-Q for third quarter 1991; Registration Statement No. 33-48498). 10.3.2 *Amendment to Nonqualified Stock Option Plan (1991), adopted 24 February 1992 (incorporated by reference to Exhibit 10.5.2 to Form 10-K for fiscal year 1991; Registration Statement No. 33-48498). 10.4 *1982 Incentive Stock Option Plan (incorporated by reference to Form S-8 Registration Statement No. 2-99944, sequentially numbered pages 10-14). 10.4.1 *Amendment to 1982 Incentive Stock Option Plan, adopted 24 February 1987 (incorporated by reference to Exhibit 10.6.1 to Form 10-K for fiscal year 1991). 10.4.2 *Amendment to 1982 Incentive Stock Option Plan, adopted 30 July 1991 (incorporated by reference to Exhibit 10.6.2 to Form 10-Q for third quarter 1991). 10.5 *Grant of Appreciation Rights (incorporated by reference to Exhibit 10.8 to Form 10-K for fiscal year 1990). 10.6 Loan and Security Agreement, dated 14 September 1992 (incorporated by reference to Exhibit 10.9 to Form 10-Q for third quarter 1992). Page Exhibit Number No. Herein 10.6.1 Waiver No. 1 to Loan and Security Agreement, dated 14 September 1992 (incorporated by reference to Exhibit 10.6.1 to Form 10-K for fiscal year 1992). 10.6.2 Waiver No. 2 to Loan and Security Agreement, dated 14 September 1992 (incorporated by reference to Exhibit 10.6.2 to Form 10-Q for first quarter 1993). 10.6.3 Waiver No. 3 to Loan and Security Agreement, dated 14 September 1992 (incorporated by reference to Exhibit 10.6.3 to Form 10-Q for second quarter 1993). 10.6.4 Waiver No. 4 to Loan and Security Agreement, dated 14 September 1992 (incorporated by reference to Exhibit 10.6.4 to Form 10-Q for third quarter 1993). 10.6.5 Waiver No. 5 to Loan and Security Agreement, dated 14 September 1992 (incorporated by reference to Exhibit 10.6.5 to Form 10-Q for third quarter 1993). 10.6.6 Waiver No. 6 to Loan and Security Agreement, dated 14 September 1992 (incorporated by reference to Exhibit 10.6.6 to Form 10-Q for third quarter 1993). 10.6.7 Amendment and Waiver No. 7 to Loan and Security Agreement, dated 14 September 1992. 10.7 *Corporate Officer Variable Compensation Plan (incorporated by reference to Exhibit 10.7 to Form 10-K for fiscal year 1992). 10.7.1 *Management Variable Compensation Plan (incorporated by reference to Exhibit 10.7.1 to Form 10-K for fiscal year 1992). 10.7.2 *U.S. Operations Variable Compensation Plan (incorporated by reference to Exhibit 10.7.2 to Form 10-K for fiscal year 1992). 10.8 Conversion Agreement, dated 30 September 1993 (incorporated by reference to Exhibit 7(c)(1) to Form 8-K dated 13 October 1993). 10.8.1 Warrant Agreement, dated 30 September 1993 (incorporated by reference to Exhibit 7(c)(2) to Form 8-K dated 13 October 1993). 11. Not applicable. 12. Not applicable. 13. Not applicable. 18. Not applicable. 19. Not applicable. Page Exhibit Number No. Herein 22. Subsidiaries of the Registrant. 38 23. Not applicable. 24. Consent of Independent Public 33 Accountants. 25. Not applicable. 28. Not applicable. Copies of these exhibits are available from the Company's Corporate Secretary upon request at a cost of 25 cents per page. (b) Reports on Form 8-K In a report filed on Form 8-K dated 13 October 1993, the Company reported that all Class B Capital Stock was converted into an equal number of Common shares. In addition, the Class B shareholders were granted warrants to purchase 1,128,994 shares of Common stock at $8.625 per share which was the market price on the date of the transaction. The warrants expire on 31 March 1995. Refer, also, to Note 6 of the Notes to the Consolidated Financial Statements. CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS To Fischer & Porter Company: As independent public accountants, we hereby consent to the incorporation of our report dated 25 March 1994 included in this Form 10-K, into the Company's previously filed Registration Statements on Form S-8 (File No. 2-99944, File No. 2-73222 and File No. 33-48498) and on Form S-3 (File No. 2-90493). /S/ Arthur Andersen & Co. Philadelphia, Pa., 25 March 1994 FISCHER & PORTER COMPANY AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES Balance Balance Beginning End Name of Debtor of Year Additions Deductions of Year For the year ended 31 December 1993: Jay H. Tolson $212,908 $ - $ - $212,908 (1) For the year ended 31 December 1992: Jay H. Tolson $212,908 $ - $ - $212,908 For the year ended 31 December 1991: Jay H. Tolson $212,908 $ - $ - $212,908 (1) Represents a non-interest bearing demand note for purposes of split- funding a life insurance policy for the named individual; collateralized by a portion of the death benefit value of said policy. FISCHER & PORTER COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Balance Additions Balance Beginning at Retire. Other End Classification of Year Cost or Sales Transfers Changes* of Year For the year ended 31 December 1993: Land and land improvements $2,290 $47 $- $- $(95) $ 2,242 Buildings 38,706 282 305 - (923) 37,760 Machinery and equipment 66,734 3,728 3,994 - (2,040) 64,428 Construction in progress 972 460 16 - (68) 1,348 $108,702 $4,517 $4,315 $- $(3,126) $105,778 For the year ended 31 December 1992: Land and land improvements $2,435 $5 $- $- $(150) $2,290 Buildings 39,031 1,258 - - (1,583) 38,706 Machinery and equipment 65,376 6,147 2,004 214 (2,999) 66,734 Construction in progress 1,494 (413) 12 - (97) 972 $108,336 $6,997 $2,016 $214 $(4,829) $108,702 For the year ended 31 December 1991: Land and land improvements $2,421 $33 $- $- $(19) $2,435 Buildings 36,260 2,710 - - 61 39,031 Machinery and equipment 60,172 4,647 510 1,291 (224) 65,376 Construction in progress 2,670 (1,034) 9 - (133) 1,494 $101,523 $6,356 $519 $1,291 $(315) $108,336 *Translation adjustments. FISCHER & PORTER COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT Balance Additions Balance Beginning Charged to Retire. Other End Classification of Year Expense or Sales Transfers Changes* of Year For the year ended 31 December 1993: Land improve- ments $580 $30 $- $- $(22) $588 Buildings 14,003 1,562 224 - (546) 15,237 Machinery and equipment 54,156 4,710 3,834 - (1,275) 53,315 $68,739 $6,302 $4,058 $- $(1,843) $69,140 For the year ended 31 December 1992: Land improve- ments $578 $32 $- $- $(30) $580 Buildings 12,970 1,621 - (20) (568) 14,003 Machinery and equipment 52,749 5,225 1,417 (26) (2,375) 54,156 $66,297 $6,878 $1,417 $(46) $(2,973) $68,739 For the year ended 31 December 1991: Land improve- ments $548 $31 $- $- $(1) $578 Buildings 11,663 1,318 - - (11) 12,970 Machinery and equipment 45,354 5,733 452 376 1,738 52,749 $57,565 $7,082 $452 $376 $1,726 $66,297 *Translation and other adjustments (In 1991, includes $1,865,000 of restructuring charges). FISCHER & PORTER COMPANY AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS & RESERVES Charged Balance Charged (Credited) Deductions Balance Beginning to to Other from End of Year Income Accounts Reserves of Year Deducted on the balance sheet from the asset to which it applies: For the year ended 31 December 1993: Reserve for bad debts $2,259,000 $371,000 $(12,000) $259,000 $2,359,000 For the year ended 31 December 1992: Reserve for bad debts $2,268,000 $197,000 $211,000 $417,000 $2,259,000 For the year ended 31 December 1991: Reserve for bad debts $2,184,000 $390,000 $ 24,000 $330,000 $2,268,000 EXHIBIT 22 SUBSIDIARIES OF THE REGISTRANT The Subsidiaries of Fischer & Porter Company, all of which are included in the consolidated financial statements, are listed below: Percentage of Stock Jurisdiction Owned Directly or of Indirectly by the Name Incorporation by the Company F&P Holding, Inc. Delaware 100% Fispo, S. A. Mexico 100% Fischer & Porter Proprietary, Limited Australia 100% Fischer & Porter (Canada) Limited Canada 100% Fischer & Porter Ltd. England 100% Otic-Fischer & Porter France 100% Fischer & Porter GmbH Germany 100% Fischer & Porter Produktiontechnik GmbH Germany 100% Fischer & Porter Systemstechnik GmbH Germany 100% Fischer & Porter Holding GmbH Germany 100% Fischer & Porter Ges.m.b.H Austria 100% Fischer & Porter Italiana, S.p.A. Italy 100% Fischer & Porter Iberica, S.A. Spain 100% Fischer & Porter B.V. Netherlands 100% Fischer & Porter N.V. Belgium 100% Fischer & Porter AB Sweden 100% Fischer & Porter Oy Finland 100% 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. FISCHER & PORTER COMPANY (Registrant) By: /S/ Jay H. Tolson Jay H. Tolson Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer) By: /S/ Nathan T. Schelle By:/S/ Laurence P. Finnegan, Jr. Nathan T. Schelle Laurence P. Finnegan, Jr. Vice President-Controller Senior Vice President, Chief (Principal Accounting Officer) Financial Officer and Treasurer (Principal Financial Officer) Date: 31 March 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. /S/ Gloria T. Chisum /S/ John J. Manion, Jr. Gloria T. Chisum (Director) John J. Manion, Jr. (Director) Date: 31 March 1994 Date: 31 March 1994 /S/ E. Joseph Hochreiter E. Joseph Hochreiter (Director) Frank J. Ryan (Director) Date: 31 March 1994 Date: 31 March 1994 /S/ William E. Learnard /S/ Jay H. Tolson William E. Learnard (Director) Jay H. Tolson (Director) Date: 31 March 1994 Date: 31 March 1994 /S/ Robert G. Williams Robert G. Williams (Director) Date: 31 March 1994

800240_1993.txt

800240_1993

1993

800240

ITEM 1. BUSINESS. GENERAL Office Depot, Inc. (the "Company") operates the largest chain of high-volume retail office supply stores in the United States, with 344 stores in 33 states and the District of Columbia and 18 stores in 5 Canadian provinces. The Company sells high-quality, brand-name office products at significant discounts primarily to small- and medium-sized businesses. The Company's stores utilize a "warehouse" format and carry a wide selection of merchandise, including general office supplies, business machines and computers, office furniture and other business-related products. The Company also operates five delivery centers and a full-service contract stationer business serving medium- and large-sized businesses in the United States through twelve contract stationer warehouses. The Company is one of the leading full service contract stationers and office furniture dealers in the western United States and Texas through its contract stationer division. The Company, through this division, sells its products primarily to medium- and large-sized businesses (generally, organizations with over 75 white-collar employees), schools and other educational institutions and governmental agencies. The Company provides its customers access to a broad selection of office supplies and office furniture, as well as specialized resources and services designed to aid its customers in achieving improved efficiencies and significant reduction in their overall office supplies and office furniture costs, including electronic ordering, stockless office procurement and business forms management services (which reduce customer needs for office supplies storage facilities), desktop delivery programs (which reduce customer personnel requirements) and comprehensive product utilization reports. The Company's business strategy is to enhance the sales and profitability of its existing stores, to add new stores in locations where the Company can achieve a significant market presence and to expand its contract stationer business. Through expansion, the Company seeks to increase efficiencies in operations, purchasing, marketing and management. During 1993, the Company added 67 new stores. The Company intends to open approximately 60 to 70 stores and additional delivery centers during 1994. The Company's merchandising strategy is to offer customers a wide selection of brand-name office products at everyday low prices. The Company believes that its prices are significantly lower than those typically offered to small- and medium-sized businesses by their traditional sources of supply. The Company is able to maintain its low competitive price policy primarily as a result of the significant cost efficiencies achieved through its operating format and purchasing power. The Company buys substantially all of its inventory directly from manufacturers in large quantities. It does not utilize a central warehouse and maintains its inventory on the sales floors of its "no frills" stores. The Company operates in a highly competitive environment and the Company believes that in the future it will face increased competition from other high-volume office supply and wholesale club chains as the Company and these chains expand their operations. The Company recently has expanded its business into the full-service contract stationer portion of the office supply industry. On May 17, 1993, the Company acquired the office supply business of Wilson Stationery & Printing Company ("Wilson") from Steelcase Inc. for approximately $15 million of Common Stock and the assumption of certain liabilities. The Company and Steelcase Inc. were not, at the time of the acquisition, and are not currently, affiliated. Wilson is a full service contract stationer with operations in Texas and North Carolina. On September 13, 1993, the Company acquired all of the outstanding common stock of Eastman Office Products Corporation ("Eastman"), a full service contract stationer and office furniture dealer headquartered in California that operates primarily in the western United States. The Company acquired the Eastman common stock for approximately $80 million of Common Stock and $20 million in cash. The - 1 - Company also acquired the outstanding preferred stock of Eastman for approximately $13 million in cash, acquired pursuant to a tender offer approximately $82 million aggregate principal amount of Eastman, Inc.'s 13% Series B Subordinated Notes due 2002 for approximately $103 million in cash and paid approximately $19 million in cash to pay off the outstanding balance of Eastman, Inc.'s revolving credit facility. No affiliation existed between the Company and Eastman prior to this transaction. Additionally, in February 1994, the Company acquired all of the outstanding common stock of L.E. Muran Co., a Boston-based contract stationer, and Yorkship Press Inc., a New Jersey-based contract stationer serving Philadelphia and southern New Jersey. No affiliation existed between the Company and either of L.E. Muran Co. or Yorkship Press Inc. prior to these transactions. OFFICE PRODUCTS INDUSTRY The office products industry is comprised of three broad categories of merchandise: office supplies, office machines and microcomputers, and office furniture. These products are distributed through different and sometimes overlapping channels of distribution, including manufacturers, distributors, dealers, retailers and catalog companies. The retail office products industry, through which smaller businesses have traditionally purchased office products, is highly fragmented with few regional or national chains and is typified by stores that do not stock a full range of office products. Retail sales of office products in the United States are made primarily through office product dealers, which generally operate one or more retail stores and utilize a central warehouse facility. Dealers purchase a significant portion of their merchandise from national or regional office supply distributors who in turn purchase merchandise from manufacturers. Dealers often employ a commissioned sales force that utilizes the distributor's catalog, showing products at retail list prices, for selection and price negotiation with the customer. Contract bids are typically available to large businesses that are offered discounts equivalent to or greater than those offered by the Company. The Company believes that small- and medium-sized businesses, however, have typically been able to obtain from dealers discounts on manufacturers' suggested retail list prices of only 20% or less. In addition, those businesses whose volume usage does not justify a dealer's one-to-one selling effort generally have been treated as retail customers and charged prices close to full retail list prices. In the past few years, high-volume office products retailers employing various formats have emerged in several geographic markets of the United States targeting the smaller businesses that traditionally purchased from dealers by offering significantly lower prices. These price advantages result primarily from direct, high-volume purchasing from manufacturers and warehouse retailing, thereby avoiding the distributor's mark-up and eliminating the need for a commissioned sales force and a central distribution facility. High-volume office products retailers typically offer substantial price savings to individuals and small- and medium-sized businesses, which traditionally have had limited opportunities to buy at significant discounts off the retail list prices. Larger customers have been, and continue to be, serviced primarily by full service contract stationers. These stationers traditionally serve larger businesses through commissioned sales forces, purchase in large quantities primarily from manufacturers and offer competitive pricing and customized services to their customers. MERCHANDISING AND PRODUCT STRATEGY The Company's merchandising strategy is to offer a broad selection of brand-name office products at everyday low prices. Each of the Company's stores offer a comprehensive selection of paper and paper products, filing supplies, computer hardware and software, calculators, copiers, typewriters, telephones, facsimile and other business machines, office furniture, art and engineering supplies and virtually every other type of office supply. Each of the Company's stores carries approximately 5,600 stock-keeping units (including variations in color and size). In the Contract Stationer Division, in order to be able to respond satisfactorily to its customers' orders, certain of the contract stationer warehouses currently carry up to 18,000 stock-keeping - 2 - units in inventory. Although the Company has not determined the number of stock-keeping units in inventory its contract stationer warehouses will carry in the future, the Company expects such number to be less than 18,000. The table below shows sales of each major product group as a percentage of total merchandise sales for the 1993, 1992 and 1991 fiscal years: (1) Includes paper, filing supplies, organizers, writing instruments, mailing supplies, desktop accessories, calendars, business forms, binders, tape, art supplies, books, engineering and janitorial supplies and revenues from the business services center located in each store. (2) Includes calculators, adding machines, typewriters, telephones, cash registers, copiers, facsimile machines, safes, tape recorders, computers, computer diskettes, computer paper and related accessories. (3) Includes, chairs, desks, tables, partitions and filing and storage cabinets. The Company buys approximately 95% of its merchandise directly from manufacturers and other primary source suppliers. Products are generally delivered from manufacturers directly to the stores or warehouses. The Company is currently expanding its cross-dock operations that utilize independent distributors' facilities to receive bulk deliveries from vendors and sort and deliver merchandise to the Company's stores. These operations use the Company's computer system and the distributors' existing facilities and trucks, which, when fully implemented, should enable the Company to realize savings from freight and handling charges and reduce store inventory levels. No single customer accounts for more than one percent of the Company's sales. The Company has no material long-term contracts or commitments with any vendor or customer. The Company has not experienced any difficulty in obtaining desired quantities of merchandise for sale and does not foresee any such difficulty in the future. Initial purchasing decisions are made at the corporate headquarters level by buyers who are responsible for selecting and pricing merchandise. Inventory levels are monitored and reorders for products are prepared by central replenishment buyers or "rebuyers" with the assistance of a computerized automatic replenishment system. This system allows buyers to devote more time to selecting products, developing new product lines, analyzing competitive developments and negotiating with vendors in order to obtain more favorable prices and product availability. Purchase orders to approximately 250 vendors are currently transmitted by electronic data interchange (EDI), which expedites orders and promotes accuracy and efficiency. During 1993, the Company started to receive Advance Ship Notices (ASN) and invoicing via EDI from selected vendors. The Company plans to expand this program in 1994. MARKETING AND SALES Retail. The Company's marketing programs are designed to attract new customers to visit its stores for the first time and to provide information to existing customers. The Company places advertisements with the major local newspapers in each of its markets. These newspaper advertisements are supplemented with local radio and television advertising and direct marketing efforts. During 1992, the Company launched a major national television advertising campaign utilizing the "Taking Care of Business" theme. The current series of television commercials is running on three national television networks and on 11 national cable stations. All print advertisements, as well as catalog layouts, are created by the Company's in-house - 3 - graphics department. The Company periodically issues catalogs featuring merchandise offered in its stores. The catalogs compare the manufacturer's suggested retail list price and the Company's price to illustrate the savings offered. The catalogs are distributed through direct mail programs and are available in each store. Upon entering a new market, the Company purchases a list of businesses for an initial mailing of catalogs. This list is continually refined and updated by incorporating the names of private label credit card holders, guarantee card holders and check paying customers and forms the basis of a highly targeted proprietary mailing list for updated catalogs and other promotional mailings. The Company has a low price guarantee policy. Under this policy, the Company will match any competitor's lower price and give the customer 50% (up to $50) of the difference towards the customer's purchase. This program assures customers of always receiving the lowest price from the Company's stores even during periodic sales promotions by competitors. Monthly competitive pricing analyses are performed to monitor each market and prices are adjusted as necessary to adhere to this pricing philosophy and ensure competitive positioning. Contract Stationer. The Company acquires and maintains its customers primarily through its direct sales force. The Company's sales force is divided between its office supplies and contract furniture divisions. All members of the Company's sales force are employees of the Company. SERVICES Retail. The Company provides three key services to its customers -- credit, telephone and facsimile ordering and delivery. The Company offers revolving credit terms to its customers through the use of private label credit cards. Every business customer can apply for one of these credit cards, which are issued without charge. Sales transactions using the private label credit cards are transmitted by computer to financial services companies, which credit the Company's bank account with the net proceeds the following day. The Company's customers nationwide can place orders by telephone or facsimile using toll-free telephone numbers through the Company's order departments in south Florida and the San Francisco area. Orders received by the order departments are transmitted electronically to the store or delivery center nearest the customer for pick-up or delivery at a nominal delivery fee or free delivery with a minimum order size. Orders are packaged, invoiced and shipped for next-day delivery. The Company opened two regional delivery warehouses in 1990 (in south Florida and northern California) and three regional delivery facilities in 1992 (in the Atlanta, Baltimore/Washington and Los Angeles markets). All delivery orders received from customers in these areas, whether through the Company's telephone centers or at its stores, are handled through these facilities. The Company believes that these facilities enable it to provide improved delivery services on a more cost effective basis and intends to open additional regional delivery warehouses during 1994. No new delivery centers were opened during 1993 pending the Company's entry into the contract stationer portion of the business and the determination of the optimal configuration of a facility which would support deliveries to both retail and contract customers. The Company's stores each have a business services center, which offers self-service and high-volume photocopying as well as facsimile, printing, binding, typesetting and other business services. Contract Stationer. The Company provides the office supplies purchasing departments of its customers with a wide range of services designed to improve efficiencies and reduce costs, including electronic ordering, stockless office procurement and business forms management services, desktop delivery programs and comprehensive product utilization reports. For contract stationer customers, the Company will typically sell on credit through an open account. - 4 - The Company services its contract stationer customers from warehouses located in Arizona, California, Colorado, Massachusetts, New Jersey, North Carolina, Texas, Utah and Washington. STORE DESIGN AND OPERATIONS The Company's stores average approximately 25,000 square feet of space and conform to a model designed to achieve cost efficiency by minimizing rent and eliminating the need for a central warehouse. Each store displays virtually all of its inventory on the sales floor according to a plan-o-gram that designates the location of each item in the store. The plan-o-gram is intended to ensure that merchandise is effectively displayed and to promote economy and efficiency in the use of merchandising space. On the sales floor, merchandise is displayed on pallets or in bins on 10 to 12 foot high industrial steel shelving that permits the bulk stacking of inventory and quick and efficient restocking. The shelving is positioned to form aisles large enough to comfortably accommodate customer traffic and merchandise movement. Additional efficiencies are gained by selling merchandise in multiple quantity packaging, which significantly reduces duplicate handling and stock costs. In all of the Company's stores, inventory that has not been bar coded by the manufacturer is bar coded in the receiving area and moved directly to the sales floor. Sales are processed through centralized check-out facilities, which transmit sales and inventory information on a stock-keeping unit basis to the Company's central computer system where this information is updated daily. Rather than individually price marking each product, merchandise is identified by its stock-keeping unit number with a master sign for each product displaying the product's price. As price changes occur, a new master sign is automatically generated for the product display and the new price is reflected in the check-out register, allowing the Company to avoid labor costs associated with price remarking. MANAGEMENT INFORMATION SYSTEMS The Company employs an IBM ES9000 mainframe and multiple IBM System AS/400 computers to aid in controlling its merchandising and operations. The system includes advanced software packages that have been customized for the Company's specific business operations. The Company is currently implementing a multi-year strategy to upgrade and convert its systems to operate in an "open system" mainframe environment. Inventory data is entered into the computer system upon its receipt by the store and sales data is entered through the use of a point-of-sale or telemarketing system. The point-of-sale system permits the entry of sales data through the use of bar code scanning laser guns and also has a price "look-up" capability that permits immediate price checking and efficient movement of customers through the check-out process. Information is centrally processed at the end of each day, permitting a perpetual daily inventory and the calculation of average unit cost by stock-keeping unit for each store or warehouse. Daily compilation of sales and margin data permits the monitoring of sales, gross margin and inventory by item and product line, as well as the results of sales promotions. For all stock-keeping units, management has immediate access to on-hand daily unit inventory, units on order, current and past rates of sale, the number of weeks' sales for which quantities are on-hand and a recommended unit purchase reorder. Data from all the Company's stores (other than those in Florida) are transmitted by satellite to the Company's headquarters, which provides faster response and is more cost efficient than traditional telephonic transmission. EXPANSION PROGRAM The Company's business strategy is to enhance the sales and profitability of its existing stores, to add new stores in locations where the Company can achieve a significant market presence and to expand its contract stationer business. Through expansion, the Company seeks to increase efficiencies in operations, - 5 - purchasing, marketing and management. The Company added 67 new stores in 1993, and plans to open approximately 60 to 70 stores and additional delivery centers during 1994. Prior to selecting a new store site, the Company obtains detailed demographic information indicating business concentrations, traffic counts, population, income levels and future growth prospects. The Company's existing and scheduled new stores are located primarily in suburban strip shopping centers on major commercial thoroughfares where the cost of space is generally lower than at urban locations. Suburban locations are generally more accessible to the Company's primary customers, have convenient parking and facilitate delivery to customers and receipt of inventory from manufacturers. The Company expands by leasing existing space and renovating it according to its specifications or by constructing new space according to its specifications. Accomplishing the Company's expansion goals will depend on a number of factors, including the Company's ability to locate and obtain acceptable sites, open new stores in a timely manner, hire and train competent managers, integrate new stores into its operations, generate funds from operations and continue to access external sources of capital. No assurances can be given that these expansion plans will be accomplished. Through its acquisitions in 1993, the Company is expanding its presence in the contract stationer portion of the office products industry. The Company's business strategy includes continued expansion in this portion of the industry, although no assurances can be given that it will be able to do so. EMPLOYEES, STORE MANAGEMENT AND TRAINING As of March 11, 1994, the Company employed approximately 20,400 persons. Additional personnel will be added as needed to implement the Company's expansion program. The Company's goal is to promote as many existing employees into management positions as possible. Due to the rate of its expansion, however, for the foreseeable future the Company will continue to hire a portion of its management personnel from outside the Company. The Company's policy is to hire and train additional personnel in advance of new store openings. In general, store managers have extensive experience in retailing, particularly with warehouse store chains or discount stores that generate high sales volumes. Each new store manager usually spends two to four months in an apprenticeship position at an existing store prior to being assigned to a new store. The Company's sales employees are required to view product knowledge videos and complete written training programs relating to certain products. The Company creates some of these videos and training programs while the remainder are supplied by manufacturers. The Company grants stock options to certain of its employees as an incentive to attract and retain such employees. The Company has never experienced a strike or any work stoppage and management believes that its relations with its employees are good. There are no collective bargaining agreements covering any of the Company's employees. COMPETITION The Company operates in a highly competitive environment. Its markets are presently served primarily by traditional office products dealers that typically operate a central warehouse and one or more retail stores. The Company believes it competes favorably against these dealers, who purchase their products from distributors and generally sell their products at prices higher than those offered by the Company, because they generally offer small- and medium-sized businesses discounts on manufacturer's suggested retail list prices of only 20% or less as compared to the Company's 30% to 60% discount to all customers. The Company also competes with wholesale clubs selling general merchandise, discount stores, mass merchandisers, conventional retail stores, catalog showrooms and direct mail companies. While these competitors generally charge small - 6 - business customers lower prices than traditional office products dealers, they typically have a more limited in-stock product selection than the Company's stores and do not provide many of the services provided by the Company. Several high-volume office supply chains that are similar in concept to the Company in terms of store format, pricing strategy and product selection and availability also operate in the United States. The Company competes with these chains and wholesale club chains in substantially all of its current and prospective markets. The Company believes that in the future it will face increased competition from these chains as the Company and these chains expand their operations. Some of the entities against which the Company competes, or may compete, are larger and have substantially greater financial resources than the Company. No assurance can be given that increased competition will not have an adverse effect on the Company. The Company believes it competes based on product price, selection, availability and service. In the contract stationer portion of the industry, principal competitors are national and regional full service contract stationers, national and regional office furniture dealers, independent office product distributors, discount superstores and to a lesser extent, direct mail order houses and stationery retail outlets. Certain discount superstores also appear to be attempting to develop a presence in the contract stationer portion of the business. - 7 - ITEM 2. ITEM 2. PROPERTIES. As of March 21, 1994, the Company operated 344 stores in 33 states and the District of Columbia and 18 stores in 5 Canadian provinces. The Company also operates five delivery centers and a full service contract stationer business through 12 contract stationer warehouses. The following table sets forth the locations of the Company's facilities. All the Company's facilities are leased or subleased by the Company with lease terms (excluding renewal options exercisable by the Company at escalated rents) expiring between 1994 and 2015, except for two Oklahoma stores, three Florida stores, four Texas stores and one California store that are owned by the Company. The Company operates its stores under the names Office Depot and The Office Place in Ontario, Canada. The Company operates its contract stationer warehouses under the names Eastman Office Products, Wilson Business Products, L.E. Muran and Yorkship Business Supply. The Company's corporate offices in Delray Beach, Florida, containing approximately 350,000 square feet in two adjacent buildings, were purchased in February 1994 for approximately $16 million. The Company had previously occupied one of the buildings under a lease covering approximately 150,000 square feet. - 8 - ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is involved in litigation arising in the normal course of its business. The Company believes that these matters will not materially affect its financial position or 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 STOCK AND RELATED SECURITY HOLDER MATTERS. The Common Stock of the Company is listed on the New York Stock Exchange ("NYSE") under the symbol "ODP." At March 18, 1994, there were 3,354 holders of record of Common Stock. The last reported sales price of the Common Stock on the NYSE on March 18, 1994 was $39-1/4. The following table sets forth, for the periods indicated, the high and low sale prices of the Common Stock quoted on the NYSE Composite Tape. These prices do not include retail mark-ups, mark-downs or commissions, and have been adjusted to reflect a two-for-one stock split in May 1992 and a three-for-two stock split in May 1993. The Company has never declared or paid cash dividends on its Common Stock and does not currently intend to pay cash dividends in the foreseeable future. Earnings and other cash resources of the Company will be used to continue the expansion of the Company's business. In addition, the Company is limited in the amount of cash dividends it can pay under the terms of its credit facility. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The selected financial data as of and for the 52 weeks ended December 28, 1991, December 26, 1992 and December 25, 1993 set forth in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993 (on the inside front cover) is incorporated herein by reference and made a part of this report. 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 set forth in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993 (on pages 17-20) is incorporated herein by reference and made a part of this report. - 9 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS. The financial statements of the Company for the 52 weeks ended December 28, 1991, December 26, 1992 and December 25, 1993 set forth in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993 (on pages 21- 36) are incorporated herein by reference and made a part of this 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 with respect to directors and executive officers of the Company is incorporated herein by reference to the information under the caption "Management--Directors and Executive Officers" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information with respect to executive compensation is incorporated herein by reference to the information under the caption "Management--Compensation" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. 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 to the tabulation under the caption "Security Ownership" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information with respect to certain relationships and related transactions is incorporated herein by reference to the information under the caption "Certain Transactions" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. 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 listed in the "Index to Financial Statements." 2. The financial statement schedules listed in "Index to Financial Statement Schedules." 3. The exhibits listed in the "Index to Exhibits." - 10 - (b) Reports on Form 8-K. None. - 11 - 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 23, 1994. OFFICE DEPOT, INC. By /s/ David I. Fuente David I. Fuente, Chairman 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 23, 1994. All other statements have been omitted because they are inapplicable, not required or the information is included elsewhere herein. ______________________________ * Incorporated herein by reference to the respective information in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993. F - 1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES To the Board of Directors of Office Depot, Inc.: We have audited the consolidated financial statements of Office Depot, Inc. and subsidiaries as of December 25, 1993 and December 26, 1992 and for each of the three years in the period ended December 25, 1993, and have issued our report thereon dated February 8, 1994; such consolidated financial statements and report are included in your 1994 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Office Depot, Inc. and subsidiaries referred to in Item 14(a)(2) and listed in the Index to Financial Statement Schedules. 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 Certified Public Accountants Fort Lauderdale, Florida February 8, 1994 F - 2 INDEX TO FINANCIAL STATEMENT SCHEDULES F - 3 SCHEDULE V OFFICE DEPOT, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) F - 4 SCHEDULE VI OFFICE DEPOT, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) F - 5 SCHEDULE VIII OFFICE DEPOT, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (In thousands) (1) Allowance for doubtful accounts of Eastman and Wilson at the respective dates of acquisition. F - 6 SCHEDULE X OFFICE DEPOT, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) F - 7 INDEX TO EXHIBITS + This information appears only in the manually signed original copies of this report. * Management contract or compensatory plan or arrangement. (1) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-66642. (2) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-39473. (3) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-54574. (4) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-70378. (5) Incorporated by reference to the respective exhibit to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 29, 1991. (6) Incorporated by reference to the respective exhibit to the Company's Current Report on Form 8-K filed October 14, 1993. (7) Incorporated by reference to the respective exhibit to the Company's Proxy Statement for the 1993 Annual Meeting of Stockholders (8) Incorporated by reference to the respective exhibit to the Company's Annual Report on Form 10-K for the year ended December 26, 1992. (9) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-51409. Upon request, the Company will furnish a copy of any exhibit to this report upon the payment of reasonable copying and mailing expenses.

71337_1993.txt

71337_1993

1993

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Item 1. BUSINESS THE SYSTEM SYSTEM ORGANIZATION New England Electric System (NEES) is a voluntary association created under Massachusetts law on January 2, 1926, and is a registered holding company under the Public Utility Holding Company Act of 1935 (the 1935 Act). NEES owns voting stock in the amounts indicated of the following companies, which together constitute the System. % Voting Securities State of Type of Owned by Name of Company Organization Business NEES --------------- ------------ --------- ---------- Subsidiaries: Granite State Electric Company N.H. Retail 100 (Granite State) Electric Massachusetts Electric Company Mass. Retail 100 (Mass. Electric) Electric The Narragansett Electric Company R.I. Retail 100 (Narragansett) Electric Narragansett Energy Resources R.I. Wholesale 100 Company (Resources) Electric Generation New England Electric Resources, Inc. Mass. Consulting 100 (NEERI) Services New England Electric Transmission N.H. Electric 100 Corporation (NEET) Transmission New England Energy Incorporated Mass. Oil and Gas 100 (NEEI) Exploration & Development New England Hydro-Transmission N.H. Electric 53.97(a) Corporation (N.H. Hydro) Transmission New England Hydro-Transmission Mass. Electric 53.97(a) Electric Company, Inc. Transmission (Mass. Hydro) New England Power Company (NEP) Mass. Wholesale 98.80(b) Electric Generation & Transmission New England Power Service Company Mass. Service 100 (Service Company) Company (a) The common stock of these subsidiaries is owned by NEES and certain participants (or their parent companies) in Phase II of the Hydro-Quebec project. See Interconnection with Quebec, page 21. (b) Holders of common stock and 6% Cumulative Preferred Stock of NEP have general voting rights. The 6% Cumulative Preferred Stock represents 1.20% of the total voting power. In 1993, the System was realigned into two strategic business units, a wholesale business unit and a retail business unit. The facilities of NEES' three retail electric subsidiaries, Mass. Electric, Narragansett, and Granite State (collectively referred to as the Retail Companies), and of its principal wholesale electric subsidiary, NEP, constitute a single integrated electric utility system that is directly interconnected with other utilities in New England and New York State, and indirectly interconnected with utilities in Canada. See ELECTRIC UTILITY OPERATIONS, page 3. NEET owns and operates a portion of an international transmission interconnection between the electric systems of Hydro-Quebec and New England. Mass. Hydro and N.H. Hydro own and operate facilities in connection with an expanded second phase of this interconnection. See Interconnection with Quebec, page 21. NEEI is engaged in various activities relating to fuel supply for the System. These activities presently include participation (principally through a partnership with a non-affiliated oil company) in domestic oil and gas exploration, development, and production (see OIL AND GAS OPERATIONS, page 43) and the sale to NEP of fuel purchased in the open market. Resources is a general partner, with a 20% interest, in each of two partnerships formed in connection with the Ocean State Power project. See Ocean State Power, page 21. The Service Company has contracted with NEES and its subsidiaries to provide, at cost, such administrative, engineering, construction, legal, and financial services as the companies request. The Service Company also provides maintenance and construction services under contract to certain non-affiliated utility customers. Profits from these contracts are used to reduce the cost of services to affiliated companies. NEERI is a wholly-owned, non-utility subsidiary of NEES which provides consulting services domestically and internationally to non-affiliates. EMPLOYEES As of December 31, 1993, NEES subsidiaries had approximately 5,000 employees. As of that date, the total number of employees was approximately 840 at NEP, 1,800 at Mass. Electric, 760 at Narragansett, 80 at Granite State, and 1,500 at the Service Company. Of the 5,000 employees, approximately 3,300 are members of labor organizations. Collective bargaining agreements with the Brotherhood of Utility Workers of New England, Inc., the International Brotherhood of Electrical Workers, and the Utility Workers Union of America, AFL-CIO expire in May 1995. FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS The business of the System is conducted in two primary business segments, electric utility operations and oil and gas operations. The financial information with respect to Electric Utility Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $2,187,040 $2,138,302 $2,056,798 Operating income 332,843 341,650 317,487 Total assets 4,460,652 4,177,781 3,964,569 Capital expenditures 304,659 241,872 209,674 The financial information with respect to Oil and Gas Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $ 46,938 $ 43,374 $ 37,580 Pre-tax loss passed (46,355) (54,607) (39,303) on to customers Total assets 335,226 407,015 485,508 Capital expenditures 18,965 21,262 32,969 ELECTRIC UTILITY OPERATIONS GENERAL NEP's business is principally generating, purchasing, transmitting, and selling electric energy in wholesale quantities. In 1993, 95% of NEP's revenue from the sale of electricity was derived from sales for resale to affiliated companies and 5% from sales for resale to municipal and other utilities. NEP is the wholesale supplier of the electric energy requirements of the Retail Companies. Narragansett, however, receives credits against its purchases of power from NEP for the cost of generation from its Providence units, which are integrated with NEP's facilities to achieve maximum economy and reliability. Discussions of NEP's generating properties, load growth, energy mix, and fuel supplies include the related properties of Narragansett. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 28 of the New England Power Company 1993 Annual Report to Stockholders (the NEP 1993 Annual Report). The combined service area of the Retail Companies constitutes the retail service area of the System and covers more than 4,400 square miles with a population of about 3,000,000 (1990 census). See Map, page 17. The largest cities served are Worcester, Mass. (population 170,000) and Providence, R.I. (population 161,000). Mass. Electric and Narragansett are engaged principally in the distribution and sale of electricity at retail. Mass. Electric provides approximately 930,000 customers with electric service at retail in a service area comprising approximately 43% of the area of The Commonwealth of Massachusetts. The population of the service area is about 2,160,000 or 36% of the total population of the Commonwealth (1990 Census). Mass. Electric's territory consists of 149 cities and towns including rural, suburban, and urban communities with Worcester, Lawrence, Lowell, and Quincy being the largest cities served. The economy of the area is diversified. Principal industries served by Mass. Electric include electrical and industrial machinery, computer manufacturing and related products, plastic goods, fabricated metals and paper, and chemical products. In addition, a broad range of professional, banking, high-technology, medical, and educational concerns is served. During 1993, 41% of Mass. Electric's revenue from the sale of electricity was derived from residential customers, 36% from commercial customers, 22% from industrial customers, and 1% from others. In 1993, the 20 largest customers of Mass. Electric accounted for less than 8% of its electric revenue. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 26 of Mass. Electric's 1993 Annual Report to Stockholders (the Mass. Electric 1993 Annual Report). Narragansett provides approximately 323,000 customers with electric service at retail. Its service territory, which includes urban, suburban, and rural areas, covers about 839 square miles or 80% of the area of Rhode Island, and encompasses 27 cities and towns including the cities of Providence, East Providence, Cranston, and Warwick. The population of the area is about 725,000 (1990 Census) which represents about 72% of the total population of the state. The economy of the territory is diversified. Principal industries served by Narragansett produce fabricated metal products, jewelry, silverware, electrical and industrial machinery, transportation equipment, textiles, and chemical and allied products. In addition, a broad range of professional, banking, medical, and educational institutions is served. During 1993, 42% of Narragansett's revenue from the sale of electricity was derived from residential customers, 40% from commercial customers, 16% from industrial customers, and 2% from others. In 1993, the 20 largest customers of Narragansett accounted for approximately 11% of its electric revenue. For details of sales of energy and operating revenue for the last five years see OPERATING STATISTICS on page 23 of Narragansett's 1993 Annual Report to Stockholders (the Narragansett 1993 Annual Report). Granite State provides approximately 35,000 customers with electric service at retail in the State of New Hampshire in an area having a population of about 73,000 (1990 Census), including the city of Lebanon and the towns of Hanover, Pelham, Salem and surrounding communities. During 1993, 48% of Granite State's revenue from the sale of electricity was derived from commercial customers, 39% from residential customers, 12% from industrial customers, and 1% from others. In 1993, the 10 largest customers of Granite State accounted for about 20% of its electric revenue. Granite State is not subject to the reporting requirements of the Securities Exchange Act of 1934, and its financial impact on the System is relatively small. Information on Granite State is provided herein solely for the purpose of furnishing a more complete description of System operations. The electric utility business of NEP and the Retail Companies is not highly seasonal. For NEP and the Retail Companies, industrial customers are broadly distributed among standardized industrial classifications. No single industrial classification exceeds 4% of operating revenue, and no single customer of the System contributes more than 1% of operating revenue. Kilowatthour (KWH) sales billed to ultimate customers in 1993 increased by 1.4% over 1992. A return to more normal weather conditions in 1993 was largely offset by the fact that 1992 included an extra day for leap year. KWH sales billed to ultimate customers increased 0.4% in 1992. COMPETITIVE CONDITIONS The electric utility business is being subjected to increasing competitive pressures, stemming from a combination of increasing electric rates, improved technologies and new regulations, and legislation intended to foster competition. Recently, this competition has been most prominent in the bulk power market in which non-utility generating sources have noticeably increased their market share. For example, in 1984, less than 1% of NEP's capacity was supplied by non-utility generation sources. By the end of 1993, non-utility power purchases accounted for 380 MW or 7% of NEP's total capacity. In addition to competition from non- utility generators, the presence of excess generating capacity in New England has resulted in the sale of bulk power by utilities at prices less than the total costs of owning and operating such generating capacity. Electric utilities are also facing increased competition in the retail market. Currently, retail competition comes from alternative fuel suppliers (principally natural gas companies) for heating and cooling, customer-owned generation to displace purchases from electric utilities, and direct competition among electric utilities to attract major new manufacturing facilities to their service territories. In the future, the potential exists for electric utilities and non-utility generators to sell electricity to retail customers of other electric utilities. The NEES companies are responding to current and anticipated competitive pressures in a variety of ways including cost control and a corporate reorganization into separate retail and wholesale business units. The wholesale business unit is positioning itself for increased competition through such means as terminating certain purchased power contracts, past and future shutdowns of uneconomic generating stations, and rapid amortization of certain plant assets. NEP's rates currently include approximately $100 million per year associated with the recovery of certain Seabrook Nuclear Generating Station Unit 1 (Seabrook 1) costs under a 1988 rate settlement and coal conversion expenditures at NEP's Salem Harbor station. The recovery of these costs will be completed prior to the end of 1995. The retail business unit's response to competition includes the development of value-added services for customers and the offering of economic development rates to encourage businesses to locate in our service territory. In its recent rate settlement, Mass. Electric was able to change the standard terms under which it offers service to commercial and industrial customers to extend the notice period a customer must give from one to two years before purchasing electricity from others or generating any additional electricity for the customer's own use. In addition, Mass. Electric began offering a discount from base rates in return for a contract requiring the customer to provide five years written notice before purchasing electricity from others or generating any additional electricity for the customer's own use. The discount is available to customers with average monthly peak demands over 500 kilowatts. Electric utility rates are generally based on a utility's costs. Therefore, electric utilities are subject to certain accounting standards that are not applicable to other business enterprises in general. These accounting rules allow regulated entities, in appropriate circumstances, to establish regulatory assets and to defer the income statement impact of certain costs that are expected to be recovered in future rates. The effects of competition could ultimately cause the operations of the NEES companies, or a portion thereof, to cease meeting the criteria for application of these accounting rules. While the NEES companies do not expect to cease meeting these criteria in the near future, if this were to occur, accounting standards of enterprises in general would apply and immediate recognition of any previously deferred costs would be necessary in the year in which these criteria were no longer applicable. RATES General In 1993, 74% of the System's electric utility revenues was attributable to NEP, whose rates are subject to regulation by the Federal Energy Regulatory Commission (FERC). The rates of Mass. Electric, Narragansett, and Granite State are subject to the respective jurisdictions of the state regulatory commissions in Massachusetts, Rhode Island, and New Hampshire. The rates of each of the Retail Companies contain a purchased power cost adjustment clause (PPCA). The PPCA is designed to allow the Retail Companies to pass on to their customers increases in purchased power expense resulting from increases allowed by the FERC in NEP's rates. The Retail Companies are also required to reflect rate decreases or refunds. PPCA changes become effective on the dates specified in the filing of the adjustments with the state regulatory commission (not earlier than 30 days after such filing) unless the state regulatory commission orders otherwise. There have been, on occasion, regulatory delays in permitting PPCA increases. Effective March 1, 1993, Narragansett and Granite State received approval for PPCA clauses that fully reconcile on an annual basis purchased power expenses incurred by the companies against purchased power related revenues. Under the doctrine of Narragansett v. Burke, a case decided by the Rhode Island Supreme Court in 1977, NEP's wholesale rates must be accepted as allowable expenses for rate-making purposes by state commissions in retail rate proceedings. In 1986 and 1988 the U.S. Supreme Court reaffirmed this doctrine in two cases that did not involve NEP. However, the Narragansett v. Burke doctrine has been indirectly challenged by a number of state regulatory commissions which have held that federal preemption of the regulation of wholesale electric rates does not preclude the state commission from reviewing the prudence of a utility's decision to purchase power under a FERC-approved rate, and from disallowing costs if it finds that the purchase was an imprudent choice among alternative sources. In a 1985 opinion, the New Hampshire Supreme Court took this position on the issue of state regulation of wholesale power purchases. Also, legislation has been filed from time to time in Congress that would have eroded or repealed the doctrine. If state commissions were to refuse to allow the Retail Companies to include the full cost of power purchased from NEP in their rates, System earnings could be adversely affected. The rates of NEP and the Retail Companies contain fuel adjustment clauses that allow the rates to be adjusted to reflect changes in the cost of fuel. NEP's fuel clause is on a current basis. Mass. Electric has a fuel clause billing procedure that provides for monthly billing of estimated quarterly fuel costs, while Narragansett's and Granite State's fuel costs are estimated on a semi-annual basis. Billings are adjusted in the subsequent period for any excess or deficiency in fuel cost recovery. The FERC rules allow up to 50% of construction work in progress (CWIP) to be included in rate base in addition to CWIP already allowed in rate base for fuel conversion projects or pollution control facilities. This rule allows NEP the option of recovering currently through rates a portion of the costs of financing its construction program, rather than recording allowance for funds used during construction (AFDC) on that portion. The FERC rules with regard to canceled plants provide that utilities may recover in rates only 50% of prudently incurred canceled plant costs. However, the FERC allows utilities to include the recoverable amount in rate base and earn a return on the unamortized balance. NEP is recovering the cost of the conversion to coal of three units at Salem Harbor Station by means of an oil conservation adjustment (OCA), a FERC-approved rate. The OCA is designed to amortize the conversion costs by the mid-1990s. Through 1993, NEP has recovered approximately 84% of the conversion costs. The Retail Companies have OCA provisions designed to pass on to their customers amounts billed through NEP's OCA, which totaled $24.6 million for 1993. NEP Rates No NEP rate cases were filed with the FERC during 1993. Seabrook 1 Nuclear Unit NEP owns approximately 10% of Seabrook 1, a 1,150 MW nuclear generating unit, that entered commercial service on June 30, 1990. NEP's rate recovery of its investment in Seabrook 1 was resolved through two separate rate settlement agreements. The pre-1988 portion of NEP's investment is being recovered over a period of seven years and five months ending in July 1995. NEP's investment in Seabrook 1 since January 1, 1988, which amounts to approximately $50 million at December 31, 1993, is being recovered over its useful life. W-92 Rate Case In May 1992, the FERC approved a settlement of NEP's W-92 rate case under which base rates were increased by $39.7 million, effective March 1992. The entire increase was attributable to costs associated with the commercial operation of Unit 2 of the Ocean State Power (OSP) generating facility. These costs had been collected through NEP's fuel clause since the unit entered service in late 1991. The settlement also incorporated new depreciation rates proposed in NEP's filing, which reduced NEP's overall revenue requirement by $18 million. Mass. Electric Rates Rate schedules applicable to electric services rendered by Mass. Electric are on file with the Massachusetts Department of Public Utilities (MDPU). In November 1993, the MDPU approved a rate agreement filed by Mass. Electric, the Massachusetts Attorney General, and two groups of large commercial and industrial customers. Under the agreement, Mass. Electric began implementing an 11- month general rate decrease effective December 1, 1993 of $26 million (on an annual basis) from the level of rates then in effect. This rate reduction will continue in effect until October 31, 1994, after which rates will increase to the previously approved levels. The agreement also provided for rate discounts of up to $4 million available for the period ending October 31, 1994 for large commercial and industrial customers who agree to give a five-year notice to Mass. Electric before they purchase power from another supplier or generate any additional power themselves. These discounts will increase after October 31, 1994 to a level of $11 million per year if all eligible customers participate. Mass. Electric also agreed not to increase its base rates above currently approved levels before October 1, 1995. The decrease in revenues will be offset by the recognition for accounting purposes of revenues for electricity delivered but not yet billed. The agreement also resolved all issues associated with providing funds and securing rate recovery for environmental cleanup costs of Massachusetts manufactured gas waste sites formerly owned by Mass. Electric and its affiliates, as well as certain other Mass. Electric environmental cleanup costs (see Hazardous Substances, page 30). The rate agreement allows for these costs to be met by establishing a special interest bearing fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. Annual contributions of $3 million, adjusted for inflation, will be added to the fund by Mass. Electric and will be recoverable in rates. In addition, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Lastly, the agreement provided for the rate recovery of $8 million of certain storm restoration and other costs previously charged to expense. Effective October 1992, the MDPU authorized a $45.6 million annual increase in rates for Mass. Electric. This general rate increase included $2.5 million representing the first step of a four-year phase-in of Mass. Electric's tax deductible costs associated with post-retirement benefits other than pensions (PBOPs). A second $2.5 million increase took effect October 1, 1993. Narragansett Rates Rate schedules applicable to electric services rendered by Narragansett are on file with the Rhode Island Public Utilities Commission (RIPUC) and the Rhode Island Division of Public Utilities and Carriers. Effective March 1993, Narragansett implemented a new rate design which reallocated costs among its various rate classes, but which are not expected to affect total revenues over a twelve month period. Among other things, the new rates reduced the seasonality of the rates applicable to Narragansett's larger commercial and industrial customers. This change will result in lower revenues in summer months and higher revenues in other months when compared to Narragansett's prior rate design. Effective May 1992, the RIPUC authorized a $3.5 million annual increase in rates for Narragansett. In addition, effective January 1993, the RIPUC approved a $1.5 million increase in rates for Narragansett representing the first step of a three-year phase-in of Narragansett's recovery of costs associated with PBOPs. A second $1.5 million increase took effect in January 1994. Effective April 1991, the RIPUC approved Narragansett's settlement of a $13 million rate increase. Granite State Rates Effective March 1993, the New Hampshire Public Utilities Commission (NHPUC) authorized a $2.0 million rate increase for Granite State, with a retroactive adjustment to September 15, 1992 to reflect the difference between the authorized amount and the $1.4 million Granite State had been collecting on an interim basis since September 15, 1992. Effective July 1, 1993, the NHPUC approved a $0.7 million increase in rates for Granite State to recover costs associated with PBOPs. Recovery of Demand-Side Management Expenditures The three Retail Companies offer conservation and load management programs, usually referred to in the industry as Demand- Side Management (DSM) programs, which are designed to help customers use electricity efficiently, as a part of meeting the System's future resource needs and customers' needs for energy services. See RESOURCE PLANNING, page 36. The Retail Companies file their DSM programs regularly with their respective regulatory agencies and have received approval to recover in rates estimated DSM expenditures on a current basis. The rates provide for reconciling estimated expenditures to actual DSM expenditures, with interest. Mass. Electric's expenditures subject to the reconciliation mechanism were $47 million, $44 million, and $55 million in 1993, 1992, and 1991, respectively. Narragansett's expenditures subject to the reconciliation mechanism were $12 million, $12 million, and $19 million in 1993, 1992, and 1991, respectively. Since 1990, the Retail Companies have been allowed to earn incentives based on the results of their DSM programs. The Retail Companies must be able to demonstrate the electricity savings produced by their DSM programs to their respective state regulatory agencies before incentives are recorded. Mass. Electric recorded $6.7 million, $8.6 million, and $6.0 million of before-tax incentives in 1993, 1992, and 1991, respectively. Narragansett recorded $0.5 million, $1.3 million, and $1.6 million of before-tax incentives in 1993, 1992, and 1991, respectively. The Retail Companies have received regulatory approvals that will give them the opportunity to continue to earn incentives based on 1994 DSM program results. GENERATION Energy Mix The following table displays the contributions of various fuel sources and other generation to total net generation of electricity by NEP during the past three years, as well as an estimate for 1994: % of Net Generation -------------------------- Estimated Actual --------- ---------------- 1994 1993 1992 1991 ---- ---- ---- ---- Coal 37 38 41 44 Nuclear 18 18 18 18 Gas (1) 16 16 15 11 Oil 11 11 10 11 Hydroelectric 6 6 6 7 Hydro-Quebec 6 5 4 3 Renewable Non-Utility Generation (2) 6 6 6 6 --- --- --- --- 100 100 100 100 (1) Gas includes both utility and non-utility generation. (2) Waste to energy and hydro. Electric Utility Properties The electric utility properties of the System companies consist of NEP's and Narragansett's fossil-fuel base load and intermediate load steam generating units, conventional and pumped storage hydroelectric stations, internal combustion peaking units, portions of fossil fuel and nuclear generating units, the ownership interests of NEET, Mass. Hydro, and N.H. Hydro in the Hydro-Quebec Interconnection, and an integrated system of transmission lines, substations, and distribution facilities. See MAP - ELECTRIC UTILITY PROPERTIES, page 17. NEP's integrated system consists of 2,290 circuit miles of transmission lines, 116 substations with an aggregate capacity of 13,265,588 kVA, and 7 pole or conduit miles of distribution lines. The properties of Mass. Electric and Narragansett include substations and distribution and transmission lines, which are interconnected with transmission and other facilities of NEP. At December 31, 1993, Mass. Electric owned 282 substations, which had an aggregate capacity of 2,859,309 kVA, 147,090 line transformers with the capacity of 7,489,447 kVA, and 15,948 pole or conduit miles of distribution lines. Mass. Electric also owns 81 circuit miles of transmission lines. At December 31, 1993, Narragansett owned 248 substations, which had an aggregate capacity of 2,838,927 kVA, 53,100 line transformers with the capacity of 2,239,554 kVA, and 4,492 pole or conduit miles of distribution lines. Narragansett, in addition, owns 325 circuit miles of transmission lines. Substantially all of the properties and franchises of Mass. Electric, Narragansett, and NEP are subject to the liens of indentures under which mortgage bonds have been issued. For details of the mortgage liens on these properties see the long-term debt note in Notes to Financial Statements in each of these companies' respective 1993 Annual Report. The properties of NEET are subject to a mortgage under its financing arrangements. (a) These units currently burn coal, but are also capable of burning oil. (b) For a discussion of the Manchester Street Station repowering project, see Manchester Street Station Repowering on page 37. (c) Includes (i) an interest in a jointly owned oil-fired unit in Yarmouth, Maine, and (ii) diesel units at various locations. (d) See Hydroelectric Project Licensing, page 28. (e) See Nuclear Units, page 21. (f) Capability includes contracted purchases (1,312 MW) less contract sales (164 MW). Net generation includes the effects of the above contracted purchases and economy interchanges through the New England Power Exchange (including Hydro-Quebec purchases and purchases from non-utility generation). For further information see Non-Utility Generation Sources, page 20. NEP and Narragansett are members of the New England Power Pool (NEPOOL), a group of over 90 New England utilities that comprises virtually all of New England's electric generation. Mass. Electric and Granite State participate in NEPOOL through NEP. The NEPOOL Agreement provides for coordination of the planning and operation of the generation and transmission facilities of its members. The NEPOOL Agreement incorporates generating capacity reserve obligations, provisions regarding the use of major transmission lines, and provisions for payment for facilities usage. The NEPOOL Agreement further provides for New England-wide central dispatch of generation through the New England Power Exchange. Through NEPOOL, operating and capital economies are achieved and reserves are established on a region-wide rather than an individual company basis. The electric energy available to NEES subsidiaries and other members is determined by the aggregate available to NEPOOL. The 1993 NEPOOL peak demand of 19,570 MW occurred on July 8, 1993. The maximum demand to date of 19,742 MW occurred on July 19, 1991. The 1993 summer peak for the System of 4,081 MW occurred on July 8, 1993. This was below the previous all time peak load of 4,250 MW which occurred on July 19, 1991. The 1993-1994 winter peak of 4,121 MW occurred on January 19, 1994. For a discussion of resource planning, see RESOURCE PLANNING, page 36. MAP (Displays electric utility properties of NEES subsidiaries) Fuel for Generation NEP burned the following amounts of coal, residual oil, and gas during the past three years: 1993 1992 1991 ---- ---- ---- Coal (in millions of tons) 3.2 3.3 3.6 Oil (in millions of barrels) 5.0 4.9 6.4 Natural Gas (in billions of cubic feet) 0.7 3.2 1.7 Coal Procurement Program Depending on coal-fired generating unit availability and the degree to which the units are dispatched, NEP's 1994 coal requirements should range between 3.0 and 3.2 million tons. NEP obtains its domestic coal under contracts of varying lengths and on a spot basis from domestic coal producers in Kentucky, West Virginia, and Pennsylvania, and from mines in Colombia and Venezuela. Three different rail systems (CSX, Norfolk Southern, and Conrail) transport coal from domestic sources to loading ports on the east coast. NEP's coal is transported from east coast ports by ocean-going collier to Brayton Point and Salem Harbor. NEP has a term charter with the Energy Independence, a self-unloading collier, which carries all of NEP's U.S. coal and a portion of foreign coal. NEP also charters other coal-carrying vessels for the balance of foreign coal. As protection against interruptions in coal deliveries, NEP maintained coal inventories at its generating stations during 1993 in the range of 40 to 60 days. A United Mine Workers strike lasting the second half of 1993 interrupted one long-term contract which was replaced prior to its 1994 expiration. To meet environmental requirements, NEP uses coal with a relatively low sulphur and ash content. NEP's average price for coal burned, including transportation costs, calculated on a 26 million Btu per ton basis, was $44.72 per ton in 1991, $44.15 in 1992, and $43.53 per ton in 1993. Based on a 42 gallon barrel of oil producing 6.3 million Btu's, these coal prices were equivalent to approximately $10.83 per barrel of oil in 1991, $10.70 in 1992 and $10.57 per barrel of oil in 1993. Oil Procurement Program The System's 1994 oil requirements are expected to be approximately 5.0 million barrels. The System obtains its oil requirements through contracts with oil suppliers and purchases on the spot market. Current contracts provide for minimum annual purchases of 2.6 million barrels at market related prices. The System currently has a total storage capacity for approximately 2.3 million barrels of residual and diesel fuel oil. The System's average cost of oil burned, calculated on a 6.3 million Btu per barrel basis, was $11.82 in 1991, $12.68 in 1992, and $13.30 in 1993. Natural Gas NEP uses natural gas at both Brayton 4 and Manchester Street Stations when gas is priced less than residual fuel oil. At Brayton 4, natural gas currently displaces 2.2% sulphur residual fuel oil. At Manchester Street Station, gas currently displaces 1.0% sulphur residual fuel oil. In 1993, approximately 0.7 billion cubic feet of gas were consumed at an average cost of $2.58 per thousand cubic feet excluding pipeline demand charges. This gas price was equivalent to approximately $16.25 per barrel of oil. Firm year-round gas deliveries to Manchester Street Station are planned as part of its repowering project. The repowered facility would use up to 95 million cubic feet of natural gas per day. See Manchester Street Station Repowering, page 37. NEP has contracted with six pipeline companies for transportation of natural gas from supply regions to these two generating stations: (1) 60 million cubic feet per day from Western Canada via TransCanada PipeLines, Ltd. (TransCanada), Iroquois Gas Transmission System, Tennessee Gas Pipeline Company and Algonquin Gas Transmission Company, and (2) 60 million cubic feet per day from the U.S. Mid-Continent region via ANR Pipeline Company, Columbia Gas Transmission Company and Algonquin. (a) NEP has entered into a firm service agreement with TransCanada. Service commenced on November 1, 1992. (b) NEP has entered into a firm service agreement with Iroquois. Service commenced on November 1, 1993. (c) NEP has entered into a firm service agreement with Tennessee. Service commenced on November 1, 1993. (d) NEP has entered into a firm service agreement with Algonquin for delivery of Canadian gas. Service commenced on November 1, 1993. Additional service for a portion of the domestic gas is expected to commence in December 1994. NEP has also entered into a firm service agreement for deliveries of gas to its Brayton Point Station. All facilities for this service have been constructed and in service since December of 1991. (e) ANR has constructed substantially all facilities necessary to serve NEP. NEP has entered into a firm service agreement with ANR. Service is expected to commence in December 1994. (f) Columbia has received and accepted a FERC certificate to construct facilities for service to NEP. NEP has entered into a firm service agreement with Columbia. Service is expected to commence in December 1994. NEP has also signed contracts with four Canadian gas suppliers for a total of 60 million cubic feet per day. NEP has not yet signed supply arrangements with Mid-Continent producers. The pipeline agreements require minimum fixed payments. NEP's minimum net payments are currently estimated to be approximately $45 million in 1994, $65 million in 1995, and $70 million each in 1996, 1997, and 1998. The amount of the fixed payments are subject to FERC regulation and will depend on FERC actions affecting the rates on each of the pipelines. As part of its W-12 rate settlement, NEP is recovering 50% of the fixed pipeline capacity payments through its current fuel clause and deferring the recovery of the remaining 50% until the Manchester Street repowering project is completed. NEP has deferred payments of approximately $13 million as of December 31, 1993. Nuclear Fuel Supply As noted above, NEP participates with other New England utilities in the ownership of several nuclear units. See Nuclear Units, page 21. The utilities responsible for supply for these units are not experiencing any difficulty in obtaining commitments for the supply of each element of the nuclear fuel cycle. Non-Utility Generation Sources The System companies purchase a portion of the electricity generated by, or provide back-up or standard service to, 139 small power producers or cogenerators (a total of 3,185,101 MWh of purchases in 1993). As of December 31, 1993, these non-utility generation sources include 32 low-head hydroelectric plants, 51 wind or solar generators, seven waste to energy facilities, and 49 cogenerators. The total capacity of these sources is as follows: In Service Future Projects (12/31/93) Under Contract Source (MW) (MW) ------ ---------- --------------- Hydro 43 - Wind - 20 Waste to Energy 169 33 Cogeneration 303 40 Independent Power Producers - 83* ---- --- Total 515 176 * Milford Power was accepted for dispatch by NEPOOL on January 20, 1994. The in-service amount includes 377 MW of capacity and 138 MW treated as load reductions and excludes the Ocean State Power contracts discussed below. Ocean State Power Ocean State Power (OSP) and Ocean State Power II (OSP II) are general partnerships that own and operate a two unit gas-fired combined cycle electric power plant in Burrillville, R.I. Resources is a general partner with a 20% interest in both OSP and OSP II and had an equity investment of approximately $40 million at December 31, 1993. The first unit began commercial operation on December 31, 1990 and the second unit went into service on October 1, 1991. The two units have a combined winter net electrical capability of approximately 562 MW. Each unit's capacity and energy output is sold under 20-year unit power agreements to a group of New England utilities, including NEP, which has contracts for 48.5% of the output of each unit. NEP is required to make certain minimum fixed payments to cover capital and fixed operating costs of these units in amounts estimated to be $70 million per year. Interconnection with Quebec NEET, Mass. Hydro, and New Hampshire Hydro own and operate, on behalf of NEPOOL participants in the project, a 450 kV direct current (DC) transmission line and related terminals to interconnect the New England and Quebec transmission systems (the Interconnection). The transfer capability of the Interconnection is 2,000 MW. NEPOOL members purchase from and sell energy to Hydro-Quebec pursuant to several agreements. The principal agreement calls for NEPOOL members to purchase 7 billion KWH of energy each year for ten years (the Firm Energy Contract). Purchases under the Firm Energy Contract totaled over 6.4 billion KWH in 1993. NEP is a participant in both the Phase I and Phase II projects of the Interconnection. NEP's participation percentage in both projects is approximately 18%. NEP and the other participants have entered into support agreements that end in 2020, to pay monthly their proportionate share of the total cost of constructing, owning, and operating the transmission facilities. NEP accounts for these support agreements as capital leases and accordingly recorded approximately $78 million in utility plant at December 31, 1993. Under the support agreements, NEP has agreed, in conjunction with any Phase II project debt financing, to guarantee its share of project debt. At December 31, 1993, NEP had guaranteed approximately $34 million. In the event any Interconnection facilities are abandoned for any reason, each participant is contractually committed to pay its pro-rata share of the net investment in the abandoned facilities. Nuclear Units General NEP is a stockholder of Yankee Atomic Electric Company (Yankee Atomic), Vermont Yankee Nuclear Power Corporation (Vermont Yankee), Maine Yankee Atomic Power Company (Maine Yankee), and Connecticut Yankee Atomic Power Company (Connecticut Yankee). Each of these companies (collectively referred to as the Yankee Companies) owns a single nuclear generating unit. In addition, NEP is a joint owner of the Millstone 3 nuclear generating unit in Connecticut and the Seabrook 1 nuclear generating unit in New Hampshire. Millstone 3 and Seabrook 1 are operated by subsidiaries of Northeast Utilities (NU). NEP pays its proportionate share of costs and receives its proportionate share of each unit's output. NEP's interest and investment in each of the Yankee Companies, Millstone 3, and Seabrook 1 and the net capability of each plant are as follows: Equity Net Investment Capability (12/31/93) Interest (MW) (in millions) -------- ---------- ------------- Yankee Atomic 30.0% * $ 7 Vermont Yankee 20.0% 93 10 Maine Yankee 20.0% 158 14 Connecticut Yankee 15.0% 87 15 ---- ---- Subtotal 338 $ 46 Net Investment in Plant** (12/31/93) (in millions) ------------- Millstone 3 12.2% 140 $405 Seabrook 1 9.9% 115 149 ---- Subtotal 255 ---- Total 593 ==== *Operations ceased **Excludes nuclear fuel NEP has a 30% ownership interest in Yankee Atomic which owns a 185 megawatt nuclear generating station in Rowe, Massachusetts. The station began commercial service in 1960. In February 1992, the Yankee Atomic board of directors decided to permanently cease power operation of, and in time, decommission the facility. In March 1993, the FERC approved a settlement agreement that allows Yankee Atomic to recover all but $3 million of its approximately $50 million remaining investment in the plant over the period extending to July 2000, when the plant's Nuclear Regulatory Commission (NRC) operating license would have expired. Yankee Atomic recorded the $3 million before-tax write-down in 1992. The settlement agreement also allows Yankee Atomic to earn a return on the unrecovered balance during the recovery period and to recover other costs, including an increased level of decommissioning costs, over this same period. Decommissioning cost recovery increased from $6 million per year to $27 million per year for the period 1993 to 1995. This level of recovery is subject to review in 1996. NEP has recorded an estimate of its entire future payment obligations to Yankee Atomic as a liability on its balance sheet and an offsetting regulatory asset reflecting its expected future rate recovery of such costs. This liability and related regulatory asset amounted to approximately $104 million each at December 31, 1993. NEP purchases the output of the other Yankee nuclear electric generating plants in the same percentages as its stock ownership of the Yankee Companies, less small entitlements taken by municipal utilities for Maine Yankee and Vermont Yankee. NEP has power contracts with each Yankee Company that require NEP to pay an amount equal to its share of total fixed and operating costs (including decommissioning costs) of the plant plus a return on equity. The stockholders of three Yankee Companies (Vermont Yankee, Maine Yankee and Connecticut Yankee) have agreed, subject to regulatory approval, to provide capital requirements in the same proportion as their ownership percentages of the particular Yankee Company. Pursuant to the terms of a lending agreement, Yankee Atomic will not pay dividends to its shareholders, including NEP, until such lender is paid in full. There is widespread concern about the safety of nuclear generating plants. The NRC regularly reviews the adequacy of its comprehensive requirements for nuclear plants. Many local, state, and national public officials have expressed their opposition to nuclear power in general and to the continued operation of nuclear power plants. It is possible that this controversy will result in cost increases and modifications to, or premature shutdown of, the operating nuclear units in which NEP has an interest. On three occasions (most recently in 1987), referenda appeared on the ballot in Maine that, if passed, would have required the prompt shutdown of Maine Yankee. All the referenda were defeated. There is no assurance that similar measures will not appear on future ballots. Pending before FERC is an initial decision of an administrative law judge disallowing full rate recovery for the unamortized portion of a nuclear plant to be retired before the end of its operating license. The decision, if affirmed, would result in rate recovery of less than the full investment in a nuclear plant retired from service prior to the end of its operating license. The amount of the disallowance would depend upon the plant's historic capacity factor and the number of years remaining on its operating license. Decommissioning Each of the Yankee Companies includes charges for all or a portion of decommissioning costs in its cost of energy. These charges vary depending upon rate treatment, the method of decommissioning assumed, economic assumptions, site and unit specific variables, and other factors. Any increase in these charges is subject to FERC approval. Each of the operating nuclear units has established decommissioning trust funds or escrow funds into which payments are being made to meet the projected cost of decommissioning its plant. If any of the units were shut down prior to the end of its operating license, the funds collected for decommissioning to that point would be insufficient. Estimates of NEP's pro-rata share (based on ownership) of decommissioning costs, NEP's share of the actual book values of decommissioning fund balances set aside for each unit at December 31, 1993 (in millions of dollars), and the expiration date of the operating license of each plant are as follows: NEP's share of ----------------------------- Estimated Decommissioning Fund License Costs Balances (1) Expiration Unit (in 1993 $) (12/31/93) Date ---- --------------- ------------ ---------- Yankee Atomic (2) $78 $26 -- Connecticut Yankee $49 $18 2007 Maine Yankee $63 $19 2008 Vermont Yankee $57 $20 2012 Millstone 3 $50 $10 2025 Seabrook 1 $36 $ 3 2026 (1) Certain additional amounts are anticipated to be available through tax deductions. (2) The estimated cost of decommissioning for Yankee Atomic does not reflect the benefit of the component removal project (CRP) for which decommissioning funds were spent in 1993. Additional expenditures for CRP will be made in 1994. NEP is currently collecting through rates amounts for decommissioning based upon cost estimates and funding methodologies authorized by FERC. Such estimates are determined periodically for each plant and may not reflect the current projected cost of decommissioning. There is no assurance that decommissioning costs actually incurred by the Yankee Companies, Millstone 3 or Seabrook 1 will not substantially exceed these amounts. For example, current decommissioning cost estimates assume the availability of permanent repositories for both low-level and high-level nuclear waste which do not currently exist. NRC rules require that reasonable assurance be provided that adequate funds will be available for the decommissioning of commercial nuclear power plants. The rule establishes minimum funding levels that licensees must satisfy. Each of the units in which NEP has an interest has filed a report with the NRC providing assurance that funds will be available to decommission the facility. A Maine statute provides that if both Maine Yankee and its decommissioning trust fund have insufficient assets to pay for the plant decommissioning, the owners of Maine Yankee are jointly and severally liable for the shortfall. The definition of owner under the statute covers NEP and may cover companies affiliated with it. NEP and the Retail Companies cannot determine, at this time, the constitutionality, applicability, or effect of this statute. If NEP or the Retail Companies were required to make payments under this statute, they would assess their legal remedies at that time. In any event, NEP and the Retail Companies would attempt to recover through rates any payments required. If any claim in excess of NEP's ownership share were enforced against a NEES company, that company would seek reimbursement from any other Maine Yankee stockholder which failed to pay its share of such costs. The Energy Policy Act of 1992 assesses the domestic nuclear power industry for a portion of costs associated with the decontamination and decommissioning of the Department of Energy's (DOE) uranium enrichment facilities. An annual assessment of $150 million (escalated for inflation) on the domestic nuclear power industry will be allocated to each plant based upon the amount of DOE uranium enrichment services utilized in the past. The total DOE assessment, which began in October 1992, will remain in place for up to 15 years and will amount to $2.25 billion (escalated). The Yankees, Millstone 3 and Seabrook have been assessed and initial billings indicate NEP's obligation for such costs over the next 14 years will be approximately $29 million. In accordance with the provisions of the Energy Policy Act, these costs are being recovered through NEP's fuel clause. High-Level Waste Disposal The Nuclear Waste Policy Act of 1982 provides a framework and timetable for selection of sites for repositories of high-level radioactive waste (spent nuclear fuel) from United States nuclear plants. The DOE has entered into contracts with the Yankee Companies, the Millstone 3 joint owners, and the Seabrook 1 joint owners for acceptance of title to, and transportation and storage of, this waste. Under these contracts, each operating unit will pay fees to the DOE to cover the development and creation of waste repositories. Fees for fuel burned since April 1983 have been collected by the DOE on an ongoing basis at the rate of one tenth of a cent per KWH of net generation. Fees for generation up through April 1983 were determined by the DOE as follows: $13.2 million for Yankee Atomic, $48.7 million for Connecticut Yankee, $50.4 million for Maine Yankee, and $39.3 million for Vermont Yankee. Neither Millstone 3 nor Seabrook 1 has been assessed any fees for fuel burned through April 1983, because they did not enter commercial operation until 1986 and 1990, respectively. The Yankee Companies had several options to pay these fees. Yankee Atomic paid its fee to the DOE for the period through April 1983. The other three Yankee Companies elected to defer payment until a future date, thereby incurring interest expense. However, payment to the DOE must occur prior to the first delivery of spent fuel. Connecticut, Maine, and Vermont Yankee have segregated a portion of their respective DOE obligations in external accounts. The remainder of the funds have been used to support general capital requirements. All expect to separately fund in full in external accounts their DOE obligation (including accrued interest) prior to payment to the DOE. To the extent that any of the three Yankee Companies is unable to fully meet its DOE obligation at the prescribed time, NEP might be required to provide additional funds. Prior to such time that the DOE takes delivery of a plant's spent nuclear fuel, it is stored on site in spent fuel pools. Connecticut Yankee and Maine Yankee have adequate existing storage through the late 1990's. Millstone 3 will be able to maintain a full core discharge capability through the end of its current license. Seabrook 1's current licensed storage capacity is adequate until at least 2010. Vermont Yankee is able to maintain a full core discharge capability until 2001. Yankee Atomic has adequate on-site storage capacity for all its spent fuel. Federal legislation enacted in December 1987 directed the DOE to proceed with the studies necessary to develop and operate a permanent high-level waste disposal site at Yucca Mountain, Nevada. There is local opposition to development of this site. Although originally scheduled to open in 1998, the DOE announced in November 1989 that the permanent disposal site is not expected to open before 2010, a date the DOE has defined as optimistic. The legislation also provides for the development of a Monitored Retrievable Storage (MRS) facility and abandons plans to identify and select a second, permanent disposal site. An MRS facility would provide temporary storage for high-level waste prior to eventual permanent disposal. It is not known when an MRS facility would begin accepting deliveries. Additional delays due to political and technical problems are likely. It is extremely unlikely deliveries would be accepted prior to 1999. Federal authorities have deferred indefinitely the commercial reprocessing of spent nuclear fuel. Low-Level Waste Disposal In 1986, the Low-Level Radioactive Waste Policy Amendments Act was enacted by Congress. This statute sets a time limit of December 31, 1992, beyond which disposal of low-level waste at any of the three existing sites is impermissible. Under the statute, individual states are responsible for finding local sites for disposal or forming regional disposal compacts by defined milestone dates. As of December 1991, all of the states in which NEP holds an interest in a nuclear facility had met the 1990 milestone which required the filing of a facility operating license application or Governor's certification that the state will provide for storage, disposal, and management of waste generated after 1992. Although New Hampshire met the 1990 milestone, the arrangements made by the state did not encompass low-level waste generated by Seabrook 1 and it is currently prohibited from shipping its low-level waste out of the state. Connecticut Yankee, Millstone 3, Vermont Yankee, Maine Yankee and Yankee Atomic are currently allowed to ship low-level radioactive waste to the existing disposal site in South Carolina. The 1992 milestone required each state to file a facility operating license application. None of the states in which NEP holds an interest in a nuclear facility has met this milestone. Failure to meet this milestone means that those states may be subject to surcharges on waste shipped out of state. Disposal costs could increase significantly. Since January 1, 1993, the South Carolina low-level waste disposal site has been the only site open to accept low-level waste from NEP's units. The South Carolina site will remain open until June 30, 1994 to generators whose states are making progress toward developing their own disposal facilities. Effective June 30, 1994, the South Carolina low-level waste disposal site will be closed permanently to non- regional wastes. However, all of the nuclear facilities in which NEP has an interest have temporary storage facilities on site to meet short-term low-level radioactive waste storage requirements. Price-Anderson Act The Price-Anderson Act limits the amount of liability claims that would have to be paid in the event of a single incident at a nuclear plant to $9.2 billion (based upon 114 licensed reactors). The maximum amount of commercially available insurance coverage to pay such claims is only $200 million. The remaining $9.0 billion would be provided by an assessment of up to $79.3 million per incident levied on each of the nuclear units in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. The maximum assessment, which was most recently calculated in 1993, is to be adjusted at least every five years to reflect inflationary changes. NEP's current interest in the Yankees, Millstone 3, and Seabrook 1 would subject NEP to an $81.8 million maximum assessment per incident. NEP's payment of any such assessment would be limited to a maximum of $10.3 million per incident per year. As a result of the permanent cessation of power operation of the Yankee Atomic plant, Yankee Atomic has petitioned the NRC for an exemption from obligations under the Price-Anderson Act. Other Items Federal legislation requires emergency response plans, approved by federal authorities, for nuclear generating units. The Yankee Companies, Seabrook 1, and Millstone 3 are not currently experiencing difficulty in maintaining approval of their emergency response plans. REGULATORY AND ENVIRONMENTAL MATTERS Regulation Numerous activities of NEES and its subsidiaries are subject to regulation by various federal agencies. Under the 1935 Act, many transactions of NEES and its subsidiaries are subject to the jurisdiction of the Securities and Exchange Commission (SEC). Under the Federal Power Act, certain electric subsidiaries of NEES are subject to the jurisdiction of the FERC with respect to rates, accounting, and hydroelectric facilities. In addition, the NRC has broad jurisdiction over nuclear units and federal environmental agencies have broad jurisdiction over environmental matters. The electric utility subsidiaries of NEES are also subject to the jurisdiction of regulatory bodies of the states and municipalities in which they operate. For more information, see: RATES, page 8, Nuclear Units, page 21, RESOURCE PLANNING, page 36, Fuel for Generation, page 18, Environmental Requirements, page 29, and OIL AND GAS OPERATIONS, page 43. Hydroelectric Project Licensing NEP is the largest operator of conventional hydroelectric facilities in New England. NEP's hydroelectric projects are licensed by the FERC. These licenses expire periodically and the projects must be relicensed at that time. NEP's present licenses expire over a period from 2001 to 2020 excluding the Deerfield River Project discussed below. Upon expiration of a FERC license for a hydro project, the project may be taken over by the United States or licensed to the existing, or a new licensee. If the project were taken over, the existing licensee would receive an amount equal to the lesser of (i) fair value of the project or (ii) original cost less depreciation and amounts held in amortization reserves, plus in either case severance damages. The net book value of NEP's hydroelectric projects was $245 million as of December 31, 1993. In the event that a new license is not issued when the existing license expires, FERC must issue annual licenses to the existing licensee which will allow the project to continue operation until a new license is issued. A new license for a project may incorporate operational restrictions and requirements for additional non-power facilities (e.g., recreational facilities) that could affect operation of the project, and may also require additional capital investment. For example, NEP has previously received new licenses for projects on the Connecticut River that involved construction of an extensive system of fish ladders. The license for the 84 MW Deerfield River Project expired at the end of 1993. NEP filed an application for a new license in 1991, which is still under review. Several advocacy groups have intervened proposing operational modifications which would reduce the energy output of the project substantially. FERC has issued NEP an annual license to continue operation of the project under the terms and conditions of the expired license until a new license issues or other disposition of the project takes place. The next NEP project to require a new license will be the 368 MW Fifteen Mile Falls Project on the Connecticut River in New Hampshire and Vermont. This license expires in 2001. The formal process of preparing an application for a new license will begin in 1996. FERC has recently issued a Notice of Inquiry regarding the decommissioning of licensed hydroelectric projects. Responses to this notice are still under review at FERC. Some parties have advocated positions in this docket that would draw into question recovery of investment and severance damages in the event of project decommissioning. Depending upon the scope of any project decommissioning regulations, the associated costs could be substantial. Environmental Requirements Existing Operations The NEES subsidiaries are subject to federal, state, and local environmental regulation of, among other things: wetlands and flood plains; air and water quality; storage, transportation, and disposal of hazardous wastes and substances; underground storage tanks; and land-use. It is likely that the stringency of environmental regulation affecting the System and its operations will increase in the future. Siting and Construction Activities for New Facilities All New England states require, in certain circumstances, regulatory approval for site selection or construction of electric generating and major transmission facilities. Connecticut, Maine, Massachusetts, New Hampshire, and Rhode Island also have programs of coastal zone management that might restrict construction of power plants and other electrical facilities in, or potentially affecting, coastal areas. All agencies of the federal government must prepare a detailed statement of the environmental impact of all major federal actions significantly affecting the quality of the environment. The New England states have environmental laws which require project proponents to prepare reports of the environmental impact of certain proposed actions for review by various agencies. Except for the planned Manchester Street Repowering Project, the System is not currently constructing generating plants or major transmission facilities. Environmental Expenditures Total System capital expenditures for environmental protection facilities have been substantial. System capital expenditures for such facilities amounted to approximately $29 million in 1991, $31 million in 1992, and $23 million in 1993, including expenditures by NEP of $25 million, $28 million, and $14 million, respectively, for those years. The System estimates that total capital expenditures for environmental protection facilities will be approximately $65 million in 1994 ($50 million by NEP) and $25 million in 1995 ($15 million by NEP). Hazardous Substances The United States Environmental Protection Agency (EPA) has established a comprehensive program for the management of hazardous waste. The program allows individual states to establish their own programs in coordination with the EPA; Massachusetts, New Hampshire, Vermont, and Rhode Island have established such programs. Both the EPA and Massachusetts regulations cover certain operations at Brayton Point and Salem Harbor. Other System activities, including hydroelectric and transmission and distribution operations, also involve some wastes that are subject to EPA and state hazardous waste regulation. In addition, numerous System facilities are subject to federal and state underground storage tank regulations. The EPA regulates the manufacture, distribution, use, and disposal of polychlorinated biphenyls (PCB), which are found in dielectric fluid used in some electrical equipment. The System has completed the removal from service of all PCB transformers and capacitors. Some electrical equipment contaminated with PCBs remains in service. At sites where PCB equipment has been operated, removal, disposal, and replacement of contaminated soils may be required. The Federal Comprehensive Environmental Response, Compensation and Liability Act, more commonly known as the "Superfund" law, imposes strict, joint and several liability, regardless of fault, for remediation of property contaminated with hazardous substances. Parties liable include past and present site owners and operators, transporters that brought wastes to the site, and entities that generated or arranged for disposal or treatment of wastes ultimately disposed of at the site. A number of states, including Massachusetts, have enacted similar laws. The electric utility industry typically utilizes and/or generates in its operations a range of potentially hazardous products and by-products. These products or by-products may not have previously been considered hazardous, and may not currently be considered hazardous, but may be identified as such by federal, state, or local authorities in the future. NEES subsidiaries currently have in place an environmental audit program intended to enhance compliance with existing federal, state, and local requirements regarding the handling of potentially hazardous products and by-products. Federal and state environmental agencies, as well as private parties, have contacted or initiated legal proceedings against NEES and certain subsidiaries regarding liability for cleanup of sites alleged to contain hazardous waste or substances. NEES and/or its subsidiaries have been named as a potentially responsible party (PRP) by either the EPA or the Massachusetts Department of Environmental Protection (DEP) for 18 sites (6 for NEP, 13 for Mass. Electric, and 2 for Narragansett) at which hazardous waste is alleged to have been disposed. NEES and its subsidiaries are also aware of other sites which they may be held responsible for remediating and it is likely that, in the future, NEES and its subsidiaries will become involved in additional proceedings demanding contribution for the cost of remediating additional hazardous waste sites. The most prevalent types of hazardous waste sites that NEES and its subsidiaries have been connected with are former manufactured gas locations. Until the early 1970s, NEES was a combined electric and gas holding company system. Gas was manufactured from coal and oil until the early 1970s to supply areas in which natural gas was not yet available or for peaking purposes. Among the waste byproducts of that process were coal and oil tars. The NEES companies are currently aware of approximately 40 locations at which gas may have been manufactured and/or stored. Of the manufactured gas locations, 17 have been listed for investigation by the DEP. Two manufactured gas plant locations that have been the subject of extensive litigation are discussed in more detail below: the Pine Street Canal Superfund site in Burlington, Vermont and a site located in Lynn, Massachusetts. Approximately 18 parties, including NEES, have been notified by the EPA that they are PRPs for cleanup of the Pine Street Canal site, at which coal tar and other materials were deposited. Between 1931 and 1951, NEES and its predecessor owned all of the common stock of Green Mountain Power Corporation. Prior to, during, and after that time, gas was manufactured at the Pine Street Canal site. The EPA had brought a lawsuit against NEES and other parties to recover all of the EPA's past and future response costs at this site. In 1990, the litigation ended with the filing of a final consent decree with the court. Under the terms of the settlement, to which 14 entities were party, the EPA recovered its past response costs. NEES recorded its share of these costs in 1989. NEES remains a PRP for ongoing and future response costs. In November 1992, the EPA proposed a cleanup plan estimated by the EPA to cost $50 million. In June 1993, the EPA withdrew this cleanup plan in response to public concern about the plan and the cost. It is not known at this time what the ultimate cleanup plan will be, how much it will cost, or what portion NEES will have to pay. On May 26, 1993, the United States Court of Appeals for the First Circuit affirmed on appeal an earlier adverse decision against NEES and two of its subsidiaries, Mass. Electric and New England Power Service Company, with respect to the Lynn, Massachusetts site which was once owned by an electric and gas utility formerly owned by NEES. The electric operations of this subsidiary were merged into Mass. Electric. The decision held NEES and these subsidiaries liable for cleanup of the properties involved in the case. Although the circumstances differ from location to location, the Court of Appeals opinion has adverse implications for the potential liability of NEES and its subsidiaries with respect to other gas manufacturing locations operated by gas utilities once owned by NEES. In November 1993, the MDPU approved a rate agreement filed by Mass. Electric (see RATES, page 8) that resolved all rate recovery issues related to Massachusetts manufactured gas sites formerly owned by NEES or its subsidiaries as well as certain other Massachusetts hazardous waste sites. The agreement allows for these costs to be met by establishing a special fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. NEES had previously established approximately $40 million of reserves related to Massachusetts manufactured gas locations earlier in 1993 and in prior years. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. The agreement also provides that contributions of $3 million, adjusted for inflation, be added to the fund each year by Mass. Electric and be recoverable in rates. Under the agreement, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Predicting the potential costs to investigate and remediate hazardous waste sites continues to be difficult. Factors such as the evolving nature of remediation technology and regulatory requirements and the particular characteristics of each site, including, for example the size of the site, the nature and amount of waste disposed at the site, and the surrounding geography and land use, make precise estimates difficult. There are also significant uncertainties as to the portion, if any, of the investigation and remediation costs of any particular hazardous waste site that may ultimately be borne by NEES or its subsidiaries. At year end 1993, NEES had total reserves for environmental response costs of $56 million and a related regulatory asset of $19 million. NEES and each of its subsidiaries believe that hazardous waste liabilities for all sites of which each is aware, and which are not covered by a rate agreement, will not be material (10% of common equity) to their respective financial positions. Where appropriate, the NEES companies intend to seek recovery from their insurers and from other PRPs, but it is uncertain whether, and to what extent, such efforts would be successful. NEP, in burning coal and oil to produce electricity, produces approximately 308,000 tons per year of coal ash and other coal combustion by-products and 18,500 tons per year of oil ash. In August 1993, the EPA determined that coal combustion byproducts would not be regulated as a hazardous waste. The EPA is expected to issue regulations regarding oil ash treatment in 1997. The EPA and the New England states in which System companies operate regulate the removal and disposal of material containing asbestos. Asbestos insulation is found extensively on power plant equipment and, to a lesser extent, in buildings and underground electric cable. System companies routinely remove and dispose of asbestos insulation during equipment maintenance. Electric and Magnetic Fields (EMF) In recent years, concerns have been raised about whether EMF, which occur near transmission and distribution lines as well as near household wiring and appliances, cause or contribute to adverse health effects. Numerous studies on the effects of these fields, some of them sponsored by electric utilities (including NEES companies), have been conducted and are continuing. Some of the studies have suggested associations between certain EMF and various types of cancer, while other studies have not substantiated such associations. In February 1993, the EPA called for significant additional research on EMF. It is impossible to predict the ultimate impact on NEES subsidiaries and the electric utility industry if further investigations were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems. Several state courts have recognized a cause of action for damage to property values in transmission line condemnation cases based on the fear that power lines cause cancer. It is difficult to predict what impact there would be on the NEES companies if this cause of action is recognized in the states in which NEES companies operate and in contexts other than condemnation cases. Bills have been introduced in the Rhode Island Legislature to require transmission lines to be placed underground. In July 1993, two bills passed by the legislature restricting the construction of overhead transmission lines were vetoed by the governor. EMF- related legislation has also been introduced in Massachusetts. Air Under federal regulations, each New England state has issued a state implementation plan that limits air pollutants emitted from facilities such as generating stations. These implementation plans are intended to ensure continued maintenance of national and state ambient air quality standards, where such standards are currently met. The plans are also intended to bring areas not currently meeting standards into compliance. In 1985, the Massachusetts legislature enacted an acid rain law that requires that sulphur dioxide (SO2) emissions from fossil fuel generating stations be reduced. Regulations implementing the statute were adopted in 1989. Emission reductions required by the regulations must be fully implemented by January 1, 1995, and will require NEP to use more costly lower sulphur oil and coal and make capital expenditures. Use of natural gas at Brayton 4 is one of NEP's methods for helping to meet the requirements of the acid rain law. See Fuel for Generation - Natural Gas, page 19. NEP may also use emission credits for conservation from non-combustion energy sources and cogeneration technology toward meeting the law's requirements. NEP produces approximately 50% of its electricity at eight older thermal generating units located in Massachusetts. The 1990 amendments to the federal Clean Air Act require a significant reduction in the nation's SO2 and nitrogen oxide (NOx) emissions by the year 2000. Under the amendments, NEP is not subject to Phase 1 of the acid rain provisions of the federal law that will become effective in 1995. However, NEP is subject to the Massachusetts SO2 acid rain law that will become effective in 1995. Phase 2 of the federal acid rain requirements, effective in 2000, will apply to NEP and its units. Under the federal Clean Air Act, state environmental agencies in ozone non-attainment areas were required to develop regulations (also known as Reasonably Available Control Technology requirements, or RACT) that will become effective in 1995 to address the first phase of ozone air quality attainment. These regulations were adopted in Massachusetts in September 1993. The RACT regulations require control technologies (such as low NOx burners) to reduce NOx emissions, an ozone precursor. Additional control measures may be necessary to ensure attainment of the ozone standard. These measures would have to be developed by the states in 1994 and fully implemented no later than 1999. The extent of these additional control measures is unknown at this time, but could range from minor additions to the RACT requirements to extensive emission reduction requirements, such as costly add-on controls or fuel switching. To date, NEP has expended approximately $7 million of one-time operation and maintenance costs and $50 million of capital costs in connection with Massachusetts and federal Clean Air Act compliance requirements. NEP expects to incur additional one-time operation and maintenance costs of approximately $18 million and capital costs of approximately $70 million in 1994 and 1995 to comply with the federal and state clean air requirements that will become effective in 1995. In addition, as a result of federal and state clean air requirements, NEP will begin incurring increased fuel costs which are estimated to reach an annual level of $13 million by 1995. The generation of electricity from fossil fuels may emit trace amounts of hazardous air pollutants as defined in the Clean Air Act Amendments of 1990. The Act mandates a study of the potential dangers of hazardous air pollutant emissions from electric utility plants. Such research is currently under way and is expected to be complete in 1995. The study conclusions could result in new emission standards and the need for additional costly controls on NEP plants. At this time, NEES and its subsidiaries cannot estimate the impact that findings of this research might have on operations. The federal Clean Air Act Amendments of 1990 and the Rio Convention on global climate change have increased the public focus on industrial emissions to the air. Electric utilities' use of fossil fuels is a significant source of emissions which evoke concerns about such issues as acid rain, ozone levels, global warming, small particulates, and hazardous air pollutants. Should the 1999 ozone attainment requirements be extensive or additional Clean Air Act Amendments or other environmental requirements be imposed, continued operation of certain existing generating units of NEP beyond 1999 could be uneconomical. NEP believes that premature retirement of substantially all of its older thermal generating units would cause substantial rate increases. Water The federal Clean Water Act prohibits the discharge of any pollutant (including heat), except in compliance with a discharge permit issued by the states or the EPA for a term of no more than five years. NEP and Narragansett have received required permits for all their steam-generating plants. NEET has received its required surface water discharge permits for all of its current operations. Occasional violations of the terms of these permits have occurred. NEES facilities store substantial amounts of oil and are required to have spill prevention control and counter-measure (SPCC) plans. Currently, major System facilities such as Brayton Point and Salem Harbor have up-to-date SPCC plans. A comprehensive study of smaller facilities has been completed to determine the appropriate plans for these facilities and a five-year implementation plan has been developed. Nuclear The NRC, along with other federal and state agencies, has extensive regulations pertaining to environmental aspects of nuclear reactors. Safety aspects of nuclear reactors, including design controls and inspection programs to mitigate any possibility of nuclear accidents and to reduce any damages therefrom, are also subject to NRC regulation. See Nuclear Units, page 21. RESOURCE PLANNING Load Forecasts and History The Retail Companies currently forecast an increase in KWH sales of 1.4% in 1994. The System has been projecting that, in the absence of significant energy conservation by its customers, annual weather-normalized peak load growth over the next 15 years will average approximately 2.3%. Peak load growth would be limited to about 1.1% annually over this period if planned DSM programs described below are successfully implemented. These projections are being updated. During the late 1980s unusually high load growth caused a tight capacity situation to develop for both the System and the New England region. More recently, the sluggish regional economy plus the addition of new generating facilities in the region alleviated concerns about inadequate resources for the next several years. Future resource additions from the Manchester Street repowering project described below and contracts with non-utility generators along with the continued demand-side management programs are expected to meet NEP's resource needs until approximately 2000. Additional new capacity may be required in that time frame. A return to the high load growth of the late 1980s, the cancellation of future planned capacity, or the shutdown of existing capacity could necessitate additional generation or power purchase contracts on the supply-side, or demand-side conservation and load management programs, in order to meet customer demands. Corporate Plans NEES has a history of planning for change to meet resource requirements and other goals. NEES' current plan, called NEESPLAN 4, was completed in 1993. NEESPLAN 4 attempts to reconcile the increasing importance and cost of environmental impact mitigation and utilities' traditional obligation to serve, with growing competition at all levels in the industry. NEESPLAN 4 also addresses planning methodology and implements a resource strategy that restricts commitments to those necessary to meet highly certain loads, and develops options on future resources to meet less certain loads and meet future fuel diversity needs. The new plan also strengthens the emission reduction goals previously established by the System and calls for CO2, SOx, and NOx reductions by 2000 to 20%, 60%, and 60%, respectively, below 1990 levels. Most of this reduction will come from current plans and commitments, including demand-side management, the Manchester Street repowering, increased use of natural gas and lower sulphur fuels, the installation of emission control equipment, low NOx burners, combustion controls, and other new power sources entering the energy mix through the year 2000. Many of these actions are being taken to comply with state and federal environmental laws. See Environmental Requirements, page 29. The remaining improvement will come from actions beyond current commitments. They may include further fuel conversions or efficiency improvements in power plants and the transmission and distribution system, as well as competitively acquired renewable resources and greenhouse gas offsets. NEP is currently participating in an experimental project investigating greenhouse gas offsets which involves funding the use of improved forestry techniques in Malaysia to limit unnecessary destruction of forests. Past NEES plans have concerned similar challenging issues the System faced and continues to address. In 1979, NEES instituted NEESPLAN, the key objectives of which were to keep customer costs to a minimum and to reduce the System's reliance on foreign oil. In 1985, NEES announced an updated plan, NEESPLAN II, the objectives of which were to provide an adequate supply of electricity to customers at the lowest possible cost and to encourage customers to use electricity efficiently. NEESPLAN 3, announced in 1990, continued these objectives and directly addressed the environmental impacts of providing electricity service. Demand-Side Management As mentioned above, the System believes that DSM programs are an important part of meeting its resource goals. Since 1987, the System has put in place a series of customer programs for encouraging electric conservation and load management. Through these DSM programs, the System has achieved over 825,000 MWh of annual energy savings. During 1993, the System spent a total of $76 million on DSM programs and related expenses. The System has budgeted to spend up to $103 million in 1994. Recovery of these expenditures through rates on a current, as incurred, basis has been approved by the various regulatory commissions. See RATES, page 8. Manchester Street Station Repowering The NEES subsidiaries' major construction project is the repowering of the Manchester Street Station, a 140 MW electric generating station in Providence, R.I. During 1993, construction continued on the joint Narragansett/NEP project. The project began in 1992 and remains on schedule and within budget, with an expected in-service date of late 1995. Narragansett and NEP operate three steam electric generating units of approximately 50 MW each which went into service at Manchester Street Station in the 1940s. During 1992, NEP acquired a 90% interest in the site and the Station in anticipation of the repowering project. As part of the repowering project, three new combustion turbines and heat recovery steam generators will be added to the Station, replacing the existing boilers. The existing steam turbines will be replaced with new and more efficient turbines of slightly larger capacity. The fuel for generation, which is now primarily residual oil, will be replaced with natural gas, using distillate oil as an emergency backup. See Fuel for Generation, page 18. Repowering will more than triple the power generation capacity of Manchester Street Station, and substantially increase the plant's thermal efficiency. It is expected that the plant's capacity factor will also increase. Certain air emissions are projected to decrease relative to historical levels because of the change in fuels and the increase in efficiency. Substantial additions to Narragansett's high voltage transmission network will be necessary in order to accommodate the output of the plant. Two 7-mile 115 kV underground transmission cables (located primarily in public ways) are under construction to connect the repowered station to existing 115 kV lines at a new substation. Total cost for the generating station, scheduled for completion in late 1995, is estimated to be approximately $525 million, including AFDC. In addition, related transmission work, which is principally the responsibility of Narragansett, is estimated to cost approximately $75 million and is scheduled for completion in late 1994. At December 31, 1993, $161 million, including AFDC, has been spent on the project which includes the related transmission work. Substantial commitments have been made relative to future planned expenditures for this project. Regulation The activities and specific projects in the System's resource plans are subject to regulation by state and federal authorities. Approval by these agencies is necessary to site and license new facilities and to recover the costs for new DSM programs and non- utility resources. See Regulation, page 28. Research and Development Expenditures for the System's research and development activities totaled $9.5 million, $8.9 million, and $8.8 million in 1993, 1992, and 1991, respectively. Total expenditures are expected to be about $12 million in 1994. About 50% of these expenditures support the Electric Power Research Institute, which conducts research and development activities on behalf of its sponsors and provides NEES companies with access to a wide range of relevant research results at minimum cost. The System also directly funds research projects of a more site-specific concern to the System and its customers. These projects include: - creating options to allow the use of economically-priced fossil fuels without adversely affecting plant performance, and to insure safe, reliable and environmentally sound production of electric energy at the lowest cost; - developing and assessing new information and methods to understand and reduce the environmental impacts of System operations including investigation of offset methods for counterbalancing greenhouse gas emissions away from the source; - developing, assessing and demonstrating new generation technologies and fuels that will ensure economic, efficient and environmentally sound production of electric energy in the future; - creating options to maintain electric service quality and reliability for customers at the lowest cost; and - developing conservation, load control, and rate design measures that will help customers use electric energy more efficiently. Construction and Financing Estimated construction expenditures (including nuclear fuel) for the System's electric utility companies are shown below for 1994 through 1996. The System conducts a continuing review of its construction and financing programs. These programs and the estimates shown below are subject to revision based upon changes in assumptions as to System load growth, rates of inflation, receipt of adequate and timely rate relief, the availability and timing of regulatory approvals, new environmental and legal or regulatory requirements, total costs of major projects, and the availability and costs of external sources of capital. The anticipated capital requirements for oil and gas operations are not included in the table below. See OIL AND GAS OPERATIONS page 43. Estimated Construction Expenditures ----------------------------------- 1994 1995 1996 Total ---- ---- ---- ----- (In Millions - excluding AFDC) NEP - --- Manchester St. Station Generation $145 $ 95 $ 40 $ 280 Manchester St. Station Substation 10 0 0 10 Other Generation (1) 70 50 60 180 Other Transmission 15 15 20 50 ---- ---- ---- ------ Total NEP $240 $160 $120 $ 520 ---- ---- ---- ------ Mass. Electric - -------------- Distribution $ 90 $ 90 $ 95 $ 275 Narragansett - ------------ Manchester St. Station Generation $ 15 $ 15 $ 5 $ 35 Manchester St. Station Transmission/ 30 0 0 30 Substation Other Transmission 15 15 15 45 Distribution 20 25 25 70 ---- ---- ---- ------ Total Narragansett $ 80 $ 55 $ 45 $ 180 ---- ---- ---- ------ Granite State - ------------- Distribution $ 5 $ 5 $ 5 $ 15 ---- ---- ---- ------ Other $ 10 $ 0 $ 0 $ 10 - ----- ---- ---- ---- ------ Combined Total - -------------- Manchester St. Station Generation $160 $110 $ 45 $ 315 Manchester St. Station Transmission/ 40 0 0 40 Substation Other Generation (1) 70 50 60 180 Other Transmission 40 30 35 105 Distribution 115 120 125 360 ---- ---- ---- ------ Grand Total $425 $310 $265 $1,000 ---- ---- ---- ------ (1) Includes Nuclear Fuel Financing The proportion of construction expenditures estimated to be financed by internally generated funds during the period from 1994 to 1996 is: NEP 80% Mass. Electric 80% Narragansett 70% Granite State 80% The general practice of the operating subsidiaries of NEES has been to finance construction expenditures in excess of internally generated funds initially by issuing unsecured short-term debt. This short-term debt is subsequently reduced through sales by such subsidiaries of long-term debt securities and preferred stock, and through capital contributions from NEES to the subsidiaries. NEES, in turn, generally has financed capital contributions to the operating subsidiaries through retained earnings and the sale of additional NEES shares. Since April 1991, NEES has been meeting all of the requirements of its dividend reinvestment and common share purchase plan and employee share plans through open market purchases. Under these plans, NEES may revert to the issuance of new common shares at any time. The ability of NEP and the Retail Companies to issue short-term debt is limited by regulatory restrictions, by provisions contained in their charters, and by certain debt and other instruments. Under the charters or by-laws of NEP, Mass. Electric, and Narragansett, short-term debt is limited to 10% of capitalization. The preferred stockholders authorized these limitations to be increased to 20% of capitalization until the late 1990's, at which time the limits will revert to 10% of capitalization. The following table summarizes the short-term debt limits at December 31, 1993, and the amount of outstanding short-term debt at such date. ($ millions) Limit Outstanding ----- ----------- NEP 315 51 Mass. Electric 139 38 Narragansett 75 20 Granite State 10 - In order to issue additional long-term debt and preferred stock, NEP and the Retail Companies must comply with earnings coverage requirements contained in their respective mortgages, note agreements, and preference provisions. The most restrictive of these provisions in each instance generally requires (1) for the issuance of additional mortgage bonds by NEP, Mass. Electric, and Narragansett, for purposes other than the refunding of certain outstanding mortgage bonds, a minimum earnings coverage (before income tax) of twice the pro forma annual interest charges on mortgage bonds, and (2) for the issuance of additional preferred stock by NEP, Mass. Electric, and Narragansett, minimum gross income coverage (after income tax) of one and one-half times pro forma annual interest charges and preferred stock dividends, in each case for a period of twelve consecutive calendar months within the fifteen calendar months immediately preceding the proposed new issue. The respective long-term debt and preferred stock coverages of NEP and the Retail Companies under their respective mortgage indentures, note agreements, and preference provisions, are stated in the following table for the past three years: Coverage ----------------------- 1993 1992 1991 ---- ---- ---- NEP - --- General and Refunding Mortgage Bonds 4.66 4.15 4.02 Preferred Stock 2.76 2.80 2.71 Mass. Electric - -------------- First Mortgage Bonds 3.15 3.60 3.07 Preferred Stock 2.02 2.14 2.12 Narragansett - ------------ First Mortgage Bonds 2.47 3.79 2.98 Preferred Stock 1.78 2.52 2.06 Granite State - ------------- Notes (1) 2.41 2.53 1.98 (1) As defined under the most restrictive note agreement. OIL AND GAS OPERATIONS GENERAL Since 1974, NEEI has engaged in oil and gas exploration and development, primarily through a partnership with Samedan Oil Corporation (Samedan), a subsidiary of Noble Affiliates, Inc. NEEI's oil and gas activities are regulated by the SEC under the 1935 Act. Under the terms of the Samedan-NEEI partnership agreement, Samedan is the managing partner and oversees all partnership operations including the sale of production. Effective January 1, 1987, NEEI decided not to acquire new oil and gas prospects due to prevailing and expected oil and natural gas market conditions. This decision did not affect NEEI's interests and commitments in oil and gas properties owned as of December 31, 1986 by the Samedan-NEEI partnership. Samedan continues to explore, develop, and manage these properties on behalf of the partnership. Thus, the results of NEEI's operations are substantially affected by the performance of Samedan. Samedan may elect to terminate the partnership at the end of any calendar year upon one year's prior notice. NEEI is required to obtain SEC approval for further investment in these oil and gas properties. On December 21, 1993, the SEC issued an order authorizing NEEI to invest up to $10 million in its partnership with Samedan during 1994. The SEC has reserved jurisdiction over an additional $5 million of spending authority. NEEI is winding down its oil and gas program. The level of expenditures for exploration and development of existing properties has declined as a result of the decision not to acquire new oil and gas prospects after December 31, 1986. NEEI's activities are primarily rate-regulated and consist of all prospects entered into prior to 1984. Savings and losses from this rate-regulated program are being passed on to NEP and ultimately to retail customers, under an intercompany pricing policy (Pricing Policy) approved by the SEC. Due to precipitate declines in oil and gas prices, NEEI has incurred operating losses since 1986 and expects to generate substantial additional losses in the future. NEP's ability to pass such losses on to its customers was favorably resolved in NEP's 1988 FERC rate settlement. This settlement covered all costs incurred by or resulting from commitments made by NEEI through March 1, 1988. Other subsequent costs incurred by NEEI are subject to normal regulatory review. NEEI follows the full cost method of accounting for its oil and gas operations, under which capitalized costs (including interest paid to banks) relating to wells and leases determined to be either commercial or non-commercial are amortized using the unit of production method. Due to the Pricing Policy, NEEI's rate-regulated program has not been subject to certain SEC accounting rules, applicable to non-rate-regulated companies, which limit the costs of oil and gas property that can be capitalized. The Pricing Policy has allowed NEEI to capitalize all costs incurred in connection with fuel exploration activities of its rate regulated program, including interest paid to banks of which $9 million, $14 million, and $22 million was capitalized in 1993, 1992, and 1991, respectively. In the absence of the Pricing Policy, the SEC's full cost "ceiling test" rule requires non-rate regulated companies to write-down capitalized costs to a level which approximates the present value of their proved oil and gas reserves. Based on NEEI's 1993 average oil and gas selling prices and NEEI's proved reserves at December 31, 1993, if this test were applied, it would have resulted in a write-down of approximately $138 million after-tax. RESULTS OF OPERATIONS Revenues from natural gas sales were approximately 13% higher in 1993 than 1992 even though NEEI's natural gas production declined by about 9%. NEEI expects 1994 natural gas revenues to be slightly higher than 1993 revenues on slightly lower total production. NEEI's 1993 oil and gas exploration and development expenditures were $9 million. NEEI's estimated proved reserves decreased from 17.3 million barrels of oil and gas equivalent at December 31, 1992, to 15.1 million barrels of oil and gas equivalent at December 31, 1993. Production, primarily from offshore Gulf properties, decreased reserves by 3.8 million equivalent barrels. Additions and revisions primarily on offshore Gulf properties increased reserves by 1.6 million equivalent barrels. Prices received by NEEI for its natural gas varied considerably during 1993, from approximately $1.31/MCF to $2.90/MCF, due principally to seasonal fluctuations and regional variations in gas prices. NEEI's overall average gas price in 1993 was $1.96/MCF. The results of NEEI's oil and gas program will continue to be affected by developments in the world oil market and the domestic market for natural gas, including actions by the federal government and by foreign governments, which may affect the price of oil and gas, the terms of contracts under which gas is sold, and changes in regulation of the domestic interstate gas pipelines. The following table summarizes NEEI's crude oil and condensate production in barrels, natural gas production in MCF, and the average sales price per barrel of oil and per MCF of natural gas produced by NEEI during the years ended December 1993, 1992, and 1991, and the average production (lifting) cost per dollar of gross revenues. Years Ended December 31, ---------------------------------- 1993 1992 1991 ---- ---- ---- Crude oil and condensate production (barrels) 477,545 506,428 435,890 Natural gas production 19,696,944 21,514,986 17,904,015 (MCF) Average sales price per barrel of oil and $17.05 $19.34 $22.80 condensate Average sales price per MCF of natural gas $1.96 $1.59 $1.61 Average production cost (including severance taxes) per dollar of gross revenue $0.14 $0.17 $0.18 OIL AND GAS PROPERTIES During 1993, principal producing properties, representing 58% of NEEI's 1993 revenues, were (i) a 50% working interest in Brazos Blocks A-52, A-53, A-65, and A-37 located in federal waters offshore Texas, (ii) a 12% working interest in Main Pass Blocks 107 and 108, located in federal waters offshore Louisiana, (iii) a 25% working interest in Main Pass Blocks 93, 102, and 90, located in federal waters offshore Louisiana, (iv) a 20% working interest in Matagorda Island 587, located in federal waters offshore Texas, and (v) a 15% working interest in Eugene Island Block 28, located in federal waters offshore Louisiana. Other major producing properties during 1993 included a 20% working interest in Vermilion Block 114, located in federal waters offshore Louisiana, a 15% working interest in High Island Blocks 21, 22, and 34, located in federal waters offshore Texas, and a 15% working interest in West Delta 18/33, located in federal waters offshore Louisiana. As used in the tables below, (i) a productive well is an exploratory or a development well that is not a dry well, (ii) a dry well is an exploratory or development well found to be incapable of producing either oil or gas in commercial quantities, (iii) "gross" refers to the total acres or wells in which NEEI has a working interest, and (iv) "net," as applied to acres or wells, refers to gross acres or wells multiplied by the percentage working interest owned by NEEI. The following table shows the approximate undeveloped acreage held by NEEI as of December 31, 1993. Undeveloped acreage is acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and gas, regardless of whether such acreage contains proved reserves. Location Gross Acres Net Acres -------- ----------- --------- Offshore-Gulf of Mexico 124,209 21,676 Other 278,203 49,756 ------- ------ Total 402,412 71,432 During the years ended December 31, 1993, 1992, and 1991 NEEI participated in the completion of the following net exploratory and development wells: Net Exploratory Wells Net Development Wells --------------------- --------------------- Year Ended Productive* Dry Productive* Dry ---------- ---------- --- ---------- --- December 31, 1993 0 2 0 0 December 31, 1992 2 0 0 0 December 31, 1991 1 4 3 5 * Includes depleted wells The following table summarizes the total gross and net productive wells and the approximate total gross and net developed acres, both as of December 31, 1993: Oil Gas Developed Acres --- --- --------------- Gross Net Gross Net Gross Net ----- --- ----- --- ----- --- 139 16 557 64 312,492 57,400 At December 31, 1993, NEEI was in the process of drilling or completing 4 gross and 0 net wells. CAPITAL REQUIREMENTS AND FINANCING Estimated expenditures in 1994 for NEEI's exploration and development program are approximately $10 million which is the amount authorized by the SEC. In addition, NEEI's estimated 1994 interest costs are approximately $10 million. Internal funds are expected to provide 100% of NEEI's capital requirements for 1994. In 1989, NEEI refinanced its outstanding borrowings through a credit agreement which currently provides for borrowings of up to $275 million. Borrowings under this credit agreement are principally secured by a pledge of NEEI's rights with respect to NEP under the Pricing Policy covering the rate-regulated program. The amount available for borrowing under the revolving credit agreement decreases by varying amounts annually, beginning December 31, 1995 and expiring December 31, 1998. NEEI MAP Major Oil and Gas Properties EXECUTIVE OFFICERS NEES - ---- All executive officers are elected to continue in office subject to Article 19 of the Agreement and Declaration of Trust until the first meeting of the Board of Directors following the next annual meeting of shareholders, or the special meeting of shareholders held in lieu of such annual meeting, and until their successors are chosen and qualified. The executive officers also serve as officers and/or directors of various subsidiary companies. John W. Rowe - Age: 48 - President and Chief Executive Officer since 1989 - Elected Chairman of NEP in 1993 - President of NEP from 1991 to 1993 - Chairman of NEP from 1989 to 1991 - President and Chief Executive Officer of Central Maine Power Company from 1984 to 1989. Frederic E. Greenman - Age: 57 - Senior Vice President since 1987 - General Counsel since 1985 - Secretary since 1984 - Vice President of NEP since 1979. Alfred D. Houston - Age: 53 - Elected Executive Vice President in 1994 - Senior Vice President-Finance from 1987 to 1994 - Vice President-Finance from 1985 to 1987 - Vice President of NEP since 1987 - Vice President of Narragansett since 1976 - Treasurer of Narragansett since 1977. John W. Newsham - Age 61 - Vice President since 1991 - Executive Vice President of NEP since 1993 - Vice President of NEP and Director of Thermal Production from 1987 to 1993. Richard P. Sergel - Age: 44 - Vice President since 1992 - Treasurer from 1990 to 1991 - Chairman of Mass. Electric and Narragansett since 1993 - Treasurer of NEP and Mass. Electric from 1990 to 1991 - Vice President of the Service Company since 1988 - Director of Rates from 1982 to 1990. Jeffrey D. Tranen - Age: 47 - Vice President since 1991 - President of NEP since 1993 - Vice President of NEP from 1984 to 1993 - Vice President of Mass. Hydro, N.H. Hydro, and NEET from 1987 to 1991 - President of Mass. Hydro, N.H. Hydro, and NEET since 1991. Michael E. Jesanis - Age: 37 - Treasurer since 1992 - Director of Corporate Finance from 1990 to 1991 - Manager, Financial Planning from 1986 to 1990. NEP - --- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the Board of Directors to hold office subject to the pleasure of the directors and until the first meeting of directors after the next annual meeting of stockholders and until their successors are duly chosen and qualified. Certain officers of NEP are, or at various times in the past have been, officers and/or directors of the System companies with which NEP has entered into contracts and had other business relations. Jeffrey D. Tranen* - President since 1993 - Vice President from 1984 to 1993. John W. Rowe* - Chairman since 1993 - President from 1991 to 1993 - Chairman from 1989 to 1991. John W. Newsham* - Executive Vice President since 1993 - Vice President from 1987 to 1993. Lawrence E. Bailey - Age: 50 - Vice President since 1989 - Plant Manager of Brayton Point Station from 1987 to 1991. Jeffrey A. Donahue - Age: 35 - Vice President since 1993 - various engineering positions with the Service Company since 1983 - Director of Construction since 1992 - Chief Electrical Engineer since 1991. Frederic E. Greenman* - Vice President since 1979. Alfred D. Houston* - Vice President since 1987 - Treasurer from 1983 to 1987. John F. Malley - Age: 45 - Vice President since 1992 - Manager of Generation Planning for the Service Company from 1986 to 1991. Arnold H. Turner - Age: 53 - Vice President since 1989 - Director of Planning and Power Supply since 1985. Jeffrey W. VanSant - Age: 40 - Vice President since 1993 - Manager of Oil and Gas Exploration and Development for the Service Company from 1985 to 1993 - Manager of Oil and Gas Procurement from 1992 to 1993 - Manager of Natural Gas Supply from 1989 to 1992. Michael E. Jesanis* - Treasurer since 1992. Howard W. McDowell - Age: 50 - Controller since 1987 - Controller of Mass. Electric and Narragansett since 1987 - Treasurer of Granite State since 1984. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding this officer. Mass. Electric - -------------- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the board of directors to hold office subject to the pleasure of the directors and until the first meeting of the directors after the next annual meeting of stockholders. Certain officers of Mass. Electric are, or at various times in the past have been, officers and directors of System companies with which Mass. Electric has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. John H. Dickson - Age: 51 - President since 1990 - Treasurer from 1985 to 1990 - Treasurer of NEES from 1985 to 1990 - Treasurer of NEP from 1987 to 1990 - Vice President of NEEI from 1982 to 1990 - Treasurer of NEEI from 1983 to 1990. David L. Holt - Age: 45 - Executive Vice President since 1993 - Vice President of NEP from 1992 to 1993 - Chief Engineer and Director of Engineering for the Service Company since 1991 - Chief Electrical Engineer for the Service Company from 1986 to 1991. John C. Amoroso - Age: 55 - Vice President since 1993 - District Manager, Southeast District from 1992 to 1993 - Manager, Southeast District from 1985 to 1992. Gregory A. Hale - Age: 43 - Vice President since 1993 - Senior Counsel for the Service Company from 1988 to 1993. Cheryl A. LaFleur - Age: 39 - Vice President since 1993 - Vice President of the Service Company from 1992 to 1993 - Assistant to the NEES Chairman and President from 1990 to 1991 - Senior Counsel for the Service Company from 1989 to 1991. Charles H. Moser - Age: 53 - Vice President since 1993 - Chief Protection and Planning Engineer for the Service Company from 1984 to 1993. Lydia M. Pastuszek - Age: 40 - Vice President since 1993 - Vice President of NEP from 1990 to 1993 - President of Granite State since 1990 - Assistant to the President of Granite State from 1989 to 1990 - Director of Demand Planning for the Service Company from 1985 to 1989. Anthony C. Pini - Age: 41 - Vice President since 1993 - Assistant Controller for the Service Company from 1985 to 1993. Nancy H. Sala - Age: 42 - Vice President since 1992 - Central District Manager since 1992 - Assistant to the President of Mass. Electric from 1990 to 1992 - Manager of the Central District for Mass. Electric from 1989 to 1990 - Manager of Petroleum Supply and NEEI Shipping for the Service Company from 1986 - 1989. Dennis E. Snay - Age: 52 - Vice President and Merrimack Valley District Manager since 1990 - Assistant to President of Mass. Electric from 1984 to 1990. Michael E. Jesanis - Treasurer since 1992 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Jesanis. Howard W. McDowell - Controller since 1987 and Assistant Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Narragansett - ------------ Officers are elected by the board of directors or appointed, as appropriate, to serve until the meeting of directors following the annual meeting of stockholders, and until their successors are chosen and qualified. Officers other than the President, Treasurer, and Secretary, serve also at the pleasure of the directors. Certain officers of Narragansett are, or at various times in the past have been, officers and directors of System companies with which Narragansett has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. Robert L. McCabe - Age: 53 - President since 1986. William Watkins, Jr. - Age 61 - Executive Vice President since 1992 - Vice President of the Service Company from 1981 to 1992. Francis X. Beirne - Age: 50 - Vice President since 1993 - Manager, Southern District from 1988 to 1993 - District Manager, Customer Service from 1983 - 1988. Richard W. Frost - Age: 54 - Vice President since 1993 - Division Superintendent of Transmission and Distribution from 1986 to 1990 - District Manager - Southern District from 1990 to 1993. Alfred D. Houston - Vice President since 1976 - Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Houston. James V. Mahoney - Age: 48 - Vice President and Director of Business Services since 1993 - President of NEEI from 1992 to 1993 - Vice President of the Service Company from 1989 to 1993 - Director of Fuel Supply for the Service Company from 1985 to 1993. Howard W. McDowell - Controller since 1987 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Item 2. Item 2. PROPERTIES See Item 1. Business - ELECTRIC UTILITY PROPERTIES, page 13 and OIL AND GAS PROPERTIES, page 45. Item 3. Item 3. LEGAL PROCEEDINGS In February 1993, a jury in Salem Massachusetts Superior Court assessed damages of $7.5 million, including interest, against Mass. Electric in a case arising from the installation by Mass. Electric of an allegedly undersized transformer for the plaintiff's manufacturing facility. Mass. Electric settled this case with its general liability insurance carrier and the plaintiff in 1993. See Item 1. RATES, page 8; Nuclear Units, page 21; Hydro Electric Project Licensing, page 28; Environmental Requirements, page 29; OIL AND GAS OPERATIONS, page 43. 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 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS NEES information in response to the disclosure requirements specified by this Item 5. appears under the captions in the NEES Annual Report indicated below: Required Information Annual Report Caption -------------------- --------------------- (a) Market Information Shareholder Information (b) Holders Shareholder Information (c) Dividends Financial Highlights The information referred to above is incorporated by reference in this Item 5. NEP, Mass. Electric, and Narragansett - The information required by this item is not applicable as the common stock of all these companies is held solely by NEES. Information pertaining to payment of dividends and restrictions on payment of dividends is incorporated herein by reference to each company's 1993 Annual Report. Item 6. Item 6. SELECTED FINANCIAL DATA NEES ---- The information required by this item is incorporated herein by reference to page 21 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to page 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to page 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to page 24 of the Narragansett 1993 Annual Report. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. NEES ---- The information required by this item is incorporated herein by reference to pages 12 through 20 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 4 through 9 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 4 through 10 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 4 through 9 of the Narragansett 1993 Annual Report. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NEES ---- The information required by this item is incorporated herein by reference to pages 21 through 40 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 3, 10 through 27, and 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 3, 11 through 25, and 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 3, 10 through 22, and 24 of the Narragansett 1993 Annual Report. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NEES, NEP, Mass. Electric, and Narragansett - None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption ELECTION OF DIRECTORS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. Reference is also made to the information under the caption EXECUTIVE OFFICERS - NEES in Part I of this report. NEP --- The names of the directors of NEP, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - NEP in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok - Director since 1979 - Age: 64 - Chairman of the Board of NEES - Vice Chairman of the Company from 1993 to 1994 - Chairman or Vice Chairman of the Company from 1988 to 1994 - Vice Chairman of the Company from 1989 to 1991 - Chairman of NEES from 1984 to 1994 (Chairman, President, and Chief Executive Officer from July 26, 1988 until February 13, 1989). Directorships of NEES System companies: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. Other directorships: Avery Dennison Corporation, John Hancock Mutual Life Insurance Company, Monsanto Company, and the Federal Reserve Bank of Boston. Frederic E. Greenman* - Director since 1986. Directorships of NEES System companies and affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, Yankee Atomic Electric Company, Connecticut Yankee Atomic Power Company, Maine Yankee Atomic Power Company, and Vermont Yankee Nuclear Power Corporation. Alfred D. Houston* - Director since 1984. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. John W. Newsham* - Director since 1991. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Resources, Inc., and New England Power Service Company. John W. Rowe* - Director since 1989. Directorships of NEES System companies and affiliates: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, and Maine Yankee Atomic Power Company. Other directorships: Bank of Boston Corporation and UNUM Corporation. Jeffrey D. Tranen* - Director since 1991. Directorships of NEES System affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES and EXECUTIVE OFFICERS - NEP in Part I of this report for other information regarding this director. Mass. Electric -------------- The names of the directors of Mass. Electric, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Mass. Electric in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Urville J. Beaumont - Director since 1984 - Age: 61 - Treasurer and Director, law firm of Beaumont & Campbell, P.A. Joan T. Bok* - Director since 1979. Sally L. Collins - Director since 1976 - Age: 58 - Health Services Administrator at Kollmorgen Corporation EOD since January 1989 - Former Director of Medical Services at Oxbow Health Associates, Inc., Hadley, Mass. - Former member of Mass. Electric Customer Advisory Council. John H. Dickson - Director since 1990 - Reference is made to material supplied under the caption EXECUTIVE OFFICERS - Mass. Electric for other information regarding Mr. Dickson. Other directorship: Worcester Business Development Corporation. Charles B. Housen - Director since 1979 - Age: 61 - Chairman, President, and Director of Erving Industries, Inc., Erving, Mass. Dr. Kathryn A. McCarthy - Director since 1973 - Age: 69 - Research Professor of Physics at Tufts University, Medford, Mass. - Senior Vice President and Provost at Tufts from 1973 to 1979 - Other directorships: State Mutual Life Assurance Company of America. Patricia McGovern - Elected Director in 1994 - Age: 52 - Of Counsel to law firm of Goulston & Storrs, P.C. since 1993 - Massachusetts State Senator and Chair of the Senate Ways and Means Committee from 1984 to 1992. John F. Reilly - Director since 1988 - Age: 61 - President and CEO of Fred C. Church, Inc., Lowell, Mass. - Other as directorships: Colonial Gas Company and NE Insurance Co., Ltd. John W. Rowe* - Director since 1989. Richard P. Sergel* - Director since 1993. Richard M. Shribman - Director since 1979 - Age: 68 - Treasurer of Norick Realty Corporation, Salem, Mass. - President of Norick Realty Corporation until 1992 - Other directorships: Eastern Bank. Roslyn M. Watson - Director since 1992 - Age: 44 - President of Watson Ventures (commercial real estate development and management) Boston, Mass. - Vice President of the Gunwyn Company (commercial real estate development) Cambridge, Mass. from 1990 - 1993 and Project Manager from 1986 - 1990 - Other directorships: The Boston Company Funds. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES in Part I of this report and/or the material supplied under the caption DIRECTORS AND OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Narragansett ------------ The names of the directors of Narragansett, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Narragansett in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok* - Director since 1979. Stephen A. Cardi - Director since 1979 - Age: 52 - Treasurer and Director of Cardi Corporation (construction), Warwick, R.I. Frances H. Gammell - Director since 1992 - Age: 44 - Director, Vice President of Finance, and Secretary of Original Bradford Soap Works, Inc. Joseph J. Kirby - Director since 1988 - Age: 62 - President of Washington Trust Bancorp, Inc., Westerly, R.I. and President and Director of the Washington Trust Company. Robert L. McCabe - President and Director of Narragansett since 1986 - Other directorship: Citizens Savings Bank - Please refer to the material supplied under the caption EXECUTIVE OFFICERS - Narragansett in Part I of this report for other information regarding Mr. McCabe. John W. Rowe* - Director since 1989. Richard P. Sergel* - Chairman and Director since 1993. William E. Trueheart - Director since 1989 - Age: 50 - President of Bryant College, Smithfield, Rhode Island - Executive Vice President of Bryant College from 1986 to 1989 - Other directorships: Fleet National Bank. John A. Wilson, Jr. - Director since 1971 - Age: 62 - Former Consultant to and President of Wanskuck Co., Providence, R.I., - Former Consultant to Hinckley, Allen, Snyder & Comen (attorneys), Providence, R.I. *Please refer to the material supplied under the caption DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Section 16(a) of the Securities Exchange Act of 1934 requires the System's officers and directors, and persons who own more than 10% of a registered class of the System's equity securities, to file reports on Forms 3, 4, and 5 of share ownership and changes in share ownership with the SEC and the New York Stock Exchange and to furnish the System with copies of all Section 16(a) forms they file. Based solely on Mass. Electric's and Narragansett's review of the copies of such forms received by them, or written representations from certain reporting persons that such forms were not required for those persons, Mass. Electric and Narragansett believe that, during 1993, all filing requirements applicable to its officers, directors, and 10% beneficial owners were complied with, except that one report on Form 3 was filed late for each of Mr. Beirne, Mr. Frost, and Mr. Mahoney. Item 11. Item 11. EXECUTIVE COMPENSATION NEES ---- The information required by this item is incorporated herein by reference to the material under the captions BOARD STRUCTURE AND COMPENSATION, EXECUTIVE COMPENSATION, PAYMENTS UPON A CHANGE IN CONTROL, PLAN SUMMARIES, and RETIREMENT PLANS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, MASS. ELECTRIC, AND NARRAGANSETT ------------------------------------- EXECUTIVE COMPENSATION The following tables give information with respect to all compensation (whether paid directly by NEP, Mass. Electric, or Narragansett or billed to it as hourly charges) for services in all capacities for NEP, Mass. Electric, or Narragansett for the years 1991 through 1993 to or for the benefit of the Chief Executive Officer and the four other most highly compensated executive officers for each company. NEP SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- John W. 1993 181,269 112,095 2,318 54,256 2,386(g) Rowe 1992 184,532 69,205 2,318 56,479 2,340 Chairman 1991 160,202 67,618 2,188 58,394 2,153 Joan T. 1993 154,428 92,949 3,323 46,245 3,444(h) Bok 1992 157,705 59,310 2,899 48,274 3,326 Vice 1991 155,392 66,005 3,135 56,641 3,615 Chairman Jeffrey D. 1993 159,936 112,105 2,974 32,753 3,563(i) Tranen 1992 120,843 52,286 2,307 23,732 2,670 President 1991 129,725 45,832 2,240 20,970 2,595 Frederic E. 1993 123,648 75,058 2,131 22,811 3,110(j) Greenman 1992 133,223 50,258 2,361 26,960 3,298 Vice 1991 125,237 43,804 2,516 24,028 3,145 President Lawrence E. 1993 135,123 61,283 101 21,286 3,790(k) Bailey 1992 129,711 47,737 101 20,985 2,594 Vice 1991 122,928 32,588 102 14,474 2,459 President (a) Certain officers of NEP are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by NEP. See description under Plan Summaries. (d) Includes amounts reimbursed by NEP for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Rowe 11,807 shares, $461,949 value; Mrs. Bok 10,241 shares, $400,679 value; Mr. Greenman 3,220 shares, $125,983 value; Mr. Tranen 2,193 shares, $85,019 value; and Mr. Bailey 1,369 shares, $53,562 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes NEP contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by NEP. (g) For Mr. Rowe, the amount and type of compensation in 1993 is as follows: $1,879 for contributions to the thrift plan and $507 for life insurance. (h) For Mrs. Bok, the amount and type of compensation in 1993 is as follows: $1,937 for contributions to the thrift plan and $1,507 for life insurance. (i) For Mr. Tranen, the amount and type of compensation in 1993 is as follows: $3,198 for contributions to the thrift plan and $365 for life insurance. (j) For Mr. Greenman, the amount and type of compensation in 1993 is as follows: $2,478 for contributions to the thrift plan and $637 for life insurance. (k) For Mr. Bailey, the amount and type of compensation in 1993 is as follows: $2,702 for contributions to the thrift plan and $1,088 for life insurance. MASS. ELECTRIC SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 93,628 71,187 1,657 20,713 2,036(h) Sergel (g) Chairman John H. 1993 156,900 116,399 3,005 28,103 3,623(i) Dickson 1992 150,469 61,561 3,087 27,801 3,442 President 1991 141,720 51,451 2,389 23,606 3,255 and CEO Nancy H. 1993 102,860 43,386 103 13,370 2,378(j) Sala (g) 1992 96,785 20,508 103 8,326 1,936 Vice President Dennis E. 1993 105,768 29,175 101 11,173 3,025(k) Snay 1992 101,208 28,448 103 12,207 2,024 Vice 1991 94,862 23,320 103 10,001 1,897 President Cheryl A. 1993 71,488 43,373 68 13,206 1,575(l) LaFleur (g) Vice President (a) Certain officers of Mass. Electric are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Mass. Electric. See description under Plan Summaries. (d) Includes amounts reimbursed by Mass. Electric for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. Dickson 2,190 shares, $85,683 value; Ms. Sala 360 shares, $14,085 value; Mr. Snay 859 shares, $33,608 value; and Ms. LaFleur 824 shares, $32,239 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Mass. Electric contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Mass. Electric. (g) Mr. Sergel and Ms. LaFleur were elected as officers of Mass. Electric in 1993, and Ms. Sala was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $1,873 for contributions to the thrift plan and $163 for life insurance. (i) For Mr. Dickson, the type and amount of compensation in 1993 is as follows: $3,138 for contributions to the thrift plan and $485 for life insurance. (j) For Ms. Sala, the type and amount of compensation in 1993 is as follows: $2,057 for contributions to the thrift plan and $321 for life insurance. (k) For Mr. Snay, the type and amount of compensation in 1993 is as follows: $2,115 for contributions to the thrift plan and $910 for life insurance. (l) For Ms. LaFleur, the type and amount of compensation in 1993 is as follows: $1,430 for contributions to the thrift plan and $145 for life insurance. NARRAGANSETT SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 48,207 36,653 854 10,665 1,048(h) Sergel (g) Chairman Robert L. 1993 139,632 98,654 2,408 22,617 3,771(i) McCabe 1992 134,536 54,109 2,041 25,076 2,603 President 1991 128,863 40,428 1,306 18,024 2,388 and CEO William 1993 118,501 39,403 101 13,370 5,847(j) Watkins, 1992 65,586 17,315 66 7,350 1,312 Jr. (g) Executive Vice President Richard W. 1993 96,408 28,667 103 11,211 2,628(k) Frost (g) Vice President Francis X. 1993 87,300 10,580 113 2,462 1,859(l) Beirne (g) Vice President (a) Certain officers of Narragansett are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Narragansett. See description under Plan Summaries. (d) Includes amounts reimbursed by Narragansett for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. McCabe 2,082 shares, $81,458 value; Mr. Watkins 954 shares, $37,325 value; Mr. Frost 942 shares, $36,855 value; and Mr. Beirne 206 shares, $8,059 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Narragansett contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Narragansett. (g) Messrs. Sergel, Frost, and Beirne were elected as officers of Narragansett in 1993, and Mr. Watkins was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $964 for contributions to the thrift plan and $84 for life insurance. (i) For Mr. McCabe, the type and amount of compensation in 1993 is as follows: $2,682 for contributions to the thrift plan and $1,089 for life insurance. (j) For Mr. Watkins, the type and amount of compensation in 1993 is as follows: $2,370 for contributions to the thrift plan and $3,477 for life insurance. (k) For Mr. Frost, the type and amount of compensation in 1993 is as follows: $1,928 for contributions to the thrift plan and $700 for life insurance. (l) For Mr. Beirne, the type and amount of compensation in 1993 is as follows: $1,746 for contributions to the thrift plan and $113 for life insurance. Directors' Compensation Members of the Mass. Electric and Narragansett Boards of Directors, except Dickson, McCabe, Rowe, and Sergel receive a quarterly retainer of $1,250, a meeting fee of $600 plus expenses, and 50 NEES common shares each year. Since all members of the NEP Board are employees of NEES System companies, no fees are paid for service on the Board except as noted below for Mrs. Bok. Mrs. Bok retired as an employee of the NEES companies on January 1, 1994 (remaining as Chairman of NEES and a director for NEES subsidiaries). Mrs. Bok has agreed to waive the normal fees and annual retainers otherwise payable for services by non- employees on NEES subsidiary boards and will receive in lieu thereof a single annual stipend of $60,000. Mrs. Bok also became a consultant to NEES as of January 1, 1994. Under the terms of her contract, she will receive an annual retainer of $100,000. No payments were made in 1993 pursuant to these arrangements. Mass. Electric and Narragansett permit directors to defer all or a portion of their retainers and meeting fees. Special accounts are maintained on Mass. Electric's and Narragansett's books showing the amounts deferred and the interest accrued thereon. Other NEP, Mass. Electric, and Narragansett do not have any share option plans. The NEES Compensation Committee administers certain of the incentive compensation plans, and the Management Committee administers the others (including the incentive share plan). Retirement Plans The following table shows estimated annual benefits payable to executive officers under the qualified pension plan and the supplemental retirement plan, assuming retirement at age 65 in 1994. PENSION TABLE Five-Year Average 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years Compensa- of of of of of of tion Service Service Service Service Service Service - --------- -------- -------- -------- -------- -------- -------- $100,000 28,000 36,600 45,000 53,400 58,900 61,600 $150,000 43,000 56,300 69,300 82,200 90,300 94,800 $200,000 58,000 76,000 93,500 111,000 122,100 128,100 $250,000 73,000 95,700 117,800 139,800 153,800 161,300 $300,000 88,100 115,400 142,000 168,600 185,500 194,500 $350,000 103,100 135,100 166,300 197,400 217,200 227,700 $400,000 118,100 154,800 190,500 226,200 249,000 261,000 $450,000 133,100 174,500 214,800 255,000 280,700 294,200 For purposes of the retirement plans, Messrs. Rowe, Tranen, Greenman, and Bailey currently have 16, 24, 30, and 25 credited years of service, respectively. Mr. Sergel, Mr. Dickson, Ms. Sala, Mr. Snay, and Ms. LaFleur currently have 15, 20, 24, 30, and 7 credited years of service, respectively. Messrs. McCabe, Watkins, Frost, and Beirne currently have 25, 21, 31, and 22 credited years of service, respectively. At the time she retired from NEP, Mrs. Bok had 38 credited years of service, and she commenced receiving the described benefits under the pension plans and the life insurance program. As a non-employee, she no longer accrues service credit or additional benefits under these plans. Benefits under the pension plans are computed using formulae based on percentages of highest average compensation computed over five consecutive years. The compensation covered by the pension plan includes salary, bonus, and restricted share awards. The benefits listed in the pension table are not subject to deduction for Social Security and are shown without any joint and survivor benefits. The Pension Table above does not include annuity payments to be received in lieu of life insurance. The policies are described above under Plan Summaries. In February 1993, NEP announced a voluntary early retirement program available to all non-union employees over age 55 with 10 or more years of service as of June 30, 1993. Mrs. Bok accepted the offer. The program offered either an annuity or a lump sum equal to the greater value of either one week's base pay times the number of years of service plus two weeks base pay or an additional five years of service and five years of age. In accordance with the terms of the offer, Mrs. Bok received an additional annuity of $12,611 from a supplemental pension plan and a lump sum of $110,896 from the qualified plan. Mrs. Bok had not been eligible for a bonus under the prior incentive compensation plan. In lieu thereof she will receive a limited cost of living (consumer price index) adjustment to her benefits from the qualified pension plan and the supplemental retirement plan. Since this plan serves to adjust the pension benefit only after retirement, there will be no supplement paid under the plan until at least 1995. Senior executives receive the same post-retirement health benefits as those offered non-union employees who retire with a combination of age and years of service equal to 85. PAYMENTS UPON A CHANGE OF CONTROL The incentive compensation plans would provide a payment of 40% of base compensation in the event of a "change in control" as defined in the plans. This payout would be made in lieu of any cash bonuses under the plans for the year in which the "change in control" occurs. A similar payment is provided for the previous plan year if awards for that year had not yet been distributed. A "change in control" is defined, generally, as an occurrence of certain events that either evidence a merger or acquisition of NEES or cause a significant change in the makeup of the NEES board of directors over a short period of time. Upon the occurrence of a "change in control," restrictions on all shares issued to participants under the incentive share plan would cease and the participants would receive an award of shares for that year, determined in the usual manner, based upon the cash awards described in the preceding paragraph. NEP, MASS. ELECTRIC, AND NARRAGANSETT PLAN SUMMARIES A brief description of the various plans through which compensation and benefits are provided to the named executive officers is presented below to better enable shareholders to understand the information presented in the tables shown earlier. The amounts of compensation and benefits provided to the named executive officers under the plans described below (and charged to NEP, Mass. Electric, or Narragansett) are presented in the Summary Compensation Tables. Goals Program The goals program covers all employees who have completed one year of service with any NEES subsidiary. Goals are established annually. For 1993, these goals related to earnings per share, customer costs, safety, absenteeism, conservation, generating station availability, transmission reliability, environmental and OSHA compliance, and customer favorability attitudes. Some goals apply to all employees, while others apply to particular functional groups. Depending upon the number of goals met, and provided the minimum goal for earnings per share is met, employees may earn a cash bonus of 1% to 4-1/2% of their compensation. Incentive Thrift Plan The incentive thrift plan (a 401(k) program) provides for a match of one-half of up to the first 4% of base compensation contributed to the System's incentive thrift plan (shown under All Other Compensation in the Summary Compensation Tables) and, based on an incentive formula tied to earnings per share, may fully match the first 4% of base compensation contributed (the additional amount, if any, is shown under Bonus in the Summary Compensation Tables). Under Federal law, contributions to these plans are restricted. In 1993, the salary reduction amount was limited to $8,994. Life Insurance NEES has established for certain senior executives life insurance plans funded by individual policies. The combined death benefit under these insurance plans is three times the participant's annual salary. After termination of employment, participants may elect, commencing at age 55 or later, to receive an annuity income equal to 40% of annual salary. In that event, the life insurance is reduced over fifteen years to an amount equal to the participant's final annual salary. Due to changes in the tax law, this plan was closed to new participants, and an alternative was established with only a life insurance benefit. The individuals listed in the NEP summary compensation table are in one or the other of these plans. Mass. Electric and Narragansett each have two executive officers eligible to participate in one or the other of these plans. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption TOTAL COMMON EQUITY BASED HOLDINGS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, Mass. Electric, and Narragansett ------------------------------------- NEES owns 100% of the voting securities of Mass. Electric and Narragansett. NEES owns 98.80% of the voting securities of NEP. SECURITY OWNERSHIP The following tables list the holdings of NEES common shares as of March 10, 1994 by NEP, Mass. Electric, and Narragansett directors, the executive officers named in the Summary Compensation Tables, and all directors and executive officers, as a group. NEP --- Name Shares Beneficially Owned (a) ---- ----------------------------- Lawrence E. Bailey 1,953 Joan T. Bok 25,162 Frederic E. Greenman 10,632 Alfred D. Houston 10,953 John W. Newsham 10,270 John W. Rowe 20,419 Richard P. Sergel 6,702 Jeffrey D. Tranen 6,604 All directors and executive officers, as a group (13 persons) 115,340 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Mass. Electric -------------- Name Shares Beneficially Owned ---- ------------------------- Urville J. Beaumont 104 (a) Joan T. Bok 25,162 (b) Sally L. Collins 105 John H. Dickson 7,883 (b) Charles B. Housen 52 Cheryl A. LaFleur 1,796 (b) Kathryn A. McCarthy 100 Patricia McGovern 0 John F. Reilly 105 John W. Rowe 20,419 (b) Nancy H. Sala 5,459 (b),(c) Richard P. Sergel 6,702 (b) Richard M. Shribman 105 Dennis E. Snay 3,720 (b) Roslyn M. Watson 205 All directors and executive officers, as a group (23 persons) 105,713 (d) (a) Mr. Beaumont disclaims a beneficial ownership interest in these shares held under an irrevocable trust. (b) Includes restricted shares and allocated shares in employee benefit plans. (c) Ms. Sala disclaims a beneficial ownership interest in 205 shares held under the Uniform Gift to Minors Act. (d) This is less than 1% of the total number of shares of NEES outstanding. Narragansett ------------ Name Shares Beneficially Owned ---- ------------------------- Francis X. Beirne 2,956 (a) Joan T. Bok 25,162 (a) Stephen A. Cardi 104 Richard W. Frost 4,521 (a) Frances H. Gammell 105 Joseph J. Kirby 105 Robert L. McCabe 7,671 (a) John W. Rowe 20,419 (a) Richard P. Sergel 6,702 (a) William E. Trueheart 105 William Watkins, Jr. 7,143 (a) John A. Wilson, Jr. 508 All directors and executive officers, as a group (15 persons) 95,477 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The construction company of Mr. Stephen A. Cardi, a director of Narragansett, was awarded two contracts by New England Power Company for construction work at its Brayton Point Station. The contract amounts totalled $600,000 and $1,000,000, respectively. Reference is made to Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT and Item 11. EXECUTIVE COMPENSATION. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K List of Exhibits Unless otherwise indicated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Commission file numbers indicated in parentheses. NEES ---- (3) Agreement and Declaration of Trust dated January 2, 1926, as amended through April 28, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 1-3446). (4) Instruments Defining the Rights of Security Holders (a) Massachusetts Electric Company First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 Form 10-K, File No. 1-3446; Twentieth Supplemental Indenture dated as of September 1, 1993 (filed herewith). (b) The Narragansett Electric Company First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4 to 1991 Form 10-K, File No. 0-898); Exhibit 4(b) to 1992 Form 10-K, File No. 1-3446; Twenty-First Supplemental Indenture dated as of October 1, 1993 (filed herewith). (c) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (filed herewith). (d) New England Power Company Indentures General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 Form 10-K, File No. 1-3446; Nineteenth Supplemental Indenture dated as of August 1, 1993 (filed herewith). (10) Material Contracts (a) Boston Edison Company et al. and New England Power Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and New England Power Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986; (Exhibit 10(b), to 1990 Form 10-K, File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to NEP with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and New England Power Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-23006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 1-3446); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to 1979 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and New England Power Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to 1983 Form 10-K, File No. 1-3446), October 1, 1984, and August 1, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20, File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446). (e) New England Energy Incorporated Contracts (i) Capital Funds Agreement with NEES dated November 1, 1974 (Exhibit 10-29(b), File No. 2-52969); Amendment dated July 1, 1976, and Amendment dated July 26, 1979 (Exhibit 10(g)(i) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(i) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10 (e)(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(i) to 1990 Form 10-K, File No. 1-3446). (ii) Loan Agreement with NEES dated July 19, 1978 and effective November 1, 1974, and Amendment dated July 26, 1979 (Exhibit 10(g)(iii) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(ii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(ii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(ii) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(ii) to 1990 Form 10-K, File No. 1-3446). (iii) Fuel Purchase Contract with New England Power Company dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 Form 10-K, File No. 1-3446). (iv) Partnership Agreement with Samedan Oil Corporation as Amended and Restated on February 5, 1985 (Exhibit 10(e)(iv) to 1984 Form 10-K, File No. 1-3446); Amendment dated as of January 14, 1992 (Exhibit 10(e)(iv) to 1991 Form 10-K, File No. 1-3446). (v) Credit Agreement dated as of April 28, 1989 (Exhibit 10(e)(v) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(v) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1992 (Exhibit 10(e)(v) to 1992 Form 10-K, File No. 1-3446). (vi) Capital Maintenance Agreement dated November 15, 1985, and Assignment and Security Agreement dated November 15, 1985 (Exhibit 10(e)(vi) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(vi) to 1989 Form 10-K, File No. 1-3446). (f) New England Power Company and New England Electric Transmission Corporation et al.: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit (10)(f) 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of New England Power Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Upper Development - Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446). (g) New England Electric Transmission Corporation and PruCapital Management, Inc. et al: Note Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Mortgage, Deed of Trust and Security Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Equity Funding Agreement with New England Electric System dated as of December 1, 1985 (Exhibit 10(g) to 1991 Form 10-K, File No. 1-3446). (h) Vermont Electric Transmission Company, Inc. et al. and New England Power Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(g) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to 1986 Form 10-K, File No. 1-3446). (i) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 Form 10-K, File No. 1-3446). (j) Public Service Company of New Hampshire et al. and New England Power Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, December 31, 1980 (Exhibit 10(i) to 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, June 15, 1984 (Exhibit 10(j) to 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986 and September 19, 1986 (Exhibit 10(j) to 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of November 1, 1990 (Exhibit 10(j) to 1991 Form 10-K, File No. 1- 3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to NEP with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 10-16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent (Exhibit 10(j) to 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446); Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, and amendment to Seabrook Project Managing Agent Agreement dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446). (k) Vermont Yankee Nuclear Power Corporation et al. and New England Power Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968, and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972 and April 15, 1983 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446) and April 24, 1985 (Exhibit 10(k) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(k) to 1987 Form 10-K, File No. 1-3446); Amendments dated as of May 6, 1988 (Exhibit 10(k) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to 1981 Form 10-K, File No. 1-3446). (l) Yankee Atomic Electric Company et al. and New England Power Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10 (l) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 Form 10-K, File No. 1- 3446). *(m) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to 1986 Form 10-K, File No. 1-3446). *(n) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to 1991 Form 10-K, File No. 1-3446). *(o) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to 1991 Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(q) to 1992 Form 10-K, File No. 1-3446). *(q) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to 1991 Form 10-K, File No. 1- 3446). *(r) New England Electric Companies' Incentive Compensation Plan II as amended dated September 3, 1992 (Exhibit 10(r) to 1992 Form 10-K, File No. 1-3446). *(s) New England Electric System Directors Deferred Compensation Plan as amended dated November 24, 1992 (Exhibit 10(s) to 1992 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program (Exhibit 10(s) to 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to 1991 Form 10-K, File No. 1-3446). (u) New England Power Company and New England Hydro-Transmission Electric Company, Inc. et al: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10(u) to 1990 Form 10-K, File No. 1-3446). (v) New England Power Company and New England Hydro-Transmission Corporation et al: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1,1988 (Exhibit 10(v) to 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10(v) to 1990 Form 10-K, File No. 1-3446). (w) New England Power Company et al: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to 1988 Form 10-K, File No. 1-3446). (x) New England Hydro-Transmission Electric Company, Inc. and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(x) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(x) to 1988 Form 10-K, File No. 1-3446). (y) New England Hydro-Transmission Corporation and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(y) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(y) to 1988 Form 10-K, File No. 1-3446). (aa) Ocean State Power, et al., and Narragansett Energy Resources Company: Equity Contribution Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power, et al., and New England Electric System: Equity Contribution Support Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K, File No. 1-3446); Ocean State Power II, et al., and Narragansett Energy Resources Company:Equity Contribution Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power II, et al., and New England Electric System: Equity Contribution Support Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446). *(bb) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 Form 10-K, File No. 1-3446). *(cc) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 Form 10-K, File No. 1-3446). *(dd) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (13) 1993 Annual Report to Shareholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (filed herewith). (22) Subsidiary list appears in Part I of this document. (25) Power of Attorney (filed herewith). NEP --- (3) (a) Articles of Organization as amended through June 27, 1987 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-1229). (b) By-laws of the Company as amended June 25, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 0-1229). (4) General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1988 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and the Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986 (Exhibit 10(b) to NEES' 1990 Form 10-K File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to the Company with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and the Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-2006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 0-1229); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to NEES' 1979 Form 10-K, File No. 1-3446); Five Year Capital Contribution Agreement dated November 1, 1980 (Exhibit 10(e) to NEES' 1980 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to NEES' 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to NEES' 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and the Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to NEES' 1983 Form 10-K, File No. 1-3446); October 1, 1984, and August 1, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20; File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446). (e) Mass. Electric and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated June 22, 1983 (Exhibit 10(b) to Mass. Electric's 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (f) The Narragansett Electric Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 4(f) to New England Power Company's 1990 Form 10-K, File No. 0-1229). Amendment of Service Agreement dated July 24, 1991 (Exhibit 10(f) to 1991 Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (g) Time Charter between Intercoastal Bulk Carriers, Inc., and New England Power Company dated as of December 27, 1989 (Exhibit 10(g) to 1989 Form 10-K, File No. 1-3446). (h) New England Electric Transmission Corporation et al. and the Company: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(f) to NEES' 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of the Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Upper Development-Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446). (i) Vermont Electric Transmission Company, Inc. et al. and the Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(g) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to NEES' 1986 Form 10-K, File No. 1-3446). (j) New England Energy Incorporated and the Company: Fuel Purchase Contract dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 NEES Form 10-K, File No. 1-3446). (k) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, March 1, 1973 (Exhibit 10-15, File No. 2-48543);Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10 (i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (l) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(l) to 1988 Form 10-K, File No. 0-1229). (m) Public Service Company of New Hampshire et al. and the Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, and December 31, 1980 (Exhibit 10(i) to NEES' 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, and June 15, 1984 (Exhibit 10(j) to NEES' 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986, and September 19, 1986 (Exhibit 10(j) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to NEES' 1990 Form 10-K, File No. 1-3446); Seventh Amendment as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to the Company with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). Settlement Agreement dated as of July 19, 1990 between Northeast Utilities Service Company and the Company (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, Amendment to Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). (n) Vermont Yankee Nuclear Power Corporation et al. and the Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968 and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972, April 15, 1983 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 0-1229) and April 24, 1985 (Exhibit 10(n) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendments dated May 6, 1988 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 NEES Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to NEES' 1981 Form 10-K, File No. 1-3446). (o) Yankee Atomic Electric Company et al. and the Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10(l) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 NEES Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(q) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(r) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(s) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446); New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(u) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10 (r) to NEES' 1992 Form 10-K, File No. 1-3446). (v) New England Hydro-Transmission Electric Company, Inc. et al. and the Company: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10 (u) to NEES' 1990 Form 10-K, File No. 1-3446). (w) New England Hydro-Transmission Corporation et al. and the Company: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to NEES' 1987 Form 10-K, File No. 1-3446). Amendment dated as of August 1, 1988 (Exhibit 10(v) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10 (v) to NEES' 1990 Form 10-K, File No. 1-3446). (x) Vermont Electric Power Company et al. and the Company: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446). Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to NEES' 1988 Form 10-K, File No. 1-3446). (y) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of January 6, 1992; Amendments dated as of March 2, 1992 and October 30, 1992 (Exhibit 10(y) to 1992 Form 10-K, File No. 0-1229). (z) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of October 30, 1992 (Exhibit 10(z) to 1992 Form 10-K, File No. 0-1229). (aa) Algonquin Gas Transmission Company and the Company: X-38 Service Agreement for Firm Transportation of natural gas dated July 3, 1992; Amendment dated July 31, 1992 (Exhibit 10(aa) to 1992 Form 10-K, File No. 0-1229). (bb) ANR Pipeline Company and the Company: Gas Transportation Agreement dated July 18, 1990 (Exhibit 10(bb) to 1992 Form 10-K, File No. 0-1229). (cc) Columbia Gas Transmission Corporation and the Company: Service Agreement for Service under FTS Rate Schedule dated June 13, 1991 (filed herewith). (dd) Iroquois Gas Transmission System, L.P. and the Company: Gas Transportation Contract for Firm Reserved Service dated as of June 5, 1991 (Exhibit 10(dd) to 1992 Form 10-K, File No. 0-1229). (ee) Tennessee Gas Pipeline Company and the Company: Firm Natural Gas Transportation Agreement dated July 9, 1992 (Exhibit 10(ee) to 1992 Form 10-K, File No. 0-1229). *(ff) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 NEES Form 10-K, File No. 1-3446). *(gg) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 NEES Form 10-K, File No. 1-3446). *(hh) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into NEP registration statements on Form S-3, Commission File Nos. 33-48257, 33-48897, and 33-49193 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (22) Subsidiary list (filed herewith). (25) Power of Attorney (filed herewith). Mass. Electric -------------- (3) (a) Articles of Organization of the Company as amended March 5, 1993, August 11, 1993, September 20, 1993, and November 15, 1993 (filed herewith). (b) By-Laws of the Company as amended February 4, 1993, July 30, 1993, and September 15, 1993 (filed herewith). (4) First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464); Exhibit 4 to 1988 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated July 22, 1983 (Exhibit 10(b) to 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(e) to 1993 NEP Form 10-K, File No. 0- 1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1988 Form 10-K, File No. 0-5464). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 4(e), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Mass. Electric registration statement on Form S-3, Commission File No. 33-49251 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (Exhibit 18 to 1993 NEES Form 10-K, File No. 1-3446). (25) Power of Attorney (filed herewith). Narragansett ------------ (3) (a) Articles of Incorporation as amended June 9, 1988 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-898). (b) By-Laws of the Company (Exhibit 3 to 1980 Form 10-K, File No. 0-898). (4) (a) First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4(b) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1993 NEES Form 10-K, File No. 1-3446). (b) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1- 3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 10(f) to 1990 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement dated July 24, 1991 (Exhibit 4(f) to 1991 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(f) to 1993 NEP Form 10-K, File No. 0-1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10 (i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES' Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to NEES' 1992 Form 10-K, File No. 1-3446. (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1989 Form 10-K, File No. 0-898). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 3(d), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan for Officers, as amended December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan, as amended April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan, as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Companies' Incentive Compensation Plan, as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Narragansett registration statement on Form S-3, Commission File No. 33-45052 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (25) Power of Attorney (filed herewith). Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules for NEES, NEP, Mass. Electric, and Narragansett on pages 100, 109, 115, and 121, respectively. Reports on Form 8-K NEES ---- NEES filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. NEP --- None. Mass. Electric -------------- Mass. Electric filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. Narragansett ------------ None. NEW ENGLAND ELECTRIC SYSTEM 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 ELECTRIC SYSTEM* s/John W. Rowe John W. Rowe President and Chief Executive Officer March 28, 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. (Signature and Title) Principal Executive Officer s/John W. Rowe John W. Rowe President and Chief Executive Officer Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Executive Vice President and Chief Financial Officer Principal Accounting Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Directors (a majority) Joan T. Bok Paul L. Joskow John M. Kucharski Edward H. Ladd Joshua A. McClure s/John G. Cochrane Malcolm McLane All by: Felix A. Mirando, Jr. John G. Cochrane John W. Rowe Attorney-in-fact George M. Sage Charles E. Soule Anne Wexler James Q. Wilson James R. Winoker Date (as to all signatures on this page) March 28, 1994 *The name "New England Electric System" means the trustee or trustees for the time being (as trustee or trustees but not personally) under an agreement and declaration of trust dated January 2, 1926, as amended, which is hereby referred to, and a copy of which as amended has been filed with the Secretary of the Commonwealth of Massachusetts. Any agreement, obligation or liability made, entered into or incurred by or on behalf of New England Electric System binds only its trust estate, and no shareholder, director, trustee, officer or agent thereof assumes or shall be held to any liability therefor. NEW ENGLAND 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 signature of the undersigned company shall be deemed to relate only to matters having reference to such company. NEW ENGLAND POWER COMPANY s/Jeffrey D. Tranen Jeffrey D. Tranen President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Jeffrey D. Tranen Jeffrey D. Tranen President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Frederic E. Greenman Alfred D. Houston s/John G. Cochrane John W. Newsham All by: John W. Rowe John G. Cochrane Jeffrey D. Tranen Attorney-in-fact Date (as to all signatures on this page) March 28, 1994 MASSACHUSETTS ELECTRIC 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. MASSACHUSETTS ELECTRIC COMPANY s/John H. Dickson John H. Dickson President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/John H. Dickson John H. Dickson President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Urville J. Beaumont Joan T. Bok Sally L. Collins John H. Dickson s/John G. Cochrane Charles B. Housen All by: Kathryn A. McCarthy John G. Cochrane Patricia McGovern Attorney-in-fact John F. Reilly John W. Rowe Richard P. Sergel Richard M. Shribman Roslyn M. Watson Date (as to all signatures on this page) March 28, 1994 THE NARRAGANSETT ELECTRIC 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. THE NARRAGANSETT ELECTRIC COMPANY s/Robert L. McCabe Robert L. McCabe President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Robert L. McCabe Robert L. McCabe President Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Vice President and Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Stephen A. Cardi Frances H. Gammell s/John G. Cochrane Joseph J. Kirby All by: Robert L. McCabe John G. Cochrane John W. Rowe Attorney-in-fact Richard P. Sergel William E. Trueheart John A. Wilson, Jr. Date (as to all signatures on this page) March 28, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of New England Electric System on Form S-3 of the Dividend Reinvestment and Common Share Purchase Plan (File No. 33-12313) and on Forms S-8 of the New England Electric System Companies Employees' Share Ownership Plan (File No. 2-89648), the New England Electric System Companies Incentive Thrift Plan (File No. 33-26066), the New England Electric System Companies Incentive Thrift Plan II (File No. 33-35470), the NEES Goals Program (File No. 2-94447) and the Yankee Atomic Electric Company Thrift Plan (File No. 2-67531) of our reports dated February 25, 1994 on our audits of the consolidated financial statements and financial statement schedules of New England Electric System and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. We also consent to the incorporation by reference in the registration statements of New England Power Company on Forms S-3 (File Nos. 33-48257, 33-48897, and 33-49193), Massachusetts Electric Company on Form S-3 (File No. 33-49251) and The Narragansett Electric Company on Form S-3 (File No. 33-45052) of our reports dated February 25, 1994 on our audits of the financial statements and financial statement schedules of New England Power Company, Massachusetts Electric Company and The Narragansett Electric Company, respectively, as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND March 25, 1994 REPORT OF INDEPENDENT ACCOUNTANTS Our reports on the consolidated financial statements of New England Electric System and subsidiaries and on the financial statements of certain of its subsidiaries, listed in item 14 herein, which financial statements and reports are included in the respective 1993 Annual Reports to Shareholders, have been incorporated by reference in this Form 10K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14 herein. In our opinion, the financial statement schedules referred to above, when considered in relation to the corresponding 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 COOPERS & LYBRAND February 25, 1994 NEW ENGLAND ELECTRIC SYSTEM AND SUBSIDIARIES CONSOLIDATED --------------------------------------------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993, 1992, and 1991

310569_1993.txt

310569_1993

1993

310569

ITEM 1. BUSINESS Anheuser-Busch Companies, Inc. (the "Company") is a Delaware corporation that was organized in 1979 as the holding company parent of Anheuser-Busch, Incorporated ("ABI"), a Missouri corporation whose origins date back to 1875. In addition to ABI, which is the world's largest brewer of beer, the Company is also the parent corporation to a number of subsidiaries that conduct various other business operations, including those related to the brewing of beer, the manufacture of metal beverage containers, the recycling of metal and glass beverage containers, the production and sale of food and food-related products, and the operation of theme parks. Financial information with respect to the Company's business segments appears in financial statement note 15, "Business Segments," on page 57 of the 1993 Annual Report to Shareholders, which note hereby is incorporated by reference. BEER AND BEER-RELATED OPERATIONS The Company's principal product is beer, produced and distributed by its subsidiary, ABI, in a variety of containers primarily under the brand names Budweiser, Bud Light, Bud Dry Draft, Michelob, Michelob Light, Michelob Dry, Michelob Golden Draft, Michelob Golden Draft Light, Michelob Classic Dark, Busch, Busch Light, Natural Light, Natural Pilsner, King Cobra, and O'Doul's (a non-alcoholic malt beverage). Additionally, ABI imports Carlsberg and Carlsberg Light beers and Elephant Malt Liquor in U.S. markets as part of an agreement with the Denmark based Carlsberg A/S (formerly United Breweries, Ltd.), brewer of the brands. A new brand, Ice Draft from Budweiser, was introduced in the fourth quarter of 1993. Sales of beer by the Company aggregated 87.3 million barrels in 1993 as compared with 86.8 million barrels in 1992 and accounted for approximately 66% of consolidated net sales dollars in 1993. In 1992 and 1991 the percentage was 67%. Budweiser, Bud Light, Bud Dry Draft, Ice Draft from Budweiser, Michelob, Michelob Light, Michelob Dry, Michelob Golden Draft, Michelob Golden Draft Light, Michelob Classic Dark, Busch, Busch Light, Natural Light, Carlsberg, Elephant Malt Liquor, and O'Doul's are sold in both draught and packaged form. Natural Pilsner, King Cobra, and Carlsberg Light are sold only in packaged form. Budweiser, Bud Light, Bud Dry Draft, Ice Draft from Budweiser, Michelob, Michelob Light, Michelob Dry, Michelob Classic Dark, Natural Light, and O'Doul's are distributed and sold on a nationwide basis. Busch and Busch Light are distributed in 46 states, Natural Pilsner in 6 states, and King Cobra is distributed in 45 states. Michelob Golden Draft and Michelob Golden Draft Light are sold in 13 states. ABI's imported beer, Carlsberg is distributed in 45 states, Carlsberg Light in 28 states, and Elephant Malt Liquor is distributed in 38 states. Normally, due to the seasonality of the industry, sales of ABI's beers are at their lowest volume level in the first and fourth quarters of each year and at their highest in the second and third quarters. In 1993 the barrels sold in the lowest quarter (first quarter) differed by almost 19% from the barrels sold in the highest quarter (third quarter). ABI's 1994 quarterly sales to wholesalers volume growth is not expected to follow a consistent pattern; first quarter shipments in 1994 increased more significantly due to the roll-out of Ice Draft from Budweiser and higher planned inventory levels. ABI has developed a system of thirteen breweries, strategically located across the country, to economically serve its distribution system. (See Item 2 ITEM 2. PROPERTIES ABI has thirteen breweries in operation at the present time, located in St. Louis, Missouri; Newark, New Jersey; Los Angeles and Fairfield, California; Jacksonville and Tampa, Florida; Houston, Texas; Columbus, Ohio; Merrimack, New Hampshire; Williamsburg, Virginia; Baldwinsville, New York; Fort Collins, Colorado; and Cartersville, Georgia. Title to the Baldwinsville, New York brewery is held by the Onondaga County Industrial Development Agency ("OCIDA") pursuant to a Sale and Agency Agreement with ABI, which enabled OCIDA to issue tax exempt pollution control and industrial development revenue notes and bonds to finance a portion of the cost of the purchase and modification of the brewery. The brewery is not pledged or mortgaged to secure any of the notes or bonds, and the Sale and Agency Agreement with OCIDA gives ABI the unconditional right to require at any time that title to the brewery be transferred to ABI. ABI's breweries operated at approximately 94% of capacity in 1993. The Company, through wholly-owned subsidiaries, operates malt plants in Manitowoc, Wisconsin, Moorhead, Minnesota and Idaho Falls, Idaho; rice mills in Jonesboro, Arkansas and Woodland, California; a wild rice processing facility in Clearbrook, Minnesota; can manufacturing plants in Jacksonville, Florida, Columbus, Ohio, Arnold, Missouri, Windsor, Colorado, Carson, California, Newburgh, New York, Ft. Atkinson, Wisconsin, and Rome, Georgia; can lid manufacturing plants in Gainesville, Florida, Oklahoma City, Oklahoma, and Riverside, California; refillable bottle sorting facilities in Marion, Ohio and Nashua, New Hampshire; and snack food production plants in Robersonville, North Carolina, Hyannis, Massachusetts, Fayetteville, Tennessee, Visalia, California, and York, Pennsylvania. BEC operates its principal family entertainment facilities in Tampa, Florida; Williamsburg, Virginia; San Diego, California; Aurora, Ohio; Orlando, Florida; San Antonio, Texas; and Winter Haven, Florida. The Tampa facility is 265 acres, Williamsburg is 364 acres, San Diego is 165 acres, Aurora is 90 acres, Orlando is 224 acres, San Antonio is 496 acres, and the Winter Haven facility is 223 acres. The Company's wholly-owned subsidiary, CTI, through its domestic subsidiaries, operates 41 bakeries and 11 manufacturing plants in 19 states. CTI's international subsidiaries own and operate eight bakeries in Spain and a refrigerated dough manufacturing plant in France. CTI's domestic bakeries operate at approximately 75% of capacity, which is about average for the baking industry. Except for the Baldwinsville brewery, the can manufacturing plants in Carson, California and in Newburgh, New York, eleven CTI facilities, one ESI plant, and the Sea World park in San Diego, California, all of the Company's principal properties are owned in fee. The lease for the land used by the Sea World park in San Diego, California expires in 2033. Title to eight CTI facilities is currently held by development authorities for the jurisdictions in which the facilities are located pursuant to Industrial Development Bonds; the remaining CTI facilities are leased. The Company considers its buildings, improvements, and equipment to be well maintained and in good condition, irrespective of dates of initial construction, and adequate to meet the operating demands placed upon them. The production capacity of each of the manufacturing facilities is adequate for current needs and, except as described above, substantially all of each facility's capacity is utilized. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any pending or threatened litigation, the outcome of which would be expected to have a material adverse effect upon its financial condition or its operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT AUGUST A. BUSCH III (age 56) is presently Chairman of the Board and President, and Director of the Company and has served in such capacities since 1977, 1974, and 1963, respectively. Since 1979 he has also served as Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Anheuser-Busch, Incorporated. During the past five years he also served as President of that subsidiary (1987-1990). JERRY E. RITTER (age 59) is presently Executive Vice President-Chief Financial and Administrative Officer of the Company and was appointed to serve in such capacity in 1990. He is also Vice President-Finance of the Company's subsidiary, Anheuser-Busch, Incorporated, and has served in such capacity since 1982. During the past five years he also served as Vice President and Group Executive of the Company (1984-1990). MICHAEL J. ROARTY (age 65) is presently Executive Vice President- Corporate Marketing and Communications of the Company and was appointed to serve in such capacity in 1990. He is also presently Chairman of the Board of the Company's subsidiary, Busch Media Group, Inc., and Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Busch Creative Services Corporation, and was appointed to serve in each such capacity in 1990. During the past five years he also served as Vice President of the Company (1988-1990) and Executive Vice President-Marketing of the Company's subsidiary, Anheuser-Busch, Incorporated (1983-1990). Mr. Roarty has elected to retire from his positions with the Company and its subsidiaries in September 1994. Details of Mr. Roarty's retirement are set forth on page 18 in the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. PATRICK T. STOKES (age 51) is presently Vice President and Group Executive of the Company and has served in such capacity since 1981. He is also presently President of the Company's subsidiary, Anheuser- Busch, Incorporated, and was appointed to serve in such capacity in 1990. During the past five years he also served as Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Campbell Taggart, Inc. (1985-1990) and Chairman of the Board and President of the Company's subsidiary, Eagle Snacks, Inc. (1987-1990). BARRY H. BERACHA (age 52) is presently Vice President and Group Executive of the Company and has served in such capacity since 1976. He is also presently Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Campbell Taggart, Inc. and has served in such capacity since September 1993. He is also Chairman of the Board of the Company's subsidiary, Metal Container Corporation and has served in such capacity since 1976. During the past five years he also served as Chief Executive Officer of Metal Container Corporation (1976-September 1993) and Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Anheuser-Busch Recycling Corporation (1978-1993). JOHN H. PURNELL (age 52) is presently Vice President and Group Executive of the Company and has served in such capacity since January 1991. He is also Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Anheuser-Busch International, Inc., and has served as Chairman since 1980 and as Chief Executive Officer since January 1991. During the past five years he also served as Senior Vice President-Corporate Planning and Development (1987-1991). W. RANDOLPH BAKER (age 47) is presently Vice President and Group Executive of the Company and has served in such capacity since 1982. During the past five years he also served as Chairman of the Board and President of the Company's subsidiaries, Busch Properties, Inc. and Busch Entertainment Corporation (1978-1991). STEPHEN K. LAMBRIGHT (age 51) is presently Vice President and Group Executive of the Company and has served in such capacity since 1984. STUART F. MEYER (age 60) is presently Vice President and Group Executive of the Company and has served in such capacity since April 1991 and has also served as Vice President-Corporate Human Resources of the Company (1984-March 1991). He was appointed President and Chief Executive Officer of the Company's subsidiary, St. Louis National Baseball Club, Inc., in January 1992 and prior to that served as Executive Vice President and Chief Operating Officer (April 1991-December 1991). He is also President and Chief Executive Officer of the Company's subsidiary, Civic Center Corporation, and has served in such capacity since April 1991. RAYMOND E. GOFF (age 48) is presently Vice President and Group Executive of the Company and has served in such capacity since 1986. He is also presently Chairman of the Board and Chief Executive Officer of the Company's subsidiary, Busch Agricultural Resources, Inc., and has served in such capacity since 1986. JAIME IGLESIAS (age 63) is presently Chairman of the Board and Senior Vice President-Europe of the Company's subsidiary, Anheuser-Busch Europe, Inc. ("ABEI") and was appointed to these positions in January 1993. Prior to that he served as Chief Executive Officer (1989-January 1993) and as President (1988-January 1993) of ABEI. He was appointed President-International Operations of the Company's subsidiary, Campbell Taggart, Inc. ("CTI"), in 1991 and prior to that served as Vice President-International (1983-1991). He is also Chairman of CTI's subsidiary, Bimbo S.A., and President and Senior Vice President-Europe of the Company's subsidiary, Anheuser-Busch International, Inc. ("ABII"), and has served in such capacities since 1978 and January 1993, respectively. He also served as President and Managing Director- Europe of ABII (1988-January 1993). ALOYS H. LITTEKEN (age 53) is presently Vice President-Corporate Engineering of the Company and has served in such capacity since 1981. WILLIAM L. RAMMES (age 52) is presently Vice President-Corporate Human Resources of the Company and has served in such capacity since June 1992. During the past five years he also served as Vice President- Operations of the Company's subsidiary, Anheuser-Busch Incorporated (1990-June 1992) and Vice President-Administration (1986-1989). JOHN B. ROBERTS (age 49) is presently Chairman of the Board and President of the Company's subsidiary, Busch Entertainment Corporation, and has served in such capacities since June 1992 and May 1991, respectively. During the past five years he also served as Executive Vice President and General Manager of Busch Entertainment Corporation (1990-May 1991) and Vice President and General Manager (1987-1990) and Vice President-Operations (1979-1987). JOSEPH L. GOLTZMAN (age 52) is presently Vice President and Group Executive of the Company and has served in such capacity since September 1993. He is also presently Chairman, Chief Executive Officer and President of the Company's subsidiary, Anheuser-Busch Recycling Corporation, President and Chief Executive Officer of the Company's subsidiary, Metal Container Corporation, and President of the Company's subsidiary, Metal Label Corporation, and has served in such capacities since January 1993, September 1993, and 1988, respectively. During the past five years he also served as President of Anheuser-Busch Recycling Corporation (1988-December 1992) and Vice President-Recycling and Metals Planning (January 1992-September 1993) and Director-Metals Planning and Recycling (1988-December 1991) of the Company. PART II The information required by Items 5, 6, 7, and 8 of this Part II are hereby incorporated by reference from pages 32 through 65 of the Company's 1993 Annual Report to Shareholders. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 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 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements with Price Waterhouse, the Company's independent accountants since 1961, on accounting principles or practices or financial statement disclosures. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required with respect to Directors is hereby incorporated by reference from pages 3 through 5 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. The information required by this Item with respect to Executive Officers is presented on pages 6 through 8 of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is hereby incorporated by reference from page 7 and pages 15 through 21 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is hereby incorporated by reference from pages 2 and 6 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is hereby incorporated by reference from pages 21 through 23 of the Company's Proxy Statement for the Annual Meeting of Shareholders on April 27, 1994. PART IV 3. Exhibits Exhibit 3.1 - Amendment to Article Fourth of the Restated Certificate of Incorporation of the Company dated June 10, 1992. (Restated Certificate of Incorporation with amendments previously filed and incorporated by reference to Exhibit 3.1 to Form 10-K for the fiscal year ended December 31, 1987.) Exhibit 3.2 - Certificate of Designation, Rights and Preferences of the Series C Convertible Preferred Stock of the Company dated November 3, 1989. (Incorporated by reference to Exhibit 3.2 to Form 10-K for the fiscal year ended December 31, 1990.) Exhibit 3.3 - By-Laws of the Company (as amended and restated October 27, 1993). (Incorporated by reference to Exhibit 3 to Form 10-Q for the quarter ended September 30, 1993.) Exhibit 4.1 - Form of Rights Agreement, dated as of December 18, 1985 between Anheuser-Busch Companies, Inc. and Centerre Trust Company of St. Louis (now Boatmen's Trust Company), as amended and restated as of December 17, 1986. Exhibit 4.2 - Indenture between the Company and Manufacturers Hanover Trust Company. (Incorporated by reference to Exhibit 4 to Registration Statement on Form S-3, Registration No. 33-14685, filed with the Commission on June 3, 1987.) (Other indentures are not filed, but the Company agrees to furnish copies of such instruments to the Securities and Exchange Commission upon request.) [FN] - - - ----- *Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. Exhibit 10.1 - Anheuser-Busch Companies, Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated February 22, 1989.) (Incorporated by reference to Exhibit 10.1 to Form 10-K for the fiscal year ended December 31, 1988.)* Exhibit 10.2 - First Amendment to Anheuser-Busch Companies, Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated February 22, 1989) effective April 24, 1991. (Incorporated by reference to Exhibit 10.2 to Form 10-K for the fiscal year ended December 31, 1991.)* Exhibit 10.3 - Second Amendment to Anheuser-Busch Companies, Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated February 22, 1989) effective January 1, 1994.* Exhibit 10.4 - Anheuser-Busch Companies, Inc. Retirement Program for Non-Employee Directors. (Incorporated by reference to Exhibit 10.1 to Registration Statement on Form S-14 filed September 14, 1982.)* Exhibit 10.5 - Anheuser-Busch Companies, Inc. 1981 Incentive Stock Option/Non-Qualified Stock Option Plan (as amended December 18, 1985, December 16, 1987, December 20, 1988 and July 22, 1992.) (Incorporated by reference to Exhibit 10.4 to Form 10-K for the fiscal year ended December 31, 1992.)* Exhibit 10.6 - Excerpts from resolutions adopted by the Anheuser-Busch Companies, Inc. Board of Directors on September 22, 1993 amending the Anheuser-Busch Companies, Inc. 1981 Incentive Stock Option/Non-Qualified Stock Option Plan.* Exhibit 10.7 - Anheuser-Busch Companies, Inc. 1981 Non- Qualified Stock Option Plan (as amended December 18, 1985, June 24, 1987, December 20, 1988 and July 22, 1992.) (Incorporated by reference to Exhibit 10.5 to Form 10-K for the fiscal year ended December 31, 1992.)* Exhibit 10.8 - Anheuser-Busch Companies, Inc. 1989 Incentive Stock Plan (as amended December 20, 1989, December 19, 1990 and December 15, 1993.)* Exhibit 10.9 - Anheuser-Busch Companies, Inc. Excess Benefit Plan.* Exhibit 10.10- First Amendment to Anheuser-Busch Companies, Inc. Excess Benefit Plan.* Exhibit 10.11- Second Amendment to Anheuser-Busch Companies, Inc. Excess Benefit Plan effective as of July 1, 1989. (Incorporated by reference to Exhibit 10.10 to Form 10-K for the fiscal year ended December 31, 1989.)* Exhibit 10.12- Excerpts from resolutions adopted by the Anheuser-Busch Companies, Inc. Board of Directors on September 22, 1993 amending the Anheuser-Busch Companies, Inc. Excess Benefit Plan.* Exhibit 10.13- Anheuser-Busch Companies, Inc. Supplemental Executive Retirement Plan Amended and Restated as of July 1, 1989. (Incorporated by reference to Exhibit 10.11 to Form 10-K for the fiscal year ended December 31, 1989.)* Exhibit 10.14- First Amendment to Anheuser-Busch Companies, Inc. Supplemental Executive Retirement Plan. (Incorporated by reference to Exhibit 10.11 to Form 10-K for the fiscal year ended December 31, 1990.)* Exhibit 10.15- Excerpts from resolutions adopted by the Anheuser-Busch Companies, Inc. Board of Directors on September 22, 1993 amending the Anheuser-Busch Companies, Inc. Supplemental Executive Retirement Plan.* Exhibit 10.16- Anheuser-Busch Executive Deferred Compensation Plan effective January 1, 1994.* Exhibit 10.17- Anheuser-Busch 401(k) Restoration Plan effective January 1, 1994.* Exhibit 10.18- Form of Indemnification Agreement with Directors and Executive Officers.* Exhibit 10.19- Investment Agreement By and Among Anheuser-Busch Companies, Inc., Anheuser-Busch International, Inc. and Anheuser-Busch International Holdings, Inc. and Grupo Modelo, S.A. de C.V., Diblo, S.A. de C.V. and certain shareholders thereof, dated as of June 16, 1993. Exhibit 10.20- Letter agreement between Anheuser-Busch Companies, Inc. and the Controlling Shareholders regarding Section 5.5 of the Investment Agreement filed as Exhibit 10.19 of this report. Exhibit 13 - Pages 32 through 65 of the Anheuser-Busch Companies, Inc. 1993 Annual Report to Shareholders, a copy of which is furnished for the information of the Securities and Exchange Commission. Portions of the Annual Report not incorporated herein by reference are not deemed "filed" with the Commission. Exhibit 21 - Subsidiaries of the Company Exhibit 23 - Consent of Independent Accountants, filed as page 16 of this report. [FN] - - - ----- * A management contract or compensatory plan or arrangement required to be filed by Item 14(c) of this report. (b) Reports on Form 8-K 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. ANHEUSER-BUSCH COMPANIES, INC. ................................... (Registrant) By AUGUST A. BUSCH III ................................... August A. Busch III Chairman of the Board and President Date: March 23, 1994 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Separate financial statements of subsidiaries not consolidated have been omitted because, in the aggregate, the proportionate share of their profit before income taxes and total assets are less than 20% of the respective consolidated amounts, and investments in such companies are less than 20% of consolidated total assets. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Anheuser-Busch Companies, Inc. Our audits of the consolidated financial statements referred to in our report dated February 7, 1994 appearing on page 41 of the 1993 Annual Report to Shareholders of Anheuser-Busch 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 St. Louis, Missouri February 7, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Forms S-3 (No. 33-31735 and No. 33-49051) and in the Registration Statements on Forms S-8 (No. 2-71762, No. 2-77829, No. 33-4664, No. 33-36132, No. 33-39714, No. 33-39715, and No. 33-46846) of Anheuser-Busch Companies, Inc. of our report dated February 7, 1994 appearing on page 41 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 15 of this Form 10-K. PRICE WATERHOUSE St. Louis, Missouri March 23, 1994

750234_1993.txt

750234_1993

1993

750234

ITEM 1. BUSINESS OF USLICO USLICO Corporation (USLICO) is an insurance holding company incorporated under the laws of Virginia in 1983. In 1984, USLICO became the parent company of the United Services Life group of companies upon the conversion and exchange of the common stock of United Services Life for USLICO common stock on a one-for-one basis. USLICO owns two life insurance companies and several smaller subsidiaries that provide such services as investment management and sale of insurance and other financial products. LIFE INSURANCE COMPANIES USLICO's subsidiary life insurance companies are authorized to write all forms of life insurance, annuities (including variable annuities) and accident and health insurance. The life companies, which collectively write business in all U.S. jurisdictions, Europe, and the Far East, are individually licensed in the following jurisdictions: - United Services Life Insurance Company ("United Services"), the predecessor of which was formed in 1937, is licensed in all states, except New York (where it is an accredited reinsurer), and in the District of Columbia, Guam, and Japan. - Bankers Security Life Insurance Society ("Bankers Security"), acquired in 1979, is licensed in all states, the District of Columbia, and the Dominican Republic. - Two other life insurance subsidiaries were merged into United Services in 1992: Provident Life Insurance Company, which was acquired in 1982, and United Olympic Life Insurance Company, which was acquired in 1984. The life insurance subsidiaries sell three major product lines: (1) individual life insurance, (2) payroll deduction and group life, and (3) individual annuities. See the accompanying 1993 Annual Report for further information regarding the business of USLICO. Underwriting The life insurance companies offer ordinary life, universal life, variable life, and term insurance with accidental death and waiver of premium benefits. The life companies also offer group term life insurance and group association life insurance. As of December 31, 1993, the life companies had $31.3 million of variable life separate account assets. Accident and health policies include group medical, long-term disability, and accidental death and dismemberment coverages. The life companies also sell individual fixed and variable annuities on both a tax-qualified and non tax-qualified basis. As of December 31, 1993, as a result of variable annuity sales, the life companies had $198.4 million under management in variable annuity separate accounts. Depending upon the age and classification of the risk, the life companies retain varying amounts of insurance up to a maximum ranging between $10,000 and $400,000 on any one life. As of December 31, 1993, the aggregate amount of reinsurance ceded was $10.4 billion and the life companies had accepted $5.0 billion of SGLI (Servicemen's Group Life Insurance) reinsurance. For individual life insurance, medical examinations may be required for any ages or amounts if information received indicates a need for examination. Approximately 50% of individual applications are issued without requiring a full medical examination. Blood testing is required for all proposed insureds ages 25 through 45 for amounts greater than $100,000. For life policies issued to individuals in payroll deduction cases, the life companies have a guaranteed issue program for groups of 50 or more participants. Beyond guaranteed issue amounts, some limited underwriting is performed. Underwriting with respect to annuities is minimal. Profitability is determined primarily by the investment spread earned on annuity assets. The individual annuities sold by the life companies have no bail-out provisions (with the exception of one annuity form sold in immaterial amounts in certain states). Competition and Regulation The life insurance industry is highly competitive. There are more than 2,000 legal reserve life insurance companies in the United States, many of which compete with subsidiaries of USLICO in one or more jurisdictions in which they are authorized to transact business. Competition in the insurance field is based upon price, product design, and services rendered to policyholders and agents. The insurance subsidiaries are subject to regulation and supervision by their states of incorporation and by other states in which they do business, including regulations governing rates, standards of solvency and business conduct, and rehabilitation and liquidation of insurance companies. In addition, the states generally require the licensing of insurers and their agents and approval of policy forms, prescribe the form and content of statutory financial statements, and restrict the type and concentration of investments. USLICO also is subject to the laws of several states regulating insurance holding companies. These laws generally impose reporting requirements on such companies and require that any subsidiary insurance company's surplus be reasonable in relation to its liabilities and adequate for its financial needs following any distributions with respect to capital stock made to affiliated companies. In addition, state laws generally provide for a ceiling on dividends which a holding company's operating insurance subsidiaries can pay without prior approval by state regulatory authorities. United Services must obtain prior regulatory approval, from the Virginia Bureau of Insurance, for any dividend if the amount of such dividend, together with all other dividends paid in the preceding 12 calendar months, exceeds the lesser of (a) 10% of the statutory policyholders surplus or (b) the net gain from operations as of the end of the prior calendar year. Bankers Security, as a New York domiciled company, must obtain prior approval of the New York Insurance Department for any dividend. Such approval generally is granted if dividends paid in the 12 most recent calendar months do not exceed the lesser of (1) 50% of the net gain from operations for the prior calendar year or (2) the increase in surplus for the prior calendar year. State insurance regulators monitor the capital adequacy of life insurance companies by means of Risk-Based Capital (RBC) ratios that relate each insurer's actual statutory capital and surplus to a calculated level of capital needed to support different types of risk inherent in the assets and liabilities of the company. RBC ratios below certain levels call for various forms of regulatory intervention. The ratios at December 31, 1993, for both United Services and Bankers Security were more than double the highest level that would require even the most minimal level of regulatory action. Insurance Ratings A. M. Best Company is the acknowledged statistical reporter on the financial condition, history and operating results of insurance companies. Best's ratings are classified in gradations from A++ (Superior) through C- (Marginal). The rating reflects the relative financial strength of the company in comparison to industry performance in such areas as underwriting, control of expenses, reserve adequacy and asset quality. United Services and Bankers Security each received A (Excellent) ratings in 1993. Ratings for 1994 had not been assigned by the date this report was filed. It should be noted that Best's ratings are published for the benefit of policyholders and not for the benefit of shareholders. Standard & Poor's (S&P) rates the claims-paying ability of insurance companies from the highest level of AAA (Superior) to the lowest levels of CCC (Extremely vulnerable) and R (Regulatory action). United Services and Bankers Security each had ratings of A+ (Good financial security) as of the date of this Annual Report. Ownership of USLICO Common Stock United Services owned 300,000 shares of USLICO common stock at December 31, 1993, and the USLICO retirement plan held 273,446 shares of USLICO common stock. Personnel The life companies employ approximately 685 full-time employees, none of whom is represented by a union. PROPERTY AND CASUALTY INSURANCE COMPANIES USLICO carried out property and casualty insurance operations through three wholly-owned insurance subsidiaries which were sold in July of 1991. A fourth subsidiary, The Northeastern Insurance Company of Hartford ("Northeastern"), was a property and casualty reinsurer. Northeastern ceased writing new business during 1986, commuted substantially all reinsurance liabilities effective December, 1993, and surrendered its insurance licenses in early 1994. See the discussion of discontinued operations in the Financial Review section on page of the accompanying 1993 Annual Report to Shareholders incorporated by reference herein for further information regarding Northeastern. OTHER BUSINESSES USLICO owned The International Trust Company of Liberia, Monrovia, Liberia until August 1993, when it was sold. See Note 2 to Consolidated Financial Statements of the accompanying 1993 Annual Report to Shareholders incorporated by reference herein. USLICO owns International Risks, an insurance agency that sells multiple lines of insurance products, including property and casualty insurance and life and health coverages. The agency markets individual, group and payroll deduction products underwritten by approximately fifteen insurance companies. International Risks employs 16 full-time employees, none of whom is represented by a union. USLICO owns a broker-dealer, USLICO Securities, which is a distributor for the fixed and variable annuities marketed by United Services and Bankers Security and which offers mutual funds through its registered representatives. USLICO Securities employs a full-time staff of 11, none of whom is represented by a union. INVESTMENTS OF USLICO For information regarding USLICO's investment portfolio, see Note 3 to Consolidated Financial Statements of USLICO Corporation in the accompanying 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K as Exhibit 13. Management actively monitors its commercial mortgage loan portfolios. Commercial properties are inspected on a yearly basis and inspection reports are documented in each file. Particular emphasis is placed upon loans that have one or more of the following conditions: 1. Past due principal and interest payment 2. Past due real estate tax payment 3. Past due hazard insurance premium payment 4. High vacancy rate in subject building (less than breakeven occupancy) 5. High vacancy rate and/or declining property values in neighborhood of subject building 6. Substantive number of leases expiring prior to loan maturity 7. Higher than market rental rates of tenants in subject building 8. Bankruptcy or financial difficulty of borrower 9. Bankruptcy or financial difficulty of major tenants 10. Deferred maintenance 11. Potential environmental liability On a loan by loan basis, management establishes a loan loss reserve for those loans where there is a reasonable likelihood that a loss will be incurred. The amount of the loss reserve for each loan is determined by estimating the difference between the outstanding loan balance and the estimated market value of the property less foreclosure and selling costs. The reserve calculation is also a function of the probability of ultimate loss. These specific loss reserves totaled $4.8 million at December 31, 1993. A full narrative appraisal is prepared by an independent appraiser at the time of foreclosure. In addition, the Company establishes aggregate unspecified loss reserves based on overall loan portfolio factors. This general reserve was $4 million at December 31, 1993. The following table sets forth information on nonaccrual, past due (accruing loans more than 90 days delinquent) and restructured mortgage loans on real estate: USLICO's policy is to stop the accrual of income on mortgage loans more than 90 days delinquent. All mortgage loans on real estate are located within the United States. Approximately 54% of the loans are on warehouse properties and 30% are on office buildings. As of December 31, 1993, 18 mortgage loans on real estate totaling $24.3 million are considered to be potential problem loans, not reported above, based on knowledge about possible credit problems of borrowers. Of these loans, 17 were current and one was 30 days delinquent. A loss reserve of $350,000 was established at 12/31/93 against one of these loans. The ratio of net charge-offs during 1993 to average loans outstanding during 1993 was 0.4%. ITEM 2. ITEM 2. PROPERTIES USLICO owns no real estate except through subsidiaries. Bankers Security owns a 60,000 square foot office building, completed in 1980, at 950 North Glebe Road, Arlington, Virginia. USLICO's life companies occupy 77% of this property. United Services owns a 72,000 square foot office building at 316 North 5th Street, Bismarck, North Dakota, completed in 1954, and occupies 54% of its space. At December 31, 1993, Bankers Security and United Services owned total foreclosed properties of $3 million. ITEM 3. ITEM 3. LEGAL PROCEEDINGS United Olympic Life Insurance Company ("UOL") and Bankers Security Life Insurance Society ("BSL") are subsidiaries of USLICO (the "Company"). UOL was merged into another subsidiary, United Services Life Insurance Company ("USL"), on October 1, 1992. In United Olympic Life Insurance Company, et. al. v. The Delaware County Bank and Trust Company ("the Bank"), Case No. C2-91-1076, in the United States District Court for the Southern District of Ohio, Eastern Division, United Olympic Life Insurance Company, et. al. v. Consultants and Administrators, Inc., Case No. C2-92-142, in the United States District Court for the Southern District of Ohio, Eastern Division, and The Delaware County Bank and Trust Company vs. United Olympic Life Insurance Company, et. al., Case No. 92CV-H-01-015, in the Court of Common Pleas for Delaware County, Ohio, USL and BSL seek to recover approximately $10 million in consequential damages and $20 million in punitive damages from the Bank for the wrongful transfer by the Bank of premium trust funds to satisfy indebtedness of Consultants and Administrators ("C&A"), a third party administrator, and for the wrongful dishonoring by the Bank of checks drawn on accounts at the Bank. The Bank has counterclaimed against USL, BSL and C&A alleging a conspiracy to defraud the Bank and others and tortious interference with the business relationship between the Bank and C&A. The Bank seeks compensatory damages of $20 million and an unspecified amount of punitive damages. C&A was also sued by USL and BSL and the Bank, and C&A has in turn filed claims against the Bank, USL and BSL claiming damages for alleged breach of contract, wrongful attachment, intentional/negligent interference, fraud, abuse of process and malicious prosecution. C&A alleges damages of $15 million, requests punitive damages of $40 million plus consequential damages in an amount to be determined. In United Olympic Life Insurance Company, et. al. v. Consultants and Administrators, Inc. et. al. Case No. C2-92-150, in the United States District Court for the Southern District of Ohio, Eastern Division, USL and BSL have filed a declaratory judgment action to determine proper allocation of approximately $200,000 in commissions. After the Court issued an opinion effectively ruling that C&A had a right to direct how commissions which were due should be paid, USL paid all but approximately $10,000 of the commissions and is now waiting for further communication from C&A on further payment. USL and BSL also have sued Paul Bargnesi, President of C&A, individually for approximately $300,000 for breach of contract. Mr. Bargnesi has counterclaimed for unspecified compensatory and punitive damages arising from alleged severe emotional distress and damage to reputation. C&A has also filed counterclaims in this action essentially identical to those described in the second case (Case No. C2-92-142) above. The Company believes its subsidiaries have substantial defenses to all of the claims asserted by C&A, the Bank and Mr. Bargnesi in all cases. The Company, including its subsidiaries, is engaged in other litigation in the ordinary course of business. In the opinion of management, the litigation is not material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The information required in answer to this item is incorporated by reference to USLICO Corporation's definitive proxy statement filed March 29, 1994, for use in connection with the Annual Meeting of Shareholders to be held on April 29, 1994. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The common stock and dividend information appearing on page of the accompanying 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report as Exhibit 13. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The five-year financial data appearing on page of the accompanying 1993 Annual Report to Shareholders is incorporated by reference in this Form 10- K Annual Report as Exhibit 13. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information required in answer to this item appears on pages through of the accompanying 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K Annual Report as Exhibit 13. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements, Notes to Consolidated Financial Statements, and Report of Independent Auditors appearing on pages through of the accompanying 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report 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 Information regarding directors and executive officers of the Registrant is incorporated by reference to USLICO Corporation's definitive proxy statement filed March 29, 1994, for use in connection with the Annual Meeting of Shareholders to be held on April 29, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation is incorporated by reference to USLICO Corporation's definitive proxy statement filed March 29, 1994, for use in connection with the Annual Meeting of Shareholders to be held on April 29, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding beneficial ownership of USLICO Corporation's voting securities by directors, officers, and persons who, to the best knowledge of USLICO Corporation, are known to be beneficial owners of more than five percent of USLICO Corporation's voting securities as of March 1, 1994, is incorporated by reference to USLICO Corporation's definitive proxy statement filed March 29, 1994, for use in connection with the Annual Meeting of Shareholders to be held on April 29, 1994. 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 - USLICO CORPORATION AND SUBSIDIARIES. The following financial statements of USLICO Corporation and Subsidiaries, together with the report of independent auditors thereon, are included in Part II of this report by incorporation by reference. Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for the three years ended December 31, 1993 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 Notes to Consolidated Financial Statements Report of Independent Auditors 2. FINANCIAL STATEMENT SCHEDULES - USLICO CORPORATION AND SUBSIDIARIES The following schedules of USLICO Corporation and subsidiaries together with the applicable report of independent auditors thereon, are submitted herewith. Independent Auditors' Report on Financial Statement Schedules 9 Schedule I - Summary of Investments at December 31, 1993 10 Schedule III - Condensed Financial Information of Parent Company 11 Schedule VI - Reinsurance 16 Schedule IX - Short-Term Borrowings 17 Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the consolidated financial statements or notes. 3. INDEX TO EXHIBITS 18 (B) 1. REPORTS ON FORM 8-K None. INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES TO: The Board of Directors and Shareholders of USLICO Corporation Under date of February 23, 1994, we reported on the consolidated balance sheets of USLICO Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income 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 the 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 Notes 1 and 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes by adopting the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" in 1992. As discussed in Note 1 to the consolidated financial statements, the Company also adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" in 1992. KPMG Peat Marwick Washington, D.C. February 23, 1994 SCHEDULE III (cont.) USLICO CORPORATION NOTE TO CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY December 31, 1993 The condensed financial information of parent company should be read in conjunction with Notes to Consolidated Financial Statements included in the Annual Report to Shareholders incorporated by reference herein. INDEX TO EXHIBITS The following exhibits are filed herewith or incorporated by reference where indicated: Exhibit Number 2 Plan of acquisition, reorganization, arrangement, liquidation, or succession (not applicable). 3.1 Articles of Incorporation as amended (dated April 27, 1990) (Incorporated by reference to Item 14, Exhibit 3.1 of USLICO's Form 10-K, filed March 27, 1991, File No. 0-12694). 3.2 By-laws, as amended (dated February 23, 1990). (Incorporated by reference to Item 14, Exhibit 3.2 of USLICO's Form 10-K, filed March 25, 1992, file No. 0-12694). 4.1 Form of Indenture between USLICO Corporation and American Security Bank, including Form of Debenture, dated as of January 15, 1986 for the 8% Convertible Subordinated Debentures due 2011. (Incorporated by reference to Exhibit 4 of USLICO's Registration on Form S-2, Registration No. 33- 1925.) 4.2 Form of Rights Agreement between USLICO and Crestar Bank, including form of Rights Certificate, dated as of February 26, 1988 (Incorporated by reference to Item 7(c) exhibit of USLICO's Form 8-K filed March 10, 1988). 4.3 Form of Indenture between USLICO Corporation and Security Trust Company, N.A., including Form of Debenture, dated as of November 8, 1989, amendment #1 filed December 13, 1989, for the 8.5% Convertible Subordinated Debentures due 2014 (Incorporated by reference to Exhibit 4 of USLICO's Registration on Form S-3, Registration No. 33-31871). 9.0 Voting trust agreement (not applicable). *10.1 USLICO Corporation Stock Option Plan (Incorporated by reference to USLICO's Proxy Statement dated March 27, 1991). *10.2 Supplemental Retirement Benefits are described and incorporated by reference to USLICO's Proxy Statement dated March 25, 1992, at page 10. *10.3 Employment Agreements dated October, 1992, between the Registrant and Messrs. Callahan, Roe, and Gettier. (Incorporated by reference to Item 14, Exhibit 10.3 of USLICO's Form 10-K, filed March 31, 1993, File No. 0-12694). *10.4 Form of Executive Severance Benefit Agreement between the Registrant and executive officers. (Incorporated by reference to Item 14, Exhibit 10.4 of USLICO's Form 10-K, filed March 31, 1993, File No. 0-12694). *10.5 USLICO Management Incentive Compensation Plan. (Incorporated by reference to Item 14, Exhibit 10.5 of USLICO's Form 10-K, filed March 31, 1993, File No. 0-12694). */**10.6 Directors' Retirement Plan. **11 Statement regarding: Computation of Per Share Earnings. 12 Statements regarding: Computation of ratios (not applicable). **13 1993 Annual Report of USLICO to security holders. 18 Letter regarding: Change in accounting principles (not applicable). 19 Previously unfiled documents (not applicable). **21 Subsidiaries to Registrant. 22 Published report regarding matters submitted to vote of security holders (not applicable). 23 Consents of experts and counsel (not applicable). 24 Power of attorney (not applicable). 27 Financial Data Schedule (not applicable). 28 Information from reports furnished to State insurance regulatory authorities (not applicable). 99 Additional Exhibits (not applicable). * Management contract or Compensatory Plan ** Filed herein 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. USLICO CORPORATION (Registrant) DANIEL J. CALLAHAN, III DANIEL J. CALLAHAN, III CHAIRMAN AND CHIEF EXECUTIVE OFFICER MARCH 29, 1994 (Date) 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. DANIEL J. CALLAHAN, III DAVID H. ROE DANIEL J. CALLAHAN, III DAVID H. ROE CHAIRMAN OF THE BOARD, PRESIDENT, CHIEF OPERATING CHIEF EXECUTIVE OFFICER OFFICER AND DIRECTOR AND DIRECTOR ROBERT E. BUCHANAN ELI WEINBERG ROBERT E. BUCHANAN ELI WEINBERG DIRECTOR DIRECTOR ROBERT F. COCKLIN DAVID W. KARSTEN ROBERT F. COCKLIN DAVID W. KARSTEN DIRECTOR SENIOR VICE PRESIDENT AND CONTROLLER GLENN H. GETTIER, JR. GLENN H. GETTIER, JR. EXECUTIVE VICE PRESIDENT, CHIEF FINANCIAL OFFICER AND DIRECTOR MARCH 29, 1994

884033_1993.txt

884033_1993

1993

884033

ITEM 1. Business. The trust fund relating to Pooling and Servicing Agreement dated as of January 1, 1992 (the "Pooling and Servicing Agreement") among First Boston Mortgage Securities Corp., as Depositor (the "Depositor"), and Security Pacific National Bank, as trustee (the "Trustee"). The Conduit Mortgage Pass-Through Certificates, Series 1992-1 will be comprised of ten classes of publicly offered certificates (the "Certificates"). The Certificates consist of the Class 1-R, Class 1-A, Class 1-B, Class 1-C, Class 1-D, Class 1-E and Class 1-M Certificates (collectively, the "Fixed Rate Certificates") and the Class 1-F, Class 1-G and Class 1-H Certificates. The Certificates evidence beneficial ownership interests in a trust fund (the "Trust Fund") to be created by First Boston Mortgage Securities Corp. (the "Depositor"), which will hold interests in a pool of conventional, level-payment, fixed-rate, fully-amortizing mortgage loans (the "Mortgage Loans") secured by deeds of trust on residential properties and certain other property held in trust for the benefit of the Certificateholders. The Mortgage Loans will be purchased by the Depositor from an affiliate and transferred by the Depositor to the Trust Fund pursuant to a Pooling and Servicing Agreement, dated as of January 1, 1992, in exchange for the Certificates and certain other consideration. The Mortgage Loans are more fully described in the Prospectus Supplement. Information with respect to the business of the Trust would not be meaningful because the only "business" of the Trust is the collection on the Mortgage Loans and distribution of payments on the Certificates to Certificateholders. This information is accurately summarized in the Monthly Reports to Certificateholders, which are filed on Form 8-K. There is no additional relevant information to report in response to Item 101 of Regulation S-K. ITEM 2. ITEM 2. Properties. The Depositor owns no property. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1992-1, in the aggregate, represent the beneficial ownership in a Trust consisting primarily of the Mortgage Loans. The Trust will acquire title to real estate only upon default of the mortgagors under the Mortgage Loan. Therefore, this item is inapplicable. 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 Certificateholders during the fiscal year covered by this report. PART II ITEM 5. ITEM 5. Market for Depositor's Common Equity and Related Stockholder Matters. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1992-1 represent, in the aggregate, the beneficial ownership in a trust fund consisting primarily of the Mortgage Loans. The Certificates are owned by Certificateholders as trust beneficiaries. Strictly speaking, Depositor has no "common equity," but for purposes of this Item only, Depositor's Conduit Mortgage Pass-Through Certificates are treated as "common equity." (a) Market Information. There is no established public trading market for Depositor's Notes. Depositor believes the Notes are traded primarily in intra-dealer markets and non-centralized inter-dealer markets. (b) Holders. The number of registered holders of all classes of Certificates on (see item 12(a)for dates) was 7. (c) Dividends. Not applicable. The information regarding dividend required by sub-paragraph (c) of Item 201 of Regulation S-K is inapplicable because the Trust does not pay dividends. However, information as to distribution to Certificateholders is provided in the Monthly Reports to Certificateholders for each month of the fiscal year in which a distribution to Certificateholders was made. ITEM 6. ITEM 6. Selected Financial Data. Not Applicable. Because of the limited activities of the Trust, the Selected Financial Data required by Item 301 of Regulation S-K does not add relevant information to that provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Not Applicable. The information required by Item 303 of Regulation S-K is inapplicable because the Trust does not have management per se, but rather the Trust has a Trustee who causes the preparation of the Monthly Reports to Certificateholders. The information provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K, does provide the relevant financial information regarding the financial status of the Trust. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. Monthly Remittance Statement to the Certificateholders as to distributions made on February 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on March 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on April 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on May 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on July 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 28, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Annual Statement of Compliance by the Master Servicer is not currently available and will be subsequently filed on Form 8. Independent Accountant's Report on Servicer's will be subsequently filed on Form 8. 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 Depositor. Not Applicable. The Trust does not have officers or directors. Therefore, the information required by items 401 and 405 of Regulation S-K are inapplicable. ITEM 11. ITEM 11. Executive Compensation. Not Applicable. The Trust does not have officers or directors to whom compensation needs to be paid. Therefore, the information required by item 402 of regulation S-K is inapplicable. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. (a) Security ownership of certain beneficial owners. Under the Pooling and Servicing Agreement governing the Trust, the holders of the Certificates generally do not have the right to vote and are prohibited from taking part in management of the Trust. For purposes of this Item and Item 13 ITEM 13. Certain Relationships and Related Transactions. (a) Transactions with management and others. Depositor knows of no transaction or series of transactions during the fiscal year ended December 31, 1992, or any currently proposed transaction or series of transactions, in an amount exceeding $60,000 involving the Depositor in which the Certificateholders identified in Item 12(a) had or will have a direct or indirect material interest. There are no persons of the types described in Item 404(a)(1),(2) and (4) of Regulation S-K, however, the information required by Item 404(a)(3) of Regulation S-K is hereby incorporated by reference in Item 12 herein. (b) Certain business relationships. None. (c) Indebtedness of management. Not Applicable. The Trust does not have management consisting of any officers or directors. Therefore, the information required by item 404 of Regulation S-K is inapplicable. (d) Transactions with promoters. Not Applicable. The Trust does not use promoters. Therefore, the information required by item 404 of Regulation S-K is inapplicable. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following is a list of documents filed as part of this report: EXHIBITS Monthly Remittance Statement to the Certificateholders as to distributions made on February 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on March 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on April 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on May 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on July 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 28, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. (c) The exhibits required to be filed by Depositor pursuant to Item 601 of Regulation S-K are listed above and in the Exhibit Index that immediately follows the signature page hereof. (d) Not Applicable. The Trust does not have any subsidiaries or affiliates. Therefore, no financial statements are filed with respect to subsidiaries or affiliates. Supplemental information to be furnished with reports filed pursuant to Section 15(d) by Depositors which have not registered securities pursuant to Section 12 of the Act. No annual report, proxy statement, form of proxy or other soliciting material has been sent to Certificateholders, and the Depositor does not contemplate sending any such materials subsequent to the filing of this report. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Depositor has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: Bankers Trust Company of California, N.A. not in its individual capacity but solely as a duly authorized agent of the Registrant pursuant to the Pooling and Servicing Agreement, dated as of January 1, 1992. By: /s/Judy L. Gomez Judy L. Gomez Assistant Vice President Date: March 3, 1999 EXHIBIT INDEX Exhibit Document 1.1 Monthly Remittance Statement to the Certificateholders as to distributions made on February 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.2 Monthly Remittance Statement to the Certificateholders as to distributions made on March 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.3 Monthly Remittance Statement to the Certificateholders as to distributions made on April 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.4 Monthly Remittance Statement to the Certificateholders as to distributions made on May 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.5 Monthly Remittance Statement to the Certificateholders as to distributions made on July 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.6 Monthly Remittance Statement to the Certificateholders as to distributions made on September 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.7 Monthly Remittance Statement to the Certificateholders as to distributions made on October 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.8 Monthly Remittance Statement to the Certificateholders as to distributions made on November 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.9 Monthly Remittance Statement to the Certificateholders as to distributions made on December 28, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.10 The Pooling and Servicing Agreement of the Registrant dated as of January 1, 1992 (hereby incorporated herein by reference and filed as part of the Registrant's Current Report on Form 8-K filed with Securities and Exchange Commission on February , 1999.

825541_1993.txt

825541_1993

1993

825541

Item 1. Business General Silgan Corporation (the "Company" or "Silgan") is a major manufacturer and seller of a broad range of steel and aluminum containers for the food and pet food markets and plastic containers for the personal care, food, pharmaceutical and household markets in the United States. In 1993, the Company had net sales of $645 million. On December 21, 1993, the Company's wholly owned subsidiary, Silgan Containers Corporation ("Containers"), acquired from Del Monte Corporation ("Del Monte") substantially all of the fixed assets and certain working capital of Del Monte's container manufacturing business in the United States ("DM Can") for approximately $73 million. See "Company History" below. In connection therewith, Containers and Del Monte entered into a ten-year supply agreement (the "DM Supply Agreement") pursuant to which Containers supplies substantially all of the metal container requirements of Del Monte. On a pro forma basis giving effect to the acquisition of DM Can, in 1993 the Company would have had net sales of $818 million. See "Sales and Marketing" below. Management believes that the Company is the largest food can producer in the United States (based on pro forma unit sales after giving effect to the acquisition of DM Can) and one of the largest producers in the United States of high density polyethylene ("HDPE") containers for the personal care market and a major producer of custom polyethylene terephthalate ("PET") products for the personal care and food markets. The Company has experienced significant growth since its inception in 1987 as a result of its acquisitions and related increased market position. Management estimates that Containers is currently the nation's largest manufacturer of metal food containers and that in 1993 Containers sold approximately 27% of all metal food containers sold in the United States by non-captive manufacturers (manufacturers of containers not owned by a user of containers) and approximately 16% of all metal food containers sold in the United States, in each case based on unit sales. On a pro forma basis giving effect to the acquisition of DM Can, Containers would have sold approximately 34% of all metal food containers sold in the United States by non-captive manufacturers and approximately 22% of all metal food containers sold in the United States. Although the food can industry in the United States is relatively stable and mature in terms of unit sales growth, Containers, on a pro forma basis after giving effect to the acquisition of DM Can, has realized compound annual unit sales growth in excess of 12% since 1987. Types of containers manufactured include those for vegetables, fruit, pet food, tomato based products, evaporated milk and infant formula. Containers has agreements (the "Nestle' Supply Agreements") with Nestle' Food Company ("Nestle'"), formerly known as The Carnation Company ("Carnation"), pursuant to which Containers supplies substantially all of the can requirements of the former Carnation operations of Nestle'. In addition to the Nestle' Supply Agreements and the DM Supply Agreement, Containers has other long-term supply arrangements with other customers. The Company estimates that in excess of 80% of Containers' sales in 1994 will be pursuant to long-term supply arrangements. See "Sales and Marketing" below. Management believes that the Company's wholly owned subsidiary, Silgan Plastics Corporation ("Plastics"), is one of the leading manufacturers of plastic containers sold in the United States for the personal care, household and pharmaceutical markets served by the Company. Plastic containers manufactured by Plastics include personal care containers for shampoos, conditioners, hand creams, lotions and cosmetics, household containers for light detergent liquids, scouring cleaners and specialty cleaning agents and pharmaceutical containers for tablets, laxatives and eye cleaning solutions. Plastics is also one of the leading manufacturers of PET containers sold in the United States for applications other than soft drinks. Plastics manufactures custom PET medicinal and health care product containers (such as mouthwash bottles), custom narrow-neck food product containers (such as salad dressing bottles), custom wide-mouth food product containers (such as mayonnaise and peanut butter containers) and custom non-soft drink beverage product containers (such as juice, water and liquor bottles). The Company's strategy is to continue to improve its market position and profitability through focus on product quality, customer service, cost efficiencies, strategic acquisitions and market share growth through customers experiencing market share growth. At Containers, management has focused on achieving operating cost advantages over its competitors, primarily through low labor costs, low overhead, technologically advanced manufacturing processes and by exploiting the favorable geographic locations of its 22 can plants. Since its inception in 1987, Containers has invested more than $82 million in its existing manufacturing facilities and has spent approximately $66 million for the purchase of additional can manufacturing assets. As a result of these efforts and management's focus on quality and service, Containers has increased its overall share of the food can market by approximately 100% in terms of unit sales, from a share of approximately 11% in 1987 to a share of approximately 22% in 1993, on a pro forma basis giving effect to the acquisition of DM Can. Plastics has increased its market position primarily by strategic acquisitions. From a sales base of $89 million in 1987, Plastics' sales increased to $186 million in 1993, or 13% on a compound annual basis. While many of Plastics' larger competitors employ technology oriented to large bottles and long production runs, Plastics has focused on mid-sized, extrusion blow-molded plastic containers requiring special decoration and shorter production runs. Plastics emphasizes value-added fabrication of the container, creative design and sophisticated decoration processes. Plastics is also aggressively pursuing new markets for plastic containers, including the post-consumer recycled ("PCR") resin segment of the market. Based upon published information and management's experience in the industry, management believes that PET custom containers are replacing glass containers for products such as mouthwash, salad dressing, peanut butter and liquor. Management also believes that Plastics is well positioned because of its technologically advanced equipment to respond to opportunities for future growth in the rigid plastic container market. Furthermore, to the extent that mandatory recycling laws, customer preferences or manufacturing costs result in increased demand for HDPE containers that are manufactured using PCR resins, the Company believes that its proprietary equipment is particularly well-suited for the production of such containers because of the relatively low capital costs required to convert its equipment from the use of virgin resins. The Company is also engaged in the manufacture and sale of paper containers primarily used by processors and packagers in the food industry. Sales of paper containers in 1993 were approximately $13 million. The Company is a Delaware corporation formed in August 1987 as a holding company to acquire interests in various packaging manufacturers. Prior to 1987, the Company did not engage in any business. In June 1989, the Company became a wholly owned subsidiary of Silgan Holdings Inc. ("Holdings"), a Delaware corporation whose principal asset is all of the outstanding common stock of the Company. See "Company History" below. Products The Company is engaged in the manufacture and sale of steel and aluminum containers that are used primarily by processors and packagers in the food and pet food industries. Types of containers manufactured include those for vegetables, fruit, pet food, tomato based products, evaporated milk and infant formula. The Company does not produce cans for use in the beer or soft drink industries. Cans are produced in a variety of sizes, ranging in diameter from 2-1/8 inches to 6-3/16 inches and in height from 1-7/16 inches to 7 inches. The Company is also engaged in the manufacture and sale of plastic containers primarily used in the personal care, food, beverage (other than carbonated soft drinks), household and pharmaceutical container markets. Plastic containers are produced by converting thermoplastic materials into plastic containers ranging in size from 1/2 to 96 ounces. Emphasis is on value-added fabrication of the container and the decoration process. The Company designs and manufactures a wide range of containers for toiletries and cosmetic products such as shampoos, hand creams and lotions. Because toiletries and cosmetic products are characterized by short product life and a demand for creative packaging, the containers manufactured for these products generally have more sophisticated designs and decorations. Food and beverage containers are designed and manufactured (generally to unique specifications for a specific customer) to contain products such as mouthwash, salad dressing, peanut butter, coffee, juice, water and liquor. Household containers are designed and manufactured to contain light-duty dishwasher and heavy-duty laundry detergents, bleach, polishes, specialty cleaning agents, insecticides and liquid household products. Pharmaceutical containers are designed and manufactured (either in a generic or in a custom-made form) to contain tablets, solutions and similar products for the ethical and over-the-counter markets. Manufacturing and Production The Company uses three basic processes to produce cans. The traditional three-piece method requires three pieces of flat metal to form a cylindrical body with a welded side seam, a bottom and a top. The Company uses a welding process for the side seam of three-piece cans to achieve a superior seal. High integrity of the side seam is further assured by the use of sophisticated electronic weld monitors and organic coatings that are thermally cured by induction and convection processes. The other two methods of producing cans start by forming a shallow cup that is then formed into the desired height using either the draw and iron process or the draw and redraw process. Using the draw and redraw process, the Company manufactures steel and aluminum two-piece cans, the height of which does not exceed the diameter. For cans the height of which is greater than the diameter, the Company also manufactures steel two-piece cans by using a drawing and ironing process. Quality and stackability of such cans are comparable to that of the shallow two-piece cans described above. Can bodies and ends are manufactured from thin, high-strength aluminum alloys and steels by utilizing proprietary tool and die designs and selected can making equipment. The Company's manufacturing operations include cutting, coating, lithographing, fabricating, assembling and packaging finished cans. The Company utilizes two basic processes to produce plastic bottles. In the blow molding process, pellets of plastic resin are heated and extruded into a tube of plastic. A two-piece metal mold is then closed around the plastic tube and high pressure air is blown into it causing a bottle to form in the mold's shape. In the injection blow molding process, pellets of plastic resin are heated and injected into a mold, forming a plastic tube. The plastic tube is then blown into a bottle-shaped metal mold, creating a plastic bottle. The Company believes that its proprietary equipment for the production of HDPE containers is particularly well-suited for the use of PCR resins because of the relatively low capital costs required to convert its equipment from the use of virgin resins. The Company's decorating methods for its plastic products include (i) silk screen decoration, which enables the application of one to six images in multiple colors to the bottle, (ii) post-molding decoration, which uses paper labels applied to the bottles with glue and (iii) pressure-sensitive decoration, which applies a paper label to a post-molded bottle by pressing against the bottle. The Company has state-of-the-art decorating equipment, including, management believes, one of the largest sophisticated decorating facilities in the Midwest, which allows the Company to custom-design new products with short lead times. As is the practice in the industry, most of the Company's can and plastic container customers provide it with annual estimates of products and quantities pursuant to which periodic commitments are given. Such estimates enable the Company to effectively manage production and control working capital requirements. At December 31, 1993, Containers had in excess of 80% of its projected 1994 sales under long-term contracts. Plastics has written purchase orders or contracts for containers with the majority of its customers. In general, these purchase orders and contracts are for containers made from proprietary molds and are for a duration of 2-5 years. Both Containers and Plastics schedule their production to meet their customers' requirements. Because the production time for the Company's products is short, the backlog of customer orders in relation to sales is not significant. Raw Materials The Company uses tin plated and chromium plated steel, aluminum, copper wire, organic coatings, lining compound and inks in the manufacture and decoration of its metal can products. The Company's steel and other material requirements are supplied through purchase orders with suppliers with whom the Company, through its predecessors, has long-term relationships or through open market purchases. The Company has a contract to obtain the majority of its requirements for aluminum at prices that are subject to adjustment based on formulas and market conditions. Such contract expires in 1996. The Company believes that it would be able to satisfy its requirements for aluminum from other suppliers in the event of the loss of the current supplier. The Company believes that it will be able to purchase sufficient quantities of steel and aluminum can sheet for the foreseeable future. The raw materials used by the Company for the manufacture of plastic containers are primarily resins in pellet form such as PCR and virgin HDPE and PET and, to a lesser extent, low density polyethylene, extrudable polyester terephthalate, polyethylene terephthalate glycol, polypropylene, polyvinyl chloride and medium density polyethylene. The Company's resin requirements are acquired through a series of informal annual purchase orders for specific quantities of resins with several suppliers of resins. The price the Company pays to purchase resin is determined at the time of purchase. The Company believes that it will be able to purchase sufficient quantities of resin for the foreseeable future. The Company does not believe that it is materially dependent upon any single supplier for any of its raw materials and, based upon the existing arrangements with suppliers discussed above, its current and anticipated requirements and market conditions, the Company believes that it has made adequate provisions for acquiring raw materials. Although increases in the prices of raw materials have generally been passed along to the Company's customers, the inability to do so in the future could have a significant impact on the Company's operating margins. In addition, should any of its suppliers fail to deliver under their arrangements, the Company would be forced to purchase raw materials on the open market, and no assurances can be given that it would be able to make such purchases at prices which would allow it to remain competitive. Sales and Marketing The Company markets its products in most areas of the continental United States primarily by a direct sales force through regional sales offices. Because of the high cost of transporting empty containers, the Company generally sells to customers within a 300 mile radius of its manufacturing plants. See also "Competition" below. In 1987, the Company, through Containers, and Nestle' entered into the Nestle' Supply Agreements pursuant to which Containers has agreed to supply Nestle' with, and Nestle' has agreed to purchase from Containers, substantially all of the can requirements of the former Carnation operations of Nestle' for a period of ten years, subject to certain conditions. The Nestle' Supply Agreements provide for certain prices and specify that such prices will be increased or decreased based upon cost change formulas set forth therein. During the duration of the Nestle' Supply Agreements, if Nestle' receives a competitive bid for any product supplied, Containers has the right to match such bid with respect to the type and volume of cans over the period of the competitive bid. In the event that Containers chooses not to match a competitive bid, Nestle' may purchase cans from the competitive bidder at the competitive bid price for the term of the bid. The Nestle' Supply Agreements contain provisions that require Containers to maintain certain levels of product quality, service and delivery in order to retain the Nestle' business. In the event of a breach of a particular Nestle' Supply Agreement, Nestle' may terminate such Nestle' Supply Agreement but the other Nestle' Supply Agreements would remain in effect. Since 1990, Nestle' has requested that Containers match certain bids received from other potential suppliers. Containers agreed to match such bids (which resulted in minor margin impact) and continues to supply substantially all of the can requirements of the former Carnation operations of Nestle'. In the future, there can be no assurance that Containers will choose to match any such bids or that, even if matched, such bids will be at a level sufficient to allow Containers to maintain margins currently received. Until any such bids are received by Nestle' and submitted to the Company, the Company cannot predict the effect, if any, of such bids upon its financial condition or results of operations. Significant reductions of margins or the loss of significant unit volume under the Nestle' Supply Agreements could, however, have a material adverse effect on the Company. On December 21, 1993, Containers and Del Monte entered into the DM Supply Agreement. Under the DM Supply Agreement, Del Monte has agreed to purchase from Containers, and Containers has agreed to sell to Del Monte, 100% of Del Monte's annual requirements for metal containers to be used for the packaging of food and beverages in the United States and not less than 65% of Del Monte's annual requirements of metal containers for the packaging of food and beverages at Del Monte's Irapuato, Mexico facility, subject to certain limited exceptions. The DM Supply Agreement provides for certain prices for all metal containers supplied by Containers to Del Monte thereunder and specifies that such prices will be increased or decreased based upon specified cost change formulas. Under the DM Supply Agreement, after five years, Del Monte may, under certain circumstances, receive proposals with terms more favorable than those under the DM Supply Agreement from independent commercial can manufacturers for the supply of containers of a type and quality similar to the metal containers that Containers furnishes to Del Monte, which proposals shall be for the remainder of the term of the DM Supply Agreement and for 100% of the annual volume of containers at one or more of Del Monte's canneries. Containers has the right to retain the business subject to the terms and conditions of such competitive proposal. The sale of metal containers to vegetable pack customers is seasonal and monthly revenues increase during the months of June through October. As is common in the packaging industry, the Company must build inventory and then carry accounts receivable for some seasonal vegetable pack customers beyond the end of the harvest season. Consistent with industry practice, such customers may return unused containers. Historically, such returns have been minimal. As part of its marketing strategy, the Company has arrangements to sell some of its plastic products to distributors, which in turn sell such products primarily to small-size regional customers. Plastic containers sold to distributors are manufactured by using generic molds with decoration, color and neck finishes added to meet the distributors' individual requirements. The distributors' warehouses and their sales personnel enable the Company to market and inventory a wide range of such products to a variety of customers. In 1993, 1992 and 1991, metal containers accounted for approximately 69%, 68% and 64%, respectively, of the Company's total sales, and plastic containers accounted for approximately 29%, 30% and 34%, respectively, of the Company's total sales. On a pro forma basis after giving effect to the acquisition of DM Can, metal and plastic containers in 1993 would have accounted for approximately 76% and 23% of the Company's total sales, respectively. The Company's total sales of paperboard cartons accounted for approximately 2% of the Company's total sales in each of 1993, 1992 and 1991. In 1993, 1992 and 1991, approximately 34%, 37% and 32%, respectively, of the Company's sales were to Nestle'. On a pro forma basis after giving effect to the acquisition of DM Can, approximately 27% of the Company's 1993 sales would have been to Nestle' and 21% of the Company's 1993 sales would have been to Del Monte. No other customer accounted for more than 10% of the Company's total sales during such years. Competition The packaging industry is highly competitive. The Company competes in this industry with other packaging manufacturers as well as fillers, food processors and packers who manufacture containers for their own use and for sale to others. The Company attempts to compete effectively through the quality of its products, pricing and its ability to meet customer requirements for delivery, performance and technical assistance. The Company also pursues market niches such as the manufacture of easy-open ends and special feature cans, which may differentiate the Company's products from its competitors' products. Management believes that the market for metal food containers is mature. Some self-manufacturers have sold or closed can manufacturing operations and entered into long-term supply agreements with the new owners or with commercial can manufacturers. Of the commercial metal can manufacturers, Crown Cork and Seal Company, Inc., American National Can Company and Ball Corporation (through its Heekin Can operations) are the Company's most significant competitors. Although metal containers face continued competition from plastic, paper and composite containers, management believes that metal containers are superior to plastic and paper containers in industry sectors where the contents are processed at high temperatures, where the contents are packaged in large or institutional quantities (14 to 64 oz.) or where long-term storage of the product is desirable. Such sectors include canned vegetables, fruits, meats, juices, non-carbonated beverages and pet foods. These sectors are the principal areas for which the Company manufactures its products. Plastics competes with a number of large national producers of food, beverage and household plastic container products, including Owens-Brockway Plastics Products, a division of Owens-Illinois, Inc., Plastic Containers Inc., Johnson Controls Inc., Constar Plastics Inc., a subsidiary of Crown Cork and Seal Company, Inc., Graham Packaging Co. and Plastipak Packaging Inc. In order to compete effectively in the constantly changing market for plastic bottles, the Company must remain current with, and to some extent anticipate innovations in, resin composition and applications and changes in the manufacturing of plastic bottles. Because of the high cost of transporting empty containers, the Company generally sells to customers within a 300 mile radius of its manufacturing plants. Strategically located existing plants give the Company an advantage over competitors from other areas, and the Company would be disadvantaged by the loss or relocation of a major customer. As of February 28, 1994, the Company operated 35 manufacturing facilities, geographically dispersed throughout the United States and Canada, that serve the distribution needs of its customers. Employees As of December 31, 1993, the Company employed approximately 630 salaried and 3,350 hourly employees on a full time basis, including 650 employees who joined the Company on December 21, 1993 as a result of the acquisition of DM Can. Approximately 60% of the Company's hourly plant employees are represented by one of the following unions: (i) Sheet Metal Workers International Association, (ii) International Association of Machinists and Aerospace Workers, (iii) The International Brotherhood of Teamsters, (iv) The United Steel Workers of America, (v) Industrial, Technical & Professional Employees Union, (vi) The Glass, Molders, Pottery, Plastics and Allied Workers International Union, (vii) The United Rubber, Cork and Plastic Workers of America and (viii) Oil, Chemical & Atomic Workers International Union. The Company's labor contracts expire at various times between 1994 and 1998. Contracts covering approximately 14% of the Company's hourly employees presently expire during 1994. The Company expects no significant changes in its relations with these unions. Management believes that its relationship with its employees is good. Regulation The Company is subject to federal, state and local environmental laws and regulations. In general, these laws and regulations limit the discharge of pollutants into the air and water and establish standards for the treatment, storage, and disposal of solid and hazardous waste. The Company believes that all of its facilities are either in compliance in all material respects with all presently applicable environmental laws and regulations or are operating in accordance with appropriate variances, delayed compliance orders or similar arrangements. In the past, the Company inadvertently made late filings with the federal Environmental Protection Agency under the Emergency Planning and Community Right to Know Act ("EPCRA"). The Company is currently in compliance in all material respects with EPCRA. In addition to costs associated with regulatory compliance, the Company may be held liable for alleged environmental damage associated with the past disposal of hazardous substances. Generators of hazardous substances disposed of at sites at which environmental problems are alleged to exist, as well as the owners of those sites and certain other classes of persons, are subject to claims under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA") regardless of fault or the legality of the original disposal. Liability under CERCLA and under many similar state statutes is joint and several, and, therefore, any responsible party may be held liable for the entire cleanup cost at a particular site. Other state statutes may impose proportionate rather than joint and several liability. The federal Environmental Protection Agency or a state agency may also issue orders requiring responsible parties to undertake removal or remedial actions at certain sites. Pursuant to the agreement relating to the acquisition in 1987 of the metal container manufacturing division of Nestle' ("Nestle' Can"), the Company has assumed liability for the past waste disposal practices of Nestle' Can. The Company has received notice that it is one of many potentially responsible parties (or similarly designated parties) for cleanup of hazardous waste at two sites to which it (or its predecessor Nestle' Can) is alleged to have shipped such waste, one site at which the Company's share of cleanup costs could exceed $100,000. See "Legal Proceedings." Pursuant to the agreement relating to the acquisition in 1987 from Monsanto Company ("Monsanto") of substantially all of the business and related fixed assets and inventory of Monsanto's plastic containers business ("Monsanto Plastic Containers"), Monsanto has agreed to indemnify the Company for substantially all of the costs attributable to the past waste disposal practices of Monsanto Plastic Containers. In connection with the acquisition of DM Can, Del Monte has agreed to indemnify the Company for a period of three years for substantially all of the costs attributable to any noncompliance by DM Can with any environmental law prior to the closing, including all of the costs attributable to the past waste disposal practices of DM Can. The Company is subject to the Occupational Safety and Health Act and other laws regulating noise exposure levels in the production areas of its plants. Management does not believe that any of the matters described above individually or in the aggregate will have a material effect on the Company's capital expenditures, earnings, financial position or competitive position. Research and Technology The Company's research, product development and product engineering efforts relating to its metal containers are conducted at its research center at Oconomowoc, Wisconsin and at other plant locations. The Company's research, product development and product engineering efforts with respect to its plastic containers are currently performed by its manufacturing and engineering personnel located at its Norcross, Georgia facility. In addition to its own research and development staff, the Company participates in arrangements with four non-U.S. plastic container manufacturers that call for an exchange of technology among these manufacturers. Pursuant to these arrangements, the Company licenses its blow molding technology to such manufacturers. Company History The Company was organized in August 1987 as a holding company to acquire interests in various packaging manufacturers. On August 31, 1987, the Company, through Containers, purchased from Nestle' the business and related assets and working capital of Nestle' Can for approximately $151 million in cash and the assumption of substantially all of the liabilities of Nestle' Can. Also on August 31, 1987, the Company, through Plastics, purchased from Monsanto substantially all the business and related fixed assets and inventory of Monsanto Plastic Containers for approximately $43 million in cash and the assumption of certain liabilities of Monsanto Plastic Containers. To finance these acquisitions and to pay related fees and expenses, the Company raised approximately $222.5 million on August 31, 1987 by issuing $6 million of common stock, $15 million of its 15% Cumulative Exchangeable Redeemable Preferred Stock (the "Preferred Stock") and $85 million of its 14% Senior Subordinated Notes due 1997 (the "14% Notes") and by borrowing $116.5 million under its credit agreement. During 1988, Containers acquired from The Dial Corporation its metal container manufacturing division known as the Fort Madison Can Company ("Fort Madison"), and from Nestle' its carton manufacturing division known as the Seaboard Carton Division ("Seaboard"). During 1989, Plastics acquired Aim Packaging, Inc. ("Aim") and Fortune Plastics, Inc. ("Fortune") in the United States, and Express Plastic Containers Limited ("Express") in Canada, to improve its competitive position in the HDPE container market. Such acquisitions were financed through additional borrowings under the Company's credit agreement. Holdings was organized in April 1989 as a holding company to acquire all of the outstanding common stock of the Company. On June 30, 1989, Silgan Acquisition, Inc. ("Acquisition"), a wholly owned subsidiary of Holdings, merged with and into the Company, and the Company became a wholly owned subsidiary of Holdings (the "1989 Mergers"). In connection with the 1989 Mergers, Holdings received $109.4 million in proceeds from the issuance of $120 million aggregate principal amount of its Senior Reset Debentures due 2004 (the "Holdings Reset Debentures"), net of debt issuance costs of $10.1 million. Additionally, Holdings received $14.6 million in proceeds from the issuance of its Class B Common Stock. With such proceeds, payments of $69.9 million were made to Silgan's stockholders and stock option holders in connection with the 1989 Mergers and $25.2 million was advanced to Silgan and used by Silgan to repay working capital loans. The balance of such proceeds, along with additional term loan borrowings under the Company's credit agreement of $24.0 million and a capital contribution of $5.0 million by the stockholders of Silgan P.E.T. Holdings Inc. ("SPHI"), was used by Holdings in connection with the purchase of Silgan P.E.T. Corp. ("Silgan PET") on August 1, 1989 for $51.4 million, including $2.2 million of acquisition costs. In 1989, Silgan PET, a wholly owned subsidiary of SPHI, acquired the business and related assets of Amoco Container Company ("Amoco Container"). On July 13, 1990, Holdings and the Company entered into a business combination (the "SPHI Business Combination") pursuant to which SPHI became a majority owned subsidiary of the Company. The SPHI Business Combination was accounted for in a manner similar to a pooling of interests. See "Selected Financial Data." In November 1991, Plastics sold its nonstrategic PET carbonated beverage bottle business (the "PET Beverage Sale"), exiting that commodity business. In 1992, Silgan and Holdings refinanced a substantial portion of their indebtedness (the "Refinancing") pursuant to a plan to improve their financial flexibility. The Refinancing included the following: (i) the public offering in June 1992 by Silgan of $135 million principal amount of its 11-3/4% Senior Subordinated Notes due 2002 (the "11-3/4% Notes"); (ii) the private placement in June 1992 by Silgan of $50 million principal amount of its Senior Secured Floating Rate Notes due 1997 (the "Secured Notes") with certain institutional investors; (iii) the public offering in June 1992 by Holdings of its 13-1/4% Senior Discount Debentures due 2002 (the "Discount Debentures") for an aggregate amount of proceeds of $165.4 million; (iv) the amendment of the Amended and Restated Credit Agreement, dated as of August 31, 1987, as amended (the "Amended and Restated Credit Agreement") among Silgan and certain of its subsidiaries, the lenders named therein and Bankers Trust Company ("Bankers Trust"), as agent, followed by the prepayment in June 1992 by Silgan of $30 million of term loans and the borrowing by Silgan of approximately $17 million of working capital loans under the Amended and Restated Credit Agreement; (v) the redemption in August 1992 of all of the outstanding 14% Notes (the "14% Notes Redemption"); (vi) the redemption in August 1992 of all of the outstanding Preferred Stock (the "Preferred Stock Redemption"); (vii) the repayment by Silgan of a $25.2 million advance from Holdings and the payment to Holdings of a $15.7 million dividend; (viii) the payment by Holdings in cash of $15.3 million of interest payable on July 1, 1992 on the Holdings Reset Debentures; (ix) the redemption by Holdings in July 1992 of all of the outstanding Holdings Reset Debentures (the "Holdings Reset Debentures Redemption;" together with the "14% Notes Redemption" and the "Preferred Stock Redemption" being sometimes herein referred to as the "Redemptions"); and (x) the payment of transaction fees and expenses relating to the Refinancing. Additionally, in June 1992 the Company merged Aim, Fortune, Silgan PET and SPHI into Plastics. On December 21, 1993, Containers acquired from Del Monte substantially all of the fixed assets and certain working capital of Del Monte's container manufacturing business in the United States for a purchase price of approximately $73 million and the assumption of certain limited liabilities. To finance the acquisition, (i) Silgan, Containers and Plastics (collectively, the "Borrowers"), entered into a credit agreement, dated as of December 21, 1993 (the "Credit Agreement") with the lenders from time to time party thereto (the "Banks"), Bank of America National Trust and Savings Association ("Bank of America"), as Co-Agent, and Bankers Trust, as Agent, and (ii) Holdings issued and sold to Mellon Bank, N.A., as trustee for First Plaza Group Trust, a group trust established under the laws of the State of New York ("First Plaza"), 250,000 shares of its Class B Common Stock, par value $.01 per share (the "Holdings Stock"), for a purchase price of $60.00 per share and an aggregate purchase price of $15 million. Additionally, Silgan, Containers and Plastics borrowed term and working capital loans under the Credit Agreement to refinance and repay in full all amounts owing under the Amended and Restated Credit Agreement. Item 2. Item 2. Properties Silgan's and Holdings' principal executive offices are located at 4 Landmark Square, Stamford, Connecticut 06901. The administrative headquarters and principal places of business for Containers and Plastics are located at 21800 Oxnard Street, Woodland Hills, California 91367 and 16216 Baxter Road, Suite 300, St. Louis, Missouri 63017, respectively. All of these offices are leased by the Company. The Company owns and leases properties for use in the ordinary course of business. Such properties consist primarily of 22 metal container manufacturing facilities, 12 plastic container manufacturing facilities and one paper container manufacturing facility. Eighteen of these facilities are owned and 17 are leased by the Company. The leases expire at various times through 2020. Some of these leases provide for options to purchase or to renew the lease. Below is a list of the Company's operating facilities, including attached warehouses, as of February 28, 1994: Approximate Building Area Location (square feet) -------- -------------- Anaheim, CA 127,000 (leased) Kingsburgh, CA 37,783 (leased) Modesto, CA 35,585 (leased) Oakland, CA 173,780 (leased) Riverbank, CA 167,000 Stockton, CA 243,500 Stockton, CA 71,785 (leased) Deep River, CT 140,000 Monroe, GA 117,000 Norcross, GA 59,000 (leased) Broadview, IL 85,000 Rochelle, IL 175,000 Ft. Dodge, IA 49,500 (leased) Fort Madison, IA 66,000 Ligonier, IN 284,000 (leased) Seymour, IN 406,000 Franklin, KY 118,000 (leased) Louisville, KY 30,000 (leased) Maysville, KY 31,300 Mt. Vernon, MO 100,000 St. Joseph, MO 173,725 Port Clinton, OH 336,000 (leased) Hillsboro, OR 47,000 Cambridge Springs, PA 55,000 Langhorne, PA 156,000 (leased) Crystal City, TX 26,045 (leased) Smithfield, UT 105,000 Toppenish, WA 98,000 Menomonee Falls, WI 116,000 Menomonie, WI 60,000 (leased) Oconomowoc, WI 105,200 Plover, WI 44,495 (leased) Waupun, WI 212,000 Mississauga, Ontario 80,000 (leased) Mississauga, Ontario 60,000 (leased) The Company owns and leases certain other warehouse facilities that are detached from its manufacturing facilities. In addition, the Company owns four other properties, two of which the Company subleases to a third party and intends to sell and the other two of which the Company is not currently using and intends to sell or sublease. The Company believes that its plants, warehouses and other facilities are in good operating condition, adequately maintained, and suitable to meet its present needs and future plans. The Company believes that it has sufficient capacity to satisfy the demand for its products in the foreseeable future. To the extent that the Company needs additional capacity, management believes that the Company can convert certain facilities to continuous operation or make the appropriate capital expenditures to increase capacity. Item 3. Item 3. Legal Proceedings Fidelity and EQJ Complaints. On June 28, 1989, a complaint was filed in the Court of Chancery in the State of Delaware in and for New Castle County jointly by Fidelity Bankers Life Insurance Company ("Fidelity"), which was the beneficial holder of 150,000 shares of Class B common stock of the Company, and Ince & Co. ("Ince," together with Fidelity, sometimes hereinafter referred to as the "Fidelity Plaintiffs"), which was the registered owner of Fidelity's shares, against the Company, Holdings, Morgan Stanley & Co. Incorporated ("Morgan Stanley"), certain officers, directors and majority stockholders of the Company and certain other parties (the "Fidelity Complaint"). In addition, on September 14, 1989, a second complaint was filed in the Court of Chancery in the State of Delaware in and for New Castle County jointly by EQJ Partnership, Equitable Life Assurance Society of the United States, Integrity Life Insurance Company, Kleinwort Benson Limited, Merrill Lynch Corporate Bond Fund, Inc., New Locke Fund, SAM Associates, L.P., the beneficial holder of shares of Class B common stock of the Company held in the name of Calmont & Co., as nominee, and SIB Nominees Ltd. (the "EQJ Plaintiffs"), which plaintiffs were the beneficial holders of an aggregate of 900,000 shares of Class B common stock of the Company, against the Company, Holdings, Acquisition and directors of the Company (the "EQJ Complaint," together with the Fidelity Complaint, sometimes hereinafter referred to as the "Complaints"). Although filed separately, the Complaints are similar and allege, among other things, that the defendants breached their fiduciary duties of loyalty and candor under Delaware law to minority stockholders of the Company by engaging in unfair dealings, attempting to effect a merger at a grossly inadequate price and distributing misleading proxy materials. See "Business-Company History." The Complaints also allege that various defendants aided and abetted these purported breaches of fiduciary duties. The Complaints ask the court, among other things, to rescind the 1989 Mergers and/or to grant to the plaintiffs such damages, including rescissory damages, as are found by the court to be proven at trial. In the fall of 1989, all defendants moved to dismiss the Complaints for failure to state a claim upon which relief can be granted. The court ruled on the motion in the Fidelity Complaint on February 7, 1991, dismissing seven of the ten claims asserted and allowing the Fidelity Plaintiffs leave to plead one additional claim. On February 27, 1991, the Fidelity Plaintiffs filed an amended complaint. On May 24, 1991, the defendants answered the amended complaint, denying the material allegations and asserting affirmative defenses. On January 29, 1992, the Company and the EQJ Plaintiffs filed a stipulation dismissing the EQJ Complaint with respect to all defendants without prejudice to the right of the EQJ Plaintiffs to reinstate the action at the conclusion of the appraisal proceeding instituted by the EQJ Plaintiffs and described below. On September 14, 1989, the EQJ Plaintiffs filed a Petition for Appraisal (the "EQJ Appraisal") against the Company in the Court of Chancery in the State of Delaware in and for New Castle County. On October 13, 1989, the Fidelity Plaintiffs filed a Petition for Appraisal (the "Fidelity Appraisal," together with the EQJ Appraisal, sometimes hereinafter referred to as the "Appraisals") against the Company in the Court of Chancery in the State of Delaware in and for New Castle County. Although filed separately, the Appraisals both purport to invoke the rights of the EQJ Plaintiffs and the Fidelity Plaintiffs to seek an appraisal of their shares of Class B common stock of the Company pursuant to Section 262 of the Delaware General Corporation Law as a consequence of the 1989 Mergers. The Fidelity Appraisal purports to seek, among other relief, a judgment awarding the Fidelity Plaintiffs the fair value of their shares of Class B common stock of the Company in an unspecified amount. On May 13, 1991, Fidelity was seized and placed into receivership by the Virginia State Corporation Commission. As a result, the Fidelity Complaint and Fidelity Appraisal were stayed until March 30, 1992. Both the Fidelity Complaint and Fidelity Appraisal were dismissed in February 1994 following settlement with the Fidelity Plaintiffs. The EQJ Appraisal alleges that the EQJ Plaintiffs' shares are worth more than three times the price offered in connection with the 1989 Mergers and seeks, among other relief, a judgment awarding the EQJ Plaintiffs the fair value of their shares of Class B common stock of the Company in an amount of no less than $24 per share. Discovery in the EQJ Appraisal is proceeding. The court has set a pre-trial conference for May 2, 1994 and the week of May 9, 1994 for trial. Management believes that there is no factual basis for the allegations and claims contained in the Complaints. Management also believes that the lawsuits are without merit and intends to defend the lawsuit vigorously. In addition, management believes that the ultimate resolution of these matters and the appraisal proceedings will not have a material effect on the financial condition or results of operations of the Company or Holdings. Katell/Desert Complaint. On November 6, 1991, Gerald L. Katell ("Katell") and Desert Equities, Inc. ("Desert"), who are limited partners of The Morgan Stanley Leveraged Equity Fund, L.P. ("MSLEF"), filed a consolidated complaint in the Court of Chancery of the State of Delaware in and for New Castle County (the "Katell/Desert Complaint") against a number of defendants, including the Company and Holdings. (The plaintiffs previously had filed similar complaints in the New York Supreme Court, but the complaints were dismissed on the grounds that, in the interests of substantial justice, the actions should be heard in the courts of Delaware.) The plaintiffs allege, among other things, that The Morgan Stanley Leveraged Capital Fund, Inc. and Cigna Leveraged Capital Fund, Inc., the general partners of MSLEF, breached duties owed to the limited partners. Holdings and the Company are named as defendants in Count III of such amended complaint, which charges them with aiding and abetting breaches of fiduciary duty by MSLEF and the general partners. These aiding and abetting claims are premised on the same allegations concerning the 1989 Mergers that form the basis of the Complaints. The plaintiffs claim damages in the amount of $4.67 million. On December 9, 1991, all defendants moved to dismiss the Katell/Desert Complaint on the grounds that (i) plaintiffs' claims are derivative in nature and cannot be maintained as individual actions, (ii) plaintiffs' claims as to shares of stock and other rights allegedly held by them directly fail to state a claim and, in some cases, are time barred and (iii) with respect to the aiding and abetting claims asserted against the Company and Holdings, the Katell/Desert Complaint fails to allege sufficient knowing participation to constitute a cause of action for aiding and abetting breaches of fiduciary duties. On February 17, 1992, the plaintiffs filed an amended complaint asserting derivative claims on behalf of the partnership alternatively to Counts I through IV of the Katell/Desert Complaint. The amended complaint also deletes specific allegations as to the amount of damages, seeking a determination of such damages by the court. All defendants moved to dismiss the amended complaint on February 27, 1992. After full briefing and oral argument, the court dismissed all claims against the Company and Holdings by memorandum opinion and order dated January 14, 1993. On January 25, 1993, the plaintiffs moved for reargument, seeking that the court amend its order to provide that the dismissal of the claims against certain defendants, including the Company and Holdings, be without prejudice to reinstatement. The court denied this motion by order dated March 29, 1993. Management believes that there is no factual basis for the allegations and claims contained in the Katell/Desert Complaint. Management also believes that the lawsuit is without merit and intends to defend the lawsuit vigorously. In addition, management believes that the ultimate resolution of these matters and the appraisal proceedings will not have a material effect on the financial condition or results of operations of the Company or Holdings. Summer del Caribe. On October 17, 1989, the State of California, on behalf of the California Department of Health Services, filed a suit in the United States District Court for the Northern District of California against the owners and operators of a recycling facility operated by Summer del Caribe, Inc., Dale Summer and Lynn Rodich. The complaint also named 16 can manufacturing companies, including Silgan, that had sent small amounts of solder dross to the facility for recycling as "Responsible Parties" under the California Superfund statute. The Court has stayed the action. The Company is one of 16 can companies participating in a steering committee. The steering committee has actively undertaken a feasibility study and has retained an environmental consultant. The Company has agreed with the other can company defendants that Silgan's apportioned share of cleanup costs would be 6.72% of the total cost of cleanup. Although the total cost of cleanup has not yet been determined, the Company understands that the State of California's current worst case estimate of total cleanup costs for all parties is $5.5 million. The steering committee believes that the cost to remediate will be no more than $3 million, approximately one-half the government's estimate. Accordingly, the Company believes its maximum exposure is not greater than 6.72% of $3 million, or approximately $202,000. Other. Other than the actions mentioned above, there are no other pending legal proceedings, other than ordinary routine litigation incidental to the business of the Company, to which the Company is a party or to which any of its properties are subject. 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 Stock and Related Stockholder Matters. The Company's common stock is not publicly traded on any market or exchange. All of the outstanding common stock of the Company is held by Holdings. Other than the payment of a $15.7 million dividend to Holdings under the Refinancing in 1992, the Company has not paid any dividends on its common stock. Unless certain financial tests are met, the Company is prohibited under the Credit Agreement from paying any dividends on its Common Stock. Also, the Secured Notes and the indenture relating to the 11-3/4% Notes limit, subject to certain exceptions, the Company's ability to pay dividends on its common stock. The Company does not intend to pay any dividends on its common stock in the foreseeable future, except for dividends to Holdings that the Company may pay to fund Holdings' consolidated federal and state tax obligations and, under limited circumstances as permitted by the Credit Agreement, the Secured Notes and the indenture in respect of the 11-3/4% Notes, certain other obligations of Holdings and, beginning no earlier than December 1996, in order to enable Holdings to pay interest on the Discount Debentures. Item 6. Item 6. Selected Financial Data. Set forth below are selected historical consolidated financial data of the Company at December 31, 1993, 1992, 1991, 1990 and 1989 and for the periods then ended. The selected historical consolidated financial data at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 (with the exception of employee data) was derived from the historical consolidated financial statements of the Company for such periods that were audited by Ernst & Young, independent auditors, whose report appears elsewhere in this Annual Report on Form 10-K. The selected consolidated historical financial data at December 31, 1991, 1990 and 1989 and for the years ended December 31, 1990 and 1989 were derived from the historical audited consolidated financial statements for such periods. The selected historical consolidated financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the audited financial statements and accompanying notes thereto included elsewhere in this Annual Report on Form 10-K. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. General Although the food can industry in the United States is relatively stable and mature in terms of unit sales growth, Containers has realized compound annual unit growth in excess of 7% since 1987. On a pro forma basis giving effect to the acquisition of DM Can, unit sales growth of Containers is in excess of 12% since 1987. Plastics is pursuing new markets for its plastic containers, including the post-consumer recycled resin segment of the market. Based upon published information and management's experience in the industry, management believes that PET custom containers are replacing glass containers for products such as mouthwash, salad dressing, peanut butter and liquor. Management also believes that Plastics is well positioned because of its technologically advanced equipment to respond to opportunities for future growth in the rigid plastic container market. Sales growth at Containers and Plastics has enabled the Company to improve EBDITA by achieving economies of scale. Since 1991 Containers has closed two smaller, higher cost facilities and Plastics has implemented an aggressive consolidation and rationalization program that resulted in the closing of three plants, the consolidation of technical and administrative centers and a substantial reduction in personnel. In November 1991, Plastics sold its nonstrategic PET carbonated beverage bottle business, exiting that commodity business. The Company has reduced its selling and administrative expenses and its manufacturing costs as a result of these actions. In 1992, the Company and Holdings completed the Refinancing to improve their financial flexibility. See "Business -- Company History." On December 21, 1993, Containers acquired the assets of Del Monte's metal food and beverage container manufacturing business ("DM Can") in the United States for approximately $73 million. In connection with the acquisition of DM Can, Containers and Del Monte entered into a ten-year supply agreement under which Containers will supply all of Del Monte's metal container requirements for the packaging of food and beverages in the United States and not less than 65% of Del Monte's annual requirements of metal containers for the packaging of food and beverages at Del Monte's Irapuato, Mexico facility. As a result of the acquisition of DM Can, the Company will produce almost all of the containers necessary to package the canned vegetable and fruit products of Del Monte, the largest provider of canned fruits and vegetables in the United States. In conjunction with the acquisition of DM Can, the Company entered into the Credit Agreement with the Banks. The proceeds from the Credit Agreement were used to finance, in part, the acquisition of DM Can, repay in full amounts owing under the Amended and Restated Credit Agreement and pay fees and expenses related thereto. Additionally, Holdings issued and sold 250,000 shares of its Class B Common Stock for $15 million, which amount Holdings contributed to the capital of Silgan. The Company believes the combination of the nine DM Can facilities with its existing thirteen can plants will create cost reduction opportunities through plant rationalization and equipment investment as well as additional cost savings from production scheduling and line reconfiguration. This discussion should be read in conjunction with the selected financial data, the historical statements of operations and the notes thereto included elsewhere in this Annual Report on Form 10-K. In addition to the discussion of historical results of operations, to provide more meaningful information about the acquisition of DM Can, management has provided a pro forma discussion of the results of operation of the Company for the year ended December 31, 1993 as compared to the year ended December 31, 1992, after giving effect to the acquisition of DM Can. Results of Operations - Historical Year Ended December 31, 1993 Compared with Year Ended December 31, 1992. Net sales of metal containers increased $20.1 million, or 4.7%, to $445.9 million for the year ended December 31, 1993, compared to $425.8 million for the same period in 1992. Net sales of metal containers to Nestle' decreased $11.6 million to $214.1 million, compared to net sales of $225.7 million for the same period in 1992, primarily due to reduced demand by Nestle'. Net sales of metal containers to other customers increased $31.7 million to $231.8 million, compared to net sales of $200.1 million for the same period in 1992. The increase was primarily due to an increase in unit sales to existing non-vegetable pack customers and the purchase of an additional manufacturing facility in May 1993, which accounted for sales of $12.5 million, offset, in part, by lower unit sales to vegetable pack customers due to the extremely wet weather in the Midwest in the summer of 1993. Net sales of plastic containers were $186.3 million for the year ended December 31, 1993, $6.3 million lower than net sales of plastic containers of $192.6 million for the same period in 1992. The decrease in net sales was primarily attributable to lower unit sales to existing customers due to soft market conditions. Sales of other containers increased approximately 15% to $13.3 million for the year ended December 31, 1993, compared to $11.6 million for the same period in 1992. Cost of goods sold was 88.5% of net sales ($571.2 million) for the year ended December 31, 1993, compared to 88.1% of net sales ($555.0 million) for the same period in 1992. The increase in cost of goods sold as a percentage of sales principally resulted from higher per unit manufacturing costs incurred as a result of higher depreciation expense, lost margin on outsourced cans due to capacity constraints in early 1993, offset, in part, by general gains in manufacturing efficiencies. Selling, general and administrative expenses were 4.9% of net sales ($31.8 million) for the year ended December 31, 1993, compared to 5.1% ($32.2 million) for the same period in 1992. The decrease in selling, general and administrative expenses as a percentage of sales was principally attributable to the maintenance of a constant level of expenditures on a greater sales base. Income from operations as a percentage of net sales was 6.6% ($42.5 million) for the year ended December 31, 1993, compared to 6.8% ($42.8 million) for the same period in 1992. The 0.2% decrease in income from operations as a percentage of sales was due primarily to the aforementioned decrease in gross profit margin. Interest expense increased by approximately $1.0 million to $27.9 million for the year ended December 31, 1993. The increase was due to additional indebtedness incurred by the Company as a result of the refinancing in June 1992 of the Company's debt and preferred stock and Holdings debt, offset, in part, by lower average interest rates. The provision for income taxes for 1993 of $6.3 million reflects the adoption of SFAS No. 109 which requires the Company to provide for taxes as if it were a separate taxpayer. Prior to the adoption of SFAS No. 109, the Company determined its income tax provision on a separate company basis with the exception of certain matters covered under a tax allocation agreement with Holdings under which Silgan obtained a federal income tax benefit for Holdings' tax losses. For purposes of SFAS No. 109, the benefit of the tax allocation agreement is reflected as a contribution to additional paid-in capital instead of a reduction in federal income tax expense. For 1992 the provision for income taxes of $2.2 million was comprised of state and foreign components and recognized the benefit of certain deductions for federal income tax which were available to Holdings. Income before the extraordinary charge and cumulative effect of changes in accounting principles for the year ended December 31, 1993 was $8.2 million, as compared to $13.7 million for the year ended December 31, 1992. The decline in income before the extraordinary charge and cumulative effects of changes in accounting principles was principally the result of the change in the financial reporting of income tax expense. As a result of the refinancing of the Amended and Restated Credit Agreement in conjunction with the acquisition of DM Can and the refinancing in June 1992 of the Company's debt and Preferred Stock and Holdings' debt, the Company incurred extraordinary charges of $0.8 million and $9.1 million for the early extinguishment of debt in 1993 and 1992, respectively. During 1993 the Company adopted SFAS No. 106, SFAS No. 109 and SFAS No. 112. The cumulative effect of these accounting changes was to decrease net income by $3.2 million, $6.0 million and $0.8 million, respectively. Year Ended December 31, 1992 Compared with Year Ended December 31, Net sales of metal containers decreased $9.5 million to $425.8 million for the year ended December 31, 1992, compared to $435.3 million for the same period in 1991. Net sales of metal containers to Nestle' increased $12.6 million to $225.7 million, compared to net sales of $213.1 million for the same period in 1991, primarily due to increased unit sales of pet food containers, offset, in part, by less demand for tomato cans due to a smaller pack in 1992 than in the prior year and by the pass through of lower material costs. Net sales of metal containers to other customers decreased $22.1 million to $200.1 million, compared to net sales of $222.2 million for the same period in 1991. The decrease was primarily due to colder and wetter summer weather experienced in the Midwest which resulted in a reduced vegetable pack as compared to the prior year along with lower unit sales volume as a result of the closing by the Company of two metal container manufacturing facilities, partially offset by increased sales to existing customers. Net sales of plastic containers were $192.6 million for the year ended December 31, 1992, $39.5 million lower than net sales of plastic containers of $232.1 million for the same period in 1991. The decrease in net sales was primarily attributable to the disposition of the PET carbonated beverage bottle business in November 1991 which accounted for sales of $33.4 million during the year ended December 31, 1991. The decrease in net sales of other plastic containers of $6.1 million was attributable to lower average sales prices due to the pass through of lower average resin costs and a change in the mix of products sold. Sales of other containers totaled $11.6 million for the year ended December 31, 1992, compared to $10.8 million for the same period in 1991. Costs of goods sold was 88.1% of net sales ($555.0 million) for the year ended December 31, 1992, compared to 89.2% of net sales ($605.2 million) for the same period in 1991. The decrease in cost of goods sold as a percentage of sales principally resulted from lower per unit manufacturing costs realized through improved manufacturing efficiencies in the Company's existing plant facilities, the benefits realized from the closing of four higher cost manufacturing plants in the latter part of 1991 and early 1992, and the sale of the lower margin PET carbonated beverage business, offset, in part, by lower margins realized on certain products due to competitive pricing conditions. Selling, general and administrative expenses were 5.1% of net sales ($32.2 million) for the year ended December 31, 1992, compared to 5.0% ($33.6 million) for the same period in 1991. The $1.4 million decrease was principally attributable to cost savings generated from a reduction in administrative personnel, partially offset by a charge for an uncollectible account that has been fully reserved. Income from operations as a percentage of net sales was 6.8% ($42.8 million) for the year ended December 31, 1992, compared to 5.8% ($39.4 million) for the same period in 1991. The 1.0% increase in income from operations as a percentage of sales was due primarily to the improved overall margins realized by the Company from its existing operations after closing four higher cost manufacturing facilities in the latter part of 1991 and early 1992 and the disposition in November 1991 of the lower margin PET carbonated beverage business. Interest expense decreased by approximately $2.1 million to $26.9 million for the year ended December 31, 1992. The decrease was due to lower average interest rates incurred on a lower average balance of bank borrowings, offset, in part, by the incurrence of additional indebtedness as a result of the Refinancing. Average bank borrowings declined due to tighter management of inventories and term loan repayments. The provisions for income tax for the years ended December 31, 1992 and 1991 were comprised of state and foreign components and recognize the benefit of certain deductions for federal income tax purposes which are available to Holdings. As a result of the items discussed above, income before the extraordinary charge and preferred stock dividends for the year ended December 31, 1992 was $13.7 million, $4.4 million greater than the net income before preferred stock dividends for the year ended December 31, 1991 of $9.3 million. As a result of the Refinancing, the Company incurred an extraordinary charge of $9.1 million for the early extinguishment of debt. Such charge reflects a $5.8 million expense for premiums paid in connection with the Redemptions and the charge-off of $3.3 million for unamortized debt financing costs related to the securities redeemed under the Redemptions. Results of Operations - Pro Forma The following discussion sets forth the pro forma results of operations of the Company for the year ended December 31, 1993 as compared to the year ended December 31, 1992, after giving effect to the acquisition of DM Can. The following table sets forth, for the years ended December 31, 1993 and 1992, certain consolidated pro forma data. This data includes the historical results of operations for the Company and DM Can and give effect to the pro forma adjustments assuming the acquisition occurred at the beginning of each year presented. The pro forma adjustments are based upon available information and upon certain assumptions that the Company believes are reasonable. The final purchase price allocation may differ from that used for the pro forma data, although it is not expected that the final allocation of purchase price will be materially different. The unaudited pro forma combined financial data do not purport to represent what the Company's financial position or results of operations would actually have been had the transactions in fact occurred on the dates or at the beginning of the period indicated, or to project the Company's financial position or results of operations for any future date or period. This discussion should be read in conjunction with the discussion of historical results of operations of the Company for the years ended December 31, 1993 and 1992. 1993 1992 ---- ---- (In Millions) Net sales $818.6 $819.6 Income from operations 51.3 57.3 Income before income taxes 18.9 25.4 Income before extraordinary charges and 10.9 22.3 cumulative effect of changes in accounting principles Net income 0.1 13.2 Management believes that pro forma income from operations in 1993 declined $6.0 million as compared to the prior year primarily as a result of a one-time inventory reduction by Del Monte in anticipation of the sale of DM Can to Containers and, to a lesser extent, due to lower vegetable pack sales as a result of adverse growing conditions in the Midwest in the summer of 1993. The pro forma income before the extraordinary charge and cumulative effect of changes in accounting principles in 1993 of $10.9 million declined $11.4 million from 1992. Management believes that this decrease principally resulted from the one-time inventory reduction and reduced demand for vegetable pack containers as referred to above and the adoption of SFAS No. 109 "Accounting for Income Taxes." The pro forma provision for income taxes for 1993 reflects the adoption of SFAS No. 109 which requires the Company to provide for taxes as if it were a separate taxpayer. As a result of this new standard, the Company's 1993 pro forma income tax expense increased by $5.9 million over the prior year. Prior to the adoption of SFAS No. 109, the provision for income taxes was comprised of state and foreign components and recognized the benefit of certain deductions for federal income tax which were available to Holdings. Capital Resources and Liquidity Silgan's liquidity requirements arise primarily from its obligations under the indebtedness incurred in connection with its acquisitions, capital investment in new and existing equipment and the funding of Silgan's seasonal working capital needs. Historically, Silgan has met these liquidity requirements through cash flow generated from operating activities and working capital borrowings. As described below, beginning in December 1996 Silgan's liquidity requirements may also be affected by the interest associated with Holdings' indebtedness. On December 21, 1993 Silgan, Containers and Plastics entered into the Credit Agreement to finance the acquisition of DM Can and to refinance and repay in full all amounts owing under the Amended and Restated Credit Agreement. In conjunction therewith the Banks loaned the Company $60.0 million of A Term Loans, $80.0 million of B Term Loans and $29.8 million of working capital loans. In addition, Holdings issued and sold 250,000 shares of its Class B Common Stock for $15.0 million and, in turn, contributed such amount to Silgan. With these proceeds, the Company (i) repaid $41.5 million of term loans and $60.8 million of working capital loans under the Amended and Restated Credit Agreement; (ii) acquired from Del Monte substantially all the fixed assets and certain working capital of Del Monte's container manufacturing business for approximately $73 million; and (iii) paid fees and expenses of $8.9 million. For 1993, the Company used cash generated from operations of $48.3 million and available cash balances of $2.5 million to fund capital expenditures of $42.5 million, repay working capital loans of $7.2 million (in addition to working capital loans which were repaid with proceeds from the Credit Agreement), and pay $1.1 million of term loans. During the year, the Company increased its annual amount of capital spending in order to reduce costs and to add incremental production capacity. The increase in inventory at December 31, 1993 as compared to the prior year principally resulted from the inventory acquired as part of the acquisition of DM Can. In June 1992, to improve their financial flexibility, Silgan and Holdings effected the Refinancing. The Refinancing (i) lowered Holdings' consolidated average cost of indebtedness by retiring the 14% Notes and the Holdings Reset Debentures with new indebtedness bearing lower interest rates, (ii) improved Silgan's liquidity and ability to further repay its indebtedness by eliminating Silgan's obligation to pay cash dividends on the Preferred Stock through the Preferred Stock Redemption and by deferring for an additional two years (until December 1996) and reducing the cash interest requirements on Holdings' indebtedness, (iii) provided Holdings with additional financial flexibility by eliminating restrictions in the indenture relating to the 14% Notes on Silgan's ability to pay dividends to Holdings in order to fund interest payments on Holdings' indebtedness through the 14% Notes Redemption and (iv) extended the average length of maturity of Silgan's indebtedness by issuing the 11-3/4% Notes and the Secured Notes to refinance $30 million of bank term loans and the 14% Notes. In connection with the Refinancing, Silgan received $174.7 million in proceeds from the issuance of the Secured Notes and 11-3/4% Notes, net of debt issuance costs of $10.3 million. Silgan repaid a $25.2 million advance from Holdings and made a $15.7 million dividend payment to Holdings, for an aggregate payment of $40.9 million which was used by Holdings, together with the proceeds received from the sale of the Discount Debentures, to redeem the Holdings Reset Debentures. In addition, Silgan repaid $30 million of term loans under the Credit Agreement. On August 16, 1992, the Company paid $31.5 million to redeem the Preferred Stock. On August 28, 1992, the Company paid $89.3 million to redeem the 14% Notes. Approximately $17 million of working capital loans were borrowed to complete such redemptions. In addition to the borrowing of working capital loans used to effect the Refinancing, Silgan borrowed working capital loans of $2.2 million during the year ended December 31, 1992 which, along with cash provided by operations during 1992 of $34.4 million, were used principally to fund capital expenditures of $23 million, to make term loan repayments of $10.2 million under the Amended and Restated Credit Agreement (in addition to the term loan repayment made in connection with the Refinancing), to pay cash dividends of $1.1 million on the Preferred Stock and to increase outstanding cash balances by $2.3 million. During 1991, cash provided from operations of $61.3 million was used to fund capital expenditures of $21.8 million and scheduled bank term loan repayments of $25 million. The balance of the cash provided from operations during the year of $14.5 million was used to repay working capital loans and principally resulted from the receipt in January 1991 of $16 million from a major customer on an account normally settled by the prior year's end. In November 1991, the Company completed the sale of its PET carbonated beverage bottle business. The proceeds of approximately $12 million, net of costs associated with such sale, were principally used to repay bank term loans. Due to reduced working capital requirements, $4 million of working capital loans was also repaid. Since a portion of the proceeds realized from the Credit Agreement on December 21, 1993 were used to repay working capital loans under the Amended and Restated Credit Agreement, the Company was able to reduce the amount of its commitment for working capital loans. Under the Credit Agreement, the commitment for working capital loans was reduced by $41 million to $70 million. As of December 31, 1993, the outstanding principal amount of working capital loans was $2.2 million and, subject to a borrowing base limitation and taking into account outstanding letters of credit, the unused portion of working capital commitments at such date was $61.7 million. The decrease of $38.2 million in the outstanding principal amount of working capital loans since December 31, 1992 resulted from the repayment of approximately $30 million of working capital loans with proceeds from the refinancing of the Credit Agreement as well as with cash generated from operations. Because the Company sells metal containers used in vegetable and fruit processing, its sales are seasonal. As a result, a significant portion of the Company's revenues are generated in the first nine months of the year. As is common in the packaging industry, the Company must access working capital to build inventory and then carry accounts receivable for some customers beyond the end of the summer and fall packing season. Seasonal accounts are generally settled by year end. Due to the Company's seasonal requirements, the Company expects to incur short term indebtedness to finance its working capital requirements, and it is estimated that approximately $50 million of the working capital revolver, including letters of credit, will be utilized at its peak in July 1994. In addition to its operating cash needs, the Company's cash requirements over the next several years are anticipated to consist primarily of (i) annual capital expenditures of $25 million to $33 million (approximately $13 million of which is nondiscretionary in each year), (ii) principal amortization payments of A Term Loans under the Credit Agreement of $20 million in each of 1994, 1995 and 1996, (iii) expenditures of approximately $13 million associated with the rationalization of facilities related to the acquisition of DM Can, (iv) the scheduled maturity on September 15, 1996 of the working capital loans and $80 million of B Term Loans under the Credit Agreement, (v) payments by Silgan to Holdings to fund Holdings' semi-annual cash interest requirements of $18.2 million on the Discount Debentures commencing in December 1996, (vi) the scheduled maturity of the $50 million principal amount of the Secured Notes in 1997, and (vii) the Company's interest requirements (including interest on working capital loans, the principal amount of which will vary depending upon seasonal requirements, the Secured Notes and bank term loans, all of which bear fluctuating rates of interest). The Company is a wholly owned subsidiary of Holdings, a holding company with no significant assets or operations other than its investment in and advances to Silgan. Holdings is highly leveraged as a result of the indebtedness that it incurred in connection with the 1989 Mergers. See "Business-Company History." Holdings' principal liabilities are the Discount Debentures and its guaranty of the Credit Agreement. Because Holdings' indebtedness does not require payment of interest until December 1996 and because the Company has not in the past provided funds to Holdings to pay interest on Holdings' indebtedness, the Company's liquidity has not been, and until December 1996 is not expected to be, affected by Holdings' indebtedness. The Credit Agreement prohibits the Company from paying any dividends or making other distributions on its capital stock, making loans to or transferring any assets to Holdings, merging or consolidating with Holdings or assuming or guaranteeing any obligations of Holdings, although the Company is permitted to advance funds to Holdings to enable Holdings to pay certain administrative expenses and taxes. Accordingly, until the maturity (scheduled to occur on September 15, 1996) or earlier repayment of borrowings under the Credit Agreement (or the amendment or waiver of the restrictive covenants contained therein), Holdings will be unable to use any amount of cash generated by the operations of the Company and its subsidiaries. However, interest on the Discount Debentures is not payable until December 15, 1996. Interest on the Discount Debentures is payable at a rate of 13- 1/4% per annum and commencing on December 15, 1996 semi-annual interest payments of $18.2 million will be required to be made thereon. The ability of Holdings to pay interest on the Discount Debentures on and after December 15, 1996 may depend upon the ability of the Company to pay dividends, or otherwise loan, advance or transfer funds, to Holdings or the ability of Holdings to refinance the Discount Debentures, obtain additional debt or equity financing or obtain amendments to the indenture relating to the Discount Debentures. There can be no assurance that any such alternative, if pursued, would be accomplished, or that any such alternative would be accomplished in sufficient time to enable Holdings to make timely payments of interest on the Discount Debentures. Neither the Secured Notes nor the 11- 3/4% Notes limits the ability of the Company to pay cash dividends to Holdings in order to enable Holdings to pay interest on the Discount Debentures. Otherwise, subject to limited exceptions, the Secured Notes and the 11-3/4% Notes prohibit the payment of dividends or other distributions by the Company on its capital stock. Silgan has no obligation, legal or otherwise, to pay dividends or otherwise loan, advance or transfer funds to Holdings in order to fund Holdings' debt service requirements. The funding requirements of Holdings to service its indebtedness (beginning in December 1996) may be met by Silgan through cash generated by operations or borrowings or by Holdings through refinancings of its existing indebtedness or additional debt or equity financings. The Discount Debentures represent "applicable high yield discount obligations" ("AHYDOs") within the meaning of Section 163(i) of the Internal Revenue Code of 1986, as amended (the "Code"). Accordingly, the tax deduction which would otherwise be available to Holdings in respect of the accretion of interest on the Discount Debentures during their noncash interest period ending June 15, 1996 ($109.6 million) has been and will continue to be deferred, which, in turn, will increase the taxable income of Holdings and reduce the after-tax cash flows of Holdings. However, as a result of Holdings' utilization of its net operating loss carryforward, which currently amounts to approximately $105 million for regular federal income tax purposes, the effect of such deferral on the regular federal income taxes of Holdings has been and will continue to be mitigated until such net operating loss carryforward is fully utilized. In 1993, Holdings became subject to alternative minimum tax ("AMT"). Because Holdings has AMT net operating loss carryforwards, Holdings has incurred and will continue to incur an AMT liability at a rate of 2%. In 1995, Holdings anticipates that the AMT loss carryforward will have been fully utilized. Thereafter, Holdings will incur an AMT liability at a rate of 20% (or the applicable rate then in effect). Any AMT paid is allowed as an indefinite credit carryover against Holdings' regular tax liability in the future when and if Holdings' regular tax liability exceeds the AMT liability. The deferred accreted interest will not be deductible until the redemption, retirement or other repayment of the Discount Debentures (other than with stock or debt of Holdings or a related party). Until the deferred accreted interest is deductible, except to the extent the net operating loss carryforward is available, Holdings will realize taxable income sooner and in a greater amount than if the deferred accreted interest on the Discount Debentures were deductible as it accretes. Depending upon its tax position and financial condition and the benefit which may be available through the deduction of the deferred accreted interest, Holdings could decide in the future to refinance the Discount Debentures or a portion thereof prior to their stated maturity date. In such event, the full amount of the deferred accreted interest (applicable to the Discount Debentures retired) should be deductible under the carryback and carryforward rules under the Code unless the holders of the Discount Debentures receive stock or debt of Holdings or a related party in exchange for the Discount Debentures. No assurance can be given that Holdings will be able to refinance the Discount Debentures at such time; however, management believes that application of the AHYDO rules will not have a material adverse effect on Holdings' financial condition or ability to repay the Discount Debentures. In addition, the IRS has broad authority to issue regulations under the AHYDO rules with retroactive effect to prevent the avoidance of the purposes of those rules through agreements to borrow amounts due under a debt instrument or other arrangements, and thus these regulations, when issued, may affect the timing or availability of the tax deductions for original issue discount on the Discount Debentures. Management believes that cash generated by operations and funds from working capital borrowings under the Credit Agreement will be sufficient to meet the Company's expected operating needs, planned capital expenditures and debt service requirements until the maturity of the working capital facility under the Credit Agreement on September 15, 1996. Management also believes that it will be able to replace the working capital facility under the Credit Agreement with another facility on or prior to September 15, 1996 on terms which will be acceptable to the Company. However, there can be no assurance that the Company will be able to replace its working capital facility. In such event, the Company could be required to consider alternative equity or debt financings in order to meet its cash needs. The ability of the Company to effect any such financing and the extent to which the Company may seek or be required to obtain additional financing will depend upon a variety of factors, including, the future performance of the Company and its subsidiaries, which will be subject to prevailing economic conditions and to financial, business and other factors (including the state of the economy and the financial markets, demand for the products of the Company and its subsidiaries, costs of raw materials, legislative and regulatory changes and other factors beyond the control of the Company and its subsidiaries) affecting the business and operations of the Company and its subsidiaries as well as prevailing interest rates, actual amounts expended for capital expenditures and other corporate purposes and the timing and amount of debt prepayments or redemptions. The Credit Agreement, the Secured Notes and the indentures relating to the 11-3/4% Notes and the Discount Debentures each contain restrictive covenants that, among other things, limit the Company's ability to incur debt, sell assets and engage in certain transactions. Management does not expect these limitations to have a material effect on the Company's business or results of operations. The Company is in compliance with all financial and operating covenants contained in such financing agreements and believes that it will continue to be in compliance during 1994 with all such covenants. Effect of Interest Rate Fluctuations and Inflation Because the Company has indebtedness which bears interest at floating rates, the Company's financial results will be sensitive to changes in prevailing interest rates. To mitigate the effect of significant changes in interest rates, the Company may enter into interest rate protection agreements (with counterparties that, in the Company's judgment, have sufficient creditworthiness) with respect to a portion of its floating rate indebtedness. At December 31, 1993, the Company was not a party to any interest rate protection agreement. Historically, inflation has not had a material effect on the Company, other than to increase its cost of borrowing. In general, the Company has been able to increase the sales prices of its products to reflect any increases in the prices of raw materials. Impact of New Accounting Standards Postretirement Benefits. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." Under Statement No. 106 the Company is required to accrue the cost of retiree health and other postretirement benefits during the years that covered employees render service. The cumulative effect of this accounting change was to decrease net income by $3.1 million after related income tax benefit. This change in accounting principle, excluding the cumulative effect, decreased pretax income for the year ended December 31, 1993 by $0.5 million. Prior to 1993, the Company recorded these benefits on a pay-as-you-go basis, and the Company has elected not to restate prior years for this change. The new rules are expected to result in an increase in net annual periodic postretirement benefit costs of less than $1.0 million. See Note 14 to consolidated financial statements of the Company included elsewhere in this Annual Report on Form 10-K. Income Taxes. Effective January 1, 1993 the Company adopted SFAS No. 109, "Accounting for Income Taxes." This Statement superseded SFAS No. 96. Under SFAS No. 96 the Company has recognized a federal income tax benefit from Holdings' tax losses. Under SFAS No. 109, this benefit will be reflected as a contribution to additional paid-in capital instead of a reduction of income tax expense. Accordingly, in 1993, the Company recorded a cumulative charge to earnings and credit to paid-in-capital of approximately $6.0 million for the difference in methods up to the date of adoption. The Company is not currently paying, and does not expect in the near future to pay, any regular federal income taxes because it has been and will be able to avail itself of Holdings' consolidated tax loss carryforwards, which amount to approximately $105 million at December 31, 1993. See Note 9 to consolidated financial statements of the Company included elsewhere in this Annual Report on Form 10-K. Item 8. Item 8. Financial Statements and Supplementary Data. See Item 14 below for a listing of financial statements and schedules included therein. 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. Management of the Company The current directors and executive officers of the Company and their respective ages, positions and principal occupations, five-year employment history and other directorships held are furnished below: Age at March 15, Five-Year Employment Name and Position 1994 History and Other Directorships Held ------------------- -------- ------------------------------------ R. Philip Silver 51 Prior to forming S&H, Inc. ("S&H") Chairman of the Board and in 1987, President of Continental Co-Chief Executive Can Company from June 1983 to August Officer of Holdings and 1986; consultant to packaging Silgan since March 1994; industry from August 1986 to August Formerly President of 1987; Vice Chairman of the Board and Holdings and Silgan; Director of Sweetheart Holdings Inc. Director of Holdings and Sweetheart Cup Company, Inc. since April 1989 and of from September 1989 to January 1991; Silgan since August 1987; Chairman of the Board and Director Chairman of the Board of of Sweetheart Holdings Inc. and Plastics since March Sweetheart Cup Company, Inc. from 1994; Director of January 1991 through August 1993; Containers and Plastics Director, Johnstown America since August 1987. Corporation. Age at March 15, Five-Year Employment Name and Position 1994 History and Other Directorships Held ------------------- -------- ------------------------------------ D. Greg Horrigan 50 Prior to forming S&H in 1987, President and Co-Chief Executive Vice President and Executive Officer of Operating Officer of Continental Can Holdings and Silgan since Company from 1984 to 1987; Chairman March 1994; Formerly of the Board and Director of Chairman of the Board of Sweetheart Holdings Inc. and Holdings and Silgan; Sweetheart Cup Company, Inc. from Director of Holdings September 1989 to January 1991; Vice since April 1989 and of Chairman of the Board and Director Silgan since August 1987; of Sweetheart Holdings Inc. and Chairman of the Board of Sweetheart Cup Company, Inc. from Containers since August January 1991 through August 1993. 1987; Chairman of the Board of Plastics from May 1991 to March 1994; Director of Containers and Plastics since August 1987. James S. Hoch 34 Principal of Morgan Stanley & Co. Director of Silgan since Incorporated since 1993, Vice January 1991; Vice President of Morgan Stanley & Co. President and Assistant Incorporated from 1991 to 1993, Secretary of Silgan since Associate of Morgan Stanley & Co. 1987; Director, Vice Incorporated from 1986 to 1990. President and Assistant Director of Fort Howard Corporation, Secretary of Holdings Sullivan Communications, Inc., since January 1991; Sullivan Graphics, Inc. Director, Vice President and Assistant Secretary of Containers since January 1991; Director, Vice President and Assistant Secretary of Plastics since January 1991. Robert H. Niehaus 38 Managing Director of Morgan Stanley Vice President, Assistant & Co. Incorporated since January 1, Secretary and Director of 1990; Principal of Morgan Stanley & Silgan since August 1987; Co. Incorporated from 1988 to 1989; Vice President, Assistant Vice President of Morgan Stanley & Secretary and Director of Co. Incorporated in 1987. Director Containers and Plastics of American Italian Pasta Company, since August 1987; Vice Randall's Food Markets, Inc., President, Assistant Randall's Management Corp., Inc., Secretary and Director of Randall's Properties, Inc., Holdings since April Randall's Warehouse, Inc., Fort 1989. Howard Corporation, Waterford Wedgwood plc, Waterford Crystal Ltd., Waterford Wedgwood UK plc, MS Distribution Inc., Tennessee Valley Steel Corporation, NCC L.P., Shuttleway and MS/WW Holdings Inc. Age at March 15, Five-Year Employment Name and Position 1994 History and Other Directorships Held ------------------- -------- ------------------------------------ Harley Rankin, Jr. 54 Prior to joining the Company, Senior Executive Vice President Vice President and Chief Financial and Chief Financial Officer of Armtek Corporation; prior Officer of Silgan since to Armtek Corporation, Vice January 1989; Treasurer President and Chief Financial of Silgan since January Officer of Continental Can Company 1992; Vice President of from November 1984 to August 1986. Containers and Plastics Vice President, Chief Financial since January 1989; Officer and Treasurer of Sweetheart Treasurer of Plastics Holdings Inc. and Vice President of since January 1994; Sweetheart Cup Company, Inc. from Executive Vice President September 1989 to August 1993. and Chief Financial Officer of Holdings since April 1989; Treasurer of Holdings since January 1992. Harold J. Rodriguez, Jr. 38 Employed by Ernst & Young from 1978 Vice President of Silgan to 1987, last serving as Senior and Holdings since March Manager specializing in taxation. 1994; Vice President of Controller, Assistant Secretary and Containers and Plastics Assistant Treasurer of Sweetheart since March 1994; Holdings Inc. and Assistant Controller and Assistant Secretary and Assistant Treasurer of Treasurer of Silgan and Sweetheart Cup Company, Inc. from Holdings since March September 1989 to August 1993. 1990; Assistant Controller and Assistant Treasurer of Holdings from April 1989 to March 1990; Assistant Controller and Assistant Treasurer of Silgan from October 1987 to March 1990. Management of Containers In addition to the persons listed under "Management of the Company" above, the following are the principal executive officers of Containers: Age at March 15, Five-Year Employment Name and Position 1994 History and Other Directorships Held ----------------- -------- ------------------------------------ James D. Beam 51 Vice President-Marketing & Sales of President and a Containers from September 1987 to non-voting Director of July 1990; Vice President and Containers since July General Manager of Continental Can 1990. Company, Western Food Can Division, from March 1986 to September 1987. Age at March 15, Five-Year Employment Name and Position 1994 History and Other Directorships Held ----------------- -------- ------------------------------------ Gerald T. Wojdon 58 General Manager of Manufacturing of Vice the Can Division of The Carnation President-Operations Company from August 1982 to August and Assistant Secretary 1987. of Containers since September 1987. Gary M. Hughes 51 Vice President, Sales and Marketing Vice President - Sales of the Beverage Division of & Marketing of Continental Can Company from Containers since July February 1988 to July 1990; prior to 1990. February 1988, was employed by Continental Can in various regional sales positions. George S. Hartley 47 Vice President - Finance of Romanoff Vice President - International, Inc. from 1990 to Finance, Treasurer and 1993; Director, Business Planning of Assistant Secretary Amphenol Corporation (Electronic since March 1994. Connectors) from 1988 to 1989; Continental Can Corporation, 1974- 1988, employed in various finance and planning positions. Dennis Nerstad 56 Vice President - Distribution and Vice President since Container Manufacturing of Del Monte March 1994. from August 1989 to December 1993; Director of Container Manufacturing of Del Monte from November 1983 to July 1989; prior to 1983, employed by Del Monte in various regional and plant positions. Management of Plastics In addition to the persons listed under "Management of the Company" above, the following are the principal executive officers of Plastics: Age at March 15, Five-Year Employment Name and Position 1994 History and Positions ----------------- -------- --------------------- Russell F. Gervais 50 President and Chief Executive President and Non-voting Officer of Aim Packaging, Inc. Director of Plastics since from March 1984 to September December 1992; Vice 1989. President-Sales & Marketing of Plastics from September 1989 until December 1992. Howard H. Cole 48 Manager of Personnel of Monsanto Vice President and Assistant Engineered Products Division of Secretary of Plastics since the Monsanto Company from April September 1987. 1986 to September 1987. Age at March 15, Five-Year Employment Name and Position 1994 History and Positions ----------------- -------- --------------------- Charles Minarik 56 President of Wheaton Industries Vice President-Operations and Plastics Group from February Commercial Development since 1991 to August 1992; Vice May 1993. President-Marketing of Constar International, Inc. from March 1983 to February 1991. Item 11. Item 11. Executive Compensation. The following table sets forth information concerning the annual and long term compensation for services rendered in all capacities to the Company and its subsidiaries during the fiscal years ended December 31, 1993, 1992 and 1991 of those persons who at December 31, 1993 were (i) the Chief Executive Officer of the Company and (ii) the other four most highly compensated executive officers of the Company and its subsidiaries. No director of the Company or its subsidiaries receives any compensation for serving as a director of the Company or its subsidiaries. See "Certain Transactions - Management Agreements." Pension Plans The Company has established pension plans (the "Pension Plans") covering substantially all of the salaried employees of Containers and Plastics, respectively, including the executive officers (the "Containers Pension Plan" and the "Plastics Pension Plan," respectively). The Pension Plans are defined benefit plans intended to be qualified pension plans under Section 401(a) of the Code, under which pension costs are determined annually on an actuarial basis with contributions made accordingly. The pension benefits at normal retirement under each Pension Plan are generally comparable to the benefits under the pension plan covering individuals at Nestle' Can or Monsanto, as the case may be, at the time of acquisition in 1987. Certain salaried employees of Containers, including Containers' executive officers, were covered by the Carnation Employees Plan Number Two for United States Employees (the "Carnation Pension Plan") immediately prior to the acquisition of Nestle' Can. The Containers Pension Plan recognizes prior service under the Carnation Pension Plan for purposes of eligibility, vesting and benefit accrual. The benefits payable at retirement under, or upon vested termination from, the Containers Pension Plan are based on the benefit formula and all other factors then in effect under the Containers Pension Plan applied to all combined pension service. Such benefit shall be offset by the accrued benefit, if any, such employee is entitled to receive under the Carnation Pension Plan as of August 31, 1987. Under the Containers Pension Plan, both the employer and participants contribute. Participants contribute approximately 3% of their annual compensation. The benefit for any participant thereunder is calculated under the greater of either (i) a career average formula of the sum of, for each year of participation up to March 31, 1991, 1% of annual base salary up to $5,400 plus 2% of such salary over $5,400 or (ii) a final pay formula of the average base salary over the final three years of employment multiplied by a percentage (not to exceed 61-1/4%) based upon the participant's years of credited service (not to exceed 35), less a percentage (not to exceed approximately 50%) of such participant's primary social security benefit at employment termination based upon the participant's years of credited service (not to exceed 35). Compensation covered by the Containers Pension Plan is a participant's base salary exclusive of any bonus, overtime or other extra compensation. A participant becomes fully vested after five years of service or upon reaching age 55, if earlier. The following table illustrates the estimated annual normal retirement benefits that are payable under the Containers Pension Plan based upon the final pay formula. Such benefit levels assume retirement at age 65, the years of service shown, continued existence of the Containers Pension Plan without substantial change and payment in the form of a single life annuity and includes benefits, if any, payable under the Carnation Pension Plan which will be paid by that plan. Pursuant to Section 401(a)(17) of the Code, there is a limit on the amount of annual compensation which can be taken into account under the Containers Pension Plan. The dollar limit on compensation for 1993 was $235,840. The dollar limit on compensation for 1994 is $150,000. The dollar limit, where applicable, will reduce the amount of benefits payable to highly compensated participants in the Containers Pension Plan. As of December 31, 1993, the years of credited service under the Containers Pension Plan for each of the eligible executive officers named in the Cash Compensation Table are as follows: James D. Beam, 6, Gary M. Hughes, 3, and Gerald T. Wojdon 34. In conjunction with the acquisition of DM Can, the employees of Del Monte that are employed by Containers will participate in the Containers Pension Plan. Pursuant to the purchase agreement for the acquisition of DM Can, Del Monte has agreed to transfer to the Containers Pension Plan assets for benefits accrued for such employees while they were employed by Del Monte. Certain salaried employees of Plastics, including Plastics' executive officers, were covered by the Monsanto Company Salaried Employees' Pension Plan (the "Monsanto Pension Plan") immediately prior to the acquisition of Monsanto Plastic Containers. The Plastics Pension Plan recognizes prior service under the Monsanto Pension Plan for purposes of eligibility, vesting and benefit accrual. The benefits payable at retirement under, or upon vested termination from, the Plastics Pension Plan are based on the benefit formula and all other factors then in effect under the Plastics Pension Plan applied to all combined pension service. Such benefit is offset by the accrued benefit, if any, such employee is entitled to receive under the Monsanto Pension Plan as of August 31, 1987. Under the Plastics Pension Plan, pensions are based on the greatest of (i) years of benefit service multiplied by 1.4% of Average Earnings, which is defined as the greater of (a) average compensation received during the final 36 months of employment or (b) average compensation received during the highest three of the final five calendar years of employment; (ii) years of benefit service multiplied by 1.5% of Average Earnings less a 50% social security offset; or (iii) years of benefit service multiplied by $30.00. For employees hired between April 1, 1986 and September 1, 1987, the formula is the greater of (i) years of benefit service multiplied by 1.2% of Average Earnings; or (ii) years of benefit service multiplied by 1.5% of Average Earnings less a 50% social security offset. For employees hired after September 1, 1987, the formula is years of benefit service multiplied by 1.1% of Average Earnings. Average Earnings under the Plastics Pension Plan is a participant's total cash income before deduction for contributions, if any, to a plan pursuant to Section 401(k) of the Code or Section 125 of the Code less any moving expense allowance but, in no event, shall Average Earnings exceed 125% of base pay of the participant. A participant becomes fully vested after five years of service or attainment of Normal Retirement Age (as defined under the Plastics Pension Plan), if earlier. The following table illustrates the estimated annual normal retirement benefits that are payable under the Plastics Pension Plan based upon the greater of 1.4% of Average Earnings, without reduction for social security or other offset amounts, or 1.5% of Average Earnings less a 50% social security offset. Such benefit levels assume retirement age at 65, the years of service shown, continued existence of the Plastics Pension Plan without substantial change and payment in the form of a single life annuity and includes benefits, if any, payable under the Monsanto Pension Plan which will be paid by that plan. Pursuant to Section 401(a)(17) of the Code, there is a limit on the amount of annual compensation which can be taken into account under the Plastics Pension Plan. The dollar limit on compensation for 1993 was $235,840. The dollar limit on compensation for 1994 is $150,000. The dollar limit, where applicable, will reduce the amount of benefits payable to highly compensated participants in the Plastics Pension Plan. Stock Option Plans Containers, Plastics and Holdings have established separate but virtually identical stock option plans entitled, respectively, the Silgan Containers Corporation Amended and Restated 1989 Stock Option Plan (the "Containers Plan"), the Silgan Plastics Corporation Amended and Restated 1989 Stock Option Plan (the "Plastics Plan") and the Silgan Holdings Inc. Amended and Restated 1989 Stock Option Plan (the "Holdings Plan"; collectively, the "Plans"). Under each such Plan, participants may be granted options to purchase shares of common stock or restricted stock and/or SARs. Options granted may be either nonstatutory stock options or incentive stock options under Section 422 of the Code. SARs granted may be related to options concurrently granted or independent of any options. The board of directors of each of the respective sponsoring companies, through a committee, administers its respective plan and has the power to, among other things, choose participants, the type of grant and all the terms and conditions thereof, including number of shares covered by a grant and the exercise price, if applicable. Only officers (including executive officers) and other key employees are eligible to participate in the plan sponsored by their employer. As of December 31, 1993, Containers and Plastics have reserved 1,200 authorized but unissued shares of their respective common stock, $.01 par value, for issuance under their respective plans and Holdings has reserved 15,000 authorized but unissued shares of its Class C common stock, $.01 par value, for issuance under the Holdings Plan. Pursuant to the Merger Agreement dated April 28, 1989 between Silgan, Holdings and Acquisition (the "Merger Agreement"), all outstanding options and SARs granted under predecessor stock option plans to the Containers Plan, Plastics Plan and Holdings Plan (the "Predecessor Option Plans") were surrendered for cancellation and, in partial consideration therefor, holders, including executive officers, were issued in 1989 nonstatutory options and related SARs under each of the Plans, as appropriate. Generally, each option granted under the Plans becomes exercisable over a period of five years, with 20% of the option having become exercisable on June 30, 1990 and an additional 20% having become or becoming exercisable on each anniversary thereafter. The purchase price of each option granted under the Containers Plan ranges from $2,122 to $2,456 per share. The purchase price of options granted under the Plastics Plan is $746 per share. The purchase price of options granted under the Holdings Plan is $35.00 per share. Each option granted under the Plans was granted with related SARs. The SARs extend to all option shares and provide for a payment by the sponsoring company to the holder of an amount equal to the excess of the book value of a share of the sponsoring company at the SAR exercise date or, if applicable, the fair market value of such share at the SAR exercise date after a public offering of such shares, over the exercise price of the SAR multiplied by the number of shares involved in the SAR exercise. Each option and related SAR granted under each of the Plans expires on June 29, 1999 or on such earlier date as the holder's employment shall terminate or within a specified period after termination as provided in the respective Plans. All options granted under any of the Plans must be evidenced by an option agreement between the sponsoring company and the option recipient embodying all the terms and conditions of the option grant; provided, however, that (i) all options must be granted before the respective Plan expires, (ii) incentive stock options granted must comply with Section 422 of the Code, (iii) all options must be exercisable no earlier than one year from the date of grant, (iv) no option shall be transferable or assignable otherwise than by will or the laws of descent and distribution and, during the lifetime of the recipient, such option shall be exercisable only by the recipient, (v) all options must expire or remain exercisable for a limited time after termination of employment, all as specified in the respective Plans, and (vi) upon exercise of all options, full payment for the shares covered shall be made in cash, shares of common stock of the sponsoring company already owned or a combination thereof. All SARs granted under any of the Plans must be evidenced by an agreement containing the terms of exercise and manner of settlement; provided, however, that (i) all SARs must be granted before the respective Plan expires, (ii) SARs must be exercisable no earlier than one year from the date of grant, (iii) SARs granted in tandem with options must have the same terms and conditions as the related option and the exercise of a related SAR extinguishes the related option to the extent exercised and vice versa and (iv) SARs may contain a provision for automatic exercise on the last day of the term thereof. Restricted stock issued under any of the Plans must bear an appropriate legend referring to the terms, conditions and restrictions applicable thereto. The sponsoring company has a right to purchase and participants have a right to require the sponsoring company to repurchase its common stock acquired pursuant to the respective Plan upon the occurrence of certain events in accordance with such Plan. In the event of a public offering of any of Holdings' common stock or a sale of Holdings to a third party, the options granted by Containers and Plastics pursuant to their respective Plans and any stock issued upon exercise of such options are convertible into either stock options or common stock of Holdings. The calculation of the number of shares to be issued upon the conversion of such options or shares will be determined based upon a valuation of Holdings and an allocation of such value among its subsidiaries (after giving effect to, among other things, that portion of the outstanding indebtedness of Holdings allocable to each such subsidiary). Certain Employment Agreements Certain executive officers and other key employees of Containers and Plastics (including Messrs. Beam and Wojdon) have executed employment agreements. The initial term of such employment agreements is generally three years from its effective date and is automatically extended for successive one year periods unless terminated pursuant to the terms of such agreement. Each such employment agreement provides for, among other things, a minimum severance benefit equal to base salary and benefits for, in most cases, a period of one year (or the remainder of the term of the agreement, if longer) (i) if the employee is terminated by his employer for any reason other than disability or for cause as specified in the agreement or (ii) if the employee voluntarily terminates employment due to a demotion and, in some cases, significant relocation, all as specified in the agreement. The foregoing summaries of the various benefit plans and agreements of the Company are qualified by reference to such plans and agreements, copies of certain of which have been filed as exhibits to this Annual Report on Form 10-K. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Certain Beneficial Owners of the Company's Capital Stock All of the outstanding shares of common stock of the Company, consisting of one share of Class A Common Stock, par value $.01 per share (the "Company Class A Stock"), and one share of Class B Common Stock, par value $.01 per share (the "Company Class B Stock"), are owned by Holdings. Holdings' address is 4 Landmark Square, Stamford, CT 06901. Certain Beneficial Owners of Holdings' Capital Stock The following table sets forth, as of March 15, 1994, certain information with respect to the beneficial ownership by certain persons and entities of outstanding shares of capital stock of Holdings: See "Description of Holdings Common Stock" and "Description of the Holdings Organization Agreement" for additional information about the common stock of Holdings, the holders thereof and certain arrangements among them. Description of Common Stock of the Company Under the Company's Restated Certificate of Incorporation, the Company has authority to issue 1,000 shares of Company Class A Stock, 1,000 shares of Company Class B Stock and 1,000 shares of Class C Common Stock, par value $.01 per share (the "Company Class C Stock"). The Company currently has one share of Company Class A Stock and one share of Company Class B Stock outstanding, which shares were issued to Holdings on June 30, 1989 in conjunction with the effectiveness of the 1989 Mergers. No shares of Company Class C Stock are currently outstanding. Description of Holdings Common Stock Certain of the statements contained herein are summaries of the detailed provisions of the Restated Certificate of Incorporation of Holdings (the "Certificate of Incorporation") and are qualified in their entirety by reference to the Certificate of Incorporation, a copy of which is filed herewith. Under the Certificate of Incorporation, Holdings has authority to issue 500,000 shares of Class A Common Stock, par value $.01 per share (the "Holdings Class A Stock"), 667,500 shares of Class B Common Stock, par value $.01 per share (the "Holdings Class B Stock"), and 1,000,000 shares of Class C Common Stock, par value $.01 per share (the "Holdings Class C Stock" and, together with the Holdings Class A Stock and Holdings Class B Stock, the "Holdings Common Stock"). Holdings has an aggregate of 1,135,000 shares of Holdings Common Stock outstanding as follows: (i) 417,500 shares of Holdings Class A Stock; (ii) 667,500 shares of Holdings Class B Stock; and (iii) 50,000 shares of Holdings Class C Stock. Except as described below, the rights, privileges and powers of Holdings Class A Stock and Holdings Class B Stock are identical, with each share of each class being entitled to one vote on all matters to come before the stockholders of Holdings. Until the occurrence of a Change of Control (as defined in the Certificate of Incorporation and as described below), the affirmative vote of the holders of not less than a majority of the outstanding shares of Holdings Class A Stock and Holdings Class B Stock, voting as separate classes, shall be required for the approval of any matter to come before the stockholders of Holdings, except that (i) the holders of a majority of the outstanding shares of Holdings Class A Stock, voting as a separate class, have the sole right to vote for the election and removal of three directors (the directors elected by the holders of Holdings Class A Stock being referred to herein as "Class A Directors"); (ii) the holders of a majority of the outstanding shares of Holdings Class B Stock, voting as a separate class, have the sole right to vote for the election and removal of all directors other than the Class A Directors (the directors elected by the holders of Holdings Class B Stock being referred to herein as "Class B Directors"); and (iii) the vote of not less than a majority of the outstanding shares of Holdings Class B Stock shall be required in certain circumstances set forth in the Certificate of Incorporation. The holders of Holdings Class C Stock have no voting rights except as provided by applicable law and except that such holders are entitled to vote as a separate class on certain amendments to the Certificate of Incorporation as provided therein. In the event Holdings sells shares of any class of its common stock to the public, the distinctions between Holdings Class A Stock and Holdings Class B Stock terminate, the powers, including voting powers, of Holdings Class A Stock and Holdings Class B Stock shall be identical upon compliance with certain provisions contained in the Certificate of Incorporation, and any Regulated Stockholder (generally defined to mean banks) will be entitled to convert all shares of Holdings Class C Stock held by such stockholder into the same number of shares of Holdings Class B Stock (or Holdings Class A Stock to the extent such Holdings Class C Stock was issued upon conversion of Holdings Class A Stock). After a Change of Control, the affirmative vote of the holders of not less than a majority of the outstanding shares of Holdings Class A Stock and Holdings Class B Stock, voting together as a single class, will be required for the approval of any matter to come before the stockholders of Holdings, except that the provisions described in clauses (i) and (ii) in the preceding paragraph shall continue to apply from and after a Change of Control, and except as otherwise provided in the Certificate of Incorporation with respect to its amendment. Also, after a Change of Control, the number of Class B Directors will be increased to five. In the event that a vacancy among the Class A Directors or the Class B Directors occurs at any time prior to the election of directors at the next scheduled annual meeting of stockholders, the vacancy shall be filled, in the case of the Class A Directors, by either (i) the vote of the holders of a majority of the outstanding shares of Holdings Class A Stock, at a special meeting of stockholders, or (ii) by written consent of the holders of a majority of the outstanding shares of Holdings Class A Stock, and, in the case of the Class B Directors, by either (i) the vote of the holders of a majority of the outstanding shares of Holdings Class B Stock at a special meeting or stockholders, or (ii) by written consent of the holders of a majority of the outstanding shares of the Holdings Class B Stock. A "Change of Control" is defined in the Certificate of Incorporation to include the occurrence of any of the following events: (i) Messrs. Silver and Horrigan shall collectively own, directly or indirectly, less than one-half of the aggregate number of outstanding shares of Holdings Class A Stock owned by them directly or indirectly on June 30, 1989 on a common stock equivalent basis, or (ii) the acceleration of the indebtedness under the Credit Agreement or the Discount Debentures, as a result of the occurrence of an event of default thereunder relating to a payment default or a financial covenant event of default. Description of the Holdings Organization Agreement Concurrently with the issuance and sale to First Plaza of the Holdings Stock, Holdings, The Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"), Bankers Trust New York Corporation ("BTNY"), First Plaza and Messrs. R. Philip Silver and D. Greg Horrigan entered into the Amended and Restated Organization Agreement dated as of December 21, 1993 (the "Holdings Organization Agreement") that provides for the termination of the Organization Agreement dated as of June 30, 1989 by and among Holdings, MSLEF II, BTNY and Messrs. Silver and Horrigan (except for the indemnification provisions thereof, which provisions survive) and for the investment by First Plaza in Holdings and the relationships among the stockholders and between the stockholders and Holdings. Certain of the statements contained herein are summaries of the detailed provisions of the Holdings Organization Agreement and are qualified in their entirety by reference to the Holdings Organization Agreement. The Holdings Organization Agreement prohibits the disposition of Holdings' common stock without the prior written consent of Messrs. Silver and Horrigan and MSLEF II, except for (i) dispositions to affiliates (which, in the case of First Plaza, includes any successor or underlying trust, and which, in the case of MSLEF II, does not include any person which is not an Investment Entity (as defined below)), (ii) dispositions to certain family members of Messrs. Silver and Horrigan or trusts for the benefit of those family members, (iii) certain transfers among MSLEF II, BTNY, First Plaza and Messrs. Silver and Horrigan that comply with certain rights of first refusal set forth in the Holdings Organization Agreement, which rights expire on June 30, 1994, (iv) dispositions to certain parties at any time on or after June 30, 1994, subject to certain other rights of first refusal discussed below, (v) the sale by First Plaza to Holdings of all of the Holdings Stock acquired by First Plaza on December 21, 1993, upon the exercise of Holdings' call option as described below, and (vi) dispositions in connection with an initial public offering of the common stock of Holdings, as described below. Any transfer of Holdings' common stock (other than transfers described in clauses (v) and (vi) of the preceding sentence) will be void unless the transferee agrees in writing prior to the proposed transfer to be bound by the terms of the Holdings Organization Agreement. At any time on or after June 30, 1994, MSLEF II may effect a sale of stock to an Investment Entity (generally defined as any person who (i) is primarily engaged in the business of investing in securities of other companies and not taking an active role in the management or operations of such companies and (ii) does not permit the participation or involvement in any way in the business or affairs of Holdings of a person who is engaged in a business not described in clause (i)) or, in the event of certain defaults under the amended and restated management services agreement by and between S&H, Inc., a company wholly-owned by Messrs. Silver and Horrigan ("S&H"), and Holdings (described below under "Description of Management Agreements"), to a third party, in each case, if it first offers such stock to: (a) Holdings, (b) the Group (defined generally to mean, collectively, Silver and Horrigan and their respective affiliates and certain related family transferees and estates, with Silver and his affiliates and certain related family transferees and estates being deemed to be collectively one member of the Group, and Horrigan and his affiliates and certain related family transferees and estates being deemed to be collectively one member of the Group) and (c) BTNY, in each case on the same terms and conditions as the proposed sale to an Investment Entity or the proposed third party sale. In addition, in any such sale by MSLEF II, BTNY and First Plaza must be given the opportunity to sell the same percentage of its stock to such Investment Entity or third party. At any time on or after June 30, 1994, each member of the Group may transfer shares of stock to a third party if such holder first offers such shares to: (a) the other member of the Group, (b) Holdings, (c) MSLEF II and (d) BTNY, in each case on the same terms and conditions as the proposed third party sale. At any time on or after June 30, 1994, BTNY may effect a sale of stock to a third party if it first offers such shares to: (a) Holdings, (b) MSLEF II and (c) the Group, in each case on the same terms and conditions as the proposed third party sale. At any time on or after June 30, 1994, either MSLEF II or the Group has the right to require a recapitalization transaction. A recapitalization transaction is defined as any transaction (such as a merger, consolidation, exchange of securities or liquidation) involving Holdings pursuant to which MSLEF II and the Group retain their proportionate ownership interest in the surviving entity if the following conditions are met: (i) the value of any securities of the surviving entity acquired or retained by the party not initiating the recapitalization transaction does not exceed 67% of the difference between (x) the value of such securities and any cash received by such party and (y) all taxes payable as a result of the transaction, (ii) if MSLEF II initiates the recapitalization transaction and will not own all the voting equity securities of the surviving entity not owned by the Group, the Group shall have the right to purchase such securities, (iii) if the Group initiates the recapitalization transaction and will not own all of the voting equity securities of the surviving entity, MSLEF II shall have the right to purchase such securities, and (iv) the majority in principal amount of the indebtedness incurred in connection with such transaction shall be held for at least one year by persons not affiliated with either MSLEF II or any member of the Group. The Holdings Organization Agreement provides that in the event that either Mr. Silver or Mr. Horrigan (each, a "Manager") dies or becomes permanently disabled prior to June 30, 1994 (an "Inactive Manager"), such Inactive Manager or his affiliates shall have the right to sell to Holdings all Holdings Class A Stock held by the Inactive Manager at the Fair Market Value (as defined in the Holdings Organization Agreement) of such stock, provided that such stock must first be offered to the remaining Manager at the same price. The Holdings Organization Agreement also provides that if either Mr. Silver or Mr. Horrigan dies, becomes permanently disabled or is convicted of any felony directly related to the business of Holdings prior to June 30, 1994, the other Manager and his affiliates shall have the right to purchase all of such person's Holdings Class A Stock at a price equal to Fair Market Value in the case of death or disability and the Adjusted Book Value (as defined in the Holdings Organization Agreement) in the case of a conviction as stated above, and Holdings shall have the right to purchase all such stock not purchased by the other Manager. At any time prior to December 21, 1998, Holdings shall have the right and option to purchase from First Plaza, and First Plaza shall have the obligation to sell to Holdings, all (but not less than all) of the Holdings Stock for a price per share equal to the greater of (i) $120 per share and (ii) the purchase price necessary to yield on an annual basis a compound return on investment of forty percent (40%). The number of shares subject to such call and the call purchase price shall be proportionately adjusted to take into account any stock dividend, stock split, combination of shares, subdivision or other recapitalization of the capital stock of Holdings. The Holdings Organization Agreement provides that at any time after June 15, 1996, the holders of a majority of the issued and outstanding shares of Holdings Class A Stock and Holdings Class B Stock (considered together as a class) may by written notice to Holdings require Holdings to pursue the first public offering of Holdings' common stock pursuant to an effective registration statement (an "IPO") on the terms and conditions provided in the Holdings Organization Agreement. In addition to the portion of the IPO which shall consist of shares of Holdings' common stock to be sold by Holdings, the IPO may also include a secondary tranche consisting of shares of Holdings' common stock to be sold by stockholders of Holdings. Pursuant to the provisions of the Holdings Organization Agreement, each of MSLEF II, BTNY, First Plaza and Messrs. Silver and Horrigan has agreed to take all action (including voting its shares of Holdings' common stock) to approve the adoption of the Restated Certificate of Incorporation of Holdings, as amended, the Amended and Restated By-laws of Holdings, and the Amended and Restated Management Services Agreement (the "Post-IPO Management Services Contract"), in each case substantially in the form agreed to pursuant to the Holdings Organization Agreement and in each case to become effective at the time an IPO is completed. The Post-IPO Management Services Contract provides, among other things, for the payment to S&H of management fees of $2.0 million annually plus reimbursement of expenses. See "Certain Relationships and Related Transactions -- Management Agreements" below. Pursuant to the provisions of the Holdings Organization Agreement, MSLEF II has agreed that it will not vote its shares of Holdings Class B Stock in favor of any changes in the Certificate of Incorporation or By-laws of Holdings which would adversely affect the rights of First Plaza, unless First Plaza has consented in writing to such change. In addition, so long as First Plaza shall hold not less than 18.73% of the issued and outstanding shares of Holdings Class B Stock, First Plaza shall have the right to nominate one of the Class B Directors to be elected at each annual meeting of stockholders in accordance with the provisions of the Certificate of Incorporation, and the holders of Holdings Class B Stock parties to the Holdings Organization Agreement have agreed to vote their shares of Holdings Class B Stock in favor of such nominee. In addition, in the event that First Plaza, MSLEF II or BTNY shall purchase any shares of Holdings Class A Stock, such purchaser has agreed that it will vote such shares in accordance with the directions of the "holders of a majority of the shares of Class A Stock held by the Group" (defined generally to mean the holders of a majority of the aggregate of 417,500 shares of Holdings Class A Stock held by Messrs. Silver and Horrigan at December 21, 1993, which at the time of any such determination have been continuously and are held by the Group) until such time as a Change of Control has occurred. In the event that Messrs. Silver or Horrigan shall purchase any shares of Holdings Class B Stock, such purchaser agrees that it will vote such shares in accordance with the directions of MSLEF II, unless MSLEF II and First Plaza (together with their respective affiliates) shall hold directly or indirectly less than one-half of the aggregate number of shares of Holdings Class B Stock held by MSLEF II and First Plaza immediately following the issuance and sale of the Holdings Stock to First Plaza on December 21, 1993. Pursuant to the terms of the Holdings Organization Agreement, Holdings entered into an amended and restated management services agreement with S&H, a corporation wholly owned by Messrs. Silver and Horrigan. See "Description of Management Agreements" below. The Holdings Organization Agreement terminates upon the earlier of (i) the mutual agreement of the parties, (ii) such time as it becomes unlawful, (iii) the completion of an IPO, and (iv) June 30, 1999. The parties may agree to extend the term of the Holdings Organization Agreement. Description of the Holdings Stockholders Agreement Concurrently with the issuance and sale to First Plaza of the Holdings Stock, Holdings, MSLEF II, BTNY, First Plaza and Messrs. Silver and Horrigan entered into a Stockholders Agreement dated as of December 21, 1993 (the "Stockholders Agreement") that provides for certain prospective rights and obligations among the stockholders and between the stockholders and Holdings. The operative provisions of the Stockholders Agreement do not take effect until after the occurrence of an IPO, at which time the Holdings Organization Agreement will have terminated in accordance with its terms as described above under "Description of the Holdings Organization Agreement." Certain of the statements contained herein are summaries of the detailed provisions of the Stockholders Agreement and are qualified in their entirety by reference to the Stockholders Agreement. The Stockholders Agreement provides that for a period of eight years after the IPO, each of MSLEF II and First Plaza shall have the right to demand two separate registrations of its shares of Holdings' common stock (equalling a total of four separate demand registrations); provided, however, that such demand right will terminate as to MSLEF II or First Plaza, as the case may be, at such time as MSLEF II or First Plaza, as the case may be, together with its affiliates, owns less than five percent of the issued and outstanding shares of Holdings' common stock at any time. If, at any time or from time to time for a period of eight years after the IPO, Holdings shall determine to register Holdings' common stock (other than in connection with certain non-underwritten offerings), Holdings will offer each of MSLEF II, BTNY, First Plaza and Messrs. Silver and Horrigan the opportunity to register shares of Holdings' common stock it holds in a "piggyback registration." The Stockholders Agreement prohibits the transfer prior to June 30, 1999 (or, in the case of any restriction applicable to First Plaza, December 21, 1998) by MSLEF II, First Plaza or Messrs. Silver or Horrigan of Holdings' common stock without the prior written consent of Messrs. Silver and Horrigan and MSLEF II, except for (i) transfers made in connection with a public offering or a Rule 144 Open Market Transaction (as defined in the Stockholders Agreement), (ii) transfers made to an affiliate, which, in the case of a transfer by First Plaza or MSLEF II to an affiliate, must be an Investment Entity (defined generally to be any person who is primarily engaged in the business of investing in securities of other companies and not taking an active role in the management or operations of such companies), (iii) transfers made to certain family members of Messrs. Silver and Horrigan or trusts for the benefit of those family members, (iv) certain transfers by First Plaza to a third party that comply with certain rights of first refusal of the Group and MSLEF II set forth in the Stockholders Agreement, (v) certain transfers by MSLEF II to an Investment Entity or, in the event of certain defaults under the amended and restated management services agreement between S&H and Holdings, to a third party, that comply with certain rights of first refusal of the Group set forth in the Stockholders Agreement, (vi) certain transfers by either member of the Group to a third party that comply with certain rights of first refusal of the other member of the Group and MSLEF II set forth in the Stockholders Agreement, and (vii) in the case of MSLEF II, a distribution of all or substantially all of the shares of Holdings' common stock then owned by MSLEF II to the partners of MSLEF II (a "MSLEF Distribution"). Notwithstanding the foregoing, MSLEF II may pledge its shares of Holdings' common stock to a lender or lenders reasonably acceptable to Holdings to secure a loan or loans to MSLEF II. In the event of any proposed foreclosure of such pledge, such shares will be subject to certain rights of first refusal of the Group set forth in the Stockholders Agreement. The Stockholders Agreement provides that until December 21, 1998, for so long as MSLEF II and its affiliates (excluding the limited partners of MSLEF II who may acquire shares of Holdings' common stock from MSLEF II in a MSLEF Distribution) shall hold at least one-half of the number of shares of Holdings' common stock held by MSLEF II on December 21, 1993 (as adjusted, if necessary, to take into account any stock dividend, stock split, combination of shares, subdivision or recapitalization of the capital stock of Holdings), the parties and their Restricted Voting Transferees (as defined in the Stockholders Agreement) shall use their best efforts (including to vote any shares of Holdings' common stock owned or controlled by such person or otherwise) to cause the nomination and election of two (2) members of the Board of Directors of Holdings to be chosen by MSLEF II; provided, however, that each such nominee shall be (i) either an employee of Morgan Stanley whose primary responsibility is managing investments for MSLEF II (or a successor or related partnership) or (ii) a person reasonably acceptable to the Group not engaged in (as a director, officer, employee, agent or consultant or as a holder of more than five percent of the equity securities of) a business competitive with that of Holdings. In addition, until December 21, 1998, for so long as the Group shall hold at least one-half of the number of shares of Holdings' common stock held by it in the aggregate on December 21, 1993 (as adjusted, if necessary, to take into account any stock dividend, stock split, combination of shares, subdivision or recapitalization of the capital stock of Holdings), the parties and their Restricted Voting Transferees shall use their best efforts (including to vote any shares of Holdings' common stock owned or controlled by such person or otherwise) to cause the nomination and election of two (2) individuals nominated by the "holders of a majority of the shares of [c]ommon [s]tock held by the Group" (as such phrase is defined in the Stockholders Agreement) as members of the Board of Directors of Holdings; provided, however, that at least one (1) of such nominees shall be Silver or Horrigan and the other person, if not Silver or Horrigan, shall be a person reasonably acceptable to MSLEF II, so long as MSLEF II and its affiliates (other than any affiliate which is not an Investment Entity and excluding the limited partners of MSLEF II who may acquire shares of Holdings' common stock from MSLEF II in a MSLEF distribution) shall hold at least one-half of the number of shares of Holdings' common stock held by MSLEF II at the Closing Date (as adjusted, if necessary, to take into account any stock dividend, stock split, combination of shares, subdivision or recapitalization of the capital stock of Holdings). Subject to the terms of the preceding two paragraphs, for so long as the Group shall hold at least one-half of the number of shares of Holdings' common stock held by it in the aggregate at the Closing Date (as adjusted, if necessary, to take into account any stock dividend, stock split, combination of shares, subdivision or recapitalization of the capital stock of Holdings), First Plaza and its Restricted Voting Transferees shall vote all shares of Holdings' common stock held by them in favor of any other directors standing for election to Holdings' Board of Directors for whom the holders of a majority of the shares of Holdings' common stock held by the Group shall direct First Plaza to vote. The Stockholders Agreement further provides that until December 21, 1998, MSLEF II and its Restricted Voting Transferees shall vote all shares of Holdings' common stock held by them against any unsolicited merger, or sale of Holdings' business or its assets, if such transaction is opposed by the holders of a majority of the shares of common stock held by the Group, unless as of the applicable record date for such vote, the Group holds less than ninety percent (90%) of the number of shares of Holdings' common stock held by it in the aggregate at the Closing Date (as adjusted, if necessary, to take into account any stock dividend, stock split, combination of shares, subdivision or recapitalization of the capital stock of Holdings). Until December 21, 1998, First Plaza and its Restricted Voting Transferees shall vote all shares of common stock held by them against any unsolicited merger, or sale of Holdings' business or its assets, if such transaction is opposed by the holders of a majority of the shares of common stock held by the Group; provided, however, that First Plaza and its Restricted Voting Transferees shall not be required to vote their shares of Holdings' common stock in accordance with the foregoing if (i) in connection with such merger or sale, (x) First Plaza and its Restricted Voting Transferees propose to sell or otherwise transfer all of their shares of Holdings' common stock to a third party for aggregate cash consideration of less than $10 million and (y) the Group and/or MSLEF II has not exercised their right of first refusal in respect of such sale or transfer by First Plaza or such right of first refusal in respect of the shares of Holdings' common stock held by First Plaza shall have terminated, or (ii) as of the applicable record date for such vote, the Group holds less than ninety percent (90%) of the number of shares of Holdings' common stock held by it in the aggregate at the Closing Date (as adjusted, if necessary, to take into account any stock dividend, stock split, combination of shares, subdivision or recapitalization of the capital stock of Holdings). Item 13. Item 13. Certain Relationships and Related Transactions. Management Agreements Holdings, Silgan, Containers and Plastics each entered into an amended and restated management services agreement dated as of December 21, 1993 (collectively, the "Management Agreements") with S&H to replace in its entirety its existing management services agreement, as amended, with S&H. Pursuant to the Management Agreements, S&H provides Holdings, Silgan, Containers and Plastics and their respective subsidiaries with general management and administrative services (the "Services"). The Management Agreements provide for payments to S&H (i) on a monthly basis, of $5,000 plus an amount equal to 2.475% of consolidated earnings before depreciation, interest and taxes of Holdings and its subsidiaries ("Holdings EBDIT"), for such calendar month until Holdings EBDIT for the calendar year shall have reached an amount set forth in the Management Agreements for such calendar year (the "Scheduled Amount") and 1.65% of Holdings EBDIT for such calendar month to the extent that Holdings EBDIT for the calendar year shall have exceeded the Scheduled Amount but shall not have been greater than an amount (the "Maximum Amount") set forth in the Management Agreements (the "Monthly Management Fee") and (ii) on a quarterly basis, of an amount equal to 2.475% of Holdings EBDIT for such calendar quarter until Holdings EBDIT for the calendar year shall have reached the Scheduled Amount and 1.65% of Holdings EBDIT for such calendar quarter to the extent that Holdings EBDIT for the calendar year shall have exceeded the Scheduled Amount but shall not have been greater than the Maximum Amount (the "Quarterly Management Fee"). The Scheduled Amount was $65.5 million for the calendar year 1993 and increases by $6.0 million for each year thereafter. The Maximum Amount is $90.197 million for the calendar year 1994, $95.758 million for the calendar year 1995, $98.101 million for the calendar year 1996, $100.504 million for the calendar year 1997, $102.964 million for the calendar year 1998 and $105.488 million for the calendar year 1999. The Management Agreements provide that upon receipt by Silgan of a notice from Bankers Trust that certain events of default under the Credit Agreement have occurred, the Quarterly Management Fee shall continue to accrue, but shall not be paid to S&H until the fulfillment of certain conditions, as set forth in the Management Agreements. The Management Agreements continue in effect until the earliest of: (i) the completion of an IPO; (ii) June 30, 1999; (iii) at the option of each of the respective companies, the failure or refusal of S&H to perform its obligations under the Management Agreements, if such failure continues unremedied for more than 60 days after written notice of its existence shall have been given; (iv) at the option of MSLEF II (a) if S&H or Holdings is declared insolvent or bankrupt or a voluntary bankruptcy petition is filed by either of them, (b) upon the occurrence of any of the following events with respect to S&H or Holdings if not cured, dismissed or stayed within 45 days: the filing of an involuntary petition in bankruptcy, the appointment of a trustee or receiver or the institution of a proceeding seeking a reorganization, arrangement, liquidation or dissolution, (c) if S&H or Holdings voluntarily seeks a reorganization or arrangement or makes an assignment for the benefit of creditors or (d) upon the death or permanent disability of both of Messrs. Silver and Horrigan; and (v) the occurrence of a Change of Control (as defined in the Restated Certificate of Incorporation of Holdings and as described under "Description of Holdings Common Stock" above). In addition to the management fees described above, the Management Agreements provide for the payment to S&H on the closing date of the IPO of an amount, if any (the "Additional Amount") equal to the sum of the present values, calculated for each year or portion thereof, of (i) the amount of the annual management fee for such year or portion thereof that otherwise would have been payable to S&H for each such year or portion thereof for the period beginning as of the time of the IPO and ending on June 30, 1999 (the "Remaining Term") pursuant to the provisions described in the preceding paragraph but for the occurrence of the IPO, minus (ii) the amount payable to S&H for the Remaining Term at the rate of $2.0 million per year. The Management Agreements further provide that the amounts described in clause (i) of the first sentence of this paragraph will be calculated based upon S&H's good faith projections of Holdings EBDIT for each such year (or portion thereof) during the Remaining Term (the "Estimated Fees"), which projections shall be made on a basis consistent with S&H's past projections. The difference between the amount of Estimated Fees for any particular year and $2 million shall be discounted to present value at the time of the IPO using a discount rate of eight percent (8%) per annum, compounded annually. Additionally, the Management Agreements provide that Holdings, Silgan, Containers, Plastics and their respective subsidiaries shall reimburse S&H, on a monthly basis, for all out-of-pocket expenses paid by S&H in providing the Services, including fees and expenses to consultants, subcontractors and other third parties, in connection with such Services. All fees and expenses paid to S&H under each of the Management Agreements are credited against amounts paid to S&H under the other Management Agreements. Under the terms of the Management Agreements, Holdings, Silgan, Containers and Plastics have agreed, subject to certain exceptions, to indemnify S&H and its affiliates, officers, directors, employees, subcontractors, consultants or controlling persons against any losses, damages, costs and expenses they may sustain arising in connection with the Management Agreements. The Management Agreements also provide that S&H may select a consultant, subcontractor or agent to provide the Services. S&H has retained Morgan Stanley to render financial advisory services to S&H. In connection with such retention, S&H has agreed to pay Morgan Stanley a fee equal to 9.1% of the fees paid to S&H under the Management Agreements. The Credit Agreement does not permit the payment of fees under the Management Agreements above amounts provided for therein. For the years ended December 31, 1993, 1992 and 1991, pursuant to the arrangements described above, S&H earned aggregate fees, including reimbursable expenses and fees payable to Morgan Stanley, of $4.4 million, $4.2 million and $4.0 million, respectively, from the Company, Holdings, Containers, Plastics, SPHI and Silgan PET and during 1993, 1992 and 1991, Morgan Stanley earned fees of $337,000, $324,000 and $306,000, respectively. Other In connection with the 1989 Mergers, subject to the provisions of Delaware law, the Company agreed to indemnify each director, officer, employee, fiduciary and agent of the Company, Containers, Plastics and its subsidiaries and their respective affiliates against costs, expenses, judgments, fines, losses, claims, damages and settlements (except for any settlement effected without the Company's written consent) in connection with any claims, actions, suits, proceedings or investigations arising out of or related to the 1989 Mergers or their financing, including certain liabilities arising under the federal securities laws. Simultaneously with the consummation of the 1989 Mergers, a tax allocation agreement was entered into by Holdings, the Company, Plastics and Containers that permits the Company and its subsidiaries to use the tax benefits provided by the debt of Holdings and permits funds to be provided to Holdings from the Company and its subsidiaries in an amount equal to the federal and state tax liabilities of Holdings, as the parent of the consolidated group consisting of Holdings, the Company and its Subsidiaries. Such tax allocation agreement has been amended and restated from time to time to include new members of the consolidated group. In connection with the Amended and Restated Credit Agreement under the Refinancing, the lenders thereunder (including Bankers Trust) received certain fees amounting to $1.4 million. In connection with the Refinancing, Morgan Stanley received as compensation for its services as underwriter for the Notes Offering and Holdings Debentures Offering and as initial purchaser of the Secured Notes an aggregate of $11.5 million. In connection with the Credit Agreement entered into in December 1993, the Banks (including Bankers Trust) received certain fees amounting to $8.1 million. G. William Sisley, Secretary of the Company and Holdings, is a partner in the law firm of Winthrop, Stimson, Putnam & Roberts. Winthrop, Stimson, Putnam & Roberts provides legal services to Holdings, the Company and the Company's subsidiaries. PART IV Item 14. Item 14. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K. (a) Financial Statements: SILGAN CORPORATION: Report of Independent Auditors . . . . . . . . . . . . . . . . . . . . Consolidated Balance Sheets at December 31, 1993 and 1992 . . . . . . . . Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statements of Common Stockholder's 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: SILGAN CORPORATION: III. Condensed Financial Information of Silgan Corporation: Condensed Balance Sheets at December 31, 1993 and 1992 . . . . Condensed Statements of Operations for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . Condensed Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . V. Schedules of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . VI. Schedules of Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . VIII. Schedules of Valuation and Qualifying Accounts for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . All other financial statements and schedules not listed have been omitted because they are not applicable, or not required, or because the required information is included in the consolidated financial statements or notes thereto. Exhibits: Exhibit Number Description - -------- ----------- *3.1 Restated Certificate of Incorporation of the Company, as amended. 3.2 By-laws of the Company (incorporated by reference to Exhibit 3(ii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 3.3 Restated Certificate of Incorporation of Holdings (incorporated by reference to Exhibit 1 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 3.4 By-laws of Holdings (incorporated by reference to Exhibit 3.4 filed with the Company's Registration Statement on Form S-1, dated May 1, 1989, Registration Statement No. 33-28409). 4.1 Indenture dated as of June 29, 1992, between the Company and Shawmut Bank, N.A., as Trustee, with respect to the Notes (incorporated by reference to Exhibit 1 filed with the Company's Current Report on Form 8-K dated July 15, 1992, Commission File No. 33-46499). 4.2 Secured Notes Purchase Agreement dated as of June 29, 1992, between the Company and Morgan Stanley (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K dated July 15, 1992, Commission File No. 33-46499). 4.3 Indenture, dated as of June 29, 1992, between Holdings and The Connecticut National Bank, as trustee, with respect to the Discount Debentures (incorporated by reference to Exhibit 1 filed with Holdings' Current Report on Form 8-K dated July 15, 1992, Commission File No. 33-47632). 4.4 Form of the Company's 11-3/4% Senior Subordinated Notes due 2002 (incorporated by reference to Exhibit 4.5 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 4.5 Form of Holdings' 13-1/4% Senior Discount Debentures due 2002 (incorporated by reference to Exhibit 4.4 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 4.6 Registration Rights Agreement, dated August 31, 1987, among the Company and each of the Purchasers who are signatory thereto with respect to the Company's Class B Common Stock (incorporated by reference to Exhibit 10(ii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 10.1 Agreement for Purchase and Sale of Assets, dated as of June 18, 1987, between Carnation Company and Canaco Corporation (Containers) (incorporated by reference to Exhibit 2(i) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 10.2 First Amendment to Agreement for Purchase and Sale of Assets, dated as of June 15, 1987, between Carnation Company and Canaco Corporation (Containers) (incorporated by reference to Exhibit 2(ii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 10.3 Second Amendment to Agreement for Purchase and Sale of Assets, dated as of August 31, 1987, between Carnation Company and Canaco Corporation (Containers) (incorporated by reference to Exhibit 2(iii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 10.4 Asset Purchase Agreement, dated as of July 29, 1987, between Plastico Corporation (Plastics) and Monsanto Company (incorporated by reference to Exhibit 2(iv) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 10.5 First Amendment to the Asset Purchase Agreement, dated as of July 29, 1987, between Plastico Corporation (Plastics) and Monsanto Company (incorporated by reference to Exhibit 2(v) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 10.6 Agreement for Purchase and Sale of Assets, dated as of September 27, 1988, between Carnation Company and Containers (incorporated by reference to Exhibit 1 filed with the Company's Current Report on Form 8-K, dated October 17, 1988). 10.7 Agreement for Purchase and Sale of Cartons, effective October 1, 1988, between Containers and Carnation Company (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K, dated October 17, 1988). 10.8 Agreement for Sale and Purchase of Containers, dated as of December 3, 1988, between Containers and Dial (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K, dated December 19, 1988). 10.9 Asset Purchase Agreement, dated as of November 7, 1988, between Containers and Dial (incorporated by reference to Exhibit 1 filed with the Company's Current Report on Form 8-K, dated December 19, 1988). 10.10 Amended and Restated Stock Purchase Agreement, dated as of January 1, 1989, among Aim, certain shareholders of Aim, and the Company (incorporated by reference to Exhibit 1 filed with the Company's Current Report on Form 8-K, dated March 15, 1989). 10.11 Assignment and Assumption, dated as of March 1, 1989, between the Company and InnoPak Plastics Corporation (Plastics) (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K, dated March 15, 1989). 10.12 Agreement for Purchase and Sale of Assets between Fortune and InnoPak Plastics Corporation (Plastics) dated as of March 1, 1989 (incorporated by reference to Exhibit 1 filed with the Company's Current Report on Form 8-K, dated April 14, 1989). 10.13 Amendment to Agreement for Purchase and Sale of Assets, dated as of March 30, 1989, between Fortune and InnoPak Plastics Corporation (Plastics) (incorporated by reference to Exhibit 2 to the Company's Current Report on Form 8-K, dated April 14, 1989). 10.14 Assignment and Assumption Agreement, dated as of March 31, 1989, between InnoPak Plastics Corporation (Plastics) and Fortune Acquisition Corporation (incorporated by reference to Exhibit 3 to the Company's Current Report on Form 8-K, dated April 14, 1989). 10.15 Agreement for Purchase and Sale of Shares between and among InnoPak Plastics Corporation (Plastics), Gordon Malloch and Jurgen Arnemann and Express, dated as of March 1, 1989 (incorporated by reference to Exhibit 5 to the Company's Current Report on Form 8-K, dated April 14, 1989). 10.16 Amendment to Agreement for Purchase and Sale of Shares, dated as of March 31 , 1989, among InnoPak Plastics Corporation (Plastics), Express, Gordon Malloch and Jurgen Arnemann (incorporated by reference to Exhibit 6 to the Company's Current Report on Form 8-K, dated April 14, 1989). 10.17 Assignment and Assumption Agreement dated as of March 31, 1989, between InnoPak Plastics Corporation (Plastics) and 827598 Ontario Inc. (incorporated by reference to Exhibit 7 to the Company's Current Report on Form 8-K, dated April 14, 1989). 10.18 Employment Agreement, dated as of September 14, 1987, between James Beam and Canaco Corporation (Containers) (incorporated by reference to Exhibit 10(vi) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33- 18719). 10.19 Amended and Restated Employment Agreement, dated as of June 18, 1987, between Gerald Wojdon and Canaco Corporation (Containers) (incorporated by reference to Exhibit 10(vii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719). 10.20 Employment Agreement, dated as of September 1, 1989, between the Company, InnoPak Plastics Corporation (Plastics), Russell F. Gervais and Aim (incorporated by reference to Exhibit 5 filed with the Company's Report on Form 8-K, dated March 15, 1989). 10.21 Supply Agreement for Gridley, California effective August 31, 1987 (incorporated by reference to Exhibit 10(ix) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.22 Amendment to Supply Agreement for Gridley, California, dated July 1, 1990 (incorporated by reference to Exhibit 10.27 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.23 Supply Agreement for Gustine, California effective August 31, 1987 (incorporated by reference to Exhibit 10(x) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.24 Amendment to Supply Agreement for Gustine, California, dated March 1, 1990 (incorporated by reference to Exhibit 10.29 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.25 Supply Agreement for Hanford, California effective August 31, 1987 (incorporated by reference to Exhibit 10(xi) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.26 Amendment to Supply Agreement for Hanford, California, dated July 1, 1990 (incorporated by reference to Exhibit 10.31 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.27 Supply Agreement for Riverbank, California effective August 31, 1987 (incorporated by reference to Exhibit 10(xii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.28 Supply Agreement for Woodland, California effective August 31, 1987 (incorporated by reference to Exhibit 10(xiii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.29 Amendment to Supply Agreement for Woodland, California, dated July 1, 1990 (incorporated by reference to Exhibit 10.34 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.30 Supply Agreement for Morton, Illinois, effective August 31, 1987 (incorporated by reference to Exhibit 10(vii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.31 Amendment to Supply Agreement for Morton, Illinois, dated July 1, 1990 (incorporated by reference to Exhibit 10.36 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.32 Supply Agreement for Ft. Dodge, Iowa, effective August 31, 1987 (incorporated by reference to Exhibit 10(xiv) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.33 Amendment to Supply Agreement for Ft. Dodge, Iowa, dated March 1, 1990 (incorporated by reference to Exhibit 10.38 filed with the Company's Registration statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.34 Supply Agreement for Maysville, Kentucky, effective August 31, 1987 (incorporated by reference to Exhibit 10(xvi) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.35 Amendment to Supply Agreement for Maysville, Kentucky, dated March 1, 1990 (incorporated by reference to Exhibit 10.40 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.36 Supply Agreement for St. Joseph, Missouri, effective August 31, 1987 (incorporated by reference to Exhibit 10(xvii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.37 Amendment to Supply Agreement for St. Joseph, Missouri, dated March 1, 1990 (incorporated by reference to Exhibit 10.42 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.38 Supply Agreement for Trenton, Missouri, effective August 31, 1987 (incorporated by reference to Exhibit 10(xviii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.39 Amendment to Supply Agreement for Trenton, Missouri, dated March 1, 1990 (incorporated by reference to Exhibit 10.44 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.40 Supply Agreement for South Dayton, New York, effective August 31, 1987 (incorporated by reference to Exhibit 10(xix) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.41 Amendment to Supply Agreement for South Dayton, New York, dated March 1, 1990 (incorporated by reference to Exhibit 10.46 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.42 Supply Agreement for Statesville, North Carolina, effective August 31, 1987 (incorporated by reference to Exhibit 10(xx) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.43 Supply Agreement for Hillsboro, Oregon, effective August 31, 1987 (incorporated by reference to Exhibit 10(xxi) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.44 Amendment to Supply Agreement for Hillsboro, Oregon, dated March 1, 1990 (incorporated by reference to Exhibit 10.49 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.45 Supply Agreement for Moses Lake, Washington, effective August 31, 1987 (incorporated by reference to Exhibit 10(xxii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.46 Amendment to Supply Agreement for Moses Lake, Washington, dated March 1, 1990 (incorporated by reference to Exhibit 10.51 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.47 Supply Agreement for Jefferson, Wisconsin, effective August 31, 1987 (incorporated by reference to Exhibit 10(xxiii) filed with the Company's Registration Statement on Form S-1, dated January 11, 1988, Registration Statement No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.48 Amendment to Supply Agreement for Jefferson, Wisconsin, dated March 1, 1990 (incorporated by reference to Exhibit 10.53 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.49 Supply Agreement for Seaboard, effective October 1, 1988 (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K, dated October 17, 1988). 10.50 Supply Agreement for Fort Madison, dated as of December 3, 1988 (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K, dated December 19, 1988). 10.51 Amendment to Supply Agreements dated November 17, 1989 for Ft. Dodge, Iowa; Hillsboro, Oregon; Jefferson, Wisconsin; St. Joseph, Missouri; and Trenton, Missouri (incorporated by reference to Exhibit 10.49 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.52 Raw Materials Agreement, dated as of November 12, 1986, by and between Carnation and Alcoa (incorporated by reference to Exhibit 10(xxxix) filed with the Company's Registration Statement on Form S-1, dated September 14, 1988, Registration Statement No. 33- 18719). 10.53 Assignment of Raw Materials Agreement, dated as of August 31, 1987, by and between Carnation and Alcoa (incorporated by reference to Exhibit 10(xi) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.54 Amendment to Raw Materials Agreement, dated February 21, 1990, by and between Containers and Alcoa (incorporated by reference to Exhibit 10.52 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 33-18719) (Portions of this Exhibit are subject to confidential treatment pursuant to order of the Commission). 10.55 InnoPak Plastics Corporation (Plastics) Pension Plan for Salaried Employees (incorporated by reference to Exhibit 10.32 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1988, Commission File No. 33-18719). 10.56 InnoPak Plastics Corporation (Plastics) Compensation Investment Plan for Salaried Employees (incorporated by reference to Exhibit (xli) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.57 Containers Pension Plan for Salaried Employees (incorporated by reference to Exhibit 10.34 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1988, Commission File No. 33-18719). 10.58 Non-Competition Agreement, dated as of January 1, 1989, among the Company, Aim, and certain shareholders of Aim (incorporated by reference to Exhibit 4 filed with the Company's Current Report on Form 8-K, dated March 15, 1989). 10.59 Sharonville Conversion Agreement, dated as of August 31, 1987, between Monsanto and InnoPak Plastics Corporation (Plastics) (incorporated by reference to Exhibit 10(xxix) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.60 Consent, dated August 11, 1987, by Yoshino Kogyosno Co., Ltd. to the Sharonville Conversion Agreement (incorporated by reference to Exhibit 10(xxx) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.61 Lease, dated as of August 31, 1987, between Monsanto and InnoPak Plastics Corporation (Plastics), concerning the land and plant in Anaheim, California (incorporated by reference to Exhibit 10(xxxi) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.62 Assignment and Assumption Agreement, dated as of August 31, 1987, between Monsanto and Innopak Plastics Corporation (Plastics), with respect to certain premises known as the Westport Plant located in Westport, Missouri (incorporated by reference to Exhibit 10(xxxii) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.63 Amendment to Lease, dated August 31, 1987, between Houston/St. Louis Properties (Successor) and InnoPak Plastics Corporation (Plastics), with respect to property located in Westport, Missouri (incorporated by reference to Exhibit 10(xxxiii) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.64 Assignment and Assumption Agreement, dated as of August 31, 1987, between Monsanto and InnoPak Plastics Corporation (Plastics), with respect to certain premises at 2469 Schuetz Road, Westport, Missouri (incorporated by reference to Exhibit 10(xxxiv) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.65 Assignment and Assumption Agreement, dated as of August 31, 1987, between Monsanto and InnoPak Plastics Corporation (Plastics), with respect to certain premises at 2451 Schuetz Road, Westport, Missouri (incorporated by reference to Exhibit 10(xxxv) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.66 Landlord Estoppel Certificates dated August 17, 1987, with respect to real property lease located in Westport, Missouri (incorporated by reference to Exhibit 10(xxxvi) filed with the Company's Post- Effective Amendment No. 4 to its Registration Statement on Form S- 1, dated September 14, 1988, Registration No. 33-18719). 10.67 Landlord Estoppel Certificates dated August 25, 1987, with respect to real property lease covering certain premises at 2451 Schuetz Road, Westport, Missouri (incorporated by reference to Exhibit 10(xxxvii) filed with the Company's Post-Effective Amendment No. 4 to its Registration Statement on Form S-1, dated September 14, 1988, Registration No. 33-18719). 10.68 Express Guaranty dated as of March 31, 1989 (incorporated by reference to Exhibit 10.66 to Holdings' Registration Statement on Form S-1, dated May 1, 1989, Registration No. 33-28409). 10.69 Express Security Agreement dated as of March 31, 1989 (incorporated by reference to Exhibit 10.67 to Holdings' Registration Statement on Form S-1, dated May 1, 1989, Registration No. 33-28409). 10.70 Canadian Holdco Guaranty dated as of March 31, 1989 (incorporated by reference to Exhibit 10.68 to Holdings' Registration Statement on Form S-1, dated May 1, 1989, Registration No. 33-28409). 10.71 Canadian Holdco Pledge Agreement dated as of March 31, 1989 (incorporated by reference to Exhibit 10.69 to Holdings' Registration Statement on Form S-1, dated May 1, 1989, Registration No. 33-28409). 10.72 Canadian Acquisition Co. Guaranty dated as of March 31, 1989 (incorporated by reference to Exhibit 10.70 to Holdings' Registration Statement on Form S-1, dated May 1, 1989, Registration No. 33-28409). 10.73 Canadian Acquisition Co. Pledge Agreement dated as of March 31, 1989 (incorporated by reference to Exhibit 10.71 to Holdings' Registration Statement on Form S-1, dated May 1, 1989, Registration No. 33-28409). 10.74 Agreement and Plan of Merger, dated as of April 28, 1989, among Holdings, Acquisition and the Company (incorporated by reference to Exhibit 2.6 to Holdings' Registration Statement on Form S-1, dated May 1, 1989, Registration No. 33-28409). 10.75 Lease between Containers and Riverbank Venture dated May 1, 1990 (incorporated by reference to Exhibit 10.99 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 33-18719). 10.76 Loan Agreement between The Iowa Department of Economic Development, City of Iowa City and Iowa City Can Manufacturing Company, dated November 17, 1988 (incorporated by reference to Exhibit 10.100 filed with the Company's Annual Report on Form 10-K for the year ended December 31,1989, Commission File No. 33-18719). 10.77 Promissory Note and Promissory Note Agreement dated November 17, 1988 from Iowa City Can Manufacturing Company to the City of Iowa City (incorporated by reference to Exhibit 10.101 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 33-18719). 10.78 Mortgage between City of Iowa City, Iowa City Can Manufacturing Company and Michael Development dated January 5, 1990 (incorporated by reference to Exhibit 10.102 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 33-18719). 10.79 Containers Master Equipment Lease with Decimus Corporation, dated as of October 11, 1989 (incorporated by reference to Exhibit 10.103 filed with the Company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 33-18719). 10.80 Underwriting Agreement dated June 22, 1989 between Holdings and Morgan Stanley (incorporated by reference to Exhibit 1 filed with Amendment No. 4 to Holdings' Registration Statement on Form S-1, dated June 23, 1989, Registration Statement No. 33-28409). 10.81 Amended and Restated Tax Allocation Agreement by and among Holdings, the Company, Containers, InnoPak Plastics Corporation (Plastics), Aim, Fortune, SPHI and Silgan PET dated as of July 13, 1990 (incorporated by reference to Exhibit 10.107 filed with Post- Effective Amendment No. 6 to the Company's Registration Statement on Form S-1, dated August 20, 1990, Registration Statement No. 33- 18719). 10.82 Sublease Agreement between Amoco and PET Acquisition Corp. (Silgan PET) dated July 24, 1989 (incorporated by reference to Exhibit 10.111 filed with Post-Effective Amendment No. 6 to the Company's Registration Statement on Form S-1, dated August 20, 1990, Registration Statement No. 33-18719). 10.83 Lease Agreement between the Trustees of Cabot 95 Trust and Amoco Plastic Products Company dated August 16, 1978 (incorporated by reference to Exhibit 10.112 filed with Post-Effective Amendment No. 6 to the Company's Registration Statement on Form S-1, dated August 20, 1990, Registration Statement No. 33-18719). 10.84 Contribution Agreement by and among Messrs. Silver, Horrigan, Rankin and Rodriguez, MSLEF II and BTNY dated as of July 13, 1990 (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K, dated July 1990). 10.85 Asset Purchase Agreement, dated as of November 1, 1991 by and among Silgan PET, Holdings and Sewell Plastics, Inc. (incorporated by reference to Exhibit 1 filed with the Company's Current Report on Form 8-K, dated December 2,1991). 10.86 Inventory and Equipment Purchase Agreement, dated as of November 1, 1991 by and among Silgan PET, Holdings and Sewell Plastics, Inc. (incorporated by reference to Exhibit 2 filed with the Company's Current Report on Form 8-K, dated December 2, 1991). 10.87 Letter Agreement, dated November 15, 1991, amending the Asset Purchase Agreement dated as of November 1, 1991 by and among Silgan PET, Holdings and Sewell Plastics, Inc. (incorporated by reference to Exhibit 3 to the Company's Current Report on Form 8-K, dated December 2, 1991). 10.88 Letter Agreement, dated November 15, 1991, amending the Inventory and Equipment Purchase Agreement dated as of November 1, 1991 by and among Silgan PET, Holdings and Sewell Plastics, Inc. (incorporated by reference to Exhibit 4 filed with the Company's Current Report on Form 8-K, dated December 2,1991). 10.89 Letter Agreement, dated November 31, 1991, amending the Inventory and Equipment Purchase Agreement dated as of November 1, 1991 by and among Silgan PET, Holdings and Sewell Plastics, Inc. (incorporated by reference to Exhibit 5 filed with the Company's Current Report on Form 8-K, dated December 2, 1991). 10.90 Containers Deferred Incentive Savings Plan (incorporated by reference to Exhibit 10.144 filed with the Company's Registration Statement on Form S-1, dated March 18, 1992, Registration Statement No. 33-46499). 10.91 Amended and Restated Credit Agreement dated as of June 18, 1992, among the Company, Containers, Plastics, various banks and Bankers Trust, as Agent (incorporated by reference to Exhibit 4 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.92 Amended and Restated Pledge Agreement dated as of June 18, 1992, made by the Company (incorporated by reference to Exhibit 5 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.93 Amended and Restated Pledge Agreement dated as of June 18, 1992, made by Containers and Plastics (incorporated by reference to Exhibit 6 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.94 Amended and Restated Pledge Agreement dated as of June 18, 1992, made by Holdings (incorporated by reference to Exhibit 7 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.95 Amended and Restated Security Agreement dated as of June 18, 1992, among Plastics, Containers and Bankers Trust (incorporated by reference to Exhibit 8 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.96 Amended and Restated Holdings Guaranty dated as of June 18, 1992 (incorporated by reference to Exhibit 9 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.97 Borrowers Guaranty, dated as of June 18, 1992, made by the Company, Containers and Plastics (incorporated by reference to Exhibit 10 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.98 Subsidiaries Guarantee, dated as of June 29, 1992, of Containers and Plastics (incorporated by reference to Exhibit 11 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.99 Underwriting Agreement, dated June 22, 1992, between the Company and Morgan Stanley with respect to the 11-3/4% Notes (incorporated by reference to Exhibit 3 filed with the Company's Current Report on Form 8-K dated, July 15, 1992, Commission File No. 33-46499). 10.100 Containers Amended and Restated 1989 Stock Option Plan (incorporated by reference to Exhibit 10.119 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 10.101 Form of Containers Nonstatutory Restricted Stock Option and Stock Appreciation Right Agreement (incorporated by reference to Exhibit 10.120 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 10.102 Plastics Amended and Restated 1989 Stock Option Plan (incorporated by reference to Exhibit 10.121 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 10.103 Form of Plastics Nonstatutory Restricted Stock Option and Stock Appreciation Right Agreement (incorporated by reference to Exhibit 10.122 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 10.104 Holdings Amended and Restated 1989 Stock Option Plan (incorporated by reference to Exhibit 10.123 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 10.105 Holdings Nonstatutory Restricted Stock Option and Stock Appreciation Right Agreement (incorporated by reference to Exhibit 10.124 filed with Holdings' Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 33-28409). 10.106 Purchase Agreement, dated as of September 3, 1993, between Containers and Del Monte (incorporated by reference to Exhibit 1 filed with Holdings' Current Report on Form 8-K, dated January 5, 1994, Commission File No. 33-28409). 10.107 Amendment to Purchase Agreement, dated as of December 10, 1993, between Containers and Del Monte (incorporated by reference to Exhibit 2 filed with Holdings' Current Report on Form 8-K, dated January 5, 1994, Commission File No. 33-28409). 10.108 Amended and Restated Organization Agreement, dated as of December 21, 1993, among R. Philip Silver, D. Greg Horrigan, MSLEF II, BTNY, First Plaza and Holdings (incorporated by reference to Exhibit 2 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.109 Stockholders Agreement, dated as of December 21, 1993, among R. Philip Silver, D. Greg Horrigan, MSLEF II, BTNY, First Plaza and Holdings (incorporated by reference to Exhibit 3 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.110 Amended and Restated Management Services Agreement, dated as of December 21, 1993, between S&H and Holdings (incorporated by reference to Exhibit 4 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.111 Amended and Restated Management Services Agreement, dated as of December 21, 1993, between S&H and Silgan (incorporated by reference to Exhibit 5 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.112 Amended and Restated Management Services Agreement, dated as of December 21, 1993, between S&H and Containers (incorporated by reference to Exhibit 6 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.113 Amended and Restated Management Services Agreement, dated as of December 21, 1993, between S&H and Plastics (incorporated by reference to Exhibit 7 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.114 Stock Purchase Agreement, dated as of December 21, 1993, between Holdings and First Plaza (incorporated by reference to Exhibit 8 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.115 Credit Agreement, dated as of December 21, 1993, among Silgan, Containers, Plastics, the lenders from time to time party thereto, Bank of America, as co-agent, and Bankers Trust, as agent (incorporated by reference to Exhibit 9 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.116 Amended and Restated Holdings Guaranty, dated as of December 21, 1993, made by Holdings (incorporated by reference to Exhibit 10 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). 10.117 Amended and Restated Borrowers Guaranty, dated as of December 21, 1993, made by Silgan, Containers, Plastics and California- Washington Can Corporation (incorporated by reference to Exhibit 11 filed with Holdings' Current Report on Form 8-K, dated March 25, 1994, Commission File No. 33-28409). *10.118 Supply Agreement, dated as of September 3, 1993, between Containers and Del Monte. (Portions of this Exhibit are subject to an application for confidential treatment filed with the Commission.) *10.119 Amendment to Supply Agreement, dated as of December 21, 1993, between Containers and Del Monte. (Portions of this Exhibit are subject to an application for confidential treatment filed with the Commission.) *22 Subsidiaries of the Registrant. (b) Reports on Form 8-K: None. _________________________ *Filed herewith 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. SILGAN CORPORATION Date: March 29, 1994 By /s/ R. Philip Silver ---------------------------- R. Philip Silver Chairman of the Board and Co-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 - --------- ----- ---- Chairman of the Board and Co-Chief Executive Officer /s/ R. Philip Silver (Principal Executive Officer) March 29, 1994 - ------------------------------ (R. Philip Silver) /s/ D. Greg Horrigan President, Co-Chief Executive March 29, 1994 - ------------------------------ Officer and Director (D. Greg Horrigan) Vice President, Assistant /s/ James S. Hoch Secretary and Director March 29, 1994 - ------------------------------ (James S. Hoch) Vice President, Assistant /s/ Robert H. Niehaus Secretary and Director March 29, 1994 - ------------------------------ (Robert H. Niehaus) Executive Vice President, Chief Financial Officer and Treasurer /s/ Harley Rankin, Jr. (Principal Financial Officer) March 29, 1994 - ------------------------------ (Harley Rankin, Jr.) Vice President, Controller and Assistant Treasurer /s/ Harold J. Rodriguez, Jr. (Principal Accounting Officer) March 29, 1994 - ------------------------------ (Harold J. Rodriguez, Jr.) REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder Silgan Corporation We have audited the accompanying consolidated balance sheets of Silgan Corporation as of December 31, 1993 and 1992, and the related consolidated statements of operations, common 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 Silgan 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 Note 2 to the consolidated financial statements, in 1993, the Company changed its method of accounting for postretirement benefits other than pensions, income taxes and postemployment benefits. Ernst & Young Stamford, CT March 10, 1994 SILGAN CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (Dollars in thousands) ASSETS 1993 1992 Current assets: Cash and cash equivalents $ 205 $ 2,672 Accounts receivable, less allowances for doubtful accounts of $1,084 and $1,643 for 1993 and 1992, respectively 44,409 44,557 Inventories 108,653 75,007 Prepaid expenses and other current assets 3,562 3,354 Total current assets 156,829 125,590 Property, plant and equipment, at cost 432,859 340,304 Less accumulated depreciation and amortization (142,464) (116,425) Net property, plant and equipment 290,395 223,879 Other assets 44,840 32,685 $492,064 $382,154 LIABILITIES AND STOCKHOLDER'S EQUITY Current liabilities: Working capital loans $ 2,200 $ 40,400 Current portion of term loans 20,000 20,899 Trade accounts payable 31,913 27,956 Accrued payroll and related costs 20,523 19,242 Accrued interest payable 783 1,067 Accrued expenses and other current liabilities 11,094 6,217 Total current liabilities 86,513 115,781 Term loans 120,000 21,681 Senior secured notes 50,000 50,000 11 3/4% Senior subordinated notes 135,000 135,000 Deferred income taxes 13,017 11,970 Other long-term liabilities 34,731 14,947 Common stockholder's equity: Common stock $0.01 par value: Class A: 1,000 shares authorized, 1 share issued and outstanding - - Class B: 1,000 shares authorized, 1 share issued and outstanding - - Class C: 1,000 authorized, none outstanding - - Additional paid-in capital (Note 8) 64,135 41,560 Retained earnings (deficit) (11,332) (8,785) Total common stockholder's equity 52,803 32,775 $492,064 $382,154 See accompanying notes. SILGAN CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) 1993 1992 1991 Net sales $645,468 $630,039 $678,211 Cost of goods sold 571,174 554,972 605,185 Gross profit 74,294 75,067 73,026 Selling, general and administrative expenses 31,786 32,249 33,619 Income from operations 42,508 42,818 39,407 Interest expense and other related financing costs 27,928 26,916 28,981 Other (income) expense 35 25 (396) Income before income taxes 14,545 15,877 10,822 Income tax provision (Note 9) 6,300 2,200 1,500 Income before extraordinary charges and cumulative effects of changes in accounting principles 8,245 13,677 9,322 Extraordinary charges relating to early extinguishment of debt, net of taxes (841) (9,075) - Cumulative effect of changes in accounting principles, net of taxes (Notes 2, 9 & 15) (9,951) - - Net income (loss) (2,547) 4,602 9,322 Preferred stock dividend requirements - 2,745 3,889 Net income (loss) applicable to common stockholder $ (2,547) $ 1,857 $ 5,433 See accompanying notes. SILGAN CORPORATION CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDER'S EQUITY For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Total Additional Retained common Common paid-in Earnings stockholder's stock capital (deficit) equity Balance at December 31, 1990 $ - $41,560 $ (351) $41,209 Preferred stock dividend requirements of Silgan - - (3,889) (3,889) Net income - - 9,322 9,322 Balance at December 31, 1991 - 41,560 5,082 46,642 Preferred stock dividend requirements of Silgan - - (2,745) (2,745) Net income - - 4,602 4,602 Dividend to Parent - - (15,724) (15,724) Balance at December 31, 1992 - 41,560 (8,785) 32,775 Capital contribution by Parent - 15,000 - 15,000 Tax benefit realized from Parent - 7,575 - 7,575 Net loss - - (2,547) (2,547) Balance at December 31, 1993 $ - $ 64,135 $ (11,332) $ 52,803 See accompanying notes. SILGAN CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) 1993 1992 1991 Cash flows from operating activities: Net income (loss) $ (2,547) $ 4,602 $ 9,322 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 31,607 29,538 30,019 Amortization 4,817 4,424 4,038 Other items 342 1,215 324 Contribution by Parent for federal income tax provision 7,575 - - Extraordinary charges relating to early extinguishment of debt 1,341 9,075 - Cumulative effect of changes in accounting principles 6,276 - - Changes in assets and liabilities, net of effect of acquisitions: (Increase) decrease in accounts receivable 707 (8,705) 23,539 (Increase) decrease in inventories (4,316) 5,541 8,471 Increase (decrease) in trade accounts payable 3,757 (4,330) (10,448) Other, net (1,228) (7,000) (3,931) Total adjustments 50,878 29,758 52,012 Net cash provided by operating activities 48,331 34,360 61,334 Cash flows from investing activities: Acquisition of Del Monte Can Manufacturing Assets (73,865) - - Capital expenditures (42,480) (23,447) (21,834) Proceeds from sale of assets 262 429 12,028 Net cash used in investing activities (116,083) (23,018) (9,806) Continued on following page. SILGAN CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) 1993 1992 1991 Cash flows from financing activities: Borrowings under working capital loans 328,050 316,050 357,560 Repayments under working capital loans (366,250) (296,850) (372,960) Repayment of term loans (42,580) (40,205) (36,507) Proceeds from issuance of term loans 140,000 - - Capital contribution by Parent 15,000 - - Proceeds from issuance of senior secured notes - 50,000 - Proceeds from issuance of 11 3/4% senior subordinated notes - 135,000 - Redemption of 14% senior subordinated notes - (89,250) - Redemption of preferred stock - (31,508) - Repayment of advance from Parent - (25,200) - Dividend to Parent - (15,724) - Cash dividends paid on preferred stock - (1,137) - Debt financing costs (8,935) (10,250) - Net cash provided (used) by financing activities 65,285 (9,074) (51,907) Net increase (decrease) in cash and cash equivalents (2,467) 2,268 (379) Cash and cash equivalents at beginning of year 2,672 404 783 Cash and cash equivalents at end of year $ 205 $ 2,672 $ 404 Supplementary data: Interest paid $ 25,733 $ 29,046 $ 27,503 Income taxes paid, net of refunds 722 1,206 764 Additional preferred stock issued in lieu of dividend - 2,130 3,817 See accompanying notes. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 1. Basis of Presentation Silgan Corporation ("Silgan", together with its wholly owned subsidiaries, Silgan Containers Corporation ("Containers") and Silgan Plastics Corporation ("Plastics"), the "Company") is a wholly owned subsidiary of Silgan Holdings Inc. ("Holdings" or "Parent"). Holdings is a company controlled by Silgan management and Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"), an affiliate of Morgan Stanley & Co. Incorporated ("MS & Co."). The Company is engaged in the packaging business which includes the manufacture and sale of steel, aluminum and paperboard containers, mainly to processors and packagers of food products, and the design, manufacture and sale of various plastic containers, mainly for food, beverage, household, pharmaceutical and personal care products. 2. Summary of Significant Accounting Policies Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions have been eliminated. Assets and liabilities of the Company's foreign subsidiary are translated at rates of exchange in effect at the balance sheet date. Income amounts are translated at the average of monthly exchange rates. Accounts Receivable Accounts receivable consist primarily of amounts due from domestic companies. Credit is extended based on an evaluation of the customer's financial condition and collateral is not generally required. The Company maintains an allowance for doubtful accounts at a level which management believes is sufficient to cover potential credit losses. Inventories Inventories are stated at the lower of cost or market (net realizable value). Finished goods, work-in-process and raw material inventories are principally accounted for by the last-in, first-out method (LIFO). Property, plant and equipment Property, plant and equipment are recorded at cost and are depreciated on the straight-line method over their estimated useful lives (ranging from 3 to 25 years). Maintenance and repair expenditures are charged to expense as incurred; major renewals and betterments are capitalized. The total amount of repairs and maintenance expense for the years ended December 31, 1993, 1992 and 1991 was $17,072, $14,962 and $16,507, respectively. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 2. Summary of Significant Accounting Policies (continued) Other Assets Cost in excess of fair value of net assets acquired is amortized on a straight-line basis over a period not exceeding forty years. Covenants not to compete are being amortized over five years. Debt issuance costs are being amortized over the terms of the related debt agreements (3 to 10 years). Cash flows For purposes of the consolidated statements of cash flows, the Company considers all highly liquid investments with a maturity of three months or less at the time of purchase and investments in money market accounts to be cash equivalents. Fair Values of Financial Instruments The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and cash equivalents: The carrying amount reported in the balance sheet for cash and cash equivalents approximates its fair value. Short and long-term debt: The carrying amounts of the Company's borrowings under its working capital loans and variable-rate borrowings approximate their fair value. The fair values of fixed-rate borrowings are based on quoted market prices. Letters of Credit: Fair values of the Company's outstanding letters of credit are based on current contractual amounts outstanding. Adoption of New Accounting Policies Postretirement Benefits Other than Pensions: Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". Under SFAS No. 106, the Company is required to accrue the estimated cost of retiree health and other postretirement benefits during the years that covered employees render service. Prior to 1993, the Company recorded these benefits on the pay-as-you-go basis. As permitted by the Statement, prior years' financials have not been restated. See Note 15 - Postretirement Benefits Other than Pensions. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 2. Summary of Significant Accounting Policies (continued) Income Taxes: Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". SFAS No. 109 requires the use of the liability method of accounting for deferred income taxes. The provision for income taxes includes federal, state and foreign income taxes currently payable and those deferred because of temporary differences between the financial statement and tax bases of assets and liabilities. The Company had previously reported under SFAS No. 96, "Accounting for Income Taxes". Under SFAS No. 96, the Company had recognized a federal income tax benefit from the tax losses of Holdings. Under SFAS No. 109, this benefit will be reflected as a contribution to additional paid-in capital instead of as a reduction of income tax expense. As permitted by the Statement, prior years' financial statements have not been restated. See Note 9 - Income Taxes. Postemployment Benefits: During 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits". The cumulative effect as of January 1, 1993 of this accounting change was to decrease net income by $826 (after related income taxes of $450). There was no effect on income before income taxes as a result of this change in accounting principle. 3. Acquisitions On December 21, 1993, Containers acquired from Del Monte Corporation ("Del Monte") substantially all of the fixed assets and certain working capital of its container manufacturing business in the United States ("DM Can"). The purchase price, which is subject to post-closing adjustments, for the assets acquired and the assumption of certain specified liabilities, including related transaction costs, was $73,865. The acquisition was accounted for as a purchase transaction and the results of operations have been included with the Company's results from the acquisition date. The total purchase cost was allocated first to the tangible assets acquired and liabilities assumed based upon their respective fair values as determined from preliminary appraisals and valuations and the excess was allocated to cost over fair value of assets acquired. The aggregate purchase cost and its preliminary allocation to the assets and liabilities is as follows: Net working capital acquired $26,400 Property, plant and equipment 57,238 Cost in excess of fair value of assets acquired 6,587 Other liabilities assumed (16,360) $73,865 SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 3. Acquisitions (continued) Set forth below is the Company's summary unaudited pro forma results of operations for the years ended December 31, 1993 and 1992. The unaudited pro forma results of operations for the year ended December 31, 1993 include the historical results of DM Can for the period ended December 21, 1993 and give effect to the pro forma adjustments. The unaudited pro forma results of operations for the year ended December 31, 1992 include the historical results of DM Can and the Company for the year ended December 31, 1992 and give effect to the pro forma adjustments. The pro forma adjustments to the historical results of operations reflect the sales prices set forth in a supply agreement with Del Monte, the estimated effect of purchase accounting adjustments based upon preliminary appraisals and evaluations, the financing of the acquisition and certain other adjustments as if these events had occurred as of the beginning of the periods mentioned therein. The following unaudited pro forma results of operations do not purport to represent what the Company's results of operations would actually have been had the transactions in fact occurred on the dates indicated or to project the Company's results for any future period: 1993 1992 Net sales $818,614 $819,579 Income from operations 51,343 57,282 Income before income taxes 18,877 25,353 Income before extraordinary charges and cumulative effect of accounting changes 10,844 22,301 Net income 52 13,226 4. Dispositions In November 1991 the Company sold substantially all of the assets used in its PET carbonated beverage bottle business. Most of the sales proceeds of $12,000 were used to repay term loans. No gain or loss was recognized as a result of the disposition. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 5. Refinancings Effective December 21, 1993, Silgan, Containers and Plastics entered into a credit agreement (the "Credit Agreement") with certain lenders (the "Banks"), Bank of America, as Co-Agent, and Bankers Trust, as Agent, to refinance in full all amounts owing under the Amended and Restated Credit Agreement, dated as of August 31, 1987, and to finance the acquisition of DM Can by Containers. Under the Credit Agreement, the Banks loaned the Company $140,000 of term loans and $29,800 of working capital loans on the effective date. In addition, Holdings contributed $15,000 to the Company. The Company used these proceeds to repay $41,452 of term loans and $60,800 of working capital loans, to acquire DM Can and pay fees and expenses. As a result of the early extinguishment of debt, the Company incurred a charge of $841 (net of $500 of taxes). See Note 10 - Bank Credit Facility. Effective June 29, 1992, the Company and Holdings refinanced a significant portion of their indebtedness (the "Refinancing"). The Refinancing included a private placement by the Company of $50,000 principal amount of its Senior Secured Floating Rate Notes due June 30, 1997 (the "Secured Notes") and a public offering of $135,000 principal amount of the Company's 11 3/4% Senior Subordinated Notes due 2002 (the "11 3/4% Notes"). The proceeds from the new debt offerings, net of $10,250 of transaction fees and expenses, were used, in part, to redeem the Company's 14% Senior Subordinated Notes (the "14% Notes") and 15% Cumulative Exchangeable Redeemable Preferred Stock (the "Preferred Stock"). The Preferred Stock (300,083 shares) was redeemed on August 16, 1992 at a redemption price of $105 per share plus accrued dividends. The 14% Notes ($85,000 aggregate principal amount) were redeemed on August 28, 1992 at a redemption price of 105% of the principal amount thereof plus accrued interest. In conjunction with the Refinancing, the Amended and Restated Credit Agreement was amended to, among other things, permit the Refinancing and the Company repaid $30,000 of term loans thereunder. In addition, the Company repaid the $25,200 advance from Holdings and advanced $16,000 to Holdings. Upon completion of the redemption of the 14% Notes, the Company paid a $15,724 dividend to Holdings which Holdings, along with additional cash earned on its short term investments of proceeds received by it in connection with the Refinancing, used to retire the outstanding advance to the Company. Such payments to Holdings, along with the public offering by Holdings of its 13 1/4% Senior Discount Debentures due 2002 (the "Discount Debentures") for an aggregate amount of proceeds of $165,435, were used by Holdings to redeem its Senior Reset Debentures due 2004 (the "Holdings Reset Debentures") on July 29, 1992. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 5. Refinancings (continued) 1992 (continued) As a result of the Refinancing, unamortized deferred financing costs elating to the 14% Notes, the Preferred Stock and the repayment of term loans under the Amended and Restated Credit Agreement totaling $3,325 in the aggregate were written off in 1992 and, along with the redemption premiums of $5,750, are reflected as an extraordinary charge. Since the Company was reporting under SFAS No. 96, there was no tax effect on this charge due to the tax allocation arrangement with Holdings and Holdings' net operating loss position. 6. Inventories Inventories at December 31, 1993 and 1992 consist of the following: 1993 1992 Raw materials and supplies $ 26,458 $ 17,623 Work-in-process 17,105 10,413 Finished goods 65,072 49,546 108,635 77,582 Adjustment to value inventory at cost on the LIFO method 18 (2,575) $108,653 $ 75,007 The amount of inventory recorded on the first-in first-out method at December 31, 1993 and 1992 was $2,178 and $2,189, respectively. 7. Property, plant and equipment Net property, plant and equipment at December 31, 1993 and 1992 consist of the following: 1993 1992 Land $ 4,469 $ 3,743 Buildings and improvements 56,087 50,382 Machinery and equipment 352,409 270,845 Construction in progress 19,894 15,334 432,859 340,304 Less: accumulated depreciation and amortization (142,464) (116,425) $290,395 $223,879 SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 8. Other Assets Other assets at December 31, 1993 and 1992 consist of the following: 1993 1992 Cost in excess of fair value of assets acquired $ 26,671 $ 20,178 Debt issuance costs 18,163 17,029 Covenants not to compete 8,500 8,500 Other 4,146 1,342 57,480 47,049 Less: accumulated amortization (12,640) (14,364) $ 44,840 $ 32,685 In 1993, upon the effectiveness of the Credit Agreement, the Company wrote off $841 of net debt issuance costs (net of tax) and capitalized $8,935 in new debt issuance costs. In 1992, as part of the Refinancing, the Company wrote off $3,325 of net debt issuance costs and capitalized $10,250 in new debt issuance costs. Amortization expense for the years ended December 31, 1993 and 1992 was $4,817 and $4,424, respectively. 9. Income Taxes Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes" which requires the use of the liability method of accounting for deferred income taxes. The Company had previously reported under SFAS No. 96, "Accounting for Income Taxes". Under SFAS No. 96, the Company had recognized a federal income tax benefit from the tax losses of Holdings. Under SFAS No. 109, this benefit will be reflected as a contribution to additional paid-in capital instead of a reduction of income tax expense. Accordingly, the Company recorded a cumulative charge to earnings and credit to paid-in capital of $6,000 for the difference in methods up to the date of adoption. As permitted by SFAS No. 109, the Company has elected not to restate prior years' financial statements. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 9. 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 at December 31 are as follows: Deferred tax liabilities: Tax over book depreciation $20,700 Book over tax basis of assets acquired 24,000 Other 6,392 Total deferred tax liabilities 51,092 Deferred tax assets: Book reserves not yet deductible for tax purposes 20,700 Net operating loss carryforwards 7,800 Benefit taken for Holdings' losses 7,575 Other 2,000 Total deferred tax assets 38,075 Net deferred tax liabilities $13,017 The Company files a consolidated Federal income tax return with Holdings. In accordance with the tax allocation agreement thereunder, the Company is obligated to reimburse Holdings for the use of Holdings losses only to the extent that Holdings has taxable income on a stand-alone basis. A liability has not been established to the extent of the use of Holdings' losses since the possibility of the ultimate payment for these benefits is considered remote. Accordingly, the use of Holdings' losses has been accounted for as a contribution of capital. Also, in accordance with the tax allocation agreement, the Company is required to reimburse Holdings for its allocable share of Holdings' tax liability. In 1993, the Company's share of Holdings' federal tax liability, for alternative minimum tax, aggregated $300. The income tax provision for 1993 reflects the adoption of SFAS No. 109 under which the Company provides for taxes as if it were a separate taxpayer. The income tax provision for 1992 and 1991 takes into consideration certain matters covered under a tax allocation arrangement with Holdings, under which the Company obtains a federal income tax benefit from Holdings' tax losses. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 9. Income Taxes (continued) The income tax provision consists of the following: 1993 1992 1991 Current Federal $ 300 $ - $ - State 1,900 1,705 682 Foreign (400) 31 380 1,800 1,736 1,062 Deferred: Federal 4,100 - - State 400 464 438 Foreign - - - 4,500 464 438 $6,300 $2,200 $1,500 The aggregate income tax provision varied from that computed by using the U.S. statutory rate as a result of the following: 1993 1992 1991 Income tax provision at the U.S. federal income tax rate $5,091 $5,398 $3,679 Income tax benefit realized from Holdings - (4,650) (3,169) State and foreign tax expense net of federal income taxes 1,209 1,452 990 $6,300 $2,200 $1,500 The Company files a consolidated federal income tax return with Holdings. On a consolidated basis the Company and Holdings have net operating loss carryforwards at December 31, 1993 of approximately $105,000 which are available to offset future consolidated taxable income of the group and expire from 2001 through 2008. The Company and Holdings, on a consolidated basis at December 31, 1993, have $1,900 of alternative minimum tax credits which are available indefinitely to reduce future tax payments for regular federal income tax purposes. At December 31, 1993 the Company, if reporting on a separate company basis, would have had net operating loss carryforwards for federal tax purposes of approximately $19,000 which are available for carryforward for a period of up to 15 years. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 10. Bank Credit Facility On December 21, 1993, the Company, Containers and Plastics (the "Borrowers") and the Banks entered into the Credit Agreement pursuant to which the Banks loaned to Silgan (i) $60,000 of term loans (the "A Term Loans") and (ii) $80,000 of term loans (the "B Term Loans"), collectively, the "Term Loans", and agreed to lend to Containers or Plastics up to an aggregate of $70,000 of working capital loans (the "Working Capital Loans"). Concurrent with the borrowings under the Credit Agreement, the Company repaid in full amounts outstanding under the Amended and Restated Credit Agreement. See Note 5 - Refinancings. To secure the obligations of Borrowers under the Credit Agreement, the Company pledged to the Banks principally all of the capital stock of its subsidiaries and the subsidiaries have each granted to the Banks security interests in substantially all of their respective real and personal property. Such collateral also secures on an equal and ratable basis the Secured Notes, subject to certain intercreditor arrangements. Holdings has pledged to the Banks all of the capital stock of the Company. Holdings and each of the Borrowers have guaranteed on a secured basis all of the obligations of the Borrowers under the Credit Agreement. The A Term Loans mature on September 15, 1996 and are payable in installments during the listed years as follows: A Term Loan Installment Repayment Date Principal Amount 1994 $ 20,000 1995 20,000 1996 20,000 The B Term Loans mature and are payable in full on September 15, 1996. Amounts repaid under the Term Loans cannot be reborrowed. Under the Credit Agreement, the Company is required to repay the Term Loans (pro rata for each tranche of Term Loans) in an amount equal to 75% of the Company's Excess Cash Flow (as defined in the Credit Agreement) in any fiscal year during the Credit Agreement (beginning with the 1994 fiscal year). Additionally, the Company is required to repay the Term Loans (pro rata for each tranche of Term Loans) and the Secured Notes, in an aggregate amount equal to 80% of the net sale proceeds from certain assets sales and 100% of the net equity proceeds from certain sales of equity, all as provided in the Credit Agreement and the Secured Notes Agreement. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 10. Bank Credit Facility (continued) The aggregate amount of Working Capital Loans which may be outstanding at any time is subject to a borrowing base limitation of the sum of (i) 85% of eligible accounts receivable of Containers and Plastics and (ii) 50% of eligible inventory of Containers and Plastics. In lieu of Working Capital Loans, Containers and Plastics may request Bankers Trust to issue up to $15,000 of letters of credit (the "Letters of Credit"). At December 31, 1993, $6,094 of Letters of Credit were outstanding. Subject to the terms of the Credit Agreement, the Working Capital Loans can be borrowed, repaid and reborrowed from time to time until September 15, 1996, on which date all Working Capital Loans mature and are payable in full. Each of the Term Loans and each of the Working Capital Loans, at the respective Borrower's election, consist of loans designated as Eurodollar rate loans or as Base Rate loans. Subject to certain conditions, each of the Term Loans and each of the Working Capital Loans can be converted from a Base Rate loan into a Eurodollar rate loan and vice versa. The term "Base Rate" means the highest of (i) 1/2 of 1% in excess of the Adjusted Certificate of Deposit Rate (as defined in the Credit Agreement), (ii) 1/2 of 1% in excess of the Federal Funds Rate (as defined in the Credit Agreement) and (iii) Bankers Trust's prime lending rate. Interest on Term Loans maintained as Base Rate loans accrues at floating rates of 1.75% (in the case of A Term Loans) and 2.25% (in the case of B Term Loans) over the Base Rate. Interest on Term Loans maintained as Eurodollar rate loans accrues at floating rates of 2.75% (in the case of A Term Loans) and 3.25% (in the case of B Term Loans) over a formula rate (the "Eurodollar Rate") determined with reference to the rate offered by Bankers Trust for dollar deposits in the New York interbank Eurodollar market. Interest on Working Capital Loans maintained as (i) Base Rate loans accrues at floating rates of 2% over the Base Rate or (ii) Eurodollar rate loans accrues at floating rates of 3% over the Eurodollar Rate. At December 31, 1993, the loans were maintained as Base Rate loans and the interest rate was between 7 3/4% and 8 1/4%. Each of Containers and Plastics has agreed to jointly and severally pay to the Banks, on a quarterly basis, a commitment commission calculated as 0.50% per annum on the daily average unused portion of the Banks' working capital commitment in respect of the Working Capital Loans until such working capital commitment is terminated. Additionally, Containers and Plastics are required to pay to Bankers Trust, on a quarterly basis in arrears, a letter of credit fee of 3.0% per annum and a facing fee of 1/4 of 1% per annum, each on the average daily stated amount of each letter of credit issued for the account of Containers or Plastics, respectively. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 10. Bank Credit Facility (continued) The Credit Agreement requires the Company to meet certain financial covenants, and restricts or limits, among other items, each of the Borrowers' ability to (i) incur additional indebtedness, (ii) create certain liens, (iii) consolidate, merge or sell assets, (iv) make capital expenditures and (v) pay dividends, except for distributions to Holdings to fund federal and state tax obligations. For 1993, 1992 and 1991, respectively, the average amount of borrowings under the Working Capital Loans was $51,935, $44,525, and $56,342; the average annual interest rate was 6.5%, 7.2% and 9.0%; and the highest amount of such borrowings at any month-end was $80,250, $80,800 and $81,300. 11. Senior Secured Notes The Secured Notes constitute senior indebtedness of the Company and are secured by a first lien on substantially all of the assets of the Company. Such collateral also secures on an equal and ratable basis, subject to certain intercreditor arrangements, all indebtedness of the Company under the Credit Agreement. The Secured Notes mature on June 30, 1997 and bear interest, which is payable quarterly, at a rate of three-month LIBOR plus 3%. The interest rate is adjusted quarterly. The interest rate in effect at December 31, 1993 was 6.38%. The Secured Notes are redeemable at the option of the Company at par plus accrued and unpaid interest to the redemption date. Net cash proceeds from certain asset sales and the issuance of capital stock by the Company are required to be applied to prepay the Secured Notes and indebtedness under the Credit Agreement on a pro rata basis, subject to certain exceptions. The Secured Notes contain covenants which are comparable to or less restrictive than those required by the Credit Agreement. These covenants limit, among other items, the Company's ability to (i) incur additional indebtedness, (ii) pay dividends, except for distributions to Holdings to fund federal and state tax obligations, (iii) enter into certain transactions with affiliates, (iv) repay subordinated indebtedness, and (v) effect certain mergers, consolidations and transfers of assets. 12. 11 3/4% Senior Subordinated Notes The 11 3/4% Notes, which mature on June 15, 2002, represent unsecured general obligations of Silgan, subordinate in right of payment to obligations of the Company under the Credit Agreement and the Secured Notes and effectively subordinate to all of the obligations of the subsidiaries of the Company. Interest is payable semi-annually on June 15 and December 15. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 12. 11 3/4% Senior Subordinated Notes (continued) The 11 3/4% Notes are redeemable at the option of the Company, in whole or in part, at any time during the twelve months commencing June 15 of the following years at the indicated percentages of their principal amount plus accrued interest: Redemption Year Percentage 1997 105.8750% 1998 102.9375% 1999 and thereafter 100.0000% The 11 3/4% Notes Indenture contains covenants which are comparable to or less restrictive than those required by the Credit Agreement and the Secured Notes. The estimated fair value of the 11 3/4% Notes at December 31, 1993 was $145,800. 13. Preferred Stock The Preferred Stock holders received cumulative preferential dividends at the rate per annum of 15% per share calculated as a percentage of $100. Dividends were, at the option of the Company, paid in additional shares of Preferred Stock. During 1992 and 1991, the Company issued 21,301 and 38,173 shares of Preferred Stock at $100 per share, representing its Preferred Stock dividend requirement for the two quarters ended May 15, 1992 and the four quarters ended November 15, 1991. A cash dividend payment of $1,137 was made for the quarter ended August 15, 1992. As of December 31, 1993, the Company has authorized 1,000 shares of Preferred Stock, of which, none is issued or outstanding. 14. Retirement Plans The Company sponsors contributory and non-contributory pension and retirement plans which cover substantially all employees, other than union employees covered by multi-employer defined benefit pension plans under collective bargaining agreements. The benefits are paid based on either a career average, final pay or years of service formula. With respect to certain hourly employees, pension benefits are provided for based on stated amounts for each year of service. The Company funds the minimum amount required under the Employee Retirement Income Security Act of 1974 with certain employees contributing approximately 3% of their annual compensation. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 14. Retirement Plans (continued) The provisions of SFAS No. 87, "Employers' Accounting for Pensions" require recognition in the balance sheet of an additional minimum liability and related intangible asset for pension plans with accumulated benefits in excess of plan assets. At December 31, 1993, an additional liability of $2,107 and an intangible asset of equal amount are reflected in the consolidated balance sheet. The additional liability is principally the result of the change in the assumed discount rate. Based on the latest actuarial information available, the following table sets forth the defined benefit plans funded status and amounts recognized in the Company's balance sheets as of December 31: 1993 1992 Actuarial present value of benefit obligations: Vested benefit obligations $ 19,096 $ 13,543 Non-vested benefit obligations 1,100 970 Accumulated benefit obligations 20,196 14,513 Additional benefits due to future salary levels 9,825 9,847 Projected benefit obligations 30,021 24,360 Plan assets at fair value 18,327 14,644 Projected benefit obligation in excess of plan assets 11,694 9,716 Unrecognized actuarial gain (loss) 2 2,431 Unrecognized prior service costs (2,093) (2,218) Additional minimum liability 2,107 114 Net pension liability $ 11,710 $10,043 The 1992 funded status amounts have been restated to reflect revisions in actuarial computations. These revisions had no effect on the Company's net pension liability. In addition to amounts set forth above, the Company has assumed defined benefit plan obligations of approximately $11,000 (as calculated at the Company's discount rate of 7 1/2%) in connection with the acquisition of DM Can. Under the terms of the DM Can purchase agreement, Del Monte will be transferring to the Company fund assets of approximately $9,000 (as computed using a discount rate of 9%). SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 14. Retirement Plans (continued) The assumptions used in determining actuarial present value of plan benefit obligations as of December 31: 1993 1992 1991 Discount rate 7.5% 8.5% 8.5% Weighted average rate of compensation increase 4.5% 5.0 - 5.5% 5.0 - 5.5% Expected long-term rate of return on plan assets 8.5% 8.5% 8.5% The components of total pension expense are as follows: 1993 1992 1991 Service cost $1,809 $1,722 $1,816 Interest cost 2,144 2,101 1,977 Net amortization and deferrals 500 75 1,298 Actual return on assets (1,784) (891) (1,717) Other (gains) (183) (183) (307) Net pension cost of defined benefit plans 2,486 2,824 3,067 Multi-employer plans 2,210 2,159 2,041 Total pension expense $4,696 $4,983 $5,108 Plan assets are invested in money market funds, equity funds and bond funds. In 1991, the Company realized a curtailment gain of $2,500 due to a reduction in the Company's work force. Such amount has not been reflected in total pension expense above. Containers sponsors a deferred incentive savings plan for eligible salaried employees where contributions are provided if Containers meets certain financial targets. The maximum aggregate amount of awards will not exceed 15% of the aggregate salaries of the participants in the Plan. Contributions of $1,630, $1,730 and $1,700 were made for 1993, 1992 and 1991, respectively. Plastics sponsors a savings and investment plan which is organized under Section 401(k) of the Internal Revenue Code. Plastics' contributions to the plan were $146, $147 and $149 in 1993, 1992 and 1991, respectively. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 15. Postretirement Benefits Other than Pensions As discussed in Note 2, the Company adopted SFAS No. 106 in 1993. The Company has elected to immediately recognize a cumulative charge of $3,125 (after related income taxes of $1,875) for this change in accounting principle which represents the accumulated postretirement benefit obligation existing as of January 1, 1993. This change in accounting principle, excluding the cumulative effect, decreased pretax income for the year ended December 31, 1993 by approximately $478. The postretirement benefit cost for 1992 and 1991, which was recorded on a pay-as-you-go basis, has not been restated and was not material. The Company has defined benefit health care and life insurance plans that provide postretirement benefits to certain employees. The plans are contributory, with retiree contributions adjusted annually, and contain cost sharing features including deductibles and coinsurance. The Company does not fund the plans. The following table presents the plan's funded status and amounts recognized in the Company's balance sheet as of December 31, 1993: Accumulated postretirement benefit obligation: Retirees $1,209 Fully eligible active plan participants 1,197 Other active plan participants 2,127 4,533 Plan assets at fair value - Accumulated postretirement benefit obligation in excess of plan assets 4,533 Unrecognized net gain or (loss) (462) Unrecognized transition obligation - Accrued postretirement benefit cost $4,071 Net periodic postretirement benefit cost for 1993 included the following components: Service cost $ 152 Interest cost 326 Net periodic postretirement benefit cost $ 478 SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 15. Postretirement Benefits Other than Pensions (continued) The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.5%. The weighted average rate of increase in future compensation levels was 4.5%. For measuring the expected postretirement benefit obligation, the weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) principally used is 14% for 1994 (15% for 1993). This rate is assumed to decrease by 1% per year to an ultimate rate of 6%. A 1% increase in the trend rate assumption would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $62 and increase the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for 1993 by approximately $12. As of December 31, 1992, the plan's unfunded accumulated postretirement benefit obligations for retirees and active participants was $1,144 and $3,856, respectively. 16. Stock Option Plans Containers and Plastics have established separate but virtually identical stock option plans for their key employees pursuant to which options to purchase shares of common stock of Holdings' and its subsidiaries and stock appreciation rights ("SARs") may be granted. Options granted under the plans may be either incentive stock options or non qualified stock options. To date, all stock options granted have been non qualified stock options. Under the plans, Containers and Plastics have each reserved 1,200 shares of their common stock in order to enable them to issue shares under the plans. Both Containers and Plastics have 10,800 shares of $0.01 par value common stock currently issued, all of which are owned by Silgan. The SARs extend to all of the shares covered by the options and provide for the payment by either Containers or Plastics, as the case may be, to the holders of the options an amount in cash or stock equal to the excess of the proforma book value, as defined, of a share of common stock (or in the event of a public offering, the fair market value of a share of common stock) over the exercise price of the option with certain adjustments for the portion of vested stock appreciation not paid at the time of recapitalization in June, 1989. The subsidiaries have the right to repurchase, and employees have the right to require the subsidiaries to repurchase, their common stock at the then proforma book value, or market value as the case may be, should employees leave the Company. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 16. Stock Option Plans (continued) At December 31, 1993, there were outstanding options for 816 shares under the Containers' Plan and 300 shares under the Plastics' Plan. The exercise prices per share range from $2,122 to $2,456 for the Containers' options and are $746 for the Plastics' options. There were 528 options and 240 options exercisable at December 31, 1993 under the Containers' and Plastics' plans, respectively. The Company incurred charges relating to the vesting and payment of benefits under the stock option plans of $200 and $350 in 1993 and 1992, respectively (none in 1991). The stock options and SARs generally become exercisable ratably over a five year period. In the event of a public offering of any of the Company's or Holdings' capital stock or a sale of the Company or Holdings to a third party, (i) the options granted by Containers and Plastics pursuant to the plans, or (ii) any stock issued upon exercise of such options issued by Containers and Plastics are convertible into either stock options or common stock of the Company or Holdings. The conversion of such options or shares will be based upon a valuation of Holdings and an allocation of such value among the subsidiaries after giving affect to, among other things, that portion of the outstanding obligation of Holdings allocable to each such subsidiary. 17. Business Information The Company is engaged in the packaging business. Its principal products are metal and plastic containers. Net sales for its metal and plastic containers were $445,871 and $186,319; $425,844 and $192,596; and $435,349 and $232,139 for the years ended December 31, 1993, 1992 and 1991, respectively. Other sales amounted to $13,278, $11,599 and $10,723 for the years ended December 31, 1993, 1992 and 1991, respectively. One customer accounted for 34.1%, 36.5% and 32.2%, of net sales during the years ended December 31, 1993, 1992 and 1991 respectively. At December 31, 1993 and 1992, 12.9% and 14.5%, respectively, of the accounts receivable balance is due from this customer. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 18. Related Party Transactions Pursuant to various management services agreements (the "Management Agreement") entered into between Holdings, Silgan, Containers, Plastics, and S&H, Inc. ("S&H"), a company wholly owned by Messrs. Silver and Horrigan, the Chairman of the Board and President of Holdings, respectively, S&H provides Holdings and the Company and its subsidiaries with general management, supervision and administrative services (the "Services"). In consideration for the Services, S&H receives a fee of 4.95% (of which 0.45% is payable to MS & Co.) of Holdings' consolidated earnings before depreciation, amortization, interest and taxes ("EBDIT") until EBDIT has reached the Scheduled Amount set forth in the Management Agreement and 3.3% (of which 0.3% is payable to MS & Co.) after EBDIT has exceeded the Scheduled Amount up to the Maximum Amount as set forth in the Management Agreement, plus reimbursement for all related out-of-pocket expenses. The total amount incurred for the years ended December 31, 1993, 1992 and 1991 was approximately $4,385, $4,225 and $4,027, respectively. Included in accounts payable at December 31, 1993 and 1992, was approximately $575 and $200, payable to S&H, respectively. Under the terms of the Management Agreement, the Company agreed, subject to certain exceptions, to indemnify S&H and any of its affiliates, officers, directors, employees, subcontractors, consultants or controlling persons against any loss or damage they may sustain arising in connection with the Management Agreement. In connection with the 1992 Refinancing, MS & Co. received as compensation for its services as underwriter for the Secured Notes, the 11 3/4% Notes and the Discount Debentures an aggregate of $11,500. In connection with the Credit Agreement entered into in 1993, the Banks (including Bankers Trust) received certain fees amounting to $8,100. 19. Commitments The Company is committed under certain noncancelable operating leases for office and plant facilities, equipment and automobiles. Minimum future rental payments under these operating leases are: 1994 $8,960 1995 6,700 1996 5,829 1997 4,873 1998 3,606 Thereafter 9,44l $39,409 Rental expense for the years ended December 31, 1993, 1992 and 1991 was approximately $7,999, $7,977 and $8,102, respectively. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 20. Litigation On June 30, 1989, Holdings acquired all of the outstanding shares of the Company for $6.50 per share (the "Merger"). In connection with the Merger, two complaints were filed during 1989 in the Court of Chancery in the State of Delaware (the "Court") by certain Silgan Class B Common Stockholders against Silgan, Holdings, MS & Co., officers and directors. The complaints allege, among other things, that certain defendants breached their fiduciary duties under Delaware law to minority stockholders of Silgan by engaging in unfair dealing, attempting to effect a merger at a grossly inadequate price and distributing misleading proxy materials. The complaints ask the Court, among other things, to rescind the Merger and/or to grant to plaintiffs such damages, including rescissory damages, as are found by the Court to be proven at trial. Additionally, the plaintiffs each filed a petition for appraisal. In 1991, the Court stayed one of the actions and related appraisal proceeding based upon the seizure and placement into receivership of one plaintiff. The Court lifted the stay of the action and appraisal proceeding on March 30, 1992 and both the action and appraisal were dismissed in February 1994 following settlement with the plaintiffs. The second action was voluntarily dismissed on January 29, 1992 without prejudice to the right of the plaintiffs to reinstate the action at the conclusion of the related appraisal proceeding. Discovery is proceeding in the appraisal. The Court has set the week of May 9, 1994 for trial. Additionally, a complaint was filed by parties who are limited partners of The Morgan Stanley Leveraged Equity Fund, L.P. ("MSLEF") against a number of defendants including Silgan and Holdings. The complaint alleges that Silgan and Holdings aided and abetted the general partners MSLEF in breaching their fiduciary duties to the limited partners. The Court dismissed all claims against Silgan and Holdings related to this action on January 14, 1993, and subsequently upheld that dismissal after the plaintiff filed a motion for reargument. The defendants believe that there is no factual basis for the allegations and claims contained in the complaints. Management also believes that the lawsuits are without merit and they intend to defend the lawsuits vigorously. In addition, management believes that the ultimate resolution of these matters and the appraisal proceedings will not have a material effect on the financial condition or results of operations of Silgan or Holdings. SILGAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands except for per share data) 20. Litigation (continued) In connection with the Merger and the litigation described above, as of December 31, 1993 approximately $6,800 of the purchase price has not been paid to certain former stockholders and such amount has been recorded by Holdings as a current liability. To the extent the Company elects to make such payments to former stockholders, the Company's stockholder's equity could be reduced by the amount of such payment. Other than the actions mentioned above there are no other pending legal proceedings, other than ordinary routine litigation incidental to the business of the Company, to which the Company is a party or to which any of its properties are subject. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF SILGAN CORPORATION CONDENSED BALANCE SHEETS December 31, 1993 and 1992 (Dollars in thousands) ASSETS 1993 1992 Current assets: Cash and cash equivalents $ 61 $ 202 Notes receivable-subsidiaries 39,850 18,644 Interest receivable-subsidiaries 810 1,456 Other current assets 214 114 Total current assets 40,935 20,416 Investment in and other amounts due from subsidiaries 37,104 38,861 Notes receivable-subsidiaries 305,072 206,180 Amount receivable from parent 607 746 Other assets 950 1,379 $384,668 $267,582 LIABILITIES AND STOCKHOLDER'S EQUITY Current liabilities: Current portion of term loans $ 20,000 $ 18,644 Accrued interest payable 763 967 Accrued expenses 1,268 331 Total current liabilities 22,031 19,942 Term loans 120,000 19,341 Senior secured notes 50,000 50,000 11 3/4% Senior subordinated notes 135,000 135,000 Amounts payable to subsidiaries 3,123 6,491 Other long-term liabilities 1,711 4,033 Stockholder's equity: Common stock - - Additional paid-in capital 64,135 41,560 Retained earnings (deficit) (11,332) (8,785) Total stockholder's equity 52,803 32,775 $384,668 $267,582 See Notes to Consolidated Financial Statements for Silgan Corporation appearing elsewhere in this Form 10-K. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF SILGAN CORPORATION CONDENSED STATEMENTS OF OPERATIONS For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) 1993 1992 1991 Net sales $ - $ - $ - Cost of goods sold - - - Gross profit - - - Selling, general and administrative expenses 368 239 313 Loss from operations (368) (239) (313) Equity in earnings (losses) of consolidated subsidiaries (7,570) 6,148 9,718 Other income 1,480 832 - Interest expense and other related financing costs (19,899) (21,429) (19,635) Interest income-subsidiaries 23,940 19,313 19,552 Income (loss) before income taxes (2,417) 4,625 9,322 Income tax provision - - - Income (loss) before extraordinary charges (2,417) 4,625 9,322 Extraordinary charges relating to early extinguishment of debt (130) (23) - Net income (loss) (2,547) 4,602 9,322 Preferred stock dividend requirements - 2,745 3,889 Net income (loss) applicable to common stockholder $ (2,547) $ 1,857 $ 5,433 See Notes to Consolidated Financial Statements for Silgan Corporation appearing elsewhere in this Form 10-K. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF SILGAN CORPORATION CONDENSED STATEMENTS OF CASH FLOWS For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) 1993 1992 1991 Cash flows from operating activities: 359 1,825 26 Cash flows from investing activities: (Increase) decrease in notes receivable-subsidiaries (117,515) (39,323) 23,000 Decrease in investment in subsidiaries - 30,008 - Cash dividends received from subsidiaries - 16,861 - Net cash provided (used) by investing activities (117,515) 7,546 23,000 Cash flows from financing activities: Repayment of term loan (37,985) (35,827) (23,000) Proceeds from issuance of term loans 140,000 - - Proceeds from issuance of senior secured notes - 50,000 - Proceeds from issuance of 11 3/4% senior subordinated notes - 135,000 Redemption of 14% senior subordinated notes - (85,000) - Redemption of preferred stock - (30,008) - Capital contribution by Parent 15,000 - - Repayment of advance from Parent - (25,200) - Dividend to Parent - (15,724) - Cash dividends paid on preferred stock - (1,137) - Debt financing costs - (1,301) - Net cash provided (used) by financing activities 117,015 (9,197) (23,000) Net increase (decrease) in cash and cash equivalents (141) 174 26 Cash and cash equivalents at the beginning of year 202 28 2 Cash and cash equivalents at end of year $ 61 $ 202 $ 28 See Notes to Consolidated Financial Statements for Silgan Corporation appearing elsewhere in this Form 10-K. SCHEDULE V SILGAN CORPORATION SCHEDULES OF PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) SCHEDULE VI SILGAN CORPORATION SCHEDULES OF ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) SCHEDULE VIII SILGAN CORPORATION SCHEDULES OF VALUATION AND QUALIFYING ACCOUNTS For the years ended December 31, 1993, 1992 and 1991 (Dollars in thousands) INDEX TO EXHIBITS Exhibit No. Exhibit ----------- ------- 3.1 Restated Certificate of Incorporation of Silgan Corporation, as amended. 10.118 Supply Agreement, dated as of September 3, 1993, between Silgan Containers Corporation and Del Monte Corporation. (Portions of this Exhibit are subject to confidential treatment pursuant to an order of the Commission.) 10.119 Amendment to Supply Agreement, dated as of December 21, 1993, between Silgan Containers Corporation and Del Monte Corporation. (Portions of this Exhibit are subject to confidential treatment pursuant to an order of the Commission.) 22 Subsidiaries of the Registrant.

717829_1993.txt

717829_1993

1993

717829

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.

36703_1993.txt

36703_1993

1993

36703

ITEM 1. BUSINESS OF FIRST OF AMERICA BANK CORPORATION General First of America Bank Corporation (herein after referred to as First of America or the Registrant) is a multi-bank holding company headquartered in Kalamazoo, Michigan. The Registrant was incorporated as a Michigan corporation in May 1971. Its principal activity consists of owning and supervising twenty affiliate financial institutions which operate general, commercial banking businesses from 572 banking offices and facilities located in Michigan, Indiana, and Illinois. The Registrant also has divisions and non-banking subsidiaries which provide mortgage, trust, data processing, pension consulting, revolving credit, discount securities brokerage and investment advisory services. At December 31, 1993, the Registrant had assets of $21.2 billion, deposits of $18.2 billion and shareholders' equity of $1.5 billion. The Registrant has responsibility for the overall conduct, direction and performance of its affiliates. The Registrant establishes direction and policies for the entire organization and monitors compliance with these policies. The Registrant provides capital funds to affiliates as required and assists affiliates in asset and liability management, marketing, planning, accounting, tax, internal audit, loan review, and human resource management of its 13,330 full time equivalent employees. The operational responsibilities of each affiliate rest with its officers and directors. The Registrant derives its income principally from dividends upstreamed from its subsidiaries and fees paid for management services provided to its subsidiaries. Subsidiary Banks As of December 31, 1993, the Registrant had three wholly owned subsidiaries, First of America Bank - Southeast Michigan, N.A., First of America Bank - Michigan, N.A., and First of America Bank - Security which met the conditions for "significant subsidiary." First of America Bank - Southeast Michigan, N.A., is a general commercial bank based in Detroit, Michigan, and at December 31, 1993, had $4.0 billion in assets and $3.5 billion in deposits. First of America Bank - Michigan, N.A., is a general commercial bank based in Kalamazoo, Michigan, and at December 31, 1993, had $1.4 billion in assets and $1.2 billion in deposits. First of America Bank - Security is a general commercial bank based in Southgate, Michigan, and at December 31, 1993, had $2.0 billion in assets and $1.7 billion in deposits. Similar to all of the Registrant's banking subsidiaries, these subsidiaries offer a broad range of lending, depository and related financial services to individual, commercial, industrial, financial, and governmental customers, including demand, savings and time deposits, secured and unsecured loans, lease financing, letters of credit, money transfers, corporate and personal trust services, cash management, and other financial services. No material part of the business of the Registrant and its subsidiaries is dependent upon a single customer, or a very few customers, where the loss of any one would have a materially adverse effect on the Registrant. Non-Banking Subsidiaries First of America Mortgage Company is a wholly owned subsidiary of the Registrant headquartered in Kalamazoo, Michigan. First of America Mortgage Company engages in the servicing of both commercial and residential real estate loans for institutional investors and certain affiliates of the Registrant and secondary market sales and loan originations. FOA Mortgage Company is a wholly owned subsidiary of First of America Mortgage Company and provides mortgage origination and servicing and secondary market sales. First of America Insurance Company is a wholly owned subsidiary of the Registrant. The insurance company reinsures credit life and disability insurance provided by an unaffiliated insurer for customers of the Registrant's affiliates. First of America Brokerage Service, Inc., is a wholly owned subsidiary of First of America Bank - Michigan, N.A. It is a registered broker-dealer and provides securities brokerage services through a clearing broker to customers of the Registrant's affiliate banks and others. First of America Investment Corporation is a wholly owned subsidiary of First of America Bank - Michigan, N.A. First of America Investment Corporation is a registered investment adviser which provides comprehensive investment advisory services to the trust division of the Registrant and to individual and institutional investors. It also serves as investment adviser for The Parkstone Group of Funds, a family of mutual funds. First of America Trust Company is a wholly owned subsidiary of the Registrant. It provides trust services to customers of the Registrant's Illinois affiliates. First of America Community Development Corporation is a wholly owned subsidiary of the Registrant. It invests in qualifying businesses or housing projects, as allowed by federal law, to address the needs of low to moderate income neighborhoods. COMPETITION Banking and related financial services are highly competitive businesses and have become increasingly so during the past few years. The banking subsidiaries of the Registrant compete primarily with other banks and savings and loan associations for loans, deposits and trust accounts. They are also faced with increasing competition from other financial intermediaries including consumer finance companies, leasing companies, credit unions, retailers and investment banking firms. Technological changes have resulted in computer and communication applications intended to meet the needs of First of America's business and consumer customers in a convenient, efficient and reliable manner. Affiliate banks of the Registrant have 387 automated teller machines (ATM's) located on bank premises to handle banking transactions 24 hours per day and 144 off-premise terminals located in high volume retail and service locations. SUPERVISION AND REGULATION The Registrant and its subsidiary banks are subject to supervision, regulation and periodic examination by various federal and state banking regulatory agencies, including the Board of Governors of the Federal Reserve Board (the "FRB"), the Office of the Comptroller of the Currency (the "OCC"), the Federal Deposit Insurance Corporation (the "FDIC"), the Office of Thrift Supervision (the "OTS"), the Illinois Commissioner of Banks and Trust Companies (the "Illinois Commissioner"), the Michigan Financial Institutions Bureau (the "Michigan FIB") and the Indiana Department of Financial Institutions (the "Indiana DFI"). The following is a summary of certain statutes and regulations affecting First of America and its affiliate financial institutions. This summary is qualified in its entirety by such statutes and regulations, which are subject to change based on pending and future legislation and action by regulatory agencies. Bank Holding Companies. As a bank holding company, First of America is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "BHCA") and by the FRB. Among other things, the BHCA and the FRB impose requirements for the maintenance of capital adequate to support a bank holding company's operations. The BHCA also restricts the geographic and product range of bank holding companies by circumscribing the types and locations of institutions which bank holding companies may own or acquire. The BHCA limits bank holding companies to owning and managing banks or companies engaged in activities determined by the FRB to be closely related to banking. The BHCA requires bank holding companies to obtain the prior approval of the FRB before acquiring substantially all the assets of any bank or bank holding company or direct or indirect ownership or control of more than 5% of the voting shares of a bank or bank holding company. Bank holding companies are also prohibited from acquiring shares of any bank located outside the state in which the operations of the bank holding company's banking subsidiaries are primarily conducted unless the acquisition is specifically authorized by statute of the state of the bank whose shares are to be acquired. Under a Michigan statute applicable to First of America, a Michigan bank holding company may acquire a bank located in any state in the United States if the laws of the other state permit ownership of banks located in that state by a Michigan bank holding company. Under the same Michigan statute, a Michigan bank or bank holding company may be acquired by a bank holding company located in any state in the United States, subject to approval of the Michigan FIB and the existence of a reciprocal law in such other state. Savings and Loan Holding Companies. Its acquisition of thrift institutions subjects First of America to regulation as a savings and loan holding company by the OTS. A savings and loan holding company that is also a bank holding company may engage only in activities permissible for a bank holding company, and may, in certain circumstances, be required to obtain approval from the OTS, as well as the FRB, before acquiring new subsidiaries or commencing new business activities. Further, a savings and loan holding company's acquisitions of savings associations and other savings and loan holding companies are subject to prior approval by the OTS comparable to the extent to which bank holding company acquisitions of banks and other bank holding companies are subject to the prior approval of the FRB. Banks. First of America's affiliate banks are subject to regulation, supervision and periodic examination by the bank regulatory agency of the state under the laws of which the affiliate bank is chartered or, in the case of national banks, the OCC. Additionally, certain of First of America affiliate state banks and all of its affiliate national banks are members of the Federal Reserve System, and as such are subject to applicable provisions of the Federal Reserve Act and regulations thereunder. These regulations relate to reserves and other aspects of banking operations. First of America's affiliate state banks that are not members of the Federal Reserve Systems are subject to federal regulation, supervision and examination by the FDIC. Deposits held by all affiliate banks of First of America are insured, to the extent permitted by law, by the FDIC. Applicable federal and state law govern, among other things, the scope of First of America's affiliate banks' businesses, maintenance of adequate capital, investments and loans they may make, transactions with affiliates and their activities with respect to mergers and establishing branches. Savings Associations. First of America may from time to time acquire and operate federally chartered savings associations subject to regulation, supervision and regular examination by the OTS. Federal law governs, among other things, the scope of the savings association's business, required reserves against deposits, the investments and loans the savings association may make, and transactions with the savings association's affiliates. Deposits held by such savings associations are insured, to the extent permitted by law, by the FDIC. Non-banking Subsidiaries. First of America has non-banking subsidiaries that are a broker-dealer and an investment adviser, each registered and subject to regulation by the Securities and Exchange Commission under federal securities laws. These subsidiaries are also subject to regulation under various state securities laws. Because they are affiliated with First of America's subsidiary banks, these subsidiaries are subject to certain limitations on their securities activities imposed by federal banking laws. Economic Conditions and Governmental Policy. First of America's earnings are affected not only by the extensive regulation described above, but also by general economic conditions. These economic conditions influence and are influenced by the monetary and fiscal policies of the United States government and its various agencies, particularly the FRB. The Registrant cannot predict changes in monetary policies or their impact on its operations and earnings. STATISTICAL DATA The statistical data as required is presented with "Item 7. Management's Discussion and Analysis" and in certain of the Notes to Consolidated Financial Statements and Supplemental Data included with "Item 8. Financial Statements and Supplementary Data" appearing later in this document. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Registrant, their ages and their positions for the last five years are shown in the following table. There are no family relationships between the executive officers or between the executive officers and the Registrant's directors. ITEM 2. ITEM 2. PROPERTIES The Registrant is headquartered in Kalamazoo, Michigan. The Registrant's subsidiaries operate a total of 572 offices of which 435 are owned by the respective banks, 108 are leased, 20 are owned by the subsidiary involved but on leased land, and 9 are owned by the banks involved, with leased parking lots. Reference is made to Note 10 of the Notes to Consolidated Financial Statements included under "Item 8. Financial Statements and Supplementary Data" included later in this document for further information regarding the terms of these leases. All of these offices are considered by management to be well maintained and adequate for the purpose intended. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The subsidiaries of the Registrant are routinely engaged in litigation, both as plaintiff and defendant, which is incident to their business, and in certain proceedings, claims or counter-claims have been asserted against the Registrant's subsidiaries. Management, after consultation with legal counsel, does not currently anticipate that the ultimate liability, if any, arising out of such litigation and threats of litigation will have a material effect on the financial position of the Registrant. Certain of First of America's subsidiaries own or previously owned certain parcels of real property with respect to which they have been notified by the Michigan Department of Natural Resources pursuant to Michigan environmental statutes that they may be potentially responsible parties (PRPs) for environmental contamination on or emanating from the properties. The costs of remediating the contamination cannot be determined at this time. While, as PRPs, these subsidiaries may be jointly and severally liable for the costs of remediating the contamination, in most cases, there are a number of other PRPs who may also be jointly and severally liable for remediation costs. Additionally, in certain cases, these subsidiaries have asserted statutory defenses to liability for remediation costs based on the subsidiaries' status as lending institutions that acquired ownership of the contaminated property through foreclosure. First of America's management, after consultation with legal counsel, does not currently anticipate that the ultimate liability, if any, arising from these matters will have a material effect on First of America's financial position. 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 three months ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The Registrant's common stock is listed for trading on the New York Stock Exchange (NYSE). The range of high and low sales prices appear under the caption "Market price of common stock" under Supplemental Information included with "Item 8. Financial Statements and Supplementary Data" included later in this document. Common stock dividends, payable in cash, were declared on a quarterly basis during 1993 and 1992. The dividends declared per common share totaled $1.55 during 1993 and $1.34 during 1992. Restrictions on the Registrant's ability to pay dividends are described in Note 11 in the paragraph beginning "The various loan agreements" and in Note 15 of the Registrant's "Notes to Consolidated Financial Statements" included under "Item 8. Financial Statements and Supplementary Data" included later in this document. The number of record holders of the Registrant's common stock as of December 31, 1993 was 28,400. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to the following information included in "Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following financial review compares the performance of First of America, on a consolidated basis, for the three years ended December 31, 1993, and should be read in conjunction with the consolidated financial statements and notes thereto. Mergers and Acquisitions Table I below and Note 2 of the Notes to Consolidated Financial Statements, included later in this document, summarize First of America's business combinations for the past three years. First of America continued to expand selected areas during 1993 through the acquisition process. On August 16th, First of America acquired five Pioneer Mortgage Company origination offices bringing the total origination offices to 18 and expanding its presence into North Carolina. Additionally, First of America continued to increase its presence in Illinois with the acquisition of Kewanee Investing Company, Inc. and 14 Illinois branches of Citizens Federal Bank which added $498 million in deposits to the balance sheet. First of America also announced the pending acquisition of LGF Bancorp, Inc. and its principal subsidiary, La Grange Federal Savings and Loan Association with $410 million in assets at December 31, 1993. Note 3 to the Notes to the Consolidated Financial Statements provides additional information about the pending acquisition of LGF Bancorp, Inc. 1993 Highlights Reported net income was $247.4 million, an increase of 67.7 percent from 1992's $147.5 million, and fully diluted earnings per share were $4.14 compared with $2.46 a year ago. The prior year's results were reduced by three substantial nonrecurring charges -- adoption of Financial Accounting Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ($22.0 million), one-time Security Bancorp merger and assimilation costs ($23.9 million), and an intangible asset writedown ($25.9 million). Compared with 1992 results from ongoing operations, which excludes these one-time charges, net income and fully diluted earnings per share for 1993 increased 12.8 percent and 12.5 percent, respectively. Reported net income for 1991 was $159.5 million, or $2.69 per fully diluted share. Also showing improvement, return on average assets for 1993 was 1.20 percent versus 0.75 percent in 1992 and 0.95 percent in 1991. Return on average total shareholders' equity for the same periods was 17.50 percent, 11.38 percent and 13.07 percent, respectively. Both of 1993's ratios exceeded 1992's ongoing operating ratios of 1.12 percent return on average assets and 16.42 percent return on total equity. The final assimilation of Champion Federal into nine Illinois affiliate banks occurred on July 1, 1993, paving the way for added market development and cost efficiencies in the company's Illinois franchise. First of America's asset quality measurements showed improvement in 1993 as non-performing assets as a percent of total assets decreased to 0.86 percent versus the 0.97 percent reported at year-end 1992 and 0.87 percent at year-end 1991. Net charge-offs as a percent of average loans also improved to 0.53 percent versus 0.57 percent for 1992, another indicator of First of America's strong asset quality. Net charge-offs as a percent of average loans was 0.53 percent for 1991. Total assets were $21.2 billion at December 31, 1993, a 5.4 percent increase over the $20.1 billion reported at December 31, 1992, while total loans, for the same periods, increased 4.6 percent to $14.4 billion. The increase in loans was primarily the result of an 18.0 percent increase in total consumer loans. These loans, which include credit cards, indirect installment, direct installment and other revolving credit, accounted for $5.1 billion or 35 percent of the total loan portfolio. The commercial loan portfolio experienced only a 0.6 percent increase from year-end 1992. Total shareholders' equity increased 14.1 percent to $1.5 billion at year-end 1993. The increase over the $1.3 billion reported for December 31, 1992 resulted from the retention of earnings and a $31.5 million mark-to-market adjustment to equity, net of tax, due to the adoption at year-end of Financial Accounting Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Statement No. 115 is discussed later in this document under the heading of Funding, Liquidity and Interest Rate Risk and in Notes 1 and 6 of the Notes to Consolidated Financial Statements. Book value per fully diluted share was $25.60 compared with $22.49 and $21.47 for year-ends 1992 and 1991. The Board of Directors increased the cash dividend paid per common share in May to $1.60, on an annualized basis, a 14.3 percent increase. This increase represents the largest percentage increase since 1986 and indicates the Board's continued confidence in the current and future profitability of First of America. - -------------------------------------------------------------------------------- Note: The Peer Group averages were calculated by First of America and include BancOne, Boatmen's Bancshares, Inc., Comerica, Firstar, First Bank Systems, Marshall and Ilsley, Michigan National, National City Corporation, NBD Bancorp, Northern Trust, Norwest, Old Kent Corporation and Society Corporation. (a) Fully taxable equivalent; based on a marginal federal income tax rate of 35% for 1993 and 34% for prior years. Income Analysis Net Interest Income -- Net interest income is the primary source of income for First of America, accounting for 76 percent of total revenue. For 1993 net interest income on a fully taxable equivalent basis (FTE) was $925.1 million, up 2.8 percent from $899.9 million in 1992. The 1993 increase was largely the result of a 5.4 percent increase in average earning assets, offset by the lower net interest margin of 4.86 percent versus 4.98 percent for 1992. For the 1992 comparison with 1991, net interest income (FTE) increased 15.4 percent due to the addition of Champion Federal's earning assets at December 31, 1991. Loans as a percent of earning assets for 1993 and 1992 were 73.5 percent and 74.1 percent, respectively. The deposits acquired with Citizens Federal's 14 Illinois offices were assumed without accompanying loans; this was the main reason for this ratio's decrease in 1993. As these deposits are used to fund loans, the ratio of loans to deposits should return to a higher level and add to the company's net interest income. Net interest income, average balance sheet amounts and the corresponding yields and costs for the years 1989 through 1993 are shown in Table IV. Table III presents a summary of the changes in net interest income resulting from changes in volumes and rates for 1993 and 1992. Volume/Rate Analysis TABLE III ($ in thousands) * Any variance attributable jointly to volume and rate changes is allocated to volume and rate in proportion to the relationship of the absolute dollar amount of the change in each. Non-taxable income has been adjusted to a fully taxable equivalent basis. (1) Interest income on obligations of states and political subdivisions and on tax exempt commercial loans has been adjusted to a taxable equivalent basis using a marginal federal tax rate of 35% for 1993 and 34% for prior years. (2) Non-accrual loans are included in average loan balances. Net Interest Margin -- The net interest margin for 1993 was 4.86 percent compared with 4.98 percent in 1992 and 5.07 percent in 1991. While the prime rate remained constant throughout 1993, yields on earning assets declined at a faster pace than did the rates paid on interest bearing liabilities (92 basis points versus 87 basis points). The reduction in earning asset yields was due to accelerated prepayments of residential mortgages and collateralized mortgage obligations. Also affecting the 1993 margin was an internal investment strategy, involving borrowing short-term money to purchase short-term securities, which added to earnings but reduced the net interest margin by approximately 3 basis points, and the August 26, 1993 acquisition of Citizens Federal adding $498 million of higher priced deposits with no offsetting earning assets, which also reduced 1993's margin by approximately 3 basis points. During 1992 the earning asset yields decreased 120 basis points while rates paid on interest bearing liabilities decreased at a faster pace (132 basis points). The decrease in the 1992 net interest margin from 1991 was the result of the acquisition of Champion Federal's higher rate thrift deposits at year-end 1991. This acquisition reduced 1992's margin by approximately 34 basis points but was partially offset by strong net interest margins at First of America's bank affiliates. Provision for Loan Losses -- The provision for loan losses is based on the current level of net charge-offs and management's assessment of the credit risk inherent in the loan portfolio. For 1993, the provision for loan losses was increased 7.5 percent to $84.7 million from $78.8 million in 1992 to keep pace with growth in the total loan portfolio, particularly consumer loans which historically have a higher charge-off ratio than other portfolios. However, net charge-offs for 1993 decreased 4.7 percent compared with 1992 contributing to the higher allowance as a percent of gross loans ratio of 1.31 percent from the 1.29 percent reported at December 31, 1992. The 1991 provision was $71.0 million. Additional information on the provision for loan losses, net charge-offs and non-performing assets is provided in Tables IX and XI and under the caption, "Credit Risk Profile," presented later in this discussion. Non-interest Income -- Non-interest income continued its double digit growth pattern in 1993 as First of America maintained its emphasis on cross sell strategies for products throughout its extensive branch network. Non-interest income increased 11.8 percent to $292.2 million in 1993 compared with $261.3 million in 1992 and $209.9 million in 1991. Non-interest income which has grown at an average compounded rate of 14.3 percent over the last five years, now represents 24.0 percent of total revenue (net interest income (FTE) plus non-interest income) versus 22.5 percent for 1989. Table V presents the major components of non-interest income from 1989 to 1993. The two largest components of First of America's non-interest income are service charges on deposit accounts and income from trust and financial services. Service charges on deposit accounts increased 6.4 percent in 1993 to $84.6 million compared with $79.5 million in 1992 and $70.3 million in 1991. The Trust and Financial Services Division provides First of America's customers with quality traditional trust services, brokerage services, investment advisory services, farm management and administration for pension and profit-sharing plans. At year-end 1993, total trust assets held in personal trust accounts, employee benefit plans, retail accounts and others exceeded $12.6 billion. Total income from trust and financial services was $77.3 million in 1993, $68.9 million in 1992 and $60.9 million in 1991. The primary component of total trust income, traditional trust income, increased 10.8 percent in 1993 to $56.7 million compared with $51.1 million in 1992 and $47.7 million in 1991. First of America's Trust and Financial Services Division expanded its income-producing capabilities in 1993. As part of its current marketing efforts, First of America increased its sales force including the placement of financial service consultants in its mortgage origination offices in Missouri, Arizona, Florida and North Carolina to cross-sell its investment products. Revenue from other financial services showed continued growth in 1993, increasing 16.4 percent to $20.6 million versus $17.7 million and $13.2 million in 1992 and 1991, respectively. This business activity has maintained double digit growth in revenue due to the increased sales efforts, the growing number of products available to customers and the consumers' increased interest in alternative investment vehicles. Retail sales of The Parkstone Group of Mutual Funds more than doubled in 1993 to $247 million versus $107 million in 1992. Investment securities gains increased slightly over 1992, adding $0.18 per fully diluted share to 1993 earnings per share versus $0.17 per fully diluted share in 1992. The total net gain from such sales in 1993 was $16.8 million compared with $15.0 million in 1992 and $1.1 million in 1991. At year-end 1993, total unrealized gains of $53.2 million and total unrealized losses of $4.4 million remained in the Securities Available for Sale portfolio. Other non-interest income totaled $113.5 million in 1993, versus $98.0 million in 1992 and $77.6 million in 1991. The most significant components of other non-interest income, retail credit fees and mortgage banking revenue, increased 10.3 percent and 93.3 percent, respectively, for the year over year comparisons. Largely attributable to growth in the credit card portfolio, credit card fees for 1993 increased to $40.0 million compared with $36.2 million and $32.5 million in 1992 and 1991, respectively. The credit card portfolio reached $1.2 billion at year-end 1993, compared with $1.0 billion last year. Contributing to this increase were credit card solicitation campaigns to selected local and national customers which added over 300,000 accounts during 1993. First of America's cost to acquire a new account is $22, approximately one-half the quoted rate of its competitors. The cost to efficiently service the credit card portfolio of approximately $34 per account compares favorably with an industry peer average of approximately $48 per account. First of America's mortgage banking revenue contributed 13.2 percent of total fee-based income recorded in 1993 versus 7.7 percent in 1992. Gains on the sale of loans, the largest component of 1993's mortgage banking revenue, totalled $29.5 million compared to $15.2 million in 1992 and $5.2 million in 1991. The other source of mortgage banking revenue, mortgage servicing, has also continued to rise, increasing 93.3 percent to $7.0 million in 1993 versus 1992's $3.6 million and the $2.4 million reported in 1991. Reducing the 1993 and 1992 mortgage servicing income were $0.5 million and $3.3 million in excess mortgage servicing rights, respectively, written-off due to the decline in residential mortgage rates and the resulting higher mortgage prepayment rate. First of America originated $3.0 billion in new residential mortgage loans in 1993, a large portion of which were sold to the secondary market contributing to the record gains recorded in 1993. As the surge of mortgage refinancings diminishes, gains from the sale of new mortgage loans will level off; when that occurs, servicing fees from the previously sold loans will continue to provide a steady revenue stream. Servicing was retained on substantially all of the loans sold to the secondary market during 1993 resulting in a total servicing portfolio of $6.3 billion at year-end versus $6.1 billion a year ago. The outstanding servicing portfolio has an average interest rate of 7.80 percent and an average original term of 19.2 years. Non-interest expense -- As detailed in Table V, non-interest expense was $763.5 million in 1993, a decrease of 4.1 percent over 1992's $796.3 million. The total expense for 1992 was affected by two major items: $29.5 million (pre-tax) of one-time charges for the merger and assimilation of Security and the $25.9 million intangible asset writedown. Excluding these amounts, total non-interest expense increased 3.1 percent in 1993 over 1992. The largest component of First of America's non-interest expense is personnel costs which were $403.1 million in 1993 versus $410.9 million in 1992 and $361.2 million in 1991. Included in the 1992 total were $12.2 million in one-time costs related to the Security merger for severance costs, employment contract expenses and early retirements. Personnel costs were up only 1.1 percent for 1993 over 1992 when adjusted for these one-time costs. Net income from ongoing operations per full time equivalent employee was $18,558 in 1993 versus $16,947 in 1992, demonstrating the benefit of First of America's program of functional consolidations and staff reductions. Net occupancy and equipment costs decreased 9.9 percent in 1993 to $108.5 million compared with $120.4 million in 1992 and $101.9 million in 1991. The 1992 total included $6.2 million in one-time costs for the write-off of duplicative fixed assets as a result of the Security acquisition. Without these one-time costs, the 1993 decrease was 5.1 percent, primarily the result of the assimilation of operating sites acquired with Champion Federal and Security. Other operating expenses, which included all other costs of doing business such as outside data processing, advertising, supplies, travel, telephone, professional fees and outside services purchased, were $203.4 million in 1993, up 8.2 percent from 1992's total of $188.0 million. One-time costs of $11.2 million related to the Security acquisition were included in the 1992 total. Excluding those costs, the 1993 percent increase would have been 15.0 percent. Increased advertising expense due to the national credit card solicitations and increased loan and collection expense due to growth in the consumer portfolio were two of the larger contributors to this growth, increasing $8.1 million, or 56.5 percent, and $2.7 million, or 31.0 percent, respectively. Efficiency ratio -- The efficiency ratio measures non-interest expense as a percent of the sum of net interest income (FTE) and non-interest income. The lower the ratio, the more efficiently a company's resources [EFFICIENCY RATIO GRAPH] produce revenues. Table V presents the efficiency ratio over the last five years. Excluding the 1992 one-time charges for the Security acquisition and the $25.9 million writedown of intangible assets, the 1993 efficiency ratio improved to 62.72 percent compared with 63.80 percent in 1992 and 67.25 percent in 1991. The growth in non-interest income, which outpaced the growth in non- interest expense, and the cost controls mentioned previously are responsible for the improvement in this ratio. Income tax expense -- Income tax expense was $98.6 million in 1993 compared with $91.5 million in 1992 and $64.6 million in 1991. The Omnibus Budget Reconciliation Act of 1993 was passed in August 1993, increasing First of America's federal income tax rate to 35 percent effective January 1, 1993. The effect of the change from the previous 34 percent is included in the 1993 financial statements as a current charge to earnings and added $3.1 million of income tax expense for the full year. However, the new Act also resulted in $2.9 million of additional tax benefits. In addition, the results for 1993, included income tax benefits of $5.6 million related to the acquisition of Champion Federal, that helped offset the increased federal income tax rate. A summary of significant tax components is provided in Note 19 of the Notes The lower the ratio, the to Consolidated Financial Statements included more efficiently resource later in this document. are being utilized to produce revenue. First of America has improved its efficiency ratio through Credit Risk Profile streamlining operations, standardizing computer First of America's community banking structure systems and increasing helps minimize its credit risk exposure. Community fee income. banking means that loans are made in local markets to consumers and small to mid-sized businesses from deposits gathered in the same market. Also in keeping with this philosophy, loans with few exceptions are limited to a total of $20 million for any one borrower or group of related borrowers. A centralized, independent loan review staff evaluates each affiliate's loan portfolio on a regular basis and shares its evaluation with bank management as well as corporate senior management. First of America's loan portfolio has shifted to include more consumer loans than other types. At year-end 1993, the portfolio was distributed among commercial loans (14.9 percent), commercial mortgages (20.2 percent), residential mortgages (29.7 percent) and consumer loans (35.2 percent). The total loan portfolio, as presented in Table VII, was $14.4 billion at year-end 1993, up 4.6 percent from $13.8 billion a year ago. Components of the Loan Portfolio TABLE VII ($ in thousands) Commercial and Commercial Mortgage Loans -- First of America's commercial and commercial mortgage loans are made in local markets to small to mid-sized businesses. No single industry accounted for more than 10 percent of the total commercial loan portfolio, including mortgages and construction loans. Investor/developer loans, made to serve local markets, totaled $1.4 billion at year-end 1993 and were spread among such diverse property types as retail, residential rental, office rental and industrial. First of America has no foreign loans, no highly leveraged transactions and no syndicated purchase participations. Approximately 36.4 percent of total commercial loans, including commercial mortgages and construction loans, were made to customers in the metropolitan areas of Detroit, Grand Rapids and Indianapolis, compared with 37.4 percent a year ago. The remainder of the commercial portfolio was spread among suburban and rural communities throughout Michigan (31.3 percent), Illinois (31.1 percent) and Indiana (1.2 percent). Maturity and rate sensitivity of selected loan categories is presented in Table VIII. Maturity and Rate Sensitivity of Selected Loans TABLE VIII ($ in thousands) Included in the commercial loan and commercial mortgage portfolio at year-end 1993 was $114.1 million in non-performing loans compared with $124.6 million at the end of 1992. First of America's loan policies and procedures seek to minimize credit risk in the commercial portfolio. Cash-flow lending procedures emphasize the earning ability of the business instead of sole dependence on the collateral value which is dependent upon many variables. Net charge-offs as a percent of average commercial and commercial mortgage loans were 0.36 percent in 1993 and 0.47 percent in 1992, as the continuing economic recovery was reflected in reduced net loss experience. Residential Mortgage Loans -- Residential mortgage loans were $4.3 billion at year-end 1993 and $4.4 billion at year-end 1992. The average balance outstanding on First of America's residential mortgages at year-end 1993 was $48,000 per loan. The asset quality of the residential mortgage loan portfolio remained excellent. Non-performing loans as a percent of total residential mortgages were 0.40 percent at year-end 1993 compared with 0.48 percent a year ago. Net charge-offs as a percent of average residential mortgage loans were 0.03 percent and 0.02 percent in 1993 and 1992, respectively. At December 31, 1993, residential mortgage loans held for sale, originated at prevailing market rates, totalled $365.9 million with a market value of $368.8 million. These residential mortgages are closed and therefore included in outstandings on the balance sheet. In addition, First of America has entered into commitments to originate residential mortgage loans, at prevailing market rates, totalling $260.7 million of which all are intended for sale. Mandatory commitments to deliver mortgage loans or mortgage backed securities to investors, at prevailing market rates, totalled $373.3 million as of December 31, 1993. Additionally, approximately $16 million of put options were in existence at December 31, 1993 as a hedge against interest rate risk. Consumer Loans -- First of America's consumer loan portfolio was $5.1 billion at the end of 1993, compared with $4.3 billion at year-end 1992. Growth in this portfolio versus a year ago was across the board as direct consumer installment loans increased 16.8 percent, indirect consumer installment loans increased 20.1 percent and credit cards increased 18.5 percent. At year-end 1993, the number of credit card holders increased to 1.9 million and other revolving accounts totalled 0.2 million. The growth in the consumer portfolio was not achieved at the expense of reduced credit quality. In accordance with corporate policy, all revolving loans are charged off when they become 120 days past due. During 1993, net charge-offs as a percent of average total consumer loans were 1.18 percent versus 1.29 percent in 1992 and 1.50 percent in 1991. Asset Quality -- Total non-performing loans, other real estate owned and other [NON-PERFORMING loans of concern for the past five years ASSETS AS A PERCENT are detailed in Table IX. Total non- OF LOANS PLUS OREO] performing assets, including nonaccrual loans, renegotiated loans and other real estate owned, totaled $182.7 million at year-end 1993, compared with $196.0 million at year-end 1992 and $168.4 million at year-end 1991. Except for the southeast Michigan region, all An example of First of America's geographic areas served by the company asset quality has been its non- showed improvement in their asset quality performing assets as a percent during 1993. Non-performing assets in the of total loans plus OREO ratio southeast Michigan region represented which has averaged 1.15 percent 1.30 percent of its total assets over the last five years. The for 1993 compared with 1.08 percent Peer Group ratio over the last for 1992. For the company as a five years averaged 1.94 percent. whole this ratio was 0.86 percent, 0.97 percent and 0.87 percent, respectively for 1993, 1992 and 1991. Other loans of concern which represent loans where known information about possible credit problems of borrowers causes management concern about the ability of such borrowers to comply with the present loan terms totaled $53.2 million at year-end 1993, an increase of 41.3 percent from 1992's year-end total of $37.7 million. While management has identified these loans as requiring additional monitoring, they do not necessarily represent future non-performing loans. Net charge-offs as a percent of average loans was 0.53 percent for 1993, 0.57 percent for 1992 and 0.53 percent for 1991. Over the last five years, First of America's net charge-offs as a percent of average loans has averaged 0.53 percent which compares favorably to the 0.64 percent experienced by its Peer Group. The Peer Group's net charge-offs as a percent of average loans for 1993 was 0.51 percent. The allowance for loan losses is determined by management, taking into consideration past charge-off experience, estimated loss exposure on specific loans and the current and projected economic climate. Quarterly each affiliate evaluates the adequacy of its allowance for loan loss and their recommendations are reviewed by corporate loan review management. Management's allocation of the allowance for loan losses over the last five years is presented in Table X. The amounts indicated for each loan type include amounts allocated for specific loans as well as a general allocation. The allowance coverage of non-performing loans at year-end 1993 was 143 percent compared with 120 percent at year-end 1992 and 131 percent at year-end 1991. It was management's determination that the level of the allowance was adequate to absorb potential loan losses. Other ratios measuring asset quality and the adequacy of the allowance for loan losses are presented in Table XI. * Allowance as a percent of year-end loans outstanding by type. Unallocated ratio is the unallocated portfolio allowance as a percent of total loans at year-end. Funding, Liquidity and Interest Rate Risk Liquidity is measured by a financial institution's ability to raise funds through deposits, borrowed funds, capital or the sale of assets. Funding is achieved through growth in core deposits and accessibility to the money and capital markets. Deposits -- First of America's primary source of funding is its core deposits which include all but negotiated certificates of deposit. As a percent of total deposits, core deposits were 95.6 percent at year-end 1993 and 95.8 percent at year-end 1992. First of America does not issue negotiated CD's in the national money markets, and the level of purchased funds is strictly limited by corporate policy to less than 10 percent of assets. The majority of negotiated CD's and purchased funds originate from the core deposit customer base, including downstream correspondents. The average deposit balances outstanding and the rates paid on those deposits for the three years ended December 31, 1993, are presented in Table XII. The maturity distribution of time deposits of $100,000 or more at year-end 1993 is detailed in Table XIII. In addition to deposits, First of America's sources of funding include money market borrowings, capital funds and long term debt. First of America has an effective shelf registration statement under the Securities Act of 1933 on file with the Securities and Exchange Commission allowing it to publicly issue, on a continuous or delayed basis, any combination of debt securities, preferred stock and/or common stock up to a maximum offering price of $500 million. In addition, First of America has in place a revolving credit agreement with various lender banks to borrow up to $100 million. First of America also upstreams dividends from its affiliates as another means of funding. The total dividends upstreamed from First of America's bank subsidiaries to the parent company were $200.7 million in 1993, $137.4 million in 1992 and $177.7 million in 1991. The dividends paid from subsidiaries met all regulatory requirements. Deposits TABLE XII ($ in thousands) Securities -- First of America adopted the Financial Accounting Standards Board Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," at December 31, 1993. In accordance with Statement No. 115, Securities Held to Maturity include only those securities which First of America has the positive intent and ability to hold to maturity. At year-end 1993, the Held to Maturity portfolio was $1.9 billion compared with $3.5 billion at year-end 1992. Also in accordance with Statement No. 115, Securities Available for Sale include only those securities which would be available to be sold prior to final maturity in response to liquidity or asset/liability management needs. Table XIV details the components of the Securities Held to Maturity and Securities Available for Sale portfolios and the amortized cost and market values of the portfolios classified by maturity at December 31, 1993. Amortized cost and average maturities for these portfolios are detailed in Table XV. * Yields on state and political obligations have been adjusted to a taxable equivalent basis using a 35% tax rate. Yields are calculated on the basis of cost and weighted for the scheduled maturity and dollar amount of each issue. - -------------------------------------------------------------------------------- Securities Available for Sale Maturity Distribution and Portfolio Yields * Yields on state and political obligations have been adjusted to a taxable equivalent basis using a 35% tax rate. Yields are calculated on the basis of cost and weighted for the scheduled maturity and dollar amount of each issue. - -------------------------------------------------------------------------------- * Represents Federal Reserve Stock of $23,082 in 1992, and $34,987 in 1991. Securities Available for Sale ($ in thousands) Interest Rate Risk -- First of America's interest rate risk policy is to minimize the effect on net income resulting from a change in interest rates through asset/liability management at all levels in the company. Each banking affiliate completes an interest rate analysis every month using an asset/liability model, and a consolidated analysis is then completed using the affiliates' data. The Asset and Liability Committees, which exist at each banking affiliate and at the consolidated level, review the analysis and as necessary, appropriate action is taken to maintain the net interest spread, even in periods of rapid interest rate movement. Interest rate swap transactions generally involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying financial instrument. The company becomes a principal in the exchange of interest payments with other parties and, therefore, is exposed to the loss of future interest payments should the counterparty default. The company minimizes this risk by performing normal credit reviews of its counterparties and collateralizing its exposure when it exceeds a predetermined limit. First of America had outstanding interest rate swap agreements at December 31, 1993, totalling $291.6 million in notional amounts. This total included notional amounts of $125 million as a hedge against long term debt and the remainder as a hedge against certain deposits. First of America had no outstanding interest rate swap agreements at December 31, 1992. Interest rate sensitivity of assets and liabilities is represented in a Gap report, Gap being the difference between rate sensitive assets and liabilities. Table XVI presents First of America's Gap position at December 31, 1993, for one year and shorter periods, and Table XVII details the company's five year Gap position. The Gap reports' reliability in measuring the risk to income from a change in interest rates is tested through the use of simulation models. The most recent simulation models show that less than one percent of First of America's annual net income is at risk if interest rates were to move up or down an immediate one percent. Management has determined that these simulations provide a more accurate measurement of the company's interest rate risk positions than the following Gap tables. Capital Strength Regulatory Requirements -- First of America's capital policy is to maintain its capital levels above minimum regulatory guidelines. At December 31, 1992, the Federal Reserve required a tier I risk based capital ratio of 4.00 percent and a total risk based capital ratio of 8.00 percent. In 1991, the Federal Reserve also adopted a new leverage capital adequacy standard. This ratio compares tier I capital to reported total assets less certain intangibles and requires a minimum ratio of 4.00 percent in order to be categorized as adequately capitalized. As shown in Table XVIII, at December 31, 1993, First of America's capital ratios exceeded required regulatory minimums with a tier I risk based ratio of 9.45 percent, a total risk based ratio of 11.87 percent and a tier I leverage ratio of 6.43 percent. The increase in the ratios was largely the result of net earnings retention. The year-end 1993 capital ratios exclude the Statement No. 115 mark-to-market adjustment to shareholders' equity in accordance with the Federal Reserve's interim regulations. The long term debt which qualified as tier II capital at December 31, 1993, consisted of $150 million in 8.5% Subordinated Notes Due February 1, 2004, a $10 million 6.35% Subordinated Note which matures ratably over a five year period beginning December 31, 2003, $21.4 million in 9.25% Senior Notes due in equal installments through 1996, and $7.8 million in 10.675% Subordinated Notes due in equal installments through 1998. This debt is included in tier II capital on a weighted maturity basis. On February 7, 1994, First of America exercised the right to prepay its 9.25% Senior Notes, incurring a $441,000 prepayment penalty. Additional information relating to First of America's various long term debt agreements is provided in Note 11 of the Notes to Consolidated Financial Statements included later in this document. *Limited to 1.25% of total risk-weighted assets. Total Shareholders' Equity -- First of America's total shareholders' equity increased 14.1 percent to $1.5 billion at year-end 1993, primarily as a result of net earnings retention and the Statement No. 115 adjustment. Common shareholders' equity was $1.5 billion at year-end 1993, a 20.8 percent increase from $1.3 billion a year ago. This growth was the result of net earnings retention and the conversion of the Series F 9% Convertible Preferred Stock to First of America Common Stock. Also impacting common shareholders' equity was the issuance of 95,668 shares of First of America Common Stock in the company's acquisition of Kewanee Investing Company, Inc. on April 1, 1993. On December 31, 1993, First of America redeemed all outstanding shares of its Series F 9% Convertible Preferred Stock which represented the remainder of its outstanding preferred issues. Series F 9% Convertible Preferred Stock had 392,557 outstanding shares prior to redemption. All shares were converted to First of America Common Stock resulting in an additional 2,355,342 common shares being issued. At December 31, 1993, First of America had one pending acquisition, LGF Bancorp, Inc., and its principal subsidiary, La Grange Federal Savings and Loan Association. This acquisition, which is currently anticipated to be completed in the first half of 1994, will require the issuance of approximately 1,662,200 shares of First of America Common Stock. Consummation of this acquisition is subject to approval by LGF Bancorp's shareholders and various regulatory agencies and other conditions. Further information concerning this acquisition is provided in Note 3 of the Notes to Consolidated Financial Statements included later in this document. In Conclusion A return on assets of 1.20 percent, an efficiency ratio of 62.72 percent and a return on total equity of 17.50 percent represented significant achievements for First of America for 1993. Based on this level of performance and the competitiveness of the financial services industry, management believes that it is appropriate to set similar high goals for the future. In the years ahead, management's goals for the company's performance include a return on assets of 1.25 percent or higher and an efficiency ratio of 60 percent or lower, while maintaining a return on equity between 17 percent and 18 percent. Looking specifically at 1994, management has stated that it is currently comfortable with the published range of investment analysts' forecasts of $4.40 to $4.70 for earnings per share. [RETURN OF AVERAGE ASSETS GRAPH] Return on average assets of 1.20% in 1993 was achieved by sustaining an above average net interest margin, while growing fee income at a faster pace than non-interest expense. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Statement of Management Responsibility The following consolidated financial statements and accompanying notes to the consolidated financial statements of First of America have been prepared by management, which has the responsibility for their integrity and objectivity. The statements have been prepared in accordance with generally accepted accounting principles to reflect, in all material respects, the substance of financial events and transactions occurring during the respective periods. In meeting its responsibility, management relies on First of America's accounting systems and related internal controls. These systems are designed to provide reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management's authorization. Augmenting these systems are written policies and procedures and audits performed by First of America's internal audit staff. The consolidated financial statements and notes to the consolidated financial statements of First of America have been audited by the independent certified public accounting firm, KPMG Peat Marwick, who were engaged to express an opinion as to the fairness of presentation of such financial statements. /s/ Daniel R. Smith /s/ Thomas W. Lambert Daniel R. Smith Thomas W. Lambert Chairman and Executive Vice President and Chief Executive Officer Chief Financial Officer Letter of Audit Committee Chairman The audit committee of the Board of Directors is composed of eight independent directors with Robert L. Hetzler as chairman. The committee held four meetings during fiscal year 1993. The audit committee oversees First of America's financial reporting process on behalf of the Board of Directors. In fulfilling its responsibility, the committee recommended to the Board of Directors, subject to shareholder approval, the selection of First of America's independent auditor. The audit committee discussed with the internal auditor and the independent auditor the overall scope and specific plans for their respective audits. The committee additionally discussed First of America's consolidated financial statements and the adequacy of First of America's internal controls. The committee also met with First of America's internal auditor and independent auditor, without management present, to discuss the results of their audits, their evaluations of First of America's internal controls and the overall quality of First of America's financial reporting. This meeting was designed to facilitate private communications between the committee, the internal auditor and the independent auditor. The audit committee believes that, for the period ended December 31, 1993, its duties, as indicated, were satisfactorily discharged and that First of America's system of internal controls is adequate. /s/ Robert L. Hetzler Robert L. Hetzler Chairman Audit Committee Report of Independent Auditors To the Shareholders and Board of Directors, First of America Bank Corporation: We have audited the accompanying consolidated balance sheets of First of America Bank Corporation and its subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, changes in shareholders' 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 First of America Bank 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 years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 1 and 6 to the consolidated financial statements, First of America Bank Corporation adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" at December 31, 1993. As discussed in Notes 1 and 17 to the consolidated financial statements, First of America Bank Corporation adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits other than Pensions" in 1992. /s/ KPMG Peat Marwick KPMG Peat Marwick Chicago, Illinois January 18, 1994 See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. Notes To Consolidated Financial Statements NOTE 1: ACCOUNTING POLICIES The consolidated financial statements have been prepared in conformity with generally accepted accounting principles and reporting practices prescribed for the banking industry. The significant accounting and reporting policies of First of America Bank Corporation and its subsidiaries follow. Consolidation: The consolidated financial statements include the accounts of First of America and its subsidiaries, after elimination of significant intercompany transactions and accounts. Goodwill, the cost over the fair value of assets acquired, is amortized on a basis which matches the periods estimated to be benefitted ranging from five to forty years. First of America's current policy is to amortize goodwill generated from acquisitions over a fifteen year period. Basis of Presentation: Certain amounts in the prior years' financial statements have been reclassified to conform with the current financial statement presentation. First of America uses the accrual basis of accounting for financial reporting purposes, except for immaterial sources of income and expenses which are recorded when received or paid. Securities: In 1993, the Financial Accounting Standards Board issued Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993 with earlier adoption allowed. First of America adopted Statement No. 115 at December 31, 1993. In accordance with Statement No. 115, Securities Held to Maturity include only those securities which First of America has the positive intent and ability to hold until maturity. Such securities are carried at cost adjusted for amortization of premium and accretion of discount, computed in a manner which approximates the interest method. Using the specific identification method, the adjusted cost of each security sold is used to compute realized gains or losses on the sales of these securities. In accordance with Statement No. 115, Securities Available for Sale include those securities which would be available to be sold prior to final maturity in response to asset-liability management needs. Using the specific identification method such securities are carried at market value with a corresponding market value adjustment carried as a separate component of the equity section of the balance sheet on a net of tax basis. The adjusted cost of each security sold is used to compute realized gains or losses on the sales of these securities. Securities held for sale were recorded at the lower of aggregate cost or estimated fair value and were primarily U.S. Treasury and Agency securities. Loans Held for Sale: Loans held for sale consist of fixed rate and variable rate residential mortgage loans with maturities of fifteen to thirty years. Such loans are recorded at the lower of aggregate cost or estimated fair value. Allowance for Loan Losses: Losses on loans are charged to the allowance for loan losses. The allowance is increased by recoveries of principal and interest previously charged to the allowance and by a provision charged against income. Management determines the adequacy of the allowance based on reviews of individual loans, recent loss experience, current economic conditions, risk characteristics of various categories of loans and such other factors which, in management's judgement, deserve recognition in estimating possible loan losses. Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation, and include capital leases, expenditures for new facilities and additions which materially extend the useful lives of existing premises and equipment. Expenditures for normal repairs and maintenance are charged to operations as incurred. The cost of assets retired or otherwise disposed of and the related accumulated depreciation are eliminated from the accounts in the year of disposal, and the resulting gains or losses are reflected in operations. Depreciation is computed principally by the straight-line method and is charged to operations over the estimated useful lives of the assets. Capital leases and leasehold improvements are being amortized over the lesser of the remaining term of the respective lease or the estimated useful life of the asset. Non-Performing Loans: Loans are considered non-performing when placed in non-accrual status or when terms are renegotiated meeting the definition of troubled debt restructuring of Financial Accounting Standards Board Statement No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructuring." Loans are placed in non-accrual status when, in the opinion of management, there is doubt as to collectibility of interest or principal, or when principal or interest is past due 90 days or more, and the loan is either not well secured or not in the process of collection. Consumer and revolving loans are generally charged off when payments are 120 days past due. Loans are considered to be renegotiated when concessions have been granted, such as reduction of interest rates or deferral of interest or principal payments, as a result of the borrower's financial condition. In 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan," effective for fiscal years beginning after December 15, 1994, with earlier adoption allowed. Statement No. 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Currently, management believes that the adoption of Statement No. 114 will not have a material effect on First of America's financial position. Other Real Estate Owned: Other real estate owned includes, primarily, properties acquired through foreclosure or deed in lieu of foreclosure and in-substance foreclosure. Other real estate is recorded in other assets at the lower of the amount of the loan balance plus unpaid accrued interest or the current fair value. Any write-down of the loan balance to fair value when the property is acquired is charged to the allowance for loan losses. Subsequent market write-downs, operating expenses, and gains or losses on the sale of other real estate are charged or credited to other operating expense. Interest Income on Loans: Fees and unearned interest income on loans is recognized over the terms of the loans based on the unpaid principal balance. Interest accrual on loans is discontinued when, in the opinion of management, the ultimate full collection of both principal and interest is in doubt. Interest previously accrued on charged off loans is reversed, by charging interest income, to the extent of the amount included in current year income. The excess, if any, is charged to the allowance for loan losses. Accounting for Loan Fees: Non-refundable loan origination fees and direct loan origination costs are deferred and amortized as an adjustment of yield by a method that approximates the interest method. The deferred fees and costs are netted against outstanding loan balances. When a loan is placed into nonaccrual status, amortization of the loan fees is stopped until the loan returns to accruing status. Deferred fees and costs related to credit card loans are included in other assets and other liabilities and are amortized to non-interest income over the life of the loans. Income Tax: In February 1992, the Financial Accounting Standards Board issued Statement No. 109, "Accounting for Income Taxes" which required a change from the deferred method to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement No. 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 No. 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, 1992, First of America adopted Statement No. 109. The adoption of Statement No. 109 did not have a material effect on the 1992 consolidated financial results. The Omnibus Budget Reconciliation Act of 1993 was passed in August 1993, increasing First of America's federal income tax rate to 35 percent effective January 1, 1993. The effect of the change from the previous 34 percent is included in 1993 earnings. Pursuant to the deferred method under APB Opinion 11, which was applied in 1991 and prior years, deferred income taxes were recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. Postretirement Benefits Other Than Pensions: In December 1990, the Financial Accounting Standards Board issued Statement No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective for fiscal years beginning after December 15, 1992 with earlier adoption allowed. Statement No. 106 required the accrual of the expected cost of providing postretirement benefits to employees during the years that the employees render services. Effective January 1, 1992, First of America adopted Statement No. 106. Prior to 1992, First of America expensed the costs of postretirement benefits as they were incurred. The cumulative effect of the change in method of accounting for postretirement benefits other than pensions is reported in the 1992 consolidated statement of income. Post-Employment Benefits: In 1993, the Financial Accounting Standards Board issued Statement No. 112, "Employers' Accounting for Post-employment Benefits," effective for fiscal years beginning after December 15, 1993. Statement No. 112 requires employers to recognize the obligation to provide post-employment benefits, such as salary continuation, supplemental unemployment benefits and severance benefits, if the obligation is attributable to employees' services already rendered. Management has determined that First of America was in compliance with Statement No. 112 prior to its issuance and accordingly there is no financial statement impact in the adoption of Statement No. 112. Interest Rate Swaps: The corporation and its subsidiaries have entered into interest rate swaps as a tool to manage the interest sensitivity of the balance sheet. The contracts represent an exchange of interest payments and the underlying principal balances of the assets or liabilities are not affected. Net settlement amounts are reported as adjustments to interest income or interest expense. NOTE 2: BUSINESS COMBINATIONS Information relating to mergers and acquisitions for the three year period ended December 31, 1993 follows. * Includes direct acquisition costs on all purchased affiliates. ** Accounted for as a pooling of interests with no restatement of prior periods as the amounts involved were not material to First of America. *** Accounted for as a pooling of interests with restatement of prior periods. Goodwill, the cost over the fair value of assets acquired, is amortized on a basis which matches the periods estimated to be benefitted ranging from five to forty years. Total intangibles, which is included in other assets in the Consolidated Balance Sheets, amounted to $138,423,000 at December 31, 1993 and $124,179,000 at December 31, 1992. At December 31, 1992, First of America accelerated the amortization of its intangible assets incurring a charge of $25,891,000 with no tax effect. NOTE 3: PENDING ACQUISITIONS On October 12, 1993, First of America Bank Corporation entered into a definitive agreement to acquire LGF Bancorp, Inc., a $410 million in assets savings and loan association based in La Grange, Illinois. Subject to regulatory approval and the shareholders of LGF Bancorp, Inc., the transaction will be based on an exchange of 0.8754 shares of First of America Common Stock for each share of LGF common stock and an exchange of 0.6322 shares of First of America Common Stock for each outstanding option to purchase LGF common stock. It is expected that the transaction will be accounted for as a pooling of interests. LGF Bancorp, Inc. has also issued a warrant to allow First of America to acquire up to 19.99 percent of its common shares under certain circumstances. NOTE 4: RESTRICTIONS ON CASH AND DUE FROM BANKS Federal regulations require First of America to maintain as reserves, minimum cash balances based on deposit levels at subsidiary banks. Cash balances restricted from usage due to these requirements were $297,497,000 and $289,582,000 at December 31, 1993 and 1992, respectively. NOTE 5: CASH FLOW For the purpose of reporting cash flows, cash and cash equivalents include only cash and due from banks. The following schedule presents noncash investing activities for the years 1993, 1992 and 1991: The following schedule details supplemental disclosures for the cash flow statements: * Transferred as a result of the final assimilation and merger of Champion Federal into nine Illinois bank affiliates. NOTE 6: SECURITIES The amortized cost and estimated market value of Securities Held to Maturity at December 31, 1993 and 1992 follow. The following table details the gross unrealized gains and losses for Securities Held to Maturity at December 31, 1993 and 1992. The amortized cost and estimated market value of Securities Available for Sale at December 31, 1993 follow. The following table details the gross unrealized gains and losses on Securities Available for Sale at December 31, 1993. First of America's December 31, 1993 adoption of Statement No. 115 resulted in a $31,531,000 mark-to-market adjustment to equity, net of $17,263,000 in taxes, from unrealized gains on the Securities Available for Sale portfolio. The amortized cost and estimated market value of Securities Held for Sale at December 31, 1992 follow. The following table details the gross unrealized gains and losses on Securities Held for Sale at December 31, 1992. Except as indicated below, total securities of no individual state, political subdivision or other issuer exceeded 10 percent of shareholders' equity at December 31, 1993. At December 31, 1993 and 1992, the book value of securities issued by the State of Michigan and all of its political subdivisions totalled approximately $189,536,000 and $213,582,000, respectively, with a market value of approximately $194,238,000 and $217,052,000, respectively. The securities at December 31, 1993, represent a wide range of ratings, all of "investment grade" with a substantial portion rated A-1 or higher. First of America has no concentration of credit risk in its investment portfolio. Assets, principally securities, carried at approximately $1,394,103,000 at December 31, 1993, and $787,455,000 at December 31, 1992, were pledged to secure public deposits, exercise trust powers and for other purposes required or permitted by law. NOTE 7: RISK ELEMENTS IN THE LOAN PORTFOLIO AND OTHER REAL ESTATE OWNED Assets earning at less than normal rates include (1) non-accrual loans, (2) restructured loans (loans for which the interest rate or principal balance has been reduced because of a borrower's financial difficulty) and (3) other real estate which has been acquired in lieu of loan balances due. Information concerning these assets, loans past due 90 days or more and other loans of concern (loans where known information about possible credit problems of borrowers causes management concern about the ability of such borrowers to comply with the present loan terms) at December 31, 1993 and 1992 follows: Interest income of $3,149,000 and $2,503,000 during 1993 and 1992, respectively, was recognized as income on non-accrual and restructured loans. Had these loans been performing under the original contract terms, an additional $6,928,000 and $6,957,000 of interest would have been reflected in interest income during 1993 and 1992, respectively. First of America has no significant concentrations of credit risk. Its loan portfolio is well balanced both by type and by geographical area. NOTE 8: LOANS TO RELATED PARTIES First of America's subsidiary banks have extended loans to directors and executive officers of the corporation and their associates and to the directors and executive officers of the corporation's significant subsidiaries and their associates (other than members of their immediate families). In conformance with First of America's written corporate policy and applicable laws and regulations, these loans to related parties were made in accordance with sound business and banking practices on non-preferential terms and rates available to non-insiders of comparable credit worthiness under similar circumstances. The loans do not involve more than the normal risk of collectibility or present other unfavorable features. All such extensions of credit must be properly documented as complying with corporate policy. The aggregate loans outstanding as reported by the directors and executive officers of the corporation and its significant subsidiaries which exceeded $60,000 during 1993 totalled $42,405,000 at December 31, 1993, which represents 2.8 percent of total shareholders' equity, and $39,489,000 at December 31, 1992. During 1993 $44,959,000 of new loans were made with repayments and other reductions totaling $42,043,000. First of America relies on its directors and executive officers for identification of loans to their associates. First of America maintains a line of credit for First of America Mortgage Company; at December 31, 1993, the amount of the borrowing was $95,600,000. In conformance with First of America's corporate policy and applicable law, such extensions of credit to subsidiaries are made in accordance with sound banking practices and on non-preferential terms and rates. In the opinion of management, the amount and nature of these loans to related parties and subsidiaries do not materially affect the financial condition of First of America. NOTE 9: ALLOWANCE FOR LOAN LOSSES An analysis of the transactions in the allowance for loan losses for 1993, 1992 and 1991 follows. Management has evaluated the loan portfolio and determined that the balance in the allowance for loan losses is adequate in light of the composition of the loan portfolio, economic conditions and other pertinent factors. NOTE 10: PREMISES AND EQUIPMENT A summary of premises and equipment at December 31, 1993 and 1992 follows. First of America and certain of its subsidiaries have capital and operating leases for premises and equipment under agreements expiring at various dates through 2034. These leases, in general, provide for renewal options and options to purchase certain premises at fair values, and require the payment of property taxes, insurance premiums and maintenance costs. Total rental expense for all operating leases was $10,936,000 in 1993, $16,329,000 in 1992, and $21,226,000 in 1991. The future minimum payments by year, and in the aggregate, under capital leases and noncancelable operating leases with initial or remaining terms of one year or more consisted of the following at December 31, 1993. NOTE 11: LONG TERM DEBT Information relating to long term debt at December 31, 1993 and 1992 follows. On April 21, 1989, First of America entered into a revolving credit agreement with various lender banks to borrow up to $100,000,000 until April 21, 1994. On December 6, 1993, First of America extended a Promissory Note, due December 5, 1994, in the amount of $35,000,000. Under the Note, First of America may request partial advances which mature before December 5, 1994, and bear interest based on a sliding scale of LIBOR-based rates tied to the amount of the advance. A facility fee is payable on the daily average balance of the commitment at a rate of 3/16 of 1%. The various loan agreements include restrictions on additional indebtedness, refinancing, payment of cash dividends and the purchase of capital stock. During 1994 First of America can, under the most restrictive loan covenants, declare and pay dividends of approximately $58,575,000 plus 50 percent of consolidated net income. The indebtedness of subsidiary banks is subordinated to the claims of its depositors and certain other creditors. Management has determined that First of America is in compliance with all of its loan covenants. Maturities of outstanding indebtedness at December 31, 1993 follow. NOTE 12: COMMITMENTS AND CONTINGENT LIABILITIES Financial Instruments with Off-Balance Sheet Risk: In First of America's normal course of business, there are various conditional obligations outstanding which are not reflected in the financial statements. These financial instruments include commitments to extend credit, standby letters of credit, commercial letters of credit, when issued securities, securities lent and commitments to purchase foreign currency. First of America's exposure to credit loss in the event of nonperformance by other parties to the financial instruments with off-balance sheet risk is represented by the contractual notational amount of these instruments. First of America uses the same credit policies in making these commitments and conditional obligations as it does for on-balance sheet instruments. Unless noted otherwise, First of America does not require collateral or other security to support financial instruments with off balance sheet credit risk. A summary of the contract or notional amounts of these financial instruments at December 31 follows: 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. Commitments generally have fixed expiration dates and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the commitment amounts included in the preceding table does not necessarily represent future cash requirements. At December 31, 1993, other commitments to extend credit were comprised of $1,246,685,000 in unused commercial loan commitments, $343,880,000 in commitments to fund commercial real estate, construction and land development of which $287,195,000 was secured by real estate, and $471,394,000 in home equity lines of credit. Collateral held on these instruments varies but may include accounts receivable, inventory, property, plant and equipment and income-producing commercial properties. Standby letters of credit and commercial letters of credit are conditional commitments issued to secure performance of a customer to a third party and are subject to the same credit review and approval process as loans. Losses to date have not been material. Foreign exchange contracts are entered into for trading activities which enable customers to transfer or reduce their foreign exchange risk. Foreign exchange forward contracts represent First of America's largest activity in this specialized area. Forward contracts are commitments to buy or sell at a future date a currency at a contracted price and are settled in cash or through delivery. The risk in foreign exchange trading arises from the potential inability of the counterparties to deliver under the terms of the contract and the possibility that the value of a foreign currency might change in relation to the U.S. dollar. In the event of a default by a counterparty, the cost to First of America would be the replacement of the contract at the current market rate. Such credit losses to date have not been material. The risk of loss from changes in market rate is substantially lessened because First of America limits its risk by entering into offsetting contracts. First of America has entered into mandatory commitments to deliver mortgage loans or mortgage backed securities to investors, at prevailing market rates, which totalled $373.3 million as of December 31, 1993. Approximately $16 million of put options were in existence at year-end as a hedge against interest rate risk. Mortgages Sold With Recourse: First of America has sold mortgage loans to the Federal National Mortgage Association (FNMA), Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and other savings institutions with full recourse. The total unpaid principal balances of these loans were $90.3 million at December 31, 1993 and are not included in the accompanying consolidated balance sheets. Interest Rate Swaps: During the second quarter of 1993, First of America instituted rate swaps to hedge its interest rate risk. At December 31, 1993, the interest rate swaps had a total notional value of $291.6 million. Although the notional amounts are often used to express the volume of these transactions, the amounts potentially subject to credit risk are much smaller. The company minimizes this risk by performing normal credit reviews of its counterparties and collateralizing its exposure when it exceeds a predetermined limit. Litigation: First of America and its subsidiaries are parties to routine litigation arising in the normal course of their respective businesses. In the opinion of management after consultation with counsel, liabilities arising from these proceedings, if any, are not expected to be material to First of America's financial position. Environmental Matters: Certain of First of America's subsidiaries own or previously owned certain parcels of real property with respect to which they have been notified by the Michigan Department of Natural Resources pursuant to Michigan environmental statutes that they may be potentially responsible parties (PRPs) for environmental contamination on or emanating from the properties. The costs of remediating the contamination cannot be determined at this time. While, as PRPs, these subsidiaries may be jointly and severally liable for the costs of remediating the contamination, in most cases, there are a number of other PRPs who may also be jointly and severally liable for remediation costs. Additionally, in certain cases, these subsidiaries have asserted statutory defenses to liability for remediation costs based on the subsidiaries' status as lending institutions that acquired ownership of the contaminated property through foreclosure. First of America's management, after consultation with legal counsel, does not currently anticipate that the ultimate liability, if any, arising from these matters will have a material effect on First of America's financial position. NOTE 13: PREFERRED STOCK On December 31, 1993, First of America redeemed all outstanding shares of its Series F 9% Convertible Preferred Stock which represented the remainder of its outstanding preferred issues. The Series F 9% Convertible Preferred Stock had 392,557 outstanding shares prior to redemption. All the shares were converted to First of America Common Stock resulting in 2,355,342 shares being issued. First of America has reserved 500,000 shares of preferred stock for issuance as Series A Junior Participating Preferred Stock ("Series A Preferred") upon the exercise of certain preferred stock purchase rights (each a "Right") issued to holders of and in tandem with shares of the common stock. The description and terms of the Rights are set forth in a Rights Agreement ("Rights Agreement"), dated July 18, 1990, between First of America and First of America Bank -- Michigan, N.A., as Rights Agent. The Rights Agreement was filed with the Securities and Exchange Commission as an exhibit to First of America's Registration Statement dated July 18, 1990 on Form 8-A under the Securities Exchange Act of 1934. Generally, the Rights Agreement provides as follows. The Rights are not exercisable until a distribution date, which occurs ten days after a person or group (an "Acquiring Person") publicly announces acquisition of or commences a tender offer which may result in the acquisition of beneficial ownership of 10 percent or more of the outstanding shares of First of America Common Stock (a "Stock Acquisition Date"). If, following a Stock Acquisition Date, First of America is merged with or engages in a business combination transaction with the Acquiring Person or the Acquiring Person increases its beneficial ownership of First of America Common Stock by more than one percent or engages in self dealing, then holders of Rights, other than the Acquiring Person, will receive upon exercise of each Right, common stock of First of America or of the entity surviving the merger or business combination or other consideration with a value of two times the exercise price of the right. First of America may, at its option, at any time after a Stock Acquisition Date and before an Acquiring Person becomes the beneficial owner of more than 50 percent of the outstanding shares of First of America Common Stock, elect to exchange all outstanding Rights for shares of First of America Common Stock at an exchange ratio of one share of First of America Common Stock per Right, subject to adjustment to prevent dilution. At any time until twenty days following the Stock Acquisition Date, First of America may redeem the Rights in whole, but not in part, at a price of $.01 per Right. Until a Right is exercised, the holder thereof, as such, will have no right as a shareholder of First of America, including, without limitation, the right to vote or to receive dividends. Other than those provisions relating to the principal economic terms of the Rights, any of the provisions of the Rights Agreement may be amended by First of America's Board of Directors prior to the distribution date. If issued upon exercise of the Rights, shares of the Series A Preferred will rank junior to any convertible preferred outstanding at such time. Each share of Series A Preferred shall be entitled to 100 votes on all matters submitted to a vote of the shareholders of the company. Additionally, in the event the company fails to pay dividends on the Series A Preferred for four full quarters, holders of the Series A Preferred have certain rights to elect additional directors of the company. Except as described above, holders of the Series A Preferred have no preemptive rights to subscribe for additional securities which the company may issue. The Series A Preferred will not be redeemable. Each share of Series A Preferred will, subject to the rights of any preferred stock the company may issue ranking senior to the Series A Preferred, be entitled to preferential quarterly dividends equal to the greater of $10.00, or subject to certain adjustments, 100 times the dividend declared per share of common stock. Upon liquidation of the company, holders of Series A Preferred will, subject to the rights of senior securities, be entitled to a preferential liquidation payment equal to $190.00 per share, plus accrued and unpaid dividends. In the event of any merger, consolidation, or other transaction in which shares of common stock are exchanged, each share of Series A Preferred will, subject to the rights of senior securities, be entitled to receive 100 times the amount received per share of common stock. The rights of the Series A Preferred are protected by customary antidilution provisions. NOTE 14: STOCK OPTION PLAN The First of America Bank Corporation Restated 1987 Stock Option Plan is administered by the Nominating and Compensation Committee of the Board of Directors, none of whom is eligible to participate therein. Under the Plan options to purchase up to 1,700,000 authorized but unissued shares of First of America Common Stock may be issued through December 9, 1997. The stock options are exercisable during the 10 year period, beginning on the date of grant and may be granted at prices not less than the fair market value on the date of grant. The following is a summary of transactions which occurred during 1991, 1992 and 1993: NOTE 15: DIVIDENDS FROM BANKING SUBSIDIARIES Dividends paid to First of America by its bank subsidiaries amounted to $200,700,000 in 1993, $137,369,000 in 1992 and $177,665,000 in 1991. Unless prior regulatory approval is obtained, banking regulations limit the amount of dividends that First of America's banking subsidiaries can declare during 1994, to the 1994 net profits, as defined in the Federal Reserve Act, plus retained net profits for 1993 and 1992, which amounted to $157,285,000. Under the FDIC Improvement Act of 1991, there is incentive to maintain banks' capital at the "well-capitalized" level. This may further restrict dividends in the future. NOTE 16: EMPLOYEE PENSION PLAN First of America and its subsidiaries have a defined benefit pension plan that covers substantially all of its full-time employees. Benefits are based on years of service and the employee's compensation. Pension costs for the years 1993 and 1992 were calculated based on Financial Accounting Standards Board Statement No. 87 "Employers' Accounting for Pensions." Pension costs for the years ended December 31, 1993, 1992 and 1991 equaled $6,508,000, $11,821,000 and $6,957,000, respectively. The following table presents the plan's funded status and amounts recognized in the consolidated balance sheets at December 31, 1993 and 1992. First of America's weighted-average discount rate was 7.0 percent at December 31, 1993 and 8 1/4 percent at December 31, 1992. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 5.00 percent at year-end 1993 and 6.00 percent at year-end 1992. The expected long term rate of return on assets was 8.75 percent and 8.00 percent at December 31, 1993 and 1992, respectively. The assumed rates in place at each year-end are used to determine the net periodic pension cost for the following year. NOTE 17: OTHER POSTRETIREMENT BENEFITS First of America and its subsidiaries have a Retiree Medical Plan which provides a portion of retiree medical care premiums. First of America's level of contribution is based on an age and service formula. First of America adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," as of January 1, 1992. Postretirement benefit costs of $2,308,000 were recorded on a cash basis for the year ended December 31, 1991. During 1993, First of America implemented several managed care initiatives and redesigned its Preferred Provider Organization. This change was measured as of December 31, 1993 and reduced the accumulated postretirement benefit obligation as of that date by $4,807,000. The following table presents the plan's funded status reconciled with amounts recognized in First of America's Consolidated Balance Sheet at December 31, 1993 and 1992: For measurement purposes of the accrued postretirement benefit cost included in other liabilities, 10.95 percent and 11.54 percent annual rates of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) were assumed at December 31, 1993 and 1992, respectively; the 1993 rate was further assumed to decline evenly to 5.0 percent in 2004. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0 percent at December 31, 1993 and 8.5 percent at December 31, 1992. To determine First of America's net periodic postretirement benefit cost for 1993 and 1992, a weighted average discount rate of 8.5 percent and the health care trend rate of 11.54 percent were used. The health care cost trend rate assumption has a significant effect 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 5.2 percent and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for the year ended December 31, 1993 by 4.4 percent. NOTE 18: SUPPLEMENTARY INCOME STATEMENT INFORMATION Other than the items listed below, other operating income and other operating expenses did not include any accounts that exceeded 1 percent of total revenue, which is the sum of total interest income and total non-interest income. NOTE 19: INCOME TAXES First of America adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes," effective January 1, 1992. The adoption of Statement No. 109 did not result in any cumulative effect for the change in accounting for income taxes to be reported in 1992. Prior years' financial statements have not been restated to apply the provisions of Statement No. 109. Income tax expense attributable to income from continuing operations consists of: Income tax expense attributable to income from continuing operations was $98,574,000, $91,506,000 and $64,625,000 for the years ended December 31, 1993, 1992 and 1991 respectively, and differed from the amounts computed by applying the U.S. federal income tax rate of 35 percent to pretax income from operations for 1993 and 34 percent for 1992 and 1991 as a result of the following: The significant components of deferred income tax expense attributable to income from continuing operations for the year ended December 31, 1993 and 1992 are as follows: For the year ended December 31, 1991, a deferred income tax benefit of $7,385,000 resulted from timing differences in the recognition of income and expense for income tax and financial reporting purposes. The sources and tax effects of those timing differences are presented below: The securities transactions tax effect for 1993, 1992 and 1991 was $6,524,000, $5,574,000 and $1,373,000, respectively. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 are presented below: The valuation allowance for deferred tax assets as of January 1, 1993 was $10,569,000. The net change in the total valuation allowance for the year ended December 31, 1993 was a decrease of $9,686,000. Subsequently recognized tax benefits of $883,000 relating to the valuation allowance for deferred tax assets as of December 31, 1993 will be allocated to the income tax benefit that would be reported in the consolidated statement of earnings. NOTE 20: EARNINGS PER SHARE CALCULATION The weighted average number of shares used in the determination of earnings per share were: Common and common equivalents per share amounts were calculated by dividing net income applicable to common shares by the weighted average number of common shares outstanding during the respective periods adjusted for the portion of stock options which were considered common equivalents, 305,240 in 1993, 212,463 in 1992 and 138,433 in 1991. Fully diluted earnings per share calculations were based on the assumption that all outstanding preferred stock was converted into common stock and the preferred dividends on these shares eliminated. In addition, the average fully diluted earnings per share included the portion of stock options which were considered common equivalents, 305,240 in 1993, 303,947 in 1992 and 190,777 in 1991. On December 31, 1993 and 1992, there were 59,520,710 and 57,014,117 common shares outstanding, respectively. At the same dates there were 100,000,000 authorized shares of $10 par value common stock. On October 20, 1993, First of America's Board of Directors called for the redemption on December 31, 1993 of all outstanding shares of the company's Series F 9% Convertible Preferred Stock. Notice of the redemption resulted in the issuance of 2,355,342 shares of First of America Common Stock upon shareholders' exercise of the conversion privilege before the redemption date. NOTE 21: FAIR VALUE DISCLOSURE The Financial Accounting Standards Board's Statement No. 107, "Disclosure about Fair Value of Financial Instruments," requires disclosure of fair value information for financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices were not available, fair values were based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of First of America. For purposes of this disclosure, estimated fair value of financial instruments with short-term maturities is assumed to equal the recorded book value. These financial instruments include cash and short term investments, accrued interest receivable and payable and short term borrowings. Estimated fair values for other financial instruments were determined as follows: Loans Held for Sale: Fair value for loans held for sale was based on quoted market prices. If a quoted market price was not available, the fair value was estimated using market prices for similar assets. Securities: Fair values for Held to Maturity and Available for Sale securities were based on quoted market prices. If a quoted market price was not available, fair value was estimated using quoted market prices for similar securities. Loans Receivable: For variable rate loans that reprice frequently and for which there has been no significant change in credit risk, fair values equal carrying values. The fair values for fixed rate loans were based on estimates using discounted cash flow analyses and current interest rates being offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of accrued interest approximates its fair value. Deposit Liabilities: The fair values disclosed for demand deposits with no stated maturity (e.g., interest and non-interest checking, passbook savings and certain types of money market accounts) were, by definition, equal to the amount payable on demand at the reporting date. The carrying amounts for variable rate, fixed-term money market accounts and certificates of deposits with less than twelve months maturities approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit with maturities greater than twelve months are estimated using a discounted cash flow calculation that applied interest rates being offered on the same or similar certificates at the reporting date to a schedule of aggregated expected maturities on the certificates of deposits. Long Term Borrowings: Fair values for First of America's long term debt (other than deposits) was estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the company for debt of the same remaining maturities. Off Balance Sheet Instruments: Fair values for unused commitments were estimated using the fees charged to enter into similar agreements at the reporting date, taking into account the remaining terms of the agreements and the present credit worthiness of the counterparties. Fair values for guarantees and letters of credit were based on fees charged for similar agreements. The fair value of forward delivery commitments, foreign exchange contracts and interest rate swaps is estimated, using dealer quotes, as the amount that the corporation would receive or pay to execute a new agreement with terms identical to those remaining on the current agreement, considering current interest rates. First of America has mandatory commitments to deliver loans totalling $373.3 million which are at prevailing market rates. First of America attributes no value to these commitments at December 31, 1993. The estimated fair values of First of America's financial instruments for which the fair value differs from the recorded book value for December 31, 1993 and 1992 were as follows: * SFAS No. 107 defines the fair value of demand deposits as the amount payable on demand, and prohibits adjusting fair value for any value derived from retaining those deposits for an expected future period of time. NOTE 22: CONDENSED FINANCIAL INFORMATION -- PARENT COMPANY ONLY The balance sheets for December 31, 1993 and 1992, and the statements of income and statements of cash flows for the three years ended December 31, 1993 follow. Supplemental Information (Unaudited) * Prior years numbers not restated. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is made to the information under the headings "Election of Directors" on pages 2 through 4 and "Other Matters" on page 20 of the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held in 1994. Such information is incorporated herein by reference. The information concerning executive officers of the Registrant appears on page 5 of this document. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is made to the information under the headings "Meetings and Committees of the Board of Directors" and those portions of the information under the heading "Executive Compensation," other than the "Compensation Committee Report on Executive Compensation" and the "Performance Graph," on pages 6 through 16 of the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held in 1994. Such information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is made to the information in the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held in 1994 under the headings "Principal Shareholders" on page 2 and "Election of Directors" on pages 2 through 4 regarding ownership of the Registrant's securities. Such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to the information under the heading "Interest of Management in Certain Transactions" on page 16 of the Registrant's definitive Proxy Statement for the Annual Meeting of Shareholders to be held in 1994. 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. Financial Statements Report of Independent Auditors Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- three years ended December 31, Consolidated Statements of Changes in Shareholders' Equity -- three years ended December 31, 1993 Consolidated Statements of Cash Flows -- three years ended December 31, Notes to Consolidated Financial Statements The above listed auditor's report, consolidated financial statements and notes to consolidated financial statements are included under "Item 8. Financial Statements and Supplementary Data" of this document. 2. Financial statement schedules required by Article 9 of Regulation S-X are inapplicable. 3. Exhibits required by Item 601 of Regulation S-K. (3) Articles of Incorporation and Bylaws A. A copy of the Restated Articles of Incorporation of the Registrant was filed as an Exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, and is incorporated herein by reference. B. A copy of the Bylaws of the Registrant as currently in effect was filed as an Exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, and is incorporated herein by reference. (4) Instruments defining the rights of security holders, including indentures A. Instruments defining the rights of security holders are included in the Registrant's Articles of Incorporation and Bylaws. See (3) A and B above. B. A copy of the Rights Agreement between the Registrant and First of America Bank - Michigan, N.A., as Rights Agent, dated as of July 18, 1990, was filed as an Exhibit to the Registrant's Current Report on Form 8-K, dated July 18, 1990, and is incorporated herein by reference. C. A copy of the Subordinated Indenture between the Registrant, as Issuer, and Continental Bank, National Association, as Trustee, dated as of November 1, 1991, was filed as an Exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, and is incorporated herein by reference. D. The Registrant is a party to various other instruments defining the rights of holders of long term debt, none of which authorizes securities in excess of 10 percent of the total assets of the Registrant and its subsidiaries on a consolidated basis. None of such instruments (except such as may be filed under (10) Material Contracts) are filed with this Report. The Registrant hereby agrees to furnish a copy of any such instrument to the Commission upon request. (9) Voting trust agreement. Not applicable. (10) Material contracts A. A copy of the $100,000,000 Credit Agreement dated as of April 21, 1989, between the Registrant and the Security Pacific National Bank as agent for five banks was filed as an Exhibit to the Registrant's Quarterly Report on Form 10-Q dated June 30, 1989, and is incorporated herein by reference. B. A copy of the Promissory Note dated as of December 6, 1993, between the Registrant and Continental Bank, N.A. for an amount of $35,000,000 is filed herewith as an Exhibit. C.* A copy of the First of America Bank Corporation Annual Incentive Compensation Plan for Key Corporate and Affiliate Executives was filed as Exhibit (10)A to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988 and is incorporated herein by reference, and a copy of the Amendment to this document was filed as Exhibit (10) to the Registrant's Quarterly Report on Form 10-Q dated September 30, 1990, and is incorporated herein by reference. D.* A copy of the Registrant's Unfunded Deferred Excess Benefit Plan as adopted during 1990 was filed as Exhibit (10) to the Registrant's Quarterly Report on Form 10-Q dated September 30, 1990, and is incorporated herein by reference. E.* A copy of the Registrant's Supplemental Retirement Plan to Compensate for Nonqualified Savings Deferrals is filed herewith as an Exhibit. F.* A copy of the Registrant's Supplemental Savings Plan and the Amendment to this document was filed as Exhibit (10) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and is incorporated herein by reference. G.* A copy of The Restated First of America Bank Corporation 1987 Stock Option Plan, as amended and adopted by the Board of Directors and recommended for approval by the company's shareholders on April 20, 1994, is filed herewith as an Exhibit. - --------------- * Denotes management contracts and compensatory arrangements required to be filed as Exhibits and in which the Registrant's executive officers participate. H.* A copy of First of America's Long-Term Incentive Plan as amended and restated for performance periods commencing July 1, 1988, and thereafter, was filed as Exhibit (10)F to the Registrant's Registration Statement on Form S-4 filed July 28, 1988 (Reg. No. 33-23365) and is incorporated herein by reference, and a copy of the Amendment to this document was filed as Exhibit (10) to the Registrant's Quarterly Report on Form 10-Q dated September 30, 1990, and is incorporated herein by reference. I.* A copy of the composite form of the Management Continuity Agreement entered into by the Registrant and its executive and certain other senior officers of the Registrant was filed as Exhibit (10) to the Registrant's Quarterly Report on Form 10-Q dated September 30, 1990, and is incorporated herein by reference. J.* A copy of First of America's Executive Management Trust Agreement, intended to fund benefits under the Management Continuity Agreements (see Exhibit (10)I above) was filed as Exhibit 10(H) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, and is incorporated herein by reference. (11) Statement re computation of per share earnings The computation of common and common equivalents and fully diluted earnings per share is described in Note 20 of the Registrant's Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data" of this document. (12) Statement re computation of ratios Not applicable. (13) Annual Report to Security Holders, Form 10-Q or Quarterly Report to Security Holders. Not applicable. (16) Letter re change in certifying accountant Not applicable. (18) Letter re change in accounting principles Not applicable. (21) Subsidiaries of the Registrant - --------------- * Denotes management contracts and compensatory arrangements required to be filed as Exhibits and in which the Registrant's executive officers participate. The subsidiaries of the Registrant as of the date of this document are as follows: (22) Published report regarding matters submitted to a vote of security holders. Not applicable. (23) Consents of experts Consent of KPMG Peat Marwick (24) Power of Attorney Power of Attorney signed by various directors of the Registrant authorizing Daniel R. Smith or Richard F. Chormann or Thomas W. Lambert to sign this Report on their behalf. (27) Financial Data Schedule Not applicable. (28) Information from reports furnished to state insurance regulatory authorities. Not applicable. (99) Additional exhibits. Not applicable. (b) Reports on Form 8-K No Reports on Form 8-K were filed by the Registrant during the three months ended December 31, 1993. (c) Exhibits An Exhibit Index and Exhibits are attached to this Report. (d) Financial Statement Schedules Financial Statement Schedules are inapplicable. See Item 14 (a) 2 above. 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. FIRST OF AMERICA BANK CORPORATION By: /s/ DANIEL R. SMITH Daniel R. Smith, Chairman 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. *By: /s/ THOMAS W. LAMBERT - ----------------------------------- Attorney in Fact APPENDIX DESCRIPTION OF GRAPHIC MATERIAL Page Number Graphic Material - ----------- ---------------- 7 Bar graph depicting growth of company's fully diluted earnings per share from 1989 to 1993. 1989 1990 1991 1992 1993 ----- ----- ----- ----- ----- Earnings per share $2.52 $2.62 $2.69 $2.46 $4.14 The 1992 bar also indicates earnings per share of $3.68 based on ongoing operations. 7 Bar graph comparing company's return on equity with that of its peer group from 1989 to 1993. 1989 1990 1991 1992 1993 ------ ----- ----- ----- ----- First of America 14.07% 13.70 13.07 11.38 17.50 Peer Group 15.29 13.79 14.40 14.76 15.98 The graph also shows First of America's 1992 return on average total equity of 16.42 percent based on ongoing operations. 15 Bar graph comparing the efficiency ratio of the company with that of its peer group from 1989 to 1993. 1989 1990 1991 1992 1993 ------ ----- ----- ----- ----- First of America 66.51% 67.44 67.25 68.58 62.72 Peer Group 64.53 64.92 64.04 66.03 65.71 The graph also indicates First of America's 1992 efficiency ratio of 63.80 percent based on ongoing operations. 17 Bar graph comparing the company's nonperforming assets as a percent of loans plus OREO with that of its peer group from 1989 to 1993. 1989 1990 1991 1992 1993 ----- ---- ---- ---- ---- First of America 0.87% 0.95 1.27 1.42 1.26 Peer Group 1.68 2.43 2.44 1.95 1.22 24 Bar graph depicting growth of company's return on average assets from 1989 to 1993. 1989 1990 1991 1992 1993 ----- ---- ---- ---- ---- Return on average assets 1.02% 0.98 0.95 0.75 1.20 The graph also indicates First of America's 1992 return on average assets of 1.12 percent based on ongoing operations. - --------------------- * Denotes management contracts and compensatory arrangements required to be filed as Exhibits and in which the Registrant's executive officers participate.

33015_1993.txt

33015_1993

1993

33015

ITEM 1. Business ENSERCH Corporation ("ENSERCH" or the "Corporation") is an integrated company focused on natural gas. It is the successor to a company originally organized in 1909 for the purpose of providing natural-gas service to North Texas. The Corporation's operations include the following: - Natural Gas Transmission and Distribution - Owning and operating interconnected natural-gas transmission pipelines, gathering lines, underground gas storage reservoirs, compressor stations, distribution systems and related properties; transporting, distributing and selling natural gas to residential, commercial, industrial, electric-generation, pipeline and other customers; and compressing natural gas for motor vehicle usage. (Lone Star Gas Company, a division of the Corporation, Enserch Gas Company, and related operations.) - Natural Gas and Oil Exploration and Production - Exploring for, developing, producing and marketing natural gas and oil. (Enserch Exploration, Inc., Enserch Exploration Partners, Ltd. [more than 99% owned], Enserch International Exploration, Inc., and related operations.) - Natural Gas Liquids Processing - Gathering natural gas, processing natural gas to produce liquids and marketing the products. (Enserch Processing Partners, Ltd.) - Power and Other - Developing, operating and maintaining independent electric-generation power plants and cogeneration facilities; and furnishing energy services under long-term contracts to large building complexes, such as universities and medical centers (Enserch Development Corporation and Lone Star Energy Company). Providing environmental engineering and contracting services from initial site assessment and feasibility studies to designs, actions and remediation (Enserch Environmental Corporation). On December 22, 1993, the Corporation completed the sale of the principal operating assets of its former engineering and construction subsidiary, Ebasco Services Incorporated, to a subsidiary of Raytheon Company. Also in December 1993, in a separate transaction, the Corporation completed the sale of its 49% interest in Dorsch Consult. See "Financial Review" and Note 11 of the Notes to Consolidated Financial Statements included in Appendix A to this report. Business Segments Financial information required hereunder is set forth under "Summary of Business Segments" included in Appendix A to this report. Natural Gas Transmission and Distribution The Corporation's transmission and distribution business ("T&D") is composed of the regulated business of Lone Star Gas Company ("Lone Star"), and the nonregulated gas marketing operations of Enserch Gas Company ("EGC"). Lone Star owns and operates interconnected natural-gas transmission lines, gathering lines, underground gas storage reservoirs, compressor stations, distribution systems and related properties. Through and by such facilities, it purchases, distributes and sells natural gas to about 1.25 million residential, commercial, industrial and electric-generation customers in approximately 550 cities and towns, including the 11-county Dallas/Fort Worth Metroplex. Lone Star also transports natural gas for unaffiliated pipeline and industrial customers as market opportunities are available. About seven million people in Texas, representing more than 40% of the total state population, reside in Lone Star's service area. EGC purchases and sells natural gas to industrial and electric-generation customers, local distribution companies and other pipeline and gas marketing companies. The Corporation holds a 50% interest in a partnership named Gulf Coast Natural Gas Company that operates a transmission system in the Texas Gulf Coast area, which transports and sells natural gas to industrial and unaffiliated pipeline customers. For the year ended December 31, 1993, residential and commercial customers accounted for 56% of T&D's total gas sales revenues and 34% of natural gas volumes sold; industrial customers accounted for 12% and 17%, respectively, and electric-generation customers accounted for 12% and 17%, respectively. Sales to other customers accounted for 20% of T&D's natural gas revenues and 32% of volumes sold. In 1993, 10% of T&D's gas sales volumes was sold to Texas Utilities Fuel Company, compared with 12% in 1992. See "Financial Review - Natural Gas Transmission and Distribution" included in Appendix A to this report for a discussion of Lone Star's gas sales margin. Operating data for the T&D segment are set forth under "Financial Review - Natural Gas Transmission and Distribution Operating Data" included in Appendix A to this report. Revenues from Lone Star's gas sales are affected by seasonal variations. The majority of Lone Star's residential and commercial gas customers uses gas for heating. Revenues from these customers are affected by the mildness or severity of the heating season. Gas sales to electric-generation customers are affected by the mildness or severity of the cooling and heating seasons. Reengineering activities taking place within Lone Star's distribution operations have resulted in a number of process and system changes being made to improve customer service and provide operating efficiencies. As a part of these changes, the workforce will be reduced and many local offices will be closed. A related $12 million pretax charge was taken in 1993 primarily to reflect severance expenses. Competition. Natural gas continues to face varying degrees of competition from electricity, coal, natural gas liquids, oil and other refined products throughout Lone Star's service territory. Pipeline systems of other companies, both intrastate and interstate, extend into or through the areas in which Lone Star's markets are located, setting up competitive situations with other sellers of natural gas for existing and potential customers. Customer sensitivity to energy prices and the availability of competitively priced gas in the nonregulated markets continue to provide intense competition in the electric- generation and industrial user markets. Competitive pressure from other pipelines and alternative fuels has caused a continuing decline in sales by Lone Star to industrial and electric-generation customers each year since 1981, most of which has been replaced by sales of the Corporation's nonregulated companies. Lone Star initiated a program in 1992 that provides its industrial cus- tomers an opportunity to have transportation service for up to 50% of their natural-gas requirements transported by Lone Star. The gas to be trans- ported may be purchased by the industrial customers from third-party suppliers. This has resulted in lower overall gas costs to the industrial customers able to take advantage of this program, helping Lone Star maintain long-term gas load, with no detrimental effect on other customers. In Lone Star's service area, the intensity of competition among natural gas, fuel oil, and coal is dependent upon relative prices of the products. During most of 1993, natural gas was generally successful competing with fuel oil but was generally unable to compete effectively with coal in existing coal-fired units. In response to highly competitive industrial and electric-generation markets, T&D continues to expand its businesses of arranging transportation and the purchase and sale of gas in the nonregulated markets. This is accomplished through the gas marketing activities of EGC. EGC sales in 1993 were 244 billion cubic feet ("Bcf"), which was 57 Bcf (including 42 Bcf purchased for resale from affiliates) greater than in 1992. EGC continues to actively pursue sales to customers not located on Lone Star's pipeline system. These "off-system" sales efforts have been enhanced by the ability to transport interstate gas under the Federal Energy Regulatory Commission ("FERC") open-access transportation plan. EGC continues to purchase and resell gas subject to the Natural Gas Policy Act of 1978 ("NGPA") without utility regulatory constraints, providing EGC more opportunities to obtain supplies and market gas throughout the United States. With more normal weather conditions in 1993, overall volumes of natural gas sold or transported to industrial, electric-generation and pipeline markets by T&D increased slightly compared with 1992 despite intense competition for gas load and the commencement of commercial operation of a second nuclear power plant in Lone Star's service area. In addition, the former Gulf Coast operations of Enserch Gas Transmission Company ("EGT"), in which Lone Star now has only a 50% interest, are not included in statistics after 1991. Transportation volumes for the entire segment were 371 Bcf in 1993, up 64 Bcf compared with 1992. In the current energy market, Lone Star's contracts for new gas reserves have been at prices below its current systemwide weighted average cost of gas and are expected to continue to be so in the foreseeable future. Source and Availability of Raw Materials. Lone Star's gas supply is based on contracts for the purchase of dedicated specific reserves and contracts with other pipeline companies in the form of service agreements that are not related to specific reserves or fields. Management has calculated that the total contracted gas supply as of January 1, 1994, was 972 Bcf, or approximately six times Lone Star's purchases during 1993. Of this total, 342 Bcf are dedicated reserves, 52 BCF are gas in storage, and 578 Bcf, (including 372 Bcf under one agreement) are committed to Lone Star under service agreements. The January 1, 1994, total gas supply estimate is 198 Bcf lower than the January 1, 1993, estimate. The difference resulted from purchases of 175 Bcf from existing gas supply, new supply additions of 5 Bcf and a net downward revision of 28 Bcf with respect to estimates for existing sources and service agreements. New reserve additions consisted of 5 Bcf of new dedicated reserves under old contracts. The Corporation also has estimated the oil and natural gas liquids reserves of Lone Star, as of January 1, 1994, to be 64,664 barrels. In 1993, about 97% of Lone Star's gas requirement was purchased from some 370 independent producers and nonaffiliated pipeline companies, one of which supplied approximately 12.8% of total requirements. The remainder of Lone Star's requirement (3.2%) was supplied by affiliates. Lone Star estimates its peak-day availability from presently contracted sources to be 1.8 Bcf. Short-term peaking contracts and withdrawals from underground storage raise this level to meet anticipated sales needs. During 1993, the average daily demand of Lone Star's residential and commercial customers was .4 Bcf. The estimated peak-day demand of such customers (based upon an arithmetic-mean outside temperature of 15 degrees F.) was 1.9 Bcf. Lone Star's greatest daily demand in 1993 was on January 10, when estimated actual deliveries to all customers reached 1.7 Bcf and there was an arithmetic-mean temperature of 33 degrees F. The estimated deliveries to residential and commercial customers on that day were 1.2 Bcf and another .9 Bcf were transported by Lone Star. To meet peak-day gas demands during winter months, Lone Star utilizes its eight active underground storage fields, all of which are located in Texas. These fields have an extraneous gas capacity of 74 Bcf. At December 31, 1993, total extraneous gas in storage was approximately 52 Bcf. Gas withdrawn from storage on January 10, 1993, the date of Lone Star's greatest daily demand in 1993, was .4 Bcf, or approximately 24% of the total 1.7 Bcf of Lone Star's sales. Lone Star historically has maintained a curtailment program designed to achieve the highest load factor possible in the use of its pipeline system while assuring continuous and uninterrupted service to its residential and commercial customers. Under the program, industrial customers select their own rates and relative priorities of service. Interruptible service contracts give Lone Star the right to curtail gas deliveries up to 100% according to a strict priority plan. Estimates of gas supplies and reserves are not necessarily indicative of Lone Star's ability to meet current or anticipated market demands or immediate delivery requirements, because of factors such as the physical limitations of gathering and transmission systems, the duration and severity of cold weather, the availability of gas reserves from its suppliers, the ability to purchase additional supplies on a short-term basis, and actions by federal and state regulatory authorities. Lone Star's curtailment rights provide flexibility to meet the human-needs requirements of its customers on a firm basis. Priority allocations and price limitations imposed by federal and state regulatory agencies, as well as other factors beyond the control of Lone Star, may affect its ability to meet the demands of its customers. Lone Star follows a program to place new supplies of gas under contract to its pipeline system. In addition to being heavily concentrated in the established gas-producing areas of central, north and east Texas, Lone Star's intrastate pipeline system also extends into or near the major gas-producing areas of the Texas Gulf Coast, and the Delaware and Val Verde Basins of West Texas. Nine basins located in Texas are estimated to contain a substantial portion of the nation's remaining onshore natural-gas reserves. Lone Star's pipeline system provides access to all of these basins. Lone Star's attractive service territory has been a primary factor in the continued addition of new customers. The number of Lone Star customers in Texas has steadily grown from 1986 to 1993. See "Financial Review - Natural Gas Transmission and Distribution Operating Data" included in Appendix A to this report. Lone Star buys gas under long-term, intrastate contracts in order to assure reliable supply to its customers. To obtain this reliability, Lone Star, in the past, entered into many gas-purchase contracts that provided for minimum- purchase ("take-or-pay") obligations to gas sellers. In the past, Lone Star was unable to take delivery of all minimum gas volumes tendered by suppliers under these contracts. Assuming normal weather conditions, it is expected that normal gas purchases will substantially satisfy purchase obligations for the year 1994 and thereafter. For a discussion of these take-or-pay obligations and the Corporation's accounting policy with respect to gas-purchase contracts, see "Financial Review - Gas-Purchase Contracts" and Note 1 to the Consolidated Financial Statements included in Appendix A to this report. Generally, EGC's gas supply is contracted for on a month-to-month basis at prevailing market prices. The availability of gas is dependent on many factors, including the overall demand for natural gas and market price. Regulation. Lone Star is wholly intrastate in character. Its utility operations in the state of Texas are subject to regulation by the Railroad Commission of Texas ("RRC") and municipalities. Lone Star owns no certificated interstate transmission facilities subject to the jurisdiction of FERC under the Natural Gas Act, has no sales for resale under the rate jurisdiction of FERC, and does not perform any transportation service that is subject to FERC juris- diction under the Natural Gas Act. In 1985, FERC issued Order 436, and later Order 500, which allow self- implementing, voluntary transportation of natural gas, as opposed to mandatory transportation for pipelines willing to assume FERC-imposed "open-access" conditions and certain other price/rate controls. The Order imposed "open- access" conditions that affect intrastate pipelines, such as Lone Star's intrastate facilities, if the intrastate pipeline "voluntarily" elects to transport gas for an interstate pipeline or local distribution company under Section 311 of the NGPA. Lone Star became an open-access transporter effective July 15, 1988, on its intrastate transmission facilities only. Transportation by each company is performed pursuant to Section 311(a)(2) of the NGPA and is subject to an exemption from the jurisdiction of the FERC under the Natural Gas Act, pursuant to Section 601 of the NGPA. The RRC regulates the intracompany charge for gas delivered to Texas distribution systems for sale to residential and commercial consumers. The RRC has original jurisdiction over rates charged to residential and commercial customers for gas delivered outside incorporated cities and towns (environs rates). Rates within incorporated cities and towns in Texas are subject to the original jurisdiction of the municipal government, with appellate review by the RRC. Proposed rate changes within the jurisdiction of the incorporated cities and towns in Texas may be suspended for a period not to exceed 90 days beyond the proposed effective date. The RRC may extend the time during which it deliberates and decides a matter within its appellate jurisdiction to a maximum of 185 days, but it may suspend rates within its original jurisdiction for 150 days beyond the proposed effective date. Lone Star continuely reviews rates for all classes of customers in its regulatory jurisdictions. Rate relief amounting to $1.9 million in annualized revenue increases over and above changes in gas cost was achieved in Texas in 1993 through rate case filings, the operation of cost of service adjustment clauses, and the operation of plant investment cost adjustments. About 110 of the 550 cities and towns served by Lone Star had approved weather normalization adjustment clauses as part of their rate structure by yearend 1993, representing about 20% of Lone Star's residential and commercial sales volumes. These clauses allow rates to be adjusted monthly to reflect the impact of warmer- or colder-than-normal weather during the winter, minimizing the impact of variations in weather on Lone Star's earnings. Sales and transportation services to industrial and electric-generation customers are provided under contract through contractual relations. Regulatory authorities in Texas have jurisdiction to revise, review and regulate rates to industrial and electric-generation customers but, historically, have not exercised this jurisdiction. Contracts with these customers permit automatic adjustment on a monthly basis for the full amount of increases or decreases in the cost of gas. Natural Gas and Oil Exploration and Production The Corporation's natural gas and oil exploration and production operations are collectively referred to herein as "Enserch Exploration." These operations and this business are conducted primarily through Enserch Exploration Partners Ltd. ("EP"), a limited partnership in which a minority interest (less than 1%) is held by the public and a group of subsidiary companies. Activities include geological and geophysical studies; acquisition of gas and oil leases; drilling of exploratory wells; development and operation of producing properties; acquisition of interests in developed or partially developed properties; and the marketing of natural gas, crude oil and condensate. In 1985, the Corporation formed EP to succeed to substantially all of the domestic gas and oil exploration and production business of the Corporation. The Corporation and an affiliate own more than 99% of the outstanding limited partnership units. The remaining units--slightly more than 800,000--are publicly held and traded on the New York Stock Exchange. EP operates through EP Operating Limited Partnership ("EPO"), a Texas limited partnership, in which EP holds a 99% limited partner's interest and the general partners own a 1% interest. Enserch Exploration, Inc. is the managing general partner and the Corporation is the special general partner of EP and EPO. Enserch Exploration is engaged in the exploration for and the development, production and marketing of natural gas and crude oil throughout Texas, offshore in the Gulf of Mexico, onshore in the Gulf Coast and Rocky Mountain areas and in various other areas in the United States. Subsidiaries currently have interests in three foreign countries. Production offices are maintained in Dallas, Houston, Athens, Bridgeport, Longview and Midland, Texas. At December 31, 1993, Enserch Exploration employed 382 persons, including 36 geologists, 21 geophysicists and 19 land representatives who investigate prospective areas, generate drilling prospects, review submitted prospects and acquire leasehold acreage in prospective areas. In addition, Enserch Exploration maintains a staff of 56 engineers and 46 technologists who plan and supervise the drilling and completion of wells, evaluate prospective gas and oil reservoirs, plan the development and management of fields, and manage the daily production of gas and oil. Enserch Exploration's natural-gas sales volumes for the year ended December 31, 1993, represented 16% of the Corporation's consolidated natural-gas sales volumes. Approximately 70% of Enserch Exploration's natural-gas sales volumes (75% of gas revenues) for the year ended December 31, 1993, was sold to affiliated customers. In 1993, affiliated revenues include gas sales under new contracts effective March 1, 1993 with Enserch Gas Company covering essentially all gas production not committed under existing contracts. Affiliated pur- chasers do not have a preferential right to purchase natural gas produced by Enserch Exploration other than under existing contracts. The statistics for this business segment, which are set forth in the table entitled "Financial Review - Natural Gas and Oil Exploration and Production Operating Data" in Appendix A to this report, reflect the fluctuations in product prices and volumes and certain unusual items which affected operating income. Following is a summary of Enserch Exploration's domestic exploration and development activity during 1993: Gulf of Mexico. Offshore exploration provides the Corporation the opportunity to improve its ratio of production to reserve base by the addition of gas wells with relatively higher production rates. This is coupled with ongoing deep-water development projects, which are expected to provide long-term reserves. State-of-the-art technology, including 3-D seismic, specialized seismic processing, and innovative well completion and production techniques, are being used to help accomplish these objectives. Mississippi Canyon Block 441, the first development project in the Gulf of Mexico that Enserch Exploration has operated, is indicative of this approach. A 3-D seismic program, prior to field development, confirmed that the majority of the reservoir lies beneath a shipping fairway. A production program was developed that involved drilling highly deviated wells under the shipping fairway, subsea completing the deep-water wells, and tying the wells back to a conventional shallow-water production platform using bundled flowlines. The high-angle wells required special gravel-pack completion techniques. After a year of production, the field has been essentially maintenance free, producing some 70 million cubic feet ("MMcf") of natural gas and more than 500 barrels ("Bbls") of condensate per day from six wells. The 3-D seismic on Mississippi Canyon Block 441 is being reprocessed, using depth migration and other state-of-the-art techniques to aid in the identification of deeper exploratory targets, which, if successfully drilled, could add to the field reserves. Enserch Exploration has a 37.5% working interest in this project. The Garden Banks Block 388 oil development project remains on schedule, with initial production anticipated by mid-1995. Installation of the offshore facilities, which consist of a subsea template, gathering and sales pipelines, and shallow-water production facilities, will begin by mid-1994. After the rig and all facilities are in place, the three existing wells will be connected, with initial production from the first well expected to be approximately 5 thousand barrels ("MBbls") of oil and 5 MMcf of gas per day. Peak daily pro- duction from the project is anticipated to be 40 MBbls of oil and 60 MMcf of gas. Enserch Exploration is 100% owner and operator of the Garden Banks 388 project. Another prospect delineated by seismic amplitude anomalies lies approximately four miles to the west of Garden Banks Block 388 on Garden Banks Blocks 386/387. If successfully drilled, this prospect could add production to the Block 388 development by incorporating some of the production technology that was utilized on Mississippi Canyon Block 441. In 1994, an offset well to Enserch Exploration's discovery on Green Canyon Block 254 is scheduled to be drilled. The exploratory well, which was drilled in 1991, encountered 11 sands with a combined thickness of more than 360 feet of oil pay. Enserch Exploration has a 25% working interest in this block and a similar working interest in three adjacent blocks believed to be part of the same project. Onshore. Enserch Exploration participated in 78 development wells (62 net) in 1993, with the majority completed as gas producers in East Texas. Thirty- nine wells were in progress at yearend. In East Texas, Enserch Exploration is positioned in a prolific gas-prone area which, despite its maturity, provides growth opportunities. Enserch Exploration is one of the oldest and most active operators in this basin in East Texas, which includes the Opelika, Tri-Cities, Whelan, Willow Springs, North Lansing and Freestone fields. In early 1993, Enserch Exploration initiated a 26-well program in East Texas to accelerate the development of natural-gas reserves from the Travis Peak formation in the Opelika field. The program was targeted to test new techniques for shortening the average life of its reserve base. The project was completed in seven months, yielding initial daily per well production rates of up to 1.8 MMcf of gas and 48 Bbls of oil. Enserch Exploration has a 100% working interest in these wells. Enserch Exploration performed additional development drilling in the Freestone field, where seven well completions flowed at daily rates ranging from 1.0 MMcf to 2.3 MMcf of gas per well. Enserch Exploration has 50% to 100% working interests in these wells. In the Bralley field in West Texas, the combined daily oil production rate from six wells increased to 800 Bbls from 500 Bbls following production optimization work. Enserch Exploration owns a 50% working interest in each of these wells. In South Texas, seven wells drilled and completed in the Fashing field flowed at daily rates of 1.2 MMcf to 2.6 MMcf of gas and 14 Bbls to 30 Bbls of oil per well. Twelve wells drilled and completed in the Boonsville field in north central Texas resulted in daily production of .4 MMcf to 1.5 MMcf of gas per well. Onshore development activity planned for 1994 includes drilling approximately 35 wells outside East Texas. Some of the larger projects include wells in the Fashing, Rancho Viejo and Boonsville fields. In the Fashing field, results of three wells and a field study indicate development potential for new wells, as well as recompletions that could result in reserve additions. Competition. Competition in the natural gas and oil exploration and production business is intense. Domestically, competition is present from a large number of firms of varying sizes and financial resources, some of which are much larger than Enserch Exploration. Internationally, competition is from a number of both U.S. and non-U.S. firms, generally major national and international oil companies. Competition involves all aspects of marketing products (including terms, prices, volumes and length of contracts), terms relating to lease bonus and royalty arrangements, and the schedule of future development activity. Regulation. Environmental Protection Agency ("EPA") rules, regulations and orders affect the operations of Enserch Exploration. EPA regulations promul- gated under the Superfund Amendments and Reauthorization Act of 1986 require Enserch Exploration to report on locations and estimates of quantities of hazardous chemicals used in Enserch Exploration's operations. The EPA has determined that most gas and oil exploration and production wastes are exempt from the hazardous waste management requirements of the Resource Conservation Recovery Act. However, the EPA determined that certain exploration and production wastes resulting from the maintenance of production equipment and transportation are not exempt, and these wastes must be managed and disposed of as hazardous waste. Also, regulations issued by the EPA under the Clean Water Act require a permit for "contaminated" stormwater discharges from exploration and production facilities. Many states have issued new regulations under authority of the Clean Air Act Amendments of 1990, and such regulations are in the process of being imple- mented. These regulations may require certain gas and oil related installations to obtain federally enforceable operating permits and may require the monitoring of emissions; however, the impact of these regulations on Enserch Exploration is expected to be minor. Several states have adopted regulations on handling, transportation, storage and disposal of naturally occurring radioactive materials that are found in gas and oil operations. Although applicable to certain Enserch Exploration facilities, it is not believed that such regulations will materially impact current or future operations. In the aggregate, compliance with federal and state environmental rules and regulations is not expected to have a material effect on Enserch Exploration's operations. The RRC regulates the production of natural gas and oil by Enserch Exploration in Texas. Similar regulations are in effect in all states in which Enserch Exploration explores for and produces natural gas and oil. These regulations generally require permits for the drilling of gas and oil wells and regulate the spacing of the wells, the prevention of waste, the rate of production, and the prevention and cleanup of pollution and other materials. Natural Gas Liquids Processing The Corporation's operations for the processing of natural gas for the recovery of natural gas liquids ("NGL") is conducted by Enserch Processing Partners, Ltd. ("Processing Partners"). Processing Partners is a limited partnership that is wholly owned by the Corporation. Processing Partners, which is among the top 25 NGL producers in the U.S., uses cryogenic and mechanical refrigeration processes at its NGL extraction facilities. During these processes, NGL are condensed at extremely low temperatures and are separated from natural gas. The mixed NGL stream containing the heavier hydrocarbons ethane, propane, butane and natural gaso- line, is pumped via pipeline to Mt. Belvieu, Texas. The remaining natural gas, primarily methane, leaves the NGL plants in gas transmission lines for transport to end-use customers. (See "Properties".) About 70% of NGL product sales are under term contracts of one-to-three years, with prices established monthly. NGL prices are influenced by a number of factors, including supply, demand, inventory levels, the product composition of each barrel, and the price of crude oil. Profitability is highly dependent on the relationship of NGL product prices to the cost of natural gas lost in the extraction process--"shrinkage." The natural gas liquids processing area is highly competitive, including competition regarding cost-sharing and interest-sharing arrangements among producers, third-party owners and processors. Power and Other Energy Project Development. Enserch Development Corporation ("EDC") was organized in 1986 to develop business opportunities primarily in the areas of independent power, including cogeneration. EDC evaluates the risk and rewards of these potential ventures; selects for development those ventures with the highest potential of success; implements and controls development of each venture; and brings together all the resources required to develop, finance, construct, operate and manage the selected ventures. EDC focuses on employing a strategy of maximizing the use of ENSERCH resources and minimizing the Corporation's risk and investment. EDC, as of December 1993, had several business opportunities in various phases of development throughout the United States and internationally. The first project completed by EDC, operating since 1989, was a gas-fired, 255-megawatt ("MW") cogeneration plant located near Sweetwater, Texas. The electricity produced by the plant is purchased by Texas Utilities Electric Company and thermal energy is sold to United Gypsum Company under a long-term agreement. EDC developed and arranged financing for the project and one of its subsidiaries is the managing general partner. Enserch Exploration and EGC provide gas to the plant; Lone Star transports the gas and Lone Star Energy Company ("LSEC") operates the plant. In 1992, the second plant developed by EDC was completed. The 62-MW natural gas-fired cogeneration facility in Buffalo, New York, supplies elec- tricity to Niagara Mohawk Company and thermal energy to Outokumpu American Brass, Inc. LSEC operates the plant. EDC's third project, a 160-MW plant located in Bellingham, Washington, began commercial operation July 1993. The electricity produced by the plant is sold under a long-term power sales agreement with Puget Sound Power & Light. Thermal energy in the form of steam and hot water is sold to Georgia-Pacific Corporation. In addition to operating the above mentioned cogeneration plants, LSEC owns and/or operates four central thermal energy plants providing heating and cooling to various institutional customers in Texas. The aggregate existing plant capacity is nearly 50,000 tons of chilled water and 750 MMBtu's of steam or hot water per hour. From the three plants owned by LSEC, institutional customers receive thermal energy under long-term agreements that contain established rates for units of steam or chilled water and certain escalation provisions for increases in ad valorem taxes, utility and labor costs. When the agreements expire, the plants become the property of the customers. Expiration dates are in 1996 and 1997. LSEC is actively pursuing new contracts to operate the plants after the existing agreements expire. The expiration of the existing thermal- energy plant agreements is not expected to have a significant impact on the Corporation. LSEC also provides predictive maintenance services to outside plant owners through its Plant Analytical Services affiliate, which was formed in 1991. As previously noted, LSEC operates the 255-MW Sweetwater cogeneration plant in West Texas. Labor for operating and maintaining this facility is provided under a fixed-cost contract with annual escalation provisions for increases in labor costs. All other costs are borne by the facility owners. LSEC also operates the 62-MW cogeneration plant in Buffalo, NY, and the 160-MW cogen- eration facility in Bellingham, Washington. At both the Buffalo and Bellingham plants, LSEC has fixed-cost operating and maintenance agreements with escalation provisions. The contracts also include bonus or penalty provisions based upon plant availability. LSEC operates in the compressed natural gas ("CNG") market through its CNG Division along with two natural gas vehicle affiliates, Fleet Star of Texas, L.C. ("Fleet Star") and TRANSTAR Technologies, L.C., ("TRANSTAR"), each 50% owned by LSEC. Fleet Star and FinaStar, a partnership between Fleet Star and Fina Oil and Chemical, had six public stations in commercial operation at December 31, 1993, and four additional stations were under construction. The CNG Division and affiliates sold more than 1 million gallons of CNG into the emerging transportation fuels market during 1993. TRANSTAR Technologies, L.C., provides turnkey natural gas vehicle conversion and other related services. TRANSTAR was involved in the conversion of more than 300 vehicles to natural gas during its first full year of operation in 1993 and enters 1994 with a backlog of 120 units under contract to be converted. The operations of the CNG Division and affiliates and the Plant Analytical Services have been aligned under the Corporation's natural gas transmission and distribution system for financial reporting purposes. Enserch Environmental Corporation. The Corporation retained and will continue to operate the former environmental division of Ebasco Services Incorporated ("Ebasco"). This business is now operated through Enserch Environmental Corporation ("Enserch Environmental"), a lower-tier subsidiary of the Corporation. Enserch Environmental employs about 1,200 people and is headquartered in New Jersey. Enserch Environmental had 1993 revenues of $169 million, operating income of $5.7 million and its backlog at the end of 1993 was $600 million. The Corporation's environmental business began in the 1960's as an out- growth of Ebasco's licensing of plant sites in connection with the company's power plant design and construction work. Enserch Environmental has extensive experience in all aspects of the environmental market, from initial site assess- ment and feasibility studies to remedial design, action and clean up. Over the last five years, Enserch Environmental has completed projects valued in excess of $1 billion in all areas of environmental and hazardous waste management ser- vices for more than 300 clients. Enserch Environmental has completed hundreds of environmental impact statements, licensing studies and baseline environmental investigations. With business, government and the public showing an increasing concern about the environment, management believes that the environmental market will grow and that Enserch Environmental will be a strong participant in it. Clean Air Act The impact of the 1990 amendments to the Clean Air Act ("CAA") on the Corporation, its division, subsidiaries and affiliates, cannot be fully ascertained until all the regulations that implement the provisions of the Act have been promulgated. It is expected that a number of facilities or emission sources will require a federally enforceable operating permit, and certain emission sources may also be required to reduce emissions or to install enhanced monitoring equipment under proposed rules and regulations. Management currently believes, however, that if the rules and regulations implementing the CAA are adopted as proposed, the cost of obtaining permits, operating costs that will be incurred under the operating permit, new permit fee structures, capital expenditures associated with equipment modifications to reduce emissions, or any expenditures on enhanced monitoring equipment, in the aggregate, will not have a material adverse effect on the Corporation's results of operations. The CAA has created new marketing opportunities for the sale of natural gas that may have a positive effect on the Corporation's results of operations. Natural gas has long been recognized as a clean and efficient fuel. Title II (Mobile Sources) requires lower emissions from light-duty vehicles and urban buses that should make alternative fuels such as natural gas more attractive and competitive. In addition, Clean Fuel Fleet programs under the CAA will require a certain percentage of fleet vehicles to utilize clean-burning alternative fuels such as natural gas in the near future. Further, because chlorofluoro- carbon compounds ("CFCs"), commonly used as refrigerants in large air- conditioning systems must be phased out of production by the year 2000, interest has increased in the use of natural gas-powered absorption cooling systems that do not use CFCs. In those areas that do not meet the CAA's National Ambient Air Quality Standards for ozone, natural gas may play an important role in reduc- ing ozone formation, and may be substituted for other fuels. Since Title IV (Acid Rain) requires major reductions in sulphur dioxide emissions, princi- pally from coal-fired electric power plants, natural gas is expected to be considered as a cost-effective alternative for achieving reduced sulphur dioxide emissions. The CAA also is expected to create new marketing opportunities for Enserch Environmental, which has considerable experience and expertise in the engineer- ing and construction implications of environmental matters. Enserch Environ- mental's comprehensive services extend into the areas regulated by the CAA, including: Title III (Air Toxins) where regulated air toxins will ultimately grow from 8 to more than 200 contaminants, and private industrial clients, par- ticularly in the petroleum, petrochemical, chemical and pharmaceutical sectors, will require air-quality assessment, monitoring, engineering and facility upgrades; Title IV (Acid Rain) where electric-utility clients will require conceptual engineering studies, air-quality studies and monitoring; Title II (Mobile Sources) where increased emphasis is expected on environmental con- sulting related to transportation systems--both the construction of new types of infrastructure projects and the development of more sophisticated transporta- tion systems; and Title V (Permits) where industrial facilities will be required to obtain operating permits involving emission inventories, performing com- pliance analysis and operational studies, and designing and installation of emission monitors and/or enhanced monitoring systems. The ultimate effect of these opportunities on the Corporation's business cannot be quantified at this time as it will depend on the extent to which natural gas is selected as an alternative fuel source and the services of Enserch Environmental Corporation are utilized in these newly regulated areas. Patent and Licenses The Corporation, Lone Star and subsidiary companies have no material patents, licenses, franchises (excluding gas-distribution franchises) or concession. Employees At December 31, 1993, the Corporation, its division and subsidiaries, employed approximately 5,600 persons. Executive Officers of Registrant There are no family relationships between any of the above officers. All officers of the Corporation, its division and subsidiaries are elected annually by their respective Boards of Directors. Officers may be removed by their respective Boards of Directors whenever, in their judgment, the best interest of the Corporation, its division or subsidiaries, as the case may be, will be served thereby. ITEM 2. ITEM 2. Properties At December 31, 1993, Lone Star and certain subsidiaries of the Corporation operated approximately 32,000 miles of transmission and gathering lines and distribution mains, and operated 37 compressor stations having a total rated horsepower of approximately 81,000. Lone Star owns eight active gas-storage fields, all located on Lone Star's system in Texas. Lone Star also owns three major gas-treatment plants to remove undesirable components from the gas stream. See "Business - Natural Gas Transmission and Distribution - Source and Availability of Raw Materials" for information concerning gas supply of Lone Star. As estimated by DeGolyer and MacNaughton, Enserch Exploration has net proved reserves, as of January 1, 1994, of 1.09 trillion cubic feet ("Tcf") of natural gas and 39.3 million barrels ("MMBbls") of oil and condensate, including NGL attributable to leasehold interests. (See Note 13 of the Notes to Consolidated Financial Statements included in Appendix A to this report for additional information on gas and oil reserves.) All of these reserves are in the United States. Enserch Exploration's 1994 capital spending budget has been set at $116 million, a 3% decrease from 1993 actual capital expenditures. More than half of the 1994 capital expenditures is earmarked for domestic onshore drilling. The exploration program includes a balance mix of projects with regard to reserve potential and risk, focusing on as many core area oppor- tunities as possible. See "Financial Review - Natural Gas and Oil Exploration and Production" included in Appendix A to this report. During 1993, Enserch Exploration filed Form EIA-23 with the Department of Energy reflecting reserve estimates for the year 1992. Such reserve estimates were not materially different from the 1992 reserve estimates reported in Note 13 of the Notes to Consolidated Financial Statements included in Appendix A to this report. Operating data relating to Enserch Exploration are set forth under "Financial Review - Natural Gas and Oil Exploration and Production Operating Data" included in Appendix A to this report. Enserch Exploration and subsidiary companies owned leasehold interests or licenses in 17 states, offshore Texas and Louisiana, and three other countries as of December 31, 1993, as follows: Enserch Exploration purchased about 220,000 net acres of leasehold interests in 1993, 26,000 of which were in the Gulf of Mexico. Enserch Explora- tion's Gulf of Mexico holdings totaled some 123,000 net acres, with an average working interest of 36% in 64 leases covering 65 blocks with an overriding royalty interest in six other leases. The company operates 23 leases cover- ing 24 offshore blocks. Enserch Exploration also canceled, or allowed to expire, eight Gulf of Mexico leases during the year. These leases had been con- demned following drilling on or near them or after geophysical and geological findings. Enserch Exploration plans further drilling on undeveloped acreage but at this time cannot specify the extent of the drilling or predict how successful it will be in establishing the commercial reserves sufficient to justify retention of the acreage. The primary terms under which the undeveloped acreage in the United States can be retained by the payment of delay rentals without the establishment of gas and oil reserves expire 30% in 1994, 17% in 1995, 25% in 1996, 13% in 1997, 4% in 1998, 1% in 1999 and 10% thereafter. A portion of the undeveloped acreage may be allowed to expire prior to the expiration of primary terms specified in this schedule by nonpayment of delay rentals. Aside from Texas, the Gulf of Mexico, Malaysia and Indonesia, Enserch Exploration has no material concentration of undeveloped acreage in single areas at this time. Undeveloped acreage in other countries, which can be retained without the establishment of gas or oil reserves, expires as follows: Indonesia - 25% in 1994, 30% in 1996, 20% in 1998 and 25% in 2000; United Kingdom - 100% in 2016; Malaysia - 100% in 1996. Enserch Exploration participated in 111 wells (79 net) during the year. Of these wells, 83 (64 net) were completed successfully, resulting in a net success rate of 81%. Of the successful wells, 7 wells (4 net) were exploratory and 76 wells (60 net) were development. At December 31, 1993, Enserch Exploration was participating in 39 wells (21 net), which were either being drilled or in some state of completion. In the 1993 domestic drilling program, 16 wells (4.9 net) were offshore. Of these wells, 9 (2.6 net) gas wells and 1 (.1 net) oil well were successfully completed. During 1992, 4 (1.6 net) offshore wells were drilled, of which 2 (.8 net) gas wells were successfully completed. At December 31, 1993, Enserch Exploration owned working interests in 1,303 (980 net) gas wells and 1,121 (277 net) oil wells in the United States. Of these, 173 (141 net) gas wells and 37 (32 net) oil wells were dual completions in single boreholes. Drilling activity by Enserch Exploration during the three years ended December 31, 1993, is set forth below: The number of wells drilled is not a significant measure or indicator of the relative success or value of a drilling program because the significance of the reserves and economic potential may vary widely for each project. It is also important to recognize that reported completions may not necessarily track capital expenditures, since Securities and Exchange Commission guidelines do not allow a well to be reported as complete until it is ready for production. In the case of offshore wells, this may be several years following initial drilling because of construction of platforms, pipelines and other necessary facilities. Additional information relating to the gas and oil activities of Enserch Exploration is set forth in Note 13 of the Notes to Consolidated Financial Statements included in Appendix A to this report. Processing Partners has interest in 18 processing plants, 13 of which are wholly owned. The products, which in 1993 were produced at an average of about 16,500 barrels per day, are sold to customers primarily at the Mt. Belvieu fractionation and storage facility near Houston for use as chemical feedstock and other purposes. The processing plants are capable of producing an aggre- gate of about 27,000 barrels of NGL per day; daily production was up slightly from the previous year. Lone Star estimates that as of January 1, 1994, 27.2 MMBbls of NGLs are attributable to contractual processing rights of Pro- cessing Partners with respect to gas reserves owned by EP or third parties and dedicated to Lone Star under various gas-purchase contracts or are being trans- ported by Lone Star under various gas transportation agreements. See "Business - - Natural Gas Transmission and Distribution - Source and Availability of Raw Materials" for additional reserves held by Lone Star. LSEC owns and operates three central plants providing heating and cooling to institutional customers in Dallas, El Paso and Galveston, Texas. LSEC also operates a similar plant in San Antonio, Texas. The Corporation owns a five-building office complex in Dallas, containing approximately 453,000 square feet of space that the Corporation, Lone Star and certain subsidiaries fully occupy. In addition, the Corporation leases a 21- story, 400,000-square-foot building in Houston under a two-year lease that is automatically extended each year unless terminated. ITEM 3. ITEM 3. Legal Proceedings The utility division of the Corporation was named as a codefendant in a lawsuit filed on November 10, 1988, in the 200th Judicial District Court of Travis County, Texas. Plaintiffs were parties to gas-sale contracts that provided for direct and indirect sale of gas to the utility division. Plain- tiffs allege that defendants implemented a series of unilateral price decreases, thereby improperly fixing prices paid for gas in three Texas counties in violation of state antitrust laws and the Texas State Natural Resources Code. Plaintiffs also allege breach of contract and fiduciary duties, fraud, interference of contracts, conspiracy, economic duress, failure to reasonably market the plaintiffs' gas, and perform the contracts in good faith and discrimination by a common purchaser. Plaintiffs seek actual damages of approximately $35 million and $20 million in punitive damages. Management believes the allegations are without merit and that liability, if any, will not have any material effect on the financial position of the Corporation. Additional information required hereunder is set forth in Note 6 and Note 10 to Consolidated Financial Statements included in Appendix A hereto. 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 information required hereunder is set forth under "Common Stock Market Prices and Dividend Information" included in Appendix A to this report. ITEM 6. ITEM 6. Selected Financial Data The information required hereunder is set forth under "Selected Financial Data" included in Appendix A to this report. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required hereunder is set forth under "Financial Review" included in Appendix A to this report. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The information required hereunder is set forth under "Independent Auditors' Report," "Management Report on Responsibility for Financial Reporting," "Statements of Consolidated Income," "Statements of Consolidated Cash Flows," "Consolidated Balance Sheets," "Statements of Consolidated Common Shareholders' Equity," "Notes to Consolidated Financial Statements" and "Summary of Business Segments" included in Appendix A to this report. ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III ITEMS 10-13. Pursuant to Instruction G(3) to Form 10-K, the information required in Items 10-13 (except for information set forth at the end of Part I under "Business - Executive Officers of Registrant") is incorporated by reference from the Corporation's definitive proxy statement which is being filed pursuant to Regulation 14A on or about March 30, 1994. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)-1 Financial Statements The following items appear in Appendix A to this report: (a)-2 Financial Statement Schedules The following items are included in Appendix B to this report: Consolidated financial statement schedules, other than those listed above, are omitted because of the absence of the conditions under which they are required or because the required information is included in the consolidated financial statements or notes thereto. (a)-3 Exhibits. The following exhibits are filed herewith unless otherwise indicated: Long-term debt is described in Notes 3 and 4 of the Notes to Consolidated Financial Statements included in Appendix A to this report. The Corporation agrees to provide the Commission, upon request, copies of instruments defining the rights of holders of such long-term debt, which instruments are not filed herewith pursuant to Paragraph (b)(4)(iii)(A) of Item 601 of Regulation S-K. ___________________ *Incorporated herein by reference and made a part hereof. (b) Reports on Form 8-K Current Report on Form 8-K dated October 18, 1993, was filed on October 22, 1993 (judgment entered in Exchange Offer suit). Current Report on Form 8-K dated November 17, 1993, was filed on November 29, 1993 (ENSERCH signs agreement to sell principal operating assets of Ebasco Services Incorporated to Raytheon Engineers & Constructors). Current Report on Form 8-K dated December 22, 1993, was filed on January 6, 1994 (ENSERCH closes Ebasco sale; sells 49% interest in Dorsch Consult). 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. ENSERCH Corporation March 30, 1994 By: /s/ D. W. Biegler D. W. Biegler, Chairman and President, 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 date indicated. Signature and Title Date D. W. Biegler, Chairman and President, Chief Executive Officer, and Director; William B. Boyd, Director; B. A. Bridgewater, Jr., Director; Lawrence E. Fouraker, Director; Preston M. Geren, Jr., Director; Marvin J. Girouard, Director; March 30, 1994 Joseph M. Haggar, Jr., Director; W. C. McCord, Director; Diana S. Natalicio, Director; W. Ray Wallace, Director; S. R. Singer, Senior Vice President, Finance and Corporate Development, Chief Financial Officer; Jerry W. Pinkerton, Vice President and Controller, Chief Accounting Officer By: /s/ D. W. Biegler D. W. Biegler As Attorney-in-Fact APPENDIX A ENSERCH CORPORATION AND SUBSIDIARY COMPANIES INDEX TO FINANCIAL INFORMATION DECEMBER 31, 1993 Page ---- Selected Financial Data............................... A-2 Financial Review...................................... A-4 Independent Auditors' Report.......................... A-18 Management Report on Responsibility for Financial Reporting................................. A-19 Financial Statements: Statements of Consolidated Income................... A-21 Statements of Consolidated Cash Flows............... A-22 Consolidated Balance Sheets......................... A-23 Statements of Consolidated Common Shareholders' Equity.............................. A-24 Notes to Consolidated Financial Statements............ A-25 Summary of Business Segments.......................... A-54 Common Stock Market Prices and Dividend Information... A-55 A-3 ENSERCH CORPORATION FINANCIAL REVIEW RESULTS OF OPERATIONS Earnings applicable to common stock for the year 1993 were $47 million ($.70 per share), compared with a loss applicable to common stock for 1992 of $41 million ($.62 per share) and 1991 earnings of $5 million ($.07 per share). Results from continuing operations, after provision for preferred dividends, were a loss of $27 million ($.41 per share) in 1993, a loss of $9 million ($.14 per share) in 1992 and income of $23 million ($.36 per share) in 1991. Results from continuing operations for 1993 were impacted by the following items: - An $8 million after-tax ($12 million pretax) charge for efficiency enhancements and severance expenses accrued for staff reductions in Natural Gas Transmission and Distribution operations; - An $11 million charge to deferred federal income taxes resulting from the 1% increase in the statutory federal income-tax rate on corpora- tions; - A $9 million after-tax ($13 million pretax) write-off of non-U.S. gas and oil assets; and - A $27 million after-tax ($41 million pretax) charge as a result of an adverse judgment in litigation that required additional payment in a limited partnership exchange offer made in 1989 beyond the amount that the Corporation believes represented fair value. In addition, there was a $4 million after-tax ($6 million pretax) charge for additional interest awarded. The 1992 results from continuing operations included an $11 million after-tax ($17 million pretax) write-off of abandoned offshore facilities and a $10 million after-tax ($15 million pretax) provision for litigation. Results from continuing operations in 1991 included after-tax gains totaling $10 mil- lion from the sale of properties. Revenues for 1993 were $1.9 billion, compared with $1.7 billion in both 1992 and 1991. Operating income for 1993 was $73 million, compared with $112 million in 1992 and $137 million in 1991. Excluding the effects on operating income of the unusual charges mentioned above, 1993 operating income was $140 million versus $129 million for 1992 and $137 million for 1991. Variations in operating income by business segment are discussed below. The 1993 results include income from discontinued operations of $74 million ($1.11 per share), representing after-tax gains totaling $68 mil- lion ($1.03 per share) from the sale of the principal operating assets of Ebasco Services Incorporated and the Corporation's 49% interest in Dorsch Consult, and income from operations before the sale of $6 million. There was a $16 million ($.25 per share) loss from discontinued operations in 1992, primarily related to the sale of Humphreys and Glasgow International and provisions for real estate formerly utilized by discontinued operations. In 1991, there was a loss of $19 million ($.29 per share). With these sales, the Corporation has concluded its involvement in the engineering and construction business and now reflects these results as discontinued operations. A-4 Results for the year 1992 also included a $15 million ($.23 per share) after-tax extraordinary loss from the extinguishment of high interest-rate debt and the termination of an interest-rate hedge. NATURAL GAS TRANSMISSION AND DISTRIBUTION The six-year statistics for Transmission and Distribution operations (See table of Operating Data) reflect the effects of variable weather patterns and increasing significance of nonregulated markets. Operating income for Transmission and Distribution operations for 1993 was $113 million before the $12 million charge relating to the ongoing reengineering of this business ($101 million after the charge), compared with $102 million for 1992 and $111 million for 1991. Normal winter weather, combined with aggressive marketing of services and increased capacity, contributed to higher sales and transportation volumes in 1993. Volumes handled during the year were 645 billion cubic feet (Bcf), a 22% increase from both 1992 and 1991. Gas throughput on Lone Star's pipeline system reached 554 Bcf in 1993, its highest level since 1981. The volume of gas sold by Lone Star Gas Company and Enserch Gas Company (EGC) in 1993 totaled 414 Bcf, 18% above the 1992 level and 14% greater than 1991. Sales by EGC accounted for 59% of total gas sales volumes in 1993 versus 53% in 1992 and 51% in 1991. Residential and commercial (R&C) sales volumes were 139 Bcf in 1993, up 16% from the 1992 volumes of 121 Bcf and 8% higher than in 1991, primarily due to colder winter weather. Heating degree days for 1993 rose 27% over the prior year and were slightly above normal for the first year since 1989. Industrial and electric-generation sales volumes of 138 Bcf were 6% greater than in 1992 but 15% less than 1991. Volumes sold to pipelines and others in 1993 totaled 136 Bcf, a 37% improvement from the 1992 level of 99 Bcf, which was improved 40% from the 1991 level of 71 Bcf. The overall gas sales margin (revenue less cost of gas purchased and off-system transportation expense) for 1993 improved 7% from the prior year. The overall gross margin per thousand cubic feet (Mcf) on Lone Star's sales was $2.09 in 1993, $2.06 in 1992 and $1.96 in 1991. Lone Star has an ongoing rate program to monitor returns from cities and towns served by its distribution system, as well as the transmission system that supplies them. In the aggregate, rate increases provided $1.9 million in annual base-rate relief in 1993. The gross margin per Mcf on gas sold by EGC was $.11 in 1993, down from $.13 in both 1992 and 1991. The total gas transportation volume in 1993 was 371 Bcf, a 21% improvement from 1992 volumes of 307 Bcf, which were slightly above the 1991 level. The gas transportation rate per Mcf averaged $.14 in 1993, compared with $.15 in 1992 and $.16 in 1991. The margins on incremental volumes generally are at lower rates and thereby reduce the average margin. Lone Star's gas purchase contracts are discussed below. A-5 NATURAL GAS AND OIL EXPLORATION AND PRODUCTION Operating income for Exploration and Production operations closely follows fluctuations in product prices and volumes that are shown in the table of Operating Data. Before the previously noted litigation charge and write-offs of non-U.S. gas and oil properties, operating income for Exploration and Production operations was $17 million for 1993, compared with $10 million for 1992 and $11 million for 1991. This improvement resulted from significantly increased natural-gas prices and higher sales volumes. Revenues for Exploration and Production operations for 1993 of $190 mil- lion were 11% higher than 1992 and 3% above 1991. In 1993, natural-gas revenues increased 23% to $146 million, with the average natural-gas price per Mcf of $2.09 up 15% from the price in 1992 of $1.82. Natural-gas sales volumes totaled 70 Bcf, a 7% increase from the year-ago period and virtually the same as 1991. The increase in volumes for 1993 was principally due to accelerated natural-gas development drilling in East Texas and offshore production from Mississippi Canyon Block 441 in the Gulf of Mexico, which went on stream in the second quarter of 1993. Oil revenues declined $8 million to $37 million in 1993 due to a 9% production decline and a 10% decrease in the average sales price to $17.24 per barrel. The lower volumes in 1993 were primarily the result of declining production from several North Texas reservoirs. Spot-market sales, which include monthly and short-term industrial sales, covered about 70% of 1993 gas sales, compared with 80% in 1992 and 75% in 1991. During 1994, the percentage of gas sold in the spot market is expected to be in the range of 75% to 85%. Drilling activity during the first half of 1993 increased to levels last experienced by the Corporation in 1987, primarily because of development work in East Texas. ENSERCH participated in more than 100 wells (79 net) in 1993, with the majority completed as gas producers in East Texas. Thirty-nine wells were in progress at yearend. Recompletions and production optimization measures played a major role in the 1993 production enhancement program. Results for 1994 will include a full year of production from the Mississippi Canyon Block 441 deep-water project in the Gulf of Mexico, which began production in early 1993. The field is producing some 70 million cubic feet (MMcf) of natural gas and more than 500 barrels of condensate per day from six wells. ENSERCH is the operator, with a 37.5% working interest in the project. The Garden Banks Block 388 oil development project, also in the Gulf, remains on schedule and on budget, with initial production anticipated by mid- 1995. The final major contract for the conversion of a semi-submersible drilling rig to a floating production facility was finalized in early 1994. Installation of the offshore facilities, consisting of the subsea template, gathering and sales pipelines and shallow-water operations, will begin by mid- year. Three previously drilled oil wells will be connected to the subsea template. Initial daily production from three predrilled wells is expected to total 15 thousand barrels (MBbls) of oil and 12 to 15 MMcf of gas by late 1995, with peak daily production from the Garden Banks project anticipated in late 1996 at 40 MBbls of oil and 60 MMcf of gas. Gross proven reserves are presently estimated to be equivalent to 28 million barrels (MMBbls) of oil by DeGolyer and MacNaughton, an independent consulting firm. ENSERCH is 100% interest owner and operator of the Garden Banks project. A-6 ENSERCH has budgeted $116 million for exploration and production activities in 1994, compared with expenditures of $120 million in 1993. In 1992, ENSERCH sharply curtailed its capital spending to $66 million in response to poor prices for both natural gas and oil. If the early 1994 weakness in oil prices persists throughout 1994, appropriate cutbacks in spending may be undertaken. More than half of ENSERCH's 1994 capital expenditures is earmarked for domestic onshore drilling. The Corporation follows the full-cost method of accounting for the acquisition, exploration and development costs of gas and oil properties. The overall rate of amortization for U.S. properties was $.98 per million British thermal units produced for both 1993 and 1992, compared with $.90 in 1991. Costs of additional offshore projects and increased development costs associated with older East Texas fields largely account for the increase from 1991. During 1993, the Corporation wrote off some $13 million representing all remaining capitalized costs associated with its non-U.S. gas and oil proper- ties. ENSERCH's natural-gas reserves at January 1, 1994, were 1.09 trillion cubic feet (Tcf), compared with 1.10 Tcf the year earlier, as estimated by DeGolyer and MacNaughton. Oil and condensate reserves, including natural gas liquids attributable to leasehold interests, were 39 MMBbls, virtually the same as the year-ago level. At January 1, 1994, estimated future pretax net cash flows from ENSERCH's owned proved gas and oil reserves, based on average prices and contracts in effect in December 1993, were $2.0 billion, about the same as the year earlier. The net present value of such cash flows, discounted at the Securities and Exchange Commission (SEC)-prescribed 10%, was $1.1 billion, virtually the same as the prior year. These discounted cash flow amounts are the basis for the SEC-prescribed cost-center ceiling for the full-cost accounting method. The margin between the cost-center ceiling and the unamortized capitalized costs of U.S. gas and oil properties was approximately $75 million at December 31, 1993. Product prices are subject to seasonal and other fluctuations. A significant decline in prices from yearend 1993 or other factors, without mitigating circumstances, could cause a future write-down of capitalized costs and a noncash charge against earnings. In November 1993, an adverse judgment in litigation required additional payment for a limited partnership exchange offer made in 1989. The award included $41 million for the units and $21 million of prejudgment and post-judgment interest ($15 million was charged against an existing reserve for litigation). The $41 million additional payment was charged against income in the fourth quarter. The Corporation had believed that any additional consideration for the units should be capitalized; however, after further review at the time of the judgment, the expensing of the final court-ordered payment was prudent and necessary because it did not bring additional value. NATURAL GAS LIQUIDS PROCESSING Operating income for Natural Gas Liquids (NGL) Processing operations for 1993 was $5 million, compared with $13 million for 1992 and $21 million for 1991. Higher prices for natural gas, the feedstock used in NGL production, and continued lower NGL sales prices caused margins to decline. The average NGL A-7 sales price per barrel in 1993 of $12.34 was down 8% from 1992 and was 11% below 1991, while NGL sales volumes of 6.0 MMBbls were virtually the same as 1992 and 1991. POWER AND OTHER ENSERCH's power and other activities, comprised of Enserch Development Corporation, Lone Star Energy Company and Enserch Environmental Corporation, had 1993 operating income of $15 million, compared with $20 million for 1992 and $9 million for 1991. Enserch Development Corporation's 1993 operating income was $5.9 million, compared with $9.8 million for 1992 and $2.1 million for 1991. Current year results included a $15 million pretax gain from the sale of a position in a power project that had been scheduled for development, while 1992 and 1991 results included development fees from cogeneration projects of $15 million and $5 million, respectively. Lone Star Energy Company's 1993 operating income was $3.9 million, some 8% higher than 1992 but slightly below 1991. Enserch Environmental Corporation, which was retained when Ebasco's principal operating assets were sold in December 1993, had operating income for 1993 of $5.7 million, compared with $6.8 million for 1992 and $2.9 million for 1991. Backlog was $600 million at December 31, 1993. OTHER INCOME AND EXPENSE ITEMS Other income/(expense) for 1993 includes pretax gains totaling $7 million from the sale of a gas storage facility and the Corporation's minority investment in an insurance entity. Partially offsetting was a $5.6 million provision for the interest awarded in the judgment described earlier, while the 1992 amount principally reflected a $15 million provision for litigation. The sale of Oklahoma utility properties and non-U.S. gas and oil properties in 1991 resulted in pretax gains of $15 million. Details of other income/(expense) are included in Note 12. Interest expense for 1993 was $80 million, including $8 million not related to borrowings, compared with $97 million for 1992 and $96 million for 1991. The reduction is the result of ongoing restructuring of long-term debt at lower rates and lower short-term interest rates. Interest capitalized in 1993 was $4.5 million, compared with $5.4 million in 1992 and $7.5 million in 1991. Income-tax expense for 1993 includes an $11 million charge to deferred federal income taxes resulting from the 1% increase in the statutory federal income-tax rate on corporations. Excluding this charge, the income-tax benefit on the loss from continuing operations equaled 46% of the pretax loss. At December 31, 1993, the Corporation had domestic net operating-loss carryfor- wards and suspended losses of $161 million and tax-credit carryforwards of $37 million. The tax benefits of these carryforwards and suspended losses, which total some $93 million, are available to reduce future income-tax payments. Note 9 provides additional information on income taxes. A-8 LIQUIDITY AND FINANCIAL RESOURCES Net cash flows from operating activities of continuing operations for 1993 were $192 million, compared with $211 million in 1992 and $184 million in 1991. Net cash flows from continuing operations, before cash flow effects of gas- purchase contract settlements and changes in current operating assets and liabilities, were $155 million versus $150 million in 1992 and $184 million in 1991. Cash flows associated with gas-purchase contract settlements improved substantially over the three-year period. Recoveries, net of payments, provided $51 million in 1993 and $26 million in 1992, while there were net payments of $7 million in 1991. (These payments are discussed in detail under "Gas-Purchase Contracts.") In 1993, there was a cash requirement of $14 mil- lion for the increase in current operating assets and liabilities, compared with decreases that provided $36 million in 1992 and $7 million in 1991. Cash of $118 million was provided by investing activities in 1993, compared with cash requirements of $105 million and $127 million in 1992 and 1991, respectively. These amounts include cash provided by discontinued operations of $320 million in 1993, $14 million in 1992 and $37 million in 1991. Cash provided by discontinued operations in 1993 includes net proceeds of $198 mil- lion from the sale of the principal operating assets of Ebasco and the 49% interest in Dorsch and proceeds of $100 million from the limited recourse sale of retained Ebasco receivables, while 1992 includes net proceeds of $41 million from the sale of Humphreys and Glasgow International. There was a net cash requirement for capital spending and other investing activities of $203 million in 1993, compared with $119 million in 1992 and $164 million in 1991. The increase in 1993 is primarily due to a higher level of capital spending for natural-gas and oil exploration and development programs. Property, plant and equipment additions by business segments for the past three years and planned for 1994 are as follows: The planned expenditures for 1994 are expected to be funded from internal cash flow and external financings as required. In 1993, net cash flows from operating and investing activities totaled $309 million. In addition, $11 million was provided by the sale of common stock to employee stock plans and there was a $29 million net decrease in cash and cash equivalents. After the payment of cash dividends of $26 million, net cash of $324 million was available to reduce outstanding borrowings, with long- term debt reduced $200 million and commercial paper and other short-term borrowings decreased $121 million. In 1992, there was $51 million available to reduce borrowings or for temporary investment. A-9 In June 1993, the Corporation borrowed $200 million under its interim-term (13-month) bank lines, with the interest rate based on the London Interbank Offering Rate plus a fixed percentage. The proceeds were used in refinancing maturing debt consisting of $76 million net due on a Swiss Franc Note that had an effective interest rate of 8.9% and $100 million of 11 5/8% Notes that matured in May 1993, with the remainder used to reduce commercial paper borrowings. The $200 million interim-term borrowing was repaid in December 1993 in connection with the sale of Ebasco assets and Dorsch. In February 1993, the Corporation announced a reduction in the quarterly cash dividend on common stock to $.05 per share from $.20 per share, resulting in a change in annual cash requirements of about $40 million. In 1992, Enserch Exploration Partners Ltd. (EP) entered into operating lease arrangements to provide financing for its portion of the offshore platforms and related facilities for the Mississippi Canyon Block 441 (37.5% owned) and Garden Banks Block 388 (100% owned) projects. A total of $34 mil- lion was required for the Mississippi Canyon Block 441 project, which was com- pleted in early 1993. The lease arrangement to fund the construction costs for the Garden Banks facility is estimated to total $235 million when completed in 1995. (See Note 6.) Total capitalization was $1.6 billion at December 31, 1993, a decrease of $184 million from yearend 1992. The decrease reflects a $226 million reduction in senior long-term debt and a $42 million increase in common shareholders' equity. Common shareholders' equity, as a percentage of total capitalization, increased to 41.7% at December 31, 1993 from 34.8% at the end of 1992. At December 31, 1993, $350 million of shareholders' equity was free of any restrictions for payment of dividends or acquisition of capital stock. The current ratio at December 31, 1993 was .72, compared with 1.0 at yearend 1992 and .95 at yearend 1991. The decline in 1993 was partially attributable to the sale of $34 million of Ebasco's working capital and the classification of a $62 million payment relating to the judgment described above as a current liability. This payment was made in January 1994. ENSERCH uses the commercial paper market and commercial banking facilities for short-term needs. Commercial paper and other short-term borrowings, net of temporary cash investments, totaled $32 million at December 31, 1993, compared with $121 million at yearend 1992 and $156 million at the end of 1991. Bank lines for either short- or interim-term borrowings totaled $650 million at yearend 1993. Presently, all of these lines are unused. In February 1994, the Corporation issued $150 million of 10-year term notes at a coupon rate of 6.375%. The proceeds were used in March to fully redeem the $75 million of Series D Adjustable Rate Preferred Stock at par value and to retire all outstanding sinking fund debentures, which had a combined principal balance of $74 million. The premium for early retirement was $1.4 million. The preferred stock had a minimum dividend rate of 7.5%, equivalent to 11.54% on a tax-adjusted basis. The sinking fund debentures had a weighted average interest rate of 8.5%. In March 1994 the Corporation filed a shelf registration statement with the Securities and Exchange Commission for the sale from time to time of up to $450 million in the aggregate of securities, which can be its senior or subordinated debt securities, or its equity securities or the securities of a special purpose subsidiary. Proceeds received from any sale will be used to repay obligations of the Corporation, unless otherwise set A-10 forth in a prospectus supplement. The type and terms of any security to be offered will be determined at the time of each offering. Even though inflation has abated considerably from the levels of the early 1980s, and was only about 2.5% in 1993, it continues to have some influence on the Corporation's operations. Most notable is that allowances for depreciation and amortization based on the historical cost of fixed assets may be insuffi- cient to cover the replacement of some long-lived fixed assets. GAS-PURCHASE CONTRACTS Lone Star is a fully integrated intrastate natural-gas utility from well- head to end use and owns its own gathering, transmission and distribution facilities. Lone Star buys gas under long-term, intrastate contracts in order to assure reliable supply to its customers. To obtain this relia- bility, Lone Star entered into many gas-purchase contracts that provide for minimum-purchase ("take-or-pay") obligations to gas sellers. In the past, Lone Star was unable to take delivery of all minimum gas volumes tendered by suppliers under these contracts. This situation principally resulted from general economic conditions, the restructuring of regulations in the natural- gas industry, customers having the availability of lower-priced natural gas from competitive sources, certain capacity limitations, Railroad Commission of Texas (RRC) rules regulating takes of gas, and warmer-than-normal winter temperatures that reduced sales demand. During past years, numerous claims have been made by gas suppliers asserting Lone Star's failure to meet its minimum purchase obligations, and other claims such as disputing prices paid for gas purchased under contracts. Lone Star has substantially reduced the potential assertions resulting from such claims through negotiations and contractual and statutory provisions. Producer settlement obligations in Lone Star's contracts have been reduced substantially in recent years. Claims asserted for events during 1992 and anticipated claims for 1993 are negligible. Take-or-pay contract provisions generally allow for payments to be recouped by taking gas in future periods without payment in accordance with the terms of the contract. When the gas is taken, the previous advance payment becomes a part of gas cost that is charged to customers. Alternatively, Lone Star, in many cases, has negotiated "nonrecoupable" payments that generally are much less in amount than comparable recoupable payments but provide no rights to recoup gas in future periods. Nonrecoupable settlement payments are included in gas costs recovered through customer billings as described below. Obligations to purchase gas in the future are estimated to be as follows (in millions): 1994, $150; 1995, $120; 1996, $95; 1997, $90; 1998, $80; and thereafter, not more than $70, with the final contracts expiring in 2003. Based on Lone Star's estimated gas demand of about 170 Bcf annually, which assumes normal weather conditions, it is expected that normal gas purchases will substantially satisfy purchase obligations for the year 1994 and thereafter; however, any payments that may be required to be made for obligations not met are recoupable under contract provisions or are recoverable from customers as gas purchase costs. Therefore, a provision for loss is not required. Lone Star's regulated rates for residential and commercial customers and its contractual rates for industrial and electric-generation customers include gas costs recorded each month (including out-of-period costs), an allowance for other costs and expenses, and a return on investment. Its residential and commercial distribution rates are set at the cost of service within each city A-11 by the local municipal governments. The RRC has appellate jurisdiction over the city distribution rates and original jurisdiction over the rates outside city limits. The RRC regulates the intracompany city gate rate or charge for the transmission service outside city limits that is included as a cost for distribution service to residential and commercial customers within city limits. The RRC provides a gas cost recovery mechanism in the city gate rate that is designed to match gas costs with revenues on a timely basis to prevent margin erosion or excesses by allowing both positive and negative gas cost changes to flow through to the customers. The Texas city gate gas cost recovery mechanism limits the amount of out-of-period gas costs, of which producer settlements are a part, that can be charged to customers in a particular month. The existing recovery mechanism does, however, allow for ultimate recovery of gas costs, including such out-of-period payments. Similarly, contractual provisions provide for recovery of the allocated share of these costs from industrial and electric-generation customers. Therefore, a provision for loss is not required. At December 31, 1993, the approximate amount of unsettled gas-purchase contract claims asserted by suppliers, as well as estimated claims that are probable of assertion, was $80 million. Of this total, approximately $70 million relates to a claim filed in 1993 primarily related to asserted obligations for purchases for early through mid-1980s. (See Note 6.) In some cases, the claimed amount includes other asserted damages in addition to the take-or-pay claim. The possibility exists that additional gas-purchase contract claims might be asserted by other claimants. Lone Star expects to resolve the foregoing claims at substantially less than the claimed amounts. Due to the different forms of settlement, as discussed above, the ultimate liability to a supplier, if any, generally cannot be reasonably estimated prior to settlement; however, a liability is recorded in the financial statements for those claims when a settlement is probable and an amount can be reasonably estimated. A provision for loss is not required since settlement payments are recoupable under contracts or recoverable through billings to customers, as previously discussed. At December 31, 1993, there was an unrecovered balance of gas-purchase contract settlements of $111 million, down from $173 million at December 31, 1992. The balances include take-or-pay settlements, amounts relating to pricing and amounts related to the settlement of other contractual matters. Of the $111 million, $63 million represented prepayments for gas expected to be recouped under contracts covering future gas purchases. The remaining $48 million represented amounts expected to be recovered from customers under the existing gas cost recovery provisions. Lone Star expects to recoup or recover the remaining balances of gas settlement payments made to date, as well as future payments to be made in settlement of remaining claims. The period of recovery is dependent on the overall demand for gas by Lone Star's customers, which is influenced by weather conditions. A summary of transactions related to unrecovered gas settlement payments during the two years ended December 31, 1993, is as follows: A-12 FOURTH-QUARTER RESULTS Earnings applicable to common stock for the fourth quarter of 1993 were $36 million ($.53 per share), compared with a loss of $33 million ($.49 per share) for the fourth quarter of 1992. Fourth quarter income from discontinued operations was $70 million ($1.04 per share), compared with a loss of $16 million ($.25 per share) for the same period a year earlier. Results for the fourth quarter of 1992 also included a $10 million after-tax extraordinary loss from debt extinguishment. There was a loss from continuing operations after provision for preferred dividends for the fourth quarter of 1993 of $34 million ($.51 per share) versus a loss of $6 million ($.08 per share) for the year-ago period. Results for the 1993 and 1992 fourth quarters included all of the unusual items noted for the full year, except for after-tax charges of $10.8 million for the increase in the statutory federal income tax rate, $3.6 million for litigation and $2.0 million for write-offs of non-U.S. gas and oil properties that occurred earlier in 1993. Before unusual items, operating income for the 1993 fourth quarter was $28 million, compared with $52 million for the year-earlier quarter. In addition to the unusual items noted, fourth quarter 1993 operating income was reduced by some $10 million of other year-end provisions. Results for the fourth quarter of 1992 were enhanced by develop- ment fees of $15 million from a cogeneration project. Fundamental results were about the same in both quarters. NEW ACCOUNTING STANDARDS SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," which mandates the accounting for medical and life insurance and other nonpension benefits provided to retired employees, was adopted by the Corporation effective January 1, 1993. (See Note 8.) SFAS No. 112, "Employer's Accounting for Postemployment Benefits," will become effective for the Corporation in 1994. This standard covers the accounting for estimated costs of benefits provided to former or inactive employees before their retirement. The Corporation currently accrues costs of benefits to former or inactive employees by varying methods. The new standard is not expected to have a significant effect on results of operations or financial condition. A-13 A-16 A-17 INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors of ENSERCH Corporation: We have audited the accompanying consolidated balance sheets of ENSERCH Corporation and subsidiary companies as of December 31, 1993 and 1992, and the related statements of consolidated income, cash flows and common shareholders' equity 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 have previously audited the consolidated balance sheets of ENSERCH Corporation and subsidiary companies as of December 31, 1991, 1990, 1989 and 1988 and the related statements of consolidated income, cash flows and common shareholders' equity for the years ended December 31, 1990, 1989, and 1988 (not presented herewith), and have expressed unqualified opinions thereon. 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 ENSERCH 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. Also, in our opinion, the information set forth in the accompanying table of selected financial data for the years 1988 through 1993 is fairly stated in all material respects in relation to the consolidated financial statements from which such information has been derived. DELOITTE & TOUCHE Dallas, Texas February 7, 1994 A-18 MANAGEMENT REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of ENSERCH Corporation is responsible for the preparation, presentation and integrity of the financial statements contained in this report. These statements have been prepared in conformity with accounting principles generally accepted in the United States and include amounts that represent management's best estimates and judgments. Management has estab- lished practices and procedures designed to support the reliability of the estimates and minimize the possibility of a material misstatement. Management also is responsible for the accuracy of the other information presented in the annual report and for its consistency with the financial statements. Management has established and maintains internal accounting controls that 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 system of internal control 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 and updated as necessary. Management continually monitors compliance with the system of internal accounting controls. The Corporation maintains a strong internal audit function that evaluates the adequacy of the system of internal accounting controls. As part of the annual audit of the financial statements, Deloitte & Touche also performs a study and evaluation of the system of internal accounting controls as necessary to determine the nature, timing, and extent of their auditing procedures. The Board of Directors maintains an Audit Committee composed of Directors who are not employees. The Audit Committee meets periodically with management, the independent auditors and the internal auditors to discuss significant accounting, auditing, internal accounting control and financial reporting matters. A procedure exists whereby either the independent or the internal auditors through the independent auditors may request, directly to the Audit Committee, a meeting with the Committee. Management has given proper consideration to the independent and internal auditors' recommendations concerning the system of internal accounting controls and has taken corrective action believed appropriate in the circumstances. Management further believes that, as of December 31, 1993, the overall system of internal accounting controls is sufficient to accomplish the objectives discussed herein. A-19 Management recognizes its responsibility for establishing and maintaining a strong ethical climate so that the Corporation's affairs are conducted according to the highest standards as defined in the Corporation's Statement of Policies. The Statement of Policies is publicized throughout the Corpora- tion and addresses, among other issues, open communication within the Corporation; the disclosure of potential conflicts of interest; compliance with the laws, including those relating to financial disclosure; and the confidenti- ality of proprietary information. s/D. W. Biegler - ------------------------------ D. W. Biegler Chairman and President, Chief Executive Officer s/S. R. Singer - ------------------------------ S. R. Singer Senior Vice President, Finance and Corporate Development, Chief Financial Officer s/J. W. Pinkerton - ------------------------------ J. W. Pinkerton Vice President and Controller, Chief Accounting Officer February 7, 1994 A-20 A-21 A-22 A-23 A-24 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ENSERCH Corporation and Subsidiary Companies 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES All dollar amounts, except per share amounts, in the notes to the consoli- dated financial statements are stated in thousands unless otherwise indicated. Basis of Financial Statements - The consolidated financial statements include all subsidiaries during the period of ownership and control. The equity method of accounting is used for investments in affiliates in which ENSERCH Corporation (ENSERCH or the Corporation) does not have voting control. Lone Star Gas Company (Lone Star), the gas utility division of ENSERCH Corporation and principal company in the natural gas transmission and distribu- tion business operations, is subject to the accounting requirements prescribed by the National Association of Regulatory Utility Commissioners. Lone Star's rates are established by the Railroad Commission of Texas and by municipal governments. The statements of consolidated income and cash flows previously reported for 1992 and 1991 have been restated to reflect the engineering and construction segment as a discontinued operation. Current year reported results reflect the realignment of the segments of business for financial reporting purposes. All prior year amounts have been reclassified to reflect the new alignments. Revenue Recognition - Lone Star records revenues on the basis of cycle meter readings throughout the month and accrues revenues for gas delivered but not billed to customers from the meter reading dates to the end of the month. The environmental business of the Corporation follows the generally accepted accounting practice of reporting revenues and income from long-term contracts on the percentage of completion basis using estimates of total contract revenue and costs at completion. These estimates are updated throughout the terms of the contracts and adjustments are made as appro- priate. All known or anticipated losses on these contracts are charged to earnings when identified. Gas and Oil Properties - The full-cost method, as prescribed by the Securi- ties and Exchange Commission (SEC), is used whereby the costs of proved and unproved gas and oil properties, together with successful and unsuccessful exploration and development costs, are capitalized by cost centers on a country-by-country basis. The carrying value for each cost center is limited to the present value of estimated future net revenues of proved reserves, the cost of excluded properties and the lower of cost or market value of unproved properties being amortized. Dry-hole costs resulting from exploration activities are classified as evaluated costs and are included in the amortiza- tion base. Costs directly associated with the acquisition and evaluation of unproved properties are excluded from the amortization base until the related properties are evaluated. Such unproved properties are assessed periodically and a provision for impairment is made to the full-cost amortization base when appropriate. Sales of gas and oil properties are credited to capitalized costs unless the sale would have a significant impact on the amortization rate. Gas Purchase Contracts - The Corporation has made accruals for payments to producers that may be required for settlement of gas purchase contract claims asserted or that are probable of assertion. Lone Star's rates billed to customers provide for the recovery of the actual cost of gas (including out-of- period costs such as gas purchase contract settlement costs). The Corporation A-25 continually evaluates its position relative to asserted and unasserted take-or- pay claims, above-market prices or future commitments. Based on this evaluation and its experience to date, management believes that the Corporation has not incurred losses for which reserves should be provided at December 31, 1993. Depreciation and Amortization - Depreciation is provided principally by the straight-line method over the estimated service lives of the related assets. Amortization of evaluated gas and oil properties is computed on the unit-of- production method by cost center using estimated proved gas and oil reserves quantified on the basis of their equivalent energy content. Lone Star's plants are depreciated over approximately 40 years; amortiza- tion of gas and oil properties was approximately 6.0% in 1993 and 5.7% in both 1992 and 1991. Earnings Per Share of Common Stock - Earnings per share applicable to com- mon stock are based on the weighted average number of common shares, including common equivalent shares when dilutive, outstanding during the year. Common equivalent shares consist of those shares issuable upon the assumed conversion of the 10% Convertible Subordinated Debentures during the periods in which they were outstanding (which were not dilutive in 1992 and 1991) and exercise of stock options under the treasury stock method. The 6 3/8% Convertible Subordinated Debentures were not common stock equivalents. Fully diluted earnings per share are not presented since the assumed exercise of stock options and conversion of debentures would not be dilutive. Gas Stored Underground - Gas stored underground is valued at average cost. The volume of gas that is available for sale within 24 months is classified as a current asset. The remainder is included in property, plant and equipment. Fair Value of Financial Instruments - The Corporation has estimated the fair values of its financial instruments using available market information and other valuation methodologies in accordance with SFAS No. 107, "Disclosures About Fair Value of Financial Instruments". Accordingly, the estimates presented are not necessarily indicative of the amounts that the Corporation could realize in a current market exchange. Determinations of fair value are based on subjective data and significant judgment relating to timing of payments and collections and the amounts to be realized. Different market assumptions and/or estimation methodologies might have a material effect on the estimated fair value amounts. The estimated fair value amounts for specific groups of financial instruments are presented within the footnotes applicable to such items. When available, values were based on market quotes from a securities exchange or a broker-dealer. When such quotes were not available, fair value estimates were made using a discounted cash flow approach based on the interest rates currently available for debt with similar terms and maturities. The fair value of financial instruments for which estimated fair value amounts have not been specifically presented is estimated to approximate the related book value. A-26 2. LINES OF CREDIT AND BORROWINGS The Corporation maintains domestic and foreign lines of credit that provide for short- and interim-term (13-month) borrowings and also support commercial paper borrowings in the U.S. and Europe. Foreign lines provide for borrowings in either U.S. dollars or in local foreign currencies, with maturities of not more than 13 months. At December 31, 1993, the aggregate lines of credit were: The domestic lines are subject to renegotiation annually by May 1 and the foreign lines by November 1. All lines are on a fee basis and do not require compensating balances or restrictions on the use of cash. All lines provide for borrowing at the prime rate or at rates related to the London Interbank Offering Rate (LIBOR), the banks' certificate of deposit rate, or a money market based rate. As of December 31, 1993, $15 million was used to support a letter of credit issued in connection with the appeal of a lawsuit. This letter of credit was canceled in January 1994, following satisfaction of amounts awarded under the lawsuit. The Corporation has an interest-rate swap agreement, expiring in 1995, whereby the Corporation pays interest at the rate of 12.26% per annum on a notional amount of $100 million and receives interest at a floating rate based on LIBOR. Through November 1992, the notional amount of the swap was matched to variable interest-rate debt, including commercial paper, and was accounted for as an interest-rate hedge. In December 1992, the Corporation repaid all variable rate debt, and the swap arrangement could no longer be accounted for as an interest-rate hedge. A charge of $10.4 million (net of income-tax benefit of $5.4 million) was recorded for the estimated cost to terminate the hedge. (See Notes 3 and 4 for other debt extinguishments.) A-27 3. SENIOR LONG-TERM DEBT Senior long-term debt as of December 31 is summarized below: In February 1994, the Corporation issued $150 million of 6 3/8% Notes due 2004 in a public offering. Part of the net proceeds of this issue will be used in March 1994 for early redemption, including call premiums of $1.4 million, of all the $73.7 million principal amount of the sinking fund debentures outstanding at December 31, 1993. The remainder of the net proceeds will be used to redeem in March 1994, all of the $75 million Adjustable Rate Preferred Stock, Series D. (See Note 5). In June 1993, the Corporation borrowed $200 million under its interim-term (13-month) bank lines, with the interest rate based on LIBOR plus a fixed percentage. The proceeds were used in refinancing maturing debt consisting of $76 million net due on a Swiss Franc Note that had an effective interest rate of 8.9% and $100 million of 11 5/8% Notes that matured in May 1993, with the remainder used to reduce commercial paper borrowings. The $200 million interim-term borrowing was repaid in December 1993 in connection with the sale of Ebasco assets and Dorsch. In March 1992, the Corporation issued $100 million of 8% Notes due 1997 and $100 million of 8 7/8% Notes due 2001 and in August 1992, issued $150 million of 7% Notes due 1999, all in public offerings. The net proceeds were used for early redemption of higher interest-rate debt and convertible subordinated debentures (see Note 4). The Corporation recognized an extraordinary loss of A-28 $2.4 million (net of income taxes of $1.2 million) representing the call premiums, unamortized costs and other expenses associated with the early extinguishment. The Corporation has a borrowing of $100 million from a foreign bank under a variable interest-rate note agreement due November 11, 1994, which provides for interest at a rate based on LIBOR plus a fixed percentage. The Corporation entered into a separate $100 million interest-rate swap that fixes interest payments at an average rate of 9.11% per annum. The 9.06% Note provides for varying increasing levels of semi-annual principal payments, including an aggregate of $10.6 million for 1994, with the last payment due December 28, 1999. Excluding the sinking fund debentures that have been called for redemption in March 1994, maturities of senior long-term debt for the following five years are: 1994, $139.9 million; 1995, $10.6 million; 1996, $13.4 million; 1997, $117.4 million; and 1998, $17.4 million. The 1994 amount includes $100 million for the 9.11% Note and $29.3 million for the 8.7% Note which will be refinanced on a long-term basis. The Corporation is not required to maintain compensating balances for any of its senior long-term debt. The estimated fair value of the Corporation's senior long-term debt, including related interest-rate swaps, was $669 million at December 31, 1993, and $888 million at December 31, 1992. Such amounts do not include prepayment penalties which would be incurred upon the early extinguishment of certain debt issues. 4. CONVERTIBLE SUBORDINATED DEBENTURES As of December 31, 1993 and 1992, $90,750 of 6 3/8% Convertible Subordinated Debentures Due 2002 were outstanding and convertible into shares of the Corporation's common stock at $26.88 per share (equal to 37.20 shares per $1 thousand principal amount). The Corporation, at its option, may redeem the 6 3/8% Debentures at 103.82% of the principal amount, plus accrued interest, through March 31, 1994, and at declining premiums there- after. The estimated fair value of the Corporation's convertible subordinated debentures was $92 million and $83 million at December 31, 1993 and 1992, respectively. An extraordinary loss of $2.5 million (net of income-tax benefit of $1.3 million) was recorded for the call premiums and other expenses associated with the early extinguishment of the 10% Debentures in 1992. 5. SHAREHOLDERS' EQUITY As of December 31, 1993, 8,368,968 shares of unissued common stock were reserved for issuance for stock plans and conversion of convertible subordinat- ed debentures. The Corporation is authorized to issue up to 2,000,000 shares of preferred stock and 2,000,000 shares of voting preference stock. A-29 Adjustable Rate Preferred Stock - Information concerning issued and out- standing shares of adjustable rate preferred stock at December 31, 1993 and 1992, is summarized below: The Corporation has called for redemption at par in March 1994, all outstanding shares of the Series D preferred stock at $50 per share, plus accrued dividends. The Series E stock is deposited with a bank under a depositary agreement and is represented by 1,000,000 Depositary Shares. The Series E preferred stock is redeemable at the option of the Corporation at $103.00 per depositary share through April 30, 1994, thereafter at $100 per depositary share. Holders of the preferred stock are entitled to its stated value upon involuntary liquidation. Dividend rates are determined quarterly, in advance, based on the "Applicable Rate" (such rate being the highest of the three-month U.S. Treasury bill rate, the U.S. Treasury ten-year constant maturity rate and the U.S. Treasury twenty-year constant maturity rate, as defined), as set forth below: Shareholder Rights Plan - The outstanding shares of common stock include one voting preference stock contingent purchase right. The rights are exercisable only if a person or group acquires beneficial ownership of 20% or more, or commences a tender or exchange offer upon consummation of which such person or group would beneficially own 30% or more of the Corporation's com- mon stock. Under those conditions, each right could be exercised to purchase one two-hundredth share of a new series of voting preference stock at an exercise price of $60. If any person becomes the beneficial owner of 30% or more of the Corpora- tion's common stock, or if a 20%-or-more shareholder engages in certain self- dealing transactions, or if in a merger transaction with the Corporation in which the Corporation is the surviving corporation and its common stock is not changed or converted, then each right not owned by such person or related parties will entitle its holder to purchase, at the right's then-current exercise price, shares of the Corporation's common stock (or, in certain circumstances as determined by the Board of Directors, other consideration) having a value of twice the right's exercise price. In addition, if the A-30 Corporation is involved in a merger or other business combination transaction with another person in which its common stock is changed or converted, or sells 50% or more of its assets or earning power to another person, each right will entitle its holder to purchase, at the right's then-current exercise price, common stock of such other person having a value of twice the right's exercise price. The rights, which have no voting privileges, expire on May 5, 1996. The Corporation will generally be entitled to redeem the rights at $.05 per right at any time until the 15th day following public announcement that a 20% position has been acquired. Management Incentive Program - As of December 31, 1993, the Corporation's Management Incentive Program consisted of two separate plans, the Unit Plan and the Non-Qualified Performance - Stock Option Plan. Key employees participating in the Unit Plan and Stock Option Plan totaled 62 and 8, respectively. Under the Unit Plan, a maximum of 900,000 units outstanding at one time could be awarded from time to time to key employees by the Board of Directors. Benefits are payable in cash. At December 31, 1993 and 1992, 316,500 and 347,750 units, respectively, were outstanding. The Unit Plan was terminated by the Board of Directors in February 1994. Under the Non-Qualified Performance - Stock Option Plan, options were granted to key employees to purchase shares of common stock at an exercise option price equal to par value ($4.45). Outstanding options at December 31, 1993, covered 13,277 shares. 1981 Stock Option Plan - Incentive Stock Options and Non-Qualified Stock Options were granted to key employees to purchase shares of the Corporation's common stock at an option price of not less than the fair market value of the common stock on the date of grant. This plan terminated on September 17, 1991, and no additional grants of stock options will be made. Options exercised in 1993 were at prices ranging from $16.375 to $21.00 per share. No options were exercised in 1992 and options exercised in 1991 were at a price of $17.00 per share. Option prices of grants outstanding at December 31, 1993, ranged from $16.375 to $25.625 per share. As of December 31, 1993, options to purchase 1,307,568 shares were outstanding under such plan. The number of key employees participating in the plan was 108 as of December 31, 1993. 1991 Stock Option Plan - Non-Qualified Stock Options may be granted to key employees for the purchase of not more than 2,000,000 shares of the Corpora- tion's common stock at an option price of not less than the fair market value of the common stock on the date of grant. In February 1994, the Board of Directors amended the 1991 Stock Option Plan, subject to shareholder approval, to include provisions for Restricted Stock. A total of 88,500 shares of performance-based Restricted Stock have been authorized for issuance to certain executive officers, subject to shareholder approval of the plan amendments. Performance criteria for lifting the restrictions is related to three-year total shareholder return compared to the weighted average of a peer group of companies. Options exercised in 1993 were at prices ranging from $12.50 to $19.00 per share. No options were exercised in 1992 or 1991. Option prices of grants outstanding at December 31, 1993, ranged from $12.50 to $19.00 per share. As of December 31, 1993, options to purchase 1,068,125 shares had been A-31 granted and were outstanding under such plan. The number of key employees participating in the plan was 122 as of December 31, 1993. A summary of all stock option transactions follows: Dividends - Restrictions on the payment of dividends on common stock (other than stock dividends) or acquisitions of the Corporation's capital stock are contained in the Corporation's several trust indentures and other agreements relating to senior long-term debt and in the Restated Articles of Incorporation of the Corporation. At December 31, 1993, the amount of dividends on common stock that could be paid under the most restrictive of these agreements exceeded the combined total of the retained earnings and paid in capital of the Corporation which was $350,099 and represented the effective limitation on common stock dividends. Following the redemption of all of the outstanding sinking fund debentures and the Adjustable Rate Preferred Stock, Series D, all of which have been called for redemption in March 1994, $342,139 of the Corporation's common shareholders' equity as of December 31, 1993, would have been free of such restrictions. Dividends declared are summarized below: A-32 6. COMMITMENTS AND CONTINGENT LIABILITIES Legal Proceedings - On June 25, 1993, a lawsuit was filed against the utility division of the Corporation in the 4th Judicial District Court of Rusk County, Texas. The plaintiff claims that the utility division failed to make certain production and minimum purchase payments under a gas- purchase contract. The plaintiff contends that it was fraudulently induced to enter into a gas-purchase contract which the utility division never intended to perform; that the plaintiff was fraudulently induced and coerced into releasing the utility division from its obligation to make minimum purchase payments; and that the contract was breached. The plaintiff seeks actual damages in excess of $100 million in addition to punitive damages equal to the savings produced from a gas price reduction program implemented by the utility in 1982 or equal to the value of gas supply in excess of its needs which were added pursuant to a program established in 1978 to increase gas supply. A lawsuit was filed on February 24, 1987, in the 112th Judicial District of Sutton County, Texas, against subsidiaries and affiliates of the Corporation as well as its utility division. The plaintiffs have claimed that defendants failed to make certain production and minimum purchase payments under a gas- purchase contract. In this connection, the plaintiffs have alleged a conspiracy to violate purchase obligations, improper accounting of amounts due, fraud, misrepresentation, duress, failure to properly market gas and failure to act in good faith. In this case, plaintiffs seek actual damages in excess of $5 million and punitive damages in an amount equal to 0.5% of the consoli- dated gross revenues of the Corporation for the years 1982-1986 (approximately $85 million), interest, costs and attorneys' fees. Management of the Corporation believes that the named defendants have meritorious defenses to the claims made in these and other actions. In the opinion of management, the Corporation will incur no liability from these and all other pending claims and suits that would be considered material for financial reporting purposes. Long-term Contracts - The Corporation's environmental business enters into contracts which have provisions for significant financial penalties should certain terms of performance not be achieved. Such contract provisions have not and are not expected to have a material effect on the Corporation's operations. Gas-Purchase Contracts - See "Financial Review - Gas-Purchase Contracts" for a discussion of commitments and contingencies relating to gas-purchase contracts. Environmental Matters - The Corporation is subject to federal, state, and local environmental laws and regulations. These laws and regulations, which are constantly changing, regulate the discharge of materials into the environment. Environmental expenditures are expensed or capitalized depending on their future economic benefit. The level of future expenditures for environmental matters, including costs of obtaining operating permits, enhanced equipment monitoring and modifications under the Clean Air Act and cleanup obligations, cannot be fully ascertained at this time. However, it is management's opinion that such costs, when finally determined, will not have A-33 a material adverse effect on the consolidated financial position of the Corporation. Lease Commitments - In May 1992, EP entered into an operating lease arrangement to provide financing for its portion of the offshore platform and related facilities for the 37 1/2% owned Mississippi Canyon Block 441 project. A total of $34 million was required for the Mississippi Canyon project, which was completed in early 1993. EP leased the facilities for an initial period through May 20, 1994, with an option to renew the lease, with the consent of the lessor, for up to 10 successive six-month periods. The lease has been renewed through November 20, 1994 and the Corporation expects to renew the lease for all renewal periods. EP has the option to purchase the facilities throughout the lease periods and as of December 31, 1993, has guaranteed an estimated residual value for the facilities of approximately $27 million should the lease not be renewed. Expenses incurred under the lease in 1993 were $2.1 million. The estimated future minimum net rentals for the Mississippi Canyon operating lease is $6.3 million for 1994. In September 1992, EP entered into an operating lease arrangement to pro- vide financing for the offshore platform and related facilities of its 100% owned Garden Banks Block 388 project. The lessor will fund the construction cost of the facilities quarterly, up to a maximum of $235 million. As of December 31, 1993, a total of $60 million had been advanced to EP under the lease as agent for the lessor, $31 million of which was unexpended and reflected as a current liability. EP will lease the facilities for an initial period through March 31, 1997, with the option to renew the lease, with the consent of the lessor, for up to three successive two-year periods. EP, as agent for the lessors, will acquire, construct and operate the units of leased property and has guaranteed completion of construction of the facilities. EP has the option to purchase the facilities throughout the lease periods and has guaranteed an estimated residual value for the facil- ities of approximately $188 million, assuming the full lease amounts are advanced and expended, should the lease not be renewed. The estimated future minimum net rentals for the Garden Banks operating lease are as follows: $4.8 million for 1994; $9.1 million for 1995; $9.1 million for 1996; and $2.3 million for 1997. Lease payments are being deferred during the con- struction period and will be amortized when production begins. In addition, the Corporation had a number of other noncancelable long-term operating leases at December 31, 1993, principally for office space and machinery and equipment. Future minimum net rentals under these noncancelable long-term operating leases aggregate $9.7 million for 1994; $8.9 million for 1995; $6.6 million for 1996; $6.5 million for 1997; $4.7 million for 1998; and $51.9 million thereafter. Future minimum rental income to be received for subleased office space is $9.3 million over the next five years. Rental expenses incurred under operating leases aggregated $14.3 million in 1993; $19.4 million in 1992; and $20.3 million in 1991. Rental income received for subleased office space was $3.4 million in 1993; $4.7 million in 1992; and $4.7 million in 1991. Sales of Receivables - The Corporation has an agreement, which has been extended to 1996, with a commercial bank for the limited recourse sale of up to $100 million of Lone Star's receivables. Additional receivables are continually sold to replace those collected. The agreement the Corporation had A-34 for the limited recourse sale of up to $75 million of Ebasco accounts receivable was assumed by the purchaser as part of the sale of Ebasco. In December 1993, the Corporation entered into an agreement with a bank for the limited recourse sale of $100 million of receivables retained from the sale of Ebasco. This program is self-liquidating as new receivables will not be sold to replace those collected. As of December 31, 1993 and 1992, the uncollected balances of receivables sold under all existing agreements were $200 million and $175 million, respectively. Contingent Support Agreement - In connection with the sale of its oil field services segment to Pool Energy Services Co. (PESC) in 1990, ENSERCH entered into a Contingent Support Agreement (Agreement) by which ENSERCH is providing PESC with limited financial support. PESC is obligated to repay ENSERCH for any amounts paid out under guarantees and contingent obligations, together with interest accrued thereon. Support provided under the Agreement at January 1, 1994, consists of (i) the guarantee supporting the financing of PESC's Saudi Arabian affiliate, Pool Arabia, Ltd., totaling $3.1 million until July 31, 1996, and (ii) the $31 million guarantee outstanding in connection with a facility lease that is reduced periodically until fully released in March 2003. The stock of Pool International, Inc. has been pledged to ENSERCH as collateral for the Agreement. ENSERCH's lien on this collateral will remain so long as the guarantee of the Pool Arabia loan is outstanding. Guarantees - In addition to guarantees mentioned above, the Corporation and/or its subsidiaries are the guarantor on various commitments and obliga- tions of others aggregating some $60 million at December 31, 1993. The Corporation is exposed to loss in the event of nonperformance by other parties. However, the Corporation does not anticipate nonperformance by the counterpart- ies. Financial Instruments With Concentrations of Credit Risk - The transmission and distribution operations have trade receivables from a few large industrial customers in the north central area of Texas arising from the sale of natural gas. The environmental operations have several large receivables from projects that are subject to governmental funding approvals. A change in economic conditions in a particular region or industry or change in local taxing authority may affect the ability of customers to meet their contractual obligations. The Corporation believes that its provision for possible losses on uncollectible accounts receivable of continuing operations is adequate for its credit loss exposure. At December 31, 1993 and 1992, the allowance for possible losses deducted from accounts receivable on the balance sheet was $4,105 and $6,590, respectively. 7. RETIREMENT PLANS The Corporation has retirement plans covering substantially all its employees and employees of its subsidiaries. Upon the sale of the principal operating assets of Ebasco in 1993, the Corporation retained the obligations related to the Ebasco pension plan, including the obligation for benefits due Ebasco employees hired by the purchaser to date of sale and Ebasco employees A-35 terminated as a result of the sale. The employees hired by the purchaser are considered fully vested with full rights in the plan but frozen benefits. The terminated employees are due the benefits for which they were eligible at the date of their termination. Since no further benefits will accrue to these two groups of former Ebasco employees, the Corporation recognized a plan curtail- ment gain in 1993 of $6.9 million, which was included as a part of the gain on the sale. The following table sets forth the funded status of all plans as of September 30, 1993 (adjusted to reflect the effects of the sale of Ebasco) and 1992, and the amounts recognized in the consolidated balance sheet at December 31: The accumulated benefit obligations represent the actuarial present value of benefits based on employees' history of service and compensation up to the measurement dates (September 30, 1993 and 1992). The projected benefit obliga- tions include additional assumptions about future compensation levels. The accumulated benefit obligations and the projected benefit obligations for 1993 and 1992 were determined using an assumed discount rate of 7.25% and 8.5%, respectively, and an assumed rate of compensation increase of 4% for both 1993 and 1992. The assumed long-term rate of return on plan assets was 9.5% for 1993 and 10% for 1992. The benefit obligations fluctuate with the assumed discount rate. When the rate declines, as it did in 1993 from the broad reduction in interest rates, the actuarial present value of benefit obligations increases. Some $68 million of the increase in the benefit obligations was primarily due to the reduction in the assumed discount rate in 1993 and is reflected in the unrecognized net actuarial gain (loss). A-36 The Corporation and its subsidiaries make annual contributions to the plans in such amounts as are necessary, on an actuarial basis, to satisfy minimum funding requirements of ERISA. Accrued pension cost represents the amount of pension cost recognized in excess of contributions paid. Benefits vary by plan and generally are determined by the participant's years of credited service and average compensation during the highest five years prior to retirement or during each participant's career. Plan assets consist primarily of preferred and common stocks, corporate bonds and U.S. government securities. The components of pension cost were as follows: 8. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," became effective in January 1993 and mandates the accounting for medical and life insurance and other nonpension benefits provided to retired employees. The new standard requires accrual of these benefits over the working life of the employee, similar in manner to the requirement for pension benefits, rather than charging to expense on a cash basis. The Corporation and its subsidiaries provide varying postretirement medical benefits to its retirees and employees based on their hiring date, years of service and retirement date. Except for Ebasco employees, retirees and their dependents who retired on or before December 31, 1990, and employees age 62 or older on that date who subsequently retire, are entitled to full medical coverage. Employees hired before July 1, 1989 who retire with a minimum of five years of service are provided with an annual subsidy, based on years of service, with which to purchase medical coverage. Employees hired after July 1, 1989, are not eligible for medical benefits when they retire. Ebasco provided limited postretirement medical benefits to certain of its employees who retired prior to January 1, 1993. Upon the sale of the principal operating assets of Ebasco in 1993, the Corporation retained the obligations to retirees of Ebasco under this plan. A-37 The Corporation does not prefund its obligations under the plan. The following table sets forth the funded status of all plans as of September 30, 1993, and the amounts recognized in the consolidated balance sheet at December 31, 1993 (in millions): The accumulated postretirement benefit obligation represents the actuarial present value of employee medical and life insurance benefits based on employees' history of service up to the measurement date (September 30, 1993.) It was determined using an assumed discount rate of 7.25% and an assumed medical cost trend rate of 12% for 1994 declining to a rate of 6% after the year 2002. If the medical cost trend rate was increased by 1%, the December 31, 1993 accumulated postretirement benefit obligation would have increased by $7.0 million and the 1993 net periodic benefit cost would have increased by $.9 million. The accumulated postretirement benefit obligation as of January 1, 1993, was $70 million assuming an 8 1/2% discount rate. This transition obligation is being amortized over allowable periods up to 20 years. In 1993, the reduction in the discount rate to 7.25% was the primary cause of the increase in the benefit obligation, which is reflected in the net actuarial loss. The components of postretirement benefit cost for 1993 were as follows (in millions): Accrued postretirement benefit cost represents the amount of benefit cost recognized in excess of benefits paid. Cash payments totaled $8.1 million in 1993, $7.5 million in 1992 and $6.9 million in 1991. A-38 Of the amounts noted above, about $34 million of the unrecognized transi- tion obligation and $4.7 million of the 1993 expense are attributable to Lone Star's rate-regulated activities. Lone Star's related cash payments in 1993 were $2.7 million. Cash basis is the method of recovery currently followed in the rate-making process. Lone Star has deferred approximately $.5 million of the $2.0 million difference in the 1993 net periodic expense and cash pay- ments, although the full amount is subject to future recovery through rates. 9. INCOME TAXES The provision (benefit) for income taxes on continuing operations is summarized below: A-39 A reconciliation between income taxes (benefit) computed at the federal statutory rate and income-tax expense (benefit) of continuing operations is shown below: Deferred income taxes are provided for all significant temporary differences by the liability method, whereby deferred tax assets and liabil- ities are determined by the tax laws and statutory rates in effect at the balance sheet date. Temporary differences which give rise to significant deferred tax assets and liabilities at December 31, 1993 are as follows: A-40 At December 31, 1993, the Corporation had domestic net operating-loss carryforwards and suspended losses from partnerships of $161 million which begin to expire in 2003, and tax-credit carryforwards of $37 million, which begin to expire in 1999. The tax benefits of these carryforwards and suspended losses, which total some $93 million as shown above, are available to reduce future income-tax payments. The Corporation made payments (received refunds) for income taxes as follows: The tax effect of the gain on sale differs from tax at the statutory rate because of permanent differences in book and tax basis of the assets sold. The determination of the gain on sale involved significant estimates including the final purchase price, realization of the estimated value of retained assets, and related income-tax matters. In management's opinion, adequate provision has been made for these matters. 12. SUPPLEMENTAL FINANCIAL INFORMATION Quarterly Results (Unaudited) - The results of operations by quarters are summarized below and have been restated for the discontinuance of the engineering and construction business segment and the realignment of operations for segment of business reporting that became effective in the first quarter of 1993. Consolidated operating income and net income were not affected by the realignment. In the opinion of the Corporation, after the restatement, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation have been made. A-43 A-44 A-45 Reconciliation of Previously Reported Quarterly Information Quarterly amounts previously reported for the year 1992 and the first three quarters of 1993 have been restated in the above tables to give effect to the discontinued engineering and construction operations referred to in Note 11. The restatement affected the various components of the quarterly results as follows: Disposal of Significant Assets In 1993, the Corporation sold a gas storage facility and a minority- investment in an insurance entity and realized a pretax gain of $7.0 million. Effective January 1, 1992, the Corporation transferred the assets and business of Enserch Gas Transmission Company to a new partnership, Gulf Coast Natural Gas Company, for $19 million and a 50% ownership of the new partner- ship. No gain or loss resulted from the transfer. The Corporation uses the equity method to account for its interest in the new partnership. In December 1991, the Corporation completed the sale of Enserch Nether- lands, Inc., for $32.1 million and recorded a pretax gain on the sale of $6.0 million. In June 1991, the Corporation completed the sale of its Oklahoma utility properties, for approximately $31 million, and recorded a pretax gain on the sale of $9.1 million. A-46 Cash Flows - The Corporation considers all highly liquid investments in the United States with a maturity of three months or less to be cash equivalents. The decrease (increase) in current operating assets and liabilities for con- tinuing operations is summarized below. Supplemental disclosure of noncash financing and investing activities The $15.8 million pretax charge in 1992 for termination of an interest-rate hedge described in Note 2 was a noncash transaction. A-47 Environmental business long-term contracts The following tabulation indicates accounts receivable and the components of unbilled costs, estimated earnings and retainages relating to uncompleted contracts as of December 31, 1993: In accordance with industry practice, unbilled costs and fees relating to contracts having a duration of longer than one year are classified as current assets. Costs and fees on long-term contracts that have been billed to clients, but that have not yet been paid, are included in accounts receivable. Unbilled costs and fees on uncompleted contracts are generally includable in the following month's billings, or become billable on a progress basis, pursuant to the terms of the contract billing schedule. The balances billable pursuant to retainage provisions in contracts will be due upon substantial completion of the contract and acceptance by the client. Assignment of Future Gas Purchase Credits - At December 31, 1993 and 1992, assignments of future gas purchase credits from advances and prepayments for gas were $38,191 and $54,114, respectively (of which $26,028 and $18,214, respectively, were current). The credits are reduced by an amount equal to the reduction in the related asset, advances and prepayments for gas, which are based upon amounts of gas purchased by the Corporation under related gas purchase contracts. The assignment of future gas purchase credits provided for an average annual finance charge of 3.6% during December 1993. Restructuring Charges - In December 1993, the Corporation recognized a $12 million charge for efficiency enhancements and severance expenses accrued for staff reductions in Natural Gas Transmission and Distribution operations. Business Segments - Information by business segments presented elsewhere herein is an integral part of these financial statements. A-48 13. SUPPLEMENTARY GAS AND OIL INFORMATION Gas and Oil Producing Activities - The following tables set forth informa- tion relating to gas and oil producing activities. Reserve data for natural gas liquids attributable to leasehold interests owned by the Corporation are included in oil and condensate. A-49 Excluded Costs - The following table sets forth the composition of capitalized costs excluded from the amortizable base as of December 31, 1993: Approximately 43% of the excluded costs relates to offshore activities in the Gulf of Mexico and the remainder is domestic onshore exploration activi- ties. The anticipated timing of the inclusion of these costs in the amortiza- tion computation will be determined by the rate at which exploratory and development activities continue, which are expected to be accomplished within ten years. Gas and Oil Reserves (Unaudited) - The following table of estimated proved and proved developed reserves of gas and oil has been prepared by the Corporation utilizing estimates of yearend reserve quantities provided by DeGolyer and MacNaughton, independent petroleum consultants. Reserve estimates are inherently imprecise and estimates of new discoveries are more imprecise than those of producing gas and oil properties. Accordingly, the reserve estimates are expected to change as additional performance data becomes available. Oil reserves (which include condensate and natural gas liquids attributable to leasehold interests) are stated in thousands of barrels (MBbl). Gas reserves are stated in million cubic feet (MMcf). A-50 Included in the U.S.-Oil reserve estimates are natural gas liquids for leasehold interest of 1,019 MBbl for 1991; and 985 MBbl for 1992; and 1,117 MBbl for 1993. A-51 Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Gas and Oil Reserve Quantities (Unaudited) - has been prepared by the Corporation using estimated future production rates and associated production and development costs. Continuation of economic con- ditions existing at the balance sheet date was assumed. Accordingly, estimated future net cash flows were computed by: applying contracts and prices in effect in December to estimated future production of proved gas and oil reserves; estimating future expenditures to develop proved reserves; and estimating costs to produce the proved reserves based on average costs for the year. Average prices used in the computations were: Because of the imprecise nature of reserve estimates and the unpredictable nature of the other variables used, the standardized measure should be interpreted as indicative of the order of magnitude only and not as precise amounts. A-52 The following table sets forth an analysis of changes in the standardized measure of discounted future net cash flows from proved gas and oil reserves: A-53 A-54 COMMON STOCK MARKET PRICES AND DIVIDEND INFORMATION MARKET PRICES - ENSERCH COMMON STOCK The Corporation's common stock is principally traded on the New York Stock Exchange. The following table shows the high and low sales prices per share of the common stock of the Corporation reported in the New York Stock Exchange - - Composite Transactions report for the periods shown as quoted in The Wall Street Journal (WSJ). DIVIDENDS PER SHARE OF COMMON STOCK As of December 31, 1993, the Corporation had paid 198 consecutive quarterly cash dividends on its common stock. At December 31, 1993, $350 million of the consolidated common shareholders' equity of the Corporation was free of restrictions as to the payment of dividends and redemption of capital stock. The declaration of future dividends will be dependent upon business conditions, earnings, the cash requirements of the Corporation and other relevant factors. In February 1994, the Corporation declared a quarterly cash dividend of 5 cents per share payable March 7, 1994, to share- holders of record on February 18, 1994. A-55 Two million shares of PESC common stock, obtained in connection with the sale of Pool Company and set aside as a special dividend to ENSERCH sharehold- ers, were distributed in November 1990. The common stock was distributed at the rate of one share of PESC for every 32.368 shares of ENSERCH common stock, equivalent to $.33 per share. A-56 APPENDIX B ENSERCH CORPORATION AND SUBSIDIARY COMPANIES INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES DECEMBER 31, 1993 Page ---- Independent Auditors' Report................................. B-2 Consolidated Financial Statement Schedules for the Three Years Ended December 31, 1993: V - Property, Plant and Equipment..................... B-3 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment................ B-6 IX - Short-Term Borrowings............................. B-9 X - Supplementary Income Statement Information........ B-10 B-1 INDEPENDENT AUDITORS' REPORT ENSERCH CORPORATION: We have audited the consolidated financial statements of ENSERCH Corporation and subsidiary companies 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 7, 1994; (included elsewhere in this Form 10-K). Our audits also included the consolidated financial statement schedules of ENSERCH Corporation listed in Item 14. These consolidated financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. 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. DELOITTE & TOUCHE Dallas, Texas February 7, 1994 B-2 B-3 B-4 B-5

856529_1993.txt

856529_1993

1993

856529

ITEM 1. Business Introduction Berlitz International, Inc. (the "Company") is a New York corporation, organized in 1989. Prior to the organization of the Company, the Company's business was conducted through subsidiaries of Macmillan, Inc. ("Macmillan") including: Berlitz Languages, Inc. (Language Instruction and Translation Services), Editions Berlitz, S.A. and Berlitz Publications, Inc. (Publishing). Prior to the Company's initial public offering in December 1989, Macmillan caused the Company to be incorporated and transferred to it the capital stock of these predecessor corporations in exchange for shares of the capital stock of the Company. In February 1993, Fukutake Publishing Co., Ltd. ("Fukutake") acquired indirectly through merger (the "Merger") 67% of the outstanding common stock, par value $.10 per share, of the Company ("New Common") and the existing public shareholders of the Company hold approximately 33% of the Company. See Items 5 and 7 for further discussion. The Company's operations are conducted through the following business segments: Language Instruction, Translation Services, and Publishing. Language Instruction is organized on a geographic basis into five (changed from four in 1992) operating divisions: North America (U.S. and Canada), Western Europe (twelve countries), Central/Eastern Europe (seven countries), East Asia (Japan, Thailand and Hong Kong) and Latin America (seven countries including Puerto Rico). Some countries are divided into regions and districts. Translation Services is organized on a geographic basis into three operating divisions: the Americas (U.S., Canada and Chile), Europe (13 countries) and East Asia (Japan). Publishing is organized on a geographic basis into two operating divisions (the U.S. and the United Kingdom). The Company's Japanese operations are conducted through its Japanese subsidiary which is owned 80% by the Company and 20% by Fukutake. At least 90% of total East Asia sales, operating profits, assets and employees are attributable to the operations in Japan. Country and division managers determine pricing, teacher/translator and administrative salaries, leasing of facilities, advertising and promotion, and other administrative matters, within guidelines established at corporate headquarters. The country managers are evaluated and provided incentives based on profit performance of their particular areas while division managers are provided incentives based on profit performance of the Company as a whole. Business segment and geographic area information is incorporated herein in the Notes to Consolidated Financial Statements within Item 8, Financial Statements and Supplementary Data, under Note 15. Language Instruction As of December 31, 1993, the Company operated 322 language centers in 31 countries using the Berlitz (Registered Trademark) Method, as described herein, and the Company's proprietary instruction material, to provide instruction in virtually all languages. Approximately 4.6 million language lessons were given in 1993, the most frequently taught languages being English, Spanish, French and German. Revenues from Language Instruction accounted for approximately 82%, 83% and 85% of total Company revenues in 1993, 1992 and 1991, respectively. The following tables set forth, by geographic division, the number of language centers and the number of lessons given over the last five years: Number of Centers at December 31, ________________________________________ 1993 1992 1991 1990 1989 ____ ____ ____ ____ ____ North America 72 73 68 67 67 Western Europe 61 68 65 65 62 Central/Eastern Europe 75 71 58 53 50 East Asia 57 59 56 53 50 Latin America 57 53 51 46 43 ____ ____ ____ ____ ____ Total 322 324 298 284 272 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ Number of Lessons (in thousands) _________________________________________ *1993 1992 1991 1990 1989 _____ _____ _____ _____ _____ North America 1,091 1,123 1,097 1,088 981 Western Europe 892 1,030 1,181 1,297 1,190 Central/Eastern Europe 904 896 841 878 910 East Asia 844 1,003 1,093 1,148 1,076 Latin America 857 818 713 693 791 _____ _____ _____ _____ _____ Total 4,588 4,870 4,925 5,104 4,948 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ * Excludes 137 lessons for language centers closed or to be closed in connection with the Merger. A lesson consists of a single 45-minute session given by a teacher (regardless of the number of students). In 1993, the United States, Japan, and Germany accounted for 21%, 17% and 13% of lessons given and 21%, 27% and 15% of Language Instruction sales, respectively. All of the Company's language centers are wholly-owned, except for a joint venture operation in Russia and two franchised language centers in Egypt. The following table sets forth, by geographic division, the number of language centers in each of the countries in which the Company owns and operates centers as of December 31, 1993: WESTERN EUROPE NORTH AMERICA Belgium 10 United States 62 Denmark 3 Canada 10 Finland 1 Total 72 France 17 Holland 1 Israel 1 LATIN AMERICA Italy 7 Argentina 5 Norway 1 Brazil 16 Portugal 1 Chile 4 Spain 13 Colombia 4 Sweden 1 Mexico 15 United Kingdom 5 Puerto Rico 4 Total 61 Venezuela 9 Total 57 CENTRAL/EASTERN EUROPE Austria 8 Czech Republic 3 Germany 48 Hungary 3 EAST ASIA Poland 2 Hong Kong 1 Russia 1 Japan 54 Switzerland 10 Thailand 2 Total 75 Total 57 In 1993, 12 language centers were opened and 14 were closed, bringing the worldwide total to 322. The average capital expenditure incurred in connection with opening a new language center in 1993 was approximately $176,000. Language centers traditionally have been wholly-owned operations and the Company has traditionally financed the cost of expansion with internally generated funds and does not anticipate that borrowing will be necessary to finance the Company's planned expansion. Berlitz (Registered Trademark) Method. At the heart of Berlitz (Registered Trademark) Instruction is the successful Berlitz (Registered Trademark) Method, a proven technique that enables students to acquire a working knowledge of the foreign language in a short period of time. Through the exclusive use of the target language in the classroom, students learn to think and speak naturally in the new language, without translation. With its primary objective to develop conversational comprehension and speaking skills, the Berlitz (Registered Trademark) Method combines the use of live instruction with proprietary written and audio-visual support materials to ensure a fast, effective, and enjoyable learning experience. Berlitz (Registered Trademark) instructors teach in their native language and are required to complete a seven to ten-day training course in the Berlitz (Registered Trademark) Method. Upon successful completion of this training course, instructors work either full-time or part-time. The Berlitz (Registered Trademark) Method does not require that an instructor be proficient in any language other than the language being taught. This feature of the Berlitz (Registered Trademark) Method greatly increases the number of potential instructors and tends to lower instructor costs. The Company's centralized management and ownership of language centers permits standardization of instructional method and materials. This standardization also allows a client to begin a Berlitz (Registered Trademark) course in one location and complete it anywhere in the worldwide network of Berlitz (Registered Trademark) language centers. Through application of uniform standards to instructor training, development of materials, and classroom instruction, the Company seeks to achieve consistent and predictable instructional results. Language Instruction Programs. The Company offers several types of language instruction programs, which vary in cost, length and intensity of study. Believing individualized instruction to be the most effective way to learn a foreign language, the Company emphasizes one-on-one instruction, including private lessons and Total Immersion (Registered Trademark) study as described below. The Company also offers semi-private and group lessons. Approximately 51% of all tuition revenues in 1993 were from private lessons (excluding Total Immersion (Registered Trademark)). Private instruction is typically provided in blocks of three or more 45-minute lessons, with a short break after each lesson. Total Immersion (Registered Trademark) courses, an intensive form of private instruction, accounted for 5% of tuition revenues in 1993. Total Immersion (Registered Trademark) programs last a full day and generally continue for two to six weeks. The Company also offers semi-private lessons designed for two to four clients, as well as group instruction, where class sizes are three or more students. Group classes generally meet over a period of weeks. Semi-private and group lessons represented 44% of tuition revenues in 1993. As a substantial majority of its clients are enrolled for business or professional reasons, the Company's business is influenced by the level of international trade and economic activity. In addition to individuals seeking work-related language skills, Berlitz (Registered Trademark) clients also include travelers and high school and university students developing course-related language skills. Included in the Language Instruction business are programs that combine intensive language instruction with first-hand exposure to the cultural environment of the country of the target language. The Company has two programs in this specialty instruction area: Language Institute For English ("L.I.F.E. (Registered Trademark)"), a Berlitz (Registered Trademark) branch since 1988, and Berlitz (Registered Trademark) Study Abroad. A third specialty program, Berlitz (Registered Trademark) Jr., provides complete language instruction programs to children in public and private schools throughout the world. Together, these specialty areas accounted for approximately 4% of the Company's revenues in 1993. Marketing and Pricing Policy. The Company directs its marketing efforts toward individuals, businesses and governments. The Company utilizes newspaper, magazine and yellow page advertising in addition to direct contacts. Marketing efforts are coordinated on a country-by-country basis. Center directors, district managers and regional managers are responsible for sales development with existing and new clients. In addition, sales forces are maintained in the Company's major markets to supplement other marketing methods. Tuition, which is payable in advance by most individual clients and some corporate clients, includes a registration fee, a charge for printed and recorded course materials, and a per lesson fee. The per lesson fee varies depending on the language being taught, type of lesson and country. Total Immersion (Registered Trademark) courses are more expensive than standard individualized instruction, while semi-private and group instruction are the least expensive. The Company generally negotiates fees with its corporate clients based on anticipated volume. Concentration on the intensive, individualized segment of the market has enabled the Company to maintain a pricing structure consistent with a premium product. The Company, whose prices are usually higher than those charged by its competitors, believes that it is able to charge premium prices because of its reputation and the high and consistent quality of instruction it provides. Competition. The language instruction industry is fragmented, varying significantly among different geographic locations. In addition to the Company, providers of language instruction generally include individual tutors, small language schools operated by individuals and public institutions, and franchises of large language instruction companies. The smaller operations typically offer large group instruction and self-teaching materials for home study. Rather than compete with these small operators, the Company concentrates on its leading position in the higher-priced, business-oriented segment of the language instruction market through its offering of intensive and individualized instruction. No competitors in this market offer language instruction through wholly-owned operations on a worldwide basis. However, the Company does have a number of competitors organized on a franchise basis which, although not as geographically diverse as the Company, compete with it internationally. The Company also faces significant competition in a number of local markets. Translation Services Berlitz (Registered Trademark) Translation Services provides high quality technical translation, interpretation, software localization, electronic publishing, and other foreign language related services. Translations represented approximately 13%, 12% and 9% of total Company revenues in 1993, 1992 and 1991, respectively, and is expected to contribute an increasingly larger percentage of total corporate revenues over the next few years as a result of recent restructuring efforts, an expanded and restructured sales force and a greater focus on larger customers. Berlitz (Registered Trademark) Translations sales focus is on industry segments viewed by management as likely to contribute to the future growth of the business, such as: information technology, automotive/manufacturing, medical technology/pharmaceutical, and telecommunications. The Company has an international network comprised of 27 translation centers in 18 countries, including Baldock (England), Bergen (Norway), Copenhagen, Dublin, Los Angeles, Montreal, New York, Paris, Santiago, Sindelfingen (Germany), Toronto, Tokyo and other locations worldwide. Materials are electronically transferred between locations to utilize specialized in-country translations and production facilities in order to produce the highest quality products and reduce costs. The Company has developed a global network of translators that provides it with a broad range of technical and linguistic resources. The Company has also developed a production process that incorporates several editing phases designed to maximize the accuracy of its translations. Production staffs at dedicated Translation facilities generally consist of production managers, editors and translators. Managers and editors are generally full-time staff members, while the translator staff is comprised of both full-time employees and freelance workers. Freelance translators provide the specialized skills that are necessary for technical translations at a more cost effective rate than that of full-time employees. Translation Services has expanded through a number of strategic alliances and acquisitions. In 1989, the Company acquired Institute for Fagsprog A/S (Copenhagen, Denmark) and in 1990 acquired Able Translations, Ltd. (Baldock, England). Kayser Coll. Technische Ubersetzer (Sindelfingen, Germany) and NorDoc A/S (Norway), were acquired in 1991. Also in 1991, Berlitz acquired a 51% interest in Softrans International Limited ("Softrans"), a Dublin-based leading supplier of software localization related services in Europe. In 1993, an additional 19% interest in Softrans was acquired. Competition. In the highly fragmented translation services market, providers compete on the basis of price, accuracy and job turnaround time. The Company does not believe that any one company accounts for a significant portion of the entire commercial translation market. Publishing The Company publishes pocket-size travel guides and language phrase books through its facilities in Europe. In addition, Publishing's list includes an extensive range of bilingual dictionaries, trade paperback travel guides and self-teaching language products. It is also involved with licensing projects that capitalize on the Berlitz (Registered Trademark) name in the international consumer market. The Publishing business accounted for approximately 5%, 5% and 6% of total Company revenues in 1993, 1992 and 1991, respectively. Approximately 52%, 55% and 63% of Publishing segment sales in 1993, 1992 and 1991, respectively were in Europe. Berlitz (Registered Trademark) Books and Guides. Pocket-size, smaller format travel guides include full-color pictures, maps, brief histories, points of interest, food and shopping information and a practical A to Z section. There are a total of 132 titles in this format published in English, plus approximately 480 titles in more than thirteen other languages. For these multiple-language titles the Company employs manufacturing techniques utilizing the same graphics and layouts to reduce manufacturing costs. Larger format travel guides, which include more detailed descriptive information, are available primarily in English in two series: The Berlitz (Registered Trademark) Travellers Guides and the Discover series. The latter series will incorporate titles previously published in the Blueprint (Registered Trademark) series. The Company's phrase books include common expressions, words and phrases most often used by travelers. These appear in color-coded sections covering such topics as accommodations, eating, sightseeing, shopping, transportation and medical reference. There are a total of 117 phrase books published in twelve languages, of which 29 are for English-speaking travelers. A European Phrase Book and a European Menu Reader are published in eight languages. Additional travel- related language products include Cassette Packs and Compact Disc Packs, which consist of a 90-minute cassette tape or a 75 minute compact disc ("CD") and phrase book packaged and sold together. Retail distribution for the books and audio products is through established national distributors. These distributors sell to wholesalers, chain stores and individual retail outlets. Berlitz (Registered Trademark) Self-Teaching. The audio cassette and CD products produced by the Company are intended for the self-instruction language market and draw on the experience of the Language Centers. These products include courses for children and business people. In the U.S., the audio cassette and CD products are marketed through in-flight airline magazine space advertising, through credit card statement inserts for which the credit card company is compensated based on orders received in response to promotions, and through another performance-based cooperative joint marketing venture with a national magazine publisher. In addition to the audio cassette and CD products, the Company is presently involved in several joint development and licensing arrangements for products which use published Berlitz (Registered Trademark) materials as the basis of alternate media products (such as hand-held electronic reference products and computer software) for which the Company receives royalties. The Company's marketing plan includes the relaunching of certain existing product lines and the creation of new products that will compete in today's market place. The Company establishes retail distribution through national distributors, who are responsible for the retail, wholesale, special sales, and travel industry sales channels. In addition to retail distribution, the Company markets the self-teaching language products through direct mail campaigns. The Company utilizes in-flight airline magazine advertising, credit card statement inserts and consumer magazine advertising in its United States marketing. In Europe and East Asia, the Company handles direct mail through a number of licensees. Competition. The market for the Company's publications and self- teaching language products is sensitive to factors that influence the level of international travel, tourism and business. There is intense competition in nearly all markets in which the Company sells its published products. The Company's market share and Berlitz (Registered Trademark) brand name recognition levels vary considerably depending on market and product line. Employees As of December 31, 1993, the Company employed 1,899 full-time employees and 1,986 full-time employee equivalents. Due to the nature of its businesses, the Company retains a large number of teachers and translators on a freelance basis. Full-time employee equivalents are calculated by aggregating all part-time instructor hours and dividing these by the average number of hours worked by a full- time employee. The Company is party to collective bargaining agreements in Canada, Denmark, France, Austria, Germany, and Italy which do not cover a significant number of employees. The Company believes it has satisfactory employee relations in the countries in which it operates. Certain countries in which the Company operates impose obligations on the Company with respect to employee benefits. None of these obligations materially inhibits the Company's ability to operate its business. General The material trademarks used by the Company and its subsidiaries are BERLITZ (Registered Trademark), TOTAL IMMERSION (Registered Trademark) (including foreign language variations used in certain foreign markets) and L.I.F.E. (Registered Trademark). The Company or its subsidiaries hold registrations for these trademarks, where possible, in all countries in which (i) material use is made of the trademarks by the Company or its subsidiaries, and (ii) failure to hold such a registration is reasonably likely to have a material adverse effect on the Company or its subsidiaries. The duration of the registrations varies from country to country. However, all registrations are renewable upon a showing of use. The effect of the registrations is to enhance the Company's ability to prevent certain uses of the trademarks by competitors and other third parties. In certain countries, the registrations create a presumption of exclusive ownership of the trademarks. Although the Company is not generally regulated as an educational institution in the jurisdictions in which it does business, it is subject to general business regulation and taxation. The Company's foreign operations are subject to the effects of changes in the economic and regulatory environments of the countries in which the Company operates. ITEM 2. ITEM 2. Properties The Company has its headquarters in Princeton, New Jersey and maintains facilities throughout the world. Except for eight facilities in France, Spain, Hungary, Brazil and Chile, all of the Company's facilities, including its headquarters, are leased. Total annual rental expense for the twelve months ended December 31, 1993 was $23,074,000. No one facility is material to the operation of the Company. A typical Berlitz (Registered Trademark) language center has private classrooms designed for one-on-one instruction, as well as some larger rooms suitable for small group instruction. The following tables set forth, as of December 31, 1993, by geographic region, the number of facilities maintained in that region, the use of the Company's facility, whether owned or leased, and the aggregate square footage: OWNED FACILITIES Number of Aggregate Region Facilities Use Square Footage ______ __________ ___ ______________ Western Europe 3 Center/Leased to Others 4,370 Central/Eastern Europe 2 Center 2,895 Latin America 3 Center 19,267 _____ ________ Total 8 Total 26,532 _____ ________ _____ ________ LEASED FACILITIES Number of Aggregate Region Facilities Use Square Footage ______ __________ ___ ______________ North America 80 Center/Offices 221,733 Western Europe 69 Center/Offices 223,852 Central/Eastern Europe 79 Center/Offices 205,823 East Asia 62 Center/Offices 142,631 Latin America 53 Center/Offices 207,662 _____ __________ Total 343 Center/Offices 1,001,701 _____ __________ _____ __________ ITEM 3. ITEM 3. Legal Proceedings In November, 1992, the Company received a complaint entitled "Irving Kas, on behalf of all others similarly situated v. Berlitz International, Inc., Joe M. Rodgers and Elio Boccitto" in the U.S. District Court for New Jersey alleging various securities law violations under the Securities Exchange Act of 1934 and alleging various omissions and misrepresentations in connection with the Company's announcements during 1992 with respect to its financial results. In 1993, plaintiff filed a supplemental and amended complaint alleging various violations of the federal securities laws and common-law breaches of fiduciary duties relating primarily to the transaction contemplated by the Merger Agreement, and seeking to add another officer of the Company as a defendant in addition to the two officers named in the initial pleading. On August 4, 1993, the Court granted defendants' motion to dismiss the amended and supplemental complaint, deemed the original complaint to be withdrawn and dismissed the lawsuit in its entirety. Plaintiff's time to appeal has expired. The Company is party to several other actions arising out of the ordinary course of its business. Management believes that none of these actions, individually or in the aggregate, will have a material adverse effect on the financial condition or results of operations of the Company. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders No matters have been submitted to a vote of security holders during the fourth quarter of 1993. Pursuant to Instruction 3 to Item 401(b) of Regulation S-K and General Instruction G(3) to Form 10-K, the following information is included in Part I of this Form 10-K. Executive Officers and Directors of the Registrant The following table sets forth certain information concerning the Executive Officers and Directors of the Company as of March 18, 1994. Name, Age, Position with Registrant Business Experience ___________________________________ Soichiro Fukutake, 48 Chairman of the Board; Director (A)(C) Mr. Fukutake joined Fukutake in 1973, and since May 1986 has served as its President and Representative Director. He also serves on the Board of Directors of a number of companies, private foundations and associations in Japan. Mr. Fukutake became a Director of the Company in February 1993. His term will expire in 1995. Hiromasa Yokoi, 54 Vice Chairman of the Board, Chief Executive Officer and President; Director (A) Mr. Yokoi was elected Vice Chairman of the Board and Chief Executive Officer of the Company in February 1993 and additionally was elected President effective on August 31, 1993. Mr. Yokoi has served as a director of Fukutake since June 1992 and General Manager of the Overseas Operations Division (formerly the International Division) of Fukutake since October 1990. Prior to that, he served as General Manager of the President's Office of Fukutake from July 1990 to September 1990. From June 1987 to July 1990, he was General Manager of the Corporate International Trade division of Matsushita Electric Industries Co., Ltd.. Between April 1981 and June 1987, he served as Managing Director and Chief Executive Officer of National Panasonic (Australia) PTY Ltd. in Sydney, Australia. Mr. Yokoi has served as a Director of the Company since January 1991. His term will expire in 1994. Susumu Kojima, 51 Executive Vice President, Corporate Planning; Director (A) Mr. Kojima has served as Executive Vice President, Corporate Planning since September 1993. Prior thereto, he was Senior Vice President, Corporate Planning from February 1993 to September 1993. He was elected Executive Vice President, Corporate Planning in February 1993. Mr. Kojima has served as Director of Fukutake since March 1993. Prior to that, he was Joint General Manager of the Business Development Department of The Industrial Bank of Japan, Limited ("I.B.J.") from June 1991 to Februar 1993. Between November 1987 and June 1991, he served as Senior Deputy General Manager, Industrial Research Department of I.B.J. after having served as Chief Representative of I.B.J.'s Washington Representative Office from September 1983. Mr. Kojima was elected as a Director of the Company in February 1993. His term will expire in 1995. Robert Minsky, 49 Executive Vice President and Chief Financial Officer; Director (A) Mr. Minsky has served as Executive Vice President, Translations since October 1, 1993, and as Chief Financial Officer since November 1990. From November 1990 to October 1993, he also served as Vice President. From January 1990 to October 1990, Mr. Minsky was Vice President and Chief Financial Officer of DRI/McGraw-Hill, Inc. Between January 1986 and June 1989, Mr. Minsky served as Vice President and Chief Financial Officer of McCormack & Dodge Corporation, a subsidiary of The Dun & Bradstreet Corporation. Mr. Minsky has served as a Director of the Company since April 1991. His term will expire in 1995. Manuel Fernandez, 57 Executive Vice President Director (A) Mr. Fernandez has served as Executive Vice President, Language Services, since September 1993. Prior thereto, he was Vice President, European Operations from October 1989 to September 1993. He previously served as Vice President, European Operations for Berlitz Languages from January 1983 to October 1989. Mr. Fernandez was first employed by Berlitz Languages in 1963 and served in various positions until becoming Vice President in 1983. Mr. Fernandez has served as a Director of the Company since July 1993. His term will expire in 1995. Owen Bradford Butler, 70 Director (B)(D) From 1986 to December 1993, Mr. Butler served as retired Chairman and consultant to The Procter & Gamble Co. He also serves as Non-Executive Chairman of the Board of Directors of Northern Telecom, Ltd., and serves on the Board of Directors of Deere & Company, and Armco, Inc. Mr. Butler became a Director of the Company in February 1993. His term will expire in 1994. Saburou Nagai, 63 Director Mr. Nagai has served as Managing Director of Fukutake since April 1988 and has supervised its general administration and accounting departments since April 1990. Since joining Fukutake in April 1985, he served as General Manager of its accounting department until April 1988 and supervised its corporate identity department (July 1991-April 1992) and personnel department (April 1990-July 1991). Mr. Nagai became a Director of the Company in February 1993. His term will expire in 1994. Edward G. Nelson, 62 Director (B)(C)(D) Since January 1985, Mr. Nelson has served as Chairman and President of Nelson Capital Corporation. From 1983 to 1985, he was Chairman and Chief Executive Officer of Commerce Union Corporation. He also serves on the Board of Directors of Clintrials, Inc., Osborn Communications Corporation, and A+ Communications, Inc. and is a nominee to Advocat. He is a trustee of Vanderbilt University. Mr. Nelson became a Director of the Company in February 1993. His term will expire in 1994. Aritoshi Soejima, 67 Director (B)(C)(D) Mr. Soejima has served as Senior Counselor of Fukutake since December 1980. From 1950 to 1981, Mr. Soejima served in various positions with the Japanese government (including the Ministry of Finance) and multilateral financial institutions (including the World Bank and International Monetary Fund). Mr. Soejima also currently serves as Chairman of Tokyo, Osaka, Tokyo Bay, Nagoya Hilton Company, Ltd. and Counselor of Nippon Hilton Company, Ltd. and Capital International Company, Ltd. and as special advisor to the Board of Directors of the Nippon Fire & Marine Insurance Company, Ltd. In addition, he serves on the Board of Directors of a number of companies, private foundations and associations in Japan. Mr. Soejima became a Director of the Company in February 1993. His term will expire in 1995. Henry D. James, 56 Vice President and Controller Mr. James has served as Vice President and Controller since November 1990. For the period from October 1989 through October 1990, he served as Chief Financial Officer in addition to his present capacity. Prior thereto, he served in the same capacity for Berlitz Languages from 1981 to October 1989. Mr. James joined Berlitz Languages in 1977 and served in various positions with that company prior to 1981. Robert C. Hendon, Jr., 56 Secretary and General Counsel Mr. Hendon has served as Secretary and General Counsel since April 1992. Prior thereto, he was first an associate then a partner at the law firm of Waller Lansden Dortch & Davis from 1964 until April 1992. Jose Alvarino, 54 Vice President Mr. Alvarino has been Vice President, Latin American Operations since October 1989. Prior thereto, he served in the same capacity with Berlitz Languages from 1985 until October 1989. Mr. Alvarino was first employed by Berlitz Languages in 1970 and served in various positions from that time until being appointed Vice President in 1985. Anthony Tedesco, 51 Vice President Mr. Tedesco has been Vice President, East Asian Operations since July 1993. Prior thereto, he has served as Vice President, North American Operations from October 1989 to July 1993. Prior thereto, he served in the same capacity with Berlitz Languages from his initial employment in 1983. Wolfgang Wiedeler, 49 Vice President Mr. Wiedeler has served as Vice President Language Instruction, European Operations since September 1993. From May 1992 to September 1993 he was Vice President, Central/Eastern European Operations. Prior thereto, he served as Divisional Manager of German-speaking countries since October 1989. Prior thereto he served in the same capacity for Berlitz Languages from his initial employment in 1984. (A) member of the Executive Committee (B) member of the Audit Committee (C) member of the Compensation Committee (D) Disinterested Director There is no family relationship between any of the directors or executive officers of the Company. From January 1, 1993 until February 8, 1993, the closing of the Merger, the Board of Directors was comprised of Elio Boccitto, John Brademas, Robert Minsky, Rudy Perpich, Rozanne L. Ridgway, Joe M. Rodgers and Hiromasa Yokoi. Mr. Rodgers served as Chairman of the Board and acting Chief Executive Officer from December 23, 1991 until the closing of the Merger. Upon closing the Merger, the Board of Directors was comprised of Soichiro Fukutake, Hiromasa Yokoi, Elio Boccitto, Robert Minsky, Owen Bradford Butler, Saburou Nagai, Edward G. Nelson, Makato Sato and Aritoshi Soejima. Mr. Sato resigned effective February 27, 1993 and the Board appointed Mr. Susumu Kojima to fill the vacancy. Mr. Boccitto resigned as a Director effective July 27, 1993 and the Board appointed Mr. Manuel Fernandez to fill the vacancy. PART II ITEM 5. ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters The New Common is traded on the New York Stock Exchange ("NYSE") under the symbol BTZ. Holders of shares of New Common are entitled to receive such dividends as may from time to time be declared by the Board of Directors; however, such dividends are subject to restrictions set forth in the debt facilities incurred in connection with the Merger Agreement with Fukutake. As a result, the Company does not expect to pay dividends during the term of such debt facilities. See Item 7, Management's Discussion and Analysis, Liquidity and Capital Resources, for further discussion. Holders of New Common are entitled to one vote per share on all matters submitted to the vote of such holders, including the election of directors. There were approximately 108 holders of record of New Common as of March 18, 1994. The sales prices per share of the New Common as reported by the NYSE for each quarter during the period from February 9, 1993 until December 31, 1993 ranged as follows: Price per Share ____________________ High Low ______ ________ February 9, 1993 to March 31, 1993 $15 7/8 $14 3/8 Second Quarter 1993 $15 5/8 $12 1/4 Third Quarter 1993 $14 1/8 $12 Fourth Quarter 1993 $14 7/8 $12 5/8 Prior to the Merger, the Company's common stock, par value $.10 per share (40,000,000 shares authorized) ("Old Common"), was traded on the NYSE under the symbol BTZ. The sales prices per share of the Old Common as reported by the NYSE for each quarter during the period from January 1, 1992 until February 8, 1993 ranged as follows: Price Per Share ____________________ High Low ______ ________ January 1, 1993 to February 8, 1993 $23 1/2 $22 1/8 Price Per Share High Low First quarter 1992 $20 1/4 $18 1/4 Second quarter 1992 $18 1/2 $16 3/4 Third quarter 1992 $24 $17 7/8 Fourth quarter 1992 $23 3/4 $16 3/4 Management believes the price per share for periods subsequent to February 8, 1993 is not directly comparable to the price per share for the periods presented prior to February 8, 1993 because the outstanding number of shares was reduced as a result of the Merger. Aggregate common stock dividends of $.42 per share of Old Common were declared in 1992, in quarterly payments. The Company declared regular cash dividends of $.14 per share of Old Common for each of the first, second and third quarters of 1992. No fourth quarter dividend for 1992 nor any dividends for 1993 were declared or paid. On February 5, 1992, the Board of Directors declared a dividend distribution of one Common Share Purchase Right (the "Right") for each outstanding share of Old Common to shareholders of record on February 17, 1992, in accordance with the Safeguard Rights Agreement between Berlitz and U.S. Trust Company of New York (the "Safeguard Rights Plan"). The Rights were redeemed prior to the closing of the Merger, so that the holders of Rights had no rights other than the right to receive the redemption price of $.01 per Right in cash payable to such shareholders at the time of the closing of the Merger. As a result of certain payment defaults on certain notes held by the Company as discussed in Item 7 and Note 12 to the Consolidated Financial Statements, no dividends were paid on the Preferred Stock during 1992 or 1993. ITEM 6. ITEM 6. Selected Financial Data (1) Income Statement Data give effect to the combination of the results of the Company for the periods January 1, 1993 through January 31, 1993 and February 1, 1993 through December 31, 1993. (2) Under the purchase method of accounting, the Post-Merger sales and expenses of facilities closed in connection with the Merger have been reclassified to "Merger-related restructuring costs" (33%) and "Excess of cost over net assets acquired" (67%). (3) Principally represents 33% of severance payments, and language center closing costs. (4) Represents the write-off of the Maxwell Note and certain Receivable Notes and other reserves related to the bankruptcy filing of Maxwell Communication Corporation plc. See Notes 2 and 11 to Consolidated Financial Statements. (5) Indicates year-over-year increase (decrease) in sales by language centers which were operating during the entirety of both years being compared. For a description of the Merger, see Note 2 to the Consolidated Financial Statements. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations General The following discussion should be read in conjunction with the Selected Financial Data and the Consolidated Financial Statements and Notes thereto contained elsewhere in this Annual Report on Form 10-K. In December 1989, the Company sold 8.4 million shares of common stock to the public in an initial public offering and issued to Macmillan Inc. ("Macmillan") 200,000 shares of the Company's 7% non-cumulative preferred stock (the "Preferred Stock") (of which 20,000 shares were subsequently retired and canceled and 180,000 shares remained outstanding) in exchange for the capital stock of its predecessor companies. See Note 11 to the Consolidated Financial Statements for further discussion. In addition, in anticipation of the initial public offering, the Company entered into a series of financial transactions with Macmillan, Maxwell Communication Corporation plc ("Maxwell Communication") and its affiliates as discussed in Note 2 to the Consolidated Financial Statements. The holder of the Preferred Stock was entitled to quarterly dividends at the quarterly rate of the lesser of the 1.75% of the $180.0 million liquidation preference of such shares (i.e. $12.6 million annually) or the quarterly rate which resulted in the aggregate dividends on all shares of the Preferred Stock being equal to the Company's after-tax income during the preceding quarter from the loan of $99.6 million to Maxwell Communication ("Maxwell Note") and the 10 year affiliate promissory notes ("Receivable Notes"). On December 16, 1991, Maxwell Communication filed a petition for protection from its creditors under Chapter 11 of the U.S. Bankruptcy Code and subsequently filed for an order of administration in the United Kingdom. As a result, in 1991 the Company wrote off or provided reserves for the Maxwell Note, Receivable Notes and other related charges, as described in Notes 2 and 11 to the Consolidated Financial Statements, totaling $195.4 million. In the fourth quarter of 1991, payment and other defaults arose on the Maxwell Note and the Receivable Notes. Consequently, as discussed in Note 12 to the Consolidated Financial Statements, the Company's obligation to pay dividends on the Preferred Stock was indefinitely suspended. In the first quarter of 1993, the Company, on behalf of the selling shareholders as discussed below, recovered $30.8 million from the sale of the Maxwell notes previously written off. On December 9, 1992, the Company and Fukutake Publishing Co., Ltd ("Fukutake") entered into an amended and restated merger agreement (the "Merger Agreement") pursuant to which Fukutake agreed to acquire through a merger of the Company with an indirect wholly-owned U.S. subsidiary (the "Merger"), approximately 67% of the outstanding common stock, par value $.10 per share of the Company ("New Common"). The Merger was consummated on February 8, 1993. The Company's shareholders received for each share of common stock outstanding prior to the Merger ("Old Common"), (i) $19.50 in cash; (ii) 0.165 share of New Common and (iii) $1.48 representing the net proceeds per share from the sale of the Maxwell Note and the Receivable Notes. In addition, the shareholders at the time of the closing received $.01 per share upon redemption of each Common Share Purchase Right (the "Right") under the terms of the Safeguard Rights Agreement between the Company and U.S. Trust Company of New York, which was redeemed pursuant to a condition of the Merger. After the Merger, public shareholders of the Company hold approximately 33% of New Common. In addition, the Company incurred approximately $115.0 million of long-term indebtedness in connection with the Merger. In January 1993, the Company entered into agreements with Maxwell Communication and Macmillan (the "Disengagement Agreements") with respect to disengaging certain relationships among such companies. Pursuant to these agreements, among other things, (i) the Company redeemed from Macmillan all of the outstanding Preferred Stock of the Company, (ii) Maxwell Communication waived a) all claims that payments to the Company should be considered preferential and returned to Maxwell Communication and b) other claims of Maxwell Communication and its affiliates against the Company and its subsidiaries which Maxwell Communication may have as a result of Maxwell Communication's bankruptcy filing on December 16, 1991, and (iii) U.S. and U.K. bankruptcy authorities allowed for all purposes a portion of the Maxwell Note and certain Receivable Notes and a claim against Maxwell Communication as subrogee for Midland Bank plc in the Chapter 11 case (and any superseding Chapter 7 case) and in the Maxwell Communication administration pending in the High Court of Justice in the United Kingdom. In addition, the Company and its subsidiaries (a) sold to Macmillan the Macmillan Note ($64.568 million) and (b) reduced by $58.0 million the amount of their claims against Maxwell Communication in respect of the Maxwell Note and certain Receivable Notes previously written off. As a result of the redemption of the Preferred Stock, the Company's obligation to pay any preferred dividends in the future was eliminated. The Company was included in the consolidated tax returns of the Macmillan Group prior to the Company's initial public offering in December 1989 and consequently is jointly and severally liable for any federal tax liabilities for the Macmillan Group arising prior to that date. Pursuant to the Disengagement Agreements, Macmillan and a new obligor which owns 100% of Macmillan School Publishing, Inc. agreed to pay all such federal tax liabilities pursuant to an amended and restated tax allocation agreement (the "Tax Allocation Agreement"), and Maxwell Communication put into escrow $39.5 million to secure Macmillan's obligations. On November 10, 1993, Macmillan commenced a voluntary Chapter 11 case in the United States Bankruptcy Court for the Southern District of New York and filed a prepackaged plan of reorganization (the "Reorganization Plan"). The Reorganization Plan provides that the Tax Allocation Agreement, along with many other contracts between Macmillan and other parties, is to be assumed by Macmillan and assigned to a trust intended to have sufficient assets to satisfy the obligations being assumed and assigned. The Reorganization Plan also provides a cash reserve to pay tax claims that are entitled to priority, which may include tax liabilities covered by the Tax Allocation Agreement. On February 18, 1994, the Bankruptcy Court confirmed the Reorganization Plan. Any tax liability assessed against the Company that would otherwise be payable by Macmillan under the Tax Allocation Agreement (as described in the preceding paragraph) is likely to be paid either by the trust or from the cash reserve described above. Management believes that any such liability will not result in a material effect on the financial condition of the Company. In November, 1992, the Company received a complaint entitled "Irving Kas, on behalf of all others similarly situated v. Berlitz International, Inc., Joe M. Rodgers and Elio Boccitto" in the U.S. District Court for New Jersey alleging various securities law violations under the Securities Exchange Act of 1934 and alleging various omissions and misrepresentations in connection with the Company's announcements during 1992 with respect to its financial results. In 1993, plaintiff filed a supplemental and amended complaint alleging various violations of the federal securities laws and common-law breaches of fiduciary duties relating primarily to the transaction contemplated by the Merger Agreement, and seeking to add another officer of the Company as a defendant in addition to the two officers named in the initial pleading. On August 4, 1993, the Court granted defendants' motion to dismiss the amended and supplemental complaint, deemed the original complaint to be withdrawn and dismissed the lawsuit in its entirety. Plaintiff's time to appeal has expired. Operations Overview For the period beginning January 1, 1991 and ending December 31, 1993, the Company's sales grew at a compound annual growth rate of 2.3%. Under the purchase method of accounting, the sales and expenses in the period February 1, 1993 to December 31, 1993 of language instruction centers to be closed in connection with the Merger have been reclassified to merger-related restructuring costs (33%) and excess of cost over net assets acquired (67%). Exclusive of these Merger-related reclassifications, sales would have grown at a compound annual growth rate of 4.0%. The following table shows the Company's income and expense data as a percentage of sales: Year Ended December 31, _____________________________ Pro Forma 1993 (1) 1992 1991 _______ ______ ______ Sales of Services and Products 100.0% 100.0% 100.0% _______ ______ ______ Costs of services and products sold (2) 62.2% 63.3% 60.3% Selling, general and administrative (3) 30.7% 29.4% 27.7% Amortization of publishing rights and excess of cost over net assets acquired 4.6% 3.7% 4.0% Interest expense on long-term debt 3.3% 0.7% 1.3% Merger-related restructuring costs (4) 1.8% - - Non-recurring Maxwell and Merger-related charges - 0.5% 75.2% Other (income) expense, net (2.6%) (1.0%) (7.0%) _______ ______ ______ Total costs and expenses 100.0% 96.6% 161.5% _______ ______ ______ Income (loss) before income taxes and cumulative effect of change in accounting principle 0.0% 3.4% (61.5%) _______ ______ ______ _______ ______ ______ (1) Gives effect to the combination of the results of the Company for the combined periods January 1, 1993 through January 31, 1993 and February 1, 1993 through December 31, 1993. (2) Consists primarily of teachers', translators', and administrative salaries, as well as cost of materials, rent, maintenance and other center operating expenses. (3) Consists of headquarters, corporate services, marketing and advertising expenses. (4) Primarily severance payments and language center closing costs, including lease cancellation penalties, writeoffs of leasehold improvements, and operating losses for closed centers. The Company's operations from 1991 to 1993 were negatively impacted by the economic downturn in Europe and Japan, which more than offset the growth in Latin America and North America. Cost of services and products sold as a percentage of sales increased from 60.3% in 1991 to 62.2% in 1993, principally as increases in translator costs and rent charges more than offset the favorable impact of decreases in teacher costs and certain administrative costs. Selling, general and administrative expenses as a percentage of sales increased from 27.7% in 1991 to 30.7% in 1993, principally as a result of increased office salaries and a reorganization of the corporate headquarters. Interest expense on long-term debt as a percentage of sales increased from 1.3% in 1991 to 3.3% in 1993 as a result of the increased indebtedness in connection with the Merger. The Company's operations are conducted through the following business segments: Language Instruction, Translation Services, and Publishing. Language Instruction sales grew from $220.9 million in 1991 to $223.6 million in 1993, a compound annual growth rate of 0.7%. Exclusive of Merger-related reclassifications, the annual growth rate would have been 2.5%. The number of lessons provided by the Company's language centers were 4.9 million, 4.9 million and 4.6 million in 1991, 1992 and 1993, respectively. Exclusive of Merger-related reclassifications, the number of lessons in 1993 would have been 4.7 million. The growth in sales is largely attributable to the increase in average revenue per lesson as a result of product mix and price increases in excess of inflation. Over the three-year period, the Company opened 55 new language centers and closed 17. While the Company has historically experienced strong growth, the continued weakness in the worldwide economy led to weak sales growth in 1992 and 1993. The following table shows the year-over-year increase/(decrease), including the impact of foreign currency rate fluctuations, in sales by centers which were operating during the entirety of both years being compared. Percentage Growth (Decline) ____________________________ 1993 (1) 1992 1991 ________ ______ ______ Same Center Sales (6.1%) 2.4% (2.8%) ________ ______ ______ ________ ______ ______ (1) Gives effect to the combination of the results of the Company for the combined periods January 1, 1993 through January 31, 1993 and February 1, 1993 through December 31, 1993. During the period from 1991 to 1993, the Company's Translations business expanded principally through internal growth and strategic acquisition of operations in the United States and Europe. Translations acquired interests aggregating 70% in Softrans International Limited ("Softrans"), a software localization service company located in Dublin, Ireland. Translations, sales grew at a compound annual growth rate of 23.5%, increasing from $23.4 million in 1991 to $35.7 million in 1993. Translations' operating results improved in 1993 as a result of an increase in large volume accounts and continued strong sales efforts, particularly in the technical translations and software localization markets. Publishing segment sales decreased from $15.5 million in 1991 to $12.4 million in 1993, reflecting the negative impact of exchange rate fluctuations and product distribution problems, particularly in the United Kingdom. However, these distribution problems were resolved in 1994. The Company's participation in numerous licensing agreements and joint ventures has allowed the Company to expand into new technologies and new markets such as the production of a new line of language instruction products on CD-ROM and multimedia courses for the home, school and business markets. During the three-year period, the percentage of the Company's annual sales denominated in currencies other than U.S. dollars ranged from 76.9% in 1991 to 73.8% in 1993. As a result, changes in exchange rates had an impact on the Company's sales revenues. The following table shows the impact of foreign currency rate fluctuations on the annual growth rate of sales during the periods presented: Percentage Year Ended December 31, Growth (Decline) 1993 (2) 1992 1991 ________________ ________ ________ ________ Sales: Operations (1) (2.4)% 5.0% (1.2)% Exchange (1.0) 3.3 0.6 ________ ________ ________ Total (3.4)% 8.3% (0.6)% ________ ________ ________ ________ ________ ________ (1) Adjusted to eliminate fluctuations in foreign currency from year-to- year by assuming a constant exchange rate over two years, using as the base the first year of the periods being compared. (2) Gives effect to the combination of the results of the Company for the combined periods January 1, 1993 through January 31, 1993 and February 1, 1993 through December 31, 1993. Results of Operations Year Ended December 31, 1993 vs. Year Ended December 31, 1992 As discussed in Note 2 to the Consolidated Financial Statements, on February 8, 1993, the Company and Fukutake consummated the Merger. The following selected financial data gives effect to the combination of the results of the Company for the combined periods January 1, 1993 through January 31, 1993 and February 1, 1993 through December 31, 1993. Twelve Months Ended December 31, ________________________________ 1993 1992 __________ __________ Sales of services and products $ 271,677 $ 281,320 Total costs and expenses 271,603 271,832 ---------- ---------- Income before income taxes and cumulative effect of change in accounting principle $ 74 $ 9,488 __________ __________ __________ __________ Income (loss) available to common shareholders $ (2,018) $ 4,041 __________ __________ __________ __________ Under the purchase method of accounting, the post-February 1, 1993 sales and expenses of centers to be closed in connection with the Merger have been reclassified to "Merger-related restructuring costs" (33%) and "Excess of cost over net assets acquired" (67%). The following selected financial data gives effect to the presentation of 1992 on a pro forma basis, excluding eleven months of activity for those centers to be closed in connection with the Merger: Twelve Months Ended December 31, ________________________________ Pro Forma 1993 1992 _________ _________ Sales of services and products $ 271,677 $ 270,790 Lessons given 4,588 4,691 Sales for the twelve months ended December 31, 1993 were $271.7 million, a decrease of $9.6 million, or 3.4%, from sales of $281.3 million in the comparable period in 1992, but an increase of $0.9 million, or 0.3%, from pro forma 1992 sales. Language Instruction sales were $223.6 million, a decrease of $9.9 million, or 4.2%, from sales of $233.4 million in the comparable period in 1992. However, sales increased $0.4 million over pro forma 1992 sales, as decreases in Western Europe were offset by increases in the other divisions. Sales in the Western European division declined $7.6 million from pro forma 1992 as a result of the unfavorable impacts of exchange rate fluctuation of $4.7 million, combined with the continued economic weakness in this region, particularly in France, Spain, Belgium and England. This decline was offset by increases in North America, Latin America and Central/Eastern Europe of $0.3 million, $4.2 million and $0.2 million, respectively. In addition, sales of the East Asian division increased by $3.2 million, or 5.5%, over pro forma 1992. However, excluding the favorable impact of exchange rate fluctuations, sales of this region decreased $4.4 million, or 7.5% as a result of the continuing recessionary environment in Japan. During the twelve-month period ended December 31, 1993, the number of lessons given was approximately 4.6 million, 5.8% below that of the same period in the prior year, and 2.2% below the pro forma 1992 period. Lesson volume in the North American division remained relatively flat at 1.1 million. East Asia and Western Europe experienced lesson volume declines from pro forma 1992 of 6.4% and 7.6%, respectively, due to the continued weak economy. Lesson volume in Latin America increased by 4.8% from prior year in most countries except Argentina, where lesson volume declined 17.2%. Lesson volume in Central/Eastern Europe increased by 2.4% over pro forma 1992 volume, as activity from the new language centers in the Czech Republic, Poland and Hungary exceeded negative volume variances in the other countries. For the twelve months ended December 31, 1993, average revenue per lesson ("ARPL") was $41.07 as compared to $40.51 in the comparable prior-year period and $40.16 in pro forma 1992. ARPL (excluding Russia) ranged from a high of approximately $67.12 in Japan to a low of $13.17 in the Czech Republic, reflecting effects of foreign exchange rates and differences in the economic value of the service. The Company opened 12 new language centers during 1993, including six in Central/Eastern Europe, five in Latin America, and one in Japan. Translation Services sales were $35.7 million for the twelve-month period ended December 31, 1993, an increase of $3.3 million, or 10.3%, from sales of $32.4 million in the comparable period in 1992. Most of this growth came from the U.S. and Ireland, as a result of an increase in large volume accounts, and continued strong sales efforts with particular attention focused on the information technology market segment. Publishing segment sales were $12.4 million for the twelve months ended December 31, 1993, a decrease of $3.1 million, or 20.1%, from sales of $15.5 million in the comparable period in 1992. Excluding the unfavorable impact of foreign exchange rate fluctuations, Publishing sales declined by $1.6 million, or 10.5%, largely due to product distribution problems which were resolved in 1994. Cost of services and products sold, and selling, general, and administrative expenses were negatively impacted by increases in certain fixed costs, primarily office salary and rent, which more than offset the favorable impact of exchange rate fluctuations and an adjustment for the settlement of a lease negotiation ($1.5 million). Amortization of publishing rights and excess of cost over net assets acquired increased by $2.0 million due to the Merger. Interest expense on long-term debt increased by $7.2 million due to the increase in borrowing in connection with the Merger. Merger-related restructuring costs of $4.8 million were recorded, primarily for severance expense and costs of closing language centers, including lease cancellation penalties, write-offs of leasehold improvements, and operating losses for closed centers. Interest income from affiliates decreased $6.7 million as a result of the sale of a promissory note due from an affiliate. The Company recognized a portion ($4.9 million) of the gain on the 1990 sale of 20% of the equity of its Japanese subsidiary, as a result of the elimination of certain contingencies upon consummation of the Merger. Joint venture losses of $1.4 million were recorded in the twelve-month period, primarily as a result of liabilities anticipated to be incurred in connection with the discontinuation of a European Publishing joint venture and an East Asian joint venture. Other income (expense), net, was also favorably impacted in the current year (income of $2.9 million) and unfavorably impacted in the prior year (expense of $1.2 million) by the effect of certain adjustments to minority interest of the Company's Japanese subsidiary. For the twelve months ended December 31, 1993, the Company reported a net loss of $2.0 million as compared to net income of $4.0 million in the same period in 1992. The Company's effective income tax rates for the 1993 Pre-Merger and Post-Merger periods were higher than for the 1992 twelve month period. The increase in the 1993 effective tax rate was due to the Company's inability to utilize net operating losses in certain countries, and to nondeductible amortization charges. The effect of the increase in the U.S. statutory Federal rate from 34 % to 35 % was not material. The Company reported, for the one-month and eleven-month periods ended January 31, 1993 and December 31, 1993, net income of $0.08 per share and net loss of $0.35 per share, respectively, compared to net income of $0.21 per share for the twelve months ended December 31, 1992. Year Ended December 31, 1992 vs. Year Ended December 31, 1991 Sales for the year ended December 31, 1992 were $281.3 million, an increase of $21.5 million, or 8.3%, from sales of $259.8 million in 1991. Excluding the positive effects of exchange rate fluctuations, the increase in total Company sales for 1992 was $13.0 million, or 5.0%. Sales of the Language Instruction business were $233.4 million, an increase of $12.5 million, or 5.7%, from sales of $220.9 million in 1991. However, excluding the impact of favorable foreign exchange fluctuations, Language Instruction sales increased only 2.1%. Exclusive of exchange fluctuations, North America, Latin America and Central/Eastern Europe reported Language Instruction sales increases of 9.1%, 21.3% and 11.1%, respectively, partially offset by decreases in East Asia and Western Europe of 8.2% and 5.6%, respectively. During 1992, the number of lessons given was approximately 4.9 million, slightly lower than the prior year. The flat lesson volume was due principally to continued weakness in the global economies. Increased lesson volume in North America, Latin America and Central/Eastern Europe was offset by decreases in the East Asian and the Western European divisions. Average revenue per lesson increased from approximately $38.42 per lesson in 1991 to $40.51 per lesson in 1992. In 1992, average revenue per lesson (excluding Central/Eastern Europe) ranged from a high of approximately $57.98 in Sweden to a low of $16.38 in Thailand, reflecting effects of foreign exchange rates and differences in the economic value of the service. The Company opened 26 new language centers during 1992, five of which were in North America, three in East Asia, including one in the recently established Hong Kong region, two in Latin America, three in Western Europe and 13 in the expanding Central/Eastern European division. Language Instruction sales of the North American division were $51.4 million, an increase of $3.9 million, or 8.6%, over sales of $47.5 million in 1991. Lesson volume of the North American division was 1.1 million lessons, an increase of 2.4% from prior year, as the rapid pace of globalization has increased the demand for language services in the corporate market. Continued growth in the group instruction market, primarily non- corporate clients, also contributed to improved operations. Language Instruction sales of the Western European division were $47.5 million, a decrease of $1.1 million, or 2.2% from prior year. However, excluding favorable exchange rate fluctuations, sales of this division decreased by 5.6%. Lesson volume in this division was 1.0 million lessons, a decrease of 12.8% from prior year. France, Italy and Spain were particularly weakened by high inflation and unemployment which contributed to reduced lesson volume and operating profit. Language Instruction sales in the Central/Eastern European division were $45.5 million, an increase of $6.8 million, or 17.5% from prior year. Exclusive of favorable exchange rate fluctuations, this increase was 11.1%. Lesson volume in this division was 0.9 million lessons, an increase of 6.4%, due to demand from non-corporate, Central/Eastern European consumers. In 1992, thirteen new language centers were opened in this division: Germany (8), Switzerland (1), Hungary (1), Austria (1), and the Czech Republic (2). These new language center openings contributed directly to the increase in sales and lesson volume. Language Instruction sales in the East Asian division decreased 2.2% to $64.7 million. Excluding the effect of favorable exchange rate fluctuations, sales of this division decreased by 8.2%. Lesson volume in East Asia for the year was 1.0 million lessons, down 8.2% from 1991. The shortfall in lesson volume was partially offset by an improved average revenue per lesson. The reduction in lesson volume, primarily in the individual consumer market, was a result of the weakened economy in Japan, combined with a slowdown in consumer spending. In addition, Japan was negatively affected by a shift in its product mix from private to group lessons. Language Instruction sales in Latin America were $24.3 million, an increase of $4.3 million, or 21.3%, from prior year. Lesson volume in the Latin American division increased by 14.7% to 0.8 million lessons, led by Argentina, Colombia and Mexico. Translation Services sales were $32.4 million, an increase of $9.0 million, or 38.2%, from sales of $23.4 million in 1991. The gain was achieved as a result of the pursuit of large accounts by a newly created sales force, with particular attention focused on the information technology market segment. Publishing sales were flat at $15.5 million. Increased sales in the U.S. were offset by a sales decline in Europe as a result of continued poor economic conditions. Operating results in 1992 were negatively impacted by the reduction in lesson volume in East Asia and Western Europe, coupled with higher fixed costs in these divisions compared to other divisions. Translation Services' results were also negatively impacted by a competitive pricing policy and the increased costs of expanding production capacity. Interest expense on long-term debt decreased by $1.4 million, to $1.9 million, as a result of an installment payment in December 1992 of $15.0 million and a prepayment in June 1991 of $10.0 million of the Company's long-term borrowing from Societe Generale, and a reduction in the floating bank rate from 6.4125% to 3.975% in 1992. The Company incurred $1.4 million net additional Maxwell and Merger-related charges during 1992. Interest on temporary investments remained flat with prior year, at $3.3 million. The Company suffered a foreign exchange loss of $3.8 million in 1992 compared to a gain of $0.2 million in 1991 as a result of the strengthening of the U.S. dollar against certain currencies, principally in Brazil. Equity in losses of joint ventures of $2.2 million was recorded in 1992 as such ventures completed their first full year of operations. A magazine joint venture in Europe significantly impacted joint venture losses after the bankruptcy of the Company's joint venture partner. Interest income from affiliates decreased by $10.8 million as a result of the payment defaults previously discussed. This amount however, is offset by the suspension of Preferred Stock dividends in 1992. Other income, net increased by $1.4 million, due to a lower charge for minority interest in connection with the Company's 1990 sale of 20% of the equity of its Japanese subsidiary. Income available to common shareholders for the year ended December 31, 1992 was $4.0 million compared to a loss of $181.2 million in 1991. The Company's effective tax rate was 57.4% in 1992 compared to 7.7% in 1991 which was significantly impacted by the establishment of reserves resulting from the Maxwell Communication bankruptcy. The 1992 effective tax rate was increased by the Company's inability to use net operating losses in certain countries, and by non deductible amortization charges. As mentioned in the previous section, payment and other defaults arose on the notes from Maxwell Communication and certain of its affiliates in the fourth quarter of 1991, resulting in the suspension of Preferred Stock dividends. Earnings per common share for the year ended December 31, 1992 were $0.21 compared to a net loss per share of $9.53 in 1991. Accounting for Income Taxes Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). As a result of the adoption of this statement, as of January 1, 1993, the Company recorded a tax credit of $3,172, or $0.17 per share, which resulted in the reduction of the deferred tax liability as of that date. This amount has been reflected in the Consolidated Statement of Operations as the cumulative effect of a change in accounting principle. Liquidity and Capital Resources The primary source of the Company's liquidity is the cash provided by operations. The Company's business is not capital intensive and, historically, capital expenditures, working capital requirements and acquisitions have been funded from internally generated cash. The Company's liquidity is principally generated from the Language Instruction and Translations segments. Similarly, cash requirements for capital expenditures and acquisitions are principally due to the Language Instruction and Translations segments. Net cash needs of Publishing are generally not material. Although each geographic area exhibits different patterns of lesson volume over the course of the year, the Company's sales are not seasonal in the aggregate; as a result, there is no need for significant amounts of cash at any point in time during the year. Generally, the Company collects cash from the customer in the form of prepayment of fees for instruction that gives rise to deferred revenues. Net cash provided by operating activities was $10.8 million, $30.9 million and $14.6 million for the years ended December 31, 1993, 1992 and 1991, respectively, reflecting net income (loss) in each of these years adjusted by non-cash charges, including amortization and certain write-offs and reserves in 1991. Included in the 1993 and 1992 amounts are tax refunds of approximately $5.1 million and $12.8 million, respectively, which were received during the year. In addition, in connection with the Merger, the Company paid $6.6 million in fees in 1993 to secure the Acquisition Debt Facilities. Net cash provided by operating activities was favorably impacted in 1992 by foreign exchange losses of $3.8 million without a similar effect in 1991, and was negatively impacted in 1991 by the payment of taxes of $4.2 million on the 1990 sale of 20% of the Japanese subsidiary. Net cash used in investing activities totalled $11.1 million, $11.9 million and $8.4 million in 1993, 1992 and 1991, respectively. The Company made capital expenditures of $8.2 million, $11.2 million, and $6.4 million, in the years ended December 31, 1993, 1992, and 1991, respectively, primarily for the opening of new centers and refurbishing of existing centers. The Company invested $2.9 million and $0.8 million in joint ventures in 1993 and 1992, respectively, primarily for shutdown costs. During 1992, the Company invested $10.5 million of its excess cash in an asset management portfolio consisting of marketable securities with varying maturities. All investments were liquidated in 1992. The Company acquired a translations operation for $3.6 million in cash in 1991. The Company repatriated certain Brazilian cash investments totaling $2.4 million in 1991. Net cash used in financing activities totalled $4.9 million in 1993, compared with $25.7 and $33.2 million in 1992 and 1991, respectively. The funds necessary to consummate the Merger on February 8, 1993 and pay related fees and expenses were derived from the following: equity capital from Fukutake of $293.1 million, borrowing under a Bank Term Facility of $59.0 million, issuance of Senior Notes of $56.0 million and the Company's available cash. Such funds were used to pay the cash portion of Merger consideration, including the redemption of certain rights under the Safeguard Rights Agreement, (other than the cash paid to shareholders from the proceeds of the Maxwell Note and certain Receivable Notes) of $374.5 million, to repay the principal amount outstanding under the term loan pursuant to the Societe Generale agreement of $25.0 million and to pay related fees and expenses of approximately $14.0 million. The Merger resulted in a net cash outlay of $11.9 million by the Company. The Company also received proceeds from the sale of the Maxwell Note and certain Receivable Notes and distributed $1.48 per share to existing shareholders as part of the Merger consideration. In addition, subsequent to the Merger, the Company repaid $3.7 million of the Bank Term Facility. As of December 31, 1992, the Company had no established line of credit facility. However, as part of the Acquisition Debt Facilities, the Company established a $10.0 million revolving credit facility in 1993 against which $3.0 million is outstanding at December 31, 1993. In 1992 and 1991, the Company made an installment payment of $15.0 million and a prepayment of $10.0 million, respectively, against its long-term note. At December 31, 1992, $25.0 million remained outstanding on such note. Common stock dividends paid were $10.7 million (including dividends for the fourth quarter of 1991 and the first three quarters of 1992), and $9.8 million in 1992 and 1991, respectively. Certain financial covenants contained in the Acquisition Debt Facilities restrict the ability of the Company to pay dividends. The Company does not expect to pay dividends during the term of the Acquisition Debt Facilities. Dividends paid on the Preferred Stock totalled $12.4 million (of which $3.1 million related to the fourth quarter of 1990) in 1991. As a result of the payment and other defaults and the recording of the write-offs and reserves in the Company's income statement with respect to the notes in the fourth quarter of 1991, no preferred dividends were paid in 1992 or 1993. Pursuant to a covenant under the Acquisition Debt Facilities, in August 1993 the Company entered into currency coupon swap agreements with a financial institution to hedge the Company's net investements in certain foreign subsidiaries and to help manage the effect of foreign currency fluctuations on the Company's ability to repay its U.S. dollar debt. These agreements require the Company, in exchange for U.S. dollar receipts, to periodically make foreign currency payments, denominated in the Japanese yen, the Swiss franc, the Canadian dollar, the British pound, and the German mark. The first exchange is scheduled for June 1994. As of December 31, 1993, the Company did not have any material commitments for capital expenditures. During 1994, the Company anticipates capital expenditures to be consistent with historical requirements. The Company underwent a significant transition during 1993, and believes that the strategic restructuring undertaken in 1993 will strengthen the core business and position the Company for future growth. Thus, the Company plans to meet its increased debt service requirements and future working capital needs through funds generated from operations, and the increase in available cash as the result of the discontinuation of dividends resulting from restrictions imposed by the Acquisition Debt Facilities. Inflation Historically, inflation has not had a material effect on the Company's business. Management believes this is due to the fact that the Company's business is a service business which is not capital intensive. The Company has historically adjusted prices to compensate for inflation. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The following Consolidated Financial Statements, Supplementary Data and Financial Statement Schedules are filed as part of this Annual Report on Form 10-K: Page ____ Report of Independent Auditors 33 Report of Independent Accountants 34 Statement of Management's Responsibility for Consolidated 35 Financial Statements Consolidated Financial Statements: Consolidated Statements of Operations, period from 36 February 1, 1993 to December 31, 1993, period from January 1, 1993 to January 31, 1993, and years ended December 31, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 37 Consolidated Statements of Shareholders' Equity, period 38 from February 1, 1993 to December 31, 1993, period from January 1, 1993 to January 31, 1993, and years ended December 31, 1992 and 1991 Consolidated Statements of Cash Flows, period from February 39 1, 1993 to December 31, 1993, period from January 1, 1993 to January 31, 1993, and years ended December 31, 1992 and 1991 Notes to Consolidated Financial Statements 40 Financial Statement Schedules: Schedule VIII. Valuation and Qualifying Accounts 62 Schedule X. Supplementary Income Statement Information 63 All other schedules are omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or the Notes thereto. REPORT OF INDEPENDENT AUDITORS To the Shareholders and Board of Directors of Berlitz International, Inc. We have audited the accompanying consolidated balance sheet of Berlitz International, Inc. and its subsidiaries as of December 31, 1993 and the related consolidated statements of operations, shareholders' equity, and cash flows for the one-month period ended January 31, 1993 and the eleven-month period ended December 31, 1993. Our audit also included the financial statement schedules for the year ended December 31, 1993, listed in the Index at Item 8. 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 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 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 present fairly, in all material respects, the financial position of Berlitz International, Inc. and its subsidiaries as of December 31, 1993 and the results of their operations and their cash flows for the one-month period ended January 31, 1993 and the eleven-month period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules for the year ended December 31, 1993, 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 financial statements, effective January 1, 1993 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. /s/ Deloitte & Touche New York, New York March 4, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of Berlitz International, Inc.: We have audited the consolidated balance sheet of Berlitz International, Inc. ("Berlitz") as of December 31, 1992 and the related consolidated statements of operations, shareholders' equity and cash flows for the years ended December 31, 1992 and 1991. We have also audited the financial statement schedules listed in the Index at Item 8 for the years ended December 31, 1992 and 1991. These financial statements and financial statement schedules are the responsibility of Berlitz 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. As described in Notes 2 and 11 to the consolidated financial statements, in 1991 the Company recorded a $195.4 million charge to earnings, representing provisions for Maxwell Communication-related matters. As discussed in Note 2 to the consolidated financial statements, the Company completed its merger with Fukutake, effective February 8, 1993. Following the Merger, approximately 67% of the outstanding common stock of the Company is held directly, or indirectly, by Fukutake. In connection with the Fukutake merger, the Company entered into Disengagement Agreements with each of Maxwell Communication and Macmillan which sever certain relationships with Maxwell Communication and Macmillan. The Company also completed the sale of certain Maxwell notes in February, 1993. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Berlitz as of December 31, 1992 and the consolidated results of its operations and its cash flows for the years ended December 31, 1992 and 1991, 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 New York, New York March 24, 1993 STATEMENT OF MANAGEMENT'S RESPONSIBILITY FOR CONSOLIDATED FINANCIAL STATEMENTS To the Shareholders of Berlitz International, Inc.: Management of Berlitz International, Inc. has prepared and is responsible for the accompanying Consolidated Financial Statements and related information. These financial statements, which include amounts based on judgments of management, have been prepared in conformity with generally accepted accounting principles. Financial data included in other sections of this Annual Report on Form 10-K are consistent with that in the Consolidated Financial Statements. Management believes that the Company's internal control systems are designed to provide reasonable assurance, at reasonable cost, that the financial records are reliable for preparing financial statements and maintaining accountability for assets and that, in all material respects, assets are safeguarded against loss from unauthorized use or disposition. These systems are augmented by written policies, an organizational structure providing division of responsibilities, qualified personnel throughout the organization, and a program of internal audits. The independent accountants are engaged to conduct an audit and render an opinion on the consolidated financial statements in accordance with generally accepted auditing standards. These standards include an assessment of the systems of internal controls and tests of the accounting records and other auditing procedures as they consider necessary to support their opinion. The Board of Directors, through its Audit Committee consisting of outside Directors of the Company, is responsible for reviewing and monitoring the Company's financial reporting and accounting practices. Deloitte & Touche and the internal auditors each have full and free access to the Audit Committee, and meet with it regularly, with and without management. /s/ Robert Minsky Robert Minsky, Executive Vice President and Chief Financial Officer See accompanying notes to the consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share amounts) 1. Summary of Significant Accounting Policies a) Principles of Consolidation - The Consolidated Financial Statements include those of the Company and its subsidiaries. The effects of all significant intercompany transactions have been eliminated. b) Foreign Currency Translation - Generally, balance sheet amounts have been translated using exchange rates in effect at the balance sheet dates and the translation adjustment has been included in the cumulative translation adjustment, a separate component of shareholders' equity, with the exception of hyperinflationary countries. Income statement amounts have been translated using the average exchange rates in effect for each period. Revaluation gains and losses on certain intercompany accounts in all countries and translation gains and losses in hyperinflationary countries have been included in other income. Revaluation gains and losses on intercompany balances for which settlement is not anticipated in the foreseeable future are included in the cumulative translation adjustment. c) Inventories - Inventories, which consist primarily of finished goods, are valued at the lower of average cost or market. d) Deffered Financing Costs - Direct costs relating to the indebtedness incurred in connection with the Merger (see Notes 2 and 8) have been capitalized and are being amortized by the straight-line method over the terms of the related debt. e) Property and Equipment - Property and equipment is stated at cost and depreciated over estimated useful lives, using principally accelerated methods. f) Publishing Rights - Publishing rights are being amortized on a straight-line basis over 25 years. g) Excess of Cost Over Net Assets Acquired - Excess of cost over net assets acquired is being amortized on a straight-line basis over 40 years. It's carrying value is evaluated periodically to determine if there has been a loss in value, by reviewing current and estimated future revenues and cashflows. The excess of cost over net assets acquired will be written off if and when it has been determined that an impairment in value has occurred. h) Deferred Revenues - Deferred revenues arise from the prepayment of fees for classroom instruction and are recognized as income over the term of instruction. The Company recognizes in income deferred revenues for lessons paid for and not expected to be taken based upon historical experience by country. i) Income Taxes - The Company has filed its own Federal income tax returns since December 1989. The Company was previously included in the consolidated Federal income tax returns of the affiliated group of which Macmillan was the parent (the "Macmillan Group"). See Note 2 for further discussion. 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 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 statement and tax bases of assets and liabilities using enacted tax rates expected to apply to taxable income in the periods in which the differences are expected to reverse. j) Cash and Temporary Investments - The Company considers all highly liquid instruments purchased with an original maturity of three months or less to be temporary investments. k) Investment in Joint Ventures - Investments in joint ventures are carried on the equity basis of accounting and the Company's share of the net profits and losses of such investments is reflected in "Other (income) expense, net" in the Consolidated Statement of Operations. The Company's investment in these joint ventures included credit balances of $2,085 and $1,195, classified as other current liabilities on the Consolidated Balance Sheets at December 31, 1993 and 1992, respectively, and represents the Company's obligation in excess of amounts invested with respect to these joint ventures. l) Reclassification - Certain reclassifications have been made in prior years' financial statements to conform with the 1993 presentation. 2. Merger Transaction Merger Agreement On December 9, 1992, the Company and Fukutake Publishing Co., Ltd. ("Fukutake") entered into an amended and restated merger agreement (the "Merger Agreement") pursuant to which Fukutake agreed to acquire, through a merger of the Company with an indirect wholly-owned U.S. subsidiary of Fukutake (the "Merger"), approximately 67% of the new common stock, par value $.10 per share ("New Common") of the Company. The Merger was consummated on February 8, 1993. The Company's shareholders received, for each of their outstanding shares of common stock held prior to the Merger ("Old Common") (i) $19.50 in cash; (ii) 0.165 share of New Common and (iii) $1.48, representing the net proceeds per share received from the sale of a certain promissory note from Maxwell Communication Corporation plc ("Maxwell Communication") (the "Maxwell Note") and certain 10 year promissory notes due from affiliates ("Receivable Notes"). Public shareholders of the Company hold the remaining approximately 33%. In addition, the Company's shareholders received $.01 per share in redemption of Rights in accordance with a Safeguard Rights Agreement between the Company and U.S. Trust Company of New York. Accounting Treatment The Merger has been accounted for by the purchase method of accounting. The purchase method of accounting contemplates a step-up in value of the Company's assets based upon the purchase price paid for the outstanding common stock. Utilizing such method, the purchase price paid for approximately 67% of the Company resulted in an increase in value of the Company's assets based upon the amount paid for such shares. The remaining (approximately 33%) ownership will continue to be carried at historical cost. The Fukutake purchase price (including a portion of long-term debt; See Note 8 for further discussion) has been allocated to the Company's assets and liabilities. The Post-Merger financial statements include an allocation of the Fukutake purchase price. The excess of Fukutake's purchase price over net assets acquired will be amortized on a straight-line basis over 40 years. Although the Merger was consummated on February 8, 1993, the Consolidated Financial Statements present the 1993 results of operations for the period from January 1, 1993 through January 31, 1993 ("Pre-Merger" period) and from February 1, 1993 to December 31, 1993 ("Post-Merger" period). Adjustments to such financial information for the period February 1, 1993 through February 8, 1993 are not material to the consolidated results of operations. A summary of the purchase price allocation follows: Fukutake purchase price $ 370,117 Net assets acquired: Historical (based on 67% of $327,798) 219,625 Allocation to net assets 15,769 _______ Total net assets acquired 235,394 _________ Excess of cost over net assets acquired $ 134,723 _________ _________ The allocation to net assets has been revised as of December 31, 1993 to reflect certain adjustments. The following selected unaudited pro forma information assumes that the transaction occurred on January 1 of each period presented for the selected income statement data. The pro forma information includes an allocation of the Fukutake purchase price and is not indicative of the results which would actually have occurred had the transaction taken place on the dates indicated or of the results which may occur in the future. Selected Pro Forma Income Statement Data (Unaudited): Twelve Months Ended December 31, ____________________________________ _______________________________ 1993 1992 ____ ____ Sales of services and products $ 271,677 $ 281,320 Loss before income taxes and cumulative effect of change in accounting principle (1,109) (7,091) Loss before cumulative effect of change in accounting principle (6,353) (6,774) Loss per common share before cumulative effect of change in account principle (0.63) (0.68) ________ ________ Average number of common shares outstanding (000's) 10,031 10,031 ________ ________ ________ ________ The primary difference between the unaudited pro forma selected income statement data and the amounts as reported (for the combined 1993 Pre-Merger and Post-Merger periods and for the twelve months ended December 31, 1992) are increases in amortization of excess of cost over net assets acquired (approximately $201 and $2,403 for the 1993 and 1992 periods, respectively), interest expense, including amortization of deferred financing costs (approximately $883 and $8,035 for the 1993 and 1992 periods, respectively) related to the Acquisition Debt Facilities as described in Note 8 and the elimination of interest income on the Macmillan Note. Disengagement Agreements and other Maxwell Matters On December 13, 1989, the Company sold 8.4 million shares of common stock to the public in an initial public offering. In contemplation of the initial public offering, Macmillan Inc. ("Macmillan") was issued, in exchange for the capital stock of the Company's predecessors, 10.6 million shares of the Company's common stock and 200,000 shares of the Company's 7% non- cumulative preferred stock (the "Preferred Stock"), of which 20,000 shares were subsequently retired and canceled and 180,000 shares remained outstanding. In anticipation of the initial public offering, the Company entered into a series of financial transactions including the loan of $99,600 to Maxwell Communication Corp plc ("Maxwell Communication") evidenced by a promissory note (the "Maxwell Note"). The Company also converted $89,243 of receivables due from affiliates into 10 year promissory notes (the "Receivable Notes"). On December 16, 1991, Maxwell Communication filed a petition for protection from its creditors under Chapter 11 of the U.S. Bankruptcy Code and subsequently filed for an order of administration in the United Kingdom. In the fourth quarter of 1991, payment and other defaults arose on the Maxwell Note and the Receivable Notes, which, in view of the bankruptcy of Maxwell Communication, were unlikely to be cured. As a result, in 1991 the Company wrote off or provided reserves totalling $195,354 with respect to the Maxwell Note, the Receivable Notes, and other related charges. Consequently, the Company's obligation to pay dividends on the Preferred Stock was indefinitely suspended. In the first quarter of 1993, the Company recovered, on behalf of the selling shareholders, $30,833 of such notes previously written off, the net proceeds of which were distributed to the shareholders as part of the Merger consideration. In January 1993, the Company entered into agreements with Maxwell Communication and Macmillan (the "Disengagement Agreements") which disengaged certain relationships among such companies. Pursuant to these agreements, among other things, (i) the Company redeemed from Macmillan all of the outstanding Preferred Stock of the Company, (ii) Maxwell Communication waived (a) all claims that payments to the Company should be considered preferential and returned to Maxwell Communication and (b) other claims of Maxwell Communication and its affiliates against the Company and its subsidiaries which Maxwell Communication may have as a result of Maxwell Communication's bankruptcy filing on December 16, 1991, and (iii) U.S. and U.K. bankruptcy authorities allowed for all purposes a portion of the Maxwell Note and certain Receivable Notes and a claim by the Company against Maxwell Communication as subrogee of Midland Bank plc in the Chapter 11 case (and any superseding Chapter 7 case) and in the Maxwell Communication administration pending in the High Court of Justice in the United Kingdom. In addition, the Company and its subsidiaries (a) sold to Macmillan the Macmillan Note ($64,568) and (b) reduced by $58,000 the amount of their claims against Maxwell Communication in respect of the Maxwell Note and certain Receivable Notes previously written off. The Company was included in the consolidated tax returns of the affiliated group of which Macmillan was the parent (the "Macmillan Group") prior to the Company's initial public offering in December 1989 and consequently is severally liable for any Federal tax liabilities for the Macmillan Group arising prior to that date. Pursuant to the Disengagement Agreements, Macmillan and a new obligor which owns 100% of Macmillan School Publishing, Inc. agreed to pay all such federal tax liabilities pursuant to an amended and restated tax allocation agreement (the "Tax Allocation Agreement"), and Maxwell Communication put into escrow $39,500 to secure Macmillan's obligations. On November 10, 1993, Macmillan commenced a voluntary Chapter 11 case in the United States Bankruptcy Court for the Southern District of New York and filed a prepackaged plan of reorganization (the "Reorganization Plan"). The Reorganization Plan provides that the Tax Allocation Agreement, along with many other contracts between Macmillan and other parties, is to be assumed by Macmillan and assigned to a trust intended to have sufficient assets to satisfy the obligations being assumed and assigned. The Reorganization Plan also provides a cash reserve to pay tax claims that are entitled to priority, which may include tax liabilities covered by the Tax Allocation Agreement. On February 18, 1994, the Bankruptcy Court confirmed the Reorganization Plan. Any tax liability assessed against the Company that would otherwise be payable by Macmillan under the Tax Allocation Agreement (as described in the preceding paragraph) is likely to be paid either by the trust or from the cash reserve described above. Management believes that any such liability will not result in a material effect on the financial condition of the Company. As part of the Merger, Fukutake established a $50,000 irrevocable letter of credit to be used in the event that income tax liabilities are imposed on the Company that relate to the Macmillan Group. The Company is obligated to pay fees as may be charged in connection with such letter of credit and to reimburse Fukutake for amounts paid by Fukutake to the issuer of the letter of credit to the extent that it is drawn upon. Merger-related restructuring costs In connection with the Company's new strategic philosophy arising from the Merger, certain restructuring costs outside the ordinary course of business have been or are anticipated to be incurred. The primary costs represent severance payments and the closing of language centers. 33% of these costs have been recorded in the consolidated statements of operations, and, in accordance with the purchase method of accounting, 67% of these costs have been allocated to the excess of cost over net assets acquired. 3. Earnings (Loss) Per Share Earnings (loss) per share of common stock is determined by dividing net income (loss) (after deducting the Preferred Stock dividend in 1991) by the weighted average number of common shares outstanding. Primary and fully diluted earnings (loss) per share of common stock are the same since common stock equivalents are either anti- dilutive or immaterial in both calculations. The Company had no such common stock equivalents outstanding as of December 31, 1993. 4. Sale of Interest in Subsidiary In November 1990, the Company completed the sale of 20% of the equity of its Japanese subsidiary, The Berlitz Schools of Languages, Inc. (Japan), to Fukutake for $27,132 and deferred the pre-tax gain of $15,021 because, under the terms of the agreement, Fukutake had an option to sell the shares back to the Company for the original yen denominated purchase price plus 7% interest. The option was terminated in February 1993 in connection with the Merger Agreement. 33% of the deferred gain has been recorded in the consolidated statement of operations and, in accordance with the purchase method of accounting, 67% of the deferred gain has been allocated to the excess of cost over net assets acquired. Fukutake's equity in the income of the Japanese subsidiary is reflected in the Company's Consolidated Statements of Operations within "other (income) expense, net". 5. Property and Equipment, Net December 31, ________________________ 1993 1992 __________ _________ Building and leasehold improvements $ 14,817 $ 20,486 Furniture, fixtures and equipment 13,197 20,001 Land 443 497 __________ _________ 28,457 40,984 Less: accumulated depreciation 2,666 14,884 __________ _________ Total $ 25,791 $ 26,100 __________ _________ __________ _________ 6. Other (Income) Expense, net 7. Income Taxes Effective January 1, 1993, the Company adopted the provisions of SFAS 109. SFAS 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included on the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates expected to apply to taxable income in the periods in which the differences are expected to reverse. As a result of the adoption of SFAS 109, as of January 1, 1993, the Company recorded a tax credit of $3,172, or $0.17 per share, which resulted in the reduction of the deferred tax liability as of that date. This amount has been reflected in the Consolidated Statement of Operations as the cumulative effect of a change in accounting principle. The principal reason for the tax credit was the difference betweeen SFAS 109 and SFAS 96 as related to the recognition of benefits for certain loss carryforwards. The components of the deferred tax liability as of December 31, 1993 were as follows: Deferred tax assets: Inventory $ 511 Joint ventures 86 Deferred revenue 1,781 Accrued expenses 5,368 Net operating losses 22,052 _________ Total deferred tax assets 29,798 --------- Deferred tax liabilities: Property and equipment depreciation (177) Publishing rights amortization (8,257) Other intangibles amortization (1,286) -------- Total deferred tax liabilities (9,720) ________ Net deferred tax assets 20,078 Less: Valuation allowance (23,602) -------- Net deferred tax liability $ (3,524) ________ ________ The valuation allowance increased by $5,432 from the balance at January 1, 1993 due to increased net operating losses in countries where the realization of a benefit for such losses is uncertain. As a result of the Merger, $16,620 of the valuation allowance will be allocated to reduce goodwill and other intangibles in future periods if realization of net operating losses becomes more likely than not. The Company's effective tax rates for the 1993 Pre-Merger and Post-Merger periods were 63.6% and 431.4%, respectively. As a result of adopting SFAS 109, $2,654 of deferred tax benefits from operating loss carryforwards were recognized at January 1, 1993 as part of the cumulative effect of adopting such Statement. Under prior accounting, a part of these benefits would have been recognized as a reduction of tax expense from continuing operations in 1993. Accordingly, the adoption of SFAS 109 at the beginning of 1993 had the effect of increasing the effective tax rate applied to continuing operations for the Pre-Merger and the Post-Merger periods by 17.2% and 231.4% respectively. The provision (benefit) for income taxes is as follows: * Pre-tax income (loss) from foreign operations of the Company was $(6,864), $(2,499), and $(13,410) for the twelve months ended December 31, 1993, 1992 and 1991, respectively. The provision (benefit) for deferred taxes is summarized as follows: The difference between the effective income tax and the U.S. statutory Federal tax rate is explained as follows: The effect of the increase in the US statutory Federal tax rate from 34 % to 35 % was not material. For financial statement purposes, at December 31, 1993 the Company has no U.S. Federal income tax losses. For tax return purposes, the Company has a U.S. Federal net operating loss carry forward of approximately $26,800. Such loss may be carried forward through the year 2006. At December 31, 1993, U.S. income and foreign withholding taxes have not been provided on approximately $27,134 of undistributed earnings of foreign subsidiaries as such earnings are intended to be permanently reinvested. However, it is estimated that foreign withholding taxes of approximately $1,348 may be payable if such earnings were distributed. These taxes, if ultimately paid, may be recoverable as foreign tax credits in the United States. The determination of deferred U.S. tax liability for the undistributed earnings of international subsidiaries is not practicable. 8. Long-Term Debt Long-Term Debt consists of the following: December 31, ________________________ 1993 1992 __________ _________ Term Loan $ 55,300 $ - Senior Notes 56,000 - Note payable to bank - 25,000 __________ _________ Total debt 111,300 25,000 Less current maturities 5,525 25,000 __________ _________ Long-term debt $ 105,775 $ - __________ _________ __________ _________ Annual maturities of long-term debt outstanding as of December 31, 1993 are as follows: 1994, $5,525; 1995, $9,225; 1996, $11,050; 1997, $14,750; 1998, $14,750; thereafter, $56,000. In connection with the Merger, the Company has outstanding indebtedness through borrowing under a bank term facility (the "Bank Term Facility") and the issuance of Senior Notes (collectively the "Acquisition Debt Facilities"). The Bank Term Facility consists of a senior term loan facility ("Term Loan") originally in an amount equal to $59,000, and a $10,000 senior revolving loan facility (the "Bank Revolving Facility"). The Company also issued an aggregate principal amount of Senior Notes of $56,000. The borrowings by the Company under the Acquisition Debt Facilities are collateralized by (i) certain shares of New Common indirectly owned by Fukutake, (ii) the capital stock of the Company's direct and indirect U.S. subsidiaries and a portion of capital stock of certain foreign subsidiaries, (iii) substantially all other tangible and intangible U.S. assets of the Company and its direct and indirect U.S. subsidiaries, other than leases of school premises, and (iv) subject to certain limitations, trademark rights of the Company and its direct and indirect U.S. subsidiaries in certain non-U.S. jurisdictions. The Term Loan amortizes quarterly, beginning March 31, 1993, until final maturity on December 31, 1998. The Company made four quarterly installments of $925 each during the year ended December 31, 1993. The Senior Notes amortize in annual installments of $14,000 on December 31 in each of the years 1999 through 2001, and have a final maturity on December 31, 2002. The Term Loan and Senior Notes are also subject to mandatory prepayment to the extent that the Company receives net proceeds from asset sales or cash flow in excess of certain specified amounts. Under certain circumstances, mandatory prepayments of the Senior Notes resulting from asset sales are required. The Company had $3,000 outstanding under the Bank Revolving Facility at December 31, 1993. Borrowings under the Bank Term Facility bear interest at variable rates based on, at the option of the Company, (i) Chemical Bank's alternate base rate plus a spread of 1.0%-1.5% or (ii) the rate offered by certain reference banks to prime banks in the interbank Eurodollar market, fully adjusted for reserves plus a spread of 2.0%-2.5%. The spread applicable to the borrowings under the Bank Term Facility will depend on a specified debt-to-cash flow ratio of the Company. In addition, a commitment fee of approximately 0.4% is charged on the average daily balance of available but unused amounts under the Bank Revolving Facility. The interest rate on the Term Loan and outstanding Bank Revolving Facility at December 31, 1993 was approximately 5.6% and 7.5%, respectively. The Senior Notes bear interest at 9.79%. The rate of interest on the Senior Notes could increase by 1.0% if the Senior Notes receive a rating from the National Association of Insurance Commissioners Securities Valuation Office other than 1 or 2 at any time prior to December 31, 1994. The Acquisition Debt Facilities contain certain covenants, including (i) limitations on the ability of the Company and its subsidiaries to incur indebtedness and guarantee obligations, to prepay indebtedness, to redeem or repurchase capital stock or subordinated debt, to enter into, grant or suffer to exist liens or sale-leaseback transactions, to make loans or investments, to enter into mergers, acquisitions or sales of assets, to change the nature of the business conducted, to amend material agreements, to enter into agreements restricting the ability of the Company and its subsidiaries to grant or to suffer to exist liens, to enter into transactions with affiliates or to limit the ability of subsidiaries to pay dividends or make loans to the Company, (ii) limitations on the payment of dividends by the Company on its capital stock and (iii) a requirement that the Company obtain, within 180 days of the Merger, foreign currency hedge agreements to fix the rate of exchange between the U.S. dollar and such foreign currencies. The Acquisition Debt Facilities also contain financial covenants requiring the Company to maintain certain levels of earnings, liquidity and net worth and imposes limitations on capital expenditures, cash flow and total debt. As of December 31, 1993, the Company was in compliance with all Acquisition Debt Facilities covenants. Based on the interest rates currently available for borrowings with similar terms and maturities, the fair values of the Term Loan and the Senior Notes at December 31, 1993 are $55,300 and $58,348, respectively. Long-term debt outstanding at December 31, 1992 under a loan agreement with Societe Generale was paid in full on February 8, 1993. 9. Commitments Lease Commitments The Company's operations are primarily conducted from leased facilities, many of which are less than 2,500 square feet, which are under operating leases that generally expire within five years. Rent expense, principally for language centers, amounted to $21,225, $1,849, $21,264, and $17,510 for the period February 1, 1993 to December 31, 1993, the period January 1, 1993 to January 31, 1993 and the years ended December 31, 1992, and 1991, respectively. Certain leases are subject to escalation clauses and/or renewal options. The minimum rental commitments under noncancellable operating leases with a remaining term of more than one year at December 31, 1993 are as follows: 1994 - $5,674; 1995 - $5,344; 1996 - $4,436; 1997 - $2,736; 1998 - $2,258, and an aggregate of $5,966 thereafter. Legal Proceedings In November 1992, the Company received a complaint entitled "Irving Kas, on behalf of all others similarly situated v. Berlitz International, Inc., Joe M. Rodgers and Elio Boccitto" in the U.S. District Court for New Jersey alleging various securities law violations under the Securities Exchange Act of 1934 and alleging various omissions and misrepresentations in connection with the Company's announcements during 1992 with respect to its financial results. In 1993, plaintiff filed a supplemental and amended complaint alleging various violations of the federal securities laws and common-law breaches of fiduciary duties relating primarily to the transaction contemplated by the Merger Agreement, and seeking to add another officer of the Company as a defendant in addition to the two officers named in the initial pleading. On August 4, 1993, the Court granted defendants' motion to dismiss the amended and supplemental complaint, deemed the original complaint to be withdrawn and dismissed the lawsuit in its entirety. The plaintiff's time to appeal has expired. The Company is party to several actions arising out of the ordinary course of its business. Management believes that none of these actions, individually or in the aggregate, will have a material adverse effect on the financial condition or results of operations of the Company. 10. Financial Instruments Pursuant to a covenant under the Acquisition Debt Facilities, in August 1993 the Company entered into six currency coupon swap agreements with a financial institution to hedge the Company's net investments in certain foreign subsidiaries and help manage the effect of foreign currency fluctuations on the Company's ability to repay its U.S. dollar debt. These agreements, which utilize fixed and floating interest rates, require the Company to periodically exchange foreign currency denominated interest payments for U.S. dollar denominated interest receipts. Under the fixed rate agreements, effective for the period from December 31, 1993 to December 31, 1998, semiannual interest exchanges begin June 30, 1994. Under the floating interest rate agreements, effective for the period from December 31, 1994 to December 31, 1998, quarterly interest exchanges, begin March 31, 1995. Credit loss from counterparty nonperformance is not anticipated. The periodic interest exchanges are based upon annual interest rates applied to notional amounts as follows: No gains or losses on these swap agreements have been recorded in the Company's Consolidated Statement of Operations. The fair market value of these swap agrements at December 31, 1993, representing the amount that could be settled based on estimates obtained from a dealer, was approximately $533. 11. Related Party Transactions a) Transactions with current related party Berlitz-Japan has a contract (the "Development Agreement") with Fukutake, originally executed in 1992 and amended in 1993, for the development of English conversation video taped programs for elementary and junior high school students in Japan. The programs consist of printed study materials, video cassettes and audio cassettes, which are used as the basis of a correspondence course. Under this contract, Fukutake will reimburse Berlitz Japan for project-related production costs incurred, including employee salaries and outside production fees, and pay to Berlitz Japan a one-time development fee of Yen 46,672 (approximately $420) and a coordination fee of 10% of project-related employee salaries, estimated at Yen 2.3 million (approximately $21). Pursuant to the Development Agreement, the Company received reimbursement for production costs of approximately $1,800 and $296 during 1993 and 1992, respectively. In addition, the Company received the development fee of approximately $420 in 1993. The Company has recorded in accounts receivable $213 and $411 at December 31, 1993 and 1992, respectively. Pursuant to a June 1, 1993 sublease agreement, the Company subleases space in Fukutake's New York offices at an annual base rent of $79 plus operating expenses. The sublease expires in 1995. The Company has entered into certain other joint business arrangements with Fukutake. It is not anticipated that these arrangements will be material to the Company's business. b) Transactions with former related parties Effective December 13, 1989, the Company, Macmillan and Maxwell Communication entered into a services agreement under which Macmillan and Maxwell Communication provided various services to the Company, including certain financial, administrative, management and other services and distribution agreements. The Company subleased space for its New York offices pursuant to a sublease agreement with Macmillan, until January 1991, when New York office personnel relocated to the Company's corporate headquarters. In connection with the disengagement of the relationship between the Company, Maxwell Communication and Macmillan in January 1993, Macmillan and the Company entered into an agreement clarifying certain commercial relationships, including formally terminating the services agreement as of December 31, 1991. The distribution agreement remains in effect. Pursuant to the terms of a distribution agreement between the Company and Maxwell Macmillan Canada, Inc. ("Maxwell Canada"), Macmillan and Maxwell Canada serve as the exclusive distributors for certain travel guide books and related publications of the Company in the United States and Canada, respectively. The Company paid Macmillan an aggregate of approximately $564 and $437 pursuant to the terms of these distribution agreements in 1992 and 1991, respectively. The costs of the services provided under the services and distribution agreements are included in the accompanying Consolidated Statements of Operations as selling, general and administrative expenses. Amounts applicable to transactions with Macmillan and Maxwell Communication are summarized below: Year Ended December 31, ___________________________ 1992 1991 ___________ __________ Balance, beginning of period $ (617) $ 185,879 Charge from Macmillan for corporate services (26) (292) Charge for distribution services (564) (437) Interest income 6,798 17,565 Cash transfers, net (1,934) 3,672 Dividends declared (4,452) (14,858) Write-off or reserve of affiliate notes - (191,354) Other activity, net 3,109 (792) ___________ __________ Total balance, end of period $ 2,314 $ (617) ___________ __________ ___________ __________ "Dividends" includes the declaration of dividends on shares previously held by Macmillan. In October 1989, the Company lent $99,600 to Maxwell Communication as evidenced by the Maxwell Note at 10.5% per annum. In addition, the Company also converted $89,243 of receivables due from affiliates into the Receivable Notes of Maxwell Communication and an affiliate of Macmillan as follows: a 3 billion (Japanese yen) note of Maxwell Communication ($24,078 based on the exchange rate at December 31, 1992), a $3,300 note of MLL Holdings Ltd. (which is a subsidiary of Maxwell Communication) and a $64,568 note of Macmillan. The Maxwell Note and the dollar-denominated Receivable Notes bore interest at 10.5% per annum and the yen-denominated note of Maxwell Communication bore interest at the discount rate of the Bank of Japan plus .25%. Interest income on the Maxwell Note and the Receivable Notes was $6,798 and $15,876 in 1992 and 1991, respectively. As a result of Maxwell Communication filing for protection under Chapter 11 of the U.S. Bankruptcy Code and administration in the United Kingdom, as discussed in Note 2, in 1991 the Company wrote off or provided reserves for the Maxwell Note and the Receivable Notes totalling $191,354. The charges recorded for the notes written off ($126,786) and the provisions for reserves ($64,568) were based on management's best estimates at that time. In addition, in 1991 the Company recorded charges totalling $4,000 representing the Company's estimated losses from cash deposits in a United Kingdom bank which such bank seized to offset debts it was owed by certain Maxwell Communication related companies as part of a credit facility, and the estimated costs for other Maxwell Communication related matters. In 1992, the Company received $975 from Midland Bank plc as a partial settlement for such loss and in January 1993, the Company's claim against Maxwell Communication as subrogee of Midland Bank plc arising from such loss less the partial settlements was admitted for all purposes by the U.S. and U.K. bankruptcy authorities pursuant to the Disengagement Agreements. In addition, the Company incurred $1,356 net additional Maxwell and Merger related costs in 1992. These amounts are included in the Consolidated Statements of Operations as "Non-recurring Maxwell and Merger related charges." During the first quarter of 1991, the Company elected to participate in the Macmillan Cash Management Investment Program whereby up to a maximum of 50% of the Company's investable excess cash would be invested in an unsecured demand note of Macmillan. The Company made an initial investment of $25,000 and earned interest of $1,689 in 1991. Interest rates during the year ranged from 7.5% to 16.0%. The balance of the Company's excess cash was invested in its own cash management program. All funds were withdrawn from the Program as of December 31, 1991. In March 1991, the Company and several of its subsidiaries agreed in principle to license certain trademarks, self-teaching materials, and copyrighted publications to Maxwell MultiMedia, Limited, a joint venture between Maxwell Communication and N.V. Philips. Also, several of the Company's subsidiaries agreed in principle to license certain trademarks, self-teaching materials and copyrighted publication to Sphere, Inc., an affiliate of Maxwell Communication, for the development, manufacture and sale of an educational foreign-language computer game. It is not anticipated that either of these agreements will be material to the Company's business. 12. Capital Stock Preferred Stock The holders of the Preferred Stock were entitled to quarterly dividends at the quarterly rate, the lesser of 1.75% of $180,000 liquidation preference of such shares (i.e. $12,600 annually) or the quarterly rate which resulted in the aggregate dividends on all shares of the Preferred Stock being equal to the Company's after-tax income during the preceding quarter from the Maxwell Note and the Receivable Notes. As a result of the payment defaults of the Maxwell Note and certain Receivable Notes and the recording of the write-offs and reserves in the Company's 1991 Consolidated Statement of Operations with respect to such Notes, no dividends were paid on the Preferred Stock during 1992 and 1993. The Preferred Stock was redeemed in 1993 in connection with the Merger. 13. Stock Option and Incentive Plans During 1989, the Company established the 1989 Stock Option and Incentive Plan (the "Plan") which authorized the issuance of up to 2,000,000 shares of common stock. The Plan authorized the issuance of various stock incentives to officers and key employees, including options, stock appreciation rights, restricted stock, deferred stock and certain other stock-based incentive awards. The options were to expire ten years from the date of grant and were exercisable as determined by the committee established to administer the plan. A summary of the activity related to the Company's Plan follows: Shares Price per Share _______ _______________ Options outstanding at January 1, 1991 552,000 $ 14.50 - $17.125 Granted 195,000 $ 17.875 - $18.625 Exercised (4,000) $ 16.50 Cancelled (36,000) $ 16.50 _______ Options outstanding at December 31, 1991 707,000 $ 14.50 - $18.625 Granted 320,000 $ 17.25 - $18.00 Exercised - Cancelled (26,500) $ 17.875 - $18.625 ________ Options outstanding at December 31, 1992 1,000,500 $ 14.50 - $18.625 Exercised (6,000) $ 16.50 Cancelled (10,000) $ 16.50 - $18.00 Merger-related liquidation (984,500) $ 14.50 - $18.625 _______ Options outstanding at December 31, 1993 - - _______ _______ Options exercisable at December 31, 1992 336,500 $ 14.50 - $18.625 _______ Options exercisable at December 31, 1991 200,400 $ 14.50 - $18.625 _______ _______ At January 1, 1991, 80,000 restricted shares to key employees were outstanding. The resale restrictions on these shares lapsed in equal installments over five years commencing from date of grant. Deferred compensation in the amount of $1,357, equivalent to the market value of the common stock at the date of grant times the number of shares granted, was charged to Shareholders' Equity as unearned compensation, and was being amortized over the service period. During 1991, 5,000 shares were issued and 10,000 shares were cancelled. During 1992, 3,000 shares were cancelled and 3,500 shares sold. During 1993, prior to the Merger, 2,000 shares were sold. All outstanding options and restricted shares were liquidated on February 8, 1993, in connection with the Merger. See Note 2. During 1991, the Company established the Non-Employee Directors Stock Plan ("Directors' Stock Plan") to provide non-employee Directors of the Company the opportunity to elect to receive a portion of their annual retainer fees in the form of common stock of the Company, or to defer receipt of a portion of such fees and have the deferred amounts treated as if invested in common stock. The Directors' Stock Plan, in which participation was elective for non-employee Directors, limited the benefits paid in the form of stock to 50% of the annual retainer. All deferred amounts outstanding under the Director's Stock Plan were settled in connection with the Merger. On December 2, 1993, the Board of Directors of the Company approved the Long-Term Executive Incentive Compensation Plan and the Short-Term Executive Incentive Compensation Plan (the "Long-Term Plan" and "Short- Term Plan", respectively). The Long-Term Plan, having an effective date of January 1, 1994, provides for potential cash awards in 1999 to key executive employees if certain financial goals and/or stock price appreciation are achieved for the five year period ending December 31, 1998. The Short-Term Plan, commencing with the 1993 calendar year, provides for potential cash awards to officers and other key employees if certain financial goals and individual discretionary performance measures are met for the applicable calendar year. The Company is not required to establish any fund or to segregate any assets for payments under the Long-Term Plan or the Short-Term Plan. The Company has severance agreements with six key employees which generally provide that if the Company were to terminate the employee's employment other than for cause or if the employee was to terminate his employment for reasons specified in the agreements, the employee would receive amounts equal to his annual base salary, (except for one employee who will receive two times his annual salary and one employee who will receive two times his annual salary until August 1995, but one time thereafter), plus a pro-rata share of the Company's bonus plan award. The agreements also provide for the continuation of certain benefits. Four of these agreements are in effect for 18 months following a change in control occurring at any time within two years from the date of these agreements. The remaining two agreements,not dependent on a change in control, extend beyond this 18 month period. The maximum contingent liability under such agreements in approximately $2,000. The Company also has a consulting agreement with its former Chief Operating Officer which provides, subject to certain conditions, for payments totalling $220 over the two-year period ended August 31, 1995. 14. Thrift and Retirement Plans Through December 31, 1991, the Company was included in the Macmillan Thrift and Retirement Plan (the "Macmillan Plan"), which covered substantially all of its domestic employees. The retirement portion of the Macmillan Plan provided for the Company to make regular contributions based on salaries of eligible employees. The thrift portion of the Macmillan Plan, in which employee participation was elective, provided for Company matching contributions of up to 3% of salary. Payments upon retirement or termination of employment were based on vested amounts credited to individual accounts. Effective December 31, 1991, the Company withdrew from the Macmillan Plan and established the Berlitz International, Inc. Retirement Plan (the "Berlitz Plan") which covers substantially all of its domestic employees and provides substantially the same terms as the Macmillan Plan. The Company's transfer of the assets from the Macmillan Plan to the Berlitz Plan occurred subsequent to the March 31, 1992 valuation. In addition, certain foreign operations have other defined contribution benefit plans. Total expense with respect to all benefit plans was $1,417, $121, $1,267, and $1,041, for the period from February 1, 1993 to December 31, 1993, the period from January 1, 1993 to January 31, 1993, and the years ended December 31, 1992 and 1991, respectively. The company does not provide health care or insurance coverage or other post retirement benefits other than pensions to retirees. Therefore, adoption of SFAS No. 106 "Postretirement Benefits other than Pensions" has no effect on the Company's consolidated financial statements. In November 1992, the FASB issued SFAS No. 112 "Employers' Accounting for Postemployment Benefits". This standard is effective in 1994 and establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirment. The Company believes that the adoption of this standard will have no effect on its consolidated financial statements. 15. Business Segment and Geographic Area Information The Company's operations are conducted through the following business segments: Language Instruction, Translation Services, and Publishing. Prior to 1992, the Translation Services business was not significant to the Company, and therefore the 1991 presentation of operating profit (loss) capital expenditures, depreciation and amorization and identifiable assets, where not practicable, has not been restated. The Company now considers the Translation Services business to be significant enough to warrant being identified as a separate operating segment for financial reporting purposes. Intersegment and intergeographical sales are not significant. General corporate identifiable assets are principally property and equipment. Depreciation and amortization relates to property and equipment, excess of cost over net assets acquired and publishing rights. Amortization of publishing rights and excess of cost over net assets acquired, included in operating profit (loss) in the period from February 1, 1993 to December 31, 1993, the period from January 1, 1993 to January 31, 1993, and the years ended December 31, 1992 and 1991, amounted to $3,414, $204, $2,452 and $2,453 for North America; $1,656, $189, $2,263 and $2,263 for Western Europe; $1,409, $102, $1,229 and $1,229 for Central/Eastern Europe; $3,382, $308, $3,697 and $3,697 for East Asia and $1,690, $69, $822 and $822 for Latin America. Merger-related restructuring costs, included in operating profit (loss) in the Post Merger period from February 1, 1993 to December 31, 1993, amounted to $122 for North America; $830 for Western Europe; $260 for Central/Eastern Europe; $2,826 for East Asia; $50 for Latin America, and $720 for Corporate Expenses-North America. No Merger-related restructuring costs were incurred in the Pre- Merger periods. 16. Quarterly Financial Data (unaudited) (1) Gives effect to the combination of the results of the Company for the Pre-Merger and Post-Merger periods. (2) Assumes 10,031,000 shares of common stock outstanding. (3) Reflects effects of Merger-related restructuring adjustments. Refer to Note 2. (1) Represents principally net losses incurred in the ordinary course of business and chargeable against the allowance. (2) Represents principally foreign currency translation. (3) See Notes 2 & 11 regarding the Maxwell Note and the Receivable Notes. (4) Gives effect to the combination of the changes in the allowance for doubtful accounts of the Company for the Pre-Merger and Post-Merger periods of the year ended December 31, 1993. BERLITZ INTERNATIONAL, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION (in thousands) Schedule X Year Ended December 31, _____________________________________ 1993 (1) 1992 1991 ________ _________ ________ Advertising Costs $ 12,933 $ 13,233 $ 11,369 ________ _________ ________ ________ _________ ________ Taxes other than payroll and income taxes, royalties and maintenance, and repairs are less than 1% of sales of services and products. (1) Gives effect to the combination of advertising costs incurred for the Pre- Merger and Post-Merger periods of the year ended December 31, 1993. 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 The information required by Item 401 of Regulation S-K with respect to Directors and Executive Officers of the Company is set forth in Part I of this Form 10-K. The information required by Item 405 of Regulation S-K with respect to directors and executive officers of the Company will be set forth in Amendment #1 to this Form 10-K. ITEM 11. ITEM 11. Executive Compensation The information required by this item will be set forth in Amendment #1 to this Form 10-K. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item will be set forth in Amendment #1 to this Form 10-K. ITEM 13. ITEM 13. Certain Relationships and Related Transactions The information required by this item will be set forth in Amendment #1 to this Form 10-K. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules and Reports On Form 8-K A. Index to Financial Statements and Financial Statement Schedules 1. Financial Statements 2. Financial Statement Schedules The Financial Statements and the Financial Statement Schedules included in the Annual Report on Form 10-K are listed in Item 8 on page 32. 3. Exhibits All Exhibits listed below are filed with this Annual Report on Form 10-K unless specifically stated to be incorporated by reference to other documents previously filed with the Commission. Exhibit No. 2.1 Amended and Restated Agreement and Plan of Merger, dated as of December 9, 1992, among the registrant, Fukutake Publishing Co., Ltd. and BAC, Inc. Exhibit 1 to the registrant's Form 8-K, dated December 9, 1992, is incorporated by reference herein. 3.1 Restated Certificate of Incorporation of the registrant filed with the State of New York on December 11, 1989. Exhibit 3.4 to Registration Statement No. 33-31589 is incorporated by reference herein. 3.2 Certificate of Merger of BAC, Inc. into the registrant (including amendments to the registrant's Certificate of Incorporation), filed with the State of New York on February 8, 1993. Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 4.1 Specimen Certificate of Old Common Stock with Legend. Exhibit 4.3 to the Company's Form 10-K for the fiscal year ended December 31, 1991 is incorporated by reference herein. 4.2 Specimen Certificate of Common Stock. Exhibit 4.1 to Registration Statement No. 33-56566 is incorporated by reference herein. 4.5 Amended and Restated Safeguard Rights Agreement between the registrant and United States Trust Company of New York. Exhibit 1 to the Company's Form 8-K, dated March 6, 1992, is incorporated by reference herein. 10.1 Credit Agreement, dated as of January 29, 1993, among the registrant, the several lenders from time to time party thereto and Chemical Bank as Agent. Exhibit 10.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 10.2 Form of Senior Note Agreement, dated as of January 29, 1993, among the registrant and each institutional lender party thereto. Exhibit 10.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 10.3 Amended and Restated Tax Allocation Agreement among the registrant, Macmillan, Inc. and Macmillan School of Publishing Holding Company, Inc., dated as of October 11, 1989. Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 10.4 Agreement among the registrant, Berlitz Financial Corporation, The Berlitz School of Language (Japan) Inc., The Berlitz Schools of Languages Limited and Maxwell Communication Corporation plc, dated January 8, 1993. Exhibit 1 to the Company's Form, 8-K, dated January 7, 1993, is incorporated by reference herein. 10.5 Agreement among the registrant, Berlitz Financial Corporation, Macmillan, Inc. and Macmillan School Publishing Holding Company, Inc., dated January 8,1993. Exhibit 2 to the Company's Form 8-K, dated January 7, 1993 is incorporated by reference herein. 10.6 Escrow Agreement among the registrant, Maxwell Communication Corporation plc, the beneficiaries named therein and IBJ Schroder Bank & Trust Company, dated as of January 29, 1993. Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 10.7 Settlement Agreement between the registrant and Macmillan, Inc., dated January 8, 1993. Exhibit 3 to the Company's Form 8-K, dated January 7, 1993 is incorporated by reference herein. 10.8 Distribution Agreement between the registrant and Macmillan, Inc., dated as of October 11, 1989. Exhibit 10.19 to Registration Statement No. 33-31589 is incorporated by reference herein. 10.9 Distribution Agreement between the registrant and Collier Macmillan Canada, Inc., dated as of October 11, 1989. Exhibit 10.4 to Registration Statement No. 33-31589 is incorporated by reference herein. 10.10 $99.6 million Term Note pursuant to Term Loan Agreement between the registrant and Maxwell Communication Corporation plc dated November 27, 1989. Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 is incorporated by reference herein. 10.11 3 billion (Japanese yen) Receivable Note from Maxwell Communication Corporation plc dated December 4, 1989. Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 is incorporated by reference herein. 10.12 $64,568,000 Receivable Note from Macmillan, Inc. dated October 1, 1989. Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 is incorporated by reference herein. 10.13 $3.3 millon Receivable Note from MLL Holdings Limited dated October 1, 1989. Exhibit 10.7 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 is incorporated by reference herein. 10.14 Short Term Executive Incentive Compensation Plan. Exhibit 10.12 to Registration Statement No. 33-31589 is incorporated by reference herein. 10.15 1989 Stock Option and Incentive Plan. Exhibit 10.13 to Registration Statement No. 33-31589 is incorporated by reference herein. 10.16 1993 Long-Term Executive Incentive Compensation Plan. Exhibit 1 to the Company's Form 8-K, dated December 2, 1993 is incorporated by reference herein. 10.17 1993 Short-Term Executive Incentive Compensation Plan. Exhibit 2 to the Company's Form 8-K, dated December 2, 1993 is incorporated by reference herein. 10.18 Form of Indemnity Agreement between the Registrant and Macmillan, Inc. dated October 11, 1989. Exhibit 10.16 to Registration Statement No. 33-31589 is incorporated by reference herein. 10.19 Letter Agreement, dated October 19, 1990, with Robert Minsky. Exhibit 10.16 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 is incorporated by reference herein. 10.20 Employment Agreement, dated April 27, 1992, between the registrant and Robert Minsky. Exhibit 10.18 to Registration Statement No. 33-56566 is incorporated by reference herein. 10.21* Employment Agreement, dated October 1, 1993, between the registrant and Robert Minsky. 10.22 Berlitz International, Inc. Non-Employee Directors' Stock Plan. Exhibit 10.17 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 is incorporated by reference herein. 10.23 Shareholders' Agreement among Berlitz Languages, Inc., Fukutake Publishing Co., Ltd. and the registrant, dated as of November 8, 1990. Exhibit 10.18 to the Company's Annual Report on Form 10- K for the fiscal year ended December 31, 1990 is incorporated by reference herein. 10.24 Amendment No. 1 to Shareholders' Agreement among Berlitz Languages, Inc., Fukutake Publishing Co., Ltd. and the registrant, dated as of November 8, 1990. Exhibit 10.18 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 is incorporated by reference herein. Exhibit 10.21 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 10.25 Stock Purchase Agreement, dated as of November 8, 1990, between Berlitz Languages, Inc., the registrant and Fukutake Publishing Co., Ltd. Exhibit 10.19 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 is incorporated by reference herein. 10.26 Form of Indemnification Agreement between the registrant and each of Robert Maxwell, Kevin Maxwell, Martin E. Maleska and David H. Shaffer. Exhibit 10.20 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 is incorporated by reference herein. 10.27 Form of Amended and Restated Indemnification Agreement between the registrant and each of Elio Boccitto, John Brademas, Rozanne L. Ridgway, Joe M. Rodgers, Robert Minsky and Rudy G. Perpich. Exhibit 10.24 to Registration Statement No. 33-56566 is incorporated by reference herein. 10.28 Amended and Restated Indemnification Agreement between the registrant and Hiromasa Yokoi. Exhibit 10.25 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 10.29 Form of Indemnification Agreement between the registrant and each of Soichiro Fukutake, Owen Bradford Butler, Susumu Kojima, Saburou Nagai, Edward G. Nelson, Makoto Sato and Aritoshi Soejima. Exhibit 10.26 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 10.30 Form of Indemnification Agreement between the registrant and each of Jose Alvarino, Manuel Fernandez, Paul Gendler, Robert C. Hendon, Jr., Henry James, Jacques Meon, Michael Mulligan, Kim Sonne, Anthony Tedesco and Wolfgang Wiedeler. Exhibit 10.24 to Registration Statement No. 33-56566 is incorporated by reference herein. 10.31 Letter Agreement, dated July 18, 1990, with Michael J. Mulligan. Exhibit 10.21 to the Company's Report on Form 10-K for the fiscal year ended December 31, 1990 is incorporated by reference herein. 10.32 Employment Agreement, dated as of December 23, 1991, between the registrant and Joe M. Rodgers with acknowledgement letter attached. Exhibit 10.24 to the registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 is incorporated by reference herein. 10.33 Employment Agreement dated December 4, 1992 between the registrant and Lyle Beasley. Exhibit 10.29 to Registration Statement No. 33-56566 is incorporated by reference herein. 10.34 Employment Agreement dated December 4, 1992 between the registrant and Robert C. Hendon, Jr. Exhibit 10.30 to Registration Statement No. 33-56566 is incorporated by reference herein. 10.35 Berlitz International, Inc., Retirement Savings Plan, effective as of January 1, 1992. Exhibit 10.31 to Registration Statement No. 33-56566 is incorporated by reference herein. 10.36* Letter Agreement, dated July 14, 1993, between the registrant and Elio Boccitto. 10.37* Employment Agreement, dated June 15, 1993, between the registrant and Anthony Tedesco. 10.38* Employment Agreement, dated February 6, 1992, between the registrant and Manual Fernandez 11 Statement regarding computation of per share earnings. Exhibit 11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 21 List of principal subsidiaries of the registrant. Exhibit 22 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. 23 Consent of Coopers & Lybrand. Exhibit 24 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 is incorporated by reference herein. * Filed herewith. B. Reports on Form 8-K: A Form 8-K was filed on December 2, 1993, relating to the Company's Long- Term and Short-Term Executive Incentive Compensation Plans. 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. As of the date of the filing of this Annual Report on Form 10-K no proxy materials have been furnished to security holders. Copies of all proxy materials will be sent to the Commission in compliance with its rules. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Berlitz International, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BERLITZ INTERNATIONAL, INC. By:/s/ HIROMASA YOKOI Hiromasa Yokoi Vice Chairman of the Board, Chief Executive Officer and President Dated: 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. /s/ SOICHIRO FUKUTAKE Chairman of the Board March 31, 1994 Soichiro Fukutake /s/ HIROMASA YOKOI Vice Chairman of the Board, March 31, 1994 Hiromasa Yokoi Chief Executive Officer, and President (Principal Executive Officer) /s/ SUSUMU KOJIMA Executive Vice President, March 31, 1994 Susumu Kojima Corporate Planning and Director /s/ ROBERT MINSKY Executive Vice President, March 31, 1994 Robert Minsky Chief Financial Officer and Director (Principal Financial Officer) /s/ MANUEL FERNANDEZ Executive Vice President and March 31, 1994 Manuel Fernandez Director /s/ HENRY D. JAMES Vice President and Controller March 31, 1994 Henry D.James (Principal Accounting Officer) Director March 31, 1994 Owen B. Butler /s/ SABUROU NAGAI Director March 31, 1994 Saburou Nagai /s/ EDWARD G. NELSON Director March 31, 1994 Edward G. Nelson /s/ ARITOSHI SOEJIMA Director March 31, 1994 Aritoshi Soejima

726927_1993.txt

726927_1993

1993

726927

Item 1. Business Balcor Realty Investors-84 (the "Registrant") is a limited partnership formed in 1982 under the laws of the State of Illinois. The Registrant raised $140,000,000 from sales of Limited Partnership Interests. The Registrant's operations consist exclusively of investment in and operation of real property, and all information included in this report relates to this industry segment. The Registrant utilized the net offering proceeds to acquire twenty-three real property investments and a minority joint venture interest in one additional property. Two properties have been sold and titles to five properties, including the property in which the Registrant had a minority joint venture interest, have been relinquished through foreclosure. As of December 31, 1993, the Registrant owned the seventeen properties described under "Properties" (Item 2). The Partnership Agreement provides that the proceeds of any sale or refinancing of the Registrant's properties will not be reinvested in new acquisitions. During 1993, the multi-family residential real estate industry in certain cities and regions of the country experienced improvements in occupancy levels and rental rates. These improvements are due in part to recoveries in local economies along with low levels of new construction of rental units in recent years, which has led to higher occupancies and increased rental revenues for existing properties. Of the Registrant's seventeen properties, during 1993, ten generated positive cash flow while seven generated marginal cash flow deficits. Many rental markets continue to remain extremely competitive; therefore, the General Partner's goals are to maintain high occupancy levels, while increasing rents where possible, and to monitor and control operating expenses and capital improvement requirements at the properties. Historically, real estate investments have experienced the same cyclical characteristics affecting most other types of long-term investments. While real estate values have generally risen over time, the cyclical character of real estate investments, together with local, regional and national market conditions, has resulted in periodic devaluations of real estate in particular markets, as has been experienced in the last few years. As a result of these factors, it has become necessary for the Registrant to retain ownership of many of its properties for longer than the holding period for the assets originally described in the prospectus. The General Partner examines the operations of each property and each local market individually when determining the optimal time to sell each of the Registrant's properties. Although investors have received certain tax benefits, the Registrant has not commenced distributions. Future distributions will depend on improved cash flow from the Registrant's remaining properties and proceeds from future property sales, as to which there can be no assurances. In light of results to date and the current market conditions, the General Partner does not anticipate that investors will recover a substantial portion of their original investment. The Registrant is largely dependent on loans from the General Partner and owed approximately $11,166,000 to the General Partner at December 31, 1993, in connection with funds advanced for working capital purposes. These loans are expected to be repaid from available cash flow from future property operations, or from proceeds received from the disposition of the Registrant's real estate investments prior to any distributions to the Limited Partners from these sources. Although an affiliate of the General Partner has, in certain circumstances, provided mortgage loans for certain properties of the Registrant, there can be no assurance that loans of this type will be available from either an affiliate or the General Partner in the future. The General Partner may continue to provide additional short-term loans to the Registrant or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Registrant would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Registrant may be required to dispose of some of its properties to satisfy these obligations. In instances where the General Partner concludes that the Registrant's investment objectives cannot be met by continuing to own a particular property and fund operating deficits, the Registrant has suspended and may in the future suspend debt service payments or sell the property at a price less than its original cost. Suspension of debt service payments may lead to a renegotiation of terms with lenders which would permit the Registrant to continue to own properties or may lead to foreclosure or other action by lenders which would result in the relinquishment of title to properties in satisfaction of the outstanding mortgage loan balances. In the case of each property, the General Partner will pursue modification of underlying debt, consider suspending debt service payments and/or deferring non-critical repair and maintenance costs and analyze present and projected market conditions and projections for operations prior to determining the disposition of a property. In April 1992, the terms of the modification of the mortgage loan payable collateralized by the Highland Glen apartment complex expired and the loan returned to its original terms, signficantly increasing the monthly debt service requirements. The Registrant suspended debt service payments while attempting to negotiate a further modification of the loan terms. In July 1992, the lender filed foreclosure proceedings against the property. A receiver was appointed and took possession of the property in September 1992. The Registrant relinquished title to the property through foreclosure during May 1993. See Note 13 of Notes to Financial Statements for additional information. The Pinebrook apartment complex is owned by a joint venture consisting of the Registrant and an affiliated partnership. The $5,185,000 wrap-around mortgage payable collateralized by the property matured in July 1993. The joint venture reviewed its options, among which were a sale of the property and a refinancing or modification of the purchase money wrap-around mortgage. However, the loan amount expected to be available on a refinancing was less than the current debt outstanding, and the joint venture partners did not have the cash reserves needed to fund the difference. Accordingly, the joint venture suspended debt service payments and began negotiations with the lender for a discounted buy-out of the $5,185,000 purchase money wrap-around mortgage note. In response, the lender filed foreclosure proceedings and in December 1992, the joint venture filed for protection under the U.S. Bankruptcy Code. In January 1994, a plan of reorganization was approved by the Bankruptcy Court. See Item 3. Legal Proceedings and Note 12 of Notes to Financial Statements for additional information. During April 1993, the Registrant completed a refinancing of the first mortgage loan collateralized by the Ridgetree - Phase I apartment complex. The refinancing resulted in new first and second mortgage loans from an unaffiliated lender. The Registrant recognized an extraordinary gain from debt forgiveness in connection with the refinancing. See Note 4 of Notes to Financial Statements for additional information. During May 1993, the Registrant completed a refinancing of the first mortgage loan collateralized by the Woodland Hills apartment complex. The refinancing resulted in a new first mortgage loan from an unaffiliated lender and a reduction of the second mortgage loan payable to an affiliate of the General Partner, as a requirement of the first mortgage loan. See Note 4 of Notes to Financial Statements for additional information. During June 1993, the Registrant obtained a first mortgage loan collateralized by the Chesapeake apartment complex. This first mortgage loan replaces the bonds collateralized by the property, which the Registrant had purchased in 1991. See Note 4 of Notes to Financial Statements for additional information. During July 1993 and March 1994, the Registrant completed modifications of the mortgage notes payable collateralized by the Antlers and Quail Lakes apartment complexes, respectively. The modifications extended the maturity dates and adjusted the interest rates. See Note 4 of Notes to Financial Statements for additional information. During October 1993, the Registrant completed a refinancing of the first mortgage loan collateralized by the Chimney Ridge apartment complex. The refinancing resulted in a new first mortgage loan from an unaffiliated lender. The Registrant recognized an extraordinary gain from debt forgiveness in connection with the refinancing. See Note 4 of Notes to Financial Statements for additional information. The officers and employees of Balcor Partners-XV, the General Partner of the Registrant, and its affiliates perform services for the Registrant. The Registrant currently has 103 full-time and 64 part-time employees engaged in its operations. Item 2. Item 2. Properties As of December 31, 1993, the Registrant owns the 17 properties described below: Location Description of Property Jacksonville, Florida Antlers Apartments: a 400-unit apartment complex located on approximately 43 acres. Chandler, Arizona Briarwood Place Apartments: a 268-unit apartment complex located on approximately 15 acres. Phoenix, Arizona Canyon Sands Village Apartments: a 412-unit apartment complex located on approximately 20 acres. Harris County, Texas Chesapeake Apartments: a 320-unit apartment complex located on approximately 11 acres. Fort Worth, Texas Chestnut Ridge Apartments (Phase II): a 160-unit apartment complex located on approximately 6 acres. Colorado Springs, Colorado Chimney Ridge Apartments: a 280-unit apartment complex located on approximately 9 acres. Dade County, Florida Courtyards of Kendall Apartments: a 300-unit apartment complex located on approximately 20 acres. Tulsa, Oklahoma Creekwood Apartments (Phase I): a 276-unit apartment complex located on approximately 13 acres. Charleston County, South Carolina Drayton Quarter Apartments: a 206-unit apartment complex located on approximately 17 acres. Lexington, Kentucky * Pinebrook Apartments: a 208-unit apartment complex located on approximately 11 acres. Oklahoma City, Oklahoma Quail Lakes Apartments: a 384-unit apartment complex located on approximately 19 acres. Dallas, Texas Ridgepoint Hill Apartments: a 309-unit apartment complex located on approximately 11 acres. Dallas, Texas Ridgepoint View Apartments: a 314-unit apartment complex located on approximately 11 acres. Dallas, Texas Ridgetree Apartments (Phase I): a 444-unit apartment complex located on approximately 11 acres. Las Vegas, Nevada Somerset Pointe Apartments: a 452-unit apartment complex located on approximately 26 acres. Overland Park, Kansas Sunnyoak Village Apartments: a 548-unit apartment complex located on approximately 33 acres. Irving, Texas Woodland Hills Apartments: a 250-unit apartment complex located on approximately 10 acres. * Owned by Registrant through a joint venture with an affiliated partnership. Each of the above properties is held subject to various forms of financing. In the opinion of the General Partner, the Registrant has provided for adequate insurance coverage for its real estate investment properties. See Notes to Financial Statements for other information regarding real property investments. Item 3. Item 3. Legal Proceedings (a & b) Pinebrook Apartments Pinebrook Apartments was originally acquired by a joint venture (the "Joint Venture") consisting of the Registrant and an affiliate (the "Affiliate"). The property is encumbered by a purchase money note and wrap-around mortgage note payable to Lexington Associates ("Lexington"). The Lexington Note wrapped around two mortgage notes payable to First Equities Corporation ("First Equities"), a mortgage note payable to Tates Creek Place ("Tates Creek"), and a first mortgage note payable to Travelers Insurance Company ("Travelers"). In January 1992, Pinebrook Limited Partnership, another joint venture consisting of the Registrant and the Affiliate purchased both of First Equities' notes. In November 1992, the Joint Venture suspended debt service payments on the Lexington Note and subsequently filed for protection under Chapter 11 of the U.S. Bankruptcy Code, In re Pinebrook Investors, U.S. Bankruptcy Court, Eastern District of Kentucky, Case #92-52183. In January 1994, a plan of reorganization (the "Plan") was approved which is expected to be effective during the second quarter of 1994. Under the Plan, the wrap-around feature of each of the notes will be terminated and the notes will become first, second, third and fourth mortgage notes. Travelers' allowed claim is expected to be equal to the outstanding principal amount under its loan, plus accrued interest, and each of Tates Creek, Pinebrook and Lexington are expected to be allowed claims equal to the equity balance in their respective notes, plus accrued interest, including the debt service payments that have been withheld since November 1992. Under the Plan, the Joint Venture will make monthly payments as follows: first, to Travelers of principal and interest, with interest at a rate of 9.75% per annum and based upon a 30 year amortization schedule, and next to Tates Creek, interest only, with interest at a rate of 8.875% per annum. Thereafter, any excess net cash flow from the property will be paid monthly as follows: (1) first, to Pinebrook, interest only at a rate of 10% per annum; (2) next to Lexington, interest only at an interest rate of 10% per annum; (3)and finally to holders of unsecured claims against the Joint Venture. Any deficiency in the payments to Pinebrook and Lexington will accrue and be paid in future months as net cash flow from property operations are available or from the proceeds of a sale of the property. If the Joint Venture is in default of any of its obligations under the Plan to Travelers or Tates Creek, the Bankruptcy Court may conduct an auction of the property upon Travelers or Tates Creek's request no later than 90 days after such request. Under the Plan, the Joint Venture must attempt to sell the property within two years after the effective date of the plan. In the event that the property is not sold by such date, the property will be put up for auction no later than 90 days thereafter. The debt service payments withheld by the Joint Venture since November 1992 have been placed in a segregated account; the Joint Venture will be required to use these funds for property operations. To the extent any of these funds remain upon the sale of the property, the funds will be distributed along with the sale proceeds in order of priority as described below. Net proceeds from a disposition of the property will be payable as follows: (1) first, to pay tax claims against the Joint Venture, if any; (2) next, to pay amounts outstanding under Travelers' note (3) next, to pay amounts outstanding under Tates Creek's note; (4) next, to pay amounts outstanding under Pinebrook's notes; (5) next, to pay amounts outstanding under Lexington's note; (6) next, to pay any unsecured claims; and (7) any remaining amount will be paid to the Joint Venture. Item 4. Item 4. Submission of Matters to a Vote of Security Holders (a, b, c & d) No matters were submitted to a vote of the Limited Partners of the Registrant during 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters There has not been an established public market for Limited Partnership Interests and it is not anticipated that one will develop; therefore, the market value of the Limited Partnership Interests cannot reasonably be determined. For information regarding distributions, see Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources. As of December 31, 1993 the number of record holders of Limited Partnership Interests of the Registrant was 13,453. Item 6. Item 6. Selected Financial Data Year ended December 31, 1993 1992 1991 1990 1989 Rental and service income $29,915,125 $30,010,121 $30,620,213 $31,472,015 $30,942,328 Interest income on short-term investments 76,829 81,558 579,883 874,380 492,051 Administrative expenses 923,660 1,021,753 1,086,288 1,023,013 1,015,964 Recognized gain on sale of property None None 1,333,480 None None Extraordinary items: Gain on forgive- ness of debt 2,058,078 None None None None Gain on foreclosure of property 4,340,843 None 2,475,016 None 991,870 Net income (loss) 2,809,966 (5,092,181) (7,075,094) (7,890,602) (5,940,757) Net income (loss) per Limited Partnership Interest 19.87 (36.01) (21.88) (55.80) (53.13) Tax income (loss) 2,718,751 (9,912,861)(10,461,294)(13,134,612)(12,867,313) Tax income (loss) per Limited Partnership Interest 43.98 (28.95) (62.63) (70.07) (91.12) Cash and cash equivalents 736,429 656,104 546,994 911,807 1,514,685 Short-term invest- ments-restricted 700,000 800,000 1,410,000 11,953,700 700,000 Total investment properties, net of accumulated depreciation 108,878,714 124,061,309 128,911,606 153,863,038 159,573,880 Total assets 117,468,061 128,763,485 132,982,864 169,019,865 164,287,383 Purchase price, promissory and mortgage notes payable 136,404,898 149,910,843 150,663,629 182,960,724 181,747,563 Properties owned on December 31 17 18 18 20 20 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balcor Realty Investors-84 (the "Partnership") was formed in 1982 to invest in and operate income-producing real property. The Partnership raised $140,000,000 from sales of Limited Partnership Interests and utilized these proceeds to acquire twenty-three real property investments and a minority joint venture interest in one additional property. To date, two properties have been sold and titles to five properties, including the property in which the Partnership held a minority joint venture interest, have been relinquished through foreclosure. The Partnership continues to operate the seventeen remaining properties. Operations Summary of Operations As discussed below, operations of the Highland Glen apartment complex, which had generated a net loss during 1992, were recognized only through September 1992, the date the property was placed in receivership. Title to this property was subsequently relinquished through foreclosure in May 1993 and the Partnership recognized an extraordinary gain in connection with the transaction. In addition, the Ridgetree Phase I first mortgage loan was repaid at a discount in April 1993 which resulted in an extraordinary gain on forgiveness of debt. As a result of these transactions, the Partnership generated net income during 1993 as compared to a net loss during 1992. In 1991, title to the Canyon Creek apartment complex was relinquished through foreclosure and the Partnership sold the Sunrise Village apartment complex. For financial statement purposes, the gains recognized by the Partnership as a result of these dispositions resulted in an increase in the net loss of the Partnership during 1992 as compared to 1991. Further discussion of the Partnership's operations is summarized below. 1993 Compared to 1992 After the Partnership suspended debt service payments on the Highland Glen apartment complex and the lender filed foreclosure proceedings, a receiver was appointed and took possession of the property in September 1992. In accordance with the Partnership's accounting policies, the financial statements do not reflect the operations of the property subsequent to the date the receiver was appointed. This caused decreases in rental and service income, interest expense on purchase price, promissory and mortgage notes payable, depreciation expense, property operating expenses, maintenance and repair expenses, real estate taxes and property management fees during 1993 as compared to 1992. These decreases were partially or, in certain cases, fully offset by the events described below. During May 1993, title to the Highland Glen apartment complex was relinquished to the mortgage holder through foreclosure. As a result, the Partnership recognized an extraordinary gain on foreclosure during 1993. Fourteen of the Partnership's remaining properties experienced improved occupancy levels and/or higher rental rates in 1993, partially offsetting the previously discussed decreases in rental and service income and property management fees during 1993 as compared to 1992. The Partnership reached a settlement with the seller of the Ridgetree Phase I apartment complex in June 1992. Prorations due from the seller pursuant to the terms of the original management and guarantee agreement on this property were previously written off due to uncertain collectibility. Pursuant to the settlement agreement, the parties have released all claims and causes of action against one another, and the Partnership received cash of $208,000 and was relieved of certain other liabilities by the seller. Other income of $259,174 was recognized in connection with this transaction and resulted in a decrease in other income during 1993 as compared to 1992. The interest rate on the Creekwood Phase I apartment complex mortgage note payable adjusts monthly based on a market rate while the interest rates on the Briarwood, Canyon Sands, Somerset Pointe and Sunnyoak Village apartment complex mortgage notes payable adjusted in 1993 based on market rates. Lower interest rates during 1993 resulted in a decrease in interest expense on these loans. In April 1993, the Ridgetree Phase I apartment complex mortgage note payable was refinanced and the original loan was repaid at a discount. As a result of a lower principal balance and interest rate on the new loan, interest expense decreased for this property. In May 1993, the first mortgage note payable on the Woodland Hills apartment complex was refinanced and the second mortgage was partially repaid. As a result of the reduced total principal balances and a lower interest rate on the new first mortgage loan, interest expense decreased for this property. These items contributed to the decrease in interest expense on purchase price, promissory and mortgage notes payable during 1993 as compared to 1992. The decreases in interest expense discussed above were partially offset during 1993 by interest expense recognized on the Chesapeake apartment complex mortgage note payable, which was obtained during June 1993, and on the Quail Lakes apartment complex loan, which had principal-only payments until June 1993. As a result of the full amortization of the deferred expenses related to prior mortgages on the Highland Glen apartment complex, which was foreclosed in 1993, and the Woodland Hills, Chesapeake and Chimney Ridge apartment complexes, which were refinanced in 1993, amortization of deferred expenses increased during 1993 as compared to 1992. Slightly higher property operating expenses at most of the remaining properties resulted in an increase in property operating expenses during 1993 as compared to 1992. During 1993, the Partnership recognized extraordinary gains on forgiveness of debt in connection with the refinancings of the Ridgetree - Phase I and Chimney Ridge apartment complex mortgage loans. 1992 Compared to 1991 As noted above, a receiver took possession of the Highland Glen apartment complex during September 1992 and the financial statements do not reflect the operations of the property subsequent to the date the receiver was appointed. In addition, the Partnership sold the Sunrise Village apartment complex in August 1991, and relinquished title to the Canyon Creek apartment complex to the first mortgage lender through foreclosure in October 1991 and recognized gains related to these property dispositions during 1991. These transactions caused decreases in rental and service income, interest expense on purchase price, promissory and mortgage notes payable, depreciation expense, amortization expense, property operating expenses, maintenance and repair expenses, real estate taxes and property management fees during 1992 as compared to 1991. These decreases were partially or, in certain cases, fully offset by the increases described below. All seventeen of the Partnership's remaining properties, excluding the Highland Glen apartment complex, experienced improved occupancy and/or higher rental rates, which partially offset the previously discussed decreases in rental and service income and property management fees during 1992 as compared to 1991. In August 1991, the Partnership secured the release of restricted investments totaling $8,530,000, which had been pledged as collateral for the Chesapeake apartment complex loan, and used these proceeds to purchase the underlying revenue bonds which finance the property. This decrease in short-term investments, along with lower interest rates during 1992, caused interest income on short-term investments to decrease during 1992 as compared to 1991. In addition, this transaction contributed to the decrease in interest expense on purchase price, promissory and mortgage notes payable during 1992 as compared to 1991. As previously discussed, the Partnership reached a settlement with the seller of the Ridgetree Phase I apartment complex in June 1992, and recognized other income of $259,174 in connection with this. The Partnership also recognized other income in 1992 in the amount of $120,513 in connection with the purchase of a note investment relating to the Pinebrook apartment complex. As a result, other income increased in 1992 as compared to 1991. Interest rates decreased significantly during 1991 and 1992. This caused interest expense on short-term loans to decrease during 1992 as compared to 1991. The interest rate on the Creekwood apartment complex mortgage note payable adjusts monthly based on a market rate. A lower market rate during 1992 resulted in a decrease in interest expense on this loan. This also contributed to the decrease in interest expense on purchase price, promissory and mortgage notes payable during 1992 as compared to 1991. Deferred expenses related to the mortgage note payable collateralized by the Courtyards of Kendall apartment complex became fully amortized upon maturity of the loan in 1991. This caused amortization expense to decrease, in addition to the previously discussed decreases, during 1992 as compared to 1991. During 1992, the Partnership incurred expenses for painting the exteriors of the Chestnut Ridge, Pinebrook, Quail Lakes, Ridgepoint View, Sunnyoak Village and Woodland Hills apartment complexes, and also incurred expenses for upgrading selected unit interiors at the Ridgepoint Hill apartment complex. During 1991, the Partnership incurred expenses for painting the exterior of the Antlers and Ridgetree apartment complexes. The timing of these transactions caused maintenance and repair expenses to increase overall, fully offsetting the decreases previously discussed, during 1992 as compared to 1991. The Pinebrook apartment complex is owned by a joint venture consisting of the Partnership and an affiliated partnership. During 1992, the exterior of the property was painted, causing an increase in total expenses and the overall loss generated by the property. This increased the affiliate's participation in loss from joint venture during 1992 as compared to 1991. Liquidity and Capital Resources The cash or near cash position of the Partnership was relatively unchanged during the year ended December 31, 1993. During 1993, the Partnership's financing activities included the receipt of net proceeds of approximately $2,550,000 from loan refinancings and modifications, net of costs and escrows, and a net loan repayment of approximately $1,246,000 to the General Partner, as well as principal payments on mortgage notes payable. Operating activities consist primarily of cash flow generated from property operations and the payment of administrative expenses and short-term interest expense. The operating cash flow includes expenditures of approximately $1,160,000 for hurricane damage at the Courtyards of Kendall apartment complex, located in Dade County, Florida, for which the Partnership expects to be reimbursed through insurance proceeds during 1994. The Partnership is largely dependent on loans from the General Partner and owes approximately $11,166,000 to the General Partner at December 31, 1993 in connection with the funding of operating deficits, the 1991 purchase of the bonds on the Chesapeake apartment complex, which borrowings were partially repaid from the proceeds of the new first mortgage loan on the property, and additional borrowings needed for the 1993 refinancings. These loans are expected to be repaid from available cash flow from future property operations, or from proceeds received from the disposition or refinancing of the Partnership's real estate investments, prior to any distributions to Limited Partners from these sources. Although an affiliate of the General Partner has, in certain circumstances, provided mortgage loans for certain properties to the Partnership, there can be no assurance that loans of this type will be available from either an affiliate or the General Partner in the future. The General Partner may continue to provide additional short-term loans to the Partnership or to fund working capital needs or property operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Partnership would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Partnership may be required to dispose of some of its properties to satisfy these obligations. The Partnership classifies the cash flow performance of its properties as either positive, a marginal deficit or a significant deficit, each after consideration of debt service payments unless otherwise indicated. A deficit is considered to be significant if it exceeds $250,000 annually or 20% of the property's rental and service income. For each of the years ended December 31, 1993 and 1992, ten of the remaining seventeen properties owned by the Partnership generated positive cash flow and seven generated marginal cash flow deficits. The Highland Glen apartment complex would have operated at a significant cash flow deficit during 1992 had the Partnership paid all contractual obligations due under the terms of the mortgage note payable. The modification of the note expired in April 1992, and the note returned to its original terms, significantly increasing the monthly debt service requirements. The Partnership suspended debt service payments in an effort to obtain additional debt service relief. After unsuccessful negotiations, the lender filed foreclosure proceedings and a receiver was appointed to manage the property. In May 1993, title to this property was relinquished through foreclosure. See Note 13 of Notes to Financial Statements for additional information. The terms of the loans on the Chestnut Ridge Phase II, Ridgepoint Hill and Ridgepoint View apartment complexes provide for deferral of certain portions of the respective interest payments. Had the Partnership been obligated to pay the deferred amounts for the current period, the properties would have generated significant cash flow deficits during 1993 and 1992. At December 31, 1993, the cumulative interest deferred and outstanding on these loans totaled approximately $1,848,622. The deferred interest amounts are payable from proceeds received upon the sale or refinancing of the properties or, in certain cases, from current property cash flow if available. While the cash flow of certain of the Partnership's properties has improved, the General Partner continues to pursue a number of actions aimed at improving the cash flow of the Partnership's properties including refinancing of mortgage loans, improving property operating performance, and seeking rent increases where market conditions allow. Despite improvements during 1993 in the local economies and rental markets where certain of the Partnership's properties are located, the General Partner believes that continued ownership of many of the properties is in the best interests of the Partnership in order to maximize potential returns to Limited Partners. As a result, the Partnership will continue to own these properties for longer than the holding period for the assets originally described in the prospectus. Each of the Partnership's properties is owned through the use of third-party mortgage loan financing and, therefore, the Partnership is subject to the financial obligations required by such loans. See Note 3 of Notes to Financial Statements for information concerning outstanding balances, maturity dates, interest rates, and other terms related to each of these mortgage loans. During 1994 and 1995, approximately $24,362,000 and $11,529,000, respectively, of mortgage loans collateralized by the Creekwood Phase I, Ridgepoint Hill, Ridgepoint View, Drayton Quarter and Quail Lakes apartment complexes mature. Of the 1994 amount, approximately $6,634,000 represents mortgage loan financing from an affiliate of the General Partner which the Partnership expects to be able to extend if not paid prior to maturity. As a result of the downturn experienced by the real estate industry over the last few years, many banks, savings and loans and other lending institutions have tightened mortgage lending criteria and are generally willing to advance less funds with respect to a property than many lenders were willing to advance during the 1980's. As a result, in certain instances it may be difficult for the Partnership to refinance a property in an amount sufficient to retire in full the current mortgage financing with respect to the property. In the event negotiations with the existing lender for a loan modification or with new lenders for a refinancing are unsuccessful, the Partnership may sell the collateral property or other properties to satisfy an obligation or may relinquish title to the collateral property in satisfaction of the outstanding mortgage loan balance. Suspension of debt service payments may lead to a renegotiation of terms with lenders which would permit the Partnership to continue to own properties or may lead to foreclosure or other action by lenders which would result in the relinquishment of title to the properties in satisfaction of the outstanding mortgage loan balances. The Pinebrook apartment complex is owned by a joint venture consisting of the Partnership and an affiliated partnership, and is financed with a $5,185,000 wrap-around mortgage payable collateralized by the property, which matured in July 1993. The joint venture reviewed its options, among which were a sale of the property and a refinancing or modification of the purchase money wrap-around mortgage. However, the loan amount available on a refinancing was less than the current debt outstanding, and the joint venture partners did not have the cash reserves needed to fund the difference. Accordingly, the joint venture suspended debt service payments and began negotiations with the lender for a discounted buy-out of the $5,185,000 purchase money wrap-around mortgage note. In response, the lender filed foreclosure proceedings, and in December 1992, the joint venture filed for protection under the U.S. Bankruptcy Code. In January 1994, a plan of reorganization was approved by the Bankruptcy Court. See Item 3. Legal Proceedings for additional information. All cash flow generated by the property had been used to pay debt service on the underlying first and second mortgage loans. In May 1993, the interest rate on the mortgage note payable collateralized by the Sunnyoak Village apartment complex adjusted to 7.33% from 9.75%, through May 1998. In October 1993, the interest rates on the mortgage notes payable collateralized by the Briarwood, Canyon Sands and Somerset Pointe apartment complexes adjusted to 6.498% from 9.75%, through maturity in October 1998. In April 1993, the first mortgage loan collateralized by Ridgetree Phase I Apartments was refinanced with new first and second mortgage loans. Simultaneously, other first mortgage loans collateralized by properties owned by partnerships affiliated with the General Partner were also refinanced. All of these loans had been held directly or indirectly by the Resolution Trust Corporation and have been purchased by Lexington Mortgage Company, an independent third party. While the mortgage loan collateralized by Ridgetree Phase I Apartments was current, many of the other mortgage loans were in default either with respect to monthly debt service requirements or the loan had matured and the properties were unable to repay the balloon payments that were due. The new loans were deposited into a trust, the beneficial interests of which were sold to unaffiliated investors. Lehman Brothers, an affiliate of the General Partner, acted as firm underwriter for the sale of the beneficial interests in the trust and received underwriting compensation in accordance with market practices. A subordinated portion of the beneficial interests in the trust continues to be owned by Lehman Brothers. The new loans include, among other things, principal balance or mortgage rate reductions, or maturity extensions, or a combination thereof. The terms of the new loans on Ridgetree Phase I Apartments decreased the interest rate from 11% to 10.05%, extended the maturity date from September 1, 1996 to May 1, 2000, and required a principal reduction which was partially funded by a principal payment by the Partnership and partially due to forgiveness of debt by the lender or a voluntary contribution from an affiliate of the General Partner. See Note 4 of Notes to Financial Statements for additional information. In May 1993, the first mortgage loan collateralized by the Woodland Hills Apartments was refinanced. The proceeds of the new loan of $5,054,563 were used to repay the existing first mortgage loan of $4,941,615 as well as $112,948 of the BREHI second mortgage loan. The Partnership also funded capital and operating reserves as well as related closing costs. The balance of the BREHI second mortgage loan of $2,498,119, including accrued interest of $390,396, was reduced to $585,171 as a requirement of the first mortgage loan. The General Partner provided short-term loans to the Partnership to fund the closing costs and the BREHI paydown. See Note 4 of Notes to Financial Statements for additional information. In June 1993, the Partnership obtained a first mortgage loan in the amount of $5,185,000 collateralized by the Chesapeake Apartments. This first mortgage loan replaces the bonds collateralized by the property, which the Partnership had purchased in 1991. The Partnership also funded capital and operating reserves as well as related closing costs. The Partnership used $4,000,000 of proceeds available from the financing to partially repay funds borrowed from the General Partner to purchase the bonds. See Note 4 of Notes to Financial Statements for additional information. In July 1993, the first mortgage loan collateralized by the Antlers Apartments was modified. In connection with the modification, the loan balance was increased by $232,334 to $10,500,000, the interest rate was reduced and the maturity date was extended. The Partnership paid fees and closing costs in connection with the modification. See Note 4 of Notes to Financial Statements for additional information. In October 1993, the first mortgage loan collateralized by the Chimney Ridge Apartments was refinanced. The proceeds of the new loan of $7,400,000 were used to repay the existing first mortgage loan of $6,023,757 at a $180,599 discount. The Partnership also funded capital and operating reserves as well as related closing costs. Proceeds of approximately $1,000,000 available from the refinancing were used to partially repay General Partner loans. See Note 4 of Notes to Financial Statements for additional information. In March 1994, the first mortgage loan collateralized by the Quail Lakes Apartments was modified. In connection with the modification, the interest rate was adjusted and the maturity date was extended. See Note 4 of Notes to Financial Statements for additional information. In connection with the May 1993 Woodland Hills refinancing, $100,000 of cash pledged as additional collateral related to the Partnership's obligation under the terms of the prior mortgage loan was released. An affiliate of the General Partner is providing a guarantee against a letter of credit in the amount of $250,000 posted as additional collateral for the funding of capital improvements on the Courtyards of Kendall apartment complex. In addition, a certificate of deposit of $700,000 is pledged as additional collateral for the mortgage loan relating to the Canyon Sands apartment complex. Woodland Hills Apartments is located near the Dallas/Ft. Worth Airport. As previously reported, the airport board is pursuing an expansion plan with the Federal Aviation Authority to build two additional runways on airport property. A proposed plan provides for varying levels of compensation to single family homeowners for the expected loss in value to their homes as a result of increased air traffic and heightened noise levels. However, no similar compensation is planned for the majority of apartment complex owners in the area, including the Partnership. In July 1993, the Partnership, certain affiliates of the General Partner which also own affected properties and other unaffiliated property owners jointly filed a lawsuit to obtain equitable compensation. The plaintiffs expect to file a motion for summary judgement with a hearing expected to be held during the first half of 1994. The Briarwood apartment complex is located in the path of the planned expansion of Price Road which is adjacent to the property. Discussions for this project have been ongoing, and the General Partner has been attending the public hearings due to its opposition to this expansion. If the current plans are approved, approximately 68 of the complex's 268 units would be condemned, which would have a significant impact on the property's value. Currently it is unclear whether the future approvals and funding for the project will be obtained and, if obtained, what compensation the Partnership would receive for the units or when the work would begin. Although investors have received certain tax benefits, the Partnership has not commenced distributions. Future distributions to investors will depend on improved cash flow from the Partnership's remaining properties and proceeds from future property sales, as to both of which there can be no assurances. In light of results to date and current market conditions, the General Partner does not anticipate that investors will recover a substantial portion of their original investment. Inflation has several types of potentially conflicting impacts on real estate investments. Short-term inflation can increase real estate operating costs which may or may not be recovered through increased rents depending on general or local economic conditions. In the long-term, inflation will increase operating costs and replacement costs and may lead to increased rental revenues and real estate values. Item 8. Item 8. Financial Statements and Supplementary Data See Index to Financial Statements and Financial Statement Schedule in this Form 10-K. The supplemental financial information specified by Item 302 of Regulation S-K is not applicable. The net effect of the differences between the financial statements and the tax returns is summarized as follows: December 31, 1993 December 31, 1992 Financial Tax Financial Tax Statements Returns Statements Returns Total assets $117,468,061 $86,235,405 $128,763,485 $96,829,331 Partners' capital accounts (deficit): General Partner (1,601,123) (18,854,592) (1,629,223) (15,269,743) Limited Partners (34,519,544) (50,849,212) (37,301,410) (57,477,066) Net income (loss): General Partner 28,100 (3,584,849) (50,922) (6,097,699) Limited Partners 2,781,866 6,627,854 (5,041,259) (3,234,358) Per Limited Part- nership Interest 19.87 47.34 (36.01) (23.10) Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no changes in or disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant (a) Neither the Registrant nor Balcor Partners-XV, its General Partner, has a Board of Directors. (b, c & e) The names, ages and business experience of the executive officers and significant employees of the General Partner of the Registrant are as follows: Name Title Marvin H. Chudnoff Chairman Thomas E. Meador President and Chief Operating Officer Allan Wood Executive Vice President, Chief Financial Officer and Chief Accounting Officer Alexander J. Darragh Senior Vice President Robert H. Lutz, Jr. Senior Vice President Michael J. O'Hanlon Senior Vice President Gino A. Barra First Vice President Daniel A. Duhig First Vice President David S. Glasner First Vice President Josette V. Goldberg First Vice President G. Dennis Hartsough First Vice President Lawrence B. Klowden First Vice President Alan G. Lieberman First Vice President Lloyd E. O'Brien First Vice President Brian D. Parker First Vice President John K. Powell, Jr. First Vice President Jeffrey D. Rahn First Vice President Reid A. Reynolds First Vice President Marvin H. Chudnoff (April 1941) joined Balcor in March 1990 as Chairman. He has responsibility for all strategic planning and implementation for Balcor, including management of all real estate projects in place and financing and sales for a varied national portfolio valued in excess of $6.5 billion. Mr. Chudnoff also holds the position of Vice Chairman of Edward S. Gordon Company Incorporated, New York, a major national commercial real estate firm, which he joined in 1983. He has also served on the Board of Directors of Skippers, Inc. and Acorn Inc., both publicly held companies, and of Waxman Laboratories of Mt. Sinai Hospital, New York. Mr. Chudnoff has been a guest lecturer at the Association of the New York Bar and at Yale and Columbia Universities. Thomas E. Meador (July 1947) joined Balcor in July 1979. He is President and Chief Operating Officer and has responsibility for all ongoing day-to-day activities at Balcor. He is a Director of The Balcor Company. Prior to joining Balcor, Mr. Meador was employed at the Harris Trust and Savings Bank in the commercial real estate division where he was involved in various lending activities. Mr. Meador received his M.B.A. degree from the Indiana University Graduate School of Business. Allan Wood (January 1949) joined Balcor in August 1983 and, as Balcor's Chief Financial Officer and Chief Accounting Officer, is responsible for all financial and administrative functions. He is directly responsible for all accounting, treasury, data processing, legal, risk management, tax and financial reporting activities. He is also a Director of The Balcor Company. Mr. Wood is a Certified Public Accountant. Prior to joining Balcor, he was employed by Price Waterhouse where he was involved in auditing public and private companies. Alexander J. Darragh (February 1955) joined Balcor in September 1988 and has primary responsibility for the Portfolio Advisory Group. He is responsible for due diligence analysis in support of asset management, institutional advisory and capital markets functions as well as for Balcor Consulting Group, Inc., which provides real estate advisory services to Balcor affiliated entities and third party clients. In addition, Mr. Darragh has supervisory responsibility of Balcor's Investor Services Department. Mr. Darragh received masters degrees in Urban Geography from Queens University and in Urban Planning from Northwestern University. Robert H. Lutz, Jr. (September 1949) joined Balcor in October 1991. He is President of Allegiance Realty Group, Inc., formerly known as Balcor Property Management, Inc. and, as such, has primary responsibility for all its management and operations. He is also a Director of The Balcor Company. From March 1991 until he joined Balcor, Mr. Lutz was Executive Vice President of Cousins Properties Incorporated. From March 1986 until January 1991, he was President and Chief Operating Officer of The Landmarks Group, a real estate development and management firm. Mr. Lutz received his M.B.A. from Georgia State University. Michael J. O'Hanlon (April 1951) joined Balcor in February 1992 as Senior Vice President in charge of Asset Management, Investment/Portfolio Management, Transaction Management and the Capital Markets Group which includes sales and refinances. From January 1989 until joining Balcor, Mr. O'Hanlon held executive positions at Citicorp in New York and Dallas, including Senior Credit Officer and Regional Director. He holds a B.S. degree in Accounting from Fordham University, and an M.B.A. in Finance from Columbia University. He is a full member of the Urban Land Institute. Gino A. Barra (December 1954) joined Balcor's Property Sales Group in September 1983. He is First Vice President of Balcor and assists with the supervision of Balcor's Asset Management Group, Transaction Management, Quality Control and Special Projects. Daniel A. Duhig (October 1956) joined Balcor in November 1986 and is responsible for various asset management matters relating to investments made by Balcor and its affiliated partnerships, including negotiations for modifications or refinancings of real estate mortgage investments and the disposition of real estate investments. David S. Glasner (December 1955) joined Balcor in September 1986 and has primary responsibility for special projects relating to investments made by Balcor and its affiliated partnerships and risk management functions. Mr. Glasner received his J.D. degree from DePaul University College of Law in June 1984. Josette V. Goldberg (April 1957) joined Balcor in January 1985 and has primary responsibility for all human resources matters relating to Balcor personnel, including training and development, employment, salary and benefit administration, corporate communications and the development, implementation and interpretation of personnel policy and procedures. Ms. Goldberg also supervises Balcor's payroll operations and Human Resources Information Systems (HRIS). In addition, she has supervisory responsibility for Balcor's Facilities, Corporate and Field Services and Telecommunications Departments. Ms. Goldberg has been designated as a Senior Human Resources Professional (SHRP). G. Dennis Hartsough (October 1942) joined Balcor in July 1991 and is responsible for asset management matters relating to all investments made by Balcor and its affiliated partnerships in office and industrial properties. From July 1989 until joining Balcor, Mr. Hartsough was Senior Vice President of First Office Management (Equity Group) where he directed the firm's property management operations in eastern and central United States. From June 1985 to July 1989, he was Vice President of the Angeles Corp., a real estate management firm, where his primary responsibility was that of overseeing the company's property management operations in eastern and central United States. Lawrence B. Klowden (March 1952) joined Balcor in November 1981 and is responsible for supervising the administration of the investment portfolios of Balcor and its loan and equity partnerships. Mr. Klowden is a Certified Public Accountant and received his M.B.A. degree from DePaul University's Graduate School of Business. Alan G. Lieberman (June 1959) joined Balcor in May 1983 and is responsible for the Property Sales and Capital Markets Groups. Mr. Lieberman is a Certified Public Accountant. Lloyd E. O'Brien (December 1945) joined Balcor in April 1987 and has responsibility for the operations and development of Balcor's Information and Communication systems. Mr. O'Brien received his M.B.A. degree from the University of Chicago in 1984. Brian D. Parker (June 1951) joined Balcor in March 1986 and is responsible for Balcor's corporate and property accounting, treasury, budget activities and corporate purchasing. Mr. Parker is a Certified Public Accountant and holds an M.S. degree in Accountancy from DePaul University and an M.A. degree in Social Service Administration from the University of Illinois. John K. Powell, Jr. (June 1950) joined Balcor in September 1985 and is responsible for Balcor Consulting Group, Inc. which provides real estate advisory services to Balcor affiliated entities and third party clients. Mr. Powell received a Master of Planning degree from the University of Virginia. Jeffrey D. Rahn (June 1954) joined Balcor in February 1983 and has primary responsibility for Balcor's Asset Management Department. He is responsible for the supervision of asset management matters relating to equity and loan investments held by Balcor and its affiliated partnerships. Mr. Rahn received his M.B.A. degree from DePaul University's Graduate School of Business. Reid A. Reynolds (April 1950) joined Balcor in March 1981 and is involved with the asset management of residential properties for Balcor. Mr. Reynolds is a licensed Real Estate Broker in the State of Illinois. (d) There is no family relationship between any of the foregoing officers. (f) None of the foregoing officers or employees are currently involved in any material legal proceedings nor were any such proceedings terminated during the fourth quarter of 1993. Item 11. Item 11. Executive Compensation (a, b, c, d & e) The Registrant has not paid and does not propose to pay any compensation, retirement or other termination of employment benefits to any of the five most highly compensated executive officers of the General Partner. 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 5% of the outstanding Limited Partnership Interests of the Registrant. (b) Balcor Partners-XV and its officers and partners own as a group the following Limited Partnership Interests of the Registrant: Amount Beneficially Title of Class Owned Percent of Class Limited Partnership Interests 116 Interests Less than 1% Relatives and affiliates of the officers and partners of the General Partner own an additional 5 Interests. (c) The Registrant is not aware of any arrangements, the operation of which may result in a change of control of the Registrant. Item 13. Item 13. Certain Relationships and Related Transactions (a & b) See Note 2 of Notes to Financial Statements for information relating to the Partnership Agreement and the allocation of distributions and profits and losses. See Note 8 of Notes to Financial Statements for information relating to transactions with affiliates. (c) No management person is indebted to the Registrant. (d) The Registrant has no outstanding agreements with any promoters. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1 & 2) See Index to Financial Statements and Financial Statement Schedule in this Form 10-K. (3) Exhibits: (3) The Amended and Restated Agreement of Limited Partnership and Amended and Restated Certificate of Limited Partnership, previously filed as Exhibits 3 and 4.1 to Amendment No. 1 to the Registrant's Registration Statement on Form S-11 dated December 16, 1983 (Registration No. 2-86317) are incorporated herein by reference. (4) Form of Confirmation regarding Interests in the Registrant set forth as Exhibit 4.2 to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1992 (Commission File No. 0-13349) are incorporated herein by reference. (b) Reports on Form 8-K: No Reports on Form 8-K were filed during the quarter ended December 31, 1993. (c) Exhibits: See Item 14(a)(3) above. (d) Financial Statement Schedules: See Index to Financial Statements and Financial Statement Schedule in this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of l934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. BALCOR REALTY INVESTORS-84 By: /s/ Allan Wood Allan Wood Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Partners-XV, the General Partner Date: March 28, 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 President and Chief Executive Officer (Principal Executive Officer) of Balcor Partners-XV, /s/ Thomas E. Meador the General Partner March 28, 1994 Thomas E. Meador Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Partners-XV, /s/ Allan Wood the General Partner March 28, 1994 Allan Wood INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE Report of Independent Accountants Financial Statements: Balance Sheets, December 31, 1993 and 1992 Statements of Partners' Capital, for the years ended December 31, 1993, 1992 and 1991 Statements of Income and Expenses, 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 Schedule: XI - Real Estate and Accumulated Depreciation, as of December 31, 1993 Financial Statement Schedules, other than that listed, are omitted for the reason that they are inapplicable or equivalent information has been included elsewhere herein. REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of Balcor Realty Investors-84: We have audited the financial statements and the financial statement schedule of Balcor Realty Investors-84 (An Illinois Limited Partnership) as listed in the index of this Form 10-K. These financial statements and financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and financial statement 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 Balcor Realty Investors-84 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. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand COOPERS & LYBRAND Chicago, Illinois March 24, 1994 BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 --------------- -------------- Cash and cash equivalents $ 736,429 $ 656,104 Certificate of deposit - restricted 700,000 700,000 Restricted investments 100,000 Net investment in note receivable 914,040 377,056 Escrow deposits 3,052,027 1,104,478 Accounts and accrued interest receivable 1,583,118 656,890 Prepaid expenses 32,847 32,826 Deferred expenses, net of accumulated amortization of $1,128,672 in 1993 and $1,068,977 in 1992 1,570,886 1,074,822 --------------- -------------- 8,589,347 4,702,176 --------------- -------------- Investment in real estate: Land 22,657,624 22,657,624 Buildings and improvements 145,783,613 145,734,839 --------------- -------------- 168,441,237 168,392,463 Less accumulated depreciation 59,562,523 54,944,729 --------------- -------------- 108,878,714 113,447,734 Real estate in substantive foreclosure, net of accumulated depreciation of $4,252,309 10,613,575 --------------- ------------- Investment in real estate, net of accumulated depreciation 108,878,714 124,061,309 --------------- -------------- $ 117,468,061 $ 128,763,485 =============== ============== LIABILITIES AND PARTNERS' CAPITAL Loans payable - affiliate $ 11,166,206 $ 12,411,979 Accounts payable 1,040,208 967,294 Due to affiliates 207,444 217,707 Accrued liabilities, principally interest and real estate taxes 4,229,868 3,544,098 Security deposits 599,835 613,144 Purchase price, promissory and mortgage notes payable 126,356,211 138,331,929 Mortgage notes payable - affiliate 10,048,687 11,578,914 --------------- -------------- Total liabilities 153,648,459 167,665,065 Affiliate's participation in joint venture (59,731) 29,053 Partners' capital (140,000 Limited Partnership Interests issued and outstanding) (36,120,667) (38,930,633) --------------- -------------- $ 117,468,061 $ 128,763,485 =============== ============== The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) STATEMENTS OF PARTNERS' CAPITAL for the years ended December 31, 1993, 1992 and 1991 Partners' Capital Accounts ---------------------------------------------- General Limited Total Partner Partners(A) ------------- --------------- -------------- Balance at December 31, 1990 $(30,745,021) $ (1,547,367) $ (29,197,654) Net loss for the year ended December 31, 1991 (3,093,431) (30,934) (3,062,497) ------------- --------------- -------------- Balance at December 31, 1991 (33,838,452) (1,578,301) (32,260,151) Net loss for the year ended December 31, 1992 (5,092,181) (50,922) (5,041,259) ------------- --------------- -------------- Balance at December 31, 1992 (38,930,633) (1,629,223) (37,301,410) Net loss for the year ended December 31, 1993 2,809,966 28,100 2,781,866 ------------- --------------- -------------- Balance at December 31, 1993 $(36,120,667) $ (1,601,123) $ (34,519,544) ============= =============== ============== (A) Includes a $110,000 investment by the General Partner, which is treated on the same basis as the other Limited Partnership Interests. The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- --------------- -------------- Income: Rental and service $ 29,915,125 $ 30,010,121 $ 30,620,213 Interest on short-term investments 76,829 81,558 579,883 Other income 167,225 434,098 74,813 ------------- --------------- -------------- Total income 30,159,179 30,525,777 31,274,909 ------------- --------------- -------------- Expenses: Interest on purchase price, promissory and mortgage notes payable 12,047,956 13,816,050 15,117,484 Interest on short-term loans 484,932 494,403 816,387 Depreciation 4,617,794 4,884,047 5,371,409 Amortization of deferred expenses 471,567 229,473 396,741 Property operating 8,085,076 7,892,370 8,128,327 Maintenance and repairs 3,207,875 3,353,405 3,196,582 Real estate taxes 2,492,324 2,502,189 2,637,431 Property management fees 1,481,954 1,493,809 1,534,923 Administrative 923,660 1,021,753 1,086,288 ------------- --------------- -------------- Total expenses 33,813,138 35,687,499 38,285,572 ------------- --------------- -------------- Loss before recognized gain on sale of property and affiliate's participation in loss from joint venture (3,653,959) (5,161,722) (7,010,663) Recognized gain on sale of property 1,333,480 Affiliate's participation in loss from joint venture 65,004 69,541 108,736 ------------- --------------- -------------- Loss before extraordinary items (3,588,955) (5,092,181) (5,568,447) ------------- --------------- -------------- Extraordinary items: Gain on forgiveness of debt 2,058,078 Gain on foreclosure of property 4,340,843 2,475,016 ------------- -------------- Total extraordinary items 6,398,921 2,475,016 ------------- --------------- -------------- Net income (loss) $ 2,809,966 $ (5,092,181) $ (3,093,431) ============= =============== ============== Loss before extraordinary items allocated to General Partner $ (35,890) $ (50,922) $ (55,684) ============= =============== ============== Loss before extraordinary items allocated to Limited Partners $ (3,553,065) $ (5,041,259) $ (5,512,763) ============= =============== ============== Loss before extraordinary item per Limited Partnership Interest (140,000 issued and outstanding) $ (25.38) $ (36.01) $ (39.38) ============= =============== ============== Extraordinary items allocated to General Partner $ 63,989 None $ 24,750 ============= =============== ============== Extraordinary items allocated to Limited Partners $ 6,334,932 None $ 2,450,266 ============= =============== ============== Extraordinary items per Limited Partnership Interest (140,000 issued and outstanding) $ 45.25 None $ 17.50 ============= =============== ============== Net income (loss) allocated to General Partner $ 28,100 $ (50,922) $ (30,934) ============= =============== ============== Net income (loss) allocated to Limited Partners $ 2,781,866 $ (5,041,259) $ (3,062,497) ============= =============== ============== Net income (loss) per Limited Partnership Interest (140,000 issued and outstanding) $ 19.87 $ (36.01) $ (21.88) ============= =============== ============== The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) STATEMENTS OF CASH FLOWS for the years ended December 31, 1993, 1992 and 1991 (Continued) 1993 1992 1991 ------------- --------------- -------------- Operating activities: Net income (loss) $ 2,809,966 $ (5,092,181) $ (3,093,431) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Recognized gain on sale of property (1,333,480) Affiliate's participation in in loss from joint venture (65,004) (69,541) (108,736) Extraordinary items: Gain on forgiveness of debt (2,058,078) Gain on foreclosure of property (4,340,843) (2,475,016) Depreciation of properties 4,617,794 4,884,047 5,371,409 Amortization of deferred expenses 471,567 229,473 396,741 Amortization of discount on note receivable (112,816) (117,185) Deferred interest on note receivable (424,168) (39,871) Deferred interest expense 806,802 649,669 Net change in: Escrow deposits (1,051,466) (426,432) (81,131) Accounts and accrued interest receivable (926,228) (243,135) (137,720) Prepaid expenses (21) (384) (834) Accounts payable 72,914 355,743 (20,542) Due to affiliates (10,263) 4,383 (39,772) Accrued liabilities 1,365,981 607,755 1,342,137 Security deposits (13,309) 2,631 (125,173) ------------- --------------- -------------- Net cash provided by operating activities 336,026 902,105 344,121 ------------- --------------- -------------- Investing activities: Proceeds from redemption of restricted investments 100,000 610,000 10,543,700 Purchase of investment in note (220,000) Additions to properties (48,774) (33,750) (60,197) Proceeds from sale of property 67,832 ------------- --------------- -------------- Net cash provided by investing activities 51,226 356,250 10,551,335 ------------- --------------- -------------- Financing activities: Capital contributions by joint venture partner - affiliate 133,342 Distributions to joint venture partner - affiliate (23,780) (7,537) (13,417) Proceeds from loan payable - affiliate 5,918,837 1,478,387 2,412,592 Repayment of loan payable - affiliate (7,164,610) (302,178) (3,692,517) Proceeds from issuance of mortgage notes payable 27,532,897 2,863,800 Proceeds from issuance of mortgage notes payable - affiliate 35,234 Repayment of mortgage notes payable (21,205,963) Repayment of mortgage notes payable - affiliate (1,912,948) (2,863,800) Principal payments on purchase price, promissory and mortgage notes payable (1,579,971) (2,093,148) (1,429,725) Principal payments on mortgage notes payable - affiliate (7,675) (43,837) (42,436) Purchase of revenue bonds (8,530,000) Payment of deferred expenses (967,631) (203,029) Payment of financing escrows (896,083) (111,245) ------------- --------------- -------------- Net cash used in financing activities (306,927) (1,149,245) (11,260,269) ------------- --------------- -------------- Net change in cash and cash equivalents 80,325 109,110 (364,813) Cash and cash equivalents at beginning of year 656,104 546,994 911,807 ------------- --------------- -------------- Cash and cash equivalents at end of year $ 736,429 $ 656,104 $ 546,994 ============= =============== ============== The accompanying notes are an integral part of the financial statements. BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies: (a) Depreciation expense is computed using straight-line and accelerated methods. Rates used in the determination of depreciation are based upon the following estimated useful lives: Years Buildings and improvements 20 to 30 Furniture and fixtures 5 to 7 Maintenance and repairs are charged to expense when incurred. Expenditures for improvements are charged to the related asset account. Interest incurred while properties were under construction was capitalized. (b) Deferred expenses consist of financing fees which are amortized over the terms of the respective agreements. (c) When debt service payments are suspended on a mortgage loan which is collateralized by one of the Partnership's properties, the lender may commence foreclosure proceedings and a receiver may be appointed for the property by the bankruptcy court while the proceedings are in progress. In such a case, the Partnership will not reflect the operations of a property in the financial statements while in receivership. (d) Properties are classified in substantive foreclosure when the lender has taken actions that result in the Partnership relinquishing control of the operations of the property, and/or the General Partner anticipates the property may be lost through foreclosure. When a property has been classified in substantive foreclosure, expenses which are not general obligations of the Partnership, but rather are liabilities collateralized by an interest in the property (such as mortgage interest expense and real estate taxes), are recorded only to the extent such items are paid. (e) Cash equivalents include all unrestricted highly liquid investments with a maturity of three months or less. (f) The Partnership is not liable for Federal income taxes and each partner recognizes his proportionate share of the Partnership income or loss in his tax return; therefore, no provision for income taxes is made in the financial statements of the Partnership. 2. Partnership Agreement: The Partnership was organized in September 1982. The Partnership Agreement provides for Balcor Partners-XV to be the General Partner and for the admission of Limited Partners through the sale of up to 150,000 Limited Partnership Interests at $1,000 per Interest, 140,000 of which were sold on or prior to June 27, 1984, the termination date of the offering. The Partnership Agreement provides that the General Partner will be allocated 99% of the profits and losses for the period prior to January 1, 1984, and 1% of the profits and losses thereafter. One hundred percent of "Net Cash Receipts" available for distribution shall be distributed to the holders of Interests in proportion to their participating percentages as of the record date for such distributions. In addition, there shall be accrued for the benefit of the General Partner as its distributive share from operations an amount equivalent to approximately 1% of the total Net Cash Receipts being distributed, which will be paid only out of Net Cash Proceeds. Under certain circumstances, the General Partner may also participate in the Net Cash Proceeds of the sale or refinancing of Partnership properties. When and as the Partnership sells or refinances its properties, the Net Cash Proceeds resulting therefrom, which are available for distribution, will be distributed only to holders of Interests until such time as holders of Interests have received an amount equal to their Original Capital plus certain levels of return as specified by the Partnership Agreement. Only after such returns are made to the Limited Partners will the General Partner receive 15% of further distributed Net Cash Proceeds, which will include the accrued distributive share of Net Cash Receipts, subject to increase by an amount equal to certain acquisition fees the General Partner would otherwise have been entitled to pursuant to the Partnership Agreement. 3. Purchase Price, Promissory and Mortgage Notes Payable: Purchase price, promissory and mortgage notes payable at December 31, 1993 and 1992 consisted of the following: Property Carrying Carrying Final Pledged as Amount of Amount of Inter- Matur- Periodic Estimated Collateral Notes at Notes at est ity Payment Balloon (Cost) 12/31/93 12/31/92 Rate Date Terms(B) Payment(C) Purchase Price, Promissory and Mortgage Notes Payable - Nonaffiliates: Antlers apt. complex ($13,513,695)(A)$10,446,268 $10,330,433 8.25% 1998 $82,787 $9,731,000 Briarwood Place apt. complex ($7,647,947) 6,261,495 6,332,257 6.498% 1998 43,961 5,606,000 Canyon Sands Village apt. complex ($11,167,970) (D,E) 9,447,725 9,559,432 6.498% 1998 66,130 8,460,000 Chesapeake apt. complex ($8,711,056)(A) 5,170,785 None 7.875% 2028 36,357 None Chimney Ridge apt. complex ($7,564,644)(A) 7,389,254 6,039,978 7.625% 2003 52,377 6,452,000 Chestnut Ridge apt. complex ($5,682,907)(F) 2,843,547 2,854,583 9.75% 2002 24,073 2,725,000 Courtyards of Kendall apt. complex ($10,262,348)(D) 9,461,431 9,565,796 9.50% 1997 83,906(G) 9,014,000 Creekwood apt. complex ($7,042,691) 5,335,504 5,528,289 (H) 1994 (H) (H) Drayton Quarter apt. complex ($5,936,122) 4,833,492 4,886,722 11.00% 1995 47,276 4,765,000 Highland Glen apt. complex (I) 14,918,362 (I) (I) (I) (I) Pinebrook apt. complex ($7,479,554)(J) 5,185,000 5,185,000 9.00% (J) 38,888(K) 5,185,000 Quail Lakes apt. complex ($10,874,908)(D) 6,847,000 7,220,481 (L) (L) (L) 6,764,000 Ridgepoint Hill apt. complex ($9,516,771) 6,186,000 6,186,000 9.025% 1994 46,524(K) 6,186,000 Ridgepoint View apt. complex ($9,544,434) 6,352,000 6,352,000 9.025% 1994 47,772(K) 6,352,000 Ridgetree apt. complex ($14,004,711)(A) 9,626,164 12,141,441 10.05% 2000 85,139 9,157,000 Somerset Pointe apt. complex ($14,715,039)(D) 11,690,016 11,817,991 6.498% 1998 80,531 10,501,000 Sunnyoak Village apt. complex ($18,247,747)(D) 14,247,685 14,458,912 7.33%(M) 2015 106,091 None Woodland Hills apt. complex (Carrying value $6,528,693)(A) 5,032,845 4,954,252 8.54% 1998 39,009 4,828,000 ----------- ----------- Subtotal 126,356,211 138,331,929 ----------- ----------- Mortgage Notes Payable - Affiliates: Chestnut Ridge apt. complex ($5,682,907)(N) 2,829,241 2,829,241 10.50% 2002 (N) 2,829,000 Ridgepoint Hill apt. complex ($9,516,771)(O) 3,288,870 3,296,545 10.25% 1994 (O) 3,289,000 Ridgepoint View apt. complex ($9,544,434)(P) 3,345,405 3,345,405 10.25% 1994 (P) 3,345,000 Woodland Hills apt. complex (carrying value $6,528,693)(Q) 585,171 2,107,723 10.50% 1999 (Q) 585,000 ------------ ------------ Subtotal 10,048,687 11,578,914 ------------ ------------ Total $136,404,898 $149,910,843 ============ ============ (A) This note was modified or refinanced in 1993. The interest rate, periodic payment terms, estimated balloon payment and final maturity date reflect the terms of the new modified loan. See Note 4 of Notes to Financial Statements for additional information. (B) Represents monthly principal and interest payments through maturity, unless otherwise indicated. (C) The balloon payment will require the sale or refinancing of the property, unless otherwise indicated. (D) The difference between the balloon payments on previously outstanding interim financing and the assumed balance on the permanent loan is payable in accordance with a non-interest bearing promissory note. These amounts on an individual basis do not exceed $49,000, and are reflected in the "Carrying Amount of Notes" at December 31, 1993 and 1992. (E) At December 31, 1993, a $700,000 certificate of deposit was posted by the Partnership as additional collateral required under the mortgage note collateralized by the Canyon Sands apartment complex. (F) An affiliate of the General Partner ("Affiliate") provided a $10,000,000 letter of credit as additional collateral related to a pool of loans in the aggregate amount of $32,336,100 collateralized by the Chestnut Ridge apartment complex and eight other properties owned by partnerships affiliated with the General Partner. A guaranty of the letter of credit by the Affiliate was required under the terms of the refinancing. Such Affiliate's guaranty shall not affect the obligations or actual liabilities of the Partnership under the mortgage note payable or the related letter of credit. (G) The Partnership is obligated to pay the lender (upon the earlier of maturity or the sale or refinancing of the property) additional interest equal to the lesser of: (i) 25% of the amount by which the agreed upon value of the property at maturity or upon sale or refinancing exceeds $10,100,000, or (ii) interest which would have accrued on the loan from June 1, 1992 through the earlier of maturity or the sale or refinancing of the property at 15% per annum. (H) The contract interest rate floats at 2.5% over the Federal Home Loan Bank System 11th District Cost of Funds. At December 31, 1993, the contract interest rate was 6.44%, and the average rate for 1993 was 6.77%. The pay rate is 10% per annum on outstanding principal with the difference between the contract and pay rates applied monthly to principal. (I) The Partnership relinquished title to the property through foreclosure on May 7, 1993. See Note 13 of Notes to Financial Statements for additional information. (J) In December 1992, the joint venture which owns the property filed for protection under the U.S. Bankruptcy Code. See Note 12 of Notes to Financial Statements for additional information. In January 1994, a plan of reorganization was approved by the Bankruptcy Court which is expected to be effective during the second quarter of 1994. Under the plan, the wrap-around feature of each of the notes collateralized by the property will be terminated and will become first, second, third and fourth mortgage notes, and the joint venture is to make payments as follows: first, monthly payments of principal and interest, with interest at a rate of 9.75% per annum to the first mortgage holder, next as interest-only payments, with interest at a rate of 8.875% per annum to the second mortgage holder, next as interest-only payments at a rate of 10% per annum to the third mortgage holder and then interest-only payments at an interest rate of 10% per annum to the fourth mortgage holder. Any deficiency in the payments to the third and fourth mortgage holders will accrue and be paid in future months as net cash flow from property operations are available or from the proceeds of a sale of the property. (K) Represents monthly interest-only payments through maturity. (L) During March 1994, this loan was modified. Effective February 1, 1994, the interest rate increased from 6.745% to 8.25%, the maturity date was extended from March 1995 to March 2001 and the monthly payment of principal and interest increased from $44,612 to $51,295. (M) The interest rate is subject to adjustment in May 1998 and every 5 years thereafter based on a market index fixed at 3.0% above the Federal Home Loan Bank Board Eleventh District cost of funds rate. (N) The balance at December 31, 1993 is comprised of a second mortgage loan in the amount of $393,025 payable to National Express Company and an unsecured loan in the amount of $2,436,216, payable to Balcor Real Estate Holdings, Inc. ("BREHI"), both of which are affiliates of the General Partner. Both loans have a contract interest rate of 10.5%. The interest pay rate on the second mortgage loan is the lower of the contract rate or the net cash flow from the property after payment of interest on the first mortgage loan. The interest pay rate on the unsecured loan is the lower of the contract rate or the net cash flow from the property limited to a maximum annual deficit of $40,000. To the extent that cash flow remains or the maximum annual deficit has not been incurred after payment of all current interest on both loans, such excess will be applied as a principal reduction on the unsecured loan. Deferred interest on the second mortgage loan is accumulated on a non-interest bearing basis while deferred interest on the unsecured loan is added to the principal balance outstanding and interest is accumulated thereon at the contract rate. (O) This balance is comprised of a second mortgage loan in the amount of $3,000,000 and an unsecured loan in the amount of $288,870, both of which are payable to BREHI. Both loans have a contract interest rate of 10.25%. The interest pay rate on the second mortgage loan is the lower of the contract rate or the net cash flow from the property after payment of interest on the first mortgage loan. The interest pay rate on the unsecured loan is the lower of the contract rate or the net cash flow from the property limited to a maximum annual deficit of $77,238. To the extent that cash flow remains or the maximum annual deficit has not been incurred, after payment of all current interest on both loans, such excess will be applied as a principal reduction on the unsecured loan. During 1993 and 1992, $7,675 and $43,837, respectively, of cash flow was applied as a principal reduction on the unsecured loan. Deferred interest on the second mortgage loan is accumulated on a non-interest bearing basis while deferred interest on the unsecured loan is added to the principal balance outstanding and interest is accumulated thereon at the contract rate. This loan matures during 1994 and the General Partner expects to extend the maturity date of the loan if it is not repaid prior to maturity. (P) This loan represents a second mortgage loan payable to BREHI. The loan has a contract interest rate of 10.25% with a pay rate equal to the lower of the contract rate or the net cash flow from the property, limited to a maximum annual deficit of $78,487. Deferred interest on the second mortgage loan is accumulated on a non-interest bearing basis. This loan matures during 1994 and the General Partner expects to extend the maturity date of the loan if it is not repaid prior to maturity. (Q) This note represents a second mortgage loan payable to BREHI. During 1993, the balance of the BREHI loan of $2,498,119, including accrued interest, was reduced to $585,171 as a requirement of the first mortgage loan. The partial repayment was conditioned upon BREHI agreeing to subordinate repayment of the remaining portion of the BREHI loan to a payment to the Partnership from sale or refinancing proceeds from this property of $1,800,000. See Note 4 of the Notes to Financial Statements for additional information. The interest pay rate is the lower of the contract rate or the net cash flow from the property, after payment of interest on the first mortgage loan, limited to a maximum annual deficit of $62,500. Deferred interest on the second mortgage loan is accumulated and bears interest at the contract rate. During the years ended December 31, 1993, 1992 and 1991, the Partnership incurred interest expense on mortgage notes payable to non-affiliates of $10,882,258, $12,561,221 and $13,588,013, respectively. The Partnership paid interest expense of $10,655,057 in 1993, $11,830,225 in 1992 and $12,893,968 in 1991. See Note 8 of Notes to Financial Statements for interest paid and incurred on loans payable to affiliates. Maturities of the purchase price, promissory and mortgage notes payable and mortgage note payable - affiliates in each of the next five years are approximately as follows: 1994 $31,032,000 1995 12,886,000 1996 1,423,000 1997 10,463,000 1998 40,298,000 4. Loan Modifications and Refinancings: The General Partner completed the refinancing or modification of loans on five properties during 1993 and on three properties during 1992. (a) In April 1993, the first mortgage loan collateralized by the Ridgetree Phase I Apartments was refinanced. The original loan, which had an outstanding balance of $12,298,669, including accrued interest of $253,759, was repaid for $10,421,190 which represents a discount to the Partnership of $1,877,479. The Partnership used proceeds from the new loans of $9,661,000, and made a principal payment of $760,190 to repay the loan. Lehman Brothers, an affiliate of the General Partner, acted as firm underwriter for the sale of the securities representing ownership of the new loans, and earned underwriting compensation in accordance with market practices. The Partnership funded capital and operating reserves of $238,000 and paid related closing costs of $168,516. (b) In May 1993, the first mortgage loan collateralized by the Woodland Hills Apartments was refinanced with a new loan of $5,054,563. The Partnership used these proceeds to repay the existing first mortgage loan of $4,941,615 as well as $112,948 of the BREHI loan. The Partnership also funded capital reserves of $123,900 and paid related closing costs of $168,801. The balance of the BREHI second mortgage loan of $2,498,119, including accrued interest of $390,396, was reduced to $585,171 as a requirement of the first mortgage loan. (c) In June 1993, the Partnership obtained a first mortgage loan of $5,185,000 collateralized by the Chesapeake Apartments. This first mortgage loan replaces the bonds collateralized by the property, which the Partnership had purchased in 1991. The Partnership also funded capital and operating reserves of $393,983 and paid related closing costs of $171,923. (d) In July 1993, the first mortgage loan collateralized by the Antlers Apartments was modified. In connection with the modification, the loan balance was increased by $232,334 to $10,500,000, and the Partnership paid fees and closing costs of $265,830. (e) In March 1994, the first mortgage loan collateralized by the Quail Lakes Apartments was modified. (f) In October 1993, the first mortgage loan collateralized by the Chimney Ridge Apartments was refinanced with a new first mortgage loan of $7,400,000. The Partnership used these proceeds to repay the existing first mortgage loan of $6,023,757 which represents a discount to the Partnership of $180,599. The Partnership also funded capital and operating reserves of $140,200 and paid related closing costs of $261,682. (g) The mortgage note payable collateralized by the Courtyards of Kendall apartment complex, in the approximate amount of $10,121,000, matured on October 1, 1991. The Partnership did not make the balloon payment but continued to pay monthly net cash flow from the property to the lender in lieu of debt service while negotiating an extension and modification of the loan terms. In January 1992, the lender drew upon the $313,000 certificate of deposit previously pledged as additional collateral and applied it against unpaid debt service, and filed foreclosure proceedings against the property. In May 1992, a settlement agreement and modification of the loan were executed, and the foreclosure proceedings were subsequently dismissed. Under the terms of the agreement, the Partnership paid $1,000,000 representing a principal payment of $440,344 and delinquent real estate taxes of $559,656, which had remained unpaid during the term of the negotiations. In addition, the Partnership agreed to make improvements to the property totaling $250,000, and the Partnership posted a letter of credit collateralizing payment of this amount. In connection with this modification, the Partnership incurred financing fees totaling $87,932. The Partnership is also obligated to pay the lender (upon the earlier of maturity or the sale or refinancing of the property) additional interest equal to the lesser of: (i) 25% of the amount by which the agreed upon value of the property at maturity or upon sale or refinancing exceeds $10,100,000, or (ii) interest which would have accrued on the loan from June 1, 1992 through the earlier of maturity or the sale or refinancing of the property at 15% per annum. (h) In January 1992, the Partnership completed a refinancing of the $5,115,644 BREHI mortgage loan and deferred interest totaling $577,397 collateralized by the Chestnut Ridge apartment complex. The refinancing resulted in a $2,863,800 new first mortgage loan from an unaffiliated lender which was used to repay a portion of the BREHI loans. The remaining portion of the BREHI loans, along with deferred interest payable thereon in the amount of $577,397, were recharacterized as a $393,025 second mortgage loan, and a $2,436,216 unsecured loan. 5. Management Agreements: As of December 31, 1993, all the properties owned by the Partnership are under management agreements with Allegiance Realty Group, Inc. (formerly Balcor Property Management, Inc.), an affiliate of the General Partner. These management agreements provide for annual fees of 5% of gross operating receipts. The Brookhollow apartment complex was sold in 1988. In September 1990, a settlement was reached with the party from which the Partnership purchased the property in 1984 relating to outstanding proration and guaranteed payments due from the seller. Under the terms of the settlement, the Partnership received a note for $340,061 pursuant to which it receives cash payments in installments of principal and interest at an annual rate of 10%, over a four year period, with the final installment due May 1, 1994. Principal collections of these amounts are recognized when received as other income for financial statement purposes. During 1993, 1992 and 1991, the Partnership recognized other income totaling $54,409, $54,411 and $74,813, respectively. In June 1992, the Partnership reached a settlement with the seller of the Ridgetree apartment complex. Under the terms of the settlement, the Partnership received cash of $208,000 and was relieved of certain liabilities by the seller. The Partnership and seller have released all claims and causes of action against one another. Other income of $259,174 was recognized during 1992 in connection with this transaction. 6. Affiliate's Participation in Joint Venture: The Pinebrook apartment complex was purchased by a joint venture between the Partnership and an affiliated partnership. All assets, liabilities, income and expenses of the joint venture are included in the financial statements of the Partnership with the appropriate deduction from income or loss for the affiliate's participation in the joint venture. Profits and losses are allocated 51.57% to the Partnership and 48.43% to the affiliate. 7. Tax Accounting: The Partnership keeps its books in accordance with the Internal Revenue Code, rules and regulations promulgated thereunder and existing interpretations thereof. The accompanying financial statements which are prepared in accordance with generally accepted accounting principles will differ from the tax basis method of accounting due to the different treatment of various items as specified in the Internal Revenue Code. The net effect of these accounting differences is that the net income for 1993 in the financial statements is $91,215 more than the tax income of the Partnership for the same period. 8. Transactions with Affiliates: Fees and expenses paid and payable by the Partnership to affiliates are: Year Ended Year Ended Year Ended 12/31/93 12/31/92 12/31/91 Paid Payable Paid Payable Paid Payable Property mgmt. fees $1,477,069 $135,884 $1,483,559 $130,999 $1,546,891 $120,749 Reimbursement of expenses to General Partner at cost: Accounting 64,346 5,325 24,802 1,840 20,722 5,371 Data processing 57,699 10,401 63,566 5,255 79,815 5,800 Investor communications 10,210 845 10,201 757 7,193 1,864 Legal 27,006 2,235 40,765 3,025 27,385 7,098 Other 32,012 2,649 35,905 2,664 10,929 2,833 Portfolio mgmt. 118,754 9,356 78,260 5,377 59,968 15,542 During 1993, the Partnership borrowed $3,482,525 from the General Partner in connection with the Woodland Hills and Ridgetree Phase I loan refinancings and repaid $5,020,426 from proceeds available from the Chesapeake and Chimmney Ridge refinancings. In connection with the Woodland Hills refinancing, $100,000 of cash pledged as additional collateral related to the prior mortgage loan was released and used to repay General Partner loans. In addition, the Partnership borrowed a net of $392,128 from the General Partner to fund operating deficits, financing escrows and administrative expenses. As of December 31, 1993, the Partnership had outstanding short-term loans totaling $11,166,206 from the General Partner with accrued interest payable on these loans totaling $40,749. During 1993, 1992 and 1991, the Partnership incurred interest expense of $484,932, $494,403 and $816,387 and paid interest expense of $511,973, $480,680 and $852,729 on these loans, respectively. Interest expense subsequent to June 30, 1991, was computed at the American Express Company cost of funds rate plus a spread to cover administrative costs. As of December 31, 1993, this rate was 3.93%. This rate is similar to the Shearson Lehman Brothers Holdings Inc. cost of funds rate used to compute interest expense on these loans through June 30, 1991. As of December 31, 1993, the Partnership had mortgage loans outstanding from affiliates of the General Partner in the aggregate amount of $10,048,687 with accrued interest payable on these loans totaling $1,848,622. The Ridgepoint Hill, Ridgepoint View and Woodland Hills apartment complexes have mortgage loans financed through Balcor Real Estate Holdings, Inc. ("BREHI"), an affiliate of the General Partner. The Chestnut Ridge Phase II apartment complex has loans financed through BREHI and another affiliate of the General Partner. See Note 3 of Notes to Financial Statements for additional information. During 1993, 1992 and 1991, the Partnership incurred interest expense of $1,165,698, $1,254,829 and $1,529,471 and paid interest expense of $770,479, $974,726 and $1,092,841 on these affiliated mortgage loans, respectively. The General Partner may continue to provide additional short-term loans to the Partnership to fund future working capital needs or operating deficits, although there is no assurance that such loans will be available. Should such short-term loans not be available, the General Partner will seek alternative third party sources of financing working capital. However, the current economic environment and its impact on the real estate industry make it unlikely that the Partnership would be able to secure financing from third parties to fund working capital needs or operating deficits. Should additional borrowings be needed and not be available either through the General Partner or third parties, the Partnership may be required to dispose of some of its properties to satisfy these obligations. 9. Property Sale: In August 1991, the Partnership sold the Sunrise Village apartment complex to an affiliate of the entity which originally sold the property to the Partnership, subject to the existing first mortgage loan held by a third party, for a gross sale price of $11,064,881. After adjustment for proration items of $124,822 and the existing first mortgage loan of $10,851,559, the Partnership received sales proceeds of $88,500. The basis of the property sold was $9,585,911, net of accumulated depreciation of $3,797,354, and the Partnership incurred selling costs of $20,668. The General Partner did not receive a real estate commission in connection with the sale of the property. For financial statement purposes, the Partnership recognized a gain of $1,333,480 from the sale of the property. 10. Rentals Under Operating Leases: The Partnership receives rental income from the leasing of apartment complexes under operating leases. Minimum rentals under operating leases with lease terms of one year or less expected to be received in 1994 from its apartment complexes based on December 31, 1993 rental and occupancy rates, are approximately as follows: Occupancy Minimum Property Rate Rentals Antlers Apartments 91% $ 2,201,000 Briarwood Place Apartments 99% 1,399,000 Canyon Sands Village Apartments 98% 2,035,000 Chesapeake Apartments 94% 1,576,000 Chestnut Ridge Apartments (Phase II) 95% 848,000 Chimney Ridge Apartments 94% 1,637,000 Courtyards of Kendall Apartments 94% 2,130,000 Creekwood Apartments (Phase I) 87% 1,271,000 Drayton Quarter Apartments 88% 1,144,000 Pinebrook Apartments 95% 1,044,000 Quail Lakes Apartments 98% 1,704,000 Ridgepoint Hill Apartments 94% 1,692,000 Ridgepoint View Apartments 93% 1,689,000 Ridgetree Apartments (Phase I) 92% 2,288,000 Somerset Pointe Apartments 97% 2,777,000 Sunnyoak Village Apartments 93% 3,119,000 Woodland Hills Apartments 94% 1,410,000 ------------ $ 29,964,000 ============ The Partnership is subject to the usual business risks regarding the collection of these rentals. 11. Restricted Investments: As of December 31, 1991, the Partnership had pledged cash of $1,410,000 as additional collateral relating to the mortgage loans on the Canyon Sands, Woodland Hills and Courtyards of Kendall apartment complexes. The amounts pledged as collateral were invested in short-term instruments pursuant to the terms of the pledge agreements with the respective lending institutions. During 1992, a $313,000 certificate of deposit pledged as collateral was applied against unpaid debt service and $297,000 was released by the lenders. In connection with the May 1993 Woodland Hills refinancing, an additional $100,000 of cash collateral was released. As of December 31, 1993, $700,000 remained pledged related to the Canyon Sands mortgage loan. This amount was invested in short-term instruments pursuant to the terms of the agreement with the lending institution. Interest earned on the collateral accumulates to the benefit of the Partnership. 12. Net Investment in Note Receivable: The Pinebrook apartment complex is owned by a joint venture consisting of the Partnership and an affiliate, and is financed with a $5,185,000 wrap-around mortgage note payable to Lexington Associates, the seller of the property ("Lexington"). Lexington's mortgage note wraps two underlying mortgage notes payable in the approximate amounts of $4,000,000 and $450,000. At December 31, 1991, these notes were payable to First Equities Corporation ("First Equities"). The First Equities notes in turn wrap a mortgage note payable to Tates Creek Place ("Tates Creek"). In January 1992, a joint venture consisting of the Partnership and the affiliate purchased First Equities' notes receivable due from Lexington for a cash payment of $220,000, (of which $106,546 was the affiliate's share), and the assumption of the mortgage note payable to Tates Creek. This purchase has been recorded by the Partnership net of a $230,000 discount, which was amortized into income over the remaining term of the note. As of December 31, 1993, the Partnership's net investment in the notes consisted of the following, including accrued interest: Balance as Interest Maturity of 12/31/93 Rate Date Wrap-around notes receivable from Lexington Associates $4,885,918 (a) 9.8803% (b) Mortgage note payable to Tates Creek (3,971,878) 9.75% (b) Net Investment in Note ---------- Receivable $ 914,040 ========== (a) Includes a $450,000 secondary note which is non-interest bearing. (b) This loan matured in September 1993. The Partnership continues to remain obligated to Lexington under the original mortgage note payable in the amount of $5,185,000. However, in November 1992, the Partnership suspended payments and began negotiations with Lexington for a discounted buy-out of the mortgage note payable. As a result, Lexington suspended payments on the note receivable to Pinebrook Limited Partnership. See Note 3 of Notes to Financial Statements for additional information. 13. Extraordinary Items: (a) In October 1993, the mortgage note collateralized by the Chimney Ridge Apartments, which had an outstanding balance of $6,023,757, was repaid for $5,843,158. This transaction resulted in an extraordinary gain on forgiveness of debt of $180,599 during 1993 for financial statement purposes. See Note 5 of Notes to Financial Statements for additional information. (b) In May 1993, title to the Highland Glen apartment complex was relinquished through foreclosure. The Partnership wrote-off the property basis of $10,613,575, net of accumulated depreciation of $4,252,309, a mortgage loan balance of $14,918,362 and accrued real estate taxes of $36,056. The Partnership recognized an extraordinary gain of $4,340,843 during 1993 for financial statement purposes. (c) In April 1993, the mortgage note collateralized by the Ridgetree Phase I Apartments, which had an outstanding balance of $12,298,669, including accrued interest, was repaid for $10,421,190. This transaction resulted in an extraordinary gain on forgiveness of debt of $1,877,479 during 1993 for financial statement purposes. See Note 5 of Notes to Financial Statements for additional information. (d) In May 1991, the General Partner suspended debt service payments on the mortgage loan collateralized by the Canyon Creek apartment complex. In June 1991, the lender filed foreclosure proceedings and in October 1991, title to the property was relinquished through a foreclosure sale. The basis of the property at the date of foreclosure was $10,054,309, net of accumulated depreciation of $3,972,157. The outstanding mortgage balance at the date of foreclosure was $12,128,278. In addition, accrued liabilities of $401,047 were written off in connection with the foreclosure. The Partnership recognized an extraordinary gain of $2,475,016 during 1991 for financial statement purposes. BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) BALCOR REALTY INVESTORS-84 (An Illinois Limited Partnership) NOTES TO SCHEDULE XI (a) See description of purchase price, promissory and mortgage notes payable in Note 3 of Notes to Financial Statements. (b) Consists of legal fees, appraisal fees, title costs, other related professional fees and capitalized construction period interest. (c) Guaranteed income earned on properties under the terms of certain management and guarantee agreements was recorded by the Partnership as a reduction of the basis of the property to which the guaranteed income related. (d) A reduction of basis was made to write down the property to its December 31, 1988 mortgage liability balance. (e) The aggregate cost of land for Federal income tax purposes is $24,232,863 and the aggregate cost of buildings and improvements for Federal income tax purposes is $139,013,086. The total of these is $163,245,949. (f) Reconciliation of Real Estate 1993 1992 1991 Balance at beginning of year $183,258,347 $183,224,597 $210,574,131 Additions during year: Improvements 48,774 33,750 60,197 Deductions during year Foreclosure of investment properties (14,865,884) None (14,026,466) Cost of real estate sold None None (13,383,265) ------------ ------------ ------------ Balance at close of year $168,441,237 $183,258,347 $183,224,597 ============ ============ ============ Reconciliation of Accumulated Depreciation 1993 1992 1991 Balance at beginning of year $ 59,197,038 $ 54,312,991 $ 56,711,093 Depreciation expense for the year 4,617,794 4,884,047 5,371,409 Accumulated depreciation of foreclosed investment properties (4,252,309) None (3,972,157) Accumulated depreciation of real estate sold None None (3,797,354) ------------ ------------ ------------ Balance at close of year $ 59,562,523 $ 59,197,038 $ 54,312,991 ============ ============ ============ (g) Depreciation expense is computed based upon the following estimated useful lives: Years Buildings and improvements 20 to 30 Furniture and fixtures 5 to 7

71222_1993.txt

71222_1993

1993

71222

Item 1. Business General Commonwealth Electric Company (the Company) is engaged in the generation, transmission, distribution and sale of electricity at retail to approximately 307,700 customers (including 48,400 seasonal) in 40 communities located in southeastern Massachusetts, including Cape Cod and the island of Martha's Vineyard, having an approximate year-round population of 549,000 and a large influx of summer residents. The results of the 1990 federal census taken in the Company's service area indicated a population increase of 18.1% since 1980. Also, the Company sells power to the New England Power Pool (NEPOOL) and is actively pursuing sales of certain available capacity to other utilities in and outside the New England region. The Company, which was organized on April 4, 1850 pursuant to a special act of the legislature of the Commonwealth of Massachusetts, operates under the jurisdiction of the Massachusetts Department of Public Utilities (DPU), which regulates retail rates, accounting, issuance of securities and other matters. In addition, the Company files its wholesale rates with the Federal Energy Regulatory Commission (FERC). Since the date of its organization, the Company has from time to time acquired or disposed of the property and franchises of or merged with various gas or electric companies. The Company is a wholly-owned subsidiary of Commonwealth Energy System ("System"), which, together with its subsidiaries, is collectively referred to as "the system." By virtue of its charter, which is unlimited in time, the Company distrib- utes electricity without direct competition in kind from any privately or municipally-owned utilities. Alternate sources of energy are available to customers within the service territory, but competition from these sources to date has not been a significant factor affecting the Company. Of the Com- pany's 1993 retail electric unit sales, 49% was sold to residential customers, 32% to commercial customers, 10% to industrial and 9% to municipal and other customers. Electric Power Supply The Company relies almost entirely on purchased power to meet its electric energy requirements. The Company owns generating facilities with a total capacity of 13.8 MW, which are principally used for emergency and peaking purposes. The Company also has a joint-ownership interest of 8.8 MW in Central Maine Power Company's oil-fired Wyman Unit 4. Power purchases for the Company and Cambridge Electric Light Company (Cambridge Electric), the other wholly-owned electric distribution subsidiary of the System, are arranged in accordance with their requirements. These arrangements include purchases from Canal Electric Company (Canal), another wholly-owned subsidiary of the System. Canal is a wholesale electric generat- ing company located in Sandwich, Massachusetts and an important source of purchased power for the Company. Under long-term contracts, system entitle- ments include one-quarter (143 MW) of the capacity and energy of Canal Unit 1 and one-half (292 MW) of the capacity and energy of Canal Unit 2. In 1991, Canal, on behalf of the Company, exchanged 50 MW of the system's entitlement in Canal Unit 2 with Central Vermont Public Service Corporation (CVPS) for 25 MW each of CVPS's entitlement in the Vermont Yankee nuclear power plant and the Merrimack 2 coal-fired unit through October 1995 in order to reduce the COMMONWEALTH ELECTRIC COMPANY Company's reliance on oil-fired generation. Additionally, in 1993, Canal executed an exchange transaction with New England Power Company whereby 20 MW of Canal Unit 2 was exchanged for 20 MW of Bear Swamp Unit Nos. 1 and 2 through October 1993. On November 1, 1993, the exchange was increased to 50 MW through April 1997. The Bear Swamp Units are pumped storage hydro-electric generating facilities. In response to solicitations made to the NEPOOL member companies by Northeast Utilities (NU), Canal, on behalf of the Company 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. The Company and Cambridge Electric are each appropriated a portion of the power received from NU based on need. In addition, the Company has a 73.1 MW entitlement from a nuclear unit in Plymouth, Massachusetts (Pilgrim) under a life-of-the-unit contract with Boston Edison Company. Also, through Canal's equity ownership in Hydro-Quebec Phase II and its 3.52% interest in the Seabrook nuclear power plant, the Company has entitlements of 48.2 MW and 32.4 MW, respectively. In-state non- utility sources which provide a portion of the Company's requirements include 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), 10.0 MW from Boott Hydropow- er, Inc., 2.0 MW from Swift River Company and 0.5 MW from Pioneer Hydropower, Inc. In addition, the Company has contracted to purchase power from: (1) five natural gas-fired cogenerating facilities as follows: 23.8 MW from Consolidat- ed Power Company; 31.4 MW from Pepperell Power Associates; 44 MW from North- east Energy Associates, and effective July 31 and September 1, 1993, 51 MW and 27.5 MW from Masspower and Altresco Pittsfield, L.P., respectively, and (2), 61.8 MW from Dartmouth Power Associates, a natural gas-fired independent power producer. The Company expects to provide for future peak load plus reserve require- ments through existing and planned system generation, including purchasing available capacity from neighboring utilities and/or non-utility generators. These and other bulk electric power purchases are necessary in order to fulfill the system's NEPOOL obligation and for Canal to acquire and deliver sufficient electric generating capacity to meet the Company's and Cambridge Electric's capacity requirements. New England Power Pool The Company, together with other electric utility companies in the New England area, is a member 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 member companies to fulfill the region's energy requirements. This concept is accomplished through the use of computers to monitor and forecast load requirements and provide for the economic dispatch of generation. The Company and the System's other 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 COMMONWEALTH ELECTRIC COMPANY 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 Contracts and Capacity Acquisition and Disposition Agreement The Company has long-term contracts for the purchase of electricity from various sources. In addition, the Company's future generation needs will be met substantially through a Capacity Acquisition and Disposition Agreement with Canal. For further information on this agreement, refer to Note 2(b) of the Notes to Financial Statements filed under Item 8 of this report. Energy Mix The Company's energy mix, including purchased power, was as follows: 1993 1992 1991 Oil 27% 39% 36% Nuclear 20 22 28 Natural gas 35 24 19 Waste-to-energy 11 9 10 Hydro 4 3 4 Coal 3 3 3 Total 100% 100% 100% The Company's energy mix has shifted during the last several years from oil to natural gas and other types of generation due to the availability of capacity from independent power producing (IPP) facilities and cogenerating units and, to a lesser extent, an effort to reduce its reliance on oil. As stated in the "Electric Power Supply" section above, in 1993, the Company began receiving power from two gas-fired sources (Altresco Pittsfield and Masspower), additional energy from the expansion of a waste-to-energy plant (SEMASS) and extended commitments from a pumped storage facility (Bear Swamp) in exchange for power from the oil-fired Canal Unit 2. In 1991, Canal arranged for a long-term exchange of power with certain CVPS nuclear (Vermont Yankee) and a coal-fired unit (Merrimack 2). In certain circumstances, it is possible to exchange capacity with another utility so that the mix of power improves the pricing for dispatch for both the seller and the purchaser. The Canal/Bear Swamp transaction alone will save the Company's customers $2.7 million over a four-year period that began in June 1993. These exchanges and other future capacity purchase power contracts with natural gas-fired IPPs will continue to shift the Company's energy mix from oil to other sources. In addition, the Company is actively pursuing sales of certain available capacity to utilities in and outside the New England region. COMMONWEALTH ELECTRIC COMPANY Rates and Regulation (a) Rate Proceedings The Company operates under the jurisdiction of the DPU, which regulates retail rates, accounting, issuance of securities and other matters. In addition, the Company files its respective wholesale rates with FERC. The DPU requires historic test-year information to support changes in rates. In its last base rate filing with the DPU in December 1990, the Company requested a $17.3 million revenue increase. On July 1, 1991, the DPU issued an order increasing the Company's retail electric revenues by $10.9 million or 3.1% over the test year ended June 30, 1990. The DPU also ordered the Company to undertake an independent management audit in 1992. In October 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 operational costs, management of outside services, employment policies and customer services. Throughout 1993, follow-up discussions were held between Commonwealth Electric and the DPU regarding the status of each audit recommen- dation with both parties expressing overall satisfaction with their progress. Changes in the implementation plan were discussed, with the plan expected to be complete in 1994. (b) Cost Recovery Rate Schedule The Company files a Fuel Charge rate schedule, subject to DPU regulation, under which it is allowed current recovery, from retail customers, of fuel used in electric generation and a substantial portion of purchased power, demand and transmission costs. This schedule requires the quarterly computation of a Fuel Charge decimal based on forecasts of fuel, purchased power and transmission costs and billed unit sales for each period. To the extent that collections under the rate schedule do not match actual costs for that period, an appropriate adjustment is reflected in the calcula- tion of the decimal for the next calendar quarter. Purchased Power The Company has long-term contracts for the purchase of electricity from various sources. Generally, these contracts are for fixed periods and require that the Company pay a demand charge for its capacity entitlement and an energy charge to cover the cost of fuel. The DPU ordered the Company, effective July 1, 1991, to collect its capacity-related costs associated with certain long-term power arrangements through base rates. Prior to that date, the Company was recovering these costs through its Fuel Charge. The current recovery mechanism utilizes a cost 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, the Company experiences 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. The Company and Cambridge Electric made a filing in late 1992 with the DPU seeking an alterna- tive method of recovery. This request was denied in a letter order issued on October 6, 1993. However, the Company and Cambridge 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 COMMONWEALTH ELECTRIC COMPANY 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. Conservation and Load Management Programs The Company and Cambridge Elec- tric have received approval from the DPU to recover conservation and load management program (C&LM) costs. The programs offer opportunities to all customers to save energy by investing in C&LM measures. The overall objective of the programs is to reduce capacity and energy requirements which in turn reduce the cost of providing service. The Company has Conservation Charge (CC) rate schedules which allow for current cost recovery from retail custom- ers. On June 30, 1993, the DPU issued an order in Phase I of a C&LM filing by the Company and Cambridge Electric which authorizes the recovery of "lost base revenues" from electric customers. The recovery of lost base revenues is allowed by the DPU to encourage effective implementation of C&LM programs. The KWH savings that are realized as a result of the successful implementation of C&LM programs serve as the basis for determining lost base revenues. The amount to be recovered is approximately $3.5 million for the Company and is based on anticipated KWH savings for the eighteen-month period beginning January 1, 1993. The revenue will be recovered from customers over a twelve- month period which began July 1, 1993. Through December 31, 1993, the Company had recovered approximately $2.3 million in lost base revenue. On October 25, 1993, the DPU issued an order in Phase II of the C&LM proceeding. In that order, the DPU disallowed approximately $195,000 in expenditures that it determined exceeded benefits to customers. In addition, the DPU ruled that approximately $1.1 million in C&LM Task Force related expenditures are not recoverable by the Company "at this time" because certain programs have yet to be implemented and thus ratepayers are receiving no current benefits. The Company removed these costs from the current CC decimal and is continuing with the development of the programs and plans to seek recovery of these costs in a subsequent filing with the DPU. Based on the language in the order and subsequent discussions with the parties involved in the proceeding, management believes that the ultimate recovery of a substan- tial portion of these costs is likely. Seabrook Costs The full commission of the FERC, in a final order issued on August 4, 1992, approved full recovery of Canal's investment in the Seabrook nuclear power plant. The Company and Cambridge Electric had been billing, subject to refund, Seabrook 1 charges to their retail customers since August 1, 1990 through Fuel Charge decimals approved by the DPU. In its June 1, 1993 rate decision, the DPU allowed Cambridge Electric to recover its Seabrook 1 costs in base rates. However, the Company continues to recover these costs through the Fuel Charge. The Company and Cambridge Electric collect, through their respective Fuel Charge, amounts being billed to them by Canal for costs associated with Seabrook 2 (over a ten-year period ending in 1997) pursuant to a Capacity Acquisition Agreement the terms of which were approved by both FERC and the DPU. (c) Economic Development Rate In an effort to foster industrial development in its service area, the Company began offering an Economic Development Rate (EDR) on October 1, 1991. COMMONWEALTH ELECTRIC COMPANY The rate is offered to new or existing commercial and industrial customers who have an electric demand of 500 kilowatts or more and meet specific financial and other criteria. As of December 31, 1993, twenty-two industrial customers are benefitting from this special rate. The rate is available for a six-year term. In 1993, the DPU conducted a generic investigation into EDRs and rendered a decision on September 1, 1993 that established rate design guide- lines and minimum customer eligibility requirements. The Company refiled its EDRs to comply with the ruling. The Company also received approval for a Vacant Space Rate which it filed in conformance with the new EDR guidelines that is available to qualifying small commercial and industrial customers who establish loads in previously unoccupied building space. Construction and Financing Information concerning the Company's financing and construction programs is contained in Note 2(a) of Notes to Financial Statements filed under Item 8 of this report. Employees The total number of full-time employees for the Company declined 12% to 917 in 1993 from 1,042 employees at year-end 1992 due to a second quarter work force reduction. Of the current total, 602 employees (66%) are represented by the Brotherhood of Utility Workers of New England, Inc. under three separate collective bargaining units with agreements expiring October 31, 1994, September 30, 1996 and October 31, 1997. Employee relations have generally been satisfactory and management views the current work force level to be appropriate to service the Company's customers. Item 2. Item 2. Properties The principal properties of the Company consist of an integrated system of transmission and distribution lines, substations, an office building in the Town of Wareham, Massachusetts and other structures such as garages and service buildings. In addition, the Company owns and operates, for standby and emergency purposes only, two diesel plants with a combined capability of 13.8 MW located on the island of Martha's Vineyard. The Company also has a 1.4% joint-ownership interest in Central Maine Power Company's Wyman Unit 4 with an entitlement of 8.8 MW. The Company also owns a 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 recovery. At December 31, 1993, the electric transmission and distribution system consisted of 5,691 pole miles of overhead lines, 3,423 cable miles of under- ground line, 142 substations and 326,674 active customer meters. Item 3. Item 3. Legal Proceedings The Company is not a party to any pending material legal proceeding. COMMONWEALTH ELECTRIC COMPANY PART II. Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters (a) Principal Market Not applicable. The Company is a wholly-owned subsidiary of Common- wealth Energy System. (b) Number of Shareholders at December 31, 1993 One (c) Frequency and Amount of Dividends Declared in 1993 and 1992 1993 1992 Per Share Per Share Declaration Date Amount Declaration Date Amount January 28, 1993 $1.90 February 24, 1992 $1.45 April 23, 1993 1.10 April 27, 1992 1.20 October 18, 1993 3.20 October 19, 1992 2.50 $6.20 $5.15 In 1992 and on January 28, 1993, dividends were declared on the 1,606,472 outstanding shares of common stock of the Company. On April 23, 1993 and October 18, 1993, dividends were declared on the 2,043,972 outstanding shares of common stock of the Company. Reference is made to Note 6 of the Notes to Financial Statements filed under Item 8 of this report for the restriction against the payment of cash dividends. (d) Future dividends may vary depending upon the Company's earnings and capital requirements as well as financial and other conditions existing at that time. COMMONWEALTH ELECTRIC COMPANY Item 7. Item 7. Management's Discussion and Analysis of Results of Operations The following is a discussion of certain significant factors which have affected operating revenues, expenses and net income during the periods included in the accompanying statements of income and is presented to facili- tate an understanding of the results of operations. This discussion should be read in conjunction with Item 1 of this report and the Notes to Financial Statements filed under Item 8 Item 8. Financial Statements and Supplementary Data The Company's financial statements required by this item are filed here- with on pages 18 through 37 of this report. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None. COMMONWEALTH ELECTRIC COMPANY Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Commonwealth Electric Company: We have audited the accompanying balance sheets of COMMONWEALTH ELECTRIC COMPANY (a Massachusetts corporation and wholly-owned subsidiary of Common- wealth Energy System) as of December 31, 1993 and 1992, and the related statements of income, retained earnings 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 upon 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 Commonwealth Electric 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 princi- ples. As discussed in Note 4 to the financial statements, effective January 1, 1993, the Company changed its method of accounting for costs associated with postretirement benefits other than pensions. 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 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. Arthur Andersen & Co. Boston, Massachusetts, February 17, 1994. COMMONWEALTH ELECTRIC COMPANY INDEX TO FINANCIAL STATEMENTS AND SCHEDULES PART II. FINANCIAL STATEMENTS Balance Sheets at December 31, 1993 and 1992 Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 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 Notes to Financial Statements PART IV. SCHEDULES III Investments in, Equity in Earnings of, and Dividends Received from Related Parties for the Years Ended December 31, 1991, 1992 and 1993 V Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 VI Accumulated Depreciation of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 VIII Valuation and Qualifying Accounts for the Years Ended December 31, 1993, 1992 and 1991 IX Short-Term Borrowings for the Years Ended December 31, 1993, 1992 and SCHEDULES OMITTED All other schedules are not submitted because they are not applicable or not required or because the required information is included in the financial statements or notes thereto. Financial statements of 50% or less owned companies accounted for by the equity method have been omitted because they do not, considered individually, constitute a significant subsidiary. COMMONWEALTH ELECTRIC COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS 1993 1992 (Dollars in Thousands) PROPERTY, PLANT AND EQUIPMENT, at original cost $475 348 $476 839 Less - Accumulated depreciation 133 349 135 684 341 999 341 155 Add - Construction work in progress 5 478 4 794 347 477 345 949 INVESTMENTS Equity in nuclear electric power company 601 601 Other 14 14 615 615 CURRENT ASSETS Cash 2 794 507 Advances to affiliates 4 485 - Accounts receivable - Affiliated companies 2 413 3 906 Customers, less reserves of $3,268,000 in 1993 and $3,131,000 in 1992 38 743 36 366 Unbilled revenues 9 332 15 444 Inventories, at average cost - Materials and supplies 4 658 6 040 Electric production fuel oil 202 485 Prepaid property taxes 2 538 2 380 Other 1 927 1 547 67 092 66 675 DEFERRED CHARGES (Notes 1, 2 and 4) 34 619 25 300 $449 803 $438 539 COMMONWEALTH ELECTRIC COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 CAPITALIZATION AND LIABILITIES 1993 1992 (Dollars in Thousands) CAPITALIZATION Common Equity - Common stock, $25 par value - Authorized and outstanding - 2,043,972 shares in 1993 and 1,606,472 shares in 1992, wholly-owned by Commonwealth Energy System (Parent) $ 51 099 $ 40 162 Amounts paid in excess of par value 97 112 73 049 Retained earnings (Note 6) 15 118 14 882 163 329 128 093 Long-term debt, including premiums, less current sinking fund requirements (Note 5) 158 858 116 213 322 187 244 306 CURRENT LIABILITIES Interim Financing (Note 5) - Notes payable to banks - 67 275 Advances from affiliates - 11 840 - 79 115 Other Current Liabilities - Current sinking fund requirements 1 053 537 Accounts payable - Affiliated companies 10 088 10 797 Other 22 044 17 231 Accrued taxes - Local property and other 3 017 2 637 Income 2 337 610 Accrued interest 4 027 3 092 Other 9 098 7 003 51 664 41 907 51 664 121 022 DEFERRED CREDITS Accumulated deferred income taxes 39 396 34 346 Unamortized investment tax credits 8 430 8 876 Other 28 126 29 989 75 952 73 211 COMMITMENTS AND CONTINGENCIES (Note 2) $449 803 $438 539 The accompanying notes are an integral part of these financial statements. COMMONWEALTH ELECTRIC COMPANY STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) ELECTRIC OPERATING REVENUES $430 484 $409 493 $423 239 OPERATING EXPENSES Electricity purchased for resale and fuel 284 980 254 316 245 561 Transmission 4 836 5 240 7 071 Other operation 68 797 76 072 72 642 Maintenance 10 714 12 143 12 855 Depreciation 15 032 15 012 14 484 Conservation and load management 4 165 11 826 34 199 Taxes - Income (Note 3) 7 158 3 556 4 814 Local property 5 023 4 694 3 730 Payroll and other 3 066 3 046 3 141 403 771 385 905 398 497 OPERATING INCOME 26 713 23 588 24 742 OTHER INCOME, net 249 253 511 INCOME BEFORE INTEREST CHARGES 26 962 23 841 25 253 INTEREST CHARGES Long-term debt 13 252 10 891 11 239 Other interest charges 1 738 4 248 4 704 Allowance for borrowed funds used during construction (106) (302) (547) 14 884 14 837 15 396 NET INCOME $ 12 078 $ 9 004 $ 9 857 The accompanying notes are an integral part of these financial statements. COMMONWEALTH ELECTRIC COMPANY STATEMENTS OF RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) Balance at beginning of year $14 882 $14 151 $12 246 Add (Deduct): Net income 12 078 9 004 9 857 Cash dividends on common stock (11 842) (8 273) (7 952) Balance at end of year $15 118 $14 882 $14 151 The accompanying notes are an integral part of these financial statements. COMMONWEALTH ELECTRIC COMPANY STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) OPERATING ACTIVITIES Net income $ 12 078 $ 9 004 $ 9 857 Effects of non-cash items - Depreciation and amortization 16 447 19 666 25 224 Deferred income taxes 4 407 (5 176) (729) Investment tax credits (446) (452) (482) Earnings from corporate joint ventures - (75) (73) Change in working capital exclusive of cash and interim financing - Accounts receivable and unbilled revenues 5 228 7 119 (7 485) Income taxes, net 1 727 (3 705) (2 280) Local property and other taxes, net 222 (25) 390 Accounts payable and other 8 935 (2 159) 4 608 Uncollected postretirement benefits costs (Note 4) (4 087) - - All other operating items (5 590) 7 580 (10 856) Net cash provided by operating activities 38 921 31 777 18 174 INVESTING ACTIVITIES Additions to property, plant and equipment (exclusive of AFUDC) (18 631) (20 821) (31 303) Allowance for borrowed funds used during construction (106) (302) (547) Advances to affiliates (4 485) - - Net cash used for investing activities (23 222) (21 123) (31 850) FINANCING ACTIVITIES Long-term debt issues 65 000 - - Sale of common stock to Parent 35 000 - - Payment of dividends (11 842) (8 273) (7 952) Proceeds from (payment of) short-term borrowings (67 275) 3 975 15 050 Advances from (payment to) affiliates (11 840) 2 290 7 215 Long-term debt issues refunded (21 300) (7 522) - Retirement of long-term debt through sinking funds (1 155) (631) (636) Net cash provided by (used for) financing activities (13 412) (10 161) 13 677 Net increase in cash 2 287 493 1 Cash at beginning of period 507 14 13 Cash at end of period $ 2 794 $ 507 $ 14 The accompanying notes are an integral part of these financial statements. COMMONWEALTH ELECTRIC COMPANY NOTES TO FINANCIAL STATEMENTS (1) Significant Accounting Policies (a) General and Regulatory Commonwealth Electric Company (the Company) is a wholly-owned subsidiary of 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 Company is regulated as to rates, accounting and other matters by various authorities including the Federal Energy Regula- tory Commission (FERC) and the Massachusetts Department of Public Utilities (DPU). The System is an exempt holding company under the provisions of the Public Utility Holding Company Act of 1935 and, in addition to its investment in the Company, has interests in other utility companies and several non- regulated companies. The Company has established various regulatory assets in cases where the DPU and/or the FERC have permitted, or are expected to permit, recovery of specific costs over time. At December 31, 1993, principal regulatory assets included in deferred charges were $8.6 million for unrecovered plant and decommissioning costs for the Yankee Atomic nuclear plant, $7.4 million in litigation costs associated with a settlement agreement with Boston Edison Company relative to the Pilgrim nuclear power plant, $4.4 million in abandon- ment costs for the Cannon Street generating station and $4.1 million for postretirement benefits costs. The more significant regulatory liabilities, reflected in deferred credits, include $8.6 million related to the Yankee Atomic nuclear plant and $4 million related to income taxes. (b) Reclassifications Certain prior year amounts are reclassified from time to time to conform with the presentation used in the current year's financial statements. (c) Transactions with Affiliates Transactions between the Company and other system companies include purchases and sales of electricity, including purchases from Canal Electric Company (Canal), an affiliate wholesale electric generating company. Other costs billed by Canal relate to the abandonment of Seabrook 2 for the three years ending in 1993 and the recovery of a portion of Seabrook 1 pre-commer- cial operation financing costs in 1991. In addition, payments for management, accounting, data processing and other services are made to affiliate COM/Ener- gy Services Company. Transactions with other system companies are subject to review by the DPU. The Company's operating revenues include the following major intercompany transactions for the periods indicated: Purchased Power and Transmission Period Ended Purchased Power Purchased Power From Canal December 31, Canal Units Seabrook 1 As Agent (Dollars in Thousands) 1993 $40 537 $36 467 $20 881 1992 46 844 37 482 22 992 1991 53 547 50 912 26 422 COMMONWEALTH ELECTRIC COMPANY The Company sold electricity to other affiliates, primarily station service for Canal, totaling $2,973,000, $2,733,000 and $8,065,000 in 1993, 1992 and 1991, respectively, and the Company also purchased natural gas from affiliate Commonwealth Gas Company totaling $106,000 in 1992 and $1,288,000 in 1991 (there were no purchases in 1993). (d) Operating Revenues Customers are billed for their use of electricity on a cycle basis throughout the month. To reflect revenues in the proper period, the estimated amount of unbilled sales revenue is recorded each month. The Company is generally permitted to bill customers currently for fuel used in electric production, purchased power and transmission costs, and conservation and load management costs through adjustment clauses. Amounts recoverable under these clauses are subject to review and adjustment by the DPU. The Company collects a portion of capacity-related purchased power costs associated with certain long-term power arrangements through base rates. The amount of such fuel and energy costs incurred but not yet reflected in customers' bills, which totaled $3,056,000 in 1993 and $6,918,000 in 1992, is recorded as unbilled revenues. (e) Depreciation Depreciation is provided using the straight-line method at rates intended to amortize the original cost and the estimated cost of removal less salvage of properties over their estimated economic lives. The average composite depreciation rates were 3.31% in 1993 and 3.39% in 1992 and 1991. (f) Maintenance Expenditures for repairs of property and replacement and renewal of items determined to be less than units of property are charged to maintenance expense. Additions, replacements and renewals of property considered to be units of property are charged to the appropriate plant accounts. Upon retirement, accumulated depreciation is charged with the original cost of property units and the cost of removal less salvage. (g) Allowance for Funds Used During Construction Under applicable rate-making practices, the Company is permitted to include an allowance for funds used during construction (AFUDC) as an element of its depreciable property costs. This allowance is based on the amount of construction work in progress that is not included in the rate base on which the Company earns a return. An amount equal to the AFUDC capitalized in the current period is reflected in the accompanying Statements of Income. While AFUDC does not provide funds currently, these amounts are recover- able in revenues over the service life of the constructed property. The amount of AFUDC recorded was at a weighted average rate of 4% in 1993, 4.50% in 1992 and 6.75% in 1991. COMMONWEALTH ELECTRIC COMPANY (2) Commitments and Contingencies (a) Financing and Construction Programs The Company is engaged in a continuous construction program presently estimated at $141 million for the five-year period 1994 through 1998. Of that amount, $24.8 million is estimated for 1994. The program is subject to periodic review and revision because of factors such as changes in business conditions, rates of customer growth, effects of inflation, maintenance of reliable and safe service, equipment delivery schedules, licensing delays, availability and cost of capital and environmental factors. The Company expects to finance these expenditures on an interim basis with internally generated funds and short-term borrowings which are ultimately expected to be repaid with the proceeds from sales of long-term debt and equity securities. (b) Power Contracts The Company has long-term contracts for the purchase of electricity from various sources. Generally, these contracts are for fixed periods and require that the Company pay a demand charge for the capacity entitlement and an energy charge to cover the cost of fuel. In addition, the Company pays its share of decommissioning expense to non-affiliate Boston Edison Company, the operator of the Pilgrim nuclear facility, as a cost of electricity purchased for resale. The Company has entered into Power Contracts with Canal for a portion of the capacity from Canal Units 1 and 2. In addition, Canal seeks to secure bulk electric power on a single system basis to provide cost savings for the customers of the Company and Cambridge Electric under terms of a Capacity Acquisition and Disposition Agreement (CADA) which has been accepted for filing as an amendment to Canal's rate schedule by the FERC. The CADA allows Canal to act as agent for the Company and Cambridge Electric in the procure- ment of additional capacity for one or both companies, or, to sell a portion of each company's entitlement of capacity and/or energy produced by Canal Unit 2. Such "Commitments" are in effect for Seabrook 1, Phases I and II of Hydro- Quebec, New England Power Company (Bear Swamp Units), Green Mountain Power Corporation, Northeast Utilities and for Central Vermont Public Service Corp. (Vermont Yankee and Merrimac 2 Unit). Exchange agreements are in place with several of these utilities whereby, in certain circumstances, it is possible to exchange capacity so that the mix of power improves the pricing for dispatch for both the seller and the purchaser. Power contracts are in place, whereby Canal bills or credits the Company and Cambridge Electric for the costs or revenues received associated with these facilities. The Company and Cambridge Electric, in turn, have billed or are billing these net charges (net of revenues from sales) to their customers through rates which are subject to DPU approval. COMMONWEALTH ELECTRIC COMPANY Pertinent information with respect to life-of-the-unit contracts for power from the Pilgrim unit and an ownership in Central Maine Power Company's Wyman Unit 4, an oil-fired unit, is as follows: Wyman Pilgrim Unit 4 (Dollars in Thousands) Joint Ownership - 1.4% Plant Entitlement 11.0% 1.4% Plant Capability (MW) 664.7 619.2 Company's Entitlement (MW) 73.1 8.8 Contract Expiration Date 2012 - 1991 Actual Cost $30 992 $296 1992 Actual Cost 37 516 332 1993 Actual Cost 40 578 163 1994 Estimated Cost 41 963 205 The Company has also contracted to purchase power and transmission capacity from various other generating and transmission facilities as follows: Estimated 1991 1992 1993 1994 MW Cost MW Cost MW Cost MW Cost (Dollars in Thousands) Purchased Power - Nuclear 82.6 $42 016 6.8 $ 1 560 3.7 $ 1 187 2.2 $ 506 Hydro 30.9 13 052 14.0 11 784 15.1 9 731 15.0 11 087 Cogenerating 117.0 34 938 162.0 69 742 161.0 104 719 261.5 135 363 Waste-to-energy and other 92.1 33 009 78.9 31 336 74.7 36 013 72.1 35 862 Transmission - (Hydro-Quebec) - 3 884 - 2 991 - 3 015 - 3 165 Costs under these and other contracts are included in electricity pur- chased for resale and fuel in the accompanying Statements of Income and are recoverable in revenues through either the Fuel Charge or in base rates. (c) Yankee Atomic Nuclear Power Plant On February 26, 1992, the Board of Directors of Yankee Atomic Electric Company agreed to permanently discontinue power operation of its plant and, in time, decommission that facility. This plant provided less than 1% of the Company's capacity. The Company's 2.5% investment in Yankee Atomic is approximately $600,000. Presently, purchased power costs, which include a provision for ultimate decommissioning of the unit, are billed to the Company and collected from customers. The Company has estimated its unrecovered share of all costs associated with the shutdown of the facility, recovery of its respective plant investment and decommissioning and closing the plant to be approximately $8.6 million. This amount is reflected in the accompanying Balance Sheets as a liability and a corresponding regulatory asset at December 31, 1993. COMMONWEALTH ELECTRIC COMPANY (d) Environmental Matters The Company is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. These laws and regulations affect, among other things, the siting and operation of electric generating and transmission facilities and can require the installa- tion of expensive air and water pollution control equipment. These regula- tions have had an impact upon the Company's operations in the past and will continue to have an impact upon future operations, capital costs and construc- tion schedules of major facilities. (3) Income Taxes For financial reporting purposes, the Company provides federal and state income taxes on a separate return basis. However, for federal income tax purposes, the Company's taxable income and deductions are included in the consolidated income tax return of the System and it makes tax payments or receives refunds on the basis of its tax attributes in the tax return in accordance with applicable regulations. The following is a summary of the Company's provisions for income taxes for the years ended December 31, 1993, 1992 and 1991. 1993 1992 1991 (Dollars in Thousands) Federal Current $ 2 627 $ (15) $ 4 948 Deferred 3 705 (4 548) (668) Investment tax credits (446) (452) (482) 5 886 (5 015) 3 798 State Current 570 (34) 1 057 Deferred 749 348 (61) 1 319 314 996 7 205 (4 701) 4 794 Amortization of regulatory liability relating to deferred income taxes (47) (976) - $ 7 158 $(5 677) $ 4 794 Federal and state income taxes charged to: Operating expense $ 7 158 $ 3 556 $ 4 814 Other income - (9 233) (20) $ 7 158 $(5 677) $ 4 794 Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). SFAS No. 109 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 statement and tax basis of assets and liabilities using tax rates in effect in the year in which the differences are expected to reverse. COMMONWEALTH ELECTRIC COMPANY Accumulated deferred income taxes consisted of the following in 1993 and 1992: 1993 1992 (Dollars in Thousands) Liabilities Property-related $44 837 $40 483 Litigation costs 2 886 2 957 Postretirement benefits plan 2 222 376 All other 1 918 2 050 51 863 45 866 Assets Investment tax credit 5 441 5 507 Pension plan 1 384 1 302 Regulatory liability - 630 Uncollectible accounts 1 282 1 137 All other 2 463 1 706 10 570 10 282 Accumulated deferred income taxes $41 293 $35 584 The year-end deferred income tax liability above includes a current deferred tax liability of $1,897,000 in 1993 and $1,238,000 in 1992 which was reported in accrued income taxes in the accompanying Balance Sheets. The following table, detailing the significant timing differences for 1991 which resulted in deferred income taxes, is required to be disclosed pursuant to accounting standards for income taxes in effect prior to adoption of SFAS No. 109: (Dollars in Thousands) Accelerated depreciation $ 3 593 Seabrook power contract settlement (2 229) Capitalized interest during construction (150) Contributions in aid of construction (451) Capitalized leases (579) Pension costs and deferred compensation (394) Conservation and load management (4 370) Replacement power costs 1 656 Transmission costs (508) Storm damage 3 638 Voluntary retirement program (20) Other (915) Deferred income tax provision $ (729) COMMONWEALTH ELECTRIC COMPANY The total income tax provision set forth above represents 37% in 1993, (171)% in 1992 and 33% in 1991 of income before such taxes. The following table reconciles the statutory federal income tax rate to these percentages: 1993 1992 1991 (000's) Federal statutory rate 35% 34% $ 1 131 34% Increase (Decrease) from statutory rate: Amortization of regulatory liability relating to deferred income taxes - (173) (5 768) - State tax net of federal tax benefit 4 7 228 5 Amortization of investment tax credit (2) (14) (452) (3) Tax versus book depreciation 1 3 111 1 Amortization of excess deferred reserves - (28) (920) (3) Other (1) - (7) (1) Effective federal tax rate 37% (171)% $(5 677) 33% On April 22, 1992, the Company reached a settlement agreement with the Attorney General of Massachusetts and a consumer group, which was approved by the DPU. The settlement resulted in the issuance of an accounting order authorizing the Company's retention of $5.7 million in excess deferred taxes subject to obtaining a favorable ruling from the Internal Revenue Service which was received on November 30, 1992. In accordance with the above settlement agreement, the Company wrote off in 1992 storm damage costs of $9.2 million ($5.7 million net of tax). The balance of the excess reserves that would have been returned to customers was removed from the deferred tax reserve account and, after adjustment to its pretax amount as required by SFAS 109, was credited to a liability account. The excess reserves/regulatory liability which the Company would retain pursuant to the settlement agreement was also removed from this liability account and credited to other income together with the related income taxes. These amounts were classified as income tax expense and were used in the reconciliation of the income tax rate. As a result of the Revenue Reconciliation Act of 1993, the Company's federal income tax rate increased to 35% effective January 1, 1993. (4) Employee Benefit Plans (a) Pension The Company has a noncontributory pension plan covering substantially all regular employees who have attained the age of 21 and have completed a year of service. Pension benefits are based on an employee's years of service and compensation. The Company makes monthly contributions to the plan consistent with the funding requirements of the Employee Retirement Income Security Act of 1974. COMMONWEALTH ELECTRIC COMPANY Components of pension expense were as follows: 1993 1992 1991 (Dollars in Thousands) Service cost $ 2 630 $ 2 728 $ 2 815 Interest cost 9 283 8 506 7 532 Return on plan assets (16 412) (10 992) (20 677) Net amortization and deferral 9 130 4 235 15 209 Total pension expense 4 631 4 477 4 879 Transfers to affiliated companies, net (465) (609) (575) Less: Amounts capitalized and deferred 1 379 2 127 839 Net pension expense $ 2 787 $ 1 741 $ 3 465 The following economic assumptions were used to measure year-end obliga- tions and the estimated pension expense for the subsequent year: 1993 1992 1991 Discount rate 7.25% 8.50% 8.50% Assumed rate of return 8.50 8.50 8.50 Rate of increase in future compensation 4.50 5.50 5.50 Pension expense reflects the use of the projected unit credit method which is also the actuarial cost method used in determining future funding of the plan. The Company, in accordance with current rate-making, is deferring the difference between pension contribution, which is allowed currently in base rates, and pension expense recognized pursuant to Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." The funded status of the Company's pension plan (using a measurement date of December 31) is as follows: 1993 1992 (Dollars in Thousands) Accumulated benefit obligation: Vested $ (95 433) $ (74 178) Nonvested (13 030) (5 815) $(108 463) $ (79 993) Projected benefit obligation $(131 066) $(104 024) Plan assets at fair market value 120 685 107 529 Projected benefit obligation less (greater) than plan assets (10 381) 3 505 Unamortized transition obligation 5 146 5 789 Unrecognized prior service cost 5 520 4 139 Unrecognized gain (5 095) (17 321) Accrued pension liability $ (4 810) $ (3 888) Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect pension expense in future years. The increase in the accumulated benefit obligation and the projected benefit obligation from December 31, 1992 to December 31, 1993 was primarily due to a reduction of the discount rate in light of current interest rates. COMMONWEALTH ELECTRIC COMPANY (b) Other Postretirement Benefits Through December 31, 1992, the Company provided postretirement health care and life insurance benefits to eligible retired employees. Employees became eligible for these benefits if their age plus years of service at retirement equaled 75 or more provided, however, that such service was performed for the Company or another subsidiary of the System. As of January 1, 1993, the Company eliminated postretirement health care benefits for those nonbargaining employees who were less than 40 years of age or had less than 12 years of service at that date. Under certain circumstances, eligible employees are now required to make contributions for postretirement benefits. Certain bargain- ing employees are also participating under these new eligibility requirements. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postre- tirement Benefits Other Than Pensions" (SFAS No. 106). This new standard requires the accrual of the expected cost of such benefits during the employ- ees' years of service and the recognition of an actuarially determined postre- tirement benefit obligation earned by existing retirees. The assumptions and calculations involved in determining the accrual and the accumulated postre- tirement benefit obligation (APBO) closely parallel pension accounting requirements. The cumulative effect of implementation of SFAS No. 106 as of January 1, 1993 was approximately $48.3 million which is being amortized over 20 years. Prior to 1993, the cost of postretirement benefits was recognized as the benefits were paid. The cost of retiree medical care and life insur- ance benefits under the traditional pay-as-you-go method totaled $1,915,000 during 1992 and $1,668,000 in 1991. In 1993, the Company began making contributions to various voluntary employee beneficiary association (VEBA) trusts that were established pursuant to section 501(c)9 of the Internal Revenue Code (the Code). The Company also made contributions to a sub-account of its pension plan pursuant to section 401(h) of the Code to satisfy a portion of its postretirement benefit obliga- tion. The Company contributed approximately $5,964,000 to these trusts during 1993. The net periodic postretirement benefit cost for the year ended December 31, 1993 included the following components: (Dollars in Thousands) Service cost $ 1 093 Interest cost 4 103 Return on plan assets (292) Amortization of transition obligation over 20 years 2 417 Net amortization and deferral 3 Total postretirement benefit cost 7 324 Less: Amounts capitalized and deferred 5 701 Net postretirement benefit cost $ 1 623 COMMONWEALTH ELECTRIC COMPANY The funded status of the Company's postretirement benefit plan using a measurement date of December 31, 1993 is as follows: (Dollars in Thousands) Accumulated postretirement benefit obligation: Retirees $ (27 520) Active participants (23 033) (50 553) Plan assets at fair market value 5 308 Projected postretirement benefit obligation greater than plan assets (45 245) Unamortized transition obligation 45 917 Unrecognized gain (672) $ - In determining its estimated APBO and the funded status of the plan, the Company assumed a discount rate of 7.25%, an expected long-term rate of return on plan assets of 8.5%, and a medical care cost trend rate of 9%, which gradually decreases to 5% in the year 2007 and remains at that level thereaf- ter. The estimate also reflects a trend rate of 14.9% for reimbursement of Medicare Part B premiums which decreases to 5% by 2007 and a dental care trend rate of 5% in all years. A one percent change in the medical trend rate would have an $836,000 impact on the Company's annual expense (interest component - $564,000; service cost - $272,000) and would change the accumulated benefit obligation by $6.9 million. Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect postretire- ment benefit expense in future years. The DPU's policy on postretirement benefits is to allow in rates the maximum tax deductible contributions made to trusts that have been established specifically to pay postretirement benefits. Effective with its June 1, 1993 rate order from the DPU, Cambridge Electric was allowed to recover its SFAS No. 106 expense in base rates over a four-year phase-in period with carrying costs on the deferred balance. The Company intends to seek recovery in its next rate proceeding. While the Company is unable to predict the outcome of that rate proceeding, it believes the DPU will authorize similar rate treat- ment as provided to Cambridge Electric and other Massachusetts electric and gas companies for the recovery of the cost of these benefits. Further, based on recent DPU action and discussions with regulators, the Company believes that it is appropriate to record the difference between the amount included in rates and SFAS No. 106 costs as a regulatory asset. At December 31, 1993, this deferral amounted to approximately $4.1 million. (c) Savings Plan The Company has an Employees Savings Plan that provides for Company contributions equal to contributions by eligible employees of up to four percent of each employee's compensation rate. Effective January 1, 1993, the rate was increased to five percent for those employees no longer eligible for postretirement benefits other than pensions. The Company's contribution was $1,700,000 in 1993, $1,808,000 in 1992 and $1,703,000 in 1991. COMMONWEALTH ELECTRIC COMPANY (5) Long-Term Debt and Interim Financing (a) Long-Term Debt Maturities and Retirements Long-term debt outstanding, exclusive of current maturities, current sinking fund requirements and related premiums, is as follows: Original Balance December 31, Issue 1993 1992 (Dollars in Thousands) 25-Year Notes - Series E, 8 1/8%, due 1995 $ 9 000 $ - $ 4 860 Series F, 8 3/8%, due 1998 20 000 - 12 000 30-Year Notes - Series B, 6 1/8%, due 1997 6 000 - 4 440 15-Year Term Loan, 9.30%, due 2002 30 000 30 000 30 000 25-Year Term Loan, 9.37%, due 2012 20 000 18 947 20 000 10-Year Notes, 7.43%, due 2003 15 000 15 000 - 15-Year Notes, 9.50%, due 2004 15 000 15 000 15 000 15-Year Notes, 7.70%, due 2008 10 000 10 000 - 18-Year Notes, 9.55%, due 2007 10 000 10 000 10 000 20-Year Notes, 7.98%, due 2013 25 000 25 000 - 25-Year Notes, 9.53%, due 2014 10 000 10 000 10 000 30-Year Notes, 9.60%, due 2019 10 000 10 000 10 000 30-Year Notes, 8.47%, due 2023 15 000 15 000 - $158 947 $116 300 The balance of long-term debt at December 31, 1992 was exclusive of $103,000 principal amount purchased by the Company and deposited with the Trustee in anticipation of future sinking fund requirements. The Company may continue to purchase its outstanding notes in advance of sinking fund require- ments under favorable conditions. Under terms of its Indentures of Trust, the Company is required to make periodic sinking fund payments for retirement of outstanding long-term debt. The required sinking fund payments for the five years subsequent to December 31, 1993 are as follows: Year Sinking Funds (Dollars in Thousands) 1994 $1 053 1995 1 053 1996 3 553 1997 3 553 1998 3 553 (b) Notes Payable to Banks The Company and other system companies maintain both committed and uncommitted lines of credit for the short-term financing of their construction programs and other corporate purposes. As of December 31, 1993, system companies had $115 million of committed lines of credit that will expire at varying intervals in 1994. These lines are normally renewed upon expiration COMMONWEALTH ELECTRIC COMPANY and require annual fees up to .1875% of the individual line. At December 31, 1993, the uncommitted lines of credit totaled $70 million. Interest rates on the outstanding borrowings generally are at an adjusted money market rate. At December 31, 1993, the Company had no notes payable to banks. The Company had short-term notes payable to banks totaling $67,275,000 at December 31, 1992. (c) Advances from Affiliates At December 31, 1993, the Company had no notes payable to the System. The Company had short-term notes payable to the System totaling $8,445,000 at December 31, 1992. These notes are written for a term of eleven months and twenty-nine days. Interest is at the prime rate (6% at December 31, 1992) and is adjusted for changes in the rate during the term of the notes. The Company is a member of the COM/Energy Money Pool (the Pool), an arrangement among the subsidiaries of the System, whereby short-term cash surpluses are used to help meet the short-term borrowing needs of the utility subsidiaries. In general, lenders to the Pool receive a higher rate of return than they otherwise would on such investments, while borrowers pay a lower interest rate than those available from banks. The Company had $4,485,000 invested in the Pool at December 31, 1993, but had borrowings from the Pool of $3,395,000 at December 31, 1992. (d) Disclosures about Fair Value of Financial Instruments As required by Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the fair value of certain financial instruments included in the accompanying Balance Sheets as of December 31, 1993 and 1992 are as follows: 1993 1992 (Dollars in Thousands) Carrying Fair Carrying Fair Value Value Value Value Long-Term Debt $159 911 $184 180 $116 750 $128 600 The carrying amount of cash, advances to/from affiliates and notes payable to banks approximates the fair value because of the short maturity of the instruments. The estimated fair value of long-term debt is based upon quoted market prices of the same or similar issues or on the current rates offered for debt with the same remaining maturity. The fair values shown above do not purport to represent the amounts at which those obligations would be settled. (6) Dividend Restriction At December 31, 1993, approximately $11,700,000 of retained earnings was restricted against the payment of cash dividends by terms of the Indenture of Trust securing long-term debt. As of the same date, retained earnings also included approximately $218,000 representing the Company's equity in undis- tributed earnings of Yankee Atomic Electric Company. COMMONWEALTH ELECTRIC COMPANY (7) Lease Obligations The Company leases equipment and office space under arrangements that are classified as operating leases. These lease agreements are for terms of one year or longer. Leases currently in effect contain no provisions which prohibit the Company from entering into future lease agreements or obliga- tions. Future minimum lease payments, by period and in the aggregate, of non-can- celable operating leases consisted of the following at December 31, 1993: Operating Leases (Dollars in Thousands) 1994 $ 3 412 1995 2 832 1996 2 020 1997 773 1998 352 Beyond 1998 1 192 Total future minimum lease payments $10 581 Total rent expense for all operating leases, except those with terms of a month or less, amounted to $3,491,000 in 1993, $3,669,000 in 1992 and $3,783,000 in 1991. There were no contingent rentals and no sublease rentals for the years 1993, 1992 and 1991. (8) Supplemental Disclosures of Cash Flow Information The Company's supplemental information concerning cash flow activities is as follows: 1993 1992 1991 (Dollars in Thousands) Cash paid during the periods for: Interest (net of capitalized amounts) $ 13 074 $ 14 084 $ 14 714 Income taxes 2 438 1 491 6 275 COMMONWEALTH ELECTRIC COMPANY PART IV. Item 14. Item 14.Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Index to Financial Statements Financial statements and notes thereto of the Company together with the Report of Independent Public Accountants, are filed under Item 8 of this report and listed on the Index to Financial Statements and Schedules (page 19). (a) 2. Index to Financial Statement Schedules Filed herewith at page(s) indicated - Schedule III - Investments in, Equity in Earnings of, and Dividends Received from Related Parties - Years Ended December 31, 1991, 1992 and 1993 (page 50). Schedule V - Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (pages 51-53). Schedule VI - Accumulated Depreciation of Property, Plant and Equip- ment - Years Ended December 31, 1993, 1992 and 1991 (page 54). Schedule VIII - Valuation and Qualifying Accounts - Years Ended Decem- ber 31, 1993, 1992 and 1991 (page 55). Schedule IX - Short-term Borrowings - Years Ended December 31, 1993, 1992 and 1991 (page 56). (a) 3. Exhibits: Notes to Exhibits - a. Unless otherwise designated, the exhibits listed below are incorporat- ed 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 previ- ously filed by the Company have been disposed of by the Commission pursuant to its Records Control Schedule and are hereby being refiled by the Company. c. During 1981, the Company sold its gas business and properties to Commonwealth Gas and changed its corporate name from New Bedford Gas and Edison Light Company 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 CEL ...................... Cambridge Electric Light Company CEC ...................... Canal Electric Company CG ....................... Commonwealth Gas Company NBGEL .................... New Bedford Gas and Edison Light Co. COMMONWEALTH ELECTRIC COMPANY Exhibit Index: Exhibit 3. Articles of incorporation and by-laws 3.1.1 By-laws of the Company as amended, (Refiled as Exhibit 1 to the CE 1991 Form 10-K, File No. 2-7749). 3.1.2 Articles of Incorporation, as amended, of NBGEL, including certif- ication of name change to Commonwealth Electric Company as filed with the Massachusetts Secretary of State on March 1, 1981 (Re- filed as Exhibit 1 to the CE 1990 Form 10-K, File No. 2-7749). Exhibit 4. Instruments defining the rights of security holders, including indentures. 4.1.1 Original Indenture on Form S-1 (Nov., 1948) (Exhibit 7(a), File No. 2-7749). 4.1.2 First Supplemental on Form S-1 (Oct., 1950) (Exhibit 7(a-1), File No. 2-8605). 4.1.3 Second Supplemental (Exhibit 1 to the CE 1984 Form 10-K, File No. 2-7749). 4.1.4 Third Supplemental on Form 8-K (Feb., 1962) (Exhibit A, File No. 2-7749). 4.1.5 Fourth Supplemental (Exhibit 2 to the CE 1984 Form 10-K, File No. 2-7749). 4.1.6 Fifth Supplemental (Exhibit 3 to the CE 1984 Form 10-K, File No. 2-7749). 4.1.7 Sixth Supplemental (Exhibit 4 to the CE 1984 Form 10-K, File No. 2-7749). 4.1.8 Seventh Supplemental on Form S-1 (Dec., 1975) (Exhibit 4(b)2, File No. 2-54955). Cape & Vineyard Electric Company**: 4.1.9 Original Indenture on Form S-1 (Apr., 1957) (Exhibit 4(b)1, File No. 2-26429). 4.1.10 First Supplemental (Exhibit 5 to the CE 1984 Form 10-K, File No. 2-7749). 4.1.11 Second Supplemental (Exhibit 6 to the CE 1984 Form 10-K, File No. 2-7749). **Merged with the Company on 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 NBGEL dated June 30, 1959, as amended April 1, 1975 (Refiled as Exhibit 2 to the CE 1991 Form 10-K, File No. 2-7749). COMMONWEALTH ELECTRIC COMPANY 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 1 to the CE Form 10-Q (June 1988), File No. 2-7749). 10.1.2.2 Fifth and Sixth Amendments to 10.1.2 as amended June 26, 1989 and July 1, 1989, respectively (Exhibit 3 to the CE Form 10-Q (Septem- ber 1989), File No. 2-7749). 10.1.3 Agreement between NBGEL and Boston Edison Company (BECO) for the purchase of electricity from BECO's Pilgrim Unit No. 1 dated Aug- ust 1, 1972 (Exhibit 7 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.3.1 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). 10.1.3.2 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). 10.1.3.3 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). 10.1.4 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: 10.1.4.1 First through Fifth Amendments to 10.1.4 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 (No- vember 7, 1975), File No. 2-54995). 10.1.4.2 Sixth through Eleventh Amendments to 10.1.4 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). 10.1.4.3 Twelfth through Fourteenth Amendments to 10.1.4 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). 10.1.4.4 Fifteenth and Sixteenth Amendments to 10.1.4 as amended April 27, 1984 and June 15, 1984, respectively (Exhibit 1 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.4.5 Seventeenth Amendment to 10.1.4 as amended March 8, 1985 (Exhibit 1 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.4.6 Eighteenth Amendment to 10.1.4 as amended March 14, 1986 (Exhibit 1 to the CEC Form 10-Q (March 1986), File No. 2-30057). 10.1.4.7 Nineteenth Amendment to 10.1.4 as amended May 1, 1986 (Exhibit 1 to the CEC Form 10-Q (June 1986), File No. 2-30057). COMMONWEALTH ELECTRIC COMPANY 10.1.4.8 Twentieth Amendment to 10.1.4 as amended September 19, 1986 (Ex- hibit 1 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.4.9 Twenty-First Amendment to 10.1.4 as amended November 12, 1987 (Exhibit 1 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.4.10 Settlement Agreement and Twenty-Second Amendment to 10.1.4, both dated January 13, 1989 (Exhibit 4 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.5 Interim Agreement to Preserve and Protect the Assets of and In- vestment in the New Hampshire Nuclear Units dated April 27, 1984 (Exhibit 2 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.6 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). 10.1.7 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). 10.1.7.1 First Amendment to 10.1.7 as amended March 8, 1985 (Exhibit 2 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.7.2 Second through Fifth Amendments to 10.1.7 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). 10.1.8 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). 10.1.8.1 Agreement to transfer ownership, construction and operational interest in the Seabrook Units 1 and 2 from CE to CEC dated Janu- ary 2, 1981 (Refiled as Exhibit 3 to the CE 1991 Form 10-K, File No. 2-7749). 10.1.9 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). 10.1.10 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 sell- er'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). COMMONWEALTH ELECTRIC COMPANY 10.1.11 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). 10.1.11.1 Amendments No. 2 and 3 to 10.1.11 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). 10.1.12 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). 10.1.13 Capacity Acquisition Agreement between CEC,CEL and CE dated Sep- tember 25, 1980 (Exhibit 1 to the CEC 1991 Form 10-K, File No. 2- 30057). 10.1.13.1 Supplement to 10.1.13 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). 10.1.13.2 Supplements to 10.1.13 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). 10.1.13.3 Amendment to 10.1.13 as amended and restated June 1, 1993, hence- forth referred to as the Capacity Acquisition and Disposition Agreement, whereby CEC, as agent, in addition to acquiring power may also sell bulk electric power which CEL and/or the Company owns or otherwise has the right to sell (Exhibit 1 to the CEC Form 10-Q (September 1993), File No. 2-30057). 10.1.13.4 Capacity Disposition Commitment dated June 25, 1993 by and between CEC (Unit 2) and the Company for the sale of a portion of the Com- pany's entitlement in Unit 2 to Green Mountain Power Corp.(Exhibit 2 to the CEC Form 10-Q (September 1993), File No. 2-30057). 10.1.14 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 (Refiled as Exhibits 5 and 6 to the 1992 CE Form 10-K, File No. 2-7749). 10.1.14.1 Amendment No. 2 to 10.1.14 as amended November 1, 1982 (Exhibit 5 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.14.2 Amendment No. 3 to 10.1.14 as amended January 1, 1986 (Exhibit 2 to the CE 1986 Form 10-K, File No. 2-7749). COMMONWEALTH ELECTRIC COMPANY 10.1.15 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). 10.1.15.1 Supplement Amending 10.1.15 as amended June 24, 1970 (Exhibit 8 to the CES Form S-7, Amendment No. 1, File No. 2-38372). 10.1.16 Power Purchase Agreement (Revised) between Weweantic Hydro Associ- ates and the Company 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 (Filed as Exhibit 1 to the CE Form 10-Q (June 1993), File No. 2-7749). 10.1.17* 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 herewith as Exhibit 1). 10.1.18* 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 herewith as Exhibit 2). 10.1.18.1 Amendment to 10.1.18 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). 10.1.19 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 Corpo- ration (NEET), other New England utilities and CE (Exhibit 1 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.19.1 Amendment No. 3 to 10.1.19 (Exhibit 2 to the CE Form 10-Q (June 1986), File No. 2-7749). 10.1.20 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, Amend- ment 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). 10.1.21 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 (Ex- hibit 3 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.21.1 Amendatory Agreement No. 3 to 10.1.21 as amended June 1, 1990, among certain NEPOOL utilities (Exhibit 1 to the CEC Form 10-Q (September 1990), File No. 2-30057). COMMONWEALTH ELECTRIC COMPANY 10.1.22 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). 10.1.23 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). 10.1.24 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). 10.1.24.1 First, Second and Third Amendments to 10.1.24 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). 10.1.24.2 Fifth, Sixth and Seventh Amendments to 10.1.24 as amended October 15, 1987, December 15, 1987 and March 1, 1988, respectively (Ex- hibit 1 to the CEC Form 10-Q (June 1988), File No. 2-30057). 10.1.24.3 Fourth and Eighth Amendments to 10.1.24 as amended July 1, 1987 and August 1, 1988, respectively (Exhibit 3 to the CEC Form 10-Q (September 1988), File No. 2-30057). 10.1.24.4 Ninth and Tenth Amendments to 10.1.24 as amended November 1, 1988 and January 15, 1989, respectively (Exhibit 2 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.24.5 Eleventh Amendment to 10.1.24 as amended November 1, 1989 (Exhibit 4 to the CEC 1989 Form 10-K, File No. 2-30057). 10.1.24.6 Twelfth Amendment to 10.1.24 as amended April 1, 1990 (Exhibit 1 to the CEC Form 10-Q (June 1990), File No. 2-30057). 10.1.25 Phase II Equity Funding Agreement for New England Hydro-Transmis- sion 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). 10.1.26 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 utili- ties (Exhibit 2 to the CEC Form 10-Q (September 1990), File No. 2- 30057). 10.1.27 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 ELECTRIC COMPANY 10.1.28 Phase II Equity Funding Agreement for New Hampshire Hydro, dated June 1, 1985, between New Hampshire Hydro and certain NEPOOL util- ities (Ex. 3 to the CEC Form 10-Q (Sept. 1985), File No. 2-30057). 10.1.28.1 Amendment No. 1 to 10.1.28 dated May 1, 1986 (Exhibit 6 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.28.2 Amendment No. 2 to 10.1.28 as amended September 1, 1987 (Exhibit 3 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.29 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). 10.1.29.1 Amendments Nos. 1 and 2 to 10.1.29 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.29.2 Amendments Nos. 3 and 4 to 10.1.29 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.30 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). 10.1.30.1 Amendments Nos. 1 and 2 to 10.1.30 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 2 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.30.2 Amendments Nos. 3 and 4 to 10.1.30 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 4 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.31 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 (Ex- hibit 8 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.32 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). 10.1.32.1 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). 10.1.32.2 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). 10.1.32.3 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). COMMONWEALTH ELECTRIC COMPANY 10.1.32.4 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). 10.1.32.5 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). 10.1.33 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). 10.1.33.1 Transmission Service Agreement between Northeast Utilities' compa- nies (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). 10.1.33.2 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). 10.1.34 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). 10.1.35 System Power Sales Agreement by and between CL&P, WMECO, as sell- ers, 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). 10.1.36 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). 10.1.37 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). 10.1.37.1 Power Sales Agreement to 10.1.37 for all capacity and related energy produced, dated October 31, 1985 (Exhibit 2 to the CE 1985 Form 10-K, File No. 2-7749). COMMONWEALTH ELECTRIC COMPANY 10.1.37.2 Amendment to 10.1.37 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). 10.1.37.3 Second Amendment to 10.1.37.2 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 the CE Form 10-Q (June 1991), File No. 2-7749). 10.1.38 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). 10.1.39 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). 10.1.40 Power Sale Agreement by and between CE (buyer) and Northeast Energy Associates, 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). 10.1.40.1 First Amendment to 10.1.40 as amended August 15, 1988 (Exhibit 1 to the CE Form 10-Q (September 1988), File No. 2-7749). 10.1.40.2 Second Amendment to 10.1.40 as amended January 1, 1989 (Exhibit 2 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.40.3 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). 10.1.40.4 Amendment to 10.1.40.3 as amended January 1, 1989 (Exhibit 3 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.41 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). 10.1.41.1 Restatement of 10.1.41 as restated March 30, 1987 (Exhibit 2 to the CE Form 10-Q (June 1987), File No. 2-7749). 10.1.42 Power Sale Agreement by and between CE (buyer) and Pepperell Power Associates Limited Partnership (seller) of all electricity pro- duced from a 38 KW generating unit, dated April 13, 1987 (Exhibit 3 to the CE Form 10-Q (March 1987), File No. 2-7749). 10.1.43 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 (Exh. 1 to the CEC Form 10-Q (September 1989), File No. 2-30057). COMMONWEALTH ELECTRIC COMPANY 10.1.43.1 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 (Exhib- it 3 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.44 Exchange of Power Agreement between Montaup Electric Company and CE dated January 17, 1991 (Exhibit 2 to the CE Form 10-Q (Septem- ber 1991), File No. 2-7749). 10.1.44.1 First Amendment, dated November 24, 1992, to Exchange of Power Agreement between Montaup Electric Company and the Company dated January 17, 1991 (Exhibit 1 to the CE Form 10-Q (March 1993), File No. 2-7749). 10.1.45 System Power Exchange Agreement by and between CE and New England Power Company dated January 16, 1992 (Exhibit 1 to the CE Form 10- Q (March 1992), File No. 2-7749). 10.1.45.1 First Amendment, dated September 8, 1992, to 10.1.45, dated January 16, 1992 (Exhibit 1 to the CE Form 10-Q (Sept. 1992), File No. 2-7749). 10.1.45.2 Second Amendment, dated March 2, 1993, to System Power Exchange Agreement by and between the Company and New England Power Company dated January 16, 1992 (Exhibit 2 to the CE Form 10-Q (March 1993), File No. 2-7749). 10.1.46 Power Purchase Agreement and First Amendment, dated September 5, 1989 and August 3, 1990, respectively, by and between 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). 10.1.47 Power Purchase Agreement by and between Masspower (seller) and the 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 the CE Form 10-Q (September 1993), File No. 2-7749). 10.1.48 Power Sale Agreement by and between Altresco Pittsfield, L.P. (seller) and the Company (buyer) for a 17.2% entitlement to the electric capacity and related energy of a 160 MW gas-fired cogen- eration facility, dated February 20, 1992 (Exhibit 2 to the CE Form 10-Q (September 1993), File No. 2-7749). 10.1.48.1 System Exchange Agreement by and among Altresco Pittsfield, L.P., CEL, the Company and New England Power Company, dated July 2, 1993 (Exhibit 3 to the CE Form 10-Q (September 1993), File No. 2-7749). COMMONWEALTH ELECTRIC COMPANY 10.2 Other agreements. 10.2.1 Pension Plan for Employees of Commonwealth Energy System and Subsidiary Companies as amended and restated January 1, 1993 (Exhibit 1 to the CES Form 10-Q (Sept. 1993), File No. 1-7316). 10.2.2 Employees Savings Plan of Commonwealth Energy System and Subsid- iary Companies as amended and restated as of January 1, 1993 (Ex- hibit 2 to the CES Form 10-Q (September 1993), File No. 1-7316). 10.2.3 New England Power Pool Agreement (NEPOOL) dated September 1, 1971 as amended through August 1, 1977, between NEGEA Service Corpora- tion, 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). 10.2.3.1 Thirteenth Amendment to 10.2.3 as amended September 1, 1981 (Re- filed as Exhibit 3 to the CES 1991 Form 10-K, File No. 1-7316). 10.2.3.2 Fourteenth through Twentieth Amendments to 10.2.3 as amended December 1, 1981, June 1, 1982, June 15, 1983, October 1, 1983, August 1, 1985, August 15, 1985 and September 1, 1985, respective- ly (Exhibit 4 to the CES Form 10-Q (Sept. 1985), File No. 1-7316). 10.2.3.3 Twenty-first Amendment to 10.2.3 as amended to January 1, 1986 (Exhibit 1 to the CES Form 10-Q (March 1986), File No. 1-7316). 10.2.3.4 Twenty-second Amendment to 10.2.3 as amended to September 1, 1986 (Exhibit 1 to the CES Form 10-Q (Sept. 1986), File No. 1-7316). 10.2.3.5 Twenty-third Amendment to 10.2.3 as amended to April 30, 1987 (Exhibit 1 to the CES Form 10-Q (June 1987), File No. 1-7316). 10.2.3.6 Twenty-fourth Amendment to 10.2.3 as amended March 1, 1988 (Exhib- it 1 to the CES Form 10-Q (March 1989), File No. 1-7316). 10.2.3.7 Twenty-fifth Amendment to 10.2.3. as amended to May 1, 1988 (Ex- hibit 1 to the CES Form 10-Q (March 1988), File No. 1-7316). 10.2.3.8 Twenty-sixth Agreement to 10.2.3 as amended March 15, 1989 (Exhib- it 1 to the CES Form 10-Q (March 1989), File No. 1-7316). 10.2.3.9 Twenty-seventh Agreement to 10.2.3 as amended October 1, 1990 (Exhibit 3 to the CES 1990 Form 10-K, File No. 1-7316). (b) Reports on Form 8-K No reports on Form 8-K were filed during the three months ended December 31, 1993. SCHEDULE III COMMONWEALTH ELECTRIC COMPANY INVESTMENTS IN, EQUITY IN EARNINGS OF, AND DIVIDENDS RECEIVED FROM RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (Dollars in Thousands) Name of Issuer and Description of Investment Common Stock - Yankee Atomic Electric Company Balance, December 31, 1990 Number of Shares: 3 835 Amount $524 Add: Equity in Earnings 73 Less: Dividends Received 71 Balance, December 31, 1991 526 Add: Equity in Earnings 75 Less: Dividends Received - Balance, December 31, 1992 601 Add: Equity in Earnings - Less: Dividends Received - Balance, December 31, 1993 $601 There were no changes in the number of shares held during the years 1991, 1992 or 1993. Under terms of the capital funds agreements and power contracts, no stock may be sold or transferred except to another stockholder and, as such, no market exists for these securities. See Note 2(c) of the Notes to Financial Statements included in Item 8 of this report for a discussion of the permanent closing of the nuclear plant owned by Yankee Atomic Electric Company. SCHEDULE VIII COMMONWEALTH ELECTRIC COMPANY VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 (Dollars in Thousands) Additions Balance Provision Deductions Balance Beginning Charged to Accounts at End Description of Year Operations Recoveries Written Off of Year Allowance for Doubtful Accounts Year Ended December 31, 1993 $3 131 $3 173 $783 $3 819 $3 268 Year Ended December 31, 1992 $2 653 $5 216 $854 $5 592 $3 131 Year Ended December 31, 1991 $2 341 $5 286 $985 $5 959 $2 653 SCHEDULE IX COMMONWEALTH ELECTRIC COMPANY SHORT-TERM BORROWINGS (a) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) Maximum Weighted Weighted Month-End Average Average Category of Average Amount Amount Interest Aggregate Balance Interest Outstanding Outstanding Rate Short-Term at End Rate at End During During the During the Borrowings of Period of Period the Period Period (b) Period (c) December 31, 1993 Notes Payable to Banks $ - - $80 350 $16 121 3.4% Notes Payable to System $ - - $12 970 $ 2 451 6.0% COM/Energy Money Pool $ - - $ 4 005 $ 858 3.2% December 31, 1992 Notes Payable to Banks $67 275 3.8% $68 700 $62 460 4.0% Notes Payable to System $ 8 445 6.0% $11 030 $ 7 765 6.3% COM/Energy Money Pool $ 3 395 3.4% $ 6 060 $ 3 856 3.7% December 31, 1991 Notes Payable to Banks $63 300 5.5% $68 250 $55 612 6.3% Notes Payable to System $ 5 950 6.5% $ 5 950 $ 2 167 8.3% COM/Energy Money Pool $ 3 600 4.6% $ 3 795 $ 2 878 5.8% (a) Refer to Note 5 of Notes to Financial Statements filed under Item 8 of this report for the general terms of each category of short-term borrowings. (b) The average amount outstanding during the period is determined by averaging the level of month-end principal balances outstanding for the prior thirteen-month period ending 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 ELECTRIC COMPANY 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 ELECTRIC COMPANY (Registrant) By: WILLIAM G. POIST William G. Poist, 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. Principal Executive Officers: WILLIAM G. POIST March 30, 1994 William G. Poist, Chairman of the Board and Chief Executive Officer R. D. WRIGHT March 28, 1994 Russell D. Wright, President and Chief Operating Officer Principal Financial Officer: JAMES D. RAPPOLI March 30, 1994 James D. Rappoli, Financial Vice President and Treasurer Principal Accounting Officer: JOHN A. WHALEN March 28, 1994 John A. Whalen, Comptroller A majority of the Board of Directors: WILLIAM G. POIST March 30, 1994 William G. Poist, Director JAMES D. RAPPOLI March 30, 1994 James D. Rappoli, Director R. D. WRIGHT March 28, 1994 Russell D. Wright, Director

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Item 1. Business The Sears Credit Account Trust 1989 E (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of November 13, 1989 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2. Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in October, 1989 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3. Item 3. Legal Proceedings None Item 4. Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. 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) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. 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. Sears Credit Account Trust 1989 E (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1989 E 8.65% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated December 5, 1989 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$86.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$86.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest.................... $0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods.................................$513,604,431.85 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.................................$122,914,483.17 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$377,741,548.61 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates.................................$79,709,401.49 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$135,862,883.24 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate..................................$43,205,081.68 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest............ $0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest...................................... $0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest............................................. $0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer..........$8,499,999.99 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods.................................$225,000,000.00 15) The aggregate amount of Investment Income during the related Due Periods.......................$6,487,500.00 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year.............................$225,000,000.00 17) The Deficit Accumulation Amount, as of the end of the reportable year...................................... $0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods...............$43,250,000.04 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year....................$3,604,166.67 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1989E November 13, 1989 Sears Credit Account Trust 1990A January 12, 1990 Sears Credit Account Trust 1990B February 22, 1990 Sears Credit Account Trust 1990C July 31, 1990 Sears Credit Account Trust 1990D October 15, 1990 Sears Credit Account Trust 1990E December 1, 1990 It is understood that this report is solely for your information and is not to be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations Report. We found such amounts to be in agreement. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Association as Trustee Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

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Item 1. Business. (a) GENERAL DEVELOPMENT OF BUSINESS. Reliability Incorporated ("Reliability") and its subsidiaries are principally engaged in the manufacture of equipment used to condition and test integrated circuits ("ICs"). The Company and its subsidiaries also operate testing laboratories which condition and test integrated circuits as a service to others and manufacture power sources, primarily a line of DC to DC power converters which convert direct current voltage into a higher or lower voltage. The following table shows the active subsidiaries of the Company as of the date of this report: Reliability Incorporated (a Texas corporation) ------------------------ RICR de Costa Rica, S.A. Reliability Singapore Pte Ltd. (a Costa Rica corporation) (a Singapore corporation) Reliability Japan Incorporated(1) (a Japanese corporation) (1) This subsidiary has discontinued operations and is in the process of being dissolved. As used in this report, the terms "Company" and "Registrant" refer to Reliability, its present subsidiaries and their predecessors, unless a different meaning is stated or indicated. The Company was incorporated under the laws of Texas in 1953. All subsidiaries are incorporated under a variant of the "Reliability" name. The Company's business was started in 1971 when substantially all of the assets of a testing laboratory owned by Texas Instruments Incorporated were acquired by Reliability, Inc. Reliability, Inc. was not at the time owned by the Registrant. The Registrant, in 1974, acquired Reliability, Inc. and began providing conditioning and testing services. In 1984, this separate company was merged into Reliability Incorporated. Reliability Singapore Pte Ltd. began operations during 1978 and provides conditioning services and manufactures certain conditioning products at a facility in Singapore. Reliability Singapore also manufactured power sources until 1993, when the power sources manufacturing operations were transferred to Costa Rica. RICR de Costa Rica, S.A. began operating in 1990, and manufactures and sells power sources. The companies described in this paragraph have discontinued operations and have been or are in the process of being dissolved. Reliability Nederland B.V. began operations in 1974 in the Republic of Ireland and manufactured power sources until 1991, when the company permanently closed the facility in Ireland. Reliability Nederland B.V. was chartered in the Netherlands and also functioned as a holding company for certain of the Company's foreign subsidiaries until December 1993, when it was dissolved, at which time subsidiaries owned by Reliability Nederland B.V. became subsidiaries of the Company. Reliability Europe Ltd. was incorporated in England in 1984 to serve as a sales representative and product demonstration facility for the Company in Europe; from 1988 to 1990 it also manufactured conditioning systems. In 1992, this company ceased operations completely. Reliability International, Inc., a U.S. Virgin Islands corporation, was incorporated in 1984 as a foreign sales corporation and ceased operations on December 31, 1992. Reliability Japan Incorporated, located in Tokyo, Japan, was incorporated in 1987 and served as a sales and technology center for conditioning and testing systems which were manufactured by the Company. Operations of the Japanese subsidiary were discontinued during 1993 and the subsidiary will be dissolved in 1994. The Company operates in three industry segments as discussed below. CONDITIONING AND TESTING PRODUCTS. ("Conditioning Products") Under current semiconductor technology and manufacturing processes, manufacturers are unable to consistently produce batches of ICs which are completely free of defects. An IC may be defective at the time it is produced, or it may have a latent defect which permits it to operate according to specifications for a period of time but eventually causes it to fail. An IC with such a defect will almost always fail during the first 500 to 1,000 hours of normal use. Accordingly, it has become customary to "condition" ICs, i.e., to subject them, during a relatively short period of time, to controlled stresses which simulate the first several hundred hours of operation in an effort to uncover defects. Such stresses may include maximum rated temperature, voltage and electrical signals and are also commonly referred to as "burn-in". Following conditioning, an IC is tested to determine whether it operates as intended. There are two general types of electrical tests to which an IC may be subjected. Parametric testing determines whether the electrical characteristics of the IC fall within certain specified limits. Functional testing determines whether the IC performs its specified function. The Company's products condition and functionally test ICs. The Company manufactures conditioning systems which are marketed under the names CRITERIA(R) and TITAN(tm); these products can perform most burn- in conditioning processes, but they do not test the ICs during conditioning. CRITERIA systems were originally designed for internal use in the Company's test labs ("TLs") but, since 1974, these systems have been sold to outside customers. Conditioning systems generally are used on new IC production lines, but may also be added to existing production lines. There are a number of different models within the product lines, each with a different capacity and conditioning capability. The CRITERIA models condition relatively large numbers of similar ICs at one time. The TITAN burn-in products provide wide range flexibility to users with relatively small quantities and multiple types of ICs to be conditioned. The TITAN products are designed primarily for IC users, but may also be used by IC manufacturers. CRITERIA products are purchased primarily by companies that manufacture large volumes of similar ICs, but they are also purchased by companies that use ICs. The Company manufactures, under the trade name INTERSECT(tm), systems which functionally test ICs during conditioning. This represents a significant difference in the way most ICs are tested. Most functional testing is performed sequentially, that is, one IC is tested at a time after the IC is conditioned; INTERSECT systems perform parallel functional testing, a process by which more than one IC is tested at a time. INTERSECT systems test ICs during the conditioning process, resulting in substantial time savings. INTERSECT systems are computer controlled for high volume burn-in and testing of semiconductor devices. The Company's INTERSECT systems can vary in their capacities and testing capabilities. The Company also produces and sells other conditioning and testing products and related equipment. The Company manufactures the RI Automatic Loader/Unloader(tm) which is appropriate for handling surface mount and dual inline IC packages. The Company also manufactures IDEA Automatic Loader and Unloader products which use a load/unload technique that is appropriate for dual inline and surface mount IC packages requiring high volume throughput. Conditioning systems and INTERSECT products are the principal products marketed and sold by the Company. The other conditioning and testing products represent options available to customers to enhance the performance of the Company's principal products. Conditioning and testing products are manufactured at the Company's Texas facility and certain limited manufacturing is also done at the Company's facility in Singapore. CONDITIONING AND TESTING SERVICES. ("Services") The Company provides conditioning and testing Services through its TLs to companies that manufacturer integrated circuits. Services revenues also include revenues from the sale of certain conditioning products, purchased by Services customers, which are used by the Company to provide services to the customers. The Company has TLs at its Durham, North Carolina and Singapore facilities, although only conditioning services are available in Singapore. The Durham TL provides conditioning and testing services to a customer in the Research Triangle area of North Carolina. The Company uses CRITERIA systems and burn-in boards to provide conditioning Services. Sequential testing equipment manufactured by other vendors is utilized by the Company in certain testing procedures. Services are generally sold on a long-term, non-binding purchase order basis. POWER SOURCES. The operating components of electronic equipment frequently have varying electrical requirements. Rather than provide electricity to each component separately, specialized devices, called DC- DC converters, or power sources, are used to convert a given electrical input into an electrical output of different voltage. By using small DC- DC converters, electronic equipment can operate from a single output power supply yet provide a specific, and different, voltage to operating components. These DC-DC converters allow a designer of electronic equipment to localize power requirements, increase modularity in the product design, and expand equipment without having to redefine power needs. The Company specializes in the one watt to twenty-five watt DC-DC converter market and manufactures a wide range of power sources classified into various product series. The Company introduced its initial product series, the V-PAC(R), in 1972. The V-PAC is a DC-DC converter compatible with electronic equipment assembly operations. The Company also manufactures the Z-PAC(R), which is a high efficiency DC-DC power source, the S-PAC(tm), a smaller one watt unit which is similar to the V-PAC, the TELECOM-PAC(R) and the ISDN-PAC(tm), which are power sources designed for the telecommunications industry, and the LAN, a power source designed to operate with Local Area Network computer applications. The Company's power sources are sold primarily to companies that manufacture computers and peripheral equipment for computers, and secondarily to companies that manufacture industrial control systems, pipeline sensing and control products, and telecommunications and telephone circuits. The Company has a power sources manufacturing facility in San Jose, Costa Rica. In 1991, the Company closed a power sources manufacturing facility in Ireland and shifted production of power sources for the European market to Costa Rica. During 1993 the power sources manufacturing capacity in Singapore was also transferred to Costa Rica. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. The Company's business is divided into three industry segments - (i) manufacture of conditioning products (Conditioning Products), (ii) conditioning services which condition and test ICs for others (Services), and (iii) manufacture of power sources (Power Sources). The table included in Note 2 of the Company's Consolidated Financial Statements provides certain information regarding the Company's industry segments. (c) NARRATIVE DESCRIPTION OF BUSINESS. The business of the Company is generally described in part (a) of this Item 1. The following paragraphs provide additional information concerning various aspects of the Company's business. Unless otherwise indicated, the information provided is applicable to all industry segments in which the Company operates. (i) PRINCIPAL PRODUCTS. Information as to the principal products and services of the Company is given in part (a) of this Item 1. The Conditioning Products segment of the Company's business is the dominant segment. The following table sets forth the percentage of the Company's total revenues by business segment: Years Ended December 31, ---------------------- Business Segment 1993 1992 1991 - ---------------- ---- ---- ---- Conditioning Products 53% 54% 45% Services 27 24 25 Power Sources 20 22 30 --- --- --- Total revenues 100% 100% 100% === === === Reference is made to Note 2 of the Company's Consolidated Financial Statements for additional information. (ii) NEW PRODUCTS. During 1993, Reliability began development of the INNOVATION(r) 2000 which further enhances the RI Automatic Loader/Unloader product line. The INNOVATION 2000 provides additional automation features such as device media and burn-in board handling. These additional features will significantly improve productivity by providing continuous and unattended device loading and unloading for approximately forty-five minutes, allowing one operator to handle multiple machines or operations. Delivery of the INNOVATION 2000 is scheduled for the first quarter of 1994. During 1993, Reliability introduced a burn-in board screener which allows INTERSECT 30 customers to prescreen and functionally test both 16 and 64 Meg DRAMs. The machine improves the utilization of the INTERSECT system and, in some cases, eliminates the need for a pre-test on a more expensive serial test system. The Company also introduced a software product called Burn-In Board Management ("BIB Management(tm)") which allows customers to track the usage, history, and defect rate of burn-in boards ("BIBs"). Using reports generated by the program, a customer can make decisions about the cost compared to performance of sockets and BIBs and will know when the BIBs become unreliable and need to be replaced. In addition, the BIB Management software can be used in conjunction with Reliability's Interactive System Controller to prevent an operator from loading an inappropriate board into a system or running an incorrect test plan. The Company, during 1993, continued to investigate the use of surface mount technology in the process of manufacturing power source products. Surface mount technology removes the human element from certain manufacturing processes thereby enhancing the reliability of the power sources. The technology also enables products to be assembled in smaller packages and therefore provides higher power output from smaller units. The Company introduced, in 1993, a new 15 watt DC-DC converter adding another higher wattage unit to the product line and continued development efforts related to reducing the cost of manufacturing power sources. (iii) RAW MATERIALS AND INVENTORY. The Company's products are designed by its engineers and are manufactured, assembled, and tested at its facilities in Houston, Texas; San Jose, Costa Rica; and to a limited degree in Singapore. The Company's products utilize certain parts which it manufactures and components purchased from others. Certain metal fabrications and subassembly functions are performed by others for the Company. The Company maintains an inventory of components and parts for its manufacturing activities. There are many sources for most of the raw materials needed for the Company's manufacturing activities, although a few components come from sole sources. The Company has not experienced any significant inability to obtain components or parts, but does experience occasional delays in receiving certain items. (iv) PATENTS, TRADEMARKS. The Company has patents and pending patent applications in the United States and certain other countries which cover key components of the CRITERIA and INTERSECT systems, and components of certain other conditioning and testing products. The Company considers its patent for the EX-SERT(tm) backplane system to be material. This patent, which was granted in the United States in February 1983, and will expire in February 2000, covers the use of a cavity at the rear wall of the burn-in chamber to isolate power and signal connectors from the harsh environment of the burn-in chamber. In many burn- in systems, the power and signal connectors are subjected to intense heat generated within the burn-in chamber, resulting in shortened connector life. The connection assembly disclosed in the patent reduces connector maintenance problems. A patent with respect to the backplane connection assembly has also been granted in Japan. The Company also considers its patents covering a method of IC extraction during the process of unloading burn-in boards and a patent for a floating head mechanism related to the loading of ICs onto burn-in boards to be significant. These patents expire in 2001 and 2005, respectively. The Company believes that its other patents and patent applications are useful, but their loss would not be material to the business of the Company. The Company believes that the rapidly changing technology in the electronics industry makes the Company's future success dependent more on the quality of its products, services, and performance and the technical skills of its personnel and its ability to adapt to the changing technological environment than upon any patents which it has or may be able to obtain. The Company has certain trademarks which are registered with the U.S. Patent & Trademark Office for use in connection with its products and services, including "ri (plus design)", "RELIABILITY", "CRITERIA", "V-PAC", "Z-PAC", "INNOVATION", "TELECOM-PAC" and "RI STINGRAY". In addition, the Company uses certain other trade names which are not presently registered, including "TITAN", "INTERSECT", "INTERACT", "INTERNET", "EX-SERT", "UNLOADER", "S-PAC", "ISDN-PAC" and "RI Automatic Loader/Unloader" and others not listed here which are used less frequently. The Company has in the past and will in the future protect vigorously all of its patents and trademarks as well as its other proprietary rights. (v) SEASONALITY. The Company's business is not seasonal, but is cyclical depending on the electronics manufacturing and semiconductor industries. (vi) WORKING CAPITAL. The Company finances its inventory and other working capital needs out of internally generated funds and periodic borrowings. The Company has short-term credit facilities on which the Company could draw additional funds as of December 31, 1993. Reference is made to Note 3 of the Company's Consolidated Financial Statements for additional information as to credit agreements under which working capital is or could be available if required. (vii) MAJOR CUSTOMERS. In 1993 and 1992, four customers accounted for 73% and 67% of the Company's consolidated revenues. The four customers are Intel Corporation, International Business Machines Corporation, Mitsubishi Semiconductor America, Inc. and Texas Instruments Incorporated. In 1993 and 1992, two of the customers accounted for approximately 52% and 45% and 46% and 49% of revenues, respectively, in the Services segment. In addition in 1993 and 1992 two other customers accounted for 46% and 44% and 24% and 57% of revenues, respectively, in the Conditioning Products segment. Note 2 to the Company's Consolidated Financial Statements discloses information concerning customers that accounted for more than 10% of consolidated revenues. In the Conditioning Products and Power Sources segments, decreased business from one customer may be replaced by new or increased business from other customers, but there is no assurance that this will occur. The Company believes that its relationships with its customers are good. The loss of or reduction in orders from a major customer and the failure of the Company to obtain other sources of revenue could have a material adverse impact on the Company. (viii) BACKLOG. The following table sets forth the Company's backlog at the dates indicated: December 31, ------------- Business Segment 1993 1992 - ---------------- ---- ---- (In thousands) Conditioning Products $ 3,653 $ 7,091 Services 649 1,517 Power Sources 1,022 824 ------ ------ Total $ 5,324 $ 9,432 ====== ====== Backlog for sales of Conditioning Products and Power Sources represents orders for delivery within twelve months from the date on which backlog is reported. Backlog for Services represents orders for services where the ICs to be conditioned have been delivered to the Company and orders for Conditioning Products that are directly related to providing services to customers. The Company's backlog as of December 31, 1993, is believed to be firm, although portions of the backlog are not subject to legally binding agreements. Orders included in backlog of the Conditioning Products segment totaling $694,000 are not currently scheduled for delivery, but management projects that the products will be scheduled for delivery in 1994. (ix) GOVERNMENTAL BUSINESS. The Company does not carry on a material amount of business with any governmental agency. (x) COMPETITION. The markets for the Company's products and services are subject to intense competition. The Company's primary competitors in the manufacture of Conditioning Products are other independent manufacturers of such systems and manufacturers of ICs who design their own equipment. The primary methods of competition in the manufacturing market are quality, service, delivery, price, and product features. The Company believes that its service after the sale, including its ability to provide installation, maintenance service, and spare parts, enhances its competitiveness. The world market for power sources is divided into the merchant and the captive markets. There are less than one thousand competitors in the merchant market of the power source manufacturing business, most of which target a particular application for their business. The Company believes there are approximately twenty significant competitors whose products compete directly with those of the Company in its U.S. and foreign markets. Competition in the power sources market is based primarily on the specific features of the power sources, price and quality. The primary areas of competition for the Company's Services are price, service level, and geographic location. The Singapore TL provides services to companies in southeast Asia that manufacture and use ICs, and the Durham TL provides services to a major IC manufacturer in the Research Triangle area of North Carolina. (xi) RESEARCH. The demand of the semiconductor industry for increasingly complex and sophisticated equipment results in the Company's continuing development of new products and review and modification of its existing products to adapt to technology changes in the industry. The Company also focuses on the development of peripheral equipment and options for its CRITERIA, INTERSECT and TITAN lines. In 1993, 1992 and 1991, the Company spent $889,000, $2,639,000 and $3,105,000, respectively, on research and development activities. Substantially all of the Company's research and development resources, during 1991 and 1992, were devoted to an INTERSECT project and other conditioning products. The Company completed development of the INTERSECT 30 in 1992. Other developmental projects, which are primarily related to the Conditioning Products segment, were undertaken in 1993. (xii) ENVIRONMENTAL MATTERS. The business of the Company is not expected to be affected by zoning, environmental protection, or other similar laws or ordinances. (xiii) EMPLOYEES. On December 31, 1993, the Company had 409 employees. Continued growth of the Company is dependent upon the Company's ability to attract and retain its technical staff and skilled employees. During recent years, the Company has experienced a low turnover rate among its employees, except that due to the very low unemployment rates in Singapore and Costa Rica, turnover at these facilities has been high. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES. See Note 2 to the Company's Consolidated Financial Statements for a table showing information about foreign and domestic operations of the Company for the last three years. Item 2. Item 2. Properties The corporate headquarters of the Company are located in a 131,000 square foot facility on a seven acre tract of land in Park 10, an office and industrial park on Interstate Highway 10 located on the west side of Houston. The Company occupies 101,000 square feet in the facility and the remaining 30,000 square feet has been sub-leased. This facility also includes manufacturing operations for conditioning products, research and development activities, and sales and marketing of power sources for the U.S. market. The lease for this facility will expire in 1995, and the Company has an option to renew for five additional years. A subsidiary of the Registrant occupies 18,200 square feet of leased space in Singapore. The Singapore facility is devoted to an TL and manufacture of burn-in boards. The Durham TL is located in 15,300 square feet of leased space in North Carolina. A subsidiary of the Registrant occupies 18,900 square feet of leased space in San Jose, Costa Rica. The plant in Costa Rica manufactures and sells power sources. See Note 7 to the Company's Consolidated Financial Statements. Item 3. Item 3. Legal Proceedings. Not applicable. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. Item 4A. Executive Officers of the Registrant. The following table sets out certain information regarding each executive officer of the Company: Officer of Reliability Position currently Incorporated held with Name Age Since Reliability Incorporated ---- --- ------------ ------------------------ Larry Edwards 52 1981 President and Chief Executive Officer Max T. Langley 47 1978 Senior Vice President and Chief Financial Officer/ Secretary/Treasurer Robert W. Hildenbrand, Jr. 45 1984 Vice President J.E. (Jim) Johnson 48 1984 Vice President James M. Harwell 39 1993 Vice President Paul Nesrsta 37 1993 Vice President Mr. Edwards became the chief executive officer of the Company in March 1993. He was president and chief operating officer of the Company from April 1990 to March 1993 and was executive vice president and chief operating officer of the Company for more than five years prior to becoming the president in 1990. Mr. Harwell has been a vice president of the Company since July 1993. Mr. Harwell was the division manager of the automation equipment division of the Company from February 1991 to July 1993 and held positions as managing director of two of the Company's foreign subsidiaries for more than five years prior to February 1991. Mr. Nesrsta has been a vice president of the Company since July 1993. Mr. Nesrsta was manager of the test systems division of the Company for more than five years prior to becoming a vice president in 1993. Each other person named above has held his present position for more than five years. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. The Common Stock of Reliability trades on The Nasdaq Stock Market under the stock symbol REAL. The high and low last trade prices for 1993 and 1992, as reported by The Nasdaq Stock Market, are set forth below. These quotations represent prices between dealers without retail mark-up, mark- down, or commission, and do not necessarily reflect actual transactions. First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------ - - - ---- High $2.50 $1.28 $4.88 $5.63 Low .81 .69 .94 2.50 - ---- High $2.13 $2.13 $2.88 $2.00 Low 1.00 1.25 1.38 1.25 A covenant in a working capital financing agreement restricts the Company's ability to pay dividends if certain criteria are not met. The Company could pay a dividend at December 31, 1993. The Company paid no dividends in 1993 or 1992. The Company intends to retain any earnings for use in its business and therefore does not anticipate paying dividends in the foreseeable future. See Note 3 to the Company's Consolidated Financial Statements. Reliability had approximately 920 shareholders of record as of February 18, 1994. Item 6. Item 6. Selected Financial Data. The following table sets out certain selected financial data for the years indicated: Years Ended December 31, ------------------------------------ 1993 1992 1991 1990 1989 ------ ------ ------ ------ ------ (In thousands, except per share data) Revenues $27,022 $31,413 $29,612 $34,311 $38,073 Costs and expenses: Operating costs 24,269 32,587 32,617 38,499 37,693 Provision for restructuring 288 1,392 1,000 - - Interest expense (income), net 43 125 83 78 (21) ------ ------ ------ ------ ------ Total costs and expenses 24,600 34,104 33,700 38,577 37,672 ------ ------ ------ ------ ------ Income (loss) before income taxes 2,422 (2,691) (4,088) (4,266) 401 Provision (benefit) for income taxes 53 (46) 101 (543) 309 ------ ------ ------ ------ ------ Net income (loss) (1) $ 2,369 $(2,645) $(4,189) $(3,723) $ 92 ====== ====== ====== ====== ====== Average shares outstanding 4,243 4,243 4,242 4,213 4,211 ====== ====== ====== ====== ====== Net income (loss) per share (1) $ .56 $ (.62) $ (.99) $ (.88) $ .02 ====== ====== ====== ====== ====== Dividends per share $ .00 $ .00 $ .00 $ .00 $ .00 ====== ====== ====== ====== ====== Total assets $11,018 $14,693 $13,615 $17,320 $23,696 Long-term debt - - - - 600 Working capital 5,846 2,413 4,298 6,661 9,561 Property and equipment, net 2,257 3,312 3,758 5,810 7,474 Stockholders' equity 8,114 5,745 8,390 12,564 16,276 - ----- (1) The net loss and net loss per share for 1992 originally reflected the tax benefit of a net operating loss carryforward as an extraordinary item. The tax benefit of the net operating loss carryforward has been reclassified and netted against the income tax provision, as explained in Note 5 to the Consolidated Financial Statements. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. FINANCIAL CONDITION. Management considers cash provided by operations and retained earnings to be primary sources of capital. The Company maintains lines of credit to supplement these primary sources of capital and has leased its major facilities, reducing the need to expend capital on such items. Changes in the Company's financial condition, liquidity, and capital requirements during the three year period ended December 31, 1993 are attributable to significant operating losses through the first quarter of 1993 and a return to profitability in the periods subsequent to the March 1993 quarter. The return to profitability resulted in a significant improvement in the Company's financial condition. The losses resulted from a general decline in demand for products sold by the Company, significant expenses to maintain certain foreign subsidiaries, costs associated with excess capacity and costs related to restructuring of operations. The reduction in expenses resulting from the restructuring of operations, which was completed in the first quarter of 1993, resulted in the Company returning to profitability in 1993. Certain ratios and amounts monitored by management in evaluating the Company's financial resources and performance are presented in the following chart: 1993 1992 1991 -------- -------- -------- Working capital: Working capital (thousands of dollars) $ 5,846 $ 2,413 $ 4,298 Current ratio 3.1 to 1 1.3 to 1 1.9 to 1 Profitability ratios: Gross profit 43 % 42 % 39 % Return on revenues 9 % ( 8)% (14)% Return on assets 22 % (18)% (31)% Return on equity 29 % (46)% (50)% Equity ratios: Total liabilities to equity 0.4 1.6 0.6 Assets to equity 1.4 2.6 1.6 The Company's financial condition improved significantly during 1993. Working capital increased to $5.8 million at December 31, 1993 from $2.4 million at December 31, 1992, and the ratio of current assets to current liabilities increased to 3.1 at the end of 1993, compared to 1.3 at the end of 1992. The improvement is attributable to a return to profitability resulting from expense reductions which included reductions in personnel levels and restructuring of operations, reduction in excess leased space and a general reduction in most expense items. Net cash provided by operating activities was $5.2 million in 1993, contrasted with $1.5 million used by operations in 1992. The principal items contributing to the cash provided by operations in 1993 are net income of $2.4 million, depreciation and amortization of $1.3 million, and decreases in accounts receivable and inventories. Cash provided by operations was used to reduce debt under financing agreements by $2.4 million in the 1993 period. Cash flows from operations were also used to reduce accounts payable and accrued liabilities by a total of $2.3 million and provided cash of $1.7 million which was used to substantially complete restructuring of operations. Accounts receivable were unusually high at December 31, 1992 due to shipment of conditioning products during the latter part of the fourth quarter of 1992. The decrease in inventories in 1993 resulted from shipment of conditioning products in the first quarter of 1993 that were partially completed at December 31, 1992 and a decrease in raw materials inventory resulting from a decrease in demand for products sold by the Company. The decrease in the current ratio and working capital in 1992 compared to 1991 resulted principally from the $2.6 million loss reported in 1992 and an increase in inventories and accounts receivable. The inventory increase resulted from an increase in work-in-progress inventory related to products that were shipped in 1993. Short-term borrowing and an increase in accounts payable were used to support cash used by operations and to purchase $1.4 million of capital equipment in 1992. Capital expenditures during 1993 totaled $492,000, a decrease from expenditures of $1.4 million in 1992. A change in product mix and volume increases at the Company's Service facilities will require additional equipment during 1994. Management currently projects that 1994 expenditures may exceed $1.0 million. The lease on the Company's corporate headquarters expires in 1995. The Company will decide during the first half of 1994 whether to continue to lease or purchase the existing facility, or to relocate to a different facility. The Company maintains bank lines of credit to provide funds to support periodic changes in liquidity. Bank debt decreased $2.4 million in 1993 after increasing $2.0 million in 1992. Cash flow from operations was used to pay off all bank debt in 1993. Borrowings under loan agreements during 1992 were used to support cash used by operations and to finance capital expenditures. The U.S. Company's working capital line of credit is evidenced by demand notes and credit availability is limited to 80% of eligible accounts receivable. The Company's Singapore subsidiary has an overdraft facility; continuation of the facility is at the discretion of the bank. The Company could borrow an additional $1.4 million under its lines of credit at December 31, 1993. Current projections indicate that cash generated by operations supplemented by incidental bank borrowing under existing agreements will be sufficient to meet the cash requirements of the Company during 1994. Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The adoption of this standard did not have a material effect on the Company's Financial Statements. Reliability's revenue is dependent on conditions within the semiconductor industry and profitability is dependent on revenues and controlling expenses. Semiconductor manufacturers experienced good sales growth during 1992 and 1993 and current forecasts indicate an increase in revenues for the industry in 1994. The Company has net operating loss carryforwards available to reduce income taxes on a portion of future taxable income. RESULTS OF OPERATIONS. OVERVIEW. Revenues from products sold by the Company declined during the three year period ending in 1993 except that an increase in revenues in the Conditioning Products segment in 1992 was attributable to revenues from the sale of INTERSECT 30 systems. Delivery of these high unit price systems began in the second quarter of 1992 and continued throughout 1993. A decline in revenues during the three year period in the Power Sources segment resulted from price competition, resulting in a significant decrease in unit prices and a decrease in unit volume. Customer requirements for conditioning Services decreased slightly in 1993. A small decrease in Services revenues in 1992 resulted from a revenue decrease at one of the Company's services facilities. REVENUES. Revenues decreased 14% in 1993 to $27 million, reflecting decreases in all business segments. Revenues in the Central America geographical segment increased while the U.S., Asia and Pacific and Western Europe segments declined. The increase in the Central America segment is attributable to shifting Power Sources manufacturing to Costa Rica from Ireland and Singapore. The overall decrease in the U.S. segment is related to volume and unit price decreases. A substantial portion of the decrease in the Asia Pacific segment is related to shifting Power Sources manufacturing from Singapore to Costa Rica and to shut-down of the Japanese operation. In 1992, revenues were $31.4 million, an increase of 6% over 1991, reflecting an increase in the Conditioning Products segment, a decrease in the Power Sources segment and a small decrease in the Services segment. Conditioning Products revenues decreased 16% in 1993 to $14.2 million after increasing 27% in 1992. A decrease in the unit volume of older models of burn-in chambers and loader and unloader products and lower average unit prices contributed to the decline. The increase in 1992 is attributable to a significant increase in revenues from the sale of INTERSECT 30 products. Revenues in the Conditioning Products segment overall, excluding INTERSECT products, declined during the three year period due to changes in requirements by the semiconductor industry for burn-in and other conditioning products and to product mix changes. Domestic conditioning and testing product shipments increased due to shipment of INTERSECT 30 systems beginning in the second quarter of 1992. Revenues from the sale of conditioning and testing products in Japan decreased significantly in 1992 due to a reduction in capital spending by Japanese semiconductor manufacturers. Revenues in the Power Sources segment decreased in 1993 to $5.4 million after decreasing 20% to $7.0 million in 1992. The decrease, in both years, resulted principally from price competition resulting in average unit sale price and volume decreases. The decline in revenues appeared to be stabilizing during the latter part of 1993. Revenues in the Services segment decreased 3% in 1993 to $7.4 million after decreasing only $6,000 in 1992. The 1993 decrease in revenues is attributable to product mix changes and unit price decreases resulting from lower operating costs being passed through to customers. Average unit prices increased during the latter part of 1993 due to a shift in product mix. Revenues included in the Services segment from the sale of conditioning products to Services customers increased during 1993 due to a change in product mix. Revenues at the Durham services facility decreased in 1992 due to volume decreases caused by product mix changes. Revenues at the Singapore facility increased in 1992 due to volume increases and increases in average unit sales prices due to product mix changes. INFLATION. The overall impact of inflation on revenues has been minimal. Salaries and wages have increased at rates less than the general inflation rate during the three year period due to salary reductions and wages freezes during 1991 and 1992. The cost of raw materials and purchased parts increased at rates somewhat greater than the general inflation rate due to general increases in demand. COSTS AND EXPENSES. Changes in costs and expenses during the three year period are primarily related to various cost reduction and restructuring measures, changes in revenue levels and the changes in research and development expenditures. Total costs and expenses, excluding the provision for restructuring, decreased $8.3 million in 1993 compared to the revenue decrease of $4.4 million. Cost of revenues decreased $2.7 million; marketing, general and administrative expenses decreased $3.8 million; and research and development expenses decreased $1.8 million. The overall decrease in expenses, in 1993, related to restructuring of operations, expense reduction programs and a decrease in revenue and volume related expenses. Total costs and expenses, excluding the provision for restructuring, decreased $30,000 in 1992 to $32.6 million, compared to a revenue increase of $1.8 million. In general, costs and expenses decreased in 1992 due to a reduction in personnel levels and various cost reduction programs. The decreases were offset in some instances by volume related expenses associated with revenues from the sale of the INTERSECT 30 products. Costs and expenses were also affected by certain operations operating below levels necessary to absorb fixed overhead costs. The Company's gross profit, as a percent of revenues, was 43%, 42% and 39% in 1993, 1992 and 1991, respectively. The 1993 increase is related to an increase in the Conditioning Products segment. The increase in the Conditioning Products segment resulted from a decrease in both fixed and variable manufacturing costs and changes in product mix. The increase also resulted from a reduction in expenses due to shut-down of the Japanese operation. A small decline in the gross profit in the Services segment is due principally to an increase in revenues from the sale of conditioning products to Services customers, because the gross profit on these products is traditionally low due to price competition. Revenues in the Power Sources segment declined 22% in 1993, but the gross profit in the segment was basically unchanged compared to 1992. Total manufacturing costs declined significantly due to the restructuring of operations and shifting of all production capacity for this segment to Costa Rica. A significant portion of the benefit of the change took effect in the third quarter of 1993. The overall 1992 gross profit increase is principally related to an increase in the Conditioning Products segment and to a lesser extent to an increase in the Service segment, reduced by a decrease in the Power Sources segment. The increase in the Conditioning Products segment resulted from a reduction in overhead expenses, including personnel and expense reductions, and a higher absorption of fixed overhead by certain operations. The increase in the Services segment in 1992 results from product mix changes and a reduction in overhead expense. Expense controls at both of the Company's services facilities and a reduction in overhead expense also contributed to the increase. The 1992 decrease in the Power Sources segment relates to volume and price decreases and the cost of carrying excess production capacity. Marketing, general, and administrative expenses decreased $3.8 million in 1993 in comparison to a $4.4 million decrease in revenues. Expenses were reduced throughout 1993 by stringent expense reduction programs, reductions in personnel levels and discontinuation of operations at two foreign facilities. Approximately 45% of the decrease is due to shut-down of the UK and Japanese operations in late 1992 and consolidation of Power Sources manufacturing in Costa Rica. In addition, expenses decreased in the Conditioning Products segment due to a decrease in revenue related expenses such as commissions and warranty and installation costs. The increase of $459,000 in 1992 is related to an increase in revenue related expenses, such as commissions, royalties and similar expenses, in the Conditioning Products segment resulting from shipment of INTERSECT systems. Expenses in the Power Sources and Services segments decreased in 1992. The decrease in expenses in the Services segment resulted from stringent expense control measures. Expenses in the Power Sources segment decreased in 1992 due to volume decreases and the shut-down of the Irish power sources facility in 1991. Expenses at the Costa Rica and Singapore power sources operations increased, but at rates less than the decrease related to the Irish operation. Expense controls and personnel reductions at most facilities during 1992 resulted in a decrease in marketing, general and administrative expenses. The expense reductions were offset by the revenue related expenses associated with the increase in INTERSECT revenues, but expenses in the Conditioning Products segment increased only 16% while revenues increased 27%. Research and development expenditures totaled $889,000 in 1993, compared to $2.6 and $3.1 million in 1992 and 1991, respectively. A significant portion of expenditures in each of the three years related to development of conditioning and testing products, with a substantial portion of these expenditures being related to development of the INTERSECT 30 line of burn- in and test systems. The decrease in 1992 and 1993 results from completion of the INTERSECT 30 development project in 1992. Costs associated with development of conditioning products increased in 1993 after declining in 1992. Development costs in the Power Sources segment declined in 1993 and also in 1992. The Company recorded in 1993 a provision for restructuring of operations totaling $288,000. The provision was composed of $319,000 related to retirement and severance pay for U.S. employees who were terminated in March 1993 and a $31,000 reduction of the 1992 restructuring provision related to downsizing power sources production capacity in Singapore. The Company recorded a $1.4 million provision for restructuring of operations in 1992. The provision was composed of $1.0 million for curtailment of operations in Japan, $216,000 related to closing of the U.K. facility, $325,000 related to reduction of power sources manufacturing capacity in Singapore and a $149,000 reduction of the 1991 provision for closing of the Irish power sources facility. The Company recorded a $1.0 million provision for shut- down of its Irish power sources facility in the third quarter of 1991. The shut-down was completed during 1992 at a cost which was $149,000 less than the original estimate. Net interest expense decreased significantly in 1993 due to a reduction in debt balances during the last half of 1993. Interest expense increased in 1992 compared to 1991 due to an increase in debt balances, reduced somewhat by a decline in interest rates. Interest income declined in 1993 and 1992 due to a decrease in investable cash balances and a decrease in interest rates in 1992. INCOME TAX EXPENSE (BENEFIT). The Company's income tax expense (benefit) was $53,000, $(46,000) and $101,000, in 1993, 1992 and 1991, respectively. This equated to an effective tax rate of 2% in 1993 and a negative 2% in 1992. The 1991 provision of $101,000 was recorded on a loss of $4.1 million. The Company's effective tax rates differed from the U.S. tax rate of 34% due to tax benefits of net operating loss carryforwards in 1993 and 1992; tax provided on a dividend from a foreign subsidiary in 1992; tax benefits, in 1993, related to expenses incurred in shutting down a foreign subsidiary; expenses of foreign subsidiaries for which tax benefits were not available in 1992 and 1991; and in 1991 tax benefits were not available to the U.S. Company due to net operating loss carryback limitations. Item 8. Item 8. Consolidated Financial Statements and Supplementary Data. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page ---- Report of independent public accountants. . . . . . . . . . . . . . . . . Consolidated balance sheets at December 31, 1993 and 1992 . . . . . . . . For each of the three years in the period ended December 31, 1993: Consolidated statements of operations . . . . . . . . . . . . . . . . . Consolidated statements of cash flows . . . . . . . . . . . . . . . . . Consolidated statements of stockholders' equity . . . . . . . . . . . . Notes to consolidated financial statements. . . . . . . . . . . . . . . . Supplementary financial information: Quarterly results of operations (unaudited) . . . . . . . . . . . . . . S-1 Schedules for each of the three years in the period ended December 31, 1993: V - Property, plant and equipment. . . . . . . . . . . . . . . . . . S-2 VI - Accumulated depreciation of property, plant and equipment . . . . . . . . . . . . . . . . . . . . . . . S-3 VIII - Valuation and qualifying accounts and reserves . . . . . . . . . S-4 IX - Short-term borrowings. . . . . . . . . . . . . . . . . . . . . . S-5 X - Supplementary income statement information . . . . . . . . . . . S-6 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. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS The Board of Directors and Stockholders Reliability Incorporated We have audited the accompanying consolidated balance sheets of Reliability Incorporated as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and stockholders' 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 on page F- 1. 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 Reliability Incorporated 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. BY/s/ERNST & YOUNG Houston, Texas February 11, 1994 RELIABILITY INCORPORATED CONSOLIDATED BALANCE SHEETS ASSETS December 31, -------------- 1993 1992 ---- ---- (In thousands) Current assets: Cash $ 2,882 $ 362 Accounts receivable (Note 3) 3,074 4,103 Inventories (Note 3) 2,356 5,939 Deferred income taxes (Note 5) - 60 Other 314 519 ------ ------ Total current assets 8,626 10,983 Property and equipment, at cost (Note 3): Machinery and equipment 11,994 12,884 Leasehold improvements 2,543 2,588 ------ ------ 14,537 15,472 Less accumulated depreciation 12,280 12,160 ------ ------ 2,257 3,312 Other assets 135 398 ------ ------ $11,018 $14,693 ====== ====== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 524 $ 1,878 Short-term borrowings (Note 3) - 2,408 Accrued liabilities (Note 8) 2,016 2,951 Current maturities on long-term debt (Note 3) 58 - Income taxes payable (Note 5) 18 53 Liability for restructuring (Note 6) 164 1,280 ------ ------ Total current liabilities 2,780 8,570 Deferred income taxes (Note 5) 124 153 Liability for restructuring (Note 6) - 225 Commitments and contingencies (Note 7) - - Stockholders' equity (Notes 3 and 4): Common stock, without par value; 20,000,000 shares authorized; 4,242,848 shares issued 5,926 5,926 Retained earnings (deficit) 2,188 (181) ------ ------ Total stockholders' equity 8,114 5,745 ------ ------ $11,018 $14,693 ====== ====== See accompanying notes. RELIABILITY INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) Years Ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- Revenues: Product sales $19,651 $23,834 $22,027 Services 7,371 7,579 7,585 ------ ------ ------ 27,022 31,413 29,612 Costs and expenses: Cost of product sales 10,986 13,759 13,245 Cost of services 4,419 4,376 4,913 Marketing, general and administrative 7,975 11,813 11,354 Research and development 889 2,639 3,105 Provision for restructuring (Note 6) 288 1,392 1,000 ------ ------ ------ 24,557 33,979 33,617 ------ ------ ------ Operating income (loss) 2,465 (2,566) (4,005) Interest expense, net (Note 3) 43 125 83 ------ ------ ------ Income (loss) before income taxes 2,422 (2,691) (4,088) Provision (benefit) for income taxes (Note 5) 53 (46) 101 ------ ------ ------ Net income (loss) $ 2,369 $(2,645) $(4,189) ====== ====== ====== Net income (loss) per share $ .56 $ (.62) $ (.99) ====== ====== ====== See accompanying notes. RELIABILITY INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Years Ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- Cash flows from operating activities: Net income (loss) $ 2,369 $(2,645) $(4,189) Adjustments to reconcile net income (loss) to cash provided by operating activities: Depreciation and amortization 1,258 1,761 2,407 Provisions for restructuring 288 1,392 1,000 Deferred income taxes 31 (51) (58) Loss (gain) on disposal of fixed assets 352 131 (1) Provision for inventory obsolescence 262 636 347 Provision for bad debts - (12 ) (30) Exchange (gain) loss (49) 62 (14) Change in assets and liabilities: (Increase) decrease in assets: Short-term investment - 100 (100) Accounts receivable 1,042 (1,498) 1,360 Inventories 3,338 (2,066) (164) Refundable income taxes - 120 703 Other assets 457 354 14 Increase (decrease) in liabilities: Accounts payable (1,366) 720 88 Accrued liabilities (978) 274 (52) Income taxes payable (35) (241) 56 Liability for restructuring (1,744) (491) (396) ------ ------ ------ Total adjustments 2,856 1,191 5,160 ------ ------ ------ Net cash provided (used) by operating activities 5,225 (1,454) 971 ------ ------ ------ Cash flows from investing activities: Expenditures for plant and equipment (492) (1,436) (665) Proceeds from sale of equipment 15 27 54 ------ ------ ------ Net cash (used) in investing activities (477) (1,409) (611) ------ ------ ------ Cash flows from financing activities: Borrowings (payments) under loan agreements (2,457) 2,035 (53) Conversion of note payable to long-term debt 393 - - Payments and current maturities on long-term debt (335) - - Issuance of common stock - - 15 ------ ------ ------ Net cash (used) provided by financing activities (2,399) 2,035 (38) ------ ------ ------ Effect of exchange rate changes on cash 171 (36) (13) ------ ------ ------ Net increase (decrease) in cash 2,520 (864) 309 Cash at beginning of year 362 1,226 917 ------ ------ ------ Cash at end of year $ 2,882 $ 362 $ 1,226 ====== ====== ====== See accompanying notes. RELIABILITY INCORPORATED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (In thousands) Common Stock ------------ Retained Earnings Total Shares Amount (Deficit) Amount ------ ------ -------- ------ Balance at December 31, 1990 4,223 $5,911 $6,653 $12,564 Net (loss) (4,189) (4,189) Shares issued to employee stock savings plan 20 15 15 ----- ----- ------ ------ Balance at December 31, 1991 4,243 5,926 2,464 8,390 Net (loss) (2,645) (2,645) ----- ----- ------ ------ Balance at December 31, 1992 4,243 5,926 (181) 5,745 Net income 2,369 2,369 ----- ----- ------ ------ Balance at December 31, 1993 4,243 $5,926 $ 2,188 $ 8,114 ===== ===== ====== ====== See accompanying notes. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are majority owned. All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts in the consolidated financial statements for the years ended December 31, 1992 and 1991 have been reclassified to conform to the 1993 presentation. CASH EQUIVALENTS For the purposes of the statements of cash flows, the Company considers all highly liquid cash investments with maturities of three months or less to be cash equivalents. INVENTORIES Inventories are stated at the lower of standard cost (which approximates first-in, first-out) or market (replacement cost or net realizable value) and include: 1993 1992 ---- ---- (In thousands) Raw materials $1,702 $2,924 Work-in-progress 553 2,553 Finished goods 101 462 ----- ----- $2,356 $5,939 ===== ===== PROPERTY, PLANT AND EQUIPMENT For financial statement purposes, depreciation is computed principally on the straight-line method using lives from 4 to 10 years for leasehold improvements and the straight-line and double-declining balance methods using lives from 2 to 8 years for machinery and equipment. INCOME TAXES The provision for income taxes includes Federal, foreign, and state income taxes. Deferred income taxes are provided for temporary differences between financial statement and income tax reporting. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 FOREIGN CURRENCY TRANSLATION The financial statements of foreign subsidiaries are translated into U.S. dollar equivalents in accordance with Statement of Financial Accounting Standards No. 52. The Company's primary functional currency is the U.S. dollar. Accordingly, translation adjustments and transaction gains or losses for foreign subsidiaries that use the U.S. dollar as their functional currency are recognized in consolidated income in the year of occurrence. The remaining entity used the local currency as its functional currency and translation adjustments were immaterial. 2. INFORMATION ON BUSINESS SEGMENTS AND GEOGRAPHIC AREAS The Company operates in three industry segments: (1) manufacture of conditioning products which are used in conditioning and testing of integrated circuits; (2) conditioning services which condition and test integrated circuits and (3) manufacture of power sources. Financial information by industry segment is as follows: 1993 1992 1991 ---- ---- ---- (In thousands) Revenues from unaffiliated customers: Conditioning products $14,218 $16,840 $13,241 Conditioning services 7,371 7,579 7,585 Power sources 5,433 6,994 8,786 ------ ------ ------ $27,022 $31,413 $29,612 ====== ====== ====== Operating income (loss): Conditioning products $ 1,892 $(1,910) $(3,649) Conditioning services 1,384 1,854 1,218 Power sources (190) (849) (276) Provision for restructuring of operations: Conditioning product (280) (1,108) - Power sources (8) (284) (1,000) General corporate expenses (333) (269) (298) ------ ------ ------ $ 2,465 $(2,566) $(4,005) ====== ====== ====== Identifiable assets: Conditioning products $ 5,718 $ 8,922 $ 7,014 Conditioning services 2,905 2,634 2,057 Power sources 2,395 3,077 4,066 General corporate assets - 60 478 ------ ------ ------ $11,018 $14,693 $13,615 ====== ====== ====== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 Financial information by industry segment is as follows (Continued): 1993 1992 1991 ---- ---- ---- (In thousands) Depreciation: Conditioning products $ 341 $ 627 $ 706 Conditioning services 597 762 1,231 Power sources 271 336 401 ------ ------ ------ $ 1,209 $ 1,725 $ 2,338 ====== ====== ====== Capital expenditures: Conditioning products $ 248 $ 422 $ 301 Conditioning services 191 933 342 Power sources 53 81 46 ------ ------ ------ $ 492 $ 1,436 $ 689 ====== ====== ====== Financial information by geographical area is as follows: 1993 1992 1991 ---- ---- ---- (In thousands) Revenues from unaffiliated customers: United States $19,469 $23,018 $20,136 Asia and Pacific 4,755 6,459 6,958 Central America 2,798 1,895 20 Western Europe - 41 2,498 Intergeographic revenues: United States 120 956 678 Asia and Pacific 408 1,453 1,816 Central America 911 935 834 Western Europe - - 6 Eliminations (1,439) (3,344) (3,334) ------ ------ ------ $27,022 $31,413 $29,612 ====== ====== ====== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 Financial information by geographical area is as follows (Continued): 1993 1992 1991 ---- ---- ---- (In thousands) Operating income (loss): United States $ 2,798 $ (200) $(2,660) Asia and Pacific 197 (812) 341 Central America 95 105 (479) Western Europe - 2 91 Provision for restructuring of operations: United States (318) - - Asia and Pacific 30 (1,325) - Western Europe - (67) (1,000) General corporate expenses (337) (269) (298) ------ ------ ------ $ 2,465 $(2,566) $(4,005) ====== ====== ====== Identifiable assets: United States $ 7,349 $ 8,948 $ 8,681 Asia and Pacific 2,100 4,497 3,255 Central America 1,569 1,131 778 Western Europe - 117 901 ------ ------ ------ $11,018 $14,693 $13,615 ====== ====== ====== The Company provides products and services to companies in the electronics and semiconductor industries, many of which are industry leaders. There are a limited number of companies which purchase conditioning products and services sold by the Company. The Company's four largest customers accounted for approximately 73%, 67% and 47% of consolidated revenues in 1993, 1992 and 1991, respectively. Accounts receivable are generally due within 30 days and collateral is not required except that export sales from the United States generally require letters of credit. Historically, the Company's bad debts have been very low, an indication of the credit worthiness of the customers to which the Company sells. Intersegment sales, which are not material, and intergeographic sales of manufactured products are priced at cost plus a reasonable profit. The Company had export revenues from its United States operation to the following geographical areas: 1993 1992 1991 ---- ---- ---- (In thousands) Asia and Pacific $2,165 $2,605 $2,517 Europe 3,140 4,331 583 North America and other 457 726 934 ----- ----- ----- $5,762 $7,662 $4,034 ===== ===== ===== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 Revenues from major customers, as a percent of total revenues and industry segments, are as follows: Total Conditioning Conditioning Power Revenues Products Services Sources -------- ------------ ------------ ------- ---- Customer A 24% 46% -% -% Customer B 23 44 - - Customer C 14 - 52 - Customer D 12 - 45 - ---- Customer A 13 24 - 1 Customer B 31 57 - - Customer C 11 - 46 - Customer D 12 - 49 - ---- Customer A 18 39 - 1 Customer B 5 11 - - Customer C 9 4 32 - Customer D 15 - 62 - 3. SHORT-TERM BORROWINGS AND LONG-TERM DEBT The Company maintains a working capital financing agreement with NationsBank of Texas, N.A. Under the agreement, the Company may request loan advances, evidenced by demand notes, up to $2,500,000. Credit availability is limited to 80% of eligible accounts receivable of the U.S. Company. Interest is payable monthly at the bank's base rate plus 2 1/2% (8 1/2% at December 31, 1993). There were no balances outstanding at December 31, 1993. The loan is collaterized by the U.S. Company's accounts receivable, inventories, fixed assets and certain other assets. The Company had credit availability of $1,206,000 at December 31, 1993. The agreement limits the Company's annual capital expenditures. The financing agreement was amended in July 1993. The amended agreement provides that if the tangible net worth, as defined, of the U.S. Company is less than $3,000,000, the U.S. Company may not pay dividends or make certain advances or loans without the written approval of the bank and becomes subject to certain other defined restrictions. The financial requirements of the financing agreement were met at December 31, 1993. The Company's Singapore subsidiary maintains an agreement with a Singapore bank to provide an overdraft facility to the Company at the bank's prime rate plus 1% (6% at December 31, 1993). The line of credit was reduced, in August 1993, from 1,500,000 Singapore dollars (U.S. $938,000) RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 to 500,000 Singapore dollars (U.S. $313,000). There were no balances outstanding at December 31, 1993, and amounts utilized under credit commitments totalled $125,000, resulting in credit availability of $188,000 at December 31, 1993. The loan is collateralized by all assets of the subsidiary and requires maintenance of a minimum net worth of the Singapore subsidiary. Payment of dividends requires written consent from the bank, and continuation of the credit facility is at the discretion of the bank. The Company's Japanese subsidiary entered into an agreement with a related party of the subsidiary, in December 1990, to provide a credit facility to the subsidiary. The related party of the subsidiary obtained a line of credit from a Japanese bank and made the amount available to the Company. The interest rate is the rate paid on the underlying loan plus 20%, which totalled 6% at December 31, 1993. In April 1993, the loan was converted to a term loan payable in monthly installments of $9,900, plus interest paid quarterly. The Company has made certain advance payments, and the loan is currently scheduled to be paid in full in June 1994. The subsidiary may not borrow additional amounts as of December 31, 1993. At December 31, 1993, the total loan balance was $58,000, and amounts due under this agreement have been classified as current maturities on long-term debt. Interest paid on debt during 1993, 1992 and 1991 was $82,000, $134,000 and $126,000, respectively. Interest expense is presented net as follows: 1993 1992 1991 ---- ---- ---- (In thousands) Interest expense $ 58 $ 147 $ 131 Interest (income) (15) (22) (48) ---- ---- ---- Interest expense, net $ 43 $ 125 $ 83 ==== ==== ==== 4. EMPLOYEE STOCK PLAN The Company sponsors an Employee Stock Savings Plan and Trust (the "Plan"). United States employees of the Company who have completed at least one year of service become participants in the Plan. The Plan allows an employee to contribute up to 15% of defined compensation to the Plan and to elect to have contributions not be subject to Federal income taxes under Section 401(k) of the Internal Revenue Code. The Company contributes a matching amount to the Plan equal to 50% of the employee's contribution, to a maximum of 2%, for employees who contribute 2% or more. The Company also contributes, as a voluntary contribution, an amount equal to 1% of the defined compensation of all participants. The Company's contribution for matching and voluntary contributions amounted to $105,000 in 1993, $121,000 in 1992 and $116,000 in 1991. Employee contributions may be invested in Company stock or other investment options offered by the Plan. The Company's contributions vest with the employee over seven years and are invested solely in Company stock. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The Company, during 1992, registered and reserved 500,000 shares of common stock for sale to the Plan. The Plan purchased, in the open market, 64,115 and 78,288 shares during 1993 and 1992, for an aggregate purchase price of $150,000 and $143,000, respectively. At December 31, 1993, 357,597 reserved shares remain unissued under the registration. The Company had previously registered and reserved 100,000 shares of common stock for sale to the Plan. At December 31, 1993 and 1992, all 100,000 of the shares had been sold to the Plan. The purchase price per share was the closing price on the day prior to purchase by the Plan. During 1991, the Plan purchased 20,000 shares of stock from the Company for an aggregate purchase price of $15,000. The Plan purchased, in the open market, 97,000 shares during 1991 for an aggregate purchase price of $146,000. The Plan did not purchase any stock from the Company during 1993 or 1992. 5. INCOME TAXES Effective January 1, 1993, the Company changed its method of accounting for income taxes and adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" which requires an asset and liability approach to financial accounting and reporting for income taxes. The difference between the financial statement and tax basis of assets and liabilities is determined annually. Deferred income tax assets and liabilities are computed for those differences that have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected to affect taxable income. Valuation allowances are established, if necessary, to reduce the deferred tax asset to the amount that will more likely than not be realized. Income tax expense is the current tax payable or refundable for the period plus or minus the net change in the deferred tax assets and liabilities. The cumulative effect of adopting SFAS 109 on the Company's financial position and results of operations was not material. As permitted under the new rules, prior period financial statements have not been restated except that the tax benefit from utilization of a net operating loss carryforward in 1992 has been reclassified to the provision for income taxes. This reclassification results in income tax for 1992 being presented in a manner consistent with the presentation required under SFAS 109. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The provision (benefit) for income taxes is based on income (loss) before income taxes as follows: Geographic area 1993 1992 1991 --------------- ---- ---- ---- (In thousands) United States $ 2,187 $( 442) $(2,502) Foreign 145 (2,192) (1,664) Eliminations and corporate items 90 (57) 78 ------ ------ ------ $ 2,422 $(2,691) $(4,088) ====== ====== ====== The components of the provision (benefit) for income taxes are as follows: Current Deferred Total ------- -------- ----- (In thousands) ---- Federal $ - $ - $ - Foreign 17 31 48 State 5 - 5 ---- ---- ---- $ 22 $ 31 $ 53 1992 ==== ==== ==== ---- Federal - Provision $ 344 $ - $ 344 Federal Tax Benefit from utilization of net operating loss carryforward (316) - (316) Foreign (28) (51) (79) State 5 - 5 ---- ---- ---- $ 5 $ (51) $ (46) 1991 ==== ==== ==== ---- Federal $ (87) $ 45 $ (42) Foreign 240 (103) 137 State 6 - 6 ---- ---- ---- $ 159 $ (58) $ 101 ==== ==== ==== RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The differences between the effective rate reflected in the provision (benefit) for income taxes on income (loss) before income taxes and the amounts determined by applying the statutory U.S. tax rate of 34% are analyzed below: 1993 1992 1991 ---- ---- ---- (In thousands) Provision (benefit) at statutory rate $ 823 $(915) $(1,390) Tax benefit of net operating loss carryforward (245) (316) - Tax effects of: Foreign expenses for which a tax benefit (is available) is not available (495) 778 715 Foreign income taxed at rates less than U.S. rate (11) (19) (10) U.S. Federal tax on dividend from foreign subsidiary - 486 - Alternative minimum tax - 29 7 Benefits not recorded due to net loss carryforward position - - 759 Other (19) (89) 20 ---- ---- ------ $ 53 $ (46) $ 101 ==== ==== ====== The components of the provision (benefit) for deferred income taxes for the years ended December 31, 1992 and 1991 are as follows: 1992 1991 ---- ---- (In thousands) Depreciation $ (8) $(215) Benefits not recorded due to net loss carryforward position 170 101 Distributions of former DISC (29) (29) (Benefit) associated with restructuring charge (98) - Inventory and other reserves (79) 45 Timing difference in recognition of intercompany transfers (29) 24 Other 22 16 ---- ---- $ (51) $ (58) ==== ==== The Company's cash requirements made it necessary for the Singapore subsidiary to remit a cash dividend to the Company during the second quarter of 1992. U.S. income taxes of $486,000 were provided on the remittance. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 The significant components of the Company's net deferred tax liabilities and assets are as follows: 1993 1992 ---- ---- (In thousands) Deferred tax liabilities: Depreciation $ 103 $ 96 Domestic international sales corp. dividend 21 42 Other - 15 ----- ------ Total deferred tax liabilities 124 153 ----- ------ Deferred tax assets: Reserves not currently deductible (416) (559) Foreign tax credits (490) (531) Net operating loss carryforwards (255) (370) Business tax credits (253) (253) Provision for restructuring - (98) Other (21) (18) ----- ------ Total deferred tax assets (1,435) (1,829) Valuation allowance 1,435 1,769 ----- ------ Net deferred tax assets - (60) ----- ------ Net deferred tax liability $ 124 $ 93 ===== ====== SFAS 109 requires that the tax benefit of net operating losses, temporary differences and credit carryforwards be recorded as an asset to the extent that management assesses that realization is more likely than not. Realization of the future tax benefits is dependent on the Company's ability to generate sufficient taxable income within the carryforward period. Because of the Company's history of operating losses, management believes that recognition of the deferred tax assets arising from the above- mentioned future tax benefits is currently not appropriate and, accordingly, has provided a valuation allowance. The Company completed a restructuring of its foreign operations in 1993. As part of the restructuring the Company changed its policy and began providing United States taxes on unremitted foreign earnings. Earnings on which United States taxes have been provided total $1,700,000 at December 31, 1993. Net income for 1992 included income of a subsidiary operating in Costa Rica under an export processing tax exemption. The subsidiary is exempt from Costa Rica income tax through 1998 and is 50% exempted from 1999 through 2002. Except for 1992, the subsidiary has operated at a loss. A 1992 tax benefit of $19,000 related to income of the subsidiary. Net cash payments (refunds) for income taxes during 1993, 1992 and 1991 were $54,000, $100,000 and $(606,000), respectively. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 At December 31, 1993, the Company had a domestic net operating loss carryforward for financial reporting purposes of approximately $2,170,000. Such carryforward for income tax purposes is $750,000 and will expire in 2007 and 2008. The net operating loss carryforward for alternative minimum tax purposes is $640,000. In addition, the Company has alternative minimum tax credit carryforwards of $73,000, which can be carried forward indefinitely, and research and development and foreign tax credit carryforwards of $743,000, expiring in various years from 1994 through 2007. 6. PROVISION FOR RESTRUCTURING The Company recorded in 1993 a provision for restructuring totaling $288,000. The provision is composed of $319,000 related to retirement and severance pay for U.S. employees who were terminated in March 1993 and a $31,000 reduction of the 1992 restructuring provision related to downsizing production capacity for power sources in Singapore. The Company recorded restructuring charges of $1,392,000 and $1,000,000 in 1992 and 1991, respectively. The 1991 charge related to costs associated with the closure of the Company's power sources facility located in Ireland. The Company completed the shut-down in 1992. The provision for shut-down was reduced by $149,000 in 1992. The 1992 amount represents a $1,000,000 provision for curtailment of operations of the Company's Japanese subsidiary, and a charge of $541,000, reduced by a $149,000 credit applicable to Irish closure, related to downsizing of the Company's UK marketing operation, downsizing production capacity for power sources in Singapore and shifting production to Costa Rica. The charge is related principally to the remaining lease obligations and associated costs at the two facilities, severance liabilities and write off of fixed assets. The provision for curtailment of operations of the Japanese subsidiary relates to estimated losses on disposal of certain assets, severance pay, estimated expenses to be incurred in curtailing operations and settling lease obligations related to the subsidiary's facility. 7. COMMITMENTS The Company leases manufacturing and office facilities under noncancelable operating lease agreements, expiring through 1998. Rental expense for 1993, 1992 and 1991 was $1,234,000, $1,627,000 and $1,636,000, respectively. Future minimum rental payments under leases in effect at December 31, 1993 are: 1994 - $1,166,000; 1995 - $654,000; 1996 - $420,000; 1997 - $297,000; 1998 - $18,000; subsequent to 1998 - None. The Company entered into an agreement in August 1993 to sub-lease manufacturing and office space in its U.S. facility. Rental income for 1993 was $41,000. Future income under the sub-lease will be: 1994 - $108,000; and 1995 - $38,000. RELIABILITY INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) December 31, 1993 8. ACCRUED LIABILITIES Accrued liabilities consist of the following: 1993 1992 ---- ---- (In thousands) Payroll $ 950 $1,091 Advanced payments 341 845 Warranty 453 291 Other 272 724 ----- ----- $2,016 $2,951 ===== ===== The advanced payments balance at December 31, 1993 relates principally to payments for conditioning products which are included in the Company's backlog at December 31, 1993. Advanced payments are refundable if the Company does not meet the terms of the orders. Revenues related to advanced payments are recognized when the products are shipped. 9. RELATED PARTY TRANSACTIONS The husband of an employee of the Company has an ownership interest in a company that provides computer software development and technical assistance for certain products sold by the Company. The net expense accrued related to these transactions, including royalties, amounted to $454,000, $964,000 and $417,000 during 1993, 1992 and 1991, respectively. The amounts payable to such Company were $1,000 and $117,000 at December 31, 1993 and 1992, respectively, and the accounts are settled in the ordinary course of business. RELIABILITY INCORPORATED SUPPLEMENTARY FINANCIAL INFORMATION QUARTERLY RESULTS OF OPERATIONS (Unaudited) (In thousands, except per share data) First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- ---- Net sales $ 6,752 $ 6,540 $ 7,239 $ 6,491 Gross profit 2,585 2,672 3,417 2,943 Net income (loss) (545)(1) 848 1,198 868(2) Net income (loss) per share (.13) .20 .28 .21 1992(3) ---- Net sales $ 6,520 $10,351 $ 8,453 $ 6,089 Gross profit 2,764 4,856 3,616 2,042 Net income (loss) (906)(4) 777 160 (2,676)(5) Net income (loss) per share (.21) .18 .04 (.63) - ---- (1) The net loss for the first quarter of 1993 includes a $319,000 provision for restructuring of U.S. operations. (2) The net income for the fourth quarter of 1993 is increased by a $31,000 reduction in cost associated with restructuring of operations in Asia. (3) The net income (loss) and net income (loss) per share for the second, third and fourth quarters of 1992 originally presented the tax benefit of a net operating loss carryforward as an extraordinary item. The tax benefit of the net operating loss carryforward has been netted against the income tax provision. See Note 5 to Consolidated Financial Statements. (4) The net loss for the first quarter of 1992 is reduced by a $120,000 decrease in a provision for restructuring of operations that was recorded in 1991. (5) The net loss for the fourth quarter of 1992 includes a $1,529,000 provision for restructuring of operations in Europe and Asia. S-1 RELIABILITY INCORPORATED SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands) Building Machinery and and Land Improvements Equipment Total ---- ------------ --------- ----- ---- Balance at beginning of year $ - $2,588 $12,884 $15,472 Additions - 43 449 492 Retirements - (88) (1,339) (1,427) --- ----- ------ ------ Balance at end of year $ - $2,543 $11,994 $14,537 === ===== ====== ====== ---- Balance at beginning of year $ - $2,613 $12,230 $14,843 Additions - 52 1,384 1,436 Retirements - (77) (730) (807) --- ----- ------ ------ Balance at end of year $ - $2,588 $12,884 $15,472 === ===== ====== ====== ---- Balance at beginning of year $ 5 $2,977 $12,661 $15,643 Additions - 88 601 689 Retirements (5) (452) (1,032) (1,489) --- ----- ------ ------ Balance at end of year $ - $2,613 $12,230 $14,843 === ===== ====== ====== S-2 RELIABILITY INCORPORATED SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands) Building Machinery and and Improvements Equipment Total ------------ --------- ----- ---- Balance at beginning of year $1,768 $10,392 $12,160 Additions 267 942 1,209 Retirements (54) (1,035) (1,089) ----- ------ ------ Balance at end of year $1,981 $10,299 $12,280 ===== ====== ====== ---- Balance at beginning of year $1,557 $ 9,528 $11,085 Additions 284 1,441 1,725 Retirements (73) (577) (650) ----- ------ ------ Balance at end of year $1,768 $10,392 $12,160 ===== ====== ====== ---- Balance at beginning of year $1,458 $ 8,375 $ 9,833 Additions 291 2,047 2,338 Retirements (192) (894) (1,086) ----- ------ ------ Balance at end of year $1,557 $ 9,528 $11,085 ===== ====== ====== S-3 RELIABILITY INCORPORATED SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Years Ended December 31, 1993, 1992 and 1991 (In thousands) 1993 1992 1991 ---- ---- ---- Inventory reserves at beginning of year $1,092 $ 753 $1,034 Additions charged to costs and expenses 262 636 347 Amounts charged to reserve (751) (297) (628) ----- ----- ----- Inventory reserves at end of year $ 603 $1,092 $ 753 ===== ===== ===== S-4 RELIABILITY INCORPORATED SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In thousands) 1993 1992 1991 ---- ---- ---- Maintenance and repairs $413 $523 $517 Taxes other than payroll and income taxes $311 $431 $506 Royalties $291 $300 $ - S-6 RELIABILITY INCORPORATED Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III In accordance with paragraph (3) of General Instruction G to Form 10-K, Part III of this Report is omitted because the Company will file with the Securities and Exchange Commission not later than 120 days after the end of 1993 a definitive proxy statement pursuant to Regulation 14A involving the election of directors. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following financial statements are filed as part of this report: 1. Consolidated Financial Statements and Supplementary Data. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). 2. Financial Statement Schedules. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). (b) The following exhibits are filed as part of this report: 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2- 90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10- Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of subsidiaries. 24. Consent of Independent Public Accountants dated March 18, 1994. (c) No reports on Form 8-K were required to be filed by the Company during the last quarter of the fiscal year covered by this report. RELIABILITY INCORPORATED SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. RELIABILITY INCORPORATED (Registrant) DATE: March 21, 1994 BY/s/Max T. Langley, Senior Vice 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 Company and in the capacities and on the dates indicated. BY/s/Larry Edwards, President and DATE: March 21, 1994 Chief Executive Officer BY/s/Max T. Langley, Senior Vice President, DATE: March 21, 1994 Chief Financial Officer, 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 Company and in the capacities and on the dates indicated. BY/s/W. L. Hampton, Director DATE: March 21, 1994 BY/s/Everett Hanlon, Director DATE: March 21, 1994 BY/s/John R. Howard, Director DATE: March 21, 1994 BY/s/Thomas L. Langford, Director DATE: March 21, 1994 BY/s/A. C. Lederer, Jr., Director DATE: March 21, 1994 RELIABILITY INCORPORATED INDEX TO EXHIBITS Exhibit Page Number Description of Exhibits Number - ------- ----------------------- ------ 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2-90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of Subsidiaries. Page 24 24. Consent of Independent Public Accountants Page 25 dated March 18, 1994. RELIABILITY INCORPORATED Exhibit 22 LIST OF SUBSIDIARIES Subsidiary Jurisdiction of Incorporation ---------- ----------------------------- Reliability Singapore Pte Ltd. Singapore Reliability Japan Incorporated (1) Japan RICR de Costa Rica, S.A. Costa Rica Each subsidiary does business under its respective corporate name. (1) Inactive as of December 31, 1993 RELIABILITY INCORPORATED Exhibit 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-47803) pertaining to the Reliability Incorporated Employee Stock Savings Plan and Trust and in the related Prospectus of our report dated February 11, 1994, with respect to the consolidated financial statements and schedules of Reliability Incorporated included in this Annual Report (Form 10-K) for the year ended December 31, 1993. BY/s/ERNST & YOUNG Houston, Texas March 18, 1994 Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following financial statements are filed as part of this report: 1. Consolidated Financial Statements and Supplementary Data. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). 2. Financial Statement Schedules. Listed in the Index to Financial Statements provided in response to Item 8 hereof (see p. for Index). (b) The following exhibits are filed as part of this report: 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2- 90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10- Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of subsidiaries. 24. Consent of Independent Public Accountants dated March 18, 1994. (c) No reports on Form 8-K were required to be filed by the Company during the last quarter of the fiscal year covered by this report. RELIABILITY INCORPORATED SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. RELIABILITY INCORPORATED (Registrant) DATE: March 21, 1994 BY/s/Max T. Langley, Senior Vice 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 Company and in the capacities and on the dates indicated. BY/s/Larry Edwards, President and DATE: March 21, 1994 Chief Executive Officer BY/s/Max T. Langley, Senior Vice President, DATE: March 21, 1994 Chief Financial Officer, 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 Company and in the capacities and on the dates indicated. BY/s/W. L. Hampton, Director DATE: March 21, 1994 BY/s/Everett Hanlon, Director DATE: March 21, 1994 BY/s/John R. Howard, Director DATE: March 21, 1994 BY/s/Thomas L. Langford, Director DATE: March 21, 1994 BY/s/A. C. Lederer, Jr., Director DATE: March 21, 1994 RELIABILITY INCORPORATED INDEX TO EXHIBITS Exhibit Page Number Description of Exhibits Number - ------- ----------------------- ------ 3.1 Restated Articles of Incorporation (with amendment). Reference is made to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 2-90034. 3.2 Restated and Amended Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990. 3.3 Amendment to Bylaws. Reference is made to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 4. Capital and Surplus Retention Agreement. Reference is made to Exhibit 4 to the Company's report on Form 10-Q for the quarter ended September 30, 1993. 22. List of Subsidiaries. Page 24 24. Consent of Independent Public Accountants Page 25 dated March 18, 1994. RELIABILITY INCORPORATED Exhibit 22 LIST OF SUBSIDIARIES Subsidiary Jurisdiction of Incorporation ---------- ----------------------------- Reliability Singapore Pte Ltd. Singapore Reliability Japan Incorporated (1) Japan RICR de Costa Rica, S.A. Costa Rica Each subsidiary does business under its respective corporate name. (1) Inactive as of December 31, 1993 RELIABILITY INCORPORATED Exhibit 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-47803) pertaining to the Reliability Incorporated Employee Stock Savings Plan and Trust and in the related Prospectus of our report dated February 11, 1994, with respect to the consolidated financial statements and schedules of Reliability Incorporated included in this Annual Report (Form 10-K) for the year ended December 31, 1993. BY/s/ERNST & YOUNG Houston, Texas March 18, 1994

54056_1993.txt

54056_1993

1993

54056

ITEM 1. BUSINESS The Registrant is a diversified communications and media company. Its 1993 revenues, broken down by business segments, are as follows: publishing - 44.1%; commercial printing - 40.4%; broadcast - 9.8% and telecommunications - 5.7%. In addition to the information provided below, see Item 6 "Selected Financial Data," Item 7, "Management Discussion and Analysis" and Item 8, "Consolidated Financial Statements and Supplementary Data." Publishing Journal/Sentinel Inc., a wholly-owned subsidiary of the Registrant publishes the two major daily newspapers in the Milwaukee, Wisconsin, market. It has published the evening Milwaukee Journal (The Journal) since 1882, the Sunday edition of The Journal since 1911, and the morning Milwaukee Sentinel (the Sentinel) since it was acquired in 1962. Average paid circulation for the twelve months ended March 31, 1993, for the last five years, as audited by the Audit Bureau of Circulation, was: 1993 1992 1991 1990 1989 Journal 238,351 240,566 260,480 275,957 272,454 Sentinel 171,271 166,085 172,772 176,097 178,736 Sunday Journal 490,077 490,361 497,777 503,994 508,188 Advertising volume in column inches and units for the Company's Milwaukee newspapers for the last five calendar years was: (in thousands) 1993 1992 1991 1990 1989 Column Inches Full Run 2,657.6 2,619.0 2,526.8 2,866.6 2,951.0 Part Run 260.9 181.3 195.5 205.3 137.5 Units Preprint 1.9 1.6 1.5 1.5 1.5 There are 108 other newspapers and shoppers published in the four-county Milwaukee market. Most of these are weekly publications, while a few are biweekly, fortnightly or monthly. Of these 108 publications, 39 are paid subscription and 69 are delivered without charge or are available free at various public locations. These publications cover a wide variety of interests, including community, business, labor, religious, ethnic, foreign language or other special interest newspapers. One other daily newspaper, The Freeman, is published in Waukesha and it is circulated in portions of Waukesha County. In addition, editions of USA Today, Chicago Tribune and New York Times are sold in the Milwaukee market. Journal/Sentinel Inc.'s newspapers also compete for advertising revenue or support with three (3) network-affiliated commercial television stations, six (6) independent television stations, two (2) of which are low power television stations, two public television stations and 35 AM and FM radio stations located in the four-county market, several cable television companies and some direct mail services. One television station and two radio stations in the Milwaukee market are owned by a subsidiary of the Registrant. Journal/Sentinel Inc.'s newspapers have separate news reporting and editorial staffs and separate news offices in Madison, West Bend, Port Washington and Waukesha, Wisconsin. The Milwaukee Journal also has a news office in Washington, D.C. The Milwaukee Sentinel also has a news office in Stevens Point, Wisconsin. Both newspapers subscribe to the Associated Press and Washington Post-Los Angeles Times news services. In addition, The Milwaukee Journal subscribes to the New York Times and Scripps Howard News Services; the Milwaukee Sentinel subscribes to the Knight-Ridder News Service. During 1993, newsprint consumption at the Milwaukee newspapers was higher than the prior year. Newsprint is purchased from four Canadian and two American suppliers and supplies for 1994 are considered sufficient. Registrant also publishes, through other subsidiaries, eight (8) weekly newspapers in southwestern Connecticut, seven (7) weekly newspapers and one (1) monthly controlled-circulation business publication in Wisconsin, three (3) weekly newspapers and one (1) daily newspaper in Florida, forty- four (44) shopper publications, with twenty-one (21) in Wisconsin, fifteen (15) in Ohio, two (2) in Florida, two (2) in Pennsylvania, two (2) in Vermont, one (1) in Georgia and one (1) in New York; three (3) paid auto publications, two (2) in Louisiana and one (1) in Wisconsin; three (3) free auto publications in Ohio; five (5) monthly real estate publications and three (3) senior citizens' publications in Ohio published six (6) times per year; and one (1) paid monthly memorabilia collector publication in Wisconsin. Commercial Printing Perry Printing Corporation, Waterloo, Wisconsin, a wholly-owned subsidiary, utilizes a wide array of printing technologies. These include heat-set web offset, sheet-fed offset, rotogravure and flexographic processes that are used to print high-quality, multi-color national consumer and trade magazines, catalogs, free-standing newspaper inserts, out-of-home media, point-of-purchase-point-of-sale materials and labels for consumer goods and industry manufacturers. Perry's principal raw materials are paper and ink. Presently, paper markets, for the grades consumed by the company, are operating at levels well below capacity and management does not believe that paper availability will be a concern for 1994. The inks utilized by the company are available in abundant supply from a number of suppliers. Perry Printing competes with the top 15 domestic and foreign-owned printing companies. Imperial Printing Company, a wholly-owned subsidiary acquired on October 6, 1992, specializes in the production of short to medium runs (1,000 to 100,000 copies) of medical and technical journals for various trade associations, documentation manuals for hardware and software manufacturers and in the duplication of floppy disks and computer tapes. Imperial is based in St. Joseph, Michigan and has additional operations in Fremont and Irvine, California. The 1993 purchase of a printing plant in northern France allowed Imperial to expand its European marketing effort. No supply restrictions in 1994 are anticipated for the raw materials Imperial utilizes. Broadcasting WTMJ, Inc., a wholly-owned subsidiary, operates three television stations and five radio stations in four states. All operate under licenses from the Federal Communications Commission. In Milwaukee, WTMJ, Inc. has been the pioneer and leading broadcaster since it started AM operations in 1927, FM in 1941 (discontinued 1950- 1960) and television in 1947. News reporting and editorial operations at WTMJ, Inc., are independent of the Registrant's newspaper operations. Registrant's three (3) Milwaukee broadcast operations consistently rank high in audience rating surveys. Competition for advertising revenue in the ten-county area of dominant influence ("ADI") includes eight (8) other commercial television stations, including two (2) low power television stations, thirty-three (33) other radio stations, several cable television companies, eight (8) daily newspapers (including two owned by Registrant), and numerous weekly newspapers. WTMJ, Inc. also operates KTNV-TV, Las Vegas, Nevada, an ABC affiliate; WSYM-TV, Lansing, Michigan, a Fox affiliate, two leading radio stations in Wausau, Wisconsin, WSAU-AM and WIFC-FM, and KQRC-FM, Kansas City/Leavenworth, Kansas. WTMJ-TV is affiliated with the National Broadcasting Company (NBC). WTMJ Radio is affiliated with the CBS and NBC Radio networks. KTNV-TV, WSAU-AM and WIFC-FM, WKTI-FM and KQRC-FM are affiliated with the American Broadcasting Company (ABC). Telecommunications MRC Telecommunications, Inc., a wholly-owned subsidiary, provides telecommunications transmission services as a licensed common carrier in Wisconsin, Minnesota, Illinois and Michigan. Its services include terrestrial and satellite transmission of message/data, video and audio signals for long distance telephone companies, resellers, corporate users (through its NorLight, Inc., subsidiary), and television and radio networks, using fiber optics, microwave and satellite technologies. Employees The Registrant and its subsidiaries, as of December 31, 1993, had approximately 4,900 full-time and 2,500 part-time employees. Financial Information About Industry Segments Financial information about Registrant's industry segments is presented in Note 8 to the Consolidated Financial Statements appearing below is this report. ITEM 2. ITEM 2. PROPERTIES Principal properties operated by the Registrant and its subsidiaries are summarized as follows: Subsidiary Location How Held Square Footage Journal/Sentinel Inc. (Publishing) Offices/Plant Milwaukee, WI Owned 464,000 Garage Milwaukee, WI Owned 67,500 Distribution Center Milwaukee, WI Leased 46,000 ADD, Inc. (Publishing) Office/Plant WI, OH, GA, FL Owned or Leased 231,000 VT, NY, PA, LA Buyers' Guide, Inc. (Publishing) Office CT Leased 5,600 Striplin Publishing, Inc. (Publishing) Office Ohio Leased 4,300 WTMJ, Inc. (Broadcasting) Office and Studios Milwaukee, WI Owned 101,500 KTNV-TV Studios Las Vegas, NV Owned 20,300 WSYM-TV Studios Lansing, MI Leased 10,300 WSAU-AM/WIFC-FM Studios Wausau, WI Owned 5,600 KQRC-FM Studios Kansas City/ Leavenworth, KS Leased 3,700 Perry Printing Corp. (Commercial Printing) Office/Plant and Warehouse Waterloo, WI Owned 445,700 Perry/Baraboo Office/Plant Baraboo, WI Owned 313,800 Perry/Milwaukee Office/Plant Brown Deer, WI Owned 127,300 Perry/Norway Office/Plant Norway, MI Owned 101,700 Perry/Watertown Office/Plant Watertown, WI Owned 201,700 Label Products & Design Inc. (Commercial Printing) Office and Plant Green Bay, WI Owned 40,000 Trumbull Printing, Inc. (Commercial Printing) Office/Plant Trumbull, CT Owned 51,600 Imperial Printing Company (Commercial Printing) Office, Plant and Warehouse St. Joseph, MI Leased 321,000 Office/Plant Fremont, CA Leased 30,000 Office/Plant Irvine, CA Leased 49,000 MRC Telecommunications, Inc. (Fiber optics & Rubicon, WI Owned 3,800 Microwave transmission Skokie, IL Owned 6,100 services) Afton, WI Owned 3,800 Arden Hills, MN Owned 1,700 Minneapolis, MN Leased 2,100 Brookfield, WI Leased 15,600 NorLight, Inc. (Fiber optics & Microwave transmission services) Office Minneapolis, MN Leased 3,400 Nordoc Software Services (Commercial Printing) Office/Plant Roncq, France Leased 41,800 ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in various claims and lawsuits incidental to its business. In the opinion of legal counsel, claims and lawsuits in the aggregate will not have a material effect on the Company's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 4A. EXECUTIVE OFFICERS OF REGISTRANT The executive officers of Registrant, as of March 1994, all of whom hold office until the next annual meeting of the board of directors, which will be held immediately following the annual meeting of shareholders on June 7, 1994, are: Name Age Office Held Since Robert A. Kahlor 60 Chairman of the Board/CEO September 4, 1992 Steven J. Smith 43 President September 4, 1992 Thomas M. Karavakis 63 Senior Vice President June 2, 1987 Peter P. Jarzembinski 41 Senior Vice President/CFO December 1, 1992 Douglas G. Kiel 45 Senior Vice President June 2, 1992 Craig A. Hutchison 42 Senior Vice President June 5, 1990 Robert M. Dye 46 Vice President June 5, 1990 Gregory H. Forbes 44 Vice President June 8, 1993 James C. Currow 50 Vice President June 8, 1993 Paul M. Bonaiuto 43 Vice President June 8, 1993 Stephen O. Huhta 38 Vice President June 8, 1993 Ronald G. Kurtis 46 Vice President June 8, 1993 Paul E. Kritzer 51 Vice President June 5, 1990 & Secretary September 1, 1992 All of the executive officers of the Company except Messrs. Forbes, Currow and Bonaiuto have been employed by the Company in key management positions for more than five years. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Registrant's common stock can be purchased only by full-time employees with two (2) years of service. As of February 23, 1994, the Journal Employes' Stock Trust owned of record 12,960,000 of the issued common stock shares or 90% of the issued common stock of the Registrant at that date. The Trust issues units, each representing one share of the Registrant's stock, to eligible employees ("unitholders"). On February 23, 1994, 2,885 unitholders owned 11,763,541 units (representing 82% of Registrant's issued common stock) and thus were the beneficial owners of a like number of shares of the Registrant's stock held by the Trust. The balance of 1,196,459 units issued by the Trust were, on the above date, held by employee benefit trusts and by the Company as treasury stock. Prior to all meetings of shareholders of the Registrant, the Trustees are required to deliver to each active employee-unitholder a proxy, with the right of substitution, for the number of the Registrant's shares represented by his or her units. Unitholders may sell their units only to other employees designated by President of the Registrant. Whenever a unitholder ceases to be an employee, for any reason except retirement, he or she must offer his or her units for resale to active employees designated by the President of the Company. Employees who retire may retain a decreasing percentage of their units for 10 years after retirement. All units held by retirees are voted by the Trustees. Units may also be held by employee benefit trusts, and unitholders may transfer units to trusts for individuals and for charitable, educational or religious purposes. All units held by such trusts are likewise voted by the Trustees of the Stock Trust. As of February 23, 1994, retirees, an employee benefit trust, and other trusts held 4,547,036 units, representing 31.6% of the Registrant's issued common stock. All of the Trustees under the Journal Employes' Stock Trust Agreement are directors of the Registrant. They have no financial interest in the Registrant's stock owned by the Trust other than through the units they own individually. The Registrant's unit option price and dividend history for the past decade are presented in the following table: Employee Stock Ownership Plan Option Option Option Return on Price Price Price Cash Total January 1 Year Jan. 1 Dec. 31 Increase Dividend Yield Option Price 1984 14.73 16.72 1.99 1.00 2.99 20.3% 1985 17.65 18.54 .89 2.38(1) 3.27 18.5 1986 18.54 20.94 2.40 1.25 3.65 19.7 1987 20.94 23.71 2.77 1.38 4.15 19.8 1988 23.71 26.65 2.94 1.50 4.44 18.7 1989 26.65 29.66 3.01 1.70 4.71 17.7 1990 29.66 31.48 1.82 1.70 3.52 11.9 1991 31.48 32.60 1.12 1.80 2.92 9.3 1992 32.60 33.60 1.00 1.80 2.80 8.6 1993 33.60 34.64 1.04 1.80 2.84 8.5 (1) Includes special dividend on sale of Teltron ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected financial data of the Registrant is presented in the following table: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Operating revenue in 1993 was $560,606,000, an increase of 12.9% over 1992 sales of $496,362,000. Operating revenue in 1991 was $465,982,000. 1993 operating earnings increased by 8.9% from $65,464,000 in 1992 to $71,283,000 for 1993. 1991 operating earnings were $59,748,000. All segments of the company contributed to the increase 1993 operating results. These results were achieved despite only a modest upturn in economic conditions during 1993. Publications The publications segment includes daily and weekly newspapers, shoppers and specialty publications. 1993 revenue was $250,298,000, up 5.0% over 1992 and 7.5% greater than 1991. 1992 and 1991 revenue for this segment was $238,386,000 and $232,756,000, respectively. Operating earnings in 1993 were $41,491,000, an increase of 1.6% over the prior year. Operating earnings for 1992 were $40,828,000, an impressive 18.3% increase over 1991 operating earnings of $34,520,000. Journal/Sentinel Inc. is the largest company in the publications segment. 1993 revenue increased by 3.1% to $196,673,000 compared to $190,727,000 in 1992. However, 1993 operating earnings were down 4.8% from the prior year. The decline in operating earnings was due to increased operating costs, including those costs attributable to the development of an alternate circulation delivery system. Advertising revenue in 1993, 1992 and 1991 was $137,974,000, $132,764,000 and $130,596,000, respectively. In 1993, retail advertising revenue was approximately equal to the prior year while classified advertising increased by 8% over 1992. General advertising revenue declined 13%, but on a much smaller base. Preprint revenue increased 11% over 1992 primarily as a result of increased volume. From 1991 to 1992, retail and classified advertising revenue increased by 1.9% and 3.5%, respectively, while general advertising revenue declined 7.2%. 1993 circulation revenue was $55,860,000, up slightly from 1992. 1992 circulation revenue was $55,396,000, while in 1991 it was $55,179,000. ADD Inc. is the other operation in the publications segment. Its 1993 revenue was $53,625,000, a 12.5% increase over 1992 revenue of $47,659,000. 1991 revenue was $44,506,000. 1993 operating earnings showed significant growth over the prior year, increasing 24.5%. This resulted not only from the increase in revenue, but also from closely monitoring its operating expenses. 1993 revenue for the Wisconsin and Ohio operations increased 17% and 15%, respectively. During 1993, operations in both the East and South continued to experience improved operating results as their regional economies began to recover from the recession. Broadcast 1993 revenue was $54,850,000, an increase of 3.7% over 1992 revenue of $52,891,000. 1993 operating earnings increased slightly over the prior year. The 1993 revenue increase was significant, since 1992 included $4.0 million in revenue from both the summer Olympics and election year political advertising. In 1993, the company's television stations accounted for 69% of this segment's revenue, and 71% of its operating earnings. Operating results at the Las Vegas and Lansing television stations were ahead of 1992, while the Milwaukee station was below its 1992 results. 1993 operating earnings for the Milwaukee and Kansas City radio stations were ahead of 1992, while Wausau was below its 1992 operating results. Operating costs and expenses were tightly controlled for 1993, 1992 and 1991. Printing Perry Printing Corp.'s 1993 revenue was $157,673,000, a 3.0% increase over the prior year's $153,098,000. 1991 revenue was $157,974,000. Operating earnings for 1993 increased by 39.5% over the prior year. 1992 operating earnings declined by 55% from 1991. The 1993 increase in both sales and operating earnings is due to the Norway and Baraboo operations. Trumbull Printing Inc.'s 1993 revenue of $7,807,000 was up 5.7% over 1992 revenue of $7,385,000. However, operating earnings increased significantly over the prior year. 1993 was the first full year of operations for Imperial Printing Company (IPC). Revenues in 1993 were $53,096,000, while operating earnings were $5.2 million. During February 1993, IPC acquired Nordoc Software Services located in France. The French company showed very good growth during the year. Telecommunications The company's telecommunications segment's 1993 revenue increased by 3.7% to $32,411,000. This increase is a result of a substantial increase in the volume of circuits sold, since the competitive nature of the telecommunications industry has resulted in a drop in the average circuit mile price charged. In 1992, revenue of $31,265,000 more than doubled the prior year. In 1991, revenue was $15,398,000. With continued growth in the telecommunications industry, 1993 operating earnings increased by 5.2% over 1992. Other Income and Expenses Dividends and interest income have continued to decline from $2,550,000 in 1992, to $1,521,000 in 1993. In 1991, this amount was $6,636,000. The decrease over the last three years resulted from a combination of less dollars invested and at significantly lower interest rates. Company investments in short-term securities have decreased due to the use of funds for acquisitions and capital expenditures of property and equipment. Income Taxes Income taxes were 39.3% of pre-tax earnings in 1993, 38.6% in 1992, and 38.7% in 1991. The increase in 1993 over the 1992 tax rate reflects the increase in the federal statutory tax rate from 34% to 35%. Permanent tax differences exist for goodwill amortization and the increase in the cash surrender value of the company's life insurance investment pool. Net Earnings Net earnings for 1993 were $44,204,000, or $3.16 per share, versus net earnings of $41,631,000, or $2.97 per share. In 1991, net earnings for the year were $40,035,000, or $2.84 per share. Liquidity and Capital Resources Cash provided by operations is the company's major source of liquidity and totalled $64,453,000 in 1993, $83,650,000 in 1992 and $61,195,000 in 1991. The reduction in cash provided by operations in 1993 is attributable to a revenue increase which resulted in a substantial increase in accounts receivable. The reduction in cash provided by operations in 1991 resulted from the litigation payment made on a patent infringement lawsuit. Principal uses of cash during this period were for property and equipment expenditures and acquisitions. Capital expenditures for property and equipment were $36,327,000, $26,211,000 and $22,775,000 in 1993, 1992 and 1991, respectively. 1994 capital expenditures will approximate the 1993 expenditure range. The company has also remained active in acquiring other businesses. During 1993, the company made smaller acquisitions expanding its shopper and printing operations. As described in the notes to consolidated financial statements (included in Item 8), the company purchased the assets of Imperial Printing Company in 1992 and the assets of NorLight in 1991. Cash used for financing activities was: 1993-$28,466,000; 1992- $28,330,000; and 1991-$38,182,000. Dividends paid during 1993 were $25,156,000, or $1.80 per share. This compares to $25,244,000 ($1.80 per share) in 1992 and $25,358,000 ($1.80 per share) in 1991. Net working capital at the end of 1993 increased $15.2 million to $111,009,000. Committments for television programs not yet produced as of December 31, 1993, were $4,858,000. The company has traditionally not used debt as a source of funds. The company anticipates that amounts necessary for capital expenditures, dividends and other working capital requirements will continue to be available from internally generated funds. Effect of Inflation The company's results of operations and financial conditions have not been significantly affected by inflation. The company has reduced the effect of rising costs through improvements in productivity, cost containment programs and, where the competitive environment permits, increased selling prices. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements: Form 10-K Page Number: Report of Independent Auditors 12 Consolidated Balance Sheets at December 31, 1993, 1992 and 1991 13 For each of the three years in the period ended December 31, 1993: --Consolidated Statements of Earnings and Retained Earnings 14 --Consolidated Statements of Cash Flows 15 Notes to Consolidated Financial Statements 16-21 Report of Independent Auditors The Board of Directors and Stockholders Journal Communications Inc. We have audited the accompanying consolidated balance sheets of Journal Communications Inc. as of December 31, 1993, 1992, and 1991, and the related consolidated statements of earnings and retained earnings, and cash flows for each of the years then ended. Our audit also included the financial statement schedules listed in the Index in 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Journal Communications Inc. at December 31, 1993, 1992, and 1991, and its consolidated results of operations and its cash flows for each of 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. As discussed in Notes 2 and 3 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits other than pensions and income taxes effective January 1, 1993. ERNST & YOUNG Milwaukee, Wisconsin February 10, 1994 See accompanying notes See accompanying notes See accompanying notes JOURNAL COMMUNICATIONS INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993, 1992 and 1991 l. Principal accounting policies Basis of consolidation - The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Foreign currency translation - Assets and liabilities of French subsidiaries are translated into U.S. dollars at year-end exchange rates while income and expense items are translated at the average exchange rates for the year. Resulting translation adjustments are reflected in retained earnings. Earnings per share - Earnings per share is based on the weighted average shares outstanding during each period. Short-term investments - Short-term investments, which consist principally of government securities, commercial paper and bank certificates of deposit with maturities of one year or less, are stated at cost, which approximates market value. Inventories - Inventories are stated at the lower of cost (first in, first out method) or market. Depreciation - Depreciation of property and equipment is computed principally using the straight-line method. Other assets - Identifiable intangible assets resulting from acquisitions are amortized on the straight-line basis. Accumulated amortization relating to intangible assets at December 31, 1993, 1992 and 1991 was $11,393,585, $8,371,103 and $6,049,956, respectively. Other assets also include the costs of television program contracts, recorded under the gross method, which are deferred and amortized over the estimated number of runs of the related programs. Goodwill - Goodwill arising from acquisitions subsequent to November 1, 1970, is amortized on the straight-line basis over 40 years. Goodwill prior to November 1, 1970 is amortized when it is determined that such intangible assets have a limited useful life. At December 31, 1993, $3,095,000 of goodwill is not being amortized. Accumulated amortization at December 31, 1993, 1992 and 1991 was $8,723,367, $8,082,677 and $7,469,696, respectively. 2. Employee benefit plans Contributory and noncontributory pension and savings plans cover substantially all employees. The amount charged against earnings with respect to all of these plans was $5,712,000, $5,256,000 and $4,611,000 in 1993, 1992 and 1991, respectively. Net pension cost for the defined benefit plan includes the following components: (thousands of dollars) 1993 1992 1991 Service cost $ 2,233 $ 2,175 $ 2,040 Interest on projected benefit obligation 5,551 5,186 4,873 Less return on plan assets (4,768) (2,325) (10,064) Net amortization and deferral (683) (3,034) 4,980 ------- ------- ------- Net pension cost $ 2,333 $ 2,002 $ 1,829 ======= ======= ======= Actuarial assumptions used to project the benefit obligations and the net pension cost were: 1993 1992 1991 Discount rate 7.25% 8.00% 8.00% Rate of increase in compensation levels 4.75% 5.50% 5.50% Expected long-term rate of return on plan assets 9.50% 9.50% 9.50% The assets of the plan consist primarily of government and other bonds and listed stocks. The actuary estimated a pension liability at December 31, 1993, 1992 and 1991 of $8,107,000, $6,155,000 and $4,962,000, respectively. The funded status of the plan was as follows: Actuarial present value of benefit obligations: (thousands of dollars) December 31, 1993 1992 1991 Vested benefits $62,651 $54,076 $49,599 Nonvested benefits 3,449 2,885 2,388 ------- ------- ------- Accumulated benefit obligation 66,100 56,961 51,987 Effect of projected compensation levels 14,477 13,429 14,082 ------- ------- ------ Projected benefit obligation 80,577 70,390 66,069 Plan assets at fair value 60,473 59,619 60,147 ------- ------ ------ Projected benefit obligation in excess of plan assets $20,104 $10,771 $ 5,922 ======= ====== ======= On January 1, 1993, the Company 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 postretirement health and life insurance benefits be charged to expense during the years the employees render service. The Company has elected to amortize the unfunded obligation of $25,324,000 at January 1, 1993 over a period of 20 years. The incremental effect of this change in accounting method was to increase 1993 postretirement benefit expense by $2,014,000. Prior to 1993, the Company recognized postretirement benefit expense in the year that the benefits were paid. Postretirement benefits paid in 1992 and 1991 were $1,337,000 and $1,372,000, respectively. Postretirement benefit expense for 1993 includes the following components: (thousands of dollars) Service cost $ 454 Interest cost on accumulated postretirement benefit obligation 2,073 Amortization of transition obligation 1,266 ------ Postretirement benefit expense $3,793 ====== The funded status of the plans on an aggregate basis at December 31, 1993 was as follows: (thousands of dollars) Accumulated postretirement benefit obligation: Retirees $16,243 Fully eligible participants 1,919 Other active participants 9,469 ------ Total accumulated postretirement benefit obligation 27,631 Less: Unrecognized transition obligation 24,058 Unrecognized actuarial loss 1,559 ------ Accrued postretirement benefit cost liability $ 2,014 ====== For measurement purposes, benefit cost trend rates of 10% and 9% annually were assumed in 1993 for pre-age 65 and 65 and over groups, respectively. These rates gradually decrease to 5% through 2010 for the pre-age 65 group and through 2008 for the 65 and over group and remained level thereafter. The benefit cost trend rates have a significant effect on the amounts reported. Increasing the assumed benefit cost trend rates by 1% in each year would increase the accumulated postretirement benefit obligation at December 31, 1993 by 5.8% and the aggregate service and interest cost components of postretirement benefit expense for 1993 by 5.0%, respectively. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5%. 3. Income Taxes 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 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 statement and tax basis of assets and liabilities using enacted tax rates for the year in which the differences are expected to reverse. The impact of adopting SFAS 109 was not material to 1993 operations. The provision for income taxes consists of the following: (thousands of dollars) 1993 1992 1991 Current Federal $23,300 $21,400 $15,600 State 6,000 5,100 5,000 ------- ------- ------- 29,300 26,500 20,600 Deferred (700) (300) 4,700 ------- ------- ------- $28,600 $26,200 $25,300 ======= ======= ======= The components of the net deferred tax liability as of December 31, 1993 were as follows: Deferred tax assets: Accrued employee benefit $ 3,304,000 Inventories 348,000 Accrued compensation 3,350,000 Accounts receivable 891,000 Deferred revenue 172,000 State credit carryforward 461,000 Other 1,405,000 ----------- Total deferred tax assets $ 9,931,000 Deferred tax liabilities: Property, plant and equipment $20,408,000 Other 246,000 ----------- Total deferred tax liabilities $20,654,000 Net deferred tax liability included in balance sheet $10,723,000 =========== 4. Litigation In September 1991, the Company paid $18.7 million in partial settlement of a patent infringement lawsuit. The one remaining issue is a technical question upon which management and legal counsel believe the Company will prevail. The Company was required to renew a $16.8 million bond until the court rules. The bond is fully guaranteed by standby letters of credit which are partially collateralized by $8.5 million of short-term investments. 5. Long-term obligations 1993 1992 1991 Capital lease & other obligations, average interest 8% $1,579,020 $ 403,115 $ 590,910 Television program contracts, due through 1997 5,643,025 3,366,920 3,150,125 ---------- ---------- ---------- 7,222,045 3,770,035 3,741,035 Less current portion 3,543,434 1,438,193 1,782,915 ---------- ---------- ---------- $3,678,611 $2,331,842 $1,958,120 ========== ========== ========== In addition, Company has the rights to broadcast certain television programs during the years 1994-1997 under contracts aggregating $4,858,000. 6. Stockholders' equity The Company periodically purchases units of beneficial interest in The Journal Employes' Stock Trust (JESTA) for use in its Incentive Compensation and Suggest and Share Plans and for resale to its employees. Treasury stock activity is as follows: 7. Acquisitions On October 6, 1992, the Company acquired the business and substantially all of the assets of Imperial Printing Company. The cash purchase price was approximately $30.7 million, with additional contingent payments, not to exceed $6.8 million, payable over six years, beginning in 1994, if target profit levels are achieved. Contingent payments, if made, will be accounted for as an adjustment to the purchase price. On December 4, 1991, the Company acquired the business and substantially all of the assets of NorLight. The cost of the acquisition totalled approximately $43 million in cash and liabilities assumed. The acquisitions were accounted for using the purchase method. Accordingly, the operating results and cash flows of the acquired businesses are included in the Company's consolidated financial statements from the date of acquisition. Had Imperial Printing Company and NorLight been acquired as of January 1, 1991 and 1990, respectively, the effect of the acquisitions on the Company's consolidated results of operations would not have been material. 8. Segment analysis (thousands of dollars) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS OF THE REGISTRANT Directors Auer, Engelmann, Felix, Gigowski, Schwartz, Thompson and Weyer are elected representatives of the Unitholders Council and have been employed by the Company for more than five years. Mr. Bonaiuto, Mr. Currow and Mr. Forbes have less than five years of service with the Company. The other directors, except for Mr. Meissner, have been employed by the Company or its subsidiaries in key management positions for more than five years. Information regarding the executive officers of the Company is set forth in Part I, Item 4A above. Mr. Meissner is President and Chief Executive Officer of Morgan&Myers/The Barkin Group, a Milwaukee public relations firm. The following chart states the equity ownership of each Director in the Registrant: ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information in response to this item is incorporated herein by reference to the Company's proxy statement, which shall be filed with the Securities and Exchange Commission no later than three (3) weeks prior to the Company's Annual Meeting which shall be held Tuesday, June 7, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in response to this item is incorporated herein by reference to the Company's proxy statement, which shall be filed with the Securities and Exchange Commission no later than three (3) weeks prior to the Company's Annual Meeting which shall be held Tuesday, June 7, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in response to this item is incorporated herein by reference to the Company's proxy statement, which shall be filed with the Securities and Exchange Commission no later than three (3) weeks prior to the Company's Annual Meeting which shall be held Tuesday, June 7, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements and Financial Statement Schedules The following consolidated financial statements of the Registrant are included in Item 8: Form 10-K Page Number Consolidated Balance Sheets at December 31, 1993, 1992 and 1991 13 Consolidated Statements of Earnings and Retained Earnings for each of the three years in the period ended December 31, 1993 14 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 15 Notes to Consolidated Financial Statements 16-21 The following consolidated financial statements schedules of the Registrant are filed as a part of this report: Form 10-K Page Number Schedule I-Consolidated Short-Term Investments at December 31, 1993 25 Schedule V-Consolidated Property & Equipment for each of the three years in the period ended December 31, 1993 26 Schedule VI-Consolidated Accumulated Depreciation of Property & Equipment for each of the three years in the period ended December 31, 1993 27 Schedule X-Consolidated Supplementary Income Statement Information for each of the three years in the period ended December 31, 1993 28 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. 2. Exhibits The exhibits listed in the accompanying index are filed as part of this annual report. JOURNAL COMMUNICATIONS, INC. SCHEDULE I - CONSOLIDATED SHORT-TERM INVESTMENTS December 31, 1993 Amount Market at cost (1) Value U. S. Government securities $41,087,798 $41,385,219 Certificates of deposit 5,500,000 5,500,000 Commercial paper 3,500,000 3,500,000 Common stock 62,881 76,975 Preferred stock 15,337 48,300 ----------- ---------- $50,166,016 $50,510,494 =========== ========== (1) Amount at which each portfolio of equity security issues and each other security issue is carried in the consolidated balance sheet Depreciation is provided on the straight line basis over the estimated useful lives of the respective assets. Land improvements - 10 to 20 years; Buildings - 20 to 50 years; Equipment - 7 to 20 years JOURNAL COMMUNICATIONS, INC. SCHEDULE X - CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $8,649,250 $7,770,945 $5,786,945 Amortization of intangible assets: Film contracts $2,948,269 $1,839,634 $2,110,056 Consulting and Non-competition agreements 3,310,064 2,527,278 2,641,572 Goodwill 633,227 635,606 1,244,194 Other 1,469,717 1,830,247 1,972,440 ---------- --------- --------- TOTAL $8,361,277 $6,832,765 $7,968,262 ========== ========== ========== Advertising costs $4,571,539 $4,251,128 $5,334,383 ========== ========= ========== 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. JOURNAL COMMUNICATIONS, INC. By: ROBERT A. KAHLOR Robert A. Kahlor Chairman of the Board and CEO Principal Executive Officer By: PETER P. JARZEMBINSKI Peter P. Jarzembinski Senior Vice President and CFO Principal Financial 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 and on the dates indicated: JAMES M. AUER March 29, 1994 James M. Auer, Director Paul M. Bonaiuto, Director Nancy B. Carey, Director James C. Currow, Director ROBERT M. DYE March 29, 1994 Robert M. Dye, Director Corinne A. Engelman, Director CHRISTINE A. FARNSWORTH March 29, 1994 Christine A. Farnsworth, Director BARBARA L. FELIX March 29, 1994 Barbara L. Felix, Director Gregory H. Forbes, Director KAREN A. GIGOWSKI March 29, 1994 Karen A. Gigowski, Director Stephen O. Huhta, Director Craig A. Hutchison, Director PETER P. JARZEMBINSKI March 29, 1994 Peter P. Jarzembinski, Director ROBERT A. KAHLOR March 30, 1994 Robert A. Kahlor, Director Thomas M. Karavakis, Director Douglas G. Kiel, Director PAUL E. KRITZER March 29, 1994 Paul E. Kritzer, Director RONALD G. KURTIS March 30, 1994 Ronald G. Kurtis, Director David G. Meissner, Director CECIL G. SCHWARTZ March 29, 1994 Cecil G. Schwartz, Director STEVEN J. SMITH March 29, 1994 Steven J. Smith, Director Lloyd M. Thompson, Director DONALD J. WEYER March 29, 1994 Donald J. Weyer, Director JOURNAL COMMUNICATIONS, INC. INDEX TO EXHIBITS (Item 14(a)) Exhibits Form 10-K Page Number ( 3) Articles of Incorporation and Bylaws as previously filed, hereby incorporated by reference N/A (22) Subsidiaries of the Registrant filed herewith (23) Consent of Independent Auditors filed herewith N/A = Not Applicable

72909_1993.txt

72909_1993

1993

72909

Item 1. Business Northern States Power Company ("the Company"), incorporated in 1901 under the laws of Wisconsin as the La Crosse Gas and Electric Company, is an operating public utility company with executive offices at 100 North Barstow Street, Eau Claire, Wisconsin 54702-0008 (Phone: (715) 839-2621). The Company is a wholly- owned subsidiary of Northern States Power Company, a Minnesota corporation ("the Minnesota Company"). The Company is engaged in the production, transmission, distribution, and sale of electric energy to approximately 196,000 retail customers in an area of approximately 18,900 square miles in northwestern Wisconsin, to approximately 9,100 electric retail customers in an area of approximately 300 square miles in the western portion of the Upper Peninsula of Michigan, and to 10 wholesale customers in the same general area. The Company is also engaged in the distribution and sale of natural gas in the same service territory to approximately 60,000 customers in Wisconsin and 4,700 customer. In Wisconsin, some of the larger communities the Company provides Eau Claire, Chippewa Falls, La Crosse, Hudson, Menomonie and Ashland. In the Upper Peninsula of Michigan, the largest community to which the Company provides natural gas is Ironwood. In 1993 the Company derived 83 percent of its total operating revenues from electric utility operations and 17 percent from gas utility operations. As of December 31, 1993, the Company had 893 full-time employees. REGULATIONS AND RATES Regulation The Public Service Commission of Wisconsin ("PSCW") and Michigan Public Service Commission ("MPSC") regulate the rates and service of the Company with respect to retail sales within the State of Wisconsin and the State of Michigan, respectively, the issuance of new securities by the Company and various other aspects of the Company's operations. The PSCW also exercises jurisdiction over the construction of certain electric and gas facilities. The Company is also subject to the jurisdiction of the Federal Energy Regulatory Commission ("FERC") with respect to its sales to wholesale electric customers and certain other aspects of its operations, including the licensing and operation of hydro projects and the Company's Interchange Agreement (see Electric Operations- Interchange Agreement). Approximately 96.9 percent of the Company's 1993 electric retail revenues from sales and 93.6 percent of its retail gas revenues from sales were subject to PSCW jurisdiction with the remaining retail revenues subject to MPSC jurisdiction. In 1993, the Company's wholesale revenues from sales were approximately 5.5 percent of the Company's electric revenues from sales. Prior to construction of all major projects, the Company is required to obtain various licenses, permits and a certificate of public convenience and necessity from the PSCW. As part of this process, advance plan hearings are held by the PSCW, whereby the Company's generation and transmission construction plans and those of several neighboring utilities are reviewed by the PSCW. For the purpose of rate regulation, all three of the regulatory jurisdic- tions allow a "forward looking" test year corresponding to the time that rates are to be put into effect. Rate Changes Wisconsin On January 14, 1993, the PSCW issued an order approving an $8.0 million (3.1 percent) increase on an annual basis in the Company's electric retail rates and a $1.1 million (1.8 percent) increase on an annual basis in its gas rates. A January 16, 1993 effective date was authorized for these rate changes. On June 3, 1993, the Company filed with the PSCW for a $1.37 million (1.9 percent) increase in gas retail rates to be effective January 1, 1994. On August 18, 1993, the Company increased its request to $1.7 million (2.4 percent) to recover a portion of the acquisition premium paid by the Minnesota Company for Viking Gas Transmission Company in recognition of reduced gas costs. Hearings were held in October 1993 regarding the rate increase request. No change in the retail electric rates was requested. On December 23, 1993, the PSCW issued an order approving a $1.41 million (2.0 percent) increase on an annual basis in the Company's gas rates. A January 1, 1994 effective date was authorized for these rate changes. Wholesale On February 26, 1993, the Company filed for an increase of $600,000 (3.7 percent) on an annual basis in its wholesale electric rates. The filing consisted of a settlement agreement between the Company and the municipal whole- sale customers. On April 22, 1993, the FERC issued an order approving the settlement agreement. The new wholesale electric rates became effective September 1, 1993. Michigan There were no changes in the Michigan electric or gas base rates during 1993. Fuel and Purchased Gas Adjustment Clauses Wisconsin The Wisconsin automatic retail electric fuel adjustment clause was eliminated for the Company in the electric retail rate order issued by the PSCW dated March 11, 1986. The electric fuel adjustment clause has been replaced by a procedure which compares actual monthly and anticipated annual fuel costs with those costs which were included in the latest retail electric rates approved by the PSCW. If the comparison results in a difference a range of eight percent for the first month, five percent for the second month, or two percent for the remainder of the year, the PSCW may hold hearings limited to revise rates. The PSCW will be holding a technical conference and possibly hearings during 1994 to determine the appropriate process to handle fuel costs under a new biennial rate filing procedure that the PSCW adopted in 1993. The Company's retail gas rate schedules include a purchased gas adjustment clause which provides for inclusion of the current unit cost of gas from its gas suppliers. The factors applied under the purchased gas adjustment clause are adjusted on an ongoing basis to reflect a reconciliation of gas costs incurred and recovered. Michigan The Company's Michigan retail gas and electric rate schedules include Gas Cost Recovery factors (GCRF) and Power Supply Cost Recovery Factors (PSCRF), respectively, which are based on a twelve-month projection. The MPSC conducts formal hearings because approval must be obtained before implementation of the factors. After each twelve-month period is completed, a reconciliation is submitted whereby over-collections are refunded and any under-collections are collected from the customers. Wholesale The Company calculates the fuel adjustment factor for the current month based on estimated fuel costs for that month. The fuel adjustment factor is adjusted for over or under collected resale fuel costs from prior month's actual operations which provide an ongoing true-up mechanism. Demand Side Management The Company continues to implement various Demand Side Management (DSM) programs designed to improve load factor and reduce the Company's power production cost and system peak demands, thus reducing or delaying the need for additional investment in new generation and transmission facilities. The Company currently offers a broad range of DSM programs to all customer sectors, including information programs, rebate and financing programs, and rate incentive programs. In management's opinion, these programs respond to customer needs and focus on increasing value of service which, over the long term, will reduce the Company's capital requirements and help its customer base become more stable, energy efficient and competitive. During 1993, the Company's programs accomplished over 19 Megawatts (MW) of system peak demand reduction in the commercial, industrial and agricultural customer sectors and over 3 MW in the residential sector. These impacts were obtained through appliance lighting, motor, and cooling efficiency improvements, peak curtailable and time of use rate applications, and direct load control of water heaters and air conditioners. Since 1986, the Company's DSM programs have achieved 126 MW of summer peak demand reduction, which is equivalent to 13% of its 1993 summer peak demand A cumulative goal of 200 MW of peak demand reduction by 1997 has been established. The Company continues to focus on improving the cost-effectiveness of its DSM programs through market research studies and program evaluations. ELECTRIC OPERATION NSP System The Company's electric production and transmission systems are interconnected with the production and transmission system of the Minnesota Company. The combined electric production and transmission systems of the Company and the Minnesota Company are hereinafter called the "NSP System." The facilities of the NSP system include coal and nuclear generating plants, hydro, waste wood, and waste wood/refuse derived fuel ("RDF") generating plants, an interconnection with Manitoba Hydro Electric Board for the purpose of exchanging power, and extra-high voltage transmission facilities for inter- connection to Kansas City, Milwaukee and St. Louis to provide the necessary back up for the large plants. Capability and Demand The Company's record peak demand occurred on August 26, 1993, and was recorded at 982 MW. The NSP System's net generating capability, plus commitments for capacity purchases, less commitments for capacity sales, must be at least equal to the NSP System obligation which is the sum of its maximum demand and its reserve requirements. Being a member of the Mid-Continent Area Power Pool ("MAPP"), NSP's reserve requirement is determined jointly with the other parties to the MAPP Agreement. Currently, the reserve requirement equals 15 percent of the NSP System's maximum demand. The reserve requirement reflects the benefit of MAPP members sharing their reserves to protect against equipment failures on their systems (See Electric Power Pooling Agreements). The Company primarily relies on the Minnesota Company, through the Inter- change Agreement (see Electric Operations - Interchange Agreement), for base load generation. Approximately 77 percent of the total kilowatt hour requirements of the Company were provided by the Minnesota Company generating facilities or purchases made by the Minnesota Company for system uses in the year 1993. The Company also has two electric steam generating facilities. One is the Bay Front Generating Plant which is located in Ashland, Wisconsin. The plant is fueled primarily by coal and wood residue. Recent modifications to the facility allow for more effective utilization of additional waste wood fuel supplies and have extended the useful life of the facility approximately 20 years from their completion in 1992. In 1992 the Company received authorization from the Wisconsin Department of Natural Resources ("burn tire derived fuel on a regular basis. The Company's second electric steam generating plant is the French Island plant located in La Crosse, Wisconsin, which has two fluidized bed boilers installed for the purpose of burning a mixture of waste wood and RDF. The Bay Front plant in Ashland and the French Island steam plant are primarily used on an intermediate load basis. The Company's thermal peaking capability consists of two oil-fired gas turbine peaking plants and a gas and oil turbine peaking plant. The Company also has 19 hydro plants that operate as peaking facilities or run-of-river facilities. Interchange Agreement The electric production and transmission costs of the NSP System are shared by the Company and the Minnesota Company. The cost-sharing arrangement between the companies is the Agreement to Coordinate Planning and Operation and Interchange Power and Energy between Northern States Power (Minnesota) and Northern States Power (Wisconsin) ("Interchange Agreement"). It is a FERC regulated agreement and has been accepted by the PSCW and the MPSC for determination of costs recoverable in rates by the Company for charges from the Minnesota Company in rate cases. Historically the Company's share of the NSP System annual production and transmission costs has been in the 14 to 17 percent range. Revenues received from billings to the Minnesota Company for its share of the Company's production and transmission costs are recorded as electric operating revenues on the Company's income statement. The portions of the Minnesota Company's production and transmission costs that were charged to the Company were recorded as purchased and interchange power expenses and other operation expenses, respectively, on the Company's income statement. (See Note 6 Financial Statements). Under the Interchange Agreement, the Company could be charged a portion of the cost of an assessment made against the Minnesota Company pursuant to the Price-Anderson liability provisions of the Atomic Energy Act of 1954. (See Note 3 to Financial Statements). Electric Power Pooling Agreements The Company is included with the Minnesota Company as one of 12 investor- owned utilities, 9 rural electric generation and transmission cooperatives, 3 public power districts, 18 municipal electric systems, 3 municipal power agencies, the Western Area Power Authority (Department of Energy) and 2 Canadian Crown corporations that are members of MAPP pursuant to an agreement, as amended , dated March 31, 1972. The agreement provides for the members to coordinate the installation and operation of generating plants and transmission line facilities. The MAPP agreement was accepted for filing by has been effective since December 1, 1972. Fuel Supply In 1993 the Company shared in the fuel supply costs incurred by the Minnesota Company in accordance with the Interchange Agreement. Coal and nuclear fuel will continue to dominate the NSP System fuel requirements for the generation of electricity. It is expected that approximately 98 percent of the NSP System annual fuel requirements in 1994 will be provided by these two sources and that 2 percent of NSP's annual fuel requirements for generation will be provided by other fuels (including natural gas, refuse derived fuel, waste materials, and wood) over the next several years. Fuel Use on Btu Basis (Est.) (Est.) 1993 1994 1995 Coal 62.3% 62.9% 61.2% Nuclear 36.2% 35.4% 37.1% Other * 1.5% 1.7% 1.7% * Includes oil, gas, refuse derived fuel and wood Environmental Matters The Wisconsin DNR has been authorized by the United States Environmental Protection Agency to administer the National Pollutant Discharge Elimination System Permits under the Federal Water Pollution Control Act Amendments of 1977. Such permits are required for the lawful discharge of any pollutant into navigable waters from any point source (e.g. power plants). Permits have been issued for all of the Company's affected plants and all plants are in compliance with permit requirements. The DNR has jurisdiction over emissions to the atmosphere from the Company's power plants. The operation of the Company's generating plants substantially conforms to federal and state limitations pertaining to discharges to the air. Occasional, infrequent exceedances of Wisconsin DNR air emission limitations occurred in 1993 at the Company's Bay Front and French Island facilities. These are being resolved through operating changes or permit modifications and no agency enforcement action is anticipated. presently operates hydro, coal, natural gas, oil-fired, wood and RDF equipment. Regulatory approval is required for the construction of generating plants and major transmission lines. Also additional regulations have been instituted governing the use, transport, disposal and inspection of hazardous material and electrical equipment containing polychlorinated biphenyls. The Company has procedures in place to comply with these regulations. The Company has been identified as a "Potentially Responsible Party" (PRP) for a solid and hazardous waste landfill. The Company contends that it did not dispose of hazardous wastes in the subject landfill during the time period in question. Because neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined, it is not feasible to determine the outcome of this matter time. GAS OPERATIONS In 1993, the Company continued its strategy of holding a diversified portfolio of natural gas supplies and transportation arrangements. The Company complied with the requirements of FERC's Order 636, which significantly changed the services available to, and provided by, local distribution companies and interstate pipelines. The Company is now relying almost entirely on third party suppliers for its natural gas supply needs, and is utilizing the pipelines only for transportation and storage services. The Company continues to hold annual and/or winter peaking transportation contracts from Northern Natural Gas Company (NNG), Great Lakes Transmission Limited Partnership, Viking Gas Transmission Company, and TransCanada Pipeline, LTD. The Company picked up three new gas supply contracts in 1993 from assignment of NNG's supply under Order 636, and purchased additional baseload and peaking supplies from two new third party suppliers. The Company is continuing its pursuit of growth and profitability through expansion of its distribution system and services both inside and outside of its existing service territories. CONSTRUCTION AND FINANCING Expenditures for the Company's construction program in 1993 totaled $60 million. The 1994 construction expenditures are estimated to be $60.7 million with approximately $38.3 million for electric facilities, $8.6 million for gas facilities and $13.8 million for general plant and equipment. Expenditures for the Company's construction programs for the next five- year period 1994-1998, are estimated to be as follows: Year Estimated Construction Expenditures 1994 $ 61 million 1995 $ 60 million 1996 $ 59 million 1997 $ 62 million 1998 $ 60 million TOTAL $302 million It is presently estimated that approximately 83 percent of the 1994-1998 construction expenditures will be provided by internally generated funds and the remainder from short-term and long-term external financing. At December 31, 1993, the Company's short-term borrowings outstanding were $23.5 million. The foregoing estimates of construction expenditures, internally generated funds and external financing requirements can be affected by numerous factors, including load growth, inflation, changes in the tax laws, rate relief, earnings and regulatory actions. Major electric and gas utility projects are subject to the jurisdiction of the PSCW and require it Hence, the above estimated construction program and financing program could change from time to time due to variations in these other factors. During the five years ended December 31, 1993, the Company had gross additions to utility plant in service of approximately $249 million. Included in the Company's gross additions is $38.5 million for electric production facilities, $155 million for other electric properties, $35 million for gas utility properties, and $20.5 million for other utility properties. Retirements during the same period were approximately $37.5 million. Based on studies made by the Company, the weighted average age of depreciable property was 13 years at December 31, 1993. Item 2. Item 2. Properties Electric Utility The Company's major electric generating facilities consist of the following: Projected Year 1993-4 Winter Station and Units Fuel Installed Capability (MW) Combustion Turbine: Flambeau Station Gas/Oil 1969 17 (1 unit) Wheaton Oil 1973 440 (6 units) French Island Oil 1974 192 (2 units) Steam: Bay Front Coal/Wood/ 1974-1960 73 (3 units) Gas French Island Wood/RDF 1940-1948 29 (2 units) Hydro Plants: (19 plants) - Various dates 248 TOTAL 999 At December 31, 1993, the Company owned approximately 2,382 pole miles of overhead electric lines, 8,029 pole miles of overhead electric distribution lines, 38 conduit miles and 976 direct buried cable miles of underground electric lines. Gas Utility The gas properties of the Company include approximately 1,313 miles of natural gas distribution mains. The Company owns two liquefied natural gas facilities with a combined storage capacity of the equivalent of 400,000 Mcf to supplement the available pipeline supply of natural gas during periods of peak demands. In January of 1993, the Company installed propane air facilities with a capacity of 144,000 gallons to further supplement gas supply in the La Crosse, Wisconsin area during peak periods. Item 3. Item 3. Legal Proceedings The Company is currently involved in various claims and lawsuits incidental to its business. In the opinion of management, if the Company were ultimately found to be liable in these claims and lawsuits, such liability would not have a material effect on the financial statements of the Company. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Omitted per conditions set forth in general instruction J (1) and (a) and (b) of Form 10-K for wholly-owned subsidiaries (reduced disclosure format). PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters This is not applicable as the Company is a wholly owned subsidiary. Item 6. Item 6. Selected Financial Data This is omitted per conditions set forth in general instructions J (1) (a) and (b) of Form 10-K for wholly owned subsidiaries (reduced disclosure format). Item 7. Item 7. Management Discussion and Analysis Management's Discussion and Analysis of Financial Condition and Results of Operations is omitted per conditions as set forth in general instructions J (1) (a) and (b) of Form 10-K for wholly owned subsidiaries. It is replaced with management's narrative analysis of the results of operations set forth in general instructions J (2) (a) of Form 10-K for wholly owned subsidiaries (reduced disclosure format). This analysis will primarily forth the Company's accounting changes and compare its revenue and expens year ended December 31, 1993 with the year ended December 31, 1992. The Company's net income for the year ended December 31, 1993 was $38.0 million, down from the $38.2 million earned in the same period of 1992. The 1993 operating income increased by $1.3 million from the 1992 level. Accounting Changes Postretirement Benefits See Note 5 for discussion of the 1993 change in accounting for postretirement medical and death benefits. There was no material effect on net income due to rate recovery of the expense increases. Income Taxes The Company adopted SFAS No. 109 - Accounting for Income Taxes, effective Jan. 1, 1993. See Note 1 for discussion of the adoption of SFAS No. 109. Adoption of SFAS No. 109 had no effect on earnings and no material effect on financial condition due to its similarity to SFAS No. 96 - Accounting for Income Taxes, which the Company adopted in 1988, and which SFAS No. 109 supersedes. 1994 Changes In 1994, the Company will adopt SFAS No. 112 - Accounting for Postemployment Benefits. SFAS No. 112 requires the accrual of certain employee costs (such as injury compensation and severance) to be paid in future periods. Its adoption in 1994 is not expected to have a material effect on the Company's results of operations or financial condition. Electric Sales and Revenues Electric revenues for 1993 increased $17.2 million, a 5.0 percent increase from the 1992 revenues. Revenues from retail sales, which accounted for 75 percent of the electric revenues in 1993, increased $14.6 million or 5.7 percent. Included in the 1993 retail increase is $6.2 million directly related to the rate changes discussed in Part I, Item 1: Business-Regulation and Rates. Also reflected in the 1993 retail revenue increase increase of $8.4 million due to increased sales. The cool summer weather of 1992 was a major cause of this increase in sales. Our wholesale customers accounted for 4.4 percent of the total electric revenues. Wholesale revenues increased $1.3 million or 8.5 percent in 1993. This increase is also largely a result of 1992's cool summer weather. Another major component of electric revenues is charges billed to the Minnesota Company through the Interchange Agreement (see Part I, Item 1; Business-Electric Operations). Interchange Agreement billings charged to the Minnesota Company increased $1.5 million primarily as a result of added transmission investment. Other electric revenues decreased $0.2 million in 1993. Gas Sales and Revenues Gas revenues in 1993 increased by $11.7 million or 19.1 percent as compared with 1992. This is the net impact of increased revenues due to the rate increase effective January 1993, increased revenues due to sales growth, increased revenues due to higher gas costs passed through the purchased gas adjustment clause, and increased revenues of $8.2 million due to 1992's warm winter weather. Operating Expenses and Other Factors Electric Production The cost of interchange power increased $6.3 million or 4.0 percent in 1993 compared to the same period one year ago. This expense represents charges billed from the Minnesota Company through the Interchange Agreement (see Part I, Item 1: Business-Electric Operations). The company's increased electric sales during 1993 over 1992, combined with increased costs associated with the NSP system's new contract with Manitoba Hydro resulted in the company's purchased power and fuel purchased under its interchange agreement with its parent to increase by approximately $7.6 million. Total interchange power is offset by decreases in operation and maintenance expenses in the charges. Fuel for electric generation, which represents the Company's fuel generation, increased $1.2 million or 56.6 percent in 1993 from 1992. This is primarily due to increased requirements due to the increased sales in 1993. Gas Purchased for Resale This cost increased $9.7 million or 23.2 percent. $3.5 million of this increase in 1993 is a result of increased volumes purchased. Increased transportation prices resulted in $4.2 million of the increase with the balance of the increase due to commodity and demand price increases. Administrative and General, Other Operation and Maintenance The $5.2 million increase in administrative and general expense is partially due to the Company having had no disbursement of the employee incentive pay program (which is dependent upon corporate earnings) in 1992, but incurring its disbursement in 1993. This accounted for $1.7 million of the $5.2 million increase. An increase of $2.1 million was due to the SFAS 106 accruals of postretirement benefits. The remaining increases were general increase and general expenses. Depreciation and Amortization The increase in depreciation between 1993 and 1992 primarily reflects higher levels of depreciable plant. Property and General Taxes The property and general taxes increase is primarily due to higher gross receipts tax (a tax assessed on prior year revenues) as a result of 1992 revenues increasing over 1991 revenues. Income Taxes $0.7 million of the increase in income taxes in 1993 over 1992 is the result of the Federal Rate increasing from 34% to 35% and the balance of the increase is primarily attributable to changes in pretax book income. See Note 8 to the Financial Statements for a detailed reconciliation of effective tax rates and statutory rates. Allowances for Funds During Construction (AFC) The differences in AFC for the reported periods are attributable to varying levels of construction work in progress and lower AFC rates associated with increased use of low-cost short- term borrowings. Other Income and Deductions The decrease in other income is primarily due to a greater number of sales of certain land and land rights in 1992 by NSP Lands, Inc., a wholly owned subsidiary of the Company. Interest Charges On March 16, 1993 the Company issued $110.0 million of first mortgage bonds due March 1, 2023 with an interest rate of 7-1/4%. The Company entered into an interest rate swap agreement with the underwriters of this bond issue relating to $20.0 million of the principal, which effectively converted the interest cost of this debt from fixed rate to variable rate, with the variable rate changing on March 1 and September each year until March 1, 1998. The net interest rate for the entire $110 millio approximately 6.9% in 1993. The proceeds from these bonds were used to redeem $47.5 million in principal amount of its First Mortgage Bonds, Series due July 1, 2016, 9-1/4% at a redemption price of 105.78%, to redeem $38.4 million in principal amount of its First Mortgage Bonds, Series due March 1, 2018, 9-3/4%, at the redemption price of 107.31% and to repay outstanding short-term borrowings, including short - -term borrowings incurred to redeem on January 20, 1993 $7.8 million in principal amount of its First Mortgage Bonds, Series due December 1, 1999, 9-1/4%, at the redemption price of 102.2%. On October 5, 1993 the Company issued $40.0 million of first mortgage bonds due October 1, 2003 with an interest rate of 5-3/4%. The proceeds from these bonds were used to redeem $24.3 million in principal amount of its First Mortgage Bonds, Series due October 1, 2003, 7-3/4% at a redemption price of 102.49%, to redeem $10.8 million in principal amount of its First Mortgage Bonds, Series due August 1, 1994, 4-1/2%, at the redemption price of 100.00% and to repay outstanding short-term borrowings. These transactions had no material impact on the 1993 interest charges compared to the charges of 1992 because in 1993, all costs associated with the redemption of these bonds were treated on a basis by which all savings of interest due to refinancing was offset by the amortization of the costs. Item 8 Item 8 Financial Statements and Supplementary Data See Item 14(a)-1 in Part IV for financial statements included herein. See Note 12 to the financial statements for summarized quarterly financial data. INDEPENDENT AUDITORS' REPORT Northern States Power Company (Wisconsin): We have audited the accompanying financial statements, of Northern States Power Company (Wisconsin), (the Company) listed in the accompanying table of contents of Item 14(a)1. Our audits also included the financial statement schedules listed in Item 14(a)2. These financial statements and the 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 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 financial statements taken as a whole , present fairly, in all material respects, the information set forth therein. As discussed in Note 5 to the financial statements, the Company changed its method of accounting for postretirement health care costs in 1993. Minneapolis, Minnesota February 4, 1994 Item 8 Financial Statements and Supplementary Data Statements of Income and Retained Earnings Year-Ended December 31 (Thousands of dollars) 1993 1992 1991 Operating Revenues Electric $362 473 $345 289 $349 027 Gas 72 760 61 071 56 348 Total 435 233 406 360 405 375 Operating Expenses Purchased and interchange power 162 510 156 196 160 324 Fuel for electric generation 3 185 2 034 2 696 Gas purchased for resale 51 501 41 814 39 332 Administrative and general 26 842 21 610 21 761 Other operation 49 907 47 470 47 054 Maintenance 21 703 21 806 23 487 Depreciation and amortization 28 585 26 832 25 321 Property and general taxes 13 091 12 925 12 107 Income taxes 23 103 22 184 21 641 Total operating expenses 380 427 352 871 353 723 Operating Income 54 806 53 489 51 652 Other Income and Deductions Allowance for funds used during construction-equity 694 907 514 Other income and deductions 844 1 361 1 128 Total Other Income 1 538 2 268 1 642 Income Before Interest Charges 56 344 55 757 53 294 Interest Charges Interest on long-term debt 16 343 17 269 15 863 Other interest and amortization 2 406 857 1 396 Allowance for funds used during construction-debt (411) (569) (517) Total interest charges 18 338 17 557 16 742 Net Income 38 006 38 200 36 552 Retained Earnings, January 1 192 816 179 510 173 508 Dividends (25 708) (24 894) (30 550) Retained Earnings, December 31 $ 205 114 $192 816 $179 510 See Notes to Financial Statements. Item 8 Financial Statements and Supplementary Data Statements of Cash Flows Year Ended December 31 (Thousands of dollars) 1993 1992 1991 Cash Flows from Operating Activities: Net Income $38 006 $38 200 $36 552 Adj to recon. net income to cash from op activities: Depreciation and amortization 33 580 28 179 26 852 Deferred income taxes 7 228 3 089 4 319 Investment tax credit adjustments (948) (956) (971) AFC-equity (694) (907) (514) Gain on sale of land (681) Other (2 440) (643) Cash used for changes in certain working capital items 299 2 438 (1 571) Net Cash Provided by Operating Activities 77 471 67 603 63 343 Cash Flows from Financing Activities: Proceeds from issuance of long-term debt 146 587 48 563 Proceeds from issuance of notes payable-parent company 12 600 Repayment of notes payable-parent company (800) (31 800) Repayment of long-term debt (136 090) (1 415) (557) Dividends paid to parent (25 708)(24 894) (30 550) Net Cash provided by (used for) Financing Activities (16 011)(13 709) (14 344) Cash Flows from Investing Activities: Construction expenditures capitalized (59 954)(54 588) (50 832) Increase (decrease) in construction payables (2 143) (2 013) 1 115 AFC-equity 694 907 514 Other (489) Net Cash Used for Investing Activities (61 892)(55 694) (48 467) Net Increase (Decrease) in Cash and Cash Equivalents (432) (1 800) 532 Cash and Cash Equivalents at Beginning of Period 881 2 681 2 149 Cash and Cash Equivalents at End of Period $449 $881 $2 681 Working Capital Changes: Accounts receivable-net $(1 597) $921 $(4 414) Materials and supplies (453) (647) (241) Accounts payable and accrued liabilities 7 633 412 1 450 Payables to affiliated companies 127 2 444 (2 899) Income and other taxes accrued (2 762) 634 3 528 Other (2 649) (1 326) 1 005 Net $299 $2 438 $(1 571) Supplemental Disclosures of Cash Flow Information: Cash paid during the year for: Interest (net of amount capitalized) $17 440 $17 136 $15 424 Income taxes $18 825 $19 256 $14 905 See Notes to Financial Statements. Item 8 Financial Statements and Supplementary Data Balance Sheets December 31 (Thousands of dollars) 1993 1992 Assets Utility Plant Electric-including construction work in progress: 1993, $16,697; 1992, $14,571 $810 691 $781 573 Gas 81 567 75 250 Other 43 279 28 565 Total 935 537 885 388 Accumulated provision for depreciation (320 938) (300 393) Net utility plant 614 599 584 995 Other Property and Investments Nonutility property - at cost 3 157 3 119 Accumulated provision for depreciation (364) (363) Other investments - at cost which approximates market 4 094 3 661 Total other property and investments 6 887 6 417 Current Assets Cash and cash equivalents 449 881 Accounts receivable 38 424 36 738 Accumulated provision for uncollectible accounts (708) (646) Materials and supplies - at average cost Fuel 2 293 2 535 Other 8 692 7 996 Accrued utility revenues 17 230 15 990 Prepayments and other 9 855 9 920 Deferred tax asset 1 254 2 980 Total current assets 77 489 76 394 Deferred Debits Unamortized debt expense 3 078 3 031 Regulatory assets 30 036 21 062 Other 4 890 2 570 Total deferred debits 38 004 26 663 Total $736 979 $694 469 See Notes to Financial Statements. Item 8 Financial Statements and Supplementary Data Balance Sheets December 31 (Thousands of dollars) 1993 1992 Liabilities Capitalization Common stock-authorized 870,000 shares of $100 par value; issued shares: 1993 and 1992, 862,000 $86 200 $86 200 Premium on common stock 10 461 10 461 Retained earnings 205 114 192 816 Total common equity 301 775 289 477 Long-term debt 217 600 187 737 Total capitalization 519 375 477 214 Current Liabilities Notes payable - parent company 23 500 24 300 Long-term debt due within one year 0 9 608 Accounts payable 15 264 12 051 Salaries, wages, and vacation pay accrued 5 481 3 204 Payables to affiliated companies (principally parent) 11 636 11 509 Federal income taxes accrued 1 606 3 862 Other taxes accrued 2 492 2 998 Interest accrued 4 823 5 934 Other 1 917 2 252 Total current liabilities 66 719 75 718 Deferred Credits Accumulated deferred income taxes 88 426 78 434 Accumulated deferred investment tax credits 23 653 24 886 Regulatory liability 22 416 29 395 Other 16 390 11 822 Total deferred credits 150 885 141 537 Commitments and Contingent Liabilities Total $736 979 $694 469 See Notes to Financial Statements. NORTHERN STATES POWER COMPANY (WISCONSIN) NOTES TO FINANCIAL STATEMENTS 1. Summary of Accounting Policies System of Accounts The Company maintains the accounting records in accordance with either the uniform system of accounts prescribed by the Federal Energy Regulatory Commission (FERC) or those prescribed by the Public Service Commission of Wisconsin (PSCW) and the Michigan Public Service Commission (MPSC) , which systems are the same in all material respects. Reclassifications Certain reclassifications have been made to the 1992 financial statements in order to conform to the 1993 presentation of regulatory deferrals. These reclassifications have no effect on the net income or common equity as previously reported. Investment in Subsidiaries The Company carries its investment in its subsidiaries (Chippewa and Flambeau Improvement Company, 75.86% owned; NSP Lands , Incorporated, 100% owned; and Clearwater Investments, Incorporated, 100% owned) at cost plus equity in earnings since acquisition. The impact of consolidation of these subsidiaries is considered immaterial to the Company's financial position. Utility Plant and Retirements Utility Plant is stated at original cost. The cost of additions to utility plant includes contracted work, direct labor and materials, allocable overheads and allowance for funds used during construction (AFC). The cost of units of property retired, plus net removal cost, is charged to the accumulated provision for depreciation and amortization. Maintenance and replacement of items determined to than units of property are charged to operating expenses. Depreciation For financial reporting purposes, depreciation is computed on the straight-line method based on the annual rates certified by the PSCW and MPSC for the various classes of property. Depreciation provisions, as a percentage of the average balance of depreciable property in service, were 3.40% in 1993, 3.38% in 1992, and 3.36% in 1991. Revenues Customers' meters are read and bills rendered on a cycle basis. The Company accrues the amount of estimated unbilled revenues for services provided from the monthly meter reading date to month-end. The current asset, accrued utility revenues, is being adjusted monthly, with a corresponding adjustment to revenues, to reflect changes in unbilled revenues. Regulatory Deferrals As a regulated utility, the Company accounts for certain income and expense items under the provisions of SFAS No. 71 - Accounting for the Effects of Regulation. In doing so, certain costs which would otherwise be charged to expense are deferred as regulatory assets based on expected recovery from customers in future rates. Likewise, certain credits which would otherwise be reflected as income are deferred as regulatory liabilities based on expected flowback to customers in future rates. Management's expected recovery of deferred costs and expected credits are generally based on specific ratemaking decisions or precedent for each item. Regulatory assets and liabilities are being amortized consistent with ratemaking treatment as established by regulators. See Note 7 for discussion of these regulatory deferrals. Income Taxes The Company records income taxes in accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109) - Accounting For Income Taxes. SFAS 109 requires the use of the liability method of accounting for deferred income taxes. Before 1993, the Company followed Statement of Accounting Standards No. 96 (SFAS 96) - Accounting for Income Taxes, resulting in substantially the same accounting for the Company as SFAS No. 109. Income taxes are deferred for temporary differences between pretax financial and taxable income, and between the book and tax bases of assets and liabilities . Deferred taxes are recorded using the tax rates scheduled by tax law to be in effect when the temporary differences reverse. Due to the effects of regulation , income tax expense is provided for the reversal of some temporary differences previously accounted for by the flow-through method. Also, regulation results in the creation of certain assets and liabilities related to income taxes as discussed in Note 7. Investment tax credits are deferred and amortized over the estimated lives of the related property. Purchased Tax Benefits The Company purchased tax-benefit transfer leases under the Safe Harbor Lease provisions of the Economic Recovery Tax Act of 1981. For both financial reporting and regulatory purposes, the Company is amortizing the difference between the cost of the purchased tax benefits and the amounts to be realized through reduced current income tax liabilities over the remaining terms of the lease after the initial investments have been recovered. Cash Equivalents The Company considers certain debt instruments (primarily commercial paper) with a remaining maturity of three months or less at the time of purchase to be cash equivalents. Environmental Costs Costs related to environmental remediation are accrued when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. 2. Long-Term Debt First Mortgage Bonds - less reacquired bonds of $0 and $42 December 31 at December 31, 1993 and 1992, respectively: 1993 1992 (Thousands of dollars) Series due: Aug. 1, 1994, 4-1/2% $10 938 Dec. 1, 1999, 9-1/4% 7 800 Oct. 1, 2003, 7-3/4% 24 570 Jul. 1, 2016, 9-1/4% 47 500 Mar. 1, 2018, 9-3/4% 38 400 Apr. 1, 2021, 9-1/8% $49 000 49 500 Mar. 1, 2023, 7 1/4% 110 000 Oct. 1, 2003, 5 3/4% 40 000 Total $199 000 $178 708 Less Dec. 1, 1999, 9 1/4% bonds redeemed in January 1993 7 800 Less sinking fund requirements not reacquired 1 808 Net $199 000 $169 100 City of LaCrosse Resource Recovery Revenue Bonds - Series due Nov. 1, 2011, 7 3/4% 18 600 18 600 Unamortized premium on long-term debt 0 37 Total long-term debt $217 600 $187 737 The Supplemental and Restated Trust Indenture dated March 1, 1991, permits an amount of established Permanent Additions to be deemed equivalent to the payment of cash necessary to redeem 1% of the highest principal amount of each series of first mortgage bonds (other than pollution control financing) at any time outstanding. This Supplemental and Restated Trust Indenture became effective for the Company on October 1, 1993. On January 20, 1993, the Company redeemed its $7.8 million of 9 1/4% bonds at 102.2%; this amount has, therefore, been classified as current on the December 31, 1992 financial statements. Except for minor exclusions, all real and personal property is subject to the lien of the Company First Mortgage Bond Trust Indenture. The Indenture also provides for certain restrictions on the payment of cash dividends on common stock. At December 31, 1993, the payment of cash dividends on common stock was not restricted. 3. Commitments and Contingent Liabilities The Company presently estimates capital expenditures will be $61 million in 1994 and $302 million for 1994-98. The Company has capital lease obligations of $3.1 million. These leases will require principle payments of $715,000, $780,000, $854,000, $524,000, and $189,000, respectively, for the years 1994 to 1998. Rentals under operating leases were approximately $2,651,000, $2,547,000 and $1,962,000, for 1993, 1992, and 1991, respectively. Although the Company does not own a nuclear facility, any assessment made against Northern States Power Company (Minnesota), the parent company, under the Price-Anderson liability provisions of the Atomic Energy Act of 1954, would be a cost included under the Interchange Agreement (Note 6) and the Company would be charged its proportion of the assessment. Such provisions set a limit of $9.4 billion for public liability claims that could arise from a nuclear incident. The parent company has secured insurance of $200 million to satisfy such claims. The remaining $9.2 billion of exposure is funded by the Secondary Financial Protection Fund, a fund available from assessments by the Federal government in the event of nuclear incidents. The parent company assessment of $79.3 million for each of its three licensed reactors to be applied for public liability arising from a nuclear incident at any licensed nuclear facility in the United States with a maximum funding requirement of $10 million per reactor during any one year. The Company has been identified as a "Potentially Responsible Party" (PRP) for a solid and hazardous waste landfill. The Company contends that it did not dispose of hazardous wastes in the subject landfill during the time period in question. Because neither the amount of cleanup costs nor the final method of their allocation among all designated PRPs has been determined, it is not feasible to determine the outcome of this matter at this time. 4. Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107 (SFAS 107) - Disclosures About Fair Value of Financial Instruments became effective in 1992. For cash and investments, the carrying amount approximates fair value. The fair value of the Company'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 Company for debt of the same remaining maturities. The estimated fair value of the Company's long-term debt (including debt due within one year classified as current) of $217.6 million at December 31, 1993 and $197.3 million at December 31, 1992, is $233.3 million and $212.2 million, respectively. 5. Pension Plans and Other Post Retirement Benefits Employees of the Company participate in the Northern States Power Company Pension Plan. This noncontributory defined benefit pension plan covers substantially all employees. Benefits are based on years of service, the employees highest average pay for 48 consecutive months and Social Security wage base. Pension costs are determined and funded under the aggregate-cost method, using market value of assets of the trust fund. The portion of annual pension costs was $1,236,000 for 1993, $2,400,000 for 1992, and $2,478,000 for 1991. Until 1993, for financial reporting and regulatory purposes, the Company's pension expense was determined and recorded under the aggregate cost method. Statement of Financial Accounting Standards No. 87 - Employers' Accounting for Pensions (SFAS 87) provides that any difference between the pension expense recorded for rate making purposes and the amounts determined under SFAS 87 should be recorded as an asset or liability on the balance sheet. Effective January 1, 1993, for financial reporting and regulatory purposes, the Company's pension expense was determined and recorded under the SFAS-87 method and the Company's accumulated SFAS-87 asset is being amortized over a 15- year period. Net periodic pension costs for the total (the Company and Minnesota Company) plan include the following components: 1993 1992 1991 (Thousands of dollars) Service Cost - benefits earned during the period $25 015 $24 080 $22 097 Interest cost on projected benefit obligation 71 075 69 853 65 557 Actual return on assets (152 019)(115 455)(246 678) Net amortization and deferral 66 299 39 019 181 543 Net periodic pension cost determined under SFAS 87 10 370 17 497 22 519 Expenses recognized (deferred) due to actions of regulators 5 117 2 741 (1 549) Pension expense recorded during the period 15 487 20 238 20 970 Portion of expense recognized for early retirement program 0 (165) (165) Net periodic pension cost recognized for ratemaking $15 487 $20 073 $20 805 The funding status for the total plan is as follows: Actuarial present value of benefit obligation: Vested $655 002 $614 446 Nonvested 139 346 129 183 Accumulated benefit obligation $794 348 $743 629 Projected benefit obligation $974 160 $914 019 Plan assets at fair value 1 244 650 1 156 782 Plan assets in excess of projected benefit obli. (270 490) (242 763) Unrecognized prior service cost (22 580) (14 790) Unrecognized net (gain) 315 049 269 086 Unrecognized net transitional (asset) 767 843 Net pension liability recorded $22 746 $12 376 The weighted average discount rate used in determining the actuarial present value of the projected obligation was 7% in 1993 and 8% in 1992. The rate of increase in future compensation levels used in determining the actuarial present value of the projected obligation was 5% in 1993 and 6% in 1992. The assumed long-term rate of return on assets used for cost determinations under SFAS 87 was 8% in 1993 and 1992 and 8.5% in 1991. Plan assets consist principally of common stock of public companies and U.S. Government Securities. Effective Jan. 1, 1993, the Company adopted the provisions of SFAS No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS No. 106 requires that the actuarially determined obligation for postretirement health care and death benefits is to be fully accrued by the date employees attain full eligibility for such benefits, which is generally when they reach retirement age. This is a significant change from the Company's prior policy of recognizing benefit costs on a cash basis after retirement. In conjunction with the adoption of SFAS No. 106, for financial reporting purposes, NSP elected to amortize on a straight-line basis over 20 years the unrecognized accumulated postretirement benefit obligation (APBO) of approximately $215.6 million (including the Company and Minnesota Company) for current and future retirees. This obligation considers anticipated 1994 plan design changes not in effect in 1993, including Medicare integration, increased retiree cost sharing and managed indemnity measures. In the past, NSP has funded benefit payments to retirees internally. While the Company generally prefers to continue using internal funding of benefits paid and accrued, there have been some external funding requirements imposed by the Company's regulators, as discussed below, including the use of tax advantaged trusts. Plan assets held in such trusts as of Dec. 31, 1993, consisted of investments in equity mutual funds and cash equivalents. The following table sets forth the total (the Company and Minnesota Company) health care plan's funded status in 1993. (Millions of dollars) Dec. 31, 1993 Jan. 1, 1993 APBO: Retirees $120.2 $105.8 Fully eligible plan participants 18.8 18.8 Other active plant participants 90.8 91.0 Total APBO 229.8 215.6 Plan Assets (6.1) 0 APBO in excess of plant assets 223.7 215.6 Unrecognized net actuarial gain (loss) (1.3) Unrecognized transition obligation (204.8) (215.6) Postretirement benefit obligation $17.6 $0 The assumed health care cost trend rate used in measuring the APBO at Dec. 31 , 1993, was 14.1 percent for those under age 65 and 8.0 percent for those over age 65. The trend rates used in the Jan. 1, 1993 calculations were 15.1 percent and 9.0 percent respectively. The assumed cost trend rates are expected to decrease each year until they reach 4.5 percent for both age groups in the year 2004, after which they are assumed to remain constant. A one percent increase in the assumed health care cost trend rate for each year would increase the APBO as of December 31, 1993, by approximately 17 percent, and service and interest cost components of the net periodic postretirement cost by approximately 20 percent. The assumed discount rate used in determining the APBO was 7 percent for Dec. 31, 1993, and 8 percent for Jan. 1, 1993, compounded annually. The assumed long-term rate of return on assets used for cost determinations under SFAS No. 106 was 8 percent for both measurement dates. While the assumption changes made for the Dec. 31 calculations had no effect on 1993 benefit costs, the effect of the changes in 1994 (for the Company and Minnesota Company) is expected to be a cost decrease of approximately $2 million. In each 1992 and 1991, the Company recognized $1.9 million as the cost attributable to postretirement health care and death benefits based on payments made. The net annual periodic postretirement benefit cost recorded for 1993 consists of the following components (millions of dollars): Service cost-benefits earned during the year $ 0.6 Interest cost (on service cost and APBO) 2.4 Amortization of transition obligation 1.5 Return on assets (.1) Net periodic postretirement health care cost under SFAS No. 106 4.4 Regulators have allowed full recovery of increased benefit costs under SFAS No. 106, effective in 1993. External funding was required in Wisconsin and Michigan to the extent it is tax advantaged. The FERC has required external funding for all benefits paid and accrued under SFAS NO. 106. Funding began for both retail and FERC in 1993. The Company will adopt SFAS No. 112-Accounting for Postemployment Benefits, which requires the accrual of certain employee costs to be paid in future periods, in 1994; its adoption will have no material effect on the Company's results of operations or financial condition. 6. Parent Company and Intercompany Agreements The Company is wholly-owned by Northern States Power Company (Minnesota). The electric production and transmission costs of the NSP system are shared by the Company and the Minnesota Company. A FERC approved agreement (Interchange Agreement) between the Company and the Minnesota Company provides for the sharing of all costs of electric generation and transmission facilities of the NSP System, including capital costs. Billings under the Interchange Agreement and an intercompany gas agreement which are included in the statement of income are as follows: Year Ended December 31 1993 1992 1991 (Thousands of dollars) Operating revenues: Electric $ 72 162 $ 70 671 $ 70 623 Gas 56 55 62 Operating expenses: Purchased and interchange power 162 510 156 196 160 324 Gas purchased for resale 267 214 183 Other operation 12 515 11 668 11 809 7. Regulatory Assets and Liabilities The following summarizes the individual components of unamortized regulatory assets and liabilities shown on the Balance Sheet at Dec. 31: (Thousands of dollars) 1993 1992 AFC recorded in plant on a net-of-tax basis 8 795 8 520 Losses on reacquired debt 10 857 5 037 Conservation and energy management programs 8 291 5 738 Pensions and other 2 093 1 767 Total Regulatory Assets 30 036 21 062 Excess deferred income taxes collected from customers 5 914 12 821 Investment tax credit deferrals 15 841 16 038 Fuel refunds and other 661 536 Total Regulatory Liabilities 22 416 29 395 The AFC regulatory asset and the tax-related regulatory liabilities result from the Company's adoption of SFAS No. 96 in 1988 and SFAS No. 109 in 1993. The excess deferred income tax liability represents the net amount expected to be reflected in future customer rates based on the collection in prior ratemaking of deferred income tax amounts in excess of the actual liabilities currently recorded by the Company. This excess is the effect of the use of "flow through" tax accounting in prior ratemaking and the impact of changes in statutory tax rates in 1981, 1986-87 and 1993. This regulatory liability will change each year as the related deferred income tax liabilities reverse. 8. Income Tax Expense The Company is included in the consolidated Federal income tax return filed by the Minnesota Company and files separate state returns for Wisconsin and Michigan. The Company records current and deferred income taxes at the statutory rates as if it filed a separate return for Federal income tax purposes . All tax payments are made directly to the taxing authorities. The total income tax expense differs from the amount computed by applying the Federal income tax statutory rate of 35% in 1993 (34% in 1992 and 1991) to net income before income tax expense. The reasons for the difference are as follows: 1993 1992 1991 (Thousands of dollars) Tax computed at statutory rate $21 387 $20 434 $19 640 Increases (decreases) in tax from: State income taxes, net of Federal income tax benefit 3 165 3 037 3 205 Allowance for funds used during construction (243) (284) (175) Investment tax credit adjustments - net (948) (956) (971) Use of the flow-through method for deprec'n in prior yr 474 673 649 Effect of tax rate changes for plant related items (487) (420) (332) Gain on sale of tax benefit transfer leases (88) Other - net (162) (583) 412 Total income tax expense $23 098 $21 901 $21 211 Effective income tax rate 37.8% 36.4% 36.7% Income tax expense is comprised of the following: Included in income taxes: Current Federal tax expense $12 919 $15 340 $13 479 Current state tax expense 3 180 3 598 3 286 Deferred Federal tax expense 6 173 3 075 4 270 Deferred state tax expense 1 778 1 127 1 577 Investment tax credit adjustments - net (948) (956) (971) Total 23 103 22 184 21 641 Included in income deductions: Current Federal tax expense 875 953 1 106 Current state tax expense (90) (123) (7) Deferred Federal tax expense (790) (1 113) (1 529) Total income tax expense $23 098 $21 901 $21 211 The components of the Company's net deferred tax liability at Dec. 31 were as follows: (Thousands of dollars) 1993 1992 Deferred tax liabilities: Differences between book and tax bases of property $91 195 $80 628 Tax benefit transfer leases 6 146 6 935 Regulatory assets 11 371 8 326 Other 398 13 Total deferred tax liabilities 109 110 95 902 Deferred tax assets: Deferred investment tax credits 9 487 9 753 Regulatory liabilities 8 726 11 310 Deferred compensation accrued vacation and other reserves not currently deductible 3 193 1 818 Other 532 567 Total deferred tax assets 21 938 23 448 Net deferred tax liability $87 172 $72 454 The Omnibus Budget Reconciliation Act of 1993 (Act) was signed into law on August 10, 1993, and increased the federal corporate income tax rate from 34 percent to 35 percent retroactive to January 1, 1993. Deferred tax liabilities were increased for the rate change by $2.7 million. However, due to the effects of regulation, earnings were reduced only by immaterial adjustments to deferred tax liabilities related to nonutility operations. 9. Segment Information Year Ended December 31 1993 1992 1991 (Thousands of dollars) Operating revenues: Electric $362 473 $345 289 $349 027 Gas 72 760 61 071 56 348 Total operating revenues $435 233 $406 360 $405 375 Operating income before income taxes: Electric $73 012 $70 202 $69 299 Gas 4 897 5 471 3 994 Total operating income before income taxes $77 909 $75 673 $73 293 Depreciation and amortization: Electric $25 179 $23 870 $22 717 Gas 3 406 2 962 2 604 Total depreciation and amortization $28 585 $26 832 $25 321 Construction expenditures: Electric $49 664 $44 332 $44 145 Gas 10 258 10 235 9 362 Total construction expenditures $59 922 $54 567 $51 507 Net utility plant: Electric $560 999 $537 576 $518 788 Gas 53 600 47 419 39 820 Total net utility plant 614 599 584 995 558 608 Other corporate assets 122 380 109 474 95 940 Total assets $736 979 $694 469 $654 548 10.Short-Term Borrowings The Company had bank lines of credit aggregating $1,000,000 at December 31, 1993. Compensating balance arrangements in support of such lines of credit were not required. These credit lines make short-term financing available by providing bank loans. During 1993 and 1992 there were no bank loans outstanding as the Company obtained short-term borrowings from the Minnesota Company at the Minnesota Company's average daily interest rate, including the cost of their compensating balance requirements. 11.Common Stock The Company's common shares have a par value of $100 per share. At December 31, 1993 and 1992, 870,000 shares were authorized and 862,000 shares were issued . 12. Summarized Quarterly Financial Data (Unaudited) Quarter Ended March 31, June 30, September December 1993 1993 30, 1993 31, 1993 (Thousands of dollars) Operating revenues $ 124 285 $ 97 107 $ 97 821 $ 116 020 Operating income 20 080 10 199 7 986 16 541 Net income 15 857 6 062 3 762 12 325 Quarter Ended March 31, June 30, September December 1992 1992 30, 1992 31, 1992 (Thousands of Dollars) Operating revenues $ 113 555 $ 91 496 $ 89 722 $ 111 587 Operating income 18 483 9 171 10 067 15 768 Net income 14 371 5 197 6 133 12 499 Item 9. Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure During 1993 there were no disagreements with the Company's independent certified public accountants on accounting procedures or accounting and financial disclosures. PART III Part III of Form 10-K has been omitted from this report in accordance with conditions set forth in general instructions J (1) (a) and (b) of Form 10-K for wholly-owned subsidiaries. Item 10. Item 10 Directors and Executive Officers of the Registrant28 Item 11 Item 11 Executive Compensation28 Item 12 Item 12 Security Ownership of Certain Beneficial Owners and Management28 Item 13 Item 13 Certain Relationships and Related Transactions28 PART IV Item 14 Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K29 SIGNATURES 41

311094_1993.txt

311094_1993

1993

311094

Item 1 Business. . . . . . . . . . . . . . . . . . . . . . . . . 2 Item 2 ITEM 2: DESCRIPTION OF PROPERTY BRANCH OFFICES AND FACILITIES The Banks are engaged in the banking business through 52 offices in eleven counties in Northern California, including twelve offices in Marin County, nine in Sonoma County, eight in Solano County, seven in Napa County, five in Contra Costa County, four in Lake County, two in Mendocino County, two in Nevada County, one in Sacramento County, one in San Francisco County and one in Placer County. All offices are constructed and equipped to meet prescribed security requirements. The Banks own fifteen banking office locations and four administrative buildings, including the Company's headquarters. Thirty-seven banking offices and two support facilities are leased. Substantially all of the leases contain multiple five-year renewal options and provisions for rental increase, principally for changes in the cost of living index, property taxes and maintenance. ITEM 3: ITEM 3: LEGAL PROCEEDINGS The Company and its subsidiaries are defendants in various legal actions which, in the opinion of management based on discussions with counsel, will be resolved with no material effect on the Company's consolidated results of operations or financial position. ITEM 4: ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to the shareholders during the fourth quarter of 1993. PART II ITEM 5: ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the American Stock Exchange (AMEX) under the symbol "WAB". The following table shows the high and low closing price for the common stock, for each quarter, as reported by AMEX. Period High Low - ----------------------------------------------------------------------- First quarter ........................... $30.25 $22.13 Second quarter ........................... 28.75 23.88 Third quarter ........................... 28.50 25.13 Fourth quarter ........................... 28.50 25.75 - ----------------------------------------------------------------------- First quarter ........................... $20.63 $18.88 Second quarter ........................... 22.25 18.50 Third quarter ........................... 22.25 18.25 Fourth quarter ........................... 23.75 19.50 As of December 31, 1993, there were 5,096 holders of record of the Company's common stock. This number does not include Napa Valley Bancorp. stockholders that as of December 31, 1993 had not yet tendered their shares for conversion to Company common stock. The Company has paid cash dividends on its common stock in every quarter since commencing operations on January 1, 1973, and it is currently the intention of the Board of Directors of the Company to continue payment of cash dividends on a quarterly basis. There is no assurance, however, that any dividends will be paid since they are dependent upon the earnings, financial condition and capital requirements of the Company and its subsidiaries. Furthermore, the Company's ability to pay future dividends is subject to contractual restrictions under the terms of three note agreements, as discussed in Note 6 to the Consolidated Financial Statements. Under the most restrictive of these contractual provisions, $17.1 million of retained earnings was available for the payment of dividends at December 31, 1993. Limitations of the Company's ability to pay dividends is discussed in Note 14 to the Consolidated Financial Statements on page 58 of this report. Additional information (required by Item 5) regarding the amount of cash dividends declared on common stock for the two most recent fiscal years is discussed in Note 16 to the Consolidated Financial Statements on page 62 of this report. *Restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. **Fully taxable equivalent *Restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. **Fully taxable equivalent ITEM 7: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion addresses information pertaining to the financial condition and results of operations of Westamerica Bancorporation (the Company) that may not be otherwise apparent from a review of the consolidated financial statements and related footnotes. It should be read in conjunction with those statements and notes found on pages 36 through 63, as well as with the other information presented throughout the report. All financial information has been restated on an historical basis to reflect the April 15, 1993 merger with Napa Valley Bancorp (the Merger) on a pooling-of-interests basis. The Company earned $9.5 million in 1993, representing a 38 percent decrease from 1992 record earnings of $15.2 million and a 21 percent reduction from 1991 earnings of $12.0 million. The 1993 results include a second quarter loss of $4.1 million, mostly due to $10.5 million after-tax merger-related charges that were taken in the form of asset write-downs, additions to the loan loss provision and other related charges. The asset write-downs and the additional loan loss provision reflect the Company's plan of asset resolution. Components of Net Income (Percent of average earning assets) 1993 1992 1991 - ------------------------------------------------------------------ Net interest income* 5.48% 5.50% 5.21% Provision for loan losses (.53) (.39) (.59) Non-interest income 1.34 1.33 1.36 Non-interest expense (5.43) (5.00) (4.82) Taxes* (.33) (.59) (.48) - ------------------------------------------------------------------- Net income .53% .85% .68% =================================================================== Net income as a percentage of average total assets .48% .77% .62% * Fully taxable equivalent (FTE) On a per share basis, 1993 net income was $1.17, compared to $1.92 and $1.52 in 1992 and 1991, respectively. During 1993, the Company continued to benefit from reductions in cost of funds, increases in service fees and other non-interest income, and expense controls. However, merger-related costs more than offset these benefits. Earnings in 1992 improved over 1991 principally due to higher net interest margin, lower provisions for loan losses and control of non-interest expense. The Company's return on average total assets was .48 percent in 1993, compared to .77 percent and .62 percent in 1992 and 1991, respectively. Return on average equity in 1993 was 6.51 percent, compared to 11.16 percent and 9.52 percent, respectively, in the two previous years. NET INTEREST INCOME Although interest rates continued to decline during most of 1993, the continuing downward repricing of interest-bearing liabilities and a more favorable composition of deposits, represented by increasing volumes of lower costing demand and savings account balances and declining volumes of higher costing time deposits, prevented declining earning-asset yields from significantly eroding the Company's net interest margin. Components of Net Interest Income (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Interest income $ 137.0 $ 154.8 $ 176.6 Interest expense (42.3) (58.9) (87.4) FTE adjustment 2.8 2.7 2.7 - ------------------------------------------------------------------- Net interest income (FTE) $ 97.5 $ 98.6 $ 91.9 - ------------------------------------------------------------------- Average interest earning assets $1,779.3 $1,793.8 $1,762.4 Net interest margin (FTE) 5.48% 5.50% 5.21% Net interest income (FTE) in 1993 decreased $1.1 million from 1992 to $97.5 million. Interest income decreased $17.8 million from 1992, due to a $14.5 million reduction in the average balance of interest earning assets and a 93 basis point decline in yields. This was partially offset by a $16.6 million decrease in interest expense, the combination of a $41.3 million decrease in the average balance of interest-bearing liabilities and a 101 basis point decline in rates paid, in part due to a more favorable composition of deposits. DISTRIBUTION OF AVERAGE ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY The following tables present, for the periods indicated, information regarding the consolidated average assets, liabilities and shareholders' equity, the amounts of interest income from average interest earning assets and the resulting yields, and the amount of interest expense paid on interest-bearing liabilities, expressed in thousand of dollars and rates. Average loan balances include non-performing loans. Interest income includes proceeds from loans on non-accrual status only to the extent cash payments have been received and applied as interest income. Yields on securities and certain loans have been adjusted upward to reflect the effect of income thereon exempt from federal income taxation at the current statutory tax rate. Amortized loan fees, which are included in interest and fee income on loans, were $1.5 million lower in 1993 than in 1992 and $2.6 million higher in 1992 than in 1991. Distribution of average assets, liabilities and shareholders' equity Yields/Rates and interest margin Full Year 1993 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $4,463 $170 3.80% Trading account securities 183 6 3.14 Investment securities 631,700 39,794 6.30 Loans: Commercial 615,981 53,990 8.76 Real estate construction 55,038 4,745 8.62 Real estate residential 168,379 13,322 7.91 Consumer 303,567 27,726 9.13 - --------------------------------------------------------------- Total interest earning assets 1,779,311 139,753 7.85 Other assets 200,561 - ------------------------------------------------------- Total assets $1,979,872 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $330,867 -- -- Savings and interest-bearing transaction 938,475 19,305 2.06% Time less $100,000 340,122 14,176 4.17 Time $100,000 or more 135,505 4,837 3.57 - --------------------------------------------------------------- Total interest-bearing deposits 1,414,102 38,318 2.71 Funds purchased 57,135 1,937 3.39 Notes and mortgages payable 17,959 2,016 11.22 - --------------------------------------------------------------- Total interest-bearing liabilities 1,489,196 42,271 2.84 Other liabilities 14,652 Shareholders' equity 145,157 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,979,872 ======================================================= Net interest spread (1) 5.01% Net interest income and interest margin (2) $97,482 5.48% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1992 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $42,964 $1,765 4.11% Trading account securities 103 4 3.67 Investment securities 534,793 40,332 7.54 Loans: Commercial 646,359 60,050 9.29 Real estate construction 76,173 7,058 9.27 Real estate residential 168,030 15,314 9.11 Consumer 325,393 33,003 10.14 - --------------------------------------------------------------- Total interest earning assets 1,793,815 157,526 8.78 Other assets 175,609 - ------------------------------------------------------- Total assets $1,969,424 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $284,366 -- -- Savings and interest-bearing transaction 903,211 26,518 2.94% Time less $100,000 406,161 20,948 5.16 Time $100,000 or more 184,799 8,365 4.53 - --------------------------------------------------------------- Total interest-bearing deposits 1,494,171 55,831 3.74 Funds purchased 15,729 698 4.44 Notes and mortgages payable 20,439 2,363 11.56 - --------------------------------------------------------------- Total interest-bearing liabilities 1,530,339 58,892 3.85 Other liabilities 18,263 Shareholders' equity 136,456 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,969,424 ======================================================= Net interest spread (1) 4.93% Net interest income and interest margin (2) $98,634 5.50% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1991 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $39,182 $2,227 5.68% Trading account securities 835 54 6.47 Investment securities 446,283 39,218 8.79 Loans: Commercial 672,999 71,512 10.63 Real estate construction 96,654 11,002 11.38 Real estate residential 150,943 15,436 10.23 Consumer 355,502 39,798 11.19 - --------------------------------------------------------------- Total interest earning assets 1,762,398 179,247 10.17 Other assets 169,089 - ------------------------------------------------------- Total assets $1,931,487 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $265,383 -- -- Savings and interest-bearing transaction 773,904 36,119 4.67% Time less $100,000 466,487 31,838 6.83 Time $100,000 or more 230,276 15,113 6.56 - --------------------------------------------------------------- Total interest-bearing deposits 1,470,667 83,070 5.65 Funds purchased 26,885 1,676 6.23 Notes and mortgages payable 22,464 2,611 11.62 - --------------------------------------------------------------- Total interest-bearing liabilities 1,520,016 87,357 5.75 Other liabilities 20,886 Shareholders' equity 125,202 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,931,487 ======================================================= Net interest spread (1) 4.42% Net interest income and interest margin (2) $91,890 5.21% =============================================================== (1) Net interest spread represents the average yield earned on interest- earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. RATE AND VOLUME VARIANCES. The following table sets forth a summary of the changes in interest income and interest expense from changes in average assets and liability balances (volume) and changes in average interest rates for the periods indicated. Changes not solely attributable to volume or rates have been allocated in proportion to the respective volume and rate components. PROVISION FOR LOAN LOSSES The provision for loan losses was $9.5 million in 1993, including a $3.1 million merger-related provision in the second quarter, reflecting a different workout strategy for loans and properties acquired in the Merger, compared to $7.0 million in 1992 and $10.4 million in 1991. The level of the provision reflects the Company's continuing efforts to improve loan quality by enforcing strict underwriting and administration procedures and aggressively pursuing collection efforts with troubled debtors. For further information regarding net credit losses and the reserve for loan losses, see the Non-Performing Assets section of this report. INVESTMENT PORTFOLIO The Company maintains a securities portfolio consisting of U.S.Treasury, U.S. Government Agencies and Corporations, State and political subdivisions, asset-backed and other securities. Investment securities are held in safekeeping by an independent custodian. 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" ("SFAS No.115"). The statement addresses the accounting and reporting for investments in equity securities that have a readily determinable fair value and for all investments in debt securities. The statement requires that all securities be classified, at acquisition, into one of three categories: held-to-maturity, available-for-sale, and trading. SFAS No. 115 is effective for fiscal years beginning after December 15, 1993; however, early implementation is permitted. The Company elected to implement SFAS No. 115 effective as of December 31, 1993. The classification of all securities is determined at the time of acquisition. In classifying securities as being held-to-maturity, available-for-sale or trading, the Banks consider their collateral needs, asset/liability management strategies, liquidity needs, interest rate sensitivity and other factors that will determine the intent and ability to hold the securities to maturity. The objective of the investment securities held-to-maturity is to strengthen the portfolio yield, and to provide collateral to pledge for federal, state and local government deposits and other borrowing facilities. The investments held-to-maturity had an average term to maturity of 47 months at December 31, 1993 and, as of the same date, those investments included $547.2 million in fixed rate and $9.9 million in adjustable rate securities. Investment securities available-for-sale are typically used to supplement the Banks' liquidity portfolio with the objective of increasing the portfolio yield. Unrealized net gains and losses on these securities are recorded as an adjustment to equity net of taxes, and are not reflected in the current earnings of the Company. If the security is sold, any gain or loss is recorded as a charge to earnings and the equity adjustment is reversed. At December 31, 1993, the Banks held $168.8 million classified as investments available-for-sale. At December 31, 1993, $2.5 million, net of taxes was recognized as the unrealized net gain related to these securities. The amount of trading securitiess at December 31, 1993, was not material. For more information on investment securities, see Notes 1 and 2 to the Consolidated Financial Statements on pages 43 to 47 of this report. The following table shows the book value of the Company's investment securities (in thousands of dollars) as of the dates indicated: December 31, 1993 1992 1991 - ----------------------------------------------------------- U.S. Treasury $249,613 $126,522 $24,411 U.S. government agencies and corporations 254,691 237,753 299,219 States and political subdivisions (domestic) 127,297 87,031 74,847 Asset backed securities 65,433 82,270 79,743 Other securities 28,842 36,660 37,404 - ----------------------------------------------------------- Total $725,876 $570,236 $515,624 =========================================================== The following table is a summary of the relative maturities (in thousands of dollars) and yields of the Company's investment securities as of December 31, 1993. Weighted average yields have been computed by dividing annual interest income, adjusted for amortization of premium and accretion of discount, by book value of the related securities. Yields on state and political subdivision securities have been calculated on a fully taxable equivalent basis using the federal tax rate of 34 percent. LOAN PORTFOLIO The following table shows the composition of loans of the Company (in thousands of dollars) by type of loan or type of borrower, on the dates indicated. Secured loans are classified by type of securities and unsecured by the purpose of the loan. Maturities and Sensitivity of Selected Loans to Changes in Interest Rates The following table shows the maturity distribution and interest rate sensitivity of Commercial and Real estate construction loans at December 31, 1993.* *Excludes loans to individuals and residential mortgages totaling $461,450. These types of loans are typically paid in monthly installments over a number of years. **Includes demand loans Commitments and Lines of Credit It is not the policy of the Company to issue formal commitments on lines of credit except to a limited number of well established and financially responsible local commercial enterprises. Such commitments can be either secured or unsecured and are typically in the form of revolving lines of credit for seasonal working capital needs. Occasionally, such commitments are in the form of Letters of Credit to facilitate the customer's particular business transaction. Commitment fees generally are not charged except where Letters of Credit are involved. Commitments and lines of credit typically mature within one year. See also Note 11 of the Consolidated Notes to the Financial Statements on page 55. RISK ELEMENTS The Company closely monitors the markets in which it conducts its lending Company's primary market areas, in Management's view such impact has not had a material, adverse effect on the Company's liquidity and capital resources. The Company continues its strategy to control its exposure to real estate development loans and increase diversification of credit risk. Asset reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. Assets receiving lesser grades fall under the classified assets category which includes all non-performing assets. These occur when known information about possible credit problems causes Management to have doubts about the ability of such borrowers to comply with loan repayment terms. These loans have varying degrees of uncertainty and may become non-performing assets. Classified assets receive an elevated level of Management attention to ensure collection. Total classified assets peaked following the second quarter Merger but declined significantly by December 31, 1993 due to extensive asset write-downs, loan collections, real estate liquidations and restructurings of the Napa Valley Bank loan portfolio reflecting the Company's workout strategy. Non-Performing Assets Non-performing assets include non-accrual loans, loans 90 days past due and still accruing, other real estate owned and loans classified as substantively foreclosed. Loans are placed on non-accrual status upon reaching 90 days or more delinquent, unless the loan is well secured and in the process of collection. Interest previously accrued on loans placed on non-accrual status is charged against interest income. Loans secured by real estate with temporarily impaired values and commercial loans to borrowers experiencing financial difficulties are placed on non-accrual status even though the borrowers continue to repay the loans as scheduled. Such loans are classied by Management as performing non-accrual and are included in total non-performing assets. Performing non-accrual loans are reinstated to accrual status when improvements in credit quality eliminate the doubt as to the full collectibility of both interest and principal. When the ability to fully collect non-accrual loan principal is in doubt, cash payments received are applied against the principal balance of the loan until such time as full collection of the remaining recorded balance is expected. Any subsequent interest received is recorded as interest income on a cash basis. Non-Performing Assets (In millions) 1993 1992 1991 1990 1989 - ---------------------------------------------------------------------------- Performing non-accrual loans $ 1.9 $ 1.1 $ 2.2 $16.0 $10.7 Non-performing non-accrual loans 7.2 14.9 37.7 9.3 -- - ---------------------------------------------------------------------------- Non-accrual loans 9.1 16.0 39.9 25.3 10.7 Loans 90 or more days past due and still accruing .3 .1 1.0 6.2 6.8 Loan collateral substantively foreclosed 5.4 16.6 7.1 6.0 6.0 Other real estate owned 12.5 17.9 4.9 2.7 4.2 - ---------------------------------------------------------------------------- Total non-performing assets $27.3 $50.6 $52.9 $40.2 $27.7 ============================================================================ Reserve for loan losses as a percentage of non-accrual loans and loans 90 or more days past due and still accruing 272% 153% 58% 60% 91% Performing non-accrual loans increased $800,000 to $1.9 million at December 31, 1993. This increase was principally due to one condominium construction loan. Non-performing non-accrual loans decreased $7.7 million to $7.2 million at December 31, 1993 due to loan collections, write-downs, foreclosure of loan collateral and reclassifications to loan collateral substantively foreclosed. Both loan collateral substantively foreclosed and other real estate owned declined $16.6 million due to asset write-downs and liquidations. The amount of gross interest income that would have been recorded for non-accrual loans for the year ending December 31, 1993, if all such loans had been current in accordance with their original terms while outstanding during the period, was $980,000. The amount of interest income that was recognized on non-accrual loans from cash payments made during the year ended December 31, 1993 totaled $345,000, representing an annualized yield of 3.06 percent. Cash payments received which were applied against the book balance of performing and non-performing non-accrual loans outstanding at December 31, 1993, totaled $534,000 compared to $104,000 in 1992. Restructured loans totaled $4,432,000 at December 31, 1993, $319,000 at December 31, 1992, $2,892,000 at December 31, 1991 $2,200,000, at December 31, 1990 and $5,927,000 at December 31, 1989. CREDIT LOSS EXPERIENCE The Company's reserve for loan losses is maintained at a level estimated by Management to be adequate to provide for losses that can be reasonably credit loss experience, the amount of past due, non-performing and classified loans, recommendations of regulatory authorities, prevailing economic conditions and other factors. Initially, the reserve is allocated to segments of the loan portfolio based in part on quantitative analyses of historical credit loss experience. Criticized and classied loan balances are analyzed using both a linear regression model and standard allocation percentages. The results of this analysis are applied to current criticized and classied loan balances to allocate the reserve to the respective segments of the loan portfolio. In addition, loans with similar characteristics not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on the historical rate of net losses and delinquency trends and are grouped by the number of days the payment on those loans are delinquent. While these factors are essentially judgmental and may not be reduced to a mathematical formula, Management considers that the $25.6 million reserve for loan losses, which constituted 2.30 percent of total loans at December 31, 1993, to be adequate as a reserve against inherent losses. Management continues to evaluate the loan portfolio and assess current economic conditions that will dictate future reserve levels. In May 1993, the Financial Accounting Standards Board (FASB) issued statement No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114) which addresses the accounting treatment of certain impaired loans and amends FASB Statements No. 5 and No. 15. SFAS 114 does not address the overall adequacy of the allowance for loan losses. SFAS 114 is effective January 1, 1995 but earlier implementation is encouraged. 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. Under SFAS 114, impairment is measured based on the present value of the expected future cash flows discounted at the loans effective interest rate. Alternatively, impairment may be measured by using the loans observable market price or the fair value of the collateral if repayment is expected to be provided solely by the underlying collateral. The Company intends to implement SFAS 114 in January 1995. The impact of implementation on the financial statements has not been determined, since measurement will be contingent upon the inventory of impaired loans outstanding as of January 1, 1995. ALLOCATION OF RESERVE FOR LOAN LOSSES The reserve for loan losses has been established to absorb possible future losses throughout the loan portfolio and off balance sheet credit risk. The Company's reserve for loan losses is maintained at a level estimated by management to be adequate to provide for losses that are reasonably foreseeable based upon specific conditions and other factors. The reserve is allocated to segments of the loan portfolio based in part upon quantitative analyses of historical net losses relative to loan balances outstanding. Criticized and classified loan balances, as identified by management using criteria similar to those used by the Banks' regulators, and historical net losses on those balances are analyzed using both a linear regression and standard allocation percentages model. The results of this statistical analysis are applied to current criticized and classified loan balances to allocate the reserve for loan losses to the respective segments of the loan portfolio. In addition, homogeneous loans, which are not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on historical rates of net loan losses experienced for loans grouped by the number of days payments are delinquent. Such rates of net loan losses are applied to the current aging of homogeneous loans to allocate the reserve for loan losses. Management may judgmentally adjust the allocation of the reserve for loan losses based on changes in underwriting standards, anticipated rates of net loan losses which may differ from historical experience, economic conditions, the experience of credit officers and any other factors considered pertinent. Management's continuing evaluation of the loan portfolio and assessment of current economic conditions will dictate future reserve levels. The following tables present the allocation of the loan loss reserve balance on the dates indicated: (in thousands) December 31 1993 1992 - ------------------------------------------------------------------------------- Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans - ------------------------------------------------------------------------------- Commercial $12,537 55.0% $13,551 53.4% Real estate construction 2,538 3.6 964 5.4 Real estate residential 85 15.5 545 14.8 Consumer 3,921 25.9 3,872 26.4 Unallocated portion of reserve 6,506 -- 5,810 -- - ------------------------------------------------------------------------------- Total $25,587 100.0% $24,742 100.0% =============================================================================== (in thousands) December 31 1991 1990 - ------------------------------------------------------------------------------ Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans -------- -------- -------- -------- Commercial $8,325 52.7% $2,698 52.5% Real estate construction 2,336 7.1 4,360 9.5 Real estate residential 50 12.9 29 10.4 Consumer 2,363 27.3 1,782 27.6 Unallocated portion of reserve 10,779 -- 10,132 -- - ------------------------------------------------------------------------------- Total $23,853 100.0% $19,001 100.0% =============================================================================== (in thousands) December 31 1989 - ------------------------------------------------------------ Loans as Allocation Percent of of reserve Total Type of loan balance Loans -------- -------- Commercial $5,216 52.4% Real estate construction 2,709 11.9 Real estate residential 0 10.3 Consumer 853 25.4 Unallocated portion of reserve 7,182 -- - ------------------------------------------------------------- Total $15,960 100.0% ============================================================= The reduced allocation to commercial loans from December 31, 1992 to December 31, 1993 is primarily due to a reduction in the balance of criticized loans. The increased allocation to construction loans over the same period is attributable to an increase in criticized loans due to the recessionary environment. The increase in the unallocated portion of the reserve is due to the establishment of an additional "recessionary reserve" to recognize the potential for increased chargeoffs. The changes in the allocation to loan portfolio segments from December 31, 1991 to December 31, 1992 reflect changes in criticized and classified loan balances. The decreased allocation to construction loans is attributable to a decrease in criticized loans due to full collection or principal reducing payments received from customers. The increased allocation to commercial and consumer loans is attributable to a reduced level of recoveries. ASSET AND LIABILITY MANAGEMENT The fundamental objective of the Company's management of assets and liabilities is to maximize its economic value while maintaining adequate liquidity and a conservative level of interest-rate risk. The principal sources of asset liquidity are investment securities available for sale. At December 31, 1993, investment securities available for sale totaled $168.8 million. The Company generates significant liquidity from its operating activities. The Company's profitability in 1993, 1992 and 1991 generated substantial increases in the cash flow provided from operations for such years to $28.4 million, $33.4 million and $26.7 million, respectively. Additional cash flow is provided by financing activities, primarily the acceptance of customer deposits and short-term borrowings from banks. After a considerable increase in deposits in 1991 of $66.2 million, growth was only $600,000 in 1992 and the Company experienced a decline of $58.7 million in 1993 mostly due to deposits sold in connection with the sale of Sonoma Valley Bank. In addition to a $57.0 million compensating increase in short-term borrowings in 1993, Westamerica Bank issued in December a ten-year, $20.0 million subordinated capital note that qualifies as Tier II Capital and will be used as a source of liquidity for working capital purposes. The Company uses cash flows from operating and financing activities to make investments in loans, money market assets and investment securities. Continuing with the strategy to reduce its exposure to real estate development loans, net loan repayments were $68.1 million, $32.8 million and $15.5 million in 1993, 1992 and 1991, respectively. The net repayment of loans resulted in added liquidity for the Company, which was used to increase its investment securities portfolios by $153.4 million, $75.8 million and $130.0 million in 1993, 1992 and 1991, respectively. Interest rate risk is influenced by market forces. However, that risk may be controlled by monitoring and managing the repricing characteristics of assets and liabilities. In evaluating exposure to interest rate risk, the Company considers the effects of various factors in implementing interest rate risk management activities, including the utilization of interest rate swaps. Interest rate swaps outstanding at December 31, 1993 had aggregate notional amounts of $110.0 million of which $50.0 million matures in 1994 and $60.0 million matures in 1995. These interest rate swaps were entered into to hedge the adverse impact interest rate fluctuations have on interest-bearing transaction and savings deposits in the current interest rate environment. The primary analytical tool used by Management to gauge interest-rate sensitivity is a simulation model used by many major banks and bank regulators. This industry standard model is used to simulate the effects on net interest income of changes in market interest rates that are up to 2 percent higher or 2 percent lower than current levels. The results of the model indicate that the mix of interest rate sensitive assets and liabilities at December 31, 1993 would not, in the view of Management, expose the Company to an unacceptable level of interest rate risk. CAPITAL RESOURCES The Company's capital position represents the level of capital available to support continued operations and expansion. The Company's primary captial resource is shareholders' equity, which increased $8.8 million or 6.1 percent from the previous year end and increased $23.0 million or 17.8 percent from December 31, 1991. As a result of the Company's profitability, the retention of earnings and slow asset growth, the ratio of equity to total assets increased to 7.6 percent at December 31, 1993, up from 7.3 percent at December 31, 1992 and 6.6 percent at December 31, 1991. Tier I risk-based capital to risk-adjusted assets increased to 11.11 percent at December 31, 1993, from 10.02 percent at year end 1992. The ratio of total risk-based capital to risk-adjusted assets increased to 14.40 percent at December 31, 1993, from 12.01 percent at December 31, 1992. Capital to Risk-Adjusted Assets Minimum Regulatory Capital Minimum Regulatory Capital At December 31, 1993 1992 Requirements - ----------------------------------------------------------- Tier I Capital 11.11% 10.02% 4.00% Total Capital 14.40 12.01 8.00 Leverage ratio 7.42 7.39 4.00 The risk-based capital ratios improved in 1993 due to two factors: equity capital grew at a faster rate than total assets, and the decline in loan volumes and increase in investment securities reduced the level of risk-adjusted assets. FINANCIAL RATIOS The following table shows key financial ratios for the periods indicated. For the Years Ended 1993 1992 1991 - ------------------------------------------------------------------------- Return on average total assets 0.48% 0.77% 0.62% Return on average shareholders' equity 6.51% 11.16% 9.52% Average shareholders' equity as a percent of: Average total assets 7.33% 6.93% 6.48% Average total loans 12.70% 11.22% 9.81% Average total deposits 8.32% 7.67% 7.21% DEPOSITS The following table sets forth, by time remaining to maturity the Company's domestic time deposits in amounts of $100,000 or more (in thousands of dollars). Time Remaining to Maturity December 31, 1993 1992 1991 - ------------------------------------------------------------ Three months or less $73,988 $92,581 $139,487 Three to six months 23,817 46,378 58,564 Six months to 12 months 10,503 12,895 10,695 Over 12 months 4,685 6,630 6,699 - ------------------------------------------------------------ Total $112,993 $158,484 $215,445 ============================================================ See additional disclosures in Note 6 to Consolidated Financial statements on page 52 of this report. SHORT-TERM BORROWINGS The following table sets forth the short-term borrowings of the Company. (In thousands) December 31 1993 1992 1991 - ----------------------------------------------------------------------- Federal funds purchased $25,000 $ -- $ -- Other borrowed funds: Retail repurchase agreements 28,038 4,099 3,204 Other 16,026 7,939 6,366 - ----------------------------------------------------------------------- Total other borrowed funds $44,064 $12,038 $9,570 - ----------------------------------------------------------------------- Total funds purchased $12,038 $12,038 $9,570 ======================================================================= Further details of the other borrowed funds are: (In thousands) December 31 1993 1992 1991 - ------------------------------------------------------------------------ Outstanding Average during the year $37,284 $11,509 $18,865 Maximum during the year 68,608 19,055 44,558 Interest rates Average during the period 3.13% 4.73% 6.51% Average at period end 3.04 3.23 6.80 NON-INTEREST INCOME Components of Non-Interest Income (In millions) 1993 1992 1991 - ----------------------------------------------------------------------- Service charges on deposit accounts $ 12.8 $ 12.4 $ 12.1 Merchant credit card 2.2 2.9 2.9 Mortgage banking income 1.5 1.8 1.5 Brokerage commissions .8 .6 .4 Net investment securities gains -- 1.1 1.7 Sale of Sonoma Valley Bank .7 -- -- Automobile receivable servicing 1.3 -- .5 Other 4.6 5.0 4.9 - ----------------------------------------------------------------------- Total $ 23.9 $ 23.8 $ 24.0 ======================================================================= Non-interest income increased to $23.9 million in 1993. Higher income from servicing automobile receivables, the sale of the Company's 50 percent interest in Sonoma Valley Bank, higher brokerage commissions, increased fees from deposit services, gains recognized on the sale of Napa Valley Bancorp cardholder portfolio and lower write-offs of mortgage service receivables, were partially offset by lower credit card merchant fees and lower mortgage servicing fees. 1992 non-interest income also reflects $1.1 million gains on the sale of investment securities held for sale. In 1992, non-interest income decreased $200,000 from the previous year, resulting principally from lower gains of investment securities held-for-sale and lower income from servicing automobile receivables partially offset by higher deposit account fees, mortgage banking income and brokerage commissions. NON-INTEREST EXPENSE Components of Non-Interest Expense (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Salaries $ 31.6 $ 33.7 $ 34.7 Other personnel benefits 7.4 7.2 7.1 Other real estate owned 13.2 6.2 2.9 Occupancy 8.6 8.5 8.4 Equipment 6.2 5.3 5.5 FDIC insurance assessment 4.1 4.0 3.5 Data processing 3.7 3.1 3.0 Professional fees 3.1 3.3 3.3 Operational losses 2.0 .7 .5 Stationery and supplies 1.9 1.7 1.8 Advertising and public relations 1.8 1.8 2.0 Loan expense 1.6 1.4 1.3 Merchant credit card 1.1 1.7 1.9 Insurance .9 1.0 .7 Other 9.4 10.0 8.3 - ------------------------------------------------------------------- Total $ 96.6 $ 89.6 $ 84.9 =================================================================== Average full-time equivalent staff 905 1,092 1,148 Non-interest expense increased $7.0 million or 8 percent in 1993 compared with an increase of $4.7 million or 6 percent in 1992. The increase in 1993 is the direct result of merger-related foreclosed real estate owned expenses, reflecting a $10.0 million write-down of assets acquired in the Merger to fair value net of estimated selling costs reflecting the implementation of the Company's workout strategy, and other costs associated with the Merger, including $1.2 million in relocation costs, chargeoffs of $921,000 for obsolete furniture and equipment, $745,000 in investment banker fees, and other merger-related costs totaling approximately $1.2 million. Partially offsetting these increases in 1993 non-interest expense, salaries decreased $2.1 million, or 6 percent, reflecting the benefits realized from consolidation of operations after the Merger. Merchant credit card, professional fees and insurance expenses also decreased from 1992. The ratio of average assets per full-time equivalent staff was $2.2 million in 1993 compared to $1.8 million in 1992; the Company strategy to improve efficiency can be clearly seen in the reduction of the average number of full-time equivalent staff from 1,092 in 1992 to 905 in 1993. PROVISION FOR INCOME TAX The provision for income tax decreased $4.9 million in 1993 as a direct result of lower pretax income and a $394,000 revaluation adjustment of deferred tax assets due to an increase in statutory tax rates. The provision was $3.0 million in 1993 compared to $7.9 million in 1992 and $5.8 million in 1991. The higher provision in 1992 is a direct result of higher pretax income. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Consolidated Balance Sheets as of December 31, 1993 and 1992 36 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 38 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 40 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 41 Notes to Consolidated Financial Statements 43 Management's Letter of Financial Responsibility 67 Independent Auditors' Report 68 CONSOLIDATED BALANCE SHEETS (In thousands) December 31, 1993 1992* - --------------------------------------------------------------------------- Assets Cash and cash equivalents (Note 14) $ 102,618 $ 139,497 Money market assets 250 1,366 Trading account securities 10 -- Investment securities available-for-sale (Note 2) 168,819 -- Investment securities held-to-maturity; market value of $563,563 in 1993 and $581,768 in 1992 (Note 2) 557,057 570,236 Loans, net of reserve for loan losses of: $25,587 at December 31, 1993 $24,742 at December 31, 1992 (Notes 3, 4 and 13) 1,089,152 1,166,205 Loan collateral substantively foreclosed and other real estate owned 17,905 34,506 Land held for sale 800 1,123 Investment in joint venture 766 1,026 Premises and equipment, net (Notes 5 and 6) 25,341 26,959 Interest receivable and other assets (Note 8) 41,701 40,431 - --------------------------------------------------------------------------- Total assets $2,004,419 $1,981,349 =========================================================================== Liabilities Deposits: Non-interest bearing $ 369,820 $ 323,719 Interest bearing: Transaction 289,322 369,871 Savings 654,766 564,763 Time (Notes 2 and 6) 417,320 531,565 - --------------------------------------------------------------------------- Total deposits 1,731,228 1,789,918 Funds purchased 69,064 12,038 Liability for interest, taxes, other expenses, minority interest and other (Note 8) 15,328 16,382 Notes and mortgages payable (Notes 6 and 14) 36,352 19,337 - --------------------------------------------------------------------------- Total liabilities 1,851,972 1,837,675 Commitments and contingent liabilities (Notes 4, 10 and 11) -- -- Shareholders' Equity (Notes 7 and 14) Common stock (no par value) Authorized- 20,000 shares Issued and outstanding- 8,080 shares in 1993 and 8,000 shares in 1992 52,499 51,053 Capital surplus 10,831 10,831 Unrealized gains on securities available for sale (Note 2) 2,527 -- Retained earnings 86,590 81,790 - --------------------------------------------------------------------------- Total shareholders' equity 152,447 143,674 - --------------------------------------------------------------------------- Total liabilities and shareholders' equity $2,004,419 $1,981,349 =========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------- Interest Income Loans $ 99,607 $115,357 $137,656 Money market assets and federal funds sold 298 1,745 2,191 Trading account securities 6 4 54 Investment securities: U.S. Treasury 10,284 4,484 6,159 Securities of U.S. government agencies and corporations 13,994 18,802 18,406 Obligations of states and political subdivisions 5,894 5,358 5,272 Asset backed 4,942 5,809 5,675 Other 1,891 3,194 1,139 - --------------------------------------------------------------------- Total interest income 136,916 154,753 176,552 - --------------------------------------------------------------------- Interest Expense Transaction deposits 4,219 7,680 13,371 Savings deposits 15,085 18,838 22,748 Time deposits (Note 6) 19,014 29,314 46,950 Funds purchased 1,937 698 1,677 Notes and mortgages payable (Note 6) 2,016 2,362 2,611 - --------------------------------------------------------------------- Total interest expense 42,271 58,892 87,357 - --------------------------------------------------------------------- Net Interest Income 94,645 95,861 89,195 Provision for loan losses (Note 3) 9,452 7,005 10,418 - --------------------------------------------------------------------- Net interest income after provision for loan losses 85,193 88,856 78,777 - --------------------------------------------------------------------- Non-Interest Income Service charges on deposit accounts 12,809 12,437 12,056 Merchant credit card 2,217 2,900 2,881 Mortgage banking 1,467 1,808 1,457 Brokerage commissions 839 555 392 Net investment securities gain 68 1,066 1,742 Other 6,546 5,061 5,448 - --------------------------------------------------------------------- Total non-interest income 23,946 23,827 23,976 - --------------------------------------------------------------------- Non-Interest Expense Salaries and related benefits (Note 12) 39,007 40,826 40,252 Other real estate owned 11,550 5,183 2,884 Occupancy (Notes 5 and 10) 8,625 8,524 8,401 Equipment (Notes 5 and 10) 6,195 5,302 5,522 FDIC insurance assessment 4,079 4,021 3,545 Data processing 3,658 3,137 2,964 Professional fees 3,071 3,332 3,346 Other 20,460 19,279 18,029 - ---------------------------------------------------------------------- Total non-interest expense 96,645 89,604 84,943 - ---------------------------------------------------------------------- Income Before Income Taxes 12,494 23,079 17,810 Provision for income taxes (Note 8) 3,039 7,857 5,833 - ---------------------------------------------------------------------- Net Income $ 9,455 $ 15,222 $ 11,977 ====================================================================== Average common shares outstanding 8,054 7,933 7,855 Per Share Data (Notes 7 and 17) Net income $ 1.17 $ 1.92 $ 1.52 Dividends declared .57 .51 .44 *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $ 15,222 $ 11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,622 4,198 4,189 Loan loss provision 9,452 7,005 10,418 Amortization of net deferred loan (cost)/fees (462) 615 433 (Increase) decrease in interest income receivable (2,542) 1,070 1,698 Decrease (increase) in other assets 2,888 (3,204) 2,062 Decrease in income taxes payable (1,529) (1,179) (2,752) Decrease in interest expense payable (1,169) (1,933) (1,145) (Decrease) increase in accrued expenses (1,809) 1,420 (405) Net gain on sale of investment securities (68) (1,066) (1,742) Loss (gain) on sale of developed land -- 2,930 (107) Loss (gains) on sales/write-down of premises and equipment 1,476 225 (86) Originations of loans for resale (92,374) (100,055) (102,300) Proceeds from sale of loans originated for resale 92,536 103,855 102,019 Loss on sale/write-down of property acquired in satisfaction of debt 9,618 3,507 2,559 Gain on sale of Sonoma Valley Bank (668) -- -- Net (purchases) maturities of trading securities (10) 779 (130) - --------------------------------------------------------------------------- Net cash provided by operating activities 28,416 33,389 26,688 - --------------------------------------------------------------------------- Investing Activities Net repayments of loans 68,109 32,782 15,470 Purchases of money market assets (325) (16,833) (34,551) Purchases of investment securities (427,886) (339,583) (269,505) Purchases of property, plant and equipment (3,481) (4,416) (5,161) Improvements on developed land -- (1,435) -- Proceeds from maturity/sale of money market assets 1,441 17,574 34,301 Proceeds from maturity of securities 274,451 263,793 139,549 Proceeds from sale of securities 184 21,128 49,580 Proceeds from sale of property and equipment -- 1,640 858 Net proceeds from sale of developed land 356 1,928 107 Proceeds from disposition of property acquired in satisfaction of debt 6,313 4,513 624 Proceeds from sale of Sonoma Valley Bank 2,733 -- -- Net repayments on loan collateral substantively foreclosed 669 1,187 629 - --------------------------------------------------------------------------- Net cash used in investing activities (77,436) (17,722) (68,099) - --------------------------------------------------------------------------- Financing Activities Net increase (decrease) in deposits (58,691) 617 66,203 Net (decrease) increase in federal funds purchased 57,026 2,468 (25,529) Proceeds from issuance of capital notes 20,000 -- -- Principal payments on notes and mortgages payable (2,985) (2,423) (1,672) Exercise of stock options 1,446 2,214 1,525 Retirement of stock -- (204) (843) Unrealized loss (gain) in marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - --------------------------------------------------------------------------- Net cash provided by (used in) financing activities 12,141 (306) 36,634 - --------------------------------------------------------------------------- Net (decrease) increase in cash and cash equivalents (36,879) 15,361 (4,777) Cash and cash equivalents at beginning of year 139,497 124,136 128,913 - --------------------------------------------------------------------------- Cash and cash equivalents at end of year $102,618 $139,497 $124,136 =========================================================================== Supplemental disclosures: Loans transferred to other real estate owned and substantively repossessed $16,111 $36,572 $9,132 Interest paid 42,982 57,491 87,163 Income tax payments 5,700 9,773 9,045 Unrealized gain on securities available for sale 2,527 -- -- *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. Westamerica Bancorporation NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: Business and Accounting Policies Westamerica Bancorporation, a registered bank holding Company, (the Company), provides a full range of banking services to individual and corporate customers in Northern California through its subsidiary banks (the Banks), Westamerica Bank and Subsidiary, Bank of Lake County and Napa Valley Bank and Subsidiary. The Banks are subject to competition from other financial institutions and to regulations of certain agencies and undergo periodic examinations by those regulatory authorities. Summary of Significant Accounting Policies The consolidated financial statements are prepared in conformity with generally accepted accounting principles and general practices within the banking industry. The following is a summary of significant accounting policies used in the preparation of the accompanying financial statements. In preparing the financial statements, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods indicated. Principles of Consolidation. The financial statements include the accounts of the Company, a registered bank holding company, and all the Company's subsidiaries which include the Banks and Community Banker Services Corporation and Subsidiary. Significant intercompany transactions have been eliminated in consolidation. All data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Cash Equivalents. Cash equivalents include Due From Banks balances and Federal Funds Sold which are both readily convertible to known amounts of cash and are so near their maturity that they present insignificant risk of changes in value because of interest rate volatility. Securities. Marketable investment securities at December 31, 1993 consist of U.S. Treasury, U. S. Government Agencies and Corporations, Municipal, asset-backed and other securities. The Company adopted the provisions of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 115) at December 31, 1993. Under SFAS No. 115, the Company classifies its debt and marketable equity securities into one of three categories: trading, available-for-sale or held-to-maturity. Trading securities are bought and held principally for the purpose of selling in the near term. Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held-to-maturity are classied as available-for-sale. Trading and available-for-sale securities are recorded at fair value. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Unrealized gains and losses on trading securities are included in earnings. Unrealized gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of shareholders' equity until realized. Unrealized gains and losses associated with transfers of securities from held-to-maturity to available-for-sale are recorded as a separate component of shareholders' equity. The unrealized gains or losses included in the separate component of shareholders' equity for securities transferred from available-for-sale to held-to-maturity are maintained and amortized into earnings over the remaining life of the security as an adjustment to yield in a manner consistent with the amortization or accretion of premium or discount on the associated security. A decline in the market value of held-to-maturity and available-for-sale securities below cost that is deemed other than temporary, results in a charge to earnings and the establishment of a new cost basis for the security. Premiums and discounts are amortized or accreted over the life of the related investment security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities classied as available-for-sale and held-to-maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Loans and Reserve for Loan Losses. The reserve for loan losses is a combination of specific and general reserves available to absorb estimated future losses in the loan portfolio and is maintained at a level considered adequate to provide for such losses. Credit reviews of the loan portfolio, designed to identify problem loans and to monitor these estimates, are conducted continually, taking into consideration market conditions, current and anticipated developments applicable to the borrowers and the economy, and the results of recent examinations by regulatory agencies. Management approves the conclusions resulting from credit reviews. Ultimate losses may vary from current estimates. Adjustments to previous estimates of loan losses are charged to income in the period which they become known. Unearned interest on discounted loans is amortized over the life of these loans, using the sum-of-the-months digits method for which the results are not materially different from those obtained by using the interest method. For all other loans, interest is accrued daily on the outstanding balances. Loans which are more than 90 days delinquent with respect to interest or principal, unless they are well secured and in the process of collection, and other loans on which full recovery of principal or interest is in doubt, are placed on non-accrual status. Non-refundable fees and certain costs associated with originating or acquiring loans are deferred and amortized as an adjustment to interest income over the estimated respective loan lives. Loans held for sale are identified upon origination and are reported at the lower of cost or fair value on an individual loan basis. Other Real Estate Owned and Loan Collateral Substantively Foreclosed. Other real estate owned includes property acquired through foreclosure or forgiveness of debt. These properties are transferred at fair value, which becomes the new cost basis of the property. Losses recognized at the time of acquiring property in full or partial satisfaction of loans are charged against the reserve for loan losses. Subsequent losses incurred due to the declines in property values as identified in independent property appraisals are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. The Company classifies loans as loan collateral substantively foreclosed (substantive repossessions) when the borrower has little or no equity in the collateral, when proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral, and the debtor has either formally or effectively abandoned control of the collateral to the Company or has retained control of the collateral but, because of the current financial condition of the debtor or the economic prospects for the debtor and/or collateral in the foreseeable future, it is doubtful that the debtor will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. Losses recognized at the time the loans are reclassified as substantive repossessions are charged against the reserve for loan losses. Subsequent losses incurred due to subsequent declines in property values, as identified in independent property appraisals, are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. Premises and Equipment. Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful life of each type of asset. Estimated useful lives of premises and equipment range from 20 to 50 years and from 3 to 20 years, respectively. Leasehold improvements are amortized over the terms of the lease or their estimated useful life, whichever is shorter. Fully depreciated and/or amortized assets are removed from the Company's balance sheet. Interest Rate Swap Agreements. The Company uses interest rate swap agreements as an asset/liability management tool to reduce interest rate risk. Interest rate swap agreements are exchanges of fixed and variable interest payments based on a notional principal amount. The primary risk associated with swaps is the exposure to movements in interest rates and the ability of the counter parties to meet the terms of the contracts. The Company controls the credit risk of the these agreements through credit approvals, limits and monitoring procedures. The Company is not a dealer but an end user of these instruments and does not use them speculatively. Accounted for as hedges, the differential to be paid or received on such agreements is recognized over the life of the agreements. Payments made or received in connection with early termination of interest rate swap agreements are recognized over the remaining term of the swap agreement. Earnings Per Share. Earnings per share amounts are computed on the basis of the weighted average of common shares outstanding during each of the years presented. Income Taxes. The Company and its subsidiaries file consolidated tax returns. For financial reporting purposes, the income tax effects of transactions are recognized in the year in which they enter into the determination of recorded income, regardless of when they are recognized for income tax purposes. Accordingly, the provisions for income taxes in the consolidated statements of income include charges or credits for deferred income taxes relating to temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Other. Securities and other property held by the Banks in a fiduciary or agency capacity are not included in the financial statements since such items are not assets of the Company or its subsidiaries. Certain amounts in prior years financial statements have been reclassified to conform with the current years presentation. These reclassifications had no effect on previously reported income. Note 2: Investment Securities An analysis of investment securities available-for-sale as of December 31, 1993, is as follows: *Includes $24.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.4 million; 1 to 5 years $15.2 million. The average yield of these securities is 5.56 percent. An analysis of investment securities held-to-maturity as of December 31, 1993, is as follows: *Includes $162.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.9 million; 1 to 5 years $9.3 million; 5 to 10 years $71.3 million; over 10 years $72.1 million. These securities have a market value of $162.4 million and an average yield of 5.45 percent. As of December 31, 1993, $173.5 million of investment securities held-to- maturity were pledged to secure public deposits. A summary of investment securities portfolio held-to-maturity as of December 31, 1992, is as follows: Gross Gross Book unrealized unrealized Fair Value gains losses Value - -------------------------------------------------------------------- U.S. Treasury securities $126,522 $2,208 ($156) $128,574 Securities of U.S. Govt. Agencies and Corporations 237,753 4,919 (517) 242,155 Obligations of States and Political Subdivisions 87,031 3,655 (197) 90,489 Asset Backed (Automobile Receivables) 82,270 1,040 (105) 83,205 Other Securities (Preferred Stocks & Corporate Bonds) 36,660 735 (50) 37,345 - -------------------------------------------------------------------- Total Securities Held-to-maturity $570,236 $12,557 ($1,025) $581,768 ==================================================================== Note 3: Loans and Reserve for Loan Losses Loans at December 31, consisted of the following: (In thousands) 1993 1992 - ------------------------------------------------------- Commercial $ 266,448 $ 439,494 Real estate-commercial 346,308 196,401 Real estate-construction 40,533 63,886 Real estate-residential 172,245 175,834 Installment and personal 304,993 334,215 Unearned income (15,788) (18,883) - ------------------------------------------------------- Gross loans 1,114,739 1,190,947 Loan loss reserve (25,587) (24,742) - ------------------------------------------------------- Net loans $1,089,152 $1,166,205 ======================================================= Included in real estate-residential at December 31, 1993 and 1992 are loans held for resale of $5.9 million and $3.6 million, respectively, the cost of which approximates market value. Changes in the loan loss reserve were: (In thousands) 1993 1992 1991 - ------------------------------------------------------------------ Balance at January 1, $24,742 $23,853 $19,002 Sale of Sonoma Valley Bank (684) -- -- Provision for loan losses 9,452 7,005 10,418 Credit losses (10,091) (8,794) (9,140) Credit loss recoveries 2,168 2,678 3,573 - ------------------------------------------------------------------ Balance at December 31, $25,587 $24,742 $23,853 ================================================================== Restructured loans were $4.4 million and $319,000 at December 31, 1993 and 1992, respectively. The following is a summary of interest foregone on restructured loans for the years ended December 31: (In thousands) 1993 1992 1991 - ------------------------------------------------------------- Interest income that would have been recognized had the loans performed in accordance with their original terms $472 $135 $173 Less: Interest income recognized on restructured loans (218) -- (8) - ------------------------------------------------------------- Interest foregone on restructured loans $254 $135 $165 ============================================================= Note 4: Concentrations of Credit Risk The Company's business activity is with customers in Northern California. The loan portfolio is well diversified with no industry comprising greater than ten percent of total loans outstanding as of December 31, 1993. The Company has a significant number of credit arrangements that are secured by real estate collateral. In addition to real estate loans outstanding as disclosed in Note 3, the Company had loan commitments and stand by letters of credit related to real estate loans of $18.7 million at December 31, 1993. The Company requires collateral on all real estate loans and generally attempts to maintain loan-to-value ratios no greater than 75 percent on commercial real estate loans and no greater than 80 percent on residential real estate loans. Note 5: Premises and Equipment A summary as of December 31, follows: Accumulated Depreciation and Net (In thousands) Cost Amortization Book Value - ------------------------------------------------------------------------- Land $ 3,735 $ -- $ 3,735 Buildings and improvements 20,072 (6,876) 13,196 Leasehold improvements 2,537 (1,513) 1,024 Furniture and equipment 14,347 (6,961) 7,386 - ------------------------------------------------------------------------- Total $40,691 $(15,350) $25,341 ========================================================================= Land $5,483 $ -- $ 5,483 Buildings and improvements 19,131 (7,225) 11,906 Leasehold improvements 4,878 (2,929) 1,949 Furniture and equipment 19,711 (12,090) 7,621 - ------------------------------------------------------------------------- Total $49,203 $(22,244) $26,959 ========================================================================= Depreciation and amortization included in non-interest expense amount to $3,621,800 in 1993, $4,198,000 in 1992 and $4,189,400 in 1991. Note 6: Borrowed Funds Notes payable include the unsecured obligations of the Company as of December 31, 1993 and 1992, as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------------ Unsecured note dated September, 1976, interest payable semiannually at 9 7/8% and principal payments of $267 due annually to September 1, 1996. $ 196 $ 463 Unsecured note dated May, 1984, interest payable quarterly at 12.95% and principal payments of $1,000 due annually beginning September 1, 1991 and ending on September 1, 1996. Note agreement provides for partial prepayment under certain conditions without penalty and for prepayment of all or a portion of the note under certain conditions with a premium which decreases over the contractual term. 2,100 3,100 Equity contract notes, originated in April 1986 and maturing on April 1, 1996. Interest payable semiannually at 11 5/8% and principal payments of $2,500 due annually, on April 1, starting in 1993. 7,500 10,000 Senior notes, originated in May 1988 and maturing on June 30, 1995. Interest payable semiannually at 10.87% and principal payment due at maturity. 5,000 5,000 Subordinated note, issued by Westamerica Bank, originated in December 1993 and maturing September 30, 2003. Interest at an annual rate of 6.99% payable semiannually on March 31 and September 30, with principal due at maturity. 20,000 -- - ------------------------------------------------------------------------ Total notes payable $34,796 $18,563 ======================================================================== Mortgages payable of $524,000 consist of a note of Westamerica Bank secured by a deed of trust on premises having a net book value of $790,000 and $824,000 at December 31, 1993 and 1992, respectively. The note, which has an effective interest rate of 10 percent, is scheduled to mature in April 1995. Included in notes and mortgages payable are senior liens on other real estate, land held for sale and investments in joint venture properties that totaled $1,032,000 and $250,000 at December 31, 1993 and 1992, respectively. The combined aggregate amount of maturities of notes payable is $3,696,000, $8,500,000, $2,600,000, $0 and $0 for the years 1994 through 1998, and $20,000,000 thereafter. At December 31, 1993, the Company had unused lines of credit amounting to $7,500,000. Compensating balance arrangements are not significant to the operations of the Company. At December 31, 1993, the Banks had $113.0 million in time deposit accounts in excess of $100,000; interest on these accounts in 1993 was $4,837,000. Note 7: Shareholders' Equity In April 1982, the Company adopted an Incentive Stock Option Plan and 413,866 shares were reserved for issuance. Under this plan, all options are currently exercisable and terminate 10 years from the date of the grant. Under the Stock Option Plan adopted by the Company in 1985, 750,000 shares have been reserved for issuance. Stock appreciation rights, incentive stock options, non-qualified stock options and restricted performance shares are available under this plan. Options are granted at fair market value and are generally exercisable in equal installments over a three-year period with the first installment exercisable one year after the date of the grant. Each incentive stock option has a maximum ten-year term while non-qualified stock options may have a longer term. The 1985 plan was amended in 1990 to provide for restricted performance share (RPS) grants. An RPS grant becomes fully vested after three years of being awarded, provided that the Company has attained its performance goals for such three-year period. At December 31, 1993, 299,046 options were available for grant under the 1985 Stock Option Plan. Information with respect to options outstanding and options exercised under the plans is summarized in the following table: Number Option Price of shares* $ per share $ Total Shares under option at December 31: 1993 313,564 8.88- 24.50 5,766,400 1992 278,544 6.06- 22.00 4,249,399 1991 400,247 6.06- 22.00 6,202,300 Options exercised during: 1993 51,260 8.88- 22.00 692,157 1992 168,423 6.06- 13.29 1,975,000 1991 120,362 6.06- 13.63 997,700 * Issuable upon exercise. At December 31, 1993, options to acquire 164,794 shares of common stock were exercisable. Shareholders have authorized issuance of two new classes of 1,000,000 shares each, to be denominated Class B Common Stock and Preferred Stock, respectively, in addition to the 20,000,000 shares of Common Stock presently authorized. At December 31, 1993, no shares of Class B or Preferred Stock had been issued. At December 31, 1993, the Company's Tier I Capital was $149,937,000 and Total Capital was $194,415,000 or 11.11 percent and 14.40 percent, respectively, of risk-adjusted assets. In December 1986, the Company declared a dividend distribution of one common share purchase right (the Right) for each outstanding share of common stock. The Rights are exercisable only in the event of an acquisition of, or announcement of a tender offer to acquire, 15 percent or more of the Company's stock or 50 percent or more of its assets without the prior consent of the Board of Directors. If the Rights become exercisable, the holder may purchase one share of the Company's common stock for $65. Following an acquisition of 15 percent of the Company's common stock or 50 percent or more of its assets without prior consent of the Company, each right will also entitle the holder to purchase $130 worth of common stock of the Company for $65. Under certain circumstances, the Rights may be redeemed by the Company at a price of $.05 per right prior to becoming exercisable and in certain circumstances thereafter. The Rights expire on December 31, 1999, or earlier, in connection with certain Board-approved transactions. Note 8: Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, (SFAS No. 109). Adoption of SFAS No. 109 required a change from the deferred method to the asset and liability method of accounting for income taxes. Under the deferred method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement reported amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.] 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. The components of the net deferred tax asset as of December 31, are as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------- Deferred tax asset Reserve for loan losses $ 10,321 $ 9,013 State franchise taxes 676 941 Deferred compensation 534 723 Real estate owned 2,742 1,851 Net deferred loan fees -- 268 Other 1,037 587 - ------------------------------------------------------------------- 15,310 13,383 Valuation allowance -- -- - ------------------------------------------------------------------- Total deferred tax asset 15,310 13,383 - ------------------------------------------------------------------- Deferred tax liability Net deferred loan costs 502 -- Fixed assets depreciation 1,164 1,171 Securities available-for-sale 1,864 -- Other 148 373 - ------------------------------------------------------------------- Total deferred tax liability 3,678 1,544 - ------------------------------------------------------------------- Net deferred tax asset $11,632 $11,839 =================================================================== The Company believes a valuation allowance is not needed to reduce the deferred tax asset because there is no material portion of the deferred tax asset that will not be realized through sufficient taxable income. The provisions for federal and state income taxes consist of amounts currently payable and amounts deferred which, for the years ended December 31, are as follows: (In thousands) 1993 1992 1991 - ------------------------------------------------------------ Current income tax expense: Federal $2,501 $6,977 $5,314 State 2,195 3,130 2,638 - ------------------------------------------------------------ Total current 4,696 10,107 7,952 - ------------------------------------------------------------ Deferred income tax benefit: Federal (646) (1,758) (1,335) State (617) (492) (784) - ------------------------------------------------------------ Total deferred (1,263) (2,250) (2,119) - ------------------------------------------------------------ Adjustment of net deferred tax asset for enacted changes in tax rates: Federal (304) -- -- State (90) -- -- - ------------------------------------------------------------- Total adjustment (394) -- -- - ------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ============================================================= The provisions for income taxes differ from the provisions computed by applying the statutory federal income tax rate to income before taxes, as follows: (In thousands) 1993 1992 1991 - -------------------------------------------------------------------- Federal income taxes due at statutory rate $4,248 $7,846 $6,056 (Reductions) increases in income taxes resulting from: Interest not taxable for federal income tax purposes (1,895) (1,735) (1,836) State franchise taxes, net of federal income tax benefit 982 1,753 1,226 Deferred benefit and other (296) (7) 387 - --------------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ===================================================================== Note 9: Fair Value of Financial Instruments The fair value of financial instruments which have a relative short period of time between their origination and their expected realization were valued using historical cost. Such financial instruments and their estimated fair values at December 31, were: (In thousands) 1993 1992 - ------------------------------------------------------------------- Cash and cash equivalents $102,618 $139,497 Money market assets 250 1,366 Interest and taxes receivable 28,799 25,741 Non-interest bearing and interest-bearing transaction and savings deposits 1,313,908 1,258,353 Funds purchased 69,064 12,038 Interest payable 2,700 3,824 The fair value at December 31 of the following financial instruments was estimated using quoted market prices: (In thousands) 1993 1992 - ------------------------------------------------------------------- Investment securities available for sale $168,819 $ -- Investment securities held to maturity 563,563 581,768 Trading account securities 10 -- Loans were separated into two groups for valuation. Variable rate loans, which reprice frequently with changes in market rates, were valued using historical cost. Fixed rate loans were valued by discounting the future cash flows expected to be received from the loans using current interest rates charged on loans with similar characteristics. Additionally, the $25,587,000 and $24,742,000 reserves for loan losses as of December 31, 1993 and 1992, respectively, were applied against the estimated fair value to recognize future defaults of contractual cash flows. The estimated fair market value of loans at December 31, was: (In thousands) 1993 1992 - -------------------------------------------------------------------- Loans $1,096,164 $1,171,630 The fair value of time deposits and notes and mortgages payable was estimated by discounting future cash flows related to these financial instruments using current market rates for financial instruments with similar characteristics. The estimated fair values at December 31, were: (In thousands) 1993 1992 - --------------------------------------------------------------------- Time deposits $420,475 $534,920 Notes and mortgages payable 36,014 20,282 The estimated fair values of the Company's interest rate swaps, which are determined by dealer quotes and generally represent the amount that the Company would pay to terminate its swap contracts, were $(600,000) and $0, respectively, at December 31, 1993 and 1992. These fair values do not represent actual amounts that may be realized upon any sale or liquidation of the related assets or liabilities. In addition, these values do not give effect to discounts to fair value which may occur when financial instruments are sold in larger quantities. The fair values presented above represent the Company's best estimate of fair value using the methodologies discussed above. Note 10: Lease Commitments Fifteen banking offices and three administrative service centers are owned and thirty-seven banking offices and two support facilities are leased. Substantially all the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living, property taxes and maintenance. The Company also leases certain pieces of equipment. Minimum future rental payments on operating leases, net of sublease income, at December 31, 1993, are as follows: (In thousands) 1994 $ 3,253 1995 3,091 1996 2,632 1997 1,679 1998 1,183 Thereafter 3,659 - ------------------------------------------------- Total minimum lease payments $15,497 ================================================= Total rentals for premises and equipment net of sublease income included in non-interest expense were $3,862,000 in 1993, $3,910,000 in 1992 and $3,829,000 in 1991. Note 11: Commitments and Contingent Liabilities Loan commitments are agreements to lend to a customer provided there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future funding requirements. Loan commitments are subject to the Company's normal credit policies and collateral requirements. Unfunded loan commitments were $159.2 million at December 31, 1993. Standby letters of credit commit the Company to make payments on behalf of customers when certain specified future events occur. Standby letters of credit are primarily issued to support customers short-term financing requirements and must meet the Company's normal credit policies and collateral requirements. Standby letters of credit outstanding were $6.4 million at December 31, 1993. Interest rate swaps are agreements to exchange interest payments computed on notional amounts. The notional amounts do not represent exposure to credit risk; however, these agreements expose the Company to market risks associated with fluctuations of interest rates. As of December 31, 1993, the Company had entered into four interest rate swaps. The first two contracts have notional amounts totaling $25 million each and the second two contracts have notional amounts totaling $30 million each. On the first two contracts, which are scheduled to terminate in November and December of 1994, the Company pays an average fixed rate of interest of 5.06 percent and receives a variable rate of interest based on the London Interbank Offering Rate (LIBOR); on the second two contracts, scheduled to terminate in August of 1995, the Company pays a variable rate based on LIBOR and receives an average fixed rate of interest of 4.11 percent. The LIBOR rate has averaged 3.39 percent from the date the first two swaps were entered through December 31, 1993 and 3.33 percent from the date the second two swaps were entered through December 31, 1993. The effect of entering into these contracts resulted in a decrease to net interest income of $659,000 for the period ended December 31, 1993. The Company, because of the nature of its business, is subject to various threatened or filed legal cases. The Company, based on the advice of legal counsel, does not expect such cases will have material, adverse effect on its financial position or results of operations. Note 12: Retirement Benefit Plans The Company sponsors a defined benefit Retirement Plan covering substantially all of its salaried employees with one or more years of service. The Company's policy is to expense costs as they accrue as determined by the Projected Unit Cost method. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. The following table sets forth the Retirement Plans funded status as of December 31 and the pension cost for the years ended December 31: (In thousands) 1993 1992 - ----------------------------------------------------------------- Actuarial present value of benefit obligations: Vested benefit obligation $(11,245) $(10,625) - ----------------------------------------------------------------- Accumulated benefit obligation (11,430) (11,064) - ----------------------------------------------------------------- Projected benefit obligation (11,612) (11,275) Plan assets at fair market value 11,677 11,429 ================================================================= Funded status-projected benefit obligation (in excess of) or less than plan assets $65 $154 ================================================================= Comprised of: Prepaid pension cost $22 $182 Unrecognized net (loss) gain (75) (194) Unrecognized prior service cost 529 628 Unrecognized net obligation, net of amortization (411) (462) - ----------------------------------------------------------------- Total $65 $154 ================================================================= Net pension cost included in the following components: Service cost during the period $364 $384 Interest cost on projected benefit obligation 744 754 Actual return on plan assets (1,012) (686) Net amortization and deferral 64 (271) - ----------------------------------------------------------------- Net periodic pension cost $160 $181 ================================================================= The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 6.75 percent and 5 percent, respectively, at December 31, 1993 and 7 percent and 5 percent, respectively, at December 31, 1992. The expected long-term rate of return on plan assets in 1993 and 1992 was 7 percent and 8 percent, respectively. Effective January 1, 1992, the Company adopted a defined contribution Deferred Profit-Sharing Plan covering substantially all of its salaried employees with one or more years of service. Participant deferred profit-sharing account balances offset benefits accrued under the Retirement Plan which was amended effective January 1, 1992 to coordinate benefits with the Deferred Profit-Sharing Plan. The coordination of benefits results in the Retirement Plan benefit formula establishing the minimum value of participant retirement benefits which, if not provided by the Deferred Profit-Sharing Plan, are guaranteed by the Retirement Plan. The costs charged to non-interest expense related to benefits provided by the Retirement Plan and the Deferred Profit-Sharing Plan were $1,160,000 in 1993, $1,037,000 in 1992 and $759,000 in 1991. In addition to the Retirement Plan and the Deferred Profit-Sharing Plan, all salaried employees are eligible to participate in the voluntary Tax Deferred Savings/Retirement Plan (ESOP) upon completion of a 90-day introductory period. This plan allows employees to defer, on a pretax basis, a portion of their compensation as contributions to the plan. Participants are allowed to invest in five funds, including a Westamerica Bancorporation Common Stock Fund. The Company's matching contributions charged to operating expense were $482,000 in 1993, $462,000 in 1992 and $452,000 in 1991. 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). Adoption of SFAS No. 106 required a change from the cash method to an actuarial based accrual method of accounting for postretirement benefits other than pensions. The Company offers continuation of group insurance coverage to employees electing early retirement, as defined by the Retirement Plan, for the period from the date of early retirement until age sixty-five. The Company contributes an amount toward early retirees insurance premiums which is fixed at the time of early retirement. The Company also reimburses Medicare Part B premiums for all retirees over age sixty-five, as defined by the Retirement Plan. The following table sets forth the net periodic postretirement benefit cost for the year ended December 31, 1993 and the funded status of the plan at December 31, 1993: (In thousands) Service cost $ 482 Interest cost 107 Actual return on plan assets -- Amortization of unrecognized transition obligation 61 Other, net (482) - ----------------------------------------------------------- Net periodic cost $ 168 =========================================================== Accumulated postretirement benefit obligation attributable to: Retirees $ 1,130 Fully eligible participants 265 Other 158 - ----------------------------------------------------------- Total 1,553 - ----------------------------------------------------------- Fair value of plan assets -- Accumulated postretirement benefit obligation in excess of plan assets $ 1,553 =========================================================== Comprised of: Unrecognized prior service cost -- Unrecognized net gain (loss) -- Unrecognized transition obligation 1,471 Recognized postretirement obligation 82 - ----------------------------------------------------------- Total $1,553 =========================================================== The discount rate used in measuring the accumulated postretirement benefit obligation was 6.75 percent at December 31, 1993. The assumed health care cost trend rate used to measure the expected cost of benefits covered by the plan was 9 percent for 1994 and declined steadily to an ultimate trend rate of 4 percent beginning in 1999. The effect of a one percentage point increase on the assumed health care cost trend for each future year would increase the aggregate of the service cost and interest cost components of the 1993 net periodic cost by $73,000 and increase the accumulated postretirement benefit obligation at December 31, 1993 by $204,000. Note 13: Related Party Transactions Certain directors and executive officers of the Company were lending customers of the Company during 1993 and 1992. All such loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral requirements. No related party loan represents more than normal risk of collection. Such loans were $5,238,000 and $10,591,000 at December 31, 1993 and 1992, respectively. Note 14: Restrictions Payment of dividends to the Company by Westamerica Bank, the largest subsidiary bank, is limited under regulations for Federal Reserve member banks. The amount that can be paid in any calendar year, without prior approval from regulatory agencies, cannot exceed the net profits (as defined) for that year plus the net profits of the preceding two calendar years less dividends declared. Under this regulation, Westamerica Bank, the largest subsidiary bank, was not restricted as to the payment of $13.6 million in dividends to the Company as of December 31, 1993. During 1992 and 1993, Napa Valley Bank, a banking subsidiary, was operating under a regulatory order which disallowed payment of dividends to the Company unless it reduced the level of problem assets, liquidated, or reserved adequately against, the real estate investments in its subsidiary company, and strengthened its loan loss reserve. Napa Valley Bank has complied with all conditions of the regulatory order which will be removed by the regulators based on their fourth quarter 1993 examination. Payment of dividends by the Company is also restricted under the terms of the note agreements as discussed in Note 6. Under the most restrictive of these agreements, $17.1 million was available for payment of dividends as of December 31, 1993. Under one of the note agreements, the Company has agreed to limit its funded debt to 40 percent of the total of funded debt plus shareholders' equity and maintain certain other financial ratios. The Company was in compliance with all such requirements as of December 31, 1993. The Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of its reservable deposits. The Banks daily average balance on deposit at the Federal Reserve Bank was $40.4 million in 1993 and $40.3 million in 1992. Note 15: Westamerica Bancorporation (Parent Company Only) Statements of Income (In thousands) Years ended December 31, 1993 1992* 1991* - ----------------------------------------------------------------------- Dividends from subsidiaries $16,671 $ 8,630 $ 6,620 Interest from subsidiaries 315 61 72 Other income 2,781 1,158 1,082 - ----------------------------------------------------------------------- Total income 19,767 9,849 7,774 - ----------------------------------------------------------------------- Interest on borrowings 1,958 2,434 2,617 Salaries and benefits 4,526 782 475 Other non-interest expense 5,464 3,451 2,261 - ----------------------------------------------------------------------- Total expenses 11,948 6,667 5,353 - ----------------------------------------------------------------------- Income before income tax benefit and equity in undistributed income of subsidiaries 7,819 3,182 2,421 Income tax benefit 3,478 1,890 1,813 Equity in undistributed (loss) income of subsidiaries (1,842) 10,150 7,743 - ----------------------------------------------------------------------- Net income $9,455 $15,222 $11,977 ======================================================================= *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Balance Sheets (In thousands) Years ended December 31, 1993 1992* - -------------------------------------------------------------------------- Assets Cash and cash equivalents $4,790 $ 1,729 Investment securities held-to-maturity 9,250 13,741 Loans 149 -- Investment in subsidiaries 154,257 145,762 Premises and equipment 29 2,506 Accounts receivable from subsidiaries 65 262 Other assets 2,056 2,704 - ------------------------------------------------------------------------- Total assets $170,596 $166,704 ========================================================================= Liabilities Long-term debt $ 14,796 $ 18,563 Notes payable to subsidiaries -- 2,493 Other liabilities 3,353 1,974 - ------------------------------------------------------------------------- Total liabilities 18,149 23,030 - ------------------------------------------------------------------------- Shareholders' equity 152,447 143,674 - ------------------------------------------------------------------------- Total liabilities and shareholders' equity $170,596 $166,704 ========================================================================= Statements of Cash Flows (In thousands) Years ended December 31, 1993 1992* 1991* - -------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $15,222 $11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 108 67 58 Equity in undistributed loss (income) of subsidiaries 1,842 (10,150) (7,743) Increase in equity in subsidiaries -- (1,797) -- (Increase) decrease in receivables from subsidiaries 197 1,020 (1,005) Provision for deferred income taxes 60 2,633 (551) Decrease (increase) in other assets 1,183 (1,394) (771) Increase in other liabilities 1,583 301 39 Gain on sale of Sonoma Valley Bank (668) -- -- Net gain on sale of land -- 43 -- - -------------------------------------------------------------------------- Net cash provided by operating activities 13,760 5,945 2,004 - -------------------------------------------------------------------------- Investing Activities Purchases of premises and equipment -- (2,189) (761) Net change in land held for sale (800) -- -- Net change in loan balances (149) -- -- Increase in investment in subsidiaries (9,874) (485) (510) Purchase of investment securities held-to-maturity (9,700) (13,991) (22,100) Proceeds from maturities of investment securities 14,191 10,500 23,100 Proceeds from sales of premises and equipment 2,369 2,149 -- Proceeds from sale of Sonoma Valley Bank 2,733 -- -- - -------------------------------------------------------------------------- Net cash used in investing activities (1,230) (4,016) (271) - -------------------------------------------------------------------------- Financing Activities Net (decrease) increase in short-term debt -- (656) 453 Principal reductions of long-term debt and notes payable to subsidiaries (6,260) (2,611) (2,767) Proceeds from issuance of note payable to subsidiaries -- 1,368 -- Proceeds from exercise of stock options 1,446 2,139 1,507 Unrealized loss (gains) on marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - -------------------------------------------------------------------------- Net cash used in financing activities (9,469) (2,738) (3,857) - -------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 3,061 (809) (2,124) Cash and cash equivalents at beginning of year 1,729 2,538 4,662 - -------------------------------------------------------------------------- Cash and cash equivalents at year end $4,790 $1,729 $2,538 ========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Note 16: Quarterly Financial Information (Unaudited) * As originally reported ** Represents prices quoted on the American Stock Exchange. Quoted prices are not necessarily representative of actual transactions. Note 17: Acquisition On April 15, 1993, the Company issued approximately 2,122,740 shares of its common stock in exchange for all of the outstanding common stock of Napa Valley Bancorp, a bank holding company, whose subsidiaries included Napa Valley Bank ("NVB"), a California-based, state-chartered banking association, and Subsidiary, 88 percent interest in Bank of Lake County ("BLC"), a national banking association, 50 percent interest in Sonoma Valley Bank, a state banking association, Suisun Valley Bank, also a state chartered bank, and Napa Valley Bancorp Services Corporation ("NVBSC"), estabilshed to provide data processing and other services to Napa Valley Bancorp's subsidiaries. This business transaction (the "Merger") was accounted for as a pooling-of-interests combination and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassifications have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. Subsequent to the combination, Westamerica Bancorporation sold the 50 percent interest in Sonoma Valley Bank at a gain of $668,000. This business combination has been accounted for as a pooling-of-interests combination; and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassification have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. The results of operations previously reported by the separate enterprises and the combined amounts presented in the accompanying consolidated financial statements are summarized as follows. Three months ended March 31, 1993 Years ended December 31, (In thousands) (unaudited) 1992 1991 - ----------------------------------------------------------------------- Net Interest Income: Westamerica Bancorporation $16,809 $67,192 $62,496 Napa Valley Bancorp 7,365 28,669 26,699 - ----------------------------------------------------------------------- Combined $24,174 $95,861 $89,195 - ----------------------------------------------------------------------- Net Income (loss): Westamerica Bancorporation $3,675 $13,979 $11,762 Napa Valley Bancorp (656) 1,243 215 - ----------------------------------------------------------------------- Combined $3,019 $15,222 $11,977 - ----------------------------------------------------------------------- Net Income (loss) Per Share: Westamerica Bancorporation* $.63 $2.40 $2.06 Napa Valley Bancorp* (.19) .36 .06 Combined $.38 $1.92 $1.52 - ----------------------------------------------------------------------- * As originally reported. Net income per share was reduced $.25 for the three months ended March 31, 1993, $.48 in 1992, and $.54 in 1991, attributable to dilution from shares issued in connection with the acquisition. In addition, net income of the Company for 1993 was reduced by an estimated $8.3 million due to the consolidation of Napa Valley Bancorp's branches and operations, certain merger-related expenses and the application of Westamerica Bancorporation's workout strategy to the non-performing assets of Napa Valley Bancorp. There were no significant transactions between Westamerica Bancorporation and Napa Valley Bancorp prior to the combination. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item 10 is incorporated herein by reference from the "Election of Directors" and "Executive Officers" section on Pages 2 through 9 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item 11 is incorporated herein by reference from the "Executive Compensation" and "Retirement Benefits and Other Arrangements" section on Pages 11 through 16 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is incorporated herein by reference from the "Security Ownership of Certain Beneficial Owners and Management" section on Pages 9 and 10 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item 13 is incorporated herein by reference from the "Indebtedness of Directors and Management" section on Page 6 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. All Financial Statements See Index to Financial Statements on page 36. (a) 2. Financial statement schedules required by Item 8 of Form 10-K and by Item 14(d). None (Information included in Financial Statements). (a) 3. Exhibits The following documents are included or incorporated by reference in this annual report on Form 10-K. Exhibit Number 3(a) Restated Articles of Incorporation (composite copy). 3(b)** By-laws. 10 Material contracts: (a)* Incentive Stock Option Plan (b)*** James M. Barnes --January 7, 1987 (Employment) (c)*** E. Joseph Bowler --January 7, 1987 (Employment) (d)*** Robert W. Entwisle --January 7, 1987 (Employment) (e)**** Amended and Restated Agreement and Plan of Reorganization by and between Westamerica Bancorporation and John Muir National Bank, proxy and prospectus dated November 27, 1991. (f)***** Agreement and Plan of Merger by and between Westamerica Bancorporation and Napa Valley Bancorp, proxy and prospectus dated November 12, 1992. 22 Subsidiaries of the registrant. *Exhibit 10(a) is incorporated by reference from Exhibit A to the Company's Proxy Statement dated March 22, 1983, which was filed with the Commission pursuant to Regulation 14A. **Exhibits 3(b), is incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ***Exhibits 3(a), 10(b), 10(c) and 10(d) are incorporated herein by reference from Exhibits 3(a), 10(n), 10(o), and 10(q) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ****Exhibit 3(e) is incorporated herein by reference from the Form S-4 dated November 27, 1991. *****Exhibit 3(f) is incorporated herein by reference from the Form S-4 dated November 12, 1992. The Corporation will furnish to shareholders a copy of any exhibit listed above, but not contained herein, upon written request to Mrs. M. Kitty Jones, Vice President and Secretary, Westamerica Bancorporation, P. O. Box 567, San Rafael, California 94915, and payment to the Corporation of $.25 per page. (b) Report on Form 8-K None MANAGEMENTS LETTER OF FINANCIAL RESPONSIBILITY To the Shareholders: The Management of Westamerica Bancorporation is responsible for the preparation, integrity, reliability and consistency of the information contained in this annual report. The financial statements, which necessarily include amounts based on judgments and estimates, were prepared in conformity with generally accepted accounting principles and prevailing practices in the banking industry. All other financial information appearing throughout this annual report is presented in a manner consistent with the financial statements. Management has established and maintains a system of internal controls that provides reasonable assurance that the underlying financial records are reliable for preparing the financial statements, and that assets are safeguarded from unauthorized use or loss. This system includes extensive written policies and operating procedures and a comprehensive internal audit function, and is supported by the careful selection and training of staff, an organizational structure providing for division of responsibility, and a Code of Ethics covering standards of personal and business conduct. Management believes that, as of December 31, 1993 the Corporation's internal control environment is adequate to provide reasonable assurance as to the integrity and reliability of the financial statements and related financial information contained in the annual report. The system of internal controls is under the general oversight of the Board of Directors acting through its Audit Committee, which is comprised entirely of outside directors. The Audit Committee monitors the effectiveness of and compliance with internal controls through a continuous program of internal audit and credit examinations. This is accomplished through periodic meetings with Management, internal auditors, loan quality examiners, regulatory examiners and independent auditors to assure that each is carrying out their responsibilities. The Corporation's financial statements have been audited by KPMG Peat Marwick, independent auditors elected by the shareholders. All financial records and related data, as well as the minutes of shareholders and directors meetings, have been made available to them. Management believes that all representations made to the independent auditors during their audit were valid and appropriate. David L. Payne Chairman, President and CEO James M. Barnes Executive Vice President and CFO Dennis R. Hansen Senior Vice President and Controller INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders of Westamerica Bancorporation We have audited the accompanying consolidated balance sheets of Westamerica Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' 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. As discussed in Note 1 to the consolidated financial statements, the consolidated balance sheet of the Company as of December 31, 1992 and the related statements of income, changes in shareholders' equity, and cash flows for each of the years in the two year period ended December 31, 1992, and the related footnote disclosures have been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. We did not audit the financial statements of Napa Valley Bancorp as of and for the periods ended December 31, 1992 and 1991, which statements reflect total assets constituting 30 percent in 1992 and net income constituting 8 percent and 2 percent in 1992 and 1991, respectively, of the related and restated consolidated totals. Those statements included in the 1992 and 1991 restated consolidated totals were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Napa Valley Bancorp, 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 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 the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Westamerica Bancorporation and subsidiaries 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. San Francisco, California January 25, 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. WESTAMERICA BANCORPORATION By Dennis R. Hansen By James M. Barnes - ---------------------- -------------------- Senior Vice President and Controller Executive Vice President and (Principal Accounting Officer) Chief Financial 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 date indicated. Signature Title Date David L. Payne Chairman of the Board and 3/24/94 ------------------------------ Director and President and CEO E. Joseph Bowler Senior Vice President 3/24/94 ------------------------------ and Treasurer Etta Allen Director 3/24/94 ------------------------------ Louis E. Bartolini Director 3/24/94 ------------------------------ Charles I. Daniels, Jr. Director 3/24/94 ------------------------------ Don Emerson Director 3/24/94 ------------------------------ Arthur C. Latno Director 3/24/94 ------------------------------ Patrick D. Lynch Director 3/24/94 ------------------------------ Catherine Cope MacMillan Director 3/24/94 ------------------------------ James A. Maggetti Director 3/24/94 ------------------------------ Dwight H. Murray,Jr.,M.D. Director 3/24/94 ------------------------------ Ronald A. Nelson Director 3/24/94 ------------------------------ Carl Otto Director 3/24/94 ------------------------------ Edward B. Sylvester Director 3/24/94 ------------------------------ Exhibit 22 WESTAMERICA BANCORPORATION SUBSIDIARIES AS OF DECEMBER 31, 1993 State of Incorporation Westamerica Bank California Napa Valley Bank California Bank of Lake County California Community Banker Services Corporation California ITEM 7: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion addresses information pertaining to the financial condition and results of operations of Westamerica Bancorporation (the Company) that may not be otherwise apparent from a review of the consolidated financial statements and related footnotes. It should be read in conjunction with those statements and notes found on pages 36 through 63, as well as with the other information presented throughout the report. All financial information has been restated on an historical basis to reflect the April 15, 1993 merger with Napa Valley Bancorp (the Merger) on a pooling-of-interests basis. The Company earned $9.5 million in 1993, representing a 38 percent decrease from 1992 record earnings of $15.2 million and a 21 percent reduction from 1991 earnings of $12.0 million. The 1993 results include a second quarter loss of $4.1 million, mostly due to $10.5 million after-tax merger-related charges that were taken in the form of asset write-downs, additions to the loan loss provision and other related charges. The asset write-downs and the additional loan loss provision reflect the Company's plan of asset resolution. Components of Net Income (Percent of average earning assets) 1993 1992 1991 - ------------------------------------------------------------------ Net interest income* 5.48% 5.50% 5.21% Provision for loan losses (.53) (.39) (.59) Non-interest income 1.34 1.33 1.36 Non-interest expense (5.43) (5.00) (4.82) Taxes* (.33) (.59) (.48) - ------------------------------------------------------------------- Net income .53% .85% .68% =================================================================== Net income as a percentage of average total assets .48% .77% .62% * Fully taxable equivalent (FTE) On a per share basis, 1993 net income was $1.17, compared to $1.92 and $1.52 in 1992 and 1991, respectively. During 1993, the Company continued to benefit from reductions in cost of funds, increases in service fees and other non-interest income, and expense controls. However, merger-related costs more than offset these benefits. Earnings in 1992 improved over 1991 principally due to higher net interest margin, lower provisions for loan losses and control of non-interest expense. The Company's return on average total assets was .48 percent in 1993, compared to .77 percent and .62 percent in 1992 and 1991, respectively. Return on average equity in 1993 was 6.51 percent, compared to 11.16 percent and 9.52 percent, respectively, in the two previous years. NET INTEREST INCOME Although interest rates continued to decline during most of 1993, the continuing downward repricing of interest-bearing liabilities and a more favorable composition of deposits, represented by increasing volumes of lower costing demand and savings account balances and declining volumes of higher costing time deposits, prevented declining earning-asset yields from significantly eroding the Company's net interest margin. Components of Net Interest Income (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Interest income $ 137.0 $ 154.8 $ 176.6 Interest expense (42.3) (58.9) (87.4) FTE adjustment 2.8 2.7 2.7 - ------------------------------------------------------------------- Net interest income (FTE) $ 97.5 $ 98.6 $ 91.9 - ------------------------------------------------------------------- Average interest earning assets $1,779.3 $1,793.8 $1,762.4 Net interest margin (FTE) 5.48% 5.50% 5.21% Net interest income (FTE) in 1993 decreased $1.1 million from 1992 to $97.5 million. Interest income decreased $17.8 million from 1992, due to a $14.5 million reduction in the average balance of interest earning assets and a 93 basis point decline in yields. This was partially offset by a $16.6 million decrease in interest expense, the combination of a $41.3 million decrease in the average balance of interest-bearing liabilities and a 101 basis point decline in rates paid, in part due to a more favorable composition of deposits. DISTRIBUTION OF AVERAGE ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY The following tables present, for the periods indicated, information regarding the consolidated average assets, liabilities and shareholders' equity, the amounts of interest income from average interest earning assets and the resulting yields, and the amount of interest expense paid on interest-bearing liabilities, expressed in thousand of dollars and rates. Average loan balances include non-performing loans. Interest income includes proceeds from loans on non-accrual status only to the extent cash payments have been received and applied as interest income. Yields on securities and certain loans have been adjusted upward to reflect the effect of income thereon exempt from federal income taxation at the current statutory tax rate. Amortized loan fees, which are included in interest and fee income on loans, were $1.5 million lower in 1993 than in 1992 and $2.6 million higher in 1992 than in 1991. Distribution of average assets, liabilities and shareholders' equity Yields/Rates and interest margin Full Year 1993 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $4,463 $170 3.80% Trading account securities 183 6 3.14 Investment securities 631,700 39,794 6.30 Loans: Commercial 615,981 53,990 8.76 Real estate construction 55,038 4,745 8.62 Real estate residential 168,379 13,322 7.91 Consumer 303,567 27,726 9.13 - --------------------------------------------------------------- Total interest earning assets 1,779,311 139,753 7.85 Other assets 200,561 - ------------------------------------------------------- Total assets $1,979,872 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $330,867 -- -- Savings and interest-bearing transaction 938,475 19,305 2.06% Time less $100,000 340,122 14,176 4.17 Time $100,000 or more 135,505 4,837 3.57 - --------------------------------------------------------------- Total interest-bearing deposits 1,414,102 38,318 2.71 Funds purchased 57,135 1,937 3.39 Notes and mortgages payable 17,959 2,016 11.22 - --------------------------------------------------------------- Total interest-bearing liabilities 1,489,196 42,271 2.84 Other liabilities 14,652 Shareholders' equity 145,157 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,979,872 ======================================================= Net interest spread (1) 5.01% Net interest income and interest margin (2) $97,482 5.48% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1992 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $42,964 $1,765 4.11% Trading account securities 103 4 3.67 Investment securities 534,793 40,332 7.54 Loans: Commercial 646,359 60,050 9.29 Real estate construction 76,173 7,058 9.27 Real estate residential 168,030 15,314 9.11 Consumer 325,393 33,003 10.14 - --------------------------------------------------------------- Total interest earning assets 1,793,815 157,526 8.78 Other assets 175,609 - ------------------------------------------------------- Total assets $1,969,424 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $284,366 -- -- Savings and interest-bearing transaction 903,211 26,518 2.94% Time less $100,000 406,161 20,948 5.16 Time $100,000 or more 184,799 8,365 4.53 - --------------------------------------------------------------- Total interest-bearing deposits 1,494,171 55,831 3.74 Funds purchased 15,729 698 4.44 Notes and mortgages payable 20,439 2,363 11.56 - --------------------------------------------------------------- Total interest-bearing liabilities 1,530,339 58,892 3.85 Other liabilities 18,263 Shareholders' equity 136,456 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,969,424 ======================================================= Net interest spread (1) 4.93% Net interest income and interest margin (2) $98,634 5.50% =============================================================== (1) Net interest spread represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. Full Year 1991 (dollars in thousands) --------------------------- Interest Rates Average income/ earned/ balance expense paid - ----------------------------------------------------------------------- Assets Money market assets and funds sold $39,182 $2,227 5.68% Trading account securities 835 54 6.47 Investment securities 446,283 39,218 8.79 Loans: Commercial 672,999 71,512 10.63 Real estate construction 96,654 11,002 11.38 Real estate residential 150,943 15,436 10.23 Consumer 355,502 39,798 11.19 - --------------------------------------------------------------- Total interest earning assets 1,762,398 179,247 10.17 Other assets 169,089 - ------------------------------------------------------- Total assets $1,931,487 ======================================================= Liabilities and shareholders' equity Deposits Non-interest bearing demand $265,383 -- -- Savings and interest-bearing transaction 773,904 36,119 4.67% Time less $100,000 466,487 31,838 6.83 Time $100,000 or more 230,276 15,113 6.56 - --------------------------------------------------------------- Total interest-bearing deposits 1,470,667 83,070 5.65 Funds purchased 26,885 1,676 6.23 Notes and mortgages payable 22,464 2,611 11.62 - --------------------------------------------------------------- Total interest-bearing liabilities 1,520,016 87,357 5.75 Other liabilities 20,886 Shareholders' equity 125,202 - ------------------------------------------------------- Total liabilities and shareholders' equity $1,931,487 ======================================================= Net interest spread (1) 4.42% Net interest income and interest margin (2) $91,890 5.21% =============================================================== (1) Net interest spread represents the average yield earned on interest- earning assets less the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by dividing net interest income by total average interest earning assets. RATE AND VOLUME VARIANCES. The following table sets forth a summary of the changes in interest income and interest expense from changes in average assets and liability balances (volume) and changes in average interest rates for the periods indicated. Changes not solely attributable to volume or rates have been allocated in proportion to the respective volume and rate components. PROVISION FOR LOAN LOSSES The provision for loan losses was $9.5 million in 1993, including a $3.1 million merger-related provision in the second quarter, reflecting a different workout strategy for loans and properties acquired in the Merger, compared to $7.0 million in 1992 and $10.4 million in 1991. The level of the provision reflects the Company's continuing efforts to improve loan quality by enforcing strict underwriting and administration procedures and aggressively pursuing collection efforts with troubled debtors. For further information regarding net credit losses and the reserve for loan losses, see the Non-Performing Assets section of this report. INVESTMENT PORTFOLIO The Company maintains a securities portfolio consisting of U.S.Treasury, U.S. Government Agencies and Corporations, State and political subdivisions, asset-backed and other securities. Investment securities are held in safekeeping by an independent custodian. 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" ("SFAS No.115"). The statement addresses the accounting and reporting for investments in equity securities that have a readily determinable fair value and for all investments in debt securities. The statement requires that all securities be classified, at acquisition, into one of three categories: held-to-maturity, available-for-sale, and trading. SFAS No. 115 is effective for fiscal years beginning after December 15, 1993; however, early implementation is permitted. The Company elected to implement SFAS No. 115 effective as of December 31, 1993. The classification of all securities is determined at the time of acquisition. In classifying securities as being held-to-maturity, available-for-sale or trading, the Banks consider their collateral needs, asset/liability management strategies, liquidity needs, interest rate sensitivity and other factors that will determine the intent and ability to hold the securities to maturity. The objective of the investment securities held-to-maturity is to strengthen the portfolio yield, and to provide collateral to pledge for federal, state and local government deposits and other borrowing facilities. The investments held-to-maturity had an average term to maturity of 47 months at December 31, 1993 and, as of the same date, those investments included $547.2 million in fixed rate and $9.9 million in adjustable rate securities. Investment securities available-for-sale are typically used to supplement the Banks' liquidity portfolio with the objective of increasing the portfolio yield. Unrealized net gains and losses on these securities are recorded as an adjustment to equity net of taxes, and are not reflected in the current earnings of the Company. If the security is sold, any gain or loss is recorded as a charge to earnings and the equity adjustment is reversed. At December 31, 1993, the Banks held $168.8 million classified as investments available-for-sale. At December 31, 1993, $2.5 million, net of taxes was recognized as the unrealized net gain related to these securities. The amount of trading securitiess at December 31, 1993, was not material. For more information on investment securities, see Notes 1 and 2 to the Consolidated Financial Statements on pages 43 to 47 of this report. The following table shows the book value of the Company's investment securities (in thousands of dollars) as of the dates indicated: December 31, 1993 1992 1991 - ----------------------------------------------------------- U.S. Treasury $249,613 $126,522 $24,411 U.S. government agencies and corporations 254,691 237,753 299,219 States and political subdivisions (domestic) 127,297 87,031 74,847 Asset backed securities 65,433 82,270 79,743 Other securities 28,842 36,660 37,404 - ----------------------------------------------------------- Total $725,876 $570,236 $515,624 =========================================================== The following table is a summary of the relative maturities (in thousands of dollars) and yields of the Company's investment securities as of December 31, 1993. Weighted average yields have been computed by dividing annual interest income, adjusted for amortization of premium and accretion of discount, by book value of the related securities. Yields on state and political subdivision securities have been calculated on a fully taxable equivalent basis using the federal tax rate of 34 percent. LOAN PORTFOLIO The following table shows the composition of loans of the Company (in thousands of dollars) by type of loan or type of borrower, on the dates indicated. Secured loans are classified by type of securities and unsecured by the purpose of the loan. Maturities and Sensitivity of Selected Loans to Changes in Interest Rates The following table shows the maturity distribution and interest rate sensitivity of Commercial and Real estate construction loans at December 31, 1993.* *Excludes loans to individuals and residential mortgages totaling $461,450. These types of loans are typically paid in monthly installments over a number of years. **Includes demand loans Commitments and Lines of Credit It is not the policy of the Company to issue formal commitments on lines of credit except to a limited number of well established and financially responsible local commercial enterprises. Such commitments can be either secured or unsecured and are typically in the form of revolving lines of credit for seasonal working capital needs. Occasionally, such commitments are in the form of Letters of Credit to facilitate the customer's particular business transaction. Commitment fees generally are not charged except where Letters of Credit are involved. Commitments and lines of credit typically mature within one year. See also Note 11 of the Consolidated Notes to the Financial Statements on page 55. RISK ELEMENTS The Company closely monitors the markets in which it conducts its lending Company's primary market areas, in Management's view such impact has not had a material, adverse effect on the Company's liquidity and capital resources. The Company continues its strategy to control its exposure to real estate development loans and increase diversification of credit risk. Asset reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. Assets receiving lesser grades fall under the classified assets category which includes all non-performing assets. These occur when known information about possible credit problems causes Management to have doubts about the ability of such borrowers to comply with loan repayment terms. These loans have varying degrees of uncertainty and may become non-performing assets. Classified assets receive an elevated level of Management attention to ensure collection. Total classified assets peaked following the second quarter Merger but declined significantly by December 31, 1993 due to extensive asset write-downs, loan collections, real estate liquidations and restructurings of the Napa Valley Bank loan portfolio reflecting the Company's workout strategy. Non-Performing Assets Non-performing assets include non-accrual loans, loans 90 days past due and still accruing, other real estate owned and loans classified as substantively foreclosed. Loans are placed on non-accrual status upon reaching 90 days or more delinquent, unless the loan is well secured and in the process of collection. Interest previously accrued on loans placed on non-accrual status is charged against interest income. Loans secured by real estate with temporarily impaired values and commercial loans to borrowers experiencing financial difficulties are placed on non-accrual status even though the borrowers continue to repay the loans as scheduled. Such loans are classied by Management as performing non-accrual and are included in total non-performing assets. Performing non-accrual loans are reinstated to accrual status when improvements in credit quality eliminate the doubt as to the full collectibility of both interest and principal. When the ability to fully collect non-accrual loan principal is in doubt, cash payments received are applied against the principal balance of the loan until such time as full collection of the remaining recorded balance is expected. Any subsequent interest received is recorded as interest income on a cash basis. Non-Performing Assets (In millions) 1993 1992 1991 1990 1989 - ---------------------------------------------------------------------------- Performing non-accrual loans $ 1.9 $ 1.1 $ 2.2 $16.0 $10.7 Non-performing non-accrual loans 7.2 14.9 37.7 9.3 -- - ---------------------------------------------------------------------------- Non-accrual loans 9.1 16.0 39.9 25.3 10.7 Loans 90 or more days past due and still accruing .3 .1 1.0 6.2 6.8 Loan collateral substantively foreclosed 5.4 16.6 7.1 6.0 6.0 Other real estate owned 12.5 17.9 4.9 2.7 4.2 - ---------------------------------------------------------------------------- Total non-performing assets $27.3 $50.6 $52.9 $40.2 $27.7 ============================================================================ Reserve for loan losses as a percentage of non-accrual loans and loans 90 or more days past due and still accruing 272% 153% 58% 60% 91% Performing non-accrual loans increased $800,000 to $1.9 million at December 31, 1993. This increase was principally due to one condominium construction loan. Non-performing non-accrual loans decreased $7.7 million to $7.2 million at December 31, 1993 due to loan collections, write-downs, foreclosure of loan collateral and reclassifications to loan collateral substantively foreclosed. Both loan collateral substantively foreclosed and other real estate owned declined $16.6 million due to asset write-downs and liquidations. The amount of gross interest income that would have been recorded for non-accrual loans for the year ending December 31, 1993, if all such loans had been current in accordance with their original terms while outstanding during the period, was $980,000. The amount of interest income that was recognized on non-accrual loans from cash payments made during the year ended December 31, 1993 totaled $345,000, representing an annualized yield of 3.06 percent. Cash payments received which were applied against the book balance of performing and non-performing non-accrual loans outstanding at December 31, 1993, totaled $534,000 compared to $104,000 in 1992. Restructured loans totaled $4,432,000 at December 31, 1993, $319,000 at December 31, 1992, $2,892,000 at December 31, 1991 $2,200,000, at December 31, 1990 and $5,927,000 at December 31, 1989. CREDIT LOSS EXPERIENCE The Company's reserve for loan losses is maintained at a level estimated by Management to be adequate to provide for losses that can be reasonably credit loss experience, the amount of past due, non-performing and classified loans, recommendations of regulatory authorities, prevailing economic conditions and other factors. Initially, the reserve is allocated to segments of the loan portfolio based in part on quantitative analyses of historical credit loss experience. Criticized and classied loan balances are analyzed using both a linear regression model and standard allocation percentages. The results of this analysis are applied to current criticized and classied loan balances to allocate the reserve to the respective segments of the loan portfolio. In addition, loans with similar characteristics not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on the historical rate of net losses and delinquency trends and are grouped by the number of days the payment on those loans are delinquent. While these factors are essentially judgmental and may not be reduced to a mathematical formula, Management considers that the $25.6 million reserve for loan losses, which constituted 2.30 percent of total loans at December 31, 1993, to be adequate as a reserve against inherent losses. Management continues to evaluate the loan portfolio and assess current economic conditions that will dictate future reserve levels. In May 1993, the Financial Accounting Standards Board (FASB) issued statement No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114) which addresses the accounting treatment of certain impaired loans and amends FASB Statements No. 5 and No. 15. SFAS 114 does not address the overall adequacy of the allowance for loan losses. SFAS 114 is effective January 1, 1995 but earlier implementation is encouraged. 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. Under SFAS 114, impairment is measured based on the present value of the expected future cash flows discounted at the loans effective interest rate. Alternatively, impairment may be measured by using the loans observable market price or the fair value of the collateral if repayment is expected to be provided solely by the underlying collateral. The Company intends to implement SFAS 114 in January 1995. The impact of implementation on the financial statements has not been determined, since measurement will be contingent upon the inventory of impaired loans outstanding as of January 1, 1995. ALLOCATION OF RESERVE FOR LOAN LOSSES The reserve for loan losses has been established to absorb possible future losses throughout the loan portfolio and off balance sheet credit risk. The Company's reserve for loan losses is maintained at a level estimated by management to be adequate to provide for losses that are reasonably foreseeable based upon specific conditions and other factors. The reserve is allocated to segments of the loan portfolio based in part upon quantitative analyses of historical net losses relative to loan balances outstanding. Criticized and classified loan balances, as identified by management using criteria similar to those used by the Banks' regulators, and historical net losses on those balances are analyzed using both a linear regression and standard allocation percentages model. The results of this statistical analysis are applied to current criticized and classified loan balances to allocate the reserve for loan losses to the respective segments of the loan portfolio. In addition, homogeneous loans, which are not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on historical rates of net loan losses experienced for loans grouped by the number of days payments are delinquent. Such rates of net loan losses are applied to the current aging of homogeneous loans to allocate the reserve for loan losses. Management may judgmentally adjust the allocation of the reserve for loan losses based on changes in underwriting standards, anticipated rates of net loan losses which may differ from historical experience, economic conditions, the experience of credit officers and any other factors considered pertinent. Management's continuing evaluation of the loan portfolio and assessment of current economic conditions will dictate future reserve levels. The following tables present the allocation of the loan loss reserve balance on the dates indicated: (in thousands) December 31 1993 1992 - ------------------------------------------------------------------------------- Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans - ------------------------------------------------------------------------------- Commercial $12,537 55.0% $13,551 53.4% Real estate construction 2,538 3.6 964 5.4 Real estate residential 85 15.5 545 14.8 Consumer 3,921 25.9 3,872 26.4 Unallocated portion of reserve 6,506 -- 5,810 -- - ------------------------------------------------------------------------------- Total $25,587 100.0% $24,742 100.0% =============================================================================== (in thousands) December 31 1991 1990 - ------------------------------------------------------------------------------ Loans as Loans as Allocation Percent of Allocation Percent of of reserve Total of reserve Total Type of loan balance Loans balance Loans -------- -------- -------- -------- Commercial $8,325 52.7% $2,698 52.5% Real estate construction 2,336 7.1 4,360 9.5 Real estate residential 50 12.9 29 10.4 Consumer 2,363 27.3 1,782 27.6 Unallocated portion of reserve 10,779 -- 10,132 -- - ------------------------------------------------------------------------------- Total $23,853 100.0% $19,001 100.0% =============================================================================== (in thousands) December 31 1989 - ------------------------------------------------------------ Loans as Allocation Percent of of reserve Total Type of loan balance Loans -------- -------- Commercial $5,216 52.4% Real estate construction 2,709 11.9 Real estate residential 0 10.3 Consumer 853 25.4 Unallocated portion of reserve 7,182 -- - ------------------------------------------------------------- Total $15,960 100.0% ============================================================= The reduced allocation to commercial loans from December 31, 1992 to December 31, 1993 is primarily due to a reduction in the balance of criticized loans. The increased allocation to construction loans over the same period is attributable to an increase in criticized loans due to the recessionary environment. The increase in the unallocated portion of the reserve is due to the establishment of an additional "recessionary reserve" to recognize the potential for increased chargeoffs. The changes in the allocation to loan portfolio segments from December 31, 1991 to December 31, 1992 reflect changes in criticized and classified loan balances. The decreased allocation to construction loans is attributable to a decrease in criticized loans due to full collection or principal reducing payments received from customers. The increased allocation to commercial and consumer loans is attributable to a reduced level of recoveries. ASSET AND LIABILITY MANAGEMENT The fundamental objective of the Company's management of assets and liabilities is to maximize its economic value while maintaining adequate liquidity and a conservative level of interest-rate risk. The principal sources of asset liquidity are investment securities available for sale. At December 31, 1993, investment securities available for sale totaled $168.8 million. The Company generates significant liquidity from its operating activities. The Company's profitability in 1993, 1992 and 1991 generated substantial increases in the cash flow provided from operations for such years to $28.4 million, $33.4 million and $26.7 million, respectively. Additional cash flow is provided by financing activities, primarily the acceptance of customer deposits and short-term borrowings from banks. After a considerable increase in deposits in 1991 of $66.2 million, growth was only $600,000 in 1992 and the Company experienced a decline of $58.7 million in 1993 mostly due to deposits sold in connection with the sale of Sonoma Valley Bank. In addition to a $57.0 million compensating increase in short-term borrowings in 1993, Westamerica Bank issued in December a ten-year, $20.0 million subordinated capital note that qualifies as Tier II Capital and will be used as a source of liquidity for working capital purposes. The Company uses cash flows from operating and financing activities to make investments in loans, money market assets and investment securities. Continuing with the strategy to reduce its exposure to real estate development loans, net loan repayments were $68.1 million, $32.8 million and $15.5 million in 1993, 1992 and 1991, respectively. The net repayment of loans resulted in added liquidity for the Company, which was used to increase its investment securities portfolios by $153.4 million, $75.8 million and $130.0 million in 1993, 1992 and 1991, respectively. Interest rate risk is influenced by market forces. However, that risk may be controlled by monitoring and managing the repricing characteristics of assets and liabilities. In evaluating exposure to interest rate risk, the Company considers the effects of various factors in implementing interest rate risk management activities, including the utilization of interest rate swaps. Interest rate swaps outstanding at December 31, 1993 had aggregate notional amounts of $110.0 million of which $50.0 million matures in 1994 and $60.0 million matures in 1995. These interest rate swaps were entered into to hedge the adverse impact interest rate fluctuations have on interest-bearing transaction and savings deposits in the current interest rate environment. The primary analytical tool used by Management to gauge interest-rate sensitivity is a simulation model used by many major banks and bank regulators. This industry standard model is used to simulate the effects on net interest income of changes in market interest rates that are up to 2 percent higher or 2 percent lower than current levels. The results of the model indicate that the mix of interest rate sensitive assets and liabilities at December 31, 1993 would not, in the view of Management, expose the Company to an unacceptable level of interest rate risk. CAPITAL RESOURCES The Company's capital position represents the level of capital available to support continued operations and expansion. The Company's primary captial resource is shareholders' equity, which increased $8.8 million or 6.1 percent from the previous year end and increased $23.0 million or 17.8 percent from December 31, 1991. As a result of the Company's profitability, the retention of earnings and slow asset growth, the ratio of equity to total assets increased to 7.6 percent at December 31, 1993, up from 7.3 percent at December 31, 1992 and 6.6 percent at December 31, 1991. Tier I risk-based capital to risk-adjusted assets increased to 11.11 percent at December 31, 1993, from 10.02 percent at year end 1992. The ratio of total risk-based capital to risk-adjusted assets increased to 14.40 percent at December 31, 1993, from 12.01 percent at December 31, 1992. Capital to Risk-Adjusted Assets Minimum Regulatory Capital Minimum Regulatory Capital At December 31, 1993 1992 Requirements - ----------------------------------------------------------- Tier I Capital 11.11% 10.02% 4.00% Total Capital 14.40 12.01 8.00 Leverage ratio 7.42 7.39 4.00 The risk-based capital ratios improved in 1993 due to two factors: equity capital grew at a faster rate than total assets, and the decline in loan volumes and increase in investment securities reduced the level of risk-adjusted assets. FINANCIAL RATIOS The following table shows key financial ratios for the periods indicated. For the Years Ended 1993 1992 1991 - ------------------------------------------------------------------------- Return on average total assets 0.48% 0.77% 0.62% Return on average shareholders' equity 6.51% 11.16% 9.52% Average shareholders' equity as a percent of: Average total assets 7.33% 6.93% 6.48% Average total loans 12.70% 11.22% 9.81% Average total deposits 8.32% 7.67% 7.21% DEPOSITS The following table sets forth, by time remaining to maturity the Company's domestic time deposits in amounts of $100,000 or more (in thousands of dollars). Time Remaining to Maturity December 31, 1993 1992 1991 - ------------------------------------------------------------ Three months or less $73,988 $92,581 $139,487 Three to six months 23,817 46,378 58,564 Six months to 12 months 10,503 12,895 10,695 Over 12 months 4,685 6,630 6,699 - ------------------------------------------------------------ Total $112,993 $158,484 $215,445 ============================================================ See additional disclosures in Note 6 to Consolidated Financial statements on page 52 of this report. SHORT-TERM BORROWINGS The following table sets forth the short-term borrowings of the Company. (In thousands) December 31 1993 1992 1991 - ----------------------------------------------------------------------- Federal funds purchased $25,000 $ -- $ -- Other borrowed funds: Retail repurchase agreements 28,038 4,099 3,204 Other 16,026 7,939 6,366 - ----------------------------------------------------------------------- Total other borrowed funds $44,064 $12,038 $9,570 - ----------------------------------------------------------------------- Total funds purchased $12,038 $12,038 $9,570 ======================================================================= Further details of the other borrowed funds are: (In thousands) December 31 1993 1992 1991 - ------------------------------------------------------------------------ Outstanding Average during the year $37,284 $11,509 $18,865 Maximum during the year 68,608 19,055 44,558 Interest rates Average during the period 3.13% 4.73% 6.51% Average at period end 3.04 3.23 6.80 NON-INTEREST INCOME Components of Non-Interest Income (In millions) 1993 1992 1991 - ----------------------------------------------------------------------- Service charges on deposit accounts $ 12.8 $ 12.4 $ 12.1 Merchant credit card 2.2 2.9 2.9 Mortgage banking income 1.5 1.8 1.5 Brokerage commissions .8 .6 .4 Net investment securities gains -- 1.1 1.7 Sale of Sonoma Valley Bank .7 -- -- Automobile receivable servicing 1.3 -- .5 Other 4.6 5.0 4.9 - ----------------------------------------------------------------------- Total $ 23.9 $ 23.8 $ 24.0 ======================================================================= Non-interest income increased to $23.9 million in 1993. Higher income from servicing automobile receivables, the sale of the Company's 50 percent interest in Sonoma Valley Bank, higher brokerage commissions, increased fees from deposit services, gains recognized on the sale of Napa Valley Bancorp cardholder portfolio and lower write-offs of mortgage service receivables, were partially offset by lower credit card merchant fees and lower mortgage servicing fees. 1992 non-interest income also reflects $1.1 million gains on the sale of investment securities held for sale. In 1992, non-interest income decreased $200,000 from the previous year, resulting principally from lower gains of investment securities held-for-sale and lower income from servicing automobile receivables partially offset by higher deposit account fees, mortgage banking income and brokerage commissions. NON-INTEREST EXPENSE Components of Non-Interest Expense (In millions) 1993 1992 1991 - ------------------------------------------------------------------- Salaries $ 31.6 $ 33.7 $ 34.7 Other personnel benefits 7.4 7.2 7.1 Other real estate owned 13.2 6.2 2.9 Occupancy 8.6 8.5 8.4 Equipment 6.2 5.3 5.5 FDIC insurance assessment 4.1 4.0 3.5 Data processing 3.7 3.1 3.0 Professional fees 3.1 3.3 3.3 Operational losses 2.0 .7 .5 Stationery and supplies 1.9 1.7 1.8 Advertising and public relations 1.8 1.8 2.0 Loan expense 1.6 1.4 1.3 Merchant credit card 1.1 1.7 1.9 Insurance .9 1.0 .7 Other 9.4 10.0 8.3 - ------------------------------------------------------------------- Total $ 96.6 $ 89.6 $ 84.9 =================================================================== Average full-time equivalent staff 905 1,092 1,148 Non-interest expense increased $7.0 million or 8 percent in 1993 compared with an increase of $4.7 million or 6 percent in 1992. The increase in 1993 is the direct result of merger-related foreclosed real estate owned expenses, reflecting a $10.0 million write-down of assets acquired in the Merger to fair value net of estimated selling costs reflecting the implementation of the Company's workout strategy, and other costs associated with the Merger, including $1.2 million in relocation costs, chargeoffs of $921,000 for obsolete furniture and equipment, $745,000 in investment banker fees, and other merger-related costs totaling approximately $1.2 million. Partially offsetting these increases in 1993 non-interest expense, salaries decreased $2.1 million, or 6 percent, reflecting the benefits realized from consolidation of operations after the Merger. Merchant credit card, professional fees and insurance expenses also decreased from 1992. The ratio of average assets per full-time equivalent staff was $2.2 million in 1993 compared to $1.8 million in 1992; the Company strategy to improve efficiency can be clearly seen in the reduction of the average number of full-time equivalent staff from 1,092 in 1992 to 905 in 1993. PROVISION FOR INCOME TAX The provision for income tax decreased $4.9 million in 1993 as a direct result of lower pretax income and a $394,000 revaluation adjustment of deferred tax assets due to an increase in statutory tax rates. The provision was $3.0 million in 1993 compared to $7.9 million in 1992 and $5.8 million in 1991. The higher provision in 1992 is a direct result of higher pretax income. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Consolidated Balance Sheets as of December 31, 1993 and 1992 36 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 38 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 40 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 41 Notes to Consolidated Financial Statements 43 Management's Letter of Financial Responsibility 67 Independent Auditors' Report 68 CONSOLIDATED BALANCE SHEETS (In thousands) December 31, 1993 1992* - --------------------------------------------------------------------------- Assets Cash and cash equivalents (Note 14) $ 102,618 $ 139,497 Money market assets 250 1,366 Trading account securities 10 -- Investment securities available-for-sale (Note 2) 168,819 -- Investment securities held-to-maturity; market value of $563,563 in 1993 and $581,768 in 1992 (Note 2) 557,057 570,236 Loans, net of reserve for loan losses of: $25,587 at December 31, 1993 $24,742 at December 31, 1992 (Notes 3, 4 and 13) 1,089,152 1,166,205 Loan collateral substantively foreclosed and other real estate owned 17,905 34,506 Land held for sale 800 1,123 Investment in joint venture 766 1,026 Premises and equipment, net (Notes 5 and 6) 25,341 26,959 Interest receivable and other assets (Note 8) 41,701 40,431 - --------------------------------------------------------------------------- Total assets $2,004,419 $1,981,349 =========================================================================== Liabilities Deposits: Non-interest bearing $ 369,820 $ 323,719 Interest bearing: Transaction 289,322 369,871 Savings 654,766 564,763 Time (Notes 2 and 6) 417,320 531,565 - --------------------------------------------------------------------------- Total deposits 1,731,228 1,789,918 Funds purchased 69,064 12,038 Liability for interest, taxes, other expenses, minority interest and other (Note 8) 15,328 16,382 Notes and mortgages payable (Notes 6 and 14) 36,352 19,337 - --------------------------------------------------------------------------- Total liabilities 1,851,972 1,837,675 Commitments and contingent liabilities (Notes 4, 10 and 11) -- -- Shareholders' Equity (Notes 7 and 14) Common stock (no par value) Authorized- 20,000 shares Issued and outstanding- 8,080 shares in 1993 and 8,000 shares in 1992 52,499 51,053 Capital surplus 10,831 10,831 Unrealized gains on securities available for sale (Note 2) 2,527 -- Retained earnings 86,590 81,790 - --------------------------------------------------------------------------- Total shareholders' equity 152,447 143,674 - --------------------------------------------------------------------------- Total liabilities and shareholders' equity $2,004,419 $1,981,349 =========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------- Interest Income Loans $ 99,607 $115,357 $137,656 Money market assets and federal funds sold 298 1,745 2,191 Trading account securities 6 4 54 Investment securities: U.S. Treasury 10,284 4,484 6,159 Securities of U.S. government agencies and corporations 13,994 18,802 18,406 Obligations of states and political subdivisions 5,894 5,358 5,272 Asset backed 4,942 5,809 5,675 Other 1,891 3,194 1,139 - --------------------------------------------------------------------- Total interest income 136,916 154,753 176,552 - --------------------------------------------------------------------- Interest Expense Transaction deposits 4,219 7,680 13,371 Savings deposits 15,085 18,838 22,748 Time deposits (Note 6) 19,014 29,314 46,950 Funds purchased 1,937 698 1,677 Notes and mortgages payable (Note 6) 2,016 2,362 2,611 - --------------------------------------------------------------------- Total interest expense 42,271 58,892 87,357 - --------------------------------------------------------------------- Net Interest Income 94,645 95,861 89,195 Provision for loan losses (Note 3) 9,452 7,005 10,418 - --------------------------------------------------------------------- Net interest income after provision for loan losses 85,193 88,856 78,777 - --------------------------------------------------------------------- Non-Interest Income Service charges on deposit accounts 12,809 12,437 12,056 Merchant credit card 2,217 2,900 2,881 Mortgage banking 1,467 1,808 1,457 Brokerage commissions 839 555 392 Net investment securities gain 68 1,066 1,742 Other 6,546 5,061 5,448 - --------------------------------------------------------------------- Total non-interest income 23,946 23,827 23,976 - --------------------------------------------------------------------- Non-Interest Expense Salaries and related benefits (Note 12) 39,007 40,826 40,252 Other real estate owned 11,550 5,183 2,884 Occupancy (Notes 5 and 10) 8,625 8,524 8,401 Equipment (Notes 5 and 10) 6,195 5,302 5,522 FDIC insurance assessment 4,079 4,021 3,545 Data processing 3,658 3,137 2,964 Professional fees 3,071 3,332 3,346 Other 20,460 19,279 18,029 - ---------------------------------------------------------------------- Total non-interest expense 96,645 89,604 84,943 - ---------------------------------------------------------------------- Income Before Income Taxes 12,494 23,079 17,810 Provision for income taxes (Note 8) 3,039 7,857 5,833 - ---------------------------------------------------------------------- Net Income $ 9,455 $ 15,222 $ 11,977 ====================================================================== Average common shares outstanding 8,054 7,933 7,855 Per Share Data (Notes 7 and 17) Net income $ 1.17 $ 1.92 $ 1.52 Dividends declared .57 .51 .44 *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) For the years ended December 31, 1993 1992* 1991* - --------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $ 15,222 $ 11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,622 4,198 4,189 Loan loss provision 9,452 7,005 10,418 Amortization of net deferred loan (cost)/fees (462) 615 433 (Increase) decrease in interest income receivable (2,542) 1,070 1,698 Decrease (increase) in other assets 2,888 (3,204) 2,062 Decrease in income taxes payable (1,529) (1,179) (2,752) Decrease in interest expense payable (1,169) (1,933) (1,145) (Decrease) increase in accrued expenses (1,809) 1,420 (405) Net gain on sale of investment securities (68) (1,066) (1,742) Loss (gain) on sale of developed land -- 2,930 (107) Loss (gains) on sales/write-down of premises and equipment 1,476 225 (86) Originations of loans for resale (92,374) (100,055) (102,300) Proceeds from sale of loans originated for resale 92,536 103,855 102,019 Loss on sale/write-down of property acquired in satisfaction of debt 9,618 3,507 2,559 Gain on sale of Sonoma Valley Bank (668) -- -- Net (purchases) maturities of trading securities (10) 779 (130) - --------------------------------------------------------------------------- Net cash provided by operating activities 28,416 33,389 26,688 - --------------------------------------------------------------------------- Investing Activities Net repayments of loans 68,109 32,782 15,470 Purchases of money market assets (325) (16,833) (34,551) Purchases of investment securities (427,886) (339,583) (269,505) Purchases of property, plant and equipment (3,481) (4,416) (5,161) Improvements on developed land -- (1,435) -- Proceeds from maturity/sale of money market assets 1,441 17,574 34,301 Proceeds from maturity of securities 274,451 263,793 139,549 Proceeds from sale of securities 184 21,128 49,580 Proceeds from sale of property and equipment -- 1,640 858 Net proceeds from sale of developed land 356 1,928 107 Proceeds from disposition of property acquired in satisfaction of debt 6,313 4,513 624 Proceeds from sale of Sonoma Valley Bank 2,733 -- -- Net repayments on loan collateral substantively foreclosed 669 1,187 629 - --------------------------------------------------------------------------- Net cash used in investing activities (77,436) (17,722) (68,099) - --------------------------------------------------------------------------- Financing Activities Net increase (decrease) in deposits (58,691) 617 66,203 Net (decrease) increase in federal funds purchased 57,026 2,468 (25,529) Proceeds from issuance of capital notes 20,000 -- -- Principal payments on notes and mortgages payable (2,985) (2,423) (1,672) Exercise of stock options 1,446 2,214 1,525 Retirement of stock -- (204) (843) Unrealized loss (gain) in marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - --------------------------------------------------------------------------- Net cash provided by (used in) financing activities 12,141 (306) 36,634 - --------------------------------------------------------------------------- Net (decrease) increase in cash and cash equivalents (36,879) 15,361 (4,777) Cash and cash equivalents at beginning of year 139,497 124,136 128,913 - --------------------------------------------------------------------------- Cash and cash equivalents at end of year $102,618 $139,497 $124,136 =========================================================================== Supplemental disclosures: Loans transferred to other real estate owned and substantively repossessed $16,111 $36,572 $9,132 Interest paid 42,982 57,491 87,163 Income tax payments 5,700 9,773 9,045 Unrealized gain on securities available for sale 2,527 -- -- *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. See accompanying notes to consolidated financial statements. Westamerica Bancorporation NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: Business and Accounting Policies Westamerica Bancorporation, a registered bank holding Company, (the Company), provides a full range of banking services to individual and corporate customers in Northern California through its subsidiary banks (the Banks), Westamerica Bank and Subsidiary, Bank of Lake County and Napa Valley Bank and Subsidiary. The Banks are subject to competition from other financial institutions and to regulations of certain agencies and undergo periodic examinations by those regulatory authorities. Summary of Significant Accounting Policies The consolidated financial statements are prepared in conformity with generally accepted accounting principles and general practices within the banking industry. The following is a summary of significant accounting policies used in the preparation of the accompanying financial statements. In preparing the financial statements, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods indicated. Principles of Consolidation. The financial statements include the accounts of the Company, a registered bank holding company, and all the Company's subsidiaries which include the Banks and Community Banker Services Corporation and Subsidiary. Significant intercompany transactions have been eliminated in consolidation. All data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Cash Equivalents. Cash equivalents include Due From Banks balances and Federal Funds Sold which are both readily convertible to known amounts of cash and are so near their maturity that they present insignificant risk of changes in value because of interest rate volatility. Securities. Marketable investment securities at December 31, 1993 consist of U.S. Treasury, U. S. Government Agencies and Corporations, Municipal, asset-backed and other securities. The Company adopted the provisions of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 115) at December 31, 1993. Under SFAS No. 115, the Company classifies its debt and marketable equity securities into one of three categories: trading, available-for-sale or held-to-maturity. Trading securities are bought and held principally for the purpose of selling in the near term. Held-to-maturity securities are those securities which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held-to-maturity are classied as available-for-sale. Trading and available-for-sale securities are recorded at fair value. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Unrealized gains and losses on trading securities are included in earnings. Unrealized gains and losses, net of the related tax effect, on available-for-sale securities are excluded from earnings and are reported as a separate component of shareholders' equity until realized. Unrealized gains and losses associated with transfers of securities from held-to-maturity to available-for-sale are recorded as a separate component of shareholders' equity. The unrealized gains or losses included in the separate component of shareholders' equity for securities transferred from available-for-sale to held-to-maturity are maintained and amortized into earnings over the remaining life of the security as an adjustment to yield in a manner consistent with the amortization or accretion of premium or discount on the associated security. A decline in the market value of held-to-maturity and available-for-sale securities below cost that is deemed other than temporary, results in a charge to earnings and the establishment of a new cost basis for the security. Premiums and discounts are amortized or accreted over the life of the related investment security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities classied as available-for-sale and held-to-maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Loans and Reserve for Loan Losses. The reserve for loan losses is a combination of specific and general reserves available to absorb estimated future losses in the loan portfolio and is maintained at a level considered adequate to provide for such losses. Credit reviews of the loan portfolio, designed to identify problem loans and to monitor these estimates, are conducted continually, taking into consideration market conditions, current and anticipated developments applicable to the borrowers and the economy, and the results of recent examinations by regulatory agencies. Management approves the conclusions resulting from credit reviews. Ultimate losses may vary from current estimates. Adjustments to previous estimates of loan losses are charged to income in the period which they become known. Unearned interest on discounted loans is amortized over the life of these loans, using the sum-of-the-months digits method for which the results are not materially different from those obtained by using the interest method. For all other loans, interest is accrued daily on the outstanding balances. Loans which are more than 90 days delinquent with respect to interest or principal, unless they are well secured and in the process of collection, and other loans on which full recovery of principal or interest is in doubt, are placed on non-accrual status. Non-refundable fees and certain costs associated with originating or acquiring loans are deferred and amortized as an adjustment to interest income over the estimated respective loan lives. Loans held for sale are identified upon origination and are reported at the lower of cost or fair value on an individual loan basis. Other Real Estate Owned and Loan Collateral Substantively Foreclosed. Other real estate owned includes property acquired through foreclosure or forgiveness of debt. These properties are transferred at fair value, which becomes the new cost basis of the property. Losses recognized at the time of acquiring property in full or partial satisfaction of loans are charged against the reserve for loan losses. Subsequent losses incurred due to the declines in property values as identified in independent property appraisals are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. The Company classifies loans as loan collateral substantively foreclosed (substantive repossessions) when the borrower has little or no equity in the collateral, when proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral, and the debtor has either formally or effectively abandoned control of the collateral to the Company or has retained control of the collateral but, because of the current financial condition of the debtor or the economic prospects for the debtor and/or collateral in the foreseeable future, it is doubtful that the debtor will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. Losses recognized at the time the loans are reclassified as substantive repossessions are charged against the reserve for loan losses. Subsequent losses incurred due to subsequent declines in property values, as identified in independent property appraisals, are recognized as non-interest expense. Routine holding costs, such as property taxes, insurance and maintenance, and losses from sales and dispositions are recognized as non-interest expense. Premises and Equipment. Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful life of each type of asset. Estimated useful lives of premises and equipment range from 20 to 50 years and from 3 to 20 years, respectively. Leasehold improvements are amortized over the terms of the lease or their estimated useful life, whichever is shorter. Fully depreciated and/or amortized assets are removed from the Company's balance sheet. Interest Rate Swap Agreements. The Company uses interest rate swap agreements as an asset/liability management tool to reduce interest rate risk. Interest rate swap agreements are exchanges of fixed and variable interest payments based on a notional principal amount. The primary risk associated with swaps is the exposure to movements in interest rates and the ability of the counter parties to meet the terms of the contracts. The Company controls the credit risk of the these agreements through credit approvals, limits and monitoring procedures. The Company is not a dealer but an end user of these instruments and does not use them speculatively. Accounted for as hedges, the differential to be paid or received on such agreements is recognized over the life of the agreements. Payments made or received in connection with early termination of interest rate swap agreements are recognized over the remaining term of the swap agreement. Earnings Per Share. Earnings per share amounts are computed on the basis of the weighted average of common shares outstanding during each of the years presented. Income Taxes. The Company and its subsidiaries file consolidated tax returns. For financial reporting purposes, the income tax effects of transactions are recognized in the year in which they enter into the determination of recorded income, regardless of when they are recognized for income tax purposes. Accordingly, the provisions for income taxes in the consolidated statements of income include charges or credits for deferred income taxes relating to temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Other. Securities and other property held by the Banks in a fiduciary or agency capacity are not included in the financial statements since such items are not assets of the Company or its subsidiaries. Certain amounts in prior years financial statements have been reclassified to conform with the current years presentation. These reclassifications had no effect on previously reported income. Note 2: Investment Securities An analysis of investment securities available-for-sale as of December 31, 1993, is as follows: *Includes $24.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.4 million; 1 to 5 years $15.2 million. The average yield of these securities is 5.56 percent. An analysis of investment securities held-to-maturity as of December 31, 1993, is as follows: *Includes $162.6 million in Collateralized Mortgage Obligations with the following maturities: 1 year or less $9.9 million; 1 to 5 years $9.3 million; 5 to 10 years $71.3 million; over 10 years $72.1 million. These securities have a market value of $162.4 million and an average yield of 5.45 percent. As of December 31, 1993, $173.5 million of investment securities held-to- maturity were pledged to secure public deposits. A summary of investment securities portfolio held-to-maturity as of December 31, 1992, is as follows: Gross Gross Book unrealized unrealized Fair Value gains losses Value - -------------------------------------------------------------------- U.S. Treasury securities $126,522 $2,208 ($156) $128,574 Securities of U.S. Govt. Agencies and Corporations 237,753 4,919 (517) 242,155 Obligations of States and Political Subdivisions 87,031 3,655 (197) 90,489 Asset Backed (Automobile Receivables) 82,270 1,040 (105) 83,205 Other Securities (Preferred Stocks & Corporate Bonds) 36,660 735 (50) 37,345 - -------------------------------------------------------------------- Total Securities Held-to-maturity $570,236 $12,557 ($1,025) $581,768 ==================================================================== Note 3: Loans and Reserve for Loan Losses Loans at December 31, consisted of the following: (In thousands) 1993 1992 - ------------------------------------------------------- Commercial $ 266,448 $ 439,494 Real estate-commercial 346,308 196,401 Real estate-construction 40,533 63,886 Real estate-residential 172,245 175,834 Installment and personal 304,993 334,215 Unearned income (15,788) (18,883) - ------------------------------------------------------- Gross loans 1,114,739 1,190,947 Loan loss reserve (25,587) (24,742) - ------------------------------------------------------- Net loans $1,089,152 $1,166,205 ======================================================= Included in real estate-residential at December 31, 1993 and 1992 are loans held for resale of $5.9 million and $3.6 million, respectively, the cost of which approximates market value. Changes in the loan loss reserve were: (In thousands) 1993 1992 1991 - ------------------------------------------------------------------ Balance at January 1, $24,742 $23,853 $19,002 Sale of Sonoma Valley Bank (684) -- -- Provision for loan losses 9,452 7,005 10,418 Credit losses (10,091) (8,794) (9,140) Credit loss recoveries 2,168 2,678 3,573 - ------------------------------------------------------------------ Balance at December 31, $25,587 $24,742 $23,853 ================================================================== Restructured loans were $4.4 million and $319,000 at December 31, 1993 and 1992, respectively. The following is a summary of interest foregone on restructured loans for the years ended December 31: (In thousands) 1993 1992 1991 - ------------------------------------------------------------- Interest income that would have been recognized had the loans performed in accordance with their original terms $472 $135 $173 Less: Interest income recognized on restructured loans (218) -- (8) - ------------------------------------------------------------- Interest foregone on restructured loans $254 $135 $165 ============================================================= Note 4: Concentrations of Credit Risk The Company's business activity is with customers in Northern California. The loan portfolio is well diversified with no industry comprising greater than ten percent of total loans outstanding as of December 31, 1993. The Company has a significant number of credit arrangements that are secured by real estate collateral. In addition to real estate loans outstanding as disclosed in Note 3, the Company had loan commitments and stand by letters of credit related to real estate loans of $18.7 million at December 31, 1993. The Company requires collateral on all real estate loans and generally attempts to maintain loan-to-value ratios no greater than 75 percent on commercial real estate loans and no greater than 80 percent on residential real estate loans. Note 5: Premises and Equipment A summary as of December 31, follows: Accumulated Depreciation and Net (In thousands) Cost Amortization Book Value - ------------------------------------------------------------------------- Land $ 3,735 $ -- $ 3,735 Buildings and improvements 20,072 (6,876) 13,196 Leasehold improvements 2,537 (1,513) 1,024 Furniture and equipment 14,347 (6,961) 7,386 - ------------------------------------------------------------------------- Total $40,691 $(15,350) $25,341 ========================================================================= Land $5,483 $ -- $ 5,483 Buildings and improvements 19,131 (7,225) 11,906 Leasehold improvements 4,878 (2,929) 1,949 Furniture and equipment 19,711 (12,090) 7,621 - ------------------------------------------------------------------------- Total $49,203 $(22,244) $26,959 ========================================================================= Depreciation and amortization included in non-interest expense amount to $3,621,800 in 1993, $4,198,000 in 1992 and $4,189,400 in 1991. Note 6: Borrowed Funds Notes payable include the unsecured obligations of the Company as of December 31, 1993 and 1992, as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------------ Unsecured note dated September, 1976, interest payable semiannually at 9 7/8% and principal payments of $267 due annually to September 1, 1996. $ 196 $ 463 Unsecured note dated May, 1984, interest payable quarterly at 12.95% and principal payments of $1,000 due annually beginning September 1, 1991 and ending on September 1, 1996. Note agreement provides for partial prepayment under certain conditions without penalty and for prepayment of all or a portion of the note under certain conditions with a premium which decreases over the contractual term. 2,100 3,100 Equity contract notes, originated in April 1986 and maturing on April 1, 1996. Interest payable semiannually at 11 5/8% and principal payments of $2,500 due annually, on April 1, starting in 1993. 7,500 10,000 Senior notes, originated in May 1988 and maturing on June 30, 1995. Interest payable semiannually at 10.87% and principal payment due at maturity. 5,000 5,000 Subordinated note, issued by Westamerica Bank, originated in December 1993 and maturing September 30, 2003. Interest at an annual rate of 6.99% payable semiannually on March 31 and September 30, with principal due at maturity. 20,000 -- - ------------------------------------------------------------------------ Total notes payable $34,796 $18,563 ======================================================================== Mortgages payable of $524,000 consist of a note of Westamerica Bank secured by a deed of trust on premises having a net book value of $790,000 and $824,000 at December 31, 1993 and 1992, respectively. The note, which has an effective interest rate of 10 percent, is scheduled to mature in April 1995. Included in notes and mortgages payable are senior liens on other real estate, land held for sale and investments in joint venture properties that totaled $1,032,000 and $250,000 at December 31, 1993 and 1992, respectively. The combined aggregate amount of maturities of notes payable is $3,696,000, $8,500,000, $2,600,000, $0 and $0 for the years 1994 through 1998, and $20,000,000 thereafter. At December 31, 1993, the Company had unused lines of credit amounting to $7,500,000. Compensating balance arrangements are not significant to the operations of the Company. At December 31, 1993, the Banks had $113.0 million in time deposit accounts in excess of $100,000; interest on these accounts in 1993 was $4,837,000. Note 7: Shareholders' Equity In April 1982, the Company adopted an Incentive Stock Option Plan and 413,866 shares were reserved for issuance. Under this plan, all options are currently exercisable and terminate 10 years from the date of the grant. Under the Stock Option Plan adopted by the Company in 1985, 750,000 shares have been reserved for issuance. Stock appreciation rights, incentive stock options, non-qualified stock options and restricted performance shares are available under this plan. Options are granted at fair market value and are generally exercisable in equal installments over a three-year period with the first installment exercisable one year after the date of the grant. Each incentive stock option has a maximum ten-year term while non-qualified stock options may have a longer term. The 1985 plan was amended in 1990 to provide for restricted performance share (RPS) grants. An RPS grant becomes fully vested after three years of being awarded, provided that the Company has attained its performance goals for such three-year period. At December 31, 1993, 299,046 options were available for grant under the 1985 Stock Option Plan. Information with respect to options outstanding and options exercised under the plans is summarized in the following table: Number Option Price of shares* $ per share $ Total Shares under option at December 31: 1993 313,564 8.88- 24.50 5,766,400 1992 278,544 6.06- 22.00 4,249,399 1991 400,247 6.06- 22.00 6,202,300 Options exercised during: 1993 51,260 8.88- 22.00 692,157 1992 168,423 6.06- 13.29 1,975,000 1991 120,362 6.06- 13.63 997,700 * Issuable upon exercise. At December 31, 1993, options to acquire 164,794 shares of common stock were exercisable. Shareholders have authorized issuance of two new classes of 1,000,000 shares each, to be denominated Class B Common Stock and Preferred Stock, respectively, in addition to the 20,000,000 shares of Common Stock presently authorized. At December 31, 1993, no shares of Class B or Preferred Stock had been issued. At December 31, 1993, the Company's Tier I Capital was $149,937,000 and Total Capital was $194,415,000 or 11.11 percent and 14.40 percent, respectively, of risk-adjusted assets. In December 1986, the Company declared a dividend distribution of one common share purchase right (the Right) for each outstanding share of common stock. The Rights are exercisable only in the event of an acquisition of, or announcement of a tender offer to acquire, 15 percent or more of the Company's stock or 50 percent or more of its assets without the prior consent of the Board of Directors. If the Rights become exercisable, the holder may purchase one share of the Company's common stock for $65. Following an acquisition of 15 percent of the Company's common stock or 50 percent or more of its assets without prior consent of the Company, each right will also entitle the holder to purchase $130 worth of common stock of the Company for $65. Under certain circumstances, the Rights may be redeemed by the Company at a price of $.05 per right prior to becoming exercisable and in certain circumstances thereafter. The Rights expire on December 31, 1999, or earlier, in connection with certain Board-approved transactions. Note 8: Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, (SFAS No. 109). Adoption of SFAS No. 109 required a change from the deferred method to the asset and liability method of accounting for income taxes. Under the deferred method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement reported amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards.] 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. The components of the net deferred tax asset as of December 31, are as follows: (In thousands) 1993 1992 - ------------------------------------------------------------------- Deferred tax asset Reserve for loan losses $ 10,321 $ 9,013 State franchise taxes 676 941 Deferred compensation 534 723 Real estate owned 2,742 1,851 Net deferred loan fees -- 268 Other 1,037 587 - ------------------------------------------------------------------- 15,310 13,383 Valuation allowance -- -- - ------------------------------------------------------------------- Total deferred tax asset 15,310 13,383 - ------------------------------------------------------------------- Deferred tax liability Net deferred loan costs 502 -- Fixed assets depreciation 1,164 1,171 Securities available-for-sale 1,864 -- Other 148 373 - ------------------------------------------------------------------- Total deferred tax liability 3,678 1,544 - ------------------------------------------------------------------- Net deferred tax asset $11,632 $11,839 =================================================================== The Company believes a valuation allowance is not needed to reduce the deferred tax asset because there is no material portion of the deferred tax asset that will not be realized through sufficient taxable income. The provisions for federal and state income taxes consist of amounts currently payable and amounts deferred which, for the years ended December 31, are as follows: (In thousands) 1993 1992 1991 - ------------------------------------------------------------ Current income tax expense: Federal $2,501 $6,977 $5,314 State 2,195 3,130 2,638 - ------------------------------------------------------------ Total current 4,696 10,107 7,952 - ------------------------------------------------------------ Deferred income tax benefit: Federal (646) (1,758) (1,335) State (617) (492) (784) - ------------------------------------------------------------ Total deferred (1,263) (2,250) (2,119) - ------------------------------------------------------------ Adjustment of net deferred tax asset for enacted changes in tax rates: Federal (304) -- -- State (90) -- -- - ------------------------------------------------------------- Total adjustment (394) -- -- - ------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ============================================================= The provisions for income taxes differ from the provisions computed by applying the statutory federal income tax rate to income before taxes, as follows: (In thousands) 1993 1992 1991 - -------------------------------------------------------------------- Federal income taxes due at statutory rate $4,248 $7,846 $6,056 (Reductions) increases in income taxes resulting from: Interest not taxable for federal income tax purposes (1,895) (1,735) (1,836) State franchise taxes, net of federal income tax benefit 982 1,753 1,226 Deferred benefit and other (296) (7) 387 - --------------------------------------------------------------------- Provision for income taxes $3,039 $7,857 $5,833 ===================================================================== Note 9: Fair Value of Financial Instruments The fair value of financial instruments which have a relative short period of time between their origination and their expected realization were valued using historical cost. Such financial instruments and their estimated fair values at December 31, were: (In thousands) 1993 1992 - ------------------------------------------------------------------- Cash and cash equivalents $102,618 $139,497 Money market assets 250 1,366 Interest and taxes receivable 28,799 25,741 Non-interest bearing and interest-bearing transaction and savings deposits 1,313,908 1,258,353 Funds purchased 69,064 12,038 Interest payable 2,700 3,824 The fair value at December 31 of the following financial instruments was estimated using quoted market prices: (In thousands) 1993 1992 - ------------------------------------------------------------------- Investment securities available for sale $168,819 $ -- Investment securities held to maturity 563,563 581,768 Trading account securities 10 -- Loans were separated into two groups for valuation. Variable rate loans, which reprice frequently with changes in market rates, were valued using historical cost. Fixed rate loans were valued by discounting the future cash flows expected to be received from the loans using current interest rates charged on loans with similar characteristics. Additionally, the $25,587,000 and $24,742,000 reserves for loan losses as of December 31, 1993 and 1992, respectively, were applied against the estimated fair value to recognize future defaults of contractual cash flows. The estimated fair market value of loans at December 31, was: (In thousands) 1993 1992 - -------------------------------------------------------------------- Loans $1,096,164 $1,171,630 The fair value of time deposits and notes and mortgages payable was estimated by discounting future cash flows related to these financial instruments using current market rates for financial instruments with similar characteristics. The estimated fair values at December 31, were: (In thousands) 1993 1992 - --------------------------------------------------------------------- Time deposits $420,475 $534,920 Notes and mortgages payable 36,014 20,282 The estimated fair values of the Company's interest rate swaps, which are determined by dealer quotes and generally represent the amount that the Company would pay to terminate its swap contracts, were $(600,000) and $0, respectively, at December 31, 1993 and 1992. These fair values do not represent actual amounts that may be realized upon any sale or liquidation of the related assets or liabilities. In addition, these values do not give effect to discounts to fair value which may occur when financial instruments are sold in larger quantities. The fair values presented above represent the Company's best estimate of fair value using the methodologies discussed above. Note 10: Lease Commitments Fifteen banking offices and three administrative service centers are owned and thirty-seven banking offices and two support facilities are leased. Substantially all the leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living, property taxes and maintenance. The Company also leases certain pieces of equipment. Minimum future rental payments on operating leases, net of sublease income, at December 31, 1993, are as follows: (In thousands) 1994 $ 3,253 1995 3,091 1996 2,632 1997 1,679 1998 1,183 Thereafter 3,659 - ------------------------------------------------- Total minimum lease payments $15,497 ================================================= Total rentals for premises and equipment net of sublease income included in non-interest expense were $3,862,000 in 1993, $3,910,000 in 1992 and $3,829,000 in 1991. Note 11: Commitments and Contingent Liabilities Loan commitments are agreements to lend to a customer provided there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future funding requirements. Loan commitments are subject to the Company's normal credit policies and collateral requirements. Unfunded loan commitments were $159.2 million at December 31, 1993. Standby letters of credit commit the Company to make payments on behalf of customers when certain specified future events occur. Standby letters of credit are primarily issued to support customers short-term financing requirements and must meet the Company's normal credit policies and collateral requirements. Standby letters of credit outstanding were $6.4 million at December 31, 1993. Interest rate swaps are agreements to exchange interest payments computed on notional amounts. The notional amounts do not represent exposure to credit risk; however, these agreements expose the Company to market risks associated with fluctuations of interest rates. As of December 31, 1993, the Company had entered into four interest rate swaps. The first two contracts have notional amounts totaling $25 million each and the second two contracts have notional amounts totaling $30 million each. On the first two contracts, which are scheduled to terminate in November and December of 1994, the Company pays an average fixed rate of interest of 5.06 percent and receives a variable rate of interest based on the London Interbank Offering Rate (LIBOR); on the second two contracts, scheduled to terminate in August of 1995, the Company pays a variable rate based on LIBOR and receives an average fixed rate of interest of 4.11 percent. The LIBOR rate has averaged 3.39 percent from the date the first two swaps were entered through December 31, 1993 and 3.33 percent from the date the second two swaps were entered through December 31, 1993. The effect of entering into these contracts resulted in a decrease to net interest income of $659,000 for the period ended December 31, 1993. The Company, because of the nature of its business, is subject to various threatened or filed legal cases. The Company, based on the advice of legal counsel, does not expect such cases will have material, adverse effect on its financial position or results of operations. Note 12: Retirement Benefit Plans The Company sponsors a defined benefit Retirement Plan covering substantially all of its salaried employees with one or more years of service. The Company's policy is to expense costs as they accrue as determined by the Projected Unit Cost method. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. The following table sets forth the Retirement Plans funded status as of December 31 and the pension cost for the years ended December 31: (In thousands) 1993 1992 - ----------------------------------------------------------------- Actuarial present value of benefit obligations: Vested benefit obligation $(11,245) $(10,625) - ----------------------------------------------------------------- Accumulated benefit obligation (11,430) (11,064) - ----------------------------------------------------------------- Projected benefit obligation (11,612) (11,275) Plan assets at fair market value 11,677 11,429 ================================================================= Funded status-projected benefit obligation (in excess of) or less than plan assets $65 $154 ================================================================= Comprised of: Prepaid pension cost $22 $182 Unrecognized net (loss) gain (75) (194) Unrecognized prior service cost 529 628 Unrecognized net obligation, net of amortization (411) (462) - ----------------------------------------------------------------- Total $65 $154 ================================================================= Net pension cost included in the following components: Service cost during the period $364 $384 Interest cost on projected benefit obligation 744 754 Actual return on plan assets (1,012) (686) Net amortization and deferral 64 (271) - ----------------------------------------------------------------- Net periodic pension cost $160 $181 ================================================================= The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 6.75 percent and 5 percent, respectively, at December 31, 1993 and 7 percent and 5 percent, respectively, at December 31, 1992. The expected long-term rate of return on plan assets in 1993 and 1992 was 7 percent and 8 percent, respectively. Effective January 1, 1992, the Company adopted a defined contribution Deferred Profit-Sharing Plan covering substantially all of its salaried employees with one or more years of service. Participant deferred profit-sharing account balances offset benefits accrued under the Retirement Plan which was amended effective January 1, 1992 to coordinate benefits with the Deferred Profit-Sharing Plan. The coordination of benefits results in the Retirement Plan benefit formula establishing the minimum value of participant retirement benefits which, if not provided by the Deferred Profit-Sharing Plan, are guaranteed by the Retirement Plan. The costs charged to non-interest expense related to benefits provided by the Retirement Plan and the Deferred Profit-Sharing Plan were $1,160,000 in 1993, $1,037,000 in 1992 and $759,000 in 1991. In addition to the Retirement Plan and the Deferred Profit-Sharing Plan, all salaried employees are eligible to participate in the voluntary Tax Deferred Savings/Retirement Plan (ESOP) upon completion of a 90-day introductory period. This plan allows employees to defer, on a pretax basis, a portion of their compensation as contributions to the plan. Participants are allowed to invest in five funds, including a Westamerica Bancorporation Common Stock Fund. The Company's matching contributions charged to operating expense were $482,000 in 1993, $462,000 in 1992 and $452,000 in 1991. 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). Adoption of SFAS No. 106 required a change from the cash method to an actuarial based accrual method of accounting for postretirement benefits other than pensions. The Company offers continuation of group insurance coverage to employees electing early retirement, as defined by the Retirement Plan, for the period from the date of early retirement until age sixty-five. The Company contributes an amount toward early retirees insurance premiums which is fixed at the time of early retirement. The Company also reimburses Medicare Part B premiums for all retirees over age sixty-five, as defined by the Retirement Plan. The following table sets forth the net periodic postretirement benefit cost for the year ended December 31, 1993 and the funded status of the plan at December 31, 1993: (In thousands) Service cost $ 482 Interest cost 107 Actual return on plan assets -- Amortization of unrecognized transition obligation 61 Other, net (482) - ----------------------------------------------------------- Net periodic cost $ 168 =========================================================== Accumulated postretirement benefit obligation attributable to: Retirees $ 1,130 Fully eligible participants 265 Other 158 - ----------------------------------------------------------- Total 1,553 - ----------------------------------------------------------- Fair value of plan assets -- Accumulated postretirement benefit obligation in excess of plan assets $ 1,553 =========================================================== Comprised of: Unrecognized prior service cost -- Unrecognized net gain (loss) -- Unrecognized transition obligation 1,471 Recognized postretirement obligation 82 - ----------------------------------------------------------- Total $1,553 =========================================================== The discount rate used in measuring the accumulated postretirement benefit obligation was 6.75 percent at December 31, 1993. The assumed health care cost trend rate used to measure the expected cost of benefits covered by the plan was 9 percent for 1994 and declined steadily to an ultimate trend rate of 4 percent beginning in 1999. The effect of a one percentage point increase on the assumed health care cost trend for each future year would increase the aggregate of the service cost and interest cost components of the 1993 net periodic cost by $73,000 and increase the accumulated postretirement benefit obligation at December 31, 1993 by $204,000. Note 13: Related Party Transactions Certain directors and executive officers of the Company were lending customers of the Company during 1993 and 1992. All such loans were made in the ordinary course of business on normal credit terms, including interest rates and collateral requirements. No related party loan represents more than normal risk of collection. Such loans were $5,238,000 and $10,591,000 at December 31, 1993 and 1992, respectively. Note 14: Restrictions Payment of dividends to the Company by Westamerica Bank, the largest subsidiary bank, is limited under regulations for Federal Reserve member banks. The amount that can be paid in any calendar year, without prior approval from regulatory agencies, cannot exceed the net profits (as defined) for that year plus the net profits of the preceding two calendar years less dividends declared. Under this regulation, Westamerica Bank, the largest subsidiary bank, was not restricted as to the payment of $13.6 million in dividends to the Company as of December 31, 1993. During 1992 and 1993, Napa Valley Bank, a banking subsidiary, was operating under a regulatory order which disallowed payment of dividends to the Company unless it reduced the level of problem assets, liquidated, or reserved adequately against, the real estate investments in its subsidiary company, and strengthened its loan loss reserve. Napa Valley Bank has complied with all conditions of the regulatory order which will be removed by the regulators based on their fourth quarter 1993 examination. Payment of dividends by the Company is also restricted under the terms of the note agreements as discussed in Note 6. Under the most restrictive of these agreements, $17.1 million was available for payment of dividends as of December 31, 1993. Under one of the note agreements, the Company has agreed to limit its funded debt to 40 percent of the total of funded debt plus shareholders' equity and maintain certain other financial ratios. The Company was in compliance with all such requirements as of December 31, 1993. The Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of its reservable deposits. The Banks daily average balance on deposit at the Federal Reserve Bank was $40.4 million in 1993 and $40.3 million in 1992. Note 15: Westamerica Bancorporation (Parent Company Only) Statements of Income (In thousands) Years ended December 31, 1993 1992* 1991* - ----------------------------------------------------------------------- Dividends from subsidiaries $16,671 $ 8,630 $ 6,620 Interest from subsidiaries 315 61 72 Other income 2,781 1,158 1,082 - ----------------------------------------------------------------------- Total income 19,767 9,849 7,774 - ----------------------------------------------------------------------- Interest on borrowings 1,958 2,434 2,617 Salaries and benefits 4,526 782 475 Other non-interest expense 5,464 3,451 2,261 - ----------------------------------------------------------------------- Total expenses 11,948 6,667 5,353 - ----------------------------------------------------------------------- Income before income tax benefit and equity in undistributed income of subsidiaries 7,819 3,182 2,421 Income tax benefit 3,478 1,890 1,813 Equity in undistributed (loss) income of subsidiaries (1,842) 10,150 7,743 - ----------------------------------------------------------------------- Net income $9,455 $15,222 $11,977 ======================================================================= *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Balance Sheets (In thousands) Years ended December 31, 1993 1992* - -------------------------------------------------------------------------- Assets Cash and cash equivalents $4,790 $ 1,729 Investment securities held-to-maturity 9,250 13,741 Loans 149 -- Investment in subsidiaries 154,257 145,762 Premises and equipment 29 2,506 Accounts receivable from subsidiaries 65 262 Other assets 2,056 2,704 - ------------------------------------------------------------------------- Total assets $170,596 $166,704 ========================================================================= Liabilities Long-term debt $ 14,796 $ 18,563 Notes payable to subsidiaries -- 2,493 Other liabilities 3,353 1,974 - ------------------------------------------------------------------------- Total liabilities 18,149 23,030 - ------------------------------------------------------------------------- Shareholders' equity 152,447 143,674 - ------------------------------------------------------------------------- Total liabilities and shareholders' equity $170,596 $166,704 ========================================================================= Statements of Cash Flows (In thousands) Years ended December 31, 1993 1992* 1991* - -------------------------------------------------------------------------- Operating Activities Net income $ 9,455 $15,222 $11,977 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 108 67 58 Equity in undistributed loss (income) of subsidiaries 1,842 (10,150) (7,743) Increase in equity in subsidiaries -- (1,797) -- (Increase) decrease in receivables from subsidiaries 197 1,020 (1,005) Provision for deferred income taxes 60 2,633 (551) Decrease (increase) in other assets 1,183 (1,394) (771) Increase in other liabilities 1,583 301 39 Gain on sale of Sonoma Valley Bank (668) -- -- Net gain on sale of land -- 43 -- - -------------------------------------------------------------------------- Net cash provided by operating activities 13,760 5,945 2,004 - -------------------------------------------------------------------------- Investing Activities Purchases of premises and equipment -- (2,189) (761) Net change in land held for sale (800) -- -- Net change in loan balances (149) -- -- Increase in investment in subsidiaries (9,874) (485) (510) Purchase of investment securities held-to-maturity (9,700) (13,991) (22,100) Proceeds from maturities of investment securities 14,191 10,500 23,100 Proceeds from sales of premises and equipment 2,369 2,149 -- Proceeds from sale of Sonoma Valley Bank 2,733 -- -- - -------------------------------------------------------------------------- Net cash used in investing activities (1,230) (4,016) (271) - -------------------------------------------------------------------------- Financing Activities Net (decrease) increase in short-term debt -- (656) 453 Principal reductions of long-term debt and notes payable to subsidiaries (6,260) (2,611) (2,767) Proceeds from issuance of note payable to subsidiaries -- 1,368 -- Proceeds from exercise of stock options 1,446 2,139 1,507 Unrealized loss (gains) on marketable equity securities -- 9 (9) Dividends paid (4,655) (2,987) (3,041) - -------------------------------------------------------------------------- Net cash used in financing activities (9,469) (2,738) (3,857) - -------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 3,061 (809) (2,124) Cash and cash equivalents at beginning of year 1,729 2,538 4,662 - -------------------------------------------------------------------------- Cash and cash equivalents at year end $4,790 $1,729 $2,538 ========================================================================== *Data has been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. Note 16: Quarterly Financial Information (Unaudited) * As originally reported ** Represents prices quoted on the American Stock Exchange. Quoted prices are not necessarily representative of actual transactions. Note 17: Acquisition On April 15, 1993, the Company issued approximately 2,122,740 shares of its common stock in exchange for all of the outstanding common stock of Napa Valley Bancorp, a bank holding company, whose subsidiaries included Napa Valley Bank ("NVB"), a California-based, state-chartered banking association, and Subsidiary, 88 percent interest in Bank of Lake County ("BLC"), a national banking association, 50 percent interest in Sonoma Valley Bank, a state banking association, Suisun Valley Bank, also a state chartered bank, and Napa Valley Bancorp Services Corporation ("NVBSC"), estabilshed to provide data processing and other services to Napa Valley Bancorp's subsidiaries. This business transaction (the "Merger") was accounted for as a pooling-of-interests combination and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassifications have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. Subsequent to the combination, Westamerica Bancorporation sold the 50 percent interest in Sonoma Valley Bank at a gain of $668,000. This business combination has been accounted for as a pooling-of-interests combination; and, accordingly, the consolidated financial statements and financial data for periods prior to the combination have been restated to include the accounts and results of operations of Napa Valley Bancorp. Certain reclassification have been made to Napa Valley Bancorp to conform to Westamerica Bancorporation's presentation. The results of operations previously reported by the separate enterprises and the combined amounts presented in the accompanying consolidated financial statements are summarized as follows. Three months ended March 31, 1993 Years ended December 31, (In thousands) (unaudited) 1992 1991 - ----------------------------------------------------------------------- Net Interest Income: Westamerica Bancorporation $16,809 $67,192 $62,496 Napa Valley Bancorp 7,365 28,669 26,699 - ----------------------------------------------------------------------- Combined $24,174 $95,861 $89,195 - ----------------------------------------------------------------------- Net Income (loss): Westamerica Bancorporation $3,675 $13,979 $11,762 Napa Valley Bancorp (656) 1,243 215 - ----------------------------------------------------------------------- Combined $3,019 $15,222 $11,977 - ----------------------------------------------------------------------- Net Income (loss) Per Share: Westamerica Bancorporation* $.63 $2.40 $2.06 Napa Valley Bancorp* (.19) .36 .06 Combined $.38 $1.92 $1.52 - ----------------------------------------------------------------------- * As originally reported. Net income per share was reduced $.25 for the three months ended March 31, 1993, $.48 in 1992, and $.54 in 1991, attributable to dilution from shares issued in connection with the acquisition. In addition, net income of the Company for 1993 was reduced by an estimated $8.3 million due to the consolidation of Napa Valley Bancorp's branches and operations, certain merger-related expenses and the application of Westamerica Bancorporation's workout strategy to the non-performing assets of Napa Valley Bancorp. There were no significant transactions between Westamerica Bancorporation and Napa Valley Bancorp prior to the combination. 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 The information required by this Item 10 is incorporated herein by reference from the "Election of Directors" and "Executive Officers" section on Pages 2 through 9 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item 11 is incorporated herein by reference from the "Executive Compensation" and "Retirement Benefits and Other Arrangements" section on Pages 11 through 16 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is incorporated herein by reference from the "Security Ownership of Certain Beneficial Owners and Management" section on Pages 9 and 10 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item 13 is incorporated herein by reference from the "Indebtedness of Directors and Management" section on Page 6 of the Company's Proxy Statement dated March 22, 1994, which has been filed with the Commission pursuant to Regulation 14A. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. All Financial Statements See Index to Financial Statements on page 36. (a) 2. Financial statement schedules required by Item 8 of Form 10-K and by Item 14(d). None (Information included in Financial Statements). (a) 3. Exhibits The following documents are included or incorporated by reference in this annual report on Form 10-K. Exhibit Number 3(a) Restated Articles of Incorporation (composite copy). 3(b)** By-laws. 10 Material contracts: (a)* Incentive Stock Option Plan (b)*** James M. Barnes --January 7, 1987 (Employment) (c)*** E. Joseph Bowler --January 7, 1987 (Employment) (d)*** Robert W. Entwisle --January 7, 1987 (Employment) (e)**** Amended and Restated Agreement and Plan of Reorganization by and between Westamerica Bancorporation and John Muir National Bank, proxy and prospectus dated November 27, 1991. (f)***** Agreement and Plan of Merger by and between Westamerica Bancorporation and Napa Valley Bancorp, proxy and prospectus dated November 12, 1992. 22 Subsidiaries of the registrant. *Exhibit 10(a) is incorporated by reference from Exhibit A to the Company's Proxy Statement dated March 22, 1983, which was filed with the Commission pursuant to Regulation 14A. **Exhibits 3(b), is incorporated by reference from Exhibit 3(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ***Exhibits 3(a), 10(b), 10(c) and 10(d) are incorporated herein by reference from Exhibits 3(a), 10(n), 10(o), and 10(q) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986. ****Exhibit 3(e) is incorporated herein by reference from the Form S-4 dated November 27, 1991. *****Exhibit 3(f) is incorporated herein by reference from the Form S-4 dated November 12, 1992. The Corporation will furnish to shareholders a copy of any exhibit listed above, but not contained herein, upon written request to Mrs. M. Kitty Jones, Vice President and Secretary, Westamerica Bancorporation, P. O. Box 567, San Rafael, California 94915, and payment to the Corporation of $.25 per page. (b) Report on Form 8-K None MANAGEMENTS LETTER OF FINANCIAL RESPONSIBILITY To the Shareholders: The Management of Westamerica Bancorporation is responsible for the preparation, integrity, reliability and consistency of the information contained in this annual report. The financial statements, which necessarily include amounts based on judgments and estimates, were prepared in conformity with generally accepted accounting principles and prevailing practices in the banking industry. All other financial information appearing throughout this annual report is presented in a manner consistent with the financial statements. Management has established and maintains a system of internal controls that provides reasonable assurance that the underlying financial records are reliable for preparing the financial statements, and that assets are safeguarded from unauthorized use or loss. This system includes extensive written policies and operating procedures and a comprehensive internal audit function, and is supported by the careful selection and training of staff, an organizational structure providing for division of responsibility, and a Code of Ethics covering standards of personal and business conduct. Management believes that, as of December 31, 1993 the Corporation's internal control environment is adequate to provide reasonable assurance as to the integrity and reliability of the financial statements and related financial information contained in the annual report. The system of internal controls is under the general oversight of the Board of Directors acting through its Audit Committee, which is comprised entirely of outside directors. The Audit Committee monitors the effectiveness of and compliance with internal controls through a continuous program of internal audit and credit examinations. This is accomplished through periodic meetings with Management, internal auditors, loan quality examiners, regulatory examiners and independent auditors to assure that each is carrying out their responsibilities. The Corporation's financial statements have been audited by KPMG Peat Marwick, independent auditors elected by the shareholders. All financial records and related data, as well as the minutes of shareholders and directors meetings, have been made available to them. Management believes that all representations made to the independent auditors during their audit were valid and appropriate. David L. Payne Chairman, President and CEO James M. Barnes Executive Vice President and CFO Dennis R. Hansen Senior Vice President and Controller INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders of Westamerica Bancorporation We have audited the accompanying consolidated balance sheets of Westamerica Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' 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. As discussed in Note 1 to the consolidated financial statements, the consolidated balance sheet of the Company as of December 31, 1992 and the related statements of income, changes in shareholders' equity, and cash flows for each of the years in the two year period ended December 31, 1992, and the related footnote disclosures have been restated on an historical basis to reflect the April 15, 1993 acquisition of Napa Valley Bancorp on a pooling-of-interests basis. We did not audit the financial statements of Napa Valley Bancorp as of and for the periods ended December 31, 1992 and 1991, which statements reflect total assets constituting 30 percent in 1992 and net income constituting 8 percent and 2 percent in 1992 and 1991, respectively, of the related and restated consolidated totals. Those statements included in the 1992 and 1991 restated consolidated totals were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Napa Valley Bancorp, 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 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 the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Westamerica Bancorporation and subsidiaries 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. San Francisco, California January 25, 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. WESTAMERICA BANCORPORATION By Dennis R. Hansen By James M. Barnes - ---------------------- -------------------- Senior Vice President and Controller Executive Vice President and (Principal Accounting Officer) Chief Financial 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 date indicated. Signature Title Date David L. Payne Chairman of the Board and 3/24/94 ------------------------------ Director and President and CEO E. Joseph Bowler Senior Vice President 3/24/94 ------------------------------ and Treasurer Etta Allen Director 3/24/94 ------------------------------ Louis E. Bartolini Director 3/24/94 ------------------------------ Charles I. Daniels, Jr. Director 3/24/94 ------------------------------ Don Emerson Director 3/24/94 ------------------------------ Arthur C. Latno Director 3/24/94 ------------------------------ Patrick D. Lynch Director 3/24/94 ------------------------------ Catherine Cope MacMillan Director 3/24/94 ------------------------------ James A. Maggetti Director 3/24/94 ------------------------------ Dwight H. Murray,Jr.,M.D. Director 3/24/94 ------------------------------ Ronald A. Nelson Director 3/24/94 ------------------------------ Carl Otto Director 3/24/94 ------------------------------ Edward B. Sylvester Director 3/24/94 ------------------------------ Exhibit 22 WESTAMERICA BANCORPORATION SUBSIDIARIES AS OF DECEMBER 31, 1993 State of Incorporation Westamerica Bank California Napa Valley Bank California Bank of Lake County California Community Banker Services Corporation California

49792_1993.txt

49792_1993

1993

49792

ITEM 1. BUSINESS - ----------------- BACKGROUND Illinois Central Railroad Company (the "Railroad"), traces its origin to 1851, when the Railroad was incorporated as the nation's first land grant railroad. Today, the Railroad operates 2,700 miles of main line track between Chicago and the Gulf of Mexico, primarily carrying chemicals, coal and paper north, with coal, grain and milled grain products moving south along its lines. The Railroad has been significantly downsized and restructured from its peak of nearly 10,000 miles of track operated in 13 states, rebuilding its main line and converting to a single-track main line with a centralized traffic control system and divesting major east-west segments. The Railroad is a wholly-owned subsidiary and a principal asset of Illinois Central Corporation ("IC"). In 1989, the Railroad was acquired by The Prospect Group, Inc. ("Prospect") by means of a public tender offer that resulted in the Railroad becoming highly leveraged. Prospect distributed the stock of the Railroad to Prospect's stockholders in 1990, and the Railroad again became publicly owned. Improved operating performance, combined with sales of non-operating assets and proceeds from equity and lower-cost debt financings since 1990 have resulted in a substantial reduction in the Railroad's leverage. Between December 31, 1989 and December 31, 1993, the Railroad reduced its debt to capitalization ratio from 89% to approximately 49%. The principal executive office of the Railroad is located at 455 North Cityfront Plaza Drive, Chicago, Illinois 60611-5504 and its telephone number is (312) 755-7500. GENERAL The Railroad is in the midst of a four year plan designed to increase its revenues and lower its operating ratio and interest costs. The plan is in sharp contrast to the Railroad's primary focus for the four years ended December 31, 1992 of significantly reducing costs and improving service offerings. With 1992 as its base, the plan will focus on capitalizing on the Railroad's leading operating ratio among Class I railroads (operating expenses divided by operating revenues) which was 68.6% at December 31, 1993. The components of the plan are: - increase annual revenues by $100 million by the end of 1996 - reduce the operating ratio by one percentage point per year for a total of four (4) points below the 1992 base - reduce annual interest expense by $10 million To accomplish this plan, revenues must grow at a compounded rate of 4.3% per year while operating expenses must not exceed a compounded annual growth rate of 2.5% per year. Management has identified the sources of planned revenue growth as economic expansion, new and expanded plants on line and market share growth. Economic expansion is the combination of industrial production improvement and freight rate increases. Market share growth is volume gained from competition, (i.e., other railroads, trucklines and barges) facilitated by being a low cost producer. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the progress made in 1993. To foster achievement of these goals, the Railroad reorganized its marketing and sales effort (see below), restructured its safety and claims group into a Risk Management Group and streamlined the operating organization. The latter effectively created teams of engineering, maintenance and transportation experts who share the common goal of moving trains safely and efficiently. As a result of these changes, decision-making authority and accountability are now at lower and more localized levels, in line with the Railroad's systematic efforts to examine and refine all aspects of its service offering to customers. COMMODITIES AND CUSTOMERS The Railroad's customers are engaged in a wide variety of businesses and ship a number of different products that can be classified into commodity groups: chemicals, coal, grain, paper, grain mill and food products and other commodities. In 1993, two customers accounted for approximately 7% and 6%, respectively, of revenues (no other customer exceeded 5%) and the ten largest customers accounted for approximately 37% of revenues. In order to address more effectively the diversity of the Railroad's customer base and move toward attainment of the four year growth plan, the Railroad's marketing department was re-organized in 1993 along major commodity groups. The new business units are chemicals and bulk, grain and grain mill, forest products, coal and coke and metals, and intermodal. The formation of separate units enables a fully integrated sales and marketing effort. Specialization allows employees to anticipate and respond to customer needs more quickly, to attract customers who previously used trucks or barges for their service needs, and to establish business relationships with new shippers. These new units work with current and prospective customers to develop customized shipping solutions. Management believes that this commitment to improved customer service has enhanced relations with shippers. The formation of the Intermodal Business Unit underscores the Railroad's commitment to intermodal through long-term relationships with major participants in this strategic market. By forming a separate business unit, the Railroad has fully integrated its intermodal hub operation with sales and marketing for unmatched control of this highly specialized, customer-oriented service. In 1993, the Railroad invested in 800 new trailers and upgraded facilities to position itself for intermodal growth, dedicated its newest, state- of-the-art terminal, just south of Chicago at the intersections of major expressways, and initiated a major expansion at the Memphis facility with completion anticipated for the first quarter of 1994. To enhance service within its corridor, the Railroad entered into several joint operating agreements in 1992 and 1993 with trucklines and other intermodal carriers. Management anticipates that these relationships will provide better service to customers and seamless transportation of goods for shippers and customers. In 1993, approximately 75% of the Railroad's freight traffic originated on its own lines, of which approximately 29% was forwarded to other carriers. Approximately 20% of the Railroad's freight traffic was received from other carriers for final delivery by the Railroad, and the balance of approximately 5% represented bridge or through traffic. The respective percentage contributions by principal commodity group to the Railroad's freight revenues and revenue ton miles during the past five years are set forth below: - ----------------- (1) A new car tracking system installed in late 1990 affects the comparability of 1993's, 1992's and 1991's ton mile data with that of the prior years, thus prior years are not presented. Some of the elements contained in these commodity groupings are as follows: CHEMICALS ................... A wide variety of chemicals and related products such as chlorine, caustic soda, potash, soda ash, vinyl chloride monomer, carbon dioxide, synthetic resins, alcohols, glycols, styrene monomer, plastics, sulfuric acid, muriatic acid, anhydrous ammonia, phosphates, mixed fertilizer compounds and carbon blacks. COAL......................... Bituminous and metallurgical coal. GRAIN ....................... Corn, wheat, soybeans, sorghum, barley and oats. PAPER........................ Pulpboard, fiberboard, woodpulp, printing paper, newsprint and scrap or waste paper. GRAIN MILL & FOOD PRODUCTS .. Products obtained by processing grain and other farm products such as feed, soybean meal, corn syrup, flour and middlings, animal packinghouse by-products (tallow), canned food, corn oil, soybean oil, vegetable oils, malt liquors, sugar and molasses. INTERMODAL................... A wide variety of products shipped either in containers or trailers on specially designed cars. OTHER........................ Pulpwood and chips, lumber and other wood products; sand, gravel and stone, coke and petroleum products, metallic ores and other bulk commodities; primary and scrap metals, machinery and metal products, appliances, automobiles and parts, transportation equipment and farm machinery; glass and clay products, ordnance and explosives, rubber and plastic products, and general commodities. - --------------- (1) Ton mile data for years subsequent to December 31, 1990, are not comparable with prior years because of the installation of a new car tracking system in late 1990. As a result, this information is not meaningful (NM) for 1990 and 1989. (2) Freight train miles equals the total number of miles traveled by the Railroad's trains in the movement of freight. (3) Revenue ton miles of freight traffic equals the product of the weight in tons of freight carried for hire and the distance in miles between origin and destination. (4) Revenue per ton mile equals net freight revenue divided by revenue ton miles of freight traffic. (5) Gallons per ton mile equals the amount of fuel required to move one ton of freight one mile. The following tables summarize operating expense-to-revenue ratios of the Railroad for each of the past four years, excluding the effect of the $8.9 million pretax special charge in 1992. The ratios for 1989 are not comparable to subsequent years because of the March 17, 1989, change in control and are not presented. The first table analyzes the various components of operating expenses based on the line items appearing on the income statements, whereas the second table is based on functional groupings. - --------------------- (1) Operating ratio means the ratio of operating expenses before special charge over operating revenues. (2) Transportation ratio means the ratio of transportation expenses (such as expenses of operating, servicing, inspecting, weighing, assembling and switching trains) over operating revenues. (3) Maintenance of way ratio means the ratio of maintenance of way expenses (such as the expense of repairing, maintaining, leasing, depreciating and retiring right-of-way and trackage structures, buildings and facilities) over operating revenues. (4) Maintenance of equipment ratio means the ratio of maintenance of equipment expenses (such as the expense of repairing, maintaining, leasing, depreciating and retiring transportation and other operating equipment) over operating revenues. EMPLOYEES; LABOR RELATIONS Railroad industry personnel are covered by the Railroad Retirement System instead of Social Security. Employer contribution rates under the Railroad Retirement System are currently more than double those in other industries, and may rise further because of the increasing proportion of retired employees receiving benefits relative to the shrinking number of working employees. Labor relations in the railroad industry are subject to extensive governmental regulation under the Railway Labor Act. Railroad industry personnel are also covered by the Federal Employer's Liability Act ("FELA") rather than by state no-fault workmen's compensation systems. FELA is a fault-based system, with compensation for injuries determined by individual negotiation or litigation. The Railroad is a party to several national collective bargaining agreements which establish the wages and benefits of its union workers -- 90% of all Railroad employees. These agreements are subject to renegotiation beginning November 1, 1994, however, cost of living allowance provisions and other terms in each agreement continue until new agreements are reached. Despite being part of a national bargaining group, the Railroad has expressed a desire to negotiate separate distinct agreements with each of its unions on a local basis. Management has been exploring that position and has held several discussions with representatives from most of its unions. It is too early to determine if separate agreements will be reached. Thus, the Railroad has not taken steps to withdraw formally from the national bargaining group. The following table shows the average annual employment levels of the Railroad: 1993 1992 1991 1990 1989 Total employees.. 3,306 3,421 3,611 3,688 3,942 A significant portion of the decline from the 1992 level is the result of a separate agreement between the Railroad and the United Transportation Union, reached in November 1991. This agreement permits the Railroad to reduce the size of all crews on all trains operated. In accordance with this agreement, 158 crew members were severed at a cost of $9.6 million to date. No further dramatic reductions in the current crew size of approximately 2.75 at December 31, 1993 is anticipated. Management believes that additional jobs in all areas may be eliminated over the next several years primarily through attrition and retirements though additional severances are possible. REGULATORY MATTERS; FREIGHT RATES; ENVIRONMENTAL CONSIDERATIONS The Railroad is subject to significant governmental regulation by the ICC and other federal, state and local regulatory authorities with respect to rates, service, safety and operations. The jurisdiction of the ICC encompasses, among other things, rates charged for certain transportation services, issuance of securities, assumption of certain liabilities by railroads, mergers or the acquisition of control of one carrier by another carrier and extension or abandonment of rail lines or services. The Federal Railroad Administration, the Occupational Safety and Health Administration and certain state transportation agencies have jurisdiction over railroad safety matters. These agencies prescribe and enforce regulations concerning car and locomotive safety equipment, track safety standards, employee work conditions and other operating practices. The amount of coal transported by the Railroad is expected to decline somewhat as the Clean Air Act is fully implemented. Much of the coal from mines currently served by the Railroad will not meet the environmental standards of the Clean Air Act without blending or installation of air scrubbers. On the other hand, the Railroad expects to participate in additional movements of Western coal. Overall, management believes that implementation of the Clean Air Act is unlikely to have a material adverse effect on the results of the Railroad. The Railroad is and will continue to be subject to extensive regulation under environmental laws and regulations concerning, among other things, discharges into the environment and the handling, storage, transportation and disposal of waste and hazardous materials. Inherent in the operations and real estate activities of the Railroad and other railroads is the risk of environmental liabilities. As discussed in Item 3. "Legal Proceedings," several properties on which the Railroad currently or formerly conducted operations are subject to governmental action in connection with environmental degradation. Additional expenditures by the Railroad may be required in order to comply with existing and future environmental and health and safety laws and regulations or to address other sites which may be discovered. Environmental regulations and remediation processes are subject to future change and cannot be determined at this time. Based on present information, in the opinion of management, the Railroad has adequate reserves for the costs of environmental investigation and remediation. However, there can be no assurance that environmental conditions will not be discovered which might individually or in the aggregate have a material adverse effect on the Railroad's financial condition. COMPETITION The Railroad faces intense competition for freight traffic from motor, water, and pipeline carriers and, to a lesser degree, from other railroads. Competition with other railroads and other modes of transportation is generally based on the quality and reliability of the service provided and the rates charged. Declining fuel prices disproportionately benefit trucking operations over railroad operations. The trucking industry frequently is more cost and transit-time competitive than railroads, particularly for distances of less than 500 miles. While deregulation of freight rates under the Staggers Act has greatly increased the ability of railroads to compete with each other and alternate forms of transportation, changes in governmental regulations (particularly changes to the Staggers Act) could significantly affect the Railroad's competitive position. To a greater degree than other rail carriers the Railroad is vulnerable to barge competition because its main routes are parallel to the Mississippi River system. The use of barges for some commodities, particularly coal and grain, sometimes represents a lower cost mode of transportation. As a result, the Railroad's revenue per ton-mile has generally been lower than industry averages for these commodities. Barge competition and barge rates are affected by navigational interruptions from ice, floods and droughts. These interruptions cause widely fluctuating rates. The Railroad's ability to maintain its market share of the available freight has traditionally been affected by its response to the navigational conditions on the river. Most of the Railroad's operations are conducted between points served by one or more competing carriers. The consolidation in recent years of major midwestern and eastern rail systems has resulted in strong competition in the service territory of the Railroad. LIENS ON PROPERTIES See Note 8 of Notes to Consolidated Financial Statements. LIABILITY INSURANCE The Railroad is self-insured for the first $5 million of each loss. The Railroad carries $295 million of liability insurance per occurrence, subject to an annual cap of $370 million in the aggregate for all losses. This coverage is considered by the Railroad's management to be adequate in light of the Railroad's safety record and claims experience. ITEM 2. ITEM 2. PROPERTIES - ------------------- PHYSICAL PLANT AND EQUIPMENT System. As of December 31, 1993, the Railroad's total system consisted of approximately 4,700 miles of track comprised of 2,700 miles of main line, 300 miles of secondary main line and 1,700 miles of passing, yard and switching track. The Railroad owns all of the track except for 190 miles operated by agreements over track owned by other railroads. Track Structures. During the five years ended December 31, 1993, the Railroad has spent $305.3 million on track structure to maintain its rail lines, as follows ($ in millions): CAPITAL Expenditures Maintenance Total ------------ ----------- ----- 1993 ................ $ 50.3 $ 25.1 $ 75.4 1992 ................ 46.4 23.0 69.4 1991 ................ 36.3 20.7 57.0 1990 ................ 34.6 20.0 54.6 1989 ................ 19.1 29.8 48.9 ------ ------ ------ Total.............. $186.7 $118.6 $305.3 These expenditures concentrated primarily on track roadway and bridge rehabilitation in 1993 and 1992. Approximately 1,300 miles and 1,400 miles of road were resurfaced in 1993 and 1992, respectively. Over the last two years, a total of $8.4 million was spent to construct new or expanded intermodal facilities in Chicago and Memphis. Expenditures in 1991 and 1990 benefited from the use of reclaimed rail, cross ties, ballast and other track materials from the second main line when the Railroad's double-track mainline was converted to a single-track mainline with centralized traffic control. Most reclaimed material has now been used and future expenditures will reflect the purchase of new materials. The reduced number of miles of track and the general good condition of the track structure should result in future expenditures approximately equal to the average of 1993 and 1992. Fleet. The Railroad's fleet has undergone significant rationalization and upgrading from its peak in 1985 of 862 locomotives and 28,616 freight cars. Over the last two years older, less efficient locomotives were replaced with newer larger horsepower and more efficient equipment. The Railroad is leasing 61 locomotives and approximately 650 cars from other subsidiaries of IC. When those leases expire, the Railroad has first right of refusal to lease the equipment. As these cars are leased to the Railroad other leased equipment will be returned to the independent, third-party lessors or short-term car hire agreements will be terminated. In 1993, the Railroad acquired 4 SD-40-2 locomotives and also upgraded its highway trailer fleet with 800 newly built trailers which replaced 880 older leased trailers. The following is the overall fleet at December 31: Total Units: 1993 1992 1991 1990 1989 Locomotives(1).... 468 449 470 471 516 Freight cars ..... 15,112 15,877 16,381 16,526 17,141 Work equipment.... 745 902 881 934 1,000 Highway trailers(2) 898 203 124 67 70 - ------------------ (1) Approximately 100 locomotives need repair before they can be returned to service. This equipment is repaired if needed on an ongoing basis or sold. In 1993 and 1992, the Railroad sold 23 and 66 surplus locomotives, respectively. The active fleet is 322 as of December 31, 1993. (2) Excludes trailers being accumulated for return to lessors. The components of the Railroad's fleet and in total for 1993 and in total for 1992 are shown below: (1) In addition, approximately 2,735 freight cars and 696 highway trailers were being used by the Railroad under short-term car hire agreements. (2) May be subject to Conditional Sales Agreements. (3) Excludes trailers being accumulated for return to lessor. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - -------------------------- State of Alabama, et al. v. Alabama Wood Treating Corporation, Inc., et al., S.D. Ala. No. 85-0642-C The State of Alabama and Alabama State Docks ("ASD") filed suit in 1985 seeking damages for alleged pollution of land in Mobile, Alabama, stemming from creosoting operations over several decades. Defendants include the Railroad, which owned the land until 1976, Alabama Wood Treating Corporation, Inc., and Reilly Industries, Inc. ("RII"), which leased the land from the Railroad and conducted creosote operations on the site. In December 1976, the Railroad sold the premises to ASD. The complaint sought payment for the clean-up cost together with punitive and other damages. In 1986, ASD, RII and the Railroad agreed to form a joint technical committee to clean the site sharing equally the cost of clean-up, and in October 1986, the court stayed further proceedings in the suit. Under the agreement the joint technical committee has spent approximately $6.6 million and has been authorized to expend up to a total of $6.9 million. The Railroad has contributed $2.2 million and has agreed to increase its contribution to a total of $2.3 million. Further clean-up activities are anticipated. Under the agreement, if any party disagrees with the amount determined by the joint technical committee to be expended or otherwise disagrees with any aspect of the clean-up, such party may decline further participation and recommence legal proceedings. However, amounts already contributed by any party will be credited against that party's eventual liability and may not be recovered from any other party. Iselin Yard, Jackson, Tennessee In 1991, the Iselin Rail Yard in Jackson, Tennessee was placed on the Tennessee Superfund list. In May 1993, the United States Environmental Protection Agency ("EPA") proposed to add a number of sites, including Iselin Rail Yard to the National Priorities List. The Railroad operated a rail yard and locomotive repair facility at the site. The shop facility was sold in 1986 and the rail yard was sold in 1988. Trichloroethylene ("TCE") has been found in several municipal water wells near the site. TCE is a common component of solvents similar to those believed to have been used at the Iselin shop. In addition, concentrations of metals and organic chemicals have been identified on the surface of the site. No order has been issued by any regulatory agency but the State of Tennessee is monitoring work at the site. The Railroad expects to cooperate with the agencies and other Potentially Responsible Parties to conduct any necessary studies and clean-up activities. The Railroad has commenced a remedial investigation and feasibility study of the site. McComb, Mississippi Elevated levels of lead and other soil contamination has been discovered at the Railroad's facility in McComb, Mississippi. The site was used for many years for sandblasting lead-based paint off freight cars. The Railroad has commenced a formal site investigation under the supervision of the Mississippi Department of Environmental Quality. The Remedial Investigation has disclosed the presence of lead in the soil and further testing of the surface and subsurface soil and groundwater is underway to assess the scope of the contamination. No order has been issued by any regulatory agency. The Railroad expects to cooperate with the State of Mississippi to conduct any necessary studies and clean-up activities. Waste Oil Generation The Railroad was notified in September 1992 that it had been identified as a Potentially Responsible Party at a federal superfund site in West Memphis, Arkansas. The Railroad is alleged to have generated waste oil which was collected by a waste oil refiner who in turn disposed of sludge at the West Memphis landfill. In December 1992, the successor to the refiner initiated legal proceedings to preserve testimony in anticipation of a future contribution action against multiple Potentially Responsible Parties including the Railroad. Similar actions have been taken by the EPA or third parties with respect to waste oil allegedly generated by the Railroad and disposed of in landfills at Livingston, LA, Griffith, IN and Nashville, TN. Based on information currently available, the Railroad believes it has substantial defenses to liability for any contamination at these sites, and that any contribution to the contamination by the Railroad was de minimis. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Intentionally omitted. See Index page of this Report for explanation. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the outstanding common stock of the Railroad (100 shares) is owned by IC and therefore is not traded on any market. Various credit agreements limit the Railroad's ability to pay cash dividends to IC. However, the Railroad was able to declare $36.0 million in dividends in 1993 and $12.8 million in dividends in 1992. At December 31, 1993, approximately $76 million of the Railroad's equity was in excess of the limitation and available for dividend to IC. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- Intentionally omitted. See Index page of this Report for explanation. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GROWTH PLAN For the four years ended December 31, 1992, the Railroad's primary drivers were reducing costs and improving service offerings. The result was the best operating ratio among Class I railroads, 68.6% at December 31, 1993. While costs continue to be scrutinized, a new direction was initiated in 1993. With 1992 as its base, a new plan was outlined as follows: - increase annual revenues by $100 million by the end of 1996. - reduce the operating ratio by one percentage point per year for a total of four (4) points below the 1992 base. - reduce annual interest expense by $10 million. To accomplish this plan, revenues must grow at a compounded annual rate of 4.3% while operating expenses must not exceed a compounded annual growth rate of 2.5% per year. Management has identified the sources of planned revenue growth as economic expansion, new and expanded plants on our line and market share growth. Economic expansion is the combination of industrial production improvement and freight rate increases. Market share growth is volume gained from competition i.e., other railroads, trucklines and barges, facilitated by being a low cost producer. In 1993, the first year of the growth plan, significant strides were made in accomplishing the plan as total revenues increased 3.1%. Two major unplanned events had an impact on revenues. In May 1993, the United Mine Workers began a strike against several companies affecting six mines served by the Railroad. As a result, approximately 35,000 carloads of coal were lost. The strike was settled in December 1993, and full production resumed in January 1994. Partially offsetting the lost coal loads was a gain of approximately 15,000 carloads of grain and grain mill products. This traffic was diverted to the Railroad as a result of the flooding of the upper Mississippi River in July and August 1993. Additionally, over 500 trains from several other Class I railroads were detoured over the Railroad's system. The result was a significant increase in traffic density over the Railroad's routes. Carloadings of paper recorded their fourth consecutive annual increase (3% for 1993). The increase was a result of the improved economy and growth in recycling. In 1993, chemical traffic increased 6%, reversing a two-year recessionary trend. While not benefiting for the full year from various truckline partnerships, intermodal traffic grew at 15% in the second half of 1993 versus the second half of 1992. While 1993 revenue lagged behind the plan compound rate of 4.3%, management believes the Railroad is positioned well for 1994. The targeted revenue growth in 1994 is 5%. For 1993, the Railroad exceeded its operating ratio goal. Actual improvement was 2.3 percentage points and the full year operating ratio was 68.6%. More efficient train crew and train scheduling coupled with reduced costs contributed to this achievement. The tender offer for and retirement of the Railroad's $145 million 14-1/8% Debentures, in the second quarter of 1993, effectively resulted in the achievement of the third goal of the growth plan as interest expense, net declined $10.5 million in 1993 to $33.1 million. Interest expense, net is expected to be below $30 million in 1994. RESULTS OF OPERATIONS The discussion below takes into account the financial condition and results of operations of the Railroad for the years presented in the consolidated financial statements. 1993 COMPARED TO 1992 Revenues for 1993 increased from the prior year by $17.3 million or 3.1% to $564.7 million. The increase was a result of a 2.9% increase in average gross freight revenue per carload, resulting from an improved commodity mix and modest rate increases. The 1993 revenue increase was attributable in part to the gain in carloads when the upper Mississippi River flooding affected barge traffic and also disrupted rail operations of other carriers which diverted traffic to the Railroad's system. Additionally, chemical loads were up 6% and paper was up 3%. Intermodal was up 5%, reflecting the Railroad's commitment to increase this aspect of operation, as evidenced by the new Chicago-area intermodal facility and expansions in Memphis. These gains were offset by lost carloads of coal resulting from the United Mine Workers strike of certain coal producers. For the year, carloadings declined .5% (or 4,400 carloads) to 847,900 carloads. Operating expenses for 1993 decreased $1.1 million, or .3% as compared to 1992, excluding the special charge recorded in 1992. Labor expense decreased $1.1 million as a result of on-going cost control programs, including the reduction in train crews, and an overall improvement in efficiency. This decrease was accomplished despite the additional expense incurred because of the flood- related detours of other railroads' trains over the Railroad's track and a 3% wage increase which was effective July 1, 1993 for union employees. Fuel expense reflects the increased traffic in 1993 and 1992 coupled with a total of $1.5 million for increased fuel taxes resulting from the Omnibus Budget Reconciliation Act of 1993 and for the costs associated with fuel hedges. The more fuel efficient locomotives acquired over the last two years partially offset the rise in fuel costs. Materials and supplies increased $3.6 million primarily as a result of track material purchases. The surplus from the single track project was substantially depleted necessitating purchase of new materials. Operating income for 1993 increased 18.2% ($27.3 million) to $177.6 million compared to $150.3 million for 1992, as a result of increased revenues cited above and decreased expenses (including the 1992 special charge). Excluding the special charge, the increase in operating income was 11.6% ($18.4 million). Net interest expense decreased by 25.9% to $31.8 million compared to $42.9 million in 1992. The issuance of new notes at 6.75% to replace the 14-1/8% Senior Subordinated Debentures (the "Debentures") and lower interest rates on floating debt account for the reduced interest expense in 1993. The Debentures were retired via a tender offer which resulted in an extraordinary loss of $23.4 million, net of $12.6 million in tax benefits. The extraordinary loss covers the costs associated with the tender (i.e., premium on repurchase, the write-off of unamortized financing fees and debt discount and the costs associated with calling the untendered Debentures). See "Liquidity and Capital Resources" for discussion of the impact of the Omnibus Budget Reconciliation Act of 1993. Effective January 1, 1993, the Railroad adopted both the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") and the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). SFAS No. 106 requires that future costs associated with providing postretirement benefits be recognized as expense over the employees' requisite service period. The pay-as-you-go method used prior to 1993 recognized the expense on a cash basis. SFAS No. 112 establishes accounting standards for employers who provide postemployment benefits and clarifies when the expense is to be recognized. As a result of adopting these two standards the Railroad recorded a decrease to net income of $84,000 (net of taxes of $46,000) as a cumulative effect of changes in accounting principles. In accordance with each standard, years prior to 1993 have not been restated. For 1993, the adoption of these two standards had no significant effect on income before cumulative effect of changes in accounting principles as compared to the Railroad's prior pay-as-you-go method of accounting for such benefits. The Railroad has no plans to fund these liabilities and will continue to pay these costs on a pay-as-you-go basis, as was done in prior years. 1992 COMPARED TO 1991 Revenues for 1992 decreased from the prior year by $2.3 million or .4% to $547.4 million. The decrease resulted from a 1.6% (or 13,900 carloads) decrease in the number of freight carloads to 852,300, offset by a 1.1% increase in the average gross revenue per carload. Net freight revenue ton miles decreased 3.2% to 18.7 billion. Gross freight revenue per thousand ton miles increased 2.7% to $28.89 from $28.12. The increase in average revenue per carload was caused by an improved commodity mix, in which a greater volume of higher revenue per carload commodities was hauled, and modest rate increases. Operating expense for 1992 decreased by $7.5 million, or 1.9% as compared to 1991, even though the Railroad recorded an $8.9 million pretax special charge in 1992. Reductions in labor expense ($5.5 million), lease and car hire expense ($5.2 million), diesel fuel expense ($3.1 million) and a favorable litigation settlement in the first quarter more than offset the special charge. The special charge covered certain organizational and other expenses associated with the retirement of E. L. Moyers, the Railroad's Chairman, President and Chief Executive Officer until February 1993, as well as various unrelated asset revaluations. Operating income for 1992 increased by 3.6% to $150.3 million compared to $145.1 million for 1991, as a result of decreased expenses cited above offset by the aforementioned pretax special charge and decreased revenues. Excluding the special charge, the Railroad's 1992 operating income was $159.2 million, an increase of $14.1 million (9.7%) as compared to 1991. This increase is a result of on-going cost reduction programs, including the reduction in train crew sizes and the overall emphasis on efficiency. Net interest expense decreased by 23.5% from $56.1 million to $42.9 million. The full year effect of the August 1991 refinancing of the Series K Mortgage Bonds and the repayment of approximately $34.0 million of the Term Facility accounted for approximately $4.0 million and $8.0 million, respectively, in reduced interest expense for 1992. Effective January 1, 1992, the Railroad adopted SFAS No. 109, "Accounting for Income Taxes." As a result, the Railroad recorded a $23.7 million reduction of its accrued deferred income tax liabilities. The Railroad elected to report this change as the cumulative effect of change in accounting principle. Therefore, prior period amounts have not been restated. LIQUIDITY AND CAPITAL RESOURCES OPERATING DATA: 1993 1992 1991 ---- ---- ---- Cash flows provided by (used for): Operating activities... $121.7 $ 124.1 $ 61.1 Investing activities... (54.1) (45.5) (25.2) Financing activities... (85.1) (67.9) (34.5) ------ ------- ------ Net change in cash and temporary cash investments. $(17.5) $ 10.7 $ 1.4 Cash from operating activities was primarily net income before depreciation, deferred taxes, extraordinary item and the cumulative effect of changes in accounting principles. A significant source of cash in 1992 ($26.4 million) was the realization of settlement proceeds with numerous insurance carriers in connection with asbestos and hearing loss casualty claims. Most of the settlements were for prior claims but some cover future claims related to prior periods. As part of the settlements, the Railroad agreed to release the carriers from liability for future hearing loss claims. An additional $6.3 million was received in 1993. During 1993, additions to property of $57.1 million included approximately $36.6 million for track and bridge rehabilitation and approximately $.6 million for the purchase of 4 locomotives. During 1992, additions to property of $50.8 million included approximately $46.4 million for track and bridge rehabilitation including approximately $5 million for the construction of a new intermodal facility in the Chicago area. The funds for this new facility were provided by advance rentals on a three-year lease agreement for the Railroad's old intermodal yard in Chicago by another railroad. The other railroad also paid for an option to acquire the old yard for cash at any time during the three-year lease period. Proceeds from the sales of excess materials generated by the single-track project ($4.1 million in 1992) partially offset the cost of property additions. Property retirements and removals unrelated to the single-track project generated proceeds of $5.3 million and $3.5 million in 1993 and 1992, respectively. The Railroad anticipates that base capital expenditures for 1994 will be approximately $50 million and will concentrate on track maintenance, renewal of track structures such as bridges, and upgrading the locomotive fleet. If additional opportunities such as lease conversions or market-driven expansions occur in 1994, the total capital spending could be approximately $70 million. These expenditures are expected to be met from current operations or other available sources. Over the last three years, management has concentrated on reducing leverage, expanding funding sources, lowering funding costs and upgrading the debt ratings issued by the rating services. During that time frame, the Railroad's public debt has moved from being designated a "Highly Leveraged Transaction" to being rated Baa3 by Moody's Investors Service ("Moody's") and BBB by Standard & Poor's Corporation ("S&P"). Likewise, the Railroad's debt has also gone from fully collateralized to unsecured. A further step in this process was the initiation of a public commercial paper program in November 1993. The commercial paper, issued by the Railroad, is rated A2 by S&P, by Fitch Investors Service, Inc. ("Fitch") and P3 by Moody's and is supported by a $100 million Revolver with the Railroad's bank lending group. At December 31, 1993, $38.1 million of commercial paper was outstanding with various maturities. The interest rates ranged from 3.45% to 3.75%. The Railroad views this program as a significant long-term funding source and intends to issue replacement notes as each existing issue matures. Therefore, the $38.1 million is classified as long-term. Twice during 1993, the Railroad renegotiated its lending arrangements with its bank lending group and the private placement noteholders. In April 1993, in connection with the Tender Offer for the $145 million 14- 1/8% Senior Subordinated Debentures (the "Debentures") (see below), the banks converted the previous Permanent Facility to a $180 million Revolving Credit Facility due 1996 at LIBOR plus 100 basis points. The banks and the holders of the $160 million senior secured notes ("Senior Notes") issued in 1991 agreed to release all collateral and continue to lend on an unsecured basis. In November 1993, the banks again modified this arrangement in connection with the commercial paper program. The new bank agreements consist of a new $100 million Revolver, due 1996 and a $50 million 364-day facility due in October 1994 (the "Bank Line"). The new Revolver will be used primarily for backup for the commercial paper but can be used for general corporate purposes. The available amount is reduced by the outstanding amount of commercial paper borrowings and any letters of credit issued on behalf of the Railroad under the facility. No amounts have been drawn under the Revolver. The $100 million was limited to $57.9 million because $38.1 million in commercial paper was outstanding and $4.0 million in letters of credit had been issued. The Bank Line was structured as a 364-day renewal instrument and the Railroad intends to renew it on an on-going basis. The $40 million borrowed at December 31, 1993, has therefore been classified as long-term. The Company believes that its available cash, cash generated by its operations and cash available via commercial paper, the Revolver and the Bank Line will be sufficient to meet foreseeable liquidity requirements. Various borrowings of the Railroad are governed by agreements which contain financial and operating covenants. The Railroad was in compliance with these covenant requirements at December 31, 1993, and management does not anticipate any difficulty in maintaining such compliance. In 1993, conditions in the financial markets provided an opportunity for the Railroad to replace its outstanding Debentures. As a result, the Railroad initiated a tender offer for the Debentures. The tender offer, costs associated with calling the $10.3 million untendered portion and the refinancing of the Permanent Facility Term Loan resulted in a $23.4 million extraordinary loss, net of $12.6 million in tax benefits. In connection with the tender offer for the Debentures, the Railroad issued $100 million of 6.75% non-callable, 10-year notes due 2003 (the "Notes") and irrevocably placed funds with a trustee to cover principal, a 6% premium and interest through the first call date of October 1, 1994, for the untendered Debentures. Additionally, the Railroad's bank lending group agreed to the termination and replacement of the previous Permanent Facility with a new $180 million unsecured Revolving Credit Facility expiring December 31, 1996 (see above). Likewise, the Senior Note holders agreed to release all the collateral specified in their original agreement and continue on an unsecured basis. Certain covenants of the Railroad's debt agreements restrict the level of dividends it may pay to IC. In 1993 and 1992, the Railroad paid dividends to IC of $27.4 million and $6.4 million, respectively. In November 1993, the Railroad declared a $15.0 million dividend which was paid in January 1994. At December 31, 1993, approximately $76 million of Railroad equity was free of such restrictions. The Railroad has paid approximately $8 million, $10 million and $18 million in 1993, 1992 and 1991, respectively, for severance and lump sum signing awards associated with the various agreements signed in 1992 and 1991. The Railroad anticipates that an additional $7 million will be required in 1994 related to all such agreements. These requirements are expected to be met from current operating activities or other available sources. The Railroad has entered into various hedge agreements designed to mitigate significant changes in fuel prices. As a result, approximately 93% of the Railroad's short-term diesel fuel requirements through March 1995 and 46% through June 1995 are protected against significant price changes. Federal Deficit Reduction Package On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993, which contains a deficit reduction package, became law. Certain aspects of the legislation increased taxes directly affecting the Railroad. Most significantly, the new law increased the maximum corporate federal income tax rate from 34% to 35% retroactive to January 1, 1993. This change required the Railroad to record additional deferred income tax expense of approximately $3.1 million in the third quarter of 1993 to reflect the new tax rate's impact on net deferred income tax liability as of January 1, 1993. The higher corporate rate did not significantly affect the Railroad's cash flow. In addition, the legislation increased the federal tax on diesel fuels by 4.3 cents per gallon effective October 1, 1993. This tax increased the fuel expense of the Railroad, which purchases approximately 4.3 million gallons of diesel fuel each month, by $.5 million in 1993. Other The Railroad is and will continue to be subject to extensive regulation under environmental laws and regulations concerning, among other things, discharges into the environment and the handling, storage, transportation and disposal of waste and hazardous materials. Inherent in the operations and real estate activities of the Railroad and other railroads is the risk of environmental liabilities. Several properties on which the Railroad currently or formerly conducted operations are subject to governmental action in connection with environmental damage. In the opinion of management, the Railroad has adequate reserves to cover the costs for investigation and remediation. However, there can be no assurance that environmental conditions will not be discovered which might individually or in the aggregate have a material adverse effect on the Railroad's financial condition. Recent Accounting Pronouncements In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS No. 114") and Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). SFAS No. 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. This statement applies to financial statements for fiscal years beginning after December 31, 1994, with earlier adoption encouraged. The Railroad is currently evaluating the impact of this statement, if any, on its reported results. Early adoption is not anticipated. SFAS No. 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. This statement is effective for fiscal years beginning after December 15, 1993. Adoption is not anticipated to have an adverse impact on reported results. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Index to Consolidated Financial Statements on page 27 of this Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENT WITH ACCOUNTANTS IN ACCOUNTING FINANCIAL DISCLOSURES NONE PART III ITEM 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 (a) 1. Financial Statements: See Index to Consolidated Financial Statements on page 27 of this Report. 2. Financial Statement Schedules: See Index to Financial Statement Schedules on page of this Report. 3. Exhibits: See items marked with "*" on the Exhibit Index beginning on page E-1 of this Report. Items so marked identify management contracts or compensatory plans or arrangements as required by Item 14. (b) 1. Reports on Form 8-K: During the fourth quarter of 1993 the Registrant filed with the Securities and Exchange Commission the following reports on Form 8-K on the dates indicated to report the events described: NONE (c) Exhibits: The response to this portion of Item 14 is submitted as a separate section of this Report. See Exhibit Index beginning on page E-1. (d) Financial Statement Schedules: The response to this portion of Item 14 is submitted as a separate section of this Report. 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, there unto duly authorized. Illinois Central Railroad Company By: /s/ DALE W. PHILLIPS Dale W. Phillips Vice President and Chief Financial Officer Date: March 16, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and on the dates indicated. SIGNATURE Title(s) Date /s/ GILBERT H. LAMPHERE Chairman of the Gilbert H. Lamphere Board and Director March 16, 1994 /s/ E. HUNTER HARRISON President and Chief E. Hunter Harrison Executive Officer (principal executive officer), Director March 16, 1994 /s/ DALE W. PHILLIPS Vice President Dale W. Phillips and Chief Financial Officer (principal financial officer) March 16, 1994 /s/ JOHN V. MULVANEY Controller John V. Mulvaney (principal accounting officer) March 16, 1994 /s/ RONALD A. LANE Director Ronald A. Lane March 16, 1994 /s/ GERALD F. MOHAN Director Gerald F. Mohan March 16, 1994 ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES ------------------ ---------------------------- F O R M 10-K FINANCIAL STATEMENTS SUBMITTED IN RESPONSE TO ITEM 8 ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Public Accountants.... Consolidated Statements of Income for the three years ended December 31, 1993........ Consolidated Balance Sheets at December 31, 1993 and 1992................. Consolidated Statements of Cash Flows for the three years ended December 31, 1993.... Consolidated Statements of Stockholder's Equity and Retained Income for the three years ended December 31, 1993.............. Notes to Consolidated Financial Statements for the three years ended December 31, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Illinois Central Railroad Company: We have audited the accompanying consolidated balance sheets of Illinois Central Railroad Company (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and stockholder's equity and retained income 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 Illinois Central Railroad 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 discussed in Note 9 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement health care and postemployment benefits. 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 herein 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 January 19, 1994 ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Statements of Income ($ in millions) The following notes are an integral part of the consolidated financial statements. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Balance Sheets ($ in millions) The following notes are an integral part of the consolidated financial statements. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Statements of Cash Flows ($ in millions) The following notes are an integral part of the consolidated financial statements. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Statements of Stockholder's Equity The following notes are an integral part of the consolidated financial statements. 1. THE RAILROAD Illinois Central Corporation, a holding company, (hereinafter, "IC") was formed originally for the purpose of acquiring, through a wholly-owned subsidiary, the outstanding common stock of Illinois Central Transportation Company ("ICTC"). Following a tender offer and several mergers, the Illinois Central Railroad Company ("Railroad") is the surviving corporation and the successor to ICTC and now a wholly-owned subsidiary of the IC. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Railroad and its subsidiaries. Significant investments in affiliated companies are accounted for by the equity method. Transactions between consolidated companies have been eliminated in the accompanying consolidated financial statements. PROPERTIES Depreciation is computed by the straight-line method and includes depreciation on properties under capital leases. Depreciation for track structure, other road property, and equipment is calculated using the composite method. In the case of routine retirements, removal cost less salvage recovery is charged to accumulated depreciation. Expenditures for maintenance and repairs are charged to operating expense. The Interstate Commerce Commission ("ICC") approves the depreciation rates used by the Railroad. In 1991, the Railroad completed a study which resulted in revised depreciation rates for road properties (excluding track properties) and equipment. The revised rates did not and will not have a significant effect on operating results. The approximate ranges of annual depreciation rates for major property classifications are as follows: Road properties .................1% - 8% Transportation equipment ........1% - 7% In 1989, the Railroad initiated a program to convert approximately 500 miles of double track main line to a single track main line, with a centralized traffic control system. This program was completed successfully in 1991. REVENUES Revenues are recognized based on services performed and include estimated amounts relating to movements in progress for which the settlement process is not complete. Estimated revenue amounts for movements in progress are not significant. INCOME TAXES Effective January 1, 1992, the Railroad adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). Under SFAS No. 109, deferred income taxes are accounted for on the asset and liability method by applying enacted statutory tax rates to differences ("temporary differences") between the financial statement carrying amounts and the tax bases of assets and liabilities. The resulting deferred tax assets and liabilities represent taxes to be collected or paid in the future when the related assets and liabilities are recovered and settled, respectively. See Note 10 for discussion of the 1992 impact of adopting SFAS No. 109. CASH AND TEMPORARY CASH INVESTMENTS Cash in excess of operating requirements is invested in certain funds having original maturities of three months or less. These investments are stated at cost, which approximates market value. INCOME PER SHARE Income per share has been omitted as the Railroad is a wholly-owned subsidiary of IC. FUTURES, OPTIONS, CAPS, FLOORS AND FORWARD CONTRACTS In March 1990, the FASB issued Statement of Financial Accounting Standards No. 105 "Disclosure of Information about Financial Instruments with Off Balance Sheet Risk and Financial Instruments with Concentration of Credit Risk" ("SFAS 105"). Disclosures required by SFAS 105 are found in various notes where the financial instruments or related risks are discussed. See specifically Notes 6, 7, 8, and 12. CASUALTY AND FREIGHT CLAIMS The Railroad accrues for injury and damage claims outstanding based on actual claims filed and estimates of claims incurred but not filed. Estimated amounts expected to be settled within one year are classified as current liabilities in the accompanying Consolidated Balance Sheets. EMPLOYEE BENEFIT PLANS All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contribution costs of the plan are funded currently. Mr. E. L. Moyers, former Chairman, President and Chief Executive Officer ("Mr. Moyers") is covered by a supplemental plan which is discussed in Note 9. Effective January 1, 1993, the Railroad adopted both the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") and the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). SFAS No. 106 requires that future costs associated with providing postretirement benefits be recognized as expense over the employees' requisite service period. The pay-as-you-go method used prior to 1993 recognized the expense on a cash basis. SFAS No. 112 establishes accounting standards for employers who provide postemployment benefits and clarifies when the expense is to be recognized. In accordance with the provisions of these standards, years prior to 1993 have not been restated. See Note 9 for discussion of the impact of adopting SFAS No. 106 and SFAS No. 112. RECLASSIFICATIONS Certain items relating to prior years have been reclassified to conform to the presentation in the current year. 3. EXTRAORDINARY ITEM AND REFINANCING The 1993 extraordinary loss resulted from the retirement of the Railroad's 14-1/8% Senior Subordinated Debentures (the "Debentures") and refinancing the Permanent Facility. The loss was $23.4 million, net of tax benefits of $12.6 million. The loss resulted from the premium paid, the write-off of unamortized financing fees and debt discount and costs associated with the calling of the $10.3 million of Debentures not tendered. The net proceeds of the 6.75% Notes (see Note 8), borrowings under the $180 million Revolving Credit Facility and other available cash were used to fund the retirement of the Debentures. 4. OTHER INCOME, NET Other Income, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 ---- ---- ---- Rental income, net...... $ 3.9 $ 3.8 $ 3.0 Net gains on real estate sales.................. .8 .4 .7 Net gain (loss) on disposal of rolling stock....... (2.3) - - Equity in undistributed earnings of affiliates. .5 .3 .4 Net gain on Series K.... - - 3.6 Other, net.............. (.1) (.9) (.7) ------ ------ ------ Other Income, Net..... $ 2.8 $ 3.6 $ 7.0 5. SUPPLEMENTAL CASH FLOW INFORMATION Cash changes in components of working capital, exclusive of Current Maturities of Long-Term Debt, included in the Consolidated Statements of Cash Flows were as follows ($ in millions): Included in changes in Other Liabilities and Reserves is approximately $6.3 million and $23.4 million for the years ended December 31, 1993 and 1992, respectively, reflecting proceeds from the settlement of casualty claims with numerous insurance carriers. In 1993, the Railroad entered into a capital lease for 200 covered hoppers. The lease expires in 2003. See Note 7 for a recap of the present value of the minimum lease payments. In 1991, the Railroad retired several Long-Term Debt obligations, most significantly its $150 million 15.5% Series K First Mortgage Bonds ("Series K"). These retirements resulted in non-cash reductions of debt balances of $4.6 million. Also, in 1991 the balance of a long term investment was reduced by $2.5 million. 6. MATERIALS AND SUPPLIES Materials and Supplies, valued using the average cost method, consist of track material, switches, car and locomotive parts and fuel. The Railroad entered into various hedge agreements designed to mitigate significant changes in fuel prices. As a result, approximately 93% of the short-term diesel fuel requirements through March 1995 and 46% through June 1995 are protected against significant price changes based on the average near-by contract for Heating Oil #2 traded on the New York Mercantile Exchange. 7. LEASES As of December 31, 1993, the Railroad leased 6,709 of its cars and 227 of its locomotives. The majority of these leases have original terms of 15 years and expire between 1994 and 2001. Under the terms of the majority of its leases, the Railroad has the right of first refusal to purchase, at the end of the lease terms, certain cars and locomotives at fair market value. Other leases include office and computer equipment, vehicles and office facilities. Net obligations under capital leases at December 31, 1993 and 1992, included in the Consolidated Balance Sheets are $5.4 million and $.2 million, respectively. At December 31, 1993, minimum rental payments under capital and operating leases that have initial or remaining noncancellable terms in excess of one year were as follows ($ in millions): Capital Operating Leases Leases 1994 ..................... $ .9 $ 34.6 1995 ..................... .9 28.4 1996 ..................... .8 19.3 1997 ..................... .8 7.8 1998 ..................... .8 4.2 Thereafter ............... 3.1 17.4 Total minimum lease ---- ------ payments............... 7.3 $111.7 Less: Imputed interest ... 1.9 Present value of minimum ---- payments............... $5.4 Total rent expense applicable to noncancellable operating leases amounted to $48.2 million in 1993, $48.4 million for 1992 and $49.4 million for 1991. Most of the leases provide that the Railroad pay taxes, maintenance, insurance and certain other operating expenses. 8. LONG-TERM DEBT AND INTEREST EXPENSE Long-Term Debt at December 31, consisted of the following ($ in millions): At December 31, 1993, the aggregate annual maturities and sinking fund requirements for debt payments for 1994 through 1999 and thereafter are $1.1 million, $.8 million, $78.9 million, $.9 million, $55.6 million, $55.6 million and $155.5 million, respectively. The weighted-average interest rate for 1993 and 1992 on total debt excluding the effect of discounts, premiums and related amortization was 9.1% and 10.8%, respectively. In November 1993, the Railroad initiated a public commercial paper program. The commercial paper is rated A2 by S&P, by Fitch and P3 by Moody's and is supported by a new $100 million Revolver with the Railroad's bank lending group. The Railroad views this program as a significant long-term funding source and intends to issue replacement notes as maturities occur. Therefore, the $38.1 million outstanding at December 31, 1993 has been classified as long-term. In connection with the commercial paper program, the bank lending group agreed to replace the $180 million Revolving Credit Facility (see below) with (i) a new $100 million Revolver, due 1996 and (ii) a $50 million 364-day facility due October 1994 ("Bank Line"). The new Revolver will be used primarily for backup for the commercial paper but can be used for general corporate purposes. The available amount is reduced by the outstanding amount of commercial paper borrowings and any letters of credit issued on behalf of the Railroad under the facility. No amounts have been drawn under the Revolver. The $100 million was limited to $57.9 million because $38.1 million in commercial paper was outstanding and $4.0 million in letters of credit had been issued. The Bank Line was structured as a 364-day renewable instrument and the Railroad intends to renew it on an on- going basis. The $40 million outstanding at December 31, 1993, has therefore been classified as long-term. During April 1993, IC and the Railroad reached an agreement with its bank lending group and the holders of the privately placed $160 million Senior Secured Notes ("Senior Notes") for a release of all collateral and those instruments are now unsecured. The bank agreed to replace the Permanent Facility with a $180 million Revolving Credit Facility. This was done in connection with the tender offer made by the Railroad for all of the Debentures. The tender offer was funded by issuance of new $100 million 6.75% Notes, due 2003 (the "Notes"), borrowing under a $180 million Revolving Credit Facility negotiated with the banks which replaced the Permanent Facility and cash on hand. See Note 3 for discussion of the extraordinary loss incurred upon tender for the Debentures. The Railroad irrevocably placed $12.6 million on deposit with a trustee to cover principal, a 6% premium and interest through the first call date of October 1, 1994, for the untendered Debentures. The Notes (issued at a slight discount 1.071%) pay interest semiannually in May and November and are covered by an Indenture. Of the Senior Notes, $109.8 million bears interest at a rate of 10.02% and $50 million at 10.4%. Principal payments of $55 million are due in each of 1998 and 1999, and $25 million in each of 2000 and 2001. The Senior Notes are governed by a Note Purchase Agreement. Various borrowings of the Railroad are governed by agreements which contain certain affirmative and negative covenants customary for facilities of this nature including restrictions on additional indebtedness, investments, guarantees, liens, distributions, sales and leasebacks, and sales of assets and capital stock. Some also require the Railroad to satisfy certain financial tests, including a leverage ratio, an earnings before interest and taxes to interest charges ratio, debt service coverage, and minimum consolidated tangible net worth requirements. The Railroad may be required to apply 100% of net after-tax proceeds of sales aggregating $2.5 million or greater of certain assets to reduce Revolver commitments. The holders of the Senior Notes can elect to receive a pro-rata share of after-tax proceeds. Interest Expense, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 Interest expense ..... $33.8 $45.1 $59.7 Less: Interest capitalized..... .8 .6 .4 Interest income....... 1.2 1.6 3.2 ----- ----- ----- Interest Expense, Net. $31.8 $42.9 $56.1 9. EMPLOYEE BENEFIT PLANS Retirement Plans. All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contributions under the plan vest immediately. Expenses relating to the defined contribution plan were $.4 million for each of the years ended December 31, 1993, 1992 and 1991. Mr. Moyers is covered by a non-qualified, unfunded supplemental retirement benefit agreement which provides for a defined benefit payable annually, commencing upon death, permanent disability or retirement (with benefits arising from retirement commencing upon his attaining age 65 and compliance with certain non-competition agreements), in the amount of $250,000 per year for a maximum of 15 years. In accordance with the term of the agreement, no payments will be made while Mr. Moyers is employed by another Class I railroad. The present value of this agreement was included in the 1992 special charge. See Note 14. Postretirement Plans. In addition to the Railroad's defined contribution plan for management employees, the Railroad has three benefit plans which provide some postretirement benefits to most former full-time salaried employees and selected former union represented employees. The medical plan for salaried retirees is contributory, with retiree contributions adjusted annually if expected inflation rate exceeds 9.5%, and contains other cost sharing features such as deductibles and co-payments. The Railroad's contribution will be fixed at the 1999 year end rate for all subsequent years. Salaried retirees are covered by a life insurance plan which provides a nominal death benefit and is non- contributory. The medical plan for locomotive engineers who retired under a special early retirement program in 1987 provides non-contributory coverage until age 65. All benefits under this plan terminate in 1998. There are no plan assets and the Railroad will continue to fund these benefits as claims are paid as was done in prior years. Postemployment Benefit Plans. The Railroad provides certain postemployment benefits such as long-term salary continuation and waiver of medical and life insurance co- payments while on long-term disability. SFAS No. 106 and SFAS No.112. As described in Note 2 effective January 1, 1993 the Railroad adopted SFAS No. 106 and SFAS No. 112. With respect to SFAS No. 106, the Railroad elected to immediately recognize the transition asset associated with adoption which resulted because the Railroad had previously recorded an amount under purchase accounting to reflect the estimated liability for such benefits as of the acquisition date of ICTC. As a result of adopting these two standards, the Railroad recorded a decrease to net income of $84,000 (net of taxes of $46,000) as a cumulative effect of changes in accounting principles ($ in millions): Postretirement Benefits (SFAS No. 106): APBO at January 1, 1993: Medical.................... $36.5 Life....................... 2.3 Total APB........... 38.8 Liability previously recorded (40.3) Transition Asset....... 1.5 Postemployment Benefits Obligation at January 1, 1993 (SFAS 112) (1.6) Pre-tax Cumulative Effect of Changes in Accounting Principles..... (.1) Related tax benefit............... - ----- Cumulative Effect of Changes in Accounting Principles..... $ (.1) Per Share Impact.................. $ - In accordance with each standard, years prior to 1993 have not been restated. For 1993, the adoption of these two standards had no significant effect on income before cumulative effect of changes in accounting principles as compared to the Railroad's prior pay-as- you-go method of accounting for such benefits. The accumulated postretirement benefit obligations ("APBO") of the postretirement plans were as follows ($ in millions): January December 31, 1993 1, 1993 Medical Life Total Total ------- ---- ----- ------- Accumulated post- retirement benefit obligation: Retirees......... $26.4 $ 2.4 $28.8 $33.4 Fully eligible active plan participants.... .7 - .7 .7 Other active plan participants.... 4.7 - 4.7 4.7 ----- ----- ----- ----- Total APBO... $31.8 $ 2.4 34.2 38.8 Unrecognized net gain 5.0 - ----- ----- Accrued liability for postretirement benefits $39.2 $38.8 The weighted-average discount rate used in determining the accumulated post-retirement benefit obligation was 8.0% at January 1, 1993. As a result of the Railroad's improved financial condition and recognizing the overall shift in the financial community, the Railroad lowered the weighted-average discount rate to 7.25% as of December 31, 1993. The change in rates resulted in approximately $2.0 million actuarial loss. The loss was offset by actual experience gains, primarily fewer claims and lower medical rate inflation, which resulted in a $5.0 million unrecognized net gain as of December 31, 1993. The components of the net periodic postretirement benefits cost for 1993 were as follows ($ in millions): Service costs............................. $ .1 Interest costs............................ 3.0 Net amortization of Corridor excess....... - Net periodic postretirement ----- benefit costs........................... $ 3.1 The weighted-average annual assumed rate of increase in the per capital cost of covered benefits (e.g., health care cost trend rate) for the medical plans is 14.0% for 1993 and is assumed to decrease gradually to 6.25% by 2001 and remain at that level thereafter. The health care cost trend rate assumption normally has a significant effect on the amounts reported; however, as discussed, the plan limits annual inflation for the Railroad's portion of such costs to 9.5% each year. Therefore, an increase in the assumed health care cost trend rates by one percentage point in each year would have no impact on the Railroad's accumulated postretirement benefit obligation for the medical plans as of December 31, 1993, or the aggregate of the service and interest cost components of net periodic postretirement benefit expense in future years. 10. PROVISION FOR INCOME TAXES Effective January 1, 1992, the Railroad adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). As a result, the Railroad recorded a $23.7 million reduction in its accrued net deferred income tax liability as of January 1, 1992. The gain recorded upon adoption could not be recognized previously in accordance with SFAS No. 96 which the Railroad had adopted in 1988. The Railroad elected to report this change as the cumulative effect of a change of accounting principle. Therefore, prior year amounts were not restated. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993, which contains a deficit reduction package, became law. Certain aspects of the Act directly affect the Railroad. Most significantly, the new law increased the maximum corporate federal income tax rate from 34% to 35% retroactive to January 1, 1993. This change required the Railroad to record additional deferred income tax expense of approximately $3.1 million to reflect the new tax rate's impact on net deferred income tax liability as of January 1, 1993. The higher corporate rate is not anticipated to significantly affect the Railroad's cash flow. The Provision for Income Taxes for continuing operations consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 Current income tax: Federal............ $23.8 $15.4 $ 9.4 State.............. .9 1.6 1.0 Deferred income taxes 31.9 20.7 20.3 Provision for Income ----- ----- ----- Taxes.............. $56.6 $37.7 $30.7 The effective income tax rates for the years ended December 31, 1993, 1992 and 1991, were 38%, 34% and 32%, respectively. See Note 3 for the tax benefits associated with the extraordinary loss. The items which gave rise to differences between the income taxes provided for continuing operations in the Consolidated Statements of Income and the income taxes computed at the statutory rate are summarized below ($ in millions): Temporary differences between book and tax income arise because the tax effects of transactions are recorded in the year in which they enter into the determination of taxable income. As a result, the book provisions for taxes differ from the actual taxes reported on the income tax returns. The net results of such differences are included in Deferred Income Taxes in the Consolidated Balance Sheets. The Railroad has an Alternative Minimum Tax ("AMT") carryforward credit of $.1 million at December 31, 1993. This excess of AMT over regular tax can be carried forward indefinitely to reduce future U.S. Federal income tax liabilities. At December 31, 1993, this credit was used to reduce the recorded deferred tax liability. At December 31, 1993, the Railroad, for tax or financial statement reporting purposes, had no net operating loss carryovers. Deferred Income Taxes consisted of the following ($ in millions): December 31, 1993 1992 Deferred tax assets.......... $ 82.2 $ 114.4 Less: Valuation allowance.... (2.2) (3.3) -------- -------- Deferred tax assets, net of valuation allowance. 80.0 111.1 Deferred tax liabilities...... (257.8) (257.1) -------- -------- Deferred Income Taxes......... $ (177.8 $ (146.0) The valuation allowance is comprised of the portion of state tax net operating loss carryforwards expected to expire before they are utilized and non-deductible expenses incurred with the previous merger of wholly- owned subsidiaries. Major types of deferred tax assets are: reserves not yet deducted for tax purposes ($64.0 million) and safe harbor leases ($11.8 million). Major types of deferred tax liabilities are: accelerated depreciation ($203.5 million), land basis differences ($10.3 million) and debt marked to market ($2.1 million). IC and the Railroad have a tax sharing agreement whereby the Railroad's federal tax liability and combined state tax liabilities (if any) are the lesser of (i) the Railroad's separate consolidated liability as if it were not a member of IC's consolidated group or (ii) IC's consolidated liability computed without regard to any other subsidiaries of the IC. 11. EQUITY AND RESTRICTIONS ON DIVIDENDS Certain covenants of the Railroad's debt restrict the level of dividends it may pay to IC. At December 31, 1993, approximately $76 million was free of such restrictions. The Railroad was able to pay dividends of $27.4 million and $6.4 million in 1993 and 1992, respectively. In November 1993, the Railroad declared a $15.0 million dividend which was paid in January 1994. In 1993 and 1992, IC made capital contributions of $2.8 million and $3.6 million respectively, to the Railroad which was equivalent to the vested portion of the restricted IC Common Stock granted to various Railroad employees, including Mr. Moyers, in accordance with an IC benefit plan. Such restricted stock vests in equal installments through May 1, 1996. In 1991, IC made a $50 million capital contribution from proceeds of a $63 million public Common Stock offering. 12. CONTINGENCIES, COMMITMENTS AND CONCENTRATION OF RISKS The Railroad is self-insured for the first $5 million of each loss. The Railroad carries $295 million of liability insurance per occurrence, subject to an annual cap of $370 million in the aggregate for all losses. This coverage is considered by the Railroad's management to be adequate in light of the Railroad's safety record and claims experience. As of December 31, 1993, the Railroad had $4.0 million of letters of credit outstanding as collateral primarily for surety bonds executed on behalf of the Railroad. Such letters of credit expire in 1994 and are automatically renewable for one year. The letters of credit reduced the maximum amount that could be borrowed under the Revolver (see Note 8). The Railroad has guaranteed repayment of certain indebtedness of a jointly owned company aggregating $7.8 million. The Railroad's primary share is $1.0 million; the remainder is a primary obligation of other unrelated owner companies. There are various regulatory proceedings, claims and litigation pending against the Railroad. While the ultimate amount of liability that may result cannot be determined, in the opinion of the Railroad's management, based on present information, adequate provisions for liabilities have been recorded. See "Management's Discussion and Analysis - Other" for a discussion of environmental matters. 13. 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 temporary cash investments. The carrying amount approximates fair value because of the short maturity of those instruments. Investments. The Railroad has investments of $9.1 million in 1993 and $11.1 million in 1992 for which there are no quoted market prices. These investments are in joint railroad facilities, railroad terminal associations, switching railroads and other transportation companies. For these investments, the carrying amount is a reasonable estimate of fair value. The Railroad's remaining investments ($5.4 million in 1993 and $3.9 million in 1992) are accounted for by the equity method. Long-term debt. The fair value of the Railroad'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 Railroad for debt of the same remaining maturities. Fuel hedge agreements. The fair value of fuel hedging agreements is the estimated amount that the Railroad would receive or pay to terminate the agreements as of year end, taking into account the current credit worthiness of the agreement counterparties. At December 31, 1993 and 1992, the fair value was a liability of $4.6 million and less than $.1 million, respectively. The estimated fair values of the Railroad's financial instruments at December 31, are as follows ($ in millions): 1993 1992 Carrying Fair Carrying Fair Amount Value Amount Value -------- ----- ------- ----- Cash and temporary cash Investments... $ 8.1 $ 8.1 $ 25.6 $ 25.6 Investments......... 9.1 9.1 11.1 11.1 Debt................ (348.4) (368.9) (368.8) (418.2) 14. SPECIAL CHARGE In 1992, the Railroad recorded a pretax special charge of $8.9 million as part of operating expense. The special charge reduced Net Income by $5.9 million. The special charge consisted of $7 million for various costs associated with the retirement of Mr. Moyers and the related organizational changes. The costs associated with Mr. Moyers' retirement include the present value of his pension, accelerated vesting of a portion of his restricted stock award and certain costs of a non-competition agreement. The remaining $1.9 million was for the disposition costs of railcars and a building and its adjacent land. - ---------------- (a) Includes the special charge recorded in the fourth quarter of 1992, see Note 14. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES ----------------- --------------------------- F O R M 10-K FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES -------------- -------------- I N D E X T O FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) Schedules for the three years ended December 31, 1993: V-Property, plant and equipment.......... VI-Accumulated depreciation and amortization of property, plant and equipment....... VII-Guarantees of securities of other issuers VIII-Valuation and qualifying accounts...... Pursuant to Rule 5.04 of General Rules of Regulation S-X, all other schedules are omitted because they are not required or because the required information is set forth in the financial statements or related notes thereto. (1) Reclassification of properties from "Other Assets." (2) Reclassification of properties from "Assets Held For Disposition." ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS AS OF DECEMBER 31, 1993, 1992 AND 1991 ($ IN MILLIONS) Column A Column B Column C Column D - -------- -------- -------- -------- Name of Title of Issue Total Amount Issuer of of Class of Guaranteed Nature of Securities Securities and Guarantee Guaranteed Guaranteed Outstanding by Person for Which Statement is Filed Terminal Refunding and Railroad Improvement Association Mortgage 4% Principal of St. Bonds, Series and Louis "C", due annual 7/1/2019 $7.8 interest ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 3.1 Articles of Incorporation of Illinois Central Railroad, as amended. (Incorporated by reference to Exhibit 3.1 to the Registration Statement of Illinois Central Railroad on Form S-1. (SEC File No. 33- 29269)) 3.2 By-Laws of Illinois Central Railroad, as amended. (Incorporated by reference to Exhibit 3.2 to the Registration Statement of Illinois Central Railroad on Form S-1. (SEC File No. 33-29269)) 4.1 Form of 14-1/8% Senior Subordinated Debenture Indenture dated as of September 15, 1989 (the "Senior Subordinated Debenture Indenture") between Illinois Central Railroad and United States Trust Railroad of New York, Trustee (including the form of 14-1/8% Senior Subordinated Debenture included as Exhibit A therein). (Incorporated by reference to Exhibit 4.1 to the Registration Statement of Illinois Central Railroad on Form S-1, as amended. (SEC File No. 33- 29269)) 4.2 Form of the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad and the Banks named therein (including the Form of the Restated Revolving Credit Note, the Form of the Restated Term Note, the Form of the Intercreditor Agreement, the Form of the Security Agreement Amendment No. 1 dated as of February 28, 1992, to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Annual Report on Form 10-K for the year ended December 31, 1991, for the Illinois Central Railroad filed March 12, 1992. (SEC File No. 1-7092)) 4.4 Form of Guaranty dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among the Illinois Central Railroad and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1- 10720)) - ------------------ * Used herein to identify management contracts or compensation plans or arrangements as required by Item 14 of Form 10-K. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.5 Form of Pledge Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among the Illinois Central Railroad and the Banks named therein and the Senior Note Purchasers that are parties to the Note Purchase Agreement dated as of July 23, 1991. (Incorporated by reference to Exhibit 4.4 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 4.6 Form Supplemental Indenture dated July 23, 1991, between Illinois Central Railroad and Morgan Guaranty Trust Railroad of New York relating to First Mortgage Adjustable Rate Bonds,Series M. (Incorporated by reference to Exhibit 4.2 to the Quarterly Report of Illinois Central Railroad on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.7 Form of Note Purchase Agreement dated as of July 23, 1991, among Illinois Central Railroad, as issuer, and Illinois Central Railroad Company, as guarantor, for 10.02% Guaranteed Senior Secured Series A Notes due 1999 and for 10.4% Guaranteed Senior Secured Series B Notes due 2001 (including the Form of Series A Note and Series B Note included as Exhibits A-1 and A-2, respectively, therein). (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of the Illinois Central Railroad on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1- 7092)) 4.8 Form of the Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of the Competitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). 4.9 Form of the Amended and Restated Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of theCompetitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.10 Form of Commercial Paper Dealer Agreement between Illinois Central Railroad Company and Lehman Commercial Paper, Inc. dated as of November 19, 1993. 4.11 Form of Issuing and Paying Agency Agreement of the Illinois Central Railroad Company related to the Commercial Paper Program between Illinois Central Railroad Company and Bank America National Trust Company dated as of November 19, 1993, (including Exhibit A the Form of Certificated Commercial Paper Note included therein). 10.1* Form of supplemental retirement and savings plan. (Incorporated by reference to Exhibit 10C to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) 10.2 * Form of management incentive compensation plan. (Incorporated by reference to Exhibit 10D to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) 10.3 Consolidated Mortgage dated November 1, 1949 between Illinois Central Railroad and Guaranty Trust Railroad of New York, Trustee, as amended. (Incorporated by reference to Exhibit 10.8 to the Registration Statement of Illinois Central Railroad on Form S-1, as amended. (SEC File No. 33-29269)) ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.4 Form of indemnification agreement dated as of January 29, 1991, between Illinois Central Railroad Company and certain officers and directors. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1990, for the Illinois Central Railroad Company filed on April 1, 1991. (SEC File No. 1- 10720)) 10.5 Railroad Locomotive Lease Agreement between IC Leasing Corporation I and Illinois Central Railroad dated as of September 5, 1991. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1991 for the Illinois Central Railroad filed March 12, 1992. (SEC File No. 1-7092)) 10.6 Railroad Locomotive Lease Agreement between IC Leasing Corporation II and Illinois Central Railroad dated as of January 14, 1993. (Incorporated by reference to Exhibit 10.6 to the Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Railroad filed March 5, 1993. (SEC File No. 1-7092)) 21 Subsidiaries of Registrant (Included at E-5) (A) Included herein but not reproduced. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: See Index to Consolidated Financial Statements on page 27 of this Report. 2. Financial Statement Schedules: See Index to Financial Statement Schedules on page of this Report. 3. Exhibits: See items marked with "*" on the Exhibit Index beginning on page E-1 of this Report. Items so marked identify management contracts or compensatory plans or arrangements as required by Item 14. (b) 1. Reports on Form 8-K: During the fourth quarter of 1993 the Registrant filed with the Securities and Exchange Commission the following reports on Form 8-K on the dates indicated to report the events described: NONE (c) Exhibits: The response to this portion of Item 14 is submitted as a separate section of this Report. See Exhibit Index beginning on page E-1. (d) Financial Statement Schedules: The response to this portion of Item 14 is submitted as a separate section of this Report. 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, there unto duly authorized. Illinois Central Railroad Company By: /s/ DALE W. PHILLIPS Dale W. Phillips Vice President and Chief Financial Officer Date: March 16, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and on the dates indicated. SIGNATURE Title(s) Date /s/ GILBERT H. LAMPHERE Chairman of the Gilbert H. Lamphere Board and Director March 16, 1994 /s/ E. HUNTER HARRISON President and Chief E. Hunter Harrison Executive Officer (principal executive officer), Director March 16, 1994 /s/ DALE W. PHILLIPS Vice President Dale W. Phillips and Chief Financial Officer (principal financial officer) March 16, 1994 /s/ JOHN V. MULVANEY Controller John V. Mulvaney (principal accounting officer) March 16, 1994 /s/ RONALD A. LANE Director Ronald A. Lane March 16, 1994 /s/ GERALD F. MOHAN Director Gerald F. Mohan March 16, 1994 ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES ------------------ ---------------------------- F O R M 10-K FINANCIAL STATEMENTS SUBMITTED IN RESPONSE TO ITEM 8 ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Public Accountants.... Consolidated Statements of Income for the three years ended December 31, 1993........ Consolidated Balance Sheets at December 31, 1993 and 1992................. Consolidated Statements of Cash Flows for the three years ended December 31, 1993.... Consolidated Statements of Stockholder's Equity and Retained Income for the three years ended December 31, 1993.............. Notes to Consolidated Financial Statements for the three years ended December 31, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Illinois Central Railroad Company: We have audited the accompanying consolidated balance sheets of Illinois Central Railroad Company (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and stockholder's equity and retained income 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 Illinois Central Railroad 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 discussed in Note 9 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement health care and postemployment benefits. 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 herein 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 January 19, 1994 ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Statements of Income ($ in millions) The following notes are an integral part of the consolidated financial statements. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Balance Sheets ($ in millions) The following notes are an integral part of the consolidated financial statements. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Statements of Cash Flows ($ in millions) The following notes are an integral part of the consolidated financial statements. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES Consolidated Statements of Stockholder's Equity The following notes are an integral part of the consolidated financial statements. 1. THE RAILROAD Illinois Central Corporation, a holding company, (hereinafter, "IC") was formed originally for the purpose of acquiring, through a wholly-owned subsidiary, the outstanding common stock of Illinois Central Transportation Company ("ICTC"). Following a tender offer and several mergers, the Illinois Central Railroad Company ("Railroad") is the surviving corporation and the successor to ICTC and now a wholly-owned subsidiary of the IC. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Railroad and its subsidiaries. Significant investments in affiliated companies are accounted for by the equity method. Transactions between consolidated companies have been eliminated in the accompanying consolidated financial statements. PROPERTIES Depreciation is computed by the straight-line method and includes depreciation on properties under capital leases. Depreciation for track structure, other road property, and equipment is calculated using the composite method. In the case of routine retirements, removal cost less salvage recovery is charged to accumulated depreciation. Expenditures for maintenance and repairs are charged to operating expense. The Interstate Commerce Commission ("ICC") approves the depreciation rates used by the Railroad. In 1991, the Railroad completed a study which resulted in revised depreciation rates for road properties (excluding track properties) and equipment. The revised rates did not and will not have a significant effect on operating results. The approximate ranges of annual depreciation rates for major property classifications are as follows: Road properties .................1% - 8% Transportation equipment ........1% - 7% In 1989, the Railroad initiated a program to convert approximately 500 miles of double track main line to a single track main line, with a centralized traffic control system. This program was completed successfully in 1991. REVENUES Revenues are recognized based on services performed and include estimated amounts relating to movements in progress for which the settlement process is not complete. Estimated revenue amounts for movements in progress are not significant. INCOME TAXES Effective January 1, 1992, the Railroad adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). Under SFAS No. 109, deferred income taxes are accounted for on the asset and liability method by applying enacted statutory tax rates to differences ("temporary differences") between the financial statement carrying amounts and the tax bases of assets and liabilities. The resulting deferred tax assets and liabilities represent taxes to be collected or paid in the future when the related assets and liabilities are recovered and settled, respectively. See Note 10 for discussion of the 1992 impact of adopting SFAS No. 109. CASH AND TEMPORARY CASH INVESTMENTS Cash in excess of operating requirements is invested in certain funds having original maturities of three months or less. These investments are stated at cost, which approximates market value. INCOME PER SHARE Income per share has been omitted as the Railroad is a wholly-owned subsidiary of IC. FUTURES, OPTIONS, CAPS, FLOORS AND FORWARD CONTRACTS In March 1990, the FASB issued Statement of Financial Accounting Standards No. 105 "Disclosure of Information about Financial Instruments with Off Balance Sheet Risk and Financial Instruments with Concentration of Credit Risk" ("SFAS 105"). Disclosures required by SFAS 105 are found in various notes where the financial instruments or related risks are discussed. See specifically Notes 6, 7, 8, and 12. CASUALTY AND FREIGHT CLAIMS The Railroad accrues for injury and damage claims outstanding based on actual claims filed and estimates of claims incurred but not filed. Estimated amounts expected to be settled within one year are classified as current liabilities in the accompanying Consolidated Balance Sheets. EMPLOYEE BENEFIT PLANS All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contribution costs of the plan are funded currently. Mr. E. L. Moyers, former Chairman, President and Chief Executive Officer ("Mr. Moyers") is covered by a supplemental plan which is discussed in Note 9. Effective January 1, 1993, the Railroad adopted both the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106") and the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). SFAS No. 106 requires that future costs associated with providing postretirement benefits be recognized as expense over the employees' requisite service period. The pay-as-you-go method used prior to 1993 recognized the expense on a cash basis. SFAS No. 112 establishes accounting standards for employers who provide postemployment benefits and clarifies when the expense is to be recognized. In accordance with the provisions of these standards, years prior to 1993 have not been restated. See Note 9 for discussion of the impact of adopting SFAS No. 106 and SFAS No. 112. RECLASSIFICATIONS Certain items relating to prior years have been reclassified to conform to the presentation in the current year. 3. EXTRAORDINARY ITEM AND REFINANCING The 1993 extraordinary loss resulted from the retirement of the Railroad's 14-1/8% Senior Subordinated Debentures (the "Debentures") and refinancing the Permanent Facility. The loss was $23.4 million, net of tax benefits of $12.6 million. The loss resulted from the premium paid, the write-off of unamortized financing fees and debt discount and costs associated with the calling of the $10.3 million of Debentures not tendered. The net proceeds of the 6.75% Notes (see Note 8), borrowings under the $180 million Revolving Credit Facility and other available cash were used to fund the retirement of the Debentures. 4. OTHER INCOME, NET Other Income, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 ---- ---- ---- Rental income, net...... $ 3.9 $ 3.8 $ 3.0 Net gains on real estate sales.................. .8 .4 .7 Net gain (loss) on disposal of rolling stock....... (2.3) - - Equity in undistributed earnings of affiliates. .5 .3 .4 Net gain on Series K.... - - 3.6 Other, net.............. (.1) (.9) (.7) ------ ------ ------ Other Income, Net..... $ 2.8 $ 3.6 $ 7.0 5. SUPPLEMENTAL CASH FLOW INFORMATION Cash changes in components of working capital, exclusive of Current Maturities of Long-Term Debt, included in the Consolidated Statements of Cash Flows were as follows ($ in millions): Included in changes in Other Liabilities and Reserves is approximately $6.3 million and $23.4 million for the years ended December 31, 1993 and 1992, respectively, reflecting proceeds from the settlement of casualty claims with numerous insurance carriers. In 1993, the Railroad entered into a capital lease for 200 covered hoppers. The lease expires in 2003. See Note 7 for a recap of the present value of the minimum lease payments. In 1991, the Railroad retired several Long-Term Debt obligations, most significantly its $150 million 15.5% Series K First Mortgage Bonds ("Series K"). These retirements resulted in non-cash reductions of debt balances of $4.6 million. Also, in 1991 the balance of a long term investment was reduced by $2.5 million. 6. MATERIALS AND SUPPLIES Materials and Supplies, valued using the average cost method, consist of track material, switches, car and locomotive parts and fuel. The Railroad entered into various hedge agreements designed to mitigate significant changes in fuel prices. As a result, approximately 93% of the short-term diesel fuel requirements through March 1995 and 46% through June 1995 are protected against significant price changes based on the average near-by contract for Heating Oil #2 traded on the New York Mercantile Exchange. 7. LEASES As of December 31, 1993, the Railroad leased 6,709 of its cars and 227 of its locomotives. The majority of these leases have original terms of 15 years and expire between 1994 and 2001. Under the terms of the majority of its leases, the Railroad has the right of first refusal to purchase, at the end of the lease terms, certain cars and locomotives at fair market value. Other leases include office and computer equipment, vehicles and office facilities. Net obligations under capital leases at December 31, 1993 and 1992, included in the Consolidated Balance Sheets are $5.4 million and $.2 million, respectively. At December 31, 1993, minimum rental payments under capital and operating leases that have initial or remaining noncancellable terms in excess of one year were as follows ($ in millions): Capital Operating Leases Leases 1994 ..................... $ .9 $ 34.6 1995 ..................... .9 28.4 1996 ..................... .8 19.3 1997 ..................... .8 7.8 1998 ..................... .8 4.2 Thereafter ............... 3.1 17.4 Total minimum lease ---- ------ payments............... 7.3 $111.7 Less: Imputed interest ... 1.9 Present value of minimum ---- payments............... $5.4 Total rent expense applicable to noncancellable operating leases amounted to $48.2 million in 1993, $48.4 million for 1992 and $49.4 million for 1991. Most of the leases provide that the Railroad pay taxes, maintenance, insurance and certain other operating expenses. 8. LONG-TERM DEBT AND INTEREST EXPENSE Long-Term Debt at December 31, consisted of the following ($ in millions): At December 31, 1993, the aggregate annual maturities and sinking fund requirements for debt payments for 1994 through 1999 and thereafter are $1.1 million, $.8 million, $78.9 million, $.9 million, $55.6 million, $55.6 million and $155.5 million, respectively. The weighted-average interest rate for 1993 and 1992 on total debt excluding the effect of discounts, premiums and related amortization was 9.1% and 10.8%, respectively. In November 1993, the Railroad initiated a public commercial paper program. The commercial paper is rated A2 by S&P, by Fitch and P3 by Moody's and is supported by a new $100 million Revolver with the Railroad's bank lending group. The Railroad views this program as a significant long-term funding source and intends to issue replacement notes as maturities occur. Therefore, the $38.1 million outstanding at December 31, 1993 has been classified as long-term. In connection with the commercial paper program, the bank lending group agreed to replace the $180 million Revolving Credit Facility (see below) with (i) a new $100 million Revolver, due 1996 and (ii) a $50 million 364-day facility due October 1994 ("Bank Line"). The new Revolver will be used primarily for backup for the commercial paper but can be used for general corporate purposes. The available amount is reduced by the outstanding amount of commercial paper borrowings and any letters of credit issued on behalf of the Railroad under the facility. No amounts have been drawn under the Revolver. The $100 million was limited to $57.9 million because $38.1 million in commercial paper was outstanding and $4.0 million in letters of credit had been issued. The Bank Line was structured as a 364-day renewable instrument and the Railroad intends to renew it on an on- going basis. The $40 million outstanding at December 31, 1993, has therefore been classified as long-term. During April 1993, IC and the Railroad reached an agreement with its bank lending group and the holders of the privately placed $160 million Senior Secured Notes ("Senior Notes") for a release of all collateral and those instruments are now unsecured. The bank agreed to replace the Permanent Facility with a $180 million Revolving Credit Facility. This was done in connection with the tender offer made by the Railroad for all of the Debentures. The tender offer was funded by issuance of new $100 million 6.75% Notes, due 2003 (the "Notes"), borrowing under a $180 million Revolving Credit Facility negotiated with the banks which replaced the Permanent Facility and cash on hand. See Note 3 for discussion of the extraordinary loss incurred upon tender for the Debentures. The Railroad irrevocably placed $12.6 million on deposit with a trustee to cover principal, a 6% premium and interest through the first call date of October 1, 1994, for the untendered Debentures. The Notes (issued at a slight discount 1.071%) pay interest semiannually in May and November and are covered by an Indenture. Of the Senior Notes, $109.8 million bears interest at a rate of 10.02% and $50 million at 10.4%. Principal payments of $55 million are due in each of 1998 and 1999, and $25 million in each of 2000 and 2001. The Senior Notes are governed by a Note Purchase Agreement. Various borrowings of the Railroad are governed by agreements which contain certain affirmative and negative covenants customary for facilities of this nature including restrictions on additional indebtedness, investments, guarantees, liens, distributions, sales and leasebacks, and sales of assets and capital stock. Some also require the Railroad to satisfy certain financial tests, including a leverage ratio, an earnings before interest and taxes to interest charges ratio, debt service coverage, and minimum consolidated tangible net worth requirements. The Railroad may be required to apply 100% of net after-tax proceeds of sales aggregating $2.5 million or greater of certain assets to reduce Revolver commitments. The holders of the Senior Notes can elect to receive a pro-rata share of after-tax proceeds. Interest Expense, Net consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 Interest expense ..... $33.8 $45.1 $59.7 Less: Interest capitalized..... .8 .6 .4 Interest income....... 1.2 1.6 3.2 ----- ----- ----- Interest Expense, Net. $31.8 $42.9 $56.1 9. EMPLOYEE BENEFIT PLANS Retirement Plans. All employees of the Railroad are covered under the Railroad Retirement Act. In addition, management employees of the Railroad are covered under a defined contribution plan. Contributions under the plan vest immediately. Expenses relating to the defined contribution plan were $.4 million for each of the years ended December 31, 1993, 1992 and 1991. Mr. Moyers is covered by a non-qualified, unfunded supplemental retirement benefit agreement which provides for a defined benefit payable annually, commencing upon death, permanent disability or retirement (with benefits arising from retirement commencing upon his attaining age 65 and compliance with certain non-competition agreements), in the amount of $250,000 per year for a maximum of 15 years. In accordance with the term of the agreement, no payments will be made while Mr. Moyers is employed by another Class I railroad. The present value of this agreement was included in the 1992 special charge. See Note 14. Postretirement Plans. In addition to the Railroad's defined contribution plan for management employees, the Railroad has three benefit plans which provide some postretirement benefits to most former full-time salaried employees and selected former union represented employees. The medical plan for salaried retirees is contributory, with retiree contributions adjusted annually if expected inflation rate exceeds 9.5%, and contains other cost sharing features such as deductibles and co-payments. The Railroad's contribution will be fixed at the 1999 year end rate for all subsequent years. Salaried retirees are covered by a life insurance plan which provides a nominal death benefit and is non- contributory. The medical plan for locomotive engineers who retired under a special early retirement program in 1987 provides non-contributory coverage until age 65. All benefits under this plan terminate in 1998. There are no plan assets and the Railroad will continue to fund these benefits as claims are paid as was done in prior years. Postemployment Benefit Plans. The Railroad provides certain postemployment benefits such as long-term salary continuation and waiver of medical and life insurance co- payments while on long-term disability. SFAS No. 106 and SFAS No.112. As described in Note 2 effective January 1, 1993 the Railroad adopted SFAS No. 106 and SFAS No. 112. With respect to SFAS No. 106, the Railroad elected to immediately recognize the transition asset associated with adoption which resulted because the Railroad had previously recorded an amount under purchase accounting to reflect the estimated liability for such benefits as of the acquisition date of ICTC. As a result of adopting these two standards, the Railroad recorded a decrease to net income of $84,000 (net of taxes of $46,000) as a cumulative effect of changes in accounting principles ($ in millions): Postretirement Benefits (SFAS No. 106): APBO at January 1, 1993: Medical.................... $36.5 Life....................... 2.3 Total APB........... 38.8 Liability previously recorded (40.3) Transition Asset....... 1.5 Postemployment Benefits Obligation at January 1, 1993 (SFAS 112) (1.6) Pre-tax Cumulative Effect of Changes in Accounting Principles..... (.1) Related tax benefit............... - ----- Cumulative Effect of Changes in Accounting Principles..... $ (.1) Per Share Impact.................. $ - In accordance with each standard, years prior to 1993 have not been restated. For 1993, the adoption of these two standards had no significant effect on income before cumulative effect of changes in accounting principles as compared to the Railroad's prior pay-as- you-go method of accounting for such benefits. The accumulated postretirement benefit obligations ("APBO") of the postretirement plans were as follows ($ in millions): January December 31, 1993 1, 1993 Medical Life Total Total ------- ---- ----- ------- Accumulated post- retirement benefit obligation: Retirees......... $26.4 $ 2.4 $28.8 $33.4 Fully eligible active plan participants.... .7 - .7 .7 Other active plan participants.... 4.7 - 4.7 4.7 ----- ----- ----- ----- Total APBO... $31.8 $ 2.4 34.2 38.8 Unrecognized net gain 5.0 - ----- ----- Accrued liability for postretirement benefits $39.2 $38.8 The weighted-average discount rate used in determining the accumulated post-retirement benefit obligation was 8.0% at January 1, 1993. As a result of the Railroad's improved financial condition and recognizing the overall shift in the financial community, the Railroad lowered the weighted-average discount rate to 7.25% as of December 31, 1993. The change in rates resulted in approximately $2.0 million actuarial loss. The loss was offset by actual experience gains, primarily fewer claims and lower medical rate inflation, which resulted in a $5.0 million unrecognized net gain as of December 31, 1993. The components of the net periodic postretirement benefits cost for 1993 were as follows ($ in millions): Service costs............................. $ .1 Interest costs............................ 3.0 Net amortization of Corridor excess....... - Net periodic postretirement ----- benefit costs........................... $ 3.1 The weighted-average annual assumed rate of increase in the per capital cost of covered benefits (e.g., health care cost trend rate) for the medical plans is 14.0% for 1993 and is assumed to decrease gradually to 6.25% by 2001 and remain at that level thereafter. The health care cost trend rate assumption normally has a significant effect on the amounts reported; however, as discussed, the plan limits annual inflation for the Railroad's portion of such costs to 9.5% each year. Therefore, an increase in the assumed health care cost trend rates by one percentage point in each year would have no impact on the Railroad's accumulated postretirement benefit obligation for the medical plans as of December 31, 1993, or the aggregate of the service and interest cost components of net periodic postretirement benefit expense in future years. 10. PROVISION FOR INCOME TAXES Effective January 1, 1992, the Railroad adopted the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). As a result, the Railroad recorded a $23.7 million reduction in its accrued net deferred income tax liability as of January 1, 1992. The gain recorded upon adoption could not be recognized previously in accordance with SFAS No. 96 which the Railroad had adopted in 1988. The Railroad elected to report this change as the cumulative effect of a change of accounting principle. Therefore, prior year amounts were not restated. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993, which contains a deficit reduction package, became law. Certain aspects of the Act directly affect the Railroad. Most significantly, the new law increased the maximum corporate federal income tax rate from 34% to 35% retroactive to January 1, 1993. This change required the Railroad to record additional deferred income tax expense of approximately $3.1 million to reflect the new tax rate's impact on net deferred income tax liability as of January 1, 1993. The higher corporate rate is not anticipated to significantly affect the Railroad's cash flow. The Provision for Income Taxes for continuing operations consisted of the following ($ in millions): Years Ended December 31, 1993 1992 1991 Current income tax: Federal............ $23.8 $15.4 $ 9.4 State.............. .9 1.6 1.0 Deferred income taxes 31.9 20.7 20.3 Provision for Income ----- ----- ----- Taxes.............. $56.6 $37.7 $30.7 The effective income tax rates for the years ended December 31, 1993, 1992 and 1991, were 38%, 34% and 32%, respectively. See Note 3 for the tax benefits associated with the extraordinary loss. The items which gave rise to differences between the income taxes provided for continuing operations in the Consolidated Statements of Income and the income taxes computed at the statutory rate are summarized below ($ in millions): Temporary differences between book and tax income arise because the tax effects of transactions are recorded in the year in which they enter into the determination of taxable income. As a result, the book provisions for taxes differ from the actual taxes reported on the income tax returns. The net results of such differences are included in Deferred Income Taxes in the Consolidated Balance Sheets. The Railroad has an Alternative Minimum Tax ("AMT") carryforward credit of $.1 million at December 31, 1993. This excess of AMT over regular tax can be carried forward indefinitely to reduce future U.S. Federal income tax liabilities. At December 31, 1993, this credit was used to reduce the recorded deferred tax liability. At December 31, 1993, the Railroad, for tax or financial statement reporting purposes, had no net operating loss carryovers. Deferred Income Taxes consisted of the following ($ in millions): December 31, 1993 1992 Deferred tax assets.......... $ 82.2 $ 114.4 Less: Valuation allowance.... (2.2) (3.3) -------- -------- Deferred tax assets, net of valuation allowance. 80.0 111.1 Deferred tax liabilities...... (257.8) (257.1) -------- -------- Deferred Income Taxes......... $ (177.8 $ (146.0) The valuation allowance is comprised of the portion of state tax net operating loss carryforwards expected to expire before they are utilized and non-deductible expenses incurred with the previous merger of wholly- owned subsidiaries. Major types of deferred tax assets are: reserves not yet deducted for tax purposes ($64.0 million) and safe harbor leases ($11.8 million). Major types of deferred tax liabilities are: accelerated depreciation ($203.5 million), land basis differences ($10.3 million) and debt marked to market ($2.1 million). IC and the Railroad have a tax sharing agreement whereby the Railroad's federal tax liability and combined state tax liabilities (if any) are the lesser of (i) the Railroad's separate consolidated liability as if it were not a member of IC's consolidated group or (ii) IC's consolidated liability computed without regard to any other subsidiaries of the IC. 11. EQUITY AND RESTRICTIONS ON DIVIDENDS Certain covenants of the Railroad's debt restrict the level of dividends it may pay to IC. At December 31, 1993, approximately $76 million was free of such restrictions. The Railroad was able to pay dividends of $27.4 million and $6.4 million in 1993 and 1992, respectively. In November 1993, the Railroad declared a $15.0 million dividend which was paid in January 1994. In 1993 and 1992, IC made capital contributions of $2.8 million and $3.6 million respectively, to the Railroad which was equivalent to the vested portion of the restricted IC Common Stock granted to various Railroad employees, including Mr. Moyers, in accordance with an IC benefit plan. Such restricted stock vests in equal installments through May 1, 1996. In 1991, IC made a $50 million capital contribution from proceeds of a $63 million public Common Stock offering. 12. CONTINGENCIES, COMMITMENTS AND CONCENTRATION OF RISKS The Railroad is self-insured for the first $5 million of each loss. The Railroad carries $295 million of liability insurance per occurrence, subject to an annual cap of $370 million in the aggregate for all losses. This coverage is considered by the Railroad's management to be adequate in light of the Railroad's safety record and claims experience. As of December 31, 1993, the Railroad had $4.0 million of letters of credit outstanding as collateral primarily for surety bonds executed on behalf of the Railroad. Such letters of credit expire in 1994 and are automatically renewable for one year. The letters of credit reduced the maximum amount that could be borrowed under the Revolver (see Note 8). The Railroad has guaranteed repayment of certain indebtedness of a jointly owned company aggregating $7.8 million. The Railroad's primary share is $1.0 million; the remainder is a primary obligation of other unrelated owner companies. There are various regulatory proceedings, claims and litigation pending against the Railroad. While the ultimate amount of liability that may result cannot be determined, in the opinion of the Railroad's management, based on present information, adequate provisions for liabilities have been recorded. See "Management's Discussion and Analysis - Other" for a discussion of environmental matters. 13. 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 temporary cash investments. The carrying amount approximates fair value because of the short maturity of those instruments. Investments. The Railroad has investments of $9.1 million in 1993 and $11.1 million in 1992 for which there are no quoted market prices. These investments are in joint railroad facilities, railroad terminal associations, switching railroads and other transportation companies. For these investments, the carrying amount is a reasonable estimate of fair value. The Railroad's remaining investments ($5.4 million in 1993 and $3.9 million in 1992) are accounted for by the equity method. Long-term debt. The fair value of the Railroad'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 Railroad for debt of the same remaining maturities. Fuel hedge agreements. The fair value of fuel hedging agreements is the estimated amount that the Railroad would receive or pay to terminate the agreements as of year end, taking into account the current credit worthiness of the agreement counterparties. At December 31, 1993 and 1992, the fair value was a liability of $4.6 million and less than $.1 million, respectively. The estimated fair values of the Railroad's financial instruments at December 31, are as follows ($ in millions): 1993 1992 Carrying Fair Carrying Fair Amount Value Amount Value -------- ----- ------- ----- Cash and temporary cash Investments... $ 8.1 $ 8.1 $ 25.6 $ 25.6 Investments......... 9.1 9.1 11.1 11.1 Debt................ (348.4) (368.9) (368.8) (418.2) 14. SPECIAL CHARGE In 1992, the Railroad recorded a pretax special charge of $8.9 million as part of operating expense. The special charge reduced Net Income by $5.9 million. The special charge consisted of $7 million for various costs associated with the retirement of Mr. Moyers and the related organizational changes. The costs associated with Mr. Moyers' retirement include the present value of his pension, accelerated vesting of a portion of his restricted stock award and certain costs of a non-competition agreement. The remaining $1.9 million was for the disposition costs of railcars and a building and its adjacent land. - ---------------- (a) Includes the special charge recorded in the fourth quarter of 1992, see Note 14. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES ----------------- --------------------------- F O R M 10-K FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES -------------- -------------- I N D E X T O FINANCIAL STATEMENT SCHEDULES SUBMITTED IN RESPONSE TO ITEM 14(a) Schedules for the three years ended December 31, 1993: V-Property, plant and equipment.......... VI-Accumulated depreciation and amortization of property, plant and equipment....... VII-Guarantees of securities of other issuers VIII-Valuation and qualifying accounts...... Pursuant to Rule 5.04 of General Rules of Regulation S-X, all other schedules are omitted because they are not required or because the required information is set forth in the financial statements or related notes thereto. (1) Reclassification of properties from "Other Assets." (2) Reclassification of properties from "Assets Held For Disposition." ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS AS OF DECEMBER 31, 1993, 1992 AND 1991 ($ IN MILLIONS) Column A Column B Column C Column D - -------- -------- -------- -------- Name of Title of Issue Total Amount Issuer of of Class of Guaranteed Nature of Securities Securities and Guarantee Guaranteed Guaranteed Outstanding by Person for Which Statement is Filed Terminal Refunding and Railroad Improvement Association Mortgage 4% Principal of St. Bonds, Series and Louis "C", due annual 7/1/2019 $7.8 interest ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 3.1 Articles of Incorporation of Illinois Central Railroad, as amended. (Incorporated by reference to Exhibit 3.1 to the Registration Statement of Illinois Central Railroad on Form S-1. (SEC File No. 33- 29269)) 3.2 By-Laws of Illinois Central Railroad, as amended. (Incorporated by reference to Exhibit 3.2 to the Registration Statement of Illinois Central Railroad on Form S-1. (SEC File No. 33-29269)) 4.1 Form of 14-1/8% Senior Subordinated Debenture Indenture dated as of September 15, 1989 (the "Senior Subordinated Debenture Indenture") between Illinois Central Railroad and United States Trust Railroad of New York, Trustee (including the form of 14-1/8% Senior Subordinated Debenture included as Exhibit A therein). (Incorporated by reference to Exhibit 4.1 to the Registration Statement of Illinois Central Railroad on Form S-1, as amended. (SEC File No. 33- 29269)) 4.2 Form of the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad and the Banks named therein (including the Form of the Restated Revolving Credit Note, the Form of the Restated Term Note, the Form of the Intercreditor Agreement, the Form of the Security Agreement Amendment No. 1 dated as of February 28, 1992, to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Annual Report on Form 10-K for the year ended December 31, 1991, for the Illinois Central Railroad filed March 12, 1992. (SEC File No. 1-7092)) 4.4 Form of Guaranty dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among the Illinois Central Railroad and the Banks named therein. (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1- 10720)) - ------------------ * Used herein to identify management contracts or compensation plans or arrangements as required by Item 14 of Form 10-K. ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.5 Form of Pledge Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among Illinois Central Railroad Company and the Banks named therein that are or may become parties to the Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1989, and amended and restated as of July 23, 1991, among the Illinois Central Railroad and the Banks named therein and the Senior Note Purchasers that are parties to the Note Purchase Agreement dated as of July 23, 1991. (Incorporated by reference to Exhibit 4.4 to the Quarterly Report of Illinois Central Railroad Company on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-10720)) 4.6 Form Supplemental Indenture dated July 23, 1991, between Illinois Central Railroad and Morgan Guaranty Trust Railroad of New York relating to First Mortgage Adjustable Rate Bonds,Series M. (Incorporated by reference to Exhibit 4.2 to the Quarterly Report of Illinois Central Railroad on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1-7092)) 4.7 Form of Note Purchase Agreement dated as of July 23, 1991, among Illinois Central Railroad, as issuer, and Illinois Central Railroad Company, as guarantor, for 10.02% Guaranteed Senior Secured Series A Notes due 1999 and for 10.4% Guaranteed Senior Secured Series B Notes due 2001 (including the Form of Series A Note and Series B Note included as Exhibits A-1 and A-2, respectively, therein). (Incorporated by reference to Exhibit 4.3 to the Quarterly Report of the Illinois Central Railroad on Form 10-Q for the three months ended September 30, 1991. (SEC File No. 1- 7092)) 4.8 Form of the Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of the Competitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). 4.9 Form of the Amended and Restated Revolving Credit Agreement dated as of October 27, 1993, among Illinois Central Railroad Company and the Banks named therein (including the Form of the Note, the Form of theCompetitive Bid Request, Form of the Notice of Competitive Bid Request, Form of the Competitive Bid and Form of the Competitive Bid Accept/Reject Letter included as Exhibits A, B-1, B-2, B-3 and B-4, respectively, therein). ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 4.10 Form of Commercial Paper Dealer Agreement between Illinois Central Railroad Company and Lehman Commercial Paper, Inc. dated as of November 19, 1993. 4.11 Form of Issuing and Paying Agency Agreement of the Illinois Central Railroad Company related to the Commercial Paper Program between Illinois Central Railroad Company and Bank America National Trust Company dated as of November 19, 1993, (including Exhibit A the Form of Certificated Commercial Paper Note included therein). 10.1* Form of supplemental retirement and savings plan. (Incorporated by reference to Exhibit 10C to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) 10.2 * Form of management incentive compensation plan. (Incorporated by reference to Exhibit 10D to the Registration Statement of Illinois Central Transportation Co. on Form 10 filed on October 7, 1988, as amended. (SEC File No. 1- 10085)) 10.3 Consolidated Mortgage dated November 1, 1949 between Illinois Central Railroad and Guaranty Trust Railroad of New York, Trustee, as amended. (Incorporated by reference to Exhibit 10.8 to the Registration Statement of Illinois Central Railroad on Form S-1, as amended. (SEC File No. 33-29269)) ILLINOIS CENTRAL RAILROAD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Sequential No. Descriptions Page No. - ------- ------------ ---------- 10.4 Form of indemnification agreement dated as of January 29, 1991, between Illinois Central Railroad Company and certain officers and directors. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1990, for the Illinois Central Railroad Company filed on April 1, 1991. (SEC File No. 1- 10720)) 10.5 Railroad Locomotive Lease Agreement between IC Leasing Corporation I and Illinois Central Railroad dated as of September 5, 1991. (Incorporated by reference to Exhibit 10.9 to the Annual Report on Form 10-K for the year ended December 31, 1991 for the Illinois Central Railroad filed March 12, 1992. (SEC File No. 1-7092)) 10.6 Railroad Locomotive Lease Agreement between IC Leasing Corporation II and Illinois Central Railroad dated as of January 14, 1993. (Incorporated by reference to Exhibit 10.6 to the Annual Report on Form 10-K for the year ended December 31, 1992, for the Illinois Central Railroad filed March 5, 1993. (SEC File No. 1-7092)) 21 Subsidiaries of Registrant (Included at E-5) (A) Included herein but not reproduced.

9435_1993.txt

9435_1993

1993

9435

ITEM 3. LEGAL PROCEEDINGS Several purported derivative actions against Bally and certain of its current and former directors, originally filed in December 1990 and January 1991, have been consolidated under the caption "In re: Bally Manufacturing Corporation Shareholders Litigation in the Court of Chancery of the State of Delaware, New Castle County." The consolidated complaint alleges, among other things, breach of fiduciary duty, corporate mismanagement, and waste of corporate assets in connection with certain actions including, among other things, payment of compensation, certain acquisitions by Bally, the dissemination of allegedly materially false and misleading information, the proposed restructuring of Bally's debt, and a subsidiary's allegedly discriminatory practices. The plaintiffs seek, among other things: (i) injunctions against payment of certain termination compensation benefits and implementation of the proposed restructuring plan, (ii) rescission of consummated transactions and a declaration that the complained of transactions are null and void, (iii) an accounting by individual defendants of damages to Bally and benefits received by such defendants, (iv) the appointment of a representative to negotiate on behalf of the stockholders in connection with any proposed restructuring, and (v) costs and disbursements, including a - -------------------------------------------------------------------------------- reasonable allowance for the fees and expenses of plaintiffs' attorneys, accountants and experts. In January 1992, a purported holder of Bally's Grand, Inc.'s bonds filed an action in the United States District Court for the Central District of California entitled "Nehus v. Bally Manufacturing Corporation, et al." against Bally, Bally's Grand, Inc. and certain of Bally's current and former officers and directors. The complaint alleged, among other things, that defendants violated the federal securities laws and the California Corporation Code, made intentional misrepresentations and breached their fiduciary obligations to plaintiff in connection with a purported exchange of Bally's Grand, Inc.'s bonds. In December 1992, the claims against former officers and a former director were dismissed for failure to effect proper service and in July 1993, Bally and Bally's Grand, Inc. settled the alleged claims against them. The Internal Revenue Service ("IRS") has completed an audit of the federal income tax returns of certain of the Company's fitness center subsidiaries for periods ending on the day these subsidiaries were acquired. Among other things, the IRS is asserting that these subsidiaries owe additional taxes of approximately $32 million and substantial amounts of interest with respect to issues arising pursuant to the Company's election in 1983 to treat the purchases of stock of these subsidiaries as if they were purchases of assets. The Company vigorously opposes the IRS' assertions and has filed petitions in the United States Tax Court contesting the IRS' proposed deficiencies with respect to these issues. This matter has been docketed for trial in October 1994, however, a resolution may occur sooner if the Company and the IRS resolve all or some of these issues by stipulation or otherwise. Based on the information presently available, there can be no assurance of the outcome of this matter. However, in the opinion of management, payment, if any, to the IRS of amounts which may be ultimately deemed owing will not have a material adverse effect on the Company's consolidated financial position or results of operations, since the Company believes that it has adequately provided deferred and current taxes related to this matter, although it could, though it is not expected to, have a material adverse effect on the Company's liquidity. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Item 4 is inapplicable. EXECUTIVE OFFICERS OF THE REGISTRANT Arthur M. Goldberg was elected Chairman of the Board of Directors and Chief Executive Officer of the Company in October 1990 and President of the Company in January 1993. He is also Chairman of the Company's Executive Committee. In June 1993, he was elected Chairman of the Board of Directors, President and Chief Executive Officer of Casino Holdings. Since January 1993, Mr. Goldberg has been Chairman of the Board of Directors and Chief Executive Officer of both Bally's Park Place, Inc. and GNAC. He has also served as Chief Executive Officer of Bally's Tunica, Inc. since April 1993 and as a director of Bally's Health & Tennis since 1990. Mr. Goldberg was elected Chairman of the Board of Directors and President of Bally's Grand, Inc. in August 1992, and its Chief Executive Officer in September 1992. Since 1990, he has been Chairman of the Board of Directors, Chief Executive Officer and President of Di Giorgio Corporation, a food distributor. Mr. Goldberg is also Managing Partner of Arveron Investments L.P. and a director of First Fidelity Bancorp. From 1985 to 1989, he was Chief Executive Officer, President and a director of International Controls Corporation, a manufacturing and engineering company. Mr. Goldberg is 52 years of age. Lee S. Hillman was elected Vice President, Chief Financial Officer and Treasurer of the Company in November 1991 and Executive Vice President in August 1992. He has been an Executive Vice President, Chief Financial Officer and a director of Casino Holdings since June 1993. Mr. Hillman has served as a director of Bally's Park Place, Inc. since January 1993 and a director of GNAC since February 1993. He has also been Chief Financial Officer of Bally's Tunica, Inc. since April 1993 and Vice President -- Administration of Bally's Grand, Inc. since August 1993. In addition, he has served as Senior Vice President of Bally's Health & Tennis since April 1991, Chief Financial Officer of that company since January 1992, one of its directors since September 1992 and its Treasurer since October 1992. From October 1989 to April 1991, he was a partner with the accounting firm of Ernst & Young. From 1987 to October 1989, he was a - -------------------------------------------------------------------------------- principal with the accounting firm of Arthur Young & Company, a predecessor to Ernst & Young. Mr. Hillman is 38 years of age. Robert G. Conover was elected Vice President, Management Information Systems and Chief Information Officer of the Company in December 1992. He has been Senior Vice President, Management Information Systems of Casino Holdings since June 1993 and Senior Vice President of GNOC, CORP. (a subsidiary of GNAC) since 1987. Mr. Conover was elected a Senior Vice President of Bally's Park Place, Inc. in January 1993 and for approximately ten years prior thereto, he was a Vice President of that company. Mr. Conover has also been President of the Bally Systems division of Gaming since October 1990. From January 1987 to September 1992, he was Vice President, Management Information Systems of Bally's Grand, Inc. Mr. Conover is 48 years of age. John W. Dwyer was elected Corporate Controller of the Company in June 1992 and Vice President in December 1992. He has been a Vice President and Controller of Casino Holdings since June 1993. From October 1989 to June 1992, he was a partner with the accounting firm of Ernst & Young. From 1986 to October 1989, Mr. Dwyer was a partner with the accounting firm of Arthur Young & Company, a predecessor to Ernst & Young. Mr. Dwyer is 41 years of age. Harold Morgan was elected Vice President, Human Resources of the Company in December 1992. Since August 1991, he has been employed by Bally's Health & Tennis and was elected a Vice President of that company in January 1992. From 1985 until August 1991, Mr. Morgan was Director of Employee and Labor Relations of the Hyatt Corporation. Mr. Morgan is 37 years of age. Bernard J. Murphy was elected Vice President, Corporate Affairs and Governmental Relations of the Company in November 1991. From March 1991 to November 1991, Mr. Murphy was employed as an executive of Bally and since March 1991, he has been a Senior Vice President of Bally's Health & Tennis. For 20 years prior to 1990, he had been with the Federal Bureau of Investigation. Mr. Murphy is 47 years of age. Jerry W. Thornburg was elected Vice President, Audit of the Company in July 1993. For approximately five years prior thereto, he was Director of Internal Audit of the Company. Mr. Thornburg is 50 years of age. Carol Stone DePaul was elected Secretary of the Company in December 1992. She has been a Vice President and Secretary of Casino Holdings since June 1993. For more than four years prior to December 1992, she was Assistant Secretary of the Company and a member of its law department. Ms. DePaul is 37 years of age. ------------------------------------ Wallace R. Barr was elected President and a director of Bally's Park Place, Inc. in February 1993 and has served as its Chief Operating Officer since January 1993. He has also been an Executive Vice President, Chief Operating Officer and a director of Casino Holdings since June 1993 and President of Bally's Tunica, Inc. since April 1993. Mr. Barr was a Senior Vice President of GNAC from June 1991 to February 1993, has served that company as its Chief Operating Officer since January 1993 and has been its President and a director since February 1993. From March 1984 to June 1991, he served as Senior Vice President -- Operations of Bally's Park Place, Inc. and from January 1987 to September 1992, he was Senior Vice President and Treasurer of Bally's Grand, Inc. Mr. Barr is 48 years of age. Michael G. Lucci, Sr. was elected President of Bally's Health & Tennis in April 1993 and Chief Operating Officer in October 1992. He has been a director of Bally's Health & Tennis since September 1992. From 1991 to April 1993, he served as Executive Vice President of Bally's Health & Tennis and supervised the eastern region of that company for more than two years prior to 1991. Mr. Lucci is 54 years of age. - -------------------------------------------------------------------------------- PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Bally Common Stock, par value $.66 2/3 per share (the "Common Stock"), is traded on the New York Stock Exchange and Chicago Stock Exchange. The Company suspended cash dividend payments on the Common Stock beginning with the fourth quarter of 1990. The high and low quarterly sales prices on the New York Stock Exchange for the past two years are as follows: The number of record holders of the Common Stock at March 24, 1994 was 16,555. For restrictions on the ability of Bally's subsidiaries to pay dividends, see Liquidity and Capital Resources in Item 7 of this Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - --------------- Note: During 1993, Casino Holdings and another subsidiary of Bally acquired approximately 5.2 million shares (approximately 50% of the shares presently outstanding) of reorganized Bally's Grand, Inc. common stock. Bally's Grand, Inc. has been consolidated since December 1, 1993 as a result of Bally's controlling interest. Prior to December 1, 1993, Bally's investment in Bally's Grand, Inc. was principally recorded on the equity method of accounting. See Notes to consolidated financial statements -- Acquisition of Bally's Grand, Inc. for additional information. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL In late 1992, after completing a major restructuring effort which began in October 1990, the Company began actively pursuing new casino gaming projects. In April 1993, Casino Holdings was formed as a holding company for Bally's Park Place, Inc. and for acquiring and developing gaming operations, including those in newly emerging gaming jurisdictions. In June 1993, Casino Holdings completed a private placement of $220.0 million principal amount of Senior Discount Notes and received net proceeds therefrom of approximately $127.9 million which - -------------------------------------------------------------------------------- have been and are being used to: (i) construct and equip Bally's Tunica (which commenced operations in December 1993), (ii) acquire a significant equity interest in Bally's Las Vegas (which caused its consolidation effective December 1, 1993), (iii) fund initial payments for construction of a riverboat (including dockside improvements) for eventual operation in New Orleans, (iv) fund an option agreement to acquire certain riverfront property in Philadelphia for the purpose of developing a dockside gaming facility if gaming were to be legalized in Pennsylvania and (v) pursue other gaming opportunities. RESULTS OF OPERATIONS Revenues and operating income (loss) from continuing operations are as follows (in millions): 1993 VERSUS 1992 CASINOS Revenues of the Company's casinos for 1993 were $619.2 million compared to $552.8 million for 1992, an increase of $66.4 million (12%). Operating income for 1993 was $104.4 million compared to $92.0 million for 1992, an increase of $12.4 million (13%). ATLANTIC CITY. Revenues of Bally's Park Place 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 increase 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. Bally's Park Place added 112 slot machines (a 6% increase) during 1993. Slot revenues represented 69% of Bally's Park Place's casino revenues in 1993 compared to 68% in 1992. Table game revenues, 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. Bally's Park Place'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 declined $.9 million from 1992 due to the elimination of an intercompany loan. Operating income 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, to a $1.4 million (1%) decrease in operating expenses. Operating expenses decreased due to a 10% reduction in selling, general and administrative expenses (due in part to a reduction in costs associated with a management restructuring) which was offset, in part, by increased marketing and promotional costs and food and beverage expenses. In July 1993, The Grand introduced a comprehensive marketing program designed to emphasize the first-class nature of the facility, personalized service provided to guests, frequent special events and entertainment offered. The Grand has directed its marketing efforts toward - -------------------------------------------------------------------------------- expanding its domestic customer base and attracting international gaming patrons. To attract and retain these gaming patrons, The Grand is providing increased complimentary services (room, food, beverage and entertainment), increased promotional expenses (customer transportation, gifts and coin giveaways) and frequent special events. Revenues of The Grand for 1993 were $239.8 million compared to $223.7 million for 1992, an increase of $16.1 million (7%). Casino revenues for 1993 were $216.3 million compared to $199.6 million in 1992, an increase of $16.7 million (8%). Table game revenues increased $13.3 million (18%) due primarily to a 19% increase in the drop. Slot revenues increased $3.4 million (3%). Slot revenues include approximately $1.2 million and $1.9 million from the discontinuation of certain progressive slot jackpots in 1993 and 1992, respectively. Excluding these adjustments, slot revenues increased $4.1 million (3%) due to a 9% increase in slot handle offset, in part, by a decline in the slot win percentage from 10.0% in 1992 to 9.5% in 1993. The Grand added 28 slot machines (a 2% increase) during 1993. Slot revenues represented 60% of The Grand's casino revenues in 1993 compared to 63% in 1992. Rooms revenue decreased $1.5 million (22%) due primarily to a reduction in the average room rate. Food and beverage revenue remained essentially unchanged. Other revenues increased $.9 million from 1992 due principally to an adjustment to the reserve for unclaimed gaming chips and tokens in 1993. Operating income for 1993 was $21.7 million compared to $30.6 million in 1992, a decrease of $8.9 million (29%), as the aforementioned increase in revenues was more than offset by a $25.0 million (13%) increase in operating expenses. Operating expenses increased primarily due to the increase in casino volume and the increased marketing efforts described above which increased the cost of providing complimentary services, promotional expenses and special events, payroll and payroll-related expenses and state gaming taxes. Management of The Grand believes the initial costs of the comprehensive marketing program are proportionately greater during implementation and, because the incremental revenues generally trail such costs, the marketing program had an adverse effect on operating results for 1993. 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 at Bally's Park Place and through the comprehensive marketing program at The Grand. 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. LAS VEGAS. As described previously, Bally's Grand, Inc. has been consolidated since December 1, 1993. Revenues of Bally's Grand, Inc. for December 1993 were $21.1 million. Casino revenues were $12.2 million, which primarily consisted of table game revenues of $6.7 million and slot revenues of $5.0 million. Rooms revenues were $2.9 million and food and beverage revenues were $2.8 million. Other revenues were $3.1 million and primarily resulted from entertainment. Operating income for December 1993 was $1.0 million. TUNICA. Revenues of Bally's Tunica, which included 24 days of operations in December 1993, were $4.2 million and included casino revenues of $4.0 million (slot revenues were $2.7 million and table game revenues were $1.3 million). - -------------------------------------------------------------------------------- Operating loss for Bally's Tunica was $1.7 million, principally resulting from the amortization of $3.1 million of pre-opening costs ($3.1 million is also being amortized in the first quarter of 1994). FITNESS CENTERS In late 1991, the Company implemented a value pricing strategy which lowered the average selling price of membership contracts thereby lowering the monthly payment for financed memberships. This strategy was designed to improve the collection experience on financed memberships. In addition, commencing at the end of the third quarter of 1992, the Company implemented programs designed to increase its emphasis on the sale of financed contracts with payments made by direct bank account electronic funds transfer ("EFT") and automatic credit card payment plans by adjusting sales commission and member incentive levels. This was done to further improve the Company's collection experience on financed membership contracts based on Company studies which indicated better collection experience for financed memberships sold under these plans compared to those sold with standard coupon book payment plans. While these changes were intended to reduce the Company's exposure to risks associated with collection of financed membership contracts, the emphasis on EFT and credit card payment programs negatively affected the number of new memberships sold. In April 1993, the Company reduced the average selling price of membership contracts even further in an attempt to increase unit volume. Management now believes that the selling price decreases implemented in April 1993 were greater than required and such price decreases did not measurably increase the number of new memberships sold. Therefore, in mid-October 1993, the Company began increasing prices modestly, which has continued into 1994. Management believes that increased prices have not resulted in significant reductions in unit sales volume or exposure to higher collection risk because the prices of the Company's memberships are comparable to or less than its competitors and significantly less than memberships sold by the Company prior to the implementation of the value pricing strategy in 1991. These price increases coupled with the changes in selling methods and cost reduction programs implemented in the last fifteen months are intended to improve the Company's operating results. Revenues for 1993 were $694.8 million compared to $741.9 million in 1992, a decrease of $47.1 million (6%). Revenues in 1992 included a gain of $3.9 million on the retirement of a portion of Bally's Health & Tennis' public debt acquired for sinking fund purposes. Excluding this gain, revenues decreased $43.2 million (6%). Revenues for the same fitness centers selling memberships throughout both years decreased $88.4 million (12%), which management believes was principally due to the changes in its sales and pricing policies described above. Revenues from new fitness centers opened during 1993 or 1992 were $45.2 million. The number of fitness centers selling memberships increased from 331 at December 31, 1992 to 339 at December 31, 1993. New membership revenues decreased $31.5 million (6%) in 1993 due to a 5% decline in the average selling price and a 4% decrease in unit volume. Management believes that unit volume has been and continues to be affected by the weak retail economy, increased competition and prevailing general economic uncertainties. Dues and renewals increased $23.3 million (16%) in 1993 due to the continuing emphasis on memberships requiring the payment of monthly dues beginning in the first month of membership and an improvement in member retention rates. Finance charges earned decreased $12.4 million (22%) due principally to a decrease in installment contracts receivable due to lower sales volume and, to a lesser extent, a lower effective interest rate on installment contracts receivable. Deferred revenues earned during 1993 decreased $22.8 million from 1992 due to an increase in the liability for membership services at December 31, 1993 as compared to December 31, 1992 and 1991. Operating income for 1993 decreased $22.4 million from 1992. Excluding the aforementioned gain on debt, operating income was $.8 million for 1993 compared to $19.3 million in 1992, a decline of $18.5 million. Excluding the provision for doubtful receivables, operating expenses increased $19.0 million (3%) in 1993 from 1992 primarily due to $26.8 million of costs related to new clubs partially offset by a $9.4 million decrease in costs related to the same fitness centers selling memberships in both years. This decrease was primarily due to reductions in payroll, commissions and employee benefits as - -------------------------------------------------------------------------------- a function of the aforementioned decline in sales and as a result of the continuation of cost reduction programs. As a percentage of revenues (excluding the gain on debt), these operating expenses were 82% in 1992 and 89% in 1993. The provision for doubtful receivables for 1993 was $72.5 million compared to $116.2 million in 1992, a decrease of $43.7 million (38%). The provision for doubtful receivables as a percentage of net financed sales was reduced from 39% in 1992 to 26% in 1993, which reflects expected improvement in the collectibility of memberships sold during 1993 due to increased emphasis on EFT and automatic credit card payment programs and lower prices as described above. CORPORATE Revenues for 1993 were $8.0 million compared to $2.5 million in 1992, an increase of $5.5 million. The increase was due principally to the forgiveness of a tax liability of $1.7 million previously owed to Gaming, the billing of $1.7 million additional insurance costs to subsidiaries and an increase in interest income and other revenues from subsidiaries of $2.0 million. Operating income for 1993 was $2.3 million compared to an operating loss of $4.2 million in 1992, an improvement of $6.5 million. Results in 1993, as compared to 1992, were positively impacted by the aforementioned revenue items totalling $5.4 million and a $1.1 million reversal of a tax accrual no longer deemed necessary. The allocation of corporate overhead (including executive salaries and benefits, public company reporting costs and other corporate headquarters' costs) to subsidiaries remained essentially unchanged. 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. INTEREST EXPENSE Interest expense, net of capitalized interest, was $129.8 million in 1993 compared to $126.1 million in 1992. The increase of $3.7 million (3%) was due principally to higher average levels of debt in 1993 due, in part, to the issuance of the Senior Discount Notes in June 1993 offset, in part, by the reversal in 1993 of a $2.0 million interest reserve no longer necessary and interest in 1992 on accrued but unpaid interest for debt in default (which did not occur in 1993). INCOME TAXES Effective rates of the income tax benefit were 20% in 1993 and 39% in 1992. The 1993 income tax rate differed from the U.S. statutory tax rate (35%) due principally to nondeductible goodwill amortization and state income taxes, partially offset by adjustments of prior years' taxes. In addition, the income tax benefit for 1993 was reduced by $1.7 million as a result of applying the change in the U.S. statutory tax rate from 34% to 35% to deferred tax balances. The 1992 income tax rate differed from the U.S. statutory tax rate (34%) due principally to adjustments of prior years' taxes, partially offset by nondeductible amortization and depreciation and state income taxes. A reconciliation of the income tax benefit with amounts determined by applying the U.S. statutory tax rate to loss from continuing operations before income taxes and minority interests is included in Notes to consolidated financial statements -- Income taxes. 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 $28.2 million ($.61 per share). The effect of this change in accounting for income taxes on the income tax benefit for 1993 was to reduce the income tax benefit by $1.7 million as a result of - -------------------------------------------------------------------------------- applying the change in the U.S. statutory tax rate described above. In 1992, the Company utilized tax loss carryforwards to offset taxable income principally arising from the sale of Gaming common stock in July 1992 and the related tax benefit of $10.6 million was reflected as an extraordinary credit. 1992 VERSUS 1991 CASINOS Revenues of the Company's Atlantic City casino hotels for 1992 were $552.8 million compared to $536.2 million for 1991, an increase of $16.6 million (3%). Operating income for 1992 was $92.0 million compared to $83.3 million for 1991, an increase of $8.7 million (10%). Revenues of Bally's Park Place for 1992 were $331.1 million compared to $322.8 million for 1991, an increase of $8.3 million (3%). Casino revenues increased $12.3 million (5%), with slot revenues increasing $15.0 million (9%) as a result of a 13% increase in the slot handle, partially offset by a 4% decline in the win percentage from 10.3% in 1991 to 9.9% in 1992. Table game revenues decreased $2.7 million (3%) as a result of a decline in the table game drop of $21.6 million (4%), partially offset by an improvement in the hold percentage from 16.8% in 1991 to 17.0% in 1992. Bally's Park Place increased its number of slot machines by 119 machines (7%) since December 1991. Slot revenues in 1992 represented 68% of casino revenues compared to 66% in 1991. All other operating revenues were essentially unchanged. Interest income from Bally in 1992 was $.8 million compared to $4.2 million in 1991. This decrease was primarily due to the declaration as a dividend to Bally by Bally's Park Place of an amount totalling $50.0 million formerly classified as a demand note receivable and the discontinuation of interest payments on such note effective April 1, 1992. Operating income for 1992 was $62.7 million compared to $54.4 million for 1991, an increase of $8.3 million (15%) due primarily to the increase in revenues. Operating expenses include charges for Bally overhead expenses allocated to Bally's Park Place of $3.7 million and $1.0 million in 1992 and 1991, respectively. Operating income was adversely impacted in 1992 by the aforementioned decrease in interest income and increase in the allocation of overhead expenses from Bally. In 1991, operating income was adversely impacted by a $3.5 million charge related to the closing and demolition of an ancillary motel property operated by Bally's Park Place and a $2.0 million charge for the estimated cost of settling certain liabilities. Revenues of The Grand for 1992 were $223.7 million compared to $215.2 million for 1991, an increase of $8.5 million (4%). Casino revenues increased $8.0 million (4%), with slot revenues increasing $9.7 million (8%), which was attributable to increased slot volume and the positive impact of discontinuation of certain progressive slot jackpots and the reversal of related reserves in 1992. Table game revenues decreased $1.7 million (2%) as a result of a decline of $21.6 million (5%) in the table game drop partially offset by an improvement in the hold percentage from 16.0% in 1991 to 16.4% in 1992. During the first half of 1992, The Grand increased its number of slot machines by 86 machines (6%) and expanded its slot marketing efforts. Slot revenues in 1992 represented 63% of casino revenues compared to 61% in 1991. All other revenues were essentially unchanged. Operating income for 1992 was $30.6 million compared to $29.8 million for 1991, an increase of $.8 million (3%), due to the increase in revenues offset, in part, by a $7.7 million (4%) increase in operating expenses. The operating expense increase includes additional spending in 1992 of $2.6 million in conjunction with intensified slot marketing efforts and $1.8 million of additional selling, general and administrative expenses. Operating expenses include charges for Bally overhead expenses allocated to The Grand of $2.2 million and $.7 million in 1992 and 1991, respectively. Atlantic City city-wide casino revenues for all operators in 1992 increased approximately 8% from 1991, which was negatively impacted in the first quarter by the Persian Gulf war. The increase was due to a 14% increase in slot revenues, partially offset by a 3% decrease in table game revenues. Slot revenues for 1992 represented 66% of total gaming revenue in Atlantic City compared to 62% in 1991. During 1992, the Company's competitors in Atlantic City intensified their promotional slot marketing efforts to expand their share of slot revenues. Additionally, changes in gaming regulations, including modifications allowing more slot machines in existing casino floor space and permitting unrestricted 24-hour gaming effective - -------------------------------------------------------------------------------- July 1992, have aided Atlantic City slot revenue growth. Management believes, however, that a weak economy in the northeastern United States during 1992 and 1991 and the increased competitive pressure had a negative impact on the operating results of the Company's Atlantic City casino hotels. FITNESS CENTERS Revenues for 1992 were $741.9 million compared to $720.4 million for 1991, an increase of $21.5 million (3%). Revenues for 1992 and 1991 include gains of $3.9 million and $10.8 million, respectively, on the retirement of Bally's Health & Tennis' public debt acquired for sinking fund purposes. Excluding these gains, revenues increased $28.4 million (4%) of which $10.7 million related to 19 fitness centers acquired in September 1992. The remaining increase of $17.7 million was due principally to the same fitness centers selling memberships throughout both years. New membership revenues increased $8.2 million (2%) in 1992 due to a 31% increase in the number of new memberships sold offset, in part, by a 22% decline in the average selling price which reflects the value pricing strategy implemented by the Company in the second half of 1991. Dues and renewals increased $20.9 million (17%) in 1992 due to the continued emphasis on memberships requiring the payment of monthly dues beginning in the first month of membership, a practice which began in mid-1991. Finance charges earned decreased 10% from $62.8 million in 1991 to $56.8 million in 1992 due principally to a decrease in net installment contracts receivable and, to a lesser extent, a lower effective interest rate on installment contracts receivable. Management believes that the weak economy had a negative effect on revenues in both years and that the Persian Gulf war and unfavorable publicity regarding Bally's financial condition negatively affected revenues in 1991. New membership sales in the second half of 1992 were negatively affected by the introduction of new selling practices and incentive compensation programs emphasizing EFT and automatic credit card charge payment plans for sales of financed memberships. The emphasis on EFT and credit card payment plans was intended to improve the Company's collection experience on financed membership contracts based on Company studies which indicate better collection experience for financed memberships sold with EFT or credit card payment plans compared to those sold with standard coupon book payment plans. It has been the Company's experience that new membership sales are adversely affected when significant changes in sales and commission programs are implemented. EFT and credit card sales as a percentage of total financed sales increased commencing in the third quarter and were approximately 50% of sales initiated during the fourth quarter of 1992. For the previous six quarters, such sales accounted for approximately 25% of financed sales. Operating income for 1992 was $23.2 million compared to an operating loss of $4.4 million in 1991. Excluding the aforementioned gains on debt, operating income was $19.3 million for 1992 compared to an operating loss of $15.2 million in 1991, an improvement of $34.5 million. This improvement was due primarily to the aforementioned revenue increase and a decrease of $5.8 million (5%) in the provision for doubtful receivables. Excluding the provision for doubtful receivables, operating expenses increased $.3 million in 1992 from 1991, due to a $2.3 million increase in the cost of membership services partially offset by a $1.4 million decrease in selling and promotion expenses. As a percentage of revenues (excluding the gains on debt), these operating expenses declined to 82% in 1992 from 85% in 1991. The provision for doubtful receivables as a percentage of net financed sales was 39% in both years. CORPORATE Revenues for 1992 were $2.5 million compared to $8.0 million in 1991, a decrease of $5.5 million. The decrease was due principally to lower gains on the purchase of debt for sinking fund purposes in 1992 ($.6 million compared to $5.5 million in 1991) and reductions in interest and other income from subsidiaries in 1992 ($.1 million compared to $1.4 million in 1991), partially offset by foreign currency transaction losses of $1.2 million in 1991. Operating loss for 1992 was $4.2 million compared to $14.4 million in 1991, an improvement of $10.2 million. Excluding the gains on the purchase of debt securities, the reductions in income from subsidiaries and the foreign currency transaction losses, the year-to-year improvement was $15.2 million. Operating results in 1992 were positively impacted by an - -------------------------------------------------------------------------------- $8.6 million reduction in general and administrative expenses, a $3.0 million reduction in restructuring costs, the elimination of litigation accruals totalling $2.7 million relating to matters which were favorably settled and a $1.0 million commission on the July 1992 sale by Bally's Grand, Inc. of the casino resort complex formerly known as "Bally's Reno." Allocations of corporate overhead to subsidiaries remained essentially unchanged. INTEREST EXPENSE Interest expense, net of capitalized interest, was $126.1 million in 1992 compared to $158.5 million in 1991. The decrease of $32.4 million (20%) was due principally to lower average levels of debt and, to a lesser extent, lower average interest rates and a decline in the amount of interest provided on prior years' income tax matters. INCOME TAXES Effective rates of the income tax benefit were 39% in 1992 and 31% in 1991. The 1992 income tax rate differed from the U.S. statutory tax rate (34%) due principally to adjustments of prior years' taxes, partially offset by nondeductible amortization and depreciation and state income taxes. The 1991 income tax rate differed from the U.S. statutory tax rate (34%) due principally to nondeductible amortization and depreciation. A reconciliation of the income tax benefit with amounts determined by applying the U.S. statutory tax rate to loss from continuing operations before income taxes and minority interests is included in Notes to consolidated financial statements -- Income taxes. In 1992, the Company utilized tax loss carryforwards to offset taxable income principally arising from the sale of Gaming common stock in July 1992 and the related tax benefit of $10.6 million was reflected as an extraordinary credit. LIQUIDITY AND CAPITAL RESOURCES PARENT COMPANY Bally is a holding company without operations of its own. Nevertheless, Bally has certain cash obligations that must be satisfied by obtaining cash from its subsidiaries or disposing of or leveraging certain assets. Bally's corporate cash operating costs, net of allocations to its subsidiaries, are expected to be less than $3 million in 1994. Bally has debt service and preferred stock dividend cash requirements of approximately $20 million in 1994. Cash requirements for Bally in 1994 may also include income tax payments which management estimates to be approximately $36 million, net of amounts to be collected from subsidiaries pursuant to tax sharing agreements. Sources of cash available to Bally are generally limited to existing cash balances ($43.5 million at December 31, 1993), dividends, management fees or cost allocations to subsidiaries, capital transactions and asset sales. Each of Bally's principal operating subsidiaries presently have debt covenants which limit the payment of dividends to Bally and the redemption of stock owned by Bally. Under the terms of the Senior Discount Notes, an amount equal to certain dividends paid pursuant to a net income test by Bally's Park Place, Inc. to Casino Holdings may be declared as a dividend by Casino Holdings and paid to Bally. In 1993, $16.7 million in dividends were paid by Bally's Park Place, Inc. to Casino Holdings and by Casino Holdings to Bally. Additional dividends may be available from Casino Holdings and are generally limited to 50% of its consolidated net income exclusive of income attributable to Bally's Park Place, Inc. Pursuant to the terms of GNAC's 10 5/8% First Mortgage Notes due 2003 (the "10 5/8% Notes") and its credit agreement, GNAC paid dividends to Bally of $7.5 million in 1993. GNAC is not expected to be able to pay dividends to Bally in 1994. Bally's Health & Tennis, which paid a $15 million dividend to Bally in January 1993, is not expected to be able to pay dividends in 1994. In addition, Casino Holdings has an obligation to Bally of approximately $18.3 million to be paid in 1994 for shares of Bally's Grand, Inc. common stock purchased from Bally during 1993. Bally believes that it will be able to satisfy its cash needs throughout 1994, but remains dependent upon the ability of subsidiaries to pay dividends and allocations to meet its cash requirements in the future. SUBSIDIARIES CASINO HOLDINGS CASINO HOLDINGS. Casino Holdings is a holding company without operations of its own and relies on obtaining cash from its subsidiaries to meet its cash obligations. Casino Holdings has no scheduled interest or principal payments on the Senior Discount Notes until 1998, but expects to incur substantial costs in the pursuit of new gaming ventures. The proceeds from the Senior Discount Notes have been and are being used to: - -------------------------------------------------------------------------------- (i) construct and equip Bally's Tunica, (ii) acquire a significant equity interest in Bally's Las Vegas, (iii) fund initial payments for construction of a riverboat (including dockside improvements) for eventual operation in New Orleans, (iv) fund an option agreement to acquire certain riverfront property in Philadelphia for the purpose of developing a dockside gaming facility if gaming were to be legalized in Pennsylvania and (v) pursue other gaming opportunities. To the extent Casino Holdings requires additional funds for existing ventures or to develop new ventures, Casino Holdings expects that it will be able to obtain financing for a significant portion of the total development costs of new gaming ventures from a combination of third party sources, including banks, suppliers and debt markets. Sources of cash available to Casino Holdings are generally limited to existing cash balances ($25.4 million at December 31, 1993) and loan repayments, dividends and management fees from subsidiaries. Bally's Park Place, Inc. and Bally's Grand, Inc. are both limited with respect to amounts which may be paid as dividends to Casino Holdings under the terms of their respective public debt indentures. In March 1994, Bally's Park Place, Inc. paid a $30 million dividend to Casino Holdings from a portion of the proceeds of the sale of its 9 1/4% First Mortgage Notes due 2004 (the "9 1/4% Notes"), which is not available to be paid by Casino Holdings to Bally. Bally's Grand, Inc. is not expected to pay dividends or make any other distributions on its common stock to Casino Holdings in 1994. Bally's Tunica, which commenced operations in December 1993, is expected to generate a significant amount of unrestricted cash flows in 1994 which will be used to reduce an advance from Casino Holdings. The New Orleans project is not expected to commence operations until February 1995. Although Casino Holdings believes it will be able to satisfy its cash needs throughout 1994, Casino Holdings remains dependent upon the ability of its subsidiaries to generate cash to repay advances and pay dividends. BALLY'S PARK PLACE, INC. In March 1994, a subsidiary of Bally's Park Place, Inc. issued $425 million principal amount of the 9 1/4% Notes. The net proceeds from the sale of the 9 1/4% Notes were used to purchase and retire certain of its 11 7/8% First Mortgage Notes due 1999 (the "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 million dividend to Casino Holdings. In connection with the sale of the 9 1/4% Notes, Bally's Park Place terminated its existing credit facility and entered into an agreement for a new $50 million revolving credit facility which expires on December 31, 1996. As adjusted for the refinancing described above, Bally's Park Place, Inc. has no scheduled principal payments under its public indebtedness until 2004, and its scheduled principal payments under other indebtedness outstanding at December 31, 1993 are not significant. Management expects to make capital expenditures of approximately $18 million in 1994. As of December 31, 1993, after giving effect to the new credit facility, Bally's Park Place, Inc. had unused lines of credit totalling $48 million. The Company believes that Bally's Park Place, Inc. will be able to satisfy its debt service and capital expenditure requirements in 1994 out of cash flow from operations. BALLY'S GRAND, INC. In December 1993, Bally's Grand, Inc. issued $315 million principal amount of 10 3/8% First Mortgage Notes due 2003 (the "10 3/8% Notes"). Bally's Grand, Inc. used a substantial portion of the net proceeds from the sale of the 10 3/8% Notes to redeem $252.5 million principal amount of its 12% First Mortgage Notes due 2001 (the "12% Notes") at a price of 103% of their principal amount plus accrued interest, thereby satisfying all obligations thereunder, and to pay approximately $9 million to Bally under a tax sharing agreement between Bally's Grand, Inc. and Bally, which amount became due and payable in connection with the redemption of the 12% Notes. The remaining proceeds are primarily being used for capital expenditures. Bally's Grand, Inc. has no scheduled principal payments on its indebtedness outstanding at December 31, 1993 until 2003, however, it expects to make several major capital improvements during 1994 and 1995. Bally's Las Vegas has commenced the construction of improvements to its frontage area along the Strip (with completion expected in mid-1994) and has formed a joint venture with a subsidiary of - -------------------------------------------------------------------------------- MGM Grand, Inc. to construct and operate a monorail that will transport passengers between Bally's Las Vegas and The MGM Grand Hotel and Theme Park (with completion expected in mid-1995). These capital improvement projects are expected to cost Bally's Las Vegas approximately $28 million and are intended to increase traffic into its casino. Other major capital projects currently anticipated to commence in 1994 include the renovation of the south tower rooms and corridors, the retail shopping arcade and other common areas which, with other capital expenditures required to maintain Bally's Las Vegas, are estimated to cost approximately $26 million. The Company believes that Bally's Grand, Inc. will be able to satisfy its debt service and capital expenditure requirements in 1994 out of existing cash balances ($97 million at December 31, 1993) and cash flow from operations. BALLY'S TUNICA. Construction of Bally's Tunica was completed in early November and operations commenced in December 1993. The total cost to construct and equip Bally's Tunica was approximately $39 million, which was advanced by Casino Holdings and is being repaid out of available cash flow. Bally's Tunica may seek third party financing to enable it to repay part or all of Casino Holdings' advance to Bally's Tunica. However, there can be no assurance that third party financing will be available on terms favorable to Bally's Tunica. Bally's Tunica expects capital expenditures during 1994 to be insignificant. OTHER. A subsidiary of Casino Holdings owns a 45% interest in Belle of Orleans, L.L.C. ("Belle"). In June 1993, Belle received a Certificate of Preliminary Approval from the Louisiana Riverboat Gaming Commission to commence construction of a riverboat casino facility (including dockside improvements) for operation in New Orleans, Louisiana. In March 1994, the Louisiana Riverboat Gaming Commission awarded Belle a permanent operating license. In August 1993, the Casino Holdings subsidiary entered into a formal operating agreement for the capitalization and development of Belle. Simultaneously, Casino Holdings and Belle entered into a management agreement with a term of five years and an option for a second five-year term granting responsibility for the development and management of Belle to Casino Holdings. Casino Holdings will receive management fees based on a percentage of the earnings of Belle. Construction of the riverboat commenced in January 1994 and operations are expected to begin in February 1995. Management estimates that as much as $75 million will be needed to develop Belle, and anticipates the cost will be funded either through third party financing (there can be no assurance that third party financing will be available on terms favorable to Belle) or by Casino Holdings, though not required to be. Another subsidiary of Casino Holdings has entered into an option agreement to acquire a 31-acre site along the Delaware River in Philadelphia for the purpose of developing a dockside gaming facility (the "Philadelphia Venture") if gaming were to be legalized in Pennsylvania. The site includes a 550 foot pier and is easily accessed by three ramps off of a major highway nearby. Pursuant to the terms of the agreement, Casino Holdings has agreed to pay $10 million, consisting of an initial cash payment of $5 million (paid in 1993) and $5 million payable over the next three years. These payments are due whether or not gaming is legalized in Pennsylvania. Additionally, in the event Casino Holdings elects to take title to the property, it will be required to deliver the balance of the purchase price in the form of a pre-payable, non-recourse note for approximately $55 million (including interest) at the closing of the transaction, which is payable in various installments over the five-year period subsequent to the closing of the transaction. Assuming legalization, the closing of the transaction is scheduled for January 1997, unless accelerated by Casino Holdings. Certain of Casino Holdings' obligations under the agreement are guaranteed by Bally. THE GRAND The Grand has no scheduled principal payments on its indebtedness outstanding at December 31, 1993 until 2003. Management expects to make capital expenditures of approximately $15 million in 1994. As of December 31, 1993, The Grand had unused lines of credit totalling $20 million. The Company believes that The Grand will be able to satisfy its debt service and capital expenditure requirements in 1994 out of cash flow from operations. - -------------------------------------------------------------------------------- BALLY'S HEALTH & TENNIS Bally's Health & Tennis has no scheduled principal payments of public indebtedness until 2003. The Bally's Health & Tennis revolving credit agreement has scheduled reductions of availability totalling $20 million in 1994, however, as of December 31, 1993, $26.6 million of borrowing capacity was available under the credit line. Management expects to make capital expenditures of approximately $30 million in 1994 which will be used primarily for maintaining and refurbishing its present fitness centers, leasehold improvements for 11 planned new fitness centers and acquisition of new fitness equipment. The Company believes that Bally's Health & Tennis will be able to satisfy its debt service and capital expenditure requirements in 1994 out of cash flow from operations. The Bally's Health & Tennis revolving credit agreement requires maintenance by Bally's Health & Tennis of certain financial ratios. Certain provisions of the revolving credit agreement applicable to those financial ratios were amended as of September 30, 1993. Although Bally's Health & Tennis was in compliance with these financial ratio requirements as of December 31, 1993, there can be no assurance that it will not be necessary in the future to amend the financial ratio requirements and, if necessary, that such amendments will be obtained. TAX MATTER The IRS has completed an audit of the federal income tax returns of certain of the Company's fitness center subsidiaries for periods ending on the day these subsidiaries were acquired. Among other things, the IRS is asserting that these subsidiaries owe additional taxes of approximately $32 million and substantial amounts of interest with respect to issues arising pursuant to the Company's election in 1983 to treat the purchases of stock of these subsidiaries as if they were purchases of assets. The Company vigorously opposes the IRS' assertions and has filed petitions in the United States Tax Court contesting the IRS' proposed deficiencies with respect to these issues. This matter has been docketed for trial in October 1994, however, a resolution may occur sooner if the Company and the IRS resolve all or some of these issues by stipulation or otherwise. Based on the information presently available, there can be no assurance of the outcome of this matter. However, in the opinion of management, payment, if any, to the IRS of amounts which may be ultimately deemed owing will not have a material adverse effect on the Company's consolidated financial position or results of operations, since the Company believes that it has adequately provided deferred and current taxes related to this matter, although it could, though it is not expected to, have a material adverse effect on the Company's liquidity. (This page intentionally left blank) - -------------------------------------------------------------------------------- ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT AUDITORS THE BOARD OF DIRECTORS AND STOCKHOLDERS BALLY MANUFACTURING CORPORATION We have audited the accompanying consolidated balance sheet of Bally Manufacturing Corporation as of December 31, 1993 and 1992, and the related consolidated statements of operations, 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). 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 Manufacturing 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 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 Chicago, Illinois February 25, 1994, except for the seventh paragraph of the "Long-term debt" note, as to which the date is March 8, 1994 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION CONSOLIDATED BALANCE SHEET See accompanying notes. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS See accompanying notes. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY See accompanying notes. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS See accompanying notes. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of Bally Manufacturing Corporation ("Bally") and the subsidiaries which it controls (collectively, the "Company"). Certain reclassifications have been made to prior years' financial statements to conform with the 1993 presentation. CASH EQUIVALENTS The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. The carrying amount of cash equivalents approximates fair value due to the short maturity of those instruments. PROPERTY AND EQUIPMENT Depreciation of property and equipment is provided principally on the straight-line method over the estimated economic lives of the related assets and the terms of the applicable leases for leasehold improvements. Depreciation expense was $96,945, $91,564 and $88,765 for 1993, 1992 and 1991, respectively. DEFERRED FINANCE COSTS Deferred finance costs associated with the Company's debt are being amortized over the terms of the related debt using the bonds outstanding method. Included in "Other assets" at December 31, 1993 and 1992 were deferred finance costs of $40,995 and $14,823, respectively, net of accumulated amortization of $12,646 and $11,564, respectively. PRE-OPENING COSTS Personnel, marketing and other operating costs incurred that are directly associated with the opening of new casinos are capitalized as pre-opening costs and amortized to expense over the first two calendar quarters of operations. During 1993, pre-opening costs of $6,105 were capitalized, of which $3,052 were amortized. INTANGIBLE ASSETS Intangible assets consist principally of cost in excess of net assets of acquired businesses (goodwill) and are being amortized on the straight-line method over periods ranging up to forty years from dates of acquisition. Bally periodically evaluates whether the remaining estimated useful life of goodwill may warrant revision or that the remaining balance of goodwill may not be recoverable. Bally has reviewed and expects to continue to evaluate the goodwill related to its casino and fitness center operations. Based on present operations and strategic plans, Bally believes that no impairment of goodwill has occurred. However, if future operations do not perform as expected, or if Bally's strategic plans for its businesses were to change and independent measures of value reflecting such changed plans indicated an impairment of goodwill, a reduction for impairment may be required. REVENUE RECOGNITION Casinos Casino revenues consist of the net win from gaming activities, which is the difference between gaming wins and losses. Operating revenues exclude the retail value of complimentary food, beverages and hotel services furnished to customers, which were $71,261, $69,177 and $65,061 for 1993, 1992 and 1991, respectively. The estimated costs of providing such complimentary services, which are classified as casino expenses through interdepartment allocations from the departments granting the services, are as follows: Fitness centers The Company's fitness centers primarily offer a dues membership, which permits members, after paying initial membership fees, to continue membership on a month-to-month basis as long as monthly dues payments are made. Revenues related to dues memberships recorded at the time of sale are limited to the portion allocable to the initial membership fee. Dues memberships also require that monthly payments be made for services provided at which time the revenue is recorded. A substantial portion of new membership revenues are collected in installments over periods ranging up to three years. Installment - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) contracts bear interest at, or are adjusted for financial accounting purposes at the time the contracts are issued to, rates for comparable consumer financing contracts. Unearned finance charges are amortized over the term of the contracts on the sum-of-the-months-digits method which approximates the interest method. Memberships with initial terms of up to three years can also be paid in full. Revenues related to these memberships include both an initial membership fee, which is recorded as revenue at the time of sale, and an annual service fee. The service fee portion of such memberships is recorded as deferred revenues and is realized over the term of the memberships. Prepaid dues and renewals revenues are recorded in a similar manner. This policy approximates the "selling and service" method, which provides for a profit being reported for both the selling and service functions. INCOME TAXES 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 $28,197 ($.61 per share). The effect of this change in accounting for income taxes on the income tax benefit for 1993 was to reduce the income tax benefit by $1,684 as a result of applying the change in the U.S. statutory tax rate from 34% to 35% to deferred tax balances. OPERATING COSTS AND EXPENSES -- OTHER, NET Operating costs and expenses -- other, net represents: (i) for 1993, the amortization of pre-opening costs totalling $3,052 associated with Bally's Saloon and Gambling Hall dockside gaming facility in Tunica, Mississippi ("Bally's Tunica") which commenced operations in December 1993, (ii) for 1992, the elimination of litigation accruals totalling $2,738 relating to matters which were favorably settled and a $1,000 commission on the July 1992 sale by Bally's Grand, Inc. of the casino resort complex formerly known as "Bally's Reno" offset by $3,722 of professional fees related to the Company's reorganization and (iii) for 1991, $6,760 of similar professional fees. EXTRAORDINARY ITEMS In 1993, three of the Company's subsidiaries completed refinancings of their debt which, in the aggregate, resulted in an extraordinary loss of $8,490, net of income taxes of $5,092 and minority interests of $412. See "Long-term debt." In 1992, the Company utilized tax loss carryforwards to offset taxable income principally arising from the sale of Bally Gaming International, Inc. ("Gaming") common stock in July 1992 and the related tax benefit of $10,605 has been reflected as an extraordinary credit. See "Discontinued operations." Also in 1992, the Company purchased $11,471 principal amount of public debt securities of Bally not related to sinking fund requirements for 952,697 shares of Bally Common Stock, par value $.66 2/3 per share ("Common Stock") and $7,900 in cash, which resulted in an extraordinary gain of $612, net of income taxes of $329. In 1991, the Company purchased $157,255 principal amount of public debt securities of Bally and a subsidiary not related to sinking fund requirements for 3,639,000 shares of Common Stock, $33,707 in cash and substantially all of the purchaser's debt securities received by the Company in conjunction with the sale of Life Fitness, Inc. See "Discontinued operations." These purchases resulted in an extraordinary gain of $56,053, net of income taxes of $27,039 and other related costs. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) EARNINGS (LOSS) PER COMMON AND COMMON EQUIVALENT SHARE Earnings (loss) per common and common equivalent share is computed by dividing net income (loss) applicable to common stock by the weighted average number of shares of common stock and common stock equivalents outstanding during each year (46,558,856 in 1993, 41,110,353 in 1992 and 33,872,044 in 1991). Common stock equivalents, which represent the dilutive effect of the assumed exercise of certain outstanding stock options, increased the weighted average number of shares outstanding by 1,645,348 in 1992. The assumed exercise of outstanding stock options was not applicable in 1993 (due to losses) and not significant in 1991. ACQUISITION OF BALLY'S GRAND, INC. On August 20, 1993 (the "Effective Date"), the Fifth Amended Plan of Reorganization (the "Chapter 11 Plan") of Bally's Grand, Inc. (a company originally acquired by Bally in 1986 which owns and operates the casino resort in Las Vegas, Nevada known as "Bally's Las Vegas") became effective and Bally's Grand, Inc. emerged from bankruptcy. For almost two years prior thereto, Bally's Grand, Inc. operated its business and managed its properties as a debtor-in-possession under chapter 11 of title 11 of the United States Code (the "Bankruptcy Code"). On the Effective Date, Bally relinquished all of its equity interest in Bally's Grand, Inc. and Bally's net intercompany receivable from Bally's Grand, Inc. was cancelled and extinguished. Bally's investment in and advances to Bally's Grand, Inc. were written down to zero in 1990. Also, Bally did not provide any type of guarantee or commitment to Bally's Grand, Inc. nor did it assume any other obligation of Bally's Grand, Inc. in connection with the Chapter 11 Plan. Accordingly, the Company did not reflect any equity in earnings of Bally's Grand, Inc. for the period from January 1, 1991 through the Effective Date. During 1993, Bally's Casino Holdings, Inc. ("Casino Holdings") and another subsidiary of Bally acquired approximately 5.2 million shares (approximately 50% of the shares presently outstanding) of reorganized Bally's Grand, Inc. common stock in several transactions in exchange for $41,714 in cash and 1,752,400 shares of Gaming common stock. The acquisitions of Bally's Grand, Inc. common stock have been recorded using the purchase method of accounting, and the excess of the purchase price over the estimated fair value of net assets acquired of $19,354 is being amortized using the straight-line method over 20 years. Bally's Grand, Inc. has been consolidated since December 1, 1993 as a result of Bally's controlling interest. From September 29, 1993 (the date a cumulative 20% equity interest in reorganized Bally's Grand, Inc. was attained) through November 30, 1993, Bally's investment in Bally's Grand, Inc. was recorded on the equity method of accounting. The equity in earnings of reorganized Bally's Grand, Inc. recognized during that period was $786. Certain employees of Bally and certain of its subsidiaries are involved in the management and operations of Bally's Grand, Inc. For services provided to Bally's Grand, Inc. prior to the Effective Date, Bally was paid $1,427, $2,247 and $3,640 during 1993, 1992 and 1991, respectively. Following the Effective Date, such services, among other things, are provided to reorganized Bally's Grand, Inc. under a management agreement pursuant to which a subsidiary of Bally receives $3,000 annually. The following unaudited pro forma summary consolidated results of operations of the Company for 1993 and 1992 were prepared to give effect to the acquisition of the controlling interest in reorganized Bally's Grand, Inc. as if the acquisition had occurred as of the beginning of each of the years presented. These pro forma results have been prepared for comparative purposes only and do not purport to present what the Company's results of operations would actually have been if the acquisition had in fact occurred at such dates or to project the Company's results of operations for any future year. In addition, the pro forma summary consolidated results of operations of the Company include adjustments to the historical results of operations of Bally's Grand, Inc. which principally reflect: (i) the elimination of the operating results of Bally's Reno, (ii) the elimination of the reorganization items of Bally's Grand, Inc., (iii) the effects of transactions related to the reorganization of Bally's Grand, Inc. pursuant to the Chapter 11 Plan, (iv) the effects of the adoption of "fresh-start reporting" and - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) (v) the income tax effects of the pro forma adjustments. The pro forma summary consolidated results of operations are based upon available information and upon certain assumptions that management believes are reasonable. RECEIVABLES The carrying amount of the Company's receivables at December 31, 1993 and 1992 approximates fair value. The fair value of fitness center installment contracts is based on discounted cash flow analyses, using interest rates in effect at the end of the year comparable to similar consumer financing contracts. The fair value of other receivables approximates their carrying amount. ACCRUED LIABILITIES LONG-TERM DEBT The carrying amounts of the Company's long-term debt at December 31, 1993 and 1992 are as follows: - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) The indentures for Bally's debt do not contain cross-default provisions. However, the indentures and credit agreements related to the indebtedness of certain of Bally's subsidiaries require, among other things, that these subsidiaries maintain certain financial ratios and restrict the amount of additional indebtedness that can be incurred. Bally has not guaranteed the payment of principal or interest under the publicly traded debt securities and credit agreements of its subsidiaries. The Bally 6% Convertible Subordinated Debentures due 1998 (the "6% Debentures") require annual sinking fund payments of $2,587 through 1997, which will retire 75% of these debentures prior to maturity. The Company may redeem these debentures at any time, in whole or in part, without premium. At any time prior to maturity or redemption, these debentures are convertible into Common Stock (current conversion price of $28.99 per share, subject to adjustment for certain subsequent changes in the Company's capitalization). In 1993, the Company purchased $2,587 principal amount of these debentures to satisfy the 1993 sinking fund requirement, which resulted in a pre-tax gain of $495 (included in "Other revenues"). The Bally 10% Convertible Subordinated Debentures due 2006 (the "10% Debentures") require annual sinking fund payments of $5,000 through 2005, which will retire 75% of these debentures prior to maturity. The Company may redeem these debentures at any time, in whole or in part, with premiums ranging from 1.96% at December 31, 1993 to zero in December 1996 and thereafter. At any time prior to maturity or redemption, these debentures are convertible into Common Stock (current conversion price of $32.68 per share, subject to adjustment for certain subsequent changes in the Company's capitalization). In 1993, the Company purchased $617 principal amount of these debentures to satisfy the remaining 1993 sinking fund requirement, which resulted in a pre-tax gain of $101 (included in "Other revenues"). The payment of the 6% Debentures and 10% Debentures is subordinated to the prior payment, in full, of all senior indebtedness of Bally, as defined (approximately $20,190 at December 31, 1993). In addition, almost all of the Company's business is conducted through subsidiaries and claims of creditors of subsidiaries are effectively senior to these debentures. In June 1993, Casino Holdings issued $220,000 principal amount of Senior Discount Notes due 1998 (the "Senior Discount Notes") at a discount to yield an interest rate of 10 1/2%. The Senior Discount Notes are not subject to any sinking fund requirement, but may be redeemed at any time, in whole or in part, at their accreted value plus a "make-whole premium," as defined. In addition, on or before June 15, 1996, a portion of the Senior Discount Notes may be redeemed with premiums ranging from 8.0% of the accreted value prior to June 15, 1994 to 4.8% of the accreted value on June 15, 1996 out of the proceeds of an initial public offering by Casino Holdings if such offering were to occur, provided that at least $154,000 principal amount of the Senior Discount Notes remains outstanding after the redemption. The net proceeds from the issuance of the Senior Discount Notes were approximately $127,900, which have been and are being used to: (i) construct and equip Bally's Tunica, (ii) acquire a significant equity interest in Bally's Las Vegas, (iii) fund initial payments for construction of a riverboat (including dockside improvements) for eventual operation in New Orleans, Louisiana, (iv) fund an option agreement to acquire certain riverfront property in Philadelphia for the purpose of developing a dockside gaming facility if gaming were to be legalized in Pennsylvania and (v) pursue other gaming opportunities. The Senior Discount Notes are effectively subordinated to all liabilities of Casino Holdings' subsidiaries, which were $779,585 at December 31, 1993. On March 8, 1994, a subsidiary of Bally's Park Place, Inc. ("Bally's Park Place") 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 Bally's Park Place 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 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) 9 1/4% Notes are secured by a first mortgage on and security interest in substantially all property and equipment at Bally's Park Place, which had a net book value of $486,498 at December 31, 1993. Bally's Park Place used the net proceeds from the sale of the 9 1/4% Notes to purchase and retire certain of its 11 7/8% First Mortgage Notes due 1999 (the "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 income taxes of approximately $14,300. In connection with the sale of the 9 1/4% Notes, Bally's Park Place 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 Bally's Park Place'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). Bally's Park Place 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. In March 1993, a subsidiary of GNAC, CORP. (which owns and operates the casino resort in Atlantic City known as "The Grand") issued $275,000 principal amount of 10 5/8% First Mortgage Notes due 2003 (the "10 5/8% Notes") at a discount to yield an interest rate of 10 3/4%. The 10 5/8% Notes are not subject to any sinking fund requirement, but may be redeemed beginning April 1998, in whole or in part, with premiums ranging from 5.25% in 1998 to zero in 2001 and thereafter. The 10 5/8% Notes are secured by a first mortgage on and security interest in substantially all property and equipment of GNAC, CORP., which had a net book value of $280,960 at December 31, 1993. GNAC, CORP. used the net proceeds from the sale of the 10 5/8% Notes, together with the collection of certain funds on deposit with Bally's Park Place, to redeem its 13 1/4% Mortgage-Backed Notes due 1995 (the "13 1/4% Notes") at a price of 102.94% of their principal amount plus accrued interest, thereby satisfying all obligations thereunder. The redemption of the 13 1/4% Notes resulted in an extraordinary loss of $2,091, net of income taxes of $1,405. During April 1993, GNAC, CORP. entered into an agreement with two banks for a $20,000 revolving credit facility. This credit facility has a term of two years, provides for interest on borrowings at the rate of 1% above the banks' stated prime rates and is secured by a pari passu lien on the collateral securing the 10 5/8% Notes. GNAC, CORP. pays a fee of 1/2% on the unused commitment. In December 1993, Bally's Grand, Inc. issued $315,000 principal amount of 10 3/8% First Mortgage Notes due 2003 (the "10 3/8% Notes"). The 10 3/8% Notes are not subject to any sinking fund requirement, but may be redeemed beginning December 1998, in whole or in part, with premiums ranging from 5.19% in 1998 to zero in 2001 and thereafter. In addition, on or before December 15, 1996, a portion of the 10 3/8% Notes may be redeemed at a premium of 9.375% out of the proceeds of one or more public equity offerings by Bally's Grand, Inc. if such offerings were to occur, provided that at least $100,000 principal amount of the 10 3/8% Notes remains outstanding after the redemption. The 10 3/8% Notes are secured by a first priority lien on the fee interests in the approximately thirty-acre site comprising Bally's Las Vegas and by a security interest in certain personal property of Bally's Grand, Inc., which together had a net book value of $331,448 at December 31, 1993. Bally's Grand, Inc. used a substantial portion of the net proceeds from the issuance of the 10 3/8% Notes to redeem its 12% First Mortgage Notes due 2001 (the "12% Notes") at a price of 103% of their principal amount plus accrued interest, thereby satisfying all obligations thereunder, and to pay approximately $9,000 to Bally under a tax sharing agreement between Bally's Grand, Inc. and Bally, which amount became due and payable in connection with the redemption of the 12% Notes. The remaining proceeds are primarily being used for capital expenditures. The redemption of the 12% Notes resulted in an extraordinary loss of $400, net of income taxes of $438 and minority interests of $412. The Bally's Health & Tennis Corporation ("Bally's Health & Tennis") revolving credit agreement, - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) which was amended in January 1993, provides for borrowings of up to $107,500 and letters of credit up to $20,000 at December 31, 1993. The commitment under the revolving credit facility is reduced by $5,000 during each quarter of 1994 and by increasing amounts thereafter through December 31, 1997. The rate of interest on the borrowings (blended rate of 6 3/4% at December 31, 1993) is at Bally's Health & Tennis' option, based upon either the agent bank's prime rate plus 1 3/4% or the Euro-dollar rate plus 3 1/4%. Bally's Health & Tennis pays an annual fee of 1/2% on the unused commitment. Outstanding letters of credit as of December 31, 1993 totalled $11,370, for which Bally's Health & Tennis pays an annual fee of 1 3/4% on outstanding letters of credit and a fee of 1/2% on the unused commitment. The revolving credit agreement is secured by substantially all real and personal property of Bally's Health & Tennis, which had a net book value of $759,848 at December 31, 1993, and a pledge of the stock of Bally's Health & Tennis. The Bally's Health & Tennis revolving credit agreement requires maintenance by Bally's Health & Tennis of certain financial ratios. Certain provisions of the revolving credit agreement applicable to those financial ratios were amended as of September 30, 1993. Although Bally's Health & Tennis was in compliance with these financial ratio requirements as of December 31, 1993, there can be no assurance that it will not be necessary in the future to amend the financial ratio requirements and, if necessary, that such amendments will be obtained. Also in January 1993, Bally's Health & Tennis issued $200,000 principal amount of 13% Senior Subordinated Notes due 2003 (the "13% Notes"). The 13% Notes are not subject to any sinking fund requirement, but may be redeemed beginning January 1998, in whole or in part, with premiums ranging from 6.5% in 1998 to zero in 2000 and thereafter. The payment of the 13% Notes is subordinated to the prior payment in full of all senior indebtedness of Bally's Health & Tennis, as defined ($124,463 at December 31, 1993). Bally's Health & Tennis used the net proceeds from the sale of the 13% Notes to prepay $101,500 of indebtedness under the Bally's Health & Tennis revolving credit agreement, redeem $69,505 principal amount of its 13 5/8% Senior Subordinated Debentures due 1997 (the "13 5/8% Debentures") at a price of 105.71% of their principal amount plus accrued interest, thereby satisfying all obligations thereunder, and pay a $15,000 dividend to Bally. The redemption of the 13 5/8% Debentures and the amendment to the revolving credit agreement resulted in an extraordinary loss of $5,999, net of income taxes of $3,249. Other secured and unsecured obligations are payable through 2018 and are collateralized by land, buildings and equipment which have a net book value of $43,395 at December 31, 1993. Interest rates averaged 8% at December 31, 1993. DIVIDEND RESTRICTIONS Each of Bally's principal subsidiaries presently have debt covenants which limit the payment of dividends to Bally. Under the terms of the Senior Discount Notes, an amount equal to certain dividends paid pursuant to a net income test by Bally's Park Place to Casino Holdings may be declared as a dividend by Casino Holdings and paid to Bally. In February 1994, Bally's Park Place declared and paid a $595 dividend (amount of unrestricted retained earnings at December 31, 1993) to Casino Holdings which subsequently declared and paid a dividend in the same amount to Bally. In addition, Bally's Park Place paid a $30,000 dividend to Casino Holdings from a portion of the proceeds of the sale of the 9 1/4% Notes in March 1994, which is not available to be paid by Casino Holdings to Bally. In connection with the sale of the 9 1/4% Notes, the New Jersey Casino Control Commission (the "New Jersey Commission") requires, among other things, that the payment of certain dividends by Bally's Park Place to Casino Holdings which are not based on net income receive prior approval from the New Jersey Commission. GNAC, CORP. and Bally's Health & Tennis are not expected to be able to pay dividends to Bally in 1994. Also, the terms of the 10 3/8% Notes limit the ability of Bally's Grand, Inc. to pay dividends, and no dividends are expected to be paid in 1994. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) Annual maturities Aggregate annual maturities of long-term debt for the five years after December 31, 1993 (adjusted for the Bally's Park Place refinancing described above) are as follows: Fair value The fair value of the Company's long-term debt at December 31, 1993 and 1992 was $1,520,926 and $1,013,552, respectively. The fair value of publicly traded debt securities is based on quoted market prices. The fair value of borrowings under revolving credit agreements and of other secured and unsecured obligations approximates their carrying amount. INCOME TAXES The income tax benefit applicable to loss from continuing operations before income taxes and minority interests 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: Based on federal income tax returns as filed, as adjusted for certain agreements with the Internal Revenue Service ("IRS"), the Company had federal net operating loss carryforwards of approximately $185,000, which expire in 2006, and Alternative Minimum Tax ("AMT") credits of approximately $41,000, which have no expiration. The Company also has substantial state tax loss carryforwards which begin to expire in 1994 and fully expire in 2008. Because of complex issues involved in the Company's tax situation and the Company's present expectations of ultimate settlements with the IRS, the Company has provided a valuation allowance for substantially all of the federal and state tax loss carryforwards and a portion of its AMT credits. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) The deferred income tax provision (benefit) applicable to loss from continuing operations before income taxes and minority interests for 1992 and 1991 arises from the tax effect of timing differences as follows: A reconciliation of the income tax benefit with amounts determined by applying the U.S. statutory tax rate to loss from continuing operations before income taxes and minority interests is as follows: The IRS has completed an audit of the federal income tax returns of certain of the Company's fitness center subsidiaries for periods ending on the day these subsidiaries were acquired. Among other things, the IRS is asserting that these subsidiaries owe additional taxes of approximately $32,000 and substantial amounts of interest with respect to issues arising pursuant to the Company's election in 1983 to treat the purchases of stock of these subsidiaries as if they were purchases of assets. The Company vigorously opposes the IRS' assertions and has filed petitions in the United States Tax Court contesting the IRS' proposed deficiencies with respect to these issues. This matter has been docketed for trial in October 1994; however, a resolution may occur sooner if the Company and the IRS resolve all or some of these issues by stipulation or otherwise. Based on the information presently available, there can be no assurance of the outcome of this matter. However, in the opinion of management, payment, if any, to the IRS of amounts which may be ultimately deemed owing will not have a material adverse effect on the Company's consolidated financial position or results of operations, since the Company believes that it has adequately provided deferred and current taxes related to this matter, although it could, though it is not expected to, have a material adverse effect on the Company's liquidity. STOCKHOLDERS' EQUITY Preferred stock The Series B Junior Participating Preferred Stock, par value $1 per share (the "Series B Junior Stock"), if issued, will have a minimum preferential quarterly dividend of $5 per share, but will be entitled to an aggregate dividend of 100 times the dividend declared on shares of Common Stock. Each share of Series B Junior Stock will have 100 votes, voting together with Common Stock, except as Delaware law may otherwise provide. In the event of liquidation, the holders of Series B Junior Stock will receive a preferred liquidation payment of $100 per share, but will be entitled to receive an aggregate liquidation payment equal to 100 times the payment made per share of Common Stock. The Series D Convertible Exchangeable Preferred Stock, par value $1 per share (the "Preferred Stock"), with a face value of $34,725 as of December 31, 1993, bears a dividend rate of 8%. The holders of Preferred Stock do not have voting rights, except that the holders would have the right to elect two additional directors of Bally if dividends on the Preferred Stock are in arrears - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) in an amount equal to at least six quarterly dividends and except as Delaware law may otherwise provide. The Preferred Stock is redeemable, in whole or in part, at the option of Bally at $51.60 per share as of December 31, 1993, declining each February 1 in equal annual amounts to $50 per share on and after February 1, 1997, in each case plus accrued and unpaid dividends. The Preferred Stock is convertible into Common Stock at a price of $25 per share, equivalent to a conversion rate of two shares of Common Stock for each share of Preferred Stock, subject to adjustment. The Preferred Stock is exchangeable at the option of Bally, in whole but not in part, on any dividend payment date for 8% Convertible Subordinated Debentures due February 1, 2007. In the event of liquidation, the holders of the Preferred Stock will receive a preferred liquidation payment of $50 per share, plus an amount equal to any dividends accrued and unpaid to the payment date, before any distribution is made to holders of junior securities. COMMON STOCK At December 31, 1993, shares of Common Stock were reserved for future issuance as follows: STOCK PLANS, AWARDS AND RIGHTS INCENTIVE PLANS In May 1989, the stockholders approved the 1989 Incentive Plan of Bally (the "1989 Plan") for officers and key employees that provides for the grant of stock options, stock appreciation rights ("SARs"), stock depreciation rights ("SDRs") and restricted stock (collectively "Awards"). In June 1992, the stockholders approved an increase in the number of shares of Common Stock available for issuance under the 1989 Plan from 2,500,000 shares to 4,000,000 shares. Amendments to the 1989 Plan increasing the aggregate number of shares of common stock which may be sold or delivered under the 1989 Plan from 4,000,000 to 6,022,000 shares and limiting the number of stock options, stock appreciation rights or stock options in tandem with stock appreciation rights that may be granted during any one calendar year to certain executive officers of the Company are subject to stockholder approval in 1994. No Awards may be granted after March 9, 1999. The 1989 Plan provides for granting incentive as well as non-qualified stock options. Generally, non-qualified stock options will be granted with an option price equal to the fair market value of the stock at the date of grant. Incentive stock options must be granted at not less than the fair market value of the stock at the date of grant. Option grants generally become exercisable in three equal annual installments commencing one year after the date of grant, but the Compensation and Stock Option Committee of the Board ("Compensation Committee"), in its discretion, may alter such terms. SARs are rights granted to an officer or key employee to receive shares of stock and/or cash in an amount equal to the excess of the fair market value of the stock on the date the SARs are exercised over the fair market value of the stock on the date the SARs were granted or, at the discretion of the Compensation Committee, the date the option was granted, if granted in tandem with an option granted on a different date. Upon exercise of stock appreciation rights, the optionee surrenders the related option in exchange for payment, in cash, of the excess of the fair market value on the date of surrender over the option price. SDRs are rights granted to an officer or key employee in conjunction with an option to receive a payment of stock and/or cash equal to the excess, if any, of the option price of stock acquired on the exercise of the related option over the greater of: (i) the fair market value of the stock, as of the date six months and one day after the option was exercised (or such other date as the Compensation Committee, in its discretion, shall determine), or (ii) if such stock was sold prior to such date, the gross sale proceeds from the sale of such stock. Stock options, SARs and SDRs granted under the 1989 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) Plan may be exercisable for a term of not more than ten years after the date of grant. At December 31, 1993, no SDRs had been granted and Bally has no current intention of granting SDRs under the 1989 Plan. Restricted stock awards are rights granted to an employee to receive shares of stock without payment but subject to forfeiture and other restrictions as set forth in the 1989 Plan. Generally, the restricted stock awarded, and the right to vote such stock or to receive dividends thereon, may not be sold, exchanged or otherwise disposed of during the restricted period. Except as otherwise determined by the Compensation Committee, the restrictions and risks of forfeiture will, after one year from the date of grant, lapse as to not more than 20% of the stock originally awarded, after two years lapse as to an aggregate of not more than 40% of the stock originally awarded, and after three years shall lapse as to all the stock originally awarded. There have been no restricted stock awards granted under this plan since 1989 and there are no shares outstanding with restrictions under this plan at December 31, 1993. In October 1993, the Board of Directors of the Company adopted, subject to stockholder approval in 1994, the 1993 Non-Employee Directors' Stock Option Plan of Bally Manufacturing Corporation (the "1993 Plan"). The 1993 Plan provides for the grant of non-qualified stock options to purchase an aggregate of 120,000 shares of Common Stock to directors of the Company who are not officers or key employees of Bally or any of its subsidiaries. Under this plan, stock options are granted with an option price equal to the fair market value of the stock on the date of grant. Option grants generally become exercisable in three equal annual installments commencing one year after the date of grant, with such options expiring ten years after the date of grant. No options may be granted under this plan after October 13, 1998. The Company also has a non-qualified and incentive stock option and stock appreciation rights plan for officers and key employees (the "1985 Plan") which has been terminated except as to options and stock appreciation rights outstanding, all of which are vested. A summary of 1993 stock option activity under the 1989 Plan, the 1993 Plan and the 1985 Plan is as follows: At December 31, 1993, options on 2,296,018 shares were exercisable and 1,103,459 shares and 80,000 shares were reserved for future grants under the 1989 Plan and 1993 Plan, respectively. Outstanding options at December 31, 1993 expire between 1994 and 2003. Included in the stock options outstanding at December 31, 1993 are options for 1,416,666 shares (options for 250,000 shares were exercised during 1993) comprising non-qualified stock options the Company granted in 1991 to two executives to each purchase 1,000,000 shares of Common Stock at an exercise price of $2 per share less than the fair market value of Common Stock at the date of grant. The awards also provided for accelerated vesting under certain circumstances. During the first quarter of 1993, the required circumstances were met, and the related compensation expense, which was being amortized over the three-year vesting period of the awards, was fully expensed. In December 1993, Bally's Board of Directors adopted, subject to stockholder approval in 1994, the Bally's Employee Stock Purchase Plan (the "Stock Purchase Plan"). The Stock Purchase Plan provides for the purchase of an aggregate of 200,000 shares of Common Stock by eligible employees (as defined) electing to participate in the plan. The stock can generally be purchased every six months at a price equal to the lesser of: (i) 85% of the fair market value of the stock on the date when a particular offering begins or (ii) 85% of the fair market value of the stock on the date when a particular offering terminates. On each offering made under the Stock Purchase Plan, each eligible employee electing to - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) participate in the Stock Purchase Plan will automatically be granted shares of Common Stock equal to the number of full shares which may be purchased from the employee's elected payroll deduction, with a maximum payroll deduction equal to 10% of eligible compensation, as defined. Assuming stockholder approval, the first offering under this plan commences on July 1, 1994 and the last offering terminates on June 30, 2004. AWARDS OF SUBSIDIARY STOCK During 1993, 600,000 shares of reorganized Bally's Grand, Inc. common stock were awarded to certain employees of Bally's Grand, Inc. (300,000 shares) and certain executive officers of Bally who also serve as executive officers of Bally's Grand, Inc. (300,000 shares) pursuant to the Bally's Grand, Inc. 1993 Incentive Stock Plan. The shares awarded to employees of Bally's Grand, Inc. are subject to forfeiture if the employee's employment by Bally's Grand, Inc. is terminated and are subject to restrictions which lapse as to approximately one-third of the shares awarded on each of December 31, 1993, 1994 and 1995 and the fair value of such shares on the date of award is being charged to expense over such period. The shares awarded to executive officers of Bally were not subject to restrictions and, accordingly, the fair value of the awards was expensed in 1993. In December 1993, the executive officers of Bally sold the shares of Bally's Grand, Inc. common stock awarded to them to a subsidiary of Bally at the fair market value of the shares at the date of sale. RIGHTS TO PURCHASE PREFERRED STOCK One preferred stock purchase right is attributable to each outstanding share of Common Stock. Under certain conditions, each right may be exercised to purchase for $60 one 1/100th of a share of Series B Junior Stock. The rights are not exercisable or transferable apart from the stock until the occurrence of one of the following: (i) ten days after the date ("Stock Acquisition Date") of a public announcement by a person or a group of beneficial ownership of 20% or more of Common Stock (an "Acquiring Person"), (ii) ten business days after a public announcement by a person or group of a tender offer for 30% or more of Common Stock, or (iii) the occurrence of a Flip-In Event. A Flip-In Event is any of: (i) a final court or administrative order finding that a person or group having beneficial ownership of 10% or more of Common Stock (a "10% Stockholder") has violated Nevada or New Jersey gaming, casino or similar laws in connection with such 10% Stockholder's interest in the Company, (ii) the failure of a 10% Stockholder to eliminate or reduce to an acceptable level its beneficial ownership of Common Stock within 20 days after a final court or administrative order finding that such 10% Stockholder is unsuitable or unqualified to hold its interest in the Company, (iii) the acquisition by a person or group of 20% or more of Common Stock without having obtained prior Nevada Gaming Commission approval to acquire control of the Company, and (iv) the consummation of certain "self-dealing" transactions between an Acquiring Person and the Company, including a merger with an Acquiring Person in which Bally is the surviving corporation and Common Stock is not changed or exchanged. Upon the occurrence of a Flip-In Event, each right, other than those held by the Acquiring Person or 10% Stockholder causing such occurrence, will entitle the holder to purchase shares of Common Stock or, in certain cases, other assets or securities of the Company having a value of $120 for $60. In the event that the Company is acquired in a merger or other business combination transaction (other than a merger with an Acquiring Person in which the Company is the surviving corporation and Common Stock is not changed or exchanged) or 50% or more of the Company's assets or earning power is sold or transferred, each holder of a right shall have the right to receive, upon exercise, common stock of the acquiring company having a calculated value equal to twice the purchase price of the right. The rights, which do not have voting privileges, are subject to adjustment to prevent dilution, expire on December 4, 1996 and may be redeemed by the Company at a price of five cents per right at any time until 20 days (subject to extension by the Board) following the Stock Acquisition Date. EMPLOYEE BENEFIT PLANS Bally and certain subsidiaries sponsor employee savings plans which cover certain full-time employees and which are considered part of the Company's overall retirement program. Pursuant to these savings plans, participating employees may contribute (defer) a percent of eligible - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) compensation. Employee contributions to the savings plans, up to certain limits, are partially matched by the Company. The expense applicable to continuing operations for the Company's savings plans and a profit-sharing plan which was terminated on January 1, 1993 was $5,243, $3,724 and $5,082 for 1993, 1992 and 1991, respectively. In addition, Bally and Bally's Park Place have noncontributory supplemental executive retirement plans for certain key executives. Normal retirement under these plans is age 60 to 65 and participants receive benefits based on years of service and compensation. Pension costs of these plans are unfunded except for one executive's benefits which are funded through annual contributions to a trust. Net periodic pension cost for these plans was $4,482, $1,627 and $6,664 for 1993, 1992 and 1991, respectively. The accrued pension liability related to the unfunded supplemental executive retirement plans in the consolidated balance sheet (principally classified as long-term) was $9,994 and $6,890 at December 31, 1993 and 1992, respectively. The weighted average discount rate and rate of increase in future compensation levels used in determining actuarial present value of the projected benefit obligations were 6.1% and 6.0% in 1993, 8.1% and 6.0% in 1992 and 8.3% and 5.5% in 1991. In 1991, Bally's Park Place 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 subsidiary. Pursuant to this agreement, the subsidiary agreed to pay the executive $27,600 over five years. The subsidiary 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 subsidiary 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, Bally and Bally's Park Place 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 Bally's Park Place paid on such date. Certain employees of the Company's casinos are covered by union-sponsored, collectively bargained, multiemployer defined benefit pension plans. The contributions and charges to expense for these plans were $1,314, $942 and $915 in 1993, 1992 and 1991, respectively. COMMITMENTS AND CONTINGENCIES LEASES Minimum future rent payments totalling $918,254 under commitments for noncancellable operating leases with initial terms in excess of one year in effect at December 31, 1993, principally for fitness center facilities, are payable $77,874, $76,204, $73,493, $72,017 and $70,073 in 1994 through 1998 and $548,593 thereafter. Rent expense was $80,514, $74,891 and $74,046 for 1993, 1992 and 1991, respectively. LITIGATION Several purported derivative actions originally filed against Bally and certain of its current and former directors and officers have been consolidated. The consolidated complaint seeks, among other things, unspecified damages and compensatory and punitive damages and costs in connection with allegations of breach of fiduciary duty, corporate mismanagement, and waste of corporate assets in connection with certain actions including, among others, payment of compensation, certain acquisitions by Bally, the dissemination of allegedly materially false and misleading information, the proposed restructuring of debt, and a subsidiary's allegedly discriminatory practices. The Company is also involved in various other matters of litigation as both plaintiff and defendant. Management believes, based upon the advice of its counsel, that the ultimate disposition of these matters will not have a materially adverse effect on the Company's consolidated financial statements. DISCONTINUED OPERATIONS In September 1993, the Company disposed of its remaining 1,752,400 shares of Gaming common stock pursuant to stock exchange agreements. This disposition, including the recognition of previously deferred cumulative translation adjustment credits of $2,506, resulted in a net gain of $6,215, including an income tax benefit of $1,452. The income tax benefit resulted from the utilization of tax loss carryforwards to offset taxable income arising from this disposition of - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) Gaming common stock, and is included in income from discontinued operations. In 1992 and 1991, the Company sold 4,547,600 shares and 3,000,000 shares, respectively, of Gaming common stock it owned in public offerings and received net proceeds of $51,243 and $33,300, respectively, which, including the recognition of previously deferred cumulative translation adjustment credits of $7,922 and $4,263, respectively, resulted in a net gain of $6,706 and $5,219, respectively, net of income taxes of $8,529 and $3,807, respectively, and other related costs. As a result of the Company's disposal of its investment in Gaming, the consolidated financial statements reflect Gaming as a discontinued operation. Income from discontinued operations in 1992 and 1991 also includes equity in earnings of Gaming of $2,879 and $4,644, respectively. Gaming's revenues in 1992 and 1991 were $163,781 and $153,648, respectively. Also in 1991, the Company sold the assets of its Life Fitness, Inc. computerized fitness equipment business and Scientific Games, Inc. lottery business in separate transactions for a total consideration of approximately $100,000, of which approximately $69,500 was paid in cash and the remainder was paid in the form of a new issue of one of the purchaser's debt securities. These sales resulted in a net gain of $18,010, net of income taxes of $18,172 and other related costs. The Company subsequently exchanged substantially all of the purchaser's debt securities received by the Company in connection with one of the sales and 800,000 shares of Common Stock with a third party for approximately $48,400 principal amount of public debt securities of Bally and one of its subsidiaries that were held by the third party, which resulted in an extraordinary gain of $10,800, net of income taxes of $4,800 and other related costs. See "Extraordinary items." The income from operations of these businesses has also been reflected as discontinued operations in the consolidated financial statements. Sales and income from operations of these businesses totalled $126,481 and $5,290 (after income taxes of $4,297), respectively, prior to their disposal dates in 1991. INDUSTRY SEGMENTS The Company operates in two segments: (i) Casinos -- includes the operation of two casino hotels in Atlantic City, New Jersey, a casino resort in Las Vegas, Nevada and a dockside gaming facility in Tunica, Mississippi; and (ii) Fitness centers -- includes the operation of 339 fitness centers. Revenues and assets of operations outside the United States are insignificant. During 1991, Bally began allocating its corporate overhead (including executive salaries and benefits, public company reporting costs and other corporate headquarters' costs) to its subsidiaries. Bally'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 Bally's oversight requirements. The allocations by Bally to its subsidiaries for 1993, 1992 and 1991 totalled $8,732, $9,591 and $9,175, respectively. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (ALL DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SUPPLEMENTARY DATA QUARTERLY CONSOLIDATED FINANCIAL INFORMATION (UNAUDITED) - --------------- NOTES: 1. The quarterly consolidated financial information reflects Bally Gaming International, Inc. ("Gaming") as a discontinued operation as a result of the Company's disposition of its remaining investment in September 1993. 2. Income from continuing operations for the quarters ended March 31 and June 30, 1993 includes gains of $.2 million and $.2 million, respectively, resulting from market purchases of the Company's public debt for sinking fund requirements. 3. Loss from continuing operations for the quarter ended September 30, 1993 includes a charge of $1.7 million ($.04 per share) as a result of applying the change in the U.S. statutory tax rate from 34% to 35% to deferred tax balances. 4. Loss from continuing operations for the quarter ended December 31, 1993 includes a charge of $1.9 million ($.04 per share) for the amortization of pre-opening costs associated with Bally's Saloon and Gambling Hall which commenced operations in December 1993. 5. Income from discontinued operations for the quarter ended September 30, 1993 represents a gain from the sale of Gaming common stock. 6. The extraordinary losses for the quarters ended March 31 and December 31, 1993 are due to early redemptions of debt. 7. The cumulative effect on prior years of change in accounting for income taxes for the quarter ended March 31, 1993 is a result of the Company changing its method of accounting for income taxes (effective January 1, 1993) as required by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." As permitted by SFAS No. 109, the Company elected to use the cumulative effect approach rather than to restate the financial statements of any prior years to apply the provisions of SFAS No. 109. 8. Income from continuing operations for the quarters ended March 31 and September 30, 1992 includes gains of $2.5 million ($.07 per share) and $.4 million ($.01 per share), respectively, resulting from market purchases of the Company's public debt for sinking fund requirements. 9. Income (loss) from continuing operations for the quarters ended March 31 and December 31, 1992 includes the elimination of litigation accruals relating to matters which were favorably settled amounting to $1.0 million ($.03 per share) and $1.2 million ($.03 per share), respectively. - -------------------------------------------------------------------------------- 10. Income from continuing operations for the quarter ended September 30, 1992 includes charges for professional fees related to the Company's reorganization of $3.2 million ($.08 per share) offset, in part, by a commission on the July 1992 sale by Bally's Grand, Inc. of the casino resort complex formerly known as "Bally's Reno" of $.7 million ($.02 per share). 11. Income from discontinued operations for the quarter ended September 30, 1992 includes a gain of $6.7 million ($.17 per share) from the sale of Gaming common stock. 12. The extraordinary gain for the quarter ended March 31, 1992 relates to the extinguishment of debt as a result of market purchases of the Company's public debt. 13. The extraordinary gains for the quarters ended September 30, 1992 and December 31, 1992 represent credits for the utilization of tax loss carryforwards. 14. The Company's operations are subject to seasonal factors. - -------------------------------------------------------------------------------- ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Item 9 is inapplicable. PART III Part III, except for certain information relating to Executive Officers included in Part I, is omitted inasmuch as the Company intends to file with the Securities and Exchange Commission within 120 days of the close of the fiscal year ended December 31, 1993 a definitive proxy statement containing such information pursuant to Regulation 14A of the Securities Exchange Act of 1934 and such information shall be deemed to be incorporated herein by reference from the date of filing such document. PART IV ITEM 14. ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (A) 1. INDEX TO FINANCIAL STATEMENTS (A) 2. INDEX TO FINANCIAL STATEMENT SCHEDULES 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. - -------------------------------------------------------------------------------- (A) 3. INDEX TO EXHIBITS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- * Incorporated herein by reference as indicated. - -------------------------------------------------------------------------------- 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 MANUFACTURING CORPORATION Dated: March 21, 1994 By /s/ ARTHUR M. GOLDBERG ------------------------------------ Arthur M. Goldberg Chairman of the Board, Chief Executive Officer and President 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. - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) - --------------- NOTE: Amounts are exclusive of accrued interest. S-1 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (PARENT COMPANY ONLY) DECEMBER 31, 1993 AND 1992 (ALL DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA) See accompanying notes. S-2 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONTINUED) CONDENSED STATEMENT OF OPERATIONS (PARENT COMPANY ONLY) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) See accompanying notes. S-3 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT--(CONTINUED) CONDENSED STATEMENT OF CASH FLOWS (PARENT COMPANY ONLY) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) See accompanying notes. S-4 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT--(CONTINUED) NOTES TO CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) (ALL DOLLAR AMOUNTS IN THOUSANDS) BASIS OF PRESENTATION The accompanying condensed financial information of Bally Manufacturing Corporation ("Bally") includes the accounts of Bally, and on an equity basis, the subsidiaries which it controls. The accompanying condensed financial information should be read in conjunction with the consolidated financial statements of Bally. LONG-TERM DEBT Scheduled annual maturities of long-term debt for the five years after December 31, 1993 are $7,587, $7,587, $7,587, $7,587 and $13,621. S-5 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE V -- PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) - --------------- NOTES: (a) Other changes include $372,792 and $4,289 arising from acquisitions of businesses in 1993 and 1992, respectively, an adjustment of $16,061 due to temporary differences resulting from the implementation of SFAS No. 109 in 1993 and reclassifications between categories in each of the years. (b) Depreciable lives are equal to the estimated economic lives of the related assets and the terms of the applicable leases for leasehold improvements. Depreciation is provided principally on the straight-line method over depreciable lives ranging from two to forty years. S-6 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) - --------------- NOTE: Other changes include $3,876 arising from the acquisition of a business in 1993, $2,342 due to temporary differences resulting from the implementation of SFAS No. 109 in 1993 and reclassifications between categories in each of the years. S-7 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) - --------------- NOTES: (a) Additions charged to accounts other than costs and expenses consist of the following: (b) Deductions include write-offs of uncollectible amounts, net of recoveries. In addition, for 1992 the allowance for doubtful receivables and cancellations also includes reclassifications of amounts ($7,040) previously reported as unearned finance charges that represent the portion of balances estimated to be related to uncollectible amounts. S-8 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE IX--SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) - --------------- NOTE: The average amount outstanding during 1992 and 1991 was computed by averaging the month-end balances during the year. The weighted average interest rate during 1992 and 1991 was computed by dividing interest expense by the weighted average amount of short-term borrowings outstanding. S-9 - -------------------------------------------------------------------------------- BALLY MANUFACTURING CORPORATION SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (ALL DOLLAR AMOUNTS IN THOUSANDS) - --------------- NOTE: Royalties are not shown as they are less than one percent of consolidated revenues in all years presented. S-10

797463_1993.txt

797463_1993

1993

797463

ITEM 1. BUSINESS. General Electric Capital Services, Inc. (herein together with its consolidated subsidiaries called "GE Capital Services" or the "Corporation," unless the context otherwise requires) was incorporated in 1984 in the State of Delaware. Until February 1993, the name of the Corporation was General Electric Financial Services, Inc. All outstanding capital stock of GE Capital Services is owned by General Electric Company, a New York corporation ("GE Company"). The business of GE Capital Services consists of ownership of three principal subsidiaries which, together with their subsidiaries and affiliates, constitute GE Company's principal financial services businesses. GE Capital Services is the sole owner of the common stock of General Electric Capital Corporation ("GE Capital"), Employers Reinsurance Corporation ("Employers Reinsurance") and Kidder, Peabody Group Inc. ("Kidder, Peabody"). GE Capital Services' principal executive offices are located at 260 Long Ridge Road, Stamford, Connecticut 06927 (Telephone number (203) 357-4000). GENERAL ELECTRIC CAPITAL CORPORATION GE Capital was incorporated in 1943 in the State of New York, under the provisions of the New York Banking Law relating to investment companies, as successor to General Electric Contracts Corporation, formed in 1932. The capital stock of GE Capital was contributed to GE Capital Services by GE Company in June 1984. Until November 1987, the name of the corporation was General Electric Credit Corporation. The business of GE Capital originally related principally to financing the distribution and sale of consumer and other products of GE Company. Currently, however, the type and brand of products financed and the financial services offered are significantly more diversified. Very little of the financing provided by GE Capital involves products that are manufactured by GE Company. GE Capital operates in four finance industry segments and in a specialty insurance industry segment. GE Capital's financing activities include a full range of leasing, loan, equipment management services and annuities. GE Capital's specialty insurance activities include providing private mortgage insurance, financial (primarily municipal) guarantee insurance, creditor insurance, reinsurance and, for financing customers, credit life and property and casualty insurance. GE Capital is an equity investor in a retail organization and certain other financial services organizations. GE Capital's operations are subject to a variety of regulations in their respective jurisdictions. Services of GE Capital are offered primarily throughout the United States, Canada and Europe. Computerized accounting and service centers, including those located in Connecticut, Ohio, Georgia and England, provide financing offices and other service locations with data processing, accounting, collection, reporting and other administrative support. GE Capital's principal executive offices are located at 260 Long Ridge Road, Stamford, Connecticut 06927. At December 31, 1993 GE Capital employed approximately 27,000 persons. EMPLOYERS REINSURANCE CORPORATION Employers Reinsurance Corporation (ERC), together with its subsidiaries, writes all lines of reinsurance other than title and annuities. ERC reinsures property and casualty risks written by more than 1,000 domestic and foreign insurers, and also writes certain specialty lines of insurance on a direct basis, principally excess workers' compensation for self-insurers, errors and omissions coverage for insurance and real estate agents and brokers, excess indemnity for self-insurers of medical benefits, and libel and allied torts. Domestic subsidiaries write property and casualty reinsurance through brokers, excess and surplus lines insurance, and provide reinsurance brokerage services. Subsidiaries in Denmark and the United Kingdom write property and casualty and life reinsurance, principally in Europe, Asia and the Middle East. Employers Reinsurance is licensed in all of the states of the United States, the District of Columbia, certain provinces of Canada and in certain other jurisdictions. Insurance and reinsurance operations are subject to regulation by various insurance regulatory agencies. ERC and its subsidiaries conduct business through 16 domestic offices and 9 foreign offices. Principal offices of ERC are located at 5200 Metcalf Avenue, Overland Park, Kansas 66201. At December 31, 1993 ERC employed approximately 1,000 persons. ITEM 1. BUSINESS (CONTINUED). KIDDER, PEABODY GROUP INC. Kidder, Peabody, a successor to a partnership founded in Boston in 1865, is incorporated in Delaware. Its principal subsidiary, Kidder, Peabody and Co. Incorporated ("Kidder"), is a member of the principal domestic securities and commodities exchanges and is a primary dealer in United States government securities. Kidder is a full-service international investment bank and securities broker. Its principal businesses include securities underwriting, sales and trading of equity and fixed income securities, financial futures activities, advisory services for mergers, acquisitions, and other corporate finance matters, research services and asset management. These services are provided to domestic and foreign business entities, governments, government agencies, and individual and institutional investors. Kidder is subject to the rules and regulations of various Federal and state regulatory agencies, exchanges and industry self-regulatory organizations that apply to securities broker-dealers and futures commission merchants, including the U.S. Securities and Exchange Commission, U.S. Commodity Futures Trading Commission, New York Stock Exchange, National Association of Securities Dealers, Chicago Mercantile Exchange and the Chicago Board of Trade. Kidder, Peabody conducts business in 42 domestic and 8 foreign branch offices. Principal offices of Kidder, Peabody are located at 10 Hanover Square, New York, New York 10005 and 100 Federal Street, Boston, Massachusetts 02110. At December 31, 1993 Kidder, Peabody employed approximately 5,650 persons. INDUSTRY SEGMENTS The Corporation provides a wide variety of financing, insurance, investment banking and securities brokerage products and services, which are organized into the following industry segments: o Specialty Insurance -- U.S. and international multiple-line property and casualty reinsurance and certain directly written specialty insurance (ERC), financial guaranty insurance, principally on municipal bonds and structured finance issues; private mortgage insurance; creditor insurance covering international customer loan repayments; and property, casualty and life insurance. o Consumer Services -- private label and bank credit card loans, time sales and revolving credit and inventory financing for retail merchants, auto leasing, inventory financing, mortgage servicing and annuities. o Mid-Market Financing -- loans and financing and operating leases for middle-market customers including manufacturers, distributors and end-users, for a variety of equipment, including data processing equipment, medical and diagnostic equipment, and equipment used in construction, manufacturing, office applications and telecommunications activities. o Equipment Management -- leases, loans and asset management services for portfolios of commercial and transportation equipment including aircraft, trailers, auto fleets, modular space units, railroad rolling stock, data processing equipment, ocean-going containers and satellites. o Securities Broker-Dealer -- Kidder, Peabody, a full-service international investment bank and securities broker, member of the principal stock and commodities exchanges and a primary dealer in U.S. government securities. Offers services such as underwriting, sales and trading, advisory services on acquisitions and financing, research and asset management. o Specialized Financing -- loans and leases for major capital assets including aircraft, industrial facilities and equipment and energy-related facilities; commercial and residential real estate loans and investments; and loans to and investments in corporate enterprises. Refer to Item 7 "Management's Discussion and Analysis of Results of Operations" in this Form 10-K for discussion of the Corporation's Portfolio Quality. ITEM 2. ITEM 2. PROPERTIES. GE Capital Services and its subsidiaries conduct their businesses from various facilities, most of which are leased. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Corporation is not involved in any material pending legal proceedings. 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. See Note 13 of Notes to Financial Statements. The common stock of the Corporation is owned entirely by GE Company and therefore there is no trading market in such stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data should be read in conjunction with the financial statements of GE Capital Services and consolidated affiliates and the related Notes to Financial Statements. The Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," on December 31, 1993 resulting in the inclusion of $812 million of net unrealized gains on investment securities in equity at the end of the year. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," was implemented in 1991 using the immediate recognition transition option. The cumulative effect to January 1 of adopting SFAS No. 106 was $19 million, net of $12 million tax credit. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS. OVERVIEW The Corporation's earnings were $1,807 million in 1993, 21% more than 1992's earnings of $1,499 million, which were 18% more than the comparable 1991 earnings of $1,275 million. The 1993 increase reflected strong performance in the Corporation's financing businesses, mainly as a result of a favorable interest rate environment, asset growth and improved asset quality. Earnings of the Corporation's Securities Broker-Dealer and Specialty Insurance segments were substantially higher in 1993. The 1992 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). increase reflected sharp improvement in the earnings of both the Specialty Insurance and Securities Broker-Dealer Segments. OPERATING RESULTS EARNED INCOME from all sources increased 20% to $22.1 billion in 1993, following a 12% increase to $18.4 billion in 1992. Asset growth in each of the Corporation's financing segments, through acquisitions of businesses and portfolios as well as origination volume, was the primary reason for increased income from time sales, loans, financing leases and operating lease rentals in both 1993 and 1992. Yields on related assets were essentially flat in 1993 compared with 1992, following a decline from 1991. Earned income in 1993 from the Corporation's annuity business, formed through two current year acquisitions, was $571 million. Specialty Insurance revenues increased 26% in 1993, compared with a 29% increase in 1992, due to higher premium and investment income as well as the impact of the creditor insurance business, which was consolidated at the end of the second quarter of 1992 when an existing equity position was converted to a controlling interest. Securities Broker-Dealer revenues increased 21% and 20% in 1993 and 1992, respectively, reflecting higher investment income and investment banking activity. INTEREST AND DISCOUNT EXPENSE on borrowings is the Corporation's principal cost. Interest and discount expense in 1993 totaled $6.5 billion, 6% higher than in 1992, which was 6% lower than in 1991. The 1993 increase was a result of funding increased security positions in the Securities Broker-Dealer segment, partially offset by substantially lower rates on higher average borrowings supporting financing operations. The 1992 decrease reflected substantially lower interest rates, which more than offset higher average borrowings and the cost of funding higher levels of security positions in the Securities Broker-Dealer segment. Composite interest rates on the Corporation's borrowings were 4.96% in 1993 compared with 5.78% in 1992 and 7.46% in 1991. OPERATING AND ADMINISTRATIVE EXPENSES increased to $7.1 billion in 1993, a 20% increase over 1992, which was 40% higher than 1991, primarily reflecting operating costs associated with businesses and portfolios acquired during the past two years. Overall, provisions for losses on investments charged to operating and administrative expense decreased in 1993, following an increase in 1992. These provisions principally related to the Commercial Real Estate and highly leveraged transaction (HLT) portfolios, and in 1993, to commercial aircraft as well. INSURANCE LOSSES AND POLICYHOLDER AND ANNUITY BENEFITS increased 62% to $3.2 billion in 1993, compared with a 21% increase to $2.0 billion in 1992. The 1993 increase principally reflected annuity benefits credited to customers following the current year annuity business acquisitions, as well as higher losses on increased volume in the property and casualty reinsurance and life reinsurance businesses. In 1992, higher losses on increased volume in the property and casualty reinsurance and the private mortgage insurance businesses, and the effects of the creditor insurance business for the second half of the year, were partially offset by lower losses in the life reinsurance business. PROVISION FOR LOSSES ON FINANCING RECEIVABLES decreased $69 million to $987 million in 1993 compared with a $46 million decrease to $1,056 million in 1992. These provisions principally related to the Consumer Services, Commercial Real Estate and HLT portfolios discussed below. DEPRECIATION AND AMORTIZATION OF BUILDINGS AND EQUIPMENT AND EQUIPMENT ON OPERATING LEASES increased to $1.6 billion in 1993, a 22% increase over 1992, which was 9% higher than 1991, primarily as a result of additions to equipment on operating leases through business and portfolio acquisitions. INCOME TAX PROVISION was $841 million in 1993 (an effective tax rate of 32%), compared with $536 million in 1992 (26%) and $382 million (23%) in 1991. The increased provision for income taxes in both 1993 and 1992 reflected the effects of additional income before taxes and, in 1993, the 1% increase in the U. S. Federal income tax rate. The higher rate in 1993, compared with 1992, primarily reflected the 1% increase in the U.S. Federal income tax rate and a lower proportion of tax-exempt income. These items were partially offset by the effects of certain unrelated financing transactions that will result in future cash savings and reduced the Corporation's obligation for previously accrued deferred taxes. The higher rate in 1992, compared with 1991, reflected a relatively lower proportion of tax-exempt income and a 1991 adjustment for tax-deductible claims reserves of the property reinsurance affiliates, for which there was no 1992 counterpart. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). OPERATING PROFIT BY INDUSTRY SEGMENT Operating profit (pre-tax income) of the Corporation, by industry segment, is summarized in Note 19 and discussed below: SPECIALTY INSURANCE operating profit of $770 million in 1993 was 20% higher than the $641 million recorded in 1992, which was 28% higher than in 1991. The 1993 increase reflected higher premium volume from bond refunding in the financial guaranty insurance business as well as reduced claims expense in the creditor insurance business. The 1992 gains primarily reflected higher premium volume and investment income at GE Capital's private mortgage and financial guaranty insurance businesses. CONSUMER SERVICES operating profit of $695 million in 1993, was 32% higher than that of 1992. This increase reflected lower provisions for receivable losses in Retailer Financial Services resulting from declines in consumer delinquency as well as strong asset growth and interest rate favorability in both Auto Financial Services and Retailer Financial Services. Operating profit of $525 million in 1992 was 53% higher than that of 1991 (excluding the impact in 1991 of the $134 million gain on the disposition of a significant portion of GE Capital's auto auction affiliate). This increase reflected higher financing spreads in Retailer Financial Services and increased asset levels in Auto Financial Services. EQUIPMENT MANAGEMENT operating profit increased $9 million to $377 million in 1993. This increase reflected higher volume in most businesses, largely the result of portfolio and business acquisitions, and improved trailer and railcar utilization, offset by lower average rental rates in Fleet Services and Computer Services, coupled with the effects of lower utilization and pricing pressures at Genstar Container. Operating profit decreased $13 million to $368 million in 1992 due to lower utilization in the Railcar Services and Genstar Container businesses, partially offset by operating profit generated as a result of Fleet Services' 1992 acquisition of the fleet leasing operations of Avis-Europe. MID-MARKET FINANCING operating profit of $454 million in 1993 was 29% higher than that of 1992 and reflected higher spreads and higher levels of invested assets, primarily as a result of business and portfolio acquisitions. Operating profit increased $104 million to $352 million in 1992 compared with 1991. Operating profit for 1992 reflected higher levels of invested assets, primarily as a result of asset portfolio acquisitions. SECURITIES BROKER-DEALER (Kidder, Peabody) operating profit was $439 million in 1993, up 46% from 1992's record $300 million, which was $181 million higher than in 1991. Strong performances in both years reflected higher investment income from trading and investment banking activities. Favorable market conditions were an important factor in both years. Higher interest expense in both years reflected costs associated with funding increased security positions. Operating and administrative expenses increased in both years, primarily because of the revenue growth and, in 1992, because of costs associated with certain litigation settlements. SPECIALIZED FINANCING operating profit was $201 million in 1993, compared with $121 million in 1992, and $220 million in 1991. The increase in 1993 principally reflected much lower provisions for losses on Corporate Finance Group HLT investments and higher gains from sales of Commercial Real Estate assets partially offset by higher loss provisions for Commercial Real Estate assets and expenses associated with redeployment and refurbishment of owned aircraft. The decline in 1992 principally reflected higher loss provisions, particularly reserves for Corporate Finance Group in-substance and owned investments, partially offset by higher gains on the sale of assets in both Commercial Real Estate and Corporate Finance Group. Further details concerning loss provisions relating to both the Commercial Real Estate portfolio and Corporate Finance Group HLT investments are discussed below. CAPITAL RESOURCES AND LIQUIDITY The Corporation's principal source of cash is financing activities that involve continuing rollover of short-term borrowings and appropriate addition of long-term borrowings, with a reasonable balance of maturities. Over the past three years, the Corporation's borrowings with maturities of 90 days or less have increased by $14.0 billion. New borrowings of $40.2 billion having maturities longer than 90 days were added during those years, while $25.6 billion of such longer-term borrowings were paid off. The Corporation has also generated significant cash from operating activities, $14.8 billion during the last three years. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). The Corporation's principal use of cash has been investing in assets to grow the business. Of $40.9 billion that the Corporation invested over the past three years, $16.1 billion was used for additions to financing receivables, $9.3 billion for new equipment, primarily for lease to others and $6.9 billion to acquire new businesses. GE Company has agreed to make payments to GE Capital, constituting additions to pre-tax income, to the extent necessary to cause GE Capital's consolidated ratio of earnings to fixed charges to be not less than 1.10 for each fiscal year commencing with fiscal year 1991. Three years advance written notice is required to terminate this agreement. No payments have been required under this agreement. GE Capital's ratios of earnings to fixed charges for the years 1993, 1992 and 1991, were 1.62, 1.44 and 1.34, respectively. The Corporation's total borrowings were $85.9 billion at December 31, 1993, of which $60.0 billion was due in 1994 and $25.9 billion was due in subsequent years. Comparable amounts at the end of 1992 were: $75.1 billion in total; $53.2 billion due within one year; and $21.9 billion due thereafter. Composite interest rates are discussed on page 4. Individual borrowings are structured within overall asset/liability interest rate and currency risk management strategies. Interest rate and currency swaps form an integral part of the Corporation's goal of achieving the lowest borrowing costs for particular funding strategies. Counterparty credit risk is closely monitored -- approximately 90% of the notional amount of swaps outstanding at December 31, 1993 was with counterparties having credit ratings of Aa/AA or better. With the financial flexibility that comes with excellent credit ratings, management believes the Corporation is well positioned to meet the global needs of its customers for capital and continue growing its diverse asset base. PORTFOLIO QUALITY THE PORTFOLIO OF FINANCING RECEIVABLES, $63.9 billion and $59.4 billion at year-ends 1993 and 1992, respectively, is the Corporation's largest asset and its primary source of revenues. Related allowances for losses aggregated $1.7 billion at the end of 1993 (2.63% of receivables -- the same level as 1992) and are, in management's judgment, appropriate given the risk profile of the portfolio. A discussion about the quality of certain elements of the portfolio of financing receivables and investments follows. Further details are included in Notes 5 and 10. CONSUMER LOANS RECEIVABLE, primarily retailer and auto receivables, were $17.3 billion and $14.8 billion at the end of 1993 and 1992, respectively. The Corporation's investment in consumer auto finance lease receivables was $5.6 billion and $4.8 billion at the end of 1993 and 1992, respectively. Non-earning receivables, 1.7% of total loans and leases (2.1% at the end of 1992), amounted to $391 million at the end of 1993. The provision for losses on retailer and auto financing receivables was $469 million in 1993, a 19% decrease from $578 million in 1992, reflecting reduced consumer delinquencies and intensified collection efforts, particularly in Europe. Most non-earning receivables were private label credit card receivables, the majority of which were subject to various loss sharing arrangements that provide full or partial recourse to the originating retailer. COMMERCIAL REAL ESTATE LOANS classified as finance receivables by the Commercial Real Estate business, a part of the Specialized Financing segment, were $10.9 billion at December 31, 1993, up $0.4 billion from the end of 1992. In addition, the investment portfolio of the Corporation's annuity business, acquired during 1993, included $1.1 billion of commercial property loans. Commercial real estate loans are generally secured by first mortgages. In addition to loans, Commercial Real Estate's portfolio also included in other assets $2.2 billion of assets that were purchased for resale from the Resolution Trust Corporation (RTC) and other institutions and $1.4 billion of investments in real estate joint ventures. In recent years, the Corporation has been one of the largest purchasers of assets from RTC and other institutions, growing its portfolio of properties acquired for resale by $1.1 billion in 1993. To date, values realized on these assets have met or exceeded expectations at the time of purchase. Investments in real estate joint ventures have been made as part of original financings and in conjunction with loan restructurings where management believes that such investments will enhance economic returns. Commercial Real Estate's foreclosed properties at the end of 1993 declined to $110 million from $187 million at the end of 1992. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). At December 31, 1993, Commercial Real Estate's portfolio included loans secured by and investments in a variety of property types that were well dispersed geographically. Property types included apartments (36%), office buildings (32%), shopping centers (14%), mixed use (8%), industrial and other (10%). These properties were located, principally across the United States, as follows: Mid-Atlantic (21%), Northeast (20%), Southwest (19%), West (15%), Southeast (12%), Central (8%), with the remainder (5%) across Canada and Europe. Reduced and non-earning receivables declined to $272 million in 1993 from $361 million in 1992, reflecting proactive management of delinquent receivables as well as write-offs. Loss provisions for Commercial Real Estate's investments were $387 million in 1993 ($248 million related to receivables and $139 million to other assets), compared with $299 million and $213 million in 1992 and 1991, respectively, as the portfolio continued to be adversely affected by the weakened commercial real estate market. HLT PORTFOLIO is included in the Specialized Financing segment and represents financing provided for highly leveraged management buyouts and corporate recapitalizations. The portion of those investments classified as financing receivables was $3.3 billion at the end of 1993 compared with $5.3 billion at the end of 1992, as substantial repayments reduced this liquidating portfolio. The year-end balance of amounts that had been written down to estimated fair value and carried in other assets as a result of restructuring or in-substance repossession aggregated $544 million at the end of 1993 and $513 million at the end of 1992 (net of allowances of $244 million and $224 million, respectively). Non-earning and reduced earning receivables declined to $139 million at the end of 1993 from $429 million the prior year. Loss provisions for HLT investments were $181 million in 1993 ($80 million related to receivables and $101 million to other assets), compared with $573 million in 1992 and $328 million in 1991. Non-earning and reduced earning receivables as well as loss provisions were favorably affected by the stronger economic climate during 1993 as well as by the successful restructurings implemented during the past few years. OTHER FINANCING RECEIVABLES, approximately $26 billion, consisted primarily of a diverse commercial, industrial and equipment loan and lease portfolio. This portfolio grew approximately $2 billion during 1993, while non-earning and reduced earning receivables decreased $46 million to $98 million at year end. The Corporation has loans and leases to commercial airlines that aggregated about $6.8 billion at the end of 1993, up from $6 billion at the end of 1992. At year-end 1993, commercial aircraft positions included conditional commitments to purchase aircraft at a cost of $865 million and financial guarantees and funding commitments amounting to $450 million. These purchase commitments are subject to the aircraft having been placed on lease under agreements, and with carriers, acceptable to the Corporation prior to delivery. Expenses associated with redeployment and refurbishment of owned aircraft totaled $112 million in 1993, compared with nominal amounts in prior years. The Corporation's increasing investment demonstrates its continued long-term commitment to the airline industry. ENTERING 1994, management believes that the diversity and strength of the Corporation's assets, along with vigilant attention to risk management, position it to deal effectively with a global and changing competitive and economic landscape. NEW ACCOUNTING STANDARDS SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," modifies the accounting that applies when it is probable that all amounts due under contractual terms of a loan will not be collected. Management does not believe that this Statement, required to be adopted no later than the first quarter of 1995, will have a material effect on the Corporation's financial position or results of operations, although such effect will depend on the facts at the time of adoption. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEPENDENT AUDITORS' REPORT To the Board of Directors General Electric Capital Services, Inc. We have audited the financial statements of General Electric Capital Services, Inc. and consolidated affiliates as listed in Item 14. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in Item 14. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of General Electric Capital Services, Inc. and consolidated affiliates 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 Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective December 31, 1993. /s/ KPMG PEAT MARWICK Stamford, Connecticut February 11, 1994 GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES STATEMENT OF CURRENT AND RETAINED EARNINGS See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES STATEMENT OF FINANCIAL POSITION See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES STATEMENT OF CASH FLOWS See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION -- The consolidated financial statements represent a consolidation of GE Capital Services and all majority-owned and controlled affiliates ("consolidated affiliates"), including General Electric Capital Corporation ("GE Capital"), Employers Reinsurance Corporation ("Employers Reinsurance") and Kidder, Peabody Group Inc. ("Kidder, Peabody"). GE Capital Services owns all of the common stock of GE Capital, Employers Reinsurance and Kidder, Peabody. All significant transactions among the parent and consolidated affiliates have been eliminated. Other affiliates in which the Corporation owns 20 percent to 50 percent of the voting rights ("nonconsolidated affiliates") are included in other assets, valued at the appropriate share of equity plus loans and advances. CASH FLOWS -- For purposes of the Statement of Cash Flows, certificates and other time deposits are treated as cash equivalents. METHODS OF RECORDING EARNED INCOME -- Income on all loans is recognized on the interest method. Accrual of interest income is suspended when collection of an account becomes doubtful, generally after the account becomes 90 days delinquent. Financing lease income, which includes related investment tax credits and residual values, is recorded on the interest method so as to produce a level yield on funds not yet recovered. Unguaranteed residual values included in lease income are based principally on independent appraisals of the values of leased assets remaining at expiration of the lease terms. Operating lease income is recognized on a straight-line basis over the term of the underlying leases. Origination, commitment and other nonrefundable fees related to fundings are deferred and recorded in earned income on the interest method. Commitment fees related to loans not expected to be funded and line-of-credit fees are deferred and recorded in earned income on a straight-line basis over the period to which the fees relate. Syndication fees are recorded in earned income at the time the related services are performed unless significant contingencies exist. Kidder, Peabody's proprietary securities and commodities transactions, unrealized gains and losses on open contractual commitments (principally financial futures), forward contracts on U.S. government and federal agency securities, and when-issued securities are recorded on a trade-date basis. Customer transactions and related revenues and expenses, investment banking revenues from management fees, sales concessions and underwriting fees are recorded on a settlement-date basis. Advisory fees are recorded as revenues when services are substantially completed and the revenue is reasonably determinable. See "Insurance and Annuity Businesses" below for information with respect to earned income of these businesses. ALLOWANCE FOR LOSSES ON FINANCING RECEIVABLES AND INVESTMENTS -- The Corporation maintains an allowance for losses on financing receivables at an amount which it believes is sufficient to provide adequate protection against future losses in the portfolio. For small-balance receivables the allowance for losses is determined principally on the basis of actual experience during the preceding three years. Further allowances are also provided to reflect management's judgment of additional loss potential. For other receivables, principally the larger loans and leases, the allowance for losses is determined primarily on the basis of management's judgment of net loss potential, including specific allowances for known troubled accounts. All accounts or portions thereof deemed to be uncollectible or to require an excessive collection cost are written off to the allowance for losses. Small-balance accounts are progressively written down (from 10% when more than three months delinquent to 100% when nine to twelve months delinquent) to record the balances at estimated realizable value. However, if at any time during that period an account is judged to be uncollectible, such as in the case of a bankruptcy, the uncollectible balance is written off. Larger-balance accounts are reviewed at least quarterly, and those accounts which are more than three months delinquent are written down, if necessary, to record the balances at estimated realizable value. When collateral is formally or substantively repossessed in satisfaction of a loan, the receivable is written down against the allowance for losses to estimated fair value and is transferred to other assets. Subsequent to such transfer, these assets are carried at the lower of cost or estimated current fair value. This accounting has been employed principally for highly leveraged transactions (HLT) and real estate loans. INCOME TAXES -- Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," was adopted effective January 1, 1992. The effect of adopting SFAS No. 109 was not material. Deferred tax balances are stated at tax rates expected to be in effect when taxes are actually paid or recovered. INVESTMENT AND TRADING SECURITIES -- On December 31, 1993, the Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires that investments in debt securities and marketable equity securities be designated as trading, held-to-maturity or available-for-sale. Trading securities are reported at fair value, with changes in fair value included in earnings. Investment securities include both available-for-sale and held-to-maturity securities. Available-for-sale securities are reported at fair value, with net unrealized gains and losses included in equity. Held-to-maturity debt securities are reported at amortized cost. See notes 3 and 4 for a discussion of the classification and reporting of these securities at December 31, 1992. For all investment securities, unrealized losses that are other than temporary are recognized in earnings. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL (REVERSE REPURCHASE AGREEMENTS) AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE (REPURCHASE AGREEMENTS) -- Such items are treated as financing transactions and are carried at the contract amount at which the securities subsequently will be resold or reacquired. Repurchase agreements relate either to marketable securities, which are carried at market value, or to securities obtained pursuant to reverse repurchase agreements. It is the Corporation's policy to take possession of securities that are subject to reverse repurchase agreements. The Corporation monitors the market value of the underlying securities in relation to the related receivable, including accrued interest, and requests additional collateral when appropriate. EQUIPMENT ON OPERATING LEASES -- Equipment is amortized, principally on a straight-line basis, to estimated net salvage value over the lease term or the estimated economic life of the equipment. BUILDINGS AND EQUIPMENT -- The Corporation records depreciation on a sum-of-the-years' digits basis or a straight-line basis over the lives of the assets. OTHER ASSETS -- Goodwill is amortized on a straight-line basis over periods not exceeding 30 years. FOREIGN OPERATIONS -- Assets and liabilities of foreign affiliates are translated into U.S. dollars at the year-end exchange rates while operating results are translated at rates prevailing during the year. Such adjustments are accumulated and reported as a separate component of equity. INSURANCE AND ANNUITY BUSINESSES -- Premiums on short-duration insurance contracts are reported as earned income over the terms of the related reinsurance treaties or insurance policies. In general, earned premiums are calculated on a pro-rata basis or are determined based on reports received from reinsureds. Premium adjustments under retrospectively rated assumed reinsurance contracts are recorded based on estimated losses and loss expenses, including both case and incurred-but-not-reported reserves. Premiums on long-duration insurance products are recognized as earned when due. Premiums received under annuity contracts are not reported as revenues but as annuity benefits -- a liability -- and are adjusted according to the terms of the respective policies. The estimated liability for insurance losses and loss expenses consist of both case and incurred-but-not-reported reserves. Where experience is not sufficient, industry averages are used. Estimated amounts of salvage and subrogation recoverable on paid and unpaid losses are deducted from outstanding losses. The liability for future policyholder benefits of the life insurance affiliates has been computed mainly by a net-level-premium method based on assumptions for investment yields, mortality and terminations that were appropriate at date of purchase or at the time the policies were developed, including provisions for adverse deviations. Deferred insurance acquisition costs for the property and casualty businesses are amortized pro-rata over the contract periods in which the related premiums are earned. For the life insurance business, these costs are amortized over the premium-paying periods of the contracts in proportion either to anticipated premium income or to gross profit, as appropriate. For certain annuity contracts, such costs are amortized on the basis of anticipated gross profits. For other lines of business, acquisition costs are amortized over the life of the related insurance contracts. Deferred insurance acquisition costs are reviewed for recoverability; for short-duration contracts, anticipated investment income is considered in making recoverability evaluations. NOTE 2. ACQUISITIONS The Corporation has acquired two individually non-significant entities (collectively "the Acquisitions"). The acquisition of GNA Corporation ("GNA") from Weyerhaeuser Company and Weyerhaeuser Financial Services, Inc. occurred on April 1, 1993, while the acquisition of United Pacific Life Insurance Company ("UPL") from Reliance Insurance Company and its parent company, Reliance Group Holdings, Inc. occurred on July 14, 1993. The acquisitions, accounted for as purchases, have been reflected in the accompanying consolidated financial statements of the Corporation since the respective acquisition dates. The acquired companies had assets of approximately $12.8 billion, principally investment securities. The aggregate estimated purchase price was $1,113 million and is subject to certain post-closing adjustments. Unaudited pro forma condensed results of operations of the Corporation for each of the years ended December 31, 1993 and 1992 as if the Acquisitions had occurred on January 1, 1993 and January 1, 1992, respectively, are as follows: The pro forma data have been prepared based on assumptions management deems appropriate and the results are not necessarily indicative of those that might have occurred had the transactions become effective at the beginning of the respective years, primarily due to changes in investment and other business strategies of the acquired companies. The aggregate effect of several other business acquisitions completed during 1993 was not material. NOTE 3. TRADING SECURITIES AND SECURITIES SOLD BUT NOT YET PURCHASED Trading securities are shown in the following table as of December 31, 1993 and 1992: The balance of trading securities at December 31, 1992, included investments in equity securities held by insurance affiliates at a fair value of $1,505 million, with unrealized pretax gains of $94 million (net of unrealized pretax losses of $37 million) included in equity. At December 31, 1993, equity securities held by insurance affiliates were classified as investment securities (see note 4). A significant portion of the Corporation's trading securities at December 31, 1993, was pledged as collateral for bank loans and repurchase agreements in connection with securities broker-dealer operations. Market value of securities sold but not yet purchased at December 31, 1993 and 1992 are shown in the following table: NOTE 4. INVESTMENT SECURITIES At December 31, 1993, investment securities were classified as available-for-sale and reported at fair value, including net unrealized gains of $1,261 million before taxes. At December 31, 1992, investment securities of $9,033 million were classified as available-for-sale and were reported at the lower of aggregate amortized cost or fair value. The balance of the 1992 investment securities portfolio was carried at amortized cost. A summary of investment securities follows. - --------------- (a) December 31, 1992 amounts include gross unrealized gains and losses of $32 million and $5 million, respectively, on investment securities carried at amortized cost. Contractual maturities of debt securities, other than mortgage-backed securities, at December 31, 1993, are shown below. It is expected that actual maturities will differ from contractual maturities because some borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Proceeds from sales of debt securities in 1993, 1992 and 1991 amounted to $6,112 million, $3,514 million and $2,814 million, respectively; gross realized gains were $173 million, $171 million and $106 million, respectively, and realized losses were $34 million, $4 million and $9 million, respectively. NOTE 5. FINANCING RECEIVABLES Financing receivables at December 31, 1993 and 1992 by principal category are shown below. Financing receivables classified as time sales and loans represent transactions with customers in a variety of forms, including time sales, revolving charge and credit, mortgages, installment loans, intermediate-term loans and revolving loans secured by business assets. The portfolio includes time sales and loans carried at the principal amount on which finance charges are billed periodically, and time sales and loans acquired on a discount basis carried at gross book value, which includes finance charges. At year-ends 1993 and 1992 commercial and industrial loans included $3,293 million and $5,262 million, respectively, for highly leveraged transactions. Note 8 contains information on commercial airline loans and leases. The financing lease operations consist of direct financing and leveraged leases of aircraft, railroad rolling stock, automobiles and other transportation equipment, data processing equipment, medical equipment, and other manufacturing, power generation, mining and commercial equipment and facilities. As the sole owner of assets under direct financing leases and as the equity participant in leveraged leases, the Corporation is taxed on total lease payments received and is entitled to tax deductions based on the cost of leased assets and tax deductions for interest paid to third-party participants. The Corporation is also entitled generally to any investment tax credit on leased equipment and to any residual value of leased assets. Investments in direct financing and leveraged leases represent unpaid rentals and estimated unguaranteed residual values of leased equipment, less related deferred income. Because the Corporation has no general obligation on notes and other instruments representing third-party participation related to leveraged leases, such notes and other instruments have not been included in liabilities but have been offset against the related rentals receivable. The Corporation's share of rentals receivable is subordinate to the share of the other participants who also have a security interest in the leased equipment. The Corporation's investment in financing leases at December 31, 1993 and 1992 is shown below. - --------------- (a) Total financing lease deferred income is net of deferred initial direct costs of $83 million and $73 million for 1993 and 1992, respectively. At December 31, 1993, contractual maturities for time sales and loans over the next five years and after are: $16,287 million in 1994; $6,286 million in 1995; $4,350 million in 1996; $4,104 million in 1997; $3,112 million in 1998; and $7,683 million in 1999 and later -- aggregating $41,822 million. At December 31, 1993, contractual maturities for finance lease rentals receivable over the next five years and after are: $6,417 million in 1994; $5,426 million in 1995; $3,919 million in 1996; $2,570 million in 1997; $1,720 million in 1998; and $9,630 million in 1999 and later -- aggregating $29,682 million. Experience of the Corporation has shown that a portion of receivables will be paid prior to contractual maturity. Accordingly, the contractual maturities of time sales and loans and of rentals receivable shown above are not to be regarded as forecasts of future cash collections. GE Capital 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. These financial instruments include financial guarantees and letters of credit. GE Capital's exposure to credit loss in the event of nonperformance by the other party to financial guarantees is represented by the contractual amount of those instruments. GE Capital uses the same credit policies and the same collateral requirements in making commitments and conditional obligations as it does for financing transactions. In addition, GE Capital is involved with sales of receivables for which it is contingently liable for credit losses for a percentage of the initial face amount sold. At December 31, 1993 and 1992, the aggregate amount of such financial guarantees were $1,863 million and $1,693 million, respectively, excluding those related to commercial aircraft (see note 8). In connection with the sales of financing receivables, GE Capital received proceeds of $1,105 million in 1993, $1,097 million in 1992 and $2,316 million in 1991. At December 31, 1993 and 1992, $3,045 million and $3,473 million, respectively, of such receivables were outstanding. Under arrangements with customers, GE Capital had committed to lend funds of $2,131 million and $1,794 million at December 31, 1993 and 1992, respectively, excluding those related to commercial aircraft (see note 8). Additionally, at December 31, 1993 and 1992, GE Capital was conditionally obligated to advance $2,244 million and $2,236 million, respectively, principally under performance-based standby lending commitments. GE Capital also was obligated for $2,946 million and $2,147 million at year-ends 1993 and 1992, respectively, under standby liquidity facilities related to third-party commercial paper programs, although management believes that the prospects of being required to fund under such standby facilities are remote. Note 12 discusses financial guarantees of insurance affiliates. Non-earning consumer time sales and loans, primarily private-label credit card receivables, amounted to $391 million and $444 million at December 31, 1993 and 1992, respectively. A majority of these receivables was subject to various loss-sharing arrangements that provide full or partial recourse to the originating private-label entity. Non-earning and reduced earning receivables other than consumer time sales and loans were $509 million and $934 million at year-ends 1993 and 1992, respectively. Earnings of $11 million and $30 million realized in 1993 and 1992, respectively, were $41 million and $75 million lower than would have been reported had these receivables earned income in accordance with their original terms. Additional information regarding financing receivables is included in Management's Discussion of the Corporation's Portfolio Quality on Page 6. NOTE 6. ALLOWANCE FOR LOSSES ON FINANCING RECEIVABLES The allowance for losses on financing receivables represented 2.63% of total financing receivables at both year-ends 1993 and 1992. The table below shows the activity in the allowance for losses on financing receivables during 1991 through 1993: Amounts written off in 1993 were approximately 1.46% of average financing receivables outstanding during the year, compared with 1.58% and 1.87% of average financing receivables outstanding during 1992 and 1991, respectively. NOTE 7. BROKER -- DEALER POSITIONS Other receivables and accounts payable include amounts receivable from and payable to brokers and dealers in connection with Kidder, Peabody's normal trading, lending and borrowing of securities. At December 31, 1993 and 1992, amounts consisted of the following: Kidder, Peabody, in conducting its normal operations, invests in a wide variety of financial instruments in order to balance its investment positions. Management believes that the most meaningful measure of these positions for a broker-dealer is market value, the value at which the positions are presented in the Statement of Financial Position in accordance with securities industry practices. The following required supplemental disclosures are indicators of the nature and extent of broker-dealer positions and are not intended to portray the much smaller credit or economic risk. At December 31, 1993, open commitments to sell mortgage-backed securities amounted to $18,539 million ($17,191 million in 1992); open commitments to purchase mortgage-backed securities amounted to $14,637 million ($13,131 million in 1992); interest rate swap agreements were open for interest on $4,084 million ($6,038 million in 1992); commitments amounting to $10,837 million ($6,711 million in 1992) were open under options written to cover price changes in securities; the face amount of open interest rate futures and forward contracts for currencies as well as money market and other instruments amounted to $30,506 million ($10,936 million in 1992); contracts establishing limits on counterparty exposure to interest rates were outstanding for interest on $1,610 million ($2,722 million in 1992); and firm underwriting commitments for the purchase of stock or debt amounted to $3,311 million ($4,094 million in 1992). At December 31, 1993 and 1992, Kidder, Peabody had obtained irrevocable letters of credit of $592 million and $314 million, respectively, from third parties, written in favor of clearing associations to satisfy margin requirements. Kidder, Peabody seeks to control the risks associated with its customer activities by requiring customers to maintain margin collateral in compliance with various regulations and internal policies. Kidder, Peabody monitors customer credit exposure and collateral values on a daily basis and requires additional collateral to be deposited with Kidder, Peabody or returned, when deemed necessary. NOTE 8. EQUIPMENT ON OPERATING LEASES Equipment on operating leases by type of equipment and accumulated amortization at December 31, 1993 and 1992 are shown in the following table: Amortization of equipment on operating leases was $1,395 million in 1993, $1,133 million in 1992 and $1,055 million in 1991. The Corporation acts as a lender and lessor to commercial enterprises in the airline industry; at December 31, 1993 and 1992, the aggregate amount of such loans, leases and equipment leased to others were $6,776 million and $5,978 million, respectively. In addition, the Corporation had issued financial guarantees and funding commitments of $450 million at December 31, 1993 ($645 million at year-end 1992) and had conditional commitments to purchase aircraft at a cost of $865 million. These purchase commitments are subject to the aircraft having been placed on lease under agreements, and with carriers, acceptable to the Corporation prior to delivery. Included in the Corporation's equipment leased to others at year-end 1993 is $244 million of commercial aircraft off-lease ($94 million in 1992). NOTE 9. BUILDINGS AND EQUIPMENT Buildings and equipment include office buildings, satellite communications equipment, data processing equipment, vehicles, furniture and office equipment used at the Corporation's offices throughout the world. Depreciation expense was $235 million for 1993, $202 million for 1992 and $170 million for 1991. NOTE 10. OTHER ASSETS Other assets at December 31, 1993 and 1992 are shown in the table below. Accumulated amortization of goodwill and other intangibles was $496 million and $382 million, respectively, at December 31, 1993 and $415 million and $231 million, respectively, at December 31, 1992. Miscellaneous investments included $75 million and $275 million at December 31, 1993 and 1992, respectively, of in-substance repossessions at the lower of cost or estimated fair value previously included in financing receivables. Investments in and advances to nonconsolidated affiliates include advances of $1,159 million and $687 million at December 31, 1993 and 1992, respectively. The Corporation's mortgage servicing activities include the purchase and resale of mortgages. At December 31, 1993 and 1992, it had open commitments to purchase mortgages totaling $5,935 million and $2,963 million, respectively. Additionally, the Corporation had open commitments to sell mortgages totalling $6,426 million and $1,777 million, at year-ends 1993 and 1992, respectively. At December 31, 1993 and 1992, mortgages sold with full or partial recourse to the Corporation aggregated $2,526 million and $3,876 million, respectively. NOTE 11. NOTES PAYABLE Notes payable at December 31, 1993 totaled $85,888 million, consisting of $85,129 million of senior debt and $759 million of subordinated debt. The composite interest rate for the Corporation's finance activities during 1993 was 4.96% compared with 5.78% for 1992 and 7.46% for 1991. Total short-term notes payable at December 31, 1993 and 1992 consisted of the following: The average daily balance of short-term debt, excluding the current portion of long-term debt, during 1993 was $47,357 million compared with $43,817 million for 1992 and $40,513 million for 1991. The December 31, 1993 balance of $60,003 million was the maximum balance during 1993. The December 31, 1992 balance of $53,183 million was the maximum balance during 1992. The December 27, 1991 balance of $49,604 million was the maximum balance during 1991. The average short-term interest rate, excluding the current portion of long-term debt, for the year 1993 was 3.29%, representing short-term interest expense divided by the average daily balance, compared with 3.93% for 1992 and 6.36% for 1991. On December 31, 1993, 1992 and 1991, average interest rates were 3.59%, 4.20% and 5.20%, respectively, for bank borrowings, 3.39%, 3.57% and 5.12%, respectively, for commercial paper, and 3.10%, 3.54% and 4.90%, respectively, for notes with trust departments of banks. Outstanding balances in notes payable after one year at December 31, 1993 and 1992 are as follows. - --------------- (a) At December 31, 1993 and 1992, the Corporation had agreed to exchange currencies and related interest payments on principal amounts equivalent to U.S. $8,101 million and $6,499 million, respectively. At December 31, 1993 and 1992, the Corporation also had entered into interest rate swaps related to interest on $13,224 million and $8,549 million, respectively. To minimize borrowing costs, the Corporation has entered into multiple currency and interest rate agreements for certain notes. (b) At December 31, 1993 and 1992, counterparties held options under which the Corporation can be caused to execute interest rate swaps associated with interest payments through 1999 on $500 million and $625 million, respectively. (c) The Corporation will reset interest rates at the end of the initial and each subsequent interest period. At each interest rate-reset date, the Corporation may redeem notes in whole or in part at its option. Current interest periods range from March 1994 to May 1996. (d) The rate of interest payable on each note is a variable rate based on the commercial paper rate each month. Interest is payable, at the option of the Corporation, either monthly or semiannually. (e) At December 31, 1993 and 1992, subordinated notes in the amount of $700 million principal were guaranteed by GE Company. Long-term borrowing maturities during the next five years, including the current portion of notes payable after one year, are: 1994 -- $6,421 million; 1995 -- $6,204 million; 1996 -- $4,868 million; 1997 -- $2,971 million; and 1998 -- $3,566 million. At December 31, 1993 GE Capital had committed lines of credit aggregating $19,045 million with 134 banks, including $6,005 million of revolving credit agreements with 69 banks pursuant to which GE Capital has the right to borrow funds for periods exceeding one year. A total of $4,627 million of these lines were also available for use by GE Capital Services. In addition, at December 31, 1993, approximately $105 million of committed lines of credit were directly available to a foreign affiliate of GE Capital. Also, at December 31, 1993, approximately $3,045 million of GE Company's credit lines were available for use by GE Capital or the Corporation. During 1993 the Corporation did not borrow under any of these credit lines. At December 31, 1993 Kidder, Peabody had established lines of credit aggregating $6,058 million of which $3,110 million was available on an unsecured basis. Borrowings from banks were primarily unsecured demand obligations, at interest rates approximating broker call loan rates, to finance inventories of securities and to facilitate the securities settlement process. The Corporation compensates banks for credit facilities in the form of fees which were immaterial for the past three years. NOTE 12. INSURANCE RESERVES AND ANNUITY BENEFITS The Corporation adopted SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," during 1993. The principal effect of this Statement was to report reinsurance receivables and prepaid reinsurance premiums, a total of $1,818 million at December 31, 1993, as assets. Such amounts were reported as reductions of insurance reserves at the end of 1992. Insurance reserves and annuity benefits represents policyholders' benefits, unearned premiums and provisions for policy losses and benefits relating to insurance and annuity businesses. The related balances at December 31, 1993 and 1992 are as follows: Financial guarantees, principally FGIC's guarantees on municipal bonds and structured debt issues, amounted to approximately $101.4 billion and $81.3 billion at year-end 1993 and 1992, respectively, before reinsurance of $17.3 billion and $13.7 billion, respectively. Related unearned premiums amounted to $803 million and $571 million at December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, reserves for losses and loss adjustment expenses were $96 million and $40 million, respectively. The Corporation's mortgage insurance operations underwrite residential mortgage guarantee insurance. Total risk in force aggregated $27.0 billion and $21.3 billion at December 31, 1993 and 1992, respectively; related unearned premiums amounted to $276 million at December 31, 1993 and $236 million at December 31, 1992. Case basis loss reserves and loss adjustment expense reserves are provided in an amount sufficient to pay all estimated losses in the portfolio, including those incurred but not reported. As of December 31, 1993 and 1992, reserves for losses and loss adjustment expenses were $511 million and $372 million, respectively. Interest rates credited to annuity contracts in 1993 ranged from 3.7% to 9.7%. For most annuities, interest rates to be credited are redetermined by management on an annual basis. The Corporation's Specialty Insurance businesses are involved significantly in the reinsurance business, ceding reinsurance on both a pro-rata and an excess basis. The maximum amount of individual life insurance retained on any one life is $740,000. When the Corporation cedes business to third parties, it is not relieved of its primary obligation to policyholders and reinsureds. Consequently, the Corporation establishes allowances for amounts deemed uncollectible due to the failure of reinsurers to honor their obligations. The Corporation monitors both the financial condition of individual reinsurers and risk concentrations arising from similar geographic regions, activities and economic characteristics of reinsurers. The effects of reinsurance on premiums written and earned during 1993, 1992 and 1991 were as follows: Reinsurance recoveries recognized as a reduction of insurance losses and policyholder and annuity benefits amounted to $304 million, $525 million and $478 million for the periods ended December 31, 1993, 1992 and 1991, respectively. NOTE 13. EQUITY CAPITAL Equity capital is owned entirely by GE Company. Cash dividends paid were $610 million in 1993 and $500 million in 1992 and $350 million in 1991. In 1992, GE Company contributed to the Corporation the assets of GE Computer Services and the minority interest in Financial Insurance Group. These contributions were reflected as a $155 million ($134 million and $21 million, respectively) addition to the Corporation's additional paid-in capital. Total GE Capital Services preferred stock at both December 31, 1993 and 1992 was $510 million. In the accompanying financial statements, such preferred shares are shown as issued to and held by consolidated affiliates. At December 31, 1993 and 1992, the statutory capital and surplus of the Corporation's insurance affiliates totaled $4,829 million and $3,416 million, respectively; amounts available for the payment of dividends without the approval of the insurance regulators totaled $382 million and $322 million, respectively. As a securities broker-dealer, Kidder, Peabody is required to maintain a minimum net capital level by the Securities and Exchange Commission. At December 31, 1993, Kidder, Peabody had net capital of $625 million, $583 million in excess of the minimum net capital requirement. Other equity at December 31, 1993 and 1992 consisted of: NOTE 14. MINORITY INTEREST IN EQUITY OF CONSOLIDATED AFFILIATES Minority interest in equity of consolidated affiliates includes 8,750 shares of $100 par value variable cumulative preferred stock issued by GE Capital with a liquidation preference value of $875 million. Dividend rates on this preferred stock ranged from 2.33% to 2.79% during 1993 and from 2.44% to 3.49% during 1992. NOTE 15. EARNED INCOME Included in earned income from financing leases were gains on the sale of equipment at lease completion of $145 million in 1993, $126 million in 1992 and $147 million in 1991. Noncancelable future rentals due from customers for equipment on operating leases as of December 31, 1993 totaled $6,133 million and are due as follows: 1994, $2,036 million; 1995, $1,455 million; 1996, $879 million; 1997, $458 million; 1998, $316 million and $989 million thereafter. Amortization of deferred investment tax credit was $29 million, $26 million and $25 million in 1993, 1992 and 1991, respectively. Time sales, loan and investment and other income includes the Corporation's share of earnings from equity investees of $106 million, $72 million and $84 million for 1993, 1992 and 1991, respectively. NOTE 16. INTEREST AND DISCOUNT EXPENSES Interest and discount expenses reported in the Statement of Current and Retained Earnings are net of interest income on temporary investments of excess funds of $42 million for 1993, $48 million for 1992, and $54 million for 1991, and net of capitalized interest of $5 million for 1993, $6 million for 1992 and $8 million for 1991. For purposes of computing the ratio of earnings to fixed charges (the "ratio") in accordance with applicable Securities and Exchange Commission instructions, earnings consist of net earnings adjusted for cumulative effect of change in accounting principle, the provision for income taxes, minority interest and fixed charges. Fixed charges consist of interest on all indebtedness and one-third of annual rentals, which the Corporation believes is a reasonable approximation of the interest factor of such rentals. The ratio was 1.42 for 1993, compared with 1.33 for 1992 and 1.25 for 1991. NOTE 17. OPERATING AND ADMINISTRATIVE EXPENSES Employees and retirees of the Corporation and its affiliates are covered under a number of pension, health and life insurance plans. The principal pension plan is the GE Company pension plan, a defined benefit plan, while employees of certain affiliates, including Employers Reinsurance and Kidder, Peabody, are covered under separate plans. The Corporation provides health and life insurance benefits to certain of its retired employees, principally through GE Company's benefit program, as well as through plans sponsored by Employers Reinsurance and Kidder, Peabody and other affiliates. The annual cost to the Corporation of providing these benefits is not material and the net transition obligation arising from the 1991 adoption of the new accounting standard, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension," was not separately determinable, except for the Employers Reinsurance and Kidder, Peabody plans, where the charge to operations aggregated $19 million after a deferred tax benefit of $12 million. GE Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," in the second quarter of 1993. The Corporation adopted this standard in conjunction with its parent. This Statement requires that employers expense the costs of postemployment benefits (as distinct from postretirement pension, medical and life insurance benefits) over the working lives of their employees. This change principally affects the Corporation's accounting for severance benefits, which previously were expensed when the severance event occurred. The net transition obligation related to the Corporation's employees covered under GE Company postemployment benefit plans is not separately determinable from the GE Company plans as a whole; accordingly, there is no financial statement impact on the Corporation. The net transition obligation for employees covered under separate plans is not material. Rental expense for 1993 aggregating $498 million, compared with $331 million for 1992 and $169 million for 1991, was principally for the rental of office space, data processing equipment and railcars. Minimum future rental commitments under noncancelable leases are: 1994, $404 million; 1995, $364 million; 1996, $340 million; 1997, $319 million; 1998, $296 million and $1,856 million thereafter. The Corporation, as a lessee, has no material lease agreements classified as capital leases. Amortization of deferred insurance acquisition costs charged to operations in 1993, 1992 and 1991 was $817 million, $624 million and $377 million, respectively. NOTE 18. INCOME TAXES Income tax provision from operations is summarized in the following table: GE Company files a consolidated Federal income tax return which includes GE Capital Services. The provisions for estimated taxes payable (recoverable) include the effect of the Corporation and its affiliates on the consolidated tax. Estimated income taxes payable were $144 million and $73 million at December 31, 1993 and 1992, respectively. A reconciliation of the Corporation's actual income tax rate to the U.S. Federal statutory rate is shown in the following table: The tax effects of principal temporary differences are shown in the following table: NOTE 19. INDUSTRY SEGMENT DATA Industry segment operating data and identifiable assets for the years 1993, 1992 and 1991 are shown below. Corporate level expenses principally include interest expense related to acquisition debt. NOTE 20. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: NOTE 21. RESTRICTED NET ASSETS OF AFFILIATES Various state and foreign regulations require that the Corporation's investment in certain affiliates, without regard to net unrealized after-tax gains on investment securities which were $663 million at December 31, 1993, be maintained at specified minimum levels to provide additional protection for insurance customers, investment certificate holders and passbook savings depositors. At December 31, 1993, such minimum investment levels aggregated approximately $5,700 million. NOTE 22. SUPPLEMENTAL CASH FLOW INFORMATION Cash used or provided in 1993, 1992 and 1991 included interest paid by the Corporation of $6,216 million, $5,907 million and $6,384 million, respectively and income taxes (paid) recovered by the Corporation of $(189) million, $(97) million and $99 million, respectively. NOTE 23. FAIR VALUES OF FINANCIAL INSTRUMENTS As required under generally accepted accounting principles, financial instruments are presented in the accompanying financial statements -- generally at either cost or fair value, based on both the characteristics of and management intentions regarding the instruments. Management believes that the financial statement presentation is the most useful for displaying the Corporation's results. However, SFAS No. 107, "Disclosure About Fair Value of Financial Instruments," requires disclosure of an estimate of the fair value of certain financial instruments. These disclosures disregard management intentions regarding the instruments, and therefore, management believes that this information may be of limited usefulness. Apart from the Corporation's own borrowings, certain marketable securities and financial instruments of Kidder, Peabody, relatively few of the Corporation's financial instruments are actively traded. Thus, fair values must often be determined by using one or more models that indicate value based on estimates of quantifiable characteristics as of a particular date. Because this undertaking is, by nature, difficult and highly judgmental, for a limited number of instruments, alternative valuation techniques indicate values sufficiently diverse that the only practicable disclosure is a range of values. Users of the following data are cautioned that limitations in the estimation techniques may have produced disclosed values different from those that could have been realized at December 31, 1993 or 1992. Moreover, the disclosed values are representative of fair values only as of the dates indicated, inasmuch as interest rates, performance of the economy, tax policies and other variables significantly impact fair valuations. Cash and equivalents, trading securities, reverse repurchase agreements, repurchase agreements and other receivables have been excluded as their carrying amounts and fair values are the same, or approximately the same. Values were estimated as follows: INVESTMENT SECURITIES. Based on quoted market prices or dealer quotes for actively traded securities. Value of other such securities was estimated using quoted market prices for similar securities. TIME SALES, LOANS AND RELATED PARTICIPATIONS. Based on quoted market prices, recent transactions, market comparables and/or discounted future cash flows, using rates at which similar loans would have been made to similar borrowers. INVESTMENTS IN AND ADVANCES TO NON-CONSOLIDATED AFFILIATES. Based on market comparables, recent transactions and/or discounted future cash flows. These equity interests were generally acquired in connection with financing transactions and, for purposes of this disclosure, fair values were estimated. OTHER FINANCIAL INSTRUMENTS. Based on recent comparable transactions, market comparables, discounted future cash flows, quoted market prices, and/or estimates of the cost to terminate or otherwise settle obligations to counterparties. BORROWINGS. Based on quoted market prices or market comparables. Fair values of interest rate and currency swaps on borrowings are based on quoted market prices and include the effects of counterparty creditworthiness. ANNUITY BENEFITS. Based on expected future cash flows, discounted at currently offered discount rates for immediate annuity contracts or cash surrender value for single premium deferred annuities. FINANCIAL GUARANTIES OF INSURANCE AFFILIATES. Based on future cash flows, considering expected renewal premiums, claims, refunds and servicing costs, discounted at a market rate. The carrying amounts and estimated fair values of the Corporation's financial instruments at December 31, 1993 and 1992 are as follows: - --------------- (a) Swap contracts are integral to the Corporation's goal of achieving the lowest borrowing costs for particular funding strategies. The above fair values of borrowings include fair values of associated interest rate and currency swaps. At December 31, 1993, the approximate settlement values of the Corporation's swaps were $340 million. Without such swaps, estimated fair values of the Corporation's borrowings would have been $86,680 million. Approximately 90% of the notional amount of swaps outstanding at December 31, 1993, was with counterparties having credit ratings of Aa/AA or better. (b) Proceeds from borrowings are invested in a variety of activities, including both financial instruments, shown in the preceding table, as well as leases, for which fair value disclosures are not required. When evaluating the extent to which estimated fair value of borrowings exceeds the related carrying amount, users should consider that the fair value of the fixed payment stream for long-term leases would increase as well. NOTE 24. GEOGRAPHIC SEGMENT INFORMATION Geographic segment operating data and total assets for the years 1993, 1992, and 1991 are as follows: U.S. amounts were derived from the Corporation's operations located in the U.S. The Corporation manages its exposure to currency movements by committing to future exchanges of currencies at specified prices and dates. Commitments outstanding at December 31, 1993 and 1992, were $1,833 million and $2,084 million, respectively, excluding Kidder, Peabody. 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. 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) 1. FINANCIAL STATEMENTS Included in Part II of this report: Independent Auditors' Report Statement of Current and Retained Earnings for each of the years in the three-year period ended December 31, 1993 Statement of Financial Position at December 31, 1993 and 1992 Statement of Cash Flows for each of the years in the three-year period ended December 31, 1993 Notes to Financial Statements (a) 2. FINANCIAL STATEMENT SCHEDULES III. Condensed financial information of registrant. All other schedules are omitted because of the absence of conditions under which they are required or because the required information is shown in the financial statements or notes thereto. (a) 3. EXHIBIT INDEX The exhibits listed below, as part of Form 10-K, are numbered in conformity with the numbering used in Item 601 of Regulation S-K of the Securities and Exchange Commission. EXHIBIT NUMBER DESCRIPTION 3 (i) A complete copy of the Certificate of Incorporation of the Corporation as last amended on February 10, 1993 and currently in effect. 3 (ii) A complete copy of the By-Laws of the Corporation as last amended on January 4, 1994 and currently in effect. 4 (iii) Agreement to furnish to the Securities and Exchange Commission upon request a copy of instruments defining the rights of holders of certain long-term debt of the registrant and all subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. 12 Computation of ratio of earnings to fixed charges. 23(ii) Consent of KPMG Peat Marwick. 24 Power of Attorney 99 Income Maintenance Agreement dated March 28, 1991 be- tween General Electric Company and General Electric Capital Corporation. (Incorporated by reference to Exhibit 28 of the Corporation's Form 10-K Report for the year ended December 31, 1992). (b) REPORTS ON FORM 8-K None. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT GENERAL ELECTRIC CAPITAL SERVICES, INC. CONDENSED STATEMENT OF FINANCIAL POSITION See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONTINUED) GENERAL ELECTRIC CAPITAL SERVICES, INC. CONDENSED STATEMENT OF CURRENT AND RETAINED EARNINGS See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONTINUED) GENERAL ELECTRIC CAPITAL SERVICES, INC. CONDENSED STATEMENT OF CASH FLOWS See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONCLUDED) GENERAL ELECTRIC CAPITAL SERVICES, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS INCOME TAX BENEFIT GE Company files a consolidated Federal income tax return which includes GE Capital Services. Income tax benefit includes the effect of the Corporation on the consolidated income tax. DIVIDENDS FROM AFFILIATES In 1993 and 1992, GE Capital Services received dividends of $150 million and $200 million, respectively, from Employers Reinsurance and $460 million and $300 million, respectively, from GE Capital. EXHIBIT 4(iii) March 22, 1994 Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Subject: General Electric Capital Services, Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 1993 -- File No. 0-14804 Dear Sirs: Neither General Electric Capital Services, Inc. (the "Corporation") nor any of its subsidiaries has outstanding any instrument with respect to its long-term debt under which the total amount of securities authorized exceeds 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. In accordance with paragraph (b)(4)(iii) of Item 601 of Regulation S-K (17 CFR sec. 229.601), the Corporation hereby agrees to furnish to the Securities and Exchange Commission, upon request, a copy of each instrument which defines the rights of holders of such long-term debt. Very truly yours, GENERAL ELECTRIC CAPITAL SERVICES, INC. By: /s/ J. A. PARKE --------------------------------------- J. A. Parke, Senior Vice President, Finance EXHIBIT 12 GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES EXHIBIT 23(ii) To the Board of Directors General Electric Capital Services, Inc. We consent to incorporation by reference in the Registration Statement on Form S-3 (No. 33-7348) of General Electric Capital Services, Inc. of our report dated February 11, 1994, relating to the statement of financial position of General Electric Capital Services, Inc. and consolidated affiliates as of December 31, 1993 and 1992 and the related statements of current and retained earnings and cash flows and related schedules for each of the years in the three-year period ended December 31, 1993, which report appears in the December 31, 1993 annual report on Form 10-K of General Electric Capital Services, Inc. Our report refers to a change in 1993 in the method of accounting for certain investments in securities. /s/ KPMG PEAT MARWICK Stamford, Connecticut March 23, 1994 EXHIBIT 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each of the undersigned, being directors and/or officers of General Electric Capital Services, Inc., a Delaware corporation (the "Corporation"), hereby constitutes and appoints Gary C. Wendt, James A. Parke, John P. Malfettone and Burton J. Kloster, Jr., and each of them, 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 one or more Annual Reports for the Corporation's fiscal year ended December 31, 1993, on Form 10-K under the Securities Exchange Act of 1934, as amended, or such other form as such attorney-in-fact may deem necessary or desirable, any amendments thereto, and all additional amendments thereto in such form as they or any one of them may approve, and to file the same with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, 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 to the end that such Annual Report or Annual Reports shall comply with the Securities Exchange Act of 1934, as amended, and the applicable Rules and Regulations of the Securities and Exchange Commission adopted or issued pursuant thereto, as fully and to all intents and purposes as he 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 substitute or resubstitute, may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, each of the undersigned has hereunto set his hand this 23rd day of March, 1994. /s/ GARY C. WENDT /s/ JAMES A. PARKE - ---------------------------------------- --------------------------------- Gary C. Wendt, James A. Parke, Chairman of the Board, Senior Vice President, Finance President and Chief Executive Officer (Principal Financial Officer) (Principal Executive Officer) /s/ JOHN P. MALFETTONE ---------------------------------- John P. Malfettone Vice President and Comptroller (Principal Accounting Officer) A MAJORITY OF THE BOARD OF DIRECTORS 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 ELECTRIC CAPITAL SERVICES, INC. March 23, 1994 By: /s/ GARY C. WENDT ------------------------------------------- (GARY C. WENDT) President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. A majority of the Board of Directors INDEX TO EXHIBITS

74783_1993.txt

74783_1993

1993

74783

ITEM 1. BUSINESS. The Company Acceptance Insurance Companies Inc. (the "Company") is a holding company engaged in the specialty property and casualty insurance business through its operating subsidiaries. At December 31, 1993, the Company had total assets of approximately $409 million and gross written premiums of approximately $256 million for the year then ended. The Company concentrates its efforts on insurance programs in which special underwriting, marketing or claims handling approaches give it a competitive advantage in underwriting particular risks and serving the needs of particular geographic regions or groups of insureds or particular insurance agents. Recent Developments Effective March 31, 1994, the Company entered into an Agreement and Plan of Merger with Statewide Insurance Corporation, the exclusive general agent for the Company's non- standard automobile insurance program underwritten by Phoenix Indemnity Insurance Company ("Phoenix Indemnity"), and the owner of 20% of the outstanding shares of common stock of Phoenix Indemnity, pursuant to which the Company will acquire by merger (the "Merger"), in consideration of shares of common stock, Statewide Insurance Corporation (except for certain assets and liabilities relating to its agency operations other than the non- standard automobile program, which will be divested prior to the Merger). Fiscal Year 1993 Developments On January 27, 1993, the Company completed a Rights Offering to its shareholders resulting in the issuance of 3,992,480 units, for a subscription price of $8.00 per unit, consisting of one share of common stock and one warrant for the purchase of one share of common stock exercisable at $11.00 per share until January 27, 1997, resulting in net proceeds of approximately $31.2 million. Proceeds were used to retire $9.5 million of Secured Subordinated Notes and to provide capital to the Company's insurance subsidiaries. See Note 2 to the Notes to Consolidated Financial Statements. Effective April 15, 1993, a $7 million secured subordinated note issued by a subsidiary of the Company was exchanged for 875,000 units identical to those issued in the Rights Offering. See Note 2 to the Notes to Consolidated Financial Statements. On August 13, 1993, the Company completed the acquisition of 100% of the outstanding common and preferred stock and common stock purchase warrants of The Redland Group, Inc. ("Redland"), a Council Bluffs, Iowa-based holding company engaged through its subsidiaries in the specialty property and casualty insurance business, concentrating on crop insurance coverages and other insurance products marketed to farmers and the rural community. The effective date of this acquisition was July 1, 1993, and the financial and other data set forth herein include the operations of Redland commencing July 1, 1993. See Note 3 to the Notes to Consolidated Financial Statements. Historical Development The Company was incorporated in 1968 in Ohio under the name National Fast Food Corp. In 1969, it was reincorporated in Delaware and thereafter operated under the names NFF Corp. (1971 to 1973), Orange-co, Inc. (1973 to 1987), Stoneridge Resources, Inc. (1987 to 1992), and Acceptance Insurance Companies Inc. from December 1992 until the present. In April 1990, the Company acquired Acceptance Insurance Holdings Inc. ("Acceptance"), a Nebraska corporation which owns as operating subsidiaries Acceptance Insurance Company, a Nebraska-domiciled insurance company; Acceptance Insurance Services, Inc. a Nebraska-domiciled licensed third-party administrator; Phoenix Indemnity, an Arizona-domiciled insurance company (80% owned); Acceptance Indemnity Insurance Company, a Nebraska-domiciled insurance company, and Seaboard Underwriters, Inc., a North Carolina specialty insurance managing general agency. See "Recent Developments" for a description of the Company's plans to acquire the remaining 20% of Phoenix Indemnity along with certain agency operations of Statewide Insurance Corporation, owner of 20% of Phoenix Indemnity. Effective July 1, 1993, the Company acquired Redland in an exchange of its common stock. Redland owns as operating subsidiaries Redland Insurance Company, an Iowa-domiciled insurance company; American Growers Insurance Company, a Nebraska-domiciled insurance company; American Agrisurance, Inc., an Iowa-domiciled marketer of crop insurance; Agro International, Inc., an Iowa-domiciled insurance consulting group (80% owned); American Agrijusters Co., an Iowa-domiciled provider of crop insurance adjusting services; U.S. Ag Insurance Services, Inc., a Texas-domiciled marketer of crop insurance (60% owned); and Crop Insurance Marketing, Inc., an Iowa-domiciled marketer of crop insurance. The insurance underwriting operations of both Acceptance and Redland commenced in 1979 with, as to Acceptance, the formation of Acceptance Insurance Company, and, as to Redland, the formation of Redland Insurance Company. Prior to becoming involved in the specialty property and casualty insurance business through the acquisitions described above, the Company had been actively engaged in the real estate business, principally in Florida, and in the citrus business in Florida. Insurance Programs The Company is a Nebraska-based specialty property and casualty insurance company concentrating on specialty insurance programs principally in the excess and surplus lines of business. The Company's insurance operations are conducted through its subsidiaries domiciled in Nebraska, Iowa, Texas, North Carolina and Arizona. The Company concentrates its efforts on insurance programs in which special underwriting, marketing or claims handling approaches give it a competitive advantage in underwriting a particular risk or serving the needs of a particular geographic region or group of insureds or particular insurance agents. The table below sets forth the amount of net written (net of reinsurance) and gross written premium, respectively, for the specialty insurance programs underwritten by the Company's insurance subsidiaries for the periods set forth below. The Company does not write environmental pollution coverages, specifically excludes environmental pollution risks in substantially all of its policies, and has not experienced any material exposure to environmental pollution claims. Specialty General Agent Programs. The Company offers a variety of specialty insurance coverages through its network of independent general agents. The Company attempts to select general agents who are experienced in specialty coverages written by the Company and can help screen risks written on behalf of the Company and to price the Company's lines of insurance adequately to guard against unanticipated risk exposure. The principal types of specialty insurance coverages written by the independent general agent network include: (1) specialty automobile lines (property and casualty coverages for high value automobiles, local haulers of specialized freight and other motor vehicle coverages not normally underwritten by standard carriers); (2) surplus lines liability and substandard property coverages for small businesses normally not actively sought out by larger insurers; (3) liquor liability or dram shop coverages for liquor stores and taverns and restaurants serving alcoholic beverages insuring against personal injuries and property damage caused by intoxicated persons served alcoholic beverages in insured facilities; (4) used car dealer and automobile repair shop property and casualty coverages; and (5) excess liability, including commercial umbrella policies (covering liability exposure in excess of underlying policies or self-insurance retention) and policies providing a layer of coverage in excess of limits provided by primary liability carriers. Non-Standard Automobile. The Company writes non-standard private passenger automobile coverages principally in the southwest United States and expects continued growth in written premiums from this line of business in future periods through geographic expansion. This program provides minimum coverages for drivers who do not qualify for standard or preferred treatment with standard line companies. Transportation Insurance. The Company's transportation coverages include property and casualty coverages written by Seaboard for long haul truckers, generally dry freight haulers, operating throughout the United States, and upper-midwest regional and national truck companies underwritten through the Redland agency network, principally for rural products, e.g., livestock, processed meat and grains. Acceptance Risk Managers, Inc. ("ARM"). ARM is an independent general agency which began operations in late 1991 specializing in underwriting difficult general liability risks, including products liability coverages, unique professional liability and excess liability coverages, on a surplus lines (non-admitted) basis. ARM currently writes business exclusively on behalf of the Company. The two founders of ARM have each been actively involved with these lines of business as insurance company executives for over 30 years. ARM operations are controlled both contractually and operationally to insure maintenance of proper underwriting standards. Contractually, officers of the Company comprise over 50% of the members of the board of directors of ARM, and the authority of ARM is limited to specific types of insurance detailed in reinsurance treaties written for this business unit. All claims are reported to the Company, and key policy and claims information is maintained in the Company's data base. Policy payments are deposited to a Company lock box account and all claims are funded individually by the Company into a Company controlled account. In addition, the Company requires weekly management reports from ARM. The Company and each of the four reinsurers participating in this business periodically audit the underwriting operations of ARM, and each has conducted at least two audits in the past twelve months. The reinsurers participating in this business are Constitution Reinsurance Corporation, ReCapital Reinsurance Corporation, Northstar Reinsurance Corporation and Christiana General Insurance Corporation, each of which is liable only for its own retention. Workers Compensation. The Company writes limited specialty workers' compensation insurance coverages principally in Minnesota. The Company's workers' compensation insurance program attempts to control losses through the application of stringent return to work claims management programs. Prior to April 1992, the return to work program was administered by an independent third party claims manager under an agreement which was terminated, as the workers' compensation program was not profitable because of the high expense ratios incurred with the third party claims manager. Redland Insurance Programs Multi-Peril Crop Insurance ("MPCI") and Hail Insurance. The written premium from MPCI and crop hail insurance represents the bulk of premium revenues for the Redland group of companies. MPCI insures a percentage (up to 75%) of the historic yield on growing crops against substantially all natural perils while crop hail insurance insures spot losses on growing crops resulting from hail storms. Rural Agents Programs. This program is designed to offer to the network of Redland agents (historically crop agents) standard basic property and casualty coverages (home, automobile and limited commercial coverages) underwritten by one of the Company's subsidiaries. The Company has found that larger insurance companies concentrate more on high volume agencies, and that many rural agencies experience difficulty in finding markets for their insureds. Specialty Lines. A variety of specialty insurance programs are offered by the Redland insurance companies through an independent agent network developed over a number of years by Redland management. These insurance programs include property and casualty coverages for race tracks, automobile repair shops, temporary help agencies and animal mortality coverages. The program also offers insurance covering damage from floods in rural areas covered by Redland general agents. Seaboard Underwriters, Inc. In October 1991, The Company acquired Seaboard, a North Carolina insurance agency acting as a general agent for insurance companies, including one or more of the Company's subsidiaries, specializing principally in the writing of property and casualty insurance coverages for long haul truckers. During the year ended December 31, 1993, Seaboard received commission income of $4,119,000, and incurred operating expenses of $3,794,000. Reinsurance The Company limits its exposure under individual policies by purchasing excess of loss and quota share reinsurance from other insurance companies, and it maintains catastrophe reinsurance to protect against catastrophic occurrences where claims can arise under several policies due to a single event. Reinsurance does not legally discharge the Company from its primary liability to the insured for the full amount of a claim, but it does make the reinsurer liable to the Company to the extent of the reinsured portion of any loss ultimately incurred. The Company retains the first $500,000 of risk under its casualty lines, ceding the next $2,500,000 to reinsurers. Under its property lines, the Company retains 25% of the first $500,000 of risk, ceding the other 75% to quota share reinsurers and the next $1,000,000 to other reinsurers. For workers' compensation lines the Company reinsures 50% of the first $230,000 of each risk, and 100% of any excess. The Company also maintains a separate 80% quota share treaty for business written through ARM. To the extent that individual policies in any line exceed reinsurance treaty limits, the Company purchases individual reinsurance on a facultative (specific policy) basis. The Company maintains catastrophe reinsurance for its casualty lines which provide coverages of $3,000,000 in excess of $3,000,000 of risk retained by the Company and its reinsurers and for its property lines which provide catastrophe coverages of 95% of $6,500,000 in excess of the $1,000,000 of risk retained by the Company. Under its non-standard automobile program, the Company maintains catastrophe reinsurance which provides coverages of 95% of $1,000,000 in excess of the $100,000 of risk retained by the Company for physical damage coverage and 100% of $900,000 in excess of the $100,000 of risk retained by the Company for liability coverage. A substantial portion (approximately 87%) of the Company's crop hail business is reinsured through quota share agreements supplemented by surplus and stop loss contracts. Surplus agreements limit quota share exposure to $1,500,000 per county or township. The stop loss reinsurance reduces the Company's net retained (not reinsured) quota share exposure by 95% once net retained losses exceed 90% of retained premiums. The Company's MPCI business is reinsured by the FCIC. Under FCIC's reinsurance program, the Company may (at the Company's election) cede to FCIC levels of exposure under MPCI policies, ranging from 0 to 80% of such exposure. In 1993, the average level of the Company's retention was 53.3% of such exposure. The reinsurance agreement also contains provisions that further reduce net retentions non-proportionally on a state- by-state basis. Net underwriting gains or losses are allocated to the company by the FCIC annually. The Company's net exposure on MPCI business is further reduced by privately placed stop loss reinsurance. The Company's farmowners business is reinsured by a 70% quota share contract. Quota share retentions are further reinsured by excess of loss and catastrophe loss contracts. Other non-crop property and casualty lines are reinsured by excess of loss agreements that limit net exposure to $250,000 per risk. Federal flood insurance is reinsured 100% by the Federal Emergency Management Administration ("FEMA") through its sub- agency, Federal Insurance Administration ("FIA"). Reinsurance treaties are renegotiated and renewed annually by the Company. The Company closely monitors the quality and performance of its reinsurers and for the year ended December 31, 1993, approximately 80% of the Company's reinsurance business was ceded to reinsurance companies rated A- (Excellent) by A.M. Best Company, or was reinsured by FCIC or FEMA. Investments The Company's investment results for the periods indicated are set forth below: The Company's investment portfolio at December 31, 1993, consisted of the following: Carrying Type of Investment Amount __________________ ________ (in thousands) Fixed maturities held for investment (1) $ 51,756 Fixed maturities available for sale (1) 95,836 Common stock 5,426 Preferred stock 8,446 Real estate 4,266 Mortgage loans and other investments 2,852 Short-term investments: Commercial Paper 4,668 U.S. Government/Agency securities 14,000 Certificate of Deposit 551 Money Market Account 185 _______ Total short-term investments 19,404 _______ Total investments (2) $187,986 ======= ______________________ (1) At December 31, 1993, approximately 68% of the fixed maturities were invested in United States Treasury and government agency securities and collateralized mortgage obligations backed by U.S. government agency securities. (2) All investments are carried at amortized cost, except common stock and preferred stock, which are carried at market value and fixed maturities held for sale which are carried at the lower of cost or market. GAAP Combined Loss and Expense Ratio The Company's underwriting experience is indicated by its "combined ratio" which is the sum of (1) the ratio of losses and loss adjustment expenses incurred to net premiums earned (the "Loss Ratio") and (2) the ratio of policy acquisition costs, other underwriting costs, and other expenses incurred to net premiums written (the "Expense Ratio"). The Company's ratios, computed in accordance with generally accepted accounting principles ("GAAP"), are set forth in the following table (a combined ratio below 100% indicates a profit from underwriting activities): Years Ended December 31, ______________________________ 1993 1992 1991 ______ __________ ______ Loss Ratio 72.5% 75.8% (1) 72.0% Expense Ratio 28.4 29.1 29.0 _____ _____ _____ Combined Ratio 100.9% 104.9% 101.0% ===== ===== ===== _______________ (1) The higher loss ratio for 1992 resulted in part from an approximate $2.1 million strengthening of the Company's loss and loss adjustment expense reserves for its workers' compensation and liquor liability lines, and $1.7 million of incurred losses relating to Hurricanes Andrew and Iniki, collectively 4.8% of the 1992 loss ratio. Losses and Loss Adjustment Expense Reserves The Company maintains reserves for estimates of liability for reported losses, losses which have occurred but which have not yet been reported, and for the expenses of investigating, processing and settling claims under outstanding policies. Such reserves are estimates by the Company primarily based on company and industry experience with the types of risks involved, knowledge of the circumstances surrounding individual claims, and company and industry experience with respect to the probable number and nature of claims arising from losses not yet reported. The effects of inflation are implicitly reflected in these loss reserves through the industry data utilized in establishing such reserves. Since 1985, the Company has annually obtained an independent review of its loss reserving process and reserve estimates by a professional actuary as part of the annual audit of its financial statements. The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance for Short-Duration and Long-Duration Contracts," effective January 1, 1993. The effect of the application of SFAS No. 113 resulted in the reclassification of amounts ceded to reinsurance previously reported as a reduction in unearned premium and unpaid losses and loss adjustment expenses, to assets on the consolidated balance sheet. The table below includes a reconciliation of net loss and loss adjustment expense reserves to amounts presented on the consolidated balance sheet after reclassifications related to the adoption of SFAS No. 113. The gross cumulative redundancy in the table on the following page is presented for 1992, the only year on the table for which the Company has restated amounts in accordance with SFAS No. 113. The following table presents an analysis of the Company's reserves, reconciling beginning and ending reserve balances for the periods indicated: The following table presents the development of balance sheet loss reserves from calendar years 1983 through 1992. The top line of the table shows the loss reserves at the balance sheet date for each of the indicated years. These amounts are the estimates of losses and loss adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The middle section of the table shows the cumulative amount paid with respect to previously recorded reserves as of the end of each succeeding year. The lower section of the table shows the reestimated amount of the previously recorded reserves based on experience as of the end of each succeeding year. The "Cumulative redundancy (deficiency)" caption represents the aggregate change in the estimates over all prior years. Conditions and trends that have affected the development of loss reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this information. The Company computes the cumulative redundancy (deficiency) annually on a calendar year basis. Uncertainties Affecting the Insurance Business The property and casualty insurance business is highly competitive, with over 3,000 insurance companies transacting such business in the United States, many of whom have substantially greater financial and other resources, and may offer a broader variety of coverages than those offered by the Company. Beginning in the latter half of the 1980s, there has been severe price competition in the insurance industry which has resulted in a reduction in the volume of premiums written by the Company in some of its lines of businesses, because of its unwillingness to reduce prices to meet competition. The specialty property and casualty coverages underwritten by the Company may involve greater risks than more standard property and casualty lines. These risks may include a lack of predictability, and in some instances, the absence of a long-term, reliable historical data base upon which to estimate losses. The Company's strategy is to offer specialized property and casualty insurance programs as to which there is limited competition from larger insurers. Pricing in the property and casualty insurance industry is cyclical in nature, fluctuating from periods of intense price competition, which led to record underwriting losses during the early 1980's, to periods of increased market opportunity as some carriers withdrew from certain market segments. Despite increased price competition in recent years, the Company has maintained consistent earned premium income during such periods, principally through geographic expansion and implementation of new insurance programs. The Company's results also may be influenced by factors influencing the insurance industry generally and which are largely beyond the Company's control. Such factors include (a) weather related catastrophes; (b) taxation and regulatory reform at both the federal and state level; (c) changes in industry standards regarding rating and policy forms; (d) significant changes in judicial attitudes towards liability claims; (e) the cyclical nature of pricing in the industry; and (f) changes in the rate of inflation, interest rates and general economic conditions. Adverse loss experience in two lines of insurance written by the Company resulted in a strengthening of loss and loss adjustment expense reserves in 1992 by approximately $2.1 million. The crop insurance coverages underwritten by the Redland group of companies has experienced adverse loss experience over the last two years largely because of unusual and adverse weather conditions which affected crop yields. During the second fiscal quarter of 1993, Redland strengthened loss and loss adjustment reserves by $3 million, partly as a result of suggestions made by the Company in the course of the negotiations leading to the acquisition of Redland. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for discussion of the impact of these uncertainties on the Company's financial condition and operating results. Marketing The Company generally markets the insurance products of the Acceptance group of companies through independent general agents. These agents deal with local agents and brokers who are in direct contact with insurance buyers. The number of general agents marketing the Company's Acceptance insurance lines has increased from approximately 58 in 1988 to approximately 104 in 1993. General agents are compensated on a commission basis. Workers' compensation coverages are written directly through agents who are in direct contact with insurance buyers. The Company writes the insurance products of the Acceptance group of companies in 22 states as an admitted carrier and in 37 states as an approved non-admitted carrier. Non-admitted carriers are normally restricted to writing lines of business not regularly written in the standard admitted market, but have greater freedom to design policy provisions and charge appropriate premiums on an unregulated basis. The Company generally seeks to have an insurance subsidiary licensed as an admitted carrier, as well as another insurance subsidiary operating as an approved non-admitted carrier in each state in which it writes insurance, in order to offer insurance products in both the admitted as well as the non-admitted market. For the years ended December 31, 1993 and 1992, the Company wrote 51% of its written premiums from the Acceptance group as a non-admitted carrier and 49% as an admitted carrier. The Company has expanded the geographic distribution of its business from the Acceptance group in recent years from 18 states in 1986 to 39 states in 1993. New insurance programs in liquor liability, workers' compensation and non-standard automobile coverages, initiated in 1989, and business written through Seaboard and ARM beginning in 1991, has led to further geographic expansion. The crop and other rural coverages underwritten by the Redland group are marketed through a network of approximately 2,500 independent agents in 43 states who sell MPCI, hail and flood insurance directly to farmers, as well as other insurance products underwritten by the Redland group of companies. The Company intends to offer standard basic property and casualty coverages (home, automobile and limited commercial coverages) underwritten by one of the Company's subsidiaries to the Redland network of rural agents. With the acquisition of Redland, at December 31, 1993, the Company now offers its insurance products, through an admitted carrier in 44 states and the District of Columbia, and through a non-admitted carrier in 41 states and the District of Columbia. During the year ended December 31, 1993, five agents produced approximately 34% of the Company's direct written premiums. Two of these agents, Acceptance Risk Managers, Inc. and Statewide Insurance Corporation produced, respectively, approximately 12% and 12%, of the direct written premiums for the year ended December 31, 1993. No other agent produced more than 10% of direct written premiums for that year. See "Recent Developments" for a discussion of the Company's plans to acquire in a stock merger Statewide Insurance Corporation. The states in which the Company wrote more than 5% of its written premium in 1993 are shown below with the amounts written in such states in the two prior years. Years Ended December 31, _________________________________ 1993 1992 1991 _____ _____ _____ Texas 13.5% 14.5% 12.0% Minnesota 8.5 15.9 19.7 California 7.5 6.5 4.5 Nebraska 7.1 1.5 1.7 Illinois 5.8 4.3 5.3 Arizona 5.6 12.0 12.9 Iowa 5.5 4.1 5.7 Regulation Insurance companies operate in a highly regulated industry and are subject to a variety of governmental regulations and the supervision of regulatory agencies in the states in which they conduct business. The primary purpose of such regulations is the protection of policyholders and claimants rather than shareholders. State insurance departments have broad regulatory authority over insurance companies selling insurance in their states. Depending on whether the insurance company is domiciled in the state and whether it is an admitted or non-admitted insurer, such authority may extend to such things as (i) periodic financial examination; (ii) approval of rates and policy forms; (iii) monitoring loss reserve adequacy; (iv) solvency monitoring; (v) restrictions on the payment of dividends; (vi) approval of changes in control and (vii) authorization of investments. The Company is also subject to statutes governing insurance holding companies. These statutes require the Company, among other things, to file periodic information with state regulatory authorities including information concerning its capital structure, ownership, financial condition and general business operations; limit certain transactions between the Company, its affiliates and its insurance subsidiaries; and restrict the ability of any one person to acquire certain levels of the Company's voting securities without prior regulatory approval. Nebraska law limits Nebraska insurance companies' capacity to pay dividends and conduct other financial transactions with their shareholders and affiliates without prior regulatory approval. Dividends or distributions made within the preceding 12 months may not exceed the lesser of (a) 10% of the policyholders' surplus as of the December 31 preceding the date of determination or (b) net income, not including realized capital gains, for the twelve-month period ending on December 31 preceding the date of determination. In determining net income available for dividends, an insurer may carry forward net income from the second and third full calendar years preceding the date of determination, again excluding realized capital gains, less dividends paid in such prior calendar years preceding the date of determination. The States of Iowa and Arizona regulate insurance companies' capacity to pay dividends and to conduct other financial transactions with their shareholders and affiliates, without prior regulatory approval, in a manner substantially similar to Nebraska. The Company's MPCI and federal flood insurance programs are federally regulated insurance products. Consequently, these programs are subject to oversight by the legislative and executive branches of the federal government. These regulations generally require compliance with federal guidelines with respect to underwriting, rating and claims administration. The Company is required to perform continuous internal audit procedures and is subject to audit by several federal government agencies. Employees At March 21, 1994 the Company and its subsidiaries employed 30 salaried executive and 534 salaried administrative personnel. The Merger with Statewide Insurance Corporation (see "Recent Developments") will result in the addition of 98 additional salaried administrative personnel in Phoenix. Acceptance believes that relations with its employees are satisfactory. There are no longer any individuals employed by the Company at the parent level. ITEM 2. ITEM 2. PROPERTIES. The following table sets forth certain information regarding the principal properties of the Company. General Location Character Size Leased/Owned ___________________ _________ ______________ ____________ Omaha, NE Office 44,000 sq. ft. Leased(1) Council Bluffs, IA Office 62,000 sq. ft. Leased(1) Burlington, NC Office 15,000 sq. ft. Leased(1) Phoenix, AZ Office 6,500 sq. ft. Month-to-Month Rental Scottsdale, AZ Office 11,000 sq. ft. Leased(1) ______________________ (1) The range of expiration dates for these leases is November 30, 2001 (Omaha), February 1, 1996 (Burlington), December, 1998 (Scottsdale), and June 30, 1997 (Council Bluffs). (2) The Company leases, generally on a month-to-month rental basis, small facilities in various parts of the United States in connection with its crop insurance operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are no material legal proceedings pending involving the Company or any of its subsidiaries which require reporting pursuant to this Item. 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 ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is listed and traded on the NYSE. The following table sets forth the high and low closing sales prices per share of Common Stock as reported on the NYSE Composite Tape for the fiscal quarters indicated. The prices set forth below through December 22, 1992, in the fourth quarter of the fiscal year ended December 31, 1992, reflect the prices of the shares of Common Stock on the NYSE prior to the one-for-four reverse stock split effected December 22, 1992. The prices set forth beginning December 23, 1992 reflect the prices of the shares of Common Stock after the reverse stock split. High Low ____ ___ Year Ended December 31, 1992 First Quarter 2-7/8 2 Second Quarter 2-7/8 2-1/4 Third Quarter 2-1/2 1-5/8 Fourth Quarter (through December 22, 1992, pre-split) 3-1/2 1-5/8 Fourth Quarter (beginning December 23, 1992, post-split) 10-5/8 9-5/8 Year Ended December 31, 1993 First Quarter 13-1/4 8-1/4 Second Quarter 14-1/3 12 Third Quarter 15-1/4 12-1/2 Fourth Quarter 15-5/8 11-1/4 Year Ended December 31, 1994 First Quarter (through March 21, 1994) 13-3/4 11-1/4 The closing sales price of the Common Stock on March 21, 1994, as reported on the NYSE Composite Tape, was $11.375 per share. As of March 21, 1994, there were approximately 1,900 holders of record of the Common Stock. As a holding company, the Company is dependent for cash flows upon dividends or other distributions from its operating subsidiaries. To the extent that the Company experiences positive cash flows from its operations, it intends, generally, to reinvest any such excess cash in the Company's insurance operations. The Company has not paid cash dividends during the periods indicated above and does not anticipate that it will pay cash dividends in the foreseeable future. Because of regulatory restrictions and the terms of the Company's loan agreements, dividends or other cash flow from the insurance subsidiaries in the foreseeable future is not anticipated. The foregoing obligations of the Company prohibit the declaration or payment of dividends to the Company by its subsidiaries, or payment of dividends by the Company to its shareholders, without approval of the bank lenders. See Note 14 to the Notes to Consolidated Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following tables set forth certain information concerning the insurance operations of the Company and its general operations, and should be read in conjunction with, and are qualified in their entirety by, the Consolidated Financial Statements and the notes thereto appearing elsewhere in this report. This selected financial data has been derived from the audited Consolidated Financial Statements of the Company and its subsidiaries. The "Pre-Acquisition" information set forth below is not included in the Company's Consolidated Financial Statements relating to periods prior to the Company's acquisition of Acceptance in April 1990. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of financial condition and results of operations of the Company and its consolidated subsidiaries is based upon the consolidated financial statements, and the notes thereto included herein. Results of Operations Year Ended December 31, 1993 Compared to Year Ended December 31, 1992. The Company's net income increased by $8.5 million from 1992 to 1993 as net income improved from a loss of $.9 million for the year ended December 31, 1992 to income of $7.6 million for the year ended December 31, 1993. This increase was attributable primarily to four factors: 1) improved underwriting results combined with an increase in premiums earned, 2) growth in the investment income of the Company, 3) continued reduction in the general and administrative expenses of the Company, and 4) a reduction in interest expense. In addition, the real estate interests of the Company had very little impact on the change in net income for 1993 as compared to 1992. Insurance premiums earned increased by 61.8% from 1992 to 1993. Excluding the increase in premiums written resulting from the merger with The Redland Group, Inc. ("Redland"), the Company's direct written premiums increased a modest 11.9%. Net premiums, however, increased 45.2% due to the Company's ability to retain more premiums as a result of increased capital from the Equity Rights Offering completed in January, 1993 which raised $31.2 million. In addition, during 1993, the new Redland operations added $16.2 million in earned premiums to the Company's revenues. With the inclusion of the Redland operations for an entire year, the expansion of the Company's general agency programs as a result of the opening of a new branch office in Scottsdale, Arizona and the business opportunities developed from the Company's merger with Redland, it is expected that the growth in premium revenue will continue during 1994. This increase in earned premium revenue translated into improved results in 1993 as compared to 1992 as the Company experienced a reduced combined loss and expense ratio from insurance operations of 100.9% during the twelve months ended December 31, 1993 as compared to 104.9% during the same period in 1992. With the inclusion of Redland, the Company's expense ratio fell slightly from 29.1% in 1992 to 28.4% in 1993. The Company's loss ratio decreased from 75.8% during 1992 to 72.5% during 1993. The results in 1992 were affected by Hurricane's Andrew and Iniki as well as reserve strengthening in the Company's workers' compensation and liquor liability lines. These events did not reoccur during 1993 contributing to the decline in the Company's loss ratio. The seasonal nature of crop insurance writings combined with unpredictable weather patterns are expected to create more volatility in the Company's quarter to quarter earnings in the future, and thus, results in one quarter will provide a less reliable forecast of subsequent quarterly results. The Company's investment income increased 41.3% from the year ended December 31, 1992 to the year ended December 31, 1993. This increase is attributable primarily to the increase in the Company's investment portfolio from an average of $113 million during 1992 to an average portfolio of $173 million during 1993. This increase in the size of the portfolio resulted from a capital infusion of funds derived from the Company's Equity Rights Offering completed in January, 1993, the Company's ability to cede less of its premium to reinsurers as a result of this capital infusion, growth in the Company's direct premiums, and additional investment assets acquired in the merger with Redland. In terms of generating investment income, the increase in the size of the portfolio more than offset the reduction in the average yield on the investment portfolio from 7.3% during the year ended December 31, 1992 to 6.3% during the 1993 year. This reduction in average yield primarily was due to the reduced yields available for investment grade securities in the marketplace, the addition to the Company's portfolio of tax free securities which, in general, have a lower yield than equivalent taxable securities, the short term nature of Redland's portfolio, and amortization of premiums paid for certain of the Company's mortgage backed securities caused by an acceleration in the prepayment speed of the underlying mortgages. If the Company's net tax operating losses continue to diminish, the Company will seek additional opportunities in the tax free investment sector. During 1993, the Company was able to further reduce its general and administrative expenses as compared to those experienced in 1992. Two factors served to decrease the general and administrative expenses. First, the Company combined its real estate and portfolio management operations during 1993, thus reducing administrative expenses associated with real estate activities. In addition, the Company continued to reduce expenses as a result of the consolidation of operations between the parent Company and its insurance company subsidiaries. This consolidation was initiated by the movement of the Company's home office from Bloomfield Hills, Michigan to Omaha, Nebraska in July, 1992. Offsetting decreases in general and administrative expenses were increases associated with Redland. These expenses include normal administrative expenses associated with the running of the Redland operations as well as the amortization of certain identifiable intangible assets and the excess of costs over acquired net assets. The Company does not expect further reductions in its general and administrative expenses during 1994. The Company's interest expense continued to decline during 1993 compared to 1992. This was due primarily to a decrease in the Company's outstanding debt as well as a reduction in the Company's average interest costs on such debt. On May 28, 1992, the Company completed the sale of its 5,355,166 shares of Common Stock of Orange-co for $31 million in cash, resulting in net proceeds of approximately $29 million. The Company applied approximately $22.4 million to retire its bank term loan. On January 27, 1993, the Company successfully completed a $31.9 million Common Stock Rights Offering. Proceeds from this offering were used to retire $9.5 million of secured subordinated notes plus accrued interest thereon. Effective April 15, 1993 the holder of a $7 million secured subordinated note of one of the Company's subsidiaries, which had been assumed by the Company, exchanged such note for 875,000 shares of Common Stock and Warrants to purchase, at a price of $11 per share during a period ending January 27, 1997, 875,000 additional shares of Common Stock. All of these events reduced debt carried at higher interest rates than the Company's other bank borrowings, and therefore, with the retirement of these debts, the Company also reduced the average cost of its outstanding debt. In March, 1994, the Company agreed to amend borrowing arrangements with its bank lenders. The new structure is a $35 million line of credit with interest payable quarterly at the prime rate or at LIBOR plus a margin of 1% to 1.75%, depending on the Company's debt to equity ratio. The line of credit will mature in four years and may be extended to five years by the bank lenders. The line of credit will be consummated once final legal documentation is completed which is anticipated to be in April, 1994. Such facility will increase the Company's borrowing capacity and, in the current interest rate environment, should reduce the interest rate which the Company pays on its debt. Since the interest rate is a floating rate, the Company has no guarantee that such reduction will be a permanent one. Year Ended December 31, 1992 Compared to Year Ended December 31, 1991 The Company's net loss decreased $42 million to $.9 million for the year ended December 31, 1992 as compared to $42.9 million for the previous year. This decrease was mainly attributable to a $19.6 million provision for the expected loss on disposal of the Company's investment in Orange-co and a $15.3 million write- down of the Company's equity investment in Major Realty to estimated net realizable value, both recorded during the year ended December 31, 1991. The remaining approximate $7.1 million related to a decrease in general and administrative expenses of $5.7 million, a decrease in other expense of $2.6 million, principally related to a loss in 1991 which did not reoccur in 1992, a decrease in interest expense of $1.3 million, and an increase in investment income of $1.2 million. These improvements were partially offset by a $2.1 million reserve strengthening in the insurance operations and a $1.7 million incurred loss from Hurricanes Andrew and Iniki. Insurance premiums earned increased 21.5% to $79.2 million for the year ended December 31, 1992 from $65.2 million in the previous year. This increase is attributable primarily to growth in workers' compensation, non-standard private passenger and specialty automobile and the Acceptance Risk Managers programs. During the year ended December 31, 1992, loss and loss adjustment expenses increased 27.9% as compared to the previous year. This higher rate of growth in losses (27.9%) compared to premium revenues (21.5%) was attributable primarily to increased loss development in the Company's workers' compensation and liquor liability lines as well as losses incurred from Hurricanes Andrew and Iniki. During 1992, through analysis of additional claims information and additional data processing capability which came "on-line," it became apparent that the liquor and workers' compensation lines of business were developing worse than had been anticipated. This judgment was based upon several factors: discussion with the claims staff and counsel regarding specific claims, adjudicated cases and the estimated effect thereof as precedents for similar claims, additional claims filed, the severity thereof, and the effect of these new claims as an indicator of additional incurred but not reported loss development. Management believes that the reserves recorded for these lines of business and events now provide adequate reserves for future payments. Insurance operational expense ratios for the years ended December 31, 1992 and 1991 remained consistent at 29.1% and 29.0%, respectively. In October 1991, Acceptance acquired Seaboard Underwriters, Inc. ("Seaboard"), a North Carolina-based managing general agency specializing in transportation business. Seaboard's agency commissions during the year ended December 31, 1992, aggregated approximately $4.0 million while agency expenses totaled approximately $3.7 million. Acceptance's insurance subsidiaries have been underwriting a portion of the business produced by Seaboard. During the year ended December 31, 1991, the Company's investment strategy provided for investment principally in U.S. Government securities with maturities of two years or less as well as realizing gains within the portfolio as the interest rate environment changed. During the year ended December 31, 1992, the Company changed its investment strategy to one whereby various securities of the U.S. Government, U.S. Government agencies, corporate securities and collateralized mortgage obligations backed by U.S. Government Agency Securities were combined to result in an average duration for the entire portfolio of between 3.5 and 4 years. This change in strategy as well as an overall increase in the size of the portfolio resulted in an increase in the interest income of the portfolio. These factors combined to create an overall increase in the Company's net investment income for the year ended December 31, 1992, as compared to the previous year. U.S. Government Securities and collateralized mortgage obligations backed by U.S. Government Agency Securities comprised 74% of the entire investment portfolio as of December 31, 1992. Revenues from the Company's real estate operations for the year ended December 31, 1992, were $2,610,000 of which $1,522,000 related to fees earned in connection with Major Group's management and real estate advisory agreement with Major Realty which terminated June 30, 1992. Included in the $1,522,000 is a non-recurring fee of $925,000 paid by Major Realty to Major Group in the form of a promissory note recorded in connection with the settlement and termination of the advisory agreement with Major Realty. On September 25, 1992, the Company completed the merger with The Major Group, Inc. Pursuant to Settlement Agreements among the Company, Major Group and certain secured creditors (the "Term Sheet Creditors"), Major Group (1) conveyed substantially all of its assets, except for certain property located in Fort Lauderdale, Florida (the "Fort Lauderdale Commerce Center Property") and two promissory notes from Major Realty Corporation (the "Major Realty Notes"), to the Term Sheet Creditors in satisfaction of all of Major Group's obligations due to them; (2) the Fort Lauderdale Commerce Center Property and the Major Realty Notes were transferred to the Company in satisfaction of all amounts due the Company under a note of a subsidiary of Major Group, which was secured by a mortgage on the Fort Lauderdale Commerce Center Property and guaranteed by Major Group; and (3) the Company issued a promissory note in the principal amount of $500,000 payable in installments over one year to the Term Sheet Creditors in exchange for all of the Major Group preferred stock held by the Term Sheet Creditors. Assets conveyed to the Term Sheet Creditors and liabilities satisfied approximated $5.7 million. Immediately upon conclusion of these transactions, Major Group was merged into a wholly owned subsidiary of the Company. In addition, Major Group settled certain claims by agreeing to pay $150,000 in cash and other consideration, payment of which is guaranteed by the Company, payable over a two year period and payment of the net cash proceeds from the sale of certain sewer connections not to exceed $150,000. In connection with the above, the Company issued approximately 52,000 shares of Common Stock to complete the merger. The net effect of the transactions among Major Group, the Term Sheet Creditors and the Company upon the results of operations was insignificant. Consolidated interest expense decreased $1.3 million from the prior year to $4.4 million for the year ended December 31, 1992. Total indebtedness was $33.6 million at December 31, 1992, a decrease of $21.9 million from $55.5 million at December 31, 1991. At December 31, 1992, the Company had approximately $23.7 million of net operating loss carryforwards for financial reporting purposes and $14 million of net operating loss carryforwards for tax reporting purposes. LIQUIDITY AND CAPITAL RESOURCES The Company has included a discussion of the liquidity and capital resources requirement of the Company and the Company's insurance subsidiaries. The Company -- Parent Only On January 27, 1993, the Company completed a $31.9 million Common Stock Equity Rights Offering. This resulted in the issuance of 3,992,480 shares of Common Stock and an equal amount of Warrants, each Warrant providing for the purchase of one share of Common Stock exercisable at $11.00 until January 27, 1997, unless called under certain conditions. The net proceeds of approximately $31.2 million were used to retire $9.5 million of secured subordinated notes plus accrued interest thereon and increase the insurance subsidiaries capital by $12.5 million with the balance retained as working capital. With this addition to working capital, the Company has been able to meet all short term cash needs, and as of December 31, 1993 has no long term liabilities or long term commitments. The Company also assumed a $7 million secured subordinated note outstanding from one of its insurance company subsidiaries and subsequently retired said note in April, 1993 in exchange for 875,000 shares of Common Stock and 875,000 Warrants identical to those issued in the Rights Offering. Dividends from the insurance subsidiaries are not available to the Company because of restrictive covenants set forth in the term and revolving loan agreements of the Company's insurance subsidiaries which prohibit dividends from the insurance subsidiaries to the Company without the expressed consent from the holders of the debt obligation. In March, 1994, the Company agreed to amend its borrowing arrangements with its bank lenders. The new arrangements will transfer the debt obligations from the holding companies of the insurance subsidiaries to the parent company. At such time, the new loan agreements will no longer impose restrictions on dividends from the insurance subsidiaries to the Company. The new structure is a $35 million line of credit with interest payable quarterly at the prime rate or at LIBOR plus a margin of 1% to 1.75% depending on the Company's debt to equity ratio. The line of credit will mature in four years and may be extended to five years by the bank lenders. This line of credit will be consummated once final legal documentation is completed which is anticipated to be in April, 1994. In addition, dividends from the insurance subsidiaries to the Company are regulated by the state regulatory authorities of the states in which each insurance subsidiary is domiciled. The laws of such states generally restrict dividends from insurance companies to parent companies to certain statutorily approved limits. As of December 31, 1993, the statutory limitations on dividends from the insurance company subsidiaries to the parent without further insurance department approval are approximately $3.4 million. Insurance Subsidiaries The Company's insurance subsidiaries are highly liquid and are able to meet their cash requirements on a timely basis. At December 31, 1993, the insurance subsidiaries outstanding debt consisted of a $12 million term loan note, a $6,597,000 revolving promissory note and $354,000 of other borrowings. The $12 million note was collateralized by the Company's Acceptance Common Stock, with principal of $1 million plus interest at prime plus .5% or at the Company's option LIBOR plus 2.5% payable quarterly with a maturity of October 1, 1996. The revolving promissory note was collateralized by Redland Common Stock with interest payable at the Federal funds rate plus 2.75%, maturing on January 5, 1995. Both of these borrowings will be replaced in April, 1994 with the funds from the new loan arrangement described above. Servicing of these debt obligations of the insurance subsidiaries has been provided by funds derived either from tax sharing payments made by the operating subsidiaries to the Company which are sheltered by the Company's tax net operating loss carryforwards and reinvested in the insurance holding company or through dividends and/or advances. On a longer term basis, the principal liquidity needs of the insurance company subsidiaries are to fund loss payments and loss adjustment expenses required in the operation of its insurance business. Primarily, the available sources to fund these obligations are new premiums received and to a lesser extent cash flows from the Company's portfolio operations. The Company monitors its cash flow carefully and attempts to maintain its portfolio at a duration which approximates the estimated cash requirements for loss and loss adjustment expenses. The seasonal nature of the Company's crop business generates a reverse cash flow with acquisition costs in the first part of the year, losses being paid over the summer months, and the related premium not collected until after the fall harvest. Cash flows from the crop programs are similar in nature to cash flows in the farming business. Changes in Financial Condition Four events occurring during 1993 strengthened the financial condition of the Company at December 31, 1993 as compared to the Company's position at December 31, 1992. These events were the completion of the Company's Equity Rights Offering, the conversion of certain subordinated notes to equity, the merger of the Company with Redland and the Company's profitable operating results for 1993. As described earlier, the Company completed a $31.9 million Common Stock Rights Offering in January, 1993. The net proceeds of approximately $31.2 million were used to retire $9.5 million of secured subordinated notes plus accrued interest thereon and increased the insurance subsidiaries capital by $12.5 million with the balance retained as working capital. In April, 1993, the Company retired $7 million of secured subordinated notes outstanding in exchange for 875,000 shares of Common Stock and 875,000 Warrants identical to those issued in the Equity Rights Offering. In August, 1993, the Company completed an Exchange Agreement whereby the holders of 100% of the outstanding Redland Class B Preferred Stock, Warrants to purchase Redland Common Stock and 100% of the outstanding Redland Common Stock were validly tendered in exchange for shares of the Company's Common Stock. The Company's acquisition of Redland resulted in an increase of approximately $112 million in total assets and $96 million in total liabilities at December 31, 1993. The most significant increases in the components comprising total assets were $11 million of investments, $21 million of receivables, $54 million of reinsurance recoverable on unpaid loss and loss adjustment expenses, $5 million of prepaid reinsurance premiums and $14 million of excess of cost over acquired net assets. The most significant increase in components comprising total liabilities were $66 million of loss and loss adjustment expenses, $14 million of unearned premiums, $6 million of accounts payable on accrued liabilities and $7 million of bank borrowings. In addition, during 1993, Company operating profit of $10.6 million and net income of $7.6 million also improved the Company's financial condition, with stockholders equity increasing 177% from $34.5 million at December 31, 1992 to $95.7 million at December 31, 1993. These four factors combined to effect the size of the Company's investment portfolio, with investments increasing by 51.2% at December 31, 1993 as compared to the same date in 1992. Within the portfolio, the Company also restructured the distribution of its investments in order to more accurately reflect the characteristics of its operating businesses as well as to provide added flexibility to respond to changes in the Company's tax position, business mix and the interest rate environment for fixed income securities. Accordingly, the Company changed its investment policy to emphasize securities categorized as available for sale, with this category accounting for 64.9% of its securities at December 31, 1993 as compared to 32.1% of its securities at December 31, 1992. The enlargement of this category of securities will provide more flexibility for the Company to respond to the changing interest rate environment as well as to allow its portfolio to more accurately reflect the characteristics of its changing business mix. In addition, short term investments increased 153.4% from 1993 to 1992. This was principally due to the nature of the portfolio which was added from Redland. Redland's principal business operations require near term payment of most of its losses, and therefore, require a greater amount of securities kept in short term investments. In addition, the more adequate capitalization provided by the aforementioned events allowed the Company to expand its equity portfolio 323.6% from December 31, 1992 as compared to December 31, 1993. The Company believes that the increased volatility and risk of this increased equity portfolio was reasonable considering the improvement in its capital position and will allow the Company to enhance the overall yield of its investment portfolio over time. As of December 31, 1993 and 1992, the Company held an approximate 33% equity investment in Major Realty, a publicly traded real estate company engaged in the ownership and development of its undeveloped land in Orlando, Florida. At December 31, 1993, the carrying value of the Company's investment in Major Realty approximated $5.4 million or $2.36 per share. Additionally at that date, Major Realty had stockholders equity of approximately $14,000 and the quoted market price of Major Realty on NASDAQ was $1.69 per share. The Company expects to realize a minimum of its carrying value in Major Realty based on the estimated net realizable value of Major Realty's underlying assets. The Company's estimate of net realizable value is based upon several factors including estimates from Major Realty's management, assets, appraisals and sales to date of Major Realty's assets. During 1993 and the first quarter of 1994, Major Realty sold five parcels of land amounting to 297.83 acres of land with gross sale proceeds of approximately $58.5 million. All of these sales and proceeds supported the Company's estimate of net realizable value of its investment in Major Realty. Consolidated Cash Flows The Company's net cash provided by operating activities increased from a negative $.7 million during 1992 to a positive $24.6 million for the year ended December 31, 1993. The Company's improved operating cash flow for the 1993 year resulted primarily from the insurance subsidiaries retaining more of their direct premium while ceding less to reinsurers. Cash flows from investing activities were effected by the investment of the proceeds from the Company's Rights Offering in January, 1993, an emphasis on purchasing securities categorized as available for sale, and faster than expected prepayments of certain of the Company's mortgage backed securities. Cash flows from financing activities were impacted by the Equity Rights Offering completed in January, 1993 including the retirement of $9.5 million of term notes from the proceeds of such Offering. Inflation The Company does not believe that inflation has had a material impact on its financial condition or the results of operations. Impact of Recently Adopted Accounting Standards The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993. The prospective application of SFAS No. 109 resulted in no effect upon net income for the year ended December 31, 1993. SFAS No. 109 requires that the Company recognize a deferred tax asset for all temporary differences and net operating loss carryforwards and a related valuation allowance account when realization of the asset is uncertain. The Company's deferred tax asset at December 31, 1993 is $16.3 million which is offset by the valuation allowance of $16.3 million. The Company adopted Statement of Financial Accounting Standards (SFAS) No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts", effective January 1, 1993. The effect of the application of SFAS No. 113 resulted in the reclassification of amounts ceded to reinsurers previously reported as a reduction in unearned premium and unpaid losses and loss adjustment expenses, to assets on the consolidated balance sheet. The application included a restatement of amounts as of December 31, 1992. In April, 1993, the Financial Accounting Standards Board approved for issuance Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The standard will be adopted effective January 1, 1994. The effect of adoption of this pronouncement will be that securities designated as available for sale will be reported at market value with unrealized gains and losses reported as a separate component of stockholders' equity which is not expected to be significant. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Item 14 hereof and the Consolidated Financial Statements attached hereto. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The disclosure called for by Item 9 was previously reported under Item 4 in the Registrant's current Report on Form 8-K, dated March 11, 1992, which is incorporated herein by reference. There have been no disagreements with the Registrant's former independent accountants of the nature calling for disclosure under Item 9. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by Item 10 with respect to the Registrant's executive officers and directors will be set forth under the captions "Election of Directors" and "Executive Officers" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 will be set forth under the caption "Compensation of Executive Officers and Directors" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by Item 12 will be set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and incorporated herein reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Item 13 will be set forth under the caption "Certain Transactions" in the Company's 1994 Proxy Statement included as Exhibit 99.4 hereto and 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. Financial Statements. The Company's audited Consolidated Financial Statements for the years ended December 31, 1993 and 1992 consisting of the following: Reports of Independent Accountants Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Consolidated Statements of Stockholders' Equity Notes to Consolidated Financial Statements 2. Financial Statement Schedules. The Company's Financial Statement Schedules as of December 31, 1993 and 1992, consisting of the following: I. Summary of Investments II. Amounts Receivable From Related Parties III. Condensed Financial Information of Registrant IV. Indebtedness to Related Parties -- Not Current V. Supplemental Insurance Information VIII. Valuation Accounts IX. Short-Term Borrowings X. Supplementary Income Statement Information All other schedules to the Consolidated Financial Statements required by Article 12 of Regulation S-X are not required under the related instruction or are inapplicable and therefore have been omitted, or are included in the Consolidated Financial Statements. 3. The Exhibits filed herewith are set forth in the Exhibit Index attached hereto. (b) No Current Reports on Form 8-K have been filed during the last fiscal 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. ACCEPTANCE INSURANCE COMPANIES INC. Kenneth C. Coon By __________________________________ Dated: March 24, 1994 Kenneth C. Coon Chairman, President and Chief Executive Officer Georgia M. Mace By __________________________________ Dated: March 24, 1994 Georgia M. Mace Treasurer and Chief 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. Jay A. Bielfield Dated: March 24, 1994 ___________________________________ Jay A. Bielfield, Director Kenneth C. Coon Dated: March 24, 1994 ___________________________________ Kenneth C. Coon, Director Edward W. Elliott, Jr. Dated: March 24, 1994 ___________________________________ Edward W. Elliott, Jr., Director Robert LeBuhn Dated: March 24, 1994 ___________________________________ Robert LeBuhn, Director Michael R. McCarthy Dated: March 24, 1994 ___________________________________ Michael R. McCarthy, Director John P. Nelson Dated: March 24, 1994 ___________________________________ John P. Nelson, Director R. L. Richards Dated: March 24, 1994 ___________________________________ R. L. Richards, Director David L. Treadwell Dated: March 24, 1994 ___________________________________ David L. Treadwell, Director Doug T. Valassis Dated: March 24, 1994 ___________________________________ Doug T. Valassis, Director ACCEPTANCE INSURANCE COMPANIES INC. ANNUAL REPORT ON FORM 10-K FISCAL YEAR ENDED DECEMBER 31, 1993 EXHIBIT INDEX NUMBER EXHIBIT DESCRIPTION 3.1 Restated Certificate of Incorporation of Acceptance Insurance Companies Inc. 3.2 Restated By-laws of Acceptance Insurance Companies Inc. 4.1 Form of Stock Certificate representing shares of Acceptance Insurance Companies Inc., Common Stock, $.40 par value. Incorporated by reference to Exhibit 4.1 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4.2 Form of Warrant Certificate representing Acceptance Insurance Companies Inc., Warrants. Incorporated by reference to Exhibit 4.2 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 4.3 Warrant Agreement dated as of December 22, 1992, between Stoneridge Resources, Inc., (now, by change of name, Acceptance Insurance Companies Inc.) and Society National Bank, Cleveland, Ohio as Warrant Agent incorporated by reference to Exhibit 10.25 to the Stoneridge Resources, Inc. Registration Statement on Form S-1, Registration No. 33-53730. 4.4 Amendment to Warrant Agreement made as of February 2, 1993, to Warrant Agreement dated as of December 22, 1992, between Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.), and Society National Bank, Cleveland, Ohio, as Warrant Agent. Incorporated by reference to Exhibit 10.19 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 8 Opinion of Deloitte & Touche, Accountants and Auditors for the Registrant, dated October 21, 1992, relating to tax matters. Incorporated by reference to Exhibit 5.2 to the Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.) Registration Statement on Form S-1, Registration No. 33-53730. 10.1 Office Building Lease dated July 19, 1991, between State of California Public Employees' Retirement System and Acceptance Insurance Company. Incorporated by reference to Exhibit 10.7 to the Stoneridge Resources, Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10.2 Intercompany Federal Income Tax Allocation Agreement between Acceptance Insurance Holdings Inc. and its subsidiaries and Stoneridge Resources, Inc. dated April 12, 1990, and related agreements. Incorporated by reference to Exhibit 10i to Stoneridge Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended August 31, 1990. 10.3 Warrant to purchase 489,919 shares of common stock ($.10 par value) of Stoneridge Resources, Inc., dated March 14, 1990, issued by Stoneridge Resources, Inc. to Samelson Development Company. Incorporated by reference to Exhibit 4a to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the period ended May 31, 1990. 10.4 Amended and Restated Registration Rights Agreement, dated April 9, 1990, between Stoneridge Resources, Inc. and Patricia Investments, Inc. Incorporated by reference to Exhibit 10d to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the period ended May 31, 1990. 10.5 Warrants to purchase a total of 389,507 shares of common stock ($.10 par value) of Stoneridge Resources, Inc. dated April 10, 1992, issued by Stoneridge Resources, Inc. to the various purchasers of the Floating Rate Secured Subordinated Notes, due 1993, Series A and B. Incorporated by reference to Exhibit 10.41 to the Stoneridge Resources, Inc., Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10.6 Term Loan Agreement dated April 10, 1992, by and among Acceptance Insurance Holdings Inc., NBD Bank, N.A., First National Bank of Omaha, Manufacturers Bank, N.A., Comerica Bank, First Bank and NBD, N.A., as Agent. Incorporated by reference to Exhibit 10.44 to the Stoneridge Resources, Inc., Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 10.7 First Amendment to Term Loan Agreement, dated as of June 1, 1992, by and among Acceptance Insurance Holdings Inc., NBD Bank, N.A., First National Bank of Omaha, Manufacturers Bank, N.A., First Bank and NBD, N.A., as Agent. Incorporated by reference to Exhibit 10.11 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10.8 Second Amendment to Term Loan Agreement, dated as of November 15, 1992, by and among Acceptance Insurance Holdings Inc., NBD Bank, N.A., First National Bank of Omaha, Manufacturers Bank, N.A., First Bank and NBD, N.A., as Agent. Incorporated by reference to Exhibit 10.12 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. 10.9 Stock Option Agreement between Stoneridge Resources, Inc. and Robert W. Anestis, dated July 2, 1991. Incorporated by reference to Exhibit 10.5 to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. 10.10 Stock Option Agreement between Stoneridge Resources, Inc. and Thomas L. Kelly, II, dated July 2, 1991. Incorporated by reference to Exhibit 10.6 to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 30, 1991. 10.11 Employment Agreement dated February 19, 1990 between Acceptance Insurance Holdings Inc., Stoneridge Resources, Inc. and Kenneth C. Coon. Incorporated by reference to Exhibit 10.65 to the Stoneridge Resources, Inc., Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 11 Computation of Income (Loss) per share. 16 Letter to the Securities and Exchange Commission from Coopers & Lybrand dated March 16, 1992, with respect to changes in Stoneridge Resources, Inc.'s certifying accountant. Incorporated by reference to Exhibit 16.1 to Stoneridge Resources, Inc.'s Current Report on Form 8-K dated March 16, 1992. 21 Subsidiaries of the Registrant. 23.1 Consent of Deloitte & Touche. 23.2 Report on schedules of Deloitte & Touche. 23.3 Consent of Crosby, Guenzel, Davis, Kessner & Kuester. 28P Schedule P -- Analysis of Losses and Loss Expenses of Consolidated Annual Statement for the year 1993. 99.1 Acceptance Insurance Companies Inc., 1992 Incentive Stock Option Plan effective as of December 22, 1992. Incorporated by reference to Exhibit 10.1 to the Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.) Registration Statement on Form S-1, Registration No. 33-53730. 99.2 Acceptance Insurance Companies Inc., Employee Stock Purchase Plan, effective as of December 22, 1992. Incorporated by reference to Exhibit 10.2 to the Stoneridge Resources, Inc. (now, by change of name, Acceptance Insurance Companies Inc.) Registration Statement on Form S-1, Registration No. 33-53730. 99.3 Acceptance Insurance Companies Inc., Employee Stock Ownership and Tax Deferred Savings Plan as merged, amended and restated effective October 1, 1990. Incorporated by reference as Exhibit 10.4 to Stoneridge Resources, Inc.'s Quarterly Report on Form 10-Q for the quarter ended November 30, 1990. 99.4 First Amendment to Acceptance Insurance Companies Inc. Employee Stock Ownership and Tax Deferred Savings Plan. 99.5 Second Amendment to Acceptance Insurance Companies Inc. Employee Stock Ownership and Tax Deferred Savings Plan. 99.6 Proxy Statement for 1994 Annual Meeting of Shareholders filed on or prior to April 30, 1994. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Acceptance Insurance Companies Inc. We have audited the accompanying consolidated balance sheets of Acceptance Insurance Companies Inc. and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity 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 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 Acceptance Insurance Companies 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 Note 1 to the consolidated financial statements, in 1993 the Company adopted Statement of Financial Accounting Standards No. 113, Accounting and Reporting of Reinsurance for Short-Duration and Long-Duration Contracts. DELOITTE & TOUCHE Omaha, Nebraska March 28, 1994 ACCEPTANCE INSURANCE COMPANIES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Operations - Acceptance Insurance Companies Inc. (the "Company") is primarily engaged in the specialty property and casualty insurance business through its wholly-owned subsidiaries, Acceptance Insurance Holdings Inc. ("Acceptance") and The Redland Group, Inc. ("Redland"), which the Company acquired on April 11, 1990 and August 13, 1993, respectively. The Company previously conducted citrus operations through its approximate 52% owned subsidiary, Orange-co, Inc. ("Orange-co"). In December 1991, the Company decided to sell its interest in Orange-co and in May 1992 its interest was sold. As a result, the Company's share of the net loss of Orange-co is presented separately as discontinued operations on the consolidated statements of operations. The Company holds a 33% equity investment in Major Realty Corporation ("Major Realty"), a Florida based real estate company. Principles of Consolidation - The Company's consolidated financial statements include the accounts of its majority-owned subsidiaries. All significant intercompany transactions have been eliminated. Insurance Accounting - Premiums are recognized as income ratably over the terms of the related policies. Benefits and expenses are associated with premiums earned, resulting in the recognition of profits over the term of the policies. This association is accomplished through amortization of deferred policy acquisition costs and provisions for unearned premiums and loss reserves. The liability for unearned premiums represents the portion of premiums written which relates to future periods and is calculated generally using the pro rata method. The Company also provides a liability for policy claims based on its review of individual claim cases and the estimated ultimate settlement amounts. This liability also includes estimates of claims incurred but not reported based on Company and industry paid and reported claim and settlement expense experience. Differences which arise between the ultimate liability for claims incurred and the liability established will be reflected in the statement of operations of future periods as additional claim information becomes available. Certain costs of acquiring new insurance business, principally commissions, premium taxes, and other underwriting expenses, have been deferred. Such costs are being amortized as the premiums are earned. Anticipated investment income is considered in computing premium deficiencies, if any. Statements of Cash Flows - The Company aggregates cash and short- term investments with maturity dates of three months or less from the date of purchase for purposes of reporting cash flows. As of December 31, 1993 and 1992, approximately $4,737,000 and $227,000 of short-term investments had maturity dates at acquisition of greater than three months. Investments - Effective September 30, 1992, the Company has designated fixed maturities as either securities held for investment or securities available for sale. Securities held for investment represent those securities which the Company has the intent and ability to hold to maturity. Securities available for sale represent those securities which might be sold in response to changes in various economic conditions to maintain a portfolio duration which approximates the estimated settlement of reserves for loss and loss adjustment expenses. Securities held for investment are valued at amortized cost while securities available for sale are valued at the lower of amortized cost or market value. Marketable equity securities are carried at market and any net unrealized gain or loss is reflected separately as a component of stockholders' equity. Mortgage loans are carried at the lower of their unpaid principal balance or their estimated net realizable value. Real estate is stated at the lower of cost or estimated net realizable value and is non-income producing. Property and Equipment - Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is recognized principally using the straight-line method over a period of five to ten years. Excess of Cost Over Acquired Net Assets - The excess of cost over equity in acquired net assets is being amortized principally using the straight-line method over periods not exceeding 40 years. Fair Value of Financial Instruments - Estimated fair values of financial instruments have been determined by the Company, using available market information and appropriate valuation methodologies. However, judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions may have an effect on the estimated fair value amounts presented. The fair value of fixed maturities and equity securities disclosed in the financial statements are determined by the quoted market price or modeling techniques for asset-backed securities not actively traded. The book value of mortgage loans, short-term investments, and other investments approximate fair value at December 31, 1993. The book value of cash, receivables, equity investment in Major Realty Corporation, accounts payable and borrowings approximate fair value. Per Share Data - Primary earnings per share and fully diluted earnings per share are based on weighted average shares outstanding of approximately 11.6 million and 11.9 million, respectively, for the year ended December 31, 1993, and approximately 3.4 million for the years ended December 31, 1992 and 1991. Included in weighted average shares outstanding in 1993 is the assumed conversion of all outstanding options and warrants utilizing the treasury stock method with appropriate adjustment to net income attributable to the assumed use of proceeds. Recent Statements of Financial Accounting Standards - The Company adopted Statement of Financial Accounting Standards (SFAS) No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts", effective January 1, 1993. The effect of the application of SFAS No. 113 resulted in the reclassification of amounts ceded to reinsurers previously reported as a reduction in unearned premium and unpaid losses and loss adjustment expenses, to assets on the consolidated balance sheet. The application included a restatement of amounts as of December 31, 1992. In April 1993, the Financial Accounting Standards Board approved for issuance Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The standard will be adopted effective January 1, 1994. The effect of adoption of this pronouncement will be that securities designated as available for sale will be reported at market value with unrealized gains and losses reported as a separate component of stockholders' equity which is not expected to be significant. Reclassifications - Certain prior period accounts have been reclassified to conform with current year presentation. 2. COMMON STOCK ISSUED On January 27, 1993, the Company completed a Common Stock Rights Offering to raise additional equity capital. The Rights Offering was fully subscribed resulting in the issuance of 3,992,480 units, at $8.00 per unit, consisting of one share of common stock and a warrant for the purchase of one share of common stock exercisable at $11.00 until January 27, 1997, unless called under certain provisions. Net proceeds of approximately $31.2 million were used to retire $9.5 million of Secured Subordinated Notes (see Note 7). Effective April 15, 1993, the holder of a $7,000,000 Secured Subordinated Note of one of the Company's subsidiaries, which had been assumed by the Company, exchanged such note for 875,000 shares of common stock and warrants to purchase, at a price of $11.00 per share during a period ending January 27, 1997, 875,000 additional shares of common stock. The shares of common stock and warrants were identical to the shares and warrants issued in the Company's Rights Offering. 3. REDLAND ACQUISITION On August 13, 1993, the Company acquired all of the outstanding common stock, warrants to purchase common stock, and preferred stock of Redland pursuant to an Exchange Agreement. Redland underwrites multi-peril crop, crop hail, specialty automobile, and farmowner insurance coverages. The acquisition of Redland was accounted for as a purchase transaction. The purchase price of approximately $15.4 million, comprised of 1,339,000 shares of the Company's common stock and acquisition related costs of $306,000, was allocated based upon the estimated fair market value of assets acquired and liabilities assumed. The purchase price in excess of the fair market value of the net assets acquired is being amortized using the straight-line method over 40 years. The results of operations for Redland are included in the accompanying financial statements effective July 1, 1993. The purchase price does not reflect 240,000 shares issued by the Company and held in escrow pursuant to the Exchange Agreement, as a fund against which the Company may assert certain claims. The primary contingency under which claims may be asserted is the ultimate development of Redland's liability for losses and loss adjustment expenses. Upon resolution of contingencies related to the acquisition, such shares will be returned to the Company or released to former Redland stockholders. The pro forma financial data, which gives effect to the acquisition of Redland as though it had been completed January 1, 1993, for the year ended December 31, 1993 and January 1, 1992, for the year ended December 31, 1992, is as follows (in thousands, except per share data): 1993 1992 Revenues $157,299 $123,598 ======== ======== Loss from continuing operations $ (1,292) $ (3,649) ======== ======== Net loss $ (1,292) $ (3,732) ======== ======== Earnings per share: Primary and fully diluted: Continuing operations $ (0.14) $ (0.76) Discontinued operations - (0.02) -------- -------- Net loss per share $ (0.14) $ (0.78) ======== ======== The pro forma financial data for the year ended December 31, 1993, is not necessarily indicative of the results had the Company actually acquired Redland on January 1, 1993, as the financial data includes $3.9 million of charges to earnings taken by Redland in the first and second quarters of 1993. The charges were comprised of a $900,000 write-down of a marketable equity security and a $3.0 million strengthening of reserves, both of which would have been adjusted to their fair market value on January 1, 1993, and thus would have been excluded from the 1993 results of operations. 4. INVESTMENTS A summary of net investment income earned on the investment portfolio for the years ended December 31, 1993, 1992 and 1991 is as follows (in thousands): 1993 1992 1991 Interest on fixed maturities $ 9,177 $7,339 $4,692 Interest on short-term investments 711 659 1,600 Net realized gains on sales of investments 2,250 1,046 1,953 Other 1,338 391 328 ------- ------ ------ 13,476 9,435 8,573 Investment expenses (382) (169) (517) ------- ------ ------ Net investment income $13,094 $9,266 $8,056 ======= ====== ====== The amortized cost and related market values of fixed maturities in the accompanying balance sheets are as follows (in thousands): The amortized cost and related market values of the debt securities as of December 31, 1993 are shown below by stated maturity dates. Actual maturities may differ from stated maturities because the borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Market Cost Value (in thousands) Fixed maturities held for investment: Due after one year through five years $ 7,345 $ 7,672 Due after five years through ten years 10,837 11,533 Due after ten years 504 530 ------- ------- 18,686 19,735 Mortgage-backed securities 33,070 34,319 ------- ------- $51,756 $54,054 ======= ======= Fixed maturities available for sale: Due after one year through five years $21,382 $21,452 Due after five years through ten years 10,071 10,225 Due after ten years 23,696 23,987 ------- ------- 55,149 55,664 Mortgage-backed securities 40,687 40,786 ------- ------- $95,836 $96,450 ======= ======= As of December 31, 1993, the weighted average duration of the mortgage-backed securities is expected to be less than four years. Proceeds from sales of debt securities during the years ended December 31, 1993, 1992 and 1991 were approximately $115,339,000, $76,457,000 and $241,216,000, respectively. Gross realized gains on sales of debt securities were approximately $2,023,000, $1,362,000 and $2,688,000, and gross realized losses on sales of debt securities were approximately $17,000, $85,000 and $506,000 during the years ended December 31, 1993, 1992 and 1991, respectively. On May 31, 1993, all of the Company's investments in fixed maturities of financial service entities were transferred to securities available for sale from securities held for investment. The Company's core business is inherently subject to the same market fluctuations as the financial services industry. Consequently, the Company believes this action is prudent to mitigate its aggregate industry exposure. The amortized cost and market value at date of transfer aggregated approximately $9,704,000 and $10,206,000, respectively. As required by insurance regulatory laws, certain bonds with an amortized cost of approximately $11,401,000 and short-term investments of approximately $376,000 at December 31, 1993 were deposited in trust with regulatory agencies. 5. RECEIVABLES The major components of receivables are summarized at December 31 as follows (in thousands): 1993 1992 Insurance premiums and agents' balances due $33,801 $18,841 Amounts recoverable from reinsurers on paid losses 10,978 5,617 Accrued interest 2,126 1,308 Installment notes receivable 1,768 1,197 Other 1,586 770 Less allowance for doubtful accounts (2,093) (1,207) ------- ------- $48,166 $26,526 ======= ======= 6. EQUITY INVESTMENT IN MAJOR REALTY CORPORATION As of December 31, 1993 and 1992, the Company held an approximate 33% equity investment in Major Realty, a publicly traded real estate company engaged in the ownership and development of its undeveloped land in Orlando, Florida. In accordance with Accounting Principles Board Opinion No. 18 and other authoritative pronouncements, the Company recorded a non- cash charge of $15,300,000 in the accompanying consolidated statement of operations for the year ended December 31, 1991 to reflect its equity investment in Major Realty at estimated net realizable value. This provision was necessitated by the weak economic conditions surrounding the real estate industry generally, which have negatively impacted the financial condition and prospects of Major Realty which, at that time, raised doubt about its ability to continue to meet its obligations as they came due. At December 31, 1993, the carrying value of the Company's investment in Major Realty approximated $5.4 million or $2.36 per share. Additionally at that date, Major Realty had a stockholders' equity of approximately $14,000 and the quoted market price of Major Realty on NASDAQ was $1.69 per share. The Company expects to realize a minimum of its carrying value in Major Realty based on the estimated net realizable values of Major Realty's underlying assets. The Company's estimate of net realizable value is based upon several factors including estimates from Major Realty's management, assets appraisals and sales to date of Major Realty's assets. Commencing in 1992, the Company has not recognized its share of net gains realized by Major Realty on sales of real estate but continues to recognize its share of expenses recorded by Major Realty. The extraordinary item reflected in the accompanying consolidated statement of operations for the year ended December 31, 1991 represents the Company's interest in an extraordinary gain recorded at Major Realty in February 1991. This extraordinary gain resulted from the conveyance of Major Realty's interest in the Major Centre Plaza office building and the payment of $170,000 in cash to the mortgage note holder in exchange for the full satisfaction and release of an $8,080,000 mortgage note. No related federal income tax provision was provided since this extraordinary gain was offset by losses incurred at Major Realty during the year ended December 31, 1991. The following summary financial data for Major Realty as of and for the years ended December 31, 1993 and 1992 was obtained from Major Realty's consolidated financial statements (in thousands): 1993 1992 Land held for sale or development $ 7,283 $56,442 Other assets 3,621 1,741 ------- ------- Total assets $10,904 $58,183 ======= ======= Mortgage and other notes payable $ 9,438 $51,745 Other liabilities 1,452 7,315 Stockholders' deficit 14 (877) ------- ------- Total liabilities and stockholders' $10,904 $58,183 equity ======= ======= Total revenues $55,199 $ 4,794 ======= ======= Gross profit $ 2,895 $ 1,640 ======= ======= Net income (loss) $ 891 $(3,671) ======= ======= 7. BANK BORROWINGS, TERM DEBT AND OTHER BORROWINGS AND NOTES PAYABLE TO AFFILIATES In March 1994, the Company agreed to amend its borrowing arrangements with its bank lenders. The proposed structure is a $35 million line of credit with interest payable quarterly at the prime rate or at LIBOR plus a margin of 1% to 1.75%, depending on the Company's debt to equity ratio. The line of credit will mature in four years and may be extended to five years by the bank lenders. The line of credit will be consummated once final legal documentation is completed which is anticipated to be in April 1994. The following information relates to the debt agreements in effect as of December 31, 1993 and 1992: December 31, 1993 1992 (in thousands) Bank borrowings: Term loan at the prime rate of interest plus .5% or at the Company's option, LIBOR plus 2.5% $12,000 $15,500 Revolving promissory note at the federal funds rate 6,597 - plus 2.75% Notes payable to affiliates: Secured subordinated notes at the prime rate of interest plus 6% - 9,500 Secured subordinated convertible note at the prime rate of interest plus 6% - 7,000 Term debt and other borrowings 354 1,567 ------- ------- $18,951 $33,567 ======= ======= At December 31, 1993, the $12.0 million note payable was collateralized by the Company's Acceptance common stock. Principal of $1,000,000 and interest on the note is due quarterly with a maturity of October 1, 1996. In August 1993, Redland refinanced its existing notes payable to a bank with a new $7,500,000 revolving promissory note with a maturity of January 5, 1995 which is collateralized by Redland common stock. At December 31, 1993, $6,597,000 was outstanding under this agreement. The Company issued $9.5 million of Secured Subordinated Notes to certain directors or stockholders in April 1992 through the exchange of previously issued secured and unsecured notes aggregating approximately $8.3 million and cash. Additionally, the Company issued to the holders of the Secured Subordinated Notes approximately 97,500 common stock warrants exercisable for five years at a price of $9.50 per share. In January 1993, these notes were redeemed. In April 1992, Acceptance issued a $7 million secured subordinated convertible note maturing in 1997. In April, 1993, this note was converted into 875,000 units of common stock and warrants identical to those issued in the Rights Offering (see Note 2). Aggregate maturities are as follows (in thousands): 1994 $ 4,354 1995 10,597 1996 4,000 ------- $18,951 ======= Cash payments for interest were approximately $2.5 million, $4.2 million and $5.7 million during the years ended December 31, 1993, 1992 and 1991, respectively. 8. INCOME TAXES The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993. The prospective application of SFAS No. 109 resulted in no effect upon net income for the year ended December 31, 1993. SFAS No. 109 requires that the Company recognize a deferred tax asset for all temporary differences and net operating loss carryforwards and a related valuation allowance account when realization of the asset is uncertain. Accordingly, a valuation allowance has been recorded for the full amount of the deferred tax asset. During 1993, the valuation allowance decreased $1,560,000, the same amount the net deferred tax asset decreased. The significant items comprising the Company's net deferred tax asset as of December 31, 1993 are as follows (in thousands): Net operating loss carryforwards expiring in varying amounts through 2006 $ 2,440 Unpaid losses and loss adjustment expenses 6,581 Unearned premiums 3,037 Allowances for doubtful accounts 712 Major Realty basis difference 7,531 -------- Deferred tax asset 20,301 -------- Deferred policy acquisition costs (4,017) Other (23) -------- Deferred tax liability (4,040) -------- 16,261 Valuation allowance (16,261) -------- Net deferred tax asset $ - ======== The Company recognized a current tax expense of approximately $167,000 for the year ended December 31, 1993 as a result of amounts due under alternative minimum taxable income provisions which limit net operating loss carryforwards. Cash payments for income taxes were approximately $232,000 during the year ended December 31, 1993. 9. OPERATING LEASES The Company leases office space and certain furniture and equipment under various operating leases. Future minimum obligations under these operating leases are as follows (in thousands): 1994 $1,675 1995 1,494 1996 1,355 1997 1,176 1998 899 Thereafter 1,886 ------ $8,485 ====== Rental expense totaled approximately $1,169,000, $1,014,000 and $569,000 for the years ended December 31, 1993, 1992 and 1991, respectively. 10. STOCK OPTIONS AND AWARDS In December 1992, stockholders approved an incentive stock option plan under which options granted to employees vest over the four years following the date of grant, options granted to non-employee directors are vested one year from the date of grant and all options terminate ten years from the date of grant. A maximum of 500,000 shares are available for the plan and 94,500 options were granted during 1993. On January 27, 1993, certain executive officers of the Company were awarded non-qualified options entitling these officers to purchase a total of 72,500 shares of the Company's Common Stock at a price of $8.75 per share, which are currently exercisable through January 27, 1998. In connection with consulting agreements entered into in May 1991 with certain of its directors, the Company incurred approximately $100,000 and $528,000 of expense during the years ended December 31, 1992 and 1991, respectively. Under the same agreements and in addition to the above, these directors received a total of 62,210 options to purchase Company common stock at a price of $10.25 per share, subject to certain antidilution provisions, which are exercisable through May 1996. Changes in stock options are as follows: All shares under option at December 31, 1993 were exercisable, except for 94,500 options issued in 1993 under the incentive stock option plan. In December 1992, stockholders approved an employee stock purchase plan whereby eligible employees will be given the opportunity to subscribe for the purchase of the Company's common stock for 85% of its fair market value as defined. During 1993, 12,639 shares were issued under this plan. 11. RELATED PARTY TRANSACTIONS Included in real estate revenues for the years ended December 31, 1992 and 1991, is fee income totaling approximately $1,522,000 and $1,850,000, respectively, for real estate advisory services provided by Major Group to Major Realty. Revenues for the year ended December 31, 1992 included a non-recurring fee of $925,000 associated with the settlement and termination of the advisory agreement in March 1992, effective January 1, 1992. As part of the termination and settlement agreement, Major Realty issued two promissory notes aggregating $1,514,581 to Major Group representing payment of all deferred fees and interest thereon and payment of the termination fee. The promissory notes bear interest at 12%, mature in 1997 and are collateralized by second and third mortgages on certain real property owned by Major Realty. One note, on which principal and accrued interest totals approximately $143,000 at December 31, 1993, is convertible into Major Realty common stock at any time, while the remaining note, on which principal and accrued interest totals approximately $278,000 at December 31, 1993, may be converted into Major Realty common stock beginning March 1995. 12. INSURANCE PREMIUMS AND CLAIMS Insurance premiums written and earned by the Company's insurance subsidiaries at December 31, 1993, 1992 and 1991 are as follows (in thousands): 1993 1992 1991 Direct premiums written $253,359 $144,464 $103,594 Assumed premiums written 2,683 7,627 1,259 Ceded premiums written (118,537) (68,006) (41,871) -------- -------- -------- Net premiums written $137,505 $ 84,085 $ 62,982 ======== ======== ======== Direct premiums earned $250,074 $134,551 $100,109 Assumed premiums earned 3,642 7,048 908 Ceded premiums earned (125,634) (62,435) (35,853) -------- -------- -------- Net premiums earned $128,082 $ 79,164 $ 65,164 ======== ======== ======== Insurance loss and loss adjustment expenses have been reduced by recoveries recognized under reinsurance contracts of $216,246,000 for the year ended December 31, 1993. Five insurance agencies produced direct premiums written aggregating approximately 34%, 51% and 46% of total direct premiums during the years ended December 31, 1993, 1992 and 1991, respectively. Insurance loss and loss adjustment expenses paid totaled approximately $68,217,000, $48,530,000 and $39,224,000 during the years ended December 31, 1993, 1992 and 1991, respectively. 13. REINSURANCE The Company's insurance subsidiaries cede insurance to other companies under quota share, excess of risk and facultative treaties. The insurance subsidiaries also maintain catastrophe reinsurance to protect against catastrophic occurrences where claims can arise under numerous policies due to a single event. The reinsurance agreements are tailored to the various programs offered by the insurance subsidiaries. The largest amount retained in any one risk by the insurance subsidiaries during 1993 was $500,000. The insurance subsidiaries are contingently liable if the reinsurance companies are unable to meet their obligations. The methods used for recognizing income and expenses related to reinsurance contracts have been applied in a manner consistent with the recognition of income and expense on the underlying direct and assumed business. 14. DIVIDEND RESTRICTIONS AND REGULATORY MATTERS Dividends from the Acceptance insurance subsidiaries and Redland insurance subsidiaries are not available to the Company because of restrictive covenants set forth in loan agreements which prohibit dividends from Acceptance or Redland to the Company without the express consent of the respective holders of these obligations. Acceptance's insurance subsidiaries reported to regulatory authorities total policyholders' surplus of approximately $57,044,000 and $33,324,000 at December 31, 1993 and 1992, respectively, and total statutory net income of $2,712,000 and $1,304,000 for the years ended December 31, 1993 and 1992, respectively. Redland's insurance subsidiaries reported to regulatory authorities total policyholders' surplus of approximately $14,719,000 at December 31, 1993 and statutory net loss of approximately $5,052,000 for the year ended December 31, 1993. 15. MAJOR GROUP ACQUISITION On September 25, 1992, the Company completed a merger with Major Group which increased the Company's ownership interest to 100%. Pursuant to Settlement Agreements among the Company, Major Group and certain secured creditors (the "Term Sheet Creditors"), Major Group (1) conveyed substantially all of its assets, except for certain property located in Fort Lauderdale, Florida (the "Fort Lauderdale Commerce Center Property") and two promissory notes from Major Realty Corporation (the "Major Realty Notes"), to the Term Sheet Creditors in satisfaction of all of Major Group's obligations due to them; (2) the Fort Lauderdale Commerce Center Property and the Major Realty Notes were transferred to the Company in satisfaction of all amounts due the Company under a note of a subsidiary of Major Group, which was secured by a mortgage on the Fort Lauderdale Commerce Center Property and guaranteed by Major Group; and (3) the Company issued a promissory note in the principal amount of $500,000 payable in installments over one year to the Term Sheet Creditors in exchange for all of the Major Group preferred stock held by the Term Sheet Creditors. Assets conveyed to the Term Sheet Creditors and liabilities satisfied approximated $5.7 million. Immediately upon conclusion of these transactions, Major Group was merged into a wholly-owned subsidiary of the Company. In addition, Major Group settled certain claims by agreeing to pay $150,000 in cash and other consideration, payment of which is guaranteed by the Company, payable over a two year period and payment of the net cash proceeds from the sale of certain sewer connections not to exceed $150,000. In connection with the above, the Company issued approximately 52,000 shares of common stock to complete the merger. The Company recorded approximately $494,000 of excess of cost over acquired net assets which is being amortized over five years. The net effect of the transactions among Major Group, the Term Sheet Creditors and the Company upon results of operations was insignificant. 16. DISCONTINUED OPERATIONS In December 1991, the Company decided to sell its approximate 52% interest in Orange-co, its Florida based subsidiary primarily engaged in growing and processing citrus products as well as packaging and marketing these citrus and other beverage products. The Company, therefore, recorded a provision for the expected loss on disposal, including estimated costs of disposition, of approximately $19,600,000, with no related federal income tax effect. Additionally, revenues and expenses of Orange-co were reclassified as net income (loss) from discontinued operations. The Company's interest in the estimated earnings of Orange-co during the disposal period were not recognized because such earnings were not expected to be realized. On May 28, 1992, the Company consummated the sale of Orange-co for $31,000,000. After payment of expenses of the transaction, $2,030,000, the Company realized a loss on the transaction of $83,000. Net sales of Orange-co for the year ended December 31, 1991, were $80,357,000. 17. CONTINGENCIES The Company is involved in various insurance related claims and other legal actions arising from the normal conduct of business. Management believes that the outcome of these proceedings will not have a material effect on the consolidated financial statements of the Company. A subsidiary of the Company has guaranteed debt of $775,000 relating to a real estate partnership in which the subsidiary has a limited partnership interest. 18. INTERIM FINANCIAL INFORMATION (UNAUDITED) Fully Primary Diluted Net Net Net Income Income Income (Loss) (Loss) Quarters Ended Revenues (Loss) Per Share Per Share (In thousands, except per share data) 1993: December 31 $ 43,821 $ 2,152 $ 0.21 $ 0.21 September 30 38,460 2,167 0.22 0.22 June 30 32,581 1,715 0.20 0.20 March 31 30,433 1,552 0.24 0.23 -------- ------- ------- ------- $145,295 $ 7,586 $ 0.86 (2) $ 0.85 (2) ======== ======= ======== ======= 1992: December 31 $ 24,434 $ 814 $ 0.24 $ 0.24 September 30 25,280 756 0.22 0.22 June 30 23,182 (2,608) (1) (0.76) (0.76) March 31 22,136 129 0.04 0.04 -------- ------- -------- ------- $ 95,032 $ (909) $ (0.26) $ (0.26) ======== ======= ======== ======= (1) The net loss for the quarter ended June 30, 1992 was primarily due to the $2,100,000 strengthening of the Company's loss reserves for its workers' compensation and liquor liability business. (2) Quarterly net income per share numbers for 1993 do not add to the annual net income per share due to rounding. 19. SUBSEQUENT EVENT In March 1994, the Company entered into an Agreement and Plan of Merger with Statewide Insurance Corporation, the exclusive general agent for the Company's non-standard automobile insurance program underwritten by Phoenix Indemnity Insurance Company ("Phoenix Indemnity"), and the owner of 20% of the outstanding shares of common stock of Phoenix Indemnity pursuant to which the Company will acquire by merger (the "Merger") Statewide Insurance Corporation (except for certain assets and liabilities relating to its agency operations other than the non-standard automobile program which will be divested prior to the merger). The effective date of the Merger is March 31, 1994. ACCEPTANCE INSURANCE COMPANIES INC. SCHEDULE III - (Continued) CONDENSED FINANCIAL INFORMATION OF REGISTRANT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 STATEMENTS OF CASH FLOWS (Parent Company Only) In January 1993, the Company assumed a $7 million note from one of its subsidiaries. In April 1993, this note was exchanged for 875,000 shares of common stock and warrants to purchase common stock. (See Note 2 to the Consolidated Financial Statements.) In August 1993, the Company acquired Redland and the purchase price of $15.4 million was comprised of 1,339,000 shares of the Company's common stock and acquisition related costs of $306,000. (See Note 3 to the Consolidated Financial Statements.) In September 1992, the Settlement Agreement and merger with Major Group resulted in non-cash transactions in which (1) the Company received certain real estate and notes receivable from Major Realty in satisfaction of a note receivable due the Company from Major Group; (2) a promissory note in the principal amount of $500,000 was issued by the Company in exchange for all of the Major Group preferred stock; and (3) the Company issued approximately 52,000 shares of common stock which increased its ownership interest in Major Group from approximately 51% to 100%. In addition, the Company contributed the notes receivable from Major Realty of approximately $1.3 million to Acceptance in September 1992. (See Note 15 to the Consolidated Financial Statements.) Cash payments for interest were $1,019,000, $1,960,000 and $3,253,000 during the years ended December 31, 1993, 1992 and 1991, respectively. ACCEPTANCE INSURANCE COMPANIES INC. ACCEPTANCE INSURANCE COMPANIES INC. SCHEDULE V SUPPLEMENTAL INSURANCE INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In Thousands) Net Claims and Claim Adjustment Expenses Incurred Related to ------------------ (1) (2) Other Current Prior Operating Year Years Expenses Year Ended December 31, 1993 $90,250 $2,555 $1,821 Year Ended December 31, 1992 $57,678 $2,347 $1,466 Year Ended December 31, 1991 $46,719 $ 198 $1,550 ACCEPTANCE INSURANCE COMPANIES INC. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In Thousands) Column B Charged to Costs and Expenses ----------------------- 1993 1992 1991 Depreciation and amortization $3,533 $1,552 $2,572 Taxes, other than payroll and income taxes $3,748 $1,859 $1,403 Other captions provided for under this schedule are excluded as the amounts related to such caption are not material.

793421_1993.txt

793421_1993

1993

793421

Item 3. Legal Proceedings. ----------------- Although FRP may be from time to time involved in various legal proceedings of a character normally incident to the ordinary course of its businesses, FRP believes that potential liability in any such pending or threatened proceedings would not have a material adverse effect on the financial condition or results of operations of FRP. FRP, through FTX, maintains liability insurance to cover some, but not all, potential liabilities normally incident to the ordinary course of its businesses as well as other insurance coverages customary in its businesses, with such coverage limits as management deems prudent. 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 information set forth under the captions "FRP Units" and "Cash Distributions", on the inside back cover of FRP's 1993 Annual Report to unitholders is incorporated herein by reference. As of March 10, 1994, there were approximately 18,606 record holders of FRP Units. Item 6. Item 6. Selected Financial Data. ----------------------- The information set forth under the caption "Selected Financial and Operating Data" on page 13 of FRP's 1993 Annual Report to unitholders is incorporated herein by reference. FRP's ratio of earnings to fixed charges for each of the years 1989 through 1993, inclusive, was 4.8x, 16.5x, 4.4x, 1.0x and a shortfall of $233.5 million, respectively. For purposes of this calculation, earnings are income from continuing operations before fixed charges. Fixed charges are interest and that portion of rent deemed representative of interest. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ----------------------------------------------------------- IMC-AGRICO COMPANY Freeport-McMoRan Resource Partners, Limited Partnership (FRP) and IMC Fertilizer, Inc. (IMC) formed a joint venture (IMC-Agrico Company), effective July 1, 1993, for their respective phosphate fertilizer businesses, including phosphate rock and uranium. IMC-Agrico Company is governed by a policy committee having equal representation from each company and is managed by IMC. Combined annual savings of at least $95 million in production, marketing, and general and administrative costs are expected to result from this transaction, the full effect beginning by the end of the second year of operations. The operating efficiencies achievable by the joint venture should enable it to generate positive cash flow in a low-price environment, such as that experienced in 1993, and to be in a position to earn significant profits if product prices rise to historical levels. As discussed below and in Note 4 to the financial statements, significant restructuring charges were recorded in connection with this transaction. As a result of the joint venture, FRP is engaged in the phosphate rock mining, fertilizer production, and uranium oxide extraction businesses only through IMC-Agrico Company. FRP will continue to operate its sulphur and oil businesses. FRP has varying sharing ratios in IMC-Agrico Company, as discussed in Note 2 to the financial statements, which were based on the projected contributions of FRP and IMC to the cash flow of the joint venture and on an equal sharing of the anticipated savings. FRP transferred the assets it contributed to IMC-Agrico Company at their book carrying cost and proportionately consolidates its interest in IMC-Agrico Company. As a result, FRP's operating results subsequent to the formation of IMC-Agrico Company vary significantly in certain respects from those previously reported. Phosphate fertilizer realizations and unit production costs were fundamentally changed as the majority of the FRP contributed fertilizer production facilities are located on the Mississippi River, whereas the IMC contributed fertilizer production facilities are located in Florida. Fertilizer produced on the Mississippi River commands a higher sales price in the domestic market because of its proximity to markets; however, raw material transportation costs at the Florida facilities are lower for phosphate rock, partially offset by increased sulphur transportation costs. 1993 RESULTS OF OPERATIONS COMPARED WITH 1992 After discussions with the staff of the Securities and Exchange Commission (SEC), FRP is reclassifying certain expenses and accruals previously recorded in 1993 as restructuring and valuation of assets. In response to inquiries, FRP advised the SEC staff that $3.2 million originally reported as restructuring and valuation of assets represented the cumulative effect of changes in accounting principle resulting from the adoption of the new accounting policies that FRP considered preferable, as described in Note 1 to the financial statements. FRP also informed the SEC staff of the components of other charges included in the amount originally reported as restructuring and valuation of assets. FRP concluded that the reclassification and the related supplemental disclosures more accurately reflect the nature of these charges to 1993 net income in accordance with generally accepted accounting principles. These reclassifications had no impact on net income or net income per share. FRP incurred a net loss of $246.1 million ($2.37 per unit) for 1993 compared with net income of $20.2 million ($.20 per unit) for 1992. Results for 1993 were adversely impacted by charges totaling $197.3 million ($1.90 per unit) related to (a) restructuring the administrative organization at Freeport-McMoRan Inc. (FTX), the general partner of FRP (Note 4), (b) asset sales/recoverability charges (Note 4), (c) adjustments to general and administrative expenses and production and delivery costs discussed below, and (d) changes in accounting principle, discussed further in Note 1 to the financial statements. Excluding these items, 1993 earnings were lower reflecting significant decreases in phosphate fertilizer, phosphate rock, sulphur, and oil revenues, primarily due to reduced sales volumes and average market prices for these products (see Selected Financial and Operating Data). Depreciation and amortization expense declined primarily because of reduced sales volumes. The reduction in general and administrative expenses reflects the benefits from the 1993 restructuring activities, partially offset by charges resulting from the restructuring project discussed below. Interest expense increased, as no interest was capitalized subsequent to the Main Pass sulphur operations becoming operational for accounting purposes in July 1993. Restructuring Activities. During the second quarter of 1993, FTX undertook a restructuring of its administrative organization. This restructuring represented a major step by FTX to lower its costs of operating and administering its businesses in response to weak market prices of the commodities produced by its operating units. As part of this restructuring, FTX significantly reduced the number of employees engaged in administrative functions, changed its management information system (MIS) environment to achieve efficiencies, reduced its needs for office space, outsourced a number of administrative functions, and implemented other actions to lower costs. As a result of this restructuring process, which included the formation of IMC-Agrico Company, the level of FRP's administrative cost has been reduced substantially over what it would have been otherwise, which benefit will continue in the future. However, the restructuring process entailed incurring certain one-time costs by FTX, a portion of which were allocated to FRP pursuant to its management services agreement with FTX. FRP's restructuring costs totaling $33.9 million, including $22.1 million allocated from FTX based on historical allocations, consisting of the following: $15.5 million for personnel related costs; $7.0 million relating to excess office space and furniture and fixtures resulting from the staff reduction; $1.8 million relating to the cost to downsize its computing and MIS structure; $8.8 million related to costs directly associated with the formation of IMC-Agrico Company; and $.8 million of deferred charges relating to FRP's credit facility which was substantially revised in June 1993. As of December 31, 1993, the remaining accrual for these restructuring costs totaled $3.1 million. In connection with the restructuring project, FRP changed its accounting systems and undertook a detailed review of its accounting records and valuation of various assets and liabilities. As a result of this process, FRP recorded charges totaling $24.9 million, comprised of the following: (a) $10.0 million of production and delivery costs consisting of $6.3 million for revised estimates of environmental liabilities and $3.7 million primarily for adjustments in converting accounting systems, (b) $7.6 million of depreciation and amortization costs consisting of $6.5 million for estimated future abandonment and reclamation costs and $1.1 million for the write-down of miscellaneous properties, and (c) $7.3 million of general and administrative expenses consisting of $4.0 million to downsize FRP's computing and MIS structure and $3.3 million for the write-off of miscellaneous assets. Agricultural Minerals Operations FRP's agricultural minerals segment, which includes its fertilizer, phosphate rock, and sulphur businesses, reported a loss of $55.9 million on revenues of $619.3 million for 1993 compared with earnings of $18.0 million on revenues of $799.0 million for 1992. Significant items impacting the segment earnings are as follows (in millions): Agricultural minerals earnings - 1992 $ 18.0 Major increases (decreases) Sales volumes (67.4) Realizations (103.2) Other (9.1) ------ Revenue variance (179.7) Cost of sales 81.4* General and administrative and other 24.4* (73.9) ------ Agricultural minerals earnings - 1993 $(55.9) ====== - - - ------- * Includes $17.5 million in cost of sales and $7.3 million in general and administrative expenses resulting from the restructuring project discussed above. Weak industrywide demand and changes attributable to FRP's participation in IMC-Agrico Company resulted in FRP's 1993 reported sales volumes for diammonium phosphate (DAP), its principal fertilizer product, declining 17 percent from that of a year-ago. The weakness in the phosphate fertilizer market prompted IMC-Agrico Company to make strategic curtailments in its phosphate fertilizer production. However, late in the year increased export purchases contributed to a rise in market prices, helping to rekindle domestic buying interests which had been unwilling to make purchase commitments. The increased demand, coupled with low industrywide production levels, caused reduced inventory levels. Late in 1993, IMC-Agrico Company increased its production levels in response to the improving markets and projected domestic and international demand for its fertilizer products. Unit production cost, excluding $17.5 million of changes related to the restructuring project, declined from 1992 reflecting initial production efficiencies from the joint venture, reduced raw material costs for sulphur, and lower phosphate rock mining expenses, partially offset by increased natural gas costs and lower production volumes. FRP's realization for DAP was lower reflecting the near 20-year low prices realized during 1993 as well as an increase in the lower-priced Florida sales by IMC-Agrico Company. FRP believes that the outlook for 1994 is for improved prices caused by more normal market demand. Spot market prices improved from a low of nearly $100 per short ton of DAP (central Florida) in July 1993 to just over $140 per ton by year end. Industry inventories at year end were below average levels, despite a fourth quarter rebound in industry production. Export demand is expected to remain at more normal levels during the first half of 1994, with China, India, and Pakistan expected to be active purchasers. Additionally, domestic phosphate fertilizer demand is expected to benefit from increased corn acreage planted due to lower government set- asides and to increased fertilizer application rates necessitated by the widespread flooding that caused a depletion of nutrients in a number of midwestern states. FRP's proportionate share of the larger IMC-Agrico Company phosphate rock operation caused 1993 sales volumes to increase from 1992, with IMC- Agrico Company operating its most efficient facilities to minimize costs. Combined sulphur production from the Caminada and Main Pass mines increased compared with 1992; however, sales volumes declined 16 percent, primarily because of reduced purchases by IMC-Agrico Company resulting from its curtailed fertilizer production. Due to the significant decline in the market price of sulphur, FRP recorded a second-quarter 1993 noncash charge to earnings (not included in segment earnings) for the excess of capitalized cost over expected realization of its non-Main Pass sulphur assets, primarily the Caminada sulphur mine (Note 4). Due to significant improvements in Main Pass sulphur production, FRP ceased the marginally profitable Caminada operations in January 1994. The shutdown of Caminada will have no material impact on FRP's reported earnings. Although reduced global demand has forced production cutbacks worldwide, sulphur prices remain depressed. A rebound in price is not expected until demand improves. At Main Pass, sulphur production increased significantly during 1993 and achieved, on schedule, full design operating rates of 5,500 tons per day (approximately 2 million tons per year) in December 1993 and has since sustained production at or above that level. As a result of the production increases, Main Pass sulphur became operational for accounting purposes beginning July 1, 1993. Recognizing Main Pass sulphur operations in income and discontinuing associated capitalized interest did not affect cash flow, but adversely affected reported operating results. Oil Operation 1993 1992 ---- ---- Sales (barrels) 3,443,000 4,884,000 Average realized price $14.43 $15.91 Earnings (in millions) $(1.5) $4.6 Since completion of development drilling in mid-April 1993, oil production for the Main Pass joint venture (in which FRP owns a 58.3 percent interest) increased significantly, averaging over 20,000 barrels per day for December 1993. Production for 1994 is expected to approximate that of 1993 if water encroachment follows current trends, with the anticipated drilling of additional wells (estimated to cost FRP approximately $4 million) offsetting a production decline in existing wells. Due to the dramatic decline in oil prices at year-end, FRP recorded a $60.0 million charge to earnings (not included in segment earnings) reflecting the excess net book value of its Main Pass oil investment over the estimated future net cash flow to be received. Future price declines, increases in costs, or negative reserve revisions could result in an additional charge to future earnings. CAPITAL RESOURCES AND LIQUIDITY Net cash used in operating activities during 1993 was $2.9 million compared with $120.1 million net cash provided during 1992, due primarily to lower income from operations. Net cash provided by investing activities was $2.5 million compared with $209.9 million used for 1992, reflecting the reduced level of capital expenditures (following completion of Main Pass development expenditures and the cost efficiency program during 1992) and the proceeds from asset sales. Net cash provided by financing activities during 1993 was $17.8 million reflecting net borrowings of $139.0 million partially offset by lower distributions resulting from unpaid distributions to FTX since early-1992 (discussed below), compared with $93.1 million for 1992 which had a net reduction of borrowings totaling $186.2 million funded by $430.5 million in proceeds from the public sale of FRP units in February 1992. Cash flow from operations for 1992 was $120.1 million compared with $106.5 million for 1991. Net cash used in investing activities declined to $209.9 million from $346.9 million in 1991, due primarily to reduced capital expenditures. Net cash provided by financing activities declined to $93.1 million in 1992 from $243.5 million in 1991, with 1991 including net borrowings of $421.2 million. Publicly owned FRP units have cumulative rights to receive quarterly distributions of 60 cents per unit through the distribution for the quarter ending December 31, 1996 (the Preference Period) before any distributions may be made to FTX. FRP has announced that beginning with the distribution for the fourth quarter of 1993 it no longer intends to supplement distributable cash with borrowings. Therefore, FRP's future distributions will be dependent on the distributions received from IMC-Agrico Company, which will primarily be determined by prices and sales volumes of its commodities and cost reductions achieved by its combined operations, and the future cash flow of FRP's oil and sulphur operations (including reclamation expenditures related to its non-Main Pass sulphur assets). On January 21, 1994, FRP declared a distribution of 60 cents per publicly held unit ($30.3 million) and 12 cents per FTX-owned unit ($6.2 million), payable February 15, 1994, bringing the total unpaid distribution due FTX to $239.2 million. Unpaid distributions due FTX will be recoverable from future FRP cash available for quarterly distributions as discussed in Note 3 to the financial statements. The January 1994 distribution included $30.9 million received from IMC-Agrico Company for its fourth-quarter 1993 distribution (including $9.3 million from working capital reductions) and $13.0 million in proceeds from the sale of certain previously mined phosphate rock acreage. In September 1993, FTX agreed to manage for one year Fertiberia, S.L., the restructured phosphate and nitrogen fertilizer businesses of FESA Fertilizantos Espanoles, a wholly owned subsidiary of ERCROS, S.A., a Spanish conglomerate. FTX has assumed no financial obligations during this period. The goal of the management services agreement is to establish Fertiberia as a financially viable concern. If financial viability can be established, FRP has agreed to negotiate the acquisition of a controlling equity interest in Fertiberia. In June 1993, FTX amended its credit agreement in which FRP participates, extending its maturity (Note 5). As of February 1, 1994, $425.0 million was available under the credit facility. To the extent FTX and its other subsidiaries incur additional debt, the amount available to FRP under the credit facility may be reduced. FRP believes that its short- term cash requirements will be met from internally generated funds and borrowings under its existing credit facility. ENVIRONMENTAL FTX and its affiliates, including FRP, have a history of commitment to environmental responsibility. Since the 1940s, long before public attention focused on the importance of maintaining environmental quality, FTX and its affiliates have conducted preoperational, bioassay, marine ecological, and other environmental surveys to ensure the environmental compatibility of its operations. FTX's Environmental Policy commits FTX and its affiliates' operations to full compliance with local, state, and federal laws and regulations, and prescribes the use of periodic environmental audits of all domestic facilities to evaluate compliance status and communicate that information to management. FTX has access to environmental specialists who have developed and implemented corporatewide environmental programs. FTX's operating units, including FRP, continue to study and implement methods to reduce discharges and emissions. Federal legislation (sometimes referred to as "Superfund") requires payments for cleanup of certain abandoned waste disposal sites, even though such waste disposal activities were performed in compliance with regulations applicable at the time of disposal. Under the Superfund legislation, one party may, under certain circumstances, be required to bear more than its proportional share of cleanup costs at a site where it has responsibility pursuant to the legislation, if payments cannot be obtained from other responsible parties. Other legislation mandates cleanup of certain wastes at unabandoned sites. States also have regulatory programs that can mandate waste cleanup. Liability under these laws involves inherent uncertainties. FRP has received notices from governmental agencies that it is one of many potentially responsible parties at certain sites under relevant federal and state environmental laws. Further, FRP is aware of additional sites for which it may receive such notices in the future. Some of these sites involve significant cleanup costs; however, at each of these sites other large and viable companies with equal or larger proportionate shares are among the potentially responsible parties. The ultimate settlement for such sites usually occurs several years subsequent to the receipt of notices identifying potentially responsible parties because of the many complex technical and financial issues associated with site cleanup. FRP believes that the aggregation of any costs associated with these potential liabilities will not exceed amounts accrued and expects that any costs would be incurred over a period of years. FRP, through FTX, maintains insurance coverage in amounts deemed prudent for certain types of damages associated with environmental liabilities which arise from unexpected and unforeseen events and has an indemnification agreement covering certain acquired sites (Note 7). FRP has made, and will continue to make, expenditures at its operations for protection of the environment. Continued government and public emphasis on environmental issues can be expected to result in increased future investments for environmental controls, which will be charged against income from future operations. Present and future environmental laws and regulations applicable to FRP's operations may require substantial capital expenditures and may affect its operations in other ways that cannot now be accurately predicted. 1992 RESULTS OF OPERATIONS COMPARED WITH 1991 FRP reported 1992 net income of $20.2 million ($.20 per unit) compared with $15.0 million ($.18 per unit) for 1991, which included an insurance settlement gain (Note 7) of $17.7 million ($.21 per unit) and a charge of $96.8 million ($1.16 per unit) to reflect the cumulative effect of the change in accounting principle for postretirement benefits other than pensions (Note 6). Excluding the nonrecurring items, income for 1992 was lower primarily because of reduced agricultural minerals and uranium earnings, partially offset by profitable Main Pass oil operations. Revenues were virtually unchanged from 1991 with increases in oil and phosphate rock revenues partially offsetting a decrease in phosphate fertilizer revenues. Production and delivery costs as a percent of revenues declined due to increased oil production, which has lower production and delivery costs than FRP's other products. Depreciation and amortization expense rose primarily because of higher oil production, and general and administrative expenses increased due to the additional effort and support required by Main Pass. Interest costs of $19.1 million for 1992 and $23.3 million for 1991, associated primarily with Main Pass development, were capitalized. Agricultural Minerals Operations Revenues and earnings for 1992 totaled $799.0 million and $18.0 million compared with $880.5 million and $78.9 million for 1991, respectively, reflecting weak market prices for phosphate fertilizers and sulphur. However, FRP's 1992 average unit production cost for phosphate fertilizers was lower than during 1991. Significant items impacting the segment earnings are as follows (in millions): Agricultural minerals earnings - 1991 $ 78.9 Major increases (decreases) Sales volumes 27.0 Realizations (107.8) Other (.7) ------ Revenue variance (81.5) Cost of sales 41.9 General and administrative and other (21.3) ------ (60.9) ------ Agricultural minerals earnings - 1992 $ 18.0 ====== Phosphate fertilizer sales volumes were slightly lower during 1992, whereas the average realization was 13 percent lower. Phosphate fertilizer realizations declined steadily throughout 1992 because of curtailed purchases by China, the largest single fertilizer importer, and supply and demand uncertainty in Europe, the former Soviet Union, and India. Also contributing to the decline in prices were lower raw material costs, most notably for sulphur, as producers in the weakening market passed along these cost savings to buyers in an attempt to preserve market share. FRP's phosphate rock and fertilizer facilities operated at or near capacity, with the 1992 phosphate fertilizer unit production cost averaging 7 percent less than during 1991 due to reduced raw material costs for sulphur and lower phosphate rock mining expenses, despite higher natural gas costs. Unit production cost also benefited during the latter part of 1992 as FRP completed a $60.0 million capital program to improve efficiency and lower costs. Sulphur production and sales volumes for 1992 declined 8 percent and 7 percent, respectively, from 1991 as the Garden Island Bay and Grand Isle mines ceased production in 1991. However, production increased at the Caminada mine, which had a significantly lower unit production cost than either Garden Island Bay or Grand Isle had prior to depletion, resulting in an average sulphur unit production cost 7 percent lower than during 1991. FRP's 1992 sulphur realization reflects the price declines which occurred since mid-1991, as world sulphur markets were burdened by the collapse of the Soviet Union as well as by a further decline in demand in Western Europe. During 1992, several Canadian sulphur marketers built inventory rather than accept depressed prices; however, others intensified their efforts to sell into the important Tampa, Florida market. Phosphate rock production and sales benefited from the capacity expansion completed in mid-1992 at one of FRP's two operated phosphate rock mines, and also reflect the output from FRP's Central Florida Pebbledale property, where sales began in July 1991 under a mining agreement with IMC. Oil Operation 1992 1991 --------- ------- Sales (barrels) 4,884,000 350,800 Average realized price $15.91 $13.34 Earnings (in millions) $4.6 $(.6) Earnings for Main Pass, which initiated oil production in late 1991, benefited from FRP's marketing efforts, which alleviated earlier problems related to its high-sulphur oil, and high average production rates. ______________________________________ The results of operations reported and summarized above are not necessarily indicative of future operating results. Item 8. Item 8. Financial Statements and Supplementary Data. ------------------------------------------- The financial statements of FRP, the notes thereto and the report thereon of Arthur Andersen & Co., appearing on pages 20 through 32 inclusive, of FRP's 1993 Annual Report to unitholders, 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. -------------------------------------------------- FRP has no directors; instead, the general partners in FRP, FTX and FMRP Inc., perform comparable functions for FRP. In addition to the elected executive officers of FRP (the "Elected FRP Executive Officers"), certain employees of the general partners have management responsibilities with respect to FRP and are thus deemed by FRP to be executive officers of FRP (the "Designated FRP Executive Officers") for purposes of the federal securities laws. The following table shows, as of March 15, 1994, the names, ages, positions with the general partners and principal occupations of the Elected FRP Executive Officers and the Designated FRP Executive Officers (collectively, the "FRP Executive Officers"): Name Age Positions and Principal Occupations ---- --- ----------------------------------- Richard C. Adkerson 47 Senior Vice President of FTX. John G. Amato 50 General Counsel of FRP. General Counsel of FTX. Director of FMRP Inc. Richard H. Block 43 Senior Vice President - Fertilizer Operations of FRP. Senior Vice President of FTX. R. Foster Duncan 40 Senior Vice President of FRP. Thomas J. Egan 49 Senior Vice President of FTX. Robert B. Foster 50 Senior Vice President - Sulphur Operations of FRP. Charles W. Goodyear 36 Senior Vice President - Finance and Accounting and Chief Financial Officer of FRP. Senior Vice President of FTX. Director of FMRP Inc. W. Russell King 44 Senior Vice President of FTX. Rene L. Latiolais 51 President and Chief Executive Officer of FRP. Director, President, and Chief Operating Officer of FTX. Director, Chairman of the Board, and President of FMRP Inc. George A. Mealey 60 Executive Vice President of FTX. Director, President, and Chief Executive Officer of Freeport-McMoRan Copper & Gold Inc., a subsidiary of FTX. James R. Moffett 55 Director, Chairman of the Board, and Chief Executive Officer of FTX. All of the individuals above, with the exceptions of Messrs. Adkerson, Amato, Duncan and Goodyear, have served FTX or FRP in various executive capacities for at least the last five years. Until 1989, Mr. Adkerson was a partner in Arthur Andersen & Co., an independent public accounting firm, Mr. Duncan was First Vice President and Manager-Corporate Finance of Howard Weil Labouisse Friedrichs Incorporated, a brokerage firm, and Mr. Goodyear was a Vice President of Kidder, Peabody & Co. Incorporated, an investment banking firm. During the past five years and prior to that period, Mr. Amato has been engaged in the private practice of law and has served as outside counsel to FTX and FRP. All Elected FRP Executive Officers and all officers of FTX serve at the pleasure of the Board of Directors of FTX. All officers of FMRP Inc. serve at the pleasure of the Board of Directors of FMRP Inc. According to (i) the Forms 3 and 4 and any amendments thereto filed pursuant to Section 16(a) of the Securities Exchange Act of 1934 ("Section 16") and furnished to FRP during 1993 by persons subject to Section 16 at any time during 1993 with respect to securities of FRP ("FRP Section 16 Insiders"), (ii) the Forms 5 with respect to 1993 and any amendments thereto filed pursuant to Section 16 and furnished to FRP by FRP Section 16 Insiders, and (iii) the written representations from certain FRP Section 16 Insiders that no Form 5 with respect to the securities of FRP was required to be filed by such FRP Section 16 Insider, respectively, with respect to 1993, no FRP Section 16 Insider failed to file altogether or timely any Forms 3, 4, or 5 required by Section 16 with respect to the securities of FRP or to disclose on such Forms transactions required to be reported thereon. Item 11. Item 11. Executive Compensation. ---------------------- FRP does not employ any of the FRP Executive Officers, nor does it compensate them for their services. The FRP Executive Officers are either employed or retained by FTX. The President and Chief Executive Officer of FRP, Rene L. Latiolais, is employed by FTX. The four most highly compensated FRP Executive Officers other than Mr. Latiolais are James R. Moffett, Richard H. Block, Charles W. Goodyear, and W. Russell King; they are also employed by FTX. The determination as to which FRP Executive Officers were the most highly compensated was made by reference to the total annual salary and bonus for 1993 of each of the FRP Executive Officers employed by FTX that was allocated to FRP by FTX pursuant to the FRP partnership agreement on the basis of time devoted to FRP activities. The services of all the FRP Executive Officers and the services of the other officers of FRP are provided to FRP by FTX under the FRP partnership agreement. FRP reimburses FTX at FTX's cost, including allocated overhead, for such services. All the FRP Executive Officers are compensated exclusively by FTX for their services to FRP. All the FRP Executive Officers are eligible to participate in certain FTX benefit plans and programs. The total costs to FTX for the FRP Executive Officers, including the costs borne by FTX with respect to such plans and programs, are allocated to FRP, to the extent practicable, in proportion to the time spent by such FRP Executive Officers on FRP affairs. No other payment is made by FRP to FTX for providing such compensation and benefit plans and programs to the FRP Executive Officers. Reference is made to the information set forth under the caption "Management" above and to the information set forth in Note 6 to the FRP Financial Statements. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. ----------------------------------------------- According to information furnished by the person known to FRP to be a beneficial owner of more than 5% of Partnership Units, the number of Partnership Units beneficially owned by such person as of December 31, 1993, was as follows: Number of Partnership Units Percent Beneficially of Name and Address of Person Owned Class - - - -------------------------- ----------------- ------- Freeport-McMoRan Inc. 52,170,192(a) 50.8 1615 Poydras Street New Orleans, Louisiana 70112 _________ (a) These Partnership Units consist of 18,582 FRP Depositary Units and 52,151,610 FRP Unit Equivalents. FTX has sole voting and investment power with respect to such Partnership Units. The other general partner in FRP, FMRP Inc., did not own beneficially any Partnership Units as of December 31, 1993. According to information furnished by each of the Elected FRP Executive Officers and the Designated FRP Executive Officers (collectively, the "FRP Executive Officers"), the number of FRP Depositary Units and shares of FTX common stock ("FTX Shares") beneficially owned by each of them as of December 31, 1993, was as follows: Number of Number of FRP Depositary Units FTX Shares Name of Individual Beneficially Beneficially or Identity of Group Owned(a) Owned(a) - - - -------------------- -------------------- ------------ Richard H. Block 2,184 70,661(b) Charles W. Goodyear 0 188,597(b)(c) W. Russell King 990 64,119(b) Rene L. Latiolais 539(d) 517,590(b) James R. Moffett 65,439(e) 3,313,162(b)(e) 11 FRP Executive Officers as a group, including those persons named above 76,468(f) 5,033,771(f) - - - -------- (a) Except as otherwise noted, the individuals referred to have sole voting and investment power with respect to such FRP Depositary Units and FTX Shares. With the exception of Mr. Moffett, who beneficially owns 2.3% of the outstanding FTX Shares, each of the individuals referred to holds less than 1% of the outstanding FRP Depositary Units and FTX Shares, respectively. (b) Includes FTX Shares held by the trustee under the Employee Capital Accumulation Program of FTX, as follows: Mr. Block, 11,765 FTX Shares; Mr. Goodyear, 2,113 FTX Shares; Mr. King, 9,510 FTX Shares; Mr. Latiolais, 15,191 FTX Shares; Mr. Moffett, 21,293 FTX Shares; all FRP Executive Officers as a group (10 persons), 79,188 FTX Shares. Also includes FTX Shares that could be acquired within 60 days after December 31, 1993 upon the exercise of options granted pursuant to the employee stock option plans of FTX, as follows: Mr. Block, 58,896 FTX Shares; Mr. Goodyear, 186,420 FTX Shares; Mr. King, 19,168 FTX Shares; Mr. Latiolais, 332,426 FTX Shares; Mr. Moffett, 1,764,434 FTX Shares; all FRP Executive Officers as a group (11 persons), 3,079,436 FTX Shares. (c) Includes 64 FTX Shares held in a retirement account for the benefit of Mr. Goodyear. (d) Includes 405 FRP Depositary Units held for the benefit of Mr. Latiolais by the custodian under FRP's Depositary Unit Reinvestment Plan. (e) Includes a total of 39,600 FRP Depositary Units and 214,648 FTX Shares held for the benefit of a trust with respect to which Mr. Moffett and an FRP Executive Officer, as co-trustees of such trust, have sole voting and investment power but have no beneficial interest therein. Mr. Moffett and such FRP Executive Officer disclaim beneficial ownership of such FRP Depositary Units and FTX Shares held for the benefit of such trust. Includes a total of 25,839 FRP Depositary Units and 85,140 FTX Shares held for the benefit of two trusts created by Mr. Moffett for the benefit of his two children, who are adults. An FRP Executive Officer and another individual, as co-trustees of the two trusts, have sole voting and investment power with respect to such FRP Depositary Units and FTX Shares held for the benefit of such trusts but have no beneficial interest therein. Mr. Moffett and such FRP Executive Officer disclaim beneficial ownership of such FRP Depositary Units and FTX Shares held for the benefit of such trusts. Includes a total of 88,000 FTX Shares held for the benefit of a trust created by Mr. Moffett for the benefit of an educational fund and his two children, who are adults. An FRP Executive Officer and another individual, as co-trustees of such trust, have sole voting and investment power with respect to such FTX Shares held for the benefit of such trust but have no beneficial interest therein. Mr. Moffett and such FRP Executive Officer disclaim beneficial ownership of such FTX Shares held for the benefit of such trust. (f) See notes (b) through (e) above. Includes 724 FTX Shares that may be acquired upon the conversion of 6.55% Convertible Subordinated Notes due January 15, 2001 of FTX ("FTX Notes") held in trust for the benefit of one of the FRP Executive Officers, 2,682 FTX Shares that may be acquired upon the conversion of Zero Coupon Convertible Subordinated Debentures due 2006 of FTX held in trust for the benefit of such FRP Executive Officer, and 90 FTX Shares that may be acquired upon the conversion of FTX Notes held in trust for the benefit of the spouse of such FRP Executive Officer. Includes 6 FRP Depositary Units and 1,516 FTX Shares held in trust for the benefit of one of the FRP Executive Officers, 92 FTX Shares held in trust for the benefit of the spouse of such FRP Executive Officer as to which beneficial ownership is disclaimed, and 1,000 FTX Shares held by such FRP Executive Officer as custodian as to which beneficial ownership is disclaimed. These total numbers of FRP Depositary Units and FTX Shares represent less than 1% of the outstanding FRP Depositary Units and approximately 3.5% of the outstanding FTX Shares, respectively. Item 13. Item 13. Certain Relationships and Related Transactions. ---------------------------------------------- Reference is made to the information set forth under the caption "Management" above, to the information set forth in Item 11 above and to the information set forth in Note 6 to the FRP Financial Statements. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. --------------------------------------------------------------- (a)(1), (a)(2), and (d). Financial Statements. Reference is made to the Index to Financial Statements appearing on page hereof. (a)(3) and (c). Exhibits. Reference is made to the Exhibit Index beginning on page E-1 hereof. (b). Reports on Form 8-K. No reports on Form 8-K were filed by the registrant during the fourth quarter of 1993. 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, on March 29, 1994. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP By: FREEPORT-McMoRan INC., Its Administrative Managing General Partner By: /s/ James R. Moffett ---------------------------- James R. Moffett Chairman of the Board 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 March 29, 1994. /s/ Rene L. Latiolais President and Chief Executive Officer - - - ----------------------- of Freeport-McMoRan Resource Rene L. Latiolais Partners, Limited Partnership and Director of Freeport-McMoRan Inc. (Principal Executive Officer) /s/ Charles W. Goodyear Senior Vice President and Chief - - - ----------------------- Financial Officer of Freeport-McMoRan Charles W. Goodyear Resource Partners, Limited Partnership (Principal Financial Officer) /s/ Nancy D. Bonner Vice President and Controller of - - - ----------------------- Freeport-McMoRan Resource Partners, Nancy D. Bonner Limited Partnership (Principal Accounting Officer) Robert W. Bruce III* Director of Freeport-McMoRan Inc. Thomas B. Coleman* Director of Freeport-McMoRan Inc. William H. Cunningham* Director of Freeport-McMoRan Inc. Robert A. Day* Director of Freeport-McMoRan Inc. William B. Harrison, Jr.* Director of Freeport-McMoRan Inc. Henry A. Kissinger* Director of Freeport-McMoRan Inc. Bobby Lee Lackey* Director of Freeport-McMoRan Inc. Gabrielle K. McDonald* Director of Freeport-McMoRan Inc. W. K. McWilliams, Jr.* Director of Freeport-McMoRan Inc. /s/ James R. Moffett Director, Chairman of the Board - - - ----------------------- and Chief Executive Officer James R. Moffett of Freeport-McMoRan Inc. George Putnam* Director of Freeport-McMoRan Inc. B. M. Rankin, Jr.* Director of Freeport-McMoRan Inc. Benno C. Schmidt* Director of Freeport-McMoRan Inc. J. Taylor Wharton* Director of Freeport-McMoRan Inc. Ward W. Woods, Jr.* Director of Freeport-McMoRan Inc. *By: /s/ James R. Moffett ----------------------- James R. Moffett Attorney-in-Fact The financial statements of FRP, the notes thereto, and the report thereon of Arthur Andersen & Co., appearing on pages 20 through 32, inclusive, of FRP's 1993 Annual Report to unitholders are incorporated by reference. The financial statement schedules listed below should be read in conjunction with such financial statements contained in FRP's 1993 Annual Report to unitholders. Page ---- Report of Independent Public Accountants.........................F-1 III-Condensed Financial Information of Registrant................F-2 V-Property, Plant and Equipment..................................F-5 VI-Accumulated Depreciation and Amortization.....................F-6 VIII-Valuation and Qualifying Accounts...........................F-7 X-Supplementary Income Statement Information.....................F-8 Schedules other than those listed above have been omitted, since they are either not required, not applicable or the required information is included in the financial statements or notes thereof. * * * REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS We have audited, in accordance with generally accepted auditing standards, the financial statements as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 included in Freeport-McMoRan Resource Partners, Limited Partnership's annual report to unitholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index above 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. The schedules for the years ended December 31, 1993, 1992 and 1991 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. /s/ Arthur Andersen & Co. ------------------------- Arthur Andersen & Co. New Orleans, Louisiana, January 25, 1994 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS December 31, ------------------- 1993 1992 ---- ---- (In Thousands) ASSETS Current assets: Cash and short-term investments $ 5,300 $ 7,099 Accounts receivable: Customers 6,193 50,399 Other 12,811 12,175 Inventories: Products 31,458 141,216 Materials and supplies 7,877 29,060 Prepaid expenses and other 273 22,214 ---------- ---------- Total current assets 63,912 262,163 Property, plant and equipment-net 532,927 1,074,332 Investment in IMC-Agrico Company 483,070 - Other assets 100,628 157,012 ---------- ---------- Total assets $1,180,537 $1,493,507 ========== ========== LIABILITIES AND PARTNERS' CAPITAL Current liabilities: Accounts payable and accrued liabilities $ 37,175 $ 102,366 Current portion of long-term debt - 1,575 ---------- ---------- Total current liabilities 37,175 103,941 Long-term debt, less current portion 475,900 356,563 Reclamation and mine shutdown reserves 58,896 55,152 Accrued postretirement benefits and other liabilities 116,162 118,156 Partners' capital 492,404 859,695 ---------- ---------- Total liabilities and partners' capital $1,180,537 $1,493,507 ========== ========== The footnotes contained in FRP's 1993 Annual Report to unitholders are an integral part of these statements. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF OPERATIONS The footnotes contained in FRP's 1993 Annual Report to unitholders are an integral part of these statements. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOW The footnotes contained in FRP's 1993 Annual Report to unitholders notes are an integral part of these statements. FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan RESOURCE PARTNERS, LIMITED PARTNERSHIP SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992, and 1991 Freeport-McMoRan Resource Partners, Limited Partnership Exhibit Index Sequentially Exhibit Numbered Number Page - - - ------- ---------------- 3.1 Amended and Restated Agreement of Limited Partnership of FRP dated as of May 29, 1987 (the "FRP Partnership Agreement") among FTX, Freeport Phosphate Rock Company and Geysers Geothermal Company, as general partners, and Freeport Minerals Company, as general partner and attorney-in-fact for the limited partners, of FRP. Incorporated by reference to Exhibit B to the Prospectus dated May 29, 1987 included in FRP's Registration Statement on Form S-1, as amended, as filed with the Commission on May 29, 1987 (Registration No. 33-13513). 3.2 Amendment to the FRP Partnership Agreement dated as of April 6, 1990 effected by FTX, as Administrative Managing General Partner of FRP. Incorporated by reference to Exhibit 19.3 to the Quarterly Report on Form 10-Q of FRP for the quarter ended March 31, 1990 (the "FRP 1990 First Quarter Form 10-Q"). 3.3 Amendment to the FRP Partnership Agreement dated as of January 27, 1992 between FTX, as Administrative Managing General Partner, and FMRP Inc., as Managing General Partner, of FRP. Incorporated by reference to Exhibit 3.3 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1991 (the "FRP 1991 Form 10-K"). 3.4 Amendment to the FRP Partnership Agreement dated as of October 14, 1992 between FTX, as Administrative Managing General Partner, and FMRP Inc., as Managing General Partner, of FRP. Incorporated by reference to Exhibit 3.4 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1992 (the "FRP 1992 Form 10-K"). 3.5 Amended and Restated Certificate of Limited Partnership of FRP dated June 12, 1986 (the "FRP Partnership Certificate"). Incorporated by reference to Exhibit 3.3 to FRP's Registration Statement on Form S-1, as amended, as filed with the Commission on June 20, 1986 (Registration No. 33-5561). 3.6 Certificate of Amendment to the FRP Partnership Certificate dated as of January 12, 1989. 3.7 Certificate of Amendment to the FRP Partnership Certificate dated as of December 29, 1989. Incorporated by reference to Exhibit 19.1 to the FRP 1990 First Quarter Form 10-Q. 3.8 Certificate of Amendment to the FRP Partnership Certificate dated as of April 12, 1990. Incorporated by reference to Exhibit 19.4 to the FRP 1990 First Quarter Form 10-Q. 4.1 Deposit Agreement dated as of June 27, 1986 (the "Deposit Agreement") among FRP, The Chase Manhattan Bank, N.A. ("Chase") and Freeport Minerals Company ("Freeport Minerals"), as attorney-in-fact of those limited partners and assignees holding depositary receipts for units of limited partnership interests in FRP ("Depositary Receipts"). Incorporated by reference to Exhibit 28.4 to the Current Report on Form 8-K of FTX dated July 11, 1986. 4.2 Resignation dated December 26, 1991 of Chase as Depositary under the Deposit Agreement and appointment dated December 27, 1991 of Mellon Bank, N.A. ("Mellon") as successor Depositary, effective January 1, 1992. Incorporated by reference to Exhibit 4.5 to the FRP 1991 Form 10-K. 4.3 Service Agreement dated as of January 1, 1992 between FRP and Mellon pursuant to which Mellon will serve as Depositary under the Deposit Agreement and Custodian under the Custodial Agreement. Incorporated by reference to Exhibit 4.6 to the FRP 1991 Form 10-K. 4.4 Amendment to the Deposit Agreement dated as of November 18, 1992 between FRP and Mellon. Incorporated by reference to Exhibit 4.4 to the FRP 1992 Form 10-K. 4.5 Form of Depositary Receipt. Incorporated by reference to Exhibit 4.5 to the FRP 1992 Form 10-K. 4.6 Custodial Agreement regarding the FRP Depositary Unit Reinvestment Plan among FTX, FRP and Chase, effective as of April 1, 1987 (the "Custodial Agreement"). Incorporated by refer- ence to Exhibit 19.1 to the Quarterly Report on Form 10-Q of FRP for the quarter ended June 30, 1987. 4.7 FRP Depositary Unit Reinvestment Plan. Incorporated by reference to Exhibit 4.4 to the FRP 1991 Form 10-K. 4.8 Credit Agreement dated as of June 1, 1993 (the "FTX/FRP Credit Agreement") among FTX, FRP, the several banks which are parties thereto (the "FTX/FRP Banks") and Chemical Bank, as Agent (the "FTX/FRP Bank Agent"). 4.9 First Amendment dated as of February 2, 1994 to the FTX/FRP Credit Agreement among FTX, FRP, the FTX/FRP Banks and the FTX/FRP Bank Agent. 4.10 Second Amendment dated as of March 1, 1994 to the FTX/FRP Credit Agreement among FTX, FRP, the FTX/FRP Banks and the FTX/FRP Bank Agent. 4.11 Subordinated Indenture as of October 26, 1990 between FRP and Manufacturers Hanover Trust Company ("MHTC") as the Trustee, relating to $150,000,000 principal amount of 8 3/4% Senior Subordinated Notes due 2004 of FRP (the "Subordinated Indenture"). 4.12 First Supplemental Indenture dated as of February 15, 1994 between FRP and Chemical Bank, as Successor to MHTC, as Trustee, to the Subordinated Indenture. 10.1 Contribution Agreement dated as of April 5, 1993 between FRP and IMC (the "FRP-IMC Contribution Agreement"). Incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K of FRP dated July 15, 1993 (the "FRP July 15, 1993 Form 8-K"). 10.2 First Amendment dated as of July 1, 1993 to the FRP-IMC Contribution Agreement. Incorporated by reference to Exhibit 2.2 to the FRP July 15, 1993 Form 8-K. 10.3 Amended and Restated Partnership Agreement dated as of July 1, 1993 among IMC-Agrico GP Company, Agrico, Limited Partnership and IMC-Agrico MP Inc. Incorporated by reference to Exhibit 2.3 to the FRP July 15, 1993 Form 8-K. 10.4 Parent Agreement dated as of July 1, 1993 among IMC, FRP, FTX and IMC- Agrico. Incorporated by reference to Exhibit 2.4 to the FRP July 15, 1993 Form 8-K. 12.1 FRP Computation of Ratio of Earnings to Fixed Charges. 13.1 Those portions of the 1993 Annual Report to unitholders of FRP which are incorporated herein by reference. 18.1 Letter of Arthur Andersen & Co. concerning changes in accounting principles. 21.1 List of Subsidiaries of Freeport McMoRan Resource Partners, Limited Partnership 23.1 Consent of Arthur Andersen & Co. dated March 25, 1994. 24.1 Powers of Attorney pursuant to which this report has been signed on behalf of certain directors of FTX.

824430_1993.txt

824430_1993

1993

824430

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

30770_1993.txt

30770_1993

1993

30770

ITEM 1. BUSINESS General Information The Company provides diversified management, technical and professional services to government and commercial customers throughout the United States and to a limited extent in certain foreign countries. Generally, these services are provided under written contracts which may be fixed-price, time-and-material or cost reimbursable depending on the work requirements and other individual circumstances. The Company performs these services through several operating units. For business reporting purposes these operating units are combined into two categories: Government Services and Commercial Services. (In 1992 and 1991 the Company reported through four operating groups: The Government Services Group, the Applied Sciences Group, the Commercial Aviation Services Group and the Postal Operations Division.) Government Services provides services to all branches of the Department of Defense and to NASA, the Department of State, the Department of Energy, the Environmental Protection Agency, the Centers for Disease Control, the National Institutes of Health, the Postal Service and other U.S. Government agencies and foreign governments. These services encompass a wide range of management, technical and professional services covering the following areas: Aviation Services, including engineering, maintenance, modification, and operational and logistical support of military aircraft and weapons systems. Facilities Management Services, including specialized facilities operations, maintenance and management support on military installations and at other federal operating locations. Security and Telecommunications Services, including the design, installation and maintenance of security and telecommunications systems. Range Operations, Test and Evaluation Services, including the test and evaluation of military hardware and weapons systems at Government test ranges, and research, development and engineering services. Computer and Information Services, including software development and maintenance, computer center operations, data processing and analysis, database administration, telecommunications, and operation and maintenance of integrated electronic systems. Health and Information Technology Services, including a full range of health services, medical care, environmental and biomedical research, and information technology services to such customers as the Centers for Disease Control, the National Institutes of Health and the Environmental Protection Agency. Energy, Environmental and Management Consulting Services, including technical and program management consulting services to the U.S. Government and private industry clients in areas such as energy, environmental engineering, robotics, nuclear weapons security, artificial intelligence and information processing. Commercial Services is composed of two major operating units that provide aircraft maintenance, ground support, cargo handling, passenger services and aircraft fueling to domestic and international air carriers throughout the U.S. In 1993, business proposals were submitted in several European countries and aviation ground support services were provided in Russia. The two major operating units of Commercial Services are as follows: Aircraft Maintenance includes maintenance checks, component overhaul, heavy structural maintenance, airframe and system maintenance and modification on a wide variety of passenger and cargo aircraft including wide-body aircraft. Ground Support Services includes cargo handling, cabin grooming, line maintenance, ticketing and passenger handling and boarding services. Auxiliary support services include bus and limousine operation, security, baggage service and passenger screening operations. Also includes into-plane fueling services and the management and operation of tank farms and fuel distribution systems. Industry Segments The Company has one line of business, which is to provide management and technical services to commercial and government organizations in support of the customers' facilities and/or operations. Backlog The Company's backlog of business (including estimated value of option years on government contracts) was $2.772 billion at the close of 1993, compared to a year-end 1992 backlog of $2.241 billion. Of the total backlog on December 31, 1993, $1.823 billion is expected to produce revenues after 1994. Contracts with the U.S. Government are generally written for periods of three to five years. Because of appropriation limitations in the federal budget process, firm funding is usually made for only one year at a time, with the remainder of the years under the contract expressed as a series of one-year options. U.S. Government contracts contain standard provisions for termination for the convenience of the U.S. Government, pursuant to which the Company is generally entitled to recover costs incurred, settlement expenses, and profit on work completed to termination. The Company's ground support services contracts with airlines generally run for one to three years. Some contracts are terminable on short notice, but the Company's experience has been that few airlines choose to exercise this option given the difficulty of integrating a replacement provider into the airline's schedule. The Company is usually paid for its ground services at a fixed contract rate on a per-flight basis (every takeoff and landing). For heavy aircraft maintenance checks, carriers solicit bids for the required services. Awards are made on the basis of price, quality of service and past performance. For routine line maintenance, the Company charges a flat rate based on the service and the frequency of visits. Competition The general fields in which the Company conducts business are all highly competitive, with competition based on a variety of factors including, but not limited to, price, service and past experience. Competitors of the Company vary in size with some having a larger financial resource base. However, the Company believes that it has been awarded many contracts because of its technical know-how and past service record. Some of the major competitors of the Company are as follows: Government Services Commercial Services SAIC AMR Services, Inc. BDM Hudson General Corp Computer Science Corp. Ogden Aviation Services Johnson Controls Lockheed Tracor Page Avjet Brown and Root Delfort Aviation Inc. Vitro ASI Foreign Operations The Company has a minority investment in an affiliate company which operates in Saudi Arabia. In addition, the Company in 1993 established operations in Mexico and Russia. None of these foreign operations are material to the Company's financial position or results of operations. Other activities of the Company presently include the providing of services within the United States to certain foreign customers. These services for foreign customers are generally paid for in United States dollars. The Company also performs services in foreign countries under U.S. Government contracts. The risks associated with the Company's foreign operations in regard to foreign currency fluctuation, and political and economic conditions in foreign countries are not significant. Incorporation The Company was incorporated in Delaware in 1946. Employees The Company had approximately 21,800 employees at December 31, 1993. ITEM 2. ITEM 2. PROPERTIES The Company is a service-oriented company, and as such the ownership or leasing of real property is an activity which is not material to an understanding of the Company's operations. Properties owned or leased include office facilities, hangars, warehouses used in connection with the storage of inventories and fabrication of materials associated with various services rendered and servicing facilities used in the Company's commercial aviation operations. None of the properties is unique; however, several of the leases constitute partially exclusive rights to operate at certain airports. All of the Company's owned facilities are located within the United States. In the opinion of management, the facilities employed by the Company are adequate for the present needs of the business. Reference is made to the Consolidated Financial Statements and Notes, included elsewhere in this Annual Report on Form 10-K, for additional information concerning capital expenditures and lease commitments for property. ITEM 3. ITEM 3. LEGAL PROCEEDINGS This item is incorporated herein by reference to Note 16 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. 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. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS DynCorp's common stock is not publicly traded. There were approximately 336 record holders of DynCorp common stock at December 31, 1993. In addition, the DynCorp Employee Stock Ownership Plan Trust owns stock on behalf of approximately 29,000 present and former employees of the Company. Cash dividends have not been paid on the common stock since 1988. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table of selected financial data of the Company should be read in conjunction with the Company's Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. (Dollars in thousands except per share data.) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview In 1993, the Company achieved record revenues, incurred the smallest loss ($11.1 million) before income taxes, minority interest and extraordinary item since the leveraged buy-out by its management and Employee Stock Ownership Plan in 1988, and ended the year with the largest backlog in its history. In fact, but for losses in the Commercial Services' aircraft maintenance business ($6.6 million), unusual write-offs and expenses in connection with two acquisitions ($3.6 million) and the above market PIK interest (approximately $4.1 million) the Company would have been profitable for the year. However, the Company continues to be highly leveraged, and its debt expense continued to be excessive in comparison to its earnings and cash flow. Some of the major events in 1993 were: - Completed the acquisition of Technology Applications, Inc. and the purchase of certain net assets of Science Management Corporation's Information Division and NMI Systems, Inc. - Eliminated the Commercial Services Administrative Group, resulting in improved efficiencies and reduced general and administrative expenses. - Completed the relocation of the Miami, Florida aircraft maintenance operation to larger hanger facilities which will permit the Company to perform maintenance on wide-body aircraft. - Received the last payment from the ESOP on its $100 million loan from the Company. Revenues from the Department of Defense were $543 million in 1993 compared to $538 million in 1992 and $523 million in 1991. These revenues represented 56.9% of total 1993 revenues compared to 59.0% in 1992 and 64.8% in 1991. This represents the Company's third year of its strategic long range plan to continue to grow or maintain its defense business while focusing primarily on the growth of non-defense business. Following is a three-year summary of operations, cash flow and long-term debt and redeemable preferred stock (in thousands): Years Ended December 31, 1993 1992 1991 Operations Revenues $953,144 $911,422 $807,186 Gross profit 39,557 28,146 23,886 Selling and corporate administrative (18,267) (20,476) (17,935) Interest, net (23,099) (22,458) (16,826) Other (9,324) (5,860) (7,717) Loss before income taxes, minority interest and extraordinary item $(11,133) $(20,648) $(18,592) Cash Flow Net loss $(13,414) $(23,342) $(12,403) Depreciation and amortization 19,818 19,372 24,473 Pay-in-kind interest 13,142 6,590 11,950 Working capital items (7,704) (7,559) (823) Other (1,222) 283 (1,920) Cash provided (used) by operations 10,620 (4,656) 21,277 Investing activities (15,611) (18,130) (8,622) Financing activities 7,817 26,868 (110) Increase in cash and short- term investments $ 2,826 $ 4,082 $ 12,545 December 31, 1993 1992 1991 Long-term Debt and Redeemable Preferred Stock Junior Subordinated Debentures, net of discount $ 86,947 $ 73,489 $ 75,612 Contract Receivable Collateralized Notes 100,000 100,000 - Employee Stock Ownership Plan Term and Revolving Credit Loan - - 38,215 Mortgages payable 23,416 19,436 - Other notes payable and capitalized leases 9,899 9,507 9,861 Class A Preferred Stock - - 24,884 $220,262 $202,432 $148,572 The following discussion of the Company's results of operations is directed toward the two major categories, Government Services and Commercial Services. Results of Operations Revenues - Revenues for 1993 were $953.1 million compared to 1992 revenues of $911.4 million, an increase of $41.7 million (4.6%). Government Services (GS) had an increase of $49.1 million (6.7%) while Commercial Services (CS) had a decrease of $7.4 million (4.0%). The increase in GS's revenues includes approximately $15.1 million from businesses acquired in December 1992 and February and December 1993, $16.0 million from the Postal contracts which were in the start-up phase in 1992 but were fully operational in 1993, and $17.9 million from new contract awards offset partially by contracts completed and/or not renewed. The overall decline in CS's 1993 revenues results from low volume in the aircraft maintenance activities and the impact of relocating the Miami, Florida maintenance operation to a new hangar facility; offset partially by increases in ground support services. Aircraft maintenance 1993 revenues decreased to $57.3 from $74.3 million in 1992 while ground support services' 1993 revenues increased to $118.6 million from $109.0 million in 1992. The increase in 1992 revenues of $104.2 million (11.9%) over 1991 was attributable to a combination of internal growth and the effect of acquisitions; GS increased $73.6 million (11.2%) and CS increased $30.6 million (20.1%). The increase in GS's revenues includes approximately $18.2 million from businesses acquired in April and May of 1991, $16.3 million from the Postal Service contracts awarded in the latter part of 1991 with the remaining increase attributable to the net increase in contract awards over contracts completed and/or not renewed. The increase in CS's revenues includes $23.0 million from higher volume in aircraft maintenance and $7.6 million from ground support services. The absence of the negative impact of the Persian Gulf War on ground support services also contributed to the overall increase in CS's 1992 revenues. Cost of Services/Gross Margins - Cost of services was 95.8% of revenues in 1993, 96.9% in 1992 and 97% in 1991 which resulted in gross margins of $39.6 million (4.1%), $28.1 million (3.1%) and $23.9 million (3.0%) respectively. GS's 1993 gross margins were improved while CS's 1993 margins declined from that of the prior year. The improvement in GS's gross margins was principally due to improved profit performance on new contracts started in 1992 and the early part of 1993 (in particular the Postal and the Department of Energy contracts). CS's decline in gross margin was the result of reduced volume in the aircraft maintenance activities, offset partially by improved gross margins of the ground support activities. Aircraft maintenance had gross margin losses of $6.6 million in 1993 compared to $.4 million in 1992. Also contributing to the decline in CS's margins were approximately $.6 million of costs associated with the relocation of the Miami, Florida aircraft maintenance operations to larger hangar facilities at the Miami, Florida airport. The 1992 gross margin, compared to 1991, was adversely impacted by approximately $7.0 million of nonrecurring insurance claims related to prior years, losses on the start-up of the new Postal contracts and a decline in GS's margins. These charges and the decline in GS's margins substantially offset increased gross margins in CS maintenance activities and a reduction in the amount of amortization of merger related contract write-ups. Selling and Corporate Administrative - Selling and corporate administrative expenses as a percentage of revenues were 1.9% in 1993 and 2.2% in both 1992 and 1991. There were both increases and decreases in 1993 of the various elements and components of these expenses, however, the two most significant factors contributing to the decrease of $2.2 million from 1992 were cost reductions made in CS's general and administrative expenses and a decrease in GS's marketing and bid and proposal costs from the unusually high amount incurred in 1992 on a contract proposal for the Department of Energy's Strategic Petroleum Reserve in Louisiana. Even though selling and corporate administrative expenses as a percentage of revenues were the same in both 1992 and 1991, the dollar amount increased $2.5 million over 1991. This increase was caused principally by marketing and proposal costs associated with the bidding of the Department of Energy Contract mentioned above and costs, principally the addition of staff, incurred in developing new nondefense business and customers. Interest - Interest expense in 1993 of $25.5 million was $.6 million higher than 1992. This small increase was primarily the result of the Contract Receivable Collateralized Notes being outstanding for the full year of 1993 compared to approximately eleven months in 1992, interest on the mortgage for the Corporate office building was for the full year of 1993 compared to five months in 1992 and an increase in the amount of capitalized leases outstanding, all of which were partially offset by a reduction in the accrual of interest on possible payments of Federal income taxes. Interest expense in 1992 was $24.9 million compared to $18.9 in 1991. This increase in 1992 was principally the result of the issuance of the Contract Receivable Collateralized Notes, compounding of Junior Subordinated Debentures due to pay-in-kind interest, accrual of interest on possible payments of federal income taxes and interest on the mortgage assumed on July 31, 1992 for the Corporate office building. Interest income in 1993 of $2.4 million was approximately the same as that in 1992 while interest income in 1992 was $.3 million higher than 1991. Even though interest rates were lower in 1992 than 1991, the Company had more excess funds available for investment and owned the Cummings Point Industries, Inc. note receivable with an interest rate of 17%. Other - The net increase in 1993 from 1992 is caused primarily by accelerated amortization of costs in excess of net assets of a recently acquired business and legal and other expenses associated with another acquired business. (The legal and other expenses relate to events which occurred prior to the businesses being acquired by the Company.) The net decrease in 1992 compared to 1991 is caused primarily by adjustment of reserves for environmental costs related to divested businesses, obligations to repurchase shares from terminated ESOP participants at a premium in excess of the fair value, and other transactions related to divested businesses. (In thousands) 1993 1992 1991 Amortization of costs in excess of net assets acquired and deferred ESOP costs $4,830 $ 3,793 $3,791 Provision for nonrecovery of receivables 1,141 965 953 ESOP Repurchase Premium 1,507 2,787 3,680 Legal and other expenses associated with an acquired business 2,070 - - Environmental costs of divested businesses - 1,000 709 Gain on sale of warrants obtained in divestitures - (756) (1,331) Other divested business adjustments(224) (1,929) (85) Total Other $9,324 $ 5,860 $7,717 Income Taxes - In 1993, the Company recorded a foreign income tax provision and a state income tax benefit and in addition, for its majority owned subsidiary which is required to file a separate return, a federal income tax provision. In 1992, the Company recorded only a foreign income tax provision. In 1993 and 1992, the Company did not recognize any federal income tax benefit on its losses because of the uncertainty regarding the level of future income. In 1991, the effective income tax rate was 32.3%. The income tax benefit for 1991 is less than the federal statutory rate because of nondeductibility of amortization of goodwill and value assigned to contracts and fixed assets in connection with the 1988 merger and reorganization. Cash Flow Cash and short-term investments increased to $22.8 million at December 31, 1993, from $20.0 million at the prior year-end. Working capital at December 31, 1993, was $73.8 million compared to $59.2 million at December 31, 1992. The working capital increase was primarily the result of expanded business volume. The 1993 ratio of current assets to current liabilities was 1.53 compared to 1.47 in 1992 (as restated). At December 31, 1993, $17.6 million of cash and short-term investments and $107.1 million of accounts receivable were restricted as collateral for the Contract Receivable Collateralized Notes. In 1993, operating activities produced cash flow of $10.6 million compared to a negative cash flow of $4.7 million in 1992 (for an improvement of $15.3 million). The two major reasons for the improved cash flow from operating activities were a decrease of $9.9 million in the amount of loss for 1993 compared to 1992 and an increase of $6.6 million of pay-in-kind interest on Junior Subordinated Debentures. In 1992, the Company had voluntarily elected to pay the interest due December 31, 1992 in cash rather than pay-in-kind. Investing activities used $15.6 million of cash, of which $10.9 million was used for the acquisition of businesses (see Note 15 to the Consolidated Financial Statements included elsewhere in this Form 10-K) and another $5.4 million was used for the purchase of property and equipment. In addition, $1.3 million of contract phase-in costs of a new long-term contract were incurred and deferred. These costs will be amortized over the duration of the contract. In 1992, investing activities used $18.1 million of cash. The primary use of cash was the purchase of property and equipment for $11.4 million and another $4.6 million was the net increase in notes receivable resulting primarily from the loan to Cummings Point Industries, Inc. In 1991, investing activities used $8.6 million of cash. The principal uses were the purchase of property and equipment for $12.1 million and the acquisitions of businesses for $6.3 million offset by proceeds received from notes receivable of $8.4 million. Financing activities provided cash of $7.8 million in 1993. Payments of $16.1 million were received on the loan to the Employee Stock Ownership Plan (the last and final payment on the loan from the Company was received in December, 1993), $6.3 million was used for payments on indebtedness and $2 million was used to purchase treasury stock. In 1992, financing activities provided cash of $26.9 million principally from the payments received from the ESOP plus surplus funds from the new financing arrangement of $100 million. During 1992, the Company used $38.1 million to pay in full its outstanding balance under the Restated Credit Agreement, $33.3 million for redemption of all of the outstanding Class A Preferred Stock plus accrued dividends and $10.2 million for the partial redemption of its 16% Junior Subordinated Debentures. In 1991, the Company received payments of $15.4 from the ESOP and borrowed $6.0 million under its revolving credit, which funds were offset by payments on indebtedness of $17.0 million and the purchase of treasury stock and Junior Subordinated Debentures of $4.9 million. Liquidity and Capital Resources At December 31, 1993, the Company's debt totaled $220.3 million compared to $202.4 million the prior year-end and $148.6 million at December 31, 1991, including redeemable preferred stock. The net increase in debt resulted principally from the pay-in-kind interest of $13.1 million on the Junior Subordinated Debentures and the $4.0 million mortgage assumed in the acquisition of Technology Applications, Inc. The Company had a net increase in cash and short-term investments of $2.8 million, $4.1 million and $12.5 million in 1993, 1992 and 1991, respectively. However, without the pay-in-kind interest on the Junior Subordinated Debentures (interest becomes payable in cash effective with the December 31, 1995 payment) and the payments received on the loan to the Employee Stock Ownership Plan (ESOP), the Company would have had a net decrease in cash and short-term investments of $26.4 million, $18.6 million and $14.8 million in 1993, 1992 and 1991, respectively. Annualized interest expense at January 1, 1994 is approximately $28.4 million of which $15.3 million of interest on the Junior Subordinated Debentures is payable in kind. The only significant debt maturing in the next three years is the mortgage of approximately $19 million on the Corporate Office, which matures in March, 1995. The Company intends to refinance this mortgage before it matures. The Company believes that it can achieve the required cash flow by continued profit improvement, reduced debt service cost and/or the continuation of its contribution to the ESOP which can be used to purchase common stock from the Company. The Company plans to continue its Value Improvement Program which was initiated in late 1992 to reduce and/or eliminate operating costs and loss operations, turn around the losses in Commercial Services' aircraft maintenance operations, and to improve the gross margins in Government Services. To reduce its debt service costs, the Company is presently in discussions with its investment bankers to replace its high interest rate Junior Subordinated Debentures through the issuance of new senior notes or an initial public offering, or both. In addition, the Company and the ESOP have an agreement in principal under which the ESOP will continue during 1994 to purchase Company common stock to fund the ESOP retirement benefit. The Company is also considering its alternatives, including the possible sale or spinoff, in respect to CS's aircraft maintenance unit which has incurred operating losses in the last three years. Selected financial operating data of the aircraft maintenance unit is as follows (in thousands except number of employees): 1993 1992 1991 Revenues $57,288 $74,253 $51,221 Operating losses $(6,629) $(428) $(1,137) Net assets including Goodwill at December 31, $44,354 $43,328 $42,775 Backlog at December 31, $11,368 $ - $12,584 Number of employees 701 631 627 These units are continuing to face an extremely competitive market with some competitors willing to buy market share at or below cost. At this point, the Company does not believe that the assets and goodwill associated with this unit has been permanently impaired; however, it is possible that future events may require a write-down of the carrying value. Although the Company has made some progress to diversify into non-defense business activities, the Company is still heavily dependent on the Department of Defense. Due to the procurement cycles of its customers (generally three to five years), the Company's revenues and margins are subject to continual recompetition. In a typical annual cycle approximately 20% to 30% of the Company's business will be recompeted, and the Company will bid on several new contracts. Existing contracts can be lost or rewon at lower margins at any time and new contracts can be won. The net outcome of this bidding process, which in any one year can have a dramatic impact on future revenues and earnings, is impossible to predict. Also, if the U.S. Government budget is reduced or spending shifts away from locations or contracts for which the Company provides services, the Company's success in retaining current contracts or obtaining new contracts could be significantly reduced. The Company's Commercial Services business is likewise highly competitive and subject to the economic conditions of the domestic and foreign airline industry. In summary, the Company continues to be highly leveraged, and its ability to meet its future debt service and working capital requirements is dependent upon increased future earnings and cash flow from operations, extension of the ESOP and the reduction of its debt expense. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information with respect to this item is contained in the Company's Consolidated Financial Statements and Financial Statement Schedules included elsewhere in this Annual Report on Form 10-K. Report of Independent Public Accountants To DynCorp: We have audited the accompanying consolidated balance sheets of DynCorp (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the periods 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 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 present fairly, in all material respects, the financial position of DynCorp 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 listed in Item 14 of the 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. Washington, D.C., March 22, 1994. ARTHUR ANDERSEN & CO. DynCorp and Subsidiaries Consolidated Balance Sheets (Dollars in thousands) December 31, 1993 1992 Assets Current Assets: Cash and short-term investments (includes restricted cash and short-term investments of $17,632 in 1993 and $16,768 in 1992) (Notes 2 and 4) $ 22,806 $ 19,980 Notes and current portion of long-term receivables (Notes 2 and 8) (a) 235 161 Accounts receivable and contracts in process (Notes 2, 3 and 4) 177,470 151,970 Inventories of purchased products and supplies, at lower of cost (first-in, first-out) or market 6,467 6,137 Prepaid income taxes (Note 10) 127 1,836 Other current assets 6,724 5,708 Total Current Assets 213,829 185,792 Long-term Receivables, due through 1998 (Note 2) 274 342 Property and Equipment, at cost (Notes 1 and 14): Land 5,539 5,234 Buildings and leasehold improvements 33,498 30,324 Machinery and equipment 64,907 50,842 103,944 86,400 Accumulated depreciation and amortization (42,996) (32,258) Net property and equipment 60,948 54,142 Intangible Assets, net of accumulated amortization (Notes 1 and 15) 93,890 94,653 Other Assets (Notes 2 and 4) 13,515 13,344 Total Assets $382,456 $348,273 (a) December 1992 has been restated to conform to the 1993 presentation. See accompanying notes. DynCorp and Subsidiaries Consolidated Balance Sheets (Dollars in thousands) December 31, 1993 1992 Liabilities, Redeemable Common Stock and Stockholders' Equity Current Liabilities: Notes payable and current portion of long-term debt (Notes 2 and 4) $ 3,837 $ 2,670 Accounts payable (Note 2) 25,376 18,763 Deferred revenue and customer advances (Note 1) 2,178 2,188 Accrued income taxes (Notes 1 and 10) 3,074 345 Accrued expenses (Note 5) 105,578 102,667 Total Current Liabilities 140,043 126,633 Long-term Debt (Notes 2, 4 and 15) 216,425 199,762 Deferred Income Taxes (Notes 1 and 10) 1,269 1,189 Other Liabilities and Deferred Credits (Note 2) 16,353 16,805 Total Liabilities 374,090 344,389 Commitments, Contingencies and Litigation (Notes 14 and 16) Redeemable Common Stock $17.50 per share redemption value, 125,714 shares issued and outstanding (Note 6) 2,200 - Stockholders' Equity (Note 7) Capital stock, par value ten cents per share - Preferred stock, Class C, 18% cumulative, convertible, $24.25 liquidation value, 123,711 shares authorized and issued and outstanding 3,000 3,000 Common stock, authorized 15,000,000 shares; issued 5,015,139 shares in 1993 and 4,913,385 shares in 1992 502 491 Common stock warrants 15,119 15,119 Unissued common stock under restricted stock plan 10,395 9,941 Paid-in surplus 95,983 96,408 Retained earnings (deficit) (105,425) (92,011) Common stock held in treasury, at cost; 285,987 shares and 178,100 warrants in 1993 and 325,211 shares and 180,210 warrants in 1992 (5,840) (6,538) Cummings Point Industries, Inc. note receivable (Note 8) (a) (7,568) (6,410) Employee Stock Ownership Plan Loan (Note 9) - (16,116) Total stockholders' equity 6,166 3,884 Total Liabilities, Redeemable Common Stock and Stockholders' Equity $382,456 $348,273 (a) December 1992 has been restated to conform to 1993 presentation. See accompanying notes. DynCorp and Subsidiaries Consolidated Statements of Operations For the Years Ended December 31 (Dollars in thousands except per share data) 1993 1992 1991 Revenues (Note 1) $953,144 $911,422 $807,186 Costs and expenses: Cost of services 913,587 883,276 783,300 Selling and corporate administrative 18,267 20,476 17,935 Interest expense 25,538 24,876 18,910 Interest income (2,439) (2,418) (2,084) Other 9,324 5,860 7,717 Total costs and expenses 964,277 932,070 825,778 Loss before income taxes, minority interest and extraordinary item (11,133) (20,648) (18,592) Provision (benefit) for income taxes (Note 10) 1,329 168 (5,997) Loss before minority interest and extraordinary item (12,462) (20,816) (12,595) Minority interest (Note 1) 952 - - Loss before extraordinary item (13,414) (20,816) (12,595) Extraordinary gain (loss) from early extinguishment of debt, net of income taxes of $99 in 1991 (Note 4) - (2,526) 192 Net loss (13,414) (23,342) (12,403) Preferred Class A dividends declared and paid and accretion of discount - 959 5,180 Net loss for common stockholders $(13,414)$ (24,301) $(17,583) Earnings (Loss) Per Common Share (Note 12) Primary and fully diluted: Loss before extraordinary item $ (2.87)$ (4.49)$ (3.97) Extraordinary item - (0.49) 0.04 Net loss for common stockholders $ (2.87)$ (4.98)$ (3.93) See accompanying notes. DynCorp and Subsidiaries Consolidated Statements of Cash Flows For the Years Ended December 31 (Dollars in thousands) 1993 1992 1991 Cash Flows from Operating Activities: Net loss $(13,414) $(23,342)$(12,403) Adjustments to reconcile net loss from operations to net cash provided by operating activities: Depreciation and amortization 19,818 19,372 24,473 Pay-in-kind interest on Junior Subordinated Debentures (Note 4) 13,142 6,590 11,950 Loss (gain) on purchase of Junior Subordinated Debentures (Note 4) - 2,526 (291) Deferred income taxes 521 (2,114) (4,933) Accrued compensation under Restricted Stock Plan 2,235 3,264 3,785 Noncash interest income (1,158) (910) - Other (2,820) (2,483) (481) Change in assets and liabilities, net of acquisitions and dispositions: Increase in accounts receivable and contracts in process (9,698) (14,904) (14,298) (Increase) decrease in inventories (326) 280 (174) (Increase) decrease in other current assets 1,159 2,797 (1,117) Increase in current liabilities except notes payable and current portion of long-term debt 1,161 4,268 14,766 Cash provided (used) by operating activities 10,620 (4,656) 21,277 Cash Flows from Investing Activities: Sale of property and equipment 1,422 1,262 1,974 Proceeds received from notes receivable 558 1,353 8,439 Purchase of property and equipment (5,423) (11,400) (12,106) Increase in notes receivable (Note 8) - (5,934) - Increase in investments in affiliates (99) (1,888) - Deferred income taxes from "safe harbor" leases (Note 10) (441) (314) (338) Deferred income taxes related to the merger and disposition of businesses - - 342 Assets and liabilities of acquired businesses, excluding cash acquired (Notes 1 and 15) (10,890) (905) (6,262) Other (738) (304) (671) Cash used by investing activities (15,611) (18,130) (8,622) Cash Flows from Financing Activities: Purchase of Class A Preferred Stock and Junior Subordinated Debentures (Note 4) - (42,466) (2,074) Treasury stock purchased (Note 7) (1,980) (3,448) (2,810) Payment on indebtedness (6,365) (41,040) (17,026) Increase in bank borrowings - - 6,000 Refinancing proceeds (Note 4) - 100,000 - Deferred financing expenses (Note 4) - (1,524) - Dividends paid on Class A Preferred Stock - (861) - Treasury stock sold under Management Employees Stock Purchase Plan 46 108 398 Reduction in loan to Employee Stock Ownership Plan (Note 9) 16,116 16,099 15,402 Cash provided (used) by financing activities 7,817 26,868 (110) Net Increase in Cash and Short-term Investments 2,826 4,082 12,545 Cash and Short-term Investments at Beginning of the Period 19,980 15,898 3,353 Cash and Short-term Investments at End of the Period $ 22,806 $ 19,980 $ 15,898 See accompanying notes. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies Principles of Consolidation -- All majority-owned subsidiaries have been included in the financial statements and all significant intercompany accounts and transactions have been eliminated. Outside investors' interest in minority owned subsidiaries is reflected as minority interest. Investments less than 50% owned are accounted for using the equity method of accounting. Contract Accounting -- Contracts in process are stated at the lower of actual cost incurred plus accrued profits or net estimated realizable value of incurred costs, reduced by progress billings. The Company records income from major fixed-price contracts, extending over more than one accounting period, using the percentage- of-completion method. During performance of such contracts, estimated final contract prices and costs are periodically reviewed and revisions are made as required. The effects of these revisions are included in the periods in which the revisions are made. On cost-plus-fee contracts, revenue is recognized to the extent of costs incurred plus a proportionate amount of fee earned, and on time-and- material contracts, revenue is recognized to the extent of billable rates times hours delivered plus material and other reimbursable costs incurred. Losses on contracts are recognized when they become known. Disputes arise in the normal course of the Company's business on projects where the Company is contesting with customers for additional funds because of events such as delays or changes in contract specifications. For fixed-price contracts, such disputes, whether claims or unapproved changes in the process of negotiation, are recorded at the lesser of their estimated net realizable value or actual costs incurred and only when realization is probable and can be reliably estimated. Claims against the Company are recognized where loss is considered probable and reasonably determinable in amount. It is the Company's policy to provide reserves for the collectibility of accounts receivable when it is determined that it is probable that the Company will not collect all amounts due and the amount of reserve requirement can be reasonably estimated. Property and Equipment -- The Company computes depreciation and amortization using both straight-line and accelerated methods. The estimated useful lives used in computing depreciation and amortization on a straight-line basis are: building, 15-33 years; machinery and equipment, 3-20 years; and leasehold improvements, term of lease. Accelerated depreciation is based on a 150% declining balance method with light-duty vehicles assigned a three-year life and machinery and equipment assigned a five-year life. Depreciation and amortization expense was $9,670,000 for 1993, $9,275,000 for 1992 and $10,759,000 for 1991. Cost of property and equipment sold or retired and the related accumulated depreciation or amortization is removed from the accounts in the year of disposal, and any gains or losses are reflected in the consolidated statement of operations. Expenditures for maintenance and repairs are charged to expense as incurred, and major additions and improvements are capitalized. Intangible Assets -- At December 31, 1993, intangible assets consist of $91,942,000 of unamortized goodwill and $1,948,000 of value assigned to contracts. Goodwill is being amortized on a straight- line basis over periods up to forty years. Amortization expense was $3,990,000, $2,953,000 and $2,952,000 in 1993, 1992 and 1991, respectively. Amounts allocated to contracts are being amortized over the lives of the contracts for periods up to ten years. Amortization of amounts allocated to contracts was $3,555,000, $4,566,000 and $7,763,000 in 1993, 1992 and 1991, respectively. Cumulative amortization of $16,116,000 and $31,720,000 has been recorded through December 31, 1993, of goodwill and value assigned to contracts, respectively. The Company assesses and measures impairment of intangible assets, including goodwill, based on several factors including the probable fair market value, probable future cash flows and net income and the aggregate value of the business as a whole. See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, on Liquidity and Capital Resources, included elsewhere in this Form 10-K concerning possible impairment. Income Taxes -- As prescribed by Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes" the Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Postretirement Health Care Benefits -- The Company provides no significant postretirement health care or life insurance benefits to its retired employees other than allowing them to continue as participants in the Company's plans with the retiree paying the full cost of the premium. The Company has determined, based on an actuarial study, that it has no liability under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Postemployment Benefits -- The Company has no liability under Statement of Financial Accounting Standard 112, "Employers' Accounting for Postemployment Benefits," as it provides no benefits as defined. New Accounting Pronouncements -- The Financial Accounting Standards Board issued Statement 114, "Accounting by Creditors for Impairment of a Loan," and Statement 115, "Accounting for Certain Investments in Debt and Equity Securities," in May 1993. The statements are required to be adopted in 1995 and 1994, respectively. The Company has no significant financial instruments of the nature described and therefore believes the statements will not have a material effect on its results of operations or financial condition. The Company intends to contribute approximately $15 million to the Employee Stock Ownership Plan in 1994 to acquire common stock at a per share value to be determined by an independent appraisal. At such time, the Company will adopt SOP 93-6, "Employer's Accounting for Employee Stock Ownership Plans," issued in November 1993 and effective for financial statements issued after December 15, 1993. Consolidated Statement of Cash Flows -- For purposes of this Statement, short-term investments which consist of certificates of deposit and government repurchase agreements with a maturity of ninety days or less are considered cash equivalents. Cash paid for income taxes was $1,232,000 for 1993, $4,054,000 for 1992 and $944,000 for 1991. Cash paid for interest, excluding the interest paid under the Employee Stock Ownership Plan term loan, was $11,706,000 for 1993, $17,212,000 for 1992 and $3,371,000 for 1991. Noncash investing and financing activities consist of the following (in thousands): 1993 1992 1991 Acquisitions of businesses: Assets acquired $31,675 $ 3,524 $14,849 Liabilities assumed (17,198) (1,248) (6,959) Stock issued (2,200) - - Notes issued and other liabilities (1,382) (592) (1,764) Cash paid for fees and noncompete covenant - - 141 Cash acquired (5) (779) (5) Net cash 10,890 905 6,262 Pay-in-kind interest on Junior Subordinated Debentures (Note 4) 13,142 6,590 11,950 Pay-in-kind dividends and accretion of discount on preferred stock - - 5,056 Unissued common stock under restricted stock plan (Note 7) 2,235 3,264 3,785 Capitalized equipment leases and notes secured by property and equipment 5,294 1,792 1,759 Mortgage note assumed (Note 4) - 19,456 - (2) 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 the value: Accounts Receivable and Accounts Payable - The carrying amount approximates their fair value. Notes and long-term receivables - The carrying amount approximates the fair value because of the short maturity of these instruments. Investments (included in "Other Assets") - The Company has an investment in convertible debentures and preferred stock of an untraded company. Based upon the financial statements of this business, the carrying value of these investments approximates their fair value. Long-term debt and other liabilities - The fair value of the Company's long-term debt is based on the quoted market price for its Junior Subordinated Debentures, the current rate as if the issue date were December 31, 1993 for its Collateralized Notes. For the remaining long- term debt (see Note 4) and other liabilities, the carrying amount approximates the fair value. Cummings Point Industries, Inc. Note Receivable - The carrying value approximates the fair value. (See Note 8.) The estimated fair values of the Company's financial instruments are as follows (in thousands): 1993 1992 Carrying Fair Carrying Fair Amount Value Amount Value Cash and short-term investments $ 22,806 $ 22,806 $19,980 $19,980 Accounts receivable 177,470 177,470 151,970 151,970 Notes and long-term receivables (a) 509 509 503 503 Investments 2,116 2,116 2,439 2,439 Accounts Payable 25,376 25,376 18,763 18,763 Long-term debt and other liabilities 218,758 229,012 200,950 208,623 Cummings Point note receivable 7,568 7,568 6,410 6,410 (a) December 1992 has been restated to conform to the 1993 presentation of the Cummings Point Industries, Inc. note receivable. (3) Accounts Receivable and Contracts in Process The components of accounts receivable and contracts in process were as follows (in thousands): 1993 1992 U.S. Government: Billed and billable $ 83,822 $ 83,722 Recoverable costs and accrued profit on progress completed but not billed 25,473 20,218 Retainage due upon completion of contracts 1,287 1,762 110,582 105,702 Commercial Customers: Billed and billable (less allowances for doubtful accounts of $1,469 in 1993 and $3,415 in 1992) 43,660 32,239 Recoverable costs and accrued profit on progress completed but not billed 23,228 14,029 66,888 46,268 $177,470 $151,970 Billed and billable include amounts earned and contractually billable at year-end but which were not billed because customer invoices had not yet been prepared at year-end. Recoverable costs and accrued profit not billed is composed primarily of amounts recognized as revenues, but which are not contractually billable at the balance sheet dates. The Company performs substantial services for the commercial aviation industry. Receivables from domestic and foreign airline and leasing companies were approximately $38,700,000 and $26,600,000 at December 31, 1993 and 1992, respectively. (4) Long-term Debt At December 31, 1993 and 1992, long-term debt consisted of (in thousands): 1993 1992 Contract Receivable Collateralized Notes, Series 1992-1 $100,000 $100,000 Junior Subordinated Debentures, net of unamortized discount of $5,175 and $5,491 86,947 73,489 Mortgages payable 23,416 19,436 Notes payable, due in installments through 2002, 9.27% weighted average interest rate 6,689 6,343 Capitalized equipment leases 3,210 3,164 220,262 202,432 Less current portion 3,837 2,670 $216,425 $199,762 Maturities of long-term debt as of December 31, 1993, were as follows (in thousands): 1994 $ 3,837 1995 21,638 1996 2,157 1997 101,527 1998 1,044 Thereafter 90,059 On January 23, 1992, the Company's wholly owned subsidiary, Dyn Funding Corporation (DFC), completed a private placement of $100,000,000 of 8.54% Contract Receivable Collateralized Notes, Series 1992-1 (the "Notes"). The Notes are collateralized by the right to receive proceeds from certain U.S. Government contracts and certain eligible accounts receivable of commercial customers of the Company and its subsidiaries. Credit support for the Notes is provided by overcollateralization in the form of additional receivables. The Company retains an interest in the excess balance of receivables through its ownership of the common stock of DFC. Additional credit and liquidity support is provided to the Notes through a cash reserve fund. Interest payments are made monthly with monthly principal payments beginning February 28, 1997. (The period between January 23, 1992 and January 30, 1997 is referred to as the Non-Amortization Period.) The notes are projected to have an average life of five years and two months and to be fully repaid by July 30, 1997. Upon receiving the proceeds from the sale of the Notes, DFC purchased from the Company an initial pool of receivables for $70,601,000, paid $1,524,000 for expenses and deposited $3,000,000 into a reserve fund account and $24,875,000 into a collection account with Bankers Trust Company as Trustee pending additional purchases of receivables from the Company. Of the proceeds received from DFC, the Company used $38,112,000 to pay the outstanding balances of the Employee Stock Ownership Plan term loan and revolving loan facility under the Restated Credit Agreement and $33,280,000 was used for the redemption of all of the outstanding Class A Preferred Stock plus accrued dividends (the redemption price per share was $25.00 plus accrued dividends of $.66). The Company expensed $1,432,000 (reported as an extraordinary loss) of unamortized deferred debt expense pertaining to the term loan and revolving loan facility which was paid in full. The Company charged $8,047,000 of unamortized discount and deferred issuance costs associated with the redemption of the Class A Preferred Stock to paid-in surplus. On an ongoing basis, cash receipts from the collection of the receivables are used to make interest payments on the Notes, pay a servicing fee to the Company, and purchase additional receivables from the Company. Beginning February 28, 1997, instead of purchasing additional receivables, the cash receipts will be used to repay principal on the Notes. During the Non-Amortization Period, cash in excess of the amount required to purchase additional receivables and meet payments on the Notes is to be paid to the Company subject to certain collateral coverage tests. The receivables pledged as security for the Notes are valued at a discount from their stated value for purposes of determining adequate credit support. DFC is required to maintain receivables, at their discounted values, plus cash on deposit at least equal to the outstanding balance of the Notes. Commencing March 30, 1994, the Notes may be redeemed in whole, but not in part, at the option of DFC at a price equal to the principal amount of the Notes plus accrued interest plus a premium (as defined). Mandatory redemption (payment of the Notes in full plus a premium) is required in the event that (i) the collateral value ratio test is equal to or less than .95 as of three consecutive monthly determination dates and the Company has not substituted receivables or deposited cash into the collection account to bring the collateral value ratio above .95; or (ii) three special redemptions are required within any consecutive 12-month period; or (iii) the aggregate stated value of all ineligible receivables which have been ineligible receivables for more than 30 days exceeds 7% of the aggregate collateral balance and the collateral value ratio is less than 1.00. Special redemption (payment of a portion of the Notes plus a premium) is required in the event that the collateral value ratio test is less than 1.00 as of two consecutive monthly determination dates and the Company has not substituted receivables or deposited cash into the collection account to bring the collateral value ratio to 1.00. Also, DFC may not purchase additional eligible receivables if the Company has an interest coverage ratio (as defined) of less than 1.10; or if the Company has more than $40 million of scheduled principal debt (as defined) due within 24 months prior to the amortization date or $20 million of scheduled principal debt due within 12 months prior to the amortization date. At December 31, 1993, $17,632,000 of cash and short-term investments and $107,091,000 of accounts receivable are restricted as collateral for the Notes. As of December 31, 1993, the Company had two separate unsecured revolving credit facilities available. One facility, which matured January 23, 1994, provided that the Company could borrow up to $10,000,000 less any outstanding letters of credit. At the Company's option, amounts borrowed under this facility bear interest at either prime rate plus 1% or Eurodollar rate plus 2%, all as defined. The other revolving credit facility, which matured January 31, 1994, provided that the Company could borrow up to $5,000,000 at a per annum interest rate equal to 1% plus the prime interest rate established by the Bank. The Company paid commitment fees of $68,000 and $73,000 in 1993 and 1992, respectively, which equal 1/2 of 1% per annum on the unused loan commitments. At December 31, 1993, the Company had $12,084,000 available under these Revolving Credit Facilities. In March 1994, the Company entered into a secured revolving credit agreement which provides a $5,000,000 line of credit plus a $2,500,000 revolving letter of credit facility. The agreement is secured by the stock of the Company's Commercial Aviation subsidiaries and selected fixed assets. Advances under the line of credit will bear interest at a per annum interest rate equal to 1% plus the prime interest rate established by the bank. For each letter of credit issued, the Company must assign a cash collateral deposit in favor of the bank for 100% of the face value of the letter of credit. The Company will pay a fee of 1.5% per annum computed on the face amount of the letter of credit for the period the letter of credit is scheduled to be outstanding. The credit agreement will expire July 1, 1994. The Junior Subordinated Debentures (Debentures) mature on June 30, 2003, and bear interest of 16% per annum, payable semi-annually. The effective interest rate is 19.4%. The Company may, at its option, prior to September 9, 1995, pay the interest either in cash or issue additional Debentures. The Debentures are subject to annual mandatory redemption beginning June 30, 1999. The Company may, at its option, redeem in whole or in part, at any time, the Debentures at their face value plus accrued interest. During 1993, 1992 and 1991, $13,142,000, $6,590,000 and $11,950,000, respectively, of additional Debentures were issued in lieu of cash interest payments. Using a lottery selection method, the Company called for partial redemption of $10,000,000 face value plus accrued interest for cash redemption on August 10, 1992. The lottery resulted in redeeming $9,698,000 face value of the Debentures. Open market purchases during 1992 retired $290,000 of the Debentures. The related unamortized discount, deferred debt expense and expenses, net of applicable income taxes, were reported as an extraordinary loss in 1992. The Company received title to its corporate office building on July 31, 1992 by assuming a mortgage of $19,456,000. At the Company's option, the interest on the mortgage may be computed from time to time under one of three methods based on the Certificate of Deposit Rate, LIBOR Rate or the Prime Rate, all as defined. Also, the Company was required to pay additional interest through May 27, 1993. The additional interest was the difference between a fixed rate of 9.36% and a floating rate based upon an imputed amount of $31,900,000. The original mortgage maturity date was May 27, 1993; however, as provided, the Company extended the mortgage to March 27, 1995 with an increase in the interest rate of 1/2% per annum plus an extension fee (based on the principal amount of the mortgage outstanding) of .42% on May 27, 1993 and .50% on March 27, 1994. The Company acquired the Alexandria, VA headquarters of Technology Applications, Inc. on November 12, 1993. A mortgage of $3,344,000 bearing interest at 8% per annum was assumed. Payments are made monthly and the mortgage matures in April 2003. Additionally, a $1,150,000 promissory note was issued. The note bears interest at 7% per annum. Payments under the note shall be made quarterly through October, 1998. Deferred debt issuance costs are being amortized using the effective interest rate method over the terms of the related debt. At December 31, 1993, unamortized deferred debt issuance costs were $1,339,000 and amortization for 1993, 1992 and 1991 was $328,000, $420,000 and $2,309,000, respectively. (5) Accrued Expenses At December 31, 1993 and 1992, accrued expenses consisted of the following (in thousands): 1993 1992 Salaries and wages $ 43,698 $ 38,906 Insurance 17,202 23,802 Interest 6,233 6,187 Payroll and miscellaneous taxes 10,412 9,123 Accrued contingent liabilities and operating reserves 19,028 16,440 Other 9,005 8,209 $105,578 $102,667 (6) Redeemable Common Stock In conjunction with the acquisition of Technology Applications, Inc. (see Note 15), the Company issued put options on 125,714 shares of common stock. The holder may, at any time commencing on December 31, 1998 and ending on December 31, 2000, sell these shares to the Company at a price per share equal to the greater of $17.50; or, if the stock is publicly traded, the market value at a specified date; or, if the Company's stock is not publicly traded, the fair market value at the time of exercise. (7) Stockholders' Equity Class C Preferred Stock is convertible, at the option of the holder, into one share of common stock, adjusted for any stock splits, stock dividends or redemption. At conversion the holders of Class C Preferred Stock are also entitled to receive such warrants as have been distributed to the holders of the common stock. Dividends accrue at an annual rate of 18%, compounded quarterly. At December 31, 1993, cumulative dividends of $5,342,000 have not been recorded or paid. Dividends will be payable only when cash dividends are declared with respect to common stock and only in an aggregate amount equal to the aggregate amount of dividends that such holders would have been entitled to receive if such Class C Preferred Stock had been converted into common stock. Each holder of Class C Preferred Stock is entitled to one vote per share on any matter submitted to the holders of common stock for stockholder approval. In addition, so long as any Class C Preferred Stock is outstanding, the Company is prohibited from engaging in certain significant transactions without the affirmative vote of the holders of a majority of the outstanding Class C Preferred Stock. The Company has issued warrants to the Class C Preferred stockholders and to certain common stockholders to purchase a maximum of 5,891,987 shares of common stock of the Company. At December 31, 1993, warrants were outstanding to purchase 5,713,887 shares of common stock of the Company. Each warrant is exercisable to obtain one share of common stock for $0.25. Rights under the warrants lapse no later than September 9, 1998. The Board of Directors has authorized a new stockholders' agreement which will permit current stockholders to convert warrants to shares on a noncash basis. The Company has a Restricted Stock Plan (the Plan) under which management and key employees may be awarded shares of common stock based on the Company's performance. The Company has reserved 1,025,037 shares of common stock for issuance under the Plan. Under the Plan, Restricted Stock Units (Units) are granted to participants who are selected by the Compensation Committee of the Board of Directors. Each Unit will entitle the participant upon achievement of the performance goals (all as defined) to receive one share of the Company's common stock. Units cannot be converted into shares of common stock until the participant's interest in the Units has vested. Vesting occurs upon completion of the specified periods as set forth in the Plan. In 1993, 1992 and 1991, the Company accrued as compensation expense $2,235,000, $3,264,000 and $3,785,000, respectively, under the Plan which was charged to cost of services and corporate administrative expenses. The Company has a Management Employees Stock Purchase Plan (the Stock Purchase Plan) whereby employees in management, supervisory or senior administrative positions may purchase shares of the Company's common stock along with warrants at current fair value. The Board of Directors is responsible for establishing the fair value for purposes of the Stockholders Agreement and the Management Employees Stock Purchase Plan. The determination has been based upon the most recent appraisal of the Company's common stock prepared by the financial advisors to the Employee Stock Ownership Plan Committee, adjusted to reflect the absence of a control-share premium, lack of liquidity, reductions in the warrant exercise price, and inflationary forces. At December 31, 1993, the fair value was determined to be $59.52 per share including 6.6767 warrants. Treasury stock, which the Company acquired from terminated employees who had previously purchased the stock from the Company, is being issued to employees purchasing stock under the Stock Purchase Plan. In accordance with ERISA regulations and the Employee Stock Ownership Plan Documents, the ESOP Trust or the Company are obligated to purchase vested common stock shares from ESOP participants (see Note 9) at the fair value (as determined by an independent appraiser) as long as the Company's common stock is not publicly traded. Participants receive their vested shares upon retirement, becoming totally disabled, or death, over a period of one to five years and for other reasons of termination over a period of one to ten years, all as set forth in the Plan. In the event the fair value of a share is less than $27.00, the Company is committed to pay through December 31, 1996, up to an aggregate of $16,000,000, the difference (Premium) between the fair value and $27.00 per share. As of December 31, 1993, the Company has purchased 327,411 shares from participants and has expended $3,069,000 of the $16,000,000 commitment. Based on the fair value of $17.99 per share at December 31, 1993, the Company estimates a total Premium of $8,500,000 and an aggregate annual commitment to repurchase shares from the ESOP participants upon death, disability, retirement and termination as follows; $3,600,000 in 1994, $5,900,000 in 1995, $4,000,000 in 1996, $3,000,000 in 1997, $4,300,000 in 1998 and $56,800,000 thereafter. The fair value is charged to Treasury Stock at the time of repurchase. The estimated Premium of $8,500,000 is being recorded over the life of the ESOP and reported as "Other" expense in the income statement. Through December 31, 1993, $7,181,000 of the Premium had been recorded and recognized as compensation expense. The Company is presently in discussions with its investment bankers to replace the Junior Subordinated Debentures through the issuance of new senior notes or an initial public offering or a combination of the two. In the event of an initial public offering, the unpaid balance of the $16 million premium may become payable. Under the DynCorp Stockholders' Agreement which expired on March 11, 1994, the Company was committed, upon an employee's termination of employment, to purchase common stock shares held by employees pursuant to the merger (Management Investor Shares), through the Stock Purchase Plan or through the Restricted Stock Plan. The share price is fair value ($59.52 per share including 6.6767 warrants at December 31, 1993) as determined by the Board of Directors for Management Investor Shares and Stock Purchase Plan shares. Such shares outstanding at December 31, 1993, were 262,298, with 1,751,285 warrants attached. The share price for Restricted Stock Plan shares ($17.99 at December 31, 1993) is fair value as set forth in the appraisal of shares held by the ESOP. However, the Company may not purchase more than $250,000 of Management Investor shares or Restricted Stock shares in any fiscal year without the approval of the Class C Preferred stockholders. The Board of Directors has authorized an extension of the Stockholders' agreement, pending acceptance by the shareholders, which will contain similar repurchase obligations. (8) Cummings Point Industries, Inc. Note Receivable The Company loaned $5,500,000 to Cummings Point Industries, Inc. ("CPI"), of which Capricorn Investors, L.P. ("Capricorn") owns more than 10%. The indebtedness is represented by a promissory note (the "Note"), bearing interest at the annual rate of 17%, which provides that interest is payable quarterly but that interest payments may not be payable in cash but may be added to the principal of the Note. The Note is subordinated to all senior debt of CPI. The Note, which was issued February 12, 1992, was due three months thereafter; however, the Company, at its option, has extended and may further extend the maturity date in three month increments to no later than February 12, 1995. By separate agreement and as security to the Company, Capricorn has agreed to purchase the Note from the Company upon three months' notice, for the amount of outstanding principal plus accrued interest. As additional security, Capricorn's purchase obligation is collateralized by certain common stock and warrants issued by the Company and owned by Capricorn. The note has been reflected as a reduction in stockholders' equity as it is anticipated the collateral will be used to satisfy the obligation. (9) Employee Stock Ownership Plan In September, 1988, the Company established an Employee Stock Ownership Plan (the Plan). The Company borrowed $100 million and loaned the proceeds, on the same terms as the Company's borrowings, to the Plan to purchase 4,123,711 shares of common stock of the Company (the "ESOP loan"). The common stock purchased by the Plan was held in a collateral account as security for the ESOP loan from the Company. The Company was obligated to make contributions to the Plan in at least the same amount as required to pay the principal and interest installments under the Plan's borrowings. The Plan used the Company contributions to repay the principal and interest on the ESOP loan. As the ESOP loan was liquidated, shares of the Company's common stock were released from the collateral account and allocated to participants of the Plan. As of December 31, 1993, the loan has been fully repaid. In March, 1991, the Employee Stock Ownership Plan was amended to provide for an additional contribution of no fewer than 25,000 shares of common stock in 1993 and 625,000 shares in 1994. The Company may, at its option, contribute cash in lieu of the aforementioned shares of common stock, based on the most recent valuation of such stock. The Company has an agreement in principle with the ESOP to contribute approximately $15 million in cash or stock in 1994, inclusive of the 625,000 shares, to satisfy its funding obligations. The Plan covers a majority of the employees of the Company. Participants in the Plan become fully vested after four years of service. All of the 4,148,711 shares owned by the ESOP have been allocated to participants as of December 31, 1993. The Company recognizes ESOP expense each year based on contributions committed to be made to the Plan. The Company's cash contributions were determined based on the ESOP's debt service. Stock contributions are determined in accordance with the amended agreement. In 1993 cash and stock contributions to the ESOP were $16,608,000 and $437,000 respectively, 1992 and 1991 cash contributions were $17,275,000 and $18,805,000, respectively. These amounts were charged to cost of services and selling and corporate administrative expenses (including $491,000, $1,450,000 and $3,231,000 of interest on the ESOP term loan). (10) Income Taxes The Company changed from Statement of Financial Accounting Standards (SFAS) No. 96 to Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" effective January 1, 1992. There was no significant cumulative effect from this change and prior year financial statements were not restated. Earnings (loss) before income taxes and minority interest (but including extraordinary item - see Note 4) were derived from the following (in thousands): 1993 1992 1991 Domestic operations $(11,240) $(23,378) $(18,393) Foreign operations 107 204 92 $(11,133) $(23,174) $(18,301) The provision (benefit) for income taxes (and including extraordinary item - see Note 4) consisted of the following (in thousands): 1993 1992 1991 Current: Federal $ 723 $ 416 $ (867) Foreign 170 168 567 State (85) 193 (665) 808 777 (965) Deferred: Federal 500 (416) (5,106) State 21 (193) 173 521 (609) (4,933) Total $ 1,329 $ 168 $(5,898) The components of and changes in deferred taxes are as follows (in thousands): The components of the changes in deferred taxes are as follows (in thousands): Difference between book and tax method of accounting for depreciation and amortization $(1,233) Difference between book and tax method of accounting for income on U.S. Government contracts 2,668 Deferred compensation expense (255) Operating reserves and other accruals (3,661) Difference between book and tax method of accounting for certain employee benefits (485) Amortization of intangibles (2,051) Other, net 84 Total temporary differences affecting tax provision (4,933) Deferred taxes from "safe harbor" lease transactions (338) Taxes related to the merger and disposition of businesses 342 $(4,929) The tax provision (benefit) differs from the amounts obtained by applying the statutory U.S. Federal income tax rate to the pre-tax loss amounts. The differences can be reconciled as follows (in thousands): 1993 1992 1991 Expected Federal income tax benefit $(3,785) $(7,879) $(6,222) Valuation allowance 3,812 6,031 - State and local income taxes, net of Federal income tax benefit (42) - (325) Nondeductible amortization of intangibles and other costs 1,552 2,300 2,651 Foreign income tax 84 99 585 Tax credits, primarily foreign (359) (222) (2,663) Other, net 67 (161) 76 Tax provision (benefit) $1,329 $ 168 $(5,898) In 1993, the Company recorded a $170,000 foreign income tax provision and a $64,000 state income tax benefit. However, due to the uncertainty regarding the level of future taxable income, the Company did not recognize any federal tax benefits on the losses incurred in 1993. The federal tax provision of $1,223,000 is that of a majority owned subsidiary which is required to file a separate federal return. The Company's U.S. Federal income tax returns have been audited through 1984. The Internal Revenue Service has performed an examination of the Company's tax returns for the period 1985- 88 and has proposed several adjustments, the most significant of which relates to deductions taken by the Company for expenses incurred in the 1988 merger. The Company and its attorneys are currently protesting these proposed adjustments with the IRS appeals office. Taxes and accrued interest associated with these proposed adjustments, including the ongoing effects of similar adjustments in future years, are approximately $15,700,000. In the opinion of management, based in part upon opinion of its attorneys, the tax liability, if any, for these proposed adjustments will not have a material adverse effect on the consolidated results of operations and financial position of the Company. The Company has state net operating losses and foreign tax credit carryforwards available to offset future taxable income and income taxes. Following are the net operating losses and foreign tax credits by year of expiration (in thousands): Year of Foreign State Net Expiration Tax Credits Operating Losses 1994 $2,341 $ - 1995 - 2,448 1996 189 20 2005 - 8,145 2006 - 66 2007 - 472 $2,530 $11,151 (11) Pension Plans Union employees who are not participants in the ESOP are covered by multiemployer pension plans under which the Company pays fixed amounts, generally per hours worked, according to the provisions of the various labor contracts. In 1993, 1992 and 1991, the Company expensed $2,400,000, $2,693,000 and $2,900,000, respectively, for these plans. Under the Employee Retirement Income Security Act of 1974 as amended by the Multiemployer Pension Plan Amendments Act of 1980, an employer is liable upon withdrawal from or termination of a multiemployer plan for its proportionate share of the plan's unfunded vested benefits liability. Based on information provided by the administrators of the majority of these multiemployer plans, the Company does not believe there is any significant amount of unfunded vested liability under these plans. The Company makes contributions to a defined benefit pension plan for employees working on one cost plus U.S. Government contract. The plan is accounted for in accordance with the requirements of Statement of Financial Accounting Standards No. 87. The pension plan had assets of $5,642,000 and projected benefit obligations of $5,356,000 at September 30, 1993 (the plan's fiscal year end). This pension plan remains in effect regardless of changes in contractors which may occur as a result of the recompetition process. (12) Earnings Per Share Primary earnings per share is based on the weighted average number of common and dilutive common equivalent shares outstanding during the period. In addition, 1993 and 1992 include as outstanding common stock, shares earned and vested but unissued under the Restricted Stock Plan. For years 1993, 1992 and 1991, the outstanding warrants and shares which would be issued under the assumed conversion of Class C Preferred Stock have been excluded from the calculation of earnings per share as their effect is antidilutive because of the losses incurred during the periods (see also Note 6). Further, the loss per common share for 1993, 1992 and 1991 includes the effect of the unpaid dividends on the Class C Preferred Stock ($1,347,000 in 1993, $1,129,000 in 1992 and $947,000 in 1991 - see Note 7) and, in addition, for 1991 and 1992 the dividends paid on Class A Preferred Stock. The average number of shares used in determining primary earnings per share was 5,141,319 for 1993, 5,102,621 for 1992 and 4,719,407 for 1991. (13) Incentive Compensation Plans The Company has several formal incentive compensation plans which provide for incentive payments to officers and key employees. Incentive payments under these plans are based upon operational performance, individual performance, or a combination thereof, as defined in the plans. Incentive compensation expense was $7,067,000 for 1993, $6,058,000 for 1992 and $5,788,000 for 1991. (14) Leases The Company has capitalized all significant leases which meet the criteria for classification as capital leases, principally leases for vehicles and equipment. Capitalized leases are amortized over the useful lives of the assets. Future minimum lease payments required under operating leases that have remaining noncancellable lease terms in excess of one year at December 31, 1993 and payments under capitalized leases are summarized below: Operating Capitalized Leases Leases Years Ending December 31, 1994 $ 6,805 $1,519 1995 6,562 1,022 1996 4,080 651 1997 3,683 489 1998 2,727 77 Thereafter 7,831 - Total minimum lease payments $31,688 $3,758 Less interest on capitalized leases 548 Present value of capitalized leases as of December 31, 1993 (Note 4) $3,210 Net rent expense for leases, excluding amounts for capitalized leases, was $16,553,000 for 1993, $14,706,000 for 1992 and $14,980,000 for 1991. (15) Acquisitions On November 12, 1993 the Company acquired Technology Applications, Inc. (TAI). Aggregate cash paid, notes issued and mortgages assumed totaled $11,419,000 and 125,714 shares of common stock valued at $2,200,000 were issued (see Note 6). TAI, located in Alexandria, Virginia, provides tactical and nontactical software engineering and logistics services to industry as well as defense and civilian government agencies. The acquisition was accounted for as a purchase and $2,710,000 of goodwill was recorded which will be amortized over 40 years. The Company also acquired certain assets of Science Management Corporation ("SMC") and NMI Systems Inc. ("NMI") on February 18, 1993 and December 10, 1993, respectively, for an aggregate of $5,352,000 in cash, notes and other liabilities. SMC provides information processing, systems management and related consulting services, primarily to the U.S. Government. Key customers include the U.S. Postal Service, Centers for Disease Control and the Department of Education. NMI, headquartered in Fairfax, VA, provides telecommunications operations, engineering and local and wide area network design and consulting services primarily for the Environmental Protection Agency, the U.S. Treasury and the Internal Revenue Service. Both of these acquisitions were accounted for as purchases. Goodwill of $3,373,000 was recorded and will be amortized over periods up to 40 years. The allocation period for the NMI acquisition remains open pending resolution of certain contract issues. Consolidated revenues, loss before extraordinary item, net loss and loss per share for the years ended December 31, 1993 and 1992, adjusted on an unaudited pro forma basis as if the above acquisitions and the acquisition in 1992 (BK Dynamics Inc. was acquired on December 15, 1992 for an aggregate of $2,277,000 in cash and notes) had been consummated at the beginning of the respective periods, are as follows (in thousands except per share amounts): Unaudited 1993 1992 Revenues $999,285 $993,180 Loss before extraordinary item $(11,951) $(19,307) Net loss for common stockholders (a) $(13,298) $(22,792) Net loss per common share $ (2.64) $ (4.58) (a) The net loss for common stockholders includes Preferred Class A dividends declared and paid and accretion of discount of $959,000 in 1992. (16) Commitments, Contingencies and Litigation The Company is involved in various claims and lawsuits, including contract disputes and claims based on allegations of negligence and other tortious conduct. The Company is also potentially liable for certain environmental, personal injury, tax and contract dispute issues related to the prior operations of divested businesses. In most cases, the Company has denied, or believes it has a basis to deny, liability, and in some cases has offsetting claims against the plaintiffs or third parties. Damages currently claimed by the various plaintiffs for these items which may not be covered by insurance aggregate approximately $34,000,000 (including compensatory and possible punitive damages and penalties). A former subsidiary, which discontinued its business activities in 1986, has been named as one of many defendants in civil lawsuits which have been filed in various state courts against manufacturers, distributors and installers of asbestos products. (The subsidiary had discontinued the use of asbestos products prior to being acquired by the Company.) The Company has also been named as a defendant in several of these actions. At the beginning of 1991, 31 claims had been filed and during the year 360 additional claims were filed with one claim being settled. In 1992, 1,755 additional claims were filed and 73 were settled. In 1993, 662 new claims were filed with 1,204 claims being settled. Defense has been tendered to and accepted by the Company's insurance carriers. The former subsidiary was a nonmanufacturer that installed or distributed industrial insulation products. Accordingly, the Company strongly believes that the subsidiary has substantial defenses against alleged secondary and indirect liability. The Company has provided a reserve for the estimated uninsured legal costs to defend the suits and the estimated cost of reaching reasonable no-fault liability settlements of $18,000,000 less estimated insurance coverages of $11,000,000. The amount of the reserve has been estimated based on the number of claims filed and settled to date, number of claims outstanding, current estimates of future filings, trends in costs and settlements, and the advice of the insurance carriers and counsel. The Company and a wholly-owned subsidiary acquired in 1991 are the subjects of separate investigations by federal investigators who are reviewing, respectively, the accuracy of the Company's equipment maintenance records on a military equipment maintenance contract, and the appropriateness of pricing proposals submitted by the subsidiary to a government agency prime contractor for software development services. The Company and subsidiary are cooperating with the investigators. The Company has provided a reserve for the estimated legal costs associated with these investigations. The Company has also been notified of certain proposed tax adjustments by the IRS relative to the deduction taken by the Company for expenses incurred in the 1988 merger. The Company is a party to other civil lawsuits which have arisen in the normal course of business for which potential liability, including costs of defense, are covered by insurance policies. The Company has recorded its best estimate of the liability that will result from these matters. While it is not possible to predict with certainty the outcome of the litigation and other matters discussed above, it is the opinion of the Company's management, based in part upon opinions of counsel, insurance in force and the facts presently known, that liabilities in excess of those recorded, if any, arising from such matters would not have a material adverse effect on the results of operations or consolidated financial position of the Company. The major portion of the Company's business involves contracting with departments and agencies of, and prime contractors to, the U.S. government and as such are subject to possible termination for the convenience of the government and to audit and possible adjustment to give effect to unallowable costs under cost-type contracts or to other regulatory requirements affecting both cost-type and fixed- price contracts. In management's opinion, there are no outstanding issues of this nature at December 31, 1993 that would have a material adverse effect on the Company's consolidated financial position or results of operations. The Company is highly leveraged, and its ability to meet its future debt service and working capital requirements is dependent upon several factors. See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion on the Company's Liquidity and Capital Resources, included elsewhere in this Form 10-K. (17) Business Segment The Company operates in one line of business, that of providing management and technical services to industry and government organizations primarily to support the customers' facilities and/or operations on a turn-key (full) service basis. The Company has no significant foreign operations or assets outside the United States. The largest single customer of the Company is the U.S. Government. The Company had prime contract revenues from the U.S. Government of $663 million in 1993, $674 million in 1992 and $600 million in 1991. Included in revenues from the U.S. Government are revenues from the Department of Defense of $543 million in 1993, $538 million in 1992 and $523 million in 1991. No other customer accounted for more than 10% of revenues in any year. (18) Quarterly Financial Data (Unaudited) A summary of quarterly financial data for 1993 and 1992 is as follows (in thousands, except per share data): ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Directors Herbert S. Winokur, Jr., 50 Director and Chairman of the Board since 1988, term expires 1996 President, Winokur Holdings, Inc. (investment company) Formerly Senior Executive Vice President, Member Office of the President, and Director, Penn Central Corporation. Director of ENRON Corporation; NacRe Corp.; NHP, Inc.; and Marine Drilling Companies, Inc. Dan R. Bannister, 63* Director since 1985, term expires Chief Executive Officer since 1985 President since 1984 Director of Industrial Training Corporation T. Eugene Blanchard, 63* Nominee for Director, term expires 1997 Director since 1988 Senior Vice President and Chief Financial Officer since 1979 Russell E. Dougherty, 73 Director since 1989, term expires 1996 Attorney, McGuire, Woods, Battle & Boothe (law firm) Retired General, United States Air Force; served as Commander-in-Chief, Strategic Air Command and Chief of Staff, Allied Command, Europe. From 1980 to 1986 served as Executive Director of the Air Force Association and Publisher of Air Force Magazine. Member of the Defense Science Board. Trustee of the Institute for Defense Analysis. Director of The Aerospace Corp. James H. Duggan, 58* Director since 1988, term expires 1996 Executive Vice President since 1987 President of Applied Sciences Group since 1991 Paul G. Kaminski, 51 Director since 1988, term expires Chairman and Chief Executive Officer of Technology Strategies & Alliances (strategic partnership consulting) Retired Colonel, United States Air Force. Director of Atlantic Aerospace & Electronics; Delfin Systems, Inc.; Geodynamics, Inc.; Jaycor; Microwave Technology Inc.; ISX Corp.; and Michigan Development Corp. Chairman of the Defense Science Board. Dudley C. Mecum II, 59 Nominee for Director, term expires 1997 Director since 1988 Partner, G.L. Ohrstrom & Co. (investment company) Formerly Chairman of Mecum Associates, Inc. Served as Group Vice President and Director, Combustion Engineering, Inc. Director of The Travelers Inc., Lyondell Petrochemical Company, Vicorp Restaurants Inc., Fingerhut Companies, Inc., and Roper Industries Inc. David L. Reichardt, 51* Director since 1988, term expires Senior Vice President and General Counsel since 1986 President of Dynalectric Company, a subsidiary of DynCorp, from 1984 to 1986. Vice President and General Counsel of DynCorp from 1977 to 1984. Other Executive Officers Patrick G. Deasy, 55* Vice President since 1993 President of DynAir Ground Services Group since 1993, President of DynAir Services Inc. since 1985 Gerald A. Dunn, 60* Vice President since 1973 Controller since 1967 H. Montgomery Hougen, 58 Corporate Secretary and Deputy General Counsel since 1984 Richard A. Hutchinson, 49 Treasurer since 1978 Marshal J. Hyman, 48 Vice President since 1993 Director of Taxes since 1986 Paul V. Lombardi, 52* Vice President since 1992 President of Government Services Group since 1992 Senior Vice President and Group General Manager, Planning Research Corporation from 1990 to 1992. Senior Vice President and Group General Manager, Advanced Technology Inc. from 1988 to 1990. Gregory Moyer, 45 Vice President, Human Resources and Administration since 1993 Vice President, Human Resources and Quality, Planning Research Corporation from 1989 to 1993. John H. Saunders, 37 Vice President, Finance since 1993 Director of Corporate Finance since 1990 Vice President, Finance, Government Services Group from 1987 to 1990 Donald S. Sullenberger, 53 Vice President, Quality Improvement since 1991. Retired Colonel, United States Air Force. Division Manager, DynCorp, Holloman Support Division from 1987 to 1991 Richard L. Webb, 61* Vice President since 1988 President of DynAir Technical Services Group since 1993, President of Aviation Services Group from 1985 to 1993 Robert G. Wilson, 52 Vice President and General Auditor since 1985 *Officers designated by an asterisk are deemed to be officers for purposes of Rule 16a-1(f), as promulgated in Release No. 34-28869. Stockholders Agreement In anticipation of the merger of DME Holdings, Inc. into the Company, which occurred in September, 1988, the stockholders and other investors in DME Holdings, Inc. entered into a Stockholders Agreement, dated March 11, 1988. This Agreement, to which most of the holders of voting stock of DynCorp, except the Employee Stock Ownership Plan Trust and participants in such Plan to whom shares have been distributed, are parties, provides that the Company's management employees as a group and the outside investors acting through Capricorn Investors as a group are each entitled to nominate four of the nine authorized directors and, in concert, to nominate a ninth director, for which nominees all the parties are required to vote. Each of the eight current directors, including those currently nominated to succeed themselves, was initially nominated by this procedure. The Stockholders Agreement expired on March 11, 1994, but a replacement Stockholders Agreement, effective as of such expiration date and having similar terms, has been approved by the Board of Directors and is expected to be adopted by the respective parties. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Compensation The following table sets forth information regarding annual and long-term compensation for the chief executive officer and the other four most highly compensated executive officers of the Company. The table does not include information for any fiscal year during which a named executive officer did not hold such a position with the Company. (1) Column (d) reflects bonuses earned and expensed during year, whether paid during or after such year. (2) Value of restricted stock units determined in accordance with Restricted Stock Plan. Units awarded in 1991 could vest in less than three years, in the event of earlier issuance of a tax ruling regarding the allocation of shares within the Employee Stock Ownership Plan (ESOP). There is no provision to pay dividends on restricted stock units. The following table reflects the number of restricted stock units in the respective accounts of the named individuals, whether vested or unvested, and the aggregate valuation as of December 31, 1993. Name No. of Value ($) Units Dan R. Bannister 55,292 967,610 James H. Duggan 58,764 1,028,370 T.Eugene Blanchard 47,980 839,650 David L. Reichardt 32,528 569,240 Paul V. Lombardi 12,000 210,000 (3) Column (i) includes individual's pro rata share of the Company's contribution to the ESOP Trust, estimated for 1993, and the Company-paid portion of group term-life insurance premiums covering the individual, as reflected in the following table. Name ESOP Contributions ($) Insurance Premiums($) 1993 1992 1991 1993 1992 1991 Dan R. Bannister 8,912 8,912 11,406 8,553 7,722 7,722 James H. Duggan 8,912 8,912 11,406 3,901 4,855 4,855 T. Eugene Blanchard 8,912 8,912 11,406 8,106 7,722 7,722 David L. Reichardt 8,912 8,912 11,406 2,881 1,448 1,448 Paul V. Lombardi 8,912 1,810 - 3,048 528 - Compensation of Directors Non-employee directors of the Company receive an annual retainer fee of $16,500 as directors and $2,750 for each committee on which they serve. The Company also pays non- employee directors a meeting fee of $1,000 for attendance at each Board meeting and $500 for attendance at committee meetings. Directors are reimbursed for expenses incurred in connection with attendance at meetings and other Company functions. Directors and Officers Liability Insurance The Company has purchased and paid the premium for insurance in respect of claims against its directors and officers and in respect of losses for which the Company may be required or permitted by law to indemnify such directors and officers. The directors insured are the directors named herein and all directors of the Company's subsidiaries. The officers insured are all officers and assistant officers of the Company and its subsidiaries. There is no allocation or segregation of the premium as regards specific subsidiaries or individual directors and officers. Employment-Type Contracts In September, 1987, the Company entered into change-in- control severance agreements with Messrs. Bannister, Duggan, Blanchard, and Reichardt, and certain other executive officers of DynCorp (the "Severance Agreements"). Each Severance Agreement provides that certain benefits, including a lump-sum payment, will be triggered if such executive is terminated following a change in control during the term of that executive's Severance Agreement, unless such termination occurs under certain circumstances set forth in the Severance Agreements. The Severance Agreements expire on December 31, 1994, but they are automatically extended. The amount of such lump sum payment would be equal to 2.99 times the sum of the executive's annual salary and the average annual amount paid to the executive pursuant to certain applicable compensation-type plans in the three years preceding the year in which the termination occurs. Other benefits include payment of any incentive compensation which has been allocated or awarded but not yet paid to the executive for a fiscal year or other measuring period preceding termination and a pro rata portion to the date of termination of the aggregate value of incentive compensation awards for uncompleted periods under such plans. Each Severance Agreement also provides that, if the aggregate of the lump sum payment to the executive and any other payment or benefit included in the calculation of "parachute payments" within the meaning of Section 280G of the Internal Revenue Code exceeds the amount the Company is entitled to deduct on its federal income tax return, the severance payments shall be reduced until no portion of the aggregate termination payments to the executive is not so deductible or the severance payment is reduced to zero. The Severance Agreements also provide that the Company will reimburse the executive for legal fees and expenses incurred by the executive as a result of termination except to the extent that the payment of such fees and expenses would not be, or would cause any other portion of the aggregate termination payments not to be, deductible by reason of Section 280G of the Code. The Company has an employment contract with Mr. Lombardi, under which Mr. Lombardi receives salary at an annual rate of $215,000; subject to earlier termination for specified reasons, the contract continues until September 30, 1994. Compensation Committee Interlocks and Insider Participation The members of the Compensation Committee of the Board of Directors during 1993 were: Herbert S. Winokur, Jr., Chairman of the Board and Director; Russell E. Dougherty, Director; and Paul G. Kaminski, Director. None of the members are current or former employees of the Company, and, except for Mr. Winokur, whose relationship to Capricorn Investors, L.P. ("Capricorn") is described in Item 12, none have any relationship with the Company of the nature contemplated by Rule 404 of Regulation S-K. On February 12, 1992, the Company loaned $5,500,000 to Cummings Point Industries, Inc. ("CPI"), a Delaware corporation of which Capricorn owns more than 10%. The indebtedness is represented by a promissory note (the "Note"), bearing interest at the annual rate of 17%, which provides that interest is payable quarterly but that interest payments may be added to the principal of the Note rather than being paid in cash. The Note is subordinated to all senior debt of CPI. The Note was due six months after issuance, but it has been, and may continue to be, automatically extended for three-month periods until no later than February 12, 1995. By separate agreement, Capricorn agreed to purchase the Note from the Company upon three months' notice, for the amount of outstanding principal plus accrued interest. The purchase obligation is secured by certain common stock and warrants issued by the Company and owned by Capricorn. No executive officer of the Company serves on the board of directors or compensation committee of any entity (other than subsidiaries of the Company) whose directors or executive officers served on the Board of Directors or Compensation Committee of the Company. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Voting Securities As of March 1, 1994, the Company had 4,728,563 shares of Common Stock and 123,711 shares of Class C Preferred Convertible Stock outstanding, which constituted all the outstanding voting securities of the Company. If all the shares issuable upon exercise of outstanding warrants, all the shares issuable upon conversion of outstanding Class C Preferred Convertible Stock and exercise of related warrants, and shares issuable as a result of scheduled expiration within 60 days of Restricted Stock Plan deferrals (but excluding any vesting of Restricted Stock Plan units or shares subsequent to March 1, 1994) were issued, the outstanding voting securities following such dilution would consist of 10,570,267 shares of Common Stock (and no shares of Class C Stock). The following tables show beneficial ownership of issued voting shares as a percentage of currently outstanding stock and beneficial ownership of issued and issuable shares as a percentage of common stock on a fully diluted basis assuming all such conversions, exercises, and issuances. Security Ownership of Certain Beneficial Owners The following table presents information as of March 1, 1994, concerning the only known beneficial owners of five percent or more of the Company's Common Stock and Class C Preferred Stock. Amount & Amount & Nature of Nature of Percent Title Ownership Percent Ownership of Name and Address of of of Outstand- of of Diluted Diluted Beneficial Owner Class ing Shares Class Shares (3) Shares (3) Chemical Bank, Common 3,816,841 80.7% 3,816,841 36.1% Trustee of the Direct(1) Direct (1) DynCorp Employee Stock Ownership Trust 450 W. 33rd Street New York, NY 10001-2697 Capricorn Investors, Common 292,369 6.2% 4,117,127 39.0% L.P.(2) Direct Direct 72 Cummings Point Road Stamford, CT 06902 Capricorn Investors, Class C 123,711 100% N/A - L.P.(2) Preferred Direct 72 Cummings Point Road Stamford, CT 06902 (1) Shares are held for the accounts of participants in the ESOP. When allocated to individual participant accounts, shares are voted upon instruction of the individual participants. Until so allocated, shares are voted upon the instruction of the ESOP Administrative Committee, 2000 Edmund Halley Drive, Reston, Virginia 22091-3436. (2) Herbert S. Winokur, Jr., Chairman of the Board and a Director of the Company, is the President of Winokur Holdings, Inc., which is the managing partner of Capricorn Holdings, G.P., which in turn is the general partner of Capricorn Investors, L.P. (3) Assumes dilution described above. Security Ownership of Management(1) Beneficial ownership of the Company's equity securities by directors and nominees for election to the Board, and all current officers and directors as a group, are set forth below: Amount & Amount & Nature of Nature of Percent Title Ownership Percent Ownership of Name and Title of of of Outstand- of of Diluted Diluted Beneficial Owner Class ing Shares(2) Class(3) Shares (4) Shares(3) (4) D. R. Bannister Common 55,030 Direct} 1.3% 305,620 Direct} 3.0% President & 6,952 Indirect} 6,952 Indirect} Director T. E. Blanchard Common 19,385 Direct} * 148,746 Direct} 1.5% Senior Vice 5,763 Indirect} 14,109 Indirect} President & Director R. E. Dougherty -- -- -- -- -- - -- Director J. H. Duggan Common 16,146 -- * 123,881 Direct} 1.3% Executive Vice 7,278 12,426 Indirect} President & Director P. J. Kaminski -- -- -- -- -- -- -- Director D. C. Mecum II -- -- -- -- -- -- -- Director D. L. Reichardt Common 10,905 Direct} * 58,430 Direct} * Senior Vice 5,994 Indirect} 10,748 Indirect} President & Director H. S. Winokur, Common 292,369 Indirect 6.2% 4,117,127 Indirect 39.0% Jr.(5) Chairman of the Class C 123,711 Indirect 100% N/A -- Board & Preferred Director All officers Common 159,793 Direct} 10.7% 910,596 Direct} 48.5% and 345,198 Indirect} 4,216,487 Indirect} directors as a group Class C 123,711 Indirect 100% N/A -- -- Preferred (1) As disclosed in filings under the Securities Exchange Act of 1934 or otherwise known to the Company as of March 1, 1994. Shares held by the ESOP trustee but within individual voting control are included in the table, whether or not vested. (2) Restricted stock units which have not been converted into shares of stock and distributed pursuant to the Company's Restricted Stock Plan as of March 1, 1994 are not transferable by or within the voting control of the participants. Such units are not included herein. (3) An asterisk indicates that beneficial ownership is less than one percent of the class. (4) Assumes dilution described above. (5) Includes securities owned by Capricorn. See preceding table for relationship of Mr. Winokur thereto. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Mr. Dougherty is of counsel to the law firm of McGuire, Woods, Battle & Boothe, which firm has provided legal services to the Company from time to time. During 1993, Bankers Trust Company was a lender to the Company pursuant to a revolving credit agreement in the amount of $10,000,000; except for letters of credit issued thereunder and still outstanding, the credit agreement has expired. Bankers Trust Company also provides various trustee, banking, and other financial and advisory services to the Company. An affiliated company of Bankers Trust Company is a partner in Capricorn. Officers and directors who obtained securities through the Company's Management Employees Stock Purchase Plan and Restricted Stock Plan are subject to the Stockholders Agreement described in Item 10. Under the terms of the Stockholders Agreement, the Company's securities can not be sold individually to outside parties. Management employees of the Company whose employment is terminated, except retiring employees who could elect to retain their securities indefinitely, are required to sell such securities, at the fair market price established by the Board of Directors from time to time, to the other stockholders or to the Company, and the Company is required to repurchase such securities at such price, subject to restrictions imposed by its Certificate of Incorporation and various financing agreements. The Stockholders Agreement expired on March 11, 1994, but a replacement Stockholders Agreement, effective as of such expiration date and having similar terms, has been approved by the Board of Directors and is expected to be adopted by the respective parties. 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 Form 10-K: 1. All financial statements. See Table of Contents 2. Financial statement Schedules. Schedule III - Condensed Financial Information of Registrant DynCorp (Parent Company) Balance Sheets Assets Liabilities and Stockholders' Equity Statements of Operations Statements of Cash Flows Notes to Condensed Financial Statements Schedule VIII - Valuation and Qualifying Accounts for the Years Ended December 31, 1993, 1992, and 1991. All other financial schedules not listed have been omitted since the required information is included in the Consolidated Financial Statements or the notes thereto, or is not applicable or required. 3. Exhibits Exhibit 3 (1) Certificate of Incorporation, as currently in effect, consisting of Restated Certification of Incorporation (incorporated by reference to Registrant's Form 10-K for 1992, File No. 1-3879) (2) Registrant's By-laws as amended to date. Exhibit 4 (1) Specimen 16% Pay-in-Kind Junior Subordinated Debentures due 2003 Certificate. (incorporated by reference to Registrant's Form 10-K for 1988, File No. 1-3879) (2) Indenture for $100,000,000 of 8.54% Contract Receivables Collateralized Notes, Series 1992-1, Due 1997, dated as of January 1, 1992, between Dyn Funding Corporation (wholly owned subsidiary of the Registrant) and Bankers Trust Company, as trustee (incorporated by reference to Registrant's Form 8-K filed February 7, 1992, File No. 1- 3879) (3) Specimen 18% Class C Preferred Stock Certificate. (incorporated by reference to Registrant's Form 10-K for 1988, File No. 1-3879) (4) Specimen Common Stock Certificate. (incorporated by reference to Registrant's Form 10-K for 1988, File No. 1-3879) (5) Specimen Class A Common Stock Warrant Certificate. (incorporated by reference to Registrant's Form 10-K for 1988, File No. 1-3879) (6) Specimen Class B Common Stock Warrant Certificate. (incorporated by reference to Registrant's Form 10-K for 1988, File No. 1-3879) (7) Indenture Agreement for 16% Pay-in-kind Junior Subordinated Debenture (incorporated by reference to Exhibit 4.1 to Form S-4 filed July 27, 1988) (8) Statement Respecting Warrants and Lapse of Certain Restrictions (incorporated by reference to Registrant's Form 10-K for 1988, File No. 1-3879) (9) Amendment (effective March 26, 1991) to Statement Respecting Warrants and Lapse of Certain Restrictions (incorporated by reference to Registrant's Form 10-K for 1990, File No. 1- 3879) (10) Article Four of the Restated Certificate of Incorporation (incorporated by reference to Registrant's Form 10-K for 1992, File No. 1-3879) The Registrant, by signing this Report, agrees to furnish the Securities and Exchange Commission, upon its request, a copy of any instrument which defines the rights of holders of long-term debt of the Registrant. Exhibit 10 (1) Deferred Compensation Plan. (incorporated by reference to Registrant's Form 10-K for 1987, File No. 1-3879) (2) Management Incentive Plan (MIP) (3) DynCorp Executive Incentive Plan (EIP) (4) Management Severance Agreements. (incorporated by reference to Exhibits (c)(4) through (c)(12) to Schedule 14D-9 filed by Registrant January 25, 1988. (5) Employment agreement of Richard L. Webb, Vice President, Aviation Services, dated June 24, 1992 (incorporated by reference to Registrant's Form 10-K for 1992, File No. 1- 3879) (6) Employment agreement of Paul V. Lombardi, Vice President, Government Services Group (7) Restricted Stock Plan. Exhibit 11 (1) Computations of Earnings Per Common Share for the Years Ended December 31, 1993, 1992, and 1991 Exhibit 21 (1) Subsidiaries of the Registrant Exhibit 24 (1) Consent of Independent Public Accountants (b) Reports on Form 8-K None filed during the fourth 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, thereunto duly authorized. DYNCORP March 31, 1994 By: D. R. Bannister D. R. Bannister President and Chief Executive Officer Pursuant to the requirements of the Securities and 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. D. R. Bannister President and Director March 31, 1994 D. R. Bannister (Principal Executive Officer) J. H. Duggan Executive Vice President March 31, 1994 J. H. Duggan and Director T. E.Blanchard Senior Vice President March 31, 1994 T. E. Blanchard Chief Financial Officer and Director D. L. Reichardt Senior Vice President March 31, 1994 D. L. Reichardt General Counsel and Director G. A. Dunn Vice President March 31, 1994 G. A. Dunn and Controller (Principal Accounting Officer) D. C. Mecum II Director March 31, 1994 D. C. Mecum II H. S. Winokur, Jr. Director March 31, 1994 H. S. Winokur, Jr. DynCorp (Parent Company) SCHEDULE III - Condensed Financial Information of Registrant Balance Sheets (Dollars in Thousands) ASSETS December 31, 1993 1992 Current Assets: Cash and short-term investments $ 6,894 $ 5,822 Notes and current portion of long-term receivables (a) - 1 Accounts receivable and contracts in process, net of allowance for doubtful accounts (Note 3) 20,723 18,153 Inventories of purchased products and supplies 513 419 Other current assets 3,718 5,710 Total current assets 31,848 30,105 Investment in and advances to subsidiaries and affiliates 70,277 50,005 Property and Equipment, net of accumulated depreciation and amortization 9,836 11,479 Intangible Assets, net of accumulated amortization 86,811 90,374 Other Assets 6,040 7,513 Total Assets $204,812 $189,476 (a) December 1992 has been restated to conform to 1993 presentation of the Cummings Point Industries, Inc. note receivable. The "Notes to Consolidated Financial Statements" of DynCorp and Subsidiaries are an integral part of these statements. See accompanying "Notes to Condensed Financial Statements" DynCorp (Parent Company) SCHEDULE III - Condensed Financial Information of Registrant Balance Sheets (Dollars in Thousands) LIABILITIES, REDEEMABLE COMMON STOCK AND STOCKHOLDERS' EQUITY December 31, 1993 1992 Current Liabilities: Notes payable and current portion of long-term debt (Note 2) $ 3,392 $ 2,601 Accounts payable (a) 11,594 7,776 Advances on contracts in process 864 668 Accrued liabilities (a) 71,855 77,283 Total current liabilities 87,705 88,328 Long-term Debt (Note 2) 93,150 80,294 Other Liabilities and Deferred Credits 15,591 16,970 Total Liabilities 196,446 185,592 Commitments, Contingencies and Litigation - - Redeemable Common Stock $17.50 per share redemption value, 125,714 shares issued and outstanding 2,200 - Stockholders' Equity: Capital stock, $0.10 par value: Preferred stock, Class C 3,000 3,000 Common stock 502 491 Common stock warrants 15,119 15,119 Unissued common stock under restricted stock plan 10,395 9,941 Paid-in surplus 95,983 96,408 Deficit (105,425) (92,011) Common stock held in treasury (5,840) (6,538) Cummings Point Industries, Inc. note receivable (b) (7,568) (6,410) Employee Stock Ownership Plan Loan - (16,116) Total Stockholders' Equity 6,166 3,884 Total Liabilities, Redeemable Common Stock and Stockholders' Equity $204,812 $189,476 (a) December 1992 has been restated to conform to the 1993 presentation. (b) December 1992 has been restated to conform to 1993 presentation of the Cummings Point Industries, Inc. note receivable. The "Notes to Consolidated Financial Statements" of DynCorp and Subsidiaries are an integral part of these statements. See accompanying "Notes to Condensed Financial Statements." DynCorp (Parent Company) SCHEDULE III - Condensed Financial Information of Registrant Statements of Operations (Dollars in Thousands) For the Years Ended December 31, 1993 1992 1991 Revenues $552,662 $557,675 $513,601 Costs and Expenses: Cost of services 528,776 542,901 501,584 Selling and corporate administrative 10,994 12,534 10,473 Interest expense 14,950 14,608 18,295 Interest income (1,969) (1,693) (2,006) Other (Note 3) 23,902 23,490 8,805 576,653 591,840 537,151 Loss before income taxes, equity in net income of subsidiaries and extraordinary item (23,991) (34,165) (23,550) Benefit for income taxes (1,561) (3,900) (7,951) Loss before equity in net income of subsidiaries and extraordinary item (22,430) (30,265) (15,599) Equity in net income of subsidiaries 9,016 9,449 3,004 Loss before extraordinary item (13,414) (20,816) (12,595) Extraordinary gain (loss) from early retirement of debt, net of income tax provision - (2,526) 192 Net Loss (13,414) (23,342) (12,403) Preferred Stock Class A dividends declared and paid and accretion of discount - 959 5,180 Net Loss for Common Stockholders $(13,414)$(24,301) $(17,583) The "Notes to Consolidated Financial Statements" of DynCorp and Subsidiaries are an integral part of these statements. See accompanying "Notes to Condensed Financial Statements." DynCorp (Parent Company) SCHEDULE III - Condensed Financial Information of Registrant Statements of Cash Flow (Dollars in Thousands) For the Years Ended December 31, 1993 1992 1991 Cash Flows from Operating Activities: Net loss $(13,414) $(23,342) $(12,403) Adjustments to reconcile net loss from operations to net cash provided by operating activities: Depreciation and amortization 7,834 9,510 14,713 Pay-in-kind interest on Junior Subordinated Debentures 13,142 6,590 11,950 Loss (gain) on purchase of Junior Subordinated Debentures - 2,526 (291) Deferred income taxes 521 (666) (5,167) Accrued compensation under Restricted Stock Plan 2,047 2,354 3,061 Noncash interest income (1,158) (910) - Other (1,936) (4,363) (1,312) Change in assets and liabilities, net of acquisitions and dispositions and sale of accounts receivable in 1993: Decrease in accounts receivable and contracts in process (2,570) (10,173) (11,446) (Increase) decrease in inventories (93) (72) 254 (Increase) decrease in other current assets 1,992 986 (577) Increase (decrease) in current liabilities except notes payable and current portion of long-term debt (976) 6,690 16,418 Cash provided (used) by operating activities 5,389 (10,870) 15,200 Cash Flows from Investing Activities: Sale of property and equipment 829 130 103 Proceeds received from notes receivable - 1,346 8,423 Purchase of property and equipment (928) (2,381) (2,519) Increase in notes receivable - (5,500) - Increase in investments and affiliates - (1,888) - Deferred income taxes from "safe harbor" leases - (20) (104) Deferred income taxes related to the merger and disposition of businesses - - 342 Other 345 (201) (66) Cash provided (used) from investing activities 246 (8,514) 6,179 Cash Flows from Financing Activities: Purchase of Preferred Stock Class A and Junior Subordinated Debentures - (42,466) (2,074) Treasury stock purchased (1,979) (3,448) (2,810) Payment on indebtedness (4,725) (41,010) (17,005) Increase in bank borrowings - - 6,000 Accounts receivable sold (Note 3) - 63,682 - Dividends paid on Class A Preferred Stock - (861) - Treasury stock sold under Management Employees Stock Purchase Plan 46 108 398 Reduction in loan to Employee Stock Ownership Plan 16,116 16,099 15,402 Change in intercompany balances, net (14,021) 14,050 (8,438) Cash provided (used) from financing activities (4,563) 6,154 (8,527) Net Increase (Decrease) in Cash and Short-term Investments 1,072 (13,230) 12,852 Cash and Short-term Investments at Beginning of the Period 5,822 19,052 6,200 Cash and Short-term Investments at End of the Period $ 6,894 $ 5,822 $ 19,052 The "Notes to Consolidated Financial Statements" of DynCorp and Subsidiaries are an integral part of these statements. See accompanying "Notes to Condensed Financial Statements." NOTES TO CONDENSED FINANCIAL STATEMENTS 1. Basis of Presentation Pursuant to the rules and regulations of the Securities and Exchange Commission, the Condensed Financial Statements of the Registrant do not include all of the information and notes normally included with financial statements prepared in accordance with generally accepted accounting principles. It is, therefore, suggested that these Condensed Financial Statements be read in conjunction with the Consolidated Financial Statements and Notes included elsewhere in this Annual Report on Form 10-K. 2. Long-term Debt At December 31, 1993 and 1992, long-term debt consisted of: 1993 1992 (In thousands) Junior Subordinated Debentures, net of unamortized discount of $5,175 and $5,491 $86,947 $73,489 Notes payable, due in installments through 2002, 9.3% weighted average interest rate 6,643 6,242 Capitalized equipment leases 2,952 3,164 96,542 82,895 Less current portion 3,392 2,601 $93,150 $80,294 Maturities of long-term debt as of December 31, 1993, were as follows: Years Ending December 31, (In Thousands) 1994 $ 3,392 1995 2,267 1996 1,747 1997 1,106 1998 688 Thereafter 92,517 3.Accounts Receivable At December 31, 1992, the Company sold $63,682,000 of its accounts receivable to Dyn Funding Corporation (DFC), a wholly owned subsidiary of the Company. DFC was established in January, 1992 to issue $100,000,000 of Contract Receivable Collateralized Notes (Notes) and to purchase eligible accounts receivable from the Company and its subsidiaries. On an ongoing basis, the cash received by DFC from collection of the receivables is used to make interest payments on the Notes, pay a servicing fee to the Company and purchase additional receivables from the Company (see Note 4 to Consolidated Financial Statements included elsewhere in this Form 10-K). The Company receives 97% of the face value of the accounts receivable sold to DFC. The 3% discount from the face value of the accounts receivable is recorded as an expense by the Company at the time of sale. In 1993 and 1992, the Company recorded as expense $16,298,000 and $17,308,000 which is reflected in "Other" in the accompanying "Statements of Operations" (in the "Consolidated Statements of Operations" of DynCorp and Subsidiaries this expense is offset by the gain recognized by DFC).

31235_1993.txt

31235_1993

1993

31235

ITEM 1. BUSINESS Eastman Kodak Company (Kodak or the Company) is engaged primarily in developing, manufacturing, and marketing imaging, information systems and health products. Kodak's sales, earnings and identifiable assets by industry segment for the past three years are shown in Segment Information on page 38. - ----------------------------------------------------------------------------- IMAGING SEGMENT Sales of imaging segment products, including intersegment sales, for the past three years were: 1993 1992 1991 (in millions) $7,257 $7,415 $7,075 The products of the imaging segment are used for capturing, recording or displaying an image. For example, traditional amateur photography requires, at a minimum, a camera, film, and photofinishing. Photofinishing requires equipment and supplies, including chemicals and paper for prints. Kodak manufactures and markets various components of imaging systems. For amateur photography, Kodak supplies films, photographic papers, processing services, photographic chemicals, cameras and projectors. Kodak products for nonamateur photography include films, photographic papers, photographic plates, chemicals, processing equipment and audiovisual equipment. Nonamateur products serve professional photofinishers, professional photographers and customers in motion picture, television, and government markets. Recent imaging products developed by Kodak include new generations of single use cameras and commercial applications for the recently introduced photo CD system. New traditional silver halide photographic products continue to be introduced to the professional and consumer markets. Marketing and Competition. Kodak's imaging products and services are distributed through a variety of channels. Individual products are often used in substantial quantities in more than one market. Most sales of the imaging segment are made through dealers. Independent retail outlets handling Kodak amateur products total many thousands. In a few areas abroad, Kodak products are marketed by independent national distributors. Kodak's advertising programs actively promote its products and services in its various markets, and its principal trademarks, trade dress, and corporate symbol are widely used and recognized. Kodak's imaging products and services compete with similar products and services of others. Competition in traditional imaging markets is strong throughout the world. Many large and small companies offer similar products and services that compete with Kodak's business. Kodak's products are continually improved to meet the changing needs and preferences of its customers. Raw Materials. The raw materials used by the imaging segment are many and varied and generally available. Silver is one of the essential materials in photographic film and paper manufacturing. - ---------------------------------------------------------------------------- INFORMATION SEGMENT Sales of information segment products for the past three years were: 1993 1992 1991 (in millions) $3,862 $4,063 $3,968 The information segment consists of businesses that serve the imaging and information needs of business, industry and government. Products in this segment are used to capture, store, process and display images and information in a variety of forms. Kodak purchases, manufactures and markets various components of information products and provides service agreements to support these products. Information products include graphic arts films, microfilm products, applications software, copiers, printers and other business equipment. These products serve the needs of customers in the commercial printing and publishing, office automation and government markets. Marketing and Competition. Kodak's information products are distributed through a variety of channels. The Company also sells and leases business equipment directly to users. Independent national distributors market information products in some overseas areas. The products in the information segment compete on a worldwide basis with similar products offered by both small and large companies. Strong competition exists throughout the world. Raw Materials. The raw materials used by the information segment are many and varied and generally available. Electronic components represent a significant portion of the cost of the materials used in the manufacture of business equipment. - --------------------------------------------------------------------------- HEALTH SEGMENT Sales of health segment products for the past three years were: 1993 1992 1991 (in millions) $5,249 $5,081 $4,917 Kodak manufactures and markets various health products. Pharmaceutical products include medicines prescribed by physicians or made specifically for use in hospitals. Pharmaceutical products also include bulk pharmaceuticals, intermediates and other life-science chemicals sold primarily to other manufacturers. Sterling Winthrop Inc., a subsidiary of Kodak, and Elf Sanofi, a company within the Elf Aquitaine Group, have formed an alliance of joint ventures for the development and marketing of pharmaceutical and over-the-counter medicines. Consumer health products include medicines sold without prescription and promoted directly to the consumer. Kodak supplies X-ray films, processors, image management systems, laser printers and chemicals for radiography markets and also supplies clinical diagnostics equipment and consumables. This segment also includes household, do-it-yourself and personal care products such as disinfectants, all purpose cleaners, floor-care products, rodenticides, septicides, wood stains, concrete and wood protectors, deodorants and hair-care products. Marketing and Competition. Products of the health segment are distributed through a variety of channels including dealers, independent distributors, wholesalers, jobbers, hospitals, retail drug stores, mass merchandisers, variety outlets, department stores, and food stores. The health care markets in the U.S. and in some countries outside the U.S. are experiencing changes resulting from concerns for escalating costs for health care, leading to competitor and customer consolidation. The segment's products are subject to competition from both large and small companies, many of which are highly regarded and well established, with substantial resources for research, product development and promotional activities. Competition in the health segment, particularly with respect to pharmaceutical, consumer health and household products, is characterized by the effort to develop and introduce new or improved products. Many of Kodak's competitors are engaged in research activities which may lead to the development of new products constituting additional competition for Kodak's products. Raw materials. Raw materials essential to the health segment business are purchased for the most part in the open market and are generally available. Silver is one of the essential materials in manufacturing radiography film. - ----------------------------------------------------------------- DISCONTINUED OPERATIONS - CHEMICALS SEGMENT On December 31, 1993, the Company distributed all of the outstanding shares of common stock of Eastman Chemical Company (Eastman), which represents substantially all of the Company's worldwide chemical business, as a dividend to the Company's shareowners (the "spin-off") in a ratio of one share of Eastman common stock for every four shares of Kodak common stock. As a result of the spin-off, Eastman became an independent publicly held company listed on the New York Stock Exchange and its operation ceased to be owned by the Company. In connection with the spin-off, Eastman assumed $1.8 billion of new borrowings, the proceeds from which will be used by the Company as part of a plan to retire certain of its indebtedness. The chemicals segment has been reported as a discontinued operation and results for prior periods have been restated. Sales of chemicals segment products, including intersegment sales, for the past three years were: 1993 1992 1991 (in millions) $3,976 $3,927 $3,740 The products of the chemicals segment include a wide variety of chemicals, plastics, and fibers. The manufacturing processes are diverse and highly integrated with intermediate products being sold to the trade, as well as being used in further internal manufacturing. The segment is also a major supplier of chemicals and plastics used in the manufacture of Kodak photographic products. Subsequent to the spin-off, it is expected that the Company will continue to purchase products from Eastman. The prices, terms and conditions of future sales have been negotiated between the Company and Eastman and are intended to reflect current market conditions. The major sales products of the chemicals segment include: - - acids, alcohols, solvents, and plasticizers used by paint, chemical, and plastic manufacturers, - - polyethylene and polypropylene plastics used in applications such as plastic film and automotive parts, - - cellulose-based plastics used by molders of plastic tool handles, brushes, eyeglass frames, and toys, - - cellulose-based fibers, such as acetate yarn and filter materials, - - polyester plastics used in food and beverage packaging, and - - specialty and fine chemicals used in health, nutrition, pharmaceutical, and photographic applications. Marketing and Competition. The chemicals segment markets products through a worldwide sales organization. The majority of the sales are direct, however, some are through other channels. Products are shipped to customers directly from the chemicals segment plants as well as from distribution centers. The chemicals segment products are marketed and categorized as industrial or performance. The performance products include chemicals and plastics sold to customers in growth markets, as well as products sold on the basis of unique performance attributes. The industrial products are chemical, plastic and fiber products sold to industrial customers, usually in large volumes, primarily on the basis of price, product quality and consistency, and reliability of supply. In the chemicals segment, competition is present from a number of large chemical manufacturers with similar products; however, the competitive environment varies among the various product markets. Raw Materials. The raw materials used by the chemicals segment are many and varied and generally available. The major raw materials are propane, ethane, chemical wood pulp, paraxylene and coal. Many are derived from petroleum products, the prices of which have fluctuated in recent years. The chemicals segment engages in research and development, located principally in United States locations in Kingsport, Tennessee and Longview, Texas. In 1993, $180 million (1992 - $168 million; 1991 - $157 million) was expended for research and development. - --------------------------------------------------------------------------- - - RESEARCH AND DEVELOPMENT Through the years, Kodak has engaged in extensive and productive efforts in research and development. In 1993, $1,301 million (1992 - $1,419 million; 1991 - $1,337 million) was expended for research and development in continuing operations. Research and development groups are located principally in United States locations in Rochester, New York; Montvale, New Jersey; and Upper Providence Township, Pennsylvania; outside the U.S., research and development groups are located in England, France, Japan and Germany. These groups, in close cooperation with manufacturing units and marketing organizations, are constantly developing new products and applications to serve both existing and new markets. It has been Kodak's general practice to protect its investment in research and development and its freedom to use its inventions by obtaining patents where feasible. The ownership of these patents contributes to Kodak's ability to use its inventions but at the same time is accompanied by a liberal patent-licensing policy. While in the aggregate Kodak's patents are considered to be of material importance in the operation of its business, it does not consider that the patents relating to any single product or process are of material significance when judged from the standpoint of its total business. - -------------------------------------------------------------------------- ENVIRONMENTAL PROTECTION Kodak is subject to various laws and governmental regulations concerning environmental matters. Some of the U.S. federal environmental legislation having an impact on Kodak includes the Toxic Substances Control Act, the Resource Conservation and Recovery Act (RCRA), the Clean Air Act, and the Comprehensive Environmental Response, Compensation and Liability Act (the "Superfund" law). Kodak continues to engage in a program for environmental protection and control. During 1993, expenditures for pollution prevention and waste treatment for continuing operations at various manufacturing facilities totaled $154 million. These costs included $107 million of recurring costs associated with managing hazardous substances and pollution in on-going operations, $38 million of capital expenditures to limit or monitor hazardous substances or pollutants, and $8 million of mandated expenditures to remediate previously contaminated sites. These expenditures have been accounted for in accordance with the Company's accounting policy for environmental costs. The Company expects these recurring and remediation costs to increase slightly and capital to increase significantly in the near future. While these costs will continue to be significant cash outflows for the Company, it is not expected that these costs will have a materially different impact on the Company's financial position, results of operations or competitive position. The Company has reviewed a draft RCRA Facility Assessment (RFA) pertaining to the Company's Kodak Park site in Rochester, New York. The Company has completed a broad-based assessment of the site in response to the RFA. While future expenditures associated with any remediation activities could be significant, it is not possible to reasonably estimate those expenditures until additional studies are performed. The Company accrues for remediation costs that relate to an existing condition caused by past operations when it is probable that these costs will be incurred and can be reasonably estimated. The Company has accrued for remediation costs of $84 million in its financial statements at December 31, 1993, compared with $90 million at December 31, 1992. Also see Item 3 Legal Proceedings. The Clean Air Act Amendments were enacted in 1990. The Company may be required to incur significant costs, primarily capital in nature, over a period of several years to comply with the provisions of this Act. The expenditures that may be required cannot be currently reasonably estimated since either implementing regulations have not been issued or compliance plans have not been finalized. - ------------------------------------------------------------------------- EMPLOYMENT At the end of 1993, Kodak's continuing operations employed 110,400 people, of whom 57,200 were employed in the United States. - ------------------------------------------------------------------------- Financial information by geographic areas for the past three years is shown in Segment Information on page 39. - ------------------------------------------------------------------------- ITEM 2. ITEM 2. PROPERTIES The imaging segment of Kodak's business in the United States is centered in and near Rochester, New York, where photographic goods are manufactured. Another manufacturing facility near Windsor, Colorado, also produces sensitized photographic goods. Regional distribution centers are located in various places within the United States. Imaging manufacturing facilities outside the United States are located in Australia, Brazil, Canada, France, Mexico and the United Kingdom. Kodak maintains marketing and distribution facilities in many parts of the world. The Company also owns processing laboratories in numerous locations outside the United States, and has an equity position in a company that provides processing services in the United States. Products in the information segment are manufactured primarily in Rochester, New York and Windsor, Colorado. Manufacturing facilities outside the United States are located in Germany, Mexico and the United Kingdom. Health segment products are manufactured in several locations in the United States including Rochester, New York; Windsor, Colorado; Lincoln, Illinois; Belle Mead, New Jersey; Myerstown, Pennsylvania; McPherson, Kansas; and Rensselaer, New York. Other manufacturing facilities and distribution centers are located in various places in the United States. The principal manufacturing facilities outside the United States are in Argentina, Australia, Brazil, Canada, France, Germany, Ireland, Mexico, Puerto Rico and the United Kingdom. In addition, the health segment has manufacturing, marketing, and distribution facilities in many other parts of the world. The Company owns or leases administrative, manufacturing, marketing, and processing facilities in various parts of the world. The leases are for various periods and are generally renewable. The manufacturing and marketing facilities are adequate and suitable, in relation to prevailing conditions, to serve the needs of their marketing areas. - ------------------------------------------------------------------------- ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is in discussion with the Environmental Protection Agency (EPA) and the Environment and Natural Resources Division of the U.S. Department of Justice concerning the EPA/NEIC (National Enforcement Investigations Center) investigation of the Company's Kodak Park site in Rochester, New York. As a result of the investigation, the Company expects to incur a civil fine of at least $100,000 for violations of federal environmental laws and regulations. The Company is participating in the EPA's Toxic Substances Control Act (TSCA) Section 8(e) Compliance Audit Program. As a participant, the Company has agreed to audit its files for materials which under current EPA guidelines would be subject to notification under Section 8(e) of TSCA and to pay stipulated penalties for each report submitted under this program. The Company anticipates that its liability under the Program will be $1,000,000. In addition to the foregoing environmental actions, the Company has been designated as a potentially responsible party (PRP) under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended (the "Superfund" law), or under similar state laws, for environmental assessment and cleanup costs as the result of the Company's alleged arrangements for disposal of hazardous substances at fewer than twenty Superfund sites. With respect to each of these sites, the Company's actual or potential allocated share of responsibility is small. Furthermore, numerous other PRPs have similarly been designated at these sites and, although the law imposes joint and several liability on PRPs, as a practical matter costs are shared with other PRPs. Settlements and costs paid by the Company in Superfund matters to date have not been material. Future costs are also not expected to be material to the Company's financial condition or results of operations. The Company and its subsidiary companies are involved in lawsuits, claims, investigations, and proceedings, including product liability, commercial, environmental, and health and safety matters, which are being handled and defended in the ordinary course of business. There are no such matters pending that the Company and its General Counsel expect to be material in relation to the Company's business, financial condition or results of operations. - ----------------------------------------------------------------------------- ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None - ----------------------------------------------------------------------------- Executive Officers of the Registrant (as of December 31, 1993) Date First Elected an to Executive Present Name Age Positions Held Officer Office George M. C. Fisher 53 Chairman of the Board, President and Chief Executive Officer 1993 1993 Richard T. Bourns 59 Senior Vice President 1988 1990 C. Michael Hamilton 49 General Comptroller 1993 1993 John R. McCarthy 62 Senior Vice President 1982 1989 Wilbur J. Prezzano 53 Group Vice President, Director 1980 1992 Leo J. Thomas 57 Group Vice President, Director 1977 1992 Gary P. Van Graafeiland 47 Senior Vice President and Secretary 1992 1992 Executive officers are elected annually in February. All of the executive officers have been employed by Kodak in various executive and managerial positions for more than five years, except for Mr. Fisher, who joined the Company on December 1, 1993, and Mr. Van Graafeiland. For the prior five years, Mr. Fisher held executive positions with Motorola, Inc., most recently as Chairman and Chief Executive Officer. Mr. Van Graafeiland, who joined the Company in 1979, was elected Secretary in 1990, and was elected to his current position in February 1992. There have been no events under any bankruptcy act, no criminal proceedings, and no judgments or injunctions material to the evaluation of the ability and integrity of any executive officer during the past five years. - ----------------------------------------------------------------------------- PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Eastman Kodak Company common stock is principally traded on the New York Stock Exchange. There were 157,797 shareholders of record of common stock as of December 31, 1993. See Cash Dividends and Market Price Data on pages 16 and 17. - ----------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company posted sales from continuing operations of $16,364 million in 1993. Earnings from continuing operations before extraordinary item and cumulative effect of changes in accounting principle for the year were $475 million ($1.44 per share) compared with earnings of $727 million ($2.24 per share) in 1992. Earnings from continuing operations before extraordinary item and the cumulative effect of changes in accounting principle were significantly reduced by restructuring costs in both years. The restructuring costs for 1993 continuing operations were $538 million ($379 million or $1.16 per share after-tax) compared with restructuring costs for 1992 continuing operations of $220 million ($141 million or $.43 per share after-tax). Earnings from continuing operations, before deducting restructuring costs in both years, declined slightly in 1993 when compared with 1992. Earnings benefited from increased unit volumes, lower marketing and administrative activity, lower research and development activity and manufacturing productivity gains; but were adversely affected by cost escalation, lower effective selling prices, higher retiree health care costs associated with the change in accounting for certain postretirement benefits, smaller gains from the sales of investments, and the unfavorable effects of foreign currency rate changes. Net earnings for 1993 were reduced by an extraordinary charge of $14 million after-tax ($.04 per share) related to the early extinguishment of debt. Net earnings for 1993 benefited by $192 million ($.58 per share) from discontinued operations compared with a benefit of $267 million ($.82 per share) in 1992. Earnings from continuing operations for the fourth quarter of 1993 were $204 million compared with earnings of $251 million in the fourth quarter of 1992, which benefited by approximately $75 million ($.23 per share) from gains on the sales of investments including the sale of Eastman Kodak Credit Corporation (EKCC). Earnings from discontinued operations for 1993 were lower when compared with 1992, as the benefits from higher unit volumes were more than offset by cost escalation, higher retiree health care costs associated with the change in accounting for certain postretirement benefits, a provision for environmental costs, transaction costs associated with the spin-off of the Company's worldwide chemicals business, and restructuring costs of $12 million ($8 million or $.02 per share after-tax). The loss from discontinued operations of $2 million in the fourth quarter of 1993 compared with earnings of $48 million in the fourth quarter of 1992 was primarily attributable to the provision for environmental costs and the transaction costs associated with the spin-off. The 1993 net loss was due to an after-tax charge of $2.17 billion ($6.60 per share) associated with the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and SFAS No. 112, Employers' Accounting for Postemployment Benefits effective as of January 1, 1993. Net earnings for 1992 benefited by $152 million ($.47 per share) from the adoption of SFAS No. 109, Accounting for Income Taxes, effective as of January 1, 1992. On December 31, 1993, the Company spun-off its worldwide chemical business, which consisted of Eastman Chemical Company operations. Results for Eastman Chemical Company operations are being reported as a discontinued operation and results for prior periods have been restated. Earnings from discontinued operations before cumulative effect of changes in accounting principle represents the Chemicals segment earnings from operations reduced by allocations of interest, taxes and the transaction costs associated with the spin-off. The Company posted record sales from continuing operations of $16,545 million in 1992. Earnings from continuing operations for the year were $727 million ($2.24 per share) compared with a loss of $302 million ($.93 per share) in 1991. Net earnings for 1992 included $267 million ($.82 per share) from discontinued operations compared with $319 million ($.98 per share) in 1991. Net earnings for 1992 also benefited by $152 million ($.47 per share) from the cumulative effect of adopting SFAS No. 109, Accounting for Income Taxes, and were adversely affected by the effects of restructuring costs of $220 million ($141 million or $.43 per share after-tax). Net earnings for 1991 were significantly reduced by the effects of restructuring costs of $1,605 million ($1,032 million or $3.18 per share after-tax). Excluding the effects of restructuring costs from both 1992 and 1991, earnings from continuing operations for 1992 increased from the prior year as the favorable effects of manufacturing productivity, higher volumes, gains from the sales of investments including the sale of EKCC, and the favorable effects of foreign currency rate changes more than offset cost escalation and higher marketing and administrative costs. Earnings from continuing operations for the fourth quarter of 1992 were $251 million compared with a net loss of $474 million in the fourth quarter of 1991. Earnings for the fourth quarter of 1992 benefited by approximately $75 million ($.23 per share) from gains on the sales of investments including the sale of EKCC. The net loss in the fourth quarter of 1991 was due to the effects of restructuring costs of $914 million ($597 million or $1.84 per share after-tax). Earnings from discontinued operations were lower in 1992, when compared with 1991, as higher manufacturing costs and higher administrative costs more than offset the benefits of higher unit volumes and higher effective selling prices. - ----------------------------------------------------------------------------- SALES Worldwide sales from continuing operations for 1993 were down one percent when compared with 1992, as slight increases in unit volumes were offset by the unfavorable effects of foreign currency rate changes and lower effective selling prices. Sales of the Health segment increased slightly, the Imaging segment recorded a slight decline and the Information segment was down when compared with last year. Currency changes against the U.S. dollar unfavorably affected 1993 sales from continuing operations by approximately $550 million before reflecting the impact of the Company's hedging program. Sales from continuing operations for 1992 were up slightly compared with 1991 as all segments posted sales increases primarily as the result of higher unit volumes. Imaging achieved moderate gains while slight increases were reported for Information and Health. Currency changes against the U.S. dollar favorably affected 1992 sales by approximately $150 million before reflecting the impact of the Company's hedging program. In the Imaging segment, sales to customers inside the U.S. in 1993 were essentially level when compared with sales for 1992, as slight increases in unit volumes were offset by lower effective selling prices. Outside the U.S., sales showed a slight decrease in 1993, as moderate increases in unit volumes were more than offset by the unfavorable effects of foreign currency rate changes and lower effective selling prices. Worldwide volume gains were led by Kodacolor 35mm films, single-use cameras and Ektacolor papers. For the Imaging segment, 1992 sales to customers inside the U.S. increased slightly when compared with sales for 1991 due to higher unit volumes and higher effective selling prices. Outside the U.S., sales registered a moderate increase in 1992, as higher unit volumes and the favorable effects of foreign currency rate changes were partially offset by lower effective selling prices. Worldwide sales increases in 1992 were led by Kodacolor films and Ektacolor papers. In the Information segment, 1993 sales comparisons for customers in the U.S. and outside the U.S. were adversely affected by the inclusion in 1992 of revenues from divested units. In addition, outside the U.S., the benefits from increased unit volumes from ongoing businesses were more than offset by the unfavorable effects of foreign currency rate changes and slightly lower selling prices. Information segment sales in 1992 to customers in the U.S. were essentially level with 1991. Outside the U.S., sales recorded a moderate increase when compared with 1991, primarily due to higher unit volumes and the favorable effects of foreign currency rate changes. In the Health segment, 1993 sales to customers inside the U.S. were up one percent when compared with 1992. Outside the U.S., moderate increases for the year resulted from significant increases in unit volumes, partially offset by the effects of unfavorable foreign currency rate changes. All business units posted worldwide volume gains for the year. Health segment sales in 1992 to customers inside the U.S. recorded good increases when compared with 1991, primarily due to volume gains. Sales comparisons between 1992 and 1991 for customers outside the U.S. were adversely affected by the inclusion of two additional months of Sterling Winthrop Inc. sales in 1991 to align company reporting periods. In addition, certain sales by former Sterling Winthrop Inc. units are no longer consolidated because of the alliance with Elf Sanofi. On a comparable basis, sales outside the U.S. in 1992 would have registered solid gains when compared with 1991 results. Worldwide sales increases in 1992 were led by consumer health and pharmaceutical products and x-ray films. In the Chemicals segment, whose results are now being reported as discontinued operations, slight increases in 1993 sales to customers in the U.S. when compared with 1992 were due to higher unit volumes. Outside the U.S., a slight decline in 1993 sales when compared with 1992 resulted from the unfavorable effects of foreign currency rate changes and lower effective selling prices, partially offset by higher unit volumes. Worldwide sales of specialty chemicals recorded a moderate increase while industrial chemicals declined slightly when compared with 1992. For the Chemicals segment, moderate increases in 1992 sales to customers in the U.S. and slight increases in sales outside the U.S. when compared with 1991 were due to higher unit volumes. Worldwide sales of specialty chemicals recorded a solid increase in 1992, while industrial chemicals were level. Earnings (loss) from operations for 1993 are shown after deducting restructuring costs of $202 million for Imaging, $278 million for Information, $58 million for Health and $12 million for Chemicals. Earnings (loss) from operations for 1992 are shown after deducting restructuring costs of $83 million for Imaging, $123 million for Information and $14 million for Health. Earnings (loss) from operations for 1991 are shown after deducting restructuring costs of $792 million for Imaging, $623 million for Information and $190 million for Health. Segment information is reported on pages 37 through 39, Notes to Financial Statements. - ----------------------------------------------------------------------------- EARNINGS Operating earnings from continuing operations for the Imaging, Information and Health segments were adversely affected by restructuring costs of $538 million in 1993, $220 million in 1992 and $1,605 million in 1991. The operating earnings for the Chemicals segment, whose results are now being reported as discontinued operations, were adversely affected by restructuring costs of $12 million in 1993. In addition, operating earnings for all segments were adversely affected by higher retiree health care costs associated with the change in accounting for certain postretirement benefits. The 1993 restructuring costs represent the cost of separation benefits for a cost reduction program expected to reduce worldwide employment by 10,000 and the cost of closing a facility in Germany that manufactures a component for the Company's ink jet printing business. The restructuring costs in 1992 and 1991 included costs of an early retirement plan, the restructuring of non-U.S. sensitized manufacturing and photofinishing operations and worldwide pharmaceutical businesses, and the Company's exit from non-strategic businesses. Imaging segment operating earnings were adversely affected by restructuring costs in 1993 and 1992 of $202 million and $83 million, respectively. Imaging segment operating earnings, before deducting restructuring costs in both years, were essentially level in 1993 when compared with 1992, as the benefits from increased unit volumes, lower marketing and administrative activity, manufacturing productivity gains and lower research and development activity offset lower effective selling prices, cost escalation and the unfavorable effects of foreign currency rate changes. Imaging segment operating earnings were adversely affected by restructuring costs in 1992 and 1991 of $83 million and $792 million, respectively. Imaging segment operating earnings, before deducting restructuring costs in both years, increased in 1992 when compared with 1991, as the favorable effects of manufacturing productivity gains and increased unit volumes were partially offset by cost escalation, lower effective selling prices, increased marketing and administrative costs and higher research and development expenditures. The Information segment operating losses were adversely affected by restructuring costs in 1993 and 1992 of $278 and $123 million, respectively. Information segment operating earnings, before deducting restructuring costs in both years, improved significantly in 1993 when compared with 1992, as the benefits of lower marketing and administrative activity and lower research and development activity were only partially offset by cost escalation. The Information segment operating losses were adversely affected by restructuring costs in 1992 and 1991 of $123 million and $623 million, respectively. The 1992 Information segment operating loss was less than the loss for 1991, before deducting restructuring costs in both years, as lower marketing and administrative costs and lower research and development costs more than offset cost escalation. Health segment operating earnings were adversely affected by restructuring costs in 1993 and 1992 of $58 million and $14 million, respectively. Health segment operating earnings, before deducting restructuring costs in both years, increased slightly in 1993 when compared with 1992, as the benefits of increased unit volumes, manufacturing productivity gains, lower marketing and administrative activity and lower research and development activity more than offset cost escalation and the unfavorable effects of foreign currency rate changes. Health segment operating earnings were adversely affected by restructuring costs in 1992 and 1991 of $14 million and $190 million, respectively. On a fully comparable basis and before deducting the effects of restructuring costs in both years, Health segment operating earnings were up slightly in 1992 when compared with 1991, as the favorable effects of increased unit volumes more than offset higher marketing costs and increased research and development expenditures. Chemicals segment operating earnings, which are now being reported as discontinued operations, were adversely affected by restructuring costs in 1993 of $12 million. Chemicals segment operating earnings, before deducting the 1993 restructuring costs, decreased when compared with 1992, as the benefits from increased unit volumes were more than offset by cost escalation, provision for the estimated cost of environmental remediation and plant closure costs, lower effective selling prices, charges for the planned exit from the Kodel polyester staple fiber business and the unfavorable effects of foreign currency rate changes. Chemicals segment operating earnings decreased for 1992 when compared with 1991, as higher manufacturing costs and increased administrative costs were only partially offset by increased unit volumes and higher effective selling prices. Research and development expenditures amounted to $1,301 million in 1993, compared with $1,419 million in 1992 and $1,337 million in 1991. Research and development expenditures in 1993 were significantly below 1992 as the benefits from lower activity levels were only partially offset by cost escalation. Cost escalation and increased activity levels were the primary reasons for the higher research and development expenditures in 1992 when compared with 1991. Amortization of goodwill amounted to $153 million in 1993, $145 million in 1992 and $147 million in 1991. Advertising and sales promotion expenses were $1,292 million in 1993, $1,339 million in 1992 and $1,199 million in 1991. Other marketing and administrative expenses totaled $3,697 million in 1993, $3,941 million in 1992 and $3,850 million in 1991. Decreases in advertising and sales promotion, and other marketing and administrative expenses in 1993 resulted from the benefit of lower activity levels and the favorable effects of foreign currency rate changes on locally incurred international costs, partially offset by cost escalation. Increases in advertising and sales promotion, and other marketing and administrative expenses for 1992 when compared with 1991 resulted from cost escalation, increased activity and the unfavorable effects of foreign currency rate changes. The comparison with 1991 benefited from divestitures in 1992 and the inclusion of two additional months of Sterling Winthrop Inc. expenditures from units outside the U.S. in 1991 to align company reporting periods. Earnings from equity interests and other revenues were $277 million in 1993, $404 million in 1992 and $259 million in 1991. The results for 1992 included gains from the sales of investments, including the sale of EKCC. Interest expense of $635 million in 1993 was lower than the $713 million incurred in 1992 and $754 million incurred in 1991 as a result of lower effective interest rates. The Company has a program in place to manage interest rate risk associated with its current and anticipated borrowings. In connection with this program, the Company has entered into various combinations of interest rate swaps, options, currency swaps and similar arrangements. The effect of this program has been to reduce the aggregate average interest rate on the Company's borrowings. The Company has a program in place to manage foreign currency risk. The Company has entered into foreign currency contracts to hedge transactions in non-U.S. dollar denominated receivables and payables. The Company has also entered into foreign currency contracts to hedge sales from foreign units denominated in currencies other than local currencies and probable anticipated export sales. The net effect of this program was a gain of $65 million in 1993, a loss of $66 million in 1992 and a loss of $7 million in 1991. Other charges increased in 1993 when compared with 1992, as the net loss in 1993 from foreign exchange transactions and the translation of net monetary items in highly inflationary economies was greater than in 1992. Other charges decreased in 1992 when compared with 1991 as the net loss in 1992 from foreign exchange transactions and the translation of net monetary items in highly inflationary economies was less than the net loss in 1991 from foreign exchange transactions and the translation of net monetary assets and liabilities. - ----------------------------------------------------------------------------- Net Earnings (Loss) 1993 1992 1991 (in millions) Amount $(1,515) $1,146 $ 17 Percent of sales (9.3%) 6.9% 0.1% - ----------------------------------------------------------------------------- CASH DIVIDENDS Total cash dividends of approximately $650 million ($.50 per share each quarter) were declared in each of the past three years. - ----------------------------------------------------------------------------- FINANCIAL POSITION Cash, cash equivalents and marketable securities increased to $1,966 million at year-end 1993 from $547 million at year-end 1992. In connection with the spin-off of the worldwide chemical business, the Company borrowed $1.8 billion in December 1993, which subsequently was assumed by the worldwide chemical business on December 31, 1993. The proceeds from the borrowings, which were retained by Kodak, are invested primarly in United States Government securities and time deposits and will eventually be used to retire other borrowings. At December 31, 1992, $1.8 billion of the Company's long-term borrowings were included in the net assets of discontinued operations. Interest expense and capitalized interest in 1993 related to such debt of $126 million and $23 million, respectively, were allocated to discontinued operations in 1993. The Company announced on March 2, 1994 that it has elected to redeem the zero coupon convertible subordinated debentures due 2011 on April 1, 1994. The redemption price is $312.14 per debenture. Each debenture may be converted into the Company's common stock at a conversion rate of 6.944 shares per debenture at any time before the close of business on April 1, 1994. Approximately $1.15 billion would be required to redeem all of the outstanding debentures. This redemption will not have a material impact on the Company's results of operations for 1994. Approximately three-fourths of the restructuring costs recorded by the Company in 1993 represented the cost of separation benefits for personnel leaving under a workforce reduction program. Most of these benefits will be paid during 1994 from operating cash flows. The remainder of the 1993 restructuring costs is associated with the closure of a facility in Germany. Most of these costs represent non-cash write-offs of assets. Most of the costs associated with the early retirement plan announced in 1991 are being funded from the Company's pension plan assets and, therefore, did not significantly affect the Company's cash flows during the past three years. The Company does not anticipate that such costs will affect its cash flows in the near future. The Company has access to a $2.5 billion revolving credit facility expiring in October 1995, which it has not used. Projected operating cash flows are expected to be adequate to support normal business operations, planned capital expenditures and dividend payments in 1994. - ----------------------------------------------------------------------------- ENVIRONMENTAL PROTECTION During 1993, expenditures for pollution prevention and waste treatment for continuing operations at various manufacturing facilities totaled $154 million. These costs included $107 million of recurring costs associated with managing hazardous substances and pollution in on-going operations, $38 million of capital expenditures to limit or monitor hazardous substances or pollutants, and $8 million of mandated expenditures to remediate previously contaminated sites. The Company expects these recurring and remediation costs to increase slightly and capital to increase significantly in the near future. While these costs will continue to be significant cash outflows for the Company, it is not expected that these costs will have a materially different impact on the Company's financial position, results of operations or cash flows. The Company has reviewed a draft Resource Conservation and Recovery Act (RCRA) Facility Assessment (RFA) pertaining to the Company's Kodak Park site in Rochester, New York. The Company has completed a broad-based assessment of the site in response to the RFA. While future expenditures associated with any remediation activities could be significant, it is not possible to reasonably estimate those expenditures until additional studies are performed. The Clean Air Act Amendments were enacted in 1990. The Company may be required to incur significant costs, primarily capital in nature, over a period of several years to comply with the provisions of this Act. The expenditures that may be required cannot currently be reasonably estimated since either implementing regulations have not been issued or compliance plans have not been finalized. - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- NEW ACCOUNTING STANDARDS SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, must be adopted in the first quarter of 1994. This standard requires that companies classify securities that it holds as held-to-maturity securities, trading securities or available-for-sale securities. Debt securities classified as held-to-maturity will be reported at amortized cost. Debt and equity securities classified as trading will be reported at fair value, with unrealized holding gains and losses included in earnings. Debt and equity securities classified as available-for-sale will be reported at fair value, with unrealized holding gains and losses excluded from earnings and reported in a separate component of shareowners' equity until realized. The Company does not believe that this standard will have a material effect on the Company's financial position or results of operations when adopted. - ----------------------------------------------------------------------------- SUMMARY OF OPERATING DATA A summary of operating data for 1993 and for the 4 years prior is shown on page 44. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation and integrity of the consolidated financial statements and related notes which appear on pages 19 through 43. These financial statements have been prepared in accordance with generally accepted accounting principles and of necessity include some amounts that are based on management's best estimates and judgments. The Company's accounting systems include extensive internal controls designed to provide reasonable assurance of the reliability of its financial records and the proper safeguarding and use of its assets. Such controls are based on established policies and procedures, are implemented by trained, skilled personnel with an appropriate segregation of duties, and are monitored through a comprehensive internal audit program. The Company's policies and procedures prescribe that the Company and all employees are to maintain the highest ethical standards and that its business practices throughout the world are to be conducted in a manner which is above reproach. The consolidated financial statements have been audited by Price Waterhouse, independent accountants, who were responsible for conducting their audits in accordance with generally accepted auditing standards. Their resulting report is shown below. The Board of Directors exercises its responsibility for these financial statements through its Audit Committee, which consists entirely of non-management Board members. The independent accountants and internal auditors have full and free access to the Audit Committee. The Audit Committee meets periodically with the independent accountants and the Director of Corporate Auditing of the Company, both privately and with management present, to discuss accounting, auditing and financial reporting matters. George M. C. Fisher C. Michael Hamilton Chairman of the Board, President and General Comptroller and Chief Executive Officer Acting Chief Financial Officer January 31, 1994 January 31, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowners of Eastman Kodak Company In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 54 of this Annual Report on Form 10-K present fairly, in all material respects, the financial position of Eastman Kodak Company 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 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 the Other Postemployment Costs note, the Company changed its method of accounting for certain postretirement benefits and other postemployment benefits in 1993. As discussed in the Income Taxes note, the Company changed its method of accounting for income taxes in 1992. PRICE WATERHOUSE New York, New York January 31, 1994, except as to the Subsequent Event note, which is as of March 2, 1994 Eastman Kodak Company and Subsidiary Companies NOTES TO FINANCIAL STATEMENTS SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of Eastman Kodak Company and its majority owned subsidiary companies. Intercompany transactions are eliminated and net earnings are reduced by the portion of the earnings of subsidiaries applicable to minority interests. TRANSLATION OF NON-U.S. CURRENCIES Effective January 1, 1992, the local currency is the "functional currency" of most subsidiary companies outside the U.S., however, the U.S. dollar will continue to be used for reporting operations in highly inflationary economies. This change did not have a material effect on the Company's statement of financial position as of January 1, 1992. INVENTORIES Inventories are valued at cost, which is not in excess of market. The cost of most U.S. inventories is determined by the last-in, first-out (LIFO) method. The cost of other inventories is determined by the first-in, first-out (FIFO), or average cost method. GOODWILL The excess of the Company's costs of its consolidated investments over the value ascribed to the equity in such companies at the time of acquisition is amortized over appropriate future periods benefited not exceeding 40 years. INVESTMENTS Included in long-term receivables and other noncurrent assets are investments in joint ventures which are managed as integral parts of the Company's segment operations and are accounted for on an equity basis. The Company's share of the earnings of these joint ventures is included in the earnings from operations for the related segments. SALES Sales represent revenue from sales of products and services, equipment rentals, and other operating fees. DEPRECIATION Depreciation expense is provided based on historical cost and the estimated useful lives of the assets. The Company generally uses the straight-line method for calculating the provision for depreciation. For assets in the United States acquired prior to January 1, 1992, the provision for depreciation is generally calculated using accelerated methods. ENVIRONMENTAL COSTS Environmental expenditures that relate to current operations are expensed or capitalized as appropriate. Remediation costs that relate to an existing condition caused by past operations are accrued when it is probable that these costs will be incurred and can be reasonably estimated. PROPERTY RETIREMENTS Properties are recorded at historical cost, reduced by accumulated depreciation. When assets are retired or otherwise disposed of, the cost of such assets and the related accumulated depreciation are removed from the accounts. Any profit or loss on retirement, or other disposition, is reflected in earnings. INCOME TAXES Effective January 1, 1992, deferred income taxes reflect the impact of temporary differences between the assets and liabilities recognized for financial reporting purposes and amounts recognized for tax purposes. Deferred taxes are based on tax laws as currently enacted. RECLASSIFICATIONS Certain 1992 and 1991 financial statement and related footnote amounts have been reclassified to conform to the 1993 presentation. - ----------------------------------------------------------------------------- DISCONTINUED OPERATIONS On December 31, 1993, the Company spun-off its worldwide chemical business through a dividend to its shareowners, following receipt of a ruling from the Internal Revenue Service that the transaction will be tax-free to Kodak and its U. S. shareowners. The Chemicals segment has been reported as a discontinued operation and results for prior periods have been restated. Summarized results of the Chemicals segment, including allocations of interest expense, income taxes and transaction costs associated with the spin-off are as follows: (in millions) 1993 1992 1991 Sales $3,695 $3,638 $3,468 ====== ====== ====== Earnings before income taxes $ 267 $ 383 $ 445 Provision for income taxes 75 116 126 ------ ------ ------ Earnings before cumulative effect of changes in accounting principle $ 192 $ 267 $ 319 ====== ====== ====== Net assets of the Chemicals segment at December 31, 1992 are presented below. As a result of the spin-off, these assets are not included in the Company's 1993 consolidated statement of financial position. December 31, (in millions) Current assets $1,002 Land, buildings and equipment, net 3,071 Other assets 164 ------ Total assets 4,237 ------ Current liabilities 486 Long-term borrowings 1,800 Other liabilities 545 ------ Total liabilities 2,831 ------ Net assets of discontinued operations $1,406 ====== Total net assets of the Chemicals segment at December 31, 1992 reflects the expected settlement of intercompany balances and an allocation of long-term borrowings as of the date of the spin-off. The effective tax rates for discontinued operations were 28%, 30% and 28% for 1993, 1992 and 1991, respectively. The differences between the provision for income taxes and income taxes computed using the U.S. federal statutory income tax rate of 35% in 1993 and 34% in 1992 and 1991 were primarily due to the allocation of foreign and state tax benefits to discontinued operations. - ----------------------------------------------------------------------------- CASH FLOW INFORMATION For purposes of the consolidated statement of cash flows, the Company considers marketable securities with maturities of three months or less at the time of purchase to be cash equivalents. Cash paid for interest and income taxes, including amounts paid attributable to discontinued operations, is as follows: (in millions) 1993 1992 1991 Interest, net of portion capitalized of $86, $94 and $112 $792 $766 $869 Income taxes 497 388 434 Certain assets have been acquired through non-cash acquisitions and are not reflected in the consolidated statement of cash flows. Except for $157 million of cash transferred with the Chemicals segment, the spin-off of the worldwide chemical business was a non-cash transaction and is not reflected in the consolidated statement of cash flows. - ----------------------------------------------------------------------------- MARKETABLE SECURITIES Marketable securities (principally U.S. Government securities and time deposits) are shown at cost which approximates market value. - ----------------------------------------------------------------------------- RECEIVABLES The Company has entered into an agreement whereby it sells an undivided interest in a designated pool of trade accounts receivable up to a maximum of $100 million. As collections reduce accounts receivable balances in the pool, the Company may sell participating interests in new receivables to bring the amount sold up to the $100 million maximum. The uncollected balance of receivables sold amounted to $100 million at each balance sheet date. The Company retains collection and administrative responsibilities on the participating interests sold as agent for the purchaser. During 1993 the Company sold $75 million of lease receivables for approximately $85 million. - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- The 6 3/8% debentures due in 2001 are convertible at the option of the holder at any time prior to maturity for the Company's common stock at $41.52 per share. The zero coupon convertible subordinated debentures due in 2011 ($3,680 million face value, 6.75% yield to maturity) are convertible at the option of the holder at any time prior to maturity for the Company's common stock at a conversion rate of 6.944 shares per debenture. At the option of the holder, the debentures must be purchased by the Company on October 15, 1994, 1995, 1996, 2001 and 2006, at a price equal to the issue price plus accrued original issue discount. The Company has an unused $2.5 billion revolving credit facility expiring in October 1995 which is available to support the Company's commercial paper borrowings. If unused, it has a commitment fee of $6.3 million per year. Interest on amounts borrowed under this facility is at rates based on spreads above certain reference rates. The amount of long-term borrowings maturing in the four years after 1994 are $861 million in 1995, $100 million in 1996, $335 million in 1997 and $1,100 million in 1998. The Company has swapped $135 million of the 7 7/8% notes into yen denominated debt and $46 million of the Sterling Winthrop Inc. 8 7/8% notes into deutsche mark denominated debt. As a result of these agreements, the effective interest rates on the 7 7/8% notes and 8 7/8% notes have been reduced. The Company has a program in place to manage interest rate risk associated with its current and anticipated borrowings. In connection with this program, the Company has entered into various combinations of interest rate swaps, options, currency swaps and similar arrangements. At December 31, 1993 and 1992, the Company had the following interest rate swap agreements with aggregate notional principal amounts of $4.7 billion and $4.1 billion, respectively. LONG-TERM BORROWINGS (continued) Notional Amounts Maturities at December 31, Through 1993 1992 Pay fixed rate (9.5% - 11.5%) and receive LIBOR or commercial paper based variable rate $ .6 $ .9 2018 Pay LIBOR or commercial paper based variable rate and receive fixed rate (9.5%) .4 .4 2000 Zero coupon swaps 3.7 2.8 1999 In addition, the Company has entered into interest rate options linked to $2.5 billion of its fixed rate callable debt at each balance sheet date. The notional principal amounts associated with these options were $2.8 billion and $3.1 billion at December 31, 1993 and 1992, respectively. The effect of these options, which are exercisable through 1998, is to change the underlying debt from callable to non-callable and to reduce the aggregate average effective interest rate on this debt. During 1988, the Company issued debt warrants that give the holders the option between 1995 and 2004 to require the Company to issue an additional $300 million of 9.5% debt maturing in 2018. The premium received for these warrants is being amortized as a reduction of interest expense. The Company is exposed to credit loss in the event of nonperformance by the counterparties to these agreements. However, the Company does not anticipate nonperformance. Also, while these agreements are part of the Company's overall interest rate management program, the fair value of these instruments will vary with changes in prevailing interest rates. The fair value of these interest rate agreements are presented in the note on Fair Values of Financial Instruments. The Company has issued letters of credit in lieu of making security deposits to insure the payment of possible Workers' Compensation claims. - ----------------------------------------------------------------------------- OTHER LONG-TERM LIABILITIES (in millions) 1993 1992 Interest rate swap and option agreements $ 654 $ 789 Deferred compensation 115 101 Other 680 618 ------ ------ Total $1,449 $1,508 ====== ====== - ----------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES The Company has entered into agreements with several companies to provide the Company with products and services to be used in its normal operations. The minimum payments for these agreements are approximately $132 million in 1994, $110 million in 1995, $101 million in 1996, $103 million in 1997, $98 million in 1998 and $155 million in 1999 and beyond. The Company has also guaranteed debt and other obligations under agreements with certain affiliated companies and customers. At December 31, 1993, these guarantees totaled approximately $230 million. The Company does not expect that these guarantees will have a material impact on the Company's future financial position or results of operations. The Company has entered into a Master Lease agreement whereby the Company leases equipment with the right to buy the equipment anytime at fair market value. The lease term is one year and is renewable annually. The total amount of assets under this lease is approximately $300 million at each balance sheet date. - ----------------------------------------------------------------------------- FAIR VALUES OF FINANCIAL INSTRUMENTS The recorded amounts of other investments as of December 31, 1993 and 1992 shown below include $81 million and $70 million, respectively, of equity investments in a number of entities for which it is not practicable to estimate fair value, since quoted market prices do not exist for any of these investments. The fair values of long-term borrowings were estimated based on quoted market prices or by obtaining quotes from brokers. As discussed above, the Company is a party to various interest rate option and swap agreements and foreign currency contracts which are included in other instruments below. The fair values of other instruments were estimated by obtaining quotes from brokers, where practicable, or by estimating the amounts the Company would receive or pay to terminate the instruments at the reporting date. The recorded amounts of certain financial instruments, such as cash and marketable securities and short-term borrowings, approximate their fair values and are excluded from the amounts below. The recorded amounts and estimated fair values of the Company's long-term borrowings and other financial instruments as of December 31, 1993 and 1992 were as follows: December 31, 1993 December 31, 1992 (in millions) Recorded Fair Recorded Fair Amount Value Amount Value Other investments $ 93 $ 93 $ 124 $ 127 Long-term borrowings (6,853) (7,513) (7,202)* (7,661)* Other instruments (816) (1,308) (689) (936) *Includes borrowings expected to be assumed by discontinued operations. - ----------------------------------------------------------------------------- There are approximately 27 million shares reserved for the conversion of the 6 3/8% convertible subordinated debentures and zero coupon convertible subordinated debentures issued by the Company. There are also 100 million shares of $10 par value preferred stock authorized, none of which has been issued. Retained earnings of subsidiary companies outside the U.S. are considered to be reinvested indefinitely. If remitted, they would be substantially free of additional tax. It is not practicable to determine the deferred tax liability for temporary differences related to these retained earnings. - ----------------------------------------------------------------------------- EARNINGS PER COMMON SHARE Fully diluted earnings per share is computed by dividing net earnings adjusted for after-tax interest expense associated with convertible securities by the average number of common shares outstanding, common stock equivalents related to dilutive stock options, and common shares issuable upon conversion of such convertible securities. The effects of such potentially dilutive convertible securities were not dilutive in 1993 and 1991. The number of common shares used to compute earnings per share amounts was as follows: (in millions) 1993 1992 1991 Primary 328.3 325.1 324.7 Fully diluted 331.2 352.2 326.4 - ----------------------------------------------------------------------------- OTHER REVENUES Other revenues include $55 million of interest income for 1993, $81 million for 1992 and $109 million for 1991. - ----------------------------------------------------------------------------- INCOME TAXES Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. The adoption of this standard changed the Company's method of accounting for income taxes from the deferred method to the liability method. The standard was adopted on a prospective basis and amounts presented for prior years were not restated. The cumulative effect of adopting the standard as of January 1, 1992 was a $71 million credit to earnings from continuing operations and a $81 million credit to earnings from discontinued operations. The components of earnings (loss) from continuing operations before income taxes and the related provision (benefit) for United States and other income taxes were as follows: The components of earnings (loss) from consolidated operations before income taxes and the related provision (benefit) for United States and other income taxes were as follows: The differences between the provision (benefit) for income taxes and income taxes computed using the U.S. federal income tax rate for continuing operations were as follows: The significant components of deferred tax assets and liabilities were as follows: The valuation allowance is primarily attributable to certain net operating loss carryforwards outside the U.S. A majority of the net operating loss carryforwards are available indefinitely. The 1991 deferred tax benefit for both continuing and consolidated operations was primarily attributable to differences related to restructuring costs of $526 million, which was partially offset by the settlement of a litigation judgement of $324 million. CURRENCY TRANSACTIONS AND TRANSLATION ADJUSTMENTS The Company has entered into foreign currency forward and option contracts. The notional amounts for these contracts were $615 million at December 31, 1993 and $783 million at December 31, 1992. Most of these contracts hedge transactions in non-U.S. dollar denominated receivables and payables. Exchange gains and losses on these hedge contracts are offset against losses and gains on the underlying receivables and payables. The Company has entered into foreign currency options and option combinations to hedge probable anticipated export sales transactions during the next two years. Realized and unrealized gains and losses on those options and option combinations that are designated and effective as hedges of such probable anticipated, but not firmly committed, foreign currency transactions are deferred and recognized in income in the same periods as the hedged transactions. The net unrealized loss deferred on such options as of December 31, 1993 totaled $69 million compared with a net unrealized gain of $11 million for 1992. These amounts represent the gain or loss that would have been recognized had these options been liquidated at market value in their respective years. The Company is exposed to credit loss in the event of nonperformance by the other parties to the foreign currency option contracts. However, the Company does not anticipate nonperformance. The net effect from foreign exchange transactions was a gain of $6 million for 1993 compared with a loss of $33 million for 1992 and a gain of $55 million for 1991. - ----------------------------------------------------------------------------- RESTRUCTURING COSTS The Company recorded restructuring costs for continuing operations in 1993 of $538 million. Approximately three-fourths of these costs represented the cost of separation benefits for a cost reduction program expected to reduce worldwide employment by 10,000 personnel, most of whom are expected to leave by the end of 1994. The remainder of the restructuring costs is associated with closing a facility in Germany that manufactures a component for the Company's ink jet printer business. This closure is expected to be completed during 1994. The accrual balance for these programs is $387 million at December 31, 1993. The Company recorded restructuring costs for continuing operations of $220 million in 1992 and $1,605 million in 1991. Approximately three-fourths of these costs were for an early retirement program. The balance for this program is $375 million at December 31, 1993, which will be paid out to early retirees and their survivors over time. Most of the costs associated with this program are being funded from the Company's pension plan assets and, therefore, did not affect the Company's cash flows during the past three years. The Company does not anticipate that such costs will significantly affect the cash flows in the near future. The remainder of the 1992 and 1991 restructuring costs is related to the Company's exit from non-strategic businesses and the restructuring of the Company's non-U.S. sensitized manufacturing and photofinishing businesses, and worldwide pharmaceutical business. The accrual balance remaining at December 31, 1993 for these programs is $52 million, which relates primarily to noncancelable lease commitments and other contractual obligations associated with divested operations to be paid out over the remaining terms of the contracts. - ----------------------------------------------------------------------------- RENTAL AND LEASE COMMITMENTS Rental expense consists of: 1993 1992 1991 (in millions) Gross rentals $226 $226 $239 Deduct: Sublease income 11 5 4 ---- ---- ---- Total $215 $221 $235 ==== ==== ==== The approximate amounts of noncancelable lease commitments with terms of more than one year, principally for the rental of real property, reduced by minor sublease income, are $107 million in 1994, $88 million in 1995, $74 million in 1996, $66 million in 1997, $49 million in 1998 and $392 million in 1999 and beyond. - ----------------------------------------------------------------------------- RETIREMENT PLANS Total worldwide pension expense, including discontinued operations, was $104 million in 1993. This compares with pension expense of $56 million in 1992 and pension income of $8 million in 1991. Discontinued operations was allocated pension expense of $10 million and $6 million in 1993 and 1992, respectively, and pension income of $7 million in 1991. The Company has defined benefit pension plans which cover substantially all of its U.S. employees. The benefits are based on years of service and generally on the employees' final average compensation as defined in the plans. The Company makes contributions to the plans as permitted by government laws and regulations. Retirement plan benefits are paid to eligible employees by insurance companies or from trust funds. The Company has retained the obligation for pension benefits for personnel who retired from Eastman Chemical Company through December 31, 1993. Pension expense for the principal U.S. plan, including discontinued operations, includes the following components: The funded status of the principal U.S. plan was as follows: The assumptions used to develop the projected benefit obligation for U.S. plans were as follows: December 31, 1993 1992 Discount rate 7 1/4% 8 1/2% Salary increase rate 4 5 Long-term rate of return on plan assets 9 1/2 10 1/2 The Company also sponsors other U.S. plans. At December 31, 1993, the projected benefit obligations for these plans totaled $217 million (1992 - $208 million) of which $145 million (1992 - $144 million) was included as a liability in the consolidated statement of financial position. The obligation for the Company's unfunded plans of $126 million in 1993 and $132 million in 1992 has been recorded as a long-term liability. Calculations indicate that the total of the pension funds and accruals for non-U.S. plans less pension prepayments and deferred charges exceeds the actuarially computed value of vested benefits under such plans as of the beginning of 1993 and 1992. OTHER POSTEMPLOYMENT COSTS The Company provides life insurance and health care benefits for eligible retirees and health care benefits for eligible survivors of retirees. In general, these benefits are provided to retirees eligible to retire under the Company's principal U.S. pension plan. Prior to January 1, 1993, the Company has recognized expense for the cost of such plans when it paid premiums, claims and other costs. The expense for such plans for continuing operations was $244 million in 1993, $100 million in 1992 and $78 million in 1991. The Company adopted SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions on January 1, 1993. As a result, the Company now accrues, during the years employees render service, the expected costs of providing postretirement health and life insurance benefits to such employees. The obligation owed to current and retired employees, including discontinued operations, as of January 1, 1993 was recognized on that date as a cumulative effect of a change in accounting principle of $2.1 billion after-tax. The Company has retained the obligation for other postretirement benefits for personnel who retired from Eastman Chemical Company through December 31, 1993. The annual after-tax effect of the expense recognized for continuing operations using the accrual method required by SFAS No. 106 is approximately $108 million ($.33 per share) higher than the annual expense that would be recognized on a cash basis. Since the Company plans to continue to fund these benefit costs on a pay-as-you-go-basis, the adoption of SFAS No. 106 will not affect cash flows. The 1993 net periodic postretirement benefit cost for the principal U.S. plans for continuing operations includes the following components: (in millions) Service cost $ 29 Interest cost 215 ------ Net periodic postretirement benefit cost $ 244 ====== Presented below are the total obligation and amount recognized in the consolidated statement of financial position for the principal U.S. plans at December 31, 1993: (in millions) Accumulated postretirement benefit obligation Retirees $2,677 Fully eligible active plan participants 61 Other active plan participants 826 ------ 3,564 Unrecognized net loss (548) ------ Accrued postretirement benefit cost $3,016 ====== To estimate these costs, health care costs were assumed to increase 11% in 1994 with the rate of increase declining ratably to 5% by 2002 and thereafter. The discount rate and salary increase rate were assumed to be 8.5% and 5.0%, respectively, as of January 1, 1993. The discount rate and salary increase rate are assumed to be 7.25% and 4.0%, respectively, as of December 31, 1993. If the health care cost trend rates were increased by one percentage point, the accumulated postretirement benefit health care obligation from continuing operations as of December 31, 1993 would increase by approximately $265 million while the net periodic postretirement health care benefit cost for the year then ended would increase by approximately $20 million. A few of the Company's non-U.S. subsidiaries have supplemental health benefit plans for certain retirees. The cost of these programs is not significant to the Company. Effective January 1, 1993, the Company adopted SFAS No. 112, Employers' Accounting for Postemployment Benefits. Adoption of SFAS No. 112 requires the Company to recognize the obligation to provide certain benefits to former or inactive employees before retirement. The obligation including discontinued operations as of January 1, 1993 has been recognized as a cumulative charge of $190 million ($117 million after-tax). The amount applicable to discontinued operations was $47 million ($29 million after-tax). Adoption of SFAS No. 112 did not have a material effect on the Company's earnings before cumulative effect of changes in accounting principle. - ----------------------------------------------------------------------------- SEGMENT INFORMATION The products of each segment are manufactured and marketed in the U.S. and in other parts of the world. The Imaging segment includes amateur, motion picture and professional films, photographic papers, chemicals and equipment for photographic imaging. The Information segment includes graphic arts films, microfilms, copiers, printers and other equipment for information management. The Health segment includes pharmaceutical specialty products, proprietary products, medical radiography and clinical diagnostic materials and equipment, and household and other products. Sales between segments are made on a basis intended to reflect the market value of the products. Sales are reported in the geographic area where they originate. Transfers among geographic areas are made on a basis intended to reflect the market value of the products, recognizing prevailing market prices and distributor discounts. The parent company's equity in the net assets of subsidiaries outside the U.S. was as follows: (in millions) 1993 1992 1991 Net assets $3,436 $3,196 $3,639 ====== ====== ====== - ----------------------------------------------------------------------------- STOCK OPTION AND COMPENSATION PLANS The 1990 Omnibus Long-Term Compensation Plan provides for a variety of awards to key employees. Some of these awards are based upon performance criteria relating to the Company established by the Executive Compensation and Development Committee of the Board of Directors. The 1990 Omnibus Long-Term Compensation Plan provides that options can be granted through January 31, 1995, to key employees for the purchase of up to 16,000,000 shares of Kodak common stock at an option price not less than 50 percent of the per share fair market value on the date of the stock option's grant. No options below fair market value have been granted to date. Options with dividend equivalents were awarded during 1993, 1992 and 1991 under the 1990 Omnibus Long-Term Compensation Plan. Accruals under this plan amounted to $5 million in 1993, $5 million in 1992 and $4 million in 1991. The 1990 Plan also provides for the granting of Stock Appreciation Rights (SARs) either in tandem with options or freestanding. SARs allow optionees to receive a payment equal to the appreciation in market value of a stated number of shares of Kodak common stock from the SARs exercise price to the market value on the date of its exercise. Exercise of a tandem SAR requires the optionee to surrender the related option. At December 31, 1993, there were 195,750 tandem SARs and 344,539 freestanding SARs outstanding at option prices ranging from $30.25 to $43.18. The 1985 Stock Option Plan provided that options could be granted through 1989 to key employees for the purchase of up to 6,000,000 (prior to giving effect to the 3-for-2 partial stock split in 1987) shares of Kodak common stock at an option price not less than the per share fair market value at the time the option was granted. Options granted have maximum durations of 7 or 10 years from the date of grant but may expire sooner if the optionee's employment terminates. The 1985 Plan also provided for the granting of SARs either in tandem with options or freestanding. At December 31, 1993, there were 610,975 tandem SARs and 69,050 freestanding SARs outstanding at option prices ranging from $33.79 to $39.53. Summarized option data as of December 31, 1993 are as follows: As a result of the spin-off of the Company's worldwide chemical business all outstanding stock options were adjusted as to option price and number of shares granted. At December 31, 1993, 13,512,298 of the options outstanding were exercisable. - ----------------------------------------------------------------------------- EASTMAN KODAK CREDIT CORPORATION The primary business purpose of Eastman Kodak Credit Corporation (EKCC), formerly a wholly-owned subsidiary of the Company, was to enhance the marketing capabilities of the Company by providing long-term product financing to Kodak customers. Summarized financial information for EKCC is as follows: (in millions) 1992 1991 Results of operations Revenues $159 $154 Earnings before taxes 25 21 Net earnings 18 14 The Company sold its investment in EKCC on December 31, 1992 to General Electric Capital. The divestiture was the primary reason for the decrease in consolidated assets and liabilities from year-end 1991, when EKCC had total assets of $951 million and total indebtedness of $865 million. - ----------------------------------------------------------------------------- LEGAL MATTERS The Company is in discussion with the Environmental Protection Agency (EPA) and the Environment and Natural Resources Division of the U.S. Department of Justice concerning the EPA/NEIC (National Enforcement Investigations Center) investigation of the Company's Kodak Park site in Rochester, New York. As a result of the investigation, the Company expects to incur a civil fine of at least $100,000 for violations of federal environmental laws and regulations. The Company is participating in the EPA's Toxic Substances Control Act (TSCA) Section 8(e) Compliance Audit Program. As a participant, the Company has agreed to audit its files for materials which under current EPA guidelines would be subject to notification under Section 8(e) of TSCA and to pay stipulated penalties for each report submitted under this program. The Company anticipates that its liability under the Program will be $1,000,000. In addition to the foregoing environmental actions, the Company has been designated as a potentially responsible party (PRP) under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended (the "Superfund" law), or under similar state laws, for environmental assessment and cleanup costs as the result of the Company's alleged arrangements for disposal of hazardous substances at fewer than twenty Superfund sites. With respect to each of these sites, the Company's actual or potential allocated share of responsibility is small. Furthermore, numerous other PRPs have similarly been designated at these sites and, although the law imposes joint and several liability on PRPs, as a practical matter costs are shared with other PRPs. Settlements and costs paid by the Company in Superfund matters to date have not been material. Future costs are also not expected to be material to the Company's financial condition or results of operations. The Company and its subsidiary companies are involved in lawsuits, claims, investigations, and proceedings, including product liability, commercial, environmental, and health and safety matters, which are being handled and defended in the ordinary course of business. There are no such matters pending that the Company and its General Counsel expect to be material in relation to the Company's business, financial condition or results of operations. - ----------------------------------------------------------------------------- SUBSEQUENT EVENT The Company announced on March 2, 1994 that it has elected to redeem the zero coupon convertible subordinated debentures due 2011 on April 1, 1994. The redemption price is $312.14 per debenture. Each debenture may be converted into the Company's common stock at a conversion rate of 6.944 shares per debenture at any time before the close of business on April 1, 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. Nominees to Serve as Directors for a Three-Year Term Expiring at the 1997 Annual Meeting (Class I Directors) MARTHA LAYNE COLLINS Governor Collins, 57, was elected to the Board of Directors in May 1988. She is President of Martha Layne Collins and Associates, a consulting firm, and is also President of St. Catharine College in Springfield, Kentucky, a position she assumed in July 1990. Following her receipt of a B.S. from the University of Kentucky, Governor Collins taught from 1959 to 1970. After acting as Coordinator of Women's Activities in a number of political campaigns, she served as Clerk of the Supreme Court of the Commonwealth of Kentucky from 1975 to 1979. She was elected to a four-year term as Governor of the Commonwealth of Kentucky in 1983 after having served as Lieutenant Governor from 1979 to 1983. Governor Collins, who has served as a Fellow at the Institute of Politics, Harvard University, is a director of R. R. Donnelley & Sons Company and Bank of Louisville. CHARLES T. DUNCAN Mr. Duncan, 69, who was elected to the Board of Directors in August 1977, has had a career that includes private practice with law firms in New York and Washington, D.C., as well as public service. Following service as Principal Assistant United States Attorney for the District of Columbia, General Counsel for the U.S. Equal Employment Opportunity Commission, and Corporation Counsel for the District of Columbia, Mr. Duncan joined the faculty of Howard Law School, where he served as Dean and Professor of Law from 1974 to 1978. Named a partner in the law firm of Reid & Priest in 1984, he became senior counsel in January 1990. Prior to joining Reid & Priest, Mr. Duncan was a partner in Peabody, Lambert & Meyers. Mr. Duncan, who was graduated from Dartmouth College in 1947 and from Harvard Law School in 1950, is a director of TRW, Inc. GEORGE M. C. FISHER Mr. Fisher, 53, became Chairman, President and Chief Executive Officer of Eastman Kodak Company effective December 1, 1993. Mr. Fisher most recently served as Chairman and Chief Executive Officer of Motorola, Inc., after having served as President and Chief Executive Officer between 1988 and 1990 and Senior Executive Vice President and Deputy to the Chief Executive Officer between 1986 and 1988. Mr. Fisher holds a bachelor's degree in engineering from the University of Illinois and a masters in engineering and doctorate in applied mathematics from Brown University. He is a member of the board of directors of the American Express Company. PAUL E. GRAY Dr. Gray, 62, was elected to the Board of Directors in September 1990. Chairman of the Corporation of the Massachusetts Institute of Technology (M.I.T.) since October 1990, Dr. Gray served for the ten preceding years as President of M.I.T. He has also served on the M.I.T. faculty and in the academic administration, including responsibilities as Associate Provost, Dean of Engineering, and Chancellor. Dr. Gray earned his bachelor's, master's, and doctorate degrees in electrical engineering from M.I.T. He is a director of Arthur D. Little, Inc., The Boeing Co., and The New England. JOHN J. PHELAN, JR. Mr. Phelan, 62, who joined the Kodak Board of Directors in December 1987, is the retired Chairman and Chief Executive Officer of the New York Stock Exchange, a position which he held from 1984 until 1990. He is President of the International Federation of Stock Exchanges, a member of the Council on Foreign Relations, and a Senior Advisor to the Boston Consulting Group. Mr. Phelan, a graduate of Adelphi University, is active in educational and philanthropic organizations and is also a director of Avon Products, Inc., Merrill Lynch & Co., Inc., Metropolitan Life Insurance Company and SONAT Inc. Directors Serving a Term Expiring at the 1995 Annual Meeting (Class II Directors) ALICE F. EMERSON Dr. Emerson, 62, is a Fellow of The Andrew W. Mellon Foundation, a position she assumed in 1991 after having served as President of Wheaton College in Massachusetts since 1975. Prior to 1975, Dr. Emerson served the University of Pennsylvania, first as Dean of Women from 1966 to 1969 and subsequently as Dean of Students. Elected to the Kodak Board of Directors in May 1992, Dr. Emerson received her bachelor's degree from Vassar College and her Ph.D. degree from Bryn Mawr College. She is a member of the boards of directors of AES Corporation, Bank of Boston Corporation and Champion International Corp. ROBERTO C. GOIZUETA Mr. Goizueta, 62, is Chairman and Chief Executive Officer of The Coca-Cola Company. He was elected to this position in March 1981, having served as President from May 1980 to March 1981. Prior to becoming President, he was a Vice Chairman and Executive Vice President. Mr. Goizueta, who was elected to the Kodak Board of Directors in May 1989, received a B.S. degree in chemical engineering from Yale University. He is a member of the boards of directors of Ford Motor Company, SONAT Inc. and SunTrust Banks, Inc. WILBUR J. PREZZANO Mr. Prezzano, 53, who joined the Kodak Board of Directors in May 1992, is a Group Vice President of Eastman Kodak Company and President of Kodak's Health Group. Mr. Prezzano joined the Company in 1965 in the statistical department and has held positions in Treasurer's, Business Systems Markets, Customer Equipment Services Division, Copy Products, Marketing Division, International Photographic Operations and Photographic Products. He served as Group Vice President and General Manager, International, from January 1990 to September 1991, when he became President of Kodak's Health Group. Mr. Prezzano received B.S. and M.B.A. degrees from the University of Pennsylvania's Wharton School. LEO J. THOMAS Dr. Thomas, 57, who joined the Kodak Board of Directors in May 1992, is a Group Vice President of Eastman Kodak Company and President of Kodak's Imaging Group. Dr. Thomas began his Kodak career in 1961, and held various positions in the Research Laboratories before being named Director of Research and elected a Vice President in 1977. In December 1978, he was elected a Senior Vice President and in 1984, he was appointed General Manager, Life Sciences. Following the acquisition of Sterling Drug Inc. in 1988, Dr. Thomas was named Sterling Vice Chairman, and was elected the subsidiary's Chairman in September 1988. He became General Manager of the Health Group in 1989 and was elected a Group Vice President in November 1989. In September 1991, Dr. Thomas became President of the Imaging Group, which was formed to consolidate Kodak's photographic and commercial imaging businesses. Dr. Thomas holds a B.S. degree from the University of Minnesota and M.S. and Ph.D. degrees from the University of Illinois. He is a member of the boards of directors of Rochester Telephone Corporation and John Wiley & Sons, Inc. Directors Serving a Term Expiring at the 1996 Annual Meeting (Class III Directors) RICHARD S. BRADDOCK Mr. Braddock, 52, was elected to the Kodak Board of Directors in May 1987. He was Chief Executive Officer of Medco Containment Services, Inc. from January 1993 until October 1993, after having served as President and Chief Operating Officer of Citicorp and its principal subsidiary, Citibank, N.A. from January 1990 through October 1992. Prior to that, he served for approximately five years as Sector Executive in charge of Citicorp's Individual Bank, one of the financial services company's three core businesses. Mr. Braddock was graduated from Dartmouth College in 1963 with a degree in history, and received his M.B.A. from the Harvard School of Business Administration in 1965. He is a director of Duty Free Shops, Lotus Development and VISX Inc. KARLHEINZ KASKE Dr. Kaske, 65, served as President and Chief Executive Officer of Siemens AG from 1981 until his retirement in September 1992. Dr. Kaske joined Siemens in 1960 and held a variety of positions with Siemens AG, including head of Process Engineering and head of the Power Engineering Group. He holds a diploma in physics from the Technical University of Aachen and a Doctorate of Engineering from the Technical University of Brunswick. Dr. Kaske is Chairman of the supervisory board of MAN Aktiengesellschaft and a member of the supervisory boards of Philipp Holzmann AG and Linde AG. RICHARD A. ZIMMERMAN Mr. Zimmerman, 62, who joined the Kodak Board of Directors in July 1989, is the retired Chairman and Chief Executive Officer of Hershey Foods Corporation. Mr. Zimmerman joined Hershey in 1958 and was named Vice President in 1971. Appointed a Group Vice President later in 1971, he became President and Chief Operating Officer in 1976. He was named Chief Executive Officer in January 1984 and Chairman of the Board in March 1985. Mr. Zimmerman was graduated from Pennsylvania State University. He is a member of the boards of directors of Hershey Trust Company and Westvaco Corporation. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION COMPENSATION OF DIRECTORS AND EXECUTIVE OFFICERS COMPENSATION OF DIRECTORS Directors who are compensated as employees of the Company receive no additional compensation as directors. Each director who is not an employee of the Company receives an annual retainer of $38,000, payable $12,000 in common stock of the Company and $26,000 in cash. In addition, each such director receives a fee of $900 for each Board meeting attended and $750 for each Board committee and special meeting attended, except the Corporate Directions Committee and the Special Search Committee (which was in existence for a few months during 1993 to lead the search for a new chief executive officer) whose members received $1,500 for each meeting. There is a deferred compensation plan available to all such directors for the cash portion of their compensation, in which two directors participated in 1993. Each director who is not an employee of the Company is eligible to participate in a retirement plan for directors which provides an annual retirement benefit equal to the then-current annual retainer, if the director has served at least five years. Directors who have served fewer than five years are entitled to a prorata retirement benefit. Each director who is not an employee of the Company is covered by group term life insurance in the amount of $100,000, which decreases to $50,000 at the later of retirement from the Board under the retirement plan described above or age 65. In the event of a change in control (as defined in the applicable plans) each account under the deferred compensation plan will be paid in a single lump sum cash payment and all retirement benefit payments will be paid in a single lump sum cash payment equal to the present value of the remaining retirement benefits. Each non-employee director is eligible to participate in the Company's Directors' Charitable Award Program, which provides for a contribution by the Company of $1,000,000 following the director's death to up to four charitable institutions recommended by the director. The individual directors derive no financial benefits from this Program, which is funded by joint life insurance policies purchased by the Company and self insurance. The purposes of the Program are to further the Company's philanthropic endeavors, with particular emphasis on education, acknowledge the service of the Company's directors, recognize the interest of the Company and the directors in supporting worthy charitable and educational institutions and to enable the Company to attract and retain directors of the highest caliber. Directors who are participating in the Program are Messrs. Braddock, Duncan, Phelan, and Zimmerman, Drs. Emerson, Gray, and Kaske, and Gov. Collins. COMPENSATION OF EXECUTIVE OFFICERS The individuals named in the following table were the Company's Chief Executive Officers and the four highest paid executive officers during 1993. Long-Term Incentive Plan In March 1993, the 1993-1995 Restricted Stock Program, a performance share unit arrangement under the 1990 Omnibus Long-Term Compensation Plan, was approved by the Executive Compensation and Development Committee. Payouts of awards, if any, are tied to achieving specified levels of stock price, return on assets, and total shareholder return relative to the Standard & Poor's 500 Index, over the period 1993-1995. The target amount will be earned if the target level for each of these three criteria is achieved. The target stock price must be achieved to trigger a payment of 100% of target. The threshold stock price must be achieved to trigger a payment of 50% of target. If the threshold stock price is not achieved, no payment is made. The Committee will determine the payout based upon its review of Company performance at the end of the performance period. Awards, if any, will be paid in the form of restricted stock, which restrictions will lapse upon the participant's attainment of age 60. Participants who terminate employment for reasons of death, disability, retirement or an approved reason, prior to the completion of the performance cycle, will receive their award, if any, at the conclusion of the performance period in the form of shares of Kodak common stock with no restrictions. EMPLOYMENT CONTRACTS On October 27, 1993, the Company entered into an Agreement covering a period of five years, for the employment of George M. C. Fisher as Chairman, President and Chief Executive Officer of the Company. Upon execution of the Agreement, Mr. Fisher received $5,000,000 as an inducement for entering into the Agreement and as reimbursement for compensation and benefits that he would forfeit upon termination of his employment with his previous employer. Mr. Fisher's base salary is $2,000,000, subject to review on an annual basis. Mr. Fisher will participate in MAPP and will have an annual target award opportunity of at least $1,000,000, with that amount guaranteed for services rendered in each of 1994 and 1995. Mr. Fisher was granted 20,000 shares of restricted stock with the restrictions lapsing at the end of five years. The contract provided for the grant to Mr. Fisher in 1993 of 1,057,055 stock options (1,323,539 after adjustment for the ECC spin-off) and no stock options are to be granted to Mr. Fisher in 1994. The contract provided for the Company to make two loans to Mr. Fisher in the total amount of $8,284,400 for five years with interest at the rate of 4.86% (which is the most recently announced rate under Section 1274(d) of the Internal Revenue Code, prior to October 27, 1993). $4,284,400 of this amount was loaned to Mr. Fisher due to his forfeiture of 80,000 stock options from his prior employer which resulted from his accepting employment with the Company. Mr. Fisher was required to use all of the loan proceeds except $1,500,000 to purchase Kodak stock. The shares he purchased are reflected in the security ownership table. Twenty percent of the principal and all of the accrued interest on each of these loans are to be forgiven on each of the first five anniversaries of such loans provided Mr. Fisher is still employed by the Company. In addition, where necessary, Mr. Fisher has been given credit for a period of service sufficient to allow him to obtain the maximum benefit available under Kodak's benefit plans. In particular, Mr. Fisher was credited with five years of service for purposes of the Wage Dividend and seventeen years of service for purposes of calculating a retirement benefit. The Company is providing Mr. Fisher with an apartment until he purchases a permanent residence in the Rochester area. The Company has agreed to purchase Mr. Fisher's current residence in Barrington Hills, Illinois. In addition, the Company has agreed to reimburse Mr. Fisher for all closing costs associated with a previous residence, which was sold after he accepted employment with the Company. The Company is providing Mr. Fisher with term life insurance equal to 3.5 times his base salary and a disability benefit equal to 60% of base salary. In the event of Mr. Fisher's death prior to the termination of this Agreement, the Agreement provides for salary continuation for ninety days, the payment of all annual and long-term incentives, vesting of all stock options and awards and the forgiveness of the loans. If Mr. Fisher's employment is terminated by the Company without cause or in the event of a change in control, Mr. Fisher is entitled to the greater of the remaining term of his employment contract or 36 months of salary continuation, immediate vesting of stock options, the lapsing of any restrictions on any restricted stock award and the payment of any incentive awards. Mr. Fisher is entitled to reimbursement for taxes paid on certain of the foregoing payments, including any amounts constituting "parachute payments" under the Internal Revenue Code. If Mr. Fisher dies prior to retirement, his spouse is entitled to a 50% survivor annuity. TERMINATION OF EMPLOYMENT The Company has a general severance arrangement available to substantially all employees. This Termination Allowance Plan provides two weeks of compensation for every year of service with a maximum of fifty-two weeks of salary. Mr. Whitmore received fifty-two weeks of termination allowance computed using the formula in the Termination Allowance Plan. The Company has entered into a retention arrangement with Mr. Prezzano. The Agreement provides that if Mr. Prezzano's employment is terminated prior to September 30, 1995 by the Company other than for cause, or by Mr. Prezzano as a result of a diminution in duties or base salary, he shall be entitled to an unreduced retirement annuity and a termination allowance equal to two weeks of pay for each year of service up to a maximum of 52 weeks of pay. The Agreement also prohibits Mr. Prezzano from working for a competitor for a period of three years following termination of employment. CHANGE IN CONTROL ARRANGEMENTS In the event of a change in control, the following would occur: (i) each participant in the Executive Deferred Compensation Plan would receive the balance in his/her account in a single lump sum cash payment; (ii) each participant in the Management Annual Performance Plan would be paid his/her target award for such year and any other year for which payment of awards had not been made as of such date; and (iii) all outstanding stock options and stock appreciation rights would become fully vested and each holder would be paid in a lump sum cash payment the difference between the exercise price and market price of Kodak common stock on the date of such event; each of the foregoing payments would be made in a single lump sum cash payment as soon as possible but no later than the 90th day following such event. RETIREMENT PLAN The Company funds a tax-qualified, defined benefit pension plan for virtually all U.S. employees. Retirement income benefits are based upon the individual's "average participating compensation," which is the average of three years of those earnings described in the Plan as "participating compensation." "Participating compensation," in the case of the executive officers included in the Summary Compensation Table, is annual compensation (salary and Management Annual Performance Plan payments), including allowances in lieu of salary for authorized periods of absence, such as illness, vacation or holidays. For an employee with up to 35 years of accrued service, the annual normal retirement income benefit is computed by multiplying the number of years of accrued service by the sum of (a) 1.3% of "average participating compensation" ("APC") for the employee's final three years, plus (b) .3% of APC in excess of the average Social Security wage base for the employee's final three years. For an employee with more than 35 years of accrued service, the amount computed above is increased by 1% for each year in excess of 35 years. The retirement income benefit is not subject to any deductions for Social Security benefits or other offsets. Officers are entitled to benefits on the same basis as other employees. The normal form of benefit is an annuity, but a lump sum payment is available as an option. Pension Plan Table Annual Retirement Income Benefits Straight Life Annuity Beginning at Age 65 "Average Years of Service Participating ----------------------------------------------------------- Compensation" 15 20 25 30 35 40 - ------------- -------- -------- -------- ---------- ---------- ---------- $ 400,000 $ 96,000 $128,000 $160,000 $ 192,000 $ 224,000 $ 235,200 600,000 144,000 192,000 240,000 288,000 336,000 352,800 800,000 192,000 256,000 320,000 384,000 448,000 470,400 1,000,000 240,000 320,000 400,000 480,000 560,000 588,000 1,200,000 288,000 384,000 480,000 576,000 672,000 705,600 1,400,000 336,000 448,000 560,000 672,000 784,000 823,200 1,600,000 384,000 512,000 640,000 768,000 896,000 940,800 1,800,000 432,000 576,000 720,000 864,000 1,008,000 1,058,400 2,000,000 480,000 640,000 800,000 960,000 1,120,000 1,176,000 2,200,000 528,000 704,000 880,000 1,056,000 1,232,000 1,293,600 2,400,000 576,000 768,000 960,000 1,152,000 1,344,000 1,411,200 NOTE: To the extent that any individual's annual retirement income benefit exceeds the amount payable from the Company's funded Plan, it is paid from one or more unfunded supplementary plans. The following table shows the years of accrued service credited to each of the six individuals named in the Summary Compensation Table. This table also shows for each named individual the amount of his "average participating compensation" at the end of 1993. "Average Years of Participating Service Compensation" G. M. C. Fisher 17* $1,999,998 K. R. Whitmore 36 1,278,325 R. T. Bourns 35 446,429 E. W. Deavenport, Jr. 33 644,265 W. J. Prezzano 28 706,940 L. J. Thomas 32 770,558 *Under the terms of his employment contract, Mr. Fisher has been credited with seventeen years of service for purposes of calculating his retirement benefit. However, any pension benefit payable to Mr. Fisher by the Company will be offset by any pension benefit paid to Mr. Fisher by his prior employer. In the event of a change in control (as defined in the Retirement Plan), a participant whose employment is terminated, for a reason other than death, disability, cause or voluntary resignation, within 5 years of the date of such event would be credited with up to 5 additional years of service and, where the participant is age 50 or over on the date of such event, up to 5 additional years of age, for the following plan purposes: (i) to determine eligibility for early and normal retirement; (ii) to determine eligibility for a vested right; and (iii) to calculate the amount of retirement benefit. The actual number of years of service and years of age that would be granted to such a participant would decrease proportionately depending upon the number of years that elapse between the date of a change in control and the date of the participant's termination of employment. Further, if the Plan is terminated within 5 years after a change in control, the benefit for each plan participant will be calculated as indicated above. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT BENEFICIAL SECURITY OWNERSHIP OF DIRECTORS, NOMINEES AND EXECUTIVE OFFICERS Directors, Nominees and Executive Number of Common Shares Officers Owned on Jan. 4, 1994 - ------------------- ----------------------- Richard T. Bourns 64,311*+ Richard S. Braddock 2,120 Martha Layne Collins 1,925 Earnest W. Deavenport, Jr. 4,929~ Charles T. Duncan 2,177 Alice F. Emerson 977 George M. C. Fisher 127,400= Roberto C. Goizueta 4,084 Paul E. Gray 1,444 C. Michael Hamilton 21,127* Karlheinz Kaske 938 John R. McCarthy 84,823* John J. Phelan, Jr. 2,283 Wilbur J. Prezzano 150,648* Leo J. Thomas 128,154* Gary P. Van Graafeiland 20,992* Kay R. Whitmore 436,059* Richard A. Zimmerman 2,504 All Directors, Nominees and 1,056,895*# Executive Officers as a Group (18), including the above NOTES: * Includes shares which may be acquired in the following amounts by exercise of stock options: R. T. Bourns - 59,729; C. M. Hamilton - 19,723; J. R. McCarthy - 83,901; W. J. Prezzano - 139,418; L. J. Thomas - 117,365; G. P. Van Graafeiland - 18,440; K. R. Whitmore - 409,607; and all directors, nominees and executive officers as a group - 848,183. The number of stock options has been adjusted to reflect the spin-off of Eastman Chemical Company. =Includes 20,000 shares of restricted stock. +The shares shown do not include 1,969 Eastman Kodak Company common stock equivalents which are held in Kodak's Executive Deferred Compensation Plan for R. T. Bourns. ~Mr. Deavenport surrendered all of his 124,898 Kodak stock options in connection with the spin-off of Eastman Chemical Company. # The total number of shares beneficially owned by all directors, nominees and executive officers as a group is less than one percent of the Company's outstanding shares. Beneficial security ownership as reported in the above table has been determined in accordance with Rule 13d-3 under the Securities Exchange Act of 1934. Accordingly, except as noted below, all Company securities over which the directors, nominees and executive officers directly or indirectly have or share voting or investment power have been deemed beneficially owned. The figures above include shares held for the account of the above persons in the Automatic Dividend Reinvestment Service for Shareholders of Eastman Kodak Company, in the Kodak Employee Stock Ownership Plan, and the interests, if any, of those of the above persons in Fund A of the Eastman Kodak Employees' Savings and Investment Plan, stated in terms of Kodak shares. The table does not include approximately 5,712,994 shares of the Company's stock (less than 2 percent of the outstanding shares) held in the Kodak Stock Fund of the Eastman Kodak Employees' Savings and Investment Plan for the benefit of some 25,195 employees and former employees, over which a committee consisting of five individuals, including four Company officers, has discretionary voting power. 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 Page No. (a) 1. Consolidated financial statements: Report of independent accountants 18 Consolidated statement of earnings 19 Consolidated statement of retained earnings 21 Consolidated statement of financial position 22 Consolidated statement of cash flows 23 Notes to financial statements 24-43 2. Financial statement schedules: I - Marketable securities 59 II - Amounts receivable from employees 60 V - Properties 61 VI - Accumulated depreciation of properties 62 VIII - Valuation and qualifying accounts 63 IX - Short-term borrowings 64 X - Supplementary consolidated statement of earnings information 65 All other schedules have been omitted because they are not applicable or the information required is shown in the financial statements or notes thereto. 3. Additional data required to be furnished: Exhibits required as part of this report are listed in the index appearing on pages 66 through 68. The management contracts and compensatory plans and arrangements required to be filed as exhibits to this form pursuant to Item 14(c) of this report are listed on pages 66 through 67, Exhibit Numbers (10)A - (10)R. (b) Report on Form 8-K. No reports on Form 8-K were filed or required to be filed 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. EASTMAN KODAK COMPANY (Registrant) By: George M. C. Fisher, Chairman of the Board, President and Chief Executive Officer Date: 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 date indicated. Harry L. Kavetas, Senior Roberto C. Goizueta, Director Vice President and Chief Financial Officer C. Michael Hamilton, General Comptroller Paul E. Gray, Director Richard S. Braddock, Director Karlheinz Kaske, Director Martha Layne Collins, Director John J. Phelan, Jr., Director Charles T. Duncan, Director Wilber J. Prezzano, Director Alice F. Emerson, Director Leo J. Thomas, Director George M. C. Fisher, Director Richard A. Zimmerman, Director Date: March 11, 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-3 (No. 33-48258, No. 33-48955, and No. 33-49285), Form S-4 (No. 33-48891) and Form S-8 (No. 2-77145, No. 33-5803, No. 33-36731, No. 33-38631, No. 33-38632, No. 33-38633, No. 33-38634, and No. 33-35214) of Eastman Kodak Company of our report dated January 31, 1994, except for the Subsequent Event note, which is as of March 2, 1994, appearing on page 18 of this Annual Report on Form 10-K. PRICE WATERHOUSE New York, New York March 11, 1994 Schedule II Eastman Kodak Company and Subsidiary Companies Amounts Receivable From Employees (in millions) Balance 1993 1993 Balance Name of Debtor 1/1/93 Additions Collections 12/31/93 George M. C. Fisher* $ - $8.4 $ - $8.4 Other employees with loans greater than $100,000** 2.1 0.5 0.7 1.9 * Interest rate on Mr. Fisher's loan is 4.86% compounded semi-annually. Twenty percent of the principal and all accrued interest shall be forgiven on each of the first five anniversaries of the date of the loan, provided that Mr. Fisher shall not be entitled to forgiveness on any such anniversary date if he has terminated his employment through voluntary termination, as defined in his employment agreement, on or prior to such anniversary date. ** Amounts each year represent housing loans for approximately ten to fifteen employees located outside the United States, primarily in Japan. Eastman Kodak Company and Subsidiary Companies Index to Exhibits Exhibit Number Page (3) A. Certificate of Incorporation. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 25, 1988, Exhibit 3.) B. By-laws, as amended through September 11, 1992. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 31, 1992,Exhibit 3.) (4) A. Indenture dated as of June 15, 1986 between Eastman Kodak Company as issuer of (i) 8.55% Notes due 1997, and (ii) 9 5/8% Notes Due 1999, and The Bank of New York as Trustee. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 28, 1986, Exhibit 4.) B. Indenture dated as of January 1, 1988 between Eastman Kodak Company as issuer of (i) 9 1/8% Notes due 1998, (ii) 9 3/8% Notes Due 2003, (iii) 9 1/2% Notes Due 2000, (iv) 10% Notes Due 2001, (v) 9.95% Debentures Due 2018, (vi) 9 7/8% Notes Due 2004, (vii) 10.05% Notes Due 1994, (viii) 9 3/4% Notes Due 2004, (ix) 9.20% Notes Due 1995, (x) 9 1/2% Notes Due 2008, (xi) 9.20% Debentures Due 2021, and (xii) 7 1/4% Notes Due 1999, and The Bank of New York as Trustee. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 25, 1988, Exhibit 4.) C. First Supplemental Indenture dated as of September 6, 1991 and Second Supplemental Indenture dated as of September 20, 1991, each between Eastman Kodak Company as issuer of Zero Coupon Exchangeable Senior Debentures Due 2006 and The Bank of New York as Trustee, supplementing the Indenture described in B. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit 4.) D. Third Supplemental Indenture dated as of January 26, 1993, between Eastman Kodak Company as issuer of Zero Coupon Exchangeable Senior Debentures Due 2006 and The Bank of New York as Trustee, supplementing the Indenture described in B. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Exhibit 4.) E. Fourth Supplemental Indenture dated as of March 1, 1993, between Eastman Kodak Company and The Bank of New York as Trustee, supplementing the Indenture described in B. 69 F. Indenture dated as of October 1, 1991 between Eastman Kodak Company as issuer of Zero Coupon Convertible Subordinated Debentures Due 2011 and The Bank of New York as Trustee. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit 4.) Eastman Kodak Company and certain subsidiaries are parties to instruments defining the rights of holders of long-term debt that was not registered under the Securities Act of 1933. Eastman Kodak Company has undertaken to furnish a copy of these instruments to the Securities and Exchange Commission upon request. (10) A. Eastman Kodak Company Retirement Plan for Directors, as amended effective March 1, 1990. B. Eastman Kodak Company 1985 Long Term Performance Award Plan, as amended effective December 31, 1993. 78 C. 1982 Eastman Kodak Company Executive Deferred Compensation Plan, as amended effective December 31, 1993. 83 D. Kodak Unfunded Retirement Income Plan, amended effective January 1, 1992. Eastman Kodak Company and Subsidiary Companies Index to Exhibits (continued) Exhibit Number Page E. Eastman Kodak Company Management Annual Performance Plan, as amended effective April 1, 1993. 94 F. Eastman Kodak Company 1956 Deferred Compensation Plan, as amended effective January 1, 1990. G. Eastman Kodak Company 1981 Incentive Stock Option Plan, as amended effective December 31, 1993. 97 H. Eastman Kodak Company Insurance Plan for Directors. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 29, 1988, Exhibit 10.) I. Eastman Kodak Company Deferred Compensation Plan for Directors, as amended effective March 1, 1990. J. Eastman Kodak Company 1985 Stock Option Plan, as amended effective December 31, 1993. 101 K. Kodak Supplementary Group Life Insurance Plan, as amended effective July 1, 1991. L. Eastman Kodak Company 1990 Omnibus Long-Term Compensation Plan, effective December 31, 1993. 106 M. Kodak Excess Retirement Income Plan, as amended effective December 1, 1991. N. Kodak Executive Financial Counseling Program. O. Umbrella Insurance Coverage. (Incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit 10.) P. Kodak Executive Health Management Plan, as amended effective December 7, 1990. Q. Wilbur J. Prezzano Retention Agreement dated September 3, 1993. 118 R. George M. C. Fisher Employment Agreement dated October 27, 1993. 121 Exhibits (10) A, F, and I are incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Exhibit 10. Exhibits (10) D, K, M, N, and P are incorporated by reference to the Eastman Kodak Company Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Exhibit 10. (11) Statement Re Computation of Earnings Per Common Share. 138 (12) Statement Re Computation of Ratio of Earnings to Fixed Charges. 141 (22) Subsidiaries of Eastman Kodak Company. 142 (24) Consent of Independent Accountants. 58 (28) A. Eastman Kodak Employees' Savings and Investment Plan Annual Report on Form 11-K for the fiscal year ended December 30, 1993 (to be filed by amendment). B. Sterling Winthrop Inc. Salaried Employees' Savings Plan Annual Report on Form 11-K for the fiscal year ended December 30, 1993 (to be filed by amendment). C. Sterling Winthrop Inc. Hourly Employees' Savings Plan Annual Report on Form 11-K for the fiscal year ended December 30, 1993 (to be filed by amendment). Eastman Kodak Company and Subsidiary Companies Index to Exhibits (continued) Exhibit Number Page D. L & F Products Employees' Savings Plan I Annual Report on Form 11-K for the fiscal year ended December 30, 1993 (to be filed by amendment). E. L & F Products Employees' Savings Plan II Annual Report on Form 11-K for the fiscal year ended December 30, 1993 (to be filed by amendment). Exhibit (4) E EASTMAN KODAK COMPANY TO THE BANK OF NEW YORK Trustee FOURTH SUPPLEMENTAL INDENTURE Dated as of March 1, 1993 TO INDENTURE Dated as of January 1, 1988 FOURTH SUPPLEMENTAL INDENTURE, dated as of March 1, 1993, between EASTMAN KODAK COMPANY, a corporation duly organized and existing under the laws of the State of New Jersey (the "Company"), having its principal office at 343 State Street, Rochester, New York 14650, and THE BANK OF NEW YORK, a corporation duly organized and existing under the laws of the State of New York, as trustee (the "Trustee"). WHEREAS, the Company has heretofore executed and delivered to the Trustee an Indenture, dated as of January 1, 1988, as supplemented by First Supplemental Indenture thereto, dated as of September 6, 1991, Second Supplemental Indenture thereto, dated as of September 20, 1991 and Third Supplemental Indenture thereto, dated as of January 26, 1993 (as so supplemented, the "Indenture"), providing for the issuance from time to time of its unsecured debentures, notes or other evidences of indebtedness (herein and therein called the "Securities"), to be issued in one or more series as in the Indenture provided; WHEREAS, Section 901(9) of the Indenture provides that, without the consent of any Holders, the Company, when authorized by a Board Resolution, and the Trustee, at any time and from time to time, may enter into one or more indentures supplemental to the Indenture for the purpose of curing any ambiguity, correcting or supplementing any provision in the Indenture which may be inconsistent with any other provision therein, or making any other provisions with respect to matters or questions arising under the Indenture, provided such action shall not adversely affect the interests of the Holders of Securities of any series in any material respect; WHEREAS, the Company, pursuant to the foregoing authority, proposes in and by this Fourth Supplemental Indenture to amend and supplement the Indenture in certain respects as set forth herein; and WHEREAS, all things necessary to make this Fourth Supplemental Indenture a valid agreement of the Company, and a valid amendment of and supplement to the Indenture, have been done. NOW, THEREFORE, THIS FOURTH SUPPLEMENTAL INDENTURE WITNESSETH: For and in consideration of the premises and the purchase of the Securities by the Holders thereof, it is mutually covenanted and agreed, for the equal and proportionate benefit of all Holders of the Securities or of any series thereof, as follows: ARTICLE ONE Relation To Indenture; Definitions SECTION 1.01. This Fourth Supplemental Indenture constitutes an integral part of the Indenture and shall be construed in connection with and as part of the Indenture. SECTION 1.02. For all purposes of this Fourth Supplemental Indenture, capitalized terms used herein without definition shall have the meanings specified in the Indenture. SECTION 1.03. The definition of "Trust Indenture Act" provided in Section 101 of the Indenture shall be amended to read in its entirety as follows: "'Trust Indenture Act' means the Trust Indenture Act of 1939, as amended by the Trust Indenture Reform Act of 1990 as in effect at the date of the Fourth Supplemental Indenture to this Indenture." SECTION 1.04. Section 104 of the Indenture is amended to add at the end thereof new subsections (e) and (f) as follows: "(e) If any Security of a series is issuable in the form of a Global Security or Securities, the Depositary therefor may grant proxies and otherwise authorize participants to give or take any request, demand, authorization, direction, notice, consent, waiver or other action which the Holder of such Security is entitled to grant or take under this Indenture. (f) The Company may set a record date for purposes of determining the identity of Holders entitled to vote or consent to any action by vote or consent authorized or permitted by the second paragraph of Section 502 or Section 512. Such record date shall be the later of 30 days prior to the first solicitation of such consent or the date of the most recent list of Holders furnished to the Trustee pursuant to Section 701 prior to such solicitation." ARTICLE TWO The Securities SECTION 2.01. The Indenture is amended to add a new Section 205 as follows: "SECTION 205. Securities in Global Form. If any Security of a series is issuable in the form of a Global Security or Securities, each such Global Security may provide that it shall represent the aggregate amount of Outstanding Securities from time to time endorsed thereon and may also provide that the aggregate amount of Outstanding Securities represented thereby may from time to time be reduced to reflect exchanges. Any endorsement of a Global Security to reflect the amount of Outstanding Debt Securities represented thereby shall be made by the Trustee and in such manner as shall be specified on such Global Security. Any instructions by the Company with respect to a Global Security, after its initial issuance, shall be in writing but need not comply with Section 102." SECTION 2.02. Section 304 of the Indenture is amended by adding the phrase "a permanent Global Security or Securities or" before the words "definitive Securities" in the first line thereof; by adding the phrase "or one or more temporary Global Securities" before the words "which are printed" in the third line thereof; and by adding the phrase "or permanent Global Security or Securities, as the case may be", before the words "in lieu of" in the fifth line thereof. SECTION 2.03. Section 308 of the Indenture is amended by inserting the following paragraph at the end thereof: "None of the Company, any Paying Agent, or the Security Registrar will have any responsibility or liability for any aspect of the records relating to or payments made on account of beneficial ownership interests in a Global Security or for maintaining, supervising or reviewing any records relating to such beneficial ownership interests." ARTICLE THREE The Trustee SECTION 3.01. Section 608(a) of the Indenture is amended by inserting directly before the word "either" appearing in the third line thereof the following: "and if the default (exclusive of any period of grace or requirement of notice) to which such conflicting interest relates has not been cured or waived or otherwise eliminated within 90 days after ascertaining that it has such conflicting interest,"; Section 608(a) is further amended by inserting directly before the word "resign" in the fourth line thereof the phrase "except as otherwise provided below in this Section". SECTION 3.02. Section 608(c) of the Indenture is hereby amended by inserting directly after the phrase "of any series" appearing in the second line thereof the following: "if such Securities are in default (exclusive of any period of grace or requirement of notice) and". SECTION 3.03. Section 608(c)(8) of the Indenture is amended by deleting the word "or" appearing in the last line thereof. SECTION 3.04. Section 608(c)(9) of the Indenture is amended by deleting the words and punctuation "on May 15 in any calendar year," appearing in the first line thereof and inserting in their place the following: "on the date of default upon Securities of any series (exclusive of any period of grace or requirement of notice) or any anniversary of such default while such default upon such Securities remains outstanding,"; Section 608(c)(9) is further amended by deleting the words and punctuation "May 15 in each calendar year," appearing in line thirteen thereof and inserting in their place the following: "the dates of any such default upon a series of Securities and annually in each succeeding year that such series of Securities remains in default,"; Section 608(c)(9) is further amended by deleting the phrase "May 15" appearing in line fifteen thereof and inserting in its place the word "dates"; and Section 608(c)(9) is further amended by deleting the period appearing in the last line thereof and inserting in its place the following: "; or (10) the Trustee, except under the circumstances described in paragraphs (1), (3), (4), (5) or (6) of this Section 608(c), shall be or shall become a creditor of the Company For purposes of paragraph (1) of this subsection the term 'series of securities' or 'series' means a series, class or group of securities issuable under an indenture pursuant to the terms of which holders of one such series may vote to direct the Trustee, or otherwise take action pursuant to a vote of holders, separately from holders of another such series; provided that 'series of securities' or 'series' shall not include any series of securities issuable under an indenture if all such series rank equally and are wholly unsecured." SECTION 3.05. Section 608(d)(1) of the Indenture is amended by deleting the phrase "three years" appearing in the second line thereof and inserting in its place the words "one year". SECTION 3.06. Section 608 of the Indenture is amended by inserting at the end thereof the following: "(f) Except in the case of a default in the payment of the principal of or interest on any series of Securities, or in the payment of any sinking or purchase fund installment, the Trustee shall not be required to resign as provided by Section 608(c) hereof if the Trustee shall have sustained the burden of proving, on application to the Commission and after opportunity for hearing thereon and in accordance with any applicable regulations of the Commission, that-- (i) the default under the Indenture may be cured or waived during a reasonable period and under the procedures described in such application, and (ii) a stay of the Trustee's duty to resign will not be inconsistent with the interests of holders of such series of Securities. The filing of such an application shall automatically stay the performance of the duty to resign until the Commission orders otherwise. Any resignation of the Trustee shall become effective only upon the appointment of a successor trustee and such successor's acceptance of such an appointment." SECTION 3.07. Section 609 of the Indenture is amended by inserting directly after the second sentence thereof the following: "Neither the Company, nor any Person directly or indirectly controlling, controlled by or under common control with the Company shall serve as Trustee for the Securities of any series." SECTION 3.08. Section 610(d)(1) of the Indenture is amended by inserting directly after the word and punctuation "months," in the third line thereof the following: "unless the Trustee's duty to resign is stayed in accordance with the provisions of Section 608(f)," SECTION 3.09. Section 613 of the Indenture is amended by deleting the phrases "four months" and "four-month" each place they appear therein and inserting in place thereof the phrases "three months" and "three-month", respectively. ARTICLE FOUR Holders' Lists and Reports by Trustee and Company SECTION 4.01. Section 703(a) of the Indenture is amended by inserting directly after the phrase "with respect to" appearing in the fourth line thereof the following: "any of the following events which may have occurred within the previous twelve months (but if no such event has occurred within such period no report need be transmitted)". SECTION 4.02. Section 703(a)(1) of the Indenture is amended by deleting the same in its entirety and inserting in its place the following: "any change to its eligibility under Section 609 and its qualifications under Section 608;". SECTION 4.03. Section 703(a) of the Indenture is amended by adding a new subsection (2) as follows and by redesignating subsections (2), (3), (4), (5) and (6) as subsections (3), (4), (5), (6) and (7), respectively: "(2) the creation of any material change to a relationship specified in paragraph (1) through (10) of Section 608(c);". SECTION 4.04. Section 703(a)(5) (as redesignated pursuant to Section 4.03 of this Fourth Supplemental Indenture) of the Indenture is amended by inserting at the beginning thereof the phrase "any change to". SECTION 4.05. Section 704 of the Indenture is amended by adding a new subsection (4) at the end thereof as follows: "(4) furnish to the Trustee, not less often than annually, a brief certificate from the principal executive officer, the principal financial officer or principal accounting officer as to his or her knowledge of the Company's compliance with all conditions and covenants under this Indenture. For purposes of this subsection (4), such compliance shall be determined without regard to any period of grace or requirement of notice provided under this Indenture." ARTICLE FIVE Covenants SECTION 5.01. Section 1001 of the Indenture is amended by inserting the following paragraph at the end thereof: "The interest, if any, due in respect of any Global Security, together with any additional amounts payable in respect thereof, as provided in the terms and conditions of the Securities represented thereby, shall be payable only upon presentation of such Global Security to the Trustee for notation thereon of the payment of such interest." ARTICLE SIX Redemption of Securities SECTION 6.01. Section 1103 of the Indenture is amended by deleting the first word "If" and inserting in place thereof the words "Except as otherwise specified as contemplated by Section 301 for Securities of any series, if". SECTION 6.02. Section 1107 is amended by inserting at the end thereof the words "; except that if a Global Security is so surrendered, the Company shall execute, and the Trustee shall authenticate and deliver to the Depositary for such Global Security, without service charge, a new Global Security in a denomination equal to and in exchange for the unredeemed portion of the principal of the Global Security so surrendered." ARTICLE SEVEN Securityholders' Meetings SECTION 7.01. The Indenture is hereby amended by adding after Article Thirteen the following new Article: "ARTICLE FOURTEEN SECURITYHOLDERS' MEETINGS" Section 14.01. Purposes for Which Meetings May be Called. A meeting of Holders of Securities of any or all series may be called at any time and from time to time pursuant to the provisions of this Article for any of the following purposes: (1) to give any notice to the Company or to the Trustee, or to give any directions to the Trustee, or to consent to the waiving of any default hereunder and its consequences, or to take any other action authorized to be taken by Holders of Securities of any or all Series, as the case may be, pursuant to any of the provisions of Article Five; (2) to remove the Trustee and appoint a successor trustee pursuant to the provisions of Article Six; (3) to consent to the execution of a Supplemental Indenture pursuant to the provisions of Section 902; or (4) to take any other action authorized to be taken by or on behalf of the Holders of any specified principal amount of the Securities of any or all series, as the case may be, under any other provision of this Indenture or under applicable law. Section 14.02. Manner of Calling Meetings. The Trustee may at any time call a meeting of Holders of Securities to take any action specified in Section 1401, to be held at such time and at such place in The City of New York, State of New York, as the Trustee shall determine. Notice of every meeting of Holders of Securities, setting forth the time and place of such meeting and in general terms the action proposed to be taken at such meeting, shall be mailed not less than 20 nor more than 60 days prior to the date fixed for the meeting. Section 14.03. Call of Meetings by Company or Securityholders. In case at any time the Company, pursuant to a resolution of its Board of Directors, or the Holders of not less than ten percent in principal amount of the Securities of any or all series, as the case may be, then Outstanding, shall have requested the Trustee to call a meeting of Holders of Securities of any or all series, as the case may be, to take any action authorized in Section 1401 by written request setting forth in reasonable detail the action proposed to be taken at the meeting, and the Trustee shall not have mailed notice of such meeting within 20 days after receipt of such request, then the Company or such Holders of Securities in the amount above specified may determine the time and place in The City of New York, New York for such meeting and may call such meeting to take any action authorized in Section 1401, by mailing notice thereof as provided in Section 1402. Section 14.04. Who May Attend and Vote at Meetings. To be entitled to vote at any meeting of Holders, a Person shall (a) be a Holder of one or more Outstanding Securities with respect to which the meeting is being held; or (b) be a Person appointed by an instrument in writing as proxy by such Holder of one or more Securities. The only Persons who shall be entitled to be present or to speak at any meeting of Holders shall be the Persons entitled to vote at such meeting and their counsel and any representatives of the Trustee and its counsel and any representatives of the Company or its counsel. Section 14.05. Regulations May be Made by Trustee; Conduct of the Meeting; Voting Rights - Adjournment. Notwithstanding any other provisions of this Indenture, the Trustee may make such reasonable regulations as it may deem advisable for any meeting of Holders, in regard to proof of the holding of Securities and of the appointment of proxies, and in regard to the appointment and duties of inspectors of votes, the submission and examination of proxies, certificates and other evidence of the right to vote, and such other matters concerning the conduct of the meeting as it shall think fit. Except as otherwise permitted or required by any such regulations, the holding of Securities shall be proved in the manner specified in Section 104 and the appointment of any proxy shall be proved in the manner specified in said Section 104; provided, however, that such regulations may provide that written instruments appointing proxies regular on their face, may be presumed valid and genuine without the proof hereinabove or in said Section 104 specified. The Trustee shall by an instrument in writing, appoint a temporary chairman of the meeting, unless the meeting shall have been called by the Company or by Holders as provided in Section 1403, in which case the Company or the Holders calling the meeting, as the case may be, shall in like manner appoint a temporary chairman. A permanent chairman and a permanent secretary of the meeting shall be elected by majority vote of the meeting. At any meeting each Holder of an Outstanding Security or proxy therefor shall be entitled to one vote for each $250,000 principal amount (in the case of Original Issue Discount Securities, such principal amount shall be equal to such portion of the principal amount as may be specified in the terms of such series) of Securities held or represented by such Holder; provided, however, that no vote shall be cast or counted at any meeting in respect of any Security challenged as not Outstanding and ruled by the chairman of the meeting to be not Outstanding. The chairman of the meeting shall have no right to vote other than by virtue of Securities held by such Person or instruments in writing as aforesaid duly designating such Person as the Person to vote on behalf of other Holders. Any meeting of Holders duly called pursuant to the provisions of Section 1402 or 1403 may be adjourned from time to time and the meeting may be held so adjourned without further notice. At any meeting of Holders, the presence of Persons holding or representing Securities in principal amount sufficient to take action on the business for the transaction of which such meeting was called shall constitute a quorum, but, if less than a quorum is present, the Persons holding or representing a majority in principal amount of the Securities represented at the meeting may adjourn such meeting with the same effect for all intents and purposes, as though a quorum had been present. Section 1406. Manner of Voting at Meetings and Records to be Kept. The vote upon any resolution submitted to any meeting of Holders shall be by written ballots on which shall be subscribed the signatures of the Holders of Securities or of their representatives by proxy and the principal amount or principal amounts of the Securities held or represented by them. The permanent chairman of the meeting shall appoint two inspectors of votes who shall count all votes cast at the meeting for or against any resolution and who shall make and file with the secretary of the meeting their verified written reports in duplicate of all votes cast at the meeting. A record in duplicate of the proceedings of each meeting of Holders shall be prepared by the secretary of the meeting and there shall be attached to said record the original reports of the inspectors of votes on any vote by ballot taken thereat and affidavits by one or more Persons having knowledge of the facts setting forth a copy of the notice of the meeting and showing that said notice was mailed as provided in Section 1402. The record shall show the principal amount or principal amounts of the Securities voting in favor of or against any resolution. The record shall be signed and verified by the affidavits of the permanent chairman and secretary of the meeting and one of the duplicates shall be delivered to the Company and the other to the Trustee to be preserved by the Trustee. Any record so signed and verified shall be conclusive evidence of the matters therein stated. Section 1407. Exercise of Rights to Trustee and Securityholders Not to be Hindered or Delayed. Nothing in this Article contained shall be deemed or construed to authorize or permit, by reason of any call of a meeting of Holders or any rights expressly or impliedly conferred hereunder to make such call, any hindrances or delay in the exercise of any right or rights conferred upon or reserved to the Trustee or to the Holders under any of the provisions of this Indenture or of the Securities. ARTICLE EIGHT Miscellaneous SECTION 8.01. The Trustee accepts the trusts created by the Indenture, as supplemented by this Fourth Supplemental Indenture, and agrees to perform the same upon the terms and conditions of the Indenture, as supplemented by this Fourth Supplemental Indenture. SECTION 8.02. The recitals contained herein shall be taken as the statements of the Company, and the Trustee assumes no responsibility for their correctness. The Trustee makes no representations as to the validity or sufficiency of this Fourth Supplemental Indenture. SECTION 8.03. Each of the Company and the Trustee makes and reaffirms as of the date of execution of this Fourth Supplemental Indenture all of its respective representations, warranties, covenants and agreements set forth in the Indenture. SECTION 8.04. All covenants and agreements in this Fourth Supplemental Indenture by the Company or the Trustee shall bind its respective successors and assigns, whether so expressed or not. SECTION 8.05. In case any provision in this Fourth Supplemental Indenture shall be invalid, illegal or unenforceable, the validity, legality and enforceability of the remaining provisions shall not in any way be affected or impaired thereby. SECTION 8.06. Nothing in this Fourth Supplemental Indenture, express or implied, shall give to any Person, other than the parties hereto and their successors under the Indenture and the Holders, any benefit or any legal or equitable right, remedy or claim under the Indenture. SECTION 8.07. If any provision hereof limits, qualifies or conflicts with a provision of the Trust Indenture Act, as it may be amended from time to time, that is required under such Act to be a part of and govern this Fourth Supplemental Indenture, the latter provision shall control. If any provision hereof modifies or excludes any provision of such Act that may be so modified or excluded, the latter provision shall be deemed to apply to this Fourth Supplemental Indenture as so modified or excluded, as the case may be. SECTION 8.08. THIS FOURTH SUPPLEMENTAL INDENTURE SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK. SECTION 8.09. All provisions of this Fourth Supplemental Indenture shall be deemed to be incorporated in, and made a part of, the Indenture; and the Indenture, as supplemented by this Fourth Supplemental Indenture, shall be read, taken and construed as one and the same instrument. * * * * * This Fourth Supplemental Indenture may be executed in any number of counterparts, each of which so executed shall be deemed to be an original, but all such counterparts shall together constitute but one and the same instrument. IN WITNESS WHEREOF, the parties hereto have caused this Fourth Supplemental Indenture to be duly executed, and their respective corporate seals (where applicable) to be hereunto affixed and attested, all as of the day and year first above written. [Corporate Seal] EASTMAN KODAK COMPANY Attest: By: David L. Vigren Gary P. Van Graafeiland Title: Treasurer Title: Secretary [Corporate Seal] THE BANK OF NEW YORK Attest: By: Salvatore D. Mineo Title: Vice President Title: Assistant Treasurer STATE OF NEW YORK) ) ss.: COUNTY OF MONROE ) On the day of , 1993, before me personally came , to me known, who being duly sworn, did depose and say that he is of EASTMAN KODAK COMPANY, one of the corporations described in and which executed the foregoing instrument; that he knows the seal of said corporation; that it was so affixed by authority of the Board of Directors of said corporation, and that he signed his name thereto by like authority. Notary Public State of New York STATE OF NEW YORK ) ) ss.: COUNTY OF NEW YORK) On the day of March, 1994, before me personally came , to me known, who being duly sworn, did depose and say that he is of THE BANK OF NEW YORK, one of the corporations described in and which executed the foregoing instrument; that he knows the seal of said corporation; that it was so affixed by authority of the Board of Directors of said corporation, and that he signed his name thereto by like authority. Exhibit (10)B As Amended December 30, 1993 Effective December 31, 1993 1985 EASTMAN KODAK COMPANY LONG-TERM PERFORMANCE AWARD PLAN 1. Purpose. The purpose of the Plan is to provide motivation to key employees of the Company to put forth maximum efforts for the long-term success of the business, and to encourage ownership of the Common Stock by such employees. 2. Definitions. 2.1 "Board" means the Board of Directors of the Company. 2.2 "Committee" means the Compensation Committee of the Board, consisting of not less than three members of the Board. A member of the Committee shall not be, and shall not within one year prior to appointment to the Committee have been, eligible to participate in the Plan or any other plan of the Company or any of its affiliates entitling participants to acquire stock, stock options or stock appreciation rights of the Company or its affiliates. 2.3 "Common Stock" means common stock of the Company. 2.4 "Company" means Eastman Kodak Company. 2.5 "Participant" means an employee of the Company or any Subsidiary, who has been selected by the Committee to participate in the Plan for one or more award cycles. 2.6 "Performance Share Unit ("PSU")" means a unit granted to a Participant in accordance with this Plan which is equivalent to one share of Common Stock. 2.7 "Plan" means the Eastman Kodak Company 1985 Long Term Performance Award Plan. 2.8 "Subsidiary" means a corporation or other business entity in which the Company directly or indirectly has an ownership interest of fifty percent or more. 2.9 "Change In Control" means a change in control of the Company of a nature that would be required to be reported (assuming such event has not been "previously reported") in response to Item l(a) of the Current Report of Form 8-K, as in effect on August 1, 1989, pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"); provided that, without limitation, a Change In Control shall be deemed to have occurred at such time as (i) any "person" within the meaning of Section 14(d) of the Exchange Act is or has become the "beneficial owner" as defined in Rule 13d-3 under the Exchange Act, directly or indirectly, of 25% or more of the combined voting power of the outstanding securities of the Company ordinarily having the right to vote at the election of directors ("Voting Securities"), or (ii) individuals who constitute the Board of Directors of the Company on August 1, 1989 (the "Incumbent Board") have ceased for any reason to constitute at least a majority thereof, provided that any person becoming a director subsequent to August 1, 1989 whose election, or nomination for election by the Company's stockholders, was approved by a vote of at least three-quarters (3/4) of the directors comprising the Incumbent Board (either by a specific vote or by approval of the proxy statement of the Company in which such person is named as a nominee for director without objection to such nomination) shall be, for purposes of this clause (ii), considered as though such person were a member of the Incumbent Board. 3. Administration. The Plan shall be administered by the Committee. The Committee is authorized to interpret, construe and implement the Plan, to prescribe, amend and rescind rules and regulations relating to it, and to make all other determinations necessary for its administration. All determinations of the Committee shall be by a majority of its members and its determinations shall be final. 4. Participation. 4.1 The Committee shall select, from time to time, Participants, from those employees of the Company and any Subsidiary who, in the opinion of the Committee, have the capacity to make a substantial contribution to the success of the Company. Directors of the Company or any Subsidiary, who are not full-time employees of the Company or any Subsidiary, shall not be eligible to participate in the Plan. 4.2 If an employee becomes a participant after commencement of an award cycle, the number of PSUs granted may be prorated for the length of time remaining in the award cycle; provided, however, that notwithstanding any Plan provision, other than Section 20.9 hereof, to the contrary, a person must participate for one full year to be eligible to earn an award. 4.3 The Committee shall grant PSUs to Participants at any time prior to or as soon after the start of an award cycle as practicable. In making such grants, the Committee may take into account the Participant's level of responsibility, rate of compensation and such other criteria as it deems appropriate. 4.4 During each award cycle, on each payment date for cash dividends on the Company's common stock each Participant shall be credited with dividend equivalents in the amount of the cash dividend declared per share for each PSU credited to him on the record date for such dividend. Each Participant shall also be credited with interest, compounded monthly, on such dividend equivalents computed at the monthly average of the lending rate as stated by Morgan Guaranty Trust Company, or its successors, to its most favored corporate customers (currently known as the bank's "Prime Rate"), such average to be determined as of the last day of each month. 5. Shares Available. The aggregate number of shares which may be issued under this Plan is 2,625,000 (par value $2.50), subject to adjustment as provided in Section 13. Such shares may be authorized and unissued shares or may be treasury shares. 6. Award Cycles. Each award cycle shall encompass three fiscal years of the Company; provided, however, that the Committee may declare a cycle completed earlier if it deems it appropriate to do so. The first award cycle shall commence at the beginning of fiscal 1986. Subsequent award cycles shall commence each fiscal year thereafter, with the last award cycle commencing at the beginning of fiscal 1990. 7. Performance Criteria. 7.1 The Committee shall establish performance criteria for each award cycle ("Criteria") relating to Company earnings, return on assets, productivity or such other factors as the Committee shall identify. 7.2 Upon the completion of each award cycle, the Committee shall review the performance of the Company and compare this performance with the Criteria for that award cycle. The relationship between such performance and the Criteria shall be used to determine the portion, if any, of the PSUs that have been earned. The Committee may consider other factors, including individual performance, in determining the portion of PSUs that have been earned. Such portion may range from 0 to 150 percent as the Committee shall determine and shall be termed the "award percentage". 8. Payment. 8.1 Payment of PSUs that have been earned shall be made in Common Stock, cash or a combination thereof as determined by the Committee. For each PSU earned, the Participant shall be entitled to one share of Common Stock or the value thereof, subject to such terms, conditions, or restrictions, including restrictions on transferability and continued employment, as the Committee may deem appropriate. 8.2 After the completion of each award cycle, each Participant shall be paid in Common Stock, cash, or a combination thereof, as determined by the Committee, an amount equal to the "award percentage" for that cycle multiplied by the dividend equivalents (together with the interest credited with respect thereto) credited during and for that cycle. 8.3 Following the payment made pursuant to Section 8.2, each Participant shall continue to be credited with dividend equivalents and interest as described in Section 4.4 for each PSU earned, but not yet paid. Together with the payment of such earned PSUs, there shall also be paid in Common Stock, cash, or a combination thereof, as determined by the Committee, an amount equal to the dividend equivalents and interest credited to the Participant with respect to such earned PSUs. 8.4 Receipt of any payment or any portion thereof, may be deferred until termination of employment by delivery of a written, irrevocable election, prior to the time such payment would otherwise be made, on a form provided by the Company. Such election shall indicate the percentage of the earned PSUs and the accompanying dividend equivalents (with interest) to be deferred. 8.5 PSUs which are deferred will continue to be credited with dividend equivalents and interest as described in Section 4.4. 8.6 Deferred payments shall be made in a single payment or in annual installments, at the sole discretion of the Committee. The maximum number of installments shall be ten. The amount of each installment payment shall be equal to the value of the deferred amount, divided by the number of installments remaining to be paid with respect to that deferral. 8.7 Anything herein to the contrary notwithstanding, Participants who cease to be employed by the Company or a Subsidiary and are employed by Eastman Chemical Company or one of its subsidiaries in connection with the distribution of the common stock of Eastman Chemical Company to the shareholders of the Company, shall not be deemed to have terminated employment for purposes of this Plan and all performance share units and restricted stock units outstanding on the date of such distribution. 9. Termination of Employment. 9.1 If a Participant's employment terminates during an award cycle for any reason other than death, disability, retirement, or for any unapproved reason, he shall not be entitled to payment with respect to any PSUs for that award cycle. 9.2 If a Participant's employment terminates during an award cycle by reason of retirement or disability or any approved reason, he shall continue to be entitled to dividend equivalents in accordance with Section 4.4, but he shall be entitled to only a fraction of any payment with respect to the PSUs earned at the end of the award cycle, based upon the number of months of participating employment during the award cycle. Such payment shall be made following the end of the award cycle in accordance with Section 8. 9.3 If a Participant dies during an award cycle, whether employed, retired or disabled at the time of death, his legal representative shall be entitled to receive, as soon as practicable, a fraction of the PSUs that would have been earned based upon the number of months of participating employment during the award cycle and assuming 100% of the Criteria for that award cycle had been met. Such payment shall be made in cash, with the PSUs valued as of the date of death. 9.4 If an individual is a Participant in more than one award cycle at the time of his termination, his entitlement, if any, for each such award cycle shall be determined as provided in this Section 9. 9.5 In the event of death, disability, retirement, or approved termination of employment, after the completion of an award cycle, any terms, conditions or restrictions in effect on any PSUs previously earned by the Participant shall lapse as of the date of such event. 9.6 Anything herein to the contrary notwithstanding, Participants who cease to be employed by the Company or a Subsidiary and are employed by Eastman Chemical Company or one of its subsidiaries in connection with the distribution of the common stock of Eastman Chemical Company to the shareholders of the Company, shall not be deemed to have terminated employment for purposes of this Plan and all performance share units and restricted stock units outstanding on the date of such distribution. 10. Non-Competitive Provision. Notwithstanding any Plan provision, other than Section 20.10 hereof, to the contrary, if a Participant, without the written consent of the Company, engages either directly or indirectly, in any manner or capacity, as principal, agent, partner, officer, director, employee, or otherwise, in any business or activity competitive with the business conducted by the Company or any Subsidiaries, or performs any act or engages in any activity which in the opinion of the Chief Executive Officer, is inimical to the best interests of the Company, prior to the completion of any award cycles in which he is participating, he shall not receive an award for any such award cycles. 11. Stock Awards. The Committee may, in addition, award restricted stock units and/or shares of Common Stock to such employees of the Company and any Subsidiary, and in such numbers and at such times during the term of the Plan as it shall determine. Such employee may, but need not be, participating in an award cycle. The Committee shall determine the terms, conditions, or restrictions, including restrictions on transferability and continued employment, relating to the awards as it may deem appropriate. The authority of the Committee under this section may also be fully exercised by the Chairman of the Committee alone, and whenever so exercised by him, he shall report annually to the Committee all awards made hereunder. One restricted stock unit is equivalent to one share of Common Stock. For every restricted stock unit credited to an employee on the record date, the employee shall be entitled to receive in cash on the payment date an amount equal to the dividend per share of Common Stock declared by the Company, until such restricted stock unit is paid in Common Stock, cash or a combination thereof, as determined by the Committee. 12. Non-Assignability. No grants or awards under this Plan shall be subject in any manner to alienation, anticipation, sale, transfer, assignment, pledge, or encumbrance. 13. Adjustment of Units and Shares Available. If there is any change in the number of outstanding shares of Common Stock of the Company through the declaration of stock dividends or through stock splits, the number of PSUs and restricted stock units granted to Participants and the maximum number of shares which may be issued under this Plan shall be automatically adjusted. If there is any change in the number of outstanding shares of Common Stock of the Company, through any change in the capital account of the Company or through any other transaction referred to in Section 425(a) of the Internal Revenue Code, the number of PSUs and restricted stock units granted to Participants and the maximum number of shares which may be issued under this Plan shall be appropriately adjusted by the Committee. 14. No Right to Continued Employment. Participation in the Plan shall not give any employee any right to remain in the employ of the Company. The Company reserves the right to terminate any Participant at any time. 15. Rights as a Shareholder. No Participant shall have any rights as a shareholder as a result of participation in this Plan until the date of issuance of a stock certificate in his name, whether or not such certificate is subject to restrictions. 16. Amendment. The Board may, from time to time, amend the Plan in any manner, but may not without shareholder approval, adopt any amendment which would (a) materially increase the benefits accruing to Participants under the Plan, (b) materially increase the number of shares which may be issued under the Plan (except as provided in Section 13), or (c) materially modify the requirements for eligibility for participation in the Plan. 17. Effective Date. The Plan shall become effective on November 8, 1985 and shall be submitted to the shareholders at the Company's 1986 Annual Meeting for approval. Notwithstanding any other provision of this Plan, no PSUs shall be earned, nor shall restrictions lapse on stock awards, prior to shareholder approval of the Plan. 18. Governing Law. The Plan shall be construed and enforced in accordance with the law of New York State. 19. Taxes. The Company will withhold, to the extent required by law, all applicable income and employment taxes from amounts paid under the Plan. 20. Change In Control. 20.1 Background. The terms of this Section 20 shall immediately become operative, without further action or consent by any person or entity, upon a Change In Control, and once operative shall supersede and control over any other provisions of this Plan and its Administrative Guide. 20.2 Award Percentage for Incomplete Award Cycles. If a Change In Control occurs during the term of one or more award cycles, each such award cycle shall immediately terminate upon the occurrence of such event. For each award cycle which is so terminated, the award percentage shall be one hundred percent (100%). 20.3 Award Percentage for Completed Award Cycles. Upon the occurrence of a Change In Control, for each completed award cycle for which the Committee has not on or before such date determined an award percentage, the award percentage shall be one hundred percent (100%). 20.4 Payment of PSUs and Dividend Equivalents. Each Participant of an award cycle for which the award percentage is deemed one hundred percent (100%) under Section 20.2 above shall be considered to have earned, and, therefore, be entitled to receive, a prorated portion of the PSUs previously granted to him for such award cycle and a prorated portion of the dividend equivalents (together with the interest credited with respect thereto) credited to him during that cycle. With regard to a Participant's PSUs, such prorated portion shall be determined by multiplying the number of PSUs granted to the Participant by a fraction, the numerator of which is the total number of whole and partial years (with each partial year being treated as a whole year) that have elapsed since the beginning of the award cycle, and the denominator of which is three (3). With regard to a Participant's dividend equivalents (together with the interest credited with respect thereto), such prorated portion shall be determined by multiplying the Participant's dividend equivalents (together with the interest credited with respect thereto) by the same fraction. Each Participant of an award cycle for which the award percentage is deemed one hundred percent (100%) under Section 20.3 above shall be considered to have earned and, therefore, be entitled to receive, all of the PSUs previously granted to him during such award cycle, as well as all the dividend equivalents (together with the interest credited with respect thereto) credited during and for that cycle. 20.5 Form and Time of Payment. Upon the occurrence of a Change In Control, a Participant, whether or not he is still employed by the Company or a Subsidiary, shall be paid in a single lump-sum cash payment as soon as practicable, but in no event later than 90 days after the date of the Change In Control: (a) all the PSUs and dividend equivalents (together with the interest credited with respect thereto) earned by him or her as a result of the application of Section 20.4; (b) all PSUs and dividend equivalents (together with interest credited with respect thereto) deferred by him or her under Section 8.4, but for which he or she has not received payment; and (c) all other PSUs and dividend equivalents (together with interest credited with respect thereto) earned by him or her on or before the date of the Change In Control, but for which he or she has not received payment. For purposes of making this payment, the value of a Participant's PSUs shall be determined by averaging the mean between the high and low at which Kodak common stock is traded on the New York Stock Exchange for each of the twenty (20) trading days preceding the date of the Change In Control. 20.6 Lapse of Restrictions. Upon a Change In Control, all terms, conditions or restrictions in effect on outstanding PSUs, restricted stock or restricted stock units shall immediately lapse as of the date of such event. In addition, no other terms, conditions or restrictions shall be imposed upon any PSUs, restricted stock or restricted stock units on or after such date. 20.7 Vesting of Restricted Stock Units. Upon a Change In Control, all outstanding restricted stock units shall automatically become one hundred percent (100%) vested immediately upon the occurrence of such event. 20.8 Payment of Restricted Stock Units. Upon the occurrence of a Change In Control, any person, whether or not he is still employed by the Company or a Subsidiary, then holding restricted stock units shall be paid all his or her outstanding restricted stock units in a single lump-sum cash payment as soon as practicable, but in no event later than 90 days after the date of the Change In Control. For purposes of making this payment, the value of a person's restricted stock units shall be determined by averaging the mean between the high and low at which Kodak common stock is traded on the New York Stock Exchange for each of the twenty (20) trading days preceding the date of the Change In Control. 20.9 Year of Participation. Upon a Change In Control, each Participant who has not completed one (1) full year of participation under the Plan as of the date of such event shall be considered to have completed a full year of participation in order to satisfy the requirements of Section 4.2 of the Plan. 20.10 Section 10. Upon a Change In Control, the terms and provisions in Section 10 of the Plan shall become null and void and shall have no further force and effect. 20.11 Amendment on or After Change In Control. On or after a Change In Control, no action, including, but not by way of limitation, the amendment, suspension or termination of the Plan, shall be taken which would affect the rights of any Participant or the operation of this Plan with respect to any PSUs to which the Participant may have become entitled hereunder on or prior to the date of such action or as a result of such Change In Control. Exhibit (10)C 1982 EASTMAN KODAK COMPANY EXECUTIVE DEFERRED COMPENSATION PLAN Amended and Restated Effective as of December 31, 1993 1982 Eastman Kodak Company Executive Deferred Compensation Plan Section Page Preamble 86 Section 1. Definitions 86 Section 2. Compensation Level 87 Section 3. Deferral of Compensation 87 Section 4. Time of Election Deferral 87 Section 5. Hypothetical Investments 87 Section 5.1 Deferred Compensation Account 87 Section 5.2 Stock Account 87 Section 6. Manner of Electing Deferral 87 Section 7. Elections to Defer for A Fixed Period During Employment 88 Section 8. Investment in Stock Account 88 Section 8.1 Elections 88 Section 8.2 Election into the Stock Account 88 Section 8.3 Election out of the Stock Account 88 Section 8.4 Dividend Equivalents 88 Section 8.5 Stock Dividends 89 Section 8.6 Recapitalization 89 Section 8.7 Distributions 89 Section 8.8 Liquidation of Stock Account 89 Section 9. Payment of Deferred Compensation 89 Section 9.1 Background 89 Section 9.2 Manner of Payment 89 Section 9.3 Timing of Payments 89 Section 9.4 Valuation 89 Section 9.5 Termination of Employment 90 Section 10. Payment of Deferred Compensation After Death 90 Section 10.1 Stock Account 90 Section 10.2 Distribution 90 Section 11. Acceleration of Payment for Hardship 90 Section 12. Non-Competition Provision 90 Section 13. Participant's Rights Unsecured 90 Section 14. No Right to Continued Employment 90 1982 Eastman Kodak Company Executive Deferred Compensation Plan Table of Contents Continued Section Page Section 15. Statement of Account 90 Section 16. Assignability 90 Section 17. Deductions 90 Section 18. Administration 91 Section 18.1 Responsibility 91 Section 18.2 Authority of the Compensation Committee 91 Section 18.3 Discretionary Authority 91 Section 18.4 Delegation of Authority 91 Section 19. Amendment 91 Section 20. Governing Law 91 Section 21. Diconix Deferred Compensation 91 Section 22. Change in Control 91 Section 22.1 Background 91 Section 22.2 Acceleration of Payment Upon Change In Control 91 Section 22.3 Amendment On or After Change In Control 91 Section 23. Severance Payments 91 Section 24. Compliance With Securities Laws 92 Schedule A 93 1982 EASTMAN KODAK COMPANY EXECUTIVE DEFERRED COMPENSATION PLAN Preamble. The 1982 Eastman Kodak Company Executive Deferred Compensation Plan is an unfunded non-qualified deferred compensation arrangement for eligible executives of Eastman Kodak Company and certain of its subsidiaries effective for compensation earned in 1982 and later years. Under the Plan, each Eligible Employee is annually given an opportunity to elect to defer payment of part of his or her compensation earned during the year following his or her election. Section 1. Definitions. Section 1.1. "Account" means the Deferred Compensation Account or the Stock Account. Section 1.2. "Board" means Board of Directors of Kodak. Section 1.3. "Change in Control" means a change in control of Kodak of a nature that would be required to be reported (assuming such event has not been "previously reported") in response to Item 1(a) of the Current Report of Form 8-K, as in effect on August 1, 1989, pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"); provided that, without limitation, a Change in Control shall be deemed to have occurred at such time as (i) any "person" within the meaning of Section 14(d) of the Exchange Act is or has become the "beneficial owner" as defined in Rule 13d-3 under the Exchange Act, directly or indirectly, of 25% or more of the combined voting power of the outstanding securities of Kodak ordinarily having the right to vote at the election of directors ("Voting Securities"), or (ii) individuals who constitute the Board of Directors of Kodak on August 1, 1989 (the "Incumbent Board") have ceased for any reason to constitute at least a majority thereof, provided that any person becoming a director subsequent to August 1, 1989 whose election, or nomination for election by Kodak's stockholders, was approved by a vote of at least three-quarters (3/4) of the directors comprising the Incumbent Board (either by a specific vote or by approval of the proxy statement of the Company in which such person is named as a nominee for director without objection to such nomination) shall be, for purposes of this clause (ii), considered as though such person were a member of the Incumbent Board. Section 1.4. "Common Stock" means the common stock of Kodak. Section 1.5. "Company" means Kodak and its United States subsidiaries listed on Schedule A. Section 1.6. "Compensation Committee" shall mean the Compensation Committee of the Board. Section 1.7. "Deferrable Amount" means an amount equal to the excess of the Eligible Employee's individual annual salary rate as of August 1 of any year over the minimum compensation level established by the Compensation Committee of the Board. Section 1.8. "Deferred Compensation Account" means the account established by the Company for each Participant for compensation deferred pursuant to this Plan. The maintenance of individual Deferred Compensation Accounts is for bookkeeping purposes only. Section 1.9. "Eligible Employee" means an employee of the Company employed in the United States whose individual annual salary rate as of August 1 is equal to or greater than the eligibility compensation level established by the Compensation Committee. Eligible Employee shall also include an employee of Kodak or any subsidiary of Kodak selected annually by the Compensation Committee whose individual annual salary rate as of August 1 is equal to or greater than the eligibility compensation level established by the Compensation Committee. However, in no event shall a non-resident alien be eligible to participate in this Plan. Any employee who becomes eligible to participate in this Plan and in a future year does not qualify as an Eligible Employee solely because his or her individual annual salary rate as of August 1 is less than the eligibility compensation level, shall nevertheless be eligible to participate in such year. Section 1.10. "Enrollment Period" means the period designated by the Compensation Committee each year, provided however, that such period shall not commence prior to August 1 and shall end on or before the last business day before the last Sunday in December of each year. Section 1.11. "Interest Rate" means the monthly average of the lending rate as stated by Morgan Guaranty Trust Company, or its successors, to its most favored corporate customers (currently known as the bank's "Prime Rate"), such average to be determined as of the last day of each month. Section 1.12. "Kodak" means Eastman Kodak Company. Section 1.13. "Market Value" means the mean between the high and low at which the Common Stock trades on the New York Stock Exchange as quoted in the New York Stock Exchange Composite Transactions as published in the Wall Street Journal on the day for which the determination is to be made, or if such day is not a trading day, the immediately preceding day. Section 1.14. "Plan" means the 1982 Eastman Kodak Company Executive Deferred Compensation Plan as adopted by the Board and amended. Section 1.15. "Participant" means an Eligible Employee who elects for one or more years to defer compensation pursuant to this Plan. All SOG Participants are Participants. Section 1.16. "SOG Participant" means a Participant who is, or was formerly, subject to the Guidelines for Senior Management Ownership of Eastman Kodak Company Stock as approved by the Compensation Committee. Section 1.17. "Stock Account" means the account established by the Company for each SOG Participant, the performance of which shall be measured by reference to the Market Value of Common Stock. The maintenance of individual Stock Accounts is for bookkeeping purposes only. Section 1.18. "Valuation Date" means the last business day of each calendar month. Section 2. Compensation Level. Each year the Compensation Committee shall select an eligibility compensation level and a minimum compensation level prior to the commencement of the Enrollment Period. Section 3. Deferral of Compensation. An Eligible Employee may elect to defer receipt of one or more of the following to his or her Deferred Compensation Account: 1) all or any portion of his or her Deferrable Amount to be earned during the year; 2) all of his or her wage dividend, if any, payable in the year, which is not eligible for contribution to the Eastman Kodak Employees' Savings and Investment Plan; and 3) all or any portion of any other compensation identified by the Compensation Committee. An Eligible Employee may not defer the receipt of any amounts to his or her Stock Account. A Participant in this Plan need not participate in the Eastman Kodak Employees' Savings and Investment Plan. No deferral shall be made of any compensation payable after termination of employment. Section 4. Time of Election of Deferral. An Eligible Employee who wishes to defer compensation must irrevocably elect to do so during the Enrollment Period immediately preceding the calendar year during which such compensation is paid. Elections shall be made annually. Section 5. Hypothetical Investments. Section 5.1. Deferred Compensation Account. Amounts in a Participant's Deferred Compensation Account are hypothetically invested in an interest bearing account which bears interest computed at the Interest Rate, compounded monthly. Section 5.2. Stock Account. Amounts in a SOG Participant's Stock Account are hypothetically invested in units of Common Stock. Amounts transferred to a Stock Account are recorded as units of Common Stock, and fractions thereof, with one unit equating to a single share of Common Stock. Thus, the value of one unit shall be the Market Value of a single share of Common Stock. The use of units is merely a bookkeeping convenience; the units are not actual shares of Common Stock. The Company will not reserve or otherwise set aside any Common Stock for or to any Stock Account. Section 6. Manner of Electing Deferral. An Eligible Employee may elect to defer compensation by executing and returning to the Compensation Committee a deferred compensation form provided by Kodak. The form shall indicate: (1) the amount of the Deferrable Amount to be deferred; (2) whether the deferral is to be at the same rate throughout the year, or at one rate for part of the year and at a second rate for the remainder of the year; (3) whether or not the wage dividend eligible to be deferred is to be deferred; and (4) the portion of any other compensation identified by the Compensation Committee to be deferred. Amounts to be deferred shall be credited to the Participant's Deferred Compensation Account as follows: 1) Deferrable Amount shall be credited each pay period on the date such amount is otherwise payable; 2) wage dividend shall be credited on the date such amount is otherwise payable; and 3) any other compensation shall be credited on the date such amount is otherwise payable. Section 7. Elections to Defer For a Fixed Period During Employment. A Participant may elect to defer receipt of his or her compensation for a fixed number of years, no less than 5, provided he or she continues as an employee of the Company during the period of deferral. Any such election shall be made during the Enrollment Period on the deferred compensation form referenced in Section 6 above. If such Participant ceases to be an employee of the Company prior to the end of the fixed period, Section 9 shall govern the payment of his or her Accounts. If a Participant has elected to defer receipt of his or her compensation for a fixed number of years, payment of such amount shall be made in cash in a single lump-sum on the fifth business day in March in the year following the termination of the deferral period. The amount of the lump-sum due the Participant shall be valued as of the Valuation Date in February in the year following the termination of the deferral period. Section 8. Investment in the Stock Account. Section 8.1. Elections. A SOG Participant may direct that all or any portion, designated as a whole dollar amount, of the existing balance of one of his or her Accounts be transferred to his or her other Account, effective as of the first day of any calendar month (hereinafter the election's "Effective Date"), by filing a written election with the Compensation Committee on or prior to the last business day of the immediately preceding calendar month. Notwithstanding the preceding sentence of this Section 8.1, a SOG Participant may not transfer to his or her Stock Account any amount subject to an election to defer for a fixed number of years pursuant to Section 7, nor may he or she transfer to his or her Stock Account any interest that has accrued on such amount. Section 8.2. Election into the Stock Account. If a SOG Participant elects pursuant to Section 8.1 to transfer an amount from his or her Deferred Compensation Account to his or her Stock Account, effective as of the election's Effective Date, (i) his or her Stock Account shall be credited with that number of units of Common Stock, and fractions thereof, obtained by dividing the dollar amount elected to be transferred by the Market Value of the Common Stock on the Valuation Date immediately preceding the election's Effective Date; and (ii) his or her Deferred Compensation Account shall be reduced by the amount elected to be transferred. Section 8.3. Election out of the Stock Account. If a SOG Participant elects pursuant to Section 8.1 to transfer an amount from his or her Stock Account to his or her Deferred Compensation Account, effective as of the election's Effective Date, (i) his or her Deferred Compensation Account shall be credited with a dollar amount equal to the amount obtained by multiplying the number of units to be transferred by the Market Value of the Common Stock on the Valuation Date immediately preceding the election's Effective Date; and (ii) his or her Stock account shall be reduced by the number of units elected to be transferred. Section 8.4. Dividend Equivalents. Effective as of the payment date for each cash dividend on the Common Stock, additional units of Common Stock shall be credited to the Stock Account of each SOG Participant who had a balance in his or her Stock Account on the record date for such dividend. The number of units that shall be credited to the Stock Account of such a SOG Participant shall be computed by multiplying the dollar value of the dividend paid upon a single share of Common Stock by the number of units of Common Stock held in the SOG Participant's Stock Account on the record date for such dividend and dividing the product thereof by the Market Value of the Common Stock on the payment date for such dividend. Section 8.5. Stock Dividends. Effective as of the payment date for each stock dividend (as defined in Section 305 of the Internal Revenue Code of 1986) on the Common Stock, additional units of Common Stock shall be credited to the Stock Account of each SOG Participant who had a balance in his or her Stock Account on the record date for such dividend. The number of units that shall be credited to the Stock Account of such a SOG Participant shall equal the number of shares of Common Stock which the SOG Participant would have received as stock dividends had he or she been the owner on the record date for such stock dividend of the number of shares of Common Stock equal to the number of units credited to his or her Stock Account on such record date. To the extent the SOG Participant would have also received cash, in lieu of fractional shares of Common Stock, had he or she been the record owner of such shares for such stock dividend, then his or her Stock Account shall also be credited with that number of units, or fractions thereof, equal to such cash amount divided by the Market Value of the Common Stock on the payment date for such dividend. Section 8.6. Recapitalization. If Kodak undergoes a reorganization as defined in Section 368 (a) of the Internal Revenue Code of 1986, the Compensation Committee may, in its sole and absolute discretion, take whatever action it deems necessary, advisable or appropriate with respect to the Stock Accounts in order to reflect such transaction, including, but not limited to, adjusting the number of units credited to a SOG Participant's Stock Account. Section 8.7. Distributions. Amounts in respect of units of Common Stock shall be distributed in cash in accordance with Sections 7, 9, 10, 11 and 22. For purposes of a distribution pursuant to Section 7, 9, 10, 11 or 22, the number of units to be distributed from a SOG Participant's Stock Account shall be valued by multiplying the number of such units by the Market Value of the Common Stock as of the Valuation Date immediately preceding the date such distribution is to occur. Pending the complete distribution under Section 9.2 or liquidation under Section 8.8 of the Stock Account of a SOG Participant who has terminated his or her employment with the Company, the SOG Participant shall continue to be able to make elections pursuant to Sections 8.2 and 8.3 and his or her Stock Account shall continue to be credited with additional units of Common Stock pursuant to Sections 8.4, 8.5, and 8.6. Section 8.8. Liquidation of Stock Account. The provisions of this Section 8.8 shall be applicable if on the second anniversary of the SOG Participant's retirement or, if earlier, termination of employment from the Company, the SOG Participant has a balance remaining in his or her Stock Account. In such case, effective as of the first day of the first calendar month immediately following the date of such second anniversary, the entire balance of the SOG Participant's Stock Account shall automatically be transferred to his or her Deferred Compensation Account and, he or she shall thereafter be ineligible to transfer any amounts to his or her Stock Account. For purposes of valuing the units of Common Stock subject to such a transfer, the method described in Section 8.3 shall be used. Section 9. Payment of Deferred Compensation. Section 9.1. Background. No withdrawal may be made from a Participant's Accounts except as provided in this Section 9 and Sections 7, 10, 11, and 22. Section 9.2. Manner of Payment. Payment of a Participant's Accounts shall be made at the sole discretion of the Committee in a single sum or in annual installments. The maximum number of installments is ten. All payments from the Plan shall be made in cash. Section 9.3. Timing of Payments. Payments shall be made on the fifth business day in March and shall commence in any year designated by the Compensation Committee up through the tenth year following the year in which the Participant retires, becomes disabled, or for any other reason, ceases to be an employee of Kodak or any subsidiary of Kodak, but in no event later than the year the Participant reaches age 71. Section 9.4. Valuation. The amount of each payment shall be equal to the value, as of the immediately preceding Valuation Date, of the Participant's Accounts, divided by the number of installments remaining to be paid. If payment of a Participant's Accounts is determined by the Compensation Committee to be paid in installments and the Participant has a balance in his or her Stock Account at the time of the payment of an installment, the amount that shall be distributed from his or her Stock Account shall be the amount obtained by multiplying the total amount of the installment determined in accordance with the immediately preceding sentence by the percentage obtained by dividing the balance in the Stock Account as of the immediately preceding Valuation Date by the total value of the Participant's Accounts as of such date. Similarly, in such case, the amount that shall be distributed from the Participant's Deferred Compensation Account shall be the amount obtained by multiplying the total amount of the installment determined in accordance with the first sentence of this Section 9.4 by the percentage obtained by dividing the balance in the Deferred Compensation Account as of the immediately preceding Valuation Date by the total value of the Participant's Accounts as of such date. Section 9.5. Termination of Employment. Anything herein to the contrary notwithstanding, Participants who cease to be employed by Kodak or any Subsidiary of Kodak and are employed by Eastman Chemical Company or one of its subsidiaries in connection with the distribution of the common stock of Eastman Chemical Company to the shareholders of Kodak, shall not be deemed to have terminated employment for purposes of this Plan. Section 10. Payment of Deferred Compensation After Death. If a Participant dies prior to complete payment of his or her Accounts, the provisions of this Section 10 shall become operative. Section 10.1. Stock Account. Effective as of the date of a SOG Participant's death, the entire balance of his or her Stock Account shall be transferred to his or her Deferred Compensation Account. For purposes of valuing the units of Common Stock subject to such a transfer, the deceased SOG Participant's Deferred Compensation Account shall be credited with a dollar amount equal to the amount obtained by multiplying the number of units in the deceased SOG Participant's Stock Account at the time of his or her death by the Market Value of the Common Stock on the date of his or her death. Thereafter, no amounts in the deceased SOG Participant's Deferred Compensation Account shall be eligible for transfer to the deceased SOG Participant's Stock Account by any person, including, but not by way of limitation, the deceased SOG Participant's beneficiary or legal representative. Section 10.2. Distribution. The balance of the Participant's Accounts, valued as of the Valuation Date immediately preceding the date payment is made, shall be paid in a single, lump-sum payment to: (1) the beneficiary or contingent beneficiary designated by the Participant on forms supplied by the Compensation Committee; or, in the absence of a valid designation of a beneficiary or contingent beneficiary, (2) the Participant's estate within 30 days after appointment of a legal representative of the deceased Participant. Section 11. Acceleration of Payment for Hardship. Upon written approval from Kodak's Chairman of the Board (the Compensation Committee, in the case of a request from the Chairman of the Board) a Participant, whether or not he or she is still employed by Kodak or any subsidiary of Kodak, may be permitted to receive all or part of his or her Accounts if the Chairman of the Board (or the Compensation Committee, when applicable) determines that an emergency event beyond the Participant's control exists which would cause such Participant severe financial hardship if the payment of his or her Accounts were not approved. Any such distribution for hardship shall be limited to the amount needed to meet such emergency. If such a distribution occurs while the Participant is employed by Kodak or any subsidiary of Kodak, any election to defer compensation for the year in which the Participant receives a hardship withdrawal shall be ineffective as to compensation earned for the pay period following the pay period during which the withdrawal is made and thereafter for the remainder of such year and shall be ineffective as to any wage dividend or any other compensation elected to be deferred for such year. Section 12. Non-Competition Provision. If a Participant, without the written consent of Kodak, engages either directly or indirectly, in any manner or capacity, as principal, agent, partner, officer, director, employee, or otherwise, in any business or activity competitive with the business conducted by Kodak or any subsidiary of Kodak, while a balance remains credited to his or her Account, the Company may, in its sole discretion, pay to the Participant the balance credited to his or her Deferred Compensation Account and/or Stock Account. Section 13. Participant's Rights Unsecured. The amounts payable under the Plan shall be unfunded, and the right of any Participant or his or her estate to receive any payment under the Plan shall be an unsecured claim against the general assets of the Company. No Participant shall have the right to exercise any of the rights or privileges of a shareholder with respect to the units credited to his or her Stock Account. Section 14. No Right to Continued Employment. Participation in the Plan shall not give any employee any right to remain in the employ of the Company. The Company reserves the right to terminate any Participant at any time. Section 15. Statement of Account. Statements will be sent no less frequently than annually to each Participant or his or her estate showing the value of the Participant's Accounts. Section 16. Assignability. Neither the Participant nor the Company shall have the right to assign any rights or obligations under the Plan. However, the Plan shall inure to the benefit of and be binding upon the successors of the Company. Section 17. Deductions. The Company will withhold to the extent required by law all applicable income and employment taxes from amounts paid under the Plan. Section 18. Administration. Section 18.1. Responsibility. The Compensation Committee shall have total and exclusive responsibility to control, operate, manage and administer the plan in accordance with its terms. Section 18.2. Authority of the Compensation Committee. The Compensation Committee shall have all the authority that may be necessary or helpful to enable it to discharge its responsibilities with respect to the Plan. Without limiting the generality of the preceding sentence, the Compensation Committee shall have the exclusive right: to interpret the Plan, to determine eligibility for participation in the Plan, to decide all question concerning eligibility for and the amount of benefits payable under the Plan, to construe any ambiguous provision of the Plan, to correct any default, to supply any omission, to reconcile any inconsistency, and to decide any and all questions arising in the administration, interpretation, and application of the Plan. Section 18.3. Discretionary Authority. The Compensation Committee shall have full discretionary authority in all matters related to the discharge of its responsibilities and the exercise of its authority under the Plan including, without limitation, its construction of the terms of the Plan and its determination of eligibility for participation and benefits under the Plan. It is the intent of Plan that the decisions of the Compensation Committee and its action with respect to the Plan shall be final and binding upon all persons having or claiming to have any right or interest in or under the Plan and that no such decision or action shall be modified upon judicial review unless such decision or action is proven to be arbitrary or capricious. Section 18.4. Delegation of Authority. The Compensation Committee may delegate some or all of its authority under the Plan to any person or persons provided that any such delegation be in writing. Section 19. Amendment. The Plan may at any time or from time to time be amended, modified, or terminated by the Board or by the Benefit Plans Committee of Kodak. However, no amendment, modification, or termination shall, without the consent of a Participant, adversely affect such Participant's accruals in his or her Accounts. Section 20. Governing Law. The Plan shall be construed, governed and enforced in accordance with the law of New York State, except as such laws are preempted by applicable federal law. Section 21. Diconix Deferred Compensation. The deferred compensation accounts maintained by Research Boulevard Realty Co., Inc. (formerly Diconix, Inc.) pursuant to the Diconix, Inc. Deferred Compensation Plan shall be treated as Deferred Compensation Accounts under this Plan and shall be subject to all the terms and conditions of this Plan. Section 22. Change in Control. Section 22.1. Background. The terms of this Section 22 shall immediately become operative, without further action or consent by any person or entity, upon a Change in Control, and once operative shall supersede and control over any other provisions of this Plan. Section 22.2. Acceleration of Payment Upon Change In Control. Upon the occurrence of a Change in Control, each Participant, whether or not he or she is still employed by Kodak or any subsidiary of Kodak, shall be paid in a single, lump-sum cash payment the balance of his or her Accounts as of the Valuation Date immediately preceding the date payment is made. Such payment shall be made as soon as practicable, but in no event later than 90 days after the date of the Change in Control. Section 22.3. Amendment On or After Change In Control. On or after a Change in Control, no action, including, but not by way of limitation, the amendment, suspension or termination of the Plan, shall be taken which would affect the rights of any Participant or the operation of this Plan with respect to the balance in the Participant's Accounts. Section 23. Severance Payments. With the exception of Sections 1, 13, 14, 16, 17, 18, 19 and 20 hereof, the provisions of this Section 23 shall operate independent of any other Sections of this Plan. Subject to the terms and conditions established in this Section 23, the Chief Executive Officer of the Company may award severance payments under the Plan to certain Eligible Employees who terminate their employment from the Company. The classification of Eligible Employees who are eligible for such severance payments shall be limited to those Eligible Employees who are officers of the Company. The amount of any such severance payment shall be determined by the Chief Executive Officer with reference to the Eligible Employee's base salary at the time of his or her termination of employment. The Chief Executive Officer shall have the sole discretion to determine the timing, manner of payment (e.g., lump sum or installments) and terms, conditions and limitations of any such severance payment, except that all such payments shall be made in cash. Any award made by the Chief Executive Officer pursuant to the provisions of this paragraph shall be evidenced by a written agreement signed by the Chief Executive Officer. Section 24. Compliance with Securities Laws. The Compensation Committee may, from time to time, impose additional, or modify or eliminate existing, Plan restrictions and requirements, including, but not by way of limitation, the restrictions regarding a SOG Participant's ability to elect into and out of his or her Stock Account under Sections 8.2 and 8.3 or the requirement of an automatic transfer pursuant to Section 10.1, as it deems necessary, advisable or appropriate in order to comply with applicable federal and state securities laws. All such restrictions shall be accomplished by way of written administrative guidelines adopted by the Compensation Committee. Schedule A Eastman Chemical Products, Inc. Eastman Chemical International Ltd. Eastman Gelatine Corporation Eastman Kodak International Capital Company, Inc. Holston Defense Corporation Kodak Processing Laboratory, Inc. Exhibit (10)E Management Annual Performance Plan SUMMARY: The Management Annual Performance Plan (MAPP) is a compensation plan for Kodak management-level individuals which delivers a portion of compensation according to business performance. The compensation of each participant consists of a base salary and an annual performance award from MAPP. Expected financial performance is considered a "C" level of performance and yields a target award. MAPP awards vary from zero, if financial goals are not met, to a maximum of two times the target award. Target awards range from 15% for lower level positions to 40% for the CEO. Payments are made to plan participants in a lump sum in April of the year following the year for which performance was measured. (i.e., MAPP payments for 1993 performance will be paid out in April, 1994). PLAN ADMINISTRATION: The Compensation Committee of the Board of Directors is responsible for: policy setting and interpretation, approving performance goals at the company and Group levels, evaluation of company and Group performance against the goals, and the determination of company and Group level performance awards. The Chief Executive Officer provides advice and counsel to the Compensation Committee. Management is responsible for administering the Plan. PARTICIPATION: The Plan is intended for management-level individuals in key roles which impact the financial performance of the organization. Participation is determined by Group Presidents and Senior Vice Presidents. The Chief Executive Officer is the final approval level for participation. Individuals who become participants as a result of a job change begin participation on the first day of the month of their appointment to the new job, or on the following January 1 if the job change occurs late in the year. Participants who retire, become disabled under the Kodak Long-Term Disability Plan, or leave the company as part of an approved early separation program, receive a pro rata award at the normal time of payout based on base salary at the time of separation and financial performance at the end of the performance cycle (year-end). The estates of participants who die receive a pro rata award based on base salary at the time of death and financial performance at the end of the performance cycle (year-end). Participants who resign or are terminated for cause only receive an award if they worked until the end of a performance cycle (complete calendar year). Participants who change jobs during a performance cycle receive a pro rata award for the interval of time spent in each job. Pro rata awards are calculated using the base salary at year-end and are based on the financial performance of the full performance cycle (complete calendar year). GOAL SETTING: The Compensahon Committee, in consultation with the Chief Executive Officer, establishes in December of each year the next year's financial goals for each performance level (A-E) for: total Company, Imaging Group, Chemicals Group, and the Health Group. Financial goals are expressed in terms of revenue, earnings and cash flow. Each goal is weighted for importance in determining final awards. Within each Group, goals may be established at organizational levels below the Group. They may be financial or non-financial in nature. The Group President is responsible for approving them. There are no individual or personal goals. GOAL WEIGHTING: Goals are weighted not only by specific financial performance measure but also by organization as follows: Position Corporate Group Chief Executive Officer 100% 0 Corporate Staffs 100% 0 Group Presidents 20% 80% Corporate Officers in The Groups 10% *90% Other 0 *100% *Group President determines the weighting of these goals within the Group. AWARDS Award Pools: MAPP award pools are determined at the Group and Corporate Staffs level. An award pool is the amount of money required to pay all the participants in a Group in relation to meeting specific levels [A through E) of financial performance in that Group. For example, Imaging, Chemicals, Health and Corporate Staffs each has a target level of financial performance set by the Compensation Committee of the Board for each MAPP performance level (A through E). A corresponding award pool is determined for each performance level. The award pools are calculated based on; 1) the number of MAPP participants in the Group; 2) their grade and salary levels at year-end; and 3) their target MAPP award (15% to 40%). The award pool amounts are calculated and presented to the Compensation Committee at its February meeting, following the conclusion of the performance cycle, at which time the Committee conducts its evaluation of performance against goals. Award Determination: The Compensation Committee, in consultation with the CEO, evaluates financial performance against agreed upon goals for the corporation as a whole and for each Group. In making its evaluation, the Committee takes into consideration unanticipated influences (e.g., economic downturn) impacting the difficulty of achieving the results as well as performance relative to peer companies. Peer company comparisons may be made at the Group level and for the corporation as a whole. The Compensation Committee decides, based on the recommendation of the CEO, the appropriate peer company comparisons for each Group and the corporation as a whole. In addition, the Compensation Committee judges results in relation to its expectations for improving overall shareowner return. Extraordinary gains and losses are included in financial performance evaluation both at corporate and, where appropriate, at Group levels. Major adjustments may be considered separately at the request of the CEO. Treatment of extraordinary gains and losses is the same for MAPP as for the calculation of wage Dividend. Taking into account these various considerations, the Compensation Committee determines the performance award level for the corporation and each Group. Group Presidents and the CEO decide how the award pool amounts are distributed within the Group. The "E" performance level established for each Group is the minimum hurdle for a MAPP award. If "E" performance level at the Group is not exceeded, there is no MAPP award for any unit within the Group, regardless of that unit's performance. The "E" performance level for the corporation applies only to those participants who have their MAPP award based on corporate results. Awards are based on unit performance as follows: Eligibility Performance Unit CEO, Corporate Staffs Total Corporation Chemicals Group President, Group Chemicals Group (Eastman Chemical Company) Staff & all units Imaging Group President, Group Imaging Group Staff & all units Health Group President & Health Group Group Staff Health Sciences Division & Health Group less Sterling Winthrop and L&F Clinical Diagnostics Division The Compensation Committee approves actual MAPP award amounts for the following: Chief Executive Officer, Group Presidents, Chief Financial Officer, Senior Vice President-Legal, Senior Vice President-Human Resources and the five highest paid officers listed in the proxy, if they are different from individuals in the positions identified above. Unacceptable individual performance, as determined by management, may result in no performance award, regardless of company, Group or unit performance. Management has discretion to override the established guidelines to avoid inappropriate or inequitable results. Final approval for such an override resides at the Group President or equivalent level. The Chief Executive Officer may recommend to the Compensation Committee that no awards be paid through this plan should the company's overall financial performance warrant such action. Award Calculation: Achievement Level Award Factor A 2X B 1.5X C (Expected Performance) 1X D .5X E 0 X=Target Award % Awards are paid in April, for performance in the previous year, based on goal achievement. In the example below, the participant has three goals, one with a weighting of 50% and each of the other two weighted 25%. The weighted performance is calculated on a scale of zero (0) to 200, with C (target) equal to 100. In this way, regardless of their target award percentage (15% to 40%), the performance for all participants can be calculated using the same scale. In the example, the performance for goal 1 was 125, resulting in a weighted performance (50% times l25) of 62.5. Goal 2 performance was 94 on the 200 scale (weighted performance was 23.5 [94 times 25%]). Goal 3 performance was 116 (weighted performance was 29 [116 times 25%]). This resulted in a total weighted performance of 115. Performance Levels A B C D E 200 150 100 50 0 Goals Weight % Weighted Performance 1 50%X 125 62.5% 2 25%X 94 23.5% 3 25%X 116 29% Total = 115% In this example, consider that the participant had a year-end base salary of $90,000 and a target award of 15%. To calculate this participant's award, the Total Target Annual Compensation is calculated as described below. Then, the Target Award for the year is determined. Knowing the Target Award and the Total Weighted Performance (115% from above), the Performance Award can be calculated. Total Targeted Annual Compensation = Base Salary divided by 1 minus the Target Award %. In this example: $90,000/1-.15 = $105,882 = Total Targeted Annual Compensation Target Award = Total Targeted Annual Compensation times Target Award Percent Target Award = $105,882 X 15% = $15,882 Performance Award = Target Award times Total Weighted Performance Performance Award = $15,882 X 115.0% = $18,264 RELATIONSHIP BETWEEN MAPP AND PERFORMANCE APPRAISALS: MAPP is intended to reward participants for the achievement of a few focused financial goals. Performance appraisals and rate reviews determine an individual's base salary with consideration for overall performance relative to the expectations for the job. MAPP is financially and organizationally oriented while performance appraisals are more individually oriented. SALARY ADJUSTMENT UPON ENTRY INTO MAPP: MAPP is a variable compensation, or pay at risk, program. Participants have their base salary administered on reduced rate ranges. New participants to MAPP are immediately administered on the reduced rate range for their assigned grade. This may reduce or eliminate promotional increases, depending upon the person's pay position in the rate range for their new grade. Subsequent salary treatment will depend upon pay/performance relationships in the reduced rate range for their assigned grade. SALARY CONVERSION UPON WITHDRAWAL FROM MAPP: In unusual circumstances when it is necessary for management to remove an individual from MAPP, the following method will be used to calculate that person's new salary on the non-MAPP rate schedule: 1) Divide the individual's current salary in his or her MAPP- reduced rate range by the midpoint of that rate range, and 2) Multiply that percentage times the midpoint of the non-MAPP schedule for the same wage grade. This is the person's new salary. 3) Should the removal from MAPP involve a reduction in grade, select an appropriate rate in the new rate range based upon applicable training and experience. Exhibit (10)G As amended December 30, 1993 Effective December 31, 1993 EASTMAN KODAK COMPANY 1981 INCENTIVE STOCK OPTION PLAN 1. Purposes The purposes of this Plan are to encourage ownership of the Company's stock by eligible key employees and to provide increased incentive for such employees to put forth maximum effort for the success of the business. 2. Administration This Plan shall be administered by the Compensation Committee of the Board of Directors of the Company (the "Committee"). A member of the Committee shall not be, and shall not within one year prior to appointment to the Committee have been, eligible to participate in the Plan or any other plan of the Company or any of its affiliates entitling participants to acquire stock, stock options or stock appreciation rights of the Company or its affiliates. The Committee is authorized to establish such rules and regulations as it deems necessary for the proper administration of the Plan, and to make such determinations and interpretations and to take such action in connection with the Plan and any options granted under the Plan as it deems necessary or advisable. All determinations of the Committee shall be by a majority of its members, and its determinations shall be final. 3. Eligibility Key employees of the Company and its subsidiaries shall be eligible to receive options under the Plan. Directors of the Company who are not full-time employees of the Company or of any of its subsidiaries shall not be eligible to receive options. 4. Shares Available An aggregate of 6,075,000 shares of common stock (par value $2.50) of the Company shall be available for grant of options under the Plan (subject to adjustment as provided in paragraph 8). Such shares may be authorized and unissued shares or may be treasury shares. Upon the expiration or termination in whole or in part of any unexercised options, shares of common stock covered by such unexercised options shall be available again for new options under the Plan. 5. Grant of Options Subject to the provisions of paragraph 6, options may be granted to such eligible employees in such numbers and at such times during the term of the Plan as the Committee shall determine. Each option shall be evidenced by a duly executed written agreement by and between the Company and the optionee. Option agreements may contain dissimilar provisions provided that all such provisions are consistent with the Plan. 6. Terms and Conditions of Options All options under the Plan shall be granted subject to the following terms and conditions: (a) Option Price -- The option price per share shall be not less than 100% of its fair market value, as determined by the Committee, on the date the option is granted. (b) Maximum Value of Shares -- The aggregate fair market value (determined as of the time the option is granted) of the shares for which any eligible employee may be granted options in any calendar year (under all stock option plans of the Company and its subsidiaries) shall not exceed $100,000 plus any unused limit carryover to such year. The carryover amount from any calendar year after 1980 shall be one-half of the amount by which $100,000 exceeds the value at the time of grant of the shares for which options were granted to an eligible employee in such year. Unused amounts may be carried forward three years. Options granted in any year shall first use up the $100,000 current year limitation and then unused carryovers in the chronological order of the calendar years in which the carryovers arose. (c) Duration of Options -- Unless sooner terminated, each option shall expire not later than ten years from the date of grant. (d) Exercise of An Option -- No option may be exercised within six months of the date on which the option is granted except that any optionee whose actual retirement date shall occur during the six calendar months following the month of grant may exercise the option at any time between the date of retirement and the date of termination of the option indicated by its terms. No option may be exercised while there is outstanding any option previously granted to the optionee which has not been exercised in full or has not expired by reason of lapse of time. Options may be exercised from time to time by written notice to the Company stating the number of shares with respect to which the option is being exercised. (e) Payment -- No shares shall be issued or delivered until full payment for the shares has been made, with cash, with Company shares valued as of the date of exercise, or with a combination of both. (f) Nontransferability of Options -- An option shall not be transferable by an optionee except by will or the laws of descent and distribution and shall be exercisable, during his lifetime, only by him. (g) Termination of Employment -- Upon termination of an optionee's employment, each option previously granted to him shall expire if not exercised before the earliest of (i) the expiration date provided in the option agreement applicable to each such option; (ii) the date one year after the date of termination if employment is terminated by reason of death or disability (within the meaning of section 105(d)(4) of the Internal Revenue Code); (iii) the date three months after the date of termination if employment is terminated by reason of retirement; or (iv) the date of termination if employment is terminated for any reason other than death, disability or retirement. Anything herein to the contrary notwithstanding, optionees who cease to be employed by the Company or one of its subsidiaries and are employed by Eastman Chemical Company or one of its subsidiaries in connection with the distribution of common stock of Eastman Chemical Company to the shareholders of the Company, shall not be deemed to have terminated employment for purposes of this Plan and all options outstanding on the date of such distribution. (h) Non-Competition Provision -- Anything herein to the contrary notwithstanding, if an optionee, without the written consent of the Company, engages either directly or indirectly, in any manner or capacity, as principal, agent, partner, officer, director, employee, or otherwise, in any business or activity competitive with the business conducted by the Company or any subsidiary of the Company, each option previously granted to him shall expire forthwith. 7. Regulatory Approvals and Listing The Company shall not be required to issue any certificate or certificates for shares of common stock upon the exercise of an option prior to (a) the obtaining of any approval from any governmental agency which the Company shall, in its sole discretion, determine to be necessary or advisable, (b) the admission of such shares to listing on any stock exchange on which the stock may then be listed, and (c) the completion of any registration or other qualification of such shares under any state or Federal law or rulings or regulations of any governmental body which the Company shall, in its sole discretion, determine to be necessary or advisable. 8. Adjustment of Shares Available If there is any change in the common stock of the Company through the declaration of stock dividends, or through recapitalization resulting in stock splits, or combinations or exchanges of shares, or otherwise, the number of shares available for option and the shares subject to any option and the option prices shall be appropriately adjusted by the Committee. 9. Prohibition of Loans to Optionees Neither the Company nor any subsidiary shall directly or indirectly lend money to an optionee for the purpose of assisting him to exercise any option granted under the Plan. 10. Amendment The Board of Directors of the Company may from time to time amend the Plan in any manner which it deems in the best interest of the Company, but may not, without the approval of the Company's shareholders, adopt any amendment which would (a) materially increase the benefits accruing to participants under the Plan, (b) materially increase the maximum number of shares which may be issued under the Plan (other than pursuant to paragraph 8), or (c) materially modify the requirements as to eligibility for participation in the Plan. 11. Term The Plan shall become effective on November 13, 1981, and shall be submitted for approval by the Company's shareholders at the 1982 annual meeting. No option shall be granted pursuant to the Plan subsequent to the fifth anniversary of the effective date of the Plan. 12. Change In Control. 12.01 Background. The terms of this Paragraph 12 shall immediately become operative, without further action or consent by any person or entity, upon a Change In Control, and once operative shall supersede and control over any other provisions of this Plan. 12.02 "Change In Control" means a change in control of the Company of a nature that would be required to be reported (assuming such event has not been "previously reported") in response to Item l(a) of the Current Report of Form 8-K, as in effect on August 1, 1989, pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act') provided that, without limitation, a Change In Control shall be deemed to have occurred at such time as (i) any "person" within the meaning of Section 14(d) of the Exchange Act is or has become the "beneficial owner" as defined in Rule 13d-3 under the Exchange Act, directly or indirectly, of 25% or more of the combined voting power of the outstanding securities of the Company ordinarily having the right to vote at the election of directors ("Voting Securities"), or (ii) individuals who constitute the Board of Directors of the Company on August 1, 1989 (the "Incumbent Board") have ceased for any reason to constitute at least a majority thereof, provided that any person becoming a director subsequent to August 1, 1989 whose election, or nomination for election by the Company's stockholders, was approved by a vote of at least three-quarters (3/4) of the directors comprising the Incumbent Board (either by a specific vote or by approval of the proxy statement of the Company in which such person is named as a nominee for director without objection to such nomination) shall be, for purposes of this clause (ii), considered as though such person were a member of the Incumbent Board. 12.03 Lapse of Restrictions. Upon a Change In Control, all terms, conditions or restrictions in effect on any outstanding stock options or SARs, regardless of whether such SARs are Tandem SARs or Freestanding SARs, shall immediately lapse as of the date of the event. In addition, no other terms, conditions, or restrictions shall be imposed on any stock options or SARs on or after such date. 12.04 Vesting of Stock Options and SARs. Upon a Change In Control, all outstanding stock options and SARs shall automatically become one hundred percent (100%) vested immediately upon the occurrence of such event. 12.05 Exercise and Payment of Freestanding SARs. Upon a Change In Control, all outstanding Freestanding SARs, i.e., SARs which are granted separately from stock options, shall automatically be exercised, without further action by the Committee or any Participant, immediately upon the occurrence of such event. As a result, any Participant, whether or not he is still employed by the Company or any Subsidiary, then holding any outstanding Freestanding SARs shall be paid the value of his or her Freestanding SARs in a single lump-sum cash payment as soon as practicable, but in no event later than 90 days after the date of the Change In Control. For purposes of making this payment, the value of such Participant's Freestanding SARs shall be determined by averaging the mean between the high and low at which Kodak common stock is traded on the New York Stock Exchange on the date of the Change In Control. 12.06 Cash Surrender of Stock Options. Upon the occurrence of a Change In Control, any Participant, whether or not he is still employed by the Company or a Subsidiary, then holding any stock options shall be paid in a single lump-sum cash payment the "Change In Control Value," as that term is hereafter defined, of such stock options as soon as practicable, but in no event later than 90 days after the date of the Change In Control. Notwithstanding the foregoing, any such Participant who, on the date of the Change In Control, holds stock options that have not been outstanding for a period of at least six months from their date of grant and who on such date is required to report under Section 16 of the Exchange Act shall not be paid the "Change In Control Value" of such stock options until the first day next following the end of such six-month period. For purposes of this Paragraph 12, the "Change In Control Value" of a given stock option shall be determined by multiplying the total number of shares of common stock the Participant would then be entitled to purchase under such option (assuming the application of Paragraphs 12.03 and 12.04 hereof) by the amount resulting from subtracting the option price of such stock option from the stock value obtained by averaging the mean between the high and low at which Kodak common stock is traded on the New York Stock Exchange on the date of the Change In Control. Upon receipt of the foregoing lump-sum cash payment by a Participant, the outstanding stock options for which such payment is being made, as well as the Tandem SARs related to such stock options, shall be automatically cancelled. 12.07 Amendment on or After Change In Control. On or after a Change in Control, no action, including, but not by way of limitation, the amendment, suspension or termination of the Plan, shall be taken which would affect the rights of any Participant or the operation of this Plan with respect to any stock options or SARs to which the Participant may have become entitled hereunder on or prior to the date of such action or as a result of such Change In Control. 12.08 Paragraph 6(g). Upon a Change In Control, the terms and provisions of Paragraph 6(g) of the Plan shall become null and void and shall have no further force and effect. Exhibit (10)J As Amended December 30, 1993 Effective December 31, 1993 EASTMAN KODAK COMPANY 1985 STOCK OPTION PLAN 1. Purposes The purposes of this Plan are to encourage ownership of the Company's stock by eligible key employees and to provide increased incentive for such employees to put forth maximum effort for the success of the business. 2. Definitions. 2.01 "Board" means the Board of Directors of Eastman Kodak Company. 2.02 "Committee" means the Compensation Committee of the Board, consisting of not less than three members of the Board. A member of the Committee shall not be and shall not within one year prior to appointment to the Committee have been, eligible to be selected to participate in the Plan or any other plan of the Company or any of its affiliates entitling participants to acquire stock, stock options or stock appreciation rights of the Company or its affiliates. 2.03 "Common Stock" means Common Stock of Eastman Kodak Company. 2.04 "Company" means Eastman Kodak Company. 2.05 "Participant" means an employee of the Company or a Subsidiary to whom a grant has been made by the Committee. 2.06 "Plan" means the Eastman Kodak Company 1985 Stock Option Plan. 2.07 "Subsidiary" means a corporation or other business entity in which the Company directly or indirectly has an ownership interest of fifty percent or more. 2.08 "Change In Control" means a change in control of the Company of a nature that would be required to be reported (assuming such event has not been "previously reported") in response to Item l(a) of the Current Report of Form 8-K, as in effect on August 1, 1989, pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"); provided that, without limitation, a Change In Control shall be deemed to have occurred at such time as (i) any "person" within the meaning of Section 14(d) of the Exchange Act is or has become the "beneficial owner" as defined in Rule 13d-3 under the Exchange Act, directly or indirectly, of 25% or more of the combined voting power of the outstanding securities of the Company ordinarily having the right to vote at the election of director ("Voting Securities"), or (ii) individuals who constitute the Board of Directors of the Company on August 1, 1989 (the "Incumbent Board") have ceased for any reason to constitute at least a majority thereof, provided that any person becoming a director subsequent to August 1, 1989 whose election, or nomination for election by the Company's stockholders, was approved by a vote of at least three-quarters (3/4) of the directors comprising the Incumbent Board (either by a specific vote or by approval of the proxy statement of the Company in which such person is named as a nominee for director without objection to such nomination) shall be, for purposes of this clause (ii), considered as though such person were a member of the Incumbent Board. 3. Administration This Plan shall be administered by the Committee. The Committee is authorized to establish such rules and regulations as it deems necessary for the proper administration of the Plan, and to make such determinations and interpretations and to take such action in connection with the Plan and any options or stock appreciation rights granted under the Plan as it deems necessary or advisable. All determinations of the Committee shall be by a majority of its members, and its determinations shall be final. 4. Eligibility Key employees of the Company and its Subsidiaries shall be eligible to receive grants under the Plan. Directors of the Company or any Subsidiary who are not full-time employees of the Company or Subsidiary shall not be eligible to receive grants. 5. Shares Available An aggregate of 9,000,000 shares of common stock (par value $2.50) of the Company shall be available for grant under the Plan (subject to adjustment as provided in paragraph 10). Such shares may be authorized and unissued shares or may be treasury shares. Upon the expiration or termination in whole or in part of any unexercised grant, shares of common stock covered by such unexercised grant shall be available again for grant under the Plan. 6. Grant of Options Subject to the provisions of paragraphs 7 and 8, options may be granted to such eligible employees in such numbers, at such times during the term of the Plan, and for such durations as the Committee shall determine. These stock options may be incentive stock options within the meaning of Section 422A of the Internal Revenue Code or non-qualified stock options (i.e., stock options which are not incentive stock options), or a combination of both. Options may contain dissimilar provisions provided that all such provisions are consistent with the Plan. 7. Terms and Conditions of Grants (a) All options granted under the Plan shall be subject to the following terms and conditions: (i) Option Price -- The option price shall be not less than 100% of the fair market value of the Common Stock, as determined by the Committee, on the date of grant. (ii) Duration of Options -- Each option shall expire not later than ten years from the date of grant, unless sooner exercised or terminated in accordance with subparagraph (vi) or (vii) below. (iii) Exercise of An Option -- No option may be exercised within one year of the date on which the option is granted. One half (50%) of an option shall become exercisable on the first anniversary of the date of grant of such option and the remaining half shall become exercisable on the second anniversary of the date of grant. Notwithstanding the preceding two sentences, if any Participant dies, becomes disabled, retires or terminates employment for any approved reason, prior to the second anniversary of the date of grant of any options to him, such options may be exercised at any time between the date of the event and the date of termination of the option indicated by its terms. Options may be exercised from time to time by written notice to the Company stating the number of shares with respect to which the option is being exercised. (iv) Payment -- No shares shall be issued or delivered until full payment for the shares has been made, with cash, with Company shares valued as of the date of exercise (including shares previously acquired pursuant to the exercise of an option), or with a combination of both. (v) Nontransferability of Options -- An option shall not be transferable by a Participant except by will or the laws of descent and distribution and shall be exercisable, during his lifetime, only by him. (vi) Termination of Employment -- On the sixtieth (60th) day after termination of a Participant's employment, each option previously granted to him shall expire; provided, however, if employment is terminated by reason of death, disability, retirement or any approved reason, the option shall terminate at such time as determined by the Committee. Transfers between the Company and a Subsidiary shall not be a termination of employment. Anything herein to the contrary notwithstanding, Participants who cease to be employed by the Company or a Subsidiary and are employed by Eastman Chemical Company or one of its subsidiaries in connection with the distribution of the common stock of Eastman Chemical Company to the shareholders of the Company, shall not be deemed to have terminated employment for purposes of this Plan and all options and SARs outstanding on the date of such distribution. (vii) Non-Competitive Provision -- Notwithstanding any Plan provision, other than Paragraph 18.07 hereof, to the contrary, if a Participant, without the written consent of the Company, engages either directly or indirectly, in any manner or capacity, as principal, agent, partner, officer, director, employee, or otherwise, in any business or activity competitive with the business conducted by the Company or any Subsidiary, or performs any act or engages in any activity which, in the opinion of the Chief Executive Officer, is inimical to the best interests of the Company, either during or after employment with the Company or Subsidiary, all options previously granted to him shall expire forthwith. (b) In addition to the terms and conditions of paragraph (a) above, incentive stock options granted under the Plan shall also be subject to the following: If a Participant disposes of shares acquired pursuant to the exercise of an incentive stock option in a disqualifying disposition within the time periods identified in Section 422A(a)(l) of the Internal Revenue Code, such Participant is required to notify the Company of such disposition and provide information as to the date of disposition, sale price, quantity disposed of and any other information about such disposition which the Company may reasonably request. 8. Stock Appreciation Rights Stock appreciation rights covering shares of Common Stock ("SARs") may be granted to such eligible employees in such numbers and at such times during the term of the Plan as the Committee shall determine. An SAR may be granted in tandem with all or a portion of a related stock option under the Plan ("Tandem SARs"), or may be granted separately ("Freestanding SAR"). Tandem SARs shall be granted concurrently with the grant of the stock option. A Tandem SAR shall be exercisable only to the extent that the related stock option is exercisable, and the "exercise price" of such an SAR (the base from which the value of the SAR is measured at its exercise) shall be the option price under the related stock option. The exercise price of a Freestanding SAR shall be not less than 100% of the fair market value of the Common Stock, as determined by the Committee, on the date of grant of the Freestanding SAR. A Tandem SAR and a Freestanding SAR shall entitle the recipient to receive a payment equal to the excess of the fair market value of the shares of Common Stock covered by the SAR on the date of exercise over the exercise price of the SAR. Such payment may be made in cash or in shares of Common Stock or a combination of both, as the Committee shall determine. The Committee may cancel or place a limit on the term of, or the amount payable for, any SAR at any time. The Committee shall determine all other terms and conditions of any SAR grant. An SAR shall not be transferable by a Participant except by will or the laws of descent- and distribution and shall be exercisable, during his lifetime, only by him. Unless the Committee shall otherwise determine, to the extent a Freestanding SAR is exercisable, it will be exercised automatically for a cash settlement on its expiration date. Upon exercise of a Tandem SAR as to some or all of the shares covered by the grant, the related stock option shall be cancelled automatically to the extent of the number of shares covered by such exercise, and such shares shall no longer be available for grant under Section 5. Conversely, if the related stock option is exercised as to some or all of the shares covered by the grant, the related Tandem SAR, if any, shall be cancelled automatically to the extent of the number of shares covered by the stock option exercise. 9. Regulatory Approvals and Listing The Company shall not be required to issue any certificate or certificates for shares of Common Stock upon the exercise of an option or SAR prior to (a) the obtaining of any approval from any governmental agency which the Company shall, in its sole discretion, determine to be necessary or advisable, (b) the admission of such shares to listing on any stock exchange on which the Common Stock may then be listed, and (c) the completion of any registration or other qualification of such shares under any state or Federal law or rulings or regulations of any governmental body which the Company shall, in its sole discretion, determine to be necessary or advisable. 10. Adjustment of Shares Available If there is any change in the number of outstanding shares of Common Stock of the Company through the declaration of stock dividends, or through stock splits, the number of shares available for options and SARs and the shares subject to any option or SAR and the option prices or exercise prices shall be automatically adjusted. If there is any change in the number of outstanding shares of Common Stock of the Company through any change in the capital account of the Company or through any other transaction referred to in Section 425(a) of the Internal Revenue Code, the number of shares available for options and SARs and the shares subject to any option or SAR and the option prices or exercise prices shall be appropriately adjusted by the Committee. 11. Prohibition of Loans to Participants Neither the Company nor any Subsidiary shall directly or indirectly lend money to a Participant for the purpose of assisting him to exercise any option granted under the Plan. 12. Amendment The Board may from time to time amend the Plan in any manner which it deems in the best interest of the Company, but may not, without the approval of the Company's shareholders, adopt any amendment which would (a) materially increase the benefits accruing to participants under the Plan, (b) materially increase the maximum number of shares which may be issued under the Plan (other than pursuant to paragraph 10), or (c) materially modify the requirements as to eligibility for participation in the Plan. 13. Term The Plan shall become effective on November 8, 1985, and shall be submitted for approval by the Company's shareholders at the 1986 annual meeting. No option or SARs shall be exercisable before shareholder approval of the Plan. No option or SAR shall be granted pursuant to the Plan after December 31, 1989. 14. Rights as a Shareholder A Participant shall possess no rights as a shareholder with respect to the shares covered by an option or SAR granted to him until the issuance to the Participant of the stock certificate for the shares purchased. 15. Governing Law The Plan shall be construed and enforced in accordance with the law of New York State. 16. Taxes The Company will withhold, to the extent required by law, all applicable income and employment taxes due as a result of transactions under this Plan and the Company may require the Participant to pay to it such tax as a condition of exercise of an option or SAR. 17. No Right to Continued Employment Participation in the Plan shall not give any employee any right to remain in the employ of the Company. The Company reserves the right to terminate any Participant at any time. 18. Change In Control 18.01 Background. The terms of this Paragraph 18 shall immediately become operative, without further action or consent by any person or entity, upon a Change In Control, and once operative shall supersede and control over any other provisions of this Plan and its Administrative Guide. 18.02 Lapse of Restrictions. Upon a Change In Control, all terms, conditions or restrictions in effect on any outstanding stock options, regardless of whether such stock options are incentive stock options or non-qualified stock options, or SARs, regardless of whether such SARs are Tandem SARs or Freestanding SARs, shall immediately lapse as of the date of the event. In addition, no other terms, conditions, or restrictions shall be imposed on any stock options or SARs on or after such date. 18.03 Vesting of Stock Options and SARs. Upon a Change In Control, all outstanding stock options and SARs shall automatically become one hundred percent (100%) vested immediately upon the occurrence of such event. 18.04 Exercise and Payment of Freestanding SARs. Upon a Change In Control, all outstanding -Freestanding SARs shall automatically be exercised, without further action by the Committee or any Participant, immediately upon the occurrence of such event. As a result, any Participant, whether or not he is still employed by the Company or any Subsidiary, then holding any outstanding Freestanding SARs shall be paid the value of his or her Freestanding SARs in a single lump-sum cash payment as soon as practicable, but in no event later than 90 days after the date of the Change In Control. For purposes of making this payment, the value of such Participant's Freestanding SARs shall be determined by averaging the mean between the high and low at which Kodak common stock is traded on the New York Stock Exchange on the day of the Change In Control. 18.05 Cash Surrender of Stock Options. Upon the occurrence of a Change In Control, any Participant, whether or not he is still employed by the Company or a Subsidiary, then holding any stock options, regardless of whether they are incentive stock options or non-qualified stock options, shall be paid in a single lump-sum cash payment the "Change In Control Value," as that term is hereafter defined, of such stock options as soon as practicable, but in no event later than 90 days after the date of the Change In Control. Notwithstanding the foregoing, any such Participant who, on the date of the Change In Control, holds stock options that have not been outstanding for a period of at least six months from their date of grant and who on such date is required to report under Section 16 of the Exchange Act shall not be paid the "Change In Control Value" of such stock options until the first day next following the end of such six-month period. For purposes of this Paragraph 18, the "Change In Control Value" of a given stock option shall be determined by multiplying the total number of shares of common stock the Participant would then be entitled to purchase under such option (assuming the application of Subparagraphs 18.02 and 18.03 hereof) by the amount resulting from subtracting the option price of such stock option from the stock value obtained by averaging the mean between the high and low at which Kodak common stock is traded on the New York Stock Exchange on the date of the Change In Control. Upon receipt of the foregoing lump sum cash payment by a Participant, the outstanding stock options for which such payment is being made, as well as the Tandem SARs related to such stock options, shall be automatically cancelled. 18.06 Amendment on or After Change In Control. On or after a Change in Control, no action, including, but not by way of limitation, the amendment, suspension or termination of the Plan, shall be taken which would affect the rights of any Participant or the operation of this Plan with respect to any stock options or SARs to which the Participant may have become entitled hereunder on or prior to the date of such action or as a result of such Change In Control. 18.07 Subparagraphs 7(a)(vi) and 7(a)(vii). Upon a Change In Control, the terms and provisions of Subparagraphs 7(a)(vi) and 7(a)(vii) shall become null and void and shall have no further force and effect. Exhibit (10)L 1990 OMNIBUS LONG-TERM COMPENSATION PLAN EASTMAN KODAK COMPANY Effective December 31, 1993 1990 OMNIBUS LONG-TERM COMPENSATION PLAN December 31, 1993 Paragraph Title Page 1 Purpose 108 2 Definitions 108 3 Administration 109 4 Eligibility 110 5 Shares Available 110 6 Term 110 7 Participation 110 8 Stock Options 110 9 Stock Appreciation Rights 111 10 Stock Awards 111 11 Performance Units 112 12 Performance Shares 112 13 Payment of Awards 112 14 Dividends and Dividend Equivalents 113 15 Deferral of Awards 113 16 Termination of Employment 113 17 Nonassignability 113 18 Adjustment of Shares Availability 113 19 Withholding Taxes 114 20 Noncompetition Provision 114 21 Amendments to Awards 114 22 Regulatory Approvals and Listings 114 23 No Right to Continued Employment or Grants 114 24 Amendment 114 25 Governing Law 114 26 Change in Ownership 115 27 Change in Control 116 28 No Right, Title, or Interest in Company Assets 117 29 Gender 117 EASTMAN KODAK COMPANY 1990 OMNIBUS LONG-TERM COMPENSATION PLAN 1. Purpose The purpose of the Plan is to provide motivation to Key Employees of the Company and its subsidiaries to put forth maximum efforts toward the continued growth, profitability, and success of the Company and its Subsidiaries by providing incentives to such Key Employees through the ownership and performance of the Common Stock of the Company. Toward his objective, the Committee may grant stock options, stock appreciation rights, Stock Awards, performance units, performance shares, and/or other incentive awards to Key Employees of the Company and its Subsidiaries on the terms and subject to the conditions set forth in the Plan. 2. Definitions 2.1 "Award" means any form of stock option, stock appreciation right, Stock Award, performance unit, performance shares, or other incentive award granted under the Plan, whether singly, in combination, or in tandem, to a Participant by the Committee pursuant to such terms, conditions, restrictions and/or limitations, if any, as the Committee may establish by the Award Notice or otherwise. 2.2 "Award Notice" means a written notice from the Company to a Participant that establishes the terms, conditions, restrictions, and/or limitations applicable to an Award in addition to those established by this Plan and by the Committee's exercise of its administrative powers. 2.3 "Board" means the Board of Directors of the Company. 2.4 "Cause" means (a) the willful and continued failure by a Key Employee to substantially perform his duties with his employer after written warnings identifying the lack of substantial performance are delivered to the Key Employee by his employer to specifically identify the manner in which the employer believes that the Key Employee has not substantially performed his duties, or (b) the willful engaging by a Key Employee in illegal conduct which is materially and demonstrably injurious to the Company or a Subsidiary. 2.5 "Change In Control" means a change in control of the Company of a nature that would be required to be reported (assuming such event has not been "previously reported") in response to Item 1(a) of the Current Report on Form 8-K, as in effect on August 1, 1989, pursuant to Section 13 or 15(d) of the Exchange Act; provided that, without limitation, a Change In Control shall be deemed to have occurred at such time as (i) any "person" within the meaning of Section 14(d) of the Exchange Act, other than the Company, a subsidiary of the Company, or any employee benefit plan(s) sponsored by the Company or any subsidiary of the Company, is or has become the "beneficial owner," as defined in Rule 13d-3 under the Exchange Act, directly or indirectly, of 25% or more of the combined voting power of the outstanding securities of the Company ordinarily having the right to vote at the election of directors, or (ii) individuals who constitute the Board on February 1, 1990 (the "Incumbent Board") have ceased for any reason to constitute at least a majority thereof, provided that any person becoming a director subsequent to February 1, 1990 whose election, or nomination for election by the Company's shareholders, was approved by a vote of at least three-quarters (3/4) of the directors comprising the Incumbent Board (either by a specific vote or by approval of the proxy statement of the Company in which such person is named as a nominee for director without objection to such nomination) shall be, for purposes of this Plan, considered as though such person were a member of the Incumbent Board. 2.6 "Change In Control Price" means the highest closing price per share paid for the purchase of Common Stock on the New York Stock Exchange during the ninety (90) day period ending on the date the Change In Control occurs. 2.7 "Change In Ownership" means a Change In Control which results directly or indirectly in the Company's Common Stock ceasing to be actively traded on the New York Stock Exchange. 2.8 "Code" means the Internal Revenue Code of 1986, as amended from time to time. 2.9 "Committee" means the Compensation Committee of the Board or such other committee designated by the Board, authorized to administer the Plan under paragraph 3 hereof. The Committee shall consist of not less than three members. A member of the Committee shall not be, and shall not within one year prior to appointment to the Committee have been, eligible to be selected to participate in the Plan or any other plan of the Company or any of its affiliates entitling participants to acquire stock, stock options, or stock appreciation rights of the Company or its affiliates. 2.10 "Common Stock" means common stock of the Company. 2.11 "Company" means Eastman Kodak Company. 2.12 "Exchange Act" means the Securities and Exchange Act of 1934, as amended. 2.13 "Key Employee" means an employee of the Company or a Subsidiary who holds a position of responsibility in a managerial, administrative, or professional capacity, and whose performance, as determined by the Committee in the exercise of its sole and absolute discretion, can have a significant effect on the growth, profitability, and success of the Company. 2.14 "Participant" means any individual to whom an Award has been granted by the Committee under this Plan. 2.15 "Plan" means the Eastman Kodak Company 1990 Omnibus Long-Term Compensation Plan. 2.16 "Stock Award" means an award granted pursuant to paragraph 10 hereof in the form of shares of Common Stock, restricted shares of Common Stock, and/or Units of Common Stock. 2.17 "Subsidiary" means a corporation or other business entity in which the Company directly or indirectly has an ownership interest of 80 percent or more. 2.18 "Unit" means a bookkeeping entry used by the Company to record and account for the grant of the following Awards until such time as the Award is paid, cancelled, forfeited or terminated, as the case may be; Units of Common Stock, performance units, and performance shares which are expressed in terms of Units of Common Stock. 3. Administration The Plan shall be administered by the Committee. The Committee shall have the authority to: (a) interpret the Plan; (b) establish such rules and regulations as it deems necessary for the proper operation and administration of the Plan; (c) select Key Employees to receive Awards under the Plan; (d) determine the form of an Award, whether a stock option, stock appreciation right, Stock Award, performance unit, performance share, or other incentive award established by the Committee in accordance with (h) below, the number of shares or Units subject to the Award, all the terms, conditions, restrictions and/or limitations, if any, of an Award, including the time and conditions of exercise or vesting, and the terms of any Award Notice; (e) determine whether Awards should be granted singly, in combination or in tandem; (f) grant waivers of Plan terms, conditions, restrictions, and limitations; (g) accelerate the vesting, exercise, or payment of an Award or the performance period of an Award when such action or actions would be in the best interest of the Company; (h) establish such other types of Awards, besides those specifically enumerated in paragraph 2.1 hereof, which the Committee determines are consistent with the Plan's purpose; and (i) take any and all other action it deems necessary or advisable for the proper operation or administration of the Plan. In addition, in order to enable Key Employees who are foreign nationals or are employed outside the United States or both to receive Awards under the Plan, the Committee may adopt such amendments, procedures, regulations, subplans and the like as are necessary or advisable, in the opinion of the Committee, to effectuate the purposes of the Plan. The Committee shall also have the authority to grant Awards in replacement of Awards previously granted under this Plan or any other executive compensation plan of the Company or a Subsidiary. All determinations of the Committee shall be made by a majority of its members, and its determinations shall be final, binding and conclusive. The Committee, in its discretion, may delegate its authority and duties under the Plan to the Chief Executive Officer and/or to other senior officers of the Company under such conditions and/or limitations as the Committee may establish; provided, however, that only the Committee may select and grant Awards to Participants who are subject to Section 16 of the Exchange Act. 4. Eligibility Any Key Employee is eligible to become a Participant of the Plan. In addition, any individual who on the effective date of the Plan is both (i) a former Key Employee of the Company or a Subsidiary, and (ii) a participant under the Eastman Kodak Company 1985 Long-Term Performance Award Plan (the "1985 Plan"), shall be eligible to become a Participant of the Plan. However, the participation of any such individual under the Plan shall be limited solely to receiving Awards granted by the Committee under this Plan in replacement of any unpaid or unearned award under the 1985 Plan on the effective date of the Plan. 5. Shares Available The maximum number of shares of Common Stock, $2.50 par value per share, of the Company which shall be available for grant of Awards under the Plan (including incentive stock options) during its term shall not exceed 16,000,000. (Such amount shall be subject to adjustment as provided in paragraph 18.) Any shares of Common Stock related to Awards which terminate by expiration, forfeiture, cancellation or otherwise without the issuance of such shares, are settled in cash in lieu of Common Stock, or are exchanged with the Committee's permission for Awards not involving Common Stock, shall be available again for grant under the Plan. Further, any shares of Common Stock which are used by a Participant for the full or partial payment to the Company of the purchase price of shares of Common Stock upon exercise of a stock option, or for any withholding taxes due as a result of such exercise, shall again be available for Awards under the Plan. Similarly, shares of Common Stock with respect to which an SAR has been exercised and paid in cash shall again be available for grant under the Plan. The shares of Common Stock available for issuance under the Plan may be authorized and unissued shares or treasury shares. 6. Term The Plan shall become effective as of February 1, 1990, subject to its approval by the Company's shareholders at the 1990 annual meeting. No awards shall be exercisable or payable before approval of the Plan has been obtained from the Company's shareholders. Awards shall not be granted pursuant to the Plan after January 31, 1995. 7. Participation The Committee shall select, from time to time, Participants from those Key Employees who, in the opinion of the Committee, can further the Plan's purposes. Once a Participant is so selected, the Committee shall determine the type or types of Awards to be made to the Participant and shall establish in the related Award Notices the terms, conditions, restrictions and/or limitations, if any, applicable to the Awards in addition to those set forth in this Plan and the administrative rules and regulations issued by the Committee. 8. Stock Options (a) Grants. Awards may be granted in the form of stock options. These stock options may be incentive stock options within the meaning of Section 422A of the Code or non-qualified stock options (i.e., stock options which are not incentive stock options), or a combination of both. (b) Terms and Conditions of Options. An option shall be exercisable in whole or in such installments and at such times as may be determined by the Committee. The price at which Common Stock may be purchased upon exercise of a stock option shall be established by the Committee, but such price shall not be less than 50 percent of the fair market value of the Common Stock, as determined by the Committee, on the date of the stock option's grant. (c) Restrictions Relating to Incentive Stock Options. Stock options issued in the form of incentive stock options shall, in addition to being subject to all applicable terms, conditions, restrictions and/or limitations established by the Committee, comply with Section 422A of the Code. Accordingly, the aggregate fair market value (determined at the time the option was granted) of the Common Stock with respect to which incentive stock options are exercisable for the first time by a Participant during any calendar year (under this Plan or any other plan of the Company or any of its Subsidiaries) shall not exceed $100,000 (or such other limit as may be required by the Code). Further, the per-share option price of an incentive stock option shall not be less than 100 percent of the fair market value of the Common Stock, as determined by the Committee, on the date of grant. Also, each option shall expire not later than ten years from its date of grant. The number of shares of Common Stock that shall be available for incentive stock options granted under the Plan is 16,000,000. (d) Additional Terms and Conditions. The Committee may, by way of the Award Notice or otherwise, establish such other terms, conditions, restrictions and/or limitations, if any, of any stock option Award, provided they are not inconsistent with the Plan. (e) Exercise. Upon exercise, the option price of a stock option may be paid in cash, shares of Common Stock, shares of restricted Common Stock, a combination of the foregoing, or such other consideration as the Committee may deem appropriate. The Committee shall establish appropriate methods for accepting Common Stock, whether restricted or unrestricted, and may impose such conditions as it deems appropriate on the use of such Common Stock to exercise a stock option. 9. Stock Appreciation Rights ` (a) Grants. Awards may be granted in the form of stock appreciation rights ("SARs"). An SAR may be granted in tandem with all or a portion of a related stock option under the Plan ("Tandem SARs"), or may be granted separately ("Freestanding SARs"). A Tandem SAR may be granted either at the time of the grant of the related stock option or at any time thereafter during the term of the stock option. SARs shall entitle the recipient to receive a payment equal to the appreciation in market value of a stated number of shares of Common Stock from the exercise price to the market value on the date of exercise. In the case of SARs granted in tandem with stock options granted prior to the grant of such SARs, the appreciation in value is from the option price of such related stock option to the market value on the date of exercise. (b) Terms and Conditions of Tandem SARs. A Tandem SAR shall be exercisable to the extent, and only to the extent, that the related stock option is exercisable, and the "exercise price" of such an SAR (the base from which the value of the SAR is measured at its exercise) shall be the option price under the related stock option. However, at no time shall a Tandem SAR be issued if the option price of its related stock option is less than 50 percent of the fair market value of the Common Stock, as determined by the Committee, on the date of the Tandem SAR's grant. If a related stock option is exercised as to some or all of the shares covered by the Award, the related Tandem SAR, if any, shall be cancelled automatically to the extent of the number of shares covered by the stock option exercise. Upon exercise of a Tandem SAR as to some or all of the shares covered by the Award, the related stock option shall be cancelled automatically to the extent of the number of shares covered by such exercise, and such shares shall again be eligible for grant in accordance with paragraph 5 hereof, except to the extent any shares of Common Stock are issued to settle the SAR. (c) Terms and Conditions of Freestanding SARs. Freestanding SARs shall be exercisable in whole or in such installments and at such times as may be determined by the Committee. The exercise price of a Freestanding SAR shall also be determined by the Committee; provided, however, that such price shall not be less than 50 percent of the fair market value of the Common Stock, as determined by the Committee, on the date of the Freestanding SAR's grant. (d) Deemed Exercise. The Committee may provide that an SAR shall be deemed to be exercised at the close of business on the scheduled expiration date of such SAR if at such time the SAR by its terms remains exercisable and, if so exercised, would result in a payment to the holder of such SAR. (e) Additional Terms and Conditions. The Committee may, by way of the Award Notice or otherwise, determine such other terms, conditions, restrictions and/or limitations, if any, of any SAR Award, provided they are not inconsistent with the Plan. 10. Stock Awards (a) Grants. Awards may be granted in the form of Stock Awards. Stock Awards shall be awarded in such numbers and at such times during the term of the Plan as the Committee shall determine. (b) Award Restrictions. Stock Awards shall be subject to such terms, conditions, restrictions, and/or limitations, if any, as the Committee deems appropriate including, but not by way of limitation, restrictions on transferability and continued employment. The Committee may modify or accelerate the delivery of a Stock Award under such circumstances as it deems appropriate. (c) Rights as Shareholders. During the period in which any restricted shares of Common Stock are subject to the restrictions imposed under paragraph 10(b), the Committee may, in its discretion, grant to the Participant to whom such restricted shares have been awarded all or any of the rights of a shareholder with respect to such shares, including, but not by way of limitation, the right to vote such shares and to receive dividends. (d) Evidence of Award. Any stock award granted under the Plan may be evidenced in such manner as the Committee deems appropriate, including, without limitation, book-entry registration or issuance of a stock certificate or certificates. 11. Performance Units (a) Grants. Awards may be granted in the form of performance units. Performance units, as that term is used in this Plan, shall refer to Units valued by reference to designated criteria established by the Committee, other than Common Stock. (b) Performance Criteria. Performance units shall be contingent on the attainment during a performance period of certain performance objectives. The length of the performance period, the performance objectives to be achieved during the performance period, and the measure of whether and to what degree such objectives have been attained shall be conclusively determined by the Committee in the exercise of its absolute discretion. Performance objectives may be revised by the Committee, at such times as it deems appropriate during the performance period, in order to take into consideration any unforeseen events or changes in circumstances. (c) Additional Terms and Conditions. The Committee may, by way of the Award Notice or otherwise, determine such other terms, conditions, restrictions, and/or limitations, if any, of any Award of performance units, provided they are not inconsistent with the Plan. 12. Performance Shares (a) Grants. Awards may be granted in the form of performance shares. Performance shares, as that term is used in this Plan, shall refer to shares of Common Stock or Units which are expressed in terms of Common Stock. (b) Performance Criteria. Performance shares shall be contingent upon the attainment during a performance period of certain performance objectives. The length of the performance period, the performance objectives to be achieved during the performance period, and the measure of whether and to what degree such objectives have been attained shall be conclusively determined by the Committee in the exercise of its absolute discretion. Performance objectives may be revised by the Committee, at such times as it deems appropriate during the performance period, in order to take into consideration any unforeseen events or changes in circumstances. (c) Additional Terms and Conditions. The Committee may, by way of the Award Notice or otherwise, determine such other terms, conditions, restrictions and/or limitations, if any, of any Award of performance shares, provided they are not inconsistent with the Plan. 13. Payment of Awards At the discretion of the Committee, payment of Awards may be made in cash, Common Stock, a combination of cash and Common Stock, or any other form of property as the Committee shall determine. In addition, payment of Awards may include such terms, conditions, restrictions and/or limitations, if any, as the Committee deems appropriate, including, in the case of Awards paid in the form of Common Stock, restrictions on transfer and forfeiture provisions. Further, payment of Awards may be made in the form of a lump sum or installments, as determined by the Committee. 14. Dividends and Dividend Equivalents If an Award is granted in the form of a Stock Award, stock option, or performance share, or in the form of any other stock-based grant, the Committee may choose, at the time of the grant of the Award or any time thereafter up to the time of the Award's payment, to include as part of such Award an entitlement to receive dividends or dividend equivalents, subject to such terms, conditions, restrictions and/or limitations, if any, as the Committee may establish. Dividends and dividend equivalents shall be paid in such form and manner (i.e., lump sum or installments), and at such time as the Committee shall determine. All dividends or dividend equivalents which are not paid currently may, at the Committee's discretion, accrue interest, be reinvested into additional shares of Common Stock or, in the case of dividends or dividend equivalents credited in connection with performance shares, be credited as additional performance shares and paid to the Participant if and when, and to the extent that, payment is made pursuant to such Award. 15. Deferral of Awards At the discretion of the Committee, payment of a Stock Award, performance share, performance unit, dividend, dividend equivalent, or any portion thereof may be deferred by a Participant until such time as the Committee may establish. All such deferrals shall be accomplished by the delivery of a written, irrevocable election by the Participant prior to the time such payment would otherwise be made, on a form provided by the Company. Further, all deferrals shall be made in accordance with administrative guidelines established by the Committee to ensure that such deferrals comply with all applicable requirements of the Code and its regulations. Deferred payments shall be paid in a lump sum or installments, as determined by the Committee. The Committee may also credit interest, at such rates to be determined by the Committee, on cash payments that are deferred and credit dividends or dividend equivalents on deferred payments denominated in the form of Common Stock. 16. Termination of Employment If a Participant's employment with the Company or a Subsidiary terminates for a reason other than death, disability, retirement, or any approved reason, all unexercised, unearned, and/or unpaid Awards, including, but not by way of limitation, Awards earned but not yet paid, all unpaid dividends and dividend equivalents, and all interest accrued on the foregoing shall be cancelled or forfeited, as the case may be, unless the Participant's Award Notice provides otherwise. The Committee shall have the authority to promulgate rules and regulations to (i) determine what events constitute disability, retirement, or termination for an approved reason for purposes of the Plan, and (ii) determine the treatment of a Participant under the Plan in the event of his death, disability, retirement or termination for an approved reason. Anything herein to the contrary notwithstanding, Participants who cease to be employed by the Company or a Subsidiary and are employed by Eastman Chemical Company or one of its subsidiaries in connection with the distribution of the common stock of Eastman Chemical Company to the shareholders of the Company, shall not be deemed to have terminated employment for purposes of this Plan and all Awards outstanding on the date of such distribution. 17. Nonassignability No Awards or any other payment under the Plan shall be subject in any manner to alienation, anticipation, sale, transfer (except by will or the laws of descent and distribution), assignment, pledge, or encumbrance, nor shall any Award be payable to or exercisable by anyone other than the Participant to whom it was granted. 18. Adjustment of Shares Available If there is any change in the number of outstanding shares of Common Stock through the declaration of stock dividends, stock splits or the like, the number of shares available for Awards, the shares subject to any Award and the option prices or exercise prices of Awards shall be automatically adjusted. If there is any change in the number of outstanding shares of Common Stock through any change in the capital account of the Company, or through any other transaction referred to in Section 425(a) of the Code, the Committee shall make appropriate adjustments in the maximum number of shares of Common Stock which may be issued under the Plan and any adjustments and/or modifications to outstanding Awards as it deems appropriate. In the event of any other change in the capital structure or in the Common Stock of the Company, the Committee shall also be authorized to make such appropriate adjustments in the maximum number of shares of Common Stock available for issuance under the Plan and any adjustments and/or modifications to outstanding Awards as it deems appropriate. 19. Withholding Taxes The Company shall be entitled to deduct from any payment under the Plan, regardless of the form of such payment, the amount of all applicable income and employment taxes required by law to be withheld with respect to such payment or may require the Participant to pay to it such tax prior to and as a condition of the making of such payment. In accordance with any applicable administrative guidelines it establishes, the Committee may allow a Participant to pay the amount of taxes required by law to be withheld from an Award by withholding from any payment of Common Stock due as a result of such Award, or by permitting the Participant to deliver to the Company, shares of Common Stock having a fair market value, as determined by the Committee, equal to the amount of such required withholding taxes. 20. Noncompetition Provision Unless the Award Notice specifies otherwise, a Participant shall forfeit all unexercised, unearned, and/or unpaid Awards, including, but not by way of limitation, Awards earned but not yet paid, all unpaid dividends and dividend equivalents, and all interest, if any, accrued on the foregoing if, (i) in the opinion of the Committee, the Participant, without the written consent of the Company, engages directly or indirectly in any manner or capacity as principal, agent, partner, officer, director, employee, or otherwise, in any business or activity competitive with the business conducted by the Company or any Subsidiary; or (ii) the Participant performs any act or engages in any activity which in the opinion of the Chief Executive Officer of the Company is inimical to the best interests of the Company. In addition, the Committee may, in its discretion, condition the deferral of any Award, dividend, or dividend equivalent under paragraph 15 hereof on a Participant's compliance with the terms of this paragraph 20, and cause such a Participant to forfeit any payment which is so deferred if the Participant fails to comply with the terms hereof. 21. Amendments to Awards The Committee may at any time unilaterally amend any unexercised, unearned, or unpaid Award, including, but not by way of limitation, Awards earned but not yet paid, to the extent it deems appropriate; provided, however, that any such amendment which, in the opinion of the Committee, is adverse to the Participant shall require the Participant's consent. 22. Regulatory Approvals and Listings Notwithstanding anything contained in this Plan to the contrary, the Company shall have no obligation to issue or deliver certificates of Common Stock evidencing Stock Awards or any other Award resulting in the payment of Common Stock prior to (a) the obtaining of any approval from any governmental agency which the Company shall, in its sole discretion, determine to be necessary or advisable, (b) the admission of such shares to listing on the stock exchange on which the Common Stock may be listed, and (c) the completion of any registration or other qualification of said shares under any state or federal law or ruling of any governmental body which the Company shall, in its sole discretion, determine to be necessary or advisable. 23. No Right to Continued Employment or Grants Participation in the Plan shall not give any Key Employee any right to remain in the employ of the Company or any Subsidiary. The Company or, in the case of employment with a Subsidiary, the Subsidiary, reserves the right to terminate any Key Employee at any time. Further, the adoption of this Plan shall not be deemed to give any Key Employee or any other individual any right to be selected as a Participant or to be granted an Award. 24. Amendment The Benefit Plans Committee of the Company may suspend or terminate the Plan at any time. In addition, the Benefit Plans Committee of the Company may, from time to time, amend the Plan in any manner, but may not without shareholder approval adopt any amendment which would (a) materially increase the benefits accruing to Participants under the Plan, (b) materially increase the number of shares of Common Stock which may be issued under the Plan (except as specified in paragraph 18), or (c) materially modify the requirements as to eligibility for participation in the Plan. 25. Governing Law The Plan shall be governed by and construed in accordance with the laws of the State of New York, except as superseded by applicable Federal Law. 26. Change In Ownership (a) Background. Upon a Change In Ownership: (i) the terms of this paragraph 26 shall immediately become operative, without further action or consent by any person or entity; (ii) all terms, conditions, restrictions, and limitations in effect on any unexercised, unearned, unpaid, and/or deferred Award, or any other outstanding Award, shall immediately lapse as of the date of such event; (iii) no other terms, conditions, restrictions and/or limitations shall be imposed upon any Awards on or after such date, and in no circumstance shall an Award be forfeited on or after such date; (iv) all unexercised, unvested, unearned, and/or unpaid Awards or any other outstanding Awards shall automatically become one hundred percent (100%) vested immediately. (b) Dividends and Dividend Equivalents. Upon a Change In Ownership, all unpaid dividends and dividend equivalents and all interest accrued thereon, if any, shall be treated and paid under this paragraph 26 in the identical manner and time as the Award under which such dividends or dividend equivalents have been credited. For example, if upon a Change In Ownership, an Award under this paragraph 26 is to be paid in a prorated fashion, all unpaid dividends and dividend equivalents with respect to such Award shall be paid according to the same formula used to determine the amount of such prorated Award. (c) Treatment of Performance Units and Performance Shares. If a Change In Ownership occurs during the term of one or more performance periods for which the Committee has granted performance units and/or performance shares (hereinafter a "current performance period"), the term of each such performance period shall immediately terminate upon the occurrence of such event. Upon a Change In Ownership, for each "current performance period" and each completed performance period for which the Committee has not on or before such date made a determination as to whether and to what degree the performance objectives for such period have been attained (hereinafter a "completed performance period"), it shall be assumed that the performance objectives have been attained at a level of one hundred percent (100%) or the equivalent thereof. A Participant in one or more "current performance periods" shall be considered to have earned and, therefore, be entitled to receive, a prorated portion of the Awards previously granted to him for each such performance period. Such prorated portion shall be determined by multiplying the number of performance shares or performance units, as the case may be, granted to the Participant by a fraction, the numerator of which is the total number of whole and partial years (with each partial year being treated as a whole year) that have elapsed since the beginning of the performance period, and the denominator of which is the total number of years in such performance period. A Participant in one or more "completed performance periods" shall be considered to have earned and, therefore, be entitled to receive all the performance shares or performance units, as the case may be, previously granted to him during each such performance period. (d) Valuation of Awards. Upon a Change In Ownership, all outstanding Units of Common Stock, Freestanding SARs, stock options (including incentive stock options), and performance shares (including those earned as a result of the application of paragraph 26(c) above) and all other outstanding stock-based Awards, including those granted by the Committee pursuant to its authority under paragraph 3(h) hereof, shall be valued and cashed out on the basis of the Change In Control Price. (e) Payment of Awards. Upon a Change In Ownership, any Participant, whether or not he is still employed by the Company or a Subsidiary, shall be paid, in a single lump- sum cash payment, as soon as practicable but in no event later than 90 days after the Change In Ownership, all of his outstanding Units of Common Stock, Freestanding SARs, stock options (including incentive stock options), performance units (including those earned as a result of the application of paragraph 26(c) above), and performance shares (including those earned as a result of paragraph 26(c) above), and all other outstanding Awards, including those granted by the Committee pursuant to its authority under paragraph 3(h) hereof. (f) Deferred Awards. Upon a Change In Ownership, all Awards deferred by a Participant under paragraph 15 hereof, but for which he has not received payment as of such date, shall be paid to him in a single lump-sum cash payment as soon as practicable, but in no event later than 90 days after the Change In Ownership. For purposes of making such payment, the value of all Awards which are stock based shall be determined by the Change In Control Price. (g) Section 16 of Exchange Act. Notwithstanding anything contained in this paragraph 26 to the contrary, any Participant who, on the date of the Change In Ownership, holds any stock options or Freestanding SARs that have not been outstanding for a period of at least six months from their date of grant and who on such date is required to report under Section 16 of the Exchange Act shall not be paid such Award until the first day next following the end of such six-month period. (h) Miscellaneous. Upon a Change In Ownership, (i) the provisions of paragraphs 16, 20 and 21 hereof shall become null and void and of no further force and effect; and (ii) no action, including, but not by way of limitation, the amendment, suspension, or termination of the Plan, shall be taken which would affect the rights of any Participant or the operation of the Plan with respect to any Award to which the Participant may have become entitled hereunder on or prior to the date of such action or as a result of such Change In Ownership. 27. Change In Control. (a) Background. All Participants shall be eligible for the treatment afforded by this Paragraph 27 if their employment terminates within two years following a Change In Control, unless the termination is due to (i) death, (ii) disability entitling the Participant to benefits under his employer's long-term disability plan, (iii) Cause, (iv) resignation other than (A) resignation from a declined reassignment to a job that is not reasonably equivalent in responsibility or compensation (as defined in the Company's Termination Allowance Plan), or that is not in the same geographic area (as defined in the Company's Termination Allowance Plan), or (B) resignation within thirty days following a reduction in base pay, or (v) retirement entitling the Participant to benefits under his employer's retirement plan. (b) Vesting and Lapse of Restrictions. If a Participant is eligible for treatment under this paragraph 27, (i) all of the terms, conditions, restrictions, and limitations in effect on any of his unexercised, unearned, unpaid and/or deferred Awards shall immediately lapse as of the date of his termination of employment; (ii) no other terms, conditions, restrictions and/or limitations shall be imposed upon any of his Awards on or after such date, and in no event shall any of his Awards be forfeited on or after such date; and (iii) all of his unexercised, unvested, unearned and/or unpaid Awards shall automatically become one hundred percent (100%) vested immediately upon his termination of employment. (c) Dividends and Dividend Equivalents. If a Participant is eligible for treatment under this paragraph 27, all of his unpaid dividends and dividend equivalents and all interest accrued thereon, if any, shall be treated and paid under this Paragraph 27 in the identical manner and time as the Award under which such dividends or dividend equivalents have been credited. (d) Treatment of Performance Units and Performance Shares. If a Participant holding either performance units or performance shares is terminated under the conditions described in (a) above, the provisions of this paragraph (d) shall determine the manner in which such performance units and/or performance shares shall be paid to him. For purposes of making such payment, each "current performance period," as that term is defined in paragraph 26(c) hereof, shall be treated as terminating upon the date of the Participant's termination of employment, and for each such "current performance period" and each "completed performance period," as that term is defined in paragraph 26(c) hereof, it shall be assumed that the performance objectives have been attained at a level of one hundred percent (100%) or the equivalent thereof. If the Participant is participating in one or more "current performance periods," he shall be considered to have earned and, therefore, be entitled to receive that prorated portion of the Awards previously granted to him for each such performance period, as determined in accordance with the formula established in paragraph 26(c) hereof. A Participant in one or more "completed performance periods" shall be considered to have earned and, therefore, be entitled to receive all the performance shares and performance units previously granted to him during each performance period. (e) Valuation of Awards. If a Participant is eligible for treatment under this paragraph 27, his Awards shall be valued and cashed out in accordance with the provisions of paragraph 26(d) hereof. (f) Payment of Awards. If a Participant is eligible for treatment under this paragraph 27, he shall be paid, in a single lump-sum cash payment, as soon as practicable but in no event later than 90 days after the date of his termination of employment, all of his outstanding Units of Common Stock, Freestanding SARs, stock options (including incentive stock options), performance units (including those earned as a result of the application of paragraph 27(d) above), and performance shares (including those earned as a result of paragraph 27(d) above), and all of his other outstanding Awards, including those granted by the Committee pursuant to its authority under paragraph 3(h) hereof. (g) Deferred Awards. If a Participant is eligible for treatment under this paragraph 27, all of his deferred Awards for which he has not received payment as of the date of his termination of employment shall be paid to him in a single lump-sum cash payment as soon as practicable, but in no event later than 90 days after the date of his termination. For purposes of making such payment, the value of all Awards which are stock based shall be determined by the Change In Control Price. (h) Section 16 of Exchange Act. Notwithstanding anything contained in this paragraph 27 to the contrary, any Participant who, on the date of his termination of employment under the conditions described in subparagraph (a) above, holds any stock options or Freestanding SARs that have not been outstanding for a period of at least six months from their date of grant and who on the date of such termination is required to report under Section 16 of the Exchange Act shall not be paid such Award until the first day next following the end of such six-month period. (i) Miscellaneous. Upon a Change In Control, (i) the provisions of paragraphs 16, 20 and 21 hereof shall become null and void and of no force and effect insofar as they apply to a Participant who has been terminated under the conditions described in (a) above; and (ii) no action, including, but not by way of limitation, the amendment, suspension or termination of the Plan, shall be taken which would affect the rights of any Participant or the operation of the Plan with respect to any Award to which the Participant may have become entitled hereunder on or prior to the date of the Change In Control or to which he may become entitled as a result of such Change In Control. (j) Legal Fees. The Company shall pay all legal fees and related expenses incurred by a Participant in seeking to obtain or enforce any payment, benefit or right he may be entitled to under the Plan after a Change In Control; provided, however, the Participant shall be required to repay any such amounts to the Company to the extent a court of competent jurisdiction issues a final and non- appealable order setting forth the determination that the position taken by the Participant was frivolous or advanced in bad faith. 28. No Right, Title, or Interest in Company Assets No Participant shall have any rights as a shareholder as a result of participation in the Plan until the date of issuance of a stock certificate in his name, and, in the case of restricted shares of Common Stock, such rights are granted to the Participant under paragraph 10(c) hereof. To the extent any person acquires a right to receive payments from the Company under this Plan, such rights shall be no greater than the rights of an unsecured creditor of the Company. 29. Gender Throughout this Plan, the masculine gender shall include the feminine. Exhibit (10)Q September 3, 1993 TO: Wilbur J. Prezzano Dear Bill: This letter will constitute an Agreement between Eastman Kodak Company (Kodak) and yourself. Once signed by both parties, this Agreement will be deemed effective as of October 1, 1993 and will continue in effect until either (i) September 30, 1995 or (ii) the date your employment by Kodak terminates pursuant to the terms of this Agreement, whichever occurs first. This Agreement supersedes, in all respects, any prior written or oral special separation, termination or retirement enhancement agreement between you and Kodak and specifically the agreement dated July 20, 1992. The purpose of this Agreement is to encourage you to remain employed by Kodak, particularly during the period of time when Kodak's Board of Directors will be selecting a new Chairman and Chief Executive Officer (CEO) and allowing time for that individual to become familiar with Kodak, its employees and its future course. Your continued efforts and enthusiastic cooperation during this period will be important to a successful transition. Although your employment with Kodak may be terminated at any time, for any or no reason, if your employment is terminated during the term of this Agreement either (i) by Kodak other than for "Cause," or (ii) by you for "Good Reason," you will be eligible to receive either of the benefits described in Subparagraphs A and B below, depending upon whether you are "retirement eligible" at the time of your termination. If you receive either of the benefits described in Subparagraphs A or B below, you will be eligible for the benefit described in Subparagraph C below. A. Retirement Eliqible. If you are "retirement eligible" under the terms of the Kodak Retirement Income Plan ("KRIP") at the time of your termination and elect to retire under KRIP at such time, you will receive an "unreduced retirement income benefit." For purposes of this Agreement, an "unreduced retirement income benefit" shall consist of the annual rate of retirement income benefit determined according to the formula in Section 4.02 of KRIP without taking into account the provisions of Article 5 of KRIP for early retirement. The unreduced retirement income benefit will be paid from, and under the terms of, KRIP, its supplements and this Agreement. You may elect to receive the difference in benefits, if any, between the "unreduced retirement income benefit" and the retirement income benefit you would otherwise receive under KRIP and its Supplements if this Agreement were not in effect (such difference hereafter being referred to as the "Delta") in any form permitted under Article 11 of KRIP. Once you elect the form of payment in which to receive the Delta, the provisions of such Article 11 relating to such form of payment shall be used to determine the amount of your payment(s). It is not necessary, however, that you elect to receive the Delta in the same form as your retirement income benefit is paid under KRIP. B. Not Retirement Eligible. In the event you are not "retirement eligible" under KRIP at the time of your termination of employment, you will receive a gross payment equal to eighteen (18) months of compensation calculated at your Total Target Annual Compensation using your salary and target annual incentive award as of the date of your termination. You may receive this amount in a lump sum payable within forty-five (45) days after the date of termination or in annual installments the first to be paid within forty-five (45) days after the date of termination and the remainder to be paid on each anniversary of the date of termination over a period of years not to exceed five (5) years. C. Severance Benefits. If (i) your termination does not entitle you to a Termination Allowance Benefit under the Termination Allowance Plan ("TAP"), and (ii) you receive either of the benefits described in Subparagraph A or B above, you will receive a severance benefit equal in amount to the Termination Allowance Benefit you would have received if you qualified for such a benefit. You may receive such severance benefit in any of the forms permitted under the terms of TAP. Any amount payable under Subparagraph A, B or C above shall be unfunded and your rights or the rights of your estate to receive any such payment shall be an unsecured claim against the general assets of Kodak. Regardless of the form in which you elect to receive such amounts, they will not be grossed up or be given any other special tax treatment by Kodak and Kodak shall be entitled to deduct from any and all such payments all applicable income, payroll and employment taxes required by law to be withheld. To the extent this Agreement constitutes an "employee benefit plan" under Section 3 (3) of the Employee Retirement Income Security Act of 1974 ("ERISA"), the Kodak Director of Benefits shall be the plan administrator of the plan. The plan administrator shall have total and exclusive responsibility to control, operate, manage and administer the plan in accordance with its terms and all the authority that may be necessary or helpful to enable him/her to discharge his/her responsibilities with respect to the plan. Without limiting the generality of the preceding sentence, the plan administrator shall have the exclusive right: to interpret the plan, to decide all questions concerning eligibility for and the amount of benefits payable under the plan, to construe any ambiguous provision of the plan, to correct any default, to supply any omission, to reconcile any inconsistency, and to decide any and all questions arising in the administration, interpretation, and application of the plan. The plan administrator shall have full discretionary authority in all matters related to the discharge of his/her responsibilities and the exercise of his/her authority under the plan including, without limitation, his/her construction of the terms of the plan and his/her determination of eligibility for benefits under the plan. It is the intent of plan, as well as both parties hereto, that the decisions of the plan administrator and his/her action with respect to the plan shall be final and binding upon all persons having or claiming to have any right or interest in or under the plan and that no such decision or action shall be modified upon judicial review unless such decision or action is proven to be arbitrary or capricious. Termination for "Cause" shall mean (i) termination due to your willful and continued failure substantially to perform your duties, other than failure due to illness, (ii) termination for gross misconduct injurious to Kodak, or (iii) your failure to fully support and cooperate in the transition to the new CEO in the manner decided upon by, and in the sole discretion of, Kodak. In the event that you should die or become permanently disabled during the term of this Agreement, all obligations under this Agreement shall be terminated, except as to salary or benefits earned or accrued prior to the date of death or termination by reason of permanent disability. For purposes of this Agreement "Good Reason" shall mean the occurrence of any of the following without your consent: (a) the assignment to you of demonstrably onerous or significantly demeaning on-going duties inconsistent with your status, duties or responsibilities as of the date this Agreement become effective; (b) your reassignment to a position that is not reasonably commensurate with your abilities, experience and employment history within Kodak; or (c) a reduction in your base salary and commensurate annual incentive award opportunity below the base salary you were receiving on the date this Agreement becomes effective if that reduction is not offset by some different form of compensation, such as, but not limited to, a bonus, stock, or dividend payment. Recognizing that there may be disagreement with respect to the interpretation of (a) or (b) above, If you believe that either, or both (a) or (b) has been violated you should first request the CEO to review the circumstances and make a determination. The CEO may designate someone else to act in his/her stead. This request should be made within thirty (30) calendar days after you become aware of the facts and circumstances that give rise to your concern. In conducting such a review the CEO, or his/her designee, may consult with others to assist in making an informed decision. The decision shall be made known to you within thirty (30) calendar days after the issue is presented to the CEO. In the event you do not agree with that decision, you may ask the Kodak Senior Vice President for Human Resources, within thirty (30) calendar days after the CEO's, or his/her designee's decision, to arrange for a mediator, acceptable to both you and Kodak to assist in the resolution of the issue. The mediator shall be selected by alternate striking of names from a list of seven (7) to be provided by either the American Arbitration Association or the Federal Mediation and Conciliation Service, the choice of agency to be at the discretion of the Senior Vice President for Human Resources, until one name remains who will be the mediator. The fees and expenses of the mediator will be shared equally by you and Kodak. The mediator will assist the parties in an effort to reach a mutually satisfactory resolution but will have no authority to issue a binding decision. Such efforts by the mediator shall be treated as private and confidential and no releases shall be made to anyone by any party to, or participant in, such proceedings. The selection and activity of the mediator must be completed within sixty (60) calendar days after notification to the Senior Vice President for Human Resources. If that mediation effort does not result in a satisfactory resolution, you may commence an action in court. It is recognized that in such a court proceeding, proprietary or trade secret information of Kodak may be revealed to the court. The parties hereby agree to a protective order that will protect such information from disclosure. If Kodak terminates your employment, other than for "Cause", you will be provided at least thirty (30) calendar days advance written notice. If you choose to terminate your employment from Kodak, for any reason, you will provide Kodak at least thirty (30) calendar days advance written notice. During the period of your continued employment by Kodak, you will be treated in all respects as a regular Kodak employee with entitlement to those compensation and benefit plans appropriate for your length of service and wage grade. In exchange for the consideration provided in this Agreement you agree that for the period from the effective date of this Agreement through and including three (3) years following the termination of your employment you will not accept employment with, provide services to, nor in any manner or in any capacity become affiliated, directly or indirectly, with any entity which is in competition with, Kodak, including any subsidiary of Kodak or any joint venture or partnership in which Kodak has at least a 49% interest. This limitation shall apply on a worldwide basis. During this non-competition period, if you are otherwise unemployed and wish to be employed, you will diligently seek non-competing employment. In the event you are unsuccessful in obtaining such non-competing employment and you have provided Kodak with evidence, on a monthly basis, of your diligent search for non-competing employment, Kodak will pay you an amount equal to your base monthly salary as of the date your employment by Kodak terminated for each month during which you have been unable to obtain such non-competing employment. Kodak may elect not to enforce this non-competition provision at its sole discretion or may discontinue the enforcement of this non-competition provision at any point during its term. In addition, you will continue to be bound by the terms of the Employee's Agreement which is currently in effect between you and Kodak. You will keep the existence of this Agreement confidential except that you may review this document with your attorney, with me, or my designee. This Agreement, its interpretation and application will be governed and controlled by the laws of the State of New York. Please indicate your acceptance of the terms and conditions set forth in this Agreement by signing the attached duplicate original and returning it to me by not later than September 24, 1993. Eastman Kodak Company - ------------------- ------------------------- Date John R. McCarthy - ------------------- ------------------------- Date Wilbur J. Prezzano Exhibit (10)R EMPLOYMENT AGREEMENT AGREEMENT, made and entered into as of the 27th day of October, 1993 by and between Eastman Kodak Company, a New Jersey corporation (together with its successors and assigns permitted under this Agreement, the "Company"), and George M. C. Fisher (the "Executive"). W I T N E S S E T H WHEREAS, the Company desires to employ the Executive and to enter into an agreement embodying the terms of such employment (this "Agreement") and the Executive desires to enter into this Agreement and to accept such employment, subject to the terms and provisions of this Agreement; NOW, THEREFORE, in consideration of the premises and mutual covenants contained herein and for other good and valuable consideration, the receipt of which is mutually acknowledged, the Company and the Executive (individually a "Party" and together the "Parties") agree as follows: 1. Definitions. (a) "Affiliate" of a person or other entity shall mean a person or other entity that directly or indirectly controls, is controlled by, or is under common control with the person or other entity specified. (b) "Base Salary" shall mean the salary provided for in Section 4 below or any increased salary granted to the Executive pursuant to Section 4. (c) "Board" shall mean the Board of Directors of the Company. (d) "Cause" shall mean: (i) the Executive is convicted of a felony involving moral turpitude; or (ii) the Executive engages in conduct that constitutes willful gross neglect or willful gross misconduct in carrying out his duties under this Agreement, resulting, in either case, in material economic harm to the Company, unless the Executive believed in good faith that such act or nonact was in the best interests of the Company. (e) A "Change in Control" shall mean the occurrence of any one of the following events: (i) any "person," as such term is used in Sections 3(a)(9) and 13(d) of the Securities Exchange Act of 1934, becomes a "beneficial owner," as such term is used in Rule 13d-3 promulgated under that act, of 25% or more of the Voting Stock of the Company; (ii) the majority of the Board consists of individuals other than Incumbent Directors, which term means the members of the Board on the date of this Agreement; provided that any person becoming a director subsequent to such date whose election or nomination for election was supported by three-quarters of the directors who then comprised the Incumbent Directors shall be considered to be an Incumbent Director; (iii) the Company adopts any plan of liquidation providing for the distribution of all or substantially all of its assets; (iv) all or substantially all of the assets or business of the Company is disposed of pursuant to a merger, consolidation or other transaction (unless the shareholders of the Company immediately prior to such merger, consolidation or other transaction beneficially own, directly or indirectly, in substantially the same proportion as they owned the Voting Stock of the Company, all of the Voting Stock or other ownership interests of the entity or entities, if any, that succeed to the business of the Company); or (v) the Company combines with another company and is the surviving corporation but, immediately after the combination, the shareholders of the Company immediately prior to the combination hold, directly or indirectly, 50% or less of the Voting Stock of the combined company (there being excluded from the number of shares held by such shareholders, but not from the Voting Stock of the combined company, any shares received by Affiliates of such other company in exchange for stock of such other company). (f) "Competition" shall mean engaging in any activities competitive with the Company or any Subsidiary, whether as an employee, consultant, partner, principal, agent, officer, director, partner or shareholder (except as a less than one percent shareholder of a publicly traded company or a less than five percent shareholder of a privately held company). A competitive activity shall mean a business that (i) is being conducted by the Company or any Subsidiary at the time in question and (ii) was being conducted at the date of the termination of the Executive's employment, provided that competitive activities shall not include any non-imaging business contributing less than 5% of the Company's revenues on a consolidated basis for the fiscal year in question. Notwithstanding anything to the contrary in this Section 1(f), an activity shall not be deemed to be a competitive activity (x) solely as a result of the Executive's being employed by or otherwise associated with a business of which a unit is in competition with the Company or any Subsidiary but as to which unit he does not have direct or indirect responsibilities for the products or product lines involved or (y) if the activity contributes less than 5% of the revenues for the fiscal year in question of the business by which the Executive is employed or with which he is otherwise associated. (g) "Constructive Termination Without Cause" shall mean a termination of the Executive's employment at his initiative as provided in Section 11(d) below following the occurrence, without the Executive's written consent, of one or more of the following events (except in consequence of a prior termination): (i) a reduction in the Executive's then current Base Salary or target award opportunity under the Company's Management Annual Performance Plan or long-term performance incentive or the termination or material reduction of any employee benefit or perquisite enjoyed by him (other than as part of an across-the-board reduction applicable to all executive officers of the Company); (ii) the failure to elect or reelect the Executive to any of the positions described in Section 3 below or removal of him from any such position; (iii) a material diminution in the Executive's duties or the assignment to the Executive of duties which are materially inconsistent with his duties or which materially impair the Executive's ability to function as the Chairman, President and Chief Executive Officer of the Company; (iv) the failure to continue the Executive's participation in any incentive compensation plan unless a plan providing a substantially similar opportunity is substituted; (v) the relocation of the Company's principal office, or the Executive's own office location as assigned to him by the Company, to a location more than 50 miles from Rochester, New York; or (vi) the failure of the Company to obtain the assumption in writing of its obligation to perform this Agreement by any successor to all or substantially all of the assets of the Company within 15 days after a merger, consolidation, sale or similar transaction. (h) "Disability" shall mean the Executive's inability to substantially perform his duties and responsibilities under this Agreement for a period of 180 consecutive days as determined by an approved medical doctor. For this purpose an approved medical doctor shall mean a medical doctor selected by the Company and the Executive. If the Parties cannot agree on a medical doctor, each Party shall select a medical doctor and the two doctors shall select a third who shall be the approved medical doctor for this purpose. (i) "Stock" shall mean the Common Stock of the Company (j) "Subsidiary" of the Company shall mean any corporation of which the Company owns, directly or indirectly, more than 50% of the Voting Stock. (k) "Term of Employment" shall mean the period specified in Section 2 below. (l) "Trading Day" is a day on which the Stock is traded on the New York Stock Exchange. (m) "Voting Stock" shall mean capital stock of any class or classes having general voting power under ordinary circumstances, in the absence of contingencies, to elect the directors of a corporation. 2. Term of Employment. The Company hereby employs the Executive, and the Executive hereby accepts such employment, for the period commencing October 27, 1993 and ending at the close of business on October 26, 1998, subject to earlier termination of the Term of Employment in accordance with the terms of this Agreement. 3. Position, Duties and Responsibilities. (a) Commencing December 1, 1993 and continuing for the remainder of the Term of Employment, the Executive shall be employed as the President and Chief Executive Officer of the Company and be responsible for the general management of the affairs of the Company. It is also the intention of the Parties that effective December 1, 1993 and continuing for the remainder of the Term of Employment the Executive shall be elected and serve as Chairman of the Board. The Executive, in carrying out his duties under this Agreement, shall report to the Board. (b) Anything herein to the contrary notwithstanding, nothing shall preclude the Executive from (i) serving on the boards of directors of a reasonable number of other corporations or the boards of a reasonable number of trade associations and/or charitable organizations, (ii) engaging in charitable activities and community affairs, and (iii) managing his personal investments and affairs, provided that such activities do not materially interfere with the proper performance of his duties and responsibilities as the Company's Chairman, President and Chief Executive Officer. 4. Base Salary. The Executive shall be paid an annualized Base Salary, payable in accordance with the regular payroll practices of the Company, of $2,000,000. The Base Salary shall be reviewed no less frequently than annually for increase in the discretion of the Board and its Executive Compensation and Development Committee. 5. Annual Incentive Awards. The Executive shall participate in all annual incentive award programs, including, without limitation, the following: (a) The Company's Management Annual Performance Plan. He shall have an annual target award opportunity under such plan of at least $l,000,000 and a minimum guaranteed payment of $1,000,000 for each of 1994 and 1995. (b) The Company's Wage Dividend. For the purposes of the Wage Dividend, he shall be deemed to have at least five years of service Payment of annual incentive awards shall be made at the same time that other senior-level executives receive their incentive awards. 6. Long-Term Incentive Programs. (a) General. The Executive shall be eligible to participate in the long-term incentive programs of the Company on the same basis as other senior-level executives of the Company, provided that he shall be entitled to the awards described in Sections 6(b) and 6(c) below, but shall not be eligible for additional restricted stock awards or additional stock option awards until 1995. (b) Restricted Stock Award. As soon as practicable after commencement of the Executive's employment, the Company shall grant the Executive 20,000 shares of Stock substantially in the form attached to the Agreement as Exhibit A, such Stock to be subject to forfeiture if the Executive's employment terminates pursuant to Section 11(c) or 11(f) below prior to the end of the Term of Employment. (c) Stock Option Award. As soon as practicable after commencement of the Executive's employment, the Company shall grant the Executive a 10-year option, substantially in the form attached to this Agreement as Exhibit B, to purchase 750,000 shares of Stock (the "Option"). The exercise price of the Option shall be the average of (i) the average closing market price for the Stock for the six-month period ending October 26, 1993 and (ii) the average closing market price for the Stock on October 26, 27 and 28, 1993. 7. Special Payments. Loans and Stock Purchases. (a) Promptly after the execution of this Agreement, the Company shall pay the Executive $5,000,000, the purpose of which is to (i) serve as an inducement for the Executive's entering into the Agreement and undertaking to perform the services referred to in the Agreement and (ii) keep the Executive whole in respect of compensation and benefits that he will forfeit upon termination of his employment with his present employer. (b) Promptly after execution of this Agreement, the Company shall loan the Executive $4,000,000 for five years with interest at the Applicable Federal Rate as provided by the Internal Revenue Service under Section 1274(d) of the Internal Revenue Code of 1986 (the "Internal Revenue Code") in the most recent announcement preceding such loan and the Executive shall deliver to the Company a note for such loan in the form of Exhibit C. Twenty percent of the principal of and all accrued interest on such note shall be forgiven on each of the first five anniversaries of such loan, provided that the Executive shall not be entitled to forgiveness on any such anniversary date if he has terminated his employment under Section 11(f) on or prior to such anniversary date. At the time of such loan, the Executive shall purchase the number of shares of Stock having a value of $2,500,000, based on the closing price on the last Trading Day preceding such purchase. (c) In addition, if as a result of his accepting employment hereunder the Executive forfeits a currently unexercisable stock option in respect of 80,000 shares of his prior employer's common stock held by the Executive, the Company shall promptly loan to the Executive an amount equal to the spread in the above 80,000-share option on the date of the execution of this Agreement (based on closing price on that date). The Executive shall promptly use all the proceeds of such loan to purchase shares of Stock and the company shall reimburse the Executive (on an after-tax basis) for any commissions incurred by him in such purchase. At the time of such loan, the Executive shall deliver to the Company a five-year recourse note in the form of Exhibit D, with interest at the Applicable Federal Rate provided by the Internal Revenue Service in the most recent announcement preceding such purchase. Twenty percent of the principal of and all accrued interest on such note shall be forgiven on each of the first five anniversaries of the date of such loan, provided that he shall not be entitled to forgiveness on any such anniversary date if he has entered into Competition with the Company on or prior to such anniversary date. (d) Payments under this Section 7 shall not be deemed to be compensation for the purpose of determining the pension benefit under Section 9. 8. Employee Benefit Programs. During the Term of Employment, the Executive shall be entitled to participate in all employee pension and welfare benefit plans and programs made available to the Company's senior level executives or to its employees generally, as such plans or programs may be in effect from time to time, including, without limitation, pension, profit sharing, savings and other retirement plans or programs, medical, dental, hospitalization, short-term and long-term disability and life insurance plans, accidental death and dismemberment protection, travel accident insurance, and any other pension or retirement plans or programs and any other employee welfare benefit plans or programs that may be sponsored by the Company from time to time, including any plans that supplement the above-listed types of plans or programs, whether funded or unfunded. The Executive shall be entitled to post-retirement welfare benefits on the same basis as other senior executives similarly situated, provided that for this purpose the Executive's period of employment shall, in accordance with the last sentence of this Section 9, be deemed to be the period necessary to obtain the maximum level of such benefits. The Executive shall, in all events, be entitled during the Term of Employment to term life insurance which, together with other life insurance under the Company's term life insurance program, shall provide face amount coverage of no less than 3.5 times Base Salary. To the extent there is a period of employment required as a condition for full benefit coverage under any employee benefit program, the Executive shall be deemed to have met such requirement. 9. Supplemental Pension. (a) The Executive shall be entitled to a pension benefit to be determined in accordance with the formula under the Company's Retirement Income Plan as in effect on the date of this Agreement (the "Plan") (without regard to any limitations that may be applicable under the Internal Revenue Code), subject to adjustment for any future enhancements in that formula. For purposes of determining his benefit under this Section 9(a), the Executive shall be deemed credited with 17 years of service under the Plan on the commencement of his employment, such 17 years of service to be in addition to credited service for actual employment with the Company. The Executive shall also be provided with credited service following certain terminations of employment as described in Section 11 below. The pension benefit provided under this Section 9(a) shall be offset by any other pension benefit provided to the Executive under any other Company pension plan or any pension plan of his prior employer. (b) If the Executive dies while employed by the Company, or during a period in which or in respect of which he is being provided salary continuation payments as provided in Section 11 below, his spouse shall be entitled to a life annuity under this Section 9 equal to 50% of the pension to which the Executive would have been entitled (less any amounts due alternate payees under any qualified domestic relations orders) assuming he had retired and had been receiving retirement payments at the time of his death based on his credited service to that date. Such survivor's benefit shall be offset by any other survivor's pension benefit provided to the Executive's spouse under any other Company pension plan or any pension plan of his prior employer. (c) Except as otherwise provided in this Section 9, the Executive's entitlements to the pension benefit under this Section 9, including without limitation any survivor benefit, claims procedures, methods of payment, etc. shall be determined in accordance with the provisions of the Plan. (d) Notwithstanding anything herein to the contrary, the Company agrees that in any event it will provide the Executive with a pension benefit under this Section 9 in an amount that shall be no less than what the Executive would have received from his prior employer's pension plan (including its supplemental plan) based on his age and years of service (both with his prior employer and with the Company), as such plans are in effect on the date of this Agreement, at the time of his retirement and assuming an annual increase in his covered compensation under his prior employer's pension plan, at the covered compensation level in effect at the time of his termination of employment with his prior employer, at the rate of 6% each year (compounded), less any pension benefit provided to the Executive under any other Company pension plan or any pension plan of his prior employer. The pension benefit guaranteed under this Section 9(d) shall be fully vested upon commencement of his employment with the Company. The Company shall keep the Executive whole to the extent of any tax incurred under 3121(a)(l) of the Internal Revenue Code in respect of pension accruals under this Section 9(d) to the extent the amounts so accrued already had been accrued at his prior employer. (e) In determining the amount of any offset under this Section 9, such amount shall be calculated assuming the same frequency of payment, the same form of annuity and the same commencement date of payment as the benefits to be paid under this Section 9. (f) Upon termination of the Executive's employment, the Company shall fund that portion, if any, of the pension obligation that is then unfunded by establishing a trust. Such trust shall be in a form that provides the Executive with the most favorable tax position that reasonably can be determined at the time it is established and funded. The formation of such trust or funding thereof shall not cause the pension obligation, if it is deemed to be a plan under ERISA, to lose its status as a "top hat plan" thereunder. The trust shall provide for distribution of amounts to the Executive in order to pay taxes, if any, that become due prior to payment of pension amounts pursuant to the trust. The amount of such fund shall equal the then present value of the pension due as determined by a nationally recognized firm qualified to provide actuarial services which has not rendered services to the Company during the two years preceding such determination. The establishment and funding of such trust shall not affect the obligation of the Company to provide the pension hereunder. 10. Reimbursement of Business and Other Expenses; Perquisites; Vacations. (a) The Executive is authorized to incur reasonable expenses in carrying out his duties and responsibilities under this Agreement and the Company shall promptly reimburse him for all business expenses incurred in connection with carrying out the business of the Company, subject to documentation in accordance with the Company's policy. (b) During the Term of Employment, the Executive shall be entitled to participate in any of the Company's executive fringe benefits in accordance with the terms and conditions of such arrangements as are in effect from time to time for the Company's senior-level executives. (c) The Company shall provide the Executive with an appropriately furnished apartment in the Rochester, New York area for a period of time ending (i) when the Executive has established a permanent residence in the Rochester, New York area or (ii) September 30, 1994, whichever occurs first. The Executive agrees that he will make a good faith effort to find a satisfactory permanent residence in the Rochester, New York area as soon as he reasonably can after the commencement of his employment with the Company. (d) The Company shall promptly reimburse the Executive for the reasonable expenses he incurs in relocating his household and family from their present location to the Rochester, New York area, including, without limitation, all expenses associated with selling his residences referred to below and all closing costs relating to his acquisition of a residence in the Rochester, New York area, such as legal fees. In the event that the Executive does not sell his former residence located at 18 West County Line Rd., Barrington, Illinois within three months after becoming Chairman, President and Chief Executive Officer of the Company, the Company shall promptly purchase such residence from him at a price of $860,000. In addition, in the event that the Executive does not sell his present residence located at 4 Mid Oak Lane, Barrington, Illinois within three months after the Executive's wife ceases to use it as a residence, the Company shall promptly purchase such residence from him at a price of $2,5OO,O0O. (e) The Company shall, at Company expense, make available to the Executive Company aircraft for business and personal use at his discretion, such use to be subject to income imputation rules pursuant to applicable Internal Revenue Service regulations. During the period in which the Executive is locating a permanent residence in the Rochester, New York area, the company shall provide him with tax gross-up payments so that after taxes incurred on any commutation between a business location and his residence in either Barrington, Illinois or Phoenix, Arizona the Executive shall be kept whole. It is recognized that some of the Executive's travel by Company aircraft may be required for security purposes and, as such, will constitute business use of the aircraft. (f) In all events, during the Term of Employment, the Company shall: (i) pay for the membership fees (including any bond requirement) and dues at one country club in the Rochester, New York area plus one or more luncheon clubs as the Executive determines are appropriate to his carrying out his duties hereunder; (ii) provide the Executive with a car and driver appropriate for his use; (iii) provide the Executive with personal financial (including tax) counseling by a firm to be chosen by the Executive from one of three providers available through the Company; and (iv) provide the Executive with a residential security system in his permanent residence in the Rochester, New York area and pay the maintenance of such system including the monthly service charges. (g) It is the intention of the Company that the Executive shall, after taking into account any taxes on reimbursements or other benefits under this Section 10, be kept whole with respect to such reimbursement or other benefit except this sentence shall not apply to fringe benefits described in Section 10(b), purchase payments to the Executive in respect of either residence in Barrington, Illinois described in Section 10(d), the use of Company aircraft described in Section 10(e) (except as otherwise expressly provided therein) or the tax, if any, attributable to any reimbursement or benefit provided under Section 10(f). Accordingly, except to the extent otherwise provided in the preceding sentence, to the extent the Executive is taxable on any such reimbursements or benefits, the Company shall pay the Executive in connection therewith an amount which after all taxes incurred by the Executive on such amount shall equal the amount of the reimbursement or benefit being provided (h) The Executive shall be entitled to one week paid vacation in 1993 and six weeks paid vacation per year thereafter. 11. Termination of Employment. (a) Termination Due to Death. In the event the Executive's employment is terminated due to his death, his estate or his beneficiaries as the case may be, shall be entitled to: (i) Base Salary for a period of 90 days following the date of death; (ii) annual incentive award for the year in which the Executive's death occurs based on the target award opportunity for such year, payable in a single installment promptly after his death; (iii) any restricted stock award outstanding at the time of his death, such award to vest fully at that time; (iv) the balance of any incentive awards earned (but not yet paid); (v) the continued right to exercise any stock option for the remainder of its term, such option to become fully exercisable at the date of his death; (vi) any pension survivor benefit that may become due pursuant to Section 9 above; (vii) any amounts earned, accrued or owing to the Executive but not yet paid under Section 7, 8 or 10 above and forgiveness of any amounts owing by the Executive under Section 7; and (viii) other or additional benefits in accordance with applicable plans and programs of the Company. (b) Termination Due to Disability. In the event the Executive's employment is terminated due to his Disability, he shall be entitled in such case to the following (but in no event less than the benefits due him under the then current disability program of the Company): (i) an amount equal to the sum of 60% of Base Salary, at the annual rate in effect at termination of his employment, for a period ending with the end of the month in which he becomes 65, less the amount of any disability benefits provided to the Executive by the Company (other than benefits attributable to the Executive's own contributions) under any disability plan; (ii) annual incentive award for the year in which termination due to Disability occurs based on the target award opportunity for such year, payable in a single installment promptly following termination due to Disability; (iii) any restricted stock award outstanding at the time of his termination due to Disability, such award to vest fully at such time; (iv) the balance of any incentive awards earned (but not yet paid); (v) the continued right to exercise any stock option for the remainder of its term, such option to become fully exercisable on the date of his termination due to Disability; (vi) any pension benefit that may become due pursuant to Section 9 above, offset by any payment in respect of the same period made pursuant to Section 11(b)(i); (vii) any amounts earned, accrued or owing to the Executive but not yet paid under Section 7, 8 or 10 above; (viii) continued accrual of credited service for the purpose of the pension benefit provided under Section 9 above during the period of the Executive's Disability or, if sooner, until the earlier of the Executive's election to commence receiving his pension under Section 9 above or his attainment of age 65; (ix) continued participation in medical, dental, hospitalization and life insurance coverage and in all other employee plans and programs in which he was participating on the date of termination of his employment due to Disability until he attains age 65; and (x) other or additional benefits in accordance with applicable plans and programs of the Company. If the Executive is precluded from continuing his participation in any employee benefit plan or program as provided in clause (ix) above, he shall be provided the after-tax economic equivalent of the benefits provided under the plan or program in which he is unable to participate. The economic equivalent of any benefit foregone shall be deemed to be the lowest cost that would be incurred by the Executive in obtaining such benefit himself on an individual basis. In no event shall a termination of the Executive's employment for Disability occur unless the Party terminating his employment gives written notice to the other Party in accordance with Section 24 below. (c) Termination by the Company for Cause. (i) A termination for Cause shall not take effect unless the provisions of this paragraph (i) are complied with. The Executive shall be given written notice by the Board of the intention to terminate him for Cause, such notice (A) to state in detail the particular act or acts or failure or failures to act that constitute the grounds on which the proposed termination for Cause is based and (B) to be given within six months of the Board learning of such act or acts or failure or failures to act. The Executive shall have 10 days after the date that such written notice has been given to the Executive in which to cure such conduct, to the extent such cure is possible. If he fails to cure such conduct, the Executive shall then be entitled to a hearing before the Board. Such hearing shall be held within 15 days of such notice to the Executive, provided he requests such hearing within 10 days of the written notice from the Board of the intention to terminate him for Cause. If, within five days following such hearing, the Executive is furnished written notice by the Board confirming that, in its judgment, grounds for Cause on the basis of the original notice exist, he shall thereupon be terminated for Cause. (ii) In the event the Company terminates the Executive's employment for Cause, he shall be entitled to: (A) the Base Salary through the date of the termination of his employment for Cause; (B) any incentive awards earned (but not yet paid); (C) any pension benefit that may become due pursuant to Section 9 above, determined as of the date of such termination; (D) any amounts earned, accrued or owing to the Executive but not yet paid under Section 7, 8 or 10 above; and (E) other or additional benefits in accordance with applicable plans or programs of the Company. (iii) Anything herein to the contrary notwithstanding, if following a termination of the Executive's employment by the Company for Cause based upon the conviction of the Executive for a felony involving moral turpitude, such conviction is overturned in a final determination on appeal, the Executive shall be entitled to the payments and the economic equivalent of the benefits the Executive would have received if his employment had been terminated by the Company without Cause. (d) Termination Without Cause or Constructive Termination Without Cause. In the event the Executive's employment is terminated without Cause, other than due to Disability or death, or in the event there is a Constructive Termination Without Cause, the Executive shall be entitled to: (i) the Base Salary through the date of termination of the Executive's employment; (ii) the Base Salary, at the annualized rate in effect on the date of termination of the Executive's employment (or in the event a reduction in Base Salary is the basis for a Constructive Termination Without Cause, then the Base Salary in effect immediately prior to such reduction), for a period of 36 months following such termination or until the end of the Term of Employment, whichever is longer; provided that at the Executive's option the Company shall pay him the present value of such salary continuation payments in a lump sum (using as the discount rate the Applicable Federal Rate for short-term Treasury obligations as published by the Internal Revenue Service for the month in which such termination occurs) and provided further that the salary continuation payment under this Section 11(d)(ii) shall be in lieu of any salary continuation arrangements under any other severance program of the Company; (iii) any restricted stock award outstanding at the time of such termination of employment, such award to become fully vested upon such termination; (iv) the balance of any incentive awards earned (but not yet paid); (v) the right to exercise any stock option in full, whether or not fully exercisable at the date of his termination without Cause or Constructive Termination Without Cause, for the remainder of the original term of such option; (vi) any pension benefit that may become due pursuant to Section 9 above; (vii) any amounts earned, accrued or owing to the Executive but not yet paid under Section 7, 8 or 10 above; (viii) continued accrual of credited service for the purpose of the pension benefit provided under Section 9 above during the period he is receiving salary continuation payments (or in respect of which a lump-sum severance payment is made); (ix) continued participation in all medical, dental, hospitalization and life insurance coverage and in other employee benefit plans or programs in which he was participating on the date of the termination of his employment until the earlier of: (A) the end of the period during which he is receiving salary continuation payments (or in respect of which a lump-sum severance payment is made); (B) the date, or dates, he receives equivalent coverage and benefits under the plans and programs of a subsequent employer (such coverage and benefits to be determined on a coverage-by-coverage, or benefit-by-benefit, basis); provided that (x) if the Executive is precluded from continuing his participation in any employee benefit plan or program as provided in this clause (ix) of this Section 11(d), he shall be provided with the after-tax economic equivalent of the benefits provided under the plan or program in which he is unable to participate for the period specified in this clause (ix) of this Section 11(d), (y) the economic equivalent of any benefit foregone shall be deemed to be the lowest cost that would be incurred by the Executive in obtaining such benefit himself on an individual basis, and (z) payment of such after-tax economic equivalent shall be made quarterly in advance; and (x) other or additional benefits in accordance with applicable plans and programs of the Company. (e) Termination of Employment Following a Change in Control. If, following a Change in Control, the Executive's employment is terminated without Cause or there is a Constructive Termination Without Cause, the Executive shall be entitled to the payments and benefits provided in Section 11(d) above, provided that the salary continuation payments shall be paid in a lump sum without any discount and provided further that the salary continuation payments under this Section 11(e) shall be in lieu of any salary continuation arrangements under any other severance program of the Company. Also, immediately following a Change in Control, all amounts, entitlements or benefits in which he is not yet vested shall become fully vested except to the extent such vesting would be inconsistent with the terms of the relevant plan. (f) Voluntary Termination. In the event of a termination of employment by the Executive on his own initiative other than a termination due to death or Disability or a Constructive Termination without Cause, the Executive shall have the same entitlements as provided in Section 11(c)(ii) above for a termination for Cause. A voluntary termination under this Section 11(f) shall be effective upon 30 days prior written notice to the Company and shall not be deemed a breach of this Agreement. (g) Payment Following a Change in Control. In the event that the termination of the Executive's employment is for one of the reasons set forth in Section 11(e) above and the aggregate of all payments or benefits made or provided to the Executive under Section 11(e) above and under all other plans and programs of the Company (the "Aggregate Payment") is determined to constitute a Parachute Payment, as such term is defined in Section 280G(b)(2) of the Internal Revenue Code, the Company shall pay to the Executive, prior to the time any excise tax imposed by Section 4999 of the Internal Revenue Code ("Excise Tax") is payable with respect to such Aggregate Payment, an additional amount which, after the imposition of all income and excise taxes thereon, is equal to the Excise Tax on the Aggregate Payment. The determination of whether the Aggregate Payment constitutes a Parachute Payment and, if so, the amount to be paid to the Executive and the time of payment pursuant to this Section 11(g) shall be made by an independent auditor (the "Auditor") jointly selected by the Company and the Executive and paid by the Company. The Auditor shall be a nationally recognized United States public accounting firm which has not, during the two years preceding the date of its selection, acted in any way on behalf of the Company or any Affiliate thereof. If the Executive and the Company cannot agree on the firm to serve as the Auditor, then the Executive and the Company shall each select one accounting firm and those two firms shall jointly select the accounting firm to serve as the Auditor. (h) No Mitigation: No Offset. In the event of any termination of employment under this Section 11, the Executive shall be under no obligation to seek other employment and there shall be no offset against amounts due the Executive under this Agreement on account of any remuneration attributable to any subsequent employment that he may obtain except as specifically provided in this Section 11. (i) Nature of Payments. Any amounts due under this Section 11 are in the nature of severance payments considered to be reasonable by the Company and are not in the nature of a penalty. 12. Confidentiality: Assignment of Rights. (a) During the Term of Employment and thereafter, the Executive shall not disclose to anyone or make use of any trade secret or proprietary or confidential information of the Company, including such trade secret or proprietary or confidential information of any customer or other entity to which the Company owes an obligation not to disclose such information, which he acquires during the Term of Employment, including but not limited to records kept in the ordinary course of business, except (i) as such disclosure or use may be required or appropriate in connection with his work as an employee of the Company or (ii) when required to do so by a court of law, by any governmental agency having supervisory authority over the business of the Company or by any administrative or legislative body (including a committee thereof) with apparent jurisdiction to order him to divulge, disclose or make accessible such information. (b) The Executive hereby sells, assigns and transfers to the Company all of his right, title and interest in and to all inventions, discoveries, improvements and copyrightable subject matter (the "rights") which during the Term of Employment are made or conceived by him, alone or with others and which are within or arise out of any general field of the Company's business or arise out of any work he performs or information he receives regarding the business of the Company while employed by the Company. The Executive shall fully disclose to the Company as promptly as available all information known or possessed by him concerning the rights referred to in the preceding sentence, and upon request by the Company and without any further remuneration in any form to him by the Company, but at the expense of the Company, execute all applications for patents and for copyright registration, assignments thereof and other instruments and do all things which the Company may deem necessary to vest and maintain in it the entire right, title and interest in and to all such rights. 13. Indemnification. (a) The Company agrees that if the Executive is made a party, or is threatened to be made a party, to any action, suit or proceeding, whether civil, criminal, administrative or investigative (a "Proceeding"), by reason of the fact that he is or was a director, officer or employee of the Company or is or was serving at the request of the Company as a director, officer, member, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, whether or not the basis of such Proceeding is the Executive's alleged action in an official capacity while serving as a director, officer, member, employee or agent, the Executive shall be indemnified and held harmless by the Company to the fullest extent legally permitted or authorized by the Company's certificate of incorporation or bylaws or resolutions of the Company's Board of Directors or, if greater, by the laws of the State of New Jersey, against all cost, expense, liability and loss (including, without limitation, attorney's fees, judgments, fines, ERISA excise taxes or penalties and amounts paid or to be paid in settlement) reasonably incurred or suffered by the Executive in connection therewith, and such indemnification shall continue as to the Executive even if he has ceased to be a director, member, employee or agent of the Company or other entity and shall inure to the benefit of the Executive's heirs, executors and administrators. The Company shall advance to the Executive all reasonable costs and expenses incurred by him in connection with a Proceeding within 20 days after receipt by the Company of a written request for such advance. Such request shall include an undertaking by the Executive to repay the amount of such advance if it shall ultimately be determined that he is not entitled to be indemnified against such costs and expenses. (b) Neither the failure of the Company (including its board of directors, independent legal counsel or stockholders) to have made a determination prior to the commencement of any proceeding concerning payment of amounts claimed by the Executive under Section 12(a) above that indemnification of the Executive is proper because he has met the applicable standard of conduct, nor a determination by the Company (including its board of directors, independent legal counsel or stockholders) that the Executive has not met such applicable standard of conduct, shall create a presumption that the Executive has not met the applicable standard of conduct. (c) The Company also agrees that if the Executive is made a party, or is threatened to be made a party, to any action, suit or proceeding by reason of the termination of his employment with his prior employer or his accepting employment with the Company, he shall be indemnified and held harmless by the Company against all cost, expense, liability and loss (including, without limitation, attorney's fees) reasonably incurred or suffered by the Executive in connection therewith. (d) The Company agrees to continue and maintain a directors and officers' liability insurance policy covering the Executive to the extent the Company provides such coverage for its other executive officers. 14. Effect of Agreement on Other Benefits. Except as specifically provided in this Agreement, the existence of this Agreement shall not prohibit or restrict the Executive's entitlement to full participation in the employee benefit and other plans or programs in which senior executives of the Company are eligible to participate. 15. Assignability: Binding Nature. This Agreement shall be binding upon and inure to the benefit of the Parties and their respective successors, heirs (in the case of the Executive) and assigns. No rights or obligations of the Company under this Agreement may be assigned or transferred by the Company except that such rights or obligations may be assigned or transferred pursuant to a merger or consolidation in which the Company is not the continuing entity, or the sale or liquidation of all or substantially all of the assets of the Company, provided that the assignee or transferee is the successor to all or substantially all of the assets of the Company and such assignee or transferee assumes the liabilities, obligations and duties of the Company, as contained in this Agreement, either contractually or as a matter of law. The Company further agrees that, in the event of a sale of assets or liquidation as described in the preceding sentence, it shall take whatever action it legally can in order to cause such assignee or transferee to expressly assume the liabilities, obligations and duties of the Company hereunder. No rights or obligations of the Executive under this Agreement may be assigned or transferred by the Executive other than his rights to compensation and benefits, which may be transferred only by will or operation of law, except as provided in Section 21 below. 16. Representation. The Company represents and warrants that it is fully authorized and empowered to enter into this Agreement and that the performance of its obligations under this Agreement will not violate any agreement between it or him and any other person, firm or organization. The Executive represents that he knows of no agreement between him and any other person, firm or organization that would be violated by the performance of his obligations under this Agreement. 17. Entire Agreement. This Agreement contains the entire understanding and agreement between the Parties concerning the subject matter hereof and supersedes all prior agreements, understandings, discussions, negotiations and undertakings, whether written or oral, between the Parties with respect thereto. 18. Amendment or Waiver. No provision in this Agreement may be amended unless such amendment is agreed to in writing and signed by the Executive and an authorized officer of the Company. No waiver by either Party of any breach by the other Party of any condition or provision contained in this Agreement to be performed by such other Party shall be deemed a waiver of a similar or dissimilar condition or provision at the same or any prior or subsequent time. Any waiver must be in writing and signed by the Executive or an authorized officer of the Company, as the case may be. 19. Severability. In the event that any provision or portion of this Agreement shall be determined to be invalid or unenforceable for any reason, in whole or in part, the remaining provisions of this Agreement shall be unaffected thereby and shall remain in full force and effect to the fullest extent permitted by law. 20. Survivorship. The respective rights and obligations of the Parties hereunder shall survive any termination of the Executive's employment the extent necessary to the intended preservation of such rights and obligations. 21. Beneficiaries/References. The Executive shall be entitled, to the extent permitted under any applicable law, to select and change a beneficiary or beneficiaries to receive any compensation or benefit payable hereunder following the Executive's death by giving the Company written notice thereof. In the event of the Executive's death or a judicial determination of his incompetence, reference in this Agreement to the Executive shall be deemed, where appropriate, to refer to his beneficiary, estate or other legal representative. 22. Governing Law/Jurisdiction. This Agreement shall be governed by and construed and interpreted in accordance with the laws of New York without reference to principles of conflict of laws. 23. Resolution of Disputes. Any disputes arising under or in connection with this Agreement shall, at the election of the Executive or the Company, be resolved by binding arbitration, to be held in Rochester, New York in accordance with the rules and procedures of the American Arbitration Association. Judgment upon the award rendered by the arbitrator(s) may be entered in any court having jurisdiction thereof. Costs of the arbitration or litigation, including, without limitation, reasonable attorneys' fees of both Parties, shall be borne by the Company. Pending the resolution of any arbitration or court proceeding, the Company shall continue payment of all amounts due the Executive under this Agreement and all benefits to which the Executive is entitled at the time the dispute arises. 24. Notices. Any notice given to a Party shall be in writing and shall be deemed to have been given when delivered personally or sent by certified or registered mail, postage prepaid, return receipt requested, duly addressed to the Party concerned at the address indicated below or to such changed address as such Party may subsequently give such notice of: If to the Company: Eastman Kodak Company 343 State Street Rochester, New York 14650 Attention: Senior Vice President and General Counsel If to the Executive: Mr. George M. C. Fisher c/o Eastman Kodak Company 343 State Street Rochester, New York 14650 25. Headings. The headings of the sections contained in this Agreement are for convenience only and shall not be deemed to control or affect the meaning or construction of any provision of this Agreement. 26. Counterparts. This Agreement may be executed in two or more counterparts. IN WITNESS WHEREOF, the undersigned have executed this Agreement as of the date first written above. Eastman Kodak Company By: Senior Vice President George M.C. Fisher Exhibit A NOTICE OF RESTRICTED STOCK GRANTED [date] PURSUANT TO EASTMAN KODAK COMPANY 1990 OMNIBUS LONG-TERM COMPENSATION PLAN ("Grant Notice") To: George M.C. Fisher You are granted 20,000 shares of Eastman Kodak Company Common Stock (the "Restricted Shares"). The Restricted Shares are granted under the Eastman Kodak Company 1990 Omnibus Long-Term Compensation Plan (the "Plan") and are subject to the terms of the Plan and the following conditions: 1. The Restricted Shares awarded hereunder shall be promptly issued and a certificate(s) for such shares shall be issued in your name. You shall thereupon be a shareholder of all the shares represented by the certificate(s). As such, you shall have all the rights of a shareholder with respect to such shares, including, but not limited to, the right to vote such shares and to receive all dividends and other distributions (subject to Paragraph 2 below) paid with respect to them, provided, however, that the shares shall be subject to the restrictions in Paragraph 4 below. The stock certificates representing such shares shall be imprinted with a legend stating that the shares represented thereby are restricted shares subject to the terms and conditions of this Grant Notice and, as such, may not be sold, exchanged, transferred, pledged, hypothecated or otherwise disposed of except in accordance with the terms of this Grant Notice. Each transfer agent for the Common Stock shall be instructed to like effect in respect of such shares. In aid of such restrictions, you shall immediately upon receipt of the certificate(s) therefor, deposit such certificate(s) together with a stock power or other like instrument of transfer, appropriately endorsed in blank, with an escrow agent designated by the Committee, which may be the Company, under a deposit agreement containing such terms and conditions as the Committee shall approve, the expenses of such escrow to be borne by the Company. 2. If under Section 18 of the Plan, entitled "Adjustment of Available Shares," you, as the owner of the Restricted Shares, shall be entitled to new, additional or different shares of stock or securities, the certificate or certificates for, or other evidences of, such new, additional or different shares or securities, together with a stock power or other instrument of transfer appropriately endorsed, shall be imprinted with a legend as provided in Paragraph 1 above, deposited by you under the deposit agreement provided for therein, and subject to the restrictions provided for in Paragraph 4 below. 3. The term "Restricted Period" with respect to the Restricted Shares shall mean the period beginning on October 27, 1993 and ending on October 26, 1998. 4. During the Restricted Period, none of the Restricted Shares shall be sold, exchanged, transferred, pledged, hypothecated or otherwise disposed of except by will or the laws of descent and distribution. Any attempt by you to dispose of your shares in any such manner shall result in the immediate forfeiture of such shares and any other shares then held by the designated escrow agent on your behalf. 5. Subject to Paragraph 6 below, if your employment is terminated pursuant to Section 11(c) or 11(f) of the Employment Agreement between you and the Company dated October 27, 1993 (the "Employment Agreement") at any time before the Restriction Period ends, you shall immediately forfeit all of the Restricted Shares then held on your behalf by the designated escrow agent. 6. The restrictions set forth in Paragraph 4 above, with respect to the Restricted Shares held by the designated escrow agent on your behalf, will lapse upon the earlier of: (i) the expiration of the Restricted Period; or (ii) the termination of your employment under Section 11(a), 11(b), 11(d) or 11(e) of the Employment Agreement. 7. Section 20 of the Plan (noncompetition) shall not apply to this grant. 8. The Company, or the designated escrow agent at the request of the Company, shall be entitled to deduct from the Restricted Shares the amount of all applicable income and employment taxes required to be withheld unless you make other arrangements with the Company for the timely payment of such taxes. Exhibit B NOTICE OF STOCK OPTION GRANTED [date] PURSUANT TO EASTMAN KODAK COMPANY 1990 OMNIBUS LONG-TERM COMPENSATION PLAN ("Grant Notice") To: George M.C. Fisher You are granted a Nonqualified Stock Option to purchase 750,000 shares* of Eastman Kodak Company Common Stock at $ per share. This option is granted under the Eastman Kodak Company 1990 Omnibus Long-Term Compensation Plan (the "Plan") subject to the terms of this Grant Notice. 1. This option shall become exercisable (vested) in 20% cumulative annual installments starting one year after grant. 2 This option, unless sooner terminated or exercised in full, shall expire on , 2003. 3. If your employment is terminated due to death, Disability, Retirement or termination for an Approved Reason, this option shall immediately become exercisable and vested in full and shall continue to be exercisable until its scheduled expiration date under Paragraph 2 above or, if sooner, its exercise in full. If your employment is terminated for any reason other than death, Disability, Retirement or an Approved Reason, any portion of the option exercisable at the time of such termination shall not be exercisable beyond the 60th day following the date of your termination of employment and any portion of the option not exercisable at the time of your termination shall be immediately forfeited. 4. You may exercise this option regardless of whether any other option you have been granted by the Company remains unexercised. 5. The option price for the shares for which this option is exercised by you shall be paid by you, on the date the option is exercised, in cash, in shares of Common Stock owned by you or a combination of the foregoing. Any share of Common Stock delivered in payment of the option price shall be valued at its "fair market value." For purposes of this paragraph, "fair market value" shall mean the opening price of the Common Stock on the New York Stock Exchange on the date of exercise; provided, however, if the Common Stock is not traded on such date, then the opening price on the immediately preceding date on which Common Stock is traded shall be used. 6. You may pay the amount of taxes required to be withheld upon exercise of the option by (i) delivering a check made payable to the Company or (ii) delivering to the Company at the time of such exercise shares of Common Stock having a "fair market value," as determined in accordance with Paragraph 5 above, equal to the amount of such withholding taxes. 7. You shall not have any of the rights of a shareholder with respect to the shares of Common Stock covered by this option except to the extent one or more certficates for such shares shall be delivered to you upon the exercise of the option. 8. Notwithstanding Paragraphs 6 and 7 above to the contrary, you may exercise this option by way of the Company's broker-assisted stock option exercise program, to the extent such program is available at the time of such exercise. Pursuant to the terms of such program, the amount of any taxes required to be withheld upon exercise of any options under the program shall be paid in cash directly to the Company. 9. "Termination for an Approved Reason" shall include, without limitation, a Termination Without Cause or Constructive Termination Without Cause under Section 11 Cd) of the Employment Agreement between you and the Company dated as of October 27, 1993 (the "Employment Agreement") or a Termination of Employment Following a Change in Control under Section 11(e) of the Employment Agreement. 10. "Disability" shall have the same meaning as ascribed to it under Section 1(h) of the Employment Agreement. 11. "Retirement" shall mean the occurrence of your retirement as determined in accordance with the terms of the Kodak Retirement Income Plan ("KRIP"). 12. Section 20 of the Plan (noncompetition) shall not apply to this grant. * Actual grant shall be for 750,000 shares less the number of shares that shall be granted concurrently under a stock option intended to qualify as an incentive stock option under Section 422 of the Internal Revenue Code. Such option grant shall be in substantially the same form as this grant except to the extent necessary to constitute an incentive stock option under Section 422. Exhibit C Promissory Note $4,000,000 October , 1993 For value received, the undersigned George M.C. Fisher (the "Borrower') promises to pay to the order of Eastman Kodak Company (the "Lender") the principal amount of $4,000,000 on October , 1998, and to pay interest on the unpaid balance of such principal amount at the rate of % per year [the Applicable Federal Rate] until paid in full, such interest to be payable on October , 1998. This note may be prepaid in whole or in part at any time, together with accrued and unpaid interest on the amount being prepaid, without premium or penalty. This note is being delivered pursuant to the provisions of an employment agreement dated October 27, 1993 among the Borrower and the Lender and shall be forgiven as provided in Section 7(b) of such agreement, subject to the conditions of such section. This note shall be governed by and construed in accordance with the laws of the State of New York without reference to principles of conflict of laws. The Borrower hereby waives presentment, demand, protest and notice of dishonor. George M.C. Fisher Exhibit D Promissory Note $ ,1993 For value received, the undersigned George M.C. Fisher (the "Borrower') promises to pay to the order of Eastman Kodak Company (the "Lender") the principal amount of $ on , 1998, and to pay interest on the unpaid balance of such principal amount at the rate of % per year [the Applicable Federal Rate] until paid in full, such interest to be payable on , 1998. This note may be prepaid in whole or in part at any time, together with accrued and unpaid interest on the amount being prepaid, without premium or penalty. This note is being delivered pursuant to the provisions of an employment agreement dated October 27, 1993 among the Borrower and the Lender and shall be forgiven as provided in Section 7(c) of such agreement, subject to the conditions of such section. This note shall be governed by and construed in accordance with the laws of the State of New York without reference to principles of conflict of laws. The Borrower hereby waives presentment, demand, protest and notice of dishonor. George M.C. Fisher October 27, 1993 Mr. George M.C. Fisher 4 Mid Oak Lane Barrington, IL 60010 Dear Mr. Fisher: This is to confirm that you are on the payroll of Eastman Kodak Company effective October 27, 1993. You will be immediately covered by all employee welfare benefit programs, including any supplemental programs applicable to senior level executives, except that to the extent that you are not covered by a particular plan because of a waiting period or other precondition to your participation, the Company shall provide you such benefit pursuant to this letter. In addition, you shall be provided with life insurance coverage, effective October 27, 1993, equal to 3.5 times your Base Salary (as described in Section 4 of the Employment Agreement between the Company and you effective October 27, 1993) to the extent not provided under the regular term life insurance program of the Company as applicable to senior level executives. Sincerely yours, Eastman Kodak Company By: Senior Vice President Exhibit (22) Subsidiaries of Eastman Kodak Company Organized Companies Consolidated Under Laws of Eastman Kodak Company New Jersey Eastman Kodak International Finance B.V. Netherlands Eastman Kodak International Sales Corporation Barbados Eastman Technology, Inc. New York Torrey Pines Realty Company, Inc. Delaware Datatape Incorporated Delaware The Image Bank, Inc. New York Northfield Pharmaceuticals Limited Delaware Kodak Health Imaging Systems, Inc. Delaware Jamieson Film Company Delaware Eastman Gelatine Corporation Massachusetts Eastman Canada, Inc. Canada Kodak Canada, Inc. Canada Kodak (Export Sales) Ltd. Hong Kong Kodak Argentina, Ltd. New York Kodak Brasileira C.I.L. Brazil Kodak Chilena S.A.F. Chile Kodak Colombiana, Ltd. New York Kodak Panama, Ltd. New York Foto Interamericana de Peru, Ltd. New York Kodak Caribbean, Limited New York Kodak Uruguaya, Ltd. New York Kodak Venezuela, S.A. Venezuela Kodak (Near East), Inc. New York Kodak (Singapore) Pte. Limited Singapore Kodak Philippines, Ltd. New York Kodak Limited England Kodak Ireland Limited Ireland Kodak-Pathe France Kodak A.G. Germany International Biotechnologies Inc. Delaware Kodak Korea Ltd. South Korea Kodak Far East Purchasing, Inc. New York Kodak New Zealand Limited New Zealand Kodak (Australasia) Proprietary Limited Australia Kodak (Kenya) Limited Kenya Kodak (Egypt) S.A. Egypt Kodak (Malaysia) S.B. Malaysia Kodak Taiwan Limited Taiwan Eastman Kodak International Capital Company, Inc. Delaware Industria Fotografica Interamericana, S.A. de C.V. Mexico N.V. Kodak S.A. Belgium Kodak a.s. Denmark Kodak Norge A/S Norway Kodak SA Switzerland Kodak (Far East) Limited Hong Kong Kodak (Thailand) Limited Thailand Eastman Kodak De Mexico, S.A. de C.V. Mexico Kodak Mexicana S.A. de C.V. Mexico Industria Mexicana de Foto Copiadoras, S.A. de C.V. Mexico Kodak G.m.b.H. Austria Kodak G.m.b.H. Germany Kodak Oy Finland Kodak Nederland B.V. Netherlands Kodak Clinical Diagnostics Ltd. United Kingdom Exhibit (22) (Continued) Organized Companies Consolidated Under Laws of Kodak S.p.A. Italy Kodak Portuguesa Limited New York Kodak S.A. Spain Kodak AB Sweden Eastman Kodak (Japan) Ltd. Japan K.K. Kodak Information Systems Japan Kodak Japan Ltd. Japan Kodak Imagica K.K. Japan Kodak Japan Industries Ltd. Japan Sterling Winthrop Inc. Delaware Sterling Products Argentina S.A. Argentina Sterling Winthrop Pty. Limited Australia The Sydney Ross Co. New Jersey Sterling-Winthrop, Inc. Canada Sterling-Winthrop, S.A. France Schulke & Mayr G.m.b.H. Germany Sterling-Winthrop K.K. Japan Sterling Health de Mexico, S.A. de C.V. Mexico Sterling Products (Nigeria) Ltd. Nigeria Sterling-Winthrop Products Inc. Panama Sterwin A.G. Switzerland Gamma Chemikalien A.G. Switzerland Saxet (U.K.) Ltd. United Kingdom Sterling-Winthrop Group Ltd. England Sterling Products Int'l, Inc. Delaware Sterling Winthrop Ireland Cook-Waite Laboratories, Inc. Delaware The d-Con Company, Inc. Delaware Minwax Company, Inc. New Jersey Thompson & Formby Inc. Florida Sterling Pharmaceuticals Inc. Arkansas The SDI Divestiture Corp. Ohio Maggioni - Winthrop S.p.A. Italy Hinds G.m.b.H. Germany Sterling Winthrop S.A. Spain Sterling Health Produtos Farmaceuticos, Lda. Portugal Winthrop Products Inc. Delaware Sanofi Winthrop Pharmaceuticals Inc. Delaware Sterling Health Europe S.A. France Sanofi Winthrop L.P. Delaware Sanofi Winthrop S.A. Argentina Sanofi Winthrop Farmaceutica Ltda. Brazil Sanofi Winthrop Canada Sanofi Winthrop S.A. de C. V. Mexico Sterling Health Belgium Sterling Health Europe S.A. and Co. OHG Germany Sterling Midy S.p.A. Italy Sterling Health v.o.f. Netherlands Sterling Health A.G. Switzerland Sterling Health Corporation y CIA S.R.C. Spain Sterling Health A/S Denmark Sterling Health OY Finland Sterling Health A/S Norway Sterling Health AB Sweden L & F Products (UK) Limited England L & F Canada Inc. Canada L & F Products International, Inc. Delaware L & F Products, Inc. Delaware L & F Products, Inc. New Jersey L & F Products Caribbean, Inc. Delaware L & F Personal Products, Inc. Delaware S & M France SARL France Note: Subsidiary Company names are indented under the name of the parent company.

350667_1993.txt

350667_1993

1993

350667

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 - XI (the "Partnership"), is a limited partnership formed in 1981 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 $137,500,000 in Limited Partnership Interests (the "Interests") to the public commencing on May 8, 1981 pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 2-70724). A total 137,500 Interests were sold to the public at $1,000 per Interest. The offering closed on May 5, 1982. 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, 2031. 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: 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 Partners) 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. Reference is made to Item 7 below for a discussion of competitive conditions and future renovation and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are set forth on a quarterly basis in the table set forth in Item 2 ITEM 2. PROPERTIES The Partnership owns directly or through joint venture partnerships the properties or interests in the properties referred to under Item 1 above to which reference is hereby made for a description of said properties. The following is a listing of principal businesses or occupations carried on in and approximate occupancy levels by quarter during fiscal years 1993 and 1992 for the Partnership's investment properties owned during 1993: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Partnership is not subject to any pending material legal proceedings, other than ordinary litigation incidental to the business of the Partnership. 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 14,080 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 8, 1981, the Partnership commenced an offering of $125,000,000 (subject to increase by up to $12,500,000) in Limited Partnership Interests ("Interests") pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. All Interests were subscribed and issued between May 8, 1981 and May 5, 1982 pursuant to the public offering from which the Partnership received gross proceeds of $137,500,000. After deducting selling expenses and other offering costs, the Partnership had approximately $121,936,000 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 to satisfy working capital requirements. Portions of the proceeds were 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 $2,313,000 and short-term investments of approximately $2,288,000. Such funds are available for future distributions to partners, and for working capital requirements including the Partnership's portion of the anticipated net cash flow deficits at the 767 Third Avenue Office Building and the National City Center Office Building. The Partnership and its consolidated ventures have currently budgeted in 1994 approximately $4,714,000 for tenant improvements and other capital expenditures. The Partnership's share of such items and its share of such similar items for its unconsolidated ventures in 1994 is currently budgeted to be approximately $3,397,000. 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. Certain of the Partnership's investment properties and properties in which the Partnership has a security interest currently operate in overbuilt markets which are characterized by lower than normal occupancies and/or reduced rent levels. Such competitive conditions will contribute to the anticipated net cash flow deficits described above. The sources of capital for such items and for future short-term and long-term liquidity and distributions to partners are expected to be from net cash generated by the Partnership's investment properties and through the sale of such investments. The Partnership does not consider the mortgage notes receivable arising from the previous sale of the Partnership's investment property to be a source of future liquidity as collection of any past due or future payments on the Partnership's notes is considered unlikely. Reference is made to Note 7(a). The Partnership's and its Ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its Ventures are not obligated to pay mortgage indebtedness unless the related property produces sufficient net cash flow from operations or sale. The Partnership currently has adequate cash and cash equivalents to maintain the operations of the Partnership. However, based upon estimated operations of certain of the Partnership's investment properties, the Partnership decided to suspend distributions to the Limited and General Partners effective as of the second quarter of 1991. In addition, the Partnership has deferred cash distributions and partnership management fees related to the first quarter of 1991 as discussed in Note 9. These amounts, which do not bear interest, are approximately $19,000 and are expected to be paid in future periods. As described more fully in Note 4(b), the Partnership is seeking or has received mortgage loan modifications on certain of its properties. If the Partnership is unable to secure new or additional modifications to the loans, based upon current market conditions, the Partnership may not commit any significant additional amounts to any of the properties which are incurring, or in the future do incur, operating deficits or deficits to underlying mortgage holders. This would result in the Partnership no longer having an ownership (or security) interest in such properties. Such decisions will be made on a property-by-property basis and may result in a gain to the Partnership for financial reporting and Federal income tax purposes, with no corresponding distributable proceeds. The lender of the existing long-term mortgage notes secured by the Scotland Yard-Phase I and II, South Point, and El Dorado View apartment complexes required the establishment of an escrow account, initially of approximately $980,000 in the aggregate, to be used towards the purchase of major capital items at the apartment complexes. Additionally, the lender required $150,000 of the proceeds from the sale of the South Point Apartments, as more fully discussed in note 7(f), to be added to the escrow account. As of December 31, 1993, the Partnership has been reimbursed from the escrow account approximately $647,000 for capital improvements at the above- referenced apartment complexes. Reference is made to Note 4(c). Wood Forest Glen Apartments During 1991, the Partnership continued to negotiate with the lender to further modify the long-term mortgage note secured by the Wood Forest Glen Apartments. During these negotiations, the Partnership continued to pay debt service at the previously modified terms through December 1990 and, effective January 1991, began to pay debt service on a cash flow basis. In December 1991, the Partnership was notified that the lender sold its mortgage note to a third party. The Partnership pursued discussions with the new lender concerning modifications to the mortgage loan and a possible sale of the property. The Partnership was not successful in securing such modifications; however, in April 1992, the Partnership sold its interest in the property to the new lender for approximately $213,000 in excess of the existing mortgage balance. As a result of the sale, the Partnership recognized a gain on sale in 1992 of $6,470,625 and $7,058,574 for financial reporting and Federal income tax purposes, respectively. Reference is made to Note 4(b). Gatehall Plaza Office Building During 1990, the Gatehall venture was informed by the mortgage lender that it was unwilling to further modify the loan secured by the Gatehall Plaza Office Building and in October 1991, the lender realized upon its security and took title to the property resulting in the Partnership no longer having an ownership interest in the property. The Partnership received no cash proceeds from the transfer of ownership interest; it did, however, recognize a gain for financial reporting and Federal income tax purposes during 1991 of $4,235,904 and $3,305,588, respectively. Reference is made to Note 4(b). Bitter Creek Apartments The original modification of the then existing long-term mortgage notes secured by the Bitter Creek Apartments located in Grand Prairie, Texas expired on June 15, 1991. The modifications provided for the deferral of interest payments for the period December 15, 1986 through June 15, 1991. In addition, principal payments were deferred for the period December 15, 1986 through December 15, 1990. During February 1992, the Bitter Creek venture received an additional modification to the long-term mortgage notes. The venture was required to pay down approximately $436,000 of the principal balance of the mortgage loan in exchange for the lender forgiving all deferred interest and extending the term of the modification. The Partnership's share of the required principal payment was approximately $58,000. The new modified interest accrual and payment rate averaging 7% for the period June 15, 1991 to June 9, 1992 was based upon the lender's prime rate. As the modification was retroactive to June 15, 1991, the Partnership recognized a gain upon forgiveness of indebtedness in 1991 aggregating $143,082 and $1,094,940 for financial reporting and Federal income tax purposes, respectively. The additional mortgage modification provided that payments of interest be paid monthly and the principal balance and any accrued interest be due and payable on December 15, 1992. On June 9, 1992, the venture sold the land and related assets of the Bitter Creek apartment complex for $10,250,000 in cash (before selling costs and prorations). A major portion of the sales proceeds was utilized to retire the related underlying mortgage note of approximately $9,064,000. The Partnership and the venture partner received approximately $339,000 and $681,000, respectively, from the sale of the property after deducting expenses in connection with the sale and the mortgage loan retirement. The Partnership recognized a gain in 1992 of $142,967 and $2,808,159 for financial reporting and Federal income tax purposes, respectively. Reference is made to Note 7(e). 767 Third Avenue Office Building During 1991 and 1992, approximately 67% of the leased space at the 767 Third Avenue Office Building expired (of which approximately 56% have been re- leased as of December 1993). In addition, approximately 12,300 square feet of space in the building is currently leased to various entities of the former Yugoslavian government. Due to certain sanctions imposed by the United States government, these tenants were ordered to vacate their premises in May, 1992. The tenants have not paid rent since they vacated their space. The joint venture is currently pursuing its legal remedies. The joint venture is aggressively marketing the remaining vacant space. Vacancy rates in Midtown Manhattan (the sub-market for this property) remain high and the increased competition for tenants has resulted in lower effective rental rates. The increased vacancy results from new office building development in the area over the past few years and corporate consolidations. Over the next few years, however, there is only a relatively small amount of new office building space planned and most of the new development is planned for the west side of Midtown. The adverse market conditions and the negative impact of effective rental rates, while temporary, will likely continue over the next few years. While this building is in a premier location, it will be adversely impacted by the lower expected effective rental rates upon leasing and from releasing costs. In order to reduce debt service payments during the tenant turnover period, the 767 Third Avenue joint venture obtained from the existing lender, in May 1992, a replacement mortgage loan bearing a substantially lower interest rate than the original loan. In connection with the replacement mortgage loan, 767 Third Avenue was required to fund $8,000,000 into an escrow account to fund any future leasing costs and debt shortfalls resulting from anticipated tenant turnover. At the inception of the escrow agreement, the venture was allowed to reduce the required reserve contributions by approximately $2,600,000 to reflect certain leasing costs that had already been incurred. The Partnership's joint venture partner loaned $5,000,000 to the joint venture in order to fund the net escrow reserve account. In June 1993, the Partnership purchased a 50% interest in the venture partner's loan including the related accrued interest. Accordingly, the Partnership's 50% interest in the principal portion of the loan ($2,500,000) is reflected as a decrease in long-term debt, less current portion in the consolidated financial statements at December 31, 1993. Reference is made to Note 4. Because the reserve account has been depleted and the property is operating at a deficit, the 767 Third Avenue venture intends to seek refinancing of the mortgage loan. There can be no assurances that any refinancing can be obtained. 824 Market Street Occupancy at the 824 Market Street Office building located in Wilmington, Delaware is currently 49%; however, rent paying occupancy is 80% due to a vacated major tenant that is obligated to pay rent on 60,500 square feet (31% of net rentable area) pursuant to the terms of its lease which expires April 1994. The 824 Market Street venture is aggressively seeking replacement tenants for the vacant space; however, competition has risen significantly due to new office building development in the area over the last few years and the contraction of tenants in the financial services industry, resulting in lower effective rental rates. In order to reduce debt service payments during the tenant turnover period, the venture had negotiated with the first mortgage lender for a possible modification to the mortgage note. Such negotiations have been unsuccessful and the lender has informed the venture of its intent to realize upon its security in 1994. The 824 Market Street venture has decided, based upon current and anticipated future market conditions, not to commit any significant additional amounts to this property. This will result in the Partnership no longer having an ownership interest in this property and will result in a gain for financial reporting and federal income tax purposes to the Partnership with no corresponding distributable proceeds. As of December 31, 1993, the venture was eighteen months delinquent in making the scheduled debt service payments of approximately $2,970,000 under the terms of the note and, in connection with the negotiations, the venture has withheld payments of contingent interest related to 1987 through 1989 aggregating $134,525. Accordingly, for financial reporting purposes, the long-term mortgage note of approximately $12,570,000 has been reflected as a current liability in the accompanying consolidated financial statements at December 31, 1993 and December 31, 1992. At the first mortgage lender's request, beginning March 1993, payments of approximately $78,000 on the second mortgage loan have also been withheld. As a result, the second mortgage loan of approximately $945,000 has also been reflected as a current liability in the accompanying consolidated financial statements at December 31, 1993 and December 31, 1992. The second mortgage lender has also been a tenant in the building but vacated upon their lease expiration in January 1994. Commencing April 1993, the tenant/second mortgage note holder has failed to remit the rent payments due under the terms of their lease. The Partnership and the first mortgage lender are currently evaluating their alternatives regarding this matter with the tenant/second mortgage note holder. Riverfront Office Building On August 28, 1990, the Riverfront joint venture acquired additional financing by way of a $5,800,000 fourth mortgage note in order to fund the costs associated with leasing vacant space. To date, the joint venture has received approximately $5,730,000 in proceeds. The balance of the proceeds, a $70,000 engineering holdback, is payable to the joint venture upon completion of certain structural repairs. Occupancy at the Riverfront Office Building has increased to 85% at December 31, 1993, up from 67% at December 31, 1992. 1993 leasing activity, although at lower effective rental rates, partially replaced a major tenant that vacated approximately 25% of the building in July 1992 due to a downsizing of its operations. The tenant met its obligation to pay rent through the remaining terms of its leases which expired in April 1993. In addition, the property began operating at a deficit in 1992 and, as a result, debt service payments since July 1992 were made on a delayed basis. At December 31, 1993, the February through December 1993 debt service payments totalling approximately $4,248,000 have not been made. Accordingly, the loan balances of approximately $34,298,000 and $34,338,000 have been reflected as a current liability in the consolidated financial statements at December 31, 1993 and 1992, respectively. In order to reduce debt service payments, the joint venture has initiated discussions with the lender to negotiate possible modifications to the mortgage notes. As of the date of this report the joint venture has submitted approximately $360,000 to the lender as partial payment of the amounts delinquent at December 31, 1993. There can be no assurances that any modification will be obtained. If the joint venture is unable to secure modifications to the mortgage notes, the joint venture would likely decide, based upon current and anticipated future market conditions, not to commit any significant additional amounts to this property. This would result in the Partnership no longer having an ownership interest in this property and would result in a gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. Yerba Buena West Office Building In June 1992, the joint venture transferred title to the property to the lender in return for an opportunity to share in future sale or refinancing proceeds above certain specified levels. In connection with the San Francisco earthquake experienced on October 17, 1989, the Yerba Buena office building incurred some structural and cosmetic damage which was repaired. Five tenants (occupying approximately 54% of the building) vacated the building and withheld substantially all of their rent (commencing at various times) since November 1989. The Partnership concluded not to pursue legal recourse against said tenants based on, among other things, the costs of pursuing its remedies, competing demands on the Partnership's resources and the prospects of any material return to the Partnership in light of the then recent events. Reference is made to Note 3(b(1)). Based upon the conditions at the Yerba Buena West Office Building, the venture had not made the debt service payments to the underlying lender, commencing with the January 1990 payment. Accordingly, the venture received a default notice from the underlying lender in late February 1990. The Partnership and Affiliated Partners had decided, based upon an analysis of current market conditions and the probability of large future cash deficits, not to fund future venture cash deficits. The venture had been negotiating with the underlying lender to obtain a loan modification to pay for expected future cash deficits. The venture was unable to negotiate a loan modification whereby the venture retained ownership of the property, and in June 1992, the venture transferred title to the property to the lender in return for an opportunity to share in future sale or refinancing proceeds above certain specified levels. In order for the joint venture to share in such proceeds, there must be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the property. In addition, during a certain period of time, the venture will have a right of first opportunity to purchase the property if the lender chooses to sell. An affiliate of the Partnership's Corporate General Partner continues to manage and lease the property for the lender. As a result of the transfer of title to the lender as discussed above, the Partnership no longer has an ownership interest in the property and recognized a gain in 1992 for financial reporting and Federal income tax purposes of $1,614,369 and $964,406, respectively, with no corresponding distributable proceeds. Reference is made to Note 3(b(1)). Mall of Memphis Although occupancy had been increasing, in order for the Mall of Memphis to maintain its competitive position in the marketplace, the Mall of Memphis venture completed a mall renovation in 1991. The renovation costs had been funded by the venture until additional financing was in place. The Partnership contributed approximately $2,252,000 in addition to foregoing their share of 1990 and a portion of the 1991 distributable cash flow from the property to cover their portion of the renovation costs. In March 1993, the venture finalized additional financing of a $9,625,000 ten year loan at a rate of 10%, of which $7,600,000 was funded at closing. The Partnership's share of the funding was $4,719,095 (net of closing costs). The Partnership deposited $1,000,000 of its' share in an escrow account as security against any currently undiscovered environmental issues. The venture may be entitled to additional proceeds of $2,025,000 should it achieve certain occupancy levels and debt coverage ratios. Reference is made to Note 4(b). Meadowcrest Apartments On June 30, 1992, the second mortgage note secured by the Meadowcrest Apartments complex, located in Dallas, Texas, was scheduled to mature. In October 1991, the Partnership entered into a contract with a prospective buyer for the sale of the property. On June 9, 1992, the Partnership sold the land, building and related improvements and personal property of the Meadowcrest Apartment Complex for $9,575,000 in cash (before selling costs and prorations). A portion of the sales proceeds was utilized to retire the related underlying mortgage notes of approximately $8,445,000. The Partnership received approximately $861,000 from the sale of the property after deducting expenses in connection with the sale and the mortgage loan retirement. As a result of the sale, the Partnership has recognized in 1992 a gain of $562,806 and $5,255,084 for financial reporting and Federal income tax purposes, respectively. Reference is made to Note 7(d). South Point Apartments In July 1993, the Partnership sold South Point Apartments to an unaffiliated buyer for approximately $1,145,000 (before closing costs and lender participation) in excess of the existing mortgage balance. As a result of the sale, the Partnership recognized a gain on sale in 1993 of $1,433,916 and $3,512,797 for financial reporting and Federal income tax purposes, respectively. Reference is made to Note 7(f). General 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 and 1992, the Partnership owned eight and nine operating properties, respectively. Reference is made to Notes 3 and 6 for a description of agreements which the Partnership had entered into with sellers or affiliates of sellers of the Partnership's properties for the operation and management of such properties. The increase in rents and other receivables at December 31, 1993 as compared to December 31, 1992 is primarily due to an increase in unbilled receivables related to 1993 at the Mall of Memphis. The decrease in escrow deposits at December 31, 1993 as compared to December 31, 1992 is primarily due to the use of the balance in the 767 Third Avenue escrow account, as more fully described in Note 4(b). This decrease is partially offset by a $1,000,000 escrow deposit of the Partnership's share of the additional financing received in March, 1993 by the Mall of Memphis venture, as more fully described in Note 4(b). The decrease in prepaid expenses at December 31, 1993 as compared to December 31, 1992 is primarily due to the timing of payment of real estate taxes at the 767 Third Avenue Office Building. The decrease in mortgage notes receivable at December 31, 1993 as compared to December 31, 1992 is due to the establishment of a reserve at September 30, 1993 due to the uncertainty of collection of the mortgage notes receivable, as more fully discussed in Note 7(a). The decrease in land and leasehold interest and in building and improve- ments at December 31, 1993 as compared to December 31, 1992 is primarily due to the sale of South Point Apartments, as more fully discussed in Note 7(f). This decrease is partially offset by the capitalization of tenant leasehold improvement costs at the 767 Third Avenue Office Building and the Riverfront Office Building. The increase in deferred expenses at December 31, 1993 as compared to December 31, 1992 is primarily due to the capitalization of approximately $1,832,000 of costs associated with leasing activities at the 767 Third Avenue Office Building and the Riverfront Office Building which has resulted in higher occupancies at December 31, 1993. Reference is made to Note 4(b). The increase in the balance of accrued rents receivable at December 31, 1993 as compared to December 31, 1992 is primarily due to the Partnership accruing rental income for certain major tenant leases at certain investment properties over the full period of occupancy rather than as due per the terms of their respective leases. The increase in venture partners' deficit in venture at December 31, 1993 as compared to December 31, 1992 is primarily due to the distribution of approximately $2,764,000 of financing proceeds to the Partnership's venture partner in the Mall of Memphis venture (as more fully described in Note 4(b)) and the venture partners' share of 1993 operating deficits at the Mall of Memphis and the Riverfront Office Building. The decrease in accounts payable at December 31, 1993 as compared to December 31, 1992 is primarily due to the timing of payment of operating expenses at the Partnership's investment properties. The increase in unearned rents at December 31, 1993 as compared to December 31, 1992 is primarily due to the timing of receipt of rental income at the Mall of Memphis. The increase in accrued interest at December 31, 1993 as compared to December 31, 1992 is primarily due to interest accruals associated with the non-recourse mortgage loans secured by the 824 Market Street Office Building and the Riverfront Office Building. The Partnership is delinquent in debt service payments at these investment properties, as more fully described in Note 4(b). The increase in due to affiliates at December 31, 1993 as compared to December 31, 1992 is primarily due to the timing of reimbursement to the Corporate General Partner for certain costs relating to administration of the Partnership. The increase in the balance of long-term debt, less current portion at December 31, 1993 as compared to December 31, 1992 is primarily due to the receipt of an additional $7,600,000 in financing proceeds at the Mall of Memphis, as more fully discussed in Note 4(b). This increase in partially offset by the reduction of $4,455,000 in mortgage debt resulting from the sale of South Point Apartments, as more fully discussed in Note 7(f) and the Partnership's purchase of a 50% interest in the venture partner's loan to the 767 Third Avenue venture, as more fully discussed in Note 4(b). The decrease in rental income and depreciation for 1993 as compared to 1992 is primarily due to the sale of South Point Apartments in July 1993. The decreases in 1992 as compared to 1991 is primarily due to the sale of the Wood Forest Glen Apartments in April 1992 and the sales of the Meadowcrest Apartments and Bitter Creek Apartments in June 1992. The decrease in interest income for 1993 and 1992 as compared to 1991 is primarily due to the decreased average investment in interest bearing U.S. Government obligations resulting from the Partnership's funding during 1991 of its share of the Mall of Memphis renovation costs, as more fully discussed in note 4(b). The increase in mortgage and other interest expense for 1993 as compared to 1992 is primarily due to interest related to the additional financing secured by the Mall of Memphis as more fully discussed in Note 4(b). This increase is partially offset by the sale of Wood Forest Glen Apartments in April 1992, the sale of the Meadowcrest Apartments and the Bitter Creek Apartments in June 1992 and the sale of South Point Apartments in July 1993. The decrease in the 1992 as compared to 1991 is primarily due to the refinancing in 1991 and sale in 1992 of certain investment properties, as more fully discussed in Notes 4(b) and 7. The increase in property operating expenses for 1993 as compared to 1992 is primarily due to the establishment of a $527,774 reserve at September 30, 1993 due to the uncertainty of collection of the mortgage notes receivable, as more fully discussed in Note 7(a). The decrease for 1992 as compared to 1991 is primarily due to the sale of the Wood Forest Glen Apartments in April 1992 and the sales of the Meadowcrest Apartments and Bitter Creek Apartments in June 1992. The increase in amortization of deferred expenses for 1993 as compared to 1992 is primarily due to increased amortization relating to capitalized leasing costs at the 767 Third Avenue Office Building and the Riverfront Office Building, as more fully discussed in note 4(b). The decrease in management fees to the corporate general partner for 1993 and 1992 as compared to 1991 is due to the suspension of distributions to the Limited and General Partners effective as of the second quarter of 1991. The decrease in the Partnership's share of loss from operations of unconsolidated ventures for 1993 as compared to 1992 and 1991 is primarily due to the transfer of title to the Yerba Buena West Office Building to the lender in June 1992. The gain from sale or disposition of investment properties for 1993 resulted from the sale of the South Point Apartments, 1992 resulted from the sale of the Wood Forest Glen Apartments, the Meadowcrest Apartments and the Bitter Creek Apartments and the disposition of the Partnership's interest in the Yerba Buena West Office Building. The gain from disposition of investment properties for 1991 resulted from the lenders realization upon its security in the Gatehall Plaza Office Building. The extraordinary item for 1991 resulted from the lender forgiving all accrued deferred interest as part of the additional modification received on the mortgage loans secured by the Bitter Creek Apartment Complex. 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 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, certain 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 - XI (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 1991 Consolidated Statements of Partners' Capital Accounts (Deficit), 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 Schedule -------- Supplementary Income Statement Information X Consolidated 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 - XI: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - XI (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 - XI 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 - XI (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 the following of its ventures (note 3): GP-1 Partners, Ltd. ("Bitter Creek") (property sold in June 1992, see note 7(e)), Mall of Memphis Associates ("Mall of Memphis"), 767 Third Avenue Associates ("767 Third Avenue"), Riverfront Office Park Joint Venture ("Riverfront"), Gatehall Corporate Center-I Associates ("Gatehall") and Excelsior Associates, LP ("824 Market Street"). 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 interest in Carlyle/National City Associates ("Carlyle/Na- tional City") and Carlyle Yerba Buena Limited Partnership ("Yerba Buena") (property transferred to lender in June 1992, see note 3(b)(1)). Accordingly, the accompanying consolidated financial statements do not include the accounts of Carlyle/National City or Yerba Buena. The Partnership's 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 reflect 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 net effect of these items is summarized as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net earnings (loss) per limited partnership interest is based upon the Limited Partnership Interests outstanding at the end of each period (137,505). 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 classifications 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 (none at December 31, 1993 and 1992) as cash equivalents with any remaining amounts reflected as short-term investments. Deferred expenses consist primarily of leasing and financing fees incurred in connection with the acquisition and operation of the properties. Deferred leasing fees are amortized using the straight-line method over the terms stipulated in the related agreements. Deferred financing fees are amortized over the related commitment periods. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due, the Partnership accrues rental income over the full period of occupancy on a straight-line basis. Certain reclassifications have been made to the 1992 and 1991 consolidated financial statements to conform with the 1993 presentation. Statement of Financial Accounting Standards No. 107 ("SFAS 107"), "Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150 million at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes the carrying amount of its financial instruments classified as current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. There is no quoted market value available for any of the Partnership's other instruments. As the debt secured by the 824 Market Street and Riverfront Office Building properties have been classified by the Partnership as a current liability at December 31, 1993 as a result of defaults (see note 4(b)) and because resolution of such defaults are uncertain, the Partnership considers the disclosure of the SFAS 107 value of such long-term debt to be impracticable. The remaining debt, with a carrying balance of $106,521,982 has been calculated to have an SFAS 107 value of $111,456,259 by discounting the scheduled loan payments to maturity. Due to restrictions on transferability and prepayment and the inability to obtain comparable financing due to previously modified debt terms or other property specific competitive conditions, the Partnership would be unable to refinance these properties to obtain such calculated debt amounts reported (see note 4). The Partnership has no other significant financial instruments. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 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 tax authorities amounts representing withholding from distributions paid to partners. (2) INVESTMENT PROPERTIES (a) General The Partnership acquired, either directly or through joint venture (note 3), ten apartment complexes, eight office buildings, and an enclosed shopping mall. During 1984, the Partnership sold its Arlington, Texas and its Red Bank, Tennessee apartment complexes. During 1986, the Partnership sold its interest in Am-Car Real Estate Partnership-I joint venture ("AM-CAR"), which had ownership interests in the Pavillion Towers office complex located in Aurora, Colorado and the Coast Federal Office Building located in Pasadena, California. During 1988, the Partnership (through Somerset Lake Associates) sold its Indianapolis, Indiana apartment complex. During 1991, the Partnership disposed of its interest in the Gatehall Plaza office building located in Parsippany, New Jersey. During 1992, the Partnership sold its interest in the Wood Forest Glen Apartments, the Meadowcrest Apartments and the Bitter Creek Apartments. In addition, during 1992, the lender realized upon its security and took title to the Yerba Buena West Office Building. During 1993, the Partnership sold its interest in the South Point Apartments. All of the properties owned at December 31, 1993 were operating. The cost of the investment properties represents the total cost to the Partnership or its ventures plus miscellaneous acquisition costs. Depreciation on the operating properties has been provided over 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, for which there is generally no recourse to the Partnership. The Partnership continues to make payments on its existing mortgage indebtedness related to its remaining investment properties, except as described in note 4 below. 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 at December 31, 1993 is a party to five operating joint venture agreements. Pursuant to such venture agreements, the Partnership made initial capital contributions of approximately $57,071,000 before legal and other acquisition costs and its share of operating deficits as discussed below. In general, the Partnership's joint venture partners, who are either the sellers (or their affiliates) of the property investments being acquired or parties which have contributed an interest in the property being developed, or were subsequently admitted to the ventures, make no cash contributions to the ventures but their retention of an interest in the property, through the joint venture, is taken into account in determining the purchase price of the Partnership's interest, which is 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. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership has acquired, through the above ventures, an enclosed shopping mall and four office buildings. The joint venture partners (who were primarily responsible for constructing the properties) 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, were to retain such excesses. The venture properties have been financed under various long-term debt arrangements as described in note 4. 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; additional 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, one, one and three of the ventures, respectively, produced net cash receipts available for distribution to the Partnership. The Partnership 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, profits or losses are allocated to the partners based upon 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 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 the Partnership. (b) Unconsolidated Ventures (1) Yerba Buena In August 1985, the partnership acquired, through the Carlyle Yerba Buena Limited Partnership ("Yerba Buena"), an interest in an existing six-story office building known as Yerba Buena West Office Building in San Francisco, California. The Partners of Yerba Buena included Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII") and Carlyle Real Estate Limited Partnership- XIV, two public partnerships sponsored by the Corporate General Partner of the Partnership (the "Affiliated Partners") and four Limited Partners unaffiliated with the Partnership or its general partners (the "Unaffiliated Partners"). The Partnership and the Affiliated Partners purchased an 80% interest in the property from the sellers and simultaneously formed Yerba Buena with the Unaffiliated Partners. The Partnership owned a 23.36% interest in the property. The Partnership was generally entitled to 23.36% of Yerba Buena's annual net cash flow, net sale or refinancing proceeds and profits or losses. The Partnership's cash investment in connection with this property was approximately $4,000,000. In connection with the October 17, 1989 San Francisco earthquake, the Yerba Buena office building incurred some structural and cosmetic damage which was repaired shortly thereafter. In addition, five tenants (occupying approximately 54% of the building), based upon concerns over the structural integrity of the building, moved out of the building after the earthquake and withheld all or portions of their rent commencing at various times since November 1989. The Partnership concluded not to pursue legal recourse against CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED these tenants based on, among other things, the costs of pursuing its remedies, demands on the Partnership's resources and the prospects of any material return to the Partnership in light of the then recent events. Based upon the conditions at Yerba Buena, the venture had not made the debt service payments to the underlying lender commencing with the January 1990 payment. Accordingly, the joint venture received a default notice from the underlying lender in late February 1990. The Partnership and Affiliated Partners had decided, based upon an analyses of current market conditions and the probability of large future cash deficits, not to fund future joint venture cash deficits. The joint venture had been negotiating with the underlying lender to obtain a loan modification to pay for expected future cash deficits. The joint venture was unable to negotiate a loan modification whereby the joint venture retained ownership of the property and in June 1992, the joint venture transferred title of the property to the lender in return for an opportunity to share in future sale or refinancing proceeds above certain specified levels. In order for the joint venture to share in such proceeds, there must be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the property. In addition, during a certain period of time, the joint venture will have a right of first opportunity to purchase the property if the lender chooses to sell. An affiliate of the Partnership's Corporate General Partner continues to manage and lease the property for the lender. As a result of the transfer of title to the lender as discussed above, the Partnership no longer has an ownership interest in the property and recognized in 1992 a gain for financial reporting and Federal income tax purposes of $1,614,369 and $964,406, respectively, with no corresponding distributable proceeds. (2) Carlyle/National City In July 1983, the Partnership acquired, through Carlyle/National City (a joint venture with Carlyle-XII), an interest in an existing thirty-five story office building in Cleveland, Ohio. The Partnership made an initial contribution of $5,445,257 to Carlyle/National City. The terms of the Carlyle/National City venture agreement provide that the capital contributions, annual cash flow, net proceeds from sale or refinancing and profit or loss will be allocated or distributed 13.7255% to the Partnership. The Partnership's cash investment in the property was $3,341,583 after distributions resulting from the increase in the first mortgage loan. The Partnership has reached an agreement in principle with the current mortgage lender to refinance the existing mortgage which would be effective February 1, 1994, with a reduced interest rate. The loan would be amortized over 22 years with a balloon payment due in seven years. There can be no assurances that any modification will be obtained. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Five year maturities of long-term debt are as follows: 1994 . . . . . . . . . $48,194,235 1995 . . . . . . . . . 422,158 1996 . . . . . . . . . 467,336 1997 . . . . . . . . . 517,396 1998 . . . . . . . . . 572,871 =========== (b) Long-Term Debt Modifications and Refinancings General As described below, the Partnership is seeking or has received mortgage note modifications on certain properties. 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, the Partnership may not commit any significant additional amounts to these properties. This would likely result in the Partnership no longer having an ownership (or security interest) in such properties. Such decisions will be made on a property-by-property basis and could result in a gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. Wood Forest Glen Apartments The modification of the existing long-term mortgage note secured by the Wood Forest Glen apartment complex located in Houston, Texas expired on June 30, 1990. The Partnership continued to negotiate for further modifications to the mortgage loan but was unsuccessful. In December 1991, the Partnership was notified that the lender sold its mortgage note to a third party. The Partnership pursued discussions with the new lender concerning modifications to the mortgage loan and a possible sale of the property. The Partnership was not successful in securing such modifications; however, in April 1992, the Partnership sold its interest in the property to the new lender for approximately $213,000 in excess of the existing mortgage balance (see note 7(c)). As a result of the sale, the Partnership recognized in 1992 a gain on sale of $6,470,625 and $7,058,574 for financial reporting and Federal income tax purposes, respectively. Bitter Creek Apartments On June 10, 1992, the venture sold the property as more fully discussed in note 7(e). The original modification of the then existing long-term mortgage notes (originally due December 15, 1995) secured by the Bitter Creek apartment complex located in Grand Prairie, Texas expired on June 15, 1991. The modifications provided for the deferral of interest payments for the period December 15, 1986 through June 15, 1991. In addition, principal payments were deferred for the period December 15, 1986 through December 15, 1990. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED During February 1992, the Bitter Creek venture received an additional modification to the long-term mortgage notes. The venture was required to pay down approximately $436,000 of the principal balance of the mortgage loan in exchange for the lender forgiving all deferred interest and extending the term of the modification. The Partnership's share of the required principal payment was approximately $58,000. The new modified interest accrual and payment rate (averaging 7% for the period June 15, 1991 to June 9, 1992) was based upon the lender's prime rate. As the modification was retroactive to June 15, 1991, the Partnership recognized a gain upon forgiveness of indebtedness in 1991 aggregating $143,082 and $1,094,940 for financial reporting and Federal income tax purposes, respectively. The additional mortgage modification provided that payments of interest be paid monthly and the principal balance and any accrued interest would be due and payable on December 15, 1992. Gatehall Plaza Office Building The Gatehall venture had reached an agreement in principle with the lender, effective September 1, 1988, to modify the terms of the mortgage note which was secured by the Gatehall Plaza office building located in Parsippany, New Jersey through August 31, 1990. The venture approached the lender to negotiate additional modifications to the mortgage loan in order to further reduce the debt service payments and extend the terms of the modification. During such negotiations, the venture made partial payments of debt service of approximately $1,016,000. During the year ended December 1990, the mortgage lender informed the venture that they were unwilling to further modify the loan and in October 1991, the lender realized upon its security and took title to the property resulting in the Partnership no longer having an ownership interest in the property. The Partnership received no cash proceeds from the transfer of ownership interest; it did, however, recognize a gain for financial reporting and Federal income tax purposes during 1991 of $4,235,904 and $3,305,588, respectively. 767 Third Avenue Office Building During 1991 and 1992, the leases for approximately 67% of the space at the 767 Third Avenue office building located in New York, New York expired (of which approximately 56% have been re-leased as of December 1993). In order to reduce debt service payments during the tenant turnover period, the 767 Third Avenue venture obtained from the existing lender, in May 1992, a replacement mortgage loan which matures in seven years and bears a substantially lower interest rate (10%) than the original loan (12 3/8%). In connection with the replacement mortgage loan, 767 Third Avenue was required to fund $8,000,000 into an escrow account for future leasing costs and debt service shortfalls resulting from anticipated tenant turnover. At the inception of the escrow agreement, the venture was allowed to reduce the required escrow contributions by approximately $2,600,000 to reflect that certain leasing costs (described above) had already been incurred. 767 Third Avenue had been reserving the property's cash flow beginning with the second quarter of 1990; however, such amounts were less than the net required reserve. The Partnership's venture partner loaned $5,000,000 to the venture in order to fund the net escrow reserve account. As of the date of this report, the reserve account has been depleted and the venture (by way of partner contributions) is funding required leasing costs and debt service shortfalls. The loan funded by the Partnership's venture partner earns interest at an adjustable rate (approximately 8% at December 31, 1993) and provides for repayment of principal and interest out of the available cash flow from property operations and sale or refinancing proceeds. In June 1993, the Partnership purchased a 50% interest in the venture partner's loan including the related accrued interest. Accordingly, the Partnership's 50% interest in the principal portion of the loan ($2,500,000) is reflected as a decrease in long-term debt, CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED less current portion in the consolidated financial statements at December 31, 1993. In conjunction with the agreement with the venture partner to loan the amounts necessary to fund the escrow account, because the Partnership did not purchase its share of the $5,000,000 loan by December 31, 1992, the Partnership's preferential return was removed from the calculation of the allocation of sale or refinancing proceeds. Because the reserve account has been depleted and the property is operating at a deficit, the 767 Third Avenue venture intends to seek refinancing of the mortgage loan. There can be no assurances that any refinancing can be obtained. 824 Market Street Office Building Occupancy at the 824 Market Street office building located in Wilmington, Delaware is currently 49%; however, rent paying occupancy is 80% due to a vacated major tenant that is obligated to pay rent on 60,500 square feet (31% of net rentable area) pursuant to the terms of its lease which expires April 1994. The 824 Market Street venture is aggressively seeking replacement tenants for the vacant space; however, competition has risen significantly due to new office building development in the area over the last few years and the contraction of tenants in the financial services industry, resulting in lower effective rental rates. In order to reduce debt service payments during the tenant turnover period, the venture had negotiated with the first mortgage lender for a possible modification to the mortgage note. Such negotiations have been unsuccessful and the first mortgage lender has informed the venture of its intent to realize upon its security in 1994. The 824 Market Street venture has decided, based upon current and anticipated future market conditions, not to commit any significant additional amounts to this property. This will result in the Partnership no longer having an ownership interest in this property and will result in a gain for financial reporting and federal income tax purposes to the Partnership with no corresponding distributable proceeds. As of December 31, 1993, the venture is eighteen months delinquent in making the scheduled debt service payments of approximately $2,970,000 under the terms of the note and, in connection with the negotiations, the venture has withheld payments of contingent interest related to 1987 through 1989 aggregating $134,525. Accordingly, for financial reporting purposes, the long-term mortgage note of approximately $12,570,000 has been reflected as a current liability in the accompanying consolidated financial statements at December 31, 1993 and December 31, 1992. At the first mortgage lender's request, beginning March 1993, payments of approximately $78,000 on the second mortgage loan have also been withheld. As a result, the second mortgage loan of approximately $945,000 has also been reflected as a current liability in the accompanying consolidated financial statements at December 31, 1993. Riverfront Office Building On August 28, 1990, the Riverfront joint venture acquired additional financing by way of a $5,800,000 fourth mortgage note in order to fund the costs associated with leasing vacant space. To date, the joint venture has received approximately $5,730,000 in proceeds. The balance of the proceeds, a $70,000 engineering holdback, is payable to the joint venture upon completion of certain structural repairs which due to cash flow operations are expected to be completed by 1996. The property began operating at a deficit in 1992 and, as a result, debt service payments since July 1992 were made on a delayed basis. At December 31, 1993, the February through December 1993 debt service payments totalling approximately $4,248,000 have not been made. Accordingly, the loan balances of approximately $34,298,000 and $34,338,000 have been reflected as a current liability in the consolidated financial statements at December 31, 1993 and 1992, respectively. In order to reduce debt service payments, the joint venture has initiated discussions with the lender to negotiate possible modifications to the mortgage notes. As of the date of CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED this report the joint venture has submitted approximately $360,000 to the lender as partial payment of the amounts delinquent at December 31, 1993. There can be no assurances that any modification will be obtained. If the joint venture is unable to secure modifications to the mortgage notes, the joint venture would likely decide, based upon current and anticipated future market conditions, not to commit any significant additional amounts to this property. This would result in the Partnership no longer having an ownership interest in this property and would result in a gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. Mall of Memphis Although occupancy had been increasing, in order for the Mall of Memphis to maintain is competitive position in the marketplace, the Mall of Memphis venture completed a mall renovation in 1991. The renovation costs had been funded by the venture until additional financing was in place. The Partnership contributed approximately $2,252,000 in addition to foregoing their share of 1990 and a portion of the 1991 distributable cash flow from the property to cover their portion of the renovation costs. In March 1993, the venture finalized additional financing of a $9,625,000 ten year loan at a rate of 10%, of which $7,600,000 was funded at closing. The Partnership's share of the funding was $4,719,095 (net of closing costs). Of the amount funded, the Partnership deposited $1,000,000 in an escrow account as security against any currently undiscovered environmental issues. The venture may be entitled to additional proceeds of $2,025,000 should it achieve certain occupancy levels and debt coverage ratios. (c) Refinancings The modification of the existing long-term mortgage notes secured by the Scotland Yard Apartments - Phase II and the South Point Apartments located in Houston, Texas expired on June 30, 1990. However, the Partnership continued to pay debt service according to the previously modified terms through December 31, 1990. Effective December 27, 1990, the Partnership obtained replacement mortgage loans from an institutional lender to retire in full satisfaction, at an aggregate discount, the previously modified existing long- term mortgage notes secured by the Scotland Yard - Phase I and II, South Point and El Dorado View apartment complexes. Commencing April 1, 1992, the loans provide for payment of contingent interest equal to 35% of the amount by which gross receipts attributable to a fiscal year (all as defined) exceed a base amount. For the fiscal years 1993 and 1992, contingent interest aggregated approximately $293,000 and $281,000, respectively. In the event that these properties are sold before the maturity date of the loan, the lender is entitled to a prepayment penalty of 6% of the mortgage principal and, in general, the higher of 65% of the sale proceeds or ten times the highest contingent interest amount in any of the three full fiscal years preceding the sale (all as defined). The Partnership sold South Point Apartments in July 1993, as further discussed in note 7(f). The lender has the right to call the remaining loan at any time after January 1, 1996. The lender required the establishment of an escrow account, initially of approximately $980,000 in the aggregate, to be used towards the purchase of major capital items at the apartment complexes. Additionally, the lender required $150,000 of the sale proceeds from South Point Apartments to be added to the escrow account. As of December 31, 1993, the Partnership has been reimbursed from the escrow account approximately $647,000 for capital improvements at the above-referenced apartment complexes. Finally, the modification provides for the lender to participate in the net proceeds from the sale or refinancing of the properties in the form of additional contingent interest. The Partnership has recorded an accrual for such participation as deferred accrued interest included in the balance of long-term debt in the accompanying consolidated financial statements at December 31, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (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 or other disposition of investment properties are allocated first to the General Partners in an amount equal to the greater of the amount distributable to the General Partners from the proceeds of any such sale (as described below) or 1% of the profits from the sale. Losses from the sale or other disposition of investment properties will be allocated 1% to the General Partners. The remaining sale profits and losses will be allocated to the Limited Partners. An amendment to the Partnership Agreement, effective January 1, 1991, generally provides that notwithstanding any allocation contained in the Agreement, if at any time profits are realized by the Partnership, any current or anticipated event which would cause the deficit balance in absolute amount in the Capital Account of the General Partners to be greater than their 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. In general, the effect of this amendment is to allow the deferral of the recognition of taxable gain 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 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). The Partnership Agreement provides that the Limited Partners shall receive 99% and the General Partners shall receive 1% of the sale or refinancing proceeds of a real property (net after expenses and retained working capital) 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 first fiscal quarter of 1983. After such distributions, the General Partners shall receive (to the extent not previously received) proceeds up to 3% of the aggregate sales price of properties previously sold by the Partnership with any remaining proceeds allocated 85% to the Limited Partners and 15% General Partners. The Limited Partners have not yet received cash distributions of sale or refinancing proceeds in an amount equal to their initial capital investment. Therefore, no sale proceeds are distributable to the General Partners pursuant to the distribution levels described above. Allocations among the partners in the accompanying accrual basis consolidated financial statements have been made in accordance with the provisions of the Partnership Agreement and the venture agreements (see note 3). The allocation percentages may differ from year to year based on future events. Differences may therefore result between allocations among the partners on the GAAP basis and the tax basis. Such differences would have no significant effect on total assets, total partners' capital or net loss. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (6) MANAGEMENT AGREEMENTS An affiliate of the Corporate General Partner has assumed management of the following properties: Scotland Yard Apartments - Phase I, Houston, Texas; El Dorado View Apartments, Webster, Texas; Scotland Yard Apartments - Phase II, Houston, Texas; South Point Apartments, Houston, Texas; (through the date of sale, July 29, 1993): Management fees for the above properties are calculated at a percentage of the gross income from the properties. (7) SALES OF INVESTMENT PROPERTIES (a) Pavillion Towers, Aurora, Colorado During April 1986, the Partnership sold its interest in Am-Car Real Estate Partnership-I ("Am-Car") (which owns the Pavillion Towers office complex located in Aurora, Colorado) to its venture partners for $1,000,000 in cash, promissory notes aggregating $3,750,000 and the venture partners' assumption of the Partnership's share of the debt encumbering the property. The two promissory notes of $3,000,000 and $750,000 bear interest at various rates and are due in April 1996. Beginning in 1991, the Partnership has not received the scheduled interest payments of $15,000 on the $750,000 note and as of the date of this report, the Partnership has not received the 1993 scheduled interest payment of $60,000 on the $3,000,000 note. Collection of all past due and future amounts from these notes are considered unlikely; however, the Partnership is evaluating all of its legal options. Due to the uncertainty of collection of all past due and future amounts from these notes, a $527,774 reserve was established at September 30, 1993 to reduce the mortgage notes receivable balance to an amount not to exceed the related deferred gain on sale. The sale was accounted for by the installment method whereby the gain on sale of $3,057,695 (net of discount on the promissory notes receivable of $1,682,305) was recognized as collections of principal were received. Effective January 1, 1990, the Partnership adopted the cost recovery method of accounting. The interest received in 1992 and 1991 ($60,000 and $60,000, respectively) was applied against the outstanding principal balance. No profit was recognized in 1993, 1992 or 1991. (b) Mortgage notes receivable relating to the above sale consist of the following: 1993 1992 ------------------------ Promissory note secured by personal guarantees of the buyers of the Partnership's interest in the Pavillion Tower office complex located in Aurora, Colorado. Payable interest only (aggregating $150,000 over the ten-year period) at various rates. The entire unpaid principal balance is due April 24, 1996. Balance is net of $199,406 of unamortized discount at December 31, 1993 and 1992 based on an im- puted rate of 8-1/2%. . . . . . . . . . . $ 543,094 543,094 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ----------- ----------- Promissory note secured by personal guarantees of the buyers of the Partnership's interest in the Pavillion Tower office complex located in Aurora, Colorado. Payable interest only (aggregating $600,000 over the ten-year period) at various rates. The entire unpaid principal balance is due April 24, 1996. Balance is net of $797,625 of unamortized discount at December 31, 1993 and 1992 based on an imputed rate of 8-1/2%. . . . . . . . . . . . . . 2,052,375 2,052,375 ---------- --------- Total long-term notes receivable 2,595,469 2,595,469 Reserve for uncollectibility . . (527,774) -- ----------- --------- Total long-term notes receivable (net of reserve for uncollectibility) . . . . . . $2,067,695 2,595,469 ========== ========= (c) Wood Forest Glen Apartments On April 2, 1992, the Partnership sold its interest in the Wood Forest Glen Apartments to the lender for approximately $213,000 in excess of the existing mortgage balance ($11,138,170 at the date of sale). The Partnership recognized in 1992 a gain of $6,470,625 and $7,058,574 for financial reporting and Federal income tax purposes, respectively. (d) Meadowcrest Apartments On June 9, 1992, the Partnership sold the land, building and related improvements and personal property of the Meadowcrest apartment complex located in Dallas, Texas for $9,575,000 in cash before selling costs and prorations. A major portion of the sales proceeds was utilized to retire the related underlying mortgage notes of approximately $8,445,000 (a portion of which were scheduled to mature June 30, 1992). The Partnership received approximately $861,000 from the sale of the property after deducting expenses in connection with the sale and the mortgage loan. As a result of the sale, the Partnership recognized in 1992 a gain of $562,806 and $5,255,084 for financial reporting and Federal income tax purposes, respectively. (e) Bitter Creek Apartments On June 10, 1992, the Partnership, through the Bitter Creek venture, sold the land, building and related improvements and personal property of the Bitter Creek apartment complex for $10,250,000 in cash before selling costs and prorations. A major portion of the sales proceeds was utilized to retire the related underlying mortgage note of approximately $9,064,000 (note 4(a)). In addition, pursuant to the venture partner agreement, the Partnership and venture partner were allocated $338,709 and $681,423 of net sales proceeds, respectively. The venture agreement generally provides that the gain of $1,024,264 from the sale of the entire property will be first allocated to the joint venture partners' respective negative capital accounts. Any amounts remaining will be allocated 50% to the Partnership and 50% to the venture partner. The venture partner's share of the gain was $881,297. The Partnership recognized in 1992 a gain of $142,967 and $2,808,159 for financial reporting and Federal income tax purposes, respectively. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (f) South Point Apartments On July 29, 1993, the Partnership sold the land, buildings and related improvements and personal property of the South Point apartments complex located in Houston, Texas to an unaffiliated buyer at a sales price determined by arm's-length negotiations. The sales price of the property was $5,600,000 (before closing costs and prorations). A major portion of the sales proceeds was utilized to retire the related underlying mortgage principal of $4,455,000. The Partnership received in connection with the sale, after all fees and expenses, approximately $932,000. Of this amount, the lender was entitled to approximately $606,000 as participation in the sales proceeds. From the sale, the Partnership received a net amount of cash of approximately $326,000, of which $150,000 was required by the lender to be escrowed for the benefit of the Partnership's other properties financed by the lender, as more fully discussed in note 3(c). As a result of the sale, the Partnership has recognized in 1993 a gain of $1,433,916 and $3,512,797 for financial reporting purposes and for federal income tax purposes, respectively. (8) LEASES (a) As Property Lessor At December 31, 1993, the Partnership's and its consolidated ventures' principal assets are three office buildings, one enclosed shopping mall and three apartment complexes. 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 building and shopping center tenants range in term from one to twenty-four years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants provide for additional rent based upon percentages of tenant sales volumes. With respect to the Partnership's shopping center investment, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. 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 $6,527,000. Cost of the leased assets net of accumulated depreciation are summarized as follows at December 31, 1993: Shopping mall: Cost. . . . . . . . . . . . $ 54,908,429 Accumulated depreciation. . (17,360,044) ------------ 37,548,385 ------------ Office buildings: Cost. . . . . . . . . . . . 131,184,365 Accumulated depreciation. . (44,560,214) ------------ 86,624,151 ------------ Apartment complexes: Cost. . . . . . . . . . . . 25,924,396 Accumulated depreciation. . (10,589,071) ------------ 15,335,325 ------------ Total . . . . . . . . . . . . $139,507,861 ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 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 above commercial operating lease agreements, are as follows: 1994. . . . . . . . . . . . . $ 19,428,455 1995. . . . . . . . . . . . . 18,558,815 1996. . . . . . . . . . . . . 16,830,400 1997. . . . . . . . . . . . . 13,079,607 1998. . . . . . . . . . . . . 9,009,056 Thereafter. . . . . . . . . . 39,174,884 ------------ Total . . . . . . . . . . . . $116,681,217 ============ Additional contingent rent (based on sales by property tenants) included in consolidated rental income was as follows for the years ended December 31, 1993, 1992 and 1991: 1991. . . . . . . . . . . . . $438,875 1992. . . . . . . . . . . . . 424,211 1993. . . . . . . . . . . . . 352,862 ======== (b) As Property Lessee The following lease agreement has been determined to be an operating lease. The Riverfront venture owns a net leasehold interest which expires in 2061 (subject to a 19-year extension) in the land underlying the Cambridge, Massachusetts office building. The lease provides for annual rent equal to the greater of 2% of gross income from the property or a minimum amount (which increases on a fixed schedule from $132,700 to $298,575 for the years 2007 through 2080). Future minimum rental commitments under this lease are as follows: 1994 . . . . . . . . . $ 179,145 1995 . . . . . . . . . 179,145 1996 . . . . . . . . . 187,417 1997 . . . . . . . . . 212,230 1998 . . . . . . . . . 212,230 Thereafter . . . . . . 18,265,909 ----------- Total. . . . . . . . . $19,236,076 =========== CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED The Corporate General Partner has deferred payment of partnership management fees as set forth in the above table. In addition, distributions to the General Partners of the first quarter 1991 net cash flow of the Partnership aggregating $7,161 have also been deferred. These amounts do not bear interest and are expected to be paid in future periods. (10) COMMITMENTS AND CONTINGENCIES The Partnership is a defendant in several actions brought against it arising in the ordinary course of business. It is the belief of the Corporate General Partner, based on its knowledge of facts and advice of counsel, that the claims made against the Partnership in such actions will not result in a material adverse effect on the Partnership's consolidated financial position or results of operations. (11) INVESTMENT IN UNCONSOLIDATED VENTURE For the Yerba Buena venture (note 3(b)(1)) for the years ended December 31, 1992 and December 31, 1991, total income was $1,431,864 and $2,987,385, respectively, expenses applicable to operating loss were $3,523,650 and $7,165,674, respectively, and the net income was $4,254,514 and the net loss was ($4,178,289), respectively. SCHEDULE X CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Depreciation . . . . . . $6,750,315 6,963,918 7,835,833 Maintenance and repairs. 5,766,650 5,462,682 6,380,656 Taxes: Real estate. . . . . 5,848,853 6,019,065 6,009,218 Other. . . . . . . . 34,470 46,010 77,453 Advertising. . . . . . . 353,295 366,016 447,265 ========== ========== ========== 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 years 1993 and 1992. 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-XI, 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 9-14 of the Prospectus, which description is hereby incorporated herein by reference to Exhibit 3-A to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-10494) dated March 19, 1993. The names, positions held and length of service therein of each director, executive officer and certain officers of the Corporate General Partner 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 and General Counsel 2/27/84 Gailen J. Hull Senior Vice President 6/01/88 Ira J. Schulman Executive 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-X ("Carlyle-X"), 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") and Carlyle Income Plus, Ltd.-II ("Carlyle Income Plus-II"), and the managing general partner of 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 officers and directors are also officers and/or directors of various affiliated companies of JMB including Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II")) and Income Growth Managers, Inc. (the Corporate General Partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG"). 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-X, 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 117-119, "Allocation of Profits or Losses for Tax Purposes" at page 117 and "Distributions and Compensations; Allocations of Profits and Losses" at pages A-5 to A-10 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- 10494) dated March 19, 1993. Reference is also made to Notes 5 and 9 for a description of such transactions, distributions and allocations. In 1993, 1992, and 1991, no cash distributions were paid to the General Partners. The General Partners have deferred distributions in 1991 of $7,161. JMB Properties Company, an affiliate of the Corporate General Partner, provided property management services to the Partnership for all of 1993 for the El Dorado View Apartments in Webster, Texas, Scotland Yard - Phase I and Scotland Yard-Phase II in Houston, Texas, and for South Point Apartments in Houston, Texas for the period January 1, 1993 through July 29, 1993. Fees are calculated at 5% of gross income for the apartment complexes. Such affiliate earned property management fees amounting to $322,125 in 1993 all of which were paid at 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 $31,165 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 of the Partnership or their affiliates may be reimbursed for their direct expenses or out-of-pocket expenses and salaries relating to the administration of the Partnership and the acquisition and operation of the Partnership's real property investments. In 1993, the Corporate General Partner of the Partnership was due reimbursement for such expenses in the amount of $146,052. Cumulative amounts unpaid at December 31, 1993 were $250,669. 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 9-14 and "Powers, Rights and Duties of the General Partners" at pages A-12 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. 0-10494) dated March 19, 1993. The relationship of the Corporate General Partner to its affiliates is set forth above in Item 10. 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 8, 1981, as supplemented on July 27, 1981, October 9, 1981, November 5, 1981, December 10, 1981, February 19, 1982 and April 23, 1982, as filed with the Commission pursuant to Rules 424(b) and 424(c), is hereby incorporated herein by reference. Pages 6-14, 117-119, A-5 to A-10 and A-12 to A-17 are hereby incorporated herein by reference. 3-B.*Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which agreement is hereby incorporated herein by reference. 4-A. Long-term debt modification relating to the 767 Third Avenue Office Building in New York, New York is hereby incorporated herein by reference. 4-B. Mortgage loan documents secured by the Mall of Memphis in Memphis, Tennessee are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-70724) dated May 8, 1981. 4-C. First through third mortgage loan documents secured by the Riverfront Office Building in Cambridge, Massachusetts are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 3 to Form S-11 (File No. 2-70724) dated May 8, 1981. 4-D.*Fourth mortgage loan document secured by the Riverfront Office Building in Cambridge, Massachusetts is hereby incorporated herein by reference. 4-E Deed of trust note document dated March 31, 1993 secured by the Mall of Memphis in Memphis, Tennessee is filed herewith. 10-A.Acquisition documents relating to the purchase by the Partnership of an interest in the 767 Third Avenue Office Building in New York, New York are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-70724) dated May 8, 1981. 10-B.Acquisition Documents relating to the purchase by the Partnership of an interest in the Mall of Memphis in Memphis, Tennessee are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-70724) dated May 8, 1981. 10-C.Acquisition documents relating to the purchase by the Partnership of an interest in the Riverfront Office Building in Cambridge, Massachusetts are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 3 to Form S-11 (File No. 2-70724) dated May 8, 1981. 21. List of Subsidiaries. 24. Powers of Attorney 99-A.The Partnership's Report on Form 8-K dated August 30, 1993 describing the July 29, 1993 sale of the South Point Apartments and exhibits thereto are hereby incorporated herein by reference. _____________ * Previously filed in Exhibits 3-A, 3-B and 4-D to the Partnership's Report on Form 10-K for December 31, 1992 of the Securities Exchange Act of 1934 (file no. 0-10494) filed on March 19, 1993. 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) No report on Form 8-K was filed since the beginning of the last quarter of the period covered by this report: No annual report or proxy material for the fiscal year 1993 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 - XI 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 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 a Power of Attorney By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 6-14, 117-119, A-5 to A-10, A-12 to A-17 of the Prospectus of the Partnership dated May 8, 1981 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan documents secured by the 767 Third Avenue Office Building Yes 4-B. Mortgage loan documents secured by the Mall of Memphis Yes 4-C. First through third mortgage loan documents secured by the Riverfront Office Building Yes 4-D. Fourth mortgage loan document secured by the Riverfront Office Building Yes 4-E. Deed of trust note dated March 31, 1993 secured by the Mall of Memphis No 10-A. Acquisition documents related to the 767 Third Avenue Office Building Yes 10-B. Acquisition documents related to the Mall of Memphis Yes 10-C. Acquisition documents related to the Riverfront Office Building Yes 21. List of Subsidiaries No 24. Powers of Attorney No 99-A. Form 8-K for July 29, 1993 Yes 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 8, 1981, as supplemented on July 27, 1981, October 9, 1981, November 5, 1981, December 10, 1981, February 19, 1982 and April 23, 1982, as filed with the Commission pursuant to Rules 424(b) and 424(c), is hereby incorporated herein by reference. Pages 6-14, 117-119, A-5 to A-10 and A-12 to A-17 are hereby incorporated herein by reference. 3-B.*Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which agreement is hereby incorporated herein by reference. 4-A. Long-term debt modification relating to the 767 Third Avenue Office Building in New York, New York is hereby incorporated herein by reference. 4-B. Mortgage loan documents secured by the Mall of Memphis in Memphis, Tennessee are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-70724) dated May 8, 1981. 4-C. First through third mortgage loan documents secured by the Riverfront Office Building in Cambridge, Massachusetts are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 3 to Form S-11 (File No. 2-70724) dated May 8, 1981. 4-D.*Fourth mortgage loan document secured by the Riverfront Office Building in Cambridge, Massachusetts is hereby incorporated herein by reference. 4-E Deed of trust note document dated March 31, 1993 secured by the Mall of Memphis in Memphis, Tennessee is filed herewith. 10-A.Acquisition documents relating to the purchase by the Partnership of an interest in the 767 Third Avenue Office Building in New York, New York are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-70724) dated May 8, 1981. 10-B.Acquisition Documents relating to the purchase by the Partnership of an interest in the Mall of Memphis in Memphis, Tennessee are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 to Form S-11 (File No. 2-70724) dated May 8, 1981. 10-C.Acquisition documents relating to the purchase by the Partnership of an interest in the Riverfront Office Building in Cambridge, Massachusetts are hereby incorporated by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 3 to Form S-11 (File No. 2-70724) dated May 8, 1981. 21. List of Subsidiaries. 24. Powers of Attorney 99-A.The Partnership's Report on Form 8-K dated August 30, 1993 describing the July 29, 1993 sale of the South Point Apartments and exhibits thereto are hereby incorporated herein by reference. _____________ * Previously filed in Exhibits 3-A, 3-B and 4-D to the Partnership's Report on Form 10-K for December 31, 1992 of the Securities Exchange Act of 1934 (file no. 0-10494) filed on March 19, 1993. 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) No report on Form 8-K was filed since the beginning of the last quarter of the period covered by this report: No annual report or proxy material for the fiscal year 1993 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 - XI 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 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 a Power of Attorney By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XI EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 6-14, 117-119, A-5 to A-10, A-12 to A-17 of the Prospectus of the Partnership dated May 8, 1981 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan documents secured by the 767 Third Avenue Office Building Yes 4-B. Mortgage loan documents secured by the Mall of Memphis Yes 4-C. First through third mortgage loan documents secured by the Riverfront Office Building Yes 4-D. Fourth mortgage loan document secured by the Riverfront Office Building Yes 4-E. Deed of trust note dated March 31, 1993 secured by the Mall of Memphis No 10-A. Acquisition documents related to the 767 Third Avenue Office Building Yes 10-B. Acquisition documents related to the Mall of Memphis Yes 10-C. Acquisition documents related to the Riverfront Office Building Yes 21. List of Subsidiaries No 24. Powers of Attorney No 99-A. Form 8-K for July 29, 1993 Yes

320335_1993.txt

320335_1993

1993

320335

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

6082_1993.txt

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1993

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ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS AMETEK, Inc. ("Ametek" or the "Company") was incorporated in Delaware in 1930 under the name of American Machine and Metals, Inc. and maintains its principal executive offices at Station Square, Paoli, Pennsylvania 19301. Ametek is an international manufacturer of high quality, engineered products for industrial and commercial markets. The Company has a significant market share for many of its products and a leading market share in electric motors for vacuum cleaners and other floor care products, the Company's most significant business. Many of the Company's products have a technological component and are engineered to customer specifications. The Company's products are produced and sold worldwide through the Company's Electro-mechanical, Precision Instruments and Industrial Materials Groups. The Company's business has grown over the years through a combination of acquisitions and internal growth into a diversified manufacturing company serving a wide range of markets. The Company has concentrated on identifying, developing and marketing high quality, technology-based products which hold, or have the potential for gaining, a significant share of one or more niche markets. In November 1993, the Company completed a broad strategic review and announced a plan intended to enhance shareholder value over the long term. From an operational point of view, the Company will seek to increase the profitability of its existing businesses through (i) growth and reinvestment, particularly in its electro-mechanical, specialty metal and water filtration operations, (ii) continued emphasis on controlling costs and (iii) an increased focus on foreign sales, especially in the Pacific Rim and Europe, through a combination of direct selling efforts and joint ventures. The Company also intends to pursue strategic acquisitions on a selective basis. In addition, the Company intends to continue its policy of reviewing, from time to time, possible divestitures of existing businesses. From a financial point of view, the Company's plan, which takes advantage of the Company's historically strong cash flow, involves repurchasing outstanding shares of its common stock for an aggregate purchase price of up to $150 million and refinancing existing debt with the net proceeds from the March 1994 sale of $150 million principal amount of 9 3/4% senior notes, borrowings under a new bank credit agreement, and available cash. The resulting increased leverage will reduce the Company's financial and operating flexibility. Accordingly, the plan also called for a reduction in the quarterly per share dividend rate on the Company's common stock from $.17 to $.06, beginning with the dividend payable on December 24, 1993, and a decrease in the Company's leverage over time. The Company also recorded certain after tax charges against earnings of $28.6 million during the fourth quarter of 1993, resulting in aggregate charges of $33.5 million for the year. A substantial portion of these charges relates to the restructuring of several businesses and the remainder reflects asset write- downs and other unusual charges against income. The restructuring charges primarily result from actions taken or planned due to the unwillingness of the union at a Precision Instruments facility in Sellersville, Pennsylvania to agree on wage and work rule concessions requested by the Company necessary to make such operation competitive. These actions include relocating, outsourcing and downsizing various manufacturing functions at this facility. The Company will also record an extraordinary after tax charge of approximately $13 million, (estimated as of December 31, 1993), in the first quarter of 1994, subject to an interest rate adjustment, for the early retirement of existing debt after completion of the sale of the senior notes and the application of the proceeds thereof. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS, FOREIGN OPERATIONS AND EXPORT SALES Business segment and geographic information is set forth on pages 31 through 33 of this report. In response to increasing globalization of the world economy and perceived opportunities for growth, the Company has expanded its foreign sales and operations over the past several years. This expansion has resulted from a combination of increasing export sales of products manufactured in the United States and overseas acquisitions and strategic alliances. The Company's strategy for growth in global markets is driven by requirements for global cost-competitiveness and especially by economic growth in the Pacific Rim. Ametek Singapore Private, Ltd. was established as a regional headquarters to enable the Company to secure more favorable supply arrangements and to expand its product sales throughout the Pacific Rim. International operations of the Company are subject to certain risks which are inherent in conducting business outside the United States, such as fluctuation in currency exchange rates and controls, restrictions on the movement of funds, import and export controls, and other economic, political and regulatory policies of the countries in which business is conducted. NARRATIVE DESCRIPTION OF BUSINESS PRODUCTS AND SERVICES The Company classifies its operations into three principal business segments. A description of the products and services offered by the Company by segment is set forth below: ELECTRO-MECHANICAL GROUP The Company's Electro-mechanical Group ("EMG") is a major supplier of fractional horsepower electric motors and blowers for vacuum cleaners and other floor care products. EMG also manufactures electric motors and blowers for furnaces, lawn tools, photocopiers, computer equipment and other applications. Through its six plants in the United States, three in Italy and one in Mexico, EMG produced approximately 18 million motors in 1993 and approximately 20 million motors in 1992. Each of these facilities is equipped with efficient state-of-the-art production lines designed to maximize manufacturing flexibility. Because of its high production volume, flexible manufacturing capability and technological know-how, EMG offers its customers cost competitive and custom designed products on a timely basis. Floor Care Products EMG participates in the production of motors and blowers for the full range of floor care products from the hand held, canister, upright and central vacuums for household use to the more sophisticated vacuum products for commercial and industrial applications. In recent years, EMG has expanded its sales in the floor care industry by marketing its motors to vertically integrated vacuum cleaner manufacturers who elect to curtail or discontinue their own motor production and instead use EMG's motors. By using EMG's motors, vacuum cleaner manufacturers are able to reduce the substantial capital expenditures they would otherwise have to make to maintain their own motor production, with frequent design changes, at acceptable levels. EMG's floor care product development activities have recently focused on improving motor-blower cost-performance through advances in power, efficiency and quieter operation. EMG has recently developed a 1200 watt brushless motor blower for high-end floor care applications in commercial vacuum cleaners and central vacuum systems, as well as a new low cost motor designed for export markets with price-sensitive, high volume vacuum applications. EMG currently maintains a significant position in the European market for floor care products based on exports from the United States and production from its Italian operations. Two of EMG's plants in Italy are dedicated to producing electric motors for vacuum cleaner manufacturers throughout Western Europe and, to a more limited extent, Eastern Europe. These motors are similar to those produced in the United States. Consistent with its strategy for long term growth, EMG is in the process of increasing its unit production capacity for floor care products by approximately 50%, primarily to meet anticipated growth in customer demand for smaller size motors over the next several years. This is being accomplished primarily by adding new production lines at the existing Graham, North Carolina facility. Technical Motor Products In order to make greater use of its technological expertise developed in the floor care products area, EMG recently formed its Technical Motor Division to consolidate and expand its production of motors and blowers used in certain non-floor care applications, particularly in the market for brushless motor technology where EMG is seeking to establish a significant position. EMG's technical motor products include motors for furnaces, lawn tools, photocopiers, computer equipment, other business machines, medical equipment and evaporative cooling equipment. Its brushless motors, which are free of static charges, are becoming increasingly popular in medical and other applications where flammability is a concern. Recent product developments in this area include the use of EMG's brushless motors in systems designed to assist patients with sleep-breathing disorders, systems which help bedridden patients avoid bedsores and systems to recover gasoline fumes at automotive refueling stations. In addition, EMG will begin producing induction motors, which were previously purchased by EMG, for use in conjunction with its blower products. The ability to produce its own induction motors offers EMG new opportunities in the high efficiency furnace, water heating and induction motor pump markets. In 1993, EMG dedicated one of its Italian plants to the manufacture of technical motor products. Through the Company's Singapore sales subsidiary and its Shanghai office, EMG is seeking to build a presence in the Pacific Rim. Consistent with its strategy for long term growth, EMG has recently increased its unit production capacity for technical motor products by approximately 25% to meet anticipated growth in customer demand for the next several years by commencing production at its new Rock Creek, North Carolina plant. Customers Although EMG is not dependent on any single customer such that its loss would have a material adverse effect on its operations, approximately 26% of EMG's sales for 1993 were made to its five largest customers. PRECISION INSTRUMENTS GROUP The Precision Instruments Group ("PI") serves a diverse group of markets, the largest of which are the aerospace, pressure gauge, process and refining and heavy-duty truck markets. PI produces cockpit instruments, process monitoring and display systems, process control gas and liquid analyzers, moisture and emissions monitoring systems, force and speed measuring instruments, air and noise monitors, pressure and temperature calibrators, pressure gauges and automotive products. Aerospace Products PI designs and manufactures cockpit instruments/displays, engine sensors and monitoring systems, fuel/liquid quantity measurement devices and electrical/thermocouple cables for aircraft and aircraft engines. These products record, process and display information for use by flight and ground crews. PI serves all segments of the commercial aerospace industry, including business and commuter aircraft and the commercial airlines, as well as the defense industry. PI's products are also marketed as spares. PI's products are designed to customer specifications and must be certified as meeting stringent operational and reliability requirements. PI's strategy in aerospace products is to operate in niche categories where it has a technological or cost advantage. PI believes that its extensive experience and technological expertise in the aerospace field, together with its long-standing relationships with several leading international manufacturers of commercial aircraft, provide it with a competitive advantage. PI was recently selected by Boeing to supply an engine vibration monitoring system for Boeing's new 777 model. Variations of this product will be marketed to other aircraft manufacturers. In addition, PI's strategic effort to expand its product line has recently yielded new orders for an advanced aircraft engine sensor, an advanced cockpit display system featuring active matrix liquid crystal display and a business jet fuel quantity system. In early 1993, PI acquired certain assets of Revere Aerospace Inc., which added a high- performance electrical and optical interconnecting cable business as a complement to its existing product lines. As a result of the overall weakness in the aerospace industry, PI sales to the military and commercial OEM aircraft markets declined significantly in 1993 and 1992. In addition, PI's sales of aerospace products for use as spares were reduced significantly as airlines lowered spare parts inventories and utilized excess equipment from surplus aircraft. In response to these conditions, PI embarked on an aggressive program to reduce costs through significant consolidation and downsizing. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Recent Developments" on page 11 of this report. Industrial Process Control and Pressure Gauge Products PI serves the process industry by designing and manufacturing process control products, including gas and liquid analyzers, emission monitors, process annunciators and control room graphic displays. PI serves numerous segments of the process industry, including refining and petrochemical processing and power and steel plants. PI also produces a wide variety of pressure gauge products for numerous industrial and commercial uses. In recent years, domestic market conditions have been, and continue to be, soft due primarily to adverse conditions in the refining and petrochemical industry. These conditions have been affected by environmental regulations which have severely reduced new refinery and petrochemical plant construction and refinery and petrochemical operating rates in the United States. PI's business strategy is to concentrate on new markets where it has a technological or cost advantage. PI develops or customizes products around core technologies to meet customer requirements. For example, PI's oxygen and combustion analyzers have a leading market position and are designed to meet customer specific applications. PI has also recently succeeded in marketing one of its aerospace based products, thermocouples, for use with land gas turbines. Pressure gauges are produced by PI's U.S. Gauge Division, a leader in the North American pressure gauge market. Pressure gauges are used in a wide variety of industrial and manufacturing processes. The general pressure gauge market has been adversely affected by poor domestic economic conditions and competition from low cost offshore producers. PI has responded to these market conditions by reducing costs and refocusing its domestic manufacturing to concentrate on higher priced pressure gauge applications. In addition, through a distributorship relationship with a Taiwanese company, PI is currently distributing in the United States low cost pressure gauges manufactured in the People's Republic of China, a product segment in which PI is not currently competitive. Automotive Products PI is the leading domestic producer and supplier of electronic instrument panels and instruments to the heavy truck market and is currently expanding into the agricultural and construction vehicle markets. In recent years, the heavy truck market has been strong. Domestic truck manufacturers have faced a growing demand for more fuel efficient trucks that satisfy applicable air pollution guidelines. PI has participated in this market by working closely with several manufacturers to develop solid state instruments to monitor engine efficiency and emissions. PI's strategy is to expand this product line into construction and agricultural equipment and into international markets with products similar to those currently produced for United States manufacturers. Customers Although the Precision Instruments Group is not dependent on any single customer such that its loss would have a material adverse effect on its operations, approximately 29% of its 1993 sales were made to its five largest customers. INDUSTRIAL MATERIALS GROUP The Industrial Materials Group ("IMG") manufactures the following principal products: water filtration products, high-purity engineered metals, high- temperature fabrics, compounded plastics and plastic packaging materials. Each of IMG's five businesses is technology-based, stressing mechanical, metallurgical or plastic processing skills. IMG consists of five divisions: Plymouth Products, (including AMETEK Filters Ltd., a U.K. subsidiary), Specialty Metal Products, Haveg, Microfoam and Westchester Plastics. IMG's strategic focus is to target niche markets by differentiating its products on the basis of quality, price and/or services and to pursue new product development by exploiting proprietary technologies and specialized manufacturing processes. The Plymouth Products Division (including AMETEK Filters Ltd.) produces water filtration products for residential, commercial and industrial uses in the United States and 80 other countries. Plymouth Products sells its products in both the retail and wholesale markets. With its acquisition in late 1992 of the Kleen Plus (R) retail water filter line, Plymouth Products broadened its cartridge filter line so that it now offers complete water filtration systems, 25 special-purpose filter housings and 60 different replacement cartridges. Plymouth's filter cartridges and housings are used in such diverse applications as water filtration and food and beverage, cosmetics and chemical production. Plymouth's point-of-use drinking water filters are used for the removal of objectionable taste and odor, hazardous chemicals and heavy metals. In addition, Plymouth Products produces a faucet-mounted filter, as well as filters, housings and cartridges for use by plumbing professionals for residential and commercial customers. The Company has identified the water filtration market as a key opportunity for expansion and, accordingly, has commenced a $4 million plant expansion. This capacity increase is the fifth such expansion in the last 13 years. The Specialty Metal Products Division uses its powder metallurgy to produce strip and wire and uses its cladding technologies to make a variety of products with multiple metallurgical properties. Specialty Metal Products sells its products for use in the manufacture of appliances, electronic connectors, rechargeable batteries and TV cathode ray tubes. Its clad metals are used in gourmet cookware and chemical and pressure vessels, and its metal matrix composites are used for thermal management in high power electronic circuits. The Haveg Division manufactures products for high temperature applications and highly corrosive environments. Haveg's products are made of silicas, phenolic resins and Teflon (R) (a registered trademark of the DuPont Company). Haveg's silica yarn, which maintains strength and flexibility at high temperatures, is used for protective welding curtains, as a textile replacement for asbestos and as a laminate for printed circuit boards. Two other Haveg products are Flexsil (R), made from Haveg's woven Siltemp (R) fabric and used in foundries to filter molten metal as it is poured into casting molds, and Teflon (R) heat exchangers, used in a number of different industrial applications because of its chemically inert construction and high purity. Additionally, Haveg produces storage tanks and pipes, made of phenolic resins, which are able to withstand highly corrosive environments. The Microfoam Division is the world's only producer of a very low density polypropylene foam used primarily for packaging items, such as furniture and agricultural products, that require cushioning, surface protection and insulation. CouchPouch (TM), one of Microfoam's products made from the division's MicroTuff (TM) composite material is stitched into various size bags large enough to protect furniture. Because they are made of pure polypropylene, the products are suitable for reuse and recycling. The Westchester Plastics Division is engaged in the toll processing and formulation of plastics compounds, including developing processing techniques that enhance such properties as fire retardance and adhesion. In addition, Westchester Plastics has state-of-the-art twin-screw extruder lines used to produce custom thermoplastics for a variety of industries. Customers Although IMG is not dependent on any single customer such that its loss would have a material adverse effect on its operations, approximately 13% of IMG's sales for 1993 were made to its five largest customers. MARKETING Generally, the Company's marketing efforts are organized and carried out at the divisional level. However, a few functions are centralized at the corporate level for reasons of cost and efficiency. Given the basic similarity of its various products, its significant market share worldwide and the technical nature of its products, EMG conducts most of its domestic and international marketing activities through its direct sales force. EMG makes limited use of sales agents in those foreign countries where its sales activity is relatively low. Because of their relatively diverse product lines, both PI and IMG make significant use of distributors and sales agents in the marketing efforts of most of their divisions. With its specialized customer base of aircraft manufacturers and airlines, PI's aerospace division relies primarily on its direct selling efforts. COMPETITION Generally, most markets in which the Company operates are highly competitive. The principal elements of competition for the products manufactured in each of the Company's business segments are price, product features, distribution, quality and service. The primary competition in the United States in the floor care market is from a few competitors, each of which has a smaller market share but is part of a company which is larger and has greater resources than Ametek. Additional competition could come from vertically integrated manufacturers of floor care products which produce their own motors and blowers. In Europe, competition is from a small group of very large competitors and numerous small competitors. In the markets served by the Precision Instruments Group, the Company believes that it is one of the world's largest pressure gauge manufacturers and a leading producer of annunciator systems. The Company also ranks among the top ten producers of certain measuring and control instruments in the United States. It is one of the leading instrument and sensor suppliers, with a broad product offering in both the military and commercial aviation industries. As a result of the continuing decline in demand for aircraft instruments and engine sensors due to the consolidation and deregulation of the airline industry and reduced military spending, competition is strong and is expected to intensify with respect to certain of the products in the aerospace markets. In the pressure gauge and automotive markets served by PI, there are a limited number of companies competing on price and technology. With respect to process measurement and control niche markets, there are numerous competitors in each niche competing, for the most part, on the basis of product quality and innovation. Many of the products sold by the Industrial Materials Group are made by few competitors and competition is mainly from producers of substitute materials. The Company's Westchester Plastics division is one of the nation's largest independent plastics compounders. In this market, the Company's competition is from other independent toll compounders and those customers which have similar in-house compounding capabilities. Plymouth Products is one of the major suppliers of household water filtration systems, a market in which it has numerous competitors. In the industrial and commercial filtration markets which Plymouth Products serves, it does not have a major market share and faces competition from numerous sources. BACKLOG AND SEASONAL VARIATIONS OF BUSINESS The Company's approximate backlog of unfilled orders at the dates specified by business segment was as follows: Of the total backlog of unfilled orders at December 31, 1993, approximately 88% is expected to be shipped by December 31, 1994. The Company believes that neither its business as a whole nor any of its business segments is subject to significant seasonal variations, although certain individual operations experience some seasonal variability. RAW MATERIALS The Company's business segments obtain raw materials and supplies from a variety of sources, generally from more than one supplier. However, in the Industrial Materials segment, certain items are only available from a limited number of suppliers. The Company believes that its sources and supply of raw materials are adequate for its needs. RESEARCH AND DEVELOPMENT Notwithstanding the recent economic recession, the Company continues to be committed to appropriate research and development activities designed to identify and develop potential new and improved products. Company-funded research and development costs during the past three years were: 1993--$15.1 million, 1992--$14.7 million, and 1991--$12.1 million. Research activities are conducted by the various businesses of the Company in the areas in which they operate. ENVIRONMENTAL COMPLIANCE Information with respect to environmental compliance by the Company is set forth in Part II of this report on page 16 in the section of Management's Discussion and Analysis of Financial Condition and Results of Operations entitled "Environmental Matters." PATENTS, LICENSES AND TRADEMARKS The Company owns numerous unexpired United States patents, United States design patents and foreign patents, including counterparts of its more important United States patents, in the major industrial countries of the world. The Company is a licensor or licensee under patent agreements of various types and its products are marketed under various registered United States and foreign trademarks and trade names. However, the Company does not consider any single patent or trademark, or any group thereof, essential to its business as a whole, or to any of its business segments. The annual royalties received or paid under license agreements are not significant to any single business segment or to the Company's overall operations. EMPLOYEES At December 31, 1993, the Company employed approximately 6,000 individuals, of whom approximately 2,400 are covered by collective bargaining agreements. WORKING CAPITAL PRACTICES The Company does not have extraordinary working capital requirements in any of its business segments. Customers generally are billed at normal trade terms with no extended payment provisions. Inventories are closely controlled and maintained at levels related to production cycles and responsive to normal delivery requirements of customers. ITEM 2. ITEM 2. PROPERTIES The Company has 32 plant facilities in 12 states and five foreign countries. Of these facilities, 26 are owned by the Company and six are leased. The properties owned by the Company consist of approximately 441 acres in total, of which approximately 3,447,000 square feet are under roof. Under lease is a total of approximately 413,000 square feet. The leases expire over a range of years from 1994 to 1999 with renewal options for varying terms contained in most of the leases. The Company also has an idle facility and certain parcels of land available for sale. The Company's executive offices in Paoli, Pennsylvania occupy approximately 32,000 square feet under a lease which will expire in 1997. Additional offices of the Company in New York City occupy approximately 4,000 square feet under a lease which will expire in 1996. The Company's machinery, plants and offices are in satisfactory operating condition and are adequate for the uses to which they are put. The operating facilities of the Company by business segment are summarized in the following table: ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Not applicable. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of the Company's security holders, through the solicitation of proxies or otherwise, during the last quarter of its fiscal year ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT. Officers are appointed by the Board of Directors to serve for the ensuing year and until their successors have been elected and qualified. Information on executive officers of the Company is shown below: - - - -------- * Office of the President, formed March 1993. WALTER E. BLANKLEY has been Chairman of the Board since April 1993. He was elected a Director and the President and Chief Executive Officer of the Company in April 1990. Mr. Blankley had served as a Senior Vice President since 1982. ROGER K. DERR has been Executive Vice President--Chief Operating Officer since April 1990. He had served as a Senior Vice President of Ametek since 1982. ALLAN KORNFELD has been Executive Vice President--Chief Financial Officer since April 1990. He has been Chief Financial Officer of Ametek since April 1986. Mr. Kornfeld was elected a Senior Vice President in 1984. MURRAY A. LUFTGLASS has been Senior Vice President--Corporate Development since May 1984. PETER A. GUERCIO has been a Group Vice President since April 1990. He was elected a Vice President of Ametek in 1989. FRANK S. HERMANCE joined the Company as a Group Vice President in November 1990. Previously he was General Manager of several instruments divisions of Tektronix, Inc. GEORGE E. MARSINEK has been a Group Vice President since April 1990. He was elected a Vice President in 1988. JOHN J. MOLINELLI has served as a Vice President and Comptroller of Ametek since April 1993. He was elected Comptroller in 1991 and General Auditor in 1989. DEIRDRE D. SAUNDERS has served as Treasurer and Assistant Secretary since April 1993. Ms. Saunders joined Ametek in 1987 as Assistant Treasurer. ROBERT W. YANNARELL has served as Secretary of the Company since April 1993. He was elected Treasurer and Assistant Secretary in 1987. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The principal market on which the Company's common stock is traded is the New York Stock Exchange. The Company's common stock is also listed on the Pacific Stock Exchange. On March 4, 1994, there were approximately 6,400 record holders of the Company's common stock. The market price and dividend information with respect to the Company's common stock are set forth on page 33 of this report in the section of the Notes to Consolidated Financial Statements entitled "Quarterly Financial Data (Unaudited)". Future dividend payments by the Company will be dependent upon future earnings, financial requirements, contractual provisions of debt agreements and other relevant factors. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - - - -------- (1) Amounts in 1993 include pre-tax charges totaling $54.9 million ($33.5 million after tax, or $.77 per share) for restructuring and other unusual items. These charges were for costs related to work force reductions, asset write-downs, relocation and consolidation of certain product lines and operations, and for other unusual items. (2) Restated to conform to 1993 presentation. (3) Earnings were insufficient to cover fixed charges by approximately $12.2 million in 1993. (4) EBITDA represents income before interest, amortization of deferred financing costs, taxes, depreciation and amortization, and 1993 restructuring and other unusual charges. EBITDA is presented as additional information as to the Company's ability to service its debt. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's discussion and analysis of the Company's financial condition and results of operations set forth below should be read in conjunction with the consolidated financial statements of the Company and the related notes shown in the index on page 17 of this report. RECENT DEVELOPMENTS Weakened market conditions in some of the markets in which the Company operates, particularly in the aerospace and process industries, have resulted in recent declines in sales and income. In November 1993, the Company completed a broad strategic review and announced a plan intended to enhance shareholder value over the long term. From an operational point of view, the Company will seek to increase the profitability of its existing businesses through (i) growth and reinvestment, particularly in its electro-mechanical, specialty metal and water filtration operations, (ii) continued emphasis on controlling costs and (iii) an increased focus on foreign sales, especially in the Pacific Rim and Europe, through a combination of direct selling efforts and joint ventures. The Company also intends to pursue strategic acquisitions on a selective basis. From a financial point of view, the Company's plan, which takes advantage of the Company's historically strong cash flow, involves repurchasing outstanding shares of its common stock for an aggregate purchase price of up to $150 million and refinancing existing debt with the net proceeds from the March 1994 $150 million public offering of 9 3/4% senior debt securities, borrowings under a new bank credit agreement, and available cash. The resulting increased leverage will reduce the Company's financial and operating flexibility. Accordingly, the plan also called for a reduction in the quarterly per share dividend rate on the Company's Common Stock from $.17 to $.06 beginning with the dividend which was payable on December 24, 1993, and a decrease in the Company's leverage over time. BUSINESS RESTRUCTURING AND OTHER UNUSUAL CHARGES In 1993, the Company recorded pre-tax charges of $54.9 million ($33.5 million after tax, or $.77 per share) for costs associated with resizing and restructuring several of its businesses and other unusual expenses. Of the $54.9 million total charge, $46.9 million ($28.6 million after tax, or $.66 per share), was recorded in the fourth quarter of 1993. The total charges, on a pre-tax basis, were for (1) work force reductions, both planned and those which occurred in 1993 (including certain pension-related costs) ($21.4 million); (2) asset write-downs ($15.0 million); (3) the relocation of certain product lines from a Precision Instruments facility in Sellersville, Pennsylvania and the overall consolidation of the Company's aerospace operations ($14.2 million); and (4) other unusual expenses ($4.3 million). The charges for resizing and restructuring are primarily related to the Company's Sellersville operations and result from actions taken or planned due to the unwillingness of the union at such facility to agree on wage and work rule concessions requested by the Company necessary to make that operation competitive. Also, the Company has reached an agreement regarding the prepayment premiums to be paid for early retirement of existing debt and will record an extraordinary charge, (estimated as of December 31, 1993), of approximately $13 million (after tax), subject to an interest rate adjustment, in the first quarter of 1994 after completion of the sale of the senior public notes and the retirement of existing debt. YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 Results of Operations Sales for 1993 were $732.2 million, a decrease of $37.4 million or 4.9% from 1992. The sales decrease was attributable to reduced domestic and European demand for electric motor products and the negative effect of translating sales of the Company's Italian operations from the weaker Italian lire to U.S. dollars. Sales by the Precision Instruments Group also declined as a result of continued poor market conditions for aerospace products and process and analytical instruments. A sales improvement was reported by the Industrial Materials Group due to the strength of demand for liquid filtration products, specialty metal products and compounded plastics. Sales by all business segments to foreign markets totalled $202.9 million in 1993 compared to $233.7 million in 1992, a decrease of 13.2%. Export shipments from the United States in 1993 were $105.7 million, a decrease of 11.4% from 1992, primarily as a result of weak economic conditions in Europe. New orders during 1993 were approximately $703.9 million, a decrease of $31.6 million or 4.3% from 1992. The backlog of orders was $212.6 million at year-end, an 11.8% decrease from 1992, reflecting the lower level of business in the Electro-mechanical and Precision Instruments Groups. Business segment operating profit before restructuring and other unusual operating charges was $74.8 million in 1993, compared to $100.1 million in 1992, a decrease of 25.3%. Along with the reduction due to the lower sales volume, this decline reflects operating inefficiencies (primarily within the Electro-mechanical and the Precision Instruments Groups) and higher expenses caused by a plant start-up and plant rearrangements in the Electro-mechanical Group. In 1993, business segment results also reflect charges totalling $52.1 million for resizing and restructuring certain operations and other unusual expenses. After reflecting these charges, business segment operating profit for 1993 was $22.7 million. Corporate expenses (including unallocated administrative expenses, interest expense and net other income) were $33.9 million in 1993, substantially unchanged from $33.3 million in 1992. The effective rate of income tax benefit for 1993 of 34.5% reflects the new U.S. federal statutory income tax rate of 35% for all of 1993. The overall effective rate of the tax benefit was reduced somewhat by a tax provision on foreign pre-tax earnings. After-tax earnings for 1993, before restructuring and other unusual charges, were $26.2 million or $.60 per share. This compares to net income of $44.4 million or $1.01 per share earned in 1992. After restructuring and other unusual charges totalling $33.5 million (after tax), the Company reported a net loss of $7.3 million, or $.17 per share for 1993. Business Segment Results - - - -------- (1) After elimination of intersegment sales, which are not significant in amount. (2) Reflects charges of $47.8 million primarily for resizing and restructuring costs associated with planned work force reductions and those which occurred in 1993, asset write-downs, relocation of product lines and the overall consolidation of the Company's aerospace operations and other unusual charges. (3) Reflects charge of $3.9 million primarily for asset write-downs. (4) Segment operating profit represents sales less all direct costs and expenses (including certain administrative and other expenses) applicable to each segment, but does not include interest expense. (5) Includes unallocated administrative expenses, interest expense and net other income and, in 1993, $2.8 million of restructuring and other unusual charges. The Electro-mechanical Group's sales decreased $28.8 million or 9.3% to $280.7 million primarily because of Italian lire currency translation and because of reduced customer demand for domestically produced electric motor products during the year. Before currency translation, the Italian operations reported 2.6% higher sales over 1992. Operating profit of this group decreased 29.8% to $35.0 million due to lower sales volume, higher costs related to new product introductions, a plant start-up and plant rearrangements, less favorable product mix and negative foreign currency translation effects. Precision Instruments Group sales in 1993 were $275.4 million, a decrease of $21.7 million or 7.3% from 1992. The sales decline reflects the continuing weakness in demand for aircraft instruments and engine sensors from commercial airlines and poor conditions in the aerospace industry and in process control markets. The sales decline was partially offset by increased sales of truck instruments, flight reference systems and sales by a new business acquired in the first quarter of 1993. Operating profit of this group before restructuring and other unusual charges was $17.1 million in 1993 compared to $28.0 million in 1992, a $10.9 million or 39.0% decline. This decrease was due to the sales decline, production inefficiencies and changes in product mix. This group's profits were further reduced by restructuring and unusual operating charges of $47.8 million in 1993, of which $39.8 million was recorded in the fourth quarter, and resizing charges of $8 million which were recorded in the first nine months of the year. These charges were primarily for work force reductions planned or which occurred in 1993 (including certain pension-related costs), asset write-downs, product line relocations of certain gauge manufacturing operations, and consolidation of the Company's aerospace businesses. Most of these actions were necessary due to the unwillingness of the union at the Company's Sellersville facility to agree to wage and work rule concessions requested by the Company necessary to make that operation competitive. After restructuring and other unusual operating charges, this group reported an operating loss of $30.6 million for 1993. Industrial Materials Group sales in 1993 were $176.1 million, an increase of $13.1 million or 8.1% from 1992 largely due to increased sales of liquid filtration products, compounded plastics and specialty metal products. Group operating profit before restructuring and other unusual charges was $22.2 million, a slight improvement over operating profit of $22.1 million reported for 1992. An increase in profits by the Specialty Metal Products Division was substantially offset by lower profits from the other businesses in this group due to operating inefficiencies and changes in product mix at certain divisions. After fourth quarter 1993 restructuring and other unusual charges of $3.9 million, primarily for certain asset write-downs, the group operating profit was $18.3 million for 1993. In February 1994, a warehouse attached to a plant in this group collapsed under the weight of heavy snow. The plant has returned to full operation and the damages and related losses are covered by insurance. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 Results of Operations For 1992, Ametek achieved record sales of $769.6 million, exceeding sales in 1991 by $54.5 million or 7.6%. The increase occurred primarily in the Electro- mechanical Group and was the result of increased worldwide demand for electric motors, the introduction of new products and increased market penetration. Sales were also enhanced by the acquisition of an electric motor business in the first quarter of 1992. A sales increase by the Industrial Materials Group was more than offset by lower sales by the Precision Instruments Group, which suffered from a sharp decline in demand for aircraft instruments and engine sensors in the commercial and military markets. Sales by all business segments to foreign markets totalled $233.7 million in 1992 compared to $211.8 million in 1991, an increase of 10.3%. Export sales from the United States totalled $119.3 million in 1992 compared to $111.6 million in 1991, a 6.9% increase. New orders during 1992 were approximately $735.5 million, an increase of $26.2 million, or 3.7% over 1991. The backlog of orders was approximately $240.9 million at year-end, a 12.4% decrease from the end of 1991, reflecting the lower level of business in the Precision Instruments Group. Business segment operating profit was $100.1 million in 1992, an increase of $11.5 million or 12.9% over last year's $88.6 million. The improved operating results for 1992 came mainly from the overall higher sales volume in the Electro-mechanical and Industrial Materials Groups and improved performance by the Company's three Italian motor divisions. Corporate expenses (including unallocated administrative expenses, interest expense and net other income) of $33.3 million in 1992 were $2.9 million lower than last year's $36.2 million, primarily due to lower interest expense resulting from the reduced level of debt. The effective tax rate for 1992 was 33.5% compared to 1991's rate of 27.5%. Both periods benefitted from favorable income tax adjustments. The 1992 rate reflects a net favorable settlement of certain tax years for United States operations, while the 1991 rate included the recognition of tax benefits from combining certain foreign operations. Net income was $44.4 million or $1.01 per share for 1992, compared to earnings of $38.0 million or $.87 per share for 1991. Net income for the fourth quarter of 1992 was $10.6 million, substantially unchanged from net income of $10.4 million in the fourth quarter of 1991, yielding earnings per share of $.24 for both periods. Lower 1992 fourth-quarter business segment operating profit in the Precision Instruments Group, and a higher effective corporate tax rate in 1992's fourth quarter due to a change in Italian tax law affecting all of 1992, were offset by lower interest expense and other nonoperating expenses. Sales in the fourth quarter of 1992 reached $191.5 million, 4.4% ahead of the $183.4 million shipped in the fourth quarter of 1991, reflecting continuing strong demand for electric motors. Business Segment Results Electro-mechanical Group sales in 1992 were $309.6 million, an increase of $59.8 million or 23.9% from 1991 largely due to improved demand and market penetration for electric motors aided somewhat by the acquisition of a new business in the first quarter of 1992. Group operating profit increased 41.1% to $49.9 million due to the higher sales volume, a more favorable product mix, and improved operating performance by the Italian motor divisions. In the Precision Instruments Group, sales were $297.0 million for 1992, a decrease of $12.9 million or 4.2% from 1991. The sales decline reflects continuing weak demand for aircraft and aerospace instruments, sensors and spare parts for commercial airlines and the military, caused by the deepening recession in this market. The overall sales decline was partially offset by increased sales of truck instruments. The group's operating profit of $28.0 million fell 14.8% from $32.9 million in 1991, largely because of the steep sales decline in some of the group's more profitable products. The Industrial Materials Group's 1992 sales increased $7.5 million or 4.8% to $163.0 million, due to increased sales of water filtration products and metal powders. Operating profit of the group totalled $22.1 million in 1992, compared to $20.3 million in 1991, an 8.7% increase, reflecting the increase in the group's sales volume and lower operating expenses in the Company's plastics compounding and foam packaging businesses. LIQUIDITY AND CAPITAL RESOURCES Liquidity Working capital at December 31, 1993 amounted to $134.2 million, a decrease of $56.0 million from December 31, 1992, caused largely by the provisions for resizing, restructuring and other unusual items. The ratio of current assets to current liabilities at December 31, 1993 was 1.80 to 1, compared to 2.38 to 1 at December 31, 1992. Cash generated by the Company's operating activities totalled $65.3 million in 1993 compared to $78.6 million in 1992. The decrease reflects the lower level of earnings, after adding back $50.9 million of restructuring and other unusual charges not requiring the use of cash in 1993. Cash flows from operating activities, less cash used for investing and financing activities of $83.9 million, resulted in a decrease in cash and cash equivalents of $18.7 million since the beginning of 1993. Cash used in 1993 included $38.3 million for the purchase of property, plant and equipment, $25.1 million for the payment of dividends, $19.4 million for the repayment of long-term debt, $16.6 million for the purchase of a business and investments and $8.9 million for the purchase of 683,400 shares of the Company's common stock in the second quarter of 1993. Cash and cash equivalents and short-term marketable securities totalled $84.7 million at December 31, 1993, a decrease of $31.0 million from December 31, 1992. Of the $54.9 million of resizing, restructuring and other unusual charges recorded in 1993, certain items require cash expenditures which are expected to be funded by normal operations. Approximately $4.0 million was expended in 1993, and the Company anticipates that approximately $25.3 million will be expended over the next two years. After all the restructuring actions are in place, the Company expects to realize continuing benefits resulting from reduced labor costs, improved productivity and other lower operating costs which, the Company believes, should more than offset these cash expenditures over time. Certain asset write-downs, provisions for pension curtailments and other unusual items totaling $25.6 million will not require the use of cash, or incremental cash, during the next five years. The proceeds of the 9 3/4% senior notes, together with borrowings under the new bank credit agreement and available cash, will be used (a) to retire (i) $106.8 million aggregate principal amount of 8.95% notes, (ii) $75.0 million aggregate principal amount of 9.35% notes and (iii) $3.6 million aggregate principal amount of 8.05% notes, (b) to repurchase outstanding shares of the Company's common stock for an aggregate purchase price of up to $150 million and (c) to pay fees and expenses related to the offering of the senior notes and the credit agreement. The Company's future interest costs are expected to increase because of the higher outstanding total debt. The Company's quarterly common stock dividend was recently reduced from $.17 per share to $.06 per share. This reduction, without giving effect to the intended repurchase of common stock, will result in an annual saving of approximately $19.4 million. This saving, along with lower near-term required debt principal payments, should more than offset the higher interest cost. The Company believes that the amounts to be available under its new bank credit agreement and the proceeds of the sale of the senior notes, together with cash on hand and cash flows generated from operations, will provide sufficient capital resources to service all debt obligations, fund the share repurchase program and finance working capital, the new lower dividend and capital expenditure requirements in the foreseeable future. Capital Expenditures Capital expenditures (excluding acquisitions) were $38.3 million during 1993. The majority of the expenditures were for additional manufacturing equipment and an additional production facility in the Electro-mechanical Group to provide expanded production capacity. The 1993 capital spending level is approximately 60% higher than 1992. The Company expects to continue its high level of capital spending in 1994, with special emphasis on the Electro- mechanical Group. The projected 1994 capital expenditures are approximately $37 million, of which $10 million has been rescheduled from 1993. Acquisitions On March 31, 1993, the Company purchased certain assets of Revere Aerospace Inc., a United States subsidiary of Dobson Park Industries PLC, for approximately $7 million in cash. Revere is a producer of thermocouple and fiber optic cable assemblies. In 1992, the Company acquired a producer of small electric motors and injection-molded components, a United Kingdom industrial filtration business, an instrument manufacturer located in Germany, and two small product lines for a total of $11.7 million in cash. The motor company acquisition was a factor in the Company's recent decision to form the Technical Motor Division in the Electro-mechanical Group. These acquisitions have complemented the Company's existing businesses and broadened its global marketing efforts. ENVIRONMENTAL MATTERS The Company is subject to environmental laws and regulations, as well as stringent clean-up requirements, and has also been named a potentially responsible party at several sites which are the subject of government-mandated clean-ups. Provisions for environmental clean-up at these sites and other sites were approximately $4.9 million in 1993 ($1.4 million in 1992). While it is not possible to accurately quantify the potential financial impact of actions regarding environmental matters, the Company believes that, based upon past experience and current evaluations, the outcome of these actions is not likely to have a material adverse effect on future results of operations of the Company. ACCOUNTING STANDARDS RECENTLY ADOPTED In November 1992 the FASB issued Statement No. 112 relating to accounting for postemployment benefits. In March 1993, Statement No. 115 relating to accounting for marketable securities was issued. The Company has adopted both of these Statements effective as of January 1, 1994. Adoption of these accounting standards did not have a material effect on the Company's results of operations. IMPACT OF INFLATION The Company attempts to minimize the impact of inflation through cost reduction programs and by improving productivity. In addition, the Company uses the LIFO method of accounting for inventories (whereby the cost of products sold approximates current costs), and therefore, the impact of inflation is substantially reflected in operating costs. In general, the Company believes that programs are in place designed to monitor the impact of inflation and to take necessary steps to minimize its effect on operations. OUTLOOK The Company is subject to economic uncertainties in its key markets around the world. However, management believes that the Company will be strengthened by the restructuring actions taken in 1993 and will benefit from its strategic plan to build long-term shareholder value. Management believes that the Company's global businesses and historically strong cash flow combine to position the Company to deal effectively with these uncertainties. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (ITEM 14(A) 1 AND 2) FINANCIAL STATEMENT SCHEDULES Schedules for each of the three years in the period ended December 31, 1993 (except where otherwise indicated): All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedules, or because the information is included in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT AUDITORS We have audited the accompanying consolidated balance sheets of AMETEK, Inc. as of 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. 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 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 AMETEK, 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. ERNST & YOUNG Philadelphia, PA February 9, 1994 AMETEK, INC. CONSOLIDATED STATEMENT OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes. AMETEK, INC. CONSOLIDATED BALANCE SHEET (DOLLARS IN THOUSANDS) See accompanying notes. AMETEK, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (DOLLARS IN THOUSANDS) See accompanying notes. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The consolidated financial statements include the accounts of the Company and subsidiaries, after elimination of all significant intercompany transactions in consolidation. Cash Equivalents, Securities and Other Investments All highly liquid investments with maturities of three months or less when purchased are cash equivalents. Cash equivalents and fixed income marketable securities (primarily U.S. Government securities), are carried at the lower of cost or market. Marketable equity investments of an insurance subsidiary are carried at market value, and unrealized gains and losses are recognized in stockholders' equity. Other fixed income investments are carried at cost, which approximates market. Inventories Inventories are stated at the lower of cost or market, cost being determined principally by the last-in, first-out (LIFO) method of inventory valuation, and market on the basis of the lower of replacement cost or estimated net proceeds from sales. The excess of the first-in, first-out (FIFO) method over the LIFO value was $29.4 million and $29.9 million at December 31, 1993 and 1992. Property, Plant and Equipment Property, plant and equipment are stated at cost. Expenditures for additions to plant facilities, or which extend their useful lives, are capitalized. The cost of tools, jigs and dies, and maintenance and repairs are charged to operations as incurred. Depreciation of plant and equipment is calculated principally on a straight-line basis over the estimated useful lives of the related assets. Research and Development Company-funded research and development costs are charged to operations as incurred and during the past three years were: 1993-$15.1 million, 1992-$14.7 million, and 1991-$12.1 million. Foreign Currency Translation Assets and liabilities of foreign operations are translated using exchange rates in effect at the balance sheet date, and their operations are translated using average exchange rates for the period. Some transactions of the Company and its subsidiaries are made in currencies other than their own. Gains and losses from these transactions (not material in amount) are included in operating results for the period. Additionally, foreign exchange contracts and foreign currency options are sometimes used to hedge firm commitments for certain export sales transactions. Gains and losses from these agreements are deferred and reflected as adjustments of the associated export sales. Earnings Per Share Earnings per share are based on the average number of common shares outstanding during the period. No material dilution of earnings per share would result for the periods if it were assumed that all outstanding stock options were exercised. Reclassifications Certain amounts in the prior years' financial statements and supporting footnote disclosures have been reclassified to conform to the current year's presentation. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 2. BUSINESS RESTRUCTURING AND OTHER UNUSUAL CHARGES Results of operations for 1993 include charges of $45.1 million ($27.5 million after tax, or $.63 per share) for costs associated with resizing and restructuring several of the Company's businesses and a charge of $9.8 million ($6 million after tax, or $.14 per share) for other unusual expenses. Most of the charges were recorded in the fourth quarter of 1993. These charges were for planned work force reductions and those which occurred in 1993 (including certain pension-related costs) ($21.4 million); asset write-downs ($15.0 million); relocation of certain product lines and overall consolidation of the Company's aerospace operations ($14.2 million); and other unusual expenses ($4.3 million). The resizing and restructuring charges primarily relate to the unwillingness of the union at a Precision Instruments facility in Sellersville, Pennsylvania to agree on wage and work rule concessions requested by the Company necessary to make that operation competitive. 3. ACQUISITIONS In March 1993, the Company purchased certain assets of Revere Aerospace Inc., a United States subsidiary of Dobson Park Industries PLC, United Kingdom, for approximately $7 million in cash. Revere is a producer of thermocouple and fiber optic cable assemblies. In February 1992, the Company purchased the Tencal operations of Cambridge- Lee Industries. Tencal is a producer of small electric motors and injection- molded plastic components. In August 1992, the Company purchased the industrial filtration operation of Eurofiltec, Ltd. Early in October 1992, the Company purchased Debro Messtechnik GmbH, an instrument manufacturer located in Germany. Also, during 1992, the Company acquired two product lines consisting of silica fiber technology, and consumer filtration products. The cost of these acquisitions was $11.7 million and the Company assumed $3.8 million in debt. In April 1991, the Company purchased Jofra Instruments, a Danish producer of temperature calibration equipment, and acquired the remaining 38% interest in Elettromotori Crema, one of its Italian electric motor manufacturers. Also, during 1991, the Company purchased product lines of consumer drinking water filters and custom-shaped alloy wire. The aggregate cost of these acquisitions was $10.5 million in cash and a two-year, 10% installment obligation of $4.5 million. All of the above acquisitions have been accounted for by the purchase method and, accordingly, the results of their operations are included from the respective acquisition dates. The above acquisitions would not have had a material effect on sales or earnings for 1993, 1992 or 1991 had they been made at the beginning of the year prior to their acquisition. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 4. BALANCE SHEET INFORMATION AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The annual future payments required by the terms of the long-term debt for the following years are: 1995-$21.3 million; 1996-$21.3 million; 1997-$21.1 million; and 1998-$21.1 million. The Company's debt agreements contain restrictions relating to total debt, working capital, dividends and capital stock repurchases. At December 31, 1993, the Company was in compliance with these restrictions. (See Note 12 "Other Matters.") The Company has a revolving credit agreement with a group of banks providing for up to $83 million effective until June 30, 1995. No borrowings are outstanding under this agreement. The agreement provides for various interest alternatives and a commitment fee on the unused portion of the credit line. (See Note 12 "Other Matters.") In addition, the Company maintains lines of credit in other currencies with various European banks in amounts equivalent to $12.1 million, in the aggregate, at December 31, 1993. At December 31, 1993, the Company was a party to a currency and interest rate swap agreement related to debt (not material in amount), which matures in 1997, of a European subsidiary. 6. STOCKHOLDERS' EQUITY The Company has a Shareholder Rights Plan, under which the Board of Directors declared a dividend of one Right for each share of Company common stock owned. The Plan provides, under certain conditions involving acquisition of the Company's common stock, that holders of Rights, except for the acquiring entity, would be entitled (i) to purchase shares of preferred stock at a specified exercise price, or (ii) to purchase shares of common stock of the Company, or the acquiring company, having a value of twice the Rights exercise price. The Rights under the Plan expire in 1999. The Company provides, among other things, for restricted stock awards of common stock to eligible employees and nonemployee directors of the Company at such cost to the recipient as the Stock Incentive Plan Committee of the Board of Directors may determine. These shares are issued subject to certain conditions, and transfer and other restrictions as prescribed by the Plan. In 1993 and 1991, respectively, the Company awarded 20,000 shares and 100,000 shares of restricted common stock to certain directors under the Plan. No restricted stock was awarded during 1992. Also, in 1991, a total of 68,272 shares of restricted common stock was awarded to certain executives of the Company in accordance with a supplemental pension benefit arrangement. Upon issuance of restricted stock, unearned compensation, equivalent to the excess of the market value of the shares awarded over the price paid by the recipient at the date of the grant, is charged to stockholders' equity and is amortized to expense over the periods until the restrictions lapse. Amortization charged to expense in 1993, 1992, and 1991 was not significant. At December 31, 1993, 4,732,053 (5,442,993 in 1992) shares of common stock were reserved under the Company's incentive and nonqualified stock option plans. The options are exercisable at prices not less than market value on dates of grant, and in installments over five- to seven-year periods from such dates. Information on options for 1993 follows: AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Options on 259,486 shares were exercised in 1992 and no options were exercised in 1991. The Company also has outstanding 293,502 stock appreciation rights exercisable for cash and/or shares of the Company's common stock when the related option is exercised. Subject to certain limitations, each right relates to the excess of the market value of the Company's stock over the exercise price of the related option. Charges and credits, immaterial in amount, are made to income for these rights and certain related options. Changes in stockholders' equity are summarized below (In thousands): AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 7. LEASES Minimum aggregate rental commitments under noncancellable leases in effect at December 31, 1993 (principally for real property, office space and equipment) amounted to $4.9 million consisting of annual payments of $2.4 million due in 1994, $1.8 million in 1995 and decreasing amounts thereafter. Rental expense of $5 million, $4 million and $4.1 million was charged to income in 1993, 1992 and 1991. 8. INCOME TAXES In 1993, income before income taxes from foreign operations amounted to $6.7 million ($9.1 million in 1992 and $4.9 million in 1991). The details of the provision for (benefit from) income taxes follow: - - - -------- *Includes the favorable tax effect of combining certain foreign operations. The provision for (benefit from) income taxes shown above includes a current provision of $14,791, $20,435 and $14,284 and a deferred provision (benefit) of $(18,656), $1,927 and $108 for 1993, 1992 and 1991. Prior to January 1, 1992, the Company followed the provisions of SFAS No. 96, Accounting for Income Taxes. Effective January 1, 1992, the Company adopted the provisions of a new accounting standard for income taxes (SFAS No. 109). The effect of adopting this standard was not material. Significant components of the Company's deferred tax (asset) liability as of December 31 are as follows: AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The effective rate of the provision for (benefit from) income taxes reconciles to the statutory rate as follows: 9. RETIREMENT AND PENSION PLANS The Company maintains noncontributory defined benefit retirement and pension plans, with benefits for eligible United States salaried and hourly employees funded through trusts established in conjunction with these plans. Employees of certain foreign operations participate in various local plans which in the aggregate are not significant. The Company also has nonqualified unfunded retirement plans for its directors and certain retired employees, and contractual arrangements with certain executives that provide for supplemental pension benefits in excess of those provided by the Company's primary pension plan. Fifty percent of the projected benefit obligation of the supplemental pension benefit arrangements with the executives has been funded by grants of restricted shares of the Company's common stock. The remaining 50% is unfunded. The Company is providing for these arrangements by charges to earnings over the periods to age 65 of the participants. The Company's funding policy with respect to its qualified plans is to contribute amounts determined annually on an actuarial basis that provides for current and future benefits in accordance with funding requirements of federal law and regulations. Assets of funded benefit plans are invested in a variety of equity and debt instruments and in pooled temporary funds. Net pension expense, excluding plan administrative expenses, consists of the following components: In addition to pension expense shown above, in 1993 the Company also recorded a charge for curtailments of $7.6 million related to an hourly pension plan as part of the resizing and restructuring of its general gauge and aerospace operations (see Note 2). The charge to income for all retirement and pension plans, including the 1993 curtailment provision, was $14.4 million in 1993, $6.7 million in 1992 and $7.2 million in 1991. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Net pension expense reflects an expected long-term rate of return on plan assets of 9 1/2% for 1993, 1992 and 1991. The actual return has been adjusted to defer gains or losses which differ from the expected return. The present value of projected benefit obligations was determined using an assumed discount rate of 7 1/4% for 1993, 8% for 1992 and 8 1/4% for 1991. The assumed rate of compensation increase used in determining the present value of projected benefit obligations was 5 1/2% for 1993 and 1992 and 6% for 1991. For pension plans with accumulated benefits in excess of assets at December 31, 1993, the balance sheet reflects an additional long-term pension liability of $11.0 million ($17.2 million--1992), a long-term intangible asset of $3.7 million ($10.8 million--1992), and a charge to stockholders' equity of $4.7 million ($4.2 million--1992 and $1.1 million--1991), net of a deferred tax benefit, representing the excess of the additional long-term liability over unrecognized prior service cost. No balance sheet recognition is given to pension plans with assets in excess of accumulated benefits. The Company provides limited postretirement benefits other than pensions to certain retirees, and a small number of employees. These benefits are accounted for on the accrual basis, thereby meeting accounting requirements of the new accounting standard for postretirement benefits other than pensions. The following table sets forth the funded status of the plans: 10. FAIR VALUE OF FINANCIAL INSTRUMENTS The recorded amount of cash, cash equivalents and marketable securities, and a derivative equity instrument approximates fair value. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The estimated fair values of the Company's other financial instruments are compared below to the recorded amounts at December 31: The fair values of securities and other investments are based on quoted market value. The fair value of long-term debt is estimated based on borrowing rates currently available to the Company for loans with similar terms and maturities. The fair value of forward currency and commodity contracts (used for hedging purposes) is based on quotes from brokers for comparable contracts. See also Note 12. 11. ADDITIONAL INCOME STATEMENT AND CASH FLOW INFORMATION Included in other income, net, is interest and other investment income of $8.4 million, $8.6 million and $11.2 million for 1993, 1992 and 1991. Income taxes paid in 1993, 1992 and 1991 were $13.8 million, $21.8 million, and $13.0 million. Cash paid for interest for each of the three years approximated interest expense. 12. OTHER MATTERS The Company is in the process of implementing a plan intended to enhance shareholder value, announced in November 1993. The financial elements of the plan involve the Company 1) completing an offering of $150 million in principal amount of senior notes to the public, 2) borrowing $175 million under a proposed $250 million secured credit agreement with a group of banks which will replace an existing revolving credit agreement, 3) retiring existing debt aggregating $185.4 million in principal amount for a payment equal to the principal amount thereof plus a prepayment premium of approximately $13 million (after tax), 4) repurchasing outstanding shares of its common stock for an aggregate purchase price of up to $150 million and 5) reducing its quarterly dividend rate on its common stock from $.17 per share to $.06 per share. In contemplation of its repurchase of common stock, the Company has, from time to time, entered into derivative instruments with a third party. Under the terms of the derivative instruments, for a specific number of shares, the Company is at risk for a decline in the market price of the Company's common stock from the inception to the expiration date, at which time the instruments will be settled in cash. As of December 31, 1993, the Company had entered into derivative instruments which were measured by the movement in market value of 3,184,500 shares of common stock. At December 31, 1993, the Company has recorded, in its equity, the effect of marking the derivative instruments to market. In February 1994, the Company settled all open derivative instruments for approximately $330,000 (including those entered into in January 1994) and entered into a new derivative instrument which will expire on May 31, 1994. Under the new derivative instrument, the Company, prior to April 5, 1994, may exercise an option to purchase 3,924,200 shares of its common stock from the counterparty for $12.125 per share plus certain costs. If the option is not exercised, the Company is at risk for a decline in the average market price, as defined, of its common stock based upon 3,924,200 shares of common stock. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 13. SEGMENT AND GEOGRAPHIC INFORMATION The Company classifies its operations into three business segments: Electro- mechanical, Precision Instruments and Industrial Materials. The Electro-mechanical Group produces motor-blower systems and injection- molded components for manufacturers of floor care appliances, and fractional horsepower motors and motor-blowers for computer, business machine, medical equipment and high-efficiency heating equipment producers. Sales of fractional horsepower electric motors and blowers represented 38% in 1993 (39% in 1992 and 35% in 1991) of the Company's consolidated net sales. The Precision Instruments Group produces aircraft cockpit instruments and displays, and pressure, temperature, flow and liquid level sensors for aircraft and jet engine manufacturers and for airlines, as well as airborne electronics systems to monitor and record flight and engine data. The group also produces instruments and complete instrument panels for heavy truck builders, process monitoring and display systems, combustion, gas analysis, moisture and emissions monitoring systems, force and speed measuring instruments, air and noise monitors, pressure and temperature calibrators and pressure-indicating and digital manometers. The Precision Instruments Group has for many years been a leading producer of the widely used mechanical pressure gauge. The Industrial Materials Group produces high-temperature-resistant materials and textiles, corrosion-resistant heat exchangers, tanks and piping for process systems; ultralightweight foam sheet packaging material; drinking water filter and treatment systems; industrial and commercial filters for other liquids; replacement filter cartridges, liquid bag filters and multiple cartridge filter housings, high-purity metals and alloys in powder, strip and wire form for high-performance aircraft, automotive and electronics requirements; and thermoplastic compounds and concentrates for automotive, appliance and telecommunication applications. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 13. SEGMENT AND GEOGRAPHIC FINANCIAL INFORMATION Business Segments (1) After elimination of intersegment sales and intercompany sales between geographic areas, which are not significant in amount. Such sales are generally priced based on prevailing market prices. (2) Segment operating profit represents sales less all direct costs and expenses (including certain administrative and other expenses) applicable to each segment, but does not include interest expense. (3) Reflects charges of $47.8 million for resizing and restructuring costs associated with planned work force reductions and those which occurred in 1993, asset write-downs, relocation of product lines and the overall consolidation of the Company's aerospace operations, and other unusual charges. (4) Reflects charge of $3.9 million primarily for asset write-downs. AMETEK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (5) Includes unallocated administrative expenses, interest expense and net other income and, in 1993, $2.8 million of restructuring and other unusual charges. (6) Includes $2.8 million in 1993, $9.5 million in 1992, and $5.9 million in 1991 from acquired businesses. (7) Included in total United States sales above. 14. QUARTERLY FINANCIAL DATA (UNAUDITED) - - - -------- (a) Includes pre-tax charges of $46.9 million ($28.6 million after tax or $.66 per share) for restructuring and other unusual items. (b) Trading ranges are based on the New York Stock Exchange composite tape. AMETEK, INC. SCHEDULE I--MARKETABLE SECURITIES--OTHER INVESTMENTS DECEMBER 31, 1993 (IN THOUSANDS) - - - -------- (A) Market value approximates carrying value. (B) Market value approximates $10.9 million. (C) Market value approximates $17.5 million. AMETEK, INC. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) Schedule V continues on next page. - - - -------- See notes to Schedule V and VI on next page. AMETEK, INC. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) Depreciation of property, plant and equipment is determined principally on a straight-line basis over the estimated useful lives of the assets. The annual ranges of depreciation rates for the above periods were: - - - -------- Notes to Schedules V and VI (A) Other includes foreign currency translation gains (losses) for 1993, 1992 and 1991 of $(8,063), $(16,659) and $(516) for property, plant and equipment, and $(3,059), $(4,583) and $399 for accumulated depreciation of property, plant and equipment. Also in 1993, includes $7,782 for asset write-downs in connection with restructuring and other unusual operating activities. (B) Includes $2,798, $9,539 and $5,895 in connection with businesses acquired in 1993, 1992 and 1991, respectively. AMETEK, INC. SCHEDULE VI--ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - - - -------- See notes to Schedules V and VI on prior page. AMETEK, INC. SCHEDULE VIII--ALLOWANCE FOR POSSIBLE LOSSES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - - - -------- (A) Royalties, advertising expenses and taxes other than payroll and income taxes do not exceed one percent of consolidated net sales and, accordingly, are not included herein. 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 Directors of the Company is incorporated herein by reference to the Company's definitive Proxy Statement to be filed with the Securities and Exchange Commission (the "Commission") not later than 120 days after the close of the fiscal year ended December 31, 1993, under the caption "Information as to Nominees for Election of Directors". Information with respect to Executive Officers of the Company appears under Part I hereof. ITEMS 11, 12 AND 13. The information required by Item 11, Executive Compensation, by Item 12, Security Ownership of Certain Beneficial Owners and Management, and by Item 13, Certain Relationships and Related Transactions, is incorporated herein by reference to the Company's definitive Proxy Statement to be filed with the Commission not later than 120 days after the close of the fiscal year ended December 31, 1993, under the headings "Executive Compensation", "Stock Ownership" and "Certain Relationships and Related Transactions". PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Financial Statements, Financial Statement Schedules and Exhibits filed. 1. and 2. Financial statements and schedules are shown in the index on page 17 of this report. 3. Exhibits Exhibits are shown in the index on page 41 of this report. (b) Reports on Form 8-K During the quarter ended December 31, 1993 and through the date of this report, the following reports on Form 8-K were filed: . Report dated November 17, 1993, under Item 5 regarding the Company's announcement of its strategic plan to restructure certain businesses, refinance existing debt, and reduce its common stock dividend. . Report dated February 10, 1994, under Item 5 regarding the Company's announcement of its 1993 results of operations. 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. Ametek, Inc. Dated: March 24, 1994 By /s/ Walter E. Blankley ---------------------------------- WALTER E. BLANKLEY, 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 TITLE DATE --------- ----- ---- /s/ Walter E. Blankley Chairman of the March 24, 1994 - - - ------------------------------------- Board and Chief WALTER E. BLANKLEY Executive Officer (Principal Executive Officer) /s/ Roger K. Derr Executive Vice March 24, 1994 - - - ------------------------------------- President--Chief ROGER K. DERR Operating Officer /s/ Allan Kornfeld Executive Vice March 24, 1994 - - - ------------------------------------- President-- Chief ALLAN KORNFELD Financial Officer (Principal Financial Officer) /s/ John J. Molinelli Vice President and March 24, 1994 - - - ------------------------------------- Comptroller JOHN J. MOLINELLI (Principal Accounting Officer) /s/ Lewis G. Cole Director March 24, 1994 - - - ------------------------------------- LEWIS G. COLE /s/ Helmut N. Friedlaender Director March 24, 1994 - - - ------------------------------------- HELMUT N. FRIEDLAENDER /s/ Sheldon S. Gordon Director March 24, 1994 - - - ------------------------------------- SHELDON S. GORDON /s/ Charles D. Klein - - - ------------------------------------- Director March 24, 1994 CHARLES D. KLEIN /s/ David P. Steinmann Director March 24, 1994 - - - ------------------------------------- DAVID P. STEINMANN /s/ Elizabeth R. Varet Director March 24, 1994 - - - ------------------------------------- ELIZABETH R. VARET INDEX TO EXHIBITS (ITEM 14(A) 3) INDEX TO EXHIBITS (ITEM 14(A)3) INDEX TO EXHIBITS (ITEM 14(A)3) - - - -------- * Management contract or compensatory plan required to be filed pursuant to Item 601 of Regulation S-K. EXHIBIT 21 SUBSIDIARIES OF AMETEK, INC. - - - -------- * Exclusive of directors' qualifying shares and shares held by nominees as required by the laws of the jurisdiction of incorporation. EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Forms S-8 Registration Nos. 33-40223 and 2-97434) pertaining to the Stock Incentive Plan, Employees' Stock Incentive Plan, Employees' Incentive Stock Option Plan, and Employees' Non-Qualified Stock Option and Stock Appreciation Rights Plan of AMETEK, Inc., and to The AMETEK Savings and Investment Plan, respectively, and in the related Prospectuses, of our report dated February 9, 1994, with respect to the financial statements and schedules of AMETEK, Inc. included in the Annual Report (Form 10-K) for the year ended December 31, 1993. Ernst & Young Philadelphia, PA March 24, 1994

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Item 1. Business -------- The company is a diversified manufacturer of engineered industrial products, serving niche markets in aerospace, fluid handling, automatic merchandising and the construction industry. The company's wholesale distribution business serves the building products markets and industrial customers. Founded in 1855, Crane Co. employs over 8,700 people in North America, Europe and Australia. The company's strategy is to maintain a balanced business mix, to focus on niche businesses with high market share and to avoid capital-intensive and cyclical businesses. In the past five years, the company has completed seven acquisitions. In 1990 it acquired Lear Romec, a manufacturer of lubrication and fuel pumps for the aerospace industry. In 1992, certain assets of Jenkins Canada, Inc., a manufacturer of bronze and iron valves, were acquired as an addition to the company's North American valve unit. In 1993, the company made five acquisitions. Perflow Instruments, Ltd., a British manufacturer of pressure and flow measurement equipment, was added to Crane Ltd. Huttig Sash and Door Company expanded its nationwide millwork distribution by acquiring Rondel's Inc., a millwork distributor serving the eastern Washington/western Idaho region, and the Whittier-Ruhle Millwork Company, serving the Mid-Atlantic region. The company significantly expanded its position as a supplier of fiberglass reinforced plastic (FRP) panels to the recreational vehicle market with the acquisition of Filon. Filon was integrated with the company's Kemlite unit in the fourth quarter of 1993. The company acquired Burks Pumps, Inc., a manufacturer of engineered pumps, in December 1993. This acquisition will complement the company's Chempump and Deming pump businesses and significantly increases its involvement in niche markets in the pump industry. In 1990 the company sold Sea-Pac Sales Co., a distributor of floor covering products, and its McAvity division, a Canadian manufacturer of waterwork valves and hydrants for an aggregate sales price of approximately $19 million. In April 1993, the company sold its precision ordnance business, UniDynamics/Phoenix for approximately $6 million. During March 1992 the company sold $100,000,000 8 1/2% notes that will mature on March 15, 2004. See page 24 of the Annual Report to Shareholders for the contributions to the company's sales and operating profit of each of its business segments and the assets employed in each segment. ENGINEERED INDUSTRIAL PRODUCTS ------------------------------ This segment is composed of operations that design and manufacture engineered products and systems for the aerospace, fluid handling, automatic merchandising, transportation, commercial construction and defense markets. The company serves the global valve market through manufacturing facilities in North America, the United Kingdom and Australia. The company sells a wide variety of valves and fluid control products for the chemical, processing, power and general industrial and commercial construction industries. Products include gate, globe, check, angle, ball and butterfly valves of steel, carbon and stainless steel, alloy, iron, cast iron and bronze designed for use under various pressures and temperatures, along with pipe fittings, actuators, pumps and flow measurement equipment. The North American unit also provides a full range of valve aftermarket services including parts, repairs, and modifications through eight service centers and the company's subsidiary in the United Kingdom also maintains repair and service facilities for valves, pumps, compressors, heat exchangers and similar equipment. PART I ------ Item 1. Business (continued) -------- Crane Pumps & Systems manufactures pumps used in the chemical, power, hydro-carbon processing, municipal, general industrial and commercial industries. Products include sealless canned motor pumps designed to handle environmentally hazardous fluids, horizontal and vertical centrifugal pumps, standard vertical turbine pumps, submersible wastewater pumps, regenerative turbine, end suction centrifugal pumps, submersible deaerator pumps, split case pumps, and in-line pumps. The pumps are marketed under the Chempump, Deming, Barnes, Burks, Weinman and Prosser brand names. The company's Cochrane Environmental Systems division designs and markets water and wastewater treatment equipment for almost every major industry. Cochrane's products include deaerators, demineralizers, hot and cold process softeners, dealkalizers, filters, multiport relief valves, condensate drainage systems and clarifiers. These products have applications for boiler feed, industrial processes and wastewater treatment and recovery and are sold principally to public utilities and authorities and major industrial plants. The above products are sold directly to end users through Crane's sales organizations and through independent distributors and manufacturers' representatives. The company designs, manufactures and sells, under the name "Hydro-Aire", anti-skid and automatic brake control systems, fuel and hydraulic pumps, and other aerospace components for the commercial, military and general aircraft industries as original equipment. In addition, the company designs and manufactures systems similar to those above for the retrofit of aircraft with improved systems and manufactures replacement parts for systems installed as original equipment by the aircraft manufacturer. All of these products are largely proprietary to the company and, to some extent, are custom designed to the requirements and specifications of the aircraft manufacturer or program contractor. These systems and replacement parts are sold directly to airlines, governments, and aircraft maintenance and overhaul companies. Lear Romec designs, manufactures and sells pumps and fluid handling systems for military and commercial aerospace industries. Lear Romec has a leading share of the non-captive market for turbine engine lube and scavenge oil pumps. Also, it is the leading supplier of fuel boost and transfer pumps for commuter and business aircraft. The company, through Resistoflex/Defense, designs and manufactures high performance fittings used primarily in military aircraft under the name "Dynatube". The company, through Crane Defense Systems is engaged in the development and manufacture of specialized handling systems, elevators, ground support equipment, cranes and associated electronics. These products are sold directly to the government and defense contractors and represented less than 2% of 1993 sales. Ferguson designs and manufactures, in the United States and through Ferguson Machine S. A. in Europe, precision index and transfer systems for use on and with machines which perform automatic forming, assembly, metal cutting, testing and inspection operations. Products include index drives and tables, mechanical parts handlers, inline transfer machines, rotary tables, press feeds and custom cams. These products are sold through company and independent sales representatives and distributors. PART I ------ Item 1. Business (continued) -------- Kemlite manufactures fiberglass-reinforced plastic panels for use principally by the transportation industry in refrigeration and dry van truck trailers and recreational vehicles. Kemlite products are also sold to the commercial construction industry for food processing, fast food restaurant and supermarket applications, and to institutions where fire rated materials with low smoke generation and minimum toxicity are required. Kemlite sells its products directly to the truck trailer and recreational vehicle manufacturers and uses distributors to serve its commercial construction market. Cor Tec is the leading domestic manufacturer of fiberglass-reinforced laminated panels. The primary market for these panels is the truck and truck trailer segment of the transportation industry. Cor Tec markets its products directly to the truck and truck trailer manufacturers. Resistoflex/Industrial is engaged in the design, manufacture and sale of plastic-lined steel pipe, fittings, valves, bellows and hose used primarily by the pharmaceutical, chemical processing, pulp and paper, petroleum distribution, and waste management industries. Resistoflex sells its products through industrial distributors who provide stocking and fabrication services to industrial users in the United States. The Canadian operations of the company are conducted by Crane Canada, Inc., a wholly-owned subsidiary. Crane Canada manufactures plumbing fixtures and related building products. The unit commands a large share of the Canadian market for these products. Polyflon manufactures radio frequency and microwave components, substrates, capacitors, and antennas for commercial and aerospace uses, and resonating structures for the medical industry. National Vendors is the largest domestic manufacturer of full line vending machines for the automatic merchandising industry. Products include machines which dispense snacks, refrigerated and frozen foods, hot and cold beverages and postal commodities. These products are marketed in North America directly to vending machine operators. In Europe products are marketed through wholly- owned subsidiaries with operations located in the United Kingdom, Germany and France. National Rejectors, GmbH designs and manufactures electronic coin validators and handling systems for vending operations throughout Europe. These devices are sold directly to the vending, amusement, soft-drink, and ticket issuing industries. WHOLESALE DISTRIBUTION ---------------------- The company distributes millwork products through its wholly-owned subsidiary, Huttig Sash & Door Company ("Huttig"). These products include doors, windows, moldings and related building products. Huttig assembles certain of these products to customer specification prior to distribution. Its principal customers are building material dealers and building contractors that service the new construction and remodeling markets. Wholesale operations are conducted nationally through forty-seven branch warehouses throughout the United States, in both major and medium-sized cities. Huttig's sales are made on both a direct shipment and out-of-warehouse basis entirely through its own sales force. Huttig maintains a saw mill and a manufacturing plant in Missoula, Montana, where it produces certain of the above products and other finished lumber, the bulk of which is sold directly to third parties, some of whom compete with Huttig branches. In addition, Huttig manufactures wood windows in Rock Hill, South Carolina. Valve Systems and Controls is a value added industrial distributor providing power operated valves and flow control systems to the petroleum, chemical, power and general processing industries. It services its customers through facilities in Texas, Louisiana, Oklahoma and California. PART I ------ Item 1. Business (continued) -------- Canadian wholesale operations are conducted through the Crane Canada Supply Division of Crane Canada, Inc. This division, a distributor of plumbing supplies, valves and piping, maintains thirty-seven branches throughout Canada and is the largest single distributor for Crane manufactured products. This division also distributes products which are both complementary to and partly competitive with Crane Canada's own manufactured products. COMPETITIVE CONDITIONS ---------------------- The company's lines of business are conducted under actively competitive conditions in each of the geographic and product areas they serve. Because of the diversity of the classes of products manufactured and sold, they do not compete with the same companies in all geographic or product areas. Accordingly, it is not possible to estimate the precise number of competitors or to identify the principal methods of competition. Although reliable statistics are not available, management believes the company and its subsidiaries are important manufacturers or suppliers in a number of market niches and geographic areas it serves. The company's products have primary application in the industrial, construction, aerospace, automated merchandising, transportation, and fluid handling industries. As such, they are dependent upon numerous unpredictable factors, including changes in market demand, general economic conditions, residential and commercial building starts, capital spending, energy exploration and energy allocations during times of scarcity. Since these products are also sold in a wide variety of markets and applications, management does not believe it can reliably quantify or predict the possible effects upon its business resulting from such changes. Seasonality is a considerable factor in Huttig and the Canadian operations. Order backlog totalled approximately $226 million as of December 31, 1993, compared with $262 million as of December 31, 1992. Management believes backlog is not material to understanding its overall business because long- term contracts are not customary to significant portions of its business, except within the defense and aerospace related businesses. RECENT DEVELOPMENTS ------------------- On March 18, 1994 pursuant to a tender offer, Crane Acquisition Corp., a wholly owned subsidiary of Crane ("Crane Acquisition"), acquired 5,620,383 shares of the common stock of ELDEC Corporation ("ELDEC") at $13.00 per share. With this purchase, Crane Acquisition Corp. acquired 98.7 percent of the outstanding shares of ELDEC and thereafter consummated the merger of ELDEC into Crane Acquisition Corp., each remaining share of ELDEC common stock would be converted into the right to receive $13.00 in cash. Therefore, ELDEC is now a wholly owned subsidiary of Crane. Funds in the amount of up to $74,000,000 required for the acquisition of ELDEC have been made available through short-term credit lines. ELDEC, a Washington based corporation, designs, manufactures and markets custom electronic and electromechanical products and systems for applications that are technically and environmentally demanding. The company serves both the commercial and military aerospace markets, and its major customers are airframe and aircraft engine manufacturers and electronic systems manufacturers. The company has four product lines; sensing systems that monitor the status of aircraft landing gear, doors and flight surfaces; low voltage and high voltage power supplies for avionic and defense electronic systems; monitor and control devices for aircraft engines, including flowmeters and engine diagnostic systems; battery chargers, transformer- rectifiers and other devices that regulate DC power on an aircraft. For the year ended March 31, 1993, ELDEC had net sales of $108,415,000, net income of $2,430,000, and total assets of $112,235,000. PART I ------ Item 1. Business (continued) -------- The company's engineering and product development activities are directed primarily toward improvement of existing products and adaptation of existing products to particular customer requirements. While the company owns numerous patents and licenses, none are of such importance that termination would materially affect its business. Product development and engineering costs aggregated approximately $18,300,000 in 1993 ($19,200,000 and $18,600,000 in 1992 and 1991, respectively). In addition, approximately $139,000, $4,100,000, and $6,900,000 were received by the company in 1993, 1992, and 1991, respectively, for customer sponsored research and development relating to projects within the Engineered Industrial Products segment. Costs of compliance with federal, state and local laws and regulations involving the discharge of materials into the environment or otherwise relating to the protection of the environment are not expected to have a material effect upon the company or its competitive position. Item 2. Item 2. Properties *Includes plants under lease agreements: Engineered Industrial operates seven valve service centers in the United States, of which three are owned. The company also operates internationally nine distribution and eight service centers. Wholesale Distribution has forty-seven Huttig branch warehouses in the United States, of which twenty-nine are owned. The Canadian wholesale operation maintains thirty-seven distribution branch warehouses in Canada, of which sixteen are owned. Valve Systems and Controls operates four leased distribution facilities in the United States. In the opinion of management, properties have been well maintained, are in sound operating condition, and contain all necessary equipment and facilities for their intended purposes. PART I ------ Item 3. Item 3. Legal Proceedings ----------------- Neither the company, nor any subsidiary of the company has become a party to, nor has any of their property become the subject of any material legal proceeding other than ordinary routine litigation incidental to their businesses. The following proceeding is included herein because it has been reported in the media. On September 22, 1992 the company was served with a complaint filed in the U.S. District Court, Eastern District of Missouri naming the company and its former subsidiary CF&I Steel Corporation ("CF&I") as defendants and alleging violations of the False Claims Act in connection with the distribution of CF&I to the company's shareholders in 1985 (Civil Actions Nos. 91-0429-C-1 and 4:92CV00514JCH). The complaint alleges a continuing agreement and concert of action between the company and CF&I to distribute CF&I to the company's shareholders, thereafter to terminate CF&I's pension plan so as to cause the Pension Benefit Guaranty Corporation ("PBGC") to assume CF&I's liability for $140 million in unfunded pension liabilities and to prevent the PBGC from obtaining any reimbursement from the company, and to publish and file misleading information in furtherance of that objective. The complaint seeks treble damages and attorney's fees. The company believes it has defenses to the complaint on the grounds, among others, that the allegations are without merit, the plaintiff has no standing and the False Claims Act does not apply. On June 1, 1993 the federal court in the Eastern District of Missouri dismissed the complaint for lack of standing of the plaintiff. The plaintiff has filed an appeal. The company expects the dismissal to be affirmed by the appellate court. The following proceedings are not considered by the company to be material to its business or financial condition and are reported herein because of the requirements of the Securities and Exchange Commission with respect to the descriptions of administrative or judicial proceedings by governmental authorities arising under federal, state or local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment. In a letter dated October 15, 1992 the office of the Attorney General of the State of Ohio advised Cor Tec, a division of Dyrotech Industries, Inc. which is a subsidiary of the company, that Cor Tec's plant facility in Washington Court House, Ohio, had operated numerous air contaminant sources in its manufacturing process which emitted air pollutants for an extended period of time without the required state permits. The Ohio Attorney General's office also alleged that certain contaminant sources at the Cor Tec facility were installed without obtaining permits to install. The main air contaminant in question is styrene, a volatile organic compound that is alleged to be a carcinogen. Cor Tec recently constructed an air remediation system in its plant which included the installation of a hood, vent and incinerator to capture and incinerate the styrene emissions. At a meeting in Columbus, Ohio on March 4, 1993 the Attorney General's office proposed that Cor Tec and the company sign a Consent Decree which would include general injunctive relief and civil penalties in the amount of $4.6 million. Cor Tec has refused to execute such a Decree or pay a penalty. No formal complaint has been filed by the Ohio Attorney General against the company or Cor Tec with regard to the styrene emissions. Cor Tec believes it has adequate defenses to the allegations made by the Attorney General and it plans to vigorously resist paying any damages, fines, or penalties. On July 12, 1985 the company received written notice from the United States Environmental Protection Agency (the "EPA") that the EPA believes the company may be a potentially responsible party ("PRP") under the Federal Comprehensive Environmental Response Compensations and Liability Act of 1980 ("CERCLA") to pay for investigation and corrective measures which may be required to be taken at the Roebling Steel Company site in Florence Township, Burlington County, New Jersey (the "Site") of which its former subsidiary, CF&I Steel Corporation ("CF&I") was a past owner and operator prior to the enactment of CERCLA. The PART I ------ Item 3. Legal Proceedings (continued) ----------------- stated grounds for the EPA's position was the EPA's belief that the company had owned and/or operated the Site. The company had advised the EPA that such was not the case and does not believe that it is responsible for any testing or clean-up at the Site based on current facts. CF&I also has received notice from the State of New Jersey Department of Environmental Protection, Office of Regulatory Services ("NJDEP)", advising CF&I that an investigation by the NJDEP had identified what was considered an existing and potential environmental problem at the Site. As a past owner and operator at the Site, CF&I was notified of the NJDEP's belief that further investigatory action was needed to identify all potential environmental problems at the Site and thereafter formulate and implement a remedial plan to address any identified problems. The NJDEP has subsequently requested information from CF&I, and CF&I has cooperated in providing information, including results of tests which CF&I has conducted at the Site. The EPA identified sources of contamination, which must be examined for potential environmental damage, including: chemical waste drums, storage tanks, transformers, impressed gas cylinders, chemical laboratories, bag house dust, rubber tires, inactive railroad cars, wastewater treatment plants, lagoons, slag disposal areas, and a landfill. On November 7, 1990 CF&I filed a petition for reorganization and protection under Chapter 11 of the United States Bankruptcy Code. The EPA has disclosed that two surface clean-ups have been performed at a cost in excess of $2,000,000 and a further surface clean-up has been announced at an estimated cost of approximately $5,000,000. On July 1, 1991 the company received a letter from the EPA providing an update of the clean-up at the Site. The EPA's July 1, 1991 letter describes a proposed third phase of the investigation, including a Focused Feasibility Study which defined the nature of contaminants and evaluated remedial alternatives for two portions of the Site. The estimated cost for the preferred remedy selected by the EPA for these locations is $12,000,000. In the bankruptcy proceeding of CF&I the EPA was allowed an unsecured claim against CF&I for $27.1 million related to EPA's environmental investigations and remediation at the Roebling Site. Based on the analysis above, the company does not believe it is responsible for any portion of the clean-up. Item 4. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- There have been no matters submitted to a vote of security holders during the fourth quarter of 1993. PART I ------ EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ The executive officers of the registrant are as follows: (1) Resigned March 16, 1994 (2) Effective January 27, 1994 (3) Effective March 21, 1994 PART II ------- The information required by Items 5 through 8 is hereby incorporated by reference to Pages 6 through 27 of the Annual Report to Shareholders. Item 9. Item 9. Changes in and Disagreements on Accounting and Financial Disclosure ------------------------------------------------------------------- Not applicable PART III -------- Item 10. Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- The information required by Item 10 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation l4A except that such information with respect to Executive Officers of the Registrant is included, pursuant to Instruction 3, paragraph (b) of Item 401 of Regulation S-K, under Part I. Item l1. Executive Compensation ---------------------- The information required by Item l1 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation l4A. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- The information required by Item 12 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation 14A. Item 13. Item 13. Certain Relationships and Related Transactions ---------------------------------------------- The information required by Item 13 is incorporated by reference to the definitive proxy statement which the company will file with the Commission pursuant to Regulation 14A. PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ---------------------------------------------------------------- *The consolidated balance sheets of Crane Co. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, changes in common shareholders' equity and cash flows for the years ended December 31, 1993, 1992 and 1991 and the financial review, appearing on Pages 6 through 27 of Crane Co.'s Annual Report to Shareholders which will be furnished with the company's proxy statement as required by Regulation 14A, Rule 14a-3(c), are incorporated herein by reference and are supplemented by schedules beginning on Page 14 of this report. All other statements and schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission have been omitted because they are not required under related instructions or are inapplicable, or the information is shown in the financial statements and related notes. (b) Reports on Form 8-K: (1) 8-K filed January 12, 1994 regarding acquisition of Burks Pumps, Inc. (2) 8-KA filed January 26, 1994 including financial statements of Burks Pumps and Crane Co. pro forma. (c) Exhibits to Form 10-K: (3) Articles of Incorporation and By-laws: There is incorporated by reference herein: (a) The company's Articles of Incorporation contained in Exhibit D to the company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. (b) The company's by-laws contained in Exhibit A to the company's Annual Report on Form 10-K for the fiscal year ended December 31, (4) Instruments Defining the Rights of Security Holders, including Indentures: (a) There is incorporated by reference herein: (1) Preferred Share Purchase Rights Agreement contained in Exhibit 1 to the company's Report on Form 8-K filed with the Commission on July 12, 1988. (2) Amendment to Preferred Share Purchase Rights Agreement contained in Exhibit 1 to the company's Report on Form 8-K filed with the Commission on June 29, 1990. PART IV ------- Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ---------------------------------------------------------------- (continued) (b) There is incorporated by reference herein: 1) Indenture dated as of April 1,1991 between the Registrant and the Bank of New York contained in Exhibit 4 to Registration Statement No. 33-39658. 2) Third Supplemental Indenture dated as of April 30, 1969 between Registrant and B of A contained in Exhibit 4.2 to Registration Statement No. 2-32586 (5% Convertible Subordinated Debentures, Series B, due July 1, 1994). (10) Material Contracts: ------------------ (iii)Compensatory Plans Exhibit A: The Crane Co. Restricted Stock Award Plan as amended through May 10, 1993. Exhibit B: The Crane Co. Non-Employee Directors Restricted Stock Award Plan as amended through May 10, 1993. There is incorporated by reference herein: (a.) The Crane Co. Restricted Stock Award Plan contained in Exhibit 4.1.1 to Post-Effective Amendment No. 2 to the Registrant's Registration Statement No. 33-22904 on Form S-8 filed on July 6, 1988 and the related agreements filed as Exhibit 4.4.2-2 to Post-Effective Amendment No. 4, Exhibit 4.4.2-3 to Post-Effective Amendment No. 5 and Exhibit 4.4.2- 4 to Post-Effective Amendment No. 6, and Exhibit 4.4.2-5 to Post-Effective Amendment No. 7. (b.) The indemnification agreements entered into with Mr. R. S. Evans, each other director of the company and Mr. P. R. Hundt the form of which is contained in Exhibit C to the company's definitive proxy statement filed with the Commission in connection with the company's April 27, 1987 Annual Meeting. (c.) The Crane Co. Retirement Plan for Non-Employee Directors contained in Exhibit E to the company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. (d.) The forms of Agreement and Supplemental Agreement between the company and each of its five most highly compensated officers which provide for the continuation of certain employee benefits upon a change of control contained in Exhibit E to the company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. (e.) The Crane Co. Stock Option Plan as amended through May 6, 1991 contained in Exhibit 1(a)(2) to Post-Effective Amendment No. 2 to the company's Registration Statement No. 33-18251 on Form S-8 filed with the Commission on November 2, 1987. (11) Statement re computation of per share earnings: Exhibit C: Computation of net income per share. (13) Annual report to security holders: Exhibit D: Annual Report to shareholders for the year ended December 31, 1993. (22) Subsidiaries of the Registrant: Exhibit E: Subsidiaries of the Registrant. (24) Consent of Experts and Counsel Exhibit F: Independent auditors' consent. All other exhibits are omitted because they are not applicable or the required information is shown elsewhere in this Annual Report on Form 10- K. SIGNATURES - ---------- Pursuant to the requirements of Section l3 or l5(d) of the Securities Exchange Act of l934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CRANE CO. ---------------------- (Registrant) By D. S. Smith ------------------------- D. S. Smith Vice President-Finance Date 3/28/94 ----------------- Pursuant to the requirements of the Securities Exchange Act of l934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. OFFICERS -------- R. S. Evans - -------------------------- R. S. Evans Chairman, Chief Executive Officer, President and Director Date 3/28/94 ------------------ D. S. Smith M. L. Raithel - -------------------------- -------------------------- D. S. Smith M. L. Raithel Vice President-Finance Controller Date 3/28/94 Date 3/28/94 ---------------------- ---------------------- DIRECTORS --------- INDEPENDENT AUDITORS' REPORT - ---------------------------- To the Shareholders of Crane Co.: We have audited the consolidated financial statements of Crane Co. and subsidiaries as of December 31, 1993 and 1992, and for each of three years in the period ended December 31, 1993 and have issued our report thereon dated January 24, 1994 (except for the note "Subsequent Event" on page 21, as to which the date is February 11, 1994); 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 consolidated financial statement schedules of Crane Co., listed in Item 14. These financial statement schedules are the responsibility of the Company's mamnagement. 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 January 24, 1994 CRANE CO. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Rates of depreciation vary from three to twenty-five years in consideration of the use and character of the assets. (1) Includes $1,703 of computer software to other assets. CRANE CO. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands) CRANE CO. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (In Thousands) CRANE CO. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (In Thousands) NOTES: (1) Average monthly borrowings are calculated using month-end balances outstanding during the year. (2) The approximated weighted average is calculated by dividing the related interest expense by monthly average borrowings. CRANE CO. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (in Thousands) NOTE: Amounts for amortization of intangible assets, taxes other than payroll and income taxes, royalties and advertising costs are not presented as such amounts are less than 1% of net sales.

804055_1993.txt

804055_1993

1993

804055

ITEM 1. BUSINESS INTRODUCTION Coca-Cola Enterprises Inc. (the "Company") is in the liquid nonalcoholic refreshment business and is the world's largest producer, marketer and distributor of bottle/can soft drink products of The Coca-Cola Company. The Company was organized under the laws of the State of Delaware in 1944 as a wholly owned subsidiary of The Coca-Cola Company. It was inactive from 1970 until August 1986, when it was reactivated with a restated certificate of incorporation and amended bylaws. Unless the context indicates otherwise, all references in this report to the "Company" include the Company and its divisions and subsidiaries. On November 21, 1986, the Company sold 71,400,000 shares of its common stock to the public, reducing the percentage of the Company's common stock owned by The Coca-Cola Company immediately after the public offering from 100% to approximately 49%. The Coca-Cola Company now owns approximately 43.5% of the outstanding common stock of the Company. The Company produces, markets and distributes carbonated soft drink products of The Coca-Cola Company, representing approximately 55% of all bottle/can sales of carbonated soft drink products of The Coca-Cola Company in the United States. The Company estimates that the territories in which it markets beverages to retailers (including portions of 38 states, the District of Columbia, the U.S. Virgin Islands, and the Netherlands) contain approximately 150 million people. Slightly more than one-half (52%) of the population of the United States and the entire population of the Netherlands reside within the Company's territories. The Company is the principal Coca-Cola bottler in the five states in the United States (California, Florida, Texas, Washington and Virginia) with the largest increases in population from 1989 to 1993. In all of its territories, the Company sold approximately 1.6 billion equivalent cases* of liquid nonalcoholic refreshments in 1993. Domestic Operations Management estimates that 1993 sales of the Company represented approximately 17% of the total 1993 dollar sales of soft drinks by all bottlers and fountain distributors in the United States. In addition, the Company's 1993 total volume sales of such products were approximately 1.5 billion equivalent cases or approximately 18% of the estimated total 1993 volume sales of soft drink products by all bottlers and fountain distributors in the United States. In 1993, approximately 70% of the equivalent case sales of the Company (excluding products in post-mix form) were beverages bearing the trademarks "Coca-Cola" or "Coke" ("Coca-Cola Trademark Beverages"), approximately 19% of its equivalent case sales were other beverages of The Coca-Cola Company ("Allied Beverages" and collectively with the Coca-Cola Trademark Beverages, "beverage products of The Coca-Cola Company"), and approximately 11% of its equivalent case sales were beverage products of companies other than The Coca-Cola Company. Equivalent case sales by the Company of products in bottles and cans, including products of companies other than The Coca-Cola Company, constituted approximately 87% of the equivalent case sales of the Company in 1993. The remaining 13% of the Company's equivalent case sales in 1993 related to post-mix for fountain sales. - --------------- * As used in this report, the term "equivalent case" refers to 192 ounces of finished beverage product (24 eight-ounce servings). Dutch Operations The Company's Dutch subsidiary, Coca-Cola Beverages Nederland B. V. ("CCB Nederland"), in 1993 sold approximately 35 million equivalent cases. Approximately 96% of CCB Nederland's equivalent case sales were of beverage products of The Coca-Cola Company. Strategy The Company's management believes that share of the liquid nonalcoholic refreshment market is the principal determinant of long-term profitability; improvements in market share, together with increases in per capita consumption and population, determine case sales growth. The Company's competitive strategy is to obtain profitable increases in case sales and over the long term to increase its total share of the liquid nonalcoholic refreshment market. The Company attempts to meet these objectives through (i) the development and superior execution of innovative marketing programs, (ii) the implementation of cost-effective production and distribution strategies, including capital investment in automation where appropriate, and (iii) an emphasis on the marketing of the products of The Coca-Cola Company, including new "alternative" and other beverages that the Company expects to introduce with increasing frequency when they can be expected to contribute to gross profit. Management of the Company believes that because its business is characterized by local competition that may differ from one territory to another, discipline in the execution of marketing programs at the local level is critical. Both the Company's local sales representatives and its senior management are accountable for the execution and success of such programs. RELATIONSHIP WITH THE COCA-COLA COMPANY The Coca-Cola Company is the Company's largest share owner. Two Directors of the Company are executive officers of The Coca-Cola Company, and two other Directors of the Company are former executive officers of The Coca-Cola Company. The Company and The Coca-Cola Company are parties to a number of significant transactions and agreements incident to their respective businesses, and the Company and The Coca-Cola Company may enter into additional material transactions and agreements from time to time in the future. The Company conducts its business primarily under contracts with The Coca-Cola Company. These contracts give the Company the exclusive right to produce, market and distribute beverage products of The Coca-Cola Company in authorized bottles and cans in specified territories and provide The Coca-Cola Company with the ability, in its sole discretion, to establish prices, terms of payment and other terms and conditions for the purchase of concentrates and syrups from The Coca-Cola Company. See "Domestic Bottle Contracts" and "International Bottler's Agreement" below. Other significant transactions and agreements relate to, among other things, arrangements for cooperative marketing, advertising expenditures and purchases of sweeteners. Since 1979, The Coca-Cola Company has assisted in the transfer of ownership or financial restructuring of a majority of its United States bottler operations and has assisted in similar transfers of bottlers operating outside the United States, such as the June 1993 acquisition of CCB Nederland by the Company. Certain bottlers and interests therein have been acquired by The Coca-Cola Company and certain of those have been sold to bottlers, including the Company, which are believed by management of The Coca-Cola Company to be the best suited to manage and develop these acquired operations. The Coca-Cola Company has advised the Company that it may continue to acquire bottling companies or interests therein to assist in the transfer of acquired bottlers to other bottlers, which may or may not include the Company, viewed as the best suited to promote the interests of The Coca-Cola Company and the Coca-Cola bottler system in acquired territories. In connection with such transactions, The Coca-Cola Company may own all or part of the equity interests of acquired bottlers for varying periods of time. See "Acquisitions and Divestitures" below and "Certain Relationships and Related Transactions -- Agreements and Transactions with The Coca-Cola Company -- Purchase of Coca-Cola Bottlers" in the 1994 Proxy Statement, which information is incorporated by reference in Item 13 hereof. The Company intends to acquire only bottling businesses offering the Company the ability to produce long-term share-owner value. From time to time The Coca-Cola Company may sell additional bottling businesses or additional ownership interests therein to, or buy bottling businesses or ownership interests therein from, the Company. ACQUISITIONS AND DIVESTITURES During 1993, the Company acquired four bottling businesses located in Knoxville and Johnson City, Tennessee, the Netherlands and Jonesboro, Arkansas. It also acquired an engineering consulting firm in Florida, Dr Pepper franchise rights in Georgia, Rhode Island, and Wisconsin, and certain assets of a post-mix business in Connecticut. For these 1993 acquisitions the Company paid an aggregate cost, including assumed and issued debt, where applicable, of approximately $430 million. In January 1994, the Company purchased 4% of the outstanding stock of The Coca-Cola Bottling Company of New York, Inc. from The Coca-Cola Company, the controlling share owner, for approximately $6 million, with a right of first refusal exercisable within five years for any additional stock proposed to be transferred by The Coca-Cola Company. These shares represent an approximate 9% voting interest. The total cost of acquisitions since reorganization in 1986, including assumed and issued debt, where applicable, has been approximately $5.6 billion. Since reorganization in 1986, the total proceeds to the Company from the sale of bottlers and other businesses approximates $455 million. However, of this amount, bottlers representing sales proceeds of approximately $404 million were reacquired by the Company in 1991 as a result of the acquisition of Johnston Coca-Cola Bottling Group, Inc. ("Johnston Coca-Cola"), now a subsidiary of the Company. In 1993, the Company sold Seven-Up bottling rights in Louisiana and Dr Pepper franchise rights in Mississippi for proceeds aggregating approximately $564,000. TERRITORIES The domestic bottling territories in which the Company markets its products include portions of 38 states, the District of Columbia and the U.S. Virgin Islands and contain approximately 135 million people, or about 52% of the U.S. population. Between 1989 and 1993, population in the territories in the United States in which the Company operates increased by approximately 5.9% as compared to an increase in the general United States population of approximately 3.6% during the same period. The Company's territory in the Netherlands has a population of approximately 15 million people. The following maps identify the territories in which the Company operates: [MAP] (MAPS NOT TO SAME SCALE) PRODUCTS The Company produces and markets beverage products of The Coca-Cola Company. The beverage products of The Coca-Cola Company include Coca-Cola, Coca-Cola classic, caffeine free Coca-Cola classic, diet Coke, caffeine free diet Coke, Sprite, diet Sprite, cherry Coke, diet cherry Coke, Fanta brand soft drinks, Fresca, Hi-C brand soft drinks, Mello Yello, diet Mello Yello, Minute Maid and diet Minute Maid brand soft drinks and Minute Maid Juices To Go, Mr. PiBB, diet Mr. PiBB, PowerAde, Ramblin' root beer and TAB. The Company also produces and markets various noncola beverage products under the trademarks of companies other than The Coca-Cola Company, including, in some markets Dr Pepper. The Company markets substantially all of the Coca-Cola Trademark Beverages, as well as TAB, Sprite and diet Sprite, and Minute Maid and diet Minute Maid orange beverages, in substantially all of its domestic territories, and markets other products of The Coca-Cola Company and other companies in selected territories. In addition to producing products for its own territories, certain of the Company's locations produce some products for sale to other Coca-Cola bottlers and major fountain accounts. The Coca-Cola Company and other companies manufacture concentrates, and in some cases the finished product, for sale to bottlers and to fountain wholesalers. Bottling and canning operations combine the concentrate with sweetener and carbonated water, and package the finished product in authorized bottles, cans and post-mix containers for sale to retailers. The Company purchases some products, such as PowerAde and Nestea, from contract packers. See "Marketing" and "Raw Materials" below. Approximately 69% of the Company's domestic equivalent case sales in 1993 (excluding post-mix) represented caloric products and the balance represented low calorie products. MARKETING The Company sells its products in a variety of cans and bottles authorized by The Coca-Cola Company and other companies. Fountain syrup for use in post-mix fountain dispensers is sold in one-gallon and five-gallon containers. In 1993, excluding post-mix syrup sales, domestic equivalent case sales of the Company were packaged approximately 61% in cans, 38% in nonrefillable bottles and the balance was in various other containers. Post-mix syrup accounted for approximately 13% of the Company's domestic equivalent case sales and approximately 6% of revenues during 1993. In the Netherlands, the approximate packaging mix was 83% in returnable PET bottles and glass, 12% in steel cans, 1% in nonreturnable glass and the balance in pre-mix and post-mix containers. The Company relies extensively on advertising and sales promotion in the marketing of its products. The Coca-Cola Company and the other beverage companies that supply concentrates and syrups and finished product to the Company, together with the Company, make substantial advertising expenditures in all major media to promote sales in the local areas served by the Company. In addition, the Company benefits from national advertising programs conducted by The Coca-Cola Company and other beverage companies. In 1993, the Company's local media advertising expenditures were approximately $39 million, in addition to cooperative media advertising payments by The Coca-Cola Company and other beverage companies of approximately $41 million. Certain of the marketing expenditures by The Coca-Cola Company are made pursuant to annual arrangements between The Coca-Cola Company and the Company. Although The Coca-Cola Company has advised the Company that it intends to continue to provide marketing support in 1994, it is not obligated to do so under either the domestic or international bottle contracts between The Coca-Cola Company and the Company. See "Domestic Bottle Contracts" and "International Bottler's Agreement" below. Sales of the Company's products are seasonal, with the second and third calendar quarters generally accounting for higher sales volumes than the first and fourth quarters. RAW MATERIALS In addition to concentrates, sweeteners and finished product, the Company purchases carbon dioxide, glass and plastic bottles, cans, closures, post-mix packaging (such as plastic bags in cardboard boxes) and other packaging materials. The Company generally purchases its raw materials, other than concentrates, syrups and sweeteners, from multiple suppliers. The bottle contracts with The Coca-Cola Company provide that, with respect to the products of The Coca-Cola Company, all authorized containers, closures, cases, cartons and other packages and labels must be purchased from manufacturers approved by The Coca-Cola Company. High fructose corn syrup currently is the principal sweetener of the beverage products, other than low-calorie products, of The Coca-Cola Company. The Company and The Coca-Cola Company have entered into arrangements for the purchase by the Company from The Coca-Cola Company of substantially all of the Company's requirements for sweeteners for 1994. See "Certain Relationships and Related Transactions -- Agreements and Transactions with The Coca-Cola Company -- Sweetener Requirements Agreement" in the Company's 1994 Proxy Statement, which information is incorporated by reference in Item 13 hereof. The Company does not directly purchase low-calorie sweeteners because sweeteners for the low-calorie beverage products of The Coca-Cola Company are contained in the concentrate purchased by the Company from The Coca-Cola Company. The Company currently purchases a significant portion of the Company's requirements for plastic bottles from cooperatives owned by it and other Coca-Cola bottlers. Management of the Company believes that ownership interests in certain suppliers and the self-manufacture of certain items serve to reduce or contain costs. There are no materials or supplies used by the Company which are currently in short supply, although the supply of specific materials could be adversely affected by strikes, weather conditions, governmental controls or national emergencies. DOMESTIC BOTTLE CONTRACTS The Company purchases concentrate and syrup from The Coca-Cola Company and manufactures, packages, distributes and sells the principal liquid nonalcoholic refreshment products in its domestic territories in the United States under two basic forms of bottle contracts with The Coca-Cola Company: bottle contracts that cover the Coca-Cola Trademark Beverages (the "Cola Bottle Contracts") and bottle contracts that cover the Allied Beverages (the "Allied Bottle Contracts") (herein referred to collectively as the "Bottle Contracts"). See "Introduction" and "Products" above. The Company and each of its wholly owned bottling company subsidiaries are parties to one or more separate Cola Bottle Contracts and to various Allied Bottle Contracts. In this section, unless the context indicates otherwise, a reference to the Company refers to the legal entity, which may be either the Company or one of its bottling company subsidiaries, which is a party to the Bottle Contracts with The Coca-Cola Company. The Cola Bottle Contracts The Cola Bottle Contracts provide that the Company will purchase its entire requirements of concentrates and syrups for Coca-Cola Trademark Beverages from The Coca-Cola Company at prices, terms of payment and other terms and conditions of supply, as determined from time to time by The Coca-Cola Company in its sole discretion. The Company has the exclusive right to distribute Coca-Cola Trademark Beverages for sale in its territories in authorized containers, which include various configurations of cans and refillable and nonrefillable bottles. The Coca-Cola Company may determine from time to time in its sole discretion what types of containers to authorize for use with products of The Coca-Cola Company. The pricing terms for concentrates and syrups under the Cola Bottle Contracts provide for prices determined from time to time by The Coca-Cola Company in its sole discretion, and pursuant to the Cola Bottle Contracts, The Coca-Cola Company has established the prices charged to the Company for concentrates and syrups for Coca-Cola Trademark Beverages annually. The Company expects that net prices charged by The Coca-Cola Company in 1994 for syrup and concentrates will increase approximately 2.5% as compared to 1993 prices. Under the Bottle Contracts, The Coca-Cola Company has no rights to establish the resale prices at which the Company sells its products. The Company is obligated to maintain such plant and equipment, staff and distribution, and vending facilities as are capable of manufacturing, packaging and distributing Coca-Cola Trademark Beverages in authorized containers in accordance with the Cola Bottle Contracts and in sufficient quantities to satisfy fully the demand for these beverages in authorized containers in its territories; to undertake adequate quality control measures prescribed by The Coca-Cola Company; to develop and stimulate the demand for Coca-Cola Trademark Beverages in those territories; to use all approved means, and spend such funds on advertising and other forms of marketing, as may be reasonably required to satisfy that objective; and to maintain such sound financial capacity as may be reasonably necessary to assure performance by the Company and its affiliates of their obligations to The Coca-Cola Company. The Cola Bottle Contracts require the Company to meet annually with The Coca-Cola Company to discuss the Company's plans for the following year. At such meetings, the Company is obligated to present plans that set out in reasonable detail its marketing, management and advertising plans with respect to the Coca-Cola Trademark Beverages for the year, including financial plans showing that the Company and all of its bottler affiliates have the consolidated financial capacity to perform their duties and obligations to The Coca-Cola Company. The Coca-Cola Company may not unreasonably withhold approval of such plans. If the Company carries out its plans in all material respects, it will be deemed to have satisfied its obligations to develop, stimulate and fully satisfy the demand for the Coca-Cola Trademark Beverages and to maintain the requisite financial capacity. Failure to carry out such plans in all material respects would constitute an event of default that, if not cured or waived by The Coca-Cola Company within 120 days of notice of the failure, would give The Coca-Cola Company the right to terminate the Cola Bottle Contract. If the Company at any time fails to carry out a plan in all material respects in any geographic segment of its territory, and if such failure is not cured within six months after notice of the failure, The Coca-Cola Company may reduce the territory covered by that Cola Bottle Contract by eliminating the portion of the territory with respect to which such failure has occurred. The Coca-Cola Company has no obligation under the Bottle Contracts to participate with the Company in expenditures for advertising and marketing, but it may, in its discretion, contribute to such expenditures and undertake independent advertising and marketing activities, as well as cooperative advertising and sales promotion programs, that would require the cooperation and support of the Company. Although The Coca-Cola Company has advised the Company that it intends to continue to provide various forms of marketing support in 1994 at a comparable level of support as provided in 1993, it is not obligated to do so under the Bottle Contracts. If the Company acquires control, directly or indirectly, of any bottler of Coca-Cola Trademark Beverages in the United States, or any party controlling a bottler of Coca-Cola Trademark Beverages in the United States, the Company must cause the acquired bottler to amend its bottle contract for the Coca-Cola Trademark Beverages to conform to the terms of the Cola Bottle Contract described above. The Cola Bottle Contracts are perpetual, subject to termination by The Coca-Cola Company in the event of default by the Company. Events of default with respect to each Cola Bottle Contract include: (1) production or sale of any cola product not authorized by The Coca-Cola Company; (2) insolvency, bankruptcy, dissolution, receivership or the like; (3) any disposition by the Company of any voting securities of any bottling company without the consent of The Coca-Cola Company; and (4) any material breach of any obligation of the Company under the Cola Bottle Contract that remains uncured for 120 days after notice by The Coca-Cola Company. If any Cola Bottle Contract is terminated, The Coca-Cola Company has the right to terminate all other Cola Bottle Contracts held by the bottler which is a party to the terminated contract, as well as the Cola Bottle Contracts of any other entity which such bottler controls. In addition, each Cola Bottle Contract held by the Company provides that The Coca-Cola Company has the right to terminate that Cola Bottle Contract if a person or affiliated group (with specified exceptions) acquires or obtains any contract, option, conversion privilege or other right to acquire, directly or indirectly, beneficial ownership of more than 10% of any class or series of voting securities of the Company; however, The Coca-Cola Company has agreed with the Company that this provision will not apply with respect to the ownership of any class or series of voting securities of Coca-Cola Enterprises Inc. although it would apply to the voting securities of each bottling company subsidiary. The provisions of the Cola Bottle Contracts of the Company which make it an event of default to dispose of any Cola Bottle Contract or voting securities of any bottling company subsidiary without the consent of The Coca-Cola Company and which prohibit the assignment or transfer of the Cola Bottle Contracts are designed to preclude any person not acceptable to The Coca-Cola Company from obtaining an assignment of a Cola Bottle Contract or from acquiring any voting securities of the Company's bottling subsidiaries. These provisions will prevent the Company from selling or transferring any of its interest in any bottling operations without the consent of The Coca-Cola Company. These provisions may also make it impossible for the Company to benefit from certain transactions, such as mergers or acquisitions, involving any of the bottling operations that might be beneficial to the Company and its share owners but which are not acceptable to The Coca-Cola Company. The terms of the Cola Bottle Contracts generally impose greater obligations upon the Company and contain events of default and termination and other provisions that are less favorable to the Company bottlers than the bottle contracts for Coca-Cola Trademark Beverages currently in effect for other Coca-Cola bottlers representing approximately 26% of 1993 domestic gallon shipments for bottled and canned beverage products of The Coca-Cola Company. Supplementary Agreement In addition to the Cola Bottle Contracts with The Coca-Cola Company described above, the Company is a party to a supplementary agreement (the "Supplementary Agreement") with The Coca-Cola Company regarding the exercise by The Coca-Cola Company of its rights under the Bottle Contracts. Pursuant to the Supplementary Agreement, The Coca-Cola Company has agreed to exercise good faith and fair dealing under the Bottle Contracts; offer marketing support and exercise its rights under the Bottle Contracts in a manner consistent with its dealings with comparable bottlers; offer to the Company any material written amendment to such Bottle Contracts which it offers to any other bottler; and, subject to certain limitations, sell syrups and concentrates to the Company at prices not greater than those charged to other bottlers which are parties to agreements substantially similar to the Bottle Contracts. The Supplementary Agreement provides for a term expiring on March 15, 1999 and may be terminated by The Coca-Cola Company upon 30 days' notice in the event that The Coca-Cola Company should cease to own more than 40% of the Company's outstanding common stock. The Allied Bottle Contracts The Allied Bottle Contracts contain provisions that are similar to those of the Cola Bottle Contracts with respect to pricing, authorized containers, planning, quality control, transfer restrictions and related matters, and grant similar exclusive rights with respect to the distribution of the Allied Beverages for sale in authorized containers in specified territories. Under the Allied Bottle Contracts, the Company likewise has advertising, marketing and promotional obligations, but without restriction as to the marketing of competitive products as long as there is no manufacturing or handling of other products that would imitate, infringe upon, or cause confusion with, the products of The Coca-Cola Company. The Coca-Cola Company has the right to discontinue any or all Allied Beverages, and the Company has a right, but not an obligation, under each of the Allied Bottle Contracts (except under the Allied Bottle Contracts for Hi-C brand soft drinks and Minute Maid orange beverages) to elect to market any new beverage introduced by The Coca-Cola Company under the trademarks covered by the respective Allied Bottle Contracts. The Allied Bottle Contracts each have a term of ten years and are renewable by the bottler for an additional ten years at the end of each ten-year period. The initial term for most of the Company's Allied Bottle Contracts will expire in 1996 and subsequent years. The Allied Bottle Contracts are subject to termination in the event of default by the Company. The Coca-Cola Company may terminate an Allied Bottle Contract in the event of: (1) insolvency, bankruptcy, dissolution, receivership or the like; (2) termination of the Cola Bottle Contract of the Company by either party for any reason; or (3) any material breach of any obligation of the Company under the Allied Bottle Contract that remains uncured for 120 days after notice by The Coca-Cola Company. Post-Mix Marketing, Fountain Appointments and Other Similar Arrangements The Company has in the past sold and delivered the post-mix products of The Coca-Cola Company pursuant to one-year post-mix distributorship appointments. In 1993, the Company sold and/or delivered such post-mix products in most of its major markets. Under the terms of the appointments, the Company is authorized to distribute such syrups to retailers for dispensing to consumers within the United States. The appointments are terminable by either party without cause upon ten days' written notice. Unlike the Bottle Contracts, there is no exclusive territory and the Company faces competition not only from sellers of other post-mix syrups but from other sellers of post-mix syrups of The Coca-Cola Company (including The Coca-Cola Company). Depending on the market, the Company is involved in the sale, distribution and marketing of post-mix syrups in differing degrees. In some markets, the Company sells syrup on its own behalf, but the primary responsibility for marketing lies with The Coca-Cola Company. In other territories, the Company is responsible for marketing post-mix syrup to certain segments of the market. See "Certain Relationships and Related Transactions -- Agency Billing and Delivery Arrangements" in the Company's 1994 Proxy Statement, which information is incorporated by reference in Item 13 hereof. Other Bottle Agreements The bottle agreements between the Company and other licensors of beverage products and syrups generally give those licensors the unilateral right to change the prices for their products and syrups at any time in their sole discretion. Some of these bottling agreements have limited terms of appointment and in most instances, prohibit the bottler from dealing in competitive products. Those agreements contain restrictions generally similar in effect to those in the Cola Bottle Contracts as to trade names, approved bottles, cans and labels, sale of imitations and cause for termination. INTERNATIONAL BOTTLER'S AGREEMENT CCB Nederland operates in the Netherlands under a Bottler's Agreement dated December 14, 1992 (the "International Bottler's Agreement") with The Coca-Cola Company; this agreement has some significant differences from the Bottle Contracts under which the Company operates domestically. Unlike the Cola Bottle Contracts, which are perpetual although subject to early termination by The Coca-Cola Company under certain circumstances described above, the International Bottler's Agreement is for a term of years, expiring September 30, 1998 unless terminated earlier as provided therein. If CCB Nederland has fully complied with the agreement during the initial term, is "capable of the continued promotion, development and exploitation of the full potential of the business" and requests an extension of the agreement, an additional ten-year term may be granted at the sole discretion of The Coca-Cola Company. The Coca-Cola Company is given the right to terminate the International Bottler's Agreement before the expiration of the stated term upon the insolvency, bankruptcy, nationalization or similar condition of CCB Nederland or the occurrence of a default under the International Bottler's Agreement which is not remedied within 60 days of notice of the default being given by The Coca-Cola Company. The International Bottler's Agreement may be terminated by either party in the event foreign exchange is unavailable or local laws prevent performance. CCB Nederland has the exclusive right to sell the beverages covered by the International Bottler's Agreement in refillable glass bottles and PET bottles within the territory, which is described as the Netherlands, excluding the Netherlands Antilles. The covered beverages include the Coca-Cola Trademark and Allied Beverages. The Coca-Cola Company has retained the rights to produce and sell or authorize third parties to produce and sell the beverages in any other manner or form, including cans, within the territory. CCB Nederland has been granted a nonexclusive authorization to purchase finished product in cans from The Coca-Cola Company or its designee and distribute them within its territory. This authorization is granted in connection with the International Bottler's Agreement and expires on September 30, 1998, with a provision for an extension of five years at the discretion of The Coca-Cola Company. The Coca-Cola Company has granted CCB Nederland a nonexclusive authorization to package and sell post-mix and pre-mix beverages in the territory; this authorization is terminable by either party with 90 days' prior notice. CCB Nederland is prohibited from making sales of the beverages outside of its territory or to anyone intending to resell the beverages outside the territory without the consent of The Coca-Cola Company, except for sales arising out of an order from a customer in another member state of the European Union or for export to another such member state. The International Bottler's Agreement contemplates that there may be instances in which large or special buyers have operations transcending the boundaries of CCB Nederland's territories, and in furtherance of this, CCB Nederland and The Coca-Cola Company are cooperating in sales to such buyers. The Company believes that the International Bottler's Agreement is substantially similar to other agreements between The Coca-Cola Company and European bottlers of Coca-Cola Trademark and Allied Beverages. Similar to the Bottle Contracts under which the Company and its other subsidiaries operate, the International Bottler's Agreement provides that the sales of beverage base and other goods to CCB Nederland are at prices which are set from time to time by The Coca-Cola Company. The Company expects that net prices charged in 1994 by The Coca-Cola Company for beverage base and other goods will increase approximately 4% over 1993 prices. The Coca-Cola Company has no commitment to provide marketing support under the International Bottler's Agreement, but it has done so in the past and has advised CCB Nederland that it intends to continue marketing support to CCB Nederland in 1994 at a similar level as provided in 1993. COMPETITION The liquid nonalcoholic refreshment business is highly competitive. Carbonated soft drink products compete with coffee, water, milk, beer and wine, sports drinks, bottled waters, tea and juices as well as with noncarbonated soft drinks, citrus and noncitrus fruit drinks and other beverages. Competitors in the soft drink industry include bottlers and distributors of nationally advertised and marketed products, regionally advertised and marketed products, and chain store and private label soft drinks. The Company estimates that in 1993 the products of The Coca-Cola Company represented approximately 33% of total food store soft drink sales in all domestic territories in which the Company operates, and that those of PepsiCo, Inc. represented approximately 30%. The Company also estimates that in each of its domestic territories, between 55% and 72% of food store soft drink sales are accounted for by the Company and its major competitor, which in most territories is the bottler of the soft drink products of PepsiCo, Inc. Private label and store brands played an increased role in domestic food store sales in 1993 over previous years and accounted for a significant percentage of soft drink sales in the Netherlands. Brand recognition and pricing are significant factors affecting the Company's competitive position, and the trademarks associated with its products are the most favorable factor for the Company. Other competitive factors among bottlers are marketing, distribution methods, service to the trade and the management of sales promotion activities. Vending machine sales, packaging changes and contracts with fountain customers are also competitive factors. The introduction of new products has been another major competitive element in the liquid nonalcoholic refreshment industry. The Company expects The Coca-Cola Company to introduce an increasing number of new "alternative" beverages during 1994. These products include teas, fruit drinks, "natural" sodas and bottled waters. EMPLOYEES As of March 1, 1994, the Company had approximately 26,500 employees, about 850 of whom are in the Netherlands. The Company is a party to collective bargaining agreements covering approximately 24% of its employees. These collective bargaining agreements expire at various dates through 1996. The Company has no reason to believe that it will be unable to renegotiate any of these agreements on satisfactory terms. Management of the Company believes that the Company's relations with its employees are generally good. GOVERNMENTAL REGULATION Anti-litter measures have been enacted in the states of California, Connecticut, Delaware, Iowa, Massachusetts, Michigan, New York, Oregon and the City of Columbia, Missouri, where some of the Company bottlers operate, prohibiting the sale of certain beverages, whether in refillable or nonrefillable containers, unless a deposit is charged by the retailer for the container. The retailer or redemption center refunds the deposit to the customer upon the return of the container. The containers are then returned to the bottler, which, in most jurisdictions, must pay the refund and, in certain others, must also pay a handling fee. In the past, similar legislation has been proposed but not adopted elsewhere, although the Company anticipates that additional states or local jurisdictions may enact such laws. Massachusetts requires the creation of a deposit transaction fund by bottlers and the payment to the state of balances in that fund that exceed three months of deposits received, net of deposits repaid and interest earned. A portion of the Massachusetts law had been held unconstitutional by the Massachusetts Supreme Judicial Court as it related to deposits escheated to the state prior to the effective date of the law, and the Company, together with beer distributors and other soft drink bottlers, is negotiating with the Commonwealth of Massachusetts for the return of such deposits. Michigan also has a statute, effective January 1, 1990, requiring bottlers to pay to the state unclaimed container deposits. The Michigan Soft Drink Association filed a lawsuit challenging the constitutionality of the Michigan law. On February 14, 1991, a Michigan trial court ruled that the sections of the Michigan statute requiring bottlers to pay unclaimed deposits to the state were unconstitutional. The Michigan Attorney General appealed that decision. On December 20, 1993, the Michigan Court of Appeals heard oral arguments in the Michigan Soft Drink Association's lawsuit. Excise taxes on sales of soft drinks have been in place in various states for several years. The states in which the Company operates currently imposing such taxes are the states of Arkansas, Louisiana, North Carolina, Ohio, Tennessee and Washington. In addition, three local jurisdictions in which the Company operates, Baltimore and Montgomery County, Maryland and Honolulu, Hawaii, have imposed a special tax on nonrefillable soft drink containers. To the knowledge of management of the Company, no similar legislation has been enacted in any other markets served by the Company. Proposals have been introduced in certain states and localities that would impose a special tax on beverages sold in nonrefillable containers as a means of encouraging the use of refillable containers. Management of the Company is unable to predict, however, whether such additional legislation will be adopted. The Company has taken actions to mitigate the adverse effects resulting from legislation concerning deposits, restrictive packaging and escheat of unclaimed deposits which impose additional costs on the Company. The Company is unable to quantify the impact on current and future operations which may result from such legislation if enacted in the future, but any such legislation could be potentially significant if widely enacted. The domestic production, distribution and sale of many of the Company's products are subject to the Federal Food, Drug and Cosmetic Act; the Occupational Safety and Health Act; the Lanham Act; various federal, state and local environmental statutes and regulations; and various other federal, state and local statutes regulating the production, packaging, sale, safety, advertising, labeling and ingredients of such products. A California law, enacted in 1986 by ballot initiative, requires that any person who exposes another to a carcinogen or a reproductive toxicant must provide a warning to that effect. Because the law does not define quantitative thresholds below which a warning is not required, virtually all manufacturers of food products are confronted with the possibility of having to provide warnings due to the presence of trace amounts of defined substances. Regulations implementing the law exempt manufacturers from providing the required warning if it can be demonstrated that the defined substances occur naturally in the product or are present in municipal water used to manufacture the product. The Company has assessed the impact of the law and its implementing regulations on its soft drink and other products and has concluded that none of its products currently requires a warning under the law. The Company cannot predict whether or to what extent food industry efforts to minimize the law's impact on food products will succeed, nor can the Company predict what impact, either in terms of direct costs or diminished sales, imposition of the law may have. Substantially all of the facilities of the Company are subject to federal, state and local provisions regulating above-ground and underground fuel storage tanks and the discharge of materials into the environment. Compliance with these provisions has not had, and the Company does not expect such compliance to have, any material effect upon the capital expenditures, net income, financial condition or competitive position of the Company. The Company's beverage manufacturing operations do not use or generate a significant amount of toxic or hazardous substances. Management believes that its current practices and procedures for the control and disposition of such wastes comply with applicable federal and state requirements. The Company has been named as a potentially responsible party in connection with certain landfill sites where the Company may have been a de minimis contributor. Under current law, the Company's liability for cleanup costs may be joint and several with other users of such sites, regardless of the extent of the Company's use in relation to other users. However, in the opinion of management of the Company, the potential liability of the Company in connection with such activity is not significant and will not have a material adverse effect on the financial condition or results of operations of the Company. Several underground fuel storage tanks used by the Company may not be in compliance with all applicable federal and state requirements for the continued maintenance and use of such tanks. The Company has adopted a plan for the testing, removal, replacement and repair, if necessary, of underground fuel storage tanks at Company bottlers and remediation of their sites, if necessary. The Company spent approximately $25 million pursuant to such plan in 1991, $8 million in 1992 and $9 million in 1993. The Company estimates it will spend approximately $15 million from 1994 through 1998 pursuant to this plan. In the opinion of management of the Company, any liabilities associated with such underground fuel storage tanks will not have a material adverse effect on the financial condition or results of operations of the Company. The business of the Company, as the exclusive manufacturer and distributor of bottled and canned beverage products of The Coca-Cola Company and other manufacturers within specified geographic territories, is subject to federal and state antitrust laws of general applicability. Under the federal Soft Drink Interbrand Competition Act, the exercise and enforcement of an exclusive contractual right to manufacture, distribute and sell a soft drink product in a geographic territory is presumptively legal if the soft drink product is in substantial and effective interbrand competition with other products of the same class in the market. Management of the Company believes that there is such substantial and effective competition in each of the exclusive geographic territories in which the Company operates. ITEM 2. ITEM 2. PROPERTIES The executive offices of the Company occupy approximately 104,000 square feet in an office building in Atlanta, Georgia leased from The Coca-Cola Company. See "Certain Relationships and Related Transactions -- Agreements and Transactions with The Coca-Cola Company -- Lease of Office Space" in the Company's 1994 Proxy Statement, which information is incorporated by reference in Item 13 hereof. The principal properties of the Company include production facilities, distribution facilities, administrative offices and service centers. The Company operates 45 soft drink production facilities, 15 of which are solely production facilities and 30 of which are combination production/distribution facilities, and also operates 206 principal distribution facilities. The Company owns all of its production facilities, except one, and owns 183 of its principal distribution facilities and leases the others. In the aggregate, the Company's owned and leased facilities cover approximately 21 million square feet. Management of the Company believes that its production and distribution facilities are generally sufficient to meet present needs. Seventeen of the facilities owned by the Company are subject to liens to secure indebtedness in an aggregate principal amount of approximately $13 million at December 31, 1993. Excluding expenditures for bottler acquisitions, the Company's capital expenditures in 1993 were approximately $353 million. The Company also owns and operates approximately 23,000 vehicles of all types used in the sale, production and distribution of its products. The Company also owns approximately 750,000 coolers, beverage dispensers and vending machines. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Immediately prior to the acquisition of Johnston Coca-Cola by the Company in 1991, a derivative suit (i.e., one which is purportedly brought on behalf of the Company) was filed by Three Bridges Investment Group in the Chancery Court of the State of Delaware against The Coca-Cola Company, Johnston Coca-Cola and the Directors of the Company then in office. The suit is seeking, among other things, a declaration that it is a proper class action, to enjoin or rescind the acquisition of Johnston Coca-Cola, damages, costs and attorneys' fees. The complaint alleged breaches of fiduciary duties on the part of The Coca-Cola Company and the Directors, and asserted a claim against Johnston Coca-Cola for allegedly aiding and abetting the alleged wrongdoing. Johnston Coca-Cola has since been dismissed from the claim, and the remaining defendants have filed answers denying all substantive allegations. The suit is still in the process of discovery. Management of the Company believes this action to be without merit and is defending it vigorously. Several of the Company's bottling subsidiaries or divisions have been named as potentially responsible parties ("PRPs") at several federal "Superfund" sites. In 1991 Johnston Coca-Cola was named by the Environmental Protection Agency ("EPA") and the Minnesota Pollution Control Agency as one of approximately 200 PRPs at the Arrowhead site near Duluth, Minnesota. Each PRP may be jointly and severally liable for the remediation of that site, which has been estimated to cost as much as $60 million. Johnston Coca-Cola's contribution of petroleum waste and solvents, which Johnston Coca-Cola had entrusted to third parties for recycling, appears to represent less than one percent of the total volume of all used oil contributed by all PRPs. Johnston Coca-Cola believes it should be successful in limiting its pro rata share of liability for the cleanup cost to an amount commensurate with the degree of its involvement in the contamination. As of December 31, 1993, Johnston Coca-Cola had paid a total of $100,000 to the site committee for investigation and cleanup; it may spend a like amount in 1994. In 1987 the Coca-Cola Bottling Company of Los Angeles ("CCBCLA") was named by the EPA as a PRP at the Operating Industries, Inc. site at Monterey Park, California. CCBCLA has contributed approximately $300,000 toward the remediation efforts, which are virtually complete. CCBCLA believes that any future contributions to the remediation efforts will not be material. Additionally, in 1992 the Florida Coca-Cola Bottling Company ("Florida CCBC") was named by the EPA as a PRP at the Peak Oil Site in Tampa, Florida, a location which was used in the 1960s and 1970s for the refining of used motor oil. Florida CCBC's involvement with this site has not yet been determined, although the Peak Oil PRP group has informed Florida CCBC that its ultimate liability could be between $600,000 and $1.4 million, based on Peak Oil records and testimony of former employees. Florida CCBC has joined the Peak Oil PRP group to contest the volume of waste oil attributed to it. It is not currently known whether Florida CCBC's ultimate liability, if any, would be material. In late 1992 a PRP for the West Memphis Landfill site in West Memphis, Arkansas brought The Coca-Cola Bottling Company of Memphis, Tenn. ("CCBC Memphis") into the remediation proceedings as an additional PRP with respect to that site. The site is alleged to have been used in the 1950s and 1960s as a dump site for by- products from the reprocessing of used motor oil. The EPA is still in the initial stages of its investigation and has not issued an estimate for the costs of remediating the site; however, the PRP naming CCBC Memphis has estimated the total cost to be as much as $45 million. The involvement of CCBC Memphis has not yet been determined; accordingly, CCBC Memphis does not yet know whether its ultimate liability, if any, would be material. During 1993 the Company settled its liability for its alleged contributions to the Kingston Steel Drum site in New Hampshire and has agreed, subject to the approval of the EPA, to settle its liability relating to the Commercial Oil Services site near Toledo, Ohio. In each case, the settlement involves payment by the Company of an immaterial amount. In August 1992, Phar-Mor, Inc. and a number of its subsidiaries (collectively "Phar-Mor"), a national retail chain customer of the Company, filed for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court of the Northern District of Ohio, Eastern Division. The Company's claim against Phar-Mor for unpaid product is approximately $10 million. Additionally, the Company is a party to contracts with Phar-Mor which, if terminated early, would increase the Company's claim. Management of the Company believes that any losses resulting from Phar-Mor's bankruptcy will be fully covered by the Company's existing allowances for uncollectible trade accounts receivable. There are various other lawsuits and claims pending against the Company. Included among such litigation are claims for injury to persons or property. Management of the Company believes that such claims are covered by insurance with financially responsible carriers or adequate provisions for losses have been recognized by the Company in its consolidated financial statements. In the opinion of management of the Company, the losses that might result from such litigation will not have a material adverse effect on the financial condition or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 4(A). EXECUTIVE OFFICERS OF THE COMPANY Set forth below is information as of March 1, 1994 regarding the executive officers of the Company: - --------------- * Designated an executive officer by the Company's Board of Directors on February 15, 1994. Summerfield K. Johnston, Jr. is the father of S. K. Johnston III. The officers of the Company are elected annually by the Board of Directors for terms of one year or until their successors are elected and qualified, subject to removal by the Board of Directors at any time. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS LISTED AND TRADED: New York Stock Exchange TRADED: Boston, Cincinnati, Midwest, Pacific, and Philadelphia Exchanges Share owners of record as of March 1, 1994: 9,037 STOCK PRICES DIVIDENDS Quarterly dividends in the amount of $0.0125 per share were paid during the fiscal years 1992 and 1993. (This page intentionally left blank) ITEM 6. ITEM 6. SELECTED FINANCIAL DATA COCA-COLA ENTERPRISES INC. SELECTED FINANCIAL DATA (Notes to Selected Financial Data begin on page 20) NOTES TO SELECTED FINANCIAL DATA The Company changed its fiscal year end in 1991, from the Friday nearest December 31 to a calendar year end. Accordingly, fiscal years presented are the periods ended December 31, 1993, 1992 and 1991, December 28, 1990, December 29, 1989, December 30, 1988, January 1, 1988 and January 2, 1987. The Company acquired subsidiaries in each year presented and divested subsidiaries in certain periods. Such transactions, except for (i) the acquisition of Johnston Coca-Cola Bottling Group, Inc. ("Johnston"), (ii) gains from the sale of certain bottling operations, and (iii) acquisitions in 1986, did not significantly affect the Company's operating results for any fiscal period. All acquisitions and divestitures have been included in or excluded from (as appropriate) the consolidated operating results of the Company from their respective transaction dates. Reclassifications have been made to certain prior period amounts to conform to the 1993 presentation. (A) On August 10, 1993, the Omnibus Budget Reconciliation Act was signed into law resulting in an increase in the corporate marginal income tax rate from 34% to 35%. The resulting one-time adjustment increased deferred taxes and income tax expense by approximately $40 million ($0.31 per common share). (B) In the fourth quarter of 1992, the Company adopted Statement of Financial Accounting Standards No. 106 ("Employers' Accounting for Postretirement Benefits Other Than Pensions") and Statement of Financial Accounting Standards No. 109 ("Accounting for Income Taxes"), retroactive to January 1, 1992, resulting in one-time charges to income reflecting the cumulative prior years' effect of changes in these accounting principles. Fiscal periods prior to 1992 were not restated for these accounting changes. (C) The pro forma Operations Summary, Other Operating Data, and Share and Per Share Data give effect to the acquisition of Johnston in December 1991, assuming such acquisition was consummated as of the beginning of 1991. (D) In June 1990, the Company sold its interest in Coca-Cola Bottling Company of Ohio and Portsmouth Coca-Cola Bottling Company. These operations were sold to Johnston and, as a result of the 1991 acquisition of Johnston, have been reacquired by the Company. (E) In February 1989, the Company sold its wholly owned subsidiaries, Goodwill Bottling Ltd. and Goodwill Bottling North Ltd. (F) In December 1988, the Company sold a wholly owned subsidiary, The Coca-Cola Bottling Company of Mid-America, Inc. The Mid-America operations were sold to Johnston and, as a result of the 1991 acquisition of Johnston, have been reacquired by the Company. (G) The pro forma Operations Summary, Other Operating Data, and Share and Per Share Data give effect to 1986 acquisitions as though they had been completed at the beginning of 1986. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS DESCRIPTION OF BUSINESS Coca-Cola Enterprises Inc. (the "Company") is the world's largest producer and distributor of bottle and can soft drink products of The Coca-Cola Company. We are the Coca-Cola bottler within 38 states, the District of Columbia, the U.S. Virgin Islands and the Netherlands. Within the United States, we operate through exclusive and perpetual rights in territories encompassing approximately 52% of the population and accounting for approximately 55% of all Coca-Cola bottled and canned products sold. Approximately 89% of our revenues are derived from the sale of The Coca-Cola Company products. Principal Stock Ownership and Relationship with The Coca-Cola Company Management has a significant vested interest in the success of our Company. Summerfield K. Johnston, Jr., our chief executive officer and vice chairman of our Board of Directors, and his family were the principal owners of Johnston Coca-Cola Bottling Group, Inc. ("Johnston") and were the recipients of virtually all of the Coca-Cola Enterprises common stock issued in the merger with Johnston. As a result, Mr. Johnston and his family hold approximately 9% of our outstanding stock. All directors and officers of the Company as a group hold approximately 10% of our outstanding stock. We also encourage employee stock ownership below the director and officer level. In 1993, we established stock ownership guidelines for all officers and senior management of the Company. Through implementation of these policies, our intent is to encourage employees to have a share-owner focus in making day-to-day operating decisions. We benefit from a special relationship with The Coca-Cola Company. The Coca-Cola Company is the supplier of the raw material beverage base for the majority of our products and is the principal marketer of these products providing us with a variety of media advertising and marketing program support. The Chairman and other members of our Board of Directors are current or former executives of The Coca-Cola Company, complementing other accomplished men and women who comprise directors elected by our share owners. The Coca-Cola Company is our largest single share owner, holding approximately 44% of our outstanding stock. The Company's success, while principally dependent upon our expertise in bottling operations, is enhanced by this relationship. International Expansion 1993 was a significant milestone in the Company's existence. It was the year we substantially completed the operational and organizational restructuring of the Company, after the merger with Johnston Coca-Cola Bottling Group, Inc. in 1991, and the year that we began our expansion outside the United States. International markets provide an increased opportunity for long-term volume growth because of existing low consumption rates when compared to the domestic market. Our first international acquisition was completed in June 1993 through the acquisition of Coca-Cola Beverages Nederland B.V. ("CCBN") in the Netherlands from The Coca-Cola Company. Through this acquisition, we purchased the franchise rights to distribute all the canned and bottled products of The Coca-Cola Company in the Netherlands. The Coca-Cola Company completed its acquisition of all outside ownership interests of CCBN during 1993. The Coca-Cola Company then began discussions with us to acquire CCBN, we believe, principally because of the successes we have achieved domestically and the opportunities for growth in this region through efficient management. We believe the operating strategies we have developed in the U.S. market to increase volume and advance market share can also be employed successfully in other international markets. We are interested in continuing international expansion given the right opportunities and provided they do not dilute our current business. Our plans for future international expansion will be guided by the availability of additional franchise opportunities that we believe will grow share-owner value. Business Strategy for Enhancing Share-Owner Value We can best achieve our goal of enhancing share-owner value by increasing long-term operating cash flows through the balancing of growth in sales volume with optimal gross profit margins. Careful consideration will be given to all the potential uses of these operating cash flows, including strategic acquisition opportunities. The liquid nonalcoholic refreshment business continues to be increasingly competitive. This increased competition strengthens our belief that market share is the principal determinant of long-term profitability. Improvements in market share, together with increases in per capita consumption and population, determine case sales growth. Our competitive strategy continues to be to obtain profitable increases in case sales by balancing case sales growth with improved margins and sustainable increases in market share. We do not intend to implement a strategy of liquidating market share to realize short-term profits. Our objective is to increase our share of liquid nonalcoholic refreshment sales and per capita consumption of our products through the development of innovative marketing programs and improved execution at the local level. In the past seven years, the Company has acquired numerous bottlers for an aggregate purchase price of approximately $5.6 billion. As a result, the Company currently maintains a high degree of financial leverage. Our capital structure, financial position and cash flow streams allow us to maintain flexibility for acquisitions and capital projects that offer an acceptable rate of return and an opportunity to implement our operating strategies. We continually evaluate alternative methods of financing acquisitions, including the use of preferred and common stock. OPERATING RESULTS Summary of One-Time Charges Operating results for each year in the period from 1991 through 1993 were affected by significant one-time charges which materially impact reported results of operations and net income per common share. In 1993, the Omnibus Budget Reconciliation Act was signed into law resulting in a one-time charge for the effect of the increase in the income tax rate from 34% to 35% on deferred income taxes. In 1992, we adopted Financial Accounting Standards No. 106 ("FAS 106") and Financial Accounting Standards No. 109 ("FAS 109") resulting in significant one-time adjustments for the cumulative effect of changes in accounting principles and increased expense under FAS 106. The increased expense under FAS 106 for 1993 was mitigated by the redesign of our postretirement benefit plans in 1993. In 1991, we recognized a provision for restructuring the Company after the merger with Johnston. Each of these items is discussed in greater detail in the following highlights of operating results. We believe comparisons of operating results are more meaningful when we exclude these one-time items. The following table identifies the effects on reported earnings of the increase in the income tax rate in 1993, FAS 106 and FAS 109, the effects of postretirement benefit plan amendments and restructuring charges on an after-tax basis. (1) The increased expense under FAS 106 for 1993 was entirely offset by the accounting treatment for the plans' redesign in 1993. (2) Does not sum to the total because of rounding of individual amounts. The consolidation and redesign of our postretirement benefit plans was completed in the first quarter of 1993 through plan amendments as of January 1, 1993. These plan amendments had the effect of decreasing the accumulated postretirement benefit obligation at January 1, 1993 from approximately $312 million to $164 million. This reduction of $148 million in the postretirement benefit obligation is being amortized over the average service life of plan participants (approximately 17 years) as a reduction in net periodic benefit cost. The accounting treatment for these plan amendments had the effect of reducing postretirement benefit expense by approximately $31 million ($0.15 per common share) in 1993. On August 10, 1993, the Omnibus Budget Reconciliation Act was signed into law. The primary effect on our operations was the increase in the corporate marginal income tax rate from 34% to 35%. The adjustment in 1993 to our deferred tax liability for the effect of the federal tax increase resulted in a one-time charge of approximately $40 million ($0.31 per common share). We adopted FAS 106 and FAS 109 in the fourth quarter of 1992, retroactive to January 1, 1992. Although these new accounting principles had no effect on cash flows, they affected the reporting of our operating results. The adoption of FAS 106 changed our practice of recognizing the cost of postretirement benefits expense as claims are paid to the practice of accruing these costs during the period employees provide service to the Company. The cumulative effect of adopting FAS 106 as of January 1, 1992 resulted in a one-time, noncash earnings charge of $148 million. The adoption of FAS 106 in 1992 also increased 1992 expense by approximately $30 million. The adoption of FAS 109 changed our method of accounting for income taxes from an income statement approach to a balance sheet approach. We recognized, as of January 1, 1992, the FAS 109 prior years' effect of $23 million as the cumulative effect of this change. This new accounting principle decreased pretax income and correspondingly decreased income tax expense by approximately $38 million in 1992 and 1993, with no effect on annual net income. Pretax income decreased from 1991 because of increased amortization expense resulting from a $1.4 billion increase in the franchise asset basis. Income tax expense for 1993 and 1992 decreased from 1991 because of the additional amortization of a deferred benefit. In 1991, we recognized a $152 million provision for restructuring relating to standardization of operations following the merger with Johnston. The restructuring charge related primarily to the reconfiguration of sales and distribution centers, standardization of information systems, and severance and relocation costs associated with the decentralization of our organizational structure and elimination of redundant staff and operating positions. Operating Results Overview The most meaningful operating results comparisons between years reflect (i) 1993 excluding the impact of the Omnibus Budget Reconciliation Act on deferred income taxes; (ii) 1992 excluding noncash charges resulting from the adoption of FAS 106 and FAS 109; (iii) pro forma 1991 excluding the restructuring charge of $152 million; and (iv) 1993, 1992 and 1991 adjusted for the effects of acquisitions, if significant. Accordingly, we refer to "comparable" results in the following discussions as the results of operations excluding the impact of the above items. Revenues, Pricing and Volume: Revenues are comprised principally of wholesale sales and agency sales. Wholesale sales are sales to retailers and accounted for approximately 96% of our net sales and 99% of our gross profit. Agency sales are sales to other independent bottlers. Comparable net operating revenues for 1993 increased approximately 4% over 1992. This increase results from an approximate 1/2% increase in net pricing and an approximate 2% increase in bottle/can case sales volume. Actual net operating revenues for 1993 increased approximately 7% over 1992. This increase was driven by an approximate 5 1/2% increase in actual bottle/can physical case sales volume for 1993 we achieved through sales volume increases and the effects of acquisitions in 1993 and 1992. The net price per case increase for 1993 is partially the result of shifts into higher priced products and packages. The sales volume growth we experienced on a comparable basis in 1993 was aided by the introductions of new products in 1993 and our marketing efforts for these products. The introductions of PowerAde and Minute Maid Juices To Go were successes in 1993, and we are optimistic about the impact these products will have on 1994. Volume growth in 1993 and 1992 for The Coca-Cola Company products and the soft drink industry was significantly influenced by the fountain segment of the business. We experienced a growth in fountain sales, excluding the effects of acquisitions, of approximately 8 1/2% and 9% in 1993 and 1992, respectively. This increase in fountain sales, however, does not have a significant impact on our operating results because operating margins on fountain sales are relatively low. Net operating revenues for 1992 increased 31% over the same period of 1991 principally from the acquisition of Johnston. Comparable net operating revenues for 1992 increased approximately 2% from 1991. This increase results primarily from an approximate 2 1/2% increase in net pricing for wholesale sales, reduced by an approximate 1/2% decrease in bottle/can case sales volume. The decrease in 1992 bottle/can physical case sales volume from 1991 resulted principally from the economic environment, higher prices and unseasonably cool, damp weather in many of the Company's territories. Cost of Sales: Cost of sales per physical case for 1993, excluding the effect of fountain sales, decreased approximately 1 1/2% over 1992. This decrease is primarily attributable to favorable packaging and ingredient costs. Comparable cost of sales per unit for 1993, excluding fountain sales, decreased approximately 2% from 1992. Comparable cost of sales per case for 1992, excluding fountain sales, increased approximately 1/2% from 1991. This increase resulted principally from increased concentrate costs in 1992. We expect concentrate costs to increase by approximately 2 1/2% in 1994, with anticipated increases in other ingredient costs as well. These increased costs, however, will be mitigated somewhat by anticipated savings in packaging costs. We expect bottle/can unit cost of sales in 1994 to increase moderately over 1993 due to the effect of these anticipated changes. Cash Operating Profit and Operating Income: We believe the best measure of the Company's performance is a comparison of cash operating profit (operating income before the deduction for depreciation and amortization). Cash operating profit growth encompasses various combinations of volume, price and cost elements. We attempt to maximize cash operating profit growth by managing volume and margins in response to existing market conditions. We do not predict trends in these factors independently, but instead manage these factors over time to achieve our cash operating profit goals. Comparable cash operating profit and comparable operating income increased approximately 8% and 12% over 1992, respectively. Actual cash operating profit and operating income for 1993 increased approximately 16% and 26% over 1992, respectively. Comparable cash operating profit and comparable operating income for 1992 increased approximately 9% and 11% over 1991, respectively. Actual cash operating profit and operating income for 1992, after giving effect in 1991 to the acquisition of Johnston, increased approximately 39% and 80%, respectively, over 1991. We believe that revenue growth for 1994 will exceed reported 1993 revenue growth of 7%, balanced between volume and price which, when combined with cost containment measures, will achieve an approximate 8% growth in cash operating profit, excluding the effect of acquisitions. We expect price increases in excess of any cost increases and volume growth for bottle/can in excess of 1993 performance. We anticipate that net income and earnings per common share, driven principally by our anticipated growth in cash operating profit, will increase by more than 50% over 1993 results excluding the $40 million one-time tax charge. Selling, General and Administrative Expenses: Selling, general and administrative expenses for 1993 increased approximately 6 1/2% from 1992 resulting primarily from the increased case sales volume and acquisitions during the year. Comparable selling, general and administrative expenses as a percentage of sales for 1993 increased approximately 1/2% from 1992, primarily as a result of increases in administrative expenses. We attribute this increase to the cost of operating a fully implemented decentralized organizational structure. Selling, general and administrative expenses for 1992 increased approximately 31% from 1991 as a result of the acquisition of Johnston and increased expense related to the adoption of FAS 106 and FAS 109. Comparable selling, general and administrative expenses as a percentage of sales for 1992 decreased approximately 1/2% from 1991. This decrease reflects our cost control efforts coupled with the fixed nature of certain costs. In response to the general decline in long-term interest rates during 1993, we decreased the rate used to discount our postretirement and pension benefit obligations. The change in the discount rate will increase net periodic benefit cost by approximately $4 million in 1994. A 0.25% additional change in the discount rate would increase or decrease, as appropriate, postretirement and pension benefit expense in the aggregate for 1994 by approximately $1.4 million. In 1991, we recognized a $152 million ($0.86 per common share) provision for restructuring as a result of the Johnston merger. This restructuring charge related primarily to the standardization of information systems, reconfiguration of sales and distribution centers, and severance and relocation costs associated with decentralizing our organizational structure and elimination of redundant staff and operating positions. Our restructuring plan is now substantially complete and we believe we are beginning to realize the effects of the restructuring in our improved financial operating performance which occurred despite the significant organizational distractions and difficult economic environment. Interest Expense: The increase in interest expense for 1993 over 1992 reflects (i) an increase in the average debt balance resulting from acquisitions and (ii) a higher weighted average borrowing rate resulting principally from fixed rate financings which occurred during 1992. The increase in net interest expense for 1992 over 1991 reflected higher average debt balances resulting from the acquisition of Johnston. Our blended borrowing rates for 1993, 1992 and 1991 were approximately 7.6%, 7.5% and 7.8%, respectively. Net interest expense for 1994 should not be appreciably different from 1993 after adjusting 1993 to give effect to ownership of acquired companies for a full year. Income Taxes: Changes in enacted tax rates are accounted for under FAS 109 as an adjustment to income tax expense in the period the change is effected. The adjustment to deferred taxes to recognize the effect of the Omnibus Budget Reconciliation Act resulted in a one-time charge of approximately $40 million ($0.31 per common share) in 1993 to increase the deferred tax liability existing at the date of enactment for the effect of the rate change. Additionally, our annual estimated effective tax rate was increased by an amount approximating the 1% marginal rate increase under the law. Other components of the law are not expected to have a material impact on the Company. Our effective tax rates for 1993, 1992 and 1991 were approximately 55% (excluding the one-time charge), 25% and 10%, respectively. The change in the effective tax rate from 1992 to 1993 is principally due to the level of pretax income in each period and the relationship of nondeductible expenses to pretax income. 1991 was not restated for the adoption of FAS 109 in 1992. Operating Contingencies We are subject to laws and regulations pertaining to special soft drink taxes, forced deposit legislation, restrictive packaging measures and escheats/unclaimed deposits. We have taken actions to mitigate the adverse effects resulting from legislation which imposes additional costs on the Company and to inform consumers of the possible resulting effect on product pricing. Similar laws and regulations are receiving increased attention by the legislatures of other states and by the Congress of the United States. We are presently unable to quantify the impact on current and future operations which may result from legislation enacted in the future, but we view this legislation to be potentially significant if widely enacted. Substantially all of the facilities of the Company are subject to federal, state and local provisions regulating fuel storage tanks and the environmental discharge of materials. Certain underground fuel storage tanks used in their present condition may not be in compliance with all applicable requirements for the continued maintenance and use of such tanks. Virtually all of such tanks were acquired through acquisitions. We have established plans for the testing, removal, replacement or repair of our underground fuel storage tanks and remediation of their sites, if necessary. We are committed to maintaining our environment and protecting our natural resources, and to achieving full compliance with all applicable laws and regulations. Expenditures related to federal and state requirements for remediation and maintenance of underground fuel storage tanks approximated $9 million, $8 million and $25 million during 1993, 1992 and 1991, respectively. We believe our reserves established for environmental remediation costs are adequate to provide for noncapitalizable costs expected to be incurred in connection with completion of the Company's multiyear remediation program. Cash expenditures remaining to complete the program are expected to aggregate approximately $15 million through 1998. The Company has been named as a potentially responsible party ("PRP") for the costs of remediation of hazardous waste at federal "Superfund" sites in Arkansas, California, Florida, Minnesota, New Hampshire and Ohio. Under current law, the Company's liability for clean up of such sites may be joint and several with other PRP's, regardless of the extent of the Company's use in relation to other users. In each case, the Company has determined that to the extent that it has any responsibility for hazardous waste deposited at any site, the amounts of such deposits are minimal compared to those of other financially responsible PRP's, and as a result, we believe the Company's ultimate liability will not have a material effect on its financial position or results of operations. The Congress of the United States is currently considering health care reform proposals which would result in significant changes in health care delivery, potentially increasing the amount of health care expenditures that companies will be required to make. Because of the present uncertainty as to the outcome of any proposed legislation, we cannot predict the impact any such legislation may have on future results of operations. FINANCIAL POSITION Cash and cash equivalents increased approximately $5 million in 1993. Our principal sources of cash consisted of (i) those provided from operations ($493 million) and (ii) the issuance of debt ($822 million). Our primary uses of cash were (i) additions to property, plant and equipment ($353 million); (ii) acquisitions of bottling companies ($287 million); and (iii) payments on debt ($668 million). On June 30, 1993, we acquired, from The Coca-Cola Company, the stock of (i) Coca-Cola Beverages Nederland B.V. in the Netherlands; (ii) Roddy Coca-Cola Bottling Company, Inc. in Knoxville, Tennessee; and (iii) Coca-Cola Bottling Company of Johnson City, in Johnson City, Tennessee for an aggregate purchase price of approximately $366 million in cash and assumed debt. On December 15, 1993, we acquired the outstanding stock of Coca-Cola Bottling Company of Northeast Arkansas, Inc. for approximately $54 million in preferred stock and assumed debt. These acquisitions were accounted for using the purchase method. The assets and liabilities of the acquired companies are included in the consolidated balance sheet at their estimated fair values representing a preliminary allocation of the purchase price. The increase in trade accounts receivable results primarily from the effect of current year acquisitions. Excluding the effect of current year acquisitions, inventories in 1993 decreased from 1992 as a result of increased purchases of ingredients during 1992, including concentrate for the production of TAB clear which was introduced to the market in January 1993. Amounts due from The Coca-Cola Company result from the timing of receipts for marketing support payments and are net of approximately $37 and $34 million in amounts payable for purchases of ingredients in 1993 and 1992, respectively. The increase in franchise and other noncurrent assets results primarily from current year acquisitions. The decrease in current maturities of long-term debt is a result of scheduled maturities during 1993. Total long-term debt increased during 1993 reflecting a $325 million increase in commercial paper, the proceeds of which were used primarily to finance current year acquisitions. The increase in deferred income taxes from 1992 is due to a one-time charge of $40 million resulting from newly enacted tax legislation and the tax effects of basis differences from current year acquisitions. During 1993, we issued preferred stock in connection with the acquisition of a bottling business. We believe the use of equity financing as an alternative to debt provides increased flexibility for both negotiating and funding future acquisitions while maintaining a desired debt to equity ratio. As a result of our entrance into the international marketplace, the Company is exposed to fluctuations in the exchange rate for the Dutch florin. Currently, gains and losses resulting from translation of foreign currency transactions are not material. Adjustments resulting from translation of our net investment in the Netherlands operation are recorded in the cumulative translation adjustment component of share-owners' equity. Our commercial paper program is supported by a $1 billion revolving bank credit agreement maturing in April 1996 and two short-term credit facilities. There are no borrowings currently outstanding under these agreements; however, under the commercial paper program supported by these agreements, an aggregate $522 million was outstanding at December 31, 1993. We believe that adequate capital resources are available to satisfy our capital expenditure program and to satisfy scheduled maturities of debt obligations. We currently expect 1994 capital expenditures to aggregate $330 to $370 million. Our sources of capital include, but are not limited to, the issuance of public or private placement debt, bank borrowings and the issuance of certain equity securities. We believe that the Company is able to generate sufficient cash flow to maintain current operations. In November 1992, the Financial Accounting Standards Board issued Statement of Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," requiring the accrual of benefits to former or inactive employees after employment but before retirement. The Company has historically accrued for postemployment benefit obligations in accordance with the requirements under the Statement, therefore no adjustments are required. In May 1993, the Financial Accounting Standards Board issued Statement of Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," requiring a fair value approach to valuing certain debt and marketable equity securities. The Company does not hold significant investments in debt and equity securities which fall within the scope of the Statement, therefore no adjustments are required. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA COCA-COLA ENTERPRISES INC. CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. COCA-COLA ENTERPRISES INC. CONSOLIDATED BALANCE SHEETS The accompanying Notes to Consolidated Financial Statements are an integral part of these balance sheets. COCA-COLA ENTERPRISES INC. CONSOLIDATED BALANCE SHEETS COCA-COLA ENTERPRISES INC. CONSOLIDATED STATEMENTS OF SHARE-OWNERS' EQUITY The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. COCA-COLA ENTERPRISES INC. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS BUSINESS AND OWNERSHIP The Company operates in a single industry segment, which encompasses the manufacture, distribution and marketing of liquid nonalcoholic refreshments under rights to acquired franchise territories. The Coca-Cola Company owns approximately 44% of the Company's outstanding common shares. PRINCIPAL ACCOUNTING POLICIES Significant accounting policies and practices of the Company follow: Basis of Presentation: The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. The fiscal years presented are the fiscal periods ended December 31, 1993, 1992 and 1991. Certain reclassifications have been made to prior year amounts to conform to the current year presentation. Net Income (Loss) Per Common Share: Net income (loss) per common share is computed by dividing net income (loss) less dividends on preferred stock by the weighted average number of common shares outstanding. Cash Equivalents: Cash equivalents include all highly liquid debt instruments purchased with original maturities of less than three months. Concentrations of Credit Risk: The Company sells products to chain store and other customers and extends credit based on an evaluation of the customer's financial condition, generally without requiring collateral. Exposure to losses on receivables varies by customer principally due to the financial condition of each customer. The Company monitors exposure to credit losses and maintains allowances for anticipated losses. Inventories: Inventories are valued at the lower of cost or market. Cost is computed principally on the last-in, first-out (LIFO) method. Property, Plant and Equipment: Property, plant and equipment is stated at cost, less allowances for depreciation. Depreciation expense is determined principally by the straight-line method. The annual rates of depreciation are 3% to 5% for buildings and improvements and 7% to 34% for machinery and equipment. The Company capitalizes, as land improvements, certain environmental remediation costs which improve the condition of the property as compared to the condition when constructed or acquired. Franchise Assets: The Company operates under franchise agreements with The Coca-Cola Company and certain other licensors of beverage products. These agreements establish performance obligations as to production, distribution and marketing arrangements. The majority of such agreements are perpetual in nature and reflect a long and ongoing relationship with The Coca-Cola Company and other franchisors. The Company has one nonperpetual franchise agreement with The Coca-Cola Company covering our Netherlands operations. This is a result of the fact that The Coca-Cola Company's franchises outside of the United States are not perpetual. Given the Company's historical relationship with The Coca-Cola Company and The Coca-Cola Company's equity ownership of approximately 44% in the Company, management of the Company believes this agreement will continue to be renewed upon expiration and that the economic period of benefit is ongoing. Franchise assets, stated at cost, are amortized on a straight-line basis over the COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) maximum allowed estimated periods to be benefitted (principally 40 years). Accumulated amortization amounted to $738 million and $577 million at December 31, 1993 and 1992, respectively. Impairment of Long-Lived Assets: In the event facts and circumstances suggest that the cost of franchise assets or other assets may be impaired, an assessment of recoverability would be performed. If the estimated future cash flows associated with an asset were less than the carrying amount of the asset, an impairment write-down to a market value or discounted cash flow value would be required. Foreign Currency: The Company uses the local currency of Dutch florins as the functional currency of its Netherlands operations. Accordingly, assets and liabilities of the Netherlands subsidiary are translated into dollars at the rate of exchange in effect at the balance sheet date. Income and expense items are translated at the monthly average exchange rates prevailing during the year. The cumulative translation adjustment is included in a separate component of share-owners' equity. Hedging Instruments: The Company is party to a variety of interest rate swaps, short positions in interest rate futures and foreign currency option contracts in the management of interest rate and foreign currency exposures. The interest differential related to interest rate swap agreements is recognized as an adjustment of interest expense. Foreign currency options were not significant at December 31, 1993. Realized and unrealized gains and losses on all financial instruments designated and effective as hedges of interest rate exposure are deferred and recognized as increases or decreases to interest expense over the periods the hedged liabilities are outstanding. Marketing Costs: The Company participates in various advertising and marketing programs, some with The Coca-Cola Company. Certain costs incurred in connection with these programs are reimbursed by The Coca-Cola Company. All unreimbursed costs related to marketing and advertising the Company's products are expensed in the period incurred. Postretirement Benefits Other Than Pensions: In 1992, the Company adopted Statement of Financial Accounting Standards No. 106 ("FAS 106"), a method of accounting for postretirement benefits by accrual of the costs of such benefits during the periods employees provide service to the Company. The Company previously accounted for such costs as expense when incurred. The effect on years prior to 1992, representing that portion of future retiree benefit costs related to past service of both active and retired employees at the date of adoption, has been reported as the cumulative effect of an accounting change and such prior periods have not been restated. Income Taxes: In 1992, the Company changed its method of accounting for income taxes from the deferred method under Accounting Principles Board Statement No. 11 to the liability method by adopting Statement of Financial Accounting Standards No. 109 ("FAS 109"). Financial statements for periods prior to 1992 have not been restated for the effects of adopting FAS 109. The effect on prior years of adopting FAS 109 has been reported as the cumulative effect of an accounting change. FAS 109 requires that deferred tax liabilities and assets be established based on the difference between the financial statement and income tax bases of assets and liabilities using existing tax rates. ACQUISITIONS AND DIVESTITURES The Company has the right to produce, distribute and market the soft drink products of The Coca-Cola Company and/or other soft drink products in the territories of acquired operations. Under the purchase method of accounting, the results of operations of acquired companies are included in the consolidated statements of operations of the Company as of their acquisition date. The assets and liabilities of acquired companies are included in the Company's consolidated COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) balance sheet at their estimated fair values on date of purchase based on a preliminary allocation of the purchase price. On June 30, 1993, the Company acquired, from The Coca-Cola Company, the stock of (i) Coca-Cola Beverages Nederland B.V. in the Netherlands ("CCBN"); (ii) Roddy Coca-Cola Bottling Company, Inc. ("Roddy") in Knoxville, Tennessee; and (iii) Coca-Cola Bottling Company of Johnson City ("JC"), in Johnson City, Tennessee for an aggregate purchase price of approximately $366 million in cash and assumed debt. The transaction was accounted for under the purchase method. In December 1991, the Company acquired the Johnston Coca-Cola Bottling Group, Inc. ("Johnston"), the second largest bottler of soft drink products of The Coca-Cola Company in the United States. Johnston's territories, with a population estimated at approximately 28 million or 11% of the U.S. population, were located principally in the Midwestern United States. All of the outstanding Johnston common stock was acquired in exchange for the issuance from treasury of 13.438 million shares of the Company's common stock and the payment of approximately $196 million in cash in a transaction accounted for under the purchase method. Assuming the Johnston bottling operations had been acquired as of January 1, 1991, and the CCBN/Roddy/JC acquisition occurred as of January 1, 1992, unaudited pro forma results of operations are as follows (in millions except per share amounts): The foregoing summary pro forma financial information reflects adjustments for the CCBN/Roddy/JC acquisition to give effect to (i) interest expense on acquisition financing through issuance of commercial paper at an annual interest rate of 3.8% for 1992 and 3.1% for the COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) preacquisition period of 1993; (ii) repayment of assumed debt; (iii) amortization of the franchise assets acquired in the acquisition; and (iv) the income tax effect of such pro forma adjustments. The foregoing also reflects adjustments for the Johnston acquisition to give effect to (i) interest expense on acquisition financing at an estimated annual interest rate of 8.4%; (ii) issuance from treasury of 13.438 million shares of the Company's common stock; (iii) amortization of the franchise asset; (iv) the effect of adjusting debt assumed from Johnston for terms anticipated for such debt to remain outstanding and to an effective annual interest rate of approximately 7.8%; (v) elimination of the gain recognized by the Company from the sale of its Ohio operations to Johnston in June 1990; and (vi) the income tax effect of such pro forma adjustments. Also in separate transactions in 1993, the Company acquired bottling operations in Arkansas and an architectural design and facility engineering company. The aggregate purchase price for these acquisitions, accounted for under the purchase method, approximated $60 million in common stock, preferred stock and debt. In separate transactions in 1992, the Company acquired bottling operations in Quincy, Illinois; Manchester, Georgia; Erie, Pennsylvania; and Laredo, Texas. The aggregate purchase price of these acquisitions, accounted for under the purchase method, approximated $40 million in cash and debt. In separate transactions in 1991, the Company acquired bottling operations in Ukiah, California; Jasper, Texas; Westminster, Annapolis and Cambridge, Maryland; and Dover, Delaware. The aggregate purchase price of these acquisitions, accounted for under the purchase method, approximated $55 million in cash and debt. Also in 1991, the Company sold its right to produce, distribute and market Dr Pepper and Barq's soft drinks in Jackson, Tennessee for approximately $3 million, resulting in a pretax gain of approximately $1 million. INVENTORIES Inventories are comprised of the following (in millions): COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses are comprised of the following (in millions): LONG-TERM DEBT Long-term debt including current maturities consists of the following (in millions): Maturities of long-term debt for the five fiscal years subsequent to December 31, 1993, are as follows (in millions): 1994 -- $308; 1995 -- $263; 1996 -- $558; 1997 -- $555; and 1998 -- $10. The Company's commercial paper program is supported by a $1 billion revolving bank credit agreement maturing in April 1996 and two short-term credit facilities. There are no borrowings outstanding under these agreements; however, under the commercial paper program supported by these agreements, an aggregate $522 million was outstanding at December 31, 1993. The weighted average interest rates of borrowings under the commercial paper program were approximately 3.2% and 3.8% for 1993 and 1992, respectively. Terms of the revolving bank credit agreement and/or the outstanding notes and debentures include various provisions which, among other things, require the Company to (i) maintain a defined leverage ratio and (ii) limit the incurrence of certain liens or encumbrances in excess of defined amounts. None of these restrictions are presently significant to the Company. COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company has outstanding certain interest rate swap agreements with financial institutions. At December 31, 1993, these interest rate swap agreements change (i) $150 million of the floating rate exposure on commercial paper to fixed rate exposure and (ii) $500 million of the fixed rate exposure on the $250 million 8% debentures due 2022 and $250 million of the $750 million 8.5% debentures due 2022 to floating rate exposure. All of the above interest rate swap agreements were in force at the beginning of 1993 except for the swap agreement related to the $250 million outstanding on the 8% debentures due 2022. These swap agreements expire in varying periods from 1994 through 1996, but may extend through 2023 depending upon interest rates at the initial expiration date. In addition, the Company has certain Eurodollar futures contracts with financial institutions which hedge its floating rate exposure on the interest rate swap agreements. At December 31, 1993, the Eurodollar futures cover the following periods: (i) $250 million from December 1993 through September 1994 and (ii) $250 million from March 1994 through June 1996. The adjustment to market of these Eurodollar futures contracts aggregate unrecognized losses of $5 million as of December 31, 1993. These unrecognized amounts will be decreased or increased, as appropriate, to the final settlement date of each contract, at which time amounts will be amortized over the ensuing contract period. Activities under interest rate swap agreements and Eurodollar futures contracts have resulted in a decrease in interest expense for 1993 of approximately $7 million. The Company is exposed to credit losses for periodic settlements of amounts due under interest rate swaps; however, amounts due under these agreements were not significant at December 31, 1993. LEASES The Company leases office and warehouse space, computer hardware, and machinery and equipment under lease agreements which expire at various dates through 2019. At December 31, 1993, future minimum lease payments under noncancellable operating leases aggregate approximately $44 million. Rent expense was approximately $25 million, $25 million and $24 million during 1993, 1992 and 1991, respectively. PREFERRED STOCK In connection with the 1993 acquisition of the Coca-Cola Bottling Company of Northeast Arkansas, Inc., the Company issued 1,000,000 shares of nonvoting convertible preferred stock with a stated value of $35 per share. Each share is convertible into one share of common stock at any time at the option of the holder. The preferred stock may be called by the Company at any time for cash equal to its stated value plus accrued dividends. The preferred stock pays cumulative cash dividends of 3% per annum for the first five years, 4.29% per annum for the following five years, adjusting to an annual rate equal to LIBOR plus 1% thereafter. Adjustment of the stated value of the preferred stock to its estimated fair value of approximately $29 million results in an annual dividend cost of approximately 6%. During 1991, the Company redeemed all of its then existing nonvoting variable dividend rate preferred stock at book value. SHARE REPURCHASE During 1993, the Company repurchased 1,153,900 shares of its common stock on the open market for an aggregate cost of approximately $17 million. The repurchased shares represent COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) additions to treasury stock and are intended, among other things, to replenish an aggregate 400,000 treasury shares issued to effect an acquisition during 1993. STOCK OPTIONS AND OTHER STOCK PLANS The Company's 1992 Restricted Stock Award Plan ("the 1992 Plan") provides for awards to certain officers and other key employees of the Company of up to an aggregate 1.5 million shares of the Company's common stock. The 1986 Restricted Stock Award Plan ("the 1986 Plan") provides for awards to certain officers and other key employees of the Company of up to an aggregate 1 million shares of the Company's common stock. Awards under both plans vest (i) when a participant dies, retires or becomes disabled; (ii) when the Compensation Committee of the Board of Directors elects, in its sole discretion, to remove certain restrictions; or, with regard to the 1992 Plan, (iii) based on the attainment of certain market price levels of the Company's stock. Such awards also entitle the participant to full dividend and voting rights. Shares awarded under both plans are restricted as to disposition and subject to forfeiture under certain circumstances. The market value of the shares at the date of grant is charged to operations ratably over the vesting periods. In 1992, the Board of Directors of the Company terminated the 1986 Plan, canceling the remaining 476,000 shares under this plan available for grant. Restricted shares issued under the 1992 Plan, totalling 22,400 shares were forfeited in 1993 and returned to treasury. Further information relating to restricted stock awards follows: The Company's 1991 Stock Option Plan (the "Stock Option Plan"), provides for the granting of nonqualified stock options to officers and certain key employees. The Stock Option Plan provides that options for 3 million shares of the Company's common stock may be granted prior to the plan's expiration in 1996. The Company's 1990 Management Stock Option Plan (the "Management Option Plan") provides for the granting of nonqualified stock options to certain key employees. The Management Option Plan provides that options for 2 million shares of the Company's common stock may be granted. Options awarded under the Stock Option Plan and the Management Option Plan (i) are generally granted at prices which equate to or are above fair market value on the date of grant; (ii) become exercisable over either a three or four year period; and (iii) expire ten years subsequent to award. COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Included in options outstanding at December 31, 1993 were various options granted under previous plans with similar terms. Further information relating to options follows: On initial offering of stock to the public, each of the seven directors who was not an officer of the Company or The Coca-Cola Company was awarded options to acquire up to 1,500 shares of common stock and certain officers of the Company were granted options to purchase 245,000 shares of the Company's common stock at $16.50 per share (the initial public offering price). Since that time, new directors, upon election, who were not an officer of the Company or The Coca-Cola Company were awarded options to acquire up to 1,500 shares of common stock at $16.50 per share. Options to purchase 198,000 shares under this plan have subsequently been canceled, and 15,000 options have been exercised. Currently exercisable options with rights totaling 45,500 shares remain outstanding and will expire in November 1996. In 1991, the Company adopted the Stock Appreciation Rights Plan (the "SAR Plan") which provides for the award of an aggregate 1 million stock appreciation rights ("units") to qualified participants prior to the SAR Plan's expiration in 1996. Each unit entitles the holder to receive cash based on the difference between the market value of a share of the Company's common stock on the date of award and the fair market value of such stock on the date of exercise. Included in stock appreciation rights outstanding at December 31, 1993 are various units awarded under a prior plan with similar terms. In 1992, units available for future grants under all stock appreciation rights plans were terminated. Further information relating to stock appreciation rights follows: PENSION AND CERTAIN BENEFIT PLANS The Company sponsors various pension plans and participates in certain multiemployer pension plans covering substantially all U.S. employees. The benefits related to company-sponsored plans are based on years of service and compensation earned during years of employment. The Company's funding policy is to contribute amounts to the plans sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974, plus such COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) additional amounts as management may determine to be appropriate but within applicable legal limits. These qualified defined benefit plans sponsored by the Company are insured by the Pension Benefit Guaranty Corporation ("PBGC"). The Company also sponsors several unfunded nonqualified defined benefit plans covering certain officers and other employees. Total pension expense amounted to approximately $19 million (including $6 million for multiemployer plans) in 1993 and 1992, and $14 million (including $5 million for multiemployer plans) in 1991. Net periodic pension cost for company-sponsored defined benefit plans included the following (in millions): The following table sets forth the funded status of domestic company-sponsored plans and amounts recognized by the Company, segregated by (i) plans whose assets exceed the accumulated benefit obligation ("ABO") and (ii) plans whose ABO exceeds assets (in millions): The weighted average discount rate utilized in determining the actuarial present value of the projected benefit obligation as of the respective valuation dates was 7.5% and 8.25% in 1993 and 1992, respectively. The weighted average rate of increase in future compensation was 5.5% and 6% COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) in 1993 and 1992, respectively. The expected long-term rate of return on plan assets was 8.5%, 9.5% and 9% in 1993, 1992 and 1991, respectively. CCBN participates in a multiemployer pension plan covering a majority of its employees. CCBN also sponsors a supplemental defined benefit plan for certain employees. At December 31, 1993, the accumulated benefit obligation for the supplemental plan was $9 million, the projected benefit obligation was $17 million and plan assets were $17 million. CCBN also sponsors an unfunded voluntary early retirement plan for certain employees allowing early retirement at age 60. At December 31, 1993, the accumulated benefit obligation, which has been fully accrued, was $5 million and the projected benefit obligation was $6 million. In addition to the defined benefit plans described above, the Company also sponsors a qualified defined contribution plan covering all full-time nonunion employees in the United States. The Company matches 50% of a participant's voluntary contributions up to a maximum of 6% of a participant's compensation. The Company's contribution expense was approximately $10 million in 1993 and 1992, and $9 million in 1991. POSTRETIREMENT BENEFIT PLANS The Company sponsors various unfunded defined benefit postretirement plans that provide health care and life insurance benefits to substantially all nonunion and certain union retirees who retire with a minimum period of service. Adoption of FAS 106 during 1992 changed the Company's method of accounting for such postretirement benefits as an expense when claims were incurred to accrual of the costs of such benefits during the periods employees provide service to the Company. The Company immediately recognized the transition obligation of adopting FAS 106. The effect on years prior to 1992 of adopting FAS 106, representing that portion of unrecognized future retiree benefit costs related to past service of both active and retired employees as of the date of adoption, has been reported as the cumulative effect of an accounting change and prior periods have not been restated. The cumulative effect of adopting FAS 106 as of January 1, 1992 decreased net income by approximately $148 million (net of income taxes of $91 million) or $1.15 per common share. In the first quarter of 1993, the Company completed the redesign and consolidation of its postretirement benefit plans by amending the plans then in effect. The effect of plan amendments was to decrease the accumulated postretirement benefit obligation at January 1, 1993 from approximately $312 million to $164 million, resulting in $148 million of excess prior service cost, and to reduce the full-year 1993 postretirement benefits expense by approximately $31 million. The excess prior service cost is being amortized over the average service life of plan participants, approximately 17 years. COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table presents the plan's funded status reconciled with amounts recognized in the Company's balance sheets at December 31, 1993 and 1992 (in millions): Net periodic postretirement benefit cost for 1993 and 1992 includes the following components (in millions): Actuarial assumptions used in determining the postretirement benefit cost and the accumulated postretirement benefit obligation include a discount rate of 7.5% and 8.5% and an average rate of increase in future compensation of 5.5% and 6%, in 1993 and 1992, respectively. The assumed weighted average annual rate of increase in the per capita cost of covered benefits (the health care cost trend rate) was 15% pre-Medicare and 11% post-Medicare for 1993 and 1992, decreasing to 6% by the year 2052 and remaining at that level thereafter. However, the postretirement benefit plan, as amended effective January 1, 1993, is a "defined dollar benefit plan" which limits the effect of medical inflation to a maximum of 4% per year after 1996. Because the amended postretirement medical plan has established dollar limits for determining company contributions, the effect of a 1% increase in the assumed health care cost trend rates is not significant. PROVISION FOR RESTRUCTURING The Company recognized in the fourth quarter of 1991 a $152 million ($0.86 per common share) provision for restructuring related primarily to the standardization of information systems, reconfiguration of sales and distribution centers, and severance and relocation costs associated with decentralizing the Company's organizational structure and eliminating redundant staff and operating positions. INCOME TAXES On August 10, 1993, the Omnibus Budget Reconciliation Act was signed into law. The Company was affected principally by the increase in the corporate marginal income tax rate from 34% to 35%. Under FAS 109, the Company's deferred income taxes were adjusted to reflect the effect of the new rate. This adjustment resulted in a one-time charge of approximately $40 million ($0.31 per common share) to increase the Company's deferred tax liability existing at the date of enactment for the effect of the rate change. Additionally, the Company's annual estimated effective tax rate was COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) increased by an amount approximating the 1% marginal rate increase. Other components of the new law are not expected to have a material impact on the financial position or results of operations of the Company. Application of FAS 109 decreases pretax income and decreases income tax expense in both 1992 and 1993 by approximately $38 million as a result of amortization of the increased franchise asset. This increased amortization results from the requirement to report assets acquired in prior business combinations at their pretax amounts, eliminating the impact of nondeductible amortization from the computation of income tax expense under the new accounting standard. During 1987, the Company filed elections under Section 338 of the Internal Revenue Code, relating to various bottling companies acquired in 1986. Tax operating loss carryforwards aggregating approximately $943 million have arisen principally from the additional tax deductions resulting from such elections. These carryforwards are available to offset future federal taxable income through their expiration in varying amounts aggregating $5 million in 1996 through 1998; $279 million in 1999 through 2003; and $659 million in 2004 through 2008. A deferred tax asset is recognized for the tax benefit of deductible temporary differences and net operating loss and tax credit carryforwards. A valuation allowance is recognized if it is "more likely than not" that some or all of the deferred tax asset will not be realized. Management believes that the future reversal of existing taxable temporary differences provides evidence that the majority of deferred tax assets will be realized. A valuation allowance of $105 million, $86 million and $77 million as of December 31, 1993, 1992 and January 1, 1992, respectively, was established for the remaining deferred tax assets. Upon realization, the tax benefit for net operating loss carryforwards of acquired companies for which a valuation allowance has been established will be applied to reduce recorded franchise values. Net operating loss carryforwards of acquired companies were approximately $59 million at December 31, 1993. Deferred income taxes reflect the tax effects of differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1993 and 1992 are as follows (in millions): COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Significant components of the provision for income taxes attributable to continuing operations, excluding the cumulative effect of accounting changes, are as follows (in millions): The current tax provision for 1993 and 1992 represents the amount of income taxes paid or payable for the year. The deferred tax provision for 1993 and 1992 represents the change in the deferred tax liabilities and assets and, for business combinations, the change since date of acquisition. The components of the provision for deferred income taxes for 1991, computed using the deferred method, are as follows (in millions): COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A reconciliation of the expected income tax expense (benefit) at the statutory federal rate to the Company's actual income tax provision follows (in millions): FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating fair values for financial instruments: Cash and cash equivalents: The carrying amount reported in the balance sheets for cash and cash equivalents approximates fair value. Long-term debt: The carrying amounts of commercial paper, variable rate debt and other short-term borrowings approximate their fair values. The fair values of the Company's long-term debt are estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. Hedging instruments and warrants: The fair values of the Company's futures contracts are estimated based on quoted market prices of comparable contracts or current settlement values. The fair values of the Company's interest rate swaps and warrants are estimated based on independent valuations from major investment banks. The carrying amounts and fair values of the Company's financial instruments at December 31, 1993 are as follows (in millions): The Company does not anticipate any significant refunding activities which would settle long-term debt at fair value. RELATED PARTY TRANSACTIONS The Company and The Coca-Cola Company have entered into various transactions and agreements related to their respective businesses. Various significant transactions and agreements entered into between the Company and The Coca-Cola Company are disclosed in other sections of COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the accompanying financial statements and related notes. The following items represent other transactions between the Company and The Coca-Cola Company, and its affiliates: Acquisition: The Coca-Cola Company had an approximate 20% ownership interest in Johnston. As a result of the acquisition in 1991, The Coca-Cola Company received 49,892 shares of the Company's common stock and $81 million in cash, reducing The Coca-Cola Company's ownership in the outstanding common stock of the Company from approximately 49% to approximately 44%. Fountain Syrup and Package Product Sales: Certain of the Company's operations sell fountain syrup to The Coca-Cola Company and deliver this syrup on behalf of The Coca-Cola Company to certain major or national accounts of The Coca-Cola Company. In addition, the Company sells bottle/can products to The Coca-Cola Company at prices that equate to amounts charged by the Company to its major customers. During 1993, 1992 and 1991, The Coca-Cola Company paid the Company approximately $220 million, $193 million and $138 million, respectively, for fountain syrups, bottle/can products and delivery and billing services. Antitrust Indemnity Agreement: During 1991, The Coca-Cola Company paid the Company approximately $1 million, pursuant to an agreement which indemnifies the Company for certain costs, settlements and fines arising out of alleged antitrust violations which occurred prior to the acquisition of certain bottlers by the Company. The indemnity period expired January 1, 1993. Marketing Support Arrangements: The Coca-Cola Company engages in a variety of marketing programs, local media advertising and other similar arrangements to promote the sale of products of The Coca-Cola Company in territories operated by the Company. For 1993, 1992 and 1991, total direct marketing support provided to the Company or on behalf of the Company by The Coca-Cola Company was approximately $256 million, $253 million and $199 million, respectively. In addition, the Company paid an additional $65 million, $63 million and $45 million in 1993, 1992 and 1991, respectively, for local media and marketing program expense pursuant to a cooperative advertising arrangement with The Coca-Cola Company. COMMITMENTS AND CONTINGENCIES The Company is contingently liable for guarantees of the indebtedness owed primarily by manufacturing cooperatives of approximately $43 million at December 31, 1993. Under the Company's insurance programs, coverage is obtained for catastrophic exposures as well as those risks required to be insured by law or contract. Generally, the Company is self-insured for certain expected losses related primarily to workers' compensation, physical loss to property, business interruption resulting from such loss and comprehensive general, product and vehicle liability. Provisions for losses expected under these programs are recorded based upon the Company's estimates of the aggregate liability for claims incurred. Such estimates utilize certain actuarial assumptions followed in the insurance industry. The Company has provided letters of credit aggregating approximately $104 million in connection with self-insurance programs. The Company has purchase agreements with various suppliers extending beyond one year. Subject to the supplier's quality and performance, the purchases covered by these agreements aggregate approximately $527 million in 1994, $529 million in 1995, $502 million in 1996, $508 million in 1997 and $103 million in 1998. Federal, state and local laws govern the Company's operation of underground fuel storage tanks and the required removal, replacement or modification of such tanks to satisfy regulations which go into effect in varying stages through 1998. Expenditures aggregating $9 million, $8 million COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and $25 million were made in 1993, 1992 and 1991, respectively, in a structured program designed to enhance compliance with such regulations including regulations governing the environmental discharge of materials. The Company has completed a majority of its multiyear program for remediation of environmental contamination. Completion of the Company's remediation program is not expected to have a material adverse effect on the financial position or results of operations of the Company. The Company has been named as a potentially responsible party ("PRP") for the costs of remediation of hazardous waste at six federal "Superfund" sites in Arkansas, California, Florida, Minnesota, New Hampshire and Ohio. Under current law, the Company's liability for clean up of such sites may be joint and several with other PRP's, regardless of the extent of the Company's use in relation to other users. In each case, the Company has determined that to the extent that it has any responsibility for hazardous waste deposited at any site, the amounts of such deposits are minimal compared to those of other financially responsible PRP's, and as a result, we believe the Company's ultimate liability will not have a material effect on its financial position or results of operations. In 1991, a Complaint was filed against the Company, each of the directors of the Company and Johnston seeking, among other things, to enjoin the Johnston acquisition. The Complaint alleges that The Coca-Cola Company, as the holder of approximately 49% (prior to the Johnston acquisition) of the outstanding common stock of the Company, owes fiduciary duties of loyalty, care and candor to the Company and the Company's public share owners and that The Coca-Cola Company breached its fiduciary duties by exerting influence over the Company in connection with the acquisition in order to maximize its financial interests at the expense of the Company and the Company's public share owners. The Complaint also alleges that the directors of the Company breached their fiduciary duties to the Company and its public share owners. Management believes that the Complaint is without merit and its ultimate disposition will not have a material adverse effect on the financial condition or results of operations of the Company. The Company is also involved in various other claims and legal proceedings, the resolution of which management believes will not have a material adverse effect on the financial position or results of operations of the Company. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Changes in assets and liabilities, net of effects from acquisitions of companies, were as follows (in millions): Cash payments during the year were as follows (in millions): COCA-COLA ENTERPRISES INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In conjunction with the acquisitions of bottling companies, liabilities were assumed as follows (in millions): QUARTERLY FINANCIAL DATA (Unaudited; in millions except per share data) Each quarter presented includes ninety-one days, except the first quarter of 1992 (eighty-seven days), the fourth quarter of 1992 (ninety-seven days) and the first quarter of 1993 (ninety-two days). Due to the method used in calculating per share data as prescribed by Accounting Principles Board Opinion No. 15 and the timing of share repurchases by the Company, the per share data does not sum in certain instances to the per share data as computed for the quarter and the year. The third quarter of 1993 includes a one-time charge of approximately $40 million ($0.31 per common share) to increase the Company's deferred tax liability as a result of a 1% increase in the corporate marginal income tax rate. The fourth quarter of 1993 included a favorable year-end inventory (LIFO) adjustment of approximately $7 million of which approximately $5 million ($0.03 per common share) applied to previous quarters. COCA-COLA ENTERPRISES INC. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS Board of Directors Coca-Cola Enterprises Inc. We have audited the accompanying consolidated balance sheets of Coca-Cola Enterprises Inc. and the related consolidated statements of operations, share-owners' 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 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 Coca-Cola Enterprises 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 notes to consolidated financial statements, in 1992 the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions. /s/ ERNST & YOUNG Atlanta, Georgia January 31, 1994 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 relating to the Directors of the Company is set forth under the captions "Election of Directors -- Nominees" and "Election of Directors -- Information Concerning Directors" on pages 3 through 7 of the Company's 1994 Proxy Statement. Such information is incorporated herein by reference. Pursuant to Instruction 3 of Item 401(b) of Regulation S-K and General Instruction G(3) of Form 10-K, information relating to the executive officers of the Company is set forth at Item 4(A) of this report under the caption "Executive Officers of the Company." Information regarding compliance with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934, as amended, by the Company's executive officers and Directors, persons who own more than ten percent of the Company's common stock and their affiliates who are required to comply with such reporting requirements is set forth in "Election of Directors -- Compliance with Section 16(a) of the Securities Exchange Act of 1934" on pages 11 and 12 of the Company's 1994 Proxy Statement. Such information is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation is set forth under the captions "Election of Directors -- Compensation of Directors" and "Election of Directors -- Executive Compensation" on pages 8 and 9 and pages 13 through 22, respectively, of the Company's 1994 Proxy Statement. Such information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding ownership of the Company's $1 par value common stock by certain persons is set forth under the captions "Voting -- Principal Share Owners" and "Election of Directors -- Security Ownership of Directors and Officers" on pages 2 and 3 and pages 9 through 11, respectively, of the Company's 1994 Proxy Statement. Such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain transactions between the Company, The Coca-Cola Company and their affiliates and certain other persons is set forth under the caption "Election of Directors -- Certain Relationships and Related Transactions" on pages 23 through 27 of the 1994 Proxy Statement. Such 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. The following consolidated financial statements of the Company are included in Item 8 of this report: Consolidated Statements of Operations for each of the three years in the period ended December 31, 1993 Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992 Consolidated Statements of Share-Owners' Equity for each of the three years in the period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Notes to Consolidated Financial Statements Report of Independent Auditors (2) Financial Statement Schedules. The following financial statement schedules of the Company are included in this report on the pages indicated: 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. (3) Exhibits. - --------------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. (b) REPORTS ON FORM 8-K. On October 27, 1993 the Company filed a Current Report on Form 8-K, the date of which report was October 19, 1993, regarding the Company's financial results for the third quarter and the first nine months of 1993. (c) EXHIBITS See Item 14(a)(3) above. (d) FINANCIAL STATEMENT SCHEDULES See Item 14(a)(2) above. 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. COCA-COLA ENTERPRISES INC. (Registrant) By: /s/ S. K. JOHNSTON, JR. --------------------------------- S. K. Johnston, Jr. Vice Chairman and Chief Executive Officer Date: March 10, 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. INDEX TO FINANCIAL STATEMENT SCHEDULES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT COCA-COLA ENTERPRISES INC. (In millions) (a) The amounts shown in Column D include amounts transferred to other assets applicable to assets identified as idle during the year. (b) The amounts shown in Column E include amounts applicable to acquired companies at date of acquisition net of (i) the effect of the restructuring reserve in 1991 and (ii) the effect of FAS 109 in 1992. (c) Additions for construction in progress are net of amounts transferred to productive asset categories for assets placed in service during the year. SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT COCA-COLA ENTERPRISES INC. (In millions) (a) Includes amounts transferred to other assets applicable to assets identified as idle during the year. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS COCA-COLA ENTERPRISES INC. (In millions) (a) Principally represents allowances for losses on trade accounts of acquired companies at date of acquisition and recoveries of amounts previously charged off. (b) Charge off of uncollectible accounts. (c) Adoption of FAS 109 as of January 1, 1992. SCHEDULE IX -- SHORT-TERM BORROWINGS COCA-COLA ENTERPRISES INC. (In millions) (a) The average amount outstanding during the period was computed by dividing the total of month-end outstanding principal balances by the number of months in the period. (b) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION COCA-COLA ENTERPRISES INC. (In millions) (a) Media advertising costs as shown above do not include administrative expenses, as it is not practical to determine that portion applicable to media advertising. In addition, the amounts shown are net of cooperative advertising credits received from soft drink licensors of $41 million in 1993, $39 million in 1992 and $32 million in 1991. (b) Royalties and taxes other than payroll and income taxes do not exceed one percent of net operating revenues and, accordingly, are not presented in the schedule. APPENDIX TO MAPS Maps of the United States and a portion of Western Europe outlining the Company's territories are displayed on page 4 of this form. These maps appear in the paper format version of the form and not in this electronic filing. EXHIBIT INDEX COCA-COLA ENTERPRISES INC. 1993 FORM 10-K *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c). *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c). *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c). - ---------------------------------- *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c). - ---------------------------------- *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c).

310979_1993.txt

310979_1993

1993

310979

ITEM 1. BUSINESS GENERAL BancTEXAS Group Inc., a bank holding company headquartered in Dallas, Texas (herein BTX or the Company), was organized as a Delaware corporation in 1978. The Company's executive office is located at 13747 Montfort Drive, Dallas, Texas. The principal function of the Company is to assist the management of its banking subsidiary which is now named BankTEXAS N.A. (herein the Bank) in asset and liability management, planning, operating policies and procedures, loan participation, personnel management, internal audit and control procedures, loan review and regulatory compliance. The Bank operates under the day-to-day management of its own officers with guidance from BTX. At December 31, 1993, BTX had, on a consolidated basis, total assets of $369 million, total deposits of $243 million, total loans of $168 million (net of unearned income) and total stockholders' equity of $15 million. For a description of the general business of BTX during the past year, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Introduction" on page 4 of BTX's 1993 Annual Report to Stockholders, which is incorporated herein by reference. SIGNIFICANT DEVELOPMENTS IN 1993 The most significant factor affecting the Bank's performance in 1993 was a significant reduction in the net interest margin earned. For most of the year the rates paid on deposits were level but the rates earned on loans, especially in the second half of the year, declined markedly. The principal reason for this decline is the heightened competition among lenders, principally for consumer loans, in addition to the decline in rates for mortgage and commercial loans. In its continuing efforts to diversify the loan portfolio, the Bank began to purchase residential mortgage loans which are held for a short period of time before their sale to permanent investors. In cooperation with a new Texas firm, the Bank is now making F.H.A. Title One home improvement loans. Both of these earn a higher rate of interest than the typical loan to purchase a motor vehicle or watercraft at this time. In the Fall, the Bank was approved as a member of the Federal Home Loan Bank of Dallas (the FHLB). In consideration of an investment in stock of the FHLB, the Bank is entitled to borrow significant sums on both a short-term basis and long-term basis at favorable rates. With this additional borrowing capacity, the Bank can leverage its balance sheet, thereby increasing its earning assets and profits. This strategy should also modestly increase the net interest margin of the Bank. In September, the Bank opened its sixth branch location. It is located in a residential area in North Dallas near the intersection of Abrams and Forest Roads in a building formerly occupied by another bank. This provides an opportunity for the Bank to again market its services and products in Dallas where its predecessor organization started doing business more than a century ago. The Company terminated its exposure in two major lawsuits during 1993. In June, the U.S. Fifth Circuit Court of Appeals upheld the trial court's opinion dismissing the class action lawsuit filed after the 1987 restructuring of BTX. In November, the Company and the remaining plaintiffs in a lawsuit filed in 1986 agreed to a settlement thus ending the claims which had stemmed from a 1984 private placement in which the Company had raised more than $8 million of new capital. For a full description of this settlement, see "Noninterest Expense - Litigation Settlement" in Management's Discussion and Analysis of Financial Condition and Results of Operations, which is incorporated by reference. THE BANK SUBSIDIARY The Company conducts substantially all of its business through its Bank. The Bank has six branches to serve the public - three are in Houston, one is in McKinney (the County Seat of Collin County), one in North Dallas, and one is in Irving (a suburb of Dallas). Prior to May 31, 1992, BTX had two bank subsidiaries, BancTEXAS Houston N.A. and BancTEXAS McKinney N.A.; on that date they were merged and renamed BankTEXAS N.A. The purpose of this merger was to increase operating efficiencies and reduce the cost of operation since several functions could be combined without decreasing the level of service offered to customers. At December 31, 1993 the Bank's capital ratios were: leverage ratio of 4.55%; ratio of Tier I capital to risk-based assets of 7.30%; and ratio of total capital to risk-based assets of 8.55%. At December 31, 1993, the Bank had total assets of $355 million, total deposits of $243 million, total loans of $167 million (net of unearned income) and stockholders' equity of $15 million. BANKING SERVICES. The Bank is engaged in a variety of commercial and personal banking activities for customers in its market areas, including the acceptance of deposits for checking, savings and time deposit accounts, the making of secured and unsecured loans to corporations, individuals and others, the issuance of charge cards, the rental of safe deposit boxes, the sale of annuities and mutual funds, and the rendering of investment and financial counsel to customers. The Bank also offers special services through its Club 55 (for persons 55 years of age or older) and its Payday Club (for individuals employed by several larger corporations in the Bank's market areas). CONSUMER LENDING. The Bank began a program of purchasing automobile loans from new car dealers in 1988 and subsequently enhanced this program by making loans directly to consumers to purchase new and used motor vehicles. This has been a major source of new business activity in the past six years. In 1990, programs were begun whereby loans are made to consumers in order to enable them to purchase marine products and to make improvements to their primary residences. In 1991, credit card lines were again offered to bank customers. Early in 1994, the Bank began to purchase home improvement loans made under the FHA Title One Program. In 1994, it is anticipated that these consumer product lines will again generate a substantial volume of new loans, since these currently represent approximately 80% of the loans on the Bank's books. REAL ESTATE LOANS. The Bank makes construction and real estate development loans, as well as other loans secured by nonresidential real estate. In 1991, the Bank commenced a program emphasizing the making of interim construction loans secured by first liens on residential real estate. In 1993, the Bank began to purchase single family mortgage loans with the intent to hold these for resale. It is anticipated that this program will be expanded in 1994. Home equity loans are prohibited under Texas law. SUPERVISION AND REGULATION The following discussion of statutes and regulations affecting bank holding companies and banks is only a summary and does not purport to be complete. This discussion is qualified in its entirety by reference to such statutes and regulations. BTX and the Bank BTX is a registered bank holding company pursuant to the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act") and, as such, is subject to regulation and examination by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). It is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and those of its subsidiaries. The Federal Reserve Board has asserted the authority under the Bank Holding Company Act to require a bank holding company such as BTX to provide capital to an undercapitalized subsidiary bank, and legislation enacted in 1991 contains provisions having a similar effect. Furthermore, the Bank Holding Company Act and the regulations thereunder limit acquisitions by a bank holding company of 5% or more of the voting shares of additional banks and companies in other businesses, and often require prior regulatory approval for those acquisitions which are permitted. A bank holding company is generally prohibited from acquiring any company unless its business is determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. BTX is also subject to periodic examinations conducted to determine its compliance with applicable statutes and regulations, its financial condition, and other aspects of its operations. These examinations are conducted by the Federal Reserve Bank of Dallas on behalf of the Federal Reserve Board. The Federal Reserve Act imposes restrictions on loans and other transactions between the Bank and BTX or any of BTX's other subsidiaries. These restrictions require, among other things, that all transactions between the Bank and the Company or its nonbank subsidiaries be on substantially similar terms as comparable transactions between the Bank and nonaffiliated enterprises. BTX is also subject to certain restrictions with respect to engaging in the securities business and in businesses not deemed "closely related" to banking. The Bank is chartered under the National Bank Act of 1864, and it is subject to regulation, supervision and examination by the Comptroller of the Currency and to regulations promulgated by both the Federal Reserve Board and the FDIC. The FDIC insures all deposits held by the Bank up to, in general, a maximum of $100,000 for each insured depositor. The operations of the Bank are also subject to numerous laws and regulations relating to the extension of credit and making of loans to individuals. Such laws include the Federal Consumer Credit Protection Act, which regulates, among other things, disclosure of credit terms, credit advertising, credit billing and collection, and expansion of credit, and the Texas Consumer Credit Code and Texas Consumer Protection Code, which regulate, among other things, interest rates, disclosure of credit terms and practices relating to the extension and collection of loans. In addition, remedies to the borrower and penalties to the lender are provided for failure of the lender to comply with such laws and regulations. The scope and requirements of such laws and regulations have been expanded significantly in recent years. The enactment of two recent federal statutes, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") and the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), has significantly affected the banking industry generally and will have an ongoing effect on both BTX and the Bank in the foreseeable future. FIRREA restructured both the deposit insurance system and the regulation of savings institutions, and it contains numerous provisions affecting banks. This legislation also includes several provisions that relate to bank holding companies including those described herein and numerous other provisions. Among the more significant of the changes, the Bank Insurance Fund of the FDIC was established to insure bank deposits, and the FDIC has increased the premiums which must be paid by banks over the next several years. FIRREA also provides for cross-guarantees for commonly controlled banks and thrifts. If the FDIC incurs a loss in connection with the default of an insured bank or thrift, any other commonly controlled depository institution may be required to reimburse the FDIC for the loss. Other important changes in banking law and regulation made by FIRREA include enhanced supervisory and enforcement powers for the federal banking regulatory agencies, creation of the Resolution Trust Corporation to dispose of failed savings institutions and their assets, and broadened authority for bank holding companies to acquire savings institutions. FDICIA increased the resources available to the FDIC for the resolution of bank failures and imposed substantial new supervisory and regulatory measures on the banking industry, particularly troubled banks. It also added substantial new enforcement mechanisms for financial institutions which do not meet capital levels specified in regulations adopted pursuant to FDICIA. FDICIA required the three federal bank regulatory agencies to establish five classifications for insured depository institutions, ranging from "well capitalized" to "critically undercapitalized", based primarily on leverage and risk-based capital requirements for institutions within the agencies' respective jurisdictions. The regulatory agencies are authorized, in their discretion, to establish additional capital requirements as to particular institutions. Any institution not meeting applicable capital requirements is deemed "undercapitalized" and the institution's primary regulator could determine that at a particular lower level of capital, an institution is "significantly undercapitalized." An institution would be "critically undercapitalized" if its capital falls below the "critical capital level," defined in regulations adopted in 1992 within certain parameters set in the 1991 Act. The "critical" capital level must require institutions to maintain a ratio of at least 2% Tier I capital to assets, but the ratio established as a critical capital level may not exceed 65% of the leverage capital requirement applicable to the institution, except that an institution could be treated as critically undercapitalized at a higher capital level if it is determined to be in an unsafe or unsound condition. If the Bank were to fail to maintain the level of capital required under the leverage or risk-based standards or under any new standards which might be adopted, it would be considered to be "undercapitalized" and subject to certain sanctions described below. FDICIA provides that an undercapitalized institution will be required to submit to the appropriate regulatory agency a capital restoration plan and will be subject to restrictions on operations, including prohibitions on branching, engaging in new activities, paying management fees, making capital distributions such as dividends, and increasing its assets and liabilities, without regulatory approval. Moreover, a company controlling an undercapitalized depository institution will be required to guarantee its subsidiaries' compliance with the capital restoration plan up to an amount equal to the lesser of 5% of such an institution's assets or the amount of the capital deficiency when such an institution first fails to meet the plan. Restrictions on loans to undercapitalized institutions from the Federal Reserve Banks also apply. Significantly or critically undercapitalized institutions and undercapitalized institutions that do not submit and comply with capital restoration plans acceptable to the applicable regulatory agency will be subject to numerous potential restrictions on their operations and intervention in their management decisions by applicable regulatory agencies, as well as limitations on compensation of senior officers. In addition to the foregoing, a critically undercapitalized institution would be subjected to more severe restrictions and supervision. FDICIA further requires the appointment of a conservator or receiver within 90 days after an institution becomes critically undercapitalized. The regulatory agencies are also required to adopt uniform capital and accounting rules requiring, where practicable, supplemental disclosure of "mark-to-market" valuation of assets and liabilities and of contingent assets and liabilities. The FDIC is required to develop deposit insurance premiums which are based on the level of risk determined by the regulatory agencies to be present in particular institutions, as discussed further below under "FDIC Insurance Premiums." FDICIA also provides for numerous other regulatory changes, including expanded roles for audit committees and independent auditors, particularly in larger financial institutions; additional regulatory reporting; consumer low- and moderate-income lending and deposit programs; and periodic review and updating of applicable standards. In addition, the FDIC was granted new authority to adopt minimum standards for various aspects of the operations of depository institutions, including asset quality, earnings, compensation arrangements and other matters. Pursuant to this authority, the FDIC may consider adopting proposals which could significantly influence the banking industry, although the impact of these proposals is expected to be most severe on institutions which fail to meet applicable capital requirements or are otherwise regarded by regulatory agencies as in an unsatisfactory condition. Regulations Governing Capital Both BTX and the Bank are subject to risk-based and leverage capital requirements, which are administered, respectively, by the Federal Reserve Board and the OCC. See Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources" on page 22 of BTX's 1993 Annual Report to Stockholders, which is incorporated herein by reference. FDIC Insurance Premiums The Bank and the industry as a whole are subject to increased FDIC deposit insurance premiums. Effective July 1, 1991, the FDIC increased deposit insurance premiums to 23 cents per $100 of deposits from 19.5 cents in the first half of 1991, 12.0 cents in 1990 and 8.3 cents prior thereto. Under FIRREA, the FDIC is authorized to charge varying premiums to different categories of banks depending on risk assessment factors (particularly capital ratios) and to set the annual premiums for depository institutions as high as determined necessary to assure stability of the insurance fund, thus eliminating the maximum annual increase of 7.5 cents and the prior overall cap of 32.5 cents per $100 of deposits. The deposit insurance premium rate currently paid by the Bank is 29 cents per $100 of deposits. Until this rate is lowered, the Bank's earnings will be adversely affected as compared with banks having lower premium rates. Acquisitions and Branch Banking; Community Reinvestment Act Requirements Since 1988 both commercial banks and savings institutions have had unlimited branch banking privileges in Texas, subject to the prior approval of an institution's primary federal and/or state regulatory authority. As a result, acquisitions of banks by other banks or bank holding companies are frequently structured so as to eliminate the separate bank charters of acquired banks, converting some or all of them into branch banks; furthermore, banking organizations operating in Texas now have the option of opening additional branch offices as an alternative to acquiring additional banks, thrift institutions or holding companies. Proposals to revise the Community Reinvestment Act ("CRA"), which imposes requirements on insured financial institutions with respect to lending to members of low- and moderate-income groups within their respective service areas, are likely to be a focal point of both legislative and regulatory attention in the next few years. The Clinton Administration has requested that the four bank and thrift regulatory agencies adopt new requirements, and proposed new rules have recently been published for comment by the four agencies. Traditionally, issues under CRA have been emphasized during regulatory consideration of bank acquisition transactions and attempts to establish new branch offices, and the regulatory agencies have within the past year more frequently required acquiring institutions to make commitments with regard to low-income and minority lending and/or investment as part of the process of obtaining necessary regulatory approvals. In certain cases, regulatory approval of a proposed transaction has been denied based upon an unsatisfactory rating of the acquirer under CRA. The Comptroller of the Currency announced in 1993 a major revision of the CRA regulations applicable to all national banks. Although it is not possible to predict the exact form of the changes which will be made, it is widely expected that all banks and thrift institutions will be required to comply with more stringent and possibly more expensive requirements in this area. These changes may impede or change the process by which an institution such as the Bank is able to grow through acquisition and/or opening new branch offices, and they could also affect any possible acquisition by BTX and the Bank. Interstate Banking As a result of a 1989 amendment to the Texas Banking Code and in conjunction with the Bank Holding Company Act, BTX is now legally able to acquire or establish banks in any state of the United States if that state's laws permit the acquisition or establishment of such banks. However, the Board of Directors has not at this time made any plans to acquire or establish banks in any state other than Texas. Proposals to greatly expand the powers of financial institutions to operate on a nationwide basis, removing most of the existing restrictions, have been debated but not yet enacted by Congress. Congress is currently considering such a proposal, which has been approved by committees in both the U.S. Senate and the House of Representatives and is reported to have substantial support. It is not possible to predict the terms of such legislation, if enacted, or its effect on BTX or the Bank. Usury Laws The maximum legal rate of interest that a bank may charge on a loan depends on a variety of factors such as the type of borrower, purpose of the loan, amount of the loan, and date that the loan is made. There are several different state and federal statutes that set maximum legal rates of interest for various lending situations. If a loan qualifies under more than one statute, a bank may often charge the highest rate for which the loan is eligible. Certain federal statutes partially preempt state usury laws. They remove, among other things, the state usury limitations on certain first lien residential real property loans made by certain federally related lenders including the Bank. Usury law interest ceilings can have substantial adverse effects on a bank's ability to lend money at profitable rates in periods when interest rates and costs of funds to the bank are high, both in absolute terms and relative to competitors. Moreover, because some competitors of the Bank are located outside of Texas and are subject to more favorable interest rate regulation or no interest rate regulation at all, they may be able to lend funds to potential customers of the Bank at higher rates of interest. Environmental Laws Many federal, state and local governmental authorities have enacted or adopted provisions regulating the discharge of materials into the environment and otherwise relating to the protection of the environment. In this regard, under the Comprehensive Environmental Response Compensation and Liability Act and under other laws enacted by various states and other governmental authorities, the costs of the clean-up of hazardous substances can be recovered. These laws have greatly expanded the potential liability of banks for hazardous waste clean-up costs. Management evaluates the potential liability of the Bank when considering a loan and before any action is taken to foreclose on a property. The Bank believes that it has not violated any provisions regulating the discharge of materials into the environment, and no capital expenditures are planned for environmental control facilities. Neither BTX nor the Bank has been notified that it is liable for any hazardous substance clean-up costs. Proposed Legislation Numerous other legislative proposals affecting the banking industry have been proposed from time to time. Such proposals include: nationwide branching by all categories of depository institutions; limitations on investments that an institution may make with insured funds and on permissible activities of such institutions; regulation of all insured depository institutions by a single regulatory agency or a reduction in the number of separate bank regulatory agencies; permitting ownership of banks by commercial enterprises; limitations on the number of accounts protected by the federal deposit insurance funds; reduction of the $100,000 coverage limit on deposits; and changes in the duties of depository institutions under community reinvestment laws. Any such proposals, if enacted, could materially affect the Company and the Bank by changing the regulatory environment in which they operate and/or by increasing competition for banking and financial services. It is uncertain which, if any, of the proposals may ultimately become law. Other Regulations In addition to the foregoing requirements, the OCC and the other federal bank regulatory agencies have very broad authority in supervising numerous aspects of the business of both BTX and the Bank. If BTX or the Bank were to become unable to meet applicable capital requirements or the requirements of other regulations, one or more of the federal bank regulatory agencies would have the authority to take additional supervisory actions or impose sanctions or operational and reporting requirements, some of which could adversely affect the ability of BTX and the Bank to operate profitably. GOVERNMENT FISCAL AND MONETARY POLICIES The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board. Some of the instruments of monetary policy available to the Federal Reserve Board are changes in the discount rate on member bank borrowings, the availability of borrowings at the "discount window", open market operations, the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates, and the placing of limits on interest rates that member banks may pay on time and savings deposits. These policies influence, to a significant extent, the overall growth of bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits. In the past, the monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks and, therefore, bank holding companies. Such policies are expected to continue to have a significant effect in the future. The effect, if any, of such policies on the future business and earnings of the Company and the Bank cannot be predicted. THE TEXAS ECONOMY AND BANKING INDUSTRY The banking industry and BTX are affected by general economic conditions, at both the national and state levels, such as inflation, recession, unemployment and numerous other factors beyond the Company's control. For a number of years, beginning in 1985, the Texas economy passed through a severe decline, especially in the energy and real estate sectors. All banks in Texas faced the results of the general economic downturn that affected the state and its businesses. Many of these banks were so severely affected by the significant increase in the nonperforming loans caused by this downturn that they failed. As a result, the federal regulators caused or assisted other larger banking institutions, many of them headquartered outside of Texas, to acquire the failed banks. This has markedly changed the nature of the banking industry in Texas after 1987 from a system made up of more than 1,000 unit banks, many of which were small and geared to serving a limited geographic market, to today's structure which has five or six "giants", each of which operates 50 to 300 branches, plus a small tier of banks having less than $1 billion of assets and approximately 600 small community banks each with total assets of less than $100 million. In 1993, several signs of economic improvement were noted in Texas as the unemployment rate and the number of bankruptcies and foreclosures began to decline. In addition, consumer loan demand remained strong. Prices for many types of real estate appear to have finally stabilized; others continue to lose value as a result of pressures generated as the federal regulators continue to sell the numerous parcels of real estate which they had acquired from failed financial institutions. Vacancy rates for office space in Texas are some of the highest in the nation. Although improving, the oil and gas industry continues to suffer because of the lack of a comprehensive "National Energy Policy." The defense industry in Texas which has suffered cutbacks recently appears likely to see additional budget trimming in the future. For several years Texas has experienced a diversification in its economy as technology firms have expanded or established new plants. Cutbacks in government spending such as the cancellation of the Super Collider project have dampened the recovery. In general, the Texas economy appears to be slowly improving, somewhat paralleling the national economy. The management of the Company is cautiously optimistic that economic conditions in Texas in 1994 are more likely to improve than to worsen. COMPETITION The Company and the Bank operate in an environment that has become increasingly competitive in recent years. In the past few years other financial institutions not subject to the same regulatory restrictions as banks have begun to compete more vigorously for a share of the market. In Texas, thrift institutions have been allowed to establish statewide branch offices to take deposits, while banks were not granted the ability to establish branch offices until 1988. In the past five years, large bank holding companies headquartered outside of Texas have acquired the assets of numerous sizeable Texas banks and thrifts, sometimes with financial assistance from the FDIC. These institutions have numerous advantages, including but not limited to larger capital resources, that the Company does not have. The Bank competes actively in the Houston, Dallas, and McKinney markets with other commercial banks located in Texas, and Texas-based offices of major money market center banks for various types of deposits, loans, and other financial services. In addition, in the conduct of certain aspects of its banking business, the Bank competes with insurance companies, savings and loan associations, credit unions, captive finance companies owned by motor vehicle manufacturers, leasing companies, mortgage companies, certain governmental agencies and other financial services companies. Many of the banks and other financial institutions with which the Bank competes have capital resources and legal loan limits substantially in excess of the capital resources and legal loan limits of the Bank. EMPLOYMENT On March 15, 1994, the Company and the Bank employed 170 persons, none of whom are covered by a collective bargaining agreement. The Company and the Bank consider their respective employee relations to be good. ITEM 2. ITEM 2. PROPERTIES The Company currently conducts its business from leased offices located at 13747 Montfort Drive, Dallas, Texas which contain approximately 16,000 square feet. The Bank occupies six branch locations. The Bank owns four banking facilities. The first located at 321 North Central Expressway in the City of McKinney contains 51,216 square feet, 10,751 square feet of which is occupied by the Bank and the remainder is leased to unrelated parties. The second located at 2010 North Main Street in the City of Houston contains 17,061 square feet all of which is occupied by the Bank. The third located at 2101 Gateway Drive in the City of Irving contains 7,784 square feet all of which is occupied by the Bank. The fourth located at 8820 Westheimer Road in the City of Houston contains 30,444 square feet all of which is occupied by the Bank. The Bank leases its two remaining locations: the Allen Parkway Branch in the City of Houston in a multistory office building at 2929 Allen Parkway where it occupies 4,922 square feet and a free-standing building containing 5,568 square feet located at 9605 Abrams Road in the City of Dallas. The Bank leases additional tracts of land used for parking and drive-in facilities. The Company believes that these premises are adequate for its present operations. Aggregate annual rental payments (net of rental income received by BTX and the Bank) for all premises during the fiscal year ended December 31, 1993 was $142,271. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In addition to the pending litigation described in Note 16 to the consolidated financial statements contained in BancTEXAS Group Inc.'s 1993 Annual Report to Stockholders, which is incorporated herein by reference, there are various other claims and pending actions against BTX and the Bank, which are routine and incidental to their businesses, with regard to matters arising out of the conduct of their businesses, including a number of lender liability claims filed against the Bank in defense of suits brought by the Bank to collect loans and otherwise enforce their rights under loan documents. Nevertheless, it is the opinion of management of BTX that the ultimate liability, if any, resulting from such claims and pending actions will not have a material adverse effect on the financial position, results of operations or liquidity of BTX. 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 STOCK AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION BTX has one class of stock, its common stock par value $.01 per share (the "Common Stock"). The Common Stock is listed on the New York Stock Exchange (NYSE) under the symbol "BTX". Continued listing on the NYSE of the Common Stock is subject, among other things, to the financial eligibility and distribution requirements of the NYSE. Set forth below are the closing high and low sale prices for the Common Stock on the NYSE as reported by the NYSE Composite Transactions Tape during the calendar periods indicated. These prices are in dollars and are recorded to the nearest 1/16. STOCKHOLDERS There were approximately 6,200 holders of record of Common Stock as of March 1, 1994. This number does not include individual participants in security position listings such as those held by clearing agencies. DIVIDENDS In January 1985, the Board of Directors of BTX suspended payment of the quarterly dividends on the Common Stock. As a bank holding company, BTX's ability to pay dividends is a function of regulatory requirements and the dividend payments received by it from the Bank. The Company is currently restricted from paying any dividends due to a deficiency in retained earnings and pursuant to the FDIC Agreement. See "Item 1. BUSINESS -- Significant Developments in 1993." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is incorporated herein by reference from Table 1 on page 5 of BTX's 1993 Annual Report to Stockholders "Management's Discussion and Analysis of Financial and Results of Operations" under the caption "Results of Operations." 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 from pages 4 through 27 of BTX's 1993 Annual Report to Stockholders under the caption "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 this item is incorporated herein by reference from pages 29 through 60 of BTX's 1993 Annual Report to Stockholders under the captions "Consolidated Balance Sheets," "Consolidated Statements of Operations," "Consolidated Statements of Changes in Stockholders' Equity," "Consolidated Statements of Cash Flows," "Notes to Consolidated Financial Statements," "Independent Auditors' Report" and "Quarterly Consolidated Statements of 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 BOARD OF DIRECTORS Each member of the Board of Directors serves until the next Annual Meeting of Stockholders or until his successor has been duly elected and qualified. The Board of Directors of BTX as of March 15, 1994 was as follows: Richard L. Brown, 55, has been the President and Chief Executive Officer of Houston General Insurance Group Inc. in Fort Worth, Texas since 1986. Mr. Brown has served as a director of BTX since July 1987. Nathan C. Collins, 59, was elected Chairman of the Board, President and Chief Executive Officer of BTX effective November 1, 1987. Prior to that time, Mr. Collins served in various executive capacities with Valley National Bank of Arizona, including Executive Vice President, Manager of Asset/Liability Management Group and Senior Credit Officer. Mr. Collins has served as a director of BTX since November 1987. Charles A. Crocco, Jr., 55, has been a partner in the law firm of Lunney, Crocco, DeMaio & Camardella, P.C., in New York City since 1968. He is a director of The Hallwood Group Incorporated (merchant banking) since January 1981 and a director of Showbiz Pizza Time, Inc. (restaurant chain) since January 1988. Mr. Crocco has served as a director of BTX since April 1988. Joseph J. Leszczynski, 62, has been Chairman of the Board of T.E.L. Associates, Inc. (management consulting) since December 1990; from April 1986 until December 1990 he was the Chairman of the Board and Chief Executive Officer of Optic-Electronics Corporation (night vision devices). Mr. Leszczynski has served as a director of BTX since July 1987. Thomas A. Stanzel, 64, who lives in Dallas, Texas is a private investor. Mr. Stanzel has served as a director of BTX since July 1987. Edward T. Story, Jr., 50, is President and Chief Executive Officer of SOCO International, Inc., a majority-owned subsidiary of Snyder Oil Corporation, engaged in international oil and gas operations since August 1991; from August 1990 until August 1991, he was Chairman of Thaitex Petroleum Company (oil and gas exploration and production); from August 1981 to August 1990, he was Vice Chairman and Chief Financial Officer of Conquest Exploration Company (oil and gas exploration and production). He has served as a director of Hi-Lo Automotive, Inc. (auto parts) since 1987. Mr. Story has served as a director of BTX since July 1987. EXECUTIVE OFFICERS The executive officers of the Company as of March 15, 1994, were as follows: Nathan C. Collins, 59, was elected Chairman of the Board, President and Chief Executive Officer of the Company effective November 1, 1987. Since November 1987, Mr. Collins has served as Chairman of the Board of the Bank and its predecessors. In April 1992 he was elected President and Chief Executive Officer of the Bank. Prior to 1987, Mr. Collins served as an executive officer of Valley National Bank of Arizona for more than ten years. Richard H. Braucher, 57, was elected Senior Vice President of the Company in July 1981. Prior to that time, Mr. Braucher served as a Vice President of the Company in addition to his present role as both General Counsel to and Secretary of the Company and the Bank. Mr. Braucher has been with the Company since 1979. D. Kert Moore, 46, joined the Company in January 1983. Mr. Moore served as Senior Vice President, Controller and Cashier of BancTEXAS Dallas from October 1985 until January 1990. Mr. Moore was elected Controller, Treasurer and Chief Accounting Officer of BancTEXAS Group in February 1990. He was elected Chief Financial Officer of BTX in April 1992. He has also served as Senior Vice President and Controller of the Bank since 1990 and was elected Chief Financial Officer and Cashier of the Bank in April 1992. SENIOR MANAGEMENT The senior management of the Bank as of March 15, 1994, included: Nathan C. Collins, 59, was elected Chairman of the Board of the Bank (and its predecessors) in November 1987. In April 1992 he was elected President and Chief Executive Officer of the Bank. David F. Weaver, 46, served as President and Chief Executive Officer of BancTEXAS Houston N.A. from January 1988 until April 1992. In April 1992 he was elected a Regional President of the Bank. Prior to 1988, Mr. Weaver served as an executive officer of Valley National Bank of Arizona for more than ten years. Allen R. Sanderson, 41, served as President and Chief Executive Officer of BancTEXAS McKinney from September 1990 until April 1992. In April 1992 he was elected a Regional President of the Bank. Mr. Sanderson was a Vice President of Hibernia National Bank in Texas from January 1990 to September 1990 and a Vice President of BancTEXAS Dallas from September 1988 to January 1990. Kathryn Aderman, 48, joined BTX in February 1991 as Vice President for Administration of the Bank. She was elected to the additional position of Director of Human Resources of the Bank in October 1991. Prior to joining the Bank, she was employed in various capacities by Team Bank, Houston and its predecessors for 17 years. Richard H. Braucher, 57, was elected a Senior Vice President of the Bank in 1981. He has also served as General Counsel to and Secretary of the Bank since 1979. Jerry V. Garrett, 53, joined BTX in April 1988 as Senior Vice President for Consumer Lending and held that title until March 1992. He has served since April 1988 as President of BancTEXAS Services Inc. (which is now a subsidiary of the Bank) and since February 1990 as a Senior Vice President of the Bank in charge of consumer lending. Patrick H. Hazelip, 35, joined BTX in June 1986. He served as Director of Audit from June 1986 until August 1990. From August 1990 until March 1992 he served as Vice President and General Auditor of the Company. In March 1992 he was elected Vice President and General Auditor of the Bank. Dennis J. Lewis, 42, joined BTX in March 1989. From March 1989 until February 1992 he was a Senior Vice President of BTX. He was elected a Senior Vice President of the Bank in charge of operations in March 1992. Since March 1989 he has been Executive Vice President of BancTEXAS Services Inc. Prior to that time, Mr. Lewis was a Vice President of First City Savings Association from March 1988 to March 1989. D. Kert Moore, 46, has served as a Senior Vice President and Controller of the Bank and its predecessors since 1985. He has also served as Chief Financial Officer and Cashier of the Bank since April 1992. James W. Parmley, 51, joined the Bank in May 1988 as Vice President and Manager of Dealer Finance. In July 1990 he was also named Manager of Consumer Lending. John G. Sprengle, 36, joined BancTEXAS Dallas as a Vice President in January 1988 and served in that position until January 1990. Mr. Sprengle served as a Senior Vice President and Chief Credit Officer of the Company from February 1990 until December 1991. He has served as a Senior Vice President and Chief Credit Officer of the Bank since February 1990. Roger M. Storkamp, 46, joined BTX in October 1987. From October 1987 until February 1989, he was a Vice President of BancTEXAS Dallas. From February 1989 until February 1990, he served as Vice President and Manager of Commercial Loan Operations for BancTEXAS Services. Mr. Storkamp served as Senior Vice President - Loan Review of the Company from February 1990 until December 1991. He has served as a Senior Vice President of the Bank since January 1992. FAMILY RELATIONSHIPS There is no family relationship between any of the directors and any executive officer of BTX or its subsidiaries. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth certain information regarding compensation earned during the year ended December 31, 1993, and specified information with respect to the two preceding years, to the chief executive officer and each of the four other most highly compensated executive officers of BTX, as determined based upon salary and bonus earned during 1993. SUMMARY COMPENSATION TABLE FOR YEAR ENDED DECEMBER 31, 1993 ____________________ (1) No response is required for years prior to 1992. For 1993 the total of all other annual compensation for each of the named officers is less than the amount required to be reported, which is the lesser of (a) $50,000 or (b) ten percent (10%) of the total of the annual salary and bonus paid to that person in 1993. (2) No response is required for years prior to 1992. All items reported are BTX's matching contribution to the 401(k) Plan for the year indicated except that in 1992 the total for Mr. Weaver is comprised of $1,592 as relocation assistance to cover mortgage rate differential and $1,350 as BTX's contribution to the 401(k) Plan. OPTION GRANTS DURING 1993 The following table is for the purpose of providing information pertaining to options granted, if any, to each of the named executive officers during the year ended December 31, 1993. OPTION/SAR GRANTS TABLE OPTION EXERCISES DURING 1993 AND YEAR-END OPTION VALUES The following table indicates the number of options, if any, exercised by the named executive officers during the year ended December 31, 1993 and the number and value of options held as of December 31, 1993. BTX does not have any outstanding stock appreciation rights. OPTION EXERCISES AND YEAR-END VALUE TABLE ____________________ (1) Value realized is before applicable taxes, based on the difference between the exercise price and the closing prices on the dates of exercise. There is no Long-Term Incentive Plan Awards Table in this Report because BTX does not currently have a plan of that nature. DIRECTOR COMPENSATION During 1993 each director of BTX (except Mr. Collins who was not paid for his service as a director) was paid $5,000 as an annual retainer and was paid $750 for each meeting of the Board of Directors which he attended. In addition, the chairman of each committee was paid an annual retainer of $2,000 and each member of a committee was paid $500 for each committee meeting which he attended. Also, directors traveling more than 75 miles to attend a meeting were reimbursed for their actual travel expenses. On September 5, 1990, the Company entered into a consulting agreement with Director Edward T. Story, Jr., whereby he is, when requested by the Chairman of the Board, obligated to assist with certain capital formation projects. Pursuant to this agreement Mr. Story was paid $1,000 in 1992 and zero in 1993. BTX EMPLOYEE BENEFIT PLANS BTX maintains various employee benefit plans. Directors are not eligible to participate in such plans (except the 1990 Stock Option Plan) unless they are also employees of BTX or one of its subsidiaries. PENSION PLAN. The BancTEXAS Group Inc. and Subsidiaries' Employees Retirement Plan (the "Pension Plan") is a noncontributory, defined benefit plan for all eligible officers and employees of BTX and its subsidiaries. Benefits under the Pension Plan are based upon annual base salaries and years of service and are payable only upon retirement or disability and, in some instances, at death. An employee is eligible to participate in the Pension Plan after completing one year of employment if he or she was hired before attaining age 60, is at least 21 years of age and worked 1,000 hours or more in the first year of employment. A participant who has fulfilled the eligibility and tenure requirements will receive, upon reaching the normal retirement age of 65, monthly benefits based upon average monthly compensation during the five consecutive calendar years out of his or her last ten calendar years that provided the highest average compensation. BTX utilizes the unit-credit cost method to compute its annual contribution requirements under the Pension Plan. Under this method, past-service costs are aggregated to determine the total past-service cost of the Pension Plan. The excess of the total past-service cost over the assets of the Pension Plan equals BTX's unfunded past-service cost, which is funded over a period of years in accordance with regulations of the Internal Revenue Service. Because this method determines Pension Plan costs in the aggregate, costs have not been allocated to the individuals in the Cash Compensation Table. Effective December 1, 1986, the Board of Directors of BTX amended the Pension Plan to provide: (1) that all persons in the Pension Plan would be vested with the number of service years actually credited by December 31, 1986, regardless of the number of years they had participated in the plan; and (2) that all persons qualifying to participate in the Pension Plan after December 1, 1986, would become 100% vested after five years of service. The following table sets forth, based upon certain assumptions, the approximate annual benefits payable under the Pension Plan at normal retirement age to persons retiring with the indicated average base salaries and years of credited service: ____________________ (1) These benefits are not subject to deduction for social security, but are subject to withholding for federal income tax purposes. (2) Maximum annual retirement income of $115,641 is permitted under section 415 of the Internal Revenue Code, as amended. Under section 401A17, the maximum compensation allowed for retirement benefit computations is $235,840. The amount of current annual covered compensation and the credited years of service under the Pension Plan at December 31, 1993, for each of the five most highly compensated executive officers of BTX set forth above in the Compensation Table are as follows: EMPLOYMENT AGREEMENT In 1987 Nathan C. Collins ("Collins") entered into an employment agreement with BTX to serve as the Chairman of the Board, President and Chief Executive Officer of BTX for the period from November 1, 1987 to January 2, 1991. For services rendered under the agreement, Collins received an annual salary of $250,000, a bonus of $100,000 for 1988 payable on January 2, 1989, use of an automobile, and reimbursement of reasonable business expenses. He also participated in all benefits provided generally to employees of BTX. As additional compensation, in 1987 BTX granted to Collins 109,500 shares of Common Stock as a stock grant and options to purchase 109,500 shares of Common Stock. These options were canceled in 1990. The agreement also provides that BTX will indemnify and advance expenses to Collins to the maximum extent permitted by applicable law with respect to any legal proceedings arising from his employment, provided his conduct meets specified standards. Prior to the expiration of its stated term, the agreement will terminate upon death or disability and may be terminated by Collins, by BTX with or without cause or upon request by any regulatory authority with specified severance arrangements. In 1990 the Board of Directors of BTX entered into a restatement and extension of the 1987 employment agreement with Collins. Under this contract, Collins' employment was extended through January 2, 1993, at an annual salary of $250,000. As additional compensation, Collins was granted options to purchase 1,000,000 shares of Common Stock at an exercise price of 25 cents per share, the fair market value at the date of grant. In May of 1991 the Board of Directors, in order to insure that BTX would continue to have Mr. Collins' service and leadership for several reasons, including the need to complete the Company's financial turnaround and to facilitate its search for additional capital, amended his employment agreement to provide that the term shall be automatically extended each month so that at all times the remaining term is 24 months. The contract was also amended to provide that Collins will be paid a bonus for any year in which the Company has positive operating earnings or meets other predetermined objectives established by the Board of Directors. Usually the bonus will be equal to 5% of the Company's net operating earnings as determined by the Board but other factors may be used in making the final determination. Nevertheless, under no circumstances can the bonus in any one year exceed $100,000. Pursuant to this contract, Collins was paid a bonus of $25,000 in 1992 with respect to BTX's 1991 results, $23,200 in 1993 with respect to BTX's 1992 results, and zero in 1994 with respect to BTX's 1993 results. The Board of Directors has also established a depository agreement with an independent trust company whereby the Company has deposited approximately $150,000 of U.S. Government securities with that trust company to insure that the Company will honor its obligation to pay severance to Mr. Collins in the event that the Company were to terminate his contract prematurely. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, as of December 31, 1993, certain information with respect to the beneficial ownership of the Common Stock of BTX by each person known to the Company to be the beneficial owner of more than five percent of the outstanding Common Stock and by each director and by all officers and directors of BTX as a group: ____________________ * Less than one-half of one percent. (1) Includes shares subject to vested stock options granted under the 1990 Stock Option Plan. 100% of the options granted in 1990 are vested and could be exercised at any time by the optionee. (2) Brown has a vested option covering 100,000 shares; he owns directly 8,525 shares. (3) Collins has a vested option covering 900,000 shares; he owns directly 71,600 shares. (4) Crocco has a vested option covering 100,000 shares; he owns directly 9,100 shares. (5) Leszczynski has a vested option covering 75,000 shares; he owns directly 8,000 shares. (6) Stanzel has a vested option covering 100,000 shares; he owns directly 15,500 shares. (7) Story has a vested option covering 100,000 shares; he owns directly 7,750 shares. (8) Braucher has a vested option covering 50,000 shares; he owns directly 413 shares. (9) Moore has a vested option covering 27,250 shares. (10) Weaver has a vested option covering 75,000 shares; he owns directly 400 shares. (11) Garrett has a vested option covering 45,000 shares. (12) Sprengle has a vested option covering 61,000 shares. (13) Calculated including all shares issued and shares subject to vested stock options. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Bank had, during the period from January 1, 1993 to December 31, 1993, and expects to have in the future, loan transactions in the ordinary course of business with directors of BTX and its affiliates. Management believes that these loan transactions have been and will be on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated persons and did not involve more than the normal risk of collection or present unfavorable features. At December 31, 1993 such loans totalled $46,000 and represented 0.30% of stockholders' equity. None of the indebtedness has been classified in any manner by regulatory authorities or charged-off by the Bank. The Bank does not extend credit to officers of BTX or the Bank except extensions of credit secured by mortgages on personal residences, loans to purchase automobiles and personal credit card accounts. Certain of the directors and officers of BTX and its affiliates have deposit accounts with the Bank. It is the policy of the Bank not to permit any officers or directors of BTX or its affiliates to overdraw their respective deposit accounts unless that person has been previously approved for overdraft protection under a plan whereby a credit limit has been established in accordance with the Bank's standard credit criteria. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. Financial Statements and Supplementary Data: The financial statements filed as part of this report are listed under Item 8. 2. Financial Statement Schedules: These schedules are omitted for the reason that they are not required or are not applicable. 3. Exhibits: The exhibits are listed in the index of exhibits required by Item 601 of Regulation S-K at Item (c) below and included on pages 25 to 26, which is incorporated herein by reference. (b) Reports on Form 8-K No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) The index of required exhibits is included beginning on page 25 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. BancTEXAS Group Inc. By /s/ Nathan C. Collins ------------------------------ Nathan C. Collins Chairman of the Board, President and Chief Executive Officer 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 date indicated. INDEX TO EXHIBITS Exhibit No. Description ----------- ----------- 3(a) - Restated Certificate of Incorporation of the Company dated August 19, 1993 and filed August 30, 1993 (filed as Exhibit 3(a) to the Company's Form 10-Q for the quarter ended September 30, 1993 and incorporated herein by reference). 3(b) - Amended Bylaws of the Company (filed as Exhibit 3.9 to the Company's Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated herein by reference). 4(a) - Indenture, dated as of May 15, 1981, among CSWI International Finance N.V., the Company and Bankers Trust Company (will be filed upon request pursuant to Item 601(b)(4)(iii) of Regulation S-K). 4(b) - Specimen Stock Certificate for Common Stock (filed as Exhibit 1.01 to the Company's Amendment No. 1 to Form 8-A on Form 8, dated September 4, 1987, and incorporated herein by reference). 10(a) - Form of Stock Purchase Agreement, dated as of December 3, 1984, by and between the Company and each of the Purchasers (filed as Exhibit 10.22 to the Company's Annual Report on Form 10-K for the year ended December 31, 1984, and incorporated herein by reference). 10(b)* - BancTEXAS Group Inc. 1990 Stock Option Plan (as amended July 22, 1993) filed as Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference). 10(c) - Agreement Concerning Subsidiary Banks dated as of November 30, 1990, executed by and between the Federal Deposit Insurance Corporation and the Company (filed as Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference). 10(d) - Agreement Concerning Warrants dated as of November 30, 1990, executed by and between the Federal Deposit Insurance Corporation and the Company (filed as Exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference). 10(e)* - Restatement and Extension of Employment Agreement, dated August 16, 1990 between the Company and Nathan C. Collins (filed as Exhibit 10(j) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference). INDEX TO EXHIBITS - (CONTINUED) Exhibit No. Description ----------- ----------- 10(f)* - Amendment to Executive Employment Agreement with Nathan C. Collins dated May 1, 1991 (filed as Exhibit 10(k) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference). 10(g)* - Depository Agreement between Brown Brothers Harriman & Co. and the Company dated November 30, 1992 (filed as Exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10(h)* - BancTEXAS Group Inc. Directors' Retirement Plan dated March 18, 1993 (filed as Exhibit 10(i) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 and incorporated herein by reference). 10(i)* - Deferred Compensation Agreement with Nathan C. Collins dated April 22, 1993 (filed as Exhibit 10(j) to the Company's Quarterly Report of Form 10-Q for the quarter ended March 31, 1993 and incorporated herein by reference). 10(j)* - 1993 Directors' Stock Bonus Plan (filed as Exhibit 10(k) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 and incorporated herein by reference). 10(k) - Settlement Agreement by and among the Company, Edward Nash, American Equitable Life Insurance Co., Dalcon, Inc., James Hammond, Curtis Leggett, Delwin W. Morton, Charles C. Rush, Charles W. Seeds, Jr., Charles J. Wilson and Robert A. Yarber, and related Releases (filed as Exhibit 10(k) to the Company's Registration Statement No. 33- 51801 on Form S-2, dated January 5, 1993 and incorporated herein by reference). 11 - Computation of Earnings (Loss) per share - filed herewith. 13 - 1993 Annual Report to Stockholders is combined with this Annual Report on Form 10-K and is not filed as an exhibit but is filed herewith. 21 - Subsidiaries of the Company - filed herewith. _______________ * Exhibits designated by an asterisk in this Index to Exhibits relate to management contracts and/or compensatory plans or arrangements.

714310_1993.txt

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1993

714310

Item 1. BUSINESS a) GENERAL DESCRIPTION OF BUSINESS VALLEY NATIONAL BANCORP Valley National Bancorp (Valley) is a bank holding company organized on May 2, 1983, under the laws of the State of New Jersey and registered with the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956. Its principal business activities are restricted to those permissible by Bank Holding Companies under the Bank Act of 1956, as amended, and include the management and control of Valley National Bank (VNB). As of December 31, 1993, Valley's subsidiaries operated 59 full service banking branches located throughout northern New Jersey. RECENT DEVELOPMENTS On June 18, 1993, Valley issued approximately 421,000 shares of its common stock at a cost of $10,962,000 in exchange for approximately 661,000 shares of common stock of PeoplesBancorp ("Peoples") of Fairfield, New Jersey, a New Jersey Corporation and a registered bank holding company of Peoples Bank, National Association, a banking association. The merger was accounted for under the purchase method of accounting. The acquisition of Peoples resulted in the following statement of condition increases as of the acquisition date: Investment securities.............................................$ 47,472,000 Loans, net of unearned income.....................................$138,459,000 Total deposits....................................................$204,825,000 SUBSIDIARIES VNB, a wholly-owned subsidiary of Valley, is a national association established in 1927 under the laws of the United States. VNB provides a full range of commercial and retail bank services, including the acceptance of demand, savings and time deposits; extension of consumer, real estate, S.B.A. and other commercial credits; and offers full personal and corporate trust services, as well as pension and other fiduciary services. VNB operates 59 full service branch offices in five (5) New Jersey Counties. Valley Investment Corporation, a wholly-owned subsidiary of VNB, was organized on December 27, 1984, under the laws of the State of Delaware. Its business activities include holding, maintaining, and managing tangible investment assets. These assets include a tax-exempt money market fund, state and municipal bonds, U.S. Treasury Notes, U.S. Agency Bonds,mortgage-backed securities and mortgages secured by real estate situated outside of the State of Delaware. VNB Mortgage Services, Inc., a wholly-owned subsidiary of VNB, was organized on March 28,1989, under the laws of the State of New Jersey. Its primary business activities include servicing residential mortgage loan portfolios for VNB and various investors. BNV Realty Incorporated, a wholly-owned subsidiary of VNB, was organized on August 16, 1991, under the laws of the state of New Jersey. Its primary business activities are limited to holding and disposing of real estate VNB may acquire as other real estate owned. VN Investment Inc., a wholly-owned subsidiary of VNB, was organized on October 28, 1993,under the laws of the State of New Jersey. Its business activities include holding,maintaining, and managing tangible investment assets. These assets include U.S. Agency Bonds and mortgage-backed securities. Mayflower Financial Corporation ("Mayflower") is a savings and loan holding company for Mayflower Savings Bank, S.L.A., (MSB) a New Jersey-chartered stock savings bank, which operated two (2) full-service offices located in Livingston, New Jersey. Mayflower was incorporated in April 1988, under the laws of the State of Delaware, as a stock corporation,at the direction of the Board of Directors of MSB for the purpose of becoming company which would own all of the outstanding capital stock of MSB upon its conversion from the mutual-to-stock form of organization. MSB was organized in 1921 as a New Jersey chartered mutual savings and loan association. MSB converted to the stock form of organization and sold all of its outstanding capital stock to Mayflower in August 1988. Valley acquired Mayflower and MSB as of December 31, 1990. As of the close of business, January 31, 1993, Mayflower Financial Corporation ("Mayflower") and its wholly-owned savings and loan subsidiary, Mayflower Savings Bank ("MSB") were merged into Valley and VNB, respectively. COMPETITION Vigorous competition for loans and deposit accounts exists in all the major areas where Valley, or any of its subsidiary companies are presently engaged in business. Competition for banking services is based on price, product type, service quality and convenience of location. VNB and its subsidiaries compete with other commercial banks, other financial institutions such as savings banks, savings and loan associations, mortgage companies, leasing companies, finance companies and a variety of financial service and advisory companies. EMPLOYEES At year-end 1993, VNB and its subsidiaries employed 1,081 full-time equivalent persons.Management considers relations with employees to be satisfactory. SUPERVISION AND REGULATION Valley and VNB are subject to regulation and supervision by federal bank regulatory agencies. Valley is regulated and examined by the Federal Reserve Board and VNB is regulated and examined by the Comptroller of the Currency. There are a variety of statutory and regulatory restrictions governing the relations among Valley and VNB. The payment of dividends by VNB to Valley is restricted under the National Bank Act. The approval of the Comptroller of the Currency is required if the dividends for the year exceed the net profits, as defined in the Act, of that year plus the retained net profits for the preceding two years. In addition, a national bank's capital surplus must be equal to or exceed the stated capital for its common stock, or else the bank must make certain transfers from retained earnings to capital surplus. The Banking Affiliates Act of 1982 severely restricts loans and extensions of credit by VNB to Valley and its 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 VNB to Valley and its affiliates in the aggregate may not exceed 20% of VNB's capital stock and surplus and, singly to Valley or any affiliate, may not exceed 10% of VNB's capital stock and surplus. Similarly, the Banking Affiliates Act of 1982 also restricts VNB in the purchase of securities issued by, the acceptance as loan collateral of securities issued by, the purchase of assets from, and the issuance of a guarantee or standby letter-of-credit on behalf of, Valley or any of its affiliates. Under the Bank Holding Company Act, Valley may not acquire directly or indirectly more than 5% of the voting shares of, or substantially all of the assets of, any bank without the prior approval of the Federal Reserve Board. Valley cannot acquire any bank located outside New Jersey unless the law of such other state specifically permits the acquisition. As of January 1, 1988, New Jersey law permits 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 banking organizations in that state on substantially the same terms and conditions applicable to banking acquisitions solely within the state). Generally, the Bank Holding Company Act limits the business of a bank holding company and its affiliates to banking, managing or controlling banks, and furnishing or performing services for banks controlled by the holding company. The major exception to this rule is that a bank holding company directly or through a subsidiary may engage in non-banking activities which the Federal Reserve Board has determined to be so closely related to banking or managing or controlling banks so as to be a proper incident thereto. The Federal Reserve under its Regulation "Y" has restricted such activities to things such as lease financing, mortgage banking, investment advice, certain data processing services and discount brokerage services and ownership of a savings and loan association. The Federal Reserve Board, the Office of the Comptroller of the Currency ("OCC") and the FDIC have issued risk-based capital guidelines for U.S. banking organizations. The objective of these efforts was to provide a more uniform capital framework that is sensitive to differences in risk profiles among banking companies. Below is a list of such requirements and shows Valley and VNB's ratios as of December 31, 1993. Valley regulatory VNB regulatory capital capital Regulatory ($ in thousands) Amount Percent(1) Amount Percent(1) capital percent(2) Risk based capital: Tier-one capital $258,622 13.93% $231,709 12.57% 6.00% Tier-one & Tier two capital $281,918 15.18% $254,904 13.83% 10.00% Tier-one leverage $260,269 7.62% $232,328 6.86% 3.00-5.00% (1) Ratio of qualifying capital to consolidated total risk-adjusted assets. (2) For qualification as a well-capitalized institution. On August 9, 1989, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") was enacted. FIRREA established new capital standards and enhanced regulatory oversight of the thrift industry. Under FIRREA, banks are now permitted to acquire all thrifts and may convert such acquired thrifts into commercial bank branches. In such a conversion the thrift may have to pay insurance fund exit and entrance fees to the FDIC. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted in December 1991. FDICIA identifies the following capital standard categories for financial institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. 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 institutions'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 FDIC has adopted many of these regulations. The deposits of VNB are insured up to applicable limits by the FDIC. Accordingly, VNB is subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") of the FDIC. Pursuant to FDICIA, the FDIC established 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. Under the risk-based assessment system, each BIF member institution is assigned to one of nine assessment risk classifications based on its capital ratios and supervisory evaluations. The lowest risk institutions presently pay deposit insurance at a rate of .23% of domestic deposits while the highest risk institutions are assessed at the rate of .31% of domestic deposits. Each institution's classification under the system is reexamined semiannually. In addition, the FDIC is authorized to increase or decrease such rates on a semiannual basis. The Bank presently pays a premium of .23%. b) STATISTICAL INFORMATION AND ANALYSIS The following information is being presented pursuant to requirements of SEC Guide 3, "Statistical Disclosure by Bank Holding Companies". I. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL A. AVERAGE BALANCE SHEETS - are incorporated by reference under the caption "Analysis of Average Assets, Liabilities and Shareholders' Equity and Net Interest Earnings on a Tax Equivalent Basis" on page 22 of the 1993 Annual Report to Shareholders. B. NET INTEREST EARNINGS AND INTEREST RATE ANALYSIS - are incorporated by reference under the caption "Analysis of Average Assets, Liabilities and Shareholders' Equity and Net Interest Earnings on a Tax Equivalent Basis" on page 22 of the 1993 Annual Report to Shareholders. C. ANALYSIS OF NET INTEREST EARNINGS, VOLUME AND RATE VARIANCE - are incorporated by reference under the caption "Change in Interest Income and Expense on a Tax Equivalent Basis" on page 23 of the 1993 Annual Report to Shareholders. II. INVESTMENT PORTFOLIO A. BOOK VALUE - The following tables set forth the book value of Valley's different types of investment securities over the last three years: INVESTMENT SECURITIES HELD TO MATURITY December 31 ($ in thousands) 1993 1992 1991 Government agencies and corporations... $ 75,106 $ 118,778 $ 353,645 Obligations of state and political subdivisions......................... 283,805 222,396 184,856 Mortgage-backed securities............. 579,839 744,625 667,364 Other securities....................... 1,243 1,954 10,223 INVESTMENT SECURITIES AVAILABLE FOR SALE December 31 ($ in thousands) 1993 1992 1991 U.S. Treasury securities and other government agencies and corporations....$ 184,019 $ 305,118 $ -- Mortgage-backed securities............... 256,417 24,783 -- Equity securities...................... 1,046 871 -- B. MATURITIES AND AVERAGE WEIGHTED YIELDS - are incorporated by reference under the caption "Maturity Distribution of Investment Securities" on page 24 of the Annual Report to Shareholders. C. SECURITIES OF A SINGLE ISSUER EXCEEDING TEN PERCENT OF SHAREHOLDERS' EQUITY - As of December 31, 1993, there were no securities, in the name of any one issuer, exceeding 10% of shareholders' equity, except for securities issued by the United States and its political subdivisions and agencies. III. LOAN PORTFOLIO A. TYPES OF LOANS - The following table sets forth Valley's different types of loans over the past five years: ($ in thousands) 1993 1992 1991 1990 1989 Commercial, financial and agricultural.............. $209,657 $ 218,789 $ 251,781 $ 320,778 $ 314,323 Real estate - construction.. 63,096 58,077 76,327 90,333 101,299 Real estate - commercial....387,503 306,167 290,038 262,848 262,970 Real estate - residential...597,423 508,308 373,884 368,676 269,620 Loans to individuals........528,616 428,828 389,293 410,443 404,684 1,786,295 1,520,169 1,381,323 1,453,078 1,352,896 Loans held for sale......... 16,905 -- -- -- -- Less: Unearned income...... (1,200) (226) (987) (1,339) (812) Loans, net of unearned income.............. 1,802,000 1,519,943 1,380,336 1,451,739 1,352,084 Less: Allowance for possible loan losses. (35,205) (28,772) (21,937) (15,921) (8,925) $1,766,795 $1,491,171 $1,358,399 $1,435,818 $1,343,159 Efforts are made to maintain a diversified portfolio as to type of borrower and loan to guard against a downward turn in any one economic sector. B. MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES - The following table sets forth Valley's commercial loans and real estate construction loans as of December 31, 1993: 1 Yr. Over 1 Over ($ in thousands) or less to 5 Yrs. 5 Yrs. Total Commercial, financial & agricultural-fixed rate....... $ 3,911 $ 27,545 $ 13,438 $ 44,894 Commercial, financial & agricultural-adjustable rate.. 64,054 32,422 68,287 164,763 Real estate construction - fixed rate.................... -- 194 -- 194 Real estate construction - adjustable rate............... 35 884 21,665 5,353 62,902 The majority of payments due after 1 year represent loans with floating interest rates. Prior to maturity of each loan, Valley generally conducts a review which normally includes an analysis of the borrower's financial condition and, if applicable, a review of the adequacy of collateral. A rollover of the loan at maturity may require a principal paydown. C. RISK ELEMENTS 1.NON ACCRUAL, PAST DUE AND RESTRUCTURED LOANS - The following table sets forth Valley's problem loans for each of the past five years: ($ in thousands) 1993 1992 1991 1990 1989 Loans on non-accrual basis...$ 18,535 $ 21,371 $ 25,837 $ 19,713 $ 2,414 Loans past due in excess of 90 days and still accruing. 8,498 11,096 10,506 7,640 6,205 $ 27,033 $ 32,467 $ 36,343 $ 27,353 $ 8,619 The amount of interest income that would have been recorded on non-accrual loans in 1993 had payments remained in accordance with the original contractual terms approximated $2,158,000, while the actual amount of interest income recorded on these types of assets in 1993 totalled $439,000, resulting in lost interest income of $1,719,000. Loans are generally placed on a non-accrual status when they become past due in excess of 90 days as to payment of principal or interest. Exceptions may be made if the loan is sufficiently collaterized and in the process of collection. Additionally, loans may be transferred to non-accrual before they are past due more than 90 days if, in management's judgment, the ultimate collectiblity of the interest is doubtful. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection and all past due amounts have been collected. Generally, all accrued but unpaid interest at the date a loan is placed on a non-accrual status is reversed against current earnings unless the aggregate amount of the principal outstanding and accrued interest on the loan is sufficiently supported by the value of the underlying collateral. Subsequent payments received on non-accrual loans are applied as a reduction of principal amounts outstanding. 2. POTENTIAL PROBLEM LOANS - Although substantially all risk elements at December 31, 1993 have been disclosed in the categories presented above, Management believes that the current economic conditions may affect the ability of certain borrowers to comply with the contractual repayment terms on certain real estate and commercial loans. As part of the analysis of the loan portfolio by management, it has been determined that there are approximately $46.8 million in potential problem loans at December 31, 1993 which have not been classified as non-accrual, past due or restructured. Potential problem loans are defined as performing loans for which management believes that the borrower's ability to repay the loan may be impaired. Of this total $5.3 million of loans were acquired in the Peoples merger. $38.0 million of these loans are considered to be adequately collaterized and supported by personal guarantees. Approximately $3.1 million has been provided for in the allowance for loan losses for these potential problem loans. There can be no assurance that Valley has identified all of its problem loans. At December 31, 1992, Valley had identified approximately $30.7 million of problems loans. 3. FOREIGN OUTSTANDINGS - None. 4. LOAN CONCENTRATIONS - There were no loan concentrations at December 31, 1993 other than those disclosed in section III A. above. Valley's lending activities are primarily concentrated within the northern section of New Jersey. For additional information, see Loan Portfolio on page 25 of the 1993 Annual Report to Shareholders. D. OTHER INTEREST BEARING ASSETS - None. IV.SUMMARY OF LOAN LOSS EXPERIENCE - The following table sets forth the relationship amongloans, loans charged-off and loan recoveries, the provision for loan losses and the allowance for loan losses for the past five years: The allowance for possible loan losses is maintained at a level necessary to absorb potential loan losses and other credit risk related charge-offs. It is the result of an analysis which relates outstanding balances to expected reserve levels required to absorb future credit losses. Current economic problems are addressed through management's assessment of anticipated changes in the regional economic climate, changes in composition and volume of the loan portfolio and variances in levels of classified loans, non-performing assets and other past due amounts. Additional factors include consideration of exposure to loss including size of credit, existence and nature of collateral, credit record, profitability and general economic conditions. The following table summarizes the allocation of the allowance for loan losses to specific loan categories for the past five years: ($ in thousands) Years Ended December 31, 1993 1992 1991 Percent Percent Pecent of Loans of Loans of Loans Category Category Category Allowance to Total Allowance to Total Allowance to Total Allocation Loans Allocation Loans Allocation Loans Loan category: Commercial, financial and agricultural...... $ 10,352 16.9% $ 8,364 14.3% $ 9,850 18.1% Real estate............. 6,312 47.6% 5,054 57.4% 4,681 53.6% Consumer................ 6,562 35.5% 4,916 28.3% 3,967 28.3% Unallocated............... 11,979 N/A 10,438 N/A 3,439 N/A $ 35,205 100.0% $ 28,772 100.0% $ 21,937 100.0% 1990 1989 Percent Percent of Loan of Loan Category Category Allowance to Total Allowance to Total Allocation Loans Allocation Loans Loan category: Commercial, financial and agricultural......$ 7,791 22.1% $ 5,015 23.2% Real estate............. 3,679 49.6% 793 46.9% Consumer................ 2,749 28.3% 1,715 29.9% Unallocated............... 1,702 N/A 1,402 N/A $ 15,921 100.0% $ 8,925 100.0% For additional information, see Asset Quality and Risk Elements on page 20 of the 1993 Annual Report to Shareholders. Net charge-offs decreased during 1993 as a result of improved current economic conditions. The amount of anticipated charge-offs for 1994 is estimated to be consistent with 1993. V. DEPOSITS - The classification of average deposits is incorporated by reference under the caption "Analysis of Average Assets, Liabilities and Shareholders' Equity and Net Interest Earnings on a Tax Equivalent Basis" on page 22 of the 1993 Annual Report to Shareholders. The following table lists, by maturity, all certificates of deposit of $100,000 and over at December 31, 1993. These certificates of deposit are generated primarily from core deposit customers and are not brokered funds. ($ in thousands) Less than three months................................ $ 74,986 Three to six months................................... 21,708 Six to twelve months.................................. 16,083 More than twelve months............................... 22,821 VI.RETURN ON EQUITY AND ASSETS - The key ratios including return on equity and assets are incorporated by reference under the caption "Selected Financial Data" on page 45 of the 1993 Annual Report to Shareholders. The following table presents the ratio of average " on page 45 of the 1993 Annual Report to Shareholders. The following table presents the ratio of average equity to assets of Valley for each of the past three years. 1993 1992 1991 Average shareholders' equity as a % of average total assets.......... 7.46% 6.97% 8.28% VII. SHORT TERM BORROWINGS - Not applicable Item 2. Item 2. Properties At present Valley owns no real property, but utilizes the offices and space provided by VNB at 615 Main Avenue, Passaic, New Jersey and 1445 Valley Road, Wayne, New Jersey. VNB operates from its administrative headquarters and three other locations, 59 branch offices and two warehouses. VNB owns the warehouses and 28 banking offices, including its main office and leases 31 branch offices, including the administrative headquarters. During 1993 VNB acquired a 62,000 square foot office building adjacent to its administrative headquarters in Wayne, New Jersey. As space becomes available, VNB will begin using the building, as early as 1994, to consolidate sections of its operations. OWNED PROPERTIES: County Square Feet Passaic 154,500 Bergen 94,260 Essex 67,959 Hudson 23,870 Morris -- 340,589 LEASED PROPERTIES: County Square Feet Passaic 90,435 Bergen 23,090 Essex 29,595 Hudson 2,520 Morris 10,800 156,440 Item 3. Item 3. Legal Proceedings There were no material pending legal proceedings to which Valley, the subsidiary banks or companies were a party, other than ordinary routine litigations incidental to business and which had no material effect on the presentation of the financial statements contained in this report. 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 incorporated by reference under the caption "Price Range of Common Stock" on page 45 of the 1993 Annual Report to Shareholders. Supervisory regulations regarding the maximum amount of cash dividends that VNB may declare annually are covered under the caption "Dividend Restrictions" on page 41 of the 1993 Annual Report to Shareholders. Cash dividends declared during the two year period ended December 31, 1993 are incorporated by reference under the caption "Consolidated Quarterly Financial Data" on page 42 of the 1993 Annual Report to Shareholders. Valley had approximately 4,406 shareholders of record at February 18, 1994. Valley's Board of Directors continues to believe that cash dividends are an important component of shareholder value and that if the current level of performance and capital strength continue, Valley expects to be able to continue its current dividend policy of a quarterly distribution of earnings to its shareholders. Item 6. Item 6. Selected Financial Data Selected Financial Data for the past five years is incorporated by reference under the caption "Selected Consolidated Financial Data", on page 45 of the 1993 Annual Report to Shareholders. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - is incorporated by reference under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations", reported on pages 17 through 25 of the 1993 Annual Report to Shareholders. Item 8. Item 8. Financial Statements and Supplementary Data The consolidated financial statements, notes to consolidated financial statements, and Independent Auditors' Report thereon are incorporated by reference on pages 26 through 44 of the 1993 Annual Report to Shareholders. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There was neither a change in accountants nor disagreement with accountants on accounting and financial disclosure during 1993. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Information regarding directors of the registrant are incorporated by reference to the sections included under the primary heading " Proposal 1 -Election of Directors" on pages 2, 3 and 4 of the Proxy Statement for the Annual Meeting of Shareholders to be held on March 22, 1994 except for certain information on Executive Officers of the Registrant which is included in Part I of this report. Executive Officers of the Registrant AGE AT IN OFFICE NAMES 12/31/93 SINCE OFFICE Gerald H. Lipkin 52 1989 Chairman of the Board and Chief Executive Officer Peter Southway 59 1987 President and Chief Operating Officer Sam P. Pinyuh 61 1990 Executive Vice President Peter Crocitto 36 1992 First Senior Vice President Robert E. Farrell 47 1992 First Senior Vice President Richard P. Garber 50 1992 First Senior Vice President Robert Mulligan 46 1993First Senior Vice President Peter John Southway 33 1992 First Senior Vice President Jack M. Blackin 51 1993 Senior Vice President Ernest Bozzo 50 1992 Senior Vice President Stephen P. Cosgrove 49 1993 Senior Vice President Alan D. Eskow 45 1993 Senior Vice President Robert Farnon 55 1992 Senior Vice President John Harris 41 1993 Senior Vice President William O'B Kelly 63 1977 Senior Vice President Lucinda P. Long 47 1992 Senior Vice President Garret G. Nieuwenhuis 53 1983 Senior Vice President John H. Prol 56 1992 Senior Vice President Peter G. Verbout 50 1992 Senior Vice President All officers serve at the pleasure of the Board of Directors. Item 11. Item 11. Executive Compensation - is incorporated by reference to the sections included under the primary headings "Executive Compensation" on pages 6 through 11 and "Compensation Committee Report" on pages 11 through 13 of the Proxy Statement for the Annual Meeting of Shareholders to be held March 22, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - is incorporated by reference under the primary heading "Stock Ownership of Management and Principal Shareholders" on pages 4 through 6 of the Proxy Statement for the Annual Meeting of Shareholders to be held March 22, 1994. Item 13. Item 13. Certain Relationships and Related Transactions - is incorporated by reference under the secondary heading "Certain Transactions with Management" on page 14 of the Proxy Statement for the Annual Meeting of Shareholders to be held March 22, 1994. The percentage of loans to directors, executive officers, and their affiliates as a percentage of shareholders' equity was 7.75 percent at December 31, 1993. 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: Consolidated Statements of Financial Condition - December 31, 1993 and 1992 Consolidated Statements of Income - for years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity - for years ended December 1993, 1992 and 1991 Consolidated Statements of Cash Flows - for years ended December 1993, 1992 and 1991 Notes to Consolidated Financial Statements Independent Auditors' Report These statements are incorporated herein by reference to the Registrant's Annual Report to Shareholders for the year ended December 31, 1993, as noted on page 2 of this Form 10-K Annual Report. 2. Financial Statement Schedules: All schedules are omitted because they are either inapplicable or not required, or because the required information is included in the Consolidated Financial Statements or notes thereto. 3. Exhibits (numbered in accordance with Item 601 of Regulation S-K): (3) Articles of incorporation and bylaws: A.Restated Certificate of Incorporation of the registrant dated March 22, 1994. B.By-Laws of the Registrant adopted as of March 14, 1989 and amended March 19, 1991. (10) Material Contracts: *** A."Employment Agreements" dated June 6, 1986 between Valley, VNB and Gerald H. Lipkin and Sam P. Pinyuh. **** B."The Valley National Bancorp Long-term Stock Incentive Plan" dated January 18, 1994. * C.Warrant Agreement by and between Valley National Bancorp and Valley National Bank, Trust Department governing the terms of 450,000 warrants to purchase Valley National Bancorp common stock dated as of December 31, 1990. ** D.Amendment to "Employee Agreements" between Valley, VNB and Gerald H. Lipkin and Sam P. Pinyuh dated December 10, 1991. ** E."Employee Agreement" dated December 10, 1991 between Valley, VNB and Peter Southway. ** F."Severance Agreements" dated December 10, 1991 between Valley, VNB and Gerald H. Lipkin, Peter Southway, and Sam P. Pinyuh. * This document is incorporated herein by reference from the Registrant's Form 10-K Annual Report for the fiscal period ending December 31, 1990. ** This document is incorporated herein by reference from the Registrant's Form 10-K Annual Report for the fiscal period ending December 31, 1991. *** This document is incorporated herein by reference from the Registrant's Form 10-K Annual Report for the fiscal period ending December 31, 1992. ****This document is incorporated herein by reference from the Registrant's Notice of Annual Meeting of Shareholders and Proxy dated March 1, 1994. (13) 1993 Annual Report to Shareholders (21) List of Subsidiaries: (a) Subsidiary of Valley: Percentage of Voting Jurisdiction of Securities Owned by Name Incorporation the Parent Valley National Bank (VNB) United States 100% (b) Subsidiaries of VNB: Valley Investment Corp. Delaware 100% VNB Mortgage Services, Inc. New Jersey 100% BNV Realty Incorporated New Jersey 100% VN Investment, Inc. New Jersey 100% (22) Published Report Regarding Matters Submitted to Vote of Security Holders Notice of Annual Meeting of Shareholders to be held Tuesday, March 22, 1994 Proxy Statement dated March 1, 1994 (23) Consents of Experts and Counsel Consent of KPMG Peat Marwick dated March 22, 1994. (b) Reports on Form 8-K There were no reports on Form 8-K filed by Valley 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. VALLEY NATIONAL BANCORP By:/s/Gerald H. Lipkin Gerald H. Lipkin, Chairman of the Board and Chief Executive Officer 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 date indicated. /s/Gerald H. Lipkin Chairman of the Board and March 22, 1994 GERALD H. LIPKIN Chief Executive Officer and Director /s/Peter Southway President and March 22, 1994 PETER SOUTHWAY Chief Operating Officer (Principal Financial Officer) and Director /s/Alan D. Eskow Senior Vice President March 22, 1994 ALAN D. ESKOW Financial Administration (Principal Accounting Officer) /s/Pamela Bronander Director March 22, 1994 PAMELA BRONANDER /s/Joseph Coccia, Jr. Director March 22, 1994 JOSEPH COCCIA, JR. /s/Austin C. Drukker Director March 22, 1994 AUSTIN C. DRUKKER /s/Thomas P. Infusino Director March 22, 1994 THOMAS P. INFUSINO /s/Gerald Korde Director March 22, 1994 GERALD KORDE /s/Robert L. Marcalus Director March 22, 1994 ROBERT L. MARCALUS /s/Robert E. McEntee Director March 22, 1994 ROBERT E. McENTEE /s/Sam P. Pinyuh Executive Vice President March 22, 1994 SAM P. PINYUH and Director /s/Rubin Rabinowitz Director March 22, 1994 RUBIN RABINOWITZ /s/Robert Rachesky Director March 22, 1994 ROBERT RACHESKY /s/Barnett Rukin Director March 22, 1994 BARNETT RUKIN /s/Richard F. Tice Director March 22, 1994 RICHARD F. TICE /s/Leonard Vorcheimer Director March 22, 1994 LEONARD VORCHEIMER /s/Joseph L. Vozza Director March 22, 1994 JOSEPH L. VOZZA

65873_1993.txt

65873_1993

1993

65873

Item 1. Business THE COMPANY GENERAL ALLTEL Corporation ("ALLTEL" or the "Company"), incorporated in June 1960 under the laws of Ohio as Mid-Continent Telephone Corporation, changed its name to ALLTEL Corporation in October 1983. During 1990, the Company changed its state of incorporation to Delaware. ALLTEL is a diversified telecommunications and information services company. The Company provides local and network access services to customers throughout 22 states. The Company owns subsidiaries or investments that provide cellular telephone, wide-area paging and fiber optic-based long-distance telephone service. Information processing management services and advanced applications software are provided to the financial, healthcare and telecommunications industries by the Company's information services subsidiaries. Telecommunications products and electronic and electric wire and cable are warehoused and sold by the Company's distribution subsidiaries. In addition, the Company publishes telephone directories and provides cable television service to more than 17,000 customers. ACQUISITIONS Effective November 1, 1993, the Company and GTE Corporation completed an exchange of telephone service areas in several states. ALLTEL exchanged approximately 95,000 access lines in Illinois, Indiana and Michigan and $443 million in cash for GTE's Georgia telephone operations, which serve approximately 320,000 access lines. In October 1993, the Company completed its merger with TDS Healthcare Systems Corporation ("TDS"). TDS is a leading provider of comprehensive patient care and healthcare enterprise information systems serving more than 200 hospitals in the United States, Canada and Europe. In October 1993, ALLTEL Publishing Corporation ("ALLTEL Publishing") completed its purchase of GTE Directories Service Corporation's ("GTE Directories") independent publishing business which includes contracts with more than 125 independent telephone companies across the country. During 1993, ALLTEL Mobile Communications, Inc. ("ALLTEL Mobile") acquired a 100% interest in one Georgia Rural Service Area ("RSA") which has a population of approximately 145,000. In addition, ALLTEL Mobile acquired interests in two other Georgia RSA's and increased its ownership in one Texas RSA and one Mississippi RSA. At December 31, 1992, ALLTEL Mobile had a transaction pending to acquire an additional 20% interest in the Ft. Smith, Ark. Metropolitan Statistical Area ("MSA"). This transaction was completed during the first quarter of 1993 and increased ALLTEL Mobile's interest in the Ft. Smith MSA to 80%. On December 31, 1992, ALLTEL Mobile acquired a 60% interest and a 90% interest in the Ft. Smith, Ark. and Fayetteville, Ark. MSAs, respectively. The Ft. Smith MSA has a population of approximately 219,000 and the Fayetteville MSA has a population of approximately 211,000. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business THE COMPANY (continued) ACQUISITIONS (continued) In December 1992, the Company acquired SLT Communications, Inc. ("SLT"). SLT serves approximately 42,000 telephone customers primarily in suburban Houston. It also has approximately 328,000 cellular "pops," including 2.34% ownership in the Houston, Galveston and Beaumont, Texas MSA, a 1% interest in the Little Rock, Ark. MSA, and has interest in four Texas RSA markets. In addition, SLT serves 6,400 cable television subscribers and owns one-third of Metropolitan Houston Paging Services, one of the largest paging networks in Texas, serving nearly 70,000 subscribers. During 1992, ALLTEL Mobile increased its ownership to 100% in the Springfield, Mo. and Charlotte, N.C. MSAs, to 80% in the Savannah, Ga. MSA and to 64% in the Little Rock, Ark. MSA. In February 1992, the Company acquired Computer Power, Inc. ("CPI"), the nation's largest provider of software and processing services to the mortgage industry. CPI has a comprehensive set of proprietary software systems which includes the Mortgage Servicing Package, Residential Loan Inventory Control Package, the Residential Loan Production Control Package, and a number of related systems as well as consulting, training, portfolio conversion and other services. During 1992, ALLTEL Mobile purchased an additional 42% interest in the Savannah, Ga., MSA, increasing its total interest to 80%, purchased operating control of the Ft. Smith and Fayetteville, Ark., MSAs, as well as additional interests in three RSAs in Arkansas and Oklahoma, one Missouri RSA, and three Alabama RSAs. In 1991, the Company acquired Missouri Telephone Company. Missouri Telephone Company serves approximately 20,000 customer access lines and 2,600 cable television customers in Missouri. It also has 320,000 cellular "pops" including 48% ownership in the Springfield, Mo. MSA cellular market where together with ALLTEL Mobile, the Company now owns a 98% interest. In early 1991, Systematics Information Services, Inc. ("Systematics") acquired Systems Limited, an international banking software firm headquartered in Hong Kong. Systems Limited is a provider of wholesale banking software. In January 1991, Systematics completed its acquisition of the cellular telephone billing and information system software of C-TEC Corporation ("C-TEC"), an independent telecommunications company. In addition, Systematics signed a long-term outsourcing agreement to manage all of C-TEC's information processing functions. In October 1990, Systematics acquired Computer Dynamics, Inc.("CDI"), a mortgage data processor that services 200,000 loans for financial institutions in six states. During 1993, these mortgages were transferred to the CPI system. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business THE COMPANY (continued) ACQUISITIONS (continued) In July 1990, Systematics acquired HORIZON Financial Software Corporation ("Horizon") of Orlando, Florida. HORIZON, now operating as Systematics Mid-Range Systems Division, develops and markets software for mid-sized community financial institutions using the IBM AS/400/ computer technology. In May 1990, the Company acquired Systematics headquartered in Little Rock, Arkansas. Systematics is one of the nation's leading providers of information processing management services and advanced application software for the financial services, healthcare and telecommunications industries. ALLTEL Mobile acquired the remaining 55% of the Aiken, S.C./ Augusta, Ga. system in 1990, where ALLTEL Mobile already held a 45% interest thereby increasing its ownership to 100% in 1990 and acquired Kansas Cellular Telephone Company's 40% interest in the Wichita, Kansas cellular system in 1989. In April 1989, the Company acquired HWC Distribution Corp. ("HWC"), headquartered in Houston, Texas. HWC is a supplier of specialty wire and cable products. DISPOSITIONS In 1992, the Company sold substantially all of the assets of Ocean Technology, Inc. ("OTI"). OTI designed, developed, and manufactured command, control and communication systems primarily for military use. In September 1991, the Company completed the sale of all of its natural gas operations. During 1990, the Company sold Denro, Inc., a manufacturing subsidiary. MANAGEMENT The Company's headquarters and regional offices staff supervise, coordinate and assist subsidiaries in management activities, investor relations, acquisitions, corporate planning, insurance and technical research. They also coordinate the financing program for the entire corporate system. EMPLOYEES At December 31, 1993, the Company had 14,864 employees. Some of the employees of the Company's telephone subsidiaries are part of collective bargaining units. The Company maintains good relations with all employee groups. INDUSTRY SEGMENTS Financial information about industry segments is included in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business TELEPHONE OPERATIONS LOCAL SERVICE General The Company's telephone operating subsidiaries provide local service to over 1,576,000 customer lines through 668 exchanges. The telephone operating subsidiaries also offer facilities for private line, data transmission and other communications services. In addition, these subsidiaries sell and lease end user telephone equipment (terminal equipment) as well as maintenance and protection plans for customer-owned equipment. Regulation The Company's telephone operating subsidiaries are subject to regulation by the utility commissions of the states in which they operate. These commissions have jurisdiction over various matters including local and intrastate toll rates, conditions of service, securities issues, depreciation rates, the encumbering or disposition of public utility properties and the prescription of a uniform system of accounts. There were no local rate increases granted to any of the Company's telephone operating subsidiaries in 1993, nor are there any rate requests currently pending before regulatory commissions. During 1993, telephone operations were affected by certain regulatory commission orders designed to reduce earnings levels. These orders did not materially impact the results of operations of the Company. Competition The Company's telephone subsidiaries provide local telephone service in their service areas without significant competition from other regulated carriers. However, ALLTEL is beginning to experience competition in its territories from alternative telecommunications systems which include facilities constructed by large end users or by interexchange carriers, satellite transmission services, cellular communications, cable television systems, radio-based personal communications services, competitive access providers and other systems which are capable of completely or partially bypassing the local telephone facilities. ALLTEL's subsidiaries are also competing for the sale and leasing of terminal equipment to business and residential customers as well as for the installation and maintenance of inside wire and terminal equipment. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business TELEPHONE OPERATIONS (continued) ACCESS SERVICES General The Company's customers have access to message and private line toll services through the local exchanges of the Company's telephone operating subsidiaries. Local exchanges provide toll service and network access for interexchange telephone traffic to locations outside of the Company's service areas through connections with other local exchange and interexchange carriers. These connections permit communications from any telephone in the ALLTEL system to nationwide locations and to points in most foreign countries. Regulation The Federal Communications Commission ("FCC") authorizes a rate-of-return ("ROR") that telephone companies may earn on interstate services they provide. Effective January 1, 1991, the FCC replaced rate-of-return regulation with price cap regulation for the Bell Operating Companies and GTE Corporation with an optional election for all other companies not remaining in the National Exchange Carrier Association ("NECA") Common Line and Traffic Sensitive Pools. The FCC reduced the ROR from 12.0% to 11.25% for companies remaining under ROR regulation. This 11.25% ROR continued through 1993 and most likely will continue through 1994. A proceeding to establish the methodology for prescribing the ROR was initiated in 1992. This proceeding should result in new rules for setting the ROR sometime in 1994. As of December 31, 1993, certain of the Company's telephone operating subsidiaries have exited the NECA traffic sensitive and end user tariffs. Price cap regulation for holding companies, such as ALLTEL, requires all affiliated operating telephone companies settling on a cost basis to choose price cap regulation at the same time or all remain under ROR regulation (with the exception of average schedule affiliates). Price cap regulation allows for different earnings potential than ROR depending on the "productivity offset" the company chooses. In addition, companies electing price cap regulation may make adjustments for the rate of inflation and exogenous (non-controllable) costs. Price cap regulation is designed to allow greater pricing flexibility and includes the risk of earnings lower than under ROR regulation. In 1992, the FCC initiated a rulemaking proceeding (CC Docket No. 92-135) to address regulatory alternatives for mid-size and small local exchange carriers. This proceeding resulted in a set of rules, adopted in September of 1993, that provide for a non price cap form of incentive regulation for which ALLTEL would be eligible. Certain states in which the Company operates, either through legislative changes or by commission actions, have adopted various forms of alternatives to rate-of-return regulation. However, most of these plans have been adopted for the Bell Operating Companies and have not been widely used by commissions in dealing with other telephone companies including the Company's telephone operating subsidiaries. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business TELEPHONE OPERATIONS (continued) ACCESS SERVICES (continued) Regulation (continued) To date, the Company has not elected price cap (incentive) regulation, but is monitoring the activity of the FCC and the states in which the Company operates telephone companies and will determine the appropriate action required as these activities develop. Interexchange carrier charges The FCC establishes procedures by which interexchange carriers reimburse the Company's telephone operating subsidiaries for the use of their local networks to complete long-distance calls. With the exception of ALLTEL New York, Inc., ALLTEL Carolina, Inc., Oklahoma ALLTEL, Inc., Sugar Land Telephone Company, ALLTEL Georgia Communications Corp. and Georgia ALLTEL Telecom Inc., all of the Company's telephone operating subsidiaries participated in NECA's interstate traffic sensitive tariff and settlements processes during 1993. All companies, with the exception of ALLTEL Georgia Communications Corp. and Georgia ALLTEL Telecom Inc., also participated in NECA's common line tariffs and pools during 1993. As of December 31, 1993, participation in the NECA revenue distribution ("pooling") process is based on nationwide average schedules for four of the Company's telephone operating subsidiaries with the remaining companies settling on actual costs. Intrastate interlata services are reimbursed to the Company's telephone operating subsidiaries under arrangements ordered by state commissions. These arrangements are based on access and can be on a bill-and-keep or pooled basis. The Company's telephone operating subsidiaries receive reimbursement for intrastate intralata services through access or toll based revenue arrangements, once again on either a bill-and-keep or pooled basis. Equal access The Company's telephone operating subsidiaries offer equal access to nearly 90% of their customers. The availability of equal access provides customers with the opportunity to choose the long-distance company they want to use. The Company's telephone operating subsidiaries then program their equipment to allow the customer to use the selected long-distance company by dialing 1, the area code, and a seven-digit telephone number. Billing and collection Interstate billing and collection services were previously detariffed as ordered by the FCC. The Company's telephone operating subsidiaries continue to provide interstate billing and collection services for interexchange carriers through various agreements and also provide intrastate billing and collection services under state tariff arrangements or under contract where these services are detariffed. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business TELEPHONE OPERATIONS (continued) ACCESS SERVICES (continued) Competition Long-distance services are provided by several competing companies. One aspect of competition is the potential bypass of the local exchange carrier's facilities by large volume toll users. Certain states in which the Company's telephone subsidiaries operate allow various forms of intralata competition for select functions or complete intralata service. There has been no significant measurable effect on the operations of the Company's telephone subsidiaries as a result of this competition. The long-range effect of competition on the provision and cost of telecommunications services and equipment will depend on technological advances, regulatory actions at both the state and federal levels, court decisions, and possible future federal and state legislation. The continued growth of competition may have an effect on the cost of telephone service to customers and on the telephone revenues of the Company's telephone operating subsidiaries. The FCC has ordered that the larger (Tier 1) local exchange carriers provide special transport interconnection for competitive providers. In addition, an order was released in late 1993, requiring the same category of companies to tariff switched transport interconnection. The switched transport interconnection tariffs will become effective in early 1994. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business INFORMATION SERVICES GENERAL Systematics provides a wide range of information processing services to the financial services, healthcare and telecommunications industries through information processing centers that it staffs, equips and operates. Information processing contracts are generally for a multi-year period. Systematics' software and services have been developed and improved continuously over the last 25 years and are designed to fulfill substantially all of the retail information processing and management information requirements of financial institutions. Systematics also markets software worldwide to financial services, healthcare and telecommunications companies operating their own information processing departments. CPI provides data processing and related computer software and systems to financial institutions originating and/or servicing single family mortgage loans. CPI's software products and processing services, combined with CPI's team of mortgage bankers, are intended to offer a cost-effective alternative to the extensive technical support staff and the enlarged group of mortgage bankers which would otherwise have to be assembled in-house by each customer. CPI's on-line systems automate processing functions required in the origination of mortgage loans, the management of such loans while in inventory before they are sold in the secondary market, and their subsequent servicing. TDS is primarily engaged in the development and marketing of comprehensive patient centered healthcare enterprise information systems to medium to large healthcare companies throughout North America and Europe. These systems are designed to enhance the quality of patient care, control processing costs and provide substantially all of the information requirements of its users. Under typical arrangements with hospitals, TDS' software is licensed under perpetual license arrangements. Software and hardware maintenance are normally contracted for periods of five to seven years. Additionally, TDS contracts with its customers to install software over periods which range from twelve to eighteeen months. Other services provided by TDS include training, consulting and data processing services. CUSTOMERS Systematics' primary market for its financial products and services are the nation's commercial banks and savings institutions and financial institutions outside the United States, primarily in Europe and Asia. Financial software and services are also marketed to mortgage service companies, credit unions and healthcare companies. Systematics' primary market for its telecommunications products and services is the top 150 telephone companies and top 50 cellular companies in the United States. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business INFORMATION SERVICES (continued) CUSTOMERS (continued) CPI provides its services primarily to financial institutions originating and/or servicing single family mortgage loans that have sold the loans in the secondary market while continuing to service the loans. These institutions which include 60 of the top 100 servicers of residential mortgages are located throughout the United States. In total, more than 13 million mortgage loans representing over $1 trillion are processed by CPI's software. TDS' primary market for its software products are hospitals with 400 or more beds. TDS also markets data processing services to smaller healthcare companies. Many of TDS' customers are large, state funded hospitals which include a significant number of university hospitals and other large healthcare providers. TDS clients are located throughout the United States, Canada and Europe. COMPETITION Systematics' competition primarily comes from "in-house" bank information processing departments and other companies engaged in active competition for financial institution outsourcing contracts. Numerous large financial institutions provide information processing for smaller institutions in their respective geographic areas, along with other companies that perform such services for small institutions. There are also other companies that provide information processing services to the telecommunications industry. CPI's competition comes from "in-house" information processing departments and from other companies that offer information processing services to the mortgage banking industry. CPI competes in its business by providing a high level of service and support. TDS' competition primarily comes from other companies that provide comprehensive integrated hospital information systems and from companies which offer solutions for individual departments within the respective healthcare enterprises. The information services subsidiaries substantially rely upon and vigorously enforce contract and trade secret laws and internal non-disclosure safeguards to protect the proprietary nature of their computer software. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business INFORMATION SERVICES (continued) REGULATION AND EXAMINATION Systematics and CPI are regulated by the federal agencies that have supervisory authority over banking, thrift, and credit union operations. Systematics is also classified as one of twelve national vendors that, as a result of their market share, process a significant portion of the financial industry assets. These industry leaders are also examined by the federal Financial Institutions Examination Council on an ongoing basis. Systematics' and CPI's management practices, policies, procedures, standards and overall financial condition are components of these reviews. In addition to these corporate examinations, Systematics' individual processing sites are examined, as if they were departments of their respective clients, by federal and state regulators, as well as, the clients' internal audit departments and their independent auditing firms. The same standards of performance are applied to those information processing centers as are applied to the client financial institutions. Reports of Systematics' and CPI's data center performance are furnished to the Board of Directors of Systematics and to the Board of Directors of the examined client. The supervisory agencies include applicable state banking departments, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the National Credit Union Administration. Systematics' and CPI's processing contracts include a commitment to install all necessary changes in its computer software that are required by changes in regulations. CPI operates transmitters at the network's information processing facility hub and operates very small aperture technology ("VSAT") earth stations at numerous customer locations. Prior to initiation, construction or operation of the transmitters used in a VSAT satellite network, operators of these transmitters such as CPI are required by the Communications Act of 1934 to be authorized by the FCC. The FCC grants licenses to VSAT operators for a predetermined number of earth stations that may be placed at unspecified locations in the domestic United States. CPI has FCC authorization to operate its domestic earth station satellite network, consisting of one hub located in Jacksonville, Florida and various 1.8m and 2.4m VSAT's. TDS is not specifically regulated by any federal or state healthcare agency. However, its software must meet all federal and state reporting requirements of its customers, including Medicare, Medicaid and other state sponsored programs. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business INFORMATION SERVICES (continued) PRODUCT DEVELOPMENT AND SUPPORT In the past five years, the information services subsidiaries have spent approximately $113 million ($35.6 million in 1993) on IBM mainframe COBOL software design and development, or an average of 5.4% of their total information services operating revenues in those years. One of the information services subsidiaries has also begun to develop products which will be utilized in a UNIX based environment. Changes in regulatory requirements of both state and federal authorities, increasing competition and the development of new products and markets create the need to continually update or modify existing software and systems offered to customers. The information services subsidiaries intend to continue to maintain, improve, and expand the functions and capabilities of their software products over the next several years. OTHER In 1993, Systematics signed a long-term agreement with GTE Telecommunications Products and Services Group to outsource GTE's cellular billing operations. This agreement further strengthens Systematics' position in the telecommunications information processing market. Within three months of acquiring TDS, Systematics signed its first hospital outsourcing contract with St. Joseph's Hospital in Parkersburg, West Virginia. Under terms of the five-year contract, Systematics will assume all healthcare information systems operations for this 375 bed hospital, including providing on-site and remote management, software implementation and support, hardware and network manangement and maintenance. In 1992, Systematics purchased an equity interest in Treasury Services Corporation of Santa Monica, California, joining forces with that organization to provide its financial services industry customers with better tools for managing profitability and risk. In 1991, Systematics entered into a worldwide strategic alliance with Andersen Consulting to jointly pursue financial services clients seeking outsourcing, software and systems integration expertise. During 1991, Systematics signed a long-term facilities management contract to handle all information processing activities for ALLTEL's telephone and cellular operations. In 1990, Systematics signed a long-term contract with C-TEC to perform data processing services for their telephone, cable television and cellular operations. The ALLTEL and C-TEC facilities management contracts emphasize Systematics' efforts to establish a strong position in the telecommunications software and services marketplace. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business PRODUCT DISTRIBUTION OPERATIONS GENERAL ALLTEL Supply, Inc., ("ALLTEL Supply") with twelve warehouses and nine counter-sales showrooms across the United States, is a major distributor of telecommunications equipment and materials. It supplies equipment to affiliated and non-affiliated telephone companies, business systems suppliers, railroads, governments and retail and industrial companies. HWC, with ten warehouses throughout the United States, is one of the nation's leading suppliers of specialty wire and cable products. COMPETITION ALLTEL Supply and HWC (the "Distribution companies") experience substantial competition throughout their sales territories from other distribution companies and direct sales by manufacturers. Competition is based primarily on quality, product availability, service, price and technical assistance. PRODUCTS ALLTEL Supply offers more than 35,000 products for sale. In addition, ALLTEL Supply inventories single and multi-line telephone sets, local area networks ("LANS"), switching equipment modules, interior cable, pole line hardware and various other telecommunications supply items. HWC inventories more than 38,000 reels of specialty wire and cable. These include shielded and unshielded power cables, flame resistant cables and high temperature precision engineered cables. The Distribution companies have not encountered any material shortages or delays in delivery of products from their suppliers. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business CELLULAR MOBILE TELEPHONE GENERAL ALLTEL Mobile provides cellular mobile telephone service in various major markets throughout the United States. Cellular telephone service combines the latest advances in telephone, radio and computer technology and is being marketed to business executives, on-the-move professional people and individual consumers. As cellular becomes increasing more popular with broader segments of the population, ALLTEL Mobile has opened several retail stores, in addition to its traditional sales offices, where customers can purchase equipment and learn more about wireless services. BUSINESS The potential of a cellular telephone market's investment is quantified by the market's population times the percent of a company's ownership interest of the cellular operation in that market ("pops"). ALLTEL Mobile owns a majority interest in cellular operations in 12 MSAs and a minority interest in 13 other MSAs. This represents 4.4 million cellular pops. ALLTEL Mobile also owns a majority interest in cellular operations in 47 RSAs and a minority interest in 23 other RSAs. This represents 3.2 million cellular pops. ALLTEL Mobile operates systems in Charlotte, N.C.; Little Rock, Ark.; Jackson, Miss.; Montgomery, Ala.; Springfield, Mo.; Ocala/Gainesville, Fla.; Albany, Ga.; Aiken, S.C./Augusta, Ga.; Savannah, Ga.; Ft. Smith, Ark.; and Fayetteville, Ark. COMPETITION Direct competition in the cellular telephone market consists of a non-wireline carrier licensed to provide cellular telephone service in the same area. Additionally, non-cellular mobile telephone service may be available in the licensed area but is not currently considered a direct competitor within the cellular market. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business PAGING ALLTEL Mobile also operates wide-area computer-driven paging networks as a complementary service to cellular telephones. In addition to paging networks in Arkansas and Florida, the Company's acquisition of SLT in 1992 added a one-third ownership in one of the largest paging networks in Texas, which serves more than 115,000 subscribers. DIRECTORY PUBLISHING ALLTEL Publishing currently coordinates advertising, sales, printing and distribution for 372 telephone directories in 39 states. In October 1993, ALLTEL Publishing completed its purchase of GTE Directories independent publishing business, which includes contracts with more than 125 independent telephone companies across the country. Under the terms of the agreement, ALLTEL Publishing will provide all directory publishing services including contract management, production and marketing. As subcontractor, GTE Directories will provide directory sales and printing services through a separate contract with ALLTEL Publishing. CABLE TELEVISION SERVICE The Company provides cable television service to more than 17,000 customers in certain areas of the Navajo Indian Reservation (which covers an area including parts of New Mexico, Arizona, and Utah), and to residents of Needles, California, Springfield, Missouri, and central Texas. NATURAL GAS DISTRIBUTION In 1991, the Company disposed of all natural gas distribution operations. MANUFACTURING During 1992, the Company sold substantially all of the assets of OTI, which designed, developed, manufactured and marketed products for use in military command, control and communications systems. During 1990, the Company sold Denro, Inc., which designs and manufactures microprocessor-based air traffic control voice switching and control systems. After the sale of OTI, the Company did not have any manufacturing operations. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 1. Business INVESTMENTS LDDS ALLTEL owns a 11.2% interest in LDDS Communications, Inc. ("LDDS"), a publicly-held company. The investment was acquired in exchange for the Company's previous interest in Advance Telecommunications Corporation ("ATC"), which was acquired by LDDS during 1992. LDDS is one of the largest regional long-distance companies in the United States and provides long-distance telecommunications services to customers located in 41 states. Max E. Bobbitt, ALLTEL's President, is a member of LDDS's Board of Directors. COMDIAL ALLTEL owns a 8.1% interest in Comdial Corporation, a producer of quality telephone sets and key systems. Max E. Bobbitt, ALLTEL's President, is a member of Comdial's Board of Directors. CHILLICOTHE ALLTEL owns a 19.8% interest in Chillicothe Telephone Company, which serves approximately 27,000 telephone lines in Ohio. Frederick G. Griech, President of ALLTEL Service Corporation's Northeast Region, and Americo Cornacchione, Senior Vice President-Accounting and Finance of ALLTEL Service Corporation's Northeast Region, are members of Chillicothe's Board of Directors. OTHER During 1991, the Company sold its stock in Luz International Limited, a provider of solar energy, to an investment group in a private transaction. During 1990, the Company completed the sale of its 14.5% interest in TPI Enterprises, Inc., which had been a supplier of business communications systems. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 2. Item 2. Properties TELEPHONE PROPERTY The Company's telephone property in service consists primarily of land and buildings, central office equipment, telephone lines, telephone instruments and related equipment. The gross investment by category in telephone property as of December 31, 1993 was as follows: (Thousands) Telephone- Land, buildings and leasehold improvements $ 252,402 Central office equipment 1,158,172 Outside plant 1,844,273 Telephone instruments, related equipment and other 300,173 Total $3,555,020 Standard practices prevailing in the telephone industry are followed by the Company's telephone operating subsidiaries in the construction and maintenance of plant and facilities. Certain properties of the Company and its telephone operating subsidiaries are pledged as collateral for long-term debt. OTHER PROPERTY Other properties of the Company in service consist primarily of property, plant and equipment used in information services, product distribution and cellular telephone operations. The total investment by category for these operations as of December 31, 1993 was as follows: (Thousands) Land, buildings and leasehold improvements $ 97,113 Data processing equipment 195,470 Cellular telephone plant and equipment 160,896 Furniture, fixtures and miscellaneous 70,353 Machinery and equipment 2,789 Total $526,621 All of the Company's property is considered to be in sound operating condition. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 3. Item 3. Legal Proceedings The Company is not currently involved in any material pending legal proceedings, other than routine litigation incidental to its business, and, to the knowledge of the Company's management, no material legal proceedings, either private or governmental, are contemplated or threatened. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to the security holders for a vote during the fourth quarter of the fiscal year. Item 10(b). Executive Officers of the Registrant. Name Age Position Joe T. Ford 56 Chairman and Chief Executive Officer Max E. Bobbitt 49 President Dennis J. Ferra 40 Senior Vice President - Accounting and Administration Francis X. Frantz 40 Senior Vice President - External Affairs, General Counsel and Secretary Tom T. Orsini 43 Senior Vice President - Finance and Corporate Development John L. Comparin 41 Vice President - Human Resources Ronald D. Payne 47 Vice President - Corporate Communications Jerry M. Green 46 Treasurer John M. Mueller 43 Controller Deborah J. Akins 38 Assistant Treasurer ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part I Item 10(b). Executive Officers of the Registrant (continued) There are no arrangements between any officer and any other person pursuant to which he was selected as an officer. Except for Francis X. Frantz and John L. Comparin, each of the officers named above has been employed by ALLTEL or a subsidiary for the last five years. Mr. Frantz joined the Company in March, 1990 as Senior Vice President and General Counsel. Prior to joining ALLTEL, Mr. Frantz was a partner in the law firm of Thompson, Hine, and Flory, in Cleveland, Ohio. Mr. Comparin joined the Company in February, 1990 as Vice President - Human Resources. Prior to joining ALLTEL, Mr. Comparin was Director of Human Resources for Maxus Corp. (formerly Diamond Shamrock Corp.) of Dallas Texas. FORM 10-K Part II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. For information pertaining to Markets for ALLTEL Corporation's Common Stock and Related Shareholder Matters, refer to pages 35, 37, 40 and the inside back cover of ALLTEL's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Item 6. Item 6. Selected Financial Data. For information pertaining to Selected Financial Data of ALLTEL Corporation, refer to page 30 of ALLTEL's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. For information pertaining to Management's Discussion and Analysis of Financial Condition and Results of Operations of ALLTEL Corporation, refer to pages 25-28 of ALLTEL's 1993 Annual Report to Stockholders, which is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. For information pertaining to Financial Statements and Supplementary Data of ALLTEL Corporation, refer to pages 29 and 31-43 of ALLTEL's 1993 Annual Report to Stockholders, which is incorporated herein by reference. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part II Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. During the two most recent fiscal years or the subsequent interim period up to the date of this Form 10-K, there were no disagreements with the Company's independent certified public accountants on any matter of accounting principles or practices, financial statement disclosures or auditing scope or procedures. In addition, none of the "kinds of events" described in item 304(a)(1)(v)(A), (B), (C) and (D) of regulation S-K have occurred. FORM 10-K PART III Item 10(a). Directors of the Registrant. For information pertaining to Directors of ALLTEL Corporation refer to "Election of Directors" in ALLTEL's Proxy Statement for its 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. Item 10(b). Executive Officers of the Registrant. For information pertaining to Executive Officers of ALLTEL Corporation, refer to Part I, pages 17 and 18 of this Report. Item 11. Item 11. Executive Compensation. For information pertaining to Executive Compensation, refer to pages 10 through 17 in ALLTEL's Proxy Statement for its 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. For information pertaining to beneficial ownership of ALLTEL securities, refer to "Security Ownership of Certain Beneficial Owners and Management" in ALLTEL's Proxy Statement for its 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part IV Item 13. Item 13. Certain Relationships and Related Transactions. For information pertaining to Certain Relationships and Related Transactions, refer to "Management Compensation" in ALLTEL's Proxy Statement for its 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. 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: The following Consolidated Financial Statements of ALLTEL Corporation and subsidiaries, included in the annual report of ALLTEL Corporation to its stockholders for the year ended December 31, 1993, are incorporated herein by reference: Annual Report Page Number Report of Independent Certified Public Accountants 29 Consolidated Balance Sheets - December 31, 1993 and 1992 32-33 Consolidated Statements of Income - for the years ended December 31, 1993, 1992, and 1991 31 Consolidated Statements of Shareholders' Equity - for the years ended December 31, 1993, 1992 and 1991 35 Consolidated Statements of Cash Flows - for the years ended December 31, 1993 1992, and 1991 34 Notes to Consolidated Financial Statements 38-43 Supplementary Information-Business Segment and Quarterly (Unaudited) Financial Information 36,37 and 43 The Consolidated Financial Statements and Supplementary Financial Information listed in the above index which are included in the 1993 Annual Report to Stockholders of ALLTEL Corporation are hereby incorporated by reference. ALLTEL Corporation Securities and Exchange Commission Form 10-K, Part IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (continued): 2. Financial Statement Schedules: Form 10-K Page Number Report of Independent Public Accountants 23 I. Marketable Securities - Other Investments 24 V. Property, Plant and Equipment 25-30 VI. Accumulated Depreciation and Amortization of Property, Plant and Equipment 31-33 VIII. Valuation and Qualifying Accounts 34 IX. Short-Term Borrowings 35 X. Supplementary Income Statement Information 36 3. Exhibits: See "Exhibit Index" located on page 37-40 of this document. (b) No reports on Form 8-K were filed during the last quarter of 1993. Separate condensed financial statements of ALLTEL Corporation have been omitted since the Company meets the tests set forth in Regulation S-X Rule 4-08(e)(3). 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. 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. ALLTEL Corporation Registrant By /s/ Joe T. Ford Joe T. Ford, Chairman and Chief Executive Date: February 18, 1994 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. By /s/ Max E. Bobbitt Date: February 18, 1994 Max E. Bobbitt, President and Director Joe T. Ford, Chairman, Chief Executive Officer, and Director (Principal Executive Officer) Max E. Bobbitt, President and Director Dennis J. Ferra, Senior Vice President - Accounting and Administration (Principal Accounting Officer) Tom T. Orsini, Senior Vice President - Finance and Corporate Development (Principal Financial Officer) By /s/ Max E. Bobbitt Ben W. Agee, Director (Max E. Bobbitt, Attorney-in-fact) Alfred E. Campdon, Director W. W. Johnson, Director Date: February 18, 1994 Emon A. Mahony, Jr., Director George C. McConnaughey, Director John H. McConnell, Director Walter G. Olson, Director Philip F. Searle, Director John E. Steuri, Director Carl H. Tiedemann, Director Ronald Townsend, Director William H. Zimmer, Jr., Director REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of ALLTEL Corporation: We have audited in accordance with generally accepted auditing standards, the financial statements included in ALLTEL Corporation's Annual Report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 27, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules on pages 24 through 36 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 required part of the basic financial statements. This information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. As explained in Note 3 to the financial statements, as of December 31, 1993, the Company changed its method of accounting for investments in conjunction with the adoption of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." ARTHUR ANDERSEN & CO. Little Rock, Arkansas January 27, 1994 (A) Securities available-for-sale are carried at fair value with unrealized gains and losses included as a separate component of shareholders' equity, net of tax. Investments for which there is no quoted market price readily determinable are carried at cost. (B) No other individual investment is greater than 2% of total assets. (A) Depreciation is calculated using primarily the straight-line method. (B) Property, plant and equipment of companies acquired in 1993. (C) Property, plant and equipment of companies exchanged in 1993. (D) Property, plant and equipment transferred between categories and other miscellaneous transactions. Continued on next page (A) Depreciation is calculated using primarily the straight-line method. (B) Property, plant and equipment of companies sold in 1992. (C) Property, plant and equipment transferred between categories and other miscellaneous transactions. Continued on next page (A) Depreciation is calculated using primarily the straight-line method. (B) Property, plant and equipment of companies sold in 1991. (C) Property, plant and equipment of companies purchased in 1991. (D) Property, plant and equipment transferred between categories and other miscellaneous transactions. (E) Write-down to net realizable value of manufacturing property, plant and equipment. (A) Accumulated depreciation of companies exchanged in 1993. (B) Miscellaneous transfers between plant categories and other. (C) Accumulated depreciation of companies purchased in 1993. (A) Accumulated depreciation of companies sold in 1992. (B) Miscellaneous transfers between plant categories and other. (A) Accumulated depreciation of companies sold in 1991. (B) Accumulated depreciation of companies purchased in 1991. (C) Miscellaneous transfers between plant categories and other. (A) Accounts charged off less recoveries of amounts previously charged off. (B) Reclassification of amount for companies purchased in 1993. (1) Short-term borrowing consists of notes payable to banks under lines of credit of certain subsidiaries purchased in 1992. (2) Based on average daily amounts outstanding. NOTE: Amounts for items other than those reported have been excluded because they appear separately in the financial statements or they amount to less than one percent of total revenue and sales. EXHIBIT INDEX Number and Name Page (3)(a) Amended and Restated Certificate of Incorporation of * ALLTEL Corporation (incorporated herein by reference to Exhibit B to Proxy Statement, dated March 9, l990). (b) By-Laws of ALLTEL Corporation (Exhibit 3(b) to Form SE * dated February 17, 1993). (4)(a) Amended and Restated Rights Agreement dated as of * April 26, l989, between ALLTEL Corporation and Ameritrust Company N.A. (incorporated herein by reference to Form 8 dated April 26, l989, filed with the Commission on April 28, l989). (b) First Amendment to Amended and Restated Rights * Agreement dated as of April l6, l990, between ALLTEL Corporation and Ameritrust Company N.A. (incorporated herein by reference to Form SE of ALLTEL Corporation filed with the Commission on April 23, l990). (c) The Company agrees to provide to the Commission, upon -- request, copies of any agreement defining rights of long-term debt holders. (10)(a)(1) Executive Compensation Agreement and amendments thereto * by and between the Corporation and Joe T. Ford (incorporated herein by reference to Exhibit 10(b) to Form 10-K for the fiscal year ended December 31, 1983). (a)(2) Modification to Executive Compensation Agreement by and * between the Corporation and Joe T. Ford effective as of January 1, 1987 (incorporated herein by reference to Exhibit 10(b)(2) to Form 10-K for the fiscal year ended December 31, 1986). (a)(3) Modification to Executive Compensation Agreement by and * between ALLTEL Corporation and Joe T. Ford, effective as of January 1, 1991 (incorporated herein by reference to Exhibit 10 of ALLTEL Corporation Registration Statement (No. 33-44736) on Form S-4 dated December 23, 1991). (a)(4) Split-dollar Life Insurance Agreement by and between * the Corporation and Joe T. Ford effective as of January 24, 1990 (incorporated herein by reference to Exhibit 10(b)(3) to Form 10-K for the fiscal year ended December 31, 1989). * Incorporated herein by reference as indicated. EXHIBIT INDEX, Continued Number and Name Page 10(b)(1) Executive Compensation Agreement by and between the Cor- * poration and Max E. Bobbitt effective as of October 29, 1986 (incorporated herein by reference to Exhibit 10(c)(1) to Form 10-K for the fiscal year ended December 31, 1986). (b)(2) Modification to Executive Compensation Agreement by and * between the Corporation and Max E. Bobbitt effective as of January 1, 1987 (incorporated herein by reference to Exhibit 10(c)(2) to Form 10-K for the fiscal year ended December 31, 1986). (b)(3) Modification to Executive Compensation Agreement by and * between ALLTEL Corporation and Max E. Bobbitt, effective as of January 1, 1991 (incorporated herein by reference to Exhibit 10 of ALLTEL Corporation Registration Statement (No. 33-44736) on Form S-4 dated December 23, 1991). (b)(4) Split-dollar Life Insurance Agreement by and between the * Corporation and Max E. Bobbitt effective as of May 26, 1989 (incorporated herein by reference to Exhibit 10(c)(3) to Form 10-K for the fiscal year ended December 31, 1989). (c) Executive Compensation Agreement by and between the * Company and John E. Steuri effective as of April l7, l990 (incorporated herein by reference to Exhibit B of ALLTEL Corporation Registration Statement (No. 33-34495) on Form S-4 dated April 23, 1990). (d) Directors' Retirement Plan of ALLTEL Corporation (as 74 amended and restated effective January 1, 1994). (e) Executive Deferred Compensation Plan of ALLTEL 77 Corporation (as amended and restated effective October 1, 1993). (f) Deferred Compensation Plan for Directors of ALLTEL 99 Corporation (as amended and restated effective October 1, 1993). (g)(l) ALLTEL Corporation 1975 Incentive Stock Option Plan (as * amended and restated effective July 26, 1988) (incorporated herein by reference to Exhibit 10(i) to Form 10-K for the fiscal year ended December 31, 1988). * Incorporated herein by reference as indicated. EXHIBIT INDEX, Continued Number and Name Page 10(g)(2) ALLTEL Corporation l99l Stock Option Plan (incorporated * herein by reference to Exhibit A to Proxy Statement, dated March 8, l99l). (h)(1) Systematics, Inc. 1981 Incentive Stock Option Plan and * Amendment No. 1 thereto (incorporated herein by reference to Form S-8 (No. 33-35343) of ALLTEL Corporation filed with the Commission on June 11, 1990). (h)(2) Stock Purchase Plan for Employees of Systematics, Inc. * and Amendment No. 1 thereto (incorporated herein by reference to Post-effective Amendment No.1 to Form S-4 on Form S-8 (No. 33-34495) of ALLTEL Corporation filed with the Commission on June 11, 1990). (i) ALLTEL Corporation Performance Incentive Compensation Plan * as amended, effective January 1, 1993 (Exhibit 10(i) to Form SE dated February 17, 1993). (j) ALLTEL Corporation Long-Term Performance Incentive * Compensation Plan, as amended and restated effective January 1, 1993 (Exhibit 10(j) to Form SE dated February 17, 1993). (k)(l) ALLTEL Corporation Pension Plan (January 1, 1989 * Restatement) and Amendment Nos. 1 - 4 thereto (incorporated herein by reference to Exhibit 10(p) to Form 10-K for the fiscal year ended December 31, 1989). (k)(2) Amendments No. 5 through 9 to ALLTEL Corporation Pension * Plan (incorporated herein by reference to Exhibit 10(m)(2) to Form 10-K for the fiscal year ended December 31, 1990). (k)(3) Amendments No. 10 and 11 to ALLTEL Corporation Pension * Plan (incorporated herein by reference to Exhibit 10 of ALLTEL Corporation Registration Statement (No. 33-44736) on Form S-4 dated December 23, 1991). (k)(4) Amendments No. 12 through 14 to ALLTEL Corporation Pension * Plan (Exhibit 10(k)(4) to Form SE dated February 17, 1993). (k)(5) Amendments No. 15 through 18 to ALLTEL Corporation Pension 122 Plan. (l)(1) ALLTEL Corporation Profit-Sharing Plan and Amendment * No. 1 thereto (incorporated herein by reference to Exhibit 10(q) to Form 10-K for the fiscal year ended December 31, 1987). (l)(2) Amendment No. 2 to ALLTEL Corporation Profit-Sharing Plan * (incorporated herein by reference to Exhibit 10(q)(2) to Form 10-K for the fiscal year ended December 31, 1988). * Incorporated herein by reference as indicated. EXHIBIT INDEX, Continued Number and Name Page 10(l)(3) Amendments No. 3 through 6 to ALLTEL Corporation * Profit-Sharing Plan (incorporated herein by reference to Exhibit 10(q)(3) to Form 10-K for the fiscal year ended December 31, 1989). (l)(4) Amendments No. 7 and 8 to ALLTEL Corporation Profit- * Sharing Plan (incorporated by reference to Exhibit 10(n)(4) to Form 10-K for the fiscal year ended December 31, 1990). (l)(5) Amendments No. 9 and 10 to ALLTEL Corporation Profit- * Sharing Plan (incorporated herein by reference to Exhibit 10 of ALLTEL Corporation Registration Statement (No. 33-44736) on Form S-4 dated December 23, 1991). (l)(6) Amendment No. 11 to ALLTEL Corporation Profit-Sharing Plan * (Exhibit 10(l)(6) to Form SE dated February 17, 1993). (l)(7) Amendments No. 12 through 16 to ALLTEL Corporation 134 Profit-Sharing Plan. (m) ALLTEL Corporation Excess Benefit Plan (incorporated * herein by reference to Exhibit 10(r) to Form 10-K for the fiscal year ended December 31, 1987). (n) Amended and Restated ALLTEL Corporation Supplemental * Medical Expense Reimbursement Plan (incorporated herein by reference to Exhibit 10(p) to Form 10-K for the fiscal year ended December 31, 1990). (11) Statement re computation of per share earnings. 41 (13) Annual report to stockholders for the year ended 46 December 31, 1993. Such report, except for the portions incorporated by reference herein, is furnished for the information of the SEC and is not "filed" as part of this report. (21) Subsidiaries of the registrant. 42 (23) Consents of experts and counsel. 45 (24) Powers of Attorney. 144 (99)(a) Annual report on Form 11-K for the Stock Purchase Plan -- for Employees of Systematics Information Services, Inc. and its Affiliates for the year ended December 31, 1993 will be filed by amendment. (99)(b) Annual report on Form 11-K for the CP National -- Corporation Incentive Thrift Savings Plan for the year ended December 31, 1993 will be filed by amendment. * Incorporated herein by reference as indicated.

28412_1993.txt

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1993

28412

ITEM 1. BUSINESS GENERAL Comerica Incorporated ("Comerica" or the "Corporation") is a registered bank holding company incorporated under the laws of the State of Delaware, headquartered in Detroit, Michigan, and was formed in 1973 to acquire the outstanding common stock of Comerica Bank (formerly Comerica Bank-Detroit), a Michigan banking corporation ("Comerica Bank"). As of December 31, 1993, Comerica owned directly or indirectly all the outstanding common stock (except for directors' qualifying shares, where applicable) of eight banking and forty-two non-banking subsidiaries. At December 31, 1993, Comerica had total assets of approximately $30.3 billion, total deposits of approximately $20.9 billion, total loans (net of unearned income) of approximately $19.1 billion, and shareholders' equity of approximately $2.2 billion. At December 31, 1993, Comerica was the second largest bank holding company headquartered in Michigan in terms of both total assets and total deposits. BUSINESS STRATEGY Comerica's business strategy focuses on five core businesses in four geographic markets. Those businesses are corporate banking, consumer banking, private banking, institutional trust and investment management, and international finance and trade services. Corporate banking incorporates highly specialized units servicing a full range of company sizes with both credit and non-credit products. Consumer banking provides deposit, credit and fee-based products to individuals needing financial services but whose income or wealth do not make them prospects for private banking services. Private banking is oriented to servicing the financial needs of the affluent market as defined by individual net income or wealth. Institutional trust and investment management activities involve providing companies, municipalities and other entities a wide spectrum of investment management products and trust products such as master trust, master custody, and corporate trust services, as well as administering and serving as trustee for employee benefit plans. International finance and trade services offer importers and exporters trade financing, letters of credit, foreign exchange and international customhouse brokerage and freight forwarding products. The core businesses are tailored to each of Comerica's four primary geographic markets: the Midwest (currently Michigan and Illinois), Texas, California and Florida. The Midwest is the only market in which all five core businesses are currently pursued. In California and Texas the primary focus is on corporate banking and private banking activities. In Florida the primary focus is on private banking. ACQUISITIONS On July 17, 1992, Comerica entered into a Stock Purchase Agreement with Hibernia Corporation, a Louisiana corporation and a registered bank holding company, for the purchase of all of the issued and outstanding capital stock of Hibernia National Bank in Texas, a national banking association ("Hibernia Bank"). The transaction was closed on December 31, 1992, with Comerica paying a purchase price of approximately $56 million in cash. The acquisition was accounted for as a purchase. As of March 31, 1993, Hibernia Bank had total assets of approximately $787 million. In May 1993, Hibernia Bank was merged into Comerica Bank-Texas, a Texas chartered bank and a wholly owned subsidiary of Comerica. On September 24, 1992, Comerica entered into an Agreement and Plan of Merger with Sugar Creek National Bank ("Sugar Creek") for the acquisition by Comerica of Sugar Creek in exchange for Comerica common stock having a market value of approximately $28 million. Sugar Creek was a national banking association with offices in the Houston, Texas metropolitan area. The transaction was closed on February 25, 1993 and was accounted for using the pooling-of-interests method. At September 30, 1993, Sugar Creek had total assets of approximately $205 million. Sugar Creek merged into Comerica Bank-Texas in November 1993. On November 4, 1992, Comerica entered into Agreements and Plans of Reorganization and Merger with Nasher Financial Corporation, a Delaware corporation ("Nasher"), and NorthPark National Corporation, a Delaware corporation and a registered bank holding company ("NNC"), for the acquisition by Comerica of those two companies in exchange for Comerica common stock having a market value of approximately $79 million. Nasher's sole asset was approximately 29 percent of the outstanding common stock of NNC. NNC owned NorthPark National Bank of Dallas, a national banking association with one office in the Dallas, Texas area. The transaction was closed on May 28, 1993 and was accounted for using the pooling-of-interests method. At June 30, 1993, NNC had consolidated assets of approximately $696 million. In August 1993, NorthPark National Bank of Dallas was merged into Comerica Bank-Texas. On September 8, 1993, Comerica, Pacific Western Bancshares, Inc., a Delaware Corporation and bank holding company ("PAC WEST"), Pacific Western Bank, a California state Form 10-K Comerica Incorporated and Subsidiaries chartered bank and wholly owned subsidiary of PAC WEST ("PWB"), and Comerica California Incorporated, a California corporation, bank holding company and wholly owned subsidiary of the Corporation ("COM CAL"), entered into an Agreement and Plan of Reorganization and Merger providing for, among other things, the merger of COM CAL into PAC WEST (the "Merger") with PAC WEST being the surviving corporation under the charter and bylaws of COM CAL and the name "Comerica California Incorporated." Subsequent to the Merger, PWB may, at the Corporation's election, be merged into a subsidiary of Comerica. PAC WEST shareholders will receive approximately 4,585,000 shares of Comerica common stock. The transaction is subject to regulatory approval and is expected to be completed in the spring of 1994. As of December 31, 1993, PAC WEST had total assets of approximately $1 billion. SUPERVISION AND REGULATION Banks, bank holding companies and financial institutions are highly regulated at both the state and federal level. As a bank holding company, Comerica is subject to supervision and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended (the "Act"). Under the Act, the Corporation is prohibited, with certain exceptions, from acquiring or retaining direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company and from engaging in activities other than those of banking or of managing or controlling banks, other than subsidiary companies and activities which the Federal Reserve Board determines to be so closely related to the business of banking as to be a proper incident thereto. Comerica Bank is chartered by the State of Michigan and is supervised and regulated by the Financial Institutions Bureau of the State of Michigan. Comerica Bank-Texas is chartered by the State of Texas and is supervised and regulated by the Texas Department of Banking. Comerica Bank-Midwest, N.A. is chartered under federal law and subject to supervision and regulation by the Office of the Comptroller of the Currency. Comerica Bank-California is chartered and regulated by the State of California. Comerica Bank & Trust, FSB is chartered under federal law and subject to supervision and regulation by the Office of Thrift Supervision. Comerica Bank-Illinois is chartered by the State of Illinois and is regulated by the State of Illinois Commissioner of Banks and Trust Companies. Comerica Bank, Comerica Bank-Illinois and Comerica Bank-Midwest, N.A. are members of the Federal Reserve System. State member banks are also regulated by the Federal Reserve Bank and state non-member banks are also regulated by the Federal Deposit Insurance Corporation. The deposits of all the banks are insured by the Bank Insurance Fund (the "BIF") of the Federal Deposit Insurance Corporation to the extent provided by law. Comerica is a legal entity separate and distinct from its banking and other subsidiaries. Most of Comerica's revenues result from dividends paid to it by its bank subsidiaries. There are statutory and regulatory requirements applicable to the payment of dividends by subsidiary banks to Comerica as well as by Comerica to its shareholders. Dividends Each state bank subsidiary that is a member of the Federal Reserve System and each national banking association is required by federal law to obtain the prior approval of the Federal Reserve Board or the Office of the Comptroller of the Currency, as the case may be, for the declaration and payment of dividends if the total of all dividends declared by the board of directors of such bank in any year will 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, these banks may only pay dividends to the extent that retained net profits (including the portion transferred to surplus) exceed bad debts (as defined by regulation). Under the foregoing dividend restrictions, at January 1, 1994 Comerica's subsidiary banks, without obtaining governmental approvals, could declare aggregate dividends of approximately $273 million from retained net profits of the preceding two years, plus an amount approximately equal to the net profits (as measured under current regulations), if any, earned for the period from January 1, 1994 through the date of declaration. Dividends paid to Comerica by its subsidiary banks amounted to $311 million in 1993 and $60 million in 1992. FIRREA Recent banking legislation, including the Financial Institutions Reform and Recovery and Enforcement Act of 1989 ("FIRREA") and the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), has broadened the regulatory powers of the federal bank regulatory agencies. Under FIRREA, a depository institution insured by the Federal Deposit Insurance Corporation (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 any commonly controlled FDIC-insured depository institution "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. FDICIA In December 1991, FDICIA was enacted, substantially revising the bank regulatory and funding provisions of the Federal Deposit Insurance Act and making revisions to several other federal banking statutes. 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 establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." A depository institution's capital tier will depend upon where its capital levels are in relation to various relevant capital measures, which will include a risk-based capital measure and a leverage ratio capital measure, and certain other factors. Regulations establishing the specific capital tiers have been issued in final form. Under these regulations, for an institution to be well capitalized it must have a total risk-based capital ratio of at least 10 percent, a Tier 1 risk-based capital ratio of at least 6 percent, a Tier 1 leverage ratio of at least 5 percent, 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 percent, a Tier 1 risk-based capital ratio of at least 4 percent, and a Tier 1 leverage ratio of at least 4 percent (and in some cases 3 percent). Under these regulations, the banking subsidiaries of Comerica would be considered to be well capitalized as of December 31, 1993. 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 growth limitations and are required to submit a capital restoration 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. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company under the guaranty is limited to the lesser of (i) an amount equal to 5 percent of the depository institution's total assets at the time it became undercapitalized, and (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Loans to an undercapitalized institution from its Federal Reserve Bank are generally restricted. 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 institutions are subject to the appointment of a receiver or conservator. Under FDICIA, the FDIC is permitted to provide financial assistance to an insured bank before appointment of a conservator or receiver only if (i) such assistance would be the least costly method of meeting the FDIC's insurance obligations, (ii) grounds for appointment of a conservator or a receiver exist or are likely to exist, (iii) it is unlikely that the bank can meet all capital standards without assistance and (iv) the bank's management has been competent, has complied with applicable laws, regulations, rules and supervisory directives and has not engaged in any insider dealing, speculative practice or other abusive activity. FDICIA directs that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares and other standards as they deem appropriate. Because most of such standards have not yet been established, management is unable to assess their overall impact. However, it appears that the cost of compliance will increase. FDICIA also contains a variety of other provisions that may affect the operations of depository institutions including new reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions, the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch and a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not well capitalized or are adequately capitalized and have not received a waiver from the FDIC. As of December 31, 1993, Comerica Bank is well capitalized under regulations relating to the brokered deposit prohibition and may accept brokered deposits without restrictions. FDIC Insurance Assessments Comerica's subsidiary banks are subject to FDIC deposit insurance assessments. On September 15, 1992, the FDIC approved the implementation of a transitional risk-based deposit premium assessment system under which each depository institution is placed in one of the nine assessment categories based on certain capital and supervisory measures. The assessment rates under the transitional system range from .23 percent to .31 percent depending upon the assessment category into which the insured institution is placed. The transitional assessment system became effective January 1, 1993. On June 17, 1993, the FDIC adopted a permanent risk-based assessment system for assessment periods beginning on and after January 1, 1994. The system retains the transitional system without substantial modification. It is possible that BIF assessments will be further increased and it is possible that there may be special additional assessments in the future. A significant increase in the assessment rate or a special additional assessment could have an adverse impact on Comerica's results of operations. COMPETITION Banking is a highly competitive business. The Michigan banking subsidiary of the Corporation competes primarily with Detroit and outstate Michigan banks for loans, deposits and trust accounts. Through its offices in Arizona, California, Colorado, Florida, Indiana, Illinois, Ohio and Texas, Comerica competes with other financial institutions for various types of loans. Through its Florida subsidiary, Comerica competes with many companies, including financial institutions, for trust business. At year-end 1993, Comerica Incorporated was the second largest bank holding company located in Michigan in terms of total assets and deposits. Based on legislation passed during 1985 that allows Michigan-based banks to acquire or be acquired by banks in states with similar laws in effect, the Corporation believes that the level of competition in Michigan will increase in the future. Comerica's banking subsidiaries also face competition from other financial intermediaries, including savings and loan associations, consumer finance companies, leasing companies and credit unions. EMPLOYEES As of December 31, 1993, Comerica and its subsidiaries had 11,424 full-time and 1,763 part-time employees. Item 2. Item 2. Properties The executive offices of the Corporation are located in the Comerica Tower at Detroit Center in Detroit, Michigan. Comerica and its subsidiaries occupies 15 floors of the building, which it leases through Comerica Bank from an unaffiliated third party. This lease extends through January 2007. As of December 31, 1993, Comerica Bank operated 360 offices within the State of Michigan, of which 260 were owned and 100 were leased. Seven other banking affiliates operate 107 offices in California, Florida, Illinois and Texas. The affiliates own 34 of their offices and lease 73 offices. One banking affiliate also operates from leased space in Toledo, Ohio. In addition, the Corporation owns an operations and check processing center in Livonia, Michigan and a ten-story building in the central business district of Detroit that houses certain departments of the Corporation and Comerica Bank. In 1983, Comerica entered into a sale/leaseback agreement with an unaffiliated party covering an operations center which was built in Auburn Hills, Michigan, and now is occupied by various departments of the Corporation and Comerica Bank. Item 5. Item 5. Market for Corporation's Common Equity and Related Stockholder Matters The common stock of Comerica Incorporated is traded on the New York Stock Exchange (NYSE Trading Symbol: CMA). At January 31, 1994, there were approximately 14,420 holders of the Corporation's common stock. Quarterly cash dividends were declared during 1993 and 1992 totaling $1.07 and $.96 per common share per year, respectively. The following table sets forth, for the periods indicated, the high and low sale prices per share of the Corporation's common stock as reported on the NYSE Composite Transactions Tape for all quarters of 1993 and 1992. All of the prices are adjusted for the January 4, 1993 two-for-one stock split. * Dividend yield is calculated by annualizing the quarterly dividend per share and dividing by an average of the high and low price in the quarter. FORM 10-K CROSS REFERENCE INDEX. Comerica Incorporated and Subsidiaries Certain information required to be included in Form 10-k is also included in the 1993 Annual Report to Shareholders or in the 1994 Proxy Statement used in connection with the 1994 annual meeting of shareholders to be held on May 20, 1994. The following cross-reference index shows the page location in the 1993 Annual Report or the section of the 1994 Proxy Statement of only that information which is to be incorporated by reference into Form 10-k. All other sections of the 1993 Annual Report or the 1994 Proxy Statement are not required in Form 10-k and should not be considered a part thereof. FORM 10-K CROSS REFERENCE INDEX - Comerica Incorporated and Subsidiaries * This copy of the 1993 Annual Report and Form 10-k does not include any exhibits. Copies of the listed exhibits will be furnished to shareholders upon request. Requests should be directed to Comerica Incorporated, Corporate Secretary, Comerica Tower at Detroit Center, Detroit, Michigan 48226-3391. ** Incorporated by reference from Registrant's Annual Report on Form 10-k for the year ended December 31, 1987--Commission File Number 0-7269. *** Incorporated by reference from Registrant's Annual Report on Form 10-k for the year ended December 31, 1991--Commission File Number 0-7269. **** Incorporated by reference from Registrant's Form 8-A Registration Statement dated January 26, 1988--Commission File Number 0-7269. ***** Incorporated by reference from Registrant's Annual Report on Form 10-k for the year ended December 31, 1992--Commission File Number 0-7269. ****** Incorporated by reference from Registrant's Annual Report on Form 10-k for the year ended December 31, 1989--Commission File Number 0-7269. FORM 10-K - Comerica Incorporated and Subsidiaries SIGNATURES Pursuant to the requirements of Section 13 and 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 Detroit, State of Michigan on the 18th day of March, 1994. COMERICA INCORPORATED Eugene A. Miller Chairman and Chief Executive Officer Paul H. Martzowka Executive Vice President and Chief Financial Officer Arthur W. Hermann Senior Vice President and Controller (Chief Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities indicated on March 18, 1994. By Directors E. Paul Casey James F. Cordes J. Philip DiNapoli Max M. Fisher John D. Lewis Patricia Shontz Longe, Ph.D. Wayne B. Lyon Gerald V. MacDonald Donald R. Mandich Eugene A. Miller Michael T. Monahan Alfred A. Piergallini Dean E. Richardson Thomas F. Russell Alan E. Schwartz Howard F. Sims

30371_1993.txt

30371_1993

1993

30371

ITEM 1. BUSINESS. Duke Power Company (the Company) is engaged in the generation, transmission, distribution and sale of electric energy in the central portion of North Carolina and the western portion of South Carolina, comprising the area in both States known as the Piedmont Carolinas. Its service area, approximately two-thirds of which lies in North Carolina, covers about 20,000 square miles with an estimated population of 4.8 million and includes a number of cities, of which the largest are Charlotte, Greensboro, Winston-Salem and Durham in North Carolina and Greenville and Spartanburg in South Carolina. During 1993, the Company's electric revenues amounted to approximately $4.3 billion, of which about 70 percent was derived from North Carolina and about 30 percent from South Carolina. The Company ranks sixth in the United States among investor-owned utilities in kilowatt-hour sales. Its executive offices are located in the Power Building, 422 South Church Street, Charlotte, North Carolina 28242-0001 (Telephone No. 704-594-0887). THE STATISTICS PRESENTED HEREIN DO NOT INCLUDE INFORMATION RELATING TO THE COMPANY'S UTILITY SUBSIDIARY, NANTAHALA POWER AND LIGHT COMPANY, UNLESS OTHERWISE INDICATED. (SEE "ENERGY REQUIREMENTS AND CAPABILITY.") SERVICE AREA The Company supplies electric service directly to approximately 1.7 million residential, commercial and industrial customers in more than 200 cities, towns and unincorporated communities in North Carolina and South Carolina. Electricity is sold at wholesale to nine incorporated municipalities and to several private utilities. In addition, in 1993 approximately 9% of total sales were made through contractual arrangements to former wholesale municipal or cooperative customers of the Company who had purchased portions of the Catawba Nuclear Station (collectively, the "Other Catawba Joint Owners") (See "Joint Ownership of Generating Facilities.") The Company's service area is undergoing increasingly diversified industrial development. The textile, manufacture of machinery and equipment, chemical and chemical related industries are of major significance to the economy of the area. Other industrial activity includes the paper and allied products, rubber and plastic products and various other light and heavy manufacturing and service businesses. The largest industry served by the Company is the textile industry, which accounted for approximately $488 million of the Company's revenues for 1993, representing 11 percent of electric revenues and 40 percent of electric industrial revenues. ENERGY REQUIREMENTS AND CAPABILITY The following table sets forth the Company's generating capability at December 31, 1993, its sources of electric energy for 1993, and certain information presently projected for 1994: (a) The data relating to capability does not reflect the possible unavailability or reduction of capability of facilities at any given time because of scheduled maintenance, repair requirements or regulatory restrictions. (b) Nuclear capability and related generation for 1993 and projected for 1994 give no effect to the joint ownership of the Catawba Nuclear Station. (See "Joint Ownership of Generating Facilities.") (c) Includes Bad Creek and Jocassee pumped storage hydroelectric stations at licensed generating capabilities of 1,065,000 KW and 610,000 KW, respectively. (d) Excludes firm purchases. (See "Energy Management and Future Power Needs.") Nantahala Power and Light Company (NP&L), which operates 11 hydroelectric stations and buys supplemental power to provide service to its 51,000 mostly residential customers located in five counties in western North Carolina, operates as a separate subsidiary of the Company. The Company is supplying supplemental power to NP&L under the terms of an interconnect agreement approved by the Federal Energy Regulatory Commission (FERC). The Company has a bulk power sales agreement with Carolina Power & Light Company (CP&L) to provide CP&L 400 megawatts of capacity as well as associated energy when needed for a six-year period which began July 1, 1993. Electric rates in all regulatory jurisdictions were reduced by adjustment riders to reflect capacity revenues received from this agreement. According to industry statistics published in 1993, the Company ranked first in the nation in terms of efficiency of its steam-fossil generating system as measured by the conversion of fuel energy to electric energy. Published rankings indicate that individual units at Marshall Steam Station ranked first, second and sixth most efficient in the nation in 1992. The Company's nuclear system continued its tradition of operating efficiency, operating at 78 percent of capacity for the year, in comparison with the industry's most current average capacity factor of 71 percent for 1992. The Company normally experiences seasonal peak loads in summer and winter which are relatively in balance. The Company currently forecasts a 2.1 percent compound annual growth in peak load through 2008. This amount is not reduced by those future demand-side management program contributions considered resources for meeting peak demand (See "Energy Management and Future Power Needs"). The 1992-1993 winter peak load of 13,314,000 KW occurred on February 19, 1993. On July 29, 1993, the Company experienced its summer peak load of 15,720,000 KW during unusually hot weather. A new all-time peak load of 16,070,000 KW occurred on January 19, 1994 during extremely cold weather. RATE MATTERS The North Carolina Utilities Commission (NCUC) and The Public Service Commission of South Carolina (PSCSC) must approve the Company's rates for retail sales within the respective states. FERC must approve the Company's rates for sales to wholesale customers, including the contractual arrangements between the Company and the Other Catawba Joint Owners. Rate requests filed by the Company in its most recent general rate case in 1991 with the NCUC, PSCSC and FERC were principally designed to reflect the Company's investment in the Bad Creek Hydroelectric Station. Rate orders issued by the NCUC and PSCSC in November, 1991 recognized costs of the Bad Creek Hydroelectric Station, including an amortization of costs deferred between commercial operation and the rate order, which the Company had requested. The Company's wholesale customers challenged its proposed rate increase and in 1991 FERC issued an order that accepted the Company's proposed rates for filing. A negotiated settlement with these customers, which provided for an increase in wholesale rates consistent with the increase in retail rates, was approved by FERC and became effective in April 1992 (See "Management's Discussion and Analysis of Results of Operations and Financial Condition, Liquidity and Resources -- RATE MATTERS"). In its most recent general rate case, the NCUC authorized a jurisdictional rate of return on common equity of 12.50 percent and the PSCSC authorized a jurisdictional rate of return on common equity of 12.25 percent. The North Carolina Supreme Court, on April 22, 1992, remanded for the second time the Company's 1986 rate order to the NCUC. In its ruling, the Court held that the record from the 1986 proceedings failed to support the rate of return of 13.2 percent on common equity authorized by the NCUC after the initial decision of the Court remanding the 1986 rate order. The NCUC issued a final order dated October 26, 1992, authorizing a 12.8 percent return on common equity for the period October 31, 1986 through November 11, 1991, that resulted in a refund to North Carolina retail customers in 1992 of approximately $95 million, including interest. FUEL COST ADJUSTMENT PROCEDURES. The Company has procedures in all three of its regulatory jurisdictions to adjust rates for fluctuations in fuel expense. The NCUC ordered the Company to follow these procedures in its August 1986 order, which was effective for periods beginning January 1, 1986. The prospective adjustment in rates of past over- or under-recovery of fuel costs was challenged in the North Carolina courts. North Carolina adopted legislation assuring the legality of such adjustments, which contains a sunset provision effective June 30, 1997. CONSTRUCTION WORK IN PROGRESS (CWIP). The NCUC is permitted in its discretion to include CWIP in rate base after giving consideration to the public interest and the Company's financial stability. The PSCSC may include CWIP in rate base in its discretion. ENERGY MANAGEMENT AND FUTURE POWER NEEDS The Company's strategy for meeting customers' present and future energy needs is composed of three components: demand-side resources, purchased power resources and supply-side resources. By utilizing these resources, the Company expects to maintain a reserve margin of approximately 20 to 25 percent of its anticipated peak load requirements through 1996. Demand-side management programs are a part of meeting the Company's future power needs. These programs benefit the Company and its customers by providing for load control through interruptible control features, shifting usage to off-peak periods, increasing usage during off-peak periods, and by promoting energy efficiency. In return for participation in demand-side management programs, customers may be eligible to receive various incentives which help to reduce their electric bills. Demand-side management programs such as Industrial Interruptible Service and Residential Load Control can be used to manage capacity availability problems. Energy-efficiency programs such as high-efficiency chillers, high-efficiency heat pumps and high-efficiency air conditioners are other examples of current demand-side management programs. The November 1991 rate orders of the NCUC and the PSCSC provided for recovery in rates of a designated level of costs for demand-side management programs and allowed the deferral for later recovery of certain demand-side management costs that exceed the level reflected in rates, including a return on the deferred costs. As additional demand-side costs are incurred, the Company ultimately expects recovery of associated costs, which are currently being deferred, through rates. The annual costs deferred, including the return, were approximately $26 million in 1993 and $18 million in 1992. The Company continues to engage in a comprehensive energy management program as part of its Integrated Resource Plan. Integrated Resource Planning is the process used by utilities to evaluate a variety of resources. The goal is to provide adequate and reliable electricity in an environmentally responsible manner through cost-effective power management. In January 1993, the PSCSC issued an order approving the Company's 1992 Integrated Resource Plan as reasonable, and approving a "shared savings" proposal for accomplishments made in the Company's demand-side management programs. In June 1993, the NCUC approved the 1992 plan, including the shared savings mechanism. The Company's current plan reduces supply side requirements in excess of 1,900 megawatts by the year 2000 due to the Company's effective use of demand side options. The purchase of capacity and energy is also an integral part of meeting future power needs. The Company currently has under contract 500 megawatts of capacity from other generators of electricity. The Company's construction program and the estimated construction costs set forth below are subject to continuing review and are revised from time to time in light of changes in load forecasts, the Company's financial condition (including cash flow, earnings and levels of rates), changing regulatory and environmental standards (See "Regulation -- ENVIRONMENTAL MATTERS") and other factors. Projected construction and nuclear fuel costs, excluding costs related to portions of the Catawba Nuclear Station owned by the Other Catawba Joint Owners, for each of 1994, 1995 and 1996 and for the three-year period 1994-1996, as now scheduled, are as follows (in millions of dollars): The Company's procedures for estimating construction costs (which include allowance for funds used during construction) utilize, among other things, past construction experience, current construction costs and allowances for inflation. The Company is building a combustion turbine facility in Lincoln County, North Carolina to provide capacity at periods of peak demand. The Lincoln Combustion Turbine Station will consist of 16 combustion turbines with a total generating capacity of 1,184 megawatts. The estimated total cost of the project is approximately $500 million. Current plans are for ten units to begin commercial operation by the end of 1995 and the remaining six to begin commercial operation before the end of 1996. During 1991, the NCUC granted the Certificate of Public Convenience and Necessity and the North Carolina Division of Environmental Management issued a final air permit for the facility. The issuance of the final air permit for the facility has been appealed. Legal proceedings with regard to the appeal are ongoing. The Company believes the permit will be upheld. The Company has nearly completed a Plant Modernization Program (PMP) to improve the efficiency and reliability of 15 older coal-fired generating units. These units, once modernized, will help the Company meet anticipated future demand. The cost of this program is estimated to average approximately $200-$300 per installed KW, a fraction of the cost of building new plants. As of December 31, 1993, eleven coal-fired units with a nameplate generating capability of 1,241,000 KW had been returned to the system. It is anticipated that three additional coal-fired generating units with nameplate generating capability of 160,000 KW will be returned to the system during 1994. The Company expects the final unit remaining in the PMP after 1994, which unit has 40,000 KW of nameplate generating capability, to be returned to the system in 1995. JOINT OWNERSHIP OF GENERATING FACILITIES In order to reduce its need for external financing, the Company, through several transactions beginning in 1978, sold an 87 1/2 percent undivided interest in the Catawba Nuclear Station to the Other Catawba Joint Owners. These transactions contemplate that the Company will operate the facility, interconnect its transmission system, wheel a certain portion of the capacity and energy of such facility to the respective participants, provide back-up services for such capacity, buy for its own use (whether or not the facility is generating electricity) that portion of the capacity not then contractually required by the respective participants, and provide supplemental power as required by the purchasers to enable them to provide service on a firm basis. The transactions also include a reliability exchange between the Catawba Nuclear Station and the McGuire Nuclear Station of the Company, which provides for an exchange of 50 percent of each Other Catawba Joint Owner's retained capacity from its ownership interest in the Catawba units for like amounts of capability and output from units of the McGuire Nuclear Station. The implementation of the reliability exchange has not had nor does the Company anticipate that such implementation will have a material effect on earnings. The Other Catawba Joint Owners and the Company are involved in various proceedings related to the Catawba joint ownership contractual agreements. The basic contention in each proceeding is that certain calculations affecting bills under these agreements should be performed differently. These items are covered by the agreements between the Company and the Other Catawba Joint Owners which have been previously approved by the Company's retail regulatory commissions (See Note 3, "Notes to Consolidated Financial Statements"). The Company and two of the four Other Catawba Joint Owners have entered into a proposed settlement agreement which, if approved by the regulators, will resolve all issues in contention in such proceedings between the Company and these owners. The Company recorded a liability as an increase to Other current liabilities on its Consolidated Balance Sheets of approximately $105 million in 1993 to reflect this proposed settlement. In addition, future estimated obligations in connection with the settlement are reflected in estimates of purchased capacity obligations in Note 3, "Notes to Consolidated Financial Statements". As the Company expects the costs associated with this settlement will be recovered as part of the purchased capacity levelization, the Company has included approximately $105 million as an increase to Purchased capacity costs on its Consolidated Balance Sheets. Therefore, the Company believes the ultimate resolution of these matters should not have a material adverse effect on the results of operations or financial position of the Company. Although the two Other Catawba Joint Owners, who are not parties to the above settlement, have not fully quantified the dollars associated with their claims in the presently outstanding proceedings, information associated with these proceedings indicates that the amount in contention could be as high as $110 million, through December 31, 1993. Arbitration hearings were held in 1992 involving substantially all of the disputed amounts, and a decision interpreting the language of the agreements on certain of these matters was issued on October 1, 1993. Further proceedings will be required to determine the amounts associated with this decision as it relates to these owners, some of which may involve refunds. However, the Company expects the costs associated with this decision will be included in and recovered as part of the purchased capacity levelization consistent with prior orders of the retail regulatory commissions. Therefore, the Company believes the ultimate resolution of these matters should not have a material adverse effect on the results of operations or financial position of the Company. FUEL SUPPLY The Company presently relies principally on nuclear and coal for the generation of electric energy. The Company's reliance on oil and gas is minimal. Information regarding the utilization of sources of power and cost of fuels is set forth in the following table: * Generating figures are net of that output required to replenish pumped storage units during off-peak periods. COAL. The Company obtains a large amount of its coal under long-term supply contracts with mining operators utilizing both underground and surface mining. The Company has on hand an adequate supply of coal. The Company's long-term supply contracts, all of which have price adjustment and price renegotiation provisions, have expiration dates ranging from 1995 to 2003. The Company believes that it will be able to renew such contracts as they expire or to enter into similar contractual arrangements with other coal suppliers for quantities and qualities of coal required. However, due to the Clean Air Act Amendments of 1990, fuel premiums may be required as contracts are renewed. The coal covered by the Company's long-term supply contracts is produced from mines located in eastern Kentucky, southern West Virginia and southwestern Virginia. The Company's short-term requirements have been and will be fulfilled with spot market purchases. The average sulfur content of coal being purchased by the Company is approximately 1 percent. Such coal satisfies the current emission limitation for sulfur dioxide for existing facilities. (See "Management's Discussion and Analysis of Results of Operations and Financial Condition, Current Issues -- The Clean Air Act Amendments of 1990.") NUCLEAR. Generally, the supply of fuel for nuclear generating units involves the mining and milling of uranium ore to produce uranium concentrates, the conversion of uranium concentrates to uranium hexafluoride, enrichment of that gas and fabrication of the enriched uranium hexafluoride into usable fuel assemblies. After a region (approximately one-third of the nuclear fuel assemblies in the reactor at any time) of spent fuel is removed from a nuclear reactor, it is placed in temporary storage for cooling in a spent fuel pool at the nuclear station site. The Company has contracted for uranium materials and services required to fuel the Oconee, McGuire and Catawba Nuclear Stations. Based upon current projections, these contracts will meet the Company's requirements through the following years: Uranium material requirements will be met through various supplier contracts, with uranium material produced primarily in the U.S., Canada and Australia. The Company believes that it will be able to renew contracts as they expire or to enter into similar contractual arrangements with other nuclear fuel materials and services suppliers. Short-term requirements have been and will be fulfilled with uranium spot market purchases. The Company purchased uranium material during 1993 at an average price of approximately $28 per pound. The Company's material nuclear supply contracts generally contain FORCE MAJEURE provisions. The Nuclear Waste Policy Act of 1982 requires that the Department of Energy (DOE) begin disposing of spent fuel no later than January 31, 1998. The Company has entered into the required contracts with the DOE for the disposal of nuclear fuel and began making payments in July 1983 for disposal costs of fuel currently being utilized. These payments, combined with a one-time payment for disposal costs of fuel consumed prior to April 7, 1983, have totaled about $525 million through 1993. In November 1989, the DOE released a report which indicated that it expects that a facility for spent fuel disposal will not be available until the year 2010. The DOE stated further that it planned an initiative to establish a monitored retrievable storage facility, with a target operation date of 1998, for earlier acceptance of spent fuel from utilities. The Company believes that it will be able to provide adequate on-system storage capacity until such time as the DOE begins receiving spent fuel. REGULATION The Company is subject to the jurisdiction of the NCUC and the PSCSC which, among other things, must approve the issuance of securities. The Company also is subject, as to some phases of its business, to the jurisdiction of FERC, the Environmental Protection Agency (EPA) and state environmental agencies and to the jurisdiction of the Nuclear Regulatory Commission (NRC) as to design, construction and operation of its nuclear power facilities. The Company is exempt from regulation as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA), except with respect to the acquisition of the securities of other public utilities. ENVIRONMENTAL MATTERS. The Company is subject to federal, state, and local regulations with regard to air and water quality, hazardous and solid waste disposal, and other environmental matters. North Carolina has enacted a declaration of environmental policy requiring all state agencies to administer their responsibilities in accordance with such policy. The NCUC has adopted rules requiring consideration of environmental effects in determining whether certificates of public convenience and necessity will be granted for proposed generation facilities. South Carolina law also requires consideration by the PSCSC of environmental effects in determining whether certificates of public convenience and necessity will be granted for proposed major utility facilities, which include certain generation and transmission facilities. All of the Company's facilities which are currently under construction have been designed to comply with presently applicable environmental regulations. Such compliance has, however, increased the cost of electric service by requiring changes in the design and operation of existing facilities, as well as changes or delays in the design, construction and operation of new facilities. In 1993, the Company's construction costs for environmental protection totaled approximately $18 million, while the on-going environmental operation costs were approximately $20 million. The Company's 1994 -- 1996 construction program includes costs for environmental protection which are estimated to be approximately $101 million, including $22.3 million in 1994, $41.8 million in 1995 and $36.9 million in 1996. These costs include expenditures to begin compliance with the Clean Air Act Amendments of 1990. However, governmental regulations establishing environmental protection standards are continually evolving and have not, in some cases, been fully established. Therefore, the Company may have to revise the estimates in response to developments in these and other areas. AIR QUALITY. See "Management's Discussion and Analysis of Results of Operations and Financial Condition, Current Issues -- The Clean Air Act Amendments of 1990" for a discussion of the Company's plans for compliance with federal clean air standards. WATER QUALITY. The Federal Water Pollution Control Act Amendments of 1987 (otherwise known as the "Clean Water Act") require permits for facilities that discharge into waters, to ensure compliance with its provisions. The Company holds numerous such permits, and such permits are reissued periodically. The Federal Water Pollution Control Act is scheduled for reauthorization by Congress in 1994. Until Congress acts upon the reauthorization, management will be unable to assess what effect, if any, such reauthorization will have on the Company's operations. OTHER ENVIRONMENTAL REGULATIONS. Contingencies associated with environmental matters are principally related to possible obligations to remove or mitigate the effects on the environment resulting from the disposal of certain substances at contamination sites. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), commonly known as "Superfund", requires any individual or entity which may have owned or operated a contaminated site, as well as transporters or generators of hazardous wastes which were sent to such site, to assume joint and several responsibility for remediation of the site. Such parties are known as "potentially responsible parties" (PRPs). In 1993, Duke as a PRP, resolved litigation at a Superfund site in West Virginia, and is currently participating in a PRP group with regard to a Superfund site in Concord, North Carolina. Additionally, the Company is a DE MINIMUS contributor at two sites in Pennsylvania. The Company is also a PRP at contamination sites in Charlotte, North Carolina and Lenoir, North Carolina, which will likely be remediated in accordance with state acts which are similar to CERCLA. While the total cost of remediation at these federal and state contamination sites may be substantial, the Company shares probable liability with other PRPs, many of which have substantial assets. Other contamination sites relate to the Company's operation of manufactured gas plant (MGP) sites prior to the early 1950s, some of which are still owned by the Company and some of which are now owned by third parties. The Company is participating in a state-sponsored program which will result in the investigation and, where appropriate, remediation of MGP sites. Management is of the opinion that resolution of these matters will not have a material adverse effect on the results of operations or financial position of the Company. CERCLA is scheduled for reauthorization by Congress in 1994. Until Congress acts upon the reauthorization, management will be unable to assess what effect, if any, such reauthorization will have on the Company's operations. GENERAL. Over the past few decades, the issue of the possible health effects of electric and magnetic fields has generated a number of generally inconclusive studies, some public concern and litigation as well as legislative action in some states regarding high voltage transmission lines. The impact of this issue on the Company cannot presently be determined. NUCLEAR FACILITIES. The Company's nuclear facilities are subject to continuing regulation by the NRC. The steam generators at the McGuire and Catawba Nuclear Stations have experienced stress corrosion cracking in their tubes. Stress corrosion cracking is a phenomenon that typically occurs in tight U-bends, at tube support plates, and where tubes are attached to the tube sheets. Stress corrosion cracking has been identified as a problem in steam generators of certain designs, including those at the McGuire and Catawba Stations. The Company believes that the stress corrosion cracking is caused by defective design, workmanship and materials used by the manufacturer of the steam generators. Both primary side and secondary side cracking and corrosion have been observed in the steam generators at the McGuire and Catawba Stations. In addition, recent inspections at McGuire Units 1 and 2 have revealed a different type of secondary side stress corrosion cracking in the free-span area of the steam generator tubes located on the "cold-leg" side of those Units (cold-leg free-span cracking). The Company conducts tests at each refueling outage to determine the extent of stress corrosion cracking during the preceding fuel cycle. The steam generators at Catawba Unit 2 have certain design differences from those at Catawba Unit 1 or either McGuire Unit, but it is too early in the life of Catawba Unit 2 to determine the extent to which stress corrosion cracking will be a problem. Although the Company has taken steps to mitigate the effects of stress corrosion cracking in the McGuire and Catawba steam generator tubes, including examining the steam generator tubes at each refueling outage, tube plugging, tube sleeving, more stringent water chemistry control, shot peening, and tight U-bend heat treatment, further stress corrosion cracking in the McGuire Units 1 and 2 and Catawba Unit 1 steam generators appears likely. Potential consequences of future stress corrosion cracking include extensive tube plugging and sleeving, additional water chemistry control, additional inspections and testing resulting in longer outages, mid-cycle outages, reduction in plant output, and requests for license amendments. The Company has compared the cost of continued repair of the steam generators with the cost of early steam generator replacement and has determined that for McGuire Units 1 and 2 and Catawba Unit 1, the most cost-effective alternative is to replace the steam generators as soon as it is feasible to do so. The Company has begun planning for the replacement of steam generators and has set the following schedule to begin the process: McGuire Unit 1 -- 1995; Catawba Unit 1 -- 1996; McGuire Unit 2 -- 1997. The order of replacement is subject to change based on performance of the existing steam generators and on the overall performance of the three units. The Company has signed an agreement with Babcock & Wilcox International to purchase 12 replacement steam generators for the McGuire and Catawba Stations. Each unit's steam generator replacement is expected to take approximately four months and cost approximately $170 million, excluding the cost of replacement power and without consideration of reimbursement of applicable costs by the Other Catawba Joint Owners of Catawba Unit 1. Stress corrosion problems are excluded under the nuclear insurance policies. The Company anticipates that the replacement of the steam generators should not have a material adverse effect on the Company's results of operations or financial position. Because Catawba Unit 2 has not shown the degree of stress corrosion cracking which has occurred in McGuire Units 1 and 2 and Catawba Unit 1, the Catawba Unit 2 steam generators have not been scheduled for replacement. The Company in connection with its McGuire and Catawba stations and on behalf of the Other Catawba Joint Owners commenced a legal action on March 22, 1990, in the United States District Court for the District of South Carolina (Charleston Division) seeking damages from Westinghouse Electric Corporation (Westinghouse) for supplying to the McGuire and Catawba Stations steam generators that were alleged to be defective in design, workmanship and materials, and that will require replacement well short of their stated design life. In the action, the Company sought a judgment against Westinghouse for damages of approximately $600 million, including the cost of necessary remedial measures, the cost of replacement of steam generators and payment for replacement power during the outages to accomplish replacement. In addition to these damages, the Company sought punitive or treble damages and attorneys' fees. The lawsuit was settled on March 17, 1994. (See "Subsequent Events.") NUCLEAR DECOMMISSIONING COSTS. Estimated site-specific nuclear decommissioning costs, including the cost of decommissioning plant components not subject to radioactive contamination, total approximately $955 million stated in 1990 dollars. This amount includes the Company's 12.5 percent ownership in the Catawba Nuclear Station. The Other Catawba Joint Owners are liable for providing decommissioning related to their ownership interest in the Catawba Nuclear Station. Both the NCUC and the PSCSC have granted the Company recovery of the estimated site-specific decommissioning costs through retail rates over the expected remaining service periods of the Company's nuclear plants. Such estimates presume that units will be decommissioned as soon as possible following the end of their license life. Although subject to extension, the current operating licenses for the Company's nuclear units expire as follows: Oconee 1 and 2 -- 2013, Oconee 3 -- 2014; McGuire 1 -- 2021, McGuire 2 -- 2023; and Catawba 1 -- 2024, Catawba 2 -- 2026. The Nuclear Regulatory Commission (NRC) issued a rulemaking in 1988 which requires an external mechanism to fund the estimated cost to decommission certain components of a nuclear unit subject to radioactive contamination. In addition to the required external funding, the Company maintains an internal reserve to provide for decommissioning costs of plant components not subject to radioactive contamination. During 1993, the Company expensed approximately $52.5 million which was contributed to the external funds and accrued an additional $5 million to the internal reserve. The balance of the external funds as of December 31, 1993, was $118.5 million. The balance of the internal reserve as of December 31, 1993, was $200 million and is reflected in Accumulated depreciation and amortization on the Consolidated Balance Sheets. Management's opinion is that the estimated site-specific decommissioning costs being recovered through rates, when coupled with assumed after-tax fund earnings of 4.5 percent to 5.5 percent, are currently sufficient to provide for the cost of decommissioning based on Company's current decommissioning schedule. A provision in the Energy Policy Act of 1992 established a fund for the decontamination and decommissioning of the DOE's uranium enrichment plants. Licensees are subject to an annual assessment for 15 years based on their pro rata share of past enrichment services. The annual assessment is recorded as fuel expense. The Company paid approximately $8.3 million during 1993 related to its ownership interest in nuclear plants. The Company has reflected the remaining liability and regulatory asset of approximately $117 million in the Consolidated Balance Sheets. NUCLEAR INSURANCE. For a discussion of the Company's nuclear insurance coverage, see "Notes to Consolidated Financial Statements, Note 13 -- Commitments and Contingencies -- Nuclear Insurance." HYDROELECTRIC LICENSES. The principal hydroelectric projects of the Company are licensed by FERC under Part I of the Federal Power Act. Eleven developments on the Catawba-Wateree River in North Carolina and South Carolina, with a nameplate rating of 804,940 KW, are licensed for a term expiring in 2008. The Company also holds a license for the Keowee-Toxaway Project for a term expiring in 2016, covering the Keowee Hydro Station and the Jocassee Pumped Storage Station for a combined total of 769,500 KW, on the upper tributaries of the Savannah River in northwestern South Carolina. Additionally, the Company is the licensee through 2027 for the Bad Creek Hydroelectric Station which uses Lake Jocassee as its lower reservoir and has a nameplate rating of 1,065,000 KW. The Federal Power Act provides, among other things, that, upon the expiration of any license issued thereunder, the United States may (a) grant a new license to the licensee for the project, (b) take over the project upon payment to the licensee of its "net investment" in the project (but not in excess of the fair value thereof) plus severance damages, or (c) grant a license for the project to a new licensee subject to payment to the former licensee of the amount specified in (b) above. INTERCONNECTIONS The Company has major interconnections and arrangements with its neighboring utilities which it considers adequate for coordinated planning, emergency assistance, exchange of capacity and energy, and reliability of power supply. COMPETITION The Company currently is subject to competition in some areas from government-owned power systems, municipally-owned electric systems, rural electric cooperatives and, in certain instances, from other private utilities. Statutes in North Carolina and South Carolina provide for the assignment by the NCUC and the PSCSC, respectively, of all areas outside municipalities in such states to power companies and rural electric cooperatives. Substantially all of the territory comprising the Company's service area has been so assigned. The remaining areas have been designated as unassigned and in such areas the Company remains subject to competition. A decision of the North Carolina Supreme Court limits, in some instances, the right of North Carolina municipalities to serve customers outside their corporate limits. In South Carolina there continues to be competition between municipalities and other electric suppliers outside the corporate limits of the municipalities, subject, however, to the regulation of the PSCSC. In addition, the Company is engaged in continuing competition with various natural gas providers. The Energy Policy Act of 1992 has far-reaching implications for the Company by moving utilities toward a more competitive environment. The Act reformed certain provisions of the Public Utility Holding Company Act of 1935 (PUHCA) and removed certain regulatory barriers. For example, the Act allows utilities to develop independent electric generating plants in the United States for sales to wholesale customers, as well as to contract for utility projects internationally, without becoming subject to registration under PUHCA as an electric utility holding company. The Act requires transmission of power for third parties to wholesale customers, provided that the reliability of service to the utility's local customer base is protected and the local customer base does not subsidize the third-party service. Although the Act does not require transmission access to retail customers, states can authorize such transmission access to and for retail electric customers. The electric utility industry is predominantly regulated on a basis designed to recover the cost of providing electric power to its retail and wholesale customers. If cost-based regulation were to be discontinued in the industry for any reason, including competitive pressure on the price of electricity, utilities might be forced to reduce their assets to reflect market basis if such basis is less than cost. Discontinuation of cost-based regulation could also require some utilities to write off their regulatory assets. Management cannot predict the potential impact, if any, of these competitive forces on the future financial position and results of operations of the Company. However, the Company is continuing to position itself to effectively meet these challenges by maintaining prices that are regionally and nationally competitive. NON-UTILITY ACTIVITIES The Company is engaged in a variety of non-utility operations, including real estate development and forest management, marketing of electrical appliances, management of passive financial investments, developing and investing in electric generation and transmission facilities outside the Company's service area and providing engineering and technical services. Most of the Company's non-utility operations are organized in separate subsidiaries. Subsidiary and diversified operations contributed $22 million after tax to corporate earnings in 1993. A major part of the future growth in the electric power market is anticipated to be outside the traditional regulated framework and, to a large extent, outside the United States. The Company, through its subsidiaries, is participating in these international opportunities and continues participating in domestic opportunities to provide additional value to its shareholders. Internationally, the Company is seeking opportunities to provide engineering consulting services, construction, operation and maintenance of generating facilities, and ownership of transmission and generating facilities. Although these opportunities are concentrated in areas that utilize the Company's expertise, they present different and greater risks than the Company's core business. The Company considers only opportunities in which the expected return is commensurate with the risks, and makes efforts to mitigate such risks. In March 1993, Duke Energy Group (DEG) invested $25 million in convertible preferred stock of J. Makowski & Company (Makowski), a developer of natural gas-fired electric projects, and is providing $10.2 million in credit support for a Makowski project. Additionally, DEG has one seat on the Board of Directors of Makowski. In June 1993, after a competitive bidding process, the Argentine government awarded the right to buy 65 percent of the stock of Compania de Transporte de Energia Electrica en Alta Tension S. A. (Transener) to a consortium led by DEG. Transener is Argentina's primary transmission company. It employs about 1,100 persons, and has 6,867 kilometers of 500 kilovolt lines, 284 kilometers of 220 kilovolt lines, and 27 substations. The consortium assumed ownership and operation of the system on July 16, 1993. Another consortium, also led by DEG, was awarded the majority ownership and operation of Hidroelectrica Piedra del Aguila S.A. on November 29, 1993. Hidroelectrica Piedra del Aguila S.A. owns a hydroelectric facility located in southwestern Argentina. When fully operational in 1995, the facility will have a capacity of 1,400 megawatts. The consortium assumed ownership of 59 percent of the stock of Hidroelectrica Piedra del Aguila S.A., and took over operation of the hydroelectric complex on December 29, 1993. EMPLOYEES At December 31, 1993, the Company employed 18,274 full-time persons, which includes 789 full-time employees of subsidiaries and affiliates. About 2,000 electrical operating employees are represented by the International Brotherhood of Electrical Workers (IBEW). The Company reached a new labor agreement with the IBEW, effective October 1, 1993, for a one year term. The Company has been engaged in a concentrated effort to more efficiently and effectively utilize its resources through better work practices. During the first quarter of 1993, the Company offered a Limited Period Separation Opportunity Program (LPSO) which gave employees the option of leaving the Company for a lump sum severance payment and, for qualifying employees, enhanced retirement benefits. On March 15, 1994, the Company announced plans to offer Enhanced Voluntary Separation (EVS), a severance package, for employees who choose to leave the Company voluntarily during the second quarter of 1994. Implementing programs such as LPSO, EVS and other efficiency practices has resulted in continued workforce reduction and in streamlined workflows. The number of full-time employees has decreased to the present level from 19,945 at year-end 1990. The 1990 amount included 496 employees of subsidiaries and affiliates. SUBSEQUENT EVENTS On January 25, 1994, the Board of Directors selected William H. Grigg, Vice Chairman of the Board, to succeed William S. Lee as Chairman of the Board, President and Chief Executive Officer, effective at the Annual Meeting of Shareholders to be held on April 28, 1994. Mr. Lee will serve the Company as a consultant after that date until his retirement following his 65th birthday in June 1994. On March 2, 1994, the Duke Endowment announced its intention to diversify its investment portfolio by selling up to 16 million shares of its Duke Power Common Stock. A registration statement was filed with the Securities and Exchange Commission on that day and underwriting agreements were entered into on March 29, 1994 relating to the sale of 14 million of such shares, with over-allotment options of up to 2 million shares. The Duke Endowment will retain approximately 10 million shares after the sale (assuming the over-allotment options are exercised), and has announced that it has no present intention to dispose of any additional shares of Common Stock. On March 17, 1994, the Company, together with the Other Catawba Joint Owners, settled the lawsuit initiated by the Company on March 22, 1990 against Westinghouse Electric Corporation seeking damages for supplying to the McGuire and Catawba Nuclear Stations steam generators that were alleged to be defective in design, workmanship and materials and that would require replacement well short of their stated design life. While the terms of the settlement may not be disclosed pursuant to court order, the Company believes the litigation was settled on terms that provided satisfactory consideration to the Company. Such settlement will not have a material effect on the Company's results of operations or financial position. (See "Regulation -- Nuclear Facilities" and "Management's Discussion and Analysis of Results of Operations and Financial Condition, Current Issues -- Stress Corrosion Cracking.") (graphic--full page map showing the Duke Power Service Area) DUKE POWER COMPANY OPERATING STATISTICS (a) Includes 100% of Catawba generation. (b) 1991 includes KWH of the Bad Creek Hydroelectric Station prior to commercial operation. (c) Kilowatt-hour sales, Electric revenues and Net interchange and purchased power for the years 1989 and 1990 include a reclassification for certain power transactions previously classified as Net interchange and purchased power prior to a 1990 FERC order. (d) Does not reflect operating statistics, kilowatt-hour sales and revenues of Nantahala Power and Light Company. (e) Includes sales to Nantahala Power and Light Company. (f) 1991 restated to eliminate certain duplicate customers. EXECUTIVE OFFICERS OF THE COMPANY OTHER OFFICERS * As of February 1, 1994. **Member of the Management Committee. Executive officers are elected annually by the Board of Directors and serve until the first meeting of the Board of Directors following the next annual meeting of shareholders and until their successors are duly elected. There are no family relationships between any of the executive officers nor any arrangement or understanding between any executive officer and any other person pursuant to which the officer was selected. All of the above executive officers have held responsible positions with the Company for the past five years. There have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions material to the evaluation of the ability and integrity of any executive officer during the past five years. ITEM 2. ITEM 2. PROPERTIES. The map on page 12 shows the location of the Company's service area and generating stations. Reference is made to Schedule V -- Property, Plant and Equipment for information concerning the Company's investment in utility plant. Substantially all electric plant is mortgaged under the Indenture relating to the First and Refunding Mortgage Bonds of the Company. For additional information concerning the properties of the Company, see "Business -- Energy Management and Future Power Needs". ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Reference is made to "Notes to Consolidated Financial Statements, Note 13 -- Commitments and Contingencies", "Business -- Regulation -- NUCLEAR FACILITIES" and "Subsequent Events". ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of the Company's security holders during the last quarter of 1993. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Common Stock of the Company is traded on the New York Stock Exchange. At December 31, 1993, there were approximately 127,688 holders of shares of such Common Stock. The following table sets forth for the periods indicated the dividends paid per share of Common Stock and the high and low sales prices of such shares reported by the New York Stock Exchange Composite Transactions: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (a) Electric revenues, Electric expenses, Kilowatt-hour sales and Net interchange and purchased power for the years 1989 and 1990 include a reclassification for certain power transactions previously classified as Net interchange and purchased power prior to a 1990 FERC order. (b) All common stock data reflects the two-for-one split of common stock on September 28, 1990. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition Results of Operations Earnings and Dividends Earnings per share increased 27 percent from $2.21 in 1992 to $2.80 in 1993. The increase was primarily due to higher kilowatt-hour sales and a one-time charge taken in 1992 related to a rate refund to North Carolina retail customers of $.32 per share. (For additional information on the refund, see Liquidity and Resources "Rate Matters," page 18.) The increase was partially offset by higher operating and maintenance expenses, additional charitable contributions to the Duke Power Company Foundation and an increase in the federal income tax rate caused by the Omnibus Budget Reconciliation Act of 1993. Higher general taxes also decreased earnings. Earnings per share increased from $2.60 in 1991 to $2.80 in 1993, indicating an average annual growth rate of 4 percent. Total Company earned return on average common equity was 13.6 percent in 1993 compared to 11.1 percent in 1992 and 13.5 percent in 1991. The Company continued its practice of increasing the common stock dividend annually. Common dividends per share increased from $1.68 in 1991 to $1.84 in 1993, rising at an average annual rate of 5 percent. Indicated annual dividends per share increased to $1.88. Revenue and Sales Revenues increased at an average annual rate of 6 percent from 1991 to 1993, primarily because of increased overall kilowatt-hour sales and the November 1991 rate increases. Kilowatt-hour sales for 1993 increased 7 percent compared to 1992. Sales to residential customers increased by 9 percent reflecting colder winter weather and a hotter-than-normal summer. General service customer kilowatt-hour sales increased by 7 percent as a result of both continued economic growth and weather trends cited above. Sales to other-industrial customers and textile customers increased by 6 percent and 2 percent, respectively, as a result of the continued economic growth in the Company's service area. Operating Expenses From 1992 to 1993, non-fuel operating and maintenance expenses rose 4 percent. Administrative and general expenses increased partly because of increased pension expenses to reflect more conservative investment return assumptions and one-time costs associated with a voluntary separation option offered during the first quarter of 1993. A winter storm during the first quarter of 1993 also increased non-fuel operating and maintenance expenses. These increases from 1992 to 1993 were partially offset by lower nuclear and fossil maintenance expenses resulting from lower outage costs. Non-fuel operating and maintenance expenses increased at an average annual rate of 5 percent from 1991 to 1993. Administrative and general expenses increased over this period because of the implementation of a new accounting standard in January 1992 that reflects accrual basis accounting for certain postretirement health care and life insurance benefits, in addition to the reasons cited in the preceding paragraph. Operating and maintenance expenses for fossil and hydro plants also increased from 1991 to 1993. Fossil increases were caused by bringing refurbished units back on-line, and hydro increases were the result of the completion of the Bad Creek Hydroelectric Station in late 1991. Net interchange and purchased power decreased at an average annual rate of 1 percent from 1991 to 1993. A slight decline in the amount of purchased power from the other Catawba joint owners as recognized on the income statement was substantially offset by increased purchases from other utilities. (For additional information on the Catawba purchase power agreements, see Note 3 to the Consolidated Financial Statements.) Fuel expense increased at an average annual rate of 6 percent from 1991 to 1993. The increase was due primarily to higher system production requirements that were satisfied by increased fossil generation. A continued decline of fuel prices over this period helped to offset the overall increase in fuel expenses. From 1991 to 1993, depreciation and amortization expense increased at an average annual rate of 6 percent primarily because of the completion of the Bad Creek Hydroelectric Station in 1991 and added investment in distribution property. Other Income and Interest Deductions Allowance for funds used during construction (AFUDC) represented 5 percent of earnings for common stock in 1993 compared to 13 percent in 1991. The decrease is primarily the result of the completion of the Bad Creek Hydroelectric Station in 1991. AFUDC is expected to represent less than 10 percent of total earnings during the next three years. The carrying charge, net of associated taxes, on the purchased capacity levelization deferral related to the joint ownership of the Catawba Nuclear Station represented 6 percent of total earnings in 1993, compared to 6 percent in 1992 and 5 percent in 1991. This carrying charge and the related tax benefits are included in Other, net and Income taxes -- other, net, respectively. The growth in this carrying charge is due to the increasing cumulative impact of the Company's funding of purchased power costs which current rates are expected to collect in future periods. The Company recovers the accumulated balance, including the carrying charge, when the declining purchased capacity payments drop below the levelized revenues. (For additional information on purchased capacity levelization, see Capital Needs "Purchased Capacity Levelization," page 19.) Interest on long-term debt decreased at an average annual rate of 3 percent from 1991 to 1993. The decrease is due to the Company's refinancing of higher cost debt beginning in late 1991 and continuing throughout 1993. From 1992 to 1993, Other interest decreased as a result of the one-time impact in 1992 of approximately $27 million in interest paid to North Carolina retail customers due to a rate refund. Income provided by diversified activities and the Company's subsidiaries was $22.0 million in 1993 compared to $25.7 million in 1992 and $23.6 million in 1991. The activities of Crescent Resources, Inc., the Company's real estate development and forest management subsidiary, generated the majority of subsidiary and non-electric earnings. Other components include subsidiary investment income, fees for engineering services, construction and operation of generation and transmission facilities outside the Company's service area, water operations and merchandising. Liquidity and Resources Rate Matters During 1991, the Company filed in both the North Carolina and South Carolina retail jurisdictions its only requests for general rate increases since 1986. The rate increases were primarily needed to recover costs associated with the construction of the Bad Creek Hydroelectric Station. In North Carolina, the Company requested a 9.22 percent rate increase and was granted a 4.15 percent increase, which resulted in additional annual revenues of $100.1 million. In South Carolina, a 7.29 percent increase was requested and a 3.0 percent rate increase was granted, resulting in additional annual revenues of $30.2 million. Also in 1991, the Company filed a request for a wholesale rate increase with the Federal Energy Regulatory Commission (FERC). A negotiated settlement between the Company and the wholesale customers was approved by the FERC on March 31, 1992. The approved agreement, effective April 1, 1992, provided for a 3.3 percent rate increase, resulting in $2.1 million in additional annual revenues. The North Carolina Supreme Court on April 22, 1992, remanded for the second time the Company's 1986 rate order to the North Carolina Utilities Commission (NCUC). In this ruling, the Court held that the record from the 1986 proceedings failed to support the rate of return on common equity of 13.2 percent authorized by the NCUC after the initial decision of the Court remanding the 1986 rate order. The NCUC issued a final order dated October 26, 1992, authorizing a 12.8 percent return on common equity for the period October 31, 1986, through November 11, 1991. This order resulted in a 1992 refund to North Carolina retail customers of approximately $95 million, including interest. The Company has a bulk power sales agreement with Carolina Power & Light Company (CP&L) to provide CP&L 400 megawatts of capacity as well as associated energy when needed for a six-year period which began July 1, 1993. Electric rates in all regulatory jurisdictions were reduced by adjustment riders to reflect capacity revenues received from this CP&L bulk power sales agreement. The other joint owners of the Catawba Nuclear Station and the Company are involved in various proceedings related to the Catawba joint ownership contractual agreements. The basic contention in each proceeding is that certain calculations affecting bills under these agreements should be performed differently. These items are covered by the agreements between the Company and the other Catawba joint owners which have been previously approved by the Company's retail regulatory commissions. (For additional information on Catawba joint ownership, see Note 3 to the Consolidated Financial Statements.) The Company and two of the four joint owners have entered into a proposed settlement agreement which, if approved by the regulators, will resolve all issues in contention in such proceedings between the Company and these owners. The Company recorded a liability as an increase to Other current liabilities on its Consolidated Balance Sheets of approximately $105 million in 1993 to reflect this proposed settlement. In addition, future estimated obligations in connection with the settlement are reflected in estimates of purchased capacity obligations in Note 3. As the Company expects the costs associated with this settlement will be recovered as part of the purchased capacity levelization, the Company has included approximately $105 million as an increase to Purchased capacity costs on its Consolidated Balance Sheets. Therefore, the Company believes the ultimate resolution of these matters should not have a material adverse effect on the results of operations or financial position of the Company. Although the two other Catawba joint owners, who are not parties to the above settlement, have not fully quantified the dollars associated with their claims in the presently outstanding proceedings, information associated with these proceedings indicates that the amount in contention could be as high as $110 million, through December 31, 1993. Arbitration hearings were held in 1992 involving substantially all the disputed amounts, and a decision interpreting the language of the agreements on certain of these matters was issued on October 1, 1993. Further proceedings will be required to determine the amounts associated with this decision as it relates to these owners, some of which may involve refunds. However, the Company expects the costs associated with this decision will be included in and recovered as part of the purchased capacity levelization consistent with prior orders of the retail regulatory commissions. Therefore, the Company believes the ultimate resolution of these matters should not have a material adverse effect on the results of operations or financial position of the Company. The Company is also involved in legal, tax and regulatory proceedings before various courts, regulatory commissions and governmental agencies regarding matters arising in the ordinary course of business, some of which involve substantial amounts. Management is of the opinion that the final disposition of these proceedings will not have a material adverse effect on the results of operations or the financial position of the Company. Cash From Operations In 1993, net cash provided by operating activities accounted for 46 percent of total cash from operating, financing and investing activities compared to 50 percent in 1992 and 77 percent in 1991. For 1993 and 1992, essentially all the Company's capital needs, exclusive of refinancing activities, were met by cash generated from operations. Financing and Investing Activities The Company's capital structure, including subsidiary capitalization, at year- end 1993 was 52 percent common equity, 39 percent long-term debt and 9 percent preferred stock. This structure is consistent with the Company's target to maintain an "AA" credit rating. As of December 31, 1993, the Company's bonds were rated "AA" by Fitch Investors Service, "Aa2" by Moody's Investors Service, and "AA-" by Standard & Poor's Ratings Group and Duff & Phelps. As a result of favorable market conditions, the Company continued refinancing activities to retire higher cost debt and preferred stock. During 1993, the Company obtained proceeds from the issuance of $1.5 billion in long-term debt and $220 million in preferred stock, most of which were used to retire $1.4 billion of long-term debt and $216 million of preferred stock. In 1992, the Company issued $940 million in long-term debt. Most of these proceeds, combined with the proceeds from bonds issued in late 1991, were used to redeem $884 million of long-term debt. During 1992, the Company also issued $284 million of preferred stock, most of which was used to redeem $229 million of preferred stock. Also on April 6, 1992, the Company redeemed all outstanding shares of the Cumulative Preference Stock 6 3/4 percent Convertible Series AA at its par value of $100 per share. The Company's embedded cost of long-term debt for 1993 decreased to 8.01 percent compared to 8.39 percent in 1992 and 8.72 percent in 1991. The embedded cost of preferred stock declined to 6.76 percent in 1993 from 7.05 percent in 1992 and 7.48 percent in 1991. These decreases are primarily the result of the Company's refinancing activities. Downward trends in embedded costs may level off because of fewer refinancing opportunities. Fixed Charges Coverage Fixed charges coverage using the SEC method increased to 4.68 times for 1993 compared to 3.48 and 3.85 times, respectively, in 1992 and 1991. Fixed charges coverage, excluding AFUDC and the return on purchased capacity levelization, was 4.40 times in 1993 compared to 3.27 in 1992 and 3.46 in 1991 and the Company goal of 3.5 times. In 1992, the coverage under both methods was lower because of the impact of the rate refund. Capital Needs Property Additions and Retirements Additions to property and nuclear fuel of $676 million and retirements of $312 million resulted in an increase in gross plant of $364 million in 1993. Since January 1, 1991, additions to property and nuclear fuel of $2.1 billion and retirements of $780 million have resulted in an increase in gross plant of $1.3 billion. Construction Expenditures Plant construction costs for generating facilities, including AFUDC, decreased from $232 million in 1991 to $182 million in 1993. Completion of the Bad Creek Hydroelectric Station in 1991 was a significant part of the decrease. Construction costs for distribution plant, including AFUDC, decreased from $275 million in 1991 to $240 million in 1993. Projected construction and nuclear fuel costs, both including AFUDC, are $2.3 billion and $394 million, respectively, for 1994 through 1996. Total projected construction costs include expenditures for the construction of the Lincoln Combustion Turbine Station and replacement of certain steam generators at the McGuire Nuclear Station and the Catawba Nuclear Station. (For additional information on steam generator replacement, see Current Issues "Stress Corrosion Cracking," page 21.) For 1994 through 1996, the Company anticipates funding its projected construction and nuclear fuel costs through the internal generation of funds and, to a lesser extent, through the issuance of securities, primarily First and Refunding Mortgage Bonds. Purchased Capacity Levelization The rates established in the Company's retail jurisdictions permit the Company to recover its investment in both units of the Catawba Nuclear Station and the costs associated with contractual purchases of capacity from the other Catawba joint owners. The contracts relating to the sales of portions of the station obligate the Company to purchase a declining amount of capacity from the other joint owners. In the North Carolina retail jurisdiction, regulatory treatment of these contracts provides revenue for recovery of the capital costs and the fixed operating and maintenance costs of purchased capacity on a levelized basis. In the South Carolina retail jurisdiction, revenues are provided for the recovery of the capital costs of purchased capacity on a levelized basis, while current rates include recovery of fixed operating and maintenance expenses. These rate treatments require the Company to fund portions of the purchased power payment until these costs, including carrying charges, are recovered at a later date. The Company recovers the accumulated costs and carrying charges when the declining purchased capacity payments drop below the levelized revenues. In the North Carolina and wholesale jurisdictions, purchased capacity payments continue to exceed levelized revenues. In the South Carolina jurisdiction, cumulative levelized revenues have exceeded purchased capacity payments. Jurisdictional levelizations are intended to recover total costs, including allowed returns, and are subject to adjustments, including final true-ups. Meeting Future Power Needs The Company's strategy for meeting customers' present and future energy needs is composed of three components: supply-side resources, demand-side resources and purchased power resources. To assist in determining the optimal combination of these three resources, the Company uses its integrated resource planning process. The goal is to provide adequate and reliable electricity in an environmentally responsible manner through cost-effective power management. The Company is building a combustion turbine facility in Lincoln County, North Carolina. The Lincoln Combustion Turbine Station will consist of 16 combustion turbines with a total generating capacity of 1,184 megawatts. The estimated total cost of the project is approximately $500 million. Current plans are for ten units to begin commercial operation by the end of 1995 and the remaining six to begin commercial operation before the end of 1996. The Lincoln facility will provide capacity at periods of peak demand. Demand-side management programs are a part of meeting the Company's future power needs. These programs benefit the Company and its customers by providing for load control through interruptible control features, shifting usage to off-peak periods, increasing usage during off-peak periods, and by promoting energy efficiency. In return for participation in demand-side management programs, customers may be eligible to receive various incentives which help to reduce their electric bills. Demand-side management programs such as Industrial Interruptible Service and Residential Load Control can be used to manage capacity availability problems. Energy-efficiency programs such as high-efficiency chillers, high-efficiency heat pumps and high-efficiency air conditioners are other examples of current demand-side management programs. The November 1991 rate orders of the NCUC and The Public Service Commission of South Carolina (PSCSC) provided for recovery in rates of a designated level of costs for demand-side management programs and allowed the deferral for later recovery of certain demand-side management costs that exceed the level reflected in rates, including a return on the deferred costs. As additional demand-side costs are incurred, the Company ultimately expects recovery of associated costs, which are currently being deferred, through rates. The annual costs deferred, including the return, were approximately $26 million in 1993 and $18 million in 1992. The purchase of capacity and energy is also an integral part of meeting future power needs. The Company currently has under contract 500 megawatts of capacity from other generators of electricity. Current Issues While the Company improved its financial performance in 1993 compared to 1992, the ability to maintain and improve its current level of earnings will depend on several factors. Future trends in the Company's earnings will depend on the continued economic growth in the Piedmont Carolinas, the Company's ability to contain costs, its ability to maintain competitive prices, the outcome of various legislative and regulatory actions and the success of the Company's diversified activities. Resource Optimization. The Company has been engaged in a concentrated effort to more efficiently and effectively use its resources through better work practices. During the first quarter of 1993, the Company offered a Limited Period Separation Opportunity program (LPSO) which gave employees the option of leaving the Company for a lump sum severance payment and, for qualifying employees, enhanced retirement benefits. Implementing programs such as LPSO and other efficiency practices has resulted in a continued workforce reduction and in streamlined workflows. The number of full-time employees has decreased from 19,945 at year-end 1990 to 18,274 at year-end 1993. Included in these amounts are 496 and 789 employees of subsidiaries and affiliates for 1990 and 1993, respectively. Income Tax Accounting Change. In January 1993, the Company implemented a standard as required by the Financial Accounting Standards Board (FASB) that requires a liability approach for financial accounting and reporting for income taxes. While classification of certain items on the Consolidated Balance Sheets has changed, principally because certain items previously reported net of tax are now being reported on a gross basis, there is no material effect on the Company's results of operations. Nuclear Decommissioning Costs. Estimated site-specific nuclear decommissioning costs, including the cost of decommissioning plant components not subject to radioactive contamination, total approximately $955 million stated in 1990 dollars. This amount includes the Company's 12.5 percent ownership in the Catawba Nuclear Station. The other joint owners of the Catawba Nuclear Station are liable for providing decommissioning related to their ownership interests in the station. Both the NCUC and the PSCSC have granted the Company recovery of the estimated site-specific decommissioning costs through retail rates over the expected remaining service periods of the Company's nuclear plants. Such estimates presume that units will be decommissioned as soon as possible following the end of their license life. Although subject to extension, the current operating licenses for the Company's nuclear units expire as follows: Oconee 1 and 2 - 2013, Oconee 3 - 2014; McGuire 1 - 2021, McGuire 2 - 2023; and Catawba 1 - 2024, Catawba 2 - 2026. The Nuclear Regulatory Commission (NRC) issued a rule-making in 1988 which requires an external mechanism to fund the estimated cost to decommission certain components of a nuclear unit subject to radioactive contamination. In addition to the required external funding, the Company maintains an internal reserve to provide for decommissioning costs of plant components not subject to radioactive contamination. During 1993, the Company expensed approximately $52.5 million which was contributed to the external funds and accrued an additional $5.0 million to the internal reserve. The balance of the external funds as of December 31, 1993, was $118.5 million. The balance of the internal reserve as of December 31, 1993, was $200.0 million and is reflected in Accumulated depreciation and amortization on the Consolidated Balance Sheets. Management's opinion is that the estimated site-specific decommissioning costs being recovered through rates, when coupled with assumed after-tax fund earnings of 4.5 percent to 5.5 percent, are currently sufficient to provide for the cost of decommissioning based on the Company's current decommissioning schedule. Environmental Update. The Company is subject to federal, state and local regulations with regard to air and water quality, hazardous and solid waste disposal, and other environmental matters. The Company was an operator of manufactured gas plants prior to the early 1950s. The Company is entering into a cooperative effort with the State of North Carolina and other owners of certain former manufactured gas plant sites to investigate and, where necessary, remediate these contaminated sites. The State of South Carolina has expressed interest in entering into a similar arrangement. The Company is considered by regulators to be a potentially responsible party and may be subject to liability at two federal Superfund sites and two comparable state sites. While the cost of remediation of these sites may be substantial, the Company will share in any liability associated with remediation of contamination at such sites with other potentially responsible parties. Management is of the opinion that resolution of these matters will not have a material adverse effect on the results of operations or financial position of the Company. The Clean Air Act Amendments of 1990. The Clean Air Act Amendments of 1990 require a two-phase reduction by electric utilities in the aggregate annual emissions of sulfur dioxide and nitrogen oxide by the year 2000. The Company currently meets all requirements of Phase I. The Company supports the national objective of clean air in the most cost-effective manner and has already reduced emissions through the use of low-sulfur coal in its fossil plants, through efficient operations and by using nuclear generation. The sulfur dioxide provisions of the Act allow utilities to choose among various alternatives for compliance. The Company is currently developing a detailed compliance plan for Phase II requirements which must be filed with the Environmental Protection Agency (EPA) by 1996. A preliminary strategy, which allows for varying options, indicates that one-time costs associated with bringing the Company into compliance with the Act could be as high as $1 billion, and that approximately $75 million in additional annual operating and maintenance expenses will be incurred as well. These one-time costs could be less depending on favorable developments in the emissions allowance market, future regulatory and legislative actions, and advances in clean air technology. All options within the preliminary strategy allow for full compliance of Phase II requirements by the year 2000. Stress Corrosion Cracking (SCC). Stress corrosion cracking has occurred in the steam generators of Units 1 and 2 at the McGuire Nuclear Station and Unit 1 at the Catawba Nuclear Station. The Company is of the opinion that the SCC is caused by the defective design, workmanship and materials used by the manufacturer of the steam generators. Catawba Unit 2, which has certain design differences and came into service at a later date, has not yet shown the degree of SCC which has occurred in McGuire Units 1 and 2 and Catawba Unit 1. It is, however, too early in the life of Catawba Unit 2 to determine the extent to which SCC will be a problem. Although the Company has taken steps to mitigate the effects of SCC, the inherent potential for future SCC in the Catawba and McGuire steam generators still exists. The Company has begun planning for the replacement of steam generators and has set the following schedule to begin the process: McGuire Unit 1 - 1995, Catawba Unit 1 - 1996, McGuire Unit 2 - 1997. The Catawba Unit 2 steam generators have not been scheduled for replacement. The order of replacement is subject to change based on performance of the existing steam generators and on the overall performance of the three units. The Company has signed an agreement with Babcock & Wilcox International to purchase replacement steam generators. Steam generator replacement at each unit is expected to take approximately four months and cost approximately $170 million, excluding the cost of replacement power and without consideration of reimbursement of applicable costs by the other joint owners of Catawba Unit 1. Stress corrosion problems are excluded under the nuclear insurance policies. The Company in connection with its McGuire and Catawba stations and on behalf of the other joint owners of the Catawba Station--North Carolina Municipal Power Agency Number 1, North Carolina Electric Membership Corporation, Piedmont Municipal Power Agency and Saluda River Electric Cooperative, Inc.-- commenced a legal action on March 22, 1990. This action alleges that Westinghouse Electric Corporation (Westinghouse), the supplier of the steam generators, knew, or recklessly disregarded information in its possession, that the steam generators supplied to McGuire and Catawba stations would be susceptible to SCC and that Westinghouse deliberately concealed such information from the Company. The Company is seeking a judgment against Westinghouse for damages of approximately $600 million, including the cost of necessary remedial measures, the cost of replacement steam generators and payment for replacement power during the outages to accomplish the replacement. In addition to these damages, the Company is seeking punitive or treble damages and attorneys' fees. A trial date has been set for March 14, 1994. Competition. The Energy Policy Act of 1992 has far-reaching implications for the Company by moving utilities toward a more competitive environment. The Act reformed certain provisions of the Public Utility Holding Company Act of 1935 (PUHCA) and removed certain regulatory barriers. For example, the Act allows utilities to develop independent electric generating plants in the United States for sales to wholesale customers, as well as to contract for utility projects internationally, without becoming subject to registration under PUHCA as an electric utility holding company. The Act requires transmission of power for third parties to wholesale customers, provided the reliability of service to the utility's local customer base is protected and the local customer base does not subsidize the third-party service. Although the Act does not require transmission access to retail customers, states can authorize such transmission access to and for retail electric customers. The electric utility industry is predominantly regulated on a basis designed to recover the cost of providing electric power to its retail and wholesale customers. If cost-based regulation were to be discontinued in the industry, for any reason, including competitive pressure on the price of electricity, utilities might be forced to reduce their assets to reflect their market basis if such basis is less than cost. Discontinuance of cost-based regulation could also require some utilities to write off their regulatory assets. Management cannot predict the potential impact, if any, of these competitive forces on the Company's future financial position and results of operations. However, the Company is continuing to position itself to effectively meet these challenges by maintaining prices that are regionally and nationally competitive. Subsidiary Activities. A major part of the future growth in the electric power market is anticipated to be outside the traditional regulated framework and, to a large extent, outside the United States. The Company, through its subsidiaries, is participating in these international opportunities and continues participating in domestic opportunities to provide additional value to its shareholders. Internationally, the Company is seeking opportunities to provide engineering consulting services, construction, operation and maintenance of generation facilities, and ownership of transmission and generation facilities. Although these opportunities are concentrated in areas that utilize the Company's expertise, they present different and greater risks than does the Company's core business. The Company considers only opportunities in which the expected returns are commensurate with the risks and makes efforts to mitigate such risks. At December 31, 1993, the Company had equity investments of $84.5 million in international transmission and generation facilities and $17.1 million in electric assets within the United States, but outside its current service area. The Company is actively pursuing additional international and domestic opportunities to capitalize on the future potential growth of this market. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. DUKE POWER COMPANY INDEX CONSOLIDATED STATEMENTS OF INCOME SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF CASH FLOWS SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED BALANCE SHEETS ASSETS SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF CAPITALIZATION AND RETAINED EARNINGS SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. Notes To Consolidated Financial Statements Note 1. Summary of Significant Accounting Policies A. Revenues Revenues are recorded as service is rendered to customers. "Receivables" on the Consolidated Balance Sheets include $175,726,000 and $167,610,000 as of December 31, 1993 and 1992, respectively, for service that has been rendered but not yet billed to customers. B. Additions to Electric Plant The Company capitalizes all construction-related direct labor and materials as well as indirect construction costs. Indirect costs include general engineering, taxes and the cost of money (allowance for funds used during construction). The cost of renewals and betterments of units of property is capitalized. The cost of repairs and replacements representing less than a unit of property is charged to electric expenses. The original cost of property retired, together with removal costs less salvage value, is charged to accumulated depreciation. C. Allowance for Funds Used During Construction (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. AFUDC, a non- cash item, is recognized as a cost of "Construction work in progress" (CWIP), with offsetting credits to "Other income" and "Interest deductions." After construction is completed, the Company is permitted to recover these construction costs, including a fair return, through their inclusion in rate base and in the provision for depreciation. The 1993 AFUDC rate of 9.29 percent reflects "Allowance for borrowed funds used during construction" calculated using a pre-tax cost of debt. The rates for 1992 and 1991 of 8.07 percent and 8.86 percent have been calculated using a net of tax cost of debt. Rates for all periods are compounded semiannually. The change in calculation from a net of income tax to a pre-tax basis is a result of the adoption of Statement of Financial Accounting Standards No. 109 (SFAS 109). (See Note 4.) D. Depreciation and Amortization Provisions for depreciation are recorded using the straight-line method. The year-end composite weighted-average depreciation rates were 3.47 percent for 1993 and 3.48 percent for 1992 and 1991. Effective with the implementation of new retail rates in November 1991, all coal-fired generating units are depreciated at a rate of 2.57 percent and all nuclear units are depreciated at a rate of 4.70 percent, of which 1.61 percent is for decommissioning. (See Note 16.) Amortization of nuclear fuel is included in "Fuel used in electric generation" in the Consolidated Statements of Income. The amortization is recorded using the units-of-production method. Under provisions of the Nuclear Waste Policy Act of 1982, the Company has entered into contracts with the Department of Energy (DOE) for the disposal of spent nuclear fuel. Payments made to the DOE for disposal costs are based on nuclear output and are included in "Fuel used in electric generation" in the Consolidated Statements of Income. A provision in the Energy Policy Act of 1992 established a fund for the decontamination and decommissioning of the DOE's uranium enrichment plants. Licensees are subject to an annual assessment for 15 years based on their pro rata share of past enrichment services. The annual assessment is recorded as fuel expense. The Company paid $8,338,000 during 1993 related to its ownership interest in nuclear plants. The Company has reflected the remaining liability and regulatory asset of $116,731,000 in the Consolidated Balance Sheets. E. Subsidiaries The Company's consolidated financial statements reflect consolidation of all of its wholly-owned subsidiaries. Intercompany transactions have been eliminated in consolidation. (See Note 11 and "Subsidiary Highlights," page 41.) F. Income Taxes The Company implemented SFAS 109, "Accounting for Income Taxes," effective January 1, 1993. (See Note 4.) The Company and its subsidiaries file a consolidated federal income tax return. Income taxes have been allocated to each company based on its separate company taxable income or loss. Income taxes are allocated to non-electric operations under "Other income" and to electric operating expense. The "Income taxes - credit" classified under "Other income" results from tax deductions of interest costs relating primarily to deferred purchased capacity costs and CWIP. Deferred income taxes have been provided for temporary differences between book and tax income, principally resulting from accelerated tax depreciation and levelization of purchased power costs. Investment tax credits have been deferred and are being amortized over the estimated useful lives of the related properties. G. Unamortized Debt Premium, Discount and Expense Expenses incurred in connection with the issuance of presently outstanding long-term debt, and premiums and discounts relating to such debt, are being amortized over the terms of the respective issues. Also, any expenses or call premiums associated with refinancing higher-cost debt obligations are being amortized over the lives of the new issues of long-term debt. H. Fuel Cost Adjustment Procedures Fuel costs are reviewed semiannually in the wholesale and South Carolina retail jurisdictions, with provisions for changing such costs in base rates. In the North Carolina retail jurisdiction, a review of fuel costs in rates is required annually and during general rate case proceedings. All jurisdictions allow the Company to adjust rates for past over- or under-recovery of fuel costs. Therefore, the Company reflects in revenues the difference between actual fuel costs incurred and fuel costs recovered through rates. The North Carolina legislature ratified a bill in July 1987 assuring the legality of such adjustments in rates. In 1991, the statute was extended through June 30, 1997. I. Consolidated Statements of Cash Flows For purposes of the Consolidated Statements of Cash Flows, the Company's investments in highly liquid debt instruments, with an original maturity of three months or less, are included in cash flows from investing activities and thus are not considered cash equivalents. Total income taxes paid were $352,697,000, $215,465,000 and $245,945,000 for years ended December 31, 1993, 1992 and 1991, respectively. Interest paid, net of amount capitalized, was $244,829,000, $298,455,000 and $269,330,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Note 2. Rate Matters The North Carolina Utilities Commission (NCUC) and The Public Service Commission of South Carolina (PSCSC) must approve rates for retail sales within their respective states. The Federal Energy Regulatory Commission (FERC) must approve the Company's rates for sales to wholesale customers. Sales to the other joint owners of the Catawba Nuclear Station, which represent a substantial majority of the Company's wholesale revenues, are set through contractual agreements. (See Note 3.) During 1991, the Company filed in both the North Carolina and the South Carolina retail jurisdictions its only requests for general rate increases since 1986. The rate increase requested by the Company in North Carolina was 9.22 percent; a 4.15 percent increase was granted resulting in $100.1 million in additional annual revenues. In South Carolina, a rate increase of 7.29 percent was requested; a 3.0 percent increase was granted resulting in $30.2 million in additional annual revenues. These increases were requested primarily to recover costs associated with the Bad Creek Hydroelectric Station. In 1991, the Company filed a request with the FERC seeking a 7.47 percent rate increase for its wholesale customers, who represent approximately 2 percent of the Company's total revenues. A negotiated settlement between the Company and the wholesale customers was approved by the FERC on March 31, 1992. The approved agreement, effective April 1, 1992, provided for a 3.3 percent rate increase, resulting in $2.1 million in additional annual revenues. The North Carolina Supreme Court on April 22, 1992, remanded for the second time the Company's 1986 rate order to the NCUC. In this ruling, the Court held that the record from the 1986 proceedings failed to support the rate of return of 13.2 percent on common equity authorized by the NCUC after the initial decision of the Court remanding the 1986 rate order. The NCUC issued a final order dated October 26, 1992, authorizing a 12.8 percent return on common equity for the period October 31, 1986, through November 11, 1991, that resulted in a refund to North Carolina retail customers in 1992 of approximately $95 million, including interest. The Company has a bulk power sales agreement with Carolina Power & Light Company (CP&L) to provide CP&L 400 megawatts of capacity as well as associated energy when needed for a six-year period which began July 1, 1993. Electric rates in all regulatory jurisdictions were reduced by adjustment riders to reflect capacity revenues received from this CP&L bulk power sales agreement. Note 3. Joint Ownership of Generating Facilities The Company has sold interests in both units of the Catawba Nuclear Station. The other owners of portions of the Catawba Nuclear Station and supplemental information regarding their ownership are as follows: Each participant has provided its own financing for its ownership interest in the plant. The Company retains a 12.5 percent ownership interest in the Catawba Nuclear Station. As of December 31, 1993, $498,930,000 of Electric plant in service and Nuclear fuel represents the Company's investment in Units 1 and 2. Accumulated depreciation and amortization of $152,698,000 associated with Catawba had been recorded as of year-end. The Company's share of operating costs of Catawba are included in the corresponding electric expenses in the Consolidated Statements of Income. In connection with the joint ownership, the Company has entered into contractual agreements with the other joint owners to purchase declining percentages of the generating capacity and energy from the plant. These agreements were effective beginning with the commercial operation of each unit. Unit 1 and Unit 2 began commercial operation in June 1985 and in August 1986, respectively. Such agreements were established for 15 years for NCMPA and PMPA and 10 years for NCEMC and Saluda River. Energy cost payments are based on variable operating costs, a function of the generation output. Capacity payments are based on the fixed costs of the plant. The estimated purchased capacity obligations through 1998 are $392,000,000 for 1994, $293,000,000 for 1995, $55,000,000 for 1996, $44,000,000 for 1997 and $32,000,000 for 1998. Payment obligations include the terms of a proposed settlement agreement between the Company and two of the four joint owners of the Catawba Nuclear Station which was executed in January 1994 and is subject to regulatory approval. (See Note 13.) Effective in its November 1991 rate order, the North Carolina Utilities Commission (NCUC) reaffirmed the Company's recovery, on a levelized basis, of the capital costs and fixed operating and maintenance costs of capacity purchased from the other joint owners. The new NCUC rate order changed the levelized basis to a 15-year period ending 2001 for all of the other joint owners compared to the previous 15-year levelization period for NCMPA and PMPA and 10-year levelization period for NCEMC and Saluda River. The Public Service Commission of South Carolina (PSCSC), in its November 1991 rate order, reaffirmed the Company's recovery on a levelized basis of the capital costs of capacity purchased from the other joint owners. The new PSCSC rate order retained the levelized basis of a 7 1/2-year period for PMPA and NCMPA; for NCEMC and Saluda River, the new levelized basis reflects the projected purchased capacity payments for the twelve-month period ended October 1992. The Federal Energy Regulatory Commission granted the Company recovery on a levelized basis of the capital costs and fixed operating and maintenance costs of capacity purchased from the other joint owners over their contractual purchased power buyback periods. As currently provided in rates in all jurisdictions, the Company recovers the costs of purchased energy and a portion of purchased capacity. The portion of costs not currently recovered through rates is being accumulated, and the Company is recording a carrying charge on the accumulated balance. The Company recovers the accumulated balance including the carrying charge when the capacity payments drop below the levelized revenues. In the North Carolina and wholesale jurisdictions, purchased capacity payments continue to exceed levelized revenues. In the South Carolina jurisdiction, cumulative levelized revenues have exceeded purchased capacity payments. Jurisdictional levelizations are intended to recover total costs, including allowed returns, and are subject to adjustments, including final true-ups. For the years ended December 31, 1993, 1992 and 1991, the Company recorded purchased capacity and energy costs from the other joint owners of $547,900,000, $514,300,000 and $536,500,000, respectively. These amounts, adjusted for the cost of capacity purchased not reflected in current rates, are included in "Net interchange and purchased power" in the Consolidated Statements of Income. As of December 31, 1993 and 1992, $768,099,000 pre-tax and $378,095,000 net of income tax, respectively, associated with the costs of capacity purchased but not reflected in current rates had been accumulated in the Consolidated Balance Sheets as "Purchased capacity costs." Accumulated deferred income taxes associated with "Purchased capacity costs" were $254,789,000 as of December 31, 1993. As of December 31, 1992, deferred income taxes reduced "Purchased capacity costs" on the Consolidated Balance Sheet by $265,255,000. The change in presentation from a net of tax to pre-tax basis is a result of the adoption of SFAS 109. (See Note 4.) Note 4. Income Tax Expense The Company implemented Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," effective January 1, 1993. No prior periods have been restated. SFAS 109 requires a liability approach for financial accounting and reporting of income taxes. While classification of certain items on the Consolidated Balance Sheets has changed, principally because of certain items previously reported net of tax now being reported on a gross basis, there is no material effect on the Company's results of operations. As a result of implementing SFAS 109, the December 1993 Consolidated Balance Sheet reflects an increase of $778 million in both Total assets and Accumulated deferred income taxes (ADIT). The increase was primarily because of a change in presentation from a net of tax to pre-tax basis which resulted in an increase in "Purchased capacity costs" of $255 million and in the creation of the "Regulatory asset related to income taxes" of $486 million. Effective January 1, 1993, "Allowance for borrowed funds used during construction" on the Consolidated Statement of Income reflects a pre-tax cost of debt. Accumulated deferred income taxes after implementation of SFAS 109 consist primarily of the following temporary differences (dollars in thousands): * The net regulatory asset related to income taxes is $486,440,000. Total deferred income tax liability was $2,701,374,000 as of December 31, 1993. Total deferred income tax asset was $493,666,000 as of December 31, 1993. Income tax expense consisted of the following (dollars in thousands): Total current income taxes were $354,366,000 for 1993, $258,800,000 for 1992 and $268,686,000 for 1991. Of these amounts, state income taxes were $61,237,000 for 1993, $44,149,000 for 1992 and $48,671,000 for 1991. Total deferred income taxes were $67,572,000 for 1993, $55,780,000 for 1992 and $38,664,000 for 1991. Of these amounts, deferred state income taxes were $14,279,000 for 1993, $13,786,000 for 1992 and $10,833,000 for 1991. Income taxes differ from amounts computed by applying the statutory tax rate to pre-tax income as follows (dollars in thousands): On August 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 which includes an increase in the federal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. Accordingly, the Company's income tax expense reflects an increase of approximately $10 million for 1993. Note 5. Short-Term Borrowings and Compensating-Balance Arrangements To support short-term obligations, the Company had credit facilities of $324,980,000, $329,385,000 and $340,385,000 as of December 31, 1993, 1992 and 1991, with 29, 49 and 52 commercial banks, respectively. Included in these facilities is a three-year, $300,000,000 revolving credit agreement with the balance in separate, annually-renewable lines of credit. These facilities are on a fee or compensating-balance basis. No short-term debt resulting from these credit facilities was outstanding as of December 31, 1993, 1992 and 1991. Cash balances maintained at the banks on deposit were $12,988,000 and $7,243,000 as of December 31, 1993 and 1992, respectively. Cash balances and fees compensate banks for their services, even though the Company has no formal compensating-balance arrangements. To compensate certain banks for credit facilities, the Company maintained balances of $49,000 and $509,000 as of December 31, 1993 and 1992, respectively. The Company retains the right of withdrawal with respect to the funds used for compensating-balance arrangements. A summary of short-term borrowings is as follows (dollars in thousands): Note 6. Common Stock and Retained Earnings Common Stock Effective April 1, 1991, the Company began issuing common stock in lieu of purchasing shares on the open market for its various stock purchase plans. The Company discontinued issuances of common stock, effective December 1, 1991, and resumed open market purchases to satisfy the requirements of the various stock purchase plans. Except as discussed earlier, open market purchases were used to satisfy the requirements of the Company's various stock plans from 1991 through 1993. During 1991 and through April 6, 1992, the Company issued common stock to satisfy the conversion rights of preference stock. (See Note 7.) As of December 31, 1993, a total of 7,004,659 shares was reserved for issuance to stock plans. Retained Earnings As of December 31, 1993, none of the Company's retained earnings were restricted as to the declaration or payment of dividends. Note 7. Preferred and Preference Stock Without Sinking Fund Requirements The following shares of stock were authorized with or without sinking fund requirements as of December 31, 1993 and 1992: On April 6, 1992, the Company redeemed all outstanding shares of the Cumulative Preference Stock, 63/4% Convertible Series AA at its par value of $100 per share. In 1992 and 1991, shares of preference stock were converted into shares of common stock as follows: Preferred and preference stock without sinking fund requirements as of December 31, 1993 and 1992, were as follows (dollars in thousands): Note 8. Preferred Stock With Sinking Fund Requirements The following shares of stock were authorized with or without sinking fund requirements as of December 31, 1993 and 1992: Preferred stock with sinking fund requirements as of December 31, 1993 and 1992, was as follows (dollars in thousands): The annual sinking fund requirements through 1998 are $1,500,000 in 1994, 1995, 1996 and 1997 and $5,750,000 in 1998. Some additional redemptions are permitted at the Company's option. The Company reacquired 15,000 shares of 7.12% Series Q Preferred Stock in 1992 to satisfy 1993 sinking fund requirements. The call provisions for the outstanding preferred stock specify various redemption prices not exceeding 105 percent of par value, plus accumulated dividends to the redemption date. Note 9. Long-Term Debt Long-term debt outstanding as of December 31, 1993 and 1992, was as follows (dollars in thousands): (a) Substantially all the Company's electric plant was mortgaged as of December 31, 1993. (b) Substantial amounts of Crescent Resources, Inc.'s real estate development projects, land and buildings are pledged as collateral. (c) Nantahala Power and Light's loan agreements impose net worth restrictions and limitations on disposal of assets and payment of cash dividends. As of December 31, 1993 and 1992, the Company had $40,000,000 in pollution-control revenue bonds backed by an unused, two-year revolving credit facility of $40,000,000 and $130,000,000 in commercial paper backed by an unused, three-year $130,000,000 revolving credit facility. These facilities are on a fee basis. Both the $40,000,000 in pollution-control bonds and the $130,000,000 in commercial paper are included in long-term debt. As of December 31, 1993, Crescent Resources, Inc. had $52,064,000 in mortgage loans which mature in 1997 and require monthly payments of principal. Interest rates are variable and ranged from 4.21 percent to 5.08 percent as of December 31, 1993. Nantahala Power and Light had $33,000,000 in senior notes maturing in 2011 and 2012 as of December 31, 1993. The two notes carry fixed interest rates of 9.21 percent and 7.45 percent and require prepayments beginning 1997 and 1998, respectively. The annual maturities of consolidated long-term debt, including capitalized lease principal payments through 1998, are $90,398,000 in 1994; $89,888,000 in 1995; $13,264,000 in 1996; $223,810,000 in 1997 and $54,522,000 in 1998. Note 10. Fair Value of Financial Instruments Estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. Judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates determined as of December 31, 1993, are not necessarily indicative of the amounts that the Company could realize in a current market exchange. Cash, Short-term investments and Notes payable The carrying amount approximates fair value because of the short maturity of these instruments. Long-term debt (excluding Capitalized leases) and Preferred stock with sinking fund requirements Fair value is based on market price estimates. As a result of substantial refinancing activity in 1993 and 1992, the Company's book value of consolidated long-term debt and preferred stock is not materially different from fair market value as of December 31, 1993. Nuclear decommissioning trust funds External funds have been established, as required by the Nuclear Regulatory Commission, as a mechanism to fund certain costs of nuclear decommissioning. (See Note 16.) These nuclear decommissioning trust funds are primarily invested in intermediate-term municipal bonds. As of December 31, 1993, the Company's book value of its nuclear decommissioning trust funds is not materially different from fair market value. Note 11. Investment in Joint Ventures Certain investments in joint ventures are accounted for by the equity method. The Company's ownership in domestic and international joint ventures is 50 percent or less. Total assets of these joint ventures as of December 31, 1993 and 1992, were $972 million and $433 million, respectively. The Company's proportionate share of these assets was $241 million and $163 million, respectively. Total liabilities of these joint ventures as of December 31, 1993 and 1992, were $413 million and $321 million, respectively. The Company's proportionate share of the liabilities was $139 million and $132 million, respectively. Of the $413 million total liabilities outstanding at December 31, 1993, $290 million represents non-recourse debt for which the Company bears no responsibility in the event the joint venture defaults on the debt. The Company's portion of net income from the joint ventures for the years ended December 31, 1993 and 1992, was $2,601,000 and ($1,179,000). Note 12. Retirement Benefits A. Retirement Plan The Company and its operating subsidiaries, with the exception of Nantahala Power and Light Company, which maintains its own retirement plans, have a non-contributory, defined benefit retirement plan covering substantially all their employees. The benefit is based on years of creditable service and the employee's average compensation based on the highest compensation during a consecutive sixty-month period. Prior to 1992, benefits have been reduced by a Social Security adjustment for employees age sixty-five and over and for early retirees with no creditable service prior to September 1, 1980. During 1991, the Company amended its plan for employees who retire after December 31, 1991. The effect of this amendment was to reduce benefits by a Social Security adjustment for all retirees. The plan was amended in 1992 to permit participants with 30 years of creditable service to retire as early as age 51. The Company's policy is to fund pension costs as accrued. During 1993, the Company made a one-time contribution of $50,000,000 to enhance the funded position of the plan. Net periodic pension cost for the years ended December 31, 1993, 1992 and 1991, include the following components (dollars in thousands): A reconciliation of the funded status of the plan to the amounts recognized in the Consolidated Balance Sheets as of December 31, 1993 and 1992, is as follows (dollars in thousands): In determining the projected benefit obligation, the weighted-average assumed discount rate used was 7.50 percent in 1993 and 8.25 percent in 1992 and 1991. The assumed increase in future compensation level for determining the projected benefit obligation is based on an age-related basis. The weighted-average salary increase was 4.50 percent in 1993, 5.40 percent in 1992 and 5.65 percent in 1991. The expected long-term rate of return on plan assets used in determining pension cost was 8.40 percent in 1993 and 9.25 percent in 1992 and 1991. During 1993 the Company offered an enhanced early retirement option, Limited Period Separation Opportunity (LPSO), for eligible employees. The Company recorded an additional one-time expense for special termination benefits associated with LPSO of approximately $7,611,000. B. Postretirement Benefits The Company and its operating subsidiaries, with the exception of Nantahala Power and Light Company, which maintains its own postretirement benefit plans, currently provides certain health care and life insurance benefits for retired employees. Employees become eligible for these benefits if they retire at age 55 or greater with 10 years of service; or if they retire as early as age 51 with 30 years or more of service. Employees retiring after January 1, 1992, receive a fixed Company allowance, based on years of service, to be used to pay medical insurance premiums. The Company reserves the right to terminate, suspend, withdraw, amend or modify the plans in whole or in part at any time. In 1992, the Company commenced funding the maximum amount allowable under section 401(h) of the Internal Revenue Code, which provides for tax deductions for contributions and tax-free accumulation of investment income. Such amounts partially fund the Company's medical and dental postretirement benefits. The Company has also established a Retired Lives Reserve, which has tax attributes similar to 401(h) funding, to partially fund its postretirement life insurance obligation. The Company contributed $14,648,000 into these funding mechanisms in 1993 and $19,338,000 in 1992. In 1992, the Company implemented a new accounting standard that requires postretirement benefits to be recognized as earned by employees rather than recognized as paid. Prior to 1992, the cost of retiree benefits was recognized as the benefits were paid. Amounts paid by the Company for 1991 amounted to $11,900,000. Net periodic postretirement benefit cost for the years ended December 31, 1993 and 1992, include the following components (dollars in thousands): A reconciliation of the funded status of the plan to the amounts recognized in the Consolidated Balance Sheets as of December 31, 1993 and 1992, is as follows (dollars in thousands): In determining the accumulated postretirement benefit obligation (APBO), the weighted-average assumed discount rate used was 7.50 percent in 1993 and 8.25 percent in 1992. The assumed increase in future compensation level is determined on an age-related basis. The weighted-average salary increase was 4.50 percent in 1993, 5.40 percent in 1992 and 5.65 percent in 1991. The expected long-term rate of return on 401(h) assets used in determining postretirement benefits cost was 8.40 percent in 1993 and 9.25 percent in 1992. For Retired Lives Reserve assets, 7.125 percent was used in 1993 and 1992. The assumed medical inflation rate was approximately 13 percent in 1993. This rate decreases by 0.5 percent to 1.0 percent per year until a rate of 5.5 percent is achieved in the year 2002, which remains fixed thereafter. A 1.0 percent increase in the medical and dental trend rates produces a 6.25 percent ($1,903,213) increase in the aggregate service and interest cost. The increase in the APBO attributable to a 1.0 percent increase in the medical and dental trend rates is 6.69 percent ($23,483,182) as of December 31, 1993. Note 13. Commitments and Contingencies A. Construction Program Projected construction and nuclear fuel costs, both including allowance for funds used during construction, are $2.3 billion and $394 million, respectively, for 1994 through 1996. The program is subject to periodic review and revisions, and actual construction costs incurred may vary from such estimates. Cost variances are due to various factors, including revised load estimates, environmental matters and cost and availability of capital. B. Nuclear Insurance The Company maintains nuclear insurance coverage in three areas: liability coverage, property, decontamination and decommissioning coverage, and extended accidental outage coverage to cover increased generating costs and/or replacement power purchases. The Company is being reimbursed by the other joint owners of the Catawba Nuclear Station for certain expenses associated with nuclear insurance premiums paid by the Company. Pursuant to the Price-Anderson Act, the Company is required to insure against public liability claims resulting from nuclear incidents to the full limit of liability of approximately $9.4 billion. The maximum required private primary insurance of $200 million has been purchased along with a like amount to cover certain worker tort claims. The remaining amount, currently $9.2 billion, which will be increased by $75.5 million as each additional commercial nuclear reactor is licensed, has been provided through a mandatory industry-wide excess secondary insurance program of risk pooling. The $9.2 billion could also be reduced by $75.5 million for certain nuclear reactors that are no longer operational and may be exempted from the risk pooling insurance program. Under this program, licensees could be assessed retrospective premiums to compensate for damages in the event of a nuclear incident at any licensed facility in the nation. If such an incident occurs and public liability damages exceed primary insurances, licensees may be assessed up to $75.5 million for each of their licensed reactors, payable at a rate not to exceed $10 million a year per licensed reactor for each incident. The $75.5 million amount is subject to indexing for inflation. This amount is further subject to a surcharge of 5 percent (which is included in the above $9.4 billion figure) if funds are insufficient to pay claims and associated costs. If retrospective premiums were to be assessed, the other joint owners of the Catawba Nuclear Station are obligated to assume their pro rata share of such assessment. The Company is a member of Nuclear Mutual Limited (NML), which provides $500 million in primary property damage coverage for each of the Company's nuclear facilities. If NML's losses ever exceed its reserves, the Company will be liable, on a pro rata basis, for additional assessments of up to $42 million. This amount represents 5 times the Company's annual premium to NML. The Company is also a member of Nuclear Electric Insurance Limited (NEIL) and purchases $1.4 billion of insurance through NEIL's excess property, decontamination and decommissioning liability insurance program. If losses ever exceed the accumulated funds available to NEIL for the excess property, decontamination and decommissioning liability program, the Company will be liable, on a pro rata basis, for additional assessments of up to $46 million. This amount is limited to 7.5 times the Company's annual premium to NEIL for excess property, decontamination and decommissioning liability insurance. The other joint owners of Catawba are obligated to assume their pro rata share of any liability for retrospective premiums and other premium assessments resulting from the NEIL policies applicable to Catawba. The Company has also purchased an additional $400 million of excess property damage insurance for its Oconee and McGuire plants and $800 million for its Catawba plant through a pool of stock and mutual insurance companies. The Company participates in a NEIL program that provides insurance for the increased cost of generation and/or purchased power resulting from an accidental outage of a nuclear unit. Each unit of the Oconee, McGuire and Catawba Nuclear Stations is insured for up to approximately $3.5 million per week, after a 21-week deductible period, with declining amounts per unit where more than one unit is involved in an accidental outage. Coverages continue at 100 percent for 52 weeks, and 67 percent for the next 104 weeks. If NEIL's losses for this program ever exceed its reserves, the Company will be liable, on a pro rata basis, for additional assessments of up to $30 million. This amount represents 5 times the Company's annual premium to NEIL for insurance for the increased cost of generation and/or purchased power resulting from an accidental outage of a nuclear unit. The other joint owners of Catawba are obligated to assume their pro rata share of any liability for retrospective premiums and other premium assessments resulting from the NEIL policies applicable to the joint ownership agreements. C. Other The other joint owners of the Catawba Nuclear Station and the Company are involved in various proceedings related to the Catawba joint ownership contractual agreements. The basic contention in each proceeding is that certain calculations affecting bills under these agreements should be performed differently. These items are covered by the agreements between the Company and the other Catawba joint owners which have been previously approved by the Company's retail regulatory commissions. (For additional information, see Note 3.) The Company and two of the four joint owners have entered into a proposed settlement agreement which, if approved by the regulators, will resolve all issues in contention in such proceedings between the Company and these owners. The Company recorded a liability as an increase to Other current liabilities on its Consolidated Balance Sheets of approximately $105 million in 1993 to reflect this proposed settlement. In addition, future estimated obligations in connection with the settlement are reflected in estimates of purchased capacity obligations in Note 3. As the Company expects the costs associated with this settlement will be recovered as part of the purchased capacity levelization, the Company has included approximately $105 million as an increase to Purchased capacity costs on its Consolidated Balance Sheets. Therefore, the Company believes the ultimate resolution of these matters should not have a material adverse effect on the results of operations or financial position of the Company. Although the two other Catawba joint owners, who are not parties to the above settlement, have not fully quantified the dollars associated with their claims in the presently outstanding proceedings, information associated with these proceedings indicates that the amount in contention could be as high as $110 million through December 31, 1993. Arbitration hearings were held in 1992 involving substantially all the disputed amounts, and a decision interpreting the language of the agreements on certain of these matters was issued on October 1, 1993. Further proceedings will be required to determine the amounts associated with this decision as it relates to these owners, some of which may involve refunds. However, the Company expects the costs associated with this decision will be included in and recovered as part of the purchased capacity levelization consistent with prior orders of the retail regulatory commissions. Therefore, the Company believes the ultimate resolution of these matters should not have a material adverse effect on the results of operations or financial position of the Company. The Company is also involved in legal, tax and regulatory proceedings before various courts, regulatory commissions and governmental agencies regarding matters arising in the ordinary course of business, some of which involve substantial amounts. Management is of the opinion that the final disposition of these proceedings will not have a material adverse effect on the results of operations or the financial position of the Company. Note 14. Other Income For the years ended December 31, 1993, 1992 and 1991, the Company reported carrying charges on purchased capacity levelization deferral related to the joint ownership of the Catawba Nuclear Station of $32,180,000, $28,820,000 and $28,765,000 (net of taxes), respectively, as components of "Other, net" and "Income taxes - other, net"on the Consolidated Statements of Income. (For additional information on purchased capacity levelization, see Note 3.) Also included in "Other, net" and "Income taxes - other, net" on the Consolidated Statements of Income is income provided by diversified activities and the Company's subsidiaries of $21,996,000, $25,728,000 and $23,587,000 (net of taxes) for years ended December 31, 1993, 1992 and 1991, respectively. The activities of Crescent Resources, Inc., the Company's real estate development and forest management subsidiary, generated the majority of subsidiary and non-electric earnings. Other components include subsidiary investment income, fees for engineering services, construction and operation of generation and transmission facilities outside the Company's current service area, water operations and merchandising. For the year ended December 31, 1991, the Company recorded a net of tax carrying charge of $36,765,000 on costs incurred on the Bad Creek Hydroelectric Station after commercial operation but prior to recovery of costs through rates. This carrying charge is a component of "Other, net" in the Consolidated Statements of Income. Note 15. Reclassification In the Consolidated Statements of Cash Flows, Consolidated Balance Sheets and the Consolidated Statements of Capitalization, certain prior-year information has been reclassified to conform with 1993 classifications. Note 16. Nuclear Decommissioning Costs Estimated site-specific nuclear decommissioning costs, including the cost of decommissioning plant components not subject to radioactive contamination, total approximately $955 million stated in 1990 dollars. This amount includes the Company's 12.5 percent ownership in the Catawba Nuclear Station. The other joint owners of the Catawba Nuclear Station are liable for providing decommissioning related to their ownership interests in the station. Both the NCUC and the PSCSC have granted the Company recovery of the estimated site-specific decommissioning costs through retail rates over the expected remaining service periods of the Company's nuclear plants. Such estimates presume that units will be decommissioned as soon as possible following the end of their license life. Although subject to extension, the current operating licenses for the Company's nuclear units expire as follows: Oconee 1 and 2 - 2013, Oconee 3 - 2014; McGuire 1 - 2021, McGuire 2 - 2023; and Catawba 1 - 2024, Catawba 2 - 2026. The Nuclear Regulatory Commission (NRC) issued a rule-making in 1988 which requires an external mechanism to fund the estimated cost to decommission certain components of a nuclear unit subject to radioactive contamination. In addition to the required external funding, the Company maintains an internal reserve to provide for decommissioning costs of plant components not subject to radioactive contamination. During 1993, the Company expensed approximately $52.5 million which was contributed to the external funds and accrued an additional $5.0 million to the internal reserve. The balance of the external funds as of December 31, 1993, was $118.5 million. The balance of the internal reserve as of December 31, 1993, was $200.0 million and is reflected in Accumulated depreciation and amortization on the Consolidated Balance Sheets. Management's opinion is that the estimated site-specific decommissioning costs being recovered through rates, when coupled with assumed after-tax fund earnings of 4.5 percent to 5.5 percent, are currently sufficient to provide for the cost of decommissioning based on the Company's current decommissioning schedule. Independent Auditors' Report Duke Power Company: We have audited the consolidated financial statements of Duke Power Company and subsidiaries (the Company) listed in the accompanying index on page 22. Our audits also included the consolidated financial statement schedules listed in the accompanying index on page 22. These financial statements and consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these 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 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 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 4 to the consolidated financial statements, in 1993, the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Deloitte & Touche Charlotte, North Carolina February 11, 1994 Responsibility for Financial Statements The financial statements of Duke Power Company are prepared by management, which is responsible for their integrity and objectivity. The statements are prepared in conformity with generally accepted accounting principles appropriate in the circumstances to reflect in all material respects the substance of events and transactions which should be included. The other information in the annual report is consistent with the financial statements. In preparing these statements, management makes informed judgments and estimates of the expected effects of events and transactions that are currently being reported. The Company's system of internal accounting control is designed to provide reasonable assurance that assets are safeguarded and transactions are executed according to management's authorization. Internal accounting controls also provide reasonable assurance that transactions are recorded properly, so that financial statements can be prepared according to generally accepted accounting principles. In addition, the Company's accounting controls provide reasonable assurance that errors or irregularities which could be material to the financial statements are prevented or are detected by employees within a timely period as they perform their assigned functions. The Company's accounting controls are continually reviewed for effectiveness. In addition, written policies, standards and procedures, and a strong internal audit program augment the Company's accounting controls. The Board of Directors pursues its oversight role for the financial statements through the audit committee, which is composed entirely of directors who are not employees of the Company. The audit committee meets with management and internal auditors periodically to review the work of each group and to monitor each group's discharge of its responsibilities. The audit committee also meets periodically with the Company's independent auditors, Deloitte & Touche. The independent auditors have free access to the audit committee and the Board of Directors to discuss internal accounting control, auditing and financial reporting matters without the presence of management. DAVID L. HAUSER David L. Hauser Controller SELECTED QUARTERLY FINANCIAL DATA Generally, quarterly earnings fluctuate with seasonal weather conditions, timing of rate changes and maintenance of electric generating units, especially nuclear units. SUBSIDIARY HIGHLIGHTS The earnings contribution of the Company's diversified activities and subsidiaries was $22.0 million in 1993, $25.7 million in 1992 and $23.6 million in 1991. (a)(b) Highlights of selected subsidiaries are presented below. (dollars in thousands) ELECTRIC POWER SUPPLY Nantahala Power and Light Company provides service to a five-county area in the western North Carolina mountains by its operation of 11 hydroelectric stations and purchases of supplemental power. FUNDS MANAGEMENT Church Street Capital Corp. (CSCC) manages investment of funds for the Company and is the parent company of several subsidiaries. CSCC has no full-time employees. Highlights of CSCC's subsidiaries are presented below: REAL ESTATE MANAGEMENT, LAND DEVELOPMENT Crescent Resources, Inc. is engaged in forest management, real estate development, and sales and leasing. ENGINEERING, CONSTRUCTION, TECHNICAL SERVICES AND POWER DEVELOPMENT Engineering, construction, technical services and power development opportunities are pursued nationally and internationally. Duke Engineering & Services, Inc. markets engineering, construction, quality assurance, consulting and other engineering-related services for utility facilities other than coal-fired plants. Duke/Fluor Daniel, a joint venture with Fluor Daniel, Inc., provides design, construction, operation and maintenance support primarily for coal-fired generating plants. Duke Energy Group, parent of Duke Energy Corp., structures, finances and manages investments in electric generation and transmission facilities. (a) 1991 EXCLUDES THE CUMULATIVE EFFECT OF AN ACCOUNTING CHANGE OF $6,727,000, AFTER TAX. (b) THE EARNINGS CONTRIBUTION OF THE COMPANY'S SUBSIDIARIES AND NON-ELECTRIC OPERATIONS INCLUDES ELIMINATION OF INTERCOMPANY PROFIT OF $509,000 AND $1,211,000, AFTER TAX, IN 1993 AND 1992, RESPECTIVELY. (c) FULL-TIME EMPLOYEES. DUKE POWER COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) DUKE POWER COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) DUKE POWER COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (DOLLARS IN THOUSANDS) (1) Principally consists of Injuries and Damages reserves and Property Insurance reserve which are included in "Deferred credits and other liabilities" in the Consolidated Balance Sheets. SCHEDULE X -- SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. No events necessary to be disclosed by the Company under this item have occurred. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information for this item concerning directors of the Company is set forth in the sections entitled "Election of Directors" and "Information Regarding the Board of Directors" in the proxy statement of the Company relating to its 1994 annual meeting of shareholders, which is being incorporated herein by reference. Information concerning the executive officers of the Company is set forth under the section entitled "Executive Officers of the Company" in this annual report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information for this item is set forth in the section entitled "Executive Compensation" in the proxy statement of the Company relating to its 1994 annual meeting of shareholders, which is being incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information for this item is set forth in the sections entitled "Voting Securities Outstanding" and "Election of Directors" in the proxy statement of the Company relating to its 1994 annual meeting of shareholders, which is being incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information for this item is set forth in the section entitled "Election of Directors" in the proxy statement of the Company relating to its 1994 annual meeting of shareholders, which is being incorporated herein by reference. PART IV. ITEM 14. ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Consolidated Financial Statements, Supplemental Financial Data and Consolidated Financial Statement Schedules included in Part II of this annual report are as follows: All other schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements or notes thereto. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of 1993. (c) Exhibits -- See Exhibit Index on page 48. 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 CHARLOTTE AND STATE OF NORTH CAROLINA ON THE 29TH DAY OF MARCH, 1994. DUKE POWER COMPANY (REGISTRANT) By: W. S. LEE 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 ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. ELLEN T. RUFF, by signing her name hereto, does hereby sign this document on behalf of the registrant and on behalf of each of the above-named persons pursuant to a power of attorney duly executed by the registrant and such persons, filed with the Securities and Exchange Commission as an exhibit hereto. /s/ ELLEN T. RUFF ELLEN T. RUFF, ATTORNEY-IN-FACT EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the Securities and Exchange Commission and pursuant to Rule 12b-32 are incorporated herein by reference. (dagger) Compensatory plan or arrangement required to be filed as an exhibit, and filed with Form 10-K for the year ended December 31, 1992, File No. 1-4928, under the same exhibit number as listed herein.

789073_1993.txt

789073_1993

1993

789073

Item 1. Business. (a) General development of business. Registrant is a holding company with subsidiaries engaged in various businesses. A subsidiary, Gallaher Limited ("Gallaher"), and certain of its subsidiaries are engaged in the manufacture and sale of cigarettes, cigars and smoking tobaccos principally in the United Kingdom, and another subsidiary, The American Tobacco Company ("ATCO"), is engaged in the manufacture and sale of cigarettes principally in the United States and, through a subsidiary, the production of cigarette-tipping and other printed packaging materials. Subsidiaries of Registrant are also engaged in the distilled spirits business, the life insurance business, and the manufacture and sale of various types of hardware and home improvement products, office products, supplies and accessories, golf products, and rubber products and, principally in the United Kingdom, the businesses of optical goods and services, retail distribution and houseware products. Registrant was incorporated under the laws of Delaware in 1985 and until 1986 conducted no business. Prior to 1986, the businesses of Registrant's subsidiaries were conducted by American Brands, Inc., a New Jersey corporation organized in 1904 ("American New Jersey"), and its subsidiaries. American New Jersey was merged into The American Tobacco Company on December 31, 1985, and the shares of the principal first-tier subsidiaries formerly held by American New Jersey were transferred to Registrant. In addition, Registrant assumed all liabilities and obligations in respect of the public debt securities of American New Jersey outstanding immediately prior to the merger. Unless the context otherwise indicates, references herein to American Brands, Inc. and to Registrant for all periods prior to January 1, 1986 are to American New Jersey. As a holding company, Registrant is a legal entity separate and distinct from its subsidiaries. Accordingly, the right of Registrant, and thus the right of Registrant's creditors (including holders of its debt securities and other obligations) and stockholders, to participate in any distribution of the assets or earnings of any subsidiary is subject to the claims of creditors of the subsidiary, except to the extent that claims of Registrant itself as a creditor of such subsidiary may be recognized, in which event Registrant's claims may in certain circumstances be subordinate to certain claims of others. In addition, as a holding company, a principal source of Registrant's unconsolidated revenues and funds is dividends and other payments from its subsidiaries. Registrant's principal subsidiaries currently are not limited by long-term debt or other agreements in their abilities to pay cash dividends or to make other distributions with respect to their capital stock or other payments to Registrant, although Registrant's subsidiaries engaged in the life insurance business are generally subject to state insurance law restrictions upon amounts that can be transferred to Registrant in the form of dividends, loans or advances without approval of the relevant state insurance authorities. These restrictions have not had and are not expected to have a material effect on the ability of Registrant to meet its cash obligations. In recent years Registrant has been engaged in a program seeking to enhance the operations of its subsidiaries in certain core businesses and the development of other core businesses as well as certain specialty businesses. Pursuant to such program Registrant has since 1986 made major acquisitions in the distilled spirits business, the office products business and the hardware and home improvement products business, which acquisitions were financed at least in part by debt or debt securities convertible into Common Stock. On June 30, 1993, ATCO acquired from B.A.T Industries, PLC the Benson and Hedges cigarette trademark in Europe in exchange for the assignment of its Lucky Strike and Pall Mall overseas cigarette trademarks, and $107.2 million in cash, including expenses, and contingent future payments based on volumes. See "Narrative description of business - Tobacco Products, The American Tobacco Company." During the fourth quarter of 1993, The Whyte & Mackay Group PLC ("Whyte & Mackay"), a subsidiary of the Registrant's Gallaher Limited subsidiary, completed its acquisition of Invergordon Distillers Group PLC ("Invergordon") by purchasing the remaining 58.7% of the outstanding shares of Invergordon for a cost, including fees and expenses, of $343.6 million. See "Narrative description of business - Distilled Spirits." In addition, Registrant has been making dispositions of businesses considered to be nonstrategic to its long-term operations. In connection therewith, major dispositions by Registrant since 1986 have included its food, security, personal care products and pumps and valves operations and certain operations in the life insurance and international tobacco businesses. Registrant continues to pursue this strategy and in furtherance thereof explores other possible acquisitions in fields related to its core businesses and possibly other fields and dispositions of any businesses that may be considered nonstrategic to its long-term operations. Although no assurance can be given as to whether or when any such acquisitions or dispositions will be consummated, if agreement with respect to any acquisitions were to be reached, Registrant might finance such acquisitions by issuance of additional debt or equity securities. The additional debt from these or any other acquisitions, if consummated, would increase Registrant's debt-to-equity ratio and such debt or equity securities might, at least in the near term, have a dilutive effect on earnings per share. Registrant also continues to consider other corporate strategies intended to enhance stockholder value. It cannot be predicted whether or when any such strategies might be implemented or what the financial effect thereof might be upon Registrant's debt or equity securities. (b) Financial information about industry segments. See the table captioned "Information on Business Segments" and the second table in the note captioned "Information on Business Segments" in the Notes to Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders of Registrant, which tables are incorporated herein by reference. (c) Narrative description of business. The following is a description of the business of the subsidiaries of Registrant in the industry segments of Tobacco Products, Distilled Spirits, Life Insurance, Hardware and Home Improvement Products and Office Products, as well as in other industries as discussed under "Specialty Businesses" below. For financial information about classes of similar products and services, see the table captioned "Information on Business Segments" and the second table in the note captioned "Information on Business Segments" in the Notes to Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders of Registrant, which tables are incorporated herein by reference. Tobacco Products Gallaher Limited Gallaher is engaged primarily in the manufacture and sale of tobacco products in the United Kingdom and elsewhere, principally in the European Community. Its sales of tobacco products are the largest in the United Kingdom. For 1993, Gallaher held approximately 41.7% of the cigarette market in the United Kingdom, compared with approximately 41.5% and 43.5% for 1992 and 1991, respectively. Total unit sales of cigarettes to retail outlets and wholesalers in that country by foreign and domestic manufacturers increased by 1.9% in 1993, and decreased 6.7% and 3% in 1992 and 1991, respectively. Gallaher's total unit sales to retail outlets and wholesalers increased by 2.3% in 1993, and decreased in 1992 and 1991 by 10.9% and 6.3%, respectively. The unit sales increases in 1993 resulted primarily from heavy retailer and wholesaler purchasing prior to the United Kingdom budget announced in November 1993. It is estimated that the underlying consumer demand declined in the area of 5.5% in 1993 and it is likely that unit sales will decline in 1994. In 1993, filter cigarettes continued to represent over 98% of total unit sales of cigarettes in the United Kingdom for Gallaher and for the industry. Gallaher's principal cigarette brands in the United Kingdom are Benson and Hedges Special Filter, Silk Cut, Berkeley Superkings and Kensitas. To respond to growing consumer preference for lower priced cigarettes, Gallaher introduced Benson and Hedges Superkings and Benson and Hedges Superkings Lights into the mid-price sector in early 1993. These new brands, together with Berkeley Superkings Menthol, resulted in Gallaher's share of that sector increasing from 32.6% in 1992 to 37.4% in 1993. Rights to some of these brands in various other countries are claimed by others. Gallaher also markets other tobacco products, among which are Hamlet cigars, Condor and Benson and Hedges Mellow Virginia smoking tobaccos and Old Holborn roll-your-own cigarette tobacco. Sales are made to retail outlets and wholesalers. Following the exchange of trademarks in Europe between ATCO and B.A.T Industries, PLC on June 30, 1993, Gallaher entered into an exclusive trademark license agreement with ATCO, pursuant to which Gallaher manufactures and sells Benson and Hedges products in tax-paid markets in Europe and pays a royalty to ATCO based on volume. Gallaher's principal competitors in the United Kingdom are Imperial Tobacco, Rothmans, Philip Morris and imported brands. Gallaher competes on the basis of the quality of its products and price and its responsiveness to consumer preferences. Gallaher buys its leaf tobacco from foreign sources, including the United States. Large inventories of leaf tobacco are maintained by Gallaher. Sufficient inventories of finished product are maintained by Gallaher to respond promptly to orders. There has been social and political unrest in Northern Ireland for many years. Notwithstanding this situation, there has been no consequential damage to Gallaher's manufacturing facilities there. The United Kingdom Finance Act, 1992 provided for an increase in the excise duties on tobacco products with the result that the price of a typical pack of cigarettes increased by 13 pence. The United Kingdom Finance Act, 1993 provided for an increase in the excise duties on tobacco products with the result that the price of a typical pack of cigarettes increased by 10 pence. The United Kingdom budget introduced on November 30, 1993 provided for an increase in the excise duties on tobacco products with the result that the price of a typical pack of cigarettes increased by 11 pence. It is believed that the continuing impact of price increases, principally due to substantial excise tax increases in 1992 and 1993, combined with the prolonged recession, have led to an overall reduction in annual industry volumes, declines in consumer demand, greater price competition and increased trading down by consumers to lower priced brands. The effect of any further excise duty increases cannot be determined, but such increases and any new duties or taxes, if enacted, will likely add to the overall industry declines and the shift to lower priced brands. An agreement took effect in September 1991 between representatives of the United Kingdom tobacco industry and the United Kingdom Health Ministers with respect to tobacco products and their packaging and advertising. Among other things, the agreement provides for limitations on expenditures for cigarette brand poster advertisements and for a reduction in the number of external cigarette advertising signs at retail premises. Specified warning statements are required to be printed on cigarette packages and to appear in advertisements. Negotiations are taking place on a new agreement, which would place further restrictions on advertising. It is not possible to predict when any such agreement would take effect. Regulations promulgated in the United Kingdom in July 1991 to implement a Council Directive of the European Community require, effective January 1, 1992, that all tobacco product packaging bear the warning statement "Tobacco Seriously Damages Health" and that cigarette packaging bear additional warning statements and carry an indication of tar and nicotine yield. In addition, the Independent Television Commission Code of Advertising Standards and Practice of December 1990, implementing a Council Directive of the European Community, prohibits, effective October 1991, the advertising of all tobacco products on television in the United Kingdom. Television and radio advertising of cigarettes has been prohibited in the United Kingdom for many years. Also, a Council Directive of the European Community has been proposed by the Commission of the European Community to provide for a total ban on tobacco advertising and sponsorship throughout the European Community and to restrict the use of tobacco brand names on non-tobacco products. In February 1992 the European Parliament, an advisory body, approved such a total ban. Any such Council Directive, even though approved by the European Parliament and the Commission, must be adopted by the Council of Ministers of the member states of the Community by a qualified majority of the member states prior to becoming effective and may be adopted so as to be binding or non-binding on individual member states. A Council Directive of the European Community adopted in May 1990 required that the tar yield of cigarettes marketed in the European Community should not be greater than 15 milligrams per cigarette after December 31, 1992, and 12 milligrams per cigarette after December 31, 1997. None of Gallaher's cigarette brands have had a tar yield in excess of 15 milligrams per cigarette since December 31, 1992. The Treaty of Rome has as an objective the removal of certain restrictions on trading among the member states of the European Community, and since January 1, 1993 trading barriers within the Community have been eliminated in accordance with the Single European Act. Actions taken by the Community effective January 1, 1993 in connection with the implementation of the Single European Act include an increase in the allowance of cigarettes for personal consumption that may be purchased duty-paid in one member state and carried to another without payment of additional duty. The removal of customs border posts was also scheduled to occur effective January 1, 1993 but implementation has not been uniform because of concerns raised by at least one member state. It is possible that the Treaty of Rome, including implementation of the Single European Act and other actions taken by the Community, will result in increased competition in the market for tobacco products in the United Kingdom and in other member states and cause a shift in sales of tobacco products brands from certain member states, such as the United Kingdom, to other member states in which prices of those brands are lower. On July 18, 1989 the Council of Ministers enacted a non-binding Council Resolution, as part of its on-going "Europe Against Cancer" program, inviting member states to introduce legislation that would ban smoking in most public places. In addition, various member states have adopted legislation or non-binding guidelines that address smoking in public places. It is not possible to state whether additional legislation, directives, regulations or action will be enacted, promulgated or taken in or by the United Kingdom or the European Community or the nature of any such legislation, directives, regulations or action, nor is it possible to predict the effect any such legislation, directives, regulations or action may have on the industry generally or on Gallaher. Gallaher's subsidiary, Gallaher (Dublin) Limited, manufactures tobacco products in the Republic of Ireland. See Item 3, "Legal Proceedings". For a description of the business of other subsidiaries of Gallaher, see "Distilled Spirits" and "Specialty Businesses - Optical goods and services - Retail distribution - Housewares". The American Tobacco Company ATCO is engaged in the manufacture and sale of filter and nonfilter cigarettes, principally in the United States. ATCO sells its cigarettes primarily to distributors, chain stores and other large retail outlets. In 1993, unit sales of cigarettes in the United States accounted for approximately 94.6% of ATCO's total unit sales. ATCO's domestic unit sales of cigarettes increased slightly in 1991 and decreased 4.3% and 9.1% in 1992 and 1993, respectively. Total unit sales of cigarettes for the domestic industry declined in 1991, 1992 and 1993 approximately 2.4%, 0.4% and 9%, respectively. However, it is estimated that the underlying decline in consumer demand in 1993 was in the range of 3% to 4%. ATCO's share of the cigarette market in the United States increased to approximately 7.03% in 1991 and decreased to approximately 6.76% and 6.75% in 1992 and 1993, respectively. Unit sales of ATCO's more profitable premium brands were down 20.9%, particularly nonfilter and charcoal filter brands which continued to decline far in excess of the overall industry decline in recent years. Unit sales of filter cigarettes (other than charcoal filter) in 1993 are estimated to have been approximately 96% of total unit sales for the domestic industry, compared to 74.9% of ATCO's total domestic unit sales. ATCO's unit sales of nonfilter cigarettes decreased from 23.4% of its total domestic unit sales of cigarettes for 1992 to 19.2% for 1993. ATCO's unit sales of charcoal filter cigarettes decreased from 7.0% of its total domestic unit sales for 1992 to 5.9% for 1993. The industry's less profitable price-value category, comprising discount and deep discount brands, grew from 30% to 37% as price increases over the years, including excise taxes, have resulted in trading down by consumers, particularly to deep discount brands. Unit sales of ATCO's price-value brands increased 5.3% as the introduction of deep discount brands more than offset declines in discount brands. Price-value brands accounted for 52% of ATCO's U.S. unit sales in 1993, compared to 45% in 1992. The intense price and promotional competition in the domestic tobacco industry continues. In April 1993, the industry promotionally reduced the prices of many leading brands. In August 1993, ATCO's principal competitors decreased list prices of their premium and discount brands and increased list prices of their deep discount brands. ATCO announced similar decreases in list prices of its premium and discount brands, but did not significantly change the list prices of its deep discount brands. In November 1993, ATCO and its competition raised prices of certain brands, but the amount of these increases was far less than the amount of the August decreases. Conditions in the U.S. tobacco market remain unsettled. ATCO products are also sold overseas, principally in Japan and other Asian countries, with expansion into the Middle East, Poland, Korea and the C.I.S. Registrant believes that ATCO is the fifth largest manufacturer of cigarettes in the United States. ATCO's principal competitors in the United States are Philip Morris, R.J. Reynolds, Brown & Williamson, Lorillard and Liggett. ATCO competes on the basis of the quality and price of its products and its responsiveness to consumer preferences. The principal brands produced by ATCO are Lucky Strike, Pall Mall, Tareyton, Carlton, American, Montclair, Misty, Riviera, Private Stock, Prime and Summit. Although ATCO has exclusive ownership in the United States of its brands mentioned above, the ownership of most of its principal brands in various foreign countries is claimed by others. On June 30, 1993, ATCO acquired from B.A.T Industries, PLC the Benson and Hedges cigarette trademark in Europe in exchange for the assignment of its Lucky Strike and Pall Mall overseas cigarette trademarks, and $107.2 million in cash, including expenses, and contingent future payments based on volumes. ATCO recognized a pretax gain of $25.5 million as a result of the assignment of the Lucky Strike and Pall Mall trademarks. Certain of the contingent payments are guaranteed and, accordingly, their present value is included in the initial $183 million of intangibles that have been recorded. Any payments in excess of the guarantees will also be amortized over periods not to exceed 40 years. In a related event, on June 30, 1993 ATCO entered into a trademark license agreement with Gallaher. Pursuant to the agreement, Gallaher has the exclusive right to manufacture and sell Benson and Hedges products in tax-paid markets in Europe and pays a royalty to ATCO based on volume. There is a federal excise tax on cigarettes, and such tax was increased by four cents per pack effective January 1, 1991, and an additional four cents per pack effective January 1, 1993. All the states, the District of Columbia and many municipalities and counties impose additional cigarette taxes. In addition, legislation has been introduced in the United States Congress to further increase the federal excise tax and to impose other federal taxes. Proposals to increase or adopt new cigarette taxes are also pending in various state and local jurisdictions. The Clinton administration has proposed a tax increase on cigarettes to 99 cents per pack from the current level of 24 cents per pack to help pay the cost of the administration's proposed health care program. As part of an alternative proposal to the Clinton administration program, the Health Subcommittee of the House Ways and Means Committee has proposed increasing the federal tax on cigarettes by $1.25 to $1.49 per pack to help pay the cost of providing universal health care. The effect of any further excise tax increases cannot be determined, but such increases and any new taxes, if enacted, will likely add to the overall industry declines and the shift to lower priced brands. Tobacco is an agricultural commodity subject to United States Government controls and price supports that can affect market prices substantially. Legislation has been introduced in the United States Congress that would eliminate the federal price support program. The market price of flue-cured tobacco decreased from an average of $1.75 per pound in calendar year 1992 to an average of $1.74 per pound in calendar year 1993. Burley leaf prices increased from an average of $1.81 per pound in calendar year 1992 to an average of $1.85 per pound in calendar year 1993. Average market prices do not necessarily reflect ATCO's actual leaf costs since ATCO's purchases are in a wide range of quality and price categories. ATCO buys its leaf tobacco on the domestic and international markets. Large inventories of leaf tobacco are maintained by ATCO because the production of leaf tobacco is subject to changing weather conditions and because most leaf tobacco, when purchased, requires additional aging. Sufficient inventories of finished product are maintained by ATCO to respond promptly to orders. The Omnibus Budget Reconciliation Act of 1993 (the "Reconciliation Act") as signed into law on August 10, 1993 contains provisions which penalize domestic cigarette companies that manufacture cigarettes containing less than 75% U.S. grown tobacco. The Reconciliation Act also imposes additional assessments and fees on imported tobacco which is generally less expensive. The Reconciliation Act will result in ATCO incurring greater cost for its leaf tobacco, as well as maintaining its current inventory of foreign tobacco for a longer period before it can be used in cigarette production. Based on the preliminary rules issued, the impact of this legislation may increase ATCO's 1994 manufacturing cost by an estimated $10 million. The Federal Cigarette Labeling and Advertising Act (the "Labeling Act") has required since 1966 that cigarettes manufactured, packaged or imported for sale or distribution in the United States include a warning statement relating to smoking and health on their packaging. ATCO and five other cigarette manufacturers are parties to consent orders, entered into with the Federal Trade Commission in 1972, which relate to the placement of prescribed statements in cigarette advertising. The Comprehensive Smoking Education Act (amending effective in 1985 the Labeling Act) requires that packages of cigarettes distributed in the United States and cigarette advertisements in the United States bear in quarterly rotation, in lieu of the previously required statement, the statements: "SURGEON GENERAL'S WARNING: Smoking Causes Lung Cancer, Heart Disease, Emphysema, And May Complicate Pregnancy"; "SURGEON GENERAL'S WARNING: Quitting Smoking Now Greatly Reduces Serious Risks to Your Health"; "SURGEON GENERAL'S WARNING: Smoking By Pregnant Women May Result in Fetal Injury, Premature Birth, And Low Birth Weight"; and "SURGEON GENERAL'S WARNING: Cigarette Smoke Contains Carbon Monoxide". Statements also are required in billboard advertisements. The Labeling Act prohibits any other requirement of a statement relating to smoking and health on any cigarette packaging, advertising or promotional material. The United States Supreme Court in a 1992 decision in Cipollone v. Liggett Group, Inc., et al., held that the 1965 version of the Labeling Act, which requires specified warnings on cigarette packaging, advertising and promotional materials, did not preempt lawsuits seeking money damages for personal injuries allegedly caused by cigarette smoking. The Supreme Court further held that the Public Health Cigarette Smoking Act of 1969, which, among other things, amended the preemption provision of the 1965 version of the Labeling Act effective July 1, 1969, preempts such lawsuits based on alleged failure to warn and neutralization of the federally mandated warnings to the extent that those claims rely on omissions or inclusions in cigarette advertising or promotions, but that the 1969 version of the Labeling Act does not preempt claims based on alleged breach of express warranty, or certain claims based on intentional fraud and misrepresentation or conspiracy. Legislation has been introduced in the United States Congress that if enacted would limit the effect of the preemption provisions of the Labeling Act. See Item 3, "Legal Proceedings". All radio and television advertising of cigarettes is prohibited by the Labeling Act. Under the Comprehensive Smoking Education Act, each person who manufactures, packages or imports cigarettes is required to provide annually to the Secretary of Health and Human Services, on a confidential basis, a list of the ingredients added to tobacco in the manufacture of cigarettes. Annual reports to the United States Congress are also required from the Secretary of Health and Human Services as to current information on the health consequences of smoking and from the Federal Trade Commission on the effectiveness of cigarette labeling and current practices and methods of cigarette advertising and promotion. In connection with the reporting responsibilities of the Secretary of Health and Human Services, the Surgeon General of the United States has from time to time issued reports addressing aspects of smoking and health issues. In December 1986, the Surgeon General released a report concluding, among other things, that "involuntary smoking is a cause of disease, including lung cancer, in healthy nonsmokers." In May 1988, the Surgeon General released a report which, among other things, reviewed literature on aspects of tobacco use and concluded that cigarettes are addicting. In February 1994, the Surgeon General released a report on the prevention of tobacco use among young people which concluded, among other things, that "[c]ommunitywide efforts that include tobacco tax increases, enforcement of minors' access laws, youth-oriented mass media campaigns, and school-based tobacco use prevention programs are successful in reducing adolescent use of tobacco." Both the Secretary of Health and Human Services and the Federal Trade Commission also are required to make recommendations with regard to further legislation. Legislation has been introduced in the United States Congress that if enacted would amend the Labeling Act to require that the statements that the Labeling Act requires to appear on cigarette packaging and advertisements include the following: "SURGEON GENERAL'S WARNING: Smoking is Addictive. Once You Start You May Not Be Able To Stop"; and "SURGEON GENERAL'S WARNING: NICOTINE IN CIGARETTES IS AN ADDICTIVE DRUG". Legislation has also been introduced in the United States Congress that if enacted would require nine rotating health warnings on cigarette packages and advertisements and would change the format of the required warnings. In addition, legislation has been introduced in the United States Congress that if enacted would make unlawful the export, by any corporation or any foreign subsidiary, from the United States or any other country any cigarettes the package of which does not contain the label statements required by the Labeling Act. In 1992, the Alcohol, Drug Abuse and Mental Health Administration Reorganization Act was adopted. This Act requires, effective January 1, 1994, states to adopt a minimum age of 18 for the purchase of tobacco products. Legislation has also been introduced in the United States Congress that if enacted would require the Secretary of Health and Human Services to establish a Center for Tobacco Products whose functions would include collecting information regarding, and determining whether to require disclosure of and impose restrictions on, additives contained in tobacco products, reviewing the information required to be contained in rotating warning labels and making federal grants to promote better enforcement of state laws concerning the sale of tobacco products to minors, to promote anti-smoking efforts, including the reduction of the incidence of smoking in the workplace, and to encourage public information campaigns concerning the use of tobacco products. Legislation has also been introduced in the United States Congress that if enacted would further restrict or ban advertising and restrict promotion of cigarettes and would ban the sale of cigarettes from vending machines. In addition, legislation has been introduced in the United States Congress that if enacted would disallow income tax deductions for tobacco products advertising expenses. In 1986 and 1987, there were proposals for legislation to eliminate the deductibility of federal excise taxes, including excise taxes on tobacco products, but these proposals were not enacted. There have also been proposals to bring the manufacture and sale of cigarettes under the jurisdiction of the Food and Drug Administration. Legislation has been introduced in the United States Congress to restrict smoking to designated areas in all federal facilities as well as to prohibit smoking in such facilities. Legislation has also been introduced to prohibit smoking in most public facilities. The Department of Defense has announced a policy prohibiting smoking in all offices and any other indoor work areas. Smoking on virtually all domestic airline flights is prohibited by federal legislation. A number of states and municipalities, as well as certain federal agencies, have enacted or promulgated or are considering legislation and regulations which are intended to discourage smoking through educational efforts or which impose various restrictions or requirements relating to smoking. On January 7, 1993, the Environmental Protection Agency ("EPA") released in final form its "risk assessment" report on environmental tobacco smoke. The EPA's report concludes that environmental tobacco smoke is a human carcinogen which causes lung cancer in nonsmokers and that exposure to environmental tobacco smoke is causally associated with an increased incidence of respiratory effects and disorders in children. While it is not possible to predict the effects of the EPA report, it has and will likely continue to result in additional regulation of smoking in public and in workplaces as well as voluntary restrictions by private entities relating to their facilities. In September 1991, the Occupational Safety and Health Administration ("OSHA") issued a request for information relating to indoor air quality, including environmental tobacco smoke. The stated purpose of the request is to assist OSHA in determining whether it is necessary and appropriate to pursue regulatory action. On March 25, 1994, OSHA proposed new rules regulating air quality in all indoor and enclosed work places under OSHA jurisdiction and restricting smoking to designated areas where employees are not required to enter in the performance of normal work activities. Under the terms of the Fire Safe Cigarette Act of 1990, the Consumer Product Safety Commission ("CPSC") submitted a report to Congress on August 10, 1993 regarding the technical and commercial feasibility, economic impact and other consequences of developing cigarettes that have a minimum propensity to ignite upholstered furniture and mattresses. This report accepted many of the recommendations of a report prepared by a technical advisory group established to assist the CPSC. The accepted recommendations include a standard test method to determine cigarette ignition propensity. However, in its report, the CPSC suggested additional research prior to the adoption of a performance standard to reduce cigarette ignition propensity. On February 23, 1994, Congressman Joseph Moakley (D-Mass.) introduced legislation which would require the CPSC to set a performance standard to reduce cigarette ignition. The CPSC would be required to set such a standard within one year of enactment of the legislation, and the tobacco industry (including ATCO) would have an additional year to meet the standard for all cigarettes manufactured or sold in the United States. It is not possible to predict the impact on ATCO or the industry of the CPSC report or any resulting legislation or regulation. It is not possible to state whether additional federal, state or local legislation, regulations or action will be enacted, promulgated or taken or the nature of any such legislation, regulations or action, nor is it possible to predict the effect any such legislation, regulations or action may have on the industry generally or on ATCO. Golden Belt Manufacturing Company ("Golden Belt"), a subsidiary of ATCO, is primarily engaged in the production of cigarette-tipping materials and other printed packaging materials, including labels and foil laminates. Sales are made primarily in the United States through its own sales force. See Item 3, "Legal Proceedings". Distilled Spirits Jim Beam Brands Co. ("Beam") and its predecessors have been distillers of bourbon whiskey since 1795. Beam, together with its subsidiaries, currently produces, or imports, and markets a broad line of distilled spirits, including bourbon and other whiskeys, cordials, gin, vodka and rum. In December 1991, Beam acquired certain trademarks relating to seven brands (Kessler, Leroux, Calvert Extra, Calvert Gin, Lord Calvert, Wolfschmidt and Ronrico) from Joseph E. Seagram & Sons, Inc. and certain of its affiliates ("Seagram"). Beam's nine leading brand names are Jim Beam bourbon, Windsor Canadian Supreme Whisky, Lord Calvert Canadian Whisky, DeKuyper cordials, Gilbey's gin, Gilbey's vodka, Kamchatka vodka, Wolfschmidt vodka and Kessler American Blended Whiskey. Principal bourbon brand names are Jim Beam, the largest-selling bourbon whiskey in the United States and in the world, Old Grand-Dad, the largest-selling bonded bourbon in the United States and in the world, Booker's, a super-premium bourbon whiskey, Old Taylor and Old Crow. Beam also produces Jim Beam Bourbon Whiskey and Cola, which combines bourbon with a cola soft drink. DeKuyper Peachtree Schnapps is the top-selling domestically-produced cordial brand in the United States. Beam also produces Chateaux and Leroux cordials, Beam's 8-Star Blend and Calvert Extra blended whiskeys, Dark Eyes vodka and Calvert Gin, and imports, in bottle or in bulk, Canada House Canadian whisky, The Dalmore and The Claymore scotch whiskies, Kamora coffee liqueur, Ronrico, Pusser's and San Tropique rums, Molinari Sambuca and Aalborg Akvavit. Beam's products are bottled in the United States and are sold through various distributors and, in the 18 "control" states (and one county) which have established government control of the purchase and distribution of alcoholic beverages, through state (or county, as the case may be) liquor authorities. Beam products are also bottled in eleven foreign countries. Beam's international volume, which accounted for approximately 20% and 18% of its total unit sales in 1993 and 1992, respectively, is exported to over 80 foreign markets for sale through distributors and brokers. The distilled spirits business is highly competitive, with many brands sold in the consumer market. Registrant believes there are approximately ten major competitors worldwide and many smaller distillers and bottlers. Registrant also believes that, based on unit sales, Beam is the second largest producer and marketer of distilled spirits in the United States and among the ten major competitors worldwide and has six million- case-selling brands in the United States. Beam competes on the basis of the quality and price of its products and its responsiveness to consumer preferences. The United States market for beverage alcohol has in recent years demanded an increasingly broad variety of products. Demand for distilled spirits generally, as well as for bourbon and other whiskeys, has declined resulting in increased price competition as competitors vie for market share. It is estimated that unit sales of distilled spirits (which do not include bulk sales) in the United States declined by approximately 6.7% in 1991, 3% in 1992 and 2.2% in 1993. Total unit sales of Beam's brands in the United States decreased by approximately 4.9% in 1991, increased 35% in 1992, primarily due to the acquisition of the trademarks for seven brands from Seagram, and decreased 4.6% in 1993. Total unit sales of Beam's brands, including export sales, decreased by 3% in 1991, increased 29% in 1992, primarily due to the acquisition from Seagram, and decreased 1.7% in 1993. In both 1993 and 1992, bourbon accounted for approximately 25% and other whiskeys for approximately 28% of Beam's total unit sales in the United States, respectively. Beam's leading brands are owned by Beam and its subsidiaries, except that DeKuyper cordials are produced and sold under a perpetual license and Gilbey's gin and Gilbey's vodka are produced and sold under a long-term license and the Kamchatka brand is claimed by another entity in California. Raw materials for the production, storage and aging of Beam's products are principally corn, rye, barley malt and white oak barrels and are readily available from a number of sources, except that white oak barrels are available from only two major sources, one of which is owned by a competitor of Beam. Because whiskeys are aged for various periods, generally from four to eight years, Beam maintains, in accordance with industry practice, substantial inventories of bulk whiskey in warehouse facilities. In addition, whiskey production is generally scheduled to meet demand for four to eight years in the future, and production schedules are adjusted from time to time to bring inventories into balance with estimated future demand. In Canada, a line of distilled spirits, including Windsor Canadian Supreme Whisky, is produced by a subsidiary, Alberta Distillers Limited. In Australia, a subsidiary, Fortune Brands Pty. Ltd., markets and distributes Beam's products as well as several brands under agency agreements. The production, storage, transportation, distribution and sale of Beam's products are subject to regulation by federal, state and local authorities. Various local jurisdictions prohibit or restrict the sale of distilled spirits in whole or in part. In the United States, Canada and many other countries, distilled spirits are subject to excise taxes and/or custom duties. State, local and other governmental authorities in such countries also impose taxes on distilled spirits. On January 1, 1991, the United States federal excise tax was increased by one dollar per proof gallon of distilled spirits. In addition, there are proposals pending to increase or impose new distilled spirits taxes in various jurisdictions. It is believed that the federal excise tax increase contributed to the increased decline in distilled spirits unit sales for Beam and the industry in 1991 and in 1992 for the industry. Increasing the federal excise tax on distilled spirits has been considered from time to time as a possible means to help pay for the cost of the national health-care program, but is not included in the Clinton administration's current proposal. The effect of any future excise tax increases cannot be determined, but it is possible that any future tax increases would have an adverse effect on unit sales and add to continuing industry declines. The Alcoholic Beverage Labeling Act of 1988 and regulations promulgated thereunder by the Bureau of Alcohol, Tobacco and Firearms of the Department of the Treasury (the "Bureau") require that containers of alcoholic beverages bottled on or after November 18, 1989 for sale or distribution in the United States or for sale, distribution or shipment to members of the United States Armed Forces abroad bear the statement: "GOVERNMENT WARNING: (1) According to the Surgeon General, women should not drink alcoholic beverages during pregnancy because of the risk of birth defects. (2) Consumption of alcoholic beverages impairs your ability to drive a car or operate machinery, and may cause health problems." The Alcoholic Beverage Labeling Act of 1988 and the regulations prohibit any other requirement of a statement relating to alcoholic beverages and health on any beverage alcohol container or package containing such a container. If the Secretary of the Treasury, after appropriate investigation and consultation with the Surgeon General, finds available scientific information justifying a change in, addition to or deletion of all or part of the required statement, he is required to report such information to the United States Congress together with specific recommendations with respect thereto. On March 8, 1991, the Bureau issued a request for information to "enable the agency to determine whether the wording . . . should be amended." Registrant understands that the Bureau has recommended that the current warning statements are sufficient and has reported its findings to the United States Congress. In addition, legislation has been introduced in the United States Congress that would require seven rotating warning statements in all beverage alcohol advertising and promotional materials. It is not possible to state whether any legislation or additional regulations or action imposing additional labeling or other warning statement requirements will be enacted, promulgated or taken in the U.S. or export markets served by Beam, nor is it possible to predict the effect, if any, that the existing labeling requirement or any additional labeling or other warning statement requirements may have on the industry generally or on Beam. See Item 3, "Legal Proceedings". Whyte & Mackay has been a distiller of scotch whisky since 1844. Whyte & Mackay and its subsidiaries produce, bottle, market and sell blended and single malt scotch whiskies, market and sell vodka and sell scotch whisky in bulk. The principal brand names are Whyte & Mackay Special Reserve, The Claymore and The Dalmore scotch whiskies and Vladivar vodka. Whyte & Mackay believes that in both 1993 and 1992, its shares of the United Kingdom scotch whisky and vodka markets were approximately 14% and 11%, respectively. Whyte & Mackay's products are sold in the United Kingdom through its own sales force and outside the United Kingdom, principally in Japan and France, through independent distributors. It is estimated that total case sales of scotch whisky in the United Kingdom decreased by approximately 3% and 6% in 1991 and 1992, respectively, but increased by 3% in 1993, and worldwide decreased by approximately 6% in 1991, but increased by approximately 3% and 4% in 1992 and 1993, respectively. Whyte & Mackay's total case sales of scotch whisky in the United Kingdom declined by approximately 9% in 1991 and 3% in 1992, but increased by approximately 4% in 1993. Whyte & Mackay's total case sales of scotch whisky worldwide decreased by approximately 8% in 1991 but increased by approximately 1% and 10% in 1992 and 1993, respectively. During 1993, 81% of Whyte & Mackay's total case sales were derived from scotch whisky. In addition, 59% of Whyte & Mackay's total scotch whisky case sales were made in the United Kingdom in 1993. Blended scotch whiskies comprise a variety of grain and malt whiskies blended to provide a consistent product. The industry is therefore dependent on a high level of trading of whiskies between whisky companies. Whyte & Mackay owns and operates three malt whisky distilleries in the Highland region of Scotland whose product is used in the production of Whyte & Mackay's blended whiskies and for trading purposes. Production is also bottled as malt whiskies from the individual distilleries. Such distilleries are located at Dalmore, Tomintoul and Fettercairn and produce The Dalmore, Tomintoul-Glenlivet and Old Fettercairn single malt scotch whiskies respectively. Whyte & Mackay imports and markets in the United Kingdom a number of brands, including Jim Beam bourbon, under agency arrangements. In the United States, Beam is an importer and distributor of Whyte & Mackay's brands. During 1991, Whyte & Mackay purchased 41.3% of the outstanding ordinary shares of Invergordon, a distiller, blender and marketer of scotch whisky for a cost, including fees and expenses, of $255.5 million. During the fourth quarter of 1993, Whyte & Mackay completed its acquisition of Invergordon by purchasing the remaining 58.7% of the outstanding shares of Invergordon for a cost, including fees and expenses, of $343.6 million. The principal brand names of Invergordon are Mackinlay, Cluny, Glayva, Isle of Jura and Bruichladdich. Invergordon owns and operates four malt distilleries and one grain distillery in the Highland region of Scotland and the Islands of Scotland whose product is used in the production of Invergordon's blended whiskies and for trading purposes. Production is also bottled as malt whiskies and as a single grain whisky from the individual distilleries. In addition, Invergordon has a 50% interest in Greenwich Distillers Limited, a distiller of neutral spirit for the distilled spirits industry. The United Kingdom Finance Act, 1992 provided for an increase in the excise duties on distilled spirits with the result that the price of a typical bottle of scotch whisky (which during 1991 decreased in size from 75 to 70 centilitres to comply with European Community standards) increased by 31 pence. The price increase which resulted from this increase in taxes on distilled spirits includes an associated increase customarily implemented in conjunction with increases in United Kingdom distilled spirits taxes to preserve wholesalers' and retailers' percentage gross margins. It is believed that the 1992 increase was a major contributor to reductions of volume sales for Whyte & Mackay and the industry in the United Kingdom in that year. The United Kingdom Finance Act, 1993 did not provide for any increase in the excise duties on distilled spirits. The United Kingdom budget introduced on November 30, 1993 also did not provide for any increase in the excise duties on distilled spirits. This second budget in 1993 reflected the change in timing of United Kingdom budget announcements from March to November. The effect of any future excise duty increases cannot be determined, but it is possible that any future tax increases would have an adverse effect on unit sales, add to the continuing industry declines and lead to an increase in already competitive pricing pressures. Life Insurance The Franklin Life Insurance Company ("Franklin") issues individual life insurance, annuity and accident and health insurance policies, group annuities and group life insurance, group credit life insurance and group credit accident and health insurance, participates in the U.S. Government's Servicemen's Group Life Insurance program and offers a variety of whole life, universal life, retirement income and level and decreasing term insurance plans. Emphasis is placed on the sale of individual insurance programs that comply with the definition of life insurance as provided in the Deficit Reduction Act of 1984. Franklin writes insurance in all states of the United States (except that only reinsurance is written in New York), the District of Columbia, Puerto Rico and the U.S. Virgin Islands. A wholly-owned subsidiary of Franklin, The Franklin United Life Insurance Company, is engaged in the writing of individual life insurance, annuity and accident and health insurance policies, group credit life and group credit accident and health insurance in New York. Another subsidiary, The American Franklin Life Insurance Company, is engaged in the writing of reinsurance, term, universal and variable universal life insurance and single premium whole life insurance and the sale of disability insurance and individual health insurance and is licensed in 46 states and the District of Columbia. Through another subsidiary, Franklin Financial Services Corporation, a registered broker- dealer, Franklin also engages in the distribution of variable annuities and mutual fund investments. Franklin and its life insurance subsidiaries are legal reserve stock life insurance companies and operate in an industry which is highly competitive. There are about 2,000 legal reserve stock life insurance companies in the United States. Competition comes from both stock and mutual companies and is based upon price, product design and services rendered to policyholders. As of December 31, 1992, according to A. M. Best Company, Inc., a statistical reporter upon financial position, history and operating results of life insurance companies, among all life insurance companies doing business in the United States and Canada, (i) Franklin had approximately 3/10 of 1% of the admitted assets of all such companies and ranked sixty- first; (ii) Franklin had approximately 2/10 of 1% of the life insurance in force in the United States and Canada and ranked eighty-fourth; and (iii) Franklin wrote approximately 3/10 of 1% of the total new insurance written in 1992 by such companies and ranked seventy-third. As of December 31, 1992, Franklin ranked thirty-sixth among United States stock life insurance companies when measured by admitted assets and fifty-sixth among such companies when measured by insurance in force. Franklin operates on the general agency plan in which insurance is sold by independent agents who are not employees of the company. Certain highly publicized claims have been brought against other companies in the industry alleging that some advertising and sales practices are in violation of state insurance laws. It is possible that this could lead to further regulation of the industry and restrictions on advertising and sales practices relating to sales of insurance products. Hardware and Home Improvement Products MasterBrand Industries, Inc. ("MasterBrand") is a holding company for subsidiaries in the Hardware and Home Improvement Products business. Subsidiaries include Moen Incorporated ("Moen"), Master Lock Company ("Master Lock"), Aristokraft, Inc. ("Aristokraft") and Waterloo Industries, Inc. ("Waterloo"). Moen manufactures single- and two-handle faucets, sinks and plumbing accessories and parts in the United States and East Asia and also manufactures and packages a wide variety of plumbing supply and repair products in the United States. Faucets are sold under a variety of tradenames, including Moen, Moentrol, Touch Control, One-Touch, Riser, Monticello, Concentrix, Chateau, Legend, Pulsation, Fountain-Flo and Sani- Stream, and other products are sold under the Moen, Chicago Specialty, Dearborn Brass, Wrightway, Anchor Brass, Shower After Shower and Hoov-R- Line brand names. Some of the plumbing parts and repair products are purchased from other manufacturers. Products are sold principally in the United States and also in Canada, East Asia and Mexico. Sales are made through Moen's own sales force and independent manufacturers' representatives primarily to wholesalers, mass merchandisers and home centers and also to industrial distributors, repackagers and original equipment manufacturers. Legislation has been introduced in the United States Congress that if enacted would require a reduction in the lead content of plumbing pipes, fittings and fixtures that convey drinking water, unless the EPA issues regulations that establish minimum leaching levels of lead from new plumbing pipes, fittings and fixtures. It is not possible to predict whether federal, state or local legislation, regulations or action will be enacted, promulgated or taken or the nature of any such legislation, regulations or action, nor is it possible to predict the effect any such legislation, regulations or action may have on the industry generally or on Moen. Master Lock manufactures key-controlled and combination padlocks, chain and cable locks, bicycle locks, built-in locker locks and other specialty security devices, and also manufactures door lock sets and door hardware. Sales of products designed for consumer use are made to wholesale distributors and to hardware and other retail outlets, while sales of lock systems are made to industrial and institutional users, original equipment manufacturers and retail outlets. Most sales are brokered through independent manufacturers' representatives, primarily in the United States and Canada. Aristokraft manufactures kitchen cabinets and bathroom vanities. Stock and semi-custom cabinets are sold under the brand names of Aristokraft and Decora, respectively. Sales under the Aristokraft brand name are made in the United States primarily through stocking distributors for resale to kitchen and bath specialty dealers, lumber and building material dealers, remodelers and builders. Decora products are sold primarily to kitchen and bath specialty dealers and regional home centers. Waterloo is the leading manufacturer of tool storage products in the United States, consisting primarily of high quality steel tool boxes, tool chests, workbenches and related products manufactured for private label sale by one of the largest national retailers in the United States. Similar products are sold under the Waterloo and All American brand names to specialty industrial and automotive dealers, mass merchandisers, home centers and hardware stores. Waterloo also manufactures hospital carts and storage units and sells such products to institutional users. See Item 3, "Legal Proceedings". Office Products ACCO World Corporation ("ACCO") is a holding company with subsidiaries engaged worldwide in designing, developing, manufacturing and marketing a wide variety of traditional and computer-related office products and supplies, time management products, presentation aids, workstation furniture and accessories. Products are manufactured by subsidiaries, joint ventures and licensees of ACCO, or manufactured to such subsidiaries' specification, throughout the world, principally in the United States, Canada, Western Europe and Australia. ACCO USA, Inc., a subsidiary of ACCO, manufactures binders, fasteners, paper clips, punches, staples, stapling equipment and storage products, as well as computer binders, supplies and accessories, in the United States, and ACCO Canada Inc., a subsidiary of ACCO, manufactures and distributes a similar range of office products in Canada. Principal brands include ACCO products, Swingline staples and stapling equipment, Wilson Jones binders and columnar pads and Perma Products corrugated board storage products. Products are sold throughout the United States and Canada by their respective sales forces to office products wholesalers, retailers and dealers and are sold to mass merchandisers either directly or brokered through independent manufacturers' representatives. Subsidiaries of ACCO Europe PLC, a subsidiary of ACCO, manufacture and distribute a wide range of office supplies and machines and storage and retrieval filing systems. Their products are sold primarily in the United Kingdom, Ireland, Western Europe and Australia through their own sales forces and distributors. Day-Timers, Inc., a subsidiary of ACCO, manufactures personal organizers and planners in the United States and Canada and is estimated by management to be the leading direct marketer of time management aids in North America. Products are sold through direct mail advertising and catalogs to consumers and businesses. A subsidiary conducts time management seminars for personnel of corporations and other entities throughout the United States and operates four retail stores. Another subsidiary markets, principally in the United States, art and craft supplies primarily to schools. Vogel Peterson Furniture Company, a subsidiary of ACCO, manufactures in the United States and distributes ergonomic chairs, workstation components, office coat racks and partitions. Products are sold in the United States and Canada to office product and furniture dealers. Kensington Microware Limited, a subsidiary of ACCO, designs, develops and markets a range of computer accessories and supplies principally in the United States. Specialty Businesses Golf products The Titleist and Foot-Joy operations of Acushnet Company ("Acushnet") are comprised of the Titleist and Foot-Joy Worldwide Division of Acushnet and, a subsidiary of Acushnet, Foot-Joy, Inc. ("Foot-Joy"). The Titleist and Foot-Joy Worldwide Division is a leading manufacturer and distributor of golf balls and golf clubs, and also has a line of golf accessories. The Division's leading brands are Titleist and Pinnacle golf balls and DCI, Pro Trajectory and Bulls Eye golf clubs. Foot-Joy is the leading manufacturer of golf shoes and golf gloves. Foot-Joy products also include dress and athletic shoes as well as socks and related accessories. Foot-Joy's leading brands are Classics and Dry-Joys golf shoes and Sta-Sof and Weather-Sof golf gloves. Titleist and Foot-Joy products are sold primarily to golf pro shops throughout the United States by the Titleist and Foot-Joy Worldwide sales force, in the United Kingdom, in Canada and in Germany through a subsidiary, in Japan through a majority-owned joint venture, and outside these areas primarily through distributors. Rubber products The Rubber Division of Acushnet manufactures in the United States and a majority-owned joint venture manufactures in Thailand a wide variety of molded products made from natural and synthetic rubber and other elastomeric materials. Sales are made primarily by the division's own sales force and through distributors to industrial users principally in the United States. Optical goods and services Dollond & Aitchison Group PLC ("Dollond & Aitchison"), a subsidiary of Gallaher, and its subsidiaries are opticians. Dollond & Aitchison is the largest retail optical group in the United Kingdom, with 447 optical service branches, and its subsidiaries form the largest retail optical groups in Italy and Spain, with 85 branches and 77 branches, respectively, and have 6 branches in the Republic of Ireland and a 50% interest in 13 branches in Switzerland. Its subsidiary, Keeler Limited, manufactures and sells a wide range of ophthalmic and medical instruments. Retail distribution Forbuoys PLC, a subsidiary of Gallaher, operates approximately 663 retail newspaper, tobacco, confectionery and stationery outlets in the United Kingdom. Marshell Group Limited, a subsidiary of Gallaher, operates approximately 562 kiosks that sell tobacco products in large stores and 66 retail newspaper, tobacco and confectionery outlets. Another subsidiary of Gallaher, TM Group PLC, the largest vending machine operator in the United Kingdom, dispenses cigarettes, snack foods and hot drinks through approximately 41,000 on-site machines. Housewares The Prestige Group PLC ("Prestige"), a subsidiary of Gallaher, manufactures houseware products, including cookware, kitchen tools and carpet sweepers, in the United Kingdom and elsewhere. Its principal brand names are Prestige and Ewbank. A subsidiary of Registrant is operated in conjunction with Prestige and manufactures kitchen utensils in the United States. Other Matters Employees Registrant and its subsidiaries (other than Gallaher and its subsidiaries) had, as of December 31, 1993, approximately 23,300 employees in the United States and Canada, a substantial number of whom were covered by collective bargaining agreements with various unions. Of this number, approximately 3,300 were employed in the Tobacco Products segment, 1,500 in the Distilled Spirits segment, 1,350 in the Life Insurance segment, 8,300 in the Hardware and Home Improvement Products segment, 5,000 in the Office Products segment and 3,850 in the Specialty Businesses segment. In addition, approximately 3,200 employees were employed in Europe by subsidiaries of Registrant in the Office Products segment, a substantial number of whom were covered by collective bargaining agreements with various unions. Gallaher and its subsidiaries had, as of December 31, 1993, approximately 19,100 employees, a substantial number of whom were covered by collective bargaining agreements with various unions and approximately 4,700 of whom were employed in the Tobacco Products segment, 1,200 in the Distilled Spirits segment and 13,200 in the Specialty Businesses segment. In addition to the approximately 1,350 employees included in the Life Insurance segment above, Franklin was represented by approximately 30 regional managers, 1,830 area managers, general agents and district managers and 870 soliciting agents. The Franklin United Life Insurance Company had approximately 210 agents. Environmental controls Registrant and its subsidiaries are subject to federal, state and local laws and regulations concerning the discharge of materials into the environment and the handling, disposal and clean-up of waste materials and otherwise relating to the protection of the environment. While it is not possible to quantify with certainty the potential impact of actions regarding environmental matters, particularly remediation and other compliance efforts that Registrant's subsidiaries may undertake in the future, in the opinion of management of Registrant compliance with the present environmental protection laws, before taking into account estimated recoveries from third parties, will not have a material adverse effect on the capital expenditures, financial condition, results of operations or competitive position of Registrant and its subsidiaries. See Item 3, "Legal Proceedings". (d) Financial information about foreign and domestic operations and export sales. Registrant's subsidiaries operate in the United States, Europe (principally the United Kingdom) and other areas (principally Canada and Australia). See the table captioned "Information on Business Segments" contained in the 1993 Annual Report to Stockholders of Registrant, which table is incorporated herein by reference. As is disclosed in such table, Registrant has sizable investments in, and derives substantial income from, Europe (principally the United Kingdom), and, therefore, changes in the value of foreign currencies (principally sterling) can have a material effect on Registrant's financial statements when expressed in dollars. Item 2. Item 2. Properties. Registrant leases its principal executive offices in Old Greenwich, Connecticut. The following is a description of properties of Registrant's subsidiaries. Tobacco Products The principal properties of Gallaher and its subsidiaries include Gallaher's head office in Weybridge, Surrey, England, office and warehouse facilities in Northolt, Middlesex, England and Crewe, Cheshire, England, a factory in Northern Ireland for the manufacture of cigarettes and smoking tobaccos, a factory in England for the manufacture of cigarettes and two factories in Wales for the manufacture of cigars. Each of these properties is owned or held under long-term lease with an option to acquire by Gallaher or one of its subsidiaries. The principal properties of Gallaher and its subsidiaries also include a factory in the Republic of Ireland, owned and operated by Gallaher (Dublin) Limited, for the manufacture of cigarettes and smoking tobaccos. Gallaher also has a research laboratory in the Northern Ireland factory complex. For a description of properties of other subsidiaries of Gallaher, see "Distilled Spirits" and "Specialty Businesses". ATCO leases its executive offices in Stamford, Connecticut. ATCO's cigarette manufacturing plant is owned by it and is located in Reidsville, North Carolina. ATCO owns its administrative offices, a research facility and an auxiliary processing facility near Richmond, Virginia. Golden Belt, a subsidiary of ATCO, owns and operates a plant in North Carolina. Distilled Spirits Beam leases its executive offices in Deerfield, Illinois, and a subsidiary leases an office in Burnaby, British Columbia. Beam and its subsidiaries own and operate five bottling plants and three distilleries and approximately 95 warehouses for the aging of bulk whiskies, and lease and operate 17 regional sales offices and several warehouses for the storage of promotional material, all located in the United States, Australia and Canada. Beam also owns and operates approximately 70 U.S. bonded warehouses. Whyte & Mackay leases its head office in Glasgow, Scotland and owns and operates three distilleries and two blending and bottling plants in Scotland. Invergordon owns its head offices in Edinburgh, Scotland and owns and operates four malt distilleries, one grain distillery and a blending and bottling plant in Scotland. Life Insurance Franklin owns its home office building in Springfield, Illinois. Hardware and Home Improvement Products MasterBrand leases its executive offices in Deerfield, Illinois and a subsidiary, Moen, owns its executive office in North Olmstead, Ohio. Principal properties of subsidiaries of MasterBrand include nineteen plants, four distribution centers and one warehouse owned and operated in the United States. A 50%-owned joint venture in Taiwan owns and operates one plant. In addition, subsidiaries of MasterBrand lease and operate three plants and four warehouses in the United States and eleven distribution centers, of which eight are in the United States and one each in Canada, Japan and Mexico. Office Products ACCO leases its executive offices in Deerfield, Illinois. Principal properties of subsidiaries of ACCO include eight plants owned and operated in the United States, seven in the United Kingdom, and one in each of Germany, Italy, France, Australia, The Netherlands, the Republic of Ireland and Mexico. In addition, subsidiaries of ACCO lease and operate eleven facilities in the United States, four in the United Kingdom, three in Canada and one in each of Australia, France and Italy. Of these leased facilities, (i) four in the United States, two in the United Kingdom, three in Canada and one in each of Australia and France, are combined manufacturing and distribution facilities, (ii) five in the United States, two in the United Kingdom and one in Italy, are distribution facilities and (iii) two in the United States are manufacturing facilities. A subsidiary also leases four retail stores in the United States. Specialty Businesses Acushnet owns its combined executive office and research and development facility in Fairhaven, Massachusetts. In addition, it owns and operates two plants, one warehouse, two plants with combined manufacturing and warehousing operations and a test facility, and leases and operates one plant, two warehouses, a research and development facility and a test facility, all located in the United States. In addition, Foot-Joy owns and operates a plant and a warehouse and leases and operates a retail store and a warehouse in the United States and also leases an office in Taiwan. A subsidiary of Acushnet leases two combined sales offices and warehouse facilities in Canada. Other Acushnet subsidiaries own and operate a plant and a warehouse in England and lease a sales office and a warehouse in Germany, Austria, Denmark and France, and lease a sales office in the Republic of Ireland. Acushnet's majority-owned joint venture in Japan leases two sales offices and one storage facility there. Acushnet's majority-owned joint venture in Thailand leases and operates one manufacturing and warehouse facility there and Foot-Joy's majority-owned joint venture in Thailand leases and operates two plants there. Plants of subsidiaries of Gallaher include three plants in England owned or leased and operated by Dollond & Aitchison. Prestige leases its head office in Egham, England and owns and operates a plant in Burnley, England. Prestige also owns and operates a plant in each of Spain and Australia. A subsidiary of Registrant, which is operated in conjunction with Prestige, leases one plant in North Carolina. Registrant and its subsidiaries are of the opinion that their properties are suitable to their respective businesses and have productive capacities adequate to the needs of such businesses. Item 3. Item 3. Legal Proceedings. (a) (i) ATCO and other leading tobacco manufacturers have been sued by parties seeking damages for cancer and other ailments claimed to have resulted from tobacco use and by certain asbestos manufacturers seeking unspecified amounts in indemnity or contribution in third-party actions against all or most of the major domestic tobacco manufacturers. At March 25, 1994, ATCO or ATCO's predecessor had disposed of 233 actions, and the industry a total of 422, all without recovery by the plaintiffs or by the third-party plaintiffs. Although there was a jury award which was overturned on appeal against another tobacco manufacturer in the Cipollone case, discussed below, there has been no actual recovery of damages to date in any such action against the tobacco manufacturers; however, unfavorable decisions in other cases could increase filing of additional actions against the tobacco manufacturers, which would add to the high cost of defending such litigation as well as increase the defendants' damage exposure. Eighteen cases have come to trial, all against manufacturers as direct defendants. Sixteen of such cases resulted in judgments for the defendant or defendants. At March 25, 1994, ATCO was a defendant in 28 pending cases. In two cases, ATCO has been joined as a defendant with members of the asbestos industry and it is alleged that the combination of smoking and exposure to asbestos produced injury and death. One case in which ATCO is a defendant, Butler, et al. v. R.J. Reynolds Tobacco Co., et al., described below, in which plaintiffs are seeking damages for alleged injuries claimed to have resulted from exposure to tobacco smoking of others, is scheduled to come to trial on September 5, 1994. In Wilkes, et al. v. The American Tobacco Company, et al., described below, the jury found in favor of the defendants on June 17, 1993. Plaintiffs have appealed from the judgment entered on the jury verdict and from the trial court's denial of their request to seek "lifetime damages" unrelated to the cause of death and their request to seek punitive damages. ATCO has cross- appealed from the trial court's pretrial ruling regarding "absolute liability" and the court's ruling striking defendants' affirmative defenses. In Horton, et al. v. The American Tobacco Company, et al., described below, on September 24, 1990, the jury found "for the plaintiffs against [T]he American Tobacco Company and against New Deal Tobacco and Candy Company, Inc. and assessed actual damages at $0." Plaintiffs have appealed from the judgment entered on the jury verdict and from the court's denial of their post-trial motion for, alternatively, an additur on damages, a new trial on the issue of damages or a new trial on all issues. ATCO has cross-appealed from the judgment and from the court's order denying its motion for judgment notwithstanding the verdict. Oral argument on the appeals took place before the Mississippi Supreme Court on August 17, 1993. In Broin, et al. v. Philip Morris Companies Inc., et al., described below, certain airline flight attendants are seeking unspecified compensatory and $5 billion punitive damages for alleged injuries claimed to have resulted from exposure to tobacco smoking of others and are seeking to establish class-action status on behalf of other alleged nonsmoking flight attendants. ATCO's counsel, Chadbourne & Parke, have advised that, in their opinion, the specified damages claimed in pending actions against ATCO, which approximate $6,618,185,000 in the aggregate, are exaggerated. It has been reported that certain groups of attorneys are interested in promoting product liability suits against the tobacco manufacturers. It has also been reported that other claims against the tobacco manufacturers may be made seeking damages for alleged injuries claimed to have resulted from exposure to tobacco smoking of others. In Cordova v. Liggett Group Inc., et al., described below, plaintiffs are seeking injunctive relief and restitution on behalf of the general public of the State of California for defendants' claimed failure to disclose to the public information regarding research relating to smoking and health sponsored by The Council for Tobacco Research, an organization whose members include ATCO and other cigarette manufacturers. Plaintiff's complaint in Cordova references the opinion filed February 6, 1992 by Judge Sarokin of the United States District Court for the District of New Jersey in the case of Haines v. Liggett Group Inc., et al., to which ATCO is not a party. In that opinion, Judge Sarokin ruled that plaintiff had made sufficient showing of evidence to warrant disclosure under the crime-fraud exception to the attorney-client privilege of documents regarding research relating to smoking and health sponsored by The Council for Tobacco Research which the defendants in that case had claimed were protected from discovery by plaintiff. Defendants in Haines sought appellate review of Judge Sarokin's February 6, 1992 opinion. On September 4, 1992, the United States Court of Appeals for the Third Circuit granted defendant's petition for writ of mandamus and directed that Judge Sarokin's February 6, 1992 ruling be vacated and that the case be remanded and assigned to another District Court judge. The opinion of the Court of Appeals also stated that the District Court judge to whom the case is reassigned on remand may reconsider the magistrate judge's order stating that the crime-fraud exception did not apply, which order had been reversed by Judge Sarokin's ruling, or alternatively may remand the proceedings to the magistrate judge for his reconsideration. On September 14, 1992, Judge Sarokin, as directed, vacated his February 6, 1992 opinion and orders in Haines. Plaintiff's allegations in Haines may be similar to allegations which have been made in other actions in which ATCO is a defendant. ATCO has been advised that the United States Attorney for the Eastern District of New York has commenced a criminal investigation in connection with activities relating to The Council for Tobacco Research following the February 6, 1992 opinion in Haines. It is not possible to predict the outcome of the investigation. Another case, Cipollone v. Liggett Group, Inc., et al., tried against manufacturers other than ATCO, resulted in a jury award of $400,000 against one of three defendants on a theory of breach of warranty. On January 5, 1990, the jury award in Cipollone was reversed and remanded for a new trial by the United States Court of Appeals for the Third Circuit. Plaintiff petitioned the United States Supreme Court to review that ruling. As described below, on June 24, 1992, the Supreme Court reversed in part and affirmed in part the ruling of the Court of Appeals. The Cipollone case was tried before Judge Sarokin. On September 11, 1992, following the September 4, 1992 decision of the United States Court of Appeals for the Third Circuit in Haines discussed above, Judge Sarokin removed himself from the Cipollone case. On November 5, 1992, plaintiff voluntarily dismissed the Cipollone case with prejudice. Counsel for plaintiff in Cipollone also represented the plaintiffs in Smith, et al. v. R.J. Reynolds Tobacco Co., et al. and the plaintiff in Haines. On December 2, 1992, plaintiffs' counsel in Smith filed a motion to withdraw as counsel of record; that motion was granted on January 8, 1993. Plaintiffs appealed the ruling. On August 9, 1993, the Appellate Division of the New Jersey Superior Court vacated the lower court's ruling which had permitted plaintiffs' counsel to withdraw. The appellate court directed that the trial court convene a hearing on plaintiffs' counsel's motion to withdraw. Plaintiff's counsel in Haines also sought to withdraw and be substituted by new counsel. The motion to withdraw in Haines, however, was denied by United States District Judge Lechner on January 26, 1993. Counsel appealed. Argument on that appeal was heard before the Court of Appeals for the Third Circuit on September 22, 1993. On June 24, 1992, the Supreme Court reversed in part and affirmed in part the ruling of the Court of Appeals for the Third Circuit in Cipollone. The Supreme Court held that the 1965 version of the Labeling Act did not preempt lawsuits seeking money damages for personal injuries allegedly caused by cigarette smoking. The Supreme Court further held that the Public Health Cigarette Smoking Act of 1969, which, among other things, amended the preemption provision of the 1965 version of the Labeling Act effective July 1, 1969, preempts such lawsuits based on alleged failure to warn and the neutralization of the federally mandated warnings to the extent that those claims rely on omissions or inclusions in cigarette advertising or promotions, but that the 1969 version of the Labeling Act does not preempt claims based on alleged breach of express warranty, or certain claims based on intentional fraud and misrepresentation or conspiracy. In addition, legislation has been introduced in the United States Congress that if enacted would limit the effect of the preemption provisions of the Labeling Act. It is not possible to predict whether or not the Supreme Court's decision in Cipollone will affect, or whether or not the enactment of any such legislation would affect, filing of additional actions against tobacco manufacturers and, as a result, litigation costs and defendant's damage exposure. ATCO has received a civil investigative demand from the U.S. Department of Justice, Antitrust Division, seeking the production of documents relating to matters including "fire-safe or self-extinguishing cigarettes". The civil investigative demand states that it has been issued in the course of an investigation to determine whether there is or has been a violation of Section 1 of the Sherman Act. It is not possible to predict the outcome of the investigation. While it is not possible to predict the outcome of pending litigation, management of Registrant does not believe that, based on failure of recovery to date except as noted above and the advice of counsel, the pending litigation will have a material adverse effect on Registrant's financial condition. If, however, there were to be a significant increase in such litigation, the increased financial burden could be material. See the note captioned "Pending Litigation" in the Notes to Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders of Registrant, which note is incorporated herein by reference. ATCO's counsel have advised that, in their opinion, on the basis of their investigations generally with respect to suits and claims of this character, ATCO has meritorious defenses to the above-mentioned actions and threatened actions. The actions will be vigorously defended on the merits. Except as otherwise noted, the following sets forth the principal parties to the above-described pending proceedings, the court in which such proceedings are pending and the date such proceedings were instituted against ATCO or ATCO's predecessor: Allgood v. R.J. Reynolds Tobacco Company, et al., United States District Court for the Southern District of Texas, January 4, 1991; Arabie v. R.J. Reynolds Tobacco Company, et al., District Court, State of Louisiana, Parish of Jefferson, October 5, 1993; Blanchard, et al. v. Brown and Williamson Tobacco Corp., et al., District Court, State of Texas, County of Galveston, December 28, 1992; Bluitt v. R.J. Reynolds Tobacco Co., et al., United States District Court for the Northern District of Texas, August 30, 1993; Bridges, et al. v. The American Tobacco Company, Supreme Court, State of New York, County of Albany, November 17, 1970; Broin, et al. v. Philip Morris Companies, Inc., et al., Circuit Court of the 11th Judicial Circuit, State of Florida, County of Dade, November 8, 1991; Butler v. R.J. Reynolds Tobacco Co., et al., United States District Court for the Southern District of Mississippi, October 23, 1992; Chustz v. R.J. Reynolds Tobacco Company, et al., United States District Court for the Middle District of Louisiana, August 13, 1993; Cordova v. Liggett Group, Inc., et al., Superior Court of the State of California for the County of San Diego, May 12, 1992; Dunn v. RJR Nabisco Holdings Corporation, et al., Superior Court State of Indiana, County of Delaware, May 28, 1993; Dyer, et al. v. American Tobacco Company, Inc., et al., District Court, State of Texas, County of Travis, December 20, 1985; Gilboy, et al. v. American Tobacco Company, et al., District Court, State of Louisiana, Parish of East Baton Rouge, April 8, 1987; Grinnell, et al. v. The American Tobacco Co., Inc., et al., District Court, State of Texas, County of Jefferson, October 22, 1985; Haight, et al. v. The American Tobacco Co., et al., Circuit Court of Kanawha County, West Virginia, May 30, 1984; Horton, et al. v. The American Tobacco Company, et al., Circuit Court, State of Mississippi, County of Lafayette, May 12, 1986; Hulin, et al. v. Fibreboard Corporation, et al., United States District Court for the Middle District of Louisiana, January 15, 1986; Hutchin v. American Tobacco Company, et al., United States District Court for the Western District of Louisiana, September 29, 1992; Manago, et al. v. Lorillard, Inc. et al., Supreme Court, State of New York, County of Queens, March 21, 1988; Miceli v. American Tobacco Company, et al., District Court, State of Louisiana, Parish of East Baton Rouge, August 3, 1987; Miceli v. Armstrong World Industries, et al., District Court, State of Louisiana, Parish of East Baton Rouge, January 18, 1989; Pitre v. GAF Corporation, et al., District Court, Parish of East Baton Rouge, State of Louisiana, December 18, 1992; Rogers, I.D., et al. v. R.J. Reynolds Tobacco Company, et al., District Court, State of Texas, County of Jefferson, March 14, 1985; Rogers, Y., Executrix v. R.J. Reynolds Tobacco Co., et al., Superior Court, State of Indiana, County of Marion, March 27, 1987; Rothgeb, et al. v. The American Tobacco Company, et al., District Court, State of Texas, County of Travis, June 9, 1986; Smith, et al. v. R.J. Reynolds Tobacco Co., et al., Superior Court, State of New Jersey, County of Middlesex, September 24, 1984; Smith, Administrator v. American Tobacco Company, Court of Common Pleas, Commonwealth of Pennsylvania, County of Philadelphia, summons served July 1, 1970; Voth v. Forsyth Tobacco Products, et al., United States District Court for the District of Oregon, August 10, 1993; Wilkes, et al. v. The American Tobacco Company, et al., Circuit Court, State of Mississippi, County of Holmes, January 6, 1988. With regard to proceedings of the above-described type which have been terminated and not previously reported as such: Jamerson v. American Brands, Inc., et al., which was previously pending in the United States District Court for the Eastern District of New York and instituted on July 25, 1990, was voluntarily dismissed by stipulation on November 5, 1993; White v. The American Tobacco Company, et al., which was previously pending in the United States District Court for the District of Nevada and instituted on February 13, 1989, was dismissed on summary judgment on December 2, 1991, and affirmed by the United States Court of Appeals for the Ninth Circuit on August 20, 1993; Bentz v. Eagle Tobacco Corp., et al., which was previously pending in the United States District Court for the District of Oregon and instituted on September 27, 1993, was dismissed with prejudice on October 21, 1993; Guillory v. R.J. Reynolds tobacco Company, et al., which was previously pending in the United States District Court for the Western District of Louisiana and instituted on February 18, 1993, was voluntarily dismissed without prejudice on November 22, 1993; Dalio v. Philip Morris, Inc., et al., which was previously pending in Superior Court, County of Middlesex, Massachusetts and instituted on January 11, 1993, was dismissed with prejudice by stipulation on January 7, 1994; and Marks v. R.J. Reynolds Tobacco Company, et al., which was previously pending in the United States District Court for the Western District of Louisiana and instituted on September 21, 1992, was dismissed with prejudice as to ATCO on January 24, 1994. (ii) Dean v. Gallaher Limited is an action commenced in the High Court of Justice in Northern Ireland in which plaintiff seeks unspecified damages including lost income for claimed personal injuries allegedly related to cigarette smoking. In March 1988, plaintiff obtained Legal Aid to proceed up to the point of trial. He served his Writ of Summons in August 1988 and his Statement of Claim in August 1989. Plaintiff filed an amended Statement of Claim on October 6, 1993. Gallaher subsequently filed a motion to strike from the amended Statement of Claim a predecessor to Gallaher, Hergall (1981) Limited (In Liquidation) ("Hergall"), as a second defendant in the action. The motion was heard on November 30, 1993 and was granted. Plaintiff served a Writ of Summons on Hergall on December 1, 1993 and a Statement of Claim against Hergall on February 22, 1994. Plaintiff's lawyers also purported to re-amend the statement of claim against Gallaher. Applications are expected to be made by Gallaher and Hergall in May 1994 to strike out parts of the statements of claim against those companies. The companies have obtained orders extending the time in which their defenses must be served until after the hearing of the "strike-out" applications. Plaintiff's appeals against those extension of time orders are also due to be heard in May 1994. Lawyers in the United Kingdom have sought Legal Aid to prepare and file other smoking and health lawsuits against tobacco manufacturers, but to date, all such requests have been denied, with the exception of the plaintiffs in the Dean case and the Brennan case described below. An application for Judicial Review of the refusal to grant Legal Aid to approximately 225 prospective plaintiffs in actions against tobacco companies, including Gallaher, is pending. Tobacco manufacturers, including Gallaher, have been advised they are entitled to participate in the Judicial Review and are seeking an order of the court to that effect. In Brennan v. Gallaher Limited, pending in the High Court of Justice in Northern Ireland, plaintiff, a former employee of Gallaher, seeks unspecified damages for claimed personal injuries from the alleged "provision of cigarettes for [sic] the plaintiff". Plaintiff served her Writ of Summons in October 1990, and no Statement of Claim has been received. Counsel have advised that, in their opinion, on the basis of their investigation, Gallaher has meritorious defenses to these actions, and they will be vigorously defended on the merits. In addition, Gallaher received a letter before action dated July 23, 1992 from a solicitor in Scotland acting for Alfred McTear stating that his client had instructed him to make a claim against Gallaher for lung cancer claimed to have been caused by smoking. In January 1993 Gallaher received a letter from plaintiff's solicitors indicating that they did not intend to proceed against Gallaher and on January 28, 1993, plaintiff filed and served a Writ of Summons and Condescendence in the Court of Session naming only Imperial Tobacco Limited as defendant. (b) Registrant is aware of four lawsuits brought against manufacturers of alcoholic beverages in which alleged birth defects in infants were claimed to have been caused by the consumption of alcohol during pregnancy by the mothers of the infants. None of those actions is currently pending. Beam was a defendant in one of these lawsuits, and such lawsuit resulted in a jury verdict in favor of Beam in 1989. The other actions were dismissed without prejudice at the request of the plaintiffs. Registrant is also aware of other lawsuits against manufacturers of alcoholic beverages in which other various claimed injuries have been alleged to have been caused by their products. Beam has successfully defended such actions brought against it in the past. On September 29, 1992, the jury in Brune v. Brown-Forman Corp., a Nueces County, Texas state court action alleging the defendant failed to warn about the risk of death from excessive alcohol consumption, returned a verdict holding the defendant responsible for 35% of $1,500,000 in damages. Brown-Forman has appealed this verdict. Neither Registrant nor any of its subsidiaries, including Jim Beam Brands Co., is a party to this action. (c) Forstmann Leff Associates, Inc., et al. v. American Brands, Inc., et al., is an action commenced in the United States District Court for the Southern District of New York on June 28, 1988. Plaintiffs, alleged holders of 12.85% Senior Subordinated Notes due 1997 and 13.05% Subordinated Debentures due 1999 of E-II Holdings Inc., formerly a subsidiary of Registrant ("E-II"), allege, inter alia, that defendants violated Sections 14(e), 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder and engaged in common law fraud by intentionally or recklessly making certain allegedly false and misleading statements of material fact, failing to disclose certain material facts and failing to correct false and misleading statements in connection with the Offer To Purchase And Consent Solicitation for All 12.85% Senior Subordinated Notes due 1997 and All 13.05% Subordinated Debentures due 1999 of E-II (the "Offer to Purchase") by AMBR Holdings Inc., formerly a subsidiary of Registrant ("AMBR"), and certain filings made by Registrant, AMBR and E-II with the Securities and Exchange Commission regarding their alleged plans for the disposition of E-II and certain subsidiaries of E-II. On August 26, 1991, plaintiffs served their fourth amended complaint making substantially the same allegations as did their previous complaints and seeking not less than $400 million in damages against Registrant and two executive officers and a former executive officer of Registrant. The Board of Directors of Registrant has determined that such officers and former officer shall be indemnified in full by Registrant for all expense, liability and loss reasonably incurred by them in connection with such action. On November 19, 1993 Registrant settled for approximately $11 million the claims of the remaining plaintiffs holding approximately 20% of the total face amount of E-II debt securities originally alleged to be represented in the Forstmann Leff action. These remaining plaintiffs also released all of their claims against two executive officers and a former executive officer of Registrant. Registrant had previously settled for approximately $37.3 million the claims of the holders of approximately 80% of the total face amount of E-II debt securities originally alleged to be represented in the action. As in the case of the earlier settlements, previously-established reserves fully covered the amount paid in the settlement with the remaining plaintiffs. (d) People of the State of California ex rel. Daniel E. Lungren, Attorney General of the State of California v. American Standard, et al., is an action commenced on December 15, 1992 against Moen and 15 other faucet manufacturers and distributors in the Superior Court of the State of California, County of San Francisco. The Attorney General of California alleges violations of California Health and Safety Code Sections 25249.5 and 25249.6 (Proposition 65), as well as two violations of the California Business and Professions Code Section 17200, for alleged intentional discharge of lead from faucets to sources of drinking water and failure to provide clear and reasonable warnings to consumers, and seeks civil penalties of up to $2,500 per day per violation on each cause of action. The Attorney General also seeks injunctive relief prohibiting further discharges of lead from faucets into drinking water sources or, in the alternative, requiring clear and reasonable warnings regarding lead in faucets, restitution to consumers and other relief. A related action against these companies and others, including Moen, MasterBrand and Registrant, has also been brought by environmental groups in the same court, Natural Resources Defense Council, et al., v. Price Pfister, Inc., et al. In that case, plaintiffs allege the same claims as the Attorney General's action and also allege certain other violations, including violation of the Consumer Legal Remedies Act, Civil Code Section 1750. The plaintiffs seek similar injunctive relief and establishment of a public information campaign concerning lead from faucets, restitution and disgorgement of funds obtained from California consumers by unlawful or unfair business practices and establishment of a fund for medical monitoring of infants exposed to lead from faucets. The plaintiffs also seek compensatory damages, statutory penalties, punitive damages, reasonable attorneys' fees and costs. On July 26, 1993, an agreement was filed whereby plaintiffs in Natural Resources Defense Council agreed to dismiss without prejudice the action as to MasterBrand and Registrant. The plaintiffs in both actions moved for injunctive relief to require certain of the defendants to post prescribed warnings. In Natural Resources Defense Council, the court refused to issue any order regarding the motion pending resolution of defendants' demurrer challenging plaintiffs' standing to bring the action, which demurrer was filed on April 16, 1993. A hearing on the demurrer has been delayed until further notice from the court. In Lungren, on May 17, 1993, the court issued an order requiring certain of the defendants in the action, including Moen, to provide warnings in accordance with the protocol voluntarily proposed by the defendants. The court made no finding of liability for failure to warn. On April 16, 1993, defendants filed a demurrer in respect of plaintiffs' claims based on defendants' alleged intentional discharge of lead from faucets to sources of drinking water. A hearing on the demurrer has been delayed until further notice from the court. These actions will be vigorously contested. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 4a. Executive Officers of the Registrant. The name, present positions and offices with Registrant, principal occupations during the past five years and age of each of Registrant's present executive officers are as follows: Present positions and offices with Registrant and principal occupations Name during the past five years Age - ---- ------------------------------------ --- William J. Alley Chairman of the Board and Chief Executive 64 Officer of Registrant Thomas C. Hays President and Chief Operating Officer of 58 Registrant Arnold Henson Executive Vice President and Chief Financial 62 Officer of Registrant Robert L. Plancher Senior Vice President and Chief Accounting 62 Officer of Registrant Robert J. Rukeyser Senior Vice President -- Corporate Affairs 51 of Registrant since 1990; Vice President -- Operations of Registrant prior thereto Gilbert L. Klemann, II Senior Vice President and General Counsel 43 of Registrant since 1991; Vice President and Associate General Counsel of Registrant during 1991; Partner, Chadbourne & Parke (law firm) prior thereto John T. Ludes Group Vice President of Registrant; President 57 and Chief Executive Officer of Acushnet since 1982; Chairman of Titleist and Foot-Joy Worldwide since 1992 Howard C. Humphrey Vice President -- Life Insurance of 60 Registrant since 1989; Chairman of the Board, President and Chief Executive Officer of Franklin since 1992; Chairman of the Board and Chief Executive Officer of Franklin from 1990 to 1992; Chairman of the Board, President and Chief Executive Officer of Franklin prior thereto Present positions and offices with Registrant and principal occupations Name during the past five years Age - ---- ------------------------------------ --- Randall W. Larrimore Vice President -- Hardware and Home 46 Improvement Products of Registrant; President and Chief Executive Officer of MasterBrand Steven C. Mendenhall Vice President and Chief Administrative 45 Officer of Registrant since 1993; Vice President -- Human Resources prior thereto Barry M. Berish Vice President -- Distilled Spirits of 61 Registrant since 1990; Chairman of the Board and Chief Executive Officer of Beam since 1993; President and Chief Executive Officer of Beam prior thereto Norman H. Wesley Vice President -- Office Products of 44 Registrant since 1990; President and Chief Executive Officer of ACCO since 1990; President and Chief Operating Officer of ACCO prior thereto Mr. Peter M. Wilson, who has been a member of the Executive Committee of the Board of Directors of Registrant and Chairman and Chief Executive of Gallaher since February 1, 1994, is deemed to be an executive officer of Registrant for the purposes of this Item 4a. Mr. Wilson was Joint Deputy Chairman of Gallaher from 1987 to 1989 and Deputy Chairman from 1989 to 1994 and has been Chairman and Chief Executive of Gallaher Tobacco Limited since 1987. His age is 52. In the case of each of the above-listed executive officers, the occupation or occupations given were his principal occupation and employment during the period or periods indicated. None of such executive officers is related to any other such executive officer. None was selected pursuant to any arrangement or understanding between him and any other person. All executive officers are elected annually. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. See the information in the tables captioned "Quarterly Common Stock Dividend Payments" and "Quarterly Composite Common Stock Prices" and the discussion relating thereto contained in the 1993 Annual Report to Stockholders of the Registrant, which information and discussion are incorporated herein by reference. On March 4, 1994, there were 63,697 record holders of Registrant's Common Stock, par value $3.125 per share. Item 6. Item 6. Selected Financial Data. See the information in the table captioned "Eleven-Year Consolidated Selected Financial Data" contained in the 1993 Annual Report to Stockholders of the Registrant, which information is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. See the discussion and analysis under the captions "Results of Operations" and "Financial Review" contained in the 1993 Annual Report to Stockholders of Registrant, which discussion and analysis are incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. See the information in the Consolidated Statement of Income, Consolidated Balance Sheet, Consolidated Statement of Cash Flows, Consolidated Statement of Common Stockholders' Equity, Notes to Consolidated Financial Statements and Report of Independent Accountants contained in the 1993 Annual Report to Stockholders of Registrant, which information is incorporated herein by reference. For unaudited selected quarterly financial data, see the table captioned "Quarterly Financial Data" contained in the 1993 Annual Report to Stockholders of Registrant, which table 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 Registrant. See the information under the caption "Election of Directors" contained in the Proxy Statement for the Annual Meeting of Stockholders of Registrant to be held on May 3, 1994, which information is incorporated herein by reference. See also the information with respect to executive officers of Registrant under Item 4a of Part I hereof, which information is incorporated herein by reference. Item 11. Item 11. Executive Compensation. See the information up to but not including the subcaption "Report of the Compensation and Stock Option Committee on Executive Compensation" under the caption "Executive Compensation" contained in the Proxy Statement for the Annual Meeting of Stockholders of Registrant to be held on May 3, 1994, which information is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. See the information in the table and notes related thereto and in the third to last paragraph under the caption "Election of Directors" and the information under the caption "Certain Information Regarding Security Holdings" contained in the Proxy Statement for the Annual Meeting of Stockholders of Registrant to be held on May 3, 1994, which information is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions. See the information in the second to last paragraph under the caption "Election of Directors" contained in the Proxy Statement for the Annual Meeting of Stockholders of Registrant to be held on May 3, 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) Financial Statements, Financial Statement Schedules and Exhibits. (1) Financial Statements (all financial statements listed below are of Registrant and its consolidated subsidiaries) Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991 contained in the 1993 Annual Report to Stockholders of Registrant is incorporated herein by reference. Consolidated Balance Sheet as of December 31, 1993 and 1992 contained in the 1993 Annual Report to Stockholders of Registrant is incorporated herein by reference. Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 contained in the 1993 Annual Report to Stockholders of Registrant is incorporated herein by reference. Consolidated Statement of Common Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 contained in the 1993 Annual Report to Stockholders of Registrant is incorporated herein by reference. Notes to Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders of Registrant are incorporated herein by reference. Report of Independent Accountants contained in the 1993 Annual Report to Stockholders of Registrant is incorporated herein by reference. (2) Financial Statement Schedules See Index to Financial Statement Schedules of Registrant and subsidiaries at page, which Index is incorporated herein by reference. (3) Exhibits 3(i). Certificate of Incorporation of Registrant as in effect on the date hereof is incorporated herein by reference to Exhibit 3a2 to the Quarterly Report on Form 10-Q of Registrant dated May 14, 1990. 3(ii). By-laws of Registrant as in effect on the date hereof are incorporated herein by reference to Exhibit 3(ii)b to the Quarterly Report on Form 10-Q of Registrant dated November 11, 1993. 10a1. Article XII ("Incentive Compensation") of the By-laws of Registrant is incorporated herein by reference to Exhibit 3(ii)b to the Quarterly Report on Form 10-Q of Registrant dated November 11, 1993.* 10b1. Stock Option Plan of American Brands, Inc., as amended is incorporated herein by reference to Exhibit 10b1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10b2. Amendment to Stock Option Plan of American Brands, Inc. constituting Exhibit 10b1 hereto is incorporated herein by reference to Exhibit 10a to the Quarterly Report on Form 10-Q of Registrant dated November 11, 1993.* 10b3. 1986 Stock Option Plan of American Brands, Inc. and amendments thereto is incorporated herein by reference to Exhibit 10b2 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10b4. Amendment to 1986 Stock Option Plan of American Brands, Inc. constituting Exhibit 10b3 hereto is incorporated herein by reference to Exhibit 10b to the Quarterly Report on Form 10-Q of Registrant dated November 11, 1993.* 10b5. 1990 Long-Term Incentive Plan of American Brands, Inc. is incorporated herein by reference to Exhibit 10b4 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1990.* 10b6. Amendment to 1990 Long-Term Incentive Plan of American Brands, Inc. constituting Exhibit 10b5 hereto is incorporated herein by reference to Exhibit 10 to the Quarterly Report on Form 10-Q of Registrant dated May 13, 1993.* 10b7. Stock Plan for Non-employee Directors of American Brands, Inc. is incorporated herein by reference to Exhibit 10b5 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1990.* 10c1. Amended Supplemental Retirement Plan of American Brands, Inc.* 10c2. Trust Agreement, made as of the 1st day of February, 1989, among Registrant, The Chase Manhattan Bank (National Association) ("Chase"), et al. establishing a trust in favor of William J. Alley for purposes of paying amounts under the Amended Supplemental Retirement Plan constituting Exhibit 10c1 hereto is incorporated herein by reference to Exhibit 10c2 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1988.* 10c3. Amendment made as of the 1st day of November, 1993 to Trust Agreement constituting Exhibit 10c2 hereto.* 10c4. Schedule identifying substantially identical agreements to the Trust Agreement and Amendment thereto constituting Exhibits 10c2 and 10c3 hereto, respectively, in favor of Thomas C. Hays, Arnold Henson, Robert L. Plancher, Gilbert L. Klemann, II, John T. Ludes, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10c5. Trust Agreement, made as of the 1st day of November, 1993, among William J. Alley, Registrant and Chase establishing a grantor trust in favor of William J. Alley for purposes of paying amounts under the Amended Supplemental Retirement Plan constituting Exhibit 10c1 hereto.* 10c6. Schedule identifying substantially identical agreements to the Trust Agreement constituting Exhibit 10c5 hereto in favor of Thomas C. Hays, Arnold Henson, Robert L. Plancher, Gilbert L. Klemann, II, John T. Ludes, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10d1. Executive mortgage program of Registrant in connection with relocation of corporate headquarters is incorporated herein by reference to Exhibit 10d1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10e1. Resolutions of the Board of Directors of Registrant adopted on October 28, 1986 and July 26, 1988 adopting and amending a retirement plan for directors of Registrant who are not officers or employees of Registrant or a subsidiary thereof are incorporated herein by reference to Exhibit 10e1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10f1. The Franklin Life Insurance Company Supplemental Retirement Plan effective January 1, 1988 as amended and restated effective January 1, 1993.* 10f2. Trust Agreement, made as of the 25th day of January, 1990, among The Franklin Life Insurance Company ("The Franklin"), The Marine Bank of Springfield and Milliman & Robertson, establishing a trust in favor of Howard C. Humphrey for purposes of paying amounts under the supplemental retirement plan constituting Exhibit 10f1 hereto is incorporated herein by reference to Exhibit 10f2 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1990.* 10f4. Trust Agreement, made as of the 16th day of December, 1993, among Howard C. Humphrey, The Franklin and Bank One, Springfield (State Association) establishing a grantor trust in favor of Howard C. Humphrey for purposes of paying amounts under the Supplemental Retirement Plan constituting Exhibit 10f1 hereto.* 10g1. Gallaher Limited Executive Incentive Plan adopted on June 20, 1990 is incorporated herein by reference to Exhibit 10g1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1990.* 10g2. Trust Deed dated March 24, 1983 between Gallaher Limited ("Gallaher") and Gallaher Pensions Limited, and amendments thereto, providing supplemental retirement benefits to certain executives of Gallaher are incorporated herein by reference to Exhibits 10g2 and 10g3 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1989.* 10g3. Trust Deed dated June 3, 1992 further amending Exhibit 10g2 hereto is incorporated herein by reference to Exhibit 10g3 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10g4. Trust Deed dated January 24, 1994 further amending Exhibit 10g2 hereto.* 10h1. ACCO World Corporation Management Incentive Plan is incorporated herein by reference to Exhibit 10h1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10i1. ACCO World Corporation Supplemental Benefit Plan for Key Employees is incorporated herein by reference to Exhibit 10k1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1989.* 10j1. American Franklin Company Senior Executive and Key Manager Incentive Plan is incorporated herein by reference to Exhibit 10j1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1990.* 10k1. Jim Beam Brands Co. Senior Executive and Key Manager Incentive Plan is incorporated herein by reference to Exhibit 10m4 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10k2. Jim Beam Brands Co. Amended Excess Benefit Plan.* 10k3. Trust Agreement, made as of December 24, 1991, among Jim Beam Brands Co. ("Beam"), Chase and Hewitt Associates, establishing a trust in favor of Barry M. Berish for purposes of paying amounts under the Amended Excess Benefit Plan constituting Exhibit 10k2 hereto is incorporated herein by reference to Exhibit 10m3 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10k4. Amendment made as of the 17th day of November, 1993 to Trust Agreement constituting Exhibit 10k3 hereto.* 10k5. Trust Agreement, made as of the 15th day of December, 1993, among Barry M. Berish, Beam and Chase establishing a grantor trust in favor of Barry M. Berish for purposes of paying amounts under the Amended Excess Benefit Plan constituting Exhibit 10k2 hereto.* 10l1. Resolution of the Board of Directors of Registrant adopted on December 11, 1985 with respect to retirement and health benefits provided to William J. Alley is incorporated herein by reference to Exhibit 10e2 to the Registration Statement on Form 8-B of Registrant dated January 27, 1986.* 10l2. Agreement dated as of March 1, 1988 between Registrant and William J. Alley and amendments thereto providing certain retirement benefits is incorporated herein by reference to Exhibit 10l2 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10m1. Resolutions of the Board of Directors of Registrant adopted on December 11, 1985 and February 23, 1988 with respect to retirement and health benefits provided to Arnold Henson is incorporated herein by reference to Exhibit 10m1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10n1. Resolution of the Board of Directors of Registrant adopted on November 27, 1990 with respect to retirement and health benefits provided to Gilbert L. Klemann, II is incorporated herein by reference to Exhibit 10p1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10o1. Service Agreement dated February 11, 1994 between Gallaher and Peter M. Wilson.* 10o2. Letter dated September 20, 1991 from Gallaher in respect of retirement benefits provided to Peter M. Wilson.* 10o3. Letter dated March 15, 1994 amending Exhibit 10o2 hereto.* 10o4. Service Agreement dated May 15, 1989 between Gallaher and Anthony D. Househam and amendments thereto are incorporated herein by reference to Exhibits 10p1 and 10q2 to the Annual Reports on Form 10-K of Registrant for the Fiscal Years ended December 31, 1989 and 1990, respectively.* 10o5. Letter dated September 20, 1991 from Gallaher in respect of retirement benefits provided to Anthony D. Househam is incorporated herein by reference to Exhibit 10q2 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10p1. ACCO World Corporation Supplemental Retirement Plan and amendment thereto is incorporated herein by reference to Exhibit 10r1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10p2. Amendment to the ACCO World Corporation Supplemental Retirement Plan constituting Exhibit 10p1 hereto is incorporated herein by reference to Exhibit 10p2 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10q1. Employment Agreement entered into as of June 8, 1987 by and between ACCO International Inc. (a predecessor of ACCO USA, Inc.) and Norman H. Wesley is incorporated herein by reference to Exhibit 10r1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1990.* 10r1. Letters dated July 31, 1984 and February 26, 1990 from Registrant with respect to deferred payment of fees to Eugene R. Anderson are incorporated herein by reference to Exhibit 10t1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10s1. Agreement dated January 2, 1991 between Registrant and Gilbert L. Klemann, II is incorporated herein by reference to Exhibit 10s1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10s2. Schedule identifying substantially identical agreements to the Agreement constituting Exhibit 10s1 hereto entered into by Registrant with William J. Alley, Thomas C. Hays, Arnold Henson, Howard C. Humphrey, Robert L. Plancher, John T. Ludes, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10s3. Agreement dated April 14, 1992 between Franklin and Howard C. Humphrey is incorporated herein by reference to Exhibit 10s3 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10t1. Trust Agreement, made as of the 1st day of February 1989, among Registrant, Chase, et al. establishing a trust in favor of William J. Alley for purposes of paying amounts under the Agreement in the form constituting Exhibit 10s1 hereto is incorporated herein by reference to Exhibit 10gg1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1988.* 10t2. Amendment made as of the 1st day of November, 1993 to Trust Agreement constituting Exhibit 10t1 hereto.* 10t3. Schedule identifying substantially identical agreements to the Trust Agreement and Amendment thereto constituting Exhibits 10t1 and 10t2 hereto, respectively, in favor of Thomas C. Hays, Arnold Henson, Robert L. Plancher, Gilbert L. Klemann, II, John T. Ludes, Howard C. Humphrey, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10u1. Agreement dated as of March 1, 1988 and amendments thereto between Registrant and William J. Alley are incorporated herein by reference to Exhibit 10u1 to the Annual Report on Form 10-k of Registrant for the Fiscal Year ended December 31, 1992.* 10v1. Agreement dated as of March 1, 1988 and amendments thereto between Registrant and Thomas C. Hays are incorporated herein by reference to Exhibit 10v1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10v2. Schedule identifying substantially identical agreements to the Agreement constituting Exhibit 10v1 hereto entered into by Registrant with Arnold Henson, Robert L. Plancher, John T. Ludes, Robert J. Rukeyser and Steven C. Mendenhall.* 10w1. Agreement dated as of January 2, 1991 between Registrant and Gilbert L. Klemann, II and amendment thereto is incorporated herein by reference to Exhibit 10y1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1991.* 10w2. Agreement dated as of October 28, 1991 amending the Agreement constituting Exhibit 10w1 hereto is incorporated herein by reference to Exhibit 10w2 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10x1. Agreement dated March 7, 1988 between Registrant and Randall W. Larrimore and amendments thereto is incorporated herein by reference to Exhibit 10x1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* l0y1. Agreement dated as of February 1, 1990 between American Franklin and Howard C. Humphrey is incorporated herein by reference to Exhibit l0mm1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1989.* l0z1. Agreement dated as of February 1, 1990 between Beam and Barry M. Berish is incorporated herein by reference to Exhibit 10pp1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1990.* l0aa1. Rights Agreement dated as of December 13, 1987 between Registrant and First Chicago Trust Company of New York, as Rights Agent, and amendments thereto is incorporated herein by reference to Exhibit 10aa1 to the Annual Report on Form 10-K of Registrant for the Fiscal Year ended December 31, 1992.* 10bb1. Stock Purchase Agreement dated as of July 20, 1990 among MI Acquisition, Inc., Stanadyne Partners, Forstmann Little & Co. Subordinated Debt and Equity Management Buyout Partnership III ("MBO") and certain individual shareholders of The Moen Group, Inc. and Amendment No. 1 to Stock Purchase Agreement dated as of August 21, 1990 are incorporated herein by reference to Exhibit 2a to the Current Report on Form 8-K of Registrant dated August 29, 1990. 10bb2. Escrow Agreement dated as of August 21, 1990 among MI Acquisition, Inc., Stanadyne Partners, MBO and Chemical Bank as successor by merger to Manufacturers Hanover Trust Company is incorporated herein by reference to Exhibit 2b to the Current Report on Form 8-K of Registrant dated August 29, 1990. 11. Statement setting forth net income for computation of earnings per Common share, primary and fully diluted, and statement setting forth computation of weighted average number of Common shares outstanding on a fully diluted basis. 12. Statement re computation of ratio of earnings to fixed charges. 13. 1993 Annual Report to Stockholders of Registrant. 22. Subsidiaries of Registrant. 23(i)a. Consent of Independent Accountants, Coopers & Lybrand. 23(i)b. Consent of Counsel, Chadbourne & Parke. 24. Powers of Attorney relating to execution of this Annual Report on Form 10-K. * Indicates that exhibit is a management contract or compensatory plan or arrangement. In lieu of filing certain instruments with respect to long-term debt of the kind described in Item 601(b)(4) of Regulation S-K, Registrant agrees to furnish a copy of such instruments to the Securities and Exchange Commission upon request. (b) Reports on Form 8-K. Registrant filed a Current Report on Form 8-K, dated October 20, 1993, in respect of Registrant's press release dated October 20, 1993 announcing Registrant's financial results for the three-month and nine-month periods ended September 30, 1993 (Items 5 and 7(c)). Registrant filed a Current Report on Form 8-K, dated October 21, 1993, in respect of Registrant's press release dated October 21, 1993 announcing the acquisition by The Whyte & Mackay Group PLC, a United Kingdom subsidiary of Registrant's Gallaher Limited subsidiary, of an additional share interest in Invergordon Distillers Group PLC and a mandatory cash offer for the remaining shares of Invergordon (Items 5 and 7(c)). Registrant filed a Current Report on Form 8-K, dated November 23, 1993, in respect of a settlement reached by Registrant and the remaining defendants in the Forstmann Leff Associates, Inc. et al. v. American Brands, Inc., et al. described in paragraph (c) Item 3 herein (Item 5). Registrant filed a Current Report on Form 8-K, dated January 26, 1994, in respect of Registrant's press release dated January 24, 1994 announcing Registrant's financial results for the three-month and twelve-month periods ended December 31, 1993 (Items 5 and 7(c)). Registrant filed a Current Report on Form 8-K, dated February 22, 1994, in respect of (i) Management's Discussion and Analysis of Results of Operations (1993 compared to 1992 and 1992 compared to 1991) and Financial Review, (ii) Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991, (iii) Consolidated Balance Sheet as of December 31, 1993 and 1992, (iv) Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991, (v) Consolidated Statement of Common Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991, (vi) Notes to Consolidated Financial Statements, (vii) Report of Independent Accountants, (viii) Report of Management, (ix) Information on Business Segments and (x) Eleven-Year Consolidated Selected Financial Data of Registrant and consolidated subsidiaries (Items 5 and 7 (c)). This annual report shall not be construed as a waiver of the right to contest the validity or scope of any or all of the provisions of the Securities Exchange Act of 1934, as amended, under the Constitution of the United States, or the validity of any rule or regulation made or to be made under such Act. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN BRANDS, INC. (Registrant) By William J. Alley William J. Alley Chairman of the Board and Date: March 28, 1994 Chief Executive Officer 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 Registrant and in the capacities and on the dates indicated. William J. Alley William J. Alley, Chairman of the Board and Chief Executive Officer (principal executive officer) and Director Date: March 28, 1994 T.C. Hays T.C. Hays, President and Chief Operating Officer and Director Date: March 28, 1994 A. Henson A. Henson, Executive Vice President and Chief Financial Officer (principal financial officer) and Director Date: March 28, 1994 R.L. Plancher* R.L. Plancher, Senior Vice President and Chief Accounting Officer (principal accounting officer) Date: March 28, 1994 Howard C. Humphrey* Howard C. Humphrey, Vice President - Life Insurance and Director Date: March 28, 1994 Eugene R. Anderson* Eugene R. Anderson, Director Date: March 28, 1994 Patricia O. Ewers* Patricia O. Ewers, Director Date: March 28, 1994 John W. Johnstone, Jr.* John W. Johnstone, Jr., Director Date: March 28, 1994 Wendell J. Kelley* Wendell J. Kelley, Director Date: March 28, 1994 Sidney Kirschner* Sidney Kirschner, Director Date: March 28, 1994 Gordon R. Lohman* Gordon R. Lohman, Director Date: March 28, 1994 Charles H. Pistor, Jr.* Charles H. Pistor, Jr., Director Date: March 28, 1994 Peter M. Wilson* Peter M. Wilson, Director Date: March 28, 1994 *By A. Robert Colby A. Robert Colby, Attorney-in-Fact INDEX TO FINANCIAL STATEMENT SCHEDULES Pages ----- AMERICAN BRANDS, INC. AND SUBSIDIARIES Report of Independent Accountants ............................. Schedules --------- III Condensed Financial Information of Registrant As of December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991 .......................................... VIII Valuation and qualifying accounts For the years ended December 31, 1993, 1992 and 1991 ............................... IX Short-term borrowings For the years ended December 31, 1993, 1992 and 1991 ............................... X Supplementary income statement information For the years ended December 31, 1993, 1992 and 1991 ............................... Schedules other than those listed above are omitted as the information is either not applicable, not required or has been furnished in the financial statements or notes thereto incorporated by reference in Item 8 hereof. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of American Brands, Inc.: Our report on the consolidated financial statements of American Brands, Inc. and Subsidiaries has been incorporated by reference in this Form 10-K from the 1993 Annual Report to Stockholders of American Brands, Inc. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 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 1301 Avenue of the Americas New York, New York February 1, 1994 AMERICAN BRANDS, INC. (PARENT COMPANY) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEET (In millions) December 31, ------------------- 1993 1992 ---- ---- Assets Current assets Receivables from affiliated companies $ 565.8 $ 568.0 Other current assets 51.4 59.6 -------- -------- Total current assets 617.2 627.6 -------- -------- Investment in subsidiaries 3,566.5 3,704.6 Long-term receivables from affiliated companies 3,724.8 3,291.3 Other assets 141.2 174.9 -------- -------- Total assets $8,049.7 $7,798.4 ======== ======== Liabilities and stockholders' equity Current liabilities Commercial paper $ 711.3 $ 433.4 Payables to affiliated companies 113.2 145.8 Other current liabilities 265.9 338.6 Current portion of long-term debt 156.5 133.6 -------- -------- Total current liabilities 1,246.9 1,051.4 Long-term debt 2,438.4 2,360.5 Postretirement and other liabilities 93.0 84.9 -------- -------- Total liabilities 3,778.3 3,496.8 -------- -------- Convertible preferred stock - redeemable at Company's option 17.1 19.1 -------- -------- Common stockholders' equity 4,254.3 4,282.5 -------- -------- Total liabilities and stockholders' equity $8,049.7 $7,798.4 ======== ======== The "Notes to Consolidated Financial Statements of American Brands, Inc. and Subsidiaries" contained in the 1993 Annual Report to Stockholders of Registrant are an integral part of these statements. See accompanying "Notes to Condensed Financial Information of Registrant." AMERICAN BRANDS, INC. (PARENT COMPANY) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF INCOME (In millions) For the Years Ended December 31, -------------------------- 1993 1992 1991 ---- ---- ---- Interest from affiliates $332.6 $357.8 $341.9 Expenses: Corporate administrative expenses 78.1 80.7 134.5 Interest: affiliates 12.9 8.2 17.6 non-affiliates 220.3 238.3 240.0 Other expenses, net 12.9 12.1 12.5 ------ ------ ------ Total expenses 324.2 339.3 404.6 ------ ------ ------ Income (loss) before income tax benefit, equity in net income of subsidiaries and cumulative effect of accounting changes 8.4 18.5 (62.7) Income tax benefit 1.4 9.4 50.6 ------ ------ ------ Income (loss) before equity in net income of subsidiaries and cumulative effect of accounting changes 9.8 27.9 (12.1) Equity in net income of subsidiaries 469.7 855.9 818.2 ------ ------ ------ Income before cumulative effect of accounting changes 479.5 883.8 806.1 Cumulative effect of accounting changes (net of income taxes of $7.4) (9.7) - - ------ ------ ------ Net income $469.8 $883.8 $806.1 ====== ====== ====== The "Notes to Consolidated Financial Statements of American Brands, Inc. and Subsidiaries" contained in the 1993 Annual Report to Stockholders of Registrant are an integral part of these statements. See accompanying "Notes to Condensed Financial Information of Registrant." AMERICAN BRANDS, INC. (PARENT COMPANY) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (In millions) For the Years Ended December 31, ------------------------- 1993 1992 1991 ---- ---- ---- Net cash provided from operating activities $663.5 $ 680.2 $ 712.4 ------ -------- -------- Investing activities Additional investment in subsidiary - (1.8) - Other, net 4.4 (4.0) (4.5) ------ -------- -------- Net cash provided (used) by investing activities 4.4 (5.8) (4.5) ------ -------- -------- Financing activities Increase (decrease) in short-term debt 278.0 261.6 (484.1) Issuance of long-term debt 473.0 351.4 1,155.4 Repayment of long-term debt (364.7) (672.6) (512.3) Dividends to stockholders (399.1) (377.8) (337.6) Cash purchases of Common stock for treasury (57.9) (100.4) (106.7) Change in intercompany balances, net (592.3) (14.2) (427.8) Redemption and purchases of $2.75 Preferred stock - (134.4) (1.8) Other financing activities, net (4.9) 12.0 6.3 ------ -------- -------- Net cash used by financing activities (667.9) (674.4) (708.6) ------ -------- -------- Net decrease in cash and cash equivalents $ - $ - $ (0.7) ====== ======== ======== Cash and cash equivalents at Beginning of year $ - $ - $ 0.7 End of year $ - $ - $ - ====== ======== ======== Cash paid during the year for Interest $220.2 $ 233.6 $ 218.4 ====== ======== ======== Income taxes $238.5 $ 280.8 $ 223.0 ====== ======== ======== The "Notes to Consolidated Financial Statements of American Brands, Inc. and Subsidiaries" contained in the 1993 Annual Report to Stockholders of Registrant are an integral part of these statements. See accompanying "Notes to Condensed Financial Information of Registrant." NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT ------------------------------------------------------ 1.Basis of Presentation Pursuant to the rules and regulations of the Securities and Exchange Commission, the Condensed Financial Statements of the Registrant do not include all of the information and notes normally included with financial statements prepared in accordance with generally accepted accounting principles. Therefore, these Condensed Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Annual Report to Stockholders of Registrant as referenced in Form 10-K, Part II, Item 8. Certain 1992 balance sheet amounts have been reclassified to conform to the 1993 presentation. 2.Accounting Changes On January 1, 1993, Registrant adopted FAS Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension" and FAS No. 112, "Employers' Accounting for Postemployment Benefits." The initial effects of adopting these statements were recorded as cumulative changes in accounting principles. 3.Investment in Subsidiaries During 1993, $134.8 million of intercompany debt was contributed to the capital of a subsidiary by Registrant. 4.Cash Dividends from Subsidiaries Dividends of $679.8 million in 1993, $648.1 million in 1992 and $681.5 million in 1991 were paid to Registrant by its subsidiaries. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Concluded) 5.Debt The components of long-term debt are as follows (In millions): 1993 1992 ---- ---- Notes payable $ 300.0 $ 200.0 Revolving credit notes 195.8 203.2 Other notes 356.5 376.5 5 3/4% Eurodollar Convertible Debentures, Due 2005 200.0 200.0 7 5/8% Eurodollar Convertible Debentures, Due 2001 150.0 150.0 Other Eurodollar Convertible Debentures 41.0 43.4 8 1/2% Notes, Due 2003 200.0 200.0 5 1/4% Notes, Due 1995 200.0 200.0 8 5/8% Debentures, Due 2021 150.0 150.0 9 1/8% Debentures, Due 2016 150.0 150.0 7 7/8% Debentures, Due 2023 150.0 - 7 1/2% Notes, Due 1999 150.0 150.0 9 3/4% Eurosterling Notes, Due 1993 - 113.6 9% Notes, Due 1999 100.0 100.0 9 1/2% Eurosterling Notes, Due 1994 74.0 75.7 9 1/4% Eurosterling Notes, Due 1998 74.0 75.7 12% Eurosterling Notes, Due 1995 59.2 60.6 12 1/2% Sterling Loan Stock, Due 2009 44.4 45.4 -------- -------- 2,594.9 2,494.1 Less current portion 156.5 133.6 -------- -------- $2,438.4 $2,360.5 ======== ======== Estimated payments for maturing long-term debt requirements during the next five years, assuming one-time put options are not exercised, are as follows: 1994, $156.5 million; 1995, $777.7 million; 1996, $101 million; 1997, $53.8 million; and 1998, $168.5 million. At December 31, 1993, the Registrant guaranteed short-term committed credit facilities of a UK-based subsidiary which provided for unsecured borrowings of up to $444 million, of which $44 million was outstanding. AMERICAN BRANDS, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1993, 1992 and 1991 (In millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E ------ ------ ------ ------ ------ Additions --------- Charged Balance Balance at to Costs at End Beginning and of Description of Period Expenses Deductions Period - --------------------------------------------------------------------------- 1993: Allowance for cash discounts $ 7.9 $ 87.3 $ 88.9(1) $ 6.3 Allowance for returns 17.3 150.6 146.0(1) 21.9 Allowance for doubtful accounts 34.8 11.7 11.7(3) 34.3 0.5(2) ----- ------ ------ ----- $60.0 $249.6 $247.1 $62.5 ===== ====== ====== ===== 1992: Allowance for cash discounts $ 7.5 $ 88.6 $ 88.2(1) $ 7.9 Allowance for returns 9.3 114.3 106.0(1) 17.3 0.3(2) Allowance for doubtful accounts 39.3 11.9 13.1(3) 34.8 3.3(2) ----- ------ ------ ----- $56.1 $214.8 $210.9 $60.0 ===== ====== ====== ===== 1991: Allowance for cash discounts $ 6.5 $ 84.8 $ 83.8(1) $ 7.5 Allowance for returns 10.8 114.4 115.7(1) 9.3 0.2(2) Allowance for doubtful accounts 37.8 8.8 6.6(3) 39.3 0.7(2) ----- ------ ------ ----- $55.1 $208.0 $207.0 $56.1 ===== ====== ====== ===== - ----------------------------- (1) Cash discounts and returns allowed customers. (2) Effect of changes in foreign exchange rates. (3) Doubtful accounts written off, net of recoveries. AMERICAN BRANDS, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS For the Years Ended December 31, 1993, 1992 and 1991 (In millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E Col. F ------ ------ ------ ------ ------ ------ Weighted Weighted Average Maximum Average Average Category of Balance Interest Amount Amount Interest Aggregate at Rate at Outstanding Outstanding Rate Short-term End of End of During the During the During the Borrowings (1) Period Period Period Period (2) Period (3) - --------------------------------------------------------------------------- 1993: Notes payable to banks $298.9 5.8% $424.9 $270.7 6.7% Commercial paper 711.3 3.4 711.3 427.1 3.4 1992: Notes payable to banks $247.1 8.1% $302.0 $194.6 10.0% Commercial paper 433.4 3.6 673.4 391.0 4.1 1991: Notes payable to banks $131.0 10.2% $217.6 $128.6 12.1% Commercial paper 271.8 5.3 770.5 449.7 6.9 - ------------------------------ (1) Notes payable to banks represents borrowings in various currencies primarily under credit agreements with banks. Commercial paper represents paper sold by American Brands, Inc. (2) Calculated on month-end outstanding balances during the year. (3) Average amount outstanding during the year divided into actual interest expense incurred. AMERICAN BRANDS, INC. AND SUBSIDIARIES SCHEDULE X-SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992 and 1991 (In millions) - --------------------------------------------------------------------------- Col. A Col. B ------ ------ Charged to Costs and Item (1) Expenses - --------------------------------------------------------------------------- 1993: 5. Advertising costs $510.2 1992: 5. Advertising costs $551.0 1991: 5. Advertising costs $519.1 - ------------------------------ (1) The items not listed either do not exceed one percent of revenues or are set forth in the financial statements or notes thereto incorporated by reference in Item 8 hereof. EXHIBIT INDEX 10c1. Amended Supplemental Retirement Plan of American Brands, Inc.* 10c3. Amendment made as of the 1st day of November, 1993 to Trust Agreement constituting Exhibit 10c2 hereto.* 10c4. Schedule identifying substantially identical agreements to the Trust Agreement and Amendment thereto constituting Exhibits 10c2 and 10c3 hereto, respectively, in favor of Thomas C. Hays, Arnold Henson, Robert L. Plancher, Gilbert L. Klemann, II, John T. Ludes, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10c5. Trust Agreement, made as of the 1st day of November, 1993, among William J. Alley, Registrant and Chase establishing a grantor trust in favor of William J. Alley for purposes of paying amounts under the Amended Supplemental Retirement Plan constituting Exhibit 10c1 hereto.* 10c6. Schedule identifying substantially identical agreements to the Trust Agreement constituting Exhibit 10c5 hereto in favor of Thomas C. Hays, Arnold Henson, Robert L. Plancher, Gilbert L. Klemann, II, John T. Ludes, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10f1. The Franklin Life Insurance Company Supplemental Retirement Plan effective January 1, 1988 as amended and restated effective January 1, 1993.* 10f3. Trust Agreement, made as of the 16th day of December, 1993, among Howard C. Humphrey, The Franklin Life Insurance Company and Bank One, Springfield (State Association) establishing a grantor trust in favor of Howard C. Humphrey for purposes of paying amounts under the Supplemental Retirement Plan constituting Exhibit 10f1 hereto.* 10g4. Trust Deed dated January 24, 1994 further amending Exhibit 10g2 hereto.* 10k2. Jim Beam Brands Co. Amended Excess Benefit Plan.* 10k4. Amendment made as of the 17th day of November, 1993 to Trust Agreement constituting Exhibit 10k3 hereto.* 10k5. Trust Agreement, made as of the 15th day of December, 1993, among Barry M. Berish, Beam and Chase establishing a grantor trust in favor of Barry M. Berish for purposes of paying amounts under the Amended Excess Benefit Plan constituting Exhibit 10k2 hereto.* 10o1. Service Agreement dated February 11, 1994 between Gallaher and Peter M. Wilson.* 10o2. Letter dated September 20, 1991 from Gallaher in respect of retirement benefits provided to Peter M. Wilson.* 10o3. Letter dated March 15, 1994 amending Exhibit 10o2 hereto.* 10s2. Schedule identifying substantially identical agreements to the Agreement constituting Exhibit 10s1 hereto entered into by Registrant with William J. Alley, Thomas C. Hays, Arnold Henson, Howard C. Humphrey, Robert L. Plancher, John T. Ludes, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10t2. Amendment made as of the 1st day of November, 1993 to Trust Agreement constituting Exhibit 10t1 hereto.* 10t3. Schedule identifying substantially identical agreements to the Trust Agreement and Amendment thereto constituting Exhibits 10t1 and 10t2 hereto, respectively, in favor of Thomas C. Hays, Arnold Henson, Robert L. Plancher, Gilbert L. Klemann, II, John T. Ludes, Howard C. Humphrey, Robert J. Rukeyser, Randall W. Larrimore and Steven C. Mendenhall.* 10v2. Schedule identifying substantially identical agreements to the Agreement constituting Exhibit 10v1 hereto entered into by Registrant with Arnold Henson, Robert L. Plancher, John T. Ludes, Robert J. Rukeyser and Steven C. Mendenhall.* 11. Statement setting forth net income for computation of earnings per Common share, primary and fully diluted, and statement setting forth computation of weighted average number of Common shares outstanding on a fully diluted basis. 12. Statement re computation of ratio of earnings to fixed charges. 13. 1993 Annual Report to Stockholders of Registrant. 22. Subsidiaries of Registrant. 23(i)a. Consent of Independent Accountants, Coopers & Lybrand. 23(i)b. Consent of Counsel, Chadbourne & Parke. 24. Powers of Attorney relating to execution of this Annual Report on Form 10-K. * Indicates that exhibit is a management contract or compensatory plan or arrangement.

351155_1993.txt

351155_1993

1993

351155

ITEM 1 - BUSINESS West One Bancorp, (the Registrant) is an Idaho corporation formed in 1981 as a bank holding company subject to regulation under the Bank Holding Company Act of 1956, as amended, and is registered with the Board of Governors of the Federal Reserve System (Federal Reserve Board). The Registrant's principal subsidiary is West One Bank, Idaho in Boise, Idaho. Other subsidiaries include West One Bank, Washington in Seattle, Washington; West One Bank, Utah in Salt Lake City, Utah; West One Bank, Oregon in Portland, Oregon; West One Bank, Oregon, S.B. in Hillsboro, Oregon; Idaho First Bank in Boise, Idaho; West One Financial Services, Inc. in Boise, Idaho; West One Trust Company in Salt Lake City, Utah; West One Trust Company, Washington in Bellevue, Washington; and West One Life Insurance Company in Boise, Idaho. The Registrant, through its subsidiaries, provides a wide variety of financial services to corporate and institutional customers, governments, individuals, and other financial institutions. Such services include domestic commercial banking, investment and funds management, personal banking, trust operations, corporate services, mortgage banking and credit life insurance. As of December 31, 1993, the Registrant and its subsidiaries employed approximately 4,477 full-time equivalent employees. WEST ONE BANK, IDAHO West One Bank, Idaho (West One, Idaho) was founded in 1867 in Boise, Idaho, and was the second national bank to be established west of the Rocky Mountains. When branch banking was authorized in 1933, West One, Idaho acquired three affiliated banks, thus beginning the development of its present statewide banking organization in Idaho. West One, Idaho is an Idaho-chartered bank supervised and regulated at the state level by the Director of the Idaho Department of Finance and at the federal level by the Federal Reserve Board. West One, Idaho is insured by the Bank Insurance Fund (BIF) and is therefore also subject to regulations issued by the FDIC. (See "Supervision and Regulation - Other Regulations.") On January 21, 1994, West One, Idaho acquired Idaho State Bank with assets of $48 million in exchange for 133,332 shares of the Registrant's common stock. The transaction is a pooling of interests in 1994. Idaho State Bank's financial position and results of operations are not material to West One's financial position and results of operations. Idaho is the primary market area of West One, Idaho. West One, Idaho offers a full range of commercial and personal banking and trust services. Its corporate banking department provides a broad range of customized credit products and services to middle market and large corporate borrowers. The principal industries in Idaho include agriculture, forest products, services, tourism, mining and manufacturing. The banking business in Idaho is highly competitive. West One, Idaho competes for deposits, loans, and trust accounts with other banks and financial institutions. At December 31, 1993, West One had $3.9 billion in assets and 79 branches. Based on assets of $3.8 billion at September 30, 1993, West One, Idaho is the largest bank in Idaho. In 1993, approximately 20 banks with approximately 306 branches were actively engaged in banking in Idaho. WEST ONE BANK, WASHINGTON West One Bank, Washington, (West One, Washington), a full-service commercial bank, has 53 branches principally in the Puget Sound region, Yakima, Spokane and the Tri-Cities, with assets of $1.9 billion at December 31, 1993. West One, Washington is regulated by the State of Washington, and deposits are insured by the FDIC. On December 31, 1993, West One, Washington and West One Bank, Eastern Washington (formerly Yakima Valley Bank and Ben Franklin National Bank) merged under the name West One, Washington. West One, Washington now includes the operations of the former Community Bank of Renton, First Security Bank of Tacoma, Bank of Tacoma, First Western Bank, West One Bank, Spokane, Yakima Valley Bank and Ben Franklin National Bank. At September 30, 1993, West One, Washington and West One Bank, Eastern Washington had combined assets of $1.9 billion making it the sixth largest bank in Washington. In 1993, approximately 103 banks with approximately 1,052 branches were actively engaged in banking in Washington. In May 1993, Ben Franklin National Bank with assets of $37 million was acquired in exchange for 206,254 shares of the Registrant's common stock. The transaction was accounted for as a pooling of interests. Ben Franklin National Bank's financial position and results of operations were not material to the Registrant's financial position and results of operations, and prior year financial statements have not been restated. WEST ONE BANCORP, WASHINGTON West One Bancorp, Washington, a bank holding company purchased in 1988, was merged into the Registrant on April 30, 1993. WEST ONE BANK, UTAH West One Bank, Utah, (West One, Utah), chartered in 1909 and acquired in November 1985, is a state-chartered, full-service commercial bank based in Salt Lake City, Utah. As of December 31, 1993, West One, Utah had 23 branches and $703 million in total assets. West One, Utah is regulated by the Federal Reserve Board, and deposits are insured by the FDIC. At September 30, 1993, West One, Utah had $689 million in total assets making it the sixth largest bank in Utah. In 1993, approximately 50 banks with approximately 424 offices were actively engaged in banking in Utah. WEST ONE BANK, OREGON West One Bank, Oregon, (West One, Oregon), acquired in 1983, operates as a state-chartered, full-service commercial bank with operations concentrated in the western Oregon market area. As of December 31, 1993, West One, Oregon had 21 branches and $602 million in total assets. West One, Oregon is regulated by the State of Oregon, and deposits are insured by the FDIC. WEST ONE BANK, OREGON, S.B. West One Bank, Oregon, S.B., acquired in 1991, is a state-chartered, full-service savings bank based in Hillsboro, Oregon. As of December 31, 1993, West One Bank, Oregon, S.B. had 14 branches and $428 million in total assets. West One Bank, Oregon, S.B. is regulated by the State of Oregon, and deposits are insured by the FDIC. West One, Oregon and West One Bank, Oregon, S.B. combined had total assets of $1.0 billion as of September 30, 1993, making it the fifth largest bank in Oregon. IDAHO FIRST BANK Idaho First Bank was formed by the Registrant in 1989. Idaho First Bank is an Idaho-chartered bank supervised and regulated at the state level by the Director of the Idaho Department of Finance and at the federal level by the Federal Reserve Board. Idaho First Bank, which is insured by the BIF, offers electronic banking services to the Registrant's cardholders through the affiliates' automated teller machine (ATM) network (AWARD); Cirrus/Mastercard, STAR System, and Exchange NW (Oregon and Washington) ATM; and ACCEL and Explore on-line debit point-of-sale networks; VISA and Mastercard credit cards; merchant bankcard and VISA Check Card Services. As of December 31, 1993, Idaho First Bank had $216 million in total assets. As of December 31, 1993, the ATM network totaled 189 branch and retail ATMs, including 74 in Idaho, 58 in Washington, 29 in Oregon, and 5 in Nevada. WEST ONE FINANCIAL SERVICES, INC. West One Financial Services, Inc. services residential and commercial mortgage portfolios for long-term investors. Total loans serviced, including loans serviced for the Registrant's affiliates, were $2.2 billion as of December 31, 1993. WEST ONE TRUST COMPANY West One Trust Company, acquired by the Registrant in 1982, operates offices in Salt Lake City, Utah and Portland, Oregon. West One Trust Company provides fiduciary, investment management and related services for corporate, institutional and individual clients. WEST ONE TRUST COMPANY, WASHINGTON West One Trust Company, Washington, formed by the Registrant in 1991, is a state-chartered trust company based in Bellevue, Washington. West One Trust Company, Washington provides fiduciary, investment management and related services for corporate, institutional and individual clients. WEST ONE LIFE INSURANCE COMPANY West One Life Insurance Company underwrites credit life and credit disability policies for borrowers of West One Bancorp affiliates. WEST ONE BANCORP, THE PARENT COMPANY The Parent Company provides a variety of services to affiliates. Through its Data Processing Center in Boise, the Registrant processes demand deposit accounts, savings accounts, installment credit loans, commercial loans and real estate loans for a majority of its subsidiaries. Most branches have on-line teller terminals which provide direct access to the centralized computer system and permit faster processing of customer transactions. SUPERVISION AND REGULATION The Registrant's banking subsidiaries are affected by the policies of regulatory authorities, including the monetary policy of the Federal Reserve Board. In order to mitigate recessionary and inflationary pressures, the Federal Reserve Board uses a variety of money supply management techniques, including engaging in open market operations in United States Government securities, changing the discount rate on member bank borrowings, and changing reserve requirements against member bank deposits. The impact of current economic conditions on the policies of the Federal Reserve Board and other regulatory authorities and their effect on the future business and earnins of the Registrant cannnot be predicted with assurance. The Registrant is subject to regulation under the Bank Holding Company Act of 1956, as amended. Under that Act, the Registrant is required to obtain the approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank or ownership or control of any voting securities of any bank not already majority owned if, after giving effect to the acquisition, the Registrant would own or control more than five percent of the voting shares of such bank. The Bank Holding Company Act of 1956 generally does not permit the Federal Reserve Board to approve an acquisition by a bank holding company of voting shares or assets of a bank located outside the state in which the operations of its banking subsidiaries are principally conducted unless the acquisition is specifically authorized by the statutes of the states in which the banks are located. Each of the states in the Registrant's marketing area have adopted legislation that permits bank acquisition by out-of-state bank holding companies, with certain restrictions. The Bank Holding Company Act of 1956 also prohibits, with certain exceptions, the Registrant from engaging in or acquiring direct or indirect control of more than five percent of the voting shares of any company engaged in nonbanking activities. One of the principal exceptions to this prohibition applies to activities found by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. Some of the activities which the Federal Reserve Board has determined by regulation to be closely related to banking are: mortgage banking, certain data processing operations, personal property leasing on a full payout basis and operation of a consumer finance business. The Registrant is not subject to territorial restrictions on the operations of nonbank subsidiaries. The Registrant and its subsidiaries are prohibited from engaging in certain "tie-in" arrangements in connection with extensions of credit or provision of any property or service. Also, the Registrant's banking subsidiaries are subject to restrictions on loans to the Registrant or its subsidiaries, investments in stock or other securities of the Registrant or its subsidiaries, or advances to any borrower collateralized by such stock or other securities. In December 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which substantially revises the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. In addition to establishing minimum capital requirements, FDICIA directs that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital and such other standards as the agency deems appropriate. FDICIA also contains a variety of other provisions that may affect the operations of the Registrant including new reporting requirements, revised regulatory standards for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days' notice to customers and regulatory authorities before closing any branch. III. LOAN PORTFOLIO Loans outstanding at December 31, 1993, (other than consumer and mortgage loans, and leases which are ordinarily on a term basis with installment repayment requirements) segregated by maturity ranges follow: A loan or lease is placed on nonaccrual status when timely collection of interest becomes doubtful. Interest payments received on nonaccrual loans and leases are applied to principal if collection of principal is doubtful or reflected as interest income on a cash basis. Loans and leases are removed from nonaccrual status when they are current and collectibility of principal and interest is no longer doubtful. Income foregone on nonaccrual and restructured loans, net of tax, was $1,086,000, $1,650,000 and $3,662,000 for the years ended December 31, 1993, 1992 and 1991, respectively. United States dollar denominated, interest bearing short-term investments located in foreign banks including United States branches of foreign banks, exceeding .75% of total assets follows: IV. SUMMARY OF LOAN LOSS EXPERIENCE V. DEPOSITS Time certificates of deposits $100,000 and over as of December 31, 1993, segregated by maturity ranges follow: ITEM 2 ITEM 2 - PROPERTIES The Registrant's main office, owned by West One, Idaho, is located in a 19-story building in downtown Boise, Idaho. The building, completed in 1978, contains approximately 285,000 square feet of which approximately 172,000 square feet are utilized by the Registrant and the remainder is leased or available for lease to others. In addition, the Registrant owns 73 of 77 branch buildings in Idaho, 16 of 22 branch buildings in Utah, 16 of 33 branch buildings in Oregon, 35 of 51 branch buildings in Washington, and 8 of 28 support service buildings. Remaining facilities are leased from others for terms expiring between 1994 and 2017. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS Various legal proceedings arising in the normal course of business are pending against subsidiaries of the Registrant. In the opinion of management, the resulting liability, if any, from these proceedings will not have a material impact on the Registrant's financial position or results of operations. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of the Registrant during the quarter ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The names, positions, ages and background of the executive officers of the Registrant, as of January 1, 1994, are set forth below: Mr. Nelson joined the Registrant in 1984. He was named an Executive Vice President of the Registrant in 1984 and elected President and Chief Operating Officer of the Registrant in 1985. In August, 1986, he was elected Chairman and Chief Executive Officer of West One, Idaho. In January, 1987, Mr. Nelson was elected Chairman of the Board and Chief Executive Officer of the Registrant. Mr. Nelson serves as a Chairman of the Board of West One, Idaho and a Director of the Registrant; West One, Idaho; and West One, Washington; and also as an officer of the Registrant and West One, Idaho. Mr. Jones joined the Registrant in 1987. He was elected President of the Registrant in 1987. Mr. Jones serves as Chairman of the Board of West One, Washington and a Director of the Registrant; West One, Utah; West One, Oregon; and West One, Washington. Mr. Lane joined West One, Idaho in 1983 as Vice President and Senior Credit Officer. In 1985, he was elected President of West One Financial Services. Later that same year, he was elected President and Chief Operating Officer of West One, Idaho and also became a Director of West One, Idaho. In 1987, he was named President and Chief Executive Officer of West One, Idaho. Mr. Lane was elected Executive Vice President of the Registrant in January 1991. Mr. Hayes joined West One, Idaho in 1981 as Vice President of Money Desk operations. In 1985, he was elected Vice President of the Registrant, and in 1986 he was elected a Senior Vice President of the Registrant. In 1987, he was named Executive Vice President and Chief Financial Officer of the Registrant. Mr. Dobson joined the Registrant in 1990 as Executive Vice President of the Capital Management Group. From 1987 through 1990, Mr. Dobson was with U.S. Bancorp as Senior Vice President of Corporate Development and then Executive Vice President of the Investment Services Group. Mr. Board joined West One, Idaho in 1971 as Legal Counsel. In 1981, he was elected Vice President, Secretary and General Counsel of the Registrant. He was elected Senior Vice President of the Registrant in 1990. Mr. Peterson joined the Registrant in 1982. In January, 1987, he was elected Vice President of the Registrant. In 1990, he was elected Vice President and Controller. He was elected Senior Vice President and Controller in January 1993, and serves as principal accounting officer of the Registrant. The executive officers of the Registrant also serve as officers and/or Directors of several other affiliated companies. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Items relating to market price for the Registrant's common equity and related stockholder matters included in the 1993 Annual Report to Shareholders at the pages indicated, are herein incorporated by reference. Page of 1993 Annual Report to Shareholders Shareholders' Equity and Capital Adequacy 15 Quarterly Common Stock Statistics 16 Shareholders' Equity, Note 9 43 Regulatory Requirements and Restrictions, Note 14 50 ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA Selected Financial Data of the Registrant on page 12 of the 1993 Annual Report to Shareholders 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 Financial Condition and Results of Operations set forth on pages 13-26 of the 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and Report of Independent Public Accountants listed in the Index to Financial Statements and Schedules on page 15 of this Annual Report on Form 10-K and included in the 1993 Annual Report to Shareholders are incorporated herein by reference. Quarterly Financial Data on page 27 of the 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes in accountants within the last 24 months, nor were there reportable disagreements with the Registrant's independent public accountants on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information on pages 2-4 in the March 8, 1994 Proxy Statement is incorporated herein by reference. Reference is made to "Executive Officers of the Registrant" in Part I of this Annual Report on Form 10-K for additional information regarding the executive and management officers of the Registrant. There are no family relationships among the directors or the executive and management officers. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION The information on pages 6-10 in the March 8, 1994 Proxy Statement is incorporated herein by reference. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information regarding security ownership of certain beneficial owners and management included in the March 8, 1994 Proxy Statement on pages 4-5 is incorporated herein by reference. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the sixth paragraph on page 5 in the March 8, 1994, 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) Financial Statements: The consolidated financial statements incorporated by reference in this Annual Report on Form 10-K are listed in the Index to Financial Statements and Schedules on page 18 herein. (2) Financial Statement Schedules: See the Index to Financial Statements and Schedules on page 18. (3) The exhibits filed herewith are listed in the Exhibit Index on pages 19 and 20 herein. (b) There were no current reports on Form 8-K filed by the Registrant during the last quarter of the year ended December 31, 1993. (c) Each management contract compensation plan and arrangement required to be filed is an exhibit to this report as listed in item 10, Executive Compensation Plans and Arrangements and Other Management Contracts, in the Exhibit Index on page 19 herein. 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: 3/24/94 WEST ONE BANCORP Registrant By /s/ Scott M. Hayes Scott M. Hayes Executive Vice President and Chief Financial Officer By /s/ Jim A. Peterson Jim A. Peterson Senior Vice President and 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 on the dates indicated. Manually signed Power of Attorney authorizing Dwight V. Board to sign the Annual Report on Form 10-K for the fiscal year ended December 31, 1993, as Attorney-in-fact for certain directors and officers of the Registrant is included herein as Exhibit 24. INDEX TO FINANCIAL STATEMENTS AND SCHEDULES FINANCIAL STATEMENTS The following consolidated financial statements and Report of Independent Public Accountants included in the 1993 Annual Report to Shareholders at the pages indicated, are incorporated herein by reference. Financial Statement Schedules All schedules have been omitted because the information is either not required, not applicable, not present in amounts sufficient to require submission of the schedule, or is included in the financial statements or notes thereto. EXHIBIT INDEX Exhibit Number Description 3-A Amended Articles of Incorporation of the Registrant 3-B Bylaw Amendment and Amended Bylaws of the Registrant Incorporated by reference to Exhibit 3-B to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 4 Shareholder Rights Plan. Incorporated by reference to Exhibit 4-B to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989 as amended by Form 8-A dated October 15, 1992. Registrant agrees to furnish copies of instruments relating to its long-term notes payable, the total amount of which does not exceed 10% of the total Consolidated Assets of the Registrant and its subsidiaries, to the Commission upon request. 10 Executive Compensation Plans and Arrangements and Other Management Contracts: 10-A Executive Compensation Program 10-B The Executive Incentive Program of the Registrant, as amended. Incorporated by reference to Exhibit 10-B to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. 10-C Registrant's Executive Deferred Compensation Plan, as amended. Incorporated by reference to Exhibit 10-C to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. 10-D Form of Employment Agreements between Registrant and certain key employees. Incorporated by reference to Exhibit 10-E to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. 10-E Form of Indemnification Agreement dated June 16, 1988, entered into by the Registrant with each of its Directors. Incorporated by reference to Exhibit 19 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988. 10-F The 1991 Performance and Equity Incentive Plan of the Registrant. Incorporated by reference to Exhibit 10-F to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. 10-G Deferred Compensation Plan for Outside Directors of the Registrant. Incorporated by reference to Exhibit 10-G to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. EXHIBIT INDEX (continued) Exhibit Number Description 11 Statement regarding computation of per share earnings. 13 Portions of the Registrant's 1993 Annual Report to Shareholders. 21 List of subsidiaries of the Registrant. 23 Consent of independent public accountants. 24 Power of Attorney of Certain Officers and Directors of Registrant.

860520_1993.txt

860520_1993

1993

860520

Item 1. Business GENERAL. Central Illinois Public Service Company (CIPS or the Company), an Illinois corporation, was organized in 1902. CIPS is a public utility operating company engaged in the sale of electricity and natural gas in portions of central and southern Illinois. CIPS generates, transmits and distributes electricity and, through interchange agreements with other utility systems, purchases and sells power on a firm basis, in emergency situations or when economical to do so. CIPS sells and distributes natural gas which it purchases from natural gas producers and other suppliers and transports natural gas purchased by end-users directly from suppliers. The principal executive offices of CIPS are located in Springfield, Illinois. CIPS furnishes electric service to about 316,000 retail customers in 557 incorporated and unincorporated communities and adjacent suburban and rural areas. See Business - Electric Operations and - Electric Power Sales/Participation Agreements regarding certain electric power arrangements with other utility systems. CIPS also furnishes natural gas service to about 164,000 retail customers in 267 incorporated and unincorporated communities and adjacent suburban and rural areas and provides gas transportation service to about 340 end-users. CIPS furnishes both electric and natural gas service in 236 of the communities served by it. The territory served by CIPS, located in 66 counties in Illinois, has an estimated population of 820,000 and is devoted principally to agriculture and diversified industrial operations. Key industries include petroleum and petrochemical industries, food processing, metal fabrication and coal mining. HOLDING COMPANY STRUCTURE. Effective October 1, 1990, CIPSCO Incorporated (CIPSCO) became the parent holding company of CIPS. CIPSCO owns 100% of the outstanding common stock of CIPS, representing in excess of 97% of the voting securities of CIPS. The electric and gas utility business of CIPS is expected to provide the major portion of CIPSCO's assets and earnings for the foreseeable future. REVENUES. The total operating revenues of CIPS for the year 1993 were $834,556,000 of which about 83% was derived from the sale of electricity and about 17% from the sale of natural gas. The retail electric revenues were derived approximately as follows (percentage of total electric operating revenue): 32% from residential customers, 26% from commercial customers, 16% from industrial customers and 2% from public authorities and other. The wholesale electric revenues were derived approximately as follows (percentage of total electric operating revenue): 10% from interchange sales (firm), 11% from interchange sales (economy/emergency) and 3% from cooperatives and municipal customers. Sales of power to the petroleum and related petrochemical industries and to the coal mining industry contributed about 6% of total electric revenues. Sales to these three industries accounted for approximately 37% of the 1993 electric revenue derived from the industrial customer group. Revenues from the coal mining industry may decline in the future as a result of declining consumption of Illinois coal, as many industrial coal customers shift to lower sulfur coal or other fuels as a means of complying with the Clean Air Act Amendments of 1990. The natural gas revenues for the year 1993 were derived approximately as follows: 63% from residential customers, 22% from commercial customers, 8% from industrial customers and 7% from transportation service customers and miscellaneous. The sources of the operating revenues of CIPS for the years indicated were as follows: Electric 1993 1992 1991 -------- ________ ________ ________ (in thousands) Residential . . . . . . . . . . . . . . . . $219,510 $197,120 $205,734 Commercial. . . . . . . . . . . . . . . . . 176,154 169,460 159,110 Industrial. . . . . . . . . . . . . . . . . 112,382 109,648 113,414 Public authorities and other. . . . . . . . 15,144 12,970 13,332 ________ ________ ________ Total retail revenues . . . . . . . . . 523,190 489,198 491,590 ________ ________ ________ Interchange sales (firm). . . . . . . . . . 68,040 58,913 56,235 Interchange sales (economy/emergency) . . . 76,272 27,949 26,624 Cooperatives and municipals . . . . . . . . 21,347 19,582 18,220 ________ ________ ________ Total wholesale revenues . . . . . . . . 165,659 106,444 101,079 ________ ________ ________ Total electric revenues. . . . . . . . . $688,849 $595,642 $592,669 ======== ======== ======== Natural Gas 1993 1992 1991 ----------- ________ ________ ________ (in thousands) Residential . . . . . . . . . . . . . . . . $ 92,213 $ 86,968 $ 78,070 Commercial. . . . . . . . . . . . . . . . . 32,023 31,036 26,751 Industrial. . . . . . . . . . . . . . . . . 12,139 6,445 3,200 Transportation service. . . . . . . . . . . 8,915 9,269 9,203 Miscellaneous . . . . . . . . . . . . . . . 417 42 312 -------- -------- -------- Total gas revenues. . . . . . . . . . . . $145,707 $133,760 $117,536 ======== ======== ======== The portions of operating income of CIPS, before income taxes, attributable to electric operations were approximately $154,779,000 (95%) in 1993, $123,228,000 (92%) in 1992 and $137,303,000 (95%) in 1991. The portions of operating income, before income taxes, attributable to gas operations were approximately $7,621,000 (5%) in 1993, $10,916,000 (8%) in 1992 and $7,161,000 (5%) in 1991. Identifiable assets relating to electric and gas operations were as follows: 1993 1992 1991 __________ __________ __________ (in thousands) Electric operations . . . . . . . . . . $1,459,073 $1,443,578 $1,419,036 Gas operations. . . . . . . . . . . . . 177,857 188,321 157,757 Other . . . . . . . . . . . . . . . . . 31,532 13,160 115,050 ---------- ---------- ---------- Total assets. . . . . . . . . . . . . $1,668,462 $1,645,059 $1,691,843 ========== ========== ========== COMPETITION -- ELECTRIC BUSINESS. Competition among suppliers of electric energy is increasing. In particular, competition for interchange sales, which is based primarily on price and availability of energy, has become much more intense in recent years with the addition of electric generating capacity by other utilities in the Midwest. However, such additional capacity has made lower cost power available for purchase by CIPS which, in certain instances, is at a cost lower than the variable cost of generating power from the generating stations owned by CIPS. CIPS is responding to overall increased competition in a number of ways designed to lower its costs and increase sales. Since instituting an economic development incentive rate in 1985, the CIPS economic development program has been expanded to include new customer and community development initiatives. An ongoing program in which senior management plays a critical role in communicating CIPS' competitive advantages to our largest industrial customers is continuing. Additional services to our customers have included energy technology assistance and market development programs. CIPS works in partnership with communities throughout the service area to implement projects to respond to growth opportunities. This, in combination with the ongoing business development initiatives including industrial site location assistance, community profiles and technical development services, is designed to maximize economic development throughout the CIPS territory. In addition to a general program of controlling costs, in 1987 CIPS initiated a major program of renegotiating long-term coal supply contracts. Savings from these renegotiation efforts continued during 1993. Further renegotiation is expected in 1994. The effect of this program has been and will be to help CIPS control its fuel costs. Passage of the National Energy Policy Act of 1992 ("NEPA") will require electric utilities, such as CIPS, to compete with nonutility power producers who can generate power. Under NEPA these producers may gain access to utility transmission lines. (See Management's Discussion and Analysis of Financial Condition and Results of Operations.) This enhances competition over time and will give customers and CIPS opportunities to take advantage of competitive markets. Furthermore, large retail customers may decide to install cogeneration or other facilities and supply their own electricity. Over the next several years, excluding the 1994 summer season, CIPS expects to have uncommitted generating capacity available to market principally because certain existing capacity sales agreements with other utility systems are scheduled to expire on various dates during that period. Such capacity sales during 1993 represented 532 megawatts, or 20% of CIPS' capacity. To compete successfully in the capacity sales market, as well as the interchange sales market, it will be important for CIPS to be a low-cost supplier. (See Business - Electric Power Sales/Participation Agreements.) COMPETITION -- GAS BUSINESS. Competition in the natural gas industry is increasing. For a number of years, CIPS customers have had the ability to purchase natural gas from producers or other suppliers and transport that gas through the interstate pipelines and the CIPS system. CIPS collects a rate for such transportation. New policies of the Federal Energy Regulatory Commission ("FERC") such as Order 636 (see "Gas Operations" below) have increased the competitive nature of the gas business. Customers have the ability to receive supply from pipelines that do not serve the CIPS system. In this case, CIPS would no longer necessarily serve the customer with either gas supply or transportation service. CIPS has negotiated or is currently negotiating with a number of its larger industrial gas customers regarding flexible rates to address the more competitive environment in which CIPS is operating. UTILITY INDUSTRY. CIPS is experiencing some of the problems common to electric and gas utility companies, namely, increased competition for customers, increased construction costs, delays and uncertainties in the regulatory process and costs of compliance with environmental and other laws and regulations. CONSTRUCTION PROGRAM AND FINANCING. Total construction expenditures for CIPS for 1994 through 1998 are estimated at $431 million. For 1994, anticipated construction expenditures are $87 million for replacements and improvements and consist of about $28 million for electric production facilities, $14 million for electric transmission facilities, $35 million for electric distribution and general facilities, and $10 million for gas utility facilities. Total capital costs through the year 2000 (including costs incurred through 1993) related to compliance with the Clean Air Act Amendments of 1990 including Phase I (effective in 1995) and Phase II (effective in 2000) are estimated to be less than $50 million. (See Business - Fuel.) CIPS continuously reviews its construction program, which may be affected by numerous factors, including the rate of load growth, escalation of construction costs, fuel shortages, changes in governmental and environmental regulations, customers' patterns of consumption and conservation of energy, the adequacy of rate relief and the ability of CIPS to raise necessary capital. Load growth projections are subject to a number of uncertainties due to influences on customer consumption, economic conditions and the effect of rates on consumption and peak load demand. CIPS has no electric generating units under construction. On May 11, 1993, the Illinois Commerce Commission (the "Illinois commission") approved CIPS' "least cost" plan which includes the 20-year generating plan of the utility. As demonstrated by the Plan, CIPS will not require additional generating capacity or demand-side resources during the 1993-2013 planning period. Pursuant to the Plan, CIPS will engage in several demand-side management activities intended to enhance its capability to deliver demand- side management resources in the future. For a discussion of the funds requirements for the period 1994-1998 and the assumptions as to the sources of funds to meet those requirements, see Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Requirements and - Financing Requirements. See Management's Discussion and Analysis of Financial Condition and Results of Operations - Financing Requirements for information regarding securities issuances and redemptions during 1993. The issuance by CIPS of first mortgage bonds, common stock, preferred stock and certain unsecured debt securities is subject to the receipt of necessary regulatory approvals. (See Business - Regulation.) The Mortgage Indenture of CIPS, as presently operative, permits the issuance of additional first mortgage bonds up to 60% of available net expenditures for bondable property, provided the "net earnings" of CIPS (determined after deducting income taxes and otherwise as provided in the Mortgage Indenture) for a recent 12-month period equal at least twice the annual interest requirements on all first mortgage bonds outstanding (and on all equally secured and prior lien indebtedness) and on the bonds then to be issued. At December 31, 1993, the more restrictive of these requirements was the "net earnings" test. The "net earnings" of CIPS for the year ended December 31, 1993, so computed, were equal to 5.70 times the interest for one year on the aggregate amount of bonds outstanding under the Mortgage Indenture at December 31, 1993. Based on the "net earnings" of CIPS (so computed) for the year ended December 31, 1993, and the bonds outstanding under the Mortgage Indenture at December 31, 1993, CIPS could have issued about $532 million of additional first mortgage bonds under the foregoing interest coverage provision (assuming an annual interest rate of 7.25% on such bonds). The Articles of Incorporation of CIPS provide, in effect, that so long as any CIPS preferred stock is outstanding, CIPS shall not, without the requisite vote of the holders of preferred stock, unless the retirement of such stock is provided for, (a) issue any preferred or equal ranking stock (except to retire or in exchange for an equal amount thereof) unless the "gross income available for interest" of CIPS for a recent 12-month period is at least one and one- half (1-1/2) times the sum of (i) one year's interest on all funded debt and notes maturing more than 12 months after the date of issuance of such shares and (ii) one year's dividend requirement on all preferred stock to be outstanding after such issue, or (b) issue or assume any unsecured debt securities maturing less than two years from the date of issuance or assumption (except for certain refunding or retirement purposes) if immediately after such issuance or assumption the total amount of all such unsecured debt securities would exceed 20% of the sum of all secured debt securities and the capital and surplus of CIPS. For the year ended December 31, 1993, the "gross income available for interest" of CIPS equalled 3.24 times the sum of the annual interest charges and dividend requirements on all such funded debt, notes and preferred stock outstanding at December 31, 1993. Such "gross income available for interest" was sufficient under the test to support the issuance of additional preferred stock (assuming an annual dividend rate on such preferred stock of 6.75%) in an amount in excess of the maximum amount ($185 million) of authorized and unissued preferred stock under the Articles. RATE MATTERS. The most recent CIPS retail rate case before the Illinois commission resulted in electric and natural gas rate increases which became effective March 20, 1992. In its decision, the Illinois commission allowed a return on net original cost rate base of 9.77% (electric) and 9.88% (natural gas) and a return on common equity of 12.28% (electric) and 12.50% (natural gas). The Illinois commission order was designed to increase annual electric and natural gas revenues of CIPS by $11.6 million. On March 6, 1991, the Illinois commission commenced a generic proceeding (Docket No. 91-0081 for CIPS) to consider whether costs related to the cleanup and restoration of former manufactured gas plant sites (environmental remediation sites) should be recoverable from ratepayers by Illinois utilities (including CIPS) and, if recoverable, what recovery mechanism should be utilized. See Note 2 of Notes to Financial Statements included under Item 8 of this report for a discussion of the regulatory and legal proceedings related to the recovery of remediation and related costs. On March 26, 1993, the Illinois commission entered an order accepting the proposed riders filed by CIPS designed to recover environmental cleanup costs and associated legal expenses relating to its environmental remediation sites (including costs previously incurred and deferred). The riders were filed in response to the Illinois commission's generic order described in Note 2 to the Financial Statements. CIPS began recovering amounts under the riders in April, 1993. On May 13, 1992, the Illinois commission entered an Order which approved a settlement agreement resolving all issues in the "show cause" proceeding which had been initiated by the Illinois commission in December 1986 for purposes of determining the effects on CIPS of the passage of the Tax Reform Act of 1986. See Note 11 of Notes to Financial Statements included under Item 8 of this report for a discussion of the impact of the settlement. The Illinois commission conducts annual proceedings to determine whether the electric fuel and purchased gas charges collected by CIPS in each year pursuant to the applicable fuel adjustment and purchased gas adjustment clauses reflect the actual costs of electric fuel and natural gas prudently purchased in that year and to reconcile revenues collected under the clauses during the year with actual costs incurred. The Illinois commission can order refunds to customers if it determines that actual costs of fuel or purchased gas were less than the amounts charged to customers pursuant to the clauses or if it finds that CIPS was imprudent in its purchases of fuel or gas. The Illinois commission has completed its review of fuel adjustment and purchased gas adjustment charges for all years prior to 1992. No significant refunds or adjustments were required for those years. Fuel reconciliation proceedings for the year 1992 commenced in October 1993. (See Business - Fuel.) The most recent general rate increase of CIPS approved by the FERC became effective in 1984. There are currently no rate proceedings pending at the FERC, and CIPS has no plans for any such rate increase filings. All of CIPS' requirements sales to cooperatives and municipals for resale are through negotiated service agreements. As a result of the retail rate increase granted to CIPS in 1992 referred to above, a corresponding rate adjustment was granted by the FERC for certain customers who purchase power from CIPS for resale. This rate adjustment was provided for in the service agreements between CIPS and these customers. In January 1985, CIPS received approval from the Illinois commission for an economic development rate which is designed to encourage industrial expansion and stimulate job creation in the service territory of CIPS. Under the economic development rate, each qualifying electric customer receives discounted rates for a maximum period of five years. In June 1986, CIPS received further approval which grants flexibility to negotiate agreements to fit the specific needs of certain industrial prospects. In August 1989, the Illinois commission granted CIPS further approval to offer customers the economic development rate through December 31, 1994. Since the rate was instituted, 117 new or existing business expansions have led to the creation of over 8,000 new jobs in the CIPS service territory. ELECTRIC OPERATIONS. Since late 1977 CIPS has been a net off-system seller of electricity and during 1993 it generated 120% of its system requirements. The maximum gross system load to date on the CIPS electrical system, on a one-hour integrated basis, occurred on August 27, 1993, and was 2,157,000 kilowatts. Gross system load includes sales to electric cooperative and municipal customers (but excludes emergency and interchange sales). The 1993 maximum gross system load of 2,157,000 kilowatts was 2.3% greater than the historical maximum gross system load of 2,108,000 which occurred in 1988. CIPS, Illinois Power Company and Union Electric Company are parties to an Interconnection Agreement providing for the coordination and interconnected operation of their respective electric systems and the interchange of power and energy at rates and under conditions set forth therein, including the maintenance by the parties of minimum reserve capacity positions. The Agreement provides that CIPS will maintain a minimum 15% system reserve capacity. CIPS, Illinois Power and Union Electric are parties to an Interconnection Agreement with Tennessee Valley Authority (TVA) providing for the interconnection of the TVA system with the systems of the three companies to exchange economy and emergency power and for other working arrangements. In addition, CIPS has interconnection agreements with various other neighboring utilities, including Central Illinois Light Company, Commonwealth Edison Company, Indiana Michigan Power Company, Public Service Company of Indiana, Inc., Iowa Electric Light and Power Company and Northern Indiana Public Service Company. These agreements provide for various interchanges, emergency services and other working arrangements. CIPS owns 20% (and three other utilities own the remaining 80%) of the common stock of Electric Energy, Inc., and is entitled to receive from it varying amounts of power. Electric Energy, Inc. owns and operates a 1,015,000 kilowatt coal-fired power station located in Joppa, Illinois. CIPS is one of 15 members of the Mid-America Interconnected Network reliability council, which has as its purpose the promotion of maximum coordination of planning, construction and utilization of generation and transmission facilities on a regional basis in order to assure the reliability of electric bulk power supply in the area served. One municipal agency, two municipal electric systems, one cooperative agency and one cooperative are engaged in the generation of electricity within, or in close proximity to, portions of the territory served by CIPS. In 1993 CIPS began the process of analyzing the economic value of each of its generating units, which will consider the cost effectiveness of continued operation, retirement or repowering of each unit and other options as well. The Electric Power Research Institute ("EPRI") is participating in this analysis with CIPS. The study is expected to be completed in mid-1994. Electric and magnetic fields (sometimes referred to as EMF) surround electric wires or conductors of electricity such as electrical tools, household wiring and appliances and electric transmission and distribution lines such as those owned by CIPS. A number of statistical and laboratory studies have investigated whether EMF pose human health risks. The United States Environmental Protection Agency (USEPA) stated in its December 1992 brochure "Questions and Answers about Electric and Magnetic Fields" that "Some epidemiological evidence is suggestive of an association between surrogate measurements of magnetic field exposure and certain cancer outcomes. Though the body of evidence cannot be dismissed, it is not complete enough at this time to draw meaningful conclusions." The nation's electric utilities, including CIPS, have participated in the sponsorship of millions of dollars of EMF research. CIPS has also agreed to participate in the National EMF Research and Public Information Dissemination Program, a 5-year $65 million effort headed by the United States Department of Energy aimed at furthering EMF research. Through its participation with EPRI, CIPS will continue its investigation and research with regard to the possible health effects posed by exposure to EMF. ELECTRIC POWER SALES/PARTICIPATION AGREEMENTS. As shown in the table below, CIPS currently has contracts with Norris Electric Cooperative, City of Newton, Village of Greenup and Mt. Carmel Public Utility Company for the sale of electric power. These contracts provide for firm full requirements service which obligates CIPS to maintain adequate system reserves to support the contracts, or to supply the requirements with off-system purchases. Peak Contract Demand Expiration Contract (Megawatts) Date - -------- ___________ __________ Norris Electric Cooperative. . . . . . . . . 49 MW 2007 City of Newton . . . . . . . . . . . . . . . 5 MW 1999 Village of Greenup . . . . . . . . . . . . . 2 MW 1999 Mt. Carmel Public Utility Co. . . . . . . . 40 MW 2001 CIPS has entered into an agreement with Central Illinois Light Company ("CILCO") to sell CILCO limited term power through May, 1998. The agreement calls for a minimum contract delivery rate of 50 megawatts in 1993 rising to 90 megawatts by the end of the contract period. At CILCO's request, and provided the capacity is available, purchases can be increased to 100 megawatts at any time during the contract period with prior written notice. In November 1992, CIPS entered into an agreement with CILCO to sell CILCO limited term power for the period of June, 1998 through May, 2002. The agreement calls for a minimum contract delivery rate of 100 megawatts for the entire period. At CILCO`s request, and provided the capacity is available, purchases can be increased to 150 megawatts with prior written notice. In addition, CIPS sells electric power to three power pooling agencies through negotiated capacity participation agreements identified in the following table. These agencies include Soyland Power Cooperative (Soyland), Illinois Municipal Electric Agency (IMEA) and Wabash Valley Power Association (WVPA). Maximum Capability Entitlement Contract (Megawatts) Expiration Contract (for years indicated) Date - -------- _____________________ __________ Soyland . . . . . . . . . 217MW 1993-1994 1999 103MW 1995-1999 IMEA. . . . . . . . . . . 116MW 1994-2014 2014 WVPA. . . . . . . . . . . 60 MW 1994 2011 65 MW 1995-2011 GAS OPERATIONS. CIPS distributes and sells natural gas to 267 incorporated and unincorporated communities located in 41 counties of Central and Southern Illinois. The CIPS service territory is predominantly made up of small towns and rural areas. Of the communities served, only 5 have populations greater than 15,000. CIPS operates 4,520 miles of transmission and distribution mains, and its customer density is approximately 36 customers per mile of main. Six interstate pipelines pass through various portions of the CIPS service area: Panhandle Eastern Pipe Line Company, Texas Eastern Transmission Corporation, Natural Gas Pipeline Company, Texas Gas Transmission Company, Midwestern Gas Transmission Company and Trunkline Gas Company. CIPS has multiple interconnections with each of these pipelines, with the total of all such interconnections being 45. Most of the CIPS system is integrated by virtue of Company-owned pipelines, or by transportation agreements with interstate pipelines. CIPS owns and operates four underground storage fields which provide a total peak day capacity of 36,500 mcf/day (thousand cubic feet per day). CIPS also operates one propane-air peak shaving facility which has a peak day capacity rating of 10,000 mcf/day. The peak day firm demand recorded by CIPS in 1993 was 254,870 mcf which was reached on February 17, 1993. This demand level is 20% less than the all- time peak demand of 319,033 mcf which occurred on December 24, 1983. During calendar year 1993, the CIPS throughput (total of sales and transportation) was 36 billion cubic feet (bcf) compared to 36.5 bcf experienced in 1972, the year of highest historical throughput. In 1993, CIPS transported 10.8 bcf of customer-owned gas which represented 30% of the total system throughput. Volumes of customer-owned gas transported in 1992 and 1991 were 11.8 bcf and 12.0 bcf, respectively. The average cost per mcf of natural gas purchased from all suppliers was about $3.66 in 1993, $3.66 in 1992 and $3.39 in 1991. The rate schedules of CIPS applicable to all of its gas sales include a uniform purchased gas adjustment clause, which permits CIPS to adjust its rates to its customers to reflect substantially all changes in the cost of purchased gas. (See Note 1 of Notes to Financial Statements included under Item 8 of this report. See Business - Rate Matters.) In 1992, the FERC issued orders (together called Order 636) which address pipeline service restructuring. Order 636 required interstate pipelines to "unbundle" their sales service, and offer separately the components of that service (i.e., gas supply, transportation and storage). Order 636 essentially precludes interstate pipelines from selling natural gas. However, many pipelines have established separate unregulated marketing affiliates which function as gas merchants in competition with producers and other sellers of gas. Each of the six pipelines providing service to CIPS have made restructured services filings at FERC to comply with Order 636. The last such filing was effective December 1, 1993. See Note 2 of Notes to Financial Statements included under Item 8 of this report for a discussion of the transition costs to be paid by CIPS and the Illinois commission order initiated to investigate the appropriate ratemaking treatment of Order 636 transition costs. Full implementation of Order 636 has resulted in several changes in CIPS' gas supply portfolio. Pipeline sales service contracts have been replaced by additional direct purchase gas supply contracts coupled with gas transportation contracts with various pipelines and storage contracts with pipelines or other independent storage service providers. In some cases CIPS has also contracted for so-called "no-notice" services with interstate pipelines. Under such contracts, the pipeline essentially combines and manages a number of independent supply, transportation and storage contracts in order to provide flexibility in the amount of gas actually delivered to CIPS on any day. Such flexibility, which was formerly provided by the pipeline sales service, is needed for CIPS to economically meet the highly weather sensitive needs of its firm service customers. In addition to its diversified portfolio of gas supply, transportation, leased storage and no-notice service contracts, CIPS' company-owned storage and propane-air facilities provide additional reliability and flexibility to meet peak day and peak season requirements. In recent years CIPS has made investments to construct additional pipeline interconnections, increase company owned storage capacity, improve reliability of existing storage facilities, modernize propane-air facilities and improve data acquisition capabilities. At the same time CIPS has reorganized and enhanced its gas supply planning and procurement functions. FUEL. Over 99% of the net kilowatthour generation of CIPS in 1993 was provided by coal-fired generating units and the remainder by an oil-fired unit. The average costs of fuel consumed by CIPS, per ton and per million Btu, for the periods shown were as follows: 1993 1992 1991 ----- ----- ----- Per ton ($) . . . . . . . . . . . . 36.62 36.46 36.68 Per million Btu ($) . . . . . . . . 1.67 1.67 1.67 In 1993, approximately 21.9% of the coal purchased for electric generation was purchased on a spot basis at average delivered costs of $31.35 per ton and $1.37 per million Btu. The retail fuel adjustment clause (FAC) of CIPS is consistent with the uniform FAC mandated by the Illinois commission for all electric utilities as applicable to retail electric sales in Illinois. The FAC provides for the recovery of changes in electric fuel costs, including certain transportation costs of coal, in billings to retail customers. CIPS adjusts fuel expense to recognize over- or under-recoveries of allowable fuel costs. The cumulative effect is deferred on the Balance Sheet as a Current Asset or Current Liability, pending automatic reflection in future billings to customers. In 1992, CIPS received Illinois commission approval to include certain coal transportation costs in the FAC in accordance with the August 1991 modifications to the Illinois Public Utilities Act. CIPS also has contractual arrangements with certain other utility system customers which contain a fuel adjustment clause which permits CIPS to adjust its rates to such customers to reflect substantially all changes in the cost of fuel (including all transportation costs) used to supply those customers. The amount of coal supplies on hand at the generating stations of CIPS varies from time to time. CIPS generally attempts to maintain a 65-day supply. High usage resulting from increased generation to meet interchange sales opportunities and increased native load requirements in 1993 led to somewhat lower than normal coal supplies in early 1994. More than 85% of the annual coal requirements of the generating facilities of CIPS are being met by long-term coal contracts expiring at various dates from 1995 to 2010. As contracts approach their expiration, or when appropriate, CIPS evaluates alternative supply arrangements based on then current and expected market conditions for coal. CIPS believes there are adequate reserves reasonably available to supply its existing generating units with the quantity and quality of coal required for the foreseeable future. Compliance with the sulfur dioxide emission requirements of Phase I (effective in 1995) and Phase II (effective in 2000) of the Clean Air Act Amendments of 1990 is expected to be accomplished through switching to lower sulfur coal for several generating units in combination with increased scrubbing with the existing scrubber at Newton Unit 1. In January 1991, CIPS entered into a long-term contract for the purchase of lower sulfur Illinois coal at its Coffeen Power Station to meet the requirements under the Clean Air Act Amendments. This new contract replaced an existing contract and, in addition to providing the source of coal for clean air compliance, resulted in lower fuel costs. The new contract provides for certain termination charges as described in Note 2 of Notes to Financial Statements included under item 8 of this report. CIPS estimates that capital costs to be incurred through the year 2000 for various equipment and coal handling facility modifications at all five of its generating stations in order to comply with the Clean Air Act Amendments will be less than $50 million. Such costs could result in electric base rate increases of approximately one to two percent by the year 2000. CIPS does not anticipate that operating costs will change materially as a result of compliance with the Clean Air Act Amendments. Under the Clean Air Act Amendments each utility must have, beginning in 1995, sufficient emission allowances, which are granted by the USEPA, to cover the amount of sulfur dioxide to be emitted each year from its generating stations. Any emission allowances in excess of a utility's needs for a year can be retained by it for future use or sold. Based upon CIPS' current compliance program, CIPS expects to have available allowances (after consideration of allowances sold) in excess of its requirements. REGULATION. CIPS is subject to regulation by the Illinois commission as to rates, accounting practices, issuance of certain securities and in other respects as provided by Illinois law. The Electric Supplier Act of Illinois permits utilities and electric cooperatives to delineate their respective service areas, subject to the approval of the Illinois commission, and gives the Illinois commission power to determine, pursuant to guidelines provided in the Act, whether a prospective electric customer will be furnished service by a public utility or by a cooperative. (See Item 3. Legal Proceedings.) The FERC has jurisdiction under the Federal Power Act over certain of the electric utility facilities and operations, accounting practices, issuance or acquisition of certain securities and electric rates of CIPS for resale and interchange customers. CIPS has been classified as a "public utility" within the meaning of that Act. CIPS has been declared exempt from the federal Natural Gas Act. CIPS is presently exempt from all the provisions of the Public Utility Holding Company Act of 1935, except provisions thereof relating to the acquisition of securities of other public utility companies, until further action by the Securities and Exchange Commission, by virtue of an annual exemption statement filed by CIPS with the Commission pursuant to Rule 2 under the Act. ENVIRONMENTAL MATTERS. CIPS is subject to regulation with respect to air and water quality standards, standards relating to the discharge and disposal of solid and hazardous wastes and other environmental matters by various federal, state and local authorities. The Illinois Pollution Control Board (the "Board") has jurisdiction over all phases of environmental control by the State of Illinois and has authority to grant variances from environmental requirements. The Illinois Environmental Protection Agency (the "Agency") has authority to issue permits, investigate violations and recommend enforcement cases. The Illinois Attorney General has the authority to prosecute enforcement cases. The USEPA has jurisdiction to promulgate and enforce air and water quality standards in addition to those standards which relate to the discharge and disposal of solid and hazardous wastes. Air pollution control regulations promulgated by the Board impose restrictions on emissions of particulate, sulfur dioxide, nitrogen oxides and other air pollutants and require that CIPS obtain permits from the Agency for the construction and operation of its generating facilities in compliance with these regulations. CIPS has secured all necessary operating permits for all of its existing generating facilities and is in substantial compliance with the provisions contained therein. Future construction projects may require additional construction permits. Water pollution control regulations promulgated by the Board impose restrictions on effluent discharges, set water quality standards and require CIPS to obtain construction permits for certain facilities and National Pollutant Discharge Elimination system ("NPDES") permits for discharges into public waters. CIPS has secured all necessary NPDES permits for all of its generating units and is in substantial compliance with the currently effective provisions contained therein. However, it would be difficult to comply with certain conditions in the recently renewed permits for the Coffeen and Newton Power Stations, scheduled to take effect in 1997. CIPS has appealed these permit conditions to the Illinois Pollution Control Board. If these appeals are unsuccessful, CIPS will seek regulatory relief under applicable rules to alter the requirements for these two stations. Pollution control regulations promulgated by the Board impose restrictions on the discharge and disposal of solid and hazardous waste, and determine design standards to prevent contamination of groundwater. CIPS has secured all necessary permits and authorizations for disposal and is in substantial compliance with the provisions contained therein. Future construction projects may require additional authorizations or permits. Beginning in 1986 and ending in October 1993, CIPS operated Units 1 and 2 at the Coffeen Power Station at a reduced load to meet applicable emission limitations. A new coal supply has allowed the operation of Coffeen Units 1 and 2 at their maximum capability of 325,000 KW and 550,000 KW, respectively, since October 1993. Total capability of the generating units was previously restricted to 750,000 KW when both units were in full operation. Removal of the operating restrictions increased total electric system capability to 2,852,000 KW. On May 21, 1993, the USEPA issued a Finding of Violation (FOV) to CIPS regarding Units 1 and 2 at the Newton Power Station. The FOV alleges that both generating units at the Newton Power Station were operated at various times from January 1991 through August 1992 in violation of applicable emission regulations, including opacity and sulfur dioxide limitations, regarding New Source Performance Standards established under the Clean Air Act for fossil fuel fired steam generating units. On January 3, 1994, CIPS entered into a consent agreement with the Illinois Environmental Protection Agency and the Illinois Attorney General resolving the issues presented in the FOV. Under terms of the consent agreement, CIPS will pay a fine of $40,000. CIPS also agreed to install a continuous emissions stack monitor on Newton Unit 2. This monitor has already been installed as part of the Company's Clean Air Act Compliance Plan. CIPS also entered into a consent agreement with the USEPA concerning these same issues. This latter agreement did not require any further action on the part of CIPS. See the subcaption "Environmental Remediation Costs" under Note 2 of the Notes to Financial Statements, included under Item 8 of this report, for information relating to costs incurred and to be incurred in connection with the remediation of certain sites where gas had been manufactured from coal and which contain potentially harmful materials. EMPLOYEES. Composition of the work force of CIPS at the payroll period nearest year-end 1993 and 1992 was as follows: Number of Employees ------------------- Employee Group 1993 1992 - -------------- ----- ----- Salaried. . . . . . . . . . . . . . . . . 1,218 1,182 IBEW - 702. . . . . . . . . . . . . . . . 922 965 IUOE - 148. . . . . . . . . . . . . . . . 479 489 ----- ----- Total . . . . . . . . . . . . . . . . . . 2,619 2,636 ===== ===== See Management's Discussion and Analysis of Financial Condition and Results of Operations--Labor Disputes for a discussion of the status of labor contracts, unfair labor practice charges and related matters involving those employees represented by labor unions. As part of the agreement leading to new labor contracts, International Brotherhood of Electrical Workers Local 702 ("IBEW 702") has dropped the class action suit filed by it against CIPS and others seeking treble damages for lost wages and benefits and other damages. The settlement is subject to court approval. Item 2. Item 2. Properties. The electric generating facilities of CIPS consist of the following: Estimated 1994 Summer Year Capability Station and Unit Fuel Installed (KW) - ---------------- ---- --------- ----------- Newton Unit 1 . . . . . . . . . . . . . . Coal 1977 555,000 Unit 2 . . . . . . . . . . . . . . Coal 1982 560,000 Coffeen Unit 1 . . . . . . . . . . . . . . Coal 1965 325,000 Unit 2 . . . . . . . . . . . . . . Coal 1972 550,000 Grand Tower Unit 3 . . . . . . . . . . . . . . Coal 1951 82,000 Unit 4 . . . . . . . . . . . . . . Coal 1958 104,000 Hutsonville Unit 3 . . . . . . . . . . . . . . Coal 1953 76,000 Unit 4 . . . . . . . . . . . . . . Coal 1954 77,000 Diesel Unit. . . . . . . . . . . . Oil 1968 3,000 Meredosia Unit 1 . . . . . . . . . . . . . . Coal 1948 62,000 Unit 2 . . . . . . . . . . . . . . Coal 1949 62,000 Unit 3 . . . . . . . . . . . . . . Coal 1960 220,000 Unit 4 . . . . . . . . . . . . . . Oil 1975 176,000 _________ Total . . . . . . . . . . . . . 2,852,000 ========== All of the generating stations are located in Illinois on land owned in fee by CIPS. At December 31, 1993, CIPS owned 12,922 pole miles of overhead electric lines and 843 miles of underground electric lines. At that date, CIPS also owned 4,520 miles of natural gas transmission and distribution mains, four underground gas storage fields and one propane-air gas plant used to supplement the available pipeline supply of natural gas during periods of abnormally high demands. Substantially all of the permanent fixed utility property of CIPS is subject to the lien of the Mortgage Indenture securing the first mortgage bonds. Item 3. Item 3. Legal Proceedings. Actions have been brought against CIPS by Southwestern Electric Cooperative, Inc. ("Southwestern") on October 30, 1991 in the Macon County, Illinois Circuit Court and by Wayne-White Counties Electric Cooperative ("Wayne-White" and together with Southwestern, the "Distribution Cooperatives") on August 15, 1991 in the White County, Illinois Circuit Court. Soyland Power Cooperative ("Soyland"), a generating and transmission cooperative that supplies power to the Distribution Cooperatives, is also a plaintiff in the actions. In various prior cases brought before the Illinois commission and finally determined on appeal, the Distribution Cooperatives prevailed in disputes between each of them and the Company as to which of them was entitled to serve certain electric customers under the Illinois Electric Supplier Act ("ESA") and certain service area agreements entered into pursuant to the ESA. Based on the results of the prior proceedings, the pending suits, in general, seek actual damages for breach of the service area agreements and punitive damages based on various grounds, such as tortious interference with contractual relationships and business expectancies and violation of the Illinois Public Utilities Act. A CIPS motion to dismiss the Southwestern/Soyland case was successful only as to certain counts. In the remaining counts, Southwestern seeks $182,000 in alleged actual damages for breach of the service area agreement and an additional $5 million in punitive damages for both interference with a contractual relationship and a business expectancy (it is not clear whether these claims are intended as separate bases for the recovery of $5 million in punitive damages or are cumulative). In addition, Soyland seeks $323,000 in alleged actual damages and $5 million in punitive damages for interference with a business expectancy. In the Wayne-White/Soyland action, Wayne-White seeks unspecified alleged actual damages for breach of the service area agreement and additional unspecified punitive damages for violation of the Public Utilities Act and interference with a business expectancy. In addition, Soyland claims $819,000 in alleged actual damages based on breach of the service area agreement and an additional $5 million in punitive damages based on interference with both a contractual relationship and a business expectancy and based on violation of the Public Utilities Act (again, it is not clear whether these claims are intended as separate bases for the recovery of $5 million in punitive damages or are cumulative). On March 11, 1993, Soyland was dismissed from the Wayne-White action on statue of limitations grounds and the claims by Wayne-White under the Illinois Public Utilities Act were dismissed. Soyland has filed an appeal of its dismissal. This action is continuing with regard to Wayne-White's other claims. While CIPS cannot predict the outcome of any of these matters, it intends to vigorously defend against all such claims. See Item 1. Business - Rate Matters, Business - Gas Operations and Business - Environmental Matters with respect to certain matters involving CIPS. See also Note 2 of Notes to Financial Statements included under Item 8 of this report. 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 three months ended December 31, 1993. Executive Officers of the Registrant (ages at December 31, 1993). Name Age Positions Held _____ ___ ______________ C. L. Greenwalt 60 President* R. W. Jackson 63 Senior Vice President Finance and Secretary* L. A. Dodd 55 Senior Vice President Operations J. G. Bachman 45 Vice President Corporate Planning W. A. Koertner 44 Vice President Corporate Services G. W. Moorman 50 Vice President Power Supply W. R. Morgan 57 Vice President Division Operations W. R. Voisin 58 Vice President Public Relations J. C. Fiaush 63 Controller (Principal Accounting Officer)* C. D. Nelson 40 Treasurer and Assistant Secretary* ______________________ * Messrs. Greenwalt and Jackson are directors of CIPS and are also officers of CIPSCO. Mr. Fiaush and Mr. Nelson are also officers of CIPSCO. The present term of office of the above executive officers extends to the first meeting of the Board of Directors of CIPS after the next annual election of Directors, scheduled to be held on April 27, 1994. There is no family relationship between any executive officer and any other executive officer or any director. All of the officers named above have been employed by CIPS in their present positions for more than the past five years except as indicated below: Mr. Greenwalt served as Senior Vice President Operations from August 4, 1980 to August 1, 1989, when he was named President. Mr. Dodd served as Vice President Corporate Planning from July 1, 1985 to August 1, 1989 and as Vice President Division Operations from August 1, 1989 to July 1, 1990 when he was named Senior Vice President Operations. Mr. Bachman served as Manager of Rates and Research from February 1, 1980 to August 1, 1989, when he was named Vice President Corporate Planning. Mr. Koertner served as Treasurer and Assistant Secretary from February 1, 1982 to August 1, 1989 and as Vice President Financial Services from August 1, 1989 to April 1, 1993, when he was named Vice President Corporate Services. Mr. Moorman served as Manager of System Operation from April 1, 1976 to June 1, 1988, when he was named Vice President Power Supply. Mr. Morgan served as Vice President Corporate Services from August 5, 1980 to July 1, 1990, when he became Vice President Division Operations. Mr. Voisin served as Superintendent of the Quincy Area from January 1, 1985 to July 1, 1989, when he was named Vice President Public Relations. Mr. Nelson served as Assistant Treasurer from January 1, 1985 to August 1, 1989 when he was named Treasurer and Assistant Secretary. Directors of the Registrant. Name, Age, Principal Occupation, and other Directorships Director Since ________________________________________________________ ______________ WILLIAM J. ALLEY, age 64. Chairman of the Board and Chief 1974 Executive Officer of American Brands, Inc. (diversified manufacturing and other businesses), Old Greenwich, Connecticut; director of American Brands, Inc., Moorman Manufacturing Company and Rayonier, Inc. ROBERT S. ECKLEY, age 72. President Emeritus of Illinois 1973 Wesleyan University, Bloomington, Illinois; director of State Farm Mutual Automobile Insurance Co. CLIFFORD L. GREENWALT, age 60. President and Chief 1986 Executive Officer of CIPS, CIPSCO and Chairman of the Board of CIPSCO Investment Company, and served as Senior Vice President - Operations of CIPS from 1980 to August 1989 when he became President; director of First of America Bank Corporation, Kalamazoo, Michigan and a director of its wholly owned subsidiary, First of America Bank - Springfield, N.A. Name, Age, Principal Occupation, and other Directorships Director Since ________________________________________________________ ______________ JOHN L. HEATH, age 58. Retired Chairman and President 1977 of the Heath Candy Company, Robinson, Illinois; served as Chairman of L.S. Heath & Sons, Inc. from 1971 until 1988 and also as President and Chief Executive Officer from 1971 until 1982 and is a director of the Biltmore Bank Corp. and of its wholly owned subsidiary, The Biltmore investors Bank of Phoenix, Arizona; and is a director of Sun Street Food Corporation of Phoenix, Arizona. ROBERT W. JACKSON, age 63. Senior Vice President - 1986 Finance and Secretary of CIPS, Senior Vice President and Chief Financial Officer and Secretary of CISPCO and President and Chief Executive Officer of CIPSCO Investment Company, and served as Senior Vice President - - Finance and Secretary of CIPS since 1980; director of Firstbank of Illinois Co. and each of its wholly owned subsidiary banks, including the First National Bank of Springfield. GORDON R. LOHMAN, age 59. President and Chief Executive 1989 Officer of AMSTED Industries Incorporated (diversified manufacturer of industrial products), Chicago, Illinois in 1988 and 1990, respectively; Executive Vice President of that firm in 1988 and Vice President from 1978 through 1987; and is a director of American Brands, Inc. HANNE M. MERRIMAN, age 52. Principal in Hanne Merriman 1990 Associates (retail business consultants), Washington, D.C.; President of Nan Duskin, Inc., from 1991 to 1992; retail business consultant since January 1990; President and Chief Executive Officer of Honeybee, Inc. a division of Spiegel, Inc. from January 1988 through December 1989; President of Garfinckels, a division of Allied Stores Corporation, from 1981 through 1987 and is a director of USAir Group, Inc., State Farm Mutual Automobile Insurance Co., The Rouse Company and AnnTaylor Stores Corporation. DONALD G. RAYMER, age 69. Retired President and Chief 1972 Executive Officer of CIPS; director of Bank One Springfield and served as President and Chief Executive Officer of CIPS from 1980 to August 1989. Name, Age, Principal Occupation, and other Directorships Director Since ________________________________________________________ ______________ THOMAS L. SHADE, age 63. Retired Chairman of the Board and 1991 Chief Executive Officer of Moorman Manufacturing Company (livestock feed products), Quincy, Illinois, having served in those capacities during 1992 and 1993 and was President and Chief Executive Officer of that firm from 1984 to 1992 and is a director of that firm and Quincy Soybean Company of Quincy, Illinois. JAMES W. WOGSLAND, age 62. Vice Chairman of Caterpillar 1992 Inc. (heavy equipment and engine manufacturer), Peoria, Illinois, since 1990 and was Executive Vice President of that firm from 1987 until 1990 and is a director of that firm and First of America Bank Corporation, Kalamazoo, Michigan and its wholly owned subsidiary First of America Bank-Illinois, N.A., Peoria, Illinois and is also a director of Protection Mutual Insurance Company. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder matters. All the common stock of CIPS is owned by CIPSCO, its corporate parent, and is not publicly traded. The following table sets forth the cash distributions on common stock paid to CIPSCO by CIPS, which, in some cases, were used to repurchase common shares of CIPS for the periods indicated: 1993 1992 ____ ____ First Quarter . . . . . . . . . . $16,500,000* $16,400,000* Second Quarter . . . . . . . . . . $16,750,000* $16,700,000* Third Quarter . . . . . . . . . . $16,750,000 $16,500,000* Fourth Quarter . . . . . . . . . . $16,750,000 $16,500,000* * Reflects the repurchase of common shares of CIPS. CIPS is subject to restrictions on the use of retained earnings for cash dividends on common stock as described in Note 6 of Notes to Financial Statements included under Item 8 of this report. Item 6. Item 6. Selected Financial Data. For the Years Ended December 31, 1993 1992 1991 1990 1989 __________ __________ __________ __________ __________ (in thousands) Operating Revenues $ 834,556 $ 729,402 $ 710,205 $ 685,226 $ 683,859 Operating Income 113,651 97,372 104,039 97,135 109,433 Net Income 84,011 72,601 75,683 71,562 71,222 Preferred Dividends 3,718 4,549 5,396 5,617 5,856 Earnings for Common Stock 80,293 68,052 70,287 65,945 65,366 As of December 31, Total Assets $1,668,462 $1,645,059 $1,691,843 $1,665,614 $1,714,544 Long-Term Debt 494,323 503,700 496,420 496,319 496,301 Preferred Stock subject to mandatory redemption - - 18,245 21,245 24,000 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. MANAGEMENT'S DISCUSSION AND ANALYSIS ____________________________________ Central Illinois Public Service Company (CIPS or the Utility) is a subsidiary of CIPSCO Incorporated (the Parent company), a holding company incorporated under the laws of the State of Illinois. FINANCIAL CONDITION. Central Illinois Public Service Company's financial position remained fundamentally strong during 1993. A strong capital structure and strong cash flows have minimized the need to access capital markets, other than for refinancings, in recent years. Neither CIPSCO nor CIPS has raised additional capital through the sale of common stock to the general public since 1980. Common stock was issued and sold to existing shareholders by CIPS through a dividend reinvestment plan until 1984. The long-range financial objectives for the capital structure of CIPS are: a debt ratio of no more than 45 percent, a common equity ratio of no less than 45 percent, and a preferred equity ratio of no more than 10 percent. At December 31, 1993, capitalization consisted of 43 percent long-term debt, 50 percent common equity and 7 percent preferred stock. At year end, 25,452,373 shares of CIPS common stock were outstanding, all of which were held by CIPSCO Incorporated. During 1993, 884,345 shares of common stock were repurchased by CIPS from CIPSCO as a means of conveying funds to the parent company for dividend payments and other corporate purposes. CAPITAL REQUIREMENTS. Construction expenditures were $88 million in 1993. Of that amount, $77 million and $11 million related to improvements and replacements to the electric and natural gas systems, respectively. In 1994 construction expenditures are expected to be about $87 million. Of that amount, $77 million is scheduled for electric facilities while gas system expenditures are estimated at $10 million. Construction expenditures are estimated at $431 million for the five-year period 1994-1998. This is $31 million, or seven percent, less than was spent in the preceding five years. In addition to construction funds, projected capital requirements for the 1994-1998 period include $93 million for scheduled debt retirements. FINANCING REQUIREMENTS. Capital requirements for the 1994-1998 period are expected to be met primarily through internally generated funds. External financing to fund scheduled debt retirements will be required. If external financing were needed to fund the construction program such financing could consist of funds from the parent, the issuance of short-term debt, long-term debt or preferred stock, or any combination of the four. Refinancings to lower the costs of capital may also occur, depending on market conditions. On April 6, 1993, CIPS issued $65 million of first mortgage bonds to refinance higher-cost debt issues. On May 4, 1993, and October 13, 1993, CIPS issued $30 million and $12.5 million of preferred stock, respectively. The new issues were used to redeem the utility's outstanding 7.48% Series and 8.08% Series of preferred stock, and to raise $15 million of additional capital. During the year, CIPS refinanced $130 million of pollution control loan obligations to achieve lower rates of interest. Financing requirements may be affected by such factors as availability and cost of capital, load growth, changes in construction expenditures, regulatory developments, changes in environmental regulations and other governmental activities. FINANCING FLEXIBILITY AND LIQUIDITY. The utility's ability to finance the construction program at reasonable cost and to provide for other capital needs is dependent upon its ability to earn a fair return on capital. Financing flexibility is enhanced by providing a high percentage of total capital requirements from internal sources and having the ability, if necessary, to issue long-term securities and to obtain short-term credit. Flexibility also is provided by the parent corporation which is capable of providing additional capital if circumstances warrant. The CIPS mortgage indenture limits the amount of first mortgage bonds which may be issued. At December 31, 1993, CIPS could have issued about $532 million of additional first mortgage bonds under the indenture, assuming an annual interest rate of 7.25 percent. CIPS' articles of incorporation limit amounts of preferred stock which may be issued. Assuming a preferred dividend rate of 6.75 percent, CIPS could have issued all $185 million of authorized, but unissued preferred stock remaining as of year end. At year-end 1993, CIPS had $2.7 million of temporary investments. There were no short-term borrowings. RESULTS OF OPERATIONS --------------------- (1991-1993) EARNINGS. Earnings for common stock increased 18 percent in 1993 to $80.3 million. The increases in electric and gas revenues were the result of increased sales due to the occurrence of more-normal weather conditions. Weather-related factors and a coal miners' strike which hampered coal deliveries to some utilities, resulted in increased sales of power by CIPS to other utility systems. The interchange sales in 1993 resulted from exceptional opportunities which are unlikely to be matched in future years. Earnings for common stock decreased three percent in 1992 to $68.1 million. Increases in gas and electric revenues resulting from the retail rate increase effective in March, and a favorable earnings adjustment of $3.3 million due to settlement of the revenues subject to refund proceeding, were offset by weather-related decreases in electric revenues. ELECTRIC OPERATIONS. Electric revenues increased $93.2 million in 1993. Cooling degree days for 1993 were 37 percent higher than in 1992. Electric kilowatthour sales, including interchange sales, were 39 percent higher than a year ago. Revenues from electric interchange sales to other utility systems for economy and emergency purposes were $76.3 million, or $48.3 million higher than a year ago, reflecting much greater sales opportunities. The greater opportunities for sales resulted from hot weather, flooding conditions which limited availablity of generating capacity at some neighboring utilities, and coal miners' strikes which hampered deliveries of coal at other utilities. These factors contributed to a significantly increased level of interchange economy and emergency sales which is unlikely to be matched in 1994. Electric revenues increased $3 million in 1992 as compared to 1991. The effects of a favorable settlement in the revenues subject to refund proceeding, and a rate increase of approximately one percent in March 1992, were offset by a one percent decrease in kilowatthour sales. The sales decrease was primarily caused by cooler summer weather in 1992. Cooling degree days for 1992 were 33 percent lower than in 1991. Fuel for electric generation increased eight percent, or $14.4 million, in 1993 primarily due to higher electric generation caused by increased kilowatthour sales. Kilowatthours generated increased 16 percent in 1993. Average fuel cost remained the same at $1.67 per million Btu in 1993, 1992 and 1991. Purchased power expense increased 185 percent, or $39.1 million in 1993 reflecting additional purchases principally used for economy and emergency interchange sales. Purchased power and fuel cost for electric generatin increased three percent, or $5.7 million, in 1992 as compared to 1991. Kilowatthours generated decreased two percent in 1992. GAS OPERATIONS. Gas revenues increased nine percent to $145.7 million in 1993 as compared to 1992 due to increases in therm sales and a full heating season of the increased rates effective March 1992. Therm sales increased 21 percent primarily due to more industrial customers purchasing gas from the utility's system rather than from other gas suppliers. Residential therm sales inreased 14 percent reflecting colder temperatures in 1993. Heating degree days were 13 percent higher in 1993 as compared to 1992. Gas revenues increased 14 percent to $133.8 million in 1992 due to increased rates effective in March 1992, and adjustments for higher purchased gas costs. Therm sales increased five percent in 1992 compared to 1991 primarily due to industrial customers purchasing gas from the utility's system rather than from other gas suppliers. The utility transported approximately 108 million therms of customer owned gas in 1993 compared with 118 million and 120 million therms in 1992 and 1991, respectively. Purchased gas costs increased $7.5 million, or nine percent, in 1993 due to higher therm sales, while the average price paid for purchased gas from suppliers remained unchanged. In 1992, purchased gas costs increased $9.4 million, or 13 percent, due to an average three-cent-per-therm price increase charged by gas suppliers. OPERATING EXPENSES. Other operation expense increased $11.4 million, or nine percent in 1993, and $15.5 million, or 13 percent in 1992 due principally, in each case, to postretirement medical expense which CIPS began accruing in April 1992 consistent with the related treatment afforded such costs for ratemaking. (See Note 4 to Financial Statements.) Depreciation expense increased $3.9 million and $4.7 million in 1993 and 1992, respectively, due to property additions. Taxes other than income taxes increased in 1993 because utility taxes, which are based upon receipts from sales, increased as sales increased. Other taxes decreased in 1992 because the rate refund reduced amounts collected from customers which in turn reduced utility taxes. Interest on long-term debt and preferred dividend requirements decreased $2.8 million, or seven percent, in 1993, due to refinancing of long-term debt and preferred stock at lower interest and dividend rates. Interest on provision for revenue refunds was not applicable in 1993 and decreased in 1992 due to settlement of the revenue subject to refund proceeding in 1992. (See Note 11 to Financial Statements.) Miscellaneous, net, for 1993 decreased $4.5 million, or 59 percent because Miscellaneous, net, for 1992 includes $3 million resulting from a Federal Energy Regulatory Commission (FERC) order issued February 12, 1992. That order reversed a 1989 order which required CIPS to refund to cooperative customers a portion of amounts paid to CIPS in a litigation settlement with a former coal supplier. Miscellaneous, net, increased in 1992 due to inclusion of the $3 million resulting from the FERC order. Income tax expense reflects the changes in pre-tax income in both 1993 and 1992. In addition, the federal tax rate changed from 34 percent to 35 percent effective January 1, 1993. OTHER MATTERS. Customer usage of electricity and natural gas varies with weather conditions, general business conditions, the state of the economy and the cost of energy services. The level of sales also is impacted by conditions in the interchange market. Further, certain large gas customers can purchase gas from alternative suppliers or bypass the utility's system by switching to other fuels or by connecting directly to pipelines. Forecasts indicate that retail sales growth will remain at the historical levels of the past decade. Rates for retail electric and gas service are regulated by the Illinois Commerce Commission. Non-retail electric rates are regulated by FERC. The utility's rates are designed to recover operating costs including depreciation on utility plant investment. Inflation continues to be a factor affecting its operations, earnings, shareholders' equity and financial performance. Changes in the cost of fuel for electric generation and purchased gas generally are reflected in billings to customers on a timely basis through fuel and purchased gas adjustment clauses. The Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" was adopted as of January 1, 1993. SFAS No. 106 requires that the expected cost of posretirement benefits be accrued during the employees' years of service. (See Note 4 to Financial Statements.) On January 1, 1993 the Company adopted SFAS No. 109, "Accounting for Income Taxes" which requires the use of the liability method for recording deferred income taxes on temporary differences using the rate at which the differences are expected to reverse. (See Notes 1 and 9 to Financial Statements.) In 1993, The Company adopted, SFAS No. 112 "Employers' Accounting for Postemployment Benefits". The new statement requires the accrual of certain postemployment benefits to former and inactive employees. (See Note 4 to Financial Statements.) ENVIRONMENTAL REMEDIATION COSTS. The utility has identified 13 former manufactured gas plant sites (environmental remediation sites) which contain potentially harmful materials. In 1990, one site was added to the United States Environmental Protection Agency (USEPA) Superfund list. The utility has a long-term remedial plan for the site. Costs and associated legal expenses related to investigation have been incurred at other sites. Commencing in 1987, the estimated incurred costs related to studies and remediation at these 13 sites and associated legal expenses and certain carrying charges are being accrued and deferred rather than expensed currently, pending recovery either from rates, from insurance carriers or from other parties. Management believes that costs incurred in connection with the sites that are not recovered from insurance carriers or other parties will be recovered through utility rates. Accordingly, management believes that costs incurred in connection with these sites will not have a material adverse effect on financial position or results of operations. (See Note 2 to Financial Statements.) CLEAN AIR ACT. CIPS' compliance strategy for Phases I and II of the Clean Air Act Amendments of 1990 is to switch to lower sulfur coal at some generating units along with increased scrubbing at Newton Unit 1. The utility estimates capital costs, including costs incurred to date, for various equipment modifications at its generating stations related to compliance will aggregate less than $50 million. These costs may result in electric base rate increases totaling about one to two percent by the year 2000. The utility does not anticipate that operating costs will change materially as a result of compliance with these amendments. (See Note 2 to Financial Statements.) FERC ORDER 636. During 1992, the FERC issued Order No. 636. This and successor orders have resulted in substantial restructuring of the service obligations of interstate pipeline suppliers. (See Note 2 to Financial Statements.) ENERGY POLICY ACT. The National Energy Policy Act of 1992 (NEPA) contains, among other provisions, legislation designed to promote competition in the development of wholesale power generation in the electric utility industry. NEPA exempts a new class of independent power producers from traditional utility regulation. This new class of producers can build generating plants and sell electricity in wholesale markets without the same constraints of regulated utilities. NEPA also allows FERC to order wholesale "wheeling" by public utilities to provide utility and non-utility generators access to public utility transmission facilities. Public utilities, not voluntarily providing access to their transportation system at agreed upon rates, may be ordered to deliver power at rates to be established by FERC. Although the final impact of the provisions of NEPA cannot be predicted, management believes that the increased competition in the area of generation and transmission may affect the traditional marketing and pricing strategies of the utility business. LABOR DISPUTES. Labor agreements ending June 1995 have been reached with the two unions representing 1,400 hourly employees of CIPS. The contracts with both unions have been signed. Before the agreements were reached, the memberships of both unions authorized a strike and institued an overtime boycott and work slowdown beginning in April 1993. CIPS initiated a lockout of union employees over a period of approximately 14 weeks beginning in May 1993. Subsequent to this date, both unions filed unfair labor practice charges with the National Labor Relations Board (NLRB) claiming back pay and other benefits during the lockout period. The Peoria Regional Office of the NLRB has issued a complaint against CIPS concerning the lockout of employees represented by one union. However, the Peoria Regional Office did not find merit to a similar charge filed by the other union and it has been dismissed. CIPS estimates the amount of back pay and other benefits for both unions to be less than $12 million. The NLRB decisions on the complaint and the charges will be subject to various appeals by the parties. Management believes that the lockout was both lawful and reasonable and that these matters will be ultimately resolved in favor of CIPS. (See Note 2 to Financial Statements.) Item 8. Item 8. Financial Statements and Supplementary Data. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY STATEMENTS OF INCOME Years Ended December 31, __________________________________ 1993 1992 1991 __________ __________ __________ (in thousands) Operating Revenues: Electric $ 688,849 $ 593,996 $ 604,565 Provision for revenue refunds - 1,646 (11,896) _________ _________ _________ 688,849 595,642 592,669 Gas 145,707 133,760 117,536 _________ _________ _________ Total operating revenues 834,556 729,402 710,205 _________ _________ _________ Operating Expenses: Fuel for electric generation 186,938 172,544 165,806 Purchased power 60,181 21,094 22,109 Gas purchased 90,097 82,553 73,189 Other operation 141,310 129,715 114,434 Maintenance 61,216 64,092 66,784 Depreciation and amortization 77,647 74,154 69,483 Taxes other than income taxes 54,767 51,106 53,936 Income taxes 48,749 36,772 40,425 _________ _________ _________ Total operating expenses 720,905 632,030 606,166 _________ _________ _________ Operating Income 113,651 97,372 104,039 _________ _________ _________ Other Income and Deductions: Allowance for equity funds used during construction 1,459 2,162 2,054 Nonoperating income taxes (631) (2,989) (2,413) Miscellaneous, net 3,632 10,978 13,472 _________ _________ _________ Total other income and deductions 4,460 10,151 13,113 _________ _________ _________ Income Before Interest Charges 118,111 107,523 117,152 _________ _________ _________ Interest Charges: Interest on long-term debt 34,421 36,397 36,990 Interest on provision for revenue refunds - (803) 4,261 Other interest charges 479 392 1,231 Allowance for borrowed funds used during construction (800) (1,064) (1,013) _________ _________ _________ Total interest charges 34,100 34,922 41,469 _________ _________ _________ Net Income 84,011 72,601 75,683 Preferred stock dividends 3,718 4,549 5,396 _________ _________ _________ Earnings for Common Stock $ 80,293 $ 68,052 $ 70,287 ========== ========== ========== The accompanying notes to financial statements are an integral part of these statements. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY BALANCE SHEETS December 31, ___________________________ 1993 1992 _____________ ____________ (in thousands) ASSETS Utility Plant, at original cost: Electric $2,172,259 $2,116,322 Gas 208,208 195,709 __________ __________ 2,380,467 2,312,031 Less--Accumulated depreciation 1,020,097 961,419 __________ __________ 1,360,370 1,350,612 Construction work in progress 61,104 45,219 __________ __________ 1,421,474 1,395,831 __________ __________ Current Assets: Cash 4,038 480 Temporary investments, at cost which approximates market 2,734 2,578 Accounts receivable, net 61,591 48,415 Accrued unbilled revenues 38,774 36,680 Materials and supplies, at average cost 40,824 38,529 Fuel for electric generation, at average cost 26,046 34,382 Gas stored underground, at average cost 14,335 12,180 Prepayments 9,847 13,152 __________ __________ 198,189 186,396 __________ __________ Other Assets 48,799 62,832 __________ __________ $1,668,462 $1,645,059 ========== ========== CAPITALIZATION AND LIABILITIES Capitalization: Common shareholder's equity: Common stock, no par value, authorized 45,000,000 shares; outstanding 25,452,373 and 26,336,718 shares respectively $ 121,282 $ 154,532 Retained earnings 443,741 398,235 __________ __________ 565,023 552,767 Preferred stock 80,000 65,000 Long-term debt 474,323 493,700 __________ __________ 1,119,346 1,111,467 __________ __________ Current Liabilities: Long-term debt due within one year 20,000 10,000 Commercial paper - 17,393 Accounts payable 55,931 56,786 Accrued wages 12,720 11,417 Accrued taxes 13,391 11,117 Accrued interest 9,204 6,564 Other 34,895 27,934 __________ __________ 146,141 141,211 __________ __________ Deferred Credits: Accumulated deferred income taxes 274,425 330,053 Investment tax credits 58,962 62,328 Regulatory liabilities, net 69,588 - __________ __________ 402,975 392,381 __________ __________ $1,668,462 $1,645,059 ========== ========== The accompanying notes to financial statements are an integral part of these statements. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY STATEMENTS OF CASH FLOW Years Ended December 31, __________________________________ 1993 1992 1991 __________ __________ __________ (in thousands) OPERATING ACTIVITIES: Net income $ 84,011 $ 72,601 $ 75,683 Adjustments to reconcile net income to net cash provided: Depreciation and amortization 77,647 74,154 69,483 Allowance for equity funds used during construction (AFUDC) (1,459) (2,162) (2,054) Deferred income taxes, net 7 16,407 10,822 Investment tax credit amortization (3,366) (3,336) (3,464) Cash flows impacted by changes in assets and liabilities: Accounts receivable, net and accrued unbilled revenues (15,270) 4,542 (9) Fuel for electric generation 8,336 2,872 664 Other inventories (4,450) (667) (893) Prepayments 3,305 23,585 (4,050) Other assets 14,033 (20,210) (12,958) Accounts payable and other 6,106 17,641 2,871 Accrued wages, taxes and interest 6,217 (5,197) (152) Accumulated provision for revenue refunds - (75,449) 16,157 Other 4,815 (5,991) (2,992) __________ __________ _________ Net cash provided by operating activities 179,932 98,790 149,108 __________ __________ _________ INVESTING ACTIVITIES: Construction expenditures, excluding AFUDC (85,453) (117,198) (110,815) Allowance for borrowed funds used during construction (800) (1,064) (1,013) Changes in temporary investments (156) 92,175 36,728 __________ __________ _________ Net cash used in investing activities. (86,409) (26,087) (75,100) __________ __________ _________ FINANCING ACTIVITIES: Proceeds from issuance of long-term debt 195,000 199,000 - Repayment of long-term debt (205,000) (190,500) - Proceeds from issuance of preferred stock 42,500 - - Redemption of preferred stock (27,500) (18,245) (3,000) Retirement of common stock (33,250) (66,100) (66,950) Proceeds from (repayment of) commercial paper (17,393) 17,393 - Dividends paid: Preferred stock (3,718) (4,549) (5,396) Common stock (33,500) - - Issuance expense, discount and premium (7,104) (11,718) - _________ _________ _________ Net cash used in financing activities. (89,965) (74,719) (75,346) _________ _________ _________ Net increase (decrease) in cash 3,558 (2,016) (1,338) Cash at beginning of period 480 2,496 3,834 _________ _________ _________ Cash at end of period $ 4,038 $ 480 $ 2,496 ========= ========= ========= Supplemental disclosures of cash flow information: Cash paid during the period for: Interest, net of amount capitalized $ 30,909 $ 38,382 $ 36,867 Income taxes 48,367 12,150 $ 42,731 The accompanying notes to financial statements are an integral part of these statements. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY STATEMENTS OF RETAINED EARNINGS Years Ended December 31, __________________________________ 1993 1992 1991 __________ __________ __________ (in thousands) Balance, beginning of year $ 398,235 $ 330,518 $ 260,304 Add (deduct); Net income 84,011 72,601 75,683 Dividends: Preferred stock (3,718) (4,549) (5,396) Common stock (33,500) - - Other (1,287) (335) (73) _________ _________ _________ Balance, end of year $ 443,741 $ 398,235 $ 330,518 ========= ========= ========= The accompanying notes to financial statements are an integral part of these statements. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES General. Central Illinois Public Service Company (CIPS or the Utility), a subsidiary of CIPSCO Incorporated (CIPSCO), provides certain services to CIPSCO and other affiliates for which all costs incurred are reimbursed to CIPS. In 1993, 1992 and 1991 these amounts were immaterial. Certain items previously reported for years prior to 1993 have been reclassified to conform with the current-year presentation. Regulation. CIPS is a public utility subject to regulation by the Illinois Commerce Commission (Illinois commission) and the Federal Energy Regulatory Commission (FERC). With respect to accounting matters, the utility maintains its accounts in accordance with the Uniform System of Accounts as defined by these agencies. Its accounting policies conform to generally accepted accounting principles applicable to rate regulated enterprises and reflect the effects of the ratemaking process. Operating Revenues. CIPS accrues an estimate of electric and gas revenues for service rendered but unbilled at the end of each accounting period. Utility Plant. Utility plant in service is stated at original cost. Substantially all of the utility plant of CIPS is subject to the lien of its first mortgage bond indenture. Additions to utility plant include the cost of contracted services, material, labor, overheads and an allowance for funds used during construction. Maintenance and repair of property and replacement of minor items of property are charged to operating expenses. Property retired is removed from utility plant accounts and charged to accumulated depreciation. Allowance for Funds Used During Construction (AFUDC). AFUDC is included in Construction Work in Progress (CWIP) and represents the cost of financing that construction. AFUDC does not represent a current source of cash funds. The inclusion of AFUDC in CWIP affords the opportunity to earn a return on the cost of construction capital after the related asset is placed in service and included in the rate base. The AFUDC rate, based on a formula prescribed by the FERC, on a before- tax basis, was 9% in 1993 and 10% in 1992 and 1991. Depreciation. Depreciation expense is based on remaining life straight-line rates (composite, approximately 3.4% in 1993 and 3.3% in 1992 and 1991) applied to the various classes of depreciable property. Concentration of Credit Risk. CIPS provides electric service to about 316,000 customers in 557 communities and natural gas service to approximately 164,000 customers in 267 communities throughout a 20,000-square-mile area in central and southern Illinois. Credit risk is spread over a diversified base of residential, commercial and industrial customers. Fuel and Purchased Gas Costs. CIPS adjusts fuel expense to recognize over- or under-recoveries from customers of allowable fuel costs through the uniform fuel adjustment clause (FAC). The FAC provides for the current recovery of changes in the cost of fuel for electric generation in billings to customers. Monthly, the difference between revenues recorded through application of the FAC and recoverable fuel costs is recorded as a current asset or liability, pending reflection in future billings to customers, with a corresponding decrease or increase in cost of fuel for electric generation. The uniform purchased gas adjustment clause (PGA) provides a matching of gas costs with revenues. Monthly, the difference between revenues recorded through application of the PGA and recoverable gas costs is recorded as a current asset or liability with a corresponding decrease or increase in the cost of gas purchased. The cumulative difference for the calendar year is collected from, or refunded to, customers over a one-year period beginning in the following April. The Illinois commission conducts annual reconciliation proceedings with respect to each year's FAC and PGA revenues and has completed its review for all years prior to 1992. Reconciliation proceedings for 1992 commenced in October 1993. No reconciliation proceeding has yet commenced for the year 1993. Income Taxes and Investment Tax Credits. Deferred income taxes are recorded which result from the use of accelerated depreciation methods, rapid amortization, repair allowance and certain other timing differences in recognition of income and expense for tax and financial statement purposes. CIPS is included as part of CIPSCO's consolidated federal income tax return. Income taxes are allocated to the individual companies, based on their respective taxable income or loss. Investment tax credits are being amortized over the estimated average useful lives of the related properties. The Company adopted, effective January 1, 1993, the liability method of accounting for deferred income taxes required by Statement of Financial Accounting Standards (SFAS) No. 109. This statement requires the establishment of deferred tax liabilities and assets for all temporary differences between the tax basis of assets and liabilities and the amounts reported in the financial statements. (See Note 9 to Financial Statements.) Cash and Temporary Investments. Temporary investments consist of deposits and U.S. Treasury obligations. For purposes of Statements of Cash Flows, temporary investments are not considered cash equivalents. 2. COMMITMENTS AND CONTINGENCIES Environmental Remediation Costs. The utility and certain of its predecessors and other affiliates operated facilities in the past for manufacturing gas from coal. In connection with manufacturing gas, various by-products were produced, some of which remain on sites where the facilities were located. The utility has identified 13 of these former manufactured gas plant sites (environmental remediation sites) which contain potentially harmful materials. Under directives from the Illinois Environmental Protection Agency (IEPA), CIPS has incurred costs and associated legal expenses related to the investigation and remediation of the sites. One site was added to the United States Environmental Protection Agency (USEPA) Superfund list on August 30, 1990. On September 30, 1992 the IEPA, in consultation with the USEPA, decided that the long-term remedial plan for this site should consist of a ground water pump-and-treat program. The IEPA and CIPS entered into an agreement, subject to court approval, for CIPS to carry out the remedial action with the IEPA providing oversight. It is not known at this time what specific remedial action will be required at the other 12 sites. In 1987, CIPS filed a lawsuit against a number of insurance carriers seeking full indemnification for all costs in connection with certain environmental sites. As of December 31, 1993 all but five insurance carriers have settled. The estimated incurred costs relating to studies and remediation at these 13 sites and associated legal expenses are being accrued and deferred rather than expensed currently, pending recovery through rates, from insurance carriers or from other parties. The total amount deferred represents costs incurred and estimates for costs of completing studies at various sites and an estimate of remediation costs at the Superfund site. At December 31, 1993, the amounts recovered have exceeded the aggregate amount deferred. In 1992, the Illinois commission issued an Order (the Generic Order) in its consolidated generic proceeding regarding appropriate ratemaking treatment of cleanup costs incurred by Illinois utilities with respect to environmental remediation sites. The Generic Order indicates that allowed cleanup costs may include prudently incurred cost of investigation, assessment and cleanup of environmental remediation sites, as well as litigation costs, including those involved in insurance recovery claims. The Generic Order authorizes utilities, including CIPS, to propose a mechanism to recover cleanup costs which is consistent with the provisions of the order. Such a mechanism must, among other things, provide for (1) recovery of cleanup costs over a five-year period, excluding carrying costs associated with the unrecovered balance of cleanup costs from the time that the recovery mechanism becomes effective; (2) a return to ratepayers over a five-year amortization period of any reimbursement of cleanup costs received from insurance carriers or other parties; and (3) a prudence review of each utility's expenditures. The Generic Order was upheld on appeal by the Third District Illinois Appellate Court. That decision held that a rate rider mechanism is an appropriate means for utilities to recover cleanup costs. An intervenor has filed a petition for leave to appeal the decision to the Illinois Supreme Court. The intervenor has maintained that no recovery of cleanup costs should be allowed. The Illinois Supreme Court has discretion to accept or deny the appeal. On March 26, 1993, the Illinois commission approved CIPS' proposed environmental cost-recovery rate riders, effective with April 1993 billings to customers. Known as the electric environmental adjustment clause and the gas environmental adjustment clause, the riders are designed to enable CIPS to recover from its customers costs associated with cleanup of the environmental remediation sites, along with associated legal expenses, over a five-year period on terms consistent with the Generic Order. The environmental adjustment clause riders provide for an annual review of amounts recovered through the riders. Amounts found to have been incorrectly included would be subject to refund. Through December 31, 1993, CIPS has collected $2.6 million from its customers pursuant to the riders. The total costs to be incurred for the cleanup of these sites or the possible recovery from insurance carriers and other parties cannot be estimated. Management believes that costs incurred in connection with the sites that are not recovered from insurance carriers or other parties will be recovered through utility rates. Accordingly, management believes that costs incurred in connection with these sites will not have a material adverse effect on financial position or results of operations. FERC Order 636. During 1992, FERC issued a series of orders that require substantial restructuring of the service obligations of interstate pipeline suppliers. These orders (together called Order 636) required mandatory unbundling of existing pipeline gas sales services. Mandatory unbundling requires pipelines to sell separately the various components previously included with gas sales services. Order 636 provides a mechanism for pipelines to recover four categories of transition costs associated with restructuring their gas sales services. Based on currently available information contained in the various interstate pipeline Order 636 compliance filings, CIPS estimates that the total amount of transition costs to be incurred by CIPS is approximately $10 million. At December 31, 1993 CIPS had recorded a liability and a related deferred gas cost for that portion of the transition costs that will be billed to CIPS regardless of future pipeline services. On September 15, 1993, the Illinois commission initiated an investigation into the appropriate ratemaking treatment of Order 636 transition costs. In January 1994, the hearing examiner released a draft order which would allow full recovery through rates by CIPS of transition costs. A final order from the Illinois commission is expected in the first quarter 1994. Management believes that all transition costs will be recoverable from customers. Clean Air Act. CIPS' compliance strategy to meet the sulfur dioxide emission reduction requirements of the Clean Air Act Amendments of 1990 (Amendments) includes complying with Phase I of the Amendments by switching to a lower sulfur coal at some of its units. Phase II compliance will be accomplished by additional fuel switching at various units and by increased scrubbing with its existing scrubber at Newton Unit 1. Phase I and Phase II emission provisions of the Amendments become effective in 1995 and 2000, respectively. The utility estimates that total capital costs, primarily for modifications to boilers, precipitators, coal handling facilities, and continuous monitoring equipment for implementation of this compliance strategy, will be less than $50 million in total including amounts spent to date. Operating costs are not expected to change materially. Compliance costs could result in electric base rate increases of approximately one to two percent by the year 2000. In 1991, in accordance with the plan to switch some units to lower sulfur coal, the utility signed a long-term coal contract with a current supplier for lower sulfur Illinois coal. Due to the magnitude of the supplier's capital investment, the contract includes a graduated termination charge. In 1994 CIPS can terminate the contract under certain conditions, and CIPS would be required to pay up to $41 million (plus an inflation adjustment) in termination charges. Each year subsequent to 1994 the termination charge is reduced according to a formula using tons of coal purchased. The termination charge would not be effective if CIPS terminated the contract due to the failure of the coal to meet quality specifications provided for in the contract. Labor Disputes. The International Union of Operating Engineers Local 148 and the International Brotherhood of Electric Workers Local 702 have both filed unfair labor practice charges with the National Labor Relations Board (NLRB) relating to the legality of the lockout by CIPS of both unions during 1993. The Peoria Regional Office of the NLRB has issued a complaint against CIPS concerning its lockout of IBEW-702 represented employees. However, the Peoria Regional Office did not find merit to a similar charge filed by IUOE 148 and it has been dismissed, subject to appeal rights. Both unions seek, among other things, back pay and other benefits for the period of the lockout. CIPS estimates the amount of back pay and other benefits for both unions to be less than $12 million. Management believes the lockout was both lawful and reasonable and that the final resolution of the disputes will not have a material adverse effect on financial position or results of operations. Other Issues. The utility is involved in other legal and administrative proceedings before various courts and agencies with respect to rates, taxes, gas and electric fuel cost reconciliations, service area disputes, environmental and other matters. Although unable to predict the outcome of these matters, management believes that appropriate liabilities have been established and that final disposition of these actions will have no material adverse effect on the results of operations or the financial position of CIPS. 3. PREFERRED STOCK The preferred stock is generally redeemable at the option of CIPS on 30 days notice at the redemption prices shown below. At December 31, 1993, 1992 and 1991 the preferred stock outstanding was: 4. PENSIONS AND OTHER POSTRETIREMENT BENEFITS CIPS sponsors a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and employees' final average pay. Pension costs are accrued and funded on a current basis based upon actuarial determinations and in compliance with income tax regulations and federal funding requirements. CIPS uses a September 30 measurement date for its valuation of pension plan assets and liabilities. The utility also provides certain employees with pension benefits which exceed the qualified plan limits imposed by federal tax law. Funded Status of Pension Plan (in thousands) 1993 1992 1991 _________ _________ ____________ Fair value of plan assets* $177,824 $150,729 $127,075 _______ _______ _______ Accumulated benefit obligations:** Vested benefits 125,641 98,770 78,515 Nonvested benefits 559 284 212 Effect of projected future compensation levels (based on 4.3% annual increases in 1993, 4.5% in 1992 and 5% in 1991) 41,214 37,025 36,791 _______ _______ _______ Total projected benefit obligation 167,414 136,079 115,518 _______ _______ _______ Plan assets in excess of projected benefit obligation $ 10,410 $ 14,650 $ 11,557 ======= ======= ======= ________________________ * Plan assets are invested in common and preferred stocks, bonds, money market instruments, guaranteed income contracts and real estate. ** The assumed weighted average discount rate was 6.50% for 1993, 7.25% for 1992 and 7.75% for 1991. Pension Plan Assets in Excess of Projected Benefit Obligation (in thousands) 1993 1992 1991 _________ _________ ____________ Plan assets in excess of projected benefit obligation $ 10,410 $ 14,650 $ 11,557 Unrecognized transition asset (being amortized over 18.2 years) (4,862) (5,325) (5,772) Unrecognized net (gain) loss (5,188) (13,617) (14,756) Unrecognized prior service cost 760 1,590 1,703 _______ _______ _______ Prepaid (Accrued) pension costs at September 30 1,120 (2,702) (7,268) Expense, net of funding October to December 1,944 91 (1,347) _______ _______ _______ Prepaid (Accrued) pension costs at December 31 $ 3,064 $ (2,611) $ (8,615) ======= ======= ======= Components of Net Pension Expense (in thousands) 1993 1992 1991 _________ _________ ____________ Service cost (present value of benefits earned during the year) $ 6,398 $ 5,721 $ 6,467 Interest cost on projected benefit obligation 10,193 9,302 8,583 Actual return on plan assets (expected long-term rate of return was 8%) (21,101) (13,755) (19,490) Deferred investment gains 10,071 4,834 11,167 Amortization of the unrecognized prior service cost 118 118 118 Amortization of the transition amount (463) (463) (463) _______ _______ _______ Net pension expense $ 5,216 $ 5,757 $ 6,382 ======= ======= ======= Effective January 1, 1993, CIPS adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The standard requires companies to recognize the cost of providing postretirement medical and life insurance benefits over the employees' service period. CIPS is funding the medical benefits under two Voluntary Employee Beneficiary Association trusts (VEBA), and a 401(h) account established within the Company's retirement income trust. The Company sponsors postretirement plans providing medical and life benefits for certain of its retirees and their eligible dependents. The medical plan pays percentages of eligible medical expenses incurred by covered retirees after a deductible has been met, and after taking into account payment by Medicare or other providers. Currently, participants become eligible for coverage if they retire from CIPS after meeting age and years of service eligiblity requirements. The life insurance plan continues for all retirees who have been in the plan as employees for ten years or more. CIPS uses a September 30 measurement date for its valuation of postretirement assets and liabilities. Funded Status of Postretirement Benefit Plans (in thousands) _________ Fair value of plan assets* $ 13,302 ________ Accumulated benefit obligations: Retirees 39,599 Fully eligible active employees 17,026 Other active employees 80,532 ________ Total accumulated benefit obligation 137,157 ________ Accumulated benefit obligations in excess of plan assets (123,855) Unrecognized transition obligation (being amortized over 20 years) 110,511 Unrecognized net loss (including changes in assumptions) 1,959 ________ Accrued postretirement benefit cost at September 30 (11,385) Expense, net of funding, October to December 9,643 ________ Accrued postretirement benefit cost at December 31 $ (1,742) ======== * Plan assets are invested in common and preferred stocks, bonds, money market instruments, guaranteed income contracts and real estate. Components of Postretirement Benefit Cost (in thousands) _________ Service costs on benefits earned $ 4,215 Interest costs on accumulated benefit obligations 9,948 Actual return on plan assets (1,038) Deferred investment gains 397 Amortization of the transition amount 5,816 _______ Postretirement benefit cost $ 19,338 ======= For purposes of calculating the postretirement benefit obligation it is assumed that health-care costs will increase by 12.75% in 1994, and that the rate of increase thereafter (the health-care cost trend rate) will decline to 4.25% in 2007 and subsequent years. The health-care cost trend rate has a significant effect on the amounts reported for costs each year as well as on the accumulated postretirement benefit obligation. To illustrate, increasing the assumed health-care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of September 30, 1993 by $20.2 million and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost $2.7 million annually. The weighted-average discount rate used to determine the accumulated postretirement benefit obligation was 7 percent. The expected long-term rate of return on plan assets is 8 percent. In March 1992, CIPS was granted rates by the Illinois commission which included its estimated postretirement costs determined on an accrual basis of accounting. CIPS' financial reporting for postretirement costs is consistent with the related rate treatment. Therefore, adoption of SFAS No. 106 did not have a material effect on financial position or results of operations. The Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," in 1993. The new statement required the accrual of certain postemployment benefits to former or inactive employees. The adoption of SFAS No. 112 did not have a material effect on financial position or results of operations. 5. LONG-TERM DEBT Maturities and sinking fund requirements of CIPS' long-term debt through 1998 are as follows: Sinking Fund Maturities Requirements Total __________ ____________ _______ (in thousands) 1994 $20,000 $300 $20,300 1995 15,000 150 15,150 1996 - 150 150 1997 58,000 - 58,000 1998 - - - In 1993 and 1992 the sinking fund requirements were satisfied by the application of net expenditures for bondable property in an amount equal to 166-2/3 percent of the annual requirement. The utility expects to meet the 1994 requirement in the same manner. Long-term debt outstanding at December 31, excluding maturities due within one year, was: 1993 1992 Amount Amount ______ ______ (in thousands) First mortgage bonds (principal amount): Series J, 4 1/2% due 5/1/1994 $ - $20,000 Series K, 4 5/8% due 6/1/1995 15,000 15,000 Series L, 5 7/8% due 5/1/1997 15,000 15,000 Series N, 7 1/2% due 4/1/2001 - 35,000 Series P, 7 1/2% due 5/1/2002 - 30,000 Series 6 5/8% due 8/1/2009 (for Newton pollution control) 1,000 1,000 Series W, 7 1/8% due 5/15/1999 50,000 50,000 Series W, 8 1/2% due 5/15/2022 33,000 33,000 Series X, 6 1/8% due 7/1/1997 43,000 43,000 Series X, 7 1/2% due 7/1/2007 50,000 50,000 Series Y, 6 3/4% due 9/15/2002 23,000 23,000 Series Z, 6% due 4/1/2000 25,000 - Series Z, 6 3/8% due 4/1/2003 40,000 - _______ _______ 295,000 315,000 _______ _______ 1993 1992 Amount Amount ______ ______ (in thousands) Pollution control loan obligations: Series A, 5.85% due 10/1/2007 - 60,000 Series B, 6.80% due 4/1/2005 - 17,500 Series B, 6 7/8% due 4/1/2009 - 17,500 Series C, 6 5/8% due 8/1/2004 - 20,000 Series C, 6 3/4% due 8/1/2009 - 15,000 1990 Series A, 7.60% due 3/1/2014 20,000 20,000 1990 Series B, 7.60% due 9/1/2013 32,000 32,000 1993 Series A, 6 3/8% due 1/1/2028 35,000 - 1993 Series B-1, 4 3/8% due 6/1/2028 17,500 - 1993 Series B-2, 5.90% due 6/1/2028 17,500 - 1993 Series C-1, 4.20% due 8/15/2026 35,000 - 1993 Series C-2, 5.70% due 8/15/2026 25,000 - _______ _______ 182,000 182,000 _______ _______ Unamortized net debt premium and discount (2,677) (3,300) _______ _______ $474,323 $493,700 ======= ======= Interest rates on the 1993 Series B-1 and 1993 Series C-1 bonds will be adjusted to a then current market rate on June 1, 1998 and August 15, 1998, respectively. Interest rates on the 1993 Series B-2 and 1993 Series C-2 bonds are subject to redetermination at the option of the utility commencing June 1, 2003 and August 15, 2003, respectively. 6. COMMON SHAREHOLDER'S EQUITY Common Stock. The authorized common stock, no par value, for CIPS was 45,000,000 shares as of December 31, 1993, 1992 and 1991. All outstanding shares were exchanged with CIPS shareholders for CIPSCO Incorporated stock on October 1, 1990. Since then, CIPSCO Incorporated which holds all CIPS common shares, has been retiring CIPS shares as detailed in the table below: Retained Earnings. CIPS is subject to restrictions on the use of retained earnings for cash dividends on common stock applicable to all corporations under the Illinois Business Corporation Act, as well as those contained in its mortgage indenture and articles of incorporation. At December 31, 1993, 1992 and 1991, no amount of retained earnings was restricted. 7. LINES OF CREDIT AND SHORT-TERM BORROWINGS CIPS has arrangements for bank lines of credit which totaled $77.9 million. CIPS compensates banks for lines of credit totaling $60 million. The bank lines of credit are for corporate purposes including the support of any commercial paper borrowings. At December 31, 1993 there were no short- term borrowings at CIPS. 8. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value at December 31, 1993 and 1992 of each class of financial instruments for which it is practicable to make such estimates. Cash and Temporary Investments - The carrying amounts approximate fair value because of the short-term maturity of these instruments. Short-Term Borrowings - The carrying amounts approximate fair value due to their short-term maturities. Preferred Stock - The fair value was estimated using market values provided by independent pricing services. Long-Term Debt - The fair value was estimated using market values provided by independent pricing services. The estimated fair value of the Company's financial instruments as of December 31, are shown below: 1993 1992 _________________ _________________ Carrying Fair Carrying Fair Value Value Value Value ________ _____ ________ _____ (in thousands) Preferred Stock $ 80,000 $ 68,403 $ 65,000 $ 50,519 Long-Term Debt 474,323 504,478 493,700 514,912 9. INCOME TAXES The Company adopted the liability method of accounting for deferred income taxes in compliance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" effective January 1, 1993. Due to rate regulation, adoption of this statement had an immaterial effect on net income. However, the adoption resulted in a balance sheet reduction of $81.3 million of deferred income taxes along with corresponding balance sheet increases of $95.3 million of regulatory liabilities, net, and $14 million of plant assets. Income tax expense continues to include provisions for deferred taxes to reflect the effect of temporary differences between the time certain costs are recorded for financial reporting and when they are deducted for income tax return purposes. As temporary differences reverse, the related accumulated deferred income taxes and a portion of the regulatory assets and liabilities are also reversed. Investment tax credits have been deferred and will continue to be credited to income over the lives of the related property. The components of federal and state income tax provisions and investment tax credits at December 31, were: 1993 1992 1991 ________ ________ ________ (in thousands) Current - - Federal $ 42,422 $ 6,859 $ 29,950 - - State 8,019 (749) 6,366 _______ _______ _______ 50,441 6,110 36,316 _______ _______ _______ Deferred - - Federal 1,483 26,551 5,800 - - State 191 7,447 1,773 _______ _______ _______ 1,674 33,998* 7,573* _______ _______ _______ Amortization of deferred investment tax credits (3,366) (3,336) (3,464) _______ _______ _______ Total 48,749 36,772 40,425 _______ _______ _______ Nonoperating income taxes: Current 1,119 2,411 1,629 Deferred (488) 578 784 _______ _______ _______ 631 2,989 2,413 _______ _______ _______ Total income taxes $ 49,380 $ 39,761 $ 42,838 ======= ======= ======= 1992 1991 ______ ______ (in thousands) *Detail of Deferred Taxes: Excess of tax depreciation and amortization over book $ 5,566 $ 7,465 Unbilled revenues - - Revenue refunds 29,526 (6,259) Deferred fuel cost (2,921) 2,030 Deferred environmental site cleanup costs 62 2,243 Alternative minimum tax credit carryforward (4,449) - Cost of removal 3,108 731 Unamortized loss on reacquired debt 3,561 (72) Miscellaneous (455) 1,435 _______ _______ Total $ 33,998 $ 7,573 ======= ======= Reconciliations with statutory federal income tax rates at December 31 were: 1993 1992 1991 ---- ---- ---- Effective income tax rate 37.0% 35.4% 36.1% Amortization of investment tax credits 2.5 3.0 2.9 Tax exempt interest and dividends .7 1.3 1.9 Out-of-period items (0.1) (0.6) (1.8) State income tax rate, net of federal income tax benefit (4.0) (4.2) (4.8) Other, net (1.1) (0.9) (0.3) ____ ____ ____ Statutory federal income tax rate 35.0% 34.0% 34.0% ==== ==== ==== The components of deferred income taxes at December 31 and January 1, 1993 are: December 31, 1993 January 1, 1993 _________________ _______________ (in thousands) Accumulated deferred income tax liabilities related to: Depreciable propeprty $316,327 $298,089 Investment tax credits (23,500) (24,145) Regulatory liabilities, net (27,423) (37,148) Other 9,021 11,773 _______ _______ Accumulated deferred income taxes per balance sheet $274,425 $248,569 ======= ======= Deferred tax assets (included in prepayments $ 5,977 $ 7,155 ======= ======= 10. SEGMENTS OF BUSINESS CIPS is a public utility engaged in the sale of electricity which it generates, transmits and distributes. CIPS also sells natural gas, which it purchases from producers and suppliers and distributes through its system, and transports customer-owned natural gas. The following is a summary of operations: Years Ended December 31, _________________________________ 1993 1992 1991 ______ ______ ______ (in thousands) OPERATING INFORMATION Electric operations: Operating revenues $ 688,849 $ 595,642 $ 592,669 Operating expenses, excluding provision for income taxes 534,070 472,414 455,366 _________ _________ _________ Pretax operating income 154,779 123,228 137,303 _________ _________ _________ Gas operations: Operating revenues 145,707 133,760 117,536 Operating expenses, excluding provision for income taxes 138,086 122,844 110,375 _________ _________ _________ Pretax operating income 7,621 10,916 7,161 _________ _________ _________ Total 162,400 134,144 144,464 _________ _________ _________ Plus other income and deductions 4,460 10,151 13,113 Less interest charges 34,100 34,922 41,469 Less income taxes 48,749 36,772 40,425 Less preferred dividends 3,718 4,549 5,396 _________ ________ _________ Earnings for common stock $ 80,293 $ 68,052 $ 70,287 ========= ========= ========= Depreciation expense: Electric $ 71,876 $ 68,902 $ 64,880 Gas 5,771 5,252 4,603 _________ ________ _________ Total $ 77,647 $ 74,154 $ 69,483 ========= ========= ========= INVESTMENT INFORMATION Identifiable assets: Electric $1,459,073 $1,443,578 $1,419,036 Gas 177,857 188,321 157,757 Temporary investments 2,734 2,578 94,753 Corporate 28,798 10,582 20,297 _________ ________ _________ Total $1,668,462 $1,645,059 $1,691,843 ========= ========= ========= Construction expenditues: Electric $ 76,956 $ 103,023 $ 99,004 Gas 10,756 17,401 14,878 _________ ________ _________ Total $ 87,712 $ 120,424 $ 113,882 ========= ========= ========= 11. REVENUES COLLECTED SUBJECT TO REFUND In May 1992, the Illinois commission approved a March 18, 1992 settlement agreement that resolved a proceeding regarding the impact on the utility of the reduced federal corporate income tax rates established by the Tax Reform Act of 1986. Under terms of the agreement, $73 million, including accrued interest, was refunded to customers from July through December 1992 in complete settlement of all issues related to the proceeding. For the 61-month period, March 1987 through March 1992, a total of $78.4 million had been accrued for refunds. The total liability recorded by the utility exceeded the settlement agreement amount by $5.4 million resulting in a $3.3 million (net of taxes) favorable impact on earnings during 1992. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The fluctuations in the quarterly results are due to the seasonal nature of the electric and gas utility business. Total Total Earnings Operating Operating for Common Revenues Income Stock _________ _________ __________ (in thousands) Quarters First $209,548 $ 24,726 $ 15,774 Second 187,385 20,093 11,610 Third 232,104 46,204 38,172 Fourth 205,519 22,628 14,737 First 182,208 17,055 10,884 Second 165,104 21,859 15,634* Third 187,154 38,129 29,441 Fourth 194,936 20,329 12,093 * Quarterly earnings reflect adjustment for settling Revenues Subject to Refund proceeding. See Note 11 to Notes to Financial Statements. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Central Illinois Public Service Company: We have audited the accompanying balance sheets of CENTRAL ILLINOIS PUBLIC SERVICE COMPANY (an Illinois corporation and a wholly owned subsidiary of CIPSCO Incorporated) as of December 31, 1993 and 1992, and the related statements of income, retained earnings and cash flows 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 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 Public Service 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. Our audits were made for the purpose of forming an opinion on the basic financial 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 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. Chicago, Illinois, January 28, 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. The information required by Item 10 relating to each director who is a nominee for election as director at the Company's 1994 Annual Meeting of Shareholders is to be set forth in the Company's definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "proxy statement") in connection with the Company's Annual Meeting of Shareholders. Such information is incorporated herein by reference to the material appearing under the caption "Election of Directors -- Director Information" in the proxy statement. Information required by Item 10 relating to directors and executive officers of the Company is set forth under a separate caption in Part I hereof. Item 11. Item 11. Executive Compensation. The information required by Item 11 is to be set forth in the proxy statement. Such information is incorporated herein by reference to the material appearing under the caption "Election of Directors -- Executive Compensation" and -- "Directors' Compensation" appearing in the proxy statement; provided, however, that no part of the information appearing under the portion of the proxy statement entitled "Election of Directors -- Compensation Committee Report on Executive Compensation" or -- "Performance Graph" is deemed to be filed as part of this Form 10-K Annual Report. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by Item 12 is to be set forth in the proxy statement. Such information is incorporated herein by reference to the material appearing under the captions "Voting Securities Beneficially Owned by Principal Holders, Directors, Nominees and Executive Officers" and "Election of Directors -- Director Information" appearing in the proxy statement. Item 13. Item 13. Certain Relationships and Related Transactions. CIPS is a subsidiary of CIPSCO. At December 31, 1993, CIPSCO owned 100% of the common stock of CIPS (representing 97% of the voting shares of CIPS). There are situations where CIPS interacts with its affiliated companies through the use of shared facilities, common employees and other business relationships. In these situations, CIPS receives payment in accordance with regulatory requirements for the services provided to affiliated companies. Each individual who is a member of the Board of Directors of CIPSCO is also a member of the Board of Directors of CIPS. Each of the officers of CIPSCO is also an officer of CIPS. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. Page of this Report on Form 10-K ____________ (a) 1. Financial statements (included in Item 8, Financial Statements and Supplementary Data): Statements of Income for the years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . 126-127 Balance Sheets - December 31, 1993 and 1992 . . . . . 128-129 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . 130-131 Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991. . . . . . . . 132 Notes to Financial Statements . . . . . . . . . . . . 133-152 Report of Independent Public Accountants. . . . . . . 153 (a) 2. Schedules supporting financial statements (included herein): Schedule V - Property, Plant and Equipment at Original Cost for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . 159-161 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equip- ment for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . 162-164 Schedule IX - Short-Term Borrowings for the years ended December 31, 1993, 1992 and 1991. . . . . . 165 Schedule X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . 166 All other schedules have been omitted as not applicable or not required or because the information required to be shown therein is included in the financial statements or notes thereto. Page of this Report on Form 10-K ____________ (a) 3. Exhibits 3.01 Amended and Restated Articles of Incorporation, as amended, of CIPS. (Exhibit 3.02 to Form 8-K, dated October 8, 1993). Incorporated by Reference. - 3.02 Bylaws of CIPS (Form 10-Q of the Company (1-3672), June 1990, Exhibit 19) Incorporated by Reference. - 4 Indenture of Mortgage or Deed of Trust dated October 1, 1941, from CIPS to Continental Illinois National Bank and Trust Company of Chicago and Edmond B. Stofft, as Trustees. (Exhibit 2.01 in File No. 2-60232.) Supplemental Indentures dated, respectively September 1, 1947, January 1, 1949, February 1, 1952, September 1, 1952, June 1, 1954, February 1, 1958, January 1, 1959, May 1, 1963, May 1, 1964, June 1, 1965, May 1, 1967, April 1, 1970, April 1, 1971, September 1, 1971, May 1, 1972, December 1, 1973, March 1, 1974, April 1, 1975, October 1, 1976, November 1, 1976, October 1, 1978, August 1, 1979, February 1, 1980, February 1, 1986, May 15, 1992, July 1, 1992, September 15, 1992 and April 1, 1993, between CIPS and the Trustees under the Indenture of Mortgage or Deed of Trust referred to above (Amended Exhibit 7(b) in File No. 2-7341; Second Amended Exhibit 7.03 in File No. 2-7795; Second Amended Exhibit 4.07 in File No. 2-9353; Amended Exhibit 4.05 in file No. 2-9802; Amended Exhibit 4.02 in File No. 2-10944; Amended Exhibit 2.02 in File No. 2-13866; Amended Exhibit 2.02 in File No. 2-14656; Amended Exhibit 2.02 in File No. 2-21345; Amended Exhibit 2.002 in File No. 2-22326; Amended Exhibit 2.02 in File No. 2-23569; Amended Exhibit 2.02 File No. 2-26284; Amended Exhibit 2.02 in File No. 2-36388; Amened Exhibit 2.02 in File No. 2-39587; Amended Exhibit 2.02 in File No. 2-41468; Amended Exhibit 2.02 in File No. 2-43912; Exhibit 2.03 in File No. 2-60232; Amended Exhibit 2.02 in File No. 2-50146; Amended Exhibit 2.02 in File No. 2-52886; Second Amended Exhibit 2.04 in File No. 2-57141; Amended Exhibit 2.04 in File No. 2-57557; Amended Exhibit 2.06 in File No. 2-62564; Exhibit 2.02(a) in File No. 2-65914; Amended Exhibit 2.02(a) in File No. 2-66380; and Amended Exhibit 4.02 in File No. 33-3188; Exhibit 4.02 to Form 8-K dated May 15, 1992; Exhibit 4.02 to Form 8-K dated July 1, 1992; Exhibit 4.02 to Form 8-K dated September 15, 1992; Exhibit 4.02 to Form 8-K dated March 30, 1993.) Incorporated by reference. - Page of this Report on Form 10-K ____________ Exhibits (Continued) 10.01 Form of Deferred Compensation Agreement for Directors . . . - (Exhibit 10.01 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.02 Amended Form of Deferred Compensation Agreement for . . . . 168-174 Directors 10.03 Form of Special Executive Retirement Plan . . . . . . . . . - (Exhibit 10.03 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.04 Amendment to Form of Special Executive Retirement . . . . . 175 Plan 10.05 Form of Employment Agreement (change in control . . . . . . - severance agreement) (Exhibit 10.05 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.06 Form of Director's Retirement Income Plan . . . . . . . . . - (Exhibit 10.06 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.07 Form of Excess Benefit Retirement Plan. . . . . . . . . . . - (Exhibit 10.07 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 10.08 Amendment to Form of Excess Benefit Retirement. . . . . . . 176 Plan 10.09 Form of Management Incentive Plan . . . . . . . . . . . . . - (Exhibit 10.09 filed with 1990 Annual Report on Form 10-K) Incorporated by Reference. 12 Computation of Ratio of Earnings to Fixed Charges . . . . . 177 21 Subsidiaries of Registrant. . . . . . . . . . . . . . . . . 178 Page of this Report on Form 10-K ____________ Exhibits (Continued) 23 Consent of Independent Public Accountants . . . . . . . . . 179 24 Powers of Attorney. . . . . . . . . . . . . . . . . . . . . 180-187 99 Description of Capital Stock. . . . . . . . . . . . . . . . 188-189 Exhibits 10.01 through 10.09 are management contracts or compensatory plans or arrangements required to be filed as exhibits pursuant to Item 14(c) hereof. The following instruments defining the rights of holders of certain unregistered long-term debt of CIPS have not been filed with the Securities and Exchange Commission but will be furnished upon request. 1. Loan Agreement dated as of March 1, 1990, between CIPS and the Illinois Development Finance Authority (IDFA) in connection with the IDFA's $20,000,000 Pollution Control Revenue Refunding Bonds, 1990 Series A due March 1, 2014 and $32,000,000 Pollution Control Revenue Refunding Bonds, 1990 Series B due September 1, 2013. 2. Loan Agreement dated January 1, 1993, between CIPS and IDFA in connection with IDFA's $35,000,000, 6-3/8% Pollution Control Revenue Refunding Bonds (Central Illinois Public Service Company Project) 1993 Series A, due January 1, 2028. 3. Loan Agreement dated June 1, 1993, between CIPS and IDFA in connection with IDFA's $17,500,000 Pollution Control Revenue Refunding Bonds, 1993 Series B-1 due June 1, 2028 and $17,500,000 Pollution Control Revenue Refunding Bonds, 1993 Series B-2 due June 1, 2028. 4. Loan Agreement dated August 15, 1993, between CIPS and IDFA in connection with IDFA's $35,000,000 Pollution Control Revenue Refunding Bonds, 1993 Series C-1 due August 15, 2026 and $25,000,000 Pollution Control Revenue Refunding Bonds, 1993 Series C-2 due August 15, 2026. 5. CIPS Credit Agreement dated October 1, 1992 with various banks providing unsecured lines of credit in an aggregate amount of $60,000,000. (b) Reports on Form 8-K (filed during the reporting period): Date of Report Item Reported ______________ _____________ October 8, 1993 Item 7. Financial Statements, Pro Forma Financial Information and Exhibits. Contains certain exhibits filed in connection with the Registration Statements of CIPS (Registration Nos. 33-59674 and 33-50349) which became effective March 29, 1993 and September 30, 1993, respectively. (c) Reports on Form 8-K (filed subsequent to the reporting period): None. SCHEDULE X CENTRAL ILLINOIS PUBLIC SERVICE COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (in thousands) = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = Column A Column B Charged to Costs and Expenses _____________________________ 1993 1992 1991 ____ ____ ____ Taxes other than income taxes: Real estate . . . . . . . . . . . . . . $ 7,517 $ 7,055 $ 7,301 Invested capital. . . . . . . . . . . . 8,876 8,888 8,989 Gross receipts and public utility . . . 30,961 27,207 30,150 Payroll . . . . . . . . . . . . . . . . 6,980 7,617 6,960 Other . . . . . . . . . . . . . . . . . 433 339 536 _______ _______ _______ $ 54,767 $ 51,106 $ 53,936 ======= ======= ======= The amounts charged to the respective accounts for royalties, advertising, and depreciation and amortization of intangible assets, preoperating costs and similar deferrals each aggregated less than one percent 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. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY (Registrant) By C. L. GREENWALT _____________________________________ C. L. Greenwalt President and Chief Executive Officer Date: March 10, 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 date indicated. Signature Title Principal Executive Officer: C. L. GREENWALT President and Chief Executive Officer and Director Principal Financial Officer: R. W. JACKSON Senior Vice President and Secretary, Director and as Attorney-in-Fact* Principal Accounting Officer: J. C. FIAUSH Controller WILLIAM J. ALLEY* Director ROBERT S. ECKLEY* Director JOHN L. HEATH* Director GORDON R. LOHMAN* Director HANNE M. MERRIMAN* Director DONALD G. RAYMER* Director THOMAS L. SHADE* Director JAMES W. WOGSLAND* Director Date: March 10, 1994 EXHIBIT 10.02 A G R E E M E N T This AGREEMENT made this_______ day of _____________, 19__, by and between CENTRAL ILLINOIS PUBLIC SERVICE COMPANY, an Illinois corporation (hereinafter called the "Company"), and ____________________________ (hereinafter called the "Director"). WITNESSETH: WHEREAS, the Director is a member of the Board of Directors of the Company; and WHEREAS, the Company and the Director desire to enter into this Agreement with respect to compensation to accrue to the Director as a member of the Board of Directors commencing __________, 19__ (the "Effective Date"); NOW, THEREFORE, in consideration of the covenants and agreements hereinafter set forth it is agreed: 1. The Director shall serve diligently and honestly in the administration of the affairs of the Company during his or her service as a director. 2. As compensation for the services to be rendered by the Director to the Company, the Company shall set up on its books an account in the name of the Director to which shall be accrued, commencing with the Effective Date and continuing for the period that compensation is to be accrued hereunder, the amounts provided in subparagraphs (a) and (b) hereof. (a) There shall be accrued to the account amounts equivalent to such amounts as the Director would have received as a director of the Company as compensation for the services rendered by the Director but for this Agreement, such accruals to commence as of the respective dates payment of such amounts would have been made by the Company. (b) There shall be accrued an additional amount equivalent to such amounts as would have been available if the amount accrued to the account were invested in CIPSCO Incorporated Common Stock at the closing price as reported in the listing of the New York Stock Exchange - Composite Transactions for the trading day coincident with or next following the date payment would have been made to the Director but for this Agreement, including subsequent cash dividends on the shares of Common Stock treated as credited to the Director's account. Such cash dividends shall be treated as automatically reinvested in CIPSCO Incorporated Common Stock at the closing price as reported in the listing of the New York Stock Exchange - Composite Transactions for the trading day concident with or next following the applicable dividend payment date. Adjustments of the value of the account for appreciation or depreciation in the market value of shares of Common Stock deemed to be so held will be made on any applicable valuation date using the closing price as reported in the listing of the New York Stock Exchange - Composite Transactions. 3. The amount accrued to the Director's account shall be paid over in accordance with the provisions of this paragraph 3. (a) Commencing with the last day of the calendar quarter in which the Director shall have retired as a director of the Company and its affiliates, the Company shall pay, or commence to pay, to the Director in cash the amount accrued to his or her account as of such date. The manner of payment shall be in accordance with Payment Method 1 below or Payment Method 2 below, whichever the Director designates at the end of this Agreement as the method of payment; provided, however, that the Director may elect from time to time to change as of any January 1 his or her payment designation by filing an appropriate written direction with the Company prior to the January 1st as which the change is to be effective. A change in payment designation, however, shall only be effective with respect to amounts to be accrued to the Director's account attributable to years of service commencing on or after the effective date of such change for which compensation is accrued under Paragraph 2(a) of this Agreement. A payment designation shall be irrevocable with respect to amounts accrued to the Director's account that are attributable to years of service commencing prior to such January 1st during which the payment designation was in effect. Payment Method 1 -- The portion of the Director's account covered by this Payment Method 1 shall be paid over in equal quarterly installments, the number of which shall be the lesser of (i) 20 or (ii) the number of calendar quarters during which compensation was accrued under this Agreement and under any similar agreement with the Company or an affiliate of the Company (but not counting any such calendar quarter more than once). In addition, the Company shall pay to the Director quarterly an amount equivalent to interest on the balance of such portion of his or her account from time to time unpaid, at a rate, in respect of each quarterly payment, equal to the rate of interest obtained at the auction of six month United States Treasury Bills taking place nearest to the first day of the calendar quarter for which the payment is made. Payment Method 2 -- The portion of the Director's account covered by this Payment Method 2 shall be paid over in one of the following methods as the Company, in its sole discretion, shall determine prior to the Director's retirement after consultation with the Director: (i) By payment in a lump sum, or (ii) By payment in equal quarterly installments, the number of which shall be the lesser of (i) 20 or (ii) the number of calendar quarters during which compensation was accrued under this Agreement and under any similar agreement with the Company or an affiliate of the Company (but not counting any such calendar quarter more than once). In addition, the Company shall pay to the Director quarterly an amount equivalent to interest on the balance of such portion of his or her account from time to time unpaid at a rate, in respect of each quarterly payment, equal to the rate of interest obtained at the auction of six month United States Treasury Bills taking place nearest to the first day of the calendar quarter for which the payment is made. (b) Upon the death of the Director prior to complete distribution of the amount accrued to his or her account, any undistributed amount shall be paid in cash in a lump sum to such beneficiaries and in such proportions among them as the Director shall have designated in the latest instrument in writing filed by the Director with the Company. If there shall be no beneficiary designated or in existence at the Director's death, any undistributed amount shall be paid to the executor or administrator of the Director's estate. If the death of the Director occurs prior to retirement, the amount to be distributed shall be based on the value of his or her account as of the last day of the calendar quarter in which death occurs. 4. The Director, by filing an appropriate written direction with the Company prior to January 1 of any calendar year, may have the amounts payable for service referred to in paragraph 2 subsequent to such January 1 paid in cash. Any such direction shall be effective with respect to all future calendar years until revoked by the Director filing an appropriate written direction with the Company prior to January 1 of any calendar year to the have the amounts payable for such services subsequent to January 1 accrued hereunder. 5. The Director shall have no power to commute, encumber, sell or otherwise dispose of the rights provided herein and such rights shall be non-assignable and non-transferable. 6. This Agreement shall be binding upon and inure to the benefit of the Director, his heirs, executors and administrators, and the Company, its successors and assigns. 7. All amounts payable under this Agreement shall be paid by the Company from its general assets. No trust fund or other fund shall be created or held for the financing of such amounts. 8. Attached hereto and incorporated herein are the Elections of Director, dated the date hereof, made under this Agreement. Such elections are hereby acknowledged by the Company. IN WITNESS WHEREOF, the parties have signed this Agreement on the day and year first above written. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By______________________________ ATTEST: ________________________ Secretary _____________________________________ Director ELECTIONS INSTRUCTION: CHECK APPROPRIATE BOXES AND FILL IN BLANKS. 1. Payment Method Under Paragraph 3: Subject to my right to change my payment designation to the extent provided in Paragraph 3 of the Agreement, I designate the following method for payment of amounts accrued to my account under the Agreement: / / Payment Method 1 / / Payment Method 2 2. Beneficiary: My beneficiary(ies) are as indicated on the attached "Designation of Beneficiary." Name of Director ________________________ Date _________________________* * Date as of date Agreement is signed, same date as in caption on page 1. _______________________________ _____________________________ Name of Director Account No. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY DEFERRED COMPENSATION AGREEMENT _______________________ DESIGNATION OF BENEFICIARY 1. Pursuant to the provisions of the Deferred Compensation Agreement ("Agreement") between Central Illinois Public Service Company and me, dated _______________, 19___, I hereby designate the following as the beneficiary(ies) to whom the entire undistributed amount accrued to my account under the Agreement shall be paid in the event of my death: Address (Street, City, Birth Perct. of Full Name State & Zip Code) Relationship Date Distribution ______________ _________________ ____________ ____ ____________ ______________ _________________ ____________ ____ ____________ ______________ _________________ ____________ ____ ____________ ______________ _________________ ____________ ____ ____________ I have designated above more than one beneficiary, payment of such undistributed amount shall be made to the beneficiary(ies) surviving me in the percentage indicated; provided, however, if any beneficiary shall not survive me, such beneficiary's share shall be paid to the beneficiaries(ies) who do survive me pro-rata based on the percentages indicated. 2.If no beneficiary designated above survives me, I hereby designate the following contingent beneficiary(ies) to whom the entire undistributed amount accrued to my account under the Agreement shall be paid in the event of my death: Address (Street, City, Birth Perct. of Full Name State & Zip Code) Relationship Date Distribution ____________ _________________ _____________ ______ ____________ ____________ _________________ _____________ ______ ____________ ____________ _________________ _____________ ______ ____________ ____________ _________________ _____________ ______ ____________ If I have designated above more than one contingent beneficiary, payment of such undistributed amount shall be made to the contingent beneficiary(ies) surviving me in the percentage indicated; provided, however, if any beneficiary shall not survive me, such beneficiary's share shall be paid to the beneficiary(ies) who do survive me pro-rata based on the percentages indicated. 3. I hereby revoke any previous beneficiary designations made by me with respect to the Agreement. IN WITNESS WHEREOF, I have signed this designation in duplicate this ______________ day of ____________, 19____. ____________________________________ Signature of Director The foregoing is in accordance with our records. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By _______________________________ EXHIBIT 10.04 AMENDMENT NO. 3 TO CENTRAL ILLINOIS PUBLIC SERVICE COMPANY SPECIAL EXECUTIVE RETIREMENT PLAN The Central Illinois Public Service Company Special Executive Retirement Plan, as heretofore amended (the "Plan"), is hereby further amended, effective as of December 1, 1993, in the following respect: 1. By adding to Article III of the Plan a new paragraph L. after paragraph K. as follows: "L. VESTED BENEFIT - Each employee of an Employer on December 31, 1993 who is eligible to take normal or early retirement under the Retirement Income Plan and who on such retirement would be an eligible participant as defined in Article I shall be fully vested in his Accrued Benefit under the Plan as of December 31, 1993 subject to the terms and conditions of the Plan. For this purpose, "Accrued Benefit" means the amount of monthly benefit to which such employee would be entitled under Article II of the Plan if he terminated his employment with the Company and its affiliates as of December 31, 1993. Such employee's Accrued Benefit shall also include the amount of monthly benefit to which the employee's Eligible Spouse would be entitled following his death." IN WITNESS WHEREOF, Central Illinois Public Service Company has executed this instrument this _7th_ day of December, 1993. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By: _______/s/Clifford L. Greenwalt_____ President [CORPORATE SEAL] ATTEST: _/s/Craig D. Nelson___ Assistant Secretary EXHIBIT 10.08 AMENDMENT NO. 1 TO CENTRAL ILLINOIS PUBLIC SERVICE COMPANY EXCESS BENEFIT PLAN (As Amended And Restated Effective As Of October 1, 1990) The Central Illinois Public Service Company Excess Benefit Plan (As Amended And Restated Effective As Of October 1, 1993), (the "Plan"), is hereby further amended, effective as of December 1, 1993, in the following respect: 1. By adding to Article II of the Plan a new paragraph L. after paragraph K. as follows: "L. VESTED BENEFIT - Each participant in the Basic Plan who is an employee of the Company on December 31, 1993 shall be fully vested in his Accrued Benefit under the Excess Benefit Plan as of December 31, 1993 subject to the terms and conditions of the Excess Benefit Plan. For this purpose, "Accrued Benefit" means the amount of monthly benefit to which a participant in the Basic Plan would be entitled under Article I of the Excess Benefit Plan if he terminated his employment with the Company and its affiliates as of December 31, 1993. A participant's Accrued Benefit shall also include the amount of monthly benefit to which the participant's Eligible Spouse would be entitled following his death." IN WITNESS WHEREOF, Central Illinois Public Service Company has executed this instrument this _7TH_ day of December, 1993. CENTRAL ILLINOIS PUBLIC SERVICE COMPANY By: _____/s/Clifford L. Greenwalt______ President [CORPORATE SEAL] ATTEST: ___/s/Craig D. Nelson____ Assistant Secretary Exhibit 21 Central Illinois Public Service Company Subsidiaries of Registrant State or Jurisdiction Subsidiary of Incorporation __________ _____________________ Illinois Steam Inc. Illinois CIPS Energy Inc. Illinois Electric Energy, Inc.* Illinois *Central Illinois Public Service Company owns 20% of the common stock of EEI. Exhibit 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS _________________________________________ As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into Central Illinois Public Service Company's previously filed Registration Statements File Nos. 33-29384, 33- 31475, 33-59674, and 33-50349 and CIPSCO Incorporated's previously filed Registration Statement File No. 33-32936. ARTHUR ANDERSEN & CO. Chicago, Illinois, March 10, 1994 Exhibit 24 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/William J. Alley _______________________________ (SEAL) William J. Alley Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Robert S. Eckley _______________________________ (SEAL) Robert S. Eckley Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/John L. Heath _______________________________ (SEAL) John L. Heath Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Gordon R. Lohman _______________________________ (SEAL) Gordon R. Lohman Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Hanne M. Merriman _______________________________ (SEAL) Hanne M. Merriman Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Donald G. Raymer _______________________________ (SEAL) Donald G. Raymer Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/Thomas L. Shade _______________________________ (SEAL) Thomas L. Shade Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 POWER OF ATTORNEY _________________ The undersigned, as a director of Central Illinois Public Service Company, does hereby constitute and appoint C. L. Greenwalt and R. W. Jackson, and each of them, his or her true and lawful attorneys and agents, each with full power and authority (acting alone and without the other) to execute in the name and on behalf of the undersigned, in his or her capacity, the Central Illinois Public Service Company Annual Report on Form 10-K for 1993, and any amendments thereto, to be filed under the Securities Exchange Act of 1934, as amended; hereby granting to such attorneys and agents, and each of them, full power of substitution and revocation in the premises; and hereby ratifying and confirming all that such attorneys and agents, or either of them, may do or cause to be done by virtue of this Power of Attorney. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 7th day of December, 1993. /s/James W. Wogsland _______________________________ (SEAL) James W. Wogsland Subscribed and sworn to before me this 7th day of December, 1993. /s/Janet K. Cooper _________________________ Notary Public My commission expires: March 27, 1995 Exhibit 99 DESCRIPTION OF CAPITAL STOCK General. The authorized capital stock of Central Illinois Public Service Company (the "Company") consists of 2,000,000 shares of Cumulative Preferred Stock, par value $100 per share, issuable in series, of which 800,000 shares are outstanding; 2,600,000 shares of Cumulative Preferred Stock without par value, issuable in series, of which no shares are outstanding (both such classes of preferred stock being hereinafter collectively referred to as the "Preferred Stock"); and 45,000,000 shares of Common Stock without par value of which 25,452,373 shares were outstanding (all of which were held by CIPSCO) at December 31, 1993. The following statements, unless the context otherwise indicates, are brief summaries of the substance or general effect of certain provisions of the Company's Restated and Amended Articles of Incorporation, as amended, and the reslutions establishing series of Preferred Stock (collectively, the "Articles"), and of its Mortgage Indenture securing its outstanding First Mortgage bonds. Such statements make use of defined terms and are not complete; they are subject to all the provisions of the Articles or the Mortgage Indenture, as the case may be. Dividend Rights. Whenever dividends on all outstanding shares of the Preferred Stock of all series for all previous quarter-yearly dividend periods and the current quarter-yearly dividend period shall have been paid or declared and set apart for payment, and whenever all amounts required to be set aside for any sinking fund for the redemption or purchase of shares of the Preferred Stock for all previous periods or dates shall have been paid or set aside, and subject to the limitations summarized below, the Board of Directors may declare dividends on the Common Stock out of any surplus or net profits of the Company legally available for the purpose. Currently, none of the series of the Preferred Stock have a sinking fund for the redemption or purchase of shares of such series. The Mortgage Indenture provides, in effect, that the Company will not declare or pay any dividends (other than in stock) on Common Stock, or make any other distribution on or purchase any Common Stock, unless the total amount charged or provided for maintenance, repairs and depreciation of the mortgaged properties subsequent to December 31, 1940, plus the surplus earned during the period and remaining after any such dividend, distribution or purchase, shall equal at least 15% of the Company's total utility operating revenues for the period, after deducting from such revenues the cost of electricity and gas purchased for resale. The Articles provide in effect that, so long as any Preferred Stock is outstanding, the total amount of all dividends or other distributions on Common Stock (other than in stock) that may be paid, and purchases of Common Stock that may be made, during any 12- month period shall not exceed (a) 75% of the Company's net income (as defined) for the 12-month period next preceding each such dividend, distribution or purchase, if the ratio of "common stock equity" to "total capital" (as defined) is 20% to 25%, or (b) 50% of such net income if such ratio is less than 20%. If such ratio is in excess of 25%, no such dividends may be paid or distributions or purchases made that would reduce such ratio to less than 25% except to the extent permitted by clauses (a) and (b). At December 31, 1993, no amount of retained earnings was restricted as to the payment of dividends on Common Stock under the foregoing provisions of the Mortgage Indenture or the Articles. Voting Rights. Under Illinois law, each share of common stock of the Company, common and preferred, is entitled to one vote on each matter voted on at all meetings of shareholders, with the right of cumulative voting in the election of directors and the right to vote as a class on certain questions. The Articles give to holders of Preferred Stock certain special voting rights designed to protect their interests with respect to specified corporate action, including certain amendments to the Articles, the issuance of Preferred Stock or parity stock, the issuance or assumption of certain unsecured indebtedness, and mergers, consolidations or sales or leases of substantially all of the Company's assets. Preemptive Rights. Holders of Common Stock have no preemptive subscription rights. Liquidation Rights. In the event of any liquidation or dissolution of the Company, holders of Common Stock are entitled to share ratably in the net assets and profits of the Company remaining after the payment in full to the holders of the Preferred Stock of the aggregate preferential amount payable in respect of the Preferred Stock in any such event. Miscellaneous. The Transfer Agents for the Common Stock are Illinois Stock Transfer Company, Chicago, Illinois, and Harris Trust and Savings Bank, Chicago, Illinois; and the Registrar is Harris Trust and Savings Bank, Chicago, Illinois. The Company reserves the right to increase, decrease or reclassify its authorized capitial stock or any class or series thereof, and to amend or repeal any provisions in the Articles; and all rights conferred on shareholders in the Articles are subject to this reservation.

83612_1993.txt

83612_1993

1993

83612

ITEM 1. BUSINESS (a) General Development of Business RJR Nabisco Holdings Corp. ("Holdings") was organized as a Delaware corporation in 1988 at the direction of Kohlberg Kravis Roberts & Co., L.P. ("KKR"), a Delaware limited partnership, to effect the acquisition of RJR Nabisco, Inc. ("RJRN"), which was completed on April 28, 1989 (the "Acquisition"). As a result of the Acquisition, RJRN became an indirect, wholly owned subsidiary of Holdings. After a series of holding company mergers completed on December 17, 1992, RJRN became a direct, wholly owned subsidiary of Holdings. The business of Holdings is conducted through RJRN. Holdings and RJRN are referred to herein collectively as the "Registrants". RJRN's operating subsidiaries comprise one of the largest tobacco and food companies in the world. In the United States, the tobacco business is conducted by R. J. Reynolds Tobacco Company ("RJRT"), the second largest manufacturer of cigarettes, and the packaged food business is conducted by the Nabisco Foods Group ("NFG"), the largest manufacturer and marketer of cookies and crackers. Tobacco operations outside the United States are conducted by R. J. Reynolds Tobacco International, Inc. ("Tobacco International") and food operations outside the United States and Canada are conducted by Nabisco International, Inc. ("Nabisco International"). NFG and Nabisco International are sometimes referred to herein collectively as "Nabisco". Together, RJRT's and Tobacco International's tobacco products are sold around the world under a variety of brand names. Nabisco's food products are sold in the United States, Canada, Latin America and certain other international markets. For financial information with respect to RJRN's industry segments, lines of business and operations in various geographic locations, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 15 to the consolidated financial statements, and the related notes thereto, of Holdings and RJRN as of December 31, 1993 and 1992 and for each of the years in the three-year period ended December 31, 1993 (the "Consolidated Financial Statements"). RJRN was incorporated in 1970 and can trace its origins back to the formation of R. J. Reynolds Tobacco Company in 1875. Activities were confined to the tobacco industry until the 1960's, when diversification led to investments in transportation, energy and food. With the acquisition of Del Monte Corporation ("Del Monte") in 1979, RJRN began to concentrate its focus on consumer products. This strategy led to the acquisition of Nabisco Brands, Inc. in 1985. RJRN today conducts its tobacco line of business through RJRT and Tobacco International and its food line of business through NFG and Nabisco International. In recent years the Registrants have completed a number of acquisitions within these lines of business. These included the 1992 acquisitions of (i) the assets of New York Style Bagel Chip Company, Inc., the country's leading producer and marketer of bagel chips and pita chips; (ii) Plush Pippin Corporation, a leading regional supplier of frozen pies to in-store supermarket bakeries; (iii) Stella D'oro Biscuit Co., Inc., a New York based specialty bakery ("Stella D'oro") which manufactures breadsticks, breakfast biscuits, specialty cakes, pastries and snacks; and (iv) the Now & Later confection brand, a fruit chewy taffy product. In 1992, the Registrants also acquired Industrias Alimenticias Maguary S.A., Brazil's largest producer and marketer of packaged fruit-based beverages, Lance S.A. de C.V., one of Mexico's leading biscuit and pasta manufacturers, and six food and pet food businesses in Mexico in exchange for Nabisco International's previous minority interest in a joint venture operating those and other businesses in Mexico. During 1993, Nabisco International acquired a 50% interest in both Royal Brands, S.A. in Spain and Royal Brands Portugal, acquired approximately 95% of Cia. Arturo Field y la Estrella Ltda., S.A. in Peru and increased its equity interest in a partially owned business in Venezuela to 100%. In addition, Tobacco International acquired a 52% interest in a cigarette factory in St. Petersburg, Russia in 1992, and constructed a factory in Turkey and acquired a 70% interest in two cigarette factories in the Ukraine in 1993. On January 4, 1993, the Registrants completed the sale of NFG's ready-to-eat cold cereal business to Kraft General Foods, Inc. and one of its affiliates, for an aggregate cash purchase price of approximately $456 million in cash, prior to post-closing adjustments. NFG acquired the Knox gelatin brand in January 1994 and has contractual arrangements pursuant to which it expects to acquire the remaining 50% of Royal Brands, S.A. and Royal Brands Portugal during 1994. RJRN will continue to assess its businesses to evaluate their consistency with strategic objectives. Although RJRN may acquire and/or divest additional businesses in the future, no decisions have been made with respect to any such acquisitions or divestitures. The Registrants' credit agreement, dated as of December 1, 1991, as amended (the "1991 Credit Agreement") and credit agreement, dated as of April 5, 1993, as amended (the "1993 Credit Agreement", and together with the 1991 Credit Agreement, the "Credit Agreements"), prohibit the sale of all or substantially all or any substantial portion of the businesses of certain subsidiaries of RJRN. (b) Financial Information about Industry Segments During 1993, the Registrants' industry segments were tobacco and food. For information relating to industry segments for the years ended December 31, 1993, 1992 and 1991, see Note 15 to the Consolidated Financial Statements. (c) Narrative Description of Business TOBACCO The tobacco line of business is conducted by RJRT and Tobacco International, which manufacture, distribute and sell cigarettes. Cigarettes are manufactured in the United States by RJRT and in over 30 foreign countries and territories by Tobacco International and subsidiaries or licensees of RJRT and are sold throughout the United States and in more than 160 markets around the world. In 1993, approximately 61% of total tobacco segment net sales (after deducting excise taxes) and approximately 65% of total tobacco segment operating income (before amortization of trademarks and goodwill and the effects of a restructuring expense) were attributable to domestic tobacco operations. DOMESTIC TOBACCO OPERATIONS The domestic tobacco business is conducted by RJRT, which is the second largest cigarette manufacturer in the United States. RJRT's largest selling cigarette brands in the United States include WINSTON, DORAL, SALEM, CAMEL, MONARCH and BEST VALUE. RJRT's other cigarette brands, including VANTAGE, MORE, NOW, STERLING, MAGNA and CENTURY, are marketed to meet a variety of smoker preferences. All RJRT brands are marketed in a variety of styles. Based on data collected for RJRT by an independent market research firm, RJRT had an overall share of retail consumer cigarette sales during 1993 of 29.8%, an increase of approximately one share point from 1992. During 1993, RJRT and the largest domestic cigarette manufacturer, Philip Morris U.S.A., together sold approximately 73% of all cigarettes sold in the United States. A primary long-term objective of RJRT is to increase earnings and cash flow through selective marketing investments in its key brands and continual improvements in its cost structure and operating efficiency. Marketing programs for full-price brands are designed to build brand awareness and add value to the brands in order to retain current adult smokers and attract adult smokers of competitive brands. In 1993, these efforts included expansion of continuity and relationship-building programs such as CAMEL Cash and the WINSTON Winners Club, and the introduction of line extensions such as CAMEL Special Lights and WINSTON Select Lights. RJRT believes it is essential to compete in all segments of the cigarette market, and accordingly offers a range of lower-priced brands including DORAL, MONARCH and BEST VALUE intended to appeal to more cost-conscious adult smokers. For a discussion on competition in the tobacco business, see "Other Matters--Competition" in this Item 1 and "1993 Competitive Activity" under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. RJRT's domestic manufacturing facilities, consisting principally of factories and leaf storage facilities, are located in or near Winston-Salem, North Carolina and are owned by RJRT. Cigarette production is conducted at the Tobaccoville cigarette manufacturing plant (approximately two million square feet) and the Whitaker Park cigarette manufacturing complex (approximately one and one-half million square feet). RJRT believes that its cigarette manufacturing facilities are among the most technologically advanced in the United States. RJRT also has significant research and development facilities in Winston-Salem, North Carolina. RJRT's cigarettes are sold in the United States primarily to chain stores, other large retail outlets and through distributors to other retail and wholesale outlets. Except for McLane Company, Inc., which represented approximately 10.9% of RJRT's sales, no RJRT customers accounted for more than 10% of sales for 1993. RJRT distributes its cigarettes primarily to public warehouses located throughout the United States that serve as local distribution centers for RJRT's customers. RJRT's products are sold to adult smokers primarily through retail outlets. RJRT employs a decentralized marketing strategy that permits RJRT's sales force to be more flexible in responding to local market dynamics by designing individual in-store programs to fit varying consumption patterns. RJRT utilizes print media, billboards, point-of-sale displays and other methods of advertising. Since 1971, television and radio advertising of cigarettes has been prohibited in the United States. INTERNATIONAL TOBACCO OPERATIONS Tobacco International operates in over 160 markets around the world. Although overall foreign cigarette sales (excluding China, in which production data indicates an approximate 2% per annum growth rate) have increased at a rate of only 1% per annum in recent years, Tobacco International believes that the American Blend segment, in which Tobacco International primarily competes is growing significantly faster. Although Tobacco International is the second largest of two international cigarette producers that have significant positions in the American Blend segment, its share of sales of this segment is approximately one-third of the share of Philip Morris International Inc., the largest American Blend producer. Tobacco International has strong brand presence in Western Europe and is well established in its other key markets in the Middle East/Africa, Asia and Canada. Tobacco International is aggressively pursuing development opportunities in Eastern Europe and the former Soviet Union. Tobacco International markets over 55 brands of which WINSTON, CAMEL and SALEM, all American Blend cigarettes, are its international leaders. WINSTON, Tobacco International's largest selling international brand, has a significant presence in Puerto Rico and has particular strength in the Western Europe and Middle East/Africa regions. CAMEL is sold in approximately 135 markets worldwide and is Tobacco International's second largest selling international brand. SALEM is the world's largest selling menthol cigarette and has particular strength in Far East markets. Tobacco International also markets a number of local brands in various foreign markets. None of Tobacco International's customers accounted for more than 10% of sales for 1993. Approximately 30% of Tobacco International's cigarette volume for 1993 was manufactured by RJRT in the United States for sale in foreign markets. The remainder was manufactured overseas, principally in owned manufacturing facilities or by licensees or joint ventures. Tobacco International operates two tobacco manufacturing facilities in Germany and one located in each of Canada, Hong Kong, Hungary, Malaysia, Poland, Puerto Rico and Switzerland. Tobacco International opened a factory in the People's Republic of China in 1988 as a part of the first cigarette manufacturing joint venture in that country, and in 1993 constructed a factory in Turkey and acquired a 70% interest in two cigarette factories in the Ukraine. In addition, in 1992, Tobacco International acquired a 52% interest in a cigarette factory in St. Petersburg, Russia. Certain of Tobacco International's foreign operations are subject to local regulations that set import quotas, restrict financing flexibility and affect repatriation of earnings or assets. In recent years, certain trade barriers for cigarettes, particularly in Asia and Eastern Europe, have been liberalized. This may provide opportunities for all international cigarette manufacturers, including Tobacco International, to expand operations in such markets; however, there can be no assurance that the liberalizing trends will be maintained or extended or that Tobacco International will be successful in pursuing such opportunities. RAW MATERIALS In its domestic production of cigarettes, RJRT primarily uses domestic burley and flue cured leaf tobaccos purchased at domestic auction. RJRT also purchases oriental tobaccos, grown primarily in Turkey and Greece, and certain other non-domestic tobaccos. Tobacco International uses a variety of tobacco leaf from both United States and international sources. Tobacco leaf is an agricultural commodity subject in the United States to government production controls and price supports that can affect market prices substantially. The tobacco leaf price support program is subject to Congressional review and may be changed at any time in the future. In addition, Congress enacted legislation during 1993 (the Omnibus Budget Reconciliation Act of 1993), which stipulates that, effective January 1, 1994, financial penalties will be assessed against manufacturers if cigarettes produced in the United States do not contain at least 75% (by weight) domestically grown flue cured and burley tobaccos. Currently RJRT expects that compliance with the content regulation will increase its future raw material costs. RJRT and Tobacco International believe there is a sufficient supply of tobacco in the worldwide tobacco market to satisfy their current production requirements. LEGISLATION AND OTHER MATTERS AFFECTING THE CIGARETTE INDUSTRY The advertising, sale and use of cigarettes has been under attack by government and health officials in the United States and in other countries for many years, principally due to claims that cigarette smoking is harmful to health. This attack has resulted in a number of substantial restrictions on the marketing, advertising and use of cigarettes, diminishing social acceptability of smoking and activities by anti-smoking groups designed to inhibit cigarette sales, the form and content of cigarette advertising and the testing and introduction of new cigarette products. Together with manufacturers' price increases in recent years and substantial increases in state and federal excise taxes on cigarettes, this has had and will likely continue to have an adverse effect on cigarette sales. Cigarettes are subject to substantial excise taxes in the United States and to similar taxes in many foreign markets. In 1990, Congress enacted legislation to increase the federal excise tax per pack of 20 cigarettes to 20 cents from 16 cents on January 1, 1991 and provide for an increase in the federal excise tax on January 1, 1993 to 24 cents. In addition, all states and the District of Columbia impose excise taxes of levels ranging from a low of 2.5 cents to a high of 65 cents per pack on cigarettes, and increases in these state excise taxes could also have an adverse effect on cigarette sales. In 1993, thirteen states and the District of Columbia enacted excise tax increases ranging from less than 2 cents per pack to 41 cents per pack. In addition, the Clinton Administration and members of Congress have introduced bills in Congress that would significantly increase the federal excise tax on cigarettes, eliminate the deductibility of a portion of the cost of tobacco advertising, ban smoking in public buildings and workplaces, add additional health warnings on cigarette packaging and advertising and further restrict the marketing of tobacco products. In January 1993, the U.S. Environmental Protection Agency (the "EPA") released a report on the respiratory effects of environmental tobacco smoke ("ETS") which concludes that ETS is a known human lung carcinogen in adults; and in children causes increased respiratory tract disease and middle ear disorders and increases the severity and frequency of asthma. RJRT has joined other segments of the tobacco and distribution industries in a lawsuit against the EPA seeking a determination that the EPA did not have the statutory authority to regulate ETS, and that, given the current body of scientific evidence and the EPA's failure to follow its own guidelines in making the determination, the EPA's classification of ETS was arbitrary and capricious. In September 1991, the U.S. Occupational Safety and Health Administration ("OSHA") issued a Request for Information relating to indoor air quality, including ETS, in occupational settings. OSHA has announced that it will commence formal rulemaking in 1994. While the Registrants cannot predict the outcome, some form of regulation of smoking in workplaces may result. Legislation imposing various restrictions on public smoking has also been enacted in nineteen states and many local jurisdictions, many employers have initiated programs restricting or eliminating smoking in the workplace and nine states have enacted legislation designating a portion of increased cigarette excise taxes to fund either anti-smoking programs, health care programs or cancer research. Federal law prohibits smoking on all domestic airline flights of six hours duration or less and the U.S. Interstate Commerce Commission has banned smoking on buses transporting passengers inter-state. A number of foreign countries have also taken steps to discourage cigarette smoking, to restrict or prohibit cigarette advertising and promotion and to increase taxes on cigarettes. Such restrictions are, in some cases, more onerous than restrictions imposed in the United States. In June 1988, Canada enacted a ban on cigarette advertising, the constitutionality of which is before the Supreme Court of Canada. On December 11, 1990, RJRN and other U.S. cigarette manufacturers, through The Tobacco Institute, announced a tobacco industry initiative to assist retailers in enforcing minimum age laws on the sale of cigarettes, to support the enactment of state laws requiring the adult supervision of cigarette vending machines in places frequented by minors, to seek the uniform establishment of 18 as the minimum age for the purchase of cigarettes in all states, to distribute informational materials to assist parents in combatting peer pressure on their children to smoke and to limit voluntarily certain cigarette advertising and promotional practices. In 1992, the Alcohol, Drug and Mental Health Act was signed into law. This Act contains a provision, effective January 1, 1994, that requires states to adopt a minimum age of 18 for purchase of tobacco products to receive federal funding for mental health and drug abuse programs. In 1964, the Report of the Advisory Committee to the Surgeon General of the U.S. Public Health Service concluded that cigarette smoking was a health hazard of sufficient importance to warrant appropriate remedial action. Since 1966, federal law has required a warning statement on cigarette packaging. Since 1971, television and radio advertising of cigarettes has been prohibited in the United States. Cigarette advertising in other media in the United States is required to include information with respect to the "tar" and nicotine content of cigarettes, as well as a warning statement. During the past three decades, various legislation affecting the cigarette industry has been enacted. In 1984, Congress enacted the Comprehensive Smoking Education Act (the "Smoking Education Act"). Among other things, the Smoking Education Act: (i) establishes an interagency committee on smoking and health that is charged with carrying out a program to inform the public of any dangers to human health presented by cigarette smoking; (ii) requires a series of four new health warnings to be printed on cigarette packages and advertising on a rotating basis; (iii) increases type size and area of the warning on cigarette advertisements; and (iv) requires that cigarette manufacturers provide annually, on a confidential basis, a list of ingredients used in the manufacture of cigarettes to the Secretary of Health and Human Services. The warnings currently required on cigarette packages and advertisements (other than billboards) are as follows: (i) "Surgeon General's Warning: Smoking Causes Lung Cancer, Heart Disease, Emphysema, And May Complicate Pregnancy"; (ii) "Surgeon General's Warning: Quitting Smoking Now Greatly Reduces Serious Risks To Your Health"; (iii) "Surgeon General's Warning: Smoking By Pregnant Women May Result in Fetal Injury, Premature Birth, and Low Birth Weight"; and (iv) "Surgeon General's Warning: Cigarette Smoke Contains Carbon Monoxide." Similar warnings are required on outdoor billboards. In August 1990, the Fire Safe Cigarette Act of 1990 was enacted, which directed the Consumer Product Safety Commission to conduct and oversee research begun under direction of the Cigarette and Little Cigar Fire Safety Act of 1984 and to assess the practicability of developing a performance standard to reduce cigarette ignition propensity. The Commission presented a final report to Congress in August 1993 describing the results of the research. The Commission concluded that while "it is practicable to develop a performance standard to reduce cigarette ignition propensity, it is unclear that such a standard would effectively address the number of cigarette-ignited fires." The Commission further found that additional work would be required before the actual development of a performance standard. Nevertheless, the Commission reported that a test method developed by the National Institute of Standards and Technology was valid and reliable within reasonable limits and could be suitable for use in a performance standard. Although the Registrants cannot predict whether further legislation on this subject may be enacted, some form of regulation of cigarettes based on their propensity to ignite soft furnishings may result. Since the initial report in 1964, the Secretary of Health, Education and Welfare and the Surgeon General have issued a number of other reports which purport to link cigarette smoking with certain health hazards, including various types of cancer, coronary heart disease and chronic obstructive lung disease. These reports have recommended various governmental measures to reduce the incidence of smoking. In addition to the foregoing, legislation and regulations potentially detrimental to the cigarette industry, generally relating to the taxation of cigarettes and regulation of advertising, labeling, promotion, sale and smoking of cigarettes, have been proposed from time to time at various levels of the federal government. Various Congressional committees and subcommittees have approved legislation in recent years that (i) would subject cigarettes to regulation in various ways under the U.S. Department of Health and Human Services, (ii) would subject cigarettes generally to regulation under the Consumer Products Safety Act, (iii) could increase manufacturers' costs, (iv) would mandate anti-smoking education campaigns or establish anti-smoking programs, (v) would provide additional funding for federal and state anti-smoking activities, (vi) would require a new list of six health warnings on cigarette packages and advertising, expand the number or required size of the warnings and restrict the contents of cigarette advertising and promotional activities, (vii) would provide that neither the provisions of the Federal Cigarette Labeling and Advertising Act, as amended (the "Cigarette Act"), nor the Smoking Education Act should be interpreted to relieve any person from liability under common law or state statutory law and (viii) would permit state and local governments to restrict the sale and distribution of cigarettes and the placement of billboard and transit advertising of tobacco products. It is not possible to determine what additional federal, state or local legislation or regulations relating to smoking or cigarettes will be enacted or to predict any resulting effect thereof on RJRT, Tobacco International or the cigarette industry generally but such legislation or regulations could have an adverse effect on RJRT, Tobacco International or the cigarette industry generally. LITIGATION AFFECTING THE CIGARETTE INDUSTRY Various legal actions, proceedings and claims are pending or may be instituted against RJRT or its affiliates or indemnitees, including those claiming that lung cancer and other diseases have resulted from the use of or exposure to RJRT's tobacco products. During 1993, 16 new actions were filed or served against RJRT and/or its affiliates or indemnitees and 18 such actions were dismissed or otherwise resolved in favor of RJRT and/or its affiliates or indemnitees without trial. A total of 35 such actions in the United States, one in Puerto Rico and one against RJRT's Canadian subsidiary were pending on December 31, 1993. As of February 7, 1994, 35 active cases were pending against RJRT and/or its affiliates or indemnitees, 33 in the United States, one in Puerto Rico and one in Canada. Four of the 33 active cases in the United States involve alleged non-smokers claiming injuries resulting from exposure to environmental tobacco smoke. One of such cases is currently scheduled for trial on September 5, 1994 and if tried, will be the first such case to reach trial. The United States cases are in 15 states and are distributed as follows: eight in Louisiana, eight in Texas, three in Mississippi, two in Indiana, two in New Jersey and one each in Alabama, Florida, Illinois, Kentucky, Maryland, Massachusetts, Minnesota, New York, Oregon and West Virginia. Of the 33 active cases in the United States, 24 are pending in state court and 9 in federal court. One of the active cases is alleged to be a class action on behalf of a purported class of 60,000 individuals. The plaintiffs in these actions seek recovery on a variety of legal theories, including strict liability in tort, design defect, negligence, breach of warranty, failure to warn, fraud, misrepresentation and conspiracy. Punitive damages, often in amounts totalling many millions of dollars, are specifically pleaded in 20 cases in addition to compensatory and other damages. The defenses raised by RJRT and/or its affiliates, where applicable, include preemption by the Cigarette Act of some or all such claims arising after 1969; the lack of any defect in the product; assumption of the risk; comparative fault; lack of proximate cause; and statutes of limitations or repose. Juries have found for plaintiffs in two smoking and health cases, but in one such case, which has been appealed by both parties, no damages were awarded. The jury awarded $400,000 in the other case, Cipollone v. Liggett Group, Inc., et al., which award was overturned on appeal and the case was subsequently dismissed. On June 24, 1992, the United States Supreme Court in Cipollone held that claims that tobacco companies failed to adequately warn of the risks of smoking after 1969 and claims that their advertising and promotional practices undermined the effect of warnings after that date were preempted by the Cigarette Act. The Court also held that claims of breach of express warranty, fraud, misrepresentation and conspiracy were not preempted. The Supreme Court's decision was announced through a plurality opinion, and further definition of how Cipollone will apply to other cases must await rulings in those cases. Certain legislation proposed in recent years in Congress, among other things, would eliminate any such preemptive effect on common law damage actions for personal injuries. RJRT is unable to predict whether such legislation will be enacted, if so, in what form, or whether such legislation would be intended by Congress to apply retroactively. The Supreme Court's Cipollone decision itself, or the passage of such legislation, could increase the number of cases filed against cigarette manufacturers, including RJRT. RJRT understands that a grand jury investigation being conducted in the Eastern District of New York is examining possible violations of criminal law in connection with activities relating to the Council for Tobacco Research-USA, Inc., of which RJRT is a sponsor. RJRT is unable to predict the outcome of this investigation. RJRT recently received a civil investigative demand from the U.S. Department of Justice requesting broad documentary information from RJRT. Although the request appears to focus on tobacco industry activities in connection with product development efforts, it also requests general information concerning contacts with competitors. RJRT is unable to predict the outcome of this investigation. Litigation is subject to many uncertainties, and it is possible that some of the legal actions, proceedings or claims could be decided against RJRT or its affiliates or indemnitees. Determinations of liability or adverse rulings against other cigarette manufacturers that are defendants in similar actions, even if such rulings are not final, could adversely affect the litigation against RJRT and its affiliates or indemnitees and increase the number of such claims. Although it is impossible to predict the outcome of such events or their effect on RJRT, a significant increase in litigation activities could have an adverse effect on RJRT. RJRT believes that it has a number of valid defenses to any such actions, including but not limited to those defenses based on preemption under the Cipollone decision, and RJRT intends to defend vigorously all such actions. FOOD The food line of business conducted by NFG, which comprises the Nabisco Biscuit Company, the LifeSavers Division, the Planters Division, the Specialty Products Company, the Fleischmann's Division, the Food Service Division and Nabisco Brands Ltd, and by Nabisco International. Food products are sold under trademarks owned or licensed by Nabisco and brand recognition is considered essential to their successful marketing. None of Nabisco's customers accounted for more than 10% of sales for 1993. NABISCO FOODS GROUP OPERATIONS Nabisco Biscuit Company. Nabisco Biscuit is the largest manufacturer and marketer in the United States cookie and cracker industry with the nine top selling brands, each of which had annual sales of over $100 million in 1993. Overall, in 1993, Nabisco Biscuit had a 39% share of the domestic cookie industry sales, more than double the share of its closest competitor, and a 55% share of the domestic cracker industry sales, more than three times the share of its closest competitor. Leading Nabisco Biscuit cookie brands include OREO, CHIPS AHOY! and NEWTONS. Leading Nabisco Biscuit cracker brands include RITZ, PREMIUM, WHEAT THINS, NABISCO GRAHAMS and TRISCUIT. OREO and CHIPS AHOY! are the two largest selling cookies in the United States. OREO, the leading sandwich cookie, is Nabisco Biscuit's largest selling cookie brand. CHIPS AHOY! is the leader in the chocolate chip cookie segment with recent line extensions such as CHUNKY CHIPS AHOY! broadening its appeal and adding incremental sales. NEWTONS, the oldest Nabisco Biscuit cookie brand, is the third leading cookie brand in the United States. The introduction of FAT FREE FIG and APPLE NEWTONS in 1992 and the addition of the FAT FREE CRANBERRY, RASPBERRY and STRAWBERRY NEWTONS in 1993 has expanded the appeal of NEWTONS and brought incremental sales to the franchise. Nabisco Biscuit's cracker division is led by RITZ, the largest selling cracker brand in the United States, which accounted for 12% of cracker sales in the United States in 1993. In addition, PREMIUM, the oldest Nabisco Biscuit cracker brand and the leader in the saltine cracker segment, is joined by WHEAT THINS, NABISCO GRAHAMS and TRISCUIT to comprise, along with RITZ, the five largest selling cracker brands in the United States. In 1991, Nabisco Biscuit introduced MR. PHIPPS PRETZEL CHIPS, the first such product of its kind. Nabisco Biscuit expanded the MR. PHIPPS franchise with the introduction of MR. PHIPPS TATER CRISPS in 1992, which deliver salty snack taste with only half the fat of potato chips, and the introduction of MR. PHIPPS TORTILLA CRISPS in 1993. In 1992, Nabisco Biscuit became the leading manufacturer and marketer of no fat/reduced fat cookies and crackers with the introduction of the SNACKWELL'S line. In 1993, the SNACKWELL'S brand recorded over $200 million in sales to become the sixth largest cookie/cracker brand in the United States. In October 1992, Nabisco Biscuit acquired STELLA D'ORO, a leading producer of breadsticks, breakfast biscuits, specialty cakes, pastries and snacks. This line of specialty items gives Nabisco Biscuit an entry to new users and usage occasions, further broadening NFG's cookie and cracker portfolio. Nabisco Biscuit's other cookie and cracker brands, which include NUTTER BUTTER, NILLA WAFERS, BARNUM'S ANIMALS CRACKERS, BETTER CHEDDARS, HARVEST CRISPS, CHICKEN IN A BISKIT, CHEESE NIPS and NEW YORK STYLE BAGEL and PITA CHIPS, compete in consumer niche segments. Many are the first or second largest selling brands in their respective segments. Nabisco Biscuit's products are manufactured in 13 Nabisco Biscuit-owned bakeries and in 16 facilities with which Nabisco Biscuit has production agreements. These facilities are located throughout the United States. Nabisco Biscuit is in the process of implementing plans to modernize certain of its facilities. Nabisco Biscuit also operates a flour mill in Toledo, Ohio, which supplies 85% of its flour needs. Nabisco Biscuit's products are sold to major grocery and other large retail chains through Nabisco Biscuit's direct store delivery system. The system is supported by a distribution network utilizing ten major distribution warehouses and 130 shipping branches where shipments are consolidated for delivery to approximately 111,000 separate delivery points. NFG believes this sophisticated distribution and delivery system provides it with a significant service advantage over its competitors. LifeSavers Division. The LifeSavers Division manufactures and markets hard roll and bite-size candy and gum primarily for sale in the United States. LifeSavers' well-known brands include LIFE SAVERS hard roll and bite-size candy, BREATH SAVERS sugar free mints, BUBBLE YUM bubble gum, CARE*FREE sugarless gum, NOW & LATER fruit chewy taffy and LIFE SAVERS GUMMI SAVERS fruit chewy candy. On the basis of the most recent data available, LIFE SAVERS is the largest selling hard roll candy in the United States, with an approximately 25% share of the hard roll candy category, BREATH SAVERS is the largest selling sugar free breath mint in the United States and BUBBLE YUM is the largest selling chunk bubble gum in the United States. LifeSavers' confectionery products are seasonally strongest during the third and fourth quarters. LifeSavers sells its products in the United States primarily to large retail outlets, chain accounts and to other retail and wholesale outlets. These include grocery stores, drug/mass merchandisers, convenience stores, and food service and military suppliers. The products are distributed from 13 distribution centers located throughout the United States. LifeSavers currently owns and operates three manufacturing facilities for its products, one in Holland, Michigan, one in Brooklyn, New York and the other in Las Piedras, Puerto Rico. Sales, for the LifeSavers Division, as well as the Planters, Specialty Products and Fleischmann's Divisions, are handled through NFG's Sales and Integrated Logistics group, which utilize both direct sales and broker sales organizations. Planters Division. The Planters Division produces and/or markets nuts and snacks largely for sale in the United States, primarily under the PLANTERS trademark. On the basis of the most recent data available, PLANTERS nuts are the clear leader in the packaged nut category, with a market share of more than five times that of its nearest competitor. Planters' products are commodity oriented and are seasonally strongest in the fourth quarter. Planters sells its products in the United States primarily to large retail outlets, chain accounts and to other retail and wholesale outlets. These include grocery stores, drug/mass merchandisers, convenience stores, and food service and military suppliers. The products are distributed from the same 13 distribution centers utilized by the LifeSavers Division. Planters currently owns and operates three manufacturing facilities for its products, all located in the United States. Specialty Products Company. NFG's Specialty Products Company manufacturers and markets a broad range of food products, with sauces and condiments, pet snacks, ethnic foods and hot cereals representing the largest categories. Many of its products are first or second in their product categories. Well-known brand names include A.1. steak sauces, GREY POUPON mustards, MILK-BONE pet snacks, ORTEGA Mexican foods and CREAM OF WHEAT hot cereals. Specialty Products' primary entries in the sauce and condiment segments are A.1. steak sauces, the leading steak sauces, and GREY POUPON mustards, which include the leading Dijon mustard. Specialty Products also markets REGINA wine vinegar, the leader in its segment of the vinegar market. A.1., GREY POUPON and REGINA products are manufactured in one facility. Specialty Products is the leading manufacturer of pet snacks in the United States with MILK-BONE dog biscuits. MILK-BONE products include MILK-BONE ORIGINAL BISCUITS, FLAVOR SNACKS, DOG TREATS, BUTCHER BONES and BUTCHER'S CHOICE. Pet snacks are produced at a single manufacturing facility. Specialty Products produces shelf-stable Mexican foods under its ORTEGA brand name. Specialty Products also participates in the dry mix dessert category with ROYAL gelatins and puddings and the non-dessert gelatin category with KNOX unflavored gelatins and has lines of regional products including COLLEGE INN broths, VERMONT MAID syrup, MY-T-FINE puddings, DAVIS baking powder and BRER RABBIT molasses and syrup. NFG, through its Specialty Products Company, is the second largest manufacturer in the hot cereal category, participating in both the cook-on-stove and mix-in-bowl segments of the category. The Quaker Oats Company, with over 60% of the hot cereal category volume sales, is the most significant participant in the hot cereal category. CREAM OF WHEAT, the leading wheat-based hot cereal, and CREAM OF RICE, participate in the cook-on-stove segment and at least seven varieties of INSTANT CREAM OF WHEAT participate in the mix-in-bowl segment. Hot cereals are manufactured in one facility. Specialty Products sells its products to retail grocery chains through independent brokers and to drug/mass merchandisers and other major retail outlets through a direct salesforce. The products are distributed from the same 13 distribution centers utilized by the LifeSavers Division. Fleischmann's Division. The Fleischmann's Division manufactures and markets various margarines and spreads as well as an egg substitute. Fleischmann's margarine business is the second largest margarine producer in the United States. Fleischmann's currently participates in all three segments of the margarine category, with FLEISCHMANN'S in the premium health segment, BLUE BONNET in the volume segment and MOVE OVER BUTTER in the premium blend segment. Fleischmann's margarines are currently manufactured in three facilities. Fleischmann's is also the market leader in the egg substitute category with EGG BEATERS. Distribution for the Fleischmann's Division is principally direct from plant to stores. Food Service Division. The Food Service Division of NFG sells a variety of specially packaged food products of the other groups of NFG through non-grocery channels, including cookies, crackers, cereals, sauces and condiments for the food service and vending machine industry. The Food Service Division is a leading regional supplier of premium frozen pies to in-store supermarket bakeries, wholesale clubs and food service accounts through the Plush Pippin Corporation. The Food Service Division provides NFG with an additional distribution method for its products. Nabisco Brands Ltd. Nabisco Brands Ltd conducts NFG's Canadian operations through a biscuit division, a grocery division and a food service division. The biscuit division produced nine of the top ten cookies and nine of the top ten crackers in Canada in 1993. Nabisco Brands Ltd's cookie and cracker brands in Canada include OREO, CHIPS AHOY!, FUDGEE-O, PEEK FREANS, DAD'S, DAVID, PREMIUM PLUS, RITZ, TRISCUIT and STONED WHEAT THINS. These products are manufactured in five bakeries in Canada and are sold through a direct store delivery system, utilizing 11 sales offices and distribution centers and a combination of public and private carriers. Nabisco Brands Ltd's grocery division produces and markets canned fruits and vegetables, fruit drinks and pet snacks. The grocery division is the leading canned fruit producer in Canada and is the second largest canned vegetable producer in Canada. Canned fruits and vegetables and fruit drinks are marketed under the DEL MONTE trademark, pursuant to a license from Del Monte, and under the AYLMER trademark. The grocery division also markets MILK-BONE pet snacks and MAGIC baking powder, each leading brands in Canada. Excluding the facility sold in connection with the sale of Nabisco's ready-to eat cold cereal business, the division operated six manufacturing facilities in 1993, five of which are devoted to canned products, principally fruits and vegetables, and one of which produced pet snacks. The grocery division's products are sold directly to retail chains and are distributed through six regional warehouses. Nabisco Brands Ltd's food service division sells a variety of specially packaged food products including cookies, crackers, canned fruits and vegetables as well as condiments to non-grocery outlets. The food service division has its own sales and marketing organization and sources product from Nabisco Brands Ltd's other divisions. NABISCO INTERNATIONAL OPERATIONS Nabisco International is a leading producer of powdered dessert and drink mixes, biscuits, baking powder and other grocery items, industrial yeast and bakery ingredients in many of the 17 Latin American countries in which it has operations. Nabisco International also exports a variety of NFG products to markets in Europe and Asia from the United States. Nabisco International is one of the largest multinational packaged food businesses in Latin America. Nabisco International manufactures and markets yeast, baking powder and bakery ingredients under the FLEISCHMANN'S and ROYAL brands, biscuits and crackers under the NABISCO brand, dessert and drink mixes under the ROYAL brand, processed milk products under the GLORIA brand, and canned fruits and vegetables under the DEL MONTE brand pursuant to a license from Del Monte. Nabisco International's largest market is Brazil, where it operates 15 plants. Nabisco International is the market leader in powdered desserts in most of Latin America, the yeast category in Brazil, biscuits in Peru, Spain, Venezuela and Uruguay, and canned vegetables in Venezuela. Nabisco International also maintains a strong position in the processed milk category in Brazil. During 1993, Nabisco International significantly increased its presence in Europe through the acquisition of a 50% interest in each of Royal Brands S.A. in Spain and Royal Brands Portugal. Nabisco International has contractual arrangements pursuant to which it expects to acquire the remaining 50% of such businesses in 1994. Nabisco International's products in Spain now include biscuits marketed under the ARTIACH and MARBU trademarks, powder dessert mixes marketed under the ROYAL trademark and various other foods, including canned meats and juices. Nabisco International's grocery products are sold to retail outlets through its own sales forces and independent wholesalers and distributors. Industrial yeast and bakery products are sold to the bakery trade through Nabisco International's own sales forces and independent distributors. RAW MATERIALS Various agricultural commodities constitute the principal raw materials used by Nabisco in its food businesses. Other raw materials used by Nabisco are purchased on the commodities market and through supplier contracts. Prices of agricultural commodities tend to fluctuate due to various seasonal, climatic and economic factors, which factors generally also affect Nabisco's competitors. Nabisco believes that the raw materials for its products are in plentiful supply and all are readily available from a variety of independent suppliers. OTHER MATTERS COMPETITION Generally, the markets in which RJRN conducts its businesses are highly competitive, with a number of large participants. Competition is conducted on the basis of brand recognition, brand loyalty and price. For most of RJRN's brands substantial advertising and promotional expenditures are required to maintain or improve a brand's position or to introduce a new brand. With respect to the tobacco industry, anti-smoking groups have undertaken activities designed to inhibit cigarette sales, the form and content of cigarette advertising and the testing and introduction of new cigarette products. Because television and radio advertising for cigarettes is prohibited in the United States and brand loyalty has tended to be higher in the cigarette industry than in other consumer product industries, established cigarette brands in the United States have a competitive advantage. RJRT has repositioned or introduced brands designed to appeal to adult smokers of the largest selling cigarette brand in the United States, but there can be no assurance that such efforts will be successful. In addition, increased selling prices and taxes on cigarettes have resulted in additional price sensitivity of cigarettes at the consumer level and in a proliferation of discounted brands in the growing savings segment of the market. Generally, sales of cigarettes in the savings segment are not as profitable as those in other segments. In April 1993, RJRT's largest competitor announced a shift in strategy designed to gain share of market while sacrificing short-term profits. The competitor's tactics included increased promotional spending and temporary price reductions on its largest cigarette brand, followed several months later by list price reductions on all its full-price and mid-price brands. RJRT defended its major full-price brands during the period of temporary price reductions and, to remain competitive in the marketplace, also reduced list prices on all its full-price and mid-price brands in August 1993. The cost of defensive price promotions and the impact of lower list prices were primarily responsible for the sharp drop in RJRT's 1993 operating company contribution. Although some improvement to the stability of the competitive environment has occurred in the fourth quarter of 1993, RJRT cannot predict if or when any further improvement to the competitive environment will occur or whether such stability will continue. In addition, growth in lower price brands was slowed in the second half of 1993 due to net price reductions on full price brands. RJRT is unable to predict whether this trend will continue. ENVIRONMENTAL MATTERS The U.S. Government and various state and local governments have enacted or adopted laws and regulations concerning protection of the environment. The regulations promulgated by the EPA and other governmental agencies under various statutes have resulted in, and will likely continue to result in, substantial expenditures for pollution control, waste treatment, plant modification and similar activities. Certain subsidiaries of the Registrants have been named "potentially responsible parties" with third parties under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") with respect to approximately fifteen sites. RJRN has been engaged in a continuing program to assure compliance with such laws and regulations. Although it is difficult to identify precisely the portion of capital expenditures or other costs attributable to compliance with environmental laws and the Registrants can not reasonably estimate the cost of resolving the above mentioned CERCLA matters, the Registrants do not expect such expenditures or costs to have a material adverse effect on the financial condition of either of the Registrants. EMPLOYEES At December 31, 1993, the Registrants together with their subsidiaries had approximately 66,500 full time employees. None of RJRT's operations are unionized. Most of the unionized workers at Nabisco's operations are represented under a national contract with the Bakery, Confectionery and Tobacco Workers International Union, which was ratified in August 1992 and which will expire in August 1996. Other unions represent the employees of a number of Nabisco's operations. In addition, several of Tobacco International's operations are unionized. RJRN believes that its relations with its employees and with the unions in which its employees are members are good. (d) Financial Information about Foreign and Domestic Operations and Export Sales For information about foreign and domestic operations and export sales for the years 1991 through 1993, see "Geographic Data" in Note 15 to the Consolidated Financial Statements. ITEM 2. ITEM 2. PROPERTIES For information pertaining to the Registrants' assets by lines of business and geographic areas as of December 31, 1993 and 1992, see Note 15 to the Consolidated Financial Statements. For information on properties, see Item 1. ITEM 3. ITEM 3. LEGAL PROCEEDINGS For information relating to litigation and legal proceedings, see "Other Matters-Environmental Matters" and "Litigation Affecting the Cigarette Industry" contained in Item 1 hereof. ------------------------------ The Registrants believe that the ultimate outcome of all pending litigation and legal proceedings should not have a material adverse effect on either of the Registrants' financial position; however, it is possible that the results of operations or cash flows of the Registrants in a particular quarterly or annual period could be materially affected by the ultimate outcome of certain pending litigation matters. Management is unable to derive a meaningful estimate of the amount or range of such possible loss in any particular quarterly or annual period or in the aggregate. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANTS EXECUTIVE OFFICERS OF HOLDINGS The executive officers of Holdings are Charles M. Harper (Chairman of the Board and Chief Executive Officer), Lawrence R. Ricciardi (President and General Counsel), Eugene R. Croisant (Executive Vice President), Stephen R. Wilson (Executive Vice President and Chief Financial Officer), Robert S. Roath (Senior Vice President and Controller) and John J. Delucca (Senior Vice President and Treasurer). The following table sets forth certain information regarding such officers. EXECUTIVE OFFICERS OF RJRN NOT LISTED ABOVE Set forth below are the names, ages, positions and offices held and a brief account of the business experience during the past five years of each executive officer of RJRN, other than those listed above. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock of Holdings, par value $.01 per share (the "Common Stock"), is listed and traded on the New York Stock Exchange (the "NYSE"). Since completion of the Acquisition there has been no public trading market for the common stock of RJRN. As of January 31, 1994, there were approximately 51,000 record holders of the Common Stock. All of the common stock of RJRN is owned by Holdings. The Common Stock closing price on the NYSE for February 22, 1994 was $7 1/2. The following table sets forth, for the calendar periods indicated, the high and low sales prices per share for the Common Stock on the NYSE Composite Tape, as reported in the Wall Street Journal: Holdings has never paid any cash dividends on shares of the Common Stock. Cash dividends paid by RJRN to Holdings are set forth in the Consolidated Statements of Cash Flows in the Consolidated Financial Statements. The operations of the Registrants are conducted through RJRN's subsidiaries and, therefore, the Registrants are dependent on the earnings and cash flow of RJRN's subsidiaries to satisfy their respective debt obligations and other cash needs. The Credit Agreements, which contain restrictions on the payment of cash dividends or other distributions by Holdings in excess of certain specified amounts, and the indentures relating to certain of RJRN's debt securities, which contain restrictions on the payment of cash dividends or other distributions by RJRN to Holdings in excess of certain specified amounts, or for certain specified purposes, effectively limit the payment of dividends on the Common Stock. In addition, the declaration and payment of dividends is subject to the discretion of the board of directors of Holdings and to certain limitations under Delaware law. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data presented below as of December 31, 1993 and 1992 and for each of the years in the three-year period ended December 31, 1993 for Holdings was derived from the Consolidated Financial Statements, which have been audited by Deloitte & Touche, independent auditors. In addition, the consolidated financial data as of December 31, 1991, 1990 and 1989, for the year ended December 31, 1990 and for the period from February 9, 1989 through December 31, 1989 for Holdings and for the period from January 1, 1989 through February 8, 1989 for RJRN was derived from the consolidated financial statements of Holdings and RJRN as of December 31, 1991, 1990 and 1989, for the year ended December 31, 1990 and for each of the periods within the one-year period ended December 31, 1989, not presented herein, which has been audited by Deloitte & Touche, independent auditors. The data should be read in conjunction with the Consolidated Financial Statements, related notes and other financial information included herein. (Footnotes on following page) (Footnotes for preceding page) - --------------- (1) The 1992 amount includes a gain of $98 million on the sale of Holdings' ready-to-eat cold cereal business. (2) The 1989 amount for Holdings included $237 million of interest expense allocated to discontinued operations. (3) On November 8, 1991, Holdings issued 52,500,000 shares of Series A Conversion Preferred Stock, par value $.01 per share ("Series A Preferred Stock") and sold 210,000,000 $.835 depositary shares (the "Series A Depositary Shares"). Each Series A Depositary Share represents a one-quarter ownership interest in a share of Series A Preferred Stock. Each share of Series A Preferred Stock bears cumulative cash dividends at a rate of $3.34 per annum and is payable quarterly in arrears on the 15th day of each February, May, August and November. Because Series A Preferred Stock mandatorily converts into Common Stock by November 15, 1994, dividends on shares of Series A Preferred Stock are reported similar to common equity dividends. (4) On December 16, 1991, an amendment to the Amended and Restated Certificate of Incorporation of Holdings was filed which deleted the provisions providing for the mandatory redemption of the redeemable preferred stock of Holdings on November 1, 2015. Accordingly, such securities were presented as a component of Holdings' stockholders' equity as of December 31, 1992 and 1991. Such securities were redeemed on December 6, 1993 (see Note 12 to the Consolidated Financial Statements). (5) Holdings' stockholders' equity at December 31 of each year from 1993 to 1989 includes non-cash expenses related to accumulated trademark and goodwill amortization of $3.015 billion, $2.390 billion, $1.774 billion, $1.165 billion and $557 million, respectively. (See Note 13 to the Consolidated Financial Statements.) See Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RJR Nabisco, Inc.'s ("RJRN") operating subsidiaries comprise one of the largest tobacco and food companies in the world. In the United States, the tobacco business is conducted by R. J. Reynolds Tobacco Company ("RJRT"), the second largest manufacturer of cigarettes, and the packaged food business is conducted by the Nabisco Foods Group ("NFG"), the largest manufacturer and marketer of cookies and crackers. Tobacco operations outside the United States are conducted by R.J. Reynolds Tobacco International, Inc. ("Tobacco International") and food operations outside the United States and Canada are conducted by Nabisco International, Inc. ("Nabisco International"). The following is a discussion and analysis of the consolidated financial condition and results of operations of RJR Nabisco Holdings Corp. ("Holdings"), the parent company of RJRN. The discussion and analysis should be read in connection with the historical financial information included in the Consolidated Financial Statements. RESULTS OF OPERATIONS Summarized financial data for Holdings is as follows: (Footnotes on following page) INDUSTRY SEGMENTS The percentage contributions of each of Holdings' industry segments to net sales and operating company contribution during the last five years were as follows: - --------------- (1) Operating income before amortization of trademarks and goodwill and exclusive of restructuring expenses (RJRT: 1993-$355 million, 1992-$43 million; Tobacco International: 1993-$189 million, 1992-$0; Total Food: 1993-$153 million, 1992-$63 million; Headquarters: 1993-$33 million, 1992- $0) and a 1992 gain ($98 million) on the sale of Holdings' ready-to-eat cold cereal business as discussed below. (2) Contributions by industry segments were computed without effects of Headquarters' expenses. (3) Includes predecessor period January 1, 1989 through February 8, 1989. TOBACCO Holdings' tobacco business is conducted by RJRT and Tobacco International. 1993 vs. 1992. Holdings' worldwide tobacco business experienced continued net sales growth in its international business that was more than offset by a significant sales decline in the domestic business, resulting in reported net sales of $8.08 billion in 1993, a decline of 11% from the 1992 level of $9.03 billion. Operating company contribution for the worldwide tobacco business of $1.84 billion in 1993 declined 31% from the 1992 level of $2.69 billion, reflecting sharp reductions for the domestic business which were partially offset by gains in the international business. Operating income for the worldwide tobacco business in 1993 of $893 million declined 60% from $2.24 billion in 1992, reflecting the lower operating company contribution and a $544 million restructuring expense in 1993 versus a restructuring expense of $43 million in 1992. The 1993 restructuring expense includes expenses to streamline both the domestic and international operations by the reduction of personnel in administration, manufacturing and sales functions, as well as rationalization of manufacturing and office facilities. Net sales for RJRT amounted to $4.95 billion in 1993, a decline of 20% from the 1992 level, reflecting the impact of industry-wide price reductions and price discounting on higher price brands, a higher proportion of sales from lower price brands and an overall volume decline of approximately 3.6%. The 1993 decrease in overall volume resulted from a decline in the full-price segment that more than offset growth in the lower price segment. The growth in lower price brands was slowed in the second half of 1993 by net price reductions on full-price brands. RJRT's operating company contribution was $1.20 billion in 1993, a 43% decline from the 1992 level of $2.11 billion, primarily due to the lower net sales and a higher proportion of sales from the lower margin segment, offset in part by lower operating expenses. RJRT's operating income was $480 million in 1993, a decline of 72% from $1.7 billion in 1992. The decline in operating income reflected the lower RJRT operating company contribution as well as a restructuring expense of $355 million in 1993 which is significantly higher than the $43 million restructuring expense recorded in 1992. Tobacco International recorded net sales of $3.13 billion in 1993, an increase of 9% from the 1992 level, due to higher volume in all regions of business, the expansion of markets through ventures in Eastern Europe and Turkey, contract sales to the Russian Republic, favorable pricing in certain regions and a change in fiscal year end, which more than offset unfavorable currency developments in Western Europe. Tobacco International's operating company contribution rose to $644 million in 1993, an increase of 12% compared to the prior year due to higher volume and pricing which was offset in part by higher operating expenses and to a lesser extent foreign currency developments. Tobacco International's operating income was $413 million for 1993, a decline of 23% from the 1992 level. The decline in operating income reflects a restructuring expense of $189 million in 1993 that more than offset the increase in operating company contribution. 1993 Competitive Activity. During recent years, the lower price segment of the domestic cigarette market has grown significantly and the full price segment has declined. The shifting of smokers of full price brands to lower price brands adversely affects RJRT's earnings since lower price brands are generally less profitable than full price brands. Although the difference in profitability is often substantial, it varies greatly depending on marketing and promotion levels and the terms of sale. Accordingly, RJRT has in recent years experienced substantial increased volume in the lower price segment, but the earnings attributable to these sales have not been sufficient to offset decreased earnings from declining sales of RJRT's full price brands. In April 1993, RJRT's largest competitor announced a shift in strategy designed to gain share of market while sacrificing short-term profits. The competitor's tactics included increased promotional spending and temporary price reductions on its largest cigarette brand, followed several months later by list price reductions on all its full-price and mid-price brands. RJRT defended its major full-price brands during the period of temporary price reductions and, to remain competitive in the marketplace, also reduced list prices on all its full-price and mid-price brands in August 1993. The cost of defensive price promotions and the impact of lower list prices were primarily responsible for the sharp drop in RJRT's 1993 operating company contribution. Currently, the domestic cigarette market has consolidated list prices for cigarettes from four or more tiers into two tiers, with price competition being conducted principally through trade and retail promotion on a brand-by-brand basis. The resulting effects from increased list prices on lower price brands and reduced promotional spending by RJRT on its full price brands have not been sufficient to offset the effect of decreased list prices on RJRT's full price brands. This has resulted in lower aggregate profit margins for RJRT. These depressed margins are expected to continue until such time as the competitive environment improves and operating costs are further reduced. Although some improvement to the stability of the competitive environment has occurred in the fourth quarter of 1993, RJRT cannot predict if or when any further improvement to the competitive environment will occur or whether such stability will continue. In addition, growth in lower price brands was slowed in the second half of 1993 due to net price reductions on full price brands. RJRT is unable to predict whether this trend will continue. RJRT's domestic cigarette volume of non-full price brands as a percentage of total domestic volume was 44% in 1993, 35% in 1992 and 25% in 1991 versus 37%, 30% and 25%, respectively, for the domestic cigarette market. 1993 Governmental Activity. Legislation recently enacted restricts the use of imported tobacco in cigarettes manufactured in the United States and is expected to increase RJRT's future raw material cost. In addition, the Clinton Administration and members of Congress have introduced bills in Congress that would significantly increase the federal excise tax on cigarettes, eliminate the deductibility of a portion of the cost of tobacco advertising, ban smoking in public buildings and workplaces, add additional health warnings on cigarette packaging and advertising and further restrict the marketing of tobacco products. It is not possible to determine what additional federal, state or local legislation or regulations relating to smoking or cigarettes will be enacted or to predict any resulting effect thereof on RJRT, Tobacco International or the cigarette industry generally but such legislation or regulations could have an adverse effect on RJRT, Tobacco International or the cigarette industry generally. 1992 vs. 1991. Net sales for RJRT rose 5% from 1991 to $6.17 billion in 1992 as higher unit selling prices and volume were offset in part by a higher proportion of sales from lower price brands. Overall volume for the 1992 year increased 3% from the prior year as a result of gains in the lower price segment more than offsetting a decline in the full price segment. RJRT's operating company contribution in 1992 was $2.11 billion, a 5% decline from the prior year. The decline in operating company contribution was primarily due to the higher proportion of sales of lower margin brands and higher marketing and selling expenditures, which when combined more than offset the effect of higher unit selling prices and volume. RJRT's operating income of $1.70 billion in 1992 declined 8% from the prior year as a result of the decline in operating company contribution as well as a $43 million charge incurred in connection with a restructuring plan, the purpose of which was to improve productivity by realigning operations in the sales, manufacturing, research and development, and administrative areas. Tobacco International recorded net sales of $2.86 billion in 1992, an increase of 7% from 1991. Excluding contract sales to the Russian Republic, for which there were major shipments in 1991, Tobacco International would have reported an increase in net sales in 1992 of 10%. The sales increase is a result of volume gains in Eastern Europe (where the company made several acquisitions), Asia and the Middle East, favorable currency developments and higher selling prices that more than offset lower volume in Western Europe. Operating company contribution and operating income for 1992 rose 15% and 16%, respectively, from the prior year to $575 million and $537 million. The increase in operating company contribution and operating income was due to higher volume, favorable currency developments and higher selling prices offset in part by a higher proportion of sales in the lower margin segment. For a description of certain litigation affecting RJRT and its affiliates, see Note 11 to the Consolidated Financial Statements. FOOD Holdings' food business is conducted by NFG, which comprises the Nabisco Biscuit Company, the LifeSavers Division, the Planters Division, the Specialty Products Company, the Fleischmann's Division, the Food Service Division and Nabisco Brands Ltd, (collectively the "North American Group") and Nabisco International. 1993 vs. 1992. NFG reported net sales of $7.03 billion in 1993, an increase of 5% from 1992. Excluding the 1992 operating results of the ready-to-eat cold cereal business, which was sold at the end of that year, net sales in 1993 increased 9% from 1992, resulting from higher volume, sales from recently acquired businesses and modest price increases in both the North American Group and Nabisco International. The North American Group volume increase was primarily attributable to the success of new product introductions in the U.S., including the Snackwell's line of low fat/fat free cookies and crackers, Fat Free Newtons, Life Savers Gummi Savers candy and Planters' stand-up bag line of peanuts and snacks. Nabisco International's net sales increased as a result of the 1993 acquisitions in Spain and Peru and higher volume and prices from its Latin American businesses. NFG's operating company contribution of $995 million in 1993 was 5% higher than the 1992 amount. Excluding the 1992 operating results of the ready-to-eat cold cereal business, operating company contribution increased 14%, with the North American Group up 13% and Nabisco International up 18%. The North American Group increase was primarily due to the gain in net sales, savings from productivity programs, and contributions from the recently acquired businesses, offset in part by higher expenses for consumer marketing programs. Nabisco International increased operating company contribution through acquisitions and gains in net sales. NFG's operating income was $624 million in 1993, a decrease of 19% from 1992, as a result of the $153 million restructuring expense in 1993, which was significantly higher than the restructuring expense of $63 million recorded in 1992, that more than offset the gain in operating company contribution. Excluding the 1992 operating results of the ready-to-eat cold cereal business and the related gain on its sale, as well as the restructuring expenses in both 1993 and 1992, NFG's operating income was up 16% as a result of the increase in operating company contribution. The 1993 restructuring expense primarily consists of expenses related to the reorganization and downsizing of manufacturing and sales functions which will reduce personnel costs, both domestically and internationally, in order to improve productivity and, to a lesser extent, the rationalization of facilities. 1992 vs. 1991. NFG reported net sales of $6.71 billion in 1992, an increase of 4% from 1991. The increase primarily results from higher volume and pricing in the Latin American subsidiaries and the addition of recently acquired businesses in Mexico and Brazil. Net sales for the North American Group were relatively flat, as higher unit selling prices and volume in U.S. cookie and selected grocery products, including new products and product varieties, were offset by lower sales in the balance of the food lines as a result of restrained consumer spending. NFG's operating company contribution increased 3% from 1991 to $947 million in 1992 as a result of the increase in net sales in Latin America. Operating company contribution in the North American Group was about even with last year reflecting the modest net sales performance in 1992. Margins in the North America Group were maintained in 1992 as a result of productivity gains offsetting the industry trends toward higher trade promotion spending. NFG's 1992 operating income, which included a restructuring expense of $63 million, as well as a gain of $98 million on the sale of the ready-to-eat cold cereal business, rose 8% from 1991 to $769 million as a result of the increase in 1992 operating company contribution. The $63 million charge was incurred in connection with a restructuring plan, the purpose of which was to reduce costs and improve productivity by realigning sales operations and implementing a voluntary separation program. RESTRUCTURING EXPENSE Holdings recorded a pre-tax restructuring expense of $730 million in the fourth quarter of 1993 ($467 million after-tax) related to a program announced on December 7, 1993. Such restructuring program was undertaken in response to a changing consumer product business environment and is expected to streamline operations and improve profitability. Implementation of the program, although begun in the latter part of 1993, will primarily occur in 1994. Approximately 75% of the restructuring program will require cash outlays which will occur primarily in 1994 and early 1995. As an offset to the cash outlays, Holdings expects annual after-tax cash savings of approximately $250 million. The cost of providing severance pay and benefits for the reduction of approximately 6,000 employees throughout the domestic and international food and tobacco businesses is approximately $400 million of the charge and is primarily a cash expense. The workforce reduction was undertaken in order to establish fundamental changes to the cost structure of the domestic tobacco business in the face of acute competitive activity in that business and to take advantage of cost savings opportunities in other businesses through process efficiency improvements. Legislation enacted during the third quarter of 1993 stipulates that, effective January 1, 1994, financial penalties will be assessed against manufacturers if cigarettes produced in the United States do not contain at least 75% (by weight) of domestically grown flue cured and burly tobaccos. As a result, the domestic and international tobacco businesses accrued approximately $70 million of related restructuring charges resulting from a reassessment of raw material sourcing and production arrangements. In addition, a shift in pricing strategy designed to gain share of market by RJRT's largest competitor has resulted in a redeployment of spending and changes in sales and distribution strategies resulting in a restructuring charge of approximately $80 million primarily related to contract termination costs. Abandonment of leases related to the above changes in the businesses results in approximately $60 million of restructuring charges. The remainder of the charge, approximately $120 million, represents non-cash costs to rationalize and close manufacturing and sales facilities in both the tobacco and food businesses to facilitate cost improvements. INTEREST EXPENSE 1993 vs. 1992. Consolidated interest expense of $1.19 billion in 1993 decreased 17% from 1992, primarily as a result of the refinancings of debt that were completed during 1992 and 1993, lower debt levels from the application of net proceeds from the issuance of preferred stock in 1993 and lower effective interest rates and the impact of declining market interest rates in 1993. 1992 vs. 1991. Consolidated interest expense of $1.43 billion in 1992 decreased 32% from 1991, primarily due to the refinancings completed during 1991 and 1992, lower effective interest rates and the impact of declining market interest rates in 1992. INCOME TAXES Effective January 1, 1993, Holdings and RJRN adopted Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), Accounting for Income Taxes. SFAS No. 109 superseded Statement of Financial Accounting Standards No. 96, the method of accounting for income taxes previously followed by the Registrants. The adoption of SFAS No. 109 did not have a material impact on the financial statements of either Holdings or RJRN. Holdings' provision for income taxes for 1993 was increased by $96 million as a result of the enactment of certain federal tax legislation during the third quarter of 1993 which increased federal corporate income tax rates to 35% from 34%, retroactively to January 1, 1993. The components of this increase to Holdings' provision for income taxes included an $86 million non-cash charge resulting primarily from the remeasurement of the balance of deferred federal income taxes at the date of enactment of the new federal tax legislation for the change in the income tax rates, and a $10 million charge resulting from the increase in current federal income taxes accrued for the change in the income tax rates and other effects of the new tax legislation. Also during 1993, Holdings' provision for income taxes was decreased by a $108 million credit resulting from a remeasurement of the balance of deferred income taxes for a change in estimate of the basis of certain deferred tax amounts relating primarily to international operations. NET INCOME 1993 vs. 1992. Holdings reported a net loss of $145 million in 1993, a decrease of $444 million from 1992. Included in Holdings' 1993 net loss is an after-tax extraordinary loss of $142 million related to the repurchases of high cost debt during 1993 and an after-tax restructuring expense of $467 million. Excluding the extraordinary loss and restructuring expense recorded in 1993, Holdings would have reported net income of $464 million in 1993. Excluding a similar after-tax extraordinary loss and an after-tax restructuring expense of $477 million and $66 million, respectively, in 1992, as well as a 1992 after-tax gain on the sale of Holdings' ready-to-eat cold cereal business of $30 million, Holdings would have reported net income of $812 million in 1992. The decrease in net income in 1993 from 1992, after such exclusions, is due to the lower operating income offset in part by lower interest expense. 1992 vs. 1991. Holdings' net income of $299 million in 1992 includes an after-tax extraordinary loss of $477 million related to the repurchases of high cost debt during 1992. However, after excluding the extraordinary loss, Holdings would have reported net income of $776 million for 1992, an increase of $408 million over last year, primarily as a result of significantly lower interest expense. Net income in 1991 was reduced by $28 million of net charges included in "Other income (expense), net" as a result of the write-off of $109 million of unamortized debt issuance costs and the recognition of $144 million of unrealized losses from interest rate hedges related to the refinancing of existing credit lines, partially offset by a $225 million credit for a change in estimated postretirement health care liabilities. Holdings' net income (loss) applicable to its common stock for 1993, 1992 and 1991 of $(213) million, $268 million and $195 million, respectively, includes a deduction for preferred stock dividends of $68 million, $31 million and $173 million, respectively. Effective January 1, 1993, RJRN adopted Statement of Financial Accounting Standards No. 112 ("SFAS No. 112"), Employers' Accounting for Postemployment Benefits. Under SFAS No. 112, RJRN is required to accrue the costs for preretirement postemployment benefits provided to former or inactive employees and recognize an obligation for these benefits. The adoption of SFAS No. 112 did not have a material impact on the financial statements of either Holdings or RJRN. LIQUIDITY AND FINANCIAL CONDITION DECEMBER 31, 1993 Holdings continued to generate significant free cash flow in 1993, although at a lower level than in 1992. Free cash flow, which represents cash available for the repayment of debt and certain other corporate purposes before the consideration of any debt and equity financing transactions, acquisition expenditures and divestiture proceeds, was $1.0 billion for 1993 and $1.6 billion for 1992. The lower level of free cash flow for 1993 primarily reflects lower operating company contribution in the domestic tobacco business, higher capital expenditures for tobacco manufacturing facilities in Eastern Europe and Turkey and for Nabisco Biscuit facilities and higher taxes paid, offset in part by lower inventory levels in the domestic tobacco business, higher sales of receivables, and a decrease in interest paid. The components of free cash flow are as follows: - --------------- * Operating cash flow, which is used as an internal measurement for evaluating business performance, includes, in addition to net cash flow from (used in) operating activities as recorded in the Consolidated Statement of Cash Flows, proceeds from the sale of capital assets less capital expenditures, and is adjusted to exclude income taxes paid and items of a financial nature (such as interest paid, interest income, and other miscellaneous financial income or expense items). --------------- In 1993, Holdings and RJRN continued to enter into a series of transactions designed to refinance long-term debt, lower debt levels and lower interest costs, thereby improving the consolidated debt cost and maturity structure. These transactions included the issuance of preferred stock and the repurchase and redemption of certain debt obligations with funds provided from the issuance of debt securities (including medium-term notes), borrowings under Holdings' and RJRN's credit agreement, dated as of December 1, 1991, as amended (the "1991 Credit Agreement"), and free cash flow, as well as RJRN's management of interest rate exposure through swaps, options, caps and other interest rate arrangements. As a result of these transactions and lower market interest rates during 1993, Holdings reduced the effective interest rate on its consolidated long-term debt from 8.7% at December 31, 1992 to 8.4% at December 31, 1993. Future effective interest rates may vary as a result of RJRN's ongoing management of interest rate exposure and changing market interest rates as well as refinancing activities and changes in the ratings assigned to RJRN's debt securities by independent rating agencies. One of Holdings' current financial objectives is to achieve a capitalization ratio of 43% over time. Holdings' capitalization ratio was 44.5% at December 31, 1993. The capitalization ratio, which is intended to measure Holdings' long-term debt (including current maturities) as a percentage of total capital, is calculated by dividing (i) Holdings' long-term debt by (ii) the sum of Holdings' total equity, consolidated long-term debt, deferred income taxes and certain other long-term liabilities. Certain of Holdings' other current financial objectives, which are all based on income before extraordinary items excluding after-tax amortization of trademarks and goodwill and referred to below as cash net income, are to achieve a 20% return on year beginning common stockholders' equity, a 2.7 interest and preferred stock dividend coverage ratio and a trendline average annual earnings per share growth of 15% over time. The 20% return on year beginning common stockholders' equity objective, which is intended to measure the return to Holdings' common equity holders on the net assets employed in the business, is calculated by dividing (i) cash net income (after deducting preferred stock dividends) by (ii) total stockholders' equity at the beginning of the year exclusive of preferred stockholders' equity interest. For purposes of calculating the return on year beginning common stockholders' equity, Series A Preferred Stock and similar convertible preferred stock securities, if any, are considered common equity and the related dividends thereon are considered common dividends. The 2.7 interest and preferred stock dividend coverage ratio objective, which is intended to measure Holdings' ability to service its annual interest and preferred stock dividend payments, is calculated by dividing (i) operating income before amortization of trademarks and goodwill and depreciation by (ii) the sum of cash interest expense and preferred stock dividends. The trendline average annual earnings per share growth of 15% as adjusted for after-tax amortization of trademarks and goodwill, is intended to measure Holdings' ability to achieve a certain level of earnings per share growth over time. At December 31, 1993, Holdings had an outstanding total debt level (notes payable and long-term debt, including current maturities) and a total capital level (total debt and total stockholders' equity) of approximately $12.4 billion and $21.5 billion, respectively, each of which is lower than the corresponding amounts at December 31, 1992. Holdings' ratio of total debt to total stockholders' equity at December 31, 1993 improved to 1.4-to-1 versus 1.7-to-1 at December 31, 1992. RJRN's ratio of total debt to common equity at December 31, 1993 was 1.3-to-1, compared with 1.6-to-1 at December 31, 1992. Total current liabilities and long-term debt of RJRN's subsidiaries was approximately $3.4 billion at December 31, 1993 and 1992. Management believes that the improvement to Holdings' and its subsidiaries' financial structure since 1991 has enhanced its ability to take advantage of opportunities to further improve its capital and/or cost structure. Management expects that it will continue to consider opportunities as they arise. Such opportunities, if pursued, could involve further acquisitions from time to time of substantial amounts of securities of Holdings or its subsidiaries through open market purchases, redemptions, privately negotiated transactions, tender or exchange offers or otherwise and/or the issuance from time to time of additional securities by Holdings or its subsidiaries. Acquisitions of securities at prices above their book value, together with the accelerated amortization of deferred financing fees attributable to the acquired securities, would reduce reported net income, depending upon the extent of such acquisitions. Nonetheless, Holdings' and its subsidiaries' ability to take advantage of such opportunities is subject to restrictions in the 1991 Credit Agreements and Holdings' and RJRN's credit agreement, dated as of April 5, 1993, as amended (the "1993 Credit Agreement", and together with the 1991 Credit Agreement, the "Credit Agreements"), and in certain of their debt indentures. For a discussion of recent developments affecting the tobacco business and the potential effect on RJRT's cash flow, see "Results of Operations--Tobacco." In addition, management currently is reviewing and expects to continue to review various corporate transactions, including, but not limited to, joint ventures, mergers, acquisitions, divestitures, asset swaps, spin-offs and recapitalizations. Although Holdings has discussed and continues to discuss various transactions with third parties, no assurance may be given that any transaction will be announced or completed. It is likely that Holdings' tobacco and food businesses would be separated should certain of the foregoing transactions be consummated. During 1993, RJRN issued $750 million principal amount of 8% Notes due 2000, $500 million principal amount of 8 3/4% Notes due 2005 and $500 million principal amount of 9 1/4% Debentures due 2013. Also during 1993, RJRN issued medium-term notes maturing in the years 1995-1998 having an aggregate initial offering price of approximately $230 million. The net proceeds from the sale of debt securities and the sale of 50,000,000 depositary shares at $25 per share issued in connection with the issuance of Series B Cumulative Preferred Stock have been or will be used for general corporate purposes, which include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases and redemptions of securities. Pending such uses, proceeds may be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. A portion of the net proceeds collected from the sale of Holdings' ready-to-eat cold cereal business was used on February 5, 1993 to redeem $216 million principal amount of RJRN's 9 3/8% Sinking Fund Debentures due 2016 at a price of $1,065.63 for each $1,000 principal amount of such debentures, plus accrued and unpaid interest thereon. The 1991 Credit Agreement is a $6.5 billion revolving bank credit facility that provides for the issuance of up to $800 million of irrevocable letters of credit. Availability under the 1991 Credit Agreement is reduced by an amount equal to the stated amount of such letters of credit outstanding, by commercial paper borrowings in excess of $1 billion and by amounts borrowed under such facility. At December 31, 1993, approximately $456 million stated amount of letters of credit was outstanding and $328 million was borrowed under the 1991 Credit Agreement. Accordingly, the amount available under the 1991 Credit Agreement at December 31, 1993 was $5.72 billion. On April 5, 1993, Holdings and RJRN entered into the 1993 Credit Agreement, which matures on April 4, 1994 and provides a back-up line of credit to support commercial paper issuances of up to $1 billion. Availability thereunder is reduced by an amount equal to the aggregate amount of commercial paper outstanding. At December 31, 1993, approximately $913 million of commercial paper was outstanding. Accordingly, $87 million was available under the 1993 Credit Agreement at December 31, 1993. Holdings and RJRN expect to obtain bank consent to extend the maturity date of the 1993 Credit Agreement for an additional 364 days. The aggregate of consolidated indebtedness and interest rate arrangements subject to fluctuating interest rates approximated $5.5 billion at December 31, 1993. This represents an increase of $800 million from the year end 1992 level of $4.7 billion, primarily due to Holdings' on-going management of its interest rate exposure. As a result of the general decline in market interest rates compared with the high interest cost on certain of Holdings' consolidated debt obligations, the estimated fair value amount of Holdings' long-term debt reflected in its Consolidated Balance Sheets at December 31, 1993 and 1992 exceeded the carrying amount (book value) of such debt by approximately $400 million and $1.1 billion, respectively. For additional disclosures concerning the fair value of Holdings' consolidated indebtedness as well as the fair value of its interest rate arrangements at December 31, 1993 and 1992, see Notes 10 and 11 to the Consolidated Financial Statements. Capital expenditures were $615 million, $519 million and $459 million for 1993, 1992 and 1991, respectively. The current level of expenditures planned for 1994 is expected to be approximately $600 million (approximately 60% Food and 40% Tobacco), which will be funded primarily by cash flows from operating activities. Management expects that its capital expenditure program will continue at a level sufficient to support the strategic and operating needs of Holdings' businesses. Holdings has operations in many countries, utilizing 35 functional currencies in its foreign subsidiaries and branches. Significant foreign currency net investments are located in Germany, Canada, Hong Kong, Brazil and Spain. Changes in the strength of these countries' currencies relative to the U.S. dollar result in direct charges or credits to equity for non-hyperinflationary countries and direct charges or credits to the income statement for hyperinflationary countries. Translation gains or losses, resulting from foreign-denominated borrowings that are accounted for as hedges of certain foreign currency net investments, also result in charges or credits to equity. Holdings also has significant exposure to foreign exchange sale and purchase transactions in currencies other than its functional currency. The exposures include the U.S. dollar, German mark, Japanese yen, Swiss franc, Hong Kong dollar, Singapore dollar and cross-rate exposure among the French franc, British pound, Italian lira and the German mark. Holdings manages these exposures to minimize the effects of foreign currency transactions on its cash flows. Certain financing agreements to which Holdings is a party and debt instruments of RJRN directly or indirectly restrict the payment of dividends by Holdings. The Credit Agreements, which contain restrictions on the payment of cash dividends or other distributions by Holdings in excess of certain specified amounts, and the indentures relating to certain of RJRN's debt securities, which contain restrictions on the payment of cash dividends or other distributions by RJRN to Holdings in excess of certain specified amounts, or for certain specified purposes, effectively limit the payment of dividends on the Common Stock. In addition, the declaration and payment of dividends is subject to the discretion of the board of directors of Holdings and to certain limitations under Delaware law. The Credit Agreements and the indentures under which certain debt securities of RJRN have been issued also impose certain operating and financial restrictions on Holdings and its subsidiaries. These restrictions limit the ability of Holdings and its subsidiaries to incur indebtedness, engage in transactions with stockholders and affiliates, create liens, sell certain assets and certain subsidiaries' stock, engage in certain mergers or consolidations and make investments in unrestricted subsidiaries. As a result of the increased competitive conditions in the domestic cigarette market and in order to provide Holdings with additional flexibility under certain financial ratios contained in the Credit Agreements, Holdings obtained an amendment to such Credit Agreements during October 1993. Holdings and RJRN believe that they are currently in compliance with all covenants and restrictions in the Credit Agreements and their other indebtedness. On February 24, 1994, Holdings filed a Registration Statement on Form S-3 for a proposed offering of 300 million depositary shares, each representing a one-tenth ownership interest in a share of a newly created series of Preferred Equity Redemption Cumulative Stock ("PERCS"). Each depositary share would mandatorily convert in three years into one share of Common Stock, subject to adjustment and subject to earlier conversion or redemption under certain circumstances. Any net proceeds of a PERCS offering may be used for general corporate purposes which may include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases or redemptions of securities. In addition, such proceeds may be used to facilitate one or more significant corporate transactions, such as a joint venture, merger, acquisition, divestiture, asset swap, spin-off and/or recapitalization, that would result in the separation of the tobacco and food businesses of Holdings. As of February 24, 1994, the specific uses of proceeds have not been determined. Pending such uses, any proceeds would be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. ENVIRONMENTAL MATTERS RJRN has been engaged in a continuing program to assure compliance with U.S. Government and various state and local government laws and regulations concerning the protection of the environment. Certain subsidiaries of the Registrants have been named "potentially responsible parties" with third parties under the Comprehensive Environmental Response, Compensation and Liability Act, ("CERCLA") with respect to approximately fifteen sites. Although it is difficult to identify precisely the portion of capital expenditures or other costs attributable to compliance with environmental laws and the Registrants can not reasonably estimate the cost of resolving the above-mentioned CERCLA matters, the Registrants do not expect such expenditures or costs to have a material adverse effect on the financial condition of either of the Registrants. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Refer to the Index to Financial Statements and Financial Statement Schedules on page 34, for the required information. 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 REGISTRANTS Item 10 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. Reference is also made regarding the executive officers of the Registrants to "Executive Officers of the Registrants" following Item 4 of Part I of this Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Item 11 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Item 12 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Item 13 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND 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, in the City of New York, State of New York on February 24, 1994. RJR NABISCO HOLDINGS CORP. By: /s/ CHARLES M. HARPER .................................... (Charles M. Harper) 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 on February 24, 1994. *By: /s/ ROBERT F. SHARPE, JR. ...................................... (Robert F. Sharpe, Jr.) 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, in the City of New York, State of New York on February 24, 1994. RJR NABISCO, INC. By: /s/ CHARLES M. HARPER ...................................... (Charles M. Harper) 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 on February 24, 1994. *By: /s/ ROBERT F. SHARPE, JR. ....................................... (Robert F. Sharpe, Jr.) Attorney-in-Fact INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES For the years ended December 31, 1993, 1992 and 1991: All other schedules for which provision is made in the applicable regulations of the Securities and Exchange Commission are omitted because they are not required under the related instructions or are not applicable or the required information is shown in the financial statements or notes thereto. REPORT OF DELOITTE & TOUCHE, INDEPENDENT AUDITORS RJR Nabisco Holdings Corp.: RJR Nabisco, Inc.: We have audited the accompanying consolidated balance sheets of RJR Nabisco Holdings Corp. ("Holdings") and RJR Nabisco, Inc. ("RJRN") as of December 31, 1993 and 1992, and the related consolidated statements of income 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 of Holdings and RJRN as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993 as listed in the accompanying Index to Financial Statements and Financial Statement Schedules. These financial statements and financial statement schedules are the responsibility of the companies' 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 audits 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, such consolidated financial statements present fairly, in all material respects, the consolidated financial position of Holdings and RJRN 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, 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 New York, New York February 1, 1994 (except with respect to the subsequent event discussed in Note 17, as to which the date is February 24, 1994) RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED FINANCIAL STATEMENTS The Summary of Significant Accounting Policies below and the notes to consolidated financial statements on pages through are integral parts of the accompanying consolidated financial statements of RJR Nabisco Holdings Corp. ("Holdings") and RJR Nabisco, Inc. ("RJRN" and, collectively with Holdings, the "Registrants") (the "Consolidated Financial Statements"). SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES This Summary of Significant Accounting Policies is presented to assist in understanding the Consolidated Financial Statements included in this report. These policies conform to generally accepted accounting principles. Consolidation Consolidated Financial Statements include the accounts of each Registrant and its subsidiaries. Cash Equivalents Cash equivalents include all short-term, highly liquid investments that are readily convertible to known amounts of cash and so near maturity that they present an insignificant risk of changes in value because of changes in interest rates. Inventories Inventories are stated at the lower of cost or market. Various methods are used for determining cost. The cost of U.S. tobacco inventories is determined principally under the LIFO method. The cost of remaining inventories is determined under the FIFO, specific lot and weighted average methods. In accordance with recognized trade practice, stocks of tobacco, which must be cured for more than one year, are classified as current assets. Depreciation Property, plant and equipment are depreciated principally by the straight-line method. Trademarks and Goodwill Values assigned to trademarks are based on appraisal reports and are amortized on the straight-line method over a 40 year period. Goodwill is also amortized on the straight-line method over a 40 year period. Other Income (Expense), Net Interest income, gains and losses on foreign currency transactions and other financial items are included in "Other income (expense), net". Income Taxes Income taxes are accounted for under the provisions of Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), Accounting for Income Taxes, and are calculated for each Registrant on a separate return basis. Postretirement Benefits Other Than Pensions Postretirement benefits other than pensions are accounted for under the provisions of Statement of Financial Accounting Standards No. 106 ("SFAS No. 106"), Employers' Accounting for Postretirement Benefits Other Than Pensions. Postemployment Preretirement Benefits Postemployment preretirement benefits are accounted for under the provisions of Statement of Financial Accounting Standards No. 112 ("SFAS No. 112"), Employers' Accounting for Postemployment Benefits. Excise Taxes Excise taxes are excluded from "Net sales" and "Cost of products sold". Reclassifications and Restatements Certain reclassifications have been made to prior years' amounts to conform to the 1993 presentation. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) See Notes to Consolidated Financial Statements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) See Notes to Consolidated Financial Statements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS) See Notes to Consolidated Financial Statements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--OPERATIONS Net sales and cost of products sold exclude excise taxes of $3.757 billion, $3.560 billion and $3.715 billion for 1993, 1992 and 1991, respectively. Operating income in the fourth quarter of 1993 was reduced by a $730 million restructuring expense for a program initiated at the domestic tobacco operations ($355 million), the international tobacco operations ($189 million), the food operations ($153 million) and Headquarters ($33 million). Such restructuring program was undertaken in response to a changing consumer product business environment and is expected to streamline operations and improve profitability. Implementation of the program, although begun in the latter part of 1993, will primarily occur in 1994. Approximately 75% of the restructuring program will require cash outlays which will occur primarily in 1994 and early 1995. As an offset to the cash outlays, Holdings expects annual after-tax cash savings of approximately $250 million. The cost of providing severance pay and benefits for the reduction of approximately 6,000 employees throughout the domestic and international food and tobacco businesses is approximately $400 million of the charge and is primarily a cash expense. The workforce reduction was undertaken in order to establish fundamental changes to the cost structure of the domestic tobacco business in the face of acute competitive activity in that business and to take advantage of cost savings opportunities in other businesses through process efficiency improvements. Legislation enacted during the third quarter of 1993 stipulates that, effective January 1, 1994, financial penalties will be assessed against manufacturers if cigarettes produced in the United States do not contain at least 75% (by weight) of domestically grown flue cured and burly tobaccos. As a result, the domestic and international tobacco businesses accrued approximately $70 million of related restructuring charges resulting from a reassessment of raw material sourcing and production arrangements. In addition, a shift in pricing strategy designed to gain share of market by RJRT's largest competitor has resulted in a redeployment of spending and changes in sales and distribution strategies resulting in a restructuring charge of approximately $80 million primarily related to contract termination costs. Abandonment of leases related to the above changes in the businesses results in approximately $60 million of restructuring charges. The remainder of the charge, approximately $120 million, represents non-cash costs to rationalize and close manufacturing and sales facilities in both the tobacco and food businesses to facilitate cost improvements. During the fourth quarter of 1992, operating income was reduced by a net charge of $8 million as a result of a $106 million restructuring expense recorded at the tobacco operations ($43 million) and the food operations ($63 million), partially offset by a $98 million gain recognized from the sale of Holdings' ready-to-eat cold cereal business for $456 million in cash, prior to post-closing adjustments. The restructuring expense was incurred in connection with a restructuring plan at the tobacco operations, the purpose of which was to improve productivity by realigning operations in the sales, manufacturing, research and development, and administrative areas and a restructuring plan at the food operations, the purpose of which was to reduce costs and improve productivity by realigning sales operations and implementing a previously announced voluntary separation program. The receivable established at December 31, 1992 for the sale of the ready-to-eat cold cereal business was collected on January 4, 1993, except for certain escrow amounts which were subsequently collected. During the fourth quarter of 1991, net income was reduced by $28 million of net charges included in "Other income (expense), net" as a result of the write-off of $109 million of unamortized debt issuance costs and the recognition of $144 million of unrealized losses from interest rate hedges related RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 1--OPERATIONS--(CONTINUED) to the refinancing of the bank credit agreement of RJR Nabisco Capital Corp. ("Capital") dated as of January 31, 1989 (as amended, the "1989 Credit Agreement") and the repayment of the $2.25 billion bank credit facility (as amended, the "1990 Credit Agreement"), partially offset by a $225 million credit for a change in estimated postretirement health care liabilities. NOTE 2--EARNINGS PER SHARE Earnings per share is based on the weighted average number of shares of common stock and Series A Depositary Shares (hereinafter defined) outstanding during the period and common stock assumed to be outstanding to reflect the effect of dilutive warrants and options. Holdings' other potentially dilutive securities are not included in the earnings per share calculation because the effect of excluding interest and dividends on such securities for the period would exceed the earnings allocable to the common stock into which such securities would be converted. Accordingly, Holdings' earnings per share and fully diluted earnings per share are the same. NOTE 3--INCOME TAXES The provision for income taxes consisted of the following: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--INCOME TAXES--(CONTINUED) The components of the deferred income tax liability disclosed on the Consolidated Balance Sheet at December 31, 1993 included the following: Pre-tax income (loss) before extraordinary item for domestic and foreign operations is shown in the following table: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--INCOME TAXES--(CONTINUED) The differences between the provision for income taxes and income taxes computed at statutory U.S. federal income tax rates are explained as follows: At December 31, 1993, there was $1.242 billion of accumulated and undistributed income of foreign subsidiaries. These earnings are intended by management to be reinvested abroad indefinitely. Accordingly, no applicable U.S. federal deferred income taxes or foreign withholding taxes have been provided nor is a determination of the amount of unrecognized U.S. federal deferred income taxes practicable. At December 31, 1993, Holdings had cumulative minimum tax credit carryforwards for U.S. federal tax purposes of $64 million. Effective January 1, 1993, Holdings and RJRN adopted SFAS No. 109. SFAS No. 109 superseded Statement of Financial Accounting Standards No. 96, the method of accounting for income taxes previously followed by the Registrants. The adoption of SFAS No. 109 did not have a material impact on the financial statements of either Holdings or RJRN. Holdings' provision for income taxes for 1993 was increased by $96 million as a result of the enactment of certain federal tax legislation during the third quarter of 1993 which increased federal corporate income tax rates to 35% from 34%, retroactively to January 1, 1993. The components of this RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--INCOME TAXES--(CONTINUED) increase to Holdings' provision for income taxes included an $86 million non-cash charge resulting primarily from the remeasurement of the balance of deferred federal income taxes at the date of enactment of the new federal tax legislation for the change in the income tax rates, and a $10 million charge resulting from the increase in current federal income taxes accrued for the change in the income tax rates and other effects of the new tax legislation. Also during 1993, Holdings' provision for income taxes was decreased by a $108 million credit resulting from a remeasurement of the balance of deferred income taxes for a change in estimate of the basis of certain deferred tax amounts relating primarily to international operations. During 1993, $101 million of previously recognized deferred income tax benefits for operating loss carryforwards ($36 million), minimum tax credit carryforwards ($44 million) and other carryforward items ($21 million) were realized for U.S. federal tax purposes. NOTE 4--EXTRAORDINARY ITEM The extinguishments of debt of Holdings and RJRN resulted in the following extraordinary losses: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5--SUPPLEMENTAL CASH FLOWS INFORMATION A reconciliation of net income (loss) to net cash flows from operating activities follows: Cash payments for income taxes and interest were as follows: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5--SUPPLEMENTAL CASH FLOWS INFORMATION--(CONTINUED) Cash equivalents at December 31, 1993 and 1992, valued at cost (which approximates market value), totaled $215 million and $99 million, respectively, and consisted principally of domestic and Eurodollar time deposits and certificates of deposit. At December 31, 1993 and 1992, cash of $62 million and $63 million, respectively, was held in escrow as collateral for letters of credit issued in connection with certain foreign currency debt. On February 7, 1990, RJRN entered into an arrangement in which it agreed to sell for cash substantially all of its domestic trade accounts receivable generated during a five-year period to a financial institution. Pursuant to amendments entered into in 1992, the length of the receivable program was extended an additional year. The accounts receivable have been and will continue to be sold with limited recourse at purchase prices reflecting the rate applicable to the cost to the financial institution of funding its purchases of accounts receivable and certain administrative costs. During 1993, 1992 and 1991, total proceeds of approximately $8.2 billion, $8.5 billion and $8.7 billion, respectively, were received by RJRN in connection with this arrangement. At December 31, 1993 and 1992, the accounts receivable balance has been reduced by approximately $437 million and $352 million, respectively, due to the receivables sold. For information regarding certain non-cash financing activities, see Notes 10 and 12 to the Consolidated Financial Statements. NOTE 6--INVENTORIES The major classes of inventory are shown in the table below: At December 31, 1993 and 1992, approximately $1.4 billion of inventory was valued under the LIFO method. The current cost of LIFO inventories at December 31, 1993 and 1992 was greater than the amount at which these inventories were carried on the Consolidated Balance Sheets by $284 million and $277 million, respectively. For the years ended December 31, 1993, 1992 and 1991, net income was increased by $6 million, $4 million, and $9 million, respectively, as a result of LIFO inventory liquidations. The LIFO liquidations resulted from programs to reduce leaf durations consistent with forecasts of future operating requirements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--PROPERTY, PLANT AND EQUIPMENT Components of property, plant and equipment were as follows: NOTE 8--NOTES PAYABLE Notes payable consisted of the following: NOTE 9--ACCRUED LIABILITIES Accrued liabilities consisted of the following: NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE Interest expense consisted of the following: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) Long-term debt consisted of the following: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) - --------------- (1) The payment of debt through December 31, 1998 is due as follows (in millions): 1995--$617; 1996--$465; 1997--$70 and 1998--$1,714. (2) RJRN maintains a revolving credit facility of $6.5 billion of which $6.2 billion was unused at December 31, 1993. At December 31, 1993, availability of the unused portion is reduced by $456 million for the extension of irrevocable letters of credit which support the principal and interest on certain existing foreign debt of RJRN and its subsidiaries. A commitment fee of 1/4% per annum is payable on the unused portion of the facility. (3) RJRN maintains a back-up line of credit to support commercial paper issuances of up to $1 billion. Commercial paper outstanding in excess of $1 billion is supported by the 1991 Credit Agreement. (4) As a result of RJRN's management of its interest rate exposure through swaps, options, caps, and other interest rate arrangements, the effective interest rate on certain debt may differ from that disclosed in the table. ------------------------ During 1991, Holdings entered into the following refinancing transactions: (i) the repayment on March 11, 1991 of the aggregate principal amount outstanding of a subordinated promissory note held by a limited partnership affiliated with Kohlberg Kravis Roberts & Co., L.P. ("KKR") plus accrued and unpaid interest thereon for a total of approximately $468 million in cash from borrowings under the revolving credit portion of the 1989 Credit Agreement, (ii) the issuance by Capital on April 25, 1991 of $1.5 billion principal amount of 10 1/2% Senior Notes due 1998 (the "10 1/2% Senior Notes") (the "Senior Note Offering") and the repayment of a portion of the amount outstanding under the 1990 Credit Agreement with a portion of the net proceeds from the Senior Note Offering equal to approximately $731 million in cash, (iii) the redemption on June 3, 1991 of 100% of the aggregate principal amount of all outstanding Subordinated Exchange Debentures Due 2007 of RJR Nabisco Holdings Group, Inc. ("Group") equal to approximately $1.86 billion plus accrued and unpaid interest thereon to the redemption date with (a) an additional portion of the net proceeds from the Senior Note Offering and (b) the entire net proceeds from the issuance by Holdings on April 18, 1991 of 115,000,000 shares of common stock of Holdings, par value $.01 per share (the "Common Stock") at $11.25 per share, (iv) open market purchases of certain of Capital's debentures totalling approximately $128 million with the remaining net proceeds from the Senior Note Offering, (v) the exchange by Holdings of 3.8 shares of Common Stock for each of the 67,997,769 shares of Cumulative Convertible Preferred Stock (the "Preferred Stock") exchanged pursuant to an exchange offer commenced on November 7, 1991 and completed on December 7, 1991, (vi) the issuance by Holdings on November 8, 1991 of 52,500,000 shares of Series A Conversion Preferred Stock, par value .01 per share ("Series A Preferred Stock") of Holdings and the sale of 210,000,000 $.835 depositary shares ("Series A Depositary RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) Shares") at $10.125 per Series A Depositary Share in connection with such issuance (the "Series A Preferred Stock Offering"), (vii) the repayment of the aggregate amount outstanding under the 1990 Credit Agreement, the repayment of a portion of the amount outstanding under the 1989 Credit Agreement and the redemption of certain notes of RJRN with the net proceeds from the Series A Preferred Stock Offering equal to approximately $2.1 billion and (viii) the repayment by Capital on December 19, 1991 of the aggregate amount outstanding under the working capital facility, revolving credit facility and term loan portions of the 1989 Credit Agreement with approximately $3.3 billion in cash from borrowings under a $6.5 billion bank credit facility (as amended, the "1991 Credit Agreement"). On May 15, 1992, Capital merged with and into its wholly-owned subsidiary, RJRN. As a result of the merger, Group became the direct parent of RJRN and RJRN assumed all of the obligations of Capital under the 1991 Credit Agreement and with respect to the following debt securities: Subordinated Discount Debentures due May 15, 2001 (the "Subordinated Discount Debentures"); 15% Payment-in-Kind Subordinated Debentures due May 15, 2001 (the "15% Subordinated Debentures"); 13 1/2% Subordinated Debentures due May 15, 2001 (the "13 1/2% Subordinated Debentures" and, collectively with the Subordinated Discount Debentures and the 15% Subordinated Debentures, the "Subordinated Debentures"); 10 1/2% Senior Notes; 8.30% Senior Notes due April 15, 1999 (the "8.30% Senior Notes"); and 8.75% Senior Notes due April 15, 2004 (the "8.75% Senior Notes" and, collectively with the 8.30% Senior Notes, the "1992 Senior Notes"). Prior to this merger, RJRN had guaranteed all of Capital's obligations with respect to such indebtedness, and the financial statements of RJRN had reflected such indebtedness and all debt related costs. On December 17, 1992, Group merged with and into its wholly-owned subsidiary, RJRN. Also during 1992, Holdings entered into the following refinancing transactions: (i) the redemption on February 15, 1992 of $250 million principal amount of Capital's Subordinated Floating Rate Notes due 1999 (the "Subordinated Floating Rate Notes") at a price of $1,005 for each $1,000 principal amount of Subordinated Floating Rate Notes plus accrued and unpaid interest thereon, (ii) the early extinguishments by Capital of approximately $1 billion aggregate principal amount of certain of Capital's subordinated debentures in a privately negotiated transaction (the "1992 Capital Debenture Repurchase") for approximately $995 million in cash, consisting of $165 million aggregate principal amount of its 15% Subordinated Debentures, $85 million aggregate principal amount of its 13 1/2% Subordinated Debentures and $750 million aggregate principal amount (approximately $550 million accreted amount) of its Subordinated Discount Debentures, (iii) the issuance by Capital on April 9, 1992 of $600 million principal amount of 8.30% Senior Notes and $600 million principal amount of 8.75% Senior Notes and the application of substantially all of the net proceeds from the issuance of the 1992 Senior Notes to repay a portion of the funds temporarily drawn under the 1991 Credit Agreement for the redemption of the Subordinated Floating Rate Notes and for the 1992 Capital Debenture Repurchase, (iv) the retirement on May 15, 1992 of $225 million aggregate principal amount of Capital's Subordinated Extendible Reset Debentures due May 15, 1991 (the "Subordinated Reset Debentures") at a price of $1,010 for each $1,000 principal amount of Subordinated Reset Debentures plus accrued and unpaid interest thereon with the remaining proceeds available from the 1992 Senior Notes plus temporary borrowings under the 1991 Credit Agreement, which were repaid with proceeds of medium-term notes and (v) the additional repurchases during 1992 for approximately $1.822 billion in cash of certain of RJRN's subordinated debentures consisting of $690 million aggregate principal amount of its 15% Subordinated Debentures, $81 million aggregate principal amount of its 13 1/2% RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) Subordinated Debentures and $941 million aggregate principal amount (approximately $728 million accreted amount) of its Subordinated Discount Debentures. The principal or accreted amount of the debentures in item (v) was refinanced with proceeds of debt securities maturing in the years 1999-2004. The purchase of most of such amount had been temporarily funded with borrowings under the 1991 Credit Agreement. Also during 1992, Holdings repurchased $126 million aggregate principal amount (approximately $209 million including accrued interest) of its Senior Converting Debentures due 2009 (the "Converting Debentures") for $229 million in cash, and RJRN repurchased $229 million aggregate principal amount of various other debentures for $240 million in cash. The funds for the repurchase of Converting Debentures and various other debentures of RJRN and for a portion of the purchase price of the Subordinated Debentures in item (v) were provided from the issuance of medium-term notes maturing in the years 1995-1997, borrowings under the 1991 Credit Agreement and cash flow from operations. During 1993, RJRN repurchased for approximately $1.0 billion in cash certain of its subordinated debentures consisting of $153 million aggregate principal amount of its 15% Subordinated Debentures, $82 million aggregate principal amount of its 13 1/2% Subordinated Debentures and $768 million aggregate principal amount (approximately $671 million accreted amount) of its Subordinated Discount Debentures. The principal or accreted amounts of such debentures was refinanced from proceeds of debt securities maturing after 1998, including debt securities issued during 1993. The purchase of most of such amount had been temporarily funded with borrowings under the 1991 Credit Agreement. The remaining portion of the ESOP participation was repurchased on January 15, 1993 for cash, plus accrued and unpaid interest thereon. Holdings redeemed on May 1, 1993, 100% of the aggregate principal amount of its outstanding Converting Debentures at a price of $1,000 for each $1,000 principal amount of Converting Debentures, plus accrued and unpaid interest thereon, for the period from February 9, 1989 through April 30, 1993, of $937.54 for each $1,000 principal amount of Converting Debentures. During 1993, RJRN issued $750 million principal amount of 8% Notes due 2000, $500 million principal amount of 8 3/4% Notes due 2005 and $500 million principal amount of 9 1/4% Debentures due 2013. Also during 1993, RJRN issued medium-term notes maturing in the years 1995-1998 having an aggregate initial offering price of approximately $230 million. The net proceeds from the sale of debt securities and the Series B Preferred Stock Offering (as hereinafter defined) have been or will be used for general corporate purposes, which include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases and redemptions of securities. Pending such uses, proceeds may be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. A portion of the net proceeds collected from the sale of Holdings' ready-to-eat cold cereal business was used on February 5, 1993 to redeem $216 million principal amount of RJRN's 9 3/8% Sinking Fund Debentures due 2016 (the "9 3/8% Debenture") at a price of $1,065.63 for each $1,000 principal amount of 9 3/8% Debentures, plus accrued and unpaid interest thereon. On April 5, 1993, the Registrants entered into a credit agreement (as amended, the "1993 Credit Agreement" and together with the 1991 Credit Agreement, the "Credit Agreements"), which matures on April 4, 1994 and provides a back-up line of credit to support commercial paper issuances of up to $1 billion. Availability thereunder is reduced by an amount equal to the aggregate amount of commercial RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) paper outstanding. At December 31, 1993, approximately $913 million of commercial paper was outstanding. Accordingly, $87 million was available under the 1993 Credit Agreement at December 31, 1993. Holdings and RJRN expect to obtain bank consent to extend the maturity date of the 1993 Credit Agreement for an additional 364 days. Based on RJRN's intention and ability to continue to refinance, for more than one year, the amount of its commercial paper borrowings outstanding either in the commercial paper market or with additional borrowings under the 1991 Credit Agreement, the commercial paper borrowings have been included under "Long-term debt". As permitted by the governing indenture, RJRN intends to pay in cash the May 15, 1994 interest payment due on its 15% Subordinated Debentures. Accordingly, the interest accrued thereon as of December 31, 1993 has been included in "Accrued liabilities". Certain financing agreements to which Holdings is a party and debt instruments of RJRN directly or indirectly restrict the payment of dividends by Holdings. The Credit Agreements, which contain restrictions on the payment of cash dividends or other distributions by Holdings in excess of certain specified amounts, and the indentures relating to certain of RJRN's debt securities, which contain restrictions on the payment of cash dividends or other distributions by RJRN to Holdings in excess of certain specified amounts, or for certain specified purposes, effectively limit the payment of dividends on the Common Stock. In addition, the declaration and payment of dividends is subject to the discretion of the board of directors of Holdings and to certain limitations under Delaware law. The Credit Agreements and the indentures under which certain debt securities of RJRN have been issued also impose certain operating and financial restrictions on Holdings and its subsidiaries. These restrictions limit the ability of Holdings and its subsidiaries to incur indebtedness, engage in transactions with stockholders and affiliates, create liens, sell certain assets and certain subsidiaries' stock, engage in certain mergers or consolidations and make investments in unrestricted subsidiaries. The estimated fair value of Holdings' consolidated long-term debt as of December 31, 1993 and 1992 was approximately $12.4 billion and $14.9 billion, respectively, based on available market quotes, discounted cash flows and book values, as appropriate. The estimated fair value exceeded the carrying amount of Holdings' long-term debt by approximately $400 million and $1.1 billion at December 31, 1993 and 1992, respectively, as a result of the general decline in market interest rates compared with the higher interest cost on certain of Holdings' debt obligations. Considerable judgment was required in interpreting market data to develop the estimates of fair value. In addition, the use of different market assumptions and/or estimation methodologies may have had a material effect on the estimated fair value amounts. Accordingly, the estimated fair value of Holdings' consolidated long-term debt as of December 31, 1993 and 1992 is not necessarily indicative of the amounts that Holdings could realize in a current market exchange. NOTE 11--COMMITMENTS AND CONTINGENCIES Various legal actions, proceedings and claims are pending or may be instituted against R. J. Reynolds Tobacco Company ("RJRT") or its affiliates or indemnities, including those claiming that lung cancer and other diseases have resulted from the use of or exposure to RJRT's tobacco products. During 1993, 16 new actions were filed or served against RJRT and/or its affiliates or indemnities and 18 such actions were dismissed or otherwise resolved in favor of RJRT and/or its RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11--COMMITMENTS AND CONTINGENCIES--(CONTINUED) affiliates or indemnities. A total of 35 such actions in the United States, one in Puerto Rico and one against RJRT's Canadian subsidiary were pending on December 31, 1993. As of February 7, 1994, 35 active cases were pending against RJRT and/or its affiliates or indemnities, 33 in the United States, one in Puerto Rico and one in Canada. Four of the 33 active cases in the United States involve alleged non-smokers claiming injuries resulting from exposure to environmental tobacco smoke. One of such cases is currently scheduled for trial on September 5, 1994 and if tried, will be the first such case to reach trial. One of the active cases is alleged to be a class action on behalf of a purported class of 60,000 individuals. The plaintiffs in these actions seek recovery on a variety of legal theories, including strict liability in tort, design defect, negligence, breach of warranty, failure to warn, fraud, misrepresentation and conspiracy. Punitive damages, often in amounts totalling many millions of dollars, are specifically pleaded in 20 cases in addition to compensatory and other damages. The defenses raised by RJRT and/or its affiliates, where applicable, include preemption by the Federal Cigarette Labeling and Advertising Act, as amended (the "Cigarette Act") of some or all such claims arising after 1969; the lack of any defect in the product; assumption of the risk; comparative fault; lack of proximate cause; and statutes of limitations or repose. Juries have found for plaintiffs in two smoking and health cases, but in one such case, which has been appealed by both parties, no damages were awarded. The jury awarded plaintiffs $400,000 in the other such case, Cipollone v. Liggett Group, Inc., et. al., which award was overturned on appeal and the case was subsequently dismissed. On June 24, 1992, the United States Supreme Court in Cipollone held that claims that tobacco companies failed to adequately warn of the risks of smoking after 1969 and claims that their advertising and promotional practices undermined the effect of warnings after that date were preempted by the Cigarette Act. The Court also held that claims of breach of express warranty, fraud, misrepresentation and conspiracy were not preempted. The Supreme Court's decision was announced through a plurality opinion, and further definition of how Cipollone will apply to other cases must await rulings in those cases. Certain legislation proposed in recent years in Congress, among other things, would eliminate any such preemptive effect on common law damage actions for personal injuries. RJRT is unable to predict whether such legislation will be enacted, if so, in what form, or whether such legislation would be intended by Congress to apply retroactively. The Supreme Court's Cipollone decision itself, or the passage of such legislation, could increase the number of cases filed against cigarette manufacturers, including RJRT. RJRT understands that a grand jury investigation being conducted in the Eastern District of New York is examining possible violations of criminal law in connection with activities relating to the Council for Tobacco Research-USA, Inc., of which RJRT is a sponsor. RJRT is unable to predict the outcome of this investigation. RJRT recently received a civil investigative demand from the U.S. Department of Justice requesting broad documentary information from RJRT. Although the request appears to focus on tobacco industry activities in connection with product development efforts, it also requests general information concerning contacts with competitors. RJRT is unable to predict the outcome of this investigation. Litigation is subject to many uncertainties, and it is possible that some of the legal actions, proceedings or claims could be decided against RJRT or its affiliates or indemnities. Determinations of RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11--COMMITMENTS AND CONTINGENCIES--(CONTINUED) liability or adverse rulings against other cigarette manufacturers that are defendants in similar actions, even if such rulings are not final, could adversely affect the litigation against RJRT and its affiliates or indemnities and increase the number of such claims. Although it is impossible to predict the outcome of such events or their effect on RJRT, a significant increase in litigation activities could have an adverse effect on RJRT. RJRT believes that it has a number of valid defenses to any such actions, including but not limited to those defenses based on preemption under the Cipollone decision, and RJRT intends to defend vigorously all such actions. The Registrants believe that the ultimate outcome of all pending litigation matters should not have a material adverse effect on either of the Registrants' financial position; however, it is possible that the results of operations or cash flows of the Registrants in a particular quarterly or annual period could be materially affected by the ultimate outcome of certain pending litigation matters. Management is unable to derive a meaningful estimate of the amount or range of such possible loss in any particular quarterly or annual period or in the aggregate. COMMITMENTS At December 31, 1993, other commitments totalled approximately $556 million, principally for minimum operating lease commitments, the purchase of machinery and equipment and other contractual arrangements. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT CONCENTRATIONS OF CREDIT RISK Certain financial instruments with off-balance sheet risk have been entered into by the RJRN to manage its interest rate and foreign currency exposures. Interest Rate Arrangements At December 31, 1993 and 1992, RJRN had outstanding interest rate swaps, options, caps and other interest rate arrangements with financial institutions having a total notional principal amount of $5.7 billion and $5.2 billion, respectively. The arrangements at December 31, 1993 mature as follows: 1994--$2.7 billion; 1995--$1.1 billion; 1996--$1.1 billion; 1997--$450 million and 1998 $350 million, respectively. The estimated fair value of these arrangements as of December 31, 1993 and 1992 was favorable by approximately $37 million and unfavorable by approximately $1 million, respectively, based on calculations from independent third parties for similar arrangements. Because interest rate swaps and purchased options and other interest rate arrangements effectively hedge interest rate exposures, the differential to be paid or received is accrued and recognized in interest expense as market interest rates change. If an arrangement is terminated prior to maturity, then the realized gain or loss is recognized over the remaining original life of the agreement if the hedged item remains outstanding, or immediately, if the underlying hedged instrument does not remain outstanding. If the arrangement is not terminated prior to maturity, but the underlying hedged instrument is no longer outstanding, then the unrealized gain or loss on the related interest rate swap, option, cap or other interest rate arrangement is recognized immediately. In addition, for written options and other similar interest rate arrangements that are entered into to manage interest rate exposure, changes in market value of such instruments would result in the current recognition of any related gains or losses. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11--COMMITMENTS AND CONTINGENCIES--(CONTINUED) Foreign Currency Arrangements At December 31, 1993 and 1992, RJRN had outstanding forward foreign exchange contracts with banks to purchase or sell an aggregate notional principal amount of $476 million and $566 million, respectively. The estimated fair value of these arrangements as of December 31, 1993 and 1992 was favorable by approximately $3 million and $4 million, respectively, based on calculations from independent third parties for similar arrangements. The forward foreign exchange contracts and other hedging arrangements entered into by RJRN generally mature at the time the hedged foreign currency transactions are settled. Gains or losses on forward foreign currency transactions are determined by changes in market rates and are generally included at settlement in the basis of the underlying hedged transaction. To the extent that the foreign currency transaction does not occur, gains and losses are recognized immediately. The above interest rate and foreign currency arrangements entered into by RJRN involve, to varying degrees, elements of market risk as a result of potential changes in future interest and foreign currency exchange rates. To the extent that the financial instruments entered into remain outstanding as effective hedges of existing interest rate and foreign currency exposure, the impact of such potential changes in future interest and foreign currency exchange rates on the financial instruments entered into would offset the related impact on the items being hedged. Also, RJRN may be exposed to credit losses in the event of non-performance by the counterparties to these financial instruments. However, RJRN continually monitors its positions and the credit rating of its counterparties and therefore, does not anticipate any non-performance. There are no significant concentrations of credit risk with any individual counterparties or groups of counterparties as a result of any financial instruments entered into including those financial instruments discussed above. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL The changes in Common Stock and paid-in capital are shown as follows: The changes in stock options are shown as follows: At December 31, 1993, options were exercisable as to 20,018,041 shares, compared with 15,590,909 shares at December 31, 1992, and 11,310,162 shares at December 31, 1991. As of December 31, 1993, options for 66,777,008 shares of Common Stock were available for future grant. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) To provide an incentive to attract and retain key employees responsible for the management and administration of the business affairs of Holdings and its subsidiaries, on June 15, 1989 the board of directors of Holdings adopted the Stock Option Plan for Directors and Key Employees of RJR Holdings Corp. and Subsidiaries (the "Stock Option Plan") pursuant to which options to purchase Common Stock may be granted. On June 16, 1989, the Stock Option Plan was approved by the written consent of the holders of a majority of the Common Stock. Any director or key employee of Holdings or any subsidiary of Holdings is eligible to be granted options under the Stock Option Plan. A maximum of 30,000,000 shares of Common Stock (which may be adjusted in the event of certain capital changes) may be issued under the Stock Option Plan. The options to key employees granted to key employees under the Stock Option Plan generally vest over a five year period and the options granted to directors under the Stock Option Plan are immediately fully vested. The exercise price of such options is generally the fair market value of the Common Stock on the date of grant. On August 1, 1990, the board of directors of Holdings adopted the 1990 Long Term Incentive Plan (the "1990 LTIP") which was approved on such date by the written consent of the holders of a majority of the Common Stock. The 1990 LTIP authorizes grants of incentive awards ("Grants") in the form of "incentive stock options" under Section 422 of the Code, other stock options, stock appreciation rights, restricted stock, purchase stock, dividend equivalent rights, performance units, performance shares or other stock-based grants. Awards under the 1990 LTIP may be granted to key employees of, or other persons having a unique relationship to, Holdings and its subsidiaries. Directors who are not also employees of Holdings and its subsidiaries are ineligible for Grants. A maximum of 105,000,000 shares of Common Stock (which may be adjusted in the event of certain capital changes) may be issued under the 1990 LTIP pursuant to Grants. The 1990 LTIP also limits the amount of shares which may be issued pursuant to "incentive stock options" and the amount of shares subject to Grants which may be issued to any one participant. As of December 31, 1993, purchase stock, stock options other than incentive stock options, restricted stock, performance shares and other stock-based grants have been granted under the 1990 LTIP. The options granted before 1993 under the 1990 LTIP generally will vest over a three year period ending December 31, 1995. Prior to January 1, 1993, such options had vested over a six to eight year period. Options granted in 1993 vest over a three year period beginning from the date of grant. The exercise prices of such options are between $4.50 and $11.56 per share. In connection with the purchase stock grants awarded during 1993, 1992 and 1991, 622,222 shares, 495,000 shares and 2,681,000 shares, respectively, of Common Stock were purchased and options to purchase four shares were granted for every share of such Common Stock purchased. In addition, arrangements were made enabling purchasers to borrow on a secured basis from Holdings the price of the stock purchased, as well as the taxes due on any taxable income recognized in connection with such purchases. The current annual interest rate on such arrangements, which was set in July 1993 at the then applicable federal rate for long-term loans, is 6.37%. These borrowings plus accrued interest and taxes must generally be repaid within two years following termination of active employment. During 1993, 1,484,840 shares of Common Stock were awarded in connection with restricted stock grants. These shares are subject to restrictions that will lapse on December 31, 1994. Performance shares were also granted under the 1990 LTIP during 1993, pursuant to which participants are granted a designated number of performance shares that may be earned over a three year performance period commencing January 1, 1993. Pay outs of awards at the end of the performance period, which are denominated in shares of Common Stock, but which may be paid at Holdings' option in either Common Stock or cash, are currently based on Holdings' cumulative cash-earnings per share during such performance period. During 1993, 3,307,500 performance shares were awarded. The maximum aggregate number of shares of Common Stock that RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) may be paid at the end of the performance period is 4,961,250. Commitments to make other stock-based awards were made in 1993 under the 1990 LTIP to individuals who previously acquired certain purchase stock under the 1990 LTIP. Under this program, such individuals may receive grants of Common Stock or cash at the Company's election on either three or four annual grant dates beginning July 1994 and ending either July 1, 1996 or July 1, 1997. The fair market value of Common Stock to be awarded on each grant date is equal to the excess, if any, of (i) 33% or 25%, respectively, of the maximum amount the individual could have borrowed to acquire purchase stock, over (ii) the then fair market value of the same percentage of such individual's purchase stock. The grant is increased by the amount of presumed borrowing costs and the amount necessary to hold the individual harmless from income taxes due as a result of the grant. No grant will be made on a grant date if, on such grant date, the amount determined under clause (ii) above equals or exceeds the amount determined in clause (i) above. In addition to the shares purchased under the 1990 LTIP, approximately 550,000 shares of Common Stock were sold during 1991 to certain management investors. No such sales occurred in 1992 or 1993. Unlike the shares sold under the 1990 LTIP, a portion of these shares remain subject to significant restrictions on transferability. The Preferred Stock, together with the Series A Preferred Stock, Series B Preferred Stock and ESOP Convertible Preferred Stock, stated value $16.00 per share and par value $.01 per share, of Holdings (the "ESOP Preferred Stock") (150,000,000 aggregate preferred shares authorized at December 31, 1993 and 1992) are senior to the Common Stock as to dividends and preferences in liquidation. On December 6, 1993, the outstanding Preferred Stock was redeemed at a redemption price of $27.0125 per share plus accrued and unpaid dividends thereon. Also during 1993, 123,523 shares of Preferred Stock were converted into 342,976 shares of Common Stock. During 1992, 379 shares of Preferred Stock were converted into 1,051 shares of Common Stock. During 1991, 884 shares of Preferred Stock were converted into 2,450 shares of Common Stock and 67,997,769 shares of Preferred Stock were exchanged for 258,391,523 shares of Common Stock in connection with the December 1991 Exchange Offer. The Preferred Stock, stated value $25 per share at par value $.01 per share, paid cash dividends at a rate of 11.5% of stated value per annum, payable quarterly in arrears commencing January 15, 1991. The Preferred Stock was convertible after May 1, 1991 into shares of Common Stock at a conversion price of $9 of stated value per share of Common Stock. Each Series A Depositary Share represents a one-quarter ownership interest in a share of Series A Preferred Stock of Holdings. Each share of Series A Preferred Stock bears cumulative cash dividends at a rate of $3.34 per annum and is payable quarterly in arrears commencing February 18, 1992. Each share of Series A Preferred Stock will mandatorily convert into four shares of Common Stock by November 15, 1994, subject to adjustment in certain events. In addition, each share of Series A Preferred Stock may be convertible upon the occurrence of certain other events, including the option by Holdings to redeem, in whole or in part, at any time at an initial optional redemption price of $64.82 per share, to be paid in shares of Common Stock, plus accrued and unpaid dividends. The initial optional redemption price declines by $.009218 on each day following the issuance of the Series A Preferred Stock to $55.36 on September 15, 1994 and $54.80 thereafter. Holders of Series A Preferred Stock have voting rights with respect to certain matters submitted to a vote of the holders of the Common RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) Stock. Because Series A Preferred Stock mandatorily converts into Common Stock, dividends on shares of Series A Preferred Stock are reported similar to common equity dividends. On August 18, 1993, Holdings issued 50,000 shares of Series B Cumulative Preferred Stock, par value $.01 per share ("Series B Preferred Stock"), and sold 50,000,000 depositary shares ("Series B Depositary Shares") at $25 per Series B Depositary Share ($1.250 billion) in connection with such issuance (the "Series B Preferred Stock Offering"). Each share of Series B Preferred Stock bears cumulative cash dividends at a rate of $2,312.50 per annum, or $2.3125 per Series B Depositary Share, and is payable quarterly in arrears commencing December 1, 1993. Each Series B Depositary Share represents .001 ownership interest in a share of Series B Preferred Stock of Holdings. At Holdings' option, on or after August 19, 1998, Holdings may redeem shares of the Series B Preferred Stock (and the Depositary will redeem the number of Series B Depositary Shares representing the shares of Series B Preferred Stock) at a redemption price equivalent to $25 per Series B Depositary Share, plus accrued and unpaid dividends thereon. On August 1, 1991, Holdings issued 2,983,904 shares of Common Stock in exchange for certain debentures of RJRN aggregating approximately $32.3 million in principal amount. On April 10, 1991, an employee stock ownership plan established by Holdings borrowed $250 million from Holdings (the "ESOP Loan") to purchase 15,625,000 shares of ESOP Preferred Stock. The ESOP Loan, which was renegotiated in 1993, has a final maturity in 2006 and bears interest at the rate of 8.2% per annum. The ESOP Preferred Stock is convertible as of December 31, 1993 into 15,573,973 shares of Common Stock, subject to adjustment in certain events, and bears cumulative dividends at a rate of 7.8125% of stated value per annum at least until April 10, 1999, payable semi-annually in arrears commencing January 2, 1992, when, as and if declared by the board of directors of Holdings. The ESOP Preferred Stock is redeemable at the option of Holdings, in whole or in part, at any time on or after April 10, 1999, at an initial optional redemption price of $16.250 per share. The initial optional redemption price declines thereafter on an annual basis in the amount of $.125 a year to $16 per share on April 10, 2001, plus accrued and unpaid dividends. Holders of ESOP Preferred Stock have voting rights with respect to certain matters submitted to a vote of the holders of the Common Stock. Effective January 1, 1992, RJRN's matching contributions to eligible employees under its Capital Investment Plan are being made in the form of ESOP Preferred Stock. RJRN's matching contribution obligation in respect of each participating employee is equal to $.50 for every pre-tax dollar contributed by the employee, up to 6% of the employee's pay. The shares of ESOP Preferred Stock are allocated at either the floor value of $16 a share or the fair market value of Common Stock, whichever is higher. During 1993 and 1992, approximately $29 million and $29 million, respectively, was contributed to the ESOP by RJRN or Holdings and approximately $20 million and $24 million, respectively, of ESOP dividends were used to service the ESOP's debt to Holdings. On February 9, 1989, 15,254,238 warrants were issued to purchase 15,254,238 shares of Common Stock. Such warrants were initially exercisable at an exercise price of $5.00 per share, subject to adjustment in certain events, at any time prior to February 9, 1999. On November 8, 1991, the exercise price for the warrants and the number of shares of Common Stock issuable upon exercise thereof were adjusted to $4.9164 and 1.017, respectively. During the third quarter of 1992, Holdings repurchased from a limited partnership of which KKR Associates, an affiliate of KKR, is the sole general partner and certain affiliates of Merrill Lynch & Co., Inc. 6,182,586 warrants of the 15,254,238 warrants issued RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) on February 9, 1989 for approximately $36 million in cash. During October 1992, Holdings repurchased from the same parties the remaining 9,071,652 warrants for approximately $51 million in cash. Each of these warrants allowed the holder to purchase 1.017 shares of Common Stock for an exercise price of $4.9164 at any time on or prior to February 8, 1999. Warrants to purchase 45,529,024 shares of Common Stock were issued in connection with the sale of the 15% Subordinated Debentures and the Subordinated Discount Debentures. Such warrants were initially exercisable at an exercise price of $0.07 per share, subject to adjustment in certain events, and expired January 31, 1992. On November 8, 1991, the exercise price for the warrants and the number of shares of Common Stock issuable upon exercise thereof were adjusted to $0.0688 and 1.017, respectively. During 1992, 12,370,936 warrants were exercised at $0.0688 per share. During 1991, 29,695,730 warrants were exercised at $0.07 per share and 3,361,323 warrants were exercised at $0.0688 per share. See Note 10 for transactions involving the exchange of capital stock for long-term debt. NOTE 13--RETAINED EARNINGS AND CUMULATIVE TRANSLATION ADJUSTMENTS Retained earnings (accumulated deficit) at December 31, 1993, 1992 and 1991 includes non-cash expenses related to accumulated trademark and goodwill amortization of $3.015 billion, $2.390 billion and $1.774 billion, respectively. The changes in cumulative translation adjustments are shown as follows: NOTE 14--RETIREMENT BENEFITS RJRN sponsors a number of non-contributory defined benefit pension plans covering most U.S. and certain foreign employees. Plans covering regular full-time employees in the tobacco operations as well as the majority of salaried employees in the corporate groups and food operations to provide pension benefits that are based on credits, determined by age, earned throughout an employee's service and final average compensation before retirement. Plan benefits are offered as lump sum or annuity options. Plans covering hourly as well as certain salaried employees in the corporate groups and food operations provide pension benefits that are based on the employee's length of service and final average compensation before retirement. RJRN's policy is to fund the cost of current service benefits and past service cost over periods not exceeding 30 years to the extent that such costs are currently tax deductible. Additionally, RJRN participates in several multi-employer and other defined contribution plans, which provide benefits to certain of RJRN's union employees. Employees in foreign countries who are not RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RETIREMENT BENEFITS--(CONTINUED) U.S. citizens are covered by various post-employment benefit arrangements, some of which are considered to be defined benefit plans for accounting purposes. A summary of the components of pension expense for RJRN-sponsored plans follows: The principal plans used the following actuarial assumptions for accounting purposes: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RETIREMENT BENEFITS--(CONTINUED) The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheets at December 31, 1993 and 1992 for RJRN's defined benefit pension plans. - --------------- (1) Of the net pension liability amounts at December 31, 1993 and 1992, $34 million and $12 million, respectively, were related to qualified plans. At December 31, 1993, approximately 99 percent of the plans' assets were invested in listed stocks and bonds and other highly liquid investments. The balance consisted of various income producing investments. In addition to providing pension benefits, RJRN provides certain health care and life insurance benefits for retired employees and their dependents. Substantially all of its regular full-time employees, including certain employees in foreign countries, may become eligible for those benefits if they reach retirement age while working for RJRN. Effective January 1, 1992, RJRN adopted SFAS No. 106. Under SFAS No. 106, RJRN is required to accrue the costs for retirees' health and other postretirement benefits other than pensions and recognize the unfunded and unrecognized accumulated benefit obligation for these benefits. RJRN had previously accrued a liability for postretirement benefits other RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RETIREMENT BENEFITS--(CONTINUED) than pensions and as a result, SFAS No. 106 did not have a material impact on RJRN's financial statements. Net postretirement health and life insurance benefit cost for 1993 consists of the following: Net postretirement health and life insurance benefit costs representing accretion on the liability balance of $89 million was charged to operations for the year ended December 31, 1991. The reduction in expense in 1992 reflects the reduction of recorded liabilities by approximately $225 million at December 31, 1991 as disclosed in Note 1 to the Consolidated Financial Statements. RJRN's postretirement health and life insurance benefit plans currently are not funded. The status of the plans was as follows: The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 8% in 1993, 9% in 1994 and 10.7% in 1995 gradually declining to 6.0% by the year 2002 and remaining at that level 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 and net postretirement health care cost by approximately 7% and 8.5%, respectively. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.5% and 8.5% as of December 31, 1993 and 1992, respectively. Effective January 1, 1993, RJRN adopted SFAS No. 112. Under SFAS No. 112, RJRN is required to accrue the costs for preretirement postemployment benefits provided to former or inactive employees and recognize an obligation for these benefits. The adoption of SFAS No. 112 did not have a material impact on the financial statements of either Holdings or RJRN. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 15--SEGMENT INFORMATION Industry Segment Data Holdings classifies its continuing operations into two industry segments which are described in Management's Discussion and Analysis of Financial Condition and Results of Operations, appearing elsewhere herein. Summarized financial information for these operations is shown in the following tables. - --------------- (1) Includes amortization of trademarks and goodwill for Tobacco and Food, respectively, for the year ended December 31, 1993, of $407 million and $218 million; for the year ended December 31, 1992, of $404 million and $212 million and for the year ended December 31, 1991, of $404 million and $205 million. (2) The 1993 and 1992 amounts include the effects of the restructuring expense at Tobacco (1993-- $544 million; 1992--$43 million), Food (1993--$153 million; 1992--$63 million) and Headquarters (1993--$33 million; 1992--$0), as applicable, and the sale of Holdings' ready-to-eat cold cereal business (See Note 1 to the Consolidated Financial Statements). (3) Cash and cash equivalents for the domestic operating companies are included in Headquarters' assets. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 15--SEGMENT INFORMATION--(CONTINUED) Geographic Data The following tables show certain financial information relating to Holdings' continuing operations in various geographic areas. - --------------- (1) Transfers between geographic areas (which consist principally of tobacco transferred principally from the United States to Europe) are generally made at fair market value. (2) The 1993 and 1992 amounts include the effects of the restructuring expense of $730 million and $106 million, respectively, and a gain on the sale of Holdings' ready-to-eat cold cereal business ($98 million) (see Note 1 to the Consolidated Financial Statements). (3) Includes amortization of trademarks and goodwill of $625 million, $616 million and $609 million for the 1993, 1992 and 1991 periods, respectively. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 16--QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the quarterly results of operations for Holdings for the quarterly periods of 1993 and 1992: - --------------- (1) Earnings per share is computed independently for each of the periods presented; therefore, the sum of the earnings per share amounts for the quarters may not equal the total for the year. In addition, assuming that the transactions discussed in Notes 10 and 12 to the Consolidated Financial Statements had occurred on January 1, 1993 or January 1, 1992, as applicable, and the net proceeds thereof were used to redeem or to repay outstanding indebtedness, the impact on earnings per share would be anti-dilutive for the reported periods. NOTE 17--SUBSEQUENT EVENT On February 24, 1994, Holdings filed a Registration Statement on Form S-3 for a proposed offering of 300 million depositary shares, each representing a one-tenth ownership interest in a share of a newly created series of Preferred Equity Redemption Cumulative Stock ("PERCS"). Each depositary share would mandatorily convert in three years into one share of Common Stock, subject to adjustment and subject to earlier conversion or redemption under certain circumstances. Any net proceeds of a PERCS offering may be used for general corporate purposes which may include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases or redemptions of securities. In addition, such proceeds may be used to facilitate one or more significant corporate transactions, such as a joint venture, merger, acquisition, divestiture, asset swap, spin-off and/or recapitalization, that would result in the separation of the tobacco and food businesses of Holdings. As of February 24, 1994, the specific uses of proceeds have not been determined. Pending such uses, any proceeds would be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. ------------------------------------ SCHEDULE II RJR NABISCO HOLDINGS CORP. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 - --------------- (A) Loan is denominated in a foreign currency. Rate fluctuations are included in the "Amounts Collected" column. The amounts presented represent loans to employees in connection with the 1990 Long Term Incentive Plan. See Note 12 to the Consolidated Financial Statements. S-1 SCHEDULE II RJR NABISCO HOLDINGS CORP. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1992 The amounts presented represent loans to employees in connection with the 1990 Long Term Incentive Plan. See Note 12 to the Consolidated Financial Statements. S-2 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF INCOME AND RETAINED EARNINGS (DOLLARS IN MILLIONS) See Notes to Condensed Financial Information. S-3 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) See Notes to Condensed Financial Information. S-4 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS (DOLLARS IN MILLIONS) See Notes to Condensed Financial Information. S-5 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION NOTE A--SUPPLEMENTAL CASH FLOWS INFORMATION For information regarding certain non-cash financing activities, see Notes 10 and 12 to the Consolidated Financial Statements. NOTE B--LONG-TERM DEBT See Note 10 to the Consolidated Financial Statements for information relating to the Converting Debentures. NOTE C--COMMITMENTS AND CONTINGENCIES Holdings has guaranteed the indebtedness of RJRN under the Credit Agreements and certain debentures. The guaranties are secured by a pledge of the capital stock of RJRN owned by Holdings. For a discussion of certain restrictive covenants associated with these debt obligations, see Note 10 to the Consolidated Financial Statements. For disclosure of additional contingent liabilities, see Note 11 to the Consolidated Financial Statements. S-6 SCHEDULE V RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - --------------- Property, plant and equipment are depreciated principally by the straight-line method. Annual depreciation rates for new assets range principally from 5% to 7% for land improvements; 2% to 33% for buildings and leasehold improvements; and 5% to 33% for machinery and equipment. Correspondingly higher depreciation rates are applicable with respect to assets in service at February 9, 1989, the date of the acquisition by Holdings and its affiliates of RJRN. S-7 SCHEDULE VI RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. 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) S-8 SCHEDULE VIII RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - --------------- (A) Miscellaneous adjustments. (B) Principally charges against the accounts. (C) Excludes valuation allowance accounts for deferred tax assets. S-9 SCHEDULE IX RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - --------------- S-10 SCHEDULE X RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) S-11 EXHIBIT INDEX - --------------- *Filed herewith.

712534_1993.txt

712534_1993

1993

712534

ITEM 1. BUSINESS. - -------------------------------------------------------------------------------- GENERAL First Merchants Corporation (the "Corporation") was incorporated under Indiana law on September 20, 1982, as the bank holding company for First Merchants Bank, National Association ("First Merchants"), a national banking association incorporated on February 6, 1893. Prior to December 16, 1991, First Merchants' name was The Merchants National Bank of Muncie. On November 30, 1988, the Corporation acquired Pendleton Banking Company ("Pendleton"), a state chartered commercial bank organized in 1872. On July 31, 1991, the Corporation acquired First United Bank ("First United"), a state chartered commercial bank organized in 1882. The Corporation is headquartered in Muncie, Indiana, and is presently engaged in conducting commercial banking business through the 21 offices of its three banking subsidiaries. As of December 31, 1993, the Corporation and its subsidiaries had 371 full-time equivalent employees. COMPETITION The Corporation's banking subsidiaries are located in Delaware, Madison, and Henry counties, Indiana. In addition to the competition provided by the lending and deposit gathering subsidiaries of national manufacturers, retailers, insurance companies and investment brokers, the banking subsidiaries compete vigorously with other banks, thrift institutions, credit unions and finance companies located within their service areas. SUPERVISION AND REGULATION The Corporation is a bank holding company ("BHC") subject to regulation under the Bank Holding Company Act of 1956, as amended (the "Act"). The Act generally requires a BHC to obtain prior approval of the Federal Reserve Board (the "FRB") to acquire or hold more than a 5% voting interest in any bank. The Act restricts the non-banking activities of BHCs to those which are closely related to banking activities. As a result of the provisions in the Financial Institutional Reform, Recovery and Enforcement Act of 1989, BHCs may now own and operate savings and loan associations or savings banks which, in the past, was prohibited. First Merchants is a national bank and is supervised, regulated and examined by the Comptroller of the Currency. Pendleton and First United are state banks and are supervised, regulated and examined by the Indiana Department of Financial Institutions. In addition, First Merchants, as a member of the Federal Reserve System, is supervised and regulated by the Federal Reserve. In addition, Pendleton and First United, which are not members of the Federal Reserve System, are supervised and regulated by the Federal Deposit Insurance Corporation ("FDIC"). The deposits of First Merchants, Pendleton, and First United (the "Banks") are insured by the FDIC. Each regulator has the authority to issue cease-and-desist orders if it determines their activities represent an unsafe and unsound practice or violation of law. Under the Act and under regulations of the FRB, the Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit and are subject to limitations as to certain intercompany transactions. - -------------------------------------------------------------------------------- SUPERVISION AND REGULATION (CONTINUED) Subject to certain limitations, an Indiana bank may establish branches de novo and may establish branches by acquisition in any location or locations within Indiana. Indiana law permits intrastate bank holding company acquisitions, subject to certain limitations. Effective July 1, 1992, Indiana bank holding companies were permitted to acquire banks, and banks and bank holding companies in Indiana were permitted to be acquired by bank holding companies, located in any state in the United States which permits reciprocal entry by Indiana bank holding companies. Prior to July 1, 1992, such interestate bank holding company acquisitions were permitted only on a regional, as opposed to national, basis. Neither the corporation nor its subsidiaries presently contemplate engaging in any non-banking related business activities. During 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act ("FDICIA"). In addition to addressing the insurance fund's financial needs, FDICIA expanded the power of the federal banking regulators. FDICIA introduced a new system of classifying financial institutions with respect to their capitalization. Effective in 1993, FDICIA also requires certain financial institutions to have annual audits and requires management to issue supplemental reports attesting to an institution's compliance with laws and regulations and to the adequacy of its internal controls and procedures. The Corporation's income is principally derived from dividends paid on the common stock of its subsidiaries. The payment of these dividends are subject to certain regulatory restrictions. STATISTICAL DATA The following tables set forth statistical data relating the Corporation and its subsidiaries. DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL The daily average balance sheet amounts, the related interest income or expense, and average rates earned or paid are presented in the following table. - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) ANALYSIS OF CHANGES IN NET INTEREST INCOME The following table presents net interest income components on a tax-equivalent basis and reflects changes between periods attributable to movement in either the average balance or average interest rate for both earning assets and interest-bearing liabilities. The volume differences were computed as the difference in volume between the current and prior year times the interest rate of the prior year, while the interest rate changes were computed as the difference in rate between the current and prior year times the volume of the prior year. Volume/rate variances have been allocated on the basis of the absolute relationship between volume variances and rate variances. - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) INVESTMENT PORTFOLIO The amortized cost, gross unrealized gains, gross unrealized losses and approximate market value of the investment securities portfolio at the dates indicated were: - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) The maturity distribution and average yields for the investment securities portfolio at December 31, 1993 were: - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) LOAN PORTFOLIO TYPES OF LOANS The loan portfolio at the dates indicated is presented below: MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES Presented in the table below are the maturities of loans (excluding commercial real estate, farmland, residential real estate and individuals' loans) outstanding as of December 31, 1993. Also presented are the amounts due after one year classified according to the sensitivity to changes in interest rates. - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) RISK ELEMENTS Nonaccruing loans are loans which are reclassified to a nonaccruing status when in management's judgment the collateral value and financial condition of the borrower do not justify accruing interest. Interest previously recorded but not deemed collectible is reversed and charged against current income. Interest income on these loans is then recognized when collected. Restructured loans are loans for which the contractual interest rate has been reduced or other concessions are granted to the borrower because of a deterioration in the financial condition of the borrower resulting in the inability of the borrower to meet the original contractual terms of the loans. Interest income of $13,154 for the year ended December 31, 1993, was recognized on the nonaccruing and restructured loans listed in the table above, whereas interest income of $52,198 would have been recognized under their original loan terms. Potential problem loans: Management has identified certain other loans totaling $4,760,200 as of December 31, 1993, not included in the risk element table, which are current as to principal and interest, about which there are doubts as to the to the borrowers' ability to comply with present repayment terms. - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) SUMMARY OF LOAN LOSS EXPERIENCE The following table summarizes the loan loss experience for the years indicated. - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES AT DECEMBER 31: Presented below is an analysis of the composition of the allowance for loan losses and per cent of loans in each category to total loans: - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) LOAN LOSS CHARGEOFF PROCEDURES The Banks have weekly meetings at which loan delinquencies, maturities and problems are reviewed. The Board of Directors receive and review reports on loans monthly. The Executive Committee of First Merchants' Board meets bimonthly to approve or disapprove all new loans in excess of $1,000,000 and the Board reviews all commercial loans in excess of $50,000 which were made or renewed during the preceding month. Pendleton's and First United's loan committees, consisting of all loan officers and the president, meet as required to approve or disapprove any loan which is in excess of an individual loan officer's lending limit. All chargeoffs are approved by the senior loan officer and are reported to the Banks' Boards. The Banks charge off loans when a determination is made that all or a portion of a loan is uncollectible or as a result of examinations by regulators and the independent auditors. PROVISION FOR LOAN LOSSES In banking, loan losses are one of the costs of doing business. Although the Banks' management emphasize the early detection and chargeoff of loan losses, it is inevitable that at any time certain losses exist in the portfolio which have not been specifically identified. Accordingly, the provision for loan losses is charged to earnings on an anticipatory basis, and recognized loan losses are deducted from the allowance so established. Over time, all net loan losses must be charged to earnings. During the year, an estimate of the loss experience for the year serves as a starting point in determining the appropriate level for the provision. However, the amount actually provided in any period may be greater or less than net loan losses, based on management's judgment as to the appropriate level of the allowance for loan losses. The determination of the provision in any period is based on management's continuing review and evaluation of the loan portfolio, and its judgment as to the impact of current economic conditions on the portfolio. The evaluation by management includes consideration of past loan loss experience, changes in the composition of the loan portfolio, and the current condition and amount of loans outstanding. - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) DEPOSITS The following table shows the average amount of deposits and average rate of interest paid thereon for the years indicated. As of December 31, 1993, certificates of deposit and other time deposits of $100,000 or more mature as follows: RETURN ON EQUITY AND ASSETS - -------------------------------------------------------------------------------- STATISTICAL DATA (Continued) SHORT-TERM BORROWINGS Securities sold under repurchase agreements are borrowings maturing within one year and are secured by U. S. Government securities. Pertinent information with respect to short-term borrowings is summarized below: ITEM 2. ITEM 2. PROPERTIES. - ------------------------------------------------------------------------------- The headquarters of the Corporation and First Merchants are located in a five- story building at 200 East Jackson Street, Muncie, Indiana. This building and seven branch buildings are owned by First Merchants; six remaining branches of First Merchants are located in leased premises. Four automated cash dispensers are located in leased premises; one cash dispenser is located in premises that are provided free of charge. All of the Corporation's and First Merchants' facilities are located in Delaware and Madison Counties of Indiana. The principal offices of Pendleton are located at 100 West State Street, Pendleton, Indiana. Pendleton also operates three branches. All of Pendleton's properties are owned by Pendleton and are located in Madison County, Indiana. The principal offices of First United are located at 790 West Mill Street, Middletown, Indiana. First United also operates two branches. All of First United's properties are owned by First United and are - -------------------------------------------------------------------------------- ITEM 2. PROPERTIES (Continued) located in Henry County, Indiana. None of the properties owned by the banks are subject to any major encumbrances. The net investment of the Corporation and subsidiaries in real estate and equipment at December 31, 1993 was $9,441,000. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. - ------------------------------------------------------------------------------- There is no pending legal proceeding, other than ordinary routine litigation incidental to the business of the Corporation or its subsidiaries, of a material nature to which the Corporation or its subsidiaries is a party or of which any of their properties are subject. Further, there is no material legal proceeding in which any director, officer, principal shareholder, or affiliate of the Corporation, or any associate of any such director, officer or principal shareholder, is a party, or has a material interest, adverse to the Corporation. None of the routine legal proceedings, individually or in the aggregate, in which the Corporation or its affiliates are involved are expected to have a material adverse impact on the financial position or the results of operations of the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. - ------------------------------------------------------------------------------- No matters were submitted during the fourth quarter of 1993 to a vote of security holders, through the solicitation of proxies or otherwise. SUPPLEMENTAL INFORMATION - EXECUTIVE OFFICERS OF THE REGISTRANT. - ------------------------------------------------------------------------------- The names, ages, and positions with the Corporation and subsidiary banks of all executive officers of the Corporation are listed below. Offices with the Corporation Principal Occupation Name and Age And Subsidiary Banks During Past Five Years ------------ ---------------------------- ---------------------- Stefan S. Anderson Chairman of the Board and Chairman of the Board of 59 President, Corporation and the Corporation and First Merchants First Merchants since 1987; President of First Merchants since 1979 and of the Corporation since Roger W. Gilcrest Executive Vice President Executive Vice President 56 and Director, First Merchants First Merchants since July, 1988; Senior Vice President, First Source Bank prior to July, 1988; Director of First Merchants since July 1992. Paul R. Hoover Senior Vice President, Senior Vice President, 52 First Merchants First Merchants since Larry R. Helms Senior Vice President and Senior Vice President 53 General Counsel, Corporation; Corporation since 1982 Senior Vice President, First and First Merchants Merchants; Director of First since 1979; Director United; Director of Pendleton of First United and Pendleton since 1992 Lowell E. Williams Senior Vice President, First Senior Vice President 62 Merchants First Merchants since James L. Thrash Senior Vice President and Chief Senior Vice President 44 Financial Officer, Corporation; and Chief Financial Senior Vice President, Officer of the First Merchants Corporation since 1990; Chief Financial Officer, Corporation prior to May 1990; Senior Vice President, First Merchants since 1990; Vice President, First Merchants prior to April Jack L. Demaree Senior Vice President and Senior Vice President, 45 Senior Commercial Loan Officer, First Merchants Bank First Merchants since March 1992, Senior Commercial Loan Officer, First Merchants since 1987; Vice President, First Merchants prior to March 1992 PART II TEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to page 2 and 3 of the Corporation's 1993 Annual Report to Stockholders, "The Spirit of Community Banking," under the caption "Stockholder Information," Exhibit 13. ITEM 6. SELECTED FINANCIAL DATA. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to page 1 of the Corporation's 1993 Annual Report to Stockholders, "Financial Review," under the caption "Five-Year Summary of Selected Financial Data," Exhibit 13. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to page 2 through 6 of the Corporation's 1993 Annual Report to Stockholders, "Financial Review," under the caption "Management's Discussion and Analysis," Exhibit 13. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ------------------------------------------------------------------------------- The financial statements and supplementary data required under this item are incorporated herein by reference to inside cover and pages 7 through 22 of the Corporation's 1993 Annual Report to Stockholders, "Financial Review," Exhibit 13. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. - ------------------------------------------------------------------------------- In connection with its audits for the two most recent fiscal years ended December 31, 1993, there have been no disagreements with the Corporation's independent certified public accountants on any matter of accounting principles or practices, financial statement disclosure or audit scope or procedure, nor have there been any changes in accountants. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. - ------------------------------------------------------------------------------- The information required under this item relating to directors is incorporated by reference to the Corporation's 1994 Proxy Statement furnished to its stockholders in connection with an annual meeting to be held March 31, 1994 (the "1994 Proxy Statement"), under the caption "Election of Directors," which Proxy Statement has been filed with the Commission. The information required under this item relating to executive officers is set forth in Part I, "Supplemental Information - Executive Officers of the Registrant" of this annual report on Form 10-K. ITEM 11. EXECUTIVE COMPENSATION. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to the Corporation's 1994 Proxy Statement, under the captions, "Compensation of Directors" and "Compensation of Executive Officers," which Proxy Statement has been filed with the Commission. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to the Corporation's 1994 Proxy Statement, under the caption, "Security Ownership of Certain Beneficial Owners and Management," which Proxy Statement has been filed with the Commission. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to the Corporation's 1994 Proxy Statement, under the caption "Interest of Management in Certain Transactions," which Proxy Statement has been filed with the Commission. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - ------------------------------------------------------------------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (Continued) - ------------------------------------------------------------------------------- (b) Reports on Form 8-K: No reports on Form 8-K were filed for the three months ended December 31, 1993. - -------------------------------------------------------------------------------- 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 this 15th day of March, 1994. FIRST MERCHANTS CORPORATION By /s/ Stefan S. Anderson --------------------------------- Stefan S. Anderson, Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Capacity Date - --------------------------- --------------------------- ------------------ /s/ Stefan S. Anderson Director and Chairman, March 15, 1994 - -------------------------- Principal Executive Officer Stefan S. Anderson /s/ Thomas B. Clark Director March 15, 1994 - --------------------------- Thomas B. Clark /s/ Michael L. Cox Director March 15, 1994 - --------------------------- Michael L. Cox /s/ Clell W. Douglass Director March 15, 1994 - --------------------------- Clell W. Douglass /s/ David A. Galliher Director March 15, 1994 - --------------------------- David A. Galliher /s/ Thomas K. Gardiner Director March 15, 1994 - --------------------------- Thomas K. Gardiner /s/ Hurley C. Goodall Director March 15, 1994 - --------------------------- Hurley C. Goodall /s/ John W. Hartmeyer Director March 15, 1994 - --------------------------- John W. Hartmeyer /s/ Nelson W. Heinrichs Director March 15, 1994 - --------------------------- Nelson W. Heinrichs - -------------------------------------------------------------------------------- Signature Capacity Date - --------------------------- --------------------------- ---------------- /s/ Jon H. Moll Director March 15, 1994 - --------------------------- Jon H. Moll /s/ Robert M. Smitson Director March 15, 1994 - -------------------------- Robert M. Smitson Director March 15, 1994 - -------------------------- Joseph E. Wilson Director March 15, 1994 - -------------------------- Robert F. Wisehart /s/ John E. Worthen Director March 15, 1994 - -------------------------- John E. Worthen /s/ James L. Thrash Principal Financial and March 15, 1994 - -------------------------- Principal Accounting James L. Thrash Officer INDEX TO EXHIBITS - -------------------------------------------------------------------------------- Form 10-K Page Exhibit No: Description of Exhibit: Number ----------- ----------------------- --------- 3.1 Articles of Incorporation, dated September 20, 1982 and the Articles of Amendment thereto dated March 13, 1985 and March 14, 1988 . . . . . . . . 27-49 3.2 Bylaws and amendments thereto dated February 12, 1985, February 20, 1987, July 14, 1987, December 8, 1987, December 13, 1988, November 14, 1989, August 13, 1991, April 14, 1992, and February 15, 1994 . . . . . . . . . . . 50-69 10.1 First Merchants Bank, National Association Management Incentive Plan . . . . . . . . . . . . (A) 10.2 Unfunded Deferred Compensation Plan, as Amended . . . . . . . . . . . . . . . . . . . . (D) 10.3 Employee Stock Purchase Plan (1989) . . . . . . . . (B) 1989 Stock Option Plan . . . . . . . . . . . . . . (C) 10.5 Employee Stock Purchase Plan (1994) . . . . . . . . 70-73 10.6 1994 Stock Option Plan . . . . . . . . . . . . . . 74-78 13 1993 Annual Report to Stockholders (except for the Pages and information thereof expressly incorporated by reference in this Form 10-K, the Annual Report to Stockholders is provided solely for the information of the Securities and Exchange Commission and is not deemed "filed" as part of this Form 10-K) . . . . . . . . . . . . . . . . . . . . . . 79-124 22 Subsidiaries of Registrant . . . . . . . . . . . . 24 23 Consent of Independent Auditors . . . . . . . . . . 25 99.1 Financial statements and independent auditor's report for First Merchants Corporation Employee Stock Purchase Plan . . . . . 26 (A) Incorporated by reference to Registrant's Registration Statement on Form S-4 (SEC File No. 33-110) ordered effective on September 30, 1988. (B) Incorporated by reference to Registrant's Registration Statement on Form S-8 (SEC File No. 33-28900) effective on May 24, 1989. (C) Incorporated by reference to Registrant's Registration Statement on Form S-8 (SEC File No. 33-28901) effective on May 24, 1989. (D) Incorporated by reference to Registrant's Form 10-K for year ended December 31, 1990. - -------------------------------------------------------------------------------- EXHIBIT 22--SUBSIDIARIES OF THE REGISTRANT - ------------------------------------------------------------------------------- State of Name Incorporation ---- ------------- First Merchants Bank, National Association. . . . . . . . . . U.S. Pendleton Banking Company . . . . . . . . . . . . . . . . . . Indiana First United Bank . . . . . . . . . . . . . . . . . . . . . . Indiana - -------------------------------------------------------------------------------- EXHIBIT 23--CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS - -------------------------------------------------------------------------------- We hereby consent to the incorporation by reference to Registration Statements on Form S-8, File Numbers 33-28900 and 33-28901, of our report dated January 21, 1994 on the consolidated financial statements of First Merchants Corporation, which report is incorporated by reference in the Annual Report on Form 10-K of First Merchants Corporation. /s/ GEO S. OLIVE & CO. Indianapolis, Indiana March 18, 1994 - -------------------------------------------------------------------------------- EXHIBIT 99.1--FINANCIAL STATEMENTS AND INDEPENDENT AUDITOR'S REPORT FOR FIRST MERCHANTS CORPORATION EMPLOYEE STOCK PURCHASE PLAN - -------------------------------------------------------------------------------- The annual financial statements and independent auditor's report thereon for First Merchants Corporation Employee Stock Purchase Plan for the year ending June 30, 1994, will be filed as an amendment to the 1993 Annual Report on Form 10-K no later than October 28, 1994. ITEM 6. SELECTED FINANCIAL DATA. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to page 1 of the Corporation's 1993 Annual Report to Stockholders, "Financial Review," under the caption "Five-Year Summary of Selected Financial Data," Exhibit 13. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to page 2 through 6 of the Corporation's 1993 Annual Report to Stockholders, "Financial Review," under the caption "Management's Discussion and Analysis," Exhibit 13. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ------------------------------------------------------------------------------- The financial statements and supplementary data required under this item are incorporated herein by reference to inside cover and pages 7 through 22 of the Corporation's 1993 Annual Report to Stockholders, "Financial Review," Exhibit 13. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. - ------------------------------------------------------------------------------- In connection with its audits for the two most recent fiscal years ended December 31, 1993, there have been no disagreements with the Corporation's independent certified public accountants on any matter of accounting principles or practices, financial statement disclosure or audit scope or procedure, nor have there been any changes in accountants. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. - ------------------------------------------------------------------------------- The information required under this item relating to directors is incorporated by reference to the Corporation's 1994 Proxy Statement furnished to its stockholders in connection with an annual meeting to be held March 31, 1994 (the "1994 Proxy Statement"), under the caption "Election of Directors," which Proxy Statement has been filed with the Commission. The information required under this item relating to executive officers is set forth in Part I, "Supplemental Information - Executive Officers of the Registrant" of this annual report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to the Corporation's 1994 Proxy Statement, under the captions, "Compensation of Directors" and "Compensation of Executive Officers," which Proxy Statement has been filed with the Commission. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to the Corporation's 1994 Proxy Statement, under the caption, "Security Ownership of Certain Beneficial Owners and Management," which Proxy Statement has been filed with the Commission. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - ------------------------------------------------------------------------------- The information required under this item is incorporated by reference to the Corporation's 1994 Proxy Statement, under the caption "Interest of Management in Certain Transactions," which Proxy Statement has been filed with the Commission. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - ------------------------------------------------------------------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (Continued) - ------------------------------------------------------------------------------- (b) Reports on Form 8-K: No reports on Form 8-K were filed for the three months ended December 31, 1993. - -------------------------------------------------------------------------------- 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 this 15th day of March, 1994. FIRST MERCHANTS CORPORATION By /s/ Stefan S. Anderson --------------------------------- Stefan S. Anderson, Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Capacity Date - --------------------------- --------------------------- ------------------ /s/ Stefan S. Anderson Director and Chairman, March 15, 1994 - -------------------------- Principal Executive Officer Stefan S. Anderson /s/ Thomas B. Clark Director March 15, 1994 - --------------------------- Thomas B. Clark /s/ Michael L. Cox Director March 15, 1994 - --------------------------- Michael L. Cox /s/ Clell W. Douglass Director March 15, 1994 - --------------------------- Clell W. Douglass /s/ David A. Galliher Director March 15, 1994 - --------------------------- David A. Galliher /s/ Thomas K. Gardiner Director March 15, 1994 - --------------------------- Thomas K. Gardiner /s/ Hurley C. Goodall Director March 15, 1994 - --------------------------- Hurley C. Goodall /s/ John W. Hartmeyer Director March 15, 1994 - --------------------------- John W. Hartmeyer /s/ Nelson W. Heinrichs Director March 15, 1994 - --------------------------- Nelson W. Heinrichs - -------------------------------------------------------------------------------- Signature Capacity Date - --------------------------- --------------------------- ---------------- /s/ Jon H. Moll Director March 15, 1994 - --------------------------- Jon H. Moll /s/ Robert M. Smitson Director March 15, 1994 - -------------------------- Robert M. Smitson Director March 15, 1994 - -------------------------- Joseph E. Wilson Director March 15, 1994 - -------------------------- Robert F. Wisehart /s/ John E. Worthen Director March 15, 1994 - -------------------------- John E. Worthen /s/ James L. Thrash Principal Financial and March 15, 1994 - -------------------------- Principal Accounting James L. Thrash Officer INDEX TO EXHIBITS - -------------------------------------------------------------------------------- Form 10-K Page Exhibit No: Description of Exhibit: Number ----------- ----------------------- --------- 3.1 Articles of Incorporation, dated September 20, 1982 and the Articles of Amendment thereto dated March 13, 1985 and March 14, 1988 . . . . . . . . 27-49 3.2 Bylaws and amendments thereto dated February 12, 1985, February 20, 1987, July 14, 1987, December 8, 1987, December 13, 1988, November 14, 1989, August 13, 1991, April 14, 1992, and February 15, 1994 . . . . . . . . . . . 50-69 10.1 First Merchants Bank, National Association Management Incentive Plan . . . . . . . . . . . . (A) 10.2 Unfunded Deferred Compensation Plan, as Amended . . . . . . . . . . . . . . . . . . . . (D) 10.3 Employee Stock Purchase Plan (1989) . . . . . . . . (B) 1989 Stock Option Plan . . . . . . . . . . . . . . (C) 10.5 Employee Stock Purchase Plan (1994) . . . . . . . . 70-73 10.6 1994 Stock Option Plan . . . . . . . . . . . . . . 74-78 13 1993 Annual Report to Stockholders (except for the Pages and information thereof expressly incorporated by reference in this Form 10-K, the Annual Report to Stockholders is provided solely for the information of the Securities and Exchange Commission and is not deemed "filed" as part of this Form 10-K) . . . . . . . . . . . . . . . . . . . . . . 79-124 22 Subsidiaries of Registrant . . . . . . . . . . . . 24 23 Consent of Independent Auditors . . . . . . . . . . 25 99.1 Financial statements and independent auditor's report for First Merchants Corporation Employee Stock Purchase Plan . . . . . 26 (A) Incorporated by reference to Registrant's Registration Statement on Form S-4 (SEC File No. 33-110) ordered effective on September 30, 1988. (B) Incorporated by reference to Registrant's Registration Statement on Form S-8 (SEC File No. 33-28900) effective on May 24, 1989. (C) Incorporated by reference to Registrant's Registration Statement on Form S-8 (SEC File No. 33-28901) effective on May 24, 1989. (D) Incorporated by reference to Registrant's Form 10-K for year ended December 31, 1990. - -------------------------------------------------------------------------------- EXHIBIT 22--SUBSIDIARIES OF THE REGISTRANT - ------------------------------------------------------------------------------- State of Name Incorporation ---- ------------- First Merchants Bank, National Association. . . . . . . . . . U.S. Pendleton Banking Company . . . . . . . . . . . . . . . . . . Indiana First United Bank . . . . . . . . . . . . . . . . . . . . . . Indiana - -------------------------------------------------------------------------------- EXHIBIT 23--CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS - -------------------------------------------------------------------------------- We hereby consent to the incorporation by reference to Registration Statements on Form S-8, File Numbers 33-28900 and 33-28901, of our report dated January 21, 1994 on the consolidated financial statements of First Merchants Corporation, which report is incorporated by reference in the Annual Report on Form 10-K of First Merchants Corporation. /s/ GEO S. OLIVE & CO. Indianapolis, Indiana March 18, 1994 - -------------------------------------------------------------------------------- EXHIBIT 99.1--FINANCIAL STATEMENTS AND INDEPENDENT AUDITOR'S REPORT FOR FIRST MERCHANTS CORPORATION EMPLOYEE STOCK PURCHASE PLAN - -------------------------------------------------------------------------------- The annual financial statements and independent auditor's report thereon for First Merchants Corporation Employee Stock Purchase Plan for the year ending June 30, 1994, will be filed as an amendment to the 1993 Annual Report on Form 10-K no later than October 28, 1994.

19617_1993.txt

19617_1993

1993

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ITEM 1. BUSINESS OVERVIEW Chemical Banking Corporation (the "Corporation") is a bank holding company organized under the laws of Delaware in 1968 and registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"). On December 31, 1991, Manufacturers Hanover Corporation ("MHC") merged with and into the Corporation (the "Merger"). The Merger was accounted for as a pooling of interests and, accordingly, the Corporation's financial statements include the consolidated results of MHC. In addition, on June 19, 1992, Manufacturers Hanover Trust Company ("MHT"), a New York banking corporation, was merged with and into Chemical Bank ("Chemical Bank"), a New York banking corporation. Certain amounts in the 1992 and 1991 financial statements have been reclassified to conform with the presentation of the 1993 financial statements. The Corporation conducts domestic and international financial services businesses through various bank and non-bank subsidiaries. The principal bank subsidiaries of the Corporation are Chemical Bank and Texas Commerce Bank National Association, a subsidiary of Texas Commerce Bancshares, Inc. ("Texas Commerce"), a bank holding company subsidiary of the Corporation headquartered in Texas. The bank and non-bank subsidiaries of the Corporation operate nationally through offices located primarily in New York, Texas and New Jersey as well as through overseas branches and an international network of representative offices, subsidiaries and affiliated banks. The financial services provided by the Corporation's domestic subsidiaries include personal and commercial checking accounts, savings and time deposit accounts, United States corporate tax depository facilities, personal and business loans, consumer financing, leasing, real estate financing, investment banking, mortgage banking, individual credit cards, money transfer, cash management, safe deposit facilities, payroll management, correspondent banking, personal trust and estate administration, full investment services, discount brokerage, United States Government and Federal agency securities dealership, and corporate debt and equity securities dealership and underwriting. Internationally, services also include correspondent banking arrangements, merchant banking, underwriting and trading of eurosecurities, and foreign exchange activities. The Corporation's bank subsidiaries also provide products to ensure that a customer will have a specific currency-exchange or interest rate at some future date. These products include interest-rate and currency swaps, interest rate options, future rate agreements, forward interest-rate contracts, foreign exchange contracts and financial futures. The Corporation retains a 40% interest in the CIT Group Holdings, Inc. ("CIT"). CIT, directly or through its subsidiaries, engages in diversified financial services activities, primarily in the United States. These activities include asset-based finance and leasing, sales finance and factoring. For additional information pertaining to CIT, see the section entitled "Noninterest Revenue" in Section B, page 30. ORGANIZATIONAL REVIEW The Corporation's activities are internally organized, for management reporting purposes, into various business sectors. Developments that have occurred during 1993 with respect to these business sectors are disclosed below . A1 THE GLOBAL BANK The Global Bank provides banking, financial advisory, trading and investment services to corporations and public sector clients worldwide through a network of offices in 35 countries, including major operations in all key international financial centers. For a discussion of the Global Bank's business activities, see the section entitled "Lines of Business Results" in Section B at page 32. Additionally, during 1993, the Corporation received approval from the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") for authority for its securities subsidiary, Chemical Securities Inc. ("CSI"), to underwrite and deal in corporate debt and equity securities. THE REGIONAL BANK The Regional Bank is a leading provider of services to consumers in the tri-state metropolitan region of New York, New Jersey and Connecticut. For a discussion of the Regional Bank's business activities, see the section entitled "Lines of Business Results" in Section B at page 33. Additionally, during 1993, the Corporation continued to build The Hanover Funds, the Corporation's proprietary mutual funds family, by increasing the number of funds available for investment from six to ten, continued the merging of the branch systems of Chemical Bank and MHT, introduced unified products throughout the Regional Bank branch network and initiated steps to sell insurance products nationwide through a joint venture with MDS/Bankmark. In 1994, the Corporation sold certain of Chemical Bank's branches located in Albany, Buffalo, Rochester, Syracuse and certain other upstate locations to Fleet Bank of New York, and plans to close approximately 50 branches located in the N.Y. metropolitan area. TEXAS COMMERCE Texas Commerce is a major financial institution in Texas with over 115 locations statewide and serving as the primary Texas bank for more than half of all companies located in Texas with annual revenues of $250 million or more. For a discussion of Texas Commerce's business activities, see the section entitled "Lines of Business Results" in Section B at page 33. In February 1993, Texas Commerce acquired certain assets of four former banks of the First City Bancorporation of Texas and in September 1993 Texas Commerce acquired Ameritrust Texas Corporation. As a result of these acquisitions, at December 31, 1993, Texas Commerce ranked, in terms of total deposits, first in the Houston and third in the Dallas/Fort Worth banking markets and had more than doubled its trust assets under management to $14 billion, the largest trust operations in the southwest United States. REAL ESTATE AND CORPORATE For a discussion on the Corporation's real estate and corporate business sectors, see the section entitled "Lines of Business Results" in Section B at page 34. ACQUISITIONS, DIVESTITURES AND STRATEGIC POSITIONING The acquisitions and divestitures undertaken by the Corporation during 1993 are consistent with the Corporation's desire to focus on businesses and markets where it has or can acquire a leadership position. The Corporation intends to continue to examine opportunities for expansion or acquisition, particularly in businesses in which economies of scale are important (such as credit cards, mortgage servicing, mutual funds and certain areas of operating services) or in which significant expense savings can be obtained from consolidation of operations (such as in-market consolidations of banking operations). Likewise, businesses that fall outside the Corporation's strategic focus (either in terms of product offering or geographic market), may be candidates for divestiture or closure. The Corporation also intends to continue its productivity efforts to focus on containing costs throughout the organization and increasing efficiency over the long term. As part of this program, the Corporation may open new branches and close existing branches from time to time in order to keep its distribution system attuned to changing economics of branch banking and changing customer preferences for delivery of banking services. A2 COMPETITION The Corporation and its subsidiaries and affiliates operate in a highly competitive environment. The Corporation's bank subsidiaries compete with other domestic and foreign banks, thrift institutions, credit unions, and money market and other mutual funds for deposits and other sources of funds. In addition, the Corporation and its bank and non-bank subsidiaries face increased competition with respect to the diverse financial services and products they offer. Competitors also include leasing companies, finance companies, brokerage firms, investment banking companies, merchant banks, and a variety of other financial services and advisory companies. Many of these competitors are not subject to the same regulatory restrictions as are domestic bank holding companies and banks, such as the Corporation and its bank subsidiaries. The Corporation expects that competitive conditions will continue to intensify as a result of technological advances. Technological advances have, for example, made it possible for non-depository institutions to offer customers automatic transfer systems and other automated payment systems services that have been traditional banking products. GOVERNMENT MONETARY POLICIES AND ECONOMIC CONTROLS The earnings and business of the Corporation are affected by general economic conditions, both domestic and international. In addition, fiscal or other policies that are adopted by various regulatory authorities of the United States, by foreign governments, and by international agencies can have important consequences on the financial performance of the Corporation. The Corporation is particularly affected by the policies of the Federal Reserve Board, which regulates the national supply of bank credit. Among the instruments of monetary policy available to the Federal Reserve Board are engaging in open-market operations in United States Government securities; changing the discount rates of borrowings of depository institutions; imposing or changing reserve requirements against depository institutions deposits and certain assets of foreign branches; and imposing or changing reserve requirements against certain borrowings by banks and their affiliates (including parent corporations such as the Corporation). These methods are used in varying combinations to influence the overall growth of bank loans, investments, and deposits, and the interest rates charged on loans or paid for deposits. The Corporation has economic, credit, legal, and other specialists who monitor economic conditions, and domestic and foreign government policies and actions. However, since it is difficult to predict changes in macroeconomic conditions and in governmental policies and actions relating thereto, it is difficult to foresee the effects of any such changes on the business and earnings of the Corporation and its subsidiaries. SUPERVISION AND REGULATION The Corporation is subject to regulation as a registered bank holding company under the BHCA. As such, the Corporation is required to file with the Federal Reserve Board an annual report and other information required quarterly pursuant to the BHCA. The Corporation is also subject to the examination powers of the Federal Reserve Board. Under the BHCA, the Corporation may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries, and may not acquire voting control of non-banking corporations, except those corporations engaged in businesses or furnishing services which the Federal Reserve Board deems to be so closely related to banking as "to be a proper incident thereto". Further, the Corporation is prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any non-banking corporation, and may not acquire direct or indirect ownership or control of more than 5% of the voting shares of any domestic bank without the prior approval of the Federal Reserve Board. Under existing laws, the Federal Reserve Board generally is prohibited from approving any application by a bank holding company to acquire voting shares of any bank in another state unless such interstate acquisitions are authorized by the laws of such state or unless, under certain circumstances, such bank is a failing bank. A3 Federal law imposes limitations on the payment of dividends by the subsidiaries of the Corporation that are state member banks of the Federal Reserve System (a "state member bank") or national banks. Non-bank subsidiaries of the Corporation are not subject to such limitations. The amount of dividends that may be paid by a state member bank, such as Chemical Bank, or by a national bank, such as Texas Commerce Bank National Association, is limited to the lesser of the amounts calculated under a "recent earnings" test and an "undivided profits" test. Under the recent earnings test, a dividend may not be paid if the total of all dividends declared by a bank in any calendar year is in excess of the current year's "net profits" combined with the "retained net profits" of the two preceding years unless the bank obtains the approval of its appropriate Federal banking regulator (which, in the case of a member bank, is the Federal Reserve Board and, in the case of a national bank, is the Office of the Comptroller of the Currency (the "Comptroller of the Currency")). Under the undivided profits test, a dividend may not be paid in excess of a bank's "undivided profits then on hand", after deducting losses and "bad debts" in excess of the allowance for loan and lease losses. Under regulations adopted by the Federal Reserve Board and the Comptroller of the Currency, the terms "net profits" and "undivided profits then on hand" are defined as the amounts reported by a bank on its Reports of Condition and Income; the term "retained net profits" is defined as net income (as defined) less any common or preferred dividends declared for the reporting period; and the term "bad debts" is defined to include matured obligations due a bank on which the interest is past due and unpaid for six months, unless the debts are well secured and in the process of collection. Generally, a debt is considered "matured" when all or a part of the principal is due and payable as a result of demand, arrival of the stated maturity date, of acceleration by contract or by operation of law. The New York Banking Department also adopted regulations in December 1990 that require net profits of New York State-chartered banks, like Chemical Bank, to be calculated in a manner similar to the method set forth in the Federal Reserve Board's regulations. At December 31, 1993, in accordance with the foregoing restrictions, the Corporation's bank subsidiaries could, without the approval of their relevant banking regulators, pay dividends of approximately $1,715 million to their respective bank holding companies, plus an additional amount equal to their net profits from January 1, 1994 through the date of any such dividend payment. In addition to the dividend restrictions described above, the Federal Reserve Board, the Comptroller of the Currency and the FDIC have authority under the Financial Institutions Supervisory Act to prohibit or to limit the payment of dividends by the banking organizations they supervise, including the Corporation and its subsidiaries that are banks or bank holding companies, if, in the banking regulator's opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the banking organization. For a further discussion of the dividend restrictions imposed on the Corporation's subsidiaries that are state member or national banks, see Note 17, "Restrictions on Cash and Intercompany Funds Transfers", in Section B on page 71. The Corporation is also subject to the risk-based capital and leverage guidelines of the Federal Reserve Board, which require that the Corporation's capital-to-assets ratios meet certain minimum standards. For a discussion of the Federal Reserve Board's guidelines and the Corporation's ratios, see the sections entitled "Capital", "Risk-Based Capital Ratios", and "Leverage Ratios" in Section B, pages 42 through 44. The FDIC, the Federal Reserve Board and the Comptroller of the Currency also have issued proposed rules which are intended to revise the risk-based capital rules to take into account interest-rate risk. For a further discussion of the proposed rulemaking and the Corporation's assessment of the impact the proposal would have on the capital ratios of the Corporation, see the section entitled "Interest Rate Sensitivity" in Section B at pages 47 through 49. A4 FDICIA On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted. Among other things, FDICIA requires the FDIC to establish a risk-based assessment system for FDIC deposit insurance and revises certain provisions of the Federal Deposit Insurance Act as well as certain other Federal banking statutes. In general, FDICIA provides for expanded regulation of depository institutions and their affiliates, including parent holding companies, by such institutions' appropriate Federal banking regulators, and requires the appropriate Federal banking regulator to take "prompt corrective action" with respect to a depository institution if such institution does not meet certain capital adequacy standards. Prompt Corrective Action. Pursuant to FDICIA, the Federal Reserve Board, the FDIC and the Office of the Comptroller of the Currency adopted regulations, effective December 19, 1992, setting forth a five-tier scheme for measuring the capital adequacy of the depository institutions they supervise. Under the regulations (commonly referred to as the "prompt corrective action" rules), an institution would be placed in one of the following capital categories: (i) well capitalized (an institution that has a total risk- based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% and a Tier 1 leverage ratio of at least 5%); (ii) adequately capitalized (an institution that has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a Tier 1 leverage ratio of at least 4%); (iii) undercapitalized (an institution that has a total risk-based capital ratio of under 8% or a Tier 1 risk-based capital ratio under 4% or a Tier 1 leverage ratio under 4%); (iv) significantly undercapitalized (an institution that has a total risk-based capital ratio of under 6% or a Tier 1 risk-based capital ratio under 3% or a Tier 1 leverage ratio under 3%); and (v) critically undercapitalized (an institution that has a ratio of tangible equity to total assets of 2% or less). Supervisory actions by the appropriate Federal banking regulator will depend upon an institution's classification within the five categories. All institutions are generally prohibited from declaring any dividends, making any other capital distribution, or paying a management fee to any controlling person, if such payment would cause the institution to become undercapitalized. Additional supervisory actions are mandated for an institution falling into one of the three "undercapitalized" categories, with the severity of supervisory action increasing at greater levels of capital deficiency. For example, critically undercapitalized institutions are, among other things, restricted from making any principal or interest payments on subordinated debt without prior approval of their appropriate Federal banking regulator. The regulations apply only to banks and not to bank holding companies, such as the Corporation; however, the Federal Reserve Board is authorized to take appropriate action at the holding company level based on the undercapitalized status of such holding company's subsidiary banking institution. In certain instances relating to an undercapitalized banking institution, the bank holding company would be required to guarantee the performance of the undercapitalized subsidiary and may be liable for civil money damages for failure to fulfill its commitments on such guarantee. At December 31, 1993, Chemical Bank and Texas Commerce National Association were each "well capitalized". Brokered Deposits. The FDIC issued a rule, effective June 16, 1992, regarding the ability of depository institutions to accept brokered deposits. Under the rule, the term "brokered deposits" is defined to include deposits that are solicited by a bank's affiliates on its behalf. A significant portion of Chemical Bank's wholesale deposits are solicited on its behalf by a broker-dealer affiliate of Chemical Bank and are considered brokered deposits. Under the rule, (i) an "undercapitalized institution is prohibited from accepting, renewing or rolling over brokered deposits, (ii) an "adequately capitalized" institution must obtain a waiver from the FDIC before accepting, renewing or rolling over brokered deposits and is not permitted to pay interest on brokered deposits accepted in such institution's normal market area at rates that "significantly exceed" rates paid on deposits of similar maturity in such area, and (iii) a "well capitalized" institution may accept, renew or roll over brokered deposits without restriction. The definitions of "well capitalized", "adequately capitalized", and "undercapitalized" are the same as those utilized in the "prompt corrective action" rules described above. As noted above, at December 31, 1993, each of Chemical Bank and Texas Commerce Bank National Association was "well capitalized". A5 FDIC Insurance Assessments. The FDIC has adopted final rules implementing, for assessment periods commencing January 1, 1994, risk- based insurance premiums. Under the assessment system, each depository institution is assigned to one of nine risk classifications based upon certain capital and supervisory measures and, depending upon its classification, will be assessed premiums ranging from 23 basis points to 31 basis points. In adopting the "permanent" risk-based assessment system, the FDIC indicated that, if future conditions so warrant, it may reconsider certain aspects of the rate schedules and of the risk classification categories. The Corporation believes that the implementation of the "permanent" risk-based FDIC assessment system will not have a material effect on the Corporation's FDIC expenses during 1994. Other FDICIA Rules. Other rules that have been adopted pursuant to FDICIA include: (i) real estate lending standards for banks, which would provide guidelines concerning loan-to-value ratios for various types of real estate loans; (ii) rules relating to consumer lending, including regulations governing advertising and disclosures required for consumer deposit accounts; (iii) rules requiring depository institutions to develop and implement internal procedures to evaluate and control credit and settlement exposure to their correspondent banks; (iv) rules implementing the FDICIA provision prohibiting, with certain exceptions, FDIC- insured state banks from making equity investments of the types and amount, or from engaging as principal in activities, not permissible for national banks; and (v) rules mandating enhanced financial reporting and audit requirements. Rules proposed, but not yet adopted, include those addressing (i) various "safety and soundness" issues, including operations and managerial standards, standards for asset quality, earnings and stock valuations, and compensation standards for the officers, directors, employees and principal stockholders of the depository institution, (ii) the degree to which the risk-based capital rules should be revised to take into account interest-rate risk, as previously mentioned and (iii) notice provisions in the case of branch closings. The Corporation expects the rules and regulations adopted and proposed to be adopted pursuant to FDICIA will result in increased compliance costs for the Corporation and its bank subsidiaries but does not expect such rules and regulations to have a material impact on the operations of the Corporation or its bank subsidiaries. POWERS OF THE FDIC UPON INSOLVENCY OF AN INSURED DEPOSITORY INSTITUTION The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") imposes liability on an FDIC-insured depository institution (such as the Corporation's bank subsidiaries), for costs incurred by the FDIC in connection with the insolvency of other FDIC-insured institutions under common control with such institution (commonly referred to as "cross-guarantees" of insured depository institutions). An FDIC cross-guarantee claim against a depository institution is superior in right of payment to claims of the holding company and its affiliates against such depository institution. In the event an insured depository institution becomes insolvent, or upon the occurrence of certain other events specified in the Federal Deposit Insurance Act, whenever the FDIC is appointed the conservator or receiver of such insured depository institution, the FDIC has the power: (i) to transfer any of such bank's assets and liabilities to a new obligor (including, but not limited to, another financial institution acquiring all or a portion of the bank's business, assets or liabilities), without the approval of such bank's creditors; (ii) to enforce the terms of such bank's contracts pursuant to their terms, or (iii) to repudiate or disaffirm any contract or lease to which such depository institution is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmance or repudiation of which is determined by the FDIC to promote the orderly administration of such depository institution's assets. Such provisions of the Federal Deposit Insurance Act would be applicable to obligations and liabilities of those of the Corporation's subsidiaries that are insured depository institutions, such as Chemical Bank and Texas Commerce Bank National Association, including without limitation, obligations under senior or subordinated debt issued by such banks to investors (hereinafter referred to as "public noteholders") in the public markets. A6 In its resolution of the problems of an insured depository institution in default or in danger of default, the FDIC is not permitted to take any action that would have the effect of increasing the losses to a deposit insurance fund by protecting depositors for more than the insured portion of their deposits or by protecting creditors of the insured depository institution (including public noteholders), other than depositors. On October 25, 1993, the FDIC issued proposed rules to implement these provisions. In addition, the FDIC is authorized to settle all uninsured and unsecured claims in the insolvency of an insured institution by making a final settlement payment after the declaration of insolvency based upon a percentage determined by the FDIC reflecting an average of the FDIC's receivership recovery experience, regardless of the assets of the insolvent institution actually available for distribution to creditors. Such a payment would constitute full payment and disposition of the FDIC's obligations to claimants. The Omnibus Budget Reconciliation Act of 1993 included a "depositor preference" provision, which provided that, in the event of a liquidation of an insured depository institution, claims of depositors and their subrogees, including the FDIC in respect of the payment of insured deposits, would be entitled to a preference over all other unsecured claimants against the depository institution, including some creditors (such as certain public noteholders), other than depositors. As a result of the provisions described above, whether or not the FDIC ever sought to repudiate any obligations held by public noteholders of any subsidiary of the Corporation that is an insured depository institution, such as Chemical Bank or Texas Commerce Bank National Association, the public noteholders would be treated differently from, and could receive, if anything, substantially less than, holders of deposit obligations of such depository institution. OTHER SUPERVISION AND REGULATION Under Federal Reserve Board policy, the Corporation is expected to act as a source of financial strength to each bank subsidiary and to commit resources to support such bank subsidiary in circumstances where it might not do so absent such policy. Any 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 the subsidiary banks. 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 at a certain level will be assumed by the bankruptcy trustee and entitled to a priority of payment. The bank subsidiaries of the Corporation are subject to certain restrictions imposed by Federal law on extensions of credit to, and certain other transactions with, the Corporation and certain other affiliates and on investments in stock or securities thereof. Such restrictions prevent the Corporation and other affiliates from borrowing from a bank subsidiary unless the loans are secured in specified amounts. Without the prior approval of the Federal Reserve Board, secured loans, other transactions and investments by any bank subsidiary are generally limited in amount as to the Corporation and as to each of the other affiliates to 10% of the bank's capital and surplus and as to the Corporation and all such other affiliates to an aggregate of 20% of the bank's capital and surplus. Federal law also requires that transactions between a bank subsidiary and the Corporation or certain non-bank affiliates, including extensions of credit, sales of securities or assets and the provision of services, be conducted on terms at least as favorable to the bank subsidiary as those that apply or that would apply to comparable transactions with unaffiliated parties. The Corporation's bank and non-bank subsidiaries are subject to direct supervision and regulation by various other Federal and state authorities. Chemical Bank, as a New York State-chartered bank and member bank of the Federal Reserve System, is subject to supervision and regulation of the New York State Banking Department as well as by the Federal Reserve Board and the FDIC. The Corporation's national bank subsidiaries, such as Texas Commerce Bank National Association, Chemical Bank New Jersey, N.A. and Chemical Bank, N.A., are subject to substantially similar supervision and regulations by the Comptroller of the Currency. Supervision and regulation by each of the foregoing regulatory agencies generally include comprehensive annual reviews of all major aspects of the relevant bank's business and condition, as well as the imposition of periodic reporting requirements and limitations on A7 investments and other powers. The activities of the Corporation's broker-dealers are subject to the regulations of the Securities and Exchange Commission and the National Association of Securities Dealers, and, in the case of CSI, are subject to the supervision and regulation of the Federal Reserve Board (which has imposed conditions governing CSI's activities, including limitations on the gross revenues that may be derived from certain of CSI's activities). Additionally, various securities activities conducted by the bank subsidiaries of the Corporation, such as dealing in municipal securities, acting as transfer agent, the making available of mutual funds and providing other types of investment management services, are subject to the regulations of the Securities and Exchange Commission, the Municipal Securities Rulemaking Board and, with respect to certain activities of its mutual funds, the Federal Reserve Board. The types of activities in which the foreign branches of Chemical Bank and the international subsidiaries of the Corporation may engage are subject to various restrictions imposed by the Federal Reserve Board. Such foreign branches and international subsidiaries are also subject to the laws and banking authorities of the countries in which they operate. Federal and state legislation affecting the banking industry has played, and will continue to play, a significant role in shaping the nature of the financial services industry. For example, there are bills currently pending in Congress that would permit, to varying degrees, the interstate expansion and branching of bank holding companies and banks, respectively. In addition, there are cases pending before Federal and state courts that seek to expand or restrict interpretations of existing laws and their accompanying regulations affecting bank holding companies and their subsidiaries. It is not possible to predict the extent to which the Corporation and its subsidiaries may be affected by any of these initiatives. FOREIGN OPERATIONS For geographic distributions of total assets, total revenue, total expense, income before income tax expense and net income, see Note 21, "International Operations", of the Notes to Consolidated Financial Statements in Section B, page 77. For a discussion of foreign loans, see the sections entitled "Cross-Border Outstandings" and "Outstandings to Countries Engaged in Debt Rescheduling" in Section B, pages 41 and 42. A8 STATISTICAL INFORMATION In addition to the statistical information that is presented in the following pages in this Section A of the Form 10-K, the following statistical information is included in Section B of the Form 10-K: A9 DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL For a five-year summary of the consolidated average balances, interest rates and interest differentials on a taxable-equivalent basis for the years 1993 through 1989, see Section B, pages 80 and 81. Income computed on a taxable-equivalent basis is income as reported in the Consolidated Statement of Income adjusted to make income and earning yields on assets exempt from income taxes (primarily Federal taxes) comparable to other taxable income. The incremental tax rate used for calculating the taxable equivalent adjustment was approximately 43% in each of the years 1993 through 1989. Within the five-year summary, the principal amounts of nonaccrual and renegotiated loans have been included in the average loan balances used to determine the average interest rate earned on loans. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed against interest income. Subsequent cash receipts are applied either to the outstanding principal balance or recorded as interest income, depending on management's assessment of the ultimate collectibility of principal and interest. Interest income is accrued on renegotiated loans at the renegotiated rates. Certain renegotiated loan agreements call for additional interest to be paid on a deferred or a contingent basis. Such interest is taken into income only as collected. A summary of interest rates and interest differentials segregated between domestic and foreign operations for the years 1993, 1992 and 1991 is presented on pages A11 and A12 herein. Regarding the basis of segregation between the domestic and foreign components, see Note 21 of the Notes to Consolidated Financial Statements in Section B, page 77. The tables on pages A13 through A16 herein present an analysis of the effect on net interest income of volume and rate changes for the periods 1993 over 1992 and 1992 over 1991. In this analysis, the change due to the volume/rate variance has been allocated to volume. A10 CHEMICAL BANKING CORPORATION AND SUBSIDIARIES INTEREST RATES AND INTEREST DIFFERENTIAL ANALYSIS OF NET INTEREST INCOME - DOMESTIC AND FOREIGN A11 A12 CHEMICAL BANKING CORPORATION AND SUBSIDIARIES CHANGE IN NET INTEREST INCOME VOLUME AND RATE ANALYSIS _______________________________________ A13 1993 OVER 1992 A14 CHEMICAL BANKING CORPORATION AND SUBSIDIARIES CHANGE IN NET INTEREST INCOME VOLUME AND RATE ANALYSIS A15 1992 OVER 1991 A16 SECURITIES PORTFOLIO On December 31, 1993, the Corporation adopted Statement of Financial Accounting Standard No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 addresses the accounting for investments in equity securities that have readily determinable fair values and all investments in debt securities. Prior to the adoption of SFAS 115, available-for-sale securities were carried at the lower of aggregate amortized cost or market value. For a further discussion of the Corporation's securities portfolio see Note 4 of the Notes to Consolidated Financial Statements in Section B, pages 60 through 61. Of the securities held in the Corporation's securities portfolio, the U.S. Government is the only issuer whose securities exceeded 10% of the Corporation's total stockholders' equity at December 31, 1993. The year-end balances of the Corporation's held-to- maturity securities for 1993, 1992 and 1991 were as follows: The year-end balances of the Corporation's available-for-sale securities for 1993 and 1992 were as follows: (a) Includes investments in debt securities issued by foreign governments, corporate debt securities, collateralized mortgage obligations of private issuers, and other debt and equity securities. A17 The following table presents, by maturity range and type of security, the amortized cost at December 31, 1993, and the average yield of the held-to-maturity securities portfolio. The following table presents, by maturity range and type of security, the fair value and amortized cost at December 31, 1993 and the average yield of the available-for-sale securities portfolio. LOAN PORTFOLIO The table below sets forth the amount of loans outstanding by type for the dates indicated: MATURITIES AND SENSITIVITY TO CHANGES IN INTEREST RATES The following table shows the maturity distribution based upon the terms of the loan agreements, and sensitivity to changes in interest rates of the loan portfolio, excluding consumer loans, at December 31, 1993: (a) LDC denotes loans to countries engaged in debt rescheduling. (b) Includes demand loans, overdrafts and loans having no stated schedule of repayments and no stated maturity. A19 RISK ELEMENTS The following table shows the principal amounts of nonaccrual and renegotiated loans at the dates indicated: See Note 7 on page 64 of Section B for interest income calculated on the carrying value of nonaccrual and renegotiated loans that would have been recorded if these loans had been current in accordance with their original terms (interest at original rates), and the amount of interest income on these loans that was included in income for the periods indicated. _______________________________________________________________________________ The following table presents loans past due 90 days or more for which interest is being accrued at the dates indicated: (a) Includes consumer loans, exclusive of residential mortgage loans, as to which interest or principal is past due 90 days or more which are generally not classified as nonperforming but, rather, are charged-off on a formula basis upon reaching certain specified stages of delinquency. A20 ALLOWANCE FOR LOSSES The table below sets forth the Allowance for Losses for the dates indicated: _________________________ (a) Includes $55 million related to the decision to accelerate the disposition of certain nonperforming residential mortgage loans. (b) Includes $175 million of recoveries on the disposition of LDC debt. (c) Includes $19 million increase in allowance related to the acquisition by Texas Commerce of certain assets of four former banks of First City Bancorporation of Texas, Inc. (d) Includes a $902 million charge to adjust Brazilian medium- and long-term outstandings to an estimated net recoverable value. (e) Includes a $349 million charge related to the Mexican debt restructuring agreement. This amount represents the difference between the carrying value of the debt exchanged and the face value of the bonds received. (f) Includes special additions of $1.7 billion for loans to countries engaged in debt rescheduling and $210 million to Texas Commerce's allowance for losses. A21 ALLOWANCE FOR LOSSES-FOREIGN The following table shows, for the years 1993-1989, the changes in the portion of the allowance for losses allocated to loans related to foreign operations, including activity related to countries engaged in debt rescheduling: (a) Includes a $902 million charge to adjust Brazilian medium- and long-term outstandings to an estimated net recoverable value. (b) Includes a $349 million charge related to the Mexican debt restructuring agreement. This amount represents the difference between the carrying value of the debt exchanged and the face value of the bonds received. (c) Includes a special addition of $1.7 billion for loans to countries engaged in debt rescheduling. The consolidated year-end allowance for losses is available to absorb potential credit losses from the entire loan portfolio, as well as from other balance sheet and off-balance sheet credit related transactions. LOAN LOSS ANALYSIS A22 DEPOSITS The following data provide a summary of the Corporation's average deposits and average interest rates for the years 1993-1991: Substantially all of the foreign deposits are in denominations of $100,000 or more. The following table presents deposits in denominations of $100,000 or more by maturity range and type for the dates indicated: At December 31, 1993, time and savings deposits in domestic offices totaled $51,940 million, of which $5,231 million were time certificates of deposit in denominations of $100,000 or more, $3,916 million were other time deposits in denominations of $100,000 or more and $34,290 million were money market deposit accounts and other savings accounts. Deposits of $100,000 or more in foreign offices totaled $22,894 million, substantially all of which were interest-bearing. At December 31, 1992, time and savings deposits in domestic offices totaled $51,353 million, of which $5,173 million were time certificates of deposit in denominations of $100,000 or more, $3,549 million were other time deposits in denominations of $100,000 or more and $33,330 million were money market deposit accounts and other savings accounts. Deposits of $100,000 or more in foreign offices totaled $20,007 million, substantially all of which were interest-bearing. A23 ITEM 2. ITEM 2. PROPERTIES The headquarters of the Corporation is located in New York City at 270 Park Avenue, which is a 50-story bank and office building owned by the Corporation. This location contains approximately 1.3 million square feet of commercial office and retail space. The Corporation also owns and occupies a 22-story bank and office building at 4 New York Plaza with 900,000 square feet of commercial office and retail space. The Corporation also occupies, under leasehold agreements, office space at 55 Water Street, 277 Park Avenue, 95 Wall Street and various other locations in New York City. The Corporation, as lessee, also occupies offices in the United Kingdom. The most significant office space leased in the United Kingdom is the 168,000 square feet at 125 London Wall, which lease expires in December 2017. In addition, the Corporation and its subsidiaries own and occupy administrative and operational facilities in Hicksville, New York; Moorestown, New Jersey; Houston, Texas; McAllen, Texas; Austin, Texas; Arlington, Texas and El Paso, Texas. The Corporation and its subsidiaries occupy branch offices and other locations throughout the United States and in foreign countries under various types of ownership and leasehold agreements which, when considered in the aggregate, are not material to its operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On January 4, 1991, Best Products Co., Inc., a catalog showroom retailer, and several of its wholly-owned subsidiaries (collectively "Best") filed under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). On or about December 29, 1992, Best commenced adversary proceedings in the Bankruptcy Court against Chemical Bank arising out of a leveraged buyout of Best. Chemical Bank acted as agent bank for a syndicate of financial institutions (the "Bank Group") that provided permanent financing of approximately $622 million (of which Chemical Bank held, as of January 4, 1991, approximately $185 million of outstanding principal and accrued and unpaid interest) to Best in connection with its leveraged buyout. Best's complaint alleges that the principal and interest payments made to the Bank Group and the fees and expenses paid to the Bank Group in return for the financing (of which Chemical Bank's share of all such payments is approximately $232 million) constituted fraudulent conveyances in violation of New York and Virginia law. In January 1994, Best filed and disseminated a plan of reorganization which, among other things, contemplates that all of the claims asserted by Best against Chemical Bank and the Bank Group would be dismissed pursuant to a compromise and settlement that is part of the plan. On February 4, 1994, the Resolution Trust Corporation (the "RTC"), acting as receiver for certain other creditors of Best, filed an adversary proceeding against the Bank Group seeking a declaration that the Bank Group cannot enforce the subordination provisions of the Intercreditor Agreement to which such other creditors, Best, and Chemical Bank, as agent for the Bank Group, are parties because the Bank Group's claims against Best constitute fraudulent conveyances. The RTC seeks a further declaration that if, by reasons of the subordination provisions of the Intercreditor Agreement, the Bank Group receives distributions from Best pursuant to a confirmed plan of reorganization, the RTC's rights to recover such distributions from the Bank Group shall survive the confirmation of such plan of reorganization. The Bankruptcy Court has approved the disclosure statement for the plan of reorganization and a creditor vote on the plan has taken place. A hearing on the compromise and settlement of Best's claims against Chemical Bank and the Bank Group commenced on March 16, 1994 and has not been concluded. Although there can be no assurance that the Bankruptcy Court will approve the compromise and settlement or confirm the proposed plan of reorganization, management believes that the above-described proceedings will be resolved without having any material adverse impact on the financial condition of Chemical Bank or the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. A24 EXECUTIVE OFFICERS OF THE REGISTRANT Unless otherwise noted, all of the Corporation's above-named executive officers have continuously held senior level positions with the Corporation and Chemical Bank during the five fiscal years ended December 31, 1993. There are no family relationships among the foregoing executive officers. A25 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The outstanding shares of the Corporation's Common Stock are listed on the New York Stock Exchange and the International Stock Exchange of the United Kingdom and the Republic of Ireland. For the quarterly high and low prices of the Common Stock on the New York Exchange and the quarterly dividends declared data for the Corporation's common stock in the last two years, see the section entitled "Quarterly Financial Information" in Section B, page 79. At February 28, 1994, there were approximately 55,637 holders of record of the Corporation's Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA For five-year selected financial data, see "Financial Review" in Section B, page 25. 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, entitled "Management's Discussion and Analysis", appears in Section B, pages 26 through 51. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements appear, together with the Notes thereto and the report of Price Waterhouse dated January 18, 1994 thereon, in Section B, pages 52 through 79. Supplementary financial data for each full quarter within the two years ended December 31, 1993 are included in Section B, page 79 in the table entitled "Quarterly Financial Information". Also included in Section B, pages 80 through 82, are the "Average Consolidated Balance Sheet, Interest and Rates" and the "Consolidated Balance Sheet" for Chemical Bank and Subsidiaries. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. A26 PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE CORPORATION 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, the information to be provided by Items 10, 11, 12 and 13 of Form 10-K (other than information pursuant to Rule 402 (i), (k) and (l) of Regulation S-K) are incorporated by reference to the Corporation's definitive proxy statement for the annual meeting of stockholders, to be held May 17, 1994, which proxy statement will be filed with Securities and Exchange Commission pursuant to Regulation 14A within 120 days of the close of the Corporation's 1993 fiscal year. A27 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) EXHIBITS 1. Financial Statements The consolidated financial statements, the Notes thereto and the report thereon listed in Item 8 are set forth in Section B, commencing on page 52 thereof. 2. Financial Statement Schedules None. 3. EXHIBITS A28 A29 A30 The Corporation hereby agrees to furnish to the Commission, upon request, copies of instruments defining the rights of holders for the following outstanding nonregistered long-term debt of the Corporation and its subsidiaries: Floating Rate Subordinated Capital Note Due 1999 of the Corporation; Floating Rate Subordinated Note Due 1998 of the Corporation; Subordinated Floating Rate Notes Due 2003 of the Corporation; Floating Rate Note Due 2002 of the Corporation; Zero-Coupon Note Due 2002 of the Corporation; Serial Zero Coupon Guaranteed Notes Due 1984-2003 of the Corporation; 7 1/4% Subordinated Notes Due 2002 of Chemical Bank; 7% Subordinated Notes Due 2005 of Chemical Bank; Floating Rate Subordinated Notes Due May 5, 2003 of Chemical Bank; Floating Rate Subordinated Notes Due June 15, 2000 of Chemical Bank; Floating Rate Subordinated Notes Due July 29, 2003 of Chemical Bank; 6.58% Subordinated Notes Due 2005 of Chemical Bank; 6.70% Subordinated Notes Due 2008 of Chemical Bank; 6.125% Subordinated Notes Due 2008 of Chemical Bank; Adjustable Rate Notes Due April 1, 2011 of Texas Commerce Bancshares, Inc.; Floating Rate Subordinated Capital Notes Due 1994 of Manufacturers Hanover Trust Company; Floating Rate Subordinated Notes Due 1997 of Manufacturers Hanover Corporation; Floating Rate Subordinated Capital Notes Due April 1997 of Manufacturers Hanover Trust Company; LIBOR Note, Series C, Due March 1998 of Manufacturers Hanover Corporation; and Subordinated Note Due April 1996 of Manufacturers Hanover Corporation. These instruments have not been filed as exhibits hereto by reason that the total amount of each issue of such securities does not exceed 10% of the total assets of the Corporation and its subsidiaries on a consolidated basis. (b) REPORTS ON FORM 8-K o A Form 8-K dated October 21, 1993 was filed setting forth the Corporation's financial results for the 1993 third quarter and the announcement that Walter V. Shipley was to succeed John F. McGillicuddy as Chairman of the Board and Chief Executive Officer of the Corporation on January 1, 1994. o A Form 8-K dated November 19, 1993 was filed relating to the redemption of Chemical Banking Corporation's 10 3/4% Cumulative Preferred Stock on December 31, 1993. A31 SECTION B Pages 1 - 23 not used A32 CHEMICAL BANKING CORPORATION AND SUBSIDIARIES FINANCIAL REPORT B24 CHEMICAL BANKING CORPORATION AND SUBSIDIARIES FINANCIAL REVIEW(a) (a) On December 31, 1991, Manufacturers Hanover Corporation ("MHC") merged with and into Chemical Banking Corporation (the "merger"). The merger was accounted for as a pooling of interests and, accordingly, all amounts include the consolidated results of MHC. (b) In March 1992, the Class B Common Stock was converted into the Corporation's Common Stock. (c) Includes the impact of a $625 million restructuring charge incurred in connection with the merger with MHC. (d) Reflects special provisions of $1.9 billion for the allowance for losses, including $1.7 billion for the allowance for losses related to countries engaged in debt rescheduling ("LDC"). n/m--As a result of the loss, these ratios are not meaningful. n/a--Not applicable. B25 MANAGEMENT'S DISCUSSION AND ANALYSIS COMPARISON BETWEEN 1993 AND 1992 OVERVIEW Chemical Banking Corporation (the "Corporation") earned record net income of $1,604 million for 1993, an increase of 48% from $1,086 million reported for 1992. Net income per common share for 1993 was $5.77, compared with $3.90 in 1992. The higher net income in 1993 reflected strong revenue growth in the Corporation's core businesses. Total noninterest revenue in 1993 increased 33% from 1992 reflecting strong performances from capital markets, corporate finance, personal trust and national consumer activities, as well as higher profits from venture capital activities. Also contributing to the strong earnings was a lower provision for losses reflecting improvement in the Corporation's credit quality. The Corporation's 1993 results included the impact of two significant accounting changes. On January 1, 1993, the Corporation adopted Financial Accounting Standards Board Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), which resulted in a charge of $415 million and Financial Accounting Standards Board Statement No. 109, "Accounting for Income Taxes" ("SFAS 109"), which resulted in an income tax benefit of $450 million. The net favorable impact of the adoption of these two new accounting standards was $35 million. Income before the effect of these accounting changes was $1,569 million ($5.63 per common share), an increase of 44% from 1992. Due to the strength of its earnings, the Corporation recognized in 1993 its remaining available Federal tax benefits. Tax benefits in 1993 amounted to $331 million (excluding the aforementioned adoption of SFAS 109), compared with $278 million in 1992. The Corporation's earnings, beginning with the fourth quarter of 1993, were reported on a fully-taxed basis. For all of 1993, the Corporation realized merger-related expense savings of $525 million related to the December 31, 1991 merger of the Corporation and MHC, compared with $280 million in 1992. The Corporation's nonperforming assets at December 31, 1993 were $3.53 billion, down 42% from $6.09 billion at the 1992 year-end. Nonperforming assets were 2.4% of total assets at the end of 1993, compared with 4.4% at December 31, 1992. At December 31, 1993, the non-LDC allowance for losses was 123% of non-LDC nonperforming loans, compared with 64% at the same date a year ago. In 1993, the Corporation increased the quarterly cash dividend on its outstanding common stock to $0.38 per share, a 27% increase from the quarterly dividend of $0.30 per share paid in 1992. This overall increase was achieved through an increase in March 1993 to $0.33 per share and in December 1993 to $0.38 per share. At December 31, 1993, the Corporation's ratios of Tier 1 Capital to risk-weighted assets and Total Capital to risk-weighted assets were 8.12% and 12.22%, respectively, well in excess of the minimum ratios specified by the Board of Governors of the Federal Reserve System ("Federal Reserve Board"), compared with 7.33% and 11.55%, respectively, at December 31, 1992. [NET INCOME BAR GRAPH -- SEE EDGAR APPENDIX] [RETURN ON AVERAGE COMMON STOCKHOLDERS' EQUITY BAR GRAPH -- SEE EDGAR APPENDIX] B26 RESULTS OF OPERATIONS NET INTEREST INCOME (a) Reflects a pro forma adjustment to the net interest income amount included in the Statement of Income to permit comparisons of yields on tax-exempt and taxable assets. The Corporation's net interest income was $4,636 million in 1993, up from $4,598 million in 1992. The improvement in net interest income for 1993 was due to the favorable impact from the reduction in nonperforming loans, higher average interest earning assets and lower funding costs (primarily as a result of the upgrades to the Corporation's credit ratings). These improvements were partially offset by a decrease in the Corporation's loan portfolio as a result of continued sluggish loan demand, loan paydowns from businesses refinancing their borrowings in the debt and equity markets, as well as management's strategic decision to reduce the credit risk profile of the Corporation. As a consequence, there was a remixing of the composition of the Corporation's average interest-earning assets to liquid assets, which support the Corporation's trading businesses. Also contributing to the reduction in net interest income was the expiration of positions taken prior to and in the early part of 1992 to take advantage of declining U.S. interest rates. The negative impact on net interest income from nonperforming loans in 1993 was $111 million, down from $293 million in 1992. The improvement is principally due to the significant reduction in the level of the Corporation's nonperforming loans as well as the lower interest rate environment in 1993. Average interest-earning assets rose 3.0% in 1993 to $124.9 billion, compared with $121.2 billion in 1992. The growth occurred in Federal funds and resale agreements, trading account assets, consumer loans and securities, partially offset by a decline in commercial lending. Although the asset remix resulted in a lower contribution to net interest income, the increase in liquid trading account assets resulting from the remix contributed to the significant increase in trading revenue, which is recorded in noninterest revenue. The Corporation's average total loans in 1993 were $78.7 billion, a decrease of $3.5 billion from a year ago. As a percentage of total interest-earning assets, the loan portfolio decreased to 63.0% in 1993 from 67.8% a year ago. The decline was due to the aforementioned reduction in commercial lending, partially offset by the continued growth in consumer loans, principally credit card and installment loans. [NET INTEREST INCOME BAR GRAPH -- SEE EDGAR APPENDIX] The securities portfolio averaged $23.7 billion in 1993, compared with $21.7 billion in 1992. The Corporation's liquid interest-earning assets averaged $22.5 billion in 1993, an increase of $5.1 billion from a year ago. As a result of the aforementioned remix of interest-earning assets, the percentage of the combined portfolio of securities and liquid assets to total interest-earning assets increased to 37.0% in 1993 from 32.2% in 1992. The $3.7 billion growth in interest-earning assets was funded by a $2.3 billion increase in interest-bearing liabilities and a $1.4 billion increase in interest-free funds. For 1993, average interest-bearing liabilities were $106.5 billion, compared with $104.2 billion for the same period in 1992. The Corporation's average core deposit base increased 7% in 1993 to $60.8 billion and funded 48.7% of average interest-earning assets, compared with 47.1% during 1992. As a result of this increase in core deposits, coupled with the issuance of long-term debt and internally generated capital during 1993, the Corporation was able to utilize lower-cost funds to support interest-earning assets in 1993. The interest rate spread, which is the difference between the average rate on interest-earning assets and the average rate on interest-bearing liabilities, was 3.20% for both 1993 and 1992. During 1993, the spread was favorably affected by the smaller negative impact from nonperforming loans and lower funding costs, offset by the aforementioned shift in the Corporation's balance sheet asset mix. The net yield on interest-earning assets, which is the average rate for interest-earning assets less the average rate paid for all sources of funds, including the impact of interest-free funds, was 3.73% in 1993, compared with 3.82% in 1992. The decline in the net yield was impacted by the same factors that affected the interest rate spread, as well as by a lower contribution from interest-free sources of funds. The contribution from interest-free funds to the net yield in 1993 was 53 basis B27 points, compared with 62 basis points in 1992. The decline resulted from the lower interest rate environment in 1993, despite an increase of $1.4 billion in interest-free funds that financed interest-earning assets. Management anticipates that the net yield on interest-earning assets will be slightly lower in 1994 than 1993. Net interest income in 1994 is expected to approximate the 1993 level as an anticipated higher level of interest-earning assets is expected to offset the anticipated decline in net yield. (a) Nonperforming loans are included in the average loan balances. DOMESTIC NET INTEREST INCOME Domestic net interest income was $3,697 million in 1993, an increase of $53 million from the prior year. The increase in 1993 was attributable to a higher level of interest-earning assets and the significant reduction in nonperforming loans, partially offset by the aforementioned remixing of the Corporation's interest-earning assets. FOREIGN NET INTEREST INCOME Net interest income from foreign operations was $939 million for 1993, compared with $954 million in 1992. In 1993, the Corporation recorded interest collections on Argentine loans of $48 million (including a one-time cash payment of $29 million related to interest arrearages), compared with $19 million in 1992. Interest income on Brazilian loans was $75 million in 1993, relatively unchanged from $76 million in 1992. [COMPOSITION OF INTEREST - EARNING ASSETS PIE CHART -- SEE EDGAR APPENDIX] PROVISION FOR LOSSES The provision for losses in 1993 was $1,259 million, a decrease of 8% from $1,365 million in 1992. In both years, the provision equaled the amount of the respective year's non-LDC net charge-offs (which was lower in 1993 than in 1992, despite a $55 million provision related to the decision to accelerate the disposition of certain nonperforming residential mortgage loans). As a result of the significant improvement in the Corporation's nonperforming assets during 1993 and the favorable credit environment anticipated for 1994, the Corporation expects a significant reduction in the provision for losses in 1994. Noninterest revenue totaled $4,024 million in 1993, an increase of 33% from last year. The growth in noninterest revenue was primarily the result of record combined trading revenue, increases in various fee-based revenue, higher venture capital gains and other revenue, principally gains from the sale of refinancing country securities. B28 Trust and investment management fees are primarily derived from corporate and personal trust activities. Services provided include custody, securities processing, and private banking to customers on a global basis. The increase of $45 million for 1993 was principally due to growth in the Corporation's personal trust and asset management businesses. Personal trust fees increased $31 million in 1993 to $196 million, principally due to a rise in the market value of investments under management and to new customer relationships developed as a result of two acquisitions by Texas Commerce Bancshares Inc. ("Texas Commerce") in 1993: the acquisition of certain assets of the former First City Bancorporation of Texas, Inc. ("First City Banks") in February 1993 and the acquisition of Ameritrust Texas Corporation ("Ameritrust") in September 1993. Corporate finance and syndication fees include revenue from managing and syndicating loan arrangements; providing financial advisory services in connection with leveraged buyouts, recapitalizations and mergers and acquisitions; and arranging private placements. Corporate finance and syndication fees in 1993 reached $338 million, a 28% increase from the prior year, principally resulting from the continued strong growth in global loan originations and distribution activities. During 1993, the Corporation acted as agent or co-agent for approximately $185 billion of syndicated credit facilities, a reflection of the Corporation's large client base and strong emphasis on distribution. During 1993, the Federal Reserve Board approved the Corporation's applications to underwrite and deal in all debt and equity securities. Fees from underwriting debt offerings also contributed to the increase. Service charges on deposit accounts totaled $288 million in 1993, an increase of 9% over last year. The increase from 1992 was primarily due to the higher level of fees related to retail accounts as well as a larger deposit base (principally resulting from the acquisition of the First City Banks). [NONINTEREST REVENUE BAR GRAPH -- SEE EDGAR APPENDIX] Fees for other banking services for 1993 were $1,067 million, an increase of $27 million from a year ago, which is indicative of the continued growth in the Corporation's core revenue businesses. The fee level for 1993 was primarily affected by changes in the following areas: * Retail credit card fees increased $28 million from last year due to increased transaction volume, reflecting a growing consumer cardholder base and the return to the balance sheet of previously securitized loans. In the fourth quarter of 1993, the Corporation initiated a program for a co-branded MasterCard with Shell Oil Company. Revenue from the Shell program was insignificant in 1993; however, it is expected to contribute to growth in retail card fees for 1994. * Mortgage servicing fees increased $6 million in 1993, reflecting the purchase of mortgage servicing rights as well as a higher level of mortgage originations resulting from the low interest-rate environment in 1993. The Corporation originated $14.7 billion of mortgage loans in 1993 versus $12.5 billion in 1992. * Loan commitment fees were $90 million in 1993, an increase of $9 million from 1992. * Loan servicing fees were $23 million in 1993, a decrease of $20 million from a year ago, primarily reflecting the reduction in the level of securitized credit card loans serviced in 1993 versus 1992. Combined revenues from trading account and foreign exchange activities in 1993 were $1,073 million, an increase of 26% from $853 million a year ago. The increase was in part due to continued efforts by the Corporation to diversify and expand its trading activities through an emphasis on market-making and sales businesses. The Corporation's sources of trading revenue are through sales, arbitrage, market-making and positioning. In 1993, the Corporation, taking advantage of its higher credit ratings and its increasing global presence, broadened its global trading activities and increased the range of products it offers and the currency markets in which it operates. The resulting growth in transaction volume, coupled with a broader range of instruments, market volatility and wider spreads (especially in the European markets) contributed to the increased revenues. The following table sets forth the components of trading account and foreign exchange revenues for 1993 and 1992. (a) Includes interest rate swaps, currency swaps, foreign exchange forward contracts, interest rate futures, and forward rate agreements. (b) Includes foreign exchange spot and option contracts. (c) Includes U.S. and foreign government agency and corporate debt securities; emerging markets debt instruments, debt-related derivatives, equity securities, equity derivatives, and commodity derivatives. B29 Trading revenues are affected by many factors including volatility of currencies and interest rates, the volume of transactions executed by the Corporation's customers, its success in proprietary positioning, its credit standings and steps taken by central banks and governments to affect financial markets. Although the Corporation believes that its improved credit standing has recently been contributing to the improvement in its trading revenue, other factors, such as market volatility, governmental actions, or success in proprietary positioning, might not be as favorable in future periods as they were in 1993. For a further discussion of the Corporation's risk-management products and related revenues, see the Off-Balance Sheet section of the Management's Discussion and Analysis and Note Eighteen of the Notes to Consolidated Financial Statements. Securities gains were $142 million in 1993, compared with $53 million in 1992. For further discussion of the Corporation's securities, see the Securities section. The Corporation's other noninterest revenue is primarily comprised of income from venture capital activities, equity income from affiliates (including the Corporation's 40% interest in The CIT Group Holdings, Inc. ("CIT")), and gains on the sale of corporate assets. The most significant items within other revenue for 1993 and 1992 are listed in the following table. (a) Principally reflects a $179 million gain from the sale of Argentine floating rate bonds and $152 million gain from the sale of interest due and unpaid bonds received from Brazil. (b) The Corporation's 40% net investment in CIT at December 31, 1993 and 1992, totaled $849 million and $816 million, respectively. Income from venture capital activities, net of valuation losses, was $301 million in 1993, an increase of $201 million from 1992. At December 31, 1993, the Corporation had equity and equity-related investments with a carrying value of $1.3 billion. On average, these investments are held for four to seven years. Income is recognized when an investment is sold or the investment is marked to market at a discount to the public value upon completion of an initial public offering. The Corporation believes that venture capital will continue to make substantial contributions to the Corporation's earnings, although the timing of the recognition of gains from such activities is unpredictable and it is expected that revenues from such activities will vary significantly from period to period. NONINTEREST EXPENSE Noninterest expense in 1993 was $5,293 million, compared with $4,930 million in 1992. Included in noninterest expense were expenses related to two acquisitions by Texas Commerce during 1993 and higher expenses associated with investments in certain key businesses, such as expansion of the Corporation's securities business and the introduction of the co-branded MasterCard program with Shell Oil Company. In the fourth quarter of 1993, the Corporation incurred $53 million in operating expenses in connection with its introduction of the Shell MasterCard from Chemical Bank. Noninterest expense for 1993 reflected $525 million in expense savings related to the December 31, 1991 merger of the Corporation and MHC, up from $280 million of expense savings for 1992. The Corporation expects to continue to realize expense savings (estimated at approximately $710 million in 1994 and approximately $750 million in 1995 and each year thereafter) and one-time merger related benefits in connection with its implementation of the merger. During 1993, the Corporation incurred a charge of $115 million, principally related to changes since the date of the merger in the Corporation's facilities plans and revised estimates of occupancy-related costs associated with headquarters and branch consolidations. The Corporation does not anticipate any further merger-related restructuring charges. During 1993, the ratio of noninterest operating expense (excluding one-time charges) to total operating revenue improved to 59.1% from 63.7% in 1992. Salaries and employee benefits expenses in 1993 were $2,466 million, compared with $2,349 million recorded in 1992. The increase from last year was primarily the result of significantly higher incentive compensation costs due to increased revenues (primarily from the Corporation's capital markets and corporate finance activities), higher expenses related to services provided by temporary employment agencies to assist with merger integration efforts, and the additional staff costs from the 1993 acquisitions by Texas Commerce. Additionally, as a result of the adoption of SFAS 106, expenses for 1993 related to other postretirement benefits ("OPEB") were approximately $20 million higher than in 1992. B30 Total staff at December 31, 1993 amounted to 41,567 compared with 39,687 at December 31, 1992. The increase in staff count from December 31, 1992 is attributable to the acquisition of the First City Banks and Ameritrust. At December 31, 1993, merger-related staff reductions totaled 6,221 from July 15, 1991 (the date the merger with MHC was first announced) exceeding the goal of 6,200 established at that time. In 1994, the Corporation expects pension and OPEB expense to be approximately $30 million higher than the 1993 level primarily due to a decrease in the discount rate utilized in determining the benefit obligation to 7.5%. For a further discussion, see Note Thirteen of the Notes to Consolidated Financial Statements. Occupancy expense in 1993 was $587 million, an increase of $21 million from 1992. The increase in 1993 principally resulted from $13 million in occupancy-related expenses associated with the facilities acquired in connection with the First City Banks and Ameritrust transactions. The remaining increase in occupancy expense largely reflected the consolidation and relocation of certain facilities in London. Equipment expense in 1993 was $337 million compared with $316 million in 1992. The increase in 1993 was primarily the result of technology enhancements to support the Corporation's investment in certain businesses, such as Geoserve, retail banking and capital markets. Foreclosed property expense was $287 million in 1993, compared with $283 million in 1992. Included in the 1993 results was $20 million related to the accelerated disposition of nonperforming assets originally extended several years ago under a reduced-documentation residential mortgage program that was discontinued in 1990. Management expects that foreclosed property expense in 1994 will be significantly lower than the 1993 level. In 1993, the Corporation incurred the aforementioned $115 million charge related to the final assessment of costs associated with the merger with MHC and $43 million in connection with the acquisition of assets and assumption of liabilities of the First City Banks from the Federal Deposit Insurance Corporation (the "FDIC"). For a further discussion, see Note Two of the Notes to Consolidated Financial Statements. Other expense comprises items such as professional services, insurance, marketing, communications expense and FDIC assessments. Other expense in 1993 was $1,458 million compared with $1,416 million in 1992. The 1992 amount included a $41 million charge incurred in combining the Corporation's employee benefit plans and a $30 million charge for the Corporation's Canary Wharf lease arrangement. The increase in other expense from last year principally reflected higher marketing costs, operating expenses associated with the First City Banks and Ameritrust acquisitions, and higher FDIC costs due to a higher deposit base as a result of such acquisitions. Marketing expense for 1993 was $187 million, an increase of $76 million from 1992. The higher level of marketing expense reflected the Corporation's marketing program for the co-branded MasterCard with Shell Oil Company, an increase in credit card solicitation costs (exclusive of Shell), and increased promotional advertising related to the Corporation's retail banking business. Included in other expense for 1993 was approximately $76 million related to the amortization of goodwill and other intangible assets and other ongoing expenses associated with the First City Banks and Ameritrust acquisitions. As a result of these acquisitions, total amortization of goodwill and intangibles increased to $106 million in 1993 from $80 million in 1992. The Corporation expects that noninterest operating expense in 1994 will be somewhat higher than that in 1993 (after taking into consideration the effects of merger-related cost savings anticipated to be realized during the year), reflecting costs associated with the continued investment by the Corporation to grow key business activities. Nevertheless, one of management's objectives for 1994 and thereafter will be to continue to improve the ratio of noninterest operating expenses to total operating revenue. [OVERHEAD RATIO BAR GRAPH -- SEE EDGAR APPENDIX] INCOME TAXES The Corporation recorded income tax expense of $539 million in 1993, compared with $243 million in 1992. Included in the 1993 and 1992 income tax expense were approximately $331 million and $278 million, respectively, of Federal income tax benefits. The Corporation adopted SFAS 109 as of January 1, 1993, and, after taking into account the additional tax benefits associated with the adoption of SFAS 106, the Corporation recognized a favorable cumulative effect on income tax expense of $450 million (or $1.81 per common share). This favorable impact was recorded within the caption "Net Effect of Changes in Account- B31 ing Principles" on the Consolidated Statement of Income. Prior years' financial statements have not been restated to apply the provisions of SFAS 109. Due to the strength of its earnings, the Corporation recognized in the third quarter of 1993 its remaining available Federal income tax benefits in accordance with SFAS 109. As a result, the Corporation's earnings beginning in the fourth quarter of 1993 were reported on a fully-taxed basis. On August 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act ("OBRA") of 1993, which increased the corporate Federal tax rate from 34% to 35% retroactive to January 1, 1993. The impact of the higher Federal tax rate increased the Corporation's tax provision; however, this was more than offset by an increase in the value of the Corporation's deferred tax assets. As a result, the Corporation's tax expense in 1993 decreased by approximately $8 million due to the enactment of OBRA. The Corporation's effective tax rate was 25.6% in 1993, compared with 18.3% in 1992. Excluding the $331 million of benefits recognized under SFAS 109 for 1993, the Corporation's effective tax rate for 1993 would have been 41.3%. Excluding the $278 million of benefits recognized in 1992, the Corporation's effective tax rate for 1992 would have been 39.2%. LINES OF BUSINESS RESULTS Profitability of the Corporation is tracked with an internal information system that produces line-of-business performance within the Global Bank, Regional Bank, Real Estate and Corporate sectors. A set of management accounting policies has been developed and implemented to ensure that the reported results of the groups reflect the economics of their businesses. Line-of-business results are subject to restatement as appropriate whenever there are refinements in management reporting policies or changes to the management organization. Thus, certain amounts reported in 1992 have been restated to conform with the presentation of the current-year's results. Line-of-business results are subject to further restatements as may be necessary to reflect future changes in internal management reporting. Guidelines exist for assigning expenses that are not directly incurred by businesses, such as overhead and taxes, as well as for allocating stockholders' equity and the provision for losses, utilizing a risk-based methodology. Noninterest expenses of the Corporation are fully allocated to the business units except for special corporate one-time charges. Management has developed a risk-adjusted capital methodology that quantifies different types of risk -- credit, operating and market -- within various businesses and assigns capital accordingly. Credit risk is computed using a risk-grading system that is consistently applied throughout the Corporation. The Corporation's businesses are evaluated on a fully-taxed basis. The tax benefits currently reflected in the Corporation's income tax expense (which results in a lower effective tax rate) are generally included in the Corporate sector. Texas Commerce's results are tracked and reported on a legal entity basis, including the return-on-common equity calculation. GLOBAL BANK The Global Bank is organized into three principal management entities: Banking & Corporate Finance (domestic wholesale banking, corporate finance and venture capital activities); Asia, Europe & Capital Markets (international wholesale banking and corporate finance, and the Corporation's trading and treasury functions); and Developing Markets (businesses include cross-border investment banking, local merchant banking and trade finance). The Global Bank seeks to optimize its risk profile by emphasizing underwriting, distribution, and risk-management skills. The Global Bank produced excellent results in 1993, as evidenced by net income of $1.181 billion and a 31.9% return on equity, a substantial increase from the 1992 results of $806 million and 20.2%, respectively. The 1993 performance was characterized by strong noninterest revenue growth. Overall trading revenues exceeded $1.050 billion in 1993, up approximately 26% from $834 million in 1992. Earnings from derivatives, foreign exchange and securities trading were particularly strong throughout the entire global network. Trading results in the emerging markets area were almost double the amounts recorded in 1992. Corporate finance and syndication fees were also strong in 1993, a reflection of the Corporation's leadership position in global loan origination and distribution, as the Global Bank continued to be the industry leader in loan syndications during 1993. In 1993, revenues from venture capital activities were $301 million, a substantial increase from $100 million in 1992. The Developing Markets Group also benefited from $301 million of noninterest revenue related to restructured country debt, principally the sale of Argentine and Brazilian debt securities. B32 REGIONAL BANK The Regional Bank includes Retail Banking (comprised of New York Markets, Retail Card Services and National Consumer Business), Regional Relationship Banking (comprised of Middle Market, Private Banking and Chemical Bank New Jersey, N.A.) and Geoserve. The Corporation's Technology and Operations group is also managed within this organizational structure. The Retail Bank provides a broad array of products and services including consumer lending, residential financing, deposit services and credit card financing. The Corporation maintains a leading market share position in serving the financial needs of Middle Market commercial enterprises in the New York metropolitan area. Private Banking serves its high-net worth clientele with banking and investment services. The Geoserve unit offers cash management, funds transfer, trade, corporate trust and securities processing to the global market and is a market leader in many of its businesses. The Regional Bank's net income of $504 million and return on equity of 23.9% in 1993 improved significantly from the 1992 results of $351 million and 15.2%, respectively. In 1993, New York Markets' net income increased modestly from 1992, reflecting a higher level of fees and wider deposit spreads. The National Consumer Business results reflected strong net interest income growth in 1993 as loan volume substantially increased. Mortgage servicing volume exceeded $36.4 billion, an increase of $6.0 billion over the prior year, and contributed to higher servicing fee revenues. Retail Card Services also benefited from higher net interest income due to increased volume. This performance was accompanied by an improvement in overall credit quality, as charge-offs in the Retail Card portfolio in 1993 declined from 1992 levels. During the fourth quarter of 1993, a program for a co-branded MasterCard with Shell Oil Company was announced. The new Shell MasterCard offers cardholders rebates towards the purchase of Shell gasoline. The start-up costs associated with this program accounted for over two-thirds of the overall increase in noninterest expense for the Regional Bank compared with 1992. Regional Relationship Banking had a significant increase in earnings, primarily due to reduced credit costs in Middle Market and Chemical Bank New Jersey, N.A. Private Banking produced higher earnings as a result of increased net interest income (represented by solid loan growth) and fees. Geoserve also reported an increase in its earnings in 1993 over the prior year, primarily due to significant growth in revenue from several new business initiatives. TEXAS COMMERCE BANCSHARES Texas Commerce is a premier corporate banking institution in the State of Texas and a leader in providing financial products and services to individuals throughout Texas. The 1993 results included the acquisitions of the First City Banks and Ameritrust. As a result of these acquisitions, Texas Commerce had the largest trust operations in the southwest United States. As of December 31, 1993, Texas Commerce had $22 billion in total assets. Texas Commerce's net income of $190 million in 1993 improved from last year's results of $180 million. The improved 1993 results also included $79 million of income tax expense compared with only $4 million for last year due to the use of net operating loss carryforwards in 1992. On a pre-tax basis, the $269 million of operating earnings posted by Texas Commerce was up 46% over last year and represented the most profitable year in its history. Although commercial loan demand remained weak, Texas Commerce benefited from its strong customer base to post substantial increases in revenue from fee-based services and growth in deposit volumes. Solid expense management also contributed to the strong earnings. The aforementioned results for the year ended December 31, 1993 exclude the restructuring charge ($43 million pre-tax; $30 million after-tax) related to the acquisition of the First City Banks and a positive $9 million after-tax net effect from the implementation of SFAS 106 and SFAS 109. Nonperforming assets declined to $219 million at December 31, 1993, down 49% from the end of 1992 and 84% below the peak of $1,303 million in mid-1988. Based on the continuing improvements in asset quality and Texas Commerce's already adequate allowance for losses, no overall credit provision was recorded in 1993. B33 REAL ESTATE Real Estate includes the management of the Corporation's commercial real estate portfolio, exclusive of those in Texas Commerce and Chemical Bank New Jersey, N.A. The net loss of $222 million in 1993 resulted from credit costs remaining at high levels, although credit quality continued to improve. Total nonperforming assets at December 31, 1993 were $1,304 million, down 33% from $1,944 million at December 31, 1992. Noninterest expense of $213 million for 1993 included $119 million of foreclosed property expense. n/m--Not meaningful due to net loss. CORPORATE Corporate had a net loss of $49 million in 1993, compared with a net loss of $6 million in 1992. Included in the $49 million loss were the following one-time items: a noninterest expense charge of $67 million ($115 million pre-tax) as a result of a reassessment of costs associated with the merger with MHC; an after-tax loss of $53 million ($75 million pre-tax) due to the writedown associated with the accelerated disposition of nonperforming residential mortgages; and a $30 million after-tax restructuring charge ($43 million pre-tax) related to the acquisition of the First City Banks. In addition, Corporate included the recognition of any Federal tax benefits and a net $35 million gain from the adoption of SFAS 106 and SFAS 109. Included in the $6 million net loss in 1992 were one-time charges of $41 million for costs incurred to combine the Corporation's employee benefit plans, and $30 million for London occupancy-related expenses in connection with the Corporation's Canary Wharf lease arrangements. Corporate also includes the management results attributed to the parent company, the Corporation's investment in CIT, and some effects remaining at the corporate level after the implementation of management accounting policies. The following examples represent management accounting policies which had a corporate impact: the performance of individual businesses are evaluated on a fully-taxed basis, whereas the Corporation's overall tax rate in 1993 was lower due to the utilization of Federal tax benefits; the difference between risk-adjusted credit loss provisions in the business units and the overall financial provision for losses taken by the Corporation; and the difference between risk-adjusted capital in the groups and the Corporation's financial capital. BALANCE SHEET ANALYSIS SECURITIES As of December 31, 1993, the Corporation adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). As a result of the adoption of SFAS 115, debt and equity securities that were previously measured at amortized cost or at the lower of aggregate amortized cost or market are measured at fair value. See Note Four of the Notes to Consolidated Financial Statements for further discussion of SFAS 115. The prepayment of mortgage-backed securities and collateralized mortgage obligations ("CMO") is actively monitored through the Corporation's portfolio management function. The Corporation typically invests in CMO's with stable cash flows and relatively short duration, thereby limiting the impact of interest rate fluctuations on the portfolio. Management regularly does simulation testing regarding the impact that interest and market rate changes would have on its CMO portfolio. Mortgage-backed securities and CMO's which management believes have high prepayment risk are included in the available-for-sale portfolio. CREDIT PORTFOLIO Loans outstanding, the most significant component of earning assets, totaled $75.4 billion at December 31, 1993, compared with $82.0 billion at December 31, 1992. The decline of $6.6 billion primarily reflected weak loan demand (except large syndicated loans discussed below), loan paydowns from businesses that are refinancing their borrowings in the debt and equity markets, as well as management's strategic decision to reduce the credit risk profile of the Corporation. Partially offsetting these declines was growth in credit card receivables and installment loans. The Corporation is a leading participant in loan originations and sales. This activity is comprised of the sale of loans and lending commitments to investors, generally without recourse. These sales include syndication, assignment and participation, and include both short- and medium-term transactions. This loan distribution capability allows the Corporation to compete aggressively and profitably in wholesale lending markets by enabling it to reduce larger individual credit exposures and thereby to price more flexibly than if all loans were held as permanent investments. The Corporation also benefits from increased liquidity. B34 The Corporation's loan balances at December 31, 1993 and 1992 were as follows: (a) Represents loans secured primarily by real property, other than loans secured by mortgages on 1-4 family residential properties. (b) Consists of 1-4 family residential mortgages, credit cards, installment loans (direct and indirect types of consumer finance) and student loans. CREDIT RISK MANAGEMENT A significant aspect of banking is understanding, measuring and managing credit risk. Credit risk represents the possibility that a loss may occur if a borrower or counterparty fails to honor fully the terms of a contract. Under the direction of the Chief Credit Officer, risk policies are formulated, approved and communicated throughout the Corporation. The Credit Risk Management Committee, chaired by the Chief Credit Officer, is responsible for maintaining a sound credit process, addressing risk issues and reviewing the portfolio. The Corporation's credit risk management is an integrated process operating concurrently at the transaction and portfolio levels. For credit origination, business units formulate strategies, target markets and determine acceptable levels of risk. Credit officers work with client managers, portfolio management and, when appropriate, the syndications group during the underwriting process. The consumer and commercial segments of the portfolio have different risk characteristics and different techniques are utilized to measure and manage their credit risks. The consumer portfolio is evaluated on a product as well as geographic basis. Within the commercial segment, each credit facility is risk graded. Facilities are subject to hold targets based on risk, and are often syndicated in order to lower potential concentration risks. Credits not syndicated remain on the balance sheet and are carefully monitored and analyzed. The loan review process includes industry specialists and country risk managers who provide independent expert insight into the portfolio. Industries and countries are also graded in a process which is incorporated into credit risk decisions through the facility risk grading system and by direct consultation with originating officers. The Corporation's global exposure system is utilized to monitor exposure by industry, obligor, business unit, product, geographic region and risk grade. This data is integral to the process of formulating strategic portfolio direction. Risk management conducts independent evaluations of business unit portfolios and risk processes, reviewing compliance with risk policies, especially facility risk grading and problem credit recognition. Remedial actions for problem credits are the responsibility of the special loan group. Significant progress was made in 1993 on the Corporation's credit risk profile. Credit quality indicators are favorable and improving, and the outlook for 1994 is for these positive trends to continue. NONPERFORMING ASSETS The following table sets forth the nonperforming assets of the Corporation at December 31, 1993 and 1992. The Corporation's total nonperforming assets at December 31, 1993 were $3,525 million, down 42% from $6,092 million at December 31, 1992. The decline from the prior year-end resulted from a $1,499 million decrease in non-LDC nonperforming loans, a $726 million decrease in LDC nonperforming loans and a $342 million decrease in assets acquired as loan satisfactions. The Corporation's nonperforming assets do not include certain assets acquired in connection with the First City Banks acquisition. See Note Seven of the Notes to Consolidated Financial Statements. Management expects a further significant reduction in the level of nonperforming assets during 1994. B35 The following table presents the reconciliation of non-LDC nonperforming assets for 1993 and 1992. RECONCILIATION OF NON-LDC NONPERFORMING ASSETS (a) Excludes charge-offs on a formula basis.. Nonperforming LDC loans at December 31, 1993 were $622 million, a decrease of $726 million from the 1992 year-end. The decrease in nonperforming LDC loans principally reflected charge-offs, sales and swaps and the removal of restructured Argentine debt from nonaccrual status. For a further discussion with respect to Argentina, see the Outstandings to Countries Engaged in Debt Rescheduling section. [NONPERFORMING ASSETS BAR GRAPH -- SEE EDGAR APPENDIX] As of December 31, 1993, the Corporation had consumer loans of $299 million (which primarily consisted of credit card and installment loans), and commercial loans of $24 million that were not characterized as nonperforming loans, although such loans were past due 90 days or more as to principal or interest. The comparable amounts at December 31, 1992 included consumer loans of $303 million and commercial loans of $90 million. Consumer loans, exclusive of residential mortgage loans, as to which interest or principal is past due 90 days or more are generally not classified as nonperforming but, rather, are charged off on a formula basis upon reaching certain specified stages of delinquency. A commercial loan on which interest or principal is past due 90 days or more is not classified as nonperforming if the loan is considered well-secured (i.e., the collateral value is considered sufficient to cover the principal and accrued interest on the loan) and is in the process of collection. At each of December 31, 1993 and 1992, the past-due consumer and commercial loans of the Corporation that were not characterized as nonperforming were substantially all domestic. ALLOWANCE FOR LOSSES The allowance for losses is available to absorb potential credit losses from the entire loan portfolio, as well as from other balance sheet and off-balance sheet credit-related transactions. The appropriate level of the allowance is based on analyses of the loan portfolio as well as other credit-related balance sheet and off-balance sheet financial instruments and reflects an amount which, in management's judgment, is adequate to provide for potential losses. The analyses include consideration of such factors as the risk rating of individual credits, the size and diversity of the portfolio, particularly in terms of industry and geography, economic and political conditions, prior loss experience and results of the Corporation's periodic credit reviews of its portfolio. If deemed appropriate, as a result of such analyses, the allowance for losses is increased or decreased by a charge or credit, respectively, to income. The accompanying table reflects the activity in the allowance for losses for the years ended December 31, 1993 and 1992. ALLOWANCE FOR LOSSES (a) Includes $55 million related to the decision to accelerate the disposition of certain nonperforming residential mortgages. (b) Related to First City Banks acquisition. B36 The Corporation's allowance for losses has been allocated between the non-LDC and LDC portfolio segments. The Corporation's non-LDC allowance at the 1993 year-end was $2.4 billion, or 3.35% of non-LDC loans outstanding, compared with $2.2 billion, or 2.83% of non-LDC loans outstanding, at December 31, 1992. The LDC allowance totaled $.6 billion at December 31, 1993, compared with $.8 billion at the end of 1992. The changes in the non-LDC and the LDC allowances during 1993 resulted primarily from the reallocation of $200 million from the LDC allowance to the non-LDC allowance. The reallocation reflected the Corporation's ongoing analysis and evaluation of its LDC loan portfolio, including the finalization of the Argentine financing program and progress in debt negotiations with Brazil. In addition, during 1993, the Corporation allocated a specific portion of the LDC allowance for Brazilian outstandings as a result of the Corporation's evaluation of its refinancing country portfolio and in consideration of recent recommendations of the Interagency Country Exposure Review Committee ("ICERC"). At December 31, 1993, the balance allocated to Brazil was $82 million. For further discussion of this allocation, see Note Six of the Consolidated Notes to the Financial Statements. The Corporation will continue to assess developments relating to the various LDC debt renegotiations. Continued progress in this area will allow the Corporation to evaluate its options with respect to the allowance currently allocated to the LDC portfolio. The following table reflects the Corporation's allowance coverage ratios at December 31, 1993 and 1992. ALLOWANCE COVERAGE RATIOS The Corporation deems its allowance for losses at December 31, 1993 to be adequate. Although the Corporation considers that it has sufficient reserves to absorb losses that may currently exist in the portfolio, but are not yet identifiable, the precise loss content from the loan portfolio, as well as from other balance sheet and off-balance sheet credit-related instruments, is subject to continuing review based on quality indicators, concentrations, changes in business conditions, and other external factors such as competition, legal and regulatory requirements. The Corporation will continue to reassess the adequacy of the allowance for losses. NET CHARGE-OFFS (a) Includes charge-offs of $51 million related to loans to the former republics of Yugoslavia (collectively "Yugoslavia"). For a discussion of net charge-offs, see the various credit portfolio sections. Management expects total non-LDC net charge-offs in 1994 to decrease significantly from the 1993 amount. COMMERCIAL REAL ESTATE PORTFOLIO Commercial real estate loans represent loans secured primarily by real property, other than loans secured by one-to-four family residential properties, which are included in the consumer loan portfolio. Commercial real estate loans outstanding for the Corporation totaled $7.9 billion at December 31, 1993, compared with $8.6 billion a year ago. The decrease during 1993 is attributable to repayments, transfers to real estate owned and charge-offs, partially offset by the addition of approximately $500 million of commercial real estate loans acquired as part of the First City Banks acquisition. The table below indicates the composition of the commercial real estate loan portfolio. B37 Commercial mortgages provide financing for the acquisition or refinancing of commercial properties, and typically have terms ranging from three to seven years. Construction loans are generally originated to finance the construction of real estate projects. When a loan financing the completed construction has cash flows sufficient to support a commercial mortgage, the loan is transferred from construction status to commercial mortgage status. The following table shows the Corporation's commercial real estate loan portfolio, nonperforming loans and foreclosed commercial real estate, by property type and geographic location. (a) Nonperforming loans are included in loan balances. Real Estate Owned denotes foreclosed commercial real estate, which is included in assets acquired as loan satisfactions. (b) Represents residential property construction, land development and multi-family permanent mortgages, excluding 1-4 family residential mortgages. The largest concentration of commercial real estate loans is in the New York/New Jersey and Texas markets, representing 48% and 23%, respectively, of the commercial real estate portfolio. No other state represented more than 3% of the commercial real estate loan portfolio. The New York/New Jersey economy stabilized during 1993, resulting in moderate improvements in commercial space leasing activity. However, in most real estate property sectors of that region, demand is not yet sufficient to result in higher prices. Improvements in the Texas economy have resulted in significant growth in employment (employment rates in Dallas and Austin are currently above the national average) and in improvements in the real estate market. In California, where the Corporation has less than 3% of its commercial real estate loans, the economy is still weak. At December 31, 1993, the portfolio included $601 million of secured international real estate loans which are primarily located in the United Kingdom and Hong Kong. The Corporation's management has a process to monitor all real estate credits to assist it in early identification of problem loans. Line credit officers work in conjunction with appraisers to review individual loans, conduct regular market analyses and evaluate portfolio segments. In addition, real estate problem assets are managed in special units staffed for restructuring, workout and collection and real estate management and disposition. The Corporation reassesses the market value of real estate owned for possible impairment on a continual basis. Nonperforming commercial real estate assets totaled $1.6 billion at December 31, 1993, a 34% decrease from a year ago. The decrease reflects nonaccrual loans returning to accrual status, charge-offs and the continuing sale of foreclosed property. Nonperforming commercial real estate loans were $707 million, down 43% from $1,251 million at December 31, 1992. Real estate owned totaled $866 million at December 31, 1993, down 22% from $1,116 million at December 31, 1992. B38 Improvement in nonperforming commercial real estate asset levels during 1993 is the result of increased liquidity in the commercial real estate markets, lower interest rates and successful focused workout activities. Commercial real estate loans entering nonperforming status declined significantly in 1993 when compared with 1992. Reductions to nonperforming assets in the form of payments, return to accrual status and sales of real estate owned were greater than the additions to nonperforming assets in each quarter of 1993. Commercial real estate net charge-offs in the 1993 totaled $284 million, compared with $354 million in 1992. Writedowns of commercial real estate owned totaled $199 million in 1993, compared with $212 million in 1992. Approximately $298 million in commercial real estate owned was sold in 1993. Generally, these assets were sold at or above carrying value. Commercial real estate net charge-offs, writedowns and nonperforming assets for 1994 are expected to be below 1993 levels. COMMERCIAL AND INDUSTRIAL PORTFOLIO The commercial and industrial portfolio totaled $25.0 billion at December 31, 1993, representing 33% of the total loan portfolio. The portfolio is diversified geographically and by industry. Approximately 75% of the commercial and industrial loans are domestic. The commercial and industrial portfolio is comprised of 39 industry groups which are graded and actively monitored by the Corporation's industry specialists. Approximately 70% of the industries each represent less than 1% of total loans. The largest industry concentration is oil and gas at approximately 2.9% of total loans. Real estate related, of approximately $1.6 billion, is the second largest concentration representing 2.2% of total loans. Included in commercial and industrial are loans related to highly leveraged transactions ("HLT"). The Corporation originates and syndicates loans in HLTs, which include acquisitions, leveraged buyouts and recapitalizations. HLT loans at December 31, 1993 totaled approximately $1.9 billion, compared with $3.3 billion at December 31, 1992. The Corporation was also committed at December 31, 1993 to lend an additional amount of approximately $.9 billion. The substantial reduction in the HLT loan portfolio from year-end 1992 can be largely attributed to repayments, charge-offs and reclassifications to non-HLT status. At December 31, 1993, the Corporation had $269 million in nonperforming HLT loans compared with $586 million at year-end 1992. Net charge-offs related to HLTs during 1993 totaled approximately $81 million, versus $185 million for 1992. FINANCIAL INSTITUTIONS, AND FOREIGN GOVERNMENTS AND OFFICIAL INSTITUTIONS PORTFOLIOS Financial institutions include commercial banks and companies whose businesses primarily involve lending, financing, investing, underwriting or insuring. Loans to financial institutions were 11% of total loans at December 31, 1993. Fifty-seven percent of these loans were to domestic financial institutions. Loans to financial institutions are predominantly to commercial banks and broker-dealers, which together comprise over half the financial institution total. At year-end 1993, 7% of the Corporation's total loans were to foreign governments, government agencies, government-owned commercial enterprises, and official institutions, exclusive of LDC loans. Approximately 65% of foreign government and official institution loans were to central and other government-owned banks and government institutions. CONSUMER PORTFOLIO The consumer loan portfolio consists of one-to-four family residential mortgages, credit cards, installment loans and student loans. The consumer loan portfolio totaled $25.8 billion at December 31, 1993, representing 34% of total loans, an increase from $23.8 billion, or 29% of total loans, at December 31, 1992. During 1993, the Corporation's consumer loan portfolio grew by 9%, primarily due to increases in credit card receivables and installment loans. The following table represents the composition of the Corporation's consumer loan portfolio at December 31, 1993 and December 31, 1992. Underlying improvements in the economy in 1993 generally strengthened the financial position of the consumer. A healthier economy and easing employment concerns stimulated revolving line and closed-end loan debt levels. Additionally, attractive mortgage rates stimulated home sales to first-time buyers. Credit card receivables at December 31, 1993, increased $1.0 billion from a year ago, of which $443 million related to the co-branded Shell MasterCard program which was introduced in the fourth quarter of 1993. B39 Total nonperforming consumer loans at December 31, 1993 were $125 million and were comprised of $101 million of loans secured by residential real estate and $24 million of installment loans. At December 31, 1992, total nonperforming consumer loans were $241 million and were comprised of $210 million of loans secured by residential real estate and $31 million of installment loans. Residential real estate owned at December 31, 1993 totaled $20 million, compared with $57 million at the 1992 year-end. The reductions in nonperforming consumer loans and residential real estate owned at December 31, 1993 reflected the decision to accelerate the disposition of $162 million of nonperforming residential mortgages. Net charge-offs in the consumer portfolio totaled $419 million in 1993 compared with $401 million in 1992. The 1993 net charge-offs consisted of $322 million in credit card receivables, $28 million in installment loans and $69 million in residential mortgages (which included the $55 million charge associated with the aforementioned accelerated disposition). The composition of the 1992 net charge-offs were $348 million in credit card receivables, $35 million in installment loans and $18 million in residential mortgages. There were essentially no credit losses in 1993 and 1992 in the student loan portfolio due to the existence of Federal and State government guarantees. Excluding the charge of $55 million for the accelerated disposition program, the decline in consumer loan charge-offs is due to the effect of further refinement of the Corporation's risk management techniques, including enhanced account monitoring standards and greater efficiencies in the collection and recovery processes. Consumer loan balances are expected to increase in 1994, particularly in the residential mortgage and the credit card portfolios. In 1994, the Corporation's strategy will continue to emphasize risk management and consumer loan portfolio credit quality. Management expects consumer loan charge-offs in 1994 will approximate the 1993 level due to the anticipated higher level of credit card receivables outstanding as a result of the Shell MasterCard program. Mortgage Banking Activities: With respect to the Corporation's mortgage banking activities, the Corporation both originates and services residential mortgage loans. After origination, the Corporation may sell loans to investors, primarily in the secondary market, while retaining the rights to service such loans. In accordance with current accounting standards, the value of such servicing rights related to originating mortgage loans is not recorded as an asset in the financial statements. The Corporation originated $14.7 billion of mortgages in 1993 versus $12.5 billion in 1992. In addition to originating mortgage servicing rights, the Corporation also purchases mortgage servicing rights. The Corporation may purchase bulk rights to service a loan portfolio or the Corporation may purchase loans directly and then sell such loans while retaining the servicing rights. The Corporation's servicing portfolio amounted to $36.4 billion at December 31, 1993 compared with $30.4 billion at December 31, 1992. Purchased mortgage servicing rights (included in other assets) amounted to $249 million at December 31, 1993 compared with $204 million at December 31, 1992. The mortgage loans to which the Corporation's servicing rights relate are, to a substantial degree, of recent vintage (i.e., originated within the past two years when interest rates have been relatively low). Additionally, the Corporation utilizes accelerated amortization and continually evaluates prepayment exposure of the portfolio, thereby adjusting the balance and remaining life of the servicing rights as a result of prepayments. Accordingly, the current interest rate environment has not had a material adverse effect on the carrying value of the Corporation's purchased mortgage servicing rights. During 1993, the Corporation wrote down $14 million with respect to its purchased mortgage servicing rights. CROSS-BORDER OUTSTANDINGS The extension of credits denominated in a currency other than that of the country in which a borrower is located, such as dollar-denominated loans made overseas, are called "cross-border" credits. In addition to the credit risk associated with any borrower, these particular credits are also subject to "country risk" -- economic and political risk factors specific to the country of the borrower which may make the borrower unable or unwilling to pay principal and interest according to contractual terms. Other risks associated with these credits include the possibility of insufficient foreign exchange and restrictions on its availability. To minimize country risk, the Corporation monitors its foreign credits in each country with specific consideration given to maturity, currency, industry and geographic concentration of the credits. In addition, the Corporation establishes limits governing lending to the various categories of the foreign portfolio. The following table lists all countries in which the Corporation's cross-border outstandings exceeded 1% of consolidated assets as of any of the dates specified. The Corporation does not have significant local currency outstandings to the individual countries listed in the following table that are not hedged or are not funded by local currency borrowings. B40 (a) Outstandings (including loans and accrued interest, interest-bearing deposits with banks, securities, acceptances and other monetary assets, except equity investments) represent those of both the public and private sectors and are presented on a risk basis, i.e., net of written guarantees and tangible liquid collateral when held outside the foreign country. At December 31, 1993, outstandings to Italy amounted to $1,281 million which was in excess of .75% of total assets. At December 31, 1993, 1992 and 1991, outstandings to Brazil amounted to $1,328 million, $1,224 million and $1,148 million, respectively, which were in excess of .75% of total assets in each of such year. At December 31, 1992, outstandings to Korea amounted to $1,074 million, which were in excess of .75% of total assets. At December 31, 1991, outstandings to Venezuela amounted to $1,162 million, which was in excess of .75% of total assets for such year. (b) Outstandings exclude equity received in debt-for-equity conversions, which is recorded initially at fair market value and generally accounted for under the cost method. Commitments (outstanding letters of credit, standby letters of credit, guarantees and unused legal commitments) are excluded. At December 31, 1993, off-balance sheet commitments, after adjusting for transfers of risk, amounted to $1,133 million for Japan, $1,247 million for the United Kingdom, and $357 million for Germany. (c) The average outstandings to Japan during 1993 and 1992 (based on quarter-end amounts) was approximately $3.6 billion and $1.2 billion, respectively. (d) The average outstandings to Germany during 1993 (based on quarter-end amounts) was approximately $1.2 billion. OUTSTANDINGS TO COUNTRIES ENGAGED IN DEBT RESCHEDULING The following table sets forth the Corporation's outstandings to countries engaged in debt rescheduling at the dates indicated. (a) Trade and short-term outstandings include accrued interest, interest-bearing deposits with banks and trade-related credits. (b) Amounts outstanding to Venezuela exclude interest rate reduction bonds with a book value of $365 million and $483 million at December 31, 1993 and 1992, respectively. The principal amount of these bonds is secured by zero-coupon U.S. Treasury securities. As of December 31, 1993, the market values of these bonds and the underlying collateral were $292 million and $65 million, respectively. (c) Amounts outstanding to Argentina exclude principal reduction bonds and interest rate reduction bonds with an aggregate book value of $17 million at December 31, 1993. The principal amount of these bonds is secured by zero-coupon U.S. Treasury securities. As of December 31, 1993, the market values of these bonds and the underlying collateral were $17 million and $4 million, respectively. (d) Amounts outstanding to Uruguay exclude interest rate reduction bonds with a book value of $129 million at each of December 31, 1993 and 1992. The principal amount of these bonds is secured by zero-coupon U.S. Treasury securities. As of December 31, 1993, the market values of these bonds and the underlying collateral were $108 million and $20 million, respectively. LDC outstandings are subject to unique economic, political and social risks. In 1993 and prior years, borrowers in LDC countries have restructured and refinanced their obligations. The Corporation expects to continue a program of close cooperation with members of the international financial community and the representatives of LDC countries. The Corporation's medium- and long-term LDC outstandings decreased to $2,248 million at December 31, 1993, from $3,463 million at December 31, 1992, a reduction of $1,215 million, or 35%. The reduction from December 31, 1992 is primarily attributable to loan sales, charge-offs, and the removal of the Argentine debt that was restructured in 1993. Following is a summary of significant recent developments with respect to the Corporation's outstandings to Brazil and Argentina. Brazil: Nonperforming loans to Brazilian borrowers totaled $403 million at December 31, 1993, down from $713 million at December 31, 1992, reflecting a reduction in medium- and long-term outstandings. Substantial progress was made during 1993 on the agreement-in-principal reached in July 1992 between the Government of Brazil and the Bank Advisory Committee ("BAC") on the debt and debt service reduction package covering $45 billion of medium- and long-term debt (the "Financing Package"). B41 During 1993, the Corporation agreed to exchange its eligible "Old" debt (multi-year Deposit Facility Agreement and other pre-1988 restructured debt) for 65% Capitalization Bonds and 35% Discount Bonds. The agreement also provides for the exchange of the Corporation's eligible "New Money" debt (credit extensions originating from the 1988 restructuring) for New Money Bonds, Debt Conversion Bonds and Cruzeiro Dollar Bonds. The Financing Package was signed by 95% of the debt holders on December 15, 1993. The exchange is expected to take place by April 15, 1994. Brazil has paid 50% of contractual interest due throughout 1993 and is expected to continue these 50% payments until the exchange date. The remaining unpaid interest due is expected to be received by the Corporation on the exchange date in the form of 12-year, uncollateralized Eligible Interest ("EI's") Bonds in the principal amount of approximately $150 million. The Corporation's total Brazilian outstandings currently affected by the Financing Package amount to $1,112 million (which includes loan amounts previously charged off). Debt tendered under the Capitalization Bonds option will be exchanged at face value for 20-year uncollateralized bonds initially bearing interest at 4% and gradually increasing to 8% in year seven and thereafter. The principal balance of the bonds will be increased semi-annually during the first six years for the difference between the interest due based on the stated rate and the rate of 8%. Equal semi-annual principal payments will commence after a ten-year grace period. Debt tendered under the Discount Bond option will be exchanged at a 35% discount for 30-year bonds bearing interest at LIBOR plus 13/16% with a bullet payment at maturity. The principal payment on the Discount Bonds is expected to be collateralized by zero-coupon U.S. Treasury obligations having a redemption value at maturity equal to the face value of the Bonds. Interest payments on these bonds are expected to be collateralized by permitted investments on a 12- month rolling basis and will become fully collateralized during a two-year phase-in period. The New Money Bonds, Debt Conversion Bonds and Cruzeiro Dollar Bonds are uncollateralized 15- or 17-year instruments bearing interest at LIBOR plus 13/16% with equal semi-annual principal payments commencing after a seven- or ten-year grace period. The Corporation does not expect to incur any additional charge-offs as a result of the Financing Package. The Corporation has sold substantially all of its Interest Due and Unpaid ("IDU") Bonds which were received in November 1992 under the agreement reached by the BAC and Brazil for the settlement of past-due interest owed to bank creditors on medium- and long-term outstandings for 1989 and 1990. During 1993, the Corporation recognized a gain of $152 million (in other revenue) from the sale of its IDU Bonds. Argentina: Argentine nonperforming loans were $7 million at December 31, 1993 compared with $316 million at December 31, 1992. The decrease in medium- and the long-term outstandings and in nonperforming loans is primarily attributable to the exchange of eligible debt for 30-year collateralized Par and Discount Bonds issued by the Republic of Argentina and the sale of local Argentine government instruments. The rescheduling agreement reached between the Republic of Argentina and the Bank Advisory Committee on the settlement of the country's medium- and long-term debt of approximately $23 billion and associated interest in arrears was completed during 1993. On April 7, 1993, the creditor banks exchanged their eligible debt into collateralized 30 year Par and Discount Bonds under the terms of the Argentine rescheduling agreement. The Corporation's total Argentine outstandings affected by the rescheduling agreement were $870 million (which includes loan amounts previously charged off). Par Bonds in the amount of $613 million and Discount Bonds in the amount of $167 million were issued to the Corporation. The Corporation did not take any additional charge-offs in connection with the debt exchange. In connection with the agreement, the Corporation received $337 million of Floating Rate Bonds ("FRB's") and $32 million in cash, of which $29 million was recorded in net interest income in 1993. The Corporation has sold substantially all of the aforementioned Par Bonds, Discount Bonds and FRB's received as a result of the refinancing agreement. The Corporation recognized a $179 million gain (in other revenue) during 1993 from the sale of its FRB's. CAPITAL Total stockholders' equity at December 31, 1993 was $11.16 billion, an increase from $9.85 billion at year-end 1992. The $1.31 billion increase in stockholders' equity from December 31, 1992 included $1.11 billion in retained earnings generated during 1993. The Corporation raised $200 million in new common equity primarily through the sale in March 1993 of [TOTAL STOCKHOLDERS' EQUITY BAR GRAPH -- SEE EDGAR APPENDIX] B42 3.8 million shares of the Corporation's common stock. Two series of fixed-rate preferred stock totaling $400 million issued during 1993 were more than offset by the redemption of three series of adjustable-rate preferred stock totaling $594 million. Such redemptions were part of the Corporation's plan to improve its capital position by achieving lower financing costs and reducing interest-rate risk. The Corporation will continue to evaluate the opportunity for future redemptions of preferred stock given current market conditions. The Corporation's ratio of common stockholders' equity to total assets was 6.34% at December 31, 1993, an increase from 5.73% at year end 1992. The ratio of total stockholders' equity to total assets at December 31, 1993 was 7.45%, an increase from 7.05% from the same date a year ago. Total capitalization (total stockholders' equity under risk-based capital guidelines, and subordinated and senior debt that qualifies as Tier 2 Capital as discussed below under "Risk-Based Capital Ratios") increased by $810 million during 1993. LONG-TERM DEBT During 1993, the Corporation issued $3.5 billion of long-term debt (including $1.6 billion of subordinated debt that qualifies as Tier 2 Capital, of which $1.1 billion was issued through its Chemical Bank subsidiary). These issuances were offset by maturities of $402 million of long-term debt (including $330 million of medium-term notes) and the redemption of $1.9 billion of long-term debt. As a result of these actions, the Corporation improved its liquidity and extended the maturities of its debt portfolio. See the Liquidity Management section for further discussion of the Corporation's long-term debt redemptions. COMMON STOCK DIVIDENDS In the first quarter of 1993, the Board of Directors of the Corporation increased the quarterly dividend on the Corporation's common stock from $0.30 per share to $0.33 per share. In the fourth quarter of 1993, the Corporation declared an increase in the quarterly dividend to be paid on its common stock in January 1994 from $0.33 per share to $0.38 per share. Future dividend policies will be determined by the Board of Directors in light of the earnings and financial condition of the Corporation and its subsidiaries and other factors, including applicable governmental regulations and policies. RISK-BASED CAPITAL RATIOS Under the Federal Reserve Board risk-based capital guidelines, banking organizations are required to maintain certain ratios of "Qualifying Capital" to "risk-weighted assets". "Qualifying Capital" is classified into two tiers, referred to as Tier 1 Capital and Tier 2 Capital. Tier 1 Capital consists of common equity, qualifying perpetual preferred equity and minority interests in the equity accounts of unconsolidated subsidiaries, less goodwill and other non-qualifying intangible assets. Tier 2 Capital consists of perpetual preferred equity not qualifying for Tier 1, qualifying allowance for credit losses, mandatory convertible debt and subordinated debt and other qualifying securities. The amount of Tier 2 Capital may not exceed the amount of Tier 1 Capital. In calculating "risk-weighted assets", certain risk percentages, as specified by the Federal Reserve Board, are applied to particular categories of both on- and off-balance sheet assets. Under the guidelines, the Corporation's Tier 1 Capital ratio and Total Capital ratio to risk-weighted assets at December 31, 1993 were 8.12% and 12.22%, respectively, well in excess of the minimum ratios specified by the Federal Reserve Board. Also on that date, Chemical Bank's ratios of Tier 1 Capital and Total Capital to risk-weighted assets, were 7.90% and 12.54%, respectively. Chemical Bank was "well capitalized" as defined by the Federal Reserve Board. To be "well capitalized," a banking organization must have a Tier 1 Capital ratio of at least 6%, Total Capital ratio of at least 10% and Tier 1 leverage ratio (as defined in the following section) of at least 5%. These ratios, as well as the leverage ratio discussed below, do not reflect any adjustment in stockholders' equity due to the adoption of SFAS No. 115. The Federal Reserve Board has proposed to permit banking corporations to include in Tier 1 Capital the net amount of any unrealized gains or losses from securities available-for-sale. If the Corporation were to treat the amount at December 31, 1993 of its net unrealized gains attributable to available-for-sale securities as regulatory capital, the Tier 1 Capital, Total Capital and Tier 1 leverage ratios would be 8.30%, 12.39% and 6.92%, respectively, at December 31, 1993. The total capitalization would have increased by an additional $215 million for a total increase of $1,025 million during 1993. [RISK-BASED CAPITAL RATIOS BAR GRAPH -- SEE EDGAR APPENDIX] B43 LEVERAGE RATIOS The Tier 1 leverage ratio is defined as Tier 1 Capital divided by average total assets (net of allowance for losses, goodwill and other non-qualifying intangible assets). The minimum leverage ratio is 3% for banking organizations that do not anticipate significant growth and that have well-diversified risk (including no undue interest rate risk), excellent asset quality, high liquidity and good earnings. Higher capital ratios could be required if warranted by the particular circumstances, or risk profile, of a given banking organization. The Federal Reserve Board has not advised the Corporation of any specific minimum Tier 1 leverage ratio applicable to it. The Corporation's Tier 1 leverage ratio was 6.77% at December 31, 1993, compared with 6.60% at December 31, 1992. At December 31, 1993, Chemical Bank's Tier 1 leverage ratio was 6.97%. The table which follows sets forth the Corporation's Tier 1 Capital, Tier 2 Capital and risk-weighted assets, and the Corporation's risk-based capital and Tier 1 leverage ratios for the dates indicated. CAPITAL RATIOS Excluding the Corporation's securities subsidiary, Chemical Securities Inc., the December 31, 1993 ratios of Tier 1 Capital to risk-weighted assets and Total Capital to risk-weighted assets were 7.93% and 11.86%, respectively, compared with 7.20% and 11.29%, respectively, at December 31, 1992. LIQUIDITY MANAGEMENT The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all financial commitments and to capitalize on opportunities for business expansion. Liquidity management addresses the Corporation's ability to meet deposit withdrawals either on demand or at contractual maturity, to repay borrowings as they mature, and to make new loans and investments as opportunities arise. Liquidity is managed on a daily basis at both the parent company and the subsidiary levels, enabling senior management to monitor effectively changes in liquidity and to react accordingly to fluctuations in market conditions. Contingency plans exist and could be implemented on a timely basis to minimize the risk associated with dramatic changes in market conditions. The primary source of liquidity for the bank subsidiaries of the Corporation derives from their ability to generate core deposits, which includes all deposits except zero-rate deposits, foreign deposits and certificates of deposit of $100,000 or more. The Corporation considers funds from such retail sources to comprise its subsidiary banks' "core" deposit base because of the historical stability of such sources of funds. The average core deposits at the Corporation's bank subsidiaries for 1993 were $61 billion, an increase from $57 billion for 1992. These deposits fund a proportion of the Corporation's asset base, thereby reducing the Corporation's reliance on other, more volatile, sources of funds. For 1993, the Corporation's percentage of average core deposits to average interest-earning assets was 49%, compared with 47% during 1992. Average core deposits as a percentage of average loans was 77% for 1993, compared with 70% in 1992. The Corporation holds marketable securities and other short-term investments which can be readily converted to cash. In addition, active asset securitization programs and loan syndication networks are maintained in order to facilitate the timely liquidation of certain assets if and when deemed desirable. The Corporation is also an active participant in the capital markets. In addition to issuing commercial paper and medium-term notes, the Corporation raises funds through the issuance of long-term debt, common stock and preferred stock. During 1993, the Corporation issued $200 million of common stock, $400 million of preferred stock, $1.6 billion of subordinated debt ($1.1 billion of which was issued by Chemical Bank) and $1.9 billion of senior debt (including $1.1 billion through its medium-term note program) in various public offerings. During 1993 and 1992, several nationally-recognized statistical rating organizations announced upgrades in the ratings of the Corporation's senior debt, subordinated debt, commercial paper and preferred stock. These rating increases enhanced and should continue to enhance the Corporation's access to global capital and money markets, a primary source of liquidity for an international money-center institution. The ability to access this geographically diverse assortment of distribution channels and to issue a wide variety of capital and money market instruments at various maturities provides the Corporation with a full array of alternatives for managing its liquidity position. During 1993, the Corporation redeemed $1.9 billion of its long-term debt and $594 million of its preferred stock. Such redemptions were and will continue to be undertaken by the Corporation in light of its ability (as a result of current market conditions in general and the recent upgrades in the Corpora- B44 tion's debt ratings in particular) to access the credit markets on terms more favorable than that of the redeemed debt and preferred stock. These redemptions were and continue to be part of the Corporation's plan to improve its capital position by achieving lower financing costs, reducing interest rate risk and lengthening maturities. The Corporation will continue to evaluate the opportunity for future redemptions of debt and preferred stock given current market conditions. The following comments apply to the Consolidated Statement of Cash Flows. Cash and due from banks decreased $2.0 billion during 1993, as net cash used by operating activities exceeded the net cash provided by investing and financing activities. The $8.5 billion net cash used by operating activities was principally due to cash outflows from a net increase in trading-related assets ($10.5 billion) and purchases of available-for-sale securities ($7.6 billion), partially offset by the maturity and sale of available-for-sale securities ($1.6 billion and $5.4 billion, respectively). The $.4 billion net cash provided from investing activities was largely the result of cash inflows from the net decrease in loans ($6.7 billion) and proceeds from the maturity of held-to-maturity securities ($5.0 billion), partially offset by cash outflows from the purchases of held-to-maturity securities ($6.4 billion), as well as increases in deposits with banks ($4.2 billion) and Federal funds sold and securities purchased under resale agreements ($2.4 billion). The $6.0 billion net cash provided by financing activities was due to increases in Federal funds purchased, securities sold under repurchase agreements and other borrowed funds ($3.3 billion), foreign deposits ($2.9 billion) and net proceeds from the issuance of long-term debt ($3.5 billion), partially offset by repayments and maturities of long-term debt ($2.3 billion). The Corporation's anticipated cash requirements (on a parent company-only basis) for 1994 include approximately $1,650 million for maturing medium- and long-term debt, anticipated dividend payments on the Corporation's common stock and preferred stock and for other parent company operations. The Corporation considers the sources of liquidity available to the parent company to be more than sufficient to meet its obligations. The sources of liquidity available to the Corporation (on a parent company-only basis) include its liquid assets (including deposits with its bank subsidiaries and short-term advances to and repurchase agreements with its securities subsidiaries) as well as dividends and the repayment of intercompany advances from its bank and non-bank subsidiaries. In addition, as of December 31, 1993, the Corporation had available to it $750 million in committed credit facilities from a syndicate of domestic and international banks. The facilities included a $241 million three-year facility and a $509 million 364-day facility. OFF-BALANCE SHEET ANALYSIS The Corporation utilizes various off-balance sheet financial instruments in two ways: trading and asset/liability management. Certain of these instruments, commonly referred to as "derivatives", represent contracts with counterparties where payments are made to or from the counterparty based upon specific interest rates, currency levels, other market rates or on terms predetermined by the contract. Derivatives, along with foreign exchange contracts, can provide a cost-effective alternative to assuming and mitigating risks associated with traditional on-balance sheet instruments. Such derivative and foreign exchange transactions involve, to varying degrees, credit risk (i.e., the possibility that a loss may occur because a party to a transaction fails to perform according to the terms of a contract) and market risk (i.e., the possibility that a change in interest or currency rates will cause the value of a financial instrument to decrease or become more costly to settle). The Corporation's actual credit losses arising from such transactions have been immaterial during 1993, 1992 and 1991. The effects of market losses have been reflected in trading revenue, as the trading instruments are marked-to-market on a daily basis. TRADING ACTIVITIES: RISK MANAGEMENT PRODUCTS The Corporation utilizes derivative and foreign exchange instruments to meet the financing needs of its customers and to generate revenues through its trading activities. The Corporation has four fundamental trading activities which generate revenue. The Corporation seeks to maintain a balance between generally stable market-making, sales and arbitrage businesses and potentially less stable positioning. Market-making: The Corporation trades with the intention of making a profit based on the spread between bid and ask prices. The Corporation views the market risk related to market-making to be relatively low and very short-term. The stability of market-making, compared to other trading activities, is considered by the Corporation to be medium, as both the spreads and the market volume can fluctuate. The Corporation considers market-making to be a key trading activity in its non-exchange traded businesses and emphasizes its use, especially in its foreign exchange, derivative and government markets businesses. Sales: The Corporation accesses products for its clients at competitive prices. The Corporation is emphasizing sales since the Corporation believes it to be a stable business, given the Corporation's worldwide client franchise. Arbitrage: This is the purchase or sale of derivatives in one market and the almost simultaneous sale or purchase in another market to take advantage of differences in interest and currency B45 rates. Because of the nature of trading markets, where there are numerous instruments that relate to one another, and the Corporation's market-making franchise, the Corporation emphasizes the use of this strategy. The Corporation considers arbitrage to be a key fundamental of its risk management business. Positioning: The Corporation takes certain positions in the market with the intention of generating revenue. This strategy has the lowest stability of all four trading activities. The Corporation's emphasis in this area is less than in the other fundamental trading activities. ASSET/LIABILITY MANAGEMENT The Corporation employs a variety of off-balance sheet instruments in managing its exposure to fluctuations in market interest rates and foreign exchange rates. In some cases, these instruments are used to hedge specific on-balance sheet exposures. For example, an interest rate swap contract may be entered into in conjunction with a debt offering, shifting the effective rate paid from fixed to variable, or vice versa, at terms more advantageous than if the debt offering had originally been fixed-rate or variable-rate, as the case may be. More often, these contracts are used as one of many tools in the Corporation's overall management of its exposure, as opposed to hedging specific transactions as described above. A swap in which the Corporation receives a fixed interest rate and pays a floating rate may serve as a substitute for an investment in a fixed-rate security. Such a swap transaction will have an effect on the Corporation's consolidated interest rate sensitivity identical to a security investment but potentially at more favorable terms depending on market conditions. For a discussion regarding the Corporation's interest rate positions, see the Interest Rate Sensitivity Section. For a discussion regarding the Corporation's asset/liability management policies, see Note One of the Notes to Consolidated Financial Statements. At December 31, 1993, the net deferred amount relating to off-balance sheet instruments used in asset/liability management activities was immaterial. CREDIT AND MARKET RISK MANAGEMENT The effective management of credit and market risk is a vital ingredient of the Corporation's trading activities and asset/liability management. The Corporation also manages the risks associated with its trading activities through geographic and product diversification. Because of the changing market environment, which results in increasingly complex financial instruments, and because of the Corporation's business strategy to maintain geographic and product diversification, the monitoring and managing of these risks is a continual process. The Corporation has reviewed both the Group of Thirty report entitled "Derivatives Practices and Principles" and the recently issued Federal Reserve Board examination guidelines for trading activities, and management considers itself to be substantially in compliance with the recommendations and general thrust of these documents. Credit Risk: The Corporation controls the credit risk arising from derivative and foreign exchange transactions through its credit approval process and the use of risk control limits and monitoring procedures. The Corporation uses the same credit procedures when entering into derivative and foreign exchange transactions as it does for traditional lending products. The credit approval process involves first evaluating each counterparty's creditworthiness, then assessing the applicability of off-balance sheet instruments to the risks the counterparty is attempting to manage, and determining if there are specific transaction characteristics which alter the risk profile. Credit limits are calculated and monitored on the basis of potential exposure which takes into consideration current market value and estimates of potential future movements in market values. The notional principal of derivative and foreign exchange instruments is the amount on which interest and other payments in a transaction are based. For derivative transactions, the notional principal typically does not change hands; it is simply a quantity that is used to calculate payments. While notional principal is the most commonly used volume measure in the derivative and foreign exchange markets, it is not a measure of credit or market risk. The notional principal of the Corporation's derivatives and foreign exchange products greatly exceeds the possible credit and market loss that could arise from such transactions. As a result, the Corporation does not consider the notional principal to be indicative of its credit or market risk exposure. The Corporation believes the true measure of credit risk exposure is the replacement cost (the cost to replace the contract at current market rates should the counterparty default prior to the settlement date). This is also referred to as the mark-to-market exposure amount. Mark-to-market exposure is a measure, at a point in time, of the value of a derivative or foreign exchange contract in the open market. When the mark-to-market is positive, it indicates the counterparty owes the Corporation and, therefore, creates a repayment risk for the Corporation. When the mark-to-market is negative, the Corporation owes the counterparty. In this situation the Corporation does not have repayment risk. When the Corporation has more than one transaction outstanding with a counterparty, the "net" mark-to-market exposure represents the netting of the positive and negative exposures with the same counterparty. If there is a net negative number, the Corporation's exposure to the counterparty is considered zero. Net mark-to-market is the best measure of credit risk when there is a master netting agreement between the Corporation and the counterparty. B46 The Corporation routinely enters into derivative and foreign exchange product transactions with regulated financial institutions, which it believes have relatively low credit risk. At December 31, 1993, over 80% of transaction counterparties were commercial banks. The remaining 20% were comprised mainly of other financial institutions and major corporations. The Corporation's trading activities are geographically diverse. Trading activities are undertaken in more than 20 countries, although a majority of the Corporation's transactions are executed in the United States, Japan and Western Europe, areas which the Corporation believes have the most developed laws regarding derivatives and foreign exchange businesses. Trading products include not only foreign exchange and derivatives but also securities, including LDC debt. The majority of derivative and foreign exchange transactions are outstanding for less than one year. At December 31, 1993, 28% of outstanding transactions were scheduled to expire within three months, 13% within three to six months, 13% within six months to one year, 26% within one to three years and 20% greater than three years. The short-term nature of these transactions along with product diversification mitigates credit risk, as transactions settle quickly. Market Risk: Market risk management is an effective and wide-ranging activity at the Corporation. A critical goal is the separation of duties of those responsible for day-to-day trading and those responsible for position valuation and limit reporting. The Chairman of the Market Risk Committee delegates instrument authorities and risk limits to individual business units and exception authority to the senior managers of divisions responsible for those units. Procedures and policies specify authorized instruments and provide for risk limits. Critical risk limits that are designated as primary involve independent daily tracking and centralized reporting, while less-critical risk limits are independently monitored and are reported centrally on a periodic basis. Individual business units often set additional internal limits that are monitored in the same manner. Criteria for risk limit determination include, among other factors, relevant market analysis, prior track record, business strategy, and management experience and depth. The Chairman of the Market Risk Committee is supported by the Market Risk Group. One focus of the group is independent analysis of instrument authority and limit requests, limit utilization, measure of revenue to risk, average risk levels, and related topics. Other focuses include measures of value at risk, criteria for official volatility and correlation statistics, and formulas for determination of market-related credit exposure. Additionally, the group reviews the market risk related to new products (as one element of the Corporation's new product process) and provides independent review of the mathematical and simulation models utilized by the Corporation. The group combines efforts with other functional units to assess cross-discipline risks in business units having significant market risk. For further discussion of the Corporation's off-balance sheet financial instruments, see Note Eighteen of the Notes to Consolidated Financial Statements. INTEREST RATE SENSITIVITY The Corporation's net interest income is affected by changes in the level of market interest rates based upon mismatches between the repricing of its assets and liabilities. Interest rate sensitivity arises in the ordinary course of the Corporation's banking business as the repricing characteristics of its loans do not necessarily match those of its deposits and other borrowings. This sensitivity can be altered by adjusting investments and the maturities of wholesale funding and with the use of off-balance sheet derivative instruments. Interest rate sensitivity is managed and controlled on a consolidated basis by the Corporation's Asset and Liability Policy Committee. A key element of the Corporation's interest rate risk management strategy is that it allows the assumption of limited interest rate sensitivities at a decentralized level by authorized units with close contacts with the markets. These units operate within authorities administered centrally which limit the size of exposures by currency and the instruments that can be used to manage the sensitivity. The positions are consolidated and reviewed frequently by the Asset and Liability Policy Committee, which seeks to maximize the Corporation's net interest income while ensuring that the risks to earnings from adverse movements in interest rates are kept within pre-specified limits deemed acceptable by the Corporation. Measuring Interest Rate Sensitivity: Management uses a variety of techniques to measure its interest rate sensitivity. One such tool is aggregate net gap analysis, an example of which is presented below. Assets and liabilities are placed in maturity ladders based on their contractual maturities or repricing dates. Assets and liabilities for which no specific contractual maturity or repricing dates exist are placed in ladders based on management's judgments concerning their most likely repricing behaviors. Derivatives used in interest rate sensitivity management are also included in the maturity ladders. The aggregate notional amounts of derivatives are netted when the repricing of the "receive-side" and "pay-side" of two swaps occur within the same gap interval. Such net amount represents the repricing mismatch of the Corporation's derivatives during the particular gap interval. It is the amount of the net repricing mismatch, rather than the aggregate notional principal of the derivatives repricing during the period, that is included in the gap analysis, because it is the amount of the mismatch that reflects the impact of the Corporation's derivatives in altering the repricing profile of the Corporation. See Note Eighteen of the Notes to Consolidated Financial Statements for the aggregate notional principal of off-balance sheet instruments used for asset/liability management. B47 (a) Represents repricing effect of off-balance sheet positions, which include interest rate swaps and options, financial futures, and similar agreements that are used as part of the Corporation's overall asset and liability management activities. A net gap for each time period is calculated by subtracting the liabilities repricing in that interval from the assets repricing. A negative gap -- more liabilities repricing than assets -- will benefit net interest income in a declining interest rate environment and will detract from net interest income in a rising interest rate environment. Conversely, a positive gap -- more assets repricing than liabilities -- will benefit net interest income if rates are rising and will detract from net interest income in a falling rate environment. At December 31, 1993, the Corporation had $7,912 million more liabilities than assets repricing within one year, amounting to 5.3% of total assets. This compares with $7,255 million, or 5.2% of total assets at December 31, 1992. The consolidated gaps include exposure to U.S. dollar interest rates as well as exposure to non-U.S. dollar rates in currency markets in which the Corporation does business. Since U.S. interest rates and non-U.S. interest rates do not move in tandem, the overall cumulative gaps will tend to overstate the exposures of the Corporation to U.S. interest rates. Simple gap analysis measures the Corporation's exposure at a particular point in time. The exposure changes continuously as a result of the Corporation's ongoing business and its management initiatives. Moreover, gap analysis cannot reveal the impact of factors such as administered rates (i.e., the prime lending rate), pricing strategies on its consumer and business deposits, changes in balance sheet mix or various options embedded in the balance sheet. Accordingly, the Asset and Liability Policy Committee supplements its gap analysis with comprehensive simulations of net interest income under a variety of market interest rate scenarios. These simulation models take explicit account of pricing strategies and deposit responses and the behavior of embedded options. At December 31, 1993, based on these simulations, net B48 interest income sensitivity to a gradual 150 basis point rise in market rates over the course of 1994 was estimated at less than two percent of projected 1994 after-tax net income. While management believes the simulation models do provide a meaningful representation of the Corporation's interest rate sensitivity, these simulation models do not necessarily take into account all business developments which can have an impact on net interest income, such as changes in credit quality or the size and composition of the balance sheet. In 1993, the Federal Reserve Board and certain other Federal banking regulators proposed a system for measuring interest rate risk and assessing capital adequacy based on the sensitivity of a banking organization's "net economic value" to changes in the level of market interest rates. The system compares the net present value of net interest income-related cash flows under current market conditions to the net present values under hypothetical, instantaneous increases and declines in market rates. The proposal envisions that banks whose net economic value sensitivity exceeds one percent of total assets would be identified as having excessive interest rate risk and, potentially, become subject to additional capital requirements. While final rules have not been adopted, management believes its current interest rate-sensitivity position falls within the range deemed acceptable by the regulators' measurement system. ACCOUNTING DEVELOPMENTS ACCOUNTING BY CREDITORS FOR IMPAIRMENT OF A LOAN In May 1993, the Financial Accounting Standards Board, ("FASB") issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). SFAS 114 requires that the carrying value of impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Under the new standard, a loan is considered impaired when, based on current information, it is probable that the borrower will be unable to pay contractual interest or principal payments as scheduled in the loan agreement. SFAS 114 is applicable to all loans that are identified for evaluation, uncollateralized as well as collateralized, with certain exceptions. SFAS 114 applies to financial statements for fiscal years beginning after December 15, 1994, although earlier application is encouraged. Management is currently evaluating the financial impact of adopting this new accounting standard. OFFSETTING OF AMOUNTS RELATED TO CERTAIN CONTRACTS The Corporation records unrealized gains and losses related to interest rate and foreign exchange contracts net on the Consolidated Balance Sheet. In March 1992, the FASB issued Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts" (the "Interpretation"), with an effective date of January 1, 1994, which changes the reporting of unrealized gains and losses on interest rate and foreign exchange contracts on the balance sheet. The Interpretation requires that gross unrealized gains be reported as assets and gross unrealized losses be reported as liabilities. The Interpretation, however, permits netting of such unrealized gains and losses with the same counterparty when master netting agreements have been executed. If this Interpretation had been in effect at December 31, 1993, giving effect to the master netting agreements in place at that time, assets and liabilities each would have increased by approximately $13.6 billion and the Tier 1 leverage ratio would have been 6.19%. In 1994, to mitigate the impact of the Interpretation, the Corporation anticipates expanding the number of master netting agreements to which it is a party. Upon adoption of this new reporting requirement, the Corporation's net income and risk-based capital ratios will not be affected, although the Corporation expects its asset-based ratios (such as the Tier 1 leverage ratio) will decrease. MANAGEMENT'S DISCUSSION AND ANALYSIS COMPARISON BETWEEN 1992 AND 1991 OPERATING HIGHLIGHTS The Corporation's net income was $1,086 million, or $3.90 per common share, for 1992, compared with $154 million, or $.11 per share, in 1991. The 1991 results reflected a pre-tax restructuring charge of $625 million taken in connection with the merger with MHC. Excluding the restructuring charge, earnings for 1991 were $779 million, or $3.56 per share. There were no tax benefits recorded in connection with the restructuring charge. The Corporation's 1992 earnings, in comparison with the prior year, benefited from a 13% increase in net interest income, a 27% improvement in combined trading account and foreign exchange revenue, as well as higher revenues from fees for other banking services, service charges on deposit accounts and trust and investment management fees. Partially offsetting these factors were higher credit costs in 1992 compared with 1991, reflecting the impact of the weak economy on certain areas of the Corporation's credit portfolio. B49 NET INTEREST INCOME The Corporation's net interest income was $4,598 million in 1992, an increase of 13% from $4,080 million for 1991. The improvement in net interest income from 1991 was attributable to wider spreads in a lower interest rate environment, lower funding costs (primarily due to upgrades received in 1992 in the Corporation's credit ratings) and effective asset/liability management. PROVISION FOR LOSSES AND NET CHARGE-OFFS The provision for losses for 1992 was $1,365 million, compared with $1,345 million for 1991. The Corporation's non-LDC net charge-offs totaled $1,365 million in 1992 an increase from $1,191 million in 1991. The increase from the prior year was principally due to the continued weak economy and its effects on certain areas of the Corporation's credit portfolio. However, non-LDC net charge-offs declined in each of the last three quarters of 1992. LDC net charge-offs in 1992 included $51 million related to Yugoslavia as a result of a recommendation of ICERC issued in the 1992 fourth quarter. LDC net charge-offs and losses on sales and swaps in 1991 included $902 million related to Brazilian loans, of which $491 million occurred in the 1991 fourth quarter. These charge-offs reflected the Corporation's evaluation of its LDC portfolio and the recommendations of ICERC and had the effect of adjusting the Corporation's medium- and long-term Brazilian outstandings to an estimated net recoverable value. NONINTEREST REVENUE Noninterest revenue totaled $3,026 million in 1992, an increase of $164 million from 1991. The increase was primarily the result of higher foreign exchange trading revenue, service charges on deposit accounts and fees for other banking services, partially offset by lower securities gains, corporate finance and syndication fees and other revenue. Trust and investment management fees increased in 1992 to $361 million from $344 million in 1991. The improvement from the prior year occurred in the stock transfer and corporate trust businesses and also reflected higher personal trust fees due to a rise in the market value of assets under management. Corporate finance and syndication fees in 1992 were $265 million, a decrease of 12% from 1991. The decline principally resulted from the sale of a nonstrategic business in the fourth quarter of 1991. Service charges on deposit accounts were $264 million in 1992, an increase from $229 million in 1991. This increase resulted from higher per-account fees, as well as growth in the Corporation's domestic deposit accounts. Fees for other banking services include revolving credit fees, commissions on letters of credit, fees in lieu of compensating balances, mortgage servicing fees, loan commitment fees and other transactional fee revenue. Such fees totaled $1,040 million in 1992, an increase from $959 million in 1991. The increase from the prior year reflected growth in a number of fee components, as well as the prospective reclassification of certain banking relationship fees from other revenue to fees for other banking services. Revenues from all trading activities (trading account revenue and foreign exchange revenue) were $853 million in 1992 compared with $671 million in 1991. In 1992, trading account revenue and foreign exchange revenue were $377 million and $476 million, respectively, compared with $382 million and $289 million, respectively, in 1991. The increases were primarily the result of increased transaction volumes, market volatility, and the Corporation's higher credit ratings, which resulted in increased opportunities in several key businesses. Securities gains in 1992 were $53 million compared with $110 million in 1991. The gains recorded in both years principally resulted from certain actions taken by the Corporation in managing its interest rate sensitivity and enhancing its securities portfolio. Other revenue for 1992 was $190 million compared with $247 million in 1991. The decrease from 1991 was principally due to lower revenue in connection with the Corporation's residential mortgage warehouse operations, the aforementioned reclassification of certain fees from other revenue to fees for other banking services and higher gains recorded in 1991 on the disposition of nonstrategic corporate assets. NONINTEREST EXPENSE Noninterest expense was $4,930 million in 1992, compared with $5,307 million in 1991. The results for 1992 included a one-time charge of $41 million related to costs incurred in combining the Corporation's employee benefit plans and a $30 million charge for London occupancy-related expenses associated with the Corporation's Canary Wharf lease arrangements. The 1991 results included a $625 million restructuring charge in connection with the merger with MHC and an $18 million reduction of expense related to an insurance settlement. Excluding the impact of the aforementioned items, noninterest expense in 1992 increased by $159 million, or 3.4%, from 1991. The 1992 full-year noninterest expense included higher foreclosed property expense, incentive compensation costs (principally due to improved revenues from the Corporation's trading businesses) and FDIC premiums, which collectively increased by $208 million. The remaining amount of noninterest expense declined from year-to-year, reflecting the impact of merger-related expense savings. B50 Salaries and employee benefit expenses in 1992 were $2,349 million, slightly lower than the $2,369 million recorded in 1991. The decline was primarily due to lower costs attributable to the reduction in staff from attrition and layoffs subsequent to the merger announcement on July 15, 1991. Partially offsetting this reduction was approximately $63 million of higher incentive compensation costs due to improved revenues primarily from the Corporation's trading businesses. Occupancy and equipment expenses for 1992 were $882 million, a slight increase from $878 million in 1991. Foreclosed property expense in 1992 was $283 million compared with $154 million in 1991. The $129 million year-to-year increase reflected higher operating expenses associated with an increased level of foreclosed assets and a higher level of expenses incurred in connection with writedowns resulting from updated market valuations. For 1992, other expense was $1,416 million compared with $1,281 million in 1991. Other expense comprises items such as professional fees, insurance, advertising and communications expense, and in 1992 and 1991 included the aforementioned one-time charges. INCOME TAXES The Corporation recorded income tax expense of $243 million in 1992, compared with $136 million in 1991. Included in the 1992 and 1991 income tax expense was approximately $278 million and $130 million, respectively, of Federal income tax benefits. The Corporation's 1991 income tax expense was reduced by $55 million as a result of settlements with the Internal Revenue Service ("IRS") of taxes from prior years. The Corporation's effective tax rate in 1992 was lower than the statutory rate primarily due to the recognition of approximately $278 million of Federal income tax benefits. For 1991, the $625 million restructuring charge, the aforementioned $130 million Federal income tax benefit and the $55 million reduction in tax expense were the most significant factors affecting the Corporation's effective tax rate. Deferred tax benefits were reflected in the financial statements in accordance with the recognition requirements of Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes". NONPERFORMING ASSETS The Corporation's total nonperforming assets at December 31, 1992 were $6,092 million, compared with $6,155 million at December 31, 1991. The decline from the prior year-end resulted from a $251 million decrease in assets acquired as loan satisfactions, partially offset by an $100 million increase in LDC nonperforming loans and an $88 million increase in non-LDC nonperforming loans. The non-LDC nonperforming assets decreased $163 million from the 1991 year-end primarily due to $1.3 billion of payments received on nonperforming loans and the sale of assets acquired, $1.1 billion of charge-offs and writedowns (excluding consumer loan charge-offs on a formula basis) and $0.6 billion of loans returning to performing status, partially offset by $2.8 billion of loans placed on nonperforming status during 1992. LDC nonperforming loans at December 31, 1992 were $1,348 million, an increase of $100 million from the 1991 year-end. The increase in nonperforming LDC loans principally reflected the placement of loans to Yugoslavia on nonperforming status during 1992, partially offset by charge-offs and sales and swaps of LDC loans. CASH FLOWS The following comments apply to the Consolidated Statement of Cash Flows. Cash and due from banks increased $1.3 billion during 1992, as net cash provided by operating activities exceeded the net cash used by investing and financing activities. The net cash provided by operating activities reflected changes in operating assets/liabilities and higher earnings adjusted for non-cash charges and credits. Financing activities used $1.1 billion of net cash, mainly due to decreases in Federal funds purchased, securities sold under repurchase agreements and other borrowed funds. The net cash used in investing activities was largely the result of cash outflows for the purchases of securities and the net increase in loans, partially offset by cash inflows from sales and maturities of securities and the decrease in loans due to sales and securitizations. B51 MANAGEMENT'S REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING To Our Stockholders The management of Chemical Banking Corporation and its subsidiaries has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. The consolidated financial statements include amounts that are based on management's best estimates and judgments. Management also prepared the other information in the annual report and is responsible for its accuracy and consistency with the consolidated financial statements. Management maintains a comprehensive system of internal control to assure the proper authorization of transactions, the safeguarding of assets, and the reliability of the financial records. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees. The Corporation maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. Management believes that as of December 31, 1993, the Corporation maintains an effective system of internal control. The Audit Committee of the Board of Directors reviews the systems of internal control and financial reporting. The Committee meets and consults regularly with management, the internal auditors and the independent accountants to review the scope and results of their work. The accounting firm of Price Waterhouse has performed an independent audit of the Corporation's financial statements. Management has made available to Price Waterhouse all of the Corporation's financial records and related data, as well as the minutes of stockholders' and directors' meetings. Furthermore, management believes that all representations made to Price Waterhouse during its audit were valid and appropriate. The firm's report appears below. /s/ WALTER V. SHIPLEY - - - --------------------- Walter V. Shipley Chairman of the Board and Chief Executive Officer /s/ PETER J. TOBIN - - - ------------------ Peter J. Tobin Executive Vice President and Chief Financial Officer /s/ JOSEPH L. SCLAFANI - - - ---------------------- Joseph L. Sclafani Senior Vice President and Controller January 18, 1994 REPORT OF INDEPENDENT ACCOUNTANTS TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF CHEMICAL BANKING CORPORATION [LOGO] PRICE WATERHOUSE 1177 AVENUE OF THE AMERICAS, NEW YORK, NY 10036 In our opinion, the accompanying consolidated balance sheet of Chemical Banking Corporation and Subsidiaries, and the related consolidated statements of income, of changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Chemical Banking 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 management of Chemical Banking Corporation; 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 described in Notes Four, Thirteen and Sixteen to the consolidated financial statements, Chemical Banking Corporation changed its methods of accounting for certain investments in debt and marketable equity securities, post-retirement benefits and income taxes in 1993. /s/ PRICE WATERHOUSE - - - --------------------- January 18, 1994 B52 CONSOLIDATED BALANCE SHEET The Notes to Consolidated Financial Statements are an integral part of these Statements. B53 CONSOLIDATED STATEMENT OF INCOME The Notes to Consolidated Financial Statements are an integral part of these Statements. B54 CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (a) Balance was ($10) million, ($15) million and ($17) million at December 31, 1993, 1992, and 1991, respectively. The Notes to Consolidated Financial Statements are an integral part of these statements. B55 CONSOLIDATED STATEMENT OF CASH FLOWS The Notes to Consolidated Financial Statements are an integral part of these Statements. B56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE ONE SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Chemical Banking Corporation (the "Corporation") is a bank holding company organized under the laws of the State of Delaware in 1968 and registered under the Bank Holding Company Act of 1956, as amended. On December 31, 1991, Manufacturers Hanover Corporation ("MHC") was merged with and into the Corporation. The merger was accounted for as a pooling of interests and, as a result, the Corporation's financial statements include the consolidated accounts of MHC. In addition, on June 19, 1992, Manufacturers Hanover Trust Company ("MHT") was merged with and into Chemical Bank. The Corporation conducts domestic and international financial services businesses through various bank and non-bank subsidiaries. The principal bank subsidiaries of the Corporation are Chemical Bank, a New York State bank ("Chemical Bank"), and Texas Commerce Bank National Association, a subsidiary of Texas Commerce Bancshares Inc. ("Texas Commerce"), a bank holding company organized under the laws of the State of Delaware. The accounting and financial reporting policies of the Corporation and its subsidiaries conform to generally accepted accounting principles and prevailing industry practices. The following is a description of significant accounting policies. BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Corporation and its majority-owned subsidiaries, after eliminating intercompany balances and transactions. Equity investments in less than majority-owned companies (20%-50% ownership interest) are generally accounted for in accordance with the equity method of accounting. The Corporation's pro-rata share of earnings (losses) of equity investments is included in other noninterest revenue. Securities and other property held in a fiduciary or agency capacity are not included in the Consolidated Balance Sheet since these are not assets or liabilities of the Corporation. Certain amounts in prior periods have been reclassified to conform to the current presentation. STATEMENT OF CASH FLOWS For purposes of preparing the Consolidated Statement of Cash Flows, the Corporation defines cash and cash equivalents as those amounts included in the balance sheet caption "cash and due from banks". Cash flows from loans and deposits are reported on a net basis. TRADING ACCOUNT ASSETS Trading account assets include securities, refinancing country loans, money market, credit and certain derivative instruments held for trading purposes. Obligations to deliver securities sold but not yet purchased are included in other borrowed funds. Trading account assets and liabilities are carried at fair value. Gains and losses on trading account assets and liabilities, including market value adjustments, are included in trading account and foreign exchange revenue. HELD-TO-MATURITY AND AVAILABLE-FOR-SALE 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 115"). Securities that may be sold in response to or in anticipation of changes in interest rates and resulting prepayment risk, or other factors, are classified as available-for-sale and carried at fair value. The unrealized gains and losses on these securities, along with any unrealized gains and losses on related hedges, are reported net of applicable taxes in a separate component of stockholders' equity. At December 31, 1992, securities available-for-sale were carried at the lower of aggregate cost or market value (see Note Four). Securities that the Corporation has the positive intent and ability to hold to maturity continue to be carried at amortized cost. Interest income on securities, including amortization of premiums and accretion of discounts, is recognized using the interest method. The Corporation anticipates prepayments of principal in the calculation of the effective yield for collateralized mortgage obligations and mortgage-backed securities. The specific identification method is used to determine realized gains and losses on sales of securities, which are reported in securities gains. LOANS Loans are generally reported at the principal amount outstanding, net of unearned income and net deferred loan fees (deferred nonrefundable yield-related loan fees, net of related direct origination costs). Mortgage loans held for sale are carried at the lower of aggregate cost or market value. Loans meeting the accounting definition of a security are reported as loans but are valued consistent with SFAS 115. Interest income is recognized using the interest method or on a basis approximating a level rate of return over the term of the loan. Net deferred loan fees are amortized into interest income over the term of the loan. Nonaccrual loans are those on which the accrual of interest has ceased. Loans, other than certain consumer loans discussed below, are placed on nonaccrual status immediately if, in the opinion of management, principal or interest is not likely to be paid in accordance with the terms of the loan agreement, or when principal or interest is past due 90 days or more and B57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS collateral, if any, is insufficient to cover principal and interest. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed against interest income. In addition, the amortization of net deferred loan fees is suspended when a loan is placed on nonaccrual status. Interest income is recognized on nonaccrual loans only to the extent received in cash. However, where there is doubt regarding the ultimate collectibility of the loan principal, cash receipts, whether designated as principal or interest, are thereafter applied to reduce the carrying value of the loan. Loans are restored to accrual status only when interest and principal payments are brought current and future payments are reasonably assured. Renegotiated loans are those for which concessions, such as the reduction of interest rates or deferral of interest or principal payments, have been granted due to a deterioration in the borrower's financial condition. Interest on renegotiated loans is accrued at the renegotiated rates. Certain renegotiated loan agreements call for additional interest to be paid on a deferred or contingent basis. Such interest is taken into income only as collected. Consumer loans (exclusive of residential mortgage products which are accounted for in accordance with the nonaccrual loan policy discussed above) are generally charged to the allowance for losses upon reaching specified stages of delinquency. Accrued interest is reversed against interest income when such consumer loans are charged off. ALLOWANCE FOR LOSSES The allowance for losses is based on periodic reviews and analysis of the portfolio, which comprises primarily loans and other financial instruments, including commitments to extend credit, guarantees, letters of credit, and derivatives and foreign exchange contracts. The analysis includes consideration of such factors as the risk rating of individual credits, the size and diversity of the portfolio (particularly in terms of industry and geography), economic and political conditions, prior loss experience and results of periodic credit reviews of the portfolio. The allowance for losses is increased by charges against income and reduced by charge-offs, net of recoveries, and losses on sales and swaps of loans to countries engaged in debt rescheduling. PREMISES AND EQUIPMENT Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation and amortization. Capital leases are included in premises and equipment at the capitalized amount less accumulated amortization. Depreciation and amortization of premises are included in occupancy expense while depreciation of equipment is included in equipment expense. Depreciation and amortization are computed using the straight-line method over the estimated useful life of the owned asset and, for leasehold improvements, over the estimated useful life of the related asset or the lease term, whichever is shorter. ASSETS ACQUIRED AS LOAN SATISFACTIONS Assets acquired in full or partial satisfaction of debt, either formally or through in-substance foreclosure, are reported at the lower of cost or fair value less estimated costs to sell. These are primarily real estate assets. Writedowns of such assets subsequent to six months from the date of acquisition are included in foreclosed property expense. Operating expenses, net of related revenue, and gains and losses on sales of such assets are reported net in foreclosed property expense. INTANGIBLES Goodwill and other acquisition intangibles are amortized over the estimated periods to be benefited, the majority of which are being amortized over periods not exceeding 25 years. OFF-BALANCE SHEET INSTRUMENTS USED IN TRADING ACTIVITIES The Corporation deals in interest rate, foreign exchange, equity and commodity contracts to generate trading revenues. Such contracts include futures, forwards, swaps and options. Contracts used in trading activities are adjusted to fair value. Realized and unrealized gains and losses on trading positions are recognized in trading account and foreign exchange revenue. A portion of the market valuation relating to certain contracts is deferred and accreted to income over the life of the contracts to match ongoing servicing costs and credit risks, as appropriate. OFF-BALANCE SHEET INSTRUMENTS USED IN ASSET/LIABILITY MANAGEMENT ACTIVITIES As part of its asset/liability management activities, the Corporation may enter into interest rate futures, forwards, swaps and options contracts. Gains and losses realized on futures and forward contracts are deferred and amortized over the terms of the related assets or liabilities and are included as adjustments to interest income or interest expense. Settlements on interest rate swaps and options contracts are recognized over the lives of the agreements as adjustments to interest income or interest expense. Interest rate contracts used in connection with the securities portfolio that is designated as available-for-sale are carried at fair value with gains and losses, net of applicable tax, reported in a separate component of stockholders' equity, consistent with the reporting of unrealized gains and losses on such securities. FOREIGN CURRENCY TRANSLATION Assets and liabilities denominated in foreign currencies are translated to U.S. dollars using prevailing rates of exchange. Gains and losses on foreign currency translation from operations for which the functional currency is other than the U.S. B58 dollar, together with related hedges and tax effects, are reported in stockholders' equity. For foreign operations for which the U.S. dollar is the functional currency, translation gains and losses, including the related hedges, are included in trading account and foreign exchange revenue. CORPORATE FINANCE AND SYNDICATION FEES Corporate finance and syndication fees primarily include fees received for managing and syndicating loan arrangements; providing investment banking and financial advisory services in connection with leveraged buyouts, recapitalizations, and mergers and acquisitions; underwriting debt securities; and arranging private placements. Syndication fees are recognized upon receipt when certain yield tests are satisfied. Corporate finance and underwriting fees are generally recognized when all services to which they relate have been provided. FEES FOR OTHER BANKING SERVICES Fees received in connection with loan commitments, standby letters of credit, related administrative services performed and other fees are generally recognized over the period the related service is provided. INCOME TAXES Effective January 1, 1993, the Corporation adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under SFAS 109, the deferred tax liability (asset) is determined based on enacted tax rates which will be in effect when the underlying items of income and expense are expected to be reported to the taxing authorities. Annual deferred tax expense (benefit) is equal to the change in the deferred tax liability (asset) account from the beginning to the end of the year. A current tax liability or asset is recognized for the estimated taxes payable or refundable for the current year. During 1992 and 1991, the Corporation followed Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" ("SFAS 96"). See Note Sixteen for further discussion. NET INCOME PER COMMON SHARE Net income per common share is computed by dividing net income, after deducting preferred stock dividends, by the weighted average number of common shares and common stock equivalents outstanding during the period. On December 31, 1991, MHC merged with and into the Corporation. Pursuant to the merger, each share of common stock of MHC was converted into 1.14 shares of common stock of the Corporation, or 91,238,025 common shares, and each share of preferred stock of MHC outstanding immediately prior to the merger was converted into one share of newly created preferred stock of the Corporation having terms similar to those of such MHC preferred stock. Common shares and common stock equivalents outstanding for 1991 is based on the combined weighted average number of shares of the Corporation's common stock and MHC's common stock outstanding during the period as adjusted to reflect the conversion of the MHC 97/8% Mandatorily Convertible Preferred Stock into shares of MHC common stock prior to the merger and the conversion of each share of MHC common stock outstanding immediately prior to the merger into 1.14 shares of the Corporation's common stock as a result of the merger. For 1991 (due to the existence during such period of the Corporation's Class B Common Stock), the earnings per share using the if-converted basis was $0.11 and using the two-class basis was $0.06. Other common stock equivalents such as stock options are not included in the calculation since their dilutive effect is immaterial. NOTE TWO ACQUISITIONS In February 1993, the Corporation, through its Texas Commerce subsidiary, acquired $3.8 billion in assets and assumed $3.4 billion in deposit liabilities of four banks (the "First City Banks") of the former First City Bancorporation of Texas, Inc. ("First City") from the Federal Deposit Insurance Corporation (the "FDIC") in a federally-assisted transaction. The First City Banks were primarily engaged in providing commercial banking services in Texas. The premium paid to the FDIC was $333 million. In September 1993, the Corporation, through Texas Commerce Bank National Association, a wholly-owned bank subsidiary of Texas Commerce, acquired Ameritrust Texas Corporation ("Ameritrust"), a corporation engaged in the delivery of personal, corporate and institutional trust and investment services. The purchase price included a premium of $130 million. These acquisitions were recorded using the purchase method of accounting. Under this method of accounting, the purchase price is allocated to the respective assets acquired and liabilities assumed based on their estimated fair values. Intangibles related to the Ameritrust acquisition are being amortized over a 10-year period. Deposit premiums and other intangibles related to the First City acquisition are being amortized over the estimated periods of benefit. Goodwill related to both acquisitions is being amortized over 25 years. B59 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE THREE TRADING ACCOUNT ASSETS Trading account assets at December 31, 1993 and 1992, which are valued at fair value, are presented in the following table. (a) Primarily includes corporate debt and eurodollar bonds. NOTE FOUR SECURITIES On December 31, 1993, the Corporation adopted SFAS 115, which addresses the accounting for investments in equity securities that have readily determinable fair values and for investments in all debt securities. Such securities are classified in three categories and accounted for as follows: debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity and are measured at amortized cost; debt and equity securities bought and held principally for the purpose of selling in the near term are classified as trading securities and are measured at fair value, with unrealized gains and losses included in earnings; debt and equity securities not classified as either held-to-maturity or trading securities are deemed available-for-sale and are measured at fair value, with unrealized gains and losses, net of applicable taxes, reported in a separate component of stockholders' equity. Prior to the adoption of SFAS 115, securities deemed available-for-sale were carried at the lower of aggregate amortized cost or market value. As a result of the adoption of SFAS 115, debt and equity securities in the amount of $15,444 million that were previously measured at amortized cost or at the lower of aggregate amortized cost or market are measured at fair value. HELD-TO-MATURITY SECURITIES The amortized cost and estimated fair value of held-to-maturity securities were as follows for the dates indicated: (a) The Corporation's portfolio of securities generally consists of investment-grade securities. The fair value of actively-traded securities is determined by the secondary market, while the fair value for non-actively-traded securities is based on independent broker quotations. (b) Collateralized mortgage obligations of private issuers generally have underlying collateral consisting of obligations of U.S. Government and Federal agencies and corporations. B60 AVAILABLE-FOR-SALE SECURITIES The amortized cost and estimated fair value of available-for-sale securities at December 31, 1993 and 1992 were as follows: (a) The Corporation's portfolio of securities generally consists of investment-grade securities. The fair value of actively-traded securities is determined by the secondary market, while the fair value for non-actively-traded securities is based on independent broker quotations. (b) Collateralized mortgage obligations of private issuers generally have underlying collateral consisting of obligations of U.S. Government and Federal agencies and corporations. Cash proceeds from the sales of held-to-maturity securities during 1993, 1992 and 1991 were $152 million, $3,736 million, and $8,238 million, respectively. Cash proceeds from the sale of available-for-sale securities during 1993 and 1992 were $5,352 million and $684 million, respectively. Net gains from available-for-sale securities sold in 1993 amounted to $139 million (gross gains of $178 million and gross losses of $39 million). Gross gains from held-to-maturity securities sold amounted to $3 million in 1993. Net gains from securities sold in 1992 and 1991 were $53 million (gross gains of $140 million and gross losses of $87 million) and $110 million (gross gains of $198 million and gross losses of $88 million), respectively. The amortized cost, estimated fair value and average yield of securities at December 31, 1993 by contractual maturity were as follows: (a) The average yield is based on effective rates on book balances at the end of the year. Yields are derived by dividing interest income, adjusted for amortization of premiums and accretion of discounts, by total amortized cost. (b) Securities with no stated maturity are included with securities with a remaining maturity of ten years or more. Substantially all of the Corporation's mortgage-backed securities are due in ten years or more based on contractual maturity. The weighted-average maturity of mortgage-backed securities, which reflects anticipated future prepayments based on a consensus of dealers in the market, is approximately 5 years. B61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE FIVE LOANS The composition of the loan portfolio at each of the dates indicated was as follows: (a) LDC denotes activity related to loans to countries engaged in debt rescheduling. As discussed in Note Four, the Corporation adopted SFAS 115 effective December 31, 1993. Certain loans that meet the accounting definition of a security are classified as loans and are measured pursuant to SFAS 115. Bonds that have been issued by foreign governments (such as Mexico and Venezuela) to financial institutions, including the Corporation, as part of a debt renegotiation are subject to the provisions of SFAS 115. Such loans are classified as loans to foreign governments or as LDC loans. At December 31, 1993, $3,783 million of loans, primarily renegotiated loans, were measured under SFAS 115, including $1,962 million that are classified as held-to-maturity and that are carried at amortized cost. Pre-tax gross unrealized gains and gross unrealized losses related to these held-to-maturity loans totaled $13 million and $362 million, respectively, at December 31, 1993. Loans that were previously recorded at amortized cost and that were designated as available-for-sale at December 31, 1993 are carried at fair value in the amount of $1,821 million. Pre-tax gross unrealized gains and gross unrealized losses on these loans totaled $86 million and $122 million, respectively, and are reported net of taxes in a separate component of stockholders' equity. The fair value of loans designated as available-for-sale was calculated after consideration of the allowance for losses that would be available to cover credit losses. Substantially all foreign government and LDC loans that meet the accounting definition of a security mature in over 10 years. RENEGOTIATED LOANS In 1992, the Corporation exchanged $375 million of its medium- and long-term loans to the Philippines for an equal amount of uncollateralized 151/2-year interest rate reduction bonds with stated interest rates of 4% for years one through two, 5% for years three through five, 6% for year six, and LIBOR plus 13/16% for each year thereafter. In 1991, the Corporation exchanged $135 million of its Uruguayan medium- and long-term loans for an equal amount of 30-year interest rate reduction bonds, which have been collateralized by zero-coupon U.S. Treasury obligations and carry a fixed rate of 6.75%. In accordance with the Mexican debt restructuring agreement of 1990, the Corporation exchanged approximately $2,527 million of Mexican medium- and long-term loans for $663 million of 30-year principal reduction bonds, $1,515 million of 30-year interest rate reduction bonds and a $7 million contribution of new money. Principal on the bonds is collateralized by zero-coupon U.S. Treasury obligations. Principal reduction bonds carry a floating rate of interest of LIBOR plus 13/16%. Interest rate reduction bonds carry a fixed rate of 6.25%. In accordance with the Republic of Venezuela 1990 Financing Plan, the Corporation exchanged approximately $605 million of Venezuelan medium- and long-term loans for an equal amount B62 of 30-year interest rate reduction bonds, which have been collateralized by zero-coupon U.S. Treasury obligations and carry a fixed interest rate of 6.75%. In addition, under the new money option of the Venezuelan 1990 Financing Plan, the Corporation purchased $194 million of new money bonds and then converted $968 million of existing outstandings into debt conversion bonds. Debt conversion bonds have a 17-year maturity and bear interest at a rate of LIBOR plus 7/8%. New money bonds have a 15-year maturity, and bear interest at rates ranging from LIBOR plus 7/8% to LIBOR plus 1%. Aside from renegotiated loans to the Philippines, Uruguay, Mexico, and Venezuela, the Corporation's remaining renegotiated loans at December 31, 1993 and 1992 were not significant. NOTE SIX ALLOWANCE FOR LOSSES The table below summarizes the changes in the allowance for losses during 1993, 1992 and 1991. (a) Includes $55 million related to the decision to accelerate the disposition of certain nonperforming residential mortgages. (b) Related to the First City Banks acquisition. (c) Includes $895 million of net charge-offs and $7 million of losses on sales and swaps related to Brazilian loans. During each of 1993 and 1992, the Corporation transferred $200 million of the allowance for losses allocated to the LDC portfolio to the non-LDC portion of the allowance. The reallocations reflect the Corporation's ongoing analysis and evaluation of its LDC loan portfolio, including the finalization of the Argentine financing program and progress in debt negotiations with Brazil. In addition, during 1993, the Corporation specifically allocated a portion of the LDC allowance to Brazilian outstandings as a result of the Corporation's evaluation of its refinancing country portfolio and in consideration of recent recommendations of the Interagency Country Exposure Review Committee. The LDC allowance allocated to Brazil was $82 million at December 31, 1993. B63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE SEVEN NONPERFORMING ASSETS The Corporation's nonperforming assets were as follows: Certain assets ("shared loss assets") acquired from First City are subject to the loss-sharing provisions of the Purchase and Assumption Agreements between the FDIC and Texas Commerce relating to the First City Banks based in Houston and Dallas/Ft. Worth. These agreements provide that, for a period of five years following the acquisition, the FDIC will absorb 80% of future losses arising from such shared loss assets up to $61 million from the Houston bank and $21 million from the Dallas/Ft. Worth bank and 95% of losses in excess of such respective amounts. Shared loss assets are certain specified commercial and real estate loans acquired by Texas Commerce at those two banks. At December 31, 1993, nonperforming shared loss assets were $98 million. Such assets are not included in the amount of nonperforming assets in the table above. The following table presents the amount of interest income recorded by the Corporation on its nonaccrual and renegotiated loans (including LDC loans) and the amount of interest income on the carrying value of such loans that would have been recorded if these loans had been current in accordance with their original terms (interest at original rates). IMPACT OF NONPERFORMING LOANS ON INTEREST INCOME NOTE EIGHT SHORT-TERM AND OTHER BORROWINGS (a) Average balances were computed using daily balances. Federal funds purchased and securities sold under repurchase agreements are generally issued on an overnight or demand basis. Commercial paper is generally issued in amounts not less than $100,000 and with maturities of 270 days or less. Other borrowings consist of demand notes and various other borrowings in domestic and foreign offices that generally have maturities of less than one year. At December 31, 1993, the Corporation had unused lines of credit available for general corporate purposes, including the payment of commercial paper borrowings, amounting to $750 million. B64 NOTE NINE (a) Includes subordinated notes in aggregate principal amounts of $3.8 billion and $3.1 billion at December 31, 1993 and 1992, respectively. The accompanying table is a summary of long-term debt (net of unamortized original issue debt discount, where applicable) displayed by remaining maturity at December 31, 1993. The distribution by remaining maturity is based on contractual maturity or the earliest date on which the debt is redeemable at the option of the holder. Fixed-rate debt outstanding at December 31, 1993 matures at various dates through 2008 at interest rates ranging from 3.26% to 11.83%. The consolidated weighted-average interest rates on fixed-rate debt at December 31, 1993 and 1992 were 8.03% and 8.70%, respectively. Variable-rate debt outstanding, with interest rates ranging from 3.32% to 6.67% at December 31, 1993, matures at various dates through 2011. The consolidated weighted-average interest rates on variable-rate debt at December 31, 1993 and 1992 were 3.94% and 4.60%, respectively. Included in long-term debt are equity commitment notes and equity contract notes totalling $923 million and $1,826 million at December 31, 1993 and 1992, respectively. Equity commitment notes require that the Corporation issue, prior to their maturity, shares of common stock or perpetual preferred stock or other securities of the Corporation (collectively, "Capital Securities") approved by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") equal to 100% of the original aggregate principal amount of the notes. Equity contract notes require the Corporation to exchange the notes at maturity for Capital Securities with a market value equal to the principal amount of the notes or, at the Corporation's option, to pay the principal of the notes from amounts representing designated proceeds from the sale of Capital Securities. At December 31, 1993, the Corporation had designated proceeds from the sale of Capital Securities in an amount sufficient to satisfy fully the dedication requirements of its equity commitment and equity contract notes. The Corporation has guaranteed several long-term debt issues of its subsidiaries. Such guaranteed debt totaled $300 million and $291 million at December 31, 1993 and 1992, respectively. At December 31, 1993, long-term debt aggregating $640 million was redeemable at the option of the Corporation, in whole or in part, prior to maturity, based on the terms specified in the respective notes. The Corporation's aggregate amounts of maturities and sinking fund requirements for the five years subsequent to December 31, 1993 are $1,664 million in 1994, $1,167 million in 1995, $701 million in 1996, $679 million in 1997 and $605 million in 1998. NOTE TEN PREFERRED STOCK At December 31, 1993, the Corporation was authorized to issue 200 million shares of preferred stock, in one or more series, with a par value of $1 per share. During 1993, the Corporation redeemed all 3.87 million outstanding shares of its Adjustable Rate Cumulative Preferred Stock, Series E, at a redemption price of $51.50 per share plus accrued but unpaid dividends; all four million outstanding shares of its Adjustable Rate Cumulative Preferred Stock, Series F, at a redemption price of $50.00 per share plus accrued but unpaid dividends; and all two million outstanding shares of its 103/4% Cumulative Preferred Stock, at a redemption price of $105.375 per share plus accrued but unpaid dividends. Two issues of preferred stock totaling $400 million were issued during 1993. At December 31, 1993, four million shares of preferred stock designated as Junior Participating Preferred Stock were reserved for issuance under the Corporation's Shareholders' Rights Plan (see Note Twentythree). During 1992, the Corporation redeemed all 3.83 million outstanding shares of its Adjustable Rate Cumulative Preferred B65 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Stock, Series A, all 2 million outstandings shares of its Adjustable Rate Cumulative Preferred Stock, Series B, and also retired all 170,000 shares of preferred stock that were held in treasury. The following is a summary of the Corporation's preferred stocks outstanding at December 31, 1993: (a) Shares may be redeemed (at option of the Corporation) in whole or in part through May 1, 1997 at $12.36 per share and at $12.00 per share thereafter. (b) Shares may be redeemed (at option of the Corporation) in whole or in part on or after June 30, 2000 at $25.00 per share. (c) Shares may be redeemed (at option of the Corporation) from May 1, 1995 at $53.00 per share, and at decreasing prices thereafter declining to $50.00 per share on May 1, 2001 and thereafter. The shares are convertible at any time at the option of the holder into shares of common stock at a conversion price equal to $26.20, subject to adjustments as set forth in the terms of the preferred stock. (d) Shares were issued in 1992 and may be redeemed (at the option of the Corporation) from June 1, 1997 at $25.00 per share. (e) Shares were issued in 1992 and may be redeemed (at the option of the Corporation) from October 1, 1997 at $100 per share. Such shares are represented by 8,000,000 depositary shares, each representing .25 of a share. (f) Shares were issued in 1993 and may be redeemed (at the option of the Corporation) from April 1, 1998 at $100 per share. Such shares are represented by 8,000,000 depositary shares, each representing .25 of a share. (g) Shares were issued in 1993 and may be redeemed (at the option of the Corporation) from June 1, 1998 at $100 per share. Such shares are represented by 8,000,000 depositary shares, each representing .25 of a share. The dividend rate on the Adjustable Rate Cumulative Preferred Stock, Series C, is adjusted quarterly based on a formula that considers the interest rates of selected short- and long-term U.S. Treasury securities prevailing at the time the rate is set. All the preferred stocks outstanding have preference over the Corporation's common stock with respect to the payment of dividends and the distribution of assets in the event of a liquidation or dissolution of the Corporation. NOTE ELEVEN COMMON STOCK At December 31, 1993, the Corporation was authorized to issue 400 million shares of common stock, $1 par value per share. At December 31, the number of shares of common stock issued and outstanding were as follows: As of December 31, 1993, approximately 18,472,629 shares of common stock were reserved for issuance under various employee incentive and stock purchase plans and under the Corporation's Dividend Reinvestment Plan. In addition, as of such date, the Corporation had reserved 7,700,000 shares of common stock for issuance upon the conversion of its 10% Convertible Preferred Stock. Under the Corporation's Dividend Reinvestment Plan, stockholders may reinvest all or part of their quarterly dividends in shares of common stock. Common stock issued during 1993, 1992 and 1991 was as follows: B66 NOTE TWELVE FEES FOR OTHER BANKING SERVICES AND OTHER REVENUE Details of fees for other banking services were as follows: In 1992, the Corporation reclassified the amortization of purchased mortgage servicing rights from other expenses to fees for other banking services. Such amounts are recorded as reductions to mortgage servicing fees. Prior period amounts have been restated to conform with the 1992 presentation. Other Revenue: Included in other revenue was venture capital income of $301 million in 1993, compared with $100 million in 1992 and $66 million in 1991. Also included in other revenue in 1993 were $179 million of gains related to the sale of Argentine past-due interest bonds and $152 million related to the sale of Brazilian interest-due-and-unpaid bonds. NOTE THIRTEEN POSTRETIREMENT BENEFITS Pension Plans: The Corporation amended its noncontributory pension plan as of January 1, 1993 (the "noncontributory plan"). It covers substantially all domestic employees and provides for defined benefits pursuant to a cash balance feature and a final-average-pay feature. Contributions will be made to the noncontributory plan within the range of levels permitted under applicable law. Through December 31, 1992, employees of the Corporation and the former MHC had separate noncontributory pension plans that covered substantially all domestic employees who satisfied minimum age and length-of-service requirements (the "prior domestic plans"). Both prior domestic plans provided a defined benefit that was determined based on years of service and either annual compensation during employment or a percentage of qualifying compensation during final years of employment. Certain benefits accrued under such prior domestic plans are added to benefits accrued after January 1, 1993 under the noncontributory plan. The Corporation also maintains a number of pension plans in foreign jurisdictions covering the employees of certain foreign operations. A new defined contribution plan was adopted in 1992 for United Kingdom employees. Contributions are made to the foreign plans in accordance with local plan and legal requirements. The accompanying tables present the aggregate funded status and the net asset amounts recognized in the Consolidated Balance Sheet and the components of net pension expense recognized in the Consolidated Statement of Income for those plans in effect at the respective dates that had assets in excess of benefit obligations. At December 31, 1993, the assumptions used to determine the actuarial present value of the benefit obligation included: a 7.5% discount rate and a 5% annual rate of increase in future compensation. For 1993 expense, an 8.75% discount rate, a 6% annual rate of increase in future compensation and a 9.5% annual long-term rate of return on plan assets were assumed. The 1992 and 1991 amounts in the accompanying tables reflect the following weighted-average assumptions: discount rates of 8.75% in 1992 and 8.5% to 9.5% in 1991; annual rates of increase in future compensation of 6% in both 1992 and 1991; and annual long-term rates of return on plan assets of 9.5% in 1992, and 9% to 10% in 1991. In 1993, the changes in the benefits design in connection with the noncontributory pension plan resulted in significantly higher net periodic pension expense. The increase in the unrecognized net loss at December 31, 1993 resulted primarily from the change in assumptions. Amortization of the loss in excess of a 10% corridor will result in an increase in expense in 1994 and subsequent years. In addition, the assumed annual long-term rate of return on plan assets will be lowered to 8.5% in 1994. B67 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In 1992, the Corporation recognized a one-time, pre-tax charge of $41 million relating to costs incurred in combining the Corporation's employee benefit plans. The $41 million included: $17 million of special-window termination benefits, net of settlement and curtailment gains, that related to the prior domestic plans; and a $24 million cost for restructuring plans covering United Kingdom employees. The Corporation also has several defined benefit plans that it has elected not to prefund fully based on plan and legal requirements. At each of December 31, 1993 and 1992, the Corporation's accrued liability related to those plans totaled $43 million and $37 million, respectively, and expense was $8 million in both 1993 and 1992. Postretirement Benefits Other Than Pensions: The Corporation provides postretirement health care and life insurance benefits to substantially all domestic employees hired prior to April 15, 1992 who meet certain age and length-of-service requirements at retirement. The amount of benefits provided varies with length of service and date of hire. The Corporation has not prefunded these benefits. Effective January 1, 1993, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"). SFAS 106 requires recognition, during the years of the employees' active service, of the employer's expected cost and obligation of providing postretirement health care and other postretirement benefits other than pensions to employees and eligible dependents. The Corporation elected to expense the entire unrecognized accumulated obligation as of the date of adoption of SFAS 106 via a one-time pre-tax charge of $415 million. During 1993, the Corporation accrued $38 million of periodic expense, which was comprised of $35 million of interest and $3 million related to the cost of benefits earned during the year. Of the $38 million, $31 million related to current retirees. Through December 31, 1992, the Corporation recognized the costs of providing postretirement benefits on a cash basis. In 1992, the Corporation recognized cash-basis costs of $22 million. At December 31, 1993, the Corporation's accumulated benefit obligation totaled $481 million, of which $419 million related to current retirees, with the remainder attributable to active employees. After consideration of an unrecognized net loss of $68 million, the accrued obligation included in accounts payable and accrued expenses on the Consolidated Balance Sheet at December 31, 1993 totaled $413 million. The unrecognized net loss in excess of a 10% corridor will be amortized commencing in 1994; however, the increase in expense resulting from such amortization will be offset by lower interest cost. As of December 31, 1993, a 7.5% discount rate was used to determine the actuarial present value of the benefit obligation. A 9% rate was used to compute the 1993 interest expense. The assumed medical benefits cost trend rate was 15% for 1993, declining by 1% per year to a floor of 6%. The effect of a 1% increase in the assumed medical-benefits cost trend rate would be to increase the December 31, 1993 accumulated obligation and related periodic expense by approximately 10%. NOTE FOURTEEN EMPLOYEE STOCK INCENTIVE PLANS In 1992, the Corporation adopted a new, consolidated stock incentive plan (the "current plan"). The current plan provides for stock-based awards, including stock options and restricted stock. The former plans of the Corporation and MHC generally provided for similar types of awards. The following discussion applies to outstanding awards issued under all of the Corporation's current and former employee stock incentive plans (the "plans"). At each of December 31, 1993 and 1992, 223,365 and 587,653 shares, respectively, of the Corporation's common stock were reserved for issuance and available for future awards under the current plan. Stock options are issued at prices at least equal to the market value of the Corporation's common stock on the grant date. Under generally accepted accounting principles, no expense is currently required to be recognized in conjunction with options granted or exercised; amounts received upon the exercise of options are recorded as common stock and capital surplus. Options generally expire ten years after the grant date. Options cannot be exercised until one year after the grant date and generally become exercisable over various periods as determined in the grant. At December 31, 1993, stock options covering 4,616,083 shares of the Corporation's common stock were exercisable under the plans. B68 Restricted stock is issued and valued as of the grant date, and the value is amortized to compensation expense over the restriction period. During 1993 and 1992, 48,500 and 28,500 shares, respectively, of restricted stock were issued under the current plan. The following table presents a summary of the aggregate options transactions which occurred under all of the Corporation's plans during 1993 and 1992. NOTE FIFTEEN RESTRUCTURING CHARGES AND OTHER EXPENSE In 1993, the Corporation completed an assessment of costs associated with the merger of the Corporation and MHC and, as a result, included in noninterest expense a charge of $115 million. The charge is related principally to changes in the Corporation's facilities plans since the merger announcement and revised estimates of occupancy-related costs associated with headquarters and branch consolidations. At December 31, 1993, the merger reserve balance was approximately $80 million. The Corporation's Texas Commerce subsidiary incurred a restructuring charge of $43 million in 1993 in connection with the acquisition of assets and assumption of liabilities of the First City Banks from the FDIC. The restructuring charge is being utilized for expenses associated with cost-saving actions arising from the acquisition. These actions include the consolidation of operations and the elimination of redundant expenses. In 1991, in connection with the merger with MHC, the Corporation incurred a pre-tax restructuring charge of $625 million, principally for expenses associated with staff reductions and office consolidations. Other Expense: Included in other expense were FDIC assessments of $175 million in 1993, compared with $159 million in 1992 and $143 million in 1991. Professional services expense in 1993 was $193 million compared with $196 million in 1992 and $213 million in 1991, and marketing expense in 1993 was $187 million compared with $111 million in 1992 and $100 million in 1991. NOTE SIXTEEN INCOME TAXES The Corporation adopted SFAS 109 as of January 1, 1993 and, after taking into account the additional tax benefits associated with the adoption of SFAS 106 (see Note Thirteen), the Corporation recognized a favorable cumulative effect on income tax expense of $450 million (or $1.81 per common share). Prior-years' financial statements have not been restated to apply the provisions of SFAS 109. Prior to 1993, the Corporation followed Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" ("SFAS 96"). The primary difference between SFAS 109 and SFAS 96 is that SFAS 96 precluded the recognition of deferred tax assets the realization of which was dependent on taxable earnings of future years. SFAS 109 requires recognition of such deferred tax assets except where, in management's judgement, the realization of such tax benefits appears unlikely. The cumulative effect adjustment upon adoption of SFAS 109 was less than the unrecognized benefits available at December 31, 1992 because of the timing of anticipated future income, tax law limitations on the utilization of tax-attribute carryovers, and the recognition of losses at the two predecessor institutions in recent years. A valuation reserve was established as of January 1, 1993, in accordance with the requirements of SFAS 109, for tax benefits available to the Corporation but for which realization was in doubt. The Corporation's valuation reserve for Federal taxes of $452 million upon adoption of SFAS 109, as restated for the Omnibus Budget Reconciliation Act of 1993 ("OBRA"), was reevaluated and reduced by $331 million during 1993 due to the strength of the Corporation's earnings. The remaining Federal valuation reserve of $121 million relates to tax benefits B69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS which are subject to tax law limitations on realization. At this time, the Corporation believes that realization of these benefits is sufficiently in doubt to preclude recognition in accordance with the criteria of SFAS 109. Additionally, a valuation reserve approximating $148 million was established as of January 1, 1993 against all New York State and City deferred tax assets. Because of the lack of any loss carryover provision under New York statutes, the Corporation is uncertain at this time whether these tax benefits can be realized. The Corporation has recorded deferred New York State and City tax liabilities of approximately $202 million, after valuation reserve, as of December 31, 1993. Foreign deferred taxes are not material. On August 10, 1993, President Clinton signed OBRA, which increased the corporate Federal tax rate from 34% to 35% retroactive to January 1, 1993. The impact on current and deferred tax assets and liabilities resulted in a decrease in the Corporation's tax expense of approximately $8 million. Deferred income tax expense (benefit) results from differences between amounts of assets and liabilities as measured for income tax return and financial reporting purposes. The significant components of Federal deferred tax assets and liabilities as of December 31, 1993 are reflected in the following table. The components of income tax expense included in the Consolidated Statement of Income were as follows: Not reflected in the accompanying table are the tax effects of foreign currency translation adjustments related to the hedging of foreign net investments. Because the functional currency used in the hedging of foreign investments is not the U.S. dollar, the tax effects are recorded directly in stockholders' equity and are not included in consolidated income. These tax effects amounted to a decrease of $2 million in 1993 and $4 million in 1992 and an increase of $4 million in 1991. Additionally, the tax effects of SFAS 115 on unrealized gains and losses, with respect to available-for-sale securities, are recorded directly in stockholders' equity and in 1993 amounted to a decrease of $145 million. The tax expense applicable to securities gains and losses for the years 1993, 1992 and 1991 was $62 million, $17 million and $31 million, respectively. A reconciliation of the income tax expense computed at the applicable statutory U.S. income tax rate to the actual income tax expense for the past three years is shown in the following table. B70 The following table presents the domestic and foreign components of income before income taxes for the past three years. (a) For purposes of this disclosure, foreign income is defined by Securities and Exchange Commission regulations as income generated from operations located outside the United States. NOTE SEVENTEEN RESTRICTIONS ON CASH AND INTERCOMPANY FUNDS TRANSFERS Federal Reserve Board regulations require depository institutions to maintain cash reserves with a Federal Reserve Bank. The average amount of reserve balances deposited by the Corporation with various Federal Reserve Banks was $1 billion during both 1993 and 1992. Restrictions imposed by Federal law prohibit the Corporation and certain other affiliates from borrowing from banking subsidiaries unless the loans are secured in specified amounts. Such secured loans to the Corporation or to each of certain other affiliates generally are limited to 10% of the banking subsidiary's capital and surplus; the aggregate amount of all such loans is limited to 20% of the banking subsidiary's capital and surplus. The principal sources of the Corporation's income are dividends and interest from Chemical Bank and the other banking and non-banking subsidiaries of the Corporation. Federal law imposes limitations on the payment of dividends by the subsidiaries of the Corporation that are state member banks of the Federal Reserve System (a "state member bank") or are national banks. Under such limitations, dividend payments by such banks are limited to the lesser of (i) the amount of "undivided profits then on hand" (as defined) less the amount of "bad debts" (as defined) in excess of the allowance for losses and (ii) absent regulatory approval, an amount not in excess of "net profits" (as defined) for the current year plus "retained net profits" (as defined) for the preceding two years. Non-bank subsidiaries of the Corporation are not subject to such limitations. At December 31, 1993, in accordance with the foregoing restrictions, the Corporation's bank subsidiaries could, without the approval of their relevant banking regulators, pay dividends of approximately $1.7 billion to their respective bank holding companies, plus an additional amount equal to their net profits from January 1, 1994 through the date of any such dividend payment. In addition to dividend restrictions, the Federal Reserve Board, the Office of the Comptroller of the Currency and the FDIC have authority under the Financial Institutions Supervisory Act to prohibit or to limit the payment of dividends by the banking organizations they supervise, including the Corporation and its subsidiaries that are banks or bank holding companies, if, in the banking regulator's opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the banking organization. NOTE EIGHTEEN FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Derivatives and Foreign Exchange Products: In the normal course of its business, the Corporation utilizes various financial instruments to meet the financing needs of its customers, to generate revenues through its trading activities, and to manage its exposure to fluctuations in interest and currency rates. Derivatives and foreign exchange transactions involve, to varying degrees, credit risk and market risk. Credit risk is the possibility that a loss may occur because a party to a transaction fails to perform according to the terms of the contract. Market risk is the possibility that a change in interest or currency rates will cause the value of a financial instrument to decrease or become more costly to settle. The Corporation controls the credit risk arising from derivative and foreign exchange transactions by using the same credit procedures when entering into such transactions as it does for traditional lending products. The credit approval process involves first evaluating each counterparty's creditworthiness, then assessing the applicability of derivative instruments to the risks the counterparty is attempting to manage and determining if there are specific transaction characteristics which alter the risk profile. If collateral is deemed necessary to reduce credit risk, the amount and nature of the collateral obtained is based B71 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS on management's credit evaluation of the customer. Collateral held varies but may include cash, investment securities, accounts receivable, inventory, property, plant and equipment, and real estate. The market risk associated with derivatives and foreign exchange products, the prices of which are constantly fluctuating, is regulated by imposing strict limits as to the types, amounts and degree of risk that traders may undertake. These limits are approved by senior management, and the risk positions of traders are reviewed on a daily basis to monitor compliance with the limits. The notional principal of derivatives and foreign exchange products is the amount upon which interest and other payments in a transaction are based. For derivative transactions, the notional principal typically does not change hands; it is simply a quantity that is used to calculate payments. While notional principal is the most commonly used volume measure in the derivatives and foreign exchange markets, it is not a measure of credit exposure. The Corporation believes that the true measure of credit exposure is the replacement cost (the cost to replace the contract at current market rates should the counterparty default prior to the settlement date). This is also referred to as the mark-to-market exposure amount. Overall counterparty credit risk assumed by the Corporation is substantially reduced through master netting agreements. The Corporation enters into master netting agreements which permit the Corporation to offset the mark-to-market exposure for derivative or foreign exchange contracts with the same counterparty. During 1993, the Corporation began to expand the number of master netting agreements for all of its instruments executed with its counterparties. Credit exposure not recorded on the consolidated balance sheet at each of December 31, 1993 and 1992 is summarized in the following table. The amount of mark-to-market exposure presented for 1993 takes into account the effects of master netting agreements in effect at December 31, 1993. The Corporation's actual credit losses arising from such transactions have been immaterial during 1993, 1992 and 1991. The following table summarizes the aggregate notional amounts of interest rates and foreign exchange contracts as of December 31, 1993 and 1992. The table should be read in conjunction with the preceding narrative as well as the descriptions of these products and their risks immediately following. (a) ALM: Asset/Liability Management. B72 The Corporation deals in interest-rate and foreign exchange contracts to generate fee income and trading revenues and also utilizes interest rate contracts to manage its own asset/liability risk. Interest rate swaps are contracts in which a series of interest rate flows in a single currency are exchanged over a prescribed period. The notional amount on which the interest payments are based is not exchanged. Most interest rate swaps involve the exchange of fixed and floating interest payments. Cross-currency interest rate swaps are contracts that involve the exchange of both interest and principal amounts in two different currencies. The risks inherent in interest rate and cross currency swap contracts are the potential inability of a counterparty to meet the terms of each contract and the risk associated with changes in the market values of the underlying interest rates. To reduce its exposure to market risk, the Corporation may enter into offsetting positions. Interest rate options, which include caps and floors, are contracts which transfer, modify, or reduce interest rate risk in exchange for the payment of a premium when the contract is initiated. As a writer of interest rate caps, floors, and other options, the Corporation receives a premium in exchange for bearing the risk of unfavorable changes in interest rates. Foreign currency options are similar to interest rate option contracts, except that they are based on currencies instead of interest rates. To reduce its exposure to market risk related to writing or purchasing options the Corporation may enter into offsetting positions. Forward rate agreements are contracts to exchange payments on a certain future date, based on a market change in interest rates from trade date to contract maturity date. The maturity of these agreements is typically less than two years. To reduce its exposure to market risk, the Corporation may enter into offsetting positions. Foreign exchange contracts are contracts for the future receipt or delivery of foreign currency at previously agreed upon terms. The risks inherent in these contracts are the potential inability of a counterparty to meet the terms of each contract and the risk associated with changes in the market values of the underlying currencies. To reduce its exposure to market risk, the Corporation may enter into offsetting positions. Futures and forwards are contracts for the delayed delivery of securities or money market instruments in which the seller agrees to deliver on a specified future date, a specified instrument, at a specified price or yield. The credit risk inherent in futures is the risk that the exchange may default. Futures contracts settle in cash daily and, therefore, there is minimal credit risk to the Corporation. The credit risk inherent in forwards arises from the potential inability of counterparties to meet the terms of their contracts. Both futures and forwards are also subject to the risk of movements in interest rates or the value of the underlying securities or instruments. The Corporation enters into other contracts such as stock index option contracts and commodity contracts. Stock index option contracts are contracts to pay or receive cash flows from counterparties based upon the increase or decrease in the underlying index. Commodity contracts include swaps, caps and floors and are similar to interest rate contracts, except that they are based on commodity indices instead of interest rates. The Corporation also enters into transactions involving "when-issued securities". When-issued securities are commitments to purchase or sell securities authorized for issuance, but not yet actually issued. Accordingly, they are not recorded on the balance sheet until issued. At December 31, 1993 and 1992, commitments to purchase were $2,194 million and $2,799 million, respectively, and commitments to sell were $1,790 million and $3,158 million, respectively. Credit-related financial instruments: In meeting the financing needs of its customers, the Corporation issues commitments to extend credit, standby and other letters of credit and guarantees, and also provides securities lending services. For these instruments, the contractual amount of the financial instrument represents the maximum potential credit risk if the counterparty does not perform according to the terms of the contract. A large majority of these commitments expire without being drawn upon. As a result, total contractual amounts do not represent future credit exposure or liquidity requirements. The following table summarizes the Corporation's maximum credit risk, which is represented by contract amounts relating to these financial instruments at December 31, 1993 and 1992. (a) Excludes credit card commitments of $18 billion and $13 billion at December 31, 1993 and 1992, respectively. Unfunded commitments to extend credit are agreements to lend to a customer who has complied with predetermined contractual conditions. Commitments generally have fixed expiration dates. Standby letters of credit and guarantees are conditional commitments issued by the Corporation generally to guarantee the performance of a customer to a third party in borrowing arrangements, such as commercial paper, bond financing, construction and similar transactions. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers and may be reduced by participations to third parties. The Corporation holds collateral to support those standby letters of credit and guarantees written for which collateral is deemed necessary. At December 31, 1993, 94% of the Corporation's standby letters of credit and guarantees written expire in less than five years. B73 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Customers' securities lent are customers' securities held by the Corporation which are lent to third parties. The Corporation obtains collateral, with a market value exceeding 100% of the contract amount, for all such customers' securities lent, which is used to indemnify customers against possible losses resulting from third-party defaults. CONCENTRATIONS OF CREDIT RISK Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Concentrations of credit risk indicate the relative sensitivity of the Corporation's performance to both positive and negative developments affecting a particular industry. Based on the nature of the banking business, management does not believe that any of these concentrations are unusual. The accompanying table presents the Corporation's significant concentrations of credit risk for all financial instruments. The Corporation has procedures to monitor counterparty credit risk and to obtain collateral when deemed necessary. Accordingly, management believes that the total credit exposure shown below is not representative of the potential risk of loss inherent in the portfolio. Geographic concentrations are a factor most directly affecting the credit risk of the real estate and LDC segments of the Corporation's loan portfolio. The Corporation's real estate portfolio is primarily concentrated in the New York Metropolitan area and in Texas. Its LDC portfolio is concentrated in Latin America. NOTE NINETEEN FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments" ("SFAS 107"), requires the Corporation to disclose fair value information about financial instruments for which it is practicable to estimate the value, whether or not such financial instruments are recognized on the balance sheet. Fair value is the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation, and is best evidenced by a quoted market price if one exists. Quoted market prices are not available for a significant portion of the Corporation's financial instruments. As a result, the fair values presented are estimates derived using present value or other valuation techniques and may not be indicative of the net realizable or liquidation value. In addition, the calculation of estimated fair value is based on market conditions at a specific point in time and may not be reflective of current or future fair values. Certain financial instruments and all nonfinancial instruments are excluded from the scope of SFAS 107. Accordingly, the fair value disclosures required by SFAS 107 provide only a partial estimate of the fair value of the Corporation; for example, the values associated with the various ongoing businesses which the Corporation operates are excluded. The Corporation has estimated the value related to the long-term relationships with its customers through its deposit base and its credit card accounts, commonly referred to as core deposit intangibles and credit card relationships, respectively, as well as the value of its portfolio of mortgage servicing rights and its owned and leased premises. In the aggregate, these items add significant value to the Corporation but their fair value is not disclosed in this Note. The following summary presents the methodologies and assumptions used to estimate the fair value of the Corporation's financial instruments required to be valued pursuant to SFAS 107. B74 FINANCIAL ASSETS Assets for Which Fair Value Approximates Book Value: The fair value of certain financial assets carried at cost, including cash and due from banks, deposits with banks, federal funds sold and securities purchased under resale agreements, due from customers on acceptances, short-term receivables and accrued interest receivable is considered to approximate their respective book values due to their short-term nature and negligible credit losses. In addition, the Corporation carries trading account assets and derivatives used in trading activities at fair value. See Note One for a description of these financial instruments. Securities: Securities held-to-maturity are carried at amortized cost at each of December 31, 1993 and 1992. Securities available-for-sale and interest rate contracts used in connection with such portfolio are carried at fair value at December 31, 1993. Such securities were carried at lower of aggregate amortized cost or market value at December 31, 1992. The valuation methodologies for securities are discussed in Note Four. Loans: The fair value of the Corporation's non-LDC commercial loan portfolio was estimated by assessing the two main risk components of the portfolio: credit and interest. The estimated cash flows were adjusted to reflect the inherent credit risk and then discounted, using rates appropriate for each maturity that incorporate the effects of interest rate changes. Generally, LDC loans were valued based on secondary market prices. For consumer installment loans and residential mortgages, for which market rates for comparable loans are readily available, the fair value was estimated by discounting cash flows, adjusted for prepayments. The discount rates used for consumer installment loans were current rates offered by commercial banks and thrifts; for residential mortgages, secondary market yields for comparable mortgage-backed securities, adjusted for risk were used. The fair value of credit card receivables was estimated by discounting expected net cash flows. The discount rate used incorporated the effects of interest rate changes only, since the estimated cash flows were adjusted for credit risk. The estimated fair value of net loans increased from 100% of carrying value at December 31, 1992 to 104% of carrying value at December 31, 1993 primarily due to the positive effect of a $2.2 billion reduction in nonperforming loans during 1993. Other: Included in other assets are equity investments, venture capital investments and securities acquired as loan satisfactions. The fair value of these investments was determined on an individual basis. The valuation methodologies included market values of publicly-traded securities, independent appraisals, and cash flow analyses. FINANCIAL LIABILITIES Liabilities for Which Fair Value Approximates Book Value: SFAS 107 requires that the fair value disclosed for deposit liabilities with no stated maturity (i.e., demand, savings and certain money market deposits) be equal to the carrying value. SFAS 107 does not allow for the recognition of the inherent funding value of these instruments. The fair value of foreign deposits, federal funds purchased and securities sold under repurchase agreements, other borrowed funds, acceptances outstanding, short-term payables and accounts payable and accrued liabilities are considered to approximate their respective book values due to their short-term nature. Domestic Time Deposits: The fair value of time deposits was estimated by discounting cash flows based on contractual maturities at the average interest rates offered by commercial banks and thrifts. Long-Term Debt: The valuation of long-term debt takes into account several factors, including current market interest rates and the Corporation's credit rating. Quotes were gathered from various investment banking firms for indicative yields for the Corporation's securities over a range of maturities. Derivatives Used for Asset/Liability Management: The Corporation employs off-balance sheet financial instruments to manage its asset/liability exposure to fluctuations in interest rates. These instruments are mostly used to manage overall exposure as opposed to hedging specific on-balance sheet items. The estimated fair value and carrying value of these instruments at December 31, 1993 was $725 million and $300 million, respectively. The estimated fair value and carrying value of these instruments at December 31, 1992 was $756 million and $246 million, respectively. Interest rate contracts were valued at the net present value of expected cash flows based upon prevailing market rates. Unused Commitments and Letters of Credit: The Corporation has reviewed the unfunded portion of commitments to extend credit as well as standby and other letters of credit, and has determined that the fair value of such financial instruments is not material. The following table presents the financial assets and liabilities required to be valued for SFAS 107. B75 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (a) Estimated fair value in 1993 includes a decrease of approximately $2 million representing estimated fair value amounts of interest rate contracts, used in connection with available-for-sale securities. (b) Estimated fair value in 1993 includes an increase of approximately $2 million representing estimated fair value amounts of interest rate contracts, used in connection with mortgages held-for-sale. (c) Estimated fair value in 1993 includes an increase of approximately $7 million representing estimated fair value amounts of interest rate contracts, used in connection with long-term debt. NOTE TWENTY COMMITMENTS AND CONTINGENCIES At December 31, 1993, the Corporation and its subsidiaries were obligated under a number of noncancelable operating leases for premises and equipment used primarily for banking purposes. Certain leases contain rent escalation clauses for real estate taxes and other operating expenses and renewal option clauses calling for increased rents. No lease agreement imposes any restrictions on the Corporation affecting its ability to pay dividends, engage in debt or equity financing transactions or to enter into further lease agreements. Future minimum rental payments required under operating leases with initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993 were as follows: Total rental expense in 1993, 1992 and 1991 was as follows: At December 31, 1993 and 1992, assets amounting to $18 billion and $26 billion, respectively, were pledged to secure public deposits and for other purposes. The significant components of the $18 billion of assets pledged at December 31, 1993 to secure public deposits and for other purposes were as follows: $4 billion were securities, $8 billion were loans, and the remaining $6 billion were primarily trading account assets. These amounts compare with $11 billion of securities, $8 billion of loans and $7 billion of trading account assets pledged at December 31, 1992. The Corporation and its subsidiaries are defendants in a number of legal proceedings. After reviewing with counsel all such actions and proceedings pending against or involving the Corporation and its subsidiaries, management does not expect the aggregate liability or loss, if any, resulting therefrom to have a material adverse effect on the consolidated financial condition of the Corporation. B76 NOTE TWENTYONE INTERNATIONAL OPERATIONS The accompanying table presents total assets and income statement information for 1993, 1992 and 1991 pertaining to international and domestic operations of the Corporation by major geographic areas, based on the domicile of the customer. The Corporation defines international activities as business transactions that involve customers residing outside of the United States. However, a definitive separation of the Corporation's domestic and foreign businesses cannot be performed because many of the Corporation's domestic operations service international business. As these operations are highly integrated, estimates and subjective assumptions have been made to apportion revenue and expenses between domestic and international operations. Estimates of the following are allocated on a management accounting basis: stockholders' equity, interest costs charged to users of funds, and overhead, administrative and other expenses incurred by one area on behalf of another. The provision for losses is allocated based on actual net charge-offs and changes in outstandings. Although the Corporation considers the balance in the non-LDC allowance for losses to be available for both domestic and foreign losses, a portion of the allowance is allocated, based on a methodology consistent with the allocation of the provision for losses, to international operations. (a) No geographic region included in other international amounts to more than 10% of the total for the Corporation. NOTE TWENTYTWO PARENT COMPANY Condensed financial information of Chemical Banking Corporation, the Parent Company, is presented on the next page. For purposes of preparing the Statement of Cash Flows, cash and cash equivalents are those amounts included in the balance sheet caption cash with banks. B77 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (a) At December 31, 1993, aggregate annual maturities and sinking fund requirements for all issues for the years 1994 through 1998 were $937 million, $844 million, $679 million, $472 million, and $596 million, respectively. B78 NOTE TWENTYTHREE SHAREHOLDERS' RIGHTS PLAN The Corporation has in place a Shareholders' Rights Plan. The Shareholders' Rights Plan contains provisions intended to protect stockholders in the event of unsolicited offers or attempts to acquire the Corporation, including offers that do not treat all stockholders equally, acquisitions in the open market of shares constituting control without offering fair value to all stockholders, and other coercive or unfair takeover tactics that could impair the Board of Directors' ability to represent stockholders' interests fully. The Shareholders' Rights Plan provides that attached to each share of common stock is one right (a "Right") to purchase a unit consisting of one one-hundredth of a share (a "Unit") of Junior Participating Preferred Stock for an exercise price of $150 per unit, subject to adjustment. The Rights have certain anti-takeover effects. The Rights may cause substantial dilution to a person that attempts to acquire the Corporation without the approval of the Board of Directors unless the offer is conditioned on a substantial number of Rights being acquired. The Rights, however, should not affect offers for all outstanding shares of common stock at a fair price and otherwise in the best interests of the Corporation and its stockholders as determined by the Board of Directors. The Board of Directors may, at its option, redeem all, but not fewer than all, of the then outstanding Rights at any time until the 10th business day following a public announcement that a person or a group had acquired beneficial ownership of 20% or more of the Corporation's outstanding common stock or total voting power. (a) The Corporation's common stock is listed and traded on the New York Stock Exchange and the International Stock Exchange of the United Kingdom and Republic of Ireland. The high, low and closing prices of the Corporation's common stock are from the New York Stock Exchange Composite Transaction Tape. B79 AVERAGE CONSOLIDATED BALANCE SHEET, INTEREST AND RATES Fees and commissions on loans included in loan interest amounted to $176 million, $159 million, $149 million, $162 million and $204 million in 1993-1989, respectively. The ratio of average stockholders' equity to average assets was 7.3%, 6.7%, 5.4%, 5.1% and 4.8% in 1993-1989, respectively. B80 B81 CHEMICAL BANK AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET B82 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 behalf of the undersigned, thereunto duly authorized on the 15th day of March, 1994. CHEMICAL BANKING CORPORATION (Registrant) By WALTER V. SHIPLEY ---------------------- (Walter V. Shipley, Chairman of the Board and Chief Executive Officer) This report has been reviewed by each member of the Board of Directors and pursuant to the requirements of the Securities Exchange Act of 1934, signed on behalf of the registrant by members present at the meeting of the Board of Directors on the date indicated. The Corporation does not exercise the power of attorney to sign on behalf of any Director. APPENDIX I NARRATIVE DESCRIPTION OF GRAPHIC IMAGE MATERIAL Pursuant to Item 304 of Regulation S-T, the following is a description of the graphic image material included in the foregoing Management's Discussion and Analysis of Financial Condition and Results of Operations in Section B. EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION - - - ------- -----------

4969_1993.txt

4969_1993

1993

4969

Item 1. BUSINESS. Introduction American Express Credit Corporation (including its subsidiaries, where appropriate, "Credco") was incorporated in Delaware in 1962 and was acquired by American Express Company ("American Express") in December 1965. On January 1, 1983, Credco became a wholly-owned subsidiary of American Express Travel Related Services Company, Inc. (including its subsidiaries, where appropriate, "TRS"), a wholly-owned subsidiary of American Express. Credco is primarily engaged in the business of purchasing most Cardmember receivables arising from the use of the American Express R Card, including the American Express R Gold Card, Platinum Card R and Corporate Card issued in the United States, and certain related extended payment plan receivables, and in designated currencies outside the United States. Credco also purchases certain receivables arising from the use of the Optima sm Card. The American Express Card and the Optima Card are referred to herein as the "Card". American Express Card Business The Card is issued by TRS. Cards are currently issued in 32 currencies. The Card, which is issued to individuals for their personal account or through a corporate account established by their employer, permits Cardmembers to charge purchases of goods and services in the United States and in most countries around the world at establishments that have agreed to accept the Card. As of December 31, 1993, there were 3.6 million establishments worldwide that have agreed to accept the Card. TRS accepts from each participating establishment the charges arising from Cardmember purchases at a discount that varies with the type of participating establishment, the volume of charges, the timing and method of payment to the establishment and the method of submission. At December 31, 1993 there were 35.4 million American Express Cards in force worldwide. In 1993, Card billed business was $124 billion. Except in the case of the Optima Card, the Card is primarily designed for use as a method of payment and not as a means of financing purchases of goods and services and carries no pre-set spending limit. Charges are approved based on a Cardmember's past spending and payment patterns, credit history and personal resources. Except in the case of the Optima Card and certain extended payment plans such as the Sign & Travel R account, payment of the full amount billed each month is due from the Cardmember upon receipt of the bill, and no finance charges are assessed. Card accounts that are past due by a given number of days are subject, in most cases, to a delinquency assessment. The Optima Card is a revolving credit card which is marketed to individuals in the United States and several other countries. The American Express Card and consumer lending businesses are subject to extensive regulation in the United States under a number of federal laws and regulations. Federal legislation regulates abusive debt collection practices. In addition, a number of states and foreign countries also have similar consumer credit protection and disclosure laws. Outside the United States, certain countries similarly regulate the provision of credit and protection of Cardmembers' rights. These laws and regulations have not had, and are not expected to have, a material adverse effect on the Card and consumer lending businesses, either in the United States or on a worldwide basis. General Nature of Credco's Business Credco purchases certain Cardmember receivables arising from the use of the Card throughout the world pursuant to agreements (the "Receivables Agreements") with TRS. Net income primarily depends on the volume of receivables arising from the use of the Card purchased by Credco, the discount rates applicable thereto, the relationship of total discount to Credco's interest expense and the collectibility of the receivables purchased. The average life and collectibility of accounts receivable generated by the use of the Card are affected by factors such as general economic conditions, overall levels of consumer debt and the number of new Cards issued. Credco purchases Cardmember receivables without recourse. Amounts resulting from unauthorized charges (for example, those made with a lost or stolen Card) are excluded from the definition of "receivables" under the Receivables Agreements and are not eligible for purchase by Credco. If the unauthorized nature of the charge is discovered after purchase by Credco, the charge is repurchased from Credco. Credco generally purchases non-interest-bearing Cardmember receivables at face amount less a specified discount agreed upon from time to time and interest-bearing Cardmember receivables at face amount. The Receivables Agreements generally require that non-interest-bearing receivables be purchased at discount rates which yield to Credco earnings of not less than 1.25 times its fixed charges on an annual basis. The Receivables Agreements also provide that consideration will be given from time to time to revising the discount rate applicable to purchases of new receivables to reflect changes in money market rates or significant changes in the collectibility of receivables. Since January 1, 1989, the annual average discount rates have varied between 1.04 and 1.78 percent, and averaged 1.04 percent for 1993. New groups of Cardmember receivables are generally purchased net of reserve balances applicable thereto. Extended payment plan receivables are primarily funded by subsidiaries of TRS other than Credco; however, Credco purchases certain extended payment plan receivables. At both December 31, 1993 and 1992, extended payment plan receivables owned by Credco totalled $1.1 billion, representing 8.8 percent and 9.6 percent, respectively, of all receivables owned by Credco. These extended payment plan receivables consist of deferred merchandise receivables and certain interest-bearing extended payment plan receivables comprised principally of Optima and Sign & Travel accounts. In August 1992, a trust was formed by TRS to purchase certain Cardmember receivables as part of an asset securitization program. In September 1993 and August 1992, Credco sold back to TRS $1 billion and $2.4 billion, respectively, of gross receivables that arose from designated domestic Cardmember accounts. TRS conveyed, through a subsidiary, American Express Receivables Financing Corporation ("RFC"), these receivables, together with the right to receive subsequent receivables arising from such Cardmember accounts, to a Master Trust. In 1993 and 1992, Credco purchased $380 million and $1.3 billion, respectively, of gross participation interests in RFC's seller's interest, representing an undivided interest in the securitized receivables owned by the Trust. Participation interests in securitized receivables represented 15.4 percent and 13.5 percent of Credco's total accounts receivable at December 31, 1993 and 1992, respectively. The Card Issuers, at their expense and as agents for Credco, perform accounting, clerical and other services necessary to bill and collect all Cardmember receivables owned by Credco. The Receivables Agreements provide that, without prior written consent of Credco, the credit standards used to determine whether a Card is to be issued to an applicant may not be materially reduced and that the policy as to the cancellation of Cards for credit reasons may not be materially liberalized. The Receivables Agreements may be terminated at any time by the parties thereto. Alternatively, such parties may agree to reduce the required 1.25 fixed charge coverage ratio, which could result in lower discount rates and, consequently, lower revenue and net income of Credco. Volume of Business The following table shows the volume of Cardmember receivables purchased by Credco net of Cardmember receivables sold to affiliates during each of the years indicated, together with the receivables owned by Credco at the end of such years (in millions): Volume of Cardmember Cardmember Receivables Owned Receivables Purchased at December 31, Year Domestic Foreign Total Domestic Foreign Total - ---- -------- ------- -------- -------- ------- ------- 1993 $80,202 $14,635 $ 94,837 $10,758 $2,210 $12,968 1992 81,311 13,041 94,352 10,412 1,287 11,699 1991 80,844 18,934 99,778 10,581 1,639 12,220 1990 87,323 16,117 103,440 11,278 1,790 13,068 1989 76,432 14,152 90,584 10,089 644 10,733 The transactions in connection with TRS's asset securitization program described above reduced the volume of domestic Cardmember receivables purchased and the amount owned by Credco at December 31, 1993 and 1992. In July 1993, Credco began purchasing certain foreign currency Cardmember receivables which had been sold to an affiliate during the period from December 1991 through June 1993. In December 1993, Credco repurchased participation interests in a portion of its receivables which had previously been sold to an affiliate during the period from December 1991 through November 1993. These transactions increased the volume of foreign Cardmember receivables purchased and the amount owned by Credco at December 31, 1993. The average life of Cardmember receivables owned by Credco for each of the five years ending December 31, 1993 (based upon the ratio of the average amount of both billed and unbilled receivables owned by Credco at the end of each month during the years indicated to the volume of Cardmember receivables purchased by Credco, net of Cardmember receivables sold to affiliates) was 43 days. The following table shows the aging of billed Cardmember receivables: December 31, ----------------------- 1993 1992 ------------------------------------------------------- Current 80.5% 77.8% 30 to 59 days 14.0 15.5 60 to 89 days 2.0 2.3 90 days and over 3.5 4.4 Loss Experience Credco generally writes off against its reserve for doubtful accounts the total balance in an account for which any portion remains unpaid 12 months from the date of original billing. Accounts are written off earlier if deemed uncollectible. The following table sets forth Credco's write-offs, net of recoveries for the year, expressed as a percentage of the volume of Cardmember receivables purchased by Credco, net of Cardmember receivables sold to affiliates, in each of the years indicated: Year - ----------------------------------------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- .57% .70% .81% .70% .57% Sources of Funds Credco's business is financed by short-term borrowings consisting principally of commercial paper, borrowings under bank lines of credit and sales of medium- and long-term debt, as well as through operations. The weighted average interest costs on an annual basis of all borrowings, after giving effect to commitment fees under lines of credit and the cost of interest rate swaps, during the following years were: Weighted Average Year Interest Cost ---- ---------------- 1993 4.61% 1992 5.80 1991 7.54 1990 8.85 1989 9.44 From time to time, American Express and certain of its subsidiaries purchase Credco's commercial paper at prevailing rates, enter into variable rate note agreements at interest rates generally above the 13-week treasury bill rate and provide lines of credit. The largest amount of borrowings from American Express or its subsidiaries at any month end during the five years ended December 31, 1993 was $2.5 billion. At December 31, 1993, the amount borrowed was $588 million. See notes 4 and 5 in "Notes to Consolidated Financial Statements" appearing herein for information about Credco's debt, including Credco's lines of credit from various banks and long-term debt. Foreign Operations See notes 2, 7 and 10 in "Notes to Consolidated Financial Statements" appearing herein for information about Credco's foreign exchange risks and operations in different geographical regions. Employees On December 31, 1993, Credco had 60 employees. Item 2. Item 2. PROPERTIES. Credco neither owns nor leases any material physical properties. Item 3. Item 3. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which Credco or its subsidiaries is a party or of which any of their property is the subject. Credco knows of no such proceedings being contemplated by government authorities or other parties. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted pursuant to General Instruction J(2)(c) to Form l0-K. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. American Express, through a wholly-owned subsidiary, TRS, owns all of the outstanding common stock of Credco. Therefore, there is no market for Credco's common stock. Credco paid a dividend of $125 million and $250 million to TRS in December, 1993 and 1992, respectively. For information about limitations on Credco's ability to pay dividends, see note 6 in "Notes to Consolidated Financial Statements" herein. Item 6. Item 6. SELECTED FINANCIAL DATA. The following summary of certain consolidated financial information of Credco was derived from audited financial statements for the five years ended December 31, 1993. 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- (dollars in millions) Income Statement Data Revenues 1,282 1,605 2,070 2,131 1,731 Interest expense 599 728 946 1,022 898 Provision for doubtful accounts, net of recoveries 475 661 855 811 565 Income tax provision 64 70 87 99 71 Extraordinary charge net of taxes 22 - - - - Net income 115 138 174 191 190 Balance Sheet Data Accounts receivable 12,968 11,699 12,220 13,068 10,733 Reserve for doubtful accounts (542) (603) (731) (719) (550) Total assets 14,943 13,631 14,127 14,222 12,610 Short-term debt 9,738 7,581 7,918 7,450 5,506 Current portion of long-term debt 692 969 768 823 771 Long-term debt 1,776 2,303 3,136 3,403 3,795 Shareholder's equity 1,662 1,672 1,784 1,610 1,422 Dividends Cash Dividends 125 250 - - - Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Liquidity and Capital Resources Credco's receivables portfolio consists of charge card receivables, participation interests in charge card receivables and extended payment plan receivables purchased without recourse from American Express Travel Related Services Company, Inc. and certain of its subsidiaries ("TRS") throughout the world. At December 31, 1993 and 1992, respectively, Credco owned $11.8 billion and $10.6 billion of charge card receivables and participations in charge card receivables, representing 91.2 percent and 90.4 percent of the total receivables owned, and $1.1 billion of extended payment plan receivables, representing 8.8 percent and 9.6 percent of the total receivables owned. At December 31, 1993 and 1992, $2 billion of variable rate loans made to American Express Centurion Bank ("Centurion Bank") were outstanding, which are secured by Optima receivables owned by Centurion Bank. The loan agreements require Centurion Bank to maintain, as collateral, Optima receivables equal to the outstanding loan balance plus an amount equal to three times the receivable reserve as applicable to such Optima receivables. Credco's assets are financed through a combination of short-term debt, long- term senior notes, equity capital and retained earnings. Daily funding requirements are met primarily by the sale of commercial paper. Credco has readily sold the volume of commercial paper necessary to meet its funding needs as well as to cover the daily maturities of commercial paper issued. The average amount of commercial paper outstanding was $8.7 billion for 1993 and $7.7 billion for 1992. An alternate source of borrowing consists of committed credit line facilities. The aggregate commitment of these facilities is generally maintained at 50 percent of short-term debt, net of short-term investments and cash equivalents. At December 31, 1993 and 1992, Credco, through its wholly-owned subsidiary, American Express Overseas Credit Corporation Limited ("AEOCC"), had outstanding borrowings of $58.4 million and $9.7 million, respectively, under these committed lines of credit. In addition, Credco, through AEOCC, had short-term borrowings under uncommitted lines of credit totalling $65 million and $37.2 million at December 31, 1993 and 1992, respectively. During 1993, Credco issued $606 million of medium- and long-term debt. The proceeds were used to reduce short-term debt incurred primarily in connection with the purchase of Cardmember receivables. During 1993, 1992 and 1991, the average long-term debt outstanding was $2.8 billion, $3.7 billion and $4.0 billion, respectively. At December 31, 1993, Credco had $810 million of medium- and long-term debt which may be issued under shelf registrations filed with the Securities and Exchange Commission. Credco has realigned its long-term debt financing strategy to better match its its liabilities with its assets. In connection with this realigned strategy, during 1993 Credco reduced its high coupon long-term debt through the defeasance of $498 million of long-term debt and the retirement of an additional $153.8 million of long-term debt through a series of open market purchases. These transactions resulted in an extraordinary charge net of income tax, of $22 million. In addition, Credco canceled an interest rate swaption resulting in additional interest expense of $13 million. Credco paid dividends to TRS of $125 million and $250 million in December, 1993 and 1992, respectively. Results of Operations Credco purchases Cardmember receivables without recourse from TRS. Non-interest-bearing Cardmember receivables are purchased at face amount less a specified discount agreed upon from time to time, and interest-bearing Cardmember receivables are purchased at face amount. Non-interest-bearing receivables are purchased under Receivables Agreements that generally provide that the discount rate shall not be lower than a rate that yields earnings of at least 1.25 times fixed charges on an annual basis. The ratio of earnings to fixed charges was 1.34, 1.29 and 1.28 in 1993, 1992 and 1991, respectively. The ratio of earnings to fixed charges in 1993 calculated in accordance with the Receivables Agreements after the impact of the extraordinary charge was 1.28. The Receivables Agreements also provide that consideration will be given from time to time to revising the discount rate applicable to purchases of new receivables to reflect changes in money market interest rates or significant changes in the collectibility of receivables. Pretax income depends primarily on the volume of Cardmember receivables purchased, the discount rates applicable thereto, the relationship of total discount to Credco's interest expense and the collectibility of the receivables purchased. The average life of Cardmember receivables was 43 days for each of the years ended December 31, 1993, 1992 and 1991. During 1993 and 1992 Credco sold participation interests in a portion of its receivables to an affiliate. These transactions were partly responsible for the decreased revenues from purchased Cardmember receivables which was offset by decreased interest expense and provision for doubtful accounts. Credco's operating results for the year ended December 31, 1993 include a $6 million one-time benefit from the change in the U.S. federal income tax rate (from 34 percent to 35 percent) in Credco's deferred tax assets. The following is an analysis of the (decrease) increase in key revenue and expense accounts (in millions): - ----------------------------------------------------------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Revenue earned from purchased accounts receivable-changes attributable to: Volume of receivables purchased $ 24 $ (89) $ (50) Discount rate (334) (333) (29) - ----------------------------------------------------------------------------- Total $(310) $(422) $ (79) - ----------------------------------------------------------------------------- Interest income from affiliates-changes attributable to: Average loan $ (7) $ 19 $ 28 Interest rates (14) (51) (49) - ----------------------------------------------------------------------------- Total $ (21) $ (32) $ (21) - ----------------------------------------------------------------------------- Interest income from investments-changes attributable to: Average investments $ 14 $ 34 $ 65 Interest rates (11) (40) (27) - ----------------------------------------------------------------------------- Total $ 3 $ (6) $ 38 - ----------------------------------------------------------------------------- Interest expense-changes attributable to: Average debt $ 24 $ 1 $ 88 Interest rates (153) (219) (164) - ----------------------------------------------------------------------------- Total $(129) $(218) $ (76) - ----------------------------------------------------------------------------- Provision for doubtful accounts-changes attributable to: Volume of receivables purchased $ 9 $ (57) $ (27) Provision rates and volume of recoveries (195) (137) 71 - ----------------------------------------------------------------------------- Total $(186) $(194) $ 44 - ----------------------------------------------------------------------------- Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. 1. Financial Statements. See "Index to Financial Statements" at page hereof. 2. Supplementary Financial Information. (a) Selected quarterly financial data. See note 11 in "Notes to Consolidated 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. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. Item 11. Item 11. EXECUTIVE COMPENSATION. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Omitted pursuant to General Instruction J(2)(c) to Form 10-K. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. Financial Statements: See "Index to Financial Statements" at page hereof. 2. Financial Statement Schedules: See "Index to Financial Statements" at page hereof. 3. Exhibits: See "Exhibit Index" hereof. (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. AMERICAN EXPRESS CREDIT CORPORATION (Registrant) DATE March 30, 1994 /s/ Vincent P. Lisanke -------------- ------------------------------- Vincent P. Lisanke President and Chief Executive Officer 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 dates indicated. DATE March 30, 1994 /s/ Vincent P. Lisanke -------------- -------------------------------- Vincent P. Lisanke President, Chief Executive Officer and Director DATE March 30, 1994 /s/ Walter S. Berman -------------- -------------------------------- Walter S. Berman Chairman of the Board and Director (principal financial officer) DATE March 30, 1994 /s/ C. J. Martin -------------- -------------------------------- C. J. Martin Vice President-Finance (principal accounting officer) DATE March 30, 1994 /s/ Michael P. Monaco -------------- -------------------------------- Michael P. Monaco Director AMERICAN EXPRESS CREDIT CORPORATION COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14(a)) Page Number -------------------------- Form 10-K Financial Statements Report of independent auditors............... F - 2 Consolidated statements of income for the three years ended December 31, 1993 ......... F - 3 Consolidated statements of retained earnings for the three years ended December 31, 1993 . F - 3 Consolidated balance sheets at December 31, 1993 and 1992 ............................... F - 4 Consolidated statements of cash flows for the three years ended December 31, 1993...... F - 5 Notes to consolidated financial statements .. F - 6 to F - 14 Schedules: VIII - Valuation and qualifying accounts for the years ended December 31, 1993, 1992 and 1991 ....................... F - 15 IX - Short-term borrowings at and for the years ended December 31, 1993, 1992 and 1991 ............................. F - 16 All other schedules are omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or notes thereto. F - 1 REPORT OF INDEPENDENT AUDITORS - ------------------------------------------------------------------------------- The Board of Directors American Express Credit Corporation We have audited the accompanying consolidated balance sheets of American Express Credit 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 American Express Credit 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 American Express Credit 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. Ernst & Young New York, New York February 3, 1994 F - 2 AMERICAN EXPRESS CREDIT CORPORATION CONSOLIDATED STATEMENTS OF INCOME (millions) Year Ended December 31, 1993 1992 1991 Revenues Revenue earned from purchased accounts receivable $1,139 $1,449 $1,871 Interest income from affiliates 70 91 123 Interest income from investments 67 64 70 Other income 6 1 6 Total $1,282 1,605 2,070 Expenses Interest 599 728 946 Provision for doubtful accounts, net of recoveries of $175, $201 and $217 475 661 855 Operating expenses 7 8 8 Total 1,081 1,397 1,809 Income before taxes 201 208 261 Income tax provision 64 70 87 Income before extraordinary charges 137 138 174 Extraordinary charges for early retirement of debt (net of income taxes of $12 million) 22 - - Net income $ 115 $ 138 $ 174 CONSOLIDATED STATEMENTS OF RETAINED EARNINGS (millions) Year Ended December 31, 1993 1992 1991 Retained earnings at beginning of year $1,542 $1,654 $1,480 Dividend paid to TRS (125) (250) - Net income 115 138 174 Retained earnings at end of year $1,532 $1,542 $1,654 See notes to consolidated financial statements. F - 3 AMERICAN EXPRESS CREDIT CORPORATION CONSOLIDATED BALANCE SHEETS (millions) December 31, 1993 1992 Assets Cash and cash equivalents $ 257 $ 126 Accounts receivable 12,968 11,699 Less reserve for doubtful accounts 542 603 12,426 11,096 Loans and deposits with affiliates 2,000 2,140 Deferred charges and other assets 260 269 Total assets $14,943 $13,631 Liabilities and Shareholder's Equity Short-term debt $ 9,738 $ 7,581 Current portion of long-term debt 692 969 Long-term debt 1,776 2,303 Due to affiliates 932 895 Accrued interest and other liabilities 97 140 Total liabilities 13,235 11,888 Deferred discount revenue 46 71 Shareholder's equity: Common stock-authorized 3,000,000 shares of $.10 par value; issued and outstanding 1,504,938 shares 1 1 Capital surplus 129 129 Retained earnings 1,532 1,542 Total shareholder's equity 1,662 1,672 Total liabilities and shareholder's equity $14,943 $13,631 See notes to consolidated financial statements. F - 4 AMERICAN EXPRESS CREDIT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (millions) Year Ended December 31, 1993 1992 1991 Cash Flows From Operating Activities: Net Income $ 115 $ 138 $ 174 Adjustments to reconcile net income to net cash provided by operating activities: Extraordinary charge for early retirement of debt 34 - - Provision for doubtful accounts, net of recoveries 475 661 855 Amortization of deferred underwriting fees and bond discount/premium 5 4 8 (Decrease) in deferred discount revenue (26) (23) (14) Decrease (increase) in deferred tax assets 46 6 (37) (Increase) decrease in interest receivable and operating assets (33) 24 (13) (Decrease) in accrued interest and other liabilities (43) (1) (9) (Decrease) increase in due to affiliates (16) (5) 50 Net cash provided by operating activities 557 804 1,014 Cash Flows From Investing Activities: Proceeds from maturities of investments - - 10 Increase in accounts receivable (2,488) (1,874) (489) Sale of participation interests in accounts receivable to an affiliate - 297 292 Sale of net accounts receivable to an affiliate 914 2,202 - Repurchase of participation interests from affiliates (435) (1,207) - Recoveries of accounts receivable previously written off 175 201 217 Repayment from affiliates of loans and deposits 141 - 168 Loans and deposits made to affiliates - (140) (660) Increase (decrease) in due to affiliates 62 692 (451) Net cash (used in) provided by investing activities (1,631) 171 (913) Cash Flows From Financing Activities: Increase (decrease) in short-term debt, net 6 197 (806) Proceeds from issuance of debt 9,071 4,750 6,103 Redemption of debt (7,747) (5,871) (5,166) Dividend paid to TRS (125) (250) - Net cash provided by (used in) financing activities 1,205 (1,174) 131 Effect of exchange rate changes on cash and cash equivalents - (2) - Net increase (decrease) in cash equivalents 131 (201) 232 Cash and cash equivalents at beginning of year 126 327 95 Cash and cash equivalents at end of year $ 257 $ 126 $ 327 See notes to consolidated financial statements. F - 5 AMERICAN EXPRESS CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation American Express Credit Corporation and its subsidiaries ("Credco") is a wholly-owned subsidiary of American Express Travel Related Services Company, Inc. ("TRS"), which is a wholly-owned subsidiary of American Express Company ("American Express"). American Express Overseas Credit Corporation Limited and its subsidiaries ("AEOCC") and Credco Receivables Corp. ("CRC") are wholly owned subsidiaries of Credco. 2. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of Credco and all its subsidiaries. All significant intercompany transactions have been eliminated. Revenue Earned from Purchased Accounts Receivable A portion of discount revenue earned on purchases of non-interest-bearing Cardmember receivables equal to the provision for doubtful accounts is recognized as income at the time of purchase; the remaining portion is deferred and recorded as income ratably over the period that the receivables are outstanding. Finance charge income on interest-bearing extended payment plan receivables is recognized as it is earned. Credco ceases accruing this income after six contractual payments are past due, or earlier, if deemed uncollectible. Accruals that cease generally are not resumed. Reserve for Doubtful Accounts The reserve for doubtful accounts is established at the time receivables are purchased and is based on historical collection experience and evaluation of the current status of existing receivable balances. Credco generally writes off against its reserve for doubtful accounts the total balance in an account for which any portion remains unpaid twelve months from the date of original billing for non-interest-bearing Cardmember receivables and after six contractual payments are past due for interest-bearing Cardmember receivables. Accounts are written off earlier if deemed uncollectible. Fair Values of Financial Instruments The fair values of financial instruments are estimates based upon current market conditions and perceived risks at December 31, 1993 and 1992 and require varying degrees of management judgment. The fair values of long-term debt and off-balance sheet financial instruments are included in the related footnotes. For all other financial instruments, the carrying amounts in the Consolidated Balance Sheets approximate the fair values. Interest Rate Transactions Credco enters into various interest rate agreements as a means of hedging its interest rate exposure. The net interest receivable or payable in these agreements is recorded as an adjustment to interest expense and is recognized in earnings over the life of the agreements. Foreign Currency Foreign currency assets and liabilities are translated into their U.S. dollar equivalents based on rates of exchange prevailing at the end of each year. Revenue and expense accounts are translated at exchange rates prevailing during the year. Credco enters into various foreign exchange transactions as a means of hedging foreign exchange exposure. Foreign exchange contracts generally are marked-to-market, with the unrealized gain or loss offset by the gain or loss on the hedged position. The net foreign exchange losses for 1993, 1992 and 1991 were not significant. Cash and Cash Equivalents Credco has defined cash and cash equivalents as cash and short-term investments with a maturity of ninety days or less at the time of purchase. 3. Accounts Receivable At December 31, 1993 and 1992, respectively, Credco owned $11.8 billion and $10.6 billion of charge card receivables and participations in charge card receivables, representing 91.2 percent and 90.4 percent of the total receivables owned. In 1992, Credco purchased participation interests in the seller's interest in Cardmember receivables owned by a Master Trust which was formed by TRS as part of an asset securitization program. In September 1993, Credco purchased additional participation interests. At December 31, 1993 and 1992, Credco owned approximately $2 billion and $1.6 billion, respectively, of participation interests in receivables, representing 15.4 percent and 13.5 percent, respectively, of its total accounts receivable. Credco purchases certain billed and unbilled Cardmember receivables arising from extended payment plans from certain TRS subsidiaries. Credco owned $1.1 billion of these receivables as of December 31, 1993 and 1992, representing 8.8 percent and 9.6 percent, respectively, of its total accounts receivable. Finance charges on such interest-bearing extended payment plan receivables ranged from .75 percent to 1.75 percent per month of the unpaid receivable balance as of December 31, 1993. These finance charges, which are included in revenues, were $136 million, $149 million and $140 million for 1993, 1992 and 1991, respectively. 4. Short-term Debt At December 31, short-term debt consisted of (millions): 1993 1992 Commercial paper $8,810 $6,977 Borrowings from affiliates 588 390 Borrowings under lines of credit 123 47 Borrowing agreements with bank trust departments and others 217 167 Total short-term debt $9,738 $7,581 Credco has various facilities available to obtain short-term credit, including the issuance of commercial paper and agreements with banks. Credco had unused committed credit lines totalling $4.4 billion and $3.4 billion at December 31, 1993 and 1992, respectively. Credco pays fees to the financial institutions that provide these credit line facilities. The fair value of the unused lines of credit is not significant at December 31, 1993 and 1992. At December 31, 1993 and 1992, Credco, through AEOCC, had short-term borrowings under uncommitted lines of credit totalling $65 million and $37.2 million, respectively, and borrowings under committed lines of credit totalling $58.4 million and $9.7 million, respectively. Credco's annual weighted average short-term interest rate was 3.57 percent, 4.73 percent and 6.75 percent for the years ended December 31, 1993, 1992 and 1991, respectively. These rates include the cost of maintaining credit line facilities for the periods and the effect of interest rate swaps. Credco paid $347 million, $354 million and $590 million of interest on short-term debt obligations in 1993, 1992 and 1991, respectively. 5. Long-term Debt At December 31, long-term debt consisted of (millions): 1993 1992 Senior notes, 6.125% to 11.625% due through 2005 $1,287 $1,714 Japanese yen senior bonds and loans, 4.9% to 8% due through 1996 218 252 Pound sterling note, 10% due 1994 - 60 Canadian dollar note, 9% due 1994 - 47 Borrowing agreements with bank trust departments - 10 Other senior notes 7 10 Medium-term notes 270 218 Net unamortized bond discount (6) (8) Total long-term debt $1,776 $2,303 Current portion: Senior notes, 7.375% to 11.625% $ 400 $ 481 Canadian dollar notes, 9% to 11.7% 45 74 Pound sterling notes, 9.625% to 10% 60 75 Japanese yen bonds, 5.875% to 6.9 33 110 Other senior notes - 2 Medium-term notes 154 227 Total current portion of long-term debt $ 692 $ 969 The book value of variable rate long-term debt that reprices within a year approximates fair value. The fair value of other long-term debt is based on quoted market price or discounted cash flow. The aggregate fair value of Credco's long-term debt including the current portion outstanding at December 31, 1993 and 1992 was $2.6 billion and $3.4 billion, respectively. Aggregate annual maturities of debt for the five years ending December 31, 1998 are as follows (millions): 1994, $692; 1995, $403; 1996, $409; 1997, $211; 1998, $753. Credco paid $290 million, $332 million and $358 million of interest on long-term debt obligations in 1993, 1992 and 1991, respectively. During 1993, Credco issued the following long- and medium-term debt: $300 million 6 1/8 percent Senior Notes due June 15, 2000; $100 million Step-up Senior Notes due August 10, 2005, which are callable on August 10, 2000, bearing interest at 6.25 percent for the first seven years and 7.45 percent for the remaining five years; and $206 million of medium-term notes at various rates and maturities. Credco has realigned its long-term debt financing strategy to better match its liabilities with its assets. In connection with this realigned strategy, during 1993 Credco reduced its high coupon long-term debt through the defeasance of $498 million of long-term debt and the retirement of an additional $153.8 million of long-term debt through a series of open market purchases. These transactions resulted in an extraordinary charge net of income tax, of $22 million. In addition, Credco canceled an interest rate swaption resulting in additional interest expense of $13 million. 6. Restrictions as to Dividends and Limitations on Indebtedness The most restrictive limitation on dividends imposed by the debt instruments issued by Credco is the requirement that Credco maintain a minimum consolidated net worth of $50 million. There are no limitations on the amount of debt that can be issued by Credco. The most restrictive of the debt instruments issued by AEOCC and its subsidiaries requires that AEOCC maintain a minimum consolidated net worth of $50 million. The net worth of AEOCC included in the December 31, 1993 Consolidated Balance Sheet was $404 million. 7. Commitments and Contingencies Credco uses certain financial instruments with off-balance sheet market risks in order to hedge market risks inherent in the valuation of items reflected in the Consolidated Balance Sheet. Credco utilizes a variety of financial instruments to achieve this objective. These instruments include interest rate swap agreements, forward interest rate agreements, foreign exchange forward contracts, and foreign currency interest rate swap agreements. The fair values of the financial instruments are estimates based upon current market conditions and perceived risks and require varying degrees of management judgment. If the counterparty in any of these transactions fails to perform its obligations, Credco's exposure to market risk is limited to the movement of interest and foreign exchange rates. The creditworthiness of the counterparties is monitored on an ongoing basis. Interest rate swap agreements generally involve the exchange of fixed or floating rate interest payment obligations on a specified principal amount without the exchange of the underlying notional amount. The notional amount of interest rate swaps outstanding as of December 31, 1993 and 1992, respectively, was $2.7 billion and $2.3 billion, ($502 million and $1.3 billion of which was with an affiliate). The fair value of these interest rate swaps was a net liability of $36 million and $48 million (net liability of $11.6 million and $25 million with an affiliate) at December 31, 1993 and 1992, respectively. These agreements have varying maturities through August 2000. The following is a summary of notional amounts of interest rate swaps with varying expirations over the next seven years (billions): 1993 1992 Short-term debt converted from variable to fixed $1.7 $1.7 Short-term variable rate debt converted to different variable rates - 0.1 Long-term debt converted from fixed to variable 1.0 0.5 Forward interest rate agreements are contracts to receive or pay the difference between a specific agreed upon interest rate and the reference rate for a specified period of time in the future. The notional amount of forward rate agreements outstanding at December 31, 1992 was $113 million. The fair value of these forward interest rate agreements was a net liability of $1.1 million at December 31, 1992. There were no forward interest rate agreements outstanding at December 31, 1993. Foreign exchange forward contracts are agreements entered into, generally with a bank, to buy or sell foreign currency on a future date at a specified foreign exchange rate. Credco had foreign exchange forward contracts totalling $750 million and $701 million ($237 million and $332 million of which was with an affiliate) outstanding at December 31, 1993 and 1992, respectively. The fair value of these foreign exchange forward contracts was not significant at December 31, 1993 and 1992. These agreements have varying maturities through March 1994. Foreign currency interest rate swap agreements are contracts to exchange currency and interest payments for a specific period of time. These swaps result in effective borrowing rates different from the stated rates on the debt which they hedge. The contract amounts of these swaps outstanding at December 31, 1993 and 1992 totalled $706 million and $900 million, respectively. The fair value of these foreign currency interest rate swaps was a $2 million net liability and a $19 million net liability at December 31, 1993 and 1992, respectively. These agreements have varying maturities through October 1998. 8. Transactions with Affiliates In 1993, 1992 and 1991 Credco purchased Cardmember receivables without recourse from TRS and certain of its subsidiaries totalling approximately $95 billion, $94 billion and $100 billion, respectively. Receivables Agreements for non-interest-bearing receivables generally provide that Credco purchase such receivables at a discount rate which yields earnings to Credco equal to at least 1.25 times its fixed charges on an annual basis. The agreements require TRS, at its expense, to perform accounting, clerical and other services necessary to bill and collect all Cardmember receivables owned by Credco. Since settlements under the agreements occur monthly, an amount due from, or payable to, such affiliates may arise at the end of the month. In August 1992, a trust was formed by TRS to purchase certain Cardmember receivables as part of an asset securitization program. In September 1993 and August 1992, Credco sold back to TRS $1 billion and $2.4 billion, respectively, of gross receivables that arose from designated domestic Cardmember accounts. TRS conveyed, through a subsidiary, American Express Receivables Financing Corporation ("RFC"), these receivables, together with the right to receive subsequent receivables arising from such Cardmember accounts, to a Master Trust. In 1993 and 1992, Credco, through a subsidiary, purchased $380 million and $1.3 billion, respectively, of participation interests in the seller's interest in the trust, representing an undivided interest in the securitized receivables conveyed to the trust. In July 1993, Credco began repurchasing certain foreign currency Cardmember receivables which had been sold to an affiliate during the period from December 1991 through June 1993. In December 1993 Credco repurchased the participation interests in a portion of its receivables which had been previously sold to an affiliate during the period from December 1991 through November 1993. In 1992, TRS entered into an agreement with Credco to indemnify Credco for unrealized losses related to certain foreign exchange and interest rate swap agreements, arising out of a decision by TRS to fund certain related foreign currency receivables through affiliates other than Credco. In 1993, Credco reduced its interest expense by $9.8 million for its recovered losses. As a result of the repurchase of the foreign currency Cardmember receivables and the participation interests in receivables described above, this agreement between Credco and TRS was terminated in December 1993. Other transactions with American Express and its subsidiaries for the years ended December 31 were as follows (millions): 1993 1992 1991 Cash and cash equivalents at December 31 3 $ 27 $ 227 Maximum month-end level of cash and cash equivalents during the year 229 475 440 Secured loans to American Express Centurion Bank at December 31 2,000 2,000 2,000 Other loans and deposits to TRS subsidiaries at December 31 - 140 - Maximum month-end level of loans and deposits to TRS subsidiaries during the year 2,001 2,140 2,000 Borrowings at December 31 588 390 173 Maximum month-end level of borrowings during the year 2,451 1,439 1,435 Interest income 70 91 123 Other income 6 7 6 Interest expense 48 78 37 At December 31, 1993, 1992 and 1991 Credco held $2 billion of variable rate secured loans from American Express Centurion Bank ("Centurion Bank"), a wholly-owned subsidiary of TRS. These loans are secured by certain interest - -bearing extended payment plan receivables owned by Centurion Bank. Interest income from these variable rate loans was $67 million, $81 million and $110 million for 1993, 1992 and 1991, respectively. Credco's employees are covered by benefit plans of American Express, which adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," using the immediate recognition transition option, effective as of January 1, 1992. Adoption of SFAS No. 106 had no material effect on Credco's financial statements. In 1994, American Express announced a plan to spin-off Lehman Brothers Holdings Inc. ("Lehman") to its shareholders as a special dividend. References to an affiliate contained in the footnotes include subsidiaries of Lehman. 9. Income Taxes The Financial Accounting Standards Board issued SFAS No. 109, "Accounting for Income Taxes," which supersedes SFAS No. 96. Credco adopted SFAS No. 109 as of January 1, 1992. The adoption of SFAS No. 109 did not materially affect Credco's results. The taxable income of Credco is included in the consolidated U.S. federal income tax return of American Express. Under an agreement with TRS, taxes are recognized on a stand-alone basis. If benefits for all future tax deductions, foreign tax credits and net operating losses cannot be recognized on a stand-alone basis, such benefits are then recognized based upon a share, derived by formula, of those deductions and credits that are recognizable on a TRS consolidated reporting basis. Deferred income tax assets and liabilities result from the recognition 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. The current and deferred components of the provision (benefit) for income taxes consist of the following (millions): 1993 1992 1991 Current $ 18 $64 $124 Deferred 46 6 (37) --- --- --- Total income tax provision before extraordinary item $ 64 $70 $ 87 Income tax benefit from extraordinary item (12) - - --- --- --- Total income tax provision $ 52 $70 $87 The components of the provision for deferred income taxes for the year ended December 31, 1991 is provision for losses of $(8) million, net income from affiliates of $(32) million and cash basis adjustment and other, net, of $3 million. Credco's net deferred tax assets consisted of the following (million): 1993 1992 Gross deferred tax assets: Reserve for loan losses $181 $226 Total gross deferred tax assets 181 226 Gross deferred tax liabilities: Foreign exchange contacts (5) (3) Other (2) (3) Total gross deferred tax liabilities (7) (6) Net deferred tax assets $174 $220 Credco has not recorded a valuation allowance. Federal tax overpayments of $14 million and accrued federal taxes payable of $1 million at December 31, 1993 and 1992, respectively, are included in Due to affiliates. Income taxes paid to TRS during 1993, 1992 and 1991 were approximately $21 million, $75 million and $73 million, respectively. The U.S. statutory tax rate and effective tax rate for 1992 and 1991 was approximately 34 percent. In 1993, the U.S. federal tax rate increased from 34 percent to 35 percent, resulting in a one-time benefit of $6 million in Credco's deferred tax assets. As a result of this one-time benefit, the income tax provision for continuing operations for 1993 is different than that computed using the U.S. statutory tax rate of 35 percent. 10. Geographic Segments Credco is principally engaged in the business of purchasing Cardmember receivables arising from the use of the American Express Card in the United States and foreign locations. The following presents information about operations in different geographic areas (millions): 1993 1992 1991 Revenues United States $ 1,134 $ 1,425 $ 1,706 International 148 180 364 Consolidated $ 1,282 $ 1,605 $ 2,070 Income before taxes United States $ 173 $ 192 $ 187 International 28 16 74 Consolidated $ 201 $ 208 $ 261 Identifiable assets United States $12,787 $12,233 $12,242 International 2,156 1,398 1,885 Consolidated $14,943 $13,631 $14,127 11. Quarterly Financial Data (Unaudited) Summarized quarterly financial data is as follows (millions): Quarter Ended 12/31 9/30 6/30 3/31 Revenues $295 $321 $336 $330 Income before taxes 40 64 39 58 Net income 26 35 25 29 Revenues $340 $389 $431 $445 Income before taxes 50 46 54 58 Net income 33 30 36 39 AMERICAN EXPRESS CREDIT CORPORATION SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (in millions) 1993 1992 1991 ---- ---- ---- Reserve for doubtful accounts: Balance at beginning of year $ 603 $ 731 $ 719 Additions: Provision for doubtful accounts charged to income (1) 650 862 1,072 Other credits (2) 55 121 10 Deductions: Accounts written off 704 864 1,023 Other charges (3) 62 240 47 Foreign translation - 7 - ----- ----- ----- Balance at end of year $ 542 $ 603 $ 731 ===== ===== ===== Reserve for doubtful accounts as a percentage of Cardmember receivables owned at year end 4.18% 5.15% 5.98% ===== ===== ===== (1) Before recoveries on accounts previously written off of (millions): 1993-$175, 1992-$201 and 1991-$217. (2) Reserve balances applicable to new groups of Cardmember receivables purchased from TRS and certain of its subsidiaries. (3) Reserve balances applicable to certain groups of Cardmember receivables and participation interests sold to affiliates. AMERICAN EXPRESS CREDIT CORPORATION SCHEDULE IX - SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (millions) Maximum Average Year-end amount out- amount Weighted weighted standing at out- average Balance average any month- standing interest at end interest end during during the rate during of period rate the period period(1) the period(2) --------- -------- ----------- ---------- ------------- Commercial paper 1993 $8,810 4.13% $9,302 $8,707 3.58% 1992 6,977 3.85 8,340 7,733 4.77 1991 7,504 5.15 9,181 8,211 6.65 Interest-bearing borrowings from affiliates 1993 $ 588 3.24% $2,451 $1,207 3.29% 1992 390 3.47 1,414 853 3.88 1991 173 5.17 1,215 112 6.39 Borrowings under lines of credit(3) 1993 $ 123 5.59% $ 174 $ 149 6.25% 1992 47 7.89 135 100 9.78 1991 153 8.71 220 112 11.71 Borrowing agreements with bank trust departments and others 1993 $ 217 3.21% $ 227 $ 155 3.28% 1992 167 3.43 167 121 3.80 1991 88 4.05 150 133 5.90 (1) The average borrowings were computed using the daily amounts outstanding. (2) Interest rates were determined by dividing the actual interest expense for the year by the average daily debt outstanding. (3) AEOCC borrowings under foreign lines of credit including borrowings with an affiliate. EXHIBIT INDEX Pursuant to Item 601 of Regulation S-K Exhibit No. Description 3(a) Registrant's Certificate of Incorporated by Incorporation, as amended reference to Exhibit 3(a) to Registrant's Registration Statement on Form S-1 dated February 25, 1972 (File No. 2-43170). 3(b) Registrant's By-Laws, amended Incorporated by and restated as of November 24, reference to Exhibit 1980 3(b) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 4(a) Registrant's Debt Securities Incorporated by ref- Indenture dated as of erence to Exhibit 4(s) September 1, 1987 to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(b) Form of Note with optional Incorporated by redemption provisions reference to Exhibit 4(t) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(c) Form of Debenture with Incorporated by optional redemption and reference to Exhibit sinking fund provisions 4(u) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(d) Form of Original Issue Incorporated by Discount Note with reference to Exhibit optional redemption 4(v) to Registrant's provision Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(e) Form of Zero Coupon Note Incorporated by with optional redemption reference to Exhibit provisions 4(w) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(f) Form of Variable Rate Note Incorporated by with optional redemption and reference to Exhibit repayment provisions 4(x) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(g) Form of Extendible Note Incorporated by with optional redemption reference to Exhibit and repayment provisions 4(y) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(h) Form of Fixed Rate Incorporated by Medium-Term Note reference to Exhibit 4(z) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(i) Form of Floating Rate Incorporated by Medium-Term Note reference to Exhibit 4(aa) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(j) Form of Warrant Agreement Incorporated by reference to Exhibit 4(bb) to Registrant's Registration Statement on Form S-3 dated September 2, 1987 (File No. 33-16874). 4(k) Form of Supplemental Indenture Incorporated by reference to Exhibit 4(cc) to Registrant's Registration Statement on Form S-3 dated September 2, l987 (File No. 33-16874). 4(l) The Registrant hereby agrees to furnish the Commission, upon request, with copies of the instruments defining the rights of holders of each issue of long-term debt of the Registrant for which the total amount of securities authorized thereunder does not exceed 10% of the total assets of the Registrant 10(a) Receivables Agreement Incorporated by dated as of January 1, 1983 reference to Exhibit between the Registrant and 10(b) to Registrant's American Express Travel Annual Report on Form Related Services Company, 10-K for the year Inc. ended December 31, 1987. 10(b) Secured Loan Agreement Incorporated by dated as of June 30, 1988 reference to Exhibit between the Registrant 10(b) to Registrant's and American Express Annual Report on Centurion Bank Form 10-K for the year ended December 31, 1988. 10(c) Participation Agreement Incorporated by dated as of August 3, 1992 reference to Exhibit between American Express 10(c) to Registrant's Receivables Financing Annual Report on Corporation and Credco Form 10-K for the year Receivables Corp. ended December 31, 1992. 12 Statement re computation of ratios Electronically filed herewith. 23 Consent of Independent Auditors Electronically filed herewith.

801124_1993.txt

801124_1993

1993

801124

Item 1. Business - ---------------- Vanguard Real Estate Fund I, A Sales-Commission-Free Income Properties Fund (the "Fund"), was organized on September 10, 1986 as a Massachusetts business trust and intends to continue to qualify as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). The Fund has a finite life and intends to commence the liquidation of its remaining real estate investments over the next five years, market conditions permitting. In addition, the Fund is precluded from making any additional real estate investments. The Fund has no employees. Pursuant to a Services Agreement dated December 23, 1986 (the "Services Agreement") between the Fund and The Vanguard Group, Inc. (the "Sponsor"), the Sponsor has been retained to provide administrative services for the Fund, including the maintenance of financial records, oversight of the performance of outside service providers and the preparation and distribution of communications to shareholders, etc., and to supervise its day-to-day business affairs. Pursuant to an Advisory Agreement dated December 23, 1986 (the "Advisory Agreement") between the Fund and Aldrich, Eastman & Waltch, Inc. (the "Adviser"), the Adviser has been retained to advise the Fund in connection with the evaluation, selection, management and disposition of its real estate investments. For additional information concerning the Sponsor, the Adviser, the Services Agreement and the Advisory Agreement, see Item 8, Financial Statements and Supplementary Data - Notes to Financial Statements, and Item 13, Certain Relationships and Related Transactions. The Fund's business consists of holding investments primarily in income- producing real properties and mortgage loans that offer the potential to achieve the following investment objectives: (i) to preserve and protect shareholders' capital; (ii) to provide shareholders with current income in the form of quarterly cash distributions and to provide growth of income over the remaining life of the Fund; and (iii) to provide long-term growth through appreciation in the value of the Fund's real estate investments. In order to achieve these objectives, the Fund has invested, through direct ownership or shared-appreciation mortgages, in five existing income- producing properties or portfolios of properties, including one portfolio of three office buildings, two shopping centers, a portfolio of warehouses and industrial properties, and one apartment complex. The Adviser believes that the Fund's investments are diversified by both type of investment and geographic location. As of February 28, 1994, the Fund had invested approximately $75 million in real estate assets, of which $44 million (59%) consisted of real estate owned directly, $29 million (39%) consisted of mortgage loan investments - including $17 million (23%) considered to be in-substance foreclosed assets and $2 million (2%) consisted of marketable securities. The Fund has elected to be treated as a REIT under the Code. The Fund intends to invest and operate in a manner that will continue to maintain its qualification as a REIT. The Fund's real estate investments are subject to competition from existing commercial, industrial, and residential properties and will be subject to competition from properties that are developed in the future. The REIT provisions of the Code impose certain financial, investment and operational restrictions that are not applicable to competing entities that are not REITs. For additional information regarding the Fund's investments, operations, and other significant events, see Item 2, Properties, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data. The following table sets forth the names and positions with the Fund of the executive officers of the Fund: NAME AGE POSITIONS ------------------ --- --------------------------------- John C. Bogle 65 Trustee and Chairman of the Board John J. Brennan 39 President Ralph K. Packard 49 Vice President and Controller Richard F. Hyland 57 Treasurer Raymond J. Klapinsky 55 Secretary All executive officers of the Fund also serve as executive officers of Vanguard Real Estate Fund II, A Sales-Commission-Free Income Properties Fund ("VREFII"). All executive officers of the Fund, with the exceptions of Mr. Packard, who was elected as an officer of the Fund in May 1988, and Mr. Klapinsky, who was elected as an officer of the Fund in May 1989, have served since the Fund's inception. Under the Fund's Declaration of Trust, the officers of the Fund serve at the pleasure of the Trustees. There are no family relationships between any Trustee or executive officer. Mr. Bogle is Chairman and Chief Executive Officer of the Fund, The Vanguard Group, Inc. (the Sponsor of the Fund) and each of the investment companies in The Vanguard Group. Mr. Bogle has served in such capacities during each of the past eight years. Mr. Bogle also serves as a Director of The Mead Corporation and General Accident Insurance Companies. Mr. Brennan is President of The Vanguard Group, Inc. and has served in such capacity since May 1989. Mr. Brennan also serves as a Director (Trustee) of The Vanguard Group, Inc., and each of the investment companies in The Vanguard Group. Mr. Brennan served as Executive Vice President and Chief Financial Officer of The Vanguard Group, Inc. from July 1986 to May 1989. Mr. Brennan served as Senior Vice President and Chief Financial Officer of The Vanguard Group, Inc. from July 1985 to July 1986, and as Assistant to the Chairman of the Board of The Vanguard Group, Inc. from July 1982 to July 1985. Mr. Packard is Senior Vice President and Chief Financial Officer of The Vanguard Group, Inc. and has served in such capacity since June 1989. Mr. Packard served as Vice President and Controller of The Vanguard Group, Inc. from February 1986 to June 1989. Prior to joining The Vanguard Group, Inc., Mr. Packard served as Senior Vice President, Controller, and Deputy Director of Finance for the Society for Savings Bank, Hartford, Connecticut. Mr. Hyland is, and has served for each of the past eight years as, Treasurer of The Vanguard Group, Inc. and each of the investment companies in The Vanguard Group. Mr. Klapinsky is, and has served for each of the past eight years as, Senior Vice President and Secretary of The Vanguard Group, Inc. and each of the investment companies in The Vanguard Group. Item 2. Item 2. Properties - ------------------ As of December 31, 1993, the Fund held the following real estate investments: Set forth below is a summary of the general competitive conditions for those properties whose book value is ten percent or more of the Fund's total assets as of December 31, 1993, or whose gross revenues are ten percent or more of the aggregate gross revenues of the Fund for the year ended December 31, 1993. Plaza del Amo - ------------- There are approximately 85,000 households (average household income of $70,000) and 210,000 people within a three-mile radius of the shopping center. Southern California's economy and, in particular, the South Bay market, have been seriously undermined by the recent recession prompted, in part, by difficulties in the defense and aerospace industries. As a result, the retail property market has suffered for several years from weak demand growth. Current market vacancy has remained relatively unchanged at approximately 10-12% and estimated effective rent at comparable properties is $15-$18 per square foot for shop space and $5.25-$8.10 for anchor space. Oakcreek Village - ---------------- There are approximately 14,500 households (average household income of $57,000) and 32,000 people within a three-mile radius of the center. Employment in the Raleigh-Durham metropolitan area grew 2.6% over the 12 month period ended December 1993. Estimated market rents for comparable properties are approximately $10-$12 per square foot. Tightening market conditions, however, have resulted in several significant proposed projects in Oakcreek Village's trade area. If built, these proposed competitive projects may reduce rent growth and increase the vacancy rate in the area. Seattle Industrial Park - ----------------------- Boeing Company is the region's driving economic force (and the Seattle Industrial Park's lead tenant). The combination of weak worldwide demand and the severe oversupply of commercial aircraft has resulted in a significant contraction at Boeing. Over the past three years the Seattle economy has had to cope with a transition from a high-growth economy to a little or no-growth environment. Currently, the market is weak with vacancy rates averaging approximately 7%. The estimated triple net market rent for comparable properties is $2.75 per square foot for Valley Industrials and $4-$5 per square foot for Sea-Tac. Sheffield Forest Apartments - --------------------------- Washington DC's superior growth over the past decade has slowed appreciably to a rate more in line with the national average. With little near-term stimulus from the region's traditional growth sectors, government and construction, total employment growth is expected to be moderate over the next several years. Estimated market rents for comparable properties stand at $0.70 to $1.10 per square foot and the estimated vacancy rate for comparable properties is 5-6%. Minnesota Portfolio - ------------------- The Twin Cities economy is characterized by a broad economic base. As a result, employment growth has remained relatively stable over the past decade, and the region has avoided significant job losses during the latest recession. Currently, employment is increasing at an annual rate of 2.1%. Vacancy rates and net market rents for comparable properties are as follows: Shoreview - rent of $7.50 to $9.00 per square foot and vacancy rate of 11%; Arden Hills - rent of $6.00 to $12.50 per square foot and vacancy rate of 5%; and Fairview - rent of $3.25 to $5.00 per square foot and vacancy rate of 13%. Set forth below is certain operating data for those properties held by the Fund whose book value is ten percent or more of the Fund's total assets as of December 31, 1993 or whose gross revenues are ten percent or more of the aggregate gross revenues of the Fund for the year ended December 31, 1993. Occupancy Rates: - ---------------- Plaza Del Oakcreek Seattle Ind. Minnesota Sheffield Amo Village Park Portfolio Forest Apt. --- ------- ---- --------- ----------- 1993 98% 96% 99% 99% 93% 1992 94% 95% 99% 99% 93% 1991 92% 94% 98% 99% 93% 1990 100% 97% 98% 75% 96% 1989 98% 91% 99% 97% 95% Avg. Effective Rental/Sq.Ft/Yr.: - ----------------- Plaza Del Oakcreek Seattle Ind. Minnesota Sheffield Amo Village Park Portfolio Forest Apt.* --- ------- ---- --------- ----------- 1993 $13.23 $9.07 $3.00 $8.06 $8,796 1992 $13.06 $9.11 $2.47 $7.95 $8,976 1991 $13.72 $9.47 $1.95 $8.71 $9,240 1990 $13.11 $8.82 $1.96 $7.40 $9,180 1989 $13.15 $9.61 $1.92 $7.74 $8,952 * Annual rent/unit. Real Estate Tax/Fiscal Year: - ---------------------------- Effective Rate Per $1000 of Assessed Value $11.63 $15.34 $14.30 $61.14 $32.92 Annual Taxes $85,723 $96,141 $239,927 $308,888 $220,639 Tenants Occupying 10% or more of rentable square footage: - --------------------------------------------------------- Lease Expirations during the next ten years: - -------------------------------------------- A mortgage loan payable, secured by the Plaza del Amo property, is outstanding at December 31, 1993. Information concerning its principal, interest rate, amortization and maturity provisions is included in Note H to the Fund's financial statements, incorporated by reference in Item 8, Financial Statements and Supplementary Data, and in Schedule XII to Item 14. Information concerning the interest rates, shared-appreciation features, and other terms of the Fund's mortgage investments is included in Note F to the Fund's Financial Statements, included in Item 8, Financial Statements and Supplementary Data, and in Schedule XII to Item 14. Excluding the Fund's Sheffield investment, the Fund believes that its direct ownership properties, and the properties underlying its mortgage investments, are well maintained, in good repair, suitable for their intended uses and are adequately covered by insurance. For additional information regarding the Fund's real estate investments see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, Item 8, Financial Statements and Supplementary Data, and Schedules XI and XII to Item 14. With respect to the Sheffield investment, cash flow from the property has been insufficient to cover debt service obligations owing to the Fund. As a result, the partnership which owns the property deferred certain maintenance on the property and subsequently defaulted on the mortgage loan in January 1994. The Fund is currently negotiating with the partnership, whose sole asset is the Sheffield property, to obtain title to the property via a transfer of all of its partnership interests to the Fund in full satisfaction of the mortgage loan outstanding. Upon gaining ownership of the property, which the Fund believes to be imminent, the Fund intends to remedy the deferred maintenance on the property. The cost of such renovations, expected to be $150,000 - $250,000, will be financed from the Fund's current operating cash flow. The Fund believes that the Sheffield property is suitable for its intended use and is adequately covered by insurance. Except for Sheffield as discussed above, the Fund has no other significant renovation, improvement or development plans for its other properties. Information concerning the Federal tax basis and depreciation method and lives of the Fund's properties and components thereof and on which deprecation is taken is included in Notes A and E to the Fund's Financial Statements, included in Item 8, Financial Statements and Supplementary Data, and in Schedule XI to Item 14. All real estate owned is depreciated over 40 years for both financial and tax reporting purposes on a straight-line basis except for leasehold improvements which are depreciated over the term of the respective lease for financial reporting purposes. Item 3. Item 3. Legal Proceedings - ------------------------- None Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ----------------------------------------------------------- None PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters - --------------------------------------------------------------------- The Fund's shares of beneficial interest ("Shares") are traded on the American Stock Exchange (AMEX) under the symbol "VRO". The Shares have been traded on the AMEX since August 20, 1991. From July 24, 1989 to August 19, 1991, the Fund's shares were traded on the over the counter market and were quoted by the National Association of Securities Dealers Automated Quotation System ("NASDAQ"). Prior to July 24, 1989, there was no trading market for the Shares. As of February 28, 1994, there were approximately 15,554 holders of record of the Fund's Shares. Set forth below is certain information regarding the Fund's Shares for each of the eight fiscal quarters in the period ended December 31, 1993: Year Ended December 31, ------------------------------------------- 1993 1992 Share Prices Share Prices ------------------ ------------------ High Low High Low -------- -------- -------- -------- For the Quarter Ended: March 31 $8-1/4 $6-5/8 $7-5/8 $6-5/8 June 30 8 7-1/4 7-3/4 6-5/8 September 30 8-1/4 7-3/8 8 6-5/8 December 31 8-3/4 7-3/8 7-1/4 6-1/4 The tables below indicate the amount of cash dividends per share declared during the years ended December 31, 1993 and 1992. Record Distribution Date Per Share ----------------- -------------- 03-31-93 $ .15 06-30-93 .15 09-30-93 .15 12-22-93 1.24 ---- Total Distributions - 1993 $1.69 Record Distribution Date Per Share ----------------- -------------- 04-01-92 $ .15 06-30-92 .15 09-30-92 .15 12-22-92 .24 ---- Total Distributions - 1992 $ .69 Status of Distributions 1993 1992 ----------------------- ---- ---- Ordinary Income $ - $ .57 Return of Capital 1.69 .12 ---- ---- Total $1.69 $ .69 Except during its offering period, the Fund has historically paid dividends on a quarterly basis, and there are currently no contractual restrictions on the Fund's present or future ability to pay such dividends. Item 6. Item 6. Selected Financial Data - ------------------------------- The information required by this Item is included on page 18 of the Fund's 1993 Annual Report to Shareholders and is incorporated herein by reference thereto. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - ----------------------------------------------------------------------- The information required by this Item is included on pages 20 through 23 of the Fund's 1993 Annual Report to Shareholders and is incorporated herein by reference thereto. Item 8. Item 8. Financial Statements and Supplementary Data - --------------------------------------------------- The Fund's financial statements at December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993 are included on pages 6-17 of the Fund's 1993 Annual Report to Shareholders and are incorporated herein by reference thereto. 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 with respect to Trustees is included in the Fund's definitive proxy statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. (Information with respect to executive officers of the Fund is included in Item 1.) Item 11. Item 11. Executive Compensation - ------------------------------- The information required by this Item is included in the Fund's definitive Proxy Statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ----------------------------------------------------------------------- The information required by this Item is included in the Fund's definitive Proxy Statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. Item 13. Item 13. Certain Relationships and Related Transactions - ------------------------------------------------------- The information required by this Item is included in the Fund's definitive Proxy Statement filed with the Securities and Exchange Commission on March 15, 1994 for its Annual Meeting of Shareholders to be held on April 22, 1994, which is incorporated herein by reference thereto. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - ------------------------------------------------------------------------- (a) 1. Financial Statements: --------------------- The following financial statements as of, and for the years ended, December 31, 1993, 1992 and 1991 are incorporated in Item 8 herein by reference from the following pages of the Fund's 1993 Annual Report to Shareholders, which is filed as an Exhibit hereto. ANNUAL REPORT PAGE NO. Balance Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Statements of Operations. . . . . . . . . . . . . . . . . . . . . . . . . 7 Statements of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . . 8-9 Statements of Changes in Shareholders' Equity . . . . . . . . . . . . . .10 Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . 11-17 Report of Independent Accountants . . . . . . . . . . . . . . . . . . . .17 The following financial statements of Lincoln Park Place II, a Maryland Limited Partnership, as of and for the year ended October 31, 1993 are filed as part of this Report on Form 10-K. Such partnership owns and operates the property underlying the Fund's Sheffield investment. FORM 10-K PAGE NO. Independent Auditors' Report. . . . . . . . . . . . . . . . . . . . . . .25 Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Statement of Operations . . . . . . . . . . . . . . . . . . . . . . . . .27 Statement of Changes in Partners' Deficit . . . . . . . . . . . . . . . .28 Statement of Cash Flows 29 Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . 30-32 2. Financial Statement Schedules: ------------------------------ The financial statement schedules included in Part IV of this report should be read in conjunction with the Fund's financial statements incorporated by reference in Item 8 of this report. FORM 10-K SCHEDULE PAGE NO. I Marketable Securities - Other Investments . . . . . . . . . . .18 X Supplementary Income Statement Information. . . . . . . . . . .19 XI Real Estate and Accumulated Depreciation. . . . . . . . . . 20-21 XII Mortgage Loans on Real Estate . . . . . . . . . . . . . . . 22-23 Report of Independent Accountants . . . . . . . . . . . . . . .33 All other schedules have been omitted since the required information is presented in the financial statements, the related notes, or is not applicable. 3. Exhibits: --------- Exhibit No. Description ----------- ----------- 3.1 Amended and Restated Declaration of Trust, dated December 9, 1986, filed as exhibit 3 to the Fund's Registration Statement on Form S-11, SEC Registration #33-8649, and incorporated herein by reference. 3.2 Amendment #1 to Amended and Restated Declaration of Trust, dated January 10, 1987, filed as exhibit 3(b) to the Fund's Registration Statement on Form S-11, SEC Registration #33-15040, and incorporated herein by reference. 3.3 Amendment #2 to Amended and Restated Declaration of Trust, dated May 31, 1988, filed as exhibit 3 to the Fund's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988, and incorporated herein by reference. 3.4 By-laws, filed as exhibit 3 to the Fund's Registration Statement on Form S-11, SEC Registration #33-8649, and incorporated herein by reference. 10.1 Advisory Agreement between the Fund and Aldrich, Eastman & Waltch, Inc. dated December 23, 1986, filed as exhibit 10.1 to the Fund's Annual Report on Form 10- K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.2 Services Agreement between the Fund and The Vanguard Group, Inc. dated December 23, 1986, filed as exhibit 10.2 to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.3(a) Loan Agreement by and between Plaza Del Amo and Lawrence W. Doyle, J. Grant Monahon and Richard F. Burns, Trustees of AEW #82 Trust, established by Declaration of Trust dated August 14, 1987, dated September 16, 1987, filed as exhibit 10.3(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.3(b) Declaration of Trust, AEW #82 Trust and Schedule of Beneficial Interest dated August 14, 1987, filed as exhibit 10.3(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.3(c) All-Inclusive Promissory Note from Plaza Del Amo in favor of Lawrence W. Doyle, J. Grant Monahon and Richard F. Burns, Trustees of AEW #82, established by Declaration of Trust dated August 14, 1987, dated September 16, 1987, filed as exhibit 10.3(c) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 and incorporated herein by reference. 10.4(a) Purchase and Sale Agreement of Oakcreek Village Shopping Center, between Pacific Guaranty Retail Development Corporation and Michael O. Craig, Richard F. Burns and J. Grant Monahon as Trustees of AEW #96 Trust, under Declaration of Trust dated November 6, 1987, dated October 31, 1987, filed as exhibit 10.4(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.4(b) Declaration of Trust, AEW #96 Trust and Schedule of Beneficial Interest, dated November 6, 1987, filed as exhibit 10.4(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.4(c) First Amendment to Purchase and Sale Agreement of Oakcreek Village Shopping Center between Pacific Guaranty Retail Development Corporation and Michael O. Craig, Richard F. Burns and J. Grant Monahon as Trustees of AEW #96 Trust, under Declaration of Trust dated November 6, 1987, dated November 24, 1987, filed as exhibit 10.4(c) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.5(a) Purchase and Sale Agreement of Valley Industrial Park and Sea-Tac Industrial Park between Prudential Insurance Company of America and Joseph F. Azrack, Richard F. Burns and J. Grant Monahon as Trustees of AEW #105 Trust, under Declaration of Trust dated December 23, 1987, dated January 8, 1988, filed as exhibit 10.5(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.5(b) Declaration of Trust, AEW #105 Trust and Schedule of Beneficial Interest, dated December 23, 1987, filed as exhibit 10.5(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.6(a) Purchase and Sale Agreement of Vita-Fresh Vitamin Facility, dated January 10, 1988, between Vita- Fresh Vitamin Company, Inc. and Lawrence W. Doyle, Richard F. Burns and J. Grant Monahon as Trustees of AEW #113 Trust, under Declaration of Trust dated January 10, 1988, filed as exhibit 10.6(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.6(b) Declaration of Trust, AEW #113 Trust and Schedule of Beneficial Interest, dated January 19, 1988, filed as exhibit 10.6(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.7(a) Purchase and Sale Agreement of Everest I, Everest II, Fairview Industrial Building and Shoreview Professional Building between Everest Development ltd. and Michael O. Craig, Richard F. Burns and J. Grant Monahon as Trustees of AEW #106 Trust, under Declaration of Trust dated December 17, 1987, dated February 8, 1988, filed as exhibit 10.7(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.7(b) Declaration of Trust, AEW #106 Trust and Schedule of Beneficial Interest, dated December 17, 1987, filed as exhibit 10.7(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. 10.8 All-Inclusive Promissory Note (Wraparound note) dated May 11, 1988, Escrow Agreement dated May 27, 1988 and Option Agreement dated May 11, 1988, all relating to the Fund's mortgage investment in the Carmel Executive Park, filed as exhibit 10 to the Fund's Quarterly Report on Form 10-Q Report for the quarter ended June 30, 1988, and incorporated herein by reference. 10.9(a) Purchase and Sale Agreement of Citadel II office building, between Crow Vista #1 and Aldrich, Eastman & Waltch, Inc., a Massachusetts Corporation acting as agent for the Fund, filed as exhibit 10(a) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, and incorporated herein by reference. 10.9(b) Citadel II Escrow Agreement, filed as exhibit 10(b) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, and incorporated herein by reference. 10.10(a) Loan Agreement for Sheffield Forest Apartments by and between Lincoln Park Place II Limited Partnership and J. Grant Monahon, Richard F. Burns and Marvin M. Franklin, Trustees of AEW #145 Trust, established by Declaration of Trust dated October 14, 1988, dated December 7, 1988, filed as exhibit 10.10(a) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and incorporated herein by reference. 10.10(b) Second Amended and Restated Promissory Note for Sheffield Forest Apartments from Lincoln Park Place II Limited Partnership in favor of J. Grant Monahon, Richard F. Burns and Marvin M. Franklin, Trustees of AEW #145 Trust, established by Declaration of Trust dated October 14, 1988, dated December 7, 1988, filed as exhibit 10.10(b) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988 and incorporated herein by reference. 10.10(c) Amended and Restated Deed of Trust for Sheffield Forest Apartments by and between Lincoln Park Place II Limited Partnership and J. Grant Monahon, Richard F. Burns and Marvin M. Franklin, Trustees of AEW #145 Trust, established by Declaration of Trust dated October 14, 1988, dated December 7, 1988, filed as exhibit 10.10(c) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and incorporated herein by reference. 10.10(d) Declaration of Trust, AEW #145 Trust and Schedule of Beneficial Interest dated October 14, 1988, filed as exhibit 10.10(d) to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and incorporated herein by reference. 10.11(a) Promissory note of Citadel II by and between the Variable Annuity Life Insurance Company and J. Grant Monahon, Richard F. Burns, and Lee H. Sandwen, Trustees of AEW #131 Trust, established by Declaration of Trust dated June 7, 1988, dated October 9, 1990, filed as exhibit 10.1(a) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 10.11(b) Mortgage and Security Agreement of Citadel II by and between the Variable Annuity Life Insurance Company and J. Grant Monahon, Richard F. Burns, and Lee H. Sandwen, Trustees of AEW #131 Trust, established by Declaration of Trust dated June 7, 1988, dated October 9, 1990, filed as exhibit 10.1(b) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 10.11(c) Assignment of Lessor's Interest in Leases of Citadel II by and between the Variable Annuity Life Insurance Company and J. Grant Monahon, Richard F. Burns, and Lee H. Sandwen, Trustees of AEW #131 Trust, established by Declaration of Trust dated June 7, 1988, dated October 9, 1990, filed as exhibit 10.1(c) to the Fund's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 10.12 Standard Offer, Agreement and Escrow Instructions for Purchase of Real Estate by and between the Fujita Corporation USA, a California Corporation, and Richard F. Burns, J. Grant Monahon, Lawrence W. Doyle, Trustees of AEW #113 Trust, established by Declaration of Trust dated January 19, 1988, filed as exhibit 10.12 to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 and incorporated herein by reference. 10.13 Purchase and Sale Agreement of the Everest I ("Zycad") Building by and between Richard F Burns, J. Grant Monahon, and Bruce H. Freedman as Trustees of AEW #106, under Declaration of Trust dated December 17, 1987 and JLS and L.P., dated April 23, 1991, filed as exhibit 10.13 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991 and incorporated herein by reference. 10.14 Settlement Agreement and Mutual Release from mortgage by and among J. Grant Monahon, Richard F Burns and Lee. H. Sandwen, Trustees of AEW #155 Trust under Declaration of Trust dated January 11, 1989, Mark C. Dickinson, Dickinson Development Corp. and Citadel III Partners, Ltd., a Florida limited partnership, dated December 30, 1991, filed as exhibit 10.14 to the Fund's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference. 10.15 First Amendment to Second Amended and Restated Promissory Note by and between Lincoln Park Place II Limited Partnership, a Maryland limited partnership and J. Grant Monahon, Richard F. Burns and Devin McCall, Trustees of AEW #145 Trust under Declaration of Trust dated October 14, 1988 dated April 30, 1992, filed as exhibit 10.15 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 10.16 Amendment No.1 to Loan Agreement by and between Lincoln Park Place II Limited Partnership, a Maryland limited partnership and J. Grant Monahon, Richard F. Burns and Kevin McCall, Trustees of AEW #145 Trust under Declaration of Trust dated October 14, 1988, dated April 30. 1992, filed as exhibit 10.16 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 10.17 Amendment No.1 to All-Inclusive Promissory Note by and between Piazzagalli Development Company, a Vermont General Partnership and J. Grant Monahon, Richard F. Burns and Lee H. Andwen, Trustees of AEW #127 Trust, under Declaration of Trust dated May 3, 1988, dated December 23, 1991 for purposes of reference, filed as exhibit 10.17 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 10.18 Amendment No.1 to Loan Agreement by and between Piazzagalli Development Company, a Vermont General Partnerhip and J. Grant Monahon, Richard F. Burns and Lee H. Sandwen, Trustees of AEW #127 Trust, under Declaration of Trust dated May 3, 1988, dated December 23, 199 for purposes of reference, filed as exhibit 10.18 to the Fund's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference. 13 1993 Annual Report to Shareholders. (With the exception of the information and data incorporated by reference in Items 6, 7, and 8 of this Annual Report on Form 10-K, no other information or data appearing in the 1993 Annual Report to Shareholders is to be deemed filed as part of this report.) (b) Reports on Form 8-K The Fund has filed no reports on Form 8-K during the fourth quarter ended December 31, 1993. SCHEDULE I VANGUARD REAL ESTATE FUND I, A SALES-COMMISSION-FREE INCOME PROPERTIES FUND MARKETABLE SECURITIES - OTHER INVESTMENTS December 31, 1993 Number of Shares or Units -- Cost and Name of Issuer and Principal Amount of Market Value Title of Issue Bonds and Notes (000) - ------------------ ------------------------- ------------ Vanguard Money Market Reserves: Prime Portfolio $2,482,738 $2,483 ------ TOTAL $2,483 ====== Temporary Cash Investments: Certificates of Deposit Commerz Bank $2,000,007 $2,000 3.35% 1/4/94 Canadian Imperial Bank 2,000,000 2,000 of Commerce 3.25% 1/5/94 Westdeutsch Landes Bank 2,000,000 2,000 3.18% 1/6/94 ------ TOTAL $6,000 ====== SCHEDULE X VANGUARD REAL ESTATE FUND I A SALES-COMMISSION-FREE INCOME PROPERTIES FUND SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, ------------------------------------------------- 1993 1992 1991 (000) (000) (000) ----- ----- ----- 1. Maintenance and repairs $ 275 $ 374 $ 448 2. Depreciation and amortization 1,503 1,610 1,519 3. Real estate taxes 823 887 897 Schedule XI VANGUARD REAL ESTATE FUND I, A SALES-COMMISSION-FREE INCOME PROPERTIES FUND REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 (000) Property Description -------------------- Seattle Oakcreek Industrial Minnesota Village, Parks, Two Portfolio, Shopping Industrial Three Office Center, Parks, Buildings, Durham, NC Seattle, WA Roseville, MN TOTALS ------------ ------------ ------------- ------- Encumbrances None None None Initial Cost to Fund Land $ 3,100 $ 8,250 $ 1,725 $13,075 Building and Improvements $ 7,492 $14,066 $10,043 $31,601 Total $10,592 $22,316 $11,768(d) $44,676 Cost capitalized subsequent to acquisition Improvements $ 606 $ 778 $ 341 $ 1,725 Gross amount at which carried at close of period (a) Land $ 3,100 $ 8,250 $ 1,440 $12,790 Building and Improvements $ 8,098 $14,844 $ 8,490 $31,432 Total (b) $11,198 $23,094 $ 9,930 $44,222 Accumulated Depreciation (c) $ 1,304 $ 2,232 $ 1,253 $ 4,789 Date of 1967 and 1978 and Construction 1986 1979 1986 Date Acquired 11/87 1/88 2/88 Depreciable Life 40 years 40 years 40 years PAGE SCHEDULE XI (Continued) (d) Zycad Building sold in 1991 with a land and building cost of $1,894,000. Schedule XII VANGUARD REAL ESTATE FUND I, A SALES-COMMISSION-FREE INCOME PROPERTIES FUND MORTGAGE LOANS ON REAL ESTATE (e) DECEMBER 31, 1993 Wraparound Mortgages Senior Mortgage -------------------- --------------- Plaza del Amo Sheffield Forest Shopping Center, Apartments, Torrance, CA (a) Silver Spring, MD (b) -------------------- --------------------- Effective Rate 10.3% 9.3% Pay Rate 9.7%-10.8% 8.5%-9% Maturity Date 1997 1998 Call Date 1994 1995 Periodic Interest only, Interest only, Payment principal due principal due Terms upon maturity upon maturity or call date. or call date. Prior Liens (a) None Face Amount of Totals Mortgages ------- (000) $10,646 $17,992 $28,638 Carrying Amount of Mortgages (000) (c)(d) $10,646 $17,192 $27,838 Principal Amount of Loans Subject to Delinquent Principal or Interest None None (a) The Fund advanced $7,750,000 to enter into a shared-appreciation, wraparound, mortgage loan secured by the Plaza del Amo Shopping Center ("Plaza"). In addition, Plaza secures two existing senior mortgage loans, which at the time of investment had an aggregate outstanding balance of $2,896,000. The funds advanced plus these two existing senior mortgages resulted in a total wraparound loan of $10,646,000. Upon repayment of the loan, the Fund is entitled to a share of Plaza's appreciation, if any, equal to 50% of Plaza's fair market value in excess of the original balance of the wraparound loan. Schedule XII (Continued) Deloitte & Touche - ---------- - ------------------------------------------------------------------------- LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP ------------------------------ Financial Statements for the Year Eanded October 31, 1993, and Independent Auditors' Report - ------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT General Partners of Lincoln Park Place II, A Maryland Limited Partnership We have audited the accompanying balance sheet of Lincoln Park Place II, A Maryland Limited Partnership (the Partnership) as of October 31, 1993, and the related statements of operations, changes in partners' deficit and cash flows for the year then ended. 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 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 financial statements present fairly, in all material respects, the financial position of the Partnership as of October 31, 1993, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 5 to the financial statements, conditions exist which raise substantial doubt about the ability of the Partnership to continue as a going concern. Management's plans in regard to these matters are also described in Note 5. The financial statements do not include any adjustment that might result from the outcome of this uncertainty. Deloitte & Touche Dallas, Texas 75201-6778 November 20, 1993 LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP BALANCE SHEET OCTOBER 31, 1993 ASSETS INVESTMENT IN REAL ESTATE, AT COST: Land $ 2,600,376 Buildings and improvements 10,796,809 Less accumulated depreciation (2,782,304) ------------- 10,614,881 DUE FROM AFFILIATE 1,788,684 DEFERRED FINANCING COSTS, NET OF ACCUMULATED AMORTIZATION OF $97,299 142,345 CASH 97,439 ESCROW DEPOSITS 26,436 OTHER ASSETS 167,035 ----------- TOTAL $ 12,836,820 ============= LIABILITIES AND PARTNERS' DEFICIT MORTGAGE PAYABLE $ 18,620,029 ACCOUNTS PAYABLE AND ACCRUED LIABILITIES 303,079 TENANT SECURITY DEPOSITS 75,629 Total liabilities 18,998,737 PARTNERS' DEFICIT (6,161,917) ------------- TOTAL $ 12,836,820 ============= See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP - ----------------------------------------------------- STATEMENT OF OPERATIONS YEAR ENDED OCTOBER 31, 1993 - --------------------------------------------------------------------------- REVENUES: Rental $ 1,982,340 Other 33,795 --------- 2,016,135 EXPENSES: Interest 1,668,949 Depreciation and amortization 447,027 Operating 589,773 Real estate taxes 225,065 --------- 2,930,814 --------- NET LOSS $ (914,679) ========= See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP STATEMENT OF CHANGES IN PARTNERS' DEFICIT YEAR ENDED OCTOBER 31, 1993 Managing General Partner,Limited Partner, Lincoln PropertyAmerican Financial Company No. 1288 Realty, Inc. Total PARTNERS' DEFICIT, NOVEMBER 1, 1992 $(5,247,738) $500 $(5,247,238) Net loss (914,679) (914,679) ----------- ----- ----------- PARTNERS' DEFICIT, OCTOBER 31, 1993 $(6,162,417) $500 $(6,161,917) =========== ==== =========== See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP STATEMENT OF CASH FLOWS YEAR ENDED OCTOBER 31, 1993 CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(914,679) Depreciation and amortization 447,027 Changes in assets and liabilities: Decrease in deposits 1,898 Decrease in other assets 7,721 Increase in accounts payable 117,064 Increase in tenant security deposits 11,938 -------- Net cash used in operating activities (329,031) CASH FLOWS FROM INVESTING ACTIVITIES: Additions to buildings and improvements (24,129) CASH FLOWS FROM FINANCING ACTIVITIES: Decrease in due from affiliate 227,614 Increase in mortgage payable 141,450 Decrease in deferred financing costs 384 --------- Net cash provided by financing activities 369,448 --------- NET INCREASE IN CASH 16,288 CASH, BEGINNING OF YEAR 81,151 --------- CASH, END OF YEAR $ 97,439 ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $1,530,388 ========== See notes to financial statements. LINCOLN PARK PLACE II, A MARYLAND LIMITED PARTNERSHIP - ----------------------------------------------------- NOTES TO FINANCIAL STATEMENTS YEAR ENDED OCTOBER 31, 1993 - --------------------------------------------------------------------------- 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Organization - Lincoln Park Place II, A Maryland Limited Partnership (the Partnership) was formed December 1, 1985, for the purpose of owning, developing and operating a 256-unit garden apartment project in Montgomery County, Maryland. Lincoln Property Company No. 1288, A Maryland Limited Partnership is the managing general partner, and American Financial Realty, Inc. (AFR) is the limited partner. The project was started in November 1986 and completed in December 1987 and had an occupancy rate of 97% at October 31, 1993. Basis of Accounting - The accounts of the Partnership are maintained on the basis of accounting used for federal income tax reporting purposes. Memorandum entries have been made to present the accompanying financial statements in accordance with generally accepted accounting principles. Depreciation and Amortization - Buildings and improvements are stated at cost and are depreciated or amortized using the straight-line method over useful lives ranging from 5 to 30 years. Deferred Financing Costs - Financing costs incurred in connection with obtaining and closing the mortgage payable have been capitalized and are being amortized over the term of the note. Other Assets - Other assets consist primarily of prepaid real estate taxes and insurance and deferred expenses. Federal Income Taxes - The financial statements include only those assets, liabilities and results of operations which relate to the business of the Partnership. The financial statements do not include any assets, liabilities, revenues or expenses attributable to the partners' individual activities. No federal or state income taxes are payable by the Partnership, and none have been provided in the accompanying financial statements. The partners are to include their respective share of partnership profits or losses in their individual tax returns. Net income or loss determined under generally accepted accounting principles is allocated among the partners based upon provisions in the partnership agreement even though actual partnership allocations are made on an income tax basis. Consequently, the amounts so allocated will not agree to the allocations on the income tax returns. 2. TRANSACTIONS WITH AFFILIATES Certain of the Partnership's expenses and other disbursements are paid from a central operating account of a general partnership affiliated with the managing general partner in the normal course of business. The Partnership reimburses the affiliate on a regular basis for disbursements made on its behalf. All disbursements are identified by partnership, and the disbursements and reimbursements are accounted for by the Partnership as due to or from the affiliate. The Partnership has entered into an agreement with Lincoln Property Company N.C., Inc., an affiliate of the managing general partner, which provides for management of the property. For its services, Lincoln Property Company N.C., Inc. is entitled to receive a fee of 5% of monthly rents, as defined, amounting to $101,804 for the fiscal year. 3. MORTGAGE PAYABLE The permanent financing was obtained from Aldrich, Eastman & Waltch #145 Trust in the amount of $18,000,000, evidenced by the second amended and restated promissory note. The note accrues interest at the base rate of 9.0% and requires monthly payments in arrears at the current pay rate of 8.5%. The pay rate increases 0.5% on December 7, 1993, and remains at the rate of 9.0% thereafter. Accrued but unpaid interest is added to the outstanding principal balance monthly and bears interest at the base rate of 9.0%. Participation interest based on adjusted gross revenue, as defined, may become due and payable quarterly (no participation interest was paid during the fiscal year ended October 31, 1993). Upon the occurrence of certain events, appreciation interest, as defined, becomes due. The note matures December 7, 1998, at which time all principal and deferred interest become due. The note may be prepaid after December 7, 1995, and the lender has the right to call the note, making it fully due and payable any time following December 7, 1994, provided six months' notice of such intention is given. The land, building and improvements serve as collateral for the note which is nonrecourse to the partners of the Partnership. However, certain partners of the managing general partner have guaranteed the payment of this indebtedness under certain conditions in an amount not to exceed $2,000,000. The note payable has an outstanding balance of $18,000,000 and deferred interest of $620,029 at October 31, 1993. 4. PARTNERS' DEFICIT Capital Contributions - In accordance with the partnership agreement, no additional contributions are required from partners to provide funds for the Partnership. Allocation of Profits and Losses - The net profits, net gains and net losses from operations of the Partnership and capital transactions shall be allocated 100% to the managing general partner, and the limited partner shall have no interest in such net profits, gains or losses. 5. CASH DEFICITS During the year ended October 31, 1993, the Partnership incurred cash deficits from operations. Management anticipates that the Partnership will continue to incur cash deficits from operations. There can be no assurance that the Partnership will be able to obtain loans to fund such deficits. Management intends to continue operating the Partnership in its present form while investigating options to improve operations of the Partnership. However, there is no assurance management will be successful in its efforts. This uncertainty raises substantial doubt about the Partnership's ability to continue as a going concern. * * * * * * REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Trustees of Vanguard Real Estate Fund I, A Sales-Commission-Free Income Properties Fund Our audits of the financial statements referred to in our report dated January 27, 1994 appearing on page 17 of the 1993 Annual Report to Shareholders of Vanguard Real Estate Fund I, A Sales-Commission-Free Income Properties Fund, (which report and financial statements are incorporated by reference in this Annual Report on Form 10-K) also included audits 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 financial statements. PRICE WATERHOUSE Philadelphia, Pennsylvania January 27, 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. VANGUARD REAL ESTATE FUND I, A Sales-Commission-Free Income Properties Fund 3/30/94 /s/ John J. Brennan _________________ _________________________________ DATE John J. Brennan 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 on the dates indicated. 3/30/94 /s/ J. Mahlon Buck, Jr. _________________ _________________________________ DATE J. Mahlon Buck, Jr. Trustee 3/30/94 /s/ William S. Cashel, Jr. _________________ _________________________________ DATE William S. Cashel, Jr. Trustee 3/30/94 /s/ David C. Melnicoff _________________ _________________________________ DATE David C. Melnicoff Trustee 3/30/94 /s/ J. Lawrence Wilson _________________ _________________________________ DATE J. Lawrence Wilson Trustee 3/30/94 /s/ Ralph K. Packard _________________ _________________________________ DATE Ralph K. Packard Vice President & Controller EXHIBIT INDEX EXHIBIT NO. DESCRIPTION PAGE NO. 13 1993 Annual Report to Shareholders . . . . . . . . . . . .36

4515_1993.txt

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1993

4515

ITEM 1. BUSINESS American Airlines, Inc. (American or the Company), the principal subsidiary of AMR Corporation (AMR), was founded in 1934. For financial reporting purposes, American's operations fall within two major lines of business: the Air Transportation Group and the Information Services Group. AIR TRANSPORTATION GROUP The Air Transportation Group consists primarily of American's Passenger and Cargo divisions. AMERICAN'S PASSENGER DIVISION is one of the largest scheduled passenger airlines in the world. At the end of 1993, American provided scheduled jet service to 106 cities in the U.S. mainland and Hawaii, 28 in Latin America, 14 in Europe and 24 other destinations worldwide, including service to six cities provided through cooperative agreements with other airlines. AMERICAN'S CARGO DIVISION provides a full range of freight and mail services to shippers throughout the airline's system. In addition, through cooperative agreements with other carriers, it has the ability to transport shipments to virtually any country in the world. INFORMATION SERVICES GROUP The Information Services Group consists of three divisions of American: SABRE Travel Information Network (STIN), SABRE Computer Services (SCS) and SABRE Development Services (SDS). STIN provides travel reservation services through its computer reservation system, SABRE -- one of the largest privately owned, real-time computer systems in the world. SCS manages AMR's data processing centers, voice and data communications networks and local-area computer networks worldwide. SDS provides applications development, software solutions, consulting, and other technology services to other AMR units. Additional information regarding business segments is included in Note 11 to the consolidated financial statements. ROUTES AND COMPETITION AIR TRANSPORTATION Service over almost all of American's routes is highly competitive. Currently, any carrier deemed fit by the U.S. Department of Transportation (DOT) is free to operate scheduled passenger service between any two points within the U.S. and its possessions. On most of its routes, American competes with at least one, and usually more than one, major domestic airline including: America West Airlines, Continental Airlines, Delta Airlines, Northwest Airlines, Southwest Airlines, Trans World Airlines, United Airlines, and USAir. American also competes with national, regional, all-cargo, and charter carriers and, particularly on shorter segments, ground transportation. Most major air carriers have developed hub-and-spoke systems and schedule patterns in an effort to maximize revenue potential of their service. American currently operates six domestic hubs: Dallas/Fort Worth, Chicago O'Hare, Miami, Raleigh/Durham, Nashville, and San Juan, Puerto Rico. During 1993, American closed its hub operation at San Jose, California. United Airlines and Delta Airlines have large operations at American's Chicago and Dallas/Fort Worth hubs, respectively. The four American Eagle carriers owned by AMR Eagle, an AMR subsidiary, increase the number of markets the Air Transportation Group serves by providing connections to American at its hubs and certain other major airports. Simmons Airlines, Inc. serves Dallas/Fort Worth and Chicago. Flagship Airlines, Inc. serves Miami, Raleigh/Durham, Nashville, and New York John F. Kennedy International Airport. Executive Airlines, Inc. serves San Juan, Puerto Rico. Wings West Airlines, Inc. serves Los Angeles, Orange County and selected other airports in the western U.S. American's competitors also own, and have marketing agreements with, regional carriers which provide service at their major hubs. In addition to its extensive domestic service, American provides service to and from cities in various other countries, primarily across North, Central and South America and Europe. In 1991, American added service to 20 cities in 15 countries in Latin America with the acquisition of route authorities from Eastern Air Lines. In 1992, American added service from several U.S. gateway cities to London's Heathrow Airport with the acquisition of Trans World Airlines' route authorities. American's operating revenues from foreign operations were approximately $3.9 billion in 1993, $3.7 billion in 1992 and $2.7 billion in 1991. Additional information about the Company's foreign operations is included in Note 10 to the consolidated financial statements. Competition in international markets is generally subject to more extensive government regulation than domestic markets. In these markets, American competes with foreign-investor owned and national flag carriers and U.S. carriers that have been granted authority to provide scheduled passenger and cargo service between the U.S. and various overseas locations. American's operating authority in these markets is subject to aviation agreements between the U.S. and the respective countries, and in some cases, fares and schedules require the approval of the DOT and the relevant foreign governments. Because international air transportation is governed by bilateral or other agreements between the U.S. and the foreign country or countries involved, changes in U.S. or foreign government aviation policy could result in the alteration or termination of such agreements, diminish the value of such route authorities, or otherwise affect American's international operations. Bilateral relations between the U.S. and various foreign countries served by American are currently being renegotiated. On all of its routes, American's pricing decisions are affected by competition from other airlines, some of which have cost structures significantly lower than American's and can therefore operate profitably at lower fare levels. American and its principal competitors use inventory and yield management systems that permit them to vary the number of discount seats offered on each flight in an effort to maximize revenues. American believes that it has several advantages relative to its competition. Its fleet is young, efficient and quiet. It has a comprehensive domestic and international route structure, anchored by efficient hubs, which permit it to take full advantage of whatever traffic growth occurs. The Company believes American's AAdvantage frequent flyer program, which is the largest program in the industry, and its superior service also give it a competitive advantage. The major domestic carriers have some advantage over foreign competitors in their ability to generate traffic from their extensive domestic route systems. In many cases, however, U.S. carriers are limited in their rights to carry passengers beyond designated gateway cities in foreign countries. Some of American's foreign competitors are owned and subsidized by foreign governments. To improve their access to each others markets, various U.S. and foreign carriers have made substantial equity investments in, or established marketing relationships with, other carriers. COMPUTER RESERVATION SYSTEMS The complexity of the various schedules and fares offered by air carriers has fostered the development of electronic distribution systems. Travel agents and other subscribers access travel information and book airline, hotel and car rental reservations and issue airline tickets using these systems. American developed the SABRE computer reservation system (CRS), which is the one of the largest CRSs in the world. Competition among the CRS vendors is strong. Services similar to those offered through SABRE are offered by several air carriers and other companies in the U.S. and abroad, including: the Covia Partnership, owned by United Airlines, USAir and various foreign carriers; Worldspan, owned by Delta Airlines, Northwest Airlines, Trans World Airlines, and ABACUS Distribution Systems; and System One, owned by Continental Airlines. The SABRE CRS has several advantages relative to its competition. The Company believes that SABRE ranks first in market share among travel agents in the U.S. The SABRE CRS is furthering its expansion into international markets and continues to be in the forefront of technological innovation in the CRS industry. REGULATION GENERAL The Airline Deregulation Act of 1978 (Act) and various other statutes amending the Act, eliminated most domestic economic regulation of passenger and freight transportation. However, the DOT and the Federal Aviation Administration (FAA) still exercise certain regulatory authority over air carriers under the Federal Aviation Act of 1958, as amended. The DOT maintains jurisdiction over international route authorities and certain consumer protection matters, such as advertising, denied boarding compensation, baggage liability, and computer reservations systems. The DOT issued certain rules governing the CRS industry which became effective on December 7, 1992, and expire on December 31, 1997. The FAA regulates flying operations generally, including establishing personnel, aircraft and security standards. In addition, the FAA has implemented a number of requirements that the Air Transportation Group is incorporating into its maintenance program. These matters relate to, among other things, inspection and maintenance of aging aircraft, corrosion control, collision avoidance and windshear detection. Based on its current implementation schedule, the Air Transportation Group expects to be in compliance with the applicable requirements within the required time periods. The U.S. Department of Justice has jurisdiction over airline antitrust matters. The U.S. Postal Service has jurisdiction over certain aspects of the transportation of mail and related services. Labor relations in the air transportation industry are regulated under the Railway Labor Act, which vests in the National Mediation Board certain regulatory powers with respect to disputes between airlines and labor unions arising under collective bargaining agreements. FARES Airlines are permitted to establish their own domestic fares without governmental regulation, and the industry is characterized by substantial price competition. The DOT maintains authority over international fares, rates and charges. International fares and rates are also subject to the jurisdiction of the governments of the foreign countries which American serves. While air carriers are required to file and adhere to international fare and rate tariffs, many international markets are characterized by substantial commissions, overrides, and discounts to travel agents, brokers and wholesalers. Fare discounting by competitors has historically had a negative effect on American's financial results because American is generally required to match competitors' fares to maintain passenger traffic. During recent years, a number of new low-cost airlines have entered the domestic market and several major airlines have begun to implement efforts to lower their cost structures. Further fare reductions, domestic and international, may occur in the future. If fare reductions are not offset by increases in passenger traffic or changes in the mix of traffic that improves yields, the Air Transportation Group's operating results will be negatively impacted. AIRPORT ACCESS The FAA has designated four of the nation's airports -- Chicago O'Hare, New York Kennedy, New York LaGuardia, and Washington National - -- as "high density traffic airports" and has limited the number of take-offs and landings per hour, known as slots, during peak demand time periods at these airports. Currently, the FAA permits the purchasing, selling and trading of these slots by airlines and others, subject to certain restrictions. During 1993, the DOT issued final rules allowing air carriers to convert up to 50 percent of their commuter slots at Chicago O'Hare for use by jets with fewer than 110 seats. Certain foreign airports, including London Heathrow, a major European destination for American, also have slot allocations. The Air Transportation Group currently has sufficient slot authorizations to operate its existing flights and has generally been able to obtain slots to expand its operations and change its schedules. There is no assurance, however, that the Air Transportation Group will be able to obtain slots for these purposes in the future, because, among other factors, slot allocations are subject to changes in government policies. ENVIRONMENTAL MATTERS The Company is subject to various laws and government regulations concerning environmental matters and employee safety and health in the U.S. and other countries. U.S. federal laws that have a particular impact on the Company include the Airport Noise and Capacity Act of 1990 (ANCA), the Clean Air Act, and the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA or the Superfund). The Company is also subject to the oversight of Occupational Safety and Health Administration (OSHA) concerning employee safety and health matters. The U.S. Environmental Protection Agency (EPA), OSHA, and other federal agencies have been authorized to promulgate regulations that have an impact on the Company's operations. In addition to these federal activities, various states have been delegated certain authorities under the aforementioned federal statutes. Many state and local governments have adopted environmental and employee safety and health laws and regulations, some of which are similar to federal requirements. As a part of its continuing environmental program, the Company has maintained compliance with such requirements without any material adverse effect on its business. The ANCA requires the phase-out by December 31, 1999, of Stage II aircraft operations, subject to certain exceptions. Under final regulations issued by the FAA in 1991, air carriers are required to reduce, by modification or retirement, the number of Stage II aircraft in their fleets 25 percent by December 31, 1994; 50 percent by December 31, 1996; 75 percent by December 31, 1998, and 100 percent by December 31, 1999. Alternatively, a carrier may satisfy the regulations by operating a fleet that is at least 55 percent, 65 percent, 75 percent, and 100 percent Stage III by the dates set forth in the preceding sentence, respectively. The ANCA recognizes the rights of airport operators with noise problems to implement local noise abatement programs so long as they do not interfere unreasonably with interstate or foreign commerce or the national air transportation system. Authorities in several cities have promulgated aircraft noise reduction programs, including the imposition of night-time curfews. The ANCA generally requires FAA approval of local noise restrictions on Stage III aircraft first effective after October 1990, and establishes a regulatory notice and review process for local restrictions on Stage II aircraft first proposed after October 1990. At December 31, 1993, approximately 83 percent of American's fleet was Stage III. While American has had sufficient scheduling flexibility to accommodate local noise restrictions imposed to date, American's operations could be adversely affected if locally- imposed regulations become more restrictive or widespread. The Clean Air Act provides that state and local governments may not adopt or enforce aircraft emission standards unless those standards are identical to the federal standards. The engines on American's aircraft meet the EPA's turbine engine emissions standards. American has been identified by the EPA as a potentially responsible party (PRP) with respect to the following Superfund Sites: Operating Industries, Inc., California; Cannons, New Hampshire; Byron Barrel and Drum, New York; Palmer PSC, Massachusetts; Frontier Chemical, New York and Duffy Brothers, Massachusetts. American has settled the Operating Industries, Cannons and Byron Barrel and Drum matters, and all that remains to complete these matters are administrative tasks. With respect to the Palmer PSC, Frontier Chemical and Duffy Brothers sites, American is one of several PRPs named at each site. Although they are Superfund Sites, American's alleged waste disposal is minor compared to the other PRPs. American does not expect these matters, individually or collectively, to have a material impact on its financial condition, operating results or cash flows. LABOR The airline business is labor intensive. On December 31, 1993, American had approximately 95,800 employees. Wages, salaries and benefits represented nearly 35 percent of American's consolidated operating expenses for the year ended December 31, 1993. To improve its competitive position, American has undertaken various steps to reduce its unit labor costs, including workforce reductions. The majority of American's employees are represented by labor unions and covered by collective bargaining agreements. American's relations with such labor organizations are governed by the Railway Labor Act. Under this act, the collective bargaining agreements among American and these organizations become amendable upon the expiration of their stated term. If either party wishes to modify the terms of any such agreement, it must notify the other party before the contract becomes amendable. After receipt of such notice, the parties must meet for direct negotiations, and if no agreement is reached, either party may request that a federal mediator be appointed. If no agreement is reached in mediation, the National Mediation Board may determine, at any time, that an impasse exists and may proffer arbitration. Either party may decline to submit to arbitration. If arbitration is rejected, a 30-day "cooling-off" period commences, following which the labor organization may strike and the airline may resort to "self-help," including the imposition of its proposed amendments and the hiring of replacement workers. American's collective bargaining agreement with the Association of Professional Flight Attendants became amendable on December 31, 1992. The National Mediation Board declared a cooling-off period in the negotiations in September 1993, following a long period of negotiation and mediation. After enduring a five-day strike by the union in November, American agreed to resolve the remaining issues through binding arbitration. American imposed certain contract amendments after the union declared the strike. The arbitration process is expected to be complex and will likely not be decided for several months. While the ultimate outcome is uncertain, the new contract will likely result in higher unit labor costs in 1994. American's collective bargaining agreements with the Allied Pilots Association and Flight Engineers International Association become amendable on August 31, 1994. American's collective bargaining agreement with the Transport Workers Union becomes amendable on March 1, 1995. FUEL American's operations are significantly affected by the availability and price of jet fuel. American's fuel costs and consumption for the years 1989 through 1993 were: Based upon American's 1993 fuel consumption, a one-cent change in the average annual price-per-gallon of jet fuel caused a change of approximately $2.5 million in American's monthly fuel costs. American's fuel cost in 1993 decreased 2.4 percent over the prior year, primarily due to a 4.9 percent decrease in the average price per gallon, offset by a 2.7 percent increase in gallons consumed. Changes in fuel prices have industry-wide impact and benefit or harm American's competitors as well as American. Accordingly, lower fuel prices may be offset by increased price competition and lower revenues for all air carriers. Fuel prices may increase in the future. There can be no assurance that American will be able to pass such cost increases on to its customers by increasing fares in the future. Most of American's fuel is purchased pursuant to contracts which, by their terms, may be terminated upon short notice. While American does not anticipate a significant reduction in fuel availability, dependency on foreign imports of crude oil and the possibility of changes in government policy on jet fuel production, transportation and marketing make it impossible to predict the future availability of jet fuel. If there were major reductions in the availability of jet fuel, American's business would be adversely affected. FREQUENT FLYER PROGRAM American established the AAdvantage frequent flyer program (AAdvantage) to develop passenger loyalty by offering awards to travelers for their continued patronage. AAdvantage members earn mileage credits for flights on American, American Eagle, or certain flights on participating airlines, or by utilizing services of other program participants, including hotels, car rental companies, and bank credit card issuers. In addition, American periodically offers special short-term promotions which allow members to earn additional free travel awards or mileage credits. American reserves the right to change the AAdvantage program rules, regulations, travel awards and special offers at any time. American may initiate changes impacting, for example, participant affiliations, rules for earning mileage credit, mileage levels and awards, blackout dates and limited seating for travel awards, and the features of special offers. American reserves the right to end the AAdvantage program with six months notice. Mileage credits can be redeemed for free, discounted or upgraded travel on American, American Eagle or participating airlines, or for other travel industry awards. Once a member accrues sufficient mileage for an award, the member may request an award certificate from American. Award certificates may be redeemed up to one year after issuance. Most travel awards are subject to blackout dates and capacity control seating. All miles earned after July 1989 must be redeemed within three years or they expire. American accounts for its frequent flyer obligation on an accrual basis using the incremental cost method. American's frequent flyer liability is accrued each time a member accumulates sufficient mileage in his or her account to claim the lowest level of free travel award (20,000 miles) and such award is expected to be used for free travel on American. American includes fuel, food, and reservations/ticketing costs, but not a contribution to overhead or profit, in the calculation of incremental cost. The cost for fuel is estimated based on total fuel burn traced by day by various categories of markets, with an amount allocated to each passenger. Food costs are tracked monthly by market category, with an amount allocated to each passenger. Reservation/ticketing costs are based on the total number of passengers (including those traveling on free awards) divided into American's total expense for these costs. No accounting is performed for non-travel awards redeemed since the cost to American, if any, is de minimis. At December 31, 1993 and 1992, American estimated that approximately 3.9 million and 3.7 million free travel awards, respectively, were eligible for redemption. At December 31, 1993 and 1992, American estimated that approximately 3.6 million and 3.4 million free travel awards, respectively, were expected to be redeemed for free travel on American. In making this estimate, American has excluded mileage in inactive accounts, mileage related to accounts that have not yet reached the lowest level of free travel award, mileage that is not expected to ever be redeemed for free travel, and mileage related to accounts that have reached the lowest level of free travel award but are estimated based on historical data to be redeemed for discounts and upgrades, free travel on participating airlines other than American, or services other than free travel, for which American has no obligation to pay the provider of those services. The liability for the program mileage that has reached the lowest level of free travel award and is expected to be redeemed for free travel on American and deferred revenues for mileage sold to others participating in the program was $380 million and $285 million, representing 9.0 percent and 5.6 percent of American's total current liabilities, at December 31, 1993 and 1992, respectively. The number of free travel awards used for travel on American during the years ended December 31, 1993, 1992 and 1991 was approximately 2,163,000, 1,474,000, and 1,237,000, respectively, representing 9.5 percent, 6.0 percent and 5.3 percent of total revenue passenger miles for each period, respectively. American believes displacement of revenue passengers is insignificant given American's load factors, its ability to manage frequent flyer seat inventory and the relatively low ratio of free award usage to revenue passenger miles. Effective February 1, 1995, the lowest level of free travel award will increase from 20,000 to 25,000 miles. OTHER MATTERS SEASONALITY AND OTHER FACTORS The Air Transportation Group's results of operations for any interim period are not necessarily indicative of those for the entire year, since the air transportation business is subject to seasonal fluctuations. Higher demand for air travel has traditionally resulted in more favorable operating results for the second and third quarters of the year than for the first and fourth quarters. The results of operations in the air transportation business have also significantly fluctuated in the past in response to general economic conditions. In addition, fare initiatives, fluctuations in fuel prices, labor strikes and other factors could impact this seasonal pattern. Unaudited quarterly financial data for the two-year period ended December 31, 1993, is included in Note 12 to the consolidated financial statements. No material part of the business of American and its subsidiaries is dependent upon a single customer, or very few customers. Consequently, the loss of the Company's largest few customers would not have a materially adverse effect upon American. INSURANCE American carries insurance for public liability, passenger liability, property damage and all-risk coverage for damage to its aircraft, in amounts which, in the opinion of management, are adequate. OTHER GOVERNMENT MATTERS In time of war or during an unlimited national emergency or civil defense emergency, American and other major air carriers may be required to provide airlift services to the Military Airlift Command under the Civil Reserve Air Fleet program. ITEM 2. ITEM 2. PROPERTIES FLIGHT EQUIPMENT Owned and leased aircraft operated by American at December 31, 1993, included: For information concerning the estimated useful lives and residual values for owned aircraft, lease terms and amortization relating to aircraft under capital leases, and acquisitions of aircraft, see Notes 1, 3 and 4 to the consolidated financial statements. See Management's Discussion and Analysis for discussion of the retirement of certain widebody aircraft from the fleet. Lease expirations for American's leased aircraft included in the above table as of December 31, 1993, were: The table excludes leases for 15 Boeing 767-300 Extended Range aircraft which can be canceled with 30 days' notice during the first 10 years of the lease term. At the end of that term in 1998, the leases can be renewed for periods ranging from 10 to 12 years. The table also excludes one Boeing 737-200 and four Boeing 737-300 aircraft which have been subleased and one McDonnell Douglas DC-10-30 aircraft which has been grounded. Substantially all of American's aircraft leases include an option to purchase the aircraft or to extend the lease term, or both, with the purchase price or renewal rental to be based essentially on the market value of the aircraft at the end of the term of the lease or at a predetermined fixed rate. GROUND PROPERTIES American leases, or has built as leasehold improvements on leased property, most of its airport and terminal facilities; certain corporate office, maintenance and training facilities in Fort Worth, Texas; its principal overhaul and maintenance base and computer facility at Tulsa International Airport, Tulsa, Oklahoma; its regional reservation offices; and local ticket and administration offices throughout the system. American has entered into agreements with the Tulsa Municipal Airport Trust; the Alliance Airport Authority, Fort Worth, Texas; and the Dallas/Fort Worth, Chicago O'Hare, Raleigh/Durham, Nashville, San Juan, New York, and Los Angeles airport authorities to provide funds for, among other things, additional facilities and equipment, and improvements and modifications to existing facilities, which equipment and facilities are or will be leased to American. American also utilizes public airports for its flight operations under lease arrangements with the municipalities or governmental agencies owning or controlling them and leases certain other ground equipment for use at its facilities. For information concerning the estimated lives and residual values for owned ground properties, lease terms and amortization relating to ground properties under capital leases, and acquisitions of ground properties, see Notes 1, 3 and 4 to the consolidated financial statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In December 1992, the U.S. Department of Justice filed an antitrust lawsuit in the U.S. District Court for the District of Columbia under Section 1 of the Sherman Act against several airlines, including the Company, alleging price fixing based upon the industry's exchange of fare information through the Airline Tariff Publishing Company. In March 1994, the Company and the remaining defendants in the case agreed to settle the lawsuit without admitting liability by entering into a stipulated final judgment that prohibits or restricts certain pricing practices including the announcement of fare increases before their effective date. The proposed final judgment is subject to approval by the Court following a public notice and comment period prescribed by statute. The Company does not anticipate a material financial impact from the settlement or compliance with the stipulated judgment. Private class action claims with similar allegations were settled by the Company and other airlines which became final in March 1993. Prior to the private class action settlement becoming final, the Company and several other airlines voluntarily altered certain pricing practices at issue in the lawsuits to avoid exposure to additional claims. American has been sued in two class action cases that have been consolidated in the Circuit Court of Cook County, Illinois, in connection with certain changes made to American's AAdvantage frequent flyer program in May, 1988. (Wolens, et al v. American Airlines, Inc., No. 88 CH 7554, and Tucker v. American Airlines, Inc., No. 89 CH 199.) In both cases, the plaintiffs seek to represent all persons who joined the AAdvantage program before May 1988. The complaints allege that, on that date, American implemented changes that limited the number of seats available to participants traveling on certain awards and established holiday blackout dates during which no AAdvantage seats would be available for certain awards. The plaintiffs allege that these changes breached American's contracts with AAdvantage members and were in violation of the Illinois Consumer Fraud and Deceptive Business Practices Act (Consumer Fraud Act). Plaintiffs seek money damages of an unspecified sum, punitive damages, costs, attorneys fees and an injunction preventing the Company from making any future changes that would reduce the value of AAdvantage benefits. American moved to dismiss both complaints, asserting that the claims are preempted by the Federal Aviation Act and barred by the Commerce Clause of the U.S. Constitution. The trial court denied American's preemption motions, but certified its decision for interlocutory appeal. In December 1990, the Illinois Appellate Court held that plaintiffs' claims for an injunction are preempted by the Federal Aviation Act, but that plaintiffs' claims for money damages could proceed. On March 12, 1992, the Illinois Supreme Court affirmed the decision of the Appellate Court. American sought a writ of certiorari from the U.S. Supreme Court; and on October 5, 1992, that Court vacated the decision of the Illinois Supreme Court and remanded the cases for reconsideration in light of the U.S. Supreme Court's decision in Morales v. TWA, et al, which interpreted the preemption provisions of the Federal Aviation Act very broadly. On December 16, 1993, the Illinois Supreme Court rendered its decision on remand, holding that plaintiffs' claims seeking an injunction were preempted, but that identical claims for compensatory and punitive damages were not preempted. On February 8, 1994, American filed petition for a writ of certiorari in the U.S. Supreme Court. The Illinois Supreme Court granted American's motion to stay the state court proceeding pending disposition of American's petition in the U.S. Supreme Court. AMR and American are vigorously defending all of the above claims. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS American is a wholly-owned subsidiary of AMR Corporation and there is no market for the Registrant's Common Stock. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA Omitted under the reduced disclosure format pursuant to General Instruction J(2)(a) of Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Abbreviated pursuant to General Instruction J(2)(a) of Form 10-K). HIGHLIGHTS SUMMARY American's net income in 1993 was $23 million. The 1993 results reflect the negative impact of a five-day strike by the union representing American's flight attendants in November. The results also include a $125 million charge ($79 million after tax) for the retirement of certain DC-10 aircraft and a positive $115 million adjustment to revenues ($67 million net of related commission expense and taxes) for a change in estimate related to certain earned passenger revenues. In 1992, American recorded a net loss of $735 million. The loss for 1992, before the effect of the adoption of two new mandatory accounting standards, was $274 million. The Company's 1993 operating income was $564 million, compared to an operating loss of $77 million in 1992. In the first quarter of 1993, AMR created and began implementing a new strategic framework, known as the Transition Plan. The Plan has three parts, each intended to improve results. First, make AMR's core airline business bigger and stronger where economically justified. Second, and conversely, shrink the airline where it cannot compete profitably. Third, reallocate resources and effort to AMR and American's growing information and management services businesses which are more profitable than the airline. Major events relating to the Transition Plan in 1993 included: . The SABRE Technology Group -- later renamed The SABRE Group -- was formed during the second quarter of 1993. . American announced its decision to retire 42 widebody DC-10 jets to reduce the airline's capacity and lower operating expenses. . American shifted domestic capacity to its major hubs in Dallas/Fort Worth and Miami. The AMR Eagle carriers added or increased service in certain other markets as American reduced or withdrew jet service. . American significantly reduced service at San Jose, California. . To provide increased value to business customers, American expanded its successful three-class transcontinental service to new markets, added more frequent flights on business routes such as Dallas/Fort Worth - Chicago, and added more first class seats on some narrowbody aircraft. . American increased capacity in Latin America by 17.5 percent over 1992. American's 1993 results benefited from strengthened domestic revenues in comparison to 1992. American's 1992 domestic revenues suffered from competitive fare reductions below the levels American established in its Value Pricing Plan in April 1992. European revenues, however, were negatively impacted in 1993 by aggressive fare discounting by competitors, weak European economies and a stronger U.S. dollar. The Company's 1993 results also reflect the dramatic adverse impact of a five-day strike by American's flight attendants' union in November. The strike's after-tax impact on fourth quarter results, estimated at $190 million, offset earnings generated earlier in the year. With the downsizing of unprofitable operations, American's workforce began to decline following years of double-digit percentage increases. In 1993, American provided $25 million for employee severance, primarily management/specialist and operations employees. REVENUES 1993 COMPARED TO 1992 American's operating revenues increased 8.4 percent to $14.7 billion in 1993, compared to $13.6 billion in 1992. Passenger revenues rose 8.4 percent, $1.0 billion, primarily as a result of an 8.8 percent increase in passenger yield (the average amount one passenger pays to fly one mile), partially offset by a 0.3 percent decline in passenger traffic. American's passenger yield in 1993 increased to 13.28 cents, primarily as a result of a very weak comparison base of 1992, when revenues were negatively impacted by competitors' drastic discounting of domestic fares. For the year, domestic yield increased 13.5 percent. International yield was mixed, increasing 13.9 percent in the Pacific, unchanged in Latin America and declining 10.1 percent in Europe. In 1993, American derived 73.8 percent of its passenger revenues from domestic operations and 26.2 percent from international operations. Although American's system capacity, as measured by available seat miles (ASMs), increased 5.2 percent, its traffic, as measured by revenue passenger miles (RPMs), decreased 0.3 percent. The drastic fare discounting drove traffic up to record levels in 1992. Traffic suffered in 1993 from American's inability to carry passengers during the flight attendants' union strike in November and the adverse effect of the strike on passenger demand during the month of December. American's domestic traffic decreased 3.5 percent, to 69.7 billion RPMs, while domestic capacity grew 2.9 percent. International traffic grew 9.1 percent, to 27.5 billion RPMs on capacity growth of 12.1 percent. The increase in international traffic was led by a 14.7 percent increase in Latin America on capacity growth of 17.5 percent, and a 7.4 percent increase in Europe on capacity growth of 10.8 percent. Cargo revenues increased 10.4 percent, $60 million, driven by a 22.5 percent increase in American's domestic and international cargo volumes, partially offset by decreasing yields brought about by strong price competition resulting from excess industry capacity. Other revenues, consisting of service fees, liquor revenues, duty-free sales, tour marketing and miscellaneous other revenues, increased 5.2 percent, $26 million, primarily as a result of increased traffic. Information Services Group revenues increased 7.3 percent, $79 million, primarily due to increased booking fees resulting from growth in booking volumes and average fees collected from participating vendors. EXPENSES 1993 COMPARED TO 1992 Operating expenses increased 3.8 percent, $515 million. American's capacity increased 5.2 percent, to 160.9 billion ASMs, due primarily to the addition of new aircraft. American's Passenger Division cost per ASM decreased by 2.0 percent, to 8.25 cents. Wages, salaries and benefits rose 5.1 percent, $237 million, due to wage and salary adjustments for existing employees and rising health-care costs. In addition, during the fourth quarter, American recorded a $25 million severance provision in conjunction with layoffs and voluntary terminations of management/specialist and operations personnel. Aircraft fuel expense decreased 2.4 percent, $44 million, due to a 4.9 percent decrease in the average price per gallon, partially offset by a 2.7 percent increase in gallons consumed. The average price per gallon decreased from $0.65 per gallon in 1992 to $0.62 per gallon in 1993. American consumed an average of 245 million gallons of fuel each month. A one-cent decline in fuel prices saves approximately $2.5 million per month. Commissions to agents increased 10.3 percent, $130 million, due principally to increased passenger revenues and increased incentives for travel agents. Depreciation and amortization increased 16.4 percent, $157 million, primarily due to the addition of 44 owned jet aircraft and other capital equipment. Food service cost was flat, reflecting the 9.1 percent increase in international traffic, where food costs are greater, offset by the 3.5 percent decrease in domestic traffic. Maintenance materials and repairs expense decreased 8.9 percent, $53 million, due principally to the retirement of older aircraft and increased operational efficiencies. Other operating expenses (including crew travel expenses, booking fees, purchased services, communications charges, credit card fees and advertising) increased 2.4 percent, $54 million, primarily due to the increase in capacity and an increase in fees paid to affiliates for passengers connecting with American flights. Interest capitalized decreased 50.0 percent, $49 million, as a result of the decrease in the average balance during the year of purchase deposits for flight equipment and the decline in interest rates. Miscellaneous - net for 1993 includes a $125 million charge related to the retirement of 31 DC-10 aircraft. Included in Miscellaneous - net for 1992 is a $14 million provision for a cash payment representing American's share of a multi-carrier antitrust settlement. OTHER INFORMATION DEFERRED TAX ASSETS As of December 31, 1993, the Company had deferred tax assets aggregating approximately $2.0 billion, including approximately $337 million of alternative minimum tax (AMT) credit carryforwards. The Company believes substantially all the deferred tax assets, other than the AMT credit carryforwards, will be realized through reversal of existing taxable temporary differences. The Company anticipates using its AMT credit carryforwards, which are available for an indefinite period of time, against its future regular tax liability within the next 10 years for several reasons. Although the Company incurred net losses in 1990 through 1993, it recorded substantial income before taxes and taxable income during the seven-year period 1983 through 1989 of approximately $3.2 billion and $1.8 billion, respectively. The Company is aggressively pursuing revenue enhancement and cost reduction initiatives to restore profitability. The Company has also substantially curtailed its planned capital spending program, which will accelerate the reversal of depreciation differences between financial and tax income, thus increasing taxable income. ENVIRONMENTAL MATTERS American has been notified of potential liability with regard to several environmental cleanup sites. At sites where remedial litigation has commenced, potential liability is joint and several. American's alleged volumetric contributions at the sites are minimal. American does not expect these actions, individually or collectively, to have a material impact on its financial condition, operating results or cash flows. DISCOUNT RATE Due to the decline in interest rates during 1993, the discount rate used to determine the Company's pension obligations as of December 31, 1993 and the related expense for 1994, has been reduced. The impact on 1994 pension expense of the change in the discount rate will be substantially offset by the significant appreciation in the market value of pension plan assets experienced during 1993. PROPOSED SETTLEMENT OF LITIGATION During 1992, American and certain other carriers agreed to settle various class action claims, subject to approval by the U.S. District Court for the Northern District of Georgia. Under the terms of the agreement, the carriers paid a total of approximately $50 million in cash and will jointly issue and distribute approximately $408 million in face amount of certificates for discounts of approximately 10 percent on future air travel on any of the carriers. A liability has not been established for the certificate portion of the settlement since American expects that, in the aggregate, future revenues received upon redemption of the certificates will exceed the related cost of providing the air travel. American anticipates that the share of the certificates redeemed on American may represent, but is not limited to, American's 26 percent market share among the carriers. The ultimate impact of the settlement on American's revenues, operating margins and earnings is not reasonably estimable since both the portion of certificates to be redeemed on American and the stimulative or depressive effect of the certificate redemption on revenues is not known. OUTLOOK FOR 1994 During 1993, AMR completed a comprehensive review of the competitive realities of its businesses and determined that it must change significantly in order to generate sufficient earnings. The fundamental problems of the airline -- increasing competition from low- cost, low-fare carriers, its inability to reduce labor costs to competitive levels, and the changing values of its customers -- demand new solutions. As an initial response to that need, AMR created and began implementing a new strategic framework known as the Transition Plan. The plan has three parts, each intended to improve AMR's results. First, make the core airline business bigger and stronger where economically justified. Second, and conversely, shrink the airline where it cannot compete profitably. Third, reallocate resources and effort to the growing information and management services businesses, which are more profitable than the airline. An integral part of the Transition Plan is the expansion of the business activities of The SABRE Group. The SABRE Group was formed as a business unit during 1993, integrating reporting relationships among American's STIN, SCS and SDS divisions and AMR's other information technology businesses. AMR plans to more fully develop and market its distinct information technology expertise through The SABRE Group and continues to investigate opportunities for further expanding its information technology businesses. These opportunities may include the combination of marketing and/or developmental functions of The SABRE Group businesses and/or a formal reorganization of The SABRE Group into one or more subsidiaries of AMR. This formal reorganization, if concluded, would likely involve the transfer to AMR, by means of a dividend, of American's STIN, SCS and SDS divisions. In addition, a formal reorganization would also result in the Company's compliance with a recent directive from the European Community Council of Ministers that, in effect, requires that a CRS operating in the European Community have a legal status that is separate and apart from its affiliated airline. Further, the Transition Plan recognizes the unfavorable and uncertain economics which have characterized the core airline business in recent years, acknowledges the airline cost problem and seeks to maximize the contribution of the Company's more profitable businesses. In 1994, AMR will continue the course of change initiated in 1993 under the Transition Plan. Over the long term, AMR will continue its best efforts to reduce airline costs and to restore the airline operations to profitability. Based on the success or failure of those efforts, AMR will make ongoing determinations as to the appropriate degree of reallocation of resources from the airline operations to its other businesses, which may include, if the airline cannot be run profitably, the disposition or termination, over the long term, of a substantial part or all of the airline operations. AIR TRANSPORTATION GROUP During 1993, American closed its hub and dramatically reduced operations at San Jose, California, and expanded its Dallas/Fort Worth and Miami hubs. The airline will continue to reduce or eliminate service where it cannot operate profitably. American's regional airline affiliates, subsidiaries of AMR Eagle, have added turboprop service on some routes where jet service has been canceled, and they will continue to pursue these opportunities in 1994. In 1993, American removed 21 McDonnell Douglas DC-10 and 28 Boeing 727 aircraft from service. In 1994, an additional 14 DC- 10s and 31 727s will be retired. As a result, in 1994 American's available seat miles are expected to decrease by almost five percent. Domestic capacity will drop by almost seven percent, while international capacity will increase slightly. The capacity reduction will be the first at American since 1981. Aircraft retirements have necessitated the furlough of about 3,700 American employees since late 1992. The Company anticipates further workforce reductions in 1994 and, accordingly, made a provision for the cost of these reductions in 1993. Fewer aircraft deliveries will also translate into lower capital spending. American's revenue plan for 1994 reflects continued emphasis on producing premium yields by attracting more full fare passengers than its competitors. As part of this plan, American will expand its successful three-class domestic transcontinental service, add more first class seats on some narrowbody aircraft and increase frequencies in business-oriented markets. In addition, American will seek to grow its cargo revenues again in 1994. In 1993, American's Passenger Division cost per available seat mile declined by 2.0 percent, largely due to a 4.9 percent drop in the cost of jet fuel. In 1994, though American will continue its rigorous program of cost control, it expects units costs, excluding fuel, to rise modestly. This increase will be driven by higher unit labor costs due to pay scale and average seniority escalations. On August 10, 1993, the Omnibus Budget Reconciliation Act was signed into law, imposing a new 4.3 cents per gallon tax on commercial aviation jet fuel for use in domestic operations. The new tax will become effective October 1, 1995, and is scheduled to continue until October 1, 1998. American estimates the resulting annual increase in fuel taxes will be approximately $90 million. AMR instituted a program in the latter half of 1993 to reduce interest costs. At year-end interest rates, the Company anticipates that this program, which involves such things as interest rate swaps, will produce significant interest cost savings. This savings is expected to largely offset the additional interest cost of new financings in 1994. In November 1993, American endured a five-day strike by its flight attendants' union; the strike ended when both sides agreed to binding arbitration. The arbitration process is expected to be complex and will likely not be decided for several months. While the ultimate outcome is uncertain, the new contract will likely result in higher unit labor costs in 1994. American's labor contract with its pilots' union becomes amendable in August 1994. The Company and the union leadership are pursuing opportunities to streamline the negotiation and settlement process. The ultimate outcome of these negotiations cannot be estimated at this time. INFORMATION SERVICES GROUP The integration of AMR's information services businesses will continue in 1994 with the integration of American Airlines Decision Technologies, which is a subsidiary of AMR, SDS and other units in The SABRE Group into SABRE Decision Technologies (SDT). SDT will develop and market The SABRE Group's expanding array of information systems products and services to a growing list of airline and other customers throughout the world. STIN will seek to sustain its revenue growth through continued geographical expansion of the SABRE computerized reservation system and the sale of its leading-edge automated reservations products such as SABRExpress, SABRExpress Ticketing and SABRE TravelBase, a new travel agency accounting system. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS Page ---- Report of Independent Auditors 17 Consolidated Statement of Operations 18 Consolidated Balance Sheet 19 Consolidated Statement of Cash Flows 21 Consolidated Statement of Stockholder's Equity 22 Notes to Consolidated Financial Statements 23 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder American Airlines, Inc. We have audited the accompanying consolidated balance sheets of American Airlines, Inc. 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. Our audits also included the financial statement schedules listed in Item 14(a) on page 40. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Airlines, 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 Notes 7 and 8 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. ERNST & YOUNG 2121 San Jacinto Dallas, Texas 75201 February 15, 1994 AMERICAN AIRLINES, INC. CONSOLIDATED STATEMENT OF OPERATIONS (in millions) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED BALANCE SHEET (in millions) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED BALANCE SHEET (in millions, except shares and par value) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (in millions) The accompanying notes are an integral part of these financial statements. AMERICAN AIRLINES, INC. CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY (in millions) The accompanying notes are an integral part of these financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF ACCOUNTING POLICIES BASIS OF CONSOLIDATION American Airlines, Inc. (American or the Company) is a wholly-owned subsidiary of AMR Corporation (AMR). The consolidated financial statements include the accounts of American and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated. Certain amounts from prior years have been reclassified to conform with the 1993 presentation. TRANSACTIONS WITH AFFILIATES Transactions with affiliates are on a basis determined by the parties. American invests funds of affiliates in a combined short-term investment portfolio and passes through interest income on such funds at the average rate earned on the portfolio. To the extent funds transferred to American exceed the invested portfolio, such amounts are converted to Long-Term Debt due to Parent under a subordinated note agreement with AMR. To the extent American invests its excess cash flows in the short-term investment portfolio, Long-Term Debt due to Parent is reduced with a corresponding increase in Payables to Affiliates. The subordinated promissory note bears interest based on the London Interbank Offered Rate (LIBOR), 3.5 percent at December 31, 1993, and the interest rate is reset every six months. The note is due May 1, 2001; however, American may prepay the note without penalty at any time. Under the provisions of this note agreement, approximately $3.86 billion and $3.06 billion was included in Long-Term Debt due to Parent as of December 31, 1993 and 1992, respectively. Payables to Affiliates includes approximately $514 million and $801 million at December 31, 1993 and 1992, respectively, representing funds of affiliates transferred to American for investment and invested in the portfolio. Interest paid to affiliates in addition to interest income passed through on invested funds was approximately $132 million, $106 million and $93 million for the years ended December 31, 1993, 1992 and 1991, respectively. Interest expense includes $16 million for the years ended December 31, 1993 and 1992, and $15 million for the year ended December 31, and 1991, relating to debentures held by AMR calculated at a 9.03 percent effective interest rate. During 1991, AMR contributed $1.0 billion of capital to American by reducing American's obligation to AMR for invested funds. American paid affiliates $138 million, $110 million and $73 million in 1993, 1992 and 1991, respectively, for ground handling services provided at selected airports, data processing services, consulting services and investment management and advisory services with respect to short-term investments and the assets of its retirement benefit plans. American issues tickets for flights on AMR Eagle. As a result, the revenue collected for such tickets is prorated between American and AMR Eagle based on the segments flown by the respective carriers. In addition, in 1993, 1992 and 1991, American paid fees of $261 million, $213 million and $111 million, respectively, included in Other Operating Expenses, to AMR Eagle primarily for passengers connecting with American flights. American paid commissions of $4 million and $19 million to AMR Foreign Sales Corporation, Ltd., a subsidiary of AMR, in 1992 and 1991, respectively, for arranging certain aircraft sale and leaseback transactions. The commissions were recognized as adjustments to the deferred gains on these sales. American charges AMR affiliates for the use of its communications, accounting and information processing systems, as well as for other services. American recognizes compensation expense associated with certain AMR common stock-based awards for employees of American. INVENTORIES Spare parts, materials and supplies relating to flight equipment are carried at average cost and are expensed when used in operations. Allowances for obsolescence are provided, over the estimated useful life of the related aircraft and engines, for spare parts expected to be on hand at the date aircraft are retired from service. EQUIPMENT AND PROPERTY The provision for depreciation of operating equipment and property is computed on the straight-line method applied to each unit of property, except that spare assemblies are depreciated on a group basis. The depreciable lives and residual values used for the principal depreciable asset classifications are: * In connection with a review of its fleet plan, American changed, effective October 1, 1991, the estimated useful lives of its Boeing 727-200 aircraft and engines from a common retirement date of December 31, 1994, to projected retirement dates by aircraft, which results in an average depreciable life of approximately 21 years. ** During 1993, American announced its intention to retire a total of 36 McDonnell Douglas DC-10-10 and six McDonnell Douglas DC-10-30 aircraft. At December 31, 1993, 21 of those aircraft had been grounded. *** Approximate common retirement date. Equipment and property under capital leases are amortized over the term of the leases and such amortization is included in depreciation and amortization. Lease terms vary but are generally 10 to 25 years for aircraft and 7 to 40 years for other leased equipment and property. MAINTENANCE AND REPAIR COSTS Maintenance and repair costs for owned and leased flight equipment are charged to operating expense as incurred. INTANGIBLE ASSETS The Company continually evaluates intangible assets to determine whether current events and circumstances warrant adjustment of the carrying values or amortization periods. Route acquisition costs and airport operating and gate lease rights represent the purchase price attributable to route authorities, airport take-off and landing slots and airport gate leasehold rights acquired and are being amortized on a straight-line basis over 10 to 40 years. PASSENGER REVENUES Passenger ticket sales are initially recorded as a current liability. Revenue derived from the sale is recognized at the time transportation is provided. FREQUENT FLYER PROGRAM The estimated incremental cost of providing free travel awards is accrued when such award levels are reached. Revenues received for miles sold to others participating in the program are deferred and recognized over a period approximating the time transportation is provided. INCOME TAXES AMR and its eligible subsidiaries, including American, file a consolidated federal income tax return. Deferred income taxes reflect the net tax effects of temporary differences between the financial reporting carrying amounts of assets and liabilities and the income tax amounts. DEFERRED GAINS Gains on the sale and leaseback of equipment and property are deferred and amortized over the terms of the related leases as a reduction of rent expense. FOREIGN EXCHANGE CONTRACTS American enters into foreign exchange contracts as a hedge against certain amounts payable or receivable in foreign currencies. Market value gains or losses are recognized and offset against foreign exchange gains or losses on those obligations or receivables. FUEL SWAP CONTRACTS American enters into swap contracts to hedge against market price fluctuations of jet fuel. Gains or losses on these contracts are included in fuel expense when the underlying fuel being hedged is used. STATEMENT OF CASH FLOWS Short-term investments, without regard to remaining maturity at acquisition, are not considered as cash equivalents for purposes of the statement of cash flows. 2. SHORT-TERM INVESTMENTS Short-term investments consisted of (in millions): The fair value of short-term investments at December 31, 1993, by contractual maturity was (in millions): All short-term investments were classified as available-for-sale and stated at fair value. 3. COMMITMENTS AND CONTINGENCIES The Company has on order 36 jet aircraft - 16 Boeing 757-200s, seven Boeing 767-300ERs and 13 Fokker 100s scheduled for delivery through 1996. Deposits of $313 million have been made toward the purchase of these aircraft. Future payments, including estimated amounts for price escalation through anticipated delivery dates for these aircraft and related equipment will be approximately $600 million in 1994, $450 million in 1995 and $150 million in 1996, a portion of which is payable in foreign currencies. In addition to these commitments for aircraft, the Company has authorized expenditures of approximately $1.1 billion for aircraft modifications, renovations of, and additions to, airport and office facilities and various other equipment and assets. American expects to spend approximately $750 million of this amount in 1994. American has included an event risk covenant in approximately $2.9 billion of lease agreements. The covenant permits the holders of such instruments to receive a higher rate of return (between 50 and 700 basis points above the stated rate) if a designated event, as defined, should occur and the credit rating of the debentures or the debt obligations underlying the lease agreements is downgraded below certain levels. 3. COMMITMENTS AND CONTINGENCIES (CONTINUED) In July 1991, American entered into a five-year agreement whereby American transfers, on a continuing basis and with recourse to the receivables, an undivided interest in a designated pool of receivables. Undivided interests in new receivables are transferred daily as collections reduce previously transferred receivables. At December 31, 1993 and 1992, Receivables are presented net of approximately $300 million of such transferred receivables. American maintains an allowance for uncollectible receivables based upon expected collectibility of all receivables, including the receivables transferred. Special facility revenue bonds have been issued by certain municipalities, primarily to purchase equipment and improve airport facilities which are leased by American. In certain cases, the bond issue proceeds were loaned to American and are included in Long-Term Debt. Certain bonds have rates that are periodically reset and are remarketed by various agents. In certain circumstances, American may be required to purchase up to $413 million of the special facility revenue bonds prior to maturity, in which case American has the right to resell the bonds or to use the bonds to offset its lease or debt obligations. American may borrow the purchase price of these bonds under standby letter-of-credit agreements. At American's option, these letters of credit are secured by funds held by bond trustees and by approximately $448 million of short-term investments. 4. LEASES American leases various types of equipment and property, including aircraft, passenger terminals, equipment and various other facilities. The future minimum lease payments required under capital leases, together with the present value of net minimum lease payments, and future minimum lease payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 1993, were (in millions): * Future minimum payments required under capital leases and operating leases include $384 million and $6.0 billion, respectively, guaranteed by AMR relating to special facility revenue bonds issued by municipalities. ** The present value of future minimum lease payments includes $132 million guaranteed by American. At December 31, 1993, the Company had 235 jet aircraft under operating leases and 80 jet aircraft under capital leases. 4. LEASES (CONTINUED) The aircraft leases can generally be renewed at rates based on fair market value at the end of the lease term for one to five years. Most aircraft leases have purchase options at or near the end of the lease term at fair market value, but generally not to exceed a stated percentage of the defined lessor's cost of the aircraft. Of the aircraft American has under operating leases, 15 Boeing 767-300ERs are cancelable upon 30 days' notice during the initial 10-year lease term. At the end of that term in 1998, the leases can be renewed for periods ranging from 10 to 12 years. In 1993, American agreed to forfeit its right to cancel leases for 25 Airbus A300-600R aircraft upon 30 days' notice and extended the terms of the leases for periods ranging from 18 to 19 years. Rent expense, excluding landing fees, was $1.2 billion, $1.1 billion and $925 million for the years ended December 31, 1993, 1992 and 1991, respectively. 5. INDEBTEDNESS Short-term borrowings at December 31, 1992, consisted of commercial paper. Long-term debt (excluding amounts maturing within one year) consisted of (in millions): Maturities of long-term debt (including sinking fund requirements) for the next five years are: 1994 - $70 million; 1995 - $44 million; 1996 - $47 million; 1997 - $44 million; 1998 - $53 million. Certain debt is secured by aircraft, engines, equipment and other assets having a net book value of approximately $1.5 billion. American has a $500 million short-term credit facility agreement which expires in 1995 and a $1.0 billion credit facility expiring in 1994. American expects to replace the $1.0 billion credit facility with a $750 million credit agreement. American also has $335 million available under a multiple option facility which expires in 1995. Interest on these agreements is calculated at floating rates based upon LIBOR. At December 31, 1993, no borrowings were outstanding and approximately $1.8 billion was available under these facilities. As of February 15, 1994, borrowings of $400 million were outstanding under the credit facilities. American's debt and credit facility agreements contain certain restrictive covenants, including a cash flow coverage test, a minimum net worth requirement and limitations on indebtedness and the declaration of dividends on shares of its capital stock. At December 31, 1993, under the most restrictive provisions of those agreements, approximately $1.3 billion of American's retained earnings were available for payment of cash dividends to AMR. 6. FINANCIAL INSTRUMENTS The fair values of the Company's long-term debt were estimated using quoted market prices, where available. For long-term debt not actively traded, fair values were estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The fair values of the Company's long-term debt, including current maturities, at December 31, 1993, were (in millions): During 1993, American entered into interest-rate swap agreements with a number of major financial institutions. Under these swap agreements, American receives fixed-rate payments (4.25% to 6.44%) in exchange for floating-rate payments (3.25% to 4.00% at December 31, 1993) on a total notional principal amount of $1.4 billion. The swap agreements expire over three to 15 years. American is exposed to credit risk in the event of default by the counterparties; however, American does not anticipate such default. Under agreements with certain counterparties, American or the counterparty may be required to post collateral based on certain credit limits and ratings. As of December 31, 1993, no collateral was required under these agreements. The fair value of the Company's interest-rate swap agreements is estimated based on the market prices for similar agreements. The net fair values of the Company's interest rate swap agreements at December 31, 1993, representing the estimated net amount the Company would have to pay to terminate the agreements, was $6 million. To hedge against the risk of future currency exchange rate fluctuations on certain lease obligations and related interest payable in foreign currencies, American has entered into various foreign currency exchange agreements. Changes in the value of the agreements due to exchange rate fluctuations are offset by changes in the value of the foreign currency denominated lease obligations translated at the current rate. In the event of default by the counterparties, American is exposed to risk for periodic settlements due under the agreements; however, American does not anticipate such default. At December 31, 1993, American had agreements to purchase 20.3 billion Japanese yen at rates ranging from 104.50 to 137.26 yen per U.S. dollar. The fair value of the Company's foreign currency exchange agreements is estimated based on quoted market prices of comparable agreements. The net fair value of the Company's foreign currency exchange agreements at December 31, 1993, representing the estimated net amount that American would receive to terminate the agreements, was approximately $18 million. American has sold options enabling two major banks to put Dutch guilders to American at a fixed rate of guilders per U.S. dollar at periodic intervals through 1994. At December 31, 1993, approximately 680 million guilders remain subject to the put options. The market risk associated with the put options is offset by American's ability, under a purchase agreement, to pay for certain equipment in U.S. dollars or, at American's option, in Dutch guilders, at the same exchange rate as the put options. At dates where American does not have a liability under the equipment purchase agreement due to changes in delivery schedules, American has purchased options to put approximately 50 million guilders to a major bank at the same rate of exchange. American's credit risk is limited to failure of the manufacturer to perform under the purchase agreement or the failure of the bank to perform under the purchased put option agreement; however, American does not anticipate non-performance. The proceeds from the sales of the put options, net of the cost of the put options purchased, were deferred and are being offset against the cost of the equipment acquired under the purchase agreement. The net fair value of these guilder put options was de minimis at December 31, 1993. 7. INCOME TAXES American, as a wholly-owned subsidiary, is included in AMR's consolidated tax return. American's provision (benefit) for income taxes has been computed on the basis that American files separate consolidated income tax returns with its subsidiaries. Effective January 1, 1992, AMR adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," (FAS 109), changing its method of accounting for income taxes. American was required to simultaneously adopt the methodology used in FAS 109 in accordance with its tax sharing agreement with AMR. As permitted under the new rules, prior years' financial statements have not been restated to reflect the change in accounting method. The cumulative effect of adopting FAS 109 decreased the net loss for the year ended December 31, 1992, by $132 million The significant components of the income tax provision (benefit) were (in millions): The income tax provision (benefit) includes a provision of $43 million in 1993 and benefit of $114 million and $67 million in 1992 and 1991, respectively, for federal taxes. In addition, a deferred tax benefit of $320 million was recognized in the year ended December 31, 1992, upon adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (FAS 106). The income tax provision (benefit) differed from amounts computed at the statutory federal income tax rate as follows (in millions): 7. INCOME TAXES (CONTINUED) The components of American's deferred tax assets and liabilities were (in millions): At December 31, 1993, American had available for federal income tax purposes approximately $337 million of alternative minimum tax credit carryforwards available for an indefinite period, and approximately $1.2 billion of net operating loss carryforwards for regular tax purposes, with $640 million expiring in 2007 and $585 million expiring in 2008. The sources of deferred income taxes and the tax effect of each for the year ended December 31, 1991, before American adopted FAS 109, were (in millions): 8. RETIREMENT BENEFITS Substantially all employees of American are eligible to participate in pension plans. The defined benefit plans provide benefits for participating employees based on years of service and average compensation for a specified period of time before retirement. Airline pilots and flight engineers also participate in defined contribution plans for which company contributions are determined as a percentage of participant compensation. Costs for all pension plans were approximately $288 million, $247 million and $187 million in 1993, 1992 and 1991, respectively. 8. RETIREMENT BENEFIT PLANS (CONTINUED) Net periodic pension cost of the defined benefit plans was (in millions): The funded status and actuarial present value of benefit obligations of the defined benefit plans were (in millions): * American's funding policy is to make contributions equal to, or in excess of, the minimum funding requirements of the Employee Retirement Income Security Act of 1974. Plan assets consist primarily of government and corporate debt securities, marketable equity securities, and money market fund and mutual fund shares, of which approximately $99 million and $86 million of plan assets at December 31, 1993 and 1992, respectively, were invested in shares of mutual funds managed by a subsidiary of AMR. The projected benefit obligation was calculated using weighted average discount rates of 7.50%, 9.00% and 9.25% at December 31, 1993, 1992 and 1991, respectively; rates of increase for compensation of 4.40% at December 31, 1993, and 4.90% at December 31, 1992 and 1991; and the 1983 Group Annuity Mortality Table. The weighted average expected long-term rate of return on assets was 10.50% in 1993 and 11.25% in 1992 and 1991. The vested benefit obligation and plan assets at fair value at December 31, 1993, for plans whose benefits are guaranteed by the Pension Benefit Guaranty Corporation are $3.1 billion and $3.5 billion, respectively. Pension costs for defined contribution plans were approximately $118 million, $108 million and $90 million in 1993, 1992 and 1991, respectively. 8. RETIREMENT BENEFITS (CONTINUED) In addition to pension benefits, other postretirement benefits, including certain health care and life insurance benefits, are also provided to retired employees. The amount of health care benefits is limited to lifetime maximums as outlined in the plan. Substantially all employees of American and employees of certain other subsidiaries may become eligible for these benefits if they satisfy eligibility requirements during their working lives. Effective January 1, 1990, American's non-union employees that are covered by the health care and life insurance plan, as well as employees who are represented by the Transport Workers Union, began making contributions toward funding a portion of their retiree health care benefits during their working lives. American funds benefits as incurred and began, effective January 1993, to match employee prefunding. Effective January 1, 1992, American adopted FAS 106, changing the method of accounting for these benefits. Prior to 1992, other postretirement benefit expense was recognized by expensing health care claims incurred and annual life insurance premiums. Such expense was $31 million in 1991 and has not been restated. The cumulative effect of adopting FAS 106 as of January 1, 1992, was a charge of $913 million ($593 million after tax). This change also increased other postretirement benefit expense by approximately $89 million ($57 million after tax) for the year ended December 31, 1992. Net other postretirement benefit cost was (in millions): The funded status of the plan, reconciled to the accrued other postretirement benefit cost recognized in American's balance sheet, was (in millions): Plan assets consist primarily of shares of a mutual fund managed by a subsidiary of AMR. 8. RETIREMENT BENEFITS (CONTINUED) For 1993, future benefit costs were estimated assuming per capita cost of covered medical benefits would increase at an 11% annual rate, decreasing gradually to a 4% annual growth rate in 2000 and thereafter. A 1% increase in this annual trend rate would have increased the accumulated other postretirement benefit obligation at December 31, 1993, by approximately $118 million and 1993 other postretirement benefit cost by approximately $17 million. In 1992, future benefit costs were estimated assuming per capita cost of covered medical benefits would increase at a 12% annual rate, decreasing gradually to a 5% annual growth rate in 1999 and thereafter. The weighted average discount rate used in estimating the accumulated other postretirement benefit obligation was 7.50% and 9.00% at December 31, 1993 and 1992, respectively. 9. REVENUE AND OTHER EXPENSE ITEMS Revenues for the second quarter of 1993 include a $115 million positive adjustment resulting from a change in estimate relating to certain earned passenger revenues. Miscellaneous - net in 1993 includes a $125 million charge related to the retirement of 31 McDonnell Douglas DC-10 aircraft. The charge represents the Company's best estimate of the expected loss based upon the anticipated method of disposition. However, should the ultimate method of disposition differ, the actual loss could be different than the amount estimated. Miscellaneous - net for 1991 includes a provision of $42 million for the anticipated cost of lease terminations and aircraft dispositions relating to the retirement of American's Boeing 737 and British Aerospace BAe 146 aircraft fleets. Also included in 1991 is a $26 million charge for the retirement of American's Boeing 747SP aircraft. 10. FOREIGN OPERATIONS American conducts operations in various foreign countries. American's operating revenues from foreign operations were (in millions): 11. OTHER FINANCIAL INFORMATION American's operations fall within two industry segments: the Air Transportation Group and the Information Services Group. For a description of each of these groups, refer to Business on page 1. Following are financial highlights for these two groups for each of the three years in the period ended December 31, 1993 (in millions): The adoption of FAS 106 reduced the 1992 operating income of the Air Transportation Group and the Information Services Group by $85 million and $4 million, respectively. Intergroup revenues consist of revenues earned by the Information Services Group from the Air Transportation Group. Identifiable assets of the industry segments were (in millions): Identifiable assets are gross assets used by a business segment, including an allocated portion of assets used jointly by more than one segment. General corporate and other consists primarily of income tax assets. 11. OTHER FINANCIAL INFORMATION (CONTINUED) Supplemental disclosures of cash flow information and non-cash activities (in millions): 12. QUARTERLY FINANCIAL DATA (UNAUDITED) Unaudited summarized financial data by quarter for 1993 and 1992 (in millions): * Results for the first quarter of 1992 have been restated for the cumulative effect of the adoption of FAS 106 and FAS 109 which resulted in a net charge of $461 million after tax. Results for the first three quarters of 1992 have also been restated by the ratable portion of the $89 million current year effect of the accounting change for FAS 106, net of tax benefit. Results for the second quarter of 1993 include a $125 million charge related to the retirement of 31 McDonnell Douglas DC-10 aircraft. Results for the fourth quarter of 1993 reflect the adverse impact of a five-day strike by American's flight attendants' union and a $25 million charge for the cost of severance of certain employees. Results for the second quarter of 1992 include a $14 million provision for a cash payment representing American's share of a multi-carrier antitrust settlement. Results for the fourth quarter of 1992 include a $22 million charge for the cost of severance of certain employees. ITEM 9. ITEM 9. DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Omitted under the reduced disclosure format pursuant to General Instruction J(2)(c) of Form 10-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) The financial statements listed in the accompanying index to financial statements and schedules are filed as part of this report. (2) The schedules listed in the accompanying index to financial statements and schedules are filed as part of this report. (3) Exhibits required to be filed by Item 601 of Regulation S-K. (Where the amount of securities authorized to be issued under any of American's long-term debt agreements does not exceed ten percent of American's assets, pursuant to paragraph (b)(4) of Item 601 of Regulation S-K, in lieu of filing such as an exhibit, American hereby agrees to furnish to the Commission upon request a copy of any agreement with respect to such long-term debt.) EXHIBIT 3(a) Composite of the Certificate of Incorporation of American, incorporated by reference to Exhibit 3(a) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-2691. 3(b) Amended Bylaws of American, incorporated by reference to Exhibit 3(b) to American's report on Form 10-K for the year ended December 31, 1990, file number 1-2691. 10(a) Purchase Agreement, dated as of February 12, 1979, between American and the Boeing Company, relating to the purchase of Boeing Model 767-323 aircraft, incorporated by reference to Exhibit 10(b)(3) to American's Registration Statement No. 2-76709. 10(b) Description of American's Split Dollar Insurance Program, dated December 28, 1977, incorporated by reference to Exhibit 10(c)(1) to American's Registration Statement No. 2-76709. 10(c) American's 1992 Incentive Compensation Plan. 10(d) 1979 American Airlines (AMR) Stock Option Plan, as amended, incorporated by reference to Exhibit 10(d) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-2691. 10(e) 1979 American Airlines (AMR) Stock Option Plan, as amended, incorporated by reference to Exhibit 10(e) to American's report on Form 10-K for the year ended December 31, 1982, file number 1-2691. 10(f) Form of Stock Option Agreement for Corporate Officers under the 1979 American Airlines (AMR) Stock Option Plan, incorporated by reference to Exhibit 10(c)(5) to American's Registration Statement No. 2-76709. 10(g) Form of Stock Option Agreement under the 1974 and 1979 American Airlines (AMR) Stock Option Plans, incorporated by reference to Exhibit 10(c)(6) to American's Registration Statement No. 2-76709. 10(h) Deferred Compensation Agreement, dated April 14, 1973, as amended March 1, 1975, between American and Robert L. Crandall, incorporated by reference to Exhibit 10(c)(7) to American's Registration Statement No. 2-76709. 10(i) Deferred Compensation Agreement, dated October 18, 1972, as amended March 1, 1975, between American and Gene E. Overbeck, incorporated by reference to Exhibit 10(c)(9) to American's Registration Statement No. 2-76709. 10(j) Deferred Compensation Agreement, dated June 3, 1970, between American and Francis H. Burr, incorporated by reference to Exhibit 11(d) to American's Registration Statement No. 2-39380. 10(k) Description of informal arrangement relating to deferral of payment of directors' fees, incorporated by reference to Exhibit 10(c)(11) to American's Registration Statement No. 2-76709. 10(l) Purchase Agreement, dated as of February 29, 1984, between American and the McDonnell Douglas Corporation, relative to the purchase of McDonnell Douglas Super 80 aircraft, incorporated by reference to Exhibit 10(l) to American's report on Form 10-K for the year ended December 31, 1983, file number 1-2691. 10(m) Purchase Agreement, dated as of June 27, 1983, between American and the McDonnell Douglas Corporation, relative to the purchase of McDonnell Douglas Super 80 aircraft, incorporated by reference to Exhibit 4(a)(8) to American's Registration Statement No. 2-84905. 10(n) Form of Executive's Termination Benefits Agreement incorporated by reference to Exhibit 10(p) to American's report on Form 10-K for the year ended December 31, 1985, file number 1-2691. 10(o) Amendment, dated June 4, 1986, to Purchase Agreement in Exhibit 10(l) above, incorporated by reference to Exhibit 10(l) to American's report on Form 10-K for the year ended December 31, 1986, file number 1-2691. 10(p) Acquisition Agreement, dated as of March 1, 1987, between American and Airbus Industrie relative to the lease of Airbus A300-600R aircraft, incorporated by reference to Exhibit 10(p) to American's report on Form 10-K for the year ended December 31, 1986, file number 1-2691. 10(q) Acquisition Agreement, dated as of March 1, 1987, between American and the Boeing Company relative to the lease of Boeing 767-323ER aircraft, incorporated by reference to Exhibit 10(q) to American's report on Form 10-K for the year ended December 31, 1986, file number 1-2691. 10(r) Acquisition Agreement, dated as of July 21, 1988, between American and the Boeing Company relative to the purchase of Boeing Model 757-223 aircraft, incorporated by reference to Exhibit 10(r) to American's report on Form 10-K for the year ended December 31, 1988, file number 1-2691. 10(s) Acquisition Agreement, dated as of February 4, 1989, among American and Delta Airlines, Inc. and others relative to operation of a computerized reservations system incorporated by reference to Exhibit 10(s) to American's report on Form 10-K for the year ended December 31, 1988, file number 1-2691. 10(t) Purchase Agreement, dated as of May 5, 1989, between American and the Boeing Company relative to the purchase of Boeing 757-223 aircraft, incorporated by reference to Exhibit 10(t) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(u) Purchase Agreement, dated as of June 9, 1989, between American and Fokker Aircraft U. S. A., Inc. relative to the purchase of Fokker 100 aircraft, incorporated by reference to Exhibit 10(u) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(v) Purchase Agreement, dated as of June 23, 1989, between American and the Boeing Company relative to the purchase of Boeing 767-323ER aircraft, incorporated by reference to Exhibit 10(v) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(w) Purchase Agreement, dated as of August 3, 1989, between American and the McDonnell Douglas Corporation relative to the purchase of MD-11 aircraft, incorporated by reference to Exhibit 10(w) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(x) Amendment, dated as of August 3, 1989, to the Purchase Agreement in Exhibit 10(l) above, incorporated by reference to Exhibit 10(x) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(y) Purchase Agreement, dated as of October 25, 1989, between American and AVSA, S. A. R. L. relative to the purchase of Airbus A300-600R aircraft, incorporated by reference to Exhibit 10(y) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(z) Amendment, dated as of November 16, 1989, to Employment Agreement among AMR Corporation, American Airlines and Robert L. Crandall, incorporated by reference to Exhibit 10(z) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(aa) Management Severance Allowance, dated as of February 23, 1990, for levels 1-4 employees of American Airlines, Inc., incorporated by reference to Exhibit 10(aa) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(bb) Management Severance Allowance, dated as of February 23, 1990, for level 5 and above employees of American Airlines, Inc., incorporated by reference to Exhibit 10(bb) to American's report on Form 10-K for the year ended December 31, 1989, file number 1-2691. 10(cc) Amendment, dated as of December 3, 1990, to Employment Agreement among AMR Corporation, American Airlines and Robert L. Crandall incorporated by reference to Exhibit 10(cc) to American's report on Form 10-K for the year ended December 31, 1990, file number 1-2691. 10(dd) Amendment, dated as of May 1, 1992, to Employment Agreement among American, American Airlines and Robert L. Crandall incorporated by reference to Exhibit 10(dd) to American's report on Form 10-Q for the period ended June 30, 1992, file number 1-2691. 12 Computation of ratio of earnings to fixed charges for the years ended December 31, 1989, 1990, 1991, 1992 and 1993. 19 The 1974 and 1979 American Airlines (AMR) Stock Option plans as amended March 16, 1983, incorporated by reference to Exhibit 19 to American's report on Form 10-K for the year ended December 31, 1983, file number 1- 2691. Refer to Exhibits 10(d) and 10(e). 23 Consent of Independent Auditors appears on page 41 hereof. (b) Reports on Form 8-K: None. AMERICAN AIRLINES, INC. INDEX TO FINANCIAL STATEMENTS AND SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (ITEM 14(A)) All other schedules are omitted since the required information is included in the financial statements or notes thereto, or since the required information is either not present or not present in sufficient amounts. Exhibit 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in Post Effective Amendment No. 2 to the Registration Statement (Form S-3 No. 33-42998) of American Airlines, Inc., and in the related Prospectus, of our report dated February 15, 1994, with respect to the consolidated financial statements and schedules of American Airlines, Inc. included in this Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG 2121 San Jacinto Dallas, Texas 75201 March 29, 1994 AMERICAN AIRLINES, INC. Schedule IV - Indebtedness of and to Related Parties - Not Current Year ended December 31, 1993 (in millions) (a) See Note 1 to consolidated financial statements included in this Form 10-K for a description of the terms of this indebtedness. AMERICAN AIRLINES, INC. Schedule IV - Indebtedness of and to Related Parties - Not Current Year ended December 31, 1992 (in millions) (a) See Note 1 to consolidated financial statements included in this Form 10-K for a description of the terms of this indebtedness. AMERICAN AIRLINES, INC. Schedule IV - Indebtedness of and to Related Parties - Not Current Year ended December 31, 1991 (in millions) (a) See Note 1 to consolidated financial statements included in this Form 10-K for a description of the terms of this indebtedness. AMERICAN AIRLINES, INC. Schedule V - Property, Plant and Equipment Year ended December 31, 1993 (in millions) Additions to Flight Equipment includes amounts transferred from Purchase Deposits upon delivery of aircraft. AMERICAN AIRLINES, INC. Schedule V - Property, Plant and Equipment Year ended December 31, 1992 (in millions) Additions to Flight Equipment includes amounts transferred from Purchase Deposits upon delivery of aircraft. Net Transfers and Other Adjustments includes the sale and subsequent leaseback of two Boeing 757 aircraft, six Boeing 767 aircraft, three Fokker 100 aircraft and one McDonnell Douglas MD-80 aircraft. Seven of these agreements were accounted for as capital leases. AMERICAN AIRLINES, INC. Schedule V - Property, Plant and Equipment Year ended December 31, 1991 (in millions) Additions to Flight Equipment includes amounts transferred from Purchase Deposits upon delivery of aircraft. Net Transfers and Other Adjustments includes the sale and subsequent leaseback of thirteen Boeing 757 aircraft, two Boeing 767 aircraft, six Fokker 100 aircraft and 29 McDonnell Douglas MD-80 aircraft. Six of these agreements were accounted for as capital leases. AMERICAN AIRLINES, INC. Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year ended December 31, 1993 (in millions) AMERICAN AIRLINES, INC. Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year ended December 31, 1992 (in millions) (a) Includes accumulated depreciation related to sale and subsequent leaseback transactions. See Schedule V. AMERICAN AIRLINES, INC. Schedule VI - Accumulated Depreciation, Amortization and Obsolescence of Property, Plant and Equipment Year ended December 31, 1991 (in millions) (a) Includes accumulated depreciation related to sale and subsequent leaseback transactions. See Schedule V. AMERICAN AIRLINES, INC. Schedule VII - Guarantees of Securities of Other Issuers December 31, 1993 (in millions) AMERICAN AIRLINES, INC. Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1993 (in millions) (a) See Schedule VI. (b) Transfer to allowance for obsolescence of inventories. AMERICAN AIRLINES, INC. Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1992 (in millions) (a) See Schedule VI. AMERICAN AIRLINES, INC. Schedule VIII - Valuation and Qualifying Accounts and Reserves (deducted from asset to which applicable) Year ended December 31, 1991 (in millions) (a) See Schedule VI. AMERICAN AIRLINES, INC. Schedule IX - Short-Term Borrowings Year ended December 31, 1993 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. AMERICAN AIRLINES, INC. Schedule IX - Short-Term Borrowings Year ended December 31, 1992 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. AMERICAN AIRLINES, INC. Schedule IX - Short-Term Borrowings Year ended December 31, 1991 (in millions) (a) Computed based on monthly amount outstanding during the year. (b) Computed by dividing total interest expense by the average amount outstanding during the year. (c) Commercial paper generally matures within 120 days after issue with no provisions for renewal. Facility agreement borrowings generally mature within 100 days after issue, with a renewal option available over the term of the facility agreement. American also borrows additional funds from various institutions on a short-term basis at the lenders' prevailing rates. AMERICAN AIRLINES, INC. Schedule X - Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 (in millions) 1993 1992 1991 ------ ------ ------ Advertising expense $ 197 $ 198 $ 241 ====== ====== ====== Exhibit 12 AMERICAN AIRLINES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES 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. AMERICAN AIRLINES, INC. /s/ Robert L. Crandall Robert L. Crandall Chairman, President and Chief Executive Officer (Principal Executive Officer) /s/ Michael J. Durham Michael J. Durham Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Date: March 16, 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 noted: Directors: /s/ Howard P. Allen /s/ William Lyon Howard P. Allen William Lyon /s/ Edward A. Brennan /s/ Ann D. McLaughlin Edward A. Brennan Ann D. McLaughlin /s/ Christopher F. Edley /s/ Charles H. Pistor, Jr. Christopher F. Edley Charles H. Pistor, Jr. /s/ Antonio Luis Ferre' /s/ Joe M. Rodgers Antonio Luis Ferre' Joe M. Rodgers /s/ Charles T. Fisher, III /s/ Maurice Segall Charles T. Fisher, III Maurice Segall /s/ Dee J. Kelly /s/ Eugene F. Williams, Jr. Dee J. Kelly Eugene F. Williams, Jr. Date: March 16, 1994

99250_1993.txt

99250_1993

1993

99250

ITEM 1. BUSINESS. GENERAL Transcontinental Gas Pipe Line Corporation (TGPL) is a wholly owned subsidiary of Transco Gas Company (TGC) which in turn is wholly owned by Transco Energy Company (Transco). As used herein, the term Transco refers to Transco Energy Company together with its wholly owned subsidiary companies unless its context otherwise requires. The principal business of TGPL is the transportation of natural gas. TGPL's main gas transmission system extends from the Gulf Coast gas supply areas to the New York City area. TGPL has an aggregate peak mainline delivery capacity of approximately 3.3 Bcf * of gas per day, an additional peak day delivery capacity of 2.6 Bcf per day through the Leidy line and market area facilities and maintains an extensive gas gathering system both onshore and offshore in the Gulf Coast area. The number of full time employees at TGPL at December 31, 1993 was 1,694. Prior to 1984, interstate pipelines, including TGPL, served primarily as merchants of natural gas, purchasing gas under long-term contracts with numerous producers in production areas and transporting and reselling gas to local utilities in market areas under long-term sales agreements. Such service was known as "bundled" service. Regulatory policies under the Natural Gas Act of 1938 (NGA), relating to both pipeline rates and conditions of service, stressed security of gas supplies and service, and the recovery by pipelines of their prudently incurred costs of providing that service. However, commencing in 1984, the Federal Energy Regulatory Commission (FERC) issued a series of orders which have resulted in a major restructuring of the natural gas transmission industry and its business practices. With Order 380, issued in 1984, the FERC freed pipeline customers from their contractual obligations to purchase certain minimum levels of gas from their pipeline suppliers. With implementation of "open access" transportation rules contained in FERC Orders 436 and 500, the FERC afforded pipeline customers the opportunity to purchase gas from others and have it transported to the customers by pipelines. ____________________ * As used in this report, the term "Mcf" means thousand cubic feet, the term "MMcf" means million cubic feet, the term "Bcf" means billion cubic feet, the term "Tcf" means trillion cubic feet, the term "MMcf/d" means million cubic feet per day, the term "Bcf/d" means billion cubic feet per day and the term "MMBtu" means British Thermal Units. Faced with these changing conditions, increased competition and declining bundled sales, TGPL altered the manner in which it had traditionally conducted its businesses and began to transport a larger percentage of gas for customers that purchased such gas from others. In 1988, TGPL accepted a certificate to become a permanent open access pipeline system under FERC Orders 436 and 500. On April 8, 1992, the FERC issued Order 636 which made further fundamental changes in the way natural gas pipelines conduct their businesses. The FERC's stated purpose of Order 636 was to improve the competitive structure of the natural gas pipeline industry by, among other things, unbundling a pipeline's merchant role from its transportation services; ensuring "equality" of transportation services; ensuring that shippers and customers have equal access to all sources of gas; providing "no-notice" firm transportation services that are equal in quality to bundled sales service; and changing rate design methodology from modified fixed-variable (MFV) to straight fixed-variable (SFV), unless the pipeline and its customers agree to, and the FERC approves, a different form of rate design methodology. Effective November 1, 1993, TGPL implemented its Order 636 restructuring plan. For a complete discussion of Order 636 see "Regulatory Matters -- Order 636" below. Prior to 1993, TGPL and Texas Gas Transmission Corporation (Texas Gas), an affiliate, were responsible for all jurisdictional gas sales to their pipeline customers and Transco Energy Marketing Company (TEMCO) and TXG Gas Marketing Company (TXG Marketing), also affiliates, were responsible for all non-jurisdictional gas sales. As a result of the Order 636 requirement that a pipeline unbundle its merchant role from its transportation services, Transco determined to implement a plan to consolidate its gas marketing businesses under the common management of Transco Gas Marketing Company (TGMC). These changes were needed to more closely coordinate gas marketing operations to improve efficiencies, reduce costs and improve profitability. After FERC approval in January 1993, TGMC, through an agency agreement, began to manage all jurisdictional sales of TGPL. MARKETS AND TRANSPORTATION TGPL's principal markets encompass eleven Southeast and Atlantic seaboard states, and include the New York City and Philadelphia metropolitan areas. A large portion of the gas transported by TGPL to its market areas is used for space heating, resulting in substantially higher daily delivery requirements for TGPL's customers during the winter months than during the summer months. TGPL has working storage capacity in five underground storage fields, located on or near its pipeline system and/or market areas, and operates three of these storage fields. The certificated storage capacity available to TGPL and its customers is approximately 213 Bcf. TGPL's total system deliveries and the mix of sales and transportation volumes for the years 1993, 1992 and 1991 are shown below. Sales as shown below include only bundled sales. TGPL's facilities are divided into six rate zones. Three are located in the production area and three are located in the market area. Long-haul transportation is gas that is received in one of the production-area zones and delivered in a market-area zone. Market-area transportation is gas that is both received and delivered within market-area zones. Production-area transportation is gas that is both received and delivered within production-area zones. As shown in the table above, TGPL's total market-area deliveries for 1993 were comparable to those in 1992. Production- area deliveries decreased 28.1 Bcf, or 14 percent for 1993 compared to 1992, primarily due to increased competition for production-area transportation. However, as a result of the new SFV rate structure that went into effect September 1, 1992, subject to refund, these decreased deliveries had no significant impact on TGPL's operating income. The following table sets forth the names of TGPL's five largest customers along with the related sales and transportation volumes shipped by such customers for the periods shown (in Bcf): As a result of the fundamental business changes resulting from FERC Order 636, especially the shifting of the responsibility for gas supply from the pipeline companies to local distribution customers (LDCs), maintaining committed proved gas reserves is no longer material to TGPL's transportation business. See "Regulatory Matters -- Order 636" below and "Capital Resources and Liquidity -- Other Capital Requirements and Contingencies -- Long-term gas purchase contracts" contained in Management's Discussion and Analysis of Financial Condition and Results of Operations included in Item 7 herein. PIPELINE PROJECTS LIBERTY PIPELINE COMPANY. In 1992, Liberty Pipeline Company, a partnership of interstate pipelines and local distribution companies, filed for FERC approval to construct and operate a natural gas pipeline to provide 500 MMcf/d in firm transportation service to the greater New York City area. The partnership is comprised of subsidiaries of Transco and two other interstate pipelines and subsidiaries of three TGPL customers in New York. The pipeline is expected to cost approximately $162 million and is proposed to be in service by the 1995-1996 winter heating season, subject to timely FERC approval. The pipeline will offer a new firm transportation route from TGPL and another interstate pipeline to a proposed new delivery point on Long Island near the John F. Kennedy Airport. Liberty Operating Company (LOC), an affiliate of TGPL, will construct and operate the pipeline. LOC has begun design work, permit application, and survey and right-of-way acquisition. The FERC has issued a notice that it intends to prepare an Environmental Impact Statement associated with the Liberty Pipeline. Transco Liberty Pipeline Company, an affiliate of TGPL, owns a 35 percent interest in the pipeline, which will be project-financed. TGPL anticipates investing approximately $78 million in existing TGPL facilities upstream of Liberty Pipeline to provide additional transportation capacity for subsequent delivery to the Liberty Pipeline. The expenditures involve looping existing facilities and adding compression in Pennsylvania and New Jersey. The majority of the expenditures for TGPL's upstream expansion are expected to be made in 1995 and 1996. SOUTHEAST EXPANSION PROJECTS. In November 1993, TGPL filed for FERC approval of its Southeast Expansion Projects. These new expansion projects will provide additional firm transportation capacity to growing southeastern markets in Alabama, Georgia, South and North Carolina and Virginia. The proposed Southeast Expansion Projects are expected to be phased into service beginning in 1994 and, upon completion, will provide a total of 200 MMcf/d of firm transportation capacity to TGPL's southeast customers by the 1996-1997 winter heating season. The new firm transportation capacity will extend from TGPL's Mobile Bay lateral interconnect, near Butler, Alabama, to delivery points upstream of TGPL's Compressor Station 165, near Chatham, Virginia. The expansion projects will include approximately 25 miles of pipeline replacement and looping and the installation of additional compression totaling approximately 70,000 horsepower. TGPL estimates the cost of the expansion to be $125 million and has proposed rates based on the SFV rate design methodology. The 1994 Southeast Expansion Project (SE94) will provide 35 MMcf/d of incremental firm capacity by the 1994-1995 winter heating season. The 1995-1996 Southeast Expansion Project (SE95-96) will be constructed in two phases: Phase I will add 115 MMcf/d of incremental firm capacity for the 1995-1996 winter heating season, and Phase II will add the remaining 50 MMcf/d for the 1996-1997 winter heating season. Subject to FERC approval, construction on SE94 is scheduled to begin in June 1994. TGPL expects to invest approximately $45 million in these projects in 1994. EMINENCE STORAGE FIELD EXPANSION PROJECT. During 1993, TGPL completed the first phase of its Eminence storage field expansion project, expanding the working capacity from 6 Bcf to 9 Bcf and increasing the withdrawal rate from 750 MMcf/d to 1.3 Bcf/d. The expansion of the salt-dome structure, located at TGPL's Compressor Station 77, near Seminary, Mississippi, will give TGPL additional flexibility to meet the peak-day and emergency demands of its customers. High deliverability from storage helps assure pipelines, such as TGPL, of gas availability for their customers during adverse weather conditions. TGPL plans further expansions of the storage field in 1994 and 1995, allowing for withdrawals of up to 1.5 Bcf/d and ultimately increasing the working capacity of the storage field to 15 Bcf. MOBILE BAY PIPELINE EXPANSION PROJECT. In September, the FERC issued an order authorizing the joint ownership and expansion of TGPL's Mobile Bay lateral with Florida Gas Transmission Company (Florida Gas). The lateral transports gas from the prolific Mobile Bay gas supply basin to the TGPL mainline, near Butler, Alabama, and the expansion will increase the capacity from 462 MMcf/d to 829 MMcf/d. The expansion will be accomplished through the addition of compression facilities and will include a new interconnect on the lateral with the Florida Gas mainline. The cost of the expansion project will be funded entirely by Florida Gas, and TGPL will receive approximately $13 million from Florida Gas for the sale of a partial interest in the lateral. The expansion will increase the TGPL portion of pipeline capacity by approximately 60 MMcf/d to 520 MMcf/d. The Mobile Bay lateral expansion is expected to be placed in service by December 1994. Also, TGPL and Exxon have agreed to construct a two-mile pipeline in 1994 to allow for connection of Exxon's recently constructed treatment plant to the Mobile Bay lateral. Both of these expansion projects will not only enhance TGPL's overall access to supply, but will also provide additional supply for the Southeast Expansion Projects. REGULATORY MATTERS RATES. TGPL's transportation rates are established through the FERC ratemaking process. Key determinants in the ratemaking process are (i) volume throughput assumptions, (ii) costs of providing service and (iii) allowed rate of return. Rate design and the allocation of costs and return on equity between the demand and commodity rates also impact profitability. TGPL, effective September 1, 1992, changed from the MFV method of rate design to the SFV method of rate design. Under MFV rate design, all fixed costs, with the exception of return on equity and income taxes, are included in a demand charge to customers and return on equity and income taxes are recovered as part of a volumetric charge to customers. Accordingly, under MFV rate design overall throughput has a significant impact on operating income. Under the SFV method of rate design, all fixed costs, including return on equity and income taxes, are included in a demand charge to customers and all variable costs are recovered through a commodity charge to customers. While the use of SFV rate design limits TGPL's opportunity to earn incremental revenues through increased throughput, it also minimizes TGPL's risk associated with fluctuations in throughput. On June 4, 1992, the FERC issued its final order on rehearing in TGPL's Rate Settlement and Gas Inventory Charge (GIC) Settlement (Docket No. RP90-8). This order became effective in July 1992. As a result, in August 1992, TGPL made refunds of approximately $102 million, including interest, for differences between filed rates and settlement rates. Certain parties appealed the FERC's June 4, 1992 order to the United States Court of Appeals for the D.C. Circuit (D.C. Circuit Court). On December 17, 1993, the D.C. Circuit Court issued its opinion affirming the FERC's order, except for one issue not material to TGPL which was remanded to the FERC for further consideration. On March 2, 1992, TGPL filed with the FERC a general rate case (Docket No. RP92-137). The general rate filing proposed an increase in transportation rates, based primarily on increases in operating and maintenance costs, including those associated with additional services provided to TGPL's markets since its last general rate filing, and increased cost of capital. The filing also included a change to SFV rate design and an increase in rate base resulting from additional plant and equipment costs and higher working capital requirements. On September 1, 1992, the increased rates went into effect subject to refund. On September 17, 1992, the FERC issued a decision addressing the single issue of the appropriate rate of return in Docket No. RP92-137. The FERC, using a hypothetical capital structure based on the average capital structure of a group of seven publicly-traded companies with pipeline subsidiaries, determined TGPL's appropriate after-tax rate of return on equity to be 14.45%. The FERC did not determine TGPL's cost of debt and preferred stock, suggesting that this issue should be the subject of further proceedings in the context of the general rate case. Consequently, TGPL's current rates reflect an after-tax rate of return on equity of 14.45% but, consistent with the FERC order, the rates continue to reflect the cost of debt and preferred stock originally filed in the general rate case. The issue of the appropriate rate of return for TGPL is currently on appeal before the D.C. Circuit Court. TGPL appealed seeking to increase the rate of return and certain other parties have appealed seeking to lower the rate of return. On May 3, 1993, TGPL filed with the FERC an Offer of Settlement (the Settlement) with regard to Docket No. RP92-137. On November 4, 1993, the FERC issued an order accepting the Settlement. The Settlement resolves all issues in Docket No. RP92-137 except (i) issues relating to TGPL's rate of return which are on appeal before the D.C. Circuit Court (see discussion above), and (ii) the issue of appropriate load factor for the design of TGPL's interruptible rates which the FERC referred to a hearing in Docket No. RP92-137 for prospective effect only (see "Regulatory Matters-Order 636" below for discussion of additional issues referred to this hearing). On December 16, 1993, TGPL filed a request to accelerate partial refunds under the Settlement on the ground that those refunds could be made without prejudice to the pending requests for rehearing or clarification. TGPL's request was granted by order of the FERC dated February 14, 1994. In early 1994, TGPL will make the initial refunds (approximately $100 million including interest) under RP92-137. TGPL has previously provided a reserve for that refund. TGPL has also provided a reserve which it believes is sufficient for any additional refunds that may be required under Docket No. RP92-137. FUEL RETENTION PROCEEDINGS. On February 23, 1989, the FERC issued an order which found, among other things, that TGPL had overcollected for fuel from transportation customers during the period April 1, 1984 to April 1, 1987. The order required TGPL to refund the difference between the amount collected and the rate allowed for fuel retention. Accordingly, TGPL made refunds to customers of approximately $35 million, including interest. In response to subsequent FERC orders, TGPL recalculated the refund and on November 30, 1993, under this revised calculation, TGPL made additional refunds of approximately $11.6 million, including interest. TGPL had previously provided a reserve that was sufficient for these refunds. On February 9, 1994, the FERC issued an order accepting TGPL's refund report, stating that TGPL made the refunds in accordance with the FERC's orders. ORDER 94-A. In 1983, the FERC issued Order 94-A, which permitted producers to collect certain production-related gas costs from pipelines on a retroactive basis. The FERC subsequently issued orders allowing several pipelines, including TGPL, to bill their customers for such production-related costs through fixed monthly charges based on a customer's historical purchases. In February 1990, the D.C. Circuit Court overturned the FERC's authorization for pipelines to bill production-related costs to customers based on gas purchased in prior periods and remanded the matter to the FERC to determine an appropriate recovery mechanism. TGPL's GIC Settlement contains a provision pursuant to which TGPL's customers, with the exception of Columbia Gas Transmission Corporation (Columbia), have agreed not to contest the Order 94-A payments previously made by them. TGPL had billed to and recovered from Columbia approximately $7 million of Order 94-A costs. On October 26, 1993, TGPL and Columbia executed a letter agreement by which the parties resolved the amount of refunds to be made to Columbia in this proceeding. Pursuant to the letter agreement, TGPL and Columbia agreed that TGPL shall refund $1.4 million to Columbia, which amount is inclusive of principal and interest, in full and final settlement of all issues in this proceeding. The letter agreement was filed with the FERC on October 26, 1993 and is subject to approval by the FERC. TGPL has provided a reserve which is sufficient to cover the refunds provided for by the letter agreement. On January 26, 1994, Columbia filed a letter with the FERC stating that, due to developments in other pipeline company proceedings involving settlements of the issue of recovery of Order 94-A costs from Columbia, Columbia could no longer support, pending rehearing in those proceedings, the letter agreement between TGPL and Columbia. Columbia requested that the FERC hold any action on the letter agreement in abeyance pending action on rehearing in the other proceedings. On February 4, 1994, TGPL filed a response opposing Columbia's January 26 letter, stating that the October 26 letter agreement constitutes a valid and binding agreement between TGPL and Columbia and requesting that the FERC approve that letter agreement without delay. This matter is pending before the FERC. Although no assurances can be given, TGPL believes that the final resolution of the recovery of production-related costs will not have a material adverse effect on its financial position or results of operations. ORDER 636. On November 1, 1993, TGPL implemented Order 636. In connection with its implementation of Order 636, TGPL received orders from the FERC which, among other things, (i) required TGPL to revise its throughput projection for rate purposes to reflect a mix of throughput that includes a higher level of interruptible transportation, (ii) accepted TGPL's proposal for rolled-in rate treatment of its Mobile Bay facilities and exempted TGPL from having to reflect Mobile Bay transportation volumes and related revenues in an interruptible revenue crediting mechanism, (iii) approved a Stipulation and Agreement filed with the FERC by TGPL and its sales customers resolving certain sales service issues and mooting potential issues regarding TGPL's recovery of gas supply realignment (GSR) costs associated with TGPL's firm sales service, and (iv) referred to the hearing in Docket No. RP92-137 the following issues: TGPL's limited Section 4 filing with the FERC relating to TGPL's production-area rate design, the allocation of certain costs to TGPL's sales service, TGPL's use of a system-wide cost of service, the level of TGPL's gathering rates and aggregation/pooling services in TGPL's production area. Any changes in TGPL's rates or services resulting from this hearing would have a prospective effect only. Order 636 provides that pipelines should be allowed the opportunity to recover all prudently incurred transition costs, including GSR costs. TGPL does not expect to incur any GSR costs associated with its firm sales service. TGPL's non-GSR transition costs are anticipated to be in a range of $5 million to $10 million. TGPL and certain other parties have filed appeals of certain of the FERC's orders to the D. C. Circuit Court. These appeals have been held in abeyance pending completion of the FERC's rehearing process and the expiration of the time to seek judicial review. TGPL has expressed to the FERC concerns that inconsistent treatment under Order 636 of TGPL and its competitor pipelines with regard to rate design and cost allocation issues in the production area may result in rates which could make TGPL less competitive, both in terms of production-area and long-haul transportation rates. A hearing before a FERC Administrative Law Judge (ALJ) dealing with, among other things, TGPL's production-area rate design has been set for April 1994. TGPL is unable at this time to fully assess the competitive effect and resulting financial impact on TGPL of having to maintain its current production-area rate design which is different than that of its competitors. TGPL expects that any Order 636 transition costs incurred should be recovered from TGPL's customers, subject only to the costs and other risks associated with the difference between the time such costs are incurred and the time those costs may be recovered from customers. Although no assurances can be given, TGPL does not believe that the implementation of Order 636 will have a material adverse effect on its financial position or results of operations. COMPETITION Competition for gas transportation has intensified in recent years due to customer access to other pipelines, rate competitiveness between pipelines and the customers' desire to have more than one supplier. The FERC's stated purpose of Order 636 is to improve the competitive structure of the natural gas pipeline industry. TGPL implemented Order 636 on November 1, 1993. Future utilization of pipeline capacity will depend on competition from other pipelines and alternative fuels, the general level of natural gas demand and weather conditions. TGPL and its primary market-area competitors, Texas Eastern Transmission Corporation (Texas Eastern), Columbia, Southern Natural Gas Company (Southern Natural), Tennessee Gas Pipeline Company (Tennessee) and Iroquois Gas Transmission System (Iroquois), implemented Order 636 on their respective systems during the period June 1993 to November 1993. TGPL and its major competitors all employ SFV rate design for firm transportation as mandated by Order 636. However, TGPL has expressed to the FERC concerns that inconsistent treatment under Order 636 of TGPL and its competitor pipelines with regard to rate design and cost allocation issues in the production area may result in rates which could make TGPL less competitive, both in terms of production-area and long-haul transportation rates. A hearing before a FERC ALJ dealing with, among other things, TGPL's production-area rate design has been set for April 1994. TGPL is unable at this time to fully assess the competitive effect and resulting financial impact on TGPL of having to maintain its current production-area rate design which is different than that of its competitors. TGPL does not expect to incur GSR costs associated with its firm sales service. TGPL's non-GSR transition costs are anticipated to be in a range of $5 million to $10 million; therefore, TGPL believes the demand charges to recover these costs will not make its rates noncompetitive in its markets. See "Regulatory Matters -- Order 636" above. Although a significant portion of TGPL's firm customers have relatively secure residential and commercial end-users, virtually all of TGPL's LDCs have some price-sensitive end-users that could switch to alternate fuels. Approximately one-third of TGPL's customer deliveries are at risk to such fuel switching; however, a recent survey of TGPL's largest customers suggests that end-users will pay a premium to burn natural gas and that LDCs intend to aggressively price their system transportation to stay competitive in alternate-fuel markets. SALES SERVICE Prior to 1993, TGPL and Texas Gas were responsible for all jurisdictional gas sales to their pipeline customers and TEMCO and TXG Marketing were responsible for all non-jurisdictional gas sales. As a result of the Order 636 requirement that a pipeline unbundle its merchant role from its transportation services, Transco determined to implement a plan to consolidate its gas marketing businesses under the common management of TGMC. These changes were needed to more closely coordinate gas marketing operations to improve efficiencies, reduce costs and improve profitability. After FERC approval in January 1993, TGMC, through an agency agreement, began to manage all jurisdictional sales of TGPL. See "Other Capital Requirements and Contingencies - Long-term gas purchase contracts" contained in Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 hereof and Notes A, J and K of the Notes to Financial Statements contained in Item 8 hereof. TGPL makes sales to customers through a Firm Sales (FS) program, an Optional Firm Sales (OFS) program and an Interruptible Sales (IS) program coupled with a firm transportation program as replacement for a contract sales quantity. These programs give customers the option to purchase daily quantities of gas from TGPL at market-responsive prices in exchange for a demand charge payment to TGPL designed to recover the costs of gas in excess of current month spot prices that TGPL is obligated to pay under its producer contracts. TGPL's gas sales volumes for the years 1993, 1992 and 1991 are shown below. (1) Effective January 1993, TGMC, through an agency management agreement with TGPL, assumed operation of TGPL's sales service. REGULATION INTERSTATE GAS PIPELINE OPERATIONS. TGPL is subject to regulation by the FERC as a "natural gas company" under the NGA. The NGA grants to the FERC authority over the construction and operation of pipeline and related facilities utilized in the transportation and sale of natural gas in interstate commerce, including the extension, enlargement and abandonment of such facilities. The FERC requires the filing of appropriate applications by natural gas companies showing that the extension, enlargement or abandonment of any facilities, as the case may be, is or will be required by a certificate of public convenience and necessity. TGPL holds certificates of public convenience and necessity issued by the FERC authorizing them to construct and operate all pipelines, facilities and properties now in operation for which certificates are required. The NGA also grants to the FERC authority to regulate rates, charges and terms of service for natural gas transported in interstate commerce or sold by a natural gas company in interstate commerce for resale, and to regulate curtailments of sales to customers. The FERC has authorized TGPL to charge natural gas sales rates that are market-based. As necessary, TGPL files with the FERC changes in its transportation and storage rates and charges designed to allow it to recover fully its costs of providing service to its interstate system's customers, including reasonable rates of return. Regulation of gas curtailment priorities and the importation of gas are, under the Department of Energy Reorganization Act of 1977, vested in the Secretary of Energy. TGPL also is subject to regulation by the Department of Transportation under the Natural Gas Pipeline Safety Act of 1968 with respect to safety requirements in the design, construction, operation and maintenance of its interstate gas transmission facilities. ENVIRONMENTAL. TGPL is subject to extensive federal, state and local environmental laws and regulations which affect TGPL's operations related to the construction and operation of its pipeline facilities. Appropriate governmental authorities may enforce these laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties, assessment and remediation requirements and injunctions as to future compliance. TGPL's use and disposal of hazardous materials are subject to the requirements of the federal Toxic Substances Control Act (TSCA), the federal Resource Conservation and Recovery Act (RCRA) and comparable state statutes. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as "Superfund," imposes liability, without regard to fault or the legality of the original act, for release of a "hazardous substance" into the environment. Because these laws and regulations change from time to time, practices which have been acceptable to the industry and to the regulators have to be changed and assessment and monitoring have to be undertaken to determine whether those practices have damaged the environment and whether remediation is required. Since 1989, TGPL has had studies underway to test their facilities for the presence of toxic and hazardous substances to determine to what extent, if any, remediation may be necessary. On the basis of the findings to date, TGPL estimates that environmental assessment and remediation costs that will be incurred over the next five years under TSCA, RCRA, CERCLA and comparable state statutes will total approximately $52 million to $62 million. This estimate depends upon a number of assumptions concerning the scope of remediation that will be required at certain locations and the cost of remedial measures to be undertaken. TGPL is continuing to conduct environmental assessments and is implementing a variety of remedial measures that may result in increases or decreases in the total estimated costs. At December 31, 1993, TGPL had a reserve of approximately $52 million for these estimated costs. TGPL considers environmental assessment and remediation costs and costs associated with compliance with environmental standards to be recoverable through rates, since they are prudent costs incurred in the ordinary course of business. To date, TGPL has been permitted recovery of environmental costs incurred, and it is TGPL's intent to continue seeking recovery of such costs, as incurred, through rate filings. Therefore, these estimated costs of environmental assessment and remediation have been recorded as regulatory assets. Since 1989, TGPL has been involved in discussions with the Pennsylvania Department of Environmental Resources (PADER) concerning environmental conditions at TGPL's operating sites in Pennsylvania. These discussions have resulted in the execution of a consent order and agreement in 1992 between PADER and TGPL. TGPL agreed to conduct an environmental assessment and remediation program at its Pennsylvania sites, fund certain beneficial environmental projects, pay oversight costs and pay a $425,000 civil penalty. Of such penalty, $142,000 remains to be paid in May 1994. The estimated costs of the environmental assessment and remediation program are included in the $52 million to $62 million range discussed above. TGPL has used lubricating oils containing polychlorinated biphenyls (PCBs) and, although the use of such oils was discontinued in the 1970s, has discovered residual PCB contamination in equipment and soils at certain gas compressor station sites. TGPL has worked closely with the Environmental Protection Agency (EPA) and state regulatory authorities regarding PCB issues, and has a program to assess and remediate such conditions where they exist, the costs of which are a significant portion of the $52 million to $62 million range discussed above. Proposed civil penalties have been assessed by the EPA against another major pipeline company for the alleged improper use and disposal of PCBs. Although similar penalties have not been asserted against TGPL to date, no assurances can be given that the EPA may not seek such penalties in the future. TGPL has been named as a potentially responsible party (PRP) in one Superfund waste disposal site, the Combustion Inc. site, and in two state sites. Based on present volumetric estimates, TGPL's exposure for remediation of the Combustion Inc. site is estimated to be $500,000. TGPL's estimated individual exposure at each of the two state sites where it has been named as a PRP is less than $100,000 per site. The estimated remediation costs for all such sites have been included in TGPL's environmental reserve discussed above. Liability under CERCLA (and applicable state law) can be joint and several with other PRPs. Although volumetric allocation is a factor in assessing liability, it is not necessarily determinative; thus, the ultimate liability could be substantially greater than the amounts described above. Although no assurances can be given, TGPL does not believe that its PRP status will have a material adverse effect on its financial position or results of operations. TGPL is also subject to the federal Clean Air Act and to the federal Clean Air Act Amendments of 1990 (1990 Amendments), which added significantly to the existing requirements established by the federal Clean Air Act. The 1990 Amendments required that the EPA issue new regulations, mainly related to mobile sources, air toxics, ozone non-attainment areas and acid rain. TGPL is installing new emission control devices where required and conducting certain emission testing programs to comply with the federal Clean Air Act standards and the 1990 Amendments. In addition, pursuant to the 1990 Amendments the EPA has issued regulations under which states must implement new air pollution controls to achieve attainment of national ambient air quality standards in areas where they are not currently achieved. TGPL has compressor stations in ozone non-attainment areas that could require substantial additional air pollution reduction expenditures, depending on the requirements imposed. While it will not be possible to estimate the ultimate costs of compliance with these new requirements until the states approve TGPL's proposed plans for modifications, TGPL expects that significant capital spending may be required to modify TGPL's facilities, particularly the compressor engines along TGPL's pipeline system. Additions to facilities for compliance with currently known federal Clean Air Act standards and the 1990 Amendments are expected to cost in the range of $20 million to $30 million over the next five years and will be recorded as assets as the facilities are added. TRANSACTIONS WITH AFFILIATES TGPL has made interest bearing advances to and incurred interest bearing advances from Transco for consolidated cash management purposes. The advances are represented by demand notes bearing interest at the rate of 1-1/2 percent below the prime rate of Citibank, N.A., not to exceed the maximum lawful rate of interest. In 1984, a wholly-owned subsidiary of Transco in partnership with a Houston development firm and a real estate investment company completed construction of a new Transco Tower at a total cost of approximately $200 million. TGPL has leased a substantial portion of the building to serve as its corporate headquarters. See also "Sales Service" above. ITEM 2. ITEM 2. PROPERTIES. See "Item 1. Business" ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The information required by this item is contained in Note D of the Notes to Financial Statements included in Item 8 herein. 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. All of the outstanding shares of TGPL's common stock is owned by TGC, a wholly owned subsidiary of Transco. TGPL's common stock is not publicly traded and there exists no market for such common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Expressed in thousands) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. (THIS DISCUSSION SHOULD BE READ IN CONJUNCTION WITH ITEM 6, SELECTED FINANCIAL DATA, AND ITEM 8, FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.) INTRODUCTION TGPL is an indirect wholly-owned subsidiary of Transco and as such may be affected by the financial position and performance of Transco and its subsidiaries other than TGPL. In October 1991, Transco's Board of Directors approved a comprehensive strategic and financial plan (Plan) designed to stabilize Transco's financial position, improve its financial flexibility and restore its earnings. Since the Plan's adoption, Transco has made significant progress in the implementation of the Plan, including the sale of certain non-core and non-strategic businesses, reduction in capital expenditures, resolution of certain material litigation and improvement in its results of operations and financial flexibility. Transco remains committed to deleveraging its balance sheet, further eliminating or mitigating the potentially adverse impact from the resolution of remaining litigation and contingencies and improving financial results. In order to further improve Transco's financial results, in conjunction with efforts to reduce debt and related interest expense, Transco will continue efforts to ensure the solid financial performance of TGPL and Texas Gas, while working to eliminate operating losses from Transco's gas marketing and gas gathering businesses. CAPITAL RESOURCES AND LIQUIDITY METHOD OF FINANCING As a subsidiary of Transco, TGPL engages in transactions with Transco and other Transco subsidiaries, characteristic of group operations. TGPL meets its working capital requirements by participation in the Transco consolidated cash management program pursuant to which TGPL both makes advances to and receives advances and capital contributions from Transco, and by accessing capital markets to refinance its long-term debt maturities. As general corporate policy, the interest rate on intercompany demand notes is 1-1/2 percent below the prime rate of Citibank, N.A. At December 31, 1993, there were outstanding advances totaling $133.3 million from TGPL to Transco. TGPL currently expects to receive payment of these advances within the next twelve months and has classified such advances as current assets. In addition, TGPL and Transco's other subsidiaries pay dividends, based on the level of their earnings and net cash flow, to assist Transco in providing the funds necessary for Transco to service its debt and pay dividends on its common and preferred stock. TGPL's Board of Directors has declared no common stock dividends in 1993, 1992 and 1991. Certain of Transco's credit facilities and indentures prohibit TGPL from, among other things, incurring or guaranteeing any additional indebtedness, except for indebtedness incurred to refinance existing indebtedness, issuing preferred stock or advancing cash to affiliates other than Transco. Further, certain of Transco's credit facilities and indentures contain restrictive covenants which could limit Transco's ability to make additional borrowings and, therefore, under certain circumstances, Transco's ability to make or repay advances to TGPL or make capital contributions to TGPL. To meet the working capital requirements of Transco and its subsidiaries, Transco has in place a $450 million working capital line with a group of fifteen banks. TGPL is guarantor of $270 million of this working capital line. At December 31, 1993, Transco had no outstanding borrowings under this facility. Transco also has in place a $50 million reimbursement facility, dated as of December 31, 1993, between Transco and a group of banks. This facility provides Transco the opportunity to obtain standby letters of credit under certain circumstances from the banks. TGPL is guarantor of $30 million of the obligations that arise under this facility. At December 31, 1993, Transco had no amounts outstanding under this facility. These credit facilities prohibit TGPL from, among other things, incurring or guaranteeing any additional indebtedness (except for indebtedness incurred to refinance existing indebtedness), issuing preferred stock or advancing cash to affiliates other than Transco. Further, these credit facilities and Transco's indentures contain restrictive covenants which could limit Transco's ability to make additional borrowings and, therefore, under certain circumstances, its ability to repay advances or make capital contributions to TGPL. Additionally, certain of TGPL's debt instruments restrict the amount of dividends distributable. As of December 31, 1993, approximately $287 million of TGPL's retained earnings of $424 million was available for distribution. TGPL repriced the interest rate on its Extendible Notes due May 15, 2000 to a rate of 6.21% beginning May 15, 1993 and ending May 14, 1996. In September 1993, TGPL entered into a new program to sell monthly trade receivables to replace a similar program, which expired. The new trade receivables program, which expires in September 1995, provides for the sale of up to $100 million of trade receivables without recourse. As of December 31, 1993, $100 million in trade receivables were held by the investor. CAPITALIZATION AND CASH FLOWS As shown in the following table, there has been an improvement in TGPL's percentage of total debt to total invested capital from December 31, 1992 to December 31, 1993. This results from both an increase in common stockholder's equity, reflecting increased net income, and a reduction in total debt. As shown in the accompanying Statement of Cash Flows, TGPL's net cash outflows exceeded net cash inflows by $0.2 million resulting primarily from producer settlement payments, retirement of long-term debt and preferred stock, the capital spending requirements for 1993 and a net increase in advances to Transco. Funding of TGPL's 1993 cash requirements for financing and investing activities, including capital expenditures, has been provided primarily through cash provided by operations, and to a lesser extent, through recoveries of producer settlement costs. For the year ended December 31, 1993, cash flows from operating activities were $253 million higher than for the year ended December 31, 1992. This improvement in cash flows is primarily the result of cash refunds TGPL paid to customers in 1992 in connection with the Transition Cost proceeding and its Rate Settlement as discussed in Note C of the Notes to Financial Statements included in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Transcontinental Gas Pipe Line Corporation: We have audited the accompanying balance sheet of Transcontinental Gas Pipe Line Corporation (a Delaware corporation and an indirect wholly owned subsidiary of Transco Energy Company) as of December 31, 1993 and 1992, and the related statements of operations, retained earnings and premium on capital stock and other paid-in capital and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the financial statement schedules referred to below 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 Transcontinental Gas Pipe Line Corporation 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 financial statement schedules listed in the index to 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. These financial statement 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. Houston, Texas February 18, 1994 MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS The financial statements have been prepared by management in conformity with generally accepted accounting principles. Management is responsible for the fairness and reliability of the financial statements and other financial data included in this report. In the preparation of the financial statements, it is necessary to make informed estimates and judgments of the effects of certain events and transactions based on currently available information. TGPL maintains accounting and other controls that management believes provide reasonable assurance that financial records are reliable, assets are safeguarded, and that transactions are properly recorded in accordance with management's authorizations. However, limitations exist in any system of internal control based upon the recognition that the cost of the system should not exceed benefits derived. TGPL's independent auditors, Arthur Andersen & Co., are engaged to audit the financial statements and to express an opinion thereon. Their audit is conducted in accordance with generally accepted auditing standards to enable them to report that the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of TGPL in conformity with generally accepted accounting principles. The Audit Committee of the Board of Directors of Transco Energy Company (Transco), composed of two directors who are not employees of Transco, meets regularly with the independent auditors and management. The independent auditors have full and free access to the Audit Committee and meet with them, with and without management being present, to discuss the results of their audits and the quality of financial reporting. TRANSCONTINENTAL GAS PIPE LINE CORPORATION BALANCE SHEET (NOTES B AND J) The accompanying notes are an integral part of these financial statements. TRANSCONTINENTAL GAS PIPE LINE CORPORATION BALANCE SHEET (NOTES B AND J) The accompanying notes are an integral part of these financial statements. TRANSCONTINENTAL GAS PIPE LINE CORPORATION STATEMENT OF OPERATIONS (NOTE B) The accompanying notes are an integral part of these financial statements. TRANSCONTINENTAL GAS PIPE LINE CORPORATION STATEMENT OF RETAINED EARNINGS AND PREMIUM ON CAPITAL STOCK AND OTHER PAID-IN CAPITAL The accompanying notes are an integral part of these financial statements. TRANSCONTINENTAL GAS PIPE LINE CORPORATION STATEMENT OF CASH FLOWS (NOTE B) The accompanying notes are an integral part of these financial statements. NOTES TO FINANCIAL STATEMENTS A. Corporate Structure and Control . . . . . . . . . . . . . . 40 B. Summary of Significant Accounting Policies . . . . . . . . 41 C. Regulatory Matters . . . . . . . . . . . . . . . . . . . . 43 D. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . 47 E. Environmental Matters . . . . . . . . . . . . . . . . . . . 50 F. Financing . . . . . . . . . . . . . . . . . . . . . . . . . 53 G. Preferred Stock . . . . . . . . . . . . . . . . . . . . . . 55 H. Employee Benefit Plans . . . . . . . . . . . . . . . . . . 56 I. Income Taxes . . . . . . . . . . . . . . . . . . . . . . . 60 J. Commitments and Contingencies . . . . . . . . . . . . . . . 61 K. Transactions with Major Customers and Affiliates . . . . . 64 L. Fair Value of Financial Instruments . . . . . . . . . . . . 66 M. Quarterly Information (Unaudited) . . . . . . . . . . . . . 66 A. CORPORATE STRUCTURE AND CONTROL Transcontinental Gas Pipe Line Corporation (TGPL) is a wholly-owned subsidiary of Transco Gas Company (TGC). TGC is a wholly- owned subsidiary of Transco Energy Company and, as used herein, the term "Transco" refers to Transco Energy Company and its wholly- owned subsidiaries unless the context otherwise requires. As a subsidiary of Transco, TGPL engages in transactions with Transco and other Transco subsidiaries, characteristic of group operations. For consolidated cash management purposes, TGPL has made interest bearing advances to Transco and received interest bearing advances and capital contributions from Transco. These advances are represented by demand notes. TGPL currently expects to receive payment of these advances within the next twelve months and has recorded such advances as current in the accompanying Balance Sheet. As general corporate policy, the interest rate on intercompany demand notes is 1-1/2 percent below the prime rate of Citibank, N.A. Certain of Transco's credit facilities and indentures prohibit TGPL from, among other things, incurring or guaranteeing any additional indebtedness, except for indebtedness incurred to refinance existing indebtedness, issuing preferred stock or advancing cash to affiliates other than Transco. Further, certain of Transco's credit facilities and indentures contain restrictive covenants which could limit Transco's ability to make additional borrowings and, therefore, under certain circumstances, its ability to make or repay advances to TGPL or make capital contributions to TGPL. TGPL's Board of Directors has declared no common stock dividends in 1993, 1992 or 1991. Prior to 1993, TGPL was responsible for all jurisdictional gas sales to its pipeline customers. After Federal Energy Regulatory Commission (FERC) approval in January 1993, Transco implemented a plan to consolidate its gas marketing businesses under the common management of Transco Gas Marketing Company (TGMC) to more closely coordinate gas marketing operations to improve efficiencies, reduce costs and improve profitability. In January 1993, TGMC, through an agency agreement, began to manage all jurisdictional sales of TGPL. Under this agency agreement, TGMC bills TGPL for the cost of managing TGPL's gas sales service and, during 1993, received all margins associated with such business. For the year ended December 31, 1993, included in TGPL's cost of sales is $25.1 million representing agency fees billed by TGMC under this agreement. Consequently, in 1993, TGPL's gas sales service had no impact on its results of operations. Pursuant to a settlement that TGPL has with its customers, TGPL has in place a gas inventory charge (GIC) designed to allow TGPL to recover its above-spot-market gas cost through March 31, 2001. Pursuant to this settlement, in 1993 and early 1994, TGPL's agreements with its customers were renegotiated by TGMC, as agent for TGPL. TGMC and TGPL believe that the GIC agreed to with TGPL's customers will be adequate to enable recovery of its above-spot-market gas costs. B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DEPRECIATION AND AMORTIZATION. Depreciation rates used for major regulated gas plant facilities at year-end 1993, 1992 and 1991 were: Depreciation of general plant is provided at straight-line rates. TAX POLICY. Transco and its wholly-owned subsidiaries, which include TGPL through its ownership by TGC, file a consolidated federal income tax return. It is Transco's policy to charge or credit each subsidiary with an amount equivalent to its federal income tax expense or benefit computed as if each subsidiary had a separate return, but including benefits from each subsidiary's losses and tax credits that may be utilized only on a consolidated basis. ACCOUNTING FOR INCOME TAXES. TGPL uses the liability method of accounting for deferred taxes which requires, among other things, adjustments to the existing deferred tax balances for changes in tax rates, whereby such balances will more closely approximate the actual taxes to be paid. Net tax rate reductions related to regulated operations and subject to refund to customers over the average remaining life of natural gas transmission plant have been shown in the accompanying Balance Sheet as income taxes refundable to customers, the current portion of which is included in other current liabilities. In the first quarter of 1993, TGPL adopted Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, which supersedes SFAS No. 96, Accounting for Income Taxes. Due to TGPL's prior adoption of SFAS No. 96 in 1987, the adoption of SFAS No. 109 in 1993 did not have a material effect on TGPL's financial position or results of operations. REVENUE RECOGNITION. TGPL recognizes revenues for the sale of its commodities in the period of delivery and recognizes revenue for the transportation of gas in the period the service is provided. TGPL is subject to FERC regulations and, accordingly, certain revenues are collected subject to possible refunds pending final FERC orders. TGPL establishes reserves, where required, for such revenues collected subject to refund. CASH FLOWS FROM OPERATING ACTIVITIES. TGPL uses the indirect method to report cash flows from operating activities, which requires adjustments to net income to reconcile to net cash flows provided by operating activities. TGPL includes short-term, highly-liquid investments that have a maturity of three months or less as cash equivalents. RESTRICTED DEPOSITS. At December 31, 1993 and 1992, TGPL had approximately $7 million and $6 million, respectively, of restricted deposits that are classified on the accompanying Balance Sheet in current assets as deposits. These restricted deposits serve as collateral for various standby letters of credit, regulatory trusts and legal proceedings. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION. The allowance for funds used during construction (AFUDC) represents the cost of funds applicable to regulated natural gas transmission plant under construction as permitted by FERC regulatory practices. The allowance for borrowed funds used during construction was $2.3 million, $(2.0) million and $5.8 million for 1993, 1992 and 1991, respectively. The negative 1992 amount reflects a reversal of $3.9 million of AFUDC, which was recorded in prior years, as a result of a FERC audit adjustment. A reserve for this adjustment was recorded in miscellaneous other income and deductions in 1991. The allowance for equity funds was $2.8 million, $2.0 million and $9.1 million for 1993, 1992 and 1991, respectively. GAS IN STORAGE. TGPL utilizes the last-in, first-out (LIFO) method of accounting for inventory gas in storage. The current replacement cost of the inventory gas in storage at December 31, 1993 and 1992 was $58 million and $43 million, respectively. GAS IMBALANCES. In the course of providing transportation services to customers, TGPL may receive different quantities of gas from shippers than the quantities delivered on behalf of those shippers. These transactions result in gas transportation and exchange imbalance receivables and payables which are recovered or repaid in cash or through the receipt or delivery of gas in the future and are recorded in the accompanying Balance Sheet. Imbalances have become of greater significance to the pipeline industry generally, since the implementation of open access transportation by the FERC in 1985, as a result of the substantial increase in the number of shippers on pipeline systems. Settlement of imbalances requires agreement between the pipelines and shippers as to allocations of volumes to specific transportation contracts and timing of delivery of gas based on operational conditions. TGPL's rate structure includes a method whereby most imbalances generated after August 1, 1991 are settled on a monthly basis. Imbalances predating August 1, 1991 are being recovered or repaid in cash or through the receipt or delivery of gas in the future upon agreements of allocation and as permitted by operating conditions. These imbalances have been classified as current assets or current liabilities to the extent TGPL believes this will occur during 1994. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS. TGPL participates in a plan with Transco and certain affiliated companies that provides certain health care and life insurance benefits for retired employees. Prior to 1993, TGPL accounted for postretirement benefits other than pensions (primarily health care) on a cash basis, which had been the accounting method followed by most employers. In the first quarter of 1993, TGPL adopted SFAS No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions, which requires TGPL to accrue, during the years that employees render the necessary service, the estimated cost of providing postretirement benefits other than pensions to those employees. The adoption of SFAS No. 106 did not have a material effect on its financial position or results of operations. POSTEMPLOYMENT BENEFITS. In November 1992, the Financial Accounting Standards Board (FASB) issued SFAS No. 112, Employers' Accounting for Postemployment Benefits, which requires TGPL, effective January 1994, to accrue the estimated cost of providing postemployment benefits to former or inactive employees after employment but before retirement if the obligation is attributable to employees' services previously rendered, employees' rights to those benefits accumulate or vest, payment of the benefits is probable and the amount of the benefits can be reasonably estimated. TGPL does not expect adoption of SFAS No. 112 to have a material effect on its financial position or results of operations. RECLASSIFICATIONS. Certain reclassifications have been made in the 1992 and 1991 financial statements to conform to the 1993 presentation. C. REGULATORY MATTERS RATE MATTERS. On June 4, 1992, the FERC issued its final order on rehearing in TGPL's Rate Settlement and GIC Settlement (Docket No. RP90-8). This order became effective in July 1992. As a result, in August 1992, TGPL made refunds of approximately $102 million, including interest, for differences between filed rates and settlement rates. Certain parties appealed the FERC's June 4, 1992 order to the United States Court of Appeals for the D.C. Circuit (D.C. Circuit Court). On December 17,1993, the D.C. Circuit Court issued its opinion affirming the FERC's order, except for one issue not material to TGPL which was remanded to the FERC for further consideration. On March 2, 1992, TGPL filed with the FERC a general rate case (Docket No. RP92-137). The general rate filing proposed an increase in transportation rates, based primarily on increases in operating and maintenance costs, including those associated with additional services provided to TGPL's markets since its last general rate filing, and increased cost of capital. The filing also included a change to straight fixed-variable (SFV) rate design and an increase in rate base resulting from additional plant and equipment costs and higher working capital requirements. On September 1, 1992, the increased rates went into effect subject to refund. On September 17, 1992, the FERC issued a decision addressing the single issue of the appropriate rate of return in Docket No. RP92-137. The FERC, using a hypothetical capital structure based on the average capital structure of a group of seven publicly- traded companies with pipeline subsidiaries, determined TGPL's appropriate after-tax rate of return on equity to be 14.45%. The FERC did not determine TGPL's cost of debt and preferred stock, suggesting that this issue should be the subject of further proceedings in the context of the general rate case. Consequently, TGPL's current rates reflect an after-tax rate of return on equity of 14.45% but, consistent with the FERC order, the rates continue to reflect the cost of debt and preferred stock originally filed in the general rate case. The issue of the appropriate rate of return for TGPL is currently on appeal before the D.C. Circuit Court. TGPL appealed, seeking to increase the rate of return, and certain other parties have appealed, seeking to lower the rate of return. On May 3, 1993, TGPL filed with the FERC an Offer of Settlement (the Settlement) with regard to Docket No. RP92-137. On November 4, 1993, the FERC issued an order accepting the Settlement. The Settlement resolves all issues in Docket No. RP92-137 except (i) issues relating to TGPL's rate of return, which are on appeal before the D.C. Circuit Court (see discussion above), and (ii) the issue of the appropriate load factor for the design of TGPL's interruptible rates, which the FERC referred to a hearing in Docket No. RP92-137, for prospective effect only (see Order 636 below for discussion of additional issues referred to this hearing). On December 16, 1993, TGPL filed a request to accelerate partial refunds under the Settlement on the ground that those refunds could be made without prejudice to the pending requests for rehearing or clarification. TGPL's request was granted by order of the FERC dated February 14, 1994. In early 1994, TGPL will make the initial refunds (approximately $100 million, including interest) under RP92-137. TGPL has previously provided a reserve for that refund. TGPL has also provided a reserve which it believes is sufficient for any additional refunds that may be required under RP92-137. TRANSITION COST PROCEEDING. In 1986, TGPL filed to recover from its customers $82 million of specific gas supply costs incurred during prior periods (the Transition Cost proceeding). The FERC ordered a hearing regarding the recovery of such costs but permitted TGPL to begin collecting such costs subject to refund. Through April 1989 when TGPL ceased collecting these costs, approximately $51 million had been collected. On January 15, 1992, the FERC issued a final order on the Transition Cost proceeding which required TGPL to pay cash refunds within thirty days of issuance of the order totaling approximately $51 million, plus interest of approximately $23 million, to its customers and forego recovery of an additional $26 million in gas costs incurred by TGPL during 1985 and 1986. TGPL made the cash refunds in 1992. TGPL appealed the FERC's decision to the United States Court of Appeals for the Fifth Circuit (the Fifth Circuit). Several customers also filed petitions for review. On August 27, 1993, the Fifth Circuit issued its opinion affirming the FERC's order in all respects. FUEL RETENTION PROCEEDINGS. On February 23, 1989, the FERC issued an order which found, among other things, that TGPL had overcollected for fuel from transportation customers during the period April 1, 1984 to April 1, 1987. The order required TGPL to refund the difference between the amount collected and the rate allowed for fuel retention. Accordingly, TGPL made refunds to customers of approximately $35 million, including interest. In response to subsequent FERC orders, TGPL recalculated the refund and on November 30, 1993 under this revised calculation, TGPL made additional refunds of approximately $11.6 million, including interest. TGPL had previously provided a reserve that was sufficient for these refunds. On February 9, 1994, the FERC issued an order accepting TGPL's refund report stating that TGPL made the refunds in accordance with the FERC's orders. ORDER 94-A. In 1983, the FERC issued Order 94-A, which permitted producers to collect certain production-related gas costs from pipelines on a retroactive basis. The FERC subsequently issued orders allowing several pipelines, including TGPL, to bill their customers for such production-related costs through fixed monthly charges based on a customer's historical purchases. In February 1990, the D.C. Circuit Court overturned the FERC's authorization for pipelines to bill production-related costs to customers based on gas purchased in prior periods and remanded the matter to the FERC to determine an appropriate recovery mechanism. TGPL's GIC Settlement contains a provision pursuant to which TGPL's customers, with the exception of Columbia Gas Transmission Corporation (Columbia), have agreed not to contest the Order 94-A payments previously made to TGPL by them. TGPL had billed to and recovered from Columbia approximately $7 million of Order 94-A costs. On October 26, 1993, TGPL and Columbia executed a letter agreement by which the parties resolved the amount of refunds to be made to Columbia in this proceeding. Pursuant to the letter agreement, TGPL and Columbia agreed that TGPL shall refund $1.4 million to Columbia, which amount is inclusive of principal and interest, in full and final settlement of all issues in this proceeding. This letter agreement was filed with the FERC on October 26, 1993 and is subject to approval by the FERC. TGPL has provided a reserve which is sufficient to cover the refund provided for by the letter agreement. On January 26, 1994, Columbia filed a letter with the FERC stating that, due to developments in other pipeline company proceedings involving settlements of the issue of recovery of Order 94-A cost from Columbia, Columbia could no longer support, pending rehearing in those proceedings, the letter agreement between TGPL and Columbia. Columbia requested that the FERC hold any action on the letter agreement in abeyance pending action on rehearing in the other proceedings. On February 4, 1994, TGPL filed a response opposing Columbia's January 26 letter, stating that the October 26 letter agreement constitutes a valid and binding agreement between TGPL and Columbia and requesting that the FERC approve that letter agreement without delay. This matter is pending before the FERC. Although no assurances can be given, TGPL believes that the final resolution of the recovery of production-related costs will not have a material adverse effect on its financial position or results of operations. ORDER 636. On November 1, 1993, TGPL implemented Order 636. In connection with its implementation of Order 636, TGPL received orders from the FERC which, among other things, (i) required TGPL to revise its throughput projection for rate purposes to reflect a mix of throughput that includes a higher level of interruptible transportation, (ii) accepted TGPL's proposal for rolled-in rate treatment of its Mobile Bay facilities and exempted TGPL from having to reflect Mobile Bay transportation volumes and related revenues in an interruptible revenue crediting mechanism, (iii) approved a Stipulation and Agreement filed with the FERC by TGPL and its sales customers resolving certain sales service issues and mooting potential issues regarding TGPL's recovery of gas supply realignment (GSR) costs associated with TGPL's firm sales service, and (iv) referred to the hearing in Docket No. RP92-137 the following issues: TGPL's limited Section 4 filing with the FERC relating to TGPL's production-area rate design, the allocation of certain costs to TGPL's sales service, TGPL's use of a system-wide cost of service, the level of TGPL's gathering rates and aggregation/pooling services in TGPL's production area. Any changes in TGPL's rates or services resulting from this hearing would have a prospective effect only. Order 636 provides that pipelines should be allowed the opportunity to recover all prudently incurred transition costs, including GSR costs. TGPL does not expect to incur GSR costs associated with its firm sales service. TGPL's non-GSR transition costs are anticipated to be in a range of $5 million to $10 million. TGPL and certain other parties have filed appeals of certain of the FERC's orders to the D.C. Circuit Court. These appeals have been held in abeyance pending completion of the FERC's rehearing process and the expiration of the time to seek judicial review. TGPL has expressed to the FERC concerns that inconsistent treatment under Order 636 of TGPL and its competitor pipelines with regard to rate design and cost allocation issues in the production area may result in rates which could make TGPL less competitive, both in terms of production-area and long-haul transportation rates. TGPL is unable at this time to fully assess the competitive effect and resulting financial impact on TGPL of having to maintain its current production-area rate design which is different than that of its competitors. TGPL expects that any Order 636 transition costs incurred should be recovered from TGPL's customers, subject only to the costs and other risks associated with the difference between the time such costs are incurred and the time when those costs may be recovered from customers. Although no assurances can be given, TGPL does not believe that the implementation of Order 636 will have a material adverse effect on its financial position or results of operations. D. LEGAL PROCEEDINGS PRODUCER CONTRACT LITIGATION. TGPL has one remaining proceeding involving take-or-pay and other producer contract claims. In this lawsuit, a producer filed in federal district court in Texas claiming that it should have received more favorable terms for settlement of its contract claims and asserting federal antitrust claims. Such producer is seeking damages of approximately $30 million, of which approximately $10 million represents claims for punitive damages. In October 1992, the court issued an order granting TGPL's motion for summary judgment on the antitrust claims and in June 1993, the court issued an order granting TGPL's motion for summary judgment on all remaining claims. The producer has filed an appeal. Although no assurances can be given, TGPL does not believe that the ultimate resolution of this litigation will have a material adverse effect on its financial position or results of operations. In 1993, TGPL resolved another case involving producer contract claims in which a pipeline company filed suit against TGPL in a federal district court in Texas claiming that TGPL failed to pay amounts due under a FERC-certificated contract. The FERC issued a final order authorizing TGPL retroactively to abandon its purchase of gas from the plaintiff, and TGPL filed a motion for summary judgment asking the court to absolve it from liability under the contract. The court issued orders granting TGPL's motion for summary judgment on all counts. On May 7, 1992, TGPL and Challenger Minerals, Inc. (Challenger) entered into a Settlement Agreement to settle all matters in controversy between them, including, but not limited to, all claims and causes of action which were asserted or which might have been asserted in the lawsuit. In settling this litigation, TGPL agreed to provide shares of Transco common stock with a market value of $15 million to Challenger in 1994 and in connection with such agreement placed 1,500,000 shares of Transco common stock in escrow. The number of shares ultimately released to Challenger was to be determined by dividing $15 million by Transco's average common stock price during January 1994, subject to certain adjustments, with Challenger receiving a minimum of 750,000 shares. In February 1994, 1,017,771 shares of Transco common stock were released to Challenger from escrow and the remainder of the shares were returned to Transco. DAKOTA GASIFICATION LITIGATION. In October 1990, Dakota Gasification Company (Dakota), the owner of the Great Plains Coal Gasification Plant (Plant), filed suit in the United States District Court in North Dakota against TGPL and three other pipeline companies alleging that TGPL and the other pipelines had not complied with their respective obligations under certain gas purchase and gas transportation contracts. Specifically at issue is the proper price to be paid by TGPL and the other pipelines for synthetic gas since August 1989, the proper rate to be charged by Dakota for transportation through the Great Plains pipeline since October 1987, and the proper quantity of synthetic gas required to be taken-or-paid for by TGPL and the other pipelines. On September 8, 1992, Dakota and the United States Department of Justice on behalf of the Department of Energy (DOJ) filed a Third Amended Complaint in the U.S. District Court in North Dakota naming as defendants in the suit, in addition to TGPL and the other pipelines, Transco and Transco Coal Gas Company, the subsidiary of Transco that was the partner in Great Plains Gasification Associates (Partnership), the partnership that originally constructed the Plant. In addition, Dakota and DOJ named as defendants all of the other partners in the Partnership and each of the parent companies of these entities. In the Third Amended Complaint, Dakota and DOJ charge: (i) the pipeline defendants with breach of contract for failure to pay for volumes of gas tendered but not taken, for underpayment for gas purchased and for failure to pay for transportation services; (ii) all defendants with breach of representations and warranties, misrepresentation and breach of an implied covenant of good faith and fair dealing; and (iii) all parent company defendants and the affiliated partner defendants of each of the pipeline defendants with intentional interference with contractual relations. Dakota and DOJ are seeking declaratory and injunctive relief; the recovery of damages, alleging that the four pipeline defendants have underpaid for gas, collectively, as of June 30, 1992, by more than $232 million plus interest and for additional damages for transportation services; and costs and expenses, including attorneys' fees. On October 30, 1992, Dakota invoiced TGPL $70.5 million for "all synthetic gas costs" Dakota claims are due from TGPL. Because the proper gas price under TGPL's gas purchase contract with Dakota is derived from a formula involving the weighted average prices paid for certain natural gas purchased by TGPL, and is further the average of each of such prices calculated for each of the four pipeline purchasers, it is not feasible at this time for TGPL to determine if it in fact has underpaid for gas. Recent settlement negotiations between all of the parties to this litigation have resulted in the execution of a nonbinding settlement term sheet. The parties are currently working toward the execution of definitive agreements which would settle the litigation subject to final nonappealable regulatory approvals. The proposed settlement is also subject to a FERC ruling that TGPL's existing authority to recover in rates certain costs related to the purchase and transportation of gas produced by Dakota will pertain to gas purchase and transportation costs TGPL will pay Dakota under the terms of the settlement. In the event that the settlement agreement is not consummated or if the necessary regulatory approvals are not obtained, TGPL, Transco and Transco Coal Gas Company intend to vigorously defend the suit. Although no assurances can be given, TGPL and Transco believe that TGPL has substantially complied with its obligation under the contracts with Dakota and that Transco and Transco Coal Gas Company have not breached representations, warranties or implied covenants and have not intentionally interfered with the parties' contractual relations. Although no assurances can be given, TGPL does not believe that the ultimate resolution of this litigation, whether settled or not, will have a material adverse effect on its financial position or results of operations. ROYALTY CLAIMS. In connection with TGPL's renegotiations with producers to resolve take-or-pay and other contract claims and to amend gas purchase contracts, TGPL has entered into certain settlements which may require the indemnification by TGPL of certain claims for "excess royalties" which the producer may be required to pay as a result of such settlements. On October 15, 1992, the United States Court of Appeals for the Fifth Circuit and the Louisiana Supreme Court, with respect to the same litigation in applying Louisiana law, determined that royalties are due on take-or-pay payments under the royalty clauses of the specific mineral leases reviewed by the Courts. Furthermore, the State Mineral Board of Louisiana has passed a resolution directing the State's lessees to pay to the State royalties on gas contract settlement payments. As a result of these and related developments, TGPL has been made aware of demands on producers for additional royalties and such producers may receive other demands which could result in claims against TGPL pursuant to the indemnification provisions in their settlements. Indemnification for excess royalties will depend on, among other things, the specific lease provisions between the producer and the lessor and the terms of the settlement between the producer and TGPL. TGPL has been notified by two producers that they believe TGPL is obligated to reimburse each of them for approximately $16.0 million and $3.6 million, respectively, in settlement payments made by such producers to certain royalty owners in East Texas. TGPL has denied liability to the two producers and believes that it has meritorious defenses to these claims which it intends to pursue vigorously. One of the producers filed a lawsuit against TGPL in a state court on January 14, 1994. TGPL has been named as a defendant in three other lawsuits involving claims by producers and/or royalty owners, two in South Texas and one in Louisiana. In one of the Texas lawsuits, the royalty owners have made allegations against the producer for breach of express obligations under the lease; breach of covenant to reasonably market gas; breach of the covenant to reasonably develop; breach of the covenant to protect against drainage; and failure to deal in good faith. In the other Texas suit, the royalty owners did not claim that the producer breached any covenant to develop or protect against drainage. However, except for this omission, the royalty owners' claims in the second suit are virtually identical to the ones made in the first. In addition, the royalty owners have sued the parent and an affiliate of the producer and TGPL for allegedly conspiring to tortiously interfere with their lease. The producer defendant in the Texas cases has cross-claimed against TGPL pursuant to the excess royalty provision in the Omnibus Contract Amendment and Settlement Agreement between TGPL and the producer. While the complaints have not specified monetary damages, the royalty owners have verbally alleged that their claims against the producers could approximate $100 million. One of the Texas lawsuits is set for trial on December 2, 1994. In the Louisiana case, the royalty owners have alleged that they were third party beneficiaries to the original gas purchase contract between TGPL and the producers and that the settlement agreement entered into between TGPL and such producers is not valid without the royalty owners' consent. Additionally, in a separate lawsuit consolidated with the TGPL lawsuit, allegations have been made that Transco Exploration Company (TXC) and TXP Operating Company (TXPO) and other defendant-producers were entitled to make claims for breach of the gas purchase contracts but failed to either make claim or receive compensation for such breaches. The royalty owners make a number of allegations with respect to breach of the leases and breach of implied covenants similar to those alleged in the South Texas cases. The royalty owners have not specified an amount of monetary damages in their complaints. Trial is set for September 1994. Each of the royalty cases is in the discovery process. TGPL, TXC and TXPO have each denied liability in the litigation and each believes that it has meritorious defenses to the claims which it intends to pursue vigorously. TGPL believes at this time that its exposure, if any, under the excess royalty provisions of its settlements with the producers is substantially less than the amounts claimed by the royalty owners. Although no assurances can be given, TGPL believes that the ultimate resolution of these royalty claims and litigation will not have a material adverse effect on its financial position or results of operations. E. ENVIRONMENTAL MATTERS TGPL is subject to extensive federal, state and local environmental laws and regulations which affect TGPL's operations related to the construction and operation of its pipeline facilities. Appropriate governmental authorities may enforce these laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties, assessment and remediation requirements and injunctions as to future compliance. TGPL's use and disposal of hazardous materials are subject to the requirements of the federal Toxic Substances Control Act (TSCA), the federal Resource Conservation and Recovery Act (RCRA) and comparable state statutes. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as "Superfund," imposes liability, without regard to fault or the legality of the original act, for release of a "hazardous substance" into the environment. Because these laws and regulations change from time to time, practices which have been acceptable to the industry and to the regulators have to be changed and assessment and monitoring have to be undertaken to determine whether those practices have damaged the environment and whether remediation is required. Since 1989, TGPL has had studies underway to test its facilities for the presence of toxic and hazardous substances to determine to what extent, if any, remediation may be necessary. On the basis of the findings to date, TGPL estimates that environmental assessment and remediation costs that will be incurred over the next five years under TSCA, RCRA, CERCLA and comparable state statutes will total approximately $52 million to $62 million. This estimate depends upon a number of assumptions concerning the scope of remediation that will be required at certain locations and the cost of remedial measures to be undertaken. TGPL is continuing to conduct environmental assessments and is implementing a variety of remedial measures that may result in increases or decreases in the total estimated costs. At December 31, 1993, TGPL had a reserve of approximately $52 million for these estimated costs. TGPL considers environmental assessment and remediation costs and costs associated with compliance with environmental standards to be recoverable through rates, since they are prudent costs incurred in the ordinary course of business. To date, TGPL has been permitted recovery of environmental costs incurred, and it is TGPL's intent to continue seeking recovery of such costs, as incurred, through rate filings. Therefore, these estimated costs of environmental assessment and remediation have been recorded as regulatory assets in the accompanying Balance Sheet. Since 1989, TGPL has been involved in discussions with the Pennsylvania Department of Environmental Resources (PADER) concerning environmental conditions at TGPL's operating sites in Pennsylvania. These discussions have resulted in the execution of a consent order and agreement in 1992 between PADER and TGPL. TGPL agreed to conduct an environmental assessment and remediation program at its Pennsylvania sites, fund certain beneficial environmental projects, pay oversight costs and pay a $425,000 civil penalty. Of such penalty, $142,000 remains to be paid in May 1994. The estimated costs of the environmental assessment and remediation program are included in the $52 million to $62 million range discussed above. TGPL has used lubricating oils containing polychlorinated biphenyls (PCBs) and, although the use of such oils was discontinued in the 1970s, has discovered residual PCB contamination in equipment and soils at certain gas compressor station sites. TGPL has worked closely with the Environmental Protection Agency (EPA) and state regulatory authorities regarding PCB issues, and has a program to assess and remediate such conditions where they exist, the costs of which are a significant portion of the $52 million to $62 million range discussed above. Proposed civil penalties have been assessed by the EPA against another major pipeline company for the alleged improper use and disposal of PCBs. Although similar penalties have not been asserted against TGPL to date, no assurance can be given that the EPA may not seek such penalties in the future. TGPL has been named as a potentially responsible party (PRP) in one Superfund waste disposal site, the Combustion Inc. site, and in two state sites. Based on present volumetric estimates, TGPL's exposure for remediation of the Combustion Inc. site is estimated to be $500,000. TGPL's estimated individual exposure at each of the two state sites where it has been named as a PRP is less than $100,000 per site. The estimated remediation costs for all such sites have been included in TGPL's environmental reserve discussed above. Liability under CERCLA (and applicable state law) can be joint and several with other PRPs. Although volumetric allocation is a factor in assessing liability, it is not necessarily determinative; thus, the ultimate liability could be substantially greater than the amount described above. Although no assurances can be given, TGPL does not believe that its PRP status will have a material adverse effect on its financial position or results of operations. TGPL is also subject to the federal Clean Air Act and the federal Clean Air Act Amendments of 1990 (1990 Amendments), which added significantly to the existing requirements established by the federal Clean Air Act. The 1990 Amendments required that the EPA issue new regulations, mainly related to mobile sources, air toxics, ozone non-attainment areas and acid rain. TGPL is installing new emission control devices where required and conducting certain emission testing programs to comply with the federal Clean Air Act standards and the 1990 Amendments. In addition, pursuant to the 1990 Amendments the EPA has issued regulations under which states must implement new air pollution controls to achieve attainment of national ambient air quality standards in areas where they are not currently achieved. TGPL has compressor stations in ozone non-attainment areas that could require substantial additional air pollution reduction expenditures, depending on the requirements imposed. While it will not be possible to estimate the ultimate costs of compliance with these new requirements until the states approve TGPL's proposed plans for modifications, TGPL expects that significant capital spending may be required to modify TGPL's facilities, particularly the compressor engines along TGPL's pipeline system. Additions to facilities for compliance with currently known federal Clean Air Act standards and the 1990 Amendments are expected to cost in the range of $20 million to $30 million over the next five years and will be recorded as assets as the facilities are added. F. FINANCING LONG-TERM DEBT. At December 31, 1993 and 1992, long-term debt issues were outstanding as follows (in thousands): Sinking fund or prepayment requirements applicable to long-term debt outstanding at December 31, 1993 are as follows (in thousands): No property is pledged as collateral under any of the long-term debt issues. REFINANCING. In May 1993, TGPL repriced the interest rate on its Extendible Notes due May 15, 2000. The interest rate for the interest period beginning May 15, 1993 and ending May 14, 1996 is 6.21%. The Extendible Notes are equal in rank with all existing indebtedness of TGPL and senior in right of payment to any future subordinated indebtedness. The Extendible Notes are redeemable at the option of TGPL, in whole or in part, at their principal amount plus accrued interest thereon on May 15, 1996. This was a refinancing and TGPL did not receive any proceeds from the resale of the Extendible Notes. RESTRICTIVE COVENANTS. Transco has in place a $450 million working capital line with a group of fifteen banks that will continue through December 31, 1996. TGPL is guarantor of $270 million of this working capital line. Effective December 31, 1993, Transco and a group of banks entered into a $50 million reimbursement facility. This facility provides Transco the opportunity to obtain standby letters of credit under certain circumstances from the banks. TGPL is guarantor of $30 million of the obligations that arise under this facility. Certain of Transco's credit facilities and indentures prohibit TGPL from, among other things, placing a lien on any of the property or assets owned by TGPL, incurring or guaranteeing any additional indebtedness, except for indebtedness incurred to refinance existing indebtedness, issuing preferred stock or advancing cash to affiliates other than Transco. Further, certain of Transco's credit facilities and indentures contain restrictive covenants which could limit Transco's ability to make additional borrowings and, therefore, under certain circumstances, its ability to make or repay advances to TGPL or make capital contributions to TGPL. Additionally, certain of TGPL's debt instruments restrict the amount of dividends distributable. As of December 31, 1993, approximately $287 million of TGPL's retained earnings of $424 million was available for distribution. SALE OF RECEIVABLES. TGPL has sold trade and producer settlement receivables and continues to sell trade receivables. The sale of trade receivables is made without recourse. In September 1993, TGPL entered into a new program to sell monthly trade receivables to replace a similar program which expired. The new trade receivable program, which expires in September 1995, provides for the sale of up to $100 million of trade receivables on substantially the same terms as the prior program. To maintain the level of trade receivables sold at approximately $100 million, new trade receivables are sold as collections reduce previously sold trade receivables. At December 31, 1993 and 1992, approximately $100 million and $108 million, respectively, of trade receivables were held by an investor. G. PREFERRED STOCK TGPL has authorized 10,000,000 shares of cumulative first preferred stock without par value, of which 757,427 shares and 1,017,410 shares were outstanding at December 31, 1993 and 1992, respectively. TGPL has authorized 2,000,000 shares of cumulative second preferred stock without par value. None of the second preferred had been issued at December 31, 1993. The first preferred stock issued and outstanding at December 31, 1993 and 1992, included the following series: The preference in involuntary liquidation is the stated value of each issue. The sinking fund redemption price for each series is the stated value per share plus accrued and unpaid dividends. The shares of each series are redeemable by various annual sinking fund requirements in each of the years 1994 through 1997. TGPL may redeem in whole or in part the preferred shares of each series at the stated value of each series. Sinking fund requirements applicable to preferred stock outstanding at December 31, 1993, are (in thousands): TGPL may not declare any common stock dividends if the sinking fund provisions of the preferred stock of TGPL are not met. The preferred stock of TGPL, excluding the $8.75 series, has no voting rights except in cases of (i) amending the Certificate of Incorporation so as to affect adversely the rights, powers or preferences of the preferred stock, (ii) the merger or consolidation by TGPL with any other corporation, (iii) the sale of all or substantially all of its assets, or (iv) whenever dividends payable on the preferred stock are in arrears in an aggregate amount equivalent to six full quarterly dividends, in which case the outstanding preferred stock shall have the exclusive right, voting separately and as a class, to elect two directors of TGPL until all past dividends have been paid. The $8.75 series has no voting rights except in cases of (i) and (ii) above. The changes in the total TGPL preferred stock in each of the years 1993, 1992 and 1991 are (in thousands): H. EMPLOYEE BENEFIT PLANS RETIREMENT PLANS. TGPL has a retirement plan (Retirement Plan) with Transco and certain affiliated companies that covers substantially all of TGPL's officers and regular employees. The benefits under the Retirement Plan are determined by a formula based on the employee's highest 36 consecutive months of earnings out of the last 60 months of service prior to actual retirement date and years of participation in the Retirement Plan. The Retirement Plan provides for the vesting of employees after five years of credited service. Transco's funding policy is to contribute an amount at least equal to the minimum funding requirements actuarially determined by an independent actuary in accordance with the Employee Retirement Income Security Act of 1974. The Retirement Plan's assets, which are managed by external investment organizations, include cash and cash equivalents, corporate and government debt instruments, preferred and common stocks, commingled funds, international equity funds and venture capital limited partnership interests. The following table sets forth the funded status of the Retirement Plan at October 1, 1993 and 1992, and the amount of accrued pension costs as of December 31, 1993 and 1992 (in thousands): The following table sets forth the components of the Retirement Plan's pension cost, including TGPL's, for the years ended December 31, 1993, 1992 and 1991 (in thousands): The projected unit credit method is used to determine the actuarial present value of the accumulated benefit obligation and the projected benefit obligation. The following table summarizes the various assumptions used to determine the projected benefit obligation for the Retirement Plan for the years 1993, 1992 and 1991(1): (1) Pension costs are 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. Effective November 15, 1991, an amendment to the Retirement Plan was adopted to allow the lump sum payment of benefits to all current active and terminated vested participants. A lump sum distribution is the discounted present value of a participant's vested benefit. The effect of this amendment was to reduce unrecognized prior service cost by $6.1 million. During 1991, TGPL offered a special voluntary retirement program (SVRP) to a certain group of employees. The SVRP included an incentive in the form of increased pension benefits to be paid out of the Retirement Plan. Approximately 124 employees elected to retire under the SVRP. The net cost of the SVRP to the Retirement Plan was approximately $0.8 million ($0.5 million, after-tax). In connection with Transco's plans to reduce TGPL's work force by a total of approximately 275 employee positions, an additional charge of $9.5 million ($6.3 million, after-tax) was recorded by TGPL for estimated severance costs. TRAN$TOCK. In January 1987, Transco's Board of Directors approved the establishment of a new employee stock ownership plan called Tran$tock, which subsequently purchased 3,966,942 shares of newly issued Transco common stock at $45-3/8 per share. The Tran$tock plan was funded by a $180 million loan at an interest rate of 7.39% due in 1994. Tran$tock subsequently used $120 million of the funds received from the restructuring of Transco's retirement plan to reduce the outstanding loan balance. Interest and principal on the remaining loan balance of $9 million at December 31, 1993, is being serviced by tax-deductible dividends paid on the common stock held by Tran$tock and contributions by Transco. Compensation expense of $2.2 million, $2.3 million and $4.0 million related to Tran$tock has been recognized by TGPL in 1993, 1992 and 1991, respectively. This expense represents the shares of Transco common stock allocated to employees of TGPL for 1993, 1992 and 1991, respectively. In each of these respective years, TGPL has recorded a capital contribution from Transco in the amount of the expense. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS. TGPL has a plan (Plan) with Transco and certain affiliated companies that provides certain health care and life insurance benefits for retired employees of TGPL and certain other Transco subsidiaries. The Plan provides medical and life insurance benefits to employees who retire under the Retirement Plan with at least ten years of participation in Transco's group insurance plans and the Retirement Plan immediately preceding retirement. Effective January 1, 1994, the Plan was amended to require monthly contributions by retirees and to increase annual deductibles, out-of-pocket limits and lifetime maximum benefits per individual. The medical benefits for all retired TGPL employees are currently funded at a specified amount per month through a trust established under the provisions of section 501(c)(9) of the Internal Revenue Code. Prior to 1993, TGPL accounted for postretirement benefits other than pensions (primarily health care) on a cash basis, which had been the accounting method followed by most employers. In the first quarter of 1993, TGPL adopted SFAS No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions, which requires TGPL to accrue, during the years that employees render the necessary service, the estimated cost of providing postretirement benefits other than pensions to those employees. At the January 1, 1993 date of adoption of SFAS No. 106, TGPL's postretirement benefits obligation (transition obligation) was $104 million. TGPL's transition obligation was reduced by approximately $9 million by the Plan amendments discussed above. The transition obligation is being amortized over twenty years. The following table sets forth the funded status of the Plan at December 31, 1993 reconciled with the accrued postretirement benefits cost at December 31, 1993 (in thousands): The following table sets forth the components of the Plan's net periodic postretirement benefit cost, including TGPL's, for the year ended December 31, 1993 (in thousands): TGPL's share of the Plan's net periodic postretirement benefit cost for 1993 was $16.2 million. TGPL's cost of providing these benefits for retirees and survivors during 1992 and 1991 on a pay-as-you-go-basis were $4.6 million and $4.1 million, respectively. The annual expense is subject to change in future periods as a result of, among other things, the passage of time, changes in participants, changes in plan benefits and changes in assumptions upon which the estimates are made. For measurement purposes as of December 31, 1993, the initial annual rate of increase in the per capita cost of covered health care benefits was assumed to be 12%. The rate was assumed to decrease gradually to 6% for the year 2005 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 assumed health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation for health care benefits as of January 1, 1994 by 11% and the aggregate of the service and interest cost components of the net periodic postretirement health care benefit cost for 1994 by 14%. To determine the accumulated postretirement benefit obligation, the Plan used a discount rate of 7.25% and a salary growth assumption of 5.0% per annum. Plan assets are managed by external investment organizations and include cash and cash equivalents, commingled funds, preferred and common stocks and government and corporate debt instruments. The expected long-term rate of return on plan assets was 7% after taxes. Realized returns on plan assets are subject to federal income taxes at a sliding scale that reaches a 39.6% tax rate. In January 1993, TGPL began recovering in rates its postretirement benefits costs accrued under SFAS No. 106. TGPL believes that all costs of providing postretirement benefits to its employees are necessary and prudent operating expenses that will be recoverable in rates. The adoption of SFAS No. 106 did not have a material adverse effect on TGPL's financial position or results of operations. I. INCOME TAXES Following is a summary of the provision for (benefit of) income taxes for 1993, 1992 and 1991 (in thousands): On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 was signed into law. Among its provisions was an overall increase in corporate federal income tax rates from 34% to 35% effective January 1, 1993. As a result, TGPL recognized additional income tax expense of $1.0 million in 1993 related to the increase in corporate federal income tax rates. Following is a reconciliation of the statutory federal income tax rate to the effective tax rate (amounts in thousands): Deferred income taxes result from temporary differences between the tax basis of an asset or liability and its reported amount in the financial statements that will result in taxable or deductible amounts in future years, or temporary differences resulting from events that have been recognized in the financial statements that will result in taxable or deductible amounts in future years. The tax effect of each type of temporary difference and carryforward reflected in deferred income tax benefits and liabilities as of December 31, 1993 and 1992 are as follows (in thousands): J. COMMITMENTS AND CONTINGENCIES LEASE OBLIGATIONS. TGPL has a 20-year lease agreement for its headquarters building which expires in 2004. The lease is with Transco Tower Limited, a partnership in which Transco has an indirect 12.5% interest. TGPL has an option to renew and extend the existing lease term under the same provisions for three successive renewal terms of five years each. The future minimum lease payments under TGPL's various operating leases are as follows (in thousands): TGPL's Transco Tower lease agreement covers all space occupied by Transco and its subsidiaries, including TGPL. TGPL is reimbursed by the other subsidiaries for their share of the building lease expense. TGPL's lease expense is as follows (amounts expressed in thousands): LONG-TERM GAS PURCHASE CONTRACTS. TGPL has long-term gas purchase contracts containing take-or-pay provisions and prices which are not variable market based. Future changes in market conditions affecting the volumes of gas sold and prices of natural gas may expose TGPL to financial risks pursuant to these provisions. Pursuant to a settlement that TGPL has with its customers, TGPL has in place a GIC designed to allow TGPL to recover its above-spot-market gas costs through March 31, 2001. TGMC and TGPL believe that the GIC agreed to with its customers will be adequate to enable recovery of TGPL's above-spot-market gas costs. As discussed in Note A, in January 1993, TGPL entered into an agency agreement with TGMC to manage all of TGPL's jurisdictional sales. However, TGPL is at risk for any above-spot-market gas costs that may be incurred in excess of the amounts recovered under the GIC. TGPL's basic business policy is to perform under the terms and conditions of its contractual obligations. To achieve this objective, an operating plan is utilized to monitor the current status of contractual obligations under each gas purchase agreement, whereby the obligation-to-date is matched against the performance-to-date. Any overperformance or underperformance is corrected by appropriate adjustments to the operating plan over the remainder of the period of the agreement. Deliverability tests, actual takes and prices paid are some of the factors reviewed at least monthly, and in most cases weekly, in order to ensure that performance is proceeding according to plan. Since TGPL has been and expects to continue to be able to perform in accordance with its contract terms, no provision has been recorded for future loss. TGPL does not believe that financial risks associated with its long-term gas purchase contracts are material to TGPL's financial position or results of operations. ROYALTY COMMITMENTS. In connection with TGPL's renegotiations of supply contracts with producers to resolve take-or-pay and other contract claims and to amend gas purchase contracts, TGPL has entered into certain settlements which may require the indemnification by TGPL of certain claims for royalties which the producer may be required to pay as a result of such settlements (see Note D. Legal Proceedings - Royalty Claims). SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK TRADE RECEIVABLES. As of December 31, 1993, TGPL had trade receivables of $54 million. These trade receivables primarily are due from local distribution companies and other pipeline companies predominantly located in the eastern United States. TGPL's credit risk exposure in the event of nonperformance by the other parties is limited to the face value of the receivables. No collateral is required on these receivables. NOTE RECEIVABLE. In April 1991, TGPL accepted a note receivable in consideration for the conveyance of certain interests in a gas field and related processing plant to a producer. The note was to be repaid out of proceeds from the field production and plant revenues. However, in October 1993, the producers sold the gas field and related processing plant. TGPL's portion of the sales proceeds was used to reduce the outstanding note receivable. The remaining balance plus certain associated costs were written off in September 1993 resulting in an after-tax non-cash charge of $12.5 million. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK FUTURES CONTRACTS. TGPL has been a party to various futures contracts in the management of its natural gas marketing activities. Futures contracts designated as hedges are carried at market value with gains and losses deferred until the hedged marketing activity is included in current net income or loss. As of December 31, 1993, in connection with open contracts on gas marketing activity designated as hedges, TGPL recorded a deferred gain of approximately $0.4 million. These contracts are expected to be closed from February 1994 through August 1994. The market value of the open contracts designated as hedged transactions is calculated using the applicable New York Mercantile Exchange (NYMEX) closing prices at December 31, 1993. TGPL is exposed to market risk on these contracts to the extent of changes in the market prices for natural gas and liquids between December 31, 1993, and the date the contracts are closed. However, market risk exposure on hedged transactions is offset by the gain or loss recognized upon the sale of the products that are hedged. While market values are used to express the amounts of futures contracts, the amounts potentially subject to credit risks, in the event of nonperformance by third parties, are substantially smaller. K. TRANSACTIONS WITH MAJOR CUSTOMERS AND AFFILIATES MAJOR CUSTOMERS. Major customers of TGPL and the related sales, transportation and storage revenues received from such customers were as follows: The gas sold for resale in 1993 was sold to customers under executed Firm Sales Agreements with primary terms of not less than three years (1995) but not greater than eight years (2001). AFFILIATES. Transactions with affiliates during 1993, 1992 and 1991 were as follows: Included in TGPL's sales and transportation revenues for 1993, 1992 and 1991 are revenues applicable to sales and transportation for affiliates, Transco Energy Marketing Company (TEMCO), TXG Gas Marketing Company (TXG Marketing), Texas Gas Transmission Corporation (Texas Gas), Transco Offshore Gathering Company (TOGCO), and Transco Energy Ventures Company (TEVCO), an affiliate until it was sold on September 13, 1993, as follows (expressed in millions): The rates charged to provide sales and transportation services to affiliates are the same as those that are charged to similarly-situated nonaffiliated customers. Prior to 1993, TGPL and Texas Gas were responsible for all jurisdictional gas sales to their pipeline customers and TEMCO and TXG Marketing were responsible for all non-jurisdictional gas sales. After FERC approval in January 1993, Transco began to implement a plan to consolidate its gas marketing businesses under the common management of TGMC. These changes were needed to more closely coordinate gas marketing operations to improve efficiencies, reduce costs and improve profitability. In January 1993, TGMC, through an agency agreement, began to manage all jurisdictional sales of TGPL. For the year ended December 31, 1993, included in TGPL's cost of sales is $25.1 million representing agency fees billed by TGMC to TGPL under this agreement. Included in TGPL's cost of sales and transportation for 1993, 1992 and 1991 is purchased gas cost from affiliates, TEMCO, TXG Marketing and Transco Exploration and Production Company (TEPCO), an affiliate until July 31, 1992, as follows (expressed in millions): All gas purchases are made at market or contract prices. The significant increase in 1993 for purchased gas cost from TEMCO reflects the consolidation of Transco's gas marketing businesses, including all jurisdictional sales of TGPL, under the common management of TGMC, as discussed above. Also included in TGPL's cost of transportation is transportation expense for 1993, 1992 and 1991 applicable to the transportation of gas by affiliates, Texas Gas and TOGCO, and High Island Offshore System (HIOS) and the U-T Offshore System (UTOS), both affiliates until July 20, 1992, as follows (expressed in millions): On July 20, 1992, Transco sold its interest in both HIOS and UTOS. TGPL was the operator of UTOS until November 1, 1993. HIOS, UTOS and Texas Gas are regulated by the FERC and their transportation rates charged to TGPL are approved by the FERC. TOGCO is a nonjurisdictional company whose transportation rates are charged to TGPL at contract prices. Transco has a policy of charging subsidiary companies for management services provided by the parent company and other affiliated companies. Included in TGPL's administrative and general expenses for 1993, 1992 and 1991, was $14.6 million, $11.8 million and $12.3 million, respectively, for management services charged by Transco. Management considers the cost of these services reasonable. L. FAIR VALUE OF FINANCIAL INSTRUMENTS CASH AND SHORT-TERM FINANCIAL ASSETS AND LIABILITIES. For short-term instruments, the carrying amount is a reasonable estimate of fair value due to the short maturity of those instruments. LONG-TERM NOTE RECEIVABLE. The carrying amount for the long-term note receivable is a reasonable estimate of fair value since the note earned an appropriate rate of interest for the risk involved. LONG-TERM DEBT. Effectively, all of TGPL's debt is publicly traded, therefore fair value is estimated based on quoted market prices at year end, less accrued interest. The carrying amount and estimated fair values of TGPL's financial instruments at December 31, 1993 and 1992 are as follows (in thousands): M. QUARTERLY INFORMATION (UNAUDITED) The following summarizes selected quarterly financial data for 1993 and 1992 (in thousands): (1) Includes $20,125 charge for write-off of note receivable. (1) Includes $31,000 provision for producer settlements. TRANSCONTINENTAL GAS PIPE LINE CORPORATION SCHEDULE IV - INDEBTEDNESS OF AND TO RELATED PARTIES - NOT CURRENT For Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) Reference is made to Note A of the Notes to Financial Statements which are included in Item 8 herein. At December 31, 1993, 1992 and 1991, there was no indebtedness to related parties - not current. TRANSCONTINENTAL GAS PIPE LINE CORPORATION SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT(1) For Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) (1) For a discussion of the methods and rates used to compute depreciation and amortization, reference is made to Note B of the Notes to Financial Statements which are included in Item 8 herein. (2) Includes reclassification of construction work-in-progress closed to various plant categories during each respective year. (3) Reclassification of gathering facilities to transmission plant under the Rate Settlement. TRANSCONTINENTAL GAS PIPE LINE CORPORATION SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) (1) Reclassification of gathering facilities to transmission plant under the Rate Settlement. TRANSCONTINENTAL GAS PIPE LINE CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT (Thousands of Dollars) ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING FOR FINANCIAL DISCLOSURE. None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Except as otherwise noted below, the following table sets forth certain information regarding all directors and executive officers of TGPL and all persons nominated to become directors of TGPL as of March 1, 1994: (1) The date shown in the above column is the date the person first became an executive officer of TGPL. Mr. DesBarres was elected as a director of TGPL in January 1992. Mr. Best was elected as a director of TGPL in February 1992. Mr. Varner was elected as a director in June 1982. With the exception of the following, all officers of TGPL have been employed by Transco or its subsidiaries for more than the last five years. John P. DesBarres joined Transco in October 1991 as President and Chief Executive Officer of Transco and became President and Chief Executive Officer of TGPL in January 1992. Prior to joining Transco, Mr. DesBarres served from April 1988 through September 1991 as Chairman, President and Chief Executive Officer of Santa Fe Pacific Pipelines, Inc. Prior to joining Santa Fe, he served as President of Sun Pipeline Company, a subsidiary of Sun Company Inc., a diversified energy company. Nicholas J. Neuhausel joined Transco in June 1993 as Senior Vice President - Human Resources and Administration of both Transco and TGPL. Prior to joining Transco, Mr. Neuhausel held various positions with Sun Company, Inc., a diversified energy company, and its subsidiaries, including Vice President of Human Resources and Administration. The officers of TGPL serve at the pleasure of the Board of Directors. No family relationship exists between any of them. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION SUMMARY COMPENSATION TABLE The table below discloses the annual and long-term compensation from Transco and TGPL awarded or paid to or earned by (i) the Chief Executive Officer, (ii) the four other most highly compensated executive officers of TGPL who were serving as executive officers at December 31, 1993, and (ii) above collectively referred to herein as the "Named Executive Officers" and individually referred to as a "Named Executive Officer" for services rendered to Transco and TGPL in all capacities for the fiscal years ended December 31, 1993, 1992, and 1991. No information is presented for Messrs. DesBarres and Best for the fiscal year ended December 31, 1991 because they were not officers of TGPL until January 1992 and February 1992, respectively. (1) Excludes perquisites and other personal benefits, securities and property paid to or earned by a Named Executive Officer, the aggregate amount of which is the lesser of $50,000 or 10% of the annual salary and bonus reported for such person in columns (c) and (d). (2) As of the close of business on December 31, 1993, Mr. DesBarres held 20,000 shares of Transco Restricted Stock with a value of $282,500. On January 1, 1995, 10,000 of such shares will vest and the remaining 10,000 shares will vest on January 1, 1996, assuming Mr. DesBarres is an employee of Transco on the vesting dates. To effect certain cost savings to the benefit of Transco, on December 14, 1993, Transco's Compensation Committee approved the accelerated vesting of 26,592 shares of Transco Restricted Stock from January 1, 1994 to December 31, 1993. As of the close of business on December 31, 1993, Messrs. Best and Dagley held 8,250 and 4,725 shares of Transco Restricted Stock, with a value of $116,531 and $66,741, respectively. Such Transco Restricted Stock shares vest at a rate of 2,750 and 1,575, respectively, annually on each March 24 in 1994, 1995 and 1996, assuming the holder is an employee of Transco on the vesting dates. TGPL has elected to report performance-based Transco Restricted Stock in column (h) upon the vesting thereof. As of the close of business on December 31, 1993, Messrs. Best, Dagley, DesBarres, Spencer and Varner held 14,800, 7,250, 30,350, 6,900 and 10,600 shares of performance-based Restricted Stock and 7,400, 3,625, 15,175, 3,450 and 5,300 corresponding Restricted Stock Units, respectively. The value of this Restricted Stock for Messrs. Best, Dagley, DesBarres, Spencer and Varner as of December 31, 1993 (excluding the 1991 grants, the payment of which is reported in column (h) and discussed in footnote 8 below) was $209,050, $102,406, $428,694, $94,463 and $149,725, respectively. This Restricted Stock is subject to performance-based vesting conditions. During the restriction period, all of the aforementioned shares of Transco Restricted Stock are entitled to receive dividends payable to Transco stockholders. All Transco Restricted Stock values in this footnote are calculated based upon the closing price of Transco's Common Stock on December 31, 1993. (3) Includes Transco director's fees of $13,000 in 1993 and $20,000 in 1992. (4) Includes (i) except for Mr. Best, the value (as of the date of allocation) of shares of Transco's Common Stock allocated pursuant to Transco's Tran$tock Plan and accruals under Transco's Benefit Restoration Plan (an Internal Revenue Code Section 415 Excess Plan) related to Tran$tock allocations which would have been made under the Tran$tock Plan but for certain limitations imposed under the Internal Revenue Code, and (ii) dividends on performance-based Transco Restricted Stock (i.e., Restricted Stock that vests only if Transco achieves certain performance goals.) (5) Also includes moving and relocation expenses including tax gross-up ($257,033) and other perquisites and personal benefits ($25,075). (6) Includes moving and relocation expenses including tax gross-up ($156,236), other perquisites and personal benefits ($19,555) and dividends on performance-based Transco Restricted Stock (i.e., Restricted Stock that vests only if Transco achieves certain performance goals). (7) Represents cash value of Transco Restricted Stock which vested pursuant to grants under Transco's 1983 Incentive Plan. This Transco Restricted Stock was issued in 1991 and vesting was subject to certain performance criteria under which all or a portion would be earned upon attainment by Transco, during a performance period beginning on January 1, 1991 and ending on December 31, 1993, of certain performance goals. (8) Includes (i) a matching contribution under the Texas Gas Thrift Plan ($10,262 for 1992 and $10,013 for 1993), (ii) a related accrual ($3,562 for 1993) under the Texas Gas Excess Benefit Plan (an Internal Revenue Code Section 415 Excess Plan), and (iii) amounts accrued to provide a retirement benefit ($35,888 for 1992 and $55,047 for 1993) and to provide a death benefit ($1,380 for 1992 and $1,560 for 1993) under the Texas Gas Salary Continuation Plan. (9) Represents cash payment for Performance Units earned pursuant to grants under Transco's 1983 Incentive Plan. When these Performance Units were granted in 1989 and 1988, the performance criteria under which all or a portion would be earned required that Transco and certain subsidiaries, including TGPL, achieve certain performance goals. In 1990, the performance criteria was revised to condition the vesting of all or a portion of the awards upon the attainment of certain performance goals solely by Transco. (10) In order to facilitate the transition to the Securities and Exchange Commission's revised proxy disclosure requirements, registrants have been permitted a transition period for disclosure of the amounts reported in columns (e) and (i). Accordingly, these columns do not include information for fiscal years ended before December 15, 1992. (11) Represents a lump sum payment pursuant to an agreement with Transco in connection with Mr. Spencer's retirement from Transco on January 1, 1994. OPTION GRANTS IN LAST FISCAL YEAR Shown below is further information on the stock options, reflected in column (g) of the Summary Compensation Table, granted pursuant to Transco's 1991 Incentive Plan during the fiscal year ended December 31, 1993 to the Named Executive Officers. OPTION GRANTS IN LAST FISCAL YEAR (1) These options vest at a rate of 25 percent annually, are exercisable for a period of ten years after the date of grant and, if held for more than 6 months, may be accelerated automatically upon a change of control in Transco or, if approved by Transco's Compensation Committee of Transco's Board of Directors, upon the occurrence of certain other events such as retirement. The exercise price is equal to the market value of Transco's Common Stock on the date of grant. The stock options contain a tax- withholding feature which permits the optionee, with the consent of Transco's Compensation Committee, to surrender shares for the payment of any taxes due in connection with the exercise of the option. (2) The estimated present value of stock options is based on the Black-scholes Model, a mathematical formula that calculates a theoretical option value based on certain assumptions. The assumptions used in calculating the values that appear in this column are as follows: a volatility factor of .3277 for the 12 months preceding date of grant, a risk-free rate of return of 6.14%, yield on U.S. Treasury zero-coupon bond expiring in May 2004, and a dividend yield of 3.69%, based on the annual dividend rate as of the date of grant. The actual value, if any, that a Named Executive Officer may realize will depend on the spread between the market price and the option price on the date the option is exercised. Therefore, there can be no assurance that the value estimated by the Black-Scholes model will be predictive of the actual value realized by the Named Executive Officer on the date the option is exercised. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES None of the Named Executive Officers exercised any stock options during the fiscal year 1993. Shown below is information with respect to the unexercised options to purchase Transco's Common Stock granted under Transco's 1991 Incentive Plan or 1983 Incentive Plan to the Named Executive Officers and held by them at December 31, 1993. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION UPDATES (1) A stock option is considered to be "in the money" if the market price of the related stock is higher than the exercise price of the option. The Transco Common stock price at December 31, 1993 was $14.125 per share. LONG-TERM INCENTIVE PLANS - AWARDS IN LAST FISCAL YEAR Shown below is information with respect to long-term incentive awards made to the Named Executive Officers in the fiscal year ended December 31, 1993 under Transco's 1991 Incentive Plan. LONG-TERM INCENTIVE PLANS AWARDS IN LAST FISCAL YEAR (1) Represents performance-based Transco Restricted Stock granted pursuant to Transco's 1991 Incentive Plan. A grantee of such Transco Restricted Stock is the record owner thereof during the restriction period and has all rights of a stockholder including the right to vote and to receive dividends; provided, however, that such grantee does not have the right to transfer such Transco Restricted Stock until the restrictions relating thereto are removed by Transco's Compensation Committee upon the achievement by Transco of certain performance goals. The performance criteria for these awards is based upon Transco's total shareholder return relative to a peer group of other companies. (2) Represents the grant of Transco Restricted Stock units which are issued in conjunction with the Transco Restricted Stock presented immediately above. A Transco Restricted Stock Unit represents one share of Transco Common Stock to be issued to the grantee in the future upon the determination by Transco's Compensation Committee that Transco has achieved specified performance goals in excess of the goals set for a corresponding grant of Transco Restricted Stock. All awards of Transco Restricted Stock and Transco Restricted Stock Units presented above are accompanied by tax withholding rights. (3) This award was forfeited by Mr. Spencer in connection with his retirement on January 1, 1994. TRANSCO ENERGY COMPANY RETIREMENT PLAN AND SUPPLEMENTAL BENEFIT PLAN PENSION TABLE The following table shows the estimated annual benefits that would be payable upon normal retirement under the Transco Retirement Plan and, if applicable, the Transco Supplemental Benefit Plan, to employees of Transco and certain subsidiaries, including TGPL, in various earnings classifications with representative years of service, assuming in each case that the employee elected a single life annuity as the form of benefit payment. Benefits listed in the table are not subject to a deduction for offsets for social security or other offset amounts. The Transco Supplemental Benefit Plan provides benefits to participating executives that cannot be paid under the Transco Retirement Plan because of limitations imposed by the Internal Revenue Code on benefits payable under a qualified plan. PENSION PLAN TABLE (1) The covered compensation upon which final average earnings are computed under the Transco Retirement Plan is the base compensation of the participant, excluding bonuses, commissions, per diem, premium pay or any other extra compensation, reimbursement for business expenses, group life insurance premiums, overtime pay, or any benefits under the Transco Retirement Plan or any other benefit plan with the exception of Internal Revenue Code Section 401(k) contributions made under the Transco Thrift Plan and salary reduction contributions made under Transco's Internal Revenue Code Section 125 cafeteria plan and is subject to the Internal Revenue Code limitation described above. This base compensation is set forth in column (c) of the Summary Compensation Table. Final average earnings are computed by averaging covered compensation over the highest three consecutive years out of the final five years prior to retirement. Under the Transco Supplemental Benefit Plan, the covered compensation includes all covered compensation under the Transco Retirement Plan, without regard to the Internal Revenue Service limitation described above, plus annual incentive compensation. This annual incentive compensation is set forth in Column (d) of the Summary Compensation Table. The current and years of service with Transco for the Named Executive Officers as of December 31, 1993 are: Mr. DesBarres 2.33 years, Mr. Dagley 8.42 years, Mr. Spencer 41.92 years and Mr. Varner 11.67 years, respectively. Mr. Best does not participate in this plan. Mr. DesBarres has also entered into a Supplemental Retirement Agreement with Transco which credits him with an additional 28 years of service for the purposes of calculating his retirement benefit. Mr. DesBarres will vest in this benefit upon his death or disability, if he is an employee of Transco on September 30, 1994 or if his employment is terminated prior to such date by Transco other than for "Cause", as defined, or if Mr. DesBarres terminates his employment for "Good Reason", as defined. Any amount received under this agreement is required to be reduced by any amount Mr. DesBarres receives under any other employer's retirement plan. This agreement was entered into by Transco and Mr. DesBarres in connection with his acceptance of employment with Transco and is intended to replace a similar benefit which he had been provided by his previous employer. TEXAS GAS RETIREMENT PLAN AND SUPPLEMENTAL BENEFIT PLAN PENSION TABLE The following table shows estimated annual benefits that would be payable on normal retirement under the Texas Gas Retirement Plan and, if applicable, the Texas Gas Supplemental Benefit Plan to employees of Texas Gas in various earnings classifications, with representative years of service, assuming in each case that the employee elected a 5-year certain and life thereafter annuity as the form of benefit payment. Benefits listed in the table are not subject to a deduction for offsets for social security or other offset amounts. The Texas Gas Supplemental Benefit Plan provides benefits to participating executives that cannot be paid under the Texas Gas Retirement Plan because of certain limitations imposed by the Internal Revenue Code on benefits payable under a qualified plan. PENSION PLAN TABLE (1) The covered compensation upon which final average earnings are computed under the Texas Gas Retirement Plan and the Texas Gas Supplemental Benefit Plan is the base compensation of the employee, excluding overtime, bonuses, commissions, payments under an employee benefit plan, or other special compensation without regard to the Internal Revenue Code limitation described above. This base compensation is set forth in column (c) of the Summary Compensation Table. Mr. Best, whose years of service at December 31, 1993 were 19.25 years, is the only Named Executive Officer who participates in the Texas Gas Retirement Plan or the Texas Gas Supplemental Benefit Plan. TERMINATION AND SEVERANCE AGREEMENTS. Transco has entered into a Termination Agreement with Mr. DesBarres. This Agreement provides that if a "change in control" of Transco, as defined, occurs and Mr. DesBarres' employment with Transco terminates within five years after the change in control and prior to his 65th birthday, Transco will pay him, as a termination payment, a lump sum equal to his annual salary, estimated bonus amounts and the value of certain benefits under Transco's employee benefit plans and programs which would have accrued during a period of up to five years after the change in control, subject to certain adjustments and offsets, including an offset relating to salary earned with a subsequent employer. Mr. DesBarres has also entered into a Severance Agreement which provides benefits similar to the Termination Agreement for the period from the date of termination and ending September 1996, but is not conditioned upon the occurrence of a change in control of Transco. The Severance Agreement terminates in September 1996, unless extended by mutual agreement. Mr. Best has entered into a Severance Agreement with provisions similar to those described for Mr. DesBarres above, except that the Severance Agreement provides, upon termination of employment by Transco, for the payment by Transco of a lump sum equal to Mr. Best's annual base salary, estimated bonus amounts and the value of certain benefits under Transco's employee benefit plans and programs which would have accrued during a period of up to three years after termination, subject to certain adjustments and offsets, including an offset relating to salary earned with a subsequent employer. Messrs. Dagley, Spencer and Varner have entered into Severance Agreements with provisions similar to those described above for Mr. Best, except that the Agreements provide for the payment by the Company of benefits which would have accrued during a one-year period after termination and the payment of the annual base salary amount is to be paid in semi-monthly installments for twelve months. Messrs. Dagley, Spencer and Varner have also entered into Termination Agreements with provisions similar to those described above for Mr. DesBarres, except that each shall be entitled to receive, upon termination within three years after a change in control, a lump sum amount equal to the sum of annual base salary, estimated bonus amounts and the value of certain benefits under Transco's employee benefits plans and programs which would have accrued during a period of up to three years after the change in control, subject to certain adjustments and offsets, including an offset relating to salary earned with a subsequent employer. COMPENSATION OF DIRECTORS All of the Directors of TGPL are officers of TGPL and receive no additional compensation for their services as a TGPL Director. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION TGPL does not have a compensation committee. Compensation determinations for TGPL executive officers are made by the Transco Board of Directors or its Compensation Committee. The Transco Board and its Compensation Committee receive input from Transco management as well as independent executive compensation consultants. 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 23, 1994. COMMON STOCK OF TRANSCO ENERGY COMPANY: (1) Includes 67,750 shares of Transco Restricted Stock granted under Transco's 1991 Incentive Plan over which Mr. DesBarres has voting power, but does not have investment power; 2,060 shares held in Transco's Tran$tock Plan over which Mr. DesBarres has voting power but does not have investment power; and 46,900 shares covered by outstanding options granted under Transco's 1991 Incentive plan which are currently exercisable or are exercisable within 60 days of March 23, 1994. (2) Includes 31,850 shares of Transco Restricted Stock over which Mr. Best has voting power but does not have investment power and 43,600 shares covered by outstanding options which are currently exercisable or are exercisable within 60 days of March 23, 1994. (3) Includes 17,575 shares of Transco Restricted Stock over which Mr. Dagley has voting power but does not have investment power; 5,983 shares held in Transco's Tran$tock Plan over which Mr. Dagley has voting power but does not have investment power; and 32,758 shares covered by outstanding options which are currently exercisable or are exercisable within 60 days of March 23, 1994. (4) Includes 4,916 shares held in Transco's Tran$tock Plan over which Mr. Spencer has voting power but does not have investment power; and 41,787 shares covered by outstanding options which are currently exercisable. Mr. Spencer retired from Transco on January 1, 1994. (5) Includes 16,450 shares of Transco Restricted Stock over which Mr. Varner has voting power but does not have investment power; 6,961 shares held in Transco's Tran$tock Plan over which Mr. Varner has voting power but does not have investment power; and 48,650 shares covered by outstanding options which are currently exercisable or are exercisable within 60 days of March 23, 1994. (6) Includes 166,775 shares of Transco Restricted Stock over which the executive officers have voting power but not investment power; 41,266 shares held in Transco's Tran$tock Plan over which the executive officers have voting power but not investing power; and 308,070 shares owned by directors and executive officers covered by outstanding options which are currently exercisable or are exercisable within 60 days of March 23, 1994. Stock held by Mr. Spencer, who is no longer with Transco, is included in this total. * Represents less than 1% of the Class of Common Stock. PREFERRED STOCK OF TGPL None of the directors and executive officers of TGPL own any preferred stock of TGPL. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. ITEM 14. ITEM 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. 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. (3) - 1 Second Restated Certificate of Incorporation, as amended, of TGPL. (Exhibit 3.1 to TGPL Form 8-K dated January 23, 1987 Commission File Number 1-7584. a) Certificate of Amendment, dated July 30, 1992, of the Second Restated Certificate of Incorporation (Exhibit (10)17(a) to Transco Form 10-K for 1993 Commission File Number 1-7513) b) Certificate of Amendment, dated December 22, 1987, of the Second Restated Certificate of Incorporation (Exhibit (10)17(b) to Transco Form 10-K for 1993 Commission File Number 1-7513) c) Certificate of Amendment, dated August 5, 1987, of the Second Restated Certificate of Incorporation (Exhibit (10)17(c) to Transco Form 10-K for 1993 Commission File Number 1-7513) - 2 By-Laws of TGPL. (Exhibit (10)13 to Transco Form 10-K for 1992 Commission File Number 1-7584) (4) - 1 Certificate of Designation, Preferences and Rights relating to Registrant's Cumulative Preferred Stock, $8.75 Series. (TGPL Form 8-K dated January 23, 1987) - 2 Indenture, dated as of June 1, 1983, between TGPL and RepublicBank Houston, National Association, as Trustee. (Exhibit (4)-5 to TGPL Form 10-K for 1989 Commission File Number 1-7584) a) First Supplemental Indenture, dated September 20, 1984, from TGPL to RepublicBank Houston, National Association related to Indenture dated as of June 1, 1983. (Exhibit (4)-5a to TGPL Form 10-K for 1989 Commission File Number 1-7584) b) Second Supplemental Indenture, dated as of May 31, 1985, from TGPL to RepublicBank Houston, National Association related to Indenture dated as of June 1, 1983. (Exhibit (4)-5b to TGPL Form 10-K for 1989 Commission File Number 1-7584) c) Third Supplemental Indenture, dated as of December 3, 1985, from TGPL to RepublicBank Houston, National Association related to the Indenture dated as of June 1, 1983. (Exhibit (4)-5c to TGPL Form 10-K for 1989 Commission File Number 1-7584) d) Certified Resolutions of a Special Committee of the Board of Directors dated October 31, 1986. (Exhibit (4)-5d to TGPL Form 10-K for 1989 Commission File Number 1-7584) e) Fourth Supplemental Indenture, dated as of November 7, 1986, from TGPL to RepublicBank Houston, National Association related to Indenture dated as of June 1, 1983. (Exhibit (4)-5e TGPL Form 10- K for 1989 Commission File Number 1-7584) f) Fifth Supplemental Indenture, dated as of January 15, 1987, from TGPL to RepublicBank Houston, National Association related to Indenture dated as of June 1, 1983. (Exhibit (4)-5f to TGPL Form 10-K for 1989 Commission File Number 1-7584) g) Certified Resolutions of a Special Committee of the Board of Directors dated January 29, 1987. (Exhibit (4)-5g to TGPL Form 10-K for 1989 Commission File Number 1-7584) h) Sixth Supplemental Indenture, dated as of September 15, 1987, from TGPL to First RepublicBank Houston, National Association related to Indenture dated as of June 1, 1983. (Exhibit (4)-5h to TGPL Form 10-K for 1989 Commission File Number 1-7584) - 3 Indenture dated September 15, 1992 between TGPL and the Bank of New York, as Trustee (Exhibit 4.2 to TGPL Form 8-K dated September 17, 1992 Commission File Number 1-7584) - 4 Amended and Restated Credit Agreement dated as of December 31, 1993 among Transco, the Banks named therein, Citibank, N.A. as Agent and Bank of Montreal, as Co-Agent (Exhibit (4)5(c) to Transco Form 10-K for 1993 Commission File Number 1-7513) - 5 Reimbursement Agreement dated as of December 31, 1993 among Transco, the Banks named herein and Bank of Montreal as Agent and Issuing Bank (Exhibit (4)7 to Transco Form 10-K for 1993 Commission File Number 1- 7513) (10) - 1 1983 Incentive Plan of Transco. (Transco Registration Statement No. 2-85895) - 2 Transco Tran$tock Employee Stock Ownership Plan. (Transco Registration Statement No. 33-11721) - 3 Incentive Compensation Plan of Transco. (Exhibit (10)-4 to Transco Form 10-K for 1989 Commission File Number 1-7513) - 4 Benefit Restoration Plan of Transco. (Exhibit (10)-4 to Transco Form 10-K for 1992 Commission File Number 1-7513) - 5 Lease Agreement, dated October 5, 1981, between TGPL and Post Oak/Alabama, a Texas partnership. (Exhibit (10)-7 to Transco Form 10-K for 1989 Commission File Number 1-7513) - 6 1991 Incentive Plan of Transco. (Transco Registration Statement No. 33-40495) - 7 Form of Supplemental Retirement Agreement which Transco has entered into with Messrs. Dagley, Spencer and Varner. (Exhibit (10)-7 to Transco Form 10-K for 1992 Commission File Number 1-7513) - 8 Form of Termination Agreement which Transco has entered into with Messrs. Best, Dagley, Spencer and Varner. (Exhibit (10)-8 to Transco Form 10-K for 1992 Commission File Number 1-7513) - 9 Severance Agreement between Transco and John P. DesBarres, effective as of September 14, 1991. (Exhibit (10)-10 to Transco Form 10-K for 1992 Commission File Number 1-7513) - 10 Termination Agreement between Transco and John P. DesBarres, effective as of September 14, 1991. (Exhibit (10)-11 to Transco Form 10-K for 1992 Commission File Number 1-7513) - 11 Severance Agreement, dated as of March 25, 1992, by and between Transco and Robert W. Best (Exhibit (10)-12 to Transco Form 10-K for 1993 Commission File Number 1-7513) - 12 Severance Agreement, dated as of March 17, 1993, by and between Transco and David E. Varner and schedule identifying substantially similar Severance Agreements between Transco and other executive officers (Exhibit (10)-13 to Transco Form 10-K for 1993 Commission File Number 1-7513) - 13 Severance Agreement, dated as of March 17, 1993, by and between Transco and Thomas W. Spencer (Exhibit (10)-14 to Transco Form 10-K for 1993 Commission File Number 1-7513) - 14 Indemnification Agreement between Transco and David E. Varner and schedule identifying substantially similar Indemnification Agreements between Transco and other executive officers (Exhibit (10)-16 to Transco Form 10-K for 1993 Commission File Number 1-7513) 4. 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, on this 30th day of March, 1994. TRANSCONTINENTAL GAS PIPE LINE CORPORATION Registrant By: /s/ Nick A. Bacile ------------------------------ Nick A. Bacile Vice President and Controller (principal accounting officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on this 30th day of March, 1994, below by the following persons on behalf of the registrant and in the capacities indicated.

64394_1993.txt

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Item 1. Business Mead manufactures and sells paper, pulp, paperboard, lumber and other wood products. Mead also manufactures and distributes school and office supplies, distributes paper and other industrial supplies and is engaged in the electronic publishing business. Mead was incorporated in 1930 under the laws of the state of Ohio as the outgrowth of a paper manufacturing business founded in 1846, and has its principal executive offices at Mead World Headquarters, Courthouse Plaza Northeast, Dayton, Ohio 45463, telephone (513) 495-6323. Except as otherwise indicated by the context, the terms "Company" or "Mead" as used herein refer to The Mead Corporation and its subsidiaries. Segment Information Segment information is also included in Note R on page 52. Paper Mead's Fine Paper division manufactures cut-size copier paper; uncoated and coated papers for commercial printing; form bond and carbonless paper and papers for conversion by others into business forms; and other uncoated papers for conversion by others into such products as greeting cards and bank checks. Mead's Publishing Paper division manufactures web coated offset paper for use by book, magazine, catalog and advertising brochure publishers. The Fine Paper division sells papers manufactured by both divisions nationwide, both on a direct basis to printers and converters and through paper merchants, including merchants owned by Mead. Additionally, Escanaba Paper Company, a wholly-owned subsidiary, sells its output to the Publishing Paper division of Mead, which resells the paper directly to publishers and printers. The pulp mills adjacent to the paper mills of these divisions and the pulp mill owned by an affiliate (see "Forest Products Affiliates") produce virtually all of the pulp required for use in these paper mills. The Company's Gilbert division manufactures cotton content and premium sulfite paper and premium recycled papers, including bond, banknote, texts and cover, and technical and specialty papers, and sells these products principally through paper merchants, including merchants owned by Mead. Mead's Specialty Paper division manufactures and sells, primarily through its own sales force, decorative laminating papers. This division also manufactures absorbent, filter, fire resistant, synthetic fiber and other specialty papers. The division's principal customers include manufacturers that serve the building materials, automotive and furniture industries. The Mead Pulp Sales division sells market pulp manufactured by Northwood Forest Industries Ltd. and by a non-affiliate, Aracruz Celulose S.A. The division maintains one sales office and is represented by affiliates and independent agents in all major pulp-consuming areas of the world. The principal market areas for pulp are in North America, western Europe and Japan. Packaging and Paperboard The Mead Packaging division designs and produces multiple packaging and packaging systems primarily for the beverage take-home market. The division operates through a network of subsidiaries, affiliates and licensees in the United States, Canada, Europe, Japan, the Far East and Pacific Rim, Mexico and Latin America. Demand for most beverage packaging is seasonal with inventories being built from November to March for the peak soft drink and beer sales of April through October. Mead Coated Board, Inc., a wholly-owned subsidiary of Mead, operates a coated paperboard mill near Phenix City, Alabama, and two sawmills in Cottonton, Alabama and Greenville, Georgia, and owns various timberlands in Alabama and Georgia. The subsidiary is engaged primarily in the manufacture of coated natural kraft products used by the beverage packaging industry and by manufacturers of folding cartons for soaps, food products, hardware and apparel. The entire output of the Phenix City mill is sold by Mead Coated Board, Inc. to the Mead Coated Board division. The division sells approximately 50% of the mill output to the Mead Packaging division. The remainder is sold to a wide range of domestic and foreign carton converters. The division's customers are most concerned about physical strength properties of the paperboard and its quality for reprographics. Mead started up a new CNK(R) paperboard facility adjacent to the Phenix City mill in late 1990, and has constructed additional sheeting facilities in foreign countries to handle a portion of the increased capacity. In 1993, the division commenced operations at new facilities at the Phenix City mill designed to enable the division to meet beverage packaging customer demand for post-consumer recycled content. The Mead Containerboard division sells standard and special purpose corrugated shipping containers manufactured at eight converting plants located in the Midwestern and Southeastern regions of the United States from raw materials received from outside sources and from the division's Stevenson, Alabama corrugating medium mill. The division also sells corrugating medium from the Stevenson mill to unaffiliated manufacturers of containers. Forest Products Affiliates Northwood Forest Industries Ltd. ("Northwood"), which is owned 50% by Mead and 50% by Noranda Forest Inc. ("Noranda"), manufactures bleached softwood kraft pulp at its 1,600 ton-per-day mill in Prince George, British Columbia. The principal markets for its pulp are in the midwestern United States, western Europe and Japan. Lumber and plywood products are also produced at Northwood's three sawmills and its plywood plant in British Columbia. Northwood has the annual capacity to produce over one billion board feet of lumber and 175 million square feet of plywood (3/8-inch basis). Northwood's solid wood products' operations provide about 670,000 tons (ODT) of wood chips or 70% of the fiber requirements for the pulp mill. A wood preserving operation also treats lumber and custom treats plywood from other sources. Northwood Panelboard Company, a partnership owned 50% by Mead and 50% by Noranda and located in Bemidji, Minnesota, has the annual capacity to produce approximately 340 million square feet of oriented structural board (3/8-inch basis). All of the wood products produced by Northwood and Northwood Panelboard Company are sold through a subsidiary of Noranda primarily in North America with approximately 20% sold to export markets. Mead has a long-term contract with Northwood pursuant to which Mead is entitled to purchase such of Northwood's pulp production as it may require. Timberlands Mead obtains most of its wood requirements from private contractors or suppliers and from Company owned timberlands. The annual wood requirement for Mead's wholly-owned operations is approximately 8,000,000 tons, of which approximately 16% is obtained from timberlands owned or leased by Mead. The approximate annual requirement of wood for Northwood is 5,800,000 tons, the majority of which is obtained from Crown Lands through various types of cutting rights which are terminable or renegotiable at the government's initiative and from third parties having similar cutting rights. As of December 31, 1993, Mead owned or controlled approximately 1,337,000 acres of timberlands in the United States. Approximately 106,000 acres of land are controlled by Mead under long-term agreements which expire at different times through 2027. Distribution and School and Office Products Zellerbach, Mead's distribution operation, is a national distribution business which distributes a full line of printing papers, industrial supplies and packaging materials and equipment. These products are distributed through a network of wholesale locations and printer-supply retail outlets. The business units carry inventory or order products against sales orders, depending upon the product and service requirements. Zellerbach distributes not only products of Mead, but also those of several hundred other manufacturers. In the distribution of paper and other products, competing merchants frequently distribute products of the same supplier. The Mead School and Office Products division manufactures and distributes a line of school supplies (including filler paper, wirebound notebooks, portfolios and looseleaf binders) as well as a line of office supply products (including envelopes, filing supplies and vinyl folders and binders). The division's products are distributed primarily through mass market retailers, office supply superstores and warehouse clubs. The school supply segment is highly seasonal with inventories beginning to be built in the winter and spring for shipment in late spring and summer, while the home and office products portion of the business is generally less seasonal in nature. Manufacturing and distribution is done from seven United States plants/distribution centers, and a small manufacturing facility operated in Nuevo Laredo, Mexico. Electronic Publishing The Mead Data Central division ("MDC") markets electronic information services worldwide to corporations, financial institutions, news media, governments and the legal, medical and accounting professions. Based in Dayton, Ohio, MDC has sales offices in approximately 50 major U. S. cities, with international offices in London, Zurich and Toronto. Principal services include LEXIS(R), a computer-assisted legal research service, and NEXIS(R), a computer-assisted news, financial, marketing and general information retrieval service. MDC's services are distributed to subscribers via subscribers' own computer equipment and custom terminals supplied by MDC. MDC operates several other businesses, including The Michie Company division, which publishes, reports and edits state statutes and other legal reference materials in book and CD-ROM format; LEXIS(R) Document Services division, which provides public records searching and retrieval services for law firms, financial institutions and other customers; and Folio Corporation and Jurisoft, software development companies. MDC also controls a minority interest in Star Data Systems, Inc., a Canadian company that provides real-time quote services to Canadian customers. International Sales and Operations Outside of the United States and Canada, Mead and its affiliates operate a paperboard sheeting facility and are engaged in the manufacture of multiple systems and folding carton packaging in Europe, Asia and Latin America. Mead also has sales subsidiaries, affiliates, agents or distributors in a number of countries in Europe, Asia, Australia and Latin America. Competition Mead competes on a world-wide basis in its product lines, and the markets in which Mead sells its products are highly competitive. Several factors affect Mead's competitive position, including quality, technology, product design, customer service, price and cost. The Fine Paper and Publishing Paper divisions compete with numerous other major paper manufacturers. The Gilbert division competes with a number of other manufacturers of premium cotton, sulphite and recycled papers. The Coated Board division competes with other boxboard producers, including manufacturers of all types of coated recycled boxboard, coated solid bleach sulfate and folding boxboard. The Packaging division competes with a number of carton suppliers and machine manufacturers and one other global systems-based multiple packaging supplier. The Containerboard division competes primarily with container producers in several market areas. The Zellerbach division competes with national and regional merchant chains, as well as independent local merchants. The School and Office Products division competes with national and regional converters, some with broad product offerings and others focused on narrow product segments. MDC faces increasing competition for new products and markets from numerous on-line and CD-ROM information providers as well as book publishers. Employee and Labor Relations Mead employs approximately 19,600 persons, of whom approximately 7,700 are production, maintenance and clerical employees represented by labor unions. Mead's 50% owned company, Northwood, employs approximately 2,300 persons. Mead and Northwood have approximately 50 labor agreements currently in force of which approximately one-third are subject to renegotiation each year. Mead's employee relation policies are based on mutual confidence and trust. All Mead labor contract negotiations during 1993 were concluded without any strikes. Trademarks, Trade Names, Patents, and Franchises Mead has a large number of trademarks and trade names under which it conducts its business, including "Mead," "Mead Papers," "Mead Packaging," "Zellerbach," "Montag," "LEXIS," "Lexpat," "NEXIS," "Super Shades," "Trans/Rite," "Trans/Tab," "Cluster-Pak," "Cambridge," "Chief," "Apex," "Info," "Moistrite," "Trapper," "Trapper Keeper," "Neatbook," "Gilbert," "OPAS," "Signature," "CNK," "Five Star," "First Gear," "Neu-Tech," "Gilcrest," "Esse," "ORGANIZER," "Spiral," "Sig-NATURE," "Management Series," "NO! RULES" and many others. Mead also has a great number and variety of patents, patent rights, licenses and franchises relating to its business. While, in the aggregate, the foregoing are of material importance to Mead's business, the loss of any one or any related group of such intellectual property rights would not have a material adverse effect on the business of Mead. Environmental Laws and Regulations Mead's operations are subject to extensive regulation by various federal, state, provincial and local environmental control statutes and regulations. These regulations impose effluent and emission limitations, waste disposal and other requirements upon the operations of Mead, and require Mead to obtain and operate in compliance with the conditions of permits and similar authorizations from the appropriate governmental authorities. Mead has obtained, has applications pending, or is making application for such permits and authorizations. Mead does not anticipate that compliance with such statutes and regulations will have a material adverse effect on its competitive position since its competition is subject to the same statutes and regulations to a relatively similar degree. During the past five years (January 1, 1989 - December 31, 1993), Mead (including its share of Northwood expenditures) constructed air and water pollution control and other environmental facilities at a cost of approximately $115 million. Significant environmental expenditures in the future are anticipated to include long-term projects for the construction of solid waste disposal facilities, and maintenance and upgrade of wastewater treatment plants and air emission controls. Due to changes in environmental laws and regulations, the application of such laws and regulations and changes in environmental control technology, it is not possible for Mead to predict with certainty the amount of capital expenditures to be incurred for environmental purposes, though management anticipates that these expenditures will increase as regulatory requirements become more stringent. Taking these uncertainties into account, Mead estimates that in the next five years it may be required to incur expenditures of approximately $200 million. A substantial portion of the expected increase in capital expenditures for the next five years is related to new regulations under the Clean Air Act and Clean Water Act, which are expected to be promulgated in final form by the United States Environmental Protection Agency ("USEPA") in late 1995. These regulations, proposed in December 1993, are intended to reduce air and water discharges of specific substances from pulp and paper mills in the United States, and to require installation of additional pollution control equipment based on best available technology. The American Forest and Paper Association estimates that these regulations, if implemented in their present form, could cost the pulp and paper industry over $10 billion in capital expenditures, and force the closing of approximately 30 plants and the loss of an estimated 19,000 mill jobs. Mead believes, based on a review of Mead's operations, that implementation of the proposed regulations in their present form could significantly increase Mead's capital investments and operating costs over the next five years. Mead opposes these regulations as proposed because it believes that the environment can be protected for billions of dollars less in capital investment and without a significant negative impact on the United States pulp and paper industry's competitive position worldwide. Mead expects that the proposed regulations will be modified before being issued in final form in 1995. The USEPA recently issued proposed regulations implementing the Federal Great Lakes Critical Programs Act of 1990 ("GLCPA"), which was enacted as a result of an agreement between the United States and Canada in the 1970s to seek greater consistency for water quality standards among the Great Lakes states. The proposed regulations establish minimum water quality criteria, anti-degradation policies and implementation procedures. Current industry estimates indicate that compliance with these proposed regulations may cost affected forest products companies, in the aggregate, over $800 million. In September 1993, in response to the USEPA's request for comments on the proposed regulations, and based on certain assumptions and uncertainties described in Mead's comment letter, Mead estimated that the cost of complying with the proposed regulations, in respect of Mead's Escanaba facility, could range from $100 million to $150 million in capital expenditures, with a significant increase in annual operating costs. These costs are not included in Mead's anticipated environmental expenditures discussed above. Mead opposes these regulations as proposed because Mead believes they are unnecessary and unreasonable. At this time, Mead cannot make any conclusions as to the effect of the final rules, which are expected to be promulgated by the USEPA in 1995. Mead believes that most of its earlier expenditures for environmental control have been beneficial. However, Mead and its trade associations have challenged and are continuing to challenge in administrative and judicial proceedings federal and state environmental control regulations which they do not believe are beneficial to the environment or the public. In some instances, those trade associations may also seek legislative remedies to correct unnecessary or impractical requirements of existing laws. Trace amounts of dioxin were first detected several years ago in the effluents and sludge of bleached paper mills. Mead has changed its bleaching process at each of its three bleached paper mills which has significantly reduced dioxin generation. Dioxin currently cannot be detected under normal operating conditions in treated effluents from Mead's three U. S. bleached paper mills. Taking into account current regulatory efforts and the process and control equipment installed at Mead's bleached paper mills, management does not believe that any required actions in response to these concerns will have a material adverse effect on the Company. Mead has been notified by the USEPA and by several state or local governments that it may be liable under federal environmental laws or under applicable local laws with respect to the cleanup of hazardous substances at several sites currently operated or used by Mead. Mead has resolved actions relating to several of these sites at minimal cost, and Mead believes that the costs associated with other sites will not be material or will be mitigated by the presence of additional potentially responsible parties, contractual indemnities, insurance coverage or other factors. Mead is currently named as a potentially responsible party ("PRP"), or has received third party requests for contribution, in several superfund proceedings under federal, state and local laws with respect to at least 24 sites sold by Mead over many years or owned by contractors used by Mead for disposal purposes. Some of these proceedings are described in more detail in Part I, Item 3, "Legal Proceedings." There are other former Mead facilities and those of contractors which may contain contamination or which may have contributed to potential superfund sites. Mead's potential liability for these sites will depend upon several factors, including the extent of the contamination, method of remediation, insurance coverage and contribution by other PRPs. Although the costs that Mead may be required to pay for remediation of these sites are not certain at this time, Mead has accrued amounts to cover estimates of such costs, based upon the number of other PRPs, their ability to pay their portion of the costs, the volumetric amount, if any, of Mead's contribution, and several other factors. These costs are not included in the anticipated capital expenditures for the next five years discussed above. Item 2. Item 2. Properties Mead considers that its facilities are suitable and adequate for the operations involved. With the exception of certain warehouses, general offices and timberlands which are leased, including properties which are leased from corporations the common shares of which are owned by The Mead Retirement Master Trust, and certain warehouses which are owned or leased and managed by third parties for Zellerbach, Mead owns all of the properties described herein. For additional information regarding leases see Note O on page 50. For additional information concerning Mead's timberlands and properties of affiliates, see Item 1. Business. Mead's corporate headquarters are in Dayton, Ohio and its principal facilities are at the locations listed below: Item 3. Item 3. Legal Proceedings In March 1989, the Ohio Attorney General filed a lawsuit against Mead alleging violations of state solid waste and water pollution laws at two landfills (the Paint Street Site and the Storage Depot Site) owned and operated by Mead Fine Paper Division's Chillicothe, Ohio mill. The lawsuit sought injunctive relief (orders closing one landfill and modifying operations at the other landfill) and civil penalties. Mead has denied the allegations in the complaint, and since the filing of the suit, Mead has ceased use of and proceeded to close both landfills. Mead is currently disposing of its solid wastes at alternate permitted facilities and using its paper mill sludge to reclaim strip mines. Mead believes that it has closed both landfills to the satisfaction of the Ohio EPA, although certain issues concerning groundwater monitoring and treatment, as well as civil penalties, remain to be resolved. While Mead cannot predict the outcome of this litigation, because the estimate of closure costs have already been accrued, Mead does not believe that the litigation will have a material adverse impact upon its financial condition or results of operations. In a related matter, in September 1993 Mead signed a Consent Order with USEPA under Section 3008(h) of the Resource Conservation and Recovery Act with respect to the Storage Depot Site. Pursuant to the terms of that Order, Mead will undertake certain investigative and remedial work designed to control releases of hazardous substances from the site. Work has begun and is expected to continue into 1995. Mead believes that the U.S. Navy is legally responsible for the groundwater contamination at the Storage Depot site, including the cost of implementing the Consent Order discussed above. In 1992, Mead filed a declaratory judgment action against the U.S. Navy seeking to have the Navy take responsibility for any required remediation. In 1993, both Mead and the U.S. Navy filed motions for partial summary judgment on the issues of liability, and allocation of responsibility for clean up costs, both of which motions were denied in January 1994. Attempts to mediate this proceeding ended in October 1993 without any resolution. In March 1991, Mead was served with a complaint entitled Beazer East ----------- Inc. v. The Mead Corporation, C.A. No. 91-0408, filed in the United States - - ---------------------------- District Court for the Western District of Pennsylvania. The complaint alleges that the USEPA seeks to require Beazer to conduct a site-wide environmental investigation regarding hazardous substances, wastes and constituents at the Woodward Facility located in Dolomite, Alabama, and to propose preferred corrective measures for the site. Mead acquired the Woodward Facility by merger in 1968, and in 1974 sold it to Koppers, Inc., which was later acquired by Beazer. The complaint alleges that Mead is liable to Beazer for contribution for past and future costs to be incurred by Beazer as a result of any corrective measures required at the site. In October 1992, the district court granted Mead's motion to dismiss all of plaintiff's allegations in this proceeding except those relating to alleged liability under CERCLA and alleged indemnity under the 1974 sale contract. In June 1993, the court granted Mead's motion for summary judgment and dismissed the case. In July 1993, the plaintiff filed a notice of appeal. Although the potential costs and damages, if any, associated with this litigation are not determinable at this time, Mead does not believe that the outcome of this litigation will have a material effect on its financial condition or results of operations, based on, among other things, rights to contribution, potential insurance coverage and indemnification and other defenses, including that the contract of sale barred any such claim by Beazer. The Tennessee Department of Conservation ("TDC") advised Mead in September 1991 that a closed coke manufacturing facility located in Chattanooga, Tennessee (formerly owned by Mead) is a hazardous substance site within the meaning of the Tennessee Hazardous Waste Management Act, and that Mead may be a potentially responsible or liable party. In August 1993, the federal Agency for Toxic Substances and Disease Registry ("ATSDR") issued a health advisory for a site which includes the facility formerly owned by Mead. The ATSDR concluded there is coal tar at the site and recommended the site be considered for inclusion on the USEPA's National Priorities List ("NPL") of hazardous waste sites. In January 1994, the USEPA proposed adding the site to the NPL. USEPA Region IV will likely take the lead on overseeing the remediation if the site is placed on the NPL. A preliminary potentially responsible party search conducted by USEPA Region IV indicates that dumping likely occurred at this Chattanooga site to meet World War II government requirements when the coke plant doubled in size. The coke plant was owned by the Defense Plant Corporation during World War II and sold by the War Assets Administration in 1946. Woodward Iron Company, formerly a division of Mead, acquired the coke plant manufacturing facility in 1964, and Mead sold the coke plant manufacturing site to third parties in 1974. Although the extent of contamination and the possible method of remediation are not known at this time, based on information currently available to Mead, rights to contribution and potential insurance coverage, Mead does not believe that this proceeding will have a material adverse effect on the Company. The USEPA informed Mead in June 1992 that the Mead Publishing Paper mill in Escanaba, Michigan, allegedly violated federal air emissions rules by exceeding limits for emissions of total reduced sulfur from one boiler and by failing to properly maintain continuous emissions monitoring systems on two boilers. The alleged violations occurred during 1990 and 1991. In August 1993, USEPA served on Mead an administrative complaint and proposed order, including a proposed penalty of $194,000, under Section 113 of the Clean Air Act for alleged air emissions violations during the preceding twelve months. USEPA and Mead have entered into settlement negotiations, and Mead does not believe that this proceeding will have a material adverse effect on the Company. Additional information is included in Part I, Item 1, "Business--Environmental Laws and Regulations." Mead is involved in various other litigation and administrative proceedings arising in the normal course of business, which, in the opinion of management, will not have a material adverse effect on the financial condition or results of operations of Mead. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Company The Executive Officers of Mead as of February 1, 1994, their ages, their positions and offices with Mead, and the principal occupation (unless otherwise stated, position is with Mead) of such Executive Officers during the past five years are as follows: All Executive Officers of Mead are elected annually by the Board of Directors. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters Mead's Common Shares are listed on the New York, Chicago and Pacific Stock Exchanges, trading under the symbol "MEA." Information on market prices and dividends is set forth below: MARKET PRICES PER COMMON SHARE - - ------------------------------ 1993 1992 ---- ---- High Low High Low ---- --- ---- --- First quarter $45.875 $37.500 $39.375 $33.75 Second quarter 47.375 40.500 39.375 33.25 Third quarter 48.500 41.250 41.625 35.00 Fourth quarter 45.750 39.500 41.50 33.125 DIVIDENDS PAID PER COMMON SHARE - - ------------------------------- 1993 1992 ---- ---- First quarter $ .25 $ .25 Second quarter .25 .25 Third quarter .25 .25 Fourth quarter .25 .25 ---- ---- Year $1.00 $1.00 ==== ==== The number of Common shareowners of record as of March 1, 1994, was 17,145. See Note G for information regarding the amount of retained earnings available for dividends. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations REVIEW OF OPERATIONS -------------------- OVERVIEW OF 1993 - - ---------------- Despite negative market conditions facing most of its businesses, Mead's earnings improved over 1992 and 1991 levels. Driving the earnings increase were significantly improved results from Mead's Northwood affiliates; the large paper mills in Escanaba, Michigan, and Chillicothe, Ohio; and the Coated Board and School and Office Products divisions. Earnings from Mead's Containerboard, Packaging and Zellerbach divisions were lower than 1992 results. Sales increased as a result of higher levels of sales volume in many businesses. Pricing pressures continued into 1993 for almost all operations resulting in lower average prices in 1993 than in 1992 and 1991. Pulp prices, which plunged in 1991, deteriorated even further in 1992 and 1993. The exception for pricing was Mead's affiliate, Northwood Forest Industries, where wood products' prices increased significantly in 1993 compared to 1992 and 1991, and provided the impetus for Northwood's earnings improvement. Within Mead's paper operations, sales volumes were higher than 1992 and 1991 but average selling prices, continuing 1991's downward trend, were slightly lower, reflecting the lackluster economy and large increases to industry capacity in recent years. Mead Coated Board's volume grew in 1993 as it did in 1992 and 1991. Mead Packaging's sales dropped from the 1992 level due in large measure to increased competitive pressures on pricing and weaker foreign markets and currencies. The Containerboard Division was adversely affected by lower prices across its businesses, despite volume increases in the converting markets, and continued strong operations at the Stevenson, Alabama, corrugated medium mill. Market difficulties in the paper and industrial/commercial supplies businesses continued to affect Zellerbach, Mead's nationwide network of paper merchant distributors. Improvements in productivity and cost reduction actions did not offset the effect of deteriorating prices. Mead School and Office Products had another good year in 1993, with earnings higher than in both 1992 and 1991. The division liquidated the inventory purchased from Union Camp's school and office products business, contributing marginally to its favorable results. Mead Data Central revenues grew 11% in 1993. However, strategic investments to enhance the features and functionality of its services, as well as expenditures for new product development and sales force restructuring, offset the effect of sales growth resulting in little earnings change from 1992. OPERATING RESULTS - - ----------------- Sales increased to $4.790 billion in 1993, compared to $4.703 billion in 1992 and $4.579 billion in 1991. The gains for both 1993 and 1992 were achieved despite the effects of lower paper prices and the sale of Ampad Corporation in July, 1992. Earnings Per Share Analysis ---------------------------------------------------------- 1993 1992 1991 ---- ---- ---- Comparable earnings $2.20 $ 1.93 $ 1.21 Other expenses (1.00) (.37) Sale of business (.30) .45 Effect of tax rate change on deferred tax balance at beginning of year (.12) ---- ----- ----- Earnings from continuing operations 2.08 .63 1.29 Discontinued operations (.17) Cumulative effect of change in accounting principle .58 (1.00) ---- ----- ----- Net earnings $2.08 $1.21 $ .12 ==== ==== ===== ---------------------------------------------------------- Comparable earnings were up almost 14% in 1993. However, the effect of the 1993 corporate tax rate increase of 1% on deferred taxes at January 1, 1993, negatively affected Mead's 1993 earnings from continuing operations by $.12 per share. 1992 comparable earnings were significantly improved over 1991 levels. The following items reduced 1992 earnings from continuing operations: - A comprehensive performance improvement program resulted in an after tax charge of $58.9 million, or $1.00 per share. - A $17.7 million after tax, or $.30 per share charge, represented a loss on the sale of the Ampad office products business. In 1991, the $.37 per share charge related to costs for changing environmental requirements, business consolidations and the writeoff of certain engineering costs. The $.45 per share gain relates to sale of Micromedex. In 1992, Mead adopted Statement of Financial Accounting Standards (SFAS) No. 109, requiring the determination of all income tax liabilities at current rates. The effect of adopting the new standard was an increase in net earnings of $34 million, or $.58 a share. In 1991, earnings were negatively impacted by adjustments affecting Mead's discontinued reinsurance business, and adoption of SFAS No. 106 related to postretirement benefits. In 1993, the company adopted SFAS No. 112, "Employers' Accounting for Post-employment Benefits." Adoption had no impact on the company. Depreciation, amortization and depletion of property, plant and equipment amounted to $261 million in 1993, compared with $246 million in 1992 and $236 million in 1991. PAPER ---------------------------------------------------------- Segment Summary ($ millions) 1993 1992 1991 --------------- ---- ---- ---- Sales $1,111.4 $1,090.6 $1,091.3 ------- ------- ------- Comparable earnings 101.9 85.6 112.8 Other expenses (22.3) (20.7) ------- ------- ------- Earnings before income taxes $ 101.9 $ 63.3 $ 92.1 ---------------------------------------------------------- Mead's paper segment earnings improved 19% on a comparable basis versus 1992, driven by strong operating results at the Chillicothe and Escanaba mills. Sales increased 2% in 1993 to $1.11 billion. Volume increased by about 11%, although prices across the board continued to be depressed. In 1992, sales were essentially flat compared with 1991, despite a 3% volume increase. Industry capacity for coated paper in North America increased 8% during the last two years. Coated paper prices decreased slightly from 1992 throughout the industry. The American Forest and Paper Association (AF&PA) reports that total coated paper capacity will grow 3% in 1994 and 2% in 1995. As general economic conditions improve, demand is expected to outpace capacity growth, relieving some price pressures. Mead Publishing Paper - - --------------------- The Publishing Paper division provides book and magazine publishers, catalog printers and commercial printers with more than 500,000 tons of medium-weight coated paper each year. The division has developed a full line of recycled book and glossy grades in response to customer interest. Sales volume increased due to improved order volume. While pricing was flat for 1993 when compared to 1992, the division's earnings grew significantly as a result of reduced costs and improved operating efficiencies. In 1992, sales were approximately 9% lower than 1991, and earnings dropped considerably as well. In spite of some optimism about economic recovery, the publishing industry is predicting modest growth, at best, but not enough to absorb a continuing oversupply of paper. To upgrade the product mix and improve quality, Mead is investing $115 million in two major capital projects that are expected to be completed in 1994 and 1995. Mead Fine Paper - - --------------- Mead Fine Paper produces both coated and uncoated papers for business, printing and specialty uses. The division is also a leading producer of carbonless paper. Continued weak market conditions and depressed prices held sales growth to a modest increase for the division's Chillicothe, Ohio, mill. However, improved productivity and good cost controls, due in part to capital investments and performance improvement efforts, resulted in significantly increased operating profit for the division. Additional savings and productivity increases are expected for 1994 as a result of continued cost reduction efforts and the effects of capital investment. Mead is investing $111 million to upgrade its coated sheet quality. Earnings growth is expected to be moderate in 1994 in light of the pricing conditions. Despite weak market conditions and depressed prices, 1992 sales were up 6% compared to 1991, while earnings were flat. The Kingsport, Tennessee, mill continued to be hit hard by market conditions. The mill did not run as well as anticipated in 1993. Sales decreased slightly, and operating results fell significantly compared to 1992. Mead Specialty Paper - - -------------------- Mead Specialty Paper manufactures saturating papers for use in decorative laminates used in commercial and home construction, remodeling and furniture; and specialty grades in various industrial applications including automobiles. Sales for 1993 were up slightly from 1992 levels while earnings decreased. Excess global capacity and poor economic conditions in Europe limited growth in 1993. Cost reduction efforts could not offset operating inefficiencies associated with the start-up of a capacity expansion project completed early in the year. The U.S. housing, remodeling and auto production markets were stronger in 1993 than 1992 and these industries are forecasting a continuation of this trend. The division reported increased sales and earnings in 1992 compared to 1991. Mead's Specialty division obtained ISO 9001 certification by meeting a set of international standards designed to improve product quality and consistency. Gilbert Paper - - ------------- The Gilbert Paper division produces high-quality communications papers, including cotton-content bonds, and specialty text and cover papers. Gilbert reported slightly lower sales and earnings in 1993 due to reduced volume, a less profitable product mix, merchant consolidations and the weak economy. Productivity initiatives and performance improvement efforts should result in improved 1994 earnings. Sales of recycled grades and laser-compatible sheets continue to grow, as does potential for export growth. The division reported a modest gain in 1992 sales compared to 1991, while earnings remained flat. PACKAGING AND PAPERBOARD ----------------------------------------------------------- Segment Summary ($ millions) 1993 1992 1991 --------------- ---- ---- ---- Sales $1,156.9 $1,163.2 $1,022.8 ------- ------- ------- Comparable earnings 132.8 140.9 106.1 Other expenses (23.8) (1.6) ------- ------- ------- Earnings before income taxes $ 132.8 $ 117.1 $ 104.5 ----------------------------------------------------------- Sales were essentially flat at $1.16 billion in 1993, and comparable earnings decreased 6%. Sales in 1992 rose 14% over 1991, while comparable earnings increased more than 32%. A weak global economy and heightened competition leading to pricing pressures were key factors inhibiting growth in this segment. While cost improvements were significant across the divisions, they were not enough to combat difficult market conditions brought on by overcapacity. Mead Packaging - - -------------- Mead Packaging is a leading supplier of multiple beverage packaging and packaging systems. It also provides multiple packages of food and other products. Customers include large and small brewers, soft drink bottlers, food and other consumer products companies. Lower brewery volume and lower than expected growth in the soft drink area, as well as price pressures, contributed to decreased sales and significantly reduced earnings for 1993 in North America. 1992 sales and earnings were flat compared with 1991. International earnings were near 1992 levels. Exchange rates, weak European and Japanese economies, and increased pricing pressures were offset by good cost controls. An ongoing series of cost-effective packaging systems solutions is expected to enhance the division's position with customers overall. To counter worldwide competition and continuing price pressures in the future, the division is intensifying ongoing cost reduction efforts and investing additional capital on productivity improvements for 1994. Packaging opened subsidiaries in Mexico and Brazil in 1993 and increased its business in Australia. Groundwork has also been laid for new operations in Argentina, Chile and Poland for 1994, as well as other points around the globe. Mead Coated Board - - ----------------- Mead Coated Board manufactures coated paperboard for use in multiple packaging and folding cartons. Customers include folding carton manufacturers in North America, Europe and Asia, in addition to Mead Packaging's worldwide business. 1993 was the third full year of operation for the expanded Mahrt mill in Alabama. Production increased more than 5% to exceed designed capacity of 800,000 tons. More significantly, production of first quality coated board increased by over 13% as operating efficiency and quality improved, and as sales increases eliminated the need to fill capacity with uncoated board. Despite weaker market conditions worldwide in 1993, sales volume increased 5% primarily due to the folding carton business worldwide. As a result of quality, cost and productivity initiatives, and more favorable results from the division's related wood products operations, earnings significantly improved. However, competitive pressures in the global board market have eroded prices for CNK(R) paperboard, Mead's coated natural kraft board. Sales rose 14% in 1992 and earnings rose compared to 1991. The global market for coated paperboard is expected to grow modestly over the next few years. Mead Coated Board, however, expects its sales growth to be above the industry average as market development efforts of the past couple of years take hold. Mead Containerboard - - ------------------- Mead's Containerboard division produces corrugating medium used in shipping containers and operates eight corrugated container plants. Solid volume growth in the converting business and good cost controls at the medium mill could not offset the effects of oversupply and price deterioration in both the medium and converted box markets. While sales were flat, earnings decreased compared to 1992. The division doubled its earnings in 1992 compared to 1991. Independently conducted surveys in customer satisfaction showed the division's medium system has moved to preferred status with its customers. Its Stevenson, Alabama, mill obtained ISO 9002 certification. Containerboard's inventory levels are stable and demand is on the upturn. It is expected that prices will solidify in 1994, and that additional productivity improvements will drive earnings improvement. DISTRIBUTION AND SCHOOL AND OFFICE PRODUCTS ---------------------------------------------------------- Segment Summary ($ millions) 1993 1992 1991 --------------- ---- ---- ---- Sales $1,970.7 $1,954.6 $1,995.7 ------- ------- ------- Comparable earnings 38.4 45.6 36.3 Other expenses (16.3) (9.2) ------- ------- ------- Earnings before income taxes $ 38.4 $ 29.3 $ 27.1 ---------------------------------------------------------- Sales increased to $1.97 billion for the Distribution and School and Office Products segment while comparable earnings were down 16% in 1993 versus 1992. Sales include those resulting from the liquidation of inventory purchased from Union Camp's school and office products division. Zellerbach's performance in a poor market and costs associated with productivity improvements and restructuring were the reasons for decline in comparable earnings. 1992 sales were 2% below 1991 primarily as a result of the loss of revenue due to the sale of Ampad Corporation. Zellerbach - - ---------- Zellerbach distributes paper, packaging materials and machines, and industrial/commercial supplies in 65 local markets throughout the United States. Continued price pressures offset the sales gains over 1992 for both the paper and industrial/commercial supplies businesses. The packaging business continued positive trends in sales growth and margin percentage. Earnings for the division declined significantly in 1993 due to market pressures and the ongoing reengineering of the logistics system, including the consolidation of warehouses and the transition to selective use of third party providers of logistics services. Sales declined slightly in 1992 compared to 1991 but earnings were substantially improved. Zellerbach accelerated strategic initiatives in 1993, including restructuring and reengineering projects that continue to improve customer satisfaction ratings, provide a competitive cost structure, and should positively impact performance in 1994. Zellerbach will continue to invest in its long-term growth in 1994. School and Office Products - - -------------------------- Mead's School and Office Products division is the nation's largest manufacturer of school supplies. It also provides stationery products for home and office use, and is an industry leader in fashion and product design. The division's sales grew 6% in 1993 and 4% in 1992. This excludes sales related to the liquidation of inventory purchased from Union Camp's school supply business in 1993, and 1992 sales of Ampad, a business that was divested in 1992. The 1993 growth was primarily fueled by sales in the Five Star(R), Five Star(R) First Gear(TM) and Cambridge(R) product lines. Pre-tax earnings for School and Office Products increased over 1992 levels due to strong sales and operating performance; 1992 earnings were penalized by losses associated with the bankruptcy of a major customer. In 1993, the division began to implement fully integrated production planning, inventory control, purchasing and accounts payable systems which are expected to reduce costs over the long term. Mead also entered into a licensing agreement with Nike, Inc., which should positively impact the 1994 back-to-school season. ELECTRONIC PUBLISHING -------------------------------------------------------- Segment Summary ($ millions) 1993 1992 1991 --------------- ---- ---- ---- Sales $ 551.3 $ 494.8 $ 469.5 ------ ------ ------- Comparable earnings 50.4 50.6 41.2 Other expenses (9.2) (3.0) ------ ------ ------- Earnings before income taxes $ 50.4 $ 41.4 $ 38.2 --------------------------------------------------------- Mead Data Central (MDC) is a leading electronic publisher of legal, business, and financial news and information. Its LEXIS(R) and NEXIS(R) information retrieval services are used by professionals in a wide range of disciplines throughout the world. MDC's sales increased by 11% to $551.3 million in 1993 compared to 1992. However, comparable earnings were essentially flat at $50.4 million, due in large part to strategic investments to enhance the features and functionality of its services, new product development, and costs associated with sales force restructuring. Competitive pressures remained intense, affecting pricing and costs in 1993. In 1992, sales increased 9%, adjusted for the 1991 sale of a subsidiary. 1992 comparable earnings increased 23% from 1991. MDC introduced a number of new products and product enhancements in 1993, most notably FREESTYLE(TM) which enables online users to search the databases using natural language rather than Boolean logic. MDC also added a FINDER(R) library of current addresses, phone numbers and demographic data on 111 million individuals which helps attorneys locate heirs, witnesses and parties in legal actions. MDC's Folio business released version 3.0 of its electronic publishing software that enables users to create their own information bases for searching and retrieving internal information. Sales from the business information services area led the way for MDC as it aggressively targeted new business while strengthening relationships with existing customers. The legal information area identified key customer segments and also expanded service to smaller firms. MDC will continue to focus on market-driven product development and anticipates increased margins in 1994 due to an overall performance improvement effort conducted in 1993, and completion of the amortization of certain intangibles acquired in the purchase of The Michie Company in 1988. Investees - - --------- Mead's primary investees are Northwood Forest Industries, Ltd., a large producer of bleached softwood kraft pulp and wood products in British Columbia, Canada, and Northwood Panelboard Company, an oriented structural board (OSB) mill at Bemidji, Minnesota. Both are 50%-owned by Mead and Noranda Forest Inc. of Canada. Pulp from Northwood is sold throughout the world by Mead Pulp Sales. Wood products sales are handled by Noranda Forest Sales Inc. Northwood's 1993 sales were up 12% from 1992. Mead's share of 1993 earnings of all investees was $18.4 million, up from $6 million in 1992. Mead's share of 1991 results was an $18.1 million loss. Lumber prices were up substantially during the year, more than offsetting depressed pulp prices. Improved housing starts and increased repair and remodeling boosted demand, as did log supply curtailments, particularly in the Pacific Northwest. The industry expects more of the same in 1994, as the outlook is strong. Pulp prices were weak in 1993. The average domestic price for 1993 was down 19% from 1992 and represents the third straight year of declining prices caused by oversupply, high inventories and sluggish paper markets, particularly overseas. A gradual improvement in prices is expected for 1994, although full year average prices are expected to remain depressed. Selling, Administrative and Research Expenses - - --------------------------------------------- Selling, administrative and research expenses rose by 2% in 1993, versus 6% in 1992. Administrative expenses decreased from 1992 levels as a result of Mead's performance improvement program. Selling and research expenses increased in 1992 and 1991 primarily due to MDC's accelerated sales and marketing programs. Interest and Debt Expense - - ------------------------- Interest and debt expense declined to $96 million in 1993 from $101 million in 1992 and from $114 million in 1991. The 1993 reduction reflected lower average interest rates, and the 1992 reduction resulted from both lower rates and a somewhat lower average level of debt. FINANCIAL REVIEW ---------------- Reflecting Mead's higher earnings, cash provided by operations rose to $376 million. That compares with $330 million in 1992 and $267 million in 1991. Working capital amounted to $420 million at year-end, compared with $400 million at the end of 1992 and $347 million at the end of 1991. Mead's current ratio was 1.6 at the end of 1993, and 1.5 at the end of both 1992 and 1991. Inventory levels rose to $447 million in 1993, compared with $426 million in 1992 and $455 million in 1991. The replacement value of inventories exceeded their LIFO value by $194 million at the end of 1993. Adjusted for LIFO, Mead's current ratio would be 1.7 at year-end. In 1992, Mead made a $95 million provision for the costs associated with the comprehensive performance improvement program. The program was undertaken to reduce costs and improve operations, and should be substantially complete in 1994. Disbursements made under the program were approximately $24 million in 1992 and $58 million in 1993. There are no significant non-cash items included in the $95 million provision as it relates primarily to personnel costs. Management will continue its efforts to improve the competitive position of Mead's businesses. These efforts could result in additional costs relating to reduction of personnel or other actions. It is anticipated that any such costs will be charged to earnings as they are incurred. Mead's long-term debt totaled $1.369 billion at the close of 1993, up slightly from the 1992 level of $1.332 billion. The 1991 level was $1.316 billion. The company's ratio of long-term debt to total capital improved slightly to 46% at the end of 1993, compared with 47% at the end of both 1992 and 1991. The ratios of the past three years reflect the combination of high rates of capital spending since 1988, the repurchase of 5.1 million Mead common shares in 1990, and the pressure on earnings caused by the disappointing worldwide economic environment of the past several years. Management believes that the appropriate debt-to-total-capital ratio for Mead over time is 30% to 40%, though it may exceed that range from time to time, as warranted by strategic opportunities. During 1993, Mead issued $150.0 million ($148.8 million net of discount) of 8-1/8% debentures due February 1, 2023, and $150.0 million ($148.3 million net of discount) of 7-1/8% debentures due August 1, 2025. The proceeds of both issues were used to retire short-term borrowings previously classified as long-term. Also, during 1993, Mead reduced the amount of its bank credit agreements from $750 million to $550 million. That action was taken to reduce expense and to reflect the debenture issues which lowered the size of the credit line needed. The $550 million bank credit agreement extends until November, 1995. Based upon the existence of this agreement, $80.2 million of short-term borrowings have been classified as long- term debt. After reduction for these financings, and the January, 1994 prepayment of the $165.5 million purchase note, Mead had $304.3 million of unused credit lines, which management believes are adequate for anticipated future needs. Mead has filed shelf registration statements with the Securities and Exchange Commission which would permit the company to offer up to $300 million of debt securities. Up to $154 million of medium-term notes are currently authorized to be issued as a part of this registered debt offering. Mead commenced its medium-term note program in 1989. Between 1989 and 1992, a total of $186 million of medium-term notes was issued with interest rates ranging from 5-2/3% to 9-7/8%. The largest medium-term note issue was in May, 1991 for $100 million of five-year notes yielding 8.33%. During 1991, Mead retired in advance of scheduled maturities $85.1 million of long-term debt, including current maturities. This was refinanced with variable rate debt issued at lower rates. Under an authorization made by its Board of Directors in 1990, Mead can repurchase up to approximately 1.6 million additional shares of its common stock. Mead common stock has paid a quarterly dividend of $.25 a share since June, 1990. Annual dividends have totaled $1.00 a share since that date. CAPITAL SPENDING - - ---------------- Capital spending totaled $347 million in 1993, compared to $271 million in 1992 and $274 million in 1991. The company announced a $226 million investment in its coated paper operations at Chillicothe, Ohio, and Escanaba, Michigan. At Chillicothe, this investment totaled $111 million, $32 million of which was spent in 1993. These projects are expected to be completed in 1995. At Escanaba, this investment totaled $115 million, $22 million of which was spent in 1993. These projects are also expected to be completed in 1995. Mead plans capital spending in 1994 in the range of $375 million to $425 million. It expects that funds to finance these projects will be internally generated. ENVIRONMENTAL PROCEEDINGS - - ------------------------- Mead is currently named a potentially responsible party (PRP), or has received third party requests for contributions, in several superfund proceedings under federal, state and local laws with respect to at least 24 sites sold by Mead over many years or owned by contractors used by Mead for disposal purposes. There are other former Mead facilities and those of contractors which may contain contamination or which may have contributed to potential superfund sites. Mead's potential liability for these sites will depend upon several factors, including the extent of the contamination, method of remediation, insurance coverage and contribution by other PRPs. Although the costs that Mead may be required to pay for remediation of these sites are not certain at this time, Mead has accrued amounts to cover estimates of such costs, based upon the number of other PRPs, their ability to pay their portion of the costs, the volumetric amount, if any, of Mead's contribution and several other factors. In 1993 the U.S. Environmental Protection Agency issued proposed regulations under the Clean Air Act and Clean Water Act intended to reduce air and water discharges of specific substances from U.S. paper and pulp mills, and other proposed regulations implementing the Federal Great Lakes Critical Programs Act. At present, these regulations are in the proposal stage, and are not expected to be finalized until 1995. However, if enacted in their present form, these regulations would significantly increase Mead's capital spending and operating costs over the next five years. EFFECTS OF INFLATION - - -------------------- Inflation remained at a moderate level in 1993 and is not expected to have a significant effect over the long term. While it is true that inflation increases the replacement cost of long-lived facilities and equipment, higher selling prices and the repayment of borrowings with cheaper dollars would work to maintain satisfactory cash flow. Item 8. Item 8. Financial Statements and Supplementary Data Financial Statements Page ---- Financial Statements:* Independent Auditors' Report. . . . . . . . . . . . . . . . . 27 Statements of earnings. . . . . . . . . . . . . . . . . . . . 28 Balance sheets. . . . . . . . . . . . . . . . . . . . . . . . 29-30 Statements of shareowners' equity . . . . . . . . . . . . . . 31 Statements of cash flows. . . . . . . . . . . . . . . . . . . 32 Notes to financial statements . . . . . . . . . . . . . . . . 33-54 Supplementary Data Selected quarterly financial data. . . . . . . . . . . . . . . 55 ____________________ *Except as otherwise indicated by the context, the "company" referred to herein means The Mead Corporation and its subsidiaries. INDEPENDENT AUDITORS' REPORT Board of Directors The Mead Corporation Dayton, Ohio We have audited the accompanying balance sheets of The Mead Corporation and consolidated subsidiaries as of December 31, 1993 and 1992, and the related statements of earnings, shareowners' 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 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 The Mead 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 financial statements taken as a whole, present fairly in all material respects the information set forth therein. The company changed its method of accounting for income taxes in 1992 (Note K) and its method of accounting for postretirement benefits other than pensions in 1991 (Note N). DELOITTE & TOUCHE Dayton, Ohio January 27, 1994 THE MEAD CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF EARNINGS (All dollar amounts in millions, except per share amounts) Year Ended December 31 1993 1992 1991 - - ------------------------------------- -------- -------- -------- Net sales $4,790.3 $4,703.2 $4,579.3 Cost of products sold 3,834.5 3,779.4 3,712.2 -------- -------- -------- Gross profit 955.8 923.8 867.1 Selling, administrative and research expenses 685.1 671.7 634.7 Other expenses (Note I) 95.0 34.5 -------- -------- -------- Earnings from operations 270.7 157.1 197.9 Other revenues (expenses) - net (Note J) 9.3 (.5) 64.5 Interest and debt expense (96.2) (101.1) (114.4) -------- -------- -------- Earnings from continuing operations before income taxes 183.8 55.5 148.0 Income taxes (Note K) 78.1 23.9 54.3 -------- -------- -------- Earnings from continuing operations before equity in net earnings (loss) of investees 105.7 31.6 93.7 Equity in net earnings (loss) of investees (Note C) 18.4 6.0 (18.1) -------- -------- -------- Earnings from continuing operations 124.1 37.6 75.6 Loss from discontinued operations (Note L) (10.0) -------- -------- -------- Earnings before cumulative effect of change in accounting principle 124.1 37.6 65.6 Cumulative effect of change in accounting principle (Notes K and N) 34.0 (58.7) -------- -------- -------- Net earnings $ 124.1 $ 71.6 $ 6.9 ======== ======== ======== Per common and common equivalent share (Note A): Earnings from continuing operations $2.08 $ .63 $1.29 Loss from discontinued operations (.17) ----- ----- ----- Earnings before cumulative effect of change in accounting principle 2.08 .63 1.12 Cumulative effect of change in accounting principle .58 (1.00) ----- ----- ----- Net earnings $2.08 $1.21 $ .12 ===== ===== ===== See notes to financial statements THE MEAD CORPORATION AND CONSOLIDATED SUBSIDIARIES BALANCE SHEETS (All dollar amounts in millions) ASSETS December 31 1993 1992 - - ------------------------------------------ -------- -------- Current assets: Cash and cash equivalents $ 9.3 $ 18.4 Accounts receivable, less allowance for doubtful accounts of $24.8 in 1993 and $24.9 in 1992 598.2 582.1 Inventories (Note B) 446.8 425.9 Deferred tax asset (Note K) 43.5 51.3 Prepaid expenses 33.5 51.7 -------- -------- Total current assets 1,131.3 1,129.4 Investments and other assets: Investments in and advances to investees (Note C) 65.1 58.9 Other assets (Note D) 555.2 493.0 -------- -------- 620.3 551.9 Property, plant and equipment, at cost (Notes E and O): Land and land improvements 135.5 128.2 Buildings 601.6 602.6 Machinery and equipment 3,300.1 3,113.5 Construction in progress 126.1 78.2 -------- -------- 4,163.3 3,922.5 Less accumulated amortization and depreciation (1,969.7) (1,785.5) -------- -------- 2,193.6 2,137.0 Timber and timberlands, net of timber depletion 219.3 213.1 -------- -------- Property, plant and equipment, net 2,412.9 2,350.1 -------- -------- Total assets $4,164.5 $4,031.4 ======== ======== See notes to financial statements THE MEAD CORPORATION AND CONSOLIDATED SUBSIDIARIES BALANCE SHEETS (All dollar amounts in millions) LIABILITIES AND SHAREOWNERS' EQUITY December 31 1993 1992 - - ------------------------------------------ -------- -------- Current liabilities: Accounts payable: Trade $ 238.6 $ 256.5 Affiliated companies 34.7 27.0 Outstanding checks 77.0 81.2 Accrued wages 96.2 92.5 Taxes, other than income 59.7 58.0 Other current liabilities 192.8 204.0 Current maturities of long-term debt 12.5 10.7 -------- -------- Total current liabilities 711.5 729.9 Long-term debt (Note E) 1,368.8 1,332.3 Deferred items: Income tax liability (Note K) 310.7 275.2 Postretirement benefits (Note N) 108.4 98.3 Other 87.1 100.3 -------- -------- Total deferred items 506.2 473.8 Commitments and contingent liabilities (Notes O and P) Shareowners' equity (Notes G and H): Common shares 176.5 175.2 Additional paid-in capital 26.3 12.3 Foreign currency translation adjustment (7.7) (.8) Net unrealized gain on securities 9.1 Retained earnings 1,373.8 1,308.7 -------- -------- 1,578.0 1,495.4 -------- -------- Total liabilities and shareowners' equity $4,164.5 $4,031.4 ======== ======== See notes to financial statements See notes to financial statements See notes to financial statements THE MEAD CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 A - Accounting Policies CONSOLIDATION. The accompanying statements include the accounts of the company and all significant wholly-owned subsidiaries. Investments in investees are stated at cost plus the company's equity in their undistributed net earnings (loss) since acquisition. All significant intercompany transactions are eliminated. CASH AND CASH EQUIVALENTS. The company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The carrying amount of these short-term investments is a reasonable estimate of fair value. INVENTORIES. The inventories of finished and semi-finished products and raw materials are stated at the lower of cost or market, determined on the last-in, first-out (LIFO) basis. Stores and supplies are stated at cost determined on the first-in, first-out (FIFO) basis. OTHER ASSETS. Included in other assets are goodwill and other intangibles which are being amortized using the straight-line method over their estimated useful lives of five to 40 years. DEPRECIATION AND DEPLETION. For financial reporting purposes, depreciation, including amortization of capital leases and land improvements, is calculated using the straight-line method over the estimated useful lives of the properties. The rates used to determine timber depletion are based on projected quantities of timber available for cutting. CAPITALIZED SOFTWARE COSTS. The company capitalizes certain costs related to the development of computer software under the requirements of Statement of Financial Accounting Standards No. 86. These costs are being amortized using the straight-line method over the five years following the general release of the software. INTEREST RATE AND FOREIGN EXCHANGE FINANCIAL INSTRUMENTS. Premiums and realized and unrealized gains or losses associated with interest rate and foreign exchange options and futures and forward contracts, which serve as hedges, are deferred and amortized over the lives of the contracts or the hedged items. ENVIRONMENTAL LIABILITIES. The company records accruals for environmental costs based on estimates developed in consultation with environmental consultants and legal counsel in accordance with the requirements of Statement of Financial Accounting Standards No. 5. The estimated costs to be incurred in closing existing landfills, based on current environmental requirements and technologies, are accrued over the expected useful lives of the landfills. INCOME TAXES. Income taxes are computed in accordance with Statement of Financial Accounting Standards No. 109 in 1993 and 1992 and APB Opinion No. 11 in 1991. Earnings of corporate investees and overseas operations are reinvested in the business, and no provision for domestic income tax is made on their earnings until distributed. POSTEMPLOYMENT BENEFITS. During 1993, the company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." Adoption of this standard had no impact on the financial statements of the company. NET EARNINGS PER COMMON AND COMMON EQUIVALENT SHARE. Net earnings per common and common equivalent share are computed by dividing net earnings by the weighted average number of common shares and the dilutive effect, if any, of common share equivalents (convertible subordinated debentures and stock options) outstanding during each year. Net earnings have been adjusted by adding back interest expense (net of tax) on the debentures when dilutive. Fully diluted net earnings per share data are substantially the same. B - Inventories (All dollar amounts in millions) December 31 1993 1992 - - ------------------------------------------ ------ ------ Finished and semi-finished products $301.3 $283.2 Raw materials 81.0 79.2 Stores and supplies 64.5 63.5 ------ ------ $446.8 $425.9 ====== ====== For purposes of comparison to non-LIFO companies, inventories valued at current replacement cost would have been $194.0 million and $199.4 million higher than reported at December 31, 1993 and 1992, respectively. C - Investees The company's principal investee is the 50%-owned Northwood Forest Industries, Ltd., which manufactures bleached softwood kraft pulp, lumber and plywood. Under an agreement with Northwood, Mead is entitled to purchase the pulp it requires. Total investments in and advances to investees are as follows: (All dollar amounts in millions) December 31 1993 1992 - - --------------------------------------------- ----- ----- Investments, at cost $24.8 $23.5 Foreign currency translation adjustment (8.1) (5.4) Equity in undistributed net earnings 48.4 40.6 ----- ----- Total investments (equal to Mead's share of investees' equity) 65.1 58.7 Advances .2 ----- ----- Total investments in and advances to investees $65.1 $58.9 ===== ===== The summarized operating data for all investees is presented in the following table: (All dollar amounts in millions) Year Ended December 31 1993 1992 1991 - - ------------------------------------ ------ ------ ------ Revenues: Sales to Mead $ 18.2 $ 26.9 $ 39.7 Sales to other customers 547.9 481.0 406.9 ------ ------ ------ $566.1 $507.9 $446.6 ====== ====== ====== Gross profit (loss) $ 86.5 $ 51.9 $(14.2) ====== ====== ====== Net earnings (loss) $ 47.0 $ 20.5 $(36.3) ====== ====== ====== Mead's share of net earnings (loss), after elimination of intercompany transactions and reduction for Mead's income taxes on partnership earnings $ 18.4 $ 6.0 $(18.1) ====== ====== ====== Dividends and partnership distributions received $ 15.7 $ 14.2 $ 6.4 ====== ====== ====== The summarized balance sheet data for all investees is as follows: (All dollar amounts in millions) December 31 1993 1992 - - ------------------------------------------ ------ ------ Current assets $171.6 $145.6 Noncurrent assets 631.6 663.7 Current liabilities (169.9) (161.0) Long-term debt and deferred items (503.1) (530.5) ------ ------ Shareholders' equity $130.2 $117.8 ====== ====== D - Other Assets (All dollar amounts in millions) December 31 1993 1992 - - ---------------------------------------------- ------ ------ Goodwill and other intangibles (net of accumulated amortization of $135.2 in 1993 and $112.9 in 1992) $206.3 $236.7 Pension asset 141.4 97.0 Rental equipment 78.3 60.7 Cash surrender value of life insurance, less policy loans of $21.4 in 1993 and $18.0 in 1992 39.6 33.3 Computer software development costs (net of accumulated amortization of $1.6 in 1993) 12.3 10.5 Miscellaneous 77.3 54.8 ------ ------ $555.2 $493.0 ====== ====== At December 31, 1993, the company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, miscellaneous other assets includes equity securities available-for-sale with a cost of $.1 million which have been recorded at the current market price ($15.1 million) along with the deferred income tax liability ($5.9 million) and the net unrealized gain ($9.1 million) recorded as a separate component of shareowners' equity. E - Long-Term Debt (All dollar amounts in millions) December 31 1993 1992 - - -------------------------------------------- -------- -------- Capital lease obligations: Industrial Development Revenue Bonds and Notes, average effective rate approximately 3.0% $ 134.3 $ 116.5 Other, average effective rate 8.25% 24.5 31.4 -------- -------- Total 158.8 147.9 Medium-term notes, 5-2/3% to 9-7/8%, face amount of $186.0, due from 1996 through 2020 (effective rate approximately 9.2%) 177.7 176.4 Purchase Note, due in 1998, interest at LIBOR plus 1/2% (4.1% at December 31, 1993) 165.5 165.5 8-1/8% debentures, face amount of $150.0, due 2023 (effective rate approximately 8.4%) 147.5 7-1/8% debentures, face amount of $150.0, due 2025 (effective rate approximately 7.4%) 146.6 6-3/4% convertible subordinated debentures 139.0 139.0 9% debentures, due in annual installments of $7.5 from 2000 through 2017 130.0 130.0 Variable-rate Escanaba tax-exempt bonds, $10.0 due in 2013 and $83.5 due in 2023, average effective rate approximately 2.2% 93.5 93.5 Variable-rate Industrial Development Revenue Bonds, due from 2001 through 2023, average effective rate approximately 2.2% 78.6 69.6 Short-term borrowings to be refinanced 80.2 378.8 Other 51.4 31.6 -------- -------- $1,368.8 $1,332.3 ======== ======== The Purchase Note, the variable-rate Industrial Development Revenue Bonds and the variable-rate Escanaba tax-exempt bonds are supported by letters of credit. The interest rates on the variable-rate tax-exempt bonds closely follow the tax-exempt commercial paper rate. The 6-3/4% convertible subordinated debentures are convertible into common shares at any time at a conversion price of $52.85 per share. The debentures are due in annual installments of $9 million in 2004, $10 million from 2005 through 2011 and $60 million in 2012, and are callable by the company at 102.7% until September 1994, and at declining prices thereafter. During 1993, the company issued $150.0 million of 8-1/8% debentures and $150.0 million of 7-1/8% debentures to replace short-term borrowings. The debentures are callable by the company at approximately 103% beginning in 2003. In January 1994, the company prepaid the $165.5 million Purchase Note, due in 1998. In addition, the company intends to refinance $80.2 million of short-term debt on a long-term basis. Since the company has the intent to consummate these transactions on a long-term basis and has the ability to do so under its $550 million bank credit agreement that extends until November 30, 1995, the amounts are classified as long-term debt at December 31, 1993. After reduction for the above transactions, the company has unused long-term lines of credit of $304.3 million. This agreement contains restrictive covenants and requires commitment fees in accordance with standard banking practice. Maturities of long-term debt for the next five years, after giving effect to the prepayment of the Purchase Note, are $12.5 million in 1994, $269.4 million in 1995, $110.0 million in 1996, $16.5 million in 1997 and $3.3 million in 1998. The fair value of the company'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 company for debt of the same remaining maturities. The fair value of long-term debt, excluding capital leases, was $1,253.8 million and $1,209.0 million at December 31, 1993 and 1992, respectively, and the related carrying amounts were $1,210.0 million and $1,184.4 million, respectively. Property, plant and equipment carried at $110.4 million is pledged as collateral under the above debt (principally capital leases). The company has guaranteed obligations of certain affiliated operations and others totaling approximately $49.2 million at December 31, 1993. In addition, the company has a 50% interest in a partnership with Scott Paper Company which has borrowed $300 million under a loan agreement with The Sumitomo Bank, Limited, New York Branch, which matures in 1998. The loan, one-half of which has been guaranteed by the company, may be prepaid at any time either in cash or by delivery of notes receivable from Georgia-Pacific Corporation held by the partnership as part of the consideration from the 1988 sale of Brunswick Pulp and Paper Company, a former affiliate. It is not practicable to estimate the fair value of the above guarantees. F - Financial Instruments The company uses various financial instruments with off-balance-sheet market risk to manage its interest rate and foreign currency exchange rate risks. The risk of loss to the company in the event of nonperformance by any party under these agreements is not significant. Option and swap agreements require payments to be calculated based upon a notional principal amount. Fair values of these contracts are estimated by obtaining quotes from brokers. Options are written as an element of an overall strategy to manage specific interest rate or foreign exchange rate risk and are generally combined with purchased options. For written options, the company receives a premium at the outset and then bears the market risk of an unfavorable change in the value of the financial instrument underlying the options. Based upon the estimated fair values at December 31, 1993, had the company entered into these foreign currency option contracts on that date it would have received $.2 million for writing the options and would have paid $2.5 million to enter into the purchased option contracts. Included in written interest rate options are options written by the company which would allow holders to enter into interest rate swap agreements with the company. If the company had entered into interest rate option contracts with similar terms on December 31, 1993, the company would have received $8.3 million on the written option contracts and would have paid $1.2 million for the purchased interest rate option contracts. Interest rate swap agreements allow counterparties to exchange interest cash flows on a specified amount of debt for a specified period. The company is exposed to market risk due to the possibility of exchanging a lower interest rate for a higher interest rate. At December 31, 1993, the company would have received $.7 million to enter into contracts with similar terms. The forward foreign currency and interest rate forward contracts (which are carried at market) reduce the company's risk due to exchange and interest rate movement because gains and losses on these contracts generally offset losses and gains on the assets, liabilities and transactions being hedged. The fair values of foreign currency forward contracts are estimated using quotes from brokers and a matrix pricing model. The fair value amounts for forward foreign exchange and interest rate contracts in the following table represent the principal to be exchanged if the existing contracts had been settled at year end. Selected information related to the company's financial instruments described above is as follows: (All dollar amounts in millions) December 31, 1993 ---------------------------------- Net Contract Fair Unrecognized or Notional Value Gain (Loss) Amount ------ ----------- ----------- Foreign currency options: Written $ (.2) $ (.2) $ 36.2 Purchased 2.5 2.5 56.5 Interest rate options: Written (8.3) - 175.0 Purchased (caps) 1.2 (4.1) 400.0 Interest rate swaps (.7) (2.4) 375.0 Forward foreign exchange contracts: Dollar purchases 80.1 (.3) 79.8 Dollar sales 35.0 .4 34.6 December 31, 1992 ---------------------------------- Net Contract Fair Unrecognized or Notional Value Gain (Loss) Amount ------ ----------- ----------- Foreign currency options: Written $(1.8) $(1.8) $ 69.4 Purchased 5.4 5.4 125.2 Interest rate options: Written (2.0) - 115.0 Purchased (caps) 1.5 (4.4) 450.0 Interest rate swaps (.2) (.8) 215.0 Forward foreign exchange contracts: Dollar purchases 82.9 2.6 85.5 Dollar sales 58.6 (1.2) 59.8 Forward interest rate contracts 43.5 - 43.5 G - Shareowners' Equity The company has authorized 300 million no par common shares. There were 59,184,894 and 58,733,725 common shares outstanding at December 31, 1993 and 1992, respectively. In prior years, the Board of Directors authorized the company to purchase up to 7,000,000 common shares for corporate purposes. A total of 5,405,292 and 5,404,519 common shares were held in treasury at December 31, 1993 and 1992, respectively. Under a Rights Plan, one right is presently attached to and trades with each outstanding common share. Generally, the rights become exercisable and trade separately ten days after a third party acquires 20% or more of the common shares or commences a tender offer for a specified percentage of the common shares. In addition, the rights become exercisable if any party becomes the beneficial owner of 10% or more of the outstanding common shares and is determined by the Board of Directors to be an adverse party. Upon the occurrence of certain additional triggering events specified in the Rights Agreement, each right would entitle its holder (other than, in certain instances, the holder of 20% or more of the common shares) to purchase common shares of the company (or, in some cases, a potential acquiring company) or other property having a value of $180 for $90, the initial exercise price. The rights expire in 1996 and are presently redeemable at $.025 per right. At December 31, 1993, there were 73,376,392 common shares reserved for issuance under this plan. The Board of Directors has approved termination benefits for certain key executives and a severance plan for all other salaried employees and established a Benefit Trust in connection with the company's unfunded supplemental retirement plan, deferred compensation plan, directors retirement plan and excess benefits plan to preserve the benefits earned thereunder in the event of a change in control of the company. A Restricted Stock Plan provides for the issuance of restricted common shares to certain selected employees and to directors who are not officers or employees of the company. As of December 31, 1993, 30,424 common shares are issued and outstanding under the plan. There were 432,997 common shares reserved for issuance under this plan at December 31, 1993. The company has preferred shares authorized but unissued as follows: 61,500 undesignated cumulative preferred, par value $100; 20,000,000 undesignated voting cumulative preferred, without par value; 20,000,000 cumulative preferred, without par value; and 295,540 cumulative second preferred, par value $50. At December 31, 1993, undistributed net earnings of investees and partially-owned foreign affiliates of $50.2 million are included in retained earnings. At December 31, 1993, there are no covenants in the company's loan agreements that significantly restrict retained earnings. H - Stock Options and Rights Officers and key employees have been granted stock options under various plans. At December 31, 1993, there were outstanding options granted under the 1991 Stock Option Plan and a prior stock option plan to purchase 2,991,203 common shares (of which 2,275,968 are exercisable) at a weighted average price of $35.69. Options as to 680,860 shares are accompanied by limited rights which may be exercised in lieu of the option under certain circumstances. The options and rights expire at various dates through October 2003. There are 5,568,848 common shares reserved for issuance under these plans. I - Other Expenses In 1992, the company recorded a $95.0 million provision in connection with a comprehensive performance improvement program. The provision was comprised of employee severance, special termination benefits in connection with the settling of pension liabilities, redeployment and relocation costs, outplacement and counseling of terminated employees and other related costs. The company has expended $58.0 million in 1993, $24.0 million in 1992 and expects to expend the remainder of the amount in 1994. J - Other Revenues (Expenses) - Net (All dollar amounts in millions) Year Ended December 31 1993 1992 1991 - - ---------------------------------------- ----- ----- ----- Investment income $ 2.3 $ 1.5 $ 2.9 Gain (loss) on sale of subsidiary (22.5) 44.1 Other 7.0 20.5 17.5 ----- ----- ----- $ 9.3 $ (.5) $64.5 ===== ===== ===== After-tax loss on sale of subsidiary was $17.7 million ($.30 per share) in 1992 and after-tax gain was $26.4 million ($.45 per share) in 1991. Net assets and results of operations of these subsidiaries were not material. K - Income Taxes Effective January 1, 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and recognized a cumulative effect to that date of the change of $34.0 million ($.58 per share). The effect of adopting Statement No. 109 for the year ended December 31, 1992 was not material. The principal current and non-current deferred tax assets and (liabilities) are as follows: (All dollar amounts in millions) December 31 1993 1992 - - ---------------------------------------------- ------- ------- Deferred tax liabilities: Accelerated depreciation for tax purposes $(344.3) $(315.8) Nontaxable pension asset (50.7) (34.5) Other (29.6) (13.9) ------- ------- (424.6) (364.2) ------- ------- Deferred tax assets: Alternative minimum tax carryforward 73.6 54.0 Nondeductible items: Allowance for doubtful accounts 8.0 8.9 Compensation and fringe benefits accruals 21.1 30.1 Postretirement benefit accrual 39.9 35.0 Other 14.8 12.3 ------- ------- 157.4 140.3 ------- ------- Net deferred liability $(267.2) $(223.9) ======= ======= Included in the balance sheets: Current assets - deferred tax asset $ 43.5 $ 51.3 Deferred items - income tax liability (310.7) (275.2) ------- ------- Net deferred liability $(267.2) $(223.9) ======= ======= The significant components of income tax expense are as follows: (All dollar amounts in millions) Year Ended December 31 1993 1992 1991 - - -------------------------------------- ------ ------ ------ Currently payable: Federal $ 26.5 $ .8 $ 29.3 Federal alternative minimum tax 19.6 12.1 29.6 State and local 3.3 2.9 5.3 Foreign 3.2 3.3 3.2 Allocation to partnership earnings (5.1) (4.3) ------ ------ ------ 47.5 14.8 67.4 ------ ------ ------ Deferred: Effect of increase in federal income tax rate as of January 1, 1993 7.6 Excess tax depreciation 17.8 18.7 26.1 Alternative minimum tax carryforward (19.6) (12.1) (29.6) Pension income 13.6 .3 7.7 Effect of loss on sale of subsidiary 15.8 Other expenses 11.4 (14.4) (10.3) Miscellaneous (.2) .8 (7.0) ------ ------ ------ 30.6 9.1 (13.1) ------ ------ ------ $ 78.1 $ 23.9 $ 54.3 ====== ====== ====== Principal reasons for the difference between the statutory federal rate and the effective tax rate are: Year Ended December 31 1993 1992 1991 - - ---------------------------------------- ----- ----- ----- Federal income tax rate 35.0% 34.0% 34.0% Effect of increase in federal income tax rate as of January 1, 1993 4.1 State and local income taxes, net of federal benefit 2.0 (3.8) (1.1) Effect of loss on sale of subsidiary 5.2 Impact of additional taxes related to foreign operations .6 8.7 2.5 Other .8 (1.0) 1.3 ----- ----- ----- Effective tax rate 42.5% 43.1% 36.7% ===== ===== ===== Earnings from continuing operations before income taxes includes $12.8 million, $6.0 million and $9.3 million in 1993, 1992 and 1991, respectively, of foreign earnings. At December 31, 1993, no domestic income taxes have been provided on Mead's share of the undistributed net earnings of corporate investees and overseas operations. Those earnings totaled $135.6 million, including foreign currency translation adjustments. The aggregate amount of unrecognized deferred tax liability is approximately $20.0 million at December 31, 1993. L - Discontinued Operations Effective November 1986, the company adopted a plan to divest the insurance operations conducted through its wholly-owned subsidiaries and wrote off its investment. The insurance subsidiaries ceased underwriting activities and are settling existing claims. In 1991, the company provided $10.0 million (net of tax benefit of $6.0 million) for additional losses during the runoff of the operations. The net assets of the insurance operations at December 31, 1993, include total assets of $181.8 million, claims reserves of $166.2 million and the remaining accrual of $15.6 million for estimated administrative costs to be incurred during runoff. In December 1990, the Board of Directors approved a plan to curtail further development of the company's imaging products. Since that date, the company has charged $12.8 million for operating losses to the accrual for operating losses. At December 31, 1993, remaining net liabilities of $6.2 million are included in other deferred items. The net amount includes assets of $10.3 million and the remaining accrual for operating losses of $16.5 million. M - Pension Plans The company has pension plans that cover substantially all employees. Pension benefits for bargaining employees are primarily based upon years of credited service. Benefits for salaried and other non-bargaining employees are based upon years of service and the employee's average final earnings. Mead's funding policy is to contribute amounts to the plans sufficient to meet or exceed the minimum requirements of the Employee Retirement Income Security Act. Summary information on the company's funded plans is as follows: (All dollar amounts in millions) December 31 1993 1992 - - ------------------------------------------------ ------ ------ Financial status of plans: Plan assets at fair value (primarily common stocks, fixed income securities and real estate) $780.1 $747.3 Actuarial present value of accumulated benefit obligation: Vested (543.3) (473.4) Non-vested (46.1) (26.8) Estimated effect of future salary increases at 1% over expected inflation (66.4) (60.7) ------ ------ Projected benefit obligation (655.8) (560.9) ------ ------ Plan assets in excess of projected benefit obligation 124.3 186.4 Reconciliation of financial status of plans to amounts recorded in Mead's balance sheets: Unamortized plan assets in excess of plan liabilities (overfunding) at January 1, 1986 - to be recognized as a reduction of future years' pension expense (69.8) (79.4) Unrecorded effect of net (gain) loss arising from differences between actuarial assumptions used to determine periodic pension expense and actual experience 76.7 (24.3) Unamortized prior service cost 10.2 14.3 ------ ------ Pension asset recorded in the balance sheets $141.4 $ 97.0 ====== ====== Benefit obligation discount rate 7.5% 8.5% ====== ====== The projected benefit obligation for the company's two unfunded plans was $20.4 million and $10.0 million at December 31, 1993 and 1992, respectively, of which $15.6 million and $10.0 million represent the accumulated benefit obligation. Of the projected benefit obligation, $14.2 million and $6.5 million at December 31, 1993 and 1992, respectively, is subject to later amortization. Unfunded accrued pension cost is $6.2 million and $3.5 million at December 31, 1993 and 1992, respectively. The components of net pension (income) for all plans are as follows: (All dollar amounts in millions) Year Ended December 31 1993 1992 1991 - - ----------------------------------- ------ ------ ------ Service cost, benefits earned during the year $ 19.8 $ 20.1 $ 18.7 Interest cost on projected benefit obligation 46.8 43.5 41.9 Actual return on plan assets (103.8) (39.8) (174.0) Net amortization and deferral 23.9 (42.6) 105.7 ------ ------ ------ Net pension (income) $(13.3) $(18.8) $ (7.7) ====== ====== ====== The expected long-term rate of return on plan assets used in determining net pension income was 10% in each of these years. The company's pension plans require the allocation of excess plan assets to plan members if the plans are terminated, merged or consolidated following a change in control (as defined) of the company opposed by the Board of Directors of the company. Amendment of these provisions after such a change in control would require approval of plan participants. N - Postretirement Benefits Other than Pensions In 1991, the company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and recognized the cumulative effect of the change in accounting for postretirement benefits of $93.5 million ($58.7 million net of income tax benefit). The company funds certain health care benefit costs principally on a pay-as-you-go basis, with the retiree paying a portion of the costs. Certain retired employees of businesses acquired by the company are covered under other health care plans that differ from current plans in coverage, deductibles and retiree contributions. Summary information on the company's plans (funded and unfunded) is as follows: (All dollar amounts in millions) December 31 1993 1992 - - ------------------------------------------------ ------- ------ Financial status of plans: Accumulated postretirement benefit obligation: Retirees $ (69.2) $(64.2) Fully eligible, active plan participants (25.1) (21.5) Other active plan participants (41.1) (32.0) ------- ------ (135.4) (117.7) Less plan assets at fair value 8.3 14.3 ------- ------ Accumulated postretirement benefit obligation in excess of plan assets (127.1) (103.4) Reconciliation of financial status of plans to amounts recorded in Mead's balance sheets - Unrecorded effect of net loss arising from differences between actuarial assumptions used to determine periodic postretirement benefit expense and actual experience 18.7 5.1 ------- ------ Accrued postretirement benefit cost $(108.4) $(98.3) ======= ====== Benefit obligation discount rate 7.5% 8.5% ====== ====== The accumulated postretirement benefit obligation for the unfunded plans at December 31, 1993 and 1992, was $128.9 million and $105.7 million, respectively. The components of net periodic postretirement benefit cost are as follows: (All dollar amounts in millions) Year Ended December 31 1993 1992 1991 - - ----------------------------------------- ----- ----- ----- Service cost, benefits attributed to employee service during the year $ 3.1 $ 2.4 $ 2.0 Interest cost on accumulated postretirement benefit obligation 9.5 9.4 8.5 Actual return on plan assets (1.1) (1.5) (.9) Net amortization and deferral .1 .4 ----- ----- ----- Net periodic postretirement benefit cost $11.6 $10.7 $ 9.6 ===== ===== ===== The expected long-term rate of return on plan assets used in determining the net periodic postretirement benefit cost was 8% in each year. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 14% in 1993, declining by 1% per year to an ultimate rate of 6%. If the health care cost trend rate assumptions were increased by 1%, the accumulated postretirement benefit obligation as of December 31, 1993, would be increased by 10%. The effect of this change on the sum of the service cost and interest cost components of net periodic postretirement benefit cost for 1993 would be an increase of 11%. O - Leases At December 31, 1993, future minimum annual rental commitments under noncancelable lease obligations are as follows: (All dollar amounts in millions) Capital Operating Leases Leases ------- --------- Year Ending December 31: 1994 $ 17.7 $ 42.4 1995 14.0 31.0 1996 10.1 22.7 1997 8.7 18.6 1998 7.7 13.5 Later years through 2025 235.8 62.6 ------ ------ Total minimum lease payments 294.0 $190.8 ====== Less: Sublease rentals (5.9) Amount representing interest (122.5) ------ Present value of net minimum lease payments 165.6 Less current maturities of capital lease obligations (6.8) ------ Capital lease obligations $158.8 ====== Capital leases are for manufacturing facilities, equipment and warehouse and office space. Capital lease property included in property, plant and equipment is as follows: (All dollar amounts in millions) December 31 1993 1992 - - ------------------------------------------ ------ ------ Land and buildings $ 37.7 $ 43.8 Machinery and equipment 165.1 157.2 ------ ------ 202.8 201.0 Less accumulated amortization (101.6) (105.4) ------ ------ $101.2 $ 95.6 ====== ====== The majority of rent expense is for operating leases having terms of up to 25 years which are for office, warehouse and manufacturing facilities and delivery, manufacturing and computer equipment. A number of these leases have renewal options. Rent expense was $60.8 million, $63.6 million and $59.9 million in 1993, 1992 and 1991, respectively. The company has additional subleases of property recorded under capital leases. Total rentals to be received in future years are approximately $15.9 million at December 31, 1993. P - Litigation and Other Proceedings The company is involved in various litigation generally incidental to normal operations, as well as proceedings regarding equal employment opportunity matters, among others. The company has also been named a potentially responsible party in several environmental proceedings. It is not possible to determine the ultimate liability, if any, in these matters. In the opinion of management, after consultation with legal counsel, the resolution of such litigation and proceedings will not have a material effect on the financial position or results of operations of the company. Q - Additional Information on Cash Flows (All dollar amounts in millions) Year Ended December 31 1993 1992 1991 - - -------------------------------------- ------ ------ ------ Cash paid during the year for: Interest $ 87.8 $101.6 $117.0 Less amount capitalized (2.6) (2.3) (4.5) ------ ------ ------ Interest, net of amount capitalized 85.2 99.3 112.5 Income taxes 33.6 39.5 41.9 Non-cash activities: Capital lease obligations 5.5 8.9 Sale of subsidiary (proceeds received in January 1992) 45.0 Debt securities issued in retirement of previously outstanding borrowings (face amount $100.0) 99.8 (1) Intersegment sales are made at substantially the same prices and on the same terms as to unaffiliated customers. (2) The earnings (loss) from continuing operations before income taxes includes other expenses related to the performance improvement program and a loss on the sale of a subsidiary in 1992; and environmental costs and costs of business consolidations and a gain on the sale of a subsidiary in 1991. (3) Earnings from continuing operations before income taxes for "Corporate and other" includes the following: Year Ended December 31 1993 1992 1991 ----------------------- ------- ------- ------- Other revenues: Gain (loss) on sale of subsidiary $ $ (22.5) $ 44.1 Other 3.7 7.6 5.2 Interest expense (96.2) (101.1) (114.4) Comprehensive performance improvement program (23.4) Other expenses (47.2) (56.2) (48.8) ------- ------- ------- $(139.7) $(195.6) $(113.9) ======= ======= ======= (4) During 1993, in connection with the comprehensive performance improvement program, the company reorganized its corporate functions whereby certain expenditures are allocated to the operating units. Accordingly, earnings before income taxes for 1992 and 1991 have been increased (decreased) from amounts previously reported as follows: Year Ended December 31 1992 1991 ----------------------------------- ----- ----- Industry segments: Paper $(1.7) $(2.8) Packaging and Paperboard (8.9) (9.6) Distribution and School and Office Products (5.1) (4.7) Electronic Publishing (4.5) (3.3) Corporate and other 20.2 20.4 ----- ----- $ 0.0 $ 0.0 ===== ===== (5) The assets of "Corporate and other" consist primarily of cash and cash equivalents, property, plant and equipment and investments in and advances to investees. The cumulative effect of the change in accounting principle in 1991 is applicable to segments as follows: Year Ended December 31 1991 - - ------------------------------------------------------- ----- Industry segments: Paper $30.2 Packaging and Paperboard 15.6 Distribution and School and Office Products 38.0 Electronic Publishing 2.8 Corporate and other 6.9 ----- $93.5 ===== Item 9. Item 9. Changes in and Disagreements with Accountants on Acco Financial Disclosure. Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Information pursuant to this item is incorporated herein by reference to pages 3 through 5 of the Company's Proxy Statement, definitive copies of which were filed with the Securities and Exchange Commission ("Commission") on March 14, 1994. Information concerning executive officers is also included in Part I of this report following Item 4. Item 11. Item 11. Executive Compensation Information pursuant to this item is incorporated herein by reference to pages 8 through 20 of the Company's Proxy Statement (excluding the "Report of Compensation Committee on Executive Compensation" on pages 10-12 and the "Performance Graph" on page 17), definitive copies of which were filed with the Commission on March 14, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information pursuant to this item is incorporated herein by reference to pages 9 and 10 of the Company's Proxy Statement, definitive copies of which were filed with the Commission on March 14, 1994. Item 13. Item 13. Certain Relationships and Related Transactions Information pursuant to this item is incorporated herein by reference to pages 19-20 of the Company's Proxy Statement, definitive copies of which were filed with the Commission on March 14, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements The financial statements of The Mead Corporation and consolidated subsidiaries are included in Part II, Item 8. 2. Financial Statement Schedules Page ---- Schedule V--Property, Plant and Equipment . . . . . . . 65-67 Schedule VI--Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment. . . . . 68 Schedule VII--Guarantees of Securities of Other Issuers. . . . . . . . . . . . . . . . . . . . . . . . 69 Schedule VIII--Valuation and Qualifying Accounts. . . . 70 Schedule IX--Short-term Borrowings. . . . . . . . . . . 71 Schedule X--Supplementary Statement of Earnings Information. . . . . . . . . . . . . . . . . . . . . . 72 The information required to be submitted in Schedules I, II, III, IV, XI, XII, XIII, and XIV for The Mead Corporation and consolidated subsidiaries has either been shown in the financial statements or notes thereto, or is not applicable or required under rules of Regulation S-X, and, therefore, those schedules have been omitted. 3. Exhibits (3) Articles of Incorporation and Bylaws: (i) Amended Articles of Incorporation of the Registrant adopted May 28, 1987 (incorporated by reference to Exhibit (3)(i) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (ii) Regulations of the Registrant, as amended April 23, 1987 (incorporated by reference to Exhibit (3)(ii) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (4) Instruments defining the rights of security holders, including indentures: (i) Credit Agreement dated as of November 15, 1989 with Bankers Trust Company, The First National Bank of Chicago, Morgan Guaranty Trust Company of New York and fifteen other banks (incorporated by reference to Exhibit (4)(i) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989) and Amendment No. 1 thereto dated as of November 30, 1991 (incorporated by reference to Exhibit (4)(i) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). (ii) Indenture dated as of July 15, 1982 between the Registrant and Bankers Trust Company, as Trustee, First Supplemental Indenture dated as of March 1, 1987 (incorporated by reference to Exhibit (4)(iv) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987), Second Supplemental Indenture dated as of October 15, 1989 (incorporated by reference to Exhibit (4) to Registrant's Current Report on Form 8-K dated October 11, 1989) and Third Supplemental Indenture dated as of November 15, 1991 (incorporated by reference to Exhibit (4)(ii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). (iii) Indenture dated as of February 1, 1993 between the Registrant and The First National Bank of Chicago, as Trustee (incorporated by reference to Exhibit (4)(iii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). The total amount of securities authorized under other long-term debt instruments does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. A copy of each such instrument will be furnished to the Commission upon request. (10) Material Contracts: (i) Agreement dated as of April 24, 1964 between Northwood Mills Limited, Canamead, Inc., the Registrant and Noranda Mines, Limited and Supplemental Agreements relating thereto dated as of July 2, 1964, April 5, 1965, March 15, 1966, February 1, 1967, December 15, 1970 and April 1, 1974 (incorporated by reference to Exhibit (10)(v) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1980 included in File No. 1-2267 in the Public Reference Room of the Securities and Exchange Commission in Washington, D.C.). (ii) Pulp Purchase Agreement dated as of April 1, 1965 among Northwood Pulp Limited, the Registrant, Northwood Mills Ltd. and Noranda Mines Limited (incorporated by reference to Exhibit (10)(vi) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1980 included in File No. 1-2267 in the Public Reference Room of the Securities and Exchange Commission in Washington, D.C.). (iii) Rights Agreement dated as of November 1, 1986 between Registrant and The First National Bank of Cincinnati, as Rights Agent, as amended December 29, 1987 and December 9, 1988 (incorporated herein by reference to Registrant's Amendment No. 1 on Form 8, dated November 28, 1986 and Exhibits 28(a) and 28(b) to Registrant's Current Report on Form 8-K dated December 9, 1988). (iv) Amended Board Purchase Agreement dated as of January 4, 1988 among the Registrant, Georgia Kraft Company and Inland Container Corporation (incorporated by reference to Exhibit (1O)(xviii) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (v) Indemnification Agreement dated as of January 4, 1988 among the Registrant, Mead Coated Board, Inc., Temple-Inland Inc., Inland Container Corporation I, Inland Container Corporation, GK Texas Holding Company and Georgia Kraft Company (incorporated by reference to Exhibit (1O)(xix) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (vi) Lease Agreement between The Industrial Development Board of the City of Phenix City, Alabama and Mead Coated Board, Inc., dated as of December 1, 1988, as amended (incorporated by reference to Exhibit (10)(xviii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 and Exhibit (10)(xviii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). The following are compensatory plans and arrangements in which directors or executive officers participate: (vii) 1984 Stock Option Plan of the Registrant, as amended and restated as of January 25, 1990 (incorporated by reference to Exhibit (10)(v) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989), and Amendment dated January 23, 1992 (incorporated by reference to Exhibit 10(iv) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). (viii) 1991 Stock Option Plan of the Registrant (incorporated by reference to Exhibit (10)(xxi) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (ix) Incentive Compensation Election Plan of the Registrant as amended November 17, 1987 (incorporated by reference to Exhibit (10)(viii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), as amended October 29, 1988 (incorporated by reference to Exhibit (10)(vi) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (x) 1985 Supplement to Registrant's Incentive Compensation Election Plan, as amended November 17, 1987 (incorporated by reference to Exhibit (1O)(xi) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985 and Exhibit (10)(ix) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), and as further amended October 29, 1988 (incorporated by reference to Exhibit (10)(vii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (xi) Excess Benefit Plan of the Registrant (1988 Restatement), dated October 29, 1988 (incorporated by reference to Exhibit (10)(vii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (xii) Supplemental Executive Retirement Plan (formerly The Mead Management Income Parity Plan) effective January 1, 1985, as amended and restated as of July 1, 1992 (incorporated by reference to Exhibit (10)(xiii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). (xiii) Form of Indemnification Agreement between Registrant and each of Samuel S. Benedict, John C. Bogle, John G. Breen, Vincent L. Gregory, Jr., William E. Hoglund, Barbara C. Jordan, Steven C. Mason, Charles S. Mechem, Jr., Paul F. Miller, Jr., William S. Shanahan, Thomas B. Stanley, Jr. and Lee J. Styslinger, Jr. (incorporated herein by reference to Exhibit (10)(xiv) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). (xiv) Form of Severance Agreement between Registrant and each of Steven C. Mason and Samuel S. Benedict (incorporated herein by reference to Exhibit (10)(xvi) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1986 and Exhibit (10)(xii) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (xv) Form of Severance Agreement between Registrant and each of William R. Graber, Elias M. Karter, Charles J. Mazza, Wallace 0. Nugent, Thomas E. Palmer and other key employees (incorporated by reference to Exhibit (10)(xiii) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (xvi) Benefit Trust Agreement dated January 9, 1987 between Registrant and Society Bank, National Association (incorporated herein by reference to Exhibit (1O)(xviii) to Registrant's Annual Report on Form 1O-K for the year ended December 31, 1986), as amended October 29, 1988 (incorporated by reference to Exhibit (10)(xiv) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988) and January 24, 1991 (incorporated by reference to Exhibit (10)(xiii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (xvii) Restricted Stock Plan effective December 10, 1987, as amended through July 23, 1992 (incorporated by reference to Exhibit (10)(xviii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). (xviii) Deferred Compensation Plan for Directors of the Registrant, as amended through October 29, 1988 (incorporated by reference to Exhibit (10)(xix) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). (xix) 1985 Supplement to Registrant's Deferred Compensation Plan for Directors, as amended through October 29, 1988 (incorporated by reference to Exhibit (10)(xx) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). (xx) Directors Retirement Plan, effective October 27, 1990 (incorporated by reference to Exhibit (10)(xx) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (xxi) Form of Executive Life Insurance Policy for Key Executives (incorporated by reference to Exhibit (10) of Registrant's Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 1991). (xxii) The "Direction 2000" Executive Incentive Plan, dated April 21, 1993 (incorporated by reference to Exhibit 10(i) of Registrant's Quarterly Report on Form 10-Q for the Quarterly Period Ended April 4, 1993). (xxiii) Mead Management Incentive Plan for 1993 (incorporated by reference to Exhibit 10(ii) of Registrant's Quarterly Report on Form 10-Q for the Quarterly Period Ended April 4, 1993). (11) Calculation of Earnings per Share. (12) Ratio of Earnings to Fixed Charges. (21) List of significant subsidiaries of the Registrant. (23) Consent of Independent Auditors. (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. THE MEAD CORPORATION Date: February 24, 1994 By Steven C. Mason ------------------------------- Steven C. Mason 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: February 24, 1994 By Steven C. Mason ------------------------------- Steven C. Mason Director, Chairman of the Board and Chief Executive Off Date: February 24, 1994 By Samuel S. Benedict ------------------------------- Samuel S. Benedict Director, President and Chief Operating Officer Date: February 24, 1994 By William R. Graber ------------------------------- William R. Graber Vice President and Chief Financial Officer (principal financial officer) Date: February 24, 1994 By John D. Fuller ------------------------------- John D. Fuller Controller (principal accounting officer) Date: February 24, 1994 By John C. Bogle ------------------------------- John C. Bogle Director Date: February 24, 1994 By John G. Breen ------------------------------- John G. Breen Director Date: February 24, 1994 By Vincent L. Gregory, Jr. ------------------------------- Vincent L. Gregory, Jr. Director Date: February 24, 1994 By William E. Hoglund ------------------------------- William E. Hoglund Director Date: February 24, 1994 By Barbara C. Jordan ------------------------------- Barbara C. Jordan Director Date: February 24, 1994 By Charles S. Mechem, Jr. ------------------------------- Charles S. Mechem, Jr. Director Date: February 24, 1994 By Paul F. Miller, Jr. ------------------------------- Paul F. Miller, Jr. Director Date: February 24, 1994 By William S. Shanahan ------------------------------- William S. Shanahan Director Date: February 24, 1994 By Thomas B. Stanley, Jr. ------------------------------- Thomas B. Stanley, Jr. Director Date: February 24, 1994 By Lee J. Styslinger ------------------------------- Lee J. Styslinger Director THE MEAD CORPORATION AND CONSOLIDATED SUBSIDIARIES ______________________ SCHEDULES FURNISHED PURSUANT TO REQUIREMENTS OF FORM 10-K ______________________ Years Ended December 31, 1993, 1992 and 1991 THE MEAD CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT- Continued (All dollar amounts in millions) (A) Inter-account transfers ($12.4) and foreign currency translation adjustment ($-.6). (B) Inter-account transfers ($180.9) and foreign currency translation adjustment ($-5.3). (C) Inter-account transfers. (D) Inter-account transfers ($7.7) and foreign currency translation adjustment ($.3). (E) Timber depletion ($-28.9) and inter-account transfers ($1.7). (F) Inter-account transfers ($16.8), foreign currency translation adjustment ($-.4) and acquisitions ($1.6). (G) Inter-account transfers ($151.4), foreign currency translation adjustment ($-1.2) and acquisitions ($1.7). (H) Inter-account transfers ($3.2) and foreign currency translation adjustment ($-.3). (I) Timber depletion ($-21.4) and inter-account transfers ($1.1). (J) Inter-account transfers ($16.7), transfers from other assets ($5.6), and foreign currency translation adjustments ($-1.1) (K) Inter-account transfers ($115.9), transfers from other assets ($9.4) and foreign currency translation adjustments ($-4.4). (L) Inter-account transfers ($-138.1) and foreign currency translation adjustments ($-.4). (M) Inter-account transfers ($4.4), transfers from other assets ($3.3), and foreign currency translation adjustments ($-.4). (N) Timber depletion ($-20.4) and inter-account transfers ($1.1). For financial reporting purposes, depreciation, including amortization of capital leases, is calculated using the straight-line method over the estimated useful lives of the properties. The range of annual depreciation rates for assets used by Mead and its subsidiaries is as follows: Concrete and brick buildings . . . . . . . 2-1/2% - 3-1/3% Machinery and equipment . . . . . . . . . . 6-1/4% - 8-1/3% Office and laboratory equipment . . . . . . 10% - 20% Autos and trucks . . . . . . . . . . . . . 16-2/3% - 33-1/3% The rates used to determine timber depletion are based on projected quantities of timber available for cutting. THE MEAD CORPORATION EXHIBITS TO FORM 1O-K ANNUAL REPORT FOR THE YEAR ENDED DECEMBER 31, 1993 EXHIBIT INDEX Exhibit No. - - ------- (3) Articles of Incorporation and Bylaws: (i) Amended Articles of Incorporation of the Registrant adopted May 28, 1987 (incorporated by reference to Exhibit (3)(i) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (ii) Regulations of the Registrant, as amended April 23, 1987 (incorporated by reference to Exhibit (3)(ii) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (4) Instruments defining the rights of security holders, including indentures: (i) Credit Agreement dated as of November 15, 1989 with Bankers Trust Company, The First National Bank of Chicago, Morgan Guaranty Trust Company of New York and fifteen other banks (incorporated by reference to Exhibit (4)(i) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989) and Amendment No. 1 thereto dated as of November 30, 1991 (incorporated by reference to Exhibit (4)(i) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). (ii) Indenture dated as of July 15, 1982 between the Registrant and Bankers Trust Company, as Trustee, First Supplemental Indenture dated as of March 1, 1987 (incorporated by reference to Exhibit (4)(iv) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987), Second Supplemental Indenture dated as of October 15, 1989 (incorporated by reference to Exhibit (4) to Registrant's Current Report on Form 8-K dated October 11, 1989) and Third Supplemental Indenture dated as of November 15, 1991 (incorporated by reference to Exhibit (4)(ii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). (iii) Indenture dated as of February 1, 1993 between the Registrant and The First National Bank of Chicago, as Trustee (incorporated by reference to Exhibit (4)(iii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). The total amount of securities authorized under other long-term debt instruments does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. A copy of each such instrument will be furnished to the Commission upon request. (10) Material Contracts: (i) Agreement dated as of April 24, 1964 between Northwood Mills Limited, Canamead, Inc., the Registrant and Noranda Mines, Limited and Supplemental Agreements relating thereto dated as of July 2, 1964, April 5, 1965, March 15, 1966, February 1, 1967, December 15, 1970 and April 1, 1974 (incorporated by reference to Exhibit (10)(v) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1980 included in File No. 1-2267 in the Public Reference Room of the Securities and Exchange Commission in Washington, D.C.). (ii) Pulp Purchase Agreement dated as of April 1, 1965 among Northwood Pulp Limited, the Registrant, Northwood Mills Ltd. and Noranda Mines Limited (incorporated by reference to Exhibit (10)(vi) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1980 included in File No. 1-2267 in the Public Reference Room of the Securities and Exchange Commission in Washington, D.C.). (iii) Rights Agreement dated as of November 1, 1986 between Registrant and The First National Bank of Cincinnati, as Rights Agent, as amended December 29, 1987 and December 9, 1988 (incorporated herein by reference to Registrant's Amendment No. 1 on Form 8, dated November 28, 1986 and Exhibits 28(a) and 28(b) to Registrant's Current Report on Form 8-K dated December 9, 1988). (iv) Amended Board Purchase Agreement dated as of January 4, 1988 among the Registrant, Georgia Kraft Company and Inland Container Corporation (incorporated by reference to Exhibit (1O)(xviii) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (v) Indemnification Agreement dated as of January 4, 1988 among the Registrant, Mead Coated Board, Inc., Temple-Inland Inc., Inland Container Corporation I, Inland Container Corporation, GK Texas Holding Company and Georgia Kraft Company (incorporated by reference to Exhibit (1O)(xix) of Registrant's Annual Report on Form 1O-K for the year ended December 31, 1987). (vi) Lease Agreement between The Industrial Development Board of the City of Phenix City, Alabama and Mead Coated Board, Inc., dated as of December 1, 1988, as amended (incorporated by reference to Exhibit (10)(xviii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 and Exhibit (10)(xviii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). The following are compensatory plans and arrangements in which directors or executive officers participate: (vii) 1984 Stock Option Plan of the Registrant, as amended and restated as of January 25, 1990 (incorporated by reference to Exhibit (10)(v) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989), and Amendment dated January 23, 1992 (incorporated by reference to Exhibit 10(iv) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). (viii) 1991 Stock Option Plan of the Registrant (incorporated by reference to Exhibit (10)(xxi) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (ix) Incentive Compensation Election Plan of the Registrant as amended November 17, 1987 (incorporated by reference to Exhibit (10)(viii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), as amended October 29, 1988 (incorporated by reference to Exhibit (10)(vi) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (x) 1985 Supplement to Registrant's Incentive Compensation Election Plan, as amended November 17, 1987 (incorporated by reference to Exhibit (1O)(xi) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985 and Exhibit (10)(ix) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), and as further amended October 29, 1988 (incorporated by reference to Exhibit (10)(vii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (xi) Excess Benefit Plan of the Registrant (1988 Restatement), dated October 29, 1988 (incorporated by reference to Exhibit (10)(vii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (xii) Supplemental Executive Retirement Plan (formerly The Mead Management Income Parity Plan) effective January 1, 1985, as amended and restated as of July 1, 1992 (incorporated by reference to Exhibit (10)(xiii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). (xiii) Form of Indemnification Agreement between Registrant and each of Samuel S. Benedict, John C. Bogle, John G. Breen, Vincent L. Gregory, Jr., William E. Hoglund, Barbara C. Jordan, Steven C. Mason, Charles S. Mechem, Jr., Paul F. Miller, Jr., William S. Shanahan, Thomas B. Stanley, Jr. and Lee J. Styslinger, Jr. (incorporated herein by reference to Exhibit (10)(xiv) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1986). (xiv) Form of Severance Agreement between Registrant and each of Steven C. Mason and Samuel S. Benedict (incorporated herein by reference to Exhibit (10)(xvi) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1986 and Exhibit (10)(xii) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (xv) Form of Severance Agreement between Registrant and each of William R. Graber, Elias M. Karter, Charles J. Mazza, Wallace 0. Nugent, Thomas E. Palmer and other key employees (incorporated by reference to Exhibit (10)(xiii) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). (xvi) Benefit Trust Agreement dated January 9, 1987 between Registrant and Society Bank, National Association (incorporated herein by reference to Exhibit (1O)(xviii) to Registrant's Annual Report on Form 1O-K for the year ended December 31, 1986), as amended October 29, 1988 (incorporated by reference to Exhibit (10)(xiv) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988) and January 24, 1991 (incorporated by reference to Exhibit (10)(xiii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (xvii) Restricted Stock Plan effective December 10, 1987, as amended through July 23, 1992 (incorporated by reference to Exhibit (10)(xviii) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). (xviii) Deferred Compensation Plan for Directors of the Registrant, as amended through October 29, 1988 (incorporated by reference to Exhibit (10)(xix) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). (xix) 1985 Supplement to Registrant's Deferred Compensation Plan for Directors, as amended through October 29, 1988 (incorporated by reference to Exhibit (10)(xx) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989). (xx) Directors Retirement Plan, effective October 27, 1990 (incorporated by reference to Exhibit (10)(xx) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). (xxi) Form of Executive Life Insurance Policy for Key Executives (incorporated by reference to Exhibit (10) of Registrant's Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 1991). (xxii) The "Direction 2000" Executive Incentive Plan, dated April 21, 1993 (incorporated by reference to Exhibit 10(i) of Registrant's Quarterly Report on Form 10-Q for the Quarterly Period Ended April 4, 1993). (xxiii) Mead Management Incentive Plan for 1993 (incorporated by reference to Exhibit 10(ii) of Registrant's Quarterly Report on Form 10-Q for the Quarterly Period Ended April 4, 1993). (11) Calculation of Earnings per Share. (12) Ratio of Earnings to Fixed Charges. (21) List of significant subsidiaries of the Registrant. (23) Consent of Independent Auditors.

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Item 1. Business. Sears DC Corp. ("SDC"), a wholly-owned subsidiary of Sears, Roebuck and Co. ("Sears") organized under the laws of Delaware in January 1987, was formed to borrow in domestic and foreign debt markets and lend the proceeds of such borrowings to direct and indirect subsidiaries of Sears ("SDC borrowers") in exchange for unsecured notes. SDC raised funds through the sale of its medium-term notes and direct placement of commercial paper with corporate and institutional investors. Commercial paper was sold by Sears Roebuck Acceptance Corp., an affiliate of SDC, as agent, with expenses, but no fees, being paid by SDC. Historically, the proceeds of SDC's borrowings were loaned to Sears Consumer Financial Corporation of Delaware ("SCFCD"), a wholly- owned subsidiary of Dean Witter, Discover & Co. ("DWDC"), to finance the accounts receivable generated by the Discover Card and consumer installment notes receivable. However, as a result of the strategic repositioning of Sears, the business of SDC changed significantly. In the last quarter of 1992, SDC stopped selling medium-term notes. On March 1, 1993, DWDC, until then a wholly-owned subsidiary of Sears, completed the sale of 19.9% of its outstanding capital stock through a primary initial public offering. Also in March 1993, SDC discontinued issuing commercial paper, and was repaid by SCFCD the amounts outstanding and owing to SDC. In June of 1993, Sears spun-off its 80.1% ownership interest in DWDC to Sears shareholders. On March 9, 1993, SDC entered into a loan agreement with Sears for the investment of funds received upon the prepayment of the notes of SCFCD. The interest rate paid to SDC by Sears under this agreement is designed to produce earnings sufficient to cover SDC's fixed charges (principally interest on SDC's indebtedness) at least 1.005 times (reduced from the previous amount of 1.25 times in March 1994, since SDC is no longer actively involved in new financing). Required payments of principal and interest to SDC under the Sears borrowing agreement will be sufficient to allow SDC to make timely payments of principal and interest to the holders of its securities. The Net Worth Maintenance Agreement between Sears and SDC is still in effect for the benefit of holders of debt securities issued by SDC. This agreement provides for Sears to maintain ownership of and positive stockholder's equity in SDC. At February 28, 1994, SDC had no employees on its payroll and its officers and directors consisted of employees of affiliated companies. Its offices are located at 3711 Kennett Pike, Greenville, Delaware 19807. Effective May 26, 1993, SDC changed its name from Discover Credit Corp. Item 2. Item 2. Properties. None. Item 3. Item 3. Legal Proceedings. None. 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. There is no established public trading market for SDC's common stock. As of February 28, 1994, Sears owned all outstanding shares of SDC's common stock. The Board of Directors of SDC declared a $167.4 million dividend on December 20, 1993 to Sears, payable on December 30, 1993. The Board also approved payment to Sears on December 30, 1993 of $319.1 million out of Capital in Excess of Par Value; such payment is characterized as a dividend under the Delaware General Corporation Law. Payment was effected by reducing SDC's investment in the Notes of Sears by $486.5 million. 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. Financial Condition On March 15, 1993, SDC received funds from DWDC's initial public offering, and a concurrent debt issuance, through SCFCD in amounts sufficient to repay the balances on the notes of SCFCD. SDC used these funds to repay short-term borrowings and current maturities of medium-term notes. SDC invested the remainder of these funds in the promissory notes of Sears, which pay interest sufficient to cover SDC's fixed charges 1.005 times, and in highly liquid short-term investments. As of December 31, 1993, the remaining proceeds of $2.2 billion were fully invested in the notes of Sears. SDC intends to use these funds to repay the maturities of its medium-term notes. In March 1993, SDC discontinued issuing commercial paper. The last of SDC's commercial paper matured in October 1993. SDC had discontinued the sale of medium-term notes in the last quarter of 1992. The $2.2 billion in outstanding medium-term notes as of December 31, 1993 are not redeemable prior to their stated maturity except for notes having a stated maturity at the time of issue of more than seven years which may be redeemed under certain circumstances in the event of declining Discover Card receivables. The financial information appearing in this annual report on Form 10-K is presented in historical dollars which do not reflect the decline in purchasing power that results from inflation. As is the case for most financial companies, substantially all of SDC's assets and liabilities are monetary in nature. Interest rates on SDC's investment in Sears notes are set to provide for a fixed charge coverage of at least 1.005. This maintenance mechanism insulates SDC from bearing the effects of inflation-based interest rate increases. Results of Operations Due to the significant reduction in the company's outstanding debt, interest and related expenses decreased 19.5% to $190.6 million in 1993 from $236.6 million in 1992. The company's net income remained at approximately the same level for both years primarily because the rate on Sears notes in the third quarter was not adjusted until after the end of the third quarter. Earnings covered fixed charges 1.32 times for 1993 compared to 1.25 times in 1992 and 1991. Item 8. Item 8. Financial Statements and Supplementary Data. SEARS DC CORP. STATEMENTS OF INCOME Year Ended December 31, millions 1993 1992 1991 ------- ------- ------- Revenues Earnings on notes of Sears $196.9 $ - $ - Earnings on notes of SCFCD 52.6 289.4 345.7 Earnings on invested cash 2.7 8.8 14.1 ------- ------- ------- Total revenues 252.2 298.2 359.8 Expenses Interest and related expense 190.6 236.6 285.4 Operating expenses 1.5 1.9 2.2 ------- ------- ------- Total expenses 192.1 238.5 287.6 ------- ------- ------- Income before income taxes 60.1 59.7 72.2 Income taxes 21.0 20.3 24.5 ------- ------- ------- Net Income $39.1 $39.4 $47.7 ------- ------- ------- Ratio of earnings to fixed charges 1.32 1.25 1.25 See notes to financial statements. SEARS DC CORP. STATEMENTS OF FINANCIAL POSITION December 31, millions 1993 1992 ------- ------- Assets Notes of Sears $2,194.4 $ - Notes of SCFCD - 4,622.4 Cash and invested cash 0.1 85.4 Accrued interest and other assets 5.6 39.7 ------- -------- Total assets $2,200.1 $4,747.5 ------- -------- Liabilities Commercial paper (net of unamortized discount of $6.5) $ - $1,840.0 Medium-term notes 2,147.8 2,405.4 Accrued interest and other liabilities 48.5 50.9 ------- -------- Total liabilities 2,196.3 4,296.3 ------- -------- Stockholder's Equity Capital stock, par value $1.00 per share 1,000 shares authorized,issued and outstanding - - Capital in excess of par value - 319.1 Retained income 3.8 132.1 ------- -------- Total stockholder's equity 3.8 451.2 ------- -------- Total liabilities and stockholder's equity $2,200.1 $4,747.5 ------- -------- See notes to financial statements. SEARS DC CORP. STATEMENTS OF STOCKHOLDER'S EQUITY Year Ended December 31, millions 1993 1992 1991 -------- -------- -------- Capital stock $ - $ - $ - -------- -------- -------- Capital in excess of par value Beginning of year $319.1 $319.1 $319.1 Return of capital paid to Sears (319.1) - - -------- -------- -------- End of year $ - $319.1 $319.1 -------- -------- -------- Retained income Beginning of year $132.1 $ 92.7 $ 87.5 Net income 39.1 39.4 47.7 Dividend paid to Sears (167.4) - (42.5) -------- -------- -------- End of year $ 3.8 $132.1 $ 92.7 -------- -------- -------- Total stockholder's equity $ 3.8 $451.2 $411.8 -------- -------- -------- See notes to financial statements. SEARS DC CORP. STATEMENTS OF CASH FLOWS Year Ended December 31, millions 1993 1992 1991 ------- ------- ------- Cash Flows From Operating Activities Net income $39.1 $ 39.4 $ 47.7 Adjustments to reconcile net income to net cash provided by operating activities Net change in other assets and other liabilities 31.7 (.7) 24.2 ------- ------- ------- Net cash provided by operating activities 70.8 38.7 71.9 Cash Flows From Investing Activities Decrease(increase) in notes of SCFCD 4,622.4 (914.9) 236.7 Increase in notes of Sears (2,680.9) - - -------- -------- --------- Net cash provided by (used in) investing activities 1,941.5 (914.9) 236.7 Cash Flows From Financing Activities Decrease in commercial paper, primarily 90 days or less (1,840.0) (225.5) (1,339.6) Proceeds from medium-term notes - 1,501.0 1,178.5 Repayments of medium-term notes (257.6) (405.4) (3.8) Proceeds from subordinated note to Sears - - 7.0 Repayments of subordinated note to Sears - - (17.0) Dividends paid to Sears - - (42.5) --------- --------- -------- Net cash (used in) provided by financing activities (2,097.6) 870.1 (217.4) --------- --------- -------- Net (decrease) increase in cash and invested cash (85.3) (6.1) 91.2 Cash and invested cash, beginning of year 85.4 91.5 0.3 --------- --------- --------- Cash and invested cash, end of year $ 0.1 $ 85.4 $ 91.5 --------- --------- --------- Supplemental Disclosure of Cash Flow Information Cash paid during the year Interest $181.7 $230.5 $250.8 Income taxes 32.1 13.1 25.5 See notes to financial statements. NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Sears DC Corp. ("SDC"), a wholly owned subsidiary of Sears, Roebuck and Co. ("Sears"), was principally engaged in the borrowing in domestic and foreign debt markets and lending the proceeds of such borrowings to certain direct and indirect subsidiaries of Sears in exchange for their unsecured notes. Effective May 26, 1993, the company's name was changed to Sears DC Corp. from Discover Credit Corp. Historically, the proceeds of SDC's borrowings were loaned to Sears Consumer Financial Corporation of Delaware ("SCFCD"), a wholly-owned subsidiary of Dean Witter, Discover & Co. ("DWDC"), to finance the accounts receivable generated by the Discover Card and consumer installment notes receivable. However, as a result of the strategic repositioning of Sears, the business of SDC changed significantly. In the last quarter of 1992, SDC stopped selling medium-term notes. On March 1, 1993, DWDC, until then a wholly-owned subsidiary of Sears, completed the sale of 19.9% of its outstanding capital stock through a primary initial public offering. Sears spun-off its 80.1% ownership interest in DWDC to Sears shareholders in June 1993. Also in March 1993, SDC discontinued issuing commercial paper, and was repaid by SCFCD the amounts outstanding and owing to SDC. On March 9, 1993, SDC entered into a loan agreement with Sears for the investment of funds received upon the prepayment of the notes of SCFCD. The interest rate paid to SDC by Sears under this agreement is designed to produce earnings sufficient to cover SDC's fixed charges (principally interest on SDC's indebtedness) at least 1.25 times. On March 22, 1994, the agreement was amended to reduce the fixed charge coverage to 1.005. Required payments of principal and interest to SDC under the Sears borrowing agreement will be sufficient to allow SDC to make timely payments of principal and interest to the holders of its securities. Cash and invested cash is defined to include all highly liquid investments with maturities of three months or less. The return of capital and dividend totalling $486.5 million paid to Sears in 1993 were effected through a non-cash transaction as a reduction in SDC's investment in Sears Notes. The results of operations of SDC are included in the consolidated federal income tax return of Sears. Tax liabilities and benefits are allocated as generated by SDC, whether or not such benefits would be currently available on a separate return basis. Taxes are provided based on the statutory federal income tax rate. Effective January 1, 1992, SDC adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The adoption of the standards did not have a material impact on the financial statements of SDC, and will have no effect on the future cash flows of the Company. 2. BORROWINGS Historically, SDC obtained funds through the direct placement of commercial paper (issued in maturities of one to 270 days) and the sale of medium-term notes. The medium-term notes are not redeemable except for notes having a stated maturity at the time of issue of more than seven years which may be redeemed under certain circumstances in the event of declining Discover Card receivables. At December 31, 1993, the fair market value of medium-term notes, carried at $2,147.8 million, was $2,297.5 million based on discounted cash flows using interest rates of comparable borrowings. Selected details of SDC's borrowings are shown below. Weighted average interest rates are based on the actual number of days in the year and borrowings net of unamortized discount. December 31, millions 1993 1992 -------- -------- Commercial paper outstanding $ - $1,846.5 Less: Unamortized discount - 6.5 -------- -------- Commercial paper outstanding (net) - 1,840.0 3.24% to 9.26% medium-term notes due 1993-2012 2,147.8 2,405.4 -------- -------- Total borrowings $2,147.8 $4,245.4 -------- -------- 1993 1992 ------------------- -------------------- Maximum Maximum millions Average (month-end) Average (month-end) ------------------- -------------------- Commercial paper outstanding $546.8 $1,781.8 $2,135.8 $2,542.1 Average Year-End Average Year-end ------------------- -------------------- Weighted Interest Rates 4.02% - 3.99% 4.17% At December 31, 1993, medium-term note maturities for the next five years were as follows: 1994 $ 626.4 1995 292.7 1996 449.8 1997 335.1 1998 111.3 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. Not applicable. Item 11. Item 11. Executive Compensation. Not applicable. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Not applicable. Item 13. Item 13. Certain Relationships and Related Transactions. Not applicable. 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. An "Index to Financial Statements" has been filed as a part of this report on page S-1 hereof. 2. No financial statement schedules are included herein because they are not required or because the information is contained in the financial statements and notes thereto, as noted in the "Index to Financial Statements" filed as part of this report. 3. An "Exhibit Index" has been filed as part of this report beginning on page E-1 hereof. (b) Reports on Form 8-K: A report on Form 8-K was filed by the Registrant dated December 20, 1993 (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. SEARS DC CORP. (Registrant) By Paul D. Melancon* Vice President and Controller 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 date indicated. Signature Title Date Alice M. Peterson* Director, President and ) Chief Executive Officer ) (Principal Executive ) Officer) ) ) ) Paul D. Melancon* Vice President and Controller ) March 30, 1994 (Principal Accounting ) Officer) ) ) Larry R. Raymond* Vice President and Treasurer ) (Principal Financial Officer)) ) James A. Blanda* Director ) ) James D. Constantine* Director ) ) Michael W. Phillips* Director ) *By /s/ PAUL D. MELANCON Individually and as Attorney-in-Fact Paul D. Melancon SEARS DC CORP. YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 PAGE STATEMENTS OF INCOME 5 STATEMENTS OF FINANCIAL POSITION 6 STATEMENTS OF STOCKHOLDER'S EQUITY 7 STATEMENTS OF CASH FLOWS 8 NOTES TO FINANCIAL STATEMENTS 9-10 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS S-2 S-1 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Stockholder and Board of Directors of Sears DC Corp. Greenville, Delaware We have audited the accompanying Statements of Financial Position of Sears DC Corp. (formerly Discover Credit Corp.) (a wholly owned subsidiary of Sears, Roebuck and Co.) as of December 31, 1993 and 1992, and the related Statements of Income, 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 financial statements present fairly, in all material respects, the financial position of Sears DC Corp. 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. DELOITTE & TOUCHE February 11, 1994 Philadelphia, Pennsylvania S-2 EXHIBIT INDEX 3(a) Certificate of Incorporation of Discover Credit Corp. dated January 9, 1987 [Incorporated by reference to Exhibit 3(a) to Form 10 of the Registrant (Form 10)*] 3(b) Amendment to Certificate of Incorporation of Discover Credit Corp. dated April 9, 1987 [Incorporated by reference to Exhibit 3(b) to Form 10*] 3(c) By-laws of Discover Credit Corp., as amended to May 22, 1992 [Incorporated by reference to Exhibit 3(c) to Annual Report on Form 10-K of the Registrant for the year ended December 31, 1992*] 4(a) Net Worth Maintenance Agreement between Discover Credit Corp. and Sears, Roebuck and Co., dated as of November 13, 1987 [Incorporated by reference to Exhibit 4 to Form 10*] 4(b) $1,850,000,000 Credit Agreement dated as of June 23, 1992, among Discover Credit Corp., the Banks Listed therein, The Lead Managers Referred to therein, The Co-Agents Referred to therein, and Chemical Bank, as Agent [Incorporated by reference to Exhibit 4(b) to Quarterly Report of the Registrant on Form 10-Q for the quarter ended June 30, 1992*] 4(c) Indenture, dated as of January 30, 1990, between Disc Credit Corp. and Bank of Delaware, as Trustee [Incorporated by reference to Exhibit 4 to Amendment No. 1 to Registration Statement No. 33-30807] 4(d) Supplemental Indenture dated as of April 30, 1990 between Discover Credit Corp. and Bank of Delaware as Trustee [Incorporated by reference to Exhibit 4 to the Registrant's Quarterly Report on Form 10-Q for the Quarter Ended June 30, 1990*] 4(e) Forms of fixed rate Medium-Term Note and floating rate Medium-Term Note [Incorporated by reference to Exhibits 4.1 and 4.2 to Current Report on Form 8-K of the Registrant dated February 9, 1990*] 4(f) Indenture, dated as of June 1, 1991 between Discover Credit Corp. and Bank of Delaware as Trustee [Incorporated by reference to Exhibit 4 to Registration Statement No. 33-40056] 4(g) Forms of fixed rate Medium-Term Note Series II and floating rate Medium-Term Note Series II [Incorporated by refere Exhibits 4.2 and 4.3 to Current Report on Form 8-K of the Registrant dated June 20, 1991*] 4(h) Indenture, dated as of February 15, 1992, between Discover Credit Corp. and Harris Trust Company of New York [Incorporated by reference to Exhibit 4.1 to Current Report on Form 8-K of the Registrant dated February 28, 1992*] ____________________________ * SEC File No. 0-17955 E-1 EXHIBIT INDEX 4(i) Forms of fixed rate Medium Term Note Series III and floating rate Medium Term Note Series III [Incorporated by reference to Exhibits 4.2 and 4.3 to Current Report on Form 8-K of the Registrant dated February 28, 1992*] 4(j) First Amendment dated as of May 28, 1993 to the $1.85 billion Credit Agreement dated as of June 23, 1993 among the Registrant, the banks listed on the signature page thereof, the lead managers and co-agents referred to therein, and Chemical Bank, as agent. [Incorporated by reference to Exhibit 4(b) to Quarterly Report on Form 10-Q of the Registrant for the Quarter Ended June 30, 1993*] 4(k) Termination Letter dated as of August 20, 1993 to the $1.85 Billion Credit Agreement dated as of June 23, 1992 among the Registrant, the banks listed on the signature page thereof, the lead managers and co-agents referred to therein, and Chemical Bank as agent. [Incorporated by reference to Exhibit 4(b) to Quarterly Report on Form 10-Q of the Registrant for the Quarter Ended September 30, 1993*] 4(l) The Registrant hereby agrees to furnish the Commission, upon request, with each instrument defining the rights of holders of long-term debt of the Registrant with respect to which the total amount of securities authorized does not exceed 10 percent of the total assets of the Registrant. 10(a) Letter Agreement dated March 9, 1993 between Sears, Roebuck and Co. and Discover Credit Corp. [Incorporated by reference to Exhibit 10(g) to Annual Report on Form 10-K of the Registrant for the year ended December 31, 1992*] 10(b) Amendment dated March 22, 1994 to Letter Agreement dated March 9, 1993 between Sears, Roebuck and Co. and Discover Credit Corp.** 12 Calculation of ratio of earnings to fixed charges** 23 Consent of Deloitte & Touche** 24 Power of attorney** 28(a) Current Report on Form 8-K of Sears, Roebuck and Co., for January 11, 1994 [Incorporated by reference, File No. 1-416] 28(b) Current Report on Form 8-K of Sears, Roebuck and Co., for February 1, 1994 [Incorporated by reference, File No. 1-416] 28(c) Current Report on Form 8-K of Sears, Roebuck and Co., for March 9, 1994 [Incorporated by reference, File No. 1-416] ____________________________ * SEC File No. 0-17955 ** Filed herewith E-2 EXHIBIT INDEX 28(d) Current Report on Form 8-K of Sears, Roebuck and Co., for March 21, 1994 [Incorporated by reference, File No. 1-416] 28(e) Annual Report on Form 10-K of Sears, Roebuck and Co. for the year ended December 31, 1993 [Incorporated by reference, File No. 1-416] ____________________________ * SEC File No. 0-17955 ** Filed herewith E-3 Exhibit 10(b) SEARS, ROEBUCK AND CO. SEARS TOWER CHICAGO, ILLINOIS 60684 March 22, 1994 Sears DC Corp. 3711 Kennett Pike Greenville, DE 19807 Gentlemen: We refer to the letter agreement relating to certain borrowing arrangements between Sears DC Corp. (formerly "Discover Credit Corp.") and Sears, Roebuck and Co. dated March 9, 1993. We confirm that the figure "1.25" referred to in paragraph 3.a of said letter agreement is amended to read "1.005", effective as of the date hereof. Otherwise than as specifically amended hereby, said letter agreement remains in full force and effect. Please indicate your acceptance of this amendment by the signature of a duly authorized officer in the space provided below and on the duplicate original of this letter which is enclosed. Very truly yours, SEARS, ROEBUCK AND CO. By /S/ ALICE M. PETERSON Alice M. Peterson Vice President and Treasurer SEARS DC CORP. By /S/ LARRY R. RAYMOND Larry R. Raymond Vice President and Treasurer Exhibit 12 SEARS DC CORP. CALCULATION OF RATIO OF EARNINGS TO FIXED CHARGES millions Year Ended December 31 1993 1992 1991 NET INCOME $ 39.1 $ 39.4 $ 47.7 INCOME TAXES 21.0 20.3 24.5 FIXED CHARGES, INTEREST AND RELATED CHARGES 190.6 236.6 285.4 (i) EARNINGS AVAILABLE FOR FIXED CHARGES 250.7 296.3 357.6 (ii) FIXED CHARGES 190.6 236.6 285.4 RATIO OF EARNINGS TO FIXED CHARGES (i/ii) 1.32 1.25 1.25 Exhibit 23 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS We consent to the incorporation by reference in Registration Statement Nos. 33- 30807, 33-40056 and 33-44671 of Sears DC Corp. (formerly Discover Credit Corp.) of our report dated February 11, 1994 appearing in this Annual Report on Form 10-K of Sears DC Corp. for the year ended December 31, 1993. DELOITTE & TOUCHE Philadelphia, Pennsylvania March 28, 1994 Exhibit POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each of the undersigned, being a director or officer, or both, of SEARS DC CORP., a Delaware corporation (the "Corporation"), does hereby constitute and appoint JAMES A. BLANDA, ALICE M. PETERSON, LARRY R. RAYMOND, PAUL D. MELANCON, RICHARD F. KOTZ and KEITH E. TROST, with full power to each of them to act alone, as the true and lawful attorneys and agents of the undersigned, with full power of substitution and resubstitution to each of said attorneys, to execute, file and deliver any and all instruments and to do any and all acts and things which said attorneys and agents, or any of them, deem advisable to enable the Corporation to comply with the Securities Exchange Act of 1934, as amended, and any requirements of the Securities and Exchange Commission in respect thereto, relating to annual reports on Form 10-K, including specifically, but without limitation of the general authority hereby granted, the power and authority to sign his name in the name and on behalf of the Corporation or as a director or officer, or both, of the Corporation, as indicated below opposite his signature, to annual reports on Form 10-K or any amendment or papers supplemental thereto; and each of the undersigned does hereby fully ratify and confirm all that said attorneys and agents, or any of them, or the substitute of any of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, each of the undersigned has subscribed these presents, as of this 25th day of March, 1994. NAME TITLE /S/ ALICE M. PETERSON Director, President and Alice M. Peterson Chief Executive Officer (Principal Executive Officer) /S/ LARRY R. RAYMOND Vice President and Treasurer Larry R. Raymond (Principal Financial Officer) /S/ PAUL D. MELANCON Vice President and Controller Paul D. Melancon (Principal Accounting Officer) NAME TITLE /S/ JAMES A. BLANDA Director James A. Blanda /S/ JAMES D. CONSTANTINE Director James D. Constantine

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Item 2. Properties ----------- The following is a summary by industry segment of the properties occupied by the Company. All plants are of adequate capacity and are utilized generally on a one-shift basis. The Winsted, CT facility of the Waring Products Division is utilized as a records storage facility and is also available for sale. Approximately 66,000 square feet of the Scranton, PA facility of the Anemostat Products Division has been leased on a short-term basis. Approximately 40,000 square feet of the New Hartford, CT facility of the Waring Products Division is available for lease. Discontinued Operations: - ------------------------ The following property, previously operated by the Company, is being held for sale or disposition by the Company: The above property is currently subleased on a short-term basis. The following property, which continues to be occupied and operated by the Fermont Division, a discontinued operation, is held for sale in connection with the sale of the business. Item 3. Item 3. Legal Proceedings ----------------- With respect to claims and actions against the Company, including environmental matters, it is the opinion of Management that they will have no material effect on the financial position of the Company. Item 4. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- Not applicable The officers named above were elected to hold the offices set opposite their respective names until the meeting of directors following the next annual meeting of shareholders. Edward J. Mooney terminated his employment on December 31, 1993, retired under the Company's pension plan and became a consultant to the Company until his death on February 7, 1994. Henry V. Kensing was elected Secretary of the Corporation by the Board of Directors on February 23, 1994. Except as above stated, the officers named above have served in their respective capacities for the past five years. There are no family relationships between any directors or executive officers of the Company. Part II Item 5. Item 5. Market for the Registrant's Common Stock and Related ---------------------------------------------------- Security Holder Matters ----------------------- Range of Stock Prices and Dividend Information on page 23 of the annual report to security holders for the year ended December 31, 1993 is incorporated herein by reference. Item 6. Item 6. Selected Financial Data ----------------------- Selected Financial Data on page 21 of the annual report to security holders 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 ----------------------------------- Management's Discussion and Analysis of Results of Operations and Financial Condition on pages 4 through 6 of the annual report to security holders for the year ended December 31, 1993 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 are included in the annual report to security holders for the year ended December 31, 1993 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 Item 10. Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- Identification of directors of the registrant and information related thereto is included in the definitive proxy statement for the Annual Meeting of Shareholders to be held on May 6, 1994, under caption "Election of Directors", and said information is incorporated herein by reference. Identification of executive officers of the registrant and information related thereto is included in Part I of this Form 10-K. Item 11. Item 11. Executive Compensation ---------------------- Remuneration of directors and officers and information related thereto is included in the definitive proxy statement for the Annual Meeting of Shareholders to be held on May 6, 1994, under the captions "Election of Directors", including information on the Stock Retirement Plan for Outside Directors, "Executive Compensation", "Pension Benefits", "Savings and Investment Plan" and "1980 Restricted Stock and Cash Bonus Plan", and said information is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and --------------------------------------------------- Management ---------- Security ownership of management and of certain beneficial owners and information related thereto is included in the definitive proxy statement for the Annual Meeting of Shareholders to be held May 6, 1994, under the captions "Election of Directors" and "Security Ownership of Certain Beneficial Owners", and said information is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions ---------------------------------------------- Not applicable. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on ------------------------------------------------------ Form 8-K -------- (a)(1) The report of independent auditors and the following consolidated financial statements of the registrant and its subsidiaries included in the annual report to security holders for the year ended December 31, 1993 are incorporated by reference in Item 8 above: Consolidated Balance Sheets-- As of December 31, 1993 and 1992 Consolidated Statements of Operations-- 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 Consolidated Statements of Cash Flows-- For the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (a)(2) and(d) The following consolidated financial statement schedules of the registrant and its subsidiaries are included in this Form 10-K. Page(s) ------- Schedule VIII--Valuation and Qualifying Accounts--For the Years Ended December 31, 1993, 1992 and 1991 15-17 Schedule X--Supplementary Income Statement Information-- For the Years Ended December 31, 1993, 1992 and 1991 18 The consolidated financial statements of CTS Corporation, the registrant's investment in which is accounted for by the equity method, are subject to the Rules and Regulations of the Securities and Exchange Commission and have been examined by Price Waterhouse, independent accountants for CTS Corporation. The following consolidated financial statement information and schedules concerning CTS Corporation, which are included in CTS Corporation's annual report on Form 10-K for the year ended December 31, 1993, certain consolidated financial statement schedules included in said Form 10-K and CTS Corporation's annual report to stockholders for 1993 attached to said Form 10-K as Exhibit 13 thereto (all of which are included as Exhibit 28 to this Form 10-K), are incorporated by reference herein. The above financial statement information and schedules concerning CTS Corporation incorporated herein by reference were furnished to the registrant by CTS Corporation and were used by the registrant as the basis of recording registrant's net income (loss) from its equity investment in CTS Corporation, and the amounts of income (loss) included in registrant's financial statements are based solely on the aforesaid CTS Corporation financial statement information and schedules and report of Price Waterhouse, independent accountants for CTS Corporation. 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 not applicable, and therefore have been omitted, or the information is included in the consolidated financial statements, or notes thereto, of registrant or of CTS Corporation incorporated by reference herein. (a) (3) and (c) Exhibits -------- The response to this portion of Item 14 appears on the Exhibits Index in a separate section of this Form 10-K on pages 19 and 20. (b) Reports on Form 8-K ------------------- There were no reports on Form 8-K filed for the three months 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. DYNAMICS CORPORATION OF AMERICA - ------------------------------- /S/ Patrick J. Dorme March 30, 1994 - ------------------------------------------- (Signature) Patrick J. Dorme - 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 date indicated. /S/ Andrew Lozyniak March 30, 1994 - --------------------------------------- Andrew Lozyniak - Chairman of the Board and President /S/ Henry V. Kensing March 30, 1994 - --------------------------------------- Henry V. Kensing - Director, Vice President, General Counsel and Secretary /S/ Patrick J. Dorme March 30, 1994 - --------------------------------------- Patrick J. Dorme - Director, Vice President- Finance and Chief Financial Officer /S/ Harold Cohan March 30, 1994 - --------------------------------------- Harold Cohan - Director /S/ Frank A. Gunther March 30, 1994 - --------------------------------------- Frank A. Gunther - Director /S/ Russell H. Knisel March 30, 1994 - --------------------------------------- Russell H. Knisel - Director /S/ Saul Sperber March 30, 1994 - --------------------------------------- Saul Sperber - Director /S/ M. Gregory Bohnsack March 30, 1994 - --------------------------------------- M. Gregory Bohnsack - Corporate Controller and Principal Accounting Officer CONSENT OF INDEPENDENT AUDITORS ------------------------------- To the Board of Directors and Stockholders Dynamics Corporation of America We consent to the incorporation by reference in this Annual Report (Form 10-K) of Dynamics Corporation of America of our report dated February 22, 1994, included in the 1993 Annual Report to Stockholders of Dynamics Corporation of America. Our audits also included the financial statement schedules of Dynamics Corporation of America listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. 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 set forth therein. ERNST & YOUNG Stamford, Connecticut February 22, 1994 DYNAMICS CORPORATION OF AMERICA AND SUBSIDIARIES DYNAMICS CORPORATION OF AMERICA AND SUBSIDIARIES DYNAMICS CORPORATION OF AMERICA AND SUBSIDIARIES DYNAMICS CORPORATION OF AMERICA AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION For The Years Ended December 31, 1993, 1992 and 1991 (in thousands) Column A Column B -------- -------- Charged to Costs Item and Expenses ---- ------------------------ 1993 1992 1991 ---- ---- ---- Maintenance and repairs $1,186 $1,244 $1,381 ------ ------ ------ Advertising costs $3,130 $3,249 $2,257 ------ ------ ------ The above information pertains to the continuing operations of the Company. All other items required by this schedule were omitted as amounts constitute less than one percent of net sales or are disclosed elsewhere in this Annual Report on Form 10-K. Exhibits Index -------------- Item 14. (a) (3) and (c) Pursuant to Regulation S-K, Item 601, following is a list of Exhibits: (A) Exhibits incorporated by reference. Exhibit 4 - Instruments defining the rights of security holders: 1. The rights of common stockholders and preferred stockholders (currently unissued) are defined in the Articles of Incorporation referred to in Exhibit 3 and in the Form 8A for registration of certain classes of securities (Rights and Preferred Stock), Rights Agreement dated as of January 30, 1986, Summary of Rights, letter to stockholders, press release and Listing Application to the New York Stock Exchange with respect to the Rights, all of which were included in the Exhibits of the registrant's Form 10-Q Quarterly Report for the period ended March 31, 1986. Exhibit 10 - Material contracts: Management Compensatory Plans, Contracts and Arrangements --------------------------------------------------------- 1. 1980 Restricted Stock and Cash Bonus Plan, as amended, was included in the registrant's definitive proxy statement for the Annual Meeting of Shareholders on May 6, 1988. 2. Employment contracts dated February 1, 1991 with: Andrew Lozyniak - Chairman of the Board and President; Edward J. Mooney - Vice Chairman of the Board, Vice President and Secretary; Patrick J. Dorme - Vice President-Finance and Chief Financial Officer and Henry V. Kensing - Vice President and General Counsel were included in the Exhibits of the registrant's Form 10-K Annual Report for the year ended December 31, 1990. 3. Stock Retirement Plan for Outside Directors, as amended, was included in the registrant's definitive proxy statement for the Annual Meeting of Shareholders on May 1, 1992. 4. Incentive Performance Plan was included in the Exhibits of the Registrant's Form 10-K Annual Report for the year ended December 31, 1992 5. Executive Life Insurance Policies was included in the Exhibits of the Registrant's Form 10-K Annual Report for the year ended December 31, 1992 6. Prescription Drug Plan for Outside Directors was included in the Exhibits of the Registrant's Form 10-K Annual Report for the year ended December 31, 1992 Other ----- Agreement dated October 9, 1990 between Dynamics Corporation of America and Gabelli Funds, Inc. and GAMCO Investors, Inc. was included in the Exhibits of the registrant's Form 10-K Annual Report for the year ended December 31, 1990. Exhibit 22 - Subsidiaries of the registrant were included in the Exhibits of the registrant's Form 10-K Annual Report for the year ended December 31, 1984. (B) Exhibits filed in or as a separate section of this report. Page ---- Exhibit 3 - Articles of incorporation and bylaws: 1. Bylaws, as amended. (a) Exhibit 13 - Annual report to security holders for the year ended December 31, 1993. (b) Exhibit 24 - Consent of Independent Auditors 14 Exhibit 28 - CTS Corporation annual report on Form 10-K for the year ended December 31, 1993, (without Exhibits except as noted), the Report of Independent Accountants and the Financial Statement Schedules V, VI and VIII included in said Form 10-K, and CTS Corporation's annual report to stockholders for 1993 included in said Form 10-K as Exhibit 13 thereto. (c) (a) Filed herewith. (b) Unnumbered and immediately following the final numbered page of this report. (c) Unnumbered and following the registrant's annual report to security holders for the year ended December 31, 1993.

352942_1993.txt

352942_1993

1993

352942

ITEM 1. BUSINESS. General United Television, Inc. ("UTV"), the registrant, was organized in 1956 under the laws of the State of Delaware. UTV is the majority owned (54.3% at February 28, 1994) subsidiary of BHC Communications, Inc. ("BHC"), which is a majority owned (71.8% at February 28, 1994) subsidiary of Chris-Craft Industries, Inc. ("Chris-Craft"). UTV operates five of BHC's eight television stations that comprise Chris-Craft's Television Division. At February 28, 1994, UTV had 423 full-time employees and 62 part-time employees. Television Broadcasting UTV operates three very high frequency ("VHF") television stations and two ultra high frequency ("UHF") television stations. Commercial tele- vision broadcasting in the United States is conducted on 68 channels numbered 2 through 69. Channels 2 through 13 are in the VHF band, and channels 14 through 69 are in the UHF band. In general, UHF stations are at a disad- vantage relative to VHF stations, because UHF frequencies are more difficult for households to receive. This disadvantage is eliminated when a viewer receives the UHF station through a cable system. Commercial broadcast television stations may be either affiliated with one of the three national networks (ABC, NBC and CBS) or may be inde- pendent. In addition, Fox Broadcasting Company has established itself as a national network by entering into affiliation agreements with independent stations in many television markets. Chris-Craft, through BHC, is organ- izing, in partnership with Paramount Communications, Inc., an additional network, The Paramount Network, which currently plans to commence broad- casting in January 1995. There can be no assurance that the network will be viable. Moreover, UTV knows of one other effort to establish a network, and it is considered unlikely that two additional networks will be viable. The following table sets forth certain information with respect to UTV's stations and their respective markets: Total Commercial DMA TV Stations Commercial Station and House- DMA Operating Cable Location(a) Channel holds(b) Rank(b) in Market(c) Penetration(d) KMSP Minneapolis/ St. Paul 9 1,389,420 14th 4VHF 47% 3UHF KTVX Salt Lake City 4 616,720 38th 4VHF 51% 2UHF KMOL San Antonio 4 610,660 40th 3VHF 63% 3UHF KBHK San Francisco 44 2,253,220 5th 4VHF 67% 10UHF KUTP Phoenix 45 1,097,480 20th 4VHF 53% 4VHF _______________ (a) All stations are independent, except for KTVX, an ABC affiliate, and KMOL, an NBC affiliate. (b) Designated Market Area ("DMA") is an exclusive geographic area consisting of all counties in which the home-market commercial sta- tions received a preponderance of total viewing hours. The ranking shown is the nationwide rank, in terms of television households in DMA, of the market served by the station. Source: Nielsen Media Research television households universe estimates. (c) Additional channels have been allocated by the Federal Communications Commission ("FCC") for activation as commercial television stations in certain of these markets. Also, additional stations may be located within the respective DMAs of UTV stations but outside the greater metropolitan television markets in which UTV stations operate. (d) Cable penetration refers to the percentage of DMA television viewing households receiving cable television service, as estimated by Nielsen Media Research. Television stations derive their revenues primarily from selling advertising time. The television advertising sales market consists primarily of national network advertising, national spot advertising and local spot advertising. An advertiser wishing to reach a nationwide audience usually purchases advertising time directly from the national networks, from "superstations" (i.e., broadcast stations carried by cable operators in areas outside their broadcast coverage area) or from "unwired" networks (groups of otherwise unrelated stations whose advertising time is combined for national sale). A national advertiser wishing to reach a particular regional or local audience usually buys advertising time from local stations through national advertising sales representative firms having contractual arrangements with local stations to solicit such advertising. Local businesses generally purchase advertising from the stations' local sales staffs. Television stations compete for television advertising revenue primarily with other television stations serving the same DMA. There are 211 DMAs in the United States. DMAs are ranked annually by the estimated number of households owning a television set within the DMA. Advertising rates that a television station can command vary in part with the size, in terms of television households, of the DMA served by the station. Within a DMA, the relative advertising rates charged by competing stations depend primarily on three factors: the stations' program ratings (number of television households or persons within those households tuned to a program as a percentage of total television households or persons within those households in the viewing area); the time of day the advertising will run; and the demographic qualities of a program's viewers (primarily age and sex). Ratings data for television markets are measured by A.C. Nielsen Co. ("Nielsen"). This rating service uses two terms to quantify a station's audience: rating points and share points. A rating point represents one percent of all television households in the entire DMA, and a share point represents one percent of all television households within the DMA actually using at least one television set at the time of measurement. Because the major networks regularly provide first-run programming during prime time viewing hours (in general, 8:00 P.M. to 11:00 P.M. Eastern time), their affiliates generally (but do not always) achieve higher audience shares during those hours than independent stations. However, independent stations generally have substantially more advertising time ("inventory") for sale than network affiliates, because the networks use almost all of their affiliates' inventory during network shows. Independent stations' smaller audiences and greater inventory during prime time hours generally result in lower advertising rates charged and more advertising time sold during those hours, whereas affiliates' larger audiences and limited inventory generally allow affiliates to charge higher advertising rates for prime time programming. By selling more advertising time, an independent station typically achieves a share of advertising revenues in its market greater than its audience ratings. On the other hand, because a nonaffiliated station broadcasts more syndicated programming than a network-affiliated station, total programming costs for an independent station are generally higher than those of a network affiliate in the same market. Programming UTV's independent stations depend heavily on independent third parties for programming, as do UTV's network affiliates for their non-network broadcasts. Recognizing the need to have a more direct influence on the quality of programming available to its stations, and desiring to participate in potential profits through national syndication of programming, UTV has begun to invest directly in the development of original programming. The aggregate amount invested through December 31, 1993 was not significant to UTV's financial position. BHC's independent stations currently expect to broadcast, as affiliates of The Paramount Network, four hours of original prime time programming over two nights per week, beginning in January 1995. UTV's television stations also produce programming directed to meet the needs and interests of the area served, such as local news and events, public affairs programming, children's programming and sports. Programs obtained from independent sources consist principally of syndicated television shows, many of which have been shown previously on a network, and syndicated feature films, which were either made for network television or have been exhibited previously in motion picture theatres (most of which films have been shown previously on network and cable television). Syndicated programs are sold to individual stations to be broadcast one or more times. Independent television stations generally have large numbers of syndication contracts; each contract is a license for a particular series or program that usually prohibits licensing the same programming to other television stations in the same market. A single syndication source may provide a number of different series or programs. Licenses for syndicated programs are often offered for cash sale (i.e., without any barter element) to stations; however, some are offered on a barter or cash plus barter basis. In the case of a cash sale, the station purchases the right to broadcast the program, or a series of programs, and sells advertising time during the broadcast. The cash price of such programming varies, depending on the perceived desirability of the program and whether it comes with commercials that must be broadcast (i.e., on a cash plus barter basis). Bartered programming is offered to stations without charge, but comes with a greater number of commercials that must be broadcast, and therefore with less time available for sale by the station. Recently, the amount of bartered and cash plus barter programming broadcast both industry-wide and by UTV's stations has increased substantially. UTV television stations are frequently required to make substantial financial commitments to obtain syndicated programming while such programming is still being broadcast by a network and before it is available for broadcast by UTV stations or before it has been produced. Generally, syndication contracts require the station to acquire an entire program series, before the number of episodes of original showings that will be produced has been determined. While analyses of network audiences are used in estimating the value and potential profitability of such programming, there is no assurance that a successful network program will continue to be successful or profitable when broadcast after network airing. For many years, the FCC has restricted the ability of television networks to acquire financial interests in the production of television shows by independent sources, or to participate in the syndication of television programs, either on a first-run or an off-network basis. These rules were based in part on concern that networks engaged in syndication would have economic incentives to discriminate against independent stations (such as those owned by UTV) in making programs available in the syndication market, either by warehousing them or favoring the network's owned or affiliated stations. Late in 1992, the United States Court of Appeals for the Seventh Circuit remanded the rules to the FCC with instructions to revisit the need for them. In 1993, the FCC adopted new rules which allow networks to acquire financial interests and passive syndication rights in off-network programs, but bar them from actively syndicating such programs in the United States or delaying the entry into syndication of any long-running prime time networked-owned series beyond the fourth year after its network debut. The new rules also bar networks from acquiring domestic financial interests or syndication rights in first- run programs unless the network is the sole producer of the program and prohibit networks from active domestic syndication of all first- run programs. However, these rules are scheduled to expire in November 1995, unless the FCC issues an order to the contrary. A number of petitions for review of these new regulations have been filed, which have been consolidated and transferred to the Seventh Circuit, where they remain pending. UTV cannot predict the outcome of the proceedings in court or before the FCC. Pursuant to generally accepted accounting principles, commitments for programming not available for broadcast are not recorded as liabilities until the programming becomes available for broadcast, at which time the related contract right is also recorded as an asset. UTV television stations had unamortized film contract for programming available for telecasting and deposits on film contracts for programming not available for telecasting aggregating $30,320,000 as of December 31, 1993. The stations were committed for film and sports rights contracts aggregating $28,497,000 for programming not available for broadcasting as of that date. License periods for particular programs or films generally run from one to five years. Long-term contracts for the broadcast of syndicated television series generally provide for an initial telecast and subsequent reruns for a period of years, with full payment to be made by the station over a period of time shorter than the rerun period. See Notes 1(D) and 7 of Notes to Consolidated Financial Statements. KTVX and KMOL are primary affiliates of their respective networks. Network programs are produced either by the networks themselves or by independent production companies and are transmitted by the networks to their affiliated stations for broadcast. In general, network primary affiliation agreements are automatically renewed for two-year periods, unless advance written notice of termination is given by either the affiliate or the network. The agreement gives the affiliate the right to broadcast all programs transmitted by the network. The affiliate must run in its entirety, together with all network commercials, any network programming the affiliate elects to broadcast and is allowed to broadcast a limited number of commercials it has sold. For each hour of programming broadcast by the affiliate, the network generally pays the affiliate a fee, specified in the agreement (although subject to change by the network), which varies in amount depending on the time of day during which the program is broadcast and other factors. Prime time programming generally earns the highest fee. A network may, and sometimes does, designate certain programs to be provided with no compensation to the station. An affiliate may accept or reject a program offered by a network and instead broadcast programming from another source. Rejection of a program gives the network the right to offer that program to another station in the area. Sources of Revenue The principal source of revenues for UTV stations is the sale of advertising time to national and local advertisers. Such time sales are represented by spot announcements purchased to run between programs and program segments and by program sponsorship. The relative contributions of national and local advertising to UTV's gross revenues vary from time to time. During the year ended December 31, 1993, national advertising con- tributed 46%, and local advertising contributed 46%, of total gross revenues. Most advertising contracts are short-term. Like that of the television broadcasting business, generally, UTV's business is seasonal. In terms of revenues, generally the fourth quarter is strongest, followed by the second, third and first. Advertising is generally placed with UTV stations through advertising agencies, which are allowed a commission generally equal to 15% of the price of advertising placed. National advertising time is usually sold through an independent national sales representative, which also receives a commission, while local advertising time is sold by each station's sales staff. Practices with respect to sale of advertising time do not differ markedly between UTV's network and non-network stations, although the network-affiliated stations have less inventory to sell. Government Regulation Television broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934, as amended (the "Communications Act"). The Communications Act empowers the FCC, among other things, to issue, revoke or modify broadcast licenses, to assign fre- quencies, to determine the locations of stations, to regulate the broadcasting equipment used by stations, to establish areas to be served, to adopt such regulations as may be necessary to carry out the provisions of the Communications Act and to impose certain penalties for violation of its regulations. UTV television stations are subject to a wide range of technical, reporting and operational requirements imposed by the Communi- cations Act or by FCC rules and policies. The Communications Act provides that a license may be granted to any applicant if the public interest, convenience and necessity will be served thereby, subject to certain limitations, including the requirement that the FCC allocate licenses, frequencies, hours of operation and power in a man- ner that will provide a fair, efficient and equitable distribution of service throughout the United States. Television licenses generally are issued for five-year terms. Upon application, and in the absence of a con- flicting application that would require the FCC to hold a hearing, or adverse questions as to the licensee's qualifications, television licenses have usually been renewed for additional terms without a hearing by the FCC. An existing license automatically continues in effect once a timely renewal application has been filed until a final FCC decision is issued. KMSP's license renewal was granted on April 15, 1993, and is due toexpire on April 1, 1998. KTVX's license renewal was granted on September 29, 1993, and is due to expire on October 1, 1998. KMOL's license renewal application is currently pending, subject to two petitions challenging the station's compliance with FCC requirements concerning equal employment opportunity; UTV has vigorously opposed the petitions, and believes that they are without merit. KUTP and KBHK have each filed timely renewal applications, which are pending. No petitions to deny any of those applications have been filed, no competing applications have been filed, and the deadlines for filing such petitions and competing applications have all expired. Pursuant to FCC requirements, each station's application has reported instances in which the station has exceeded the commercial limits applicable to children's programs. In the case of KBHK, these instances have been substantial, and the FCC has recently granted renewals, in such cases, subject to forfeitures of as much as $80,000. WWOR's license renewal was granted on January 22, 1992 and expires on June 1, 1994. A renewal application was timely filed on January 31, 1994. The deadline for filing petitions to deny or competing applications against that application has not yet expired. Under existing FCC regulations governing multiple ownership of broadcast stations, a license to operate a television or radio station generally will not be granted to any party (or parties under common control) if such party directly or indirectly owns, operates, controls or has an attributable interest in another television or radio station serving the same market or area. The FCC, however, is favorably disposed to grant waivers of this rule for certain radio station-television station combinations in the top 25 television markets, in which there will be at least 30 separately owned, operated and controlled broadcast licenses, and in certain other circumstances. FCC regulations further provide that a broadcast license will not be granted if that grant would result in a concentration of control of radio and television broadcasting in a manner inconsistent with the public interest, convenience or necessity. FCC rules generally deem such con- centration of control to exist if any party, or any of its officers, directors or stockholders, directly or indirectly, owns, operates, controls or has an attributable interest in more than 12 television stations, or in television stations capable of reaching, in the aggregate, a maximum of 25% of the national audience. This percentage is determined by the DMA market rankings of the percentage of the nation's television households considered within each market. Because of certain limitations of the UHF signal, however, the FCC will attribute only 50% of a market's DMA reach to owners of UHF stations for the purpose of calculating the audience reach limits. Applying the 50% reach attribution rule to UHF stations KBHK and KUTP, the eight BHC stations are deemed to reach approximately 18% of the nation's television households. To facilitate minority group participation in radio and television broadcasting, the FCC will allow entities with attributable ownership interests in stations controlled by minority group members to exceed the ownership limits. The FCC's multiple ownership rules require the attribution of the licenses held by a broadcasting company to its officers, directors and certain of its stockholders, so there would ordinarily be a violation of FCC regulations where an officer, director or such a stockholder and a television broadcasting company together hold interests in more than the permitted number of stations or more than one station that serves the same area. In the case of a corporation controlling or operating television stations, such as UTV, there is attribution only to stockholders who own 5% or more of the voting stock, except for institutional investors, including mutual funds, insurance companies and banks acting in a fiduciary capacity, which may own up to 10% of the voting stock without being subject to such attribution, provided that such entities exercise no control over the management or policies of the broadcasting company. The Communications Act and FCC regulations prohibit the holder of an attributable interest in a television station from having an attributable interest in a cable television system located within the predicted coverage area of that station. FCC regulations also prohibit the holder of an attributable interest in a television station from having an attributable interest in a daily newspaper located within the predicted coverage area of that station. The Communications Act limits the amount of capital stock that aliens may own in a television station licensee or any corporation directly or indirectly controlling such licensee. No more than 20% of a licensee's capital stock and, if the FCC so determines, no more than 25% of the capital stock of a company controlling a licensee, may be owned or voted by aliens or their representatives. Should alien ownership exceed this limit, the FCC may revoke or refuse to grant or renew a television station license or approve the assignment or transfer of such license. UTV believes the ownership of its stock by aliens to be below the applicable limit. The Communications Act prohibits the assignment of a broadcast license or the transfer of control of a licensee without the prior approval of the FCC. Legislation was introduced in the past that would impose a transfer fee on sales of broadcast properties. Although that legislation was not adopted, similar proposals, or a general spectrum licensing fee, may be advanced and adopted in the future. Recent legislation has imposed annual regulatory fees applicable to UTV's stations, currently ranging as high as $18,000 per station. The foregoing does not purport to be a complete summary of all the provisions of the Communications Act or regulations and policies of the FCC thereunder. Reference is made to the Communications Act, such regulations and the public notices promulgated by the FCC for further information. Other Federal agencies, including principally the Federal Trade Commission, also impose a variety of requirements that affect the business and operations of broadcast stations. Proposals for additional or revised requirements are considered by the FCC, other Federal agencies or Congress from time to time. UTV cannot predict what new or revised Federal requirements may result from such consideration or what impact, if any, such requirements might have upon the operation of UTV television stations. Competition UTV television stations compete for advertising revenue in their respective markets, primarily with other broadcast television stations and cable television channels, and compete with other advertising media, as well. Such competition is intense. In addition to programming, management ability and experience, technical factors and television network affiliations are important in determining competitive position. Competitive success of a television station depends primarily on public response to the programs broadcast by the station in relation to competing entertainment, and the results of this competition affect the advertising revenues earned by the station from the sale of advertising time. Audience ratings provided by Nielsen have a direct bearing on the competitive position of television stations. In general, network programs achieve higher ratings than independent station programs. There are at least five other commercial television stations in each market served by a UTV station. UTV believes that, in Minneapolis/St. Paul, KMSP generally attracts a smaller viewing audience than the three VHF network-affiliated stations, but a larger viewing audience than the other independent stations, all of which are UHF stations. In Salt Lake City, KTVX generally ranks first of the six television stations in terms of audience share. In San Antonio, KMOL ranks third of the six stations in terms of audience share. KBHK generally ranks fifth in terms of audience share, behind the one independent and three network-affiliated VHF television stations, of the 14 commercial television stations in San Francisco. KUTP ranks sixth in terms of audience share, of the eight commercial stations in the Phoenix market. UTV stations may face increased competition in the future from additional television stations that may enter their respective markets. See note (c) to the table under Television Broadcasting. Cable television has become a major competitor of television broadcasting stations. Because cable television systems operate in each market served by a UTV station, the stations are affected by rules governing cable operations. If a station is not widely accessible by cable in those markets having strong cable penetration, it may lose effective access to a significant portion of the local audience. Even if a television station is carried on a local cable system, an unfavorable channel position on the cable system may adversely affect the station's audience ratings and, in some circumstances, a television set's ability to receive the station being carried on an unfavorable channel position. Some cable system operators may be inclined to place broadcast stations in unfavorable channel locations. FCC regulations requiring cable television stations to carry or reserve channels for retransmission of local broadcast signals have twice been invalidated in Federal court. In October 1992, Congress enacted legislation designed to provide television broadcast stations the right to be carried on cable television stations (and to be carried on specific cable channel positions), or (at the broadcaster's election) to prohibit cable carriage of the television broadcast station without its consent. This legislation is currently being challenged in the United States Supreme Court, and UTV cannot predict the outcome. While Federal law now generally prohibits local telephone companies from providing video programming to subscribers in their service areas, this restriction has been invalidated by one federal district court and is currently being challenged in other federal courts; legislation eliminating or relaxing the law has been proposed. "Syndicated exclusivity" rules allow television stations to prevent local cable operators from importing distant television programming that duplicates syndicated programming in which local stations have acquired exclusive rights. In conjunction with these rules, network nonduplication rules protect the exclusivity of network broadcast programming within the local video marketplace. The FCC is also reviewing its "territorial exclusivity" rule, which limits the area in which a broadcaster can obtain exclusive rights to video programming. UTV believes that the competitive position of UTV stations would likely be enhanced by an expansion of broadcasters' permitted zones of exclusivity. Alternative technologies could increase competition in the areas served by UTV stations and, consequently, could adversely affect their profitability. Direct broadcast satellite ("DBS") systems and subscription television ("STV"), recognized as potential competitors a few years ago, have thus far failed to materialize as such. However, at least two DBS operators are scheduled to begin service in 1994. An additional challenge is now posed by multichannel multipoint distribution services ("MMDS"). Two four-channel MMDS licenses have been granted in most television markets. MMDS operation can provide commercial programming on a paid basis. A similar service can also be offered using the instructional television fixed service ("ITFS"). The FCC now allows the educational entities that hold ITFS licenses to lease their "excess" capacity for commercial purposes. The multichannel capacity of ITFS could be combined with either an existing single channel MDS or a new MMDS to increase the number of available channels offered by an individual operator. The emergence of home satellite dish antennas has also made it possible for individuals to receive a host of video programming options via satellite transmission. Technological developments in television transmission have created the possibility that one or more of the broadcast and nonbroadcast television media will provide enhanced or "high definition" pictures and sound to the public of a quality that is technically superior to that of the pictures and sound currently available. It is not yet clear when and to what extent technology of this kind will be available to the various television media; whether and how television broadcast stations will be able to avail themselves of these improvements; whether all television broadcast stations will be afforded sufficient spectrum to do so; what channels will be assigned to each of them to permit them to do so; whether viewing audiences will make choices among services upon the basis of such differences; or, if they would, whether significant additional expense would be required for television stations to provide such services. Many segments of the television industry are intensively studying enhanced and "high definition" television technology, and both Congress and the FCC have initiated proceedings and studies on its potential and its application to television service in the United States. The broadcasting industry is continuously faced with technological changes, competing entertainment and communications media and governmental restrictions or actions of Federal regulatory bodies, including the FCC. These technological changes may include the introduction of digital compression by cable systems that would significantly increase the number and availability of cable program services with which BHC stations compete for audience and revenue, the establishment of interactive video services, and the offering of multimedia services that include data networks and other computer technologies. Such factors have affected, and will continue to affect, the revenue growth and profitability of UTV. ITEM 2. ITEM 2. PROPERTIES. Physical facilities consisting of offices and studio facilities are owned by UTV in Minneapolis, San Antonio and Phoenix and are leased in Salt Lake City and San Francisco. The Salt Lake City lease agreement expires in 1999 and is renewable, at an increased rental, for two five-year periods. The San Francisco lease expires in 2007. The Minneapolis facility includes approximately 49,700 square feet of space on a 5.63-acre site. The Salt Lake City facility is approximately 30,400 square feet on a 2.53-acre site. The San Antonio facility is approximately 41,000 square feet on a .92-acre site. The San Francisco facility is approximately 27,700 square feet in downtown San Francisco. The Phoenix facility is approximately 26,400 square feet on a 3.03-acre site. Smaller buildings containing transmission equipment are owned by UTV at sites separate from the studio facilities. UTV owns a 55-acre tract in Shoreview, Minnesota, of which 40 acres are used by KMSP for transmitter facilities and tower. KTVX's transmitter facilities and tower are located at a site on Mt. Nelson, close to Salt Lake City, under a lease that expires in 2004. KTVX also maintains back-up transmitter facilities and tower at a site on nearby Mt. Vision under a lease that expires in 2002 and is renewable, at no increase in rental, for a 50-year period. KMOL's transmitter facilities are located at a site near San Antonio on land and on a tower owned by Texas Tall Tower Corporation, a corporation owned in equal shares by UTV and another television station that also transmits from the same tower. KBHK's transmitter is located on Mt. Sutro, as part of the Sutro Tower complex, which also houses equipment for other San Francisco television stations and many of its FM radio stations. The lease for the Mt. Sutro facilities expires in February 1995. KUTP's transmitter facilities and tower are located on a site within South Mountain Park, a communications park owned by the City of Phoenix, which also contains transmitter facilities and towers for the other television stations in Phoenix as well as facilities for several FM radio stations. The license for this space expires in 2012. UTV believes its properties are adequate for their present uses. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Not applicable. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of UTV, as of February 28, 1994, are as follows: Positions with UTV; principal occupation; Has served and age as of February as officer Name 28, 1994 since Herbert J. Siegel Chairman of the Board; 1982 Chairman of the Board and President, Chris-Craft and BHC; 65 Evan C Thompson President and Chief Executive 1983 Officer; Executive Vice Presi- dent, and President, Tele- vision Division, Chris-Craft; 51 Garth S. Lindsey Executive Vice President, Chief 1977 Financial Officer and Secre- tary; 49 Thomas L. Muir Treasurer and Controller; 45 1981 John C. Siegel President, UTV of San Fran- 1983 cisco, Inc., which owns KBHK; Senior Vice President, Chris- Craft; 41 Chris-Craft, through its majority ownership of BHC, is principally engaged in television broadcasting. The principal occupation of each of the individuals for the past five years is stated in the foregoing table. All officers hold office until the meeting of the Board following the next annual meeting of stockholders or until removed by the Board. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information appearing in the Annual Report under the caption STOCK PRICE, DIVIDENDS AND RELATED INFORMATION is incorporated herein by this reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information appearing in the Annual Report under the caption SELECTED FINANCIAL INFORMATION is incorporated herein by this reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information appearing in the Annual Report under the caption Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by this reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements, notes thereto, report of independent accountants thereon and quarterly financial information (unaudited) appearing in the Annual Report are incorporated herein by this reference. Except as specifically set forth herein and elsewhere in this Form 10-K, no information appearing in the Annual Report is incorporated by reference into this report nor is the Annual Report deemed to be filed, as part of this report or otherwise, pursuant to the Securities Exchange Act of 1934. 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. The information appearing in the Proxy Statement under the captions ELECTION OF DIRECTORS--Nominees of the Board of Directors and ELECTION OF DIRECTORS-- Compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated herein by this reference. Information relating to UTV's executive officers is set forth in Part I under the caption EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS--Executive Compensation is incorporated herein by this reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS--Voting Securities of Certain Beneficial Owners and Management is incorporated herein by this reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information appearing in the Proxy Statement under the caption ELECTION OF DIRECTORS--Certain Relationships and Related Transactions is incorporated herein by this 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 financial statements and quarterly financial information incorporated by reference from the Annual Report pursuant to Item 8. 2. The report of predecessor independent public accountants and the schedules and report of independent accountants thereon, listed in the Index to Consolidated Financial Statements and Schedules. 3. Exhibits listed in the Exhibit Index, including the following compensatory plans listed below: Benefit Equalization Plan 1988 Stock Option Plan (b) No reports on Form 8-K were filed by the registrant 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. Date: March 29, 1994 UNITED TELEVISION, INC. (Registrant) By EVAN C THOMPSON Evan C Thompson 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 and Title Date HERBERT J. SIEGEL March 29, 1994 Herbert J. Siegel Chairman and Director EVAN C THOMPSON March 29, 1994 Evan C Thompson President, Chief Executive Officer and Director (Principal Executive Officer) GARTH S. LINDSEY March 29, 1994 Garth S. Lindsey Executive Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer) LAWRENCE R. BARNETT March 29, 1994 Lawrence R. Barnett Vice Chairman and Director JOHN L. EASTMAN March 29, 1994 John L. Eastman Director JAMES D. HODGSON March 29, 1994 James D. Hodgson Director NORMAN PERLMUTTER March 29, 1994 Norman Perlmutter Director ABRAHAM A. RIBICOFF March 29, 1994 Abraham A. Ribicoff Director HOWARD F. ROYCROFT March 29, 1994 Howard F. Roycroft Director ROCCO C. SICILIANO March 29, 1994 Rocco C. Siciliano Director JOHN C. SIEGEL March 29, 1994 John C. Siegel Director UNITED TELEVISION, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES CONSOLIDATED FINANCIAL STATEMENTS: Report of Independent Accountants Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- For the Three Years Ended December 31, 1993 Consolidated Statements of Cash Flows -- For the Three Years Ended December 31, 1993 Consolidated Statements of Shareholders' Investment -- For the Three Years Ended December 31, 1993 Notes to Consolidated Financial Statements SCHEDULES: Report of Predecessor Independent Public Accountants Report of Independent Accountants on Financial Statement Schedules I. Marketable Securities - Other Investments II. Amounts Receivable from Related Parties, Underwriters, Promoters and Employees other than Related Parties VIII. Valuation and Qualifying Accounts X. Supplementary Income Statement Information Schedules other than those listed above have been omitted since the information is not applicable, not required or is included in the respective financial statements or notes thereto. REPORT OF PREDECESSOR INDEPENDENT PUBLIC ACCOUNTANTS To United Television, Inc.: We have audited the consolidated statements of income, share- holders'investment and cash flows of United Television, Inc. (a Delaware corporation) and subsidiaries (UTV) for the year ended December 31, 1991. These financial statements and the schedules referred to below are the responsibility of UTV's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. We conducted our audit in accordance with generally accepted audit- ing 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 results of operations and cash flows of United Television, Inc. and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to consolidated financial statements and schedules for the year ended December 31, 1991 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. Los Angeles, California February 10, 1992 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of United Television, Inc. Our audits of the consolidated financial statements referred to in our report dated February 4, 1994 appearing on page 21 of the 1993 Annual Report to Shareholders of United Television, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included audits of the Financial Statement Schedules as of December 31, 1993 and 1992, and the years then ended, 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 Century City, California February 4, 1994 SCHEDULE I UNITED TELEVISION, INC. AND SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 (Columns C, D, and E in Thousands) SCHEDULE II UNITED TELEVISION, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 The loan was made for the purpose of assisting Mr. Lindsey in relocating his home in connection with the relocation of UTV's executive offices from Minneapolis to Los Angeles. The loan was represented by a non-interest bear- ing five-year note, with no payment due before maturity. In December 1988, the note was revised and extended. Under the Revision and Extension Agree- ment, 10% of the original balance is due and payable December 31 of each year through December 31, 1997. Such installments will be forgiven on each such December 31 if the borrower is still employed by UTV on each such for- giveness date. The note is secured by a deed of trust on the borrower's home and provides that at the option of the holder the loan will become due and payable upon sale or further encumbrance of the borrower's home without the consent of the holder or upon the borrower's voluntary termin- ation of employment with UTV. Schedule VIII UNITED TELEVISION, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands of Dollars) SCHEDULE X UNITED TELEVISION, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands of Dollars) Column A Column B Item 1993 1992 1991 Amortization of Intangible Assets $ 610 $ 610 $ 610 Advertising Costs $4,682 $4,194 $4,442 EXHIBIT INDEX Incorporated by Exhibit Reference to: No. Exhibit Exhibit 3(a)[1] 3(a) Restated Certificate of Incorporation Exhibit 3(b)[2] (b) Restated By-Laws Exhibit A to registrant's Proxy Statement dated March 23, 1988 (File No. 0-9786) 10(a) 1988 Stock Option Plan Exhibit 10(a)(1)[7] (a)(1) Amendment No. 1 thereto Exhibit 10(i)[3] (b) Employment Agreement, dated January 1, 1981, between registrant and Garth S. Lindsey, as amended Exhibit 10(m)[3] (c) Employment Agreement, dated January 1, 1981, between registrant and Thomas L. Muir, as amended Exhibit 10(t)[4] (d)(1) Note, dated as of January 6, 1984 in the original principal amount of $200,000 from Garth S. Lindsey, as maker, to registrant, as payee Exhibit 10(n)(2)[5] (d)(2) Revision and Extension Agreement, dated as of December 19, 1988, from Garth S. Lindsey, as maker, to registrant, as payee Exhibit 10(u)[4] (e)(1) Note dated as of January 25, 1984 in the original principal amount of $100,000 from Thomas L. Muir, as maker, to registrant, as payee Exhibit 10(o)(2)[5] (e)(2) Revision and Extension Agreement, dated as of December 20, 1988, from Thomas L. Muir, as maker to registrant, as payee Exhibit 10(s)[6] (f) Benefit Equalization Plan of registrant * 13 Portions of the Annual Report incorporated by reference * 22 Subsidiaries of registrant * 24(a) Consent of Price Waterhouse * (b) Consent of Arthur Andersen & Co. __________ * Filed herewith [1] Registrant's Annual Report on Form 10-K for the year ended December 31, 1987. [2] Registrant's Annual Report on Form 10-K for the year ended December 31, 1984. [3] Registrant's Annual Report on Form 10-K for the year ended December 27, 1981. [4] Registrant's Annual Report on Form 10-K for the year ended December 31, 1983. [5] Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. [6] Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. [7] Registrant's Annual Report on Form 10-K for the year ended December 31, 1991.

36029_1993.txt

36029_1993

1993

36029

700949_1993.txt

700949_1993

1993

700949

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 - XII (the "Partnership"), is a limited partnership formed in late 1981 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 $160,000,000 in Limited Partnership Interests (the "Interests"), to the public pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 2-76443). A total of 160,000 Interests have been sold to the public at $1,000 per Interest. The offering closed on April 19, 1983. 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, 2032. 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: 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 Partners) 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. Reference is made to Item 7 below for a discussion of competitive conditions and future renovation and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are set forth in the table set forth 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 16,628 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 other 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 June 21, 1982, the Partnership commenced an offering of $160,000,000 pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. All Interests were subscribed and issued between June 21, 1982 and April 19, 1983 from which the Partnership received gross proceeds of $160,000,000. After deducting selling expenses and other offering costs, the Partner- ship had approximately $141,004,000 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 to satisfy working capital requirements. Portions of the proceeds were 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 $2,790,000. Such funds and short- term investments of approximately $6,866,000 are available for capital improvements, future distributions to partners, and for working capital requirements, including capital improvements and leasing costs currently being incurred at the National City Center Office Building. Certain of the Partnership's investment properties currently operate in overbuilt markets which are characterized by lower occupancies and/or reduced rent levels. The Partnership currently has adequate cash and cash equivalents to maintain the operations of the Partnership. The Partnership has taken steps to preserve its working capital by deciding to suspend distributions to the Limited and General Partners effective as of the first quarter of 1992. The Partnership had also deferred cash distributions and partnership management fees, payable to the Corporate General Partner related to the third and fourth quarters of 1991. In addition, as of December 31, 1993, the General Partners and their affiliates have deferred payment of certain property management and leasing fees of approximately $3,523,000 (approximately $22 per Interest) as more fully described in Note 9. These amounts do not bear interest and are expected to be paid in future periods. The Partnership and its consolidated ventures have currently budgeted for 1994 approximately $3,555,000 for tenant improvements and other capital expenditures. The Partnership's share of such items in 1994 is currently budgeted to be approximately $3,029,000. Included in this amount is the roof and parking lot at the Permian Mall which are currently in need of repair. To fund the Permian Mall improvements, the Partnership intends to initiate discussions with the mortgage lender regarding a modification to the loan. There can be no assurance that a loan modification can be obtained. Actual amounts expended in 1994 may vary depending on a number of factors including actual leasing activity, results of operations, liquidity considerations and other market conditions over the course of the year. The source of capital for such items and for both short-term and long-term future liquidity and distributions is expected to be through net cash generated by the Partnership's investment properties and through the sale of such investments. In addition, the Partnerships does not consider the remaining mortgage note receivable (related to San Mateo Fashion Island) to be a source of future liquidity. Reference is made to Note 7(b). The Partnership's and its Ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its Ventures are not obligated to pay mortgage indebtedness unless the related property produces sufficient net cash flow from operations or sale. As described more fully in Note 4, the Partnership has received mortgage note modifications on certain of its properties which expire on various dates commencing June 30, 1994. One of the long-term mortgage lenders on the Country Square Apartments would not modify or extend its mortgage which became due January 1, 1993. Based upon current market conditions, the Partnership decided not to commit additional funds to the Country Square Apartments. In February 1993, the lender realized upon its security by obtaining title to the property. Therefore, the Partnership no longer has an ownership interest in the property. The above noted transaction resulted in a gain for financial reporting purposes of approximately $1,521,000 and a gain for Federal income tax purposes with no corresponding distributable proceeds. The mortgage on Stonybrook Apartments II matures October 1, 1994 (Stonybrook Apartments I is not subject to a mortgage loan) with an outstanding balance of approximately $5,633,000 at December 31, 1993. The Partnership intends to initiate discussions with the mortgage lender regarding an extension or modification to the mortgage loan. If the Partnership is unable to secure an extension or modification to the loan, based upon current market conditions, the Partnership would likely not commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property. Such a decision could result in a gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The lease for Carrara Place Office Building's major tenant, which represented 46% of the building's leasable area and provided for rental payments that were significantly greater than current market rental rates, expired in December 1992. The Denver, Colorado region has been adversely affected by increased competition for tenants as a result of overbuilding in the area. As a result of the current market rental rates, the cash flow generated by the property would have been significantly less than the payments required under the original mortgage note even if the space was re-leased. Further, re-leasing the space requires significant re-leasing costs. Additionally, the lease for a tenant occupying approximately 17% of the building's leasable area was scheduled to expire in June 1994. The venture has reached an agreement with the tenant to extend their lease for an additional five years. The Carrara venture initiated discussions with the mortgage lender regarding a modification to the mortgage loan and in September 1993 reached an agreement to modify the loan retroactive to January 1, 1993. Under the modification, the maturity date is extended from June 30, 1994 until January 1, 1998. Interest continues to accrue at 9.875% from January 1, 1993 until January 1, 1998. Effective January 1, 1993, the net cash flow of the property, subject to certain reserves, will be paid to the lender and applied toward the payment of accrued and unpaid interest, current interest and principal balance of the loan, respectively. Any capital costs, including re- leasing costs, are to be funded by the lender, subject to their approval, and such costs added to the principal balance of the loan. Approximately $203,900 has been funded by the lender as of December 31, 1993. Concurrent with the modification, the Carrara venture was reorganized such that the Partnership became the sole general partner of the venture, with its venture partner becoming a limited partner of the venture. In addition, the property manager (an affiliate of the unaffiliated venture partner) was replaced effective September 1993. Based upon an analysis of current and anticipated market conditions, the Partnership has decided not to commit additional funds to the Carrara Place Office Building. There must be a significant improvement in market and property conditions in order for the value of the property to be greater than the mortgage payoff amount at any point in time, including accrued interest. Therefore, it is unlikely that any significant proceeds would be received by the Partnership in the event the property were sold or refinanced. In conjunction with the modification, the Carrara venture has agreed to transfer title to the lender if the venture fails to pay the loan in full on the earlier of the extended maturity date or an acceleration of the loan as a result of the occurrence of an event of default (as defined). Regarding the First Interstate Center, although new construction in the Seattle office market has virtually ceased, the overall office market remains very competitive due to significant amount of sublease space on the market. In May 1989, an initiative was passed in Seattle to limit future development of downtown office space. Over time, this initiative (which is effective for ten years) may have a favorable impact on the Seattle office market. Although the occupancy (97% at December 31, 1993) at 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. At the National City Center Office Building located in Cleveland, Ohio, a major tenant (Baker & Hostetler) extended its lease term to 2001, but reduced its space leased by approximately 18,000 square feet as of January 1993. The extended lease requires tenant improvement costs of approximately $92,000 per year through the expiration of the lease with an additional amount to paid in 1996 of approximately $730,000. The Partnership received a lease termination fee of approximately $1,100,000 from another tenant (KPMG Peat Marwick) for vacating approximately 19,700 square feet (which was subsequently leased to National City Bank). In addition, the Partnership has signed a lease with a law firm to occupy approximately 20,400 square feet and the leasing costs required under the lease for this new tenant will result in the property incurring a slight deficit for 1994. In January 1994, the debt service payments under the existing mortgage are scheduled to increase from 9-5/8% to 11-7/8% until the maturity of the loan in December 1995. The Partnership reached an agreement in principle with the current mortgage lender to refinance the existing mortgage which would be effective February 1, 1994, with an interest rate of 8.5%. The loan would be amortized over 22 years with a balloon payment due in seven years. The Partnership paid a refundable loan commitment fee of $1,164,000 in 1993. The Partnership also expects to pay a prepayment penalty of approximately $600,000, based on the outstanding mortgage balance at the time of refinancing. In addition, the lender would require an escrow account of approximately $610,000 to be established at the inception of the refinancing which would be supplemented from time to time for scheduled future tenant improvements costs at the property. Real estate taxes payable in 1994 are expected to increase due to a 25% reduction of a real estate tax abatement that was received when the property was purchased. The remaining 25% abatement expires in 1998 for taxes payable in 1999. During 1992, the Partnership entered into a contract (that was subsequently terminated) to sell the Sierra Pines Apartments subject to certain contingencies. Based upon the proposed sales price, the Partnership would not have recovered the net carrying value of the investment property. The Partnership, therefore, as a matter of prudent accounting practice, made a provision for value impairment on such investment property of $2,682,822. Such provision was recorded in September 1992 to effectively reduce the net carrying value of the investment property concurrently based upon the proposed sale price. On July 29, 1993, the Partnership sold the Sierra Pines and Crossing Apartments to an unaffiliated buyer. After the deduction of additional interest and normal costs of sale, the Partnership received proceeds of approximately $950,000 (including $288,000 in advisory fees) in the aggregate. In connection with the San Francisco earthquake experienced on October 17, 1989, the Yerba Buena office building incurred some structural and cosmetic damage which was repaired. Five tenants (approximately 54% of the building) vacated the building and withheld substantially all of their rent (commencing at various times) since November 1989. The Partnership concluded not to pursue legal recourse against said tenants based on, among other things, the costs of pursuing its remedies, competing demands on the Partnership's resources and the prospects of any material return to the Partnership in light of recent events. Reference is made to Note 3(c) for further discussion. Based upon the conditions at Yerba Buena, the joint venture had not made the debt service payments to the underlying lender, commencing with the January 1990 payment. Accordingly, the joint venture received a default notice from the underlying lender in late February 1990. The Partnership and Affiliated Partners had decided, based upon analysis of current market conditions and the probability of large future cash deficits, not to fund future joint venture cash deficits. The joint venture had been negotiating with the underlying lender to obtain a loan modification to pay for expected future cash deficits. The joint venture was unable to negotiate a loan modification whereby the joint venture retained ownership of the property and in June, 1992 the joint venture transferred title to the property to the lender in return for an opportunity to share in future sale or refinancing proceeds above certain specified levels. In order for the joint venture to share in such proceeds, there must be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the property. In addition, during a certain period of time, the joint venture will have a right of first opportunity to purchase the property if the lender chooses to sell. An affiliate of the Partnership's Corporate General Partner continues to manage and lease the property for the lender. As a result of the transfer of title to the lender as discussed above, the Partnership no longer has an ownership interest in the property and recognized a gain for financial reporting and Federal income tax purposes during 1992 of $2,261,223 and $1,350,845, respectively with no corresponding distributable proceeds. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's 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 the Partnership. In response to the weakness of the economy and the general security of credit in the real estate industry 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. Also, in light of the current severely depressed real estate markets, it currently appears that the Partnership's goal of capital appreciation will not be achieved. Although the Partnership expects to distribute from sale proceeds some portion of the Limited Partners' original capital, without a dramatic improvement in market conditions the Limited Partners will not receive a full return of their original investment. RESULTS OF OPERATIONS The increase in short-term investments as of December 31, 1993 as compared to December 31, 1992 is primarily due to (i) the Partnership suspending cash distributions from operations effective with the first quarter of 1992 as discussed above, and (ii) the Partnership withholding the proceeds from the Sierra Pines Apartments and The Crossing Apartments sales for future capital requirements. The increase in loan commitment fee as of December 31, 1993 as compared to December 31, 1992 is due to the payment of a refundable loan commitment fee (approximately $1,164,000) for the National City Center Building mortgage refinancing in 1993 (see Note 4(e)). The decrease in escrow deposits as of December 31, 1993 as compared to December 31, 1992, primarily reflects the refund in 1993 of an escrow account of approximately $477,000 established for capital improvements at Sierra Pines and Crossing Apartments at the time the Partnership obtained replacement loans for previously existing long-term mortgage notes. This decrease is partially offset by the increase of escrow accounts at the Carrara Place Office Building for operating reserves and real estate taxes required by the mortgage loan modification. Reference is made to Note 4. The decrease in investment properties, current portion of long-term debt and tenant security deposits as of December 31, 1993 as compared to December 31, 1992 is primarily due to the second mortgage lender's realization upon its security represented by the Country Square Apartments in February 1993 and the sales of the Sierra Pines and Crossing Apartments in July 1993. (See Notes 4(b) and 7(c)). In addition, the decrease in current portion of long-term debt and corresponding increase in long-term debt, less current portion is primarily due to the reclassification of the mortgage at the Carrara Place Office Building due to the Partnership no longer being in default as more fully described in Note 3(d). The current portion of long-term debt in 1993 primarily reflects the Stonybrook-II apartment complex mortgage and second mortgage obligations payable in October 1994. Reference is made to Note 4. The decrease in deferred expenses at December 31, 1993 as compared to December 31, 1992 is primarily due to amortization of leasing commissions and lease assumptions in 1993 at First Interstate Office Building. The increase in accrued interest as of December 31, 1993 as compared to December 31, 1992 reflects the cumulative unpaid interest attributable to the Carrara Place Office Building mortgage. Reference is made to Note 4. The decrease in accounts payable and accrued real estate taxes as of December 31, 1993 as compared to December 31, 1992 is primarily due to the second mortgage lender's realization upon its security represented by the Country Square Apartments in February 1993 and the sale of the Sierra Pines and Crossing Apartments in July 1993. The decrease in rental income for the year ended December 31, 1993 as compared to the years ended December 31, 1992 and 1991 is primarily due to decreased occupancy at the Carrara Place Office Building, the second mortgage lender's realization upon its security represented by the Country Square Apartments in February 1993 and the sale of the Sierra Pines and Crossing Apartments in July 1993. This decrease is partially offset by a lease termination fee received in January 1993 at the National City Center Office Building. The decrease in interest income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily due to a decrease in interest income recognized on the promissory note receivable for San Mateo Fashion Island (reference is made to Note 7(b)). The decrease in interest income for the year ended December 31, 1992 as compared to 1991 is primarily due to a decrease in interest income recognized on the wrap-around notes receivable for Arbor Town Apartments-I and Arbor Town Apartments-II (reference is made to Note 7(a)). The decrease in mortgage and other interest, depreciation and property operating expenses for the year ended December 31, 1993 as compared to 1992 is primarily due to the second mortgage lender's realization upon its security represented by the Country Square Apartments in February 1993 and the sale of the Sierra Pines and Crossing Apartments in July 1993. In addition, the decrease in mortgage and other interest is also due to the lenders realizing upon their security in the Arbor Town Apartments-I and Arbor Town Apartments- II in December 1992. (See Notes 4(b), 4(d), 7(a) and 7(c)). The decrease in mortgage and other interest for the year ended December 31, 1992 as compared to 1991 is primarily due to a decrease in interest expense recognized on the underlying mortgage notes payable at the Arbor Town Apartments-I and Arbor Town Apartments-II in 1992 (as described above). The decrease in management fees to the Corporate General Partner for the year ended December 31, 1993 as compared to 1992 and 1991 is due to the Partnership reducing the Limited Partners cash distribution effective as of the third and fourth quarters of 1991 and suspending distributions to the Limited and General Partners effective as of the first quarter 1992 (reference is made to Note 9). The provision for value impairment for the year ended December 31, 1992 is due to the Partnership recording a provision to reduce the net carrying value of the Sierra Pines Apartments, based upon a proposed sales price (see Note 1). The provision for uncollectible note receivable for the year ended December 31, 1991 is due to the Partnership's reserve on the note receivable on the San Mateo Fashion Island shopping center. (See Note 7(b).) The increase in Partnership's share of operations of unconsolidated venture for the year ended December 31, 1993 as compared to 1992 is due to the transfer of title to the property to the lender of the Yerba Buena West Office Building in June 1992. The increase in venture partners' share of ventures' operations for the year ended December 31, 1993 as compared to 1992 and 1992 as compared to 1991 and the corresponding increase in venture partners' deficits in venture as of December 31, 1993 as compared to 1992, is primarily due to decreased rental income at the Carrara Place Office Building primarily due to decreased occupancy. The gain on sale or disposition of investment properties for the year ended December 31, 1993 is due to the second mortgage lender's realization upon its security represented by the Country Square Apartments in February 1993 of $1,520,734 and the $2,570,949 gain on sale of the Sierra Pines and Crossing Apartments in July 1993. The gain on disposition of investment property for the year ended December 31, 1992 is due to the transfer of title to the property to the lender of the Yerba Buena West Office Building in June 1992. In addition, the lenders of Arbor Town Apartments - I and Arbor Town Apartments - II realized upon their security and took title to the properties in December 1992. The gain on disposition in 1991 is due to the lender realizing upon its security in Summerfield/Oakridge Apartments and taking title to the properties in January 1991. Reference is made to Note 7. 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 - XII (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 1991 Consolidated Statements of Partners' Capital Accounts (Deficit), 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 SCHEDULE -------- Supplementary Income Statement Information X Consolidated 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 consolidated financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - XII (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 - XII 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 - XII (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 Carlyle Seattle Associates ("Carlyle Seattle"), Stonybrook Partners Limited Partnership ("Stonybrook"), Carrara Place Limited ("Carrara"), Carlyle/P.M. Apartments Partnership ("Carlyle/P.M."), Carlyle Carrollton Associates ("Carlyle Carrollton"), and Carlyle/National City Associates ("Carlyle/National City"), Carlyle Seattle's venture, Wright-Carlyle Seattle ("First Interstate"), Carlyle Carrollton's venture, Country Square, Ltd. ("Country Square"), and Carlyle/P.M.'s venture, Oakridge Apartments Partnership ("Oakridge"). 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 interest in Carlyle Yerba Buena Limited Partnership ("Yerba Buena"), through the date of its disposition (note 3(c)). Accordingly, the accompanying consolidated financial statements do not include the accounts of Yerba Buena. 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 net effect of these items is summarized as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net earnings (loss) per limited partnership interest is based upon the limited partnership interests outstanding at the end of each year (160,005). 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 classifications 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. In addition, the Partnership records amounts held in U.S. Government obligations and certificates of deposit at cost which approximates market. Therefore, 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 (none held at December 31, 1993 and 1992) as cash equivalents with any remaining amounts reflected as short-term investments. Deferred expenses are comprised principally of deferred leasing commissions and deferred lease assumption costs which are amortized over the lives of the related leases and deferred mortgage costs which are amortized over the term of the related notes. 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. Statement of Financial Accounting Standards No. 107, ("SFAS 107"),"Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150 million at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes the carrying amount of its financial instruments classified as current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. There is no quoted market value available for any of the Partnership's other instruments. The debt, with a carrying balance of $201,201,952, has been calculated to have an SFAS 107 value of $213,686,333 by discounting the scheduled loan payments to maturity. Due to restrictions on transferability and prepayment, and the inability to obtain comparable financing due to previously modified debt terms or other property specific competitive conditions, the Partnership would be unable to refinance these properties to obtain such calculated debt amounts reported. (See note 4.) The Partnership has no other significant financial instruments. During 1992, the Partnership entered into a contract (that was subsequently terminated) to sell the Sierra Pines Apartments subject to certain contingencies. Based upon the proposed sales price, the Partnership would not have recovered the net carrying value of the investment property. The Partnership, therefore, as a matter of prudent accounting practice, made a provision for value impairment on such investment property of $2,682,822. Such provision was recorded in September 1992, to effectively reduce the net carrying value of the investment property, based upon the proposed sale price. The Sierra Pines Apartments was sold in July 1993 (note 7(c)). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 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. (2) INVESTMENT PROPERTIES The Partnership has acquired, either directly or through joint ventures, ten apartment complexes, four office buildings, and two enclosed shopping malls. During 1984, the Partnership sold its interest in the Arbor Town Apartments-I and the Arbor Town Apartments-II complexes. Subsequently, in 1992, the lenders on the Arbor Town Apartments-I and Arbor Town Apartments-II complexes realized upon their security and obtained title to the properties resulting in the Partnership no longer having a security interest in the properties (note 4(d)). In 1986, the Partnership conveyed its interest in the Presidio West Apartments-II and sold its interest in the San Mateo shopping center. In 1990, the Partnership disposed of its interest in the Timberline Apartments and sold its interest in the Meadows Southwest Apartments. In 1991, the Partnership, through its joint venture, disposed of its interest in the Summerfield/Oakridge Apartments. In 1992, the Yerba Buena venture transferred title to the property to the lender (note 3(c)). In 1993, the Partnership sold its interest in the Sierra Pines Apartments and The Crossing Apartments, and disposed of its interest in the Country Square Apartments (note 7). The five properties owned at December 31, 1993 were completed and in operation. Depreciation on the operating properties has been provided over estimated useful lives of 5 to 40 years using the straight-line method. All investment properties are pledged as security for long-term debt, for which there is no recourse to the Partnership. The second mortgage on the Stonybrook apartment complex represented a mortgage loan which was subordinate to an existing senior mortgage loan. The Stonybrook second mortgage note was assigned to the Partnership during 1987. The mortgage loans secured by Stonybrook Apartment II mature in October 1994. The Partnership intends to initiate discussions with the mortgage lender regarding an extension or modification to the mortgage loan. If the Partnership is unable to secure an extension or modification to the loan, based upon current market conditions, the Partnership would likely not commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property. Such a decision could result in a gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. As of December 31, 1993 the outstanding balances are reflected in the current portion of long- term debt in the accompanying consolidated financial statements. 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, at December 31, 1993, is a party to four operating joint venture agreements. Pursuant to such agreements, the Partnership made aggregate capital contributions of $99,276,831. In general, the joint venture partners, who are either the sellers (or their affiliates) of the property CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED investments being acquired, or parties which have contributed an interest in the property being developed, or were subsequently admitted to the ventures, make no cash contributions to the ventures, but their retention of an interest in the property, through the joint venture, is taken into account in determining the purchase price of the Partnership's interest, which is 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, one apartment complex and three office buildings. In some instances, the properties were acquired (as completed) for a fixed purchase price. In other instances, properties were developed by the ventures and, in those instances, the contributions of the Partnership were generally fixed. The joint venture partners (who were primarily responsible for constructing the properties) 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, were to retain such excess. The venture properties have been financed under various long-term debt arrangements as described in note 4. The Partnership has a cumulative preferred interest in net cash receipts (as defined) from two of the Partnership's venture properties-Carrara Place Office Building and First Interstate Center. 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; additional net cash receipts are generally shared in a ratio relating to the various ownership interests of the Partnership and its venture partners. One of the ventures' properties produced net cash receipts during 1993, two in 1992. In general, operating profits and losses are shared in the same ratio as net cash receipts. If there are no net cash receipts, substantially all profits or losses are allocated in accordance with the partners' respective economic interests. 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. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's 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 the Partnership. (b) First Interstate Center During 1982, the Partnership acquired, through a joint venture ("First Interstate") between an affiliated 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-X, 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 73.3% by the Partner- ship and 26.7% by the affiliated partner. The initial required contribution by the Partnership to the Carlyle Seattle venture was $22,000,000. The Carlyle Seattle venture agreement further provides that all of the venture's CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 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 73.3% to the Partnership and 26.7% 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. 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 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) Yerba Buena West Office Building In August 1985, the Partnership acquired, through the Carlyle Yerba Buena Limited Partnership ("Yerba Buena"), an interest in an existing six-story office building known as Yerba Buena West Office Building in San Francisco, California. The Partners of Yerba Buena include Carlyle Real Estate Limited Partnership-XI and Carlyle Real Estate Limited Partnership-XIV, two public partnerships sponsored by the Corporate General Partner of the Partnership (the "Affiliated Partners") and four limited partners unaffiliated with the Partnership or its General Partners (the "Unaffiliated Partners"). The Partnership and the Affiliated Partners purchased an 80% interest in the property from the sellers and simultaneously formed Yerba Buena with the Unaffiliated Partners. The Partnership was generally entitled to 32.72% of Yerba Buena's annual net cash flow, net sale or refinancing proceeds and profits and losses. As has been previously reported, in connection with the October 17, 1989 San Francisco earthquake, the Yerba Buena office building incurred some structural and cosmetic damage which has been repaired. In addition, five tenants (approximately 54% of the building), based upon concerns over the structural integrity of the building, moved out of the building after the earthquake and have withheld all or portions of their rent commencing at various times since November 1989. The Partnership concluded not to pursue legal recourse against said tenants based on, among other things, the costs of pursuing its remedies, competing demands on the Partnership's resources and the prospects of any material return to the Partnership in light of recent events. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Based upon the conditions at Yerba Buena and the probability of large future cash deficits, the Partnership and its Affiliated Partners had decided not to fund future deficits and, therefore, the joint venture has not made the debt service payments to the underlying lender commencing with the January 1990 payment. Accordingly, the joint venture received a default notice from the underlying lender in late February 1990. The joint venture had been negotiating with the underlying lender to obtain a loan modification to pay for expected future cash deficits. The joint venture was unable to negotiate a loan modification whereby the joint venture retained ownership of the property and in June 1992, the joint venture transferred title to the property to the lender in return for an opportunity to share in future sale or refinancing proceeds above certain specified levels. In order for the joint venture to share in such proceeds, there must be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the property. In addition, during a certain period of time, the joint venture will have a right of first opportunity to purchase the property if the lender chooses to sell. An affiliate of the Partnership's Corporate General Partner continues to manage and lease the property for the lender. As a result of the transfer of title to the lender as discussed above, the Partnership no longer has an ownership interest in the property and recognized a gain for financial reporting and Federal income tax purposes of $2,261,223 and $1,350,845, respectively, in 1992 with no corresponding distributable proceeds. (d) Carrara The Carrara joint venture agreement provides that operating profits and losses of the venture are allocated 50% to the venture and 50% to the venture partner. Gain arising from the sale or other disposition of the property would be allocated to the venture partner or partners then having a deficit balance in its or their respective capital accounts in accordance with the terms of the venture agreement. Any additional gain would be allocated in accordance with the distribution of sales proceeds. The lease for Carrara Place Office Building's major tenant, which represented 46% of the building's leasable area and provided for rental payments that were significantly greater than current market rental rates, expired in December 1992 and the tenant vacated. The Carrara venture initiated discussions with the mortgage lender regarding a modification to the mortgage loan and in September 1993 reached an agreement to modify the loan retroactive to January 1, 1993. Under the modification, the maturity date has been extended from June 30, 1994 until January 1, 1998. Interest continues to accrue at 9.875% from January 1, 1993 until January 1, 1998. Effective January 1, 1993, the net cash flow of the property (after the required minimum interest payments of $8,333 monthly or $100,000 annually), subject to certain reserves including a $350,000 operating reserve to fund deficits, will be paid to the lender and applied toward the payment of accrued and unpaid interest, current interest and principal balance of the loan, respectively. Any capital costs, including re-leasing costs, are to be funded by the lender, (subject to their approval) and will be added to the principal balance of the loan. Approximately $203,900 has been funded by the lender as of December 31, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Concurrent with the modification, the Carrara venture has been reorganized such that the Partnership became the sole general partner of the venture, with its venture partner becoming a limited partner of the venture. In addition, the property manager (an affiliate of the unaffiliated venture partner) was replaced effective September 1993. Based upon an analysis of current and anticipated market conditions, the Partnership has decided not to commit additional funds to the Carrara Place Office Building. There must be a significant improvement in market and property conditions in order for the value of the property to be greater than the mortgage pay off amount at any point in time, including accrued interest. Therefore, it is unlikely that any significant proceeds would be received by the Partnership from a sale of the property or that the mortgage loan could be refinanced when it becomes due. In conjunction with the modification, the venture has agreed to transfer title to the lender if the venture fails to pay the loan in full on the earlier of the extended maturity date or an acceleration of the loan as a result of the occurrence of an event of default (as defined). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Included in the above total long-term debt is $2,055,549 and $3,418,549 at December 31, 1993 and 1992, respectively, which represents mortgage interest accrued but not currently payable pursuant to the terms of the notes (as modified). Five year maturities of long-term debt (exclusive of amortization of discount) are as follows: 1994 . . . . . . . . . .$ 6,489,518 1995 . . . . . . . . . . 155,348,654 1996 . . . . . . . . . . 720,851 1997 . . . . . . . . . . 795,347 1998 . . . . . . . . . . 23,640,728 ============ (b) Debt Modifications The Partnership modified the $5,800,000 second mortgage note secured by the Country Square apartment complex in Carrollton, Texas effective June 1, 1989. The pay rate was raised from 4% per annum to 5% per annum (payable in monthly installments of interest only) through December 1, 1992. Interest accrued and was deferred at a rate of 11% per annum from June 1, 1989 through December 31, 1990 and 12% per annum from January 1, 1991 through December 31, 1992; payable each April 30 to the extent of any annual cash flow (as defined) or upon the earlier of subsequent sale of the property or the January 1, 1993 maturity of the note. The lender notified the Partnership that it would not modify the existing terms of the second mortgage. The Partnership was unable to secure new or additional modifications or extensions to the loan, therefore as of December 31, 1992, the outstanding balance of $7,163,000 was reflected in the current portion of long-term debt in the accompanying consolidated financial statements. On February 2, 1993, the second mortgage lender concluded proceedings to realize upon its security and took title to the property. As a result, the Partnership recognized a gain for financial reporting purposes of $1,520,734 and a gain for Federal income tax purposes of $5,633,431 in 1993 with no corresponding distributable proceeds. The long-term mortgage notes secured by the Summerfield/Oakridge Apart- ments, located in Aurora, Colorado were modified, effective August 1, 1986. Beginning October 1, 1990, the scheduled monthly payments to the lender were not made. The lender provided the venture with a notice of default and placed the property in receivership October 16, 1990. Negotiations for further debt relief were not successful. In January 1991, the lender concluded proceedings to realize upon its security and took title to the property resulting in the Partnership recognizing a gain of $1,637,840 (net of venture partners' share of $270,551) for financial reporting purposes. Although no distributable proceeds were realized on this transaction, a gain of approximately $7,493,000 for Federal income tax purposes was recognized in 1991. As of December 31, 1992, the outstanding loan balance of the long-term mortgage note secured by the Carrara Place Office Building was reflected in the current portion of long-term debt due to the venture not making the scheduled debt service payments beginning January 1, 1993. The note was subsequently modified effective January 1, 1993. Under the modification, the maturity date has been extended from June 30, 1994 until January 1, 1998. Interest continues to accrue at 9.875% from January 1, 1993 until maturity. Effective January 1, 1993, the net cash flow of the property (after the required minimum interest payments of $8,333 monthly or $100,000 annually), subject to certain reserves including a $350,000 operating reserve to fund deficits, will be paid to the lender and applied toward the payment of accrued and unpaid interest, current interest and principal balance of the loan, CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED respectively. Any capital costs, including re-leasing costs, are to be funded by the lender, (subject to their approval) and will be added to the principal balance of the loan. In conjunction with the modification, the venture has agreed to transfer title to the lender if the venture fails to pay the loan in full on the earlier of the extended maturity date or an acceleration of the loan as a result of the occurrence of an event of default (as defined). (c) Refinancings Effective December 27, 1990, the Partnership obtained replacement loans from an institutional lender to retire in full satisfaction, at an aggregated discount, the previously modified existing long-term mortgage notes secured by the Sierra Pines Apartments and the Crossings Apartments. The new lender required the establishment of escrow accounts, of approximately $253,000 and $291,000, to be used toward the purchase of capital items at the Sierra Pines Apartments and the Crossings Apartments, respectively. As of the date of sale (see note 7(c)) approximately $62,000 and $6,000 were used for such purposes for the respective properties. The new mortgage loans, which were cross- collateralized, required interest only payments at 9.5% plus contingent interest (as defined) until January 1, 1999, when the remaining balance was payable. In 1993 and 1992, $176,334 and $145,029 were paid for 1992 and 1991 contingent interest, respectively for the properties. $107,945 was paid in 1993 for 1993 contingent interest for both properties through the date of sale. In the event that these properties were sold before the maturity date of the loan, the lender was to receive additional interest of 6% of the mortgage principal and, in general, the higher of 65% of the sale proceeds (as defined) or ten times the highest contingent interest (as defined) amount in any of the three full fiscal years preceding the sale. In 1993, the Partnership sold its interest in the Sierra Pines Apartments and The Crossing Apartments (see note 7(c)). (d) Arbor Town Apartments-I and Arbor Town Apartments-II In 1984, the Arbor Town Apartments-I and Arbor Town Apartments-II were sold, at which time the Partnership received $12,400,000 in wrap-around notes receivable. The Partnership elected to retain the original mortgages and planned to ultimately pay off the outstanding original mortgage balances from proceeds of the wrap-around notes receivable. The buyer voluntarily filed for protection under Chapter 11 of the United States Bankruptcy Code in May 1988. In April 1989, the United States Bankruptcy Court approved a plan of reorganization whereby the underlying mortgage notes payable were allowed to be modified. The subsequent modifications on the underlying mortgage notes payable were made retroactively effective to April 24, 1989 and September 1, 1988. The wrap-around notes receivable held by the Partnership had been modified to the extent the Partnership had agreed that the buyer make payments directly to the lenders (note 7(a)). (e) National City Center Office Building In January 1994, the debt service payments under the existing mortgage for the National City Center Office Building are scheduled to increase from 9- 5/8% to 11-7/8% until the maturity of the loan in December 1995. The Partnership reached an agreement in principle with the current mortgage lender to refinance the existing mortgage which would be effective February 1, 1994, with an interest rate of 8.5%. The loan would be amortized over 22 years with a balloon payment due in seven years. The Partnership paid a refundable loan commitment fee of $1,164,000 in 1993 in conjunction with the proposed refinancing. The Partnership also expects to pay a prepayment penalty of approximately $600,000, based on the outstanding mortgage balance at the time CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED of refinancing. In addition, the lender would require an escrow account of approximately $610,000 to be established at the inception of the refinancing which would be supplemented from time to time for scheduled future tenant improvements costs at the property. There can be no assurance that the loan refinancing can be obtained. The buyer retroactively modified the terms of the mortgage note payable and related accrued interest secured by the Arbor Town Apartments-I under the reorganization mentioned above. The modified principal balance (including deferred fees) was determined to be $3,261,865. Monthly payments of interest only at 9.875% per annum were due until August 1991. Beginning September 1, 1991, through the scheduled maturity date of December 20, 1994, monthly payments of principal and interest were due at 9.875%. The maturity date of the mortgage note payable could have been extended to August 31, 1998, at the option of the buyer. The buyer also retroactively modified the terms of the mortgage note payable and related accrued interest secured by the Arbor Town Apartments-II under the reorganization mentioned above. Monthly payments of interest only of 8%, 8.5% and 9% were effective September 1, 1990, 1991 and 1992, respectively. The interest accrual rate was reduced from 14.5% per annum to 9% per annum. The difference between the accrual interest rate and the pay rates was added to the outstanding principal balance which would have been due January 1, 1993. The buyer was in default on the underlying first mortgage payments made directly to the lenders. As a result, the lenders provided the Partnership with letters of default. In December 1992, the lenders concluded proceedings to realize upon their security and obtained title to the properties resulting in the Partnership no longer having a security interest in the properties. Although the Partnership received no cash proceeds from the transfer of its security interest; it did, however, recognize a gain for financial reporting purposes and a loss for Federal income tax purposes in 1992 of $1,556,577 and $275,509, respectively. (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 or other disposition of investment properties will be allocated first to the General Partners in an amount equal to the greater of the amount distributable to the General Partners as sale or refinancing proceeds from sale or other disposition of investment properties (as described below) or 1% of the profits from the sale or refinancing. Losses from the sale or other disposition of investment properties will be allocated 1% to the General Partners. The remaining sale or other disposition of investment properties profits and losses will be allocated to the Limited Partners. An amendment to the Partnership Agreement, effective January 1, 1991, generally provides that notwithstanding any allocation contained in the Agreement, if at any time profits are realized by the Partnership, any current or anticipated event that would cause the deficit balance in absolute amount in the Capital Account of the General Partners to be greater than their 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 (as defined) after such event. In general, the effect of this amendment is to allow the deferral of the recognition of taxable gain to the Limited Partners. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 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 will 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 99% to the Limited Partners and 1% to the General Partners until receipt by the Limited Partners of their initial contributed capital plus a stipulated return thereon. Thereafter, distributions of "sale proceeds" and "financing proceeds" are to be allocated to the General Partners until the General Partners have received an amount equal to 3% of the gross sales prices of any properties sold, then the balance 85% to the Limited Partners and 15% to the General Partners. (6) MANAGEMENT AGREEMENTS The Partnership has entered into agreements with sellers or affiliates of the sellers for the operation and management of several properties. Such agreements provided that, during the term of these agreements, the managers paid all expenses of the properties and retained the excess, if any, of cash revenues from operations over costs and expenses, as defined, as a management fee. Upon termination of the agreements, an affiliate of the General Partners assumed management under agreements providing for management fees calculated at a percentage of the gross income from the properties. An affiliate of the General Partners of the Partnership manages the following properties for a fee calculated at a percentage of gross income from the following properties: Sierra Pines Apartments, Houston, Texas (through July 29, 1993) Country Square Apartments, Carrollton, Texas (through February 1, 1993) Permian Mall, Odessa, Texas National City Center, Cleveland, Ohio Crossing Apartments, Houston, Texas (through July 29, 1993) Stonybrook Apartments-I & II, Tucson, Arizona (7) SALE OF INVESTMENT PROPERTIES (a) Arbor Town Apartments-I and Arbor Town Apartments-II During November 1984, the Partnership concurrently sold the land and related improvements of the Arbor Town Apartments-I and Arbor Town Apartments-II located in Arlington, Texas for $15,500,000, consisting of $3,100,000 in cash and $12,400,000 of wrap-around notes receivable. The purchase wrap-around notes were subject to existing mortgage notes (note 4). The sale was accounted for by the installment method whereby the gain on sale of $2,724,491 (net of discount on the notes receivable of $890,413) was recognized as collections of principal were received. No profit was recognized by the Partnership in 1992 and 1991. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership did not receive the scheduled interest only payments of approximately $2,000,000 on the wrap-around notes receivable from January 1988 through May 1989 and, therefore, the Partnership did not make the corresponding scheduled monthly payments on the underlying indebtedness. The buyer voluntarily filed for protection under Chapter 11 of the United States Bankruptcy Code in May 1988. In April 1989, the United States Bankruptcy Court approved a plan of reorganization, whereby scheduled payments on the wrap-around notes receivable and related underlying mortgage notes payable were allowed to be modified by the buyer. Under the terms of the Bankruptcy Reorganization Plan, the Partnership's wrap-around notes receivable and underlying non-recourse mortgage notes payable remained outstanding. The buyer subsequently negotiated the modification of the underlying non-recourse mortgage notes payable directly with the lenders while the wrap-around notes receivable had been modified to the extent the Partnership had agreed that the buyer make payments directly to the lender. These modifications modified the terms of the original underlying loan agreements resulting in permanent interest expense reductions. For financial reporting purposes, these interest expense reductions had been offset by adjustments to the wrap-around notes receivable. No reserve for collectibility had been established previously due to the existence of deferred gain exceeding the net equity in the wrap-around notes receivable, with the underlying indebtedness being non-recourse to the Partnership. The Partnership recognized interest income on the wrap-around notes receivable only to the extent interest had been paid by the buyer on the modified underlying indebtedness. In December 1992, the lenders concluded proceedings to realize upon their security and obtained title to the properties resulting in the Partnership no longer having a security interest in the properties (see note 4(d)). (b) San Mateo Fashion Island On December 31, 1986, the Partnership sold its right, title and interest in the land, leasehold interest and related improvements of the San Mateo Fashion Island shopping center for $44,202,559 and recognized profit in full of $9,528,813. The sale price consisted of $950,000 in cash at closing, the assumption of the existing mortgage note having an unpaid principal balance of $39,302,559 (for financial reporting purposes the principal balance was $28,895,264) and an additional promissory note in the amount of $3,950,000 ($950,000 paid in March 1988) secured by a subordinated deed of trust on the property. In addition to the sale price, the Partnership received $7,600,000 from the venture partner during 1986 under the terms of the venture agreement. During the first quarter of 1992, the Partnership was advised by the buyer (in which the Corporate General Partner has an interest) that it had initiated discussions directly with the first mortgage lender regarding a modification to the first mortgage note. The buyer is currently making reduced payments to the first mortgage lender and has discontinued making payments to the Partnership as of March 1992. Due to uncertainty regarding the value of the underlying collateral, the Partnership reserved for the entire outstanding principal balance and accrued interest ($3,720,000) on the note receivable as of December 31, 1993 and 1992 in the accompanying consolidated financial statements. In addition, the entire outstanding principal balance and accrued interest was written off for Federal income tax purposes in 1992. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (c) Sierra Pines and Crossing Apartments On July 29, 1993, the Partnership sold the land, buildings, related improvements and personal property of the Sierra Pines and Crossing Apartments located in Houston, Texas. The purchaser is not affiliated with the Partnership or its General Partners and the sale price was determined by arm's-length negotiations. The sale prices of the land, buildings, related improvements and personal property for Sierra Pines and Crossing Apartments were $4,880,000 and $9,535,000, respectively. A portion of the cash proceeds was utilized to retire the first mortgage notes with outstanding balances of $4,380,000 and $7,600,000, respectively, secured by the properties. The Partnership paid additional interest of $1,230,923 in the aggregate in connection with the retirement of the mortgage notes. The Partnership received in connection with these sales, after additional interest and normal costs of sale, a net amount of cash of approximately $950,000 (including $288,000 in advisory fees) in the aggregate. As a result of these sales, the Partnership recognized gains for financial reporting purposes of $44,030 and $2,526,916, respectively, and recognized a gain for Federal income tax purposes of $1,510,727 and $6,164,118, respectively. (8) LEASES (a) As Property Lessor At December 31, 1993, the Partnership and its consolidated ventures' principal assets are one apartment complex, one enclosed shopping mall and three office buildings. 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 cost of land, is depreciated over the estimated useful life. Leases with commercial tenants range in term from one to thirty years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants provide additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investment, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. 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 $1,762,376. Cost and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Shopping mall: Cost. . . . . . . . . . . . $ 24,294,375 Accumulated depreciation. . (7,666,062) ------------ 16,628,313 ------------ Office buildings: Cost. . . . . . . . . . . . 221,682,710 Accumulated depreciation. . (71,337,019) ------------ 150,345,691 ------------ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Apartment complex: Cost. . . . . . . . . . . . 8,022,749 Accumulated depreciation. . (3,543,125) ------------ 4,479,624 ------------ Total. . . . . . . . . . $171,453,628 ============ 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 above commercial operating lease agreements, are as follows: 1994 . . . . . . . . . . . $ 29,940,250 1995 . . . . . . . . . . . 26,817,970 1996 . . . . . . . . . . . 24,999,921 1997 . . . . . . . . . . . 22,656,470 1998 . . . . . . . . . . . 22,120,863 Thereafter . . . . . . . . 114,672,214 ------------ Total. . . . . . . . . $241,207,688 ============ (b) As Property Lessee The First Interstate 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 rent of $670,000 and has been determined to be an operating lease. (9) TRANSACTIONS WITH AFFILIATES Fees, commissions and other expenses required to be paid by the Partnership to the General Partners and their affiliates as of December 31, 1993 and for the years ended December 31, 1993, 1992 and 1991 are as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED The General Partners and their affiliates have deferred through June 30, 1988 payment of certain property management and leasing fees of $3,522,816. In addition, the Partnership deferred the General Partners' cash distribution and management fee of $19,666 and $33,334, respectively, for the third and fourth quarters of 1991. These deferred amounts (approximately $22 per Interest in the aggregate) and amounts currently payable do not bear interest and are expected to be paid in future periods. SCHEDULE X CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII (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. $4,852,082 5,068,044 4,825,845 Depreciation . . . . . . 9,144,746 9,598,560 9,476,084 Taxes: Real estate. . . . . . 4,747,734 5,198,223 5,009,727 Other. . . . . . . . . 11,727 459,393 7,009 Advertising. . . . . . . 289,171 363,351 380,435 ========== ========= ========= 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 1993 and 1992. 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, as the Corporate General Partner, 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-XII, 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 9-14 of the Prospectus, which description is hereby incorporated herein by reference to exhibit 3-A to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. The names, positions held and length of service therein of each director and executive officer and certain officers of the Corporate General Partner 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 8/02/93 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President and 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-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), 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") and Carlyle Income Plus, Ltd.-II ("Carlyle Income Plus-II") and the managing general partner of 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 Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II")) and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). 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-X, Carlyle-XI, 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, 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 138-139, "Allocation of Profits or Losses for Tax Purposes" at page 137 and "Distributions and Compensations; Allocations of Profits and Losses" at pages A-6 to A-11 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- 12433) dated March 19, 1993. Reference is also made to Notes 5 and 9 for a description of such transactions, distributions and allocations. In 1993, 1992 and 1991, cash distributions of $0, $0 and $55,002 were paid, respectively, to the General Partners. Effective as of the third and fourth quarters of 1991, the Partnership deferred the General Partner's cash distribution and deferred management fees. The General Partners received a share of the Partnership's long-term capital gain for tax purposes aggregating $1,456,799 in 1993. In addition, the General Partners received a share of the Partnership's operating losses aggregating $354,098. 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 9-14 and "Powers, Rights and Duties of the General Partners" at pages A-13 to A-19 of the Prospectus, which 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. 0-12433) dated March 19, 1993. The relationship of the Corporate General Partner (and its directors and officers) to its affiliates is set forth above in Item 10. JMB Properties Company, an affiliate of the Corporate General Partner, provided property management services to the Partnership for all or part of 1993 for the Sierra Pines Apartments, and Crossing Apartments in Houston, Texas, the Country Square Apartments in Carrollton, Texas, the Stonybrook Apartments - I & II in Tucson, Arizona, the Permian Mall in Odessa, Texas and National City Center Office Building in Cleveland, Ohio at fees calculated at a percentage of gross income from the properties. In 1993, such affiliate earned property management fees amounting to $1,055,773 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 specified in the Prospectus), 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 insurance brokerage commissions in 1993 aggregating approximately $50,000, all of which were paid in 1993 in connection with the providing 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 of the Partnership or their affiliates may be reimbursed for their direct expenses or out-of-pocket 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 $219,787, of which $77 was unpaid as of 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 $40,427, all of which were unpaid at December 31, 1993. The General Partners earned no disbursement agent fees in 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 (see Note 3(c) to the accompanying Notes to Consolidated Financial Statements). 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 June 21, 1982, as supplemented on August 24, 1982, October 21, 1982, November 1, 1982, December 22, 1982 and February 18, 1983, as filed with the Commission pursuant to Rules 424(b) and 424(c), is hereby incorporated herein by reference. Copies of pages 6-14, 137-139, A-6 to A-11 and A-13 to A-19 are incorporated by reference to the Partnership's Registration Statement on Form S-11 (File No. 2-76443) dated June 21, 1982. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, is incorporated by reference to the Partnership's Registration Statement on Form S-11 (File No. 2-76443) dated June 21, 1982. 4-A. Mortgage loan agreement between Wright-Carlyle Seattle and The Prudential Insurance Company dated October 16, 1985, relating to the First Interstate Center is hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 4-B. Mortgage loan agreement between Carlyle/National City Associates and New York Life Insurance Company dated November 15, 1983, relating to the National City Center Office Building is hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 10-A.Acquisition documents including the venture agreement relating to the purchase by the Partnership of an interest in the First Interstate Center in Seattle, Washington are hereby incorporated by reference to the Partnership's prospectus on Form S-11 (File No. 2-76443), dated June 21, 1982. 10-B.Acquisition documents including the venture agreement relating to the purchase by the Partnership of an interest in the National City Center Office Building in Cleveland, Ohio are hereby incorporated by reference to the Partnership's Report on Form 8-K, dated August 8, 1983. 10-C.Bargain and Sale Deed relating to the Partnership's disposition of the Timberline Apartments in Denver, Colorado, dated July 25, 1990 is hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 10-D.Sale documents and exhibits thereto relating to the Partnership's sale of the Meadows Southwest Apartments in Houston, Texas are hereby incorporated herein by reference to the Partnership's Report on Form 8- K, dated January 11, 1991 by reference. 10-E.Non-Merger Quit Claim Deeds relating to the Partnership's disposition of the Summerfield/Oakridge Apartments in Aurora, Colorado, dated January 7, 1991 are hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 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 SEC upon request. (b) No report on Form 8-K was filed since the beginning of the last quarter of the period covered by this report. No annual report for the 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 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 - XII 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 a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 6-14, 137-139, A-6 to A-11 and A-13 to A-19 of the Prospectus of the Partnership dated June 21, 1982, as supplemented on August 24, 1982, October 21, 1982, November 1, 1982, December 22,1982 and February 28, 1983Yes 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus Yes 4-A. Mortgage loan agreement related to the First Interstate Center Yes 4-B. Mortgage loan agreement related to the National City Center Office Building Yes 10-A. Acquisition documents related to First Interstate Center Yes 10-B. Acquisition documents related to National City Center Office Building Yes 10-C. Bargain and Sale Deed related to Timberline Apartments Yes 10-D. Sale documents related to the Meadows Southwest Apartments Yes 10-E. Non-Merger Quit Claim Deeds related to the Summerfield/Oakridge Apartments 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 (see Note 3(c) to the accompanying Notes to Consolidated Financial Statements). 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 June 21, 1982, as supplemented on August 24, 1982, October 21, 1982, November 1, 1982, December 22, 1982 and February 18, 1983, as filed with the Commission pursuant to Rules 424(b) and 424(c), is hereby incorporated herein by reference. Copies of pages 6-14, 137-139, A-6 to A-11 and A-13 to A-19 are incorporated by reference to the Partnership's Registration Statement on Form S-11 (File No. 2-76443) dated June 21, 1982. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, is incorporated by reference to the Partnership's Registration Statement on Form S-11 (File No. 2-76443) dated June 21, 1982. 4-A. Mortgage loan agreement between Wright-Carlyle Seattle and The Prudential Insurance Company dated October 16, 1985, relating to the First Interstate Center is hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 4-B. Mortgage loan agreement between Carlyle/National City Associates and New York Life Insurance Company dated November 15, 1983, relating to the National City Center Office Building is hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 10-A.Acquisition documents including the venture agreement relating to the purchase by the Partnership of an interest in the First Interstate Center in Seattle, Washington are hereby incorporated by reference to the Partnership's prospectus on Form S-11 (File No. 2-76443), dated June 21, 1982. 10-B.Acquisition documents including the venture agreement relating to the purchase by the Partnership of an interest in the National City Center Office Building in Cleveland, Ohio are hereby incorporated by reference to the Partnership's Report on Form 8-K, dated August 8, 1983. 10-C.Bargain and Sale Deed relating to the Partnership's disposition of the Timberline Apartments in Denver, Colorado, dated July 25, 1990 is hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 10-D.Sale documents and exhibits thereto relating to the Partnership's sale of the Meadows Southwest Apartments in Houston, Texas are hereby incorporated herein by reference to the Partnership's Report on Form 8- K, dated January 11, 1991 by reference. 10-E.Non-Merger Quit Claim Deeds relating to the Partnership's disposition of the Summerfield/Oakridge Apartments in Aurora, Colorado, dated January 7, 1991 are hereby incorporated by reference to the Partnership's report for December 31, 1992 on Form 10-K (File No. 0-12433) dated March 19, 1993. 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 SEC upon request. (b) No report on Form 8-K was filed since the beginning of the last quarter of the period covered by this report. No annual report for the 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 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 - XII 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 a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 6-14, 137-139, A-6 to A-11 and A-13 to A-19 of the Prospectus of the Partnership dated June 21, 1982, as supplemented on August 24, 1982, October 21, 1982, November 1, 1982, December 22,1982 and February 28, 1983Yes 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus Yes 4-A. Mortgage loan agreement related to the First Interstate Center Yes 4-B. Mortgage loan agreement related to the National City Center Office Building Yes 10-A. Acquisition documents related to First Interstate Center Yes 10-B. Acquisition documents related to National City Center Office Building Yes 10-C. Bargain and Sale Deed related to Timberline Apartments Yes 10-D. Sale documents related to the Meadows Southwest Apartments Yes 10-E. Non-Merger Quit Claim Deeds related to the Summerfield/Oakridge Apartments Yes 21. List of Subsidiaries No 24. Powers of Attorney No

78853_1993.txt

78853_1993

1993

78853

ITEM 1. BUSINESS Pitt-Des Moines, Inc. and its subsidiaries (PDM or the Company) began conducting business in 1892 and was incorporated in Pennsylvania on February 14, 1916. The Company's principal executive offices are located at 3400 Grand Avenue, Pittsburgh, Pennsylvania 15225, telephone number (412) 331-3000. The Company is comprised of four business segments: Engineered Construction Division, Steel Construction Division, Steel Service Centers and CVI Incorporated. Each segment is a profit center except the Steel Construction Division business segment which is divided into four profit centers as noted below. A summary of the Company's products and services by business segment is set forth below. Additional business segment information is included in Part II of this Form 10-K. ENGINEERED CONSTRUCTION DIVISION Beginning in 1994, the Engineered Construction Division organized into three profit centers: Water, Industrial, and International and Technology. These market groups provide: a) The capability to design, fabricate and erect many types of facilities and structures; services offered include research and design, material selection, preparation of detailed drawings, shop fabrication, field erection and subcontract management. b) The capability to design, fabricate and erect elevated and flat bottom water storage tanks for water service and fire protection requirements and treatment tanks for the purification, filtration and softening of water. The principal purchasers of the Company's water storage tanks and wastewater treatment facilities are government agencies and private industry. c) The capability to design, fabricate and erect oil and chemical storage tanks used for storing crude oil, petroleum, gasoline and other petroleum derivatives and chemicals. The Company has developed and patented certain systems, parts and sealing devices which help to reduce the hazards of fire and explosion from the stored products, as well as to decrease air pollution and vapor loss. Additionally, the Company fabricates and erects various vessels used in the processing of a variety of oil and chemical products. The oil and chemical tanks, sealing devices and process vessels are produced principally for the petroleum, petrochemical, chemical and food processing industries as well as government agencies. d) The capability to fabricate and erect miscellaneous plate work which includes penstocks and breechings, stacks and stack liners, scrubbers, absorbers, flow conductors and heat exchangers for utilities and private industry. e) The capability to design, fabricate and erect high speed wind tunnels, altitude test chambers, hydrospace test facilities and high vacuum and thermal test facilities for use in connection with energy, aerospace and defense research. f) The capability to design and build supercritical fluid extraction facilities for the food processing industry. g) The capability to design and build anaerobic digesters for the wastewater treatment industry. ITEM 1. BUSINESS (CONT'D) STEEL CONSTRUCTION DIVISION a) The capability to fabricate and erect structural steel for commercial, institutional and public sector buildings for government agencies, private developers and general contractors. b) The capability to fabricate structural steel for new bridges and fabricate and erect structural steel for bridge rehabilitation for government agencies and general contractors. STEEL SERVICE CENTERS The operation of six steel service centers and three culvert facilities located in the west and midwest regions of the United States. The Company processes and distributes a general line of carbon steel products including plates, sheets, structural shapes, bars, tubes, pipe and other miscellaneous metal products. The Company also manufactures and markets corrugated metal culvert pipe and accessories. The Steel Service Centers' primary markets include steel fabricators, original equipment manufacturers and the mining, logging, agricultural and road construction industries. CVI INCORPORATED a) The capability to design, fabricate and construct low temperature and cryogenic systems and storage vessels for various liquefied gases such as anhydrous ammonia, propane, natural gas and elements of air used primarily in the chemical, petrochemical, natural gas and aerospace industries. b) The capability to design and manufacture cryogenic pumps, cryogenic valves, vacuum seal-off valves, cryopumps, nuclear spares, vacuum insulated pipe and other specialty cryogenic components. On July 11, 1993, the Company's Des Moines Steel Construction plant, along with the headquarters office building for the Engineered Construction Division, both located in Des Moines, Iowa, were severely damaged by the devastating flood in the Midwest. The Company has completed the flood related cleanup of both facilities and is continuing to evaluate the future costs of the flood. All work which was in process at the Des Moines Steel Construction plant was completed or transferred to other locations while the Company evaluates alternatives for the facility. The headquarters personnel for the Engineered Construction Division continue to operate from temporary quarters at that Division's plant in Clive, Iowa. On November 3, 1993, an accident occurred at the construction site of a new United States Post Office in Chicago where the Company's Steel Construction business segment is in the process of fabricating and erecting the steel structure of the building. Two men were killed and five seriously injured when a portion of the erected steel collapsed. An investigation of the cause of the accident is being conducted by the Federal Occupational Safety and Health Administration. Several large companies compete nationally in some product lines with the Company and there are several local and regional companies that compete in certain product lines in specific geographic areas. The majority of the Company's business is secured through open competitive ITEM 1. BUSINESS (CONT'D) bidding or through direct negotiations with industry or government agencies. Competition is based primarily on performance including the ability to provide design, engineering and on-site field construction services in a cost-effective, timely manner. The Steel Service Centers' volume of business is based on the price, delivery and credit terms, and first stage preprocessing operations offered to its customers as well as its reputation. Earned revenue was $354 million in 1993, compared with $383 million in 1992 and $392 million in 1991. For further financial information refer to pages 14 through 29. The principal raw materials essential to the Company's business are steel, alloys and other metal plates and structural sections. The Company procures these raw materials from various domestic and foreign sources including, the mills of USX Corporation, Bethlehem Steel Corporation, Northwestern Steel and Wire Company, Nucor Steel, British Steel and Mitsubishi International Corporation. The Company has a license and technical assistance agreement with Roediger, a German corporation, which gives the Company exclusive rights in North America and other selected countries worldwide to use the Roediger technology, a process which utilizes anaerobic digestion in the treatment of wastewater. Revenues to date from this technology have not been material to the Company. Some components of the other products made and erection techniques used by the Company are covered by patents owned or licensed by the Company. None of these are deemed to be material to the Company from an overall financial viewpoint. The Company had a backlog of uncompleted contracts of $190 million on December 31, 1993 compared to $142 million on December 31, 1992. Approximately 5 percent of the backlog on December 31, 1993 is not expected to be completed during 1994. Factors such as the type and scope of operations in progress at any given time, including weather conditions at field sites, create fluctuations in the employment level at PDM. On December 31, 1993, the Company employed 1,987 persons, of which 674 were salaried personnel and 1,313 were hourly personnel. International sales during 1993 were minimal as the Company continues to concentrate on a few selected foreign projects and to negotiate additional cooperation agreements which allow for the supply of experience and technology without incurring overseas, on-site risk. ITEM 2. ITEM 2. PROPERTIES Operations of the Company are conducted at both owned and leased properties. In addition, certain owned properties of the Company are leased to third party tenants. The following table indicates each of the Company's facilities in the United States by: segment, location, year operations began, approximate floor space and acreage owned or leased on December 31, 1993: - ----------------- (1) Company leased facility from outside third party. (2) Company pursues the sale or development of all idle facilities and regularly evaluates similar opportunities for facilities not fully utilized. (3) Company is leasing facility to a third party with a purchase option which expires on December 31, 1995. (4) Company leases land from outside third party. Lease will expire January 31, 2003. ITEM 2. PROPERTIES (CONT'D) The Company also has a 50 percent ownership in a joint venture, PDM Saudi Arabia, Ltd., which operates a heavy steel fabrication and machining facility in Saudi Arabia. All significant properties are utilized by the Company's business segments. The Company's production capacity is adequate for its present needs. The Company believes that its properties have been adequately maintained, are generally in good condition and are suitable for the Company's business as now conducted. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are various claims and legal proceedings against the Company arising from the normal course of business. As previously reported, in May 1984, Washington Public Power Supply System (WPPSS) filed a complaint against the Company and its surety in the United States District Court for the Eastern District of Washington. Various claims in connection with retrofit work performed by the Company at Nuclear Unit #2, Hanford, Washington, were alleged. Four alternative damages theories were presented, ranging in amounts from $53 million to $86 million. In January 1986, the District Court granted partial summary judgment and dismissed some of WPPSS' claims. After a trial in June 1986, and a jury verdict favorable to the Company, the Court entered final judgment dismissing all the claims of WPPSS against the Company. WPPSS filed a notice of appeal to the United States Court of Appeals for the Ninth Circuit. In May 1989, the Court of Appeals affirmed the judgment of the District Court that the Company was not liable for breach of warranties in connection with its construction of the retrofit of the containment vessel at Nuclear Unit #2, Hanford, Washington. However, the Court of Appeals remanded the case to the District Court for a determination of whether WPPSS had released its claims against the Company for breach of contract with respect to the Company's retrofit contract. After several preliminary rulings in 1990 in favor of the Company, the District Court entered an order dismissing WPPSS' complaint with prejudice on May 1, 1991. In an order filed January 26, 1993, the United States Court of Appeals affirmed the judgment of the District Court in part, but reversed and again remanded the case to the District Court for determination of whether WPPSS had released its claims against the Company for breach of contract with respect to the retrofit contract, including its original claims for consequential damages. The District Court has scheduled a jury trial to commence in June of 1994. In an order filed October 21, 1993, the District Court ruled that the June 1994 trial will be bifurcated; the trial will determine whether WPPSS reserved its breach of contract claims, without any determination of the amount of WPPSS' damages, or the extent of the Company's liability, if any. Although counsel is unable to predict with certainty the ultimate outcome, management and counsel believe the Company has significant and meritorious defenses to any claims and intend to pursue them vigorously. The Company's operations, including idle facilities and other property, are subject to and affected by federal, state and local laws and regulations regarding protection of the environment. The Company accrues for environmental costs where such obligations are either known or considered probable and can be reasonably estimated. The Company is participating as a potentially responsible party (PRP) at several different sites pursuant to proceedings under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA). Other parties have also been identified as PRP's at the sites. Investigative and/or remedial activities are ongoing. The Company believes, based upon information presently available to it, that such future costs will not have a material effect on the Company's financial position, results of operations or liquidity. However, the imposition of more stringent requirements under environmental laws or regulations, new developments or changes regarding site cleanup costs or the allocation of such costs among PRP's or a determination that the Company is potentially responsible for the release of hazardous substances at sites other than those currently identified, could result in additional costs. Management believes it is improbable that the ultimate outcome of any matter currently pending against the Company will materially affect the financial position of the Company; accordingly, no provision for such liability has been recorded in the Company's consolidated financial statements in the Annual Report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding executive officers of the Registrant is presented in Part III following and incorporated herein by reference. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the American Stock Exchange under the symbol "PDM". The following is the range of high and low sales prices and dividends paid per share for fiscal 1993 and 1992 by quarters. On February 28, 1994, there were 2,323,978 shares outstanding and approximately 462 stockholders of record of the Company's Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table summarizes information with respect to the operations of the Company. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The Company realized net income of $1.0 million in 1993 compared with $4.9 million in 1992 and $7.9 million in 1991. The related earnings per share were $.45 in 1993 compared with $2.02 in 1992 and $3.19 in 1991. Earned revenue decreased 7.5 percent in 1993 compared with 1992 and also decreased 2.4 percent in 1992 compared with 1991. The Company normally lags the general economy and as a result the Company's overall financial performance in 1993 was still affected by the recession. ENGINEERED CONSTRUCTION DIVISION Throughout 1993 and 1992, the Engineered Construction Division faced poor economic conditions including lower housing starts, municipal funding restraints and lack of capital spending. This resulted in declines in both earned revenue and profitability realized by the Engineered Construction Division in 1993 compared with 1992 and 1991. This Division downsized its field, plant and office personnel to address these market conditions. Earned revenue for this Division was $128.4 million in 1993 compared with $187.9 million and $199.6 million in 1992 and 1991, respectively. After profitability of $12.8 million in 1991 and $6.0 million in 1992, income from operations decreased $7.7 million, for a loss of $1.7 million in 1993. New awards were $160.3 million in 1993 compared with $138.8 million in 1992 and $205.4 million in 1991. In 1993, capital expenditures of $882,000 were primarily for purchase of plant and construction equipment. Capital expenditures of $1.6 million and $2.0 million in 1992 and 1991, respectively, were for the purchase of construction equipment and computer aided design (CAD) engineering equipment. STEEL CONSTRUCTION DIVISION Steel Construction Division's earned revenue contributed approximately 27 percent to consolidated earned revenue in 1993. In 1993, earned revenue for this segment was $95.8 million compared with $81.6 million and $93.7 million in 1992 and 1991, respectively. Income from operations in 1993 was approximately level with 1992 although a charge of $2.0 million was recorded in 1993 in order to provide for insurance deductibles relating to the Post Office project in Chicago. PDM may be responsible for future uninsured costs relating to this accident. The Company believes these uninsured costs would not have a material adverse effect on the financial position of the Company. In 1992, income from operations, adversely impacted by the recession, was $395,000 compared with $1.5 million in 1991. In 1993, the increase in earned revenue compared with 1992 was primarily due to the substantial completion of the United States Post Office project in Chicago. In 1992, the decrease in earned revenue and income from operations as compared with 1991 was due to a continued downturn in the commercial high-rise building market. Bridge market activity was also restrained during 1993 and 1992 due to the federal government withholding release of funds from the Federal Highway Trust Fund and the lack of state matching funds. New awards were $121.3 million in 1993 compared with $98.9 million in 1992 and $81.9 million in 1991. In 1993, the Company was awarded a $68 million contract for the McCormick Place Exhibition Center located in Chicago. This award continues to demonstrate PDM's success in competing in the public sector building market. Although this award is positive, the market conditions experienced by this business segment during 1992 and 1993 are expected to continue into 1994. Capital expenditures were $1.5 million in 1993 compared with $1.8 million and $1.1 million in 1992 and 1991, respectively. During the last three years, a significant portion of capital expenditures were for purchases of plant and construction equipment. In 1992 and 1991, the Chicago facility was renovated to expand its structural and bridge fabrication capabilities. STEEL SERVICE CENTERS PDM's Steel Service Centers represented in 1993 approximately 28 percent of the Company's consolidated earned revenue. Earned revenue was $99.5 million in 1993 compared with $85.5 million in 1992 and $77.1 million in 1991. During 1993 and 1992, earned revenue increased 16 percent and 11 percent, respectively, as the Steel Service Centers increased actual tons shipped and market share. The increase in earned revenue was primarily due to increased marketing efforts. Income from operations in 1993 was approximately level with the prior year. Operating profits increased 33 percent to $5.0 million in 1992 compared with $3.8 million in 1991, primarily the result of increased volume. This business segment expects to continue its excellent performance in 1994 despite the competitive market environment. Capital expenditures were $1.6 million in 1993 compared with $1.1 million and $1.3 million in 1992 and 1991, respectively. In 1993, Steel Service Centers purchased various first-stage processing machinery and also upgraded its delivery fleet. In 1992 and 1991, capital expenditures were primarily used to finance expansion projects at the various plant facilities. CVI INCORPORATED CVI Incorporated has averaged less than 10 percent of the Company's consolidated earned revenue over the last three years. Earned revenue in 1993 was $30.6 million compared with $27.9 million and $22.1 million in 1992 and 1991, respectively. Income from operations, adversely impacted by the cancellation of Superconducting Super Collider (SSC), was $671,000 in 1993 compared with $1.6 million in 1992 and $326,000 in 1991. In 1992, earned revenue increased 26 percent over 1991 due to a higher volume of systems projects. The increase in earned revenue was the result of increased demand for helium refrigeration systems generated by superconducting applications and programs. This increase, along with higher margins on CVI's standard products, significantly improved income from operations in 1992. New awards for CVI were $20.7 million in 1993 compared with $32.0 million in 1992 and $30.2 million in 1991. New awards decreased in 1993 due to the uncertainty of funding for superconducting applications. Capital expenditures averaged $142,000 over the last three years. OTHER Corporate unallocated expenses, consisting primarily of salaries, benefits, outside professional services, taxes and insurance were $6.5 million in 1993 compared with $6.7 million in 1992 and 1991. In 1993, the Company's interest income was $540,000 compared with $688,000 in 1992 and $1.7 million in 1991. Interest income decreased significantly in 1992 compared with 1991 due to a lower level of interest earning funds and a reduction in average interest rates. Interest expense has steadily decreased over the last three years to $248,000 in 1993 from $579,000 in 1992 and $1.2 million in 1991. The reduction in interest expense is due to a decrease in the Company's total debt obligations of $9.3 million over the last three years. The Company had no debt obligations on December 31, 1993. The Company's total debt obligations were $875,000 on December 31, 1992 compared with $9.3 million on December 31, 1991. Interest expense in 1993 includes $200,000 relating to possible additional tax assessments. The gain on the sale of assets was $3.6 million in 1993 compared with $930,000 in 1992 and $765,000 in 1991. In 1993, the Company realized gains on the sale of idle properties compared with gains on the sale of foreign marketable securities in 1992 and 1991. Net miscellaneous income was $10,000 in 1993, $290,000 in 1992 and $62,000 in 1991. The increase in 1992 was primarily due to an increase in dividend income associated with a joint venture company. The effective income tax rate was 45 percent in 1993, compared with 36 percent in 1992 and 40 percent in 1991. In 1993, the effective tax rate was adversely impacted as a result of foreign taxes of $81,000 with no corresponding tax credit while 1992 was favorably impacted by the realization of investment tax credit of $142,000. The Revenue Reconciliation Act of 1993 did not have a material effect on the consolidated financial position or results of operations. During the first quarter of 1993, the Company adopted Statements of Financial Accounting Standards No. 106, "Employees' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106) and No. 109, "Accounting for Income Taxes" (SFAS No. 109). The adoption of these accounting changes did not have a material impact on the Company's financial position or results of operations. In 1994, the Company will adopt the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). The Company has completed a preliminary assessment of the impact of this accounting change and does not expect it to have a material impact on the Company's financial position or results of operations. In recognition of the current interest and inflation rate environment as of December 31, 1993, the company adjusted the discount rate and the rate of salary increase assumptions used in the determination of its benefit obligations from 8.9 percent to 7.5 percent and 6.5 percent to 6.0 percent, respectively. It is estimated that these changes will increase benefit expense for 1994 as compared to 1993 approximately $600,000. The Company's operations, including idle facilities and other property, are subject to federal, state and local laws and regulations regarding protection of the environment. The Company accrues for environmental costs where such obligations are either known or considered probable and can be reasonably estimated. The Company has been notified it is a potentially responsible party (PRP) at several waste disposal sites under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA). Other parties have also been identified as PRP's at the sites. Investigative and/or remedial activities are ongoing. The Company believes, based upon the information presently available to it, that such costs will not have a material adverse effect on the Company's financial position, results of operations or liquidity. However, the imposition of more stringent requirements under environmental laws or regulations, new developments or changes in site cleanup costs or the allocation of such costs among PRP's, or a determination that the Company is potentially responsible for the release of waste or pollutants at sites other than those currently identified, could result in additional costs. LIQUIDITY AND CAPITAL RESOURCES During 1993, the Company's primary sources of liquidity included cash provided by investing activities and cash on hand. These sources financed working capital, capital expenditures, and the payments of debt obligations and dividends. On December 31, 1993, cash and cash equivalents were $15.9 million compared with $19.9 million and $17.2 million on December 31, 1992 and 1991, respectively. In 1993, the Company decreased cash and cash equivalents by $4.0 million. This decrease resulted from $3.6 million utilized by operations, $3.1 million utilized for financing activities offset by $2.7 million provided by investing activities. Working capital remained relatively unchanged. Capital expenditures during 1993 were $4.1 million compared with $4.7 million and $4.5 million during 1992 and 1991, respectively. In 1993, capital expenditures were primarily for plant and construction equipment in addition to the purchase of Cascade Culvert Corp.'s assets. Capital expenditures in 1994, which are expected to be financed by operations, should approximate $5.0 million. In addition, the Company intends to continue to pursue acquisition opportunities closely aligned with its existing core businesses. During 1993, the Company's total debt of $875,000 was paid. The Company paid total cash dividends of $.90 per common share in 1993. On January 20, 1994, the Board of Directors declared a $.22-1/2 cash dividend per common share for the first quarter of 1994. The payment of future dividends will be evaluated based on business conditions. The Company has on hand and access to sufficient sources of funds to meet its anticipated operating, expansion and capital needs. These sources include cash on hand and a $30 million unsecured revolving credit facility which matures on December 31, 1995. This facility contains an annual option to renew for an additional one-year period, subject to lender approval. On December 31, 1993, $14.9 million of this facility was committed to support stand-by letters of credit. The Company expects that it will have to borrow under the credit facility for working capital requirements in 1994. The Company is currently incurring costs related to the Midwest flood. At December 31, 1993, actual flood related costs were $5.7 million and future costs are estimated to be $4.3 million. The total cost of $10.0 million has been reimbursed under the Company's insurance policy. As described in the Notes to Consolidated Financial Statements under the caption Commitments, the Company has an outstanding commitment to purchase 124,800 shares of its Common Stock from certain members of the Jackson family, principal stockholders, upon the stockholder's death. The outstanding commitment for these shares was $3.3 million based on the closing stock price of the Common Stock on December 31, 1993. Inflation and changing prices did not significantly impact the Company during the last three years. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA REPORT OF INDEPENDENT AUDITORS STOCKHOLDERS AND BOARD OF DIRECTORS PITT-DES MOINES, INC. We have audited the accompanying consolidated statements of financial condition of Pitt-Des Moines, 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. 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 Pitt-Des Moines, 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. 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 notes to the consolidated financial statements, Washington Public Power Supply System (WPPSS) brought a complaint against the Company in 1984 seeking unspecified damages for contract work completed in a prior year. The ultimate outcome of this matter is still uncertain and cannot be presently determined. Accordingly, no provision for any liability that may result has been made in the financial statements. /s/ ERNST & YOUNG ------------------ ERNST & YOUNG Pittsburgh, Pennsylvania March 3, 1994 PITT-DES MOINES, INC. CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 PITT-DES MOINES, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 PITT-DES MOINES, INC. CONSOLIDATED BALANCE SHEET DECEMBER 31, 1993 AND 1992 PITT-DES MOINES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 PITT-DES MOINES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. PITT-DES MOINES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation -- The consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany accounts and transactions are eliminated in consolidation. Certain amounts in the 1991 and 1992 consolidated financial statements and notes to consolidated financial statements have been reclassified to conform with the 1993 presentation. Classifications of Current Assets and Liabilities -- The Company includes in current assets and current liabilities amounts realizable and payable under contracts which extend beyond one year. Other assets and liabilities are classified as current or non-current on the basis of expected realization or payment within or beyond one year, respectively. Cash and Cash Equivalents -- Cash and cash equivalents are defined as cash and short-term investments with maturities of three months or less at the time of acquisition. Inventories -- Inventories of raw materials and fabricated parts are principally valued at the lower of last-in, first-out (LIFO) cost or market, except for certain inventories which are valued at the lower of first-in, first-out (FIFO) cost or market. Contract material inventories included in accumulated contract costs are valued using the specific identification method. Property, Plant and Equipment -- Land, buildings, machinery and equipment are carried at cost. Buildings, machinery and equipment, including capitalized leases, are depreciated by accelerated methods. Revenue Recognition -- The Company follows the percentage of completion method of reporting income from contracts. This method takes into account the cost, estimated profit and earned revenue to date on contracts not yet completed. Revenue recognized is the portion of the total contract price that the man-hours expended to date bears to the estimated final total man-hours, based on current estimates of man-hours to complete. Revenue recognition is not related to progress billings to customers. Revenues recognized for CVI are measured by the percentage of costs incurred to date to estimated final costs for each contract. This method is used because management considers expended costs to be the best available measure of progress for these contracts. As long-term contracts extend over one or more years, revisions in estimates of costs and estimated profits during the course of work are reflected in the accounting period in which the facts which require the revision become known. At the time a loss on a contract becomes known, the entire amount of the estimated ultimate loss is recognized in the financial statements. Revenue from change orders and claims is recognized when the settlement is probable and the amount can be reasonably estimated. Contract costs include all direct material, labor, subcontract costs and those indirect costs related to contract performance. Costs and estimated profits in excess of billings are classified as a current asset. Amounts billed in excess of costs and estimated profits are classified as a current liability. Income Taxes -- In 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). SFAS No. 109 requires recognition of deferred 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. Net Income per Share of Common Stock -- Earnings per share is based on the weighted average number of shares outstanding during the year and include the dilutive effect of the assumed exercise of outstanding stock options, as computed under the treasury stock method. ACQUISITIONS Hartwig Mfg. Corp. -- On July 31, 1991, the Company acquired Hartwig Mfg. Corp. (HMC), a steel bridge fabricator. The total cost of this acquisition, financed from the Company's internal cash resources, was $7.7 million. In addition, a total of $1.1 million will be paid in connection with non-compete agreements, expiring in July 1997, with two former shareholders of HMC. Cascade Culvert Corp. -- On November 30, 1993, Oregon Culvert Co., Inc., a majority-owned subsidiary, acquired the assets and assumed certain liabilities of Cascade Culvert Corp., a corrugated metal culvert pipe manufacturer. The total cost of this acquisition was $1.3 million. These acquisitions were accounted for as purchases and, accordingly, the acquired assets and liabilities were recorded at their estimated fair value at the date of their respective acquisitions. Operating results have been included since acquisition dates but pro forma information has not been presented because it is immaterial. ACCOUNTS RECEIVABLE On December 31, 1993 and 1992, accounts receivable included approximately $15.2 million and $15.1 million, respectively, which have been billed under retainage provisions in contracts and will become due upon completion of the contracts. Accounts receivable on December 31, 1993 included approximately $1.1 million which is expected to be collected after December 31, 1994. The allowance for doubtful accounts was approximately $1.0 million on December 31, 1993 and 1992. The majority of accounts receivable are from customers in various locations and industries throughout the United States. The Company maintains adequate reserves for potential credit losses and such losses have been minimal and within management's estimates. INVENTORIES Inventories aggregating approximately $14.5 million and $11.2 million on December 31, 1993 and 1992, respectively, are valued at the lower of LIFO cost or market. If these amounts had been valued on the FIFO method, which approximates replacement cost, these amounts would have been approximately $13.0 million and $12.5 million higher than reported on December 31, 1993 and 1992, respectively. Inventories carried on a FIFO basis were $3.6 million on December 31, 1993 and 1992. COSTS AND ESTIMATED PROFITS ON UNCOMPLETED CONTRACTS Costs and estimated profits on uncompleted contracts are summarized as follows for December 31: Costs, estimated profits and billings on uncompleted contracts are included in the accompanying Consolidated Statements of Financial Condition under the following captions for December 31: INVESTMENTS AND OTHER ASSETS Investments and other assets include prepaid pension costs, notes receivable and foreign marketable equity securities. On December 31, 1993 and 1992, the Company held 11,000 shares of a foreign marketable equity security at a cost of $1,162 with a market value of $52,500 as of December 31, 1993. In 1992, the Company sold 133,100 shares and realized a gain of approximately $970,000. PENSIONS The Company has a number of noncontributory defined benefit pension plans covering most employees. Plans covering salaried employees provide monthly benefits at retirement age based on the participant's monthly salary and years of employment. Plans covering hourly employees generally provide benefits of stated amounts for each year of service although certain of such plans provide benefits based on the participant's hourly wage rate and years of service. The plans permit the Company, at any time, to amend or terminate the plans subject to union approval, if applicable. The Company's policy is to fund the legal minimum required contributions. Plan assets on December 31, 1993 consisted primarily of listed stocks, bonds, investments in pooled funds and group annuity contracts of insurance carriers. The Company also makes contributions to certain multi-employer defined benefit pension plans for field union employees. These contributions are determined in accordance with the provisions of negotiated labor contracts and generally are based on the number of man-hours worked. Company contributions and cost recognized for these plans were approximately $521,000, $598,000 and $852,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The estimated accumulated plan benefits and plan assets for these plans are not available. The Company sponsors defined contribution plans which cover nearly all salaried employees, certain hourly groups in accordance with their union labor contracts and nearly all non-union field employees. Based upon the plan, the Company contributions represent either a stated matching percentage of the participant's basic contribution or a stated rate per hour worked. Company contributions and cost recognized for these plans were $1.2 million, $1.8 million and $1.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. Net periodic pension expense (income) for the Company's defined benefit pension plans include the following components for the years ended December 31: As a result of restructuring activities and the flood in the Midwest, curtailment losses of $382,000 are reflected in the net amortization and deferral component of net periodic pension expense for the year ended December 31, 1993. The following assumptions were used in the determination of net periodic cost for the years ended December 31: In recognition of the current interest and inflation rate environment as of December 31, 1993, the Company adjusted the discount rate used in the determination of its benefit obligation to 7.5 percent and the rate of salary increases to 6.0 percent. The following table sets forth the status of the Company's defined benefit pension plans: Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106). The Company has elected to recognize this change in accounting on a prospective recognition basis utilizing a twenty-year amortization as permitted by SFAS No. 106. The adoption of SFAS No. 106 did not have a material impact on the Company's financial position or results of operations. In 1994, the Company will adopt the Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). The Company has completed a preliminary assessment of the impact of this accounting change and does not expect it to have a material impact on the Company's financial position or results of operations. ACCRUED LIABILITIES On July 11, 1993, the Company's Des Moines Steel Construction plant, along with the headquarters office building for the Engineered Construction Division, both located in Des Moines, Iowa, were severely damaged by the devastating flood in the Midwest. The Company has completed the flood related cleanup of both facilities and is continuing to evaluate the future costs of the flood. All work which was in process at the Des Moines Steel Construction plant was completed or transferred to other locations while the Company evaluates alternatives for the facility. The headquarters personnel for the Engineered Construction Division continue to operate from temporary quarters at that Division's plant in Clive, Iowa. Actual flood related costs incurred through December 31, 1993 were $5.7 million with estimated future costs of approximately $4.3 million. The total cost of $10.0 million has been reimbursed under the Company's insurance policy as of December 31, 1993. On November 3, 1993, an accident occurred at the construction site of a new United States Post Office in Chicago where the Company's Steel Construction business segment is in the process of fabricating and erecting the steel structure of the building. Two men were killed and five seriously injured when a portion of the erected steel collapsed. An investigation of the cause of the accident is being conducted by the Federal Occupational Safety and Health Administration. The Company and its insurance carriers are assessing the damages and related policy coverages. Insurance coverages contain various deductible amounts for which the Company recorded a charge of $2.0 million in the fourth quarter of 1993 relating to the accident. PDM may be responsible for future uninsured costs relating to this accident. EMPLOYEE STOCK OWNERSHIP PLAN In 1990, the Company established a noncontributory Employee Stock Ownership Plan (ESOP) which provides salaried employees, who have at least one year of continuous service, an opportunity to own Company Common Stock and to accumulate additional retirement benefits. The Company's contributions, whether in cash or in stock, are determined annually by the Board of Directors in an amount not to exceed the maximum allowable as an income tax deduction. Company contributions are 100 percent vested after five years of continuous service. The ESOP contribution is allocated to the participant's account based upon the actual salary paid to the participant during that year. The Company's contributions, recorded as compensation expense, were approximately $543,000, $557,000 and $520,000 for the years ended December 31, 1993, 1992 and 1991, respectively. LONG-TERM OBLIGATIONS The Company has an unsecured revolving credit agreement with several banks from which it may borrow up to $30 million. This agreement matures on December 31, 1995, at which time all borrowings must be repaid in full. This agreement contains an annual option to renew for an additional one-year period, subject to lender approval. The agreement provides for various interest rate options at the Company's election. A commitment fee of one-fourth of one percent per annum is charged on any unused amount of this revolving credit commitment. This agreement contains restrictive financial covenants that require minimum levels of net worth and maintenance of specific financial ratios. On December 31, 1993, $14.9 million of stand-by letters of credit were outstanding under this agreement. In December 1993, the Company made a final payment on CVI's revolving credit and term loan. The Company made cash payments of interest totaling $385,000 for the year ended December 31, 1993 and $562,000 and $1.1 million for the years ended December 31, 1992 and 1991, respectively. INCOME TAXES During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). The adoption of this accounting change did not have a material impact on the Company's financial position or results of operations. Income tax expense consisted of the following for the years ended December 31: A reconciliation of reported income taxes (credits) to that based on the statutory federal income tax rate follows for the years ended December 31: Deferred taxes reflected the tax effects of differences between the amounts recorded as assets and liabilities for financial reporting purposes and the amounts recorded for income tax purposes. The tax effects of significant temporary differences giving rise to deferred tax assets and liabilities are as follows for December 31: Income taxes paid for the years ended December 31, 1993, 1992 and 1991 were approximately $1.1 million, $5.6 million and $6.2 million, respectively. STOCK PLAN The Stock Option Plan of 1990 (Plan) provides for grants of incentive stock options to officers and key employees. The Plan is administered by a committee consisting of at least three directors of the Company, none of whom are eligible to participate in the Plan. A total of 200,000 shares of the Company's Common Stock may be issued pursuant to the Plan. Grant prices are determined by the committee and are established at the fair market value of the Company's Common Stock at the date of grant. Options vest over a four-year period in equal annual amounts, or over such other period as the committee shall determine, and may be accelerated in the event of certain other circumstances such as death or disability of the optionee. These options generally expire within ten years after the date of grant. The following table summarizes option activity for the two years ended December 31, 1993: CONTINGENCIES There are various claims and legal proceedings against the Company arising from the normal course of business. As previously reported, in May 1984, Washington Public Power Supply System (WPPSS) filed a complaint against the Company and its surety in the United States District Court for the Eastern District of Washington. Various claims in connection with retrofit work performed by the Company at Nuclear Unit #2, Hanford, Washington, were alleged. Four alternative damages theories were presented, ranging in amounts from $53 million to $86 million. In January 1986, the District Court granted partial summary judgment and dismissed some of WPPSS' claims. After a trial in June 1986, and a jury verdict favorable to the Company, the Court entered final judgment dismissing all the claims of WPPSS against the Company. WPPSS filed a notice of appeal to the United States Court of Appeals for the Ninth Circuit. In May 1989, the Court of Appeals affirmed the judgment of the District Court that the Company was not liable for breach of warranties in connection with its construction of the retrofit of the containment vessel at Nuclear Unit #2, Hanford, Washington. However, the Court of Appeals remanded the case to the District Court for a determination of whether WPPSS had released its claims against the Company for breach of contract with respect to the Company's retrofit contract. After several preliminary rulings in 1990 in favor of the Company, the District Court entered an order dismissing WPPSS' complaint with prejudice on May 1, 1991. In an order filed January 26, 1993, the United States Court of Appeals affirmed the judgment of the District Court in part, but reversed and again remanded the case to the District Court for determination of whether WPPSS had released its claims against the Company for breach of contract with respect to the retrofit contract, including its original claims for consequential damages. The District Court has scheduled a jury trial to commence in June of 1994. In an order filed October 21, 1993, the District Court ruled that the June 1994 trial will be bifurcated; the trial will determine whether WPPSS reserved its breach of contract claims, without any determination of the amount of WPPSS' damages, or the extent of the Company's liability, if any. Although counsel is unable to predict with certainty the ultimate outcome, management and counsel believe the Company has significant and meritorious defenses to any claims, and intend to pursue them vigorously. The Company's operations, including idle facilities and other property, are subject to and affected by federal, state and local laws and regulations regarding the protection of the environment. The Company accrues for environmental costs where such obligations are either known or considered probable and can be reasonably estimated. The Company is participating as a potentially responsible party (PRP) at several different sites pursuant to proceedings under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA). Other parties have also been identified as PRP's at the sites. Investigative and/or remedial activities are ongoing. The Company believes, based upon information presently available to it, that such future costs will not have a material effect on the Company's financial position, results of operations or liquidity. However, the imposition of more stringent requirements under environmental laws or regulations, new developments or changes regarding site cleanup costs or the allocation of such costs among PRP's or a determination that the Company is potentially responsible for the release of hazardous substances at sites other than those currently identified, could result in additional costs. Management believes it is improbable that the ultimate outcome of any matter currently pending against the Company will materially affect the financial position of the Company; accordingly, no provision for such liability has been recorded in the accompanying financial statements. COMMITMENTS The Company entered into agreements with certain members of the Jackson family, principal stockholders, to purchase shares of the Company's Common Stock upon the stockholder's death. The price for such purchases will be the closing price of the Common Stock on the American Stock Exchange on the date of such stockholder's death. The outstanding commitment for 124,800 shares was $3.3 million based on the closing stock price of the Company's Common Stock on December 31, 1993. Pursuant to a similar agreement, the Company purchased 130,000 shares in 1992 of its Common Stock for $4.6 million. These shares were included in the Company's treasury stock as of December 31, 1992. BUSINESS SEGMENT INFORMATION In 1993, Steel Construction Division's earned revenue included $39.5 million related to the United States Post Office project. For the two years ended December 31, 1992, neither any single customer nor customers outside the United States accounted for 10 percent or more of total earned revenue. TWO YEAR QUARTERLY RESULTS OF OPERATION The following is a summary of the quarterly results of operations: A separate computation of earnings per share is made for each quarter presented. The dilutive effect on earnings per share resulting from the assumed exercise of stock options is included in each quarter in which dilution occurs. The earnings per share computation for the year is a separate annual calculation. Accordingly, the sum of the quarterly earnings per share amounts will not necessarily equal the earnings per share for the year. 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 Regarding the directors of the Registrant, reference is made to the information set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement anticipated to be dated April 8, 1994 (Proxy Statement) which information is incorporated by reference herein. The principal executive officers of the Company and their recent business experience are as follows: W. R. JACKSON, AGE 85 Director since 1940; Chairman Emeritus since 1988; formerly Chairman of the Board since 1971. Mr. Jackson has been with the Company since 1936. P. O. ELBERT, AGE 63 (2) Director since 1988; Chairman of the Board of the Company since 1990; formerly President of the Company since 1988 and President, PDM Structural Group since 1987. Mr. Elbert joined the Company in 1987. Prior to 1987, Mr. Elbert was Vice Chairman of Chicago Steel Corporation since 1986; formerly a partner of Elbert and McKee Company since 1984; formerly President and Chief Executive Officer of Flint Steel Corporation since 1979; and formerly Group Vice President of Inryco, Inc., a subsidiary of Inland Steel Company since 1969. W. W. MCKEE, AGE 55 (3) Director since 1988; President and Chief Executive Officer of the Company since 1990; formerly President, PDM Plate Group since May 1987 and formerly Executive Vice President, PDM Structural Group since April 1987. Mr. McKee joined the Company in 1987. Prior to 1987, Mr. McKee was Secretary of Chicago Steel Corporation since 1986; formerly a partner of Elbert and McKee Company since 1984; formerly a consultant with McKee and Associates since 1983; formerly President of Hogan Manufacturing since 1980; and formerly President of Herrick Corporation since 1973. R. A. BYERS, AGE 46 (3) Treasurer since 1988 and Vice President, Finance and Administration since 1987; formerly Vice President, Finance since 1984; formerly Controller since 1982; formerly Assistant Controller since 1981; formerly Manager of Financial Reporting since 1979; and formerly with Ernst & Young for ten years. T. R. LLOYD, AGE 45 (3) Secretary and General Counsel since 1990; formerly Senior Attorney of Buchanan Ingersoll Professional Corporation, since 1989; formerly Vice President, Secretary and General Counsel for Arch Mineral Corporation since 1984; and formerly Director and Secretary of U.S. Steel Mining Co., Inc. since 1979. __________________________ (1) Except where otherwise indicated, all references are to positions held with Pitt-Des Moines, Inc. Each executive officer of the Company is elected annually by the Board of Directors until his successor is elected and qualified, and each has served continually as an officer since first elected. (2) The Company has a severance agreement with Mr. Elbert. (3) The Company has agreements with each of Messrs. McKee, Byers and Lloyd covering, among other things, their positions as executive officers of the Company after a change of control. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is made to the information set forth under the captions "Board of Directors and Committees of the Board," "Executive Compensation and Other Information," "Compensation Committee Interlocks and Insider Participation" appearing in the Company's Proxy Statement, which information is incorporated herein by reference; provided, however, that the information set forth under the captions "Compensation Committee Report on Executive Compensation" and "Performance Graph" in the Proxy Statement shall not be deemed to be soliciting material or to be "filed" with the Commission or subject to Regulation 14A or 14C (other than as provided in Item 402 of Regulation S-K) or to the liabilities of Section 18 of the Securities Exchange Act of 1934, as amended. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is made to the information contained under the captions "Stockholdings of Management" and "Principal Holders of Common Stock" in the Company's Proxy Statement which information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to the information contained under the caption "Compensation Committee Interlocks and Insider Participation" in the Company's Proxy Statement which information is incorporated herein by reference. 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. The following consolidated financial statements of Pitt-Des Moines, Inc. and subsidiaries are included in Item 8: All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. 3. Exhibits: 3.1 Articles of Incorporation, as amended to date (filed as Exhibit 3.1 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1989 and incorporated herein by reference) 3.2 Bylaws, as amended to date (filed as Exhibit 3.2 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1989 and incorporated herein by reference) 4.1 Amended and Restated Credit Agreement dated as of June 30, 1992 by and among Pitt-Des Moines, Inc. and Pittsburgh National Bank, Wells Fargo Bank, N.A. and American National Bank (filed as Exhibit 4.1 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 4.2 First Amendment dated November 23, 1992 to Credit Agreement filed as Exhibit 4.1 hereto (filed as Exhibit 4.2 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 4.3 Second Amendment dated June 10, 1993 to Credit Agreement filed as Exhibit 4.1 hereto (filed as Exhibit 4.1 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1992 and incorporated herein by reference) 4.4 Third Amendment dated December 16, 1993 to Credit Agreement filed as Exhibit 4.1 (filed herewith) 10.1* Agreement executed by and between the Company and W. W. McKee (filed as Exhibit 10.1 to the Company's annual report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference) 10.2* Agreement executed by and between the Company and R. A. Byers (filed as Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference) 10.3* Agreement executed by and between the Company and T. R. Lloyd (filed as Exhibit 10.2 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference) 10.4* Severance Pay Agreement executed by and between the Company and P. O. Elbert (filed as Exhibit 10.3 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference) 10.5* Management Incentive Plan (filed as Exhibit 10.5 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.6* Pitt-Des Moines, Inc. Savings and Investment Plan and Trust as Amended and Restated September 1, 1990 (filed as Exhibit 10.6 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.7* Retirement Plan for PDM Outside Directors (filed as Exhibit 10.7 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.8* Stock Option Plan of 1990 (filed as Exhibit 4.01 to the Company's Registration Statement No. 33-34787 on Form S-8 filed May 7, 1990 and incorporated herein by reference) 10.9* Employee Stock Ownership Plan (filed as Exhibit 10.8 to the Company's annual report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference) 10.10* Retirement Plan for Salaried Employees of Pitt-Des Moines, Inc. as amended effective January 1, 1984 (filed as Exhibit 10.10 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.11 Stock Purchase Agreements dated April 19, 1990 between the Company and each of W. R. Jackson, and S. M. Jackson (filed as Exhibits 10.01 and 10.03, respectively, to current report on Form 8-K filed on April 30, 1990 and incorporated herein by reference) 10.12* Investment Letter and Registration Rights Agreement dated September 21, 1993 by and between Pitt-Des Moines, Inc. and William W. McKee, Jr. (filed as Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1993 and incorporated herein by reference) 10.13* Investment Letter and Registration Rights Agreement dated September 21, 1993 by and between Pitt-Des Moines, Inc. and Phillip O. Elbert (filed as Exhibit 10.2 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1993 and incorporated herein by reference) 11 Computation of Per Share Earnings (filed herewith) 21 Subsidiaries of Pitt-Des Moines, Inc. (filed herewith) 23 Consent of Independent Auditors, Ernst & Young (filed herewith) (b) Reports on Form 8-K: There were no reports on Form 8-K filed during the quarter ended December 31, 1993. - ----------------------------- * Denotes 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. PITT-DES MOINES, INC. March 30, 1994 By: /s/ W. W. McKee ------------------ W. W. McKee President 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. SIGNATURES TITLE Date ---- PRINCIPAL EXECUTIVE OFFICER: /s/ W. W. McKee President, Chief March 30, 1994 - ------------------- Executive Officer and W. W. McKee Director PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER: /s/ R. A. Byers Chief Financial Officer March 30, 1994 - ------------------- and Chief Accounting R. A. Byers Officer OTHER DIRECTORS: /s/ J. C. Bates Director March 30, 1994 - ------------------- J. C. Bates /s/ R. W. Dean Director March 30, 1994 - ------------------- R. W. Dean /s/ P. O. Elbert Director March 30, 1994 - ------------------- P. O. Elbert SIGNATURES (CONT'D) SIGNATURES TITLE Date ---- /s/ W. R. Jackson Director March 30, 1994 - ------------------------- W. R. Jackson /s/ W. R. Jackson, Jr. Director March 30, 1994 - ------------------------- W. R. Jackson, Jr. /s/ W. E. Lewellen Director March 30, 1994 - ------------------------- W. E. Lewellen /s/ J. H. Long Director March 30, 1994 - ------------------------- J. H. Long /s/ A. J. Paddock Director March 30, 1994 - ------------------------- A. J. Paddock /s/ P. J. Townsend Director March 30, 1994 - ------------------------- P. J. Townsend SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS PITT-DES MOINES, INC. DECEMBER 31, 1993 SCHEDULE VII - GUARANTEES OF SECURITIES OF OTHER ISSUERS PITT-DES MOINES, INC. DECEMBER 31, 1993 - -------------- (1) PDM Saudi Arabia Ltd. is a 50 percent owned affiliate of Pitt-Des Moines, Inc. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS PITT-DES MOINES, INC. - --------------------- (1) Write-off of accounts deemed to be uncollectible SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION PITT-DES MOINES, INC. __________________ Amounts for depreciation and amortization of intangible assets, preoperating costs and similar deferrals, royalties, taxes (other than payroll and income taxes) and advertising costs are not presented as such amounts are less than 1 percent of total earned revenue for each of the years ended December 31, 1993, 1992 and 1991. EXHIBIT INDEX 3.1 Articles of Incorporation, as amended to date (filed as Exhibit 3.1 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1989 and incorporated herein by reference) 3.2 Bylaws, as amended to date (filed as Exhibit 3.2 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1989 and incorporated herein by reference) 4.1 Amended and Restated Credit Agreement dated as of June 30, 1992 by and among Pitt-Des Moines, Inc. and Pittsburgh National Bank, Wells Fargo Bank, N.A. and American National Bank (filed as Exhibit 4.1 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 4.2 First Amendment dated November 23, 1992 to Credit Agreement filed as Exhibit 4.1 hereto (filed as Exhibit 4.2 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 4.3 Second Amendment dated June 10, 1993 to Credit Agreement filed as Exhibit 4.1 hereto (filed as Exhibit 4.1 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1992 and incorporated herein by reference) 4.4 Third Amendment dated December 16, 1993 to Credit Agreement filed as Exhibit 4.1 (filed herewith) 10.1 Agreement executed by and between the Company and W. W. McKee (filed as Exhibit 10.1 to the Company's annual report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference) 10.2 Agreement executed by and between the Company and R. A. Byers (filed as Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference) 10.3 Agreement executed by and between the Company and T. R. Lloyd (filed as Exhibit 10.2 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference) 10.4 Severance Pay Agreement executed by and between the Company and P. O. Elbert (filed as Exhibit 10.3 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference) 10.5 Management Incentive Plan (filed as Exhibit 10.5 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.6 Pitt-Des Moines, Inc. Savings and Investment Plan and Trust as Amended and Restated September 1, 1990 (filed as Exhibit 10.6 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.7 Retirement Plan for PDM Outside Directors (filed as Exhibit 10.7 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.8 Stock Option Plan of 1990 (filed as Exhibit 4.01 to the Company's Registration Statement No. 33-34787 on Form S-8 filed May 7, 1990 and incorporated herein by reference) 10.9 Employee Stock Ownership Plan (filed as Exhibit 10.8 to the Company's annual report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference) 10.10 Retirement Plan for Salaried Employees of Pitt-Des Moines, Inc. as amended effective January 1, 1984 (filed as Exhibit 10.10 to the Company's annual report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.11 Stock Purchase Agreements dated April 19, 1990 between the Company and each of W. R. Jackson, and S. M. Jackson (filed as Exhibits 10.01 and 10.03, respectively, to current report on Form 8-K filed on April 30, 1990 and incorporated herein by reference) 10.12 Investment Letter and Registration Rights Agreement dated September 21, 1993 by and between Pitt-Des Moines, Inc. and William W. McKee, Jr. (filed as Exhibit 10.1 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1993 and incorporated herein by reference) 10.13 Investment Letter and Registration Rights Agreement dated September 21, 1993 by and between Pitt-Des Moines, Inc. and Phillip O. Elbert (filed as Exhibit 10.2 to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1993 and incorporated herein by reference) 11 Computation of Per Share Earnings (filed herewith) 21 Subsidiaries of Pitt-Des Moines, Inc. (filed herewith) 23 Consent of Independent Auditors, Ernst & Young (filed herewith)

9892_1993.txt

9892_1993

1993

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Item 1. Business General Development of Business The Company was started by Charles Russell Bard in 1907. One of its first medical products was the silk urethral catheter imported from France. In 1923, the Company was incorporated as C. R. Bard, Inc. and distributed an assortment of urological and surgical products. Bard became a publicly-traded company in 1963 and five years later was traded on the New York Stock Exchange. In 1966, Bard acquired its supplier of urological and cardiovascular specialty products - the United States Catheter & Instrument Co. In 1980 Bard acquired its major source of the Foley catheter - Davol Inc. Numerous other acquisitions were made over the last thirty-three years broadening Bard's product lines. Today, C. R. Bard, Inc. is a leading multinational developer, manufacturer and marketer of health care products. 1993 sales of $970.8 million decreased 2% from 1992. Net income for 1993 totaled $56 million or $1.07 per share, and both decreased 25 percent against 1992. Product Group Information Bard is engaged in the design, manufacture, packaging, distribution and sale of medical, surgical, diagnostic and patient care devices. Hospitals, physicians and nursing homes purchase approximately 90% of the Company's products, most of which are used once and discarded. The following table sets forth for the last three years ended December 31, 1993, the approximate percentage contribution to Bard's consolidated net sales. The figures are on a worldwide basis. Years Ended December 31, 1993 1992 1991 Cardiovascular 40% 41% 41% Urological 26% 25% 25% Surgical 34% 34% 34% Total 100% 100% 100% I-1 Narrative Description of Business General Traditionally, Bard has been known for its products in the urological field, where its Foley catheter is the leading device for bladder drainage. Today, Bard's largest product group is in cardiovascular care devices, contributing approximately 40% of consolidated net sales, with a wide range of products, including USCI balloon angioplasty catheters used for nonsurgical treatment of obstructed arteries. Additionally, Bard has important positions in the area of surgical products. Bard continually expands its research toward the improvement of existing products and the development of new ones. It has pioneered in the development of disposable medical products for standardized procedures. Bard's domestic sales may be grouped into three principal product lines: cardiovascular, urological and surgical. International sales include most of the same products manufactured and sold by Bard's domestic operations. Domestic and international sales are combined for product group sales presentation. Cardiovascular - Bard's line of cardiovascular products includes balloon angioplasty catheters, steerable guidewires, guide catheters and inflation devices; angiography catheters and accessories; introducer sheaths; electrophysiology products including cardiac mapping and electrophysiology laboratory systems, and diagnostic and temporary pacing electrode catheters; cardiopulmonary support systems; and blood oxygenators and related products used in open-heart surgery. Urological - Bard offers a complete line of urological products including Foley catheters, procedural kits and trays and related urine monitoring and collection systems; biopsy and other cancer detection products; ureteral stents; and specialty devices for incontinence, ureteroscopic procedures and stone removal. Surgical - Bard's surgical products include specialty access catheters and ports; implantable blood vessel replacements; fabrics and meshes for vessel and hernia repair; surgical suction and irrigation devices; wound and chest drainage systems; devices for endoscopic, orthopaedic and laparoscopic surgery; blood management devices; products for wound management and skin care; and percutaneous feeding devices. International - Bard markets cardiovascular, urological and surgical products throughout the world. Principal markets are Japan, Canada, the United Kingdom and Continental Europe. Approximately two-thirds of the sales in this segment are of I-2 products manufactured by Bard in its facilities in the United Kingdom, Ireland and Malaysia. The balance of the sales are from products manufactured in the United States, Puerto Rico or Mexico, for export. Bard's foreign operations are subject to the usual risks of doing business abroad, including restrictions on currency transfer, exchange fluctuations and possible adverse government regulations. See footnote 10 in the Notes to Consolidated Financial Statements for additional information. Product Recalls - In February 1990 the Mini-Profile and Probe balloon angioplasty catheters were withdrawn from the U.S. market due to claims from the FDA that the Company had failed to follow appropriate legal and regulatory procedures. In March 1990, the Company voluntarily withdrew its Sprint and Solo angioplasty catheters from the U.S. market after an internal investigation revealed the commercial versions had not received proper regulatory approval. These withdrawals, accompanied with the withdrawal in 1989 of the New Probe angioplasty catheter, had effectively withdrawn the Company from the U.S. balloon angioplasty market. In 1991 the Company received approval from the FDA to market the New Probe, Force and Sprint balloon angioplasty catheters in the U.S. During the fourth quarter of 1992 the Solo balloon angioplasty catheter was approved for U.S. marketing. See Item 3. Legal Proceedings for additional information. Competition The Company knows of no published statistics permitting a general industry classification which would be meaningful as applied to the Company's variety of products. However, products sold by the Company are in substantial competition with those of many other firms, including a number of larger well-established companies. The Company depends more on its consistently reliable product quality and dependable service and its ability to develop products to meet market needs than on patent protection, although some of its products are patented or are the subject of patent applications. Marketing The Company's products are distributed domestically directly to hospitals and other institutions as well as through numerous hospital/surgical supply and other medical specialty distributors with whom the Company has distributor agreements. In international markets, products are distributed either directly or through distributors with the practice varying by country. Sales promotion is carried on by full-time representatives of the Company in domestic and international markets. I-3 In 1993 no commercial customer accounted for more than 8% of the Company's sales and the five largest commercial customers combined accounted for approximately 22% of such sales. Combined sales to federal agencies accounted for less than 2% of sales in 1993. In order to service its customers, both in the U.S. and outside the U.S., the Company maintains inventories at distribution facilities in most of its principal marketing areas. Orders are normally shipped within a matter of days after receipt of customer orders, except for items temporarily out of stock, and backlog is normally not significant in the business of the Company. Most of the products sold by the Company, whether manufactured by it or by others, are sold under the BARD trade name or trademark or other trademarks owned by the Company. Such products manufactured for the Company by outside suppliers are produced according to the Company's specifications. Regulation The development, manufacture, sale and distribution of the Company's products are subject to comprehensive government regulation. Government regulation by various federal, state and local agencies, which includes detailed inspection of and controls over research and laboratory procedures, clinical investigations, manufacturing, marketing, sampling, distribution, recordkeeping, storage and disposal practices, substantially increases the time, difficulty, and costs incurred in obtaining and maintaining the approval to market newly developed and existing products. Government regulatory actions can result in the seizure or recall of products, suspension or revocation of the authority necessary for their production and sale, and other civil or criminal sanctions. In the United States comprehensive legislation has been proposed that would make significant changes to the availability, delivery and payment for healthcare products and services. It is the intent of such proposed legislation to provide health and medical insurance for all United States citizens and to reduce the rate of increases in United States healthcare expenditures. The Company believes it is not possible to predict the extent to which the Company or the healthcare industry in general might be affected by the enactment of such or similar legislation. Raw Materials The Company uses a wide variety of readily available plastic, textiles, alloys and rubbers for conversion into its devices. Two large, U.S.-based chemical suppliers have sought to restrict the sale of certain of their materials to the device industry for use in implantable products. Although one guiding principle in the I-4 adoption of this policy is the avoidance of negative economic effect on the health care industry, a small portion of our product lines may face a short-term threat to the continuity of their raw material supply. The companies have indicated that their action is based on product liability concerns. Bard and the medical device industry are working to resolve this problem in general and with these suppliers to assure a continuing supply of necessary raw materials. Environment The Company continues to address current and pending environmental regulations relating to its use of Ethylene Oxide and CFC's for the sterilization of some of its products. The Company is complying with regulations reducing permitted EtO emissions by installing scrubbing equipment and adjusting its processes. The Company recognizes the Montreal Protocol Treaty which plans for the reduction of CFC use worldwide and the Company has established a goal of reducing its own use of CFC's for sterilization more rapidly than is required by this treaty. Facilities, processes and equipment are required to achieve these goals and meet these regulations. The Company has eliminated over 95% of CFC use for sterilization. The Company intends to continue to reduce this use of CFC's faster than treaty goals. Capital expenditures required will not significantly adversely affect the Company's earnings or competitive position. Employees The Company employs approximately 8,450 persons. Seasonality The Company's business is not affected to any material extent by seasonal factors. Research and Development The Company's research and development expenditures amounted to approximately $66,300,000 in 1993, $60,500,000 in 1992 and $55,600,000 in 1991. Item 2. Item 2. Properties The executive offices of the Company are located in Murray Hill, New Jersey in facilities which the Company owns. Domestic manufacturing and development units are located in California, Georgia, Kansas, Massachusetts, New Hampshire, New Jersey, New York, Ohio, Puerto Rico, Rhode Island, South Carolina, Utah, Washington and Wisconsin. Sales offices and distribution points are in these locations as well as others. I-5 Outside the U.S., the Company has plants or offices in Australia, Belgium, Canada, France, Germany, Hong Kong, Ireland, Italy, Japan, Malaysia, Mexico, Netherlands, Portugal, Singapore, Spain and the United Kingdom. The Company owns approximately 2,267,000 square feet in 21 locations and leases approximately 1,272,000 square feet of space in 61 locations. All these facilities are well maintained and suitable for the operations conducted in them. Item 3. Item 3. Legal Proceedings On October 14, 1993, the Company entered into a Plea Agreement with the Department of Justice in connection with charges stemming from violations, primarily during the 1980s by the Company's USCI division, of the Federal Food, Drug and Cosmetic Act and other statutes. The Agreement, which is subject to approval by the court, requires the Company to pay a fine and civil damages totaling $61 million, senior management approval of all pre-market applications made by the Company's USCI division to the Food and Drug Administration (the "FDA") for the next four years, oversight of the USCI division by an outside consultant and the hiring of an officer with responsibility for regulatory and medical programs. The Company has also received notice of suspension by the Defense Logistics Agency (DLA) relative to any new federal government contracts. The Company's existing contracts, representing less than 2% of consolidated revenues, will continue to run until their expiration dates. Furthermore, the Company will continue discussions with the DLA to explore a possible resolution of this matter, but these discussions await approval by the court of the Plea Agreement. In January 1994 the Company received notification that the FDA had determined that provisions of the Applications Integrity Policy should be applied to the Company's USCI division. Consequently, the FDA suspended its review of pending pre-market applications that have been submitted by the USCI division. Based upon regulatory compliance audits to be conducted by the Company, the FDA will assess the validity of data and information in USCI's pending pre-market applications. The Company cannot predict how long the FDA's suspension of the USCI division's pre-market applications from review will last or the extent of the impact such suspension could have on USCI's competitive position. The Company is continuing discussions in certain related areas raised by the FDA to finally conclude this matter. As previously discussed, in January 1992 a civil complaint was filed in federal court regarding the Company's efforts to obtain FDA approval for and market an atherectomy device. In July 1992 the federal court dismissed certain provisions of the complaint. In January 1993 the court granted the Company's motion and entered a stay of the case. The court subsequently dissolved its previous I-6 order staying the proceedings in this case, and discovery is now under way. In late 1993 the plaintiffs filed an amended complaint which claims a breach of contract and realleges claims of fraud. The Company has answered the amended complaint and seeks to dismiss the fraud charges. During 1991 the Company settled all previously disclosed shareholder litigation brought against the Company and certain present and former officers and directors in connection with the withdrawal from the U.S. market of certain of the Company's angioplasty catheters. All claims were dismissed without any admission of liability or wrong doing. The settlement involved the payment of approximately $18 million and had no material impact on the 1991 earnings of the Company because it had been previously provided for through established reserves and insurance coverages. In November 1993, a shareholder moved in the Superior Court of New Jersey to set aside the settlement as inadequate based upon the amount which the Company had agreed to pay as a fine and civil damages in the criminal procedures as set forth above. This petition was dismissed and a notice of appeal was filed. The appeal has now been dismissed by the Appellate Division of the Superior Court and the shareholder has 20 days from March 24 to appeal to the N.J. Supreme Court. During 1992 the Company was notified by the United States Environmental Protection Agency that it had been identified as a potentially responsible party in connection with an ongoing investigation of the Solvents Recovery Service of New England site in Southington, Connecticut. Although the full extent of liability in this case is unknown, the Company has been identified with less than one-half percent of the total gallonage of waste materials. The final resolution of this matter is not expected to have a material adverse financial impact on the Company. The Company is also subject to other legal proceedings and claims which arise in the ordinary course of business. Item 4. Item 4. Results of Votes of Security Holders Not applicable. I-7 Executive Officers of the Registrant Set forth below is the name, age, position, five year business history and other information with respect to each executive officer of the Company as of February 28, 1994. No family relationships exist among the officers of the Company. Name Age Position William H. Longfield 55 President and Chief Operating Officer and Director Benson F. Smith 46 Executive Vice President - Operations William C. Bopp 50 Senior Vice President and Chief Financial Officer Timothy M. Ring 36 Group Vice President Richard J. Thomas 44 Group Vice President William T. Tumber 59 Group Vice President Terence C. Brady, Jr. 62 Senior Vice President and Controller E. Robert Ernest 53 Vice President - Business Development Gerald L. Messerschmidt, M.D. 43 Vice President - Scientific Affairs Richard A. Flink 59 Vice President, General Counsel and Secretary Earle L. Parker 50 Treasurer All officers of the Company are elected annually by the Board of Directors. Mr. Longfield has been delegated the duties and responsibilities of Chairman and Chief Executive Officer by the Board of Directors. I-8 Mr. Longfield joined the Company in 1989 and was elected executive vice president and chief operating officer. In 1991 he was elected to his present position. Prior to joining the Company, he was chief executive officer since 1984 of the Cambridge Group, Inc., a provider of long term health services for the elderly. Prior to joining Cambridge, he was employed by Lifemark, Inc., a health care management company, and for over 20 years with American Hospital Supply Corporation. Mr. Smith joined Bard in 1980. Subsequently he was appointed general manager of Bard Electro Medical Systems, Inc. and in 1986 became vice president and general manager of Bard Home Health division. In 1987, he was promoted to president of Bard Urological division. In 1990, he was appointed to the position of group executive. In 1991, he was elected group vice president. In December 1993, he was elected to the position of executive vice president with worldwide responsibility for operations. Mr. Bopp joined the Company in 1980 as controller of Bard International, Inc., was promoted to assistant corporate controller in 1983 and was elected to the position of treasurer later that year. He was named vice president and treasurer in 1989. In 1992 he was elected to his present position. Mr. Ring joined the Company in 1992 and was elected vice president- human resources. Prior to joining the Company he had been with Abbott Laboratories Inc., a pharmaceutical company, since 1982 and his last position with their Hospital Products division had been director of personnel. In December 1993, he was elected to the position of group vice president. Mr. Thomas joined Bard in 1984. In 1986 he was promoted to vice president and general manager of the Bard Cardiovascular Ventures division. In 1990 he was appointed to the position of group executive. In October 1991, he was elected to his present position. Mr. Tumber joined Bard in 1980. In 1988 he was promoted to vice president and general manager of Davol Inc. In 1990 he was promoted to president of Davol Inc. and subsequently appointed to the position of group executive. In September 1991, he was elected to his present position. Mr. Brady joined the Company in 1969, was elected corporate controller in 1973 and vice president and controller in 1979. He was elected to his present position in 1987. Mr. Ernest joined the Company in 1977 and was elected to his present position in 1979. I-9 Dr. Messerschmidt joined the Company in January 1994 and was elected to his present position. Prior to joining the Company he had been with DNX Corporation, a molecular engineering company, where he was vice president of medical and regulatory affairs. Prior to DNX he held various positions with the Pharmaceuticals Division of Ciba Geigy Corporation, the University of Michigan Medical Center, Wilford Hall U.S.A.F. Medical Center and the National Cancer Institute of the National Institutes of Health. Mr. Flink joined the Company in 1970, was elected vice president and general counsel in 1973 and was elected to his present position in 1985. Mr. Parker joined the Company in 1979. In 1985 he was promoted to vice president and controller of the USCI division. In December 1990 he was promoted to vice president-operations for the USCI division and, later that year, was promoted to vice president and general manager of the USCI Angiography division. In 1992 he was elected to his present position. I-10 PART II Item 5. Item 5. Market for Registrant's Common Stock and Related Stockholder Matters Market and Market Prices of Common Stock The Company's common stock is traded on the New York Stock Exchange using the symbol: BCR. The following table illustrates the high and low sales prices as traded on the New York Stock Exchange for each quarter during the last two years. Quarters 1st 2nd 3rd 4th Year High 35-1/4 28 27-5/8 26-7/8 35-1/4 Low 22-7/8 21-1/4 20-1/2 21-3/4 20-1/2 High 34 28-5/8 31-1/2 35-7/8 35-7/8 Low 26-1/8 22-1/2 23-3/4 25-1/2 22-1/2 Approximate Number of Equity Security Holders Approximate Number of Record Holders Title of Class as of February 28, 1994 Common Stock - $.25 par value 8,280* *Included in the number of shareholders of record are shares held in "nominee" name. Dividends The Company paid cash dividends of $28,200,000 or $.54 per share in 1993 and $26,500,000 or $.50 per share in 1992. The following table illustrates the quarterly rate of dividends paid per share. Quarters 1st 2nd 3rd 4th Year 1993 $ .13 $ .13 $ .14 $ .14 $ .54 1992 $ .12 $ .12 $ .13 $ .13 $ .50 In January 1994, the first quarter dividend of $.14 per share was declared, indicating an annual rate of $.56 per share. The first quarter dividend was paid on February 4, 1994 to shareholders of record on January 24. II-1 II-2 Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and of Financial Conditions General Bard is a leading multinational developer, manufacturer and marketer of products for the large and growing health care industry. Worldwide health care expenditures approximated $1.9 trillion in 1993 with about half that amount spent in the United States. Bard's segment of this industry, itself a multi-billion dollar market, is primarily specialized products used primarily in hospitals, in outpatient centers and in physician's offices to meet the needs of the medical profession in caring for their patients. The Company seeks to focus and concentrate on selected markets with cost-effective, innovative products and specialized sales forces to maximize the opportunities in these markets. Operating Results Net sales decreased 2% in 1993, reflecting the sale of the MedSystems division, the impact of foreign currency translations and the dramatic changes in the industry. Net income decreased 25%, reflecting several nonrecurring items, primarily the $61 million pretax provision for the settlement with the Justice Department. 1993 Sales Data Consolidated net sales totaled $970.8 million in 1993, a decrease of $19.4 million or 2% for the year. Sales were lowered a total of 4% by the impact of the sale of the Bard MedSystems division in February 1993 (3%) and the impact of generally lower foreign currency values (1%). Sales in 1993 were also negatively affected by a slowdown in U.S. procedural rates, consolidations of health care providers, limited FDA approvals, increasingly conservative medical practices fostered by the growth of managed care and weaker European economies. Worldwide sales increased 1% in the urological product group. Good increases in several relatively new specialty devices were partially offset by declines in other areas. Sales of surgical products decreased 1% but increased 8% after adjusting for the sale of the MedSystems division. Specialty access, endoscopic, laparo- scopic and blood management products contributed significantly to this increase. Cardiovascular product sales decreased 5% worldwide with most product areas in this group showing declines. Sales in the United States decreased 1% in 1993 to $687.9 million, representing 71% of total sales. Urological product sales increased while sales of surgical products (due to the sale of MedSystems) and cardiovascular products decreased. II-3 Sales outside the U.S. were $282.9 million in 1993, a decline of 3% from 1992 and represented 29% of total sales. Changes in foreign currency values in 1993 lowered these sales by nearly 5%. Growth in sales of surgical products were more than offset by decreases in urological and cardiovascular sales. Sales increases were good in Japan and Germany. The geographic breakdown of sales outside the U.S. for 1993 is: Europe, Middle East, Africa - 56%; Japan, Asia/Pacific - 37% and Western Hemisphere, excluding the United States - 7%. 1992 Sales Data In 1992 consolidated net sales totaled $990.2 million, an increase of $114.2 million or 13% from the prior year. U.S. sales, which were 70% of total consolidated sales, increased 13% while sales outside the U.S. increased 12% for the year. Changes in foreign currency values in 1992 accounted for approximately 2 percentage points of the sales growth outside the U.S. Operating Income Gross profit margins rose in 1993 for the third straight year. The rates were 50.9% in 1993, 48.4% in 1992 and 46.6% in 1991. Productivity gains, cost reductions and a favorable product mix in many product areas contributed to this improvement in the last three years. A pretax charge of $2.6 million for severance costs related to a plant closing is included in 1993 cost of goods sold. Bard uses the LIFO method of valuing substantially all U.S. inventories, which results in current costs (higher in a period of inflation) being charged to cost of goods sold. Bard generally has been able to recover these costs through its strong product position in its markets. The Company also strives to offset the effect of inflation through its cost reduction programs. Marketing, selling and administrative expenses (which exclude research and development) increased $2.9 million in 1993, or less than 1%. R&D expenses increased nearly 10% in 1993 as the Company works toward new technologies and enhancements for the future. Operating income of $128.5 million increased 5.0% in 1993, reflecting the increased gross profit margin and, as a percent of net sales, was 13.2% compared with 12.4% in 1992. Operating income in 1992 increased 31.6% from 1991 due primarily to a higher gross profit margin. II-4 Other Expense, Net The 1993 results included a third quarter pretax provision for the Justice Department settlement of $61 million, a fourth quarter pretax gain of $32.7 million from the sale of shares of the common stock of Ventritex, Inc., and a first quarter pretax gain of $10.9 million from the sale of the MedSystems division net of several nonrecurring charges. The 1992 results included a gain of $5.9 million from the sale of common stock of Ventritex and a comparable amount for provisions for expenses associated with legal and regulatory matters. Income Tax The effective income tax rate was 37.2% in 1993, 29.9% in 1992 and 25.6% in 1991. The increase in 1993 was primarily due to the $61 million Justice Department settlement, which was not fully deductible, and a 1% tax rate increase to 35% effective January 1, 1993. The increase in the 1992 rate was primarily due to a reduction in the portion of Bard's taxable income being generated outside the United States at lower effective tax rates. The tax benefit from operations in Puerto Rico and Ireland favorably affected the tax rate in each year. As a result of the Omnibus Tax Reconciliation Act of 1993, the effective tax rate in 1994 will be affected slightly, primarily due to a reduction in the tax benefit derived from the Company's manufacturing operations in Puerto Rico. Income Net income for 1993 totaled $56 million, or $1.07 per share, which was 25% lower than in 1992. As a percent of sales, net income was 5.8% in 1993 compared with 7.6% in 1992 and 6.5% in 1991. Nonrecurring items that affected net income in 1993 were (in millions): Gain on sale of Ventritex stock $ 19.4 Gain on sale of MedSystems division and other one-time charges 6.0 Severance costs related to plant closing (1.8) Effect of accounting change for postretirement benefits (6.1) Provision for the Justice Department settlement agreement (45.4) Net income effect of nonrecurring items $(27.9) After adjusting for these items, net income would have been higher than reported by $27.9 million, or $.53 per share. In 1992 net income was $1.42 per share, or $75 million in total, which was 31% higher than 1991. II-5 Financial Condition Bard's financial condition remained strong in 1993. Net cash provided by operating activities increased to $124 million in 1993 from $103.6 million in 1992. While the Company had cash outlays totaling $101.4 million for acquisitions of businesses, patents, trademarks and other long-term investments, total debt increased a modest $20 million from $133 million to $153 million in 1993. The ratio of total debt to total capitalization increased from 25.3% to 28.5% with total capitalization increasing $10.7 million to $536.1 million. Long-term debt was essentially unchanged at $68.5 million at the end of 1993, with $60 million of it at a fixed rate of 8.69% until scheduled repayment in September 1999. Bard maintains credit lines with banks for short-term cash needs. These facilities were used as needed during 1993. The current unused lines of credit total $141 million. As now structured, the Company should generate substantially all funds needed for operations and capital expenditures. The Company believes it could borrow adequate funds at competitive terms and rates, should it be necessary, including the payments to the Justice Department required as a result of the plea agreement reached in October 1993. Under the terms of the settlement, $30.5 million is payable 30 days after court approval plus two annual instalments of $15.25 million each. As presented in the Consolidated Statements of Cash Flows on page II-11 of this report, net cash flows from operating activities totaled $124 million in 1993. Net income, depreciation and amortization provided a total of $91.5 million, and included the gain on disposal of assets of $50.4 million. Increases in current liabilities, excluding debt, provided a total of $27 million, including $30.5 million of the $61 million payable under the Justice Department settlement. Other long-term liabilities increased by $46.2 million, of which $30.5 million is the balance of the settlement amount and $10 million is the accumulated postretirement benefit obligation charged to income in the first quarter of 1993. All other operating activities provided $9.7 million net including a total of $12.9 million provided from decreases in accounts receivable and inventories. Investing activities used $67.1 million in 1993. Capital expenditures totaled $30.7 million and proceeds from the sale of assets provided $65 million. $101.4 million was used for the acquisition of businesses, patents, trademarks and other related items, and long-term investments. Financing activities in 1993 used a total of $30.4 million. Common stock purchases used $24.4 million and dividends used $28.2 million. Other financing activities, primarily proceeds from short-term borrowings, provided $22.2 million net. II-6 Total cash flows, including a $1.3 million translation adjustment, resulted in an increase in cash and short-term investments of $25.2 million. As noted, capital expenditures in 1993 were $30.7 million compared with $30 million in the prior year. Expenditures for 1994 are anticipated at $35-$40 million. Research and development spending was $66.3 million in 1993, up 9.6% from 1992. Planned expenditures for 1994 are about $80 million, a 20% increase. Purchases of Bard common stock by the Company totaled (in millions) $24.4, $14.0 and $6.4 in 1993, 1992 and 1991, respectively. In January 1993 the Board of Directors authorized the purchase from time to time of up to 2 million shares of which 1 million were purchased in 1993. The Board of Directors declared dividends of 13 cents per share for the first two quarters of 1993 and in July 1993 increased the dividend to 14 cents per share. At February 1994 the indicated annual dividend rate is 56 cents per share. Dividends for 1993 of 54 cents per share were up from 50 cents per share paid in 1992. Legal Proceedings For a discussion of pending legal proceedings and related matters, please see Note 5, Commitments and Contingencies, of the Notes to Consolidated Financial Statements on page II-16. Acquisitions and Dispositions In 1993 the Company acquired the operations of Solco Hospital Products Group, Inc., Pilot Cardiovascular Systems, Inc. and Bainbridge Sciences, Inc. in separate transactions for a total of $70 million. The Bard MedSystems division was sold in 1993 with a pretax gain of $15.9 million. The 1993 acquisitions, and several other investments and acquisitions in 1993, 1992 and 1991 were not significant to the Company's operations as a whole. II-7 Item 8. Item 8. Financial Statements and Supplementary Data Report of Independent Public Accountants To the Shareholders and Board of Directors of C. R. Bard, Inc.: We have audited the accompanying consolidated balance sheets of C. R. Bard, Inc. (a New Jersey 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 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 C. R. Bard, 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 Note 8 to the consolidated financial statements, effective January 1, 1993 the Company changed its method of accounting for postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial 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 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. Roseland, New Jersey February 9, 1994 II-8 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Significant Accounting Policies Consolidation All subsidiaries are consolidated and intercompany transactions have been eliminated. Income Per Share The computations of income per share are based on the weighted average number of shares outstanding: 52,196,645 in 1993, 52,909,360 in 1992 and 53,062,933 in 1991. The effect of outstanding stock options and stock awards is not material and has been excluded from the computations. Inventories Inventories are stated at the lower of cost or market. Substantially all domestic inventories are accounted for using the LIFO method of determining costs. All other inventories are accounted for using the FIFO method. Inventories valued under the LIFO method were $127,000,000 in 1993, $127,000,000 in 1992 and $116,000,000 in 1991; under the FIFO method such inventories would have been higher by $15,800,000, $13,000,000 and $16,400,000, respectively. Inventories were approximately 58% and 60% finished goods at year end 1993 and 1992, 30% and 27% work in process at year end 1993 and 1992, and 12% and 13% raw materials at year end 1993 and 1992. Depreciation Property, plant and equipment are depreciated on a straight-line basis over the useful lives of the various classes of assets. Investments Long-term investments include long-term bonds and equity securities accounted for on the cost basis. The fair value of such investments, determined primarily by market quotes, approximated their carrying value at December 31, 1993 and was approximately $46,000,000 at December 31, 1992. For purposes of the Consolidated Statements of Cash Flows all short-term investments which have a maturity of ninety days or less are considered cash equivalents. Such investments are stated at cost which approximates their fair value. Intangible Assets Intangible assets are recorded at cost and are amortized using the straight-line method over appropriate periods not exceeding 40 years. As of December 31, 1993 and 1992, intangible assets include the following: (Thousands of dollars) 1993 1992 Goodwill net of amortization $ 76,500 $ 51,600 Other intangibles (primarily patents) 72,600 26,900 Intangible assets, net $149,100 $ 78,500 II-12 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Federal Income Taxes The Company has not provided for Federal income taxes on the undistributed earnings of its foreign operations (primarily in Ireland) as it is the Company's intention to permanently reinvest undistributed earnings (approximately $177,000,000 as of December 31, 1993). Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." This statement did not have a significant effect on the Company's financial position or results of operations. Translation of Foreign Currencies Annual foreign currency translation adjustments are included in retained earnings. As of December 31, 1993 the cumulative adjustment has decreased retained earnings by $11,100,000. Research and Development Research and development costs are charged to operations as incurred. New Accounting Pronouncements Effective January 1, 1994, the Company is required to adopt SFAS No. 112 "Employers' Accounting for Postemployment Benefits" and SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities." Adoption of these statements will not have a significant effect on the Company's financial position or results of operations. 2. Acquisitions and Dispositions In 1993, the Company acquired three separate businesses for approximately $70,000,000 which served to enhance or expand upon the Company's existing product lines. Assets acquired in these acquisitions were primarily patents and other intangibles. These acquisitions together with several other minor investments made during 1992 and 1991 did not have a significant effect on the Company's results of operations. The Company sold its MedSystems division in 1993 resulting in a pretax gain of approximately $15,900,000 which is recorded in other expense, net, in the statement of consolidated income. In the fourth quarter of 1993 and 1992, the Company sold certain long-term investments resulting in pretax gains of approximately $32,700,000 and $5,900,000, respectively which are recorded in other expense, net, in the statements of consolidated income. II-13 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Income Tax Expense Income tax expense consists of the following: (Thousands of dollars) 1993 1992 1991 Currently payable: Federal $31,900 $20,300 $ 4,100 Foreign 8,100 9,500 11,100 State 3,900 4,100 2,600 43,900 33,900 17,800 Deferred: Federal (6,600) (1,700) 2,900 Foreign (500) (200) (1,000) (7,100) (1,900) 1,900 $36,800 $32,000 $19,700 During 1993, the Company adopted SFAS No. 109 "Accounting for Income Taxes." The cumulative effect of the change was not significant to the Company's results of operations and the Company has not restated prior periods. The standard requires a change from the deferred to the liability method of computing deferred income taxes. Deferred income taxes are recognized for tax consequences of "temporary differences" by applying enacted statutory tax rates, applicable to future years, to differences between the financial reporting and the tax basis of assets and liabilities. At December 31, 1993, the Company's net deferred tax asset amounted to approximately $8,000,000 which is recorded in other assets. This amount is principally composed of differences between tax and financial accounting treatment of depreciation ($7,000,000) and employee benefits ($15,000,000). The following is a reconciliation between the effective tax rates and the statutory rates: 1993 1992 1991 Tax based on statutory rate 35% 34% 34% State income taxes net of Federal income tax benefits 3 2 2 Operations taxed at less than statutory rate, primarily Ireland and Puerto Rico (11) (10) (9) Justice Department settlement 7 -- -- Other, net 3 4 (1) Effective tax rate 37% 30% 26% Cash payments for income taxes were $31,400,000, $28,600,000 and $17,500,000 in 1993, 1992 and 1991, respectively. II-14 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. Short-Term Borrowings and Long-Term Debt Short-term bank borrowings amounted to $84,400,000 and $64,000,000 at December 31, 1993 and 1992, respectively. The maximum amount outstanding during 1993 was approximately $110,500,000 with an average outstanding balance of $80,100,000 and an effective interest rate of 3.7%. The maximum amount outstanding during 1992 was approximately $84,900,000 with an average outstanding balance of $75,100,000 and an effective interest rate of 5.1%. The maximum outstanding during 1991 was approximately $82,000,000 with an average outstanding balance of $72,300,000 and an effective interest rate of 7.8%. Unused lines of credit amounted to $141,000,000 at December 31, 1993. The following is a summary of long-term debt: (Thousands of dollars) 1993 1992 8.69% Unsecured Notes due 1999 $ 60,000 $ 60,000 Other, primarily 5.75% to 11.75% industrial development revenue bonds 8,600 9,000 68,600 69,000 Less: amounts classified as current 100 400 $ 68,500 $ 68,600 Under three deposit loan agreements with a bank, $55,000,000 has been borrowed at floating rates (4.0% at December 31, 1993) with maturity dates of September 1996, December 1999 and December 2002. At maturity, the loans are to be repaid through matured certificates of deposit held by the Company at the same bank. Since the Company has the right of offset under these agreements and it is the Company's intention to present certain certificates of deposit for repayment of these loans at their maturity, these borrowings have been offset against these certificates of deposit in the accompanying consolidated balance sheets at December 31, 1993 and 1992. The related interest income has been offset against the interest expense. The Company's long-term debt agreements contain restrictions which, among other things, require the maintenance of minimum net worth levels and limitations on the amounts of debt. The aggregate maturities of long-term debt for the five year period from 1994 through 1998 are approximately $200,000 in total and from 1999 and thereafter - $68,400,000. The fair value of the Company's long-term debt is not significantly different from its recorded value. II-15 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Commitments and Contingencies On October 14, 1993, the Company entered into a Plea Agreement with the Department of Justice in connection with charges stemming from violations, primarily during the 1980s by the Company's USCI division, of the Federal Food, Drug and Cosmetic Act and other statutes. The Agreement, which is subject to approval by the court, requires the Company to pay a fine and civil damages totaling $61 million. In accordance with the terms of the Agreement, a provision has been made for this amount in the quarter ended September 30, 1993, with one-half of the amount reflected as a short-term obligation in accrued expenses and the balance reflected in other long-term liabilities. The Company has also received notice of suspension by the Defense Logistics Agency (DLA) relative to any new Federal Government contracts. The Company's existing contracts, representing less than 2% of consolidated revenues, will continue to run until their expiration dates. Furthermore, the Company is continuing discussions with the DLA to explore a possible resolution of this matter. In January 1994, the Company received notification that the Food and Drug Administration (FDA) had determined that provisions of the Applications Integrity Policy should be applied to the Company's USCI division. Consequently, the FDA suspended its review of pending pre-market applications that have been submitted by the USCI division. Based upon regulatory compliance audits to be conducted by the Company, the FDA will assess the validity of data and information in USCI's pending pre-market applications. The Company is continuing discussions in certain related areas raised by the FDA to finally conclude this matter. As previously discussed, in January 1992, a civil complaint was filed in federal court regarding the Company's efforts to obtain FDA approval for and market an atherectomy device. In July 1992, the federal court dismissed certain provisions of the complaint. In January 1993, the court granted the Company's motion and entered a stay of the case. The court subsequently dissolved its previous order staying the proceedings in this case, and discovery is now under way. In late 1993, the plaintiffs filed an amended complaint which claims a breach of contract and realleges claims of fraud. The Company has answered the amended complaint and seeks to dismiss the fraud charges. During 1991 the Company settled all previously disclosed shareholder litigation brought against the Company and certain present and former officers and directors in connection with the withdrawal from the U.S. market of certain of the Company's angioplasty catheters. All claims were dismissed without any II-16 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Commitments and Contingencies (continued) admission of liability or wrong doing. The settlement involved the payment of approximately $18 million and had no material impact on the 1991 earnings of the Company because it had been previously provided for through established reserves and insurance coverages. The Company is also subject to other legal proceedings and claims which arise in the ordinary course of business. The Company believes that the pending legal proceedings and other matters discussed in this Note will likely be disposed of over an extended period of time and should not have a material adverse impact on the Company's financial position or results of operations. The Company is committed under noncancelable operating leases involving certain facilities and equipment. The minimum annual rentals under the terms of these leases are as follows: 1994 - $18,300,000; 1995 - $12,400,000; 1996 - $8,300,000; 1997 - $4,100,000; 1998 - $2,800,000; and thereafter - $2,600,000. Total rental expense for all leases amounted to $26,500,000 in 1993, $26,600,000 in 1992 and $27,500,000 in 1991. 6. Stock Rights In 1985 the Board of Directors declared a dividend distribution of one Common Share Purchase Right for each outstanding share of Bard common stock. These Rights will expire in October 1995 and trade with the common stock. They are not presently exercisable and have no voting power. In the event a person acquires 20% or more, or makes a tender or exchange offer for 30% or more of the common stock, the Rights detach from the common stock and become exercisable and entitle a holder to buy one share of common stock at $31.25 (adjustable to prevent dilution). If, after the Rights become exercisable, Bard is acquired or merged, each Right will entitle its holder to purchase $62.50 market value of the surviving company's stock for $31.25, based upon the current exercise price of the Rights. The Company may redeem the Rights, at its option, at $.025 per Right, prior to a public announcement that any person has acquired beneficial ownership of at least 20% of the common stock. These Rights are designed primarily to encourage anyone interested in acquiring Bard to negotiate with the Board of Directors. 7. Shareholders' Investment The Company has stock option, stock award and restricted stock plans under which certain directors, officers and employees are participants. At December 31, 1993, 1,938,498 shares were reserved for future issuance under these plans. II-17 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Shareholders' Investment (continued) Under the Company's stock option plans, options have been granted to certain directors, officers and employees at prices equal to the market value of the shares at the date of grant, become exercisable in four annual instalments and expire not more than 10 years after the date of grant. A summary of option transactions during 1993 follows: Number Option Of Price Shares Per Share* Options outstanding, January 1 2,291,169 $20.60 Granted 558,822 26.70 Exercised (187,291) 15.98 Canceled (75,508) --- Options outstanding, December 31 2,587,192 $22.22 (1,442,773 currently exercisable) * Weighted average price Under the Company's stock award plans for key employees and directors, shares are granted at no cost to the recipients and distributed in three separate instalments. During 1993, awards for 37,860 shares (net of cancelations) were granted and 37,685 shares were issued. Awards are charged to income over the vesting period. At December 31, 1993, 43,205 awarded shares (aggregate market price at date of grant $1,142,000) have not been issued. Under the Company's restricted stock plan that was established in 1993, common stock may be granted at no cost to certain officers and key employees. Shares are issued to the participants at the date of grant entitling the participants to cash dividends and the right to vote their respective shares. Restrictions limit the sale or transfer of these shares during a five year period from the grant date. Upon issuance of stock under the plan, unearned compensation equivalent to the market value of the stock at the date of grant is reflected as a reduction in retained earnings and subsequently amortized to expense over the five year restriction period. During 1993, 60,720 restricted shares were granted, net of forfeitures. Additions to capital in excess of par value of $4,800,000 in 1993 and $2,300,000 in 1992 represents the cost of shares issued under these plans in excess of the related par value of the shares. II-18 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Shareholders' Investment (continued) For shares purchased by the Company, common stock is charged for the par value of the shares retired and retained earnings is charged for the excess of the cost over the par value of shares retired. 8. Postretirement Benefits The Company has defined benefit pension plans which cover substantially all domestic and certain foreign employees and its policy is to fund accrued pension expense for these plans up to the full funding limitations. These plans provide for benefits based upon individual participants' compensation and years of service. The Company also has a supplemental defined contribution plan for certain officers and key employees. Individual participant accounts under the supplemental plan are credited annually based upon a percentage of compensation. The amounts charged to income for these plans amounted to $7,800,000 in 1993, $5,400,000 in 1992 and $5,000,000 in 1991. The following table sets forth the funded status of the defined benefit pension plans as of September 30, 1993 and 1992 and amounts recognized in the Company's consolidated balance sheets at December 31, 1993 and 1992: (Thousands of dollars) 1993 1992 Actuarial present value of accumulated benefit obligation, including vested benefits of $67,700 in 1993 and $53,300 in 1992 $ 76,300 $ 60,800 Plan assets at fair value, primarily investment securities $ 71,900 $ 63,500 Less: Actuarial present value of projected benefit obligation for service rendered to date 95,400 71,400 Projected benefit obligation in excess of plan assets (23,500) (7,900) Unrecognized (gain) loss 14,400 (500) Unrecognized prior service cost 7,200 7,700 Unrecognized net asset at transition amortized over 12 years (6,400) (7,700) Accrued pension cost included in other liabilities $ (8,300) $ (8,400) II-19 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Postretirement Benefits (continued) Pension costs related to the defined benefit pension plans for the years ended December 31, 1993, 1992 and 1991 are as follows: (Thousands of dollars) 1993 1992 1991 Net pension cost includes: Service cost $ 6,300 $ 5,400 $ 4,600 Interest cost 5,800 4,700 4,400 Actual return on assets - (gain) loss (8,200) (3,900) (11,200) Net amortization and deferral 2,100 (2,300) 5,300 Net pension cost $ 6,000 $ 3,900 $ 3,100 The average discount rate used was 7% in 1993 and 8% in 1992. The decrease in the discount rate used between years is the primary factor for the increase in the Plans' projected benefit obligation and the unrecognized loss at December 31, 1993. The rate of increase in future salary levels ranged from 4% to 7% in determining the projected benefit obligation. The expected long-term rate of return on assets used in determining net pension cost ranged from 8.5% to 9.5%. The Company also provides postretirement health care benefits and life insurance coverage to a limited number of employees at a subsidiary. The health care benefits include cost-sharing features based on years of service for future retirees. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS 106 requires the Company to recognize expense as employees earn postretirement benefits, rather than on the cash basis as paid. The Company elected to recognize the accumulated postretirement benefit obligation as a cumulative catch-up adjustment in the first quarter of 1993. This resulted in a one-time charge of approximately $10,000,000 pretax or $6,100,000 net of taxes. Postretirement benefit expense for 1993, exclusive of the accumulated postretirement benefit obligation, amounted to $850,000 which is composed of $100,000 of service cost and $750,000 of interest cost. II-20 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Postretirement Benefits (continued) Actuarial assumptions included a discount rate of 7%. Health care cost trends have been projected at annual rates beginning at 13% for 1994 decreasing gradually down to 6% in 2001 and later years. The effect of a 1% annual increase in these assumed cost trend rates would increase the accumulated postretirement benefit obligation at December 31, 1993 by $1,000,000 and postretirement benefit cost by $100,000. 9. Supplementary Income Statement Information Royalty expense amounted to $8,600,000 in 1993, $10,200,000 in 1992 and $7,500,000 in 1991. Interest income amounted to $4,600,000 in 1993, $3,900,000 in 1992 and $3,300,000 in 1991. II-21 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Segment Information The Company is engaged in the design, manufacture, packaging, distribution and sale of medical, surgical, diagnostic and patient care devices. Hospitals, physicians and nursing homes purchase approximately 90% of the Company's products, most of which are used once and discarded. Information pertaining to domestic and foreign operations as of December 31, 1993, 1992 and 1991 and for the years then ended is given below. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. II-23 C. R. BARD, INC. AND SUBSIDIARIES PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Directors of the Registrant Information with respect to Directors of the Company is incorporated herein by reference to the material contained under the heading "Proposal No. 1 - Election of Directors" appearing on pages 1 through 3 of the Company's definitive Proxy Statement dated March 10, 1994. Executive Officers of the Registrant Information with respect to Executive Officers of the Registrant are on pages I-8 through I-10 of this filing. Item 11. Item 11. Executive Compensation The information contained under the caption "Executive Compensation" appearing on Pages 5 through 14 of the Company's definitive Proxy Statement dated March 10, 1994 is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information contained under the caption "Securities Ownership of Management" on pages 3 and 4 of the Company's definitive Proxy Statement dated March 10, 1994 is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information contained under the caption "Compensation Committee Interlocks and Insider Participation" on page 11 of the Company's definitive Proxy Statement dated March 10, 1994 is incorporated herein by reference. III-1 C. R. BARD, INC. AND SUBSIDIARIES PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) l. Financial Statements and Supplementary Data Included in Part II Item 8 of this report: Page II- 8 Report of Independent Public Accountants. II- 9 Statements of Consolidated Income and Statements of Consolidated Retained Earnings for the three years ended December 31, 1993. II-10 Consolidated Balance Sheets at December 31, 1993 and 1992. II-11 Consolidated Statements of Cash Flows for the three years ended December 31, 1993. II-12 Notes to Consolidated Financial Statements. II-23 Quarterly Financial Data. 2. Financial Statement Schedules Included in Part IV of this report: Page IV-5 Schedule I - Marketable Securities IV-6 Schedule V - Property, Plant and Equipment IV-7 Schedule VI - Accumulated Depreciation and Amortization - Property, Plant and Equipment IV-8 Schedule VIII - Valuation and Qualifying Accounts Schedules other than those listed above are omitted because they are not applicable or are not required or the information required is included in the financial statements or notes thereto. 3. Exhibits, No. 3a Registrant's Restated Certificate of Incorporation, as amended, as of April 19, 1989. (p. IV-11). IV-1 C. R. BARD, INC. AND SUBSIDIARIES 3. Exhibits, No. (Continued) 3b Registrant's Bylaws revised as of April 18, 1990. (p. IV-23). 4 Rights Agreement dated as of October 9, 1985 between C. R. Bard, Inc. and Morgan Guaranty Trust Company of New York as Rights Agent. (p. IV-48) 10 Plea Agreement with attachments and Civil Settlement Agreement between United States of America and C. R. Bard, Inc. dated October 14, 1993, filed as Exhibit 10 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-6926 is incorporated herein by reference. 10a* George T. Maloney Severance Agreement dated as of August 18, 1981. (p. IV-105) 10b* William H. Longfield Severance Agreement dated as of July 12, 1989. (p. IV-112) 10c* William C. Bopp Severance Agreement dated as of January 14, 1991. (p. IV-139) 10d* Terence C. Brady, Jr. Severance Agreement dated as of February 22, 1988. (p. IV-166) 10e* Richard A. Flink Severance Agreement dated as of February 22, 1988. (p. IV-193) 10f* E. Robert Ernest Severance Agreement dated as of January 21, 1991. (p. IV-220) 10g* William H. Longfield Supplemental Executive Retirement Agreement dated as of January 12, 1994. (p. IV-258) 10h* 1990 Stock Option Plan. (p. IV-258) 10i* 1989 Employee Stock Appreciation Rights Plan. (p. IV-265) 10j* C. R. Bard, Inc. Agreement and Plans Trust. (p. IV-272) IV-2 C. R. BARD, INC. AND SUBSIDIARIES 3. Exhibits, No. (Continued) 10k* Supplemental Insurance/Retirement Plan, Plan I - For new corporate officer when previous agreement as non- officer exists, Plan II - For new corporate officer when no previous agreement exists. (p. IV-290) 10l* Retirement Plan for Outside Directors of C. R. Bard, Inc. (p. IV-309) 10m* Deferred Compensation Contract Deferral of Directors' Fees, as amended entered into with directors William T. Butler, M.D., Regina E. Herzlinger, and Robert P. Luciano. (p. IV-319) 10n* 1988 Directors Stock Award Plan, as amended in October 1991. (p. IV-361) 10o* Excess Benefit Plan. (p. IV-364) 10p* Supplemental Executive Retirement Plan. (p. IV-370) 10q* 1993 Executive Bonus Plan. (p. IV-380) 10r* Long Term Performance Incentive Plan. (p. IV-383) 10s* Deferred Compensation Contract Deferral of Discretionary Bonus. (p. IV-389). 10t* Deferred Compensation Contract Deferral of Salary. (p. IV-396) 10u* 1993 Long Term Incentive Plan. (p. IV-403) 21 Parents and subsidiaries of registrant. (p. IV-415) 23 Arthur Andersen & Co. consent to the incorporation by reference of their report on Form 10-K as amended into previously filed Forms S-8. (p. IV-416) 99 Indemnity agreement between the Company and each of its directors and officers. (p. IV-417) * Each of these exhibits listed under the number 10 constitutes a management contract or a compensatory plan or arrangement. All other exhibits are not applicable. IV-3 C. R. BARD, INC. AND SUBSIDIARIES (b) Reports on Form 8-K Registrant filed a Current Report on Form 8-K dated October 8, 1993 with respect to confirming Company discussions with the Department of Justice concerning a possible disposition of the subject matter of the Boston Federal grand jury investigation into its angioplasty operations. Registrant filed a Current Report on Form 8-K dated October 15, 1993 announcing it had entered into a plea agreement in connection with charges stemming from violations of the Federal Food, Drug and Cosmetic Act. Registrant filed a Current Report on Form 8-K dated October 18, 1993 disclosing the financial impact of the Justice Department settlement on the third quarter earnings. Registrant filed a Current Report on Form 8-K dated November 15, 1993 announcing the Company's decision to close its Fitzwilliam, New Hampshire facility. IV-4 C. R. BARD, INC. AND SUBSIDIARIES 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. C. R. BARD, INC. (Registrant) By: William C. Bopp /s/ William C. Bopp Senior Vice President and Chief Financial Officer Date: March 28, 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. Signatures Title Date William H. Longfield /s/ President and March 28, 1994 William H. Longfield Chief Operating Officer and Director (Principal Executive Officer) William C. Bopp /s/ Senior Vice President March 28, 1994 William C. Bopp and Chief Financial Officer (Principal Financial Officer) Terence C. Brady, Jr. /s/ Senior Vice President March 28, 1994 Terence C. Brady, Jr. and Controller (Principal Accounting Officer) IV-9 C. R. BARD, INC. AND SUBSIDIARIES Signatures Title Date Joseph F. Abely, Jr. /s/ Director March 28, 1994 Joseph F. Abely, Jr. William T. Butler, M.D. /s/ Director March 28, 1994 William T. Butler, M.D. Raymond B. Carey, Jr. /s/ Director March 28, 1994 Raymond B. Carey, Jr. Daniel A. Cronin, Jr. /s/ Director March 17, 1994 Daniel A. Cronin, Jr. Regina E. Herzlinger /s/ Director March 28, 1994 Regina E. Herzlinger Robert P. Luciano /s/ Director March 18, 1994 Robert P. Luciano Robert H. McCaffrey /s/ Director March 28, 1994 Robert H. McCaffrey Ralph H. O'Brien /s/ Director March 28, 1994 Ralph H. O'Brien IV-10

90185_1993.txt

90185_1993

1993

90185

Item 1. Business. Sigma-Aldrich Corporation engages through subsidiaries in two lines of business: the production and sale of a broad range of biochemicals, organic and inorganic chemicals, radiolabeled chemicals, diagnostic reagents, chromatography products and related products (hereinafter referred to as "chemical products"), and the manufacture and sale of metal components for strut, cable tray, pipe support and telecommunication systems and electrical enclosures (hereinafter referred to as "metal products" or "B-Line"). Its principal executive offices are located at 3050 Spruce Street, St. Louis, Missouri 63103. Sigma-Aldrich Corporation (hereinafter referred to as the "Company", which term includes all consolidated subsidiaries of the Company) was incorporated under the laws of the State of Delaware in May 1975. Effective July 31, 1975 ("Reorganization"), the Company succeeded, as a reporting company, Sigma International, Ltd., the predecessor of Sigma Chemical Company ("Sigma"), and Aldrich Chemical Company, Inc. ("Aldrich"), both of which had operated continuously for more than 20 years prior to the Reorganization. Effective December 9, 1980, B-Line Systems, Inc., previously a subsidiary of Sigma, became a subsidiary of the Company. Effective June 23, 1989, the Company purchased all of the issued and outstanding capital stock of Fluka Chemie AG ("Fluka"), a Swiss corporation, from Ciba-Geigy International AG, F. Hoffman- LaRoche & Co. Limited and eleven minority shareholders. Effective May 5, 1993, the Company acquired the net assets and business of Supelco, Inc.("Supelco"), a worldwide supplier of chromatography products used in chemical research and production, from Rohm and Haas Company. (a) Chemical Products. 1) Products: The Company distributes approximately 71,000 chemical products for use primarily in research and development, in the diagnosis of disease, and as specialty chemicals for manufacturing. In laboratory applications, the Company's products are used in the fields of biochemistry, synthetic chemistry, quality control and testing, immunology, hematology, pharmacology, microbiology, neurology, and endocrinology, and in the studies of life processes. Sigma diagnostic products are used in the detection of heart, liver and kidney diseases and various metabolic disorders. Certain of these diagnostic products are used in measuring concentrations of various naturally occurring substances in the blood, indicative of certain pathological conditions. The diagnostic products are used in manual, semi-automated and automated testing procedures. Supelco offers a full line of chromatography products and application technologies for analyzing and separating complex chemical mixtures. The line includes items for the collection and preparation of various samples for further chemical analysis, gas and liquid chromatography, reference standards and related laboratory products. Aldrich also offers approximately 38,000 esoteric chemicals as a special service to customers interested in screening them for application in many areas (such as medicine and agriculture). This area accounts for less than 1% of the Company's sales. Because of continuing developments in the field of research, there can be no assurance of a continuing market for each of the Company's products. However, through a continuing review of technical literature, along with constant communications with customers, the Company keeps abreast of the trends in research and diagnostic techniques. This information, along with its own research technology, determines the Company's development of improved and/or additional products. 2) Production and Purchasing: The Company has chemical production facilities in Milwaukee and Sheboygan, Wisconsin (Aldrich); St. Louis, Missouri (Sigma); Bellefonte, Pennsylvania (Supelco); Germany (Aldrich Chemie GmbH and Co. K.G.); Israel (Makor Chemicals Limited); Switzerland (Fluka) and the United Kingdom (Sigma Chemical Company Ltd.). A minor amount of production is done by some of the Company's other subsidiaries. Biochemicals and diagnostic reagents are primarily produced by extraction and purification from yeasts, bacteria and other naturally occurring animal and plant sources. Organic and inorganic chemicals and radiolabeled chemicals are primarily produced by synthesis. Chromatography media and columns are produced using proprietary chemical synthesis and proprietary preparation processes. Similar processes are used for filtration and sample collection processes. Of the approximately 71,000 products listed in the Sigma, Aldrich, Fluka and Supelco catalogs, the Company produced approximately 31,000 which accounted for 44% of the net sales of chemical products for the year ended December 31, 1993. The remainder of products were purchased from a large number of sources either under contract or in the open market. No one supplier accounts for as much as 10% of the Company's chemical purchases. The Company has generally been able to obtain adequate supplies of products and materials to meet its needs. Whether a product is produced by the Company or purchased from outside suppliers, it is subjected to quality control procedures, including the verification of purity, prior to final packaging. This is done by a combined staff of 201 chemists and lab technicians utilizing sophisticated scientific equipment. 3) Distribution and Sales: The Company markets its chemical products primarily through Sigma, Aldrich, Fluka and Supelco under their own trademarks and labels. Marketing of products is primarily done through the distribution of over 2,600,000 comprehensive catalogs to customers and potential customers throughout the world. This is supplemented by certain specialty catalogs, by advertising in chemical and other scientific journals, by direct mail distribution of in-house publications and special product brochures and by personal visits by technical and sales representatives with customers. For customer convenience, Sigma packages approximately 300 combinations of certain of its individual products in diagnostic kit form. A diagnostic kit will include products which, when used in a series of manual and/or automated testing procedures, will aid in detecting particular conditions or diseases. The sale of these kits is promoted by a field sales unit. Diagnostic kits accounted for less than 10% of the Company's net sales of chemical products in the year ended December 31, 1993. During the year ended December 31, 1993, products were sold to approximately 129,000 customers, including hospitals, universities, clinical laboratories as well as private and governmental research laboratories. The majority of the Company's sales are small orders in laboratory quantities averaging less than $200. The Company also makes its chemical products available in larger-than-normal laboratory quantities for use in manufacturing. Sales of these products accounted for approximately 15% of chemical sales in 1993. During the year ended December 31, 1993, no one customer and no one product accounted for more than 1% of the net sales of chemical products. Sigma, Aldrich, Fluka and Supelco encourage their customers and potential customers, wherever located, to contact them by telephone "collect" or on "toll-free" WATS lines for technical staff consultation or for placing orders. Order processing, shipping, invoicing and product inventory are computerized. Shipments are made seven days a week from St. Louis, six days a week from Milwaukee, England, Germany, Israel and Japan and five days a week from all other locations. The Company strives to ship its products to customers on the same day an order is received and carries significant inventories to maintain this policy. 4) International Operations: In the year ended December 31, 1993, approximately 50% of the Company's net sales of chemical products were to customers located in foreign countries. These sales were made directly by Sigma, Aldrich, Fluka and Supelco, through distributors and by subsidiaries organized in Australia, Belgium, Brazil, Canada, Czech Republic, England, France, Germany, Holland, Hungary, India, Israel, Italy, Japan, Mexico, Scotland, Singapore, South Korea, Spain and Switzerland. Several foreign subsidiaries also have production facilities. For sales with final destinations in a foreign market, the Company has a Foreign Sales Corporation ("FSC") subsidiary which provides the Company certain Federal income tax advantages. The effect of the tax rules governing the FSC is to lower the effective Federal income tax rate on export income. The Company intends to continue to comply with the provisions of the Internal Revenue Code relating to FSCs. The Company's foreign operations and domestic export sales are subject to currency revaluations, changes in tariff restrictions and restrictive regulations of foreign governments, among other factors inherent in these operations. The Company is unable to predict the extent to which its business may be affected in the future by these matters. During the year ended December 31, 1993, approximately 10% of the Company's domestic operations' chemical purchases were from foreign suppliers. Additional information regarding international operations is included in Note 9 to the consolidated financial statements on pages 21 and 22 of the 1993 Annual Report which is incorporated herein by reference. 5) Patents and Trademarks: The Company's patents are not material to its operations. The Company's significant trademarks are the brand names "Sigma", "Aldrich", "Fluka", "Supelco" and "B-Line" and their related logos which have various expiration dates and are expected to be renewed indefinitely. 6) Regulations: The Company engages principally in the business of selling products which are not foods or food additives, drugs, or cosmetics within the meaning of the Federal Food, Drug and Cosmetic Act, as amended (the "Act"). A limited number of the Company's products, including in-vitro diagnostic reagents, are subject to labeling, manufacturing and other provisions of the Act. The Company believes it is in compliance in all material respects with the applicable regulations. The Company believes that it is in compliance in all material respects with Federal, state and local environmental and safety regulations relating to the manufacture, sale and distribution of its products. The following are brief summaries of some of the Federal laws and regulations which may have an impact on the Company's business. These summaries are only illustrative of the extensive regulatory requirements of the Federal, state and local governments and are not intended to provide the specific details of each law or regulation. The Clean Air Act (CAA), as amended, and the regulations promulgated thereunder, regulates the emission of harmful pollutants to the air outside of the work environment. Federal or state regulatory agencies may require companies to acquire permits, perform monitoring and install control equipment for certain pollutants. The Clean Water Act (CWA), as amended, and the regulations promulgated thereunder, regulates the discharge of harmful pollutants into the waters of the United States. Federal or state regulatory agencies may require companies to acquire permits, perform monitoring and to treat waste water before discharge to the waters of the United States or a Publicly Owned Treatment Works (POTW). The Occupational Safety and Health Act of 1970 (OSHA), including the Hazard Communication Standard ("Right to Know"), and the regulations promulgated thereunder, requires the labeling of hazardous substance containers, the supplying of Material Safety Data Sheets ("MSDS") on hazardous products to customers and hazardous substances the employee may be exposed to in the workplace, the training of the employees in the handling of hazardous substances and the use of the MSDS, along with other health and safety programs. The Resource Conservation and Recovery Act of 1976 (RCRA), as amended, and the regulations promulgated thereunder, requires certain procedures regarding the treatment, storage and disposal of hazardous waste. The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund Amendments and Reauthorization Act of 1986 (SARA), and the regulations promulgated thereunder, require notification of certain chemical spills and notification to state and local emergency response groups of the availability of MSDS and the quantities of hazardous materials in the Company's possession. The Toxic Substances Control Act of 1976 (TSCA), requires reporting, testing and pre-manufacture notification procedures for certain chemicals. Exemptions are provided from some of these requirements with respect to chemicals manufactured in small quantities solely for research and development use. The Department of Transportation (DOT) has promulgated regulations pursuant to the Hazardous Materials Transportation Act, referred to as the Hazardous Material Regulations (HMR), which set forth the requirements for hazard labeling, classification and packaging of chemicals, shipment modes and other goods destined for shipment in interstate commerce. Approximately 700 products, for which sales are immaterial to the total sales of the Company, are subject to control by either the Drug Enforcement Administration ("DEA") or the Nuclear Regulatory Commission ("NRC"). The DEA and NRC have issued licenses to several Company sites to permit importation, manufacture, research, analysis, distribution and export of certain products. The Company screens customer orders involving products regulated by the NRC and the DEA to verify that a license, if necessary, has been obtained. (b) Metal Products. Components for strut, cable tray and pipe support systems are manufactured by B-Line at its facilities in Highland and Troy, Illinois; Norcross, Georgia and Reno, Nevada. Components and complete systems used to support telecommunications apparatus and cabling are manufactured and sold by B-Line through its Saunders Communications unit, which is located in Santa Fe Springs, California. Circle AW Products Company, which was acquired on June 16, 1993 and operates as a wholly-owned subsidiary of B-Line, manufactures electrical enclosures at its facilities in Portland, Oregon and Modesto, California. Strut and pipe support systems are metal frameworks and related accessories used in industry to support pipes, lighting fixtures and conduit. Strut systems can be easily assembled with bolts and spring-loaded nuts, eliminating the necessity of drilling or welding associated with other types of frameworks. B-Line manufactures and sells a wide variety of components for these systems, including steel struts rolled from coils, stamped steel fittings for interconnecting struts, shelf-supporting brackets, pipe and conduit supporting clamps, and accessories for the installation of strut systems on location. Pipe hangers are generally used in conjunction with strut systems to support heavy and light duty piping runs in the mechanical, plumbing and refrigeration industry. The principal materials used by B-Line in manufacturing are coils of steel and extruded aluminum which B-Line purchases from a number of suppliers. No one supplier is essential to B-Line's production. A limited number of components for strut and pipe support systems, including bolts and nuts and certain forged and cast components, are purchased from numerous sources and sold by B-Line as accessories to its own manufactured products. Cable tray systems are continuous networks of ventilated or solid trays used primarily in the routing of power cables and control wiring in power plant or industrial installations. The systems are generally hung from ceilings or supported by strut frameworks. Cable tray is produced from either extruded aluminum or roll-formed steel in various configurations to offer versatility to designers and installers. Non-metallic strut and cable tray products, which are used primarily in corrosive environments, are also available. Telecommunications equipment racks and cable runways are manufactured from aluminum or steel. The systems are installed in the central offices of telephone operating companies. As switching equipment is changed and upgraded, the systems are replaced. Electrical enclosures are metal enclosure boxes, generally manufactured with steel, that are used to contain and protect electric meters, fuse and circuit breaker boards and electrical panels. These products are used in industrial, commercial and residential installations. B-Line also manufactures a line of lightweight support fasteners to be used in commercial and industrial facilities to attach electrical and acoustical fixtures. B-Line sells primarily to electrical, mechanical and telecommunications wholesalers. Products are marketed directly by district sales offices and by regional sales managers through independent manufacturers' representatives. Products are shipped to customers from the Highland and Troy, Illinois; Norcross, Georgia; Reno, Nevada; Portland, Oregon; and Modesto and Santa Fe Springs, California plants, from two regional warehouses and 42 consigned stock locations. B-Line's products are advertised in trade journals and by circulation of comprehensive catalogs. (c) Competition. Substantial competition exists in all the Company's marketing and production areas. Although no comprehensive statistics are available, the Company believes it is a major supplier of organic chemicals and biochemicals for research and for diagnostic testing procedures involving enzymes and of chromatography products for analyzing and separating complex chemical mixtures. A few competitors, like the Company, offer thousands of chemicals and stock and analyze most of their products. While the Company generally offers a larger number of products, some of the Company's products are unusual and have relatively little demand. In addition, there are many competitors who offer a limited quantity of chemicals, and several companies compete with the Company by offering thousands of chemicals although few of them stock or analyze substantially all of the chemicals they offer for sale. The Company believes its B-Line subsidiary to be among the three largest producers of metal strut framing, pipe hangers and cable tray component systems, although reliable industry statistics are not available. In all product areas the Company competes primarily on the basis of customer service, quality and price. (d) Employees. The Company employed 5,110 persons as of December 31, 1993. Of these, 4,198 were engaged in production and distribution of chemical products. The B-Line subsidiary employed 912 persons. The total number of persons employed within the United States was 3,792, with the balance employed by the foreign subsidiaries. The Company employed over 1,400 persons who have degrees in chemistry, biochemistry, engineering or other scientific disciplines, including approximately 235 with Ph.D. degrees. Employees engaged in chemical production, research and distribution are not represented by any organized labor group. B-Line's production workers at the Highland and Troy, Illinois facilities are members of the International Association of Machinists and Aerospace Workers, District No. 9 (AFL-CIO). The labor agreement covering these employees expires November 12, 1995. B-Line's production workers at the Norcross, Georgia facility are members of the United Food and Commercial Workers International (AFL-CIO), Retail Clerks Union Local 1063. The labor agreement covering these employees expires June 11, 1994. (e) Back-log of Orders. The majority of orders for chemical products in laboratory quantities are shipped from inventory, resulting in no back-log of these orders. However, individual items may occasionally be out of stock. These items are shipped as soon as they become available. Some orders for larger-than-normal laboratory quantities are for future delivery. On December 31, 1993 and 1992, the back-log of firm orders and orders for future delivery of chemical products was approximately $9,100,000 and $6,800,000, respectively. The Company estimates that substantially all of the December 31, 1993, back-log will be shipped during 1994. On December 31, 1993 and 1992, B-Line had a back-log of orders amounting to $2,400,000 and $2,200,000, respectively. B-Line estimates that substantially all of the December 31, 1993, back-log will be shipped during 1994. (f) Information as to Industry Segments. Information concerning industry segments for the years ended December 31, 1993, 1992 and 1991, is located in Note 9 to the consolidated financial statements on page 21 of the 1993 Annual Report which is incorporated herein by reference. (g) Executive Officers of the Registrant Information regarding executive officers is contained in Part III, Item 10, and incorporated herein by reference. Item 2. Item 2. Properties. The Company's primary chemical production facilities are located in St. Louis, Missouri; Milwaukee and Sheboygan, Wisconsin; Bellefonte, Pennsylvania and Buchs, Switzerland. In St. Louis, the Company owns a 320,000 square foot building used for manufacturing, a complex of buildings aggregating 349,000 square feet which is currently being used for warehousing and production, a 75,000 square foot building used for warehousing and a 30,000 square foot building used for production, quality control and packaging. A 280,000 square foot building in St. Louis is being partially utilized to provide additional quality control, packaging and warehousing capacity. Also in St. Louis, the Company owns 30 acres upon which is located a 240,000 square foot administration and distribution facility, in which its principal executive offices are located, and a 175,000 square foot diagnostic production and office building. In Milwaukee, the Company owns a 165,000 square foot building which is used for manufacturing, warehousing and offices, a 110,000 square foot building which is used for additional manufacturing and warehousing and a complex of buildings aggregating 331,000 square feet which is used primarily for warehousing and distribution. Also in Milwaukee, the Company owns a 151,000 square foot building which is used for manufacturing and warehousing, a 56,000 square foot administration facility and a 615,000 square foot building which is being renovated for use as a distribution facility. The Company also owns 515 acres in Sheboygan, Wisconsin, upon which are located multiple buildings totaling 160,000 square feet for production and packaging. Fluka owns an 11 acre site in Buchs, Switzerland, upon which are located its primary production facilities. Approximately 220,000 square feet of owned production, warehousing and office facilities are at this site. In Greenville, Illinois, the Company owns 555 acres of land for future development of biochemical production facilities. Supelco owns 72 acres near Bellefonte, Pennsylvania, upon which is located a 160,000 square foot building used for manufacturing, warehousing, research and administration. The Company's B-Line manufacturing business is conducted in Highland and Troy, Illinois; Norcross, Georgia; Reno, Nevada; Portland, Oregon; and Modesto and Santa Fe Springs, California. B-Line owns a 270,000 square foot building in Highland, a 55,000 square foot building in Troy, Illinois, a 68,000 square foot building in Portland, Oregon, a 173,000 square foot building in Reno, Nevada, and a 125,000 square foot building in Modesto, California. B-Line leases a 101,000 square foot facility in Norcross, Georgia, and an 18,000 square foot building in Santa Fe Springs, California. The Company also owns warehouse and distribution facilities containing approximately 35,000 and 8,000 square feet in Metuchen, New Jersey and Ronkonkoma, New York, respectively, and leases warehouses in Chicago, Illinois and Dallas, Texas under short-term leases. Manufacturing and warehousing facilities are also owned or leased in England, Germany, Israel, Japan, Scotland and Switzerland. Sales offices are leased in all other locations. The Company considers the properties to be well maintained, in sound condition and repair, and adequate for its present needs. The Company will continue to expand its production and distribution capabilities in select markets. Item 3. Item 3. Legal Proceedings. There are no material pending legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted by the Registrant to the stockholders for a vote during the fourth quarter of 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Information concerning market price of the Registrant's Common Stock and related shareholder matters for the years ended December 31, 1993 and 1992, is located on page 11 of the 1993 Annual Report which is incorporated herein by reference. As of March 4, 1994, there were 2,356 record holders of the Registrant's Common Stock. Items 6 through 8. Selected Financial Data, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Financial Statements. The information required by Items 6 through 8 is incorporated herein by reference to pages 11 - 24 of the 1993 Annual Report. See Index to Financial Statements and Schedules on page of this report. Those pages of the Company's 1993 Annual Report listed in such Index or referred to in Items 1(a)(4), 1(f) and 5 are incorporated herein by reference. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10. Directors and Executive Officers of the Registrant. Information under the captions "Nominees for Board of Directors" and "Security Ownership of Directors, Executive Officers and Principal Beneficial Owners" of the 1994 Proxy Statement is incorporated herein by reference. The executive officers of the Registrant are: Name of Executive Officer Age Positions and Offices Held ------------------------- --- -------------------------- Carl T. Cori 57 Chairman of the Board, President and Chief Executive Officer Peter A. Gleich 48 Vice President and Secretary David R. Harvey 54 Executive Vice President and Chief Operating Officer Kirk A. Richter 47 Controller Thomas M. Tallarico 49 Vice President and Treasurer There is no family relationship between any of the officers. Dr. Harvey and Mr. Richter have held the positions indicated for more than five years. Dr. Cori has been President and Chief Executive Officer of the Company for more than five years. He was elected Chairman of the Board in May 1991. Mr. Gleich has been Vice President and Secretary of the Company for more than five years. He also served as Treasurer of the Company from 1975 to May 1991. Mr. Tallarico has served as Vice President of the Company since February 1991 and as Treasurer of the Company since May 1991. He served as publisher of the St. Louis Sun Publishing Company, St. Louis, Missouri, from March 1989 to July 1990. He served as Senior Vice President and General Manager of Pulitzer Publishing Co., St. Louis Post-Dispatch, St. Louis, Missouri, from 1986 to March 1989. The present terms of office of the officers will expire when the next annual meeting of the Directors is held and their successors are elected. Item 11. Executive Compensation. Information under the captions "Director Compensation and Transactions" and "Information Concerning Executive Compensation" of the 1994 Proxy Statement is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management. Information under the caption "Security Ownership of Directors, Executive Officers and Principal Beneficial Owners" of the 1994 Proxy Statement is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions. Information under the caption "Director Compensation and Transactions" of the 1994 Proxy Statement is incorporated herein by reference. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as part of this report: 1. Financial Statements. See Index to Financial Statements on page of this report. Those pages of the Company's 1993 Annual Report listed in such Index or referred to in Items 1(a)(4), 1(f) and 5 are incorporated herein by reference. 2. Financial Statement Schedules. See Index to Financial Statement Schedules on page of this report. 3. Exhibits. See Index to Exhibits on page of this report. (b) Reports on Form 8-K: No reports on Form 8-K have been 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. SIGMA-ALDRICH CORPORATION (Registrant) By /s/ Thomas M. Tallarico March 30, 1994 -------------------------------------- -------------- Thomas M. Tallarico, Vice President and Date Treasurer KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Carl T. Cori, Peter A. Gleich, David R. Harvey, Kirk A. Richter and Thomas M. Tallarico and each of them (with full power to each of them to act alone), his true and lawful attorneys-in- fact and agents, 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 amendments (including post-effective 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, 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 he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their 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. By /s/ Carl T. Cori March 30, 1994 -------------------------------------- -------------- Carl T. Cori, Director, Chairman of the Date Board, President and Chief Executive Officer By /s/ David R. Harvey March 30, 1994 ----------------------------------------- -------------- David R. Harvey, Director, Executive Vice Date President and Chief Operating Officer By /s/ Peter A. Gleich March 30, 1994 -------------------------------------- -------------- Peter A. Gleich, Vice President and Date Secretary By /s/ Kirk A. Richter March 30, 1994 -------------------------------------- -------------- Kirk A. Richter, Controller Date By /s/ Thomas M. Tallarico March 30, 1994 --------------------------------------- -------------- Thomas M. Tallarico, Vice President and Date Treasurer By /s/ David M. Kipnis March 30, 1994 -------------------------------------- -------------- David M. Kipnis, Director Date By /s/ Andrew E. Newman March 30, 1994 --------------------------------------- -------------- Andrew E. Newman, Director Date By /s/ Jerome W. Sandweiss March 30, 1994 --------------------------------------- -------------- Jerome W. Sandweiss, Director Date SIGMA-ALDRICH CORPORATION AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Page Number Reference Annual Report Form 10-K to Shareholders Comparative financial data for the years 1993, 1992, 1991, 1990, and 1989 11 Management's discussion of financial condition and results of operations 12 FINANCIAL STATEMENTS: Consolidated Balance Sheets December 31, 1993 and 1992 15 Consolidated statements for the years ended December 31, 1993, 1992 and 1991 Income 14 Stockholders' Equity 16 Cash Flows 17 Notes to consolidated financial statements 18 Reports of independent public accountants EX-23 FINANCIAL STATEMENT SCHEDULES: V Property, plant and equipment for the years ended December 31, 1993, 1992 and 1991 VI Accumulated depreciation of property, plant and equipment for the years ended December 31, 1993, 1992 and 1991 IX Short-term borrowings for the years ended December 31, 1993, 1992 and 1991 X Supplementary income statement information for the years ended December 31, 1993, 1992 and 1991 All other schedules are not submitted because they are not applicable, not required or because the information is included in the consolidated financial statements or notes thereto. SCHEDULE X SIGMA-ALDRICH CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, (in thousands) Charged to Costs and Expenses 1993 1992 1991 ------- ------- ------- Maintenance and repairs $10,575 $ 8,857 $ 8,902 Depreciation and amortization 32,505 28,863 26,826 Advertising 28,674 25,274 24,466 Royalties and taxes, other than payroll and income taxes, incurred during 1993, 1992 and 1991 were less than 1% of sales. INDEX TO EXHIBITS These Exhibits are numbered in accordance with the Exhibit Table of Item 6. Item 6.01 of Regulation S-K: Exhibit Reference (3) Certificate of Incorporation and By-Laws: (a) Certificate of Incorporation and Amendments Incorporated by reference to Exhibit 3(a) of Form 10-K filed for the year ended December 31, 1991, Commission File Number 0-8135. (b) By-Laws as amended February 1993 Incorporated by reference to Exhibit 3(b) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (4) Instruments Defining the Rights of Shareholders, Including Indentures: (a) Certificate of Incorporation and Amendments See Exhibit 3(a) above. (b) By-Laws as amended February 1993 See Exhibit 3(b) above. (c) The Company agrees to furnish to the Securities and Exchange Commission upon request pursuant to Item 601(b)(4)(iii) of Regulation S-K copies of instruments defining the rights of holders of long-term debt of the Company and its consolidated subsidiaries. (10) Material Contracts: (a) Incentive Stock Bonus Plan* Incorporated by reference to Exhibit 10(a) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (b) First Amendment to Incentive Incorporated by reference to Exhibit Stock Bonus Plan* 10(b) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (c) Second Amendment to Incentive Incorporated by refence to Exhibit Stock Bonus Plan* 10(c) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (d) Share Option Plan of 1987* Incorporated by reference to Exhibit 10(d) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (e) First Amendment to Share Option Incorporated by refence to Exhibit Plan of 1987* 10(e) of Form 10-K filed for the year ended December 31, 1992, Commission File Number 0-8135. (f) Employment Agreement with Carl T. Incorporated by reference to Exhibit Cori* (Similar Employment Agreements 10(f) of Form 10-K filed for the also exist with Peter A. Gleich, year ended December 31, 1992, David R. Harvey, Kirk A. Richter Commission File Number 0-8135. and Thomas M. Tallarico) (g) Letter re: Consultation Services Incorporated by reference to Exhibit with Dr. David M. Kipnis* 10(g) of Form 10-K field for the year ended December 31, 1992, Commission File Number 0-8135. (11) Statement Regarding Computation Incorporated by reference to the of Per Share Earnings information on net income per share included in Note 1 to the Company's 1993 financial statements filed as Exhibit 13 below. (13) Pages 11-24 of the Annual Report to Shareholders for the year ended December 31, 1993 (21) Subsidiaries of Registrant (23) Consent of Independent Public Accountants *Represents management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.

352049_1993.txt

352049_1993

1993

352049

Item 1. Business THE CENTERIOR SYSTEM Centerior Energy is a public utility holding company and the parent company of the Operating Companies and the Service Company. Centerior was incorporated under the laws of the State of Ohio in 1985 for the purpose of enabling Cleveland Electric and Toledo Edison to affiliate by becoming wholly owned subsidiaries of Centerior. The affiliation of the Operating Companies became effective in April 1986. Nearly all of the consolidated operating revenues of the Centerior System are derived from the sale of electric energy by Cleveland Electric and Toledo Edison. The Operating Companies' combined service areas encompass approximately 4,200 square miles in northeastern and northwestern Ohio with an estimated popula- tion of about 2,600,000. At December 31, 1993, the Centerior System had 6,748 employees. Centerior Energy has no employees. Cleveland Electric, which was incorporated under the laws of the State of Ohio in 1892, is a public utility engaged in the generation, purchase, transmis- sion, distribution and sale of electric energy in an area of approximately 1,700 square miles in northeastern Ohio, including the City of Cleveland. Cleveland Electric also provides electric energy at wholesale to other elec- tric utility companies and to two municipal electric systems (directly and through AMP-Ohio) in its service area. Cleveland Electric serves approxi- mately 748,000 customers and derives approximately 75% of its total electric revenue from customers outside the City of Cleveland. Principal industries served by Cleveland Electric include those producing steel and other primary metals; automotive and other transportation equipment; chemicals; electrical and nonelectrical machinery; fabricated metal products; and rubber and plastic products. Nearly all of Cleveland Electric's operating revenues are derived from the sale of electric energy. At December 31, 1993, Cleveland Electric had 3,606 employees of which about 51% were represented by one union having a collective bargaining agreement with Cleveland Electric. Toledo Edison, which was incorporated under the laws of the State of Ohio in 1901, is a public utility engaged in the generation, purchase, transmission, distribution and sale of electric energy in an area of approximately 2,500 square miles in northwestern Ohio, including the City of Toledo. Toledo Edison also provides electric energy at wholesale to other electric utility companies and to 13 municipally owned distribution systems (through AMP-Ohio) and one rural electric cooperative distribution system in its service area. Toledo Edison serves approximately 285,000 customers and derives approximately 55% of its total electric revenue from customers outside the City of Toledo. Among the principal industries served by Toledo Edison are metal casting, forming and fabricating; petroleum refining; automotive equipment and assembly; food processing; and glass. Nearly all of Toledo Edison's operating revenues are derived from the sale of electric energy. At December 31, 1993, Toledo Edison had 1,909 employees of which about 55% were represented by three unions having collective bargaining agreements with Toledo Edison. The Service Company, which was incorporated in 1986 under the laws of the State of Ohio, is also a wholly owned subsidiary of Centerior Energy. It pro- vides management, financial, administrative, engineering, legal, governmental and public relations and other services to Centerior Energy and the Operating Companies. At December 31, 1993, the Service Company had 1,233 employees. On March 25, 1994, Centerior Energy announced plans to merge Toledo Edison into Cleveland Electric. Since Cleveland Electric and Toledo Edison affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO, the PaPUC and other regulatory authorities. The merger must be approved by Toledo Edison preferred stock share owners. Preferred stock share owners of Cleveland Electric must approve the authori- zation of additional shares of preferred stock. Upon the merger becoming effective, the outstanding shares of Toledo Edison preferred stock will be exchanged for shares of Cleveland Electric preferred stock having sub- stantially the same terms. Cleveland Electric and Toledo Edison plan to seek preferred share owner approval in the summer of 1994. The merger is expected to be effective late in 1994. See Note 15 to the Operating Companies' Financial Statements for further discussion of this matter and "3. Combined Pro Forma Condensed Financial Statements (Unaudited)" contained under Item 14. of this Report for selected historical and combined pro forma financial information of Cleveland Electric and Toledo Edison. CAPCO GROUP Cleveland Electric and Toledo Edison are members of the CAPCO Group, a power pool created in 1967 with Duquesne, Ohio Edison and Pennsylvania Power. This pool affords greater reliability and lower cost of providing electric service through coordinated generating unit operations and maintenance and generating reserve back-up among the five companies. In addition, the CAPCO Group has completed programs to construct larger, more efficient electric generating units and to strengthen interconnections within the pool. The CAPCO Group companies have placed in service nine major generating units, of which the Operating Companies have ownership or leasehold interests in seven (three nuclear and four coal-fired). Each CAPCO Group company owns, as a tenant-in-common, or leases a portion of certain of these generating units. Each company has the right to the net capability and associated energy of its respective ownership and leasehold portions of the units and is, severally and not jointly, obligated for the capital and operating costs equivalent to its respective ownership and leasehold portions of the units and the required fuel, except that the obligations of Pennsylvania Power are the joint and several obligations of that company and Ohio Edison and except that the leasehold obligations of Cleveland Electric and Toledo Edison are joint and several. (See "Operations--Fuel Supply".) For all plants but one, the company in whose service area a generating unit is located is responsible for the operation of that unit for all the owners, except for the procurement of nuclear fuel for a nuclear generating unit. The Mansfield Plant, which is located in Duquesne's service area, is operated by Pennsylvania Power. Each company owns the necessary interconnecting transmission facilities within its service area, and the other CAPCO Group companies contribute toward fixed charges and operating costs of those transmission facilities. All of the CAPCO Group companies are members of ECAR, which is comprised of 28 electric companies located in nine contiguous states. ECAR's purpose is to improve reliability of bulk power supply through coordination of planning and operation of member companies' generation and transmission facilities. CONSTRUCTION AND FINANCING PROGRAMS Construction Program The Centerior System carries on a continuous program of constructing trans- mission, distribution and general facilities and modifying existing generating facilities to meet anticipated demand for electric service, to comply with governmental regulations and to protect the environment. The Operating Companies' 1993 long-term (20-year) forecast, as filed with the PUCO (see "General Regulation--State Utility Commissions"), projects long-term annual growth rates in peak demand and kilowatt-hour sales for the Operating Companies of 1.1% and 1.4%, respectively, after demand-side management con- siderations. The Centerior System's integrated resource plan for the 1990s (which is included in the long-term forecast) combines demand-side management programs with maximum utilization of existing generating capacity to postpone the need for new generating units until the next decade. Demand-side manage- ment programs, such as energy-efficient lighting and motors, curtailable load and energy management, are expected to assist customers in achieving greater energy efficiency. Centerior plans to invest up to $35,000,000 in demand-side programs in 1994 and 1995. Operable capacity margins over the next ten years are expected to be adequate without adding generating capacity. According to the current long-term integrated resource plan, the next increment of generating capacity that the Centerior System plans to put into service will be two 136,000-kilowatt units in 2003, with additional small, short-lead-time capacity in subsequent years. The following tables show, categorized by major components, the construction expenditures by Cleveland Electric and Toledo Edison and, by aggregating them, for the Centerior System during 1991, 1992 and 1993 and the estimated cost of their construction programs for 1994 through 1998, in each case including AFUDC and excluding nuclear fuel: *Construction of Perry Unit 2 was suspended in 1985. In 1992, Cleveland Electric purchased Duquesne's ownership share of Perry Unit 2 for $3,324,000. At December 31, 1993, Centerior Energy, Cleveland Electric and Toledo Edison wrote off their investment in Perry Unit 2 (see Note 4(b)). Each company in the CAPCO Group is responsible for financing the portion of the capital costs of nuclear fuel equivalent to its ownership and leased interest in the unit in which the fuel will be utilized. See "Operations-- Fuel Supply--Nuclear" for information regarding nuclear fuel supplies and Note 6 regarding leasing arrangements to finance nuclear fuel capital costs. Nuclear fuel capital costs incurred by Cleveland Electric, Toledo Edison and the Centerior System during 1991, 1992 and 1993 and their estimated nuclear fuel capital costs for 1994 through 1998 are as follows: Financing Program Reference is made to Centerior Energy's, Cleveland Electric's and Toledo Edison's Management's Financial Analysis contained under Item 7 of this Report and to Notes 11 and 12 for discussions of the Centerior System's financing activity in 1993; debt and preferred stock redemption requirements during the 1994-1998 period; expected external financing needs during such period; re- strictions on the issuance of additional debt securities and preferred stock; short-term and long-term financing capability; and securities ratings for the Operating Companies. In the second quarter of 1994, Cleveland Electric and Toledo Edison expect to issue $46,100,000 and $30,500,000, respectively, of first mortgage bonds as collateral security for the sale by a public authority of equal principal amounts of tax-exempt bonds. The proceeds from the sales of the public authority's bonds will be used to refund $46,100,000 and $30,500,000, respec- tively, of tax-exempt bonds that were issued in 1988 and have been continu- ously remarketed on a floating rate basis. The new series of bonds will each be issued at a fixed rate of interest for the remaining term to July 1, 2023. Centerior expects to raise about $35,000,000 in 1994 from the sale of authorized but unissued common stock under certain of its employee and share owner stock purchase plans. GENERAL REGULATION Holding Company Regulation Centerior Energy is currently exempt from regulation under the Holding Company Act. The Energy Act contains, among other provisions, amendments to the Holding Company Act and the Federal Power Act. The Energy Act also adopted nuclear power licensing and related regulations, energy efficiency standards and incentives for the use of alternative transportation fuels. Amendments to the Holding Company Act create a new class of independent power producers known as "Exempt Wholesale Generators", which are exempt from the Holding Company Act corporate structure regulations and operate without SEC approval or regulation. Exempt Wholesale Generators may be owned by holding companies, electric utility companies or any other person. State Utility Commissions - ------------------------- The Operating Companies are subject to the jurisdiction of the PUCO with re- spect to rates, service, accounting, issuance of securities and other matters. Under Ohio law, municipalities may regulate rates, subject to appeal to the PUCO if not acceptable to the utility. See "Electric Rates" for a description of certain aspects of Ohio rate-making law. The Operating Companies are also subject to the jurisdiction of the PaPUC in certain respects relating to their ownership interests in generating facilities located in Pennsylvania. The PUCO is composed of five commissioners appointed by the Governor of Ohio from nominees recommended by a Public Utility Commission Nominating Council. Nominees must have at least three years' experience in one of several disci- plines. Not more than three commissioners may belong to the same political party. Under Ohio law, a public utility must file annually with the PUCO a long-term forecast of customer loads, facilities needed to serve those loads and prospective sites for those facilities. This forecast must include the following: (1) Demand Forecast--the utility's 20-year forecast of sales and peak demand, before and after the effects of demand-side management programs. (2) Integrated Resource Plan (required biennially)--the utility's projected mix of resource options to meet the projected demand. (3) Short-Term Implementation Plan and Status Report (required biennially)-- the utility's discussion of how it plans to implement its integrated resource plan over the next four years. Estimates of annual expenditures and security issuances associated with the integrated resource plan over the four-year period must also be provided. The PUCO must hold a public hearing on the long-term forecast at least once every five years to determine the reasonableness of such forecast. The PUCO and the OPSB are required to consider the record of such hearings in proceed- ings for approving facility sites, changing rates, approving security issues and initiating energy conservation programs. Ohio law also permits electric utilities under PUCO jurisdiction to submit environmental compliance plans for PUCO review and approval. Ohio law requires that the PUCO make certain statutory findings prior to approving the environmental compliance plan, which includes that the plan is a reasonable least cost strategy for compliance with air quality requirements. In 1992, the PUCO held hearings on the Operating Companies' 1992 long-term forecast and environmental compliance plan. Centerior and the parties intervening in the proceeding reached agreement on the forecast and environmental compliance plan, and the agreement was sub- sequently approved by the PUCO in February 1993. The PUCO has jurisdiction over certain transactions by companies in an elec- tric utility holding company system if it includes at least one Ohio electric utility and is exempt from regulation under Section 3(a)(1) or (2) of the Holding Company Act. An Ohio electric utility in such a holding company system, such as Centerior, must obtain PUCO approval to invest in, lend funds to, guarantee the obligations of or otherwise finance or transfer assets to any nonutility company in that holding company system, unless the transaction is in the ordinary course of business operations in which one company acts for or with respect to another company. Also, the holding company in such a hold- ing company system must obtain PUCO approval to make any investment in any nonutility subsidiaries, affiliates or associates of the holding company if such investment would cause all such capital investments to exceed 15% of the consolidated capitalization of the holding company unless such funds were provided by nonutility subsidiaries, affiliates or associates. The PUCO has a reserve capacity policy for electric utilities in Ohio stating that (i) 20% of service area peak load excluding interruptible load is an appropriate generic benchmark for an electric utility's reserve margin; (ii) a reserve margin exceeding 20% gives rise to a presumption of excess capacity, but may be appropriate if it confers a positive net present benefit to cus- tomers or is justified by unique system characteristics; and (iii) appropriate remedies for excess capacity (possibly including disallowance of costs in rates) will be determined by the PUCO on a case-by-case basis. Ohio Power Siting Board The OPSB has state-wide jurisdiction, except to the extent pre-empted by Federal law, over the location, need for and certain environmental aspects of electric generating units with a capacity of 50,000 kilowatts or more and transmission lines with a rating of at least 125 kV. Federal Energy Regulatory Commission The Operating Companies are each subject to the jurisdiction of the FERC with respect to the transmission and sale of power at wholesale in interstate com- merce, interconnections with other utilities, accounting and certain other matters. Cleveland Electric is also subject to FERC jurisdiction with respect to its ownership and operation of the Seneca Plant. Nuclear Regulatory Commission The nuclear generating units in which the Operating Companies have an interest are subject to regulation by the NRC. The NRC's jurisdiction encompasses broad supervisory and regulatory powers over the construction and operation of nuclear reactors, including matters of health and safety, antitrust considera- tions and environmental impacts. Owners of nuclear units are required to purchase the full amount of nuclear liability insurance available. See Note 5(b) for a description of nuclear in- surance coverages. Other Regulation The Operating Companies are subject to regulation by Federal, state and local authorities with regard to the location, construction and operation of certain facilities. The Operating Companies are also subject to regulation by local authorities with respect to certain zoning and planning matters. ENVIRONMENTAL REGULATION General The Operating Companies are subject to regulation with respect to air quality, water quality and waste disposal matters. Federal environmental legislation affecting the operations and properties of the Operating Companies includes the Clean Air Act, the Clean Air Act Amendments, the Clean Water Act, Superfund, and the Resource Conservation and Recovery Act. The requirements of these statutes and related state and local laws are continually changing due to the promulgation of new or revised laws and regulations and the results of judicial and agency proceedings. Compliance with such laws and regulations may require the Operating Companies to modify, supplement, abandon or replace facilities and may delay or impede construction and operation of facilities, all at costs which could be substantial. The Operating Companies expect that the impact of such costs would eventually be reflected in their respective rate schedules. Cleveland Electric and Toledo Edison plan to spend, during the period 1994-1996, $70,000,000 and $20,000,000, respectively, for pollution control facilities, including Clean Air Act Amendments compliance costs. The Operating Companies believe that they are currently in compliance in all material respects with all applicable environmental laws and regulations, or to the extent that one or both of the Operating Companies may dispute the applicability or interpretation of a particular environmental law or regula- tion, the affected company has filed an appeal or has applied for permits, revisions in requirements, variances or extensions of deadlines. Concerns have been raised regarding the possible health effects associated with electric and magnetic fields. Although scientific research as to such effects has yielded inconclusive results, additional studies are being con- ducted. If electric and magnetic fields are ultimately found to pose a health risk, the Operating Companies may be required to modify transmission and distribution lines or other facilities. Air Quality Control Under the Clean Air Act, the Ohio EPA has adopted Ohio emission limitations for particulate matter and sulfur dioxide for each of the Operating Companies' plants. The Clean Air Act provides for civil penalties of up to $25,000 per day for each violation of an emission limitation. The U.S. EPA has approved the Ohio EPA's emission limitations and the related implementation plans ex- cept for some particulate matter emissions and certain sulfur dioxide emis- sions. The U.S. EPA has adopted separate sulfur dioxide emission limitations for each of the Operating Companies' plants. In November 1990, the Clean Air Act Amendments were signed into law imposing restrictions on nitrogen oxides emissions and making sulfur dioxide emission limitations significantly more severe beginning in 1995. See Note 4(a) for a description of the Operating Companies' compliance strategy, which was in- cluded in the agreement approved by the PUCO in February 1993 in connection with the Operating Companies' 1992 long-term forecast. The Clean Air Act Amendments also require studies to be conducted on the emission of certain potentially hazardous air pollutants which could lead to additional restrictions. In 1985, the U.S. EPA issued revised regulations specifying the extent to which power plant stack height may be incorporated into the establishment of an emission limitation. Pursuant to the revised regulations, the Operating Companies submitted to the Ohio EPA information intended to support continua- tion of the stack height credit received under the previous regulations for stacks at Cleveland Electric's Avon Lake and Eastlake Plants and Toledo Edison's Bay Shore Station. The Ohio EPA has accepted the submissions and forwarded them to the U.S. EPA for approval. In January 1988, the District of Columbia Circuit Appeals Court remanded portions of the 1985 regulations to the U.S. EPA for further consideration; however, the U.S. EPA has not taken action specifically on this issue. Congress is considering legislation to reduce emissions of gases such as those resulting from the burning of coal that are thought to cause global warming. If such legislation is adopted, the cost of operating coal-fired plants could increase significantly and coal-fired generating capacity could decrease significantly. Water Quality Control The Clean Water Act requires that power plants obtain permits that contain certain effluent limitations (that is, limits on discharges of pollutants into bodies of water). It also requires the states to establish water quality standards (which could result in more stringent effluent limitations than those required under the Clean Water Act) and a permit system to be approved by the U.S. EPA. Violators of effluent limitations and water quality standards are subject to a civil penalty of up to $25,000 per day for each such violation. The Clean Water Act permits thermal effluent limitations to be established for a facility which are less stringent than those which otherwise would apply if the owner can demonstrate that such less stringent limitations are sufficient to assure the protection and propagation of aquatic and other wildlife in the affected body of water. By 1978, the Operating Companies had submitted to the Ohio EPA such demonstrations for review with respect to their Ashtabula, Avon Lake, Lake Shore, Eastlake, Acme and Bay Shore plants. The Ohio EPA has taken no action on the submittals. The Operating Companies have received NPDES permit renewals from the Ohio EPA or have applied for such renewals for all of their power plants. In those situations where a permit application is pending, the affected plant may con- tinue to operate under the expired permit while such application is pending. Any violation of an NPDES permit is considered to be a violation of the Clean Water Act subject to the penalty discussed above. In 1990, the Ohio EPA issued revised water quality standards applicable to Lake Erie and waters of the State of Ohio. Based upon these revised water quality standards, the Ohio EPA placed additional effluent limitations in their most recent NPDES permits. The revised standards also may serve as the basis for more stringent effluent limitations in future NPDES permits. Such limitations could result in the installation of additional pollution control equipment and increased operating expenses. The Operating Companies are monitoring discharges at their plants to support their position that addi- tional effluent limitations are not justified. On April 16, 1993, the U.S. EPA issued proposed rules for water quality standards applicable to all states abutting the Great Lakes, including Ohio. These states would be required to adopt state water quality standards and procedures consistent with the rules within two years of final publication. Preliminary reviews indicate that the cost of complying with these rules could be significant. However, Centerior cannot determine what impact these rules will have on its operations until such rules are issued in final form and are incorporated into Ohio regulations. Waste Disposal See "Hazardous Waste Disposal Sites" in Management's Financial Analysis contained under Item 7 of this Report and Note 4(c) for a discussion of the Operating Companies' potential involvement in certain hazardous waste disposal sites, including those subject to Superfund. See "Nuclear Units" and "Fuel Supply--Nuclear" under "Operations", below, for discussions concerning the disposal of nuclear waste. The Resource Conservation and Recovery Act exempts certain fossil fuel com- bustion waste products, such as fly ash, from hazardous waste disposal re- quirements. The Operating Companies are unable to predict whether Congress will choose to amend this exemption in the future or, if so, the costs relat- ing to any required changes in the operations of the Operating Companies. ELECTRIC RATES Under Ohio law, rate base is the original cost less depreciation of a utility's total plant adjusted for certain items. The law permits the PUCO, in its discretion, to include CWIP in rate base when a construction project is at least 75% complete, but limits the amount included to 10% of rate base ex- cluding CWIP or, in the case of a project to construct pollution control fa- cilities which would remove sulfur and nitrous oxides from flue gas emissions, 20% of rate base excluding CWIP. When a project is completed, the portion of its cost which had been included in rate base as CWIP is excluded from rate base until the revenue received due to the CWIP inclusion is offset by the revenue lost due to its exclusion. During this period of time, an AFUDC-type credit is allowed on the portion of the project cost excluded from rate base. Also, the law permits inclusion of CWIP for a particular project for a period not longer than 48 consecutive months, plus any time needed to comply with changed governmental regulations, standards or approvals. The PUCO is em- powered to permit inclusion for up to another 12 months for good cause shown. If a project is canceled or not completed within the allowable period of time after inclusion of its CWIP has started, then CWIP is excluded from rate base and any revenues which resulted from such prior inclusion are offset against future revenues over the same period of time as the CWIP was included. Current Ohio law further provides that requested rates can be collected by a public utility, subject to refund, if the PUCO does not make a decision within 275 days after the rate request application is filed. If the PUCO does not make its final decision within 545 days, revenues collected thereafter are not subject to refund. A notice of intent to file an application for a rate in- crease cannot be filed before the issuance of a final order in any prior pend- ing application for a rate increase or until 275 days after the filing of the prior application, whichever is earlier. The minimum period by which the notice of intent to file must precede the actual filing is 30 days. The test year for determining rates may not end more than nine months after the date the application for a rate increase is filed. Under Ohio law, electric rates are adjusted every six months to reflect changes in fuel costs. The PUCO reviews such adjustments annually. Any difference between actual fuel costs during a six-month period and the fuel revenues recovered in that period is deferred and is taken into account in setting the fuel recovery factor for a subsequent six-month period. The PUCO has authorized the Operating Companies to adjust their rates on a seasonal basis such that electric rates are higher in the summer. Also, under Ohio law, municipalities may regulate rates charged by a utility, subject to appeal to the PUCO if not acceptable to the utility. If municipally fixed rates are accepted by the utility, such rates are binding on both parties for the specified term and cannot be changed by the PUCO. See Note 7 and Management's Financial Analysis contained under Item 7 of this Report for information relating to the PUCO's January 1989 rate orders and the Rate Stabilization Program that was approved by the PUCO for the Operating Companies in October 1992. OPERATIONS Sales of Electricity Kilowatt-hour sales by the Operating Companies follow a seasonal pattern marked by increased customer usage in the summer for air conditioning and in the winter for heating. Historically, Cleveland Electric has experienced its heaviest demand for electric service during the summer months because of a significant air conditioning load on its system and a relatively low amount of electric heating load in the winter. Toledo Edison, although having a significant electric heating load, has experienced in recent years its heaviest demand for electric service during the summer months because of heavy air conditioning usage. The Centerior System's largest customer is a steel manufacturer which has two major steel producing facilities served by Cleveland Electric. Sales to these facilities accounted for 2.5% and 3.5% of the 1993 total electric operating revenues of Centerior Energy and Cleveland Electric, respectively. The loss of these facilities (and the resultant loss of another large customer whose primary product is purchased by the two steel producing facilities) would reduce Centerior Energy's and Cleveland Electric's net income by about $34,000,000 based on 1993 sales levels. The largest customer served by Toledo Edison is a major automobile manufac- turer. Sales to this customer accounted for 1.4% and 3.9% of the 1993 total electric operating revenues of Centerior Energy and Toledo Edison, re- spectively. The loss of this customer would reduce Centerior Energy's and Toledo Edison's net income by about $10,000,000 based on 1993 sales levels. Operating Statistics For data on operating revenues by service category, electric sales by service category, customers by service category and electric energy generation for 1983 and 1989 through 1993, see the attached Pages and for Centerior Energy, and for Cleveland Electric and and for Toledo Edison. Nuclear Units The Operating Companies' generating facilities include, among others, three nuclear units owned or leased by the CAPCO Group--Perry Unit 1, Beaver Valley Unit 2 and Davis-Besse. These three units are in commercial operation. Cleveland Electric has responsibility for operating Perry Unit 1, Duquesne has responsibility for operating Beaver Valley Unit 2 and Toledo Edison has re- sponsibility for operating Davis-Besse. Cleveland Electric and Toledo Edison own, respectively, 31.11% and 19.91% of Perry Unit 1, 24.47% and 1.65% of Beaver Valley Unit 2 and 51.38% and 48.62% of Davis-Besse. Cleveland Electric and Toledo Edison also lease, as joint lessees, another 18.26% of Beaver Valley Unit 2 as a result of a September 1987 sale and leaseback transaction (see Note 2). Davis-Besse was placed in commercial operation in 1977, and its operating license expires in 2017. Perry Unit 1 and Beaver Valley Unit 2 were placed in commercial operation in 1987, and their operating licenses expire in 2026 and 2027, respectively. As part of its January 1989 rate orders, the PUCO approved nuclear plant performance standards for the Operating Companies based on rolling three-year industry averages of operating availability for pressurized water reactors and for boiling water reactors over the 1988-1998 period. Operating availability is the ratio of the number of hours a unit is available to generate elec- tricity (whether or not the unit is operated) to the number of hours in the period, expressed as a percentage. The three-year operating availability averages of the Operating Companies' nuclear units are compared against the industry averages for the same three-year period with a resultant penalty or banked benefit. If the industry performance standards are not met, a penalty would be incurred which would require the Operating Companies to refund in- cremental replacement power costs to customers through the semiannual fuel cost rate adjustment. However, if the performance of the Operating Companies' nuclear units exceeds the industry standards, a banked benefit results which can be used to offset disallowances of incremental replacement power costs should future performance be below industry standards. The relevant industry standards for the 1991-1993 period are 78.0% for pressurized water reactors such as Davis-Besse and Beaver Valley Unit 2 and 72.8% for boiling water reactors such as Perry Unit 1. The 1991-1993 availability average for Davis-Besse and Beaver Valley Unit 2 was 87.1% and for Perry Unit 1 was 69.2%. At December 31, 1993, the total banked benefit for the Operating Companies is estimated to be between $18,000,000 and $20,000,000. All three nuclear units have received generally favorable evaluations from the NRC in their most recent SALP reviews. Each of the functional areas evaluated is rated according to three performance categories, with category 1 indicating performance substantially exceeding regulatory requirements and that reduced NRC attention may be appropriate; category 2 indicating performance above that needed to meet regulatory requirements and that NRC attention may be main- tained at normal levels; and category 3 indicating performance does not significantly exceed that needed to meet minimal regulatory requirements and that NRC attention should be increased above normal levels. The most recent review periods and SALP review scores for Perry Unit 1 and Davis-Besse are: The NRC increased its attention to Perry Unit 1 in 1993 and placed the unit on a newly created list for units identified as showing "safety performance trending downward." Centerior made specific organizational changes and developed a comprehensive course of action to improve the operating performance of Perry Unit 1. In response to this course of action, on January 27, 1994, the NRC removed Perry Unit 1 from the performance trending downward list. In 1993, the NRC revised the functional areas which comprise the SALP grading process. Plant Support is a new category which covers the areas previously covered by Security, Emergency Preparedness and Radiological Controls. The Safety Assessment/Quality Verification category is now an integral part of each category and is no longer being singled out. Beaver Valley Unit 2 is the only Centerior System unit to have been graded under the new system. Perry Unit 1 and Davis-Besse will be graded under the new system when their next SALP scores are issued. The most recent review period and SALP review scores for Beaver Valley Unit 2 are: The Operating Companies ship low-level radioactive waste produced at their nuclear plants to an offsite disposal facility which may not accept such shipments after mid-1994. The Operating Companies' ability to continue offsite disposal depends on whether the State of Ohio develops a low-level radioactive waste disposal facility within the next several years. If offsite disposal becomes unavailable, the Operating Companies have facilities to temporarily store such waste on site at each of the nuclear plants. However, the Operating Companies do not intend to store such waste on site until all available off-site options have been exhausted. See Note 4(b) for a discussion of the write-off of Perry Unit 2, and see Note 5(a) and "Outlook--Nuclear Operations" in Management's Financial Analysis contained under Item 7 of this Report for a discussion of potential risks facing Centerior and the Operating Companies as owners of nuclear generating units. Competitive Conditions General. The Operating Companies compete in their respective service areas with suppliers of natural gas to satisfy customers' energy needs with regard to heating and appliance usage. The Operating Companies also are engaged in competition to a lesser extent with suppliers of oil and liquefied natural gas for heating purposes and with suppliers of cogeneration equipment. One competitor provides steam for heating purposes and provides chilled water for cooling purposes in certain areas of downtown Cleveland. The Operating Companies also compete with municipally owned electric systems within their respective service areas. As discussed below, two of the munici- palities served by the Operating Companies, the City of Toledo and the City of Garfield Heights, are investigating the economic feasibility of establishing and operating municipally owned electric systems. A few other communities have evaluated municipalization of electric service and decided to continue service from Cleveland Electric and Toledo Edison. Officials in still other communities have indicated an interest in evaluating the municipalization issue. The Operating Companies face continuing competition from locations outside their service areas which are promoted by governmental and private agencies in attempts to influence potential and existing commercial and industrial cus- tomers to locate in their respective areas. Cleveland Electric and Toledo Edison also periodically compete with other producers of electricity for sales to electric utilities which are in the market for bulk power purchases. The Operating Companies have inter- connections with other electric utilities (see "Item 2. Item 2. Properties GENERAL The Centerior System The wholly owned, jointly owned and leased electric generating facilities of the Operating Companies in commercial operation as of February 28, 1994 pro- vide the Centerior System with a net demonstrated capability of 5,980,000 kilowatts during the winter. These facilities include 20 generating units (3,634,000 kilowatts) at seven fossil-fired steam electric generation sta- tions; three nuclear generating units (1,856,000 kilowatts); a 351,000 kilo- watt share of the Seneca Plant; seven combustion turbine generating units (135,000 kilowatts) and one diesel generator (4,000 kilowatts). Operations at two fossil-fired generating units (320,000 kilowatts) ceased in 1993 and the units are being preserved for future use. All of the Centerior System's generating facilities are located in Ohio and Pennsylvania. The Centerior System's net 60-minute peak load of its service area for 1993 was 5,397,000 kilowatts and occurred on August 27. At the time of the 1993 peak load, the operable capacity available to serve the load was 5,998,000 kilowatts. The Centerior System's 1994 service area peak load is forecasted to be 5,250,000 kilowatts, after demand-side management considerations. The operable capacity expected to be available to serve the Centerior System's 1994 peak is 5,670,000 kilowatts. Over the 1994-1996 period, Centerior Energy forecasts its operable capacity margins at the time of the projected Centerior System peak loads to range from 7% to 9.5%. Each Operating Company owns the electric transmission and distribution facili- ties located in its respective service area. Cleveland Electric and Toledo Edison are interconnected by 345 kV transmission facilities, some portions of which are owned and used by Ohio Edison. The Operating Companies have a long- term contract with the CAPCO Group companies, including Ohio Edison, relating to the use of these facilities. These interconnection facilities provide for the interchange of power between the two Operating Companies. The Centerior System is interconnected with Ohio Edison, Ohio Power, Penelec and Detroit Edison. Cleveland Electric The wholly owned, jointly owned and leased electric generating facilities of Cleveland Electric in commercial operation as of February 28, 1994 provide a net demonstrated capability of 4,148,000 kilowatts during the winter. These facilities include 16 generating units (2,709,000 kilowatts) at five fossil- fired steam electric generation stations; its share of three nuclear generat- ing units (1,026,000 kilowatts); a 351,000 kilowatt share of the Seneca Plant; two combustion turbine generating units (58,000 kilowatts) and one diesel gen- erator (4,000 kilowatts). Operations at one fossil-fired generating unit (245,000 kilowatts) ceased in October 1993 and the unit is being preserved for future use. All of Cleveland Electric's generating facilities are located in Ohio and Pennsylvania. The net 60-minute peak load of Cleveland Electric's service area for 1993 was 3,862,000 kilowatts and occurred on July 28. The operable capacity at the time of the 1993 peak was 4,122,000 kilowatts. Cleveland Electric's 1994 service area peak load is forecasted to be 3,790,000 kilowatts, after demand- side management considerations. The operable capacity, which includes firm purchases, expected to be available to serve Cleveland Electric's 1994 peak is 4,018,000 kilowatts. Over the 1994-1996 period, Cleveland Electric forecasts its operable capacity margins at the time of its projected peak loads to range from 6% to 9%. Cleveland Electric owns the facilities located in the area it serves for transmitting and distributing power to all its customers. Cleveland Electric has interconnections with Ohio Edison, Ohio Power and Penelec. The intercon- nections with Ohio Edison provide for the interchange of electric power with the other CAPCO Group companies and for transmission of power from the tenant- in-common owned or leased CAPCO Group generating units as well as for the interchange of power with Toledo Edison. The interconnection with Penelec provides for transmission of power from Cleveland Electric's share of the Seneca Plant. In addition, these interconnections provide the means for the interchange of electric power with other utilities. Cleveland Electric has interconnections with each of the municipal systems operating within its service area. Toledo Edison The wholly owned, jointly owned and leased electric generating facilities of Toledo Edison in commercial operation as of February 28, 1994 provide a net demonstrated capability of 1,832,000 kilowatts during the winter. These facilities include six generating units (925,000 kilowatts) at three fossil- fired steam electric generation stations; its share of three nuclear generating units (830,000 kilowatts) and five combustion turbine generating units (77,000 kilowatts). Operations at one fossil-fired generating unit (75,000 kilowatts) ceased in July 1993 and the unit is being preserved for future use. All of Toledo Edison's generating facilities are located in Ohio and Pennsylvania. The net 60-minute peak load of Toledo Edison's service area for 1993 was 1,568,000 kilowatts and occurred on August 27. The operable capacity at the time of the 1993 peak was 1,874,000 kilowatts. Toledo Edison's 1994 service area peak load is forecasted to be 1,490,000 kilowatts, after demand-side management considerations. The operable capacity, which includes the effect of firm sales, expected to be available to serve Toledo Edison's 1994 peak is 1,652,000 kilowatts. Over the 1994-1996 period, Toledo Edison forecasts its operable capacity margins at the time of its projected peak loads to range from 0% to 10%. Toledo Edison owns the facilities located in the area it serves for trans- mitting and distributing power to all its customers. Toledo Edison has interconnections with Ohio Edison, Ohio Power and Detroit Edison. The in- terconnection with Ohio Edison provides for the interchange of electric power with the other CAPCO Group companies and for transmission of power from the tenant-in-common owned or leased CAPCO Group generating units as well as for the interchange of power with Cleveland Electric. In addition, these inter- connections provide the means for the interchange of electric power with other utilities. Toledo Edison has interconnections with each of the municipal systems operating within its service area. TITLE TO PROPERTY The generating plants and other principal facilities of the Operating Companies are located on land owned in fee by them, except as follows: (1) Cleveland Electric and Toledo Edison lease from others for a term of about 29-1/2 years starting on October 1, 1987 undivided 6.5%, 45.9% and 44.38% tenant-in-common interests in Units 1, 2 and 3, respectively, of the Mansfield Plant located in Shippingport, Pennsylvania. Cleveland Electric and Toledo Edison lease from others for a term of about 29-1/2 years starting on October 1, 1987 an 18.26% undivided tenant-in-common interest in Beaver Valley Unit 2 located in Shippingport, Pennsylvania. Cleveland Electric and Toledo Edison own another 24.47% interest and 1.65% interest, respectively, in Beaver Valley Unit 2 as a tenant-in- common. Cleveland Electric and Toledo Edison continue to own as a tenant-in-common the land upon which the Mansfield Plant and Beaver Valley Unit 2 are located, but have leased to others certain portions of that land relating to the above-mentioned generating unit leases. (2) Most of the facilities of Cleveland Electric's Lake Shore Plant are situated on artificially filled land, extending beyond the natural shore- line of Lake Erie as it existed in 1910. As of December 31, 1993, the cost of Cleveland Electric's facilities, other than water intake and discharge facilities, located on such artificially filled land aggregated approximately $112,026,000. Title to land under the water of Lake Erie within the territorial limits of Ohio (including artificially filled land) is in the State of Ohio in trust for the people of the State for the public uses to which it may be adapted, subject to the powers of the United States, the public rights of navigation, water commerce and fishery and the rights of upland owners to wharf out or fill to make use of the water. The State is required by statute, after appropriate pro- ceedings, to grant a lease to an upland owner, such as Cleveland Elec- tric, which erected and maintained facilities on such filled land prior to October 13, 1955. Cleveland Electric does not have such a lease from the State with respect to the artificially filled land on which its Lake Shore Plant facilities are located, but Cleveland Electric's position, on advice of counsel for Cleveland Electric, is that its facilities and occupancy may not be disturbed because they do not interfere with the free flow of commerce in navigable channels and constitute (at least in part) and are on land filled pursuant to the exercise by it of its property rights as owner of the land above the shoreline adjacent to the filled land. Cleveland Electric holds permits, under Federal statutes relating to navigation, to occupy such artificially filled land. (3) The facilities of Cleveland Electric's Seneca Plant in Warren County, Pennsylvania, are located on land owned by the United States and occupied by Cleveland Electric and Penelec pursuant to a license issued by the FERC for a 50-year period starting December 1, 1965 for the construction, operation and maintenance of a pumped-storage hydroelectric plant. (4) The water intake and discharge facilities at the electric generating plants of Cleveland Electric and Toledo Edison located along Lake Erie, the Maumee River and the Ohio River are extended into the lake and rivers under their property rights as owners of the land above the water line and pursuant to permits under Federal statutes relating to navigation. (5) The transmission systems of the Operating Companies are located on land, easements or rights-of-way owned by them. Their distribution systems also are located, in part, on interests in land owned by them, but, for the most part, their distribution systems are located on lands owned by others and on streets and highways. In most cases, permission has been obtained from the apparent owner of the property or, if the distribution system is located on streets and highways, from the apparent owner of the abutting property. Their electric underground transmission and distri- bution systems are located, for the most part, in public streets. The Pennsylvania portions of the main transmission lines from the Seneca Plant, the Mansfield Plant and Beaver Valley Unit 2 are not owned by Cleveland Electric or Toledo Edison. All Cleveland Electric and Toledo Edison properties, with certain exceptions, are subject to the lien of their respective mortgages. The fee titles which Cleveland Electric and Toledo Edison acquire as tenant- in-common owners, and the leasehold interests they have as joint lessees, of certain generating units do not include the right to require a partition or sale for division of proceeds of the units without the concurrence of all the other owners and their respective mortgage trustees and the trustees under Cleveland Electric's and Toledo Edison's mortgages. Item 3. Item 3. Legal Proceedings Regulatory Proceedings and Suits Contesting Sulfur Dioxide Emission Limitations and Related Regulations Applicable to the Operating Companies. See "Item 1. Business--Environmental Regulation--Air Quality Control". Westinghouse Lawsuit. In April 1991, the CAPCO Group companies filed a lawsuit against Westinghouse in the United States District Court for the Western District of Pennsylvania. The suit alleges that six steam generators supplied by Westinghouse for Beaver Valley Power Station Units 1 and 2 contain serious defects, particularly defects causing tube corrosion and cracking. Steam generator maintenance costs have increased due to these defects and will likely continue to increase. The condition of the steam generators is being monitored closely. If the corrosion and cracking continue, replacement of the steam generators could be required earlier than their 40-year design life. The suit seeks monetary and corrective relief. General Electric Lawsuit. On February 2, 1994, the CAPCO Group companies announced that a settlement had been reached with General Electric regarding the lawsuit filed by the CAPCO Group companies against General Electric in August 1991. In that suit which was filed in the United States District Court in Cleveland, the CAPCO Group companies as joint owners of the Perry Plant alleged that General Electric had provided defective design information relating to the containment vessels for Perry Units 1 and 2. The CAPCO Group companies also alleged that the required corrective actions caused extensive delays and cost increases in the construction of the Perry Plant. Under the settlement agreement, General Electric will provide the CAPCO Group companies with discounts on future purchases and cash payments. The value of the settlement depends on the volume of future purchases. Because the payments will be made over a period of years and the discounts will be offered over the life of the plant, they will not have a material impact on the financial results of Centerior, Cleveland Electric and Toledo Edison in any particular year or on their financial conditions. The terms of the settlement agreement are the subject of a confidentiality agreement. Item 4. Item 4. Submission of Matters to a Vote of Security Holders CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART II Item 5. Item 5. Market for Registrants' Common Equity and Related Stockholder Matters The information regarding common stock prices and number of share owners required by this Item is not applicable to Cleveland Electric or Toledo Edison because all of their common stock is held solely by Centerior Energy. Market Information Centerior Energy's common stock is traded on the New York, Chicago and Pacific Stock Exchanges. The quarterly high and low prices of Centerior common stock (as reported on the composite tape) in 1992 and 1993 were as follows: Share Owners As of March 15, 1994, Centerior Energy had 159,506 common stock share owners of record. Dividends See Note 14 to Centerior's Financial Statements for quarterly dividend pay- ments in the last two years. See "Outlook--Common Stock Dividends" in Management's Financial Analysis contained under Item 7 of this Report for a discussion of the payment of future dividends by Centerior and the Operating Companies. At December 31, 1993, Centerior Energy had a retained earnings deficit of $523 million and capital surplus of $2 billion, resulting in an overall surplus of $1.477 billion that was available to pay dividends under Ohio law. Any current period earnings in 1994 will increase surplus under Ohio law. See Note 11(c) to Centerior's Financial Statements and Note 11(b) to the Operating Companies' Financial Statements for discussions of dividend restrictions affecting Cleveland Electric and Toledo Edison. Dividends paid in 1993 on each of the Operating Companies' outstanding series of preferred stock were fully taxable. The Operating Companies believe that all or a portion of their preferred stock dividends paid in 1994 will be a return of capital because they intend to take a deduction for the abandonment of Perry Unit 2. Item 6. Item 6. Selected Financial Data CENTERIOR ENERGY The information required by this Item is contained on Pages and attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages and attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages and attached hereto. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CENTERIOR ENERGY The information required by this Item is contained on Pages through attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages through attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages through attached hereto. Item 8. Item 8. Financial Statements and Supplementary Data CENTERIOR ENERGY The information required by this Item is contained on Pages and through attached hereto. CLEVELAND ELECTRIC The information required by this Item is contained on Pages and through attached hereto. TOLEDO EDISON The information required by this Item is contained on Pages and through attached hereto. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrants CENTERIOR ENERGY The information required by this Item for Centerior regarding directors is incorporated herein by reference to Pages 4 through 8 of Centerior's definitive proxy statement dated March 23, 1994. Reference is also made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the executive officers of Centerior Energy. CLEVELAND ELECTRIC Set forth below are the name and other directorships held, if any, of each director of Cleveland Electric. The year in which the director was first elected to Cleveland Electric's Board of Directors is set forth in paren- thesis. Reference is made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the directors and executive officers of Cleveland Electric. The directors received no remuneration in their capacity as directors. Robert J. Farling* Mr. Farling is a director of National City Bank. (1986) Murray R. Edelman Mr. Edelman is a director of Society Bank & Trust. (1993) Fred J. Lange, Jr. (1993) *Also a director of Centerior Energy and the Service Company. TOLEDO EDISON Set forth below are the name and other directorships held, if any, of each director of Toledo Edison. The year in which the director was first elected to Toledo Edison's Board of Directors is set forth in parenthesis. Reference is made to "Executive Officers of the Registrants and the Service Company" in Part I of this Report for information regarding the directors and the executive officers of Toledo Edison. The directors received no remuneration in their capacity as directors. Robert J. Farling* Mr. Farling is a director of National City Bank. (1988) Murray R. Edelman Mr. Edelman is a director of Society Bank & Trust. (1993) Fred J. Lange, Jr. (1993) *Also a director of Centerior Energy and the Service Company. Item 11. Item 11. Executive Compensation CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON The information required by this Item for Centerior is incorporated herein by reference to the information concerning compensation of directors on Page 9 and the information concerning compensation of executive officers, stock option transactions, long-term incentive awards and pension benefits on Pages 17 through 25 of Centerior's definitive proxy statement dated March 23, 1994. The named executive officers for Centerior are included for Cleveland Electric and Toledo Edison regardless of whether they were officers of Cleveland Electric or Toledo Edison because they were key policymakers for the Centerior System in 1993. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management CENTERIOR ENERGY The following table sets forth the beneficial ownership of Centerior common stock by individual directors of Centerior, the named executive officers and all directors and executive officers of Centerior Energy and the Service Company as a group as of February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Centerior Energy and the Service Company as a group were considered to own bene- ficially 0.1% of Centerior's common stock and none of the preferred stock of Cleveland Electric and Toledo Edison. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all directors and executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Owned by the Sisters of Notre Dame. (4) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. CLEVELAND ELECTRIC Individual directors of Cleveland Electric, the named executive officers and all directors and executive officers of Cleveland Electric as a group as of March 15, 1994 beneficially owned the following number of shares of Centerior common stock on February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Cleveland Electric as a group were considered to own beneficially 0.03% of Centerior's common stock and none of Cleveland Electric's serial preferred stock. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all directors and executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. TOLEDO EDISON Individual directors of Toledo Edison, the named executive officers and all directors and executive officers of Toledo Edison as a group as of March 15, 1994 beneficially owned the following number of shares of Centerior common stock on February 28, 1994: (1) Beneficially owned shares include any shares with respect to which voting or investment power is attributed to a director or executive officer because of joint or fiduciary ownership of the shares or relationship to the record owner, such as a spouse, even though the director or executive officer does not consider himself or herself the beneficial owner. On February 28, 1994, all directors and executive officers of Toledo Edison as a group were considered to own beneficially 0.03% of Centerior's common stock. Certain individuals disclaim beneficial ownership of some of those shares. (2) Includes the following numbers of shares which are not owned but could have been purchased within 60 days after February 28, 1994 upon exercise of options to purchase shares of Centerior common stock: Mr. Farling - 6,832; Mr. Edelman - 5,550; Mr. Monseau - 1,665; and all other executive officers as a group - 15,612. None of those options have been exercised as of March 28, 1994. (3) Mr. Phillips is included in the table because he would have been one of the five most highly compensated executive officers had he not retired on November 1, 1993. Item 13. Item 13. Certain Relationships and Related Transactions CENTERIOR ENERGY, CLEVELAND ELECTRIC AND TOLEDO EDISON None. 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. Financial Statements: Financial Statements for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Index to Selected Financial Data; Management's Discussion and Analysis of Financial Condition and Re- sults of Operations; and Financial Statements. See Page. 2. Financial Statement Schedules: Financial Statement Schedules for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Index to Schedules. See Page S-1. 3. Combined Pro Forma Condensed Financial Statements (Unaudited): Combined Pro Forma Condensed Financial Statements (unaudited) for Cleveland Electric and Toledo Edison related to their pending merger. See Pages P-1 to P-4. 4. Exhibits: Exhibits for Centerior Energy, Cleveland Electric and Toledo Edison are listed in the Exhibit Index. See Page E-1. (b) Reports on Form 8-K During the quarter ended December 31, 1993, Centerior Energy, Cleveland Electric and Toledo Edison did not file any 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 has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CENTERIOR ENERGY CORPORATION Registrant March 30, 1994 By *ROBERT J FARLING, Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, 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. THE CLEVELAND ELECTRIC ILLUMINATING COMPANY Registrant March 30, 1994 By *ROBERT J. FARLING, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, 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. THE TOLEDO EDISON COMPANY Registrant March 30, 1994 By *ROBERT J. FARLING, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this re- port has been signed below by the following persons on behalf of the regi- strant and in the capacities and on the date indicated: *By J. T. PERCIO J. T. Percio, Attorney-in-Fact REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - -------------------------------------------------------------------------------- To the Share Owners and Board of Directors of [Logo] Centerior Energy Corporation: We have audited the accompanying consolidated balance sheet and consolidated statement of preferred stock of Centerior Energy Corporation (an Ohio 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 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 Centerior 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. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules of Centerior Energy Corporation and subsidiaries listed in the Index to 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. Cleveland, Ohio February 14, 1994 (Centerior Energy) (Centerior Energy) MANAGEMENT'S FINANCIAL ANALYSIS - -------------------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 1.5% increase in 1993 operating revenues are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $53 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential, commercial and wholesale kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. As a result, total sales increased 3.1% in 1993. Residential and commercial sales increased 4.6% and 3.1%, respectively. Industrial sales increased 1.2%. Increased sales to large automotive manufacturers, petroleum refiners and the broad-based, smaller industrial group were partially offset by lower sales to large steel industry customers. Other sales increased 5.9% because of increased sales to wholesale customers. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. The net decrease in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors increased slightly for The Toledo Edison Company (Toledo Edison) but decreased 5% for The Cleveland Electric Illuminating Company (Cleveland Electric). Operating expenses increased 13.7% in 1993. The increase in total operation and maintenance expenses resulted from the $218 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $54 million and an increase in other operation and maintenance expenses. Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. The increase in other operation and maintenance expenses resulted from higher environmental expenses, power restoration and repair expenses following a July 1993 storm in the Cleveland area, and an increase in other postretirement benefit expenses. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $583 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.8% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $77 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. As a result, total kilowatt-hour sales decreased 1.1% in 1992. Residential and commercial sales decreased 4.5% and 1.3%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales were virtually the same as in 1991 as sales increases to steel producers and auto manufacturers of 10.9% and 2.7%, respectively, offset a decline in sales to other industrial customers. Other sales increased 2.3% because of increased sales to wholesale customers. Operating revenues in 1991 included the recognition by Toledo Edison of $24 million of deferred revenues over the period of a refund to customers under a provision of its January 1989 rate order. No such revenues were reflected in 1992 as the refund period ended in December 1991. The decrease in 1992 fuel cost recovery revenues resulted from the good performance of our generating units, which in turn decreased our fuel cost factors. The weighted averages of these factors decreased approximately 3% for Cleveland Electric and Toledo Edison (Operating Companies). Operating expenses decreased 4% in 1992. Lower fuel and purchased power expense resulted from less amortization of previously deferred fuel costs than the amount amortized in 1991 and lower generation requirements stemming from less electric sales. A reduction of $17 million in other operation and maintenance expenses resulted primarily from cost-cutting measures. Federal income (Centerior Energy) (Centerior Energy) taxes decreased because of the amortization of certain tax benefits under the Rate Stabilization Program discussed in Note 7 and the effects of adopting the new accounting standard for income taxes (SFAS 109) in 1992. These decreases were partially offset by higher depreciation and amortization, caused primarily by the adoption of SFAS 109, and by higher taxes, other than federal income taxes, caused by increased Ohio property and gross receipts taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program. The federal income tax provision for nonoperating income decreased because of lower carrying charge credits and a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income decreased primarily because of lower phase-in carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, we announced a comprehensive strategic action plan to strengthen our financial and competitive position. The plan established specific objectives and was designed to guide us through the year 2001. While the plan has a long-term focus, it also required us to take some very difficult, but necessary, financial actions at that time. We reduced the quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. We also wrote off our investment in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs was $1.023 billion which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. We also recognized other one-time charges totaling $39 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $87 million after taxes representing a portion of the VTP costs. We will realize approximately $50 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of our strategic plan are to maximize share owner return from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, we will continue controlling our operation and maintenance expenses and capital expenditures, reduce our outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of our plants and take other appropriate actions. COMMON STOCK DIVIDENDS The indicated quarterly common stock dividend is $.20 per share. We believe that the new level is sustainable barring unforeseen circumstances and that the new strategic plan will provide the opportunity to grow the dividend as the objectives are achieved. Nevertheless, future dividend action by our Board of Directors will continue to be decided on a quarter-to-quarter basis after the evaluation of financial results, potential earning capacity and cash flow. The lower dividend reduces our cash outflow by about $120 million annually, which we intend to use to repay debt more quickly than would otherwise be the case. This will help improve our capitalization structure and interest coverage ratios, both of which are key measures considered by securities rating agencies in determining credit ratings. Improved credit ratings and less outstanding debt, in turn, will lower our interest costs. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are a number of rural and municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems and the expansion of an existing system. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. Cleveland Public Power continues to expand its operations into areas we have served exclusively. We have been successful in retaining most of the large industrial and commercial customers in those areas by providing economic incentive packages in exchange for sole-supplier contracts. We also have similar contracts with customers in other areas. Most of these contracts have remaining terms of one to five years. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. (Centerior Energy) (Centerior Energy) The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. Our analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS Our three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(e). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Operating Companies have been named as "potentially responsible parties" (PRPs) for three sites listed on the Superfund National Priorities List (Superfund List) and are aware of their potential involvement in the cleanup of several other sites not on such list. The allegations that the Operating Companies disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all PRPs to a particular site can be held liable on a joint and several basis. Consequently, if the Operating Companies were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $400 million. However, we believe that the actual cleanup costs will be substantially lower than $400 million, that the Operating Companies' share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Operating Companies have accrued a liability totaling $19 million at December 31, 1993 based on estimates of the costs of cleanup and their proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing pro- (Centerior Energy) (Centerior Energy) gram of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $1.4 billion. In addition, we exercised various options to redeem and purchase approximately $900 million of our securities. We raised $2.2 billion through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Operating Companies also utilized their short-term borrowing arrangements to help meet their cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for Cleveland Electric and Toledo Edison, respectively, are $791 million and $249 million for their construction programs and $715 million and $324 million for the mandatory redemption of debt and preferred stock. Cleveland Electric and Toledo Edison expect to finance internally all of their 1994 cash requirements of approximately $239 million and $109 million, respectively. About 15-20% of the Operating Companies' 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $128 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Operating Companies under their respective mortgages on the basis of property additions, cash or refundable first mortgage bonds. Under their respective mortgages, each Operating Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, Cleveland Electric and Toledo Edison would have been permitted to issue approximately $78 million and $323 million of additional first mortgage bonds, respectively. After the fourth quarter of 1994, Cleveland Electric's ability to issue first mortgage bonds is expected to increase substantially when its interest coverage ratio will no longer be affected by the write-offs recorded at December 31, 1993. As discussed in Note 11(e), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused Centerior Energy Corporation (Centerior Energy) and the Operating Companies to violate certain of those covenants. The affected creditors have waived those violations in exchange for our commitment to provide them with a second mortgage security interest on our property and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $219 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. For the next five years, the Operating Companies do not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, the Operating Companies believe that they could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Operating Companies also are able to raise funds through the sale of preference stock and, in the case of Cleveland Electric, preferred stock. Toledo Edison will be unable to issue preferred stock until it can meet the interest and preferred dividend coverage test in its articles of incorporation. Centerior Energy will continue to raise funds through the sale of common stock. The Operating Companies currently cannot sell commercial paper because of their low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. We have a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused us to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Operating Companies' needs over the next several years. The availability and cost of capital to meet our external financing needs, however, also depend upon such factors as financial market conditions and our credit ratings. Current credit ratings for both Operating Companies are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Operating Companies. (Centerior Energy) (Centerior Energy) INCOME STATEMENT CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ------------------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Centerior Energy) (Centerior Energy) CASH FLOWS CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ---------------------------------------------------------------------- (1) Interest paid (net of amounts capitalized) was $295 million, $299 million and $339 million in 1993, 1992 and 1991, respectively. Income taxes paid were $50 million, $32 million and $57 million in 1993, 1992 and 1991, respectively. (2) Increases in Nuclear Fuel and Nuclear Fuel Lease Obligations in the Balance Sheet resulting from the noncash capitalizations under nuclear fuel agreements are excluded from this statement. The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES (Centerior Energy) (Centerior Energy) STATEMENT OF PREFERRED STOCK CENTERIOR ENERGY CORPORATION AND SUBSIDIARIES - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Centerior Energy) (Centerior Energy) NOTES TO THE FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL Centerior Energy is a holding company with two electric utility subsidiaries, Cleveland Electric and Toledo Edison. The consolidated financial statements also include the accounts of Centerior Energy's other wholly owned subsidiary, Centerior Service Company (Service Company), and Cleveland Electric's wholly owned subsidiaries. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to Centerior Energy and the Operating Companies. The Operating Companies operate as separate companies, each serving the customers in its service area. The preferred stock, first mortgage bonds and other debt obligations of the Operating Companies are outstanding securities of the issuing utility. All significant intercompany items have been eliminated in consolidation. Centerior Energy and the Operating Companies follow the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission and adopted by The Public Utilities Commission of Ohio (PUCO). As rate-regulated utilities, the Operating Companies are subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The Service Company follows the Uniform System of Accounts for Mutual Service Companies prescribed by the Securities and Exchange Commission under the Public Utility Holding Company Act of 1935. The Operating Companies are members of the Central Area Power Coordination Group (CAPCO). Other members are Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO or on ordinances of individual municipalities. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (C) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Operating Companies defer the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Operating Companies have accrued the liability for their share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Operating Companies to recover the assessments through their fuel cost factors. (D) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Operating Companies to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $17 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Operating Companies deferred certain operating expenses and both interest and equity carrying charges pursuant to PUCO-approved rate phase-in plans for their investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Operating Companies also defer certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (Centerior Energy) (Centerior Energy) (E) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depreciable utility plant in service was 3.5% in 1993 and 3.4% in both 1992 and 1991. Effective January 1, 1991, the Operating Companies, after obtaining PUCO approval, changed their method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $36 million and increased 1991 net income $28 million (net of $8 million of income taxes) and earnings per share $.20 from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Operating Companies currently use external funding for the future decommissioning of their nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $8 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Operating Companies' share of the future decommissioning costs are $92 million in 1992 dollars for Beaver Valley Unit 2 and $223 million and $300 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Operating Companies used these estimates to increase their decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $74 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (F) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rates averaged 9.9% in 1993, 10.8% in 1992 and 10.7% in 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (G) DEFERRED GAIN AND LOSS FROM SALES OF UTILITY PLANT The sale and leaseback transactions discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant) and a net loss for the sale of Beaver Valley Unit 2. The net gain and net loss were deferred and are being amortized over the terms of leases. These amortizations and the lease expense amounts are recorded as other operation and maintenance expenses. (H) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (Centerior Energy) (Centerior Energy) (I) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (2) Utility Plant Sale and Leaseback Transactions The Operating Companies are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Operating Companies are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Operating Companies have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(e). In April 1992, nearly all of the outstanding Secured Lease Obligation Bonds (SLOBs) issued by a special purpose corporation in connection with financing the sale and leaseback of Beaver Valley Unit 2 were refinanced through a tender offer and the sale of new bonds having a lower interest rate. As part of the refinancing transaction, Toledo Edison paid $43 million as supplemental rent to fund transaction expenses and part of the tender premium. This amount has been deferred and is being amortized over the remaining lease term. The refinancing transaction reduced the annual rental expense for the Beaver Valley Unit 2 lease by $9 million. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $115 million. The amounts recorded in 1993, 1992 and 1991 as annual rental expense for the Beaver Valley Unit 2 lease were $63 million, $66 million and $72 million, respectively. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. Toledo Edison is selling 150 megawatts of its Beaver Valley Unit 2 leased capacity entitlement to Cleveland Electric. We anticipate that this sale will continue indefinitely. (Centerior Energy) (Centerior Energy) (3) Property Owned with Other Utilities and Investors The Operating Companies own, as tenants in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Operating Companies' share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Operating Companies as tenants in common with other utilities and Lessors: Depreciation for Eastlake Unit 5 has been accumulated with all other nonnuclear depreciable property rather than by specific units of depreciable property. (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of our construction program for the 1994-1998 period is $1.088 billion, including AFUDC of $48 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $222 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses will be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be about 1-2% in the late 1990s. Cleveland Electric may need to install sulfur emission control technology at one of its generating plants after 2005 which could require additional expenditures at that time. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $583 million ($425 million after taxes) for our 64.76% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Operating Companies are aware of their potential involvement in the cleanup of three sites listed on the Superfund List and several other waste sites not on such list. The Operating Companies have accrued a liability totaling $19 million at December 31, 1993 based on estimates of the costs of cleanup and their proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (Centerior Energy) (Centerior Energy) (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS Our three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), our maximum potential assessment under that plan would be $155 million (plus any inflation adjustment) per incident. The assessment is limited to $20 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, our share of such excess amount could have a material adverse effect on our financial condition and results of operations. Under these policies, we can be assessed a maximum of $25 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. We also have extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (6) Nuclear Fuel Nuclear fuel is financed for the Operating Companies through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $370 million of nuclear fuel was financed. The Operating Companies severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments of $110 million, $78 million and $46 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $14 million in 1993, $15 million in 1992 and $21 million in 1991. The estimated future lease amortization payments based on projected consumption are $111 million in 1994, $97 million in 1995, $87 million in 1996, $77 million in 1997 and $69 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plans approved by the PUCO in January 1989 rate orders for the Operating Companies. The phase-in plans were designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plans required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Operating Companies' deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plans. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 were $172 million and $705 million, respectively (totaling $598 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current (Centerior Energy) (Centerior Energy) assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in our service area by freezing base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $216 million for Cleveland Electric and $89 million for Toledo Edison over the 1996-1998 period. As part of the Rate Stabilization Program, the Operating Companies are allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988 and the deferral of Toledo Edison operating expenses equivalent to an accumulated excess rent reserve for Beaver Valley Unit 2 (which resulted from the April 1992 refinancing of SLOBs as discussed in Note 2). The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $95 million and $84 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets and the remaining lease period, or approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $46 million and $12 million, respectively. The Rate Stabilization Program also authorized the Operating Companies to defer and subsequently recover the incremental expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $96 million pursuant to this provision. Amortization and recovery of this deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying the income before taxes and preferred dividend requirements of subsidiaries by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: (Centerior Energy) (Centerior Energy) In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $90 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $90 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $619 million and deferred tax liabilities of $2.198 billion at December 31, 1993 and deferred tax assets of $563 million and deferred tax liabilities of $2.598 billion at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $309 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $108 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $171 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN We sponsor a noncontributing pension plan which covers all employee groups. Two existing plans were merged into a single plan on December 31, 1993. The amount of retirement benefits generally depends upon the length of service. Under certain circumstances, benefits can begin as early as age 55. Our funding policy is to comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, we offered the VTP, an early retirement program. Operating expenses for 1993 included $205 million of pension plan accruals to cover enhanced VTP benefits and an additional $10 million of pension costs for VTP benefits paid to retirees from corporate funds. The $10 million is not included in the pension data reported below. A credit of $81 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs (credits) for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the plan(s) at December 31, 1993 and 1992. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (Centerior Energy) (Centerior Energy) (B) OTHER POSTRETIREMENT BENEFITS We sponsor a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. We adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs totaled $9 million in 1992 and $10 million in 1991, which included medical benefits of $8 million in 1992 and $9 million in 1991. The total amount accrued for SFAS 106 costs for 1993 was $111 million, of which $5 million was capitalized and $106 million was expensed as other operation and maintenance expenses. In 1993, we deferred incremental SFAS 106 expenses totaling $96 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 are summarized as follows: At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $11 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $1 million. (C) POSTEMPLOYMENT BENEFITS In 1993, we adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect our 1993 results of operations or financial position. (10) Guarantees Cleveland Electric has guaranteed certain loan and lease obligations of two mining companies under two long-term coal purchase arrangements. Toledo Edison is also a party to one of these guarantee arrangements. This arrangement requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining companies' loan and lease obligations guaranteed by the Operating Companies was $80 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Shares sold, retired and purchased for treasury during the three years ended December 31, 1993 are listed in the following tables. (Centerior Energy) (Centerior Energy) Shares of common stock required for our stock plans in 1993 were either acquired in the open market, issued as new shares or issued from treasury stock. The Board of Directors has authorized the purchase in the open market of up to 1,500,000 shares of our common stock until June 30, 1994. As of December 31, 1993, 225,500 shares had been purchased at a total cost of $4 million. Such shares are being held as treasury stock. (B) COMMON SHARES RESERVED FOR ISSUE Common shares reserved for issue under the Employee Savings Plan and the Employee Purchase Plan were 1,962,174 and 469,457 shares, respectively, at December 31, 1993. Stock options to purchase unissued shares of common stock under the 1978 Key Employee Stock Option Plan were granted at an exercise price of 100% of the fair market value at the date of the grant. No additional options may be granted. The exercise prices of option shares purchased during the three years ended December 31, 1993 ranged from $14.09 to $17.41 per share. Shares and price ranges of outstanding options held by employees were as follows: (C) EQUITY DISTRIBUTION RESTRICTIONS The Operating Companies make cash available for the funding of Centerior Energy's common stock dividends by paying dividends on their respective common stock, which are held solely by Centerior Energy. Federal law prohibits the Operating Companies from paying dividends out of capital accounts. However, the Operating Companies may pay preferred and common stock dividends out of appropriated retained earnings and current earnings. At December 31, 1993, Cleveland Electric and Toledo Edison had $125 million and $42 million, respectively, of appropriated retained earnings for the payment of dividends. However, Toledo Edison is prohibited from paying a common stock dividend by a provision in its mortgage. (D) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $40 million in 1994, $51 million in 1995, $41 million in 1996, $31 million in 1997 and $16 million in 1998. The annual mandatory redemption provisions are as follows: * All outstanding shares to be redeemed on December 1, 2001. In June 1993, Cleveland Electric issued $100 million principal amount of Serial Preferred Stock, $42.40 Series T. The Series T stock was deposited with an agent which issued Depositary Receipts, each representing 1/20 of a share of the Series T stock. The annualized preferred dividend requirement for the Operating Companies at December 31, 1993 was $68 million. The preferred dividend rates on Cleveland Electric's Series L and M and Toledo Edison's Series A and B fluctuate based on prevailing interest rates and market conditions. The dividend rates for these issues averaged 7%, 7%, 7.41% and 8.22%, respectively, in 1993. Cleveland Electric's Series P had a 6.5% dividend rate in 1993 until it was redeemed in August 1993. (Centerior Energy) (Centerior Energy) Preference stock authorized for the Operating Companies are 3,000,000 shares without par value for Cleveland Electric and 5,000,000 shares with a $25 par value for Toledo Edison. No preference shares are currently outstanding for either company. With respect to dividend and liquidation rights, each Operating Company's preferred stock is prior to its preference stock and common stock, and each Operating Company's preference stock is prior to its common stock. (E) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, for the Operating Companies was as follows: Long-term debt matures during the next five years as follows: $87 million in 1994, $317 million in 1995, $242 million in 1996, $94 million in 1997 and $117 million in 1998. The Operating Companies issued $550 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The mortgages of the Operating Companies constitute direct first liens on substantially all property owned and franchises held by them. Excluded from the liens, among other things, are cash, securities, accounts receivable, fuel, supplies and, in the case of Toledo Edison, automotive equipment. Certain unsecured loan agreements of the Operating Companies contain covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting Centerior Energy and the Operating Companies. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused Centerior Energy and the Operating Companies to violate certain covenants contained in a Cleveland Electric loan agreement and the two reimbursement agreements. The affected creditors have waived those violations in exchange for our commitment to provide them with a second mortgage security interest on our property and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $219 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Operating Companies. Centerior Energy plans to transfer any of its borrowed funds to the Operating Companies, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The (Centerior Energy) (Centerior Energy) revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $300 million for Cleveland Electric and $150 million for Toledo Edison. The Operating Companies are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Operating Companies had no commercial paper outstanding. The Operating Companies are unable to rely on the sale of commercial paper to provide short-term funds because of their below investment grade commercial paper credit ratings. (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Operating Companies' preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $81 million, or $.56 per share, as a result of the recording of $125 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $583 million write-off of Perry Unit 2 (see Note 4(b)), the $877 million write-off of the phase-in deferrals (see Note 7) and $58 million of other charges. These adjustments decreased quarterly earnings by $1.06 billion, or $7.24 per share. Earnings for the quarter ended September 30, 1992 were increased by $41 million, or $.29 per share, as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $61 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (Centerior Energy) (Centerior Energy) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) Operating Expenses (millions of dollars) Income (Loss) (millions of dollars) NOTE: 1983 data is the result of combining and restating data for the Operating Companies. (a) Includes early retirement program expenses and other charges of $272 million in 1993. (b) Includes write-off of phase-in deferrals of $877 million in 1993, consisting of $172 million of deferred operating expenses and $705 million of deferred carrying charges. (c) In 1991, the Operating Companies adopted a change in accounting for nuclear plant depreciation, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Centerior Energy) (Centerior Energy) Investment (millions of dollars) Capitalization (millions of dollars & %) (d) Includes write-off of Perry Unit 2 of $583 million in 1993. (e) Average shares outstanding and related per share computations reflect the Cleveland Electric 1.11-for-one exchange ratio and the Toledo Edison one-for-one exchange ratio for Centerior Energy shares at the date of affiliation, April 29, 1986. (f) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Centerior Energy) (Centerior Energy) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - ---------------------------------------------------------------------- To the Share Owners of The Cleveland Electric [Logo] Illuminating Company: We have audited the accompanying consolidated balance sheet and consolidated statement of preferred stock of The Cleveland Electric Illuminating Company (a wholly owned subsidiary of Centerior Energy 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 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 The Cleveland Electric Illuminating 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 discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purposef of forming an opinion on the basic financial statements taken as a whole. The schedules of The Cleveland Electric Illuminating Company and subsidiaries listed in the Index to Schedules are presented for purposes of complying with the Securities and Exchange Commission 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. Cleveland, Ohio February 14, 1994 (except with respect to the matter discussed in Note 15, as to which the date is March 25, 1994) (Cleveland Electric) (Cleveland Electric) MANAGEMENT'S FINANCIAL ANALYSIS - ---------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 0.5% increase in 1993 operating revenues for The Cleveland Electric Illuminating Company (Company) are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $36 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential, commercial and wholesale kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northeastern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. As a result, total sales increased 2.9% in 1993. Residential and commercial sales increased 4.4% and 3.1%, respectively. Industrial sales decreased 1%. Lower sales to large steel industry customers were partially offset by increased sales to large automotive manufacturers and the broad-based, smaller industrial customer group. Other sales increased 11.9% because of increased sales to wholesale customers. The net decrease in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors decreased approximately 5%. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. Operating expenses increased 12.4% in 1993. The increase in total operation and maintenance expenses resulted from the $130 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $35 million and an increase in other operation and maintenance expenses. The VTP benefit expenses consisted of $102 million of costs for the Company plus $28 million for the Company's pro rata share of the costs for its affiliate, Centerior Service Company (Service Company). Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. The increase in other operation and maintenance expenses resulted from higher environmental expenses, power restoration and repair expenses following a July 1993 storm, and an increase in other postretirement benefit expenses. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $351 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.5% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $55 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. As a result, total kilowatt-hour sales decreased 3.5% in 1992. Residential and commercial sales decreased 4.4% and 0.5%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales declined 0.4% as an 8.1% decrease in sales to the broad-based, smaller industrial customer group completely offset an 8.8% increase in sales to the larger industrial customer group. Sales to steel producers and auto manufacturers within the large industrial customer group rose 10.9% and 7%, respectively. Other sales decreased 16.1% because of decreased sales to wholesale customers and public authorities. The decrease in 1992 fuel cost recovery revenues resulted primarily because of the good performance of our generating units, which in turn decreased our fuel cost factors. The weighted averages of these factors decreased approximately 3%. Operating expenses decreased 3.6% in 1992. Lower fuel and purchased power expense resulted from lower generation requirements stemming from less electric sales and less amortization of previously deferred fuel costs than the amount amortized in 1991. Federal income taxes decreased because of the amortization of certain tax benefits under the Rate Stabilization Program discussed (Cleveland Electric) (Cleveland Electric) in Note 7 and the effects of adopting the new accounting standard for income taxes (SFAS 109) in 1992. These decreases were partially offset by higher depreciation and amortization, caused primarily by the adoption of SFAS 109, and by higher taxes, other than federal income taxes, caused by increased Ohio property and gross receipts taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program. The federal income tax provision for nonoperating income decreased because of lower carrying charge credits and a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income decreased primarily because of lower phase-in-carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, Centerior Energy Corporation (Centerior Energy), along with the Company and The Toledo Edison Company (Toledo Edison), announced a comprehensive strategic action plan to strengthen their financial and competitive positions. The Company and Toledo Edison are the two wholly owned electric utility subsidiaries of Centerior Energy. The plan established specific objectives and was designed to guide Centerior Energy and its subsidiaries through the year 2001. Several actions were taken at that time. Centerior Energy reduced its quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. The Company and Toledo Edison also wrote off their investments in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs for the Company was $691 million which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. The Company also recognized other one-time charges totaling $25 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $51 million after taxes representing a portion of the VTP costs. The Company will realize approximately $30 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of the strategic plan are to maximize share owner return on Centerior Energy common stock from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, the Company will continue controlling its operation and maintenance expenses and capital expenditures, reduce its outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of its plants and take other appropriate actions. COMMON STOCK DIVIDENDS Centerior Energy's common stock dividend has been funded in recent years primarily by common stock dividends paid by the Company. We expect this practice to continue for the foreseeable future. Centerior Energy's lower common stock dividend reduces its cash outflow by about $120 million annually which, in turn, reduces the common stock dividend demands placed on the Company. The Company intends to use the increased retained cash to repay debt more quickly than would otherwise be the case. This will help improve the Company's capitalization structure and interest coverage ratios. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are two municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems and the expansion of an existing system. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. Cleveland Public Power continues to expand its operations into areas we have served exclusively. We have been successful in retaining most of the large industrial and commercial customers in those areas by providing economic incentive packages in exchange for sole-supplier contracts. We also have similar contracts with customers in other areas. Most of these contracts have remaining terms of one to five years. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses (Cleveland Electric) (Cleveland Electric) for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. As mentioned above, we have contracts with many of our large industrial and commercial customers. We will attempt to renew those contracts as they expire which will help us compete if retail wheeling is permitted in the future. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS The Company's three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(f). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Company has been named as a "potentially responsible party" (PRP) for three sites listed on the Superfund National Priorities List (Superfund List) and is aware of its potential involvement in the cleanup of several other sites not on such list. The allegations that the Company disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all PRPs to a particular site can be held liable on a joint and several basis. Consequently, if the Company were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $250 million. However, we believe that the actual cleanup costs will be substantially lower than $250 million, that the Company's share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Company has accrued a liability totaling $13 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. (Cleveland Electric) (Cleveland Electric) Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing program of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $970 million. In addition, we exercised various options to redeem and purchase approximately $430 million of our securities. We raised $1.2 billion through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Company also utilized its short-term borrowing arrangements to help meet its cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for the Company are $791 million for its construction program and $715 million for the mandatory redemption of debt and preferred stock. The Company expects to finance internally all of its 1994 cash requirements of approximately $239 million. About 20% of the Company's 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $87 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Company under its mortgage on the basis of property additions, cash or refundable first mortgage bonds. Under its mortgage, the Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, the Company would have been permitted to issue approximately $78 million of additional first mortgage bonds. After the fourth quarter of 1994, the Company's ability to issue first mortgage bonds is expected to increase substantially when its interest coverage ratio will no longer be affected by the write-offs recorded at December 31, 1993. As discussed in Note 11(d), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused the Company, Toledo Edison and Centerior Energy to violate certain of those covenants. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Toledo Edison and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $47 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Toledo Edison. For the next five years, the Company does not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, we believe that the Company could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Company also is able to raise funds through the sale of preference and preferred stock. The Company currently cannot sell commercial paper because of its low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. The Company is a party to a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused the Company, Toledo Edison and Centerior Energy to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Company's needs over the next several years. The availability and cost of capital to meet the Company's external financing needs, however, also depend upon such factors as financial market conditions and its credit ratings. Current credit ratings for the Company are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Company. (Cleveland Electric) (Cleveland Electric) INCOME STATEMENT THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - -------------------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Cleveland Electric) (Cleveland Electric) CASH FLOWS THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - -------------------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES (Cleveland Electric) (Cleveland Electric) STATEMENT OF PREFERRED STOCK THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Cleveland Electric) (Cleveland Electric) NOTES TO THE FINANCIAL STATEMENTS - ---------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL The Company is an electric utility and a wholly owned subsidiary of Centerior Energy. Centerior Energy has two other wholly owned subsidiaries, Toledo Edison and the Service Company. The Company follows the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by The Public Utilities Commission of Ohio (PUCO). As a rate-regulated utility, the Company is subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The financial statements include the accounts of the Company's wholly owned subsidiaries, which in the aggregate are not material. The Company is a member of the Central Area Power Coordination Group (CAPCO). Other members are Toledo Edison, Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) RELATED PARTY TRANSACTIONS Operating revenues, operating expenses and interest charges include those amounts for transactions with affiliated companies in the ordinary course of business operations. The Company's transactions with Toledo Edison are primarily for firm power, interchange power, transmission line rentals and jointly owned power plant operations and construction. See Notes 2 and 3. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to the Company and other affiliated companies. The Service Company billed the Company $180 million, $150 million and $138 million in 1993, 1992 and 1991, respectively, for such services. (C) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (D) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Company defers the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Company has accrued a liability for its share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Company to recover the assessments through its fuel cost factors. (E) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Company to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $10 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Company deferred certain operating expenses and both interest and equity carrying charges pursuant to a PUCO-approved rate phase-in plan for its investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Company also defers certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (F) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depre- (Cleveland Electric) (Cleveland Electric) ciable utility plant in service was 3.4% in 1993, 1992 and 1991. Effective January 1, 1991, the Company, after obtaining PUCO approval, changed its method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $22 million and increased 1991 net income $17 million (net of $5 million of income taxes) from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Company currently uses external funding for the future decommissioning of its nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $4 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Company's share of the future decommissioning costs are $51 million in 1992 dollars for Beaver Valley Unit 2 and $136 million and $154 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Company used these estimates to increase its decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $41 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (G) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rate was 9.63% in 1993, 10.56% in 1992 and 10.47% in 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (H) DEFERRED GAIN FROM SALE OF UTILITY PLANT The sale and leaseback transaction discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant). The net gain was deferred and is being amortized over the term of leases. The amortization and the lease expense amounts are recorded as other operation and maintenance expenses. (I) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (J) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. (Cleveland Electric) (Cleveland Electric) Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (2) Utility Plant Sale and Leaseback Transactions The Company and Toledo Edison are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Company and Toledo Edison are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Company and Toledo Edison have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(d). As co-lessee with Toledo Edison, the Company is also obligated for Toledo Edison's lease payments. If Toledo Edison is unable to make its payments under the Beaver Valley Unit 2 and Mansfield Plant leases, the Company would be obligated to make such payments. No payments have been made on behalf of Toledo Edison to date. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $70 million. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. The Company is buying 150 megawatts of Toledo Edison's Beaver Valley Unit 2 leased capacity entitlement. We anticipate that this purchase will continue indefinitely. Purchased power expense for this transaction was $103 million, $108 million and $107 million in 1993, 1992 and 1991, respectively. The future minimum lease payments through the year 2017 associated with Beaver Valley Unit 2 aggregate $1.47 billion. (3) Property Owned with Other Utilities and Investors The Company owns, as a tenant in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Company's share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Operating Company as a tenant in common with other utilities and Lessors: Depreciation for Eastlake Unit 5 has been accumulated with all other nonnuclear depreciable property rather than by specific units of depreciable property. (Cleveland Electric) (Cleveland Electric) (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of the Company's construction program for the 1994-1998 period is $829 million, including AFUDC of $38 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $165 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses will be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be about 1-2% in the late 1990s. The Company may need to install sulfur emission control technology at one of its generating plants after 2005 which could require additional expenditures at that time. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $351 million ($258 million after taxes) for the Company's 44.85% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Company is aware of its potential involvement in the cleanup of three sites listed on the Superfund List and several other waste sites not on such list. The Company has accrued a liability totaling $13 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS The Company's three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), the Company's maximum potential assessment under that plan would be $85 million (plus any inflation adjustment) per incident. The assessment is limited to $11 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, the Company's share of such excess amount could have a material adverse effect on its financial condition and results of operations. Under these policies, the Company can be assessed a maximum of $14 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. The Company also has extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been (Cleveland Electric) (Cleveland Electric) incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (6) Nuclear Fuel Nuclear fuel is financed for the Company and Toledo Edison through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $216 million of nuclear fuel was financed for the Company. The Company and Toledo Edison severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments for the Company of $57 million, $48 million and $26 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $9 million in both 1993 and 1992 and $12 million in 1991. The estimated future lease amortization payments based on projected consumption are $63 million in 1994, $56 million in 1995, $50 million in 1996, $44 million in 1997 and $39 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plan approved by the PUCO in a January 1989 rate order for the Company. The phase-in plan was designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plan required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Company's deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plan. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 by the Company were $117 million and $519 million, respectively (totaling $433 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in the Company's service area by freezing the Company's base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $216 million over the 1996-1998 period. As part of the Rate Stabilization Program, the Company is allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988. The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $56 million and $52 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets, approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $28 million and $7 million, respectively. The Rate Stabilization Program also authorized the Company to defer and subsequently recover the incremental (Cleveland Electric) (Cleveland Electric) expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $60 million pursuant to this provision. Amortization and recovery of this deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying income before taxes by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: The Company joins in the filing of a consolidated federal income tax return with its affiliated companies. The method of tax allocation reflects the benefits and burdens realized by each company's participation in the consolidated tax return, approximating a separate return result for each company. In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $61 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $61 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $426 million and deferred tax liabilities of $1.531 billion at December 31, 1993 and deferred tax assets of $415 million and deferred tax liabilities of $1.807 billion at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $197 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $69 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $94 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN Prior to December 31, 1993, the Company and Service Company jointly sponsored a noncontributing pension plan which covered all employee groups. The plan was merged with another plan which covered the employees of Toledo Edison into a single plan on December 31, 1993. The amount of retirement benefits generally depends (Cleveland Electric) (Cleveland Electric) upon the length of service. Under certain circumstances, benefits can begin as early as age 55. The funding policy is to comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, the Company and Service Company offered the VTP, an early retirement program. Operating expenses for both companies for 1993 included $146 million of pension plan accruals to cover enhanced VTP benefits and an additional $7 million of pension costs for VTP benefits paid to retirees from corporate funds. The $7 million is not included in the pension data reported below. A credit of $66 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs (credits) for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the former plan of the Company and Service Company at December 31, 1992 with comparable information for a portion of the merged plan at December 31, 1993. The December 31, 1993 benefit obligation estimates were derived from information for the former plans. Plan assets of the merged plan were allocated based on a pro rata share of the projected benefit obligation. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (B) OTHER POSTRETIREMENT BENEFITS Centerior Energy sponsors jointly with its subsidiaries a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. The Company adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs for the Company totaled $5 million in 1992 and $6 million in 1991, which included medical benefits of $4 million in 1992 and $5 million in 1991. The total amount accrued by the Company for SFAS 106 costs for 1993 was $69 million, of which $4 million was capitalized and $65 million was expensed as other operation and maintenance expenses. In 1993, the Company deferred incremental SFAS 106 expenses totaling $60 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: These amounts included costs for the Company and a pro rata share of the Service Company's costs. The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 (Cleveland Electric) (Cleveland Electric) for the Company and its share of the Service Company's obligation are summarized as follows: The Balance Sheet classification of Other Noncurrent Liabilities at December 31, 1993 includes only the Company's accrued postretirement benefit cost of $52 million and excludes the Service Company's portion since the Service Company's total accrued cost is carried on its books. At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $7 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $0.5 million. (C) POSTEMPLOYMENT BENEFITS In 1993, the Company adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect the Company's 1993 results of operations or financial position. (10) Guarantees The Company has guaranteed certain loan and lease obligations of two mining companies under two long-term coal purchase arrangements. One of these arrangements requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining companies' loan and lease obligations guaranteed by the Company was $60 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Preferred stock shares sold and retired during the three years ended December 31, 1993 are listed in the following table. (B) EQUITY DISTRIBUTION RESTRICTIONS Federal law prohibits the Company from paying dividends out of capital accounts. However, the Company may pay preferred and common stock dividends out of appropriated retained earnings and current earnings. At December 31, 1993, the Company had $125 million of appropriated retained earnings for the payment of preferred and common stock dividends. (C) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $29 million in 1994, $40 million in 1995, $30 million in both 1996 and 1997 and $15 million in 1998. The annual preferred stock mandatory redemption provisions are as follows: * All outstanding shares to be redeemed on December 1, 2001. In June 1993, the Company issued $100 million principal amount of Serial Preferred Stock, $42.40 Series T. The Series T stock was deposited with an agent which issued (Cleveland Electric) (Cleveland Electric) Depositary Receipts, each representing 1/20 of a share of the Series T stock. The annualized preferred dividend requirement at December 31, 1993 was $47 million. The preferred dividend rates on the Company's Series L and M fluctuate based on prevailing interest rates and market conditions. The dividend rates for both issues averaged 7% in 1993. The Company's Series P had a 6.5% dividend rate in 1993 until it was redeemed in August 1993. Preference stock authorized for the Company is 3,000,000 shares without par value. No preference shares are currently outstanding. With respect to dividend and liquidation rights, the Company's preferred stock is prior to its preference stock and common stock, and its preference stock is prior to its common stock. (D) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, was as follows: Long-term debt matures during the next five years as follows: $42 million in 1994, $246 million in 1995, $151 million in 1996, $55 million in 1997 and $78 million in 1998. The Company issued $275 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The Company's mortgage constitutes a direct first lien on substantially all property owned and franchises held by the Company. Excluded from the lien, among other things, are cash, securities, accounts receivable, fuel and supplies. An unsecured loan agreement of the Company contains covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting the Company, Toledo Edison and Centerior Energy. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused the Company, Toledo Edison and Centerior Energy to violate certain covenants contained in the loan agreement and the two reimbursement agreements. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Toledo Edison and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $47 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Toledo Edison. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Company and Toledo Edison. Centerior Energy plans to transfer any of its borrowed funds to the Company and Toledo Edison, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed (Cleveland Electric) (Cleveland Electric) below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios for the Company, Toledo Edison and Centerior Energy. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $300 million for the Company. The Company and Toledo Edison are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Company had no commercial paper outstanding. The Company is unable to rely on the sale of commercial paper to provide short-term funds because of its below investment grade commercial paper credit ratings. (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Company's preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $46 million as a result of the recording of $71 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $351 million write-off of Perry Unit 2 (see Note 4(b)), the $636 million write-off of the phase-in deferrals (see Note 7) and $38 million of other charges. These adjustments decreased quarterly earnings by $716 million. Earnings for the quarter ended September 30, 1992 were increased by $26 million as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $39 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (15) Pending Merger of the Company with Toledo Edison On March 25, 1994, Centerior Energy announced that its operating utility subsidiaries, the Company and Toledo Edison, plan to merge into a single operating entity. Since the Company and Toledo Edison affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO and other regulatory authorities. The merger must be approved by share owners of Toledo Edison's preferred stock. Share owners of the Company's preferred stock must approve the authorization of additional shares of preferred stock. Share owners of Toledo Edison's preferred stock will exchange their shares for preferred stock shares of the successor corporation having substantially the same terms, while the (Cleveland Electric) (Cleveland Electric) Company's preferred stock will automatically become shares of the successor corporation. Debt holders of the merging companies will become debt holders of the successor corporation. The merging companies plan to seek preferred stock share owner approval in the summer of 1994. The merger is expected to be effective in late 1994. For the merging companies, the combined pro forma operating revenues were $2.475 billion, $2.439 billion and $2.561 billion and the combined pro forma net income (loss) was $(876) million, $276 million and $296 million for the years ended December 31, 1993, 1992 and 1991, respectively. The pro forma data is based on accounting for the merger on a method similar to a pooling of interests. The pro forma data is not necessarily indicative of the results of operations which would have been reported had the merger been in effect during those years or which may be reported in the future. The pro forma data should be read in conjunction with the audited financial statements of both the Company and Toledo Edison. (Cleveland Electric) (Cleveland Electric) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) Operating Expenses (millions of dollars) Income (Loss) (millions of dollars) Income (Loss) (millions of dollars) (a) Includes early retirement program expenses and other charges of $165 million in 1993. (b) Includes write-off of phase-in deferrals of $636 million in 1993, consisting of $117 million of deferred operating expenses and $519 million of deferred carrying charges. (c) In 1991, a change in accounting for nuclear plant depreciation was adopted, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Cleveland Electric) (Cleveland Electric) THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES (d) Includes write-off of Perry Unit 2 of $351 million in 1993. (e) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Cleveland Electric) (Cleveland Electric) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS - ---------------------------------------------------------------------- To the Share Owners of The Toledo [Logo] Edison Company: We have audited the accompanying balance sheet and statement of preferred stock of The Toledo Edison Company (a wholly owned subsidiary of Centerior Energy Corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings 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 The Toledo Edison 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. As discussed further in Notes 1 and 9, changes were made in the methods of accounting for nuclear plant depreciation in 1991 and for postretirement benefits other than pensions in 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules of The Toledo Edison Company listed in the Index to 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. Cleveland, Ohio February 14, 1994 (except with respect to the matter discussed in Note 15, as to which the date is March 25, 1994) (Toledo Edison) (Toledo Edison) MANAGEMENT'S FINANCIAL ANALYSIS - -------------------------------------------------------------------------------- Results of Operations 1993 VS. 1992 Factors contributing to the 3.1% increase in 1993 operating revenues for The Toledo Edison Company (Company) are as follows: The net revenue increase resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $17 million of the higher 1993 revenues. Hot summer weather in 1993 boosted residential and commercial kilowatt-hour sales. In contrast, the 1992 summer was the coolest in 56 years in Northwestern Ohio. Residential and commercial sales also increased as a result of colder late-winter temperatures in 1993 which increased electric heating-related demand. Residential and commercial sales increased 5.1% and 3.2%, respectively, in 1993. Industrial sales increased 6% as a result of increased sales to large automotive manufacturers, petroleum refiners and the broad-based, smaller industrial customer group. Other sales decreased 18.4% because of fewer sales to wholesale customers. Generating plant outages and retail customer demand limited power availability for bulk power transactions. As a result, total sales decreased 2.2% in 1993. Base rates and miscellaneous revenues decreased in 1993 primarily from lower revenues under contracts having reduced rates with certain large customers and a declining rate structure tied to usage. The contracts have been negotiated to meet competition and encourage economic growth. The net increase in 1993 fuel cost recovery revenues resulted from changes in the fuel cost factors. The weighted average of these factors increased about 2%. Operating expenses increased 12.6% in 1993. The increase in total operation and maintenance expenses resulted from the $88 million of net benefit expenses related to an early retirement program, called the Voluntary Transition Program (VTP), other charges totaling $19 million and a slight increase in other operation and maintenance expenses. The VTP benefit expenses consisted of $75 million of costs for the Company plus $13 million for the Company's pro rata share of the costs for its affiliate, Centerior Service Company (Service Company). Other charges recorded at year-end 1993 related to a performance improvement plan for Perry Nuclear Power Plant Unit 1 (Perry Unit 1), postemployment benefits and other expense accruals. See Note 9 for information on retirement and postemployment benefits. Deferred operating expenses decreased because of the write-off of the phase-in deferred operating expenses in 1993 as discussed in Note 7. Federal income taxes decreased as a result of lower pretax operating income. As discussed in Note 4(b), $232 million of our Perry Nuclear Power Plant Unit 2 (Perry Unit 2) investment was written off in 1993. Credits for carrying charges recorded in nonoperating income decreased because of the write-off of the phase-in deferred carrying charges in 1993 as discussed in Note 7. The federal income tax credit for nonoperating income in 1993 resulted from the write-offs. 1992 VS. 1991 Factors contributing to the 4.8% decrease in 1992 operating revenues are as follows: The revenue decreases resulted primarily from the different weather conditions and the changes in the composition of the sales mix among customer categories. Weather accounted for approximately $22 million of the lower 1992 revenues. Winter and spring in 1992 were milder than in 1991. In addition, the cooler summer in 1992 contrasted with the summer of 1991 which was much hotter than normal. Total kilowatt-hour sales increased 0.2% in 1992. Residential and commercial sales decreased 4.9% and 3.8%, respectively, as moderate temperatures in 1992 reduced electric heating and cooling demands. Industrial sales increased 0.6% as increased sales to glass and metal manufacturers and to the broad-based, smaller industrial customer group offset lower sales to petroleum refining and auto manufacturing customers. Other sales increased 5.2% because of increased sales to wholesale customers. Operating revenues in 1991 included the recognition of $24 million of deferred revenues over the period of a refund to customers under a provision of a January 1989 rate order. No such revenues were reflected in 1992 as the refund period ended in December 1991. Operating expenses decreased 4.4% in 1992. A reduction of $14 million in other operation and maintenance expenses resulted primarily from cost-cutting measures. Lower fuel and purchased power expense resulted from less amortization of previously deferred fuel costs than the amount amortized in 1991. These decreases were par- tially offset by higher depreciation and amortization, caused primarily by the adoption of the new accounting (Toledo Edison) (Toledo Edison) standard for income taxes (SFAS 109) in 1992, and by higher taxes, other than federal income taxes, caused by increased Ohio property taxes. Deferred operating expenses increased as a result of the deferrals under the Rate Stabilization Program discussed in Note 7. The federal income tax provision for nonoperating income decreased because of a greater tax allocation of interest charges to nonoperating activities. Credits for carrying charges recorded in nonoperating income increased primarily because of Rate Stabilization Program carrying charge credits. Interest charges decreased as a result of debt refinancings at lower interest rates and lower short-term borrowing requirements. Outlook RECENT ACTIONS In January 1994, Centerior Energy Corporation (Centerior Energy), along with the Company and The Cleveland Electric Illuminating Company (Cleveland Electric), announced a comprehensive strategic action plan to strengthen their financial and competitive positions. The Company and Cleveland Electric are the two wholly owned electric utility subsidiaries of Centerior Energy. The plan established specific objectives and was designed to guide Centerior Energy and its subsidiaries through the year 2001. Several actions were taken at that time. Centerior Energy reduced its quarterly common stock dividend from $.40 per share to $.20 per share effective with the dividend payable February 15, 1994. This action was taken because projected financial results did not support continuation of the dividend at its former rate. The Company and Cleveland Electric also wrote off their investments in Perry Unit 2 and certain deferred charges related to a January 1989 rate agreement (phase-in deferrals). The aggregate after-tax effect of these write-offs for the Company was $332 million which resulted in a net loss in 1993 and a retained earnings deficit. The write-offs are discussed in Notes 4(b) and 7. The Company also recognized other one-time charges totaling $15 million after taxes related to a performance improvement plan for Perry Unit 1, postemployment benefits and other expense accruals. Also contributing to the net loss in 1993 was a charge of $36 million after taxes representing a portion of the VTP costs. The Company will realize approximately $20 million of savings in annual payroll and benefit costs beginning in 1994 as a result of the VTP. STRATEGIC PLAN The objectives of the strategic plan are to maximize share owner return on Centerior Energy common stock from corporate assets and resources, achieve profitable revenue growth, become an industry leader in customer satisfaction, build a winning team and attain increasingly competitive power supply costs. To achieve these objectives, the Company will continue controlling its operation and maintenance expenses and capital expenditures, reduce its outstanding debt, increase revenues by finding new uses for existing assets and resources, implement a broad range of new marketing programs, increase revenues by restructuring rates for various customers where appropriate, improve the operating performance of its plants and take other appropriate actions. COMMON STOCK DIVIDENDS In recent years, the Company has retained all of its earnings available for common stock. The Company has not paid a common stock dividend to Centerior Energy since February 1991. Because the Company is currently prohibited from paying a common stock dividend by a provision in its mortgage (see Note 11(b)), the Company does not expect to pay any common stock dividends in the foreseeable future. COMPETITION Our electric rates are among the highest in our region because we are recovering the substantial investment in our nuclear construction program. Accordingly, some of our customers continue to seek less costly alternatives, including switching to or working to create a municipal electric system. There are a number of rural and municipal systems in our service area. In addition, we face threats of other municipalities in our service area establishing new systems. We have entered into agreements with some of the communities which considered establishing systems. Accordingly, they will not proceed with such development at this time in return for rate concessions and/or economic development funds. Others have determined that developing a system was not feasible. We will continue to address municipal system threats through aggressive marketing programs and emphasizing to our customers the value of our service and the risks of a municipal system. The Energy Policy Act of 1992 (Energy Act) will provide additional competition in the electric utility industry by requiring utilities to wheel to municipal systems in their service areas electricity from other utilities. This provision of the Energy Act should not significantly increase the competitive threat to us since the operating licenses for our nuclear units have required us to wheel to municipal systems in our service area since 1977. The Energy Act also created a class of exempt wholesale generators which may increase competition in the wholesale power market. A further risk is the possibility that the government could mandate that utilities deliver power from another utility or generation source to their retail customers. We have entered into contracts with many of our (Toledo Edison) (Toledo Edison) large industrial and commercial customers which have remaining terms of one to five years. We will attempt to renew those contracts as they expire which will help us compete if retail wheeling is permitted in the future. RATE MATTERS Our Rate Stabilization Program remains in effect. Under this program, we agreed to freeze base rates until 1996 and limit rate increases through 1998. In exchange, we are permitted to defer through 1995 and subsequently recover certain costs not currently recovered in rates and to accelerate the amortization of certain benefits. The amortization and recovery of the deferrals will begin with future rate recognition and will continue over the average life of the related assets, or approximately 30 years. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The analysis leading to the year-end 1993 financial actions and strategic plan also included an evaluation of our regulatory accounting measures. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. NUCLEAR OPERATIONS The Company's three nuclear units may be impacted by activities or events beyond our control. Operating nuclear generating units have experienced unplanned outages or extensions of scheduled outages because of equipment problems or new regulatory requirements. A major accident at a nuclear facility anywhere in the world could cause the Nuclear Regulatory Commission (NRC) to limit or prohibit the operation or licensing of any nuclear unit. If one of our nuclear units is taken out of service for an extended period of time for any reason, including an accident at such unit or any other nuclear facility, we cannot predict whether regulatory authorities would impose unfavorable rate treatment. Such treatment could include taking our affected unit out of rate base or disallowing certain construction or maintenance costs. An extended outage of one of our nuclear units coupled with unfavorable rate treatment could have a material adverse effect on our financial condition and results of operations. We externally fund the estimated costs for the future decommissioning of our nuclear units. In 1993, we increased our decommissioning expense accruals for revisions in our cost estimates. We expect the increases associated with the new estimates will be recoverable in future rates. See Note 1(f). HAZARDOUS WASTE DISPOSAL SITES The Comprehensive Environmental Response, Compensation and Liability Act of 1980 as amended (Superfund) established programs addressing the cleanup of hazardous waste disposal sites, emergency preparedness and other issues. The Company is aware of its potential involvement in the cleanup of several sites. Although these sites are not on the Superfund National Priorities List, they are generally being administered by various governmental entities in the same manner as they would be administered if they were on such list. The allegations that the Company disposed of hazardous waste at these sites and the amounts involved are often unsubstantiated and subject to dispute. Superfund provides that all "potentially responsible parties" (PRPs) to a particular site can be held liable on a joint and several basis. Consequently, if the Company were held liable for 100% of the cleanup costs of all of the sites referred to above, the cost could be as high as $150 million. However, we believe that the actual cleanup costs will be substantially lower than $150 million, that the Company's share of any cleanup costs will be substantially less than 100% and that most of the other PRPs are financially able to contribute their share. The Company has accrued a liability totaling $6 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. 1993 TAX ACT The Revenue Reconciliation Act of 1993 (1993 Tax Act), which was enacted in August 1993, provided for a 35% income tax rate in 1993. The 1993 Tax Act did not materially impact the results of operations for 1993, but did affect certain Balance Sheet accounts as discussed in Note 8. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. INFLATION Although the rate of inflation has eased in recent years, we are still affected by even modest inflation which causes increases in the unit cost of labor, materials and services. Capital Resources and Liquidity 1991-1993 CASH REQUIREMENTS We need cash for normal corporate operations, the mandatory retirement of securities and an ongoing pro- (Toledo Edison) (Toledo Edison) gram of constructing new facilities and modifying existing facilities. The construction program is needed to meet anticipated demand for electric service, comply with governmental regulations and protect the environment. Over the three-year period of 1991-1993, these construction and mandatory retirement needs totaled approximately $440 million. In addition, we exercised various options to redeem approximately $490 million of our securities. We raised $815 million through security issues and term bank loans during the 1991-1993 period as shown in the Cash Flows statement. During the three-year period, the Company also utilized its short-term borrowing arrangements to help meet its cash needs. Although the write-offs of Perry Unit 2 and the phase-in deferrals in 1993 negatively affected our earnings, they did not adversely affect our current cash flow. 1994 AND BEYOND CASH REQUIREMENTS Estimated cash requirements for 1994-1998 for the Company are $249 million for its construction program and $324 million for the mandatory redemption of debt and preferred stock. The Company expects to finance internally all of its 1994 cash requirements of approximately $109 million. About 15% of the Company's 1995-1998 requirements are expected to be financed externally. If economical, additional securities may be redeemed under optional redemption provisions, which will help improve the Company's capitalization structure and interest coverage ratios. Our capital requirements are dependent upon our implementation strategy to achieve compliance with the Clean Air Act Amendments of 1990 (Clean Air Act). Cash expenditures for our plan are estimated to be approximately $41 million over the 1994-1998 period. See Note 4(a). LIQUIDITY Additional first mortgage bonds may be issued by the Company under its mortgage on the basis of property additions, cash or refundable first mortgage bonds. Under its mortgage, the Company may issue first mortgage bonds on the basis of property additions and, under certain circumstances, refundable bonds only if the applicable interest coverage test is met. At December 31, 1993, the Company would have been permitted to issue approximately $323 million of additional first mortgage bonds. As discussed in Note 11(d), certain unsecured debt agreements contain covenants relating to capitalization, fixed charge coverage ratios and secured financings. The write-offs recorded at December 31, 1993 caused the Company, Cleveland Electric and Centerior Energy to violate certain of those covenants. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Cleveland Electric and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $172 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Cleveland Electric. For the next five years, the Company does not expect to raise funds through the sale of debt junior to first mortgage bonds. However, if necessary or desirable, we believe that the Company could raise funds through the sale of unsecured debt or debt secured by the second mortgage referred to above. The Company also is able to raise funds through the sale of preference stock. The Company will be unable to issue preferred stock until it can meet the interest and preferred dividend coverage test in its articles of incorporation. The Company currently cannot sell commercial paper because of its low commercial paper ratings by Standard & Poor's Corporation (S&P) and Moody's Investors Service, Inc. (Moody's) of "B" and "Not Prime", respectively. The Company is a party to a $205 million revolving credit facility which will run through mid-1996. However, we currently cannot draw on this facility because the write-offs taken at year-end 1993 caused the Company, Cleveland Electric and Centerior Energy to fail to meet certain capitalization and fixed charge coverage covenants. We expect to have this facility available to us again after it is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. These financing resources are expected to be sufficient for the Company's needs over the next several years. The availability and cost of capital to meet the Company's external financing needs, however, also depend upon such factors as financial market conditions and its credit ratings. Current credit ratings for the Company are as follows: These ratings reflect a downgrade in December 1993. In addition, S&P has issued a negative outlook for the Company. (Toledo Edison) (Toledo Edison) INCOME STATEMENT THE TOLEDO EDISON COMPANY - ---------------------------------------------------------------------- RETAINED EARNINGS - ---------------------------------------------------------------------- The accompanying notes are an integral part of these statements. (Toledo Edison) (Toledo Edison) CASH FLOWS THE TOLEDO EDISON COMPANY - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) [THIS PAGE INTENTIONALLY LEFT BLANK] BALANCE SHEET - ---------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) The Toledo Edison Company (Toledo Edison) (Toledo Edison) STATEMENT OF PREFERRED STOCK THE TOLEDO EDISON COMPANY - -------------------------------------------------------------------------------- The accompanying notes are an integral part of this statement. (Toledo Edison) (Toledo Edison) NOTES TO THE FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- (1) Summary of Significant Accounting Policies (A) GENERAL The Company is an electric utility and a wholly owned subsidiary of Centerior Energy. Centerior Energy has two other wholly owned subsidiaries, Cleveland Electric and the Service Company. The Company follows the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by The Public Utilities Commission of Ohio (PUCO). As a rate-regulated utility, the Company is subject to Statement of Financial Accounting Standards (SFAS) 71 which governs accounting for the effects of certain types of rate regulation. The Company is a member of the Central Area Power Coordination Group (CAPCO). Other members are Cleveland Electric, Duquesne Light Company, Ohio Edison Company and its wholly owned subsidiary, Pennsylvania Power Company. The members have constructed and operate generation and transmission facilities for their use. (B) RELATED PARTY TRANSACTIONS Operating revenues, operating expenses and interest charges include those amounts for transactions with affiliated companies in the ordinary course of business operations. The Company's transactions with Cleveland Electric are primarily for firm power, interchange power, transmission line rentals and jointly owned power plant operations and construction. See Notes 2 and 3. The Service Company provides management, financial, administrative, engineering, legal and other services at cost to the Company and other affiliated companies. The Service Company billed the Company $76 million, $60 million and $61 million in 1993, 1992 and 1991, respectively, for such services. (C) REVENUES Customers are billed on a monthly cycle basis for their energy consumption based on rate schedules or contracts authorized by the PUCO or on ordinances of individual municipalities. An accrual is made at the end of each month to record the estimated amount of unbilled revenues for kilowatt-hours sold in the current month but not billed by the end of that month. A fuel factor is added to the base rates for electric service. This factor is designed to recover from customers the costs of fuel and most purchased power. It is reviewed and adjusted semiannually in a PUCO proceeding. (D) FUEL EXPENSE The cost of fossil fuel is charged to fuel expense based on inventory usage. The cost of nuclear fuel, including an interest component, is charged to fuel expense based on the rate of consumption. Estimated future nuclear fuel disposal costs are being recovered through the base rates. The Company defers the differences between actual fuel costs and estimated fuel costs currently being recovered from customers through the fuel factor. This matches fuel expenses with fuel-related revenues. Owners of nuclear generating plants are assessed by the federal government for the cost of decontamination and decommissioning of nuclear enrichment facilities operated by the United States Department of Energy. The assessments are based upon the amount of enrichment services used in prior years and cannot be imposed for more than 15 years. The Company has accrued a liability for its share of the total assessments. These costs have been recorded in a deferred charge account since the PUCO is allowing the Company to recover the assessments through its fuel cost factors. (E) DEFERRED CARRYING CHARGES AND OPERATING EXPENSES The PUCO authorized the Company to defer operating expenses and carrying charges for Perry Unit 1 and Beaver Valley Power Station Unit 2 (Beaver Valley Unit 2) from their respective in-service dates in 1987 through December 1988. The annual amortization and recovery of these deferrals, called pre-phase-in deferrals, are $7 million which began in January 1989 and will continue over the lives of the related property. Beginning in January 1989, the Company deferred certain operating expenses and both interest and equity carrying charges pursuant to a PUCO-approved rate phase-in plan for its investments in Perry Unit 1 and Beaver Valley Unit 2. These deferrals, called phase-in deferrals, were written off at December 31, 1993. See Note 7. The Company also defers certain costs not currently recovered in rates under a Rate Stabilization Program approved by the PUCO in October 1992. See Notes 7 and 14. (F) DEPRECIATION AND AMORTIZATION The cost of property, plant and equipment is depreciated over their estimated useful lives on a straight-line basis. The annual straight-line depreciation provision for nonnuclear property expressed as a percent of average depreciable utility plant in service was 3.6% in both 1993 and 1992 and 3.4% in 1991. Effective January 1, 1991, the Company, after obtaining PUCO approval, changed its method of accounting for nuclear plant depreciation from the units-of-production method to the straight-line method at about a 3% rate. This change decreased 1991 depreciation expense $14 million and increased 1991 net (Toledo Edison) (Toledo Edison) income $11 million (net of $3 million of income taxes) from what they otherwise would have been. The PUCO subsequently approved in 1991 a change to lower the 3% rate to 2.5% retroactive to January 1, 1991. Pursuant to a PUCO order, the Company currently uses external funding for the future decommissioning of its nuclear units at the end of their licensed operating lives. The estimated costs are based on the NRC's DECON method of decommissioning (prompt decontamination). Cash contributions are made to the trust funds on a straight-line basis over the remaining licensing period for each unit. The current level of annual expense being recovered from customers based on prior estimates is approximately $4 million. However, actual decommissioning costs are expected to significantly exceed those estimates. Current site-specific estimates for the Company's share of the future decommissioning costs are $41 million in 1992 dollars for Beaver Valley Unit 2 and $87 million and $146 million in 1993 dollars for Perry Unit 1 and the Davis-Besse Nuclear Power Station (Davis-Besse), respectively. The estimates for Perry Unit 1 and Davis-Besse are preliminary and are expected to be finalized by the end of the second quarter of 1994. The Company used these estimates to increase its decommissioning expense accruals in 1993. It is expected that the increases associated with the revised cost estimates will be recoverable in future rates. In the Balance Sheet at December 31, 1993, Accumulated Depreciation and Amortization included $34 million of decommissioning costs previously expensed and the earnings on the external funding. This amount exceeds the Balance Sheet amount of the external Nuclear Plant Decommissioning Trusts because the reserve began prior to the external trust funding. (G) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at original cost less amounts ordered by the PUCO to be written off. Construction costs include related payroll taxes, pensions, fringe benefits, management and general overheads and allowance for funds used during construction (AFUDC). AFUDC represents the estimated composite debt and equity cost of funds used to finance construction. This noncash allowance is credited to income. The AFUDC rate was 10.22% in 1993 and 10.96% in both 1992 and 1991. Maintenance and repairs are charged to expense as incurred. The cost of replacing plant and equipment is charged to the utility plant accounts. The cost of property retired plus removal costs, after deducting any salvage value, is charged to the accumulated provision for depreciation. (H) DEFERRED GAIN AND LOSS FROM SALES OF UTILITY PLANT The sale and leaseback transactions discussed in Note 2 resulted in a net gain for the sale of the Bruce Mansfield Generating Plant (Mansfield Plant) and a net loss for the sale of Beaver Valley Unit 2. The net gain and net loss were deferred and are being amortized over the terms of leases. These amortizations and the lease expense amounts are recorded as other operation and maintenance expenses. (I) INTEREST CHARGES Debt Interest reported in the Income Statement does not include interest on obligations for nuclear fuel under construction. That interest is capitalized. See Note 6. Losses and gains realized upon the reacquisition or redemption of long-term debt are deferred, consistent with the regulatory rate treatment. Such losses and gains are either amortized over the remainder of the original life of the debt issue retired or amortized over the life of the new debt issue when the proceeds of a new issue are used for the debt redemption. The amortizations are included in debt interest expense. (J) FEDERAL INCOME TAXES The Financial Accounting Standards Board (FASB) issued SFAS 109, a new standard for accounting for income taxes, in February 1992. We adopted the new standard in 1992. The standard amended certain provisions of SFAS 96 which we had previously adopted. Adoption of SFAS 109 in 1992 did not materially affect our results of operations, but did affect certain Balance Sheet accounts. See Note 8. The financial statements reflect the liability method of accounting for income taxes. This method requires that deferred taxes be recorded for all temporary differences between the book and tax bases of assets and liabilities. The majority of these temporary differences are attributable to property-related basis differences. Included in these basis differences is the equity component of AFUDC, which will increase future tax expense when it is recovered through rates. Since this component is not recognized for tax purposes, we must record a liability for our tax obligation. The PUCO permits recovery of such taxes from customers when they become payable. Therefore, the net amount due from customers through rates has been recorded as a deferred charge and will be recovered over the lives of the related assets. Investment tax credits are deferred and amortized over the lives of the applicable property as a reduction of depreciation expense. See Note 7 for a discussion of the amortization of certain unrestricted excess deferred taxes and unrestricted investment tax credits under the Rate Stabilization Program. (Toledo Edison) (Toledo Edison) (2) Utility Plant Sale and Leaseback Transactions The Company and Cleveland Electric are co-lessees of 18.26% (150 megawatts) of Beaver Valley Unit 2 and 6.5% (51 megawatts), 45.9% (358 megawatts) and 44.38% (355 megawatts) of Units 1, 2 and 3 of the Mansfield Plant, respectively, all for terms of about 29 1/2 years. These leases are the result of sale and leaseback transactions completed in 1987. Under these leases, the Company and Cleveland Electric are responsible for paying all taxes, insurance premiums, operation and maintenance expenses and all other similar costs for their interests in the units sold and leased back. They may incur additional costs in connection with capital improvements to the units. The Company and Cleveland Electric have options to buy the interests back at the end of the leases for the fair market value at that time or to renew the leases. Additional lease provisions provide other purchase options along with conditions for mandatory termination of the leases (and possible repurchase of the leasehold interests) for events of default. These events include noncompliance with several financial covenants discussed in Note 11(d). As co-lessee with Cleveland Electric, the Company is also obligated for Cleveland Electric's lease payments. If Cleveland Electric is unable to make its payments under the Mansfield Plant leases, the Company would be obligated to make such payments. No payments have been made on behalf of Cleveland Electric to date. In April 1992, nearly all of the outstanding Secured Lease Obligation Bonds (SLOBs) issued by a special purpose corporation in connection with financing the sale and leaseback of Beaver Valley Unit 2 were refinanced through a tender offer and the sale of new bonds having a lower interest rate. As part of the refinancing transaction, the Company paid $43 million as supplemental rent to fund transaction expenses and part of the tender premium. This amount has been deferred and is being amortized over the remaining lease term. The refinancing transaction reduced the annual rental expense for the Beaver Valley Unit 2 lease by $9 million. Future minimum lease payments under the operating leases at December 31, 1993 are summarized as follows: Rental expense is accrued on a straight-line basis over the terms of the leases. The amount recorded in 1993, 1992 and 1991 as annual rental expense for the Mansfield Plant leases was $45 million. The amounts recorded in 1993, 1992 and 1991 as annual rental expense for the Beaver Valley Unit 2 lease were $63 million, $66 million and $72 million, respectively. Amounts charged to expense in excess of the lease payments are classified as Accumulated Deferred Rents in the Balance Sheet. The Company is selling 150 megawatts of its Beaver Valley Unit 2 leased capacity entitlement to Cleveland Electric. We anticipate that this sale will continue indefinitely. Revenues recorded for this transaction were $103 million, $108 million and $107 million in 1993, 1992 and 1991, respectively. The future minimum lease payments through the year 2017 associated with Beaver Valley Unit 2 aggregate $1.47 billion. (3) Property Owned with Other Utilities and Investors The Company owns, as a tenant in common with other utilities and those investors who are owner-participants in various sale and leaseback transactions (Lessors), certain generating units as listed below. Each owner owns an undivided share in the entire unit. Each owner has the right to a percentage of the generating capability of each unit equal to its ownership share. Each utility owner is obligated to pay for only its respective share of the construction costs and operating expenses. Each Lessor has leased its capacity rights to a utility which is obligated to pay for such Lessor's share of the construction costs and operating expenses. The Company's share of the operating expenses of these generating units is included in the Income Statement. The Balance Sheet classification of Property, Plant and Equipment at December 31, 1993 includes the following facilities owned by the Company as a tenant in common with other utilities and Lessors: (Toledo Edison) (Toledo Edison) (4) Construction and Contingencies (A) CONSTRUCTION PROGRAM The estimated cost of the Company's construction program for the 1994-1998 period is $259 million, including AFUDC of $10 million and excluding nuclear fuel. The Clean Air Act will require, among other things, significant reductions in the emission of sulfur dioxide in two phases over a ten-year period and nitrogen oxides by fossil-fueled generating units. Our compliance strategy provides for compliance with both phases through at least 2005 primarily through greater use of low-sulfur coal at some of our units and the banking of emission allowances. The plan will require capital expenditures over the 1994-2003 period of approximately $57 million for nitrogen oxide control equipment, emission monitoring equipment and plant modifications. In addition, higher fuel and other operation and maintenance expenses may be incurred. The anticipated rate increase associated with the capital expenditures and higher expenses would be less than 2% over the ten-year period. The PUCO has approved this plan. We also are seeking United States Environmental Protection Agency (U.S. EPA) approval of the first phase of our plan. We are continuing to monitor developments in new technologies that may be incorporated into our compliance strategy. If a different plan is required by the U.S. EPA, significantly higher capital expenditures could be required during the 1994-2003 period. We believe Ohio law permits the recovery of compliance costs from customers in rates. (B) PERRY UNIT 2 Perry Unit 2, including its share of the facilities common with Perry Unit 1, was approximately 50% complete when construction was suspended in 1985 pending consideration of various options. These options included resumption of full construction with a revised estimated cost, conversion to a nonnuclear design, sale of all or part of our ownership share, or cancellation. We wrote off our investment in Perry Unit 2 at December 31, 1993 after we determined that it would not be completed or sold. The write-off totaled $232 million ($167 million after taxes) for the Company's 19.91% ownership share of the unit. See Note 14. (C) HAZARDOUS WASTE DISPOSAL SITES The Company is aware of its potential involvement in the cleanup of several hazardous waste disposal sites. The Company has accrued a liability totaling $6 million at December 31, 1993 based on estimates of the costs of cleanup and its proportionate responsibility for such costs. We believe that the ultimate outcome of these matters will not have a material adverse effect on our financial condition or results of operations. See Management's Financial Analysis -- Outlook-Hazardous Waste Disposal Sites. (5) Nuclear Operations and Contingencies (A) OPERATING NUCLEAR UNITS The Company's three nuclear units may be impacted by activities or events beyond our control. An extended outage of one of our nuclear units for any reason, coupled with any unfavorable rate treatment, could have a material adverse effect on our financial condition and results of operations. See discussion of these risks in Management's Financial Analysis -- Outlook-Nuclear Operations. (B) NUCLEAR INSURANCE The Price-Anderson Act limits the liability of the owners of a nuclear power plant to the amount provided by private insurance and an industry assessment plan. In the event of a nuclear incident at any unit in the United States resulting in losses in excess of the level of private insurance (currently $200 million), the Company's maximum potential assessment under that plan would be $70 million (plus any inflation adjustment) per incident. The assessment is limited to $9 million per year for each nuclear incident. These assessment limits assume the other CAPCO companies contribute their proportionate share of any assessment. The CAPCO companies have insurance coverage for damage to property at the Davis-Besse, Perry and Beaver Valley sites (including leased fuel and clean-up costs). Coverage amounted to $2.75 billion for each site as of January 1, 1994. Damage to property could exceed the insurance coverage by a substantial amount. If it does, the Company's share of such excess amount could have a material adverse effect on its financial condition and results of operations. Under these policies, the Company can be assessed a maximum of $11 million during a policy year if the reserves available to the insurer are inadequate to pay claims arising out of an accident at any nuclear facility covered by the insurer. The Company also has extra expense insurance coverage. It includes the incremental cost of any replacement power purchased (over the costs which would have been incurred had the units been operating) and other incidental expenses after the occurrence of certain types of accidents at our nuclear units. The amounts of the coverage are 100% of the estimated extra expense per week during the 52-week period starting 21 weeks after an accident and 67% of such estimate per week for the next 104 weeks. The amount and duration of extra expense could substantially exceed the insurance coverage. (Toledo Edison) (Toledo Edison) (6) Nuclear Fuel Nuclear fuel is financed for the Company and Cleveland Electric through leases with a special-purpose corporation. The total amount of financing currently available under these lease arrangements is $382 million ($232 million from intermediate-term notes and $150 million from bank credit arrangements). Financing in an amount up to $750 million is permitted. The intermediate-term notes mature in the period 1994-1997, with $75 million maturing in September 1994. At December 31, 1993, $154 million of nuclear fuel was financed for the Company. The Company and Cleveland Electric severally lease their respective portions of the nuclear fuel and are obligated to pay for the fuel as it is consumed in a reactor. The lease rates are based on various intermediate-term note rates, bank rates and commercial paper rates. The amounts financed include nuclear fuel in the Davis-Besse, Perry Unit 1 and Beaver Valley Unit 2 reactors with remaining lease payments for the Company of $52 million, $29 million and $20 million, respectively, at December 31, 1993. The nuclear fuel amounts financed and capitalized also included interest charges incurred by the lessors amounting to $6 million in both 1993 and 1992 and $9 million in 1991. The estimated future lease amortization payments based on projected consumption are $49 million in 1994, $42 million in 1995, $37 million in 1996, $33 million in 1997 and $30 million in 1998. (7) Regulatory Matters Phase-in deferrals were recorded beginning in 1989 pursuant to the phase-in plan approved by the PUCO in a January 1989 rate order for the Company. The phase-in plan was designed so that the projected revenues resulting from the authorized rate increases and anticipated sales growth provided for the phase-in of certain nuclear costs over a ten-year period. The plan required the deferral of a portion of the operating expenses and both interest and equity carrying charges on the Company's deferred rate-based investments in Perry Unit 1 and Beaver Valley Unit 2 during the early years of the plan. The amortization and recovery of such deferrals were scheduled to be completed by 1998. As we developed our strategic plan, we evaluated the future recovery of our deferred charges and continued application of the regulatory accounting measures we follow pursuant to PUCO orders. We concluded that projected revenues would not provide for the recovery of the phase-in deferrals as scheduled because of economic and competitive pressures. Accordingly, we wrote off the cumulative balance of the phase-in deferrals. The total phase-in deferred operating expenses and carrying charges written off at December 31, 1993 by the Company were $55 million and $186 million, respectively (totaling $165 million after taxes). See Note 14. While recovery of our other regulatory deferrals remains probable, our current assessment of business conditions has prompted us to change our future plans. We decided that, once the deferral of expenses and acceleration of benefits under our Rate Stabilization Program are completed in 1995, we should no longer plan to use regulatory accounting measures to the extent we have in the past. In October 1992, the PUCO approved a Rate Stabilization Program that was designed to encourage economic growth in the Company's service area by freezing the Company's base rates until 1996 and limiting subsequent rate increases to specified annual amounts not to exceed $89 million over the 1996-1998 period. As part of the Rate Stabilization Program, the Company is allowed to defer and subsequently recover certain costs not currently recovered in rates and to accelerate amortization of certain benefits. Such regulatory accounting measures provide for rate stabilization by rescheduling the timing of rate recovery of certain costs and the amortization of certain benefits during the 1992-1995 period. The continued use of these regulatory accounting measures will be dependent upon our continuing assessment and conclusion that there will be probable recovery of such deferrals in future rates. The regulatory accounting measures we are eligible to record through December 31, 1995 include the deferral of post-in-service interest carrying charges, depreciation expense and property taxes on assets placed in service after February 29, 1988 and the deferral of operating expenses equivalent to an accumulated excess rent reserve for Beaver Valley Unit 2 (which resulted from the April 1992 refinancing of SLOBs as discussed in Note 2). The cost deferrals recorded in 1993 and 1992 pursuant to these provisions were $39 million and $32 million, respectively. Amortization and recovery of these deferrals will occur over the average life of the related assets and the remaining lease period, or approximately 30 years, and will commence with future rate recognition. The regulatory accounting measures also provide for the accelerated amortization of certain unrestricted excess deferred tax and unrestricted investment tax credit balances and interim spent fuel storage accrual balances for Davis-Besse. The total amount of such regulatory benefits recognized in 1993 and 1992 pursuant to these provisions was $18 million and $5 million, respectively. The Rate Stabilization Program also authorized the Company to defer and subsequently recover the incremental expenses associated with the adoption of the accounting standard for postretirement benefits other than pensions (SFAS 106). In 1993, we deferred $37 million pursuant to this provision. Amortization and recovery of this (Toledo Edison) (Toledo Edison) deferral will commence prior to 1998 and is expected to be completed by no later than 2012. See Note 9(b). (8) Federal Income Tax Federal income tax, computed by multiplying income before taxes by the statutory rate (35% in 1993 and 34% in both 1992 and 1991), is reconciled to the amount of federal income tax recorded on the books as follows: Federal income tax expense is recorded in the Income Statement as follows: The Company joins in the filing of a consolidated federal income tax return with its affiliated companies. The method of tax allocation reflects the benefits and burdens realized by each company's participation in the consolidated tax return, approximating a separate return result for each company. In August 1993, the 1993 Tax Act was enacted. Retroactive to January 1, 1993, the top marginal corporate income tax rate increased to 35%. The change in tax rate increased Accumulated Deferred Federal Income Taxes for the future tax obligation by approximately $29 million. Since the PUCO has historically permitted recovery of such taxes from customers when they become payable, the deferred charge, Amounts Due from Customers for Future Federal Income Taxes, also was increased by $29 million. The 1993 Tax Act is not expected to materially impact future results of operations or cash flow. Under SFAS 109, temporary differences and carryforwards resulted in deferred tax assets of $178 million and deferred tax liabilities of $649 million at December 31, 1993 and deferred tax assets of $154 million and deferred tax liabilities of $794 million at December 31, 1992. These are summarized as follows: For tax purposes, net operating loss (NOL) carryforwards of approximately $111 million are available to reduce future taxable income and will expire in 2003 through 2005. The 35% tax effect of the NOLs is $39 million. The Tax Reform Act of 1986 provides for an alternative minimum tax (AMT) credit to be used to reduce the regular tax to the AMT level should the regular tax exceed the AMT. AMT credits of $77 million are available to offset future regular tax. The credits may be carried forward indefinitely. (9) Retirement and Postemployment Benefits (A) RETIREMENT INCOME PLAN Prior to December 31, 1993, the Company sponsored a noncontributory pension plan which covered all employee groups. The plan was merged with another plan which covered employees of Cleveland Electric and the Service Company into a single plan on December 31, 1993. The amount of retirement benefits generally depends upon the length of service. Under certain circumstances, benefits can begin as early as age 55. The funding policy is to (Toledo Edison) (Toledo Edison) comply with the Employee Retirement Income Security Act of 1974 guidelines. In 1993, the Company offered the VTP, an early retirement program. Operating expenses for 1993 included $59 million of pension plan accruals to cover enhanced VTP benefits and an additional $3 million of pension costs for VTP benefits paid to retirees from corporate funds. The $3 million is not included in the pension data reported below. A credit of $15 million resulting from a settlement of pension obligations through lump sum payments to almost all the VTP retirees partially offset the VTP expenses. Net pension and VTP costs for 1991 through 1993 were comprised of the following components: The following table presents a reconciliation of the funded status of the Company's former plan at December 31, 1992 with comparable information for a portion of the merged plan at December 31, 1993. The December 31, 1993 benefit obligation estimates were derived from information for the former plans. Plan assets of the merged plan were allocated based on a pro rata share of the projected benefit obligation. At December 31, 1993, the settlement (discount) rate and long-term rate of return on plan assets assumptions were 7.25% and 8.75%, respectively. The long-term rate of annual compensation increase assumption was 4.25%. At December 31, 1992, the settlement rate and long-term rate of return on plan assets assumptions were 8.5% and the long-term rate of annual compensation increase assumption was 5%. Plan assets consist primarily of investments in common stock, bonds, guaranteed investment contracts, cash equivalent securities and real estate. (B) OTHER POSTRETIREMENT BENEFITS Centerior Energy sponsors jointly with its subsidiaries a postretirement benefit plan which provides all employee groups certain health care, death and other postretirement benefits other than pensions. The plan is contributory, with retiree contributions adjusted annually. The plan is not funded. A policy limiting the employer's contribution for retiree medical coverage for employees retiring after March 31, 1993 was implemented in February 1993. The Company adopted SFAS 106, the accounting standard for postretirement benefits other than pensions, effective January 1, 1993. The standard requires the accrual of the expected costs of such benefits during the employees' years of service. Previously, the costs of these benefits were expensed as paid, which is consistent with ratemaking practices. Such costs for the Company totaled $4 million in both 1992 and 1991, which included medical benefits of $3 million in both years. The total amount accrued by the Company for SFAS 106 costs for 1993 was $42 million, of which $1 million was capitalized and $41 million was expensed as other operation and maintenance expenses. In 1993, the Company deferred incremental SFAS 106 expenses totaling $37 million pursuant to a provision of the Rate Stabilization Program. See Note 7. The components of the total postretirement benefit costs for 1993 were as follows: These amounts included costs for the Company and a pro rata share of the Service Company's costs. The accumulated postretirement benefit obligation and accrued postretirement benefit cost at December 31, 1993 (Toledo Edison) (Toledo Edison) for the Company and its share of the Service Company's obligation are summarized as follows: The Balance Sheet classification of Other Noncurrent Liabilities at December 31, 1993 includes only the Company's accrued postretirement benefit cost of $33 million and excludes the Service Company's portion since the Service Company's total accrued cost is carried on its books. At December 31, 1993, the settlement rate and the long-term rate of annual compensation increase assumptions were 7.25% and 4.25%, respectively. The assumed annual health care cost trend rates (applicable to gross eligible charges) are 9.5% for medical and 8% for dental in 1994. Both rates reduce gradually to a fixed rate of 4.75% in 1996 and later years. Elements of the obligation affected by contribution caps are significantly less sensitive to the health care cost trend rate than other elements. If the assumed health care cost trend rates were increased by 1% in each future year, the accumulated postretirement benefit obligation as of December 31, 1993 would increase by $4 million and the aggregate of the service and interest cost components of the annual postretirement benefit cost would increase by $0.3 million. (C) POSTEMPLOYMENT BENEFITS In 1993, the Company adopted SFAS 112, the new accounting standard which requires the accrual of postemployment benefit costs. Postemployment benefits are the benefits provided to former or inactive employees after employment but before retirement, such as worker's compensation, disability benefits and severance pay. The adoption of this accounting method did not materially affect the Company's 1993 results of operations or financial position. (10) Guarantees The Company has guaranteed certain loan and lease obligations of a mining company under a long-term coal purchase arrangement. This arrangement requires payments to the mining company for any actual expenses (as advance payments for coal) when the mines are idle for reasons beyond the control of the mining company. At December 31, 1993, the principal amount of the mining company's loan and lease obligations guaranteed by the Company was $20 million. (11) Capitalization (A) CAPITAL STOCK TRANSACTIONS Preferred stock shares retired during the three years ended December 31, 1993 are listed in the following table. (B) EQUITY DISTRIBUTION RESTRICTIONS Federal law prohibits the Company from paying dividends out of capital accounts. However, the Company may pay dividends out of appropriated retained earnings and current earnings. At December 31, 1993, the Company had $42 million of appropriated retained earnings for the payment of preferred stock dividends. The Company is currently prohibited from paying a common stock dividend by a provision in its mortgage. (C) PREFERRED AND PREFERENCE STOCK Amounts to be paid for preferred stock which must be redeemed during the next five years are $12 million in each year 1994 through 1996 and $2 million in both 1997 and 1998. The annual preferred stock mandatory redemption provisions are as follows: The annualized preferred dividend requirement at December 31, 1993 was $21 million. The preferred dividend rates on the Company's Series A and B fluctuate based on prevailing interest rates and market conditions. The dividend rates for these issues averaged 7.41% and 8.22%, respectively, in 1993. Preference stock authorized for the Company is 5,000,000 shares with a $25 par value. No preference shares are currently outstanding. With respect to dividend and liquidation rights, the Company's preferred stock is prior to its preference stock and common stock, and its preference stock is prior to its common stock. (Toledo Edison) (Toledo Edison) (D) LONG-TERM DEBT AND OTHER BORROWING ARRANGEMENTS Long-term debt, less current maturities, was as follows: Long-term debt matures during the next five years as follows: $45 million in 1994, $71 million in 1995, $91 million in 1996 and $39 million in both 1997 and 1998. The Company issued $275 million aggregate principal amount of secured medium-term notes during the 1991-1993 period. The notes are secured by first mortgage bonds. The Company's mortgage constitutes a direct first lien on substantially all property owned and franchises held by the Company. Excluded from the lien, among other things, are cash, securities, accounts receivable, fuel, supplies and automotive equipment. Certain unsecured loan agreements of the Company contain covenants relating to capitalization ratios, fixed charge coverage ratios and limitations on secured financing other than through first mortgage bonds or certain other transactions. Two reimbursement agreements relating to separate letters of credit issued in connection with the sale and leaseback of Beaver Valley Unit 2 contain several financial covenants affecting the Company, Cleveland Electric and Centerior Energy. Among these are covenants relating to fixed charge coverage ratios and capitalization ratios. The write-offs recorded at December 31, 1993 caused the Company, Cleveland Electric and Centerior Energy to violate certain covenants contained in the two reimbursement agreements. The affected creditors have waived those violations in exchange for commitments to provide them with a second mortgage security interest on property of the Company and Cleveland Electric and other considerations. We expect to complete this process in the second quarter of 1994. We will provide the same security interest to certain other creditors because their agreements require equal treatment. We expect to provide second mortgage collateral for $172 million of unsecured debt, $228 million of bank letters of credit and a $205 million revolving credit facility. The bank letters of credit and revolving credit facility are joint and several obligations of the Company and Cleveland Electric. (12) Short-Term Borrowing Arrangements In May 1993, Centerior Energy arranged for a $205 million, three-year revolving credit facility. The facility may be renewed twice for one-year periods at the option of the participating banks. Centerior Energy and the Service Company may borrow under the facility, with all borrowings jointly and severally guaranteed by the Company and Cleveland Electric. Centerior Energy plans to transfer any of its borrowed funds to the Company and Cleveland Electric, while the Service Company may borrow up to $25 million for its own use. The banks' fee is 0.5% per annum payable quarterly in addition to interest on any borrowings. That fee is expected to increase to 0.625% when the facility agreement is amended as discussed below. There were no borrowings under the facility at December 31, 1993. The facility agreement contains covenants relating to capitalization and fixed charge coverage ratios for the Company, Cleveland Electric and Centerior Energy. The write-offs recorded at December 31, 1993 caused the ratios to fall below those covenant requirements. The revolving credit facility is expected to be available for borrowings after the facility agreement is amended in the second quarter of 1994 to provide the participating creditors with a second mortgage security interest. Short-term borrowing capacity authorized by the PUCO annually is $150 million for the Company. The Company and Cleveland Electric are authorized by the PUCO to borrow from each other on a short-term basis. At December 31, 1993, the Company had no commercial paper outstanding. The Company is unable to rely on the sale of commercial paper to provide short-term funds because of its below investment grade commercial paper credit ratings. (Toledo Edison) (Toledo Edison) (13) Financial Instruments' Fair Value The estimated fair values at December 31, 1993 and 1992 of financial instruments that do not approximate their carrying amounts are as follows: The fair value of the nuclear plant decommissioning trusts is estimated based on the quoted market prices for the investment securities. The fair value of the Company's preferred stock with mandatory redemption provisions and long-term debt is estimated based on the quoted market prices for the respective or similar issues or on the basis of the discounted value of future cash flows. The discounted value used current dividend or interest rates (or other appropriate rates) for similar issues and loans with the same remaining maturities. The estimated fair values of all other financial instruments approximate their carrying amounts in the Balance Sheet at December 31, 1993 and 1992 because of their short-term nature. (14) Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the two years ended December 31, 1993. Earnings for the quarter ended September 30, 1993 were decreased by $35 million as a result of the recording of $54 million of VTP pension-related benefits. Earnings for the quarter ended December 31, 1993 were decreased as a result of year-end adjustments for the $232 million write-off of Perry Unit 2 (see Note 4(b)), the $241 million write-off of the phase-in deferrals (see Note 7) and $19 million of other charges. These adjustments decreased quarterly earnings by $345 million. Earnings for the quarter ended September 30, 1992 were increased by $15 million as a result of the recording of deferred operating expenses and carrying charges for the first nine months of 1992 totaling $22 million under the Rate Stabilization Program approved by the PUCO in October 1992. See Note 7. (15) Pending Merger of the Company with Cleveland Electric On March 25, 1994, Centerior Energy announced that its operating utility subsidiaries, the Company and Cleveland Electric, plan to merge into a single operating entity. Since the Company and Cleveland Electric affiliated in 1986, efforts have been made to consolidate operations and administration as much as possible to achieve maximum cost savings. The merger of the two companies into a single entity is the completion of this consolidation process. Various aspects of the merger are subject to the approval of the FERC, the PUCO and other regulatory authorities. The merger must be approved by share owners of the Company's preferred stock. Share owners of Cleveland Electric's preferred stock must approve the authorization of additional shares of preferred stock. Share owners of the Company's preferred stock will exchange their shares for preferred stock shares of the successor corporation having substantially the same terms, while Cleveland Electric's preferred stock will automatically become shares of the successor corporation. Debt holders of the merging companies will become debt holders of the successor corporation. The merging companies plan to seek preferred stock share owner approval in the summer of 1994. The merger is expected to be effective in late 1994. For the merging companies, the combined pro forma operating revenues were $2.475 billion, $2.439 billion and $2.561 billion and the combined pro forma net income (loss) was $(876) million, $276 million and $296 million for the years ended December 31, 1993, 1992 and 1991, respectively. The pro forma data is based on accounting for the merger on a method similar to a pooling of interests. The pro forma data is not necessarily indicative of the results of operations which would have been reported had the merger been in effect during those years or which may be reported in the future. The pro forma data should be read in conjunction with the audited financial statements of both the Company and Cleveland Electric. (Toledo Edison) (Toledo Edison) FINANCIAL AND STATISTICAL REVIEW - ---------------------------------------------------------------------- Operating Revenues (millions of dollars) - -------------------------------------------------------------------------------- Operating Expenses (millions of dollars) - -------------------------------------------------------------------------------- Income (Loss) (millions of dollars) - -------------------------------------------------------------------------------- Income (Loss) (millions of dollars) - -------------------------------------------------------------------------------- (a) Includes early retirement program expenses and other charges of $107 million in 1993. (b) Includes write-off of phase-in deferrals of $241 million in 1993, consisting of $55 million of deferred operating expenses and $186 million of deferred carrying charges. (c) In 1991, a change in accounting for nuclear plant depreciation was adopted, changing from the units-of-production method to the straight-line method at a 2.5% rate. (Toledo Edison) (Toledo Edison) The Toledo Edison Company - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Investment (millions of dollars) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (d) Includes write-off of Perry Unit 2 of $232 million in 1993. (e) Restated for effects of capitalization of nuclear fuel lease and financing arrangements pursuant to Statement of Financial Accounting Standards 71. (Toledo Edison) (Toledo Edison) S-1 S-2 S-3 S-4 S-5 S-6 S-7 S-8 S-9 S-10 S-11 S-12 S-13 S-14 S-15 S-16 S-17 S-18 S-19 S-20 S-21 S-22 S-23 S-24 S-25 S-26 S-27 S-28 S-29 S-30 S-31 THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES AND THE TOLEDO EDISON COMPANY COMBINED PRO FORMA CONDENSED FINANCIAL STATEMENTS The following pro forma condensed balance sheets and income statements give effect to the agreement between Cleveland Electric and Toledo Edison to merge Toledo Edison into Cleveland Electric. These statements are unaudited and based on accounting for the merger on a method similar to a pooling of interests. These statements combine the two companies' historical balance sheets at December 31, 1993 and December 31, 1992 and their historical income statements for each of the three years ended December 31, 1993. The following pro forma data is not necessarily indicative of the results of operations or the financial condition which would have been reported had the merger been in effect during those periods or which may be reported in the future. The statements should be read in conjunction with the accompanying notes and with the audited financial statements of both Cleveland Electric and Toledo Edison. P-1 P-2 COMBINED PRO FORMA CONDENSED INCOME STATEMENTS OF CLEVELAND ELECTRIC AND TOLEDO EDISON (Unaudited) (Millions of Dollars) P-3 NOTES TO COMBINED PRO FORMA CONDENSED BALANCE SHEETS AND INCOME STATEMENTS (Unaudited) The Pro Forma Financial Statements include the following adjustments: (A) Elimination of intercompany accounts and notes receivable and accounts and notes payable. (B) Reclassification of prepaid pension costs or pension liabilities. (C) Elimination of intercompany operating revenues and operating expenses. (D) Elimination of intercompany working capital transactions. (E) Elimination of intercompany interest income and interest expense. (R) Rounding adjustments. P-4 EXHIBIT INDEX The exhibits designated with an asterisk (*) are filed herewith. The exhibits not so designated have previously been filed with the SEC in the file indi- cated in parenthesis following the description of such exhibits and are in- corporated herein by reference. An exhibit designated with a pound sign (#) is a management contract or compensatory plan or arrangement. COMMON EXHIBITS (The following documents are exhibits to the reports of Centerior Energy, Cleveland Electric and Toledo Edison.) E-1 E-2 E-3 E-4 E-5 E-6 E-7 E-8 E-9 E-10 Pursuant to Paragraph (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Regis- trants have not filed as an exhibit to this Form 10-K any instrument with respect to long-term debt if the total amount of securities authorized there- under does not exceed 10% of the total assets of the applicable Registrant and its subsidiaries on a consolidated basis, but each hereby agrees to furnish to the Securities and Exchange Commission on request any such instruments. Pursuant to Rule 14a-3(b)(10) under the Securities Exchange Act of 1934, copies of exhibits filed by the Registrants with this Form 10-K will be fur- nished by the Registrants to share owners upon written request and upon re- ceipt in advance of the aggregate fee for preparation of such exhibits at a rate of $.25 per page, plus any postage or shipping expenses which would be incurred by the Registrants. E-11

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2648

Item 1. Business. A. Organization of Business Aetna Life and Casualty Company was organized in 1967 as a Connecticut insurance corporation. Aetna Life and Casualty Company and its subsidiaries (collectively, "Aetna" or the "company") constitute one of the nation's largest insurance/financial services organizations in the United States based on its assets at December 31, 1992. Based on 1992 premium rankings, the company also is one of the nation's largest stock insurers of property-casualty lines and one of the largest writers of group health and managed care products, and group life, annuity and pension products. Although the company offers insurance and financial services products in foreign countries, 90% of its total revenue in 1993 was derived from domestic sources. The company's reportable segments and principal products included in such segments are: Health and Life Insurance and Services: Group life Group health and disability Managed health care Individual life Financial Services: Group pensions and related financial services Individual and group annuities Investment products Commercial Property-Casualty Insurance and Services: Automobile Fidelity and surety Fire and allied lines General liability Marine Multiple peril Professional liability Workers' compensation Personal Property-Casualty: Automobile Homeowners International: Group life, health and disability, and pensions Individual life, health, accident and disability, and annuities Property-casualty Investment products B. Financial Information about Industry Segments Revenue, income (loss) from continuing operations before income taxes, extraordinary item and cumulative effect adjustments, net income (loss), and assets by industry segment are set forth in Note 14 to the Financial Statements which is incorporated by reference from the Annual Report. Revenue and income (loss) from continuing operations before extraordinary item and cumulative effect adjustments attributable to each industry segment are incorporated herein by reference from the Selected Financial Data in the Annual Report. Certain reclassifications have been made to 1992 and 1991 financial information to conform to 1993 presentation. C. Description of Business Segments 1. Health and Life Insurance and Services Principal Products __________________ Group health and life insurance products and services, including managed health care products and services, are marketed through units of the Health and Life Insurance and Services segment ("Health and Life") primarily to employers and employer-sponsored groups. These products and services are provided to employees or other individuals covered under benefit plans sponsored by those organizations. Individual life insurance products also are included in Health and Life. Group life insurance consists chiefly of renewable term coverage, the amounts of which frequently are linked to individual employee wage levels. The company also offers group universal life and sponsored universal and whole life products. Group health and disability insurance includes coverage for medical and dental care expenses and for disabled employees' income replacement benefits. Health coverage is provided under both traditional indemnity and prepaid arrangements, whereby Aetna assumes the full insurance risk, and under alternative risk- sharing plans, whereby employers assume all or a significant portion of the insurance risk. Health and Life also provides administrative and claim services and, in many cases, partial insurance protection, for an appropriate fee or premium charge. Continuing concern over the rising costs of health care and the need for quality assurance have resulted in a continuation of a market shift away from traditional forms of health benefit coverage to a variety of "managed care" products. Managed care products, which may be sold on a stand-alone basis or in combination with traditional indemnity products, vary from traditional indemnity products primarily through the use of health care networks (physicians and hospitals) and the implementation of medical management procedures designed to enhance the quality and reduce the cost of medical services provided. Such procedures, including contracted physician reimbursement rates and required pre-authorization for certain medical procedures, are designed to enable managed care companies and their customers to control medical costs more effectively. The company offers a broad spectrum of traditional indemnity and managed care group products. The latter include preferred provider organizations ("PPOs"), which offer enhanced coverage benefits for services received from participating providers; point-of-service ("POS") plans, which typically combine PPO-style benefit designs with stronger utilization management; and health maintenance organizations ("HMOs"), which arrange for non-emergency services exclusively through the HMO's network of providers. The company's HMOs are primarily Individual Practice Associations in which the HMO generally shares some financial risk with the physicians based on medical utilization results. At year-end 1993, Aetna operated various types of managed care networks in approximately 211 Standard Metropolitan Statistical Areas with enrollment of approximately 5 million. The number of members covered under all arrangements, including traditional health plans, was 15 million at December 31, 1993. Health and Life units continue to develop a wide range of products and services tailored to help employers manage their employee benefit plan costs effectively. Through its individual life unit, the company markets a variety of universal life, interest-sensitive whole life and term products. Aetna's universal life product accounted for approximately 86% of individual life sales in 1993. Life insurance agents are typically paid a renewal commission or service fee to encourage them to retain business. The company's universal and interest-sensitive whole life insurance contracts typically impose a surrender penalty on policyholder balances withdrawn in the first 10 to 15 years of the contract life. The period of time and level of the penalty vary by product. In addition, more favorable credited rates and policy loan terms may be offered after policies have been in force more than 10 years. Certain of the company's life insurance and annuity products allow for customers to borrow against their policies. At December 31, 1993, approximately 17% of outstanding policy loans were on individual annuity policies and had fixed interest rates ranging from 1% to 3%. Approximately 79% of outstanding policy loans at December 31, 1993 were on individual life policies and had fixed interest rates ranging from 5% to 8%. The remaining 4% of outstanding policy loans had variable interest rates averaging 8% at December 31, 1993. Investment income on outstanding policy loans was $24 million for the year ended December 31, 1993. The company ceased selling individual health insurance products in mid-1990 and transferred this business to another company in 1991. The following table summarizes group life, group health and disability, and individual life and health premiums for the years indicated: Competition ___________ The markets for Health and Life products are highly competitive. In addition to competition among insurance companies, competition in the health field arises from organizations such as Blue Cross and Blue Shield, from various specialty service providers, from local and regional HMOs and other types of medical and dental provider organizations, from integrated health care delivery organizations and, in certain coverages, from the federal and state governments. Additionally, in recent years, many large employers have moved to totally self-insured and self-administered benefit plans. Competition largely is based upon product features and prices and, in the case of managed health care products, upon the quality of services provided, the geographic scope of the provider networks and the medical specialties available in such networks. Based on 1992 written premiums, Aetna is one of the largest insurance company providers of group health and life benefits in the United States. Method of Distribution ______________________ Group products are sold principally through salaried field representatives and home office marketing personnel who often work with independent consultants and brokers who assist in the production and servicing of business. Individual life insurance products are marketed primarily by independent agents and brokers who also may sell insurance products for other companies. Certain life insurance products are sold by agents and brokers who are registered representatives of selected broker-dealers. Reserves ________ For group life products, policy reserve liabilities are established as premiums are received to reflect the present value of expected future obligations net of the present value of expected future premiums. Reserves for most of these products reflect retrospective experience rating except for the smaller group insurance cases which currently are not retrospectively experience rated. Policy reserves for group paid-up life insurance generally reflect long-term fixed obligations and are computed on the basis of assumed or guaranteed yield and benefit payments. Assumptions are based on Aetna's experience, which is periodically reviewed against published industry data. For group health products, reserves reflect estimates of the ultimate cost of claims including (i) claims that have been reported but not settled, and (ii) claims that have been incurred but have not yet been reported. Group health and life claim reserves are based on factors derived from past experience. Reserves for universal life products are equal to cumulative premiums less charges plus credited interest thereon. Reserves for all other fixed individual life and health contracts are computed on the basis of assumed investment yield, mortality, morbidity and expenses (including a margin for adverse deviation), which generally vary by plan, year of issue and policy duration. Reserve interest rates as of December 31, 1993 ranged from 2.25% to 11.25%. Investment yield is based on the company's experience. Mortality, morbidity and withdrawal rate assumptions also are based on the experience of the company, and in addition, are periodically reviewed against both industry standards and experience. Reinsurance ___________ Aetna utilizes a variety of reinsurance agreements with non- affiliated insurers to share insurance risks on group health and life business as directed by the insured and to control its exposure to large losses. Generally, these agreements are established on a case-by-case basis to reflect the circumstances of specific group insurance risks. The company retains no more than $10.0 million of risk per individual life policy. Amounts in excess of the retention limit are reinsured with unaffiliated companies. For additional information on reinsurance, see Note 15 of Notes to Financial Statements in the Annual Report. Group Life Insurance In Force and Other Statistical Data ________________________________________________________ The following table summarizes changes in group life insurance in force before deductions for reinsurance ceded to other companies for the years indicated: Individual Life Insurance In Force and Other Statistical Data _____________________________________________________________ The following table summarizes changes in individual life insurance in force before deductions for reinsurance ceded to other companies for the years indicated(1): 2. Financial Services Principal Products __________________ Business units in the Financial Services segment ("Financial Services") market a variety of retirement and other savings and investment products (including pension and annuity products) and services to businesses, government units, associations, collectively bargained welfare trusts, hospitals, educational institutions and individuals. Financial Services units offer pension, annuity and other investment products to employers and individuals for retirement and savings plan funding and disbursement. Some of these products provide a variety of investment guarantees, funding and benefit payment distribution options and other services. (For additional information regarding the products offered by Financial Services, see Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") - Financial Services in the Annual Report). In January 1994, the company announced its decision to discontinue the sale of its fully guaranteed large case pension products and recorded an $825 million after-tax charge in 1993 for the anticipated future losses on such products. The company will honor all obligations under existing fully guaranteed, large case pension contracts. Such obligations are expected to run off over approximately 30 years. (For additional information, see MD&A - Financial Services in the Annual Report.) Individual annuity contracts typically impose a surrender penalty on policyholder balances withdrawn in the first 10 years of the contract life. The period of time and level of the penalty vary by product. Existing tax penalties on annuity distributions prior to age 59-1/2 provide an additional disincentive to premature surrenders of annuity balances. The majority of those products which utilize Separate Accounts provide contractholders with a vehicle for investments under which the contractholders assume the investment risks as well as the benefit of favorable performance. Separate Accounts offered include accounts that invest in real estate, mortgages, international investments, mutual funds, and a variety of other equity and fixed income investments. Aetna earns a management fee on these Separate Accounts or on the mutual funds in which certain of the Separate Accounts invest. Various investment advisory services also are offered through a number of wholly owned subsidiaries that are registered investment advisors. At December 31, assets under management, including Separate Accounts, were $67.1 billion in 1993, $61.8 billion in 1992, $60.7 billion in 1991, $57.7 billion in 1990, and $53.7 billion in 1989. The following table summarizes pension and annuity premiums for the years indicated: Deposits, which are not included in premiums or revenue under Financial Accounting Standard No. 97 ("FAS 97"), are shown in the following table for the years indicated: Competition ___________ In the pension and annuity markets, competition arises from other insurance companies, banks, bank trust departments, mutual funds and other investment managers. Principal competitive factors are cost, service, level of investment performance and the perceived financial strength of the investment manager. (For additional information, see MD&A - Liquidity and Capital Resources in the 1993 Annual Report.) Measured by assets under management at December 31, 1992, Aetna is the 19th largest manager of pension assets in the United States. Method of Distribution ______________________ Group pension products are sold principally through salaried field representatives and home office marketing personnel, who often work with independent consultants and brokers who assist in the production and servicing of business. Annuity products are distributed primarily through dedicated annuity agents selling only Aetna annuity products. Reserves ________ The loss on discontinuance of fully guaranteed large case pension products ($825 million as of the December 31, 1993 measurement date) represents the present value of anticipated net cash flow shortfalls as the liabilities are run off. Such net cash flow shortfalls include anticipated losses from negative interest margins (i.e., the amount by which interest credited to holders of such contracts exceeds interest earned on investment assets supporting the contracts), future capital losses, and operating expenses and other costs expected to be incurred as the liabilities are run off. In addition to the reserve described above, the company maintains reserves for guaranteed investment contracts equal to the amount on deposit for such contracts plus credited interest thereon. Reserves for annuity contracts reflect the present value of benefits based on actuarial assumptions established at the time of contract purchase. Such assumptions are based on Aetna's experience, which is periodically reviewed against published industry data. Reserves for experience rated contracts reflect cumulative deposits, less withdrawals and charges, plus credited interest thereon, less net realized capital gains/losses (which the company seeks to recover through credited rates). 3. Commercial Property-Casualty Insurance and Services Principal Products __________________ The business units in the Commercial Property-Casualty Insurance and Services segment ("Commercial Property-Casualty") provide most types of property-casualty insurance, bonds, and insurance-related services for businesses, government units and associations. Commercial coverages accounted for 67% of Aetna's 1993 property- casualty net written premiums. These coverages are sold for risks of all sizes and include fire and allied lines, multiple peril, marine, workers' compensation, general liability (including product liability), commercial automobile, certain professional liability, and fidelity and surety bonds. In addition, Aetna offers various services to businesses that choose to self-insure certain exposures. Aetna also reinsures various property and liability risks, primarily through agreements with non-affiliated insurers, on both a treaty and facultative basis. Approximately 82% of Aetna's 1993 commercial business was voluntary. The remainder was written by various assigned risk plans, facilities and pools of which Aetna is a member. These organizations are formed to meet statutory requirements relating to the writing of certain types of commercial risk or to spread particularly large loss exposures among insurers pursuant to a prearranged allocation formula. Participation is mandatory, and underwriting decisions are made by such facilities independent of their membership. For a significant portion of the commercial property-casualty business, Aetna uses advisory or compulsory rate structures and, in some instances, forms that were developed by agencies and bureaus in which insurance companies are authorized to participate through state regulation. However, in recent years, Aetna has emphasized the development of independent coverages designed for sale to specific market segments. The following table sets forth the premium revenue, underwriting results and net investment income, fees and other income and net realized capital gains of Commercial Property-Casualty for the years indicated: Property-casualty underwriting profitability generally is expressed in terms of combined ratios. When the combined ratio is under 100%, underwriting results are considered profitable; when the ratio is over 100%, underwriting results are considered unprofitable. The combined ratio is the sum of (i) the percentage of earned premiums that is paid or reserved for losses and related loss adjustment expenses (the "loss ratio"), (ii) the percentage of earned premiums that is paid or reserved for dividends to policyholders, and (iii) the percentage of written premiums that is paid or reserved for sales commissions, premium taxes, administrative and other underwriting expenses (the "expense ratio"). The combined ratio does not reflect net investment income, fees and other income, net realized capital gains/losses or federal income taxes. The statutory combined ratio does not reflect adjustments to underwriting results in accordance with GAAP. Adjusted underwriting income/loss reflects GAAP adjustments (primarily deferred policy acquisition costs and pre-1992 salvage and subrogation) to underwriting results. The following table sets forth for major domestic Commercial Property-Casualty coverages for the years indicated (a) the percentage of Commercial Property-Casualty statutory net written premiums (NWP) and (b) statutory combined ratios before policyholders' dividends: PERCENTAGE DISTRIBUTION OF STATUTORY NET WRITTEN PREMIUMS AND COMBINED RATIOS The following table summarizes Commercial Property-Casualty statutory net written premiums for the years indicated: The following table sets forth Aetna's percentage distributions of Commercial Property-Casualty direct written premiums in various jurisdictions for the years indicated: GEOGRAPHIC DISTRIBUTION OF DIRECT WRITTEN PREMIUMS Competition ___________ Commercial property-casualty insurance is highly competitive in the areas of price, service and agent relationships. There are approximately 3,900 property-casualty insurance companies in the United States. Approximately 900 of these operate in all or most states and write the vast majority of the business. In addition, an increasing amount of commercial risks are covered by purchaser self-insurance, risk-purchasing groups, risk-retention groups and captive companies. Based on 1992 written premiums, Aetna is one of the largest underwriters of commercial property-casualty coverages in the United States. Method of Distribution ______________________ Aetna's commercial property-casualty coverages are sold through approximately 4,400 independent agents and brokers supervised and serviced by 41 field offices. Reserves ________ See Reserves Related to Property-Casualty Operations on pages 18 through 21. Reinsurance ___________ Approximately one-half of the property-casualty reinsurance ceded by Aetna arises in connection with its servicing relationships with various pools (frequently involuntary pools). Aetna services or writes a portion of the pool's individual policies, handling all premium and loss transactions. These "service" premiums and losses are then 100% ceded (net of an expense reimbursement) to the pools, whose members are jointly liable to Aetna as a servicer. In addition to the above, Aetna utilizes a variety of reinsurance agreements, primarily with non-affiliated insurers, to control its exposure to large property-casualty losses. These agreements, most of which are renegotiated annually as to coverage, limits and price, are structured either on a treaty basis (where all risks meeting prescribed criteria are automatically covered) or on a facultative basis (where the circumstances of specific individual insurance risks are reflected). The amount of risk retained by Aetna depends on the underwriter's evaluation of the specific account, subject to maximum limits based on risk characteristics and the type of coverage. The principal catastrophe reinsurance agreement currently in force covers approximately 81% of specified property losses between $150 million and $325 million. For additional information on reinsurance, see MD&A - Property- Casualty Reserves and Note 15 of Notes to Financial Statements in the Annual Report. Aetna has internal property-casualty reinsurance arrangements under which the risks and premiums of virtually all coverages written by the company's property-casualty subsidiaries are redistributed among those subsidiaries on a percentage basis. The percentages are adjusted from time to time to reflect the relative underwriting capacities and other capital needs of participants in the reinsurance agreement. 4. Personal Property-Casualty Principal Products __________________ The business units in the Personal Property-Casualty segment ("Personal Property-Casualty") provide primarily personal automobile insurance and homeowners insurance. Personal coverages accounted for 33% of Aetna's 1993 property-casualty net written premiums. The following table sets forth the premium revenue, underwriting results and net investment income, other income and net realized capital gains/losses of the personal property-casualty operations for the years indicated: Approximately 86% of Aetna's 1993 personal property-casualty business was voluntary. The remainder was written by various assigned risk plans, facilities and pools of which Aetna is a member. These organizations are formed to meet statutory requirements relating to certain types of property-casualty risk or to spread particularly large loss exposures among insurers pursuant to prearranged allocation formulas. Participation is mandatory, and underwriting decisions are made by such facilities independent of their membership. The following table sets forth for major personal property- casualty coverages for the years indicated (a) the percentage of total personal property-casualty statutory net written premiums (NWP) and (b) the statutory combined ratios: The following table summarizes personal property-casualty statutory net written premiums for the years indicated: The following table sets forth Aetna's percentage distributions of Personal Property-Casualty direct written premiums in various jurisdictions for the years indicated: Reserves ________ See Reserves Related to Property-Casualty Operations on pages 18 through 21. Competition ___________ Personal property-casualty insurance is highly competitive in the areas of price, service, agent relationships and method of distribution (i.e., use of independent agents, captive agents and/or employees). Currently, there are over 2,400 property- casualty companies in the United States that offer one or more individual products similar to those marketed by Aetna. Measured by 1992 premium volume, Aetna is the 11th largest underwriter of personal property-casualty products in the United States. State Farm and Allstate have significant market share in the personal property-casualty market. Method of Distribution ______________________ Aetna's personal property-casualty products are marketed by independent agents and brokers who may sell insurance products for other companies. Reinsurance ___________ See Reinsurance on page 15. 5. Reserves Related to Property-Casualty Operations Aetna establishes reserve liabilities designed to reflect estimates of the ultimate cost of claims (including claim adjustment expenses). Such liabilities for workers' compensation life table indemnity claims are discounted. Estimating the ultimate cost of claims is a complex and uncertain process that relies on actuarial and statistical methods of analysis. The company's reserves include: (i) claims that have been reported but not settled ("case" reserves), and (ii) claim costs that have been incurred but have not yet been reported ("IBNR" reserves). The establishment of case reserves is dependent upon, among other things, the extent to which coverage was provided, the extent of injury or damage, and, in the case of a contested claim, an estimate of the likely outcome of the adjudication process (to the extent such outcome is estimable). IBNR reserves, established to reflect events and occurrences that are not known to the company but, based on actuarial and historical data (adjusted for the effects of current social, economic and legal developments, trends and factors), are likely to result in claims, also include provision for development on case reserves. As claims are reported and valued by the company, IBNR reserves are reduced by the amount of the reported claim cost. IBNR reserves also are adjusted as the estimates of losses for a given accident year develop. The length of time for which the cost of claims must be estimated varies depending on the coverage and type of claim involved. Estimates become more difficult to make (and are therefore more subject to change) as the length of time increases. Actual claim costs are dependent upon a number of complex factors including social and economic trends and changes in doctrines of legal liability and damage awards. Reserves for property-casualty coverage are recomputed periodically using a variety of actuarial and statistical techniques for producing current estimates of actual claim costs, claim frequency, and other economic and social factors. A provision for inflation in the calculation of estimated future claim costs is implicit since reliance is placed on both actual historical data that reflect past inflation and on other factors which are judged to be appropriate modifiers of past experience. Adjustments to reserves are reflected in the net income of the period in which such adjustments are made. Aetna also establishes unearned premium reserves that are calculated on a pro rata basis and reserves for additional premiums or refunds on retrospectively rated policies based on experience. This means that when a loss which will produce an additional premium payment is incurred on a retrospectively rated policy, the premium is recorded at the same time. Likewise when loss experience is favorable, reserves for premium refunds are established. During the fourth quarter of 1993, the company added $574 million (pretax, before discount) to prior accident year loss reserves for workers' compensation claims. This increase resulted from a recently completed study of the company's workers' compensation reserves which indicated that workers' compensation claims have a longer duration than previously estimated. Concurrent with the addition to workers' compensation reserves, the company implemented a change in accounting to discount reserves for workers' compensation life table indemnity claims consistent with industry practice. This discounting resulted in a reduction of $634 million (pretax) to loss reserves for workers' compensation claims in 1993. For additional information on property-casualty reserves, including reserves for asbestos and environmental-related claims, see MD&A-Property Casualty Reserves in the Annual Report. The following represents changes in aggregate reserves, net of reinsurance, for the combined property-casualty experience (1,2): The following table reconciles, as of year end, reserves determined in accordance with accounting principles and practices prescribed or permitted by insurance regulatory authorities ("statutory basis reserves") to reserves determined in accordance with generally accepted accounting principles ("GAAP basis reserves"), net of reinsurance for the combined property-casualty unpaid claims and claim adjustment expense experience (1): The following reserve runoff table represents Aetna's combined property-casualty loss and loss expense experience. Each column shows, for the year indicated: the reserve held at year end; cumulative data for payments made in each subsequent year for that reserve year; liability reestimates made in each subsequent year for that reserve year; the redundancy (deficiency) represented by the difference between the original reserve held at the end of that year and the reestimated liability as of the end of 1993; and the change in redundancy (deficiency) from the end of each reserve year shown to the end of each subsequent reserve year. The majority of increases to prior accident year reserves were for losses and related expenses for asbestos and other product liability risks attributable to policies written prior to 1978 and for workers' compensation claims. The table represents historical data; it would not be appropriate to use such data to project the company's future reserving activity or its future performance generally. 6. International The International segment ("International"), through subsidiaries and joint venture operations, sells primarily life insurance and financial services products in non-U.S. markets including Canada, Malaysia, Taiwan, Chile, Mexico, the United Kingdom, Hong Kong, Korea and New Zealand. International operations are subject to regulation in the various jurisdictions in which they do business. In most of the geographic areas and markets in which International has operations, the competition is extensive. Methods of distribution vary by country and by product, and include direct sales, sales through agents and brokers, and sales through joint ventures. On June 30, 1993, the company completed the sale of its U.K. life and investment management operations. The company realized an after-tax capital loss of $12 million on the sale as well as $37 million of tax benefits from cumulative operating losses of the subsidiary not previously available for tax benefits. The company completed the sale of its 43% interest in La Estrella S.A. de Seguros, a Spanish insurance company, to Banco Hispano Americano in May 1991. The company realized a net capital gain of $33 million (after-tax) on the sale. Operations outside the U.S. have added risks such as nationalization, expropriation, and the potential for restrictive capital regulations. Given the particular countries in which International has operations, and the current size and nature of those operations, management does not believe such risks are material to the company. The following table sets forth International's premium revenue, net investment income, other income and net realized capital gains/losses and life insurance in force, before deductions for reinsurance ceded to other companies: Premium growth in 1992 included $128 million from the second quarter consolidation of a previously unconsolidated subsidiary as a result of an increase in the company's ownership percentage. 7. Investments The investment income and realized capital gains and losses from the investment portfolios of the company's insurance subsidiaries contribute to the results of the insurance operations described above. Investment strategies and portfolios are designed to reflect the liability profiles, competitive requirements and tax characteristics of the company's different products. The distribution of maturities is monitored, and security purchases and sales are executed with the objective of having adequate funds available to satisfy the company's maturing liabilities. The company also utilizes futures and forward contracts and swap agreements in order to manage investment returns and to align maturities, interest rates, currency rates and funds availability with its obligations. See MD&A - Investments in the Annual Report for a further discussion of investments. a. Investments Related to Life, Health, Annuity and Pension Operations Consistent with the nature of the contract obligations involved in the company's group and individual life, health and disability, annuity and pension operations, the majority of the general account assets attributable to such operations have been invested in intermediate and long-term, fixed income obligations such as treasury obligations, mortgage-backed securities, corporate debt securities and mortgage loans. For information concerning the valuation of investments, see Notes 1, 5, and 6 of Notes to Financial Statements in the Annual Report. The following table sets forth the distribution of invested assets, cash and cash equivalents and accrued investment income as of the end of the years indicated (1): Mortgage-backed securities at December 31, 1993, 1992 and 1991 included the following categories of collateralized mortgage obligations (1): The following table summarizes investment results of the company's life, health, annuity and pension operations (1): b. Investments Related to Property-Casualty Operations The investment strategies for assets related to personal and commercial property-casualty operations are designed to maximize yield with appropriate liquidity and preservation of principal, and to permit periodic adjustment of the portfolio mix, in order to reflect changes in underwriting results and thus maximize after-tax income. Common stocks are held with the primary objective of achieving portfolio appreciation through capital gains and income. The size of common stock holdings is controlled in relation to surplus levels. For information concerning the valuation of investments, see Notes 1, 5, and 6 of Notes to Financial Statements in the Annual Report. The following table sets forth the distribution of invested assets, cash and cash equivalents and accrued investment income as of the end of the years indicated (1): Mortgage-backed securities at December 31, 1993, 1992 and 1991 included the following categories of collateralized mortgage obligations (1): The following table summarizes investment results of the company's property-casualty insurance operations (1): 8. Other Matters a. Regulation General Aetna's insurance businesses are subject to comprehensive, detailed regulation throughout the United States and the foreign jurisdictions in which they do business. The laws of the various jurisdictions establish supervisory agencies with broad authority to regulate, among other things, the granting of licenses to transact business, premium rates for certain coverages, trade practices, agent licensing, policy forms, underwriting and claims practices, reserve adequacy, insurer solvency, the maximum interest rates that can be charged on life insurance policy loans, and the minimum rates that must be provided for accumulation of surrender value. Many also regulate investment activities on the basis of quality, distribution and other quantitative criteria. Further, many jurisdictions compel participation in, and regulate composition of, various residual market mechanisms. Aetna's operations and accounts are subject to examination at regular intervals by domestic and other insurance regulators. Although the federal government does not directly regulate the business of insurance, many federal laws do affect that business. Existing or recently proposed federal laws that may significantly affect or would affect, if passed, the insurance business cover such matters as employee benefits (including regulation of federally qualified HMOs), controls on medical care costs, medical entitlement programs (e.g., Medicare), environmental regulation and liability, product liability, civil justice procedural reform, earthquake insurance, removal of barriers preventing banks from engaging in the insurance and mutual fund businesses, repeal of some portions of the McCarran-Ferguson exemption of the business of insurance from federal antitrust laws, the taxation of insurance companies (see Notes 1 and 10 of Notes to Financial Statements in the Annual Report), and the tax treatment of insurance products. Health Care In addition to regulations applicable to insurance companies generally (described above), Aetna's managed health care products are subject to varying levels of state insurance, health maintenance organization ("HMO") and/or health department regulation. Among other things, these regulations address health care network composition, new product offerings, product and benefit contracts and the extent to which insurance companies may provide incentives to insureds to use services from "preferred" health care service providers or pay contractual and non- contractual health care providers unequally for equivalent services. Some jurisdictions also regulate the extent to which managed health care plans may offer their enrollees the option of receiving health care services from non-contracting providers. Additionally, these plans are subject to state, and in some cases federal, regulation concerning solvency and other operational requirements. Both the Clinton Administration and a number of states have proposed significant health care reform legislation. (For additional discussion, see MD&A - Health and Life Insurance and Services in the Annual Report.) Insurance and Insurance Holding Company Laws Several states, including Connecticut, regulate affiliated groups of insurers such as Aetna under insurance holding company statutes. Under such laws, intercorporate asset transfers and dividend payments from insurance subsidiaries may require prior notice to or approval of the insurance regulators, depending on the size of such transfers and payments relative to the financial position of the affiliate making the transfer. These laws also regulate changes in control, as do Connecticut corporate laws (which also apply to insurance corporations). See Note 8 of Notes to Financial Statements in the Annual Report. As a licensed Connecticut-domiciled insurer, the company is subject to Connecticut insurance laws. These laws, among other things, enable insurers to redeem their stock from any shareholder who fails, in the good faith determination of the insurer's board of directors, to (i) meet the qualifications prescribed under Connecticut law for licensure or (ii) to secure the regulatory approvals required under Connecticut law for ownership of such stock. Securities Laws The Securities and Exchange Commission ("SEC") and, to a lesser extent, the states regulate the sales and investment management activities of broker-dealer and investment advisory subsidiaries of the company. The SEC also regulates some of its pension, annuity, life insurance and other investment and retirement products. Additionally, certain Separate Accounts and mutual funds of Aetna Life Insurance and Annuity Company are subject to SEC regulation under the Investment Company Act of 1940. As a stock company, Aetna also is subject to extensive reporting obligations under the Securities Exchange Act of 1934. Property-Casualty Over the past several years, the company's insurance businesses, particularly personal automobile and workers' compensation, have been the target of various regulatory and legislative initiatives that management believes have limited the basis upon which the company conducts its activities. Such initiatives have, among other things, sought to (1) freeze or reduce rates that may be charged for certain insurance products, (2) force the company to issue and renew insurance in markets where the company cannot achieve an acceptable rate of return, and (3) restructure residual or involuntary markets. Residual or involuntary markets are established to provide coverage to insureds unable to obtain policies in the private marketplace. As state-mandated rates are frequently inadequate, these markets are in effect often subsidized by the insurance industry. More recently, attempts have been made to apply these initiatives to the property insurance lines as a means of addressing the availability of property insurance in certain urban and shorefront locations. Insurance Company Guaranty Fund Assessments Under insurance guaranty fund laws existing in all states, insurers doing business in those states can be assessed (up to prescribed limits) for certain obligations of insolvent insurance companies to policyholders and claimants. The after-tax charges to earnings for guaranty fund obligations for the years ended December 31, 1993, 1992 and 1991 were $17 million, $49 million, and $23 million, respectively. The increase in the 1992 provision is principally related to insolvencies of certain large insurance companies. The amounts ultimately assessed may differ from the amounts charged to earnings because such assessments may not be made for several years and will depend upon the final outcome of regulatory proceedings. While the company has historically recovered more than half of guaranty fund assessments through statutorily permitted premium tax offsets and policy surcharges, significant increases in assessments could jeopardize future efforts to recover such assessments. The company has actively supported improved insurer solvency regulation, including measures that would facilitate earlier identification of troubled insurers, and amendments to guaranty fund laws that would reduce the costs of such insolvencies to solvent insurers such as Aetna. Proposition 103 In March 1992, the California Insurance Commissioner ("Commissioner") issued a notice of hearing to the company requiring that it show cause why it should not be ordered to pay refunds with interest pursuant to Proposition 103. Proposition 103 is a voter initiative adopted in November 1988 which requires, among other things, certain premium rollbacks or refunds by insurance companies. The Commissioner alleged that the company's refund obligation was $110 million, plus 10% interest from May 1989 (or $51 million as of December 31, 1993). On January 13, 1994, the company entered into a stipulation with the California Department of Insurance ("Department") under which the company agreed to make refunds of $31 million, including interest, with respect to certain California policies issued or renewed between November 8, 1988 and November 7, 1989. The Department has agreed that this refund constitutes the company's complete and entire rollback and refund obligation. Given applicable reserves, the agreement with the Department will not materially affect the company's earned premium revenue or net income. See MD&A - Regulatory Environment in the Annual Report for additional discussion of regulatory matters. b. NAIC IRIS Ratios The NAIC "IRIS" ratios cover 12 categories of financial data with defined acceptable ranges for each category. The ratios are intended to provide insurance regulators "early warnings" as to when a given company might warrant special attention. An insurance company may fall out of the acceptable range for one or more ratios and such variances may result from specific transactions that are in themselves immaterial or eliminated at the consolidated level. In 1992, two of Aetna Life and Casualty Company's significant subsidiaries had more than two IRIS ratios that were outside of NAIC acceptable ranges, as discussed below. Aetna Life Insurance Company ("ALIC") fell outside acceptable ranges in 1992 for: (i) the Net Change in Capital and Surplus Ratio which is calculated by dividing the change in capital and surplus between the prior and the current year (net of any capital and surplus paid in) by the prior year capital and surplus; (ii) the Adequacy of Investment Income Ratio which compares investment income to credited interest; (iii) the Change in Product Mix Ratio which measures changes in the percentage of total premiums by product line; and (iv) the Change in Reserving Ratio which is designed for an open growing block of business. During 1992, significant capital was contributed by Aetna Life and Casualty Company to ALIC. The regulators were satisfied, after analysis, that ALIC did not warrant special attention. In 1992, The Aetna Casualty and Surety Company ("AC&S") fell outside of acceptable ranges for: (i) the Two-year Overall Operating Ratio, which is a combination of a two-year combined ratio minus a two-year investment income ratio; (ii) the Change in Surplus which measures the improvement or deterioration in a company's financial condition during the year; and (iii) the Ratio of Liabilities to Liquid Assets which measures the liquidity of a company. During 1992, AC&S sold its wholly owned subsidiary, American Re-Insurance Company. Proceeds from this sale were dividended to Aetna Life and Casualty Company. This one-time event caused certain of the ratios described above to fall outside of acceptable ranges. The regulators were satisfied, after analysis, that AC&S did not warrant special attention. Management expects that certain of the company's significant subsidiaries will have more than two IRIS ratios outside of NAIC acceptable ranges for 1993. c. Ratios of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends The following table sets forth Aetna's ratio of earnings to fixed charges and ratio of earnings to combined fixed charges and preferred stock dividends for the years ended December 31: For purposes of computing both the ratio of earnings to fixed charges and the ratio of earnings to combined fixed charges and preferred stock dividends, "earnings" represent consolidated earnings from continuing operations before income taxes, cumulative effect adjustments and extraordinary items plus fixed charges and minority interest. "Fixed charges" consist of interest (and the portion of rental expense deemed representative of the interest factor). Preferred stock dividends, which are not deductible for income tax purposes, have been increased to a taxable equivalent basis. This adjustment has been calculated by using the effective tax rate of the applicable year. All shares of Aetna's preferred stock were redeemed in 1989 and, as a result, for the years ended December 31, 1993, 1992, 1991 and 1990 the ratios of earnings to combined fixed charges and preferred stock dividends were the same as the ratios of earnings to fixed charges. d. Miscellaneous Aetna had approximately 42,600 domestic employees at December 31, 1993. Management believes that the company's computer facilities, systems and related procedures are adequate to meet its business needs. The company's data processing systems and backup and security policies, practices and procedures are regularly evaluated by the company's management and its internal auditors and are modified as considered necessary. Portions of Aetna's insurance business are seasonal in nature. Reported claims under group health and certain property-casualty products are generally higher in the first quarter. Sales, particularly of individual life products, are generally lowest in the first quarter and highest in the fourth quarter. No customer accounted for 10% or more of Aetna's consolidated revenues in 1993. In addition, no segment of Aetna's business is dependent upon a single customer or a few customers, the loss of which would have a significant effect on the segment. See Note 14 of Notes to Financial Statements regarding segment information in the Annual Report. The loss of business from any one, or a few, independent brokers or agents would not have a material adverse effect on the company or any of its segments. In general, the company is not contractually obligated or committed to accept a fixed portion of business submitted by any of its property-casualty agents or brokers. The company generally reviews all of its policy applications, both new and renewal, for approval and acceptance. There are cases where the company has delegated limited underwriting authority to select agents generally for smaller business for specific classes of risks. The risks accepted by the company under these conditions are reviewed by company underwriters. This authority generally can be rescinded at any time at the discretion of the company and without prior notice to the agents. Item 2. Item 2. Properties. The home office of Aetna, owned by Aetna Life Insurance Company, is a building complex located at 151 Farmington Avenue, Hartford, Connecticut, with approximately 1.6 million square feet. The company also owns or leases other space in the greater Hartford area as well as various field locations throughout the country. The company expects to vacate certain of these facilities in 1994 (please see MD&A - Overview in the Annual Report). The foregoing does not include numerous investment properties held by Aetna in its general and separate accounts. Item 3. Item 3. Legal Proceedings. In Re: Stepak v. Aetna Life and Casualty Company et al. On October 22, 1990, a shareholder filed a lawsuit in United States District Court for the District of Connecticut ("District Court"). The suit, which was filed on behalf of a class of company shareholders, named as defendants Aetna Life and Casualty Company ("Aetna") and certain present and former Aetna officers and directors. The suit alleges that the defendants fraudulently and in violation of federal securities laws failed, among other things, to adequately disclose alleged deterioration in the value of mortgage loan and real estate investment portfolios and that the plaintiff, acting in reliance upon such allegedly misleading public statements, purchased Aetna common stock at artificially inflated prices. The suit seeks certification of the class and unspecified compensatory and punitive damages. In November 1990, the plaintiff filed an amended complaint. The defendants moved to have the amended complaint dismissed. The plaintiff subsequently filed a second amended complaint, and in August 1991 the District Court denied the defendants' motion to dismiss this complaint. In the interim, the plaintiff dropped all but two of the original individual defendants. Subsequently, a class was conditionally certified composed of purchasers of Aetna common stock during the period from February 16, 1989 through November 13, 1990, with some exceptions. Aetna has answered the complaint, denying all substantive averments, and discovery is substantially complete. Aetna believes that the suit is neither supported as a matter of fact nor as a matter of law and, with the other defendants, will continue to contest vigorously the litigation. In Re: Standard Financial Indemnity Corporation et al. v. The Aetna Casualty and Surety Company et al. In 1989, the Standard Financial Indemnity Corporation ("SFIC") filed an antitrust suit in Texas state court against The Aetna Casualty and Surety Company ("Aetna Casualty") and all other insurers acting as servicing carriers for the Texas workers' compensation assigned risk pool (collectively, "defendants"). The complaint alleged that the plaintiff's application to become a servicing carrier had been wrongfully denied pursuant to a conspiracy among the servicing carriers. In February 1990, Preferred Employers' Insurance Company ("Preferred") joined the suit as a plaintiff and made an additional claim alleging that the servicing carriers had intentionally overpaid claims in order to raise prices and to drive workers' compensation customers into the assigned risk pool. The defendants' motion to dismiss the original suit brought by SFIC, which Preferred had later joined as a plaintiff, was granted in March 1990. SFIC appealed this ruling and on May 19, 1993, the Court of Appeal, Third District of Texas ("Court of Appeal") reversed and remanded the matter to the trial court. Preferred did not appeal the initial dismissal of the original suit and, therefore, is no longer a party to the litigation. On March 12, 1992, the Texas Commissioner of Insurance placed SFIC into receivership. On August 25, 1993, the Court of Appeal denied defendant's motion for rehearing. On September 24, 1993, defendants filed an application for writ of error with the Supreme Court of Texas. A settlement for an amount not material to the company has been reached with SFIC's receiver and has become final. In Re: Attorneys General Antitrust Litigation The description of this litigation is contained in Note 16 of Notes to Financial Statements in the Annual Report and is incorporated herein by reference. Other Litigation Aetna is continuously involved in numerous other lawsuits arising, for the most part, in the ordinary course of its business operations either as a liability insurer defending third-party claims brought against its insureds or as an insurer defending coverage claims brought against itself, including lawsuits related to issues of policy coverage and judicial interpretation. One such area of coverage litigation involves legal liability for asbestos and environmental-related claims. These lawsuits and other factors make reserving for asbestos and environmental-related claims subject to significant uncertainties. See MD&A - Property-Casualty Reserves in the Annual Report. While the ultimate outcome of the litigation described herein cannot be determined at this time, management does not believe it likely that such litigation, net of reserves established therefor and giving effect to reinsurance, will result in judgments for amounts material to the financial condition of the company, although it may affect results of operations in future periods. Litigation related to asbestos and environmental claims is subject to significant uncertainties; therefore management is unable to determine whether the effects on operations in future periods will be material. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. EXECUTIVE OFFICERS OF AETNA LIFE AND CASUALTY COMPANY* The Chairman of Aetna Life and Casualty Company is elected and all other executive officers listed below are appointed by the Board of Directors of the company at its Annual Meeting each year to hold office until the next Annual Meeting of the Board or until their successors are elected or appointed. None of these officers have family relationships with any other executive officer or Director. (1) Mr. Compton has served as Chairman since March 1, 1992. He is also President, a position he has held since July 1988. (2) Ms. Baird has served in her current position since April 1992. From July 1990 to April 1992 she served as Vice President and General Counsel. From 1986 to July 1990 she was with General Electric Company, Fairfield, Connecticut, most recently as Counselor and Staff Executive. (3) Mr. Benanav has served in his current position since December 1993. From April 1992 to December 1993 he served as Group Executive responsible for International, individual life insurance, annuities, mutual funds, and small case pensions. From April 1990 through April 1992, he served as Senior Vice President, International Insurance. From August 1989 until April 1990, he served as Vice President, International Insurance Division. From June 1986 to August 1989 he served as Vice President - Finance and Treasurer. (4) Ms. Champlin has served in her current position since November 1992. From February 1991 through November 1992 she served as Vice President, Aetna Human Resources. From June 1989 through January 1991 she served as Assistant Vice President, Corporate Management, Office of the Chairman. From August 1988 to May 1989 she served as Director, Corporate Management, Office of the Chairman. (5) Mr. Kearney has served in his current position since December 1993. From February 1991 to December 1993 he served as Group Executive responsible for investments and large case pensions. From 1990 to February 1991 he served as the principal of Daniel P. Kearney, Inc. From 1989 to 1990 he served as President and Chief Executive Officer of the Oversight Board of the Resolution Trust Corporation. From 1988 to 1989 he served as a principal of Aldrich, Eastman and Waltch, Inc. (a pension fund advisor). (6) Mr. Kenny has served in his current position since March 1992. From January 1988 through February 1992, he served as Senior Vice President, Finance. (7) Ms. Krupnick has served in her current position since November 1992. From October 1989 through November 1992, she served as Vice President, Corporate Affairs. From January 1988 to October 1989 she served as Assistant Vice President, Corporate Affairs. (8) Mr. McLane has served in his current position since December 1993. From April 1992 to December 1993, he served as Group Executive responsible for group health and life insurance including managed care operations. From February 1991 through April 1992 he served as Chief Executive Officer, Aetna Health Plans; from 1985 through 1991 he served as Senior Vice President, Global Insurance Division, Citicorp. (9) Mr. McMurtry has served in his current position since November 1992. From February 1989 through November 1992 he served as Staff Director and Chief Counsel, Committee on Finance, United States Senate. From January 1986 through February 1989 he served as Legislative Director for Lloyd M. Bentsen Jr., United States Senate. (10) Mr. Broatch has served in his current position since December 1993. From May 1988 to December 1993, he served as Vice President and Corporate Controller. (11) Mr. Loewenberg has served in his current position since March 1989. From September 1987 to March 1989 he served as Senior Vice President and Chief Administrative Officer, Agency Group, Capital Holding Corporation. (12) Mr. Scott has served in his current position since November 1991. From April 1991 until November 1991, he served as Vice President, Standard Commercial Accounts. From October 1988 through April 1991, he served as Senior Vice President, Standard Markets Department, Commercial Insurance Division. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Aetna Life and Casualty Company's common stock is listed on the New York and Pacific Stock Exchanges, with unlisted trading privileges on other regional exchanges. Its symbol is AET. The common stock also is listed on the Swiss Stock Exchanges at Basel, Geneva and Zurich. Call and put options on the common stock are traded on the American Stock Exchange. As of February 25, 1994, there were 27,452 record holders of the common stock. The dividends declared and the high and low sales prices with respect to Aetna Life and Casualty Company's common stock for each quarterly period for the past two years are incorporated herein by reference from "Quarterly Data" in the Annual Report. Information regarding restrictions on the company's present and future ability to pay dividends is incorporated herein by reference from Note 8 of Notes to Financial Statements in the Annual Report. Item 6. Item 6. Selected Financial Data. The information contained in "Selected Financial Data" in the Annual Report is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The 1993 Consolidated Financial Statements and the report of the registrant's independent auditors and the unaudited information set forth under the caption "Quarterly Data" is incorporated herein by reference to the 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 the Registrant. Information concerning Executive Officers is included in Part I pursuant to General Instruction G to Form 10-K. Information concerning Directors and concerning compliance with Section 16 (a) of the Securities Exchange Act of 1934 is incorporated herein by reference to the Proxy Statement. Item 11. Item 11. Executive Compensation. The information under the caption "Executive Compensation" is incorporated herein by reference to the Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information under the caption "Security Ownership of Certain Beneficial Owners, Directors, Nominees and Executive Officers" is incorporated herein by reference to the Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. The information under the caption "Certain Transactions and Relationships" is incorporated herein by reference to the Proxy Statement. 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 Consolidated Financial Statements and the report of the registrant's independent auditors are incorporated herein by reference to the Annual Report. 2. Financial statement schedules: The supporting schedules of the consolidated entity are included in this Item 14. See Index to Financial Statement Schedules on page 41. 3. Exhibits: * (3) Articles of Incorporation and By-Laws. Certificate of Incorporation of Aetna Life and Casualty Company, incorporated herein by reference to the registrant's 1992 Form 10-K, filed on March 17, 1993. By-Laws of Aetna Life and Casualty Company. (4) Instruments defining the rights of security holders, including indentures. Conformed copy of Indenture, dated as of October 15, 1977 between Aetna Life and Casualty Company and Morgan Guaranty Trust Company of New York, Trustee, incorporated herein by reference to the registrant's 1992 Form 10-K, filed on March 17, 1993 (the "1992 Form 10-K"). Conformed copy of Indenture, dated as of October 15, 1986 between Aetna Life and Casualty Company and The First National Bank of Boston, Trustee, incorporated herein by reference to the 1992 Form 10-K. Conformed copy of Indenture, dated as of August 1, 1993, between Aetna Life and Casualty Company and State Street Bank and Trust Company of Connecticut, National Association, as Trustee, incorporated herein by reference to the registrant's Registration Statement on Form S-3 (File No. 33-50427). Rights Agreement dated as of October 27, 1989, between Aetna Life and Casualty Company and First Chicago Trust Company of New York incorporated herein by reference to the 1992 Form 10-K. Summary of Rights to Purchase Preferred Stock, incorporated herein by reference to the 1992 Form 10-K. (10) Material contracts. The 1984 and 1979 Stock Option Plans of Aetna Life and Casualty Company and amendments thereto, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's Supplemental Incentive Savings Plan, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's Supplemental Pension Benefit Plan, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's Performance Unit Plan, incorporated herein by reference to the 1992 Form 10-K. Aetna Life and Casualty Company's 1986 Management Incentive Plan, as amended effective February 25, 1994. The Aetna Life and Casualty Directors' Deferred Compensation Plan, incorporated herein by reference to the 1992 Form 10-K. Letter Agreement, dated December 18, 1993, between Aetna Life and Casualty Company and David A. Kocher. Aetna Life and Casualty Company Non-Employee Director Deferred Stock Plan, incorporated herein by reference to the 1992 Form 10-K. Description of certain arrangements not embodied in formal documents, as described with respect to Directors' fees and benefits, and under the caption "Executive Compensation," are incorporated herein by reference to the Proxy Statement. (11) Statement re computation of per share earnings. Incorporated herein by reference to Note 1 of Notes to Financial Statements in the company's 1993 Annual Report. (12) Statement re computation of ratios. Statement re: computation of ratio of earnings to fixed charges. Statement re: computation of ratio of earnings to combined fixed charges and preferred stock dividends. (13) Annual Report to security holders. Selected Financial Data, Management's Discussion and Analysis of Financial Condition and Results of Operations, Consolidated Financial Statements and the report of the registrant's independent auditors, and unaudited Quarterly Data from the Annual Report. (18) Letter re change in accounting principles Letter from Independent Auditors regarding the preferability of the change in accounting principle for reporting reserves for workers' compensation life table indemnity claims to a discounted basis. (21) Subsidiaries of the registrant. A listing of subsidiaries of Aetna Life and Casualty Company. (23) Consents of experts and counsel. Consent of Independent Auditors to Incorporation by Reference in the Registration Statements on Form S-3 and Form S-8. (28) Information from Reports Furnished to State Insurance Regulatory Authorities. 1993 Consolidated Schedule P of Annual Statements provided to state regulatory authorities. ** (b) Reports on Form 8-K None. * Exhibits other than those listed are omitted because they are not required or are not applicable. Copies of exhibits are available without charge by writing to the Office of the Corporate Secretary, Aetna Life and Casualty Company, 151 Farmington Avenue, Hartford, Connecticut 06156. ** Filed under cover of Form SE. INDEX TO FINANCIAL STATEMENT SCHEDULES AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES Page ____ Independent Auditors' Report........................ 42 I Summary of Investments - Other than Investments in Affiliates as of December 31, 1993.......................... 43 III Condensed Financial Information of the Registrant as of December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991........................... 44 V Supplementary Insurance Information as of and for the years ended December 31, 1993, 1992 and 1991................................. 50 VIII Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991...................................... 53 IX Short-term Borrowings for the years ended December 31, 1993, 1992 and 1991.............. 54 X Supplemental Information Concerning Property-Casualty Operations for the years ended December 31, 1993, 1992 and 1991........ 55 Schedules other than those listed above are omitted because they are not required or are not applicable, or the required information is shown in the Financial Statements or Notes thereto in the company's 1993 Annual Report. Columns omitted from schedules filed have been omitted because the information is not applicable. Certain reclassifications have been made to 1992 and 1991 financial information to conform to 1993 presentation. INDEPENDENT AUDITORS' REPORT The Shareholders and Board of Directors Aetna Life and Casualty Company: Under date of February 8, 1994, we reported on the consolidated balance sheets of Aetna Life and Casualty Company 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 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 1 to the consolidated financial statements, in 1993 the company changed its methods of accounting for certain investments in debt and equity securities, reinsurance of short-duration and long-duration contracts, postemployment benefits, workers' compensation life table indemnity reserves and retrospectively rated reinsurance contracts. In 1992, the company changed its methods of accounting for income taxes and postretirement benefits other than pensions. By KPMG PEAT MARWICK _____________________ (Signature) KPMG PEAT MARWICK Hartford, Connecticut February 8, 1994 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE I Summary of Investments - Other than Investments in Affiliates As of December 31, 1993 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Statements of Income AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Balance Sheets AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Statements of Shareholders' Equity AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Statements of Cash Flows AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Notes to Condensed Financial Statements The accompanying condensed financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto in the company's 1993 Annual Report. Certain reclassifications have been made to 1992 and 1991 financial information to conform to 1993 presentation. 1. Long-Term Debt See Note 9 to the Consolidated Financial Statements in the Annual Report for a description of the long-term debt and aggregate maturities for 1994 to 1998 and thereafter. 2. Dividends The amounts of cash dividends paid to Aetna Life and Casualty Company by insurance affiliates for the years ended December 31, 1993, 1992 and 1991 were as follows: See Note 8 to the Consolidated Financial Statements in the Annual Report for a description of dividend restrictions from the consolidated insurance subsidiaries to the company. AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE III Condensed Financial Information AETNA LIFE AND CASUALTY COMPANY Notes to Condensed Financial Statements (Continued) 3. Accounting Changes See Note 1 to the Consolidated Financial Statements in the Annual Report for a description of accounting changes. 4. Discontinued Products See Note 2 to the Consolidated Financial Statements in the Annual Report for a description of discontinued products. 5. Sales of Subsidiaries See Note 3 to the Consolidated Financial Statements in the Annual Report for a description of the sales of subsidiaries. 6. Severance and Facilities Charge See Note 4 to the Consolidated Financial Statements in the Annual Report for a description of the severance and facilities charges. 7. Federal and Foreign Income Taxes See Note 10 to the Consolidated Financial Statements in the Annual Report for a description of federal and foreign income taxes. 8. Litigation See Note 16 to the Consolidated Financial Statements in the Annual Report for a description of the Attorneys General Antitrust litigation. AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE V Supplementary Insurance Information As of and for the year ended December 31, 1993 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE V Supplementary Insurance Information As of and for the year ended December 31, 1992 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE V Supplementary Insurance Information As of and for the year ended December 31, 1991 AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE VIII Valuation and Qualifying Accounts and Reserves AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE IX Short-Term Borrowings AETNA LIFE AND CASUALTY COMPANY AND SUBSIDIARIES SCHEDULE X Supplemental Information Concerning Property-Casualty Operations 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 18, 1994 AETNA LIFE AND CASUALTY COMPANY (Registrant) By ROBERT E. BROATCH ______________________________ (Signature) Robert E. Broatch Senior Vice President, Finance and 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 indicated on March 18, 1994. Signature Title RONALD E. COMPTON ________________________ Ronald E. Compton Chairman, President and Director (Principal Executive Officer) WALLACE BARNES ________________________ Wallace Barnes Director JOHN F. DONAHUE ________________________ John F. Donahue Director WILLIAM H. DONALDSON ________________________ William H. Donaldson Director BARBARA HACKMAN FRANKLIN ________________________ Barbara Hackman Franklin Director EARL G. GRAVES ________________________ Earl G. Graves Director GERALD GREENWALD ________________________ Gerald Greenwald Director MICHAEL H. JORDAN ________________________ Michael H. Jordan Director JACK D. KUEHLER ________________________ Jack D. Kuehler Director FRANK R. O'KEEFE JR. ________________________ Frank R. O'Keefe Jr. Director DAVID M. RODERICK ________________________ David M. Roderick Director PATRICK W. KENNY ________________________ Patrick W. Kenny Group Executive, Finance and Administration (Principal Financial Officer)

844718_1993.txt

844718_1993

1993

844718

ITEM 1: BUSINESS (a) General Development of Business The Corporation was incorporated in Colorado on October 25, 1988 for the purpose of acquiring or completing a merger with another company. Effective July 22, 1991, the Company entered into a common stock exchange agreement with Finca Consulting Costa Brava, S.A. whereby the Company transferred essentially 100% of its net assets to Finca Consulting Costa Brava, S.A. As a result of the merger, Finca Consulting Costa Brava, S.A. remained as the sole ongoing entity for accounting purposes. Finca Consulting Costa Brava, S.A. is located in and was incorporated in Spain on June 14, 1989 and its principal business is acting as a real estate broker for sales of Spanish properties, mainly holiday homes. Subsequent to the aforementioned July 22, 1991 merger, the Corporation generated capital through an offering of preferred stock in Europe and in September 1991 formed an additional wholly-owned subsidiary, Finca Consulting Ltd, incorporated in the United Kingdom. Finca Consulting Ltd. was formed to assist Finca Consulting Costa Brava,S.A. in the marketing and sales of Spanish properties. In January 1991, the Corporation formed another new wholly-owned subsidiary, Finca Consulting GmbH, incorporated in Germany. Finca Consulting GmbH was formed to engage in the buying, selling and administration of Spanish real estate. In May, 1992, the Company commenced an offering of its Common Shares in Europe. In July 1992, the corporation entered into and consummated a common stock exchange agreement with King National Corporation,a U.S. corporation,whereby the sole transferable asset was a 100% ownership interest of Opti-Wert-Interest AG ("OWI-AG") a Swiss corporation. OWI-AG is primarily engaged in the buying and selling of marketable securities and options on behalf of its customers in Germany via a network of independent brokers. The sale of securities, including futures options contracts are subject to regulation in Germany by the Banking Supervisory Authority. On October 1, 1992, Finca Consulting Limited acquired three additional companies incorporated in the United Kingdom, each of which are engaged as real estate agencies. The Corporation is currently subject to the reporting requirements under the Securities Exchange Act of 1934, as amended. The Corporation has the authority to issue an aggregate of Twenty Million (20,000,000) common shares, par value $.01 and Twenty Million (20,000,000) preferred shares, $.00001 par value. As of December 31, 1993, there were outstanding 2,146,633 Common Shares and 16,305 Preferred Shares. The Corporation did not acquire or dispose of any material amount of assets during the fiscal year ended December 31, 1993. (b) Financial Information About Industry Segments. The Corporation operates in two business segments, acting as a real estate broker for sales and rentals of properties in Europe and, through its subsidiary, OWI-AG, the buying and selling of marketable securities and options on behalf of OWI-AG's customers in Germany. The Corporation operates primarily in Europe. Information regarding each geographic area on an unconsolidated basis for 1993 and 1992 is as follows: (c) Narrative Description of Business The Corporation and its subsidiaries operate in two segments, acting as a real estate broker for sales and rentals of properties in Europe and the buying and selling of marketable securities and options on behalf of its customers in Germany through its subsidiary, Opti-Wert-Interest AG, a Swiss corporation ("OWI-AG"). The Corporation's activities have been limited to raising capital and through its subsidiary, OWI-AG, the buying and selling of marketable securities and options on behalf of its customers in Germany. Historically, the Company operated solely in the European real estate market. However, since its acquisition of OWI-AG, in July, 1992, the Company has focused its business operation chiefly in the buying and selling of equities and options on behalf of German customers. The Corporation and its subsidiaries derived revenues from its real estate operations in the approximate amount of $36,369 in 1992 and $51,848 in 1991. No revenues were earned from this business segment in fiscal 1993. The Corporation and its subsidiaries generated revenues from its securities brokerage operations of $16,603,901 in 1993 and $2,656,076 in 1992. Neither industry segment in which the Corporation does business is seasonal. The Corporation is not dependent upon a single customer or a few customers. Accordingly, the loss of any one or more of such customers would not have a material adverse effect on either industry segment. In its securities brokerage operations, the Corporation competes with established companies, private investors, limited partnerships and other entities (many of which may possess substantially greater resources than the Corporation) in connection with its brokerage business securities and options brokerage business. A majority of the companies with which the Corporation competes are substantially larger, have more substantial histories, backgrounds, experience and records of successful operations, greater financial, technical, marketing and other resources, more employees and more extensive facilities than the Corporation now has, or will have in the foreseeable future. It is also likely that other competitors will emerge in the near future. The Corporation competes with these entities on the basis of service and sales commissions. The Corporation and its subsidiaries employ no full time persons and no part time persons in its real estate operations and 16 full time persons and no part time persons in its securities brokerage operations. (d) Financial information about foreign and domestic operations and export sales. ITEM 2: ITEM 2: Properties Real Estate Operations. During 1993, the Corporation's executive offices were located at 665 Finchley Road, London NW2 2HN Telephone No. 011-44-71-431-4529. The offices have since been relocated to 106 Koenigsallee, 40215 Duesseldorf, Germany. The Corporation leases 1,000 square feet in office and showroom space in Play de Aro, Spain under a five year lease which commenced February 1991. The lease is cancelable with a 90 day notice and provides for annual rent increases based on a price index. the Corporation paid rents of $32,103 and $40,631 for the years 1993 and 1992, respectively. In January 1993, the Company leased the Spanish property, consisting of a residential dwelling located in Gerona, Spain to Volker Montag, an officer and director of the Company. The term of the lease is for a period of five years commencing January 1, 1993 and requires payment of $1,000 rent per month for each of the ensuing sixty months. Securities Operations. In January 1992, the Corporation entered into a lease agreement for 9,600 square feet of office space in Dusseldorf, Germany. The lease required a deposit of $37,345 and requires monthly rental payments of $12,448 through December 1996. The monthly rent may be increased based on a price index and the lease provides for a five year renewal option. The Corporation (by virtue of its acquisition of King National Corporation) leases 13,700 square feet in office space in Zug, Switzerland, as well as automobiles and office equipment under operating leases. The Corporation paid $21,807 for the six month period from July 1, 1992 to December 31, 1992 and $84,546 for the year ended December 31, 1993. ITEM 3: ITEM 3: LEGAL PROCEEDINGS The Corporation is not involved in any legal proceedings as of the date of this Form 10-K nor are any material proceedings known to be contemplated. 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 this fiscal period. PART II ITEM 5: ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a)(1)(i) The Corporation is not currently trading on the over-the- counter "Pink Sheet" market or on any exchange. (b) As of December 31, 1993 there were approximately 671 shareholders of record for the Common Stock. (c) the Corporation has not declared or paid any cash dividends. ITEM 6: ITEM 6: SELECTED FINANCIAL DATA The selected financial information presented below under the captions "Statement of Operations" and "Balance Sheet" for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 is derived from the financial statements of the Corporation and should be read in conjunction with the financial statements and notes thereto. Statement of Operations ITEM 7: ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Quarter Ended December 31, 1993 The Corporation's wholly owned Swiss subsidiary, Opti-Wert-Interest AG ("OWI-AG") continues to be the sole source of revenues for the Corporation. OWI-AG operates a securities brokerage business in Germany, utilizing commissioned sales brokers to sell equity stocks and options to its customers in Germany. For the quarter ended December 31, 1993 the Corporation had revenues of $5,627,646, resulting in a net loss of $1,820,337. This loss was substantially due to the high cost of equity securities and options of $5,394,281 and selling, general and administrative expenses of $2,050,174, incurred for the quarter. Year Ended December 31, 1993 For the year ended December 31, 1993, the Corporation had gross revenues of $16,603,901, generated exclusively by its subsidiary, OWI-AG, through its securities brokerage business in Germany. For the year ended December 31, 1993, the Corporation experienced a net loss of $2,457,631. This loss was the result of the high cost of products - equity securities and options - purchased by OWI-AG in the course of its trading business, in the amount of $13,728,846, and the substantial administrative costs incurred as well as commissions paid in the amount of $5,314,366. OWI-AG utilizes the administrative services of a German affiliate, Telecom GmbH, which provides the facilities and infrastructure for the Company's network of brokers for its equity securities and options business. During fiscal year 1993, the Corporation, through OWI-AG, paid Telecom GmbH $1,703,792, for these administrative services and $1,891,704, in brokerage fees: see, Note 2 to Consolidated Financial Statements annexed hereto as Exhibit A. Fiscal Year 1993 Compared to Fiscal Year 1992 On July 15, 1992, the Corporation consummated a stock exchange agreement with King National Corporation, a Nevada corporation, the principal result of which was the acquisition of Opti-Wert-Interest AG ("OWI-AG"), the Corporation's currently wholly owned subsidiary and sole revenue generating business (the "OWI-AG Acquisition"): see, Note 5 to Consolidated Financial Statements annexed hereto as Exhibit A. During fiscal 1992 and prior to the OWI-AG Acquisition, the Corporation derived its revenues from its real estate sales and rental operations of holiday residential units in Spain: this real estate business produced no revenues during fiscal year 1993, as compared to revenues of $36,369 during fiscal year 1992. During 1993, the Corporation's revenues of $16,603,901 were all derived from OWI-AG's securities brokerage activities in Germany as compared to 1992, which showed revenues of $2,656,076 attributable to OWI-AG and revenues of $36,369 from its Spain-based real estate operations. During 1993, the Corporation sustained a loss of $2,457,631, as compared to a loss of $1,786,637 in fiscal year 1992. The OWI-AG Acquisition resulted in a material increase in selling, general and administrative expenses which totaled $5,314,366 in 1993 as compared to $2,732,421 in 1992. For the year ended December 31, 1993, the Corporation experienced a nominal decrease in cash used in operations, from $(1,686,186) for the year ended December 31, 1992, to $(1,539,520)for the year ended December 31, 1993. Cash flow from operations was affected primarily by an increase in customer credit balances to $749,929 at December 31, 1993,as compared to $176,783 at December 31, 1992, due to the increased customer brokerage activities of OWI-AG. Conjunctively, cash flow from operating activities was materially reduced by a $234,402 increase in receivables. Depreciation and amortization contributed $246,181 to cash flow from operations in 1993. The Corporation materially reduced cash outlays for investing activities during fiscal 1993, from utilizing $1,099,990 during fiscal year 1992 to total expenditures of $132,651 during fiscal year 1993. $90,120 was spent on real estate and property and equipment during 1993 as compared to expenditures aggregating $775,741 during 1992, while an investment of $42,531 in vintage cars was made during 1993 as compared to a total investment of $226,226 in such assets in 1992. Cash flow from financing activities during fiscal year 1993 amounted to $1,654,161, most of which represented proceeds derived from the private placement of the Corporation's Common Shares with European investors pursuant o Regulation S promulgated under the Securities Act of 1933, as amended. During fiscal year 1992, the Corporation derived a material amount of its cash through similar financing activities, i.e., the private placement of its preferred and common stock with European investors, producing cash of $2,362,381: see, Consolidated Statements of Changes in Stockholders' Equity annexed hereto as Exhibit A. At December 31, 1993, the Corporation experienced a decrease in its cash position of $5,204 due to the effects of currency exchange rates as compared to a $74,888 decrease at December 31, 1992 for the same reasons. Fiscal Year 1992 Compared To Fiscal Year 1991 Prior to the OWI-AG Acquisition (see above) the Corporation's business and source of revenue was in the sale and rental of holiday residential units in Spain. Through subsidiaries located in the United Kingdom and Germany, the Corporation sold and rented holiday homes in Spain to European residents. Gross revenues in this real estate business amounted to $36,369 at December 31, 1992, a decrease of approximately 22% from revenues of $46,914 at December 31, 1991. As a result of the OWI-AG Acquisition in July 1992 resulting in the Corporation's refocus from its core Spain-based real estate business to OWI-AG's Germany-based securities brokerage operations, selling, general and administrative expenses increased materially, from $245,746 at December 31, 1991 to $2,732,421 at December 31, 1992. The Corporation suffered a loss of $1,786,637 at December 31, 1992, as compared to a loss of $186,605 at December 31, 1991. The material increase in the Corporation's losses at December 31, 1992, was due chiefly to the cost to purchase equity securities and options, amounting to $1,749,426, as well as the material increase in selling, general and administrative expenses, mentioned above, arising from OWI-AG's securities brokerage business. The OWI-AG Acquisition, with its accompanying shift in the Corporation's business, materially changed the Corporation's sources and uses of cash. Substantial amounts of cash were utilized during fiscal 1992 by the Corporation for investments: $551,263 was used to invest in real estate in Spain; $224,778 for property and equipment; $226,226 for vintage automobiles; $37,480 was invested in marketable securities; $43,018 to purchase goodwill, and $17,534 was used for certain capitalized lease expenses. Conjunctively, $2,294,866 was derived from proceeds resulting from the private placement by the Corporation of its common and preferred shares to investors in Europe. At December 31, 1992, the Corporation's cash was decreased by $74,888, as compared to $13,343 at December 31, 1991 due to adjustments resulting from currency exchange rates. ITEM 8: ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Corporation's Financial Statement and Notes to Financial Statements are attached hereto as Exhibit A and incorporated herein by reference. ITEM 9: ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Changes in Registrant's Certifying Accountant. (a) 304(a)(1)(i): Neil James & Associates, P.C., Registrant's former independent accountant previously engaged as the principal accountant to audit the Registrant's financial statements, was dismissed on December 18, 1995. (a)(1)(ii): Mr. Neil James & Associates, P.C. did not issue any reports on the Registrant's financial statements for the past two fiscal years. (a)(1)(iii): The Registrant's Board of Directors recommended and approved the hiring of Rosenberg Rich Baker Berman & Company Certified Public Accountants, 380 Foothill Road, Bridgewater, New Jersey as the Registrant's principal independent accountant and to dismiss Neil James & Associates, P.C. (a)(1)(iv)(A): Registrant is unaware of any disagreements between Registrant and Neil James & Associates, P.C. on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure. (a)(1)(iv)(B)(1),(2) and (3): Not applicable. (a)(1)(iv)(C): Not applicable. (a)(1)(iv)(D): Not applicable. (a)(1)(iv)(E): Registrant authorized its former accountant, Neil James & Associates, P.C., to respond fully to inquiries of Rosenberg Rich Baker Berman & Company, its successor accountant, concerning the subject matter of each and every disagreement or event, if any, known by Registrant's former accountant. (a)(2): Registrant's new independent auditors are Rosenberg Rich Baker Berman & Company who were engaged on December 15, 1995. (a)(2)(i): Registrant's management engaged in general business conversation with its new accountant, who did not, during such conversations, render any advice to Registrant, oral or written, which was an important factor considered by Registrant in reaching any accounting, auditing or financial reporting issue decisions. (a)(2)(ii): Registrant's management did not consult its new accountant regarding any matter that was the subject of a disagreement or event referred to in (a)(1)(iv) above since Registrant is unaware and has no knowledge of any such disagreement or event. (a)(2)(ii)(A),(B), and (C): Not applicable. (a)(2)(ii)(D): Registrant has requested its new accountant to review the disclosure required by this Item before it is filed with the Securities and Exchange Commission and has been provided the opportunity to furnish Registrant with a letter addressed to the Commission containing any new information, clarification of Registrant's expression of its views, or the respects in which it does not agree with the statements made in response to this Item. PART III ITEM 10: ITEM 10: DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS The names and ages of all directors and executive officers of the Corporation are as follows: There are no family relationships among the Corporation's Officers and Directors. All Directors of the Corporation hold office until the next annual meeting of the shareholders and until successors have been elected and qualified. Executive Officers of the Company are appointed by the Board of Directors at the annual meeting of the Corporation's Directors and hold office for a term of one year or until they resign or are removed from office. Resumes: Volker Montag - Mr. Montag was born in Essen, Germany and makes his home in Weeze, Germany. From 1990 he has been an officer and Director of King National Corporation (acquired by the Corporation in July 1992.) From 1988 to 1990, Mr. Montag was the Managing Director of Opti-Wert Interest, AG, Switzerland, a Swiss brokerage company, which is a wholly owned subsidiary of the Corporation. He was also associated with VISA Enterprise PLC, London, United Kingdom. Hugo Winkler - Mr. Winkler was born in Switzerland and currently makes his home in London. Mr. Winkler is an international business consultant and holds directorships in seventeen companies throughout the world. He is the founder and Managing Director of Hugo Winkler & Co., Ltd., a managing consulting company located in London since the early 1980s. Mr. Winkler also has extensive holdings in Southeast Asia, including Singapore and Malaysia. Mr. Winkler is a Qualified Business Administrator from Kaukfmaennischer Verein Zurich, Switzerland in 1974. He is a member of the United Kingdom Institute of Directors in London. Mr. Winkler resigned as Director effective November 1, 1995. Norani Mohammad Zin - Mr. Zin was born in Malaysia and currently makes is home in Maui, Malaysia. Since 1981, Mr. Zin has been the General Manager of Hugo Winkler & Co., Ltd. in Singapore. Mr. Zin resigned as Director effective November 1, 1995. Roland Schoneberg - Mr. Schoneberg was born in Germany and currently lives in Koln, Germany. He is member of the board of Telecom GmbH, an affiliate of the Company. He served as director of the Company since November 1995. ITEM 11: ITEM 11: EXECUTIVE COMPENSATION No compensation was paid to the officers and directors of the Corporation over the last fiscal year. The Corporation has reimbursed and will continue to reimburse its officers and directors for any and all out of pocket expenses incurred relating to the business of the Corporation. In addition, it is not expected that the officers and directors of the Corporation will begin drawing salary until such time as the business operations of the Corporation can substantiate the same. However, in the event any officer and/or director performs extraordinary services on behalf of the Corporation, it is the position of the Board of Directors to reward such services by issuance of a bonus to such person(s). ITEM 12: ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT As of December 31, 1993, there were 2,146,633 Common Shares outstanding. The following tabulates holdings of shares of the Corporation by each person who, subject to the above, at the date of this Memorandum, holds of record or is known by Management to own beneficially more than 5.0% of the Common Shares and, in addition, by all directors and officers of the Corporation individually and as a group. There were 16,305 Preferred Shares outstanding issued to individuals who are neither officers or directors. Title of Name and Address of Amount and Nature of Percent of Class Beneficial Owner Beneficial Ownership Class - ----- ---------------- -------------------- ----- Common Secure Securities, Ltd. Stock c/o Hugo Winkler 665 Finchley Road London, UK 260,240* 12.12% Visa International, PLC c/o Hugo Winkler 665 Finchley Road London, UK 266,667* 12.42% Bernd Nagel Hessenweg 10 A D-4422 Ahaus Germany 119,667 5.57% Volker Montag c/o Opti-Wert-Interest Industriel Str. 9 Postfach 6300 ZUB Switzerland 526,907* 24.55% Hugo Winkler 665 Finchley Road London, UK 0 0% Norani Mohammad Zin 665 Finchley Road London, UK 0 0% Roland Schoneberg c/o Opti-Wert-Interest Industriel Str. 9 Postfach 6300 ZUB Switzerland 526,907* 24.55% All Directors and Officers as a Group 526,907* 24.55% - --------------- *Messrs. Volker Montag and Roland Schoneberg are majority shareholders of Secure Securities, Ltd. and Visa International, PLC. ITEM 13: ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Minority Interest in Subsidiary. One of the Corporation's subsidiaries Opti-Wert-Interest, AG ("OWI-AG") has issued participation certificates with a minimal value of Sfr. 10(U.S. $6.60) for a subscription price of U.S. $9.07. These participation certificates carry no voting rights and do not have a fixed return. The Corporation subscribed to 5,040 certificates (49,603). Subsequently in 1992, OWI-AG's parent company (King National Corporation) was acquired by the Corporation thus causing this investment to be eliminated in the consolidation process. The remaining 5,460 certificates are held by various investors. (b) Commissions to Affiliate. Secure Securities, Ltd., a shareholder of the Corporation, controlled by Messrs. Volker Montag and Roland Schoneberg, owns a German company, Telecom GmbH, having its principal offices located in Dusseldorf, Germany ("Telecom"). Telecom provides all of the administrative services to Opti-Wert-Interest AG, the Corporation's wholly owned subsidiary ("OWI-AG"), for its securities brokerage business. During fiscal year 1993 OWI-AG paid Telecom $1,703,792 for their administrative services. Telecom also pays all of OWI-AG's brokerage commissions due to non-affiliated third parties arising out of OWI-AG sales to its customers, which amounted to $1,891,704 during 1993. (c) Loan to Officer and Director. OWI-AG made a loan in the amount of $141,750 to Mr. Volker Montag, an officer and director of the Company during 1993. The loan's outstanding principal balance accrues interest at the rate of five (5%) percent, per annum, and payments in the amount of $7,020 are due quarterly. (d) Payments to Officers and Directors. During 1992, the Corporation paid $4,300 for various office services to a company owned by Hugo Winkler, an officer and director. (e) Office space to Subsidiary. Finca Consulting Limited, a wholly-owned subsidiary of the Corporation is provided, free of charge, office spacein London, England in the business office of an officer and director. PART IV ITEM 14: ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Financial Statements The response to this portion of Item 14 is included as a separate section, Exhibit A, attached hereto and incorporated herein by reference. (a)(2) Financial Statements Schedules All schedules are omitted since the required information is not applicable or of insufficient materiality. (a)(3) Exhibits The Exhibits that are filed with this report or that are incorporated by reference are set forth in the Exhibit Index. (b) Reports on form 8-K There were no reports filed 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. FINCA CONSULTING, INC. Date: December 20, 1997 By: /s/Volker Montag ---------------- Volker Montag 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. Name Date ---- ---- /s/Volker Montag December 20, 1997 - ---------------- Volker Montag, President and Director /s/Roland Schoneberg December 20, 1997 - -------------------- Roland Schoneberg, Secretary and Director EXHIBIT INDEX (2) Agreement and Plan of Reorganization between the Corporation and King National Corporation dated July 1992 incorporated by reference to Form 8-K. (3)(i) Articles of Incorporation incorporated by reference to Form S- 18 filed October 17, 1989. Articles of Amendment to Articles of Incorporation incorporated by reference to the Exhibit to the Company's Form 10-K for the fiscal year ended December 31, 1991 filed on June 4, 1992. (3)(ii) By Laws incorporated by reference to Form S-18 filed October 17, 1989. (13) Quarterly report incorporated by Reference to Quarterly Report on Form 10-Q for period ended September 30, 1993. (16) Letter regarding change in certifying accountant incorporated by reference to Form 8-K filed in February, 1993. (21) Subsidiaries of the Company: (i) Finca Consulting Costa Brava, S.A. - is a corporation formed under the laws of the Country of Spain and is the name under which it conducts business. (ii) Finca Consulting, Limited - is a corporation formed under the laws of the Country of the united Kingdom and is the name under which it conducts business. (iii) Finca Consulting, GmbH - is a corporation formed under the laws of the Country of Germany and is the name under which it conducts business. (iv) Opti-Wert-Interest, AG - is a corporation formed under the laws of the Country of Switzerland and conducts its retail securities and options business in Germany. (27) Financial Data Schedule - attached to Exhibit A EXHIBIT A Finca Consulting, Inc. and Subsidiaries Consolidated Financial Statements December 31, 1993 Finca Consulting, Inc. and Subsidiaries Index to the Consolidated Financial Statements December 31, 1993 Independent Auditors' Report on the Financial Statements........................ Financial Statements Consolidated Balance Sheets................................................ Consolidated Statements of Operations...................................... Consolidated Statements of Changes in Stockholders' Equity................. Consolidated Statements of Cash Flows...................................... Notes to the Consolidated Financial Statements............................. Independent Auditors' Report Rosenberg Rich Baker Berman & Company 380 Foothill Road Bridgewater, New Jersey 08807 To the Board of Directors and Stockholders of Finca Consulting, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheets of Finca Consulting, 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. These consolidated 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 audits 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 provides 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 Finca Consulting, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. /s/Rosenberg Rich Baker Berman & Company - ---------------------------------------- Rosenberg Rich Baker Berman & Company Bridgewater, New Jersey December 15, 1995 See notes to the consolidated financial statements. See notes to the consolidated financial statements. See notes to the consolidated financial statements. See notes to the consolidated financial statements. See notes to the consolidated financial statements. Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Finca Consulting, Inc. (formerly Charter Ventures, Inc.) (the Company) was incorporated in the State of Colorado on October 25, 1988 for the purpose of acquiring or completing a merger with another company. Effective July 22, 1991 the Company entered into a common stock exchange agreement (NOTE 5) with Finca Consulting Costa Brava, S.A. (Finca) whereby, the Company transferred essentially 100% of its net assets to Finca. Subsequent to this stock exchange agreement, the Company and Finca remain as two separate legal entities (the Company as the parent of Finca) however, at the date of the merger Finca remained as the sole ongoing entity for accounting purposes. Finca is located in and was incorporated in Spain on June 14, 1989 and its principal business is acting as a real estate broker for sales of Spanish properties, mainly holiday homes. Subsequent to the aforementioned July 22, 1991 merger, the Company generated capital through an offering of preferred stock (NOTE 6) and in September 1991 formed an additional wholly-owned subsidiary, Finca Consulting Limited, incorporated in the United Kingdom. Finca Consulting Limited assists Finca in marketing and sales of Spanish properties. In January 1992, the Company formed another new wholly-owned subsidiary, Finca Consulting GmbH, incorporated in Germany. Finca Consulting GmbH is engaged in the buying, selling and administration of the Spanish real estate. In July 1992, the Company entered into a common stock exchange agreement (NOTE 5) with King National Corporation, a U.S. corporation, whereby the sole transferrable asset was a 100% ownership interest of Opti-Wert - Invest AG (OWI-AG) a Switzerland corporation. OWI-AG is principally engaged in the buying and selling of marketable securities and options on behalf of its customers in Germany via a network of independent brokers. On October 1, 1992, Finca Consulting Limited acquired three additional companies incorporated in the United Kingdom, each of which are engaged as real estate agencies. A summary of the Company's significant accounting policies is as follows: Principles of Consolidation The accompanying consolidated financial statements include the accounts of Finca Consulting, Inc. (for the period after the July 22, 1991 merger) and its wholly-owned subsidiaries, Finca Consulting Costa Brava, S.A., Finca Consulting Limited (and Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 1 - ORGANIZATION OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Subsidiaries after October 1, 1992), Finca Consulting GmbH, and King National Corporation for the period July 1, 1992 through December 31, 1992 (collectively hereinafter referred to as the Company). All significant intercompany accounts and transactions have been eliminated. Property and Equipment Property and equipment are recorded at cost with depreciation and amortization being recorded by using the straight-line method over estimated economic useful lives as follows: Expenditures for maintenance and repairs are charged to expense when incurred. Property replacements and betterments, which improve or extend the useful lives of assets, are capitalized and subsequently depreciated. Amortization Goodwill and Capital Costs - Office Premium is stated at cost. Goodwill is being amortized over 40 years using a straight-line basis. Office premium is being amortized over 19 years using a straight-line basis. Vintage Cars - Vintage cars are being amortized based on their estimated book value. Stock Offering Costs Costs relating to the offering of the Company's common and preferred stock (NOTE 6 and 7) have been charged against the proceeds of the respective offerings. Income Taxes The provision for income taxes is based on income (loss) as reported for financial statement purposes. Such provision may differ from amounts currently payable, if any, because certain items are reported for income tax purposes in periods different from those in which they are reported in the financial statements. If applicable, the tax effects of these timing differences are reflected as deferred income taxes. Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 1 - ORGANIZATION OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) International subsidiaries are taxed according to applicable laws of the countries in which they do business. Translation of Foreign Currencies For international subsidiaries operating in their local currency environment, net assets are translated at year-end exchange rates while revenue and expenses are translated at average exchange rates in effect during the year. Adjustments resulting from these translations are accumulated in a separate component of stockholders' equity. Net (Loss) Per Share The net income (loss) per share has been computed using the weighted average number of common stock shares outstanding during the year. During the period January 1, 1991 through July 21, 1991, 651,842 shares are reported as outstanding. Effective with the July 22, 1991 recapitalization (NOTE 5), 162,961 shares of common stock are reported as issued for a $29,402 capital contribution. During 1992 and 1993, common shares were outstanding as follows: A. January 1, 1992 through July 15, 1992 - 814,803 B. July 16, 1992 through September 14, 1992 - 1,733,228 (500,000 shares issued for all of King National Corporation common shares (NOTE 5) C. September 15, 1992 through December 31, 1992 - 1,939,895 (206,667 additional common shares issued) (NOTE 7) D. January 1, 1993 through May 15, 1993 - 2,012,582 E. May 16, 1993 through November 14, 1993 - 2,040,937 F. November 15, 1993 through December 31, 1993 - 2,146,633 Common stock purchase warrants and common stock issuable upon conversion of the Company's preferred stock have been excluded from the computation in that their effects are anti-dilutive. NOTE 2 - RELATED PARTY TRANSACTIONS (1) On December 31, 1991 the Company made a $49,603 investment in participation certificates of OWI AG (NOTE 8). The investment has been recorded at cost which approximates market value at December 31, 1991. Subsequently in 1992, OWI AG's parent company (King National Corporation) was acquired by the Company thus causing this $49,603 investment to be eliminated in the consolidation process. (2) During 1993 and 1992, the Company paid $0 and $19,743, respectively for legal fees to Andrew J. Telsey, P.C. and Andrew I. Telsey, a stockholder of the Company. Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 2 - RELATED PARTY TRANSACTIONS (continued) (3) Finca Consulting Limited, a wholly-owned subsidiary of the Company, is provided, free of charge, office space in London, England in the business office of a Company officer and director. (4) OWI AG pays fees for sales administration services to Telecom GmbH, Dusseldorf. Both companies have the same manager. Fees paid for the years ended 1993 and 1992 amounted to $1,703,792 and $994,498, respectively. Telecom also pays certain brokerage fees on behalf of the company which amounted to $1,891,704 and $1,068,907 for 1993 and 1992, respectively. (5) OWI AG has granted a loan of $141,750 to its company manager. The loan is payable in quarterly installments of $7,020 with interest at five percent per annum. NOTE 3 - INCOME TAXES As of December 31, 1993, the Company has $2,918,238 of domestic and foreign net operating loss carryforwards as follows: Net Operating Available Through Losses - ----------------- ------ United States 2004 $ 10,075 2005 677 2006 34,835 2007 74,177 2008 154,223 --------------- $ 273,987 =============== Spain 1996 $ 156,356 1997 73,757 1998 238,634 --------------- $ 468,747 =============== Germany 1997 $ 442,556 1998 488,110 --------------- $ 930,666 =============== Switzerland 1998 $ 1,059,919 =============== United Kingdom Indefinite $ 184,919 =============== Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 4 - OPERATING LEASES The Company leases office space in Playa de Aro, Spain under a five year lease which commenced February 1991. The lease is cancelable with a 90 day notice and provides for annual rent increases based on a price index. The Company paid $32,103 and $40,631 for the years 1993 and 1992, respectively. In January 1992 the Company entered into a lease agreement for office space in Dusseldorf, Germany. The lease required a deposit of $37,345 and requires monthly rental of $12,448 through December 1996. The monthly rent may be increased based on a price index and the lease provides for a five year renewal option. In January 1993, the Company leased the Spanish property, consisting of a residential dwelling located in Gerona, Spain to Volker Montag, an officer and director of the Company. The term of the lease is for a period of five years commencing January 1, 1993 and requires payment of $1,000 rent per month for each of the ensuing sixty months. The Company (by virtue of its acquisition of King National Corporation) leases office space in Switzerland, as well as automobiles and office equipment under operating leases. The Company paid $84,546 for the year ended December 31, 1993. The following is a schedule years of future minimum rental payments required under operating leases that have initial or remaining noncancelable terms: Year Ending December 31, Total ------------------------ ----- 1994 $ 237,361 1995 230,262 1996 170,518 1997 13,930 1998 8,625 Thereafter 36,750 --------------- Total Minimum Payments Required $ 697,446 =============== Total rental expense for all operating leases, except those with terms of a month or less that were not renewed, amounted to $284,049 and $185,796 for the year ended December 31, 1993 and 1992, respectively. Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 5 - BUSINESS ACQUISITION Effective July 22, 1991, Charter Ventures, Inc. (Charter) (Note 1) entered into a common stock exchange agreement with Finca Consulting Costa Brava, S.A. (Finca). Charter acquired 100% of Finca's issued and outstanding shares of common stock by issuing 325,921,000 shares (651,842 shares as adjusted for a 1 for 500 reverse stock split) of $.00001 ($.01 as amended) per value common stock which represents 80% of the new combined common stock outstanding. Charter was incorporated under the laws of the State of Colorado on October 25, 1988 to engage in all aspects of review and evaluation of private companies, partnerships and sole proprietorships for the purpose of completing mergers with or acquisitions by Charter. Effective with the common stock exchange agreement, Charter changed its name to Finca Consulting, Inc. (the Company) and effected a reverse split of its common stock which provided that every 500 shares of common stock would be exchanged for 1 share of common stock. In addition, the number of authorized common shares was amended to 20,000,000 shares, par value $.01. As of July 21, 1991 the Company's capital structure consisted of the following: Preferred Stock - $.00001 par value; 20,000,000 shares authorized, none issued (NOTE 6). Common Stock - $.01 (as amended) par value; 20,000,000 (as amended) shares authorized, 162,961 (as adjusted for reverse split) shares issued and outstanding. Effective with the stock exchange agreement, the Company transferred $29,402 of cash to Finca which represented essentially 100% of the Company's net assets at the merger date. The common stock exchange agreement has been accounted for as "a recapitalization and issuance of shares for net assets (reverse purchase of the Company by Finca)". Subsequent to the July 22, 1991 recapitalization, the Company and Finca remain as two separate legal entities (the Company as the parent of Finca) however, at the date of the merger Finca remained as the sole ongoing entity for accounting purposes. The accompanying consolidated financial statements exclude the financial condition, results of operations and cash flows of Charter for the period prior to the July 22, 1991 merger. As a result of the recapitalization, the stockholders' equity section of the balance sheet has been presented to reflect the 325,921,000 shares (651,961 shares as adjusted for reverse stock split) of common stock issued to Finca in the stock exchange agreement, 81,480,250 shares (162,961 shares as adjusted for reverse stock split) of common stock issued for $29,402, and reflects the preferred stock available for issuance by the new combined equity. In December 1990, the Company completed a public offering of 5,175 units with each unit consisting of 1,000 shares (2 shares as adjusted for the reverse split) of common stock. As part of the common stock exchange agreement, two former officers of the Company assigned to Secure Securities, Ltd., a stockholder of the Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 5 - BUSINESS ACQUISITION (Continued) Company, 100,000,000 (200,000 as adjusted for the reverse split) common stock purchase warrants. Each warrant entitles the holder to purchase one share of common stock at $10.00 (as adjusted) per share at any time prior to June 29, 1992 though a one-year extension has been approved by the Board of Directors effectively extending the expiration date to June 30, 1993. The notice at $.005 (as adjusted) per warrant, providing a current registration statement covering the warrants in effect. To date none of the warrants have been exercised and the Company has not called any of the warrants for redemption. As of December 31, 1990, Charter previously reported net assets of approximately $42,000, consisting primarily of cash. During the period January 1, 1991 through July 22, 1991 Charter, as a separate entity, incurred a net loss of approximately $12,600, which included income of approximately $1,000 and the following general and administrative expenses: Administrative $ 2,958 Accounting 500 Legal 10,142 -------------- $ 13,600 ============== As of July 22, 1991, Charter had cash of $29,402 which essentially represented 100% of its net assets. As previously discussed, this cash was transferred to Finca effective with the July 22, 1991 merger. If Charter's net loss of approximately $12,600 for the period January 1, 1991 through July 22, 1991 is combined with the Company's net loss of $186,605 included in the accompanying reported statement of operations for the year ended December 31, 1991, the earnings (loss) per share is as follows: Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 5 - BUSINESS ACQUISITION (Continued) During the period January 1, 1991 through July 22, 1991 Charter paid $10,142 in legal fees to Andrew I. Telsey, P.C. and Andrew I. Telsey is a company stockholder. In January 1992, the Company formed as a wholly-owned subsidiary Finca Consulting GmbH, incorporated in Germany. Finca Consulting GmbH is engaged in the buying, selling and administration of the Spanish real estate. The Company capitalized the subsidiary with $284,810 of its cash. On July 15, 1992, the Company entered into a common stock exchange agreement with King National Corporation, a U.S. Corporation (King) whereby 500,000 common shares of Finca Consulting, Inc. were exchanged for all 7,500,000 outstanding shares of King in a 15 for 1 exchange. Since both Finca Consulting, Inc. and King are controlled by the same interests, this transaction is accounted for as neither a purchase or pooling of interests. The assets and liabilities of the acquired company (King) are recorded at historical cost with the excess of liabilities assumed over assets acquired in the amount of $147,052 resulting in a reduction of consolidated equity. The sole transferrable asset of King is a 100% ownership interest in the common stock of Opti-Wert-Invest AG (OWI AG), a Switzerland corporation. OWI AG is principally engaged in the buying and selling of marketable securities and options on behalf of its customers in Germany via a network of independent brokers. Activity during the period July 1, 1992 through December 31, 1992 for OWI AG has been included in the consolidated statements of operations. King did not have any activity during this period. For the period January 1, 1992 to June 30, 1992 King and OWI AG, as a separate consolidated entity, incurred a consolidated loss of $70,029. Consolidated assets of $442,934 are essentially comprised of cash, vintage car, and fixed assets. If the net loss of $70,029 for the period January 1, 1992 to June 30, 1992 is combined with the Company's net loss of $1,786,637 included in the accompanying reported statement of operations for the year ended December 31, 1992 the (loss) per share is as follows: Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 5 - BUSINESS ACQUISITION (Continued) On October 1, 1992 Finca Consulting Limited (a United Kingdom subsidiary) acquired the net assets of three additional companies incorporated in the United Kingdom as wholly-owned subsidiaries. This transaction was accounted for under the purchase method and, accordingly, the three month activity from October 1, 1992 through December 31, 1992 in each of these acquired companies has been included in the consolidated statement of operations. The assets and liabilities of the acquired companies are recorded at historical cost with the excess of liabilities assumed over assets acquired in the amount of $443,018 recorded as goodwill. NOTE 6 - PREFERRED STOCK OFFERING In August 1991 the Company's Board of Directors authorized the offering of 100,000 convertible preferred shares of the Company's $.00001 par value preferred stock at a price of $20 per share. The offering was undertaken pursuant to Regulation S under the Securities Act of 1993 as amended. Each preferred share is convertible into five shares of the Company's common stock within a five year period from the date of subscription for the preferred shares. No call provision exists relevant to the preferred shares and the preferred shares do not include any voting or redemption rights and are not subject to any operation of a retirement or sinking fund. In the event of a liquidation of the Company, either voluntary or involuntary, dissolution or winding up of the Company or any distribution of the assets of the Company, the holders of the preferred shares shall be entitled to any and all amounts payable upon such shares superior to those similar rights available to holders of the Company's common shares, but subordinate to all creditors of the Company. The Company has reserved for issuance from its authorized but unissued common shares, 500,000 common stock shares relating to the conversion rights of the preferred shares. During 1991 the Company sold 69,920 shares of convertible preferred stock and recorded gross proceeds of $1,398,400. Commissions of $90,000 on the shares sold were paid to an affiliate (NOTE 2) and as of December 31, 1991, $311,200 of the gross proceeds remained payable to the Company by the same affiliated brokerage firm (NOTE 2). During 1992, the Company sold 30,070 shares of convertible preferred stock and recorded gross proceeds of $601,400. To date, preferred stockholders have exercised their right to convert 83,685 preferred shares into 418,425 common stock shares and at December 31, 1992, 16,305 preferred shares remain outstanding. The Company's commission arrangement with an affiliate (OWI-AG) provided that $90,000 of commissions were payable December 31, 1991, and that an additional $100,000 could be paid during 1992 based upon the successful completion of the offering of the 100,000 convertible preferred shares. However, the affiliate received no additional payments in 1992. Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements NOTE 7 - COMMON STOCK ISSUANCE For the years ended December 31, 1993 and 1992, respectively the Company authorized the issuance of 206,738 and 206,667 additional common shares with a par value per share of $.01. The offering was undertaken pursuant to Regulation S under the Securities Act of 1993 as amended. NOTE 8 - MINORITY INTEREST IN SUBSIDIARY One of the Company's subsidiaries (OWI-AG) has issued participation certificates with a minimal value of Sfr. 10 (US $6.60) for a subscription price of US $9.07. These participation certificates carry no voting rights and do not have a fixed return. The 5,040 certificates have been subscribed to by the Company and have been eliminated in the consolidation process. The remaining 5,460 certificates are held by various investors. NOTE 9 - OPERATIONS OF BUSINESS SEGMENTS AND IN GEOGRAPHIC AREAS Business Segments The Company operates in two business segments, acting as a real estate broker for sales of properties in Europe and through its subsidiary OWI-AG buying and selling of marketable securities and options on behalf of its customers in Germany. Geographic Areas The Company operates primarily in Europe. Information regarding each geographic area on an unconsolidated basis for 1993 and 1992 is as follows: Finca Consulting, Inc. and Subsidiaries Notes to the Consolidated Financial Statements Operating (loss) consists of sales less operating expenses. General corporate assets represent parent company cash, receivable due from affiliate for preferred stock offering proceeds and the Company's stock investment in an affiliate. NOTE 10 - CONCENTRATIONS OF CREDIT RISK The Company maintains cash balances in several foreign financial institutions which are not insured by the respective countries. At December 31, 1993, the Company's uninsured cash balances total $345,668.

770461_1993.txt

770461_1993

1993

770461

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.

351979_1993.txt

351979_1993

1993

351979

ITEM 1. BUSINESS and ITEM 2. ITEM 2. PROPERTIES Burlington Northern Inc. (BNI) was incorporated in Delaware in 1981 as part of a holding company reorganization. BNI and its majority-owned subsidiaries (collectively BN) are primarily engaged in the rail transportation business. The principal subsidiary is Burlington Northern Railroad Company (Railroad). BN Leasing Corporation, a wholly owned subsidiary of BNI, was formed during 1989 to acquire railroad rolling stock and other equipment necessary for the transportation and other business affairs of BN. Railroad transportation Railroad operates the largest railroad system in the United States based on miles of road and second main track, with approximately 24,500 total miles at December 31, 1993. The principal cities served include Chicago, Minneapolis-St. Paul, Fargo-Moorhead, Billings, Spokane, Seattle, Portland, St. Louis, Kansas City, Des Moines, Omaha, Lincoln, Cheyenne, Denver, Fort Worth, Dallas, Houston, Galveston, Tulsa, Wichita, Springfield (Missouri), Memphis, Birmingham, Mobile and Pensacola. During 1993, BN refined Railroad's customer oriented business units by creating smaller, more focused business units. The following table presents BN's revenue information by Railroad business unit, and includes reclassification of prior-year information to conform to current year presentation. Percent of revenues was calculated before consideration of shortline payments and other miscellaneous revenues. The principal contributors to rail transportation revenues were as follows (revenues and revenue ton miles in millions, carloadings in thousands): Coal The transportation of coal is Railroad's largest source of revenues, accounting for approximately one-third of the total. Based on carloadings and tons hauled, Railroad is the largest transporter of Western low-sulfur coal in the United States. Over 90 percent of Railroad's coal traffic originated in the Powder River Basin of Montana and Wyoming during the three years ended December 31, 1993. These coal shipments were destined for coal-fired electric generating stations primarily in the North Central, South Central and Mountain regions of the United States with smaller quantities exported. Railroad also handles increasing amounts of low-sulfur coal from the Powder River Basin for delivery to markets in the eastern and southeastern portion of the United States. The low-sulfur coal from the Powder River Basin is abundant, inexpensive to mine and clean-burning. Since the Clean Air Act of 1990 requires power plants to reduce harmful emissions either by burning coal with a lower sulfur content or by installing expensive scrubbing units, opportunities for increased shipments of this low-sulfur coal still exist. Agricultural Commodities Based on carloadings and tons hauled, Railroad is the largest rail transporter of grain in North America. Railroad's system is strategically located to serve the Midwest and Great Plains grain producing regions where Railroad serves most major terminal, storage, feeding and food-processing locations. Additionally, Railroad has access to major export markets in the Pacific Northwest, western Great Lakes and Texas Gulf regions as well as direct entry to consuming markets in southern Mexico through its Protexa Burlington International affiliate. Intermodal Intermodal transportation moves traffic on specially designed flatcars or doublestack equipment which competes with motor carriers. Railroad's intermodal transportation system integrates the movement of approximately 46 daily trains operating between 30 rail hubs and 28 satellite rail hubs (Railroad-operated marshalling points for trailer/container movements). These operations are strategically located across Railroad's rail network and also serve major distribution centers outside BN's system. Strategic alliances have been formed to enhance Railroad's market access both with other railroads and with major truck transportation providers. Forest Products The Forest Products business unit is primarily comprised of lumber, plywood, pulpmill feedstock, wood pulp and paper products. These products primarily come from the Pacific Northwest, upper Midwest and Southeast areas of the United States. Chemicals The Chemicals business unit is comprised of fertilizer, petroleum and chemical commodities as well as Railroad's environmental logistics business. Primary origin markets for Railroad include the Gulf Coast, the Pacific Northwest, and various Canadian ports of entry. Environmental logistics is an area of significant opportunity as municipalities exhaust their traditional disposal sources and must increasingly transport their waste longer distances. Consumer Products Products included in Railroad's Consumer Products business unit represent a wide variety of commodities. Some of the major products in this group are food products, beverages, frozen foods, canned foods, appliances and electronics. Because this business unit handles a wide variety of consumer goods, the business unit performance typically mirrors the country's economy. Minerals Processors Commodities in this group include clays, cements, sands and other minerals and aggregates. This group services both the oil and construction industries. Iron & Steel The Iron & Steel business unit handles virtually all of the commodities included in or resulting from the production of steel. Taconite, an iron ore derivative produced in northern Minnesota, scrap steel and coal coke are the business unit's primary input products, while finished steel products range from structural beams and coil to wire and nails. Vehicles & Machinery The Vehicles & Machinery business unit is responsible for both domestic and international vehicle manufacturers as well as an assortment of primary and secondary markets for heavy machinery. Through the development and implementation of Autostack technology (using containers to move motor vehicles), Railroad is redefining transit time and ride quality. Heavy machinery includes primary markets for aircraft, construction, farm and railroad equipment and secondary markets for used equipment. The business unit is also responsible for military and other miscellaneous traffic for the United States government. Aluminum, Non-Ferrous Metals & Ores The Aluminum, Non-Ferrous Metals & Ores business unit handles alumina and aluminum products, petroleum coke and a variety of other metals and ores such as zinc, copper and lead. Operating factors Certain significant operating statistics were as follows: - --------------- * Beginning in 1990, BN reduced revenues and mileage for the effects of shortline railroads, which complete hauls for BN. In prior years, payments to shortline railroads were classified in operating expenses. Properties In 1993, approximately 96 percent of the total ton miles, both revenue and non-revenue generating, carried by Railroad were handled on its main lines. At December 31, 1993, approximately 18,828 miles of Railroad's track consisted of 112-lb. per yard or heavier rail, including approximately 10,461 track miles of 132-lb. per yard or heavier rail. Additions and replacements to properties were as follows: Equipment BN owned or leased, under both capital and operating leases, with an initial lease term in excess of one year, the following units of railroad rolling stock at December 31, 1993: In addition to the owned and leased locomotives identified above, BN operates 199 freight locomotives under power purchase agreements. The average age of locomotives and freight cars was 14.5 years and 18.6 years, respectively, at December 31, 1993, compared with 13.5 years and 18.4 years, respectively, at December 31, 1992. The average percentage of BN's locomotives and freight cars awaiting repairs during 1993 was 7.4 and 3.3, respectively, compared with 7.4 and 4.1, respectively, in 1992. The average time between locomotive failures was 67.9 days in 1993 compared with 71 days in 1992. During 1993, BN entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. BN anticipates reduced locomotive operating costs as well as an increase in both horsepower and traction, meaning fewer locomotives will be needed for many freight operations. BN accepted delivery of one locomotive during 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. Employees BN employed an average of 30,502 employees in 1993 compared with 31,204 in 1992 and 31,760 in 1991. BN's payroll and employee benefits costs, including capitalized labor costs, were approximately $1.9 billion for each of the years ended December 31, 1993, 1992 and 1991. Almost 90 percent of BN's employees are covered by collective bargaining agreements with 14 different labor organizations. In October 1991, Railroad entered into an agreement (Crew Consist Agreement No. 1) with the United Transportation Union (UTU) covering the southern portion of Railroad's system. Crew Consist Agreement No. 1 provided for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. Under the terms of Crew Consist Agreement No. 1, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $60,000 per employee. Remaining conductors or brakemen who, as a result of Crew Consist Agreement No. 1, were unable to hold a position in active service, due to relative seniority, were placed on a reserve board. Employees in reserve status received compensation at a rate equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. Each UTU member on the southern portion of Railroad's system received a lump-sum payment of $1,000 upon ratification of Crew Consist Agreement No. 1. In May 1993, Railroad entered into an agreement (Crew Consist Agreement No. 2) with the UTU covering approximately 3,400 UTU members in the northern portion of Railroad's system. Crew Consist Agreement No. 2 provides for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. It is similar to Crew Consist Agreement No. 1, covering the southern portion of Railroad's system. Each UTU member on the northern portion of Railroad's system received a one-time lump-sum payment of $5,000, pursuant to Crew Consist Agreement No. 2. Under the terms of Crew Consist Agreement No. 2, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $80,000 per employee. Conductors and brakemen who choose not to accept the voluntary separation offer can elect volunteer surplus status pursuant to which they will receive $60,000 to be paid out over a period of 18 to 48 months, as each selects. If such employee has not been recalled to active service by the time such payments cease upon expiration of the selected period, such employee will remain in volunteer surplus status, without further compensation or benefits, until recalled to active service. Employees in volunteer surplus status may be called back to service only after the individuals in reserve status, within their own subdivided seniority district, have been recalled. Remaining conductors and brakemen who, as a result of Crew Consist Agreement No. 2, are not needed in train service, and who do not elect one of the above severance options, will be placed on a reserve board. Employees in reserve status will receive compensation equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. In October 1993, the UTU elected to adopt Crew Consist Agreement No. 2 for those southern portion UTU members who were previously covered by Crew Consist Agreement No. 1. Crew Consist Agreement No. 2 was implemented on the southern portion of the Railroad's system during the fourth quarter of 1993. Upon implementation, each of the approximately 3,300 UTU members on the southern portion of Railroad's system received a one-time lump-sum payment of $4,000, which was the incremental difference between the $1,000 lump-sum payment received following ratification of Crew Consist Agreement No. 1 and the amount received by UTU members following adoption of Crew Consist Agreement No. 2. Railroad will continue to remove excess positions from train service through the implementation of Crew Consist Agreement No. 2. Approximately 1,350 excess positions have been removed as a result of employees accepting severance or voluntary surplus payments. Other excess positions have been eliminated and personnel formerly in those positions have been assigned to reserve boards, absorbed through additional train starts and/or utilized in quality and safety initiatives. Based upon its experience under Crew Consist Agreement No. 1, Railroad anticipates that the number of employees on reserve status will decline over time. In July 1993, the American Train Dispatchers Association ratified an April agreement which will facilitate the consolidation of all dispatching functions into a centralized train dispatching office in Fort Worth, Texas by the end of 1995. Competition The general environment in which BN operates remains highly competitive. Depending on the specific market, deregulated motor carriers, other railroads and river barges exert pressure on various price and service combinations. The presence of advanced, high service truck lines with expedited delivery, subsidized infrastructure and minimal empty mileage continues to impact the market for non-bulk, time sensitive freight. The potential expansion of long combination vehicles could further encroach upon markets traditionally served by railroads. In order to remain competitive, BN and other railroads continue to develop and implement technologically supported operating efficiencies to improve productivity. As railroads streamline, rationalize and otherwise enhance their franchises, competition among rail carriers intensifies. BN's primary rail competitors in the western region of the United States consist of Atchison, Topeka & Santa Fe Railway Company; Chicago & Northwestern Transportation Company (C&NW); Southern Pacific Transportation Company; and Union Pacific Railroad Company (UP). Coal, one of BN's primary commodities, has experienced significant pressure on rates due to competition from the joint effort of C&NW/UP and BN's efforts to penetrate into new markets. In addition to the railroads discussed above, numerous regional railroads and motor carriers operate in parts of the same territory served by BN. Environmental BN's operations, as well as those of its competitors, are subject to extensive federal, state and local environmental regulation. In order to comply with such regulation and to be consistent with BN's corporate environmental policy, BN's operating procedures include practices to protect the environment. Amounts expended relating to such practices are inextricably contained in the normal day-to-day costs of BN's business operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Wheat and barley transportation rates In September 1980 a class action lawsuit was filed against Railroad in United States District Court for the District of Montana (District Court) challenging the reasonableness of Railroad's export wheat and barley rates. The class consists of Montana grain producers and elevators. The plaintiffs sought a finding that Railroad's single car export wheat and barley rates for shipments moving from Montana to the Pacific Northwest were unreasonably high and requested damages in the amount of $64 million. In March 1981 the District Court referred the rate reasonableness issue to the Interstate Commerce Commission (ICC). Subsequently, the State of Montana filed a complaint at the ICC challenging Railroad's multiple car rates for Montana wheat and barley movements occurring after October 1, 1980. The ICC issued a series of decisions in this case from 1988 to 1991. Under these decisions, the ICC applied a revenue to variable cost test to the rates and determined that Railroad owed $9,685,918 in reparations plus interest. In its last decision, dated November 26, 1991, the ICC found Railroad's total reparations exposure to be $16,559,012 through July 1, 1991. The ICC also found that Railroad's current rates were below a reasonable maximum and vacated its earlier rate prescription order. Railroad appealed to the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit) those portions of the ICC's decisions concerning the post-October 1, 1980 rate levels. Railroad's primary contention on appeal was that the ICC erred in using the revenue to variable cost rate standard to judge the rates instead of Constrained Market Pricing/Stand Alone Cost principles. The limited portions of decisions that cover pre-October 1, 1980 rates were appealed to the Montana District Court. On March 24, 1992, the Montana District Court dismissed plaintiffs' case as to all aspects other than those relating to pre-October 1, 1980 rates. On February 9, 1993, the D.C. Circuit served its decision regarding the appeal of the several ICC decisions in this case. The Court held that the ICC did not adequately justify its use of the revenue to variable cost standard as Railroad had argued and remanded the case to the ICC for further administrative proceedings. On July 22, 1993, the ICC served an order in response to the D.C. Circuits' February 9, 1993 decision. In its order, the ICC stated it would use the Constrained Market Pricing/Stand Alone Cost standards in assessing the reasonableness of BN wheat and barley rates moving from Montana to Pacific Coast ports from 1978 forward. The ICC assigned the case to the Office of Hearings to develop a procedural schedule. The parties are now engaged in discovery. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, no matters were submitted to a vote of security holders. EXECUTIVE OFFICERS OF THE REGISTRANT AND PRINCIPAL SUBSIDIARY The following information concerning executive officers is as of February 14, 1994: GERALD GRINSTEIN, 61 Chairman and Chief Executive Officer Burlington Northern Inc. July 1991 to Present Director October 1985 to Present Chairman and Chief Executive Officer Burlington Northern Railroad Company July 1991 to Present Chairman, President and Chief Executive Officer, October 1990 to July 1991, Burlington Northern Inc.; Chairman, President and Chief Executive Officer, February 1990 to July 1991, Burlington Northern Railroad Company; President and Chief Executive Officer, January 1989 to October 1990, Burlington Northern Inc.; Chief Operating Officer, February 1989 to February 1990, Burlington Northern Railroad Company. Mr. Grinstein is a Director of Delta Air Lines, Inc., Browning Ferris Industries, Inc., Seafirst Corporation and Sunstrand Corporation. WILLIAM E. GREENWOOD, 55 Chief Operating Officer Burlington Northern Railroad Company February 1990 to Present Executive Vice President, Marketing and Sales, January 1987 to January 1990, Burlington Northern Railroad Company. DAVID C. ANDERSON, 52 Executive Vice President, Chief Financial Officer and Chief Accounting Officer Burlington Northern Inc. October 1991 to Present Executive Vice President, Chief Financial Officer Burlington Northern Railroad Company October 1991 to Present Senior Vice President and Chief Financial Officer, July 1983 to September 1991, Federal Express Corporation. Mr. Anderson is a Director of Concord EFS, Inc. JOHN Q. ANDERSON, 42 Executive Vice President, Marketing and Sales Burlington Northern Railroad Company February 1990 to Present Principal, January 1982 to January 1990, McKinsey & Company, Inc. DOUGLAS J. BABB, 41 Vice President and General Counsel Burlington Northern Railroad Company December 1986 to Present EDMUND W. BURKE, 45 Executive Vice President, Law and Secretary Burlington Northern Inc. August 1989 to Present Executive Vice President, Law and Government Affairs Burlington Northern Railroad Company February 1990 to Present Executive Vice President, Law and Government Affairs and Secretary, September 1989 to February 1990, Burlington Northern Railroad Company; Senior Vice President, Law and Secretary, January 1989 to July 1989, Burlington Northern Inc.; Senior Vice President, Law and Government Affairs and Secretary, December 1986 to August 1989, Burlington Northern Railroad Company. MARK S. CANE, 38 Vice President, Intermodal Burlington Northern Railroad Company September 1992 to Present Vice President, Equipment Management, March 1991 to September 1992; Vice President, Service Design, December 1989 to March 1991; Assistant Vice President, Marketing Resources, May 1988 to December 1989, Burlington Northern Railroad Company. JOHN T. CHAIN, JR., 59 Executive Vice President, Safety and Corporate Support Burlington Northern Railroad Company March 1993 to Present Executive Vice President, Operations, February 1991 to February 1993, Burlington Northern Railroad Company. Commander in Chief of the Strategic Air Command, June 1986 to January 1991. Mr. Chain is a Director of Kemper Corporation, Northrop Corporation and R.J.R. Nabisco. JAMES B. DAGNON, 54 Executive Vice President, Employee Relations Burlington Northern Inc. January 1992 to Present Executive Vice President, Employee Relations Burlington Northern Railroad Company January 1992 to Present Senior Vice President, Human Resources, August 1991 to January 1992; Senior Vice President, Labor Relations, June 1987 to August 1991, Burlington Northern Railroad Company. WILLIAM W. FRANCIS, 53 Executive Vice President, Network Management Burlington Northern Railroad Company February 1993 to Present Senior Vice President, Network Management, July 1990 to January 1993; Vice President, Northern Region, October 1988 to July 1990, Burlington Northern Railroad Company. DAVID L. HULL, 46 Vice President, Revenue Management Burlington Northern Railroad Company April 1992 to Present Vice President, Financial Planning, December 1989 to April 1992; Vice President, Revenue and Cost Accounting, March 1988 to September 1989, Burlington Northern Railroad Company. FRANCIS T. KELLY, 46 Securities and Finance Counsel Burlington Northern Railroad Company November 1989 to Present SEC Counsel, December 1988 to November 1989, Burlington Northern Railroad Company. RICHARD L. LEWIS, 53 Senior Vice President, Corporate Development Burlington Northern Railroad Company February 1993 to Present Vice President, Strategic Planning, February 1991 to January 1993; Vice President, Freight Equipment and Strategic Planning, January 1989 to January 1991; Vice President, Strategic Planning, May 1988 to January 1989, Burlington Northern Railroad Company. ROBERT F. MCKENNEY, 40 Senior Vice President and Treasurer Burlington Northern Inc. October 1991 to Present Senior Vice President and Treasurer Burlington Northern Railroad Company October 1991 to Present Senior Vice President, Treasurer, Acting Chief Financial Officer and Acting Chief Accounting Officer, April 1991 to October 1991, Burlington Northern Inc.; Senior Vice President, Treasurer and Acting Chief Financial Officer, April 1991 to October 1991, Burlington Northern Railroad Company; Vice President and Treasurer, October 1989 to April 1991, Burlington Northern Inc. and Burlington Northern Railroad Company; Vice President, September 1985 to September 1989, D'Accord Incorporated and D'Accord Financial Services, Inc. RICHARD A. RUSSACK, 55 Vice President, Communications Burlington Northern Railroad Company October 1991 to Present Managing Director, October 1989 to September 1991, Ogilvy, Adams & Rinehart, Inc.; Executive Vice President, September 1985 to September 1989, Gavin Anderson & Co., Inc. DON S. SNYDER, 45 Vice President, Controller and Chief Accounting Officer Burlington Northern Railroad Company April 1990 to Present Vice President, Controller, December 1987 to March 1990, Burlington Northern Railroad Company. PHILIP F. WEAVER, 53 Vice President, Agricultural Commodities Burlington Northern Railroad Company July 1990 to Present Acting Assistant Vice President, Marketing Resources, December 1989 to July 1990; Assistant Vice President Agricultural Products, August 1987 to July 1990, Burlington Northern Railroad Company. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS BNI's common stock is traded on the New York, Chicago and Pacific Stock Exchanges. At January 31, 1994, the number of common stockholders of record was 28,131. Information on quarterly dividends and common stock prices is shown on page 46. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data shown below should be read in conjunction with the consolidated financial statements and related notes. (1) Beginning in 1990, shortline expenses were reported as a reduction of revenues. Prior to 1990, these expenses had been included in purchased services expense. The reclassification had no effect on net income. Previously issued consolidated financial statements were not restated to reflect the reclassification. (2) The 1991 pre-tax special charge relates to: (i) restructuring costs for reducing surplus crew positions and a management separation pay program, (ii) increases in estimated personal injury costs and (iii) increases in estimated environmental clean-up costs. (3) During 1991, BN extinguished debt through an early redemption resulting in an extraordinary loss, net of income taxes, of $14 million, or $.18 per common share. During 1990, BN extinguished debt through note exchange agreements and the purchase of certain debentures. The net income for the year ended December 31, 1990 includes a resulting extraordinary gain, net of income taxes, of $14 million, or $.18 per common share. (4) Results for 1992 reflect the cumulative effect of the change in accounting method for revenue recognition, and the cumulative effect of the implementation of the accounting standard for postretirement benefits (Statement of Financial Accounting Standards (SFAS) No. 106). The cumulative effect of the change in accounting method for revenue recognition decreased 1992 net income by $11 million, or $.13 per common share. The cumulative effect of the change in accounting method for postretirement benefits decreased 1992 net income by $10 million, or $.11 per common share, and had no immediate effect on cash flows. (5) Results for 1993 include the effects of the Omnibus Budget Reconciliation Act of 1993 (the Act) which was signed into law on August 10, 1993. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. (6) Beginning in November 1991, shares used in computation of earnings (loss) per common share reflect a November 1991 public offering of 10,350,000 shares. (7) During 1993, BN adopted SFAS No. 109, "Accounting for Income Taxes." The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. Certain 1992 balance sheet data was reclassified to conform to the 1993 presentation. These reclassifications had no effect on previously reported net income, stockholders' equity or cash flows. (8) The 1991 operating ratio excludes the special charge discussed in note (2) above. (9) Net income used to calculate return on average stockholders' equity excludes, in the year of occurrence, the special charge, extraordinary items and the cumulative effect of accounting changes. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis relates to the financial condition and results of operations of Burlington Northern Inc. (BNI) and its majority-owned subsidiaries (collectively BN). The principal subsidiary is Burlington Northern Railroad Company (Railroad). CAPITAL RESOURCES AND LIQUIDITY Cash from operations and other resources Cash generated from operations is BN's principal source of liquidity and is primarily used for dividends and capital expenditures. Operating activities provided cash of $578 million in 1993, compared with $680 million in 1992 and $368 million in 1991. The decrease in cash from operations in 1993 compared with 1992 was primarily attributable to an $81 million increase in labor-related payments, a decline in the level of accounts receivables sold and a one-time settlement agreement payment received in 1992. These items were partially offset by a decrease in interest paid during 1993. The increase in cash from operations in 1992 over 1991 was primarily due to increased profitability, a smaller decline in the level of accounts receivable sold and the one-time settlement agreement payment received in 1992. While operating cash flows for 1993 and 1991 were sufficient to fund dividends, such cash flows were not sufficient to completely fund capital expenditures. In 1992, operating cash flows were sufficient to fund both dividends and capital expenditures. Cash shortfalls as a result of these cash outlays are generally financed with debt. Sources available for such financing are discussed below. During the first quarter of 1993, BN entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. BN accepted delivery of one locomotive during 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. Future cash from operations during this strategic investment period may not, at times, be sufficient to completely fund dividends as well as capital expenditures and strategic investments. Therefore, these requirements will likely be financed using a combination of sources including, but not limited to, cash from operations, operating leases, debt issuances and other miscellaneous sources. Each financing decision will be based upon the most appropriate alternative available. During December 1993, BNI filed a registration statement with the Securities and Exchange Commission for the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. Net proceeds from the sale of the debt securities, if any are offered and sold, will be used to pay down debt or for other general corporate purposes. BNI acquired equipment which was financed in December 1993 through the issuance of $78 million of 6.32 percent notes due 1994 to 2012. In July 1993, BNI issued $150 million of 7 1/2 percent senior unsecured debentures due 2023 and used the proceeds for general corporate purposes, including working capital. These debentures were the final borrowing under the registration statement filed on September 24, 1991 covering the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. Railroad maintains an effective program for the issuance, from time to time, of commercial paper. These borrowings are supported by Railroad's bank credit agreement, thus outstanding commercial paper balances reduce available borrowings under this agreement. The bank credit agreement allows borrowings of up to $500 million on a short-term basis. The agreement is currently scheduled to expire in November 1994. At Railroad's option, borrowing rates are based on prime, certificate of deposit or London Interbank Offered rates. Annual facility fees are 0.25 percent. The maturity value of commercial paper outstanding at December 31, 1993 was $27 million, leaving a total of $473 million of the credit agreement available, while no commercial paper was outstanding at December 31, 1992. Railroad has an agreement to sell, on a revolving basis, an undivided percentage ownership interest in a designated pool of accounts receivable with limited recourse. As of December 31, 1993, the agreement allowed for the sale of accounts receivable up to a maximum of $175 million. The agreement expires not later than December 1994. At December 31, 1993 and 1992, accounts receivable were net of $100 million and $189 million, respectively, representing receivables sold. In November 1992, BNI completed a public offering of 6,900,000 shares of 6 1/4 percent cumulative convertible preferred stock at $50 per share. Most of the $337 million net proceeds from the offering were placed in trust to fund the redemption of BNI's $300 million 9 5/8 percent notes due 1996. Under the terms of the indenture, the 9 5/8 percent notes were redeemable at par, commencing February 1, 1993. The notification for redemption of the 9 5/8 percent notes was issued to holders of the notes in December 1992 with a redemption date of February 1, 1993. The debt was considered to be extinguished as of December 31, 1992, because BNI had irrevocably placed assets in trust, prior to such date, to be used solely to satisfy scheduled payments of both the interest on and principal of the $300 million 9 5/8 percent notes. The difference between BNI's redemption price and the net carrying value resulted in an immaterial loss which was recorded in other income (expense), net in 1992. In July 1992, BNI issued $150 million of 7 percent senior unsecured notes due 2002. The proceeds were used to retire $100 million of 14 3/4 percent notes due August 15, 1992 and to reduce outstanding commercial paper balances. In February 1992, BNI issued $200 million of 8 3/4 percent senior unsecured debentures due 2022 and used the proceeds to reduce outstanding commercial paper balances. These debt instruments provided favorable long-term interest rates and matched long-term borrowing to the long-lived assets of BN's capital program. In November 1991, BNI completed a public offering of 10,350,000 shares of common stock. The transaction resulted in net proceeds of $359 million which were used primarily to retire $250 million of 11 5/8 percent subordinated debentures. Capital expenditures and resources A breakdown of capital expenditures is set forth in the following table (in millions): Equipment expenditures for 1993 increased primarily as a result of acquiring freight cars through purchases rather than through operating leases and increased information system purchases. Capital roadway expenditures for 1993 increased compared with 1992 primarily due to spending related to the severe flooding in the Midwest. Spending for signal and communication projects and new strategic initiatives for transportation network management further contributed to this increase. The average age of locomotives and freight cars at year-end 1993 was 14.5 years and 18.6 years compared to 13.5 years and 18.4 years at year-end 1992. Capital roadway spending in 1992 reflects an increase in track programs in the Powder River Basin to support BN's coal unit train service, as well as additional signal and communication projects. Equipment expenditures were lower in 1992 primarily due to the 1991 purchase of 50 high horsepower locomotives at a cost of $76 million. BN projects capital spending for the next few years to be higher than in previous years partially as a result of certain strategic investments, with a projection for 1994 of approximately $650 million. As discussed in "Cash from operations and other resources," BN has a commitment to acquire 350 new-technology alternating current traction motor locomotives through 1997. Also, BN will continue its implementation of several strategic initiatives for transportation network management using information systems technology. In addition to capital expenditures, BN continues to utilize operating leases to fulfill certain equipment requirements. In 1994, BN anticipates financing approximately $200 million of equipment through operating leases. The method used to finance this equipment will depend upon current market conditions and other factors. During 1993, BN renewed leases primarily for intermodal doublestack cars and containers, and locomotives. In 1992, renewals were primarily for covered hoppers, locomotives and coal cars. Dividends Common stock dividends declared have remained constant at $1.20 per common share for 1993, 1992 and 1991. Dividends paid on common and preferred stock during these periods were $125 million, $106 million and $92 million, respectively. The increase in 1993 dividends was primarily attributable to the issuance of 6,900,000 shares of 6 1/4 percent cumulative convertible preferred stock in November 1992. The increase in 1992 was due in large part to the issuance of 10,350,000 shares of common stock in November 1991. BNI expects to continue its current policy of paying regular quarterly dividends on its common and preferred stock, however, dividends are declared by the Board of Directors based on profitability, capital expenditure requirements, debt service and other factors. Capital structure BN's ratio of total debt to total capital, excluding redeemable preferred stock, was 48 percent at the end of both 1993 and 1992 and 62 percent at the end of 1991. In 1992, the total debt to total capital ratio improved from 1991 because debt was reduced, the 6 1/4 percent cumulative convertible preferred stock was issued and net income exceeded dividend requirements. RESULTS OF OPERATIONS Year ended December 31, 1993 compared with year ended December 31, 1992 BN had net income of $296 million, or $3.06 per common share, on 89.7 million shares for 1993 compared with net income of $278 million, or $3.11 per common share, on 88.6 million shares for 1992. Results for 1993 included the effects of severe flooding in the Midwest, most notably in the third quarter. The floods slowed and often halted operations, forced extensive detours, increased car, locomotive and crew costs and resulted in extensive rebuilding of damaged track and bridges. BN estimated that the third quarter flooding reduced revenues during 1993 by $44 million and increased operating expenses by $35 million, for a combined reduction of $79 million or $.55 per common share. Net income for 1993 included the retroactive effects of the Omnibus Budget Reconciliation Act of 1993 (the Act), which was passed into law during August 1993. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. BN recognized a one-time, non-cash charge of $28 million to income tax expense to adjust deferred taxes as of the enactment date and a charge of $1 million to current income tax expense. Net income for 1992 included settlement payments received for the reimbursement of attorneys' fees and costs incurred by BN in connection with litigation filed by Energy Transportation Systems, Inc., and others, and reimbursement of a portion of the amount paid by BN in settlement of that action. The pre-tax amount recorded in other income (expense), net was approximately $47 million. Also during 1992, BN's net income included a $21 million, or $.24 per common share, cumulative effect of changes in accounting methods and a $17 million, or $.19 per common share, favorable tax settlement with the Internal Revenue Service (IRS). Revenues During 1993, BN refined Railroad's customer oriented business units by creating smaller, more focused business units. The following table presents BN's revenue information by Railroad business unit, and includes reclassification of prior-year information to conform to current year presentation: Coal revenues improved $12 million compared with 1992, primarily as a result of increased traffic caused by a rise in the demand for electricity. Higher revenues resulting from volume increases were partially offset by lower yields arising from competitive pricing pressures in contract renegotiations, traffic mix and other factors. Additionally, BN estimated lost coal revenues of approximately $35 million for the third quarter of 1993 as a result of flood-related problems in July and August which interrupted service to several utilities. Agricultural Commodities revenues were $7 million higher than 1992 as stronger yields were partially offset by lower volumes. Improved yields resulted from a traffic mix with a greater portion of wheat traffic in 1993. Stronger export demand, for high-quality wheat grown in regions served by BN, contributed to a $74 million improvement in wheat revenues. Reduced crop quality and production problems, stemming from poor planting and growing conditions, resulted in lower corn volumes and produced a year-over-year decline in corn revenues of $45 million. Intermodal revenues were $19 million higher in 1993 compared with 1992. BN AMERICA (BNA) revenues in 1993 surpassed revenues in 1992 as a result of continued escalating demand for containerized transportation and an increased demand for intermodal service due generally to a shortage in truck capacity. As import traffic expanded and shifted from ports in California to ports served by BN in the Pacific Northwest, intermodal-international revenues increased. Domestic trailer revenues declined as trailer traffic continued to convert to containers, partially offsetting other Intermodal increases. Chemicals revenues for 1993 were $17 million greater than in 1992. Increased plastics shipments for existing customers led improvements in overall Chemicals revenues. Environmental logistics and fertilizer traffic in 1993 surpassed 1992 levels, also contributing to the higher revenues for Chemicals. Revenues for Minerals Processors increased $15 million compared with 1992. As drilling activity increased, export traffic for clays and aggregates expanded, contributing to greater revenues in 1993 than in 1992. Glass minerals and cement revenues exceeded 1992 levels. This increase was due to expanded sand traffic, which also benefited from increased drilling activity, and increased cement traffic, related to certain highway and airport construction projects. Vehicles & Machinery revenues were $21 million greater than in 1992. This improvement was due in part to growth in production and sales of light vehicles which increased domestic traffic volumes. A rise in demand for heavy machinery also contributed to greater revenues. Yields increased in 1993 primarily as a result of a decline in the average length of haul. Forest Products, Iron & Steel and Aluminum, Non-Ferrous Metals & Ores had lower revenues in 1993 compared with 1992. Current year Forest Products revenues were $6 million less than in 1992 because of reduced lumber traffic, resulting from a weak timber industry market, which was partially offset by increased particle and construction board traffic. Iron & Steel revenues declined $6 million compared with 1992, primarily due to lower taconite traffic caused by labor strikes at two large customers. Aluminum, Non-Ferrous Metals & Ores revenues decreased by $5 million as aluminum production declined. Revenues for Consumer Products were relatively flat compared with 1992. Expenses Total operating expenses for 1993 were $4,038 million compared with $4,033 million for 1992. Despite the adverse effects of the Midwest flooding on operating expenses during the third quarter of 1993, BN's year-to-date operating ratio improved one percentage point, to 86 percent, compared with 87 percent for 1992. Overall compensation and benefits expenses for 1993 remained constant with 1992. Cost of living allowances (COLAs) for union employees were $24 million lower during 1993 compared with 1992 due to timing differences of vesting periods. Work force reductions and a decrease in railroad unemployment taxes lowered expenses in 1993. These savings were offset by increases in incentive compensation, wages and salaries, and higher costs for union health, welfare and life insurance benefits. Increased wages were partially caused by a scheduled three percent basic wage increase effective July 1993 and inefficiencies associated with the Midwest flooding during 1993. Fuel expenses were $14 million higher during 1993 compared with 1992, primarily due to weather-related reductions in fuel efficiency. Increased fuel consumption due to higher traffic volume was substantially offset by the decrease in the average price paid for diesel fuel, 61.5 cents per gallon in 1993 compared with 62.2 cents per gallon in 1992. Included in the 1993 average price per gallon is a 4.3 cents per gallon increase in the federal fuel tax effective October 1, 1993, as part of the Omnibus Budget Reconciliation Act of 1993. This increased tax added approximately $7 million to expense in the fourth quarter. Materials expenses for 1993 increased $5 million compared with 1992. The combination of flood-related problems and a larger fleet size increased materials costs for locomotive repairs. Also, safety and protective equipment expenditures were higher due to continued emphasis of BN's safety programs. Offsetting these increases were lower car materials expenses. Equipment rents expenses were $6 million higher in 1993 compared with 1992 due to increases in both car-hire expenses and locomotive rentals. A reduction in car-hire expenses during the first half of 1993, due to improved utilization of equipment, was more than offset by flood-related inefficiencies which increased car-hire expenses during the second half of 1993. Purchased services expenses for 1993 were $8 million higher than in 1992. Contributing to this increase were cost increases for intermodal logistics, training, moving and derailments. Lower trackage rights credits, which reduces purchased services expenses, were received from the Southern Pacific Transportation Company (SPTC) as the floods reduced SPTC volumes over BN track. These increases were partially offset by decreases in contracted locomotive repairs and consultant fees. Depreciation expense for 1993 was $14 million higher compared with 1992 primarily due to an increase in the asset base. The $42 million decrease in other operating expenses compared with 1992 was primarily due to a $35 million decline in costs associated with personal injury claims. BN has introduced a number of programs to improve worker safety and counter increasing personal injury costs. Reductions in bad debt expense and various other costs were partially offset by losses on property retired due to flood damages and increased moving expenses. Interest expense declined $41 million in 1993 compared with 1992. This decline was mainly due to a lower average long-term debt balance outstanding during 1993 and the refinancing of higher interest rate debt throughout 1992. Other income (expense), net was $36 million lower in 1993 than in 1992. The higher 1992 income was due to a first quarter net gain of $47 million for payments and reimbursements received for the settlement of prior litigation. This decline was partially offset by an increase in the net gain on property dispositions in 1993 compared with 1992. The effective tax rate was 43.2 percent for 1993 compared with 33.8 percent for 1992. This increase resulted primarily from the retroactive increase, effective January 1, 1993, in tax rates as part of the Omnibus Budget Reconciliation Act of 1993. Excluding the retroactive effect of the tax rate change on deferred tax balances at January 1, 1993, BN's effective tax rate was 38.2 percent for 1993. Additionally, a favorable tax settlement with the IRS reduced the 1992 effective tax rate by 3.8 percent. Year ended December 31, 1992 compared with year ended December 31, 1991 BN had net income of $278 million, or $3.11 per common share, on 88.6 million shares for 1992 compared with a net loss of $320 million, or $4.14 per common share, on 77.5 million shares for 1991. Results for 1992 were reduced by $11 million, or $.13 per common share, net of tax, cumulative effect of an accounting change in revenue recognition method and $10 million, or $.11 per common share, net of tax, cumulative effect of an accounting change for postretirement benefits. Results for 1991 included an after-tax special charge of $442 million, or $5.79 per common share, related to railroad restructuring costs and increases in liabilities for casualty and environmental clean-up costs, and an extraordinary loss of $14 million, or $.18 per common share, net of tax benefits, as a result of early retirement of debt. The 1991 special charge included the following pre-tax components (in millions): Revenues During 1993, BN refined Railroad's customer oriented business units by creating smaller, more focused business units. The following table presents BN's revenue information by Railroad business unit, and includes reclassification of prior-year information to conform to current year presentation: Coal revenues in 1992 were $34 million below 1991. The decrease included the effects of a two-day work stoppage during the second quarter. The effects of the work stoppage were not recovered later in 1992 because of continued weak demand. Mild weather during the first three quarters of 1992 decreased demand for coal and slowed traffic compared with the prior year. In addition, competitive pricing pressures in contract renegotiations and declining cost indices, on which many coal contract rates are based, also contributed to lower 1992 revenues. Revenues for Agricultural Commodities were $1 million less in 1992 than in 1991. The decrease was primarily due to weak export demand for corn in the latter three quarters of 1992 which contributed to a $36 million reduction compared with 1991. This decrease was substantially offset by a $34 million increase in wheat that resulted from strong export shipments during 1992. The $24 million increase in Intermodal revenues was driven by a $59 million increase in BNA traffic that was attributable to increased demand for containerized transportation. A portion of the increase in containerized transportation was due to a conversion from trailer transportation which decreased by $24 million compared with 1991. Forest Products revenues increased $20 million compared with 1991. The increase reflects an improvement in lumber revenues that resulted from good spring building conditions, favorable movements because of product pricing pressures and increased demand caused by Hurricane Andrew's destruction. Pulpmill feedstock revenues also increased because of higher demand for woodchips. These increases were slightly offset by a decreased demand for paper and paper products during 1992, partly due to excess supplies of newsprint. Revenues for Chemicals were $42 million greater in 1992 than in 1991. The increase was primarily due to increased plastics shipments from new contracts. Higher fertilizer and petroleum products revenues were also contributing factors. Fertilizer traffic improved due to a strong spring application season and increased shipments at the beginning of the year to replenish low inventory levels from the fall of 1991. Petroleum products benefited from a stronger economy in 1992 than in 1991. Revenues in 1992 for Consumer Products and Iron & Steel both improved by $8 million compared with 1991. The improvement for Consumer Products resulted from higher bulk food products revenues, due largely from an increased movement of sugar, and higher frozen foods revenues. Frozen foods revenues improved over the prior year due largely to increased french fry traffic resulting from favorable product prices. Iron & Steel revenues improved due to increased traffic because of two new pipe projects. Revenues for Minerals Processors, Vehicles & Machinery and Aluminum, Non-Ferrous Metals & Ores were relatively flat in 1992 compared with 1991. While Vehicles & Machinery revenues were flat overall, automotive revenues increased as higher traffic volume more than offset lower yields. Declining yields reflect the rates used in late 1991 and 1992 long-term contract renewals, which were influenced by competitive pricing pressures. This increase in automotive revenues was offset by declines in heavy machinery and government traffic revenues. The slight decrease in Minerals Processors revenues was attributable to a weaker demand for glass minerals and cement products related to the construction and automobile industries. Aluminum, Non-Ferrous Metals & Ores benefited from a stronger economy in 1992 than in 1991. Expenses Total operating expenses for 1992 were $4,033 million compared with expenses of $4,090 million, excluding a $708 million special charge, in 1991. The operating ratio for 1992 was 87 percent compared with the 1991 ratio, excluding the special charge, of 90 percent. The improvement in operating expenses was primarily attributable to savings in compensation and benefits and fuel costs. Compensation and benefits expenses decreased by $47 million compared with 1991. During 1991, BN recorded a $77 million accrual for union employees' signing bonuses and for COLAs. The 1992 COLA accruals were $58 million. Current-year savings of $22 million were also noted in health, welfare and life insurance benefits due to union contract modifications. Smaller crew sizes and a full year of reduced pay rates for employees on reserve boards, which were established in the second half of 1991, also contributed to lower wages and salaries in 1992. These combined savings were somewhat offset by increases in mechanical, maintenance crew and other wages. Also, increasing use of the wage continuation program for injured employees, which was phased in during 1991, served to further offset the savings. Fuel expenses were $20 million lower than in 1991. In 1992, BN paid 62.2 cents per gallon compared with 65.5 cents in 1991. This lower average fuel price per gallon resulted in approximately $19 million of the overall savings. Reduced consumption also contributed slightly to the overall decrease. Materials expenses for 1992 were $12 million higher than in 1991. Materials costs were higher due to increased locomotive repairs during 1992. Increasing track repair cost and related work equipment repair cost also contributed to the overall increase. The $12 million decrease in equipment rents expenses compared with 1991 was largely due to a decline in locomotive related expenses. Locomotive cost savings resulted from a renegotiated purchased power agreement and the expiration, during 1992, of several locomotive leases which were not renewed. These cost savings were somewhat offset by an increase in car-hire expenses due to lower 1992 than 1991 recoveries for prior period car-hire overpayments, which offset car-hire expenses in the period recovered. Purchased services expenses increased $7 million in 1992 compared with 1991. The increases over 1991 were a result of higher expenses related to computer programming costs associated with the implementation of several strategic initiatives, the expansion of a BNA customer service center due to increased BNA traffic, payments for car repairs and intermodal logistics costs. These increases were somewhat offset by lower environmental clean-up expenses, decreased relocation costs, fewer locomotive overhauls and increased payments from SPTC for trackage rights. Depreciation expense for 1992 was $9 million lower than in 1991. The decrease was primarily attributable to reduced depreciation for rail subsequent to the current-year implementation of an Interstate Commerce Commission required service life study for rail. The effect of the study on rail depreciation was to reduce 1992 expense by $28 million. This decrease was partially offset by increased depreciation, due to a larger asset base. Other expenses for 1992 was $12 million greater than in 1991. Although reported injury claims decreased, personal injury expense, excluding wage continuation costs discussed in compensation and benefits, increased by approximately $18 million as settlement costs for claims settled increased, and hearing loss claims continued to develop. Bad debt accruals also contributed to this increase. Lower derailment expenses and a decline in moving expenses partially offset this increase. Interest expense decreased $40 million in 1992 compared with 1991. Lower market interest rates and reduced commercial paper balances were significant contributors to this decrease. The reduction of long-term debt and the refinancing of high interest rate debt, during 1992 and late 1991, added to the current-year savings. Also, 1991 interest expense included an interest accrual related to a rate litigation case. In 1992, BN recorded other income, net of expense, of $41 million versus other expense, net of income, of $25 million in 1991. The 1992 income is due primarily to a first quarter net gain of $47 million for payments and reimbursements received for the settlement of prior litigation. Loss on investment and loss on sale of receivables were also lower in 1992 than in 1991. The effective tax rate was 33.8 percent and 37.6 percent in 1992 and 1991, respectively. The lower 1992 rate was the result of a fourth quarter Appeals Division settlement of IRS audits for the years 1981 through 1985. The total tax benefit recorded in 1992 was $17 million which reduced the effective tax rate by 3.8 percent. OTHER MATTERS In October 1991, Railroad entered into an agreement (Crew Consist Agreement No. 1) with the United Transportation Union (UTU) covering the southern portion of Railroad's system. Crew Consist Agreement No. 1 provided for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. Under the terms of Crew Consist Agreement No. 1, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $60,000 per employee. Remaining conductors or brakemen who, as a result of Crew Consist Agreement No. 1, were unable to hold a position in active service, due to relative seniority, were placed on a reserve board. Employees in reserve status received compensation at a rate equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. Each UTU member on the southern portion of Railroad's system received a lump-sum payment of $1,000 upon ratification of Crew Consist Agreement No. 1. In May 1993, Railroad entered into an agreement (Crew Consist Agreement No. 2) with the UTU covering approximately 3,400 UTU members in the northern portion of Railroad's system. Crew Consist Agreement No. 2 provides for crews on most through-freight trains to consist of one conductor and one engineer and for crews on all other trains to consist of one brakeman, one conductor and one engineer. It is similar to Crew Consist Agreement No. 1, covering the southern portion of Railroad's system. Each UTU member on the northern portion of Railroad's system received a one-time lump-sum payment of $5,000, pursuant to Crew Consist Agreement No. 2. Under the terms of Crew Consist Agreement No. 2, Railroad offered the opportunity for voluntary separation from employment in return for severance payments of up to $80,000 per employee. Conductors and brakemen who choose not to accept the voluntary separation offer can elect volunteer surplus status pursuant to which they will receive $60,000 to be paid out over a period of 18 to 48 months, as each selects. If such employee has not been recalled to active service by the time such payments cease upon expiration of the selected period, such employee will remain in volunteer surplus status, without further compensation or benefits, until recalled to active service. Employees in volunteer surplus status may be called back to service only after the individuals in reserve status, within their own subdivided seniority district, have been recalled. Remaining conductors and brakemen who, as a result of Crew Consist Agreement No. 2, are not needed in train service, and who do not elect one of the above severance options, will be placed on a reserve board. Employees in reserve status will receive compensation equal to either 75 percent of their previous 12-month earnings, or 75 percent of the basic five-day yard helper rate of pay, whichever is greater, and are required to be available for return to active service on 15 days' notice. In October 1993, the UTU elected to adopt Crew Consist Agreement No. 2 for those southern portion UTU members who were previously covered by Crew Consist Agreement No. 1. Crew Consist Agreement No. 2 was implemented on the southern portion of the Railroad's system during the fourth quarter of 1993. Upon implementation, each of the approximately 3,300 UTU members on the southern portion of Railroad's system received a one-time lump-sum payment of $4,000, which was the incremental difference between the $1,000 lump-sum payment received following ratification of Crew Consist Agreement No. 1 and the amount received by UTU members following adoption of Crew Consist Agreement No. 2. Railroad will continue to remove excess positions from train service through the implementation of Crew Consist Agreement No. 2. Approximately 1,350 excess positions have been removed as a result of employees accepting severance or voluntary surplus payments. Other excess positions have been eliminated and personnel formerly in those positions have been assigned to reserve boards, absorbed through additional train starts and/or utilized in quality and safety initiatives. Based upon its experience under Crew Consist Agreement No. 1, Railroad anticipates that the number of employees on reserve status will decline over time. In July 1993, the American Train Dispatchers Association ratified an April agreement which will facilitate the consolidation of all dispatching functions into a centralized train dispatching office in Fort Worth, Texas by the end of 1995. Since 1935, BN has participated in the national railroad retirement system which is separate from the national social security system. Under this system, an independent Railroad Retirement Board administers the determination and payment of benefits to all railroad workers. Both BN and its employees are subject to a tax on employee earnings which is above the normal social security rate assessed to those who are employed outside the railroad industry. Personal injury claims, including work-related injuries to employees, are a significant expense for the railroad industry. Employees of BN are compensated for work-related injuries according to the provisions of the Federal Employers' Liability Act (FELA). FELA's system of requiring finding of fault, coupled with unscheduled awards and reliance on the jury system, has resulted in significant increases in expense. The result has been a trend during the last several years of significant increases in BN's personal injury expense which reflects the combined effects of increasing medical expenses, legal judgments and settlements. To improve worker safety and counter increasing costs, BN has introduced a number of programs to reduce the number of personal injury claims and the dollar amount of claims settlements which helped reduce cost in 1993. If these efforts continue to be successful, future expenses could be further reduced. The total amount of personal injury expenses (including wage continuation payments) were $216 million, $253 million and $224 million in 1993, 1992 and 1991, respectively. BN is also working with others through the Association of American Railroads to seek changes in legislation to provide a more equitable program for injury compensation in the railroad industry. BN's operations, as well as those of its competitors, are subject to extensive federal, state and local environmental regulation. In order to comply with such regulation and to be consistent with BN's corporate environmental policy, BN's operating procedures include practices to protect the environment. Amounts expended relating to such practices are inextricably contained in the normal day-to-day costs of BN's business operations. Under the requirements of the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and certain other laws, BN is potentially liable for the cost of clean-up of various contaminated sites identified by the U.S. Environmental Protection Agency and other agencies. BN has been notified that it is a potentially responsible party (PRP) for study and clean-up costs at a number of sites and, in many instances, is one of several PRPs. BN generally participates in the clean-up of these sites through cost-sharing agreements with terms that vary from site to site. Costs are typically allocated based on relative volumetric contribution of material, the amount of time the site was owned or operated, and/or the portion of the total site owned or operated by each PRP. However, under Superfund and certain other laws, as a PRP, BN can be held jointly and severally liable for all environmental costs associated with a site. Environmental costs include initial site surveys and environmental studies of potentially contaminated sites as well as costs for remediation and restoration of sites determined to be contaminated. Liabilities for environmental clean-up costs are initially recorded when BN's liability for environmental clean-up is both probable and a reasonable estimate of associated costs can be made. Adjustments to initial estimates are recorded as necessary based upon additional information developed in subsequent periods. BN conducts an ongoing environmental contingency analysis, which considers a combination of factors, including independent consulting reports, site visits, legal reviews, analysis of the likelihood of participation in and ability to pay for clean-up by other PRPs, and historical trend analysis. BN is involved in a number of administrative and judicial proceedings in which it is being asked to participate in the clean-up of sites contaminated by material discharged into the environment. BN paid $27 million, $20 million and $21 million during 1993, 1992 and 1991, respectively, relating to mandatory clean-up efforts, including amounts expended under federal and state voluntary clean-up programs. At this time, BN expects to spend approximately $120 million in future years to remediate and restore these sites. Liabilities for environmental costs represent BN's best estimates for remediation and restoration of these sites and include asserted and unasserted claims. BN's best estimate of unasserted claims was approximately $5 million as of the end of 1993. Although recorded liabilities include BN's best estimates of all costs, without reduction for anticipated recovery from insurance, BN's total clean-up costs at these sites cannot be predicted with certainty due to various factors such as the extent of corrective actions that may be required, evolving environmental laws and regulations, advances in environmental technology, the extent of other PRPs participation in clean-up efforts, developments in ongoing environmental analyses related to sites determined to be contaminated, and developments in environmental surveys and studies of potentially contaminated sites. As a result, charges to income for environmental liabilities could possibly have a significant effect on results of operations in a particular quarter or fiscal year as individual site studies and remediation and restoration efforts proceed or as new sites arise. However, expenditures associated with such liabilities are typically paid out over a long period, in some cases up to 40 years, and are therefore not expected to have a material adverse effect on BN's consolidated financial position, cash flow or liquidity. In November 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires employers to recognize benefits provided to former or inactive employees after employment but before retirement, if certain conditions are met. In the first quarter of 1994, BN will adopt SFAS No. 112. The principal effect of adopting this standard will be to establish liabilities for long-term and short-term disability plans. The effect upon earnings to adopt this standard is expected to be approximately $15 to $20 million. The initial effect of applying this standard will be reported as the effect of a change in accounting method and previously issued financial statements will not be restated. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 addresses the accounting and reporting requirements for investments in equity securities that have readily determinable fair values and for all investments in debt securities, and is effective for fiscal years beginning after December 15, 1993. The initial effect of applying this standard is to be reported as the effect of a change in accounting method and previously issued financial statements may not be restated. No material effect on BN's financial condition or results of operations is anticipated from the adoption of SFAS No. 115. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED STATEMENTS OF OPERATIONS BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY BURLINGTON NORTHERN INC. AND SUBSIDIARIES (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS BURLINGTON NORTHERN INC. AND SUBSIDIARIES 1. ACCOUNTING POLICIES Principles of consolidation The consolidated financial statements include the accounts of Burlington Northern Inc. (BNI) and its majority-owned subsidiaries (collectively BN). The principal subsidiary is Burlington Northern Railroad Company (Railroad). All significant intercompany accounts and transactions have been eliminated. Property and equipment Main line track is depreciated on a group basis using a units-of-production method. All other property and equipment are depreciated on a straight-line basis over estimated useful lives. Interstate Commerce Commission (ICC) regulations require periodic formal studies of ultimate service lives for all railroad assets. Resulting service life estimates are subject to review and approval by the ICC. An annual review of rates and accumulated depreciation is performed and appropriate adjustments are recorded. Significant premature retirements are recorded as gains or losses at the time of their occurrence, which would include major casualty losses, abandonments, sales and obsolescence of assets. Expenditures which significantly increase asset values or extend useful lives are capitalized. Repair and maintenance expenditures are charged to operating expense when the work is performed. All properties are stated at cost. Materials and supplies Materials and supplies consist mainly of diesel fuel, repair parts for equipment and other railroad property and are valued at average cost. Revenue recognition Transportation revenues are recognized proportionately as a shipment moves from origin to destination. Income taxes Income taxes are provided based on earnings reported for tax return purposes in addition to a provision for deferred income taxes. The provision for income taxes includes deferred taxes determined by the change in the deferred tax liability, which is computed based on the differences between the financial statement and tax basis of assets and liabilities as measured by applying enacted tax laws and rates. Deferred tax expense is the result of changes in the net liability for deferred taxes. Investment tax credits were accounted for under the "flow-through" method. Earnings (loss) per common share Earnings (loss) per common share are determined by dividing net income, after deduction of preferred stock dividends, by the weighted average number of common shares outstanding and common share equivalents. Common share equivalents were not included in the computation of the loss per common share in 1991 since their effect would have been antidilutive. Cash and cash equivalents All short-term investments which mature in less than 90 days when purchased are considered cash equivalents for purposes of disclosure in the consolidated balance sheets and consolidated statements of cash flows. Cash equivalents are stated at cost, which approximates market value. Reclassifications Certain prior year data has been reclassified to conform to the current year presentation. These reclassifications had no effect on previously reported net income, stockholders' equity or cash flows. 2. ACCOUNTS RECEIVABLE, NET Railroad has an agreement to sell, on a revolving basis, an undivided percentage ownership interest in a designated pool of accounts receivable with limited recourse. As of December 31, 1993, the agreement allowed for the sale of accounts receivable up to a maximum of $175 million. The agreement expires not later than December 1994. Average monthly proceeds from the sale of accounts receivable were $182 million, $190 million and $269 million in 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, accounts receivable were net of $100 million and $189 million, respectively, representing receivables sold. Included in other income (expense), net were expenses of $9 million, $11 million and $20 million in 1993, 1992 and 1991, respectively, relating to the sale. BN maintains an allowance for doubtful accounts based upon the expected collectibility of all trade accounts receivable, including receivables sold with recourse. Allowances for doubtful accounts and recourse on receivables sold of $17 million and $16 million have been recorded at December 31, 1993 and 1992. 3. PROPERTY AND EQUIPMENT, NET Property and equipment, net was as follows (in millions): Certain noncancellable leases were classified as capital leases and were included in property and equipment. The consolidated balance sheets at December 31, 1993 and 1992 included $36 million and $35 million, respectively, of property and equipment under capital leases. The related depreciation was included in depreciation expense. Accumulated depreciation for property and equipment under capital leases was $31 million and $29 million at December 31, 1993 and 1992, respectively. Main line track is depreciated on a group basis using a units-of-production method. The accumulated depreciation and annual depreciation accrual rates for railroad assets other than main line track are calculated using a straight-line method and statistical group measurement techniques, which closely approximate unit depreciation. The group techniques project depreciation expense and estimated accumulated depreciation utilizing historical experience and expected future conditions relating to the timing of asset retirements, cost of removal, salvage proceeds, maintenance practices and technological changes. In this manner, the net book value of reported assets reflects estimated remaining asset utility on a historical cost basis. Due to the imprecision of annual reviews using statistical group measurement techniques for long-term asset retirement, replacement and deterioration patterns, BN adjusts accumulated depreciation for significant differences between recorded accumulated depreciation and computed requirements. Differences between recorded accumulated depreciation and computed requirements are recognized prospectively on a straight-line basis. Under ICC regulations, BN conducts service life studies on an annual basis. Results of service life studies are recorded over the remaining life of the asset group studied. During 1993, BN completed service life studies of equipment and road property. During 1992, the service life studies consisted of rail. The effect of implementing the results of new service life studies and similar rate adjustments were to decrease depreciation expense in 1993 by $2 million compared with 1992 and to decrease depreciation expense in 1992 by $28 million compared with 1991. In future periods, service life studies will be conducted on other asset groups as well as these same assets under ICC requirements. However, the impact of such studies is not determinable at this time. In 1993, capitalization of certain software development costs increased as a result of new strategic initiatives. Capitalization of software development costs begins upon establishment of technological feasibility. The establishment of technological feasibility is based upon completion of planning, design and other technical performance requirements. Capitalized software development costs are amortized over a seven-year estimated useful life using the straight-line method. No amortization was recorded for the year ended December 31, 1993. Unamortized capitalized software costs were $6 million as of December 31, 1993. 4. DEBT Debt outstanding was as follows (in millions): Railroad maintains an effective program for the issuance, from time to time, of commercial paper. These borrowings are supported by Railroad's bank credit agreement, thus outstanding commercial paper balances reduce available borrowings under this agreement. The bank credit agreement allows borrowings of up to $500 million on a short-term basis. The agreement is currently scheduled to expire in November 1994. At Railroad's option, borrowing rates are based on prime, certificate of deposit or London Interbank Offered rates. Annual facility fees are 0.25 percent. The maturity value of commercial paper outstanding at December 31, 1993 was $27 million, leaving a total of $473 million of the credit agreement available, while no commercial paper was outstanding at December 31, 1992. The financial covenants of the bank credit agreement require that Railroad's consolidated tangible net worth, as defined in the agreement, be at least $1.4 billion, and its debt, as defined in the agreement, cannot exceed the lesser of 140 percent of its consolidated tangible net worth or $2.5 billion. The agreement contains an event of default arising out of the occurrence and continuance of a "Change in Control." A "Change in Control" is generally defined as the acquisition of more than 50 percent of the voting securities of BNI, which has not been approved by the BNI Board of Directors, a change in the control relationship between BNI and Railroad, and finally, a "Change in Control" is deemed to occur when a majority of the seats on the BNI Board of Directors is occupied by persons who are neither nominated by BNI management nor appointed by directors so nominated. The commercial paper program is further summarized as follows (dollars in millions): Maturities of commercial paper averaged 4 and 14 days in 1993 and 1992, respectively. During December 1993, BNI filed a registration statement with the Securities and Exchange Commission for the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. Net proceeds from the sale of the debt securities, if any are offered and sold, will be used to pay down debt or for other general corporate purposes. BNI acquired equipment which was financed in December 1993 through the issuance of $78 million of 6.32 percent notes due 1994 to 2012. In July 1993, BNI issued $150 million of 7 1/2 percent senior unsecured debentures due 2023 and used the proceeds for general corporate purposes, including working capital. These debentures were the final borrowing under the registration statement filed on September 24, 1991 covering the issuance, from time to time, of up to $500 million aggregate principal amount of debt securities. In November 1992, BNI completed a public offering of 6,900,000 shares of 6 1/4 percent cumulative convertible preferred stock at $50 per share. Most of the $337 million net proceeds from the offering were placed in trust to fund the redemption of BNI's $300 million 9 5/8 percent notes due 1996. Under the terms of the indenture, the 9 5/8 percent notes were redeemable at par, commencing February 1, 1993. The notification for redemption of the 9 5/8 percent notes was issued to holders of the notes in December 1992 with a redemption date of February 1, 1993. The debt was considered to be extinguished as of December 31, 1992, because BNI had irrevocably placed assets in trust, prior to such date, to be used solely to satisfy scheduled payments of both the interest on and principal of the $300 million 9 5/8 percent notes. The difference between BNI's redemption price and the net carrying value resulted in an immaterial loss which was recorded in other income (expense), net in 1992. In July 1992, BNI issued $150 million of 7 percent senior unsecured notes due 2002. The proceeds were used to retire $100 million of 14 3/4 percent notes due August 15, 1992 and to reduce outstanding commercial paper balances. In February 1992, BNI issued $200 million of 8 3/4 percent senior unsecured debentures due 2022 and used the proceeds to reduce outstanding commercial paper balances. Aggregate long-term debt scheduled maturities for 1994 through 1998 and thereafter are $185 million, $31 million, $25 million, $248 million, $24 million and $1,266 million, respectively. Substantially all Railroad properties and certain other assets are pledged as collateral to or are otherwise restricted under the various Railroad long-term debt agreements. 5. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of BN's financial instruments at December 31, 1993 and 1992 and the methods and assumptions used to estimate the fair value of each class of financial instruments held by BN, were as follows: Cash and short-term investments The carrying amount approximated fair value because of the short maturity of these instruments. Notes receivable The fair value of notes receivable was estimated by discounting the anticipated cash flows. Discount rates of 8.7 percent and 10 percent at December 31, 1993 and 1992, were determined to be appropriate when considering current U.S. Treasury rates and the credit risk associated with these notes. Accrued interest payable The carrying amount approximated fair value as the majority of interest payments are made semiannually. Long-term debt and commercial paper The fair value of BN's long-term debt, excluding unamortized discount, was primarily based on secondary market indicators. For those issues not actively quoted, estimates were based on each obligation's characteristics. Among the factors considered were the maturity, interest rate, credit rating, collateral, amortization schedule, liquidity and option features such as optional redemption or optional sinking funds. These features were compared to other similar outstanding obligations to determine an appropriate increment or spread, above U.S. Treasury rates, at which the cash flows were discounted to determine the fair value. The carrying amount of commercial paper approximated fair value because of the short maturity of these instruments. Redeemable preferred stock The fair value of BN's redeemable preferred stock represented the market value as shown on the New York Stock Exchange at December 31, 1992. Recourse liability from sale of receivables It is unlikely that BN would be able to pay a second entity to assume its recourse obligation. Therefore, the carrying value of the allowance for doubtful accounts on receivables sold approximated the fair value of the recourse liability related to those receivables. The carrying amount and estimated fair values of BN's financial instruments were as follows (in millions): BN also holds investments in, and has advances to, several unconsolidated transportation affiliates. It was not practicable to estimate the fair value of these financial instruments, which were carried at their original cost of $19 million and $22 million in the December 31, 1993 and 1992 consolidated balance sheets. There were no quoted market prices available for the shares held in the affiliated entities, and the cost of obtaining an independent valuation would have been excessive considering the materiality of these investments to BN. In addition, BN has a note receivable, from a shortline railroad, that has principal payments which are based on traffic volume over a segment of line. The carrying value of the note was $5 million at December 31, 1993 and 1992. As it is not practicable to forecast the traffic volume over the remaining life of the note, it was not included in the notes receivable amount shown above. In May 1993, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 addresses the accounting and reporting requirements for investments in equity securities that have readily determinable fair values and for all investments in debt securities, and is effective for fiscal years beginning after December 15, 1993. The initial effect of applying this standard is to be reported as the effect of a change in accounting method and previously issued financial statements may not be restated. No material effect on BN's financial condition or results of operations is anticipated from the adoption of SFAS No. 115. 6. INCOME TAXES Effective January 1, 1993, BN adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 modifies SFAS No. 96, which established the liability method of accounting for income taxes, and had been adopted by BN effective January 1, 1986. BN adopted SFAS No. 109 consistent with the transitional guidelines of SFAS No. 109. The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. There was no effect on net income, stockholders' equity or cash flows. Income tax expense (benefit), excluding the effect of the extraordinary item and the cumulative effect of changes in accounting methods, was as follows (in millions): Reconciliation of the federal statutory income tax rate to the effective tax rate, excluding the extraordinary item and the cumulative effect of changes in accounting methods, was as follows: The components of deferred tax assets and liabilities were as follows (in millions): As of December 31, 1993, approximately $5 million of alternative minimum tax credit carryovers with no expiration date are available to offset future tax liabilities. The alternative minimum tax credits have been fully recognized for financial accounting purposes. In 1993, tax benefits of $4 million related to the adjustment to recognize a minimum pension liability were allocated directly to stockholders' equity. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. A one-time, non-cash charge of $28 million to income tax expense was recorded as an adjustment to deferred taxes as of the enactment date and a charge of $1 million to income tax expense was recorded as an adjustment to current income taxes. In December 1992, BN received notification that an Appeals Division settlement of the Internal Revenue Service audits for the years 1981 through 1985 had been approved by the Joint Committee on Taxation. This action settled all unagreed issues for those years. The tax effect of the settlement was included in the 1992 tax provision as shown below (in millions, except per share data): 7. REDEEMABLE PREFERRED STOCK On July 15, 1993, BNI redeemed all of the outstanding shares of its $10 Par Value 5 1/2 percent Cumulative Redeemable Preferred Stock. BNI purchased the shares for $10.067222 per share or for a total of $9 million, representing the redemption price of $10 per share plus accrued dividends for the period from June 2, 1993 to July 15, 1993. Redeemable preferred stock activity was as follows (dollars in millions): 8. PREFERRED CAPITAL STOCK No Par Value Preferred Stock, authorized 25,000,000 shares -- 6,900,000 shares issued In November 1992, BNI issued 6,900,000 shares of 6 1/4 percent Cumulative Convertible Preferred Stock, Series A No Par Value. The convertible preferred stock is not redeemable prior to December 26, 1995. Thereafter, the shares may be redeemed at BNI's option, in whole or in part, during the twelve months beginning November 24 of each year except for 1995 which commences December 26, at the following redemption prices per share: $52.1875 in 1995, $51.875 in 1996, $51.5625 in 1997, $51.25 in 1998, $50.9375 in 1999, $50.625 in 2000, $50.3125 in 2001, and $50 in 2002 and thereafter. The convertible preferred stock may be converted, at the option of the holder at any time, into the number of shares of BNI's common stock equal to the liquidation preference of each share of convertible preferred stock, $50, divided by the conversion price of $47 per share of common stock. The convertible preferred stockholders have no voting rights unless six quarterly dividend payments are in default. In a default, such stockholders may vote separately as a class with all other series of the No Par Value Preferred Stock to elect two additional directors. Voting rights will continue until all arrearages have been paid. As of December 31, 1993, there had been no such defaults. Class A Preferred Stock Without Par Value, authorized 50,000,000 shares -- unissued At December 31, 1993, BNI had available for issuance 50,000,000 shares of Class A Preferred Stock Without Par Value. The Board of Directors has the authority to issue such stock in one or more series, to fix the number of shares and to fix the designations and the powers. On July 10, 1986, the Board of Directors designated a series of 800,000 shares of Class A Preferred Stock Without Par Value as Series A Junior Participating Class A Preferred Stock. On December 19, 1991, the Board of Directors increased the Series A Junior Participating Class A Preferred Stock designation to 3,000,000 shares. Each one one-hundredth of a share will have dividend and voting rights approximately equal to those of one share of common stock of BNI. In addition, on July 10, 1986, the Board of Directors declared a dividend distribution of one right for each outstanding share of common stock of BNI. The rights become exercisable if, without BNI's prior consent, a person or group acquires securities having 20 percent or more of the voting power of all of BNI's voting securities or announces a tender offer which would result in such ownership. Each right, when exercisable, entitles the registered holder to purchase from BNI one one-hundredth of a share of Series A Junior Participating Class A Preferred Stock at a price of $190 per one one-hundredth of a share, subject to adjustment. If, after the rights become exercisable, BNI were to be acquired through a merger, each right would permit the holder to purchase, for the exercise price, stock of the acquiring company having a value of twice the exercise price. In addition, if any person acquires 25 percent or more of BNI (other than as a result of a cash offer for all shares), each right not owned by the holder of such 25 percent would permit the purchase, for the exercise price, of stock of BNI having a value of twice the exercise price. The rights may be redeemed by BNI under certain circumstances until their expiration date for $.05 per right. 9. COMMON STOCK AND ADDITIONAL PAID-IN CAPITAL BNI is authorized to issue 300,000,000 shares of Common Stock Without Par Value. At December 31, 1993, there were 88,796,139 shares of common stock outstanding. Each holder of common stock is entitled to one vote per share in the election of directors and on all matters submitted to a vote of stockholders. Subject to the rights and preferences of the convertible preferred stock and any future issuance of additional preferred stock, each share of common stock is entitled to receive dividends as may be declared by the Board of Directors out of funds legally available and to share ratably in all assets available for distribution to stockholders upon dissolution or liquidation. No holder of common stock has any preemptive right to subscribe for any securities of BNI. Effective December 1991, the Board of Directors of BNI authorized the transfer, to additional paid-in capital, of $1,343 million representing capital in excess of the stated value of common stock. 10. STOCK OPTIONS AND OTHER CAPITAL STOCK Stock options Under BN's stock option plans, options may be granted to officers and key salaried employees at fair market value on the date of grant. All options expire within ten years after the date of grant. BN may also grant stock appreciation rights (SARs) in tandem with stock options which would be exercisable during the same period as the options. SARs entitle an option holder to receive a payment equal to the difference between the option price and the fair market value of the common stock at the date of exercise of the SAR. To the extent the SAR is exercised, the related option is cancelled and to the extent the option is exercised the related SAR is cancelled. Any change in the current market value over the SARs exercise price would be recognized at such time as an adjustment to compensation expense. During the third quarter of 1991, following a change in rules 16(a) and 16(b) promulgated under the Securities and Exchange Act of 1934, as amended, substantially all holders of SARs relinquished those rights. As a result, there were no further adjustments to compensation expense in times of changing market prices after the year ended December 31, 1991. Adjustments to compensation expense during the year ended December 31, 1991 were not significant. Activity in stock option plans was as follows: Shares issued upon exercise of options may be issued from treasury shares or from authorized but unissued shares. Other capital stock BN has restricted stock award plans under which up to 1,700,000 common shares may be awarded to eligible employees and directors of BN. No cash payment is required by the individual. Shares awarded under the plan may not be sold, transferred or used as collateral by the holder until the shares awarded become free of the restrictions, generally by one-thirds on the third, fourth and fifth anniversaries of the date of grant. All shares still subject to restrictions are generally forfeited and returned to the plan if the employee or director's relationship with BN is terminated. If the employee or director retires, becomes disabled or dies, the restrictions will lapse at that time. The compensation expense resulting from the award of restricted stock is valued at the average of the high and low market prices of BNI common stock on the date of the award, recorded as a reduction of stockholders' equity, and charged to expense evenly over the service period. Restricted stock awards under these plans, net of forfeitures, were 232,354, 214,475 and 223,850 shares in 1993, 1992 and 1991, respectively. A total of 870,525, 824,877 and 757,565 restricted common shares were outstanding at December 31, 1993, 1992 and 1991, respectively. Compensation expense was not significantly affected for all periods presented. BN also has a stock award plan which provides for grants of shares of BNI's common stock to full-time employees, excluding officers, based upon performance. A total of 100,000 shares of common stock has been authorized for these awards. The shares awarded contain no restrictions and the recipients have full shareholder rights and privileges. Compensation expense is based upon the average of the high and low market prices of BNI common stock on the date of grant. During the years ended December 31, 1993, 1992 and 1991, 5,540, 11,720 and 7,790 shares were awarded under this plan. The related compensation expense was not significant. An employee stock purchase plan was adopted in 1992 effective in 1993 as a means to encourage employee ownership of BNI common stock. A total of 500,000 shares of common stock were authorized for distribution under this plan. The plan allows eligible BN employees to use the proceeds of incentive compensation awards to purchase shares of BNI common stock at a discount, as determined by the BNI Board of Directors, from the market price and may require that the shares purchased be held for a specific time period as also determined by the Board of Directors. The difference between the market price and the employees' purchase price is recorded as additional compensation expense. During the year ended December 31, 1993, 34,629 shares were awarded under this plan. The related compensation expense was not significant. 11. RETIREMENT PLANS BN has non-contributory defined benefit pension plans covering substantially all non-union employees. The benefits are based on years of credited service and the highest five-year average compensation levels. Contributions to the plans are based upon the projected unit credit actuarial funding method and are limited to amounts that are currently deductible for tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The funded status of BN plans and the net accrued pension cost reflected in the consolidated balance sheets were as follows (in millions): Components of the net pension cost were as follows (in millions): Net pension cost for 1993 was lower than 1992 primarily due to a decrease in the rate of future compensation growth from 6 percent to 5.5 percent. The changes in pension cost for the two years ended December 31, 1992 were primarily attributable to the expected year-to-year changes in the discount rates. The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the benefit obligations were 7 percent and 5.5 percent at December 31, 1993 and 8.5 percent and 5.5 percent at December 31, 1992. The expected long-term rate of return on assets was 9.5 percent for 1993 and 10 percent for the other years presented. BN sponsors a 401(k) thrift and profit sharing plan which covers substantially all non-union employees. BN matches 35 percent of the first 6 percent of the employees' contributions, which is subject to certain percentage limits of the employees' earnings, at the end of each quarter. Depending on BN's performance, an additional matching contribution of 20 to 40 percent can be made at the end of the year. BN's expense was $6 million, $4 million and $6 million in 1993, 1992 and 1991, respectively. Effective January 1, 1994, BN also sponsors a 401(k) retirement savings plan covering substantially all union employees which is non-contributory on the part of BN. 12. OTHER BENEFIT PLANS Postretirement benefits Effective January 1, 1992, BN adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." BN provides certain postretirement health care benefits, payable until age 65, for a small number of retirees who retired on or before March 1986. Both the accumulated postretirement benefits obligation and cost associated with this plan were insignificant. Life insurance benefits are provided for eligible non-union employees. BN adopted accrual accounting for the expense of these plans in 1992 by taking a $16 million cumulative effect charge to income in order to establish a liability for those benefits. BN pays benefits as claims are processed. The following table presents the status of the plans and the accrued postretirement benefit cost reflected in the consolidated balance sheets (in millions): Components of the postretirement benefit cost were as follows (in millions): The discount rate used in determining the benefit obligation was 7 percent at December 31, 1993 and 8.5 percent at December 31, 1992. The health care cost trend rate is assumed to decrease gradually from 15 percent in 1994 to 6 percent in 2003 and thereafter. Increasing the assumed health care cost trend rate by one percentage point in each year would have an insignificant effect on the accumulated postretirement benefit obligation at December 31, 1993 and 1992 as well as the aggregate of the service and interest cost components in 1993 and 1992. Under collective bargaining agreements, Railroad participates in multi-employer benefit plans which provide certain postretirement health care and life insurance benefits for eligible union employees. Insurance premiums attributable to retirees, which are expensed as incurred, were $10 million in 1993 and $11 million in both 1992 and 1991. Postemployment benefits In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This standard requires employers to recognize benefits provided to former or inactive employees after employment but before retirement, if certain conditions are met. In the first quarter of 1994, BN will adopt SFAS No. 112. The principal effect of adopting this standard will be to establish liabilities for long-term and short-term disability plans. The effect upon earnings to adopt this standard is expected to be approximately $15 to $20 million. The initial effect of applying this standard will be reported as the effect of a change in accounting method and previously issued financial statements will not be restated. 13. CASUALTY AND ENVIRONMENTAL RESERVES Casualty reserves consist primarily of personal injury claims, including work-related injuries to employees. Employees of BN are compensated for work-related injuries according to the provisions of the Federal Employers' Liability Act. Liabilities for personal injury claims are estimated through an actuarial model that considers historical data and trends and is designed to record those costs in the period of occurrence. BN conducts an ongoing review and analysis of claims and other information to ensure the continued adequacy of casualty reserves. To the extent costs exceed recorded accruals they will not materially affect BN's financial condition, results of operations or liquidity. Under the requirements of the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund) and certain other laws, BN is potentially liable for the cost of clean-up of various contaminated sites identified by the U.S. Environmental Protection Agency and other agencies. BN has been notified that it is a potentially responsible party (PRP) for study and clean-up costs at a number of sites and, in many instances, is one of several PRPs. BN generally participates in the clean-up of these sites through cost-sharing agreements with terms that vary from site to site. Costs are typically allocated based on relative volumetric contribution of material, the amount of time the site was owned or operated, and/or the portion of the total site owned or operated by each PRP. However, under Superfund and certain other laws, as a PRP, BN can be held jointly and severally liable for all environmental costs associated with a site. Environmental costs include initial site surveys and environmental studies of potentially contaminated sites as well as costs for remediation and restoration of sites determined to be contaminated. Liabilities for environmental clean-up costs are initially recorded when BN's liability for environmental clean-up is both probable and a reasonable estimate of associated costs can be made. Adjustments to initial estimates are recorded as necessary based upon additional information developed in subsequent periods. BN conducts an ongoing environmental contingency analysis, which considers a combination of factors, including independent consulting reports, site visits, legal reviews, analysis of the likelihood of participation in and ability to pay for clean-up by other PRPs, and historical trend analysis. Liabilities for environmental costs represent BN's best estimates for remediation and restoration of these sites and include asserted and unasserted claims. BN's best estimate of unasserted claims was approximately $5 million as of the end of 1993. Although recorded liabilities include BN's best estimates of all costs, without reduction for anticipated recovery from insurance, BN's total clean-up cost at these sites cannot be predicted with certainty due to various factors such as the extent of corrective actions that may be required, evolving environmental laws and regulations, advances in environmental technology, the extent of other PRPs participation in clean-up efforts, developments in ongoing environmental analyses related to sites determined to be contaminated, and developments in environmental surveys and studies of potentially contaminated sites. As a result, charges to income for environmental liabilities could possibly have a significant effect on results of operations in a particular quarter or fiscal year as individual site studies and remediation and restoration efforts proceed or as new sites arise. However, expenditures associated with such liabilities are typically paid out over a long period, in some cases up to 40 years, and are therefore not expected to have a material adverse effect on BN's consolidated financial position, cash flow or liquidity. 14. COMMITMENTS AND CONTINGENCIES Lease commitments BN has substantial lease commitments for railroad, highway and data processing equipment, office buildings and a taconite dock facility. Most of these leases provide the option to purchase the equipment at fair market value at the end of the lease. However, some provide fixed purchase price options. Lease rental expense for operating leases was $175 million, $189 million and $195 million for the years ended December 31, 1993, 1992 and 1991, respectively. Minimum annual rental commitments were as follows (in millions): In addition to the above, BN also receives and pays rents for railroad equipment on a per diem basis, which is included in equipment rents. Other commitments and contingencies During 1993, BN entered into an agreement to acquire 350 new-technology alternating current traction motor locomotives. BN accepted delivery of one locomotive in 1993 and anticipates delivery of between approximately 60 and 100 each year from 1994 through 1997. BN has two locomotive electrical power purchase agreements, expiring in 1998 and 2001, that currently involve 199 locomotives. Payments required by the agreements are based upon the number of megawatt hours of energy consumed, subject to specified take-or-pay minimums. The rates specified in the two agreements are renegotiable every two years. BN's 1994 minimum commitment obligation is $48 million. Based on projected locomotive power requirements, BN's payments in 1994 are expected to be in excess of the minimum. Payments under the agreements totaled $53 million, $56 million and $55 million in 1993, 1992 and 1991, respectively, which exceeded the applicable minimums in each year. In 1990, BN entered into a letter of credit for the benefit of a vendor. This letter of credit is a performance guarantee for up to $15 million in major overhauls to be performed on the power purchase equipment. In connection with its program to transfer certain rail lines to independent operators, BN has agreed to make certain payments for services performed by the operators in connection with traffic that involves the shortlines and Railroad as carriers. These payments are not fixed in amount, will vary with such factors as traffic volumes and shortline costs and are not expected to exceed normal business requirements for services received. These payments are reflected as reductions to revenue to conform with reporting to the ICC. Revenues for these joint moves, including amounts applicable to the independent operator portion of the line haul, are reflected by BN as revenue from operations. There are no other commitments or contingent liabilities which BN believes would have a material adverse effect on the consolidated financial position, results of operations or liquidity. 15. OTHER INCOME (EXPENSE), NET Other income (expense), net includes the following (in millions): In the first quarter of 1992, BN entered into a settlement agreement relating to the reimbursement of attorneys' fees and costs incurred by BN in connection with litigation filed by Energy Transportation Systems, Inc., and others, and reimbursement of a portion of the amount paid in prior years by BN in settlement of that action. Under the terms of the settlement, BN received approximately $50 million before legal fees. 16. ACCOUNTING CHANGES Effective January 1, 1993, BN adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 modifies SFAS No. 96, which established the liability method of accounting for income taxes, and had been adopted by BN effective January 1, 1986. BN adopted SFAS No. 109 consistent with the transitional guidelines of SFAS No. 109. The effect of the adoption was to increase the current portion of the deferred income tax asset with a corresponding increase in the noncurrent deferred income tax liability of $26 million at January 1, 1993. There was no effect on net income, stockholders' equity or cash flows. In January 1992, the Emerging Issues Task Force of the FASB reached a consensus that origination of service revenue recognition was not an acceptable method beginning in 1992 for the freight services industry. Accordingly, effective January 1, 1992, BN changed its method of revenue recognition from one which recognized transportation revenue at the origination point, to a method whereby transportation revenue is recognized proportionately as a shipment moves from origin to destination. The cumulative effect, net of a $7 million income tax benefit, of the change on the prior year's revenue, at the time of adoption, decreased 1992 net income by $11 million, or $.13 per common share. In the fourth quarter of 1992, effective January 1, 1992, BN adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and elected immediate recognition of the $16 million transition obligation. The cumulative effect, net of a $6 million income tax benefit, of the change on prior years', at the time of adoption, decreased 1992 net income by $10 million, or $.11 per common share. Financial results for the first quarter of 1992 have previously been restated for the cumulative effect of the change in accounting method for revenue recognition, which had previously been reported in other income (expense), net and for the cumulative effect of the implementation of the accounting standard for postretirement benefits. There was no material effect on the second and third quarter, and those quarters were not restated for the adoption of SFAS No. 106. 17. 1991 SPECIAL CHARGE Included in 1991 results was a pre-tax special charge of $708 million related to railroad restructuring costs and increases in liabilities for casualty claims and environmental clean-up costs. The 1991 special charge included the following components: Restructuring This program provided for work force reduction of employees. The restructuring program and related charge had two components: - $185 million to provide for employee related costs for the elimination of surplus crew positions. - $40 million to provide for employee related costs for a separation program. Other - $350 million to increase casualty reserves based on an actuarial valuation and escalations in both the cost and number of projected hearing loss claims. - $133 million to increase environmental reserves based on studies and analyses of potential environmental clean-up and restoration costs. The special charge reduced 1991 net income by $442 million, or $5.79 per common share. 18. EXTRAORDINARY ITEM The extraordinary loss for 1991 of $14 million, $.18 per common share, resulted from the loss on redemption of 11 5/8 percent debentures, net of an $8 million income tax benefit. The 1991 redemption of the 11 5/8 percent debentures was completed using proceeds from the issuance of common stock. REPORT OF MANAGEMENT To the Stockholders and Board of Directors of Burlington Northern Inc. and Subsidiaries The accompanying consolidated financial statements have been prepared by management in conformity with generally accepted accounting principles. The fairness and integrity of these financial statements, including any judgments and estimates, are the responsibility of management, as is all other information presented in this Annual Report on Form 10-K. In the opinion of management, the financial statements are fairly stated, and, to that end, BN maintains a system of internal control which: provides reasonable assurance that transactions are recorded properly for the preparation of financial statements; safeguards assets against loss or unauthorized use; maintains accountability for assets; and requires proper authorization and accounting for all transactions. Management is responsible for the effectiveness of internal controls. This is accomplished through accounting and other control systems, policies and procedures, employee selection and training, appropriate delegation of authority and segregation of responsibilities, and an established code of ethics for employees. To further ensure compliance with established standards and related control procedures, BN conducts a substantial corporate audit program. Our independent accountants provide an objective independent review through their audit of BN's financial statements. Their audit includes a review of internal accounting controls to the extent deemed necessary for the purposes of their audit. The Audit Committee of the Board of Directors, composed solely of outside directors, meets regularly with the independent accountants, management and corporate audit to review the work of each and to ensure that each is properly discharging its financial reporting and internal control responsibilities. To ensure complete independence, the independent accountants and the corporate audit department have full and free access to the Audit Committee to discuss the results of their audits, the adequacy of internal accounting controls and the quality of financial reporting. David C. Anderson Executive Vice President, Chief Financial Officer and Chief Accounting Officer January 17, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Burlington Northern Inc. and Subsidiaries We have audited the consolidated financial statements and financial statement schedules of Burlington Northern Inc. and Subsidiaries listed in Item 14 of this Form 10-K. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits according to 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 Burlington Northern 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. 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 16 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 and for revenue recognition and postretirement benefits other than pensions in 1992. COOPERS & LYBRAND Fort Worth, Texas January 17, 1994 QUARTERLY FINANCIAL DATA-UNAUDITED (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) - --------------- (1) Results for the third quarter of 1993 include the effects of the Omnibus Budget Reconciliation Act of 1993 (the Act) which was signed into law on August 10, 1993. The Act increased the corporate federal income tax rate by one percent, effective January 1, 1993, which reduced net income by $29 million, or $.32 per common share, through the date of enactment. Results for the third quarter of 1993 also include the effects of the severe flooding in the Midwest. BN estimates the flooding reduced revenues and operating income during the quarter by $44 million and $79 million, respectively, and reduced net income by $49 million, or $.55 per common share. (2) Amounts may not total to the annual earnings per share because each quarter and the year are calculated separately based on average outstanding shares and common share equivalents during that period. (3) The higher of average or end of period market price is used to determine common share equivalents for fully diluted earnings per share. In addition, the if-converted method is used for convertible preferred stock when computing fully diluted earnings per common share. (4) Results for 1992 reflect the cumulative effect of the change in accounting method for revenue recognition, and the cumulative effect of the implementation of the accounting standard for postretirement benefits (Statement of Financial Accounting Standards No. 106). The cumulative effect of the change in accounting method for revenue recognition decreased 1992 net income by $11 million, or $.13 per common share. The cumulative effect of the change in accounting method for postretirement benefits decreased 1992 net income by $10 million, or $.11 per common share, and had no immediate effect on cash flows. (5) Results for the fourth quarter of 1992 include a $17 million reduction in income tax expense as a result of a favorable Internal Revenue Service settlement which allowed BN to recognize additional depreciation deductions for income taxes. 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 and ITEM 11. ITEM 11. EXECUTIVE COMPENSATION A definitive proxy statement of Burlington Northern Inc. will be filed not later than 120 days after the end of the fiscal year with the Securities and Exchange Commission. The information set forth therein under "Election of Directors" and "Executive Compensation" will be incorporated herein by reference. Executive Officers of Burlington Northern Inc. and the principal subsidiary are listed on pages 8-11 of this Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required is set forth under the caption "Election of Directors" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and will be incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required is set forth under the caption "Executive Compensation" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and will be incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Schedules other than those listed above are omitted for the reason that they are not required or not applicable, or the required information is included in the consolidated financial statements or related notes. EXHIBIT INDEX The following exhibits are filed as part of this report. EXHIBIT INDEX (CONTINUED) - --------------- * Exhibit is incorporated by reference as indicated. ** Exhibit is filed with Form 10-K for the year ended December 31, 1993. REPORTS ON FORM 8-K During the fourth quarter of 1993, there were no reports filed on Form 8-K. SIGNATURES REQUIRED FOR FORM 10-K Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Burlington Northern Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BURLINGTON NORTHERN INC. /s/ GERALD GRINSTEIN Gerald Grinstein Chairman, Chief Executive 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 Burlington Northern Inc. and in the capacities and on the dates indicated. DIRECTORS OF BURLINGTON NORTHERN INC. SCHEDULE II BURLINGTON NORTHERN INC. AND 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 - --------------- NOTE: Mr. Gerald Grinstein, Chairman of the Board, received noninterest-bearing loans, payable upon demand, in the principal amount of $1,600,000 and $880,000 in 1993 and 1992, respectively. Both loans are secured by shares of BNI common stock. SCHEDULE V BURLINGTON NORTHERN INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- (1) Relates primarily to reused track materials from Materials and Supplies inventory used for additions to property. See accompanying notes to consolidated financial statements for information regarding depreciation methods and other matters. SCHEDULE VI BURLINGTON NORTHERN INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- (1) Relates primarily to estimated net book value of retirements plus the cost to remove property before determination of excess depreciation on assets retained. See accompanying notes to consolidated financial statements for information regarding depreciation methods and other matters. SCHEDULE VIII BURLINGTON NORTHERN INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- Notes: (1) Principally represents cash payments. (2) Classified in the consolidated balance sheets as follows: SCHEDULE X BURLINGTON NORTHERN INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN MILLIONS) - --------------- Note: Items omitted are either less than one percent of consolidated revenues or are disclosed elsewhere in the consolidated financial statements or notes thereto. EXHIBIT INDEX

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1993

51303

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.

817946_1993.txt

817946_1993

1993

817946

ITEM 1. BUSINESS GENERAL Jan Bell provides fine jewelry, watches and certain other select non-jewelry consumer products to the value-conscious consumer. The Company markets principally through the warehouse club industry, which in 1993 accounted for approximately 85% of the Company's net sales. During 1993, Jan Bell moved substantially from being primarily a wholesale vendor to becoming a fully-integrated retailer in the warehouse club industry as well as a wholesale distributor. In May 1993, the Company entered into an arrangement to operate an exclusive leased department at all existing Sam's Wholesale Clubs and future locations through February 1, 1999. The products to be sold include all fine jewelry, watches, fragrances, fine writing instruments, sunglasses and certain collectibles and accessories. Additionally, in late 1993 the Pace Membership Club operations were purchased by Sam's and 87 of the 117 former Pace locations are now being operated as Sam's Clubs. The other locations were closed. See "Warehouse Clubs." The terms "JBM", "Jan Bell" and the "Company" when used herein refer to Jan Bell Marketing, Inc. and its consolidated subsidiaries, as required by the context. The Company's principal offices are located at 13801 Northwest 14th Street, Sunrise, Florida 33323 (telephone: (305) 846-8000). PRODUCTS The following table sets forth the approximate percentage of net sales for the Company's principal products for the periods specified: The Company's principal products are gold jewelry set with diamonds and/or other precious and semi-precious gemstones, gold chain, other forms of gold and silver jewelry and watches. The Company's jewelry product line includes chains, pendants, bracelets, watches, rings and earrings. Other consumer products sold by the Company include perfumes and fragrances, sunglasses, writing instruments, leather and giftware products. The Company's products are typically classic in design to offer broad consumer appeal. The Company follows the warehouse club philosophy of limiting the assortment in each product category. A typical location at a warehouse club is anticipated to be merchandised at any one time with approximately 310 jewelry items, approximately 150 watches and approximately 200 other consumer products, which is substantially less than the average number of items typically stocked by jewelry counters in department stores and other jewelry retailers. Items for wholesale customer programs are selected from the Company's current product line, which the Company periodically edits and updates with new styles. The Company works with its wholesale customers to balance their on-site inventory levels and generally accepts returned merchandise in this regard. WAREHOUSE CLUBS The Company's principal customers during 1993 were members of the warehouse club industry. In 1989, 1990, 1991, 1992, and 1993 approximately 79%, 64%, 71%, 81% and 85%, respectively, of the Company's net sales originated from the warehouse clubs. The Company's principal warehouse club relationships in 1993 were Sam's and Pace, which in 1993 accounted for 62% and 23%, respectively, of the Company's net sales. Warehouse clubs are mass merchandisers offering a variety of product categories to targeted consumers. By limiting the assortment in each product category and operating on a no-frills basis, warehouse clubs generally provide name brand products at prices significantly below conventional retailers and department, discount and catalog stores. Warehouse club members, the majority of whom pay a nominal annual membership fee, include businesses, credit unions, employee groups, schools, churches and other organizations, as well as eligible individuals. In addition to jewelry, merchandise offered by warehouse clubs typically includes groceries, health and beauty aids, clothing, sporting goods, automotive accessories, hardware, electronics and office equipment. Successful execution of the warehouse club concept requires high sales volumes, rapid inventory turnover, low merchandise returns and strict control of operating costs. Prior to May 1993, the Company had an agreement to be the primary supplier of fine jewelry, watches and fragrances to all present and future Sam's club locations until February 1997. In May 1993, the arrangement was changed to provide that the Company will operate an exclusive leased department at all Sam's existing and future locations through February 1, 1999. Each location is staffed by Jan Bell employees with the inventory owned by Jan Bell until sold to Sam's members. The products to be sold include all fine jewelry, watches, fragrances, fine writing instruments, sunglasses and certain collectibles and accessories. In exchange for the right to operate the department and the use of the retail space, Jan Bell pays a tenancy fee of 9.25% of net sales. While Sam's is responsible for paying utility costs, maintenance and certain other expenses associated with operation of the departments, the Company provides and maintains all fixtures and other equipment necessary to operate the departments. Prior to December 1993, the Company had an agreement with Pace to operate departments staffed with Jan Bell employees at all present and future Pace warehouses and merchandise fine jewelry, watches, fragrances, fine writing instruments and sunglasses on an exclusive basis until January 1997. In late 1993, Sam's purchased the Pace operations and 87 of the 117 locations are now being operated by Sam's. The other locations were closed by Sam's. In 1992, the Company signed an agreement to be the primary supplier of fine jewelry, watches and fragrances with Club Aurrera, a warehouse club joint venture in Mexico between Wal-Mart Stores and Cifra S.A. The initial agreement runs through February 1, 1997. The Company also supplies sunglasses, fine writing instruments and collectibles to Club Aurrera. The retail department operation represents a significant change in the Company's operations which, among other things, requires retail expertise in the areas of personnel, training, systems and accounting. The loss of the Company's leased department arrangement with Sam's or a material reduction of sales at Sam's could have a material adverse effect on the business of the Company. There can be no assurance that increases in the number of retail locations, thereby increasing the Company's customer base, will occur or that all of the Company's products will be marketed in all of such new locations or that further consolidation of the warehouse club industry due to geographic constraints and market consolidation will not adversely affect the Company's existing relationships. The opening and success of the leased locations and locations to be opened in later years, if any, will depend on various factors, including general economic and business conditions affecting consumer spending, the performance of the Company's wholesale and retail operations, the acceptance by consumers of the Company's retail programs and concepts, and the ability of the Company to manage the leased operations and future expansion and hire and train personnel. GENERAL MERCHANDISERS AND SPECIALTY RETAILERS The Company believes that its strategy, first developed and successfully executed with the warehouse club industry, can be applied to certain general merchandise and specialty retailers who serve value-conscious consumers through locations designed to generate high traffic and sales volume. The Company at all times continues to evaluate its ongoing relationships with general merchandise and specialty retailers. Such evaluation criteria include sales results, level of overhead in maintaining accounts, financial strength of a customer, a customer's growth plans, a customer's market share and competition with other customers. There can be no assurance that any of these programs will be successful. OTHER CUSTOMERS The Company also sells to a limited number of discount stores, drug stores, wholesalers and jewelry chains both directly and pursuant to consignment arrangements. PURCHASING DIAMONDS AND GEMSTONES The Company purchases diamonds and other gemstones directly in international markets located in Tel Aviv, New York, Antwerp, and elsewhere. The Company buys cut and polished gemstones in various sizes. During 1990, the Company acquired a purchasing and trading unit based in Israel. The Company meets its diamond requirements with purchases on a systematic basis throughout the year. Hedging is not available with respect to possible fluctuations in the price of gemstones. If such fluctuations should be unusually large or rapid and result in prolonged higher or lower prices, there is no assurance that the necessary price adjustments could be made quickly enough to prevent the Company from being adversely affected. The world supply and price of diamonds is influenced considerably by the Central Selling Organization ("CSO"), which is the marketing arm of DeBeers Consolidated Mines, Ltd. ("DeBeers"), a South African company. Through CSO, DeBeers, over the past several years, has supplied approximately 80% of the world demand for rough diamonds, selling to gem cutters and polishers at controlled prices periodically throughout the year. The continued availability of diamonds to the Company is dependent, to some degree, upon the political and economic situation in South Africa and Russia, which have been unstable. Several other countries are also major suppliers of diamonds, including Botswana and Zaire. In the event of an interruption of diamond supplies, or a material or prolonged reduction in the world supply of finished diamonds, the Company could be adversely affected. GOLD PRODUCTS Finished gold products and gold castings are purchased from a relatively small number of manufacturers in Israel, Italy, New York and California. The Company believes that there are numerous alternative sources for gold chain and castings, and the failure of the above manufacturers would not have a material adverse effect on the Company. The Company directly supplies most of its gold subcontractors with gold bullion which the subcontractors fabricate into chain and castings according to specifications provided by the Company. The gold bullion is generally purchased through Prudential-Bache Securities Inc. at market prices prevailing at the time of purchase on the London and New York Commodities Exchanges. Following purchase, the gold is either held in the Company's name in London or New York, or shipped to the Company's offices in Sunrise, Florida. Upon placing an order with a subcontractor, the Company generally ships the required amount of gold to the subcontractor to be made into final product. Upon receipt and inspection, the Company will pay the subcontractor a manufacturing charge based on labor and value added as well as all applicable duties. Subcontractors are selected and evaluated continuously based primarily on craftsmanship, cost, financial strength and reliability. The Company pays for its gold purchases at the time of purchase, allowing it to avoid carrying charges generally imposed by gold fabricators and the cost of leasing gold from third parties. WATCHES In May 1990, the Company formed a joint venture with Big Ben Corporation, a privately held distributor and marketer of watches and other accessories. Under the joint venture, Jan Bell provided and arranged for inventory financing and managed the venture's integration into the Jan Bell fine jewelry programs. In September 1991, Jan Bell purchased the minority joint venture interest from Big Ben Corporation, resulting in the entire watch program being integrated into Jan Bell. The program, initially implemented in the wholesale clubs, has been expanded to include substantially all of the Company's other customers. The program features Seiko and Citizen watches as well as other select name brands, private label and designer watches. The Company has license or distribution agreements for Pierre Cardin, Givenchy, Mathey Tissot and Ted Lapidus watches. During 1993, the Company purchased approximately 40.4% of watches directly from certain manufacturers as well as approximately 59.6% of watches through parallel marketed means. Parallel marketed goods are products to which trademarks are legitmately applied but which were not necessarily intended by their foreign manufacturers to be imported and sold in the United States. See "Regulation." OTHER PRODUCTS The Company purchases sunglasses, fine writing instruments, fragrances and collectibles directly from manufacturers as well as from parallel marketed means. See "Regulation." AVAILABILITY Although purchases of several critical raw materials, notably gold and gemstones, are made from a limited number of sources, the Company believes that there are numerous alternative sources for all raw materials used in the manufacture of its finished jewelry, and that the failure of any principal supplier would not have a material adverse effect on operations. Any changes in foreign or domestic laws and policies affecting international trade may have a material adverse effect on the availability or price of the diamonds, other gemstones, precious metals and non-jewelry products purchased by the Company. Because supplies of parallel marketed products are not always readily available, it can be a difficult process to match the customer demand to market availability. See "Regulation." SEASONALITY The Company's jewelry business is highly seasonal, with the fourth calendar quarter (which includes the Christmas shopping season) historically contributing significantly higher sales than any other quarter during the year. Approximately 50% of the Company's 1993 annual sales were made during the fourth quarter. MANUFACTURING The Company performs certain jewelry manufacturing and all quality control functions at its headquarters in Sunrise, Florida and performs jewelry manufacturing in Israel. Almost all gold and watch products are manufactured by third parties. During 1993, approximately 26% and 11% of gemstone products received were manufactured by the Company in Israel and Florida, respectively. The remaining portion of gemstone products were manufactured or purchased complete from third parties. The Company utilizes independent subcontractors and craftsmen to manufacture a significant portion of its jewelry products according to design specifications approved by the Company, thereby shifting certain risks and capital costs of manufacturing to third parties. Such risks and capital costs of manufacturing shifted to third parties include costs of labor, cash for capital expenditures and equipment, cost of design, environmental issues, insurance and labor issues. Diamonds and gemstones purchased by the Company are furnished to independent goldsmiths for setting, polishing and finishing pursuant to Company instructions and procedures. Gold acquired for manufacture is at least .999 fine and is then combined with other metals to produce 14 karat gold. Varying quantities of metals such as silver, copper, nickel and zinc are combined with gold to produce 14 karat gold of different colors. Manufacturing processes performed for the Company by independent contractors include refining (mixing alloys with pure gold and silver), casting, fabricating, assembling, stone setting, polishing and machining. Research and development expenses have been and remain insignificant. RETAIL OPERATIONS, MERCHANDISING AND MARKETING GENERAL Each retail department is supervised by a manager whose primary duties include member sales and service, scheduling and training of associates, and maintaining loss prevention and visual presentation standards. The departments are generally staffed by the manager, a full-time associate and two to four part-time associates depending on sales volume. The departments employ temporary associates during peak selling seasons such as Christmas. Each department is open for business during the same hours as the warehouse club in which it operates. Except for extended hours during certain holiday seasons, Sam's is generally open Monday through Friday from 10:00 a.m. to 8:30 p.m., 9:30 a.m. to 7:00 p.m. on Saturdays and 12:00 noon to 6:00 p.m. on Sundays. The department manager reports to a district manager. A district manager supervises between nine to eleven clubs and reports to a regional director. The Company presently has five regional directors who report to the Vice President of Field Operations. The fixtures and equipment located in the Company's departments generally consist of eight to ten showcases, four corner towers, a safe, a POS terminal, storage cabinets for merchandise and supplies, display elements, signage and miscellaneous equipment such as telephones, scales, calculators and diamond testers. In certain larger volume clubs, the department will have additional fixtures consisting of one or more of the following: two showcases, two towers or a center island display fixture. The Sam's Clubs are membership only, cash and carry operations. The Company's departments are required to accept only the forms of payment accepted by Sam's which presently includes cash, checks and Discover Card. The Company's departments operating in Pace accepted MasterCard and Visa until Sam's acquired these clubs. Sam's does not accept MasterCard or Visa and the Company was required to cease accepting these cards. The Company believes that this will have an adverse effect on sales in the former Pace Clubs in the short-term. Certain factors, such as the Sam's Clubs historical ability to attract a higher membership base and member traffic, may mitigate this adverse effect on sales in the long-term; however, there are no assurances that this will occur. Traditionally, a substantial portion of sales in the retail jewelry industry has been made at prices discounted from listed retail prices by emphasizing special events and sale prices. The Company endeavors to generally undersell competition while maintaining uniform prices, except where lower prices are necessary to meet local competition. The Company's objective is to maximize sales volume and inventory turn while minimizing expenses. The Company sells its merchandise at gross margin levels significantly below that of traditional retail jewelers and does not use the sales concepts of high initial markups followed by sale priced events using significant markdowns. The Company will permanently markdown its program goods to clear out slow-moving or discontinued merchandise. DEPARTMENT COUNT The following table sets forth data regarding the number of departments which the Company operated: (a) In April, 1991, the lease arrangement with Pace commenced. Includes the initial conversion of 62 Pace locations and the subsequent acquisition of 19 Price Savers Clubs by Pace. (b) Includes the initial conversion of 315 Sam's retail departments and the closing of 30 locations as a result of Pace ceasing operations. Generally the Company's departments have been between 260 and 275 of square feet of selling space usually located in higher traffic areas of the clubs near or adjacent to the cart rails, front entrances or check out areas of the clubs. PERSONNEL AND TRAINING The Company considers its associates to be one of the most important aspects of its ability to successfully carry out its business objectives and intends to devote a substantial amount of resources to support its associates with training programs, technology and facilities. The Company has implemented a comprehensive training program covering its relationship selling techniques, member service skills, product knowledge and operational procedures. The Company compensates its associates at rates it believes are competitive in the discount retail industry and seeks to motivate its associates through a flexible incentive program. The flexible incentive program is not based on the typical commission system (i.e. % of sales revenue), but rewards the associate for exceeding target sales levels or meeting other criteria which the Company establishes from time to time. ADVERTISING AND PROMOTION In accordance with the Sam's philosophy, the Company does not promote its products sold in the departments by direct mail catalogs, newspaper or other periodical advertising or the broadcast media. The Company does utilize promotional materials such as signage, banners and takeaway brochures within the clubs to promote its products. The Company also advertises in connection with its licensed products. During the fourth quarter of 1993, the Company did advertise in newspapers and radio for promotional events in the Pace clubs. Such advertising ceased with the acquisition of the Pace clubs by Sam's. DISTRIBUTION The Company's retail departments receive the majority of their merchandise directly from distribution warehouses located in Sunrise, Florida. Merchandise is shipped from the distribution warehouses utilizing various air and ground carriers. Presently, a small portion of merchandise is delivered directly to the retail departments from suppliers. The Company anticipates increasing the amount of merchandise shipped directly from suppliers in the future. The Company transfers merchandise between retail departments to balance inventory levels and to fulfill customer requests. During 1993, the Company operated three distribution warehouses in Sunrise, Florida to distribute merchandise to its retail departments. The Company's primary distribution warehouse located in the same facility with the corporate headquarters was principally utilized to warehouse and distribute diamonds and gemstones, gold products and fine watches. The Company's two satellite warehouses were utilized to distribute promotional watches and sunglasses, fine writing instruments, fragrances and collectibles. During 1993, the Company began construction of a new 123,000 square foot distribution center in Sunrise, Florida. The new distribution center was substantially completed in March 1994 and the consolidation of warehousing and distribution activities previously handled by the three separate distribution warehouses is projected to be completed by June 1994. WHOLESALE OPERATIONS The Company's wholesale shipments are processed through its distribution warehouses in Sunrise, Florida and regional centers in Miami, Florida and Los Angeles, California. The Company operates a distribution facility in Mexico City, Mexico; this facility warehouses and distributes merchandise sold to Club Aurrera. The Company does not believe that the dollar amount of unfilled orders is significant to an understanding of the Company's business due to the relatively short time between receipt of a customer order and shipment of the product. COMPETITION The Company's competitors include foreign and domestic jewelry retailers, national and regional jewelry chains, department stores, catalog showrooms, discounters, direct mail suppliers, televised home shopping networks, manufacturers, distributors and large wholesalers and importers, some of whom have greater resources than the Company. The Company believes that competition in its markets is based primarily on price, design, product quality and service. With the increase in the consolidation of the retail industry, the Company believes that competition both within the warehouse club industry and with other competing general and specialty retailers and discounters will continue to increase. REGULATION The Company utilizes the services of independent customs agents to comply with U.S. customs laws in connection with its purchases of gold, diamonds and other raw materials from foreign sources. Jan Bell bears certain risks in purchasing parallel marketed goods which include a substantial portion of watches and other accessories. Parallel marketed goods are products to which trademarks are legitimately applied but which were not necessarily intended by their foreign manufacturers to be imported and sold in the United States. The laws and regulations governing transactions involving such goods lack clarity in significant respects. From time to time, trademark holders and their licensees initiate private suits or administrative agency proceedings seeking damages or injunctive relief based on alleged trademark infringement by purchasers and sellers of parallel marketed goods. While Jan Bell believes that its practices and procedures with respect to the purchase of parallel marketed goods lessen the risk of significant litigation or liability, Jan Bell is from time to time involved in such proceedings and there can be no assurance that additional claims or suits will not be initiated against Jan Bell or any of its affiliates, or, if any such claims or suits are initiated, as to the results thereof. Further, legislation has been introduced in Congress in recent years and is currently pending regarding parallel marketed goods. Certain legislative or regulatory proposals, if enacted, could materially limit Jan Bell's ability to sell parallel marketed goods in the United States. For instance, a court recently issued an order enjoining the customs service from enforcing a regulatory exception regarding foreign made goods that bear a trademark identical to a valid United States trademark but which are materially physically different. There can be no assurances as to whether or when any such proposals might be acted upon by Congress or that future judicial, legislative or administrative agency action will restrict or eliminate these sources of supply. Jan Bell has identified alternate sources of supply, although the cost of certain products may increase or their availability may be lessened. EMPLOYEES As of March 5, 1994, the Company employed approximately 1,490 persons on a full-time basis, including approximately 920 in regional and local sales, (primarily the Sam's retail locations) 350 in inventory, distribution and manufacturing and 220 in administrative and support functions. In addition, the Company also employed approximately 920 persons on a part-time basis which varies with the seasonal nature of its business. None of its employees are governed by a collective bargaining agreement, and the Company believes that its relations with employees are good. ITEM 2. ITEM 2. PROPERTIES PROPERTIES AND LEASES The Company's corporate headquarters and primary distribution facility are owned by the Company and located on 3.7 acres in a 60,000 square foot building in Sunrise, Florida. The Company owns an additional 11.1 acres adjacent to the existing facility. A 123,000 square foot building for use primarily in distribution and shipping was substantially completed during March 1994. The Company leases an aggregate of 26,402 square feet of warehouse space in Sunrise, Florida for shipping and distribution and approximately 3,000 square feet of office space in Miami, Florida. Such leases are expected to be terminated during April 1994. The Company leases approximately 5,500 square feet of office and warehouse space in Los Angeles, California. Such lease expires in March 1995. The Company leases one distribution and one office facility with an aggregate of approximately 7,000 square feet in Mexico City pursuant to leases which expire in May 1994. The Company leases facilities in Israel of 3,800 square feet for manufacturing and 1,140 square feet for production and offices. As of March 25, 1994, the Company has leased department operations at 424 Sam's club's located in 48 states throughout the United States and Puerto Rico. The typical leased department consists of approximately 266 square feet. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is from time to time involved in litigation incident to the conduct of its business. While it is not possible to predict with certainty the outcome of such matters, management believes that all litigation currently pending to which the Company is a party will not have a material adverse effect on the Company's financial position or results of operations. 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 in the fourth quarter of the fiscal year ending December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of Jan Bell are: ALAN H. LIPTON Mr. Lipton has been a Director of the Company and its predecessors since 1983, the President from 1983 and the Chief Executive Officer since July 1987. ELIAHU BENSHMUEL Mr. Benshmuel has been a Director of the Company since June, 1993 and has been Executive Vice President of Procurement - Watches and Accessories since May 1993. Mr. Benshmuel had been Director of the Watch Division of Jan Bell since September 1991. From 1990 to September 1991, Mr. Benshmuel was President of Big Ben '90, a watch joint venture formed with the Company. Prior to this, Mr. Benshmuel was engaged in the marketing and sale of watches with Big Ben Corporation based in Miami. RICHARD W. BOWERS Mr. Bowers has been the Senior Executive Vice President and General Counsel of Jan Bell since May 1991, Vice Chairman of the Board since July 1991 and Secretary since September 1992. Prior to such time, he was engaged in the private practice of law with the firm of Gaston & Snow. JON E. FULLER Mr. Fuller was appointed Executive Vice President of Operations and Chief Operating Officer of Jan Bell in May 1993. From June 1982 to May 1993, Mr. Fuller was with the accounting firm of Deloitte & Touche. FRANK S. FUINO, JR. Mr. Fuino was appointed Executive Vice President of Finance and Chief Financial Officer of Jan Bell in May 1993. From January 1992 to April 1993, Mr. Fuino was an independent consultant providing financial services. From June 1988 to January 1992, Mr. Fuino served as a reorganization and management specialist for various corporations. Prior to this, Mr. Fuino served in various capacities, including Vice President and Treasurer for Allied Stores Corporation from May 1977 to September 1987. DONOVAN H. LARSEN Mr. Larsen was appointed Executive Vice President of Merchandising and General Merchandise Manager in December 1993. From July 1990 to December 1993, Mr. Larsen was the Assistant Vice President with Service Merchandise. Mr. Larsen was Vice President of Sales at Gruen Marketing Corp. from August 1986 to July 1990. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's Common Stock has been listed on the American Stock Exchange since the Company's initial public offering in August 1987. The following table sets forth for the periods indicated the range of sales prices per share on the American Stock Exchange Composite Tape as furnished by the National Quotation Bureau, Inc. The last reported sales price of the Common Stock on the American Exchange Composite Tape on March 25, 1994 was $6.75. On March 25, 1994, the Company had 835 stockholders of record. The Company has never paid a cash dividend on its Common Stock. The Company currently anticipates that all of its earnings will be retained for use in the operation and expansion of its business and does not intend to pay any cash dividends on its Common Stock in the foreseeable future. Any future determination as to cash dividends will depend upon the earnings, capital requirements and financial condition of the Company at that time, applicable legal restrictions and such other factors as the Board of Directors may deem appropriate. Currently, the Company's bank lines and senior debt prohibit dividend payments. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected data should be read in conjunction with the Consolidated Financial Statements and Related Notes thereto appearing elsewhere in this Form 10-K and "Management's Discussion and Analysis of Financial Condition and Results of Operations." (1) As a result of the new agreement with Sam's, the Company recorded a sales reversal of $99.7 million for the amount of inventory previously sold by Jan Bell to Sam's which was subject to repurchase. In addition, cost of sales was reduced by $79.7 million resulting in a $20.0 million one-time charge to pre-tax earnings. (2) Other costs in 1993 are approximately $6.0 million in one-time charges related to the Sam's agreement and other retail transition costs, and charges of $4.2 million related to compensation costs in connection with the departure of Mr. Mills as Chairman of the Board. Other costs in 1991 include expenses of $2.0 million incurred as a result of the terminated acquisition of Michael Anthony Jewelers, Inc. in August of that year, and $4.4 million for the settlement of the class action litigation. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS A YEAR OF TRANSITION In early 1991, the Company signed an agreement to be the primary supplier of fine jewelry, watches and fragrances to all present and future Sam's Wholesale Club ("Sam's") locations for a two year period ending in February 1993. During 1992, the term of the agreement was extended to February 1997. Goods were sold to Sam's and revenues were recognized when goods were shipped to Sam's. In May 1993, the Company commenced its transition to a fully-integrated retailer in the wholesale club industry by entering into an agreement with Sam's to operate an exclusive leased jewelry department at all existing and future Sam's locations through February 1, 1999. The operational rollout began on September 21, 1993 and was completed on October 28, 1993, during which time the Company took over the operations of the then existing 331 jewelry departments at Sam's. Under the terms of the agreement, the Company repurchased Sam's existing inventory which included goods that Sam's had previously purchased from the Company as well as from other vendors. In addition, as consideration for this agreement, the Company paid to Sam's a one-time fee of $7.0 million which is being amortized by the Company over the term of the contract and will pay a tenancy fee to Sam's of 9 1/4% of future net sales. As a result of this new agreement with Sam's, the Company recorded a sales reversal of $99.7 million for the amount of inventory previously sold by Jan Bell to Sam's which became subject to repurchase. In addition, cost of sales was reduced by $79.7 million resulting in a $20.0 million one-time charge to pre-tax earnings. The Company had previously estimated the amount of inventory subject to repurchase at $77.1 million and the related cost of sales at $59.0 million which resulted in an $18.1 million one-time charge to pre-tax earnings which was recorded in the first quarter of 1993. In connection with the transition to become a fully-integrated retailer, Jan Bell also incurred approximately $6.0 million (included in "Other Costs") additional one-time charges for costs such as hiring and training personnel, systems implementations, other activities related to commencing operations under the new agreement, the transition to primarily retail operations, and a valuation adjustment for certain inventory acquired which Sam's had purchased from other vendors. Of this amount, $805,000 was recorded in the third quarter of 1993 and the balance during the fourth quarter. When the Company began operating the departments, its operating expenses increased significantly for items such as payroll, tenancy, interest costs associated with the inventory repurchase and other costs typically associated with retail operations. The Company believes that although these incremental operating expenses will be offset in part by the incremental margin the Company will achieve as a result of selling at retail rather than wholesale prices, sales increases will also be necessary. Although this arrangement is resulting in an initial negative impact on earnings, management believes that this arrangement will further strengthen the Company's relationship with Sam's and better position the Company for growth. In addition, this agreement will provide the Company with the ability to generate increased sales by having its own trained and incentivised sales force behind the counter. It will also enable the Company to control inventory levels while expanding into new product lines. In 1991, the Company signed an agreement with Pace Membership Warehouses ("Pace") to operate departments at all present and future Pace locations and to merchandise fine jewelry, watches, fragrances, fine writing instruments and sunglasses on an exclusive basis until January 1997. The Pace agreement required payments based upon a percentage of monthly net sales subject to an adjustment based on Pace total merchandise sales growth. In early November 1993, Wal-Mart Stores, Inc. announced that it would purchase in late 1993 most of the Pace locations and would operate them as Sam's. The Pace locations not being acquired would be closed. As of the date of the announcement, Jan Bell was operating the jewelry department at all 117 Pace locations, of which 30 were closed after the Christmas selling season and 87 were converted to Sam's during January 1994. Jan Bell continues to operate its jewelry departments in the converted locations in accordance with the terms of leased department arrangement with Sam's. Included in selling, general and administrative expenses are $648,000 in direct costs associated with the Pace location closings. RESULTS OF OPERATIONS The following table sets forth for the periods indicated the percentage of net sales for certain items in the Company's Statements of Operations: (1) Excluding effect of Sam's agreement. SALES In 1993, net sales (excluding the effect of the Sam's agreement) decreased $58.3 million following an increase of $109.3 in 1992 from 1991. Approximately 85% of 1993 net sales were derived from the combined retail operations of Sam's and Pace. The remaining 15% was from the Company's wholesale operations in Mexico, Israel and the United States. The operational rollout at Sam's commenced on September 21, 1993 and was completed on October 28, 1993. Until such time as the Company began operating the departments, the Company continued to ship and bill Sam's under the same terms as it did prior to the new agreement. However, beginning with the second quarter of 1993, Jan Bell recognized sales and costs of sales as goods were sold to the club member rather than when goods were shipped to Sam's. The sales continued to be recorded at Jan Bell's selling price to Sam's until such time as Jan Bell began operating the departments at which point sales began to be recorded at retail prices to the club member. The transition period had a significant adverse impact on the Company financially. Sales prior to the rollout were lost due to certain factors, including reduced merchandise levels, lower staffing levels by Sam's personnel and a decline in the number of promotional events. These factors, when combined with the closing of 30 Pace locations and the resultant loss of sales even prior to the closings and the overall decline in same store sales at the warehouse clubs, were the primary factors contributing to the 1993 sales decline. Wholesale sales to customers other than Sam's were $42 million in 1993 compared to $64 million in 1992 as the Company concentrated its focus on the transition with Sam's. The Company believes that current and future promotional events are an important response to consumer demand based upon providing quality and value at low prices. Promotional events must constantly be updated and evaluated for consumer demand and involve significant operating and marketing efforts. Promotional events were significantly curtailed during 1993, and the Company is working closely with Sam's towards developing new events, consistent with Sam's merchandising philosophy. The 1992 sales increase was primarily a result of expanded volume of goods sold, principally from the expansion of existing business as well as additional locations with core customers and an increase in promotional sales events. Future sales may be adversely impacted by uncertain general economic conditions, the level of spending in the wholesale club environment and changes to the Company's existing relationship with Sam's. The retail jewelry market is particularly subject to the level of consumer discretionary income and the subsequent impact on the type and value of goods purchased. With the consolidation of the retail industry, the Company believes that competition both within the warehouse club industry and with other competing general and specialty retailers and discounters will continue to increase. COST OF SALES Gross margin in 1993 (excluding the effect of the new agreement with Sam's) was 10.9% compared to 17.0% and 17.8% in 1992 and 1991, respectively. Gross margin for the nine months ended September 30, 1993 was 16.8%, but declined to 4.8% in the fourth quarter of 1993 resulting in the 10.9% margin for the year. The fourth quarter margins were primarily impacted by a number of significant factors including the following; First, as a result of purchasing more inventory than anticipated under the Sam's agreement, the Company had to liquidate third party merchandise at below normal margin levels. Second, during the fourth quarter the Company recorded a provision for shrinkage which approximated 5% of sales. The Company recognizes that the level of shrinkage is unacceptable and believes this amount to be primarily related to transition issues. The Company has enhanced its control procedures related to inventory shrinkage and believes that significant improvement will be achieved in 1994. Third, as a result of the inventory repurchase from Sam's, the Company's normal fourth quarter purchases and manufacturing of inventory were significantly curtailed. Due to the lower than normal level of inventory production, certain costs which would normally relate to inventory production were charged directly to cost of sales. Finally, due to the high inventory levels, the Company determined that reserves had to be established during the fourth quarter to address slow moving, valuation and damaged inventory issues. The decrease in gross margin in 1992 was a result of several factors, none of which were individually significant. To reduce its exposure to the effects of changes in the price of its gold inventories, the Company hedges its gold positions and commitments with gold futures contracts. Accordingly, changes in the market value of gold during the holding period are generally offset by changes in the market value of the futures contracts. As a result of the Company's conversion to a retailer from a wholesaler, the Company is in the process of evaluating the need for continued hedging. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses increased by $9.7 million in 1993 from 1992 and $11.1 million in 1992 from 1991. Of the 1993 increase, $1.8 million was incurred during the nine months ended September 30, 1993, while the remaining increase of $7.9 million was incurred during the fourth quarter of 1993. The increase as of September 30, 1993 reflected the higher costs associated with servicing approximately 100 additional retail locations in 1993 versus 1992. The fourth quarter increase was primarily attributable to the payroll and other costs related to the Sam's leased department operation and also includes $648,000 in costs related to the Pace location closings. The increase in 1992 was due primarily to the payroll and related costs associated with the increase in the Pace retail operations as well as costs associated with product marketing and development. Future expenses will continue to be impacted by costs associated with the Sam's leased department operation, expenditures related to expansion of management, systems and controls, and costs associated with new marketing concepts, other promotional events and product development. OTHER COSTS Included in Other Costs are the previously mentioned $6.0 million of charges related to the Sam's agreement and retail transition. Also included in Other Costs are charges of $4.2 million related to the compensation costs in connection with the departure of Mr. Mills as Chairman of the Board of Directors on March 29, 1994, consisting primarily of the acceleration of vesting of previously granted stock bonus awards and amounts due under his employment contract. INTEREST AND OTHER INCOME AND INTEREST EXPENSE Interest and other income was $635,000 in 1993, $550,000 in 1992 and $3.0 million in 1991. The increase in 1993 is not deemed to be significant. The decrease for 1992 reflects the decline of interest income resulting from the non-interest bearing refundable deposit of $17.8 million established as a result of the Company's agreement with Sam's, and an overall drop in interest rates. Interest expense in 1993 increased to $3.2 million from $0.9 million in 1992. The increase primarily is attributable to the $33.5 million (net of debt financing costs) long-term debt which was outstanding for all of 1993, and only for three months in 1992. In addition, average short-term borrowings increased to $5.6 million in 1993 from $4.1 million last year. Interest expense decreased to $0.9 million in 1992 from $2.4 million in 1991 as the Company reduced its need for short-term borrowings through improved timing of the purchase of its inventories and lower interest rates. INCOME TAXES The Company's provision (benefit) for income taxes were (24.7%), 31.1% and 25.9% of income before income taxes for the years ended 1993, 1992 and 1991, respectively. The Company will have a federal net operating loss carryforward, after carryback, of approximately $12.6 million, and state net operating loss carryforward of approximately $48.2 million. The Federal net operating loss carryforward expires in 2008 and the state net operating loss carryforward expires beginning in 1998 through 2008. The Company also will have an alternative minimum tax credit carryforward of $794,000 to offset future federal income taxes. The changes in the effective rates primarily relate to the level of earnings in 1993, 1992 and 1991 of the Company's subsidiaries in Israel in relation to consolidated earnings. When the Company purchased Exclusive Diamonds International, Limited ("EDI") in August of 1990, EDI applied to and received from the Israeli government under the Encouragement of Capital Investments Law of 1959 "approved enterprise" status, which results in reduced tax rates given to foreign owned corporations to stimulate the export of Israeli manufactured products. This benefit allows a favorable tax rate ranging from zero to ten percent during the first ten years in which the subsidiary recognizes a profit. The "approved enterprise" benefit is available to the Company until the year 2000. The Company has not provided for federal and state income taxes on earnings of foreign subsidiaries which are considered indefinitely invested. The Company adopted Statement of Financial Accounting Standards No. 109 ("Accounting for Income Taxes"), effective January 1, 1993. Such adoption did not have a material effect on the financial statements. See Note H to the Financial Statements. INVENTORY LEVELS As of December 31, 1993, the Company had $177.5 million of inventory, an increase of $70.8 million over 1992. Although a significant portion of the increase is attributable to becoming a fully integrated retailer, inventory levels are in excess of desired levels and the Company expects that it will experience margin pressures during the first nine months of the new year as inventory is reduced to such levels. The primary area of overstock in inventory is watches. At year-end approximately 35% of inventory was watches compared to 39% in 1992. However, watch sales as a percent of total net sales decreased to 26% in 1993 from 38% in 1992. The Company believes that watch sales as a percent of total net sales will further decline in 1994. As a result, the Company has significantly curtailed its watch purchases, has developed a number of promotional events based on existing inventory and is utilizing its wholesale operation to sell watch inventory. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 1993, cash and cash equivalents totalled $30.2 million and the Company had no short-term borrowings outstanding under its revolving credit facility. However, the Company owed Sam's approximately $42.5 million, of which $33.4 million is for inventory repurchased from Sam's and $9.1 million, which is included in accounts payable, is for certain third-party merchandise acquired by the Company from Sam's. Final payment of these amounts is due in May 1994. Working capital decreased by $23.5 million in 1993. The decrease is reflective of the loss sustained in 1993 and capital expenditures of $12.0 million. A refundable non-interest bearing cash deposit of $17.8 million was posted with Sam's in 1991 in consideration for the Company becoming the primary jewelry vendor over the term of the agreement and any renewals. In July 1992, the Company and Sam's agreed to reduce the amount of the deposit to be refunded to $15.8 million. The $2 million reduction represented a payment for the extension of the agreement for a three year period from February 1, 1994 to February 1, 1997. The aggregate $17.8 million was applied towards the $7.0 million one-time fee and the repurchased inventory. The Company has partially financed its inventory and accounts receivable with short-term borrowings. During 1993, 1992 and 1991, the Company's peak levels of inventory and accounts receivable were $275.5 million, $224.2 million and $152.5 million and peak outstanding short-term borrowings pursuant to lines of credit were $20.0 million, $29.4 million and $30.4 million respectively. Average amounts of outstanding short-term borrowings for the respective years were $5.6 million, $4.1 million and $21.0 million. The Company has historically financed its working capital requirements through a combination of proceeds of public offerings, internally generated cash, short-term borrowings under bank lines of credit and a senior note placement. The Company finalized in August 1992 a $50 million, two year unsecured revolving bank credit facility. The bank facility, which was due to expire in August 1994 and bears interest at the bank's prime rate or two percent over LIBOR (London Interbank Offered credit) or the applicable secondary CD rate, was renewed for $25 million and extended to February 1, 1995. In addition, the Company is seeking renewal of the remaining $25 million. In October 1992, the Company finalized a $35 million unsecured private placement of senior notes with an interest rate of 6.99%. Semi-annual interest payments on the notes began in April 1993 and annual principal payments of $6.5 million commence in April 1996 with a final $9.0 million principal payment due in October 1999. Each of the agreements requires the Company to maintain various financial ratios and covenants and prohibit dividend payments. The Company has obtained waivers and amendments for less restrictive levels related to covenants with which the Company did not comply as a result of the 1993 loss. See Note F to the Financial Statements. The Company's net capital expenditures were $12.0 million in 1993 and $6.7 million in 1992. The increase was primarily attributable to costs associated with the new distribution facility and fixturization costs associated with Sam's retail locations. Funds will continue to be required to expand management systems, controls and physical facilities. Funding is anticipated to come from operations, bank lines of credit or the capital markets. In addition, the Company believes its asset management program, which is primarily focused on reducing the working capital requirements of the Company by eliminating excess inventory, will represent a significant source of funds in 1994. EFFECTS OF INFLATION Gold prices are affected by political, industrial and economic factors and by changing perceptions of the value of gold relative to currencies. Investors commonly purchase gold and other precious metals perceived to be rising in value as a hedge against a perceived increase in inflation, thereby bidding up the price of such metals. During 1993, gold prices increased $65.60 per ounce, or 20.0% percent, and in 1992 they had decreased by $24.00 per ounce, or 6.8%. The Company's sales volume and net income are potentially affected by the fluctuations in prices of gold, diamonds and other precious or semi-precious gemstones as well as watches and other accessories. In general the Company has historically sought to protect its gold inventory against gold price fluctuations through its hedging transactions. Hedging is not available with respect to possible fluctuations in the price of precious and semi-precious gemstones, watches or other accessories. The Company is in the process of evaluating the need for continued hedging due to its transition from being primarily a wholesale operation to being primarily a retail operation. The Company's selling, general and administrative expenses are directly affected by inflation resulting in an increased cost of doing business. Although inflation has not had and the Company does not expect it to have a material effect on operating results, there is no assurance that the Company's business will not be affected by inflation in the future. CHANGE IN FISCAL YEAR In February 1994, the Company determined to change its fiscal year from December 31 to a retail 52/53 week fiscal year ending on the last Sunday of each January. The first such fiscal year began on January 31, 1994 and will end on January 29, 1995. The period from January 1, 1994 to January 30, 1994 will be reported on Form 10-Q for the first quarter ending May 1, 1994 of the new fiscal year. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders Jan Bell Marketing, Inc. Sunrise, Florida We have audited the accompanying consolidated balance sheets of Jan Bell Marketing, Inc. and its subsidiaries (the "Company") as of December 31, 1993 and 1992, and the related consolidated statements of operations, 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 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 the Company 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. Certified Public Accountants Fort Lauderdale, Florida March 31, 1994 JAN BELL MARKETING, INC. CONSOLIDATED BALANCE SHEETS (AMOUNTS SHOWN IN THOUSANDS EXCEPT SHARE AND PER SHARE DATA) See notes to consolidated financial statements. JAN BELL MARKETING, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (AMOUNTS SHOWN IN THOUSANDS EXCEPT SHARE AND PER SHARE DATA) See notes to consolidated financial statements. JAN BELL MARKETING, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (AMOUNTS IN THOUSANDS EXCEPT SHARE AND SHARE DATA) See notes to consolidated financial statements. JAN BELL MARKETING, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS SHOWN IN THOUSANDS) JAN BELL MARKETING, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (AMOUNTS SHOWN IN THOUSANDS) (CONTINUED) See notes to consolidated financial statements. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 A. The Company: The Company is principally engaged in the sale of jewelry, watches and other consumer products through leased departments in wholesale clubs and through its own wholesale operations. B. Agreement with Sam's Wholesale Club: In May 1993, the Company entered into an agreement (the "Agreement") to operate an exclusive leased department at all existing and future Sam's Wholesale Club ("Sam's") locations through February 1, 1999. Under the terms of the Agreement, the Company repurchased Sam's existing inventory which included goods Sam's had previously purchased from the Company as well as from other vendors. As consideration for entering into the Agreement, the Company paid to Sam's a one-time fee of $7.0 million, which is included in Other Assets in 1993 and is being amortized over the term of the Agreement. The unamortized amount as of December 31, 1993 was approximately $6.7 million. The Company will pay Sam's a tenancy fee of 9 1/4% of future net sales. As a result of this new Agreement with Sam's, the Company recorded a sales reversal of $99.7 million for the amount of inventory previously sold by Jan Bell to Sam's which became subject to repurchase. In addition, cost of sales was reduced by $79.7 million resulting in a $20.0 million one-time charge to pre-tax earnings. The Company had originally estimated the amount of inventory subject to be repurchase at $77.1 million and the related cost of sales at $59.0 million which resulted in an $18.1 million one-time charge to pre-tax earnings which was recorded in the first quarter of 1993. In connection with the transition to become a fully-integrated retailer, Jan Bell also incurred approximately $6.0 million (included in "Other Costs"), including additional one-time charges for costs such as hiring and training personnel, systems implementations, other activities related to commencing operations under the new Agreement, and JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) the transition to primarily retail operations, and a valuation adjustment for certain inventory acquired which Sam's had purchased from other vendors. As of year end, the Company owed Sam's approximately $42.5 million, of which approximately $33.4 million is for inventory repurchased from Sam's and approximately $9.1 million which is included in accounts payable, for certain third party merchandise acquired by the Company from Sam's. Final payment of this amount is due in May 1994. A refundable non-interest bearing cash deposit of $17.8 million was paid with Sam's in 1991 in consideration for the Company becoming the primary jewelry vendor over the term of the agreement and any renewals. In July 1992, the Company and Sam's agreed to reduce the amount of the deposit to be refunded to $15.8 million. The $2.0 million reduction represented a payment for the extension of the Agreement for a three year period from February 1, 1994 to February 1, 1997. The aggregate $17.8 million was applied towards the $7.0 million one-time fee and the repurchased inventory. During 1991, the Company entered into an agreement with Pace Membership Warehouse ("Pace") to operate leased jewelry departments at all present and future Pace locations and to merchandise fine jewelry, watches, fragrances, fine writing instruments and sunglasses on an exclusive basis until January 1997. The Pace agreement required payments based upon a percentage of monthly net sales subject to an adjustment based on Pace total merchandise sales growth. In November 1993, Wal-Mart Stores, Inc. announced that it would purchase most of the Pace locations and operate them as Sam's. The Pace locations not being acquired would be closed. At that time, the Company was operating leased jewelry departments at all 117 Pace locations, 30 of which were closed and 87 were converted to Sam's during January 1994. The Company is operating leased jewelry departments in the converted Pace locations in accordance with the Sam's Agreement through February 1, 1999. Included in selling, general and administrative expenses are $648,000 in direct costs associated with the Pace location closings. Net sales to certain customer relationships which exceed ten percent of the Company's net sales for the respective periods were as follows: C. Summary of Significant Accounting Policies: (1) Principles of Consolidation -- The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in the consolidation. (2) Sales of Consignment Merchandise -- Income is recognized on the sale of consignment merchandise at such time as the merchandise is sold by the consignee. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) (3) Allowance for Sales Returns -- The Company generally gives its customers the right to return merchandise purchased by them and records an allowance for the amount of gross profit on estimated returns. (4) Hedging Activities -- The Company uses gold commodities futures contracts to hedge gold inventories. Commodity futures contracts are contracts for delayed delivery of commodities in which the seller agrees to make and the purchaser agrees to take delivery at a specified future date of a specified commodity, at a specified price. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from movements in commodity values and interest rates. Gains and losses on futures used to hedge gold inventories valued at cost are deferred and included in the determination of income upon disposition of such inventories. Gains and losses on futures contracts used to hedge gold inventories valued at market are included in the determination of income currently. At December 31, 1993, the Company had futures contracts maturing at various dates through December 1994 to purchase 277,000 ounces and sell 308,400 ounces of gold at various specified prices for an aggregate of $95.2 million and $120.6 million, respectively. U.S. Treasury securities with a carrying value of $500,000 and $350,000 at December 31, 1993 and 1992, respectively, have been pledged to cover margin requirements under futures contracts. The Company is in the process of evaluating the need for continued hedging activities due to its transition from being primarily a wholesale operation to being primarily a retail operation. (5) Inventories -- Inventories of precious and semi-precious stones and gem jewelry-related merchandise (and associated gold) watches, and other consumer products are valued at the lower of cost (first-in, first-out method) or market. Inventories of gold jewelry-related merchandise, exclusive of the gold component of precious and semi-precious gem jewelry related inventories, are valued principally at market, which includes adjustments for unrealized gains or losses. Costs of activities related to acquiring, receiving, preparing and distributing inventory to the point of being ready for sale are included in inventory. (6) Property -- Property is stated at cost and is depreciated using the straight-line method over the estimated useful lives of the respective assets. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) (7) Income Taxes -- The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("SFAS No. 109") effective January 1, 1993. This Statement supersedes SFAS No. 96, "Accounting for Income Taxes," which was adopted by the Company in 1988. During 1993, the Company provided deferred taxes in accordance with SFAS No. 109 for the future effects on income taxes of temporary differences between financial reporting and tax bases of assets and liabilities. (8) Net Income (Loss) Per Common Share -- Net income (loss) per common share is based upon the weighted average number of shares of common stock outstanding in each period, adjusted for the dilutive effects, if any, of options granted under the Company's option plans. (9) Cash and Cash Equivalents -- For the purpose of the statements of cash flows, the Company considers all highly-liquid investments purchased with maturities of three months or less to be cash equivalents. (10) Cost in Excess of Fair Value of Assets Acquired -- Cost in excess of fair value of assets acquired, which arises from acquisitions, is amortized on a straight-line basis over 20 to 30 years. Accumulated amortization of these assets at December 31, 1993 and 1992 was approximately $2.7 million and $1.6 million, respectively. Amortization expense for 1993, 1992 and 1991 was approximately $1.1 million, $1.1 million and $0.5 million, respectively. (11) Reclassifications - Certain reclassifications have been made to the 1992 and 1991 consolidated financial statements to conform to the 1993 presentation. D. Inventories: Inventories are summarized as follows: JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) E. Property: The components of property are as follows: Depreciation expense for the years ended December 31, 1993, 1992 and 1991 was approximately $4.6 million, $3.6 million and $2.8 million, respectively. F. Financing Arrangements The Company finalized in August 1992 a $50 million two year unsecured revolving bank credit facility. The bank credit facility, which was due to expire in August 1994 and bears interest at the bank's prime rate or two percent over LIBOR (London Interbank Offered Rate) or the applicable secondary CD rate, was renewed for $25 million and extended to February 1, 1995. In addition, the Company is seeking renewal of the remaining $25 million. In October 1992, the Company finalized a $35 million unsecured private placement of senior notes with an interest rate of 6.99%. Semi-annual interest payments on the notes began in April 1993 and annual principal payments of $6.5 million commence in April 1996 with a final $9.0 million principal payment due in October 1999. Each of these financing agreements require the Company to maintain various financial ratios and covenants and with respect to the bank credit facility, prohibit dividend payments. As of year-end, the Company had violated certain covenants in the foregoing arrangements with respect to fixed charge coverage. The Company has obtained waivers and amendments with respect to such violations and amendments to make such violated covenants less restrictive for the next fiscal year. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) In connection with issuing the senior notes, the Company entered into agreements to protect against interest rate increases while preparing the documentation and completing other activities necessary to obtain fixed interest rate commitments from the purchasers of the senior notes. The impact of these arrangements resulting from decreases in interest rates has been deferred as debt financing costs and are amortized using the interest method over the term of the senior notes. Information concerning the Company's short-term borrowings follows: G. Joint Venture and Acquisition: In May 1990, the Company and a watch distributor formed a joint venture partnership, Big Ben '90. The Company contributed $10.0 million to the partnership's capital and received a 50.1% controlling interest and, accordingly, the accounts of the partnership have been consolidated in the accompanying financial statements. During September 1991, the Company acquired the remaining minority interest, in exchange for 2,583,000 newly issued shares of the Company's common stock. The acquisition was accounted for under the purchase method of accounting. Proforma consolidated net income for 1991, assuming the acquisition of the minority interest had occurred as of January 1, 1991, is $6.7 million ($.27 per share). H. Income Taxes: Effective January 1, 1993, the Company adopted SFAS No. 109. SFAS No. 109 supersedes SFAS No. 96, "Accounting for Income Taxes," which the Company previously used. There was no material effect of adopting SFAS No. 109 on the Company's financial statements. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) Under SFAS 109, 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) operating loss and tax credit carryforwards. The tax effects of significant items composing the Company's net deferred tax liability as of January 1, and December 31, 1993 are as follows: JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) The components of income (loss) before taxes are as follows: The current and deferred income tax components of the provision (benefit) for income taxes consist of the following: The provision (benefit) for income taxes varies from the amount computed by applying the statutory rate for reasons summarized below: JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) The Company will have a federal net operating loss carryforward, after carryback, of approximately $12.6 million and a state net operating loss carryforward of approximately $48.2 million. The Federal net operating loss carryforward expires in 2008 and the state net operating loss carry forward expires beginning in 1998 through 2008. The Company also will have an alternative minimum tax credit carryforward of $794,000 to offset future federal income taxes. At the time the Company purchased Exclusive Diamonds International, Limited ("EDI") in August of 1990, EDI applied to and received from the Israeli government under the Capital Investments Law of 1959 "approved enterprise" status, which results in reduced tax rates given to foreign owned corporations to stimulate the export of Israeli manufactured products. The benefit to the Company amounted to approximately $1.2 million or $0.05 per share, $2.0 million or $0.08 per share, and $1.1 million or $0.05 per share in 1993, 1992, and 1991, respectively. The "approved enterprise" tax benefit is available to the Company until the year 2000. The Company has not provided federal and state taxes on approximately $12.4 million of undistributed earnings of foreign subsidiaries which it considers invested in such subsidiaries indefinitely. The amount of unrecognized deferred tax liability on the unremitted earnings of the foreign subsidiaries at December 31, 1993 approximates $4.6 million exclusive of any benefit from utilization of foreign tax credits. At December 31, 1993, the Company has approximately $1.3 million of unrecognized foreign tax credits which, depending on circumstances, may be available to reduce federal income taxes on the unremitted earnings of the foreign subsidiaries in the event such earnings are repatriated. I. Commitments and Contingencies: (1) The Company leases approximately 84,000 square feet of office and warehouse space in various locations. Such leases expire between March 1994 and June 1997. The aggregate commitment under such leases was $1.5 million at December 31, 1993. (2) At December 31, 1993 commitments under letters of credit amounted to $9.0 million. (3) The Company has entered into employment agreements with certain employees providing for minimum annual compensation of $2.8 million in the aggregate between 1994 through 1997. Five of these agreements provide for additional annual compensation aggregating three and one-half percent of income before income taxes and after minority interest. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) (4) During 1994, under various licensing and agency agreements, the Company is obligated to pay minimum amounts approximating $2.7 million in the aggregate between 1994 through 1998. (5) The Company has issued warrants to purchase 700,000 shares of common stock. The warrants expire December 16, 1998 and have an exercise price of $24.70. (6) In connection with the acquisition of EDI, the Company entered into non-compete agreements with the prior owners which provide for the issuance of an aggregate of 317,881 shares of the Company's common stock over five years commencing August 1991. During 1991, 1992 and 1993, 63,688 shares valued at $550,000 were issued each year. J. Legal Proceedings and Other Costs: The Company is from time to time involved in litigation incident to the conduct of its business. While it is not possible to predict with certainty the outcome of such matters, management believes that all litigation currently pending to which the Company is a party will not have a material adverse effect on the Company's financial position and results of operations. Other costs in 1991 include expenses of $2.0 million incurred as a result of the terminated acquisition of Michael Anthony Jewelers, Inc. in August of that year. Such costs include legal, accounting, investment banking and certain compensation related expenses. Additionally, $4.4 million in other costs reflects the expense for the settlement of the class action litigation which includes the amounts of cash paid, legal and other professional expenses, estimated value of the warrants issued, and certain costs which resulted from terminated customer relationships that were involved in the litigation. Included in Other Costs in 1993 are the $6.0 million in charges discussed in Note B related to the Sam's agreement and retail transition. Also included are compensation costs of $4.2 million in connection with the departure of Mr. Mills as Chairman of the Board of Directors on March 29, 1994, consisting primarily of the acceleration of vesting of previously granted stock bonus awards and amounts due under his employment contract. K. Stock Benefit Plans: The Company maintains various stock option, bonus and purchase plans for the benefit of its employees, officers, directors and certain third parties. A summary of the activity in the stock option plans is as follows: JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) As of December 31, 1993, options to purchase 596,743 shares were exercisable. Bonus shares have been granted to various executive officers. Deferred compensation relating to these plans is included in stockholders' equity and is being amortized to expense over the term of the agreements. A total of 562,500 shares are reserved for issuance under the Employee Stock Purchase Plan of which 12,236, 12,101, and 4,142 shares were issued during the years ended December 31, 1993, 1992 and 1991, respectively. L. 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 appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) Accordingly, the estimates presented herein are not necessarily indicative of the amounts that would be realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. (1) Cash and Cash Equivalents, Accounts Receivable, Accounts Payable, Accrued Expenses, and Liability for Inventory Repurchased -- The carrying amount of these items are a reasonable estimate of their fair value. (2) Long Term Debt -- The present value of the future principal and interest payments on the senior notes issued in October, 1992 is used to estimate fair value for this debt which is not quoted on an exchange. The notes have a net book value of $33.5 million and are estimated to have a fair value at December 31, 1993 and 1992 of approximately $36.2 million and $37.0 million, respectively. (3) Gold Futures Contracts -- The fair value of gold futures contracts is the amount at which they could be settled, based on market prices on commodity exchanges. At December 31, 1993 and 1992 open gold futures contracts are included in the financial statements at their fair value which approximates $13.2 million and $9.9 million, respectively. (4) Letters of Credit -- Letters of credit principally support corporate obligations. At December 31, 1993, $4.1 million of commercial letters of credit expire within a 30 day period, and $4.9 million of standby letters of credit expire within a 120 day period. At December 31, 1992, $2.0 million of commercial letters of credit expired within a 30 day period, and $1.1 million of standby letters of credit expired within a 334 day period. The estimated fair value, which is estimated using fees currently charged for similar arrangements, is insignificant. JAN BELL MARKETING, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (continued) M. Selected Quarterly Financial Data (unaudited): (1) As a result of the new agreement with Sam's, the Company recorded a sales reversal of $99.7 million for the amount of inventory previously sold by Jan Bell to Sam's which became subject to repurchase. In addition, cost of sales was reduced by $79.7 million resulting in a $20.0 million one-time charge to pre-tax earnings. In the first quarter of 1993, the Company had estimated the amount of inventory subject to repurchase at $77.1 million and the related cost of sales at $59.0 million which resulted in an $18.1 million one-time charge to pre-tax earnings. (2) Pre-tax income in the fourth quarter of 1993 was decreased by (a) Other Costs consisting of $5.2 million of one-time charges related to the Sam's agreement and other retail transition costs, and compensation expense of $4.2 million related to the departure of the Company's Chairman of the Board and (b) adjustments for slow-moving and damaged inventory and shrinkage of approximately $8.5 million. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no Form 8-K filed within 24 months prior to the date of the most recent financial statements reporting a change of accountants or reporting disagreements on any matter of accounting principle or financial statement disclosure. PART III ITEMS 10 THROUGH 13. Within 120 days after the close of the fiscal year, the Company intends to file with the Securities and Exchange Commission a definitive proxy statement pursuant to Regulation 14A which will involve the election of directors. The answers to Items 10 through 13 are incorporated by reference pursuant to General Instruction G(3); provided, however, the Compensation Committee Report, the Performance Graphs, and all other items of such report that are not required to be incorporated are not incorporated by reference into this Form 10-K or any other filing with the Securities and Exchange Commission by the Company. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Financial Statements. The following is a list of the financial statements of Jan Bell Marketing, Inc. included in Item 8 of Part II. Independent Auditors' Report. Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Operations - Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Stockholders' 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. (a)(2) Financial Statement Schedules. The following is a list of financial statement schedules filed as part of this annual report on Form 10-K: Schedule II and Schedule VIII. 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. (a)(3) The following list of schedules and exhibits are incorporated by reference as indicated in this Form 10-K: SCHEDULE II. JAN BELL MARKETING, INC. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES (Amounts shown in thousands) SCHEDULE VIII. JAN BELL MARKETING, INC. VALUATION AND QUALIFICATION ACCOUNTS (Amounts shown in thousands) INDEX TO EXHIBITS 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 of the undersigned, thereunto duly authorized. JAN BELL MARKETING, INC. Date: March 31, 1994 By: /s/ Alan Lipton --------------------------------- Alan Lipton, 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:

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ITEM 1. BUSINESS GENERAL AmSouth Bancorporation (AmSouth) is a bank holding company which was organized in 1970 as a corporation under the laws of Delaware and commenced doing business in 1972. At December 31, 1993, AmSouth had total consolidated assets of approximately $12.5 billion. AmSouth offers a broad range of bank and bank-related services through its subsidiaries. AmSouth's principal banking subsidiaries are AmSouth Bank N.A., AmSouth Bank of Florida, and AmSouth Bank of Tennessee. AmSouth Bank N.A. (AmSouth Alabama), headquartered in Birmingham, Alabama, is the largest subsidiary of AmSouth. As of December 31, 1993, AmSouth Alabama had total consolidated assets of approximately $8.8 billion and total consolidated deposits of approximately $6.5 billion. AmSouth Alabama is a full service national banking association with 147 banking offices located throughout Alabama at December 31, 1993. Based upon total consolidated assets as of December 31, 1993, AmSouth Alabama was the largest bank headquartered in Alabama. It offers complete consumer and commercial banking and trust services to businesses and individuals. The Commercial Banking Group of AmSouth Alabama offers a variety of products and services, including commercial lending, international banking, and cash management sales and operations. The Investment Services Department offers a range of investment products. Consumer Banking encompasses a wide variety of transaction, credit, and investment services to meet the needs of a diverse and growing consumer customer base. AmSouth Alabama's network of automated teller machines is linked with shared automated tellers in all 50 states. The Trust Division of AmSouth Alabama is the largest in Alabama with more assets under management than any other bank in Alabama. It offers a complete array of trust services including estate and trust planning, investment management for individuals and corporations, land and natural resources management, employee benefit administration, and management of debt and equity issues for corporations. AmSouth Alabama also provides additional services through several subsidiaries. AmSouth Mortgage Company, Inc. (AmSouth Mortgage) offers first mortgage loans through 41 originating offices in nine states. It sells these loans to investors, generally retaining the right to service the loans for a fee. AmSouth Leasing Corporation is a specialized lender providing equipment leasing. Brokerage services and investment sales are provided by AmSouth Investment Services, Inc., a registered broker-dealer. On January 21, 1994, AmSouth filed applications to convert AmSouth Alabama from a national banking association to a state-chartered bank that is a member of the Federal Reserve System. AmSouth expects to realize certain cost savings as a result of the conversion. AmSouth Bank of Florida (AmSouth Florida), is a state-chartered nonmember bank currently headquartered in Pensacola, Florida. AmSouth Florida is in the process of moving its headquarters to Tampa, Florida, as a result of the completed and pending acquisitions that will result in a significant portion of its assets and deposits being located in west and central Florida. At December 31, 1993, AmSouth Florida had total consolidated assets of approximately $2.6 billion and total consolidated deposits of approximately $2.1 billion. AmSouth Bank of Tennessee (AmSouth Tennessee) is a state-chartered nonmember bank headquartered in Chattanooga, Tennessee. At December 31, 1993, AmSouth Tennessee had total assets of approximately $1.0 billion and total deposits of approximately $779.3 million. AmSouth Florida and AmSouth Tennessee offer banking services similar to those of AmSouth Alabama. At December 31, 1993, AmSouth Florida operated 65 offices in Florida, and AmSouth Tennessee operated 20 offices in Tennessee. AmSouth also owns four other smaller banking subsidiaries: AmSouth Bank of Walker County, located in Jasper, Alabama; AmSouth Bank of Georgia, located in Summerville, Georgia; and The Georgia State Bank of Rome, located in Rome, Georgia. The Georgia State Bank of Rome will merge into AmSouth Bank of Georgia during the first half of 1994. During 1993, AmSouth completed five business combinations, which are reflected, to the extent required, in the Consolidated Financial Statements contained in this Form 10-K for the year ended December 31, 1993. For further information concerning these transactions see Note B of the Notes to Consolidated Financial Statements. As of February 28, 1994, AmSouth and its subsidiaries had 5,177 full-time employees and 855 part-time employees. SUBSEQUENT EVENTS Since December 31, 1993, AmSouth has completed the following business combinations: Effective January 3, 1994, Orange Banking Corporation (Orange), headquartered in Orlando, Florida, the parent company of Orange Bank, merged with AmSouth. AmSouth issued approximately 1,332,000 shares of common stock in exchange for all of the outstanding shares of Orange common stock. This acquisition was accounted for as a pooling-of-interests under generally accepted accounting principles (GAAP). At December 31, 1993, Orange had total consolidated assets of approximately $354.4 million and total consolidated deposits of approximately $322.5 million. Effective February 10, 1994, FloridaBank, a Federal Savings Bank (FloridaBank), headquartered in Jacksonville, Florida, merged with AmSouth Florida. AmSouth issued approximately 759,000 shares of common stock in exchange for all of the outstanding shares of FloridaBank common stock. This transaction was accounted for as a pooling-of-interests under GAAP. At December 31, 1993, FloridaBank had total consolidated assets of approximately $271.5 million and total consolidated deposits of approximately $202.6 million. In addition, AmSouth is a party to the pending business combinations described below. Except as noted, consummation of each of these transactions remains subject to fulfillment of a number of conditions, including shareholder and regulatory approvals. No assurances can be given that such conditions will be fulfilled or that such transactions will be consummated. On July 29, 1993, AmSouth signed an agreement to enter into a business combination with Parkway Bancorp, Inc. (Parkway), which is headquartered in Fort Myers, Florida, parent company of Parkway Bank. As of December 31, 1993, Parkway had total consolidated assets of approximately $126.8 million and total consolidated deposits of approximately $115.9 million. Under the terms of the agreement, AmSouth will issue 0.4886 of a share of AmSouth common stock for each of the outstanding shares of Parkway common stock. At December 31, 1993, Parkway had 1,002,041 shares of common stock outstanding. Shareholder and regulatory approvals have been received. This transaction will be accounted for as a pooling-of-interests under GAAP. On August 3, 1993, AmSouth signed an agreement to acquire First Federal Savings Bank, Calhoun, Georgia (Calhoun), headquartered in Calhoun, Georgia. At December 31, 1993, Calhoun had total assets of approximately $72.2 million and total deposits of approximately $59.2 million. Under the terms of the agreement, AmSouth will issue 0.9991 of a share of AmSouth common stock for each of the outstanding shares of Calhoun common stock, subject to adjustment. At December 31, 1993, Calhoun had 414,330 shares of common stock outstanding. This transaction will be accounted for as a pooling-of-interests under GAAP. The Calhoun shareholder meeting is scheduled for March 18, 1994. On August 9, 1993, AmSouth signed an agreement to enter into a business combination with Citizens National Corporation (Citizens), which is headquartered in Naples, Florida, and its subsidiary, Citizens National Bank of Naples. At December 31, 1993, Citizens had total consolidated assets of approximately $300.1 million and total consolidated deposits of approximately $270.0 million. Under the terms of the agreement, AmSouth will issue 0.3609 of a share of AmSouth common stock for each of the outstanding shares of Citizens common stock. At December 31, 1993, Citizens had 4,111,388 shares of common stock outstanding. Shareholder and regulatory approvals have been received. This transaction will be accounted for as a pooling-of-interests under GAAP. On September 12, 1993, AmSouth signed an agreement to acquire Fortune Bancorp, Inc. (Fortune), headquartered in Clearwater, Florida, and its subsidiary, Fortune Bank, a Savings Bank. Under the terms of the agreement, Fortune shareholders may make an election to receive either cash or AmSouth common stock based on a formula which takes into consideration AmSouth's stock price during a future pricing period. Approximately one-half of Fortune's shares will be exchanged for cash and one-half for AmSouth common stock (subject to adjustment based upon the average price per share of AmSouth common stock), with AmSouth issuing a total of approximately 4,481,000 shares and approximately $142.5 million in cash. At December 31, 1993, Fortune had total consolidated assets of approximately $2.7 billion and total consolidated deposits of approximately $1.8 billion. This transaction will be accounted for as a purchase under GAAP. On March 9, 1994, AmSouth signed an agreement to enter into a business combination with The Tampa Banking Company (Tampa), headquartered in Tampa, Florida, and its subsidiary, The Bank of Tampa. At December 31, 1993, Tampa had total consolidated assets of approximately $211.1 million and total consolidated deposits of approximately $196.0 million. Under the terms of the agreement, AmSouth will issue 1.5592 shares of AmSouth common stock for each of the outstanding shares of Tampa common stock, subject to adjustment. At December 31, 1993, Tampa had approximately 626,000 shares of common stock outstanding. The transaction will be accounted for using the pooling-of- interests method of accounting under GAAP. AmSouth continually evaluates business combination opportunities and frequently conducts due diligence activities in connection with them. As a result, business combination discussions and, in some cases, negotiations frequently take place, and transactions involving cash, debt or equity securities can be expected. Any future business combination or series of business combinations that AmSouth might undertake may be material, in terms of assets acquired or liabilities assumed, to AmSouth's financial condition. Recent business combinations in the banking industry have typically involved the payment of a premium over book and market values. This practice may result in dilution of book value and net income per share for the acquirers. COMPETITION AmSouth's subsidiaries compete aggressively with banks located in Alabama, Florida, Tennessee, and Georgia, as well as large banks in major financial centers and with other financial institutions, such as savings and loan associations, credit unions, consumer finance companies, brokerage firms, insurance companies, investment companies, mortgage companies, and financial service operations of major retailers. Areas of competition include prices, interest rates, services, and availability of products. AmSouth also competes with the other bank holding companies headquartered in Alabama, Florida, Tennessee, Georgia, and other Southeastern states for the acquisition of financial institutions. At December 31, 1993, of the bank holding companies headquartered in Alabama, AmSouth was the largest in terms of equity capital and second largest in terms of assets. However, in several geographic areas AmSouth's market share is smaller than that of other banks and financial institutions competing in those areas. Also, AmSouth is significantly smaller than many of the financial institutions competing in Florida, Tennessee, and Georgia. Various regulatory developments and existing laws have allowed financial institutions to conduct significant activities on an interstate basis for a number of years. During recent years, a number of financial institutions have expanded their out-of-state activities, and various states have enacted legislation intended to allow certain interstate banking combinations which otherwise would be prohibited by federal law. Under the Bank Holding Company Act of 1956, as amended (the BHCA), generally no company which owns or controls a commercial bank in the United States may acquire ownership or control of a commercial bank in a state other than the state in which the company's banking subsidiaries are principally located unless the acquisition is specifically authorized by the laws of the state in which the bank being acquired is located. Congress is currently considering legislation that would generally provide for nationwide interstate banking, subject to certain limitations, including the ability of states to opt out of coverage. However, the management of AmSouth 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. Alabama has a reciprocal interstate banking law that allows banks in several other states (primarily in the Southeast) and the District of Columbia to acquire banks in Alabama provided there is reciprocal legislation in the other jurisdictions. Alabama bank holding companies are thereby permitted to acquire banks in the jurisdictions specified in the law which have adopted such reciprocal legislation. These laws have resulted in a significant increase in competition for banking services in Alabama, Florida, Tennessee, Georgia, and the other affected areas. In 1989, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) was enacted. Among other things, FIRREA amended the Bank Holding Company Act to give the Federal Reserve Board the authority to approve the acquisition of savings associations by bank holding companies. A bank holding company may also consolidate a savings association it has acquired with a bank subsidiary. SUPERVISION AND REGULATION As a bank holding company, AmSouth is subject to the regulation and supervision of the Board of Governors of the Federal Reserve System (Federal Reserve Board) under the BHCA. Under the BHCA, bank holding companies may not in general directly or indirectly acquire the ownership or control of more than 5% 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. In addition, bank holding companies are generally prohibited under the BHCA from engaging in nonbanking activities, subject to certain exceptions. AmSouth's subsidiary banks (the Subsidiary Banks) are subject to supervision and examination by applicable federal and state banking agencies. AmSouth Alabama is a national banking association subject to regulation and supervision by the Comptroller of the Currency (the Comptroller). All of the other Subsidiary Banks are state-chartered banks that are not members of the Federal Reserve System, and therefore are generally subject to the regulations of and supervision by the Federal Deposit Insurance Corporation (FDIC). The Subsidiary Banks are also subject to various requirements and restrictions under federal and state law, including 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 Subsidiary Banks. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy. PAYMENT OF DIVIDENDS AmSouth is a legal entity separate and distinct from its banking and other subsidiaries. The principal source of cash flow of AmSouth, including cash flow to pay dividends on AmSouth common stock, is dividends from the Subsidiary Banks. There are statutory and regulatory limitations on the payment of dividends by the Subsidiary Banks to AmSouth as well as by AmSouth to its shareholders. AmSouth Alabama 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 will exceed the total of (i) the 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. A national bank also can pay dividends only to the extent that retained net profits (including the portion transferred to surplus) exceed bad debts (as defined by regulation). All of the Subsidiary Banks other than AmSouth Alabama are subject to varying restrictions on the payment of dividends under applicable state laws. With respect to AmSouth Florida and AmSouth Tennessee, state law imposes dividend restrictions substantially similar to those imposed under federal law on AmSouth Alabama. Furthermore, if, in the opinion of the applicable federal bank regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and hearing, that such bank cease and desist from such practice. The Comptroller and the FDIC have indicated that paying dividends that deplete a bank's capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), an insured bank may not pay any dividend if payment would cause it to become undercapitalized or once it is undercapitalized. See Item 1. Business -- FDICIA. Moreover, the Federal Reserve Board, the Comptroller, and the FDIC have issued policy statements which provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings. If AmSouth Alabama converts to a state-chartered bank that is a member of the Federal Reserve System, its operations, including its capital adequacy and capacity for the payment of dividends, are not expected to change in any material respect. As an Alabama-chartered bank, AmSouth Alabama would no longer be subject to the regulations of the Comptroller with respect to payment of dividends, but would be subject to similar restrictions under federal and Alabama state law. The payment of dividends by AmSouth and the Subsidiary Banks may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. At December 31, 1993, under dividend restrictions imposed under federal and state laws, AmSouth's subsidiary banks, without obtaining government approvals, could declare dividends of approximately $150.0 million. TRANSACTIONS WITH AFFILIATES There are various legal restrictions on the extent to which AmSouth and its nonbank subsidiaries can borrow or otherwise obtain credit from its Subsidiary Banks. Each Subsidiary Bank (and its subsidiaries) is limited in engaging in borrowing and other "covered transactions" with nonbank or nonsavings bank affiliates to the following amounts: (i) in the case of any such affiliate, the aggregate amount of covered transactions of the Subsidiary Bank and its subsidiaries may not exceed 10% of the capital stock and surplus of such Subsidiary Bank; and (ii) in the case of all affiliates, the aggregate amount of covered transactions of the Subsidiary Bank and its subsidiaries may not exceed 20% of the capital stock and surplus of such Subsidiary Bank. Covered transactions also are subject to certain collateralization requirements. "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 Board), the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance, or letter of credit on behalf of an affiliate. CAPITAL ADEQUACY The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies. The minimum guideline for the ratio of total capital (Total Capital) to risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) is 8%. At least half of the Total Capital must be composed of common stock, minority interests in the equity accounts of consolidated subsidiaries, noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less certain goodwill and other intangible assets (Tier 1 Capital). The remainder may consist of subordinated debt, other preferred stock, and a limited amount of loan loss reserves. At December 31, 1993, AmSouth's consolidated Tier 1 Capital and Total Capital ratios were 10.95% and 13.31%, respectively. In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to quarterly average assets, less goodwill and certain other intangible assets (the Leverage Ratio), of 3% for bank holding companies that meet certain specific criteria, including 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. AmSouth's Leverage Ratio at December 31, 1993 was 8.65%. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Federal Reserve Board has indicated that it will consider a "tangible Tier 1 Capital leverage ratio" (deducting all intangibles) and other indicia of capital strength in evaluating proposals for expansion or new activities. Each of the Subsidiary Banks is subject to risk-based and leverage capital requirements, similar to those described above, adopted by the Comptroller or the FDIC, as the case may be. Each of the Subsidiary Banks was in compliance with applicable minimum capital requirements as of December 31, 1993. Neither AmSouth nor any of the Subsidiary Banks has been advised by any federal banking agency of any specific minimum Leverage Ratio requirement applicable to it. Failure to meet capital guidelines could subject a bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC, and to certain restrictions on its business. See Item 1. Business -- FDICIA. All of the federal banking agencies have made proposals that would add an additional risk-based capital requirement based upon the amount of an institution's exposure to interest rate risk. However, the management of AmSouth is unable to predict whether and when higher capital requirements would be imposed and, if so, at what levels and on what schedule. SUPPORT OF SUBSIDIARY BANKS Under Federal Reserve Board policy, AmSouth is expected to act as a source of financial strength to, and to commit resources to support, each of the Subsidiary Banks. This support may be required at times when, absent such Federal Reserve Board policy, AmSouth may not be inclined to provide it. 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. Under the Federal Deposit Insurance Act (the FDI Act), 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 after August 9, 1989 in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to any commonly controlled FDIC-insured depository institution "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. FDICIA On December 19, 1991, FDICIA was enacted. FDICIA substantially revised the depository institution regulatory and funding provisions of the FDI Act and made revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take prompt corrective action in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Under applicable regulations, a FDIC-insured bank is defined to be well capitalized if it maintains a Leverage Ratio of at least 5%, a risk-adjusted Tier 1 Capital Ratio of at least 6%, and a Total Capital Ratio of at least 10% and is not otherwise in a "troubled condition" as specified by its appropriate federal regulatory agency. A FDIC-insured depository institution is defined to be adequately capitalized if it maintains a Leverage Ratio of at least 4%, a risk-adjusted Tier 1 Capital Ratio of at least 4%, and a Total Capital Ratio of at least 8%. In addition, a FDIC-insured depository institution will be considered: (i) undercapitalized if it fails to meet any minimum required measure; (ii) significantly undercapitalized if it is significantly below such measure; and (iii) critically undercapitalized if it fails to maintain a level of tangible equity equal to not less than 2% of total assets. A FDIC-insured 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. The capital-based prompt corrective action provisions of FDICIA and the implementing regulations apply to FDIC-insured depository institutions and are not directly applicable to holding companies which control such institutions. However, the Federal Reserve Board has indicated that, in regulating bank holding companies, it will take appropriate action at the bank holding company level based on an assessment of the effectiveness of supervisory actions imposed upon subsidiary depository institutions pursuant to such provisions and regulations. Although the capital categories defined under the prompt corrective action regulations are not directly applicable to AmSouth under existing law and regulations, if AmSouth were placed in a capital category it would qualify as well-capitalized as of December 31, 1993. FDICIA generally prohibits a FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to 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 of the capital deficiency when the institution fails 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. At December 31, 1993, all of the Subsidiary Banks were well capitalized under the criteria described above. Various other legislation, including proposals to revise the bank regulatory system and to limit the investments that a depository institution may make with insured funds, is from time to time introduced in Congress. AmSouth management is unable to predict whether and when other legislative changes would be imposed. BROKERED DEPOSITS The FDIC has adopted regulations under FDICIA governing the receipt of brokered deposits. Under the regulations, a bank cannot accept, rollover, or renew brokered deposits unless (i) it is well capitalized or (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that cannot receive brokered deposits also cannot 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 all the Subsidiary Banks were well capitalized as of December 31, 1993, AmSouth believes the brokered deposits regulation will have no material effect on the funding or liquidity of any of the Subsidiary Banks. FDIC DEPOSIT INSURANCE ASSESSMENTS The Subsidiary Banks are subject to FDIC deposit insurance assessments. As required by FDICIA, the FDIC has adopted a new risk-based premium schedule which has increased the assessment rates for most FDIC-insured depository institutions. Under the new schedule, the premiums initially range from $.23 to $.31 for every $100 of deposits. Each insured depository institution is assigned to one of three capital groups--well capitalized, adequately capitalized, or undercapitalized--and further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution's primary federal and, if applicable, state supervisors and 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. The FDIC is authorized to raise insurance premiums in certain circumstances. Any increase in premiums would have an adverse effect on AmSouth's earnings. Under the FDI Act, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, or condition imposed by a federal bank's regulatory agency. DEPOSITOR PREFERENCE The recently adopted Omnibus Budget Reconciliation Act of 1993 provides that deposits and certain claims for administrative expenses and employee compensation against an insured depository institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the "liquidation or other resolution" of such an institution by any receiver. ITEM 2. ITEM 2. PROPERTIES The executive offices of AmSouth and AmSouth Alabama are located in the 30- story AmSouth-Sonat Tower in downtown Birmingham, Alabama. An undivided one- half interest in this building is owned by AmSouth Alabama through an unincorporated joint venture. AmSouth Alabama is a principal tenant of this building. AmSouth Alabama is also a principal tenant of the AmSouth/Harbert Plaza, a 32-story office building also located in downtown Birmingham, Alabama. AmSouth Alabama's headquarters and most of its operations are located in the AmSouth-Sonat Tower and the AmSouth/Harbert Plaza. An additional administrative and training facility for AmSouth Alabama is currently under construction in the Birmingham, Alabama area. AmSouth Alabama anticipates occupying the facility by mid-year 1995. Other bank subsidiaries of AmSouth also have headquarters, banking, and operational offices located in Alabama, Florida, Tennessee, and Georgia. AmSouth Mortgage has offices in nine Southeastern states. At December 31, 1993, AmSouth and its subsidiaries had 282 offices (principally bank buildings) of which 168 were owned and 114 were either leased or subject to a ground lease. ITEM 3. ITEM 3. LEGAL PROCEEDINGS AmSouth's subsidiaries are routinely involved in litigation incidental to their business. However, management believes that the ultimate resolution of these matters will not materially affect the consolidated financial condition and results of operations of AmSouth. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters brought to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of AmSouth, their ages, the positions held by them with AmSouth and certain of its subsidiaries, and their principal occupations for the last five years are as follows: John W. Woods, 62, Chairman and Chief Executive Officer (1972 to date), and President (August 1993 to date) of AmSouth; Chairman and Chief Executive Officer (1983 to date), and President (August 1990 to date) of AmSouth Alabama; Director of AmSouth Mortgage. C. Stanley Bailey, 44, Vice Chairman of the Board of AmSouth and AmSouth Alabama (July 1993 to date); Director of AmSouth Bank of Georgia, AmSouth Mortgage, AmSouth Realty, Inc., and Alabanc Properties, Inc.; formerly Senior Executive Vice President and Chief Financial Officer of AmSouth and Senior Executive Vice President and Chief Financial Officer and Financial Management Group Head of AmSouth Alabama (June 1990 to July 1993) and Senior Executive Vice President of AmSouth and Senior Executive Vice President and Operations and Administration Group Head of AmSouth Alabama (August 1988 to June 1990). C. Dowd Ritter, 46, Vice Chairman of the Board of AmSouth and AmSouth Alabama (July 1993 to date); Director of AmSouth Bank of Georgia, AmSouth Mortgage, and AmSouth Investment Services, Inc.; formerly Senior Executive Vice President of AmSouth and Senior Executive Vice President and General Banking Group Head of AmSouth Alabama (May 1991 to July 1993) and Senior Executive Vice President, Trust Officer and Trust and Financial Services Group Head of AmSouth Alabama (August 1988 to May 1991). A. Fox deFuniak, III, 53, Senior Executive Vice President and Birmingham Banking Group Head of AmSouth Alabama (May 1991 to date); Director of AmSouth Mortgage; formerly Senior Executive Vice President and Retail Banking and Marketing Group Head of AmSouth Alabama (November 1989 to May 1991) and Senior Executive Vice President and Regional Executive for the North Central Region of AmSouth Alabama (August 1988 to November 1989). W. Michael Graves, 47, Senior Executive Vice President (December 1993 to date) and Alabama Banking Group Head (July 1993 to date) of AmSouth Alabama; Director of AmSouth Mortgage; formerly Executive Vice President and Regional Executive for the Central Region of AmSouth Alabama (May 1991 to July 1993), Executive Vice President in charge of Birmingham and Shelby County Branch System of AmSouth Alabama (November 1989 to May 1991), and Executive Vice President and Division Head of the Retail Banking Division of AmSouth Alabama (August 1988 to November 1989). E. W. Stephenson, Jr., 47, Chairman of the Board and Chief Executive Officer of AmSouth Florida and Senior Executive Vice President of AmSouth (July 1993 to date); Director of AmSouth Florida; formerly Executive Vice President and Consumer and Marketing Division Head of AmSouth Alabama (May 1991 to July 1993), Executive Vice President and Regional Executive for the North Central Region of AmSouth Alabama (November 1989 to May 1991) and Executive Vice President and Regional Executive for the Northern Region of AmSouth Alabama (1987 to November 1989). PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AmSouth's common stock is listed for trading on the New York Stock Exchange under the symbol ASO. The following table sets forth certain common stock data for the last five years. Quarterly high and low sales prices of and cash dividends declared on AmSouth common stock are set forth in Note U of the Notes to Consolidated Financial Statements. As of March 4, 1994, there were approximately 14,000 holders of record of AmSouth's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected financial data for the last five years. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the year ended December 31, 1993, AmSouth reported earnings per share of $3.10, which includes the effect of business combinations accounted for by the pooling-of-interests method, versus $2.51 for the year ended 1992 and $2.07 for the year ended 1991. Net income exceeded $146 million compared to $108 million for 1992, a 35.3% increase. Balance sheet growth was strong, the gross interest margin continued at historically wide spreads, credit quality costs were at a minimum, noninterest revenue growth was solid, and noninterest expense control was strong. The return on average assets for 1993 was 1.28% versus 1.13% for the preceding year. Return on average equity was 14.93% versus 13.66% for 1992. Two increasingly important ratios are the efficiency ratio and the productivity ratio. The efficiency ratio is defined as total noninterest expense as a percent of the sum of the gross interest margin on a fully taxable equivalent basis plus total noninterest revenues. The efficiency ratio for 1993 was 62.3%, which was an improvement of 1992's efficiency ratio of 64.1%. Management's goal is to reduce the efficiency ratio below 60%. The productivity ratio, which is defined as total noninterest expense as a percentage of total average assets, was 3.66% for 1993 versus 3.86% for 1992. EARNING ASSETS AmSouth's earning assets consist of loans, investment securities, securities held for sale, and other earning assets. Further discussion of the significant aspects of each of these earning assets follows. Table 1 illustrates the composition of average earning assets for the years ended December 31, 1993, 1992, and 1991. TABLE 1--COMPOSITION OF AVERAGE EARNING ASSETS LOANS AND LOAN QUALITY Loans are the predominant earning asset for AmSouth. As expected, loans provide the highest level of revenues and the highest degree of risk for the company. When analyzing potential loans, management assesses both interest rate objectives and credit quality objectives in determining whether to extend a given loan and the appropriate pricing for that loan. AmSouth maintains a diversified portfolio in order to spread its risk and reduce its exposure to economic downturns which may occur in different segments of the economy or in particular industries. TABLE 2--COMPOSITION OF LOANS The composition of the loan portfolio at AmSouth, as shown in Table 2, has shifted over the last several years. In 1989, consumer loans represented approximately 40% of total loans outstanding, while in 1993, consumer loans represented approximately 53% of total loans outstanding. Residential first mortgages have increased as a percentage of the total consumer portfolio. In 1989, residential first mortgages represented 38% of total consumer loans compared to 54% in 1993. Residential first mortgages grew $1.2 billion from December 31, 1992 to December 31, 1993. Of this total growth, $820.5 million was related to the acquisitions of First Chattanooga Financial Corporation (FCFC) and Mid-State Federal Savings Bank (Mid-State). Both of these financial institutions were thrifts prior to the mergers, and residential first mortgages represented the majority of loans held in their portfolios. The remaining $381.5 million was growth in the existing AmSouth portfolio. At December 31, 1993, the residential first mortgages held by AmSouth's subsidiaries were predominantly adjustable-rate mortgages. The majority of fixed-rate residential loans maintained by AmSouth on its balance sheet had 15-year final maturities or shorter. Other residential mortgages primarily consisted of home equity lines of credit as well as second mortgages on residential property. Table 3 provides the composition of the loan portfolio by industry. Real estate loans are categorized by the type of collateral. At December 31, 1993, 38% of the total commercial real estate portfolio was represented by owner occupied properties. Owner occupied properties include mortgages where the borrower is a primary tenant, such as a factory or warehouse loan. Nonowner occupied lending represents those loans where the primary method of repayment is anticipated to come from rental income. The former is considered to have inherently less credit risk than the latter. TABLE 3--LOANS BY INDUSTRY Industry and loan type diversification is reviewed quarterly by AmSouth's management. Exposure limits, where appropriate, for particular industries or types of loans are established. For example, AmSouth internally monitors loans which are defined as highly leveraged transactions (HLT) and loans to lesser developed countries. HLT loans comprised less than 4% of the total commercial portfolio at December 31, 1993. At December 31, 1993, AmSouth had $1.9 million in foreign assets of which $816 thousand were loans. AmSouth's foreign assets and foreign loans at December 31, 1992 were $2.5 million and $1.6 million, respectively. AmSouth offers loan products to customers with varying maturity schedules. Table 4 presents the maturities of certain loans at December 31, 1993. TABLE 4--SELECTED LOAN MATURITIES AND SENSITIVITY TO CHANGE IN INTEREST RATES AmSouth has written loan policies which include loan underwriting procedures and the approval process. Depending primarily on the amount of the loan, there are various approval levels including the branch or department level, the area level, and the centralized Corporate Credit Committee. In addition, loans in excess of $10.0 million are approved by the Executive Committee of the Board of Directors. AmSouth has a Loan Review Department which performs ongoing, independent reviews of specific loans for credit quality and proper documentation and of the risk management process. This department is centralized and independent of the lending function. The results of its examinations are reported to the Audit Committee of the Board of Directors as well as AmSouth's independent auditors. In addition, regular reports are made to senior management regarding the credit quality of the loan portfolio as well as trends. Each commercial loan booked at AmSouth is assigned a risk rating on a numerical scale from one to eight by the loan officer, subject to review by the Loan Review Department. Consumer loan portfolios are assigned bulk ratings by Loan Review on the same scale by type of loan and performance. The risk profile of the loan portfolio established by these ratings and trends are reported to management and the Audit Committee. Designated credit officers who are organizationally independent of the production areas oversee the loan approval process, review adherence to credit policies and performance of the credit administration function, and monitor efforts to reduce nonperforming assets and classified assets. Management closely monitors loans and other assets which are classified as nonperforming assets. Nonperforming assets include nonaccrual loans, loans restructured because of the debtor's financial difficulties, foreclosed properties, and repossessions. Loans are generally placed on nonaccrual if full collection of principal and interest becomes doubtful (even if all payments are current), or if the loan is delinquent in principal or interest payments for 90 days or more, unless the loan is well secured and in the process of collection. Table 5 details the components of nonperforming assets at year end for each of the last five years. Nonperforming assets excluding accruing loans 90 days past due (nonperforming assets), decreased $25.2 million, or 25.7%, during 1993. This follows a $61.4 million, or 38.5%, decrease during 1992. The continued decrease in nonperforming assets during 1993 was the result of management's proactive efforts to reduce AmSouth's level of nonperforming assets as well as a favorable economic condition resulting from stabilization of the commercial real estate market. During 1993, AmSouth incurred net credit related costs (provision for loan losses and foreclosed properties expense) of $14.7 million. This included both a $6.3 million recovery of a loan previously charged off as well as a series of gains on the sale of foreclosed properties. Gains on sales of foreclosed properties for 1993 totaled $4.7 million. Management does not expect gains on the sale of foreclosed property to be at this level in future years. TABLE 5--NONPERFORMING ASSETS - -------- *Exclusive of accruing loans 90 days past due. TABLE 6--LOANS AND CREDIT QUALITY - -------- *Exclusive of accruing loans 90 days past due. Table 6 compares the balances of loans at December 31, 1993 and 1992 with the related nonperforming loans, excluding accruing loans 90 days past due. In addition, the net charge-offs by those categories for 1993 and 1992 are presented. For the year ended December 31, 1993, net charge-offs as a percentage of average loans net of unearned income totaled 25 basis points as compared with 57 basis points for year ended December 31, 1992. Normalizing the net charge-off ratio for the above- mentioned large recovery of a loan previously charged off, the net charge-offs to average loans net of unearned income would have been 34 basis points for 1993. For the year ended December 31, 1993, the level of foreclosed properties decreased $16.5 million, or 41.0%, compared to 1992, primarily due to the continued sales of properties. The coverage ratio, which is computed as the appraised value as a percentage of carrying value, was 143.2% at December 31, 1993, compared to 138.3% at December 31, 1992. Table 7 presents a listing of foreclosed properties by type of property and their carrying value at December 31, 1993. TABLE 7--COMPOSITION OF FORECLOSED PROPERTIES Table 8 is a reconcilement of the allowance for foreclosed property losses for 1993, 1992, and 1991. The balance in this allowance account represents temporary decreases in the value of AmSouth's foreclosed properties and reflects the company's intention to sell the majority of these properties in the near future. TABLE 8--ALLOWANCE FOR FORECLOSED PROPERTY LOSSES During 1993, 1992, and 1991, the average balance of foreclosed properties and repossessions totaled $33.3 million, $71.1 million, and $99.5 million, respectively. The approximate pre-tax cost of carrying these assets, assuming a cost of funds equal to the average rate paid on interest-bearing liabilities for the year, was $1.2 million for 1993, $3.0 million for 1992, and $6.0 million for 1991. Due to changing interest rates, these costs may not be an accurate indicator of the possible impact on future earnings if these assets were converted into earning assets. AmSouth recognizes interest income on nonaccrual loans on a cash basis only when there is no substantial doubt as to the collection of principal. During 1993, $3.6 million in revenue would have been recognized had the loans included in nonaccrual at year end been on an accrual basis for the entire year. Revenues included approximately $130 thousand recorded in 1993 for these loans. Despite AmSouth's high audit standards, internal controls, and continuous loan review system, the risk inherent in the nature of lending results in periodic loan charge-offs. AmSouth maintains an allowance for loan losses which it believes is adequate to absorb losses in the loan portfolio. A formal review is prepared quarterly to assess the risk in the portfolio in determining the adequacy of the allowance for loan losses. The review includes analyses of historical performance, the level of nonperforming and rated loans, specific analyses of certain problem loans, loan activity since the previous quarter, reports prepared by the Loan Review Department, consideration of current economic conditions, and other pertinent information. The review is then presented to and subsequently approved by management and the Audit Committee of the Board of Directors. The level of allowance to net loans outstanding will vary depending on the overall results of this quarterly review. Over the past several years, as AmSouth's overall credit quality has improved, management has maintained an allowance for loan losses at the end of the period to loans net of unearned income approximating 1.50%. At December 31, 1993, the allowance at the end of the period to loans net of unearned income was 1.49%. This produces a coverage ratio for nonperforming loans of 245.8%. Management will continue to evaluate the level of the allowance for loan losses. With the change in mix of the company's portfolio, including the increase in residential first mortgage loans which inherently have less risk, management will continue to monitor not only the absolute level of the allowance but also the coverage ratio of nonperforming loans. Table 9 is a summary of the allocation of the allowance for loan losses as determined by internal formulas. Although the table assigns amounts to certain classifications of loans, the balance of the allowance for loan losses at December 31, 1993 is considered to be a general allowance and, therefore, is available for charge-offs of any type of loan which may be necessary in the future. TABLE 9--ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES - -------- *Net of unearned income. Table 10 summarizes AmSouth's loan loss experience and coverage ratios for the last five years. TABLE 10--ALLOWANCE FOR LOAN LOSSES - -------- *Exclusive of accruing loans 90 days past due. INVESTMENT SECURITIES AND SECURITIES HELD FOR SALE The investment securities portfolio consists primarily of U.S. Treasury obligations, federal agency securities, federally-sponsored mortgage securities, corporate securities, and state, county, and municipal debt instruments. Investment securities are purchased with the intent and ability to be held until maturity. Investment securities are utilized to provide an alternative investment for available funds and to provide a stable source of interest income. These securities are also used to pledge as collateral for certain types of transactions. The 1993 average balance of investment securities declined $136.5 million, or 5.4%, compared to 1992. Slightly over half of the decline was due to the maturities and calls of tax-free securities. At December 31, 1993, a total of 48% of AmSouth's tax-free securities were rated by leading independent agents with 92% of those securities rated "A" or above. The remaining tax-free securities were not rated, generally because of the size of the issue and the expense associated with obtaining a rating. At December 31, 1993, AmSouth did not have more than 10% of its shareholders' equity invested in the tax-free obligations of any one issuer where the securities are payable from the same source of income or taxing authority. TABLE 11--INVESTMENT SECURITIES AND SECURITIES HELD FOR SALE Beginning in 1991, management segregated from its investment portfolio certain securities which are labeled as held for sale. AmSouth defines securities held for sale as securities to be held for an indefinite period of time, including securities that management intends to use as part of its asset/liability strategy, or that may be sold in response to potential liquidity needs, changes in interest rates, change in prepayment risk, or other similar factors. These securities are accounted for at the lower of cost or market. At December 31, 1993, securities held for sale had a carrying value of $1.3 billion, which approximated market value, and consisted of U.S. Treasury and federal agency securities, mortgage-backed securities and other securities. This compares to December 31, 1992, when the company had $336.7 million in securities held for sale which also consisted of U.S. Treasury and federal agency securities, mortgage-backed securities and other securities. During 1993 net gains of $12.9 million were recognized on sales of these securities, compared to $1.0 million in 1992. At the end of 1993, the investment securities and securities held for sale portfolios included $1.9 billion of mortgage-backed securities, consisting of mortgage-backed pass-throughs and collateralized mortgage obligations (CMO's). Substantially all of the holdings in the mortgage-backed securities are either direct issues or collateralized by direct issues of the United States Government or federally sponsored agencies. Approximately 59% of the mortgage- backed securities are fixed-rate securities. Fixed-rate mortgage-backed pass- through securities have maximum final maturities of five to fifteen years and an expected average life of approximately four years. While the final maturities on floating-rate mortgage-backed pass-through securities are longer, the average life is estimated to be less than five years and the yields fluctuate with a variety of short-term indices. The yields on floating-rate CMO securities fluctuate with LIBOR and other short-term indices and have an expected average life of less than six years. Fixed-rate CMO securities are included in the held for sale portfolio and are planned amortization classes or sequential payment classes. While the final stated maturities on these securities are seven to thirty years, the expected average life is less than five years. Table 12 presents maturities of the investment and held for sale securities portfolios at December 31, 1993. TABLE 12--INVESTMENT SECURITIES AND SECURITIES HELD FOR SALE RELATIVE MATURITIES AND WEIGHTED AVERAGE YIELDS - -------- Notes: 1. The weighted average yields were computed by dividing the taxable equivalent interest income by the book value of the appropriate securities. The taxable equivalent interest income does not give effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax- free assets. 2. The amount of securities indicated as maturing after five but within ten years includes $344 million of mortgage-backed securities and those indicated as maturing after ten years includes $1,450 million of mortgage- backed securities. Although these securities have long-term maturities, according to mortgage industry standards, the estimated weighted average remaining life of these securities held in AmSouth's investment portfolio is less than five years. 3. Federal Reserve Bank stock, Federal Home Loan Bank stock, and preferred stock of other corporations held by AmSouth are not included in the above table. OTHER EARNING ASSETS The other earning assets category consists of federal funds sold and securities purchased under agreements to resell, trading account securities, and mortgage loans held for sale. These assets generally carry relatively low balances while serving as short-term investment alternatives, assisting in the management of AmSouth's asset and liability interest rate sensitivity, and providing a short-term inventory of assets for sale to customers. The average balance of other earning assets for 1993 was $495 million compared to $381 million for 1992. The increase over the 1992 average balance resulted primarily from the increase in mortgage loans held for sale. At December 31, 1993, other earning assets included $335.4 million of mortgage loans held for sale compared to $231.3 million at year end 1992. These loans are primarily originated through AmSouth Mortgage. For 1993, the loan production volume totaled $2.0 billion compared to $1.6 billion for 1992. This increase was primarily due to a continued lower interest rate environment and the maintenance of significant volumes of mortgage refinancing. None of the loans originated and sold by AmSouth Mortgage are subject to recourse provisions. Mortgage loans serviced for others are not included in the consolidated statement of condition. The outstanding principal balances of these loans were $5.0 billion and $4.0 billion at December 31, 1993 and 1992, respectively. DEPOSITS Table 13 outlines the composition of the average deposits of AmSouth for the last five years. AmSouth's principal source of funds is its deposits, and AmSouth is committed to provide its customers with a wide variety of products with modern technology at competitive interest rates. Management continues to emphasize quality customer service and a strong sales culture as key to strengthening AmSouth's deposit base. TABLE 13--AVERAGE DEPOSITS Average noninterest-bearing demand deposits continued to increase during 1993 from 1992. Average noninterest-bearing demand deposits increased $285.4 million or 23.7% in 1993 over 1992. This increase in noninterest-bearing demand deposits has primarily been within the commercial deposits base. Average time deposits increased approximately $423.7 million with 65.7% of the increase from retail or consumer time deposits and 29.7% increase from individual retirement accounts. The major contributor to both of these increases was the acquisition of FCFC, completed February 1, 1993. Table 14 provides a maturity schedule for time deposits of $100,000 or more at December 31. TABLE 14--MATURITY OF TIME DEPOSITS OF $100,000 OR MORE OTHER INTEREST-BEARING LIABILITIES Other interest-bearing liabilities includes all interest-bearing liabilities except deposits. Short-term liabilities included in this category consist of federal funds purchased and securities sold under agreements to repurchase (repurchase agreements), and other borrowed funds. Average federal funds purchased and repurchase agreements, which provide an overnight source of funds, increased $241.7 million in 1993 as AmSouth funded its earning asset growth. For 1992, average federal funds purchased and repurchase agreements decreased $88.3 million as a result of the growth in deposits and sluggish loan demand. At December 31, 1993, 1992, and 1991, federal funds purchased and repurchase agreements totaled $791.2 million, $988.6 million, and $569.9 million, respectively, with weighted average interest rates of 2.73%, 2.85%, and 3.82% respectively. The maximum amount outstanding at any month end during each of the last three years was $1.2 billion, $988.6 million, and $962.5 million, respectively. The average daily balance and average interest rates for each year are presented in Table 17 entitled "Yields on Average Earning Assets and Rates on Average Interest-Bearing Liabilities". Other borrowed funds include master notes, commercial paper, Eurodollars purchased, term federal funds purchased, the current portion of long-term debt, interest-bearing deferred compensation, and a treasury, tax and loan note. During 1993, the average balance of other borrowed funds increased $276.8 million primarily as the result of an increase in term federal funds purchased and the treasury, tax and loan note. In 1992, compared to 1991, the average balance of other borrowed funds increased $109.1 million as a result of a $104.6 million increase in the average balance of the treasury, tax and loan note. At December 31, 1993 and 1992, AmSouth had long-term debt outstanding of $163.1 million and $136.2 million, respectively. In general, the debt has been used to fund acquisitions, inject capital into subsidiary banks, provide capital for nonbanking subsidiaries, and for other general corporate purposes. Note K of the Notes to Consolidated Financial Statements includes details and descriptions of the composition of long-term debt. On December 21, 1993, the Securities and Exchange Commission declared effective AmSouth's registration statement on Form S-3, pursuant to which AmSouth may offer from time to time not more than $300.0 million of unsecured senior debt securities, unsecured subordinated debt securities, and/or warrants to purchase such debt securities. AmSouth intends to utilize approximately $142.5 million of the proceeds from the issuance of such securities to fund the cash portion of the Fortune Bancorp, Inc. purchase price. Additionally, AmSouth has lines of credit arrangements with two financial institutions enabling it to borrow up to $21.0 million subject to such terms as AmSouth and the banks mutually agree. SHAREHOLDERS' EQUITY AmSouth has always placed great emphasis on maintaining its strong capital base. At December 31, 1993, shareholders' equity totaled $1.1 billion, or 8.69% of total assets, compared to $824.8 million, or 8.08% of total assets, at December 31, 1992. Management is committed to maintaining shareholders' equity at a level sufficient to assure its shareholders, customers, and regulators that AmSouth is financially sound, and to enable AmSouth to sustain an appropriate degree of leverage to provide a desirable level of profitability. Regulators use a risk-adjusted capital calculation to aid in their assessment of capital adequacy. This ratio is weighted to reflect the credit risk associated with an institution's assets, both recorded and unrecorded. At December 31, 1993, the minimum required risk-adjusted capital ratio for Tier I capital (shareholders' equity less certain intangibles) was 4.00% and the minimum required risk-adjusted total capital ratio was 8.00%. Table 15 illustrates the calculation of the risk-adjusted capital ratios for AmSouth at year end 1993 and 1992. TABLE 15--CAPITAL RATIOS In addition, the total risk-adjusted capital ratios for the company's banking subsidiaries at December 31, 1993, along with other pertinent measures of capital adequacy, were well above the minimum regulatory requirements. The total risk adjusted capital ratio for each of AmSouth's major subsidiaries was: At December 31, 1993, the book value per share for AmSouth's common stock was $22.01 compared to $19.10 at December 31, 1992. The market value per common share at December 31, 1993 was $31.25 or 142.0% of book value, compared to $32.625 or 170.8% of book value at December 31, 1992. Management believes this decline in the market value to book value ratio generally resulted from a cyclical move by sector investors out of bank stocks as well as concerns over the banking industry's ability to sustain 1993 profit levels. Management closely monitors its capital ratios and the market value of its common stock. At December 31, 1993, total market capitalization was $1.55 billion compared to $1.41 billion at December 31, 1992. During 1993, shareholders' equity increased $265 million, of which $162 million relates to the 5.5 million shares issued for the purchases of FCFC and Mid-State. Management monitors the level of goodwill and other intangibles on both a consolidated and parent company basis. At December 31, 1993, AmSouth had $130.1 million of goodwill of which $43.4 million was at the parent company. The parent company's double leverage ratio at year end 1993 and 1992 was 104.0% and 101.7%, respectively. AmSouth is generally dependent upon dividends from its subsidiary banks to fund the dividends to its shareholders, capital injections to subsidiaries, and certain other costs. During 1993, AmSouth declared dividends of $1.22 per common share, which totaled $57.6 million, compared to $1.07 per common share and $44.7 million in 1992. The dividend payout ratio for 1993 was 39.35%, compared to 42.63% in 1992. Table 16 shows AmSouth's computation of its rate of internal capital generation for the last five years. TABLE 16--RATE OF INTERNAL CAPITAL GENERATION GROSS INTEREST MARGIN The gross interest margin is defined as the difference between the revenue from earning assets, primarily interest income, and interest expense related to interest-bearing liabilities. The gross interest margin is a function of the average balances of earning assets and interest-bearing liabilities and the yields earned and rates paid on those balances. In managing the gross interest margin, management must maintain a satisfactory spread between the yields on earning assets and the related cost of interest-bearing funds. The gross interest spread is determined by comparing the taxable equivalent gross interest margin to average earning assets before deducting the allowance for loan losses. This ratio reflects the overall profitability of earning assets, including both those funded by interest- bearing sources and those which incur no interest cost (primarily noninterest- bearing demand deposits). This ratio is most often used when analyzing a banking institution's overall gross interest margin profitability compared to that of other financial institutions. The incremental interest spread compares the difference between the yields on earnings assets and the cost of interest- bearing funds. This calculation and similar ratios are used to assist in pricing decisions for interest related products. Table 17 illustrates for each of the last three years by major categories of assets and liabilities, the average balances, the components of the gross interest margin (on a taxable equivalent basis), the yield or rate, and the incremental and gross interest spreads. TABLE 17--YIELDS ON AVERAGE EARNING ASSETS AND RATES ON AVERAGE INTEREST- BEARING LIABILITIES - -------- Note: The taxable equivalent adjustment for 1993 has been computed based on a 35% federal income tax rate (34% for 1992 and 1991) and has given effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax-free assets. Loans net of unearned income includes nonaccrual loans for all years presented. For 1993, AmSouth experienced compression in its spread as the gross interest spread and incremental spread declined 17 and 13 basis points, respectively. The compression in spreads was not unique to AmSouth as banking institutions throughout the country experienced the same trend. Another effect on the gross interest spread of the company was the acquisition of FCFC. FCFC was a thrift prior to merger and, accordingly, had a gross interest spread which was lower than AmSouth's prior to the merger. Table 18 outlines the analysis of change in the gross interest spread. TABLE 18--ANALYSIS OF CHANGE IN THE GROSS INTEREST SPREAD Much of the maintenance of the gross interest spread during 1993 is attributable to lower cost deposits matching the declines in assets repricing. The spread between the prime rate and the rate on federal funds purchased (prime to fed funds spread) for the year ended 1993 approximated 300 basis points. Management does not anticipate the prime to fed funds spread to be maintained at those levels. Management anticipates that AmSouth's gross interest spread will reflect the narrowing of the prime to fed funds spread to more historically consistent levels. Table 19 shows the change from year to year for each component of the taxable equivalent gross interest margin separated into the amount generated by volume changes and the amount generated by changes in the yield/rate. The $66.2 million increase in the margin during 1993 was due to increased balances slightly offset by a lower yield/rate. In 1992, the higher gross interest margin compared to 1991 resulted both from positive trends in the volume as well as yield/rate. TABLE 19--VOLUME AND YIELD/RATE VARIANCES - -------- Notes: 1. The change in interest resulting from both volume and yield/rate has been allocated to change due to volume and change due to yield/rate in proportion to the relationship of the absolute dollar amounts of the change in each. 2. The computation of the taxable equivalent adjustment has given effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax-free assets. ASSET AND LIABILITY MANAGEMENT AND LIQUIDITY AmSouth maintains a formal asset and liability management process to control interest rate risk and assist management in maintaining stability in the gross interest margin as a result of changes in the level of interest rates and/or the spread relationships among interest rates. AmSouth uses an earnings simulation model to evaluate the impact of different interest rate scenarios on the gross interest margin. Management feels that a traditional interest sensitivity gap analysis does not provide a complete picture of a corporation's exposure to interest rate change. Static gap models are a static point-in-time measurement and do not incorporate the effects of future balance sheet trends, changes in the relationship between yields earned and rates paid, patterns of rate movements, and changes in prepayment speeds due to rate movements. Static gap models also do not fully incorporate the effects of off-balance sheet alternatives such as interest rate caps and floors. AmSouth's earnings simulation model incorporates all of these factors as well as reflecting management's actions based on different interest rate environments. The model projects the gross interest margin over the next twelve months under a variety of higher and lower interest rate environments. Each month, the Asset/Liability Committee reviews the earnings simulation model output with respect to the estimated impact of various interest rate scenarios on the gross interest margin and approves any major adjustments in the company's interest rate sensitivity which are deemed necessary. During 1993, AmSouth's gross interest margin continued to benefit from the wider than normal interest rate spreads, although management expects interest rate spreads to compress somewhat in 1994. At December 31, 1993, interest rate exposure was within the approved AmSouth guidelines, which limit the negative impact attributable to a 300 basis point change in market interest rates, spread evenly over a twelve month period, to less than 6% of the projected gross interest margin under a stable rate environment. Another tool used to monitor AmSouth's overall interest rate sensitivity is a gap analysis. Table 20 illustrates the company's position at December 31, 1993. The analysis indicates that AmSouth is in a slightly positive gap position over the next six-month and twelve-month time horizons. TABLE 20--INTEREST SENSITIVITY ANALYSIS - -------- Note: Based on historical experience, certain deposit accounts, such as statement savings, NOW accounts, and other similar accounts, reprice slowly in a changing interest rate environment; therefore such deposits are included in the Over One and Less Than Five Years category and the Over Five Years category. If they had been included in the 0--30 Days category, the rate sensitivity gap as a percent of total earning assets would have been a negative 15.9% for the category at December 31, 1993. AmSouth's management believes it has adequate flexibility to alter the overall interest rate sensitivity structure as necessary to minimize exposure to changes in interest rates. Additional tools and control reports exist beyond the earnings simulation and gap reports. These include an extensive internal Treasury transfer pricing system which basically centralizes the management of interest rate risk as well as the use of such measurements as duration of equity and the corresponding mark-to-market evaluation of equity which provide an indication of risk over an extended period of time. In addition, AmSouth utilizes various off-balance sheet instruments such as interest rate swaps, caps, and floors to manage interest rate risk. The notional amounts of all off- balance sheet financial instruments which existed at December 31, 1993 are disclosed in Table 21. TABLE 21--INTEREST RATE SWAPS, CAPS, AND FLOORS Table 22 summarizes the expected maturities and interest rates exchanged on AmSouth's interest rate swaps, caps, and floors portfolios at December 31, 1993. Both the timing of the maturities and the variable interest payments and receipts vary as certain interest rates change. This schedule assumes that interest rates remain unchanged from December 31, 1993 in order to estimate and calculate the maturities and periodic rates shown below. The schedule could change substantially as interest rates move. However, as part of its interest rate risk management process AmSouth simulates the expected maturities and periodic rates over several interest rate environments. TABLE 22--MATURITIES AND INTEREST RATES EXCHANGED ON SWAPS, CAPS, AND FLOORS Additionally, AmSouth Mortgage, in the normal course of business, enters into forward commitments to sell certain mortgages it originates. These forward commitments normally have a term of 60 to 90 days. During 1993, 1992, and 1991, AmSouth Mortgage originated $2.0 billion, $1.6 billion, and $611 million, respectively. AmSouth's goal in liquidity management is to satisfy the cash flow requirements of depositors and borrowers while at the same time meeting the cash flow needs of AmSouth. This is accomplished through the active management of both the asset and liability sides of the statement of condition. The liquidity position of AmSouth is monitored on a daily basis. In addition, the Asset/Liability Committee reviews liquidity reports on a monthly basis and makes any changes necessary as a result of the asset/liability management process or anticipated cash flow changes. The Committee also compares on a monthly basis the company's liquidity position to established corporate liquidity guidelines. At December 31, 1993, AmSouth was within all of the limits which have been established. Management considers the liquidity of AmSouth to be excellent. The primary sources of liquidity on the asset side of the statement of condition are maturities and cash flows from both loans and investments. Liquidity on the liability side is maintained primarily through the growth in core deposits and the ability to obtain economical wholesale funding in national and regional markets. AmSouth's most commonly used sources of short-term borrowings are: (1) federal funds (i.e., the excess reserves of other financial institutions); (2) repurchase agreements, whereby U.S. government and government agency securities are pledged as collateral for short-term borrowings; and (3) pledging acceptable assets as collateral for public deposits and certain tax collection monies. In addition to these sources, AmSouth has the ability to borrow from the Federal Reserve Bank, and access other wholesale funding sources such as Eurodollar deposits, certificates of deposit, commercial paper, and lines of credit. Selected bank subsidiaries also have the ability to borrow from Federal Home Loan Banks. NONINTEREST REVENUES AND NONINTEREST EXPENSES AmSouth's management stresses the importance of growth in noninterest revenues, as well as the control of noninterest expenses. Noninterest revenues have increased at a five year compound growth rate of 9.46%. For 1993, noninterest revenues increased $30.1 million, or 18.3%, compared to 1992. This increase included an $11.9 million increase in gains on securities held for sale for 1993 compared to 1992. Exclusive of investment securities gains and gains on securities held for sale, noninterest revenues increased $21.7 million, or 13.7%, from the prior year. Investment securities gains and gains on securities held for sale resulted primarily from the restructuring of the securities portfolios acquired in business combinations. Trust income increased $1.6 million during 1993 versus 1992, compared to a $2.2 million increase during 1992 over 1991 levels. Service charges on deposit accounts increased $6.6 million, or 13.4%, during 1993 over 1992. This compares to a $2.3 million increase in service charges on deposit accounts during 1992 over 1991. The increase for both years was the result of higher corporate analysis income, higher overdraft fee income, and increased fees earned on certain interest- bearing accounts. Investment services income increased $3.0 million, or 17.5%, compared to a $4.2 million increase in 1992. Both of these increases were related to the favorable bond markets and an increased emphasis on sales of investment products during 1993 and 1992. TABLE 23--NONINTEREST REVENUES AND NONINTEREST EXPENSES Other noninterest revenues increased $23.1 million in 1993 compared to 1992. The increase primarily resulted from an increase of $11.9 million in gains on sale of securities held for sale, a $1.6 million increase in gains on sale of mortgages, a $2.4 million increase in credit card fees, and $3.9 million increase in portfolio options income. Portfolio options income for 1993 of $6.5 million is partially offset by $4.8 million in options expense included in noninterest expenses. Noninterest expenses for 1993 increased $50.0 million, or 13.5%, compared to a 1992 increase of 8.6%. Salaries and employee benefits increased $38.6 million over 1992. Approximately $8.5 million is attributable to the Chattanooga franchise which resulted from the purchase of FCFC on February 1, 1993. The remainder of the increase included normal merit increases, $1.0 million in severance pay, $12.2 million in employee benefits related to AmSouth's early retirement offering and $1.3 million in commissions related to mortgage loan originations. The early retirement offering was one component of a Productivity Plan initiative announced by AmSouth in 1993. Management completed a comprehensive study to determine steps to improve the overall efficiency of the company. One component of the Productivity Plan included the elimination of 750 positions. Over 300 reductions were achieved through the early retirement offering. An additional 130 positions had been eliminated by December 31, 1993. This phase of the plan is scheduled to be complete by mid-year 1994. Another component of the Productivity Plan is the centralization of certain bank functions which will affect noninterest expense amounts other than salaries and benefits. AmSouth continues to place emphasis on its sales and service initiatives. An increase of $2.8 million in nonexecutive incentive compensation reflected the continued high levels of performance of AmSouth's employees. In 1993, the consumer sales force opened 42% more deposit accounts than in 1992, approved 38% more loans, and opened 63% more credit card accounts. The commercial sales force achieved similar results in 1993 with respect to deposit and fee growth. Management believes that an effective sales culture is an essential element to a continued high level of performance for the company. Salaries and benefits increased $19.3 million in 1992 over 1991. The salary and employee benefit increases in the 1992 year were mainly due to increased staffing levels and sales related incentive compensation in income producing areas, as well as merit increases. Net occupancy expense increased 17.6% in 1993, and 14.2% in 1992. Both 1993 and 1992 increases reflect the greater number of AmSouth offices, higher rents paid for facilities, higher depreciation on leasehold improvements, and increased contract maintenance services. Equipment expense increased 11.3% and 10.7% for 1993 and 1992, respectively. The five year compound growth rate for equipment expense is 6.53%. The increases in the past two years resulted from a greater number of AmSouth offices and capital investments in technology. Foreclosed properties expense decreased $26.4 million in 1993 compared to 1992. This decrease included $3.5 million in recoveries on foreclosed properties in the third quarter of 1993 as well as gains on sales of foreclosed properties throughout 1993. The decrease in 1992 compared to 1991 reflected the continued improvement in the loan portfolio and management's efforts to restore foreclosed properties to more normalized levels from the 1991 peak related to the weak real estate market at that time. Management does not anticipate gains on the sale of foreclosed properties to repeat the 1993 levels. FDIC deposit insurance premiums increased $2.2 million in 1993 versus a $1.8 million increase in 1992. Other operating expenses increased $27.2 million, or 26.2%, in 1993 due to operating expenses related to FCFC, additional expenses related to the current acquisition program, and other general corporate expenses. INCOME TAXES AmSouth's income tax expense was $71.1 million in 1993, $43.0 million in 1992, and $27.6 million in 1991. The significant increase in income tax expense over the past three years is due primarily to the combined effects of increased levels of pretax income in each succeeding year and an increase in the company's effective tax rate. The effective tax rate for 1993 was 32.7% compared to 28.5% in 1992 and 25.0% in 1991. The effective tax rate is significantly impacted by the mix of taxable versus tax-exempt revenues from investment securities and loans. The 1993 increase resulted from a continued decrease in tax-exempt revenues and an increase in the statutory federal tax rate effective January 1, 1993. Cash outlays for income taxes have exceeded income tax expense in 1993, 1992, and 1991 primarily due to the income tax treatment required for accounting for loan losses. A detail of the deferred tax assets and liabilities is included in Note R of the Notes to Consolidated Financial Statements. Currently, AmSouth's consolidated tax returns for 1987 through 1990 are under review by the Internal Revenue Service. Management does not anticipate these reviews to result in any material impact on AmSouth's financial condition or results of operations. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards, No. 109, entitled "Accounting for Income Taxes" which requires companies to change from the deferred method of accounting for income taxes to the liability method. AmSouth adopted this statement effective January 1, 1993. There was no material impact on AmSouth's financial condition or results of operations upon adoption of this statement. BUSINESS COMBINATIONS AmSouth has a twenty-year history of successful mergers and acquisitions. From 1971 through 1992, AmSouth integrated 40 financial services institutions. Currently, AmSouth is carrying out a series of acquisitions in accordance with a strategy to solidify its presence in Florida, Tennessee, and Georgia. Transactions are described in Note B of the Notes to Consolidated Financial Statements. AmSouth's strategy for expansion focuses on markets where population growth expectations indicate a favorable future banking environment. AmSouth's recent acquisitions are concentrated primarily in the following geographic areas: the Chattanooga, Tennessee metropolitan statistical area and the Interstate-75 corridor in Northwest Georgia; the west coast of central Florida from Tampa to Naples; and central Florida from Jacksonville to Orlando. Management evaluates each potential business combination on a number of factors including, but not limited to, the effect of the business combination on AmSouth's capital adequacy, liquidity, and future earnings. On a pro forma combined basis after giving effect to the pending business combinations at December 31, 1993, listed in Note B of the Notes to Consolidated Financial Statements, AmSouth's consolidated Tier 1 Capital and Total Capital ratios would have been approximately 9.71% and 13.15%, respectively. This compares to December 31, 1993 actual ratios of 10.95% and 13.31%, respectively. Another capital adequacy ratio used by regulators is the "leverage ratio" (defined as Tier 1 capital to quarterly average assets, less certain goodwill and other intangible assets). Bank holding companies are generally required to maintain a leverage ratio of at least 3.00% plus an additional 100 to 200 basis points. AmSouth's leverage ratio at December 31, 1993, was 8.65%. On a pro forma combined basis after giving effect to the pending business combinations at December 31, 1993, outlined in Note B of the Notes to Consolidated Financial Statements, AmSouth's leverage ratio would have been approximately 7.09%. AmSouth enjoys a strong capital position and does not anticipate the current or pending business combinations to materially adversely effect its capital position. SUPPLEMENTAL FINANCIAL STATEMENTS CONSOLIDATED STATEMENT OF CONDITION AMSOUTH BANCORPORATION AND SUBSIDIARIES DECEMBER 31, 1984-1993 CONSOLIDATED STATEMENT OF EARNINGS AMSOUTH BANCORPORATION AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1984-1993 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of AmSouth and supplementary data are set forth in the pages listed below. MANAGEMENT'S STATEMENT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of AmSouth is responsible for content and integrity of the financial statements and all other financial information included in this annual report on Form 10-K. Management believes that the financial statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis to reflect, in all material respects, the substance of events and transactions that should be included, and that the other financial information in the annual report on Form 10-K is consistent with those financial statements. The financial statements necessarily include amounts that are based on management's best estimates and judgments. Management maintains and depends upon AmSouth's accounting systems and related systems of internal controls. The internal control systems are designed to ensure that transactions are properly authorized and recorded in the corporation's financial records and to safeguard the corporation's assets from material loss or misuse. The corporation maintains an internal audit staff which monitors compliance with the corporation's systems of internal controls and reports to management and to the Audit Committee of the Board of Directors. The Audit Committee of the Board of Directors, composed solely of outside directors, has responsibility for recommending to the Board of Directors the appointment of the independent auditors for AmSouth. The Audit Committee meets periodically with the internal auditors and the independent auditors to review the scope and findings of their respective audits. The internal auditors, independent auditors and management each have full and free access to meet privately as well as together with the Audit Committee to discuss internal controls, accounting, auditing or other financial reporting matters. The consolidated financial statements of AmSouth have been audited by Ernst & Young, independent auditors, who were engaged to express an opinion as to the fairness of presentation of such financial statements. /s/ John W. Woods /s/ M. List Underwood, Jr. John W. Woods M. List Underwood, Jr. Chairman of the Board Executive Vice President and Chief Executive Officer and Chief Financial Officer REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS Board of Directors AmSouth Bancorporation We have audited the accompanying consolidated statement of condition of AmSouth Bancorporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, 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 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of AmSouth Bancorporation 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. /s/ Ernst & Young Birmingham, Alabama January 31, 1994 AMSOUTH BANCORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CONDITION See notes to consolidated financial statements. AMSOUTH BANCORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS See notes to consolidated financial statements. AMSOUTH BANCORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY See notes to consolidated financial statements. AMSOUTH BANCORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See notes to consolidated financial statements. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 NOTE A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting policies of AmSouth Bancorporation (AmSouth) and the methods of applying those policies which materially affect the accompanying financial statements are presented below. BASIS OF PRESENTATION The consolidated financial statements include the accounts of AmSouth and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Prior year financial statements have been restated to include the accounts of business combinations accounted for as poolings-of-interests unless immaterial. Results of operations of companies purchased are included from the dates of acquisition. CASH FLOWS For the Consolidated Statement of Cash Flows, AmSouth has defined cash and cash equivalents as those amounts included in the Consolidated Statement of Condition caption as "Cash and due from banks." For the years ended December 31, 1993, 1992 and 1991 AmSouth paid interest of $313,593,000, $321,180,000 and $454,518,000, respectively. For the years ended December 31, 1993, 1992, and 1991, noncash transfers from loans to foreclosed properties were $11,422,000, $15,094,000, and $55,360,000, respectively. Noncash transfers from foreclosed properties to loans for the years ended December 31, 1993, 1992, and 1991 were $16,384,000, $22,635,000, and $19,520,000, respectively. For the years ended December 31, 1993, 1992, and 1991, noncash transfers from investment securities to securities held for sale were $736,721,000, $428,533,000, and $79,750,000, respectively. TRADING ACCOUNT SECURITIES Trading account securities are carried at market. Monthly market adjustments and realized gains or losses on the sale of trading account securities are reported as other operating revenues. SECURITIES HELD FOR SALE AmSouth defines securities held for sale as securities to be held for indefinite periods of time, including securities that management intends to use as part of its asset and liability management strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, or other similar factors. These securities are stated at the lower of aggregate cost or market value. Monthly market adjustments and realized gains or losses upon sale of the securities are classified as other operating revenues. In May 1993, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (Statement 115). The Statement generally will require that debt and equity securities that have readily determinable fair values be carried at fair value unless they are intended to be held to maturity. Securities will be classified as held for investment and carried at amortized cost only if AmSouth has a positive intent and ability to hold those securities to maturity. If not classified as held for investment, such securities would be classified as trading securities or securities available for sale. Net unrealized holding gains or losses for securities available for sale would be excluded from earnings and reported as a separate component of shareholders' equity. In management's opinion, the adoption of Statement 115, effective January 1, 1994, will not have a material impact as of that date on the financial condition of AmSouth. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) INVESTMENT SECURITIES Investment securities are securities which at December 31 management had the intent and ability to hold to maturity. Investment securities are stated at cost, adjusted for amortization of premiums and accretion of discounts on the straight-line method. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale are carried at the lower of aggregate cost or market value. Monthly market adjustments and realized gains and losses are classified as other operating revenues. INTEREST RATE SWAPS AmSouth, from time to time, enters into interest rate swaps to hedge imbalances in sensitivity to fluctuating interest rates among certain assets and liabilities. Any gains or losses realized are deferred and amortized as yield/rate adjustments of the hedged assets or liabilities over the original life of the swap. FUTURES AND FORWARD CONTRACTS Any gains and losses on futures and forward contracts that qualify as hedges are deferred and recognized as an adjustment of the carrying amount of the hedged asset or liability or anticipated transaction. Futures and forward contracts used for trading purposes are recorded at market value. Changes in market value are recognized in other operating revenues. LOANS Interest income on commercial and real estate loans is accrued daily based upon the outstanding principal amounts except for those classified as nonaccrual loans. Interest income on certain consumer loans is accrued monthly based upon the outstanding principal amounts except for those classified as nonaccrual loans. Interest accrual is discontinued when it appears that future collection of principal or interest according to the contractual terms may be doubtful. Interest collections on nonaccrual loans for which the ultimate collectibility of principal is uncertain are applied as principal reductions. Otherwise, such collections are credited to income when received. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is maintained at a level which is considered adequate to provide for potential losses based upon management's evaluation of known and inherent risk characteristics of the loan portfolio, the fair value of underlying collateral, recent loan loss experience, current economic conditions, and other pertinent factors. A provision for loan losses is charged to operations based on management's periodic evaluation of these risks. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" (Statement 114). Statement 114 generally will require all creditors to account for impaired loans, except those loans that are accounted for at fair value or at the lower of cost or fair value, at the present value of the expected future cash flow discounted at the loan's effective interest rate or if collateral dependent, at the fair value of the underlying collateral. Statement 114, when adopted in 1995, is not expected to have a material impact on AmSouth's financial condition or results of operations. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) PREMISES AND EQUIPMENT Premises and equipment are stated at cost, less accumulated depreciation and amortization. The provisions for depreciation and amortization are computed generally by the straight-line method over the estimated useful lives of the assets or terms of the leases, as applicable. The annual provisions for depreciation and amortization have been computed principally using estimated lives of five to forty years for premises and three to ten years for furniture and equipment. FORECLOSED PROPERTIES Foreclosed properties, including in-substance foreclosures, are carried at the lower of the estimated net realizable value or cost and are included in other assets, net of the allowance for foreclosed property losses. For the years ended December 31, 1993, 1992, and 1991, a (reduction)/provision of $(3,773,000), $15,508,000 and $29,452,000 was (credited)/charged to expense and write downs of properties charged to the allowance totaled $2,887,000, $14,701,000 and $22,775,000, respectively. At December 31, 1993, 1992 and 1991, the allowance had a balance of $3,347,000, $7,484,000 and $6,677,000, respectively. INTANGIBLE ASSETS Intangible assets, primarily goodwill and purchased mortgage servicing rights, are included in other assets. Goodwill is amortized on a straight-line basis primarily over twenty to twenty-five years. The carrying value of goodwill will be reviewed if the facts and circumstances suggest that it may be impaired. 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, AmSouth's carrying value of the goodwill will be reduced by the estimated shortfall of cash flows. At December 31, 1993 and 1992, goodwill totaled $130,062,000 and $69,335,000, respectively. Purchased mortgage servicing rights are amortized over the estimated average lives of the related loans. At December 31, 1993 and 1992, purchased mortgage servicing rights totaled $32,649,000 and $29,698,000, respectively. INCOME TAXES The consolidated financial statements have been prepared on the accrual basis. When income and expenses are recognized in different periods for financial reporting purposes and for purposes of computing income taxes currently payable, deferred taxes are provided on such timing differences. Effective January 1, 1993, AmSouth adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement 109). Under Statement 109 deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. Prior years' financial statements have not been restated to apply the provisions of Statement 109. The adoption of Statement 109 did not have a material impact on AmSouth's financial condition or results of operations. PENSION AND OTHER EMPLOYEE BENEFIT PLANS AmSouth has pension and other employee benefit plans for the benefit of substantially all regular, full-time employees. The plans are trusteed and noncontributory. Costs of AmSouth's pension plan are actuarially determined by the projected unit credit method with actuarial gains or losses recognized each year and amortized separately. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) AmSouth adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting For Postretirement Benefits Other than Pensions" (Statement 106) as of January 1, 1993. Statement 106 requires employers to recognize postretirement benefits on an accrual basis during the periods employees provide services to earn those benefits. As permitted under Statement 106, AmSouth chose to amortize the transition postretirement benefit obligation of approximately $4,400,000 over a 20 year period on a straight line basis. Net income for the year ended December 31, 1993 included a pre-tax charge of approximately $1,200,000 for the effect of this accounting change. The FASB has also issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting For Postemployment Benefits" which requires employers who provide benefits to former or inactive employees after employment but before retirement to recognize the obligation of postemployment benefits on an accrual basis over the related service period. Adoption is required for fiscal years beginning after December 31, 1993. In management's opinion, the adoption will not have a material impact on the financial condition or results of operations of AmSouth. EARNINGS PER COMMON SHARE Earnings per common share are based on the average outstanding shares of common stock excluding treasury stock. The effects of stock options outstanding and convertible debentures are immaterial to the calculation of earnings per common share. FAIR VALUES OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (Statement 107), requires the disclosure of estimated fair values for all financial instruments, both assets and liabilities on- and off-balance sheet, for which it is practicable to estimate their value along with pertinent information on those financial instruments for which such values are not available. Fair value estimates are made at a specific point in time and are based on relevant market information which is continuously changing. Because no quoted market prices exist for a significant portion of AmSouth's financial instruments, fair values for such instruments are based on management's assumptions with respect to future economic conditions, estimated discount rates, estimates of the amount and timing of future cash flows, expected loss experience, and other factors. These estimates are subjective in nature involving uncertainties and matters of significant judgment; therefore, they cannot be determined with precision. Changes in the assumptions could significantly affect the estimates. Statement 107 fair value estimates include certain on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, AmSouth has a substantial trust department that contributes net fee income annually. The trust department is not considered a financial instrument, and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include the mortgage banking operation, brokerage network, premises and equipment, core deposit intangible, and goodwill. In addition, the 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 in the estimates. As a result, the Statement 107 fair value disclosures should not be considered an indication of the fair value of the corporation taken as a whole. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following methods and assumptions were used by AmSouth in estimating its fair value disclosures for financial instruments: Cash and short-term instruments: The carrying amounts reported in the statement of condition for cash and short-term instruments approximate their fair values. Investments: Fair values for investment securities, securities held for sale, trading account securities, and mortgage loans held for sale are based on quoted market prices, where available. Where quoted market prices are not available, fair values are based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. Loans: The fair values of variable rate loans that reprice frequently and have no significant change in credit risk are assumed to approximate carrying values. The fair values for credit card loans and equity lines of credit are estimated using pricing models with assumptions based on current conditions in the secondary market for those instruments. The fair values for other loans (e.g., commercial, commercial real estate, certain mortgage loans and consumer loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality and estimates of maturity based on AmSouth's historical experience. The carrying amount of accrued interest receivable approximates its fair value. Commitments to extend credit and standby letters of credit: The fair value of commitments to extend credit is estimated based on the amount of unamortized deferred loan commitment fees. The fair value of letters of credit is based on the amount of unearned fees plus the estimated cost to terminate the letters of credit. Off-balance sheet instruments: The fair value of interest rate swaps, financial futures, and interest rate caps and floors are obtained from dealer quotes. These values represent the estimated amount the corporation would receive or pay to terminate the contracts or agreements, taking into account current interest rates and, when appropriate, the current creditworthiness of the counterparties. Deposit liabilities: The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings accounts, and money market and interest-bearing checking accounts is, by definition, equal to the amount payable on demand (carrying amount). The fair value for variable rate fixed-term money market accounts and certificates of deposit approximate their carrying values. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of deposit to a schedule of aggregated expected monthly maturities on time deposits. Short-term borrowings: The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings approximate their fair values. Long-term borrowings: The fair values of long-term borrowings (other than deposits) are estimated using discounted cash flow analyses, based on AmSouth's current incremental borrowing rates for similar types of borrowing arrangements. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE B BUSINESS COMBINATIONS During the year ended December 31, 1993, AmSouth completed the following acquisitions which were accounted for using the purchase method of accounting: The resulting goodwill from the acquisitions of FCFC, Charter, and Mid-State of $59.7 million will be amortized on a straight line basis over 20 years. The operating results of these acquisitions are included in AmSouth's consolidated statement of earnings since the dates of acquisition. The following unaudited pro forma summary presents the consolidated statement of earnings as if the acquisitions occurred at the beginning of 1992, after giving effect to certain adjustments, including amortization of goodwill and related income tax effects. These pro forma results have been prepared for comparison purposes only and do not purport to be indications of what would have occurred had the acquisitions been made as of the beginning of 1992 or of results which may occur in the future. During the year ended December 31, 1993, AmSouth completed the following business combinations which were accounted for using the pooling-of-interests method of accounting: AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) AmSouth's 1993 consolidated financial statements include Mickler/Clearwater, and Sunbelt for the entire year. AmSouth's consolidated financial statements for all periods prior to 1993 have been restated to include Mickler/Clearwater, but have not been restated to include Sunbelt, the effect of which is not material to AmSouth's financial condition or results of operations. Gross interest margin, net income, and earnings per common share have been restated as follows: During January and February, 1994, AmSouth completed business combinations with Orange Banking Corporation (Orange), headquartered in Orlando, Florida, and FloridaBank, A Federal Savings Bank (FloridaBank), headquartered in Jacksonville, Florida, both of which will be accounted for using the pooling- of-interests method of accounting. AmSouth issued approximately 1,332,000 and 759,000 shares of common stock for all of the outstanding shares of common stock of Orange and FloridaBank, respectively. At December 31, 1993, Orange and FloridaBank had total consolidated assets of $354.4 million and $271.5 million, respectively. In the aggregate, when 1993 is restated for the pooling-of- interests, AmSouth's gross interest margin will be $488.6 million, net income will be $144.9 million, and earnings per common share will be $2.94. These business combinations will not have a material effect on AmSouth's financial condition or results of operations when restated for 1992 and 1991. AmSouth has announced the following business combinations which are expected to be completed in 1994, pending all regulatory and shareholder approvals, and will be accounted for using the pooling-of-interests method of accounting: On September 12, 1993, AmSouth signed an agreement to acquire Fortune Bancorp, Inc. (Fortune) and its subsidiary, Fortune Bank, a Savings Bank. Upon completion of the transaction, AmSouth will issue a total of approximately 4,481,000 shares and approximately $142.5 million in cash. At December 31, 1993, Fortune had total consolidated assets of approximately $2.7 billion and total consolidated deposits of approximately $1.8 billion. AmSouth anticipates that the acquisition of Fortune will be accounted for using the purchase method of accounting. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE C CASH AND DUE FROM BANKS AmSouth's bank subsidiaries are required to maintain average reserve balances with the Federal Reserve Bank based on a percentage of deposits. The average amount of those reserves for the year ended December 31, 1993 was approximately $124,000,000. NOTE D SECURITIES HELD FOR SALE The amounts at which securities held for sale are carried and their approximate fair market values at December 31 are summarized as follows: The carrying amount and approximate market value of securities held for sale by maturity at December 31, 1993, were as follows: Sales of securities held for sale were $990,840,000 and $685,229,000, during 1993 and 1992, respectively. Gross gains of $13,797,000 and $4,208,000 and gross losses of $934,000 and $3,199,000 were realized on these sales for 1993 and 1992, respectively. Securities held for sale with a carrying amount of $487,431,000 and $233,375,000 at December 31, 1993 and 1992, respectively, were pledged for collateral for public funds and trust deposits. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE E INVESTMENT SECURITIES The amounts at which investment securities are carried and their approximate fair market values at December 31 are summarized as follows: The carrying amount and approximate market value of investment securities by maturity at December 31, 1993, were as follows: Sales of investment securities were $66,327,000 and $188,185,000 during 1993 and 1992, respectively. Gross gains of $1,342,000 and $4,619,000 and gross losses of $126,000 and $4,000 were realized on these sales for 1993 and 1992, respectively. Investment securities with a carrying amount of $974,164,000 and $1,344,388,000 at December 31, 1993 and 1992, respectively, were pledged as collateral for public funds and trust deposits. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE F LOANS The major categories of loans at December 31 are summarized as follows: At December 31, 1993 and 1992, nonaccrual and/or restructured loans totaled $48,038,000 and $56,576,000, respectively. The amount of interest income actually recognized on these loans during 1993 and 1992 was $130,000 and $735,000, respectively. The additional amount of interest income that would have been recorded during 1993 and 1992 if the above amounts had been current in accordance with their original terms was $3,461,000 and $4,291,000, respectively. Certain directors of AmSouth and its significant subsidiaries, including their immediate families and companies in which they are principal owners, were loan customers of AmSouth during 1993 and 1992. Such loans are made in the ordinary course of business at normal credit terms, including interest rates and collateral, and do not represent more than a normal risk of collection. Total loans to these persons at December 31, 1993 and 1992 amounted to $84,225,000 and $92,760,000, respectively. Activity during 1993 in loans to related parties resulted in additions of $141,378,000 representing new loans, reductions of $150,580,000 representing payments, and net additions of $667,000 representing other changes. The fair value estimate of net loans as of December 31, 1993 is $7,904 million compared to the net book value of $7,812 million. Management has made estimates of the fair value based on assumptions that it believes to be reasonable as discussed in Note A. However, because there is no market for many of these loans, management has no basis to determine whether the fair value computed would be indicative of the value negotiated in an actual sale. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE G ALLOWANCE FOR LOAN LOSSES A summary of changes in the allowance for loan losses is shown below: NOTE H PREMISES AND EQUIPMENT Premises and equipment at December 31 are summarized as follows: NOTE I DEPOSITS The carrying amounts and fair values of deposits consisted of the following at December 31, 1993: As disclosed in Note A, Statement 107 defines the fair value of deposits with no defined maturities as the amount payable on demand, and prohibits adjusting fair value for any value derived from retaining those deposits for an expected future period of time. That component, commonly referred to as a deposit base intangible, is neither considered in the above fair value amounts nor is it recorded as an intangible asset in the balance sheet. The aggregate amounts of time deposits of $100,000 or more, excluding certificates of deposit of $100,000 or more, in domestic bank offices at December 31, 1993 and 1992 were $181,841,000 and $125,230,000 respectively. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE J OTHER BORROWED FUNDS Other borrowed funds at December 31 is summarized as follows: At December 31, 1993, AmSouth had lines of credit arrangements for short-term debt with two banks enabling the parent company to borrow up to $21,000,000 subject to such terms as AmSouth and the banks may mutually agree. These arrangements are reviewed annually for renewal of the credit lines. AmSouth pays commitment fees of 1/4% per annum on $1,000,000 of these lines which is available solely to support commercial paper borrowings. Neither of the lines was in use at December 31, 1993. NOTE K LONG-TERM DEBT Long-term debt at December 31 is summarized as follows: The Subordinated Capital Notes Due 1999 were issued in 1987 at a discounted price of 99 1/8. The net proceeds to AmSouth after commissions totaled $98,450,000 for an effective rate to maturity of 9.60%. The notes will mature on May 1, 1999 and will be repaid with either equity securities with a market value of $100,000,000 or with cash generated from the sale of equity securities. Advances from the Federal Home Loan Bank had maturities ranging from 1996 to 2013 and interest rates ranging from 3.00% to 9.30%. The average outstanding balance and average interest rate for 1993 on the Floating Rate Notes Due 1999 were $8,172,000 and 4.03%, respectively. The rate per annum for each semiannual period is the higher of one percent above the three month Treasury Bill rate or a rate fixed by AmSouth. The interest rate payable for the period ending February 28, 1994 is 4.05%. The notes are redeemable at the option of the holder on any March 1 or September 1 at their principal amount plus accrued interest. The 7 1/2% Convertible Subordinated Debentures, due 2001, are redeemable on August 1, 1996 and debentureholders may thereafter elect, during the 30-day period following the call, to convert their debentures AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) into either $170.91 cash per $100 principal amount, or 17.18199 shares of AmSouth common stock (maximum of 419,103 shares) or a combination of each. The redemption premium is being amortized to August 1, 1996. Long-term notes payable at December 31, 1993, included $23,359,000 of notes maturing from 2006 to 2017 with interest rates ranging from 3.25% to 5.22%. The remaining $451,000 of notes will mature in 1997 and have an interest rate of 9.00%. The fair value of long-term debt at December 31, 1993 is approximately $178.5 million, based on the current interest rate environment. The aggregate maturities of long-term debt outstanding at December 31, 1993 are summarized as follows: On December 21, 1993, the Securities and Exchange Commission declared AmSouth's registration statement on Form S-3 effective pursuant to which AmSouth may offer from time to time not more than $300 million of unsecured senior debt securities, unsecured subordinated debt securities, and/or warrants to purchase such debt securities. NOTE L OFF-BALANCE SHEET FINANCIAL AGREEMENTS AmSouth enters into a variety of financial instrument agreements to help customers manage their exposure to interest rate and foreign currency fluctuations, and finance international activities. AmSouth also trades in similar instruments to manage its exposure to changes in interest and foreign exchange rates, as well as to profit from arbitrage opportunities. Futures and forward contracts provide customers and AmSouth a means of managing the risks of changing interest and foreign exchange rates. These contracts represent commitments either to purchase or sell securities, other money market instruments, or foreign currency at a future date and at a specified price. AmSouth is subject to the market risk associated with changes in the value of the underlying financial instrument as well as the risk that another party will fail to perform. The gross contract amount of futures and forward contracts represents the extent of AmSouth's involvement. However, those amounts significantly exceed the future cash requirements as AmSouth intends to close out open trading positions prior to settlement and thus is subject only to the change in value of the instruments. The gross amount of contracts represents AmSouth's maximum exposure to credit risk. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Interest rate swaps are agreements to exchange interest payments computed on notional amounts. Swaps subject AmSouth to market risk associated with changes in interest rates, as well as the risk that another party will fail to perform. Interest rate caps and floors are contracts in which a counterparty pays or receives a cash payment from another counterparty if a floating rate index rises above or falls below a predetermined level. Market risk resulting from a position in a particular off-balance sheet financial instrument may be offset by other on- or off-balance sheet transactions. AmSouth monitors overall sensitivity to interest rate changes by analyzing the net effect of potential changes in interest rates on the market value of both on- and off-balance sheet financial instruments and the related future cash flow streams. AmSouth manages the credit risk of counterparty defaults in these transactions by limiting the total amount of arrangements outstanding, both by individual counterparty and in the aggregate, and by monitoring the size and maturity structure of the off-balance sheet portfolio. The following table identifies the gross contract or notional amounts of off- balance sheet financial instruments: The fair value of the off-balance sheet financial instruments at December 31, 1993 is approximately $9.8 million. NOTE M COMMITMENTS AND CONTINGENCIES AmSouth and its subsidiaries lease land, premises, and equipment under cancellable and noncancellable leases some of which contain renewal options under various terms. The leased properties are used primarily for banking purposes. The total rental expense on operating leases is shown below: AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Future minimum payments, by year and in the aggregate, for noncancellable operating leases with initial or remaining terms of one year or more consisted of the following at December 31, 1993: AmSouth and its subsidiaries are contingently liable with respect to various loan commitments and other contingent liabilities in the normal course of business. AmSouth's maximum exposure to credit loss for loan commitments (unfunded loans and unused lines of credit), standby letters of credit, loans sold with recourse, and securities underwriting at December 31, 1993 was as follows (in millions): The credit risk associated with loan commitments and standby letters of credit is essentially the same as that involved in extending loans to customers and is subject to the company's credit policies. Collateral is obtained based on management's assessment of the customer. The estimated fair value of commitments to extend credit and standby letters of credit at December 31, 1993 is approximately $1.9 million. At December 31, 1993, AmSouth had a contract with a related party for the construction of a training and administration facility in the Birmingham, Alabama area. This contract represents approximately $64.0 million of the estimated total construction cost of $100.0 million. Various legal proceedings are pending against AmSouth and its subsidiaries. Based upon legal counsel's opinion, management considers that any liability resulting from various legal proceedings would not have a material impact on the financial condition or results of operations of AmSouth. NOTE N SHAREHOLDERS' EQUITY AmSouth offers a Dividend Reinvestment and Common Stock Purchase Plan, whereby shareholders can reinvest dividends to acquire shares of common stock. Shareholders may also invest additional cash up to $5,000 per quarter with no brokerage commissions or fees charged. On June 15, 1989, AmSouth's Board of Directors approved a Stockholder Protection Rights Agreement and distributed Rights to common shareholders. Each Right entitles its registered holder, upon occurrence of certain events, to purchase from AmSouth one one-hundredth of a share of Series A Preferred Stock, without par value, for $115, subject to adjustment. The Rights will be exercisable only if a person or group acquires 15% or more of AmSouth's common stock or commences a tender offer that will result in such AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) person or group owning 15% or more of AmSouth's common stock. The Rights may be redeemed by action of the Board of Directors for one cent per Right. In August 1991, AmSouth completed a public sale of 2,760,000 shares of its common stock, par value $1.00 per share, which generated net proceeds of $76,911,000. In November 1991, AmSouth's Board of Directors authorized a three-for-two common stock split. The common stock split was payable to shareholders of record as of December 13, 1991, and the shares were issued in January 1992. Accordingly, the equity accounts and the shares of common stock issued and outstanding at December 31, 1991 were adjusted to reflect the common stock split. At the Annual Meeting of Shareholders on April 15, 1993, an amendment of AmSouth's Restated Certificate of Incorporation to increase the authorized common stock, $1.00 par value, from 75,000,000 to 200,000,000 shares was approved. At December 31, 1993, there were 121,558 shares reserved for issuance under the Dividend Reinvestment and Common Stock Purchase Plan, 1,874,727 shares reserved for issuance under stock compensation plans and 256,838 shares reserved for issuance under the employee stock purchase plan for a total of 2,253,123 shares. As disclosed in Note B, approximately 9,035,000 shares of common stock were issued for various acquisitions that were consummated during 1993. NOTE O LONG-TERM INCENTIVE COMPENSATION PLAN AmSouth has long-term incentive compensation plans which permit the granting of incentive awards in the form of stock options, restricted stock awards, and stock appreciation rights. The following table summarizes the activity relating to stock options during 1991, 1992 and 1993: The option period for the stock options is ten years. Of the options outstanding at December 31, 1993, those granted during 1993 have a one year restriction period from the date of grant. All other options outstanding were exercisable. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) AmSouth also has issued common stock as restricted stock awards to key officers with the restriction that they remain employed with AmSouth for a period ranging from three to five years at the same or a higher level. During 1991, 96,300 restricted shares were awarded, 3,375 shares of restricted stock awards were forfeited and the restrictions were removed on 87,300 shares. During 1992, 57,000 restricted shares were awarded and 12,000 shares of restricted stock awards were forfeited. During 1993, 51,875 restricted shares were awarded, 11,200 shares of restricted stock awards were forfeited and the restrictions were removed on 35,200 shares. At December 31, 1993, AmSouth had 197,775 shares of common stock outstanding representing restricted stock awards. At December 31, 1993, there were no stock appreciation rights outstanding. NOTE P RESTRICTIONS ON TRANSFER OF FUNDS Certain restrictions exist regarding the ability of banking subsidiaries to transfer funds to the parent company as loans, advances or dividends. The approval of regulatory authorities is required to pay dividends in excess of earnings retained in the current year plus retained net profits for the preceding two years. At December 31, 1993, $149,960,000 of the subsidiary banks' net assets were available for dividends without prior regulatory approval. Substantially all of the parent company's retained earnings at December 31, 1993 and 1992 represented undistributed earnings of its banking subsidiaries. NOTE Q PENSION AND OTHER EMPLOYEE BENEFIT PLANS As of December 31, 1993, AmSouth maintained a corporate pension plan, which covers substantially all regular full-time employees. The pension plan benefits are based on years of service and the employee's compensation during the last 120 months of employment. AmSouth's policy is to fund the minimum level allowed by ERISA. Net periodic pension cost includes the following components: AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table sets forth the funded status of the plan and the amounts shown in the accompanying Consolidated Statement of Condition at December 31: 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 obligation were 7.50% and 5.00%, respectively, at December 31, 1993, 8.50% and 5.50%, respectively, at December 31, 1992 and 8.50% and 6.00%, respectively, at December 31, 1991. The average expected long-term rate of return on plan assets is approximately 8.50% at December 31, 1993 and 1992, and 9.00% at December 31, 1991. At December 31, 1993, the plan assets included AmSouth common stock with a market value of $10,331,000. AmSouth also maintains a thrift plan which covers substantially all regular full-time employees. AmSouth makes matching contributions of 50% of each employee's contributions to the thrift plan, up to 5% of their base pay. The cost of the thrift plan for the years ended December 31, 1993, 1992, and 1991 was $2,075,000, $2,128,000, and $1,839,000, respectively. AmSouth also sponsors other postretirement benefit plans. In 1993, AmSouth adopted Statement of Financial Accounting Standards No. 106, "Employers Accounting for Postretirement Benefits Other than Pensions" (Statement 106). The effect of the adoption of Statement 106 did not have a material impact on the financial condition or results of operations of AmSouth. AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE R INCOME TAXES The provisions for income taxes charged to earnings are summarized as follows: During 1992 and 1991, deferred income taxes were provided for timing differences in the recognition of revenue and expense for tax and financial reporting purposes. The tax effects of these differences for 1992 and 1991 were as follows: The differences between the actual income tax expense and the amount computed by applying the statutory federal income tax rate to income before income taxes were as follows: AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The significant temporary differences which create deferred tax assets and liabilities at December 31, 1993 are as follows (in thousands): Income taxes paid were $67,120,000, $42,895,000, and $35,316,000, for 1993, 1992, and 1991, respectively. Applicable income taxes of $457,000, $1,694,000, and $4,502,000 on investment securities gains for 1993, 1992, and 1991, respectively, are included in the provision for income taxes. NOTE S OTHER OPERATING REVENUES AND OTHER OPERATING EXPENSES The components of other operating revenues and other operating expenses are as follows: AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE T CONDENSED PARENT COMPANY INFORMATION STATEMENT OF CONDITION STATEMENT OF EARNINGS AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) STATEMENT OF CASH FLOWS AMSOUTH BANCORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) NOTE U QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Selected quarterly results of operations for the four quarters ended December 31, 1993 and 1992 are as follows: 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 on the directors and director nominees of AmSouth included at pages 6, 8, 10, and 11 of AmSouth's Proxy Statement for the Annual Meeting of Shareholders to be held on April 21, 1994 (the Proxy Statement) is incorporated herein by reference. Information on AmSouth's executive officers is included in Part I of this report. Current director Mr. B. Phil Richardson will retire as a director effective April 21, 1994 pursuant to the mandatory retirement provisions of AmSouth's bylaws. Mr. Richardson, age 68, has served as a director of AmSouth since 1980 and during the last five years has been Executive Vice President--Operations of Alfa Insurance Companies (auto, fire casualty and life insurance). Mr. Richardson is also a director of Alfa Corporation. Information regarding late filings under Section 16(a) of the Securities Exchange Act of 1934 included at page 14 of the Proxy Statement is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding compensation of directors and executive officers included at pages 15 through 22 of the Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the caption "Voting Securities and Principal Holders Thereof" at pages 2 through 5 of the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth in the Proxy Statement under the caption "Certain Transactions" at pages 14 and 15 and in paragraphs (a), (b), and (c) under the caption "Information with Respect to Compensation Committee Interlocks and Insider Participation in Compensation Decisions" at page 19 is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) FINANCIAL STATEMENT SCHEDULES The following report of independent auditors and consolidated financial statements of AmSouth and its subsidiaries are included in Item 8: Report of Independent Auditors Consolidated Statement of Condition -- December 31, 1993 and 1992 Consolidated Statement of Earnings -- Years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Shareholders' 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 -- Years ended December 31, 1993, 1992, and 1991 FINANCIAL STATEMENT SCHEDULES All schedules to the consolidated financial statements required by Article 9 of Regulation S-X and all other schedules to the financial statements of AmSouth required by Article 5 of Regulation S-X are not required under the related instructions or are inapplicable and therefore have been omitted. (B) REPORTS ON FORM 8-K The following reports on Form 8-K were filed during the fourth quarter of 1993: a) Report on form 8-K filed October 18, 1993 reporting AmSouth's preliminary results of operations through the third quarter of 1993. b) Report on Form 8-K filed November 24, 1993 to present pro forma financial statements reflecting certain pending acquisitions, including (i) an Unaudited Pro Forma Condensed Statement of Condition as of September 30, 1993, and (ii) Unaudited Pro Forma Combined Condensed Statements of Earnings for the year ended December 31, 1992 and the nine months ended September 30, 1993. c) Report on Form 8-K filed December 21, 1993 reporting the completion of the acquisition of Mid-State Federal Savings Bank. (C) EXHIBITS The exhibits listed in the Exhibit Index at page 72 of this Form 10-K are filed herewith or are incorporated herein by reference. 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. AmSouth Bancorporation By /s/ John W. Woods ---------------------------------- JOHN W. WOODS Chairman of the Board, Chief Executive Officer and President Date: March 21, 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/ John W. Woods By /s/ M. List Underwood, Jr. ---------------------------------- ---------------------------------- JOHN W. WOODS M. LIST UNDERWOOD, JR. Chairman of the Board, Chief Executive Vice President and Chief Executive Officer, President and A Financial Officer (Principal Director (Principal Executive Financial Officer) Officer) Date: March 21, 1994 Date: March 21, 1994 By /s/ Ricky W. Thomas ---------------------------------- RICKY W. THOMAS Senior Vice President and Controller (Principal Accounting Officer) Date: March 21, 1994 By /s/ C. Stanley Bailey By ---------------------------------- ---------------------------------- C. STANLEY BAILEY GEORGE W. BARBER, JR. A Director and Officer A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ William D. Biggs, Sr. By /s/ Barney B. Burks, Jr. ---------------------------------- ---------------------------------- WILLIAM D. BIGGS, SR. BARNEY B. BURKS, JR. A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ William J. Cabaniss, Jr. By /s/ Joseph M. Farley ---------------------------------- ---------------------------------- WILLIAM J. CABANISS, JR. JOSEPH M. FARLEY A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ M. Miller Gorrie By /s/ Robert A. Guthans ---------------------------------- ---------------------------------- M. MILLER GORRIE ROBERT A. GUTHANS A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ Elmer B. Harris By /s/ James I. Harrison, Jr. ---------------------------------- ---------------------------------- ELMER B. HARRIS JAMES I. HARRISON, JR. A Director A Director Date: March 21, 1994 Date: March 21, 1994 By By /s/ Hugh B. Jacks ---------------------------------- ---------------------------------- DONALD E. HESS HUGH B. JACKS A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ Ronald L. Kuehn, Jr. By /s/ E. Roberts Leatherbury ---------------------------------- ---------------------------------- RONALD L. KUEHN, JR. E. ROBERTS LEATHERBURY A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ Mrs. H. Taylor Morrissette By /s/ Claude B. Nielsen ---------------------------------- ---------------------------------- MRS. H. TAYLOR MORRISSETTE CLAUDE B. NIELSEN A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ Arthur R. Outlaw By /s/ Z. Cartter Patten, III ---------------------------------- ---------------------------------- ARTHUR R. OUTLAW Z. CARTTER PATTEN, III A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ Benjamin F. Payton, Ph.D. By /s/ B. Phil Richardson ---------------------------------- ---------------------------------- BENJAMIN F. PAYTON, PH.D. B. PHIL RICHARDSON A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ C. Dowd Ritter By /s/ William J. Rushton, III ---------------------------------- ---------------------------------- C. DOWD RITTER WILLIAM J. RUSHTON, III A Director and Officer A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ Herbert A. Sklenar By ---------------------------------- ---------------------------------- HERBERT A. SKLENAR W. A. WILLIAMSON, JR. A Director A Director Date: March 21, 1994 Date: March 21, 1994 By /s/ Spencer H. Wright ---------------------------------- SPENCER H. WRIGHT A Director Date: March 21, 1994 EXHIBIT INDEX The following is a list of exhibits including items incorporated by reference. Compensatory plans and arrangements are identified by an asterisk. NOTES TO EXHIBITS (1) Filed as Exhibit 2 to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-53088), incorporated herein by reference (2) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-60164), incorporated herein by reference (3) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-49865), incorporated herein by reference (4) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-64960), incorporated herein by reference (5) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-50041), incorporated herein by reference (6) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-50605), incorporated herein by reference (7) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-50727), incorporated herein by reference (8) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-51767), incorporated herein by reference (9) Filed as Exhibit 2(a) to AmSouth's Registration Statement on Form S-4 (Registration Statement No. 33-50865), incorporated herein by reference (10) Filed as Exhibit 2(a) to AmSouth's Report on Form 8-K filed on September 16, 1993, as amended by a Form 8-K/A filed on September 23, 1993, incorporated herein by reference (11) Filed as Exhibit 3-b to AmSouth's Form 10-Q Quarterly Report for the quarter ended March 31, 1993, incorporated herein by reference (12) Instruments defining the rights of holders of long-term debt of AmSouth are not filed herewith pursuant to Item 601(b)(4)(iii) of Regulation S-K, and AmSouth hereby agrees to furnish a copy of said instruments to the SEC upon request (13) Filed as Exhibit 4-a to AmSouth's Form 10-Q Quarterly Report for the quarter ended June 30, 1989, incorporated herein by reference (14) Filed as Exhibit 4-c to AmSouth's Form 10-Q Quarterly Report for the quarter ended June 30, 1989, incorporated herein by reference (15) Filed as Exhibit 10(b) to AmSouth's Form 10-Q Quarterly Report for the quarter ended September 30, 1993, incorporated herein by reference (16) Filed as Exhibit 10-b to AmSouth's Form 10-Q Quarterly Report for the quarter ended September 30, 1991, incorporated herein by reference (17) Filed as part of Exhibit 23 to AmSouth's Form 10-Q Quarterly Report for the quarter ended March 31, 1984, incorporated herein by reference (18) Filed as Exhibit 10-e to AmSouth's Form 10-K Annual Report for the year ended December 31, 1985, incorporated herein by reference (19) Filed as Exhibit 10-b to AmSouth's Form 10-Q Quarterly Report for the quarter ended March 31, 1987, incorporated herein by reference (20) Filed as Exhibit 10(b) to AmSouth's Form 10-Q Quarterly Report for the quarter ended September 30, 1988, incorporated herein by reference (21) Filed as Exhibit 10-i to AmSouth's Form 10-K Annual Report for the year ended December 31, 1988, incorporated herein by reference (22) Filed as Exhibit 10 to AmSouth's Form 10-Q Quarterly Report for the quarter ended March 31, 1993, incorporated herein by reference (23) Filed as Exhibit 10-a to AmSouth's Form 10-Q Quarterly Report for the quarter ended March 31, 1988, incorporated herein by reference (24) Filed as Exhibit 10-k to AmSouth's Form 10-K Annual Report for the year ended December 31, 1992, incorporated herein by reference (25) Filed as Exhibit 10-a to AmSouth's Form 10-Q Quarterly Report for the quarter ended June 30, 1986, incorporated herein by reference (26) Filed as Exhibit 10(a) to AmSouth's Form 10-Q Quarterly Report for the quarter ended September 30, 1993, incorporated herein by reference

788816_1993.txt

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1993

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Item 1. BUSINESS OGLETHORPE POWER CORPORATION GENERAL Oglethorpe Power Corporation (An Electric Membership Generation & Transmission Corporation) ("Oglethorpe") is an electric generation and transmission cooperative ("G&T") incorporated in 1974 in the State of Georgia. It is headquartered in metropolitan Atlanta. Oglethorpe is entirely owned by its 39 retail electric distribution cooperative members (the "Members"), who, in turn, are entirely owned by their retail consumers. Oglethorpe is the largest G&T in the United States in terms of operating revenues, assets, kilowatt-hour ("kWh") sales and, through the Members, consumers served. It is one of the ten largest electric utilities in the United States in terms of land area served. As of February 28, 1994, Oglethorpe had 505 full-time and 43 part-time employees. As with cooperatives generally, Oglethorpe operates on a not-for-profit basis. Oglethorpe's principal business is providing wholesale electric service to the Members. The Members are local consumer-owned distribution cooperatives providing retail electric service on a not-for-profit basis. In general, the membership of the distribution cooperative Members consists of residential, commercial and industrial consumers within specific geographic areas. As of December 31, 1993, the Members served approximately 1 million electric consumers (meters) representing a total population of approximately 2.3 million people. Each Member purchases capacity and energy from Oglethorpe pursuant to a long-term, "all-requirements" wholesale power contract between Oglethorpe and the Member (each a "Wholesale Power Contract" and collectively the "Wholesale Power Contracts"). Oglethorpe supplies the capacity and energy requirements of the Members from a combination of owned and leased generating plants and from power purchased under long-term contracts with other power suppliers, principally Georgia Power Company ("GPC"), a wholly owned subsidiary of The Southern Company. MEMBER CONTRACTS Each Wholesale Power Contract will remain in effect through the year 2025 and thereafter until terminated by three years' written notice by Oglethorpe or the respective Member. Each Wholesale Power Contract provides that, except for power purchased from the Southeastern Power Administration ("SEPA"), Oglethorpe shall sell and deliver to the Member, and the Member shall purchase and receive from Oglethorpe, all electric capacity and energy that the Member requires for the operation of its system to the extent that Oglethorpe has capacity and energy and facilities available. In 1993, the aggregate SEPA allocation to the Members was 542 megawatts ("MW") plus associated energy, representing approximately 13% of total Member peak demand and approximately 6% of total Member energy requirements. Because the amount of capacity and energy available from SEPA is not expected to increase in an amount sufficient to serve a material portion of the projected growth in the Members' requirements, such growth is expected to be served primarily through Oglethorpe's resources. (See "Member Demand and Energy Requirements--DISPERSED GENERATION" and "THE MEMBERS OF OGLETHORPE--Contracts with SEPA" herein.) Each Wholesale Power Contract provides that, without the approval of both Oglethorpe and the Rural Electrification Administration ("REA"), no Member may reorganize, consolidate or merge, or sell, lease or transfer all or a substantial part of its assets (or make any agreement therefor), so long as Oglethorpe has notes outstanding to REA and the FFB, without first paying such portion of any such outstanding notes as may be determined by Oglethorpe with the prior written consent of REA and otherwise complying with such reasonable terms as Oglethorpe and REA may require. MEMBER DEMAND AND ENERGY REQUIREMENTS The following table shows the aggregate peak demand and energy requirements of the Members for the years 1991 through 1993 and also shows the amounts of such requirements supplied by Oglethorpe and SEPA. For the years 1991 through 1993, demand and energy requirements increased at an average annual compound growth rate of 8.1% and 7.3%, respectively. Prior to 1993, no Member accounted for 10% or more of Oglethorpe's total revenues. In 1993, however, Cobb EMC accounted for approximately 10% of Oglethorpe's total revenues. SEASONAL VARIATIONS Although the demand for energy by the Members is influenced by seasonal weather conditions, Oglethorpe's rate structure is designed to cause capacity revenues, which include margins, to remain relatively level throughout the year. Energy revenues, which do not include margins, track energy costs as they are incurred. Although energy charges, which are based on variable costs, fluctuate from month to month, capacity charges, which are based on annual peak demands, do not fluctuate based on a Member's usage during a given year. Historically, Oglethorpe's peak demand occurs during the months of June through September. CONSERVATION AND LOAD MANAGEMENT Oglethorpe and the Members have implemented various demand management programs. The program goal, developed in conjunction with Oglethorpe's integrated resource planning process, is to modify demand patterns so that current resources are used efficiently and the need for additional generating resources is delayed. The programs that have been implemented include an energy efficient home program (the "Good Cents Home" program), remote-controlled switching of air conditioners, water heaters and irrigation pumps, residential energy audits and public appeals to encourage consumers to use less energy during periods of peak demand. The demand management programs have reduced, and are expected to continue to reduce, the growth of peak demand and have resulted in an increase in off-peak sales. (See "THE POWER SUPPLY SYSTEM--Future Power Resources--OTHER FUTURE RESOURCES".) DISPERSED GENERATION Oglethorpe and the Members have been discussing the desire of a number of the Members to make greater use of dispersed generation units. If permitted by REA, such units would be used to maintain reliability of electric service during emergencies on a Member's distribution system, to serve specific customer needs and otherwise to be available to Oglethorpe to serve the demands of Members on its system. The installation and use of dispersed generation units by any Member would be governed by policies and procedures, consistent with the Wholesale Power Contract, designed to ensure system reliability and prevent any material adverse effect on Oglethorpe's revenues or on any other Member's power costs. ELECTRIC RATES Each Member is required to pay Oglethorpe for capacity and energy furnished under its Wholesale Power Contract in accordance with rates established by Oglethorpe. Oglethorpe reviews its rates at such intervals as it deems appropriate but is required to do so at least once every year. Oglethorpe is required to revise its rates as necessary so that the revenues derived from such rates will be sufficient, but only sufficient, with its revenues from all other sources to pay operating and maintenance costs, the cost of purchased power, the cost of transmission services, and principal and interest on all indebtedness (including capital lease obligations) of Oglethorpe and to provide for the establishment and maintenance of reasonable reserves. Rates are also required to be established so as to enable Oglethorpe to comply with all requirements (including coverage ratios) under the Consolidated Mortgage and Security Agreement dated as of September 1, 1993 (the "REA Mortgage") among Oglethorpe, as mortgagor, and the United States of America acting through the Administrator of REA, the National Bank for Cooperatives ("CoBank"), Credit Suisse, acting by and through its New York Branch ("Credit Suisse"), and Trust Company Bank ("Trust Company"), as trustee under certain pollution control bond indentures identified in the REA Mortgage. (See "General--RATES AND FINANCIAL COVERAGE REQUIREMENTS" in Item 7.) Oglethorpe's current monthly rate for electric service for capacity and energy delivered to each Member includes energy charges that recover fuel and variable operation and maintenance costs, adjusted semiannually to assure full recovery of such costs, and capacity charges. The rate also includes a provision to reflect the amortization of the deferred margins accumulated from 1985 through 1993, which amounts will be fully amortized by the end of 1995. (See Note 1 of Notes to Financial Statements in Item 8.) Oglethorpe's rate policy provides for a number of separate rates for certain qualified consumer loads, which are designed to have a favorable impact on the Members' competitiveness for certain new industrial and commercial loads. (See "THE MEMBERS OF OGLETHORPE--Service Area and Competition".) Oglethorpe's rates, as established by its Board of Directors, are subject to review and approval by REA. Oglethorpe is required under the REA Mortgage to implement rates designed to maintain a Times Interest Earned Ratio ("TIER") of not less than 1.05, Debt Service Coverage Ratio ("DSC") of not less than 1.0 and an Annual Debt Service Coverage Ratio ("ADSCR") of not less than 1.25. Oglethorpe has always met or exceeded the TIER, DSC and ADSCR requirements of the REA Mortgage. (See "General--RATES AND FINANCIAL COVERAGE REQUIREMENTS" in Item 7.) The Wholesale Power Contracts provide that no rate revision shall be effective unless approved by REA, but such rate revisions are not subject to the approval of any other Federal or state agency or authority, including the Georgia Public Service Commission (the "GPSC"). To date, REA has not reduced or delayed the effectiveness of any rate increase proposed by Oglethorpe. For information regarding future rates, see "Results of Operations-- OPERATING REVENUES--SALES TO MEMBERS" in Item 7. CERTAIN FACTORS AFFECTING THE UTILITY INDUSTRY IN GENERAL The electric utility industry is becoming increasingly competitive as a result of deregulation, competing energy suppliers, technologies, and other factors. The Energy Policy Act of 1992 (the "Energy Policy Act") amended the Federal Power Act and the Public Utility Holding Company Act to allow for increased competition among wholesale electricity suppliers and increased access to transmission services by such suppliers. A number of other significant factors have affected the operations of electric utilities. They include the availability and cost of fuel for the generation of electric energy, fluctuating rates of load growth, compliance with environmental and other governmental regulations, licensing and other delays affecting the construction, operation and cost of new and existing facilities, and the effects of conservation, energy management and other governmental regulations on the use of electric energy. All of these factors present an increasing challenge to companies in the electric utility industry, including Oglethorpe and the Members, to reduce costs and improve the management of resources. (See "THE POWER SUPPLY SYSTEM--General", "--Future Power Resources" and "--Environmental and Other Regulations".) RELATIONSHIP WITH GPC Oglethorpe's relationship with GPC is a significant factor in several aspects of Oglethorpe's business. GPC is Oglethorpe's principal supplier of purchased power, and Oglethorpe is one of GPC's largest customers. In 1993, Oglethorpe derived 15% of its total revenues from sales to GPC, making GPC Oglethorpe's largest customer. Substantially all of Oglethorpe's generating facilities were purchased at various stages of construction from GPC and were constructed and are now operated by GPC. Oglethorpe is the construction and operating agent for the Rocky Mountain Project, a pumped storage hydroelectric facility ("Rocky Mountain"), in which it acquired an interest from GPC. Oglethorpe purchases coordination services from GPC to schedule its power resources and its off-system purchases and sales. Oglethorpe, through the Members, is one of GPC's principal competitors in the State of Georgia for electric service to new customers that have a choice of supplier under the Georgia Territorial Electric Service Act (the "Territorial Act"). Likewise, GPC is the principal competitor of the Members for such customers. Oglethorpe and GPC also own transmission facilities that are part of the Integrated Transmission System (the "ITS"). GPC provides system operator services and performs most of the required maintenance of Oglethorpe's transmission facilities. GPC and Oglethorpe are parties to an agreement that makes allowance for the joint planning of future generation and transmission facilities. For further information regarding the various relationships and agreements with GPC, see "THE MEMBERS OF OGLETHORPE--Service Area and Competition", "THE POWER SUPPLY SYSTEM--General", "--Fuel Supply", "--Power Sales to and Purchases from GPC", "--Future Power Resources--ROCKY MOUNTAIN", "-Transmission and Other Power System Arrangements", "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--Co-Owners of the Plants--GEORGIA POWER COMPANY", "--The Plant Agreements", "--Agreements Relating to the Integrated Transmission System", and "--The Joint Committee Agreement". RELATIONSHIP WITH REA Federal loan programs administered by REA have provided the principal source of financing for electric cooperatives. Direct loans from REA have been a major source of funding for the Members, while loans guaranteed by REA and made by the Federal Financing Bank ("FFB") have been a major source of funding for Oglethorpe. Through provisions of the REA Mortgage, REA exercises substantial control and supervision over Oglethorpe in such areas as accounting, issuing secured indebtedness, rates and charges for the sale of power, construction and acquisition of facilities, and the purchase and sale of power. In recent years, there have been legislative, administrative and budgetary initiatives intended to reduce or, in some cases, eliminate federal funding for electric cooperatives. In addition, the REA loan and guarantee programs have been characterized by the imposition of increasingly problematic terms and conditions and extended delays in access to necessary funding. The President's budget for fiscal year 1995 proposes to set the level of funding for the 100% guarantee program at $275 million, which if sustained at that level in future years would not likely provide adequate funding for the transmission and power supply needs of REA borrowers. Congress historically has increased Administration-proposed lending levels to those necessary to meet borrower demand. Notwithstanding historical practices, however, the future cost, availability and magnitude of REA-guaranteed loans cannot be predicted. See "THE MEMBERS OF OGLETHORPE-Members' Relationship with REA" for a discussion of the impact of the budget proposal on the direct loan program. REA continues to re-evaluate its regulatory and lending relationship with its borrowers through what it has described as a comprehensive rule-making project. The purpose of the project is to improve the credit-worthiness of loans made or guaranteed by REA. In addition to adopting new rules regulating policies and procedures for insured and guaranteed loans and lien accommodations, REA has published a proposed rule describing a new form of wholesale power contract and has, in an advance notice of proposed rule-making, requested suggestions for revisions to its standard form of mortgage. Many of these rule-makings have taken many months or years to complete and the outcome of these various rule-making initiatives, whether others may be forthcoming, whether any of such rule-making initiatives may achieve the objectives stated by REA, or the extent to which such initiatives may affect Oglethorpe or the Members cannot be predicted. The Clinton Administration has proposed that the Department of Agriculture, which includes REA, be reorganized to improve its efficiency. Legislation has been introduced that would authorize the Secretary of Agriculture to implement this reorganization. Under the proposed reorganization, the electric and telephone programs of REA would be included in a new Rural Utilities Service. The rural development functions of REA would be included in a Rural Business and Cooperative Development Service. Both agencies would report to an Under Secretary for Rural Economic and Community Development. Oglethorpe's management does not believe that the reorganization, if implemented as proposed, will have a significant adverse effect on it or the Members. THE MEMBERS OF OGLETHORPE SERVICE AREA AND COMPETITION The Members are identified in Item 10(a) of this Report and include 39 of the 42 electric distribution cooperatives in the State of Georgia. As of December 31, 1993, the Members served approximately 1 million electric consumers (meters) representing a total population of approximately 2.3 million people. The Members serve a region covering approximately 40,000 square miles, which is approximately 70% of the land area of Georgia served by the owners of the ITS, encompassing 150 of the State's 159 counties. Sales by the Members in 1993 amounted to approximately 16.2 million megawatt-hours ("MWh"), with 74% to residential consumers, 24% to commercial and industrial consumers and 2% to other consumers. No single consumer of any Member constituted more than 1% of the Members' aggregate sales in 1993. The Members are the principal suppliers for the power needs of rural Georgia. While the Members do not serve any major cities, portions of their service territories are in close proximity to urban areas and are experiencing growth due to the expansion of urban areas, including metropolitan Atlanta, into suburban areas and the growth of suburban areas into neighboring rural areas. The Members have experienced average annual compound growth rates from 1991 through 1993 of 4.5% in number of consumers, 6.9% in MWh sales and 8.9% in electric revenues. The Territorial Act regulates the service rights of all retail electric suppliers in the State of Georgia. Pursuant to the Territorial Act, the GPSC assigned substantially all areas in the State to specified retail suppliers. The Members have the exclusive right to provide retail electric service in their respective assigned territories, which are predominately outside of municipal limits. The GPSC may not reassign territory or transfer service except in limited circumstances provided by the Territorial Act. The GPSC may transfer service for specific premises only: (i) upon a determination by the GPSC, after joint application of electric suppliers and proper notice and hearing, that the public convenience and necessity require a transfer of service from one electric supplier to another; or (ii) upon a finding by GPSC, after proper notice and hearing, that an electric supplier's service to a premise is not adequate or dependable or that its rates, charges, service rules and regulations unreasonably discriminate in favor of or against the consumer utilizing such premises and the electric utility is unwilling or unable to comply with an order from GPSC regarding such service. The GPSC may reassign territory only if it determines that an assignee electric supplier has breached the tenets of public convenience and necessity. The territorial assignments under the Territorial Act are also subject to an exception that permits the owner of any new facility located outside of existing municipal limits and having a connected demand upon initial full operation of 900 kilowatts or greater to receive electric service from the retail supplier of its choice. The Members, with Oglethorpe's support, are actively engaged in competition with other retail electric suppliers for these new industrial and commercial loads. The number of commercial and industrial loads served by the Members has increased in recent years. COOPERATIVE STRUCTURE The Members operate their systems on a not-for-profit basis. Accumulated margins derived after payment of operating expenses and provision for depreciation constitute patronage capital of the consumers of the Members. Refunds of accumulated patronage capital to the individual consumers may be made from time to time subject to limitations contained in mortgages between the Members and REA. These mortgages generally prohibit such distributions unless, after any such distribution, the Member's total equity will equal at least 40% of its total assets, except that distributions may be made of up to 25% of the margins and patronage capital received by the Member in the preceding year. As a general matter, the Members distribute accumulated patronage capital from time to time subject to their respective financial policies and in conformity with their respective REA mortgages. Oglethorpe is a membership corporation, and the Members are not subsidiaries of Oglethorpe. Except with respect to the obligations of the Members under each Member's Wholesale Power Contract with Oglethorpe and Oglethorpe's rights under such contracts to receive payment for power and energy supplied, Oglethorpe has no legal interest in, or obligations in respect of, any of the assets, liabilities, equity, revenues or margins of the Members. (See "OGLETHORPE POWER CORPORATION--Member Contracts".) The revenues of the Members are not pledged as security to Oglethorpe but are the source from which moneys are derived by the Members to pay for power supplied by Oglethorpe under the Wholesale Power Contracts. Revenues of the Members are, however, pledged under the respective REA mortgages of the Members. RATE REGULATION OF MEMBERS Through provisions in the loan documents securing loans to the Members, REA exercises control and supervision over the Members in such areas as: (i) accounting; (ii) borrowings; (iii) rates and charges for the sale of power; (iv) construction and acquisition of facilities; and (v) the purchase and sale of power. The individual REA mortgages of the Members require them to design rates with a view to maintaining an average TIER of not less than 1.50 and an average DSC of not less than 1.25 for the two highest out of every three successive years. Although the setting of the rates of the Members is not subject to approval of any Federal or state agency or authority other than REA, the Territorial Act prohibits the Members from unreasonable discrimination in the setting of rates, charges, service rules or regulations. CONTRACTS WITH SEPA In addition to energy received from Oglethorpe under the Wholesale Power Contracts, the Members purchase hydroelectric power under contracts with SEPA. In 1993, the aggregate SEPA allocation to the Members was 542 MW plus associated energy, representing approximately 13% of total Member peak demand and approximately 6% of total Member energy requirements. (See "OGLETHORPE POWER CORPORATION-Member Contracts" and "-Member Demand and Energy Requirements" and the table thereunder.) In September 1993, SEPA issued a Notice of Intent to revise its marketing policy for the Georgia-Alabama-South Carolina system of projects, from which the Members purchase SEPA power. This policy will govern the renewal of SEPA's contracts with the Members, which are subject to renewal on May 31, 1994. Although Oglethorpe does not anticipate that such revised policy will result in a significant change, the final marketing policy and its effect on the Members' allocations of capacity and energy cannot be predicted with certainty. MEMBERS' RELATIONSHIP WITH REA Federal loan programs providing direct loans from REA to electric cooperatives have been a major source of funding for the Members. On November 1, 1993, the President signed into law the Rural Electrification Loan Restructuring Act of 1993, which contains significant revisions to the REA loan program utilized by the Members. The Members previously relied on the 5% insured loan program, under which the REA Administrator could require that up to 30% of a borrower's capital needs be obtained from private sources. The 1993 Act provides for loans to be made at an interest rate equal to that being paid on municipal bonds with comparable maturities. Certain borrowers with either (i) low consumer density or (ii) higher than average rates and consumers having lower than average incomes will have borrowing rates capped at 7%. The 1993 Act continues to make 5% loans available for hardship cases. Loans will also be available to fund demand-side management and conservation programs. Although the 1993 Act will reduce the Government's cost associated with the REA loan program, there is no guarantee that further changes in the cost and availability of the REA lending program will not be made, since the level of funding will remain subject to the Congressional budget and appropriation processes. The President's budget proposal for the fiscal year 1995 includes a proposal to replace most of the "municipal bond rate" program with higher-cost loans made at the cost to the United States Department of the Treasury. The outcome of this budget proposal and the future cost, availability and amount of REA direct and guaranteed loans cannot be predicted. For further information regarding the REA program, see "OGLETHORPE POWER CORPORATION-Relationship with REA". THIRD-PARTY INTEREST IN MEMBER SYSTEMS From time to time, utilities may be approached by other utilities or other parties interested in purchasing their systems. Some of Oglethorpe's Members have been approached in the past by third parties indicating an interest in purchasing their systems. The Wholesale Power Contract between Oglethorpe and each Member provides that no Member may reorganize, consolidate or merge, or sell, lease or transfer all or a substantial portion of its assets (or make any agreement therefor), so long as Oglethorpe has notes outstanding to REA and the FFB, without first paying such portion of any such outstanding notes as may be determined by Oglethorpe with the prior written consent of REA and otherwise complying with such reasonable terms and conditions as Oglethorpe and REA may require. The enforceability of the REA form of wholesale power contract has been consistently upheld by the courts in several jurisdictions. In addition, REA has recently stated its policy that it will not encourage or facilitate the buyout of borrowers by third parties and that it will expect cooperative distribution utilities to retire a proportionate share of the associated G&T indebtedness and to pay other appropriate costs and expenses of the G&T as a condition of a buyout. Oglethorpe's management is unable to predict what transactions, if any, might result from the past third-party interest or whether any other proposals will be made to the Members. Oglethorpe has received an opinion of its counsel that each of the Wholesale Power Contracts is a valid, binding and enforceable obligation of each respective Member. Based on this opinion and other factors, Oglethorpe's management believes that no sale or transfer of Member assets would have a material adverse effect upon its financial condition or results of operations. THE POWER SUPPLY SYSTEM GENERAL Oglethorpe supplies the capacity and energy requirements of the Members from a combination of owned and leased generating plants and power purchased under long-term contracts with other power suppliers. These resources are scheduled and dispatched so as to minimize the operating cost of Oglethorpe's system. In addition, Oglethorpe purchases and sells capacity and energy in the bulk power market to make the best use of its resources and thus minimize the cost of capacity and energy delivered to the Members. The following table sets forth certain information with respect to the generating facilities in which Oglethorpe currently has ownership or leasehold interests, all of which are in commercial operation except for Rocky Mountain, which is under construction. The Edwin I. Hatch Plant ("Plant Hatch"), the Hal B. Wansley Plant ("Plant Wansley"), the Alvin W. Vogtle Plant ("Plant Vogtle") and the Robert W. Scherer Units No. 1 and No. 2 ("Scherer Units No. 1 and No. 2") are co-owned by Oglethorpe, GPC, the Municipal Electric Authority of Georgia ("MEAG") and the City of Dalton ("Dalton"). GPC is the operating agent for each of these plants, except Rocky Mountain. Rocky Mountain is co-owned by Oglethorpe and GPC, and Oglethorpe is the construction and operating agent. Oglethorpe is the sole owner of the Tallassee Project at the Walter W. Harrison Dam ("Tallassee"). (See "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--The Plant Agreements".) Upon completion of Rocky Mountain, Oglethorpe will own or lease 1,500.6 MW of coal-fired capacity, 1,185 MW of nuclear-fueled capacity, an estimated 635.9 MW of pumped storage hydroelectric capacity, 14.8 MW of oil-fired combustion turbine capacity and 2.1 MW of hydroelectric capacity. Oglethorpe and the other co-owners of the above plants also own transmission facilities which together form the ITS. Through agreements, common access to the combined facilities that compose the ITS enables the owners to use their combined resources to make deliveries to their respective consumers, to provide transmission service to third parties and to make off-system purchases and sales. (See "Transmission and Other Power System Arrangements" herein and "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--Agreements Relating to Integrated Transmission System".) PLANT PERFORMANCE The following table sets forth certain operating performance information of each of the major generating facilities in which Oglethorpe currently has ownership or leasehold interests, except for Rocky Mountain which is not yet in commercial operation: The nuclear refueling cycle for Plants Hatch and Vogtle exceeds twelve months. Therefore, in some calendar years the units at these plants are not taken out of service for refueling, resulting in higher levels of equivalent availability and capacity factor. Although Plant Scherer is designed for base load operation, it has primarily operated in peaking service due to the historically higher cost of its fuel supply (low-sulfur coal under long-term contracts) relative to the cost of Oglethorpe's other resources. Thus, the capacity factors for Scherer Units No. 1 and No. 2 have been lower than those typical of base loaded units. With the planned acquisition of lower cost low-sulfur coal and expected increases in Member sales, Oglethorpe's management anticipates higher utilization of Scherer Units No. 1 and No. 2 in the future. FUEL SUPPLY Coal for Plant Wansley is purchased under long-term contracts, which are estimated to be sufficient to provide the majority of the coal requirements of Plant Wansley through 1997, with the remainder being provided through spot market transactions. To comply with the requirements of the Clean Air Act, as amended (the "Clean Air Act"), Plant Wansley is being modified to burn low-sulfur coal. As of February 28, 1994, there was a 20-day coal supply at Plant Wansley based on nameplate rating. Low-sulfur "compliance" coal for Scherer Units No. 1 and No. 2 is purchased under long-term contracts and spot market transactions. As of February 28, 1994, the coal stockpile at Plant Scherer contained a 29-day supply based on nameplate rating. Further, Plant Scherer is being converted to burn both sub-bituminous and bituminous coals, and a separate stockpile of sub-bituminous coal is being built in addition to the stockpile of bituminous coal. The coal supply at Plants Scherer and Wansley is lower than normal due to (i) higher than expected use of Plant Scherer during the summer of 1993 and the winter of 1994 because of abnormal temperatures, (ii) transportation interruptions resulting from severe weather conditions, and (iii) deferred deliveries because of higher replacement prices due to the United Mine Workers of America strike. The supply is planned to be replenished as needed and as competitively priced coal becomes available. The Scherer ownership and operating agreements were amended effective October 1993 to allow each co-owner (i) to dispatch separately its respective ownership interest in conjunction with contracting separately for long-term coal purchases procured by GPC and (ii) to procure separately long-term coal purchases. Oglethorpe elected to dispatch separately in November 1993. Pursuant to the amendments, GPC is expected to implement separate dispatch by May 1, 1994. Oglethorpe intends to continue to use GPC as its agent for fuel procurement. In anticipation of these changes, Oglethorpe formed a wholly owned subsidiary to acquire rail cars designed for hauling coal from the western coal mining regions. The subsidiary, Black Diamond Energy, Inc., has acquired 115 cars, and Oglethorpe anticipates the acquisition of approximately 350 additional cars during the next three years for both Plants Scherer and Wansley. Oglethorpe has entered into an initial 15-year lease with the subsidiary which obligates Oglethorpe to pay all of the ownership and operating expenses of the subsidiary relating to the leased rail cars during the lease term. The co-owners are currently negotiating a similar amendment to the Plant Wansley operating agreement. For information relating to the impact that the Clean Air Act will have on Oglethorpe, see "Environmental and Other Regulations" herein. GPC, as operating agent, has the responsibility to procure nuclear fuel for Plant Hatch and Plant Vogtle. GPC has contracted with Southern Nuclear Operating Company ("SONOPCO") to provide nuclear services, including nuclear fuel procurement. SONOPCO employs both spot purchases and long-term contracts to satisfy nuclear fuel requirements. The nuclear fuel supply and related services are expected to be adequate to satisfy current and future nuclear generation requirements. Plants Hatch and Vogtle currently have on-site spent fuel storage capacity. Based on normal operations and retention of all spent fuel in the reactor, it is anticipated that existing on-site pool capacity would not be sufficient in 2003 and 2009, respectively, to accept the number of spent fuel assemblies that would normally be removed from the reactor during a refueling. Contracts with the Department of Energy ("DOE") have been executed to provide for the permanent disposal of spent nuclear fuel produced at Plant Hatch and Plant Vogtle. The services to be provided by DOE are scheduled to begin in 1998. However, the actual year that these services will begin is uncertain. If DOE does not begin receiving the spent fuel from Plant Hatch in 2003 or from Plant Vogtle in 2009, alternative methods of spent fuel storage will be needed. One option available is expansion of spent fuel storage at the plant sites. (See "Environmental and Other Regulations" herein for a discussion of the Nuclear Waste Policy Act and Note 1 of Notes to Financial Statements in Item 8 regarding nuclear fuel cost.) PROPOSED CHANGES TO NUCLEAR PLANT OPERATING ARRANGEMENTS In September 1992, GPC filed applications with the Nuclear Regulatory Commission (the "NRC") to add SONOPCO to the operating license of each unit of Plants Hatch and Vogtle and designate SONOPCO as the operator. The application is currently pending before the Atomic Safety and Licensing Board. SONOPCO, a subsidiary of The Southern Company specializing in nuclear services, currently provides certain operating, maintenance, and other services to GPC in accordance with the Amended and Restated Nuclear Managing Board Agreement (the "Amended and Restated NMBA") and the agreements referenced in the Amended and Restated NMBA. The co-owners have agreed to a Nuclear Operating Agreement between GPC and SONOPCO, which will be entered into in the event the NRC approves the application. (See "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--The Plant Agreements--HATCH, WANSLEY, VOGTLE AND SCHERER".) POWER SALES TO AND PURCHASES FROM GPC A significant portion of Oglethorpe's sales are made to GPC and a significant portion of Oglethorpe's purchased power is obtained from GPC. The following table sets forth a summary of Oglethorpe's electric purchases from and sales to GPC and all other utilities as a group: The sales to GPC are made under the GPC Sell-back (as herein defined) and the Coordination Services Agreement (the "CSA"). The purchases from GPC are made under the Block Power Sale Agreement (the "BPSA") and the CSA. GPC SELL-BACK Pursuant to the contractual arrangements with GPC, Oglethorpe has an obligation to sell to GPC, and GPC has an obligation to buy from Oglethorpe, commencing with the commercial operation of each co-owned unit (other than Rocky Mountain) and extending for various periods, a declining percentage of Oglethorpe's entitlement to the capacity and energy of such unit (the "GPC Sell-back"). The GPC Sell-back has expired in accordance with its terms for Plants Wansley, Hatch and Scherer Units No. 1 and No. 2 and continues to decline for Plant Vogtle. The GPC Sell-back will expire for Unit No. 1 of Plant Vogtle at the end of May 1994 and for Unit No. 2 of Plant Vogtle at the end of May 1995. For 1993, the GPC Sell-back represented 6% of total energy sales by Oglethorpe. Capacity and energy revenues from the GPC Sell-back represented 10% of Oglethorpe's total revenues in 1993. As GPC's entitlement to capacity and energy under the GPC Sell-back has decreased and continues to decrease, Oglethorpe's increased entitlement to the output of each unit has been and will continue to be used to serve its own requirements. The increased costs thereof will be recovered through Member rates and through off-system sales transactions. The historical ability of Oglethorpe to sell power from new units to GPC under the GPC Sell-back while at the same time purchasing power from GPC under lower-cost arrangements has enabled Oglethorpe to moderate the effects of the higher costs associated with new generating units on Oglethorpe's costs of service, and therefore on the rates charged the Members. (See "Other Power Purchases" herein, and "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--The Plant Agreements-- HATCH, WANSLEY, VOGTLE AND SCHERER" and Note 1 of Notes to Financial Statements in Item 8.) The following table sets forth the contractual schedule for the fractional portion of capacity and energy retained by GPC for the units for which GPC is currently making GPC Sell-back payments: POWER PURCHASE ARRANGEMENTS Oglethorpe purchases 1,250 MW of capacity and associated energy from GPC on a take-or-pay basis under the BPSA. The contract expires December 31, 2001. The BPSA, along with the Revised and Restated Integrated Transmission System Agreements (the "ITSA") and the CSA, were entered into in 1990 and made effective in 1991 as part of a comprehensive restructuring of the way Oglethorpe plans for and meets the Members' power requirements. These agreements have improved Oglethorpe's ability to buy and sell power and transmission services in the bulk power markets. The capacity purchases under the BPSA are from six Component Blocks (as defined in the BPSA), composed of four Component Blocks of 250 MW each (coal-fired units) and two Component Blocks of 125 MW each (combustion turbine units). Although Oglethorpe may not increase its purchases under the BPSA, it may reduce its purchases by eliminating one or more Component Blocks upon written notice to GPC. Oglethorpe may reduce up to 250 MW with two years' notice, above 250 to 500 MW with four years' notice, and more than 500 MW with seven years' notice. Oglethorpe is entitled to extend the purchase of one or more Component Blocks one additional year at a time under the same notice conditions. The capacity in one or more Component Blocks may, however, be less than 250 MW, as the result of scheduled retirement of units or retirements due to force majeure events. All units in the combustion turbine Component Blocks are scheduled to be retired by 2003. Under the CSA, Oglethorpe schedules and directs GPC to dispatch and coordinate power from all of Oglethorpe's generation and purchased power resources through December 31, 1999. The CSA requires Oglethorpe to give GPC one hour's notice in order to schedule any off-system transactions, which will limit Oglethorpe's ability to compete with GPC for short-term energy transactions requiring less than one hour's notice. Oglethorpe may elect to establish its own control area and terminate regulation services under the CSA upon one year's notice to GPC. Upon such termination, the parties will, if necessary, negotiate new service schedules and applicable rates. In order to optimize its use of coordination services, Oglethorpe is currently installing the equipment that would be necessary to operate its own control area. For a further discussion of the new power supply arrangements, see "Other Power Purchases", "Future Power Resources", and "Transmission and Other Power System Arrangements" herein, and "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--The Plant Agreements--HATCH, WANSLEY, VOGTLE AND SCHERER". OTHER POWER PURCHASES Oglethorpe has entered into power purchase contracts with Entergy Power, Inc. ("EPI") and Big Rivers Electric Corporation ("Big Rivers"), each for the purchase of 100 MW, extending through June and July 2002, respectively. The EPI contract is subject to the approval of REA. The availability of capacity under the EPI contract is dependent on the availability of two specific generating units available to EPI. The Tennessee Valley Authority ("TVA") provides the transmission service to deliver the power from the Big Rivers electric system to the ITS. TVA and Southern Company Services, as agent for Alabama Power Company and Mississippi Power Company, provide the transmission service necessary to deliver the power from EPI to the ITS. (See "Transmission and Other Power System Arrangements" herein and Note 10 of the Financial Statements in Item 8.) In addition to the purchases from GPC, Big Rivers and EPI, Oglethorpe also purchases small amounts of capacity and energy from "qualifying facilities" under the Public Utility Regulatory Policies Act of 1978 ("PURPA"). Under a waiver order from the Federal Energy Regulatory Commission ("FERC"), Oglethorpe will make all purchases the Members would have otherwise been required to make under PURPA and Oglethorpe was relieved of its obligation to sell certain services to "qualifying facilities" so long as the Members make those sales. Oglethorpe provides the Members with the necessary services to fulfill these sale obligations. Purchases by Oglethorpe from such qualifying facilities provided 0.4% of Oglethorpe's energy requirements for the Members in 1993. FUTURE POWER RESOURCES Oglethorpe uses an integrated resources planning process to study regularly the need for and feasibility of adding additional generation facilities. This planning process also considers demand-side management options that could be implemented by the Members as well as off-system sales of capacity and energy to optimize the use of Oglethorpe's resources. Oglethorpe's current resources (both owned or leased generation and purchased power) consist predominately of resources that can be best used in base-load operation. As a result, all of Oglethorpe's currently planned resource additions are for peaking capacity. To further optimize the use of its resources, Oglethorpe is seeking to sell certain amounts of base capacity and associated energy and to replace it with the acquisition of peaking capacity when necessary (see "Future Long-Term Power Sales" herein). ROCKY MOUNTAIN Rocky Mountain, which is currently under construction by Oglethorpe, is a pumped storage hydroelectric facility with no conventional hydroelectric capability. The facility is designed to consist of three units with a combined nameplate rating of 847.8 MW at maximum head and a FERC-licensed capacity of 760 MW at minimum head. Under optimal operations, the maximum output of the plant will decline steadily over a period of approximately eight hours as the upper reservoir is emptied. In 1988, Oglethorpe acquired from GPC an undivided ownership interest in Rocky Mountain. Under the Rocky Mountain ownership arrangement, Oglethorpe, as agent, is responsible for the design, construction and operation of Rocky Mountain. The license issued by FERC for Rocky Mountain expires in 2027. Among other conditions, the license requires that construction be completed by June 1, 1996. As of February 28, 1994, Rocky Mountain was approximately 92% complete. Rocky Mountain is currently scheduled to begin commercial operation in early 1995. Construction at Rocky Mountain is currently on schedule and under budget. Under the Ownership Participation Agreement (as hereinafter defined), GPC has not been required to expend any funds for construction of Rocky Mountain since December 15, 1988, and is not required to make any additional contributions. Oglethorpe is required to finance and complete Rocky Mountain. (See "Liquidity and Capital Resources" in Item 7.) Each party's undivided interest in Rocky Mountain is equal to the proportion that its respective investment bears to the total investment in Rocky Mountain (excluding each party's cost of funds and ad valorem taxes). (See "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--The Plant Agreements--ROCKY MOUNTAIN".) As of December 31, 1993, Oglethorpe's ownership interest in Rocky Mountain was approximately 70%. Based on current arrangements, Oglethorpe's ultimate ownership interest in Rocky Mountain is estimated to be approximately 75%, with GPC owning the remaining 25%. Oglethorpe, GPC and certain third parties have had preliminary discussions regarding alternatives by which Oglethorpe may acquire the output of GPC's remaining interest in Rocky Mountain. Options being discussed include a long-term lease or power purchase arrangement with a third party which would purchase GPC's interest or a purchase of such interest directly by Oglethorpe. The nameplate rating of GPC's ultimate ownership interest is estimated to be approximately 212 MW, and if any such transaction is consummated, such output would satisfy a portion of Oglethorpe's long-term capacity needs. The outcome of these discussions cannot be determined at this time. HARTWELL PURCHASE In 1992, Oglethorpe entered into a contract for the purchase of approximately 300 MW of capacity with Hartwell Energy Limited Partnership ("Hartwell"), a partnership owned 50% by Destec Energy, Inc. and 50% by American National Power, Inc., a subsidiary of National Power, PLC. The contract has a term of 25 years, commencing upon commercial operation, which by contract is scheduled to be no later than June 1994. Under the contract, Hartwell is constructing two 150 MW gas-fired turbine generating units on a site near Hartwell, Georgia. Oglethorpe intends to use the units for peaking capacity but has the right to dispatch the units fully. If Hartwell misses any of a specified list of project milestones, Oglethorpe may terminate the contract and, if it so chooses, purchase the project at fair market value. Hartwell has provided an irrevocable letter of credit payable to Oglethorpe in the amount of $10,360,000, which can be drawn upon if the project is not in service by the scheduled date or as liquidated damages in case of a default by Hartwell. Hartwell has advised Oglethorpe that it expects to begin deliveries of power to Oglethorpe prior to June 1994. OTHER FUTURE RESOURCES In its current integrated resource plan, Oglethorpe has identified a potential need for additional peaking capacity in the late 1990s. In November 1993, Oglethorpe issued a Request for Proposals for the purchase of up to 600 MW of long-term peaking capacity to be available by June 1, 1999. Proposals were due March 29, 1994. Oglethorpe has reserved the right to reject any and all bids, and should it do so, Oglethorpe may construct that capacity itself. Oglethorpe has also agreed to purchase from Florida Power Corporation 50 MW of peaking capacity during the summer of 1997 and 275 MW of peaking capacity during the summer of 1998. This purchase is subject to regulatory approval. TRANSMISSION AND OTHER POWER SYSTEM ARRANGEMENTS As of February 28, 1994, Oglethorpe owned approximately 2,186 miles of transmission line and 404 substations of various voltages. Oglethorpe provides power and energy to the Members through the ITS consisting of transmission system facilities owned by Oglethorpe, GPC, MEAG and Dalton. As a result of its participation in the ITS, Oglethorpe is entitled to use any of the transmission facilities included in the system, regardless of ownership. Oglethorpe's rights and obligations with respect to the system are governed by the ITSA. (See "Power Sales to and Purchases from GPC--POWER PURCHASE ARRANGEMENTS" herein and "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS--Agreements Relating to Integrated Transmission System".) In addition to the interconnections available to Oglethorpe through the ITS, Oglethorpe has interconnection, interchange, transmission and/or short-term capacity and energy purchase or sale agreements with Alabama Electric Cooperative, Cajun Electric Power Cooperative, Big Rivers, Seminole Electric Cooperative, Entergy Services (as agent for the Entergy operating companies), TVA, Florida Power Corporation, Jacksonville Electric Authority, Tampa Electric Company, Louisville Gas & Electric Company, Florida Power & Light Company, SEPA, South Carolina Electric & Gas (subject to approval by FERC), South Carolina Public Service Authority, Arkansas Electric Cooperative Corporation and East Kentucky Power Cooperative. The agreements provide variously for the purchase and/or sale of capacity and energy and/or for transmission service. Implementation of such contracts and other off-system transactions are accomplished by the CSA (see "Power Sales to and Purchases from GPC--POWER PURCHASE ARRANGEMENTS" herein). In addition, Oglethorpe has sold to GPC a portion of its entitlement to the interface capability between the ITS and the Florida electric system through May 1994. Oglethorpe has purchased from GPC sufficient entitlement to the interface between the Integrated Transmission System and TVA to implement the purchases from Big Rivers and EPI. Oglethorpe regularly buys and sells power in the short-term bulk power market. FUTURE LONG-TERM POWER SALES Oglethorpe has signed a Letter of Intent with Alabama Electric Cooperative for the sale of 100 MW of base capacity beginning June 1, 1998, and extending through December 31, 2005. This arrangement is subject to the approval of a definitive agreement by the Boards of Directors of each party. The agreement would also be subject to approval by REA. No assurances can be given that such definitive agreement will be consummated. Oglethorpe has also submitted bids to various formal and informal solicitations for capacity sales. Whether any such bid will be successful is uncertain. ENVIRONMENTAL AND OTHER REGULATIONS GENERAL As is typical in the utility industry, Oglethorpe is subject to Federal, State and local air and water quality requirements which, among other things, regulate emissions of particulates, sulfur dioxide and nitrogen oxide into the air and discharges of pollutants, including heat, into waters of the United States. Oglethorpe is also subject to Federal, State and local waste disposal requirements which regulate the manner of transportation, storage and disposal of solid and other waste. In general, environmental requirements are becoming increasingly stringent, and further or new requirements may substantially increase the cost of electric service by requiring changes in the design or operation of existing facilities as well as changes or delays in the location, design, construction or operation of new facilities. Failure to comply with such requirements could result in the imposition of civil and criminal penalties as well as the complete shutdown of individual generating units not in compliance. There is no assurance that the units in operation or under construction will always remain subject to the regulations currently in effect or will always be in compliance with future regulations. Compliance with environmental standards or deadlines will continue to be reflected in Oglethorpe's capital and operating costs. Oglethorpe's direct capital costs to achieve compliance with air and water quality control facilities were approximately $6.5 million in 1993 and are expected to be approximately $3.1 million in 1994, $4.1 million in 1995 and $8.6 million in 1996. CLEAN AIR ACT The Clean Air Act seeks to improve the ambient air quality throughout the United States by the year 2000 and beyond. The acid rain provisions of Title IV require the reduction of sulfur dioxide and nitrogen oxide emissions from affected units, including coal-fired electric power facilities. The sulfur dioxide reductions required by Title IV will be achieved in two phases. Phase I addresses specific generating units named in the Clean Air Act. Both units of Plant Wansley are "affected units" under Phase I. Scherer Units No. 1 and No. 2 are not "affected units" under Phase I but are affected units under Phase II. In Phase II, the total U.S. emissions of sulfur dioxide will be capped at 8.9 million tons by the year 2000, using a "tradeable allowance" plan. Final Phase II sulfur dioxide allocations have been published by Environmental Protection Agency ("EPA") regulations. Compliance with the Clean Air Act will require expenditures for monitoring, annual permit fees, and in some instances may involve increased operating or maintenance expenses or capital expenditures for pollution control and continuous monitoring equipment. Capital improvements, of which Oglethorpe's share is approximately $6.4 million, are in progress at Plant Wansley. Scheduled to be completed in 1994, these improvements are designed to bring the plant into compliance with anticipated requirements for both Phase I and Phase II. Approximately $500,000 in capital improvements, to be completed in 1994, will be made at Plant Scherer. The estimated cost of additional improvements at Plant Wansley and Plant Scherer are dependent upon the chosen compliance plan and may be affected by future plan amendments and future regulation. In addition, the final capital cost of improvements and any effect on operating costs will be determined by the compliance plan as finally implemented and any applicable regulatory changes. Title I of the Clean Air Act requires the State of Georgia to conduct specific studies and establish new rules regulating sources of nitrogen oxide and volatile organic compounds. The new rules must be promulgated by November 1994, with attainment demonstrated by November 1999. Metropolitan Atlanta is classified as a "serious non-attainment area" with regard to the ozone ambient air quality standards. Plant Wansley is near although not in this non-attainment area. The results of these studies and new rules could require nitrogen oxide controls more stringent than those required for Title IV compliance. The Clean Air Act also requires that several studies be conducted regarding the health effects of power plant emissions of certain hazardous air pollutants. The studies will be used in making decisions on whether additional controls of these pollutants are necessary. The effect of any of these potential regulatory changes under Title I, including new rules under the amended provisions, cannot now be predicted. The Clean Air Act requires the EPA to review all National Ambient Air Quality Standards ("NAAQS") periodically, revising such standards as necessary. EPA continues to evaluate the need for a new short-term standard for sulfur oxides (measured as sulfur dioxide). Preliminary results from an EPA study indicate that a new short-term NAAQS for sulfur dioxide might require numerous power plants to install emission controls, perhaps in addition to any required under Title IV of the Clean Air Act. These controls could result in substantial costs to Oglethorpe. EPA is also evaluating the need to revise the NAAQS for nitrogen dioxide and will be updating the criteria document used in its recent decision not to revise the NAAQS for ozone. EPA is not currently formally revising the particulate matter NAAQS but is gathering information which may be used in a revision. The impact of any change in the ozone, sulfur dioxide, nitrogen dioxide or particulate matter NAAQS cannot now be determined because the effect of any change would depend in part on the final ambient standards. Although Oglethorpe's management is currently unable to determine the overall effect that compliance with requirements under the Clean Air Act will have on its operations, it does not believe that any required increases in capital or operating expenses would have a material effect on its results of operations or financial condition. Compliance with requirements under the Clean Air Act may also require increased capital or operating expenses on the part of GPC. Any increases in GPC's capital or operating expenses may cause an increase in the cost of power purchased from GPC. (See "Power Sales to and Purchases from GPC--POWER PURCHASE ARRANGEMENTS" herein.) CLEAN WATER ACT Oglethorpe is subject to provisions of the Clean Water Act, as amended. As a result of the 1987 Amendments to the Clean Water Act, the State of Georgia has amended its State Water Quality Standards to make them more stringent. These amendments will cause an increase in Oglethorpe's cost to comply. These costs include capital expenditures for improvements at Plant Scherer to comply with Georgia's new clean water regulations covering waste water discharge. Oglethorpe's share of these improvements, completed in early 1994, was approximately $2 million. Congress is considering reauthorizing the Clean Water Act. If that occurs, Oglethorpe's operations could be affected. However, the full impact of any reauthorization cannot now be determined and will depend on the specific changes to the statute, as well as to any implementing state or federal regulations that might be promulgated. NUCLEAR REGULATION Oglethorpe is subject to the provisions of the Atomic Energy Act of 1954, as amended (the "Atomic Energy Act"), which vests jurisdiction in the NRC over the construction and operation of nuclear reactors, particularly with regard to certain public health, safety and antitrust matters. The National Environmental Policy Act has been construed to expand the jurisdiction of the NRC to consider the environmental impact of a facility licensed under the Atomic Energy Act. Plants Hatch and Vogtle are being operated under licenses issued by the NRC. All aspects of the operation and maintenance of nuclear power plants are regulated by the NRC. From time to time, new NRC regulations require changes in the design, operation and maintenance of existing nuclear reactors. Operating licenses issued by the NRC are subject to revocation, suspension or modification, and the operation of a nuclear unit may be suspended if the NRC determines that the public interest, health or safety so requires. (See "Proposed Changes to Nuclear Plant Operating Arrangements" herein.) Pursuant to the Nuclear Waste Policy Act of 1982, as amended, the Federal government has the regulatory responsibility for the final disposition of commercially produced high-level radioactive waste materials, including spent nuclear fuel. Such Act requires the owner of nuclear facilities to enter into disposal contracts with DOE for such material. These contracts require each such owner to pay a fee which is currently one dollar per MWh for the net electricity generated and sold by each of its reactors. (See "Fuel Supply" herein.) For information concerning nuclear insurance, see Note 9 of Notes to Financial Statements in Item 8. For information regarding NRC's regulation relating to decommissioning of nuclear facilities and regarding DOE's assessments pursuant to the Energy Policy Act for decontamination and decommissioning of nuclear fuel enrichment facilities, see Note 1 of Notes to Financial Statements in Item 8. OTHER ENVIRONMENTAL REGULATION Oglethorpe is subject to other environmental statutes including, but not limited to, the Toxic Substances Control Act, the Resource Conservation & Recovery Act, the Endangered Species Act, the Comprehensive Environmental Response, Compensation and Liability Act, and the Emergency Planning and Community Right to Know Act, and to the regulations implementing these statutes. Oglethorpe does not believe that compliance with these statutes and regulations will have a material impact on its operations. Changes to any of these laws could affect many areas of Oglethorpe's operations. Furthermore, compliance with new environmental legislation could have a significant impact on Oglethorpe. Such impacts cannot be fully determined at this time, however, and would depend in part on any such legislation and the development of implementing regulations. The scientific community, regulatory agencies and the electric utility industry are examining the issues of global warming and the possible health effects of electric and magnetic fields. While no definitive scientific conclusions have been reached regarding these issues, it is possible that new laws or regulations pertaining to these matters could increase the capital and operating costs of electric utilities, including Oglethorpe or entities from which Oglethorpe purchases power. ENERGY POLICY ACT The Energy Policy Act creates a new class of utilities called Exempt Wholesale Generators ("EWGs"), which are exempt from certain restrictions otherwise imposed by the Public Utility Holding Company Act. The effect of this exemption is to facilitate the development of independent third-party generators potentially available to satisfy utilities' needs for increased power supplies. (See "Future Power Resources--OTHER FUTURE RESOURCES" herein.) Unlike purchases from qualifying facilities under PURPA (see "Other Power Purchases" herein), however, utilities have no statutory obligation to purchase power from EWGs. Furthermore, EWGs are precluded from making direct sales to retail electricity customers. The Energy Policy Act also broadens the authority of FERC to require a utility to transmit power to or on behalf of other participants in the electric utility industry, including EWGs and qualifying facilities, but FERC is precluded from requiring a utility to transmit power from another entity directly to a retail customer. CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS CO-OWNERS OF THE PLANTS Plants Hatch, Vogtle, Wansley and Scherer Units No. 1 and No. 2 are co-owned by Oglethorpe, GPC, MEAG and Dalton, and Rocky Mountain is co-owned by Oglethorpe and GPC. Each such co-owner owns, and Oglethorpe owns or leases, undivided interests in the amounts shown in the following table (which excludes the Plant Wansley combustion turbine). GPC is the construction and operating agent for each of these plants, except for Rocky Mountain for which Oglethorpe is the construction and operating agent. (See "The Plant Agreements" herein.) GEORGIA POWER COMPANY GPC is a wholly owned subsidiary of The Southern Company, a registered holding company under the Public Utility Holding Company Act, and is engaged primarily in the generation and purchase of electric energy and the transmission, distribution and sale of such energy within the State of Georgia at retail in over 600 communities (including Athens, Atlanta, Augusta, Columbus, Macon, Rome and Valdosta), as well as in rural areas, and at wholesale to Oglethorpe, MEAG and three municipalities. GPC is the largest supplier of electric energy in the State of Georgia. (See "OGLETHORPE POWER CORPORATION-- Relationship with GPC".) GPC is subject to the informational requirements of the Securities Exchange Act of 1934, as amended, and, in accordance therewith, files reports and other information with the Securities and Exchange Commission (the "Commission"). Copies of this material can be obtained at prescribed rates from the Commission's Public Reference Section at 450 Fifth Street, N.W., Room 1024, Washington, D.C. 20549. Certain securities of GPC are listed on the New York Stock Exchange, and reports and other information concerning GPC can be inspected at the office of such Exchange. MUNICIPAL ELECTRIC AUTHORITY OF GEORGIA MEAG, an instrumentality of the State of Georgia, was created for the purpose of providing electric capacity and energy to those political subdivisions of the State of Georgia that owned and operated electric distribution systems at that time. MEAG has entered into power sales contracts with each of 47 cities and one county in the State of Georgia. Such political subdivisions, located in 39 of the State's 159 counties, collectively serve approximately 268,000 electric customers. CITY OF DALTON, GEORGIA The City of Dalton, located in northwest Georgia, supplies electric capacity and energy to consumers in Dalton, and presently serves more than 10,000 residential, commercial and industrial customers. THE PLANT AGREEMENTS HATCH, WANSLEY, VOGTLE AND SCHERER Oglethorpe's rights and obligations with respect to Plants Hatch, Wansley, Vogtle and Scherer are contained in a number of contracts between Oglethorpe and GPC and, in some instances, MEAG and Dalton. Oglethorpe is a party to four Purchase and Ownership Participation Agreements ("Ownership Agreements") under which it acquired from GPC a 30% undivided interest in each of Plants Hatch, Wansley and Vogtle, a 60% undivided interest in Scherer Units No. 1 and No. 2 and a 30% undivided interest in those facilities at Plant Scherer intended to be used in common by Scherer Units No. 1, No. 2, No. 3 and No. 4 (the "Scherer Common Facilities"). Oglethorpe has also entered into four Operating Agreements ("Operating Agreements") relating to the operation and maintenance of Plants Hatch, Wansley and Vogtle and Scherer, respectively. The Operating Agreements and Ownership Agreements relating to Plants Hatch and Wansley are two-party agreements between Oglethorpe and GPC. The other Operating Agreements and Ownership Agreements are agreements among Oglethorpe, GPC, MEAG and Dalton. The parties to each Ownership Agreement and each Operating Agreement are referred to as "Participants" with respect to each such agreement. In 1985, in four separate transactions, Oglethorpe sold its entire 60% undivided ownership interest in Scherer Unit No. 2 to four separate owner trusts established by four different institutional investors. (See Note 4 of Notes to Financial Statements in Item 8.) Oglethorpe retained all of its rights and obligations as a Participant under the Ownership and Operating Agreements relating to Scherer Unit No. 2 for the term of the leases. (In the following discussion, references to Participants "owning" a specified percentage of interests include Oglethorpe's rights as a deemed owner with respect to its leased interests in Scherer Unit No. 2.) The Ownership Agreements appoint GPC as agent with sole authority and responsibility for, among other things, the planning, licensing, design, construction, renewal, addition, modification and disposal of Plants Hatch, Vogtle, Wansley and Scherer Units No. 1 and No. 2 and the Scherer Common Facilities. Under the Ownership Agreements, Oglethorpe is obligated to pay a percentage of capital costs of the respective plants, as incurred, equal to the percentage interest which it owns or leases at each plant. GPC has responsibility for budgeting capital expenditures subject to, in the case of Scherer Units No. 1 and No. 2, certain limited rights of the Participants to disapprove capital budgets proposed by GPC and to substitute alternative capital budgets. Each Operating Agreement gives GPC, as agent, sole authority and responsibility for the management, control, maintenance, operation, scheduling and dispatching of the plant to which it relates. However, as provided in the recent amendments to the Plant Scherer Ownership and Operating Agreements, Oglethorpe has elected to dispatch separately its ownership share of Scherer Units No. 1 and No. 2. (See "THE POWER SUPPLY SYSTEM--Fuel Supply".) In 1990, the co-owners of Plants Hatch and Vogtle entered into the NMBA which amended the Plant Hatch and Plant Vogtle Ownership and Operating agreements, primarily with respect to GPC's reporting requirements, but did not alter GPC's role as agent with respect to the nuclear plants. In 1993, the co-owners entered into the Amended and Restated NMBA which provides for a managing board (the "Nuclear Managing Board") to coordinate the implementation and administration of the Plant Hatch and Plant Vogtle Ownership and Operating Agreements and provides for increased rights for the co-owners regarding certain decisions and allowed GPC to contract with a third party for the operation of the nuclear units. In connection with the recent amendments to the Plant Scherer Ownership and Operating Agreements, the co-owners of Plant Scherer entered into the Plant Scherer Managing Board Agreement which provides for a managing board (the "Plant Scherer Managing Board") to coordinate the implementation and administration of the Plant Scherer Ownership and Operating Agreements and provides for increased rights for the co-owners regarding certain decisions, but does not alter GPC's role as agent with respect to Plant Scherer. The Operating Agreements provide that Oglethorpe is entitled to a percentage of the net capacity and net energy output of each plant or unit equal to its percentage undivided interest owned or leased in such plant or unit, subject to its obligation to sell capacity and energy to GPC as described below. Except as otherwise provided, each party is responsible for a percentage of Operating Costs (as defined in the Operating Agreements) and fuel costs of each plant or unit equal to the percentage of its undivided interest which is owned or leased in such plant or unit. For Scherer Units No. 1 and No. 2, each party will be responsible for variable Operating Costs in proportion to the net energy output for its ownership interest, while responsibility for fixed Operating Costs will continue to be equal to the percentage undivided ownership interest which is owned or leased in such unit. GPC is required to furnish budgets for Operating Costs, fuel plans and scheduled maintenance plans subject to, in the case of Scherer Units No. 1 and No. 2, certain limited rights of the Participants to disapprove such budgets proposed by GPC and to substitute alternative budgets. (See "THE POWER SUPPLY SYSTEM--Proposed Changes to Nuclear Plant Operating Arrangements".) During the first seven years of Commercial Operation (as defined in the Operating Agreement for Plant Vogtle) of Plant Vogtle, GPC is entitled to a declining percentage of Oglethorpe's capacity and energy for all or a portion of each contract year ending May 31. (See "THE POWER SUPPLY SYSTEM--Power Sales to and Purchases from GPC--GPC SELL-BACK" and Note 1 of the Financial Statements in Item 8.) Regardless of the amount of capacity available, GPC is obligated to pay Oglethorpe monthly for the capacity of each unit to which it is entitled, if any, an amount derived by a formula set forth in the Operating Agreement based upon an average of GPC's annual fixed costs and Oglethorpe's annual fixed costs with respect to each unit. In addition, GPC is responsible for the same percentage of Oglethorpe's share of the Operating Costs and fuel-related costs incurred. The Ownership Agreements and Operating Agreements provide that, should a Participant fail to make any payment when due, among other things, such nonpaying Participant's rights to output of capacity and energy would be suspended. TERMS. The Operating Agreement for Plant Hatch will remain in effect with respect to Hatch Units No. 1 and No. 2 until 2009 and 2012, respectively. The Operating Agreement for Plant Vogtle will remain in effect with respect to each unit at Plant Vogtle until 2018. The Operating Agreement for Plant Wansley will remain in effect with respect to Wansley Units No. 1 and No. 2 until 2016 and 2018, respectively. The Operating Agreement for Scherer Units No. 1 and No. 2 will remain in effect with respect to Scherer Units No. 1 and No. 2 until 2022 and 2024, respectively. Upon termination of each Operating Agreement, GPC will retain such powers as are necessary in connection with the disposition of the property of the applicable plant, and the rights and obligations of the parties shall continue with respect to actions and expenses taken or incurred in connection with such disposition. ROCKY MOUNTAIN Oglethorpe's rights and obligations with respect to Rocky Mountain are contained in several contracts between Oglethorpe and GPC, the co-owners of Rocky Mountain. Pursuant to Rocky Mountain Pumped Storage Hydroelectric Ownership Participation Agreement, by and between Oglethorpe and GPC (the "Ownership Participation Agreement"), on December 15, 1988, Oglethorpe acquired a 3% undivided interest in Rocky Mountain, together with a future interest in the remaining 97% undivided interest. In connection with this acquisition, Oglethorpe and GPC also entered into the Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement (the "Rocky Mountain Operating Agreement"). Under the Ownership Participation Agreement, Oglethorpe has responsibility for financing and completing the construction of Rocky Mountain. As Oglethorpe expends funds for construction, GPC's ownership interest decreases and Oglethorpe's ownership interest increases. At all times, each party's undivided interest in the project is equal to the proportion that its respective investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Except as described below in respect of the exercise by GPC of its option to retain a minimum ownership interest, GPC is not required to expend any funds for construction. GPC's prior investment is determined in "as-spent" dollars, while Oglethorpe's investment is discounted to constant 1987 dollars (computed using a semi-annual Handy-Whitman Index). The Ownership Participation Agreement appoints Oglethorpe as agent with sole authority and responsibility for, among other things, the planning, licensing, design, construction, operation, maintenance and disposal of Rocky Mountain. The Ownership Participation Agreement provides that Oglethorpe must use its reasonable best efforts in accordance with Prudent Utility Practices (as defined therein) to have Rocky Mountain in commercial operation by June 1, 1996. The Rocky Mountain Operating Agreement gives Oglethorpe, as agent, sole authority and responsibility for the management, control, maintenance and operation of Rocky Mountain. In general, each co-owner is responsible for payment of its respective ownership share of all Operating Costs and Pumping Energy Costs (as defined in the Rocky Mountain Operating Agreement) as well as costs incurred as the result of any separate schedule or independent dispatch. A co-owner's share of net available capacity and net energy is the same as its respective ownership interest under the Ownership Participation Agreement. GPC will schedule and dispatch Rocky Mountain on a continuous economic dispatch basis, on behalf of itself and Oglethorpe, and will notify Oglethorpe in advance of estimated operating levels, until such time as Oglethorpe may elect to schedule separately its ownership interest. The Rocky Mountain Operating Agreement will terminate on the fortieth anniversary of the Completion Adjustment Date (as defined therein). AGREEMENTS RELATING TO THE INTEGRATED TRANSMISSION SYSTEM Oglethorpe and GPC have entered into the ITSA to provide for the transmission and distribution of electric energy in the State of Georgia, other than in certain counties, and for bulk power transactions, through use of the ITS. The ITS, together with transmission system facilities acquired or constructed by MEAG and Dalton under agreements with GPC referred to below, was established in order to obtain the benefits of a coordinated development of the parties' transmission facilities and to make it unnecessary for any party to construct duplicative facilities. The ITS consists of all transmission facilities, including land, owned by the parties on the date the ITSA became effective and those thereafter acquired, which are located in the State of Georgia other than in the excluded counties and which are used or usable to transmit power of a certain minimum voltage and to transform power of a certain minimum voltage and a certain minimum capacity (the "Transmission Facilities"). GPC has entered into agreements with MEAG and Dalton that are substantially similar to the ITSA, and GPC may enter into such agreements with other entities. The ITSA will remain in effect through December 31, 2012 and, if not then terminated by five years' prior written notice by either party, will continue until so terminated. The ITSA is administered by a Joint Committee established by a Joint Committee Agreement, summarized below. Each year, the Joint Committee determines a four-year plan of additions to the Transmission Facilities that will reflect the current and anticipated future transmission requirements of the parties. Oglethorpe and GPC are each required to maintain an original cost investment in the Transmission Facilities in proportion to their respective Peak Loads (as defined in the ITSA). Oglethorpe and GPC are parties to a Transmission Facilities Operation and Maintenance Contract (the "Transmission Operation Contract"), under which GPC provides System Operator Services (as defined in the Transmission Operation Contract) for Oglethorpe. In addition, GPC is required to provide such supervision, operation and maintenance supplies, spare parts, equipment and labor for the operation, maintenance and construction as may be specified by Oglethorpe. GPC is also required to perform certain emergency work under the Transmission Operation Contract. Oglethorpe is permitted, upon notice to GPC, to perform, or contract with others for the performance of, certain services performed by GPC. Absent termination or amendment of the Transmission Operation Contract, however, GPC will continue to perform System Operator Services for Oglethorpe. The term of the Transmission Operation Contract will continue from year to year unless terminated by either party upon four years' notice. Oglethorpe is required to pay its proportionate share of the cost for the services provided by GPC. THE JOINT COMMITTEE AGREEMENT Oglethorpe, GPC, MEAG and Dalton are parties to a Joint Committee Agreement. In the past, the Joint Committee coordinated the implementation and administration of the various Ownership Agreements and Operating Agreements, the various integrated transmission system agreements, and the various integrated transmission system operation and maintenance agreements among the parties. However, the Nuclear Managing Board has assumed such responsibilities for Plants Hatch and Vogtle, the Plant Scherer Managing Board has assumed such responsibilities for Plant Scherer and, if agreed by the co-owners, an operating committee would also assume such responsibilities for Plant Wansley. (See "The Plant Agreements--HATCH, WANSLEY, VOGTLE AND SCHERER" herein.) The Joint Committee Agreement also makes allowance for the joint planning of future transmission and generation facilities. ITEM 2. ITEM 2. PROPERTIES Information with respect to Oglethorpe's properties is set forth under the caption "THE POWER SUPPLY SYSTEM" included in Item 1 and is incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Oglethorpe is a party to various actions and proceedings incident to its normal business. Liability in the event of final adverse determinations in any of these matters is either covered by insurance or, in the opinion of Oglethorpe's management, after consultation with counsel, should not in the aggregate have a material adverse effect on the financial position or results of operations of Oglethorpe. 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 Not Applicable. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - ----------------------------------------------------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL MARGINS AND PATRONAGE CAPITAL Oglethorpe operates on a not-for-profit basis and, accordingly, seeks only to generate revenues sufficient to recover its cost of service and to generate margins sufficient to establish reasonable reserves and meet certain financial coverage requirements. Revenues in excess of current period costs in any year are designated in Oglethorpe's statements of revenues and expenses and patronage capital as net margin. Retained net margins are designated on Oglethorpe's balance sheets as patronage capital, which is allocated to each of its 39 retail electric distribution cooperatives (Members) on the basis of its electricity purchases from Oglethorpe. Since its formation in 1974, Oglethorpe has generated a positive net margin in each year and, as of December 31, 1993, had a balance of $290 million in patronage capital. Patronage capital constitutes the principal equity of Oglethorpe. As a means of accumulating additional equity, Oglethorpe's Board of Directors amended in 1992 the patronage capital retirement policy for returning margins to the Members to extend the retirement schedule from 13 years to 30 years after the year in which the margins were generated. Pursuant to such policy, no patronage capital would be retired until 2010, at which time the 1979 patronage capital would be returned. Any distributions of patronage capital are subject to the discretion of the Board of Directors and approval by the Rural Electrification Administration (REA). Oglethorpe's equity ratio (patronage capital and membership fees divided by total capitalization) increased from 5.7% at December 31, 1992 to 6.2% at December 31, 1993. RATES AND FINANCIAL COVERAGE REQUIREMENTS Oglethorpe's policy is to design its rates to generate sufficient revenues to recover its Member cost of service and produce net margins at such levels as Oglethorpe's Board of Directors determines to be consistent with sound financial practice. Rate revisions by Oglethorpe are subject to the approval of the REA and, to date, the REA has not reduced or delayed the effectiveness of any rate increase proposed by Oglethorpe. Oglethorpe has entered into a wholesale power contract with each of its Members that requires rates to be designed to recover all costs as described in such contracts. Oglethorpe's rates include an energy charge that is set annually and adjusted at mid-year to recover actual fuel and variable operations and maintenance costs. Oglethorpe reviews its rates at least annually to ensure that its fixed costs are being adequately recovered and, if necessary, adjusts its rates to meet its net margin goals. Oglethorpe utilizes a Times Interest Earned Ratio (TIER) as the basis for establishing its annual net margin goal. TIER is determined by dividing the sum of Oglethorpe's net margin plus interest on long-term debt (including interest charged to construction) by Oglethorpe's interest on long-term debt (including interest charged to construction). The REA Mortgage requires Oglethorpe to implement rates that are designed to maintain an annual TIER of not less than 1.05. In addition to the TIER requirement under the REA Mortgage, Oglethorpe is also required under the REA Mortgage to implement rates designed to maintain a Debt Service Coverage Ratio (DSC) of not less than 1.0 and an Annual Debt Service Coverage Ratio (ADSCR) of not less than 1.25. DSC is determined by dividing the sum of Oglethorpe's net margin plus interest on long-term debt (including interest charged to construction) plus depreciation and amortization (excluding amortization of nuclear fuel and debt discount and expense) by Oglethorpe's interest and principal payable on long-term debt (including interest charged to construction). ADSCR is determined by dividing the sum of Oglethorpe's net margin plus interest on long-term debt (excluding interest charged to construction) plus depreciation and amortization (excluding amortization of nuclear fuel and debt discount and expense) by Oglethorpe's interest and principal payable on long-term debt secured under the REA Mortgage (excluding interest charged to construction). Oglethorpe has always met or exceeded the TIER, DSC and ADSCR requirements of the REA Mortgage. TIER, DSC and ADSCR for the years 1991 through 1993 were as follows: In 1992, as part of a plan to build additional equity, Oglethorpe's Board of Directors revised its annual net margin goal to be the amount required to produce a TIER of 1.07 in each year through 1995, 1.08 in 1996, 1.09 in 1997 and 1.10 in 1998 and thereafter. Historically, by setting rates to meet the TIER goals established by Oglethorpe's Board, the DSC and ADSCR requirements of the REA Mortgage have always been met or exceeded. Based on Oglethorpe's current financial projections, however, rates based on these levels of TIER may not be sufficient to meet the ADSCR requirement of the REA Mortgage. In that event, rates sufficient to meet the ADSCR requirements would have to be established. HISTORICAL FACTORS AFFECTING FINANCIAL PERFORMANCE Over the past several years, the most significant factor affecting Oglethorpe's financial performance has been the mechanisms Oglethorpe has utilized to moderate the financial impact of new generating plants. During this period, Oglethorpe's Members absorbed much of the cost of its ownership interests in Plant Vogtle and Scherer Units No. 1 and No. 2. The mechanisms used by Oglethorpe to mitigate the rate impact of absorbing these costs have included both long-term contractual arrangements with Georgia Power Company (GPC) and Board of Directors policies that have resulted in the gradual absorption of costs over several years. Contractual arrangements with GPC provide that Oglethorpe sell to GPC and GPC purchase from Oglethorpe a declining percentage of Oglethorpe's entitlement to the capacity and energy of certain co-owned generating plants during the initial years of operation of such units (GPC Sell-back). The GPC Sell-back will expire for Plant Vogtle Unit No. 1 as of May 31, 1994, and for Plant Vogtle Unit No. 2 as of May 31, 1995. The GPC Sell-back for Scherer Unit No. 1 expired in May 1991 and for Scherer Unit No. 2, in May 1993. (See Note 1 of Notes to Financial Statements.) The historical ability of Oglethorpe to sell power from new units to GPC under the GPC Sell-back has enabled Oglethorpe to moderate the effects of the higher costs associated with new generating units on Oglethorpe's cost of service and therefore on the rates charged Members. Furthermore, the GPC Sell-back has enabled Oglethorpe to obtain the generating capacity needed to serve anticipated increases in Member loads while minimizing the risks and costs of excess generating capacity. Prior to the completion of the first unit of Plant Vogtle in 1987, Oglethorpe's Board of Directors implemented policies that have resulted in the gradual absorption of the costs of Plant Vogtle by the Members. In each of the years 1985 through 1993, Oglethorpe exceeded its net margin goal. The Board adopted resolutions in each of these years requiring that these excess margins be deferred and used to mitigate rate increases associated with Plant Vogtle. In each year beginning with 1989, a portion of these margins has been returned to the Members through billing credits. (See Note 1 of Notes to Financial Statements.) Furthermore, during 1986 and 1987, Oglethorpe's rates to its Members included a one mill per kilowatt-hour (kWh) charge (Vogtle Surcharge). The Vogtle Surcharge represented a pre-collection of charges prior to commercial operation of Plant Vogtle the effect of which was to mitigate future rate increases. In addition, two of the Members elected to increase the level of this charge for their systems during this period. As of December 31, 1993, Oglethorpe held a balance of approximately $48 million from deferred margins and the voluntary Vogtle Surcharges to two Members which will be utilized for future rate mitigation. Oglethorpe's Board of Directors and the two Members intend to utilize these amounts as offsets to rates charged during 1994 and 1995. By the end of 1995, all costs associated with Plant Vogtle will be included in Member rates. RESULTS OF OPERATIONS OPERATING REVENUES Oglethorpe's operating revenues are derived from sales of electric services to the Members and non-Members. Revenues from Members are collected pursuant to the wholesale power contracts and are a function of the demand for power by the Members' consumers and Oglethorpe's cost of service. Historically, most of Oglethorpe's non-Member revenues have resulted from various plant operating agreements with GPC as discussed below. For the period 1991 through 1993, although total revenues have remained virtually unchanged, the scheduled reduction of the GPC Sell-back has resulted in the planned decrease of non- Member revenues from GPC of almost $130 million. As expected, the capacity and energy no longer being sold to GPC have been used by Oglethorpe to meet increased Member requirements. In addition to increasing sales to Members, Oglethorpe has increased revenues from energy sales and transmission sales to other utilities in order to mitigate the need to recover from the Members costs which were previously recovered through sales to GPC. SALES TO MEMBERS. Revenues from sales to Members increased 10.3% in 1993 compared to 1992, and increased 6.9% in 1992 compared to 1991. These increases reflect two factors: first, higher capacity rates, offset by the pass-through of savings in energy costs (see discussion of savings in fuel costs under "OPERATING EXPENSES" herein); and second, increased amounts of energy sold. Concerning the first factor, as non-Member revenues from GPC have declined, Oglethorpe has increased rates to Members to recover the fixed costs which had previously been recovered from GPC through the GPC Sell-back. Since December 28, 1990, Oglethorpe has placed into effect four rate changes, as set forth below: Oglethorpe was able to implement a rate reduction for 1994 because the anticipated additional revenues to be derived based on the increase in the Members' 1993 peak demand more than offset the reduction in revenues from the GPC Sell-back. Oglethorpe's wholesale rate to the Members sets forth the manner in which energy costs are to be recovered. Oglethorpe's rate provides that actual energy costs be passed through to the Members such that energy revenues equal energy costs. The following table summarizes the amounts of kilowatt-hours sold to Members during each of the past three years: The net impact of the above capacity and energy rate factors, combined with the spreading of fixed capacity costs over an increasing number of kWh sold each year, have resulted in the following average Member revenues: Oglethorpe is reducing the need to recover from Members the additional costs resulting from reductions to the GPC Sell-back by increasing revenues from off-system sales and reducing fixed and operating costs. In addition to the impact of reductions in GPC Sell-back revenues, future Member rates will also be affected by such factors as fixed costs relating to the Rocky Mountain Project, a pumped storage hydroelectric facility (Rocky Mountain), the cost of adding to Oglethorpe's existing transmission system, changes in fuel costs, environmental and other governmental regulations applicable to Oglethorpe and its suppliers and the completion in 1995 of the amortization of deferred margins. Oglethorpe's future rates will also be affected by its ability to forecast accurately its future power resource needs and by its ability to obtain and manage its power resources, including its purchases and construction of generating capacity and its procurement of coal. SALES TO NON-MEMBERS. Sales of electric services to non-Members are primarily made pursuant to three different types of contractual arrangements with GPC and from off-system sales to other non-Member utilities. The following table summarizes the amounts of non-Member revenues from these sources for the past three years: Revenues from sales to non-Members declined in 1993 compared to 1992, and in 1992 compared to 1991. These decreases were primarily attributable to scheduled reductions in plant operating agreement revenues attributable to the GPC Sell-back with respect to Plants Vogtle and Scherer. The second source of non-Member revenues is power supply arrangements with GPC. These revenues are derived, for the most part, from energy sales arising from dispatch situations whereby GPC causes co-owned coal-fired generating resources to be operated when Oglethorpe's system does not require all or part of its contractual entitlement to the generation. These revenues essentially represent reimbursement of costs to Oglethorpe because, under the operating agreements, Oglethorpe is responsible for its share of fuel costs any time a unit operates. The greater amount of such revenues in 1992 compared to 1993 and 1991 was largely attributable to GPC's operational decisions causing a higher level of generation at Plant Scherer in 1992. The third source of non-Member revenues is payments from GPC for use of the Integrated Transmission System (ITS) and related transmission interfaces. GPC compensates Oglethorpe to the extent that Oglethorpe's percentage of investment in the ITS exceeds its percentage use of the system. In such case, Oglethorpe is entitled to income as compensation for the use of its investment by the other ITS participants. In addition, beginning in 1991, GPC purchased the right to use the majority of Oglethorpe's share of the interface capability between the ITS and the Florida electric system through May 1994. The higher amount of transmission agreement revenues in 1992 compared to 1993 and 1991 was partially attributable to the receipt by Oglethorpe in 1992 of a payment of $10.5 million from GPC as a result of adjustments of transmission income for the years 1990 through 1992. Other revenues from non-Members increased significantly in 1993 compared to 1992 and 1991. This increase reflects greater revenues from off-system energy sales. Oglethorpe is continuing to seek to make off-system sales to non-Members. OPERATING EXPENSES Oglethorpe's operating expenses increased 9.4% in 1993 compared to 1992 and decreased 5.6% in 1992 compared to 1991. The increase in operating expenses in 1993 compared to 1992 was primarily attributable to higher production expenses, purchased power expenses and taxes other than income taxes. The decrease in operating expenses in 1992 compared to 1991 was primarily due to declines in production expenses, depreciation and amortization, taxes other than income taxes and income taxes. Generally, over the years 1991 through 1993, the Members have received the benefit of declining average fuel costs of Oglethorpe's generating resources through the pass-through of lower energy costs. The average fuel costs of Oglethorpe's nuclear and fossil generating resources for the last three years are as follows: Much of the reduction in average fuel costs was attributable to Oglethorpe's nuclear units. Fuel savings were particularly significant at Plant Vogtle where average fuel costs declined by 29% in 1993 compared to 1991. The decline was primarily due to the lower cost of replacement fuel relative to the cost of the initial core loading of fuel. These initial fuel supplies were purchased well in advance of commercial operation of these units and carried a significantly higher amount of capitalized interest than subsequent fuel reloads. Additionally, as a result of purchases of nuclear fuel in the spot market, Oglethorpe's costs for nuclear fuel in the last three years have been favorably impacted. The lower amount of production expenses in 1992 compared to 1993 and 1991 was attributable to a reduced number of nuclear refueling outages in 1992. Two of Oglethorpe's nuclear units underwent planned outages in 1992, as compared to three units in both 1993 and 1991. The increase in 1993 in purchased power expenses was the result of a 22% increase in kWh purchases. This increase was, for the most part, necessitated by the greater energy needs of the Members (see "OPERATING REVENUES - SALES TO MEMBERS" herein) and by Oglethorpe's increased off-system energy sales (see "OPERATING REVENUES - SALES TO NON-MEMBERS" herein). The decline in power delivery expenses from 1991 through 1993 was due to the lengthening of maintenance cycles, particularly on substation equipment, and to delays in 1993 by GPC, Oglethorpe's primary transmission maintenance contractor, in performing authorized work. Additionally, in 1991 Oglethorpe incurred a transmission charge of $3.8 million resulting from a greater percentage use of the ITS compared to its projected percentage of investment. (This amount was subsequently returned to Oglethorpe in 1992. See discussion of transmission income adjustment in 1992 under "OPERATING REVENUES - SALES TO NON- MEMBERS" herein.) The increase in sales, administrative and general expense in 1992 compared to 1991 was primarily attributable to increases in property insurance for co-owned plants, expanded marketing programs, and the expenses associated with one-time payments made to separated employees and to the utilization of consultants in a workforce reduction undertaken in 1992. Decreases in depreciation and amortization, income taxes and taxes other than income taxes also contributed to the decrease in total operating expenses in 1992 compared to 1991. These lower expense categories also directly contributed to the substantial amount of margins earned in excess of the 1992 TIER-based goal. (See the discussion below under "OTHER INCOME" concerning the disposition of this excess.) As a result of depreciation studies undertaken by GPC as operating agent in the fall of 1991, Oglethorpe implemented lower depreciation rates for all co-owned generating units. The lower rates are primarily due to a plant life extension program undertaken by GPC for the co-owned units. Property taxes, which constitute the majority of taxes other than income taxes, decreased in 1992 as a result of the favorable resolution of Oglethorpe's property tax appeal with the State of Georgia for the years 1985 through 1988. The negotiated settlement of this appeal resulted in a reduction of 1992 property tax expense in the amount of approximately $7.5 million. Income taxes were substantially lower in 1992 compared to 1991 due to several factors, including lower interest income, less gain in 1992 than in 1991 from the sale of debt service reserve fund securities (see "OTHER INCOME" below) and increased energy sales to GPC and other utilities. These sales to GPC were $16 million higher in 1992, and sales to other utilities were $3 million higher. (See "OPERATING REVENUES - SALES TO NON-MEMBERS" herein.) Oglethorpe deducts both fixed and variable costs from the revenues from these energy sales which generated tax losses resulting in lower taxable income from non-Member sales. OTHER INCOME Interest income decreased in 1993 and in 1992, as a result of lower average interest rates on investments. In 1992 and 1991, Oglethorpe realized the capital appreciation on securities invested for its debt service reserve funds by selling investments bearing coupon yields which were higher than prevailing market rates. The securities sold in 1991 had been held for a number of years and their average rates were substantially higher than market rates at the time of the sale. The 1992 gain captured only the capital appreciation resulting from declining interest rates during the 12 months following the 1991 sale. In 1993, 1992 and 1991, Oglethorpe's Board of Directors authorized the retention of approximately $5 million, $40 million and $12 million, respectively, in excess of the 1.07 TIER margin requirement as deferred margins. The remaining amounts will be available in 1994 and 1995 to mitigate rate increases. Amortization of deferred margins for 1993 was set by Oglethorpe's Board of Directors at $4 million, significantly less than the amounts utilized in 1992 and 1991. (See Note 1 of Notes to Financial Statements for a discussion of deferred margins and amortization of deferred margins.) INTEREST CHARGES Net interest charges declined in 1993 compared to 1992, and in 1992 compared to 1991. The decrease in interest on long-term debt and capital leases in 1993 was due, for the most part, to the refinancing efforts discussed under "LIQUITY AND CAPITAL RESOURCES" herein. Allowance for debt and equity funds used during construction (AFUDC) increased in 1993 and in 1992 as a result of increased construction activity at Rocky Mountain. The decrease in other interest expense in 1993 was primarily due to higher interest expense in 1992 associated with the settlement of the property tax appeal and the federal income tax case. Additionally, Oglethorpe paid a premium in 1992 in connection with its repricing of Federal Financing Bank (FFB) advances at reduced rates. In order to modify the FFB advances, Oglethorpe paid a premium equal to approximately one year's interest on these repriced advances. LIQUIDITY AND CAPITAL RESOURCES In the past, Oglethorpe, like most other G&Ts, has obtained the majority of its long-term financing from REA-guaranteed loans funded by the FFB. Oglethorpe has also obtained a substantial portion of its long-term financing requirements from tax-exempt pollution control bonds (PCBs). In addition, Oglethorpe's operations have consistently provided a sizable contribution to the financing of construction programs, such that internally generated funds have provided interim funding or long-term capital for nuclear fuel reloads, new generation, transmission and general plant facilities, and replacements and additions to existing facilities. Oglethorpe's investment in electric plant, net of depreciation, was approximately $4.5 billion as of December 31, 1993. Expenditures for property additions during 1993 amounted to approximately $235 million, of which $198 million was provided from operations. These expenditures were primarily for the construction of Rocky Mountain and replacements and additions to generation and transmission facilities. As part of its ongoing capital planning, Oglethorpe forecasts expenditures required for generation and transmission facilities and related capital projects. Actual construction costs may vary from the estimates below because of factors such as changes in business conditions, fluctuating rates of load growth, environmental requirements, design changes and rework required by regulatory bodies, delays in obtaining necessary Federal and other regulatory approvals, construction delays, and cost of capital, equipment, material and labor. The table below indicates Oglethorpe's estimated capital expenditures through 1996, including AFUDC: Based on its current construction budget, Oglethorpe anticipates that it will fund all capital expenditures through 1996, other than for Rocky Mountain, from operations. In 1988, Oglethorpe acquired from GPC an undivided ownership interest in Rocky Mountain and assumed responsibility for its construction and operation. As of December 31, 1993, Rocky Mountain was approximately 90% complete and Oglethorpe's investment in the project was $414 million. Oglethorpe is financing its share of Rocky Mountain from the proceeds of an REA-guaranteed loan funded through the FFB. As of December 31, 1993, $248 million had been advanced under this loan and $459 million remained available to be drawn as permanent financing for Rocky Mountain. Oglethorpe intends to finance all direct expenditures and capitalized interest associated with the construction of Rocky Mountain through such FFB loan, and management believes the amounts remaining to be drawn under such loan are more than adequate to complete the project. The obligation to advance funds under this loan, however, is subject to certain conditions, including the requirement that Oglethorpe maintain an annual TIER of at least 1.0 and that the REA shall not have determined that there has occurred any material adverse change in the assets, liabilities, operations or financial condition of Oglethorpe or any circumstances involving the nature or operation of the business of Oglethorpe. In management's opinion, no such material adverse change has occurred. The current schedule anticipates commercial operation in early 1995. Oglethorpe has a commercial paper program under which it may issue commercial paper not to exceed $355 million outstanding at any one time. The commercial paper may be used as a source of short-term funds and is not designated for any specific purpose. Oglethorpe's commercial paper is backed 100% by a committed line of credit provided by a group of banks for which Trust Company Bank acts as agent. Historically, Oglethorpe has not relied on commercial paper for short-term funding due to the availability of internally generated funds and has never utilized the backup line of credit. Oglethorpe has also arranged one committed and two uncommitted lines of credit to provide additional sources of short-term financing. As of December 31, 1993, Oglethorpe's short-term credit facilities were as follows: The maximum amount that can be outstanding at any one time under the commercial paper program and the lines of credit totals $425 million due to certain restrictions contained in the CFC and Trust Company Bank line of credit agreements. As of December 31, 1993, no commercial paper was outstanding and there was no outstanding balance on any line of credit. As part of a March 1993 PCB refinancing transaction involving two forward interest rate swap agreements, Oglethorpe is obligated to maintain minimum liquidity in an amount equal to 25% of the principal amount of the variable rate refunding bonds issued or to be issued in connection therewith. This minimum liquidity requirement currently equals $81 million and will decrease proportionately as such variable rate refunding bonds are retired. The minimum liquidity must consist of (a) any combination of (i) amounts available under committed lines of credit and commercial paper programs to pay termination payments, if any, due upon early termination of the forward interest rate swap transactions, (ii) cash, (iii) United States government securities, and (iv) accounts receivable due within 30 days, less (b) monetary obligations due within 30 days. As of December 31, 1993, Oglethorpe had approximately $467 million of such liquidity available to meet this requirement. Oglethorpe's scheduled maturities of long-term debt over the next five years total $425 million. Of this amount, $299 million, or seventy percent, relates to the repayment of REA and FFB debt. REFINANCING TRANSACTIONS Over the past few years, Oglethorpe has implemented a program to reduce its interest costs by refinancing or prepaying a sizable portion of its high- interest PCB and FFB debt. Several transactions were completed in 1993 and early 1994, covering approximately $1.3 billion in existing PCB and FFB debt (See Note 5 of Notes to Financial Statements.) The net result of the 1993 transactions was to reduce the average interest rate on total long-term debt from 8.18% at December 31, 1992 to 7.94% at December 31, 1993. The average interest rate was further reduced to 7.13% as a result of the transactions completed in early 1994. In March 1993, Oglethorpe entered into two forward interest rate swap agreements totaling $322 million to refinance $364 million of existing high- interest PCBs. Through this forward swap transaction, Oglethorpe arranged synthetic fixed rate financing at an average effective rate of 6.15% for $200 million of variable rate refunding bonds which were issued on November 30, 1993 and $122 million of variable rate refunding bonds to be issued in the fall of 1994. Interest savings totaling $9.1 million and an additional $4.3 million will occur during the first full year following each respective issuance. In February 1994, Oglethorpe refunded $205 million of PCBs through an issuance of $195 million of fixed rate refunding bonds. With an effective interest rate of 4.8%, this transaction will generate net interest savings of about $10.5 million during the first full year. Oglethorpe expects to achieve additional interest savings through a $35 million current refunding of PCBs in the fall of 1994. In addition to these refinancings, Oglethorpe has also recently taken certain actions to reduce the interest expense on its FFB debt. In January 1993, Oglethorpe prepaid six FFB advances totaling $75 million with interest rates exceeding 10%. These advances, which had become at least 12 years old, were prepaid with one year's interest premium. The net annual average savings in the first full year are $6.9 million. During 1993, Oglethorpe pursued refinancing all of its approximately $3 billion in outstanding REA and FFB debt (the REA Indebtedness) through the issuance of bonds in the public market which would have resulted in Oglethorpe exiting the REA program (the REA Refinancing). In January 1994, FFB advised Oglethorpe that the Department of the Treasury would not take certain actions requested to facilitate the REA Refinancing. Oglethorpe continues to believe that an REA Refinancing is in its long-term best interest and will continue to evaluate options to exit the REA program. If the REA Refinancing were to be consummated, it would require, among other things, a substitution of the REA Mortgage with a trust indenture which would secure all of Oglethorpe's first lien indebtedness, regulation of Oglethorpe's rates by the Federal Energy Regulatory Commission, and certain amendments to the wholesale power contracts between Oglethorpe and each of its Members. Oglethorpe's management is unable to give any assurance at this time that Oglethorpe will be able to effect the REA Refinancing, or, if so, on what terms and conditions. Although Oglethorpe continues to pursue the REA Refinancing, it has taken advantage of an option currently available to reduce the interest expense on its FFB debt. At the beginning of 1994, Oglethorpe had over $1 billion of advances that had been outstanding for more than 12 years under notes to the FFB that were eligible to be modified to reduce their interest rates. In two separate transactions in early 1994, Oglethorpe modified certain FFB notes and thereby reduced the interest rates on approximately $795 million of advances. In connection with such note modification, a premium was paid in an amount equal to one year's interest on the advances of approximately $64 million, which will be expensed over the longest remaining life of the subject advances, which is 22 years. These transactions will generate net interest savings of $18.5 million in the first full year. Oglethorpe may elect to reduce the interest rates on approximately $250 million of additional FFB advances through this note modification process. The timing of such election depends on the magnitude of the interest rate savings that can be achieved. Oglethorpe is also evaluating and may seek to reduce its interest expense by refinancing certain of its other FFB notes upon payment of a premium as permitted under the recently enacted Section 306C of the Rural Electrification Act. Under 306C, an FFB borrower is able to refinance its outstanding indebtedness at interest rates based on the then current Treasury rates upon payment of a premium. Based on current interest rates and the premium that would be due under Section 306C, Oglethorpe is evaluating refinancing a portion of its FFB indebtedness and financing at least a portion of the premium. Oglethorpe's management has not determined whether Oglethorpe will avail itself of such refinancing option. MISCELLANEOUS As with utilities generally, inflation has the effect of increasing the cost of Oglethorpe's operations and construction program. Operating and construction costs have been less affected by inflation over the last few years because rates of inflation have been relatively low. The implementation of recently released pronouncements of the Financial Accounting Standards Board, including Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and Statement No. 112, "Employer's Accounting for Postemployment Benefits", are not expected to have a material effect on Oglethorpe's results of operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA OGLETHORPE POWER CORPORATION STATEMENTS OF REVENUES AND EXPENSES - ------------------------------------------------------------------------------- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 STATEMENTS OF PATRONAGE CAPITAL - ------------------------------------------------------------------------------- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 BALANCE SHEETS - ------------------------------------------------------------------------------- DECEMBER 31, 1993 AND 1992 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE BALANCE SHEETS. STATEMENTS OF CAPITALIZATION - ------------------------------------------------------------------------------- DECEMBER 31, 1993 AND 1992 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS. STATEMENTS OF CASH FLOWS - ------------------------------------------------------------------------------- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS. NOTES TO FINANCIAL STATEMENTS - ---------------------------------------------------------------------------- FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: A. BASIS OF ACCOUNTING Oglethorpe Power Corporation (Oglethorpe) follows generally accepted accounting principles and the practices prescribed in the Uniform System of Accounts of the Federal Energy Regulatory Commission (FERC) as modified and adopted by the Rural Electrification Administration (REA). B. ELECTRIC PLANT Electric plant is stated at original cost, which is the cost of the plant when first dedicated to public service, plus the cost of any subsequent additions. Cost includes an allowance for the cost of equity and debt funds used during construction. The cost of equity and debt funds is calculated at the embedded cost of all such funds. The plant acquisition adjustments represent the excess of the cost of the plant to Oglethorpe over the original cost, less accumulated depreciation at the time of acquisition, and are being amortized over a ten-year period. Maintenance and repairs of property and replacements and renewals of items determined to be less than units of property are charged to expense. Replacements and renewals of items considered to be units of property are charged to the plant accounts. At the time properties are disposed of, the original cost, plus cost of removal, less salvage of such property, is charged to the accumulated provision for depreciation. C. OPERATING REVENUES Sales to Members consist primarily of electricity sales pursuant to long-term wholesale power contracts which Oglethorpe maintains with each of its 39 retail electric distribution cooperatives (Members). These wholesale power contracts obligate each Member to pay Oglethorpe for capacity and energy furnished in accordance with rates established by Oglethorpe. Energy furnished is determined based on meter readings which are conducted at the end of each month. For the year ended December 31, 1993, revenues from Cobb EMC, one of Oglethorpe's Members, accounted for 10.3% of Oglethorpe's total revenues. Prior to 1993, no individual Member accounted for 10% or more of Oglethorpe's total revenues. Sales to non-Members consist primarily of capacity and energy sales to Georgia Power Company (GPC) under terms of sell-back agreements entered into when Oglethorpe purchased interests in certain of GPC's generation facilities. Pursuant to these agreements, GPC purchases from Oglethorpe a declining fractional part of the capacity and energy during the first seven to ten years of an applicable generating unit's commercial operation. The portion of Oglethorpe's capacity and energy retained by GPC is shown as follows: - ---------------------------------------------------------------------------- Fractional Part of Capacity and Energy Retained by GPC during Contract Year Ended May 31 - ---------------------------------------------------------------------------- Pursuant to these sell-back agreements and to other contractual arrangements with GPC, revenues from GPC accounted for approximately 15%, 24%, and 28% of Oglethorpe's total revenues in 1993, 1992, and 1991, respectively. D. DEPRECIATION Depreciation is computed on additions when they are placed in service using the composite straight-line method. Annual depreciation rates in effect in 1993, 1992 and 1991 were as follows: Oglethorpe's portion of the cost of decommissioning co-owned nuclear facilities, based on current price levels and decommissioning promptly after the unit is taken out of service, is estimated at approximately $71,000,000 for Hatch Unit No. 1, $93,000,000 for Hatch Unit No. 2, $79,000,000 for Vogtle Unit No.1 and $99,000,000 for Vogtle Unit No. 2. The depreciation rate for nuclear production includes a factor to provide for such expected cost of decommissioning. Oglethorpe accounts for this provision for decommissioning as depreciation expense with an offsetting credit to a decommissioning reserve. Imputed interest calculated based on current investment rates is applied to the decommissioning reserve balance and charged to interest expense. The estimates for the expected cost of decommissioning and the corresponding decommissioning factor in the depreciation rate are adjusted periodically to reflect changing price levels and technology. In compliance with a Nuclear Regulatory Commission (NRC) regulation, Oglethorpe maintains an external trust fund to provide for a portion of the cost of decommissioning its nuclear facilities. The NRC regulation requires funding levels based on average expected cost to decommission only the radioactive portions of a typical nuclear facility. Investment earnings generated from the external trust fund increase the decommissioning fund and interest income. E. NUCLEAR FUEL COST The cost of nuclear fuel, including a provision for the disposal of spent fuel, is being amortized to fuel expense based on usage. The total nuclear fuel expense for 1993, 1992 and 1991 amounted to $49,647,000, $55,804,000 and $62,349,000, respectively. Contracts with the U.S. Department of Energy (DOE) have been executed to provide for the permanent disposal of spent nuclear fuel for the life of Plant Hatch and Plant Vogtle. The services to be provided by DOE are scheduled to begin in 1998. However, the actual year that these services will begin is uncertain. The Plant Hatch spent fuel storage is expected to be sufficient into 2003. The Plant Vogtle spent fuel storage is expected to be sufficient into 2009. If DOE does not begin receiving spent fuel from Plant Hatch in 2003 or from Plant Vogtle in 2009, alternative spent fuel storage will be needed. The Energy Policy Act of 1992 requires that utilities with nuclear plants be assessed, over the next 15 years, an amount which will be used by DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The amount of each utility's assessment is based on its past purchases of nuclear fuel enrichment services from DOE. Based on its ownership in Plants Hatch and Vogtle, Oglethorpe has recorded a nuclear fuel asset of approximately $20,000,000, which is being amortized to nuclear fuel expense over the 15-year assessment period. Oglethorpe has also recorded, net of sell-back, an obligation to DOE which approximated $14,000,000 at December 31, 1993. F. PATRONAGE CAPITAL AND MEMBERSHIP FEES Oglethorpe is organized and operates as a cooperative. The Members paid a total of $195 in membership fees. Patronage capital is the retained net margin of Oglethorpe. As provided in the bylaws, any excess of revenue over expenditures from operations is treated as advances of capital by the Members and is allocated to each of them on the basis of their electricity purchases from Oglethorpe. The margin and patronage capital retirements policy adopted by the Oglethorpe Board of Directors in 1992 extended from 13 years to 30 years the period that each year's net margin will be retained by Oglethorpe. Pursuant to the previous 13-year patronage capital retirement schedule, 1978 patronage capital assignments were retired in 1992, and 1977 assignments in 1991. Under the new 30-year retirement schedule, no patronage capital would be returned to the Members until 2010, at which time the 1979 patronage capital would be returned. G. INCOME TAX ACCOUNTING Oglethorpe is a not-for-profit membership corporation subject to Federal, State of Georgia and State of Alabama income taxes. For years 1981 and prior, Oglethorpe claimed tax-exempt status under Section 501(c)(12) of the Internal Revenue Code of 1954, as amended (the Code). In 1982, Oglethorpe reported as a taxable entity as a result of income received by it from GPC under the capacity and energy sell-back agreement applicable to Scherer Unit No. 1. In connection with its 1985 tax return. Oglethorpe made an election under Section 168(j)(4)(E)(ii) of the Code to remain taxable from 1985 until at least 2005 without regard to the amount of its income from GPC or other non-Members. As a taxable electric cooperative, Oglethorpe has annually allocated its income and deductions between Member and non-Member activities. Any Member taxable income has been offset with a patronage exclusion. As of January 1, 1993, Oglethorpe prospectively adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". In adopting SFAS No. 109, Oglethorpe recorded a $13,340,000 reduction in accumulated deferred income taxes and an increase in income from the cumulative effect of a change in accounting principle. SFAS No. 109 requires the 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 differences between the financial and tax bases using enacted tax rates in effect for the year in which the differences are expected to reverse. A detail of the provision for income taxes in 1993, 1992 and 1991 is shown as follows: The difference between the statutory federal income tax rate on income before income taxes and accounting changes and Oglethorpe's effective income tax rate is summarized as follows: The components of the net deferred tax liabilities as of December 31, 1993 were as follows: Oglethorpe has federal tax net operating loss carryforwards (NOLs) and unused general business credits (consisting primarily of investment tax credits) as follows: Based on Oglethorpe's historical taxable transactions and the timing of the reversal of existing temporary differences, management believes it is more likely than not that Oglethorpe's future taxable income will be sufficient to realize the benefit of the NOLs existing at December 31, 1993 before their respective expiration dates. However, as reflected in the above valuation allowance, management does not believe it is more likely than not that the tax credits will be utilized before expiration. During 1992 and 1991, deferred income taxes were provided for significant timing differences between revenues and expenses for tax and financial statement purposes. The source and deferred tax effect of these differences are summarized as follows: H. MARGIN POLICY Oglethorpe's margin policy is based on the provision of a Times Interest Earned Ratio (TIER) established annually by the Oglethorpe Board of Directors. For 1993, 1992, and 1991, the margin goal was the amount required to produce a TIER of 1.07. Oglethorpe's Board of Directors adopted a new margin and patronage capital retirements policy in 1992. Pursuant to the new policy, the annual net margin goal will be the amount required to produce a TIER of 1.07 each year through 1995, 1.08 in 1996, 1.09 in 1997 and 1.10 in 1998 and thereafter. The Oglethorpe Board of Directors adopted resolutions annually requiring that Oglethorpe's net margins for the years 1985 through 1993 in excess of its annual margin goals be deferred and used to mitigate rate increases associated with Plant Vogtle. In addition, during 1986 and 1987, Oglethorpe's wholesale electric rate to its Members provided for a one mill per kilowatt-hour charge (Vogtle Surcharge), also to be used to mitigate the effect of Plant Vogtle on rates. In addition, two of Oglethorpe's Members, with the concurrence of REA, elected to increase the level of this charge for their systems during this period. Pursuant to rate actions by Oglethorpe's Board of Directors, specified amounts of deferred margins and Vogtle Surcharge were returned in 1989 through 1993 and will be returned in 1994. A summary of deferred margins and Vogtle Surcharge as of December 31, 1993 and 1992 is as follows: - --------------------------------------------------------------------------- I. CASH AND TEMPORARY CASH INVESTMENTS Oglethorpe considers all temporary cash investments purchased with a maturity of three months or less to be cash equivalents. Temporary cash investments with maturities of more than three months are classified as other short-term investments. J. ENERGY COST BILLED IN EXCESS OF ACTUAL Oglethorpe's wholesale power rate sets forth the manner in which energy costs are to be recovered from its Members. The rate in effect for 1993 and 1992 provided that an energy rate be determined based on projected costs and kilowatt-hour sales and that the resulting rate be used to bill Members for a six-month period. Actual energy costs were compared, on a monthly basis, to the billed energy costs, and an adjustment to revenues was made such that energy revenues were equal to actual energy costs. The offset to this adjustment is a payable to or receivable from Members for over or under-collected energy costs. The rate further provides that any cumulative over or under-collection for the previous six-month period be utilized to adjust projected costs for the next six-month period. Therefore, the amounts owed to Members as of December 31, 1993 and 1992 will be and have been utilized to reduce Member billings in 1994 and 1993, respectively. 2. CAPITAL LEASES: In December 1985, Oglethorpe sold and subsequently leased back from four purchasers its 60% undivided ownership interest in Scherer Unit No. 2. The gain from the sale is being amortized over the 36-year term of the leases. The minimum lease payments under the capital leases together with the present value of net minimum lease payments as of December 31, 1993 are as follows: The capital leases provide that Oglethorpe's rental payments vary to the extent of interest rate changes associated with the debt used by the lessors to finance their purchase of undivided ownership shares in Scherer Unit No. 2. The debt of three of the lessors is financed at fixed interest rates averaging 9.58%. As of December 31, 1993, the variable interest rates of the debt of the remaining lessor ranged from 5.93% to 8.25% for an average rate of 7.27%. Oglethorpe's future rental payments under its leases will vary from amounts shown in the table above to the extent that the actual interest rates associated with the fixed and variable rate debt of the lessors vary from the 11.05% debt rate assumed in the table. The Scherer Unit No. 2 lease meets the definitional criteria to be reported on Oglethorpe's balance sheets as a capital lease. For rate-making purposes, however, Oglethorpe treats this lease as an operating lease; that is, Oglethorpe considers the actual rental payment on the leased asset in its cost of service. Oglethorpe's accounting treatment for this capital lease has been modified, therefore, to reflect it rate-making treatment. Interest expense is applied to the obligation under the capital lease; then, amortization of the leasehold is recognized, such that interest and amortization equal the actual rental payment. Through 1994 the level of actual rental payments is such that amortization of the Scherer Unit No. 2 leasehold calculated in this manner is less than zero. Thereafter, the scheduled cash rental payments increase such that positive amortization of the leasehold occurs, and the entire cost of the leased asset is recovered through the rate-making process. The difference in the amortization recognized in this manner on the statements of revenues and expenses and the straight-line amortization of the leasehold is reflected on Oglethorpe's balance sheets as a deferred charge. In 1991 and 1992, all four of the lessors received Notices of Proposed Adjustments from the IRS proposing adjustments to the tax benefits claimed by these lessors in connection with their purchase and ownership of an undivided interest in Scherer Unit No. 2. The proposed adjustments, if ultimately upheld, would have the effect of reducing the lessors' tax benefits resulting from the sale and leaseback transactions. The lessors filed responses contesting the IRS's assertions as contained in the Notices of Proposed Adjustments. In February 1994, the IRS issued a revised Notice of Proposed Adjustments to one of the lessors which reduced the proposed adjustments to the tax benefits claimed by this lessor in connection with its purchase and ownership of an undivided interest in Scherer Unit No. 2. The IRS has indicated that it will take consistent positions with the other three lessors. If the IRS's current positions regarding the sale and leaseback transactions were ultimately upheld, Oglethorpe would be required to indemnify the four lessors. Oglethorpe's potential indemnification liability in this event is estimated to be approximately $1,200,000 as of February 1994. 3. FAIR VALUE OF FINANCIAL INSTRUMENTS: A detail of the estimated fair values of Oglethorpe's financial instruments as of December 31, 1993 and 1992 is as follows: Oglethorpe uses the methods and assumptions described below to estimate the fair value of each class of financial instruments. For cash and temporary cash investments and other short-term investments, the carrying amount approximates fair value because of the short-term maturity of those instruments. The fair values of bond, reserve and construction funds and the decommissioning fund are estimated based on quoted market prices for the investments held in the respective funds. The fair value of Oglethorpe'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 Oglethorpe for debt of similar maturities. Investment in associated organizations was as follows at December 31, 1993 and 1992: As a member of National Rural Utilities Cooperative Finance Corporation (CFC), Oglethorpe was obligated to purchase CFC Capital Term Certificates annually through 1984. Such certificates begin maturing in the year 2075 and bear interest at 5%. As a borrower from the National Bank for Cooperatives (CoBank), Oglethorpe is obligated to purchase capital stock in that bank. Under CoBank's capitalization plan, Oglethorpe is required to maintain an investment in the bank equal to 7%-13% of its five-year average loan volume with the bank. The required investment of 1993 was 11.5% of Oglethorpe's five-year average loan volume. It is not anticipated that Oglethorpe will be required to make any additional investments during 1994. The investments in these associated organizations are similar to compensating bank balances in that they are required in order to maintain current financing arrangements. Accordingly, there is no market for these investments. 4. BOND, RESERVE AND CONSTRUCTION FUNDS: Bond, reserve and construction funds for pollution control bonds are maintained as required by Oglethorpe's bond agreements. Bond funds serve as payment clearing accounts, reserve funds maintain amounts equal to the maximum annual debt service of each bond issue and construction funds hold bond proceeds for which construction expenditures have not yet been made. As of December 31, 1993 and 1992, substantially all of the funds were invested in U.S. Government securities. 5. LONG-TERM DEBT: Long term debt consists of mortgage notes payable to the Unites States of America acting through the FFB and the REA, mortgage notes issued in conjunction with the sale by public authorities of pollution control revenue bonds and notes payable to CoBank. Oglethorpe's headquarters facility is pledged as security for the CoBank headquarters note; substantially all of the owned tangible and certain of the intangible assets of Oglethorpe are pledged as security for the FFB and REA notes, the remaining CoBank notes and the notes issued in conjunction with the sale of pollution control revenue bonds. The detail of the notes is included in the statements of capitalization. Oglethorpe currently has ten REA-guaranteed FFB notes of which $3,040,767,000 and $3,111,160,000 were outstanding at December 31, 1993 and 1992, respectively, with rates ranging from 6.61% to 10.95%. In March 1993, Oglethorpe entered into two forward interest rate swap arrangements obligating Oglethorpe to sell $199,690,000 of variable rate refunding bonds in the fall of 1993 and $122,740,000 of variable rate refunding bonds in the fall of 1994, the proceeds of which, together with certain other funds provided or to be provided by Oglethorpe, have been and will be used in January 1994 and January 1995, respectively, to refund certain pollution control revenue bonds previously issued. At December 31, 1993, Oglethorpe accounted for the pending January 1994 retirement of $233,010,000 of previously issued bonds as an in-substance defeasance. Therefore, debt service reserve funds, bonds payable, and the premium and loss on reacquired debt are stated as though the event of retiring the refunded bonds had occurred in 1993. In connection with the March 1993 swap transaction, Oglethorpe recorded redemption premiums which, combined with unamortized transaction costs, totaled $38,128,000. This amount has been reported as a deferred charge on the balance sheets and is being or will be amortized over the life of the related new bonds. Pursuant to the forward interest rate swap arrangements, Oglethorpe makes payments to the counterparty based on the notional principal at a fixed rate and the counterparty makes payments to Oglethorpe based on the notional principal and on the existing variable rate of the refunding bonds. The differential to be paid or received is accrued as interest rates change and is recognized as an adjustment to interest expense. For the fall 1993 transaction, the notional principal was $199,690,000 and the fixed swap rate is 5.67% (the variable rate at December 31, 1993 was 3.10%). With respect to the fall 1994 transaction, the notional principal will be $122,740,000 and the fixed swap rate is 6.01%. The notional principal amount is used to measure the amount of the swap payments and does not represent additional principal due to the counterparty. The swap arrangements extend for the life of the refunding bonds, with reductions in the outstanding principal amounts of the refunding bonds causing corresponding reductions in the notional amounts of the swap payments. The annual interest requirement for 1994, based upon all debt outstanding at December 31, 1993, will be approximately $339,000,000. Maturities for the long-term debt through 1998 are as follows: Oglethorpe has a commercial paper program under which it may issue commercial paper not to exceed a $355,000,000 balance outstanding at any time. The commercial paper may be used as a source of short-term funds and is not intended for any specific purpose. Oglethorpe's commercial paper is backed 100% by a committed line of credit provided by a group of banks for which Trust Company Bank (Trust Company) acts as agent. As of December 31, 1993 and 1992, no commercial paper was outstanding. Oglethorpe has arranged for uncommitted short-term lines of credit with CoBank and CFC, and a committed line of credit with Trust Company. The CoBank line amounts to $70,000,000; the CFC line amounts to $50,000,000; and the Trust Company line amounts to $30,000,000. The maximum amount that can be outstanding under these lines of credit and the commercial paper program at any one time totals $425,000,000 due to certain restrictions contained in the CFC and Trust Company line of credit agreements. No balance on any of these three lines of credit was outstanding at either December 31, 1993 or 1992. In January 1994, Oglethorpe completed a note modification pursuant to which it repriced $590,909,000 of FFB advances. In connection with such modification, Oglethorpe paid a premium of $50,745,000. This amount will be reported as a deferred charge on the balance sheets and will be amortized over 22 years, the longest remaining life of the subject advances. 6. ELECTRIC PLANT AND RELATED AGREEMENTS: Oglethorpe and GPC have entered into agreements providing for the purchase and subsequent joint operation of certain of GPC's electric generating plants and transmission facilities. A summary of Oglethorpe's plant investments as of December 31, 1993 is as follows: In 1988, Oglethorpe acquired from GPC an undivided ownership interest in the Rocky Mountain Project, a pumped storage hydroelectric facility (Rocky Mountain). Under the Rocky Mountain agreements, Oglethorpe assumed responsibility for construction of the facility, which construction was commenced by GPC. Under the agreements, GPC retained its current investment in Rocky Mountain. The ultimate ownership interests of Oglethorpe and GPC in the facility will be based on the ratio of each party's direct construction costs to total project direct construction costs with certain adjustments. It is expected that the ownership interests of Oglethorpe and GPC in Rocky Mountain at project completion will be approximately 75% and 25%, respectively. Rocky Mountain is subject to a license issued by FERC to Oglethorpe and GPC. This license requires that construction be completed by June 1, 1996. The current schedule anticipates commercial operation in early 1995. Rocky Mountain was approximately 90% complete as of December 31, 1993. Oglethorpe is financing its share of Rocky Mountain from the proceeds of an REA-guaranteed loan funded through the FFB. As of December 31, 1993, a total of approximately $459,000,000 remained available to be drawn as permanent financing for Rocky Mountain. Such amount is considered more than adequate by Oglethorpe to complete the project. The obligation to advance funds under the FFB loan commitment, however, is subject to certain conditions, including the requirement that Oglethorpe maintain an annual TIER of at least 1.0 and that the REA shall not have determined that there has occurred any material adverse change in the assets, liabilities, operations, or financial condition of Oglethorpe or any circumstances involving the nature or operation of the business of Oglethorpe. In management's opinion, no such material adverse change has occurred. Oglethorpe is engaged in a continuous construction program and as of December 31, 1993, estimates property additions (including capitalized interest) to be approximately $284,000,000 in 1994, $204,000,000 in 1995 and $148,000,000 in 1996, primarily for construction of Rocky Mountain and replacements and additions to generation and transmission facilities. Primarily as a result of its ownership of a majority interest in Rocky Mountain, Oglethorpe has determined that the Pickens County Pumped Storage Hydroelectric Project is not needed within its present planning horizon. Accordingly, Oglethorpe is amortizing the accumulated project costs in excess of the value of the land purchased. The remaining unamortized project costs of approximately $18,314,000 are reflected as deferred charges on the accompanying balance sheets. Oglethorpe's Board of Directors has authorized that these projects costs be amortized and fully recovered through future rates over a period of 15 years beginning in 1992. In April 1992, Oglethorpe sold to three purchasers certain of the income tax benefits associated with Scherer Unit No. 1 and related common facilities pursuant to the safe harbor lease provisions of the Economic Recovery Tax Act of 1981. Oglethorpe received a total of approximately $110,000,000 from the safe harbor lease transactions. Oglethorpe accounts for the proceeds as a deferred credit, sale of income tax benefits, and is amortizing the amount over the 20- year term of the leases. In October 1989, Oglethorpe sold to GPC a 24.45% ownership interest in the Plant Scherer common facilities as required under the Plant Scherer Purchase and Ownership Agreement to adjust its ownership in the Scherer units. Oglethorpe realized a gain on the sale of $50,600,000. The REA and Oglethorpe's Board of Directors approved a plan whereby this gain was deferred and is being amortized over 60 months beginning in October 1989. Oglethorpe's proportionate share of direct expenses of joint operation of the above plants is included in the corresponding operating expense captions (e.g., fuel, production or depreciation) on the accompanying statements of revenues and expenses. 7. INVENTORIES: Oglethorpe maintains inventories of fossil fuels for its generation plant and spare parts for certain of its generation and transmission plant. These inventories are stated at weighted average cost on the accompanying balance sheets. For its co-owned generating plants, Oglethorpe accounts for inventories on the basis of information furnished by its operating agent, GPC. GPC has historically accounted for spare parts at its generating plants on an expensed- as-purchased basis. Prior to the commercial operation of Vogtle Unit No. 1 in 1987, GPC established a spare parts inventory for that generating facility and used an expensed-as-consumed method of inventory accounting. Subsequently, the spare parts inventories at Plants Hatch, Wansley and Scherer were converted to an expensed-as-consumed method. In connection with these conversions, other income totaling $18,877,000 was recorded by Oglethorpe in 1988 and 1989. In 1992, GPC completed a study the objective of which was to determine the original accounting for spare parts inventory at all of its generating plants, including Plants Hatch, Wansley and Scherer. As a result of this study, Oglethorpe recorded an adjustment of $4,827,000 to the original conversion which reduced other income and plant investment. A detail of Oglethorpe's investment in inventories at December 31, 1993 and 1992 is as follows: 8. EMPLOYEE BENEFIT PLANS: Oglethorpe has a noncontributory defined benefit pension plan covering substantially all employees. Oglethorpe's pension cost was approximately $1,038,000 in 1993, $362,000 in 1992 and $1,113,000 in 1991. For 1992, pension cost was reduced by $539,000 by a net gain from a plan curtailment. The plan curtailment resulted from a workforce reduction undertaken in the second quarter of 1992. Plan benefits are based on years of service and the employee's compensation during the last ten years of employment. Oglethorpe's funding policy is to contribute annually an amount not less than the minimum required by the Internal Revenue Code and not more than the maximum tax deductible amount. The plan's funded status and pension cost recognized in Oglethorpe's financial statements as of December 31, 1993 and 1992 were as follows: The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations shown above were 7.5% and 5.0% in 1993, and 8.5% and 5.5% in 1992, respectively. The expected long-term rate of return on plan assets was 8% in 1993 and 1992, and the discount rate used in determining the pension expense was 8.5% in 1993 and 1992. Oglethorpe has a contributory employee thrift plan covering substantially all employees. Employee contributions to the plan may be invested in one or more of three funds. The employee may contribute up to 10% of his compensation. Oglethorpe will match the employee's contribution up to one-half of the first 6% of the employee's compensation, as long as there is sufficient net margin to do so. Oglethorpe's contributions to the plan were approximately $503,000 in 1993, $503,000 in 1992 and $491,000 in 1991. In December 1990, the FASB issued Statement No. 106 on postretirement benefits other than pensions. The new statement requires the accrual of the expected cost of such benefits during the employees' years of service. Oglethorpe has no postretirement benefits other than pensions available to retirees. 9. NUCLEAR INSURANCE: GPC, on behalf of all the co-owners of Plants Hatch and Vogtle, is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance coverage in an amount up to $500,000,000 for members' nuclear generating facilities. In the event that losses exceed accumulated reserve funds, the members are subject to retroactive assessments (in proportion to their participation in the mutual insurer). The portion of the current maximum assessment for GPC that would be payable by Oglethorpe, based on ownership share adjusted for sell-back, is limited to approximately $8,600,000 for each nuclear incident. GPC, on behalf of all the co-owners of Plants Hatch and Vogtle, is also a member of Nuclear Electric Insurance Limited (NEIL), a mutual insurer, and has coverage with American Nuclear Insurers and Mutual Atomic Energy Liability Underwriters, which provide insurance to cover decontamination, debris removal and premature decommissioning as well as excess property damage to nuclear generating facilities of up to $2,250,000,000 for losses in excess of the $500,000,000 NML coverage described above. Under the NEIL policy, members are subject to retroactive assessments in proportion to their participation if losses exceed the accumulated funds available to the insurer under the policy. The portion of the current maximum assessment for GPC that would be payable by Oglethorpe, based on ownership share adjusted for sell-back, is limited to approximately $8,000,000 for each nuclear incident. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or annually renewed on or after April 2, 1991 shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are next to be applied toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Price-Anderson Act, as amended in 1988, limits public liability claims that could arise from a single nuclear incident to $9,400,000,000, which amount is to be covered by private insurance and agreements of indemnity with the NRC. Such private insurance (in the amount of $200,000,000 for each plant, the maximum amount currently available) is carried by GPC for the benefit of all the co-owners of Plants Hatch and Vogtle. Agreements of indemnity have been entered into by and between each of the co-owners and the NRC. In the event of a nuclear incident involving any commercial nuclear facility in the country involving total public liability in excess of $200,000,000, a licensee of a nuclear power plant could be assessed a deferred premium of up to $79,275,000 per incident for each licensed reactor operated by it, but not more than $10,000,000 per reactor per incident to be paid in a calendar year. On the basis of its sell-back adjusted ownership interest in four nuclear reactors, Oglethorpe could be assessed a maximum of $89,320,000 per incident, but not more than $11,270,000 in any one year. Oglethorpe participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Oglethorpe could be subject to a total maximum assessment of $3,750,000. 10. POWER PURCHASE AGREEMENTS: Oglethorpe has entered into long-term power purchase agreements with GPC, Big Rivers Electric Corporation (Big Rivers), and Entergy Power, Inc. (EPI). Under the agreement with GPC, Oglethorpe will purchase on a take-or-pay basis 1,250 megawatts (MW) of capacity through the period ending December 31, 2001, subject to reductions or extension with proper notice. The Big Rivers agreement commenced in August 1992 and is effective through July 2002. Oglethorpe is obligated under this agreement to purchase on a take-or-pay basis 100 MW of firm capacity and certain minimum energy amounts associated with that capacity. The EPI agreement commenced in July 1992, has a term of ten years and represents a take-or-pay commitment by Oglethorpe to purchase 100 MW of capacity. The EPI contract is subject to approval by REA. Oglethorpe has a contract with Hartwell Energy Limited Partnership (Hartwell), a partnership 50% owned by Destec Energy, Inc. and 50% owned by American National Power, Inc., a subsidiary of National Power, PLC, for the purchase of approximately 300 MW of capacity from two 150 MW gas-fired turbine generating units, now under construction, for a 25-year period commencing no later than June 1994. Under the terms of this contract, Oglethorpe does not have responsibility for constructing or financing this project. As of December 31, 1993, Oglethorpe's minimum purchase commitments under the above agreements, without regard to capacity reductions or adjustments for changes in costs, for the next five years are as follows: Oglethorpe's power purchases from these agreements amounted to approximately $192,059,000 in 1993, $192,321,000 in 1992 and $88,500,000 in 1991. 11. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: Oglethorpe's business is influenced by seasonal weather conditions. The negative net margin for the fourth quarter of 1993 was attributable to the deferral of excess margins and to the incurrence of certain non-recurring expenses. The negative net margin for the same period of 1992 was primarily due to the deferral of excess margins. For a discussion of the amounts of excess margins deferred see Note 1. REPORT OF MANAGEMENT The management of Oglethorpe Power Corporation has prepared this report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgements of management. Financial information throughout this annual report is consistent with the financial statements. Oglethorpe maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions. Limitations exist in any system of internal control based upon the recognition that the cost of the system should not exceed its benefits. Oglethorpe believes that its system of internal accounting control, together with the internal auditing function, maintains appropriate cost/benefit relations. Oglethorpe's system of internal controls is evaluated on an ongoing basis by its qualified internal audit staff. The Corporation's independent public accountants (Arthur Andersen & Co.) also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. Arthur Andersen & Co. also provides an objective assessment of how well management meets its responsibility for fair financial reporting. Management believes that its policies and procedures provide reasonable assurance that Oglethorpe's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flow of Oglethorpe Power Corporation. /s/T.D. Kilgore T.D. Kilgore President and Chief Executive Officer /s/Eugen Heckl Eugen Heckl Senior Vice President and Chief Financial Officer REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Oglethorpe Power Corporation: We have audited the accompanying balance sheets and statements of capitalization of Oglethorpe Power Corporation (a Georgia corporation) as of December 31, 1993 and 1992 and the related statements of revenues and expenses, patronage 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 Oglethorpe'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 standard require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit included 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 (pages 33 through 47) referred to above present fairly, in all material respects, the financial position of Oglethorpe Power Corporation 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. As explained in Note 1 of notes to financial statements, effective January 1, 1993, Oglethorpe Power 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 schedules listed in the index in Item 14 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. /s/Arthur Andersen & Co. Arthur Andersen & Co. Atlanta Georgia, February 11, 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 (a) IDENTIFICATION OF DIRECTORS: Oglethorpe is governed by a Board of 39 Directors, 13 of whom are elected each year for a three-year term. Each of the 39 Members nominates one Director who must also be on the Member's Board of Directors. The Directors are then elected by the Members at their annual meeting. The Members also elect Alternate Directors. Each Alternate Director must serve as the manager of a Member to be eligible to serve as an Alternate Director. Under Oglethorpe's Bylaws, Alternate Directors may attend all Board meetings, but can be counted for quorum purposes and can exercise the powers and duties of a Director only during the period when the directorship for whom he is the alternate is vacant or at any meeting of the Board of Directors when the Director for whom he is the alternate is absent. The Board of Directors generally meets monthly. Six standing committees are appointed by the Chairman of the Board and include both Directors and Alternate Directors. Two of these Committees, the External Affairs Committee and the Human Resources Management Committee, are joint committees of Oglethorpe and Georgia Electric Membership Corporation ("GEMC"), an affiliated trade organization, and include directors of GEMC. Special committees, as deemed necessary, are also appointed by the Chairman of the Board or the Board of Directors. Committee recommendations and management recommendations, subject to the approval of the Board of Directors, determine the policies and activities of Oglethorpe. The Directors and Alternate Directors of Oglethorpe are as follows: ALTAMAHA EMC Jmon Warnock--Director, age 68, is a farmer. He has served on the Board of Directors of Oglethorpe since September 1974. His present term as a Director will expire in March 1995. He is a member of the Finance Committee of Oglethorpe. Mr. Warnock is the President of Altamaha EMC and a Director of GEMC. James D. Musgrove--Alternate Director, age 47, is the General Manager of Altamaha EMC. He has served as an Alternate Director of Oglethorpe since May 1989, with his present term to expire in March 1995. Mr. Musgrove is a Director of Montgomery County Bankshares in Ailey, Georgia. AMICALOLA EMC Charles R. Fendley--Director, age 48, is a Vice-President of Jasper Yarn Processing, Inc., which processes yarn. He has served on the Board of Directors of Oglethorpe since November 1993, with his present term to expire in March 1995. Mr. Fendley is the President of Amicalola EMC. He is also a Director of GEMC and a Director of Crescent Bank & Trust Co. in Jasper, Georgia. John S. Dean, Sr.--Alternate Director. For a description of Mr. Dean's background and experience, see "Identification of Executive Officers and Senior Executives" below. CANOOCHEE EMC George C. Martin--Director, age 76, is the owner and operator of a farm in Ellabell, Bryan County, Georgia where he raises beef cattle. He also manages timberland in Bryan County, Georgia and rental properties in Savannah and Pembroke, Georgia. He has served on the Board of Directors of Oglethorpe since March 1977, with his present term to expire in March 1995. From March 1978 to March 1984, he served as Vice President of Oglethorpe. Donald F. Kennedy--Alternate Director, age 64, is the General Manager of Canoochee EMC. He has served as an Alternate Director of Oglethorpe since 1985, with his present term to expire in March 1995. He is a member of the GEMC/Oglethorpe External Affairs Committee. Mr. Kennedy is also a Director of the Tattnall Bank in Reidsville, Georgia. CARROLL EMC J. G. McCalmon--Director, age 76, is the owner of a farm in Carrollton, Georgia, where he raises chickens and beef cattle. He has served on the Board of Directors of Oglethorpe since September 1974, with his present term to expire in March 1996. He is Chairman of the Board of Carroll EMC. Mr. McCalmon is also a Director of GEMC, a Director of the Farm Bureau, a Director of Carroll County Sales Barn, and a Director of the Carroll County Chamber of Commerce. Gary M. Bullock--Alternate Director, age 52, is President and Chief Executive Officer of Carroll EMC. He has served as an Alternate Director of Oglethorpe since June 1978, and his present term will expire in March 1996. He is a member of the Operations Committee. Mr. Bullock is also the Secretary of Southeastern Data Cooperative, Inc., a member of the Institute of Electrical and Electronic Engineers, a Trustee for the GEMC Workers' Compensation Fund, a Director for the Georgia Council of Farmer Cooperatives, a Director of the Carroll County Chamber of Commerce, and a Director of Carrollton Federal Savings & Loan Association in Carrollton, Georgia. CENTRAL GEORGIA EMC D. A. Robinson, III--Director, age 53, is the owner and operator of a dairy farm in Griffin, Georgia. He has served on the Board of Directors of Oglethorpe since March 1984, and his term will expire in March 1995. He serves as Secretary-Treasurer of Central Georgia EMC. George L. Weaver--Alternate Director, age 46, has been the President of Central Georgia EMC since 1989. Prior to that time he was General Manager, Manager of Accounting, and Financial Manager. He has served as an Alternate Director of Oglethorpe since 1983, and his present term will expire in March 1995. He is a member of the Operations Committee. He is also a Director of Federated Rural Electric Insurance Corporation in Shawnee Mission, Kansas and serves on the Advisory Board of NationsBank of GA, N.A. COASTAL EMC James E. Estes--Director, age 58, has served on the Board of Directors of Oglethorpe since March 1982, with his present term to expire in March 1994. He is a member of the Executive Committee. He is also Vice President of the Board of Directors of Coastal EMC. Additionally, he works in avionic maintenance for Georgia Air National Guard, is President of Ways Company, Inc., a real estate development company in Richmond Hill, Georgia, and is a proprietor of Estes Tax Service, an income tax service in Richmond Hill, Georgia. Wayne Collins--Alternate Director, age 43, is the General Manager of Coastal EMC and has served as an Alternate Director of Oglethorpe since March 1977. His present term as an Alternate Director will expire in March 1994. COBB EMC Larry N. Chadwick--Director, age 53, is the owner of Chadwick's Hardware in Woodstock, Georgia. He has served on the Board of Directors of Oglethorpe since July 1989, with his present term to expire in March 1995. He is Chairman of the Board of Cobb EMC. He is Chairman of the Operations Committee. Dwight Brown--Alternate Director, age 48, is President and Chief Executive Officer of Cobb EMC. He previously served as Vice President of Engineering and Operations for Cobb EMC. He has served as an Alternate Director of Oglethorpe since October 1993, with his present term to expire in March 1995. COLQUITT EMC Simmie King--Director, age 50, is the owner and operator of a farm. He has served on the Board of Directors of Oglethorpe since March 1991, with his present term to expire in March 1996. R. L. Gaston--Alternate Director, age 46, is the General Manager of Colquitt EMC. From January 1985 to January 1990, he was Manager of Engineering and Operations for Colquitt EMC. He has served as an Alternate Director of Oglethorpe since February 1990, with his present term to expire in March 1996. He is currently a member of the Planning and Construction Committee. COWETA-FAYETTE EMC W. F. Farr--Director, age 81, is a banker. He has served on the Board of Directors of Oglethorpe since March 1975, with his present term to expire in March 1995. He is currently the Chairman of the GEMC/Oglethorpe Human Resources Management Committee. He has been President of Coweta-Fayette EMC since 1974. He previously served as President of the Fayette State Bank in Peachtree City, Georgia and as a Director and Consultant for Citizens and Southern National Bank, South Metro Board in Atlanta, Georgia. Since June 1985, he has been the owner and President of Pioneer Financial Associates, Inc. in Peachtree City, Georgia. Michael C. Whiteside--Alternate Director, age 51, has been General Manager of Coweta-Fayette EMC since August 1983. He previously served as Administrative Assistant of Coweta-Fayette EMC. He has served as an Alternate Director of Oglethorpe since September 1983, with his present term to expire in March 1995. He is currently a member of Oglethorpe's Planning and Construction Committee. EXCELSIOR EMC Vacant--Director Gary T. Drake--Alternate Director, age 45, is the General Manager of Excelsior EMC. He has served as an Alternate Director of Oglethorpe since January 1979, with his present term to expire in March 1994. He was Secretary-Treasurer of Oglethorpe from March 1984 through March 1989. He is currently a member of the Operations Committee. Mr. Drake is also a Director of GEMC and a Director of Pineland State Bank in Metter, Georgia. FLINT EMC Jeff S. Pierce, Jr.--Director, age 62, has served on the Board of Directors of Oglethorpe since June 1992, with his present term to expire in March 1994. He has served as a Director of Flint EMC since 1964. He previously served 28 years as Chief Executive Officer and as a Director for the First Federal Savings and Loan Association in Warner Robins, Georgia. He is also a Director of GEMC. Harold B. Smith--Alternate Director, age 57, has been employed as General Manager of Flint EMC since November 1978. He has served as an Alternate Director of Oglethorpe since 1978, with his present term to expire in March 1994. He is currently a member of the Planning and Construction Committee of Oglethorpe and Chairman of the GEMC/Oglethorpe External Affairs Committee. Mr. Smith is also the Chairman of the Board of the Food and Energy Council. GRADY EMC Donald C. Cooper--Director, age 63, is the owner, operator and President of Cooper Farms, Inc., a farm in Grady County, Georgia where he grows row crops and raises cattle. He has served on the Board of Directors of Oglethorpe since March 1975, with his present term to expire in March 1996. Thomas A. Rosser--Alternate Director, age 46, has been employed as General Manager of Grady EMC since January 1992. He has served as an Alternate Director of Oglethorpe since January 1992, with his present term to expire in March 1996. Mr. Rosser is also a Director of the Cairo Banking Company in Cairo, Georgia. GREYSTONE POWER CORPORATION, AN EMC J. Calvin Earwood--Director. For a description of Mr. Earwood's background and experience, see "Identification of Executive Officers and Senior Executives" below. Tim B. Clower--Alternate Director, age 57, is President and Chief Executive Officer of GreyStone Power Corporation, an EMC. He has served as an Alternate Director of Oglethorpe since September 1974, with his present term to expire in March 1995. Mr. Clower serves on the Boards of Directors of Citizens & Merchants State Bank and GEMC Workers' Compensation Fund. HABERSHAM EMC Herbert Church--Director, age 57, is a logging contractor. He has served on the Board of Directors of Oglethorpe since August 1991, with his present term to expire in March 1996. He has been a Director of Habersham EMC since 1977. William E. Canup--Alternate Director, age 58, is the General Manager of Habersham EMC. Mr. Canup was Manager of Engineering/Operations of Habersham EMC from 1979 to 1984 and served as Assistant Manager of Habersham EMC from 1984 to 1986. He has served as an Alternate Director of Oglethorpe since July 1986, with his present term to expire in March 1996. HART EMC Mac F. Oglesby--Director, age 61, served as Assistant Secretary-Treasurer of Hart EMC from July 1986 through December 1987, when he was appointed President. He has served as a Director of Oglethorpe since February 1987, with his present term to expire in March 1994. He is currently a member of the Planning and Construction Committee of Oglethorpe. He also was a U.S. Postal Service Rural Carrier for 30 years. Grooms Johnson--Alternate Director, age 64, has been the General Manager of Hart EMC since March 1991. Prior to that time, he served as Assistant Manager of Hart EMC. He has served as an Alternate Director of Oglethorpe since March 1991, with his present term to expire in March 1994. Mr. Johnson is also a Director of Bank of Hartwell in Hartwell, Georgia. IRWIN EMC Benny W. Denham--Director. For a description of Mr. Denham's background and experience, see "Identification of Executive Officers and Senior Executives" below. Harold Randall Crenshaw--Alternate Director, age 42, has been the General Manager of Irwin EMC since February 1988. He has served as an Alternate Director of Oglethorpe since February 1988, with his present term to expire in March 1995. He is a member and past Vice Chairman of the Finance Committee of Oglethorpe. JACKSON EMC E. L. McLocklin--Director, age 81, is a cattle farmer. He is also Chairman of the Board of Directors of Jackson EMC. He has served as a Director of Oglethorpe since October 1989, with his present term to expire in March 1996. Randall Pugh--Alternate Director, age 50, is President and Chief Executive Officer of Jackson EMC. From August 1984 to January 1988 he was General Manager of Jackson EMC. He was also General Manager of Walton EMC from 1977 to August 1984. He has served as an Alternate Director of Oglethorpe since 1977. His present term as Alternate Director will expire in March 1996. He is currently the Chairman of the Finance Committee. Mr. Pugh is also a Director of the First National Bank of Jackson County in Gainesville, Georgia. JEFFERSON EMC Sam Rabun--Director, age 62, is part owner of a livestock farm. He has served as a Director of Oglethorpe since March 1993 with his present term to expire in March 1996. Mr. Rabun is the President of Jefferson EMC. Ralph E. Lewis--Alternate Director, age 49, has been the General Manager of Jefferson EMC since 1979. He has served as an Alternate Director of Oglethorpe since 1979, with his present term to expire in March 1996. He is also Vice President of the GEMC Workers' Compensation Fund. LAMAR EMC E. J. Martin, Jr.--Director, age 66, is the owner of the Country Kitchen restaurant in Barnesville, Georgia. He is a retired tax assessor and appraiser for Lamar County. He has served on the Board of Directors of Oglethorpe since March 1982, with his present term to expire in March 1994. He is a member of the GEMC/Oglethorpe Human Resources Management Committee. Mr. Martin is the President of Lamar EMC and a Director of GEMC. J. Raleigh Henry--Alternate Director, age 43, is General Manager of Lamar EMC. Prior to becoming General Manager, he served as Office Manager of Lamar EMC. He has served as an Alternate Director of Oglethorpe since 1990, with his present term to expire in March 1994. LITTLE OCMULGEE EMC J. D. Williams--Director, age 81, is currently retired. He has served on the Board of Directors of Oglethorpe since March 1986, with his present term to expire in March 1994. He is a member of Oglethorpe's Planning and Construction Committee. He previously served as President, then as Vice President of Little Ocmulgee EMC. Mr. Williams is also a Director of Security State Bank in McRae, Georgia, and a Director of Farmers State Bank in Dublin, Georgia. A. Arnold Horton--Alternate Director, age 47, is the General Manager of Little Ocmulgee EMC. He previously served as Manager of Engineering and Operations, and has been with Little Ocmulgee EMC since 1983. He has served as the Alternate Director of Oglethorpe since March 1993, with his present term to expire in March 1994. MIDDLE GEORGIA EMC Ronnie Fleeman--Director, age 59, is a self-employed land and timber developer. He has served on the Board of Directors of Oglethorpe since 1990. His present term as a Director will expire in March 1995. He is a member of the GEMC/Oglethorpe Human Resources Management Committee. Charles Hugh Richardson--Alternate Director, age 40, has been General Manager of Middle Georgia EMC since June 1983. From January 1983 to June 1983, he was Acting General Manager of Middle Georgia EMC, and from September 1976 to January 1983, he was Manager of Engineering at Middle Georgia EMC. He has served as an Alternate Director of Oglethorpe since 1983, with his present term to expire in March 1995. MITCHELL EMC D. Lamar Cooper--Director, age 58, operates a dairy farm. He has served on the Board of Directors of Oglethorpe since September 1974. His present term as a Director will expire in March 1996. He is a member of the Operations Committee of Oglethorpe. Gerald Freehling--Alternate Director, age 50, has been General Manager of Mitchell EMC since September 1987. Since that time, he has served as an Alternate Director of Oglethorpe. His present term expires in March 1996. He previously served as General Manager of Steuben Rural Electric Cooperative in Bath, New York. OCMULGEE EMC Barry H. Martin--Director, age 45, is a farmer. He has served on the Board of Directors of Oglethorpe since March 1983. His present term as a Director expires in March 1994. Mr. Martin is the President of Ocmulgee EMC. Dennis Grenade--Alternate Director, age 53, has been employed by Ocmulgee EMC since December 1957. He has been General Manager since October 1987 and was previously Acting Manager and Manager of Operations. He has served as an Alternate Director since October 1987 and his present term expires in March 1994. He is a member of the Finance Committee. OCONEE EMC John B. Floyd, Jr.--Director, age 51, has served on the Board of Directors of Oglethorpe since March 1980, with his present term to expire in March 1996. He is currently a member of the Finance Committee. He is the Vice Chairman of the Board of Oconee EMC and is a Director of CFC. Mr. Floyd also serves as First Vice President of The Four County Bank, as Vice President of The Four County Insurance Agency, Inc., and as President of Twiggs Gin, Inc., a home construction company in Allentown, Georgia. Preston L. Johnson--Alternate Director, age 59, is President and Chief Executive Officer of Oconee EMC. He has served as an Alternate Director of Oglethorpe since September 1974, with his present term to expire in March 1996. He was Secretary-Treasurer of Oglethorpe from September 1974 to March 1984. OKEFENOKE RURAL EMC Steve Rawl, Sr.--Director, age 47, has been President of Rawls, Inc., a gift shop, since 1972. He has served as a Director of Oglethorpe since September 1993, with his present term to expire in March 1994. He is also a Director of GEMC. W. Don Holland--Alternate Director, age 43, is General Manager of Okefenoke Rural EMC. He has served as an Alternate Director of Oglethorpe since 1979, with his present term to expire in March 1994. He was formerly General Manager of Little Ocmulgee EMC. He is currently Chairman of the Planning and Construction Committee of Oglethorpe. PATAULA EMC James Grubbs--Director, age 71, is a farmer. He is involved with fertilizer and chemical sales, and operates an air spray service and a peanut purchasing plant. He has served on the Board of Directors of Oglethorpe since March 1983. His present term as a Director will expire in March 1996. He is a member of the Finance Committee of Oglethorpe. Gary W. Wyatt--Director, age 41, is General Manager of Pataula EMC. He has served as an Alternate Director of Oglethorpe since July 1986, with his present term to expire in March 1996. He previously was Operations Manager and Assistant Operations Superintendent of Coosa Valley Electric Cooperative. PLANTERS EMC Sammy M. Jenkins--Director, age 67, is in the farm machinery business and has been President of Jenkins Ford Tractor Co., Inc. since 1973. He has served on the Board of Directors of Oglethorpe since March 1988, with his present term to expire in March 1994. He is Vice President of Planters EMC. He was Vice Chairman of the Board of Oglethorpe from March 1989 to March 1990. Ellis H. Lovett--Alternate Director, age 58, is General Manager of Planters EMC and has served as an Alternate Director of Oglethorpe since 1983. His present term as an Alternate Director will expire in March 1994. He is a member of the Operations Committee of Oglethorpe. RAYLE EMC J. M. Sherrer--Director, age 58, is the owner of a grocery, hardware, gas and feed store. He has served on the Board of Directors of Oglethorpe since September 1993, with his present term to expire in March 1994. Wayne Poss--Alternate Director, age 48, has served as General Manager of Rayle EMC since December 1992. Prior to that time, he served as Manager of Engineering for Rayle EMC. He has served as an Alternate Director to Oglethorpe since February 1993, with his present term to expire in March 1994. He is a member of the GEMC/Oglethorpe External Affairs Committee. SATILLA RURAL EMC Jack D. Vickers--Director, age 76, is the owner and operator of a farm in Coffee County, Georgia. He has served on the Board of Directors of Oglethorpe since March 1975. His present term will expire in March 1994. R. Lehman Lanier--Alternate Director, age 74, is President and Chief Executive Officer of Satilla Rural EMC. He has served as an Alternate Director of Oglethorpe since September 1974, and his present term expires in March 1994. He is a member of the Operations Committee of Oglethorpe. He is also a Director of Southeastern Data Cooperative, Inc. SAWNEE EMC C. W. Cox, Jr.--Director, age 66, is the owner of Cox Digging & Grading, a general contracting sole proprietorship. He has served as a member of the Board of Directors of Oglethorpe since February 1987, with his present term to expire in March 1994. He is a member of the Planning and Construction Committee. Michael A. Goodroe--Alternate Director, age 37, is Executive Vice President and General Manager of Sawnee EMC. He previously served as Assistant General Manager of Sawnee EMC. He has served as an Alternate Director of Oglethorpe since 1990, with his present term to expire in March 1994. He is a member of the GEMC/Oglethorpe External Affairs Committee. SLASH PINE EMC Johnnie Crumbley--Director, age 71, is President of Slash Pine EMC. He retired in 1982 from the Seaboard Coastline System. He has served as a member of the Board of Directors of Oglethorpe since March 1978, with his present term to expire in March 1996. He is also a Director of GEMC. Edward Teston--Alternate Director, age 59, is Manager of Slash Pine EMC. He has served as an Alternate Director of Oglethorpe since 1985, with his present term to expire in March 1996. SNAPPING SHOALS EMC Jarnett W. Wigington--Director, age 61, is a self-employed wallpapering contractor. He has served on the Board of Directors of Oglethorpe since 1990. His present term expires in March 1994. He is a member of the Executive Committee of Oglethorpe. J. E. Robinson--Alternate Director, age 74, is President, Cheif Executive Officer and Manager of Snapping Shoals EMC. He has been Manager of Snapping Shoals EMC since 1953. He has served as an Alternate Director of Oglethorpe since September 1974, with his present term to expire in March 1994. Mr. Robinson is also a Director of the First National Bank of Newton County. SUMTER EMC Bob Jernigan--Director, age 66, is a manager for Mike L. Moon Enterprises in Columbus, Georgia, which among other things, is involved in real estate development and wholesale and retail women's apparel. He has served as a Director of Oglethorpe since March 1976, with his present term to expire in March 1996. He served as Vice Chairman of the Board of Directors of Oglethorpe from March 1990 to March 1993. He is currently a member of the Executive Committee. He is the President of Sumter EMC and a Director of GEMC. James T. McMillan--Alternate Director, age 44, has been General Manager of Sumter EMC since 1984. Prior to that time, he served as Manager of the Staff Services Department of Sumter EMC, Manager of the Construction and Maintenance Department of Sumter EMC, and Manager of the Office Services Department of Sumter EMC. He has served as an Alternate Director of Oglethorpe since 1984, with his present term to expire in March 1996. THREE NOTCH EMC C. Willard Mims--Director, age 47, is a farmer. He has served on the Board of Directors since 1991, with his present term to expire in March 1996. He is a member of the GEMC/Oglethorpe External Affairs Committee. He is also a Director of GEMC. Carlton O. Thomas--Alternate Director, age 46, has been General Manager of Three Notch EMC since 1990. Prior to that time, he served as Office Manager of Three Notch EMC. He has served as an Alternate Director of Oglethorpe since 1990, with his present term to expire in March 1996. He is also a Director of First Federal Savings Bank of Southwest Georgia. TRI-COUNTY EMC James E. Dooley--Director, age 67, is self-employed in the real estate business. He has served on the Board of Directors of Oglethorpe since November 1986, with his present term to expire in March 1996. Prior to his retirement in 1982, he was employed as a Director in the U.S. Department of Agriculture. Carol Robertson--Alternate Director, age 45, is the General Manager of Tri-County EMC. She has served as an Alternate Director of Oglethorpe since July 1988, with her present term to expire in March 1996. She is a member of the GEMC/Oglethorpe External Affairs Committee. TROUP EMC Willis T. Woodruff--Director, age 68, is a self-employed cattleman. He has served on the Board of Directors of Oglethorpe since March 1987, with his present term to expire in March 1995. He is also a Director of GEMC. Wayne Livingston--Alternate Director, age 42, has been the Executive Vice President and General Manager of Troup EMC since September 1987. Prior to that time, he was General Manager of Ocmulgee EMC. He has served as an Alternate Director of Oglethorpe since 1978, with his present term to expire in March 1995. He is a member of the Finance Committee. UPSON COUNTY EMC Hubert Hancock--Director, age 77, has been President of the Upson County EMC for the past 33 years. He has served as a Director of Oglethorpe since September 1974, serving as Vice President from 1975 to 1978, as President from March 1984 to July 1986, and as Chairman of the Board from July 1986 to March 1989. His present term as Director expires in March 1995, and he currently serves on the Executive Committee of Oglethorpe. Prior to his involvement with Oglethorpe and Upson County EMC, Mr. Hancock was a general farmer as well as a peach farmer and cattle farmer. Mr. Hancock is also a Director of West Central Georgia Bank in Thomaston, Georgia, Chairman of Upson County Hospital Authority, and a member of the Thomaston Upson County Industrial Authority. Walter E. Hammond--Alternate Director, age 62, is General Manager of Upson County EMC. He has served as an Alternate Director of Oglethorpe since 1978, and his present term will expire in March 1995. WALTON EMC Bob J. Dickens--Director, age 67, retired in 1988 from Thornton Brothers Paper Company, Inc. in Athens, Georgia. He has served on the Board of Directors of Oglethorpe since March 1987, and his present term expires in March 1995. He is a member of Oglethorpe's Operations Committee. D. Ronnie Lee--Alternate Director, age 45, has been General Manager of Walton EMC since August 1993. Prior to that time, he served as Manager of Engineering and Operations from January 1979 to August 1993 for Walton EMC. He has served as an Alternate Director of Oglethorpe since September 1993, with his present term to expire in March 1995. WASHINGTON EMC W. W. Archer--Director, age 62, is a self-employed insurance agent and cattle farmer. He has served on Oglethorpe's Board of Directors since September 1987, and his present term expires in March 1995. He is also a Director of the Bank of Hancock County in Sparta, Georgia. Robert S. Moore, Sr.--Alternate Director, age 64, has been General Manager of Washington EMC since April 1982. Prior to that time, he was Assistant General Manager of Washington EMC. He has served as an Alternate Director of Oglethorpe since 1982, with his present term to expire in March 1995. He is a member of the Planning and Construction Committee of Oglethorpe. (b) IDENTIFICATION OF EXECUTIVE OFFICERS AND SENIOR EXECUTIVES: Oglethorpe is managed and operated under the direction of a President and Chief Executive Officer, who is appointed by the Board of Directors. The executive officers of Oglethorpe and their principal occupations are as follows: J. Calvin Earwood, Chairman of the Board, age 52, has served as a principal executive officer of Oglethorpe since March 1984 (from March 1984 to July 1986, as Vice President; from July 1986 to March 1989, as Vice Chairman of the Board; and since March 1989, as Chairman of the Board). Mr. Earwood has served as a Director of Oglethorpe since March 1981, with his present term to expire in March 1995. He is currently the Chairman of the Executive Committee of Oglethorpe and a member of the GEMC/Oglethorpe Human Resources Management Committee. He was previously a member of the Operations Review Committee of Oglethorpe. From 1965 through 1982, Mr. Earwood was a salesman and part owner of Builders Equipment Company. Since January 1983 he has been the owner and President of Sunbelt Fasteners, Inc., which sells specialty tools and fasteners to the commercial construction trade. He is also Chairman of the Board of Directors of Community Trust Bank in Hiram, Georgia and a Director of GreyStone Power Corporation. Benny W. Denham--Vice Chairman of the Board, age 63, has served as a principal executive officer of Oglethorpe since March 1993. He has served as a member of Oglethorpe's Executive Committee and on the Board of Directors of Oglethorpe since December 1988. His present term will expire in March 1995. He was previously a member of the Power Planning and Technical Advisory Committee of Oglethorpe. He is also the past President of GEMC and currently serves on GEMC's Executive Committee and is a Director of Community National Bank in Ashland, Georgia. Mr. Denham is a Director of Irwin EMC. John S. Dean, Sr., Secretary-Treasurer, age 54, has served as Secretary-Treasurer of Oglethorpe since March 1989. He has served as an Alternate Director of Oglethorpe since 1975, with his present term to expire in March 1995. He is currently a member of the Finance Committee and an ex officio member of the Executive Committee. He previously served on Oglethorpe's Operations Review Committee. Mr. Dean has been General Manager/Chief Executive Officer of Amicalola EMC since 1974. Prior to his employment with Amicalola EMC, he was Controller of Pickens General Hospital. Currently, he is on the Board of Directors of Southeastern Data Cooperative, Inc., Crescent Bank & Trust Company, CoBank, and GEMC Workers' Compensation Fund. Mr. Dean has a Bachelor of Arts degree in Accounting from the University of Georgia. T. D. Kilgore, President and Chief Executive Officer, age 46, has served as an executive of Oglethorpe since July 1984 (from July 1984 to July 1986, as Division Manager, Power Supply; July 1986 to July 1991, as Senior Vice President, Power Supply; and since July 1991, as President and Chief Executive Officer). Mr. Kilgore served as Executive Vice President of GEMC from December 1991 to June 1992. He has served as President and Chief Executive Officer of GEMC from June 1992 until the present. Mr. Kilgore has over 20 years of utility experience, including five years in senior management positions with Arkansas Power & Light Co. and seven years as a civilian employee with the Department of the Army in positions ranging from reliability engineering to construction management. Mr. Kilgore has served on various industry committees including Electric Power Research Institute's Board of Directors and its Advanced Power Systems Division and Coal System Division Advisory Committees. He has also served on the Boards of Directors of the U.S. Committee for Energy Awareness, the Advanced Reactor Corporation, on the Edison Electric Institute's Power Plant Availability Improvement Task Force and the Nuclear Power Oversight Committee, an organization of industry executives which considers policy issues for the nation's nuclear power industry. Mr. Kilgore currently serves on the Board of Directors of the Georgia Chamber of Commerce and on the National Rural Electric Cooperative Association's Power and Generation Committee. Mr. Kilgore has a BS degree in mechanical engineering from the University of Alabama, where he has been recognized as a Distinguished Engineering Fellow, and a ME degree in industrial engineering from Texas A&M. The senior executives assisting Mr. Kilgore, their areas of responsibility and a brief summary of their experience are as follows: Charles T. Autry, Senior Vice President and General Counsel, age 45, has served as an executive of Oglethorpe since February 1986 (from February 1986 to July 1986, as Corporate Counsel; from July 1986 to December 1989, as General Counsel; from December 1989 to November 1991, as Senior Vice President, Governmental Affairs and General Counsel; from November 1991 to February 1994, as Senior Vice President, Corporate Services and General Counsel; and since February 1994, as Senior Vice President and General Counsel). Prior to that time, Mr. Autry served as Staff Attorney from August 1979 to January 1985 and as Corporate Attorney from January 1985 to February 1986. Mr. Autry joined Oglethorpe in August 1979 after five years of military and private practice experience. He has been admitted to practice before all State Courts in Georgia as well as the Federal District Court for the Northern District of Georgia, and the Fifth and Eleventh Circuit Courts of Appeal and the U. S. Tax Court. He has a BA degree from the University of Georgia, a JD degree from the University of Alabama School of Law, a LLM degree in Taxation from Emory University School of Law, and an MBA degree from Georgia State University. Eugen Heckl, Senior Vice President and Chief Financial Officer, age 59, has served as an executive of Oglethorpe since March 1975 (from March 1975 to July 1986, as senior finance and accounting executive; from July 1986 to February 1994 as Senior Vice President, Finance; and since February 1994, as Senior Vice President and Chief Financial Officer). Mr. Heckl has approximately 30 years of experience, including ten years as a consultant and auditor to electric utilities with Arthur Andersen & Co. and two years as Secretary-Treasurer of Davis Brothers, Inc. Mr. Heckl is a Certified Public Accountant in Georgia and has a BS degree in accounting from Samford University and an MBA degree from Emory University. Mr. Heckl has served as a Director of the GEMC Federal Credit Union since 1983, and as its Chief Financial Officer since 1984. G. Stanley Hill, Senior Vice President, External Affairs, age 58, has served as an executive of Oglethorpe since October 1975 (from October 1975 to November 1988, as Director of Planning, Director of Power Supply and Planning, Division Manager, Power Supply and Engineering, Division Manager, Engineering, Senior Vice President, Planning and System Operations; from November 1988 to November 1991, as Senior Vice President, Administration; from November 1991 to February 1994, as Senior Vice President, Marketing and Customer Service and since February 1994, as Senior Vice President, External Affairs). Mr. Hill has approximately 36 years experience with electric utilities, including four years in the Engineering Department of the South Carolina Public Service Authority and 11 years as engineer and senior engineer with Southern Engineering Company of Georgia, a consulting engineering firm. Mr. Hill is a registered Professional Engineer and a certified Cogeneration Professional in Georgia and has a BS degree in electrical engineering from Clemson University and an MBA degree from Georgia State University. Mr. Hill is presently an Oglethorpe representative on the Joint Committee. For information about the Joint Committee, see "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS-The Joint Committee Agreement" in Item 1. W. Clayton Robbins, Senior Vice President and Group Executive, Support Services, age 47, has served as an executive of Oglethorpe since December 1991 (from December 1991 to February 1994, as Vice President, Corporate Performance, and since February 1994, as Senior Vice President and Group Executive, Support Services). Prior to that time, Mr. Robbins served as Department Manager, Project Services, from September 1986 to November 1988; as Program Director, Marketing Research and Analysis, from November 1988 to December 1989; and as Vice President, Marketing Research and Analysis, from December 1989 to December 1991. Before coming to Oglethorpe, Mr. Robbins spent 17 years with the Stearns-Catalytic World Corporation and various subsidiaries, including 13 years in management positions responsible for Human Resources, Information Systems, Contracts, Insurance, Accounting, and Project Controls. Mr. Robbins has a BA degree in Business Administration from the University of North Carolina at Charlotte. David L. Self, Senior Vice President and Group Executive, Generation, age 65, has served as an executive of Oglethorpe since August 1991 (from August 1991 to November 1991, as Senior Vice President, Power Supply; from November 1991 to February 1994, Senior Vice President, Operations; and since February 1994, as Senior Vice President and Group Executive, Generation). Mr. Self joined Oglethorpe in February 1988 as the corporation's on-site representative at Plant Hatch after 30 years in the United States Navy and five years with Illinois Power Company. He is a member of the Board of Trustees of Southern Tech Foundation, Inc. He has a BS degree from Saint Mary's College in California. Mr. Self is presently the Oglethorpe representative on both the Nuclear Managing Board and the Plant Scherer Managing Board, and is an Oglethorpe representative on the Joint Committee. For information about the Managing Boards and the Joint Committee, see "CO-OWNERS OF THE PLANTS AND THE PLANT AND TRANSMISSION AGREEMENTS-The Plant Agreements" and "-The Joint Committee Agreement" in Item 1. Nelson G. Hawk, Vice President and Group Executive, Marketing, age 44, joined Oglethorpe in February 1994 after almost 24 years of electric utility experience. Prior to coming to Oglethorpe, he held various management positions with Florida Power & Light Company and related subsidiaries, including as Director of Regulatory Affairs at Florida Power & Light from October 1993 to January 1994; as Director of Market Planning from July 1991 to September 1993; and as Director of Strategic Business and President of FPL Enersys Services, Inc. (a utility subsidiary providing energy services to commercial/industrial customers) from April 1989 to June 1991. Mr. Hawk has a BS degree in Electrical Engineering from Georgia Institute of Technology and an MBA degree from Florida International University. Wylie H. Sanders, Vice President and Group Executive, Transmission, age 57, joined Oglethorpe in January 1994 after 35 years of utility experience, including 20 years in management positions with Florida Power & Light Company. Prior to coming to Oglethorpe, he served as Division Commercial Manager from April 1973 to August 1983; as District General Manager from August 1983 to July 1991; and as Director of Transmission from July 1991 to September 1993 with Florida Power & Light. Mr. Sanders has a Bachelor's degree in Industrial Engineering from Georgia Institute of Technology and has participated in Harvard University's postgraduate Program for Management Development. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION SUMMARY COMPENSATION TABLE The following table sets forth for Oglethorpe's President and Chief Executive Officer and the four most highly compensated senior executives all compensation paid or accrued for services rendered in all capacities during the years ended December 31, 1993, 1992 and 1991. Amounts included in the table under "Bonus" represent payments based on an incentive compensation policy. All amounts paid under this policy are fully at risk each year and are earned based upon the achievement of corporate goals and each individual's contribution to achieving those goals. In conjunction with this policy, base salaries remain fairly stable and are targeted below the market valuations for similar positions. PENSION PLAN TABLE The preceding table shows estimated annual straight life annuity benefits payable upon retirement to persons in specified compensation and years-of-service classifications assuming such persons had attained age 65 and retired during 1993. For purposes of calculating pension benefits, compensation is defined as total salary and bonus, as shown in the above Summary Compensation Table. Because covered compensation changes each year, the estimated pension benefits for the classifications above will also change in future years. The above pension benefits are not subject to any deduction for Social Security or other offset amounts. As of December 31, 1993, the years of credited service under the Pension Plan for the individuals listed in the Summary Compensation Table are as follows: COMPENSATION OF DIRECTORS Oglethorpe pays its Directors a per diem fee of $200 for meetings attended or $50 for meetings conducted by conference call. Additionally, Oglethorpe reimburses its Directors for out-of-pocket expenses incurred in attending a meeting. Alternate Directors serving as a Director at any meeting receive neither the per diem payment nor the expense reimbursement to which a Director is entitled. The Member of which the Alternate Director is the manager receives reimbursement for the Alternate Director's out-of-pocket expenses. The Chairman of the Board is also paid at least one day's per diem of $200 each month for time involved in carrying out his official duties in addition to the regularly scheduled Board Meeting. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION W. F. Farr, J. Calvin Earwood, Ronnie Fleeman, E. J. Martin, Jr. and Robert A. Reeves serve as members of the GEMC/Oglethorpe Human Resources Management Committee which functions as Oglethorpe's compensation committee. J. Calvin Earwood has served as an executive officer of Oglethorpe since 1984 and has served as the Chairman of the Board since 1989. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Not applicable. 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 PAGE ---- (a) LIST OF DOCUMENTS FILED AS A PART OF THIS REPORT. (1) FINANCIAL STATEMENTS (Included under "Item 8. Financial Statements and Supplementary Data") Statements of Revenues and Expenses, For the Years Ended December 31, 1993, 1992 and 1991. . . . . . . . . . 33 Statements of Patronage Capital, For the Years Ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . . 33 Balance Sheets, As of December 31, 1993 and 1992 . . . . . 34 Statements of Capitalization, As of December 31, 1993 and 1992. . . . . . . . . . . . . . . . . . . . . . . . . 36 Statements of Cash Flows, For the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . 37 Notes to Financial Statements. . . . . . . . . . . . . . . 38 Report of Management . . . . . . . . . . . . . . . . . . . 48 Report of Independent Public Accountants . . . . . . . . . 48 (2) FINANCIAL STATEMENT SCHEDULES Schedule I -- Marketable Securities--Other Security Investments, As of December 31, 1993 78 Schedule V -- Utility Plant, Including Intangibles, For the Years Ended December 31, 1993, 1992 and 1991 79 Schedule VI -- Accumulated Provision for Depreciation of Utility Plant, For the Years Ended December 31, 1993, 1992 and 1991 82 Schedule X -- Supplementary Income Statement Information, For the Years Ended December 31, 1993, 1992 and 1991 85 (3) EXHIBITS NUMBER DESCRIPTION - ------ ----------- *3(i) -- Restated Articles of Incorporation of Oglethorpe, dated as of July 26, 1988. (Filed as Exhibit 3.1 to the Registrant's Form 10-K for the fiscal year ended December 31, 1988, File No. 33-7591.) *3(ii) -- Bylaws of Oglethorpe as amended November 8, 1993. (Filed as Exhibit 3.2 to the Registrant's Form 10-Q for the quarterly period ended September 30, 1993, File No. 33- 7591.) *4.1 -- Serial Facility Bond (included in Collateral Trust Indenture listed as Exhibit 4.2). *4.2 -- Collateral Trust Indenture, dated as of October 15, 1986, between OPC Scherer Funding Corporation, Oglethorpe and Trust Company Bank, a banking corporation, as Trustee. (Filed NUMBER DESCRIPTION - ------ ----------- as Exhibit 4.2 to the Registrant's Form S-1 Registration Statement, File No. 33- 7591, filed on October 9, 1986.) *4.3 -- Refunding Lessor Notes. (Filed as Exhibit 4.3.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.4(a) -- Nonrecourse Promissory Secured Note, due June 30, 2011, from Wilmington Trust Company and William J. Wade, as Owner Trustees, to Columbia Bank for Cooperatives. (Filed as Exhibit 4.3.4 to the Registrant's Form S-1 Registration Statement, File No. 33- 7591, filed on October 9, 1986.) *4.4(b) -- First Amendment to Nonrecourse Promissory Secured Note, dated as of June 30, 1987, by Wilmington Trust Company and The Citizens and Southern National Bank, as Owner Trustee under Trust Agreement No. 1 with IBM Credit Financing Corporation, to Columbia Bank for Cooperatives. (Filed as Exhibit 4.3.4(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1987, File No. 33-7591.) *4.5(a) -- Indenture of Trust, Deed to Secure Debt and Security Agreement No. 2, dated December 30, 1985, between Wilmington Trust Company and William J. Wade, as Owner Trustees under Trust Agreement No. 2 dated December 30, 1985, with Ford Motor Credit Company and The First National Bank of Atlanta, as Indenture Trustee, together with a Schedule identifying three other substantially identical Indentures of Trust, Deeds to Secure Debt and Security Agreements. (Filed as Exhibit 4.4(b) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.5(b) -- First Supplemental Indenture of Trust, Deed to Secure Debt and Security Agreement No. 2 (included as Exhibit A to the Supplemental Participation Agreement No. 2 listed as 10.1.1(b)). *4.5(c) -- First Supplemental Indenture of Trust, Deed to Secure Debt and Security Agreement No. 1, dated as of June 30, 1987, between Wilmington Trust Company and The Citizens and Southern National Bank, collectively as Owner Trustee under Trust Agreement No. 1 with IBM Credit Financing Corporation, and The First National Bank of Atlanta, as Indenture Trustee. (Filed as Exhibit 4.4(c) to the Registrant's Form 10-K for the fiscal year ended December 31, 1987, File No. 33-7591.) *4.6(a) -- Lease Agreement No. 2 dated December 30, 1985, between Wilmington Trust Company and William J. Wade, as Owner Trustees under Trust Agreement No. 2, dated December 30, 1985, with Ford Motor Credit Company, Lessor, and Oglethorpe, Lessee, with a Schedule identifying three other substantially identical Lease Agreements. (Filed as Exhibit 4.5(b) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.6(b) -- First Supplement To Lease Agreement No. 2 (included as Exhibit B to the Supplemental Participation Agreement No. 2 listed as 10.1.1(b)). *4.6(c) -- First Supplement to Lease Agreement No. 1, dated as of June 30, 1987, between The Citizens and Southern National Bank as Owner Trustee under Trust Agreement No. 1 with IBM Credit Financing Corporation, as Lessor, and Oglethorpe, as Lessee. (Filed as Exhibit 4.5(c) to the Registrant's Form 10-K for the fiscal year ended December 31, 1987, File No. 33-7591.) NUMBER DESCRIPTION - ------ ----------- *4.7(a) -- Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America, as amended and supplemented, together with eleven notes executed and delivered pursuant thereto. (Filed as Exhibit 4.6 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.7(b) -- Amendments, dated October 17, 1986, and January 9, 1987, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1986, File No. 33-7591.) *4.7(c) -- Amendment, dated September 30, 1988, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(b) to the Registrant's Form 10-K for the fiscal year ended December 31, 1988, File No. 33-7591.) *4.7(d) -- Amendment, dated March 20, 1990, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(c) to the Registrant's Form 10-K for the fiscal year ended December 31, 1989, File No. 33-7591.) *4.7(e) -- Amendment, dated July 1, 1991, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(d) to the Registrant's Form 10-K for the fiscal year ended December 31, 1991, File No. 33-7591.) *4.7(f) -- Amendment, dated April 6, 1992, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(e) to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591.) *4.7(g) -- Amendment, dated June 12, 1992, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(f) to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591.) *4.7(h) -- Amendment, dated October 20, 1992, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(g) to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591.) *4.7(i) -- Amendment, dated February 25, 1993, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. (Filed as Exhibit 4.6(h) to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591.) 4.7(j) -- Amendment, dated August 26, 1993, to Amended and Consolidated Loan Contract dated as of June 1, 1984 between Oglethorpe and the United States of America. NUMBER DESCRIPTION - ------ ----------- *4.8.1(a) -- Mortgage and Security Agreement made by Oglethorpe to United States of America dated as of January 8, 1975. (Filed as Exhibit 4.12(b) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.1(b) -- Supplemental Mortgage made by Oglethorpe to United States of America dated as of January 6, 1977. (Filed as Exhibit 4.12(a) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.2(a) -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of November 1, 1978. (Filed as Exhibit 4.11(c) to the Registrant's Form S-1 Registration Statement, File No. 33- 7591, filed on October 9, 1986.) *4.8.2(b) -- Confirmation of Execution And Delivery of Notes And First Amendment to Consolidated Mortgage and Security Agreement, dated as of January 11, 1979. (Filed as Exhibit 4.11(b) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.2(c) -- Supplement and Second Amendment to Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America and Trust Company Bank, as Trustee, Mortgagees, dated April 30, 1980. (Filed as Exhibit 4.11(a) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.3 -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of September 15, 1982. (Filed as Exhibit 4.10 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.4 -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, Columbia Bank for Cooperatives, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of June 1, 1984. (Filed as Exhibit 4.9 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.5 -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, Columbia Bank for Cooperatives, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of December 1, 1984. (Filed as Exhibit 4.8 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.6(a) -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, Columbia Bank for Cooperatives, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of October 15, 1985. (Filed as Exhibit 4.7 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.8.6(b) -- First Supplement and Amendment to Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, Columbia Bank for NUMBER DESCRIPTION - ------ ----------- Cooperatives, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of November 1, 1988. (Filed as Exhibit 4.7(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1988, File No. 33- 7591.) *4.8.7(a) -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, National Bank for Cooperatives, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of December 1, 1989. (Filed as Exhibit 4.19 to the Registrant's Form 10-K for the fiscal year ended December 31, 1989, File No. 33-7591.) *4.8.7(b) -- Supplement to Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, National Bank for Cooperatives, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of November 20, 1990. (Filed as Exhibit 4.19(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) *4.8.8 -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, National Bank for Cooperatives, Credit Suisse, acting by and through its New York branch, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of April 1, 1992. (Filed as Exhibit 4.21 to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591.) *4.8.9 -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, National Bank for Cooperatives, Credit Suisse, acting by and through its New York branch, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of October 1, 1992. (Filed as Exhibit 4.22 to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591.) *4.8.10 -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, National Bank for Cooperatives, Credit Suisse, acting by and through its New York branch, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of December 1, 1992. (Filed as Exhibit 4.23 to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591.) 4.8.11 -- Consolidated Mortgage and Security Agreement made by and among Oglethorpe, Mortgagor, and United States of America, National Bank for Cooperatives, Credit Suisse, acting by and through its New York branch, and Trust Company Bank, as trustee under certain indentures identified therein, Mortgagees, dated as of September 1, 1993. ++4.9.1 -- Loan Agreement, dated as of October 1, 1992, between Development Authority of Monroe County and Oglethorpe relating to Development Authority of Monroe County Pollution Control Revenue Bonds (Oglethorpe Power Corporation Scherer Project), Series 1992A. ++4.9.2 -- Note, dated October 1, 1992, from Oglethorpe to Trust Company Bank, as trustee acting pursuant to a Trust Indenture, dated as of October 1, 1992, between Development Authority of Monroe County and Trust Company Bank. NUMBER DESCRIPTION - ------ ----------- ++4.9.3 -- Trust Indenture, dated as of October 1, 1992, between Development Authority of Monroe County and Trust Company Bank, Trustee, relating to Development Authority of Monroe County Pollution Control Revenue Bonds (Oglethorpe Power Corporation Scherer Project), Series 1992A. +4.10.1 -- Loan Agreement, dated as of April 1, 1992, between Development Authority of Burke County and Oglethorpe relating to Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1992A. +4.10.2 -- Note, dated April 1, 1992, from Oglethorpe to Trust Company Bank, as trustee acting pursuant to a Trust Indenture, dated as of April 1, 1992, between Development Authority of Burke County and Trust Company Bank. +4.10.3 -- Trust Indenture, dated as of April 1, 1992, between Development Authority of Burke County and Trust Company Bank, as trustee, relating to Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1992A. +4.10.4 -- First Amended and Restated Letter of Credit Reimbursement Agreement, dated as of June 1, 1992, as amended by First Amendment to First Amended and Restated Letter of Credit Reimbursement Agreement, dated as of September 15, 1993, between Credit Suisse and Oglethorpe relating to an Irrevocable Letter of Credit issued in connection with the Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1992A. +++4.11.1 -- Loan Agreement, dated as of December 1, 1992, between Development Authority of Burke County and Oglethorpe relating to Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1993A. +++4.11.2 -- Note, dated December 1, 1992, from Oglethorpe to Trust Company Bank, as trustee acting pursuant to a Trust Indenture, dated as of December 1, 1992, between Development Authority of Burke County and Trust Company Bank. +++4.11.3 -- Trust Indenture, dated as of December 1, 1992, from Development Authority of Burke County to Trust Company Bank, as trustee, relating to Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1993A. +++4.11.4 -- Interest Rate Swap Agreement, dated as of December 1, 1992, by and between Oglethorpe and AIG Financial Products Corp. relating to Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1993A. +++4.11.5 -- Liquidity Guaranty Agreement, dated as of December 1, 1992, by and between Oglethorpe and AIG Financial Products Corp. relating to Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1993A. NUMBER DESCRIPTION - ------ ----------- +4.11.6 -- Standby Bond Purchase Agreement, dated as of November 30, 1993, between Oglethorpe and The Industrial Bank of Japan, Limited relating to Development Authority of Burke County Adjustable Tender Pollution Control Revenue Bonds (Oglethorpe Power Corporation Vogtle Project), Series 1993A. *4.12.1 -- Loan Agreement, Loan No. T-840901, between Oglethorpe and Columbia Bank for Cooperatives, dated as of September 14, 1984. (Filed as Exhibit 4.14.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.12.2 -- Promissory Note, Loan No. T-840901, in the original principal amount of $8,995,000 from Oglethorpe to Columbia Bank for Cooperatives, dated as of November 1, 1984. (Filed as Exhibit 4.14.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.13.1 -- Loan Agreement, Loan No. T-831222, between Oglethorpe and Columbia Bank for Cooperatives, dated as of December 30, 1983. (Filed as Exhibit 4.16.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.13.2 -- Promissory Note, Loan No. T-831222, in the original principal amount of $2,376,000 from Oglethorpe to Columbia Bank for Cooperatives, dated as of June 1, 1984. (Filed as Exhibit 4.16.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.14.1 -- Loan Agreement, Loan No. T-830404, between Oglethorpe and Columbia Bank for Cooperatives, dated as of April 29, 1983. (Filed as Exhibit 4.18.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.14.2 -- Promissory Note, Loan No. T-830404-1, in the original principal amount of $9,935,000, from Oglethorpe to Columbia Bank for Cooperatives, dated as of April 29, 1983. (Filed as Exhibit 4.18.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *4.14.3 -- Security Deed and Security Agreement, dated April 29, 1983, between Oglethorpe and Columbia Bank for Cooperatives. (Filed as Exhibit 4.18.3 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.1(a) -- Participation Agreement No. 2 among Oglethorpe as Lessee, Wilmington Trust Company as Owner Trustee, The First National Bank of Atlanta as Indenture Trustee, Columbia Bank for Cooperatives as Loan Participant and Ford Motor Credit Company as Owner Participant, dated December 30, 1985, together with a Schedule identifying three other substantially identical Participation Agreements. (Filed as Exhibit 10.1.1(b) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.1(b) -- Supplemental Participation Agreement No. 2. (Filed as Exhibit 10.1.1(a) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.1(c) -- Supplemental Participation Agreement No. 1, dated as of June 30, 1987, among Oglethorpe as Lessee, IBM Credit Financing Corporation as Owner Participant, Wilmington Trust Company and The Citizens and Southern National Bank as Owner Trustee, The First National Bank of Atlanta, as Indenture Trustee, and Columbia Bank for Cooperatives, as NUMBER DESCRIPTION - ------ ----------- Loan Participant. (Filed as Exhibit 10.1.1(c) to the Registrant's Form 10-K for the fiscal year ended December 31, 1987, File No. 33-7591.) *10.1.2 -- General Warranty Deed and Bill of Sale No. 2 between Oglethorpe, Grantor, and Wilmington Trust Company and William J. Wade, as Owner Trustees under Trust Agreement No. 2, dated December 30, 1985, with Ford Motor Credit Company, Grantee, together with a Schedule identifying three substantially identical General Warranty Deeds and Bills of Sale. (Filed as Exhibit 10.1.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.3(a) -- Supporting Assets Lease No. 2, dated December 30, 1985, between Oglethorpe, Lessor, and Wilmington Trust Company and William J. Wade, as Owner Trustees, under Trust Agreement No. 2, dated December 30, 1985, with Ford Motor Credit Company, Lessee, together with a Schedule identifying three substantially identical Supporting Assets Leases. (Filed as Exhibit 10.1.3 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.3(b) -- First Amendment to Supporting Assets Lease No. 2, dated as of November 19, 1987, together with a Schedule identifying three substantially identical First Amendments to Supporting Assets Leases. (Filed as Exhibit 10.1.3(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1987, File No. 33-7591.) *10.1.4(a) -- Supporting Assets Sublease No. 2, dated December 30, 1985, between Wilmington Trust Company and William J. Wade, as Owner Trustees under Trust Agreement No. 2 dated December 30, 1985, with Ford Motor Credit Company, Sublessor, and Oglethorpe, Sublessee, together with a Schedule identifying three substantially identical Supporting Assets Subleases. (Filed as Exhibit 10.1.4 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.4(b) -- First Amendment to Supporting Assets Sublease No. 2, dated as of November 19, 1987, together with a Schedule identifying three substantially identical First Amendments to Supporting Assets Subleases. (Filed as Exhibit 10.1.4(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1987, File No. 33-7591.) *10.1.5 -- Tax Indemnification Agreement No. 2, dated December 30, 1985, between Ford Motor Credit Company, Owner Participant, and Oglethorpe, Lessee, together with a Schedule identifying three substantially identical Tax Indemnification Agreements. (Filed as Exhibit 10.1.5 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.6 -- Assignment of Interest in Ownership Agreement and Operating Agreement No. 2, dated December 30, 1985, between Oglethorpe, Assignor, and Wilmington Trust Company and William J. Wade, as Owner Trustees under Trust Agreement No. 2, dated December 30, 1985, with Ford Motor Credit Company, Assignee, together with Schedule identifying three substantially identical Assignments of Interest in Ownership Agreement and Operating Agreement. (Filed as Exhibit 10.1.6 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.7 -- Consent, Amendment and Assumption No. 2 dated December 30, 1985, among Georgia Power Company and Oglethorpe and Municipal Electric Authority of Georgia and City of Dalton, Georgia and Gulf Power Company and Wilmington Trust Company and William NUMBER DESCRIPTION - ------ ----------- J. Wade, as Owner Trustees under Trust Agreement No. 2, dated December 30, 1985, with Ford Motor Credit Company, together with a Schedule identifying three substantially identical Consents, Amendments and Assumptions. (Filed as Exhibit 10.1.9 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.1.7(a) -- Amendment to Consent, Amendment and Assumption No. 2, dated as of August 16, 1993, among Oglethorpe, Georgia Power Company, Municipal Electric Authority of Georgia, City of Dalton, Georgia, Gulf Power Company, Jacksonville Electric Authority, Florida Power & Light Company and Wilmington Trust Company and NationsBank of Georgia, N.A., as Owner Trustees under Trust Agreement No. 2, dated December 30, 1985, with Ford Motor Credit Company, together with a Schedule identifying three substantially identical Amendments to Consents, Amendments and Assumptions. (Filed as Exhibit 10.1.9(a) to the Registrant's Form 10-Q for the quarterly period ended September 30, 1993, File No. 33-7591.) *10.2.1 -- Section 168 Agreement and Election dated as of April 7, 1982, between Continental Telephone Corporation and Oglethorpe. (Filed as Exhibit 10.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.2.2 -- Section 168 Agreement and Election dated as of April 9, 1982, between National Service Industries, Inc. and Oglethorpe. (Filed as Exhibit 10.3 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.2.3 -- Section 168 Agreement and Election dated as of April 9, 1982, between Rollins, Inc. and Oglethorpe. (Filed as Exhibit 10.4 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.2.4 -- Section 168 Agreement and Election dated as of December 13, 1982, between Selig Enterprises, Inc. and Oglethorpe. (Filed as Exhibit 10.5 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.3.1(a) -- Plant Robert W. Scherer Units Numbers One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of May 15, 1980. (Filed as Exhibit 10.6.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.3.1(b) -- Amendment to Plant Robert W. Scherer Units Numbers One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of December 30, 1985. (Filed as Exhibit 10.1.8 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.3.1(c) -- Amendment Number Two to the Plant Robert W. Scherer Units Numbers One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of July 1, 1986. (Filed as Exhibit 10.6.1(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1987, File No. 33-7591.) *10.3.1(d) -- Amendment Number Three to the Plant Robert W. Scherer Units Numbers One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, NUMBER DESCRIPTION - ------ ----------- Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of August 1, 1988. (Filed as Exhibit 10.6.1(b) to the Registrant's Form 10-Q for the quarterly period ended September 30, 1993, File No. 33-7591.) *10.3.1(e) -- Amendment Number Four to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of December 31, 1990. (Filed as Exhibit 10.6.1(c) to the Registrant's Form 10-Q for the quarterly period ended September 30, 1993, File No. 33-7591.) *10.3.2(a) -- Plant Robert W. Scherer Units Numbers One and Two Operating Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of May 15, 1980. (Filed as Exhibit 10.6.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.3.2(b) -- Amendment to Plant Robert W. Scherer Units Numbers One and Two Operating Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of December 30, 1985. (Filed as Exhibit 10.1.7 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.3.2(c) -- Amendment Number Two to the Plant Robert W. Scherer Units Numbers One and Two Operating Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of December 31, 1990. (Filed as Exhibit 10.6.2(a) to the Registrant's Form 10-Q for the quarterly period ended September 30, 1993, File No. 33-7591.) *10.3.3 -- Plant Scherer Managing Board Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia, City of Dalton, Georgia, Gulf Power Company, Florida Power & Light Company and Jacksonville Electric Authority, dated as of December 31, 1990. (Filed as Exhibit 10.6.3 to the Registrant's Form 10-Q for the quarterly period ended September 30, 1993, File No. 33-7591.) *10.4.1(a) -- Alvin W. Vogtle Nuclear Units Numbers One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of August 27, 1976. (Filed as Exhibit 10.7.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.4.1(b) -- Amendment Number One, dated January 18, 1977, to the Alvin W. Vogtle Nuclear Units Numbers One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia. (Filed as Exhibit 10.7.3 to the Registrant's Form 10-K for the fiscal year ended December 31, 1986, File No. 33-7591.) *10.4.1(c) -- Amendment Number Two, dated February 24, 1977, to the Alvin W. Vogtle Nuclear Units Numbers One and Two Purchase and Ownership Participation Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia. (Filed as Exhibit 10.7.4 to the Registrant's Form 10-K for the fiscal year ended December 31, 1986, File No. 33-7591.) NUMBER DESCRIPTION - ------ ----------- *10.4.2 -- Alvin W. Vogtle Nuclear Units Numbers One and Two Operating Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and City of Dalton, Georgia, dated as of August 27, 1976. (Filed as Exhibit 10.7.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.5.1 -- Plant Hal Wansley Purchase and Ownership Participation Agreement between Georgia Power Company and Oglethorpe, dated as of March 26, 1976. (Filed as Exhibit 10.8.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.5.2 -- Plant Hal Wansley Operating Agreement between Georgia Power Company and Oglethorpe, dated as of March 26, 1976. (Filed as Exhibit 10.8.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.5.3 -- Plant Hal Wansley Combustion Turbine Agreement between Georgia Power Company and Oglethorpe, dated as of August 2, 1982 and Amendment No. 1, dated October 20, 1982. (Filed as Exhibit 10.18 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.6.1 -- Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement between Georgia Power Company and Oglethorpe, dated as of January 6, 1975. (Filed as Exhibit 10.9.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.6.2 -- Edwin I. Hatch Nuclear Plant Operating Agreement between Georgia Power Company and Oglethorpe, dated as of January 6, 1975. (Filed as Exhibit 10.9.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.7.1 -- Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement, dated as of November 18, 1988, by and between Oglethorpe and Georgia Power Company. (Filed as Exhibit 10.22.1 to the Registrant's Form 10-K for the fiscal year ended December 31, 1988, File No. 33-7591.) *10.7.2 -- Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement, dated as of November 18, 1988, by and between Oglethorpe and Georgia Power Company. (Filed as Exhibit 10.22.2 to the Registrant's Form 10-K for the fiscal year ended December 31, 1988, File No. 33-7591.) *10.8.1(a) -- Wholesale Power Contract dated September 5, 1974, between Oglethorpe and Planters Electric Membership Corporation and all schedules thereto, the Supplemental Agreement dated September 5, 1974, between Oglethorpe and Planters Electric Membership Corporation, relating to such Wholesale Power Contract, and Amendment No. 1 to Wholesale Power Contract dated May 12, 1980, between Oglethorpe and Planters Electric Membership Corporation, together with a Schedule identifying 37 other substantially identical Wholesale Power Contracts, and an additional Wholesale Power Contract that is not substantially identical (filed herewith to reflect update to Schedule A to Wholesale Power Contract). (Filed as Exhibit 10.10 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.8.1(b) -- Amended and Consolidated Wholesale Power Contract, dated as of December 1, 1988, between Oglethorpe and Planters Electric Membership Corporation and all schedules thereto, and the Amended and Consolidated Supplemental Agreement, dated December 1, 1988, NUMBER DESCRIPTION - ------ ----------- between Oglethorpe and Planters Electric Membership Corporation, together with a Schedule identifying 37 other substantially identical Wholesale Power Contracts, and an additional Wholesale Power Contract that is not substantially identical. (Filed as Exhibit 10.10(a) to the Registrant's Form 10-K for the fiscal year ended December 31, 1988, File No. 33-7591.) *10.9 -- Transmission Facilities Operation and Maintenance Contract between Georgia Power Company and Oglethorpe dated as of June 9, 1986. (Filed as Exhibit 10.13 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.10(a) -- Joint Committee Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and the City of Dalton, Georgia, dated as of August 27, 1976. (Filed as Exhibit 10.14(b) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.10(b) -- First Amendment to Joint Committee Agreement among Georgia Power Company, Oglethorpe, Municipal Electric Authority of Georgia and the City of Dalton, Georgia, dated as of June 19, 1978. (Filed as Exhibit 10.14(a) to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.11 -- Interconnection Agreement between Oglethorpe and Alabama Electric Cooperative, Inc., dated as of November 12, 1990. (Filed as Exhibit 10.16(a) to the Registrant's Form 10- K for the fiscal year ended December 31, 1990, File No. 33-7591.) *10.12 -- Oglethorpe Deferred Compensation Plan for Key Employees, as Amended and Restated January, 1987. (Filed as Exhibit 10.19 to the Registrant's Form 10-K for the fiscal year ended December 31, 1986, File No. 33-7591.) *10.13.1 -- Assignment of Power System Agreement and Settlement Agreement, dated January 8, 1975, by Georgia Electric Membership Corporation to Oglethorpe. (Filed as Exhibit 10.20.1 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.13.2 -- Power System Agreement, dated April 24, 1974, by and between Georgia Electric Membership Corporation and Georgia Power Company. (Filed as Exhibit 10.20.2 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.13.3 -- Settlement Agreement, dated April 24, 1974, by and between Georgia Power Company, Georgia Municipal Association, Inc., City of Dalton, Georgia Electric Membership Corporation and Crisp County Power Commission. (Filed as Exhibit 10.20.3 to the Registrant's Form S-1 Registration Statement, File No. 33-7591, filed on October 9, 1986.) *10.14 -- Distribution Facilities Joint Use Agreement between Oglethorpe and Georgia Power Company, dated as of May 12, 1986. (Filed as Exhibit 10.21 to the Registrant's Form 0-K for the fiscal year ended December 31, 1986, File No. 33-7591.) *10.15.1 -- Long Term Firm Power Purchase Agreement, dated as of July 19, 1989, by and between Oglethorpe and Big Rivers Electric Corporation. (Filed as Exhibit 10.24.1 to the Registrant's Form 10-K for the fiscal year ended December 31, 1989, File No. 33-7591.) *10.15.2 -- Coordination Services Agreement, dated as of August 21, 1989, by and between Oglethorpe and Georgia Power Company. (Filed as Exhibit 10.24.2 to the Registrant's Form 10-K for the fiscal year ended December 31, 1989, File No. 33-7591.) NUMBER DESCRIPTION - ------ ----------- *10.15.3 -- Long Term Firm Power Purchase Agreement between Big Rivers Electric Corporation and Oglethorpe, dated as of December 17, 1990. (Filed as Exhibit 10.24.3 to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) *10.15.4 -- Interchange Agreement between Oglethorpe and Big Rivers Electric Corporation, dated as of November 12, 1990. (Filed as Exhibit 10.24.4 to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) *10.16 -- Block Power Sale Agreement between Georgia Power Company and Oglethorpe, dated as of November 12, 1990. (Filed as Exhibit 10.25 to the Registrant's Form 8-K, filed January 4, 1991, File No. 33-7591.) *10.17 -- Coordination Services Agreement between Georgia Power Company and Oglethorpe, dated as of November 12, 1990. (Filed as Exhibit 10.26 to the Registrant's Form 8-K, filed January 4, 1991, File No. 33-7591.) *10.18 -- Revised and Restated Integrated Transmission System Agreement between Oglethorpe and Georgia Power Company, dated as of November 12, 1990. (Filed as Exhibit 10.27 to the Registrant's Form 8-K, filed January 4, 1991, File No. 33-7591.) *10.19 -- ITSA, Power Sale and Coordination Umbrella Agreement between Oglethorpe and Georgia Power Company, dated as of November 12, 1990. (Filed as Exhibit 10.28 to the Registrant's Form 8-K, filed January 4, 1991, File No. 33-7591.) *10.20 -- Amended and Restated Nuclear Managing Board Agreement among Georgia Power Company, Oglethorpe Power Corporation, Municipal Electric Authority of Georgia and City of Dalton, Georgia dated as of July 1, 1993. (Filed as Exhibit 10.36 to the Registrant's 10-Q for the quarterly period ended September 30, 1993, File No. 33-7591.) *10.21 -- Supplemental Agreement by and among Oglethorpe, Tri-County Electric Membership Cooperation and Georgia Power Company, dated as of November 12, 1990, together with a Schedule identifying 38 other substantially identical Supplemental Agreements. (Filed as Exhibit 10.30 to the Registrant's Form 8-K, filed January 4, 1991, File No. 33-7591.) *10.22 -- Unit Capacity and Energy Purchase Agreement between Oglethorpe and Entergy Power Incorporated, dated as of October 11, 1990. (Filed as Exhibit 10.31 to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) *10.23 -- Interchange Agreement between Oglethorpe and Arkansas Power & Light Company, Louisiana Power & Light Company, Mississippi Power & Light Company, New Orleans Public Service, Inc., Energy Services, Inc., dated as of November 12, 1990. (Filed as Exhibit 10.32 to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) *10.24 -- Interchange Agreement between Oglethorpe and Seminole Electric Cooperative, Inc., dated as of November 12, 1990. (Filed as Exhibit 10.33 to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) NUMBER DESCRIPTION - ------ ----------- *10.25.1 -- Excess Energy and Short-term Power Agreement between Oglethorpe and Tennessee Valley Authority, effective as of January 23, 1991. (Filed as Exhibit 10.34.1 to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) *10.25.2 -- Transmission Service Agreement between Oglethorpe and Tennessee Valley Authority, effective as of January 23, 1991. (Filed as Exhibit 10.34.2 to the Registrant's Form 10-K for the fiscal year ended December 31, 1990, File No. 33-7591.) *10.26 -- Power Purchase Agreement between Oglethorpe and Hartwell Energy Limited Partnership, dated as of June 12, 1992. (Filed as Exhibit 10.35 to the Registrant's Form 10-K for the fiscal year ended December 31, 1992, File No. 33-7591). 22.1 -- Subsidiary of Oglethorpe (not included because the subsidiary does not constitute a "significant subsidiary" under Rule 1-02(v) of Regulation S-X). - ------------------------- * Incorporated herein by reference. + Pursuant to 17 C.F.R. 229.601(b)(4)(iii), this document is not filed herewith, however the registrant hereby agrees that such documents will be provided to the Commission upon request. ++ For the reason stated in footnote (+), this document and eight other substantially identical documents are not filed as exhibits to this Registration Statement. +++ For the reason stated in the footnote (+), this document and another substantially identical document are not filed as exhibits to this Registration Statement. All other schedules and exhibits are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements and related notes to financial statements. (b) REPORTS ON FORM 8-K. No reports on Form 8-K were filed by Oglethorpe for the quarter ended December 31, 1993. SCHEDULE I OGLETHORPE POWER CORPORATION MARKETABLE SECURITIES--OTHER SECURITY INVESTMENTS AS OF DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) SCHEDULE V OGLETHORPE POWER CORPORATION UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) SCHEDULE V OGLETHORPE POWER CORPORATION UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN THOUSANDS) SCHEDULE V OGLETHORPE POWER CORPORATION UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN THOUSANDS) SCHEDULE VI OGLETHORPE POWER CORPORATION ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) SCHEDULE VI OGLETHORPE POWER CORPORATION ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN THOUSANDS) SCHEDULE VI OGLETHORPE POWER CORPORATION ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN THOUSANDS) SCHEDULE X OGLETHORPE POWER CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) J - - 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 31st day of March, 1994. OGLETHORPE POWER CORPORATION (AN ELECTRIC MEMBERSHIP GENERATION & TRANSMISSION CORPORATION) By: /s/ J. CALVIN EARWOOD ----------------------------------------- J. CALVIN EARWOOD, CHAIRMAN OF THE BOARD 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. 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. The registrant is a membership corporation and has no authorized or outstanding equity securities. Proxies are not solicited from the holders of Oglethorpe's public bonds. No annual report or proxy material has been sent to such bondholders.

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22764_1993

1993

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Item 1. Business The following discussion should be read in conjunction with the industry segment information presented in the notes to the financial statements appearing in item 8. Overview The Company is a leading provider of psychiatric services for adults, adolescents and children with acute psychiatric, emotional, substance abuse and behavioral disorders. The Company offers a broad spectrum of inpatient, partial hospitalization, outpatient and residential treatment programs through 37 hospitals (as of 11/30/93; excludes one restructured hospital still in operation) in 17 states and Puerto Rico and nine hospitals in the United Kingdom. The Company also offers long-term critical care services in five states through four freestanding hospitals and three units within its psychiatric hospitals. Psychiatric Services The inpatient psychiatric hospital industry in the United States is undergoing significant change due to the expanding influence of managed care and cost-containment measures imposed by governmental and third party payors and employers. In recent years, providers such as the Company have experienced a significant increase in the percentage of revenues from payors that reimburse on a negotiated per diem or capitated rate, or on a discounted basis. In addition, this same trend has resulted in higher deductibles and co-insurance for patients. Payors also have increasingly stringent admission and length of stay criteria and other treatment constraints. All of these adversely affect utilization and reimbursement for psychiatric services. The Company's operating results for the periods presented have been adversely affected by the influence of managed care and efforts by government and private payors to contain or reduce the cost of psychiatric care, as well as the Company's efforts to address the changing demands of the marketplace. The Company has, among other things (i) changed and expanded senior management, (ii) significantly expanded the scope of its psychiatric programs to provide the patient, clinical team and payor a continuum of care from which the most appropriate and cost-effective treatments can be selected, (iii) increased its marketing efforts to managed care organizations and (iv) implemented company-wide cost control and reduction measures and closed underutilized facilities. Operating results were negatively impacted from the third fiscal quarter of 1992 through the first fiscal quarter of 1993 as the Company incurred substantial operating expenses to implement its program expansion and marketing initiatives. Long-Term Critical Care In November 1992, to diversify beyond psychiatric care, the Company, through its wholly-owned subsidiary Transitional Hospitals Corporation ("THC"), began to offer long-term critical care services in converted, previously underutilized psychiatric hospitals and newly-acquired freestanding acute care facilities. The Company incurs significant capital and start-up costs in connection with the acquisition and conversion of each facility, and each of the new facilities is expected to generate significant operating losses until the facility is certified as a long-term critical care hospital at which time it qualifies for cost-based reimbursement. Such certification typically occurs after the facility's first six months of operations. Legislation On October 27, 1993, the Clinton Administration proposed the Health Security Act of 1993 to Congress designed to reform the United States health care system. The Health Security Act proposes a major restructuring of the United States health care system, including (i) providing universal access to health care to all United States residents, (ii) reforming the payment methodology for health care goods and services by both the public (Medicare and Medicaid) and private sectors, (iii) implementing measures to control or Overview (continued) Legislaton (continued) reduce public and private spending on health care, and (iv) imposing a moratorium on the designation of additional long-term care hospitals. Alternative federal health care reform legislation is being formulated in Congress. The Health Security Act and other proposed federal legislation are expected to undergo significant discussion prior to any Congressional approval and implementation. The Company cannot predict the ultimate form or timing of enacted legislation, if any, or its effect on the Company, and no assurance can be given that any such legislation will not have a material adverse effect on the Company's business and results of operations. Business Strategy Psychiatric Hospitals--United States To address the changing needs and demands of its marketplace, the Company has adopted the following strategies and programs: - Expanded Services. The Company has significantly expanded and expects to continue to broaden the scope of its psychiatric treatment programs to create a continuum of care from which the most appropriate and cost-effective treatments can be selected to meet the needs of its patients. In addition to offering traditional inpatient treatment programs, the Company now provides less costly treatment alternatives such as partial hospitalization, residential treatment and intensive and nonintensive outpatient programs. By offering a continuum of care through a single organization, the Company believes that patients receive the most appropriate treatment, and that the transition among differing intensities of care occurs rapidly and smoothly from the perspective of the patient, clinical team and payor. - Decentralized Operations. The Company has installed a new senior management team, upgraded its field management and adopted a more decentralized operating philosophy. The Company has reorganized its field operations into four regional divisions, each managed by a Senior Vice President of the Company with its own financial, marketing and clinical services functions. Each hospital is supported by its regional division team, but is operated as a separate business unit and managed by its own Chief Executive Officer, most of whom have been recruited within the last two years. The Company believes this decentralized approach to management facilitates the attraction and retention of highly capable managers who can be responsive to the needs and opportunities of local markets served by the Company. - Increased Managed Care Focus. The Company's management and marketing organization are focusing increasingly on the demands and needs of managed care payors. In addition to expanding the range of treatment programs it provides to offer less costly alternatives to inpatient care, the Company, through its Managed Care Division, has placed increased emphasis on developing and using internal systems to measure outcomes, develop treatment plans, create and maintain documentation, perform utilization review and communicate effectively with external case managers. - Implemented Operating Cost Controls. To position itself to remain a high quality provider of cost-competitive services, the Company has undertaken cost-reduction and cost-containment measures such as the closure or disposition of underutilized facilities, reduction of personnel and overhead. The Company intends to continue to closely monitor the utilization of its hospitals and operating costs and management is committed to taking such future action as it believes is necessary, including discontinuing operations of underperforming hospitals, to remain profitable and competitive. Item 1. Business (continued) Business Strategy (continued) Psychiatric Hospitals and Dialysis Units--United Kingdom As of November 30, 1993, the Company owned nine psychiatric hospitals and operated five smaller units in the United Kingdom through which it provides primarily inpatient treatment to patients covered by private health insurance. It also operates two kidney dialysis facilities for the National Health Service ("NHS"). The Company is the leading commercial provider of psychiatric services in the United Kingdom, where psychiatric services are generally available to residents without charge from NHS hospitals which are British government-owned. (Approximately 12% of the population is covered by private health insurance.) Management also intends to continue to explore acquisitions and alliances to take advantage of an increasing willingness on the part of the British government to contract with private providers, and to expand the dialysis business. THC Hospitals Traditionally, patients suffering from long-term complex medical problems have stayed in the intensive care unit of general acute care hospitals until they were sufficiently well to be transferred to less intensive care settings. Such stays are relatively expensive, reflecting the cost of extensive on-site equipment and services that, while necessary for hospitals to accomplish their primary missions, are not required for the treatment of these critically ill patients. Over the past ten years, hospitals have come under increasing pressure to reduce the length of patient stays as a means of containing costs. Managed care organizations have limited hospitalization costs by controlling hospital utilization and negotiating discounted fixed rates for hospital services. Traditional third party indemnity insurers have begun to limit reimbursement to pre-determined amounts of "reasonable charges," regardless of actual costs, and to increase the co-payments required to be paid by patients. Also, in 1983, Congress sought to contain Medicare hospital costs by adopting the Prospective Payment System ("PPS"), rather than payment of actual costs plus a specified profit. Under PPS, hospitals generally receive a specified reimbursement rate regardless of how long the patient remains in the hospital or the volume of ancillary services ordered by the attending physician. The effect of these various cost-containment measures have provided hospitals with an incentive to discharge patients more quickly. The aging of the population, advancements in medical care, the desire of payors and patients for lower cost and more specialized alternatives to traditional acute care hospitals and the disincentive for such hospitals to provide long-term care has led to a growing demand for long-term critical care services. The Company believes that providers such as skilled nursing facilities and home care providers are not well positioned to efficiently provide health care services to critically ill patients. Traditional skilled nursing facilities have generally focused on providing long-term custodial care to persons eligible for Medicaid. As a result of Medicaid "cost ceilings" on reimbursement for each patient, nursing homes face an economic disincentive to treat medically complex patients. Home health care is not a viable alternative to inpatient care for such patients because of their continued need for more intensive and specialized medical care and equipment, the availability of physicians and 24-hour nursing care and a comprehensive array of rehabilitative therapy. As a result, the Company believes that a significant market opportunity exists for providers dedicated exclusively to providing long-term critical care. Item 1. Business (continued) THC Hospitals (continued) To capitalize on this opportunity, the Company formed THC to offer long-term critical care to patients who do not require the intensive care provided by traditional acute care hospitals but who are too ill to return home or be placed in a nursing home. THC provides care to those suffering from pulmonary diseases, kidney failure and other complex medical problems; they require a variety of intensive services including life-support systems, post-surgical stabilization, intravenous therapy, subacute rehabilitation and wound care. THC's strategy is to provide a comprehensive range of long-term critical care that will enable it to treat most types of critical care patients, regardless of their diagnosis or medical condition, with the objectives of returning these patients to full activity and offering managed care organizations and indemnity insurance payors a single source from which to obtain long-term critical care services. The Company believes THC addresses cost-containment pressures affecting the health care industry by offering a high quality, cost-effective alternative to traditional acute care hospitals. THC has embarked on a rapid expansion plan, and plans to open up to 18 additional facilities by the end of December 1994. THC has primarily targeted larger-population markets which have significant populations of persons over the age of 65. The Company will expand THC's operations primarily by (i) converting the Company's previously underutilized psychiatric hospitals to long-term critical care use, (ii) acquiring and converting freestanding acute care and psychiatric facilities and (iii) leasing beds in acute care facilities owned by others. Psychiatric Care Operations Services and Programs The Company offers a continuum of specialized treatment programs that are designed to provide high quality care that is specific to the patient's needs and is cost-effective to payors. The Company's programs include: - Inpatient. Inpatient treatment is provided when the patient's disorder prevents him or her from safely performing routine daily activities without 24-hour supervision. Intensive individual or group therapy is provided and the patient's daily activities are highly structured. Treatment regimens are designed to enable transition to a less intensive treatment program as soon as feasible. - Residential. Residential treatment programs specialize in providing treatment for adolescents who need more structured treatment than can be provided through outpatient care. The Company's 21 residential treatment centers typically have 10 to 30 beds and each is staffed with a psychiatrist, 24-hour nursing and an on-site licensed program therapist. - Partial Hospitalization. Partial hospitalization (including outpatient visits) is provided when the patient's disorder does not require 24-hour supervision and is such that the patient may be treated while living at home. Treatment regimens are generally for 6-12 hours per day, up to 7 days per week, and are structured to meet the patient's specific clinical needs as well as the patient's work, school and home life requirements. Item 1. Business (continued) Psychiatric Care Operations (continued) Services and Programs (continued) - Intensive Outpatient. Intensive outpatient programs are provided when a patient is manifesting symptoms of a disorder that necessitate routine observation, supervision or intervention but they do not require inpatient or partial hospitalization treatment. Treatment is generally provided for 3-4 hours per day, typically 3-4 days per week, according to the patient's clinical needs and daily routine. - Outpatient. Outpatient treatment is offered when a patient's disorder requires therapeutic intervention at a level that is less intensive than the Company's other psychiatric services. This type of treatment generally involves individual, family or group therapy of 45-90 minutes per session on a scheduled basis. Typically, the Company will refer these types of patients to community-based clinicians as appropriate to the needs and location of the patient. For the year ended November 30, 1993, the average length of stay for psychiatric hospitals for the Company's domestic inpatient and residential treatment programs was 12.4 days and 88.3 days, respectively. Adjusted patient days for inpatient, partial hospitalization (including outpatient visits), and residential treatment programs were 570,416, 56,632 and 112,370, respectively, for the same period. Psychiatric Hospitals Pro Forma Operating Data The following is a comparison of the quarterly and annual statistical data for fiscal years 1993 and 1992 for the Company's 37 United States psychiatric hospitals and its nine United Kingdom hospitals throughout the entire period. In all periods presented, adjusted patient days include inpatient days and equivalent days for partial hospitalization and outpatient programs. Item 1. Business (continued) Psychiatric Care Operations (continued) Psychiatric Hospitals As of November 30, 1993, the Company was operating the following psychiatric hospitals: Item 1. Business (continued) Psychiatric Care Operations (continued) Note: The above includes one hospital included in the restructured group but still in operation at November 30, 1993. Note: Since November 30, 1993, the United Kingdom division has added facilities in Bristol (42 beds), Essex (26 beds) and Riegate (21 beds, a 50% joint venture). Item 1. Business (continued) Psychiatric Care Operations (continued) Sources of Psychiatric Hospital Revenues - U.S. Patients are typically referred to the Company by physicians and other health care professionals, managed care organizations, employee assistance programs, the clergy, law enforcement officials, schools, emergency rooms and crisis intervention services. In some areas, the Company provides a community outreach program called the Psychiatric Assessment Team which is able to respond on a 24-hour basis to emergency calls for help in assessing people's problems and making referrals to the appropriate mental health service or setting. Psychiatrists and, in some states, psychologists are authorized to admit patients to the Company's facilities. It is against Company policy to pay referral sources for hospital admissions. The Company believes it obtains referrals from both physicians and secondary sources primarily as a result of its competitive pricing and the quality and scope of its programs. The Company receives payment for its psychiatric hospital services from patients, private health insurers, managed care organizations, and from the Medicare, Medicaid and CHAMPUS governmental programs. While variations or hybrid programs may exist, the following four categories include all methods by which the Company's hospitals receive payment for services: - Negotiated Rate. Negotiated rate reimbursement is at prices established in advance by negotiation or competitive bidding for contracts with insurers and other payors such as health maintenance organizations, preferred provider organizations and other similar plans. - Private Pay. Payment by patients and their private indemnity health insurance plans is generally based on the Company's schedule of rates for that location. The Company's general policy is to set rates for services at amounts equal to or less than the average rates of its competitors' comparable facilities in each hospital market. - Cost-Based. Cost-based reimbursement is predicated on the allowable cost of services, plus an incentive payment where costs fall below a target rate. It is used by Medicare and Medicaid to reimburse psychiatric hospital services and provides a lower rate of reimbursement than the Company's schedule of rates. - CHAMPUS. CHAMPUS is a federal program which provides health insurance for certain active and retired military personnel and their dependents. CHAMPUS reimbursement is at either (i) regionally set rates, (ii) 1988 charges adjusted upward by the Medicare Market Basket Index, or (iii) a fixed rate per day at certain of the Company's California facilities where CHAMPUS contracts with a benefit administration group. The following table summarizes, as a percentage of operating revenues for all of the Company's United States psychiatric hospitals (excluding the seven Restructured Hospitals), the percentage of operating revenues from each reimbursement method for the periods presented. In 1993, as a percentage of U.S. psychiatric patient days, negotiated rate represented 53%, private pay 16%, cost-based 24%, and CHAMPUS 7%. Item 1. Business (continued) Psychiatric Care Operations (continued) Sources of Psychiatric Hospital Revenues - U.K. Approximately 12% of England's population has private health insurance which provides benefits for psychiatric and substance abuse treatment. There are few private psychiatric hospitals in the United Kingdom because NHS hospitals (British government-owned) are available to its residents without charge. Virtually all the Company's revenues for services in its psychiatric hospitals and alcoholism treatment facilities in the United Kingdom are derived from private sources not subject to any governmental payment limitations, but which would be affected by reimbursement restrictions imposed by private insurers. Long-Term Critical Care The Company, through THC, provides long-term critical care in converted psychiatric and freestanding acute care facilities. Although THC's patients range in age from pediatric to geriatric, a substantial portion of THC's patients are over 65 years of age. THC's long-term critical care facilities include the equipment and physician and other professional staff necessary to care for most types of critically ill patients regardless of their diagnosis or medical condition. THC's professional staffs work in inter-disciplinary teams to evaluate patients upon admission to determine a treatment plan with an appropriate level and intensity of care. Where appropriate, the treatment programs may involve the services of several disciplines, such as pulmonary and rehabilitation therapy. Currently, THC offers a complex medical care program, ventilator management program, wound care program and low tolerance rehabilitation program. Patients who successfully complete treatment programs are discharged to skilled nursing homes, rehabilitation hospitals or home care settings. Long-Term Critical Care Hospitals As of November 30, 1993, THC was operating the following long-term critical care hospitals: TRANSITIONAL HOSPITALS CORPORATION Note: Since November 30, 1993, THC has opened additional facilities in Las Vegas, NE (52 beds), Albuquerque, NM (61 beds) and Chicago, IL (107 beds). Three additional facilities are under development in Minneapolis, Milwaukee and Brea, CA. The Company conducts market research prior to opening a new facility to determine (i) the need for placement of ventilator-dependent patients or other classes of critically ill patients, (ii) the existing physician referral patterns, (iii) the presence of competitors, (iv) the payor mix and (v) the political and regulatory climate. The Company generally seeks hospitals with fewer than 100 beds in major metropolitan areas and also considers hospitals in other markets where its research indicates the need for such hospitals. Item 1. Business (continued) Long-Term Critical Care (continued) Patient Admission Substantially all of the patient admissions to THC's hospitals are transfers from other health care providers. Patients are referred from general acute care hospitals, rehabilitation hospitals, skilled nursing facilities and home care settings. The majority of THC's admissions are directly from the intensive care units of general acute care hospitals. Referral sources include discharge planners, case managers of managed care plans, social workers, physicians, third party administrators, HMOs and insurance companies. THC has directors of patient referrals who educate health care professionals from traditional acute care hospitals as to the unique nature of the services provided by THC's hospitals. The directors of patient referrals develop an annual admission plan for each hospital, with assistance from the hospital's administrator. The admission plans involve ongoing education of local physicians and the employees of managed care organizations and acute care hospitals. THC anticipates that it will direct increased admission efforts toward insurance company case managers and managed care organizations. Sources of Long-Term Critical Care Revenues For long-term critical care services rendered to patients, THC receives payment from (i) the federal government under Medicare, (ii) certain states under Medicaid, (iii) commercial insurers and patients and (iv) managed care organizations. Payments from Medicare and Medicaid are generally based upon cost; payments from commercial insurers are generally based upon charges and payments from managed care organizations are based on negotiated rates. The Company anticipates reimbursement from Medicare will constitute a significant portion of THC's revenues in the future. See "Business--Regulation and Reimbursement." Competition The Company's psychiatric hospitals compete with psychiatric units in medical/surgical hospitals as well as with other specialty psychiatric hospitals. Some competing hospitals are either owned or supported by government agencies. Others are owned by nonprofit corporations and supported by endowments and charitable contributions. In each case, they are substantially exempt from income and property taxation. The competitive position of a hospital is, to a significant degree, dependent upon the number and quality of physicians practicing at the hospital and the members of its medical staff. The Company also believes that the competitive position of a hospital is dependent upon the variety of services offered by a facility, and the Company strives to implement programs best suited to the needs of patients and payors in each particular market. THC's hospitals compete with medical/surgical hospitals, certain long-term care hospitals, sub-acute facilities, rehabilitation hospitals and nursing homes specializing in providing care to medically complex patients. Many of these providers are larger and more established than THC. The Company believes that, to offer programs providing a cost-effective continuum of care, nursing homes and other companies are converting their facilities and developing programs that will be competitive with THC's hospitals. This trend is expected to continue due to and cost-containment pressures. Item 1. Business (continued) Competition (continued) The competitive position of a hospital, including the Company's psychiatric hospitals and THC's hospitals, is affected by the ability of its management to negotiate service contracts with purchasers of group health care services, including private employers, PPOs and HMOs. Such organizations attempt to obtain discounts from established hospital charges. The importance of obtaining contracts with PPOs, HMOs and other organizations which finance health care, and its effect on a hospital's competitive position, vary from market to market, depending on the number and market strength of such organizations. It is the Company's policy to enter into these contracts wherever feasible. Generally, hospitals holding major contracts with managed care organizations are able to attract more doctors to their active medical staffs than hospitals without such contracts. Employees As of November 30, 1993, the Company had approximately 6,968 employees, of which approximately half were employed full time and half were employed part time. The employees at one of the Company's psychiatric hospitals (representing less than 1% of total employees) are covered by a union agreement. The Company considers its labor relations to be satisfactory. There is a national shortage of nursing personnel which, in general, has required the Company to pay a wage premium in excess of the normal standards to recruit a satisfactory complement of nurses. However, the effect of these higher wages, when related to the Company's overall business, is not material. Regulation and Reimbursement The Company's hospitals are subject to substantial and continuous federal, state and local government regulation. Such regulations provide for periodic inspections and other reviews by state and local agencies, the United States Department of Health and Human Services (the "Department") and CHAMPUS to determine compliance with their respective standards pertaining to medical care, staffing utilization, safety and equipment necessary for continued licensing or participation in the Medicare, Medicaid or CHAMPUS programs. The admission and treatment of patients at the Company's psychiatric hospitals are also subject to state and federal regulation relating to confidentiality of medical records. State certificate of need ("CON") regulations generally provide that prior to the expansion of existing facilities, the construction of new facilities, the addition of beds, the acquisition of existing facilities or major items of equipment or certain changes in services, approval must be obtained from the designated state health planning agency. The stated objective of the CON process is to promote quality health care at the lowest possible cost and avoid unnecessary duplication of services, equipment and facilities. If the Company and THC are unable to obtain the requisite CONs, their growth and business could be adversely affected. State licensing of hospitals is a prerequisite to the operation of each hospital and to participation in all federally funded programs. Once a hospital has been licensed, it must continue to comply with federal, state and local licensing requirements in addition to local building and life-safety codes. All of the Company's hospitals have obtained the necessary licenses to conduct business. A substantial portion of the Company's revenues is derived from patients covered by Medicare and Medicaid. Medicare is a federal program that provides certain hospital and medical insurance benefits to persons age 65 and over and certain disabled persons. Medicaid is a medical assistance program administered by the states and partially funded by the federal government under which hospital benefits are available to the medically indigent. Within the Medicare and Medicaid statutory framework, there are substantial areas subject to administrative rulings, interpretations and discretion which may affect payments made to providers. Item 1. Business (continued) Regulation and Reimbursement (continued) In order to receive Medicare reimbursement, each hospital must meet the applicable conditions of participation set forth by the Department relating to the type of hospital, its equipment, personnel and standard of medical care, as well as comply with state and local laws and regulations. Hospitals undergo periodic on-site Medicare certification surveys. The Medicare survey is limited if the hospital is accredited by the Joint Commission on Accreditation of Healthcare Organizations ("JCAHO"). All but one of the Company's operating hospitals are certified as Medicare providers. All of the Company's operating hospitals are certified by their respective state Medicaid programs. A loss of certification could adversely affect a hospital's ability to receive payments from Medicare and Medicaid. Hospitals receive accreditation from JCAHO, a nationwide commission which establishes standards relating to the physical plant, administration, quality of patient care and operation of medical staffs of hospitals. Generally, hospitals and certain other health care facilities are required to have been in operation at least six months in order to be eligible for accreditation by JCAHO. After conducting on-site surveys, JCAHO awards accreditation for up to three years to hospitals found to be in substantial compliance with JCAHO standards. Accredited hospitals are periodically resurveyed, including, at the option of JCAHO, upon a major change in facilities or organization and after merger or consolidation. All of the Company's hospitals are accredited by JCAHO. The Company intends to seek and obtain JCAHO accreditation for any additional hospitals it may purchase or lease. Prior to 1983, Medicare reimbursed hospitals for the reasonable direct and indirect cost of the services provided to beneficiaries. The Social Security Amendments of 1983 implemented PPS in an effort to reduce and control Medicare costs. Under PPS, inpatient costs are reimbursed based upon a fixed payment amount per discharge using Diagnosis Related Groups ("DRGs"). The DRG payment under PPS is based upon the national average cost of treating Medicare patients with the same diagnosis. Although the average length of stay varies for each DRG, the average stay for all Medicare patients subject to PPS is approximately six days. An additional outlier payment is made for patients with unusually long lengths of stay or higher treatment costs. Outliers are designed to cover only marginal costs. Additionally, PPS payments can only be made once every 60 days for each patient. Thus, PPS creates an economic incentive for general acute care hospitals to discharge Medicare patients as soon as clinically possible. The Social Security Amendments of 1983 exempted psychiatric, rehabilitation, cancer, children's and long-term hospitals from PPS. A long- term hospital is defined as a hospital which has an average length of stay of greater than 25 days. THC's facilities are expected to meet this definition. Under current law, inpatient operating costs for long-term hospitals are reimbursed under a cost-based reimbursement system, except for their initial six months of operation, when they are subject to PPS reimbursement. As a result of the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), reimbursement under the cost-based system is subject to a computed target amount per discharge (the "Target") for inpatient operating costs. A hospital's Target is currently computed by multiplying the hospital's Target during the preceding period by the change in a hospital "market basket" wage and price index. Prior to October 1, 1991, allowable Medicare operating costs per discharge in excess of the Target were not reimbursed. Effective October 1, 1991, if a hospital exceeds the Target, Medicare reimburses the lower of (i) the hospital's target amount plus 50% of the allowable Medicare operating costs per discharge in excess of the Target or (ii) 110% of the Target. With regard to hospitals certified prior to October 1, 1992, the TEFRA Target provisions do not apply with respect to hospitals that have been in operation for less than three full years. For hospitals certified after October 1, 1992, the TEFRA Target provisions do not apply with respect to hospitals that have been in operation for less than two full years. Under The Omnibus Budgeting Reconciliation Act of 1993 ("OBRA"), increases in the Target for fiscal years 1994 through 1997 are generally limited to the hospital market basket increase minus one percentage point. Item 1. Business (continued) Regulation and Reimbursement (continued) Medicare and Medicaid reimbursements are generally determined from annual cost reports filed by the Company. These cost reports are subject to audit by Medicare and Medicaid. The Company has established reserves for possible adjustments at levels which management believes to be adequate to cover any downward adjustments resulting from audits of these cost reports. Federal regulations provide that admission to and utilization of hospitals by Medicare and Medicaid patients must be reviewed by peer or utilization review organizations ("PROs") in order to ensure efficient utilization of hospitals and services. A PRO may conduct such review either prospectively or retroactively and may, as appropriate, recommend denial of payments upon admission or retrospectively for services provided to a patient. Such review is subject to administrative and judicial appeal. Health Care Reform The Health Security Act, the Clinton Administration's proposed health care reform legislation, was submitted to Congress on October 27, 1993. Section 4105 of the Health Security Act provides that critical care hospitals (such as THC's) which are not reimbursed as such prior to the date of enactment of the Health Security Act will be reimbursed under PPS rather than the cost-based system under which they currently receive reimbursement. Generally, reimbursement under PPS may be inadequate for THC to operate its business profitably and, if Section 4105 is passed in its current form, it could adversely affect THC's operations and expansion. However, Section 4105 provides that PPS will not apply to hospitals which are being reimbursed under the cost-based system as of the date of the enactment of the Health Security Act. To the extent THC's hospitals are entitled to cost-based reimbursement as of the date the Health Security Act is enacted, such hospitals would continue to be reimbursed under the current cost-based system and would not be adversely affected by the legislation. Although several other legislative proposals have been or are expected to be made shortly, none of the proposals so far submitted to Congress contains a provision like Section 4105; however, no assurance can be given that future health care reform legislation, if an affect THC's operations. Reimbursement Limitations and Cost-Containment Regardless of the outcome of the proposed health care reform bills, Congress and the administration can be expected to continue vigorous efforts to effectuate cost savings in the Medicare program. These efforts could include change in the reimbursement of the Company's long-term critical care hospitals to the DRG method and OBRA mandates a study of methods of bringing under PPS hospitals such as the Company's and THC's which are currently exempt from that system. Even if cost-based reimbursement for the THC facilities continues, it is anticipated that additional reimbursement limits will be imposed and that the return on invested capital will be reduced as part of the 1994 budgetary pro- cess. Such cost-containment initiatives may vary substantially from the proposed structural reforms discussed above and may impact the Company more quickly and directly. Similar changes in reimbursement of psychiatric services could adversely impact the Company's business and results of operations. Conversely, there is also potential for a positive effect which mandated mental health benefits for all Americans could have on the Company's psychiatric operations. Rate Setting Laws In recent years various forms of prospective reimbursement legislation have been proposed or enacted in states in which the Company owns hospitals. For example, the Company's Florida hospitals are governed by a prospective reimbursement law which generally allows rate increases based on the Consumer Price Index. The Company's Washington hospital was subject to a prospective reimbursement law based on each facility's budgeted costs until June 30, 1989, when the law lapsed and was not renewed. If prospective reimbursement laws were to be enacted in the future in one or more of the states in which the Company operates hospitals, it could have an adverse effect on the Company's business and results of operations. In addition, the enactment of such legislation in states where the Company does not now have hospitals could have a deterrent effect on the decision to acquire or establish facilities in such states. Item 1. Business (continued) Regulation and Reimbursement (continued) Relationships With Clinicians The Company is subject to federal and state laws that regulate its relationships with physicians and other providers of health care services. These laws include the "fraud and abuse" provisions of the Social Security Act, under which criminal penalties can be imposed upon persons who pay or receive any remuneration in return for referrals of patients eligible for reimbursement under the Medicare, Medicaid or comparable state programs. Violations of these laws may result in civil penalties. Civil penalties range from monetary fines that may be levied on a per violation basis to temporary or permanent exclusion from these programs. The Company is also subject to state and federal laws prohibiting false claims. The Department, courts and officials of the Office of Inspector General have broadly construed the fraud and abuse provisions of the Social Security Act. "Safe harbor" regulations promulgated by the Department define a narrow range of practices that will be exempted from prosecution or other enforcement action. These regulations may, however, be followed by more aggressive enforcement against relationships that do not fit within the specified safe harbor rules. Similarly, state fraud and abuse laws, which vary from state to state, are often vague and have infrequently been interpreted by courts or regulatory agencies. The Company believes its arrangements with providers are within the safe harbor regulations. Given the breadth of these laws and the dearth of court rulings dealing with businesses like the Company's, there can be no assurance that the Company's arrangements with its providers will not be challenged. OBRA contains provisions prohibiting physicians having a financial relationship with an entity from making referrals eligible for Medicare reimbursement to that entity for "designated health services," including clinical laboratory services; radiation therapy services; durable medical equipment; parenteral and enteral nutrients, equipment, and supplies; prosthetics, orthotics, and prosthetic devices; home health services; outpatient prescription drugs; and inpatient and outpatient hospital services. In addition, if such a financial relationship exists, the entity is prohibited from billing for or receiving reimbursement on account of such referral. These provisions take effect January 1, 1995. Numerous exceptions are allowed under OBRA for financial arrangements that would otherwise trigger the referral prohibitions. These provide, under certain conditions, exceptions for relationships involving rental of office space and equipment, employment relationships, personal service arrangements, payments unrelated to designated services, physician recruitment, and certain isolated transactions. The Department may adopt regulations in the future which expand upon the conditions attached to qualification for these exceptions. The Company believes it is in compliance with these provisions. Item 1. Business (continued) Litigation Immediately following the Company's public announcement of the increased charge for uncollectible accounts in September of 1991, eleven securities class action lawsuits were filed against the Company and several of its officers and directors in the United States District Court for the Central District of California. These suits allege generally that the Company has in the past made materially false and misleading public statements or failed to disclose material adverse information regarding its earnings, financial condition and business prospects. A shareholders' derivative action was filed at about the same time in the Superior Court for Orange County, California, against the Company and all of its directors alleging breach of fiduciary duty, waste of corporate assets and gross mismanagement based largely on the same operative facts. The Company maintains that the public statements and reports in question were complete and correct and that its policy is and always has been to disclose material adverse information publicly and on a timely basis. It has not been possible to assess the likely outcome of these actions, but the Company intends to defend them vigorously. Each of its officers and directors has broad indemnification contracts with the Company and are entitled to indemnity under circumstances prescribed by applicable law. In addition, the Company's Articles of Incorporation and applicable law restrict the liability of its officers and directors for damages for breach of their fiduciary duties. The Company is subject to ordinary and routine litigation incidental to its business, including those arising from patient treatment, injuries or death for which it is covered by liability insurance. Management believes that the ultimate resolution of all pending proceedings will not have a material adverse effect on the Company. Item 2. Item 2. Properties This item incorporates by reference the tables of psychiatric and long-term critical care hospital and dialysis facility locations set forth in Item 1. Ownership information is set forth in the text of this item. Psychiatric Hospital Properties The Company owns, in fee simple, all of the real property on which its acute psychiatric hospital facilities are located. Twenty-one of these facilities are detached, single story wood frame or structural steel, and thirty are multi-storied, structural steel or brick structures. All facilities have been constructed or extensively remodeled since 1969. Nineteen facilities are located on sites ranging from one to five acres and thirty-two facilities are on sites ranging from five to forty-two acres. In 1993, three of the above described facilities were shared with THC. As of November 30, 1993, the Company was in the process of converting two other facilities to long-term critical care facilities. All of the Company's existing hospital facilities range in size from 20,000 to 100,000 square feet and each facility has sufficient acreage to allow space for outdoor recreation. All of the existing hospital buildings meet all state and local requirements for licensing as hospitals to provide the services indicated. However, seven facilities have suspended operations to date. Two of these hospitals were sold in January and February of 1994. The Company has four separate mortgage loans with lenders, each of which is secured by one of the Company's hospitals. Other properties: The Company also owns a three-story building completed in 1988 used for its Corporate headquarters; medical office buildings adjacent to twenty of its hospital facilities; three parcels of land for potential hospital development or future sale, two parcels of land being developed for sale for investment purposes (non-hospital related), and one apartment in a location central to the Company's operations for use by employees whose duties require them to travel. Item 2. Properties (continued) THC Properties: The Company owns, in fee simple, all of the real property on which its long-term critical care facilities are located. Two of these facilities are detached single story buildings and five are multi-storied buildings. Three facilities are located on sites ranging from one to five acres and four facilities are located on sites ranging from five to forty-two acres. Three of these facilities were opened after year-end. As of November 30, 1993, THC operated additional units within three of the Company's psychiatric hospitals. Item 3. Item 3. Legal Proceedings Immediately following the Company's public announcement of the increased charge for uncollectible accounts referred to in "Management's Discussion and Analysis of Results of Operations and Financial Condition 1991 Compared to 1990", eleven securities class action lawsuits were filed against the Company and several of its officers and directors in the United States District Court for the Central District of California. These suits allege generally that the Company has in the past made materially false and misleading public statements or failed to disclose material adverse information regarding its earnings, financial condition and business prospects. These suits have been consolidated into a single action. A shareholders' derivative action was filed at about the same time in the Superior Court for Orange County, California, against the Company, its then directors and certain other officers alleging breach of fiduciary duty, waste of corporate assets and gross mismanagement based largely on the same operative facts. The Company maintains that the public statements and reports in question were complete and correct and that its policy is and always has been to disclose material adverse information publicly and on a timely basis. It has not been possible to assess the likely outcome of these actions, but the Company intends to defend them vigorously. Each of its officers and directors has broad indemnification contracts with the Company and are entitled to indemnity under circumstances prescribed by applicable law. In addition, the Company's Articles of Incorporation and applicable law restrict the liability of its officers and directors for damages for breach of their fiduciary duties. The Company is subject to ordinary and routine litigation incidental to its business, including those arising from patient treatment, injuries or death for which it is covered by liability insurance. Management believes that the ultimate resolution of all 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 Not applicable. PART II Item 5. Item 5. Market for the Company's Common Equity and Related Stockholder Matters (a) Market Information (1) (i) The Common Stock of Community Psychiatric Centers is traded on the New York, Boston, Midwest and Pacific Stock Exchanges. Ticker symbol: CMY. (ii) The information in response to this portion of Item 5 is incorporated by reference from footnote 13 to the financial statements in Item 8. (b) Holders (1) Approximate number of holders of the $1.00 Par Value Common Stock of the Company at January 31, 1994 2,636 * The number of record holders includes banks and brokerage houses which are holding shares of the Company's Common Stock for an undetermined number of beneficial owners. (c) Dividends (1) The information in response to this portion of Item 5 is incorporated by reference from footnote 13 to the financial statements in Item 8. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources (continued) In January 1992, the Board of Directors authorized the expenditure of up to $50.0 million of cash on hand for the repurchase of the Company's common stock from time-to-time in the open market. As of November 30, 1992, the Company had purchased 2,890,000 shares for $31.1 million, including 451,000 at market value from the former chairman, under that authorization. Through November 30, 1993, an additional 85,000 shares were repurchased for $0.8 million. Under an authorization in effect prior to January 31 ,1992, the Company had repurchased 549,800 shares for $6.3 million. The Company received net cash proceeds of approximately $5 million in January and February of 1994 from the sale of two closed facilities. Unused revolving credit facilities of approximately $20 million remain available to the Company at November 30, 1993. In December 1994, the Company received a commitment letter from a bank to provide a $50 million revolving credit facility with a term loan conversion option; the option is subject to the Company maintaining certain financial covenants. A definitive credit facility is subject to completing final loan documentation. The Company believes that its current cash and cash equivalent balances, its operating cash flow, and the amounts available under its revolving credit facilities will be sufficient to fund the Company's operations and capital expenditures through the middle of fiscal 1994. The Company is also presently evaluating proposals for additional funding from other financing sources. The level of expansion of THC operations will be dependant on successfully obtaining such additional funding. The increase in accounts receivable, accounts payable, and accrued expenses in 1993 is due to the expansion of THC's operations. The increase in the amount payable to third parties under reimbursement contracts results from interim reimbursement rates being higher than final settlement rates, the effect of which is to create a short-term liability. Fiscal Year 1993 Compared to Fiscal Year 1992 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Fiscal Year 1993 Compared to Fiscal Year 1992 (continued) The following discussion excludes the restructuring charge and operating results of the Restructured Hospitals. Total revenues for the year ended November 30, 1993 increased by approximately 7% to $329.3 million from $309.0 million for the prior year. This increase was due primarily to the addition of $18.1 million of THC revenue in 1993 as compared to effectively no THC revenue in 1992. Net operating revenues from the United States psychiatric hospitals increased by 1.1% or approximately $2.9 million as a result of a 5.9% increase in adjusted patient days to 581,397 from 549,072 which was partially offset by a decrease in the net revenue per adjusted patient day. The increase in adjusted patient days was due in large part to (i) a 82% increase in residential treatment patient days to 106,495 from 58,402 and (ii) a 72.7% increase in partial hospitalization visits to 113,899 from 65,958. The increase in adjusted patient days more than offset the 8.1% decrease in average length of stay. The decrease in net revenue per adjusted patient day was the result of the continu- ing shift in reimbursement to negotiated rates and cost-based reimbursement from private pay. Net operating revenues from the Company's United Kingdom operations increased by 1.2% or approximately $412,000 as a result of an increase in inpatient admissions and average length of stay which was partially offset by a decline in net revenue per adjusted patient day. Operating expenses as a percentage of total revenues increased to 49.7% from 46.9% in the year ended November 30, 1993 compared to the prior year. This increase was primarily attributable to expenses incurred in connection with the Company's THC operations which were not existent in the 1992 period and an increase in personnel costs in the first quarter of 1993 related to the Company's expansion of its continuum of care. General and administrative expenses increased by approximately 17.1% to $132.3 million from $113.0 million and increased as a percentage of total revenues to 40.2% from 36.6% due primarily to (i) an increase in personnel costs related to the Company's initiatives to enhance the quality of its services and strengthen its revenue generation efforts (ii) the expenses incurred in connection with providing a continuum of care and (iii) THC operations which were not existent in the 1992 period. Provision for uncollectible accounts, exclusive of a 1992 recovery of previously written off accounts receivable, increased as a percentage of total revenues to 6.5% from 4.6%. Cost-containment programs, which included reduction of personnel and elimination of overhead, were implemented during the second and third quarters of 1993 and resulted in reductions of operating expenses as a percentage of total revenues from 52.0% in the first quarter to 49.7% in the fourth quarter. Similarly, general and administrative expenses as a percentage of total revenues were reduced from 47.5% to 36.4% between the first and fourth quarters of 1993. For the reasons described above, earnings before depreciation, amortization, interest, and income taxes for the twelve months ended November 30, 1993 declined by approximately 33.4% to $35.1 million from $52.7 million in the prior year period and net earnings declined to $11.4 million from $24.1 million compared to the prior year period. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Fiscal Year 1993 Compared to Fiscal Year 1992 (continued) Other operating results, after the effect of the restructuring charge, are described as follows: - Depreciation expense decreased because the Restructured Hospitals were excluded from operations subsequent the end of the first quarter of 1993. - Interest expense increased in 1993 because of the decrease in amounts capitalized and the increase in long-term debt. - Income taxes (benefit) as a percent of pre-tax income (loss) was (35.4%) in 1993 compared to 37% in 1992. In 1993, approximately 30% of the Company's net revenues were paid by private sources and insurance companies which based reimbursement on the Company's price schedule. Approximately 24% of the Company's net revenues were paid by Medicare, Medicaid and other programs which based reimbursement on the Company's costs and DRG rates. Therefore, to the extent that costs increased, higher reimbursement was generally received on a dollar-for-dollar basis. Approximately 5% was paid by CHAMPUS, a Federal Government Program which based reimbursement generally on a regional average rate. The balance of approxi- mately 41% was paid based upon rates negotiated with insurers and other payors including managed care companies, health maintenance organizations, preferred provider organizations and similar plans. The number of patients covered under negotiated rate plans has grown significantly in recent years and such growth is expected to continue in the future. The Company's ability to negotiate rate increases successfully with these plans that are comparable to the Company's cost increases is significant to maintaining adequate operating margins. Fiscal Year 1992 Compared to Fiscal Year 1991 Operating revenues decreased by $48.6 million in 1992. Adjusted patient days decreased by approximately 7.8% while inpatient admissions increased by 2.8%. Average length of stay declined 10.0% from 20.1 days in 1991 to 18.1 days in 1992. The decline in length of stay principally results from restricting use and duration of inpatient psychiatric treatment as more payors shift benefits coverage to managed care plans and seek to contain costs through tighter restrictions on inpatient treatment and length of stay. The Company believes that it was also negatively impacted by the publicity about fiscal and treatment abuses in the psychiatric hospital industry involving other providers. Net revenue per patient day declined 5.0% in 1992. On a net revenue basis, the percentage of revenue attributable to patients paying at the price levels contained in the Company's price schedule declined in 1992 as compared to 1991. The movement to negotiated rate contracting with payors and utilization by Medicare and other cost-based payors continued during 1992 and utilization by Medicare and other cost-based programs increased as a percentage of the total. The Company expects a continuing decline in the percentage of price schedule-based patients as measured by net revenue. Operating expenses increased by $7.8 million in 1992. The Company maintains staffing levels at its hospitals necessary to promote high quality care while also attempting to adapt the levels for census fluctuations. The Company continues to strive to increase the quality of services and marketing, and develop new programs while adapting to increasing payor restrictions. Additional operating staff is required to support these efforts. In addition, the Company's operations are labor intensive and require highly qualified workers with specific Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Fiscal Year 1992 Compared to Fiscal Year 1991 (continued) professional skills such as nurses and therapists. The Company pays wages prevailing in the areas necessary to obtain skilled personnel, and the Company does not feel that it is possible to obtain or retain such qualified personnel unless reasonably steady employment can be provided. Accordingly, the Company's labor costs do not vary in direct proportion with census fluctuations at its facilities, even though staffing levels are closely monitored in an attempt to improve efficiency. In 1991, general and administrative costs included a special charge of approximately $37.0 million for the write down of uncollectible accounts receivable. In 1992, a specific reversal of a $4.2 million charge in fiscal 1991 was realized due to the recovery from the Ontario (Canada) Health Insurance Plan ("OHIP"). The provision for uncollectible accounts included in general and administrative costs adjusted for the items described above increased by approximately $7.4 million in 1992 compared to 1991. In general, current economic conditions have negatively impacted patients' ability to pay deductions and co-payments, and scrutiny of coverage limitations and medical necessity issues by payors continues to intensify. Exclusive of the change in the provision for uncollectible accounts and write off in 1991 of $1.6 million of abandoned acquisition costs, general and administrative costs increased by approximately $15.1 million or 13.2% in fiscal 1992. This increase is principally attributable to increased staffing in the marketing, managed care, clinical and fiscal consulting areas. Depreciation increased $690,000 as a result of current year equipment additions and routine renovations. Interest expense increased due to the decreased amount capitalized. Only one hospital project was in progress during 1992. Income taxes as a percent of pre-tax income increased to 37% from 36.4%. Earnings before depreciation, amortization, interest, and income taxes for the twelve months ended November 30, 1992 declined by 38.7% to $52.7 million from $85.9 million in 1991 and net earnings declined to $23.1 million from $45.3 million compared to the prior year period. In 1992, approximately 45% of the Company's hospital net revenues were paid by private sources and insurance companies which based reimbursement on the Company's price schedule. Approximately 16% of the Company's hospital net revenues were paid by Medicare, Medicaid and other programs which based reimbursement on the Company's costs. Therefore, to the extent that costs increased, higher reimbursement was generally received on a dollar-for-dollar basis. Approximately 4% was paid by CHAMPUS, a Federal Government Program which based reimbursement generally on a regional average rate. The balance of approximately 35% was paid based upon rates negotiated with insurers and other payors including managed care companies, health maintenance organizations, preferred provider organizations and similar plans. The number of patients covered under negotiated rate plans has grown significantly in the past few years and such growth is expected to continue in the future. The Company's ability to successfully negotiate rate increases with these plans that are comparable to the Company's cost increases is significant to maintaining adequate operating margins. The Company has generally good rela- tions with such plans and anticipates this will continue. Item 8. Item 8. Financial Statements and Supplementary Data The information in response to this item is incorporated by reference from Exhibit 1 in Item 14. Item 9. Item 9. Change in and Disagreement with Accountants on Accounting and Financial Disclosure. Not Applicable. PART III Information under the following items required by Part III of Form 10-K is incorporated by reference from Registrant's definitive Proxy Statement applic- able to Registrant's 1993 Annual Meeting of Shareholders, or will be provided by Amendment to Form 10-K on Form 10-K/A, to be filed with the Commission by Registrant no later than March 29, 1994. 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. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements. The Financial Statements listed in response to Item 8 are filed herewith. 2. The following Financial Statement Schedules are filed herewith: Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties Property, Plant and Equipment Accumulated Depreciation and Amortization of Property, Plant and Equipment Valuation and Qualifying Accounts Supplementary Income Statement Information 3. Exhibits: (3) Articles of Incorporation and By-laws 3.1 Restated Articles of Incorporation as adopted by vote of shareholders on May 20, 1993 (filed as Appendix B to Registrant's Proxy Statement dated April 20, 1993 relating to the annual meeting of its shareholders on May 20, 1993 and incorporated in full herein by this reference). 3.2 By-Laws of Registrant as amended by vote of shareholders on May 23, 1991 (filed as Exhibit 3.2 to Registrant's Annual Report on Form 10-K for its fiscal year ended November 30, 1991 and incorporated in full herein by this reference) and as amended by vote of shareholders on May 20, 1993 (filed as Appendix A to Registrant's Proxy Statement dated April 20, 1993 relating to the annual meeting of its shareholders on May 20, 1993 and incorporated in full herein by this reference). PART IV (continued) Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (continued) (10) Material Contracts 10.1 Employment Contract between Registrant and Richard L. Conte, dated as of May 1, 1992. 10.2 Employment Contract between Registrant and Steven S. Weis, effective as of December 1, 1991, dated January 28, 1992, which is required to be filed as an exhibit pursuant to Item 14(c), (filed as Exhibit 10.2 to Registrant's Annual Report on Form 10-K for its fiscal year ended November 30, 1991 and incorporated in full herein by this reference). 10.3 Form of Indemnification Agreements between Registrant and its Directors and Executive Officers (filed as Exhibit C to Registrant's Proxy Statement, dated April 24, 1987, relating to the annual meeting of its shareholders on June 1, 1987, and incorporated in full herein by this reference). 10.4 Supplemental Retirement Contract between Registrant and Richard L. Conte, dated as of September 1, 1988 (filed as Exhibit 10.4 to Registrant's Annual Report on Form 10-K for its fiscal year ended November 30, 1988, and incorporated in full herein by this reference). 10.5 Termination Agreement between Registrant and James W. Conte dated as of December 1, 1992 (filed as Exhibit 10.8 to Registrant's amendment on Form 8 to Registrant's Annual Report on Form 10-K for its fiscal year ended November 30, 1992, and incorporated in full herein by this reference). 10.6 Registrant's 1989 Stock Incentive Plan. (filed as Exhibit A to Registrant's Proxy Statement, dated July 12, 1989, and incorporated in full herein by this reference.) 10.6.1 Form of Stock Option Agreement (filed as Exhibit 10.6.1 to Registrant's Report on Form 10-K for its fiscal year ended November 30, 1990 and incorporated in full herein by this reference). 10.6.2 Form of Nonstatutory Stock Option Agreement with Director (filed as Exhibit 10.6.2 to Registrant's Report on Form 10-K for its fiscal year ended November 30, 1990 and incorporated in full herein by this reference). 10.7 Registrant's Combined Stock Option Plan for Key Employees and Amendment Numbers One, Two, Three, Four and Five thereto (filed as Exhibit 10.7 to Registrant's Report on Form 10-K for its fiscal year ended November 30, 1989 and incorporated in full herein by this reference). 10.7.1 Form of Stock Option Agreement -- General Stock Option (filed as Exhibit 10.7.1 to Registrant's Report on Form 10-K for its fiscal year ended November 30, 1989 and incorporated in full herein by this reference). 10.7.2 Form of Stock Option Agreement -- Incentive Stock Option (filed as Exhibit 10.7.2 to Registrant's Report on Form 10-K for its fiscal year ended November 30, 1989 and incorporated in full herein by this reference). PART IV (continued) Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (continued) (10) Material Contracts (continued) 10.8 Credit Agreement among Registrant, Transitional Hospitals Corporation and Bank of America National Trust and Sav- ings Association, dated as of September 20, 1993 (filed as Exhibit 10 to Registrant's Report on Form 10-Q for its fiscal quarter ended August 31, 1993 and incorporated in full herein by this reference). 10.9 Employment Contract between Registrant and Kay Seim dated as of June 15, 1992, which is required to be filed as an exhibit pursuant to Item 14(c). 10.10 Termination Agreement between Registrant and Loren B. Shook dated as of October 11, 1993, which is required to be filed as an exhibit pursuant to Item 14(c). 10.11 Credit Agreement among Registrant, Priory Hospitals Group Limited and Bank of America National Trust and Savings Association dated as of December 23, 1993. (11) Statement re computation of earnings per share (22) Subsidiaries of the Registrant (24) Consents of Experts (b) Report 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. COMMUNITY PSYCHIATRIC CENTERS By:/s/ RICHARD L. CONTE Date: February 25, 1994 Richard L. Conte Chairman of the Board of Directors and Chief Executive Officer (Principal 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 regis- trant and in the capacities and on the dates indicated. /s/ RICHARD L. CONTE Date: February 25, 1994 Richard L. Conte Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer) /s/ STEVEN S. WEIS Date: February 25, 1994 Steven S. Weis Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/ DAVID WAKEFIELD Date: February 25, 1994 David Wakefield Director and Executive Vice President /s/ HARTLY FLEISCHMANN Date: February 25, 1994 Hartly Fleischmann Director /s/JACK H.LINDHEIMER,M.D. Date:February 25, 1994 Jack H. Lindheimer, M.D. Director /s/DANA L. SHIRES, M.D. Date: February 25, 1994 Dana L. Shires, Jr., M.D. Director /s/ DAVID L. DENNIS Date: February 25, 1994 David L. Dennis Director /s/ STEPHEN J. POWERS Date: February 25, 1994 Stephen J. Powers Director /s/ ROBERT L. THOMAS Date: February 25, 1994 Robert L. Thomas Director /s/ STEVEN M. GRAY Date: February 25, 1994 Steven M. Gray Principal Accounting Officer or Controller Annual Report Form 10-K Item 8, Item 14(a)(1) and (2), (c) and (d) Financial Statements and Supplementary Data List of Financial Statements and Financial Statements Schedules Certain Exhibits Financial Statement Schedules Community Psychiatric Centers and Subsidiaries Laguna Hills, California Year Ended November 30, 1993 Community Psychiatric Centers Form 10-K Item 14(a)(1) and (2) List of Financial Statements and Financial Statement Schedules The following consolidated financial statements of Community Psychiatric Centers and subsidiaries are included in Item 8: Report of Independent Auditors Consolidated statements of operations - Years ended November 30, 1993, 1992 and 1991 Consolidated balance sheets - November 30, 1993 and 1992 Consolidated statements of stockholders' 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 - November 30, 1993 The following consolidated financial statement schedules of Community Psychiatric Centers and subsidiaries are included in Item 14(d): Schedule II - Amounts receivable from related parties and underwriters, promoters, and employees other than related parties 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 income statement information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. Report of Independent Auditors Board of Directors Community Psychiatric Centers We have audited the accompanying consolidated balance sheets of Community Psychiatric Centers and Subsidiaries as of November 30, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended November 30, 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 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 Community Psychiatric Centers and Subsidiaries at November 30, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the 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 financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 5 to the consolidated financial statements, effective December 1, 1992, the Company adopted Statement of Financial Accounting Standard No. 109 Accounting for Income Taxes. ERNST & YOUNG Los Angeles, California January 28, 1994 Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements November 30, 1993 Note 1--Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany transactions have been eliminated in the accompanying consolidated financial statements. The excess of investment in subsidiaries over net assets acquired resulting from acquisitions subsequent to 1970 is being amortized on a straight-line basis over 40 years. Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Those highly liquid assets with a maturity of more than three months are classified as short-term investments. Property, Buildings and Equipment Depreciation is generally computed on the straight-line method based on the estimated useful lives of buildings or items of equipment. Preopening Costs Costs incurred prior to the opening of new facilities are deferred and amortized on a straight-line basis over a five-year period. Capitalization of Interest Interest incurred in connection with development and construction of hospitals is capitalized as part of the related property. Net Operating Revenues Net operating revenues include amounts for hospital services estimated by management to be reimbursable by federal and state government programs (Medicare, Medicaid and CHAMPUS); negotiated programs (managed care companies, health maintenance organizations and preferred provider organizations) and private pay payors (private sources and insurance companies which base reimbursement on the Company's price schedule). The following table summarizes the percent of net operating revenue generated from all payors (1993 percentages include THC operations). Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 1--Summary of Significant Accounting Policies (continued) Concentration of Credit Risk Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash investments and receivables from government programs. The Company maintains cash equivalents and short-term investments with various financial institutions. The Company's policy is designed to limit exposure to any one institution. The Company performs periodic evaluations of the relative credit standing to those financial institutions that are considered in the Company's investment strategy. The Company and management do not believe that there are any credit risks associated with receivables from governmental programs. Negotiated and private receivables consist of receivables from various payors, including individuals involved in diverse activities, subject to differing economic conditions, and do not represent any concentrated credit risks to the Company. Furthermore, management continually monitors and adjusts its reserves and allowances associated with these receivables. Stock Options Proceeds from the exercise of stock options are credited to common stock, to the extent of par value, and the balance to additional paid-in capital, except when shares held in the treasury are issued. The difference between the cost of the treasury stock and the option price is charged or credited to additional paid-in capital. No charges or credits are made to earnings with respect to options granted or exercised. Income tax benefits derived from exercise of non-incentive stock options and from sales of stock obtained from incentive stock options before the minimum holding period are credited to additional paid-in capital. Earnings (Loss) Per Share Earnings (loss) per share have been computed based upon the weighted average number of shares of common stock outstanding during the year. Dilutive common stock equivalents have not been included in the computation of earnings (loss) per share because the aggregate potential dilution resulting therefrom is less than 3%. Translation of Foreign Currencies The financial statements of the Company's foreign subsidiaries have been translated into U.S. dollars in accordance with FASB Statement No. 52. All balance sheet accounts have been translated at year-end exchange rates. Statements of earnings amounts have been translated at the average exchange rate for the year. The resulting currency translation adjustments were made directly to a separate component of Stockholders Equity. The effect on the statement of earnings of translation gains and losses is insignificant for all years presented. Reclassifications Certain amounts have been reclassified to conform with 1993 presentations. Note 2--Restructuring Charge Effective February 28, 1993, the Company recorded a pre-tax charge of $54,950,000 ($34,906,000 net of tax) in connection with the restructuring of certain of its psychiatric hospitals. The charge comprised $35,270,000 to Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 2--Restructuring Charge (continued) write-down buildings and other fixed assets, $2,121,000 to write-off intangibles, $14,369,000 for future operating losses of the seven hospitals and related corporate restructuring costs associated with terminating employees, and $3,190,000 for additional accounts receivable allowances at the seven hospitals. Six of the restructured hospitals have ceased operations. As of November 30, 1993, one of the seven restructured hospitals remains operating. The ultimate disposition of this hospital will be determined shortly. The operating results of these hospitals are excluded from the Company's operations after February 28, 1993. The Company received cash proceeds of approximately $5 million in January and February of 1994 from the sale of two of these restructured hospitals. Note 3--Acquisitions In April 1990, the Company acquired the assets of Harvard Medical Limited, a patient liaison business in West Germany for approximately $2,250,000 including acquisition costs. The purchase agreement provided for additional annual payments through 1993 if certain economic performance criteria are achieved. In September 1991, October 1992, and October 1993, total additional payments of $2,300,000 were made. During 1993, the Company acquired six buildings and the related fixed assets and modified the buildings into six long-term critical care facilities. Total consideration paid was $33,047,000. The Company also acquired a substance abuse center in the United Kingdom for a purchase price of $4,307,000. The aggregate total costs of these acquisitions exceeded the fair value of the assets acquired by approximately $7.8 million. The excess is being amortized on a straight-line basis over a 40-year period. The acquisitions have been accounted for as purchases and, accordingly, the results of operations of the acquired facilities have been included in the consolidated statement of earnings since the date of acquisition. The results of operations of the acquired businesses prior to the date of acquisition were not material to the consolidated financial statements. During 1991, the Company incurred costs of approximately $1,600,000 in the pursuit of two acquisitions that were eventually abandoned. The write-off of these costs reduced earnings per share by $0.02. Note 4--Property, Buildings and Equipment Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 5--Income Taxes Effective December 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes". The changes required by FASB No. 109 (principally adjusting the balances of certain deferred tax accounts) did not have a significant effect on the financial statements of the Company. 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 November 30, 1993 are as follows (in thousands): Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) During September 1993, the Company entered into a credit agreement ("the Agreement") whereby the Company may borrow, repay and reborrow up to $25 million through November 30, 1995 (the revolving loan period), at which time any amount outstanding is converted into a term loan payable in equal quarterly install- ments through November 30, 1998. Interest is payable at the lesser of (1) LIBOR plus 1.25% during the revolving loan period and LIBOR plus 1.50% during the term loan period or (2) the greater of (a) the Bank's reference rate or (b) the Fed Funds rate plus .5%. During October 1993, the Company's subsidiary in the United Kingdom entered into a temporary revolving credit facility whereby the Company was allowed to borrow up to $7.5 million through December 31, 1993. Interest was to be calculated at the rate of interest at which sterling pounds deposits would be offered to major banks in the London interbank market, plus 1.25%. A final loan agreement was signed in December 1993 to replace the temporary facility whereby the Company may borrow up to 10 million sterling pounds through November 30, 1995, at which time any amount outstanding is converted into a term loan payable in equal quarterly installments through November 30, 1998. Interest is payable at the sterling LIBOR rate plus 1.25% up to the conversion date and LIBOR plus 1.50% after the conversion date. The Agreements contain provisions which, among other things, place restrictions on borrowing, capital expenditures and the payment of dividends, and requires the maintenance of certain financial ratios including tangible net worth, fixed charge coverage and funded debt. Management believes that the Company is currently in compliance with all material covenants and restrictions contained in the Agreements. Borrowings are unsecured and are guaranteed by the Company's domestic subsidiaries. Under the terms of the Debenture Payment Assumption Agreement, Vivra Incorporated is obligated to pay $4,139,000 of the 8 1/2% Subordinated Guaran- teed Debentures due 1995. The balance shown above has been reduced by that amount. The Company has guaranteed the payment by Vivra. Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 6--Long-Term Debt at November 30, 1993 (continued) The conversion price of the convertible debentures is subject to antidilutive provisions. Note 7--Capital Stock and Stock Options The Company has stock option plans whereby options may be granted at not less than 100% of fair market value at the date of grant and are exercisable at any time thereafter for a period of ten years, or five years for options granted prior to November 8, 1990. Options granted on and after November 8, 1990, are exercisable 20% at date of grant with the remaining 80% becoming exercisable at the rate of 20% each December 1 thereafter, with the exception of 100,000 op- tions re-issued to certain officers of the Company (see below) which vested immediately. At the time of exercise, at least one-third is payable in cash and the balance, if any, with a five-year note bearing interest at 8%. The unpaid portion of options exercised, evidenced by a note, has been deducted from Stockholders' Equity in the accompanying Consolidated Balance Sheet. Stock options may also be exercised by the return of previously acquired shares of common stock. Shares obtained by such exercises are included in treasury stock and valued at the market value at date of exercise. On May 20, 1993, the Company issued 860,000 of non-qualified options to several key executives. The option price is $20 above the closing price of the Company's stock on the date of grant, or $29.50 per share. For each year during which the Company meets specified performance targets, the option price will decrease by $5.00 until the option price and market price converge. The option price will be fixed at the market price on the date of convergence and the options will vest. If convergence does not occur during the first five years after grant of the options, the options will be cancelled and the shares will revert to the 1989 Stock Incentive Plan and be available for reissuance. On February 14, 1992, 315,200 outstanding options granted in previous years at prices ranging from $18.54 to $34.13 were revalued to $14.63, the market price on that day. Options granted previously to the five then most highly- compensated officers were not revalued. On January 29, 1993, 717,249 options granted previously to those individuals were cancelled, revalued, and re-issued at a 1 to 2 ratio. The options were granted in previous years at prices ranging from $24.08 to $26.81. The options were revalued to $10.88, $.25 higher than the closing market price on that day. Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 7--Capital Stock and Stock Options (continued) Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 8--Deferred Compensation On May 21, 1992, the then Chairman of the Board of Directors of the Company resigned. During the course of his employment with the Company, the former Chairman had an employment contract which provided for consideration for consulting services and a noncompetition agreement to commence in 1995 or earl- ier in the event of permanent disability. The consideration was equivalent to one-half of the total qualifying compensation paid during full time employment from December 1, 1970 through November 30, 1990 and commencing December 1, 1975, the amount on which such qualifying consideration based was increased by 6.5% annually through November 30, 1990 and 8% annually thereafter. The amount due under the terms of the contract was payable in equal annual installments over the life of the former Chairman. At the time of the former Chairman's resignation, an acceleration of payments due him was agreed to by the Company. Based on a computation of the present value of the contractually due amount, a payment of $6,286,000 was made in December 1992. Of this amount, $3,356,000 was provided for in the financial statements of the Company through November 30, 1992. The remaining amount, $2,930,000, is being amortized as consideration (approximately $244,000 annual- ly) for services rendered over the term of the consulting and non-competition agreements which extend to November 30, 2004. Effective November 30, 1989, a former Chairman of the Board of Directors (and current Chairman of the Board of Directors of Vivra Incorporated) termin- ated his employment with the Company and began receiving deferred compensation benefits in accordance with contract terms substantially the same as the con- tract described above. Approximately $162,000 of the annual payment of $323,000 is charged to expense as consideration for services rendered over the term of the consulting and noncompetition agreements which extend to November 30, 2000. Deferred compensation accrued for 1993, 1992 and 1991 was $329,000, $292,000 and $241,000, respectively. Note 9--Profit Sharing Plan The Company has a noncontributory, trusteed profit sharing plan which is qualified under Section 401 of the Internal Revenue Code. All regular nonunion employees in the United States (union employees are eligible if the collective bargaining agreement so specifies) with at least 1,000 hours of service per annum, over 21 years of age, and employed at year-end are eligible for participation in the plan after one year of employment. The Company's contribution to the plan for any fiscal year, as determined by the Board of Directors, is discretionary, but is limited to an amount which is deductible for federal income tax purposes. Contributions to the plan are allocated among eligible participants in the proportion of their salaries to the total salaries of all participants. There were no contributions made by the Company in 1993, 1992 and 1991. During the current year, a 401(k) segment was added to the plan which allows employees to defer a portion of their salary on a pre-tax basis. The Company may match a portion of the amount deferred. The Company's matching contribution is determined by the Board of Directors each year. During 1993, no matching contribution was made. Note 10--Business Segment Information The Company is engaged in two principal business segments. The Company provides psychiatric services for adults, adolescents, and children with acute psychiatric, emotional, substance abuse, and behavioral disorders in the United States and the United Kingdom. The Company also offers long-term critical care services. Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 10--Business Segment Information (continued) Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 11--Fair Value of Financial Instruments The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and cash equivalents: The carrying amount reported in the balance sheet for cash and cash equivalents approximates its fair value. Short-term investments: The fair values for marketable securities are based on quoted market prices. Long-term and short-term debt: The carrying amounts of the Company's long-term and short-term debt approximates its fair value. Note 12--Contingencies Following the release of the Company's third quarter earnings in September 1991, several securities class action lawsuits and one related shareholder derivative action were filed against the Company and certain of its officers and directors. These suits allege the Company made false and misleading statements about its financial condition and business prospects in past periods. The Company maintains its actions were correct and will vigorously defend these suits. The Company is subject to other claims and suits arising in the ordinary course of business. In the opinion of management, ultimate resolution of all pending legal proceedings will not have a material adverse effect on the Company's business or financial condition. Community Psychiatric Centers and Subsidiaries Notes to Consolidated Financial Statements (continued) Note 13--Quarterly Results of Operations (Unaudited) [TEXT] Exhibit 24 Consent of Independent Auditors We consent to the incorporation by reference in Registration Statement No. 33-37920 on Form S-8 dated November 21, 1990, and No. 33-14747 on Form S-3 dated August 6, 1987 of our report dated January 28, 1994 on the consolidated financial statements and financial statement schedules included in the Annual Report on Form 10-K of Community Psychiatric Centers and Subsidiaries for the year ended November 30, 1993. ERNST & YOUNG Los Angeles, California February 24, 1994 [/TEXT] EXHIBIT 10.1 EMPLOYMENT CONTRACT NUMBER FOUR ------------------------------- THIS EMPLOYMENT CONTRACT NUMBER FOUR (the "Contract"), dated as of May 1, 1992, is made between COMMUNITY PSYCHIATRIC CENTERS, a Nevada Corporation ("CPC") and RICHARD L. CONTE, an individual ("Conte"). RECITALS -------- A. CPC has employed Conte as an executive employee pursuant to prior and existing employment agreements. B. CPC desires to revise the terms of Conte's employment and to continue to employ him, and Conte desires to continue in CPC's employment. NOW THEREFORE, Conte and CPC agree as follows: 1. DEFINITIONS. As used in this Contract, the following terms have the following meanings: 1.1 Beneficiarv. "Beneficiary" means any Person or Persons designated from time to time by Conte pursuant to paragraph 6.5.1. 1.2 Board. "Board" means the Board of Directors of CPC. 1.3 Change of Control. "Change of Control" means a change of control that would be required to be reported pursuant to Item 6(e) of Schedule 14A of Rule 14 under the Exchange Act; and, without limitation of the foregoing clause, such a change of control shall be deemed to have occurred if (i) any Person is or becomes the beneficial owner (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of CPC representing 20% or more of the combined voting power of CPC's then outstanding securities, or (ii) during any twenty-four-month period during the Employment Term, individuals who at the beginning of such period constitute the Board cease for any reason to constitute at least a majority thereof, unless the election of each director who was not a director at the beginning of such period has been approved in advance by directors representing at least four-fifths of the directors then in office who were directors at the beginning of such twenty-four-month period. However, a Change of Control does not include a distribution to CPC's shareholders of stock of any subsidiary or a purchase of securities or assets of CPC by a group controlled by directors or executive officers of CPC. 1.4 Code. "Code" means the Internal Revenue Code of 1986 as amended. 1.5 Commission. "Commission" means the Securities and Exchange Commission. 1.6 Compete. "Compete" means either directly or indirectly to own, initiate, manage, operate, join, control, advise, consult with or participate in the ownership, operation, management or control (other than as a shareholder owning less than five percent (5%) of the capital stock of any entity, the shares of which are traded on a national exchange) of any business similar to the Existing Businesses or the Proposed Businesses within the United States, the United Kingdom or any foreign country in which Existing or Proposed Businesses are located, or to lease or sell real or personal property to any such business. 1.7 Confidential Information. "Confidential Information" means 1.7.1 Locations. Data regarding location of proposed and existing hospitals, facilities and buildings; 1.7.2 Markets. Market surveys, studies and analyses; 1.7.3 Personnel. Information concerning the identity, location and qualifications of professionals and employees, existing and prospective; 1.7.4 Referrals. Information concerning referral sources; 1.7.5 Reimbursement. Information concerning reimbursement sources, insurers and other third-party payors and related procedures; 1.7.6 Legal and Regulatory. Tabulated and organized information concerning legislative, administrative, regulatory and zoning requirements, bodies, procedures and officials; 1.7.7 Medical and Personnel Records. Medical and personnel records; 1.7.8 Data. Statistical, financial, cost and accounting data. 1.7.9 Patient and Customer Lists. Existing and prospective patient and customer lists; and 1.7.10 Manuals. Administrative, operations and procedure manuals and directives. 1.7.11 Ideas. Business ideas pertaining to any Existing or Proposed Businesses. Business ideas include, but are not limited to, ideas, concepts or proposals that are conceived, developed or implemented by or communicated to Conte. 1.8 Death Benefit. "Death Benefit" means the death benefit of not less than Five Million Dollars ($5,000,000) payable under the Policy to Conte's Beneficiaries on his death. 1.9 Deliver the Policy. "Deliver the Policy" means to transfer the ownership of and title to the Policy to Conte or his Beneficiary free and clear of all liens, claims, security interests and other encumbrances except for Policy Loans, together with cash sufficient to pay all premiums on the Policy due after such transfer, to the extent such premiums cannot be financed by Policy Loans without reducing the Death Benefit. 1.10 Employment Term. "Employment Term" means the period commencing May 1, 1992 and continuing for a period of four (4) years and seven (7) months ending November 30, 1996 unless earlier terminated pursuant to paragraph 5; provided however, that on December 1, 1993 and on each December 1 thereafter, the Employment Term shall be automatically extended until the earliest to occur of (i) the fourth anniversary of the immediately preceding November 30 or (ii) termination of this Contract pursuant to paragraph 5. 1.11 Exchange Act. "Exchange Act" means the Securities Exchange Act of 1934, as amended. 1.12 Existing Businesses. "Existing Businesses" means the following businesses in which CPC is currently engaged: 1.12.1 Dialysis. Ownership, operation and management of facilities and businesses which provide hemodialysis services and treatments to patients with chronic or acute kidney diseases or conditions; 1.12.2 Psychiatric Hospitals. Ownership and operation of acute psychiatric hospitals, medical office buildings and pharmacies and related facilities; 1.12.3 Substance Abuse. Ownership and operation of facilities which provide chemical, drug and alcohol dependency treatment and services; 1.12.4 Transitional Care. Ownership and operation of transitional care facilities which provide medically complex treatment to patients with subacute illnesses. 1.13 Fiscal Year. "Fiscal Year" means CPC's annual accounting period for financial accounting and reporting purposes, which on the date hereof is the period from each December I to and including the next following November 30. 1.14 Permanent Disability. "Permanent Disability" means any mental or physical illness, disease or condition which in the opinion of an independent, duly licensed physician will or does result in Conte's inability to perform his duties during normal working hours for six months. 1.15 Person. "Person" means any individual, corporation, partnership, business trust, joint venture, association, joint stock company, trust, unincorporated organization or government or agency or political subdivision thereof. 1.16 Policy. "Policy" means a life insurance policy insuring Conte's life, which provides a death benefit of not less than Five Million Dollars ($5,000,000). 1.17 Policy Loan. "Policy Loan" means any loan secured by the cash surrender value of the Policy. 1.18 Prior Contracts. "Prior Contracts" means the following employment contracts between Conte and CPC: (i) the Employment Agreement executed by Conte and CPC on January 21, 1982 and effective December 1, 1981, (ii) the Employment Agreement executed by Conte on September 1, 1988 and by CPC on November 1, 1988 and effective August 1, 1988, and (iii) the Employment Agreement executed by Conte and CPC on December 1, 1991 and effective December 1, 1991. 1.19 Proposed Businesses. "Proposed Businesses" means businesses other than and whether or not related to Existing Businesses in which CPC may from time to time be or plan to be engaged. 1.20 Salary. "Salary" means $550,000 per Fiscal Year, as adjusted from time to time pursuant to paragraph 3.1.1; provided, however, that the Salary shall not include any bonuses or other employment benefits or remuneration paid or payable by CPC to Conte. 1.21 Supplemental Retirement Agreement. "Supplemental Retirement Agreement" means the Supplemental Retirement Agreement dated as of September 1, 1988 between CPC and Conte. 2. Employment and Duties. 2.1 Duties. During the Employment Term, CPC shall employ Conte and Conte shall serve CPC as its Chief Executive Officer or in another capacity in which he has primary and official authority and responsibility for the business, operation and management of CPC. During the Employment Term, Conte shall devote his full productive time, energies and abilities to the business of CPC under the authority of the Board. 2.2 Place of Business. During the Employment Term, Conte's principal place of business shall be in Orange County, California, and he shall not be obliged to maintain his principal place of business elsewhere. 3. Compensation and Benefits. 3.1 Salary. During the Employment Term, CPC shall pay the Salary to Conte in equal monthly or more frequent installments in accordance with CPC's general practice and subject to legally required withholdings. 3.1.1 Salary Review. The Salary for any Fiscal Year commencing after December 1, 1992 shall be subject to annual review by the Board, but in no event shall the Salary be reduced below the greater of $550,000 or the Salary most recently determined by the Board pursuant to this paragraph 3.1.1. Conte understands that the requirement of annual review by the Board shall not be construed in any manner as an express or implied agreement by CPC to raise the Salary. 3.2 Expense Reimbursement. During the Employment Term, CPC shall promptly reimburse Conte, upon submission to CPC by Conte of adequate documentation, for all reasonable out-of-pocket expenses respecting entertainment, travel, meals, hotel accommodations and other like-kind expenses, in each case incurred by Conte in the interest of CPC's business. 3.3 Group Insurance. During the Employment Term, CPC shall provide group life insurance, group travel and accident insurance and group medical, dental and hospital insurance to Conte in the amount and on the terms such insurance is made available to other senior executives of CPC. 3.4 Life Insurance. CPC shall pay the entire cost of the Policy. a policy of life insurance insuring Conte's life, which provides a death benefit to his Beneficiaries of not less than Five Million Dollars ($5,000,000). 3.5 Profit Sharing Plan. During the Employment Term, Conte shall be a participant in CPC's Profit Sharing Plan. 3.6 Other Benefits. During the Employment Term and the Post-Employment Term, by mutual agreement with CPC, Conte may participate in employment benefits made available to other senior executives of CPC; provided, however, that this Contract itself shall neither prevent nor compel such participation. 4. Protection of Business Information: Noncompetition; Nonsolicitation. 4.1 Nondisclosure. 4.1.1 Confidential Information. In the operation and expansion of the Existing Businesses and in the planning and development of the Proposed Businesses, CPC has generated and will generate Confidential Information which is and will be proprietary and confidential and the disclosure of which would be extremely detrimental to CPC and of great assistance to its competitors. 4.1.2 Information Held as a Fiduciary. All of the Confidential Information which is acquired by, communicated to or in any way comes into the possession or control of Conte shall be held by Conte in a fiduciary capacity for the exclusive benefit of CPC. 4.1.3 Nondisclosure Covenant. Conte shall not disclose any Confidential Information to any person, without the consent of CPC. 4.1.4 Exemptions. The restrictions set forth in this paragraph 4.1 shall not apply to any part of the Confidential Information which: (i) is or becomes generally available to the public or publicly known other than as a result of disclosure in breach of any obligation of confidentiality; (ii) becomes available to Conte on a nonconfidential basis from a source other than CPC or its agents or affiliates; (iii) is disclosed pursuant to the requirement of a governmental agency or court of competent jurisdiction or as otherwise required under applicable law; or (iv) was otherwise known or available to Conte without any obligation of confidentiality. 4.1.5 Following Employment. Upon termination of this Agreement, Conte shall promptly relinquish and return to CPC all Confidential Information and all files, correspondence, memoranda, diaries and other records, minutes, notes, manuals, papers and other documents and data, however prepared or memorialized, and all copies thereof, belonging to or relating to the business of CPC, that are in Conte's custody or control whether or not they contain Confidential Information. 4.2 Noncompetition Covenant. During the Employment Term and for a period of three (3) five (5) years thereafter, Conte shall not compete or plan or prepare to compete with CPC. 4.3 Nonsolicitation Covenant. Conte shall not solicit other employees, independent contractors, customers, referral sources or reimbursement sources of CPC for use or employment other than in the Existing or Proposed Businesses. 4.4 Scope and Duration: Severability. CPC and Conte understand and agree that the scope and duration of the covenants contained in this paragraph 4 are reasonable both in time and area and are fairly necessary to protect the business of CPC. Nevertheless, it is further agreed that such covenants shall be regarded as divisible and shall be operative as to time and area to the extent that they may be made so operative and, if any part of them is declared invalid or unenforceable, the validity and enforceability of the remainder shall not be affected. 4.5 Injunction. Conte understands and agrees that, due to the highly competitive nature of the health care industry, the breach of any of the covenants set out in paragraphs 4.1.3, 4.2 and 4.3 will cause irreparable injury to CPC for which it will have no adequate monetary or other remedy at law. Therefore, CPC shall be entitled, in addition to such other remedies as it may have hereunder, to a temporary restraining order and to preliminary and permanent injunctive relief for any breach or threatened breach of the covenants without proof of actual damages that have been or may be caused hereby. In addition, CPC shall have available all remedies provided under state and federal statutes, rules and regulations as well as any and all other remedies as may otherwise be contractually or equitably available. 4.6 Assignment. Except as provided in paragraphs 5.2.4 and 5.2.5, Conte agrees that the covenants contained in paragraph 4 shall inure to the benefit of any successor or assign of CPC with the same force and effect as if such covenants had been made by Conte with such successor or assign. 5. Termination. This Contract shall be terminated before the end of the Employment Term for the reasons set out in paragraph 5.1, in each case with the consequences set out in paragraph 5.2. 5.1 Grounds for Termination. 5.1.1 By CPC. This Contract may be terminated by CPC at any time on 30 days written notice to Conte, for any of the following reasons, provided, however, that CPC no termination described in subparagraphs (a) and (b) (i) shall have be made or take effect unless (i) CPC has the burden of proving proved the causes described in subparagraphs (a) and (b) by clear and convincing evidence and (ii) the termination has been approved by the votes of at least seventy-five percent (75%) of all of the members of the Board: (a) Willful Breach. Breach of any material provision of this Contract by Conte or breach or gross neglect by Conte of his duties as director, officer or employee of CPC; (b) Cause. For cause which shall consist of any act of intentional dishonesty or self-dealing by Conte, in each case in connection with his duties as director, officer or employee of CPC; (c) Termination upon Permanent Disability Conte's Permanent Disability. 5.1.2 Termination by Conte. This Contract may be terminated by Conte at any time upon thirty (30) days' written notice for any of the following reasons: (a) Breach. Breach of any material provision of this Contract by CPC which is not remedied within thirty days after written notice specifying such breach in reasonable detail; (b) Change of Control. A Change of Control; provided, however, that termination pursuant to this 5. 1. 2 (b) shall be effective if and only if Conte gives CPC written notice of such termination within one year after such Change of Control; (c) Permanent Disability. Conte's Permanent Disability. 5.1.3 Termination upon Death. This Contract shall terminate immediately upon the death of Conte. 5.2 Effect of Termination. If this Contract is terminated pursuant to paragraph 5.1, the parties shall have the following rights and obligations: 5.2.1 By CPC for Breach or Cause: Wrongful Termination. If this Contract is terminated by CPC pursuant to paragraphs 5.1.1(a) or (b), Conte shall not have the right or obligation to perform the services described in paragraph 2.1, nor shall Conte have the right to receive the Salary or any other compensation or benefits described in paragraph 3 after the date of termination; but Conte shall be obligated to CPC as provided in paragraph 4, and CPC shall have all remedies available at law or in equity. 5.2.2 By CPC or Conte upon Permanent Disability. If this Contract is terminated by CPC or Conte pursuant to paragraph 5.1.1(c), or 5.1.2(c), (i) Conte shall thereafter have the obligations described in paragraph 4, and (ii) CPC shall (A) pay to Conte or his Beneficiary, within sixty (60) days after such termination, the aggregate Salary through the November 30 next following the fourth (4th) anniversary of the date of termination, (B) continue to have the obligations described in paragraphs 3.3 through 3.6, but, as to paragraphs 3.3 and 3.5, only to the extent those benefits are available under the plans then in effect, and (C) sell to Conte, at his option, at its net book value the automobile then being provided to him. 5.2.3 Death. If Conte dies, CPC shall (i) cause the proceeds of the life insurance policy described in paragraph 3.4 to be paid to Conte's Beneficiary as soon as reasonably possible (ii) within sixty (60) days pay the Salary to the date of his death if he dies during the Employment Term and (iii) pay or continue such other benefits as may be due pursuant to paragraphs 3.3, 3.5 and 3.6. 5.2.4 By Conte for Breach. If this Contract is terminated by Conte pursuant to paragraph 5.1.2(a), he shall not have any further obligation to CPC under paragraphs 2 and 4, and CPC shall (i) pay to him, within sixty (60) days after such termination, the aggregate Salary through the November 30 next following the fourth anniversary of the date of termination, (ii) transfer to Conte deliver the life insurance Policy described in paragraph 3.4 with sufficient funds to pay all future premiums and (iii) continue to have the obligations described in paragraphs 3.3, 3.4 and 3.6, but only to the extent those benefits are available under those plans as then in effect. Conte shall have all remedies available at law or in equity and shall have no duty to mitigate his damages. 5.2.5 By Conte upon Change of Control. If this Contract is terminated by Conte pursuant to paragraph 5.1.2(b), (a) Payments. CPC shall, within 30 days after the effective date of such termination, pay to him (i) the aggregate Salary through the November 30 next following the fourth anniversary of the date of termination, plus (ii) of all other compensation and benefits remaining to be paid to him under this Contract, and (iii) all sums due him under the Supplemental Retirement Agreement, accrued and with all credits thereunder to the date of termination of this Contract; (b) Vesting of Options, etc. Whether or not Conte terminates this Contract pursuant to paragraph 5.1.2 (b) , all stock options and related stock appreciation rights, restricted stock, contingent bonuses or payments and similar deferred benefits held by Conte shall vest and become exercisable immediately upon a Change of Control, and any restrictions on shares of stock of CPC or on stock units that were awarded to Conte under any plan or arrangement maintained by CPC for his benefit shall lapse upon the occurrence of such an event; (c) Life Insurance Policy. CPC shall transfer to Conte the life insurance Policy described in paragraph 3.4 with sufficient funds to pay all future premiums to Conte; (d) Automobile. Conte shall have the option to purchase at net book value the automobile then provided for him by CPC; and (e) Release of Conte Obligations. Conte shall not be obligated to perform any duties under paragraph 2.1, any obligations under paragraph 4 or any other duty, obligation or covenant under this Contract or as an employee of CPC. 5.3 Withholding. Anything in this contract to the contrary notwithstanding, 5.3.1 Withholding. All payments required to be made to Conte or the Beneficiary under this Contract shall be subject to the withholding of such amounts, if any, for income and other payroll taxes and deductions as CPC may reasonably determine should be withheld pursuant to any applicable law or regulation. 6. Miscellaneous. 6.1 Prior Contracts Null and Void. CPC and Conte agree that upon execution and delivery of this Contract by each of them, the Prior Contracts shall terminate and be deemed null and void, and shall have no further force or effect. 6.2 Assignment by CPC. Subject to paragraphs 5.2.4 and 5.2.5, this Contract shall be binding upon and shall inure to the benefit of any successors or assigns of CPC. As used in this Contract, the term "successor" includes any Person or combination of Persons acting in concert which at any time in any form or manner acquires all or substantially all of the assets or business or more than twenty percent (20%) of the voting stock of CPC. 6.3 Nonassignability by Conte. Neither Conte nor any Beneficiary shall assign, transfer, pledge or hypothecate any rights, interests or benefits created hereunder or hereby. Any attempt to do so contrary to the provisions of this Contract, and any levy of any attachment, execution or similar process created thereby, shall be null and void and without effect. 6.4 Spendthrift Provision. Prior to actual receipt by Conte or the Beneficiary, as the case may be, no right or benefit under this Contract and, without limitation, no interest in any payment hereunder shall be: 6.4.1 Anticipation. Anticipated, assigned or encumbered or subject to any creditor's claim or subject to execution, attachment or similar legal process, or 6.4.2 Liability for Debts: Claims. Applied on behalf of or subject to the debts, contracts, liabilities or torts of the Person entitled or who might become entitled to such benefits, or subject to the claims of any creditor of any such Person. 6.5 Beneficiary: Recipients of Payments: Designation of Beneficiary. The Salary, the proceeds of the life insurance policy described in paragraph 3.4 and other compensation and benefits payable by CPC pursuant to this Contract shall be made only to Conte during his lifetime or, in the event of his death, to the Beneficiary. If Conte has not designated a Beneficiary, the payments shall be made to his estate. CPC shall have no obligation to make payments to any person not designated pursuant to paragraph 6.5.1 and shall be discharged, defended and held harmless from any liability for payments actually made to any Beneficiaries or to Conte's estate if no Beneficiaries have been designated. 6.5.1 Designation of Beneficiary. Conte may designate and from time to time change the Beneficiary only by giving a written, signed designation to CPC's Corporate Secretary pursuant to paragraph 6.7. 6.5.2 Elections. Whenever this Contract provides for any option or election by Conte or the Beneficiary, the option shall be exercised or the election made solely by the person or persons receiving payments pursuant to this Contract at that time, and shall be made in that Person's sole discretion and without regard to the effect of the decision on subsequent recipients of payments. Such decision by such Person shall be final and binding on all subsequent recipients of payments. 6.6 Arbitration. If any controversy, question or dispute arises out of or relating to the construction, application or enforcement of this Contract, it shall be settled by arbitration as follows: 6.6.1 Appointment of Arbitrators. Within five days after the delivery of written notice of any such dispute from one to the other, CPC and Conte shall each appoint one person to hear and determine the dispute, and, if the two persons so selected are unable to agree on its resolution with ten (10) days after their appointment, they shall select a third impartial arbitrator, and the three arbitrators so selected shall hear and determine the dispute within sixty (60) days thereafter. 6.6.2 Finality. The determination of a majority of the arbitrators shall be final and conclusive on Conte and CPC. 6.6.3 Rules. The arbitration shall be conducted in accordance with the rules of the American Arbitration Association, and judgment on any award rendered by the arbitrators may be entered in any court having jurisdiction. 6.6.4 Discovery. The parties shall be entitled to avail themselves of all discovery procedures available in civil actions in the State of California, and, without limitation, Conte and CPC hereby incorporate Section 1283.05 of the California Code of Civil Procedure into this Contract pursuant to Section 1283.1 of that Code. 6.7 Notices. Any notice provided for by this Contract and any other notice, demand, designation or communication which either party may wish to send to the other (the "Notices") shall be in writing and shall be deemed to have been properly given if served by (i) personal delivery, (ii) registered or certified mail, return receipt requested, in a sealed envelope, postage and other charges prepaid, or (iii) telegram, telecopy, telex, facsimile or other similar form of transmission followed by delivery pursuant to clause (i) or (ii), in each case addressed to the party for which such notice is intended as follows: If to CPC: Community Psychiatric Centers Board of Directors 24502 Pacific Park Drive Laguna Hills, California 92656 FAX: (714) 831-2202 If to Conte: Richard L. Conte 30971 Hunt Club Drive San Juan Capistrano, California 92675 FAX: (714) 831-2875 6.7.1 Change of Address. Any address or name specified in this paragraph 6.6 may be changed by a Notice given by the addressee to the other party in accordance with paragraph 6.6. 6.7.2 Effective Date of Notice. All notices shall be given and effective as of the date of personal delivery thereof or the date of receipt set forth on the return receipt. The inability to deliver because of a changed address of which no Notice was given, or rejection or other refusal to accept any Notice shall be deemed to be the receipt of the Notice as of the date of such inability to deliver or rejection or refusal to accept. 6.8 Governing Law; Jurisdiction. This Contract shall be construed in accordance with and governed by the laws of the State of California as that State is presently constituted. CPC hereby consents and submits to the jurisdiction of the state and federal courts in California in any suit for the enforcement or construction of or otherwise arising out of this Contract. IN WITNESS WHEREOF, this Contract has been executed and delivered by the parties as of the date first set forth above. Richard L. Conte COMMUNITY PSYCHIATRIC CENTERS By: EXHIBIT 10.9 EMPLOYMENT AGREEMENT -------------------- 1. Parties. This Employment Agreement ("Agreement") is made between COMMUNITY PSYCHIATRIC CENTERS, a Nevada corporation with its International Headquarters located in Laguna Hills, California ("CPC"), and KAY SEIM an individual ("Employee"), under the following circumstances: 2. Continuation of Employment, End of Prior Contract. Pursuant to all the terms and conditions of this Agreement, CPC desires to continue to employ Employee and she desires to continue in her employment, and each of them desires to terminate and cancel any prior contract. 2.1 Employment and Duties. CPC shall employ Employee and Employee shall serve CPC as one of its executive employees and shall perform such duties as the President or Chief Executive Officer of CPC may direct. Employee shall devote her full productive time, energies and abilities to the business of CPC. 2.2 Subsidiaries of CPC. From time to time, Employee may be assigned to work for or on behalf of various subsidiaries of CPC. All obligations of Employee to CPC shall also apply between Employee and all subsidiaries of CPC. 3. Employment Term. The initial Employment Term of this Agreement shall commence on July 1, 1992 and shall continue for a period of three years, ending on July 1, 1995. Unless either party gives written notice of non-renewal to the other not less than sixty (60) days prior to the expiration of any Employment Term, this Agreement shall automatically renew for additional Employment Terms of one (1) year each. 4. Compensation. 4.1 Salary. CPC shall pay to Employee an initial salary of $200,000.00 (Two Hundred Thousand Dollars) per year in equal semi- monthly or more frequent installments in accordance with CPC's payroll practices from time to time in effect. 4.1.1 Salary Review. For fiscal years commencing on or after December 1, 1992, Employee's salary shall be subject to annual review by the parties but this requirement of annual review shall not be construed in any manner as an express or implied agreement by CPC to raise Employee's salary. 4.2 Expense Reimbursement. Upon submission of appropriate vouchers and in accordance with the reimbursement policy stated in CPC's Administrative Manual from time to time in effect, CPC shall reimburse Employee for all authorized travel and entertainment expenses. 4.3 Other Benefits. Employee shall be entitled to participate in employment benefits made available to other salaried employees of CPC and described in Chapter 700 of the CPC's Administrative Manual from time to time in effect. This Agreement shall not restrict in any way the right of CPC to add to, modify or eliminate any employment benefits. 4.4 Bonus Plan. Employee shall be allowed to participate in a bonus plan as approved from time to time by CPC's Board of Directors. 5. Termination. This Agreement may be terminated prior to the end of the Employment Term as follows: 5.1 Mutual Consent. By mutual written consent of the parties. 5.2 CPC. By CPC, for any of the following reasons: 5.2.1 Breach. Upon breach by Employee of any of her duties as Employee or the breach by Employee of any term of this Agreement; 5.2.2 Neglect, etc. For habitual neglect or nonperformance by Employee of her duties; 5.2.3 Incapacity. Upon incapacity of Employee to perform her duties under this Agreement for any consecutive period of more than ninety (90) business days; or 5.2.4 Cause. For cause. 5.3 Employee. By Employee, for any of the following reasons: 5.3.1 Breach. Upon breach by CPC of any of its material obligations to Employee under this Agreement; 5.3.2 Cause. For cause; or 5.3.3 Change in Control. Within ninety (90) days after the occurrence of any of the following events: 5.3.3.1 Tender or Exchange Offer. The purchase of thirty-three and one-third percent (33-1/3%) of the outstanding shares of the CPC's One Dollar par value Common Stock (the "Common Stock") pursuant to any tender or exchange offer (other than such an offer by CPC), whether or not such purchase is opposed by CPC; 5.3.3.2. Other Acquisition of Controlling Stock. The date CPC receives notice that any person or group deemed to be a person under Section 13(d) (3) of the Securities Exchange Act of 1934 and regulations thereunder, in any transaction or series of transactions, becomes the beneficial owner directly or indirectly of Common Stock sufficient to entitle such person or group to thirty-three and one-third percent (33-1/3%) or more or all votes which all shareholders of CPC would be entitled to cast in an election held on such date; 5.3.3.3 Change in Directors. A date during any one-year period when individuals, who at the beginning of that period, constituted the Board of Directors of CPC cease for any reason to constitute a majority thereof, unless the election, or the nomination for election by the shareholders of CPC of each new director was approved by a vote of at least two-thirds of the directors in office who were directors at the beginning of the period; 5.3.3.4 Reorganization, Sale of Assets. The date of approval by the shareholders of CPC of an agreement providing for: 5.3.3.4.1 The merger or consolidation of CPC with another corporation where the shareholders of CPC immediately prior to the merger or consolidation do not beneficially own immediately thereafter shares of the corporation issuing cash or securities in the merger or consolidation, entitling such shareholders to fifty percent (50%) or more of all votes to which all shareholders of such corporation would be entitled in the election of Directors, or where the members of the board of Directors of CPC immediately prior to the merger or consolidation do not immediately thereafter constitute a majority of the Board of Directors of the corporation issuing cash or securities in the merger or consolidation; or 5.3.3.4.2 The sale or other disposition of all or substantially all of the assets of CPC. 5.5 Payment on Termination. 5.5.1 Change in Control. If Employee terminates her employment pursuant to paragraph 5.3.3, he shall be entitled to receive, in addition to any amounts due pursuant to paragraph 5.5.2, a cash payment equivalent to two (2) year's salary as severance pay, regardless of the Employment Term remaining at the time of such termination. 5.5.2 Other Termination. Upon termination of Employee's employment for any reason, she shall be paid all salary and vacation time (not including sick time) accrued to the date of termination; provided, however, that: 5.5.2.1 Notice of and Payments upon Termination. Employee shall give at least sixty (60) days prior written notice to CPC of her intention to terminate her employment pursuant to paragraphs 5.3.1 or 5.3.2 and if she fails to give such notice to CPC, she shall pay to CPC, as liquidated damages, an amount equal to one month's salary which amount shall be used by employer to offset the costs incurred in replacing Employee on short notice; and 5.5.2.2 Repayment of Obligations, etc. Upon termination of her employment for any reason, Employee shall pay to CPC all sums due under any notes or other obligations from her to it and all such obligations shall then become due and payable. Such obligations include, but are not limited to, those incurred for purchase of CPC stock upon exercise of stock options held by Employee. 5.5.3 Return of Property. Upon termination of employment for any reason, Employee shall return to CPC all property belonging to CPC, in her possession or under her control. 5.5.4 Stock Options. Employee acknowledges that CPC's Qualified, Non-qualified and Combined Stock Option Plans for Key Employees provide that all unexercised options held by her thereunder shall expire upon termination of employment for any reason, except for termination by Employee pursuant to paragraph 5.3.3. Upon termination of employment pursuant to that paragraph, Employee will be entitled to a cash payment in the amount of the difference between the option price of shares of CPC stock subject to options held by her and the then fair market value of such shares, all as more fully described in CPC'S stock option plans. The plans may be changed or eliminated and may not be modified or controlled by this Agreement. 6. Protection of Business Information. 6.1 Existing Businesses. At the present time, CPC is engaged in the following businesses (the "Existing Businesses"): 6.1.1 ownership and operation of acute psychiatric hospitals and related facilities, which include, but are not limited to, medical buildings and pharmacies; 6.1.2 ownership and operation of facilities which provide chemical, drug and alcohol dependency treatment and services; 6.2 Proposed Businesses. In addition, CPC plans to be engaged in other businesses (the "Proposed Businesses") related and unrelated to the Existing Businesses. 6.3 Information. In the operation, planning and development of the Existing Businesses and the Proposed Businesses, CPC generates and will generate business information, confidential information and trade secrets which are and will be proprietary and confidential ("Information") and the disclosure of which would be extremely detrimental to CPC and of great assistance to its competitors. The Information includes, but is not limited to: 6.3.1 Data regarding location of proposed and existing facilities; 6.3.2 Market survey, studies and analyses; 6.3.3 Information concerning the identity, location and qualifications of professionals and employees, existing and prospective; 6.3.4 Information concerning referral sources; 6.3.5 Information concerning reimbursement sources, insurers and other third-party payors; 6.3.6 Tabulated and organized information concerning legislative, administrative, regulatory and zoning requirements, bodies and officials; 6.3.7 Medical and personnel records; 6.3.8 Statistical, financial, cost and accounting data; 6.3.9 Existing and prospective customer lists; and 6.3.10 Administrative, operations and procedure manuals and directives. 6.3.11 Business ideas pertaining to any Existing or Proposed Businesses of CPC. Business ideas include, but are not limited to, ideas, concepts or proposals that are conceived, developed or implemented by or communicated to Employee. 6.4 Information Held as a Fiduciary. All of the Information which is acquired by, communicated to or in any way comes into the possession or control of Employee shall be held by employee in a fiduciary capacity for the exclusive benefit of CPC. 6.5 During Employment. Prior to termination of this Agreement, Employee shall have these obligations: 6.5.1 No Competition. Employee shall not compete with CPC. "Compete" means to either directly or indirectly own, manage, operate, control or participate or join in or advise, consult with or assist in the establishment or operation of any business similar to the Existing Businesses or the Proposed Businesses which is located within any county or equivalent jurisdiction in which any of the Existing Businesses or Proposed Businesses are located or proposed to be located; within any contiguous county; within the United Kingdom; or within a two hundred mile radius of any Prospective Business located in any foreign country. 6.5.2 No Planning to Compete Following Employment. Employee shall not plan or otherwise prepare to compete with CPC following Employee's employment with CPC. 6.5.3 No Solicitation to Compete. Employee shall not solicit other employees, independent contractors, customers, referral sources or reimbursement sources of CPC to compete with CPC during or following Employee's employment with CPC. 6.5.4 No Disclosure. Employee shall not disclose to any person, who, on behalf of CPC, has no business reason to know, any business information, confidential information or trade secrets of CPC. 6.6 Following Employment. Upon termination of this Agreement, Employment shall have the following obligations: 6.6.1 Return of Information. Employee will promptly relinquish to CPC all files, correspondence, memoranda, diaries and other records, minutes, notes, manuals, papers and other documents and data, however prepared or memorialized, and all copies thereof, belonging to or relating to the business of CPC, that are in Employee's custody or control. 6.6.2 No Use of Trade Secrets. Employee shall not use or disclose any trade secret acquired from or on behalf of CPC before, during or after Employee's employment with CPC. 6.6.3 No Use of Confidential Information. Employee shall not use or disclose any confidential information acquired from, for or about CPC before, during or after Employee's employment with CPC. 6.6.4 No Use of Business Information. Employee shall not use or disclose any business information acquired from, for or about CPC before, during or after Employee's employment with CPC. 6.6.5 No Interference. Employee shall not interfere with any contracts or business relationships of CPC. 6.6.6 No Solicitation. Employee shall not solicit other employees, independent contractors, customers, referral sources or reimbursement sources of CPC to compete with CPC. 6.6.7 No Competition. Employee shall not compete with CPC for a period of two years following termination of employment. 6.7 Exception for Publicly Held Companies. Notwithstanding the provisions of paragraphs 6.5 and 6.6 above, Employee may participate as a non-controlling shareholder (but not in any other capacity) , holding less than five percent (5%) of any class of stock in a publicly owned corporation whose stock is traded on a National securities Exchange or on the over-the-counter market. 6.8 Exception for Change of Control. The provisions of paragraph 6.6 shall not apply if employee's employment is terminated pursuant to paragraph 5.3.3 above. 6.9 Scope of Covenant. It is expressly understood and agreed that the scope of the various covenants in this paragraph 6 are reasonable both in time and area and are fair and necessary to protect the investment of CPC against the material adverse effects which would result from the violation of any of these covenants. 6.10 Divisibility of covenants. The covenants of this paragraph 6 shall be regarded as divisible and shall be given the greatest operative effect possible. If any part of them is declared invalid or unenforceable in any respect, the validity and enforceability of the remainder shall not be affected. 6.11 Remedies for Breach of Obligations Regarding Business Information. In addition to CPC's right to seek damages for any violation of the covenants in this paragraph 6, Employee acknowledges that because her duties are of a special, unique, unusual, extraordinary or intellectual character, which gives them peculiar value which cannot be reasonably or adequately compensated by an award of damages, equitable relief in the form of injunction or other order will be available to CPC. 7. Notices. Any notice provided for by this Contract and any other notice, demand or communication which either party may wish to send to the other ("Notices") shall be in writing and shall be deemed to have been properly given when received if delivered by personal delivery; certified mail, return receipt requested; or other commercially acceptable means. Notices shall be addressed as follows: If to CPC: Richard L. Conte, Chairman & Chief Executive Officer Community Psychiatric Centers 24502 Pacific Park Drive Laguna Hills, California 92656 If to Employee: Kay Seim 422 Waverly Way Kirkland, WA 98033 Either party may change its address for Notices by giving notice of the change to the other party. 8. Successors, Assignment. Except as provided in paragraph 5.3.3, this agreement shall be binding on the heirs, assigns, personal representatives and successors of CPC and Employee. However, due to the nature of the services to be provided by Employee, Employee shall have no power to assign any rights or duties under this Agreement. 9. Applicable Law. This agreement shall be governed by and construed in accordance with the laws of the State of California and the parties consent to the jurisdiction of its courts. 10. Divisibility of Agreement. This Agreement shall be divisible and if any part of it is determined to be invalid or unenforceable the remaining portions shall not be affected and the Agreement shall be carried out to the greatest extent possible in accordance with all of its provisions. 11. Entire Agreement. This Agreement represents the entire agreement between CPC and Employee, and this Agreement supersedes any other agreements, oral or written, that may define the employment relationship between Employee and CPC. Neither CPC nor Employee has relied upon any promise or other inducement which is not expressed in this Agreement. 12. Amendment. This Agreement may be amended only by written agreement of CPC and Employee and may not be modified by any oral agreement. 13. Practices Inconsistent with this Agreement. No provision of this Agreement shall be modified or construed by any practice or occurrence that is inconsistent with any provision. Failure of either party to insist upon compliance with any provision shall not constitute an amendment or a waiver of the right to insist upon compliance with that provision or nay other provision. EMPLOYEE: Dated: Kay Seim Executive Vice President COMMUNITY PSYCHIATRIC CENTERS Dated: By: Richard L. Conte, Chairman Chief Executive officer ADDENDUM TO EMPLOYMENT CONTRACT BETWEEN CPC AND KAY E. SEIM 1. EXEMPTION OF CONFLICT OF INTEREST: CPC acknowledges the joint ownership of Continuum Healthcare by Richard A. and Kay E. Seim. Continuum Healthcare is a business incorporated in the State of Washington which is a community property state. CPC acknowledges that Kay Seim is a shareholder, officer and director of Continuum Healthcare. CPC consents to Kay Seim continuing to hold and perform her obligations under such offices while employed at CPC. CPC agrees that Mr. Seims' current or future work with or on behalf of Continuum Healthcare in the areas of residential, partial and in-home mental health care shall not be deemed to place Kay Seim into a conflict of interest situation. CPC recognizes Mr. Seim's involvement with Continuum Healthcare in King County and Pierce County in the State of Washington and hereby notices both Mr. & Mrs. Seim that such work by Mr. Seim is acceptable to CPC. CPC agrees that such work shall not be deemed to infringe upon or to otherwise compromise the employment relationship of Kay Seim with CPC. 2. CAPITALIZATION NEEDS: During the course of its operation, the shareholders and directors of Continuum Healthcare may deem it necessary to infuse Continuum Healthcare with additional capital. CPC hereby agrees that not only is such expansion of Continuum Healthcare's business acceptable to CPC but that CPC would seriously consider advancing sums to Continuum Healthcare or to otherwise joint venture with Continuum Healthcare in its future expansion plans. 3. COMPANY LOAN: CPC agrees to grant to Kay Seim upon request a home equity loan in the amount desired by Ms. Seim up to $300,000 or such greater amount then authorized by CPC at an annual interest rate of 5% or whatever current lower rate may be in effect to enable Kay Seim to purchase a new home, remodel existing home or for such other purposes desired by Kay Seim. 4. COVENANTS NOT TO COMPETE: CPC and Continuum Healthcare agree to not compete with each other if such competition might be detrimental to the working relationship of CPC and Kay Seim or the personal relationships of Rick and Kay Seim. Furthermore, CPC rather than to create its own competing business agrees to use its best efforts to work with, subcontract or co-venture with Continuum Healthcare in King and Pierce Counties in the State of Washington in a mutually agreed upon manner. Given the exceedingly close physical proximity of Continuum Healthcare's Kirkland operation and the location of CPC Fairfax Hospital, it would be clearly disadvantageous to all parties to set up two similar operations in such a limited market place which can, at best, properly support one such operation. /s/ KAY E. SEIM /s/ RICHARD CONTE - - ------------------------------- ------------------------------- Kay E. Seim, Employee Richard L. Conte, Chairman Community Psychiatric Centers 6-15-92 6-12-92 - - ------------------------------- ------------------------------- Date Date EXHIBIT 10.10 SEPARATION AGREEMENT AND GENERAL RELEASE ---------------------------------------- This Separation Agreement and General Release ("Agreement") is entered into by and between Community Psychiatric Centers ("EMPLOYER") and Loren B. Shook ("EMPLOYEE"). I. RECITALS 1.1 EMPLOYEE has been employed by EMPLOYER pursuant to a written Employment Agreement, most recently in the position of President, Chief Operating Officer, and member of the Board of Directors of EMPLOYER and certain of its subsidiaries. 1.2 EMPLOYEE was relieved of his duties effective September 7, 1993 and was advised BY EMPLOYER that he would be terminated immediately if he did not resign from all positions with EMPLOYER and its subsidiaries. EMPLOYEE elected to resign and EMPLOYEE and EMPLOYER have subsequently agreed to an effective date of October 7, 1993 (Effective Date). 1.3 EMPLOYER and EMPLOYEE desire to enter into an agreement which will assist EMPLOYEE in finding new employment, provide for the release of any claims related to EMPLOYEE'S employment or the termination of said employment, facilitate the payment of the loans referred to in Paragraphs 2.5 and 2.6 and resolve various other matters between EMPLOYER and EMPLOYEE. II. AGREEMENTS 2.1 Review Period. EMPLOYEE shall have until the close of business on October 7, 1993, to accept the terms of this Agreement. EMPLOYEE has been encouraged to consult with an attorney before signing this Agreement and has done so. 2.2 Termination of Employment. EMPLOYEE'S employment with EMPLOYER and its subsidiaries, as President, Chief Operating Officer, member of the Board of Directors, and all other capacities, is terminated for all purposes, effective October 7, 1993. 2.3 Payments. Following execution of this Agreement, EMPLOYER shall pay to EMPLOYEE a severance benefit, equal to EMPLOYEE'S most recent rate of pay ($450,000 per year) for EMPLOYEE'S regularly scheduled hours (bonuses, overtime or other enhancements will not be included in the rate or hours), for the period from the Effective Date through November 30, 1994, plus 100% of the amount accrued for EMPLOYEE'S account in the EMPLOYER'S Deferred Compensation Plan ($258,505, including the amount which would otherwise be credited on June 1, 1994), all less deductions required by law. Payment will be made in one installment of $262,632.21 gross on Employer's regular payroll date of October 22, 1993, followed BY five equal monthly installments, without interest, beginning on the first regular pay day in November 1993 and continuing on the first regular pay day of each succeeding month until all five payments have been made. Payment will be mailed to Employee's most recent address on file with Employer. These payments, the additional benefits specified below, and other consideration have been agreed upon by EMPLOYER and EMPLOYEE as consideration for the EMPLOYEE'S promises set forth in this Agreement. EMPLOYEE acknowledges that he has timely received, in accordance with all applicable provisions of law, rules and regulations of the State Labor Code, all wages and vacation benefits due him. (Regular wages paid through October 7, 1993; vacation accrued and paid through September 7, 1993.) 2.4 Additional Benefits. a. Medical Insurance. During the period from the Effective Date until the earlier of November 30, 1994 or the date on which EMPLOYEE is first eligible for health care benefits under another employer's plan (Conversion Date), EMPLOYEE will continue to be covered under the EMPLOYER'S usual health insurance programs on terms not less favorable to EMPLOYEE than those provided to other corporate office employees of EMPLOYER. Within ten (10) calendar days next following the Conversion Date, EMPLOYER shall provide EMPLOYEE, and any members of his family eligible to receive such notice, written notice of his and/or their rights to continue medical insurance under the provisions of the Consolidated Omnibus Reconciliation Act of 1986 ("COBRA"). Following the Conversion Date, EMPLOYEE, or any member of EMPLOYEE'S family otherwise eligible to receive such notice will be responsible for the full cost of continuation coverage in accordance with the provisions of COBRA. EMPLOYEE will notify EMPLOYER promptly of his new employment and any applicable waiting period for eligibility under the new employer's health insurance plan. b. Profit Sharing. For purposes of calculating EMPLOYEE'S service under the "CPC Employees' Profit Sharing Plan" ("Plan"), EMPLOYEE shall be deemed to have been employed until the Effective Date and not thereafter. This Agreement is not intended to change any of EMPLOYEE'S rights or responsibilities as provided in the Plan documents for persons whose employment with EMPLOYER terminates. c. Stock Options. Stock options granted to EMPLOYEE by EMPLOYER which are vested and exercisable as of the Effective Date, to wit, options to purchase a total of 200,000 shares of the common stock of EMPLOYER (50,000 shares at $14.625 per share and 150,000 shares at $10.875 per share), will remain valid and exercisable through February 28, 1994, except that EMPLOYER will not extend credit to EMPLOYEE for the purpose of exercising those options. Any options not vested as of the Effective Date will automatically terminate at that time, as provided in applicable stock option plan documents and agreements. EMPLOYEE will remain responsible for compliance with all applicable requirements concerning exercise of stock options and acquisition or disposition of EMPLOYER stock, including but not limited to prohibitions on insider trading, short-swing profits and the like. d. Automobile. EMPLOYER will deliver to EMPLOYEE a Bill of Sale and the Certificate of Ownership for the company car assigned to EMPLOYEE, along with the mobile telephone installed in the car. Normal expenses for fuel, maintenance, repairs, insurance and mobile telephone service will be paid or reimbursed by EMPLOYER, in accordance with its usual practices, for the period from the Effective Date through November 30, 1993. e. Outplacement. EMPLOYER will provide outplacement services for EMPLOYEE from EMPLOYEE'S choice of three such agencies to be nominated by EMPLOYER. These services will be limited to one placement, and will be further detailed in materials to be provided EMPLOYEE prior to his selection of the agency to be used. f. Indemnification. EMPLOYER will honor the Indemnification Agreement between EMPLOYER and EMPLOYEE dated June 1, 1987, in accordance with its terms, provided EMPLOYEE cooperates fully in any such matter. g. Non-Competition Covenant. EMPLOYER releases EMPLOYEE from any obligation under the provisions of Paragraph 6.6.7 of the Employment Agreement between EMPLOYEE and EMPLOYER. h. Tax Services. EMPLOYER will continue to pay for tax preparation services to EMPLOYEE, on substantially the same terms as EMPLOYER provides for other of its executives who receive this service, through November 30, 1994. 2.5 Residential Loan. The Residential Loan Agreement dated June 15, 1982 between EMPLOYEE and EMPLOYER ("Loan Agreement"), the Installment Note dated July 2, 1982 issued by EMPLOYEE ("Note"), and the Short Form Deed of Trust and Assignment of Rents dated July 6, 1982, executed BY EMPLOYEE and Carolyn Shook as Trustors ("Deed of Trust"), shall be amended to extend the maturity date of loan evidenced by the Note to September 30, 1998. The parties agree that the Note shall be further modified to reflect the correct unpaid principal balance on the Note as of October 1, 1993, which sum is Two Hundred Thirty-Four Thousand Seven Hundred Fifty-Nine and 67/100 Dollars ($234,759.67) (assuming the payment due on that date is made) and to modify the interest rate payable on the unpaid principal balance of the Note. The Note shall be modified to provide that interest per annum on the amount of principal remaining unpaid on the Note shall be five percent (5%) for the period from October 1, 1993 to September 30, 1994, six percent (6%) for the period from October 1, 1994 to September 30, 1995, seven percent (7%) for the period from October 1, 1995 to September 30, 1996, and seven and one-half percent (7-1/2%) for the period from October 1, 1996 until the maturity date of the Note, on September 30, 1998. The Note shall be dated as of October 1, 1993, and principal and interest shall be paid in equal monthly installments in an amount required to fully amortize the outstanding principal amount of the modified Note over a period of thirty (30) years, such installments to be calculated for each payment period at the rate of interest applicable for such payment period as specified hereinabove. The amendments to the Loan Agreement, Note and Deed of Trust shall be evidenced by amendments to or restatements of such agreements and instruments which shall contain such other terms and conditions as are customary in loan modifications. EMPLOYER'S agreement to extend and modify the Loan as described in this Paragraph 2.5 shall be conditioned upon EMPLOYEE'S satisfaction of all of the following conditions on or before October 31, 1993: (i) all payments on the Note must be current; (ii) execution and at the election of EMPLOYER, recordation, of a modification to the Deed of Trust executed BY EMPLOYEE and any other person(s) whose signatures are necessary to complete the transaction; (iii) issuance for the benefit of EMPLOYER, of an endorsement to the original lender's policy of title insurance which insured the Deed of Trust or of a new lender's policy of title insurance insuring the first lien position of the Deed of Trust on the property which is the subject of said Deed of Trust ("Property"), or a commitment from an acceptable title insurance company that such policy or endorsement shall be issued promptly following recordation of the modified Deed of Trust; (iv) the satisfaction and discharge by EMPLOYEE at his sole expense, of any liens or encumbrances which may have been recorded against the Property or become a lien thereon subsequent to the recordation of the original Deed of Trust, and (v) EMPLOYEE'S continued performance of his obligations under this Agreement. 2.6 Stock Option Loan. The total balance of any other loans to EMPLOYEE (e.g., stock option loans) will be paid to EMPLOYER on or before November 30, 1993. 2.7 Further Documents. Each party agrees to timely execute and deliver, at any time and from time to time, upon the request of another party, such further instruments or documents as may be necessary or appropriate to carry out the provisions contained herein, and to take such other action as another party may reasonably request to effectuate the purposes of this Agreement. 2.8 Release of Claims. (a) Release by EMPLOYEE. Subject only to Paragraph 2.9, EMPLOYEE on EMPLOYEE'S own behalf, and on behalf of EMPLOYEE'S successors and assigns releases the EMPLOYER and its officers, directors, employees, agents, and attorneys and any parent, subsidiary, affiliated or related companies and their respective successors and assigns ("Released Parties") from all claims, demands, actions, or other legal responsibilities of any kind which EMPLOYEE may have against EMPLOYER or any of the Released Parties, including but not limited to any arising under Title VII of the Civil Rights Act of 1964, as amended, which prohibits discrimination in employment based on race, color, sex, religion or national origin, or any other federal, state or local law or regulation prohibiting employment discrimination. This Release also includes, but is not limited to, any claims arising under the Employment Agreement, relating to EMPLOYEE'S employment or the termination of it, for emotional distress, wrongful discharge, violation of any public policy or statute, breach of any implied or express contract between EMPLOYER and EMPLOYEE or any policy of the EMPLOYER, any acts or omissions of the Released Parties, and any remedy for any such claim. (b) Release by EMPLOYER. EMPLOYER on its own behalf, and on behalf of its successors and assigns releases the EMPLOYEE from all claims, demands, actions, or other legal responsibilities of any kind which EMPLOYER may have against EMPLOYEE ("Claim"), except: (1) any Claim for which EMPLOYER would not be required to provide indemnification or advancement of expenses under the Indemnification Agreement or applicable law; (2) any Claim arising under the terms of the Indemnification Agreement; and (3) any Claim arising from a breach by EMPLOYEE of this Agreement. 2.9 Claims Not Affected by Release. This Release does not affect these claims or rights of EMPLOYEE: (a) any rights of a terminated employee under the terms of the CPC Employees' Profit Sharing Plan; (b) any rights to apply for continuation or conversion of insurance coverage to the extent that the EMPLOYER'S insurance plans or applicable law provide for such continuation or conversion; (c) any claim for workers' compensation under any federal or state workers' compensation or occupational disease law; (d) any claim under the Indemnification Agreement; and (e) any claim arising from a breach by EMPLOYER of this Agreement. 2.10 Unknown Claims. EMPLOYEE and EMPLOYER understand that the releases given by each of them in this Agreement cover claims which each of them knows about and those they may not know about. EMPLOYEE and EMPLOYER expressly waive all rights under Section 1542 of the California Civil Code, which Section they have read and understand, and which provides as follows: "Section 1542. A GENERAL RELEASE DOES NOT EXTEND TO CLAIMS WHICH THE CREDITOR DOES NOT KNOW OR SUSPECT TO EXIST IN HIS FAVOR AT THE TIME OF EXECUTING THE RELEASE, WHICH IF KNOWN BY HIM MUST HAVE MATERIALLY AFFECTED HIS SETTLEMENT WITH THE DEBTOR." Nothing in this Paragraph 2.10 is intended to release any claims which are otherwise reserved under this Agreement. 2.11 Agreement Not to Sue. EMPLOYEE and EMPLOYER promise never to file a lawsuit asserting any claims that are released BY this Agreement. 2.12 Warranty of Non-Assignment. EMPLOYEE warrants that EMPLOYEE has not assigned to any other person or entity the claims which are the subject of Paragraphs 2.8 and 2.10 above. EMPLOYER warrants that EMPLOYER has not assigned to any other person or entity the claims which are the subject of Paragraphs 2.8 and 2.10 above. 2.13 Consequences of Violation of Promises. IF EMPLOYEE violates EMPLOYEE'S promises contained herein, EMPLOYER shall have all remedies provided by law, and EMPLOYEE will pay for all costs incurred by any of the Released Parties, including reasonable attorney's fees, in defending against the EMPLOYEE'S claim. If EMPLOYER violates EMPLOYER'S promises contained herein, EMPLOYEE shall have all remedies provided by law, and EMPLOYER will pay for all costs incurred by EMPLOYEE in remedying EMPLOYER'S breach of this Agreement. 2.14 EMPLOYER'S Property. EMPLOYEE has, or forthwith will vacate the offices assigned to him and return to EMPLOYER all physical property of any kind of the EMPLOYER in EMPLOYEE'S possession, including, without limitation, directories, documents, lists, plans, files, software programs, tapes, materials, manuals, keys, access cards and credit cards. 2.15 Confidentiality. EMPLOYEE and EMPLOYER both agree not to disclose the terms and conditions of this Agreement for any reason to any person or entity not a party hereto unless such communication is required by law or is necessary to prosecute or defend an alleged breach of this Agreement, and except as may be necessary for any party to obtain tax, legal or other professional advice regarding the implications of this Agreement. 2.16 Parties' Reputations. EMPLOYEE agrees not to make any unfavorable or disparaging communication regarding EMPLOYER or EMPLOYEE'S employer-employee relationship with EMPLOYER. EMPLOYER agrees not to make any unfavorable or disparaging communication regarding EMPLOYEE or EMPLOYER'S employer-employee relationship with EMPLOYEE. 2.17 Other Employment. EMPLOYEE shall not, at any time, be foreclosed from seeking, soliciting or accepting employment with any persons other than the Released Parties referred to in Paragraph 2.8. EMPLOYER waives any future employment rights with any of the Released Parties. 2.18 Protection of Business Information. EMPLOYEE agrees that the provisions of Paragraph 6, "Protection of Business Information," in the Employment Agreement between EMPLOYEE and EMPLOYER, remain in force as stated in the Employment Agreement, except for Paragraph 6.6.7, which is specifically nullified by this Agreement. Notwithstanding the provisions of Paragraph 6.6.1 of the Employment Agreement, EMPLOYEE may make and retain copies of all notes, letters, records, files, memoranda, papers and the like, relating to his service as an employee, officer or director of EMPLOYER, which are reasonably related to pending or threatened suits or claims involving EMPLOYEE, provided EMPLOYEE preserves the confidentiality of the copies except as may be necessary to defend such suits or claims. EMPLOYEE and EMPLOYER will cooperate to arrange the identification and copying of such documents. The following categories of information are agreed not to be included in the terms trade secret, confidential information or business information mentioned in Paragraphs 6.6.2, 6.6.3 and 6.6.4 of the Employment Agreement: (i) information that is generally available to the public other than by reason of any prohibited disclosure by EMPLOYEE or others, (ii) information that is or becomes known or available from a source other than EMPLOYER or its employees or representatives and is not the subject of any other confidentiality agreement, and (iii) information that is subsequently and independently developed by an agent or representative of EMPLOYEE and to whom EMPLOYEE has not directly or indirectly divulged the information. 2.19 Acknowledgment of Benefits. EMPLOYEE understands and acknowledges that the payments provided for in Paragraph 2.3, the additional benefits provided for in Paragraph 2.4 and the other consideration set forth in this Agreement are all that EMPLOYEE is entitled to receive from the EMPLOYER, and are more than the EMPLOYER is required to provide under its normal policies and procedures and any prior or current agreements between EMPLOYER and EMPLOYEE, and are in lieu of any other monies or benefits which EMPLOYEE may claim to have earned or accrued. 2.20 Governing Law. This Agreement shall be governed by, and construed and enforced in accordance with and subject to the laws of the State of California. 2.21 Notices. All notices or other communications provided for by this Agreement shall be made in writing and shall be deemed properly delivered: (i) when delivered personally or (ii) by the mailing of such notice by registered or certified mail, postage pre-paid, to the parties at the addresses set forth on the signature page of this Agreement (or to such other address as one party designates to the other in writing). 2.22 Amendments. No addition, modification, amendment or waiver of any part of this Agreement shall be binding or enforceable unless executed in writing by both parties hereto. 2.23 Entire Agreement. This is the entire Agreement between EMPLOYEE and EMPLOYER. EMPLOYER has made no promises other than those set forth in this Agreement. This Agreement supersedes all prior agreements between EMPLOYER and EMPLOYEE, including without limitation, the Employment Agreement between EMPLOYER and EMPLOYEE, a copy OF which is attached to this Agreement. EMPLOYEE ACKNOWLEDGES THAT EMPLOYEE HAS READ THIS AGREEMENT, UNDERSTANDS IT AND IS VOLUNTARILY ENTERING INTO IT WITH THE INTENTION OF RELINQUISHING ALL CLAIMS AND RIGHTS OTHER THAN THOSE SPECIFICALLY RESERVED. EMPLOYER: COMMUNITY PSYCHIATRIC CENTERS Attention: Morgan L. Staines 24502 Pacific Park Drive Laguna Hills, California 92656-3035 By /s/ MORGAN L. STAINES ---------------------------------------- Morgan L. Staines Vice President and General Counsel Date 10/11/93 -------------------------------------- EMPLOYEE: /s/ LOREN B. SHOOK - - ------------------------------------------- Loren B. Shook Date: 10/11/93 ------------------------------------- EXHIBIT 10.11 PRIORY HOSPITALS GROUP LIMITED AND BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION 10,000,000 POUNDS STERLING LOAN AGREEMENT Dated 23 December, 1993 THIS LOAN AGREEMENT is made the day of December One thousand nine hundred and ninety three. BETWEEN:- (1) Priory Hospitals Group Limited (Registered No: 1505382) whose registered office is at The Priory, Priory Lane, Roehampton, London SW15 5JJ (the "Borrower"); (2) BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION acting through its London Branch of Bank of America House, 1 Alie Street, London El 8DE. (the "Bank"); WHEREAS the Bank has agreed to make available to the Borrower a revolving term loan facility (the "Facility") in the maximum aggregate principal amount of 10,000,000 pounds sterling upon and subject to the terms and conditions contained in this Agreement and the Guarantor has agreed to guarantee the obligations expressed to be assumed by the Borrower in or pursuant to this Agreement NOW IT IS HEREBY AGREED as follows: CLAUSE 1 DEFINITIONS In this Agreement and the Recitals and Schedules hereto the following expressions shall, unless there is something in the subject or context inconsistent therewith, have the following meanings:- "ACCOUNTS" means the audited accounts of the Borrower for the year ended 30 November 1992. "ACQUISITION" means any transaction or series of related transactions for the purpose of or resulting, directly or indirectly, in (a) the acquisition of all or substantially all of the assets of a Person, or of any business or division of a Person (including, without limitation, acquisition by, assumption, purchase, assignment, sublease or in any other manner of leases, leasehold interests or lease rights or obligations), (b) the acquisition, of in excess of 50% of the share capital, partnership interests or equity of any Person or otherwise causing any Person to become a Subsidiary, or (c) a merger or consolidation or any other combination with another Person (other than a Person that is a Subsidiary of the Guarantor) provided that the Guarantor or the Guarantor's Subsidiary (as appropriate) is the surviving entity or retains legal and beneficial ownership of in excess of fifty percent (50%) of the voting capital thereof. "ADVANCE" means an advance under the Facility made pursuant to Clause 3.01. "AFFILIATE" means, as to any Person, any other Person which, directly or indirectly, is in control of, is controlled by, or is under common control with, such Person. A Person shall be deemed to control another Person if the controlling Person possesses, directly or indirectly, the power to direct or cause the direction of the management and policies of the other Person, whether through the ownership of voting securities, by contract or otherwise. Notwithstanding the foregoing and for the avoidance of doubt, the Bank shall not be deemed an "Affiliate" of the Company or of any Subsidiary of the Company. "BUSINESS DAY" means a day (other than a Saturday or Sunday) on which banks are open for banking business in London. "CAPITAL EXPENDITURE" means, for any period and with respect to any Person, the aggregate of all expenditure by such Person and its Subsidiaries for the acquisition or leasing of fixed or capital assets or additions to equipment (including replacements, capitalized repairs and improvements during such period) which should be capitalized under Generally Accepted Accounting Principles on a consolidated balance sheet of such Person and its Subsidiaries. Without limiting the foregoing, each Acquisition is a Capital Expenditure. "CAPITAL LEASE" has the meaning specified in the definition of "Capital Lease Obligations." "CAPITAL LEASE OBLIGATIONS" means all monetary obligations of the Guarantor or any of its Subsidiaries under any leasing or similar arrangement which, in accordance with Generally Accepted Accounting Principles, is classified as a capital lease ("CAPITAL LEASE"). "CASH EQUIVALENTS" means: (a) securities issued or fully guaranteed or insured by the United States Government or the Government of the United Kingdom or any agency thereof and backed by the full faith and credit of the United States or the United Kingdom (as the case may be) having maturities of not more than twelve months from the date of acquisition; (b) certificates of deposit, time deposits, Eurodollar time deposits, repurchase agreements, reverse repurchase agreements, or bankers' acceptances, having in each case a tenor of not more than twelve months, issued by any bank having combined capital and surplus of not less than US$100,000,000 (or its equivalent) whose short term securities are rated at least A-1 by Standard & Poor's Corporation and P-1 by Moody's Investors Service, Inc.; (c) commercial paper of an issuer rated at least A-1 by Standard & Poor's Corporation or P-1 by Moody's Investors Service Inc. and in either case having a tenor of not more than three months. "CONTINGENT OBLIGATION" means, as to any Person, (a) any Guarantee Obligation of that Person; and (b) any direct or indirect obligation or liability, contingent or otherwise, of that Person (i) in respect of any Surety Instrument issued for the account of that Person or as to which that Person is otherwise liable for reimbursement of drawings or payments, (ii) to purchase any materials, supplies or other Property from, or to obtain the services of, another Person if the relevant contract or other related document or obligation requires that payment for such materials, supplies or other Property, or for such services, shall be made regardless of whether delivery of such materials, supplies or other Property is ever made or tendered or such services are ever performed or tendered to such Person, or (iii) in respect of any Rate Contract that is not entered into in connection with a bona fide hedging operation that provides offsetting benefits to such Person. The amount of any Contingent Obligation shall (subject, in the case of Guarantee Obligations, to the last sentence of the definition of "Guarantee Obligation") be deemed equal to the maximum reasonably anticipated liability in respect thereof, and shall, with respect to item (iii) of this definition, be marked to to market on a current basis. "CONVERSION DATE" means 30 November 1995; "CURRENT ASSETS" means the amount (less the amount of any depreciations or provisions applicable thereto) which would be included in respect of tangible current assets in a balance sheet of the Borrower prepared on a basis and in accordance with accounting policies consistent with that of and those applied in preparing the balance sheet contained in the Accounts and in accordance with Generally Accepted Accounting Principles. "DEFAULT" means any event or circumstance which, with the giving of notice, the lapse of time, or both, would (if not cured or otherwise remedied during such time) constitute an Event of Default. "ENCUMBRANCE" means any mortgage, charge (whether fixed or floating), pledge, lien, encumbrance, hypothecation, title retention or other security interest or security agreement of any kind whatsoever and howsoever arising and whether legal or equitable. "ENVIRONMENTAL CLAIMS" means all claims, however asserted, by any Person alleging liability or responsibility for violation of any Environmental Law, or for release or injury to the environment, threat to public health, personal injury (including sickness, disease or death), property damage, natural resources damage, or otherwise alleging liability or responsibility for damages (punitive or otherwise), cleanup, removal, remedial or response costs, restitution, civil or criminal penalties, injunctive relief, or other type of relief, resulting from or based upon the presence, placement, discharge, emission or release (including intentional and unintentional, negligent and non-negligent, sudden or non-sudden, accidental or non-accidental, placement, spills, leaks, discharges, emissions or releases) of any Hazardous Material at, in, or from Property, whether or not owned by the Guarantor or any of its Subsidiaries. "ENVIRONMENTAL Laws" means all governmental, federal, state or local laws, statutes, common law duties, rules, regulations, ordinances and codes, together with all administrative orders, directed duties, requests, licenses, authorisations and permits of, and agreements with, any Governmental Authorities, in each case relating to environmental, health, safety and land use matters; "EVENTS OF DEFAULT" means any one of the events specified in Clause 8.01. "GENERALLY ACCEPTED ACCOUNTING PRINCIPLES" means accounting principles generally accepted (i) in the case of the Guarantor, in the United States; and (ii) in the case of the Borrower, in the United Kingdom. "GOVERNMENTAL AUTHORITY" means any nation or government, any state or other political subdivision thereof, any central bank (or similar monetary or regulatory authority) thereof, any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government, and any corporation or other entity owned or controlled, through stock or capital ownership or otherwise, by any of the foregoing. "GUARANTOR" means Community Psychiatric Centers, a Nevada Corporation having its chief office at 24502 Pacific Park Drive, Laguna Hills, California 92656, USA. "GUARANTEE OBLIGATION" means, as applied to any Person, any direct or indirect liability of that Person with respect to any Indebtedness, lease, dividend, letter of credit or other obligation (the "primary obligations") of another Person (the "primary obligor"), including any obligation of that Person, whether or not contingent, (a) to purchase, repurchase or otherwise acquire such primary obligations or any property constituting direct or indirect security therefor, or (b) to advance or provide funds (i) for the payment or discharge of any such primary obligation, or (ii) to maintain working capital or equity capital of the primary obligor or otherwise to maintain the net worth or solvency or any balance sheet item, level of income or financial condition of the primary obligor, or (c) to purchase property, securities or services primarily for the purpose of assuring the owner of any such primary obligation of the ability of the primary obligor to make payment of such primary obligation, or (d) otherwise to assure or hold harmless the holder of any such primary obligation against loss in respect thereof; in each case (a), (b), (c) or (d), including arrangements wherein the rights and remedies of the holder of the primary obligation are limited to repossession or sale of certain property of such Person. The amount of any Guaranty Obligation shall be deemed equal to the stated or determinable amount of the primary obligation in respect of which such Guaranty Obligation is made or, if not stated or if indeterminable, the maximum reasonably anticipated liability in respect thereof. "HAZARDOUS MATERIALS" means all those substances which are regulated by, or which may form the basis of liability under, any Environmental Law, including all substances identified under any Environmental Law as a pollutant, contaminant, hazardous waste, hazardous constituent, special waste, hazardous substance, hazardous material, or toxic substance, or petroleum or petroleum derived substance or waste. "INDEBTEDNESS" of any Person means, without duplication, (a) all indebtedness for borrowed money; (b) all obligations issued, undertaken or assumed as the deferred purchase price of property or services (other than trade payables entered into in the ordinary course of business pursuant to ordinary terms); (c) all non-contingent reimbursement or payment obligations with respect to Surety Instruments; (d) all obligations evidenced by notes, bonds, debentures or similar instruments, including obligations so evidenced incurred in connection with the acquisition of property, assets or business; (e) all indebtedness created or arising under any conditional sale or other title retention agreement, or incurred as financing, in either with respect to Property acquired by the Person (even though the rights and remedies of the seller or bank under such agreement in the event of default are limited to repossession or sale of such property); (f) all Capital Lease Obligations; (g) all net obligations with respect to Rate Contracts; (h) all indebtedness referred to in clauses (a) to (g) above secured by (or for which the holder of such Indebtedness has an existing right, contingent or otherwise, to be secured by) any Encumbrance upon or in Property (including accounts and contracts rights) owned by such Person, even though such Person has not assumed or become liable for the payment of such Indebtedness; and (i) all Guaranty Obligations in respect of indebtedness or obligations of others of the kinds referred to in clauses (a) to (g) above. "INSOLVENCY PROCEEDING" means (a) any case, action or proceeding before any court or other Governmental Authority relating to bankruptcy, reorganization, insolvency, liquidation, receivership, administrative receivership, administration, dissolution, winding-up or relief of debtors, or (b) any general assignment for the benefit of, or composition with, creditors or other similar arrangement in respect of its creditors generally or any substantial portion of its creditors; in each case (a) and (b) undertaken under U.S. Federal, United Kingdom, US State or foreign law, including the Bankruptcy Code of the USA or the Insolvency Act 1986 of the United Kingdom. "INTEREST PAYMENT DATE" means the last day of an Interest Period and additionally, in the case of any Interest Period having a duration of more than three months, the date or dates falling at three monthly intervals after the commencement of such Interest Period. "INTEREST PERIOD" means: (i) in relation to any Advance, the period from (and including) the date on which such Advance is made to (and including) its Maturity Date; (ii) in relation to the Term Loan Drawing, a period of 1, 2, 3 or 6 months (or such other period as may be agreed between the Bank and the Borrower) to apply to the whole or a part of the Term Loan Drawing as selected by the Borrower by irrevocable notice given to the Bank prior to 11.00 a.m. (London time) on the date on which the relevant Interest Period commences, provided that: (a) each part of the Term Loan Drawing shall have a first Interest Period or, as the case may be, first Interest Periods which shall commence on the Conversion Date; (b) the first day of each Interest Period (other than a Interest Period which is the first to apply in respect of any part of the Term Loan Drawing) shall be the last day of the immediately preceding Interest Period; (c) (i) Interest Periods shall be selected or deemed to have been selected by the Borrower so as to ensure that a part or parts of the Term Loan Drawing equal or, as the case may be equal in aggregate, to the repayment instalment due on each Repayment Date shall have a final Interest Period or, as the case may be, final Interest Periods, which shall expire on such Repayment Date; and (ii) the final Interest Period(s) shall end on the final Repayment Date; (d) if the Borrower shall fail to give notice in accordance with the foregoing provisions selecting the duration of any Interest Period, the Borrower shall (without prejudice to the provisions of subparagraph (d) above) be deemed to have selected for the relevant Interest Period a period of three months; and (e) subject to the provisions of clause 4.02, the exact length of each interest Period shall be determined by the Bank in accordance with London interbank market practices for dealing with sterling deposits of similar maturity. A certificate of the Bank as to the length of any Interest Period shall, save for any manifest error, be conclusive and binding. "JOINT VENTURE" means a single-purpose company or corporation, partnership, joint venture or other similar legal arrangement (whether created pursuant to contract or conducted through a separate legal entity) now or hereafter formed by the Borrower with another Person in order to conduct a common venture or enterprise with such Person. "LEVERAGE RATIO" means the ratio of Total Liabilities to Tangible Net Worth. "LIBOR" means, in relation to any Interest Period, the rate per annum determined by the Bank to be the rate (rounded up to the nearest 1/16%) at which sterling deposits of an amount equal to the Advance in respect of which the interest rate to be ascertained by reference to the said rate is to apply would have been offered by the Bank's principal London office to prime banks in the London interbank market at such banks' request at or about 11.00 a.m. (London time) on the date on which the relevant Interest Period commences for a period equal thereto. "LOAN" means the aggregate principal amount advanced and for the time being outstanding under the Facility. "MARGIN" means:- (a) in respect of the period from (and including) the date on which the first Advance is made to (but excluding) the Conversion Date one and one quarter per cent. (1 1/4%); and (b) in respect of any period commencing on or after the Conversion Date one and one half per cent. (1 1/2%). "MATERIAL ADVERSE EFFECT" means in relation to a Person (a) a material adverse change in or a material adverse effect upon the operations, business, properties, condition (financial or otherwise) or prospects of that Person or that Person and its Subsidiaries taken as a whole, or (b) an impairment of the ability of that Person to perform under this Agreement or the Guarantee and to avoid any Event of Default, or (c) the illegality, invalidity, non-binding effect or unenforceability of this Agreement or the Guarantee. However, the effectuation of the restructuring disclosed in the Form 10Q of the Guarantor for the financial quarter ended February 28, 1993 shall not be deemed to be a subsequent Material Adverse Effect. "MATURITY DATE" means, in relation to any Advance, the date on which such Advance is to mature in accordance with Clauses 3.01(A)(b) and 3.01(B). "MAXIMUM Amount" means the maximum aggregate principal amount for which the Facility is for the time being available, such amount being, subject to reduction in accordance with Clause 3.02, 1O,000,000 pounds sterling. "NET ISSUANCE PROCEEDS" means, in respect of any issuance of share capital or equity of a Person, cash proceeds and non-cash proceeds received or receivable by that Person in connection therewith, net of commission and underwriting discounts and reasonable out-of-pocket costs and expenses paid or incurred in connection therewith in favor of any Person (not being an Affiliate of such Person), such costs and expenses not to exceed 5% of the gross proceeds of such issuance. "NOTICE OF ADVANCE" means a notice of advance in the form set out Schedule 1. "PERMITTED ENCUMBRANCES" has the meaning specified in Section 7.01. "PERSON" means an individual, partnership, company, corporation, business trust, joint stock company, trust, unincorporated association, joint venture or Governmental Authority. "PROPERTY" means any interest in any kind of property or asset, whether real, personal or mixed, and whether tangible or intangible. "RATE CONTRACTS" means interest rate or currency swap agreements and any other agreements or arrangements designed to provide protection against fluctuations in interest or currency exchange rates. "REPAYMENT DATE" means the last Business Day of each February, May, August and November, from (and including) 28 February 1996 to (and including) 30 November 1998. "REQUIREMENT OF LAW" means, as to any Person, any law (statutory or common), treaty, rule or regulation or determination of an arbitrator or of a Governmental Authority, in each case applicable to or binding upon the Person or any of its propety or to which the Person or any of its property is subject. "RESPONSIBLE OFFICER" means (i) in relation to the Guarantor, the chief executive officer or the president of the Guarantor, or any other officer having substantially the same authority and responsibility; or, with respect to compliance with financial covenants, the chief financial officer or the treasurer of the Guarantor, or any other officer having substantially the same authority and responsibility; and (ii) in relation to the Borrower, any director or the secretary of the Borrower. "ROLLOVER DATE" means, in relation to the Term Loan Drawing, the last day of an Interest Period. "SUBSIDIARY" in relation to a Person, means any subsidiary (as defined in Clause 736 of the Companies Act, 1985 as such section may be amended or substituted) for the time being such person. "SURETY INSTRUMENTS" means all letters of credit (including standby and commercial), banker's acceptances, bank guarantees, shipside bonds, surety bonds and similar instruments. "TANGIBLE NET WORTH" means the amount (less the amount of any depreciations or provisions applicable thereto) which would be included in respect of tangible assets (both current and otherwise) in a balance sheet minus the amount of the Consolidated Total Liabilities; and "TOTAL LIABILITIES" means the amount which would be included in respect of liabilities (both current and otherwise) in a balance sheet of the Borrower. "TERM LOAN DRAWING" means the drawing deemed to be made by the Borrower on the Conversion Date pursuant to Clause 3.02; CLAUSE 2 CONDITIONS PRECEDENT The obligation of the Bank to make any Advance pursuant to Clause 3.01 is conditional upon the following documents having been received by the Bank and found by it to be satisfactory not later than noon (London time) on the fifth Business Day prior to the date on which the first Advance is to be made:- (a) copies of the following:- (i) the Memorandum and Articles of Association of the Borrower, certified as of such date by the Secretary of the Borrower as being a true, complete and up-to-date copy; (ii) a resolution of the Board of Directors of the Borrower, certified as of such date by the Secretary of the Borrower as being a true and complete copy, approving the borrowings under, and the terms and conditions of, this Agreement and authorising a person or persons to sign, deliver, give and/or despatch on behalf of the Borrower this Agreement, Notices of Advance and all other notices, letters and other communications to be given by the Borrower hereunder and generally to operate the Facility on behalf of the Borrower; (iii) a duly executed copy of the Guarantee; (iv) the by-laws and other constitutional documents of the Guarantor, certified as of such date by a Responsible Officer of the Guarantor as being a true, complete and up-to-date copy; (v) a resolution of the Board of Directors of the Guarantor, certified as of such date by a Responsible Officer of the Guarantor as being a true and complete copy, approving the borrowings under, and the terms and conditions of, this Agreement and the Guarantee and authorising a person or persons to sign, deliver, give and/or despatch the Guarantee on behalf of the Guarantor and any notices, letters and other communications to be given by the Guarantor pursuant thereto; and (b) specimen signatures (authenticated to the satisfaction of the Bank) of the person or persons mentioned in paragraphs (a)(ii) and (a)(v) above. CLAUSE 3 THE LOAN 3.01 ADVANCES (A) Subject to:- (i) the provisions of Clause 2; (ii) no Default or Event of Default having occurred; and (iii) the Bank having received prior to 11.00 a.m. (London time) on the date upon which the relevant Advance is to be made a Notice of Advance duly completed on behalf of the Borrower by one of the persons authorised for such purpose as specified in paragraph (a) (ii) of Clause 2 the Borrower may (subject to the other provisions of this Agreement) draw an Advance on any Business Day prior to the Conversion Date in the manner provided in this Clause and otherwise in accordance with the relevant Notice of Advance, provided that:- (a) each Notice of Advance shall be given for an Advance of no less than 1,000,000 pounds sterling (one million pounds) and in integral multiples of 500,000 pounds sterling (FIVE hundred thousand pounds); (b) each Notice of Advance shall be given for an Advance of either 1, 2, 3 or 6 months (or such other period as may be agreed between the Bank and the Borrower); (c) a Notice of Advance shall not be given for an Advance which:- (i) would cause the Loan to exceed the Maximum Amount on the proposed date of the Advance; (ii) would mature on any day after the Conversion Date; and (B) Subject to the provisions of Clause 4.02, the exact maturity of each Advance shall be determined by the Bank in accordance with London interbank market practices for dealing with sterling deposits of similar maturity. The certificate of the Bank as to the maturity of any Advance shall, save for any manifest error, be conclusive and binding. (C) Subject to the other provisions of this Agreement, the Borrower shall repay the principal amount of each Advance to the Bank on its Maturity Date. 3.02 TERM LOAN DRAWING (A) Subject to no Default or Event of Default having occurred, the Borrower shall, on the Conversion Date, be deemed to have made a term loan drawing in an amount equal to the Loan immediately prior to the Conversion Date. (B) Subject to the other provisions of this Agreement, the Borrower shall repay the Term Loan Drawing to the Bank in twelve equal instalments on each Repayment Date. 3.03 PREPAYMENT AND CANCELLATION (A) The Borrower may not voluntarily cancel or prepay the whole or any part of any Advance or the Term Loan Drawing except as expressly provided in Clause 10, or cancel the whole or any part of the Facility except as expressly provided in this Clause or in Clause 10. (B) Prior to the Conversion Date, the Borrower may cancel the whole or any part of the unutilized portion of the Facility without penalty or premium provided that:- (i) any such cancellation may only be effected on a Business Day; (ii) the Borrower must give to the Bank not less than 5 days' prior notice (which shall be irrevocable) of its intention to make such cancellation, specifying the amount thereof and the Business Day on which it is to be made; (iii) any cancellation shall be in a minimum amount and in integral multiples of 500,000 pounds sterling; and (iv) the amount which is to be cancelled on any Business Day shall not exceed the amount by which the Maximum Amount, but for such cancellation, would exceed the Loan at the close of business on that Business Day. (C) On the expiry of a notice given in accordance with paragraph (B) of this Clause such cancellation shall take effect accordingly and the Maximum Amount shall be reduced by the amount specified in such notice. (D) After the Conversion Date, the Borrower may prepay the whole or any part of the Term Loan Drawing without penalty or premium provided that:- (i) any such prepayment may only be effected on a Rollover Date applicable to that part of the Loan to be prepaid; (ii) the Borrower must give to the Bank not less than thirty days' prior notice of its intention to make such prepayment, specifying the amount thereof and the Rollover Date on which it is to be made; (iii) any partial prepayment of the Loan shall be in a minimum amount, and in multiples, of 500,000 pounds sterling; and (iv) the Borrower shall simultaneously pay all interest accrued to the date of prepayment on the amount prepaid. (E) Once having given notice of an intended prepayment under sub-clause (D) above, the Borrower shall be obliged to make the prepayment in accordance with the notice. (F) No amount prepaid after the Conversion Date may be redrawn. (G) Any partial prepayment shall be applied towards to reducing the prepayment instalments referred to in Clause 3.02(B) in inverse order of maturity. 3.04 INTEREST (A) Subject to the provisions of Clause 8.02, the Borrower shall pay interest on each Advance and on each part of the Term Loan Drawing for the Interest Period relating thereto at the rate per annum determined by the Bank to be the aggregate of (i) LIBOR and (ii) the Margin. (B) Interest at the rates determined as aforesaid shall (i) accrue from (and including) the first day to (but excluding) the last day of each Interest Period and (ii) be paid in arrears on each Interest Payment Date. (C) The Borrower shall also pay additional interest on each Advance on each Interest Payment Date relating thereto in such amounts as may be calculated by the Bank in accordance with Schedule 2, and such additional interest shall be treated as interest for all the purposes of this Agreement. (D) The certificate of the Bank as to any rate or amount of interest payable pursuant to this Agreement shall, save for any manifest error, be conclusive and binding. Each determination of an interest rate made by the Bank in accordance with this Agreement shall be promptly notified by the Bank to the Borrower. 3.05 COMMITMENT FEE The Borrower shall pay to the Bank a commitment fee calculated, from (and including) the date of this Agreement up to (but excluding) the Conversion Date, at the rate of one half of one percent (1/2%) per annum upon the amount (calculated on a daily basis) by which the Maximum Amount exceeds the Loan. Such commitment fee shall be paid in arrears at the end of each successive period of three months from the date hereof and on the last day upon which such fee shall accrue as aforesaid. 3.06 ARRANGEMENT FEE The Borrower shall pay to the Bank on the date hereof the Arrangement Fee agreed between the Borrower and the Bank. CLAUSE 4 PAYMENTS 4.01 PAYMENTS BY THE BORROWER All payments due to be made by the Borrower pursuant to this Agreement shall be made in immediately available funds before 12 noon (London time) on the date on which payment is due in such manner as the Bank may from time to time direct. 4.02 PAYMENT DUE ON NON-BUSINESS DAY TO BE MADE ON NEXT BUSINESS DAY If any sum becomes due for payment pursuant to this Agreement on a day which is not a Business Day, such payment shall be made on the next succeeding Business Day and interest and commitment fee shall be adjusted accordingly. 4.03 PAYMENTS TO BE CLEAR OF ALL TAXES All sums payable by the Borrower pursuant to this Agreement shall be paid in full without set-off or counter-claim and free and clear of and without deduction of or withholding for or on account of any present or future taxes, duties or other charges wheresoever and howsoever arising and including, without limitation, any interest or penalties which may attach as a consequence of non-payment. If any such payment shall be subject to any such tax or if the Borrower shall be required by law to make any such deduction or withholding, the Borrower will pay such tax, will ensure that such payment, deduction or withholding will not exceed the minimum legal liability therefor and will simultaneously pay to the Bank such additional amounts as will result in the Bank receiving a net amount equal to the full amount which the Bank would have received had no such payment, deduction or withholding been required. If the Borrower shall make any such payment, deduction or withholding, the Borrower shall within 30 days thereafter forward to the Bank an official receipt or other official documentation evidencing such payment or the payment of such deduction or withholding. 4.04 CALCULATIONS All sums which accrue pursuant to this Agreement by reference to the passage of time shall (a) accrue from day to day and (b) be calculated on the basis of actual days elapsed and a 365 day year. 4.05 RIGHT OF SET-OFF The Borrower hereby. authorises the Bank, at any time and from time to time, without prior notice or demand, to debit to any of its existing or future accounts with the Bank at any of its branches anywhere all or any part of any sum due from it to the Bank hereunder. Nothing in this Agreement shall be construed as voiding, negating or restricting any right of set-off or any other right whatsoever in the Bank's favour existing or arising at common law, by statute or otherwise howsoever. CLAUSE 5 REPRESENTATIONS AND WARRANTIES 5.01 The Borrower represents and warrants to the Bank that: (1) CORPORATE EXISTENCE AND POWER Each of the Borrower and the Guarantor: (a) is a corporation duly organized, validly existing and in good standing under the laws of the jurisdiction of its incorporation; (b) has the power and authority and all governmental licenses, authorisations, consents and approvals to own its assets, carry on its business and execute, deliver, and perform its obligations (if any) under, this Agreement and the Guarantee; (c) is duly qualified as a foreign corporation, and licensed 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 or license; and (d) is in compliance with all Requirements of Law; except, in each case referred to in clause (C), to the extent that the failure to do so could not reasonably be expected to have a Material Adverse Effect. (2) CORPORATE AUTHORISATION; NO CONTRAVENTION The execution, delivery and performance by the Borrower and the Guarantor of this Agreement, and the Guarantee have been duly authorised by all necessary corporate action, and do not and will not: (a) contravene the terms of the Borrower's or the Guarantor's Memorandum or Articles of Association or equivalent constitutional documents; (b) conflict with or result in any breach or contravention of, or the creation of any Encumbrance under, any agreement to which the Borrower or the Guarantor is a party or any order, injunction, writ or decree of any Governmental Authority to which the Borrower or the Guarantor or its Property is subject; or (c) violate any Requirement of Law. (3) GOVERNMENTAL AUTHORISATION No approval, consent, exemption, authorisation, or other action by, or notice to, or filing with, any Governmental Authority is necessary or required in connection with the execution, delivery or performance by, or enforcement against, the Borrower or the Guarantor of this Agreement or the Guarantee; (4) BINDING EFFECT This Agreement and the Guarantee constitute the legal, valid and binding obligations of the Borrower or the Guarantor (as appropriate) enforceable against such Person in accordance with their respective terms, except as enforceability may be limited by applicable bankruptcy, insolvency, or similar laws affecting the enforcement of creditors' rights generally or by equitable principles relating to enforceability. (5) LITIGATION Except as specifically disclosed in Schedule 5.05 of the Credit Agreement dated as of September 20, 1993 among Community Psychiatric Centre, Transitional Hospitals Corp. and the Bank (the "Credit Agreement"), there are no actions, suits, proceedings, claims or disputes pending, or to the best knowledge of the Borrower, threatened or contemplated, at law, in equity, in arbitration or before any Governmental Authority, against the Guarantor or the Borrower or any of their respective Properties which: (a) purport to affect or pertain to this Agreement or the Guarantee or any of the transactions contemplated hereby or thereby; or (b) if determined adversely to the Guarantor or the Borrower, would reasonably be expected to have a Material Adverse Effect. No injunction, writ, temporary restraining order or any order of any nature has been issued by any court or other Governmental Authority purporting to enjoin or restrain the execution, delivery or performance of this Agreement or the Guarantee or directing that the transactions provided for herein or therein not be consummated as herein or therein provided. (6) NO DEFAULT No Default or Event of Default exists or would result from the Borrower entering into the Agreement or the Guarantor entering into the Guarantee. None of the Borrower nor the Guarantor nor any of their respective Subsidiaries is in default under or with respect to any agreement to which it is a party in any respect which, individually or together with all such defaults, could reasonably be expected to have a Material Adverse Effect or that would, if such default had occurred after the date hereof, create an Event of Default under subsection 8.01(e). (7) TITLE TO PROPERTIES The Borrower and the Guarantor have good record and marketable title in fee simple to, or valid leasehold interests in, all real Property necessary or used in the ordinary conduct of their respective businesses, except for such defects in title as could not, individually or in the aggregate, have a Material Adverse Effect. As of the date hereof, the Property of the Borrower and the Guarantor is subject to no Encumbrances, other than Permitted Encumbrances. (8) TAXES The Borrower and the Guarantor have filed all tax returns and reports required to be filed, and have paid all taxes, assessments, fees and other governmental charges levied or imposed upon them or their Properties, income or assets otherwise due and payable, except those which are being contested in good faith by appropriate proceedings and for which adequate reserves have been provided in accordance with Generally Accepted Accounting Principles. There is no proposed tax assessment against the Guarantor or any of its Subsidiaries which would, if the assessment were made, have a Material Adverse Effect. (9) FINANCIAL CONDITION (a) The audited consolidated financial statements of financial condition of the Guarantor and its Subsidiaries dated November 30, 1992, and the related consolidated statements of income or operations, shareholders' equity and cash flows for the fiscal year ended on that date and the audited profit and loss account and balance sheet of the Borrower for the year ended on that date: (i) were prepared in accordance with Generally Accepted Accounting Principles consistently applied throughout the period covered thereby, except as otherwise expressly noted therein; (ii) fairly present the financial condition of the Guarantor and its Subsidiaries and the Borrower respectively as of the date thereof and the results of operations for the period covered thereby; and (iii) show all material indebtedness and other liabilities, direct or contingent of the Guarantor and its consolidated Subsidiaries and the Borrower respectively as of the date thereof, including liabilities for taxes, material commitments and Contingent Obligations. (b) Since 28 February 1993, there has been no Material Adverse Effect. (10) ENVIRONMENTAL MATTERS (a) The on-going operations of the Guarantor and each of its Subsidiaries (including the Borrower) comply in all respects with all Environmental Laws, except such non-compliance which would not (if enforced in accordance with applicable law) result in liability in excess of $500,000 (or its equivalent) in the aggregate. (b) The Guarantor and the Borrower have obtained all licenses, permits, authorisations and registrations required under any Environmental Law ("Environmental Permits") and necessary for their respective ordinary business operations, all such Environmental Permits are valid and in full force and effect and the Guarantor and each of its Subsidiaries (including the Borrower) are in compliance with all material terms and conditions of such Environmental Permits. (c) None of the Guarantor, the Borrower, any of their respective Subsidiaries or any of their respective present Property or operations, is subject to any outstanding written order from or agreement with any Governmental Authority, nor subject to any judicial or administrative proceeding with respect to any Environmental Law, Environmental Claim or Hazardous Material. (d) There are no Hazardous Materials or other conditions or circumstances existing with respect to any Property, or arising from the business prior to the date hereof, of the Guarantor or any of its Subsidiaries (including the Borrower) that would reasonably be expected to give rise to Environmental Claims with a potential liability of the Guarantor and its Subsidiaries (including the Borrower) in excess of $1,000,000 (or its equivalent) in the aggregate. In addition, (i) neither the Guarantor, nor any of its Subsidiaries (including the Borrower) has any underground storage tanks (x) that are not properly registered or permitted under applicable Environmental Laws, or (y) that are leaking or disposing of Hazardous Materials off-site, and (ii) the Guarantor and each of its Subsidiaries (including the Borrower) have notified all of their employees of the existence, if any, of any health hazard arising from the conditions of their employment and have met all notification requirements under all Environmental Laws. (11) REGULATED ENTITIES None of the Guarantor, any Person controlling the Guarantor, or any Subsidiary of the Guarantor, is (a) an "Investment Company" within the meaning of the Investment Company Act of 1940 of the USA; or (b) subject to regulation under the Public Utility Holding Company Act of 1935 of the USA, the Federal Power Act of the USA, the Interstate Commerce Act of the USA, any US state public utilities code, or any other U.S. Federal or state statute or regulation limiting its ability to incur Indebtedness. (12) NO BURDENSOME RESTRICTIONS Neither the Guarantor nor the Borrower is a party to or bound by any agreement or subject to any restriction, or any Requirement of Law, which could reasonably be expected to have a Material Adverse Effect. (13) SOLVENCY Neither the Guarantor on a consolidated basis nor the Borrower are insolvent as defined in Section 123 of the Insolvency Act 1986. (14) LABOUR RELATIONS There are no significant strikes, lockouts or other labour disputes against the Guarantor or the Borrower or, to the best of their knowledge, threatened against or affecting the Guarantor or the Borrower, and no significant unfair labour practice complaint is pending against the Guarantor or the Borrower or, to the best of their knowledge, threatened against any of them before any Governmental Authority. (15) INTELLECTUAL PROPERTY The Guarantor and the Borrower own or are licensed or otherwise have the right to use all of the patents, trademarks, service marks, trade names, copyrights, contractual franchises, authorisations and other rights that are reasonably necessary for the operation of their respective businesses, without conflict with the rights of any other Person. To the best knowledge of the Guarantor and the Borrower, no slogan or other advertising device, product, process, method, substance, part or other material now employed, or now contemplated to be employed, by the Guarantor or the Borrower infringes upon any rights held by any other Person:[except as specifically disclosed in Schedule 5.15 of the Credit Agreement, no claim or litigation regarding any of the foregoing is pending or threatened, and no patent, invention, device, application, principle or any statute, law, rule, regulation, standard or code is pending or, to the knowledge of the Guarantor or the Borrower, proposed, which, in any case, could reasonably be expected to have a Material Adverse Effect. (16) SUBSIDIARIES As of the date hereof, neither the Guarantor nor the Borrower have any Subsidiaries other than those specifically disclosed in part (a) of Schedule 3 hereto and have no equity investments in any other corporation or entity other than those specifically disclosed in part (b) of Schedule 3. (17) BROKER'S; TRANSACTION FEES Neither the Guarantor nor any of its Subsidiaries (including the Borrower) have any obligation to any Person in respect of any finder's, broker's or investment banker's fee in connection with the transactions contemplated hereby. (18) INSURANCE The Properties of the Guarantor and its Subsidiaries (including the Borrower) are insured with financially sound and reputable insurance companies not Affiliates of the Guarantor, in such amounts, with such deductibles and covering such risks as are customarily carried by companies engaged in similar businesses and owning similar Properties in localities where the Guarantor or such Subsidiary operates. (19) FULL DISCLOSURE None of the representations or warranties made by the Borrower in this Agreement as of the date such representations and warranties are made or deemed made, and none of the statements contained in each exhibit, report, statement or certificate furnished by or on behalf of the Guarantor in connection with this Agreement (including the offering and disclosure materials delivered by or on behalf of the Borrower to the Bank prior to the date hereof), contains any untrue statement of a material fact or omits any material fact required to be stated therein or necessary to make the statements made therein, in light of the circumstances under which they are made, not misleading as of the time when made or delivered. 5.02 The representations and warranties specified in Clause 5.01 shall be made as of the date hereof and deemed repeated on the date of each Notice of Advance and on the first day of each Interest Period with reference to the facts existing at that time. CLAUSE 6 AFFIRMATIVE COVENANTS The Borrower covenants and agrees that, so long as the Bank shall have any commitment hereunder, or any Advance or the Term Loan Drawing shall remain outstanding, unless the Bank otherwise agrees in writing: 6.01 FINANCIAL STATEMENTS The Borrower shall deliver to the Bank in form and detail satisfactory to the Bank: (a) as soon as available, but not later than 120 days after the end of each financial year, a copy of the audited balance sheet of the Borrower as at the end of such year and the related profit and loss account for such year, setting forth in each case in comparative form the figures for the previous year, certified by an appropriate Responsible Officer as being materially complete and correct and fairly presenting, in accordance with Generally Accepted Accounting Principles, the financial position and the results of operations of the Borrower and accompanied by the opinion of the auditors of the Borrower which report shall state that such accounts present fairly the financial position for the periods indicated in conformity with Generally Accepted Accounting Principles applied on a basis consistent with prior years. Such opinion shall not be qualified or limited in any material way; (b) as soon as available, but not later than 90 days after the end of each financial year, the annual financial projections (balance sheet, income statement and statement of cash flows) for the Borrower for the period up to and including the final Repayment Date. 6.02 CERTIFICATES; OTHER INFORMATION The Borrower shall furnish to the Bank: (a) concurrently with the delivery of the financial statements referred to in sub-clause 6.01(a) above, a certificate of the auditors of the Borrower reporting on such financial statements stating that in making the examination necessary therefor no knowledge was obtained of any Default or Event of Default, except as specified in such certificate; (b) concurrently with the delivery of the financial statements referred to in sub-clause 6.01(a) a certificate of a Responsible Officer of the Borrower (i) stating that, to the best of such Responsible Officer's knowledge, the Borrower, during such period, has observed and performed all of its covenants and other agreements, and satisfied every condition contained in this Agreement to be observed, performed or satisfied by it, and that such Responsible Officer has obtained no knowledge of any Default or Event of Default except as specified (by applicable subsection reference) in such certificate, and (ii) showing in detail the calculations supporting such statement in respect of all financial covenants hereunder; (c) promptly after they are sent, copies of all financial statements and reports which the Borrower sends to its shareholders; and promptly after they are filed, copies of all financial statements and regular, periodical or special reports which the Borrower may make to, or file with any Governmental Authority; and (d) promptly, such additional business, financial, corporate affairs and other information as the Bank may from time to time reasonably request. 6.03 NOTICES The Borrower shall promptly notify the Bank: (a) (i) of the occurrence of any Default or Event of Default; or (ii) of the occurrence or existence of any event or circumstance that is reasonably likely to result in a violation of any covenant contained in clause 7 of this Agreement. (b) of any material dispute, litigation, investigation, proceeding or suspension which may exist at any time between the Borrower, the Guarantor or any of its Subsidiaries and any Governmental Authority; (c) of the commencement of, or any material development in, any litigation or proceeding affecting the Borrower or the Guarantor (i) in which the amount of damages claimed is $ 1,000,000 (or its equivalent in another currency or currencies) or more, (ii) in which injunctive or similar relief is sought and which, if adversely determined, would reasonably be expected to have a Material Adverse Effect, or (iii) in which the relief sought is an injunction or other stay of the performance of this Agreement or the Guarantee; (d) upon, but in no event later than 10 days after, becoming aware of (i) any and all governmental or regulatory actions instituted, completed, or threatened against the Borrower or the Guarantor or any of their Property pursuant to any applicable Environmental Laws, (ii) all other material Environmental Claims, and (iii) any Environmental Claims relating to any real property adjoining or in the vicinity of any material Property of the Borrower or the Guarantor that can reasonably be anticipated to cause such Property or any part thereof to be subject to any restrictions on its ownership, occupancy, transferability or use under any Environmental Laws; (g) of any Material Adverse Effect subsequent to 28 February, 1993; (h) of any change in accounting policies or financial reporting practices by the Guarantor or any of its Subsidiaries (including the Borrower); and (i) of any labour controversy resulting in or threatening to result in any strike, work stoppage, boycott, shutdown or other labour disruption against or involving the Guarantor or any of its Subsidiaries (including the Borrower). Each notice pursuant to this clause shall be accompanied by a written statement by a Responsible Officer of the Borrower setting forth details of the occurrence referred to therein, and stating what action the Borrower proposes to take with respect thereto and at what time. Each notice under sub-clause 6.03(a) shall describe in reasonable detail any and all clauses or provisions of this Agreement or the Guarantee that have been breached or violated. 6.04 PRESERVATION OF CORPORATE EXISTENCE, ETC The Borrower shall: (a) preserve and maintain in full force and effect its incorporation and good standing under English law; (b) preserve and maintain in full force and effect all rights, privileges, qualifications, permits, licenses and franchises necessary or desirable in the ordinary course of the Borrower's business; (c) use its reasonable efforts, in the ordinary course of business, to preserve its business organisation and preserve the goodwill and business of the customers, suppliers and others having material business relations with it; and (d) preserve or renew all of its registered trademarks, trade names and service marks, the non-preservation of which could reasonably be expected to have a Material Adverse Effect. 6.05 MAINTENANCE OF PROPERTY The Borrower shall maintain and preserve all its Property which is used or useful in its business in good working order and condition, ordinary wear and tear excepted, and make all necessary repairs thereto and renewals and replacements thereof except where the failure to do so could not reasonably be expected to have a Material Adverse Effect. The Borrower shall use the standard of care typical in the industry in the operation and maintenance of its facilities. 6.06 INSURANCE The Borrower shall maintain with financially sound and reputable independent insurers, insurance with respect to its properties and businesses against loss or damage of the kinds customarily insured against by Persons engaged in the same or similar business, of such types and in such amounts as are customarily carried under similar circumstances by such other Persons; including workers' compensation insurance. Upon request of the Bank, the Borrower shall furnish the Bank, at reasonable intervals (but not more than once per calendar year) a certificate of a Responsible Officer of the Borrower (and, if requested by the Bank, any insurance broker of the Borrower) setting forth the nature and extent of all insurance maintained by the Borrower and its Subsidiaries in accordance with this Clause 6.06. 6.07 PAYMENT OF OBLIGATIONS The Borrower shall pay and discharge as the same shall become due and payable, all their respective obligations and liabilities, including: (a) all tax liabilities, assessments and governmental charges or levies upon it or its properties or assets, unless the same are being contested in good faith by appropriate proceedings and adequate reserves in accordance with Generally Accepted Accounting Principles are being maintained by the Borrower; (b) all lawful claims which, if unpaid, would by law become an Encumbrance upon its Property; and (c) all Indebtedness, as and when due and payable, but subject to any subordination provisions contained in any instrument or agreement evidencing such Indebtedness. 6.08 COMPLIANCE WITH LAWS The Borrower shall comply in all material respects with all Requirements of Law of any Governmental Authority having jurisdiction over it or its business, except such as may be contested in good faith or as to which a bona fide dispute may exist. 6.09 INSPECTION OF PROPERTY AND BOOKS AND RECORDS The Borrower shall maintain proper books of record and account, in which full, true and correct entries in conformity with Generally Accepted Accounting Principles consistently applied shall be made of all financial transactions and matters involving the assets and business of the Borrower. The Borrower shall permit representatives and independent contractors of the Bank to visit and inspect any of their respective Properties, to examine their respective corporate, financial and operating records, and make copies thereof or abstracts therefrom, and to discuss their respective affairs, finances and accounts with their respective directors, officers, and independent public accountants, all at the expense of the Borrower and at such reasonable times during normal business hours and as often as may be reasonably desired, upon reasonable advance notice to the Borrower; provided, however, when an Event of Default exists the Bank may do any of the foregoing at the expense of the Borrower at any time during normal business hours and without advance notice. 6.10 ENVIRONMENTAL LAWS (a) The Borrower shall conduct its operations and keep and maintain its Properties in compliance with all Environmental Laws. (b) Upon the written request of the Bank, the Borrower shall submit to the Bank, at the Borrower's sole cost and expense, at reasonable intervals, a report providing an update of the status of any environmental, health or safety compliance, hazard or liability issue identified in any notice or report required pursuant to sub-clause 6.03(d), that could, individually or in the aggregate, result in liability in excess of L100,000. 6.11 FURTHER ASSURANCES (a) The Borrower shall ensure that all written information, exhibits and reports furnished to the Bank do not and will not contain any untrue statement of a material fact and do not and will not omit to state any material fact or any fact necessary to make the statements contained therein not misleading in light of the circumstances in which made, and will promptly disclose to the Bank and correct any defect or error that may be discovered therein or in the execution or acknowledgement thereof. (b) Promptly upon request by the Bank, the Borrower shall do, execute, acknowledge, deliver, record, re-record, file, re-file, register and re-register, any and all such further acts as the Bank may reasonably require from time to time in order to carry out more effectively the purposes of this Agreement or the Guarantee. CLAUSE 7 NEGATIVE COVENANTS 7.01 The Borrower hereby covenants and agrees that, so long as the Bank shall have any commitment hereunder, or any Advance or the Term Loan Drawing or any interest thereon shall remain unpaid or unsatisfied, unless the Bank otherwise agrees in writing: (1) LIMITATION ON ENCUMBRANCES The Borrower shall not, and shall not suffer or permit any of its Subsidiaries to, directly or indirectly, make, create, incur, assume or permit to subsist any Encumbrance upon or with respect to any part of its Property, whether now owned or hereafter acquired, other than the following ("PERMITTED ENCUMBRANCES"): (a) any Encumbrance existing on the date hereof and set forth in Schedule 4 securing Indebtedness outstanding on such date; (b) any Encumbrance created under the Guarantee; (c) Encumbrances for taxes, fees, assessments or other governmental charges which are not delinquent or remain payable without penalty; (d) Encumbrances arising in the ordinary course of business which are not delinquent or remain payable without penalty or which are being contested in good faith and by appropriate proceedings, which proceedings have the effect of preventing the forfeiture or sale of the property subject thereto; (e) Encumbrances consisting of pledges or deposits required in the ordinary course of business in connection with workers' compensation, unemployment insurance and other social security legislation; (f) Encumbrances securing (i) the non-delinquent performance of bids, trade contracts (other than for borrowed money), leases or statutory obligations, (ii) contingent obligations on surety and appeal bonds, and (iii) other non-delinquent obligations of a like nature; in each case, incurred in the ordinary course of business, provided all such Encumbrances in the aggregate would not (even if enforced) cause a Material Adverse Effect; (g) Encumbrances consisting of judgment or judicial attachment Encumbrances, provided that the enforcement of such Encumbrances is effectively stayed and all such Encumbrances in the aggregate at any time outstanding for the Borrower do not exceed 100,000 pounds sterling; (h) easements, rights-of-way, restrictions and other similar encumbrances incurred in the ordinary course of business which, in the aggregate, are not substantial in amount, and which do not in any case materially detract from the value of the property subject thereto or interfere with the ordinary conduct of the businesses of the Borrower; (i) Encumbrances on assets of companies which become Subsidiaries after the date of this Agreement, provided however that such Encumbrances existed at the time the respective companies became Subsidiaries and were not created in anticipation thereof, (j) security interests existing on the date of this Agreement on any Property acquired or held by the Borrower in the ordinary course of business in favour of the seller thereof, securing Indebtedness incurred or assumed for the purpose of financing all or any part of the cost of acquiring such Property; (k) Encumbrances securing Capital Lease Obligations on assets subject to such Capital Leases, provided that such Capital Leases are permitted under sub-clause 7.01(9); (l) Encumbrances arising solely by virtue of any statutory or common law provision relating to banker's liens, rights of set-off or similar rights and remedies as to deposit accounts or other funds maintained with a creditor depository institution; (m) Other Encumbrances in the ordinary course of business securing obligations not exceeding 100,000 pounds sterling in the aggregate securing Indebtedness permitted to be incurred pursuant to clause 7.01(5)(g). (2) DISPOSITION OF ASSETS The Borrower shall not directly or indirectly, sell, assign, lease, convey, transfer or otherwise dispose of (whether in one or a series of transactions) any of its Property (including accounts and notes receivable, with or without recourse) or enter into any agreement to do any of the foregoing, except: (a) dispositions of inventory, or used, worn-out or surplus equipment, all in the ordinary course of business; (b) the sale of equipment to the extent that such equipment is exchanged for credit against the purchase price of replacement equipment, or the proceeds of such sale are reasonably promptly applied to the purchase price of such replacement equipment; (c) dispositions for fall value of inventory or equipment by the Borrower to any of the Subsidiaries of the Guarantor pursuant to reasonable business requirements; (d) dispositions of accounts receivable in the ordinary course of business on a nonrecourse basis; (e) sales for full value of surplus real property; and (f) other dispositions of assets not exceeding 200,000 pounds sterling in the aggregate of gross book value of the assets so disposed in any financial year. (3) CONSOLIDATIONS AND MERGERS The Borrower shall not merge, consolidate with or into, or convey, transfer, lease or otherwise dispose of (whether in one transaction or in a series of transactions) all or substantially all of its assets (whether now owned or hereafter acquired) to or in favour of any Person. (4) LOANS AND INVESTMENTS The Borrower shall not purchase or acquire, or make any commitment to purchase or acquire, any share capital, equity interest, or any obligations or other securities of, or any interest in, any Person, or make or commit to make any Acquisitions, or make or commit to make any advance, loan, extension of credit or capital contribution to, or any other investment in, any Person including any Affiliate of the Guarantor, except for: (a) investments in Cash Equivalents; (b) extensions of credit in the nature of accounts receivable or notes receivable arising from the sale or lease of goods or services in the ordinary course of business; (c) extensions of credit by the Borrower to any of its wholly-owned Subsidiaries or by any of its wholly-owned Subsidiaries to another of its wholly-owned Subsidiaries; (d) any transaction not exceeding two and one half percent (2-1/2%) of the amount of the Borrower's Current Assets; and (e) loans to the Borrower's employees not exceeding 100,000 pounds sterling in the aggregate. (5) LIMITATION ON INDEBTEDNESS The Borrower shall not create, incur, assume, suffer to exist, or otherwise become or remain directly or indirectly liable with respect to, any Indebtedness, except: (a) Indebtedness incurred pursuant to this Agreement; (b) Indebtedness consisting of Contingent Obligations permitted pursuant to clause 7.01(7); (c) Indebtedness existing on the date hereof and set forth in Schedule 5; (d) Indebtedness secured by Encumbrances permitted by clauses 7.01(l)(h)(i) and (j); (e) Indebtedness incurred in connection with leases permitted pursuant to clause 7.01(10); (f) Indebtedness in the ordinary course of business in connection with corporate credit cards; (g) Indebtedness secured by Encumbrances permitted by Clause 7.01(l)(m) under terms that are not more restrictive than this Agreement and on which no principal payment shall be made prior to the final Repayment Date; and (6) TRANSACTIONS WITH AFFILIATES The Borrower shall not enter into any transaction with any Subsidiary of the Guarantor except (a) as expressly permitted by this Agreement, or (b) in the ordinary course of business and pursuant to the reasonable requirements of the business of the Borrower in each case (a) and (b), upon fair and reasonable terms no less favourable to the Borrower than would obtain in a comparable arm's-length transaction with a Person not a Subsidiary of the Guarantor. (7) CONTINGENT OBLIGATIONS The Borrower shall not create, incur, assume or suffer to exist any Contingent Obligations except: (a) endorsements for collection or deposit in the ordinary course of business; (b) Rate Contracts entered into in the ordinary course of business; (8) JOINT VENTURES The Borrower shall not enter into any Joint Venture, other than in the ordinary course of business. (a) LEASE OBLIGATIONS The Borrower shall not create or suffer to exist any obligations for the payment of rent for any Property under lease or agreement to lease, except for: (a) leases of the Borrower in existence at the date hereof, (b) Operating Leases entered into by the Borrower after the date hereof in the ordinary course of business; (c) Capital Leases, entered into by the Borrower after the date hereof to finance the acquisition of equipment; provided that the aggregate annual rental payments for all such Capital Leases shall not exceed in any fiscal year 100,000 pounds sterling; and (d) Capital Leases for real estate where the related obligations constitute Capital Expenditure. 7.11 RESTRICTED PAYMENTS The Borrower shall not declare or make any dividend payment or other distribution of assets, properties, cash, rights, obligations or securities on account of any class of its share capital, or purchase, redeem or otherwise acquire for value any of its share capital or any warrants, rights or options to acquire such shares, now or hereafter outstanding; except that the Borrower may: (a) declare and make dividend payments or other distributions payable solely in its ordinary shares; (b) purchase, redeem or otherwise acquire its ordinary shares or warrants or options to acquire any such shares with the proceeds received from the substantially concurrent issue of new shares of its ordinary share capital; and (c) declare or pay cash dividends to its shareholders and purchase, redeem or otherwise acquire its share capital or warrants, rights or options to acquire any such shares for cash solely out of 25% of net income of the Borrower arising after the date hereof and computed on a cumulative basis, provided that, immediately after giving effect to such proposed action, no Default or Event of Default would exist. 7.12 LEVERAGE RATIO The Company shall not permit its Leverage Ratio to be more than the applicable maximum amount set forth opposite such period below: 7.13 TANGIBLE NET WORTH The Borrower shall not permit (as of the end of any fiscal quarter) its Tangible Net Worth to be less than 95% of its Tangible Net Worth as of the last financial quarter end prior to the date hereof plus 75% of the Borrower's net income (not to be reduced by losses) earned in each financial quarter plus 75% of the Net Issuance Proceeds since the date hereof. 7.14 CHANGE IN BUSINESS The Borrower shall not engage in any material line of business substantially different from those lines of business carried on by it on the date hereof. 7.15 ACCOUNTING CHANGES The Borrower shall not make any significant change in accounting treatment or reporting practices, except as required by Generally Accepted Accounting Principles, or change its fiscal year. CLAUSE 8 EVENTS OF DEFAULT 8.01 EVENT OF DEFAULT Any of the following shall constitute an "EVENT OF DEFAULT": (a) NON-PAYMENT. The Borrower fails to pay, (i) when and as required to be paid herein, any amount of principal payable hereunder, or (ii) within two days after the same shall become due, any interest, fee or any other amount payable hereunder; or (b) REPRESENTATION OR WARRANTY. Any representation or warranty by the Borrower made or deemed made herein or which is contained in any certificate, document or financial or other statement by the Borrower or its Responsible Officers furnished at any time under this Agreement shall prove to have been incorrect in any material respect on or as of the date made or deemed made; or (c) SPECIFIC DEFAULTS. The Borrower fails to perform or observe any term, covenant or agreement contained in Clauses 6.01, 6.02, 6.03 and 6.09 or Clause 7; or (d) OTHER DEFAULTS. The Borrower fails to perform or observe any other term or covenant contained in this Agreement and such default shall continue unremedied for a period of 20 days after the earlier of (i) the date upon which a Responsible Officer of the Borrower knew or should have known of such failure or (ii) the date upon which written notice thereof is given to the Borrower by the Bank; or (e) CROSS-DEFAULT. The Borrower or the Guarantor or any of its Subsidiaries (i) fails to make any payment in respect of any Indebtedness or Contingent Obligation having an aggregate principal amount (including undrawn committed or available amounts and including amounts owing to all creditors under any combined or syndicated credit arrangement) of more than $1,000,000 (or its equivalent) when due (whether by scheduled maturity, required prepayment, acceleration, demand, or otherwise) and such failure continues after the applicable grace or notice period, if any, specified in the document relating thereto on the date of such failure; or (ii) fails to perform or observe any other condition or covenant, or any other event shall occur or condition exist, under any agreement or instrument relating to any such Indebtedness or Contingent Obligation, and such failure continues after the applicable grace or notice period, if any, specified in the document relating thereto on the date of such failure if the effect of such failure, event or condition is to cause, or to permit the holder or holders of such Indebtedness or beneficiary or beneficiaries of such Indebtedness (or a trustee or agent on behalf of such holder or holders or beneficiary or beneficiaries) to cause such Indebtedness to be declared to be due and payable prior to its stated maturity, or such Contingent Obligation to become payable or cash collateral in respect thereof to be demanded; or (f) INSOLVENCY; VOLUNTARY PROCEEDINGS. The Borrower or the Guarantor or any of its Subsidiaries (i) becomes insolvent as defined in Section 123 of the Insolvency Act 1986, or generally fails to pay, or admits in writing its inability to pay, its debts as they become due, subject to applicable grace periods, if any, whether at stated maturity or otherwise; (ii) voluntarily ceases to conduct its business in the ordinary course; (iii) commences any Insolvency Proceeding with respect to itself, or (iv) takes any action to effectuate or authorise any of the foregoing; or (g) INSOLVENCY: INVOLUNTARY PROCEEDINGS. (i) Any involuntary Insolvency Proceeding is commenced or filed against the Borrower or the Guarantor or any of its Subsidiaries, or any writ, judgment, warrant of attachment, execution or similar process, is issued or levied against a substantial part of the Borrower's or the Guarantor's or any of its Subsidiaries' Properties, and any such proceeding or petition shall not be dismissed, or such writ, judgment, warrant of attachment, execution or similar process shall not be released, vacated or fully bonded within 60 days after commencement, filing or levy; (ii) the Borrower or the Guarantor or any of its Subsidiaries admits the material allegations of a petition against it in any Insolvency Proceeding, or an order for relief is ordered in any Insolvency Proceeding; or (iii) the Borrower or the Guarantor or any of its Subsidiaries acquiesces in the appointment of a receiver, administrative receiver, administrator, trustee, custodian, conservator, liquidator, mortgagee in possession (or agent therefor), or other similar Person for itself or a substantial portion of its Property or business; or (i) MONETARY JUDGMENTS. One or more final judgments, orders or decrees shall be entered against the Borrower or the Guarantor or any of its Subsidiaries involving in aggregate a liability (not fully covered by independent third-party insurance) as to any single or related series of transactions, incidents or conditions, of $1,000,000 (or its equivalent) or more, and the same shall remain unsatisfied, unvacated and unstayed pending appeal for a period of 30 days after the entry thereof, or (j) NON-MONETARY JUDGMENTS. Any non-monetary judgment, order or decree shall be rendered against the Borrower or the Guarantor which does or would reasonably be expected to have a Material Adverse Effect, and there shall be any period of 10 consecutive days during which a stay of enforcement of such judgment or order, by reason of a pending appeal or otherwise, shall not be in effect; or (k) LOSS OF LICENSES. Any Governmental Authority shall finally revoke or fail to renew any material license, permit or franchise of the Borrower or the Guarantor or either of them shall for any reason lose any material license, permit or franchise or the Borrower or the Guarantor or any of its Subsidiaries shall suffer the imposition of any restraining order, escrow, suspension or impound of funds in connection with any proceeding (judicial or administrative) with respect to any material license, permit or franchise; or (l) ADVERSE CHANGE. There shall occur a Material Adverse Effect; or (m) GUARANTOR DEFAULTS. The Guarantor shall fail in any material respect to perform or observe any term, covenant or agreement in the Guarantee; or the Guarantee shall for any reason be in material part (including with respect to future advances) or wholly revoked or invalidated, or otherwise cease to be in full force and effect, or the Guarantor or any other Person shall contest in any manner the validity or enforceability thereof or deny that it has any further liability or obligation thereunder. 8.02 REMEDIES If any Event of Default occurs and is not remedied during any applicable grace period, the Bank may: (a) terminate the commitments of the Bank to make Advances or the Term Loan Drawing available, whereupon such commitment shall forthwith be terminated; (b) declare the unpaid principal amount of all outstanding Advances or the Term Loan Drawing, all interest accrued and unpaid thereon, and all other amounts owing or payable hereunder to be immediately due and payable; without presentment, demand, protest or other notice of any kind, all of which are hereby expressly waived by the Borrower; and (c) exercise all rights and remedies available to it under this Agreement or applicable law; PROVIDED, HOWEVER, that upon the occurrence of any event specified in paragraph (f) or (g) of clause 8.01 (in the case of clause (i) of paragraph (g) upon the expiration of the 60-day period mentioned therein), the obligation of the Bank to make Advances or the Term Loan Drawing shall automatically terminate and the unpaid principal amount of all Advances or the Term Loan Drawing, and all interest and other amounts shall automatically become due and payable without further act of the Bank. 8.03 DEFAULT INTEREST AND INDEMNITY (A) If default is made in the payment of any sum due under this Agreement interest shall accrue on the amount in respect of which such default has been made from the date of default until payment calculated (after as well as before judgment) at the rate of two percent (2%) per annum above the cost to the Bank of obtaining such funds from such sources and for such periods as the Bank may in its absolute discretion and from time to time decide and will be due and payable at the end of each such period. (B) Without prejudice to paragraph (A) above but taking into) account any payments of interest made thereunder, the Borrower will reimburse to the Bank all amounts as the Bank may specify to be necessary to compensate it for all costs, expenses, liabilities and losses (including, but not limited to, any loss of any anticipated receipt of interest in respect of any sum repaid by the Borrower for the remainder (if any) of the then current Interest Period applicable thereto and all losses incurred in liquidating or re-employing deposits from third parties acquired to effect or maintain any outstanding Advance or the Term Loan Drawing or any part or parts thereof) sustained or incurred by it howsoever as a result of any prepayment of the Loan made other than in accordance with Clause 3.03, of the occurrence of an Event of Default and/or of the declaration of each outstanding Advance or the Term Loan Drawing to be immediately due and payable pursuant to Clause 8.01 and/or of the timing of any payment made by the Borrower under this Agreement following the occurrence of an Event of Default and/or of any failure by the Borrower to pay any sum expressed to be due under this Agreement on the due date therefor and/or of the occurrence of a Default which, by reason of paragraph (A) (ii) of Clause 3.01, causes an Advance not to be made in accordance with the Notice of Advance served in respect thereof. (C) The certificate of the Bank as to the amount of such costs, expenses, liabilities and losses as are mentioned in sub-paragraph (B) above or any such cost as is mentioned in sub-paragraph (A) above shall, save in the case of any manifest error, be conclusive and binding on the Borrower. CLAUSE 9 EXPENSES The Borrower shall reimburse to the Bank on demand all expenses (including, but not limited to, legal fees and expenses and any value added tax and any stamp or other similar duties or taxes and any court, registration or recording fees in any applicable jurisdiction) incurred by the Bank in connection with the negotiation, preparation and signature of this Agreement and the Appendices hereto and in preserving, maintaining, protecting, perfecting or enforcing or seeking to preserve, maintain, protect, perfect or enforce any of its rights under this Agreement. CLAUSE 10 CHANGE5 IN CIRCUMSTANCES 10.01 UNLAWFUL FOR THE BANK TO FUND OR MAINTAIN ITS OBLIGATIONS If, by reason of any applicable present or future law or regulation or regulatory requirement (whether of the United States of America, any State therein, England or elsewhere) or the interpretation or application thereof or any change therein or judicial decision relating thereto, it shall be unlawful or otherwise prohibited for the Bank to maintain or give effect to any of its obligations as contemplated by this Agreement, then the Bank may despatch a notice to the Borrower cancelling the Facility whereupon the Facility shall be cancelled and no further Advance may be made and the Borrower shall forthwith prepay each outstanding Advance or the Term Loan Drawing to the Bank together with any accrued interest and commitment fee and all other sums expressed to be payable by the Borrower to the Bank pursuant to this Agreement. 10.02 ADDITIONAL COSTS If the Bank shall at any time be of the opinion that the effect of any applicable present or future law, regulation or regulatory requirement (whether of the United States of America, any State therein, England or elsewhere) or the interpretation or application thereof or any change therein or any judicial decision relating thereto or of complying with any applicable present or future direction, request or requirement (whether or not having the force of law) of any central bank or any governmental, monetary or other authority is to increase the cost to the Bank of making the Facility available or maintaining any Advance or the Term Loan Drawing, to reduce the amount of any payment received or receivable by the Bank from the Borrower pursuant to this Agreement, to oblige the Bank to make any payment on, or calculated by reference to, the amount of any sum received or receivable by it from the Borrower pursuant to this Agreement, to reduce the rate of return on its capital resources which it would have been able to achieve but for the Bank entering into and/or performing its obligations hereunder, or to oblige the Bank to forgo any interest or other return on or in relation to the Facility or otherwise in connection with this Agreement, in any case by an amount which the Bank deems material, then and in any such case (the Bank being under no obligation to mitigate the effect of any such increase or reduction or the amount of any such payment or forgone return):- (a) the Bank shall notify the Borrower; (b) the Borrower shall from time to time pay to the Bank on demand such amounts as the Bank may specify to be necessary to compensate the Bank for such increase, reduction, payment or forgone return; and (c) the Borrower shall be at liberty at any time after receipt of any such notice, so long as the circumstances giving rise to such increase, reduction, payment or forgone return continue, to give not less than fifteen days irrevocable notice of cancellation to the Bank and upon the expiry of such notice the Facility shall be cancelled and no further Advance shall be made and the Borrower shall forthwith prepay each outstanding Advance or the Term Loan Drawing to the Bank together with any accrued interest and commitment fee and all other sums expressed to be payable by the Borrower to the Bank pursuant to this Agreement. Provided that nothing in this Clause shall apply to any deduction or withholding contemplated by or referred to in Clause 4.03, to any reserve or deposit requirement to which Appendix B applies or to any tax on the Bank's overall net income imposed in the United States of America or England. 10.03 EFFECT OF CANCELLATION UNDER CLAUSE 10.01 OR CLAUSE 10.02 Where the Facility is to be cancelled and/or each Advance or the Term Loan Drawing is to be prepaid pursuant to Clause 10.01 or Clause 10.02 the Borrower will reimburse to the Bank all amounts as the Bank may specify to be necessary to compensate it for all costs, expenses liabilities and losses (including, but not limited to, any loss of any anticipated receipt of interest in respect of any sum repaid by the Borrower for the remainder (if any) of the then current Interest Period applicable thereto and all losses incurred in liquidating or re-employing deposits from third parties acquired to effect or maintain any Advance or the Term Loan Drawing or any part or parts thereof) sustained or incurred by it howsoever as a result of such cancellation and/or prepayment. 10.04 CERTIFICATE OF THE BANK CONCLUSIVE The certificate of the Bank as to any of the matters referred to in any of the foregoing provisions of this Clause shall, save for any manifest error, be conclusive and binding. CLAUSE 11 ASSIGNMENT 11.01 ASSIGNMENT BY THE BANK The Bank may at any time and from time to time without the consent of the Borrower assign, grant a participation in, transfer or otherwise dispose of or deal with all or any part of its rights and benefits under this Agreement to any one or more banks or other financial institutions (an "Assignee"). For this purpose the Bank may disclose to a potential or actual Assignee such credit and other information relating to the Borrower and the Guarantor and their respective conditions as the Borrower and/or the Guarantor shall have made available to the Bank or as shall be known to the Bank otherwise howsoever. 11.02 ASSIGNMENT BY THE BORROWER The Borrower may not assign or transfer or otherwise dispose of or deal with all or any of its rights, benefits and/or obligations under this Agreement. 11.03 "BANK" TO INCLUDE SUCCESSORS and ASSIGNS The expression "Bank" wherever used in this Agreement shall include every Assignee of the Bank and every successor in title of any such Assignee or of the Bank. CLAUSE 12 MISCELLANEOUS 12.01 NOTICES (A) Any notice, demand or other communication given or sent to the Bank or the Borrower in connection with this Agreement shall be given in writing or by cable, telex or facsimile transmission addressed to the Bank at 1 Alie Street, London El 8DE (telex number 888412, fax number 071 634 4707) or, as the case may be, to the Borrower at Priory Lane, London SW15 5JJ (fax number 081 878 8491) or at such other address (or telex or fax number) as may be, notified by the Bank or the Borrower to the other from time to time for that purpose. (B) Except where actual receipt is expressly required by the provisions of this Agreement, any notice, demand or other communication sent to the Borrower or the Bank as provided in this Clause 12.01 shall be deemed to have been given, if sent by post, two week days after the time when the same was put into the post in the United Kingdom and in providing delivery it shall be sufficient to prove that the same was properly addressed and put in the post. Any such notice, demand or other communication sent by cable, telex or facsimile transmission shall be deemed to have been given at the time of despatch. 12.02 REMEDIES AND WAIVERS No delay or omission of the Bank in exercising any right, power privilege or remedy in respect of this Agreement shall impair such right, power, privilege or remedy or be construed as a waiver thereof nor shall any single or partial exercise of any such right, power, privilege or remedy preclude any further exercise thereof or the exercise of any other right, power, privilege or remedy. The rights, powers, privileges and remedies herein provided are cumulative and not exclusive of any rights, powers, privileges or remedies provided by law. 12.03 LAW This Agreement shall be governed by and construed in accordance with English law and it is irrevocably agreed for the exclusive benefit of the Bank that the courts of England are to have jurisdiction to settle any disputes which may arise out of or in connection with this Agreement and that accordingly any suit, action or proceeding arising out of or in connection with this Agreement (in this Clause referred to as "Proceedings") may be brought in such courts. Nothing in this Clause shall limit the right of the Bank to take Proceedings against the Borrower in any other court of competent jurisdiction, nor shall the taking of Proceedings in one or more jurisdictions preclude the taking of Proceedings in any other jurisdiction, whether concurrently or not. 12.04 DISCLOSURE In addition to any disclosure as may be permitted under Clause 11.01, the Bank is hereby authorised to disclose any information whatsoever in relation to the Borrower or this Agreement if required to do so by any law or regulation or by any request or requirement (whether or not having the force of law) of any central bank, governmental, monetary or other authority. 12.05 CLAUSES, SECTIONS, HEADINGS AND APPENDICES The headings to Clauses and Sections in this Agreement are inserted for convenience only and shall be ignored when construing this Agreement. Unless otherwise specified, all references in this Agreement to Clauses, Sections and Appendices are to Clauses, Sections and Appendices of this Agreement. Signed by the duly authorised representatives of the parties hereto the day and year first above written. The Borrower: PRIORY HOSPITALS GROUP LIMITED By: /s/ D. A. WAKEFIELD ------------------------------- Chairman The Bank: - - --------- BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION By: /s/ T. ISDALIN ------------------------------- Vice President SCHEDULE I ---------- NOTICE OF ADVANCE To:- The Bank Advance No. [ ] [ , 19 ]. REVOLVING TERM FACILITY In the maximum aggregate principal amount of 10,000,000 pounds sterling made available pursuant to a Loan Agreement dated December, 1993 (the "Loan Agreement"). We refer to the Loan Agreement and hereby:- (1) give you irrevocable notice that we wish an Advance to be made to us under the Loan Agreement of ( pounds sterling) on , 19 . (2) request that the proceeds of such Advance be made available to us on such date by payment to account no.[ ] in the name of [ ] at [ ] [in our favour]; (3) confirm that the borrowing to be effected by such Advance has been validly authorised by appropriate corporate and other action, that no Default or Event of Default has occurred, that the representations and warranties contained in Clause 5 of the Loan Agreement, if repeated at the date hereof by reference to the facts subsisting at the date hereof, would be true and accurate and that the covenants contained in Clauses 6 and 7 of the Loan Agreement have been complied with as at the date hereof provided that the reference in Clause 5 to 30 November 1992 shall, for the purposes of the confirmation contained in this paragraph be to [latest year end]; and (4) select (subject to the provisions of Clause 3.01(B) of the Loan Agreement) a period of [ ] month[s] as the period applicable to such Advance. Expressions defined in the Loan Agreement have the same meanings when used in this Notice of Advance. For and on behalf of Priory Hospitals Group Limited SCHEDULE 2 Additional Interest The additional interest (if any) payable on each Interest Payment Date pursuant to Clause 3.04(C) will be calculated by the Bank as follows:- 1. In this Appendix the following expressions shall have the following meanings:- (a) "Additional Rate" means, in relation to any Interest Payment Period, the additional percentage rate per annum calculated by the Bank at the end of such Interest Payment Period in accordance with paragraph 3 below. (b) "Cost Determination Day" means the first Business Day of each week and any day on which there is a change in the value of "A!' or "R" or "S" as defined in paragraph 2 below. (c) "eligible bank" and "eligible liabilities" shall have the meanings assigned to them by the Bank of England from time to time. (d) "Interest Payment Period" means:- (i) in relation to any Interest Period having a duration of 3 months or less - that Interest Period; and (ii) in relation to any Interest Period having a duration of more than 3 months - each successive period ending on each Interest Payment Date within such Interest Period. 2. On each Cost Determination Day falling within the Interest Payment Period ending on the relevant Interest Payment Date a rate of interest shall be calculated by reference to the following formula:- Rate of interest = AC + R (C-D) + S (C-T) (expressed as a 100 - (A+S) percentage) where: A = the percentage of eligible liabilities which the Bank is required to maintain as non-operational non-interest bearing deposits with the Bank of England as at the close of business on such Cost Determination Day. C = the average interest rate (expressed as a percentage per annum) at which one week fixed sterling deposits are offered to the Bank in the ordinary course of business in the London interbank market at the Bank's request at or about 11.00 a.m. on such Cost Determination Day. R = the percentage of eligible liabilities which the Bank is required, in order to qualify as an eligible bank, to maintain on average on deposit with members of the London Discount Market Association, money-brokers and gilt-edged jobbers as at the close of business on such Cost Determination Day. D = the lower of C and the average interest rate (expressed as a percentage per annum) for one week callable sterling deposits offered to the Bank in the ordinary course of business by members of the London Discount Market Association at the Bank's request at or about 11.00 a.m. on such Cost Determination Day. S = the percentage of eligible liabilities which the Bank is required to maintain as special deposits with the Bank of England as at the close of business on such Cost Determination Day. T = the lower of C and the interest rate (expressed as a percentage per annum) being paid by the Bank of England on special deposits placed with it by the Bank as at the close of business on such Cost Determination Day. 3. At the end of the relevant Interest Payment Period the rates of interest calculated on each Cost Determination Day failing within such Interest Payment Period will be averaged to three decimal places to produce the average rate applicable over the whole of such Interest Payment Period. Such average rate shall be the Additional Rate applicable to such Interest Payment Period, unless, in its sole and absolute discretion, the Bank shall agree that such Additional Rate shall be taken as zero. 4. Interest on the Advance or the Term Loan Drawing to which the relevant Interest Payment Period relates at the Additional Rate determined as aforesaid shall (i) accrue from (and including) the first day to (but excluding) the last day of the relevant Interest Payment Period and (ii) be paid in arrears on the relevant Interest Payment Date as additional interest pursuant to Clause 3.04(C). SCHEDULE 3 ---------- COMMUNITY PSYCHIATRIC CENTERS ("CPC") AND PRIORY HOSPITALS GROUP LTD. ("PHG") WHOLLY OWNED SUBSIDIARIES AND EQUITY INVESTMENTS (i) SUBSIDIARIES OF CPC ------------------- CORPORATION - - ----------- Belmedco C.P.C. of Louisiana CPC Investment Corp. CPC Laboratories, Inc. CPC Pharmacy, Inc. CPC Properties of Arkansas, Inc. CPC Properties of Illinois, Inc. CPC Properties of Indiana, Inc. CPC Properties of Kansas, Inc. CPC Properties of Louisiana, Inc. CPC Properties of Mississippi, Inc. CPC Properties of Missouri, Inc. CPC Properties of North Carolina, Inc. CPC Properties of Wisconsin, Inc. CPC of Georgia, Inc. CalProp I, Inc. CalProp II, Inc. Community Psychiatric Centers Community Psychiatric Centers Properties Incorporated Community Psychiatric Centers Properties of Oklahoma, Inc. Community Psychiatric Centers Properties of Texas, Inc. Community Psychiatric Centers Properties of Utah, Inc. Community Psychiatric Centers of Arkansas, Inc. Community Psychiatric Centers of California Community Psychiatric Centers of Florida, Inc. Community Psychiatric Centers of Idaho, Inc. Community Psychiatric Centers of Indiana, Inc. Community Psychiatric Centers of Kansas, Inc. Community Psychiatric Centers of Mississippi, Inc. Community Psychiatric Centers of Missouri, Inc. Community Psychiatric Centers of North Carolina, Inc. Community Psychiatric Centers of Oklahoma, Inc. Community Psychiatric Centers of Oregon, Inc. Community Psychiatric Centers of Puerto Rico, Inc. Community Psychiatric Centers of Texas, Inc. Community Psychiatric Centers of Utah, Inc. Community Psychiatric Centers of Wisconsin Peachtree-Parkwood Hospital, Inc. P.P.P., Inc. Psychiatric Hospitals Consultants Florida Hospital Properties, Inc. Old Orchard Hospital, Inc. Cottonwood Hill, Inc. Counterpoint Center of Old Orchard, Inc. Miami Valley Community Centers, Inc. Community Psychiatric Centres Limited CPC (Londinium) Limited Priory Hospitals Group Harvard Medical Ltd Transitional Hospitals Corporation Transitional Hospitals Corporation of Indiana, Inc. Transitional Hospitals Corporation of Louisiana, Inc. Transitional Hospitals Corporation of Massachusetts Transitional Hospitals Corporation of Nevada, Inc. Transitional Hospitals Corporation of North Carolina, Inc. Transitional Hospitals Corporation of Tampa, Inc. Transitional Hospitals Corporation of Texas, Inc. Transitional Hospitals Corporation of Wisconsin, Inc. (a)(ii) SUBSIDIARIES OF PHG ------------------- Regency Park Limited Jacques Hall Foundation Limited (b)(i) EQUITY INVESTMENTS OF CPC ------------------------- Welcam 80 Venture Camino Station Investors Leeds JV Michael A Bell Agency (Germany) (b)(ii) EQUITY INVESTMENTS OF PHG ------------------------- Harvard Medical Limited 20% owned by PHG Fulford Grange Medical Centre Limited 50% owned by PHG Pinnacle Counselling Limited 35% owned by PHG Interpres Medical Limited 60% owned by PHG SCHEDULE 4 ---------- EXISTING ENCUMBRANCES --------------------- 1. Debenture granted by Fulford Grange Medical Centre Limited in favour of Goldsborough Limited dated 7 May 1993. 2. Debenture granted by Fulford Grange Medical Centre Limited in favour of the Borrower dated 7 May 1993. SCHEDULE 5 ---------- EXISTING INDEBTEDNESS --------------------- 1. 1,000,000 Pounds sterling Overdraft facility with Midland Bank PLC dated 26 August 1993 and accepted by the Borrower on 1 September 1993. Legal\CDRS\Priory - - -----------------

68589_1993.txt

68589_1993

1993

68589

ITEM 3. LEGAL PROCEEDINGS There are various legal and regulatory proceedings pending against the Company and its affiliates. While it is not feasible to predict or determine the outcome of these proceedings, the Company's management believes that the outcome will not have a material adverse effect on the Company's financial position. Mountain Fuel, as a result of acquiring Questar Pipeline's gas purchase contracts, is responsible for any judgment rendered against Questar Pipeline in a lawsuit that was tried before a jury. The jury awarded an independent producer compensatory damages of approximately $6,100,000 and punitive damages of $200,000 on his claims involving take-or-pay, tax reimbursement, contract breach, and tortious interference with a contract. A judgment will not be entered until the parties have an opportunity to determine appropriate volumes and Questar Pipeline can submit motions for judgment notwithstanding the verdict. The producer's counterclaims originally exceeded $57,000,000, but were reduced to less than $10,000,000, when the presiding judge dismissed with prejudice some of the claims prior to the jury trial. Mountain Fuel expects that any amounts arising from the breach of contract claims will be included in its gas balancing account and recovered in its rates for natural gas sales service. As a result of its former ownership of Entrada and Wasatch Chemical Company, Mountain Fuel has been named as a "potentially responsible party" for contaminants located on property owned by Entrada in Salt Lake City, Utah. Questar and Entrada have also been named as potentially responsible parties. (Entrada and the Company are both direct, wholly owned subsidiaries of Questar; prior to October 2, 1984, Mountain Fuel was the parent of Entrada.) The property, known as the Wasatch Chemical property, was the location of chemical operations conducted by Entrada's Wasatch Chemical division, which ceased operation in 1978. A portion of the property is included on the national priorities list, commonly known as the "Superfund" list. In September of 1992, a consent order governing clean-up activities was formally entered by the federal district court judge presiding over the underlying litigation involving the property. This consent order was agreed to by Questar, Entrada, the Company, the Utah Department of Health and the Environmental Protection Agency. Entrada has obtained approval for a specific design using an in situ vitrification procedure to clean up the Wasatch Chemical property and expects the in situ process to begin prior to year- end. The clean-up procedure may take as long as three years. Entrada has accounted for all costs spent on the environmental claims and has also accounted for all settlement proceeds, accruals and insurance claims. It has received cash settlements, which together with accruals and insurance receivables, should be sufficient for future clean-up costs. Mountain Fuel has consistently maintained that Entrada should be responsible for any liability imposed on the Questar group as a result of actions involving Wasatch Chemical. The Company has not paid any and does not expect to pay any costs associated with the clean-up activities for the property. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, Mountain Fuel did not submit any matters to a vote of security holders. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S EQUITY AND RELATED STOCKHOLDER MATTERS The Company's outstanding shares of common stock, $2.50 par value, are owned by Questar. Information concerning the dividends paid on such stock and the ability to pay dividends is reported in the Statements of Common Shareholder's Equity and the Notes to Financial Statements included in Item 8. 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 Following is a summary of revenues and operating information for the Company's operations: Natural gas volumes sold to residential and commercial customers increased 16% in 1993 following a 10% decrease in 1992. Temperatures were 5% colder than normal in 1993 and 10% warmer than normal in 1992. The number of customers increased 3.4% in 1993 and 3.2% in 1992 because of expanding population and construction in Mountain Fuel's service area. Natural gas deliveries to industrial customers increased 5% in 1993 and 7% in 1992, due to increased usage by metals, mining and petroleum customers. These customers are using more natural gas because of expanded operations and environmental concerns. The Company's industrial customers have not switched to residual fuel oil with the decline in oil prices because gas prices have been competitive and sufficient fuel oil is not readily available. Mountain Fuel assumed the responsibility for purchasing its own gas supplies on September 1, 1993, when Questar Pipeline began operating in accordance with FERC Order No. 636. Questar Pipeline transferred its gas purchase contracts to Mountain Fuel. The majority of these contracts are priced using a current natural gas market value. Mountain Fuel also acquired an inventory of working gas to meet customer requirements. Mountain Fuel has reserved transportation capacity on Questar Pipeline's system of approximately 800,000 decatherms per day and pays an annual demand charge of approximately $49 million for this reservation. Mountain Fuel releases excess capacity to its industrial transportation or other customers and receives a credit from Questar Pipeline for the released-capacity revenues and a portion of Questar Pipeline's interruptible-transportation revenues. Mountain Fuel reached a settlement of its Wyoming general rate case in July 1993, with the new rates effective August 1, 1993. The settlement approved an annualized increase in rates of $721,000, including recovery of costs attributable to FERC Order No. 636 and higher federal income tax rates. In April 1993, Mountain Fuel filed a general rate case with the Public Service Commission of Utah (PSCU). The original rate increase request was revised to $10.3 million based on September 30, 1993 results and included a 12.1% rate of return on equity. Hearings on the case were held in November 1993 and a rate order was received in January 1994. The PSCU rate order granted Mountain Fuel a $1.6 million decrease in general rates and a $2.1 million increase in costs allowed through the purchased-gas adjustment account for a net increase in rates of $500,000. The PSCU allowed a return on equity of 11%, required Mountain Fuel to reduce rates over a five-year period for unbilled revenues, and disallowed rate coverage for certain incentive compensation and advertising costs. Mountain Fuel requested a rehearing of the PSCU order for the allowed return on equity and the treatment of unbilled revenues, and the PSCU granted a rehearing on these issues. Natural gas purchases increased 6% in 1993 and decreased 14% in 1992. These changes were consistent with changes in volumes sold to residential and commercial customers, which were primarily weather related. Operating and maintenance expenses increased 16% in 1993 and decreased 1% in 1992. The 1993 increase was due to more customers, expanded service territory, a reduction in the percentage of labor costs capitalized, and recording of postretirement medical and life insurance benefits on an accrual basis. The 1992 decrease was due to increased percentage of labor costs capitalized as a result of the system expansion projects which offset increased costs from a larger natural gas distribution service territory and inflation. Depreciation and amortization expense increased 12% in 1993 and 8% in 1992 due to capital expenditure programs and higher natural gas production. The Company adopted the provisions of SFAS No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. Questar is amortizing the transition obligation over a 20-year period. Total cost of postretirement benefits other than pensions under SFAS No. 106 was $3,350,000 in 1993 compared with the costs based on cash payments to retirees totaling $876,000 in 1992 and $464,000 in 1991. The impact of SFAS No. 106 on the Company's future net income will be mitigated by recovery of these costs from customers. Both the PSCU and the PSCW allowed Mountain Fuel to recover future SFAS No. 106 costs in the 1993 rate cases if the amounts are funded in an external trust. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $1,538,000. The Company may offset this amount with a regulatory asset depending on expected regulatory treatment and recovery of costs from customers. The effect on ongoing net income is not expected to be significant. The effective income tax rate was 23.5% in 1993, 24.2% in 1992 and 39.4% in 1991. The 1993 and 1992 rates were reduced by tight-sands gas production on Mountain Fuel-owned gas reserves amounting to $5,463,000 in 1993 and $4,281,000 in 1992. The 1993 federal income tax rate increased to 35%. The effect on the higher tax rate on deferred income taxes was recorded as income taxes recoverable from customers because the Company has adopted procedures with its regulatory commissions to include under-provided deferred taxes in customer rates on a systematic basis. Mountain Fuel is responsible for a judgment in a lawsuit involving the Company, Questar Pipeline and a gas producer. In March 1994, a jury awarded the gas producer damages of approximately $6.3 million on claims involving take-or-pay, tax reimbursement and breach of contract. Mountain Fuel expects that substantially all of the judgment will be included in its gas balancing account and recovered through customer rates. The judgment is not expected to have a significant impact on the Company's results of operations, financial position or liquidity. LIQUIDITY AND CAPITAL RESOURCES The majority of the Company's cash needs for capital expenditures and dividend payments has been met with cash from operations. Net cash from operating activities was $37,139,000 in 1993, $50,600,000 in 1992 and $54,655,000 in 1991. Inventories increased by $20,869,000 in 1993, primarily for gas stored underground. Changes in the purchased-gas adjustment account provided cash of $4,686,000 in 1993, $4,586,000 in 1992 and $16,662,000 in 1991. Following is a summary of capital expenditures for 1993, and a forecast of 1994 expenditures. Mountain Fuel's number of customers increased 18,075 during 1993 and 16,284 in 1992 due to population growth and building construction activity in its service area. The 1994 capital expenditures anticipate a similar level of customer growth. The Company funded 1993 capital expenditures with cash provided from operations and borrowings under short-term credit lines. The 1994 capital expenditures are expected to be financed with cash provided from operations, borrowings under Mountain Fuel's medium-term note program, equity investment from Questar and short-term credit arrangements. The Company has a short-term line-of-credit arrangement with a bank under which it may borrow up to $500,000, below the prime interest rate. The arrangements are renewable on an annual basis. At December 31, 1993, no amounts were borrowed under this arrangement. Questar loans funds to the Company under a short-term borrowing arrangement. Outstanding short-term notes payable to Questar totaled $57,800,000 and had an interest rate of 3.59% at December 31, 1993. During 1993, Mountain Fuel issued $91,000,000 of 15-year and 30-year medium-term notes at interest rates of 7.19% to 8.28%. Proceeds from these notes and $16,000,000 remaining from the 1992 issuances were used to redeem Mountain Fuel's $100,000,000 9 3/8% debentures and pay the associated refinancing costs. At December 31, 1993, Mountain Fuel had a registration statement filed with the Securities and Exchange Commission to issue an additional $17,000,000 of medium-term notes. The Company typically has negative net working capital at the end of the year because of short-term borrowings. These borrowings are seasonal and generally peak at the end of December because of cold-weather gas purchases. The assumption of gas-purchase contracts and the gas-supply purchase activity resulted in several changes to Mountain Fuel's working capital. Mountain Fuel acquired an inventory of gas stored underground to meet customer requirements. Accounts payable to unaffiliated parties increased while accounts payable to affiliates decreased because of direct purchases from gas producers. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's financial statements are included in Part IV, Item 14, herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Mountain Fuel has not changed its independent auditors or had any disagreements with them concerning accounting matters and financial statement disclosures within the last 24 months. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the Company's directors and executive officers is located in the following chart: Business Experience and Positions Held Name Age With the Company and Affiliates Robert H. Bischoff 72 Director, May 1982; Director, Questar, May 1984; Chairman of Board, Key Bank of Utah (commercial bank), through December 31, 1993; Director, Deseret News Publishing Company; Trustee, Intermountain Health Care, Inc. (through April 1994). M. E. Benefield 54 Vice President, Gas Supply, May 1992; Vice President, Planning and Corporate Development, Questar (March 1989 to May 1992.) R. D. Cash 51 Director, May 1977; Chairman of the Board, May 1985; Director, President and Chief Executive Officer, Questar, May 1984; Chairman of the Board, Questar, May 1985. Director, Zions First National Bank and Zions Bancorporation; Trustee, Southern Utah University. W. F. Edwards 48 Vice President and Chief Financial Officer, May 1984; Senior Vice President and Chief Financial Officer, Questar, February 1989; Vice President and Chief Financial Officer, Questar, May 1984 to February 1989. Susan Glasmann 46 Vice President, Marketing, February 1994; General Manager, Marketing, April 1991 to February 1994; Manager, Corporate Communications, Questar, October 1989 to April 1991. Robert E. Kadlec 60 Director, March 1987; Director, Questar, March 1987; President and Chief Executive Officer, BC Gas Inc. (Vancouver, British Columbia); Director, BC Gas Inc., Trans Mountain Pipe Line Company Ltd., Bank of Montreal, and British Pacific Properties Ltd. and affiliated companies. B. Z. Kastler 73 Director, May 1969; Senior Director, Questar, May 1991; Director, Questar, May 1984 to May 1991; Consultant, January 1984 to December 1988; Chairman of the Board, May 1976 to May 1985. Dixie L. Leavitt 64 Director, May 1987; Director, Questar, May 1987; Chairman of the Board, Leavitt Group Agency Association (a group of approximately 42 separate insurance agencies); Director, Zions First National Bank. Gary G. Michael 53 Director, February 1994; Director, Questar, February 1994; Chairman and Chief Executive Officer, Albertson's; Director, Albertson's and member of Board of Directors of the Federal Reserve Bank of San Francisco. D. N. Rose 49 President and Chief Executive Officer, October 1984; Director, May 1984; Director, Questar, May 1984; Director, Key Bank of Utah; Trustee, Westminster College. G. H. Robinson 43 Vice President and Controller, April 1991; Vice President, Marketing, March 1985 to April 1991. Roy W. Simmons 78 Director, May 1968; Senior Director, Questar, May 1992; Director, Questar, May 1984 to May 1992; Chairman, Zions Bancorporation (commercial bank holding company) and Chairman, Zions First National Bank (commercial bank); Chief Executive Officer, Zions First National Bank to January 1989; Chief Executive Officer, Zions Bancorporation to January 1991; Director, Beneficial Life Insurance Company and Ellison Ranching Company. S. C. Yeager 46 Vice President, Customer Service, April 1991; Vice President, Retail Operations, March 1985 to April 1991. Except as otherwise indicated, the executive officers and directors have held the principal occupations described above for more than the past five years. There are no family relationships among the directors and executive officers of the Company. Directors of the Company are elected to serve three-year terms. Executive officers of the Company serve at the pleasure of the Board of Directors. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following Summary Compensation Table lists annual and long-term compensation earned by Mr. D. N. Rose, the Company's President and Chief Executive Officer, and the other four most highly compensated officers during 1991, 1992, and 1993: 1/Amounts listed under this heading for 1993 include payments made in 1994 on 1993 target bonuses established under the Company's Annual Management Incentive Plan and cash payments made in 1993 on 1990 and 1991 target bonuses under such plan. They include the Company's portion of the amounts paid to Mr. Cash under Questar's Annual Management Incentive Plan for the same years and the Company's portion of the amounts paid to Mr. Benefield in 1992 as well as the payments made in 1993 and 1994 by the Company. Bonus payments reported for prior years are handled in a similar fashion. 2/Amounts under this heading include the value (as of the grant date) of any restricted shares of Questar's common stock used in 1993 and 1994, in lieu of cash, as partial payment of bonuses earned under the Company's 1992 and 1993 Annual Management Incentive Plans and the Company's allocated portion of the value of restricted shares granted to Mr. Cash under Questar's 1992 and 1993 Annual Management Incentive Plans. All shares of restricted stock vest in two equal, annual installments with the first installment occurring on the first anniversary of the grant date. Dividends are paid on the restricted shares at the same rate dividends are paid on other shares of Questar's common stock. As of year-end 1993, Messrs. Rose, Cash, Benefield, Robinson and Yeager owned 1,086; 2,891; 603; 446; and 446 shares of restricted stock, respectively. 3/Mountain Fuel's executive officers are granted nonqualified stock options to purchase shares of Questar's common stock under Questar's Long-Term Stock Incentive Plan. 4/Amounts listed under this heading include employer matching and nonmatching contributions to the Employee Stock Purchase Plan, matching "contributions" to the Deferred Share Plan, and directors' fees. The figures opposite Mr. Rose's name include $12,228 in contributions to the Employee Stock Purchase Plan for 1993, $10,499 for 1992 and $10,000 for 1991. They also include directors' fees amounting to $5,200 for 1993, $5,600 for 1992, and $4,600 for 1991 and matching "contributions" to the Deferred Share Plan of $1,358 for 1993, $903 for 1992, and $355 for 1991. The figures opposite Mr. Cash's name include the Company's allocated portion of the matching and nonmatching contributions to the Employee Stock Purchase Plan of $5,124 for 1993, $4,511 for 1992, and $4,365 for 1991. They also include directors' fees amounting to $5,200 for 1993, $5,600 for 1992, and $4,600 for 1991 and the Company's allocated portion of "contributions" to the Deferred Share Plan of $6,399 for 1993, $5,154 for 1992, and $4,439 for 1991. The figures opposite the names of Messrs. Benefield, Robinson, and Yeager include the matching and nonmatching contributions made by the Company to the Employee Stock Purchase Plan for their respective accounts. 5/Mr. Cash also serves as an executive officer of Questar and other affiliated companies. The base salary shown for Mr. Cash is the combination of the amount directly paid by the Company and the amount allocated to the Company. 6/Mr. Benefield did not become an executive officer of the Company until May 19, 1992. The base salary information reported for him in 1992 includes the amount that the Company paid directly and the amount allocated to the Company when Mr. Benefield served as an officer of Questar. The following table lists information concerning the nonqualified stock options to purchase shares of Questar's common stock that were granted to Mountain Fuel's five highest paid officers during 1993 under Questar's Long-Term Stock Incentive Plan. No stock appreciation rights were granted during 1992. 1/These nonqualified stock options vest in four annual, equal installments, with the first installment exercisable as of August 8, 1993. Participants can use cash or previously-owned shares as consideration for option shares. Participants can also elect to use newly-acquired shares to satisfy the minimum tax withholding obligation or previously-owned shares to satisfy either the minimum tax withholding obligation or maximum tax payment obligation. Options expire when a participant terminates his employment, unless termination is caused by an approved retirement, death, or disability. Options can be exercised for three months following a participant's approved retirement and 12 months following a participant's death or disability. 2/When calculating the present value of options granted in 1993, Questar used the Black-Scholes option pricing model. Questar assumed a volatility of .179, a risk free interest rate of 6.26 percent, a dividend yield of 5.00 percent and assumed that the shares would be exercised evenly throughout the four- year vesting schedule. The following table lists information concerning the nonqualified stock options to purchase shares of Questar's common stock that were exercised by the officers named above during 1993 and the total options and their value held by each at year-end 1993: 1/Stock appreciation rights (SARs) have not been granted since February of 1989. At year-end 1993, there were no SARs outstanding. 2/The "value" is calculated by subtracting the fair market value of the shares purchased on the date of exercise minus the option price. The value is equal to the amount of ordinary income recognized by each officer. The current value of the shares may be higher or lower than the aggregate value reported in the table. Retirement Plan Company employees (including executive officers) participate in the employee benefit plans of Questar. The Company has agreed to pay its share of the costs associated with the plans that are described below. Questar maintains a noncontributory Retirement Plan that is funded actuarially and does not involve specific contributions for any one individual. The following table lists the estimated annual benefits payable under the Retirement Plan as of December 31, 1993, and, if necessary, the Supplemental Executive Retirement Plan (described below). The benefits shown are based on earnings and years of service reaching normal retirement age of 65 in 1993 and do not include Social Security benefits. Benefits under the Retirement Plan are not reduced or offset by Social Security benefits. Questar's Retirement Plan, as of January 1, 1989, has a "step rate/excess" benefit formula. The formula provides for a basic benefit that is calculated by multiplying the employee's final average earnings by a specified base benefit factor and by subsequently multiplying such sum by the employee's years of service (up to a maximum of 25). This basic benefit is increased for each year of service in excess of 25 and is reduced for retirement prior to age 62. Employees also receive a supplemental benefit calculated by multiplying the difference between the employee's final average earnings and his "covered compensation" by a supplemental factor that varies by age. (The term covered compensation refers to the 35-year average Social Security wage base tied to year of an employee's birth.) Employees who retire prior to age 62 also receive a temporary supplement that is tied to years of service until they are eligible to receive Social Security benefits. The "final average earnings" (average annual earnings for the last three years) for purposes of calculating retirement benefits for the executive officers named above in the table as of December 31, 1993, is as follows: $247,024 for Mr. Rose; $157,253 for Mr. Benefield; $146,629 for Mr. Robinson; and $146,129 for Mr. Yeager. (No figure is given for Mr. Cash because his final average earnings for purposes of the Retirement Plan would include compensation paid by the Company's affiliates.) The years of credited service for the individuals listed in the compensation table are: 18 years for Mr. Cash; 25 years for Mr. Rose; 16 years for Mr. Benefield; 20 years for Mr. Robinson; and 18 years for Mr. Yeager. The Company also participates in Questar's Executive Incentive Retirement Plan (the EIRP). Under the terms of this nonqualified plan, a participant will receive monthly payments upon retirement until death equal to 10 percent of the highest average monthly compensation (excluding incentive compensation) paid to the officer during any period of 36 consecutive months of employment. The plan also provides for a family benefit in the event of the death of an officer. Although not required to do so, Questar and its affiliates have purchased life insurance on the life of each participant, with Questar named as owner and beneficiary. The covered officers have no rights under or to such insurance policies. All of the Company's officers listed in the compensation table have been nominated to participate in the plan, have satisfied the 15 years of service requirement and have a vested right to receive benefits under the EIRP. The annual benefits payable to the named officers under this plan as of December 31, 1993, are as follows: Mr. Rose, $19,065; Mr. Benefield, $12,823; and Messrs. Robinson and Yeager, $12,155. (No figure is given for Mr. Cash because his compensation for purposes of calculating benefits under the EIRP would include compensation paid by the Company's affiliates.) Any benefits payable under the SERP are offset against payments for the EIRP. Consequently, an officer would not receive any benefits for the SERP unless his benefit under the EIRP was less than the difference between what he could be paid under Questar's Retirement Plan at the date of retirement and what he had earned under such plan absent federal tax limitations. Given this relationship between the two nonqualified plans, the amounts listed in the table above do not include benefits payable under the EIRP. Executive Severance Compensation Plan Questar has an Executive Severance Compensation Plan that covers the Company's executive officers. Under this plan, participants, following a change in control of Questar, are eligible to receive compensation equal to up to two years' salary and miscellaneous benefits upon a voluntary or involuntary termination of their employment, provided that they have continued working or agree to continue working for six months following a potential change in control of Questar. This plan was adopted in 1983 by Mountain Fuel, was assumed by Questar as of October 2, 1984, and was amended and restated effective January 1, 1986. The amended plan also contains a provision that limits compensation and benefits payable under the plan to amounts that can be deducted under Section 280G of the Internal Revenue Code of 1986. The dollar amounts payable to the Company's executive officers (based on current salaries paid by the Company) in the event of termination of employment following a change in control of Questar are as follows: $422,000 to Mr.Rose; $280,800 to Mr. Benefield; and $268,000 each to Messrs. Yeager and Robinson. (The amount payable to Mr. Cash is not given since such amount is based on each officer's total salary.) The Company's executive officers would also receive certain supplemental retirement benefits, welfare benefits, and cash bonuses. Under the plan, a change in control is defined to include any change in control required to be reported under Item 6(e) of Schedule 14A of the Securities Exchange Act of 1934, as amended. A change in control is also deemed to occur once any person becomes the beneficial owner, directly or indirectly, of securities representing 20 percent or more of Questar's outstanding shares of common stock. Directors' Fees All directors receive an annual fee of $3,600 payable in 12 monthly installments and fees of $400 for each meeting of the Board of Directors that they attend. The Company has a Deferred Compensation Plan for Directors under which directors can elect to defer all or any portion of the fees received for service as directors until their retirement from such service and can choose to have the deferred amounts earn interest as if invested in long-term certificates of deposit or be accounted for with "phantom shares" of Questar's common stock. Upon retirement, the phantom shares of stock are "converted" to their fair market cash equivalent. During 1993, several directors of the Company chose to defer receipt of all or a portion of the compensation earned by them for their service. (Any shares of phantom stock credited to directors are not included in the number of shares listed opposite their names below.) ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Company is a direct, wholly owned subsidiary of Questar. The following table sets forth information, as of December 31, 1993, with respect to each person known or believed by Questar to be the beneficial owner of 5 percent or more of its common stock: Shares and Name and Nature of Address of Beneficial Percent Beneficial Owner Ownership of Class First Security Bank of Utah 4,169,225 10.38 N.A., 79 South Main Street Trustee for Salt Lake City, Utah 84111 Company Employee Benefit Plans and Bank 1 The Equitable Companies Incorporated 2,493,225 6.21 787 Seventh Avenue Parent Holding New York, New York 10019 Company for Insurance Company and Investment Advisor Subsidiaries 2 1/Of this total, First Security beneficially owns 4,077,906 shares in its role as trustee of employee benefit plans sponsored by Questar or a subsidiary of Questar. Participating employees control the voting of 4,071,927 shares. 2/In an initial Schedule 13G dated as of December 31, 1993, and filed on behalf of a group, The Equitable Companies Incorporated reported sole voting power for 2,337,325 shares, shared voting power for 117,700 shares and sole dispositive power for 2,493,225 shares. The following table sets forth information, as of March 1, 1994, concerning the shares of Questar's common stock beneficially owned by each of the Company's named executive officers and directors and by the Company's executive officers and directors as a group: 1/The Company's executive officers own shares through their participation in Questar's Employee Investment Plan. The number of shares owned through this plan as of December 31, 1993, is as follows for the named officers: Mr. Benefield, 3,722 shares; Mr. Cash, 26,318 shares; Mr. Robinson, 6,234 shares; Mr. Rose, 13,990 shares; and Mr. Yeager, 6,829 shares. 2/The Company's executive officers have been granted nonqualified stock options under Questar's Stock Option Plan and Long-Term Stock Incentive Plan. The number of shares listed opposite the named officers attributable to vested options as of March 1, 1994, is as follows: Mr. Cash, 16,873 shares; Mr. Rose, 12,700 shares; and Mr. Yeager, 4,500 shares. 3/The Company's executive officers acquired restricted shares of Questar's common stock in partial payment of bonuses earned in the 1993 bonus plans. The number of restricted shares beneficially owned by each of the named officers as of March 1, 1994, is as follows: Mr. Benefield, 845 shares; Mr. Cash, 4,279 shares; Mr. Robinson, 738 shares; Mr. Rose, 1,766 shares; and Mr. Yeager, 738 shares. 4/Unless otherwise listed, the percentage of shares owned is less than .1 percent. The percentages of beneficial ownership have been calculated in accordance with Rule 13d-3(d)(1) under the Securities Exchange Act of 1934, as amended. 5/Messrs. Bischoff, Hawkins, Kadlec, and Leavitt, as nonemployee voting directors of Questar, have been granted nonqualified stock options to purchase shares of Questar's common stock as follows: Mr. Bischoff, 5,200 shares; Mr. Hawkins, 3,500 shares; Mr. Kadlec, 12,650 shares; and Mr. Leavitt, 9,100 shares. These shares are included in the numbers listed opposite their respective names. 6/Mr. Cash is the Chairman of the Board of Trustees of the Questar Corporation Educational Foundation and the Questar Corporation Arts Foundation, two nonprofit corporations that own an aggregate of 39,282 shares of Questar's common stock. As the Chairman, Mr. Cash has voting control for such shares, but disclaims any beneficial ownership of them. 7/Of the total shares reported for Mr. Cash, 3,270 shares are owned jointly with his wife and 4,549 are controlled by him as custodian for his son. Messrs. Leavitt and Yeager own their shares of record with their respective wives. 8/The total number of shares reported for this group includes vested options to purchase 102,648 shares of Questar's common stock. Committee Interlocks and Insider Participation The Company itself has no formal "Compensation Committee." Questar's Board of Directors has a Management Performance Committee that makes recommendations to the Company's Board of Directors concerning base salary and bonus payments. (Questar's Board approves all stock options.) Messrs. Cash and Rose, as directors and officers of the Company, are formally excused from all discussions by the Company's Board involving their compensation. Mr. Kastler, a retired employee and officer, is a director of the Company and does participate in these discussions. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There are no relationships or transactions involving the Company's directors and executive officers. As described above, there are significant business relationships between the Company and its affiliates, particularly Wexpro and Questar Pipeline. Questar, the Company's parent, also provides certain administrative services, e.g., personnel, legal, public relations, financial, tax, and audit to the Company and other members of the consolidated group. The costs of performing such services are allocated to the Company. Questar Service, another affiliate, provides data processing and communication services for the Company; the charges for such services are based on cost of service plus a specified return on assets. See Note I to the financial statements for additional information concerning transactions between the Company and its affiliates. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) Financial Statements and Financial Statement Schedules. The financial statements and schedules identified in the List of Financial Statements and Financial Statement Schedules are filed as part of this report. (3) Exhibits. The following is a list of exhibits required to be filed as a part of this report in Item 14(c). Exhibit No. Exhibit 3.1.* Restated Consolidated Articles of Incorporation dated August 15, 1980. (Exhibit No. 4(a) to Registration Statement No. 2-70087, filed December 1, 1980.) 3.2.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1982. (Exhibit No. 3(b) to Form 10-K Annual Report for 1982.) 3.3.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 10, 1983. (Included in Exhibit No. 4.1. to Registration Statement No. 2-84713, filed June 23, 1983.) 3.4.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated August 16, 1983. (Exhibit No. 3(a) to Form 8 Report amending the Company's Form 10-Q Report for Quarter Ended September 30, 1983.) 3.5.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated October 26, 1984. (Exhibit No. 3.5. to Form 10-K Annual Report for 1984.) 3.6.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1985. (Exhibit No. 3.1. to Form 10-Q Report for Quarter Ended June 30, 1985.) 3.7.* Articles of Amendment to Restated Consolidated Articles of Incorporation dated February 10, 1988. (Exhibit No. 3.7. to Form 10-K Annual Report for 1987.) 3.8.* Bylaws (as amended effective August 11, 1992). (Exhibit No. 3.8. to Form 10-K Annual Report for 1992.) 4.* Indenture dated as of May 1, 1992, between the Company and Citibank, as trustee, for the Company's Debt Securities. (Exhibit No. 4. to Form 10-Q Report for Quarter Ended June 30, 1992.) 10.1.* Stipulations and Agreement, dated October 14, 1981, executed by Mountain Fuel Supply Company; Wexpro Company; the Utah Department of Business Regulations, Division of Public Utilities; the Utah Committee of Consumer Services; and the staff of the Public Service Commission of Wyoming. (Exhibit No. 10(a) to Form 10-K Annual Report for 1981.) 10.7.* Data Processing Services Agreement effective July 1, 1985, between Questar Service Corporation and Mountain Fuel Supply Company. (Exhibit 10.7. to Form 10-K Annual Report for 1988.) 10.8.*1 Mountain Fuel Supply Company Annual Management Incentive Plan as amended and restated effective February 11, 1992. (Exhibit No. 10.8. to Form 10-K Annual Report for 1991.) 10.9.*1 Mountain Fuel Supply Company Window Period Supplemental Executive Retirement Plan effective January 24, 1991. (Exhibit No. 10.9. to Form 10-K Annual Report for 1990.) 12. Statement of Ratio of Earnings to Fixed Charges. 24. Consent of Independent Auditors. 25. Power of Attorney. *Exhibits so marked have been filed with the Securities and Exchange Commission as part of the referenced filing and are incorporated herein by reference. 1 Exhibits so marked are management contracts or compensation plans or arrangements. (b) Mountain Fuel did not file any Current Reports on Form 8- K during the last quarter of 1993. ANNUAL REPORT ON FORM 10-K ITEM 8. ITEM 14 (a) (1) and (2), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 MOUNTAIN FUEL SUPPLY COMPANY SALT LAKE CITY, UTAH FORM 10-K--ITEM 14 (a) (1) and (2) MOUNTAIN FUEL SUPPLY COMPANY LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following financial statements of Mountain Fuel Supply Company are included in Item 8: Statements of income -- Years ended December 31, 1993, 1992 and 1991 Balance sheets -- December 31, 1993 and 1992 Statements of common shareholder's equity -- Years ended December 31, 1993, 1992 and 1991 Statements of cash flows -- Years ended December 31, 1993, 1992 and 1991 Notes to financial statements The following financial statement schedules of Mountain Fuel Supply Company are included in Item 14(d): Schedule II -- Amounts receivable from related parties and underwriters, promoters, and employees other than related parties Schedule V -- Property, plant and equipment Schedule VI -- Accumulated depreciation, depletion and amortization of property, plant and equipment Schedule X -- Supplementary income statement information 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. Report of Independent Auditors Board of Directors Mountain Fuel Supply Company We have audited the accompanying balance sheets of Mountain Fuel Supply Company as of December 31, 1993 and 1992, and the related statements of income, common shareholder'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 financial statements referred to above present fairly, in all material respects, the financial position of Mountain Fuel Supply 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. As discussed in Note H to the financial statements, in 1993 Mountain Fuel Supply changed its method of accounting for postretirement benefits other than pensions. ERNST & YOUNG Salt Lake City, Utah February 11, 1993 MOUNTAIN FUEL SUPPLY COMPANY STATEMENTS OF INCOME See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY BALANCE SHEETS ASSETS See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY STATEMENTS OF COMMON SHAREHOLDER'S EQUITY See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY STATEMENTS OF CASH FLOWS See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY NOTES TO FINANCIAL STATEMENTS Note A - Summary of Accounting Policies Mountain Fuel Supply Company (the Company or Mountain Fuel) is a wholly-owned subsidiary of Questar Corporation (Questar). Business and Regulation: The Company's business consists of natural gas distribution operations for industrial, residential and commercial customers. Mountain Fuel is regulated by the Public Service Commission of Utah (PSCU) and the Public Service Commission of Wyoming (PSCW). These regulatory agencies establish rates for the sale and transportation of natural gas. The regulatory agencies also regulate, among other things, the extension and enlargement or abandonment of jurisdictional natural gas facilities. Regulation is intended to permit the recovery, through rates, of the cost of service including, a rate of return on investment. The financial statements are presented in accordance with regulatory requirements. Methods of allocating costs to time periods, in order to match revenues and expenses, may differ from those of nonregulated businesses because of cost allocation methods used in establishing rates. Purchased-Gas Adjustments: The Company accounts for purchased-gas costs in accordance with procedures authorized by the PSCU and PSCW whereby purchased-gas costs that are different from those provided for in the present rates are accumulated and recovered or credited through future rate changes. Credit Risk: The Company's primary market area is the Rocky Mountain region of the United States. The Company's exposure to credit risk may be impacted by the concentration of customers in this region due to changes in economic or other conditions. The Company's customers include individuals and numerous industries that may be impacted differently by changing conditions. The Company believes that it has adequately reserved for potential credit-related losses. Property, Plant and Equipment: Property, plant and equipment are stated at cost. The provision for depreciation and amortization is based upon rates which will amortize costs of assets over their estimated useful lives. The costs of natural gas distribution property, plant and equipment, excluding gas wells, are amortized using the straight-line method. The costs of gas wells were amortized using the unit-of-production method at $.18 per Mcf of natural gas production during 1993. Historically, the Company used the successful efforts method to account for costs incurred for exploration and development of gas reserves; however, the Company has not incurred any such costs during the last three years. Income Taxes: On January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109. The deferred tax balance at December 31, 1993, represents the temporary differences between book and taxable income multiplied by the effective tax rates. These temporary differences relate primarily to depreciation, unbilled revenues and purchased-gas adjustments. The Company uses the deferral method to account for investment tax credits as required by regulatory commissions. See Note F. Reacquisition of Debt: Gains and losses on the reacquisition of debt are deferred and amortized as debt expense over the life of the replacement debt in order to match regulatory treatment. Allowance for Funds Used During Construction: The Company capitalizes the cost of capital during the construction period of plant and equipment using a method required by regulatory authorities. This amounted to $528,000 in 1993, $588,000 in 1992 and $527,000 in 1991. Note B - Cash and Short-Term Investments Short-term investments at December 31, 1993 and 1992, valued at cost (approximates market), amounted to $1,379,000 and $4,336,000, respectively. Short-term investments consisted of Euro-time deposits and repurchase agreements with maturities of three months or less. Note C - Debt The Company has a short-term line-of-credit arrangement with a bank under which it may borrow up to $500,000, below the prime interest rate. The arrangements are renewable on an annual basis. At December 31, 1993, no amounts were borrowed under this arrangement. Questar loans funds to the Company under a short-term borrowing arrangement. Outstanding short-term notes payable to Questar totaled $57,800,000 and had an interest rate of 3.59% at December 31, 1993. The details of long-term debt at December 31, were as follows: During 1993, Mountain Fuel issued $91,000,000 of 15-year and 30-year medium-term notes at interest rates of 7.19% to 8.28%. Proceeds from these notes and $16,000,000 remaining from the 1992 issuances were used to redeem Mountain Fuel's $100,000,000 9 3/8% debentures and pay the associated refinancing costs. At December 31, 1993, Mountain Fuel had a registration statement filed with the Securities and Exchange Commission to issue an additional $17,000,000 of medium-term notes. There are no maturities of long-term debt for the five years following December 31, 1993 nor long-term debt provisions restricting the payment of dividends. Cash paid for interest was $14,698,000 in 1993, $15,970,000 in 1992 and $14,969,000 in 1991. Note D - Redeemable Cumulative Preferred Stock The Company has authorized 4,000,000 shares of nonvoting redeemable cumulative preferred stock with no par value. The two current outstanding issues of stock have a stated and redemption value of $100 per share. Redemption requirements for the five years following December 31, 1993, are as follows: Note E - Estimated Fair Values of Financial Instruments The carrying amounts and estimated fair values of the Company's financial instruments were as follows: The Company used the following methods and assumptions in estimating fair values: (1) Cash and short-term investments - the carrying amount approximates fair value; (2) Short-term loans - the carrying amount approximates fair value; (3) Long-term debt - the fair value of the medium-term notes is based on the discounted present value of cash flows using the Company's current borrowing rates; (4) Redeemable cumulative preferred stock - the fair value is based on the discounted present value of cash flows using current preferred stock rates. Note F - Income Taxes The Company's operations are consolidated with those of Questar and its subsidiaries for income tax purposes. The income tax arrangement between the Company and Questar provides that amounts paid to or received from Questar are substantially the same as would be paid or received by the Company if it filed a separate return except that the Company is paid for tax benefits used in the consolidated tax return even if such benefits would not have been usable had the Company filed a separate return. 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. The Company did not restate prior years' financial statements. The application of the new rules did not have a significant impact on the 1992 net income. The Company records cumulative increases in deferred taxes as income taxes recoverable from customers. The Company has adopted procedures with its regulatory commissions to include under-provided deferred taxes in customer rates on a systematic basis. The amount of income taxes recoverable from customers was higher in 1993 due to an increase in the federal income tax rate. The components of income taxes were as follows: The difference between income tax expense and the tax computed by applying the statutory federal income tax rate to income before income taxes is explained as follows: Significant components of the Company's deferred tax liabilities and assets were as follows: The Company recorded a deferred tax asset of $4,035,000 for alternative minimum tax paid and production credits recognized but not yet realized on the tax return. The Company expects to realize this deferred tax asset within the next several years. Cash paid for income taxes was $8,631,000 in 1993, $6,805,000 in 1992 and $18,072,000 in 1991. Note G - Rate Matters, Litigation and Commitments On September 1, 1993, Questar Pipeline began operating in compliance with Federal Energy Regulatory Commission (FERC) Order No. 636. The order unbundled the sale-for-resale service from the transportation, gathering and storage services provided by natural gas pipelines. Questar Pipeline eliminated its merchant function. That activity was assumed by Mountain Fuel along with the gas-purchase contracts. In its order approving Questar Pipeline's Order No. 636 implementation plan, the FERC accepted Questar Pipeline's plan for the assignment of gas-purchase contracts to Mountain Fuel. Mountain Fuel filed a general rate case for its Utah operations in April 1993. The revised amount of deficiency requested in the case was $10.3 million, including a 12.1% return on equity. In January 1994, the PSCU issued a rate order granting Mountain Fuel a $1.6 million decrease in general rates and a $2.1 million increase in costs allowed through the purchase-gas adjustment account for a net increase in rates of $500,000. The PSCU allowed a return on equity of 11%, required Mountain Fuel to reduce rates over a five-year period for unbilled revenues, and disallowed rate coverage for certain incentive compensation and advertising costs. Mountain Fuel requested a rehearing of the PSCU order for the allowed return on equity and the treatment of unbilled revenues and the PSCU granted a rehearing on these issues. In 1993, Mountain Fuel began accruing gas distribution revenues for gas delivered to residential and commercial customers but not billed at the end of the year. The impact of these accruals on the income statement has been deferred in accordance with a rate order received from the PSCU. This rate order reduces customer rates by $2,011,000 per year over the five-year period from 1994 through 1998. Mountain Fuel will recognize the unbilled revenues and the associated gas costs over this same five-year period to offset the reduction in rates. In July 1993, the PSCW issued an order in Mountain Fuel's general rate case for Wyoming operations. The order approved a stipulation that had been negotiated by the Company and the PSCW's staff which allowed for an increase in general rates of $721,000 including recovery of costs attributable to FERC Order No. 636 and higher federal income tax rates. Many of Mountain Fuel's gas-purchase contracts include take-or-pay provisions that obligate it, on an annual basis, to take delivery of at least a specified percentage of volumes producible from wells or pay for such volumes. The contracts allow for the subsequent delivery of the gas within a specified period. Other gas-purchase contracts include provisions that obligate Mountain Fuel to schedule a specific volume for delivery on a daily or monthly basis. All gas-purchase contracts were transferred from Questar Pipeline to Mountain Fuel in 1993. Purchases of natural gas under gas-purchase contracts subsequent to the transfer of contracts from Questar Pipeline in September 1993 totalled $38,529,000. Following is a summary of projected purchase commitments under gas-purchase contracts with terms of one year or more. Prices under these contracts are based on the current market price. These commitments will change as a result of future negotiations with sellers. The Company has received notice that it may be partially liable in several environmental clean-up actions on sites that involve numerous other parties. Management believes that the Company's responsibility for remediation will be minor and that any potential liability will not be significant to the results of operations or its financial position. Mountain Fuel is responsible for a judgment in a lawsuit involving the Company, Questar Pipeline and a gas producer. In March 1994, a jury awarded the gas producer damages of approximately $6.3 million on claims involving take-or-pay, tax reimbursement and breach of contract. Mountain Fuel expects that substantially all of the judgment will be included in its gas balancing account and recovered through customer rates. The judgment is not expected to have a significant impact on the Company's results of operations, financial position or liquidity. There are various legal proceedings against the Company. While it is not currently possible to predict or determine the outcome of these proceedings, it is the opinion of management that the outcome will not have a material adverse effect on the Company's results of operations, financial position or liquidity. Note H - Employee Benefits Substantially all Company employees are covered by Questar's defined benefit pension plan. Benefits are generally based on years of service and the employee's 36-month period of highest earnings during the ten years preceding retirement. It is Questar's policy to make contributions to the plan at least sufficient to meet the minimum funding requirements of applicable laws and regulations. Plan assets consist principally of equity securities and corporate and U.S. government debt obligations. Pension cost was $3,251,000 in 1993, $2,991,000 in 1992 and $2,835,000 in 1991. The Company's portion of plan assets and benefit obligations is not determinable because the plan assets are not segregated or restricted to meet the Company's pension obligations. If the Company were to withdraw from the pension plan, the pension obligation for the Company's employees would be retained by the pension plan. At December 31, 1993, Questar's fair value of plan assets exceeded the accumulated benefit obligation. The Company participates in Questar's Employee Investment Plan, which allows the majority of employees to purchase Questar stock or other investments with payroll deductions. The Company makes contributions to the plan of approximately 75% of the employee's purchases. The Company's expense and contribution to the plan was $1,167,000 in 1993, $1,194,000 in 1992 and $1,405,000 in 1991. The Company participates in a Questar program that pays a portion of the health-care costs and all the life insurance costs for retired employees. Effective January 1, 1992, this program was changed for employees retiring after January 1, 1993, to link the health-care benefit to years of service and to limit the Company's monthly health-care contribution per individual to 170% of the 1992 contribution. Questar's policy is to fund amounts allowable for tax deduction under the Internal Revenue Code. Plan assets consist of equity securities, corporate and U.S. government debt obligation, and insurance company general accounts. The Company adopted the provisions of SFAS No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. Questar is amortizing the transition obligation over a 20-year period. Total cost of postretirement benefits other than pensions under SFAS No. 106 was $3,350,000 in 1993 compared with the costs based on cash payments to retirees totaling $876,000 in 1992 and $464,000 in 1991. The impact of SFAS No. 106 on the Company's future net income will be mitigated by recovery of these costs from customers. Both the PSCU and the PSCW allowed Mountain Fuel to recover future SFAS No. 106 costs in the 1993 rate cases if the amounts are funded in an external trust. The Company's portion of plan assets and benefit obligations related to postretirement medical and life insurance benefits is not determinable because the plan assets are not segregated or restricted to meet the Company's obligations. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $1,538,000. The Company may offset this amount with a regulatory asset depending on expected regulatory treatment and recovery of costs from customers. The effect on ongoing net income is not expected to be significant. Note I - Related Party Transactions The Company receives a portion of Wexpro's income from oil operations after recovery of Wexpro's operating expenses and a return on investment. This amount, which is included in revenues, was $1,028,000 in 1993, $3,389,000 in 1992 and $4,190,000 in 1991. The Company paid Wexpro for the operation of Company-owned gas properties. These costs are included in natural gas purchases and amounted to $49,595,000 in 1993, $43,324,000 in 1992 and $33,783,000 in 1991. The Company purchased gas from Questar Pipeline amounting to $81,813,000 in 1993, $135,779,000 in 1992 and $174,359,000 in 1991. The Company did not purchase gas from Questar Pipeline subsequent to September 1, 1993 when Questar Pipeline began operating in accordance with FERC Order No. 636. Also included in natural gas purchases are amounts paid to Questar Pipeline for the transportation and gathering of Company-owned gas and purchased gas. These costs were $38,862,000 in 1993, $31,808,000 in 1992 and $18,389,000 in 1991. The Company paid $4,131,000 to Questar Pipeline for storage services subsequent to the implementation of FERC Order No. 636. Mountain Fuel has reserved transportation capacity on Questar Pipeline's system of approximately 800,000 decatherms per day and pays an annual demand charge of approximately $49 million for this reservation. Mountain Fuel releases excess capacity to its industrial transportation or other customers and receives a credit from Questar Pipeline for the released-capacity revenues and a portion of Questar Pipeline's interruptible-transportation revenues. Questar Service Corporation is an affiliated company that provides data processing and communication services to Mountain Fuel. The Company paid Questar Service $14,847,000 in 1993, $12,437,000 in 1992 and $11,530,000 in 1991. Questar charges the Company for certain administrative functions amounting to $5,609,000 in 1993, $5,517,000 in 1992 and $5,597,000 in 1991. These costs are included in operating and maintenance expenses and are allocated based on each affiliated company's proportional share of revenues; property, plant and equipment; and labor costs. Management believes that the allocation method is reasonable. Note J - Oil and Gas Producing Activities (Unaudited) The following information discusses the Company's oil and gas producing activities. All of the properties are cost-of-service properties with the return on investment established by state regulatory agencies. The Company has not incurred any costs for oil and gas producing activities for the three years ended December 31, 1993. Wexpro develops and produces gas reserves owned by the Company. See Note I for the amounts paid by the Company to Wexpro. Estimated Quantities of Proved Oil and Gas Reserves: The following estimates were made by Questar's reservoir engineers. Reserve estimates are based on a complex and highly interpretive process which is subject to continuous revision as additional production and development drilling information becomes available. The quantities are based on existing economic and operating conditions using current prices and operating costs. All oil and gas reserves reported are located in the United States. The Company does not have any long-term supply contracts with foreign governments or reserves of equity investees. No estimates are available for proved undeveloped reserves that may exist. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES MOUNTAIN FUEL SUPPLY COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT MOUNTAIN FUEL SUPPLY COMPANY NOTE A - Other changes consist of transfers to or from affiliated companies. NOTE B - The annual provisions for depreciation have been computed using the straight-line method at 3% to 33 1/3% per year (average of 3.9% in 1993). SCHEDULE V I- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT MOUNTAIN FUEL SUPPLY COMPANY NOTE A - Other changes consist of transfers to or from affiliated companies. NOTE B - The annual provisions for depreciation have been computed using the straight-line method at 3% to 33 1\3% per year (average of 3.8% in 1993). SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION MOUNTAIN FUEL SUPPLY COMPANY The Company has no depreciation and amortization of intangibles assets. Amounts for advertising costs are 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, on the 28th day of March, 1994. MOUNTAIN FUEL SUPPLY COMPANY (Registrant) By /s/ D. N. Rose D. N. Rose 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. /s/ D. N. Rose President and Chief Executive D. N. Rose Officer; Director (Principal Executive Officer) /s/ W. F. Edwards Vice President and Chief Financial W. F. Edwards Officer (Principal Financial Officer) /s/ G. H. Robinson Vice President and Controller G. H. Robinson (Principal Accounting Officer) *Robert H. Bischoff Director *R. D. Cash Chairman of the Board *W. Whitley Hawkins Director *Robert E. Kadlec Director *B. Z. Kastler Director *Dixie L. Leavitt Director *Gary G. Michael Director *D. N. Rose Director *Roy W. Simmons Director March 28, 1994 *By /s/ D. N. Rose Date D. N. Rose, Attorney in Fact EXHIBIT INDEX Sequential Exhibit Page Number Number Exhibit 3.1.* Restated Consolidated Articles of Incorporation dated August 15, 1980. (Exhibit No. 4(a) to Registration Statement No. 2-70087, filed December 1, 1980.) 3.2.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1982. (Exhibit No. 3(b) to Form 10-K Annual Report for 1982.) 3.3.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 10, 1983. (Included in Exhibit No. 4.1. to Registration Statement No. 2- 84713, filed June 23, 1983.) 3.4.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated August 16, 1983. (Exhibit No. 3(a) to Form 8 Report amending the Company's Form 10-Q Report for Quarter Ended September 30, 1983.) 3.5.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated October 26, 1984. (Exhibit No. 3.5. to Form 10-K Annual Report for 1984.) 3.6.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1985. (Exhibit No. 3.1. to Form 10-Q Report for Quarter Ended June 30, 1985.) 3.7.* Articles of Amendment to Restated Consolidated Articles of Incorporation dated February 10, 1988. (Exhibit No. 3.7. to Form 10-K Annual Report for 1987.) 3.8.* Bylaws (as amended effective August 11, 1992). (Exhibit No. 3.8. to Form 10-K Annual Report for 1992.) 4.* Indenture dated as of May 1, 1992, between the Company and Citibank, as trustee, for the Company's Debt Securities. (Exhibit No. 4. to Form 10-Q Report for Quarter Ended June 30, 1992.) 10.1.* Stipulations and Agreement, dated October 14, 1981, executed by Mountain Fuel Supply Company; Wexpro Company; the Utah Department of Business Regulations, Division of Public Utilities; the Utah Committee of Consumer Services; and the staff of the Public Service Commission of Wyoming. (Exhibit No. 10(a) to Form 10-K Annual Report for 1981.) 10.7.* Data Processing Services Agreement effective July 1, 1985, between Questar Service Corporation and Mountain Fuel Supply Company. (Exhibit 10.7. to Form 10-K Annual Report for 1988.) 10.8.* 1 Mountain Fuel Supply Company Annual Management Incentive Plan as amended and restated effective February 11, 1992. (Exhibit No. 10.8. to Form 10-K Annual Report for 1991.) 10.9.* 1 Mountain Fuel Supply Company Window Period Supplemental Executive Retirement Plan effective January 24, 1991. (Exhibit No. 10.9. to Form 10-K Annual Report for 1990.) 12. Statement of Ratio of Earnings to Fixed Charges. 24. Consent of Independent Auditors. 25. Power of Attorney. * Exhibits so marked have been filed with the Securities and Exchange Commission as part of the referenced filing and are incorporated herein by reference. 1 Exhibits so marked are management contracts or compensation plans or arrangements.

723371_1993.txt

723371_1993

1993

723371

ITEM 1 - -BUSINESS General and Operating Segments Hartmarx Corporation functions essentially as a holding company, overseeing its various operating companies and providing them with resources and services in the financial, administrative, legal, human resources, advertising, and other areas. The operating subsidiaries are separate profit centers. Their respective managements have responsibility for optimum use of the capital invested in them and for planning their growth and development in coordination with the strategic plans of Hartmarx and the other operating entities (collectively, the "Company"). Established in 1872, the Company is the largest manufacturer and marketer of men's suits, sportcoats and slacks ("men's tailored clothing") in the United States. From this established position, Hartmarx has diversified into men's sportswear and women's career apparel and sportswear. Substantially all of the Company's products are sold to a wide variety of retail channels under established brand names or the private labels of major retailers. The Company owns two of the most recognized brands in men's tailored clothing--Hart Schaffner & Marx(R), which was introduced in 1887, and Hickey- Freeman(R), which dates from 1899. The Company also offers its products under other brands which it owns such as Sansabelt(R), Kuppenheimer(R), Racquet Club(R) and Barrie Pace(R) and under license agreements for specified product lines including Tommy Hilfiger(R), Jack Nicklaus(R), Bobby Jones(R), Austin Reed(R), Gieves & Hawkes(R), KM by Krizia(TM), MM by Krizia(TM), Henry Grethel(R), Karl Lagerfeld(R), Nino Cerruti(R), Pierre Cardin(R) and Fumagalli's(R). To broaden the distribution of the apparel sold under its owned and licensed trademarks, the Company has also entered into over 35 license or sublicense agreements with third parties for specified product lines to produce, market and distribute products in 14 countries outside the United States. Additionally, the Company has commenced direct marketing in Europe and Asia, selling golf wear in these markets through distributors in 17 countries. In 1992, the Company implemented a comprehensive operational and financial restructuring (the "Restructuring") to refocus its business operations around its profitable core wholesale men's apparel franchise and to restructure its balance sheet. The operational aspects of the Restructuring included the sale of Hartmarx Specialty Stores, Inc. ("HSSI"), the Company's principal retail unit; the discontinuance of its Country Miss retail and manufacturing operations; the closing of certain Kuppenheimer retail stores not achieving minimum profitability requirements; the reduction of production capacity which was no longer required to support reduced retail operations; and the sale or closing of non-strategic manufacturing businesses which manufactured outerwear and military and commercial uniforms. The total sales for fiscal 1992 for all of the businesses and operations sold or discontinued in conjunction with the Restructuring was approximately $365 million. The Company's financial statements for fiscal 1992 include restructuring charges of $191 million. As part of the Restructuring, the Company's borrowing facilities were consolidated and extended in maturity, a $35 million seasonal borrowing facility was added and shares of its common stock and a warrant to purchase its common stock were sold for $30 million. The Company's operations can be categorized within two operating segments-- wholesale and direct-to-consumer. The wholesale segment comprises the Men's Apparel Group ("MAG") and International Women's Apparel ("IWA") businesses; the direct-to-consumer segment consists principally of the Kuppenheimer and Barrie Pace Ltd. ("Barrie Pace") businesses. The Operating Segment Information on pages 34 and 35 of this Form 10-K further describes the Company's wholesale and direct-to-consumer operations. Products Produced and Services Rendered The Company's merchandising strategy is to market a wide selection of men's tailored clothing and sportswear and women's career apparel and sportswear across a wide variety of fashion directions, price points and distribution channels. In 1993, the Company's business units that primarily manufacture men's tailored clothing represented approximately 66% of the Company's sales. Those business units that primarily manufacture men's sportswear and slacks represented approximately 27% of consolidated sales and women's apparel represented approximately 7% of consolidated sales. As a vertically integrated manufacturer and marketer, the Company is responsible for the designing, manufacturing and sourcing of its apparel. Substantially all of its men's tailored clothing is manufactured in its own factories, all of which are located in the United States. The Company utilizes domestic and foreign contract manufacturers to produce its remaining products, principally men's and women's sportswear, in accordance with Company specifications and production schedules. The Company's largest operating group, MAG, designs, manufactures and markets on a wholesale basis substantially all of the Company's men's tailored clothing through its Hart Schaffner & Marx ("HSM"), Hickey-Freeman and Intercontinental Branded Apparel business units. Slacks and sportswear are manufactured and marketed principally through the Trans-Apparel Group, Biltwell and Bobby Jones business units. Kuppenheimer is the Company's vertically integrated, factory- direct-to-consumer business. Kuppenheimer manufactures substantially all of its tailored clothing in Company-owned facilities and sells these products exclusively through Kuppenheimer operated stores. Kuppenheimer also offers men's furnishings and sportswear purchased from other manufacturers. The Women's Apparel Group is comprised of Barrie Pace, a direct mail company that offers a wide range of apparel and accessories to the business and professional woman, and IWA, which designs and sources women's career apparel and sportswear for sale to department and specialty stores under owned and licensed brand names. The Barrie Pace women's catalog features branded products, purchased from both affiliated and unaffiliated sources. At January 31, 1994, the Company operated 132 direct-to-consumer stores in the United States selling apparel primarily manufactured by the Company, as well as products purchased from unaffiliated sources. The shipment of products manufactured by the Company to its owned stores is excluded from consolidated sales. Kuppenheimer's 115 stores reflect the closing of 54 poor performing stores related to the Restructuring. Seventeen Sansabelt shops are operated by the Trans-Apparel Group, primarily carrying merchandise it manufactures. Sources and Availability of Raw Materials Raw materials, which include fabric, linings, thread, buttons and labels, are obtained from domestic and foreign sources based on quality, pricing, fashion trends and availability. The Company's principal raw material is fabric, including woolens, cottons, polyester and blends of wool and polyester. The Company procures and purchases its raw materials directly for its owned manufacturing facilities and may also procure and retain ownership of fabric relating to garments cut and assembled by contract manufacturers. In other circumstances, fabric is procured by the contract manufacturer directly but in accordance with the Company's specifications. For certain of its product offerings, the Company and selected fabric suppliers jointly develop fabric for the Company's exclusive use. Approximately 25% of the raw materials purchased by the Company is imported from foreign mills. A substantial portion of these purchases is denominated in United States dollars. Purchases from Burlington Industries, Inc., the Company's largest fabric supplier, accounted for 48% of the Company's total fabric requirements in fiscal 1993. No other supplier accounts for over 6% of the Company's total raw material requirements. As is customary in its industry, the Company has no long-term contracts with its suppliers. The Company believes that a variety of alternative sources of supply are available to satisfy its raw material requirements. Product lines are developed primarily for two major selling seasons, spring and fall, with smaller lines for the holiday season. The majority of the Company's products are purchased by its customers on an advance order basis, five to seven months prior to shipment. Seasonal commitments for a portion of the expected requirements are made approximately three to five months in advance of the customer order. Certain of the Company's businesses maintain in- stock inventory programs on selected product styles giving customers the capability to order electronically with resulting shipment within 24 to 48 hours. Programs with selected fabric suppliers provide for availability to support in-stock marketing programs. The normal production process from fabric cutting to finished production is five to six weeks for tailored suits and sportcoats and three to four weeks for tailored slacks. A substantial portion of sportswear and women's apparel is produced from Company designs utilizing unaffiliated contractors. Competition and Customers The Company emphasizes quality, fashion, brand awareness and service in engaging in this highly competitive business. While no manufacturer of men's clothing accounts for more than a small percentage of the total amount of apparel produced by the entire industry in the United States, the Company believes it is the largest domestic manufacturer and marketer of men's tailored clothing as well as men's slacks with expected retail prices over $50. However, its retail sales of apparel directly to the end consumer do not represent a significant percentage of total retail apparel sales. The Company's customers include major United States department and specialty stores (certain of which are under common ownership and control), mass merchandisers, value-oriented retailers and direct mail companies. The Company's largest customer, Dillard Department Stores, represented approximately 12% of 1993 consolidated sales. No other customer exceeded 7% of net sales. Research and Patents In the apparel industry, new product development is directed primarily towards new fashion and design changes and does not require significant expenditures for research. The Company's fixed assets include expenditures for new equipment developed by others. The Company does not spend material amounts on research activities relating to the development of new equipment. Conditions Affecting the Environment Regulations relating to the protection of the environment have not had a significant effect on capital expenditures, earnings or the competitive position of the Company. The making of apparel is not energy intensive and the Company is not engaged in producing fibers or fabrics. Employees The Company presently has approximately 11,200 employees, of whom approximately 85% are employed in manufacturing-wholesale and 15% in the direct-to-consumer businesses. Most of the men's apparel employees engaged in manufacturing and distribution activities are covered by union contracts with the Amalgamated Clothing and Textile Workers Union; a small number of the women's apparel and direct-to-consumer employees are covered by other union contracts. The Company considers its employee relations to be satisfactory. Seasonality The men's tailored clothing business has two principal selling seasons, spring and fall. Additional lines for the summer and holiday seasons are marketed in men's and women's sportswear. Men's tailored clothing, especially at higher price points, generally tends to be less sensitive to frequent shifts in fashion trends, economic conditions and weather, as compared to men's sportswear or women's career apparel and sportswear. While there is typically little seasonality to the Company's sales on a quarterly basis, seasonality can be affected by a variety of factors, including the mix of advance and fill-in orders, the distribution of sales across retail trade channels and overall product mix between traditional and fashion merchandise. The Company generally receives orders from its wholesale customers approximately five to seven months prior to shipment. Some of the Company's operating groups also routinely maintain in-stock positions of selected inventory in order to fulfill customer orders on a quick response basis. A summary of the order and delivery cycle for the Company's two primary selling seasons is illustrated below: The Company's borrowing needs are typically lowest in July and January. Financing requirements begin to rise as inventory levels increase in anticipation of the spring and fall advance order shipping periods. Borrowings reach their highest levels in April and October, just prior to the collection of receivables from men's tailored clothing advance order shipments. Sales and receivables are recorded when inventory is shipped, with payment terms generally 30 to 60 days from the date of shipment. With respect to the tailored clothing advance order shipments, customary industry trade terms are 60 days from the seasonal billing dates of February 15 and August 15. ITEM 2 ITEM 2 - -PROPERTIES The Company's principal executive and administrative offices are located in Chicago, Illinois. Its principal office, manufacturing and distribution operations are conducted at the following locations: - -------- *Properties owned by the Registrant The Company believes that its properties are well maintained and its manufacturing equipment is in good operating condition and sufficient for current production. Substantially all of the Company's retail stores occupy leased premises. For information regarding the terms of the leases and rental payments thereunder, refer to the "Leases" note to the consolidated financial statements on pages 28 and 29 of this Form 10-K. ITEM 3 ITEM 3 - -LEGAL PROCEEDINGS Dior Proceedings. In 1989, HSM and Christian Dior-New York, Inc. ("Dior") were adverse parties in various lawsuits filed in the Circuit Court of Cook County, Illinois, (the "Circuit Court") arising out of a Trademark License Agreement under which HSM manufactured and sold apparel products bearing Dior's trademark(s). These lawsuits were eventually settled and dismissed; however, the settlement agreement among the parties has been the subject of an unfavorable award against HSM in a subsequent arbitration proceeding and lawsuit which is currently being appealed. In addition, HSM has initiated a separate arbitration proceeding against Dior. It is the opinion of management that neither matter will have a material effect on the Company's business or financial condition. Spillyards Litigation. In September 1992, David Spillyards, represented to be the holder of approximately 1,800 shares of common stock of the Company, filed a class action complaint in the Circuit Court of Cook County, Illinois, against the Company, its directors and former director Harvey A. Weinberg. The complaint claimed that the Company's directors breached certain duties owed to the Company's shareholders and sought certification as a class action, the appointment of Mr. Spillyards' counsel as class counsel and related damages. The complaint, which also included a derivative action, alleged that the purpose of the sale of the Company's principal retail unit, HSSI, to HSSA Group, Ltd. ("HSSA"), was to benefit Mr. Weinberg (who was also alleged to have been a director of the Company at the time of the announcement of the sale). The complaint was subsequently amended to include additional allegations pertaining to the ultimate sale of 5,714,286 shares of common stock of the Company and a three-year warrant for 1,649,600 shares of common stock of the Company to Traco (the "Traco Agreement"). The complaint, as amended, was dismissed on November 30, 1992 and Mr. Spillyards was given permission by the Court to file another amended complaint, which was filed on December 28, 1992 (the "Second Amended Complaint"). The Second Amended Complaint, denominated as a class action and derivative complaint, again challenged certain aspects of the Traco Agreement and alleged that the Company made certain misleading representations in its July 17, 1991 prospectus. After the Company's motion to dismiss the Second Amended Complaint was granted on June 24, 1993, Mr. Spillyards filed a Third Amended Complaint (purportedly asserting new issues regarding the Traco Agreement), which was again dismissed on September 29, 1993. Mr. Spillyards filed notice of appeals with the Illinois Appellate Court on October 29, 1993 and December 23, 1993. The appeals were consolidated by court order on February 8, 1994. HSSI Matters. On September 18, 1992, the Company sold the common stock of HSSI (the "HSSI Stock") to HSSA, for a promissory note in the principal amount of $43 million due September 18, 1994 (the "HSSA Note"), which was subject to adjustment based on inventories to be taken after the closing and was subsequently adjusted to $35 million. Pursuant to a Stock Pledge Agreement (the "Pledge Agreement"), the HSSA Note was secured by a pledge of the HSSI Stock and HSSI also guaranteed the obligations of HSSA under the HSSA Note. The Company believes that HSSA is 100% owned by the three sons of the sole shareholders of Maurice L. Rothschild & Co. ("MLR") and at least one of the shareholders of HSSA is also a director of MLR. On November 23, 1993, after the Company determined that certain obligations under the HSSA Note and related documents had been breached, the Company exercised certain of its rights under the Pledge Agreement to, among other things, cause the HSSI Stock to be voted to elect a new Board of Directors. On November 23, 1993 and December 2, 1993, HSSI filed complaints against MLR in the Circuit Court, seeking (i) to enjoin MLR from foreclosing under an inventory credit agreement between HSSI and MLR pursuant to which MLR provided credit support to HSSI, (ii) over $4 million in compensatory damages and (iii) $30 million in punitive damages for, among other things, breach of contract and conversion. On January 28, 1994, both of these actions were removed by MLR to federal court to be administered in the HSSI Chapter 11 case. On November 29, 1993, HSSA filed a complaint for declaratory and preliminary and permanent injunctive relief against the Company in the Circuit Court, seeking an order declaring, among other things, that HSSA is and remains the owner of HSSI. The complaint alleges that the Company improperly and wrongfully seized ownership of HSSI. HSSA's request for a temporary restraining order in this regard was denied and the case remains before the Circuit Court. On January 24, 1994, HSSA was granted leave, subject to pending objections, to file an amended complaint. The amended complaint seeks actual damages in an unspecified amount and punitive damages of at least $10 million for, among other things, breach of contract, tortious interference with contract and conversion. The Circuit Court has reserved ruling on the propriety of the filing of the amended complaint. Primarily, these theories of liability are based on claims that the Company unilaterally and wrongfully took the HSSI Stock in the absence of an event of default and in the absence of any notice to HSSA and failed to dispose of the HSSI Stock in a commercially reasonable manner, all in breach of the Company's obligations under the HSSA Note, the Stock Purchase Agreement, the Pledge Agreement and Part 5 of Article 9 of the Illinois Commercial Code. On December 3, 1993, HSM and certain other subsidiaries of the Company filed a complaint against MLR in the Circuit Court seeking damages for goods sold pursuant to orders of MLR for shipment to HSSI and other retailers to which MLR provides credit support. On December 21, 1993, HSSI and 25 affiliates filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division (the "Bankruptcy Court"). On January 19, 1994, the Company filed a complaint against the directors of HSSA in the Circuit Court seeking damages for wrongfully causing HSSI to make distributions, returns of capital and compensation and other payments to principals of HSSA in violation of the HSSA Note. On January 24, 1994, HSSI filed a complaint in the Bankruptcy Court against MLR which included many of the claims asserted in the Circuit Court case described above and which additionally seeks (i) to equitably subordinate the claim asserted by MLR in HSSI's bankruptcy case and (ii) monetary damages from the former directors of HSSI and related parties for breach of fiduciary duty. Also on January 24, 1994, MLR filed a complaint (which was amended on February 4, 1994) against the Company and six subsidiaries, among others, in the Circuit Court seeking actual damages of $19 million and punitive damages of over $100 million for tortious interference with contract and interference with prospective economic advantage. These theories of liability are based, in part, on claims that no default existed under the HSSA Note and that the subsequent sale of the HSSI Stock was improper because the Company did not give notice of the time or location of the sale of the HSSI Stock. MLR further alleges that counsel for the Company conceded in the hearing on HSSA's unsuccessful attempt to obtain a temporary restraining order that HSSA was entitled to such notice. On February 4, 1994, MLR filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in the Bankruptcy Court and filed an adversary proceeding against the Company to recover a payment of approximately $4.8 million to the Company as a voidable preference under the Bankruptcy Code. The preference action was dismissed without prejudice on February 10, 1994. After consultation with counsel, management of the Company believes that the Company has meritorious defenses to the actions against the Company referred to above and that such actions will not have a material adverse effect on the Company's business or financial condition. ITEM 4 ITEM 4 - -SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None Executive Officers of the Registrant Each of the executive officers of the Registrant listed below has served the Registrant or its subsidiaries in various executive capacities for the past five years, with the exception of Mr. Rueckel. Each officer is elected annually by the Board of Directors, normally for a one-year term and is subject to removal powers of the Board. Wallace L. Rueckel became Executive Vice President and Chief Financial Officer in March 1993. Prior to joining the Company, he served as a key financial officer at Guardian Industries and its affiliates for nine years. Mr. Stein is presently on a medical leave of absence from the Company. PART II ITEM 5 ITEM 5 - -MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Hartmarx common shares are traded on the New York and Chicago Stock Exchanges. The quarterly composite price ranges of the Company's common stock for the past three years were as follows: The most recent quarterly dividend paid was in November, 1991, in the amount of $.15 per share. Cash dividends may not be declared or paid during the term of the Company's current financing agreements. The current financing agreements also include various restrictive covenants pertaining to capital expenditures, asset sales, operating leases, minimum working capital and current ratio, debt leverage, consolidated tangible net worth, earnings before interest, taxes, depreciation and amortization, and interest coverage. The Company is prohibited from purchasing or redeeming its stock, warrants, rights or options, or from making certain acquisitions, without lender consent. Consolidated tangible net worth at November 30, 1993, as defined, was approximately $130 million compared to the minimum required level of $107 million. The ratio of consolidated funded indebtedness to consolidated tangible net worth, as defined, was 1.8 compared to the maximum permitted ratio of 2.7. As of February 16, 1994, there were approximately 7,400 stockholders of its $2.50 par value common stock. The number of stockholders was estimated by adding the number of registered holders furnished by the Company's registrar and the number of participants in the Hartmarx Employee Stock Ownership Plan. ITEM 6 ITEM 6 - -SELECTED FINANCIAL DATA The following table summarizes data from the Company's annual financial statements for the years 1989 through 1993 and the notes thereto; the Company's complete annual financial statements and notes thereto for fiscal 1993 are on pages 18 through 35 of this Form 10-K. Management's Discussion and Analysis of Financial Condition and Results of Operations, along with the Financing, Sale of Receivables, Taxes on Earnings and Restructuring and Retail Consolidation Charges footnotes to the consolidated financial statements provide additional information relating to the comparability of the information presented above. ITEM 7 ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Fiscal 1993 results reflect the strengthening of the Company's financial condition as a result of the Restructuring commenced in 1992, which refocused the Company's business operations around its profitable core wholesale men's apparel franchise and restructured its balance sheet. See "Business--General and Operating Segments." The Company's continuing businesses currently comprise: (i) MAG, which designs, manufactures and markets men's tailored clothing, on a wholesale basis, principally through its HSM, Intercontinental Branded Apparel and Hickey-Freeman business units, and slacks and sportswear, principally through its Trans-Apparel Group, Biltwell and Bobby Jones business units; (ii) Kuppenheimer, the vertically integrated factory-direct-to-consumer manufacturer of popular priced men's tailored clothing whose products are sold, along with related apparel procured from unaffiliated third parties, exclusively through Kuppenheimer operated retail stores; and (iii) Women's Apparel Group, comprised of Barrie Pace, a direct mail business offering a wide range of apparel and accessories to the business and professional woman through its catalogs, and IWA, which markets women's career apparel and sportswear to department and specialty stores under owned and licensed brand names. For financial reporting purposes, the Company's business units are identified as the wholesale segment, which principally consists of MAG and IWA, and the direct-to-consumer ("consumer") segment, which is principally comprised of Kuppenheimer and Barrie Pace. RESULTS OF OPERATIONS Consolidated 1993 sales were $732.0 million compared to $1.054 billion in 1992 and $1.215 billion in 1991. The 1993 sales decline of 30.5% compared to 1992 and the 13.3% decrease in 1992 compared to 1991 were substantially attributable to the disposition or discontinuance of various businesses as a result of the Restructuring. Over this period, sales of the Company's continuing businesses experienced small increases, principally related to the start-up of IWA and growth at Barrie Pace and in men's tailored clothing (excluding the sales of the Company's continuing businesses to HSSI.) Consolidated 1993 pre-tax income was $6.4 million compared to pre-tax losses of $226.9 million in 1992 and $60.0 million in 1991. Results for 1992 reflected, in addition to $190.8 million of restructuring charges, the aggregate operating losses associated with businesses sold or discontinued in connection with the Restructuring. Results for 1991 included a $13.5 million pre-tax charge taken to consolidate the Company's retail operations. Over this period, pre-tax earnings for the Company's continuing businesses showed a small improvement, principally related to reductions in corporate expenses. Net income for 1993 was $6.2 million or $.20 per share and reflected an effective tax rate of 3.0%. As discussed below, the Company's deferred tax assets include significant operating loss carryforwards available to offset future taxable income, which are substantially offset by valuation allowances due to uncertainties associated with the realization of such tax benefits. The net loss for 1992 was $220.2 million or $8.59 per share, which reflected a tax benefit of 2.9%. The net loss of $38.4 million or $1.74 per share in 1991 reflected a full tax benefit of 36.1%. Wholesale and Consumer Segments. Wholesale segment sales, which represent products manufactured by the Company and sold to unaffiliated retailers for resale to consumers, were $567 million in 1993, $592 million in 1992 and $578 million in 1991. The 4.2% decrease in 1993 as compared to 1992 was substantially attributable to the sale or closing of non-strategic manufacturing businesses which manufactured outerwear and commercial and military uniforms. This decrease in sales was partially offset by a slight increase in sales of the Company's continuing businesses and by $37 million of sales to HSSI being reflected in consolidated sales in 1993 compared to $18 million in 1992 which represented only those sales to HSSI subsequent to the Company's disposition of HSSI in September 1992. Prior to this disposition, sales to HSSI were considered intercompany and not reflected in consolidated sales. In 1992, such intercompany sales to HSSI were over $50 million. The 2.5% increase in wholesale segment sales in 1992 over 1991 was principally attributable to the introduction of new women's apparel brands and a slight increase in men's apparel sales, which were attributable to $18 million of sales to HSSI subsequent to its disposition by the Company. As a result of the Restructuring, the percentage of wholesale segment sales to consolidated sales increased to 77.5% in 1993 as compared to 56.2% in 1992 and 47.6% in 1991. Also as a result of the Restructuring, sales in the consumer segment (identified for reporting purposes in prior years as the retail segment) declined to $165 million in 1993 from $462 million in 1992 and $637 million in 1991, and, as a result, represented 22.5% of consolidated sales in 1993 compared to 43.8% in 1992 and 52.4% in 1991. The consumer segment was principally comprised of the Kuppenheimer and Barrie Pace businesses during 1993. The consumer segment in 1992 and 1991 also included HSSI and the operations of the Old Mill stores. The 64.3% decrease in 1993 compared to 1992 and the 27.6% reduction in 1992 compared to 1991 were substantially attributable to the disposition of HSSI and discontinuance of the Old Mill stores as part of the Restructuring. Barrie Pace continued to experience sales increases during this period. Kuppenheimer's full year comparable store sales declined 6% in 1993, 5% in 1992 and 4% in 1991. Consumer segment sales for 1992 reflected declines in comparable store sales at HSSI and Country Miss, prior to the sale or discontinuance of the stores, of approximately 13% and 9%, respectively. Consumer segment sales as a percentage of total sales are expected to decline further in the future, reflecting fewer Kuppenheimer stores as a result of the Restructuring and the Company's emphasis on its wholesale businesses. Wholesale segment earnings before interest and taxes, which include the manufacturing gross margin on products sold to unaffiliated retailers, were $37 million in 1993, $25 million in 1992 and $27 million in 1991. Men's tailored clothing represented a substantial portion of segment earnings in each year. Wholesale segment earnings for 1992 included an $8 million restructuring charge associated with discontinued businesses. The remaining 1993 increase compared to 1992 was principally attributable to improvements within the slacks and sportswear businesses. Also, the operating losses associated with women's wholesale apparel were reduced in each year. Consumer segment earnings before interest and taxes include the gross margin between retail selling price and cost associated with products manufactured by the Company and products purchased from unaffiliated sources. Consumer segment earnings were $2.5 million in 1993 compared to losses of $199 million in 1992 and $41 million in 1991. Segment results for 1993 include earnings in the Barrie Pace catalog business, partially offset by an operating loss at Kuppenheimer, which was principally attributable to its lower comparable store sales. Consumer segment results include $168 million in restructuring charges in 1992 and a $13.5 million provision associated with the consolidation of retail operations in 1991, actions which followed previous programs to improve retail operations through selective store closings and expense reductions. In addition to the non-recurring charges described above, additional factors contributing to the consumer segment losses in 1992 and 1991 were lower comparable store sales, high markdowns relative to sales and certain occupancy and administrative costs which did not decrease proportionately with the lower sales. Gross Margins. The consolidated gross margin percentage of sales was 31.0% in 1993, 33.2% in 1992 and 35.7% in 1991, a decline which primarily resulted from the Company's change in business mix as a result of the Restructuring. Wholesale sales generally produce a lower gross margin ratio to sales (and lower selling, administrative and occupancy expenses) compared to the consumer segment and represented 77.5% of consolidated sales in 1993 compared to 56.2% in 1992 and 47.6% in 1991. The percentage of wholesale sales to total sales is expected to increase in 1994 due to fewer stores operated by Kuppenheimer. While the consolidated ratio of gross margin to sales declined in 1993 compared to 1992, gross margin in both the wholesale and consumer segments improved compared to 1992. Current year results included $3.6 million of income resulting from lower LIFO inventories compared to $3.3 million of LIFO income in 1992; LIFO income in 1993 produced a .5% favorable impact on gross margin in 1993 compared to a .3% favorable impact in 1992. The consolidated gross margin percentage decline in 1992 compared to 1991 also reflected lower consumer segment margins, as wholesale margins were approximately even. Selling, Administrative and Occupancy Expenses. Selling, administrative and occupancy expenses represented 27.8% of sales in 1993 compared to 35.6% in 1992 and 38.5% in 1991. Consolidated expenses of $204 million in 1993 declined by approximately $171 million compared to 1992. The lower dollar level and percentage of sales ratio of these expenses reflected the disposition of HSSI, the effect of expense reduction programs in ongoing businesses and the greater proportion of wholesale business with its lower operating expense ratio to sales compared to the consumer segment. Both the dollar level and corresponding ratio to sales are expected to decline further in 1994 from the reduced level of retail operations compared to 1993. Wholesale segment operating expenses in 1993 declined in comparison to 1992 principally from discontinued businesses, although the percentage of sales was approximately the same. Consumer segment operating expenses declined substantially, both in dollars and as a percentage to sales in 1993 as compared to 1992, and in 1992 as compared to 1991, reflecting the disposition of HSSI, the wind down of the Old Mill retail store operations, expense reduction programs in ongoing businesses and the greater proportion of consolidated sales represented by the wholesale businesses. Aggregate 1992 expenses of $375 million declined by approximately $93 million from 1991, attributable to the disposition of HSSI and closing most of the Old Mill retail stores in 1992. Advertising expenditures, which are included in Selling, Administrative and Occupancy Expenses, declined to $20 million in 1993 from $33 million in 1992 and $48 million in 1991, representing 2.7%, 3.1% and 4.0% of consolidated sales, respectively. The dollar and percentage declines in each year were principally attributable to the disposition of HSSI and the wind down of the Old Mill retail stores, although wholesale segment advertising expenditures also declined both in dollars and as a percentage of sales in each year. Advertising expenditures applicable to wholesale operations are expected to increase during 1994 relating to both new and existing brands. Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions ("FAS 106"), requires the recognition of an obligation related to employee service pursuant to a postretirement benefit plan and is mandatory for the Company's fiscal year ending November 30, 1994. As retiree contributions offset the full cost of the Company-sponsored medical programs, no transition obligation is expected upon adoption of FAS 106 and there would be no effect on either net earnings or shareholders' equity. Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits, requires the recognition of obligations related to benefits provided by an employer to former or inactive employees after employment but before retirement, and is mandatory for the Company's fiscal year ending November 30, 1995. The Company believes that adoption is not expected to have a material impact on its financial condition. Other Income. Finance charges, interest and other income aggregated $6.0 million in 1993, $9.6 million in 1992 and $10.8 million in 1991. Other income was comprised principally of licensing income in 1993, and also included service charges on the retail receivables of HSSI in 1992 and 1991. The decrease in each year was principally attributable to the impact of the receivables sale program, described in the accompanying Notes to Consolidated Financial Statements, which commenced in June 1990 and terminated in October 1992. Interest Expense. Interest expense was $23 million in 1993, $21 million in 1992 and $24 million in 1991. The increase of approximately $2 million in 1993 compared to 1992 was attributable to increased interest rates associated with the Company's refinancing along with higher financing fee amortization. On a weighted average basis, total borrowing rates increased by approximately 1%; this rate increase was mitigated by lower average borrowings from reduced working capital requirements and the $30 million equity investment. The decrease of approximately $3 million in 1992 compared to 1991 reflected a 1.5% decline in average bank borrowing rates; total borrowings averaged $10 million higher during 1992 compared to 1991, in part attributable to the termination of the receivable sale program during 1992. Income Taxes. The effective tax provision (benefit) rate was 3.0% in 1993, (2.9)% in 1992 and (36.1)% in 1991. The effective tax rates for 1993 and 1992 reflect the adoption of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("FAS 109"), in the 1992 fiscal year. A substantial portion of the Company's tax assets are reserved by a tax valuation allowance aggregating $69 million at November 30, 1993. This valuation allowance reflects the uncertainties associated with the realization of the available tax benefit of net operating loss carryforwards, after giving consideration to the Company's recent operating losses. Although the Company achieved income during 1993 for financial reporting purposes, a tax operating loss resulted from the reversal of temporary differences associated with the Restructuring. The realization of the tax benefit arising from $137 million of net operating loss carryforwards at November 30, 1993 requires the generation of future taxable income. The net operating loss carryforwards expire in 2008. Approximately $2 million of the valuation allowance offsetting the deferred tax asset, associated with 1993 pre-tax income for financial reporting, was reversed during 1993. The 1993 effective tax provision rate was applicable to state income taxes. Upon the determination that the realization of some or all of the remaining reserved tax asset is more likely than not, earnings for the applicable year and shareholders' equity would be increased accordingly. The 1991 benefit rate reflected the recoverable federal and state income taxes from the carryback of operating losses to prior years. CASH FLOW AND FINANCIAL CONDITION In connection with the Restructuring, the Company consolidated and extended its borrowing facilities in December, 1992 pursuant to which, among other things, (i) the maturity of $307 million of the Company's outstanding indebtedness was consolidated and extended until December 30, 1995 pursuant to the terms of the Override Agreement, (ii) an additional seasonal borrowing availability of $35 million was obtained under the Bridge Facility and (iii) certain restrictive covenants with respect to the Company's indebtedness were added and existing covenants were adjusted to reflect the condition of the Company following the commencement of the Restructuring. The Company also raised $30 million through the sale of shares of its common stock and a warrant to purchase additional common shares in a private placement to Traco International, N.V. Borrowings under the Override Agreement and Bridge Facility (collectively, "the Agreements") substantially replaced or amended the provisions of the principal financing agreements existing as of November 30, 1992, and are secured by substantially all assets of the Company and its subsidiaries, subject to a priority of up to $15 million for trade creditors. At November 30, 1992, total debt was $314.6 million and reflected full utilization of then available lines. Upon execution of the Agreements and related private equity placement, borrowings and other arrangements under the predecessor Multiple Option Facility and various other agreements were superceded. The $307 million Override Agreement matures December 30, 1995. The Bridge Facility, originally $35 million and maturing November 30, 1993, was extended by the Company for one year at the $15 million commitment level, which satisfied the $20 million commitment reduction required as of November 30, 1993 under the Agreements. Additional required commitment reductions are $10 million on May 31, 1994 and $15 million on each of November 30, 1994 and May 31, 1995, with the balance expiring December 30, 1995. Additional commitment reductions may be required to the extent of certain asset sales, equity proceeds and available working capital based on calculations specified in the Agreements. The Agreements include various restrictive covenants pertaining to capital expenditures, asset sales, operating leases, minimum working capital and current ratio, debt leverage, consolidated tangible net worth, earnings before interest, taxes, depreciation and amortization and interest coverage. Cash dividends may not be declared or paid during the term of the Agreements and the Company is prohibited from purchasing or redeeming its stock, warrants, rights or options, or from making certain acquisitions or investments without specific lender consent. Any borrowings under the Bridge Facility would be repaid for a minimum thirty day period during 1993 and for two thirty day periods in 1994. During 1993, the Company did not borrow under the Bridge Facility and no other commitment reductions were required. At November 30, 1993, the Company had $89 million of borrowing availability under the Agreements. During 1993, the Company continued to evaluate refinancing alternatives, including, but not limited to, extending the maturities of a portion of its borrowings. In January 1994, two industrial development bonds ("IDBs") aggregating $15.5 million, associated with the Override Agreement, were refinanced independent of the Override Agreement. The refinanced bonds bear a fixed coupon rate of 7.25% and were issued at a discount to yield 7.5%. The $7.5 million IDB matures on July 1, 2014 while the $8.0 million IDB matures on July 1, 2015. The Company, at its option, may redeem the IDBs beginning July 1, 2000 at a 3% premium, declining to par on July 1, 2003. The IDBs are now unsecured obligations of Hartmarx Corporation and include certain customary covenants, representations and warranties in events of default, but do not contain financial covenants or cross default provisions. In January 1994, the Company filed a Registration Statement with respect to a proposed public offering of $100 million aggregate principal amount of its senior subordinated notes due 2002 ("Notes"). The ultimate issuance of these Notes is contingent upon several factors, including a public market environment acceptable to the Company with respect to interest rates. In addition, the issuance of the Notes would require the Company to obtain either the consent of the existing Override Agreement and Bridge Facility lenders or a new credit facility which, in conjunction with the subordinated debt issue, would provide sufficient availability to repay and terminate the Agreements. As discussed in the accompanying Notes to Consolidated Financial Statements, the Company executed a commitment letter ("Financing Commitment") on January 11, 1994 with General Electric Capital Corporation as managing agent ("Managing Agent") with respect to a proposed new credit facility for an aggregate maximum amount of $175 million ("New Credit Facility"). The Financing Commitment is subject to, among other things, (i) there being no material adverse change in the business or financial condition of the Company and its subsidiaries taken as a whole and (ii) definitive documentation for the New Credit Facility acceptable to the Managing Agent. The Financing Commitment terminates if, among other things, the Notes are not issued by April 30, 1994. Assuming that the New Credit Facility was consummated as of March 31, 1994 and the Agreements cancelled, the Company would expect to record an extraordinary pre-tax charge in fiscal 1994 of approximately $4 million, representing the loss from early extinguishment of debt. The New Credit Facility is expected to contain restrictions on the operation of the Company's business, including covenants pertaining to capital expenditures, asset sales, operating leases, minimum net worth and incurrence of additional indebtedness, and ratios relating to minimum accounts payable to inventory, maximum funded debt to EBITDA and minimum fixed charge coverage, as well as other customary covenants, representations and warranties, funding conditions and events of default. The Company does not believe that the restrictions contained in these financial and operating covenants will cause significant limitations on the Company's financial flexibility. In addition, the terms of the New Credit Facility will require the obligations under the New Credit Facility to be reduced to no more than $135 million for a minimum of 30 consecutive days during the period between April 1 and June 30 during each fiscal year. As noted above, the proposed Notes and New Credit Facility are subject to certain conditions precedent. While the consummation of the above noted transactions are believed to be beneficial to the longer term interests of the Company, the Company believes its existing arrangements provide sufficient borrowing availability and flexibility to currently operate its businesses in the normal course. However, if the Notes and New Credit Facility transactions are not completed, the Company would need to enter into new financing agreements by the December 30, 1995 expiration of the Override Agreement. As indicated in the accompanying Consolidated Statement of Cash Flows, the net cash provided by operating activities was $30 million in 1993 compared to net cash used in operating activities of $7 million in 1992 and $11 million in 1991. The cash and cash equivalent balance at November 30, 1993 was $1.5 million, compared to $22.4 million at November 30, 1992 which reflected approximately $13 million of short-term investments and the full utilization of then available credit lines. Net accounts receivable of $120.4 million at November 30, 1993 declined $39.3 million or 24.6% compared to November 30, 1992, principally attributable to the Restructuring, and 1992 receivables included certain consumer receivables which have subsequently been collected or written off. The allowance for doubtful accounts decreased to $9.9 million from $16.0 million in 1992, representing 7.6% of gross receivables in 1993 compared to 9.1% in 1992; the 1992 reserve reflected increased requirements for the then remaining consumer receivables. Inventories of $193.8 million at November 30, 1993 declined $22.9 million or 10.6% from November 30, 1992, attributable to both improvements in ongoing operations and the completion of inventory liquidations in the Old Mill retail stores and uniform businesses during fiscal 1993. Inventory turn in continuing businesses improved. Recoverable income taxes of $.7 million at November 30, 1993 and $8.2 million at November 30, 1992 arise from the carryback of operating losses to prior years. Deferred income taxes were $5.9 million at November 30, 1993 compared to $5.6 million in 1992. The November 30, 1993 balance reflects a $69 million valuation allowance ($71 million in 1992) related to a substantial portion of the tax asset resulting from prior years' operating losses. The Company has and will continue to assess the necessity for the valuation allowance taking into consideration such factors as earnings trends and prospects, anticipated reversal of temporary differences between financial and taxable income, the expiration or limitations of net operating loss carryforwards and available tax planning strategies (including the ability to adopt the FIFO inventory valuation method for those inventories currently valued under the LIFO valuation method). A future reversal of the valuation allowance in whole or in part represents a contingent asset which would increase earnings and shareholders' equity. Also, see discussion under "Income Taxes" above. At November 30, 1993, net properties were $56.5 million compared to $66.8 million in 1992. The decline principally reflected depreciation expense exceeding capital additions by approximately $8 million. Capital additions in 1993 were $6.0 million compared to $9.5 million in 1992 which included additions relating to businesses discontinued pursuant to the Restructuring; capital additions for 1992 in continuing businesses were $8.1 million. The Company's current borrowing agreements provide for annual limitations of capital expenditures, including $9.9 million applicable to 1994. These limitations are not expected to result in delaying capital expenditures otherwise planned by the Company. Upon consummation of the New Credit Facility, the permitted capital expenditures are anticipated to increase from the current levels. Capital expenditures in the next several years are expected to be funded from cash generated from operations and principally utilized for productivity improvements in various manufacturing locations. The operational aspects of the Restructuring have been substantially completed. Following the sale of HSSI in September, 1992, all of the Old Mill stores were closed. The store closings associated with Kuppenheimer were substantially completed by January 1994. Production facilities supporting the above noted reduced retail operations have been closed or sold along with facilities related to the rainwear and military and commercial uniform businesses. At November 30, 1993, approximately $8 million of accrued restructuring charges were reflected in the accompanying balance sheet, representing rent, severance and other employee benefits. At November 30, 1993, total debt of $233.1 million declined by $81.5 million as compared to November 30, 1992, as a result of the application of proceeds of the $30 million equity investment and approximately $21 million of cash and equivalents to the reduction of outstanding indebtedness, lower working capital requirements related to both ongoing and discontinued businesses, and lower capital expenditures. The $25 million of notes payable classified as current at November 30, 1993 reflects the anticipated seasonal repayments within fiscal 1994. Long-term debt was $207.4 million at November 30, 1993, representing 66% of the total $316.4 million capitalization, compared to 78% at November 30, 1992; the lower percentage reflected 1993 net earnings, the debt reduction and equity sales during the year. Total debt, including short- term borrowings and current maturities, represented 68% of total capitalization at November 30, 1993, compared to 82% at November 30, 1992. Shareholders' equity of $109.0 million at November 30, 1993 increased $38.6 million during 1993 and represented $3.41 book value per share at year end compared to $2.72 book value per share at November 30, 1992 ($100.4 million or $3.18 per share on a pro forma basis reflecting the $30 million equity proceeds and issuance of 5.7 million additional shares). The increase reflected the net income for the year, the private placement of equity, ongoing equity sales to employee benefit plans and recognition of previously unearned employee benefits associated with the Company's Employee Stock Ownership Plan. Dividends were not paid in fiscal 1993 or 1992 and dividend payments are prohibited under the current lending facility. The proposed terms of the Notes and New Credit Facility restrict the payment of dividends. Consolidated tangible net worth at November 30, 1993, as defined in the current Agreements, was $130 million compared to $107 million required under the Agreements. Considering the impact of inflation, earnings would be lower than reported due to assuming higher depreciation expense without a corresponding reduction in taxes. The current value of net assets would be higher than the Company's $109 million book value after reflecting the Company's use of the LIFO inventory method and increases in the value of the properties since acquisition. HSSI has continued as a customer of the Company subsequent to its disposition, although its purchases of the Company's products are declining. The Company's fiscal 1993 sales to HSSI were approximately $37 million (representing 5% of the Company's fiscal 1993 total sales), a decrease from the approximate $67 million wholesale value of shipments produced by the Company's continuing businesses for HSSI in 1992. In connection with the 1992 sale to HSSA, HSSI agreed to purchase from the Company, in each of the two twelve-month periods following the closing of the sale, products having an aggregate wholesale purchase price of at least $35 million. On December 21, 1993, HSSI and 25 affiliates filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code and are currently operating as debtors-in- possession. Any supply agreement entered into between the Company and HSSI prior to December 21, 1993 may be deemed an executory contract subject to assumption or rejection by HSSI under the United States Bankruptcy Code, and there can be no assurance that HSSI will assume any such supply agreement if such agreement is deemed an executory contract. When HSSI's Chapter 11 petitions were filed, HSSI's total outstanding indebtedness to the Company (excluding its guaranty of a $35 million promissory note of HSSA, the original direct obligor, to the Company) was approximately $4.5 million. MLR has extended credit support to HSSI and others in connection with purchases from the Company and, as a result, has total outstanding indebtedness to the Company at November 30, 1993 of approximately $10.8 million (including interest charges). The foregoing amounts of indebtedness of HSSI and MLR have not been adjusted for amounts received by the Company aggregating approximately $4.8 million in November 1993. On February 4, 1994, MLR filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code. For additional information concerning these and other legal proceedings involving HSSI and the Company, see "Part I, Item 3 - -Legal Proceedings". Under current circumstances, there can be no assurance that the Company will have any future sales to HSSI, that the Company will be able to collect amounts owed by HSSI or MLR, that MLR will provide any future credit support to HSSI or that either HSSI or MLR will continue as a going concern, events which could adversely affect the Company's total revenues or earnings. For the two months ended January 31, 1994, sales to HSSI aggregated $4.8 million and were on a cash-in-advance basis. While there can be no assurance that a decrease in business with HSSI can be fully replaced in the next several years, new retail customers have been added and volume with existing customers has increased in various markets where HSSI operates or has vacated. Debt reduction and extension of debt maturities continue to be a priority for the Company, as demonstrated by the Notes and the New Credit Facility. Following the Restructuring, the Company has continued to focus its operating and capital resources principally on its wholesale apparel businesses. The Company intends to maintain its position as the market leader in men's tailored clothing, while continuing to expand in men's slacks and sportswear, which includes the golf-inspired collections under the Jack Nicklaus(R) and Bobby Jones(R) brands. As anticipated, unit volume with HSSI declined significantly in 1993 compared to 1992, and further reductions are likely in 1994. The Company intends to mitigate the impact of reduced volume with HSSI by adding new customers and increasing volume with existing accounts, as well as by introducing new brands. Ongoing quick response and electronic data interchange relationships with major customers, enabling the rapid replenishment of inventory for selected product styles and enhanced service capabilities, are expected to continue as an important element of product distribution. The Company intends to continue its international licensing programs, while gradually developing merchandising and marketing expertise to sell branded apparel directly in international markets, which could include joint ventures, acquisitions and selling agencies. Conditions in the women's wholesale and men's direct-to-consumer businesses resulted in operating losses in 1993 for the IWA and Kuppenheimer operations. As a result, specific marketing and expense reduction actions have been implemented with the objective of improving results in these businesses. The Company is reviewing the profitability prospects and strategic direction of the IWA business, and may discontinue one or more of IWA's product lines or modify its distribution channels. Kuppenheimer's total sales are expected to decline due to fewer stores. Its merchandising strategy has been refocused to emphasize three distinct fashion silhouettes, each having a defined brand identification. The Company intends to expand the profitable Barrie Pace catalog business through increasing catalog circulation and by broadening its merchandise mix to include women's sportswear and more informal career apparel, while continuing to target the upscale and professional woman. ITEM 8 ITEM 8 - -FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Schedules and notes not included have been omitted because they are not applicable or the required information is included in the consolidated financial statements and notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of Hartmarx Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Hartmarx Corporation and its subsidiaries at November 30, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended November 30, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of Hartmarx Corporation'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 Chicago, Illinois January 12, 1994, except as to the Legal Proceedings Note on page 33 which is as of February 4, 1994 RESPONSIBILITY FOR FINANCIAL STATEMENTS Management of Hartmarx Corporation is responsible for the preparation of the Company's financial statements. These financial statements have been prepared in accordance with generally accepted accounting principles and necessarily include certain amounts based on management's reasonable best estimates and judgments, giving due consideration to materiality. In fulfilling its responsibility, management has established cost-effective systems of internal controls, policies and procedures with respect to the Company's accounting, administrative procedures and reporting practices which are believed to be of high quality and integrity. Such controls include approved accounting, control and business practices and a program of internal audit. The Company's business ethics policy, which is regularly communicated to all key employees of the organization, is designed to maintain high ethical standards in the conduct of Company affairs. Although no system can ensure that all errors or irregularities have been eliminated, management believes that the internal accounting controls in place provide reasonable assurance that assets are safeguarded against loss from unauthorized use of disposition, that transactions are executed in accordance with management's authorization, and that financial records are reliable for preparing financial statements and maintaining accountability for assets. The Audit Committee of the Board of Directors meets periodically with the Company's independent public accountants, management and internal auditors to review auditing and financial reporting matters. This Committee is responsible for recommending the selection of independent accountants, subject to ratification by shareholders. Both the internal and independent auditors have unrestricted access to the Audit Committee, without Company management present, to discuss audit plans and results, their opinions regarding the adequacy of internal accounting controls, the quality of financial reporting and other relevant matters. HARTMARX CORPORATION CONSOLIDATED STATEMENT OF EARNINGS (000'S OMITTED) (See accompanying notes to consolidated financial statements) HARTMARX CORPORATION CONSOLIDATED BALANCE SHEET (000'S OMITTED) (See accompanying notes to consolidated financial statements) HARTMARX CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (000'S OMITTED) (See accompanying notes to consolidated financial statements) HARTMARX CORPORATION CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (000'S OMITTED) (See accompanying notes to consolidated financial statements) HARTMARX CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING POLICIES Principles of Consolidation--The Company and its subsidiaries ("the Company") are engaged in the manufacturing and marketing of quality men's and women's apparel to independent retailers and through owned retail stores and catalogs. The consolidated 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 to the current year's presentation. Cash and Cash Equivalents--The Company considers as cash equivalents all highly liquid investments with an original maturity of three months or less. Inventories--Inventories are stated at the lower of cost or market. Approximately 18% and 23% of the Company's inventories at November 30, 1992 and 1993, respectively, primarily work in process and finished goods, are valued using the last-in, first-out (LIFO) method. The first-in, first-out (FIFO) method is used for substantially all raw materials and the remaining manufacturing and retail inventories. Property, Plant and Equipment--Properties are stated at cost. Additions, major renewals and betterments are capitalized; maintenance and repairs which do not extend asset lives are charged against earnings. Profit or loss on disposition of properties is reflected in earnings and the related asset costs and accumulated depreciation are removed from the respective accounts. Depreciation is generally computed on the straight line method based on useful lives of 20 to 45 years for buildings, 5 to 20 years for building improvements and 3 to 15 years for furniture, fixtures and equipment. Leasehold improvements are amortized over the terms of the respective leases. Revenue Recognition--Wholesale sales are recognized at the time the order is shipped. Retail sales, which include sales of merchandise and leased department income, are net of returns and exclude sales taxes. Store Opening/Closing Costs--Non-capital expenditures incurred for new or remodeled retail stores are expensed upon construction completion. When a store is closed, the remaining investment in fixtures and leasehold improvements, net of expected salvage, is charged against earnings; the present value of any remaining lease liability, net of expected sublease recovery, is also expensed. Intangibles--Intangible assets are included in "Investments and Other Assets" at cost, less amortization, which is provided on a straight-line basis over their economic lives, usually 10 years or less. Income Taxes--Effective December 1, 1991, the Company adopted 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 differences 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 fiscal 1992, the provision (benefit) for income taxes was based on income and expenses included in the accompanying consolidated statement of earnings whereby timing differences were classified as deferred tax assets or liabilities based on the respective tax rates then in effect. Retirement Plans--The Company and its subsidiaries maintain benefit plans covering substantially all employees other than those covered by multi-employer plans. In accordance with Statement of Financial Accounting Standards No. 87-- Employers' Accounting for Pensions, pension expense or income for the Company's principal defined benefit plan is determined using the projected unit credit method. Pension expense under each multi-employer plan is based upon a percentage of the employer's union payroll established by industry-wide collective bargaining agreements; such pension expenses are funded as accrued. Retiree Medical Program--Certain health and insurance programs are made available to non-union retired employees and eligible dependents. Approximately 175 retired employees are currently participating; substantially all non-union employees employed prior to September 1, 1993 could ultimately remain eligible upon attaining retirement age while employed by the Company. These retiree programs, after considering retiree contributions which offset the full cost, did not have a significant effect on earnings. Statement of Financial Accounting Standards No. 106--Employers' Accounting for Postretirement Benefits Other Than Pensions is mandatory for the Company's fiscal year ending November 30, 1994. Adoption of the statement will have no impact on cash flows. Since the retiree contributions offset the full cost of the available medical programs, no transition obligation is expected upon adoption and, accordingly, there would be no effect on either net income or shareholders' equity. Other Postemployment Benefits--Statement of Financial Accounting Standards No. 112--Employers' Accounting for Postemployment Benefits requires the recognition of obligations related to benefits provided by an employer to former or inactive employees after employment but before retirement, and is mandatory for the Company's fiscal year ending November 30, 1995. The Company believes that adoption is not expected to have a material impact on its financial condition. Stock Options--When stock options are exercised, common stock is credited for the par value of shares issued and capital surplus is credited with the consideration in excess of par. For stock appreciation rights, compensation expense is recognized on the aggregate difference between the market price of the Company's stock and the option price only when circumstances indicate that the right, and not the option, will be exercised. Compensation expense related to restricted stock awards is recognized over the vesting period. For director stock options and director deferred stock awards, compensation expense is recognized at the date the option is granted or the award is made to the outside director. Per Share Information--The computation of earnings or loss per share in each year is based on the weighted average number of common shares outstanding. When dilutive, stock options and warrants are included as share equivalents using the treasury stock method. The number of shares used in computing the earnings (loss) per share was 22,056,000 in 1991, 25,629,000 in 1992 and 31,375,000 in 1993. Primary and fully diluted earnings per share are the same for each of these years. In July 1991, the Company sold 4.3 million shares of common stock, pursuant to a public offering. Net proceeds of $38.5 million were used to repay bank borrowings. Effective December 30, 1992, the Company completed the sale to an unrelated third party of 5,714,286 shares of its common stock along with a three year warrant to purchase an additional 1,649,600 shares at an exercise price of $6.50 per share, for an aggregate price of $30 million. If this transaction had occurred as of December 1, 1992, the net earnings per share for the year would have been the same as the reported net earnings of $.20 per share. FINANCING In December 1992, the Company and its subsidiaries entered into new financing agreements with its principal lenders ("Override Agreement" and "Bridge Facility", collectively "the Agreements") aggregating $307 million, which substantially replaced or amended the provisions of prior agreements covering the Company's $196 million Multiple Option Revolving Credit Facility with 13 banks, $45 million of insurance term loans, $38 million of bank term loans, the ESOP loan guarantee and guarantees related to certain industrial development bonds having aggregate borrowings of $15.5 million. The Agreements also provided for additional seasonal borrowings of up to $35 million during 1993. At November 30, 1993, $226.4 million of the total $233.1 million debt outstanding related to borrowings under the provisions of the Agreements. Borrowings under the Agreements are secured by substantially all assets of the Company and its subsidiaries, subject to a priority of up to $15 million for trade creditors. The Override Agreement is in effect through December 30, 1995. The Bridge Facility, originally $35 million and maturing on November 30, 1993, has been extended by the Company for one year and currently provides for a $15 million commitment through November 30, 1994. In addition to the aggregate commitment reduction of $20 million on November 30, 1993, the Agreements provide for additional commitment reductions of $10 million on May 31, 1994, $15 million on November 30, 1994 and May 31, 1995, with the balance expiring on December 30, 1995; additional commitment and principal reductions may be required to the extent of certain asset sales, equity proceeds and excess working capital based on calculations specified in the Agreements. Generally, principal payments apply first to the Bridge Facility and then to the Override Agreement. The Bridge Facility also requires that borrowings, if any, be repaid for a minimum 30 day period during 1993 and for two 30 day periods in 1994; the Company may reborrow after these periods. The Company had no borrowings under the Bridge Facility during 1993. Borrowings under the Override Agreement bear interest at prime plus 2% for bank lenders, 10.3% for the insurance lenders, and 9.19% related to the ESOP loan guaranteed by the Company. Borrowings under the Bridge Facility bear interest at prime plus 1.5%. Fees pertaining to the Agreements aggregating $3.8 million were paid as of the closing date and certain other fees principally based on utilization are also payable. An additional $2.4 million is payable at the expiration of the Override Agreement. The Agreements, as amended, include various restrictive covenants pertaining to capital expenditures, asset sales, operating leases, minimum working capital and current ratio, debt leverage, consolidated tangible net worth, interest coverage and earnings before interest, taxes, depreciation and amortization. Cash dividends may not be declared or paid during the term of the Agreements and the Company is prohibited from purchasing or redeeming its stock, warrants, rights or options, or from making certain acquisitions without lender consent. The Company is in compliance with the various covenants contained in the Agreements. At November 30, 1993, working capital and the current ratio, as defined, were $274.7 million and 5.4, respectively, compared to the minimum required levels of $261.5 million and 4.9, respectively. Consolidated tangible net worth, as defined, was approximately $130 million compared to the minimum required level of $107 million. The ratio of consolidated funded indebtedness to consolidated tangible net worth, as defined, was 1.8 compared to the maximum permitted ratio of 2.7. At November 30, 1992 and 1993, long term debt, less current maturities, comprised the following (000's omitted): The industrial development bonds (IDBs), which mature on varying dates through 2015, were issued by development authorities for the purchase or construction of various manufacturing facilities having a carrying value of $13 million at November 30, 1993. Interest rates on the various borrowing agreements range from 7/8 of 1% to 8.5% (average of 4.1% at November 30, 1992 and 4.4% at November 30, 1993). In January 1994, two IDBs aggregating $15.5 million, associated with the Override Agreement, were refinanced independent of the Override Agreement. The $7.5 million IDB matures on July 1, 2014, while the $8.0 million IDB is due on July 1, 2015. The IDBs are callable by the Company beginning July 1, 2000 at a 3% premium, declining to par on July 1, 2003; the effective interest rate on these obligations is 7.5%. Other long term debt includes installment notes and mortgages with interest rates ranging from 8% to 11.5% per annum. (Average interest rate of 10.3% at November 30, 1992 and 10.2% at November 30, 1993.) The approximate principal requirements during the next five fiscal years, including reductions under the Override Agreement, are as follows: $.7 million in 1994; $.7 million in 1995; $211.5 million in 1996; $.1 million in 1997; $.1 million in 1998. In January 1994, the Company filed a Registration Statement with respect to a proposed public offering of $100 million aggregate principal amount of its senior subordinated notes ("Notes"), due 2002. The ultimate issuance of these Notes is contingent upon several factors, including a public market environment acceptable to the Company with respect to interest rates. In addition, the issuance of the Notes would require the Company to obtain either the consent of the existing lenders under the Agreements or a new credit facility which, in conjunction with the subordinated debt issue, would provide sufficient availability to repay and terminate the Agreements. On January 11, 1994, the Company executed a commitment letter ("Financing Commitment") with General Electric Capital Corporation as managing agent ("Managing Agent") with respect to a proposed new credit facility ("New Credit Facility"). The Financing Commitment is subject to, among other things, (i) there being no material adverse change in the business or financial condition of the Company and its subsidiaries taken as a whole and (ii) definitive documentation for the New Credit Facility acceptable to the Managing Agent. The Financing Commitment terminates if, among other things, the Notes are not issued by April 30, 1994. The New Credit Facility would be a three year secured revolving credit facility in an aggregate maximum amount of $175 million (including a $25 million letter of credit facility), subject to a borrowing base formula based upon 85% of eligible accounts receivable and 55% of eligible inventory. The New Credit Facility would be used to repay borrowings under the Override Agreement and Bridge Facility, to finance ongoing working capital and letter of credit requirements and for general corporate purposes. The New Credit Facility would be secured by a first priority security interest in substantially all of the current and intangible assets of the Company and its subsidiaries. The New Credit Facility is expected to include a negative pledge on all assets of the Company and its subsidiaries, be guaranteed by the subsidiaries of the Company and contain various restrictive covenants pertaining to net worth, additional debt incurrence, fixed charge coverage, as well as other customary covenants. Borrowing under the New Credit Facility would be established as either base rate or LIBOR loans, as the Company may elect. Base rate loans would be priced at the greater of (a) a rate based on the weighted average of various 90-day commercial paper rates or (b) the base rate of a bank to be selected by the Managing Agent plus 1.50%. LIBOR loans would be priced at LIBOR plus 2.50%. On December 1, 1988 The Hartmarx Employee Stock Ownership Plan ("ESOP") borrowed $15 million from a financial institution and purchased from the Company 620,155 shares of treasury stock at the market value of $24.19 per share. The loan is guaranteed by the Company and, accordingly, the amount outstanding has been included in the Company's consolidated balance sheet as a liability, net of a $.6 million payment made by the Company to the financial institution holding the ESOP note, and shareholders' equity has been reduced for the amount representing unearned employee benefits. Company contributions to the ESOP plus the dividends accumulated on unallocated Company common stock held by the ESOP are used to repay loan principal and interest. The common stock is allocated to ESOP participants as the loan principal and interest is repaid or accrued and amounts reflected as the loan guarantee and unearned employee benefits are correspondingly reduced. Information related to dividends received and loan repayments by the ESOP are as follows (000's omitted): As of November 30, 1993, 188,394 shares of common stock have been allocated to the accounts of the ESOP participants. NOTES PAYABLE TO BANKS The following summarizes information concerning notes payable to banks (000's omitted): As more fully discussed in the Financing Note, in December, 1992 the Company entered into a new three year financing agreement through December 30, 1995. At November 30, 1993, $25 million of the aggregate $153.7 million of bank borrowings outstanding was classified as current, representing expected seasonal repayments within the fiscal 1994 year. The Company enters into interest rate protection agreements from time to time, based on management's assessment of market conditions, with several currently in effect covering $100 million of borrowings. Payments to the Company would occur to the extent the prime interest rate exceeds 6.0%. The payments made for the rate protection agreements in effect during each of the three years ended November 30, 1993 were nominal. RESTRUCTURING AND RETAIL CONSOLIDATION CHARGES Consistent with the Company's strategies to concentrate operations around its profitable manufacturing and wholesale businesses and to refinance its capital structure, fiscal 1992 third quarter and full year results included pre-tax restructuring charges aggregating $190.8 million ("the Restructuring"). The Restructuring comprised the direct costs associated with businesses and facilities sold or disposed of and included the loss on the sale of stock of Hartmarx Specialty Stores, Inc. ("HSSI"), the parent company of the Company's principal retail unit. Restructuring components applicable to other operations sold or liquidated included impairment of leasehold improvements, fixtures and other properties, anticipated lease settlement obligations, severance, advisory fees and costs to liquidate inventories. As further discussed in the Taxes on Earnings footnote, a tax benefit relating to the restructuring charges was not recorded. At November 30, 1993, accrued restructuring charges of $8 million were included in the accrued expense caption in the accompanying balance sheet ($34 million at November 30, 1992) principally relating to lease, severance and employee benefit obligations. The operational aspects of the Restructuring have been substantially implemented. Following the sale of the HSSI business in September, 1992 for a note due on September 18, 1994, all of the Old Mill stores operated by the Company's Country Miss subsidiary were closed. The store closings associated with Kuppenheimer were substantially completed by January, 1994. Production facilities supporting the above noted operations have been closed or sold along with facilities related to the rainwear and military and commercial uniform businesses. The note received in connection with the sale of HSSI, originally $43 million, was subsequently adjusted to $35 million, including interest, based on the value of physical inventories. This note has been accounted for on a cash collection basis. Accordingly, no value was assigned to the note in calculating the loss on the sale. During 1993, HSSA Group, Ltd., the original direct obligor of the note, breached certain of its obligations under the note and ancillary agreements and, on November 23, 1993, the Company exercised certain of its rights to cause, among other things, the common stock of HSSI to be voted to elect a new Board of Directors. Fiscal 1991 fourth quarter and full year results included a pre-tax provision of $13.5 million for expenses associated with the consolidation of certain retail administrative functions of HSSI and Kuppenheimer, including severance, lease settlements, and other one time costs. SALE OF RECEIVABLES In June 1990, the Company entered into an agreement with an unrelated third party to sell up to $60 million of undivided interests in a designated pool of accounts receivable, principally related to revolving charge accounts. The Company acted as an agent for the purchaser by performing recordkeeping and collection functions on the interests sold, and was obligated to pay the purchaser's carrying cost plus fees typical in such transactions, which are included in the finance charges, interest and other income caption in the accompanying Consolidated Statement of Earnings for fiscal 1992 and 1991. The agreement terminated effective October 10, 1992. At November 30, 1992 and 1993, no sold receivables were outstanding under the program. INVENTORIES Inventories at fiscal year end were as follows (000's omitted): The excess of current cost over LIFO costs for certain inventories was $42.0 million at November 30, 1991, $38.7 million at November 30, 1992 and $35.0 million at November 30, 1993. TAXES ON EARNINGS The accompanying financial statements reflect the adoption of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("FAS 109"), as of December 1, 1991, the commencement of the Company's 1992 fiscal year. Previously, accounting for income taxes was based on the provisions of Accounting Principles Board Opinion No. 11. Among other things, FAS 109 requires an asset and liability approach in the measurement of deferred taxes, which are adjusted to reflect changes in statutory tax rates, and permits the recognition of net deferred tax assets subject to an ongoing assessment of realization. The net tax provision (benefit) is summarized as follows (000's omitted): A substantial portion of the Company's tax assets are reserved in accordance with FAS 109. The valuation allowance was recorded upon consideration of the operating losses incurred during the 1990-1992 fiscal years and related uncertainty associated with realization of the tax benefit of net operating loss carryforwards, which require the generation of future income from operations. The net tax assets recorded consider amounts recoverable from carrying back operating losses to prior years and available tax planning strategies (such as the ability to adopt the FIFO inventory valuation method for those inventories currently valued under the LIFO valuation method). During 1993, $2.1 million of the valuation allowance offsetting the deferred tax asset, associated with 1993 pre-tax income for financial reporting, was reversed. The valuation allowance offsetting the deferred tax asset will continue to be evaluated in future periods on an ongoing basis. The difference between the tax benefit reflected in the accompanying statement of earnings and the amount computed by applying the federal statutory tax rate to the pre-tax income (loss), taking into account the applicability of enacted tax rate changes, is summarized as follows: At November 30, 1992, the Company had a net deferred tax asset of $5.6 million comprised of deferred tax assets of $103.1 million less deferred tax liabilities aggregating $26.6 million and a $70.9 million valuation allowance. The principal deferred tax assets included $9.2 million attributable to Tax Reform Act of 1986 ("TRA") items (allowance for bad debts, accrued vacation and capitalization of certain inventory costs for tax purposes), net operating loss carryforwards of $59.2 million, alternative minimum tax credit carryforwards ("AMT") of $4.0 million, and $23.5 million attributable to expenses deducted in the financial statements not currently deductible for tax purposes, principally related to the Restructuring. Deferred tax liabilities included excess tax over book depreciation of $6.7 million and $8.8 million related to employee benefits, principally pensions. At November 30, 1993, the Company had a net deferred tax asset of $5.9 million comprised of deferred tax assets of $93.7 million less deferred tax liabilities aggregating $18.9 million and a $68.9 million valuation allowance. The principal deferred tax assets included $9.4 million attributable to TRA items, net operating loss carryforwards of $48.1 million, AMT credit carryforwards of $4.0 million, and $31.4 million attributable to expenses deducted in the financial statements not currently deductible for tax purposes, including expenses related to the Restructuring. Deferred tax liabilities included excess tax over book depreciation of $4.2 million and $6.9 million related to employee benefits, principally pensions. As of November 30, 1993, the Company had approximately $137 million of tax net operating loss carryforwards available to offset future income tax liabilities. In general, such carryforwards must be utilized within fifteen years of incurring the net operating loss; the loss carryforward expires in 2008. Foreign tax credit carryforwards of $.8 million are also available, the substantial portion of which expire in 1996. The $4.0 million of AMT tax credit carryforwards can be carried forward indefinitely. LEASES The Company and its subsidiaries lease office, manufacturing, warehouse/distribution, showroom and retail space, automobiles, computers and other equipment under various noncancellable operating leases. A number of the leases contain renewal options ranging up to 10 years. Some retail leases provide for contingent rental payments, generally based on the sales volume of the retail unit. At November 30, 1993, total minimum rentals are as follows (000's omitted): Rental expense, including rentals under short term leases, comprised the following (000's omitted): Most leases provide for additional payments of real estate taxes, insurance, and other operating expenses applicable to the property, generally over a base period level. Total rental expense includes such base period expenses and the additional expense payments, as part of the minimum rentals. EMPLOYEE BENEFITS Pension Plans The Company participates with other companies in the apparel industry in making collectively-bargained contributions to pension funds covering most of its union employees. The contribution rate of applicable payroll is based on the actuarially recommended amount necessary to fund the costs of the benefits. Pension costs relating to multi-employer plans were approximately $12 million in 1991, $10 million in 1992 and $8 million in 1993. The Multi-Employer Pension Plan Amendment Act of 1980 amended ERISA to establish funding requirements and obligations for employers participating in multi-employer plans, principally related to employer withdrawal from or termination of such plans, whereupon separate actuarial calculations would be made to determine the Company's position with respect to multi-employer plans. The principal Company sponsored pension plan is a non-contributory defined benefit pension plan covering substantially all eligible non-union employees. Certain of the Company's subsidiaries have other defined benefit and contribution plans, in which the aggregate expense was $.6 million in 1991, $.3 million in 1992 and nominal in 1993. Under the principal pension plan, retirement benefits are a function of years of service and average compensation levels during the highest five consecutive salary years occurring during the last ten years before retirement. To the extent that the calculated retirement benefit under the formula specified in the plan exceeds the maximum allowable under the provisions of the tax regulations, the excess is provided on an unfunded basis. Under the provisions of the Omnibus Budget Reconciliation Act of 1993, the annual compensation limit that can be taken into account for computing benefits and contributions under qualified plans was reduced from $235,840 to $150,000, effective as of January 1, 1994. It is the Company's policy to fund the plans on a current basis to the extent deductible under existing tax laws and regulations. Such contributions are intended to provide for benefits attributed to service to date and also for those expected to be earned in the future. Pension data covering the principal plan for the three years ended November 30, 1993 included the following components in accordance with Statement of Financial Accounting Standards No. 87--Employers' Accounting for Pensions (000's omitted): The above amounts do not include periodic pension expense related to the benefits provided on an unfunded basis of $.2 million in 1991, $.3 million in 1992, and $.6 million in 1993. The Company sold its Hartmarx Specialty Stores subsidiary ("HSSI") in 1992 and the accrual of further pension benefits related to HSSI employees ceased as of the sale date. This event qualified as a curtailment under the provisions of Statement of Financial Accounting Standards No. 88. The projected benefit obligation exceeded the accumulated benefit obligation for employees of HSSI and, accordingly, the accompanying financial statements for 1992 reflect an additional pre-tax pension gain of $5.0 million, which was considered in the determination of the 1992 restructuring charge. Plan assets consist primarily of publicly traded common stocks and corporate debt instruments, and units of certain trust funds administered by the Trustee of the plan. At November 30, 1993, the plan assets included 519,612 shares of the Company's stock with a market value of $3.6 million. The following sets forth the funded status of the principal pension plan at November 30 (000's omitted): The weighted average discount rate used in determining the projected benefit obligation was 8 3/4% in 1992 and 7% in 1993. The assumed rate of increase in future compensation levels was 6% in 1992 and 5.5% in 1993, and the expected long term rate of return on the Company sponsored plan assets was 8 3/4% in 1992 and 1993. Savings Investment and Employee Stock Ownership Plans The Company offers an employee savings-investment plan, The Hartmarx Savings- Investment Plan ("SIP"), which is a qualified salary reduction plan under Section 401(k) of the Internal Revenue Code. Eligible participants in SIP can invest from 1% to 16% of earnings among several investment alternatives, including a company stock fund. Employees participating in this plan automatically participate in The Hartmarx Employee Stock Ownership Plan ("ESOP"). Participation in SIP is required to earn retirement benefits under the Company's principal pension plan. An employer contribution is made through the ESOP, based on the employee's level of participation, and invested in common stock of the Company. While employee contributions up to 16% of earnings are permitted, contributions in excess of 6% are not subject to an employer contribution. In 1992 and 1993, the employer contribution was one-fourth of the first 1% contributed by the employee plus one-twentieth thereafter. During 1991, the employer contribution was one-fourth of employee's contribution up to the 6% limit. The Company's expense related to the ESOP is based upon the principal and interest payments on the ESOP loan, the dividends on unallocated ESOP shares, and the cost and market value of shares allocated to employees' accounts. The Company's annual expense, which approximates the Company's annual contributions, was $2.8 million in 1991, $2.1 million in 1992 and $2.2 million in 1993. At November 30, 1993, the assets of SIP and ESOP funds had a market value of approximately $39.1 million, of which approximately $17.4 million was invested in 2,491,059 shares of the Company's common stock. Health Care and Postretirement Benefits Certain of the Company's subsidiaries make contributions to multi-employer union health and welfare funds pursuant to collective bargaining agreements. These payments are based upon wages paid to the Company's active union employees. Health and insurance programs are also made available to non-union active and retired employees and their eligible dependents. Retirees, who elect to receive the coverage, make contributions which offset the full cost of the retiree program. Statement of Financial Accounting Standards No. 106--Employers' Accounting for Postretirement Benefits Other than Pensions requires the recognition of an obligation related to employee service pursuant to a postretirement benefit plan and is mandatory for the Company's fiscal year ending November 30, 1994. Adoption of the statement will have no impact on cash flows. Since the retiree contributions offset the full cost of the available medical programs, no transition obligation is expected upon adoption and, accordingly, there would be no effect on either net income or shareholders' equity. EQUITY SALE On September 21, 1992, the Company entered into an agreement with Traco International, N.V., a Netherlands Antilles Corporation ("Traco"), pursuant to which Traco agreed to purchase 5,714,286 shares of common stock of the Company and receive a three-year warrant to purchase an additional 1,649,600 shares of common stock of the Company at an exercise price of $6.50 per share, for an aggregate purchase price of $30 million. The agreement was completed effective as of December 30, 1992. Traco is also party to an agreement with the Company providing representation on the Company's Board of Directors and restricting Traco's rights to acquire, sell and vote the Company's shares. STOCK PURCHASE RIGHTS A dividend of one Right per common share was distributed to stockholders of record January 31, 1986, and effective July 12, 1989, the Agreement governing the Rights was amended. Each common share, adjusted for the May 1986 3-for-2 stock split, now represents .6667 Right. Each Right, expiring January 31, 1996, continues to represent a right to buy from the Company 1/100th of a share of Series B Junior Participating Preferred Stock, $1.00 par value, at a price of $120. This dividend distribution of the Rights was not taxable to the Company or its stockholders. Separate certificates for Rights will not be distributed, nor will the Rights be exercisable, unless a person or group acquires 15 percent or more, or announces an offer to acquire 15 percent or more, of the Company's common shares. Following an acquisition of 15 percent or more of the Company's common shares (a "Stock Acquisition"), each Right holder, except the 15 percent or more stockholder, has the right to receive, upon exercise, common shares valued at TWICE the then applicable exercise price of the Right (or, under certain circumstances, cash, property or other Company securities), unless the 15 percent or more stockholder has offered to acquire all of the outstanding shares of the Company under terms that a majority of the independent directors of the Company have determined to be fair and in the best interest of the Company and its stockholders. Similarly, unless certain conditions are met, if the Company engages in a merger or other business combination following a Stock Acquisition where it does not survive or survives with a change or exchange of its common shares or if 50 percent or more of its assets, earning power or cash flow is sold or transferred, the Rights will become exercisable for shares of the acquiror's stock having a value of TWICE the exercise price (or, under certain circumstances, cash or property). The Rights are not exercisable, however, until the Company's right of redemption described below has expired. Generally, Rights may be redeemed for $.033 cents each (in cash, common shares or other consideration the Company deems appropriate) until the earlier of (i) the tenth day following public announcement that a 15 percent or greater position has been acquired in the Company's stock or (ii) the final expiration of the Rights. In connection with the previously discussed sale of 5.7 million shares of common stock and three year warrant to purchase an additional 1.6 million shares ("stock sale"), the Agreement governing the Rights was amended to exclude the stock sale from qualifying as an event which would give rise to the distribution or exercisability of the Rights. Until exercise, a Right holder, as such, has no rights as a stockholder of the Company. At the annual meeting in April 1993, a majority of the stockholders voted in favor of a non-binding stockholder proposal calling for either the submission of the Rights Plan to a binding shareholder vote or a redemption of the Rights. However, the Company's current financing agreements prohibit the purchase or redemption of the Rights. STOCK OPTION PLANS The Company has stock option plans under which officers and key employees may be granted options to purchase the Company's common stock at prices equal to the fair market value at date of grant. Generally, options under the 1982 and 1985 Stock Option Plans are exercisable to the extent of 25% each year (cumulative) from the second through the fifth year, and expire ten years after date of grant; however, all or any portion of the shares granted are exercisable during the period beginning one year after date of grant for participants employed by the Company for at least five years. A portion of the options granted under the 1988 Stock Option Plan have exercise provisions similar to the other plans; the remaining grants become exercisable over a three to five year period based upon the achievement of company-wide performance goals. Under certain circumstances, the vesting may be accelerated. All options expire ten years after date of grant under the Plans. The 1982, 1985 and 1988 Plans also provide for the discretionary grant of stock appreciation rights in conjunction with the option, which allows the holder a combination of stock and cash equal to the gain in market price from the grant until its exercise; the cash payment is limited to one-half of the gain. Under certain circumstances, the entire gain attributable to rights granted under the 1988 Plan may be paid in cash. When options and stock appreciation rights are granted in tandem, the exercise of one cancels the other. The 1985 and 1988 Plans provide for the discretionary grant of restricted stock awards which allows the holder to obtain full ownership rights subject to terms and conditions specified at the time each award is granted. The 1988 Plan provides for an annual grant of Director Stock Options (DSO) to outside members of the Board of Directors at market value on the date of grant. In addition, each outside director may make an irrevocable election to receive a DSO in lieu of all or part of his or her retainer. The number of whole shares to be granted is based on the annual retainer divided by the market value minus one dollar and the exercise price is $1. Each outside director is also eligible for an annual grant of a Director Deferred Stock Award (DDSA) equal to 150 DDSA units, with a unit equal to one share of the Company's common stock; DDSA units are payable in shares of common stock upon death, disability or termination of service. Dividend equivalents may be earned on qualifying DSO and DDSA units and allocated to directors' respective accounts in accordance with the terms of the Plan. During fiscal 1993, 23,336 DSO were granted, no DSO were exercised and 64,132 DSO were outstanding at November 30, 1993. Stock options outstanding at November 30, 1993 included 265,989 shares granted in tandem with stock appreciation rights. Activity for 1992 included the October 14th grant of 326,500 stock options at $5.25 per share, which exceeded the market price of $3.83 per share, to employees who agreed to the cancellation of 1,035,606 options granted to them from 1983 through 1992. In general, one-third of these options are exercisable on each of the first three anniversaries of the grant date. Options for 503,140 shares were exercisable at November 30, 1993 at prices ranging from $5.25 to $30.81. At November 30, 1993, 2,012,161 shares were reserved for options and restricted stock awards granted or to be granted including 496,181 shares for future stock options and/or restricted stock awards (958,770 at November 30, 1992). Information regarding stock option activity for the three years ended November 30, 1993 is as follows: LEGAL PROCEEDINGS The Company is involved in certain litigation as described in "Item 3 - -Legal Proceedings." The Company believes that it has meritorious defenses to the actions against the Company referred to under such caption and that such actions will not have a material adverse effect on the Company's financial condition. OPERATING SEGMENT INFORMATION The Company is engaged in the business of manufacturing and marketing apparel to unaffiliated retailers (identified below as the wholesale segment) and directly to consumers through its owned retail stores and catalogs (identified below as the direct-to-consumer segment and previously called the retail segment). Information on the Company's wholesale and direct-to-consumer operations for the three years ended November 30, 1993 is summarized as follows (in millions): The largest customer represents approximately 12% of consolidated sales in 1993. The wholesale segment reflects products sold to unaffiliated retailers for resale to consumers, principally from the Men's Apparel Group. The direct- to-consumer segment reflects sales to end consumers through owned retail stores and catalogs, comprised of products manufactured by the Company's subsidiaries as well as products purchased from unaffiliated sources. In 1993, approximately 76% of Kuppenheimer's sales and 6% of Barrie Pace catalog sales represented products manufactured by the Company. Prior to the disposition of HSSI to an unaffiliated third party in September, 1992, sales of those products manufactured by certain of the Company's subsidiaries and sold by HSSI were reported in the direct-to-consumer segment upon their ultimate sale to consumers. Direct-to-consumer segment sales for 1992 included approximately $250 million related to sales made by HSSI prior to its disposition and $34 million related to the Old Mill stores. Wholesale segment earnings before taxes reflect the manufacturing gross margin associated with products sold to unaffiliated retailers. The earnings (loss) before taxes of the direct-to-consumer segment reflect the gross margin between retail selling price and cost associated with products manufactured by the Company and those purchased from unaffiliated sources. Segment results for 1992 include pre-tax restructuring charges of $190.8 million, principally attributable to the disposition and liquidation of retail operations. Direct- to-consumer segment assets reflect the disposition of HSSI during 1992. The direct-to-consumer segment results for 1991 include the $13.5 million of expenses provided for the retail consolidation. Operating expenses incurred by the Company in generating sales are charged against the respective segment's sales; indirect operating expenses are allocated to the segments benefited. Segment results exclude any allocation of general corporate expense, interest expense or income taxes. Adjustments of earnings before taxes consist of interest expense and general corporate expenses. Adjustments of gross assets are for cash, recoverable income taxes and corporate properties, investments and other assets. Adjustments of depreciation and amortization and net property additions are for corporate properties. QUARTERLY FINANCIAL SUMMARY (UNAUDITED) Selected quarterly financial and common share information for each of the four quarters in fiscal 1992 and 1993 is as follows (000's omitted): The net loss for the third quarter of 1992 includes $190.8 million or $7.44 per share after-tax restructuring charge. The full year 1992 loss per share was $8.59 compared to $8.56 when aggregating the individual quarters, the difference attributable to the number of outstanding shares during the third quarter when the restructuring charge was recorded. 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 to be included under the caption "Information About Nominees For Directors" contained in the section entitled "Election of Directors" in the Company's definitive Proxy Statement for the annual meeting of stockholders to be held April 14, 1994 (the "Proxy Statement") which will be filed with the Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, is incorporated herein by reference. Information on Executive Officers of the Registrant is included as a separate caption in Part I of this Form 10-K Annual Report. ITEM 11 ITEM 11 - -EXECUTIVE COMPENSATION Information to be included under the captions "Executive Officer Compensation" and "Information About Nominees for Directors" in the Proxy Statement is incorporated herein by reference. ITEM 12 ITEM 12 - -SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information to be included under the captions "Information About Nominees for Directors" and "Ownership of Common Stock" in the Proxy Statement is incorporated herein by reference. ITEM 13 ITEM 13 - -CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information to be included under the caption "Information About Nominees for Directors" 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) Financial Statements Financial statements for Hartmarx Corporation listed in the Index to Financial Statements and Supplementary Data on page 16 are filed as part of this Annual Report. (a)(2) Financial Statement Schedules Financial Statement Schedules for Hartmarx Corporation listed in the Index to Financial Statements and Supplementary Data on page 16 are filed as part of this Annual report. (b) Reports on Form 8-K The Registrant did not file any reports on Form 8-K during the quarter ended November 30, 1993. HARTMARX CORPORATION INDEX TO EXHIBITS - -------- *Exhibits incorporated herein by reference. (1) File No. 1-8501 **Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c) of Form 10-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. Hartmarx Corporation (Registrant) /s/ Wallace L. Rueckel /s/ Glenn R. Morgan By:__________________________________ and By:______________________________ Wallace L. Rueckel Glenn R. Morgan Executive Vice President and Chief Financial Officer Senior Vice President and Controller and Chief Accounting Officer Date: February 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. Elbert O. Hand* Homi B. Patel* - ------------------------------------- ------------------------------------- Elbert O. Hand Homi B. Patel Chairman, Chief Executive Officer, President, Chief Operating Officer, Director Director A. Robert Abboud* Charles Marshall* - ------------------------------------- ------------------------------------- A. Robert Abboud, Director Charles Marshall, Director Letitia Baldrige* Charles K. Olson* - ------------------------------------- ------------------------------------- Letitia Baldrige, Director Charles K. Olson, Director Jeffrey A. Cole* Talat M. Othman* - ------------------------------------- ------------------------------------- Jeffrey A. Cole, Director Talat M. Othman, Director Raymond F. Farley* Stuart L. Scott* - ------------------------------------- ------------------------------------- Raymond F. Farley, Director Stuart L. Scott, Director Donald P. Jacobs* Sam F. Segnar* - ------------------------------------- ------------------------------------- Donald P. Jacobs, Director Sam F. Segnar, Director Miles L. Marsh* /s/ Wallace L. Rueckel - ------------------------------------- ------------------------------------- Miles L. Marsh, Director Wallace L. Rueckel Executive Vice President Chief Financial Officer Principal Financial Officer /s/ Wallace L. Rueckel *By:_________________________________ Glenn R. Morgan* Wallace L. Rueckel, Attorney-in-fact ------------------------------------- Glenn R. Morgan Senior Vice President, Controller Principal Accounting Officer - -------- Date: February 25, 1994 HARTMARX CORPORATION SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS FOR FISCAL YEARS ENDED NOVEMBER 30, 1991, 1992 AND 1993 (000'S OMITTED) - -------- (1) Notes and accounts written off as uncollectible, net of recoveries of accounts previously written off as uncollectible. SCHEDULE IX--SHORT TERM BORROWINGS FOR FISCAL YEARS ENDED NOVEMBER 30, 1991, 1992 AND 1993 (000'S OMITTED) SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR FISCAL YEARS ENDED NOVEMBER 30, 1991, 1992 AND 1993 (000'S OMITTED) CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Commission File Nos. 33-21549 and 33-42202) of Hartmarx Corporation of our report dated January 12, 1994, except as to the Legal Proceedings Note, which is as of February 4, 1994, appearing on page 17 of this Form 10-K. PRICE WATERHOUSE Chicago, Illinois February 25, 1994

40730_1993.txt

40730_1993

1993

40730

ITEM 1. BUSINESS General The following information is incorporated herein by reference to the indicated pages in Part II: Item Page ------------------------------------------------------------- ----- Worldwide Wholesale Sales . . . . . . . . . . . . . . . . . . II-54 Employment and Payrolls . . . . . . . . . . . . . . . . . . . II-58 Note 17 of Notes to Financial Statements (Segment Reporting). II-38 While the major portion of the Corporation's operations is derived from the automotive products industry segment, GM also has financing and insurance operations and produces products and provides services in other industry segments. The automotive products segment consists of the design, manufacture, assembly, and sale of automobiles, trucks, and related parts and accessories. The financing and insurance operations assist in the merchandising of General Motors' products as well as other products. General Motors Acceptance Corporation (GMAC) and its subsidiaries, as well as certain other subsidiaries of GM, offer financial services and certain types of insurance to dealers and customers. In addition, GMAC and its subsidiaries are engaged in mortgage banking and investment services. The other products segment consists of military vehicles, radar and weapon control systems, guided missile systems, and defense and commercial satellites; the design, installation, and operation of business information and telecommunication systems; as well as the design, development, and manufacture of locomotives. Substantially all of the products in the automotive segment are marketed through retail dealers and through distributors and jobbers in the United States and Canada and through distributors and dealers overseas. At December 31, 1993, there were approximately 8,900 General Motors motor vehicle dealers in the United States, 1,100 in other North America (Canada and Mexico), and approximately 5,400 outlets overseas. Backlog of Orders Shipments of General Motors' automotive products are made as promptly as possible after receipt of firm sales orders; therefore, no significant backlog of unfilled orders accumulates. GM Hughes Electronics Corporation had a $13.4 billion and $14.0 billion backlog of defense and commercial contracts at the end of 1993 and 1992, respectively. I-1 GENERAL MOTORS CORPORATION AND SUBSIDIARIES Raw Materials and Services General Motors purchases materials, parts, supplies, freight transpor- tation, energy, and other services from numerous unaffiliated firms. Interruptions in production or delivery of these goods or services could adversely affect General Motors. Competitive Position General Motors' principal competitors in passenger cars and trucks in the United States and Canada include Ford Motor Company, Chrysler Corporation, Toyota Corporation, Nissan Motor Corporation, Ltd., Honda Motor Company, Ltd., Mazda Motor Corporation, Mitsubishi Motors Corporation, Isuzu Motors, Ltd., Fuji Heavy Industries, Ltd. (Subaru), Volkswagen A.G., Hyundai Motor Company, Ltd., Daimler-Benz A.G. (Mercedes), Bayerische Motoren Werke AG (BMW), and Volvo AB. All but Volkswagen, Daimler-Benz, and BMW currently operate vehicle manufacturing facilities in the United States or Canada although BMW and recently Mercedes have announced plans to build assembly plants in the United States. Toyota and GM operate the New United Motor Manufacturing, Inc. facility in Fremont, California as a joint venture which currently builds passenger cars and light-duty trucks. Worldwide wholesale unit sales of General Motors passenger cars and trucks during the three years ended December 31, 1993 are summarized in Management's Discussion and Analysis in Part II. Total industry new motor vehicle (passenger cars, trucks, and buses) registrations of domestic and foreign makes and General Motors' competitive position during the three years ended December 31, 1993 were as follows: 1993(1) 1992 1991 ------ ------ ------ (Units in Thousands) Total industry registrations In the United States. . . . . . . . . . . . . . 13,941 12,867 12,579 In other North America (2). . . . . . . . . . . 1,778 1,881 1,936 In other countries (3). . . . . . . . . . . . . 27,171 29,337 29,098 ------ ------ ------ Total industry registrations - all countries. . . 42,890 44,085 43,613 ====== ====== ====== 1993(1) 1992 1991 ------ ------ ------ (Percent of Total Industry) General Motors' registrations In the United States. . . . . . . . . . . . . . 33% 34% 35% In other North America (2). . . . . . . . . . . 27 27 28 In other countries (3). . . . . . . . . . . . . 10 10 8 Total General Motors' registrations - all countries . . . . . . . . . . . . . . . . . . . 18 18 17 (1) Preliminary (2) Includes Canada and Mexico. (3) Includes China and Eastern Europe. 1992 data were restated to include China and 1992 and 1991 data were restated to include Eastern Europe. The above information on registrations of new cars, trucks, and buses was obtained from outside sources and that pertaining to General Motors' registrations includes units which are manufactured overseas by other companies and which are imported and sold by General Motors and affiliates. I-2 GENERAL MOTORS CORPORATION AND SUBSIDIARIES Research and Development In 1993, General Motors spent $6,029.9 million for research, manufacturing engineering, product engineering, and development activities related primarily to the development of new products or services or the improvement of existing products or services, including activities related to vehicle emissions control, improved fuel economy, and the safety of persons using General Motors products. In addition, $1,340.3 million was spent for customer-sponsored activities, the majority of which were government related. Comparable data for 1992 were $5,916.9 million for company-sponsored activities and $1,185.5 million for customer-sponsored activities and for 1991, $5,887.4 million and $1,239.4 million, respectively. Environmental Matters Automotive Emissions Control Both the Federal and California governments currently impose stringent emission control requirements on motor vehicles sold in their respective jurisdictions. These requirements include pre-production testing of vehicles, testing of vehicles after assembly, the imposition of emission defect and performance warranties, and the obligation to recall and repair customer-owned vehicles determined to be non-compliant with emissions requirements. Both the U.S. Environmental Protection Agency (EPA) and the California Air Resources Board (CARB) continue to place great emphasis on compliance testing of customer-owned vehicles. Failure to comply with the emission standards or defective emission control hardware discovered during such testing can lead to substantial cost for General Motors related to emissions recalls. New CARB and Federal requirements will increase the time and mileage over which manufacturers are responsible for a vehicle's emission performance. Both the EPA and the CARB emission requirements will become even more stringent in the future. A new tier of exhaust emission standards for cars and trucks, the "Tier 1" standards began phasing in for California vehicles in the 1993 model year and for Federal vehicles in the 1994 model year. The phase-in of these "Tier 1" standards will be completed by the 1997 model year. In addition to the Tier 1 standards is the CARB Low Emission Vehicle (LEV) Program that begins with the 1994 model year and defines requirements through model year 2003 and beyond. This program sets even more stringent exhaust emission standards for cars and trucks. General Motors will have to meet the LEV Program requirements by marketing a mix of vehicles complying with the Tier 1 standards, Transitional Low Emission Vehicles (TLEV), Low Emission Vehicles (LEV), Ultra-Low Emission Vehicles (ULEV), or Zero Emission Vehicles (ZEV). From model years 1998 to 2000, 2% of cars and small light- duty trucks (up to 3,750 lb Loaded Vehicle Weight) must be ZEVs. This requirement increases to 5% in 2001 and 10% in 2003 and thereafter. The Clean Air Act permits states that have areas with air quality problems to adopt the California car and truck emission standards in lieu of the Federal requirements and two states (New York and Massachusetts) have done so. In addition, the Ozone Transport Commission, representing twelve Northeast states and the District of Columbia, have asked the EPA to impose the California LEV program requirements. This could mean that vehicles designed for the California LEV program, including ZEVs, would have to be offered for sale in that region of the country. I-3 GENERAL MOTORS CORPORATION AND SUBSIDIARIES In addition to the above-mentioned exhaust emission programs, onboard diagnostic (OBD) devices, far more complex than those currently used to diagnose problems with emission control systems, will be required both Federally and in California effective with the 1996 model year. This new system has the potential of increasing warranty costs and the chance for recall. New evaporative emission control requirements for cars and trucks begin phasing in with the 1995 model year in California and the 1996 model year Federally. Systems will need to be further modified to accommodate Federal onboard refueling vapor recovery (ORVR) control standards. ORVR phases in on passenger cars in the 1988 through 2000 model years and on light-duty trucks in the 2001 through 2006 model years. Industrial Environmental Control General Motors is subject to various laws relating to the protection of the environment, and is in various stages of investigation or remediation for sites where contamination has been alleged. GM has recorded an accrued liability of $659 million at December 31, 1993 and $519 million at December 31, 1992 for worldwide environmental cleanup as summarized below: . GM has been identified as a potentially responsible party at sites identified by the EPA and state regulatory agencies for cleanup under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and similar state statutes. GM voluntarily and actively participates in cleanup activity where such involvement is verified. The foreseeable total liability for 1994 and beyond for sites involving GM is estimated to be $231 million, which was recorded at December 31, 1993. This compares to $203 million at December 31, 1992. . For closed or closing plants owned by the Corporation, an estimated liability for environmental cleanup is typically recognized at the time the restructuring charge is made and is based on an environmental assessment of the plant property. The liability estimate includes amounts for actions which are not specifically required by regulations or government action but which serve to minimize future liability. Such liability is estimated at $187 million, which was recorded at December 31, 1993. This compares to $120 million at December 31, 1992. . GM is involved in cleanup actions at additional locations worldwide with a foreseeable minimum liability of approximately $241 million, which was recorded at December 31, 1993. This compares to $196 million at December 31, 1992. The U.S. Federal Resource Conservation and Recovery Act (RCRA) regulations require an owner/operator of hazardous waste management facilities to file annually with the EPA financial assurance to provide funds for closure and post-closure care of hazardous waste management facilities (HWMFs). As of December 31, 1993, GM had financial assurance to cover total closure, post- closure, and mandated liability coverage totaling $138.6 million ($127.6 million closure and post-closure costs and $11 million aggregated liability) for the HWMFs owned and/or operated by the Corporation. These costs will be incurred only when an HWMF is closed and only for the amount covered for the individual HWMF. The annual inflator used by the EPA is projected to be 2.73% for 1993 (this is applied to the closure and post-closure costs); therefore, the total financial guarantee to be filed in 1994 to cover the closure and post-closure cost amounts is estimated to be approximately $142.1 million. I-4 GENERAL MOTORS CORPORATION AND SUBSIDIARIES The RCRA regulations require an owner/operator of underground storage tanks (UST) to meet, between now and 1998, standards for release detection, tank performance, and spill/overfill control and to provide for remediation of contamination where necessary. The associated expenditure forecast for these activities is expected to be approximately $104 million to be spent over the next six years. Also, owner/operators of petroleum-containing USTs are required to demonstrate financial responsibility for corrective action and third-party compensation. The appropriate coverage level for 1994 will be $2.0 million in aggregate. Nuclear Regulatory Commission rules require the GM Technical Center Research Laboratories to demonstrate financial assurance for decommissioning certain licensed facilities in the amount of $154,815. The intent of this rule is to ensure that decommissioning will be accomplished in a safe and timely manner and that licensees will provide adequate funds to cover all costs associated with decommissioning. The capital cost impact of 1990 Clean Air Act Amendments on GM stationary sources will depend on the specific requirements of new state and Federal regulations which must be developed and implemented over the next 10 years. These regulations include operating permit programs, nitrogen oxide control programs, chloro-fluoro-carbon phase out, and hazardous air pollutant control programs. Estimated cost of these programs over the next 10-15 years is approximately $1 billion. Annual operating permit emission fees will be approximately $9 million with phase-in started in 1993 and expected to be fully effective in 1995. Expenditures by General Motors in the United States for industrial environmental control facilities during the three years ended December 31, 1993 were (in millions): 1993-$186; 1992-$150; and 1991-$130. The Corporation currently estimates that future expenditures for industrial environmental control facilities through 1997 will be (in millions): 1994- $171; 1995-$144; 1996-$174; and 1997-$83. Specific environmental expenses are difficult to isolate since expenditures may be made for more than one purpose, making precise classification difficult. Vehicular Noise Control The Federal Truck Regulation preempts all state/local noise regulations for trucks over 10,000 lb Gross Vehicle Weight Rating (GVWR). All jurisdictions regulating noise levels of school buses which are built on medium-duty truck chassis have adopted standards compatible with Federal regulations for medium-duty trucks. Passenger cars and light-duty trucks are subject to state and local motor vehicle noise regulations. The current standard for vehicles in these classes, 80 dB as measured at 50 feet, has been in effect since 1975. Since the end of 1991, manufacturers have the option of meeting the 80 dB light vehicle standard using the test protocol for vehicle exports as measured at 25 feet. While General Motors is well positioned for compliance with the 80 dB standard for light vehicles, future implementation of more stringent exhaust emission regulations and more stringent fuel economy regulations will require an assessment of increased costs of noise control. I-5 GENERAL MOTORS CORPORATION AND SUBSIDIARIES Automotive Safety Engineering Expenditures to maintain the operational safety, occupant protection, and vehicle theft deterrence capability of new GM models continue. These expenditures include amounts for the study of alternative approaches for meeting the needs of all three areas. A final rule allowing use of Daytime Running Lights (DRL) as an option was issued by the National Highway Traffic Safety Administration (NHSTA). As a result, GM has announced its intent to provide DRL starting in 1995 on selected models. It is believed that this feature will enhance the overall crash avoidance capability of GM vehicles thus reducing crashes and increasing product sales. GM is meeting the government requirement for passive restraints by selectively installing automatic lap/shoulder belts or driver supplemental inflatable restraints (air bags) on all passenger cars. The driver-side air bag concept has been approved for all remaining passenger cars, light-duty trucks, and vans during the 1994 through 1997 model years. Current plans call for a phase-in of the passenger-side air bag in these same cars from the 1994 through 1999 model years. A new government requirement for passenger car side impact protection was issued in 1990 affecting future model year cars. A phase-in of the new requirement began September 1, 1993. The NHTSA will propose that dynamic side impact protection requirements be extended to light-duty trucks and vans. If a final rule is promulgated, side structure and interior trim designs of future models will be affected. Regarding GM light-duty trucks and vans, a final rule required center high-mounted stop lamps by September 1, 1993. Also, head restraints are now required on all light-duty trucks and vans. A final rule covering roof crush resistance has also been issued by the NHTSA for light-duty trucks and vans that is more stringent than for passenger cars. This rule addresses vehicles with a GVWR less than or equal to 6,000 lb and will be effective September 1, 1994. A final rule has been issued by NHSTA that will extend the passenger car automatic restraint requirements to light-duty trucks and vans on a phased-in basis beginning September 1, 1994. Lastly, a final rule has been issued by NHSTA that will require air bags be the only means used to meet the automatic restraint requirements for passenger cars and light-duty trucks and vans on a phased-in basis beginning September 1, 1996. The NHTSA currently is considering the effects of fuel system crash integrity requirements of the Federal Motor Vehicle Safety Standard (FMVSS) (301). If any of the considerations ultimately are adopted as final rules, some undetermined redesign, cost, and weight increase could be expected for most of GM's vehicles. See Item 3, Legal Proceedings, Other Matters. I-6 GENERAL MOTORS CORPORATION AND SUBSIDIARIES With the passage of the Anti-Car Theft Act of 1992, implementation costs for the 1993 calendar year will affect approximately 22 passenger car assembly plants and 9 light-duty truck plants. For the affected truck plants, the major expenditures will be for new label printer installations and additional stamping equipment. Both passenger car and truck plants affected will probably require some extra tooling to accommodate full VIN-stamping on the frame of each vehicle and noise-pollution reduction facilities to alleviate noise associated with VIN-stamping operations. A bill has been recently introduced into Congress by Representative Danforth that changes the current Federal bumper impact requirement from 2.5 mph to 5 mph. The bill also calls for labeling that defines bumper performance. This bill may have an effect on future GM products that are designed to meet the existing FMVSS requirements. Additionally, performance labeling may cause additional testing that will lead to increased costs. Automotive Fuel Economy The Energy Policy and Conservation Act passed in 1975 provided for production-weighted average fuel economy standards for passenger cars for 1978 and thereafter. Based on EPA combined city-highway test data, the General Motors 1993 model year domestic passenger car fleet is projected to attain a Corporate Average Fuel Economy (CAFE) of 27.4 miles per gallon (mpg) versus the standard of 27.5 mpg. The CAFE estimate for 1994 model year passenger cars is projected at 27.4 mpg versus the standard of 27.5 mpg. The projected shortfalls for 1993 and 1994 will be offset by credits projected to be earned in future model years. Fuel economy standards for light-duty trucks became effective in 1979. General Motors' CAFE fleet average for the 1993 model year is 20.2 mpg versus the standard of 20.4 mpg. For the 1994 model year, GM's estimated fleet average CAFE is projected to be 19.9 mpg versus a standard of 20.5 mpg. The shortfall for 1993 will be offset by credits earned in 1991. The projected shortfall for 1994 will be partially offset by credits earned in 1991 and 1992. It is expected that the remaining shortfall will be offset by credits from future model years. However, the exact amount cannot be determined because standards have not been set beyond 1995. GM's ability to meet increased CAFE standards is contingent on various future economic, consumer, legislative, and regulatory factors that GM cannot control and cannot predict with certainty. If GM could not comply with any new CAFE standards, GM could be subject to sizable civil penalties and could have to close plants or severely restrict product offerings to remain in compliance. Seasonal Nature of Business In the automotive business, there are retail sales fluctuations of a seasonal nature, so that production varies from month to month. In addition, the changeover period related to the annual new model introduction has traditionally occurred in the third quarter of each year. For this reason, third quarter operating results are, in general, less favorable than those in the other three quarters of the year, depending on the magnitude of the changeover needed to commence production of new models incorporating, for example, design modifications related to more fuel-efficient vehicle packaging, stricter government standards for safety and emission controls, and consumer-oriented improvements in performance, comfort, convenience, and style. Segment Reporting Data Industry segment and geographic segment data for 1993, 1992, and 1991 are summarized in Note 17 of Notes to Financial Statements in Part II. ****** I-7 GENERAL MOTORS CORPORATION AND SUBSIDIARIES The Registrant makes no attempt herein to predict the future trend of its business and earnings or the effect thereon of the results of changes in general economic, industrial, regulatory, and international conditions. ITEM 2. ITEM 2. PROPERTIES The Corporation, excluding General Motors Acceptance Corporation, has 292 locations operating in 35 states and 158 cities in the United States. Of these, 25 are engaged in the final assembly of GM cars and trucks; 26 are service parts operations responsible for distribution or warehousing; 13 are associated with Electronic Data Systems Corporation as large information processing centers; 33 major plants, offices, and research facilities relate to the operations of Hughes Aircraft Company; and the remainder are offices or involved primarily in the testing of vehicles or the manufacture of automotive components and power products. In addition, the Corporation has 20 locations in Canada and assembly, manufacturing, distribution, or warehousing operations in 51 other countries, including equity interests in associated companies which conduct assembly, manufacturing, or distribution operations. The major facilities outside the United States and Canada, which are principally vehicle manufacturing and assembly operations, are located in Germany, the United Kingdom, Brazil, Mexico, Austria, Belgium, and Spain. Most facilities are owned by the Corporation or its subsidiaries. Leased properties consist primarily of warehouses and administration, engineering, and sales offices. The leases for warehouses generally provide for an initial period of five years and contain renewal options. Leases for sales offices are generally for shorter periods. Properties of the Registrant and its subsidiaries include facilities which, in the opinion of management, are suitable and adequate for the manufacture, assembly, and distribution of their products. Additional information regarding worldwide expenditures for plants and equipment is presented under Management's Discussion and Analysis in Part II. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Corporation is a party as of December 31, 1993 are summarized on the following pages. Reference should also be made to Note 19 of notes to financial statements in Part II. Environmental Matters On February 19, 1991, a complaint was filed in the Superior Court of Connecticut by the Connecticut Commissioner of Environmental Protection alleging that the plant in Bristol, Connecticut operated by GM's Delco Moraine NDH Division (now part of the Delco Chassis Division) had violated Connecticut's hazardous waste regulations in connection with its inspection, recordkeeping, and remediation of a spill of chromic acid at the plant site. The complaint seeks penalties of up to $25,000 per day for a period commencing sometime prior to April 1989 and running through November 1990. GM contends that its inspection, recordkeeping, and remediation practices in relation to the spill complied with applicable rules and regulations. * * On March 12, 1991, the Region II office of the Environmental Protection Agency (EPA) issued a Civil Administrative Complaint alleging that the plant operated by GM's Central Foundry Division (now part of the GM Powertrain Division) of the Corporation in Massena, New York had improperly disposed of polychlorinated biphenyl contaminated sludge during the period February 1984 through October 1987. The complaint seeks a fine of $14,176,000. GM believes that its disposal practices at Massena were in general compliance with applicable rules and regulations. * * I-8 GENERAL MOTORS CORPORATION AND SUBSIDIARIES On March 1, 1993, the U.S. EPA Region V issued a civil administrative complaint alleging that stormwater from the Chevrolet-Pontiac-GM of Canada Group's Pontiac Fiero plant in Pontiac, Michigan exceeded the facility's National Pollutant Discharge System Permit from May 1989 through May 1992. The EPA complaint, as amended, cites the Corporation for 94 exceedances of copper, lead, and zinc and is seeking $125,000 in penalties. There has been no production at the Fiero Plant since August 1988. The Corporation believes that the very low concentrations of metals found in the stormwater during the specified time period occurred as a result of acid rain dissolving metal from the gutters and roof. General Motors is contesting the allegations and has requested a hearing. * * On March 26, 1993, the Region V office of the EPA issued a Civil Administration Complaint against the Corporation alleging that 65 petroleum and hazardous substance underground storage tanks (USTs) which it has operated at its Technical Center in Warren, Michigan have been in violation of certain of the EPA UST regulations. The EPA has proposed a civil penalty of $267,447. Based upon its current evaluation of this matter, General Motors believes that the operations cited by the EPA's complaint have been and remain in substantial compliance with applicable UST regulations. * * In March 1993, the Michigan Department of National Resources (MDNR) notified the Corporation's Powertrain Division (PD) that MDNR was making a referral to the Michigan Attorney General for resolution of allegations by MDNR that a PD facility in Saginaw, Michigan had failed to conduct a timely environmental investigation to MDNR's satisfaction of a landfill and certain other areas at the facility's property, and that PD's on-site water recycling basins were improperly discharging contaminants to the groundwater and the Saginaw River. * * Other Matters U.S. Government contracts held by the Corporation and its subsidiaries are subject to termination by the U.S. Government either for its convenience or for default by the contractor. The costs recovered for terminations for convenience do not always fully reimburse the contractor, and the profit or fee received by the contractor may be lower than that which it had expected for the portion of the contract performed. In cases of termination for default, normal contract remedies generally apply. In addition, the U.S. Government has broad discretion to suspend or debar a contractor from engaging in new government business, including discretion as to the period of suspension and activities affected. A contractor may be debarred based on a conviction or civil judgment involving certain offenses, including fraud in connection with obtaining or performing a public contract, or subcontract thereunder, and may be suspended if indicted for such an offense or if there is other adequate evidence that such an offense has been committed. Like other government contractors, GM and its subsidiaries are subject to civil audits and criminal investigations relating to their contracting activity. * * Hughes is cooperating with Federal authorities conducting a grand jury investigation in Boston, Massachusetts relating to the circumstances behind the delivery and the quality of certain components of two missile guidance systems. Hughes has been advised that it is a target of the investigation. Hughes has conducted its own review of the matter. * * I-9 GENERAL MOTORS CORPORATION AND SUBSIDIARIES In September 1973, Hughes filed suit against the U.S. Government in the U.S. Court of Claims seeking reasonable and entire compensation for the unauthorized manufacture or use by the United States of the invention claimed in a Hughes patent (the "Williams Patent") covering "Velocity Control and Orientation of a Spin Stabilized Body," principally satellites. In late 1983, the United States Court of Appeals for the Federal Circuit (the U.S. Court with appellate jurisdiction for patent cases) ruled that the Williams Patent was valid and that the Government had infringed that patent. The compensation which Hughes is entitled to recover as a result of the Government's infringement is now being determined by the U.S. Court of Claims, as well as whether additional U.S. Government satellites also infringe. The trial concluded in December 1988. Subsequently, both Hughes and the Government sought and obtained discovery and additional court hearings on various issues. At the latest hearing, which concluded January 24, 1991, Hughes introduced evidence that additional satellites should be added to the royalty base. Hughes contends that its recovery should be calculated in accordance with either of two methods for computing delay compensation and introduced evidence to support an award of approximately $4.8 billion or $1.5 billion depending upon the methods used. The Government sought to demonstrate to the Court that any damages awarded to Hughes in this case should not exceed $20-30 million. Based upon the advice of counsel, Hughes believes that its recovery will be substantially in excess of that amount; however, Hughes is not able to predict what the ultimate recovery will actually be. In August 1993, the Court determined that approximately $4 billion in satellite purchases infringed the patent. The Court must still determine an appropriate royalty rate and "delay compensation" to apply for the infringing sales. The Court has indicated that a decision on these remaining issues may be expected sometime in 1994. It is anticipated that thereafter the Government will endeavor to exhaust all possible appeal rights while Hughes will resist such efforts and seek to recover the judgment as promptly as possible. It is not possible to reasonably estimate when the decision will actually be rendered or the duration of the Government's appeal efforts. * * On January 9, 1992, Electronic Data Systems Corporation, a wholly owned subsidiary of General Motors Corporation, filed a lawsuit against Computer Associates International, Inc. ("Computer Associates"), in the United States District Court for the Northern District of Texas, alleging principally breach of contract, breach of the duty of good faith and fair dealing, misuse of copyright, fraud, interference with business relations, and violations of anti- trust laws. EDS is requesting unspecified damages and injunctive relief. On January 29, 1992, Computer Associates filed its answer, denying the claims of EDS and seeking dismissal of certain claims. On that date, Computer Associates filed counterclaims alleging principally breach of contract, breach of the duty of good faith and fair dealing, copyright infringement, fraud, interference with business relations, and misappropriation of trade secrets. Under various counts, Computer Associates is asserting separate compensatory damage claims which individually range from $100 million to $1.3 billion, and separate exemplary damage claims which individually range from $200 million to $1.3 billion and injunctive relief. In addition, on January 29, 1992, Computer Associates filed a separate lawsuit against General Motors in New York Supreme Court, Nassau County, alleging breach of contract and breach of the duty of good faith and fair dealing based on essentially the same factual allegations, and claiming damages of not less than $250 million on each of the two counts. EDS believes the amount of damages asserted in the claims against General Motors are duplicative of and included within Computer Associates' counterclaim against EDS. On May 6, 1992, the court granted General Motors I-10 GENERAL MOTORS CORPORATION AND SUBSIDIARIES motion to dismiss the action on procedural grounds. On October 9, 1992, Computer Associates, and two of its wholly owned subsidiaries, On-Line Software International, Inc. and Pansophic Systems, Inc., filed a lawsuit against General Motors and EDS in New York Supreme Court, Suffolk County, seeking a declaratory judgment as to their ongoing rights and obligations with respect to General Motors and EDS under two computer software licensing agreements. On January 29, 1993, Computer Associates filed a stipulation discontinuing the suit against General Motors. In the continuing suit against EDS, the action was removed to the Federal Court for the Eastern District of New York where it was dismissed. Management of EDS believes that EDS has strong and meritorious defenses to the claims asserted by Computer Associates. EDS intends to vigorously defend against such claims and EDS intends to press for the relief sought in the claims asserted by EDS against Computer Associates. * * On August 21, 1992, EDS filed a breach of contract suit against the State of Florida (the "State") in the Circuit Court of the Second Judicial Circuit in Leon County, Florida, seeking recovery under various counts of more than $46 million in payment for unpaid computer equipment and information technology services. The suit arises out of a 1989 contract entered into between EDS and the Department of Health and Rehabilitative Services ("DHRS") of the State of Florida under which EDS had agreed to provide an information management system to the DHRS that would integrate its offices and computer programs statewide. EDS completed the system and turned it over to the Department in May 1992. On September 21, 1993, the State filed an Answer and Counterclaims, alleging principally breach of contract and breach of warranty. Under various counts, the State is requesting approximately $90 million in damages and approximately $140 million in indemnification for potential liability of the State to the Federal government. On October 13, 1993, the Court granted EDS summary judgment on one of the computer equipment counts, awarding EDS $17.5 million. However, on December 10, 1993, the Florida First District Court of Appeals reversed that award and dismissed EDS' action and the State's counterclaims on the grounds that EDS should have pursued remedies under the dispute resolution clause in its contract with the State. EDS has filed its claims with the DHRS contracting officer. EDS management believes that it has strong and meritorious defenses to any counterclaims which the State may have and intends to defend itself vigorously while continuing to pursue recovery against the State under the claims which it has filed. * * On August 7, 1992, Jerome Lemelson filed a patent infringement suit in the U.S. District Court, District of Nevada, against General Motors Corporation, Ford Motor Company (Ford) and Chrysler Corporation (Chrysler). The patents in suit are alleged by Lemelson to cover bar coding techniques employed by the respective defendants. In response, each of the defendants has denied infringement, and General Motors and Chrysler have counterclaimed to have these Lemelson patents held invalid (Ford is seeking to have such patents declared invalid in a separate action). On August 31, 1992, GM filed suit against Lemelson in the same court seeking a judgment that selected Lemelson patents alleged by him to cover certain machine vision applications are invalid and not infringed by General Motors. In response, on September 30, 1992, Lemelson filed a counterclaim charging GM with infringement of not only the patents sued on by GM, but also other Lemelson patents alleged by him to cover further machine vision applications, certain semi-conductor devices, and the use of lasers in manufacturing. General Motors has denied infringement of these additional Lemelson patents and has counterclaimed to have such patents declared invalid. In each of the above-described lawsuits, Lemelson is I-11 GENERAL MOTORS CORPORATION AND SUBSIDIARIES seeking an injunction and an unspecified amount of damages. Based upon representations by Lemelson's counsel, the aggregate damages sought by Lemelson may be material to GM. In the opinion of its counsel, GM's position is meritorious in each of these litigations. GM has entered into a "standstill" agreement with Lemelson pursuant to which dismissal without prejudice of the Lemelson action against GM is now pending before the court. Upon resolution of the Lemelson litigation against Ford and Chrysler, Lemelson may reinstitute his suit against General Motors in a separate action. If either Ford or Chrysler ultimately settle, the standstill agreement provides that GM may settle with Lemelson on a proportionate basis. * * Several actions seeking compensatory and punitive damages in unspecified amounts have been filed against Hughes Aircraft Company (Hughes) by plaintiffs alleging that they suffered injuries as a result of the migration into the Tucson, Arizona water supply of toxic substances that were disposed of at a facility owned by the United States Government which Hughes operates under a contract with the U.S. Air Force. These actions include a class action filed in Arizona State Court, BAHRS, ET AL. V. HUGHES AIRCRAFT COMPANY, ET AL. (Super. Ct. Pima County), an individual action filed on behalf of approximately 500 plaintiffs in Federal District Court in ARIZONA, ACEVEDO, ET AL. V. HUGHES AIRCRAFT COMPANY, and a class action filed in Federal District Court in Arizona, LANIER V. HUGHES AIRCRAFT COMPANY. Other governmental and private entities are known to have also been the source of toxic substances which may have migrated into the Tucson water supply. Hughes believes that it has strong defenses to the claims asserted against it and that it may have claims for contribution against the other entities. The facts alleged in these cases are similar to the facts alleged in the previously reported action entitled VALENZUELA V. HUGHES AIRCRAFT COMPANY. As previously reported, the VALENZUELA action was settled pursuant to an agreement under which Hughes' principal insurers provided $70.7 million and Hughes provided $13.8 million. At the time of such settlement, Hughes and its insurers were litigating in the United States District Court in Arizona their respective ultimate liability to one another for the amounts paid in the VALENZUELA settlement. This litigation, entitled SMITH, ET AL. V. HUGHES AIRCRAFT COMPANY, was commenced in 1988 by various insurers seeking a declaratory judgment that the VALENZUELA claims are not covered under the terms of the insurance policies issued to Hughes. These insurers have taken a similar position with respect to the more recently filed actions. In September 1991, the SMITH court entered summary judgment in favor of Hughes' insurers who issued policies from 1971 to 1985, based upon "pollution exclusions" contained in those policies. In September 1992, the SMITH court entered summary judgment in favor of Hughes' pre-1971 insurers based upon findings and conclusions that could have been adverse to Hughes with respect to other claims and proceedings. Hughes appealed these rulings to the Ninth Circuit Court of Appeals. In November 1993, the Ninth Circuit affirmed in substantial part the District Court's summary judgment on the "pollution exclusion" policies, but reversed the District Court's summary judgment on pre- 1971 policies. The Ninth Circuit remanded the case for further proceedings in the District Court. On January 10, 1994, Hughes and the carriers each filed petitions for rehearing with the Ninth Circuit. Contracts under which Hughes has operated the Air Force facility contain provisions under which indemnification from the Air Force may be provided for certain liabilities which Hughes may incur in connection with its operation of the facility to the extent such liabilities are not covered by insurance. Hughes intends to prosecute all appropriate claims it may have for insurance coverage and, if necessary, to pursue all appropriate claims for indemnif- ication or contribution relating to the actions described above. * * I-12 GENERAL MOTORS CORPORATION AND SUBSIDIARIES In December 1992, the National Highway Traffic Safety Administration (NHTSA), granting a petition previously filed by the Center for Auto Safety and Public Citizen, opened an investigation to determine whether 1973-1987 model Chevrolet and GMC full-size pickup trucks contain a safety defect resulting in an unreasonably high incidence of fuel-fed fires in side impact collisions. NHTSA emphasized then and has repeated that granting the petition does not indicate that the agency has determined that a safety-related defect exists in these vehicles. On April 9, 1993, NHTSA made an informal request of GM that it voluntarily conduct a safety-related recall campaign on the vehicles. Although in its April 9, 1993 letter, NHTSA stated that its Office of Defects Investigation "believes that GM's fuel tank system in the subject vehicles contains a defect that relates to motor vehicle safety, " it nevertheless stated that "this recommendation to conduct a safety recall does not reflect a formal conclusion by the agency, ... should not be confused with an Initial or Final Determination of a safety defect pursuant to ... the National Traffic and Motor Vehicle Safety Act, ... (and) should (not) be confused with a recall order ..." A recall order can only be issued by the agency if it makes a Final Determination (which it has not done in this case) that a defect exists which presents an unreasonable risk to motor vehicle safety. On April 30, 1993, in a written response to NHTSA's letter of April 9, 1993, General Motors stated that based upon its evaluation of the data which NHTSA had then made available to GM as having been the basis for requesting the voluntary recall in its letter, General Motors continued to believe that its 1973-1987 pickup trucks are neither defective nor present an unreasonable risk, and that consequently no safety recall of such trucks is warranted. General Motors remains strongly of this view, and intends to press its position vigorously while continuing to cooperate with NHTSA's investigative efforts. There are also pending individual product liability claims and lawsuits involving allegations of defects in the design of such vehicles resulting in fuel-fed fires following side impact collisions. GM intends to defend these cases vigorously. In addition to the NHTSA investigation and the product liability cases, 38 class actions were filed in state and Federal courts against the Corporation, claiming that 1973-1987 model Chevrolet and GMC full-size pickup trucks are defective because their fuel tanks are mounted below the cab and outside the frame rails. 24 Federal court class actions were transferred to the Federal court in Philadelphia, Pennsylvania by the Judicial Panel on Multidistrict Litigation. In these actions, plaintiffs claimed that the fuel tank locations make the vehicles unreasonably susceptible to fuel-fed fires following side impact collisions. Plaintiffs alleged breach of contract and warranty, negligence, fraud, and negligent misrepresentation, as well as violation of various state consumer protection laws. The lawsuits seek compensatory and punitive damages and injunctions requiring notice to owners, repairs, retrofitting, and "disgorgement" of revenues. In July 1993, a nationwide class action settlement of the C/K pickup truck class actions was submitted to the Pennsylvania Federal court and a state court in Texas. After notice of the proposed settlement was sent to 6.3 million registered owners, the Pennsylvania and Texas courts held hearings to determine if the settlement was fair, reasonable and adequate. Both courts subsequently entered orders giving final approval of the settlement. Certain objectors have filed appeals of those approvals in the U.S. Third Circuit Court of Appeals and a Texas state Court of Appeals. Those appeals are pending. I-13 GENERAL MOTORS CORPORATION AND SUBSIDIARIES Additionally, on October 14, 1993, CROWDER, ET AL V. GENERAL MOTORS CORPORATION was filed as a purported class action in the Federal court in Dallas, Texas on behalf of owners of full-size pickup trucks and chassis cabs covered by the class action settlements who elected to be excluded from the settlements or purchased their trucks used after July 19, 1993. The allegations are essentially the same as those made in the other class actions. No determination has been made that the case may proceed as a class action. GM intends to vigorously defend the case and oppose certification of a class. The settlement provides for owners of 1973-1986 model C/K and 1987-1991 R/V pickup trucks and chassis cabs as of July 19, 1993, the date the settlement was announced, to receive $1,000 Certificates from General Motors which may be used in connection with the purchase of any new GMC Truck or Chevrolet light-duty truck. The Certificates can be used in combination with other GM and GMAC incentive programs during the 15-month period after eligible owners are notified of the procedures for obtaining their Certificates. The Certificates are redeemable by the eligible owner or immediate family members residing at the same address. Within the original redemption period, Certificates also can be transferred at face value with the truck. Original Certificate holders also can elect to exchange the $1,000 Certificate for a non-transferable $500 Certificate issuable in the name of another person, such certificate being redeemable only toward the purchase of a new C/K pickup truck, and not being usable in combination with other incentives offered by GM or GMAC. Both the $1,000 and $500 Certificates can only be used at authorized Chevrolet and GMC Truck dealers and cannot be redeemed for cash or any other consideration. The Corporation believes that the settlement will not have a material adverse impact on its operations or financial condition. * * ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable (N/A). * * * I-14 GENERAL MOTORS CORPORATION PART II AND SUBSIDIARIES CROSS REFERENCE SHEET 10-K Item Page (and caption) in Part II -------------------------------------- ---------------------------------- 5. Market for Registrant's Common Equity and Related Stockholder Matters (a) Market information.............. II-46 - Selected Quarterly Data (b) Approximate number of holders of common stocks................ II-48 - Selected Quarterly Data (c) Dividends (1) History................... II-46 - Selected Quarterly Data (2) Policy.................... II-23 - Dividends on Common Stocks 6. Selected Financial Data............... II-49 - Selected Financial Data 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....................... II-52 - Management's Discussion and Analysis 8. Financial Statements and Supplementary Data................................ II-2 - Responsibilities for Consolidated Financial Statements II-3 - Independent Auditors' Report II-4 - Statement of Consolidated Operations for the Years Ended December 31, 1993, l992, and l991 II-6 - Consolidated Balance Sheet, December 31, 1993 and 1992 II-8 - Statement of Consolidated Cash Flows for the Years Ended December 3l, 1993, 1992, and 1991 II-10 - Notes to Financial Statements II-44 - Selected Quarterly Data 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure................ None II-1 GENERAL MOTORS CORPORATION AND SUBSIDIARIES RESPONSIBILITIES FOR CONSOLIDATED FINANCIAL STATEMENTS The following consolidated financial statements of General Motors Corporation and subsidiaries were prepared by management which is responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles and, as such, include amounts based on judgments of management. Financial information elsewhere in Part II is consistent with that in the consolidated financial statements. Management is further responsible for maintaining a system of internal accounting controls, designed to provide reasonable assurance that the books and records reflect the transactions of the companies and that its established policies and procedures are carefully followed. From a stockholder's point of view, perhaps the most important feature in the system of control is that it is continually reviewed for its effectiveness and is augmented by written policies and guidelines, the careful selection and training of qualified personnel, and a strong program of internal audit. Deloitte & Touche, an independent auditing firm, is engaged to audit the consolidated financial statements of General Motors Corporation and its subsidiaries and issue reports thereon. The audit is conducted in accordance with generally accepted auditing standards which comprehend a review of internal accounting controls and a test of transactions. The Independent Auditors' Report appears on the next page. The Board of Directors, through the Audit Committee (composed entirely of non-employee Directors), is responsible for assuring that management fulfills its responsibilities in the preparation of the consolidated financial statements. The Committee selects the independent auditors annually in advance of the Annual Meeting of Stockholders and submits the selection for ratification at the Meeting. In addition, the Committee reviews the scope of the audits and the accounting principles being applied in financial reporting. The independent auditors, representatives of management, and the internal auditors meet regularly (separately and jointly) with the Committee to review the activities of each, to ensure that each is properly discharging its responsibilities, and to assess the effectiveness of the system of internal accounting controls. It is management's conclusion that the system of internal accounting controls at December 31, 1993 provides reasonable assurance that the books and records reflect the transactions of the companies and that its established policies and procedures are complied with. To ensure complete independence, Deloitte & Touche has full and free access to meet with the Committee, without management representatives present, to discuss the results of the audit, the adequacy of internal accounting controls, and the quality of the financial reporting. s/John F. Smith, Jr. s/G. Richard Wagoner, Jr. John F. Smith, Jr. G. Richard Wagoner, Jr. Chief Executive Officer Chief Financial Officer and President II-2 GENERAL MOTORS CORPORATION AND SUBSIDIARIES INDEPENDENT AUDITORS' REPORT General Motors Corporation, its Directors, and Stockholders: We have audited the Consolidated Balance Sheets of General Motors Corporation and subsidiaries as of December 31, 1993 and 1992 and the related Statements of Consolidated Operations 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 at Item 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. All Financial Statements See Part II 2. Financial Statement Schedules Page No. -------- General Motors Corporation and Subsidiaries ------------------------------------------- Independent Auditors' Report.................................... II-3 Schedule V-Property for the Years Ended December 31, 1993, 1992, and 1991................................................ IV-5 Schedule VI-Accumulated Depreciation of Real Estate, Plants, and Equipment for the Years Ended December 31, 1993, 1992, and 1991...................................................... IV-7 Schedule VIII-Allowances for the Years Ended December 31, 1993, 1992, and 1991.......................................... IV-8 Schedule X-Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992, and 1991............. IV-9 Financial Statements and Financial Statement Schedules Omitted -------------------------------------------------------------- Financial statements of associates are omitted because the conditions requiring such filing, as stated in paragraph (a) of Rule 3-09 of Regulation S-X, have not been met. Other financial statements and financial statement schedules are omitted (1) because of the absence of the conditions under which they are required or (2) because the information called for is shown in the financial statements and notes thereto. 3. Exhibits (Including Those Incorporated by Reference). Exhibit No. Page No. - ----------- --------- (3)(a) Restated Certificate of Incorporation as amended to November 2, 1992, incorporated by reference to the Form SE of General Motors Corporation dated March 22, 1993, and Amendment to Article Fourth of the Certificate of Incorporation - Division III - Preference Stock, by reason of the Certificates of Designations filed with the Secretary of State of the State of Delaware on September 14, 1987 and the Certificate of Decrease filed with the Secretary of State of the State of Delaware on September 29, 1987 (pertaining to the six series of Preference Stock contributed to the General Motors pension trusts), incorporated by reference to Exhibit 19 to the Quarterly Report on Form 10-Q of General Motors Corporation for the quarter ended June 30, 1990 in the Form SE of General Motors Corporation dated August 6, 1990; as further amended by the Certificate of Designations filed with the Secretary of State of the State of Delaware on June 28, 1991 (pertaining to Series A Conversion Preference Stock), incorporated by reference to Exhibit 4(a) to Form S-8 Registration Statement No. 33- 43744 in the Form SE of General Motors Corporation dated November 1, 1991; as further amended by the Certificate of Designations filed with the Secretary of State of the State of Delaware on December 9, 1991 IV-1 GENERAL MOTORS CORPORATION AND SUBSIDIARIES (pertaining to Series B 9-1/8% Preference Stock), incorporated by reference to Exhibit 4(a) to Form S-3 Registration Statement No. 33- 45216 in the Form SE of General Motors Corporation dated January 27, 1992; as further amended by the Certificate of Designations filed with the Secretary of State of the State of Delaware on February 14, 1992 (pertaining to Series C Convertible Preference Stock), incorporated by reference to Exhibit (3)(a) to the Annual Report on Form 10-K of General Motors Corporation for the year ended December 31, 1991 in the Form SE of General Motors Corporation dated March 20, 1992; as further amended by the Certificate of Designations filed with the Secretary of State of the State of Delaware on July 15, 1992 (pertaining to Series D 7.92% Preference Stock), incorporated by reference to Exhibit 3(a)(2) to the Quarterly Report on Form 10-Q of General Motors Corporation for the quarter ended June 30, 1992 in the Form SE of General Motors Corporation dated August 10, 1992; and as further amended by the Certificate of Designations filed with the Secretary of State of the State of Delaware on December 15, 1992 (pertaining to Series G 9.12% Preference Stock), incorporated by reference to Exhibit 4(a) to Form S-3 Registration Statement No. 33-49309 in the Form SE of General Motors Corporation dated January 25, 1993 N/A (b) By-Laws as amended to December 6, 1993, incorporated by reference to Exhibit 3(ii) to the Current Report on Form 8-K of General Motors Corporation dated December 6, 1993 . . . . N/A (4)(a) Form of Indenture relating to the $500,000,000 8-1/8% Debentures Due April 15, 2016 dated as of April 1, 1986 between General Motors Corporation and Citibank, N.A., Trustee, incorporated by reference to Exhibit 4 to Amendment No. 1 to Form S-3 Registration Statement No. 33-4452 and resolutions adopted by the Special Committee on April 15, 1986, incorporated by reference to Exhibit 4(a) to the Current Report on Form 8-K of General Motors Corporation dated April 24, 1986. . . . . . . N/A (b) Form of Indenture relating to the $700,000,000 9-5/8% Notes Due December 1, 2000 and the $1,400,000,000 Medium-Term Note Program dated as of November 15, 1990 between General Motors Corporation and Citibank, N.A., Trustee, incorporated by reference to Exhibit 4(a) to Form S-3 Registration Statement No. 33-37737 . . . . . . . . N/A (c) Instruments defining the rights of holders of nonregistered debt of the Registrant have been omitted from this exhibit index because the amount of debt authorized under any such instrument does not exceed 10% of the total assets of the Registrant and its subsidiaries. The Registrant agrees to furnish a copy of any such instrument to the Commission upon request . . . . . N/A (10)(a) The General Motors Hourly-Rate Employes Pension Plan, incorporated by reference to Exhibit 19(b) to the Quarterly Report on Form 10-Q of General Motors Corporation for the quarter ended June 30, 1988 in the Form SE of General Motors Corporation dated August 8, 1988 . . . . . . . . . . . . . . . . . . . . . . . N/A IV-2 GENERAL MOTORS CORPORATION AND SUBSIDIARIES (b) General Motors Retirement Program for Salaried Employes, incorporated by reference to Exhibit 19(c) to the Quarterly Report on Form 10-Q of General Motors Corporation for the quarter ended June 30, 1985 in the Form SE of General Motors Corporation filed August 5, 1985 and Amendments to this Program incorporated by reference to Exhibit 19(c) to the Quarterly Report on Form 10-Q of General Motors Corporation for the quarter ended June 30, 1988 in the Form SE of General Motors Corporation dated August 8, 1988 . . . . . . . . . . . . . N/A (c)*General Motors Amended 1987 Stock Incentive Plan, incorporated by reference to Exhibit A to the Proxy Statement of General Motors Corporation dated April 13, 1992 . . . . . . . . . . . . . . . . . . . . . . N/A (d)*General Motors Performance Achievement Plan, incorporated by reference to Exhibit A to the Proxy Statement of General Motors Corporation dated April 16, 1982. . . . . . N/A (e)*General Motors 1987 Performance Achievement Plan, incorporated by reference to Exhibit A to the Proxy Statement of General Motors Corporation dated April 17, 1987 . . . . . . . . . . . . . . . . . . . . . . N/A (f)*General Motors 1992 Performance Achievement Plan, incorporated by reference to Exhibit A to the Proxy Statement of General Motors Corporation dated April 13, 1992 . . . . . . . . . . . . . . . . . . . . . . N/A (11) Computation of Earnings (Loss) Per Share Attributable to Common Stocks for the Three Years Ended December 31, 1993. IV-13 (12) Computation of Ratios of Earnings to Fixed Charges for the Three Years Ended December 31, 1993. . . . . . . . . . IV-16 (21) Subsidiaries of the Registrant as of December 31, 1993. . . . IV-17 (23) Consents of Independent Auditors. . . . . . . . . . . . . . . IV-24 and IV-26 (99)(a) Electronic Data Systems Corporation and Subsidiaries Consolidated Financial Statements and Management's Discussion and Analysis. . . . . . . . . . . . . . . . . . IV-25 (b) GM Hughes Electronics Corporation and Subsidiaries Consolidated Financial Statements and Management's Discussion and Analysis. . . . . . . . . . . . . . . . . . IV-52 (c) Class H stock agreement between Howard Hughes Medical Institute and General Motors Corporation, incorporated by reference to the Form SE of General Motors Corporation dated March 7, 1989. . . . . . . . . . . . . . . . . . . . N/A *Required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. (b) Reports on Form 8-K One report on Form 8-K, dated November 16, 1993, was filed during the quarter ended December 31, 1993 reporting matters under Item 5, Other Events. IV-3 GENERAL MOTORS CORPORATION AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES IV-4 IV-5 IV-6 IV-7 IV-8 GENERAL MOTORS CORPORATION SCHEDULE X-SUPPLEMENTARY AND SUBSIDIARIES OPERATING STATEMENT INFORMATION Charged principally to costs and Item expenses ---- ------------------------------ Years Ended December 31, ------------------------------ 1993 1992 1991 -------- -------- -------- (Dollars in Millions) Maintenance and repairs (including the cost of replacements of special tools for reasons other than changes in products) . . $5,731.2 $5,599.9 $5,777.5 ======== ======== ======== Taxes, other than payroll and United States, foreign, and other income taxes United States and foreign excise taxes. . $271.6 $229.7 $142.9 State and local "ad valorem" taxes and other state and local taxes . . . . . . 798.5 635.5 772.8 -------- -------- -------- Total . . . . . . . . . . . . . . . . $1,070.1 $865.2 $915.7 ======== ======== ======== Advertising costs . . . . . . . . . . . . . . $2,547.1 $2,414.1 $2,323.1 ======== ======== ======== IV-9 GENERAL MOTORS CORPORATION SIGNATURES AND SUBSIDIARIES 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. GENERAL MOTORS CORPORATION -------------------------- (Registrant) Date: March 7, 1994 By s/John F. Smith, Jr. ---------------------------- (John F. Smith, Jr. Chief Executive Officer, President and Director) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on this 7th day of March 1994 by the following persons on behalf of the Registrant and in the capacities indicated. Signature Title --------- ----- s/John G. Smale Chairman of the Board of Directors - ------------------------------ (John G. Smale) s/John F. Smith, Jr. Chief Executive Officer, President - ------------------------------ (John F. Smith, Jr.) and Director s/William E. Hoglund Executive Vice President - ------------------------------ (William E. Hoglund) and Director s/G. Richard Wagoner, Jr. Executive Vice President ) - ------------------------------ (G. Richard Wagoner, Jr.) and Chief Financial ) Officer ) )Principal s/Leon J. Krain Vice President and )Financial - ------------------------------ (Leon J. Krain) Group Executive )Officers ) s/Heidi Kunz Vice President and ) - ------------------------------ (Heidi Kunz) Treasurer ) s/Wallace W. Creek Comptroller )Principal - ------------------------------ (Wallace W. Creek) )Accounting )Officers s/David J. FitzPatrick Chief Accounting Officer ) - ------------------------------ (David J. FitzPatrick) IV-10 GENERAL MOTORS CORPORATION AND SUBSIDIARIES s/Anne L. Armstrong Director - -------------------------------- (Anne L. Armstrong) s/John H. Bryan Director - --------------------------------- (John H. Bryan) s/Thomas E. Everhart Director - -------------------------------- (Thomas E. Everhart) s/Charles T. Fisher, III Director - -------------------------------- (Charles T. Fisher, III) s/J. Willard Marriott, Jr. Director - -------------------------------- (J. Willard Marriott, Jr.) s/Ann D. McLaughlin Director - -------------------------------- (Ann D. McLaughlin) s/Paul H. O'Neill Director - -------------------------------- (Paul H. O'Neill) s/Edmund T. Pratt, Jr. Director - -------------------------------- (Edmund T. Pratt, Jr.) s/Louis W. Sullivan Director - -------------------------------- (Louis W. Sullivan) s/Dennis Weatherstone Director - -------------------------------- (Dennis Weatherstone) s/Thomas H. Wyman Director - -------------------------------- (Thomas H. Wyman) IV-11 GENERAL MOTORS CORPORATION AND SUBSIDIARIES EXHIBITS IV-12

313749_1993.txt

313749_1993

1993

313749

ITEM 1. BUSINESS - ----------------- INTRODUCTION Santa Anita Realty Enterprises, Inc. ("Realty") and Santa Anita Operating Company ("Operating Company") are two separate companies, the stocks of which trade as a single unit under a stock-pairing arrangement on the New York Stock Exchange. Realty and Operating Company were each incorporated in 1979 and are the successors of a corporation originally organized in 1934 to conduct thoroughbred horse racing in Southern California. As used herein, the terms "Realty" and "Operating Company" include wholly owned subsidiaries of Realty and Operating Company, respectively, unless the context requires otherwise. This document constitutes the annual report on Form 10-K for both Realty and Operating Company. REALTY Realty is incorporated under the laws of the State of Delaware. Realty's principal executive offices are located at 363 San Miguel Drive, Suite 100, Newport Beach, California 92660-7805. Realty operates as a real estate investment trust ("REIT") under the provisions of the Internal Revenue Code of 1986 (the "Code"). As such, Realty is principally engaged in investing in and holding real property, including Santa Anita Racetrack, 622,000 square feet of industrial space, the real estate underlying the Santa Anita Fashion Park shopping center ("Fashion Park"), a 50 percent interest in the operation of Fashion Park and a 32.5 percent interest in Towson Town Center (major regional shopping centers), and a number of neighborhood shopping centers and office buildings. Until February 18, 1994, Realty also owned 2,654 apartment units and an additional 185,000 square feet of industrial space. Realty is a self-administered equity REIT. PACIFIC GULF PROPERTIES INC. In June 1993, Realty's Board of Directors approved management's recommendation to recapitalize certain assets of Realty. Pursuant to this recapitalization, in November 1993, Realty entered into a Purchase and Sale Agreement to sell its multifamily and industrial operations to Pacific Gulf Properties Inc. ("Pacific"), in conjunction with Pacific's proposed public offering of common stock. The transaction was structured into two parts: (1) Realty would sell all of its apartments and industrial properties to Pacific with the exception of Realty's interest in the Baldwin Industrial Park joint venture; and (2) Pacific would enter into a binding agreement to buy Realty's interest in Baldwin Industrial Park. On February 18, 1994, Realty completed the first part of this transaction by selling to Pacific ten multifamily properties, containing 2,654 apartment units, located in Southern California, the Pacific Northwest, and Texas and three industrial properties, containing an aggregate of 185,000 leasable square feet of industrial space, located in the State of Washington (the "Transferred Properties"). Realty's corporate headquarters building and related assets were also acquired by Pacific. The sale of the Transferred Properties followed the public offerings of common stock and convertible subordinated debentures by Pacific. Pursuant to the Purchase and Sale Agreement, Pacific agreed to buy Realty's interest in Baldwin Industrial Park subject to satisfaction of certain conditions, for a minimum price of $8.9 million payable in additional shares of Pacific common stock, with the final price dependent upon completion of negotiations with other owners of Baldwin Industrial Park and an appraisal process. Management believes the sale of Realty's interest in Baldwin Industrial Park will be completed in the second half of 1994. Pacific is required to issue to Realty non-refundable letters of credit totaling up to $2.5 million by March 31, 1994 to secure its obligation to ITEM 1. BUSINESS (CONTINUED) - ---------------- acquire Realty's interest in Baldwin Industrial Park and pay for the corporate headquarters building and other assets related to the Transferred Properties. In consideration of the sale of the Transferred Properties, Realty received approximately $44.4 million in cash and 149,900 shares of the common stock of Pacific. In addition, Realty was relieved of approximately $44.3 million of mortgage debt on the Transferred Properties. Realty will also receive, at the time the acquisition of Baldwin Industrial Park is completed, up to $1.2 million in additional common stock of Pacific as consideration for its corporate headquarters and other net assets related to the Transferred Properties. The two parts of the above transaction will result in a loss of $10,974,000. This loss has been reflected in the Realty and Realty and Operating Company combined statements of operations for the year ended December 31, 1993. If the Baldwin Industrial Park portion of the transaction described above does not occur, an additional loss of approximately $5,900,000 will be recognized by Realty in 1994. (See "Notes to Financial Statements - Note 2 - Disposition of Multifamily and Industrial Properties Subsequent to Year End.") In connection with the sale, the executive officers, various managers and most other employees of Realty resigned and became officers and employees of Pacific on February 18, 1994. Realty and Pacific have also entered into a one-year management agreement whereby Pacific has agreed to provide management services to Realty. Finally, with respect to the common stock of Pacific owned by Realty, Pacific has entered into a registration rights agreement with Realty which, under certain circumstances, allows Realty to require the registration of the Pacific stock it owns. As a result of the February 18, 1994 sale to Pacific, Realty owns approximately 3.6% of Pacific's outstanding common shares. Upon completion of Pacific's acquisition of Baldwin Industrial Park assuming a price per share equal to $18.25 (the public offering price of Pacific's common shares) and the minimum price for Realty's interest in Baldwin Industrial Park and the corporate headquarters building and certain other assets related to the Transferred Properties, Realty will own approximately 14.9% of Pacific's outstanding common shares. The February 18, 1994 sale also accomplished the following objectives: (1) the transaction de-leveraged Realty by paying down its lines of credit by $44.4 million and transferring certain debt in the amount of $44.3 million related to the apartment and industrial properties to Pacific; (2) Realty's existing shareholders' interest in Santa Anita Racetrack and Fashion Park was not diluted; and (3) Realty shareholders will participate in the potential growth of Pacific through Realty's ownership position. Item 1. Business (continued) - ---------------- SUMMARY FINANCIAL INFORMATION The following table sets forth certain unaudited financial information with respect to Realty: - ------------------------- (a) See Item 1. "Business - Realty - Pacific Gulf Properties." (b) Calculated in accordance with the definition of funds from operations as defined by the National Association of Real Estate Investment Trusts ("NAREIT"), except 1993 which excludes $5,734,000 received from the California Franchise Tax Board related to the settlement of certain state tax issues. Net income (computed in accordance with generally accepted accounting principles), excluding gains (losses) from debt restructuring and sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated joint ventures were calculated by adding distributions from unconsolidated joint ventures net of equity in the earnings (losses) of the venture and excluding distributions associated with the sale of property by the venture. (c) Pro forma funds from operations for the year ended December 31, 1993, after giving effect to the Pacific transaction, was $16,151,000. ITEM 1. BUSINESS (CONTINUED) - ---------------- REAL ESTATE INVESTMENTS AND POLICIES Realty's portfolio of real estate investments is outlined below. Information with respect to the real estate investments subject to the Pacific transaction are separately listed: SUMMARY OF REAL ESTATE INVESTMENTS AS OF DECEMBER 31, 1993 - ------------------------------------- (a) Square feet except as indicated. (b) Net book value (total cost of project less accumulated depreciation) at December 31, 1993. Amounts represent 100% of project net book value. (c) Amounts represent 100% of project encumbrances. (d) Subsequent to December 31, 1993, the loan was refinanced (see Item 1. "Business - Realty - Regional Malls - Santa Anita Fashion Park"). (e) A major shopping center which was expanded into a 980,000 square foot regional mall. Expanded mall area opened in October 1991. Additional anchor tenant opened in fall of 1992. (f) Realty is entitled to receive a preferred return on its equity investment. (g) A retail building adjacent to the Towson Town Center project that is expected to become part of the regional mall described in (e) above. (h) Pacific has an option to acquire this property (see Item 1. "Business - Realty - Land"). (i) Corporate offices of Realty and Pacific. (j) Pacific has agreed to acquire this property during 1994 (see Item 1. "Business - Realty - Pacific Gulf Properties"). ITEM 1. BUSINESS (CONTINUED) - ----------------- The following table presents information with respect to Realty's wholly owned and consolidated joint venture projects, other than Santa Anita Racetrack, by type as of December 31, 1993. Information with respect to the projects subject to the Pacific transaction is separately listed. Information on the consolidated joint venture projects represents 100% of the projects' leasable area and net operating income. - ---------------------- (a) Rental property revenues less rental property operating expenses for all wholly owned properties and consolidated joint venture properties. (b) Does not include square footage in Towson Town Center (980,000 square feet) or Joppa Associates (240,000 square feet), or land underlying Fashion Park of 73 acres. (c) Net operating income includes only actual number of months of activity for each project. (d) Includes - property Pacific has agreed to acquire during 1994 (see Item 1. "Business - Realty - Pacific Gulf Properties"). The disposition of the multifamily and industrial operations to Pacific is consistent with Realty's plan to focus its efforts on the Santa Anita Racetrack and related property in Arcadia. Realty's current investment policy is to focus its efforts on the Santa Anita Racetrack and related property in Arcadia. Realty's investment policies are subject to ongoing review by its Board of Directors and may be changed in the future depending on various factors, including the general climate for real estate investments. SANTA ANITA RACETRACK Santa Anita Racetrack, which is leased by Realty to the Los Angeles Turf Club, Incorporated ("LATC"), a subsidiary of Operating Company, is located on approximately 312 acres, 14 miles northeast of downtown Los Angeles, adjacent to major transportation routes. LATC conducts one of the largest thoroughbred horse racing meets in the United States in terms of both average daily attendance and average daily pari-mutuel wagering. The Santa Anita Racetrack was opened for thoroughbred horse racing in 1934 by a group of investors led by Dr. Charles H. Strub. The Santa Anita Meet has been held at Santa Anita Racetrack each year since its founding except for three years during World War II. Over the years, the racetrack facilities have been expanded. At present, the physical plant consists of a large grandstand structure, stalls for approximately 2,000 horses, and a parking area covering approximately 128 acres which can accommodate approximately 20,000 automobiles. The grandstand facilities include clubhouse and Turf Club accommodations, a general admission Item 1. Business (continued) - ---------------- area, and food and beverage facilities, which range from fast food stands to restaurants, both at outdoor terrace tables and indoor dining areas. The grandstand has seating capacity for 25,000 as well as standing room for additional patrons. The structure also contains Operating Company's executive and administrative offices. The grounds surrounding the grandstand are extensively landscaped and contain a European-style paddock and infield accommodations, including picnic facilities for special groups and the general public. The lease rental payable to Realty by LATC is 1.5% of total live on-track wagering at Santa Anita Racetrack, including live on-track wagering during the meet conducted by the Oak Tree Racing Association ("Oak Tree"). In addition, Realty receives 40% of LATC's revenues from satellite wagering (not to exceed 1.5% of such wagering) and the simulcasting of races originating from Santa Anita Racetrack after mandated payments to the State, to horse owners and to breeders. Accordingly, the rental income which Realty receives from Santa Anita Racetrack is directly affected by and dependent upon the racing activities and the wagering by patrons (see Item 1. "Business -- Operating Company -- Santa Anita Racetrack"). Based upon the rental formula for the year ended December 31, 1993, Realty received approximately $11.6 million in rental income from horse racing. The lease expires in December 1994 at which time it is expected to be renewed on terms to be renegotiated by Realty and LATC which, in light of Operating Company's declining profitability, may result in reduced revenue to Realty (see Item 1. "Business -- Operating Company" and Item 6. "Selected Financial Data - - - Operating Company"). The following table shows rental earned by Realty under the LATC lease for the last five years: - ------------------------- (a) Oak Tree races five weeks in even-numbered years and six weeks in odd- numbered years. For a further description of the Santa Anita Meet and the Oak Tree Meet, see Item 1. "Business -- Operating Company -- Santa Anita Racetrack." REGIONAL MALLS SANTA ANITA FASHION PARK Santa Anita Fashion Park is a completely enclosed, climate-controlled regional mall located adjacent to Santa Anita Racetrack with approximately 900,000 square feet of leasable area. Fashion Park is owned and operated by a partnership, Anita Associates, of which Realty is a 50% limited partner. The general partner of Anita Associates is Hahn-UPI, which in turn is a limited partnership of which The Hahn Company, a developer of shopping centers, is the general partner. Fashion Park is currently undergoing an expansion which is anticipated to be completed in the fall of 1994. In addition to the existing major tenants, Robinsons/May, J.C. Penney and Broadway, a new 146,000 square foot Nordstrom store is being added. During 1993, the Robinsons/May store was expanded by Item 1. Business (continued) - ---------------- approximately 40,000 square feet. In 1994, an additional 45,000 square feet of mall stores will be completed with the Nordstrom expansion. During 1993, a food court of approximately 13,000 square feet was completed and opened. In January 1994, the partnership refinanced its existing debt by entering into a loan agreement with an insurance company whereby a maximum of $62,355,000 may be borrowed, bearing interest at 9%, with repayment over ten years. On January 25, 1994, $46,577,193 of the total loan amount was drawn. There are currently 116 tenants operating mall stores with original lease terms varying up to 10 years. New leases are generally seven to ten years with clauses providing for escalation of the basic rent every three years. Typically, leases with mall tenants are structured to provide Anita Associates with overage rents upon attainment by the tenant of certain sales levels, which are specified under the individual leases of the various stores. Overage rents represent a fixed percentage of the gross sales of a tenant less its base rent. Realty has leased the land underlying Fashion Park to Anita Associates and to the major tenants of Fashion Park until 2037, with two additional ten-year option periods and one additional five-year option period. The ground rent is $527,000 annually until 1996 when the annual rent will increase to $794,000 through 2007. During the remaining 30-year term and the three additional option periods, the annual ground rent may be increased up to 25% based upon the appraised value of the land. Under the provisions of the ground leases, Anita Associates is responsible for real estate taxes and other operating expenses. Robinsons/May, J. C. Penney and The Broadway pay their own real estate taxes. The following table contains certain information pertaining to the mall stores in Fashion Park (excluding major tenants): - ------------------- (a) Decline due primarily to certain leases not being renewed in anticipation of the expansion discussed above. The land underlying Fashion Park is security for a loan maturing in 2009 with a balance at December 31, 1993 of $4,100,000. Payments on this indebtedness, which is without recourse to Realty, are approximately $473,000 annually. The security to the lender also includes an assignment of the ground rents received by Realty and a collateral assignment of the ground leases. TOWSON TOWN CENTER Towson Town Center located in Towson, Maryland, is a 563,000 square foot (excluding major tenants) regional mall which opened in 1991. Realty is a 50% partner with The Hahn Company in H-T Associates, a joint venture which owns a 65% interest in a partnership which owns the Towson Town Center. Realty has invested a total of $7.5 million in H-T Associates. The major tenants at Towson Town Center are Nordstrom and Hecht's department stores. There are 183 other tenants operating mall stores with original lease terms varying up to 15 years. The average annual rental rate per square foot including overage rents was $28.23 per square foot for the operating mall stores. The mall tenant leases generally provide for escalation of the basic rent every three years and are structured to provide Towson Town Center with overage rents upon attainment by the tenant of certain sales levels, which are specified under the individual leases of the various stores. Overage rents represent a fixed percentage of the gross sales of a tenant less its base rent. ITEM 1. BUSINESS (CONTINUED) - ----------------- Realty is a joint and several guarantor of loans used to expand the Towson Town Center and a department store and land adjacent to the Towson Town Center in the amount of $82,630,000. In 1993 the guarantee amount was reduced by $93,337,000. Annually, the guarantors may request a reduction in the amount of the guaranty based on the economic performance of the regional mall (see "Notes to Financial Statements -- Note 3 -- Investments in Joint Ventures"). SHOPPING CENTERS Realty owns a portfolio of six neighborhood shopping centers. The shopping centers typically consist of a major supermarket, retail store or drugstore as a major tenant and often include a variety or general merchandise store and smaller service store tenants. The major tenant in two centers owns its building and the underlying land, while in the four other centers, the land or improvements are leased to the major tenant. Leases on the properties range from two to ten years in duration, but typically are from three to five years. They are generally triple net leases (tenant pays all operating costs, insurance and property taxes) and provide for future rental increases. At December 31, 1993, the average occupancy of the three shopping centers located in California was 88% and the average occupancy of the three shopping centers located in Arizona was 90%. OFFICE BUILDINGS Realty owns interests in four office buildings located in Arcadia, Santa Ana, Upland and Newport Beach, California. The office buildings in Santa Ana and Upland are for general office use, the building in Arcadia is a medical office building and the building in Newport Beach was occupied by Realty in March 1993 and was sold to Pacific on February 18, 1994. Office leases are typically for a period of five to ten years and are offered on a full-service gross basis. In addition, tenants are given a tenant improvement allowance and rental concessions in the form of additional tenant improvement allowances or free rent. At December 31, 1993, the occupancy of the office buildings, was 82%. Effective as of December 31, 1993, Realty acquired the minority partnership interest in the office building located in Santa Ana. The partnership interest was acquired in consideration for the cancellation of certain receivables from the minority partner, payment of $250,000 and the assumption of the minority partner's capital account. LAND Realty is a 50% partner in French Valley Ventures, a partnership which acquired 24 acres of unimproved land located in Temecula, California. The partnership is actively seeking the necessary entitlements on the property and is reviewing the possibility of developing an industrial project on the site. Subsequent to year-end, Realty granted to Pacific an option to acquire this partnership interest in the undeveloped parcel of land for $1,957,000. The option is exercisable beginning March 1, 1994 and expires December 31, 1994. APARTMENTS On July 1, 1993, Realty acquired a 256-unit apartment complex located in Austin, Texas, which was subsequently sold to Pacific. Realty acquired the project for $6,750,000. At December 31, 1993 the complex was 96% leased. During 1993, prior to the sale of its apartments to Pacific, Realty acquired the minority partnership interests in Applewood Village Partners and SAREFIM, partnerships which owned 406 and 504 units, respectively, from the minority partners. The partnership interests were acquired in consideration for cash, the cancellation of certain receivables from the minority partners and the assumption of the minority partners' share of the excess of partnership liabilities over assets. ITEM 1. BUSINESS (CONTINUED) - ---------------- INDUSTRIAL BALDWIN INDUSTRIAL PARK Realty is a 50% limited partner in a partnership formed to develop an industrial park on a 45-acre parcel of land in Baldwin Park, California. The land is leased from one of the partners for a period of 55 years. The industrial park is comprised of a total of approximately 622,000 square feet of office and industrial space in a complex of buildings ranging in size from 25,000 to 65,000 square feet. The park is currently 90% leased to tenants which include Gerber's Foods, Federal Express and Home Savings of America ("Home"). Home, the current lessee of a ten-acre parcel in the industrial park and of a 55,656 square foot building in the industrial park, has options to purchase both the ten-acre parcel and the building and land underlying the building under the terms of its leases. Home has exercised its options under both agreements. Under the partnership agreement, Realty is entitled to receive 80% of the cash flow from the partnership in order to provide Realty with a cumulative return of 12% per annum on its invested capital. To the extent there is sufficient cash flow for Realty to receive its 12% cumulative return, the remaining partners are entitled to 80% of the excess cash flow to provide them with a cumulative annual return equal to that received by Realty. Additional cash flow is to be divided equally between Realty and the remaining partners. The partnership exercised an option to buy the land underlying the Home parcel in 1991 and has the option to acquire the remaining parcels in 1994. If the partnership does not exercise any portion of its option to acquire the land, Realty then has the right to exercise that portion of the option under the same terms as the partnership. In addition to the above-mentioned partnership option, Realty has an option to purchase the partnership interests of the other partners in 1994 at the fair market value of the interests in 1994. Subsequent to year-end, Realty agreed to sell its interest in the partnership and assigned its option to purchase the partnership interest of the other partners to Pacific. (See Item 1. "Business - Realty-Pacific Gulf Properties Inc." and "Notes to Financial Statements - Note 2 - Disposition of Multifamily and Industrial Operations Subsequent to Year End"). Pacific has exercised this option to purchase the partnership interest of the other partners. SEATTLE INDUSTRIAL BUILDINGS During 1993, prior to the sale of its industrial properties to Pacific, Realty acquired the minority partnership interest in SARESAM Ventures, a partnership which owned 185,000 square feet of industrial buildings located in the Seattle, Washington area. The partnership interest was acquired in consideration for the cancellation of certain receivables from the minority partners and the assumption of the minority partners' share of the excess of partnership liabilities over assets. MANAGEMENT OF PROPERTIES Realty manages its shopping centers (other than the regional malls) and office buildings directly. Based on a normal property management fee charged by outside managers, Realty believes it realizes an economic benefit as well as the benefits of direct control by managing the properties directly. ITEM 1. BUSINESS (CONTINUED) - ---------------- COMPETITIVE AND OTHER CONDITIONS The industrial buildings, regional shopping malls, shopping centers and office buildings owned by Realty encounter significant competition from similar or larger industrial buildings, regional shopping malls, shopping centers and office buildings developed and owned by other companies. Realty's income from its real estate assets is also affected by general economic conditions. The current recession has adversely affected vacancy rates in office buildings and industrial parks generally. The current recession and other competitive conditions have also affected the rent payable by LATC (see Item 1. "Business -- Operating Company -- Competitive and Other Conditions"). Continuation of the recession could adversely impact vacancy rates, the nature of Realty's tenants, the rents Realty is able to obtain from its tenants and its financial results. Some of Realty's properties are located in Southern California, which is an area prone to earthquakes. To date, none of Realty's projects have sustained any significant damage as a result of earthquakes. However, there can be no assurance that any potential earthquakes will not damage Realty's properties or negatively impact the financial position or results of Realty. EMPLOYEES At December 31, 1993, Realty employed 58 persons on a full-time basis. In connection with the sale to Pacific, the executive officers, various managers and most other employees of Realty resigned and became officers and employees of Pacific on February 18, 1994. Realty has entered into a one-year management agreement with Pacific to assure an orderly transaction, and, as of March 16, 1994, appointed a new Chief Executive Officer (see Item 4a. "Executive Officers of Realty and Operating Company"). Realty believes that relations with its employees are satisfactory. Item 1. Business (continued) SEASONAL VARIATIONS IN BUSINESS Realty is subject to significant seasonal variation in revenues due primarily to the seasonality of thoroughbred horse racing. The following table presents unaudited quarterly results of operations for Realty during 1993 and 1992: ITEM 1. BUSINESS (CONTINUED) - ---------------- Operating Company Santa Anita Operating Company ("Operating Company") is organized under the laws of the State of Delaware. Operating Company's principal executive offices are located at Santa Anita Racetrack, 285 West Huntington Drive, Post Office Box 60014, Arcadia, California 91066-6014. Operating Company is engaged in thoroughbred horse racing. The thoroughbred horse racing operation is conducted by a subsidiary of Operating Company, Los Angeles Turf Club, Incorporated ("LATC"), which leases Santa Anita Racetrack from Realty. The lease expires in December 1994 when its terms will be renegotiated (see Item 1. "Business -- Realty -- Santa Anita Racetrack"). SANTA ANITA RACETRACK LATC conducts an annual 17-week thoroughbred horse racing meet which commences immediately after Christmas and continues through mid-April. LATC conducts one of the largest thoroughbred racing meets in the United States in terms of both average daily attendance and average daily pari-mutuel wagering. LATC leases the racetrack from Realty for the full year under a master lease for a fee of 1.5% of the total live on-track wagering at Santa Anita Racetrack, which includes the Oak Tree meet. In addition, LATC pays to Realty 40% of its revenues from satellite wagering (not to exceed 1.5% of such wagering) and the simulcasting of races originating from Santa Anita Racetrack after mandated payments to the State, to horse owners and to breeders. When LATC operates as a satellite for Hollywood Park Racetrack ("Hollywood Park") and Del Mar Racetrack ("Del Mar"), LATC does not pay any additional rent to Realty. LATC has sublet the racetrack to Oak Tree to conduct its annual thoroughbred horse racing meet (31 days in 1993), which commences in late September or early October. Oak Tree races five weeks in even-numbered years and six weeks in odd- numbered years. Under a sublease which expires in 2000, Oak Tree makes annual rental payments to LATC equal to 1.5% of the total live on-track pari-mutuel wagering from its racing meet and 25% of its satellite and simulcast revenues after mandated payments to the State, to horse owners and to breeders. LATC pays to Realty 40% of all satellite and simulcast revenues received from Oak Tree. Because the rental received from Oak Tree's on-track pari-mutuel wagering is identical to the rental paid to Realty, LATC does not reflect these amounts in its financial statements. In addition, Oak Tree reimburses LATC an amount equal to 0.8% of its on-track pari-mutuel wagering for certain expenses of operating Santa Anita Racetrack on behalf of Oak Tree. LATC also receives supplemental rent representing Oak Tree's adjusted profits above an agreed-upon level and will rebate rent to Oak Tree if Oak Tree's adjusted profits fall below such level (see Item 1. "Business -- Operating Company -- Santa Anita Racetrack -- Pari-Mutuel Wagering"). The number of racing days at the Santa Anita meet declined from 90 in 1989 to 83 in 1993. Total pari-mutuel wagering on the Santa Anita meet decreased from $654.1 million in 1989 to $613.5 million in 1993. For all years prior to 1989, all of Santa Anita pari-mutuel wagering was conducted on-track. In 1989, $122.1 million of the total amount wagered was wagered at satellite locations with $532.0 million being wagered on-track. In 1993, $362.8 million of the total amount wagered was wagered at satellite locations with $250.7 million being wagered on-track. Total attendance was 2.9 million in 1989, of which 621,000 was at satellite locations. By 1993, on-track attendance had declined to 1.2 million, down from 1.5 million in 1992. Although 1,332,126 and 1,576,763 patrons attended satellite locations during the Santa Anita meets in 1993 and 1992, respectively, LATC does not share in the revenues from admissions, parking and food and beverage sales at the satellite locations. Item 1. Business (continued) - ---------------------------- The following tables summarize key operating statistics for the 1989-1993 Santa Anita meets and the 1989-1993 Oak Tree meets, together with the attendance and wagering statistics relating to the transmission of the Del Mar and Hollywood Park signals to Santa Anita Racetrack. - ------------------ (a) Total handle or total attendance divided by the number of race days will produce a different average daily result due to the fact that satellite locations may not have operated from the beginning of the Santa Anita meet, therefore, average daily attendance and wagering is calculated based upon the number of days each satellite location is open. (b) Includes simulcast wagering on races originating at other racetracks. (c) Satellite wagering expanded to include Hollywood Park and Los Alamitos effective with the 1991 Oak Tree meet. (d) Interstate wagering (common pooling) began in October 1990. (e) Oak Tree races five weeks in even-numbered years and six weeks in odd- numbered years. - ------------------- (a) Began in November 1991. Management anticipates that the general trend of increases in off-track wagering will continue and the decrease experienced in on-track attendance and on-track wagering will also continue albeit at a slower rate. During the last five years, 54% of the annual revenues of LATC resulted from pari-mutuel and other wagering commissions. The remaining revenues resulted from admissions, parking, food and beverage sales, sale of programs and interest and other income. The following table sets forth certain unaudited financial information with respect to LATC: The mix of revenues has changed significantly from 1989 to 1993 primarily as a result of the introduction of satellite wagering on races originating at Santa Anita Racetrack, operating as a satellite location for Del Mar and Hollywood Park, changes in average daily pari-mutuel wagering, selective price increases, the introduction of additional exotic wagering opportunities on which the retention amount is higher than on conventional wagering and a new lease with Oak Tree, all of which have largely offset declines in commissions from on- track wagering. In addition, LATC recognized $400,000 in 1990 and $1,000,000 in 1991 from the 1990 sale of the Canterbury Downs management consulting contract. Also, interest income has fluctuated as a function of cash balances available for investments and changing interest rates. LATC's total expenses decreased from $63.8 million in 1989 to $61.5 million in 1993. The majority of these expenses are pari-mutuel wagering or attendance- related, the result of operating as a satellite location for Del Mar and Hollywood Park and the aggregate effect of a new lease with Oak Tree. In 1991, costs and expenses included $1.1 million in earthquake damage. From 1991 to 1992, total costs and expenses increased by $2,064,000 primarily due to the fact that LATC operated as a satellite location for the first time for Hollywood Park's spring thoroughbred meet, the engagement of outside consultants in the amount of $660,000 to review the company's operations, and additional rent paid to Realty in the amount of $1,027,000. From 1992 to 1993, total costs and expenses decreased primarily due to fewer race days and lower on-track attendance and wagering. ITEM 1. BUSINESS (CONTINUED) - ---------------- For further information regarding operating results, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Santa Anita Operating Company." PARI-MUTUEL WAGERING Pari-mutuel means literally a mutual wager, or wagering by individuals against each other. The racetrack acts as the broker for the wagers made by the public and deducts a "take-out" or gross commission which is fixed by the State and shared with the State, the racetrack operator, the horse owners and breeders, and the municipality in which the racetrack is located. The racetrack operator has no interest in which horse wins a given race. As a condition of the issuance of a racing license, California law requires that a certain number of racing days be conducted as charity days. The net proceeds from these charity days are distributed to beneficiaries through a nonprofit organization approved by the California Horse Racing Board (the "Horse Racing Board"). LATC is required to conduct five charity days. ON-TRACK WAGERING The State has vested administrative authority for racing and wagering at horse racing meets with the Horse Racing Board. The Horse Racing Board, which consists of seven members appointed by the governor of the State, is charged with the responsibility of regulating the form of wagering, the length and conduct of meets and the distribution of the pari-mutuel wagering within the limits set by the California legislature. The Horse Racing Board is also charged with the responsibility of licensing horse racing associations on an annual basis to conduct horse racing meets and of licensing directors, officers and persons employed by the associations to operate such meets. California law specifies the percentage distribution of pari-mutuel wagering with the percentage varying based upon the total wagering for the meet, breed of horse and type of wager. The following table sets forth the allocation of the total pari-mutuel wagering, on- and off-track, by percentage and dollar amount during the 1992-93 Santa Anita meet: ITEM 1. BUSINESS (CONTINUED) - ---------------- SATELLITE WAGERING - CALIFORNIA LATC and Oak Tree send televised racing signals to other southern California racetracks, wagering facilities on Indian reservation land in California and non-racing fair sites in central and southern California. Pari- mutuel wagering at a satellite facility is included in the pari-mutuel pools at the host racing associations. LATC's and Oak Tree's share of the satellite wagering was approximately 4.3% of the satellite pari-mutuel wagering on races originating at Santa Anita Racetrack. In the fall of 1993, California law permitted LATC and Oak Tree to send and receive televised racing signals on races with purses exceeding $20,000 to and from northern California racetracks and nonracing fairs. In 1993, Bay Meadows, San Mateo, California became an additional satellite location during the Santa Anita meet. LATC's commission on the northern California satellite wagering was about 3.3%. LATC has been advised that other Indian tribes are planning satellite wagering facilities on reservation land in southern California. Any other facilities opened by an Indian tribe must obtain approval from the State and must enter into an agreement with the racing associations with respect to the pari-mutuel operations. During the Hollywood Park and Del Mar meets, LATC and other Southern California racing associations and fairs operate as satellite facilities. In addition to retaining 2% of the pari-mutuel wagering at Santa Anita Racetrack as its commission, LATC receives income from admissions, parking and food and beverage sales. In 1993, Santa Anita Racetrack operated 141 days as a satellite for Hollywood Park and Del Mar. SATELLITE WAGERING - INTERSTATE Legislation has been enacted in certain states permitting the transmission of pari-mutuel wagers across state lines. This format permits patrons wagering in those states on races held at Santa Anita Racetrack to participate in the same pari-mutuel pool payouts available to LATC's on-track patrons and Southern California satellite patrons. LATC currently participates in satellite wagering with numerous sites in Nevada, and additional locations in Alabama, Arizona, Colorado, Connecticut, Delaware, Florida, Idaho, Iowa, Kansas, Louisiana, Maryland, Massachusetts, Montana, Nebraska, New Hampshire, New Jersey, New York, North Dakota, Oregon, Pennsylvania, Rhode Island, Texas, Washington and West Virginia and receives a negotiated percentage of the pari-mutuel wagering at such sites. Interstate satellite wagering started in 1991 with total pari-mutuel wagering of $39,445,000 which increased to $95,411,000 for 1993. LATC's share of the commissions from interstate satellite wagering was $1,811,000 for 1993. SIMULCASTING In 1993, LATC and Oak Tree transmitted their live racing signals (simulcast) to numerous locations in the United States, Mexico and Canada. LATC's share of the commissions for transmitting its racing signal, was $1,280,000 in 1993 and $1,416,000 in 1992. During the Oak Tree meet, LATC receives 25% of Oak Tree's share of simulcasting revenues. LATC is pursuing the opportunity to transmit its signal to other locations. CANTERBURY DOWNS In 1984, LATC entered into a management consulting contract with Minnesota Racetrack, Inc. ("MRI"). MRI developed and owned a horse racing facility, Canterbury Downs, in the Minneapolis area of Minnesota, which opened in June 1985. In 1990, LATC sold its interest in the management consulting contract with Canterbury Downs and recognized $400,000 as income. In 1991, LATC recognized an additional $1,000,000 as income. ITEM 1. BUSINESS (CONTINUED) - ---------------- COMPETITIVE AND OTHER CONDITIONS The southern California area offers a wide range of leisure time spectator activities, including professional and college teams which participate in all major sports. LATC and Oak Tree compete with such sporting events for their share of the leisure time market and with other numerous leisure time activities available to the community, some of which are broadcast on television. As an outdoor activity, horse racing is more susceptible to inclement weather than some other leisure time activities. This is particularly true of the Santa Anita meet which is held during the winter. Prior to the 1992-1993 meet, LATC had never lost a race due to inclement weather. During the 1992-1993 meet, LATC lost two full days and two partial days of racing because of inclement weather. A local Arcadia ordinance presently limits live horse racing to daylight hours but allows the importation of a horse racing broadcast signal one evening per week. The Horse Racing Board has annually licensed LATC and Oak Tree to conduct racing meets at Santa Anita Racetrack. At present, the Horse Racing Board has not licensed other thoroughbred racetracks in Southern California to conduct racing during these meets. Since 1972, however, night harness racing and night quarterhorse meets have been conducted at other racetracks in Southern California during portions of these meets. LATC and Oak Tree could be adversely affected by legislative or Horse Racing Board action which would increase the number of competitive racing days, reduce the number of racing days available to LATC and Oak Tree, or authorize other forms of wagering. The California State Lottery Act of 1984, which provides for the establishment of a state-operated lottery, was implemented in 1985. In the opinion of management, the State lottery has had an adverse impact and will continue to have an adverse impact on total attendance and pari-mutuel wagering at Santa Anita Racetrack (see Item 1 "Business -- Operating Company -- Santa Anita Racetrack"). Although it is unaware of any empirical studies, management believes that the State lottery has had and will continue to have an adverse impact on many other businesses in the State of California. In the future, legislation could be enacted to allow casino gaming or other forms of gaming which are competitive with pari-mutuel wagering at Santa Anita Park. Under federal law, certain types of gaming are lawful on Indian lands if conducted in conformance with a Tribal-State compact, which the applicable state must negotiate with an Indian tribe in good faith. Certain Indian tribes seeking to establish gaming in California have instituted litigation against the State of California to compel the State to permit them to do so. In 1993, one court held that California has a public policy prohibiting casino gaming and need not negotiate a compact with respect to casino gaming. However, the court also held that certain other forms of gaming were the proper subject of a compact. Other courts are not bound by that decision and may hold differently. If the Indian tribes are successful in establishing casino gaming or other forms of gaming in California, such gaming could have an adverse impact on LATC. DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS No material part of Operating Company's business is dependent upon a single customer or a few customers; therefore, the loss of any one customer would not have a materially adverse effect on the business of Operating Company. EMPLOYEE AND LABOR RELATIONS During the year ended December 31, 1993, LATC regularly employed approximately 1,600 employees. Substantially all are employed on a seasonal basis in connection with live thoroughbred horse racing or satellite meets at Santa Anita Racetrack. During the relatively short periods when live or satellite racing meets at Santa Anita Racetrack are not being conducted, LATC maintains a staff of approximately 260 employees, most of whom are engaged in maintaining or improving the physical facilities at Santa Anita Racetrack or are engaged in preparing for the next live or satellite meet. All of LATC's employees, except for approximately 70 full-time management and clerical employees, are covered by collective bargaining agreements with labor unions. A majority of the current labor agreements covering racetrack employees will expire in April 1995 after the Santa Anita meet. SEASONAL VARIATIONS IN BUSINESS Operating Company is also subject to significant seasonal variation. LATC conducts an annual meet commencing immediately after Christmas and continuing through mid-April. This seasonal variation is indicated by the following unaudited quarterly results of operations for Operating Company during 1993 and 1992: In 1993, revenues and cost of sales from food and beverage operations have been reflected as a separate component in Operating Company's and Combined Realty and Operating Company's statement of operations. In prior years these operations were in horse racing revenues. All prior year and interim financial statements and disclosures for Operating Company and Combined Realty and Operating Company have been restated to reflect this reclassification. Operating Company has adopted an accounting practice whereby the revenues associated with thoroughbred horse racing at Santa Anita Racetrack are reported as they are earned. Costs and expenses associated with thoroughbred horse racing revenues are charged against income in those interim periods in which the thoroughbred horse racing revenues are recognized. Other costs and expenses are recognized as they actually occur throughout the year. ITEM 1. BUSINESS (CONTINUED) - ---------------- INCOME TAX MATTERS In the opinion of management, Realty has operated in a manner which has qualified it as a REIT under Sections 856 through 860 of the Code. Realty intends to continue to operate in a manner which will allow it to qualify as a REIT under the Code. Under these sections, a corporation that is principally engaged in the business of investing in real estate and that, in any taxable year, meets certain requirements that qualify it as a REIT generally is not subject to federal income tax on its taxable income and gains that it distributes to its shareholders. Income and gains that are not so distributed will be taxed to a REIT at regular corporate rates. In addition, a REIT is subject to certain taxes on net income from "foreclosure property" as defined in the Code, income from the sale of property held primarily for sale to customers in the ordinary course of business and excessive unqualified income. REIT REQUIREMENTS To qualify for tax treatment as a REIT under the Code, Realty at a minimum must meet the following requirements: (1) At least 95% of Realty's gross income each taxable year (excluding gains from the sale of property other than foreclosure property held primarily for sale to customers in the ordinary course of its trade or business) must be derived from: (a) rents from real property; (b) gain from the sale or disposition of real property that is not held primarily for sale to customers in the ordinary course of business; (c) interest on obligations secured by mortgages on real property (with certain minor exceptions); (d) dividends or other distributions from, or gains from the sale of, shares of qualified REITs that are not held primarily for sale to customers in the ordinary course of business; (e) abatements and refunds of real property taxes; (f) income and gain derived from foreclosure property; (g) most types of commitment fees related to either real property or mortgage loans; (h) gains from sales or dispositions of real estate assets that are not "prohibited transactions" under the Code; (i) income attributable to stock or debt instruments acquired with the proceeds from the sale of stock or certain debt obligations ("new capital") of Realty received during a one-year period beginning on the day such proceeds were received ("qualified temporary investment income"); (j) dividends; (k) interest on obligations other than those secured by mortgages on properties; and (l) gains from sales or dispositions of securities not held primarily for sale to customers in the ordinary course of business. ITEM 1. BUSINESS (CONTINUED) - ---------------- In addition, at least 75% of Realty's gross income each taxable year (excluding gains from the sale of property other than foreclosure property held primarily for sale to customers in the ordinary course of its trade or business) must be derived from items (a) through (i) above. For purposes of these requirements, the term "rents from real property" is defined in the Code to include charges for services customarily furnished or rendered in connection with the rental of real property, whether or not such charges are separately stated, and rent attributable to incidental personal property that is leased under, or in connection with, a lease of real property, provided that the rent attributable to such personal property for the taxable year does not exceed 15% of the total rent for the taxable year attributable to both the real and personal property leased under such lease. The term "rents from real property" is also defined to exclude: (i) any amount received or accrued with respect to real property, if the determination of such amount depends in whole or in part on the income or profits derived by any person from the property (except that any amount so received or accrued shall not be excluded from "rents from real property" solely by reason of being determined on the basis of a fixed percentage of receipts or sales); (ii) any amount received or accrued, directly or indirectly, from any person or corporation if ownership of a 10% or greater interest in the stock, assets or net profits of such person or corporation is attributed to Realty; (iii) any amount received or accrued from property that Realty manages or operates or for which Realty furnishes services to the tenants, which would constitute unrelated trade or business income if received by certain tax-exempt entities, either itself or through another person who is not an "independent contractor" (as defined in the Code) from whom Realty does not derive or receive income; and (iv) any amount received or accrued from property with respect to which Realty furnishes (whether or not through an independent contractor) services not customarily rendered to tenants in properties of a similar class in the geographic market in which the property is located. If Realty should fail to satisfy the foregoing income tests but otherwise satisfies the requirements for taxation as a REIT and if such failure is held to be due to reasonable cause and not willful neglect and if certain other requirements are met, then Realty would continue to qualify as a REIT but would be subject to a 100% tax on the excessive unqualified income reduced by an approximation of the expenses incurred in earning that income. (2) Less than 30% of Realty's gross income during any taxable year can be derived from the sale or disposition of: (i) stock or securities held for less than one year; (ii) property held primarily for sale to customers in the ordinary course of business (other than foreclosure property); and (iii) real property (including interests in mortgages on each property) held for less than four years (other than foreclosure property and gains arising from involuntary conversions). (3) At the end of each calendar quarter, at least 75% of the value of Realty's total assets must consist of real estate assets (real property, interests in real property, interests in mortgages on real property, shares in qualified real estate investment trusts and stock or debt instruments attributable to the temporary investment of new capital), cash and cash items (including receivables) and government securities. With respect to securities that are not included in the 75% asset class, Realty may not at the end of any calendar quarter own either (i) securities representing more than 10% of the outstanding voting securities of any one issuer or (ii) securities of any one issuer having a value that is more than 5% of the value of Realty's total assets. Realty's share of income earned or assets held by a partnership in which Realty is a partner will be characterized by Realty in the same manner as they are characterized by the partnership for purposes of the assets and income requirements described in this paragraph (3) and in paragraphs (1) and (2) above. (4) The shares of Realty must be "transferable" and beneficial ownership of them must be held by 100 or more persons during at least 335 days of each taxable year (or a proportionate part of a short taxable year). More than 50% of the outstanding stock may not be owned, directly or indirectly, actually or constructively, by or for five or fewer "individuals" at any time during the last half of any taxable year. For the purpose of such determination, shares owned directly or indirectly by or for a ITEM 1. BUSINESS (CONTINUED) - ---------------- corporation, partnership, estate or trust are considered as being owned proportionately by its shareholders, partners or beneficiaries; an individual is considered as owning shares directly or indirectly owned by or for members of his family; and the holder of an option to acquire shares is considered as owning such shares. In addition, because of the lessor- lessee relationship between Realty and LATC, no person may own, actually or constructively, 10% or more of the outstanding voting power or total number of shares of stock of the two companies. The bylaws of Operating Company and Realty preclude any transfer of shares which would cause the ownership of shares not to be in conformity with the above requirements. Each year Realty must demand written statements from the record holders of designated percentages of its shares disclosing the actual owners of the shares and must maintain, within the Internal Revenue District in which it is required to file its federal income tax return, permanent records showing the information it has thus received as to the actual ownership of such shares and a list of those persons failing or refusing to comply with such demand. (5) Realty must distribute to its shareholders dividends in an amount at least equal to the sum of 95% of its "real estate investment trust taxable income" before deduction of dividends paid (i.e., taxable income less any net capital gain and less any net income from foreclosure property or from property held primarily for sale to customers, and subject to certain other adjustments provided in the Code); plus (i) 95% of the excess of the net income from foreclosure property over the tax imposed on such income by the Code; less (ii) a portion of certain noncash items of Realty that are required to be included in income, such as the amounts includable in gross income under Section 467 of the Code (relating to certain payments for use of property or services). The distribution requirement is reduced by the amount by which the sum of such noncash items exceeds 5% of real estate investment trust taxable income. Such undistributed amount remains subject to tax at the tax rate then otherwise applicable to corporate taxpayers. During 1993, Realty has, or will be deemed to have, distributed at least 95% of its real estate investment trust taxable income as adjusted. For this purpose, certain dividends paid by Realty after the close of the taxable year may be considered as having been paid during the taxable year. However, if Realty does not actually distribute each year at least the sum of (i) 85% of its real estate investment taxable income, (ii) 95% of its capital gain net income and (iii) any undistributed taxable income from prior periods, then the amount by which such sums exceed the actual distributions during the taxable year will be subject to a 4% excise tax. If a determination (by a court or by the Internal Revenue Service) requires an adjustment to Realty's taxable income that results in a failure to meet the percentage distribution requirements (e.g., a determination that increases the amount of Realty's real estate investment taxable income), Realty may, by following the "deficiency dividend" procedure of the Code, cure the failure to meet the annual percentage distribution requirement by distributing a dividend within 90 days after the determination, even though this deficiency dividend is not distributed to the shareholders in the same taxable year as that in which income was earned. Realty will, however, be liable for interest based on the amount of the deficiency dividend. (6) The directors of Realty must have authority over the management of Realty, the conduct of its affairs and, with certain limitations, the management and disposition of Realty's property. (7) Realty must have the calendar year as its annual accounting period. (8) Realty must satisfy certain procedural requirements. TAXATION OF REALTY AS A REIT In any year in which Realty qualifies under the requirements summarized above, it generally will not be taxed on that portion of its ordinary income or net capital gain that is distributed to shareholders, other than net income from foreclosure property, excess unqualified income and gains from property held primarily for sale. ITEM 1. BUSINESS (CONTINUED) - ---------------- Realty will be taxed at applicable corporate rates on any undistributed taxable income or net capital gain and will not be entitled to carry back any net operating losses. It also will be taxed at the highest rate of tax applicable to corporations on any net income from foreclosure property and, subject to the safe harbor described below, at the rate of 100% on any income derived from the sale or other disposition of property, other than foreclosure property, held primarily for sale. In computing its net operating losses and the income subject to these latter taxes, Realty will not be allowed a deduction for dividends paid or received. Although Realty will also be subject to a 100% tax on the gain derived from the sale of property (other than foreclosure property) held primarily for sale, a safe harbor is provided such that gains from the sale of real property are excluded from this 100% tax for a given year if each of the following conditions is satisfied: (a) the property has been held by Realty for at least four years; (b) total capital expenditures with respect to the property during the four-year period preceding the date of sale do not exceed 30% of the net selling price of the property; (c) either (i) Realty does not make more than seven sales of properties (other than foreclosure property) during the taxable year or (ii) the aggregate adjusted bases (as determined for purposes of computing earnings and profits) of property (other than foreclosure property) sold by Realty during the taxable year do not exceed 10% of the aggregate adjusted bases (as so determined) of all of the assets of Realty as of the beginning of the taxable year; (d) if the property has not been acquired through foreclosure or lease termination, the property has been held by Realty for the production of rental income for at least four years; and (e) if the requirement of paragraph (c)(i) is not satisfied, substantially all of the marketing and development expenditures with respect to the sold properties were made through independent contractors from whom Realty does not derive or receive any income. TERMINATION OR REVOCATION OF REIT STATUS If, in any taxable year after it has filed an election with the Internal Revenue Service to be treated as a REIT, Realty fails to so qualify, Realty's election will be terminated, and Realty will not be permitted to file a new election to obtain such tax treatment until the fifth taxable year following the termination. However, if Realty's failure to qualify was due to reasonable cause and not due to willful neglect and if certain other requirements are met, Realty would be permitted to file a new election to be treated as a REIT for the year following the termination. If Realty voluntarily revokes its election for any year, it will not be eligible to file a new election until the fifth taxable year following such revocation. If Realty fails to qualify for taxation as a REIT in any taxable year and the above relief provisions do not apply, then Realty would be subject to tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. Distributions to shareholders of Realty with respect to any year in which Realty failed to qualify would not be deductible by Realty nor would they be required to be made. In such event, distributions to shareholders, to the extent out of current or accumulated earnings and profits, would be taxed as ordinary income and subject to certain limitations of the Code, eligible for the dividends-received deduction for corporations (see "Taxation of Realty's Shareholders"). Failure to qualify could result in Realty incurring substantial indebtedness (to the extent borrowings are feasible) or disposing of substantial investments, in order to pay the resulting taxes or, in the discretion of Realty, to maintain the level of Realty's distributions to its shareholders. ITEM 1. BUSINESS (CONTINUED) - ---------------- TAXATION OF REALTY'S SHAREHOLDERS So long as Realty qualifies for taxation as a REIT, distributions made to its shareholders out of current or accumulated earnings and profits (or deemed to be from current or accumulated earnings or profits), other than capital gain dividends (discussed below), will be dividends taxable as ordinary income. Distributions to shareholders of a REIT are not eligible for the dividends- received deduction for a corporation. Dividends to shareholders that are properly designated by Realty as capital gain dividends generally will be treated as long-term capital gain (to the extent they do not exceed Realty's actual net capital gain for the taxable year) regardless of how long a shareholder has owned his or her shares. However, corporate shareholders may be required to treat up to 20% of certain capital gain dividends as ordinary income. In general, any gain or loss realized upon a taxable disposition of shares will be treated as long-term capital gain or loss if the shares have been held for more than twelve months and otherwise as short-term capital gain or loss. However, if a shareholder receives a long-term capital gain dividend and such shareholder has held his or her stock for six months or less, any loss realized on the subsequent sale of the shares will, to the extent of the gain, be treated as long-term capital loss. Certain constructive ownership rules apply to determine the holding period. In the event that Realty distributes cash generated by its activities which exceeds its net earnings, and provided there are no undistributed current or accumulated earnings and profits and the distribution does not qualify as a "deficiency dividend," such distributions will constitute a return of capital to the extent they do not exceed a shareholder's tax basis for the shareholder's shares and will be tax free to the shareholder. In such event, the tax basis of the shares held by each shareholder must be reduced correspondingly by the amount of such distributions. If such distributions exceed the tax basis of the shares of a shareholder, the shareholder will recognize capital gain in an amount equal to such excess, provided the shareholder holds the shares as a capital asset. Shareholders may not include on their own returns any of Realty's ordinary or capital losses. Realty will notify each shareholder after the close of its taxable year as to the portions of the distributions that constitute ordinary income, return of capital and capital gain. For this purpose, any dividends declared in October, November or December of a year, which are payable to shareholders of record on any day of such a month, shall be treated as if they had been paid and received on December 31 of such year, provided such dividends are actually paid in January of the following year. Shareholders are required to include on their own returns any ordinary dividends in the taxable year in which such dividends are received. If in any taxable year Realty does not qualify as a REIT, it will be taxed as a corporation, and distributions to its shareholders will neither be required to be made nor will they be deductible by Realty in computing its taxable income, with the result that the assets of Realty and the amounts available for distribution to shareholders would be reduced to the extent of any tax payable. Disqualification as a REIT could occur even though Realty had previously distributed to its shareholders all of its income for such year, or years, in which it did not qualify as a REIT. In such circumstances, distributions, to the extent made out of Realty's current or accumulated earnings and profits, would be taxable to the shareholders as dividends, but, subject to certain limitations of the Code, would be eligible for the dividends-received deduction for corporations. TAX-EXEMPT INVESTORS The Internal Revenue Service has ruled that amounts distributed by a REIT to a tax-exempt employee's pension trust do not constitute ''unrelated trade or business income" and should therefore be nontaxable to such trust. This ruling does not apply to the extent the tax-exempt investor has borrowed to acquire shares of the REIT's stock. Moreover, the application of this ruling is subject to additional limitations that are beyond the scope of this disclosure. ITEM 1. BUSINESS (CONTINUED) - ---------------- STATE AND TERRITORIAL TAXES The state or territorial income tax treatment of Realty and its shareholders may not conform to the federal income tax treatment above. As a result, prospective shareholders should consult their own tax advisors for an explanation of the effect of state and territorial tax laws on their investment in Realty. FOREIGN INVESTORS The preceding discussion does not address the federal income tax consequences to foreign investors of an investment in Realty. Foreign investors should consult their own tax advisors concerning the federal income tax considerations to them of the ownership of shares in Realty. BACKUP WITHHOLDING The Code imposes a modified form of "backup withholding" for payments of interest and dividends. This withholding applies only if a shareholder, among other things: (i) fails to furnish Realty with a properly certified taxpayer identification number; (ii) furnishes Realty with an incorrect taxpayer identification number; (iii) fails to report properly interest or dividends from any source or; (iv) under certain circumstances, fails to provide Realty or his or her securities broker with a certified statement, under penalty of perjury, that he or she is not subject to backup withholding. The backup withholding rate is 31% of "reportable payments" which include dividends. Shareholders should consult their tax advisors as to the procedure for ensuring that Realty distributions to them will not be subject to backup withholding. TAXATION OF OPERATING COMPANY Operating Company pays ordinary corporate income taxes on its taxable income. Any income, net of taxes, will be available for retention in Operating Company's business or for distribution to shareholders as dividends. Any dividends distributed by Operating Company will be subject to tax at ordinary rates and generally will be eligible for the dividends received deduction for corporate shareholders to the extent of Operating Company's current or accumulated earnings and profits. Distributions in excess of current or accumulated earnings and profits are treated first, as a return of investment and then, to the extent that such distribution excludes a shareholder's investment, as gain from the sale or exchange of such shares. However, there is no tax provision which requires Operating Company to distribute any of its after-tax earnings and Operating Company does not expect to pay cash dividends in the foreseeable future. FUTURE LEGISLATION It should be noted that future legislation could be enacted or regulations promulgated, the nature and likelihood of which cannot be predicted, that might change in whole or in part, the income tax consequences summarized herein and reduce or eliminate the advantages which may be derived from the ownership of paired common stock. The foregoing is a summary of some of the more significant provisions of the Code as it relates to REITs and is qualified in its entirety by reference to the Code and regulations promulgated thereunder. ITEM 2. ITEM 2. PROPERTIES - ------------------- Information concerning property owned by Realty and Operating Company may be found under Item 1. "Business." ITEM 3. ITEM 3. LEGAL PROCEEDINGS - ------------------------- Certain claims, suits and complaints arising in the ordinary course of business have been filed or were pending against Realty and/or Operating Company and its subsidiaries at December 31, 1993. In the opinion of the managements of Realty and Operating Company, all such matters are adequately covered by insurance or, if not so covered, are without merit or are of such kind, or involve such amounts, as would not have a significant effect on the financial position or results of operations of Realty and Operating Company if disposed of unfavorably. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ----------------------------------------------------------- Not applicable. ITEM 4A. EXECUTIVE OFFICERS OF REALTY AND OPERATING COMPANY - ----------------------------------------------------------- (a) The names, ages and business experience of Realty's executive officers during the past five years are set forth below: Each executive officer of Realty is appointed by the Board of Directors annually and holds office until his successor is duly appointed. (b) The names, ages and business experience of Operating Company's executive officers during the past five years are set forth below: Each executive officer of Operating Company is appointed by the Board of Directors annually and holds office until a successor is duly appointed. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED SHAREHOLDER - -------------------------------------------------------------------------- MATTERS - ------- The paired Common Stock of Realty and Operating Company is traded on the New York Stock Exchange as Santa Anita Realty Enterprises under the symbol SAR. The following table sets forth the high and low closing prices for the paired Common Stock on the New York Stock Exchange Composite Tape and the cash dividends declared by Realty for the periods indicated. Operating Company has not declared cash dividends. - ---------- (a) $.56 of the dividends paid per share during 1992 represented a return of capital. (b) $.56 of the dividends paid per share during 1993 represented a return of capital. A regular quarterly dividend of $.34 per share is payable on April 8, 1994 to shareholders of record on March 8, 1994. The closing price of the paired Common Stock on the New York Stock Exchange Composite Tape on March 8, 1994 was $17- 5/8 per share. As of March 8, 1994, there were approximately 22,000 holders of the paired Common Stock, including the beneficial owners of shares held in nominee accounts. Realty intends to pay regular quarterly dividends based upon a percentage of management's estimate of funds from operations for the entire year and, if necessary, to pay special dividends after the close of the year to effect distribution of at least 95% of its taxable income (other than net capital gains) (see item 1. "Business -- Income Tax Matters -- REIT Requirements"). In order to retain earnings to finance its capital improvement program and for the growth of its business, Operating Company has not paid cash dividends since its formation and does not expect to pay cash dividends in the foreseeable future. ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED SHAREHOLDER - -------------------------------------------------------------------------- MATTERS (CONTINUED) - ------- The statement on the face of this annual report on Form 10-K regarding the aggregate market value of paired voting stock of Realty and Operating Company held by nonaffiliates is based on the assumption that all directors and officers of Realty and Operating Company were, for purposes of this calculation only (and not for any other purpose), affiliates of Realty or Operating Company. ITEM 6. Item 6. "Selected Financial Data - Operating Company"). Rental revenues from other real estate investments for the year ended December 31, 1993 were $38,953,000, an increase of 10.4% from those reported in 1992 of $35,290,000. The 1993 increases are due primarily to additional revenues from a new multifamily property acquisition in 1993 and the full year inclusion of several multifamily properties acquired in 1992. Interest and other income increased 115.3% to $4,991,000 for the year ended December 31, 1993 from $2,318,000 reported for 1992. The increase is primarily attributable to $3,211,000 of interest income in 1993 on a tax settlement from the California Franchise Tax Board. The settlement was for tax years prior to 1980 related to Realty's predecessor. In addition to the interest earned on the settlement, Realty recorded a $2,523,000 income tax benefit. Costs and expenses of $55,482,000 for the year ended December 31, 1993 increased 38.4% from those reported for 1992 of $40,080,000. The increase is primarily due to the loss on the disposition of the multifamily and industrial operations to Pacific and increases in depreciation and rental property operating expenses associated with the acquisitions of real estate projects noted above. In June 1993, Realty's Board of Directors approved management's recommendation to recapitalize certain assets of Realty. Pursuant to this recapitalization, in November 1993, Realty entered into a Purchase and Sale Agreement to sell its multifamily and industrial operations to Pacific Gulf Properties Inc. ("Pacific"), in conjunction with its proposed public offering of common stock. The transaction was scheduled to be completed in two parts: (1) Realty would sell all of its apartments and industrial properties to Pacific with the exception of Realty's interest in the Baldwin Industrial Park joint venture; and (2) Pacific would enter into a binding agreement to buy Realty's interest in Baldwin Industrial Park. On February 18, 1994, Realty completed the first part of this transaction by selling to Pacific ten multifamily properties, containing 2,654 apartment units, located in Southern California, the Pacific Northwest, and Texas and three industrial properties, containing an aggregate of 185,000 leasable square feet of industrial ITEM 7. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) --------------------- space, located in the State of Washington (the "Transferred Properties"). Realty's corporate headquarters building and related assets were also acquired by Pacific. The sale of the Transferred Properties followed the public offerings of common stock and convertible subordinated debentures by Pacific. Pursuant to the Purchase and Sale Agreement, Pacific agreed to buy Realty's interest in Baldwin Industrial Park subject to satisfaction of certain conditions, for a minimum price of $8.9 million payable in additional shares of Pacific common stock with the final price dependent upon completion of negotiations with other owners of Baldwin Industrial Park and an appraisal process. Management believes the sale of Realty's interest in Baldwin Industrial Park will be completed in the second half of 1994. Pacific is required to issue to Realty non-refundable letters of credit totaling up to $2.5 million by March 31, 1994 to secure its obligation to acquire Realty's interest in Baldwin Industrial Park and pay for the corporate headquarters building and other assets related to the Transferred Properties. In consideration of the sale of the Transferred Properties, Realty received approximately $44.4 million in cash and 149,900 shares of the common stock of Pacific. In addition, Realty was relieved of approximately $44.3 million of mortgage debt on the Transferred Properties. Realty will also receive, at the time the acquisition of Baldwin Industrial Park is completed, up to $1.2 million in additional common stock of Pacific as consideration for its corporate headquarters and other net assets related to the Transferred Properties. The two parts of the above transaction will result in a loss of $10,974,000. This loss has been reflected in the Realty and Realty and Operating Company combined statements of operations for the year ended December 31, 1993. If the Baldwin Industrial Park portion of the transaction described above does not occur, an additional loss of approximately $5,900,000 will be recognized by Realty in 1994. (See "Notes to Financial Statements - Note 2 - Disposition of Multifamily and Industrial Properties Subsequent to Year End.") In connection with the sale, the executive officers, various managers and most other employees of Realty resigned and became officers and employees of Pacific on February 18, 1994. Realty and Pacific have also entered into a one-year management agreement whereby Pacific has agreed to provide management services to Realty. Finally, with respect to the common stock of Pacific owned by Realty, Pacific has entered into a registration rights agreement with Realty which, under certain circumstances, allows Realty to require the registration of the Pacific stock it owns. Net income for the year ended December 31, 1993 was $2,619,000, a decrease of 74.4% compared with the $10,211,000 reported in 1992 due to the factors described above. RESULTS OF OPERATIONS -- 1992 COMPARED WITH 1991 Realty's revenues were derived principally from the rental of real property. Total revenues for the year ended December 31, 1992 were $50,291,000 compared with $45,408,000 reported for the year ended December 31, 1991, a 10.8% increase. Rental revenue from real estate properties amounted to $47,973,000 for the year ended December 31, 1992, up 12.4% from the year-earlier level of $42,699,000. In 1992, the most significant source of rental revenue was the lease with Santa Anita Racetrack. Revenues for 1992 rose to $12,683,000, up 7.3% from $11,817,000 reported in 1991. The increase resulted from an increase in total wagering at Santa Anita Racetrack due to six additional racing days during 1992 and increases in out-of-state simulcast revenues. Rental revenues from other real estate investments for 1992 increased to $35,290,000, up 14.3% from $30,882,000 in 1991. This increase was due primarily to additional revenues from new property ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) --------------------- acquisitions, the receipt of previously reserved past due rents and increased revenues from Santa Anita Fashion Park. Interest and other income declined 14.4% to $2,318,000 in 1992 from $2,709,000 in 1991. The decrease is due to reduced funds held for investment and lower interest rates on funds held for investment, offset in part by the sale of a neighborhood shopping center in Phoenix, Arizona, net of a loss on a lease agreement, which generated a net gain of $646,000 (net of cost of $4,475,000). Realty reported a gain of $177,000 (net of cost of $223,000) in 1991 from the sale of a small land parcel in Southern California. Costs and expenses increased 12.2 percent to $40,080,000 in 1992, up from $35,709,000 in 1991. The increase is due primarily to higher levels of depreciation, interest and rental property operating expenses associated with the acquisition of 1,109 new apartment units, and the expensing in 1992 of $580,000 of nonrecurring charges for the engagement of consultants to review the operations of the Realty and to assist in preparing a long range strategic plan. Realty reported a loss of $1,446,000 from the Towson Town Center unconsolidated joint venture primarily due to depreciation (the project was under construction in the prior periods). Net income for the year ended December 31, 1992 increased 5.3% to $10,211,000 compared with income of $9,699,000 reported in 1991 due to the factors described above. LIQUIDITY AND CAPITAL RESOURCES Realty had liquidity available from a combination of short- and long- term sources. Short-term sources included cash of $7,633,000 at December 31, 1993. In connection with the sale of properties to Pacific, Realty paid down its lines of credit by $44.4 million and transferred to Pacific $44.3 million of indebtedness associated with the multifamily and industrial properties. As of December 31, 1993, Realty was not in compliance with certain covenants contained in its credit agreements. The banks have waived such noncompliance through April 30, 1994 conditioned, among other things, on no additional borrowings under the credit agreements (at December 31, 1993, $78,361,000 loans and letters of credit were outstanding under these agreements). Realty is in the process of renegotiating these credit agreements. Management is of the opinion that Realty has sufficient liquidity from other sources to assure that its operations will not be adversely affected pending this renegotiation. Realty had approximately $13,591,000 of long-term receivables at December 31, 1993, with maturities ranging from 1994 to 2002. For the year ended December 31, 1993, long-term receivables earned interest income of $996,000. In the opinion of management, as of December 31, 1993 Realty's real estate investments had a market value substantially in excess of the historical costs and indebtedness related to such real estate investments. Management believes that this provides significant additional borrowing capacity. IMPACT OF INFLATION Realty's management believes that, for the foreseeable future, revenues and income from Santa Anita Racetrack, Fashion Park and its other real estate should not be adversely affected in a material way by inflationary pressures. Leases at Fashion Park include clauses enabling Realty to participate in tenants' future increases and gross revenues. Tenant leases on many other properties include provisions which tie the lease payments to the Consumer Price Index or include step-up provisions. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) - --------------------- SANTA ANITA OPERATING COMPANY Operating Company is engaged in thoroughbred horse racing through its wholly owned subsidiary, Los Angeles Turf Club, Incorporated ("LATC") which leases the Santa Anita Racetrack ("Santa Anita") from Realty. The following narrative discusses Operating Company's results of operations for the years ended December 31, 1993, 1992 and 1991 together with liquidity and capital resources as of December 31, 1993. RESULTS OF OPERATIONS -- 1993 COMPARED WITH 1992 Operating Company derives its revenues from thoroughbred horse racing activities. Total revenues were $61,347,000 in 1993, down 9.3% from $67,654,000 in 1992. In 1993, live thoroughbred horse racing at Santa Anita Racetrack totaled 83 days compared with 94 days in 1992. Total and average daily on- track attendance at the live racing events in 1993 were down 20.4% and 9.8%, respectively, from 1992. Total wagering at the live racing events was down 10.6% while average daily wagering increased 1.2% in 1993 compared with 1992. On-track wagering and inter-track wagering declined 20.2% and 13.6%, respectively, while interstate wagering increased 43.8% in 1993 compared with 1992. In addition to a weak California economy and the continued negative effect of inter-track wagering on the on-track attendance and wagering, management believes the declines in average daily attendance and wagering were the result of inclement weather (in excess of 41 inches of rain, three times normal) during much of the 1992-1993 race meet, which caused the cancellation of two full race days and two partial race days in January. Also, Santa Anita Racetrack operated 42 days in 1993 and 43 days in 1992 as a satellite wagering facility for Del Mar and 99 days in 1993 and 101 days in 1992 as a satellite wagering facility for Hollywood Park. Total attendance and wagering as a satellite wagering facility were down 3.5% and 2.5%, respectively, in 1993 compared with 1992. Average daily attendance and wagering were down 1.4% and 0.4%, respectively, in 1993 compared with 1992. Horse racing revenues and direct operating costs declined in 1993 compared with 1992 due to fewer race days, lower attendance and lower wagering at both the live racing events and as a satellite wagering facility. Horse racing revenues in 1993 were $49,081,000 down 8.6% from $53,683,000 in 1992. Direct horse racing operating costs in 1993 were $40,981,000, down 9.1% from $45,089,000 in 1992. Food and beverage revenues and cost of sales were also lower in 1993 compared with 1992 due to the factors described above. As a percentage of sales, cost of sales increased to 29.2% in 1993 compared with 27.5% in 1992. General and administrative expenses were $6,693,000 in 1993, down 19.9% from $8,361,000 in 1992 due to administrative staff reductions in 1993 and to the costs related to the engagement of outside consultants in the prior year to review the Operating Company's operations. Partially offsetting the declines in general and administrative expenses, however, was the one-time charge of $759,000 in 1993 for the post-retirement benefits payable as a result of the death of the former Chairman of the Board of Operating Company. Interest expense increased to $493,000 in 1993 from $194,000 in 1992 due to a higher level of debt at LATC. Rental expense to Realty was $9,233,000 in 1993 compared with $10,955,000 in 1992. The decrease in rental expense of $1,722,000 reflects the decline in wagering. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) - --------------------- Due to the revenue and expense items previously discussed, Operating Company reported a net loss of $2,232,000 or $.20 per share in 1993 compared with a net loss of $2,896,000 or $.26 per share in 1992. RESULTS OF OPERATIONS -- 1992 COMPARED WITH 1991 In 1992, the expansion of intertrack wagering within Los Angeles and Orange Counties caused intertrack revenues to increase $7,657,000 while on-track revenues decreased $7,246,000. On-track attendance-related revenues declined as a result of a 24.0% drop in on-track attendance at the 1991-1992 Santa Anita race meet and a decline in on-track wagering of $147,248,000, or 31.3 percent at the same meet. The on-track attendance and wagering decreases were, in part, caused by the continuing economic recession in Southern California. These changes, combined with a decline in interest income of $1,842,000 as a result of declining interest rates, primarily account for the total decline of $899,000 in total revenues to $67,654,000 for the year ended December 31, 1992. The decline in revenues from live racing events was partially offset by an increase in revenue by Santa Anita Racetrack operating as a satellite location, selected price increases and increased interstate simulcasting revenues. Santa Anita Racetrack operated as a satellite location for Hollywood Park for an additional 69 days in 1992. Direct operating costs related to horse racing operations were $45,089,000 in 1992, virtually equal with $45,093,000 reported in 1991, in spite of the fact Santa Anita Racetrack operated as a satellite location for Hollywood Park for an additional 69 days. General and administrative expenses were $8,361,000 for 1992, an increase of $1,493,000 or 21.7 percent, compared with the $6,868,000 in 1991. The increase resulted primarily from the expanded satellite racing season at Santa Anita Racetrack and the engagement of outside consultants ($660,000) to review the company's operations, including cost efficiencies, and to identify opportunities to enhance revenue. Depreciation and amortization expenses were $2,732,000 for 1992, an increase of $98,000 or 3.7 percent, compared with $2,634,000 reported for 1991. These non-cash charges resulted from the ongoing capital improvement program at Santa Anita Racetrack. Total rent paid to Realty was $10,955,000 for the year ended December 31, 1992, compared with $9,928,000 in 1991. The increase of $1,027,000 reflects increases in interstate simulcast revenues offset by decreases in the on-track and intertrack wagering. Due to the revenue and expense items previously discussed, Operating Company reported a net loss of $2,896,000 or $.26 per share in 1992 compared with net income of $259,000 or $.02 per share in 1991. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, Operating Company's sources of liquidity included cash and short-term investments of $14,388,000 and an unsecured line of credit with Realty of $10,000,000, of which approximately $3,500,000 was utilized in connection with a guarantee of a capital lease. Operating Company's ability to utilize Realty's line of credit is dependent upon Realty's liquidity and capital resources. As a result of Realty's noncompliance with certain covenants contained within its credit agreements, Realty is currently unable to borrow additional moneys under its lines of credit. Accordingly, borrowings by Realty under these agreements would not provide a source of liquidity for Operating Company. Realty is in the process of renegotiating its credit agreements. (See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Realty - Liquidity and Capital Resources"). For the year ended December 31, 1993, short-term investments earned interest income of $326,000. ITEM 7. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS (continued) - --------------------- The cash balances and related interest income from short-term investments reflect seasonal variations associated with the Santa Anita meet. During the meet, large cash balances and short-term investments are maintained by LATC, including amounts to be disbursed, for payment of license fees payable to the state, purses payable to horse owners and uncashed winning pari-mutuel tickets payable to the public. IMPACT OF INFLATION LATC's expenses are heavily labor-intensive with labor rates being covered by negotiated contracts with labor unions. Labor contracts with the pari- mutuel, service and operational employees were successfully renegotiated in April 1992. These new contracts expire in 1995. Management continues to address cost containment and labor productivity in all areas. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- See Index to Financial Statements for a listing of the financial statements and supplementary data filed with this report. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ------------------------------------------------------------- Not applicable. PART III Pursuant to General Instruction G(3) to Form 10-K, the information called for by this part of Form 10-K is incorporated herein by reference to the registrants' definitive joint proxy statement to be filed, pursuant to Regulation 14A, with the Securities and Exchange Commission not later than 120 days after the end of the year ended December 31, 1993. 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 2. Financial Statement Schedules See Index to Financial Statement Schedules 3. Exhibits See Exhibit Index (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. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Realty and Operating Company have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized. SANTA ANITA REALTY ENTERPRISES, INC. SANTA ANITA OPERATING COMPANY By: /s/ SHERWOOD C. CHILLINGWORTH By: /s/ STEPHEN F. KELLER ----------------------------- ---------------------------- Sherwood C. Chillingworth Stephen F. Keller Vice Chairman of the Board and Chairman of the Board, President Chief Executive Officer and Chief Executive Officer (Principal Executive Officer) (Principal Executive Officer) March 29, 1994 March 29, 1994 ---------------------------- ---------------------------- Date Date By: /s/ GLENNON E. KING /s/ RICHARD D. BRUMBAUGH ---------------------------- ---------------------------- Glennon E. King Richard D. Brumbaugh Acting Chief Financial Officer Vice President-Finance (Principal Financial and (Principal Financial and Accounting Officer) Accounting Officer) March 29, 1994 March 29, 1994 ---------------------------- ----------------------------- Date Date 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 the capacity and on the date indicated. Date: March 29, 1994 --------------- SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENT SCHEDULES The schedules listed below relate to Realty and Operating Company as indicated: Schedules not listed above have been omitted because either the conditions under which they are required are absent, not applicable, or the required information is included in the financial statements and related notes thereto. INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors Santa Anita Realty Enterprises, Inc. and Santa Anita Operating Company We have audited the financial statements and the related financial statement schedules, listed on pages 42 and 43 of: (a) Santa Anita Realty Enterprises, Inc.; (b) Santa Anita Operating Company and Subsidiaries; and (c) Santa Anita Realty Enterprises, Inc. and Santa Anita Operating Company and Subsidiaries Combined. These financial statements and financial statement schedules are the responsibility of the companies' 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 audits 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 the above-listed entities 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. Further, it is our opinion that the financial statement schedules referred to above present fairly, in all material respects, the information set forth therein. KENNETH LEVENTHAL & COMPANY Newport Beach, California March 1, 1994 SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA REALTY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31 ,1993, 1992 AND 1991 See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES COMBINED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes. SANTA ANITA REALTY ENTERPRISES, INC. AND SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS DECEMBER 31 , 1993, 1992 AND 1991 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Santa Anita Realty Enterprises, Inc. ("Realty") and Santa Anita Operating Company and Subsidiaries ("Operating Company") are two separate companies, the stock of which trades as a single unit under a stock-pairing arrangement on the New York Stock Exchange. Realty and Operating Company were each incorporated in 1979 and are the successors of a corporation originally organized in 1934 to conduct thoroughbred horse racing in Southern California. Realty is principally engaged in holding and investing in retail, commercial, industrial and multifamily real property located primarily in the western United States. Subsequent to year-end Realty disposed of its multifamily and industrial properties (Note 2). Realty operates as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986 and, accordingly, pays no income taxes on earnings distributed to shareholders. Operating Company is engaged in thoroughbred horse racing. The thoroughbred horse racing operation is conducted by a subsidiary of Operating Company, Los Angeles Turf Club, Incorporated ("LATC"), which leases the Santa Anita Racetrack from Realty. Separate and combined financial statements have been presented for Realty and Operating Company. Realty and Combined Realty and Operating Company use an unclassified balance sheet presentation. The separate results of operations and the separate net income per share of Realty and Operating Company cannot usually be added together to total the combined results of operations and net income per share because of adjustments and eliminations arising from inter-entity transactions. All significant intercompany and inter-entity balances and transactions have been eliminated in consolidation and combination. REAL ESTATE ASSETS Investment properties are carried at cost and consist of land, buildings, and related improvements. Depreciation is provided on a straight-line basis over the estimated useful lives of the properties, ranging primarily from 15 to 40 years. INVESTMENTS IN JOINT VENTURES All joint ventures in which Realty exercises significant control and has a 50% or greater ownership interest are consolidated. The ownership interests of outside partners in Realty's consolidated joint ventures are reflected as minority interest (excess of liabilities over assets) on the balance sheets for Realty and Combined Realty and Operating Company. Investments in unconsolidated joint ventures are accounted for using the equity method of accounting. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CASH AND CASH EQUIVALENTS Highly liquid short-term investments, with maturities of three months or less, at the date of acquisition, are considered cash equivalents. PROPERTY, PLANT AND EQUIPMENT Depreciation of property, plant and equipment and the capital lease obligation is provided primarily on the straight-line method generally over the following estimated useful lives: Building and improvements 25 to 45 years Machinery and other equipment 5 to 15 years Leasehold improvements 5 to 32 years Expenditures which materially increase property lives are capitalized. The cost of maintenance and repairs is charged to expense as incurred. When depreciable property is retired or disposed of, the related cost and accumulated depreciation is removed from the accounts and any gain or loss is reflected in current operations. INCOME TAXES Realty and Operating Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. The new standard of accounting replaces SFAS No. 96 which the company adopted in 1988. The cumulative effect of adopting Statement 109 was immaterial for the year ended December 31, 1993. DEFERRED REVENUES Operating Company's deferred revenues consist of prepaid admission tickets and parking, which are recognized as income ratably over the period of the related race meets. Also, deferred revenue includes prepaid rent from Oak Tree which is recognized over the remaining term of the lease. SHAREHOLDERS' EQUITY The outstanding shares of Realty common stock and Operating Company common stock are only transferable and tradable in combination as a paired unit consisting of one share of Realty common stock and one share of Operating Company common stock. OPERATING COMPANY'S REVENUES AND COSTS Operating Company has adopted an accounting policy whereby the revenues associated with thoroughbred horse racing at Santa Anita Racetrack are reported as they are earned. Costs and expenses associated with thoroughbred horse racing revenues are charged against income in those periods in which the thoroughbred horse racing revenues are recognized. Other costs and expenses are recognized as they actually occur throughout the year. The rental fee paid by Operating Company to Realty is recognized by both Realty and Operating Company as it is earned. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) RENTAL PROPERTY REVENUES Rental property revenues are recorded on a straight-line basis over the related lease term. As a result, deferred rent is created when rental income is recognized during free rent periods of a lease. The deferred rent is included in prepaid expenses and other assets, evaluated for collectibility and amortized over the remaining term of the lease. HORSE RACING REVENUES AND DIRECT OPERATING COSTS Operating Company's horse racing revenues and direct operating costs are shown net of state and local taxes, stakes, purses and awards. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject Realty and Operating Company to concentrations of credit risk are primarily cash investments and receivables. Realty and Operating Company place their cash investments in investment grade short-term instruments and limit the amount of credit exposure to any one commercial issuer. Concentrations of credit risk with respect to accounts receivable are limited due to the number of retail, commercial and residential tenants, and Santa Anita catering patrons. Real estate receivables are secured by first trust deeds on commercial real estate located in Southern California, and Phoenix, Arizona. Advances to unconsolidated joint ventures are unsecured and due from partnerships in which Realty is a 50% or less general partner. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Realty is an issuer of financial instruments with off-balance sheet risk in the normal course of business which exposes Realty to credit risks. These financial instruments include commitments to extend credit, financial guarantees and letters of credit. FAIR VALUE OF FINANCIAL INSTRUMENTS Management has estimated the fair value of its financial instruments using available market information and appropriate valuation methodologies. Considerable judgment is required in interpreting market data to develop estimates of fair value. Accordingly, the estimated values for Realty and Operating Company as of December 31, 1993 are not necessarily indicative of the amounts that could be realized in current market exchanges. For those financial instruments for which it is practicable to estimate value, management has determined that the carrying amounts of Realty's and Operating Company's financial instruments approximate their fair value as of December 31,1993. DIVIDEND REINVESTMENT PLAN In November 1992 Realty and Operating Company terminated their dividend reinvestment and stock purchase plan (the "Plan") which had enabled shareholders to reinvest dividends and purchase shares of Realty and Operating Company stock. Since October 1990, shares issued under the terms of the Plan had been purchased in the open market. Prior to that date, new shares had been issued. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) COMMON STOCK AND NET INCOME (LOSS) PER COMMON SHARE Net income (loss) per common share is computed based upon the weighted average number of common shares outstanding during each period for each company. Stock options have not been included in the computation since they have no material dilutive effect. Operating Company holds shares of Realty's common stock which are unpaired pursuant to a stock option plan approved by the shareholders. The shares held totaled 115,500 as of December 31, 1993, 1992 and 1991, respectively. These shares affect the calculation of Realty's net income per common share but are eliminated in the combined calculation of net income per common share. RECLASSIFICATIONS Certain prior year amounts have been restated to conform to current year presentation. NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL PROPERTIES SUBSEQUENT TO YEAR END In November 1993, Realty entered into a Purchase and Sale Agreement to sell its multifamily and industrial operations to Pacific Gulf Properties Inc. ("Pacific"), in conjunction with Pacific's proposed public offering of common stock and debentures. The transaction was structured into two parts: (1) Realty would sell all of its apartments and industrial properties to Pacific with the exception of Realty's interest in the Baldwin Industrial Park joint venture; and (2) Pacific would enter into a binding agreement to buy Realty's interest in Baldwin Industrial Park. On February 18, 1994, Realty completed the first part of this transaction by selling to Pacific ten multifamily properties, containing 2,654 apartment units, located in Southern California, the Pacific Northwest, and Texas and three industrial properties, containing an aggregate of 185,000 leasable square feet of industrial space, located in the State of Washington (the "Transferred Properties"). Realty's corporate headquarters building and related assets were also acquired by Pacific. The sale of the Transferred Properties followed the public offerings of common stock and convertible subordinated debentures by Pacific. Pursuant to the Purchase and Sale Agreement, Pacific agreed to buy Realty's interest in Baldwin Industrial Park subject to satisfaction of certain conditions, for a minimum price of $8.9 million payable in additional shares of Pacific common stock, with the final price dependent upon completion of negotiations with the other owners of Baldwin Industrial Park and an appraisal process. Management believes the sale of Realty's interest in Baldwin Industrial Park will be completed in the second half of 1994. Pacific is required to issue to Realty non-refundable letters of credit totaling $2.5 million by March 31, 1994 to secure its obligation to acquire Realty's interest in Baldwin Industrial Park and pay for the corporate headquarters building and other assets related to the Transferred Properties. In consideration of the sale of the Transferred Properties, Realty received approximately $44.4 million in cash and 149,900 shares of the common stock of Pacific. In addition, Realty was relieved of approximately $44.3 million of mortgage debt on the Transferred Properties. Realty will also receive, at the time the acquisition of Baldwin Industrial Park is completed, up to $1.2 million in additional common stock of Pacific as consideration for its corporate headquarters and other net assets related to the Transferred Properties. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) The two parts of the above transaction will result in a loss of $10,974,000. This loss has been reflected in the Realty and Realty and Operating Company combined statements of operations for the year ended December 31, 1993. If the Baldwin Industrial Park portion of the transaction described above does not occur, an additional loss will be recognized by Realty in 1994. The loss could approximate $5,900,000, depending upon whether the $2.5 million in letters of credit are drawn. Realty and Pacific have also entered into a one-year management agreement whereby Pacific has agreed to provide management services to Realty. Finally, with respect to the common stock of Pacific owned by Realty, Pacific has entered into a registration rights agreement with Realty which, under certain circumstances, allows Realty to require the registration of the Pacific stock it owns. The following unaudited pro forma condensed balance sheets of Realty and Realty and Operating Company combined are presented as if both parts of the transaction had occurred on December 31, 1993. The unaudited pro forma condensed balance sheets are not necessarily indicative of what the actual financial position of Realty or Realty and Operating Company combined would have been at December 31, 1993 nor do they purport to represent the future financial position of Realty or Realty and Operating Company combined. The accompanying notes are an integral part of this pro forma balance sheet. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) Notes: - ------ (a) Reflects the disposition of the assets and liabilities of the Multifamily and Industrial Operations as if both parts of the transaction had occurred on December 31, 1993. The amounts reflected represent the assets and liabilities directly identifiable with the Multifamily and Industrial Operations transferred by Realty to Pacific. (b) As a result of the February 18, 1994 sale to Pacific, Realty will have an investment in the common shares of Pacific totaling $2,738,000. Upon completion of Realty's disposition of Baldwin Industrial Park, assuming a price per share equal to $18.25 (the initial public offering price of Pacific's common shares) and the minimum price for Realty's interest in Baldwin Industrial Park and the corporate headquarters building and certain other assets related to the Transferred Properties, Realty will receive additional Pacific stock totaling approximately $10,064,000. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) The following unaudited pro forma statements of operation of Realty and Realty and Operating Company combined are presented as if both parts of the transaction had occurred on January 1, 1993. The unaudited pro forma statements of operation are not necessarily indicative of what the actual results of operations would have been if the transaction had been consummated on January 1, 1993 nor do they purport to represent the results of operations of Realty or Realty and Operating Company combined for any future period. The accompanying notes are an integral part of this pro forma statement of operations. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 - DISPOSITION OF MULTIFAMILY AND INDUSTRIAL OPERATIONS SUBSEQUENT TO YEAR END (CONTINUED) Notes: - ------ (1) Reflects the operations for the year ended December 31, 1993 of the Multifamily and Industrial Operations directly identifiable with, and allocations of other costs and expenses related to, the Multifamily and Industrial Operations being transferred by Realty to Pacific. (2) Estimated annual distributions to be received on Realty's investment in Pacific ($1.56 per common share) less the amount of such distributions estimated to represent the return of capital ($.56 per common share). (3) Elimination of interest expense on real estate and other loans payable repaid or assumed by Pacific. (4) Elimination of the minority interest in earnings of joint ventures resulting from Realty's acquisition of the Partnership interests and subsequent transfer to Pacific. NOTES TO FINANCIAL STATEMENTS (continued) Note 3 - Investments in Joint Ventures Realty's real estate properties include investments in the following consolidated real estate joint ventures: The financial condition and operations of the above-listed joint ventures are consolidated with the financial statements of Realty and Combined Realty and Operating Company. Combined condensed financial information for consolidated joint ventures as of December 31, 1993, 1992 and 1991 and for the years then ended is as follows: NOTE 3 - INVESTMENTS IN JOINT VENTURES (CONTINUED) During 1993, Realty acquired the partnership interests of its minority partners in the following joint ventures: SARESAM, SAREFIM, Applewood Village Partners and Hubanita. The partnership interests were acquired in consideration for cash, the cancellation of certain receivables from the minority partners and the assumption of the minority partners' capital account and payment of $250,000 related to Hubanita. The financial statements of Realty and Combined Realty and Operating Company reflect the acquisition of the minority interests. Realty's investments in unconsolidated joint ventures include investments in the following commercial real estate ventures: Unaudited combined condensed financial statement information for unconsolidated joint ventures as of December 31, 1993, 1992 and 1991 and for the years then ended is as follows: NOTE 3 - INVESTMENTS IN JOINT VENTURES (CONTINUED) Realty is a joint and several guarantor of loans issued to expand the Towson Town Center located in Towson, Maryland (owned 65% by H-T Associates) and a department store and land (owned 100% by Joppa Associates) adjacent to Towson Town Center in the amount of $82,630,000. The maximum loan balance to which the guarantees relate is $188,500,000. Realty's two partners in the ventures have also each executed repayment guarantees, although one of the partners has a limited repayment guaranty. Annually, the guarantors may request a reduction in the amount of the guaranty based on the economic performance of the regional mall. NOTE 4 - REAL ESTATE LOANS AND ADVANCES RECEIVABLE Realty's real estate loans and advances receivable as of December 31, 1993 and 1992 consist of the following: Contractual principal repayments on real estate loans and advances receivable as of December 31, 1993 are due as follows: The prime rate was 6.0% during 1993 and at December 31, 1993. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 5 - LOANS PAYABLE Realty's real estate loans payable related to real estate as of December 31, 1993 and 1992 consist of the following: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 5 - LOANS PAYABLE (CONTINUED) Realty's other loans payable as of December 31, 1993 and 1992 consist of the following: As of December 31, 1993, Realty was not in compliance with certain covenants contained in its credit agreements. The banks have waived such noncompliance through April 30, 1994 conditioned, among other things, on no additional borrowings under the credit agreements. Realty is in the process of renegotiating these credit agreements. Management is of the opinion that Realty has sufficient liquidity from other sources to assure that its operations will not be adversely affected pending this renegotiation. Under the terms of these agreements, Realty may borrow funds, at Realty's option, based upon prime rates, LIBOR (London Interbank Offered Rate) based rates or Certificate of Deposit rates. At December 31, 1993, all funds are borrowed on prime or LIBOR-based rates. LIBOR-based rates ranged from 2.80% to 3.84% and the prime rate was 6.0% at December 31, 1993. The revolving lines of credit require certain compensating balances. Under the lines of credit agreements, the compensating balance requirements at December 31, 1993, which represent cash balances that are not available for withdrawal, amounted to $1,000,000. In addition, Realty is required to pay annual commitment fees ranging from 0.15% to 0.25% on the unused portion of these lines of credit. Operating Company entered into a sale-leaseback transaction related to the financing of certain television, video monitoring and production equipment under a five-year lease expiring in December 1997. This financing arrangement is accounted for as a capital lease. Accordingly, the equipment and related lease obligation are reflected as machinery and other equipment and other loans payable, respectively, on Operating Company's and Realty and Operating Company's combined balance sheets. Realty has guaranteed $3,500,000 of the lease obligation. NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 5 - LOANS PAYABLE (CONTINUED) The assets recorded under this capital lease are: Total future minimum lease payments under this capital lease and the present value of the minimum lease payments as of December 31, 1993 consist of the following: For the year ending December 31, Interest costs for the years ended December 31, 1993, 1992 and 1991 are as follows: NOTES TO FINANCIAL STATEMENTS (COINTINUED) NOTE 5 - LOANS PAYABLE (CONTINUED) NOTE 6 - OTHER LIABILITIES Other liabilities as of December 31, 1993 and 1992 consist of the following: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 6 - OTHER LIABILITIES (CONTINUED) Advances payable represent amounts due to Realty's other partner in Anita Associates. The amount is expected to be repaid from the proceeds of the refinancing of Anita Associates' existing debt. The advances bear interest at 10% and are unsecured. NOTE 7 - INCOME TAXES As a REIT, Realty is taxed only on undistributed REIT income. During each of the years ended December 31, 1993, 1992 and 1991, Realty distributed at least 95% of its REIT taxable earnings to its shareholders. For the years ended December 31, 1993, 1992 and 1991, 41.2%, 41.2% and 52.9%, respectively, of the dividends distributed to shareholders represented a return of capital. None of the dividends distributed to shareholders during 1993, 1992 and 1991 represented capital gains. The composition of Combined Realty and Operating Company's income tax provision (benefit) and income taxes paid for the years ended December 31, 1993, 1992 and 1991 is as follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 7 - INCOME TAXES (CONTINUED) Deferred income taxes arise from temporary differences in the recognition of certain items of revenues and expenses for financial statement and tax reporting purposes. The sources of temporary differences and their related tax effect for the years ended December 31, 1993, 1992 and 1991 are as follows: A reconciliation of Combined Realty and Operating Company's total income tax provision for the years ended December 31, 1993, 1992 and 1991 to the statutory federal corporate income tax rate of 34% follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 7 - INCOME TAXES (CONTINUED) The deferred tax assets (liabilities) as of December 31, 1993 and 1992 consist of the following: In prior years, Realty had filed claims with the California Franchise Tax Board for refunds with respect to the 1970 through 1979 tax years; LATC was assessed California franchise tax and interest for the years 1980 through 1982; and, Operating Company was assessed additional franchise tax for the years 1983 through 1985. In 1993, a refund of interest and taxes in the amount of $6,082,000 was received from the California Franchise Tax Board in the settlement of the above claims. Realty has recognized $3,211,000 of interest income, net of expenses of $120,000 and an income tax benefit in the amount of $2,523,000. Operating Company has recorded additional deferred taxes payable in the amount of $228,000. The Franchise Tax Board has audited the 1986 through 1988 tax years of Operating Company. Operating Company has protested these proposed assessments. The additional assessment has been accrued by Operating Company. In February 1994, the Franchise Tax Board initiated an audit of Operating Company's 1989 through 1991 tax years. At December 31, 1993, for federal income tax purposes, Operating Company's net operating loss carryforward is approximately $6,504,000 which substantially expires in 2004. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 8 - COMMITMENTS AND CONTINGENCIES Realty's wholly owned and consolidated real estate investments consist of Santa Anita Racetrack, Fashion Park (a regional mall), various neighborhood shopping centers, industrial parks, apartment complexes and office buildings. The racetrack is leased to LATC (Note 11); the land underlying Fashion Park has been ground leased for 65 years; each of the various neighborhood shopping centers has been leased to non-anchor tenants with terms ranging from three to five years; and, the office buildings have been leased with terms generally ranging from two to ten years. The minimum future lease payments to be received from Realty's wholly owned and consolidated real estate investments (excluding rentals relating to the Santa Anita Racetrack which are paid by LATC to Realty) for the five years ending December 31, are as follows: Substantially all of the retail leases provide for additional contingent rentals based upon the gross income of the tenants in excess of stipulated minimums. Realty's share of these contingent rentals totaled $258,000 in 1993, $337,000 in 1992 and $362,000 in 1991. Realty leases the Santa Anita Racetrack to Operating Company's subsidiary, LATC. The lease provides for a rental fee of 1.5% of the total gross on-track pari-mutuel wagering generated at the racetrack. The lease, which is subject to renewal, expires in 1994. Realty also receives 40% of LATC's revenues from satellite wagering and the simulcasting of races originating from the Santa Anita Racetrack after mandated payments to the State of California and to horse owners. The lease amounts are eliminated in combination. Realty has entered into several general and limited partnerships to own and operate real estate. As of December 31, 1993, Realty has committed to invest an additional $307,000 in these partnerships. Realty has obtained a standby letter of credit totaling $448,000 related to financing on a real estate investment. In 1992, Realty and Operating Company entered into severance agreements with certain officers. Under certain circumstances, the severance agreements provide for a lump sum payment if there is a "change in control" of the entities. No provision under these severance agreements has been accrued or funded. Certain other claims, suits and complaints arising in the ordinary course of business have been filed or are pending against Realty and Operating Company. In the opinion of management, all such matters are adequately covered by insurance or, if not so covered, are without merit or are of such kind or involve such amounts as would not have a significant effect on the financial position or results of operations if disposed of unfavorably. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS STOCK OPTION PROGRAM During 1984, Realty reserved 400,000 shares of common stock for sale under its Stock Incentive Plan. During 1984, Operating Company also reserved 400,000 shares for sale under its Stock Option Program. Each company also reserved 400,000 shares for issuance under the other company's plan. During 1993, Operating Company reserved an additional 222,820 shares for sale. The shares are to be issued either as Incentive Stock Options or Non-Qualified Stock Options. The options, which are contingent upon continuous employment, are exercisable at any time once vested, for up to three years after the date of retirement or death and for up to 90 days after resignation. For both Realty and Operating Company, Incentive Stock Options and Non-Qualified Stock Options expire in 1995 through 2003. Information with respect to shares under option as of December 31, 1993, 1992 and 1991 is as follows: (a) In connection with the disposition of the multifamily and industrial operations (Note 2), the executive officers of Realty resigned effective February 18, 1994. In accordance with the stock option program, the nonvested portion of their stock options terminated on February 18, 1994. The nonvested stock options totaled 41,200 as of December 31, 1993. The unexercised vested portion of their stock options still outstanding 90 days subsequent to the resignation date will be terminated on that date. As of December 31, 1993 the vested portion of their stock options totaled 33,800. Certain officers and/or directors of Realty and Operating Company have exercised stock options. At the time of the exercise, the individuals signed notes for the purchase price of the stock (Note 11). At the time of exercise of Realty options, employees also have to buy directly from Operating Company shares of Operating Company stock at its fair market value per share to pair with Realty shares. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) In addition, Operating Company is required to purchase Realty shares to pair with the Operating Company shares being purchased by its employees. In 1984, Operating Company purchased 200,000 shares of Realty stock for this purpose. RETIREMENT INCOME PLAN Realty and Operating Company have a defined benefit retirement plan for year-round employees who are at least 21 years of age with one or more years of service and who are not covered by collective bargaining agreements. Plan assets consist of investments in a life insurance group annuity contract. Plan benefits are based primarily on years of service and qualifying compensation during the final years of employment. Funding requirements comply with federal requirements that are imposed by law. The net periodic pension cost for 1993 for Realty and Operating Company was $104,000 and $367,000 respectively; for 1992 was $109,000 and $339,000, respectively; and for 1991 was $87,000 and $300,000, respectively. The provisions include amortization of past service cost over 30 years. Based upon an actuarial valuation date of January 1, 1993, the present value of accumulated plan benefits (calculated using a rate of return of 8.5%) at December 31, 1993 was $6,280,000, and the plan's net assets available for benefits were $5,607,000. The combined net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 for the retirement income plan included the following components: NOTES TO FINANCIAL STATEMENTS (Continued) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) The following table sets forth the funded status of Realty's and Operating Company's retirement income plan and amounts recognized in the balance sheets at December 31, 1993 and 1992: Assumptions used in determining the funded status of the retirement income plan are as follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) DEFERRED COMPENSATION PLAN Realty and Operating Company have defined benefit deferred compensation agreements which provide selected management employees with a fixed benefit at retirement. Plan benefits are based primarily on years of service and qualifying compensation during the final years of employment. The net periodic pension cost for 1993 for Realty and Operating Company was $263,000 and $860,000, respectively; for 1992 was $93,000 and $243,000, respectively; and for 1991 was $98,000 and $233,000 respectively. During 1993, Realty and Operating Company recorded a combined $961,000 of pension expense, net of $793,000 of life insurance proceeds as a nonrecurring charge to the plan resulting from the death of an officer. It is the policy of Realty and Operating Company to fund only amounts sufficient to cover current deferred compensation benefits payable to retirees. The present value of unfunded benefits at December 31, 1993, based upon an actuarial valuation date of January 1, 1993, was $4,280,000 (calculated using a rate of return of 10%) and Realty's and Operating Company's combined accrued liability totaled $3,792,000. Net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 for the deferred compensation plan included the following components: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 - STOCK OPTION PROGRAM AND EMPLOYEE DEFINED BENEFIT PLANS (CONTINUED) The following table sets forth the funded status of Realty's and Operating Company's deferred compensation plan and amounts recognized in the balance sheets at December 31, 1993 and 1992: Assumptions used in determining the funded status of the deferred compensation plan are as follows: NOTE 10 - SHAREHOLDER RIGHTS PLAN In June 1989, the Board of Directors of Realty adopted a shareholder rights plan and declared the distribution of one right for each outstanding share of common stock. The distribution was made in August 1989. Each right entitles the holder to purchase from Realty, initially, one one-hundredth of a share of junior participating preferred stock at a price of $100 per share, subject to adjustment. The rights are attached to all outstanding common shares, and no separate rights certificates will be distributed. The rights are not exercisable or transferable apart from the common stock until the earlier of ten business days following a public announcement that a person or group has acquired beneficial ownership of 10% or more of Realty's general voting power or ten business days following the commencement of, or announcement of the intention to commence, a tender or exchange offer that would result in a person or group beneficially owning 10% or more of Realty's general voting power. Upon the occurrence of certain other events related to changes in the ownership of Realty's outstanding common stock or business combinations involving a holder of more than 10% of Realty's general voting power, each holder of a right would be entitled to purchase shares of Realty's common stock, or an acquiring corporation's common stock, having a market value of two times the exercise price of the right. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 10 - SHAREHOLDER RIGHTS PLAN (CONTINUED) During such time as the stock-pairing arrangement between Realty and Operating Company shall remain in effect, Operating Company will issue, on a share-for-share basis, Operating Company common shares, or, as the case may be, Operating Company junior participating preferred shares to each person receiving Realty common shares or preferred shares upon exercise or in exchange for one or more rights. Realty is entitled to redeem the rights in whole, but not in part, at a price of $.001 per right prior to the earlier of the expiration of the rights in August 1999 or the close of business ten days after the announcement that a 10% position has been acquired. NOTE 11 - RELATED PARTY TRANSACTIONS LATC leases the Santa Anita Racetrack from Realty. Rent is based upon 1.5% of the aggregate live on-track wagering and 40% of LATC's revenues received from simulcast and satellite wagering on races originating at Santa Anita Racetrack. For the years ended December 31, 1993, 1992 and 1991, LATC paid Realty (including charity days) $11,634,000, $12,683,000 and $11,817,000, respectively, in rent, of which $9,233,000, $10,955,000 and $9,928,000, respectively, were attributable to the Santa Anita meets (exclusive of charity days), with the remainder being attributable to the Oak Tree meets and charity days. The lease arrangement between LATC and Realty requires LATC to assume costs attributable to taxes, maintenance and insurance. Both Realty and Operating Company have notes receivable from certain officers, former officers and/or former directors resulting from their exercise of stock options (Note 9). Notes receivable from officers, former officers and/or former directors as of December 31, 1993 and 1992, for Realty were $81,000 and $184,000, respectively, and for Operating Company were $393,000 and $ 890,000, respectively. NOTE 12 - COMBINED QUARTERLY FINANCIAL INFORMATION - UNAUDITED Condensed combined unaudited quarterly results of operations for Combined Realty and Operating Company are as follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 12 - COMBINED QUARTERLY FINANCIAL INFORMATION - UNAUDITED (CONTINUED) In 1993, revenues and cost of sales from food and beverage operations have been reflected as a separate component in Operating Company's and Combined Realty and Operating Company's statements of operations. In prior years these operations were reflected in horse racing revenues. All prior year and interim financial statements and disclosures for Operating Company and Combined Realty and Operating Company have been restated to reflect this reclassification. Operating Company adopted an accounting practice whereby the revenues associated with thoroughbred horse racing at Santa Anita Racetrack are reported as they are earned. Costs and expenses associated with thoroughbred horse racing revenues are charged against income in those interim periods in which the thoroughbred horse racing revenues are recognized. Other costs and expenses are recognized as they actually occur throughout the year. The total of the amounts shown above as quarterly net income per common share may differ from the amount shown on the Combined Statements of Operations because the annual computation is made separately and is based upon the average number of shares outstanding for the year. Realty and Operating Company are subject to significant seasonal variations in revenues and net income (loss) due primarily to the seasonality of thoroughbred horse racing. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Realty. (b) Resigned effective December 27, 1993. (c) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1994, arising from the exercise of stock options of Realty. (d) Note receivable at 7% interest, payable in five annual installments through 1992, arising from the exercise of stock options of Realty. SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Realty. (b) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1994, arising from the exercise of stock options of Realty. (c) Note receivable at 7% interest, payable in five annual installments through 1992, arising from the exercise of stock options of Realty. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1995, arising from the exercise of stock options of Operating Company. (b) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Operating Company. (c) Decreased May 5, 1993. (d) The balance of Mr. Strub's note will be reduced at the rate of $5,000 per month by his widow, Mrs. Elizabeth Strub, who has personally guaranteed the note. Additionally, irrevocable escrow instructions have been executed by the trustee of Mr. Strub's estate wherein escrow proceeds arising from the sale of a single family residence will be applied to the outstanding balance. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------------- (a) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1992, arising from the exercise of stock options of Operating Company. (b) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1995, arising from the exercise of stock options of Operating Company. (c) Note receivable at the prime rate, adjusted annually, payable in five annual installments through 1993, arising from the exercise of stock options of Operating Company. (d) Note receivable at 7% interest, payable in five annual installments through 1992, arising from the exercise of stock options of Operating Company. SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA OPERATING 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 SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1993 SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA OPERATING COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 The accompanying notes are an integral part of this schedule. SANTA ANITA REALTY ENTERPRISES, INC. SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 (CONTINUED) - ------------ Notes (a) Initial costs December 31, 1979 book value (b) Component depreciation used (c) All dollar figures represent 100% of amounts attributable to the property (d) Initial costs December 31, 1987 book value (e) Property subject to Pacific transaction (Note 2) INDEPENDENT AUDITORS' REPORT ----------------------------- To the Partners H-T Associates We have audited the accompanying consolidated balance sheet of H-T Associates (a Maryland general partnership) and subsidiary (a Maryland general partnership) as of December 31, 1993, and the related consolidated statements of operations, partners' capital and cash flows for the year then ended. These consolidated financial statements are the responsibility of H-T Associates' management. Our responsibility is to express an opinion on these consolidated 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. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of H-T Associates and subsidiary as of December 31, 1993, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. KPMG PEAT MARWICK San Diego, California February 11, 1994 INDEPENDENT AUDITORS' REPORT ----------------------------- To the Partners H-T Associates San Diego, California We have audited the accompanying consolidated balance sheet of H-T Associates (a Maryland general partnership) and subsidiary (a Maryland general partnership) as of December 31, 1992, and the related consolidated statements of operations, partners' capital and cash flows for the year then ended. These financial statements are the responsibility of H-T Associates' 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. In our opinion, the 1992 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of H-T Associates and subsidiary as of December 31, 1992, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. KENNETH LEVENTHAL & COMPANY Newport Beach, California January 28, 1993 INDEPENDENT AUDITORS' REPORT ---------------------------- To the Partners H-T Associates San Diego, California We have audited the accompanying consolidated statements of operations, partners' capital and cash flows of H-T Associates (a Maryland general partnership) and subsidiary (a Maryland general partnership) for the year ended December 31, 1991. These financial statements are the responsibility of H-T Associates' 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. In our opinion, such 1991 consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of H-T Associates and subsidiary for the year ended December 31, 1991, in conformity with generally accepted accounting principles. DELOITTE & TOUCHE San Diego, California February 3, 1992 H-T ASSOCIATES (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED BALANCE SHEETS --------------------------- See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL -------------------------------------------- YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -------------------------------------------- See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- See notes to consolidated financial statements. H-T ASSOCIATES (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- (Continued) See notes to consolidated financial statements. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ DECEMBER 31, 1993, 1992 AND 1991 -------------------------------- A. Organization and Accounting Policies: ------------------------------------ H-T Associates (the "Partnership") is a Maryland general partnership formed on July 28, 1987. Its primary asset is a 65% ownership in Towson Town Center Associates ("TTCA"), formed to develop and operate a regional shopping center near Baltimore, Maryland. The general partners of the Partnership are Ernest W. Hahn, Inc. and Santa Anita Realty Enterprises, Inc. The Partnership is to continue until December 31, 2087, unless terminated earlier. Profits and losses are shared as follows: Ernest W. Hahn, Inc. ("Hahn") 50% Santa Anita Realty Enterprises, Inc. ("Santa Anita") 50% The consolidated financial statements of the Partnership include the accounts of the Partnership and TTCA. TTCA is a Maryland general partnership comprised of the Partnership and DeChiaro Associates ("DeChiaro") as 65% and 35% general partners, respectively. All significant intercompany balances and transactions have been eliminated. Certain reclassifications of prior year amounts have been made in order to conform with the current year presentation. The Partnership's accounting policies are as follows: 1. Shopping center property is recorded at cost and includes direct construction costs, interest, construction loan fees, property taxes and related costs capitalized during the construction period, as these amounts are expected to be recovered from operations. 2. The costs of shopping center buildings and improvements, less a 5% salvage value, are depreciated using the straight-line method over the estimated useful life of 40 years. 3. Direct costs of obtaining leases and permanent financing are deferred and are being amortized over the lease and loan periods, respectively. 4. Maintenance and repairs are charged to operations as incurred. 5. Expenditures for betterments are capitalized and depreciated over the remaining depreciable life of the property. 6. Costs incurred in connection with early termination of a tenant lease are amortized over the life of the lease with the replacement tenant. To the extent payments received from an incoming tenant do not represent future rentals or cost recoveries for tenant improvements, they are recorded as income when received. H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) ------------------------------------------------------ A. Organization and Accounting Policies: (continued) ------------------------------------ 7. Taxable income or loss of the Partnership is reported by, and is the responsibility of, the respective partners. Accordingly, the Partnership makes no provision for income taxes. 8. The Partnership recognizes scheduled rent increases on a straight-line basis. Accordingly, a deferred receivable for rents which are to be received in subsequent years is reflected in the accompanying consolidated balance sheets. 9. The differential to be paid or received under interest rate swap agreements is accrued as interest rates change, and is recognized over the life of the agreements (Note B). B. Notes payable: ------------- In 1990, TTCA entered into a building loan agreement with a commercial bank, secured by an indemnity deed of trust encumbering the property. In connection with the loan, Hahn and Santa Anita executed a repayment guaranty of $66,135,000 each and DeChiaro executed a limited repayment guaranty of $4,513,000. TTCA can borrow up to $170,000,000. The principal balance of the loan is due May 1999. The agreement provides that TTCA can: (1) obtain funds at the then current prime rate of the commercial bank; (2) obtain funds based on the then current London Interbank Offered Rate ("LIBOR") plus a spread (as defined); or, (3) obtain funds through the issuance of commercial paper at rates based upon the interest rates offered in the commercial paper market plus letter of credit fees. For the years ended December 31, 1993 and 1992, all funds were obtained under the commercial paper option for a total outstanding balance of $164,641,000 and $159,473,000, respectively. Interest is payable monthly. The variable interest rate in effect on the outstanding balance as of December 31, 1993 and 1992 was 3.2% and 3.7%, respectively. TTCA has also entered into interest rate swap agreements to reduce the impact of changes in interest rates on its loan. As of December 31, 1993 and 1992, TTCA had two interest rate swap agreements outstanding with a commercial bank which have a total notional principal amount of $82,000,000. The agreements provide for TTCA to pay fixed rates of interest of 9.3% and 8.8% on swaps of $45,000,000 and $37,000,000, respectively, and to receive floating interest based on 30 day commercial paper rates. The effective variable rate of interest on the swap agreements as of December 31, 1993 is 3.2%. The interest rate swap agreements mature at the time the building loan matures. TTCA is exposed to credit loss in the event of nonperformance by the commercial bank with the interest rate swap agreements. The net effective interest rates on amounts outstanding under the building loan agreement at December 31, 1993, 1992 and 1991, after giving effect to the interest rate swaps, was 6.9%, 6.4% and 8.3%, respectively. H-T ASSOCIATES (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) B. Notes payable: (continued) ------------- The differential between the amounts paid and received under the interest rate contract is included as either an addition to, or a reduction in, interest incurred. Total interest incurred was $11,383,329, $11,420,746, and $10,419,887 of which $0, $3,491,669 and $8,515,010 was capitalized, for the years ended December 31, 1993, 1992, and 1991, respectively. C. Commitments: ------------ Partnership as Lessor: --------------------- TTCA leases space to tenants in the shopping center for which it charges minimum rents and receives reimbursement for real estate taxes and certain other operating expenses. The terms of the leases range from 5 to 30 years and generally provide for additional overage rents during any year that tenants' gross sales exceed stated amounts. Future minimum rental revenues to be received under leases in force at December 31, 1993 are as follows: Property Under Development: --------------------------- During 1991, TTCA completed a major expansion and renovation of the previously existing shopping center. Pursuant to the Development Manager's Agreement between TTCA and Hahn, Hahn is to receive an estimated $5.1 million as compensation for managing the development of the project. Of this amount $5,080,619, $5,041,792 and $4,682,015 were incurred as of December 31, 1993, 1992 and 1991, respectively. H-T ASSOCIATES -------------- (a Maryland general partnersip) AND SUBSIDIARY (A Maryland general partnership) D. Advances from Partners: ---------------------- Hahn and Santa Anita have both made advances to the Partnership to finance certain construction funding requirements and other cash flow needs. These advances bear interest at 1% above the prime rate and they are required to be repaid prior to any distributions to the partners, other than distributions of Net Cash Flow from Operations (Note E). Interest incurred on the advances totaled $540,555, $558,918 and $702,773 for the years ended December 31, 1993, 1992 and 1991, respectively. The prime rate was 6.0%, 6.0% and 6.5% at December 31, 1993, 1992 and 1991, respectively. E. Partnership Distributions: ------------------------- Distributions of Net Cash flow from Operations of the Partnership (as defined by the Amended and Restated Partnership Agreement) are subject to certain priorities. The period from inception of the Partnership through October 16, 1991 (the Grand Opening Date of the shopping center) is referred to as the Initial Term. During the Initial Term, both partners were entitled to a cumulative, compounded return (at the Prime Rate, as defined) on their capital contributions. A $500,000 distribution was made during the Initial Term. The "Primary Term" follows the Initial Term, and ends when cash flow for a consecutive 12-month period exceeds the sum of $1,192,000 plus any unpaid cumulative returns. During the "Primary Term," Santa Anita receives a cumulative return of $447,000 for the first year, $521,500 for the second year, and $596,000 for each year thereafter. Hahn receives non-cumulative returns of the same amounts. Following the Primary Term, distributions of Net Cash Flow from Operations are made to the partners in accordance with their percentage interests. F. Related Party Transactions: -------------------------- Hahn and its wholly owned subsidiary, Hahn Property Management Corporation ("HMPC"), provide property management, leasing and various legal services to TTCA. A summary of costs and fees incurred by Hahn and HMPC by TTCA during 1993, 1992 and 1991 is presented below: H-T ASSOCIATES -------------- (a Maryland general partnership) AND SUBSIDIARY (a Maryland general partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) ------------------------------------------------------ F. Related Party Transactions: (continued) -------------------------- Related Property: ----------------- Certain property adjacent to TTCA's regional shopping center is owned by Joppa Associates ("Joppa"). The partners of TTCA are also the partners of Joppa. TTCA has benefitted from Joppa's ownership of the adjacent property. The partners consider the two properties one project. G. Disclosures About the Fair Value of Financial Instruments: --------------------------------------------------------- In the opinion of management, the carrying amounts of TTCA's financial instruments approximate fair value except: Interest Rate Swaps (Note B): ---------------------------- The fair value of interest rate swaps (used for hedging purposes) is the estimated amount that TTCA would pay to terminate the swap agreements at the reporting date, taking into account current interest rates and the current credit worthiness of the swap counterparties. The fair value of the interest rate swaps is a net payable of $13,593,031. EXHIBIT INDEX EXHIBIT INDEX (CONTINUED) EXHIBIT INDEX (CONTINUED) EXHIBIT INDEX (CONTINUED)

316618_1993.txt

316618_1993

1993

316618

877930_1993.txt

877930_1993

1993

877930

ITEM 1. BUSINESS GENERAL MESA Inc. is one of the largest independent oil and gas companies in the United States and considers itself one of the most efficient operators of domestic natural gas properties. As of December 31, 1993, Mesa owned approximately 1.7 trillion cubic feet of equivalent proved natural gas reserves ("Tcfe"). Over 70% of Mesa's total equivalent proved reserves are natural gas and the balance are principally natural gas liquids ("NGLs"), which are extracted from natural gas through processing plants. Substantially all of Mesa's reserves are proved developed reserves. The estimated future net cash flows before income taxes from Mesa's proved reserves, as determined in accordance with the regulations of the Securities and Exchange Commission (the "Commission") as of December 31, 1993, were approximately $2.3 billion and had a net present value (discounted at 10%) before income taxes of approximately $1.1 billion. Estimates of reserves for approximately 96% of the quantities shown herein have been prepared by DeGolyer and MacNaughton ("D&M"), independent petroleum engineering consultants. Quantities stated as equivalent natural gas reserves are based on a factor of 6 thousand cubic feet ("Mcf") of natural gas per barrel ("Bbl") of liquids. See "-- Reserves." Mesa's principal business strategy includes (i) maximizing the value of its existing high-quality, long-life reserves through efficient operating and marketing practices, (ii) processing natural gas to extract value-added products such as natural gas liquids and helium, (iii) conducting selective exploratory and development activities, principally in existing areas of operations, (iv) making acquisitions of producing properties with exploration and development potential in areas where Mesa has operating experience and expertise, and (v) promoting the use of natural gas as a transportation fuel and developing and marketing natural gas fuel equipment for the transportation market. MESA Inc. (the "Company") is a holding company and conducts its operations through its subsidiaries. Unless the context otherwise requires, the term "Mesa" means the Company and its subsidiaries taken as a whole and includes the Company's predecessors, Mesa Limited Partnership (the "Partnership") and Mesa Petroleum Co. ("Original Mesa"). Mesa maintains its principal executive offices at 2001 Ross Avenue, Suite 2600, Dallas, Texas 75201, where its telephone number is (214) 969-2200. At December 31, 1993, Mesa employed 383 persons. PROPERTIES Over 96% of Mesa's reserves are concentrated in the Hugoton field of southwest Kansas and the West Panhandle field of Texas. The two fields are each part of a reservoir that extends from southwest Kansas, through the Oklahoma panhandle, and into the Texas panhandle. These fields, which produce gas from depths of 3500 feet or less, are known for their stable long-life production profiles. Although the two fields are part of the same reservoir, Mesa's interests in these fields are operated separately and are subject to different contractual and marketing arrangements. Due to the long-life nature of the Hugoton and West Panhandle properties, Mesa expects to be able to maintain a relatively stable production profile for the remainder of the decade, regardless of exploration or development success in other areas. Mesa's other properties are primarily in the Gulf of Mexico. Over the past several years Mesa has concentrated its efforts on fully developing its existing long-life reserve base and improving its marketing flexibility. In the Hugoton field, these efforts have included infill drilling, additional compression and gathering facilities, and construction of a new natural gas processing plant. In the West Panhandle field, development activities have included well workovers and deepenings, adding compression facilities, and expansion and upgrading of natural gas processing facilities. In addition, Mesa restructured its contractual arrangements in the West Panhandle field to more clearly define its rights to production and to create greater marketing flexibility. Mesa has also negotiated new natural gas sales contracts over the past several years to provide market based pricing on most of its production. Two significant gas sales contracts will expire in 1995, thus giving Mesa a substantial amount of uncommitted deliverability available for sale after that date. Hugoton Field The Hugoton field in southwest Kansas began producing in 1922, and is the largest producing gas field in the continental United States. Mesa's Hugoton properties, which represent approximately 13% of the total field, are concentrated in the center of the field on over 230,000 net acres, covering approximately 400 square miles. The gas from these properties is produced from over 1,000 wells, approximately 950 of which are operated by Mesa, in which Mesa has an average working interest of 95%. Mesa owns substantially all of the gathering and processing facilities which service its production from the Hugoton field and which allow Mesa to control the production stream from the well bore to the various interconnects it has with major intrastate and interstate pipelines. Mesa's Hugoton properties are capable of producing over 260 million cubic feet ("MMcf ") of wellhead natural gas per day. Substantially all of Mesa's Hugoton production is processed through its newly constructed Satanta natural gas processing plant ("Satanta Plant"). After processing, Mesa has available to market over 175 MMcf of residue (processed) gas and 13 thousand barrels ("MBbls") of NGLs on a peak production day. Mesa's production in the Hugoton field is limited by allowables set by state regulators. Mesa attempts to shift as much of its production as is practicable into the heating season, when prices are generally higher. Mesa believes that its ability to aggregate significant volumes of natural gas and NGLs at central delivery points enhances its marketing opportunities and competitive position within the industry. Substantially all of Mesa's Hugoton properties are owned by a wholly owned subsidiary, Hugoton Capital Limited Partnership ("HCLP"). Mesa Hugoton properties accounted for 64% of Mesa's equivalent proved reserves and 71% of the present value of estimated future net cash flows before income taxes, determined as of December 31, 1993 in accordance with Commission guidelines. The Hugoton properties accounted for approximately 48%, 40% and 44% of Mesa's oil and gas revenues for the years ended December 31, 1993, 1992 and 1991, respectively. The percentage of revenues from the Hugoton field has been less than the percentage of equivalent proved reserves due primarily to the longer life of the Hugoton properties compared to Mesa's other properties and, in 1992 and 1993, to lower production levels caused by allowable restrictions. See "Production -- Hugoton Field." West Panhandle Field The West Panhandle properties are located in the northern panhandle region of Texas, and are geologically similar to Mesa's Hugoton properties. Natural gas from these properties is produced from 586 wells which Mesa operates on 191,000 net acres. All of Mesa's West Panhandle production is processed through Mesa's recently expanded Fain natural gas processing plant (the "Fain Plant"). Mesa's West Panhandle reserves are owned and produced pursuant to contracts (collectively called the "B Contract") with Colorado Interstate Gas Company ("CIG"), originally executed in 1928 by predecessors of both companies. A recent amendment to the B Contract, the Production Allocation Agreement ("PAA"), allocates 77% of the production from the West Panhandle field properties to Mesa and 23% to CIG, effective as of January 1, 1991. Under the B Contract and associated agreements, Mesa operates the wells and production equipment and CIG owns and operates the gathering system by which Mesa's production is transported to the Fain Plant. CIG also performs certain administrative functions. Each party reimburses the other for certain costs and expenses incurred for the joint account. Mesa's West Panhandle properties are owned by Mesa Operating Co. ("MOC"), a wholly owned subsidiary. As of December 31, 1993, Mesa's West Panhandle properties represented approximately 32% of Mesa's equivalent proved reserves, and approximately 29% of the present value of estimated future net cash flows before income taxes, determined in accordance with Commission guidelines. Production from the West Panhandle properties accounted for approximately 40%, 39% and 36% of Mesa's oil and gas revenues for the years ended December 31, 1993, 1992 and 1991, respectively. Although the West Panhandle properties are long-life, the percentage of Mesa's revenues represented by West Panhandle production has been greater than the percentage of equivalent proved reserves represented by such properties. This is a result of higher prices received under a sales contract for approximately 40% of Mesa's West Panhandle residue gas production, as well as the higher yield of NGLs extracted from West Panhandle natural gas as compared to Hugoton natural gas. The Fain Plant is capable of processing up to 120 MMcf of natural gas per day. West Panhandle Field natural gas contains a high quantity of NGLs. As a result, processing this gas yields relatively greater liquid volumes than recoveries realized in other natural gas fields. For example, on a peak day, Mesa can extract over 11 MBbls of NGLs at its Fain Plant from an inlet gas volume of 120 MMcf. Gulf Coast and Other Mesa's Gulf Coast properties are located offshore Texas and Louisiana. Mesa has operated in the Gulf of Mexico since 1970 and currently owns interests in 37 blocks which have produced approximately 400 Bcfe (net to Mesa's interest) over their productive lives. As of December 31, 1993, these properties had an estimated 26 Bcfe of remaining proved reserves. In previous years, Mesa owned interests in approximately 200 blocks in the Gulf of Mexico. In addition, Mesa maintains a seismic database covering over 100,000 miles in the Gulf of Mexico and an office in Lafayette, Louisiana to oversee production from its properties. Mesa's working interests in 7 of its 37 blocks are subject to a net profits interest owned by the Mesa Offshore Trust. Mesa's other producing properties are located in the Rocky Mountain area in the United States. Together, Mesa's Gulf Coast and other producing properties accounted for 4% of 1993 year-end reserves. Mesa's non-oil and gas tangible properties include buildings, leasehold improvements and office equipment, primarily in Amarillo, Dallas, and Fort Worth, Texas, and certain other assets. Non-oil and gas tangible properties comprise less than 5% of the net book value of Mesa's properties. RESERVES Proved reserve estimates for Mesa's Hugoton and West Panhandle properties were prepared in accordance with Commission guidelines by D&M. The reserve estimates for Mesa's Gulf Coast and Rocky Mountain properties were prepared by Mesa engineers, also in accordance with Commission guidelines. The properties on which reserves were estimated by D&M represent approximately 96% of Mesa's total proved reserves. The following table summarizes the estimated proved reserves and estimated future cash flows associated with Mesa's oil and gas properties as of December 31, 1993 (dollar amounts in thousands): In accordance with Commission guidelines, future prices for natural gas were based on market prices as of December 31, 1993 without future escalation and, where applicable, contract terms (including fixed and determinable price escalations under existing contracts). Market prices as of December 31, 1993 were used for future sales of oil, condensate and natural gas liquids. Future operating costs, production and ad valorem taxes and capital costs were based on current costs as of year-end 1993, with no escalation. Natural gas prices in effect at December 31, 1993 (having a weighted average of $2.14 per Mcf) may not be the most appropriate or representative prices to use for estimating future cash flows from the reserves since such prices are influenced by the seasonal demand for natural gas. The average price received by Mesa for sales of natural gas in 1993 was $1.79 per Mcf. Assuming all other variables used in the calculation of reserve data are held constant, Mesa estimates that each $.10 change in the average sales price per Mcf for natural gas would affect Mesa's estimated future net cash flows and the present value thereof, both before income taxes, by $108 million and $48 million, respectively. The following table summarizes estimated proved reserves as of December 31, 1993 by major area of operation: Estimates of reserves for approximately 96% of the quantities shown above have been prepared by D&M. Mesa's internal estimates of proved reserves as of December 31, 1993, for the Hugoton and West Panhandle areas, exceed those of D&M by about 450 Bcfe or approximately 27%. The higher reserve estimates are primarily attributable to higher recoveries that Mesa expects to realize from the 381 infill wells that have been drilled on its Hugoton properties, most of which were drilled between 1987 and 1990. Petroleum engineering is not an exact science. Information relating to Mesa's oil and gas reserves is based upon engineering estimates. Estimates of economically recoverable oil and gas reserves and of future net revenues necessarily depend upon a number of variable factors and assumptions, such as historical production performance, the assumed effects of regulations by governmental agencies and assumptions concerning future oil and gas prices, future operating costs, severance and excise taxes, development costs and workover and remedial costs, all of which may in fact vary considerably from actual results. For these reasons, estimates of the economically recoverable quantities of oil and gas attributable to any particular group of properties, classifications of such reserves based on risk of recovery and estimates of the future net revenues expected therefrom prepared by different engineers or by the same engineers at different times may vary substantially. Actual production, revenues and expenditures with respect to Mesa's reserves will likely vary from estimates, and such variances may be material. The present values of future net revenues referred to herein should not be construed as the current market value of the estimated oil and gas reserves attributable to Mesa's properties. In accordance with applicable requirements of the Commission, the estimated discounted future net revenues from proved reserves are generally based on prices and costs as of the date of the estimate, whereas actual future prices and costs may be materially higher or lower. Actual future net revenues also will be affected by factors such as the amount and timing of actual production, supply and demand for oil and gas, curtailments or increases in consumption by gas purchasers, changes in governmental regulations or taxation and the impact of inflation on costs. Mesa's producing properties in the Hugoton field and the West Panhandle field are subject to production limitations imposed by state regulatory authorities, by contracts or both, and any future limitation on production would affect the expected decline in reserves. The timing of actual future net revenues from proved reserves, and thus their actual present value, will be affected by the timing of both the production and the incurrence of expenses in connection with development and production of oil and gas properties. In addition, the 10% discount factor, which is required by the Commission to be used to calculate discounted future net revenues for reporting purposes, is not necessarily the most appropriate discount factor based on interest rates in effect from time to time and risks associated with the oil and gas industry. During 1993, Mesa filed Form EIA-23, which includes reserve estimates prepared by D&M, with the Energy Information Administration of the Department of Energy ("EIA"). Such reserve estimates did not vary from those estimates contained herein by more than five percent. The estimated quantities of proved oil and gas reserves, the standardized measure of future net cash flows from proved oil and gas reserves ("Standardized Measure") and the changes in the Standardized Measure for each of the three years in the period ended December 31, 1993 are included under "Supplemental Financial Data" in the Consolidated Financial Statements of the Company. PRODUCTION Mesa's Hugoton and West Panhandle fields are both mature reservoirs that are substantially developed and have long-life production profiles. Assuming continuation of existing economic and operating conditions (including the Hugoton field regulatory changes discussed below), Mesa expects to be able to maintain annual productive capacity from its existing properties through the end of this decade that approximates or exceeds such properties' 1993 equivalent production of approximately 115 Bcfe. Certain factors affecting production in Mesa's various fields are discussed in greater detail below. Hugoton Field Natural gas production from the Hugoton field is subject to numerous state and federal laws and Federal Energy Regulatory Commission ("FERC") regulations. The Kansas Corporation Commission (the "KCC") is the state regulatory agency that regulates oil and gas production in Kansas. One of the KCC's most important responsibilities is the determination of market demand (allowables) for the field and the allocation of allowables among the more than 5,000 wells in the field. Twice each year, the KCC sets the fieldwide allowable production at a level estimated to be necessary to meet the Hugoton market demand for the summer and winter production periods. The fieldwide allowable is then allocated among individual wells based on a series of calculations that are principally based on each well's pressure, deliverability and acreage. The allowables assigned to individual wells are affected by the relative production, testing and drilling practices of all producers in the field, as well as the relative pressure and deliverability performance of each well. Generally, fieldwide allowables are influenced by overall gas market supply and demand in the United States, as well as specific nominations for gas from the parties who produce or purchase gas from the field. Since 1987, fieldwide allowables have increased in each year except 1991. The total field allowable in 1993 was 578 Bcf. Between 1989 and 1991, Mesa's percentage of actual field production increased from a historical average of 13% to 16% because other operators produced less than their assigned allowables, and because Mesa produced its assigned allowable share and its underages (cumulative allowables not produced in the periods assigned) from prior years. Mesa also increased its productive capacity by substantially completing its infill well development program before other producers. In 1992 and 1993, Mesa's share of allowables was reduced, essentially presenting other producers with an opportunity to catch up to Mesa's more aggressive production rate from 1989 through 1991. In 1992 and 1993, Mesa's net Hugoton production totaled 55.5 Bcfe and 57.0 Bcfe, respectively, compared to 72.1 Bcfe in 1991. The KCC held hearings from August 1992 to September 1993 to consider changes to the manner in which fieldwide allowables are allocated among individual wells within the Hugoton field. Specifically, the KCC considered proposals from various producers to amend calculations of well deliverability, the allocation of allowables for infilled units, and the makeup of underages from prior periods. On February 2, 1994, the KCC issued an order, effective as of April 1, 1994, establishing new field rules which modify the formulas and calculations used to allocate allowables among wells in the field. For example, the standard pressure against which each wells' deliverability is measured will be reduced by 35%, greatly benefitting Mesa's high deliverability wells. Also, the new rules assign a 30% greater allowable to 640-acre units with infill wells than similar units without infill wells. Substantially all of Mesa's Hugoton infill wells have been drilled, resulting in an increase to Mesa in assigned allowables for 1994. The new field rules also allow Hugoton producers to make up underages over a 10-year period. The KCC reported underages for the entire field of approximately 950 Bcf, of which Mesa's share is 27 Bcf. Mesa expects to continue producing its underages during the make-up period. Mesa anticipates that the implementation of the new Hugoton field rules, the increased yield of NGLs from the Satanta Plant and certain other factors will result in an approximately 25% increase in its Hugoton field production in 1994 to over 70 Bcfe, assuming continuation of existing economic and operating conditions. Excluding reserve acquisitions, Mesa has invested over $120 million in capital expenditures in Hugoton since 1986, but expects future capital expenditures to be substantially lower. The previous capital expenditures included $54 million to drill 381 infill wells, $43 million to construct the new Satanta Plant and related facilities, and $26 million to upgrade compression facilities, production equipment and pipeline interconnects in order to increase production capacity and marketing flexibility. During periods of peak demand, Mesa's wells in the Hugoton field are capable of producing more than 260 MMcf of wet gas per day on a sustained basis. West Panhandle Field Mesa's production of wet gas from the West Panhandle field (i.e., gas production at the wellhead before processing and before reduction for royalties) is governed by the B Contract. Mesa was entitled to wet gas production of 35 Bcf for 1993 and will be entitled to 32 Bcf per year for 1994 through 1996. After deductions for processing and royalties, Mesa expects that 32 Bcf of wet gas production will result in annual net production volumes of 21 Bcf of residue gas and 3 million Bbls of NGLs. Beginning in 1997, Mesa will have the right to market and sell as much gas as it can produce, subject to specific CIG seasonal and daily entitlements as provided for under the B Contract. Assuming continuation of existing economic and operating conditions, Mesa expects its existing West Panhandle properties will be able to produce an average of 33 Bcf of wet gas per year for sale in the years 1997 through 2000. The PAA contains provisions which allocate 77% of ultimate production from the B Contract properties after January 1, 1991 to Mesa and 23% to CIG. As a result, Mesa records 77% of total annual B Contract production as sales, regardless of whether Mesa's actual deliveries are greater or less than the 77% share. The difference between Mesa's 77% entitlement and the amount of production actually sold by Mesa to its customers is recorded monthly as production revenue with corresponding accruals for operating costs, production taxes, depreciation, depletion and amortization and gas balancing receivables. At December 31, 1993, a long-term gas balancing receivable of $34.3 million relating to the B Contract was recorded in Mesa's balance sheet in other assets. In future years, as Mesa sells to customers more than its 77% entitlement share of field production, this receivable will be realized. NATURAL GAS PROCESSING Mesa, like other producers, processes its natural gas production for the extraction of NGLs because the components of the gas stream have higher market value in processed form than in non-processed, wet gas form. Mesa has recently made substantial capital investments to enhance its natural gas processing and helium extraction capabilities in the Hugoton and West Panhandle fields. Mesa owns and operates its own processing facilities so that it can (i) capture the processing margin for itself, as third party processing agreements generally available in the industry result in retention of a significant portion of the processing margin by the contract processor; and (ii) control the quality of the residue gas stream, permitting it to market gas directly to pipelines for delivery to end users. In addition, Mesa believes that the ability to control its production stream from the wellhead through its processing facilities to disposition at central delivery points enhances its marketing opportunities and competitive position in the industry. Through its natural gas processing plants, Mesa extracts raw NGLs and crude helium from the wet natural gas stream. The NGLs are then transported and fractionated into their constituent hydrocarbons such as propane, butane, ethane, isobutane and natural gasolines. The NGLs and helium are then sold pursuant to contracts providing for market based prices. Mesa produced 5 million Bbls of NGLs in 1993. Satanta Natural Gas Processing Plant Historically, approximately one-half of Mesa's Hugoton production was processed through the Ulysses natural gas processing plant for the extraction of NGLs. In the third quarter of 1993, Mesa completed the Satanta Plant. The Satanta Plant has the capacity to process 250 MMcf of natural gas per day, and enables Mesa to extract natural gas liquids from substantially all of the gas produced from its Hugoton field properties. The Satanta Plant also has the ability to extract helium from the gas stream. In December 1993, the Satanta Plant averaged 225 MMcf per day of inlet gas and produced a daily average of 11 MBbls of NGLs, 430 Mcf of crude helium and 175 MMcf of residue natural gas. Fain Natural Gas Processing Plant Wet gas produced from the West Panhandle field contains a high quantity of NGLs, yielding relatively greater NGL volumes than realized from other natural gas fields. Mesa completed an expansion of the Fain Plant in late 1992 to increase its inlet capacity from 90 MMcf per day to 120 MMcf per day. In December 1993, the Fain Plant averaged 107 MMcf per day of inlet gas and produced a daily average of 10.7 MBbls of NGLs, 280 Mcf of crude helium and 80 MMcf of residue natural gas. SALES AND MARKETING Following the processing of the wet gas, Mesa sells the dry, or residue, natural gas and the NGLs pursuant to various short-term and long-term sales contracts. Substantially all of Mesa's gas and NGL sales are made at market prices, with the exception of certain West Panhandle field volumes. Due to a number of market forces, including the seasonal nature of demand for natural gas, both sales volumes from Mesa's properties and sales prices received vary on a seasonal basis. Sales volumes and price realizations for natural gas are generally higher during the first and fourth quarters of each calendar year. The following table shows Mesa's natural gas and natural gas liquids production and prices by area for the past three years. - --------------- (1) Includes production through the date of sale from properties that have been sold. The most significant property sales occurred in 1991. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for disclosure of production from sold properties. - --------------- (1) The average natural gas price for all properties for the years 1990, 1991 and 1992 reflects $(.01) per Mcf, $.08 per Mcf and $.06 per Mcf, respectively, related to hedges of natural gas production in the natural gas futures market. Hugoton Gas Sales Contracts A substantial portion of Mesa's Hugoton field production is subject to gas purchase contracts with Western Resources, Inc. ("WRI"). The WRI contracts, which became effective January 1, 1990 and expire in May 1995, provide WRI the right to annual purchases of 34.0 Bcf in 1993, 37.5 Bcf in 1994 and 19.9 Bcf during the first five months of 1995. These volumes are subject to minimum seasonal purchase volumes. The contracts also provide that any gas not nominated for purchase by WRI is released to Mesa for sale to other parties. WRI pays market prices for volumes purchased as determined monthly based on a price index published by a third party. WRI purchased 29.5 Bcf in 1993 at an average price of $1.85 per Mcf. Under a purchase contract with Williams Natural Gas Company ("Williams"), effective as of December 1, 1989, Williams has the right, for the life of the leases on the properties governed by the contract, to purchase certain volumes of natural gas during each winter season from leases representing approximately 35% of Mesa's Hugoton production. Williams has not exercised its right to purchase gas pursuant to this agreement in previous years, and Mesa has sold such gas to other buyers at market prices. Mesa's attempts to maximize its annual production and to direct natural gas sales to the most favorable markets available, consistent with regulatory and contractual requirements. Any Hugoton production not taken under the applicable contracts by WRI or Williams is released for sale to other parties. Mesa markets such production to marketers, pipelines, local distribution companies and end users, generally under short-term contracts at market prices. West Panhandle Gas Sales Contracts Most of Mesa's West Panhandle field residue gas is sold pursuant to gas purchase contracts with two major customers in the Texas panhandle area. Approximately 10 Bcf per year of residue gas is sold to a gas utility that serves residential, commercial and industrial customers in Amarillo, Texas under the terms of a long-term agreement dated January 2, 1993, which supercedes the original contract in effect since 1949. The contract contains a pricing formula for the five-year period 1993 through 1997. Beginning in 1993, 70% of the volumes sold to the gas utility under this contract are sold at fixed prices of $2.71 per Mcf in 1993, and escalating 5% per annum in 1994 and 1995 and then at 7 1/2% per annum in 1996 and 1997. The other 30% of the volumes sold under this contract are priced at a regional market index based on spot prices plus $.10 per Mcf. Prices for 1998 and beyond will be determined by renegotiation. Mesa provides the gas utility significant volume flexibility, including a right to the residue gas volumes required to meet the seasonal needs of its residential and commercial customers. The average price received by Mesa for natural gas sales to the gas utility in 1993 was $2.52 per Mcf. Mesa's principal industrial customer for West Panhandle field gas is an intrastate pipeline company which serves various markets including an electric power generation facility near Amarillo. In 1990, Mesa entered into a five-year contract with the pipeline company to supply gas to the power generation facility. The contract provides for minimum annual volumes of 7 Bcf in 1993, 8.4 Bcf in 1994 and 8.4 Bcf in 1995 at fixed prices per MMBtu of $1.64, $1.71 and $1.79 for the respective years. Mesa has periodically made sales to the pipeline company in excess of the minimum volumes specified in the contract. In 1993, Mesa sold approximately 11 Bcf to the pipeline for an average price of $1.59 per Mcf. Other industrial customers purchase natural gas from Mesa under short to intermediate term contracts. These sales totaled approximately 4 Bcf in 1993 and 5 Bcf in 1992. Mesa intends to continue to seek new customers for additional sales of West Panhandle field natural gas production. Prior to 1993, Mesa's right to market natural gas produced from the West Panhandle field was limited by the B Contract to Amarillo, Texas and its environs. An amendment to the PAA in 1993 removed this restriction and Mesa now has the right to market its production elsewhere. Through 1995, a substantial portion of Mesa's West Panhandle production is under contract to customers in Amarillo as described above. Mesa expects to continue to focus its marketing efforts in the Amarillo area. Mesa believes that the right to market production outside the Amarillo area will ensure that Mesa receives competitive terms for its West Panhandle field production. NGL and Helium Sales NGL production from both the Satanta and the Fain Plants are sold by component pursuant to a seven year contractual arrangement with Mapco Oil and Gas Company ("Mapco"), a major transporter and marketer of NGLs, at the greater of Midcontinent or Gulf Coast prices at the time of sale. Helium is sold to an industrial gas company under a fifteen year agreement that provides for annual price adjustments. Major Customers See Note 11 of Notes to Consolidated Financial Statements for information on sales to major customers. RESERVE REPLACEMENT In the last three years, Mesa's capital budget has been directed principally toward the construction of NGL processing facilities and improvements in its compression and gathering systems, rather than toward reserve replacement. While Mesa expects to direct additional capital expenditures (see "-- Management's Discussion and Analysis of Financial Condition and Results of Operations") toward reserve replacement in 1994 and in future years, Mesa does not expect that the presently budgeted amounts will be sufficient to replace annual production with new reserve additions. However, as Mesa progresses in its plan to deleverage its capital structure, it expects that cash flows formerly devoted to debt service will be used to increase the level of capital expenditures for reserve replacement. Mesa's strategy for replacing its annual production with new reserve additions is based on a multi-step approach, including (i) developing additional reserves in certain deeper portions of the West Panhandle field reservoir; (ii) development and exploratory drilling in the Gulf of Mexico based on evaluation of three-dimensional ("3-D") seismic data, principally on existing properties; and (iii) acquisitions of producing properties with development and exploration potential, particularly in areas where Mesa presently or historically has operated. The extent to which Mesa pursues these activities is largely dependent on the success and extent of its capital raising and deleveraging activities. West Panhandle Development In the last three years, Mesa has deepened or redrilled 39 wells in the West Panhandle field, adding reserves and increasing deliverability. Mesa has also identified in excess of 100 drilling locations targeting reserves in deeper portions of the reservoir not currently reached by existing wells. Mesa anticipates development of the reserves over the next three to four years, in anticipation of its contractual right to increase its share of B Contract production in 1997 (see -- "Production -- West Panhandle Production"). Gulf Coast Development and Exploration Mesa currently owns interests held by production on 37 offshore blocks encompassing 22 producing fields. Mesa has operated in the Gulf of Mexico since 1970, and has an extensive data base, including over 100,000 miles of seismic data. Over the last three years, Mesa has evaluated its offshore producing properties utilizing conventional well information, seismic and production data, combined with new 3-D seismic surveys to identify further development and exploration potential. Mesa currently has six 3-D seismic surveys under analysis and plans to obtain an additional nine surveys in 1994. Mesa has currently identified three prospects it plans to drill in 1994 and expects to complete evaluation of 10 other blocks in 1994. Mesa intends to continue its evaluation and identify additional prospects for drilling in 1995, depending on the success of its initial program and other factors. Because it has existing infrastructure and production facilities on these properties, Mesa expects that it will be able to bring its successful wells, if any, on line more quickly and at lower development costs than have been typical for offshore production. Acquisitions Mesa has also maintained a large geological and geophysical data base covering the Midcontinent and other areas where it has historically operated. As capital becomes available and conditions permit, Mesa intends to exploit its data base and make selective acquisitions of producing properties with development and exploration potential in the Texas panhandle, the Hugoton field, and other areas of the Midcontinent and Gulf Coast regions. DRILLING ACTIVITIES The following table shows the results of Mesa's drilling activities for the last five years. At December 31, 1993, the Company was not participating in the drilling of any wells. PRODUCING ACREAGE AND WELLS, UNDEVELOPED ACREAGE Mesa's ownership of oil and gas acreage held by production, producing wells and undeveloped oil and gas acreage as of December 31, 1993 is set forth in the table below. Mesa has interests in 2,015 gross (1,467.3 net) gas wells and 64 gross (20.8 net) oil wells in the United States. Mesa also owns approximately 84,643 net acres of producing minerals and 40,732 net acres of nonproducing minerals in the United States. THE NGV BUSINESS Mesa believes that the natural gas vehicle ("NGV") market will develop and expand in the next decade, particularly in light of (i) the National Energy Policy Act of 1992, (ii) the amendments to the 1990 Federal Clean Air Act which require the use of alternative fuels by certain fleets, (iii) the requirements of numerous state and municipal environmental regulations, (iv) generally increased awareness of the adverse environmental and pollution effects of crude oil based motor fuels and (v) the development of more efficient equipment to convert gasoline and diesel burning vehicles to operate on natural gas. Mesa's principal objectives are (i) to increase public awareness and acceptance of natural gas as a premium fuel for use in the transportation sector, thus creating a potentially large, high-value market for natural gas; and (ii) to become a leading provider of NGV conversion equipment and fueling services. Mesa's present strategies to accomplish these objectives are (i) the development, manufacture and sale of engine- specific, conversion equipment which meets the most stringent emissions standards; (ii) pursuing conversion equipment sales, fleet conversions, fueling installations and administration of conversion and fueling programs; and (iii) pursuing developing opportunities for related products such as fuel tanks, compressors and dispenser systems. As of December 31, 1993, Mesa had invested approximately $14 million in its indirect, wholly owned subsidiary, Mesa Environmental Ventures Co. ("Mesa Environmental"), to fund its overhead and business development. Mesa Environmental is a start-up business in a newly developing industry and the ultimate capital investment required to insure its viability is uncertain. In addition, Mesa cannot predict when, or if, Mesa Environmental's operations will begin to earn a profit. ORGANIZATIONAL STRUCTURE In order to simplify its organizational and capital structure, Mesa effected a series of mergers, in early 1994, which resulted in the conversion of each of Mesa's subsidiary partnerships, other than HCLP, into corporate form. Pursuant to these mergers, Mesa Operating Limited Partnership ("MOLP") was merged into MOC, Mesa Midcontinent Limited Partnership and Mesa Holding Limited Partnership were merged into Mesa Holding Co. ("MHC") and Mesa Environmental Ventures Limited Partnership was merged into Mesa Environmental. Pursuant to certain of these mergers, all of the general partner interests in Mesa's subsidiary partnerships held directly or indirectly by Boone Pickens were converted into the number of shares of common stock of Mesa, as contemplated by the Conversion Agreement dated December 31, 1991, between Mesa and Mr. Pickens. As a result, all of Mesa's subsidiaries are now wholly owned by Mesa. Unless the context otherwise requires, the terms "MOC", "MHC" and "Mesa Environmental" include their respective predecessors. The Company's significant subsidiaries are described below: MOC MOC owns Mesa's properties in the West Panhandle field of Texas and its interests in the Gulf of Mexico and the Rocky Mountain area. MOC also owns a 99% limited partnership interest in HCLP. In addition, MOC owns helium attributable to its West Panhandle field properties, as well as helium and certain NGLs produced from HCLP's Hugoton properties. MOC is Mesa's principal operating subsidiary. Most of Mesa's employees are employed by MOC, and MOC is generally responsible for all of Mesa's operations, administration and marketing, including the operations of HCLP. In 1991, MOC entered into a services agreement with HCLP pursuant to which MOC operates HCLP's Hugoton field properties and provides certain services necessary to market production therefrom, process remittances of production revenues and perform certain other administrative functions in exchange for a services fee. The services fee totaled approximately $11.4 million in 1993. HCLP Substantially all of Mesa's Hugoton property interests (including gathering systems, compression and gas processing facilities, but excluding certain NGL and helium reserves) are owned by HCLP. HCLP also owns the Satanta Plant, which was constructed by MOC. MOC operates the plant under a long-term lease. HCLP was formed in 1991 to own substantially all of Mesa's Hugoton properties and to issue certain long-term notes secured by those properties (the "HCLP Secured Notes"). The indenture and mortgage for the HCLP Secured Notes contain various covenants which, among other things, limit HCLP's ability to sell or acquire oil and gas property interests, incur additional indebtedness, make unscheduled capital expenditures, make distributions of property or funds subject to the mortgage, or enter into certain types of long-term contracts or forward sales of production. The agreements also require HCLP to remain in partnership form; its general partner, Hugoton Management Co., is a wholly owned subsidiary of the Company. The assets of HCLP, which is required to maintain separate existence from Mesa, are generally not available to pay creditors of Mesa or its subsidiaries other than HCLP. The HCLP agreements require proceeds from production to be applied towards payment of HCLP's operating, administrative and capital costs and to service HCLP's debt. To the extent cash flows exceed these requirements, such excess cash is generally available for distribution to the Mesa subsidiaries that own HCLP's equity. Other Subsidiaries MHC principally conducts various investment activities. At December 31, 1993, MHC (including its predecessors) held $92 million of cash and securities and a 19% limited partnership interest in HCLP and had an intercompany payable to MOC of $123 million. The payable to MOC was repaid to a balance of $4.5 million on February 28, 1994 with a combination of cash and the transfer of an 18% limited partnership interest in HCLP to MOC. After the subsidiary merger and intercompany transaction, MHC owns all of the equity of Mesa Environmental, a 1% limited partnership interest in HCLP and approximately $63 million of cash and securities as of February 28, 1994. Mesa Capital Corporation is a wholly owned finance subsidiary of MOC. Neither MHC nor Mesa Environmental is an obligor with respect to any of Mesa's debt securities. HISTORY OF MESA In 1964, Original Mesa was formed as a public corporation engaged in the business of exploring for and producing oil and natural gas. Original Mesa's reserves and revenues grew significantly throughout the 1960's, 1970's and early 1980's as a result of successful exploration, development and acquisitions. Original Mesa conducted operations in the U.S. and, at various times, Canada, the North Sea and Australia. Original Mesa was reorganized as the Partnership, a publicly traded limited partnership, in 1985 and the Partnership was converted to corporate form as MESA Inc. in 1991. Mesa has also made significant acquisitions, principally in the Hugoton and West Panhandle fields. Mesa's two most recent significant acquisitions, Pioneer Corporation in 1986 (which included Mesa's West Panhandle field) and Tenneco Inc.'s midcontinent division in 1988 (which included approximately one-fourth of Mesa's current Hugoton holdings), increased reserves from 1.4 Tcfe at year-end 1985 to over 2.8 Tcfe at year-end 1988. Mesa incurred significant debt to make the reserve acquisitions and made cash distributions to Partnership unitholders of over $1.1 billion from 1986 through 1991. The increased debt associated with the acquisitions, the distributions and declining gas prices through the mid-1980's and early 1990's, significantly impaired Mesa's financial strength and flexibility. As a result, in 1991 Mesa began to sell assets and refinance and restructure its debt. From 1989 through 1993, Mesa sold nearly 600 Bcfe of proved producing reserves for an aggregate of over $633 million. Mesa used the proceeds principally to reduce debt. Mesa refinanced $550 million of bank debt in 1991 with the formation of HCLP and the issuance of the HCLP Secured Notes. In 1993, Mesa restructured substantially all of its $600 million of outstanding subordinated debt in a debt exchange transaction which had the effect of deferring over $150 million of cash interest requirements through the end of 1995. COMPETITION The oil and gas business is highly competitive in the search for, acquisition of and sale of oil and gas. Mesa's competitors in these endeavors include the major oil and gas companies, independent oil and gas concerns, and individual producers and operators, as well as major pipeline companies, many of which have financial resources greatly in excess of those of Mesa. Mesa believes that its competitive position is affected by, among other things, price, contract terms and quality of service. Mesa is one of the largest owners of natural gas reserves in the United States. Mesa's major gas sales contracts (see "-- Sales and Marketing" above) allow production not sold to the contract purchaser to be sold to other purchasers in the spot market. Production from Mesa's properties has access to a substantial portion of the major metropolitan markets in the United States through numerous pipelines and other purchasers. Mesa is not dependent upon any single purchaser or small group of purchasers. Mesa believes that its competitive position is enhanced by its substantial long-life reserve holdings and related deliverability, its flexibility to sell such reserves in a diverse number of markets, and its ability to produce its reserves at a low cost. OPERATING HAZARDS AND UNINSURED RISKS Mesa's oil and gas activities are subject to all of the risks normally incident to exploration for and production of oil and gas, including blowouts, cratering and fires, each of which could result in damage to life and property. Offshore operations are subject to a variety of operating risks, such as hurricanes and other adverse weather conditions and lack of access to existing pipelines or other means of transporting production. Furthermore, offshore oil and gas operations are subject to extensive governmental regulations, including certain regulations that may, in certain circumstances, impose absolute liability for pollution damages, and to interruption or termination by governmental authorities based on environmental or other considerations. In accordance with customary industry practices, Mesa carries insurance against some, but not all, of these risks. Losses and liabilities resulting from such events would reduce revenues and increase costs to Mesa to the extent not covered by insurance. REGULATION AND PRICES Mesa's operations are affected from time to time in varying degrees by political developments and federal, state and local laws and regulations. In particular, oil and gas production operations and economics are, or in the past have been, affected by price controls, taxes, conservation, environmental and other laws relating to the petroleum industry, by changes in such laws and by constantly changing administrative regulations. Natural Gas Regulations Prior to January 1, 1993, various aspects of Mesa's natural gas operations were subject to regulations by the FERC under the Natural Gas Act of 1938 (the "NGA") and the Natural Gas Policy Act of 1978 (the "NGPA") with respect to "first sales" of natural gas, including price controls and certificate and abandonment authority regulations. However, as a result of the enactment of the Natural Gas Decontrol Act of 1989, the remaining "first sales" restrictions imposed by the NGA and the NGPA terminated on January 1, 1993. Historically, interstate pipeline companies generally acted as wholesale merchants by purchasing natural gas from producers and reselling the gas to local distribution companies and large end-users. Commencing in late 1985, the FERC has issued a series of orders that have had a major impact on natural gas pipeline operations, services and rates and thus have significantly altered the marketing and price of natural gas. Order 636, issued by the FERC in April 1992, requires each pipeline company, among other things, 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 and their affiliates are not required to remain "merchants" of gas, and some of the interstate pipeline companies have or will become "transporters only." In subsequent orders, the FERC largely affirmed Order 636 and denied a stay of the implementation of the new rules pending judicial review. In addition, the FERC has generally accepted rate filings implementing Order 636 on essentially every interstate pipeline as of the end of 1993. Order 636, as well as the FERC orders approving the individual pipeline rate filings implementing Order 636, are the subject of numerous appeals to the United States Courts of Appeals. Mesa cannot predict whether the latest orders will be affirmed on appeal or what the effects will be on its business. State and Other Regulation All of the jurisdictions in which Mesa owns producing oil and gas properties have statutory provisions regulating the production and sale of crude oil and natural gas. The regulations often require permits for the drilling of wells but extend also to the spacing of wells, the prevention of waste of oil and gas resources, the rate of production, prevention and clean-up of pollution and other matters. In Texas, the Railroad Commission regulates the amount of oil and gas produced within the state by assigning to each well or proration unit an allowable rate of production. Certain other jurisdictions, including Kansas, impose similar restrictions. See "-- Production" for a discussion of recent changes to Mesa's allowables in the Hugoton field. Certain producing states, including Texas, Louisiana, Oklahoma and Kansas, have recently adopted or considered adopting 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 allowables, a procedure which resulted in substantial excess allowables over volumes actually produced. Mesa cannot predict what ultimate effect the new prorationing regulations will have on its production of gas or whether other states will adopt similar or other gas prorationing procedures. On October 24, 1992, comprehensive national energy legislation was enacted which focused on electrical power, renewable energy sources and conservation. The legislation requires equal treatment of domestic and imported natural gas supplies, mandates expanded use of natural gas and other alternative fuels vehicles, funds natural gas research and development, permits continued offshore drilling and use of natural gas feedstock for electric generation, and adopts various conservation measures designed to reduce consumption of imported oil. Mesa cannot predict what effect, if any, this legislation will have on its business. Mesa owns, directly or indirectly, certain natural gas facilities that it believes meet the traditional tests the FERC has used to establish a pipeline's status as a gatherer not subject to FERC jurisdiction under the NGA. Mesa transports its own gas through these facilities. Mesa also has gas that is transported through gathering facilities owned by others, including interstate pipelines. State regulation of gathering facilities generally includes various safety, environmental, and in some circumstances, non-discriminatory take requirements, but does not generally entail rate regulation. Natural gas gathering may receive greater regulatory scrutiny at both the state and federal levels as the pipeline restructuring under Order 636 is implemented. For example, Oklahoma recently enacted a prohibition against discriminatory gathering rates. In certain recent cases the FERC has implied that it has ancillary NGA jurisdiction over gathering activities of interstate pipelines and their affiliates. In addition, the FERC recently convened a conference to consider issues relating to gathering services performed by interstate pipelines or their affiliates. The FERC intends to use information obtained to reevaluate the appropriateness of its traditional gathering criteria and the appropriateness of regulating gathering in light of Order 636, and to establish consistent policies for gathering rates and services for both interstate pipelines and their affiliates. It is not possible at this time to predict the outcome of this proceeding although it could ultimately affect access to and rates of interstate gathering service. Federal Royalty Matters By a letter dated May 3, 1993, directed to thousands of producers holding interests in federal leases, the United States Department of the Interior ("DOI") announced its interpretation of existing federal leases to require the payment of royalties on past natural gas contract settlements which were entered into in the 1980s and 1990s to resolve, among other things, take-or-pay and minimum take claims by producers against pipelines and other buyers. The DOI's letter set forth various theories of liability, all founded on the DOI's interpretation of the term "gross proceeds" as used in federal leases and pertinent federal regulations. In an effort to ascertain the amount of such potential royalties, the DOI sent a letter to producers on June 18, 1993 requiring producers to provide all data on all natural gas contract settlements, regardless of whether gas produced from federal leases was involved in the settlement. Mesa received a copy of this information demand letter. In response to the DOI's action, in July 1993 various industry associations and others filed suit in the United States District Court for the Northern District of West Virginia seeking an injunction to prevent the collection of royalties on natural gas contract settlement amounts under the DOI's theories. The lawsuit has recently been transferred to the United States District Court in Washington, D.C. Because this lawsuit is pending and because of the complex nature of the calculations necessary to determine potential additional royalty liability under the DOI's theories, it is impossible to predict what, if any, additional or different royalty obligation the DOI may assert with respect to any of Mesa's prior natural gas contract settlements. Likewise, Mesa cannot predict what effect, if any, the DOI's claims will have on it. Environmental Matters Mesa's operations are subject to numerous United States federal, state, and local laws and regulations controlling the discharge of materials into the environment or otherwise relating to the protection of the environment, including the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") also known as the "Superfund Law." Such regulations, among other things, impose absolute liability on the lessee under a lease for the cost of clean-up of pollution resulting from a lessee's operations, subject the lessee to liability for pollution damages, may require suspension or cessation of operations in affected areas, and impose restrictions on the injection of liquids into subsurface aquifers that may contaminate groundwater. Mesa maintains insurance against costs of clean-up operations, but it is not fully insured against all such risks. A serious incident of pollution may, as it has in the past, also result in the DOI requiring lessees under federal leases to suspend or cease operation in the affected area. In addition, the recent trend toward stricter standards in environmental legislation and regulation may continue. For instance, legislation has been proposed in Congress from time to time that would reclassify certain oil and gas production wastes as "hazardous wastes" which would make the reclassified exploration and production wastes subject to much more stringent handling, disposal and clean-up requirements. If such legislation were to be enacted, it could have a significant impact on Mesa's operating costs, as well as the oil and gas industry in general. State initiatives to further regulate the disposal of oil and gas wastes are also pending in certain states, and these various initiatives could have a similar impact on Mesa. The Oil Pollution Act of 1990 ("OPA") and regulations thereunder impose a variety of regulations on "responsible parties" (which include owners and operators of offshore facilities) related to the prevention of oil spills and liability for damages resulting from such spills in United States waters. In addition, OPA imposes ongoing requirements on responsible parties, including proof of financial responsibility to cover at least some costs in a potential spill. On August 25, 1993, the Minerals Management Service ("MMS") published an advance notice of its intention to adopt a rule under OPA that would require owners and operators of offshore oil and gas facilities to establish $150 million in financial responsibility. Under the proposed rule, financial responsibility could be established through insurance, guaranty, indemnity, surety bond, letter of credit, qualification as a self-insurer or a combination thereof. There is substantial uncertainty as to whether insurance companies or underwriters will be willing to provide coverage under OPA because the statute provides for direct lawsuits against insurers who provide financial responsibility coverage, and most insurers have strongly protested this requirement. The financial tests or other criteria that will be used to judge self-insurance are also uncertain. Mesa cannot predict the final form of the financial responsibility rule that will be adopted by the MMS, but such rule has the potential to result in the imposition of substantial additional annual costs on Mesa or otherwise materially adversely affect Mesa's operations in the Gulf of Mexico. Mesa is not involved in any administrative or judicial proceedings arising under federal, state or local environment protection laws and regulations which would have a material adverse effect on Mesa's financial position or results of operations. ITEM 2. ITEM 2. PROPERTIES Reference is made to Item 1 of this Form 10-K for a description of Mesa's properties. ITEM 3. ITEM 3. LEGAL PROCEEDINGS UNOCAL SETTLEMENT On January 11, 1994, Mesa settled a lawsuit brought by Unocal Corporation ("Unocal") and a purported stockholder of Unocal against Mesa and certain other defendants. The Unocal lawsuit was originally filed in 1986 against Original Mesa, certain subsidiaries of Original Mesa and certain other parties. The lawsuit alleged that the defendants had purchased and sold Unocal common shares within a six-month period in 1985 in transactions subject to Section 16(b) of the Securities Exchange Act of 1934, resulting in alleged short-swing profits of approximately $99 million that were recoverable by Unocal under Section 16(b). The plaintiffs also asked the Court to grant prejudgment interest, which amount could have exceeded $50 million. Mesa and the other defendants contended that none of the transactions in the Unocal shares were subject to Section 16(b) and, further, that no profit was realized. However, in light of the significant uncertainties relating to continuing the litigation and other relevant circumstances, Mesa determined that entering into a settlement agreement with Unocal (the "Unocal Settlement") would be in the best interests of Mesa and its stockholders. The settlement was approved by the U.S. District Court for the Central District of California at a hearing held on February 28, 1994. Pursuant to the Unocal Settlement, Mesa and the other defendants agreed to pay Unocal an aggregate of $47.5 million, of which $42.75 million was paid by Mesa and $4.75 million was paid by certain other defendants not affiliated with Mesa. On March 2, 1994, Mesa issued and sold approximately $48.2 million face amount of 12 3/4% Secured Discount Notes due 1998 in a registered public offering to certain institutional investors. The proceeds of the sale (approximately $42.75 million) were used to fund Mesa's portion of the Unocal Settlement. PREFERENCE UNITHOLDERS Mesa and Mr. Pickens are defendants in lawsuits filed in early 1992 related to the conversion of the Partnership into Mesa Inc., styled Odmark, et al. v. Mesa Limited Partnership, et al., Gerardo, et al. v. Mesa Limited Partnership, et al., and McBride Trust, et al. v. Mesa Limited Partnership, et al., pending in the U.S. District Court for the Northern District of Texas -- Dallas Division. The first two lawsuits have been consolidated and certified as a class action and the third is an individual action by or on behalf of former holders of preference units of the Partnership. All three allege substantially the same claims under the federal securities laws and common law. Plaintiffs allege, among other things, that (i) the proxy materials delivered to unitholders in connection with the corporate conversion contained material misstatements and omissions, (ii) the general partners of the Partnership breached fiduciary duties to the preference unitholders in structuring the transaction and allocating the common stock of Mesa and (iii) the corporate conversion was implemented in breach of the partnership agreement of the Partnership because the defendants allegedly did not obtain the requisite opinion of independent counsel regarding certain tax effects of the transaction. Mesa and the other defendants have denied the allegations and believe they are without merit. Plaintiffs seek a declaration declaring the corporate conversion void and rescinding it, an order requiring payment to the former preference unitholders of $164 million in respect of the preferential distribution rights of their units, unspecified compensatory and punitive damages and other relief. In August 1993, Mesa and Mr. Pickens filed a motion for summary judgment in the individual action, and such motion is awaiting decision by the Court. Discovery has commenced and is proceeding in the class action, in which the Court has set an August 1994 trial date. Mesa and the other defendants have denied the plaintiffs' allegations. Several lawsuits making allegations substantially the same as those referenced in clauses (i) and (ii) above were filed by preference unitholders in Delaware Chancery Court in 1991 following the proposal of the corporate conversion. In December 1991, the Chancery Court denied the plaintiffs' request for a preliminary injunction to enjoin consummation of the corporate conversion. In August 1992, the Chancery Court granted a motion by the plaintiffs to dismiss the Delaware lawsuits and awarded attorneys' fees to plaintiffs' counsel. MASTERSON LAWSUIT In 1986, Mesa, through MOC, acquired rights in certain properties located in the West Panhandle field of Texas when it acquired the assets of Pioneer Corporation. In particular, Mesa acquired an interest in gas production from an oil and gas lease (the Gas Lease) dated April 30, 1955, between R. B. Masterson, et al., as lessor, and CIG, as lessee. In February 1992, the current lessors under the Gas Lease sued CIG in Federal District Court in Amarillo, Texas, claiming that CIG had underpaid royalties due under the Gas Lease. The plaintiffs alleged that the underpayment was the result of CIG's using an improper gas sales price upon which to calculate royalties, and that the proper price should have been determined pursuant to a pricing clause in a July 1, 1967 amendment to the Gas Lease. The complaint did not specify the damages sought and appeared to relate only to royalties for periods after October 1, 1988. The plaintiffs also sought a declaration by the court as to the proper price to be used for calculating future royalties. In August 1992, CIG filed a third party complaint against Mesa for any such royalty underpayments which may be allocable to Mesa's interest in the Gas Lease. On December 22, 1992, the plaintiffs filed a Second Amended Complaint, including both CIG and Mesa as defendants, again alleging that the use of an erroneous price in calculating royalties resulted in underpayments of royalties, but for the first time alleging that the underpayments amounted to approximately $250 million (including interest) and covered the period July 1, 1967 to present. Mesa was subsequently dismissed by the plaintiffs for procedural reasons, but remains in the case as a defendant in CIG's third party complaint. The plaintiffs have recently filed court papers alleging royalty underpayments of approximately $450 million (including interest at 10%) covering the period from July 1, 1967 to the present. In addition, the plaintiffs seek exemplary damages. Management believes that Mesa has several substantial defenses to plaintiffs' claims, including (i) that the royalties for all periods were properly computed and paid and (ii) that plaintiffs' claims with respect to all periods prior to October 1, 1988 (which appear to account for the large majority of the claims) were explicitly released by a 1988 written agreement among plaintiffs, CIG and Mesa and are further barred by the statute of limitations. If the plaintiffs were to prevail, the manner in which any resulting liability would be shared between Mesa and CIG would depend on the resolution of issues relating to the contractual agreements and the relationship between Mesa, CIG and the lessors during the period in question. No trial date has been set, but Mesa expects that the Court may set a trial date in 1994. OTHER Mesa is also a defendant in various other lawsuits and legal proceedings and, as the successor entity to the Partnership and Original Mesa, has assumed certain other obligations from those entities. Mesa does not expect the resolution of any of these other matters to have a material adverse effect on its results of operations or financial position. 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 following table sets forth, for the periods indicated, the high and low closing prices for Mesa's common stock as reported by the New York Stock Exchange. - --------------- Mesa's common stock currently trades on the New York Stock Exchange under the symbol MXP. At December 31, 1993, there were 46,511,439 common shares outstanding. Mesa has not paid any dividends with respect to its common stock and does not expect to pay dividends in the future unless and until there is a material and sustained increase in natural gas prices and adequate provision has been made for further reduction of debt. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of restrictions on the payment of dividends. At March 4, 1994, there were 26,701 record holders of Mesa's common shares. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected financial information of Mesa as of the dates or for the periods indicated. This table should be read in conjunction with the Consolidated Financial Statements of the Company and related notes thereto included elsewhere in this Form 10-K. 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, 1993, 1992 and 1991, Mesa reported consolidated net losses of $102.4 million, $89.2 million and $79.2 million, respectively. The results of operations for each year have been influenced by certain income and expenses which are either non-recurring or not directly associated with Mesa's primary operations. See discussion of these items under "Other Income (Expense)" below. The following table presents a summary of the results of operations of Mesa for the years indicated. In 1993, Mesa sold primarily oil producing properties in the deep Hugoton and Rocky Mountain areas. In 1992, Mesa sold oil and gas properties located in Canada and in 1991 sold oil and gas properties located primarily in Oklahoma, the Texas Panhandle and the San Juan Basin of New Mexico. Results from operations related to sold properties are included in Mesa's results through the closing dates of such sales. The following table presents the contribution made to Mesa's operating results by the sold properties. REVENUES The table below presents, for the years indicated, the revenues, production and average prices received from sales of natural gas, natural gas liquids and oil and condensate. - --------------- * The average natural gas prices reported above for the years ended December 31, 1992 and 1991 reflect gains of $.06 per Mcf and $.08 per Mcf, respectively, related to hedges of natural gas production in the natural gas futures market. Natural gas revenues decreased from 1991 to 1993 as a result of decreased production partially offset by increased average prices for each year. Natural gas liquids revenues did not fluctuate significantly as increases in natural gas liquids production from 1991 to 1993 were offset by decreases in the average prices received. Oil and condensate revenues increased in 1992 compared with 1991 as a result of increased production from Gulf Coast properties and from new development in the Rocky Mountain area. The decrease in 1993 compared to 1992 is a result of decreased production from the Gulf Coast properties and the sale of a portion of the Rocky Mountain properties. Average oil prices received decreased in each year from 1991 through 1993. Natural gas production decreased by 18% from 1991 to 1992 and an additional 11% from 1992 to 1993. The decrease from 1991 to 1992 resulted primarily from Mesa's reduced share of allowables in the Hugoton field. The decrease from 1992 to 1993 resulted primarily from a 5.4 Bcf decrease in Gulf Coast production and a 6.1 Bcf decrease in West Panhandle field production recorded as gas balancing sales. Gulf Coast natural gas production for 1993 declined, in part, because 1992 production included over 2.6 Bcf allocated to Mesa for the recovery of capital costs paid by Mesa, as operator, on behalf of the Mesa Offshore Trust (the "Trust"). Upon full recovery of costs (which occurred in late 1992), Mesa's share of production from properties subject to the Trust's interest declined. Hugoton field production in 1993 was relatively flat compared with 1992. Sales from the West Panhandle field, excluding gas balancing, increased by 3.4 Bcf in 1993 due to increased sales to industrial customers. Effective January 1, 1991, Mesa and CIG entered into a contract which entitles Mesa to 77% of the ultimate reserves and production from the West Panhandle field. As a result of this contract, Mesa records its share of the total field production as revenue, even though its actual sales volumes are presently less than 77% of the total cumulative field production. Entitlement production in excess of sales totaled 4.8 Bcf in 1991, 6.8 Bcf in 1992 and .7 Bcf in 1993. See additional discussion below under "Production Allocation Agreement." Mesa's production from the Hugoton field is affected by the allowables set for the entire field and by the portion of allowables allocated to Mesa's wells. Allowables are assigned to individual wells based on a series of calculations which are influenced by the relative production, testing and drilling practices of all producers in the field, as well as the relative pressure and deliverability performance of each well. In October 1991, Mesa's share of Hugoton field allowables was substantially reduced below historical levels. This reduction resulted from Mesa's aggressive production and drilling practices between 1989 and 1991, which caused the pressures and deliverability of Mesa's wells to decline relative to those of other operators in the field. The KCC has recently issued new regulations relating to calculations of well deliverability, allocation of allowables, and makeup of underages in the Hugoton field. Generally, Mesa expects the new regulations to increase its allowable share and add 15 to 20 Bcf to production volumes over the next three years. Natural gas liquids production increased by approximately 7% from 1991 to 1993 as a result of increases in West Panhandle and Hugoton field liquids production. In the fourth quarter of 1992, Mesa completed the expansion of its Fain natural gas processing plant in the West Panhandle field, increasing its natural gas inlet capacity from 90 MMcf per day to 120 MMcf per day. In the third quarter of 1993, the Satanta plant in the Hugoton field was completed. The new plant, which is capable of processing up to 250 MMcf of natural gas per day, replaced Mesa's older Ulysses plant which could process up to 160 MMcf per day. Natural gas prices increased from 1991 to 1992 and increased again in 1993. According to the American Gas Association, aggregate domestic demand for natural gas has increased in each of the last three years. Prices were positively affected by colder-than-normal spring temperatures in 1993 and a hurricane in the Gulf of Mexico in 1992. Oil and condensate prices decreased in each year from 1991 through 1993 reflecting the continuing downturn in market prices since the end of the Persian Gulf war in early 1991. Natural gas liquids prices generally fluctuate with oil prices. COSTS AND EXPENSES Mesa's aggregate costs and expenses declined by approximately 5% from 1992 to 1993 due primarily to decreases in exploration and depreciation, depletion and amortization expenses partially offset by an increase in lease operating expenses. Lease operating expenses were $8.0 million greater in 1993 than in 1992 due to increased production costs in the West Panhandle field. Exploration charges were $7.3 million lower in 1993 than in 1992 as a result of exploratory dry hole expense in the Gulf Coast area in 1992. Depreciation, depletion and amortization expense was $13.8 million lower in 1993 than in 1992 due primarily to lower production in 1993. Mesa's aggregate costs and expenses in 1992 were slightly lower than in 1991. Exploration charges were $5.3 million greater in 1992 than in 1991 as a result of exploratory dry hole expense in the Gulf Coast area in 1992. Depreciation, depletion and amortization expense was $3.1 million lower in 1992 than in 1991 primarily due to lower production in 1992. Certain components of lease operating expenses and production and other taxes decreased in 1992 from 1991 as a result of the 1991 property sales. These decreases, however, were substantially offset by an increase in ad valorem taxes in Kansas and the increase in production and gathering costs associated with entitlement production in the West Panhandle field. See additional discussion below under "Production Allocation Agreement." The table below presents Mesa's lease operating costs by area of operation (in thousands): Hugoton field operating expenses have not increased substantially over the last three years. The 1993 increase is a result of additional costs from added compression facilities and from the new Satanta processing plant. West Panhandle field operating expenses increased significantly in 1992 and in 1993. The increases are primarily a result of increased gathering and administrative fees paid to CIG as operator of the gathering system in the West Panhandle field. Operating expenses in Mesa's other producing areas decreased in 1992 from 1991 due to property sales. OTHER INCOME (EXPENSE) Interest expense in 1993 was not materially different than 1992 as average aggregate debt outstanding did not materially change. Interest expense decreased by $7.4 million from 1991 to 1992 primarily due to a $49 million decrease in weighted average debt outstanding. Results of operations for the years 1993, 1992 and 1991 include certain items which are either non-recurring or are not directly associated with Mesa's oil and gas producing operations. The following table sets forth the amounts of such items (in thousands): The securities gains (losses) relate to Mesa's investments in marketable securities and futures contracts that are not accounted for as hedges of production. See discussion above under "Results of Operations" regarding oil and gas property sales. The gain recorded from collection of a note receivable relates to a note receivable from Bicoastal Corporation, which was in bankruptcy. Mesa's claims in the bankruptcy exceeded its recorded receivable. As of year-end 1993, Mesa had collected the full amount of its allowed claims plus a portion of the interest due on such claims. The litigation settlement charge relates to Mesa's early 1994 settlement of a lawsuit with Unocal Corporation ("Unocal"). The litigation related to a 1985 investment in Unocal by Mesa's predecessor and certain other defendants. The plaintiffs had sought to recover alleged "short-swing profits" plus interest totaling over $150 million pursuant to Section 16(b) of the Securities Exchange Act of 1934. In early 1994, Mesa and the other defendants reached a settlement with the plaintiffs and agreed to pay $47.5 million to Unocal, of which Mesa's share was $42.8 million. The Court approved the settlement on February 28, 1994 and Mesa issued additional 12 3/4% secured discount notes due June 30, 1998 with a face amount of $48.2 million. Mesa used the proceeds from the issuance of notes of $42.8 million to pay its share of the settlement. In the fourth quarter of 1993, Mesa completed a settlement with the Internal Revenue Service ("IRS") resolving all tax issues relating to the 1984 through 1987 tax returns of Mesa's predecessor. Mesa had previously established contingency reserves for the IRS claims and certain other contingent liabilities in excess of the actual and estimated liabilities. As a result of the settlement with the IRS and the resolution and revaluation of certain other contingent liabilities, Mesa recorded a net gain of $24 million in the fourth quarter of 1993. The debt exchange expense relates to costs associated with Mesa's debt exchange completed in 1993. See additional discussion under "Capital Resources and Liquidity" below. The corporate conversion expense relates to costs associated with the year-end 1991 conversion of Mesa Limited Partnership to MESA Inc. PRODUCTION ALLOCATION AGREEMENT Effective January 1, 1991, Mesa entered into the PAA with CIG which allocates 77% of reserves and production from the West Panhandle field to Mesa and 23% to CIG. During 1993, 1992 and 1991, Mesa produced and sold 74%, 61% and 58%, respectively, of total production from the field; the balance of field production was sold by CIG. Mesa records its 77% ownership interest in natural gas production as revenue. The difference between the net value of production sold by Mesa and the net value of its 77% entitlement is accrued as a gas balancing receivable. The revenues and costs associated with such accrued production are included in results of operations. The following table presents the incremental effect on production and results of operations from entitlement production recorded in excess of actual sales as a result of the PAA. At December 31, 1993, the long-term gas balancing receivable from CIG, net of accrued costs, relating to the PAA was $34.3 million, which is included in other assets in the consolidated balance sheet. The provisions of the PAA allow for periodic and ultimate cash balancing to occur. The PAA also provides that CIG may not take in excess of its 23% share of ultimate production. Mesa entered into an amendment to the PAA in 1993 which allows Mesa, for the first time, to market its residue natural gas production outside of Amarillo, Texas, but which also limits Mesa's production to 35 Bcf of unprocessed gas in 1993 and 32 Bcf annually in 1994 through 1996. Mesa produced its entire 35 Bcf entitlement in 1993. CAPITAL RESOURCES AND LIQUIDITY Financial Condition and Cash Requirements Mesa is a highly leveraged company with $1.2 billion of long-term debt. In recent years, Mesa has repaid or refinanced over $1.6 billion of its long-term debt. The most recent transaction was completed in 1993 when almost $600 million of subordinated notes and $100 million of bank debt was restructured in a debt exchange transaction. See additional discussion below. In 1994, Mesa intends to continue efforts to reduce, refinance and restructure its debt, including through the issuance of new equity securities. Mesa owns and operates its oil and gas properties through direct and indirect subsidiaries. HCLP owns substantially all of Mesa's Hugoton field natural gas properties. HCLP was established in 1991 to own these properties and to issue the HCLP Secured Notes. The assets and cash flows of HCLP are dedicated to service HCLP's debt and are not available to pay creditors of Mesa or its subsidiaries other than HCLP. MOC owns all of Mesa's interest in the West Panhandle field of Texas and the Gulf Coast and the Rocky Mountain areas. At December 31, 1993, MOC owned an approximate 81% limited partnership interest in HCLP. Subsequent to December 31, 1993, MOC received an additional 18% interest in HCLP from another subsidiary as partial payment for intercompany debt. The following table summarizes certain components of Mesa's financial position and cash flows as of and for the year ended December 31, 1993 (in thousands): - --------------- (a) MOLP was merged into MOC on January 5, 1994. (b) In March 1994, the Company issued additional 12 3/4% secured discount notes and used the proceeds of $42.8 million to settle the Unocal litigation. See "Other Income (Expense)." (c) Included in working capital (deficit). (d) Cash interest payments, net of interest income. The HCLP Secured Notes, for which HCLP is the sole obligor, are secured by its Hugoton field properties and are due in semiannual installments through August 2012, but may be repaid earlier depending on the rate of production from the properties. Mesa's bank credit agreement, as amended (the "Credit Agreement"), is a credit facility under which approximately $59 million of borrowings and $10 million of letter of credit obligations were outstanding at December 31, 1993. Obligations under the Credit Agreement are secured by a first lien on MOC's West Panhandle properties, Mesa's equity interest in MOC and a 76% equity interest in HCLP. Borrowings under the Credit Agreement are due in various installments through June 1995. Mesa and MOC are obligors under the Credit Agreement. The 12 3/4% secured discount notes are due in 1998 and are secured by second liens on MOC's West Panhandle properties and a 76% equity interest in HCLP. The 12 3/4% unsecured discount notes are due in 1996. The 12% subordinated notes are unsecured and have a stated maturity of August 1996 and the 13 1/2% subordinated notes (also unsecured) have a stated maturity of May 1999. The 12 3/4% secured discount notes, 12 3/4% unsecured discount notes (together, the "Discount Notes") and both issues of subordinated notes are obligations of MOC, Mesa and Mesa Capital Corporation, a financing subsidiary of MOC. On August 26, 1993, Mesa completed a debt exchange (the "Debt Exchange") whereby new debt securities (primarily the Discount Notes) and $13.2 million in cash were issued in exchange for substantially all of the 12% and 13 1/2% subordinated notes ("Subordinated Notes") and accrued interest thereon. Prior to the completion of the Debt Exchange, there had been $600 million of principal outstanding under the Subordinated Notes and approximately $55.0 million of accrued interest. The new Discount Notes accrue, but do not pay, interest through June 30, 1995, after which interest will be payable semiannually in cash, commencing December 31, 1995. The Debt Exchange results in deferrals of $75 million per year of interest payments which would have been paid from mid-1993 through June 30, 1995. In connection with the Debt Exchange, Mesa and its bank lenders amended the Credit Agreement in order to extend the payment of a portion of the outstanding principal, which was scheduled to mature in June 1994 (or earlier as a result of the then current default in the payment of interest on the Subordinated Notes, which default was cured upon completion of the Debt Exchange), and to amend certain covenants thereunder, including a reduction in Mesa's tangible adjusted equity requirement, as defined. In return, the banks received, among other things, additional security, earlier payment of a portion of the outstanding principal and an increase in the rate of interest payable on the loans. The following tables summarize Mesa's 1993 actual and 1994 through 1997 forecast cash requirements, assuming no changes in its capital structure, for interest, debt principal and capital expenditures (in thousands): - --------------- (a) Cash interest payments, net of interest income. (b) Forecast capital expenditures represent Mesa's best estimate of drilling and facilities expenditures required to attain projected levels of production from its existing properties during the forecast period. Contractual commitments with a major gas purchaser in the Hugoton field require expenditures, primarily for compression, of approximately $7.1 million by HCLP during 1994 and 1995, which amounts are included in amounts set forth in the table for such years. Mesa may incur capital expenditures in addition to those reflected in the table. (c) Does not consider potential acceleration if Mesa's tangible adjusted equity falls below the requirement set forth in the Credit Agreement. See discussion under "Debt Covenants." Debt Covenants The Credit Agreement contains restrictive covenants which require Mesa to maintain tangible adjusted equity, as defined, of at least $50 million and a ratio of cash flow and available cash to debt service, as each is defined, of at least 1.50 to 1. At December 31, 1993, tangible adjusted equity was $114.9 million and the ratio was 2.32 to 1. Assuming no changes in its capital structure or in existing business conditions, Mesa's financial forecasts indicate that it will continue to report net losses and that tangible adjusted equity, as defined, is likely to fall below the $50 million requirement in the second half of 1994. The financial forecasts also indicate that Mesa will have adequate financial resources, including available cash and securities, to satisfy any obligations which may become due under the Credit Agreement in the event the tangible adjusted equity covenant is not satisfied and cannot be renegotiated or compliance therewith waived. At December 31, 1993, Mesa had approximately $110 million of cash and securities excluding cash held at HCLP. In addition, payment of the settlement amount to Unocal did not cause the ratio of cash flow and available cash to debt service to fall below the required level. The indentures governing the Discount Notes restrict, among other things, Mesa's ability to incur additional indebtedness, pay dividends, acquire stock or make investments, loans and advances. The Credit Agreement also restricts, among other things, Mesa's ability to incur additional indebtedness, create liens, pay dividends, acquire stock or make investments, loans and advances. Company Resources and Alternatives Mesa's cash flows from operating activities are substantially dependent on the amount of oil and gas produced and the price received for such production. Production and prices received from HCLP properties, together with cash held within HCLP, are expected, under Mesa's current operating plan, to generate sufficient cash flow to meet HCLP's required principal, interest and capital obligations. However, HCLP cash flows are not expected to be sufficient to permit HCLP to distribute any excess cash until at least 1995. In addition, Mesa may advance as much as $10 million to HCLP in 1994 to cover HCLP capital expenditures in excess of required scheduled capital expenditures. Mesa expects production and prices related to MOC's properties to generate cash from operating activities which, together with available cash and securities balances, are expected to be sufficient to cover MOC's debt principal and interest obligations and capital expenditures through December 31, 1995. On December 31, 1995, Mesa will begin making interest payments on the Discount Notes. Assuming no changes in Mesa's capital structure prior to such date, Mesa will be required to make cash interest payments related to the Discount Notes totaling approximately $51 million on December 31, 1995 and cash interest payments totaling approximately $90 million during 1996. In addition, the 12 3/4% unsecured discount notes in the amount of $178.8 million and 12% subordinated notes in the amount of $6.3 million become due in mid-1996. Mesa's current financial forecasts indicate that Mesa will be unable to fund such payments in 1996 with cash flows from operating activities and available cash and securities balances. Depending on industry and market conditions, Mesa may generate cash by issuing new equity or debt securities or by selling assets. However, Mesa has limited ability to sell assets since its two largest assets, its interests in the Hugoton and West Panhandle fields, are pledged under long-term debt agreements. Mesa intends to continue its efforts to strengthen its financial condition by raising equity capital and applying the proceeds thereof to retire debt, and to issue new lower-cost debt to refinance its existing higher-cost debt securities. There can be no assurance that Mesa will be able to raise equity capital or otherwise refinance its debt. Other Mesa recognizes its ownership interest in natural gas production as revenue. Actual production quantities sold may be different from Mesa's ownership share of production in a given period. Mesa records these differences as gas balancing receivables or as deferred revenue. Net gas balancing underproduction represented approximately 3% of total equivalent production in 1993 compared with 12% during the same period in 1992. The gas balancing receivable or deferred revenue component of natural gas and natural gas liquids revenues in future periods is dependent on future rates of production, field allowables and the amount of production taken by Mesa or by its joint interest partners. Mesa invests from time to time in marketable equity and other securities and in commodity and futures contracts, primarily related to crude oil and natural gas. Mesa also enters into natural gas futures contracts as a hedge against natural gas price fluctuations. Management does not anticipate that inflation will have a significant effect on Mesa's operations. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements, and notes thereto, together with report of Arthur Andersen & Co. dated March 4, 1994, and supplementary data are included in this Form 10-K under Item 14 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 Information regarding Directors and Executive Officers of Mesa appears in Mesa's Proxy Statement for the 1994 Annual Meeting of Stockholders ("Proxy Statement"), which is to be filed with the Commission, and such information is incorporated by reference herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The presentation of Executive Compensation of the Registrant appears in the Proxy Statement, which is to be filed with the Commission, and such information (other than information that is not required to be set forth in this 10-K) is incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The presentation of the Security Ownership of Certain Beneficial Owners and Management of the Registrant appears in the Proxy Statement, which is to be filed with the Commission, and such information is incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in Item 11, "Executive Compensation," and in the Proxy Statement under "Election of Directors," which is to be filed with the Commission, is incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Consolidated Financial Statements and Supplementary Data Schedules other than those listed above are omitted because they are not required, are not applicable or the information required has been included elsewhere herein. (a)(3) Exhibits (Asterisk indicates exhibits are incorporated by reference herein). (b) Reports on Form 8-K 1. Current Report on Form 8-K dated January 11, 1994 regarding a series of merger transactions resulting in the conversion of each of Mesa's subsidiary partnerships, other than Hugoton Capital Limited Partnership, to corporate form. 2. Current Report on Form 8-K dated January 12, 1994 regarding the Unocal litigation settlement. 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. MESA INC. By: /s/ BOONE PICKENS (Boone Pickens, Chief Executive Officer) Date: March 8, 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. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To MESA Inc.: We have audited the accompanying consolidated balance sheets of MESA Inc. (a Texas corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, 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. As discussed further in Note 2 to the consolidated financial statements, the Company's current financial forecasts indicate the Company will be unable to fund certain principal and interest payments on its debt in 1996 with cash flows from operating activities and available cash and securities balances. Depending on industry and market conditions, the Company may generate cash by issuing new equity or debt securities or selling assets. However, the Company has a limited ability to sell assets and there can be no assurances that the Company will be able to raise equity capital or otherwise refinance its debt. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MESA 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. 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 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. Houston, Texas March 4, 1994 MESA INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (See accompanying notes to consolidated financial statements.) MESA INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) (See accompanying notes to consolidated financial statements.) MESA INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (See accompanying notes to consolidated financial statements.) MESA INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS) (See accompanying notes to consolidated financial statements.) MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES MESA Inc., a Texas corporation, was formed in 1991 in connection with a transaction (the Corporate Conversion) which reorganized the business of Mesa Limited Partnership (the Partnership). The Partnership was formed in 1985 to succeed to the business of Mesa Petroleum Co. (Original Mesa). Unless the context otherwise requires, as used herein the term "Company" refers to MESA Inc. and its subsidiaries taken as a whole and includes its predecessors. Pursuant to the Corporate Conversion, the Partnership transferred substantially all its assets and liabilities to the Company on December 31, 1991 in exchange for all outstanding shares of the Company's common stock. The common units and general partner interests in the Partnership that were held by Boone Pickens (the General Partner) (which would otherwise have been converted into 4.14% of the Company's common stock) were converted into a 4.14% general partner interest in each direct subsidiary partnership of the Company. The Partnership allocated 1.0 share of the Company's common stock for each common unit and 1.35 shares of the Company's common stock for each preference unit to its unitholders (other than the General Partner). Concurrently, the Company effected a one-for-five reverse split of the common stock and the Partnership distributed to its former unitholders (other than the General Partner) .2 shares of common stock for each common unit and .27 shares of common stock for each preference unit. Principles of Consolidation The Company owns and operates its oil and gas properties and other assets through various direct and indirect subsidiaries. At the beginning of 1993, the Company owned a 95.86% limited partnership interest and the General Partner owned a 4.14% general partner interest in the direct subsidiary partnerships. The debt exchange described in Notes 2, 4 and 7 included issuance of approximately $29.3 million of 0% convertible notes which were converted into approximately 7.5 million shares of common stock prior to December 31, 1993. In addition, on December 31, 1993, the General Partner converted approximately one-fourth of his general partner interests into 416,890 shares of common stock. As a result of these issuances of common stock, the Company's interest in the direct subsidiaries increased to 97.38% and the general partner interest decreased to 2.62%. The accompanying consolidated financial statements reflect the consolidated accounts of the Company and its subsidiaries after elimination of intercompany transactions. The general partner interest is reflected as a minority interest. In January 1994, the Company effected a series of merger transactions which resulted in the conversion of each of its direct subsidiary partnerships to corporate form (see Note 13). Pursuant to these mergers, the remaining general partner interests in the Company's subsidiary partnerships held directly or indirectly by the General Partner were converted into 1,250,670 shares of common stock, thereby eliminating the minority interest. Certain reclassifications have been made to amounts reported in previous years to conform to 1993 presentation. Statements of Cash Flows For purposes of the statements of cash flows, the Company classifies all cash investments with original maturities of three months or less as cash and cash investments. Investments Investments in marketable securities are stated at the lower of cost or market value and are classified as current or noncurrent, depending on management's intent at the balance sheet date. Periodic changes in the stated value of the marketable securities portfolios are reflected in income in the case of current investments and in stockholders' equity in the case of noncurrent investments. The cost of securities sold is determined on MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the first-in, first-out basis. The Company also enters into various futures contracts which are not intended to be hedges of future natural gas or crude oil production and are periodically adjusted to market prices. Gains and losses from such contracts are included in securities gains (losses) in the consolidated statements of operations. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which is required to be adopted in 1994. SFAS No. 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. The Company's current portfolio of securities would be classified as trading securities under the provisions of SFAS No. 115 and would be reported at fair value, with unrealized gains and losses included in earnings. The Company's securities transactions are currently reported as cash flows from investing activities in the consolidated statements of cash flows. Under the provisions of SFAS No. 115, cash flows from transactions in trading securities will be classified as cash flows from operating activities. The Company does not expect the adoption of SFAS No. 115 to have a material effect on its financial position or results of operations. Oil and Gas Properties Under the successful efforts method of accounting, all costs of acquiring unproved oil and gas properties and drilling and equipping exploratory wells are capitalized pending determination of whether the properties have proved reserves. If an exploratory well is determined to be nonproductive, the drilling and equipment costs of the well are expensed at that time. All development drilling and equipment costs are capitalized. Capitalized costs of proved properties and estimated future dismantlement and abandonment costs are amortized on a property-by-property basis using the unit-of-production method. Geological and geophysical costs and delay rentals are expensed as incurred. Unproved properties are periodically assessed for impairment of value and a loss is recognized at the time of impairment. The aggregate carrying value of proved properties is periodically compared with the undiscounted future net cash flows from proved reserves, determined in accordance with Securities and Exchange Commission (SEC) regulations, and a loss is recognized if permanent impairment of value is determined to exist. A loss is recognized on proved properties expected to be sold in the event that carrying value exceeds expected sales proceeds. Net Loss Per Common Share The computations of net loss per common share are based on the weighted average number of common shares outstanding during each period. Fair Value of Financial Instruments The Company's financial instruments consist of cash, marketable securities, short-term trade receivables and payables, restricted cash and long-term debt. The carrying values of cash, marketable securities, short-term trade receivables and payables and restricted cash approximate fair value. The fair value of long-term debt is estimated based on the market prices for the Company's publicly traded debt and on current rates available for similar debt with similar maturities and security for the Company's remaining debt. Gas Revenues The Company recognizes its ownership interest in natural gas production as revenue. Actual production quantities sold by the Company may be different than its ownership share of production in a given period. If the Company's natural gas sales exceed its ownership share of production, the excess is recorded as deferred revenue. Gas balancing receivables are recorded when the Company's ownership share of production exceeds MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) its natural gas sales. The Company also accrues production expenses based on its ownership share of production. At December 31, 1993, the Company had produced and sold a net 13.6 billion cubic feet (Bcf) of natural gas less than its ownership share of production and had recorded gas balancing receivables, net of deferred revenues, of approximately $27.5 million. Substantially all of the Company's gas balancing receivables and deferred revenue is classified as long-term. The Company periodically enters into natural gas futures contracts as a hedge against natural gas price fluctuations. Gains or losses on such futures contracts are deferred and recognized as natural gas revenue when the hedged production occurs. The Company recognized net gains of $8.3 million and $5.6 million in 1991 and 1992, respectively, and net losses of $.3 million in 1993 related to hedging activities. The Company did not enter into any new hedge contracts in 1993. At December 31, 1993, the Company had no deferred gains or losses related to hedging activities and did not own any natural gas futures contracts accounted for as hedges. Taxes The Company provides for income taxes using the asset and liability method under which deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The effect on deferred taxes of a change in tax laws or tax rates is recognized in income in the period that includes the enactment date. (2) RESOURCES AND LIQUIDITY The Company is highly leveraged but in recent years has repaid or refinanced over $1.6 billion of long-term debt. The most recent transaction was completed in 1993 when substantially all of the Company's $600 million of subordinated notes and $100 million of bank debt was restructured in a debt exchange transaction. In 1994, the Company intends to continue efforts to reduce, refinance and restructure its debt, including through the issuance of new equity securities. At December 31, 1993, the Company's long-term debt, net of current maturities, totaled approximately $1.2 billion (see Note 4). The Company also had approximately $76 million of working capital; cash and securities totaled approximately $150 million. Included in the $150 million of cash and securities is $40 million of cash held by Hugoton Capital Limited Partnership (HCLP), an indirect subsidiary partnership. The assets of HCLP (which include substantially all of the Company's Hugoton field natural gas properties and approximately $63 million of restricted cash) are dedicated to service HCLP's $542 million of secured debt (the HCLP Secured Notes) and are not available to pay creditors of the Company or its other subsidiaries. See Note 4 for additional discussion. The Company's cash flows from operating activities are substantially dependent on the amount of oil and gas produced and the prices received for such production. Production and prices received from HCLP properties, together with cash held by HCLP, are expected, under the Company's current operating plan, to generate sufficient cash flow to meet HCLP's required principal, interest and capital obligations. However, HCLP's cash flows are not expected to be sufficient to permit HCLP to distribute any excess cash to other Company subsidiaries until at least 1995. The Company may advance as much as $10 million to HCLP in 1994 to cover HCLP capital expenditures in excess of required scheduled capital expenditures. During the third quarter of 1993, the Company completed the debt exchange (Debt Exchange) described in Note 4. The notes issued in the Debt Exchange replaced substantially all of the Company's $600 million of previously outstanding subordinated notes. The Debt Exchange resulted in the deferral of cash interest requirements of approximately $75 million annually from mid-1993 through June 30, 1995. Completion of the Debt Exchange also resulted in an amendment to the Company's bank credit agreement (Credit Agreement), which advanced the maturity of $41 million of principal payments from 1994 to 1993 but also extended the maturity of $40 million of principal and $10 million of letter of credit obligations from 1994 to 1995. The MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company believes that completion of the Debt Exchange and amendments to the Credit Agreement have increased its ability to obtain traditional equity or debt financing to repay or refinance its indebtedness. As a result of the completion of the Debt Exchange and the amendments to the Credit Agreement, the Company expects to service its debt obligations and meet capital expenditure requirements through 1995 with cash flows from operating activities and available cash and securities balances. On December 31, 1995, the Company will begin making interest payments on the 12 3/4% secured discount notes due June 30, 1998 and the 12 3/4% unsecured discount notes due June 30, 1996 (together, the Discount Notes) issued in the Debt Exchange. Assuming no changes in the Company's capital structure prior to such date, the Company will be required to make cash interest payments related to the Discount Notes totaling approximately $51 million on December 31, 1995 and approximately $90 million during 1996. In addition, 12 3/4% unsecured discount notes in the amount of $178.8 million and 12% subordinated notes in the amount of $6.3 million become due in mid-1996. The Company's current financial forecasts indicate that the Company will be unable to fund such payments in 1996 with cash flows from operating activities and available cash and securities balances. Depending on industry and market conditions, the Company may generate cash by issuing new equity or debt securities or selling assets. However, the Company has a limited ability to sell assets since its two largest assets, its interests in the Hugoton and West Panhandle fields, are pledged under long-term debt agreements. The Company intends to continue its efforts to strengthen its financial condition by raising equity capital and applying the proceeds thereof to retire debt, and to issue new lower-cost debt to refinance its existing higher-cost debt securities. However, there can be no assurances that the Company will be able to raise equity capital or otherwise refinance its debt. (3) MARKETABLE SECURITIES The value of marketable securities is as follows (in thousands): For the year ended December 31, 1993, the Company recognized a net gain of $4.0 million from its investments in securities and futures contracts compared with a net gain of $7.8 million in 1992 and a net loss of $2.1 million in 1991. The net securities gains and losses do not include gains or losses from natural gas futures contracts accounted for as hedges of natural gas production. Hedge gains or losses are included in natural gas revenue in the period in which the hedged production occurs (see Note 1). The net securities gains and losses recognized during a period include both realized and unrealized gains and losses. During 1993, the Company realized net gains of $2.3 million from securities transactions and futures contracts. The Company realized a net gain from securities transactions and futures contracts of $10.0 million in 1992 and a net loss of $7.8 million in 1991. MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (4) LONG-TERM DEBT Long-term debt and current maturities are as follows (in thousands): HCLP SECURED NOTES HCLP holds substantially all of the Company's Hugoton field natural gas properties. In 1991, HCLP issued $616 million of secured notes in a private placement with a group of institutional lenders. The issuance replaced $550 million of bank debt and funded a $66 million restricted cash balance within HCLP. The restricted cash balance is available to supplement cash flows from the HCLP properties in the event such cash flows are not sufficient to fund principal and interest payments on the HCLP Secured Notes when due. As the HCLP Secured Notes are repaid, the restricted cash balance is reduced proportionately. The HCLP Secured Notes were issued in 15 series and have final stated maturities extending through 2012 but are expected to be retired earlier based on the rate of production from the Hugoton properties. As of December 31, 1993, approximately $75.0 million of principal has been repaid as scheduled. In February 1994, an additional $21.4 million of principal was repaid as scheduled. The HCLP Secured Notes outstanding at December 31, 1993 bear interest at fixed rates ranging from 8.80% to 11.30% (weighted average 10.21%). Principal and interest payments are made semiannually. Provisions in the HCLP Secured Note agreements require interest rate premiums to be paid to the noteholders in the event that the HCLP Secured Notes are repaid more rapidly or slowly than scheduled in the agreements. Such premiums, if required, would increase the effective interest rate of the HCLP Secured Notes. The HCLP Secured Note agreements contain various covenants which, among other things, limit HCLP's ability to sell or acquire oil and gas property interests, incur additional indebtedness, make unscheduled capital expenditures, make distributions of property or funds subject to the mortgage, or enter into certain types of long-term contracts or forward sales of production. The agreements also require HCLP to maintain separate existence from the Company and its other subsidiaries. The assets of HCLP are dedicated to service HCLP's debt and are not available to pay creditors of the Company or its subsidiaries other than HCLP. Revenues received for production from HCLP's Hugoton properties are deposited in a collection account maintained by a collateral agent (Collateral Agent). The Collateral Agent releases or reserves funds, as appropriate, for the payment of royalties, taxes, operating costs, capital expenditures and principal and interest on the HCLP Secured Notes. Only after all required payments have been made may any remaining funds held by the Collateral Agent be released from the mortgage. However, HCLP's cash flows are not expected to be sufficient to permit HCLP to distribute any excess cash to other Company subsidiaries until at least 1995. MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The restricted cash balance and cash held by the Collateral Agent for payment of interest and principal on the HCLP Secured Notes are invested by the Collateral Agent under the terms of a guaranteed investment contract (GIC) with Morgan Guaranty Trust Co. of New York (Morgan). Morgan was paid $13.9 million at the date of issuance of the HCLP Secured Notes to guarantee that funds invested under the GIC would earn an interest rate equivalent to the weighted average coupon rate on the outstanding principal balance of the HCLP Secured Notes (10.21% at December 31, 1993). A portion of this amount may be refunded if the HCLP Secured Notes are repaid earlier than if HCLP had produced according to its scheduled production, depending primarily on prevailing interest rates at that time. In the first quarter of 1992, the Company contributed $32 million in cash to HCLP, which funds were previously not subject to the mortgage. A portion of such funds has been used to supplement HCLP's cash flows in order to make scheduled principal payments on the HCLP Secured Notes. At December 31, 1993, approximately $10.3 million of HCLP's cash was not subject to the mortgage. In February 1994, the Company contributed an additional $5.8 million to HCLP which, along with the $10.3 million of HCLP cash not subject to the mortgage, was used to supplement HCLP's cash flows in order to make the February 1994 scheduled principal payment. The Company may also advance to HCLP up to $10 million in 1994 to fund expected capital expenditures in excess of scheduled capital expenditures. HCLP cash balances were as follows (in thousands): In connection with the formation of HCLP and the issuance of the HCLP Secured Notes, Mesa Operating Co. (MOC), the successor to Mesa Operating Limited Partnership, a Company subsidiary which owns substantially all of the limited partnership interests of HCLP, entered into a services agreement with HCLP. MOC provides services necessary to operate the Hugoton field properties and market production therefrom, process remittances of production revenues and perform certain other administrative functions in exchange for a services fee. The fee totaled approximately $11.4 million in 1993 and $10.7 million in 1992. CREDIT AGREEMENT As of December 31, 1993, the Company had borrowed approximately $59.1 million under its Credit Agreement and had outstanding approximately $10.4 million in letter of credit obligations secured under the Credit Agreement. Upon consummation of the Debt Exchange (see "Discount Notes" below and Note 2), the Company and its bank lenders amended the Credit Agreement. Pursuant to the amendment, the Credit Agreement was reduced from a $150 million revolving credit facility to a credit facility providing for $80 million of initial borrowings and $10 million in letter of credit obligations. The Company had borrowed $100 million under the Credit Agreement prior to completion of the Debt Exchange. Accordingly, the Company made a $20 million principal payment under the Credit Agreement on August 26, 1993 and agreed to make additional scheduled principal payments of $10 million in the fourth quarter of 1993, $30 million in the first half of 1994, and the remaining balance at final maturity in the second quarter of 1995 (including an obligation to cash collateralize any remaining letter of credit obligations outstanding at that time). The terms of the amended Credit Agreement require prepayment of the next scheduled principal payment in the amount of one-half of any proceeds from asset sales or collections from Bicoastal Corporation (Bicoastal) (see Note 8). As a result of proceeds from asset sales and collections from Bicoastal during 1993, approximately $10.5 million of the $30 million due under the Credit Agreement in the first half of 1994 was prepaid in 1993 and an additional $2.7 million was prepaid in January 1994. MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The rate of interest payable on borrowings under the Credit Agreement is the prime rate plus 1/2% or the Eurodollar rate plus 2 1/2% until borrowings are reduced to $50 million, and thereafter reduced, subject to certain conditions, to a rate equal to the Eurodollar rate plus 1 1/2% or the prime rate. Obligations under the Credit Agreement are secured by a first lien on the Company's West Panhandle field properties, by the Company's equity interest in MOC and by 76% of MOC's equity interest in HCLP. The amendments to the Credit Agreement reduced the Company's tangible adjusted equity requirement, as defined, from $150 million to $50 million and increased the Company's required ratio of cash flow and available cash to debt service, as each is defined, from at least 1.25 to 1 to 1.50 to 1. At December 31, 1993, the Company's tangible adjusted equity, as defined, was $114.9 million and the ratio of cash flow and available cash to debt service was 2.32 to 1. Assuming no changes in its capital structure and in existing business conditions, the Company's financial forecasts indicate that the Company will continue to report net losses and that tangible adjusted equity, as defined, is likely to fall below the $50 million requirement in the second half of 1994. The financial forecasts also indicate that the Company will have adequate financial resources, including available cash and securities balances, to satisfy any obligations which may become due under the Credit Agreement in the event the tangible adjusted equity covenant is not satisfied and cannot be renegotiated or compliance therewith waived. At December 31, 1993, the Company had approximately $110 million of cash and securities excluding cash held at HCLP. In addition, payment of $42.8 million on March 3, 1994 to settle a lawsuit (see Note 9) did not cause the ratio of cash flow and available cash to debt service to fall below the required level. The provisions of the Credit Agreement prohibit the Company from paying any dividends to equity holders, other than those paid in the form of equity securities. DISCOUNT NOTES The Debt Exchange was consummated on August 26, 1993. Under the terms of the Debt Exchange, holders of approximately $293.7 million aggregate principal amount of 12% subordinated notes and $292.6 million aggregate principal amount of 13 1/2% subordinated notes (together with approximately $28.6 million of accrued interest claims thereon) received approximately $435.5 million initial accreted value, as defined, of 12 3/4% secured discount notes due June 30, 1998; $136.9 million initial accreted value of 12 3/4% unsecured discount notes due June 30, 1996; $29.3 million principal amount of 0% convertible notes due June 30, 1998; and, in the case of 13 1/2% subordinated noteholders, $13.2 million in cash. The new notes, which rank pari passu with each other, are senior in right of payment to the remaining 12% and 13 1/2% subordinated notes (together, the Subordinated Notes) and subordinate to all permitted first lien debt, as defined, including the Credit Agreement. The Discount Notes will bear no interest through June 30, 1995; however, the accreted value, as defined, of both series will increase from May 1, 1993 through June 30, 1995 at 12 3/4% per year, compounded semiannually, with the first compounding date being June 30, 1993. After June 30, 1995, each series will accrue interest at an annual rate of 12 3/4%, payable in cash semiannually in arrears, with the first payment due December 31, 1995. The 0% convertible notes earned no interest and were converted into approximately 7.5 million shares of common stock in December 1993. The 12 3/4% secured discount notes are secured by second liens on the Company's West Panhandle field properties and on 76% of MOC's equity interest in HCLP, both of which currently secure obligations under the Credit Agreement. The Company's right to maintain first lien debt, as defined, is limited by the terms of the Discount Notes to $82.5 million. The indentures governing the Discount Notes restrict, among other things, the Company's ability to incur additional indebtedness, pay dividends, acquire stock or make investments, loans and advances. MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company incurred approximately $9.6 million of costs associated with completion of the Debt Exchange; such costs are included in the 1993 consolidated statement of operations as other income (expense). On March 2, 1994, the Company issued $48.2 million face amount of additional 12 3/4% secured discount notes due June 30, 1998. The proceeds of $42.8 million were used to pay the settlement amount arising from the early 1994 settlement of a lawsuit with Unocal Corporation (Unocal). The additional indebtedness incurred to settle the Unocal lawsuit is specifically permitted under the terms of the indentures governing the Discount Notes and under the Credit Agreement. See Note 9 for additional discussion of the Unocal litigation. SUBORDINATED NOTES The 12% subordinated notes are unsecured and mature in 1996. Interest on these notes is payable quarterly and, at the option of the Company, may be paid in common stock of the Company. The 13 1/2% subordinated notes are unsecured and mature in 1999. Interest on these notes is payable semiannually in cash. INTEREST AND MATURITIES The aggregate interest payments made during 1993, 1992 and 1991 were approximately $89.4 million, $142.7 million and $128.1 million, respectively. Payment of approximately $64.6 million of interest incurred during 1993 has been deferred under the terms of the Debt Exchange until the repayment dates of the Discount Notes. Such interest is included in interest expense in the 1993 consolidated statement of operations. The scheduled principal repayments of long-term debt for the next five years are as follows (in millions): - --------------- (a) Excludes approximately $10 million in letter of credit obligations currently outstanding and required to be cash collateralized in 1995. (b) Includes $48.2 million of notes issued in March 1994 to settle the Unocal lawsuit. FAIR VALUE OF LONG-TERM DEBT Based on borrowing rates currently available for secured debt with similar maturities and credit rating, the fair value of the HCLP Secured Notes at December 31, 1993 is estimated to be approximately $615 million. Based on borrowing rates currently available for bank loans with similar collateral, the fair value of the borrowings under the Credit Agreement at December 31, 1993 is estimated to be their carrying value. The Discount Notes are publicly traded but not listed on a national trading exchange. Based on trading prices available at December 31, 1993, the fair value of the 12 3/4% secured discount notes is estimated to be $487 million and the fair value of the 12 3/4% unsecured discount notes is estimated to be $142 million. MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Subordinated Notes are publicly traded but have not experienced significant activity since consummation of the Debt Exchange. Based on recent trades, the fair values of the Subordinated Notes are not materially different from their carrying value. Based on the current financial condition of the Company, there is no assurance that the Company could obtain borrowings under long-term debt agreements with terms similar to those described above and receive proceeds approximating the estimated fair values. (5) INCOME TAXES Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires the asset and liability method under which deferred tax assets and liabilities are recognized by applying the enacted statutory tax rates applicable to future years to temporary differences between the financial statement and tax bases of existing assets and liabilities. The primary difference to the Company between the standards is that SFAS No. 109 allows recognition of deferred tax assets under certain circumstances. In accordance with the SFAS No. 109 transition rules, the Company elected to adopt the change in method of accounting for income taxes prospectively in 1993. Any cumulative effect on prior years resulting from prospective adoption is required to be recorded as an adjustment to the Company's net loss in 1993. After consideration of offsetting valuation allowances, there was no cumulative effect on prior years of adopting SFAS No. 109. The tax basis of the Company's consolidated net assets is greater than the financial basis of those net assets; therefore, a net deferred tax asset has been recorded. However, due to the Company's history of net operating losses and its current financial condition, a valuation allowance has been recorded which offsets the entire net deferred tax asset. A summary of the Company's net deferred tax asset is as follows (in millions): The principal components of the Company's net deferred tax asset (utilizing a 39% combined federal and state income tax rate) and the valuation allowance are as follows (in millions): As of December 31, 1993, the Company had a regular tax net operating loss carryforward of approximately $290 million. Additionally, the Company had an alternative minimum tax loss carryforward available to offset future alternative minimum taxable income of approximately $280 million. If not used, both of these carryforwards will expire in 2007 and 2008. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the Act) was signed into law resulting in, among other things, an increase in the top Federal corporate income tax rate from 34% to 35%, MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) effective January 1, 1993. This and other tax law changes resulting from the Act did not have a material effect on the Company's net deferred tax asset or related valuation allowance. The Company's income tax returns for 1991 through 1993, which include all net operating loss carryforward amounts, and the tax returns of the Partnership for 1990 and 1991 are subject to examination by the taxing authorities. If examinations of the Partnership returns result in changes to taxable income or loss, the taxable income or loss of the former partners and the tax basis of the Company's assets will be changed accordingly. The Company assumed from the Partnership any tax liabilities or refunds which arise as a result of any changes to Original Mesa's taxable income or loss for open tax years. During 1993, the Internal Revenue Service (IRS) completed two field examinations of the tax returns filed by Original Mesa for the tax years 1984 through 1987. In December 1993, the Company made a payment to the IRS of approximately $13 million, which payment includes interest, in full settlement of all claims for these years. The Company was fully reserved for the additional tax assessment relating to the tax years 1984 through 1987. See Note 9 for discussion of a gain recognized in the fourth quarter of 1993 related to the tax settlement and resolution and revaluation of other contingency amounts. As of January 1, 1994, there are no remaining open tax years for Original Mesa for federal income tax purposes. (6) PROPERTY SALES In April 1993, the Company sold a portion of its Rocky Mountain area properties for approximately $7.1 million, after adjustments, and recorded a gain on the sale of approximately $4.1 million. The Company also retained a reversionary interest in the properties under which the Company will receive a 50% net profits interest in the properties after the purchaser has recovered its investment and certain other costs and expenses. In June 1993, the Company sold its interest in the deep portion of the Hugoton field not owned by HCLP for approximately $19.0 million, after adjustments, and recorded a gain on the sale of approximately $5.5 million. In June 1992, the Company sold all of its Canadian interests (consisting of overriding royalty interests in producing and nonproducing acreage) for approximately $12 million in cash and recognized an approximate $12 million gain. In April 1991, the Company sold its producing gas properties in the San Juan Basin of New Mexico and Colorado for approximately $161 million in cash and the assumption by the purchaser of approximately $2 million in liabilities resulting in a gain of approximately $34 million. In March 1991, the Company sold certain of its producing oil and gas properties and undeveloped leasehold acreage in the Texas Panhandle and in Oklahoma for an aggregate of approximately $267 million in cash and the assumption by the purchasers of approximately $7 million in liabilities. The Company recognized a loss of $75 million in 1990 as a result of these transactions. (7) STOCKHOLDERS' EQUITY At December 31, 1993, the Company had outstanding 46.5 million shares of common stock and owned a 97.38% interest in its direct subsidiaries; the General Partner owned a 2.62% interest. Subsequent to year end, the remaining 2.62% general partner interest was converted into approximately 1.25 million shares of common stock. See Note 1 for further discussion of the conversion in 1994 of the remaining general partner interest into common stock of the Company. Pursuant to the Debt Exchange (see Note 4), the Company issued approximately $29.3 million of 0% convertible notes which were converted into approximately 7.5 million shares of common stock of the Company in the fourth quarter of 1993. MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company has authorized 10 million shares of preferred stock. No shares of preferred stock have been issued as of December 31, 1993. (8) NOTES RECEIVABLE As of December 31, 1992, notes receivable consisted primarily of claims against Bicoastal. A plan of reorganization for Bicoastal was approved by the Bankruptcy Court in September 1992. At such time, the Company held allowed claims of $68 million, exclusive of interest. During 1992 and 1993, the Company collected approximately $28 million and $46 million, respectively, from Bicoastal, representing all of the Company's principal amount of allowed claims in the bankruptcy reorganization plan plus an amount representing a portion of its interest claims. As a result, the Company recorded gains in the third and fourth quarters of 1993 of approximately $13.8 million and $4.7 million, respectively, relating to collections in excess of the recorded receivable. (9) CONTINGENCIES UNOCAL The Company was subject to a lawsuit relating to a 1985 investment in Unocal which asserted that certain profits allegedly realized by Original Mesa and other defendants upon the disposition of Unocal common stock in 1985 were recoverable by Unocal pursuant to Section 16(b) of the Securities Exchange Act of 1934. On January 11, 1994, the Company and the other defendants entered into a settlement agreement (the Settlement Agreement) whereby they agreed to pay Unocal an aggregate of $47.5 million, of which $42.75 million was to be paid by the Company and $4.75 million by the other defendants. The Settlement Agreement was approved by the court on February 28, 1994. The Company funded its share of the settlement amount with proceeds from issuance of additional long-term debt. See Note 4 for discussion of the issuance of the additional long-term debt. As a result of the settlement, the Company recognized a $42.8 million loss in the fourth quarter of 1993. The loss is included as other income (expense) in the 1993 consolidated statement of operations and the obligation is included in other liabilities in the December 31, 1993 consolidated balance sheet. MASTERSON In February 1992, the current lessors of an oil and gas lease (the Gas Lease) dated April 30, 1955, between R. B. Masterson, et al., as lessor, and Colorado Interstate Gas Company (CIG), as lessee, sued CIG in Federal District Court in Amarillo, Texas, claiming that CIG has underpaid royalties due under the Gas Lease. The Company owns an interest in the Gas Lease. The plaintiffs, in their Second Amended Complaint, included the Company as a defendant. The plaintiffs allege that the underpayment is the result of CIG's use of an improper gas sales price upon which to calculate royalties and that the proper price should be determined pursuant to a pricing clause in a July 1, 1967 amendment to the Gas Lease. The plaintiffs also sought a declaration by the court as to the proper price to be used for calculating future royalties. In August 1992, CIG filed a third-party complaint against the Company for any such royalty underpayments which may be allocable to the Company's interest in the Gas Lease. The plaintiffs subsequently dismissed their claims against the Company for reasons relating to the jurisdiction of the federal court; however, the third-party complaint by CIG against the Company is not affected by the dismissal. The plaintiffs allege royalty underpayments of approximately $450 million (including interest at 10%) covering the period July 1, 1967 to the present. In addition, the plaintiffs seek exemplary damages. Management believes that the Company has several defenses to the plaintiffs' claims, including (i) that the MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) royalties for all periods were properly computed and paid and (ii) that plaintiffs' claims with respect to all periods prior to October 1, 1988 (which appear to account for the substantial portion of the claims) were explicitly released by a 1988 written agreement among plaintiffs, CIG and the Company and are further barred by the statute of limitations. If the plaintiffs were to prevail, the manner in which any resulting liability would be shared between the Company and CIG would depend on the resolution of issues relating to the contractual agreements and the relationship between the Company, CIG and the lessors during the period in question. No determination can be made at this time as to the ultimate outcome of the litigation and no trial date has been set. PREFERENCE UNITHOLDERS The Company is a defendant in lawsuits related to the Corporate Conversion pending in the U.S. District Court for the Northern District of Texas -- Dallas Division. Plaintiffs allege, among other things, that (i) the proxy materials delivered to unitholders of the Partnership in connection with the Corporate Conversion contained material misstatements and omissions, (ii) the general partner of the Partnership breached fiduciary duties to the preference unitholders in structuring the transaction and allocating the common stock of the Company and (iii) the Corporate Conversion was implemented in breach of the partnership agreement of the Partnership because defendants allegedly did not obtain the requisite opinion of independent counsel regarding certain tax effects of the transaction. The Company and the other defendants have denied the allegations and believe they are without merit. Plaintiffs seek a declaration declaring the Corporate Conversion void and rescinding it, an order requiring payment of $164 million to the former preference unitholders in respect of the preferential distribution rights of their units, unspecified compensatory and punitive damages and other relief. Discovery has commenced and is proceeding in the litigation for which the Court has set an August 1, 1994 trial date. OTHER The Company is also a defendant in other lawsuits and has assumed liabilities relating to Original Mesa and the Partnership. The Company does not expect the resolution of the Masterson lawsuit, preference unitholder lawsuits or any of these other matters to have a material adverse effect on its financial position or results of operations. The Company assumed certain litigation and tax-related obligations from Original Mesa and the Partnership and also recorded certain contingent liabilities relating to various matters, including litigation, office space leases and retirement benefit obligations, in conjunction with the 1986 acquisition of Pioneer Corporation (Pioneer) and the 1988 acquisition of Tenneco Inc.'s midcontinent division. During the fourth quarter of 1993, the Company settled certain claims with the IRS (see Note 5) and resolved or revalued certain other contingent liabilities to reflect actual or estimated liabilities. The Company had previously reserved for the IRS claims and certain other contingencies in excess of the actual or estimated liabilities. As a result, the Company recorded a net gain of $24 million in the fourth quarter of 1993. (10) EMPLOYEE BENEFIT PLANS RETIREMENT PLANS The Company maintains two defined contribution retirement plans for the benefit of its employees. The Company expensed $3.2 million in 1993, $3.3 million in 1992, and $3.1 million in 1991 in connection with these plans. MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) OPTION PLAN In December 1991, the stockholders of the Company approved the 1991 Stock Option Plan of the Company (the Option Plan), which authorized the grant of options to purchase up to two million shares of common stock to officers and key employees. The exercise price of each share of common stock placed under option cannot be less than 100% of the fair market value of the common stock on the date the option is granted. Upon exercise, the grantee may elect to receive either shares of common stock or, at the discretion of the Option Committee of the Board of Directors, cash or certain combinations of stock and cash in an amount equal to the excess of the fair market value of the common stock at the time of exercise over the exercise price. At December 31, 1993, the following stock options were outstanding: The outstanding options at December 31, 1993 are detailed as follows: Options are exercisable from date of grant as follows: after six months, 30%; after one year, 55%; after two years, 80%; and after three years, 100%. At December 31, 1993, options for 45,950 shares were available for grant. POSTRETIREMENT BENEFITS Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires that the costs of such benefits be recorded over the periods of employee service to which they relate. For the Company, this standard primarily applies to postretirement medical benefits for retired and current employees. The liability for benefits existing at the date of adoption (Transition Obligation) will be amortized over the remaining life of the retirees or 20 years, whichever is shorter. The Company maintains two separate plans for providing postretirement medical benefits. One plan covers the Company's retirees and current employees (the Mesa Plan). The other plan relates to the retirees of Pioneer, which was acquired by the Company in 1986 (the Pioneer Plan). Under the Mesa Plan, employees who retire from the Company and who have had at least 10 years of service with the Company after attaining age 45 are eligible for postretirement health care benefits. These benefits may be subject to deductibles, copayment provisions, retiree contributions and other limitations and the Company has reserved the right to change the provisions of the plan. The Pioneer Plan is maintained for Pioneer retirees and dependents only and is subject to deductibles, copayment provisions and certain maximum payment provisions. The Company does MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) not have the right to change the Pioneer Plan or to require retiree contributions. Both plans are self-insured indemnity plans and both coordinate benefits with Medicare as the primary payer. Neither plan is funded. The following table reconciles the status of the two plans with the amount included under other liabilities in the consolidated balance sheet at December 31, 1993 (in thousands): - --------------- (a) The Company established an accrued liability associated with the Pioneer Plan in conjunction with its acquisition of Pioneer in 1986. For measurement purposes, the 1993 annual rate of increase in per capita cost of covered health care benefits was assumed to be 12.5% for those participants under age 65 and 11.0% for those participants over age 65. The rates were assumed to decrease gradually to 5.0% by the year 2000 and to remain at that level thereafter. The health care cost trend rate assumption affects the amount of the Transition Obligation and periodic cost reported. An increase in the assumed health care cost trend rates by 1% in each year would increase the APBO as of December 31, 1993 by approximately $735,000 and the aggregate of the service and the interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 by approximately $77,000. The net periodic postretirement benefit cost for the year ended December 31, 1993 was approximately $1.4 million based on these assumptions. The discount rate used in determining the APBO as of December 31, 1993 was 8.0%. The following table presents the Company's cost of postretirement benefits other than pensions for the years ended December 31 (in thousands): MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) - --------------- (a) SFAS No. 106 was adopted effective January 1, 1993. (b) Actual costs of providing benefits in 1992 and 1991 under the Mesa Plan were recorded to expense in the consolidated statements of operations in those years. Actual cost of providing benefits in 1993 under the Mesa Plan were applied as incurred against the accrued postretirement benefit obligation. (c) Actual costs of providing benefits in 1992 and 1991 under the Pioneer Plan were applied as incurred against the previously accrued liability. Actual cost of providing benefits in 1993 under the Pioneer Plan were applied as incurred against the accrued postretirement benefit obligation. DEFERRED COMPENSATION The Company had agreements with two officers to provide postretirement deferred compensation at a rate of one-half of the participant's final rate of compensation (subject to minimum amounts specified in the agreements) for a period of 10 years following the date of retirement or death. In 1992, in order to terminate the deferred compensation agreements, the Company established life insurance plans, executed agreements with the two officers and purchased insurance policies at an aggregate cost of $4.9 million. At the time they were terminated, approximately $3.9 million had been accrued under the deferred compensation agreements. The Company has fully funded the life insurance policies and has no further obligations under such policies or under the deferred compensation agreements. (11) MAJOR CUSTOMERS Revenues include sales to Mapco Oil and Gas Company (Mapco) of $60.2 million (27.5%), Western Resources, Inc. (WRI) of $51.8 million (23.6%), and Natural Gas Clearinghouse of $23.1 million (10.5%) in 1993. In 1992, revenues included sales to Mapco of $45.7 million (19.4%), WRI of $39.7 million (16.8%) and Energas Company of $23.7 million (10.0%). In 1991, revenues included sales to Mapco of $51.9 million (20.9%) and WRI of $27.9 million (11.2%). (12) CONCENTRATIONS OF CREDIT RISK Substantially all of the Company's accounts receivable at December 31, 1993 result from oil and gas sales and joint interest billings to third party companies in the oil and gas industry. This concentration of customers and joint interest owners may impact the Company's overall credit risk, either positively or negatively, in that these entities may be similarly affected by changes in economic or other conditions. In determining whether or not to require collateral from a customer or joint interest owner, the Company analyzes the entity's net worth, cash flows, earnings, and credit ratings. Receivables are generally not collateralized. Historical credit losses incurred by the Company on receivables have not been significant. (13) CONDENSED CONSOLIDATING FINANCIAL STATEMENTS The Company conducts its operations through various direct and indirect subsidiaries. On December 31, 1993, the Company's direct subsidiary partnerships were Mesa Operating Limited Partnership (MOLP), Mesa Midcontinent Limited Partnership (MMLP), and Mesa Holding Limited Partnership (MHLP). At December 31, 1993, MOLP owned all of the Company's interest in the West Panhandle field of Texas, the Gulf Coast and the Rocky Mountain areas, as well as an approximate 81% limited partnership interest in HCLP. At December 31, 1993, MMLP owned an approximate 19% limited partnership interest in HCLP. See discussion below for 1994 changes in subsidiaries and HCLP ownership. HCLP owns substantially all of the Company's Hugoton field natural gas properties and is liable for the HCLP Secured Notes (see Note 4). The assets and cash flows of HCLP are dedicated to service the HCLP Secured Notes and are not available to pay creditors of the Company or its subsidiaries other than HCLP. MOLP and the Company are liable for the Credit Agreement, the Subordinated Notes and the Discount Notes. Mesa Capital Corp. (Mesa Capital), a MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) wholly owned financing subsidiary of MOLP, is also an obligor under the Subordinated Notes and the Discount Notes. Mesa Capital has insignificant assets and results of operations. Mesa Capital is included with MOLP in the condensed consolidating financial statements. In early 1994, the Company effected a series of merger transactions which resulted in the conversion of each of its subsidiary partnerships, other than HCLP, to corporate form. Pursuant to these mergers, MOLP was merged into MOC, and MMLP and MHLP were merged into Mesa Holding Co. (MHC). As of December 31, 1993, MHC had intercompany payables to MOC of approximately $123 million. In January 1994, MHC repaid approximately $5 million of its intercompany payable to MOC. On February 28, 1994, MHC assigned an 18% limited partnership interest in HCLP (out of its total interest of approximately 19%) to MOC as consideration for $90 million of intercompany payables. Provisions of the Discount Note indentures required the repayment of intercompany indebtedness to specified levels and provided that any HCLP limited partnership interests transferred in satisfaction of intercompany debt would be valued at $5 million for each percent of interest assigned. MHC also repaid an additional $24 million of intercompany debt to MOC in cash. As a result of these transactions, MOC now owns 99% of the limited partnership interest in HCLP, and substantially all of the Company's intercompany debt has been eliminated. The following are condensed consolidating financial statements of MESA Inc., HCLP, MOLP and the Company's other direct and indirect subsidiaries combined (in millions): CONDENSED CONSOLIDATING BALANCE SHEETS MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS YEARS ENDED: MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS YEARS ENDED: MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTES TO CONDENSED CONSOLIDATING FINANCIAL STATEMENTS (a) These condensed consolidating financial statements should be read in conjunction with the consolidated financial statements and notes thereto of the Company of which this note is an integral part. (b) As of December 31, 1993, MESA Inc. owned a 97.38% limited partnership interest in each of MOLP, MMLP and MHLP. The General Partner owned a 2.62% general partner interest in each of these subsidiary partnerships. These condensed consolidating financial statements present MESA Inc.'s investment in its subsidiaries and MOLP's and MMLP's investments in HCLP using the equity method. Under this method, investments are recorded at cost and adjusted for the parent company's ownership share of the subsidiary's cumulative results of operations. In addition, investments increase in the amount of contributions to subsidiaries and decrease in the amount of distributions from subsidiaries. (c) In connection with the formation of HCLP, MOLP and MMLP contributed producing natural gas properties in the Hugoton field and long-term debt to HCLP in return for limited partnership interests. These transactions did not require cash and are not reflected in the statements of cash flows of HCLP, MOLP or MMLP. Non-cash contributions by MOLP and MMLP from inception (June 12, 1991) to December 31, 1993 are summarized below (in thousands): (d) The consolidation and elimination entries (i) eliminate the equity method investment in subsidiaries and equity in loss of subsidiaries, (ii) eliminate the intercompany payables and receivables, (iii) eliminate other transactions between subsidiaries including contributions and distributions and (iv) establish the MESA INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) General Partner's minority interest in the consolidated results of operations and financial position of the Company. (e) MOLP was merged into MOC and MMLP and MHLP were merged into MHC in a series of merger transactions effected in early 1994. In conjunction with these transactions, the General Partner converted all of his remaining general partner interests in the Company's subsidiaries into common stock of the Company, thereby eliminating the minority interest. On February 28, 1994, MHC repaid substantially all of its intercompany debt to MOC. MESA INC. SUPPLEMENTAL FINANCIAL DATA OIL AND GAS RESERVES AND COST INFORMATION (UNAUDITED) Net proved oil and gas reserves as of December 31, 1993 and 1992 associated with the Company's two most significant natural gas producing fields were estimated by DeGolyer and MacNaughton, independent petroleum engineering consultants (D&M). These two fields, the Hugoton and West Panhandle fields, represent over 96% of the Company's net proved equivalent natural gas reserves at December 31, 1993. The Company's remaining reserves, substantially all of which are in the Rocky Mountain and Gulf Coast regions, were estimated by Company engineers. A portion of the Rocky Mountain properties and all of the Hugoton field deep reserves were sold in 1993. All of the Company's reserves at December 31, 1993 and 1992 were in the United States. Net proved oil and gas reserves in the United States and Canada as of December 31, 1991 were estimated by D&M. The reserves in Canada were less than 2% of the total equivalent reserves of the Company and are not presented separately in this report. The Company's interests in Canada were sold in 1992. In accordance with regulations established by the SEC, the reserve estimates were based on economic and operating conditions existing at the end of the respective years. Future prices for natural gas were based on market prices as of each year end and contract terms, including fixed and determinable price escalations. Market prices as of each year end were used for future sales of oil, condensate and natural gas liquids. Future operating costs, production and ad valorem taxes and capital costs were based on current costs as of each year end, with no escalation. Over 70% of the Company's equivalent proved reserves (based on a factor of 6 thousand cubic feet [Mcf] of gas per barrel of liquids) at December 31, 1993 are natural gas. The natural gas prices in effect at December 31, 1993 (having a weighted average of $2.14 per Mcf) were used in accordance with SEC regulations but may not be the most appropriate or representative prices to use for estimating future cash flows from reserves since such prices were influenced by the seasonal demand for natural gas and contractual arrangements at that date. The average price received by the Company for sales of natural gas in 1993 was $1.79 per Mcf. Assuming all other variables used in the calculation of reserve data are held constant, the Company estimates that each $.10 change in the price per Mcf for natural gas production would affect the Company's estimated future net cash flows and present value thereof, both before income taxes, by $108 million and $48 million, respectively. At December 31, 1993, the Company's standardized measure of future net cash flows from proved reserves (Standardized Measure) and the pre-tax Standardized Measure were less than the net book value of proved oil and gas properties by approximately $188 million and $106 million, respectively. The Company believes that the ultimate value to be received for production from its oil and gas properties will be greater than the current net book value of its oil and gas properties. There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting the future rates of production and timing of development expenditures. Reserve data represent estimates only and should not be construed as being exact. Moreover, the Standardized Measure should not be construed as the current market value of the proved oil and gas reserves or the costs that would be incurred to obtain equivalent reserves. A market value determination would include many additional factors including (i) anticipated future changes in oil and gas prices, production and development costs; (ii) an allowance for return on investment; (iii) the value of additional reserves, not considered proved at present, which may be recovered as a result of further exploration and development activities; and (iv) other business risks. MESA INC. SUPPLEMENTAL FINANCIAL DATA CAPITALIZED COSTS AND COSTS INCURRED (UNAUDITED) Capitalized costs relating to oil and gas producing activities at December 31, 1993, 1992 and 1991 and the costs incurred during the years then ended are set forth below (in thousands): MESA INC. SUPPLEMENTAL FINANCIAL DATA ESTIMATED QUANTITIES OF RESERVES (UNAUDITED) - --------------- * Proved natural gas liquids, oil and condensate reserve quantities include oil and condensate reserves at December 31 of the respective years as follows: 1993, 3,296 MBbls; 1992, 7,268 MBbls; and 1991, 3,956 MBbls. * In addition to the proved reserves disclosed above, the Company owned proved helium and carbon dioxide (CO2) reserves at December 31 of the respective years as follows: 1993, 5,198 MMcf of helium and 46,376 MMcf of CO2; 1992, 5,634 MMcf of helium and 46,457 MMcf of CO2; and 1991, 5,705 MMcf of helium and 44,837 MMcf of CO2. * The General Partner's minority interest in the proved natural gas and natural gas liquids, oil and condensate reserves of the Company at December 31 of the respective years was as follows: 1993, 31,504 MMcf and 2,160 MBbls, respectively; 1992, 52,828 MMcf and 3,618 MBbls, respectively; and 1991, 56,634 MMcf and 3,446 MBbls, respectively. The General Partner converted all of his general partner interests in the direct subsidiary partnerships of the Company into common stock of the Company on January 5, 1994, thereby eliminating the minority interest. MESA INC. SUPPLEMENTAL FINANCIAL DATA STANDARDIZED MEASURE OF FUTURE NET CASH FLOWS FROM PROVED RESERVES (UNAUDITED) - --------------- * The estimate of future income taxes is based on the future net cash flows from proved reserves adjusted for the tax basis of the oil and gas properties but without consideration of general and administrative and interest expenses. * The General Partner's minority interest in the Standardized Measure at December 31 of the respective years was as follows: 1993, $25.9 million; 1992, $42.9 million; and 1991, $41.2 million. The General Partner converted all of his general partner interests in the direct subsidiary partnerships of the Company into common stock of the Company on January 5, 1994, thereby eliminating the minority interest. MESA INC. SUPPLEMENTAL FINANCIAL DATA CHANGES IN STANDARDIZED MEASURE (UNAUDITED) QUARTERLY RESULTS (UNAUDITED) - --------------- (1) Gross profit consists of total revenues less lease operating expenses and production and other taxes. (2) See Notes 8 and 9 to the Company's consolidated financial statements for information on items affecting fourth quarter 1993 results. (A)(2) CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES S-1 SCHEDULE V MESA INC. PROPERTY, PLANT AND EQUIPMENT AS OF DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-2 SCHEDULE VI MESA INC. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT AS OF DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-3 SCHEDULE X MESA INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) S-4

752302_1993.txt

752302_1993

1993

752302

Item 1. Business - ------- -------- Organization - ------------ Guaranteed Mortgage Corporation III (the "Company") was incorporated under the laws of the State of Michigan on October 18, 1982, as a wholly-owned limited purpose financing subsidiary of Pulte Financial Companies, Inc. ("PFCI"), a wholly-owned subsidiary of Pulte Corporation (formerly known as PHM Corporation), a publicly-owned holding company listed on the New York Stock Exchange. Issuance of Collateralized Mortgage Bonds - ----------------------------------------- The Company was organized to facilitate the financing of long-term mortgage loans on single-family residential homes, including homes built by Pulte Home Corporation ("PHC"), through the issuance and sale of bonds secured by mortgage-backed securities ("Certificates") or by funding agreements with various limited-purpose financing companies ("Funding Companies") and the notes issued thereunder that are secured by Certificates ("Funding Notes"), or by a combination thereof. Such Certificates consist of Guaranteed Mortgage Pass-Through Certificates ("FNMA Certificates"), issued and guaranteed as to the full and timely payment of principal and interest by the Federal National Mortgage Association, Fully Modified Pass-Through mortgage-backed certificates ("GNMA Certificates"), guaranteed as to the full and timely payment of principal and interest by the Government National Mortgage Association, Mortgage Participation Certificates ("FHLMC Certificates"), issued and guaranteed as to the full and timely payment of interest and as to the ultimate payment of principal by the Federal Home Loan Mortgage Corporation, or a combination of such Certificates. To accomplish its purpose, the Company issued collateralized mortgage bonds in series and used the net proceeds of such sales to purchase Certificates backed by mortgage loans, some of which were originated by ICM Mortgage Corporation, a wholly-owned subsidiary of PHC, and are secured by homes, some of which were built by PHC. Alternatively, the Company remitted a portion of the net proceeds of such sales of collateralized mortgage bonds in series to a Funding Company that, in turn, pledged to the Company certain Funding Notes, which, together with certain other collateral, serve as security for the obligations of that Funding Company to the Company. The Company, although incorporated in October, 1982 and capitalized in August, 1984, did not commence operations until it issued its first series of bonds on October 24, 1984. Prior to 1993, the Company issued fifteen series of bonds, all of which were offered and sold to the public pursuant to a registration statement filed with the Securities and Exchange Commission. The bonds had an aggregate original principal amount of $1,208,697,000, with stated annual interest rates ranging from 7.0% to 12.5%. The Company did not issue any additional series of bonds in 1993. At December 31, 1993, the Company had $270,921,793 in aggregate principal amount of bonds outstanding, with stated annual interest rates ranging from 8.50% to 9.00%. This aggregate principal amount includes $29,961,727 in outstanding aggregate principal amount of the Company's Series H Bonds, secured by Funding Notes, and $82,929,778 in outstanding aggregate principal amount of the Company's Series L and Series M Bonds, all of which are non-recourse obligations and do not represent a liability of the Company. Each series of the Company's bonds is secured by a separate collateral package consisting, in part, of the Certificates purchased in connection with the issuance of a bond series, or Funding Notes or a combination thereof, additional pledged GNMA certificates and cash. The collateral package for a series is pledged to NBD Bank, N.A., as trustee on behalf of the holders of the bonds of such series. Funds held by the trustee with respect to the bonds are restricted so as to assure the payment of principal and interest on the bonds to the extent of such funds. Under the Company's articles of incorporation and the terms of the indenture governing the issuance of the Company's collateralized mortgage bonds, the Company may only issue collateralized mortgage bonds rated in the highest category by Standard & Poor's Corporation. Item 2. Item 2. Properties - ------ ---------- The Company has no material physical properties. Its primary asset is ownership of the various Certificates, and the mortgage loans underlying such Certificates, pledged to NBD Bank, N.A., as trustee, to secure the Company's collateralized mortgage bonds. Item 3. Item 3. Legal Proceedings - ------- ----------------- None. Item 4. Item 4. Submission of Matters to a Vote of - ------- Security Holders ---------------------------------- Information in response to this item is omitted pursuant to General Instruction J(2). PART II ------- Item 5. Item 5. Market for Registrant's Common Equity - ------- and Related Stockholder Matters ------------------------------------- The Company is a wholly-owned subsidiary of PFCI. (See "Business - Organization" in Item 1 of this Report.) Thus, there is no market for its common stock. Item 6. Item 6. Selected Financial Data - ------- ----------------------- Information in response to this item is omitted pursuant to General Instruction J(2). Item 7. Item 7. Management's Discussion and Analysis of - ------- Financial Condition and Results of Operations --------------------------------------------- Results of Operations - --------------------- The Company's mortgage-backed securities (Certificates) or finance companies' notes secured by Certificates (Funding Notes) are used as collateral for associated bonds payable. Mortgage-backed securities were acquired from affiliates. Any difference between the acquisition price and the principal balance of the securities at their date of acquisition (mortgage discounts/premiums) is amortized into operations over the estimated lives of the securities. The Company's pretax loss before extraordinary item was $794,434 for 1993 as compared to pretax income before extraordinary item of $4,905,355 and $1,439,721 for 1992 and 1991, respectively. Earnings decreased during 1993 from 1992 primarily due to reduced net interest carry as a result of volume declines resulting from accelerated mortgage prepayments related to heavy refinancing activity in 1993. Earnings increased during 1992 from 1991 primarily due to gains from the sale of mortgage-backed securities in conjunction with the early redemption of certain bonds prior to scheduled maturity. This increase was partially offset by reduced interest carry (i.e. interest income less interest expense) as a result of volume declines. Pretax extraordinary losses from the bond extinguishments during 1993 and 1992 were $2,028,327 and $1,872,795, respectively. These losses resulted from the write-off of unamortized bond discounts and issue costs. There was no similar activity in 1991. Financial Condition - ------------------- The Company will have no additional capital or liquidity requirements, assuming the mortgage-backed securities continue to pay principal and interest in accordance with their terms. Item 8. Item 8. Financial Statements and Supplementary Data - ------- -------------------------------------------- Page ----- Balance Sheets at December 31, 1993 and 1992 8 Statements of Operations for the years ended December 31, 1993, 1992 and 1991 9 Statements of Shareholder's Equity for the years ended December 31, 1993, 1992 and 1991 10 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 11 Notes to Financial Statements 13 Report of Ernst & Young, Independent Auditors 16

20740_1993.txt

20740_1993

1993

20740

ITEM 1. DESCRIPTION OF BUSINESS. (A) GENERAL DEVELOPMENT OF BUSINESS CLARCOR Inc. ("CLARCOR") was organized in 1904 as an Illinois corporation and in 1969 was reincorporated in the State of Delaware. As used herein, the "Company" refers to CLARCOR and its subsidiaries unless the context otherwise requires. In fiscal 1991, CLARCOR converted from a fiscal year ending on November 30 to a fiscal year ending on the Saturday closest to November 30. For fiscal year 1993, the year ended on November 27, 1993 and for fiscal year 1992 the year ended on November 28, 1992. In this Form 10-K, all references to fiscal year ends will be stated as November 30 for consistency of presentation. (I) CERTAIN SIGNIFICANT EVENTS. On December 31, 1992, CLARCOR completed the sale of its Precision Products Group to a privately held company. The sale was deemed to be effective as of November 30, 1992. The Precision Products Group manufactured and sold springs and tubular products for original equipment markets. On April 30, 1993 the Company purchased all of the outstanding shares of Airguard Industries, Inc. for cash. Airguard is a leading international producer and distributor of air filtration products. With five manufacturing plants, Airguard makes a broad line of air filters and markets them through a network of more than 500 distributors throughout the world. Airguard primarily serves the commercial, industrial and institutional markets by providing air filters for heating, ventilation and environmental control systems. Airguard's principal manufacturing facility is in New Albany, Indiana, with other manufacturing and assembly plants located in Louisville, Kentucky; Corona, California; Garland, Texas; and Tijuana, Mexico. Airguard also has seven factory-owned distribution centers located in key major markets. Annual sales approximate $40 million. On June 25, 1993, the Company purchased substantially all of the assets and business of Guardian Filter Company, a manufacturer of filters for liquids based in Louisville, Kentucky, for cash. The purchase was deemed to be effective as of June 1, 1993. Guardian Filter's filtration products serve the automotive, railroad and industrial markets. Annual sales approximate $8 million. Effective January 31, 1994, the Company sold the assets and ongoing business of OilpureSystems for cash. OilpureSystems is engaged in manufacturing and purification of industrial process oils. The transaction will have no material effect on the Company's results of operations for fiscal 1994. (II) SUMMARY OF BUSINESS OPERATIONS. During 1993, the Company conducted business in two principal industry groups: (1) Filtration Products and (2) Consumer Products. FILTRATION PRODUCTS. Filtration Products include filters used primarily in the replacement market in the trucking, construction, industrial, farm equipment, diesel locomotive, automotive and environmental industries. It also includes filters used in clean room applications in the medical, pharmaceutical and food and beverage processing industries. The Company's Filtration Products include filters for oil, air, fuel, coolants and hydraulic fluids for trucks, automobiles, construction and industrial equipment, locomotives, marine and farm equipment. The Company distributes filters and filtration products throughout Europe through its Baldwin Filters N.V. and Baldwin Filters Limited subsidiaries. The Company also owns 20% of the outstanding Common Stock of G.U.D. Holdings Limited ("GUD") and has a 50-50 joint venture with GUD named Baldwin Filters (Aust.) Pty. Ltd. to market heavy duty liquid and air filters in Australia and New Zealand. CONSUMER PRODUCTS. Consumer Products include a wide variety of custom styled containers and packaging items used primarily by the food, spice, drug, toiletries, tobacco and chemical specialties industries. The Company's Consumer Products consist of lithographed metal containers, flat sheet decorating, combination metal and plastic containers, plastic closures, collapsible metal tubes, composite containers and various specialties, such as spools for wire and cable, dispensers for razor blades and outer shells for dry cell batteries. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Business segment information for the fiscal years 1991 through 1993 is included on page 45 of the Company's 1993 Annual Report to Shareholders (the "Annual Report"), is incorporated herein by reference and is filed as part of Exhibit 13(a)(vi) to this 1993 Annual Report on Form 10-K ("1993 Form 10-K"). (C) NARRATIVE DESCRIPTION OF THE BUSINESS FILTRATION PRODUCTS The Company's filtration products business is conducted by the Filtration Products Group which includes the following wholly-owned subsidiaries: Baldwin Filters, Inc.; Airguard Industries, Inc.; Clark Filter, Inc.; CLARCOR Air Filtration, Inc.; Guardian Filter Company; MicroPure Filtration, Inc.; Baldwin Filters N.V.; and Baldwin Filters Limited. In addition, the Company owns (i) 20% of GUD, and (ii) 50% of Baldwin Filters (Aust.) Pty. Ltd., and (iii) 60% of PleaTech Co. PleaTech is a technology and manufacturing joint venture for extended life, high-efficiency filters. The Company markets a line of over 4,000 types of oil, air, fuel, coolant and hydraulic fluid filters. The Company's filters are used in a wide variety of applications including engines, equipment, environmentally controlled areas and processes where effectiveness, reliability and durability are essential. Impure air or fluid impinge upon a paper, cotton, synthetic, chemical or membrane filter media which collects the impurities which are disposed of when the filter is changed. Paper filters have pleated paper elements held in specially treated paper or metal containers and the cotton and synthetic filters use wound or compressed fibers with high absorption characteristics. The Company's filters are sold throughout the United States and Canada and world-wide, primarily in the replacement market for truck, automobile, marine, construction, industrial and farm equipment and food and beverage processing. In addition, some filters are sold to the original equipment market. CONSUMER PRODUCTS The Company's consumer products business is conducted by the Consumer Products Group which includes the Company's wholly-owned subsidiary, J. L. Clark, Inc. ("J. L. Clark"). In fiscal 1993 over 1,500 different types and sizes of containers and metal packaging specialties were manufactured for the Company's customers. Flat sheet decorating is provided by use of state-of-the-art lithography equipment. Metal, plastic and paper containers and plastic closures manufactured by the Company are used in marketing a wide variety of dry and paste form products, such as food specialties (tea, spices, dry bakery products, potato chips, pretzels, candy and other confections); cosmetics and toiletries; drugs and pharmaceuticals; chemical specialties (hand cleaners, soaps and special cleaning compounds); and tobacco products. Metal packaging specialties include shells for dry batteries, dispensers for razor blades, spools for insulated and fine wire, and custom decorated flat steel sheets. Containers and metal packaging specialties are manufactured only upon orders received from customers and individualized containers and packaging specialties are designed and manufactured, usually with distinctive decoration, to meet each customer's marketing and packaging requirements and specifications. Through the Tube Division of J. L. Clark, the Company manufactures collapsible metal tubes for packaging ointments, artists' supplies, adhesives, cosmetic creams and other viscous materials. Over 150 types and sizes of collapsible metal tubes are manufactured. Tubes are custom manufactured from aluminum to the customer's specifications as to size, shape, neck design and decoration. Both coating and lithographic tube printing decoration techniques are used. DISTRIBUTION Filtration Products are sold primarily through a combination of independent distributors and dealers for original equipment manufacturers. The Australian joint venture markets heavy duty filtration products through the distributors of GUD, the Company's joint venture partner. Baldwin filters are distributed in Canada by the largest Canadian distributor of heavy duty filters. Consumer Products Group salespersons call directly on customers and prospective customers for containers and packaging specialties. Each salesperson is trained in all aspects of the Company's manufacturing processes with respect to the products sold and as a result is qualified to consult with customers and prospective customers concerning the details of their particular requirements. CLASS OF PRODUCTS The percentage of the Company's sales volume contributed by each class of similar products within the Company's Consumer Products Group which contributed 10% or more of sales is as follows: No class of products within the Company's Filtration Products Group accounted for as much as 10% of the total sales of the Company. RAW MATERIAL Steel (black plate and tin plate), filter media, aluminum sheet and coil, stainless steel, MB hard drawn and oil tempered wire, chrome vanadium, chrome silicon, resins and aluminum slugs for tubes, roll paper, bulk and roll plastic materials and cotton, wood and synthetic fibers are the most important raw materials used in the manufacture of the Company's products. All of these are purchased or are available from a variety of sources. The Company has no long-term purchase commitments. The Company did not experience shortages in the supply of raw materials during 1993. PATENTS Certain features of some of the Company's Filtration and Consumer products are covered by domestic and, in some cases, foreign patents or patent applications. While these patents are valuable and important for certain products, the Company does not believe that its competitive position is dependent upon patent protection. CUSTOMERS The largest 10 customers of the Filtration Products Group accounted for 14.9% of the $156,165,000 of fiscal year 1993 sales of such Group. The largest 10 customers of the Consumer Products Group accounted for 42.7% of the $69,154,000 of fiscal year 1993 sales of such Group. No single customer accounted for 10% or more of the Company's consolidated 1993 sales. BACKLOG At November 30, 1993, the Company had a backlog of firm orders for products amounting to approximately $25,100,000. The comparable backlog figure for 1992 was approximately $20,100,000. All of the orders on hand at November 30, 1993 are expected to be filled during fiscal 1994. The Company's backlog is not subject to significant seasonal fluctuations. COMPETITION The Company encounters strong competition in the sale of all of its products. In the Filtration Products Group, the Company competes in a number of markets against a variety of competitors. The Company is unable to state its relative competitive position in all of these markets due to a lack of available industry-wide data. However in the replacement market for heavy duty liquid and air filters used in internal combustion engines the Company believes that it is among the top five measured by annual sales with a market share of approximately 13%. In addition, the Company believes that it is the largest manufacturer of liquid and air filters for diesel locomotives. In the Consumer Products Group, its principal competitors are approximately 10 manufacturers whose sales and product lines are smaller than the Company's and who often compete on a regional basis only. In the Consumer Products market, strong competition is also presented by manufacturers of paper, plastic and glass containers. The Company's competitors generally manufacture and sell a wide variety of products in addition to packaging products of the type produced by the Company and do not publish separate sales figures relative to these competitive products. Consequently, the Company is unable to state its relative competitive position in those markets. The Company believes that it is able to maintain its competitive position because of the quality of its products and services. PRODUCT DEVELOPMENT The Company's laboratories test filters, containers, filter components, paints, inks, varnishes, adhesives and sealing compounds to insure high quality manufacturing results, aid suppliers in the development of special finishes and conduct controlled tests of finishes and newly designed filters and containers being perfected for particular uses. Product development departments are concerned with the improvement of existing filters, consumer products and the creation of new and individualized filters, containers and consumer products, in order to broaden the uses of these items, counteract obsolescence and evaluate other products available in the marketplace. During fiscal 1993, construction was completed on a new 25,000 square foot technical center in Kearney, Nebraska to enhance the technology in the heavy duty filter industry. In fiscal 1993, the Company employed 45 professional employees on a full-time basis on research activities relating to the development of new products or the improvement or redesign of its existing products. During this period the Company spent approximately $2,824,000 on such activities as compared with $2,248,000 for 1992 and $2,159,000 for 1991. ENVIRONMENTAL FACTORS The Company is not aware of any facts which would cause it to believe that it is in material violation of existing applicable standards respecting emissions to the atmosphere, discharges to waters, or treatment, storage and disposal of solid or hazardous wastes. There are no pending material claims or actions against the Company alleging violations of such standards. The Company does anticipate, however, that it may be required to install additional pollution control equipment to augment existing equipment in the future in order to meet applicable environmental standards. The Company is presently unable to predict the timing or the cost of such equipment and cannot give any assurance that the cost of such equipment may not have an adverse effect on earnings. EMPLOYEES As of November 30, 1993, the Company had approximately 2,062 employees. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Foreign sales were not material in any of the fiscal years ended November 30, 1993, 1992 or 1991. Export sales for the fiscal years ended November 30, 1993, 1992 and 1991 were $18,008,000, $10,882,000 and $10,175,000, respectively. ITEM 2. ITEM 2. PROPERTIES. (I) LOCATION The corporate office building located in Rockford, Illinois, houses the Corporate offices and the Group offices for the Filtration and Consumer Products headquarters in 32,000 square feet of office space. FILTRATION PRODUCTS. The following is a description of the principal properties owned and utilized by the Company in conducting its Filtration Products business: The Baldwin Filters' Kearney, Nebraska plant contains 410,000 square feet of manufacturing and warehousing space, 25,000 square feet of research and development space, and 40,000 square feet of office space. It is located on a site of approximately 40 acres. Airguard Industries has five manufacturing locations. It leases 167,000 square feet in New Albany, Indiana on a 8.5 acre tract of land, 20,000 square feet in Louisville, Kentucky on a 2.5 acre tract of land, 15,000 square feet in Garland, Texas on a .7 acre tract of land, and 15,000 square feet in Tijuana, Mexico on a .7 tract of land. Airguard owns a 38,000 square foot manufacturing facility on a 1.8 acre tract of land in Corona, California. Airguard sales outlets with warehousing are located in Louisville, Kentucky; Cincinnati, Ohio; Nashville, Tennessee; Atlanta, Georgia; Birmingham, Alabama; Dallas, Texas; and Corona, California. The Company also manufactures Clark and HEFCO brand filters at the Hempfield Division plant located in Lancaster, Pennsylvania on an 11.4-acre tract of land. The building, constructed about 1968, contains 168,000 square feet of manufacturing and office space. The Guardian Filter plant, located in Louisville, Kentucky on a 7.5 acre tract of land, contains 73,000 square feet of manufacturing and office facilities. The Company assembles MicroPure products in 5,000 square feet of manufacturing and laboratory space in its Rockford, Illinois facilities. The Company has a capital lease for a 100,000 square foot manufacturing facility on a site of 20 acres in Gothenburg, Nebraska. CONSUMER PRODUCTS. The following is a description of the principal properties owned and utilized by the Company in conducting its Consumer Products business: The Company's J. L. Clark, Rockford, Illinois plant, located on 34 acres, consists of one-story manufacturing buildings, the first of which was constructed in 1910. Since then a number of major additions have been constructed and an injection molding plant was constructed in 1972. Approximately 429,000 square feet of floor area are devoted to manufacturing, warehouse and office use. Of the 34 acres, approximately 12 are vacant. A J. L. Clark plant is located in Lancaster, Pennsylvania on approximately 11 acres. It consists of a two-story office building containing approximately 7,500 square feet of floor space and a manufacturing plant and warehouse containing 236,000 square feet of floor space, most of which is on one level. These buildings were constructed between 1924 and 1964. The J. L. Clark Tube Division's manufacturing plant is located in Downers Grove, Illinois on a 5-acre tract of land. The one-story building, constructed in 1963, currently contains 58,000 square feet of floor space and can be expanded by an additional 100,000 square feet under present zoning ordinances. The various properties owned by the Company are considered by it to be in good repair and well maintained. All of the manufacturing facilities are adequate for the current sales volume of the Company's products and can accommodate significant expansion of production levels before plant additions are required. (II) FUNCTION FILTRATION PRODUCTS. Oil, air, fuel, hydraulic fluid and coolant filters are produced at Baldwin in Kearney, and Gothenburg, Nebraska. Much of the Baldwin plant equipment has been built or modified by Baldwin. The various processes of pleating paper, winding cotton and synthetic fibers, placing the filter element in a metal or fiber container and painting the containers are mechanized but require manual assistance. The plant also maintains an inventory of special dies and molds for filter manufacture. Air filters for the environmental market are produced in the Airguard and Guardian facilities. Oil, air and fuel filters primarily for use in the railroad industry are produced at Clark Filter in Lancaster, Pennsylvania. This facility also produces ASHRAE rated and HEPA filters for HEFCO which are used in medical, pharmaceutical and clean room applications. This plant supplies some of the Company's filter customers in the United States as well as foreign markets. The Company serves the food and beverage markets through its MicroPure brand. CONSUMER PRODUCTS. The Company's metal, combination metal and plastic packaging products are produced in J. L. Clark plants located in Rockford, Illinois, and Lancaster, Pennsylvania. The Rockford and Lancaster metal container plants are completely integrated facilities which include creative and mechanical art departments and photographic facilities for color separation, preparation of multiple-design negatives and lithographing plates. Metal sheets are decorated on high speed coating machines and lithographing presses connected with conveyor ovens. Decorated sheets are then cut to working sizes on shearing equipment, following which fabrication is completed by punch presses, can-forming and can-closing equipment and other specialized machinery for supplementary operations. Most tooling for fabricating equipment is designed and engineered by the Company's engineering staffs, and much of it is produced in the Company's tool rooms. Plastic packaging capabilities include printing and molding of irregular shaped plastic containers and customized plastic closures. J. L. Clark is the only company in the packaging industry to mold and offset lithograph a one-piece irregular shaped semi-rigid plastic container with a living hinge cover. A growing area of specialty is custom-designed plastic closures for products which have tamper-evidency as well as convenience features. Collapsible metal tubes are produced at the J. L. Clark Tube Division plant in Downers Grove, Illinois from aluminum slugs on fully-automated production lines which consist of extrusion presses, trimming machines, annealing ovens, coating machines, printing presses and capping machines. When necessary for customer specifications, tubes can be internally waxed or lined in order to achieve chemical compatibility with products to be packed. Composite containers of both spiral and convolute construction, as well as some specialty items, are produced at J. L. Clark divisions in Rockford, Illinois and Lancaster, Pennsylvania. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In December, 1992, a jury trial resulted in a judgment against the Company in the amount of $4,900,000. GERALD D. FLOWERS MFG. REP., INC. AND GERALD D. FLOWERS v. J.A. BALDWIN MFG. CO., BALDWIN FILTERS, INC., CLARCOR FILTRATION PRODUCTS INC. AND CLARCOR INC., Case No. 30,323, District Court of Harden County Texas, 88th Judicial District. In November 1993, the district court in Texas ordered that a joint motion filed by the two parties to dismiss the judgment be granted, that the judgment of the trial court be vacated, and that the cause be remanded to the trial court for entry of a take-nothing judgment pursuant to a settlement agreement by the two parties. Two additional lawsuits have been filed by former distributors of Baldwin filters. F.W. MORRIS AGENCY, INC. AND F.W. MORRIS v. BALDWIN FILTERS, INC., Civil Action No. 93-108-ATH(DF) United States District Court for the Middle District of Georgia, Athens Division; JOHN NIEMEYER v. J.A. BALDWIN MFG. CO., ET AL., Case No. CV 93-21818, Circuit Court of Jackson County, Missouri. Generally, the plaintiffs in these actions seek damages for alleged breach of oral contracts pursuant to which they acted as independent sales representatives for Baldwin filters. The Company intends to vigorously defend each of these actions and believes that it has fully discharged any and all obligations to these plaintiffs. In management's opinion these cases, when concluded, will not have any material adverse effect on the consolidated financial position of the Company. There are no other material pending legal proceedings (other than ordinary routine litigation incidental to the Company's business) to which the Company is a party or of which any of its property is the subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. ADDITIONAL ITEM: EXECUTIVE OFFICERS OF THE REGISTRANT Each executive officer of the Company is elected for a term of one year which begins at the Board of Directors Meeting at which he is elected, held following the Annual Meeting of Shareholders, and ends on the date of the next Annual Meeting of Shareholders or upon the due election and qualification of his successor. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS. On March 18, 1992, the Company's Common Stock was listed on the New York Stock Exchange; it is traded under the symbol CLC. Prior to that date the stock was traded on the NASDAQ National Market System. The following table sets forth the high and low market prices as quoted during the relevant periods by NASDAQ and the New York Stock Exchange and dividends paid for each quarter of the last two fiscal years. The approximate number of holders of common stock of the Company as at February 1, 1994 is 1,960. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information required hereunder is set forth on pages 28 and 29 of the Annual Report under the caption "13-Year Financial Summary", is incorporated herein by reference and is filed as Exhibit 13a(ix) to this 1993 Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The information required hereunder is set forth on pages 18, 20, 22, 24, 25 and 26 of the Annual Report under the caption "Market-Focused Strategy: 1991-Present", is incorporated herein by reference and is filed as Exhibit 13a(x) to this 1993 Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Consolidated Financial Statements, the Notes thereto and the report thereon of Coopers & Lybrand, independent accountants, required hereunder with respect to the Company and its consolidated subsidiaries are set forth on pages 30 through 46, inclusive, of the Annual Report, are incorporated herein by reference and is filed as Exhibits 13(a)(ii) through 13(a)(vii) to this 1993 Form 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. Certain information required hereunder is set forth on pages 1 and 2 of the Company's Proxy Statement dated February 24, 1994 (the "Proxy Statement") for the Annual Meeting of Shareholders to be held on March 31, 1994 under the caption "Election of Directors -- Nominees for Election to the Board" and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required hereunder is set forth on pages 6 through 14 inclusive, of the Proxy Statement under the caption "Compensation of Executive Officers and Other Information" and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required hereunder is set forth on pages 4 through 6 of the Proxy Statement under the caption "Beneficial Ownership of the Company's Common Stock" and 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) FINANCIAL STATEMENTS The following financial information is incorporated herein by reference to the Company's Annual Report to Shareholder's for the fiscal year ended November 30, 1993: *Consolidated Balance Sheets at November 30, 1993 and 1992 *Consolidated Statements of Earnings for the years ended November 30, 1993, 1992 and 1991 *Consolidated Statements of Shareholders' Equity for the years ended November 30, 1993, 1992 and 1991 *Consolidated Statements of Cash Flows for the years ended November 30, 1993, 1992 and 1991 *Notes to Consolidated Financial Statements *Report of Independent Accountants *Management's Report on Responsibility for Financial Reporting *Filed herewith as part of Exhibit 13(a) to this 1993 Form 10-K The following items are set forth herein on the pages indicated: Financial statements and schedules other than those listed above are omitted for the reason that they are not applicable, are not required, or the information is included in the financial statements or the footnotes therein. (B) There were no Reports on Form 8-K filed during the fourth quarter of the fiscal year ended November 30, 1993. (C) EXHIBITS 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. CLARCOR Inc. (Registrant) By: LAWRENCE E. GLOYD -------------------------------- Lawrence E. Gloyd CHAIRMAN, PRESIDENT & CHIEF EXECUTIVE OFFICER Date: February 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. REPORT OF INDEPENDENT ACCOUNTANTS The Board of Directors and Shareholders CLARCOR Inc. Rockford, Illinois Our report on the consolidated financial statements of CLARCOR Inc. has been incorporated by reference in this Form 10-K from page 46 of the 1993 Annual Report to Shareholders of CLARCOR Inc. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed on pages through 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 Rockford, Illinois January 7, 1994 CLARCOR INC. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED NOVEMBER 30, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) CLARCOR INC. SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED NOVEMBER 30, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) CLARCOR INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED NOVEMBER 30, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) CLARCOR INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED NOVEMBER 30, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) NOTE: Includes amounts in 1992 and 1991 related to Precision Products Group which was sold effective November 30, 1992. Items 3, 4 and 5 omitted as the amounts did not exceed one percent of total sales and revenues in the related consolidated statements of earnings.

36340_1993.txt

36340_1993

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36340

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

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1993

41719

Item 1. Business. - ------ -------- The Registrant, a paper manufacturing company, began operations in Spring Grove, Pennsylvania in 1864 and was incorporated as a Pennsylvania corporation in 1905. On January 30, 1979 the Registrant acquired by merger Bergstrom Paper Company ("Bergstrom") with paper mills located in Wisconsin and Ohio. The Ohio mill was sold on September 10, 1984. On May 7, 1987 the Registrant acquired all of the outstanding capital stock of Ecusta Corporation ("Ecusta") with a paper mill located in North Carolina and other operations in North Dakota, Canada and Australia. Ecusta was merged into and became a division of the Registrant on June 30, 1987. The Registrant's present papermaking operations are located in Spring Grove, Pennsylvania, Pisgah Forest, North Carolina and Neenah, Wisconsin. It manufactures printing papers and tobacco and other specialty papers. The Registrant's products are used principally for case bound and quality paperback books, commercial and financial printing, converting and cigarette manufacturing. The Registrant sells its products throughout the United States and in a number of foreign countries. Net export sales in 1993, 1992 and 1991 were $38,577,000, $48,830,000 and $60,311,000, respectively. In 1993, sales of paper for book publishing and commercial printing generally were made through wholesale paper merchants, whereas sales of paper to cigarette manufacturers, financial printers and converters generally were made directly. No single user of the Registrant's products accounted for more than 10% of the Registrant's 1993 net dollar sales. In 1993, the Registrant did not supply tobacco paper products to the domestic tobacco operations of Philip Morris Companies, Inc., in accordance with a decision communicated by Philip Morris to the Registrant on October 29, 1992. Philip Morris had been one of Registrant's six domestic customers for tobacco paper products. Sales to Philip Morris amounted to 7.5% of the Registrant's total sales in 1992. During 1993, the Registrant succeeded in redirecting the lost Philip Morris product volume to printing paper customers. However, these sales were not as profitable as sales to Philip Morris in 1992. In addition, due to increased competitive pressure and cost- cutting measures within the tobacco industry, sales to remaining tobacco paper customers in 1993 were less profitable than in 1992. As a result, the 1993 profit performance of the Registrant's Pisgah Forest mill was sharply below that of 1992. The Registrant continues its efforts to maximize utilization of its Pisgah Forest mill assets by attempting to direct sales volume to its most profitable grades and by controlling costs. Even with these efforts, the 1994 profit performance of the Pisgah Forest mill is not expected to improve over that of 1993. Set forth below is the amount (in thousands) and percentage of net sales contributed by each of the Registrant's two classes of similar products during each of the years ended December 31, 1993, 1992 and 1991. Printing and specialty papers are manufactured in each of the Registrant's mills. Tobacco papers are manufactured in the Registrant's Pisgah Forest mill. The competitiveness of the markets in which the Registrant sells its products varies. There are numerous concerns in the United States manufacturing printing papers, and no one company holds a dominant position. Capacity in the uncoated free-sheet industry, which includes uncoated printing papers, is expected to increase in the first quarter of 1994. Industry operating rates should improve, particularly in the latter half of the year, once the new capacity is absorbed by the market. In the interim, competition with respect to printing papers is likely to be intense with continuing pressure on prices. In the tobacco papers business, while there is only one significant domestic competitor, there are numerous international competitors. Despite recent events described above, the Registrant remains a major tobacco papers supplier to the domestic tobacco products industry. Declining consumption of cigarettes in the United States, the shift to lower-priced and lower-cost cigarettes and lower- priced tobacco paper products from foreign manufacturers caused tobacco companies to pressure the Registrant to reduce prices, but have not, and are not expected to, affect the Registrant's relative competitive position. Increasing foreign production of tobacco products by U.S. companies may have an adverse effect on the Registrant's overall competitive position. Service, product performance and technological advances are important competitive factors in the Registrant's business. The Registrant believes its reputation in these areas continues to be excellent. Backlogs are not significant in the Registrant's business. The principal raw material used at the Spring Grove mill is pulpwood. In 1993, the Registrant acquired approximately 83% of its pulpwood from saw mills and independent logging contractors and 17% from Company-owned timberlands. Hardwood purchases constituted slightly more than half of the pulpwood acquired and softwood the balance. Hardwoods are growing in abundance within a relatively short distance of the Registrant's Spring Grove mill. Softwood is obtained primarily from Maryland, Delaware and Virginia. In order to protect its sources of pulpwood, the Registrant has actively promoted conservation and forest management among suppliers and woodland owners. In addition, its subsidiary, The Glatfelter Pulp Wood Company, has acquired, and is acquiring, woodlands, particularly softwood growing land, with the objective of having sufficient softwood growing on its lands to provide a significant portion of the Spring Grove mill's future softwood requirements. Wood chips produced from sawmill waste also accounted for a substantial amount of the Registrant's pulpwood purchases for the Spring Grove mill. The Neenah mill uses high-grade recycled wastepaper as its principal raw material. There is currently an adequate supply of wastepaper. The major raw materials used at the Pisgah Forest mill are purchased wood pulp and processed flax straw, which is derived from linseed flax plants. Flax has become a less important raw material as a result of the loss of business of Philip Morris (referred to above), since it was the Registrant's major customer for flax-based products. In addition, declining consumption of cigarettes in the United States and the shift to lower-priced and lower-cost cigarettes, which are manufactured using predominately wood pulp-based tobacco papers, has caused further deterioration in demand for flax-based papers. This has necessitated the purchase of additional wood pulp to manufacture products to replace the lost flax-based business. The current supply of flax and wood pulp is sufficient for the present and anticipated future operations at the Pisgah Forest mill. Due to sufficient levels of processed flax straw inventory, the Registrant elected not to contract for the purchase of flax straw for 1994. The Registrant's future operations in North Dakota and Canada are contingent upon the Registrant's ongoing review of the demand for and profitability of its flax- based tobacco papers. Wood pulp purchased from others comprised approximately 109,000 short tons or 25% of the total 1993 fiber requirements of the Registrant. Wood pulp is currently in more than adequate supply. The Registrant is subject to numerous Federal, state and foreign laws and rules and regulations thereunder with respect to solid waste disposal and the abatement of air and water pollution and noise. It has been the Registrant's experience over many years that directives with respect to the abatement of pollution have periodically been made increasingly stringent. During the past twenty years or more, the Registrant has taken a number of measures and spent substantial sums of money both for the installation of facilities and operating expenses in order to abate air, water and noise pollution and to alleviate the problem of disposal of solid waste. In spite of the measures it has already taken, the Registrant expects that compliance with the laws and the rules and regulations thereunder relating to solid waste disposal and the abatement of air and water pollution could become increasingly difficult and that such compliance, when and if technologically feasible, will require additional capital expenditures and operating expenses. For further information with respect to such compliance, reference is made to Item 3 of this report. Compliance with government environmental regulations is a matter of high priority to the Registrant. In order to meet environmental requirements, the Registrant has undertaken certain projects, the most significant of which is the Spring Grove pulpmill modernization. The related construction cost for all of these projects, based on presently available information, is estimated to be $34 million in 1994 and $7 million in 1995, including approximately $31 million in 1994 for the Spring Grove pulpmill modernization project. The pulpmill modernization project began in 1990 and is expected to be completed in 1994. The total cost of the pulpmill modernization project is expected to be $170 million (exclusive of capitalized interest) of which $20 million was expended in 1991 or prior thereto, $48 million in 1992 and $71 million in 1993. Since capital expenditures for pollution abatement generally do not increase the productivity or efficiency of the Registrant's mills, the Registrant's earnings will be adversely affected to the extent that selling prices cannot be increased to offset incremental operating costs, including depreciation, resulting from such capital expenditures, additional interest expense or the loss of any income which otherwise could have been earned on the amounts expended for environmental purposes. The Registrant does not expect, however, that its capital expenditures for, or operating costs of, pollution abatement facilities for its present mills will have a significant adverse effect on its competitive position. The Registrant's Spring Grove mill generates all of its steam requirements and is 100% self-sufficient in electrical energy generation. It also produces excess electricity which is sold to the local power company under a long-term co-generation contract, which resulted in 1993 net energy sales of $5,602,000. Principal fuel sources used by the Registrant's Spring Grove mill are coal, spent chemicals, bark and wood waste, and oil which in 1993 were used to produce approximately 66%, 27%, 6% and 1%, respectively, of the total energy internally generated at the Spring Grove mill. The Pisgah Forest mill generates all of its steam requirements and a majority of its electrical requirements (63% in 1993) and purchases electric power for the remainder. The principal fuel source used at the Pisgah Forest mill is coal (98.5% in 1993). The Neenah mill generates all of its steam requirements and a portion of its electric power requirements (13% in 1993) and purchases the remainder of its electric power requirements. Gas and oil were used to produce 81% and 19%, respectively, of the mill's internally generated energy during 1993. At December 31, 1993, the Registrant had 3,019 active full-time employees. Hourly employees at the Registrant's mills are represented by different locals of the United Paperworkers International Union, AFL-CIO. A labor agreement covering approximately 1,025 employees at the Pisgah Forest mill expires in October 1996. Under this agreement, wages increased 2.75% in 1993 and are to increase 3% in both 1994 and 1995. A five-year labor agreement covering approximately 770 hourly employees in Spring Grove was ratified in 1993 and expires in January 1998. Under this agreement, wages increased by 2.5% in 1993 and are to increase by 3% in each of the four years, 1994 through 1997. In January 1994, a new five-year labor agreement covering Neenah employees (approximately 320) was ratified. Under this agreement, which expires in August 1997, wages increased 2.75% in 1993 and are to increase 3% in each of 1994, 1995 and 1996. Item 2. Item 2. Properties. - ------ ---------- The Registrant's executive offices are located in Spring Grove, Pennsylvania, 11 miles southwest of York. The Registrant's paper mills are located in Spring Grove, Pennsylvania, Pisgah Forest, North Carolina and Neenah, Wisconsin. The Spring Grove facilities include seven uncoated paper machines with a daily capacity ranging from 11 to 273 tons and an aggregate annual capacity of about 279,000 tons of finished paper. The machines have been rebuilt and modernized from time to time. A high speed off-machine coater gives the Registrant a potential annual production capacity for coated paper of approximately 48,000 tons. Since uncoated paper is used in producing coated paper, this does not represent an increase in the Spring Grove plant capacity. The pulpmill has a production capacity of approximately 550 tons of bleached pulp per day. The Pisgah Forest facilities include twelve paper machines, stock preparation equipment and a modified kraft bleached flax pulpmill with thirteen rotary digesters. The annual light weight paper capacity is approximately 98,000 tons. This represents a recent 7,000 ton increase due to a shift from tobacco paper to printing paper. Nine paper machines are essentially identical while the newer three machines have design variations specific for the products produced. Converting equipment includes winders, calendars, slitters, perforators and printing presses. The Neenah facilities, consisting of a paper manufacturing mill, converting plant and offices, are located at two sites. The Neenah mill includes three paper machines, with an aggregate annual capacity of approximately 156,000 tons, a wastepaper processing and warehousing building, a wastepaper de-inking and bleaching plant, stock preparation equipment, power plant, water treatment and waste treatment plants, and warehousing space. The converting plant contains a paper processing area and warehouse space. The Glatfelter Pulp Wood Company, a subsidiary of the Registrant, owns and manages approximately 109,000 acres of land, most of which is timberland. The Registrant owns substantially all of the properties used in its papermaking operations except for certain land leased from the City of Neenah under leases expiring in 2050, on which wastewater treatment and storage facilities and a parking lot are located. All of the Registrant's properties, other than those which are leased, are free from any major liens or encumbrances. The Registrant considers that all of its buildings are in good structural condition and well maintained and its properties are suitable and adequate for present operations. Item 3. Item 3. Pending Legal Proceedings. - ------ ------------------------- The Registrant does not believe that the environmental matters discussed below will have a material effect on its business or consolidated financial position. On May 16, 1989, the Pennsylvania Environmental Hearing Board approved and entered an Amended Consent Adjudication between the Registrant and the Pennsylvania Department of Environmental Resources ("DER") in connection with the Registrant's permit to discharge effluent into the West Branch of the Codorus Creek. The Amended Consent Adjudication establishes limitations on in- stream color, and requires the Registrant to conduct certain studies and to submit certain reports regarding internal and external measures to control the discharge of color and certain other adverse byproducts of chlorine bleaching to the West Branch of the Codorus Creek. During 1990 and again in 1991, the Pennsylvania DER proposed to reissue the Registrant's waste water discharge permit on terms with which the Registrant does not agree. The Registrant is contesting these terms. Among those terms is an unacceptable term concerning a suspected discharge of 2,3,7,8 tetrachlorodibenzo-p-dioxin ("dioxin"). At the behest of the United States Environmental Protection Agency ("EPA"), DER has included the Registrant's Spring Grove mill on the list of dischargers submitted to and approved by EPA pursuant to Section 304(l) of the Clean Water Act. EPA has approved that list because EPA suspects that the Spring Grove mill may discharge dioxin in concentrations of concern. The Registrant believes that the Spring Grove mill should not be included on the discharger list. The Registrant has been identified by EPA and the Ohio Environmental Protection Agency as one of 34 potentially responsible parties ("PRP") for the clean-up of the Cardington Road Landfill in Montgomery County, Ohio. EPA has selected a remedy estimated to cost approximately $8.2 million and, by letter dated February 9, 1994, demanded that the PRPs perform a remedial design. Appleton Paper, Inc., which purchased the Registrant's West Carrolton, Ohio mill, was previously identified as a PRP and has demanded that the Company indemnify it for costs incurred in connection with this landfill, but did not receive the February 9 letter. On March 25, 1994 the Registrant received notice that the court in Cardington Road Site Coalition v. Snyder Properties, ------------------------------ ------------------ Inc. (Case No. C-3-88-632 S.D. Ohio), a superfund cost recovery action brought - ---- by the PRPs who implemented the remedial investigation, had authorized the filing of a complaint naming the Registrant as a third-party defendant in such action. The Wisconsin DNR has reissued the Registrant's wastewater discharge permit for the Neenah mill on terms unacceptable to the Registrant. The Registrant has requested an adjudicatory hearing on the terms of that permit. The Wisconsin Paper Council is presently engaged in joint negotiation of some issues common to a number of permits issued at the same time to similar mills. The Registrant has been named as a fourth-party defendant in an action captioned United States v. Modern Trash Removal of York, Inc., Civil No. --------------------------------------------------- 92-0819, pending in the United States District Court for the Middle District of Pennsylvania. The action, brought pursuant to the Comprehensive Environmental Response, Compensation and Liability Act and the Pennsylvania Hazardous Sites Cleanup Act, seeks contribution from the Registrant for its alleged share of past and future costs incurred during the cleanup of the Modern Sanitation Landfill (the "Landfill") located in Windsor and Lower Windsor Townships, York County, Pennsylvania. Modern Trash Removal York, Inc., a subsidiary of Waste Management, Inc., has agreed in principle to defend and to indemnify the Registrant against any liability the Registrant may have with respect to the cleanup of the Landfill. The terms of a definitive agreement are currently being negotiated. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------ --------------------------------------------------- Not Applicable. Executive Officers of the Registrant. - ------------------------------------ Officers are elected to serve at the pleasure of the Board of Directors. Except in the case of officers elected to fill a new position or a vacancy occurring at some other date, officers are elected at the annual meeting of the Board held immediately after the annual meeting of shareholders. ____________________ (a) Unless otherwise indicated, the offices listed have been held for five or more years. (b) Mr. Newcomer became Vice President and Treasurer on May 1, 1993. From June 1, 1989 to April 30, 1993 he was Assistant Comptroller. From January 1, 1988 to May 31, 1989 he was Corporate Manager, Budgets and Financial Analysis. (c) Mr. Lawrence became Vice President - General Manager, Ecusta Division on May 1, 1993. From February 1, 1989 to April 30, 1993 he was Director of Planning, Acquisitions and Governmental Affairs. (d) Dr. Myers became Vice President - Manufacturing Technology on April 26, 1989. From April 27, 1988 to April 26, 1989, he was Vice President - Manufacturing, Glatfelter Paper Division. (e) Mr. Glatfelter became Vice President - General Manager, Glatfelter Paper Division on May 1, 1993. From April 1989 until May 1993, he was General Manager, Glatfelter Paper Division. From April 1988 to April 1989, he was Assistant to the Chief Executive Officer. (f) Mr. Smith became Comptroller on May 1, 1993. From December 1990 to May 1993, he was a Financial Analyst. From January 1988 to December 1990, he was Comptroller for Flagship Cleaning Services, Inc. (g) Mr. Wood became Secretary and Assistant Treasurer on September 23, 1992. From December 22, 1987 to September 22, 1992 he was Assistant Secretary and Assistant Treasurer. PART II ------- Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder - ------ ---------------------------------------------------- ----------- Matters. ------- Common Stock Prices and Dividends Paid Information The table below shows the high and low prices of the Company's common stock on the American Stock Exchange (Ticker Symbol "GLT") and the dividends paid per share for each quarter during the past two years. Stock prices and dividends paid per share have been adjusted to reflect the two-for-one common stock split effected April 22, 1992. As of December 31, 1993, the Company had 5,030 shareholders of record. A number of the shareholders of record are nominees. Item 6. Item 6. Selected Financial Data. - ------ ----------------------- Five-Year Summary of Selected Consolidated Financial Data (a) After impact of an after tax charge for unusual items of $8,430,000 or $.19 per share and the effect of an increased federal corporate income tax rate of $3,587,000 or $.08 per share. (b) Includes an increase of $61,062,000 for the adoption of Statement of Financial Accounting Standard No. 109. 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 Financial Condition Liquidity: During 1993, the primary source of cash and marketable securities was the Company's issuance of $150,000,000 principal amount of its 5 7/8% Notes. The Notes will mature on March 1, 1998, and may not be redeemed prior to maturity. In addition to the proceeds of such issuance, the Company generated $45,380,000 of cash from operations. These funds were used for, among other things, capital spending of $112,820,000, the payment of $30,847,000 in dividends and the retirement of $41,100,000 of short-term debt, $10,100,000 of which was outstanding as of December 31, 1992. During 1993, the Company's cash and cash equivalents increased by $16,089,000. In addition, the Company's marketable securities increased by $27,184,000. The Company expects to meet all its near and long-term cash needs from internally generated funds, cash, cash equivalents, marketable securities and bank lines of credit, as discussed in Note 12 of the Notes to Consolidated Financial Statements, or a combination of these sources. Capital Resources: Capital spending in 1993 of $112,820,000 was $22,504,000 higher than in 1992, due primarily to the Company's pulpmill modernization project at its Spring Grove mill. Capital spending in 1994 is expected to decrease significantly from 1993 due to the completion of the pulpmill modernization project, offset somewhat by an estimated $15,000,000 of cash expenditures related to the purchase and installation of a new turbine generator. The new turbine generator is expected to be operational in the first quarter of 1995 at a total cost in excess of $20,000,000. Results of Operations The Company classifies its sales into two product groups: 1) printing papers; and 2) tobacco and other specialty papers. Significant production capacity increases have occurred in the printing paper industry in 1991, 1992 and 1993. As a result, printing paper prices were down slightly in 1993 compared to 1992. The Company's printing paper volume was up slightly in 1993, as printing paper volume gains at the Pisgah Forest mill offset volume decreases at the Neenah mill. The trend of declining domestic tobacco consumption continued in 1993, with no change in the trend expected. On October 29, 1992, Philip Morris Companies, Inc. informed the Company that, effective January 1, 1993, it would cease to make purchases from the Company for its domestic tobacco operations. Sales to this customer in 1992 were 7.5% of total sales for the year. The Company's dollar amount of sales of tobacco paper products direct to foreign tobacco product manufacturers declined in 1993 as a result of sharply lower unit prices due to increased foreign competition. Most of the Company's printing paper sales are directed at the uncoated free-sheet segment of the industry. Industry uncoated free-sheet capacity is expected to increase in the first quarter of 1994. Industry operating rates should improve, particularly in the latter half of the year once the new capacity is absorbed by the market. Product pricing is expected to be relatively flat compared to 1993, with any significant improvements not anticipated until the third or fourth quarter. Profit from operations for the Spring Grove and Neenah mills is expected to decline modestly in 1994 as a result of unchanged selling prices and increases in wood costs, pulp costs, depreciation, salaries, wages and other manufacturing costs. During 1993, the Company succeeded in redirecting the lost Philip Morris product volume to printing paper customers. These sales were not as profitable as sales to Philip Morris were in 1992. In addition, due to increased competitive pressure and cost-cutting measures within the tobacco industry, sales to remaining tobacco customers in 1993 were less profitable than in 1992. As a result, the 1993 profit performance of the Company's Pisgah Forest mill was sharply below that of 1992. The Company continues its efforts to maximize utilization of its Pisgah Forest mill assets by attempting to direct sales volume to its most profitable grades and by controlling costs. Even with these efforts, the 1994 profit performance of the Pisgah Forest mill is not expected to improve over that of 1993. Effective January 1, 1993, the Company adopted the provisions of Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension" ("SFAS No. 106"), No. 109 "Accounting for Income Taxes" ("SFAS No. 109"), and No. 112 "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). The combined 1993 net of tax charge due to the adoption of these standards was approximately $4.2 million, or $.09 per common share. Note 1(h) of the Notes to Consolidated Financial Statements further describes the expected effects of implementing these Standards. During 1993, the Company incurred net unusual charges of $13,229,000, or $.19 per common share, due to rightsizing and restructuring costs of $16,363,000, partially offset by a gain of $1,492,000 on the disposal of its Ecusta Division's airplane and a credit of $1,642,000 resulting from the updating of estimates relating to SFAS No. 106, subsequent to its adoption on January 1, 1993. The rightsizing and restructuring costs include provisions for the costs of early retirements and other terminations in 1993 and other one-time net costs relating to the rightsizing and restructuring of the Company's operations. During 1993, the Company's inventory level increased approximately $10,500,000. This increase was primarily due to an increase in the Company's finished goods inventory. This increase was the result of increased stocking levels to meet customer demand, primarily in the financial printing market. The Company also purchased a large quantity of pulp near the end of 1993 at an attractively low price. This purchase also resulted in an increase in the Company's accounts payable balance at December 31, 1993. 1993 Compared to 1992 Net sales in 1993 decreased $66,548,000 from 1992 with lower tobacco paper sales accounting for 94% of this decrease. Tobacco paper sales were adversely impacted by the loss of the Philip Morris domestic tobacco paper business. Increased competitive pressure and cost-cutting measures taken by the remaining domestic and foreign customers resulted in lower unit prices and lower revenues. Profit from operations, before restructuring charges, accounting changes, interest income and expense and taxes, was $48,563,000 compared to $90,302,000 in 1992, a decrease of 46.2%. The Company's Pisgah Forest mill showed a decline in profits from operations of $29,018,000 in 1993 compared to 1992. Net sales decreased $47,707,000 for the reasons noted above. Profit from operations at the Neenah mill showed a decline of $6,997,000 in 1993 compared to 1992. Net sales declined $8,651,000 in 1993 due primarily to lower sales volume. The Spring Grove mill had a decrease in its profits from operations of $5,724,000 in 1993 compared to 1992. Net sales were $10,190,000 lower in 1993. The Spring Grove mill had a 4% decrease in average net selling price, primarily as a result of less favorable product mix. Selling, administrative and general expenses decreased $3,728,000 in 1993, $3,640,000 of which was the result of lower management incentive bonuses and profit sharing expenses. Net interest income increased by $2,414,000 in 1993 due to increased cash available for investment as a result of the $150,000,000 debt issuance. Interest on debt increased by $2,824,000, net of an increase in capitalized interest of $4,050,000. 1992 Compared to 1991 Net sales in 1992 decreased $27,707,000 from 1991. Lower printing paper sales accounted for 60% of this decrease with lower sales of tobacco and other specialty papers accounting for the balance. Higher unit sales were more than offset by lower unit prices and unfavorable mix changes within both product categories. In 1992, profit from operations, before net interest income and income taxes, was $90,302,000 compared to $120,912,000 in 1991, a decrease of 25.3%. The Company's Pisgah Forest mill showed a decline in profit from operations of $12,278,000 in 1992 compared to 1991. Net sales declined $12,814,000 as a result of a less favorable mix of product sales and lower international and domestic tobacco paper sales. Profit from operations at the Neenah mill showed a decline of $9,999,000 in 1992. Net sales declined $9,187,000 in 1992 due mainly to lower unit prices as volume was virtually the same. The Spring Grove mill had a decrease in its profits from operations of $8,333,000 in 1992. Net sales were $5,706,000 lower in 1992. Volume increased by 2.1% in 1992, but lower unit prices and a less favorable product mix more than offset the increased volume. Increases in salaries, wages, depreciation and other manufacturing costs were also contributing factors. Selling, administrative and general expenses decreased by $6,999,000 in 1992; $4,406,000 of which was the result of lower management incentive bonus and profit sharing expenses. The balance was as a result of the Company's ongoing cost control measures. Net interest income declined by $1,814,000 in 1992 due to reduced investment in interest-bearing securities and lower interest rates. Effects of Changing Prices The moderate levels of inflation during recent years have not had a material effect on the Company's net sales, revenues or income from operations. Although the replacement cost of assets increases during inflationary periods, earnings and cash flow can be maintained through an increase in selling prices. Item 8. Item 8. Financial Statements and Supplementary Data. - ------ ------------------------------------------- Consolidated Statements of Income and Retained Earnings P. H. Glatfelter Company and subsidiaries For the Years Ended December 31, 1993, 1992 and 1991 See notes to consolidated financial statements. Consolidated Balance Sheets P. H. Glatfelter Company and subsidiaries December 31, 1993 and 1992 See notes to consolidated financial statements. Consolidated Statements of Cash Flows P. H. Glatfelter Company and subsidiaries For the Years Ended December 31, 1993, 1992 and 1991 See notes to consolidated financial statements. 1. Summary of Significant Accounting Policies (a) Principles of Consolidation The accounts of the Company, and its wholly-owned, significant subsidiaries, are included in the consolidated financial statements. All intercompany transactions have been eliminated. Certain reclassifications have been made of previously reported amounts in order to conform with classifications used in the current year. (b) Earnings per Share Net income per share of common stock is computed on the basis of the weighted average number of shares of common stock and common stock equivalents (Note 5) outstanding during each year. The 1993 net income per share of common stock of $.37, as presented in the Consolidated Statements of Income and Retained Earnings, appropriately reflects the negative impact of rightsizing and restructuring charges (Note 2), adopting certain Statements of Financial Accounting Standards (Note 1(h)) and the increase in the federal corporate income tax rate from 34% to 35% (Note 8). The 1993 net income per share of common stock, exclusive of these items, would have been $.73. A reconciliation of these amounts follows: (c) Cash Equivalents and Investments The Company considers all highly liquid financial instruments with effective maturities at date of purchase of three months or less to be cash equivalents. Highly liquid financial instruments with maturities in excess of three months but which the Company considers available for sale are classified as marketable securities on the Company's Consolidated Balance Sheets. Effective January 1, 1994, the Company changed its accounting for investments in debt and equity securities to conform to Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). All of the Company's securities are either "available for sale" or "held to maturity" as defined by SFAS No. 115. As noted in Note 1(i), the Company's marketable securities approximate fair value. The adoption of this standard is not expected to have a material impact on the Company's Consolidated Balance Sheets or Consolidated Statements of Income and Retained Earnings. (d) Inventories Inventories are stated at the lower of cost or market. Raw materials and in-process and finished inventories are valued using the last-in, first-out (LIFO) method, and the supplies inventory is valued principally using the average cost method. Inventories at December 31 are as follows: If the Company had valued all inventories using the average cost method, inventories would have been $2,141,000 lower than reported at December 31, 1993, and $1,105,000 and $3,168,000 greater than reported at December 31, 1992 and 1991, respectively. Net income would not have been significantly different than that reported. At December 31, 1993, the value of the above inventories exceeded inventories for income tax purposes by approximately $27,000,000. (e) Plant, Equipment and Timberlands Depreciation is computed for financial reporting on the straight-line method over the estimated useful lives of the respective assets and for income taxes principally on accelerated methods over lives established by statute or Treasury Department procedures. Provision is made for deferred income taxes applicable to this difference. Maintenance and repairs are charged to income and major renewals and betterments are capitalized. At the time property is retired or sold, the cost and related reserve are eliminated and any resultant gain or loss is included in income. Depletion of the cost of timber is computed on a unit rate of usage by growing area based on estimated quantities of recoverable material. (f) Income Tax Accounting Effective January 1, 1993, the Company changed its policy of accounting for income taxes to conform to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109") (Note 8). The Company previously followed Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes". Deferred taxes are provided for differences between amounts shown for financial reporting purposes and those included with tax return filings that will reverse in future periods. (g) Interest Expense Capitalized The Company capitalizes interest expense incurred in connection with qualified additions to property. The Company capitalized $4,138,000 and $88,000 of interest in 1993 and 1992, respectively. No interest was capitalized in 1991. (h) Accounting Changes for Statements of Financial Accounting Standards Effective January 1, 1993, the Company adopted the provisions of Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS No. 106"), No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"), and No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). The cumulative effect of the accounting changes, net of tax charges (credits) due to the adoption of these Standards, is as follows: SFAS No. 106 requires recognition of the cost of retiree health and insurance benefits during an employee's active service. The cumulative effect, as of January 1, 1993, of the adoption of SFAS No. 106 was a one-time charge for postretirement health care costs of $20,900,000 which, after deferred income tax benefits of $8,050,000, resulted in a 1993 first quarter net charge of $12,850,000. The Company had previously recognized the cost of postretirement benefits in the period benefits were paid. The effect of this change in accounting for the year ended December 31, 1993 was an additional pre-tax expense of approximately $770,000. The postretirement expense for the years ended December 31, 1992 and 1991 were approximately $1,320,000 and $1,358,000, respectively. The pro forma effect on operations of this change for the years ended December 31, 1992 and 1991 would have been an additional pre-tax expense of approximately $855,000 and $647,000, respectively. SFAS No. 112 requires employers to recognize the obligation to provide postemployment benefits under certain conditions. Such benefits, relating primarily to disability-related benefits, were not previously recognized by the Company until paid. The cumulative effect as of January 1, 1993 of the adoption of SFAS No. 112 was a provision for accrued postemployment benefits of $3,201,000 which, after deferred income tax benefits of $1,234,000, resulted in a 1993 first quarter net charge of $1,967,000. The pro forma effect on operations of this change for the years ended December 31, 1992 and 1991 would not have been significant. SFAS No. 109 requires a remeasurement of the Company's Ecusta Division acquisition which results in an increase in the fair value of the acquired assets and the establishment of a deferred income tax liability for the difference between the book and tax values of such assets. The adoption of SFAS No. 109 also resulted in a reversal of deferred income taxes provided during years when the effective income tax rates were higher than those currently in effect. The cumulative effect of these changes was an increase in plant and equipment of approximately $61,062,000; an increase in deferred income taxes of approximately $50,438,000; and a credit to operations as a cumulative effect of the change in method of accounting for income taxes of approximately $10,624,000. The pro forma effect on operations of this change for the years ended December 31, 1992 and 1991, would not have been significant. (i) Fair Market Value of Financial Instruments In 1993, the Company adopted SFAS 107, "Disclosures About Fair Value of Financial Instruments". This Statement requires that fair values be disclosed for most of the Company's financial instruments. The amounts reported in the Consolidated Balance Sheets for cash and cash equivalents, marketable securities, trade receivables, certain other current assets and long-term debt approximate fair value. 2. Rightsizing and Restructuring (Unusual Items) During 1993, the Company incurred net pre-tax unusual charges of $13,229,000, including rightsizing and restructuring costs of $16,363,000, partially offset by a gain of $1,492,000 on the disposal of its Ecusta Division's airplane and a credit of $1,642,000 resulting from the updating of estimates relating to SFAS No. 106, subsequent to its adoption on January 1, 1993. The rightsizing and restructuring costs include provisions for the costs of early retirements and other terminations in 1993 and other one-time net costs relating to the rightsizing and restructuring of the Company's operations. The after tax impact of these charges was $8,430,000, or $.19 per common share. 3. Capital Stock A summary of the number of shares of common stock outstanding follows: Under the employee stock purchase plans, eligible employees may acquire shares of the Company's common stock at its fair market value. Employees may contribute up to 10% of their compensation, as defined, and the Company will contribute, as specified in the plans, amounts up to 50% of the employee's contribution but not more than 3% of the employee's compensation, as defined. On September 22, 1993, the Company's Board of Directors called for the redemption of all 3,147 outstanding shares of 4 5/8 % preferred stock. The preferred shares were redeemed on October 27, 1993 for $50.75 per share. The redeemed shares of preferred stock and all shares of preferred stock held in treasury were cancelled on October 27, 1993. At December 31, 1993, the Company had 40,000 shares of preferred stock which are authorized but not issued. A summary of preferred stock follows: 4. Capital in Excess of Par Value A summary of changes in capital in excess of par value follows: 5. Key Employee Long-Term Incentive Plan and Restricted Common Stock Award Plan On April 22, 1992, the common shareholders approved the 1992 Key Employee Long-Term Incentive Plan which authorizes the issuance of up to 3,000,000 shares of the Company's common stock to eligible participants. The Plan provides for incentive stock options, non-qualified stock options, restricted stock awards, performance shares and performance units. The Company's 1988 Restricted Common Stock Award Plan (1988 Plan) was simultaneously amended to provide that no further awards of common shares may be made thereunder. On May 1, 1993, the Company granted to certain key employees non-qualified stock options to purchase an aggregate of up to 940,000 shares of common stock. Subject to certain conditions, beginning on January 1, 1994, the stock options are exercisable for 25% of such common stock and for an additional 25% of such common stock beginning on January 1 of each of the next three years. The stock options, which expire on April 30, 2003, were granted at an exercise price of approximately $18 per share, representing the average of the fair market values of the Company's common stock on April 30, 1993 and May 3, 1993. During 1988 and 1991, 755,000 and 76,000 shares, respectively, were awarded under the 1988 Plan. Awarded shares will be subject to forfeiture, in whole or in part, if the recipient ceases to be an employee within a specified period of time. Compensation expense equal to the market value of awarded shares on the award date is recognized over the period from the award date to the date the forfeiture provisions lapse. The Company may reduce the number of shares otherwise required to be delivered by an amount which would have a market value equal to the taxes withheld by the Company on delivery. The Company may also, at its sole discretion, elect to pay to the recipients in cash an amount equal to the market value of the shares that would otherwise be required to be delivered. In conjunction with the Company's rightsizing and restructuring, the vesting dates were accelerated to 1993 for 120,000 shares and to 1994 for 28,000 shares. In 1993, under the 1988 Plan, in lieu of delivering 271,000 shares, the Company elected to pay in cash an amount equal to market value of such shares. On May 1, 1992, 62,256 shares were delivered from treasury (after reduction of 33,744 shares for taxes). On December 1, 1992, the Company paid cash in lieu of delivering 26,000 shares. In 1991, the Company paid cash in lieu of delivering 36,000 shares. Shares awarded under the 1988 Plan cease to be subject to forfeiture as follows: 52,000 in 1994, 182,000 in 1996, and 20,000 in each of 1997, 1998, and 1999. 6. Pension Plans The Company and its subsidiaries have trusteed, noncontributory pension plans covering substantially all of their employees. The benefits are based, in the case of certain plans, on average salary and years of service and, in the case of other plans, on a fixed amount for each year of service. Plan provisions and funding met the requirements of the Employee Retirement Income Security Act of 1974. Pension income of $4,205,000, $2,760,000, and $1,868,000 was recognized in 1993, 1992 and 1991, respectively. As discussed in Note 2, during 1993, the Company incurred rightsizing and restructuring costs, including provisions for the costs of termination benefits. In accordance with Statement of Financial Accounting Standards No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits", the Company recognized a charge of $7,978,000 related to early retirement termination benefits. The following table sets forth the status of the Company's plans at December 31, 1993 and 1992: Net pension income, excluding unusual charges, includes the following components (in thousands): The assumed rates of discount, increase in long-term compensation levels and expected long-term return on assets were 7.0%, 3.5% and 8.5%, respectively, in 1993 and 7.5%, 3.5% and 8.0%, respectively, in 1992 and 1991. 7. Other Postretirement Benefits The Company provides certain health care benefits to eligible retired employees. These benefits include a comprehensive medical plan for retirees prior to age 65 and supplemental premium payments to retirees over age 65 to help defray the costs of Medicare. As discussed in Note 1(h), the Company adopted SFAS No. 106, effective January 1, 1993. The plan is not funded; claims are paid as incurred. The following table sets forth the plan's status as of December 31, 1993: Net periodic postretirement benefit cost for 1993 included the following components: The Company assumes an increase in the annual rate of per capita cost of covered health benefits of 11.0% for 1994 decreasing by approximately 1% per year to 5.5% in 2000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation is 7.0%. An increase in the assumed health care cost trend rate of 1% for each year would increase the December 31, 1993 accumulated postretirement benefit obligation by approximately $1,820,000 and the net periodic postretirement benefit cost by approximately $215,000. 8. Income Taxes As discussed in Note 1(f), effective January 1, 1993, the Company adopted SFAS No. 109. Under SFAS No. 109, income taxes are recognized for (a) the amount of taxes payable or refundable for the current year, and (b) deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company's financial statements or tax returns. The effects of income taxes are measured based on effective tax law and rates. During 1993, federal tax legislation was enacted that significantly changed the Company's 1993 income tax provisions. The principal provision of the new law affecting the Company is an increase in the federal corporate income tax rate from 34% to 35%. Taxes currently payable and deferred tax liabilities increased by $226,000 and $3,361,000, respectively, as a result of the new law. As a result, income tax expense from continuing operations for the year was increased by $3,587,000, causing a reduction in net income by the same amount and a reduction in earnings per share of $.08. Set forth below are the domestic and foreign components of income before income taxes and accounting changes: The income tax provision consists of the following: The net deferred tax amounts reported on the Company's Consolidated Balance Sheet at December 31, 1993 are as follows: Following are components of the net deferred tax balance at December 31, 1993: The tax effects of temporary differences at December 31, 1993 are as follows: A reconciliation between the provision for income taxes, computed by applying the statutory federal income tax rate of 35% for 1993, and 34% for 1992 and 1991, to income before income taxes, and the actual provision for income taxes follows: 9. Commitments and Contingencies In order to meet environmental requirements, the Company has undertaken certain projects, the most significant of which relates to the modernization of the Spring Grove pulpmill. The related construction cost for all of these projects, based on presently available information, is estimated to be $34 million in 1994 and $7 million in 1995, including approximately $31 million in 1994 for the pulpmill modernization project. The pulpmill modernization project began in 1990 and is expected to be completed in 1994. The total cost of the project is expected to be $170 million (exclusive of capitalized interest) of which $20 million was expended through 1991, $48 million in 1992 and $71 million in 1993. On October 29, 1992, Philip Morris Companies, Inc. informed the Company that, effective January 1, 1993, it would cease to make purchases from the Company for its domestic tobacco operations. Sales to this customer in 1992 were 7.5% of total sales for the year. During 1993, the Company succeeded in redirecting the lost Philip Morris product volume to printing paper customers. These sales were not as profitable as sales to Philip Morris in 1992. In addition, due to increased competitive pressure and cost-cutting measures within the tobacco industry, sales to remaining tobacco paper customers in 1993 were less profitable than in 1992. As a result, the 1993 profit performance of the Company's Pisgah Forest mill was sharply below that of 1992. The Company continues its efforts to maximize utilization of its Pisgah Forest mill assets by attempting to direct sales volume to its most profitable grades and by controlling costs. Even with these efforts, the 1994 profit performance of the Pisgah Forest mill is not expected to improve over that of 1993. 10. Legal Proceedings The Company is involved in lawsuits and administrative proceedings under the environmental protection laws and various lawsuits pertaining to other matters. Although the ultimate outcome of these matters cannot be predicted with certainty, the Company's management, after consultation with legal counsel, does not expect that they will have a material adverse effect on the Company's financial position or results of operations. 11. Foreign Sales Net sales in dollars to foreign customers were 8.1%, 9.0% and 10.6% of total net sales in 1993, 1992, and 1991, respectively. 12. Borrowings The Company has available lines of credit from two different banks aggregating $70,000,000 at interest rates approximating money market rates. In March 1993, the Company issued $150,000,000 principal amount of its 5 7/8% Notes. These Notes will mature on March 1, 1998 and may not be redeemed prior to maturity. Interest on the Notes is payable semiannually on March 1 and September 1. The Notes are unsecured obligations of the Company. In March 1993, the Company entered into an interest rate swap agreement having a total notational principal amount of $50,000,000. Under the agreement, the Company receives a fixed rate of 5 7/8 % and pays a floating rate, as determined at six-month intervals. The floating rate is 4.0375% for the six-month period ending March 1, 1994. The agreement converts a portion of the Company's debt obligation from a fixed rate to a floating rate basis. During 1993, the Company recognized $2,448,000 of interest income and $1,677,000 of interest expense, resulting in a net credit of $771,000. This net amount is included in "Interest on debt" on the Company's Consolidated Statements of Income and Retained Earnings. The Company has pledged $2,500,000 of its marketable securities as security under the swap agreement. The Company has approximately $9,500,000 of letters of credit outstanding as of December 31, 1993. The Company bears the credit risk on this amount to the extent that the Company does not comply with the provisions of certain agreements. The letters of credit do not reduce the amount available under the Company's lines of credit. Independent Auditors' Report P. H. Glatfelter Company, Its Shareholders and Directors: We have audited the accompanying consolidated balance sheets of P. H. Glatfelter Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income 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 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 these financial statements and the 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 P. H. Glatfelter Company 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. 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 1(h) to the consolidated financial statements, the Company changed its method of accounting for income taxes, postretirement benefits other than pensions and postemployment benefits as of January 1, 1993. Deloitte & Touche Philadelphia, Pennsylvania February 11, 1994 QUARTERLY FINANCIAL DATA (a) Adjusted for two-for-one common stock split effected April 22, 1992. (b) After impact of an after tax charge for unusual items of $8,430,000 or $.19 per share. (c) After impact of the effect of an increased federal corporate income tax rate of $3,472,000 or $.08 per share. (d) After impact of an after tax charge for unusual items of $8,430,000 or $.19 per share and the effect of an increased federal corporate income tax rate of $3,587,000 or $.08 per share. 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. - ------- -------------------------------------------------- (a) Directors. The information with respect to directors required --------- under this item is incorporated herein by reference to pages 1 through 3 of the Registrant's Proxy Statement dated March 17, 1994. (b) Executive Officers of the Registrant. The information with ------------------------------------ respect to the executive officers required under this item is set forth in Part I of this Report. Item 11. Item 11. Executive Compensation. - ------- ---------------------- The information required under this item is incorporated herein by reference to pages 5 through 12 of the Registrant's Proxy Statement dated March 17, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------- -------------------------------------------------------------- The information required under this item is incorporated herein by reference to pages 13 through 15 of the Registrant's Proxy Statement dated March 17, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- The information required under this item is incorporated herein by reference to page 12 of the Registrant's Proxy Statement dated March 17, 1994. PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. - ------- ---------------------------------------------------------------- (a) 1. A. Financial Statements filed as part of this 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 Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements for the Years Ended December 31, 1993, 1992 and B. Supplementary Data for each of the three years in the period ended December 31, 1993. 2. Financial Statement Schedules (Consolidated): For Each of the Three Years in the Period Ended December 31, 1993: V - Plant, Equipment, and Timberlands VI - Reserves for Depreciation of Plant and Equipment IX - Short-term Borrowings Schedules other than those listed above are omitted because of the absence of conditions under which they are required or because the required information is included in the Notes to the Consolidated Financial Statements. Individual financial statements of the Registrant are not presented inasmuch as the Registrant is primarily an operating company and its consolidated subsidiaries are wholly-owned. 3. Executive Compensation Plans and Arrangements: see Exhibits 10(a) through 10(h), described below. Exhibits: Number Description of Documents - ------ ------------------------ (3)(a) Articles of Amendment dated April 27, 1977, including restated Articles of Incorporation, as amended by Articles of Merger dated January 30, 1979, by Articles of Amendment dated April 25, 1984 (incorporated by reference to Exhibit (3) of Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1984) and by Articles of Amendment dated April 23, 1986 (incorporated by reference to Exhibit (3) of Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1986; a Statement of Reduction of Authorized Shares dated May 12, 1980; a Statement of Reduction of Authorized Shares dated September 23, 1981; a Statement of Reduction of Authorized Shares dated August 2, 1982; a Statement of Reduction of Authorized Shares dated July 29, 1983; a Statement of Reduction of Authorized Shares dated October 15, 1984 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1984); a Statement of Reduction of Authorized Shares dated December 24, 1985 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1985); a Statement of Reduction of Authorized Shares dated July 11, 1986 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1986); a Statement of Reduction of Authorized Shares dated March 25, 1988 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1987); a Statement of Reduction of Authorized Shares dated November 9, 1988 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1988); a Statement of Reduction of Authorized Shares dated April 24, 1989 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1989); Articles of Amendment dated November 29, 1990 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1990); Articles of Amendment dated June 26, 1991 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1991); and Articles of Amendment dated August 7, 1992 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1992). (3)(b) Articles of Amendment dated July 30, 1993 and dated January 26, 1994. (3)(c) Articles of Incorporation, as amended through January 26, 1994 (restated for the purpose of filing on EDGAR). (3)(d) By-Laws as amended through March 16, 1994. (4)(a) Indenture between P. H. Glatfelter Company and Wachovia Bank of Georgia, N.A. as Trustee dated as of January 15, 1993. (4)(b) Form of Note issued to Purchasers of 5 7/8% Notes due March 1, 1998 (incorporated by reference to Exhibit 4(b) of Registrant's Form 10-K for the year ended December 31, 1992). (9) P. H. Glatfelter Family Shareholders' Voting Trust dated July 1, 1993 (incorporated by reference to Exhibit 1 of the Schedule 13D filed by P. H. Glatfelter Family Shareholders' Voting Trust dated July 1, 1993). (10)(a) P. H. Glatfelter Company Management Incentive Plans, effective January 1, 1982, as amended and restated effective January 1, 1994. (10)(b) P. H. Glatfelter Company Management Incentive Plans, Operating Rules, as revised through February 18, 1994. (10)(c) P. H. Glatfelter Company 1988 Restricted Common Stock Award Plan, as amended and restated June 24, 1992 (incorporated by reference to Exhibit (10)(c) of Registrant's Form 10-K for the year ended December 31, 1992). (10)(d) P. H. Glatfelter Company Supplemental Executive Retirement Plan, effective January 1, 1988, as amended and restated March 17, 1993 (incorporated by reference to Exhibit (10)(d) of Registrant's Form 10-K for the year ended December 31, 1992). (10)(e) Deferral Benefit Pension Plan of Ecusta Division, effective May 22, 1986 (incorporated by reference to Exhibit (10)(ee) of Registrant's Form 10-K for the year ended December 31, 1987). (10)(f) Description of Executive Salary Continuation Plan (incorporated by reference to Exhibit (10)(g) of Registrant's Form 10-K for the year ended December 31, 1990). (10)(g) P. H. Glatfelter Company Plan of Supplemental Retirement Benefits for the Management Committee, as amended and restated effective June 28, 1989 (incorporated by reference to Exhibit (10)(h) of Registrant's Form 10-K for the year ended December 31, 1989). (10)(h) P.H. Glatfelter Company 1992 Key Employee Long-Term Incentive Plan, effective April 22, 1992 (incorporated by reference to Exhibit (10)(i) of Registrant's Form 10-K for the year ended December 31, 1992). (11) Computation of Earnings Per Share (21) Subsidiaries of the Registrant (23) Consent of Independent Certified Public Auditors (b) The Registrant filed the following report on Form 8-K during the quarter ended December 31, 1993: N O N E 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. P. H. GLATFELTER COMPANY (Registrant) March 25, 1994 By /s/ T. C. Norris ------------------------ T. C. Norris Chairman of the Board 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: P. H. GLATFELTER COMPANY AND SUBSIDIARIES Supplementary Data and Financial Statement Schedules For Each of the Three Years in the Period Ended December 31, 1993 Prepared for Filing As Part of Annual Report (Form 10-K) to the Securities and Exchange Commission P. H. GLATFELTER COMPANY AND SUBSIDIARIES SUPPLEMENTARY DATA FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- A. PLANT, EQUIPMENT AND TIMBERLANDS Plant and equipment are depreciated for financial reporting purposes over the following estimated service lives: Additions to buildings and machinery and equipment in 1993 include $3.8 million relating to the precision sheeter and $1.0 million relating to the sludge water treatment project at the Spring Grove Mill; $6.5 million for the #5 paper machine rebuild at the Neenah Mill; and $4.7 million for the refining stock blend system and $2.0 million related to the #10 paper machine dryer rebuild at the Pisgah Forest Mill. Additions to construction in progress in 1993 include $71.1 million relating to the ongoing Pulp Mill Modernization project at the Spring Grove Mill. Retirements in 1993 include $1.5 million related to the disposal of the Pisgah Forest Mill's airplane and $0.4 million related to the #10 paper machine dryer at the Pisgah Forest Mill. Additions to buildings and machinery and equipment in 1992 include $4.2 million for the Mill Information Processing System, $3.3 million relating to upgrades of one of the largest paper machines, and $2.2 million relating to the woodwaste/sludge/bark project, all at the Spring Grove Mill. Additions to construction in progress in 1992 include $47.7 million relating to the ongoing Pulp Mill Modernization project at the Spring Grove Mill. Retirements in 1992 include $3.6 million for retirement of equipment being removed as part of the Pulp Mill Modernization project and $2.4 million for trade-in of an airplane. Additions to buildings and machinery and equipment in 1991 include $5.2 million relating to the sludge combustor at the Neenah Mill and $1.8 million for the rebuild of one of the largest paper machines at the Pisgah Forest Mill. Net additions to construction in progress in 1991 included approximately $17.4 million primarily relating to the new wood yard currently under construction at the Spring Grove Mill. B. ALLOWANCES FOR DOUBTFUL ACCOUNTS AND SALES DISCOUNTS The provision for doubtful accounts is included in administrative expense and the provision for sales discounts is deducted from sales. The related allowances are deducted from accounts receivable. C. SUPPLEMENTARY INCOME STATEMENT INFORMATION Maintenance and repairs charged to costs and expenses for each of the three years in the period ended December 31, 1993 were: 1993 - $48,156,000; 1992 - $49,111,000; and 1991 - $47,045,000. Depreciation and amortization of intangible assets, taxes (other than payroll and income taxes), royalties and advertising costs have not been shown since each does not exceed 1% of total net sales as reported in the consolidated statements of income and retained earnings. FINANCIAL STATEMENT SCHEDULE V P. H. GLATFELTER COMPANY AND SUBSIDIARIES (a) Depletion credited directly to asset account and charged to costs and expenses. (b) Net change during year. (c) See supplementary data (Note A) for description of significant additions and retirements. (d) Reclassification and other. (e) Adjustment for the implementation of FASB Statement No. 109 Accounting for Income Taxes. FINANCIAL STATEMENT SCHEDULE VI P. H. GLATFELTER COMPANY AND SUBSIDIARIES (a) Reclassification and other. (b) Accumulated depreciation with respect to retirements. See supplementary data (Note A). FINANCIAL STATEMENT SCHEDULE IX P. H. GLATFELTER COMPANY AND SUBSIDIARIES (a) Maximum amount outstanding at any month end during period. (b) Average computed by summing amount outstanding at month end during the year and dividing by 12. (c) Weighted average computed using balance outstanding at end of each month and interest rate in place at that time. (d) No short-term borrowings during the year ended December 31, 1991. Note - In March of 1993 the Company issued $150,000,000 principal amount of notes and used a portion of the proceeds to repay the outstanding balance of short-term borrowings of $41,100,000. N/A - Not applicable. Index to Exhibits ----------------- Number - ------ (3)(a) Articles of Amendment dated April 27, 1977, including restated Articles of Incorporation, as amended by Articles of Merger dated January 30, 1979, by Articles of Amendment dated April 25, 1984 (incorporated by reference to Exhibit (3) of Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1984) and by Articles of Amendment dated April 23, 1986 (incorporated by reference to Exhibit (3) of Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1986; a Statement of Reduction of Authorized Shares dated May 12, 1980; a Statement of Reduction of Authorized Shares dated September 23, 1981; a Statement of Reduction of Authorized Shares dated August 2, 1982; a Statement of Reduction of Authorized Shares dated July 29, 1983; a Statement of Reduction of Authorized Shares dated October 15, 1984 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1984); a Statement of Reduction of Authorized Shares dated December 24, 1985 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1985); a Statement of Reduction of Authorized Shares dated July 11, 1986 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1986); a Statement of Reduction of Authorized Shares dated March 25, 1988 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1987); a Statement of Reduction of Authorized Shares dated November 9, 1988 (incorporated by reference to Exhibit (3)(b) of Registrant's Form 10-K for the year ended December 31, 1988); a Statement of Reduction of Authorized Shares dated April 24, 1989 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1989); Articles of Amendment dated November 29, 1990 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1990); Articles of Amendment dated June 26, 1991 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1991); and Articles of Amendment dated August 7, 1992 (incorporated by reference to Exhibit 3(b) of Registrant's Form 10-K for the year ended December 31, 1992). (3)(b) Articles of Amendment dated July 30, 1993 and dated January 26, 1994. (3)(c) Articles of Incorporation, as amended through January 26, 1994 (restated for the purpose of filing on EDGAR). (3)(d) By-Laws as amended through March 16, 1994. (4)(a) Indenture between P. H. Glatfelter Company and Wachovia Bank of Georgia, N.A. as Trustee dated as of January 15, 1993. (4)(b) Form of Note issued to Purchasers of 5 7/8% Notes due March 1, 1998 (incorporated by reference to Exhibit 4(b) of Registrant's Form 10-K for the year ended December 31, 1992). (9) P. H. Glatfelter Family Shareholders' Voting Trust dated July 1, 1993 (incorporated by reference to Exhibit 1 of the Schedule 13D filed by P. H. Glatfelter Family Shareholders' Voting Trust dated July 1, 1993). (10)(a) P. H. Glatfelter Company Management Incentive Plans, effective January 1, 1982, as amended and restated effective January 1, 1994. (10)(b) P. H. Glatfelter Company Management Incentive Plans, Operating Rules, as revised through February 18, 1994. (10)(c) P. H. Glatfelter Company 1988 Restricted Common Stock Award Plan, as amended and restated June 24, 1992 (incorporated by reference to Exhibit (10)(c) of Registrant's Form 10-K for the year ended December 31, 1992). (10)(d) P. H. Glatfelter Company Supplemental Executive Retirement Plan, effective January 1, 1988, as amended and restated March 17, 1993 (incorporated by reference to Exhibit (10)(d) of Registrant's Form 10-K for the year ended December 31, 1992). (10)(e) Deferral Benefit Pension Plan of Ecusta Division, effective May 22, 1986 (incorporated by reference to Exhibit (10)(ee) of Registrant's Form 10-K for the year ended December 31, 1987). (10)(f) Description of Executive Salary Continuation Plan (incorporated by reference to Exhibit (10)(g) of Registrant's Form 10-K for the year ended December 31, 1990). (10)(g) P. H. Glatfelter Company Plan of Supplemental Retirement Benefits for the Management Committee, as amended and restated effective June 28, 1989 (incorporated by reference to Exhibit (10)(h) of Registrant's Form 10-K for the year ended December 31, 1989). (10)(h) P.H. Glatfelter Company 1992 Key Employee Long-Term Incentive Plan, effective April 22, 1992 (incorporated by reference to Exhibit (10)(i) of Registrant's Form 10-K for the year ended December 31, 1992). (11) Computation of Earnings Per Share (21) Subsidiaries of the Registrant (23) Consent of Independent Certified Public Auditors

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Item 1. Business The Registrant, incorporated in December 1925, serves business, professional and educational markets around the world with information products and services. Key markets include finance, business, education, law, construction, medical and health, computers and communications, aerospace and defense. As a multimedia publishing and information company, the Registrant employs a broad range of media, including books, magazines, newsletters, software, on-line data services, CD-ROMs, facsimile and television broadcasting. Most of the Registrant's products and services face substantial competition from a variety of sources. The Registrant's 15,661 employees are located worldwide. They perform the vital functions of analyzing the nature of changing demands for information and of channeling the resources necessary to fill those demands. By virtue of the numerous copyrights and licensing, trade, and other agreements, which are essential to such a business, the Registrant is able to collect, compile, and disseminate this information. Substantially all book manufacturing and magazine printing is handled through a number of independent contractors. The Registrant's principal raw material is paper, and the Registrant has assured sources of supply, at competitive prices, adequate for its business needs. Descriptions of the company's principal products, broad services and markets, and significant achievements are hereby incorporated by reference from Exhibit (13), pages 2 and 3 and pages 7 through 22 (textual material) of the Registrant's 1993 Annual Report to Shareholders. Information as to Industry Segments The relative contribution of the industry segments of the Registrant and its subsidiaries to operating revenue and operating profit and geographic information for the three years ended December 31, 1993 and the identifiable assets of each segment at the end of each year, are included in Exhibit (13), on page 38 and page 39 in the Registrant's 1993 Annual Report to Shareholders and is hereby incorporated by reference. Impact of Change In Segments In 1993, the Registrant realigned its segments to combine the Broadcasting and Information and Publication Services segments and Tower Group International into one segment, Information and Media Services. The Registrant's segments are: (1) Information and Media Services, which includes Broadcasting, all of the company's publications, construction information products and Tower Group International; (2) Educational and Professional Publishing, which includes College, professional and legal publishing and now also includes the Macmillan/McGraw-Hill School Publishing Company. The Registrant acquired the remaining 50% of the Macmillan/McGraw-Hill School Publishing Company from its partner in October 1993 and (3) Financial Services, which includes the Standard & Poor's Ratings Group and all of the Registrant's Financial Information Services. A summary of the company's revenue and operating profit (unaudited) for the realigned segments by quarter for the years 1993 and 1992 follows: Item 2. Item 2. Properties The Registrant leases office facilities at 394 locations, 322 are in the United States. In addition, the Registrant owns real property at 25 locations; 22 are in the United States. The principal facilities of the Registrant are as follows: The Registrant's major lease covers space in its headquarters building in New York City. The building is owned by Rock-McGraw, Inc., a corporation in which the Registrant and Rockefeller Group, Inc. are the sole shareholders. The Registrant occupies approximately 950,000 square feet of the rentable space under a 30-year lease which includes renewal options for two additional 15- year periods. In addition, the Registrant subleases for its own account approximately 693,000 square feet of space for periods up to 25 years. The largest complex owned by the Registrant is located in Highstown, NJ where a book distribution center and offices for accounting operations, data processing services, order fulfillment and other service departments are housed. The Registrant plans to consolidate its domestic book distribution operations by centralizing the distribution operations in Blue Ridge Summit, PA and Hightstown, NJ to Columbus and Blacklick, OH. Item 3. Item 3. Legal Proceedings While the Registrant and its subsidiaries are defendants in numerous legal proceedings in the United States and abroad, neither the Registrant nor its subsidiaries are a party to, nor are any of their properties subject to, any known material pending legal proceedings which Registrant believes will result in a material adverse effect on Registrant's financial statements or business operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of Registant's security holders during the last quarter of the period covered by this Report. Executive Officers of Registrant All of the above executive officers of the Registrant have been full-time employees of the Registrant for more than five years except for Thomas J. Kilkenny. Mr. Kilkenny, prior to his becoming an officer of the Registrant on December 1, 1993, was a director of the Registrant's Corporate Audit Department since October 1, 1991. Previously he was with Ernst & Young from 1980 through 1991. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters The approximate number of holders of the Company's common stock as of February 28, 1994 was 5,724. Information concerning other matters is incorporated herein by reference from Exhibit (13), from page 46 of the 1993 Annual Report to Shareholders. Item 6. Item 6. Selected Financial Data Incorporated herein by reference from Exhibit (13), from the 1993 Annual Report to Shareholders, page 30 and page 31. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Incorporated herein by reference from Exhibit (13), from the 1993 Annual Report to Shareholders, pages 24 to 29 and page 32. Item 8. Item 8. Consolidated Financial Statements and Supplementary Data Incorporated herein by reference from Exhibit (13), from the 1993 Annual Report to Shareholders, pages 33 to 44 and page 46. 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 is incorporated herein by reference from the Registrant's definitive proxy statement dated March 21, 1994 for the annual meeting of shareholders to be held on April 27, 1994. Item 11. Item 11. Executive Compensation Incorporated herein by reference from the Registrant's definitive proxy statement dated March 21, 1994 for the annual meeting of shareholders to be held on April 27, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated herein by reference from the Registrant's definitive proxy statement dated March 21, 1994 for the annual meeting of shareholders to be held April 27, 1994. Item 13. Item 13. Certain Relationships and Related Transactions Incorporated herein by reference from the Registrant's definitive proxy statement dated March 21, 1994 for the annual meeting of shareholders to be held April 27, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. Financial Statements. 2. Financial Statement Schedules. McGraw-Hill, Inc. And Financial Statement Schedules All other schedules have been omitted since the required information is not present or 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. The financial statements listed in the above index which are included in the Annual Report to Shareholders for the year ended December 31, 1993 are hereby incorporated by reference in Exhibit (13). With the exception of the pages listed in the above index, the 1993 Annual Report to Shareholders is not to be deemed filed as part of Item 14 (a)(1). (a) (3) Exhibits. A report on Form 8-K/A No. 1 was filed on October 27, 1993. Item 7 was reported in said report on Form 8-K/A. The unaudited interim balance sheet of the Macmillan/McGraw-Hill School Publishing Company as of September 30, 1993 and the related unaudited statements of income and cash flows for the nine month period ended September 30, 1993 were incorporated by reference in said report on Form 8-K/A. The pro forma statements of income reflecting the acquisition by the Registrant of the additional 50% of the Macmillan/McGraw-Hill School Publishing Company were filed in said report on Form 8-K/A. Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized. McGraw-Hill, Inc. - ----------------- Registrant By: /s/ ROBERT N. LANDES -------------------------------- Robert N. Landes Executive Vice President, Secretary and General Counsel March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 30, 1994 on behalf of Registrant by the following persons who signed in the capacities as set forth below under their respective names. Registrant's board of directors is comprised of fifteen members and the signatures set forth below of individual board members, constitute at least a majority of such board. /s/ JOSEPH L. DIONNE -------------------------------- Joseph L. Dionne Chairman and Chief Executive Officer Director /s/ HAROLD McGRAW III -------------------------------- Harold McGraw III President and Chief Operating Officer Director /s/ ROBERT J. BAHASH -------------------------------- Robert J. Bahash Executive Vice President and Chief Financial Officer /s/ THOMAS J. KILKENNY -------------------------------- Thomas J. Kilkenny Vice President and Controller /s/ VARTAN GREGORIAN -------------------------------- Vartan Gregorian Director /s/ JOHN T. HARTLEY -------------------------------- John T. Hartley Director /s/ GEORGE B. HARVEY -------------------------------- George B. Harvey Director /s/ RICHARD H. JENRETTE -------------------------------- Richard H. Jenrette Director /s/ DON JOHNSTON -------------------------------- Don Johnston Director /s/ PETER O. LAWSON-JOHNSTON -------------------------------- Peter O. Lawson-Johnston Director /s/ LINDA KOCH LORIMER -------------------------------- Linda Koch Lorimer Director /s/ DAVID L. LUKE III -------------------------------- David L. Luke III Director /s/ JOHN L. McGRAW -------------------------------- John L. McGraw Director /s/ LOIS D. RICE -------------------------------- Lois D. Rice Director /s/ PAUL J. RIZZO -------------------------------- Paul J. Rizzo Director /s/ JAMES H. ROSS -------------------------------- James H. Ross Director /s/ ALVA O. WAY -------------------------------- Alva O. Way Director Exhibit Index

728391_1993.txt

728391_1993

1993

728391

Item 1. BUSINESS ORGANIZATION IPALCO Enterprises, Inc. (IPALCO) is a holding company and was incorporated under the laws of the State of Indiana on September 14, 1983. IPALCO has two (2) subsidiaries: Indianapolis Power & Light Company (IPL), an electric utility, and Mid-America Capital Resources, Inc. (Mid-America), a holding company for unregulated businesses. DESCRIPTION OF BUSINESS OF SUBSIDIARIES INDIANAPOLIS POWER & LIGHT COMPANY GENERAL IPL is engaged primarily in generating, transmitting, distributing and selling electric energy in the City of Indianapolis and neighboring cities, towns, communities, and adjacent rural areas, all within the State of Indiana, the most distant point being about forty miles from Indianapolis. It also produces, distributes and sells steam within a limited area in such city. There have been no changes in the services rendered, or in the markets or methods of distribution, since the beginning of the fiscal year. IPL intends to do business of the same general character as that in which it is now engaged. No private or municipally-owned electric public utility companies are competing with IPL in the territory it serves. IPL operates under indeterminate permits subject to the jurisdiction of the Indiana Utility Regulatory Commission (IURC). Such permits are subject to revocation by the IURC for cause. The Public Service Commission Act of Indiana (the PSC Act), which provides for the issuance of such permits, also provides that if the PSC Act is repealed, indeterminate permits will cease and a utility will again come into possession of such franchises as were surrendered at the time of the issue of the permit, but in no event shall such reinstated franchise be terminated within less than five years from the date of repeal of the PSC Act. The electric utility business is affected by the various seasonal weather patterns throughout the year and, therefore, the operating revenues and associated operating expenses are not generated evenly by months during the year. IPL's electric system is directly interconnected with the electric systems of Indiana Michigan Power Company, PSI Energy, Inc., Southern Indiana Gas and Electric Company, Wabash Valley Power Association and Hoosier Energy Rural Electric Cooperative, Inc. Also, IPL and 28 other electric utilities, known as the East Central Area Reliability Group (the Group), are cooperating under an agreement which provides for coordinated planning of generating and transmission facilities and the operation of such facilities to provide maximum reliability of bulk power supply in the nine- state region served by the Group. In 1993, approximately 99.7% of the total kilowatthours sold by IPL were generated from coal, .2% from middle distillate fuel oil and .1% from secondary steam purchased from the Indianapolis Resource Recovery Project. In addition to use in oil-fired generating units, fuel oil is used for start up and flame stabilization in coal-fired generating units as well as for coal thawing and coal handling. IPL's long-term coal contracts provide for the supply of the major portion of its burn requirements through the year 1999, assuming environmental regulations can be met. The long-term coal agreements are with six suppliers and the coal is produced entirely in the State of Indiana (these six suppliers are located in the following counties: Clay, Daviess, Greene, Knox, Pike, Sullivan and Warrick, and are not affiliates of IPL). See Exhibits listed under Part IV Item 14(a)3(21). It is presently believed that all coal used by IPL will be mined by others. IPL normally carries a 70-day supply of coal and fuel oil to offset unforeseen occurrences such as labor disputes, equipment breakdowns, power sales to other utilities, etc. When strikes are anticipated in the coal industry, IPL increases its stockpile to an approximate 103-day supply. The combined cost of coal and fuel oil used in the generation of electric energy for 1993 averaged 1.151 cents per kilowatthour or $24.49 per equivalent ton of coal, compared with the 1992 average fuel cost for electric generation of 1.146 cents per kilowatthour or $24.55 per equivalent ton of coal. Fuel costs are expected to experience only moderate changes in the near future due to increased supplier productivity, the stabilizing of coal prices and a low dependency on oil. However, an acceleration of inflation and/or changes in laws, regulations or ordinances which impact the mining industry or place more restrictive environmental controls on utilities could have a detrimental effect on such prices. IPL has a long-term contract to purchase steam for use in its steam distribution system with Ogden Martin Systems of Indianapolis, Inc. (Ogden Martin). Ogden Martin owns and operates the Indianapolis Resource Recovery Project which is a waste-to- energy facility located in Marion County, Indiana. During 1993, IPL's steam system purchased 49.4% of its total therm requirement from Ogden Martin. Additionally, 33.3% of its 1993 one-hour peak load was met with steam purchased from Ogden Martin. IPL also purchased 3.2 million secondary therms which represent Ogden Martin send-out in excess of the IPL steam system requirements. Such secondary steam is used to produce electricity at the IPL Perry K and Perry W facilities. CONSTRUCTION The cost of IPL's construction program during 1993, 1992 and 1991 was $149.3 million, $115.3 million and $96.3 million, respectively, including Allowances for Funds Used During Construction (AFUDC) of $3.6 million, $3.2 million and $1.6 million, respectively. IPL's construction program is reviewed periodically and is updated to reflect among other things the changes in economic conditions, revised load forecasts and cost escalations under construction contracts. The most recent projections indicate that IPL will need about 800 megawatts (MW) of additional energy resources by the year 2000. IPL plans to meet this need through the combination of the use of Demand Side Management, power purchases, peaking turbines and base-load generation. During 1992, IPL entered into a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP), which will supply additional capacity for the near-term requirements. IPL receives 200 MW of capacity. IPL can also elect to extend the agreement through November 1999. See Item 7, "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" under "Capital Requirements" for additional information regarding the IMP agreement. IPL's construction program for the five-year period 1994- 1998, is estimated to cost $1.0 billion including AFUDC. The estimated cost of the program by year (in millions) is $234.4 in 1994; $191.9 in 1995; $116.6 in 1996; $221.4 in 1997; and $251.8 in 1998. It includes $113.7 million for four 80 MW combustion turbines with in-service dates of 1994, 1995, 1998 and 1999, respectively, and $217.2 million for base-load capacity with in- service dates of 2000 and 2002, or beyond. The forecast also includes $284.4 million for additions, improvements and extensions to transmission and distribution lines, substations, power factor and voltage regulating equipment, distribution transformers and street lighting distribution. With respect to the expenditures for pollution control facilities to comply with the Clean Air Act and with respect to the regulatory authority of the IURC as it relates to the integrated resource plan, see "REGULATORY MATTERS" and Item 7, "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS". FINANCING IPL's 1994-1998 long-term financing program anticipates sales of debt and equity securities totaling $447.7 million. The timing and amounts of such activities are contingent upon the timing and cost of any new capacity, as well as market conditions and other factors near the dates of the required financings. In addition to the sale of new securities, IPL has authority from the IURC to redeem and replace certain of its existing securities should favorable market conditions arise. Such action, if considered, may result in additional financing in the form of long-term debt. (With respect to restrictions on the issuance of certain securities, see Item 7, "LIQUIDITY AND CAPITAL RESOURCES".) EMPLOYEE RELATIONS As of December 31, 1993, IPL had 2,276 employees of whom 1,155 were represented by the International Brotherhood of Electrical Workers, AFL-CIO (IBEW) and 411 were represented by the Electric Utility Workers Union (EUWU), an unaffiliated labor organization. In December 1993, the membership of the IBEW ratified a new labor agreement which remains in effect until December 16, 1996. The agreement provides for general pay adjustments of 4% in 1993, 3.5% in both 1994 and 1995, and changes in pension and health care coverage. In March, 1992, the membership of the EUWU ratified a new labor agreement which remains in effect until February 27, 1995. The agreement provides for general pay adjustments of 4.5% in both 1992 and 1993, and 3% in 1994, as well as changes in health care coverage. REGULATORY MATTERS IPL is subject to regulation by the IURC as to its services and facilities, valuation of property, the construction, purchase or lease of electric generating facilities, classification of accounts, rates of depreciation, rates and charges, issuance of securities (other than evidences of indebtedness payable less than twelve months after the date of issue), the acquisition and sale of public utility properties or securities, and certain other matters. In addition, IPL is subject to the jurisdiction of the Federal Energy Regulatory Commission, in respect of short-term borrowings not regulated by the IURC, the transmission of electric energy in interstate commerce, the classification of its accounts and the acquisition and sale of utility property in certain circumstances as provided by the Federal Power Act. IPL is also subject to federal, state, and local environmental laws and regulations, particularly as to generating station discharges affecting air and water quality. The impact of such regulations on the capital and operating costs of IPL has been and will continue to be substantial. IPL's 1994-1998 construction program includes $335 million in environmental costs, including AFUDC, of which approximately $207 million pertains to the Clean Air Act. Accordingly, IPL has developed a plan to reduce sulfur dioxide and nitrogen oxide emissions from several generating units. This plan has been approved by the IURC. Annual costs for all air, solid waste, and water environmental compliance measures are $106 million and $112 million in 1994 and 1995, respectively. MID-AMERICA CAPITAL RESOURCES, INC. (Mid-America) GENERAL Mid-America, the holding company for the unregulated activities of IPALCO, has as subsidiaries Indianapolis Campus Energy, Inc. (ICE), Store Heat And Produce Energy, Inc. (SHAPE) and Mid-America Energy Resources, Inc. (Energy Resources). Mid- America also holds an investment in the Evergreen Media Corporation (Evergreen) and manages other financial investments. Energy Resources has as subsidiaries Cleveland Thermal Energy Corporation (Cleveland Thermal) and Cleveland District Cooling Corporation (Cleveland Cooling). Energy Resources was formed on November 17, 1989, to construct and operate a multi-phased district cooling system in near downtown Indianapolis. The completion of phase I construction and the commencement of operations occurred in mid- 1991. Phase II construction commenced in June 1992, and was completed in November 1992. In 1991, Energy Resources acquired Cleveland Thermal, which owns and operates the district steam heating system in Cleveland, Ohio. During 1992, Energy Resources formed Cleveland Cooling for the purpose of constructing and operating a district cooling system in downtown Cleveland. Operations commenced April 15, 1993. Both Cleveland Thermal and Cleveland Cooling jointly conduct business under the name Cleveland Energy Resources. At December 31, 1993, Mid-America held 70 percent of the common stock of SHAPE. SHAPE conducts research and development of energy storage technology. ICE was formed to construct, own, and operate energy systems in campus settings such as industrial complexes or college campuses. On August 3, 1993, ICE entered into a contractual agreement with Eli Lilly and Company (Lilly) to provide cooling capacity to the Lilly Technical Center. Construction of the chilled water facility, located near Morris Street and Kentucky Avenue in Indianapolis, will begin in mid-1994 with operations scheduled to begin in March 1996. Mid-America holds a $7.5 million investment in Evergreen, representing approximately 5 percent equity ownership at December 31, 1993. Evergreen owns and operates eleven radio stations in major markets across the United States. During the next five years, 1994-1998, IPALCO may continue to become involved in unregulated businesses through the formation of one or more additional Mid-America subsidiaries. The cash assets of Mid-America are invested in a variety of short-term financial investments and marketable securities, pending investment in any such business. The sources of capital to finance these subsidiaries will be determined at the time they are established. Opportunities for future diversification investments into other businesses are continually being reviewed. CONSTRUCTION AND FINANCING During 1993, 1992 and 1991, the construction expenditures of Mid-America and its subsidiaries totaled $8.8 million, $29.8 million and $14.0 million respectively. These costs were financed with internal funds and a $9.5 million debt issue in 1991. Construction requirements during the next five years are estimated to be $18.8 million, $.4 million, $17.9 million, $9.3 million and $29.4 million for ICE, SHAPE, Energy Resources, Cleveland Thermal and Cleveland Cooling, respectively. Such expenditures are highly contingent upon the development of markets for the products and services offered by the Mid-America family of companies. The cash requirements of ICE, SHAPE, Energy Resources, Cleveland Thermal and Cleveland Cooling are expected to be funded by Mid-America from existing liquid assets, future cash flows from operations and $46.3 million of project specific debt financing. EMPLOYEES As of December 31, 1993, Mid-America had 8 employees, Energy Resources had 18 employees, Cleveland Thermal had 91 employees and SHAPE had 4 employees. There were no labor organizations. Item 2. Item 2. PROPERTIES IPL IPL owns and operates five primarily coal-fired generating plants, three of which are used for total electric generation and two of which are used for a combination of electric and steam generation. In relation to electric generation, there exists a total gross nameplate rating of 2,885 MW, a winter capability of 2,862 MW and a summer capability of 2,829 MW. All figures are net of station use. In relation to steam generation, there exists a gross capacity of 2,290 Mlbs. per hour. Total Electric Stations: H. T. Pritchard plant (Pritchard), 25 miles southwest of Indianapolis (six units in service - one in 1949, 1950, 1951, two in 1953 and one in 1956) with 367 MW nameplate rating and net winter and summer capabilities of 344 MW and 341 MW, respectively. E. W. Stout plant (Stout) located in southwest part of Marion County (five units in service - one each in 1941, 1947, 1958, 1961 and 1973) with 771 MW nameplate rating and net winter and summer capabilities of 798 MW and 767 MW, respectively. Petersburg plant (Petersburg), located in Pike County, Indiana (four units in service - one each in 1967, 1969, 1977 and 1986) with 1,716 MW nameplate rating and net winter and summer capabilities of 1,690 MW and 1,690 MW, respectively. Combination Electric and Steam Stations: C.C. Perry Section K plant (Perry K), in the city of Indianapolis with 20 MW nameplate rating (net winter capability 20 MW, summer 19 MW) for electric and a gross capacity of 1,990 Mlbs. per hour for steam. C.C. Perry Section W plant (Perry W), in the city of Indianapolis with 11 MW nameplate rating (net winter capability 10 MW, summer 12 MW) for electric and a gross capacity of 300 Mlbs. per hour for steam. Net electrical generation during 1993, at the Petersburg, Stout and Pritchard stations accounted for about 74.9%, 19.6% and 5.5%, respectively, of IPL's total net generation. All steam generation by IPL for the steam system was produced by the Perry K and Perry W stations. Included in the above totals are three gas turbine units at the Stout station added in 1973 with a combined nameplate rating of 64 MW, one diesel unit each at Pritchard and Stout stations, and three diesel units at Petersburg station, all added in 1967. Each diesel unit has a nameplate rating of 3 MW. IPL's transmission system includes 454 circuit miles of 345,000 volt lines, 353 circuit miles of 138,000 volt lines and 275 miles of 34,500 volt lines. Distribution facilities include 4,686 pole miles and 19,785 wire miles of overhead lines. Underground distribution and service facilities include 436 miles of conduit and 4,900 wire miles of conductor. Underground street lighting facilities include 110 miles of conduit and 668 wire miles of conductor. Also included in the system are 74 bulk power substations and 85 distribution substations. Steam distribution properties include 22 miles of mains with 286 services. Other properties include coal and other minerals, underlying 798 acres in Sullivan County and coal underlying about 6,215 acres in Pike and Gibson Counties, Indiana. Additional land, approximately 4,722 acres in Morgan County, and approximately 884 acres in Switzerland County has been purchased for future plant sites. OTHER SUBSIDIARIES Energy Resources owns and operates a district cooling facility in near downtown Indianapolis, which is designed to distribute chilled water to subscribers located downtown for their air conditioning needs. The plant is equipped with four 5,000 ton chillers powered by steam purchased from IPL. Cleveland Thermal owns and operates two steam plants in Cleveland, Ohio, with a total of nine boilers having a gross capacity of 1,050 Mlbs. per hour. The distribution system includes 20 miles of mains with 230 services. Cleveland Cooling owns and operates a district cooling facility in near downtown Cleveland, which is designed to distribute chilled water to subscribers located downtown for their air conditioning needs. The plant is equipped with two 5,000 ton chillers. Item 3. Item 3. LEGAL PROCEEDINGS On March 16, 1993, Smith Cogeneration of Indiana, Inc., and its affiliates (Smith) filed a petition with the Indiana Utility Regulatory Commission (IURC) requesting that IPL be ordered to enter into a power sales agreement to purchase power from Smith's proposed 240 megawatt plant. On September 24, 1993, IPL filed a motion for summary adjudication of Smith's petition. This motion is currently pending, has been fully briefed and no further proceedings have been scheduled in this matter. In June 1993, IPL received a Notice of Violation from the Indianapolis Air Pollution Control Section (IAPCS) regarding fugitive dust emissions at its Perry K Generating Station. IPL met with IAPCS to discuss four alleged violations over a span of 15 months. Each violation was subject to a fine of up to $2,500. IPL agreed to a settlement in the amount of $3,500 for all violations, but settlement has not yet been finalized. On August 18, 1993, the IURC entered an order in Cause No. 39437, approving IPL's Environmental Compliance Plan to comply with the Clean Air Act Amendments of 1990. The estimated cost of IPL's Environmental Compliance Plan is approximately $250 million before including allowance for funds used during construction. A primary part of IPL's Plan, scrubbing IPL's Petersburg 1 and 2 coal-fired units by 1996 to enable IPL to continue to burn high sulfur coal, was opposed by the Office of Utility Consumer Counselor (OUCC), the Citizens Action Coalition, and the Industrial Intervenors Group (IIG). OUCC and IIG are in the process of appealing the Commission's order to the Indiana Court of Appeals. In October 1993, IPL received a Findings of Violation from EPA, Region V, regarding IPL's compliance with the thermal limitations of the NPDES (water discharge) permit under which IPL operates its Petersburg Generating Station. On February 20, 1992, IPL filed an application for renewal of that permit but the application has not been acted upon by the Indiana Department of Environmental Management. Although unclear to IPL, EPA's action seems to have resulted from its misinterpretation of data IPL supplied to EPA in response to the latter's Clean Water Act information request that preceded issuance of the Findings of Violation. IPL believes it continues to be in compliance with the requirements of the permit and has made continuing efforts to meet with EPA to discuss the matter. If IPL is found to be in violation of its permit, it could be subject to maximum fines of $25,000 per day per violation. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT AT FEBRUARY 22, 1994. Name, age (at December 31, 1993), and positions and offices held for the past five years: From To John R. Hodowal (48) Chairman of the Board and President of IPALCO May, 1989 Vice President and Treasurer of IPALCO September, 1983 May, 1989 Chairman of the Board of IPL February, 1990 Chief Executive Officer of IPL May, 1989 Executive Vice President of IPL April, 1987 May, 1989 Ramon L. Humke (61) Vice Chairman of IPALCO May, 1991 President and Chief Operating Officer of IPL February, 1990 President and Chief Executive Officer of Ameritech Services and Senior Vice President of Ameritech Bell Group September, 1989 February, 1990 President and Chief Executive Officer of Indiana Bell Telephone Company October, 1983 September, 1989 John R. Brehm (40) Vice President and Treasurer of IPALCO May, 1989 Assistant Secretary and Assistant Treasurer of IPALCO December, 1983 May, 1989 Senior Vice President - Finance and Information Services of IPL May, 1991 Senior Vice President - Financial Services of IPL May, 1989 May, 1991 Treasurer of IPL August, 1987 May, 1989 Maurice O. Edmonds (62) Vice President - Corporate Affairs of IPALCO December, 1992 Vice President - Human Resources of IPL May, 1989 December, 1992 Vice President - General Services of IPL July, 1988 May, 1989 From To N. Stuart Grauel (49) Vice President - Public Affairs of IPALCO May, 1991 Vice President - Public Affairs of IPL May, 1989 May, 1991 Public Affairs Manager of IPL October, 1981 May, 1989 Joseph A. Gustin (46) Vice President of SHAPE May, 1993 President of ICE April, 1993 President of Energy Resources May, 1991 Vice President of Mid-America May, 1991 Vice President of Energy Resources January, 1990 May, 1991 Vice President - Steam Operations of IPL May, 1989 May, 1991 Manager - Power Production of IPL June, 1981 May, 1989 Robert W. Rawlings (52) Senior Vice President - Electric Production of IPL May, 1991 Vice President - Electric Production of IPL May, 1989 May, 1991 Vice President - Engineering and Construction of IPL April, 1986 May, 1989 Gerald D. Waltz (54) Senior Vice President - Business Development of IPL May, 1991 Senior Vice President - Engineering and Operations of IPL April, 1986 May, 1991 Max Califar (40) Vice President - Human Resources of IPL December, 1992 Assistant Treasurer of IPALCO May, 1989 December, 1992 Treasurer of IPL May, 1989 December, 1992 Assistant Controller of IPL July, 1987 May, 1989 Stephen J. Plunkett (45) Controller of IPALCO and IPL May, 1991 Assistant Controller of IPL May, 1989 May, 1991 PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS At December 31, 1993, Enterprises had 24,299 holders of common stock (not including approximately 1,900 shareholders who hold shares only through Enterprises' Automatic Dividend Reinvestment and Stock Purchase Plan). Enterprises' common stock is principally traded on the New York Stock Exchange and the Chicago Stock Exchange. The high and low sales prices for Enterprises' common stock during 1993 and 1992 as reported on the Composite Tape in The Wall Street Journal, were as follows: 1993 1992 High Low High Low Sale Price Sale Price Sale Price Sale Price ----------------------- ---------------------- First Quarter $40 $34 3/8 $33 5/8 $31 1/2 Second Quarter 39 1/4 35 1/2 36 1/8 32 1/4 Third Quarter 38 3/4 35 3/4 36 7/8 34 1/8 Fourth Quarter 38 33 1/8 36 33 3/8 The high and low sales prices for Enterprises' common stock as reported on the Composite Tape in The Wall Street Journal for the period January 1, 1994, through February 22, 1994, were: High - $35 3/8, Low - $31 3/4. Quarterly dividends paid on the common stock during 1993 and 1992 were as follows: 1993 1992 First Quarter $ .49 $ .47 Second Quarter .51 .49 Third Quarter .51 .49 Fourth Quarter .51 .49 The Enterprises' Board of Directors at its meeting on February 22, 1994, declared a regular quarterly dividend on common stock of $.53 per share, payable April 15, 1994, to shareholders of record on March 25, 1994. Dividend Restrictions The following restrictions pertain to IPL but to the extent that the earnings of Enterprises depend upon IPL dividends it may have an effect on Enterprises. So long as any of the several series of bonds of IPL issued under the Mortgage and Deed of Trust, dated as of May 1, 1940, as supplemented and modified, executed by IPL to American National Bank and Trust Company of Chicago, as Trustee, remain outstanding, IPL is restricted in the declaration and payment of dividends, or other distribution on shares of its capital stock of any class, or in the purchase or redemption of such shares, to the aggregate of its net income, as defined in Section 47 of such Mortgage, after December 31, 1939, available for dividends. The amount which these Mortgage provisions would have permitted IPL to declare and pay as dividends at December 31, 1993, exceeded retained earnings at that date. Such restrictions do not apply to the declaration or payment of dividends upon any shares of capital stock of any class to an amount in the aggregate not in excess of $1,107,155, or to the application to purchase or redemption of any shares of capital stock of any class of amounts not to exceed in the aggregate the net proceeds received by IPL from the sale of any shares of its capital stock of any class subsequent to December 31, 1939. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS IPALCO Enterprises, Inc. (IPALCO) is a holding company incorporated under the laws of the State of Indiana. Indianapolis Power & Light Company (IPL) and Mid-America Capital Resources, Inc. (Mid-America) are subsidiaries of IPALCO. Mid-America was formed as a holding company for the unregulated activities of IPALCO. LIQUIDITY AND CAPITAL RESOURCES IPL On a national basis, competition for wholesale and retail sales within the electric utility industry has been increasing. In Indiana, competition has been primarily focused on the wholesale power markets. Existing Indiana law provides for public utilities to have an exclusive permit at the retail level. The impact of continuing competitive pressures on IPL's wholesale and retail electric and steam markets cannot be determined at this time. Rate Matters Environmental Compliance Plan IPL is subject to the new air quality provisions specified in the federal Clean Air Act Amendments of 1990 and related regulations (the Act). During 1993, IPL obtained an order from the Indiana Utility Regulatory Commission (IURC) approving its environmental compliance plan, together with the costs and expenses associated therewith, which provides for the installation of sulfur dioxide and nitrogen oxide emissions abatement equipment and the installation of continuous emission monitoring systems to meet the requirements of both Phase I and Phase II of the Act - See "Capital Requirements". Certain intervenors in the hearing before the IURC have requested a transcript preparatory to an appeal of that order which appeal has not yet been perfected As required by the Act, IPL filed its proposed compliance plan with the Environmental Protection Agency in February 1993. As provided in the Act, effective January 1, 1995, IPL is scheduled to receive annual emission "allowances" for certain of its generating units. Each allowance would permit the emission of one ton of sulfur dioxide. IPL presently expects that annual sulfur dioxide emissions will not exceed annual allowances provided to IPL under the Act. Allowances not required in the operation of IPL facilities may be reserved for future periods or sold. The value of such unused allowances that may be available to IPL for use in future periods or for sale is subject to a developing market and is unknown at this time. The IURC Order provides for the deferral of net gains and losses resulting from any sale of emission allowances for future amortization to cost of service on a basis to be determined in the next general retail electric rate proceeding. Demand Side Management Program On September 8, 1993, IPL obtained an order from the IURC approving a Stipulation of Settlement Agreement between IPL, the Office of Utility Consumer Counsel, Citizens Action Coalition of Indiana, Inc., an industrial group, the Trustees of Indiana University and the Indiana Alliance for Fair Competition relating to IPL's Demand Side Management Program (DSM). The order provides for the deferral and subsequent recovery in rates of certain approved DSM costs. The order also provides for the recording of a return on deferred costs until recognized in rates. Postretirement Benefits On December 30, 1992, the IURC issued an order authorizing Indiana utilities to account for postretirement benefits on the basis required by the Statement of Financial Accounting Standard No. 106 -- Accounting for Postretirement Benefits other than Pensions (SFAS 106). Generally, SFAS 106 requires the use of an accrual basis accounting method for determining annual costs of postretirement benefits. Prior to 1993, IPL used a pay-as-you-go method to account for such costs. IPL was required to adopt SFAS 106 effective January 1, 1993. Additionally, the order authorized the deferral of SFAS 106 costs in excess of such costs determined on a pay-as-you-go and the recording of a resulting regulatory asset. The order further provides for the recovery in rates of such costs in a subsequent general rate proceeding on an individual company basis in an amount to be determined in each such proceeding. IPL is deferring as a regulatory asset the non-construction related SFAS 106 costs associated with its electric business. IPL is expensing its non- construction related SFAS 106 costs associated with its steam business. Regulatory Asset Deferrals Balance sheet deferrals of regulatory assets for DSM, postretirement benefits, income taxes and other such costs amounted to $33.1 million in 1993. Future deferrals for such items are expected to increase due to SFAS 106, and DSM costs and related carrying charges until IPL's next retail electric rate order. Future Rate Relief IPL presently anticipates that it will petition the IURC to increase its electric rates and charges during 1994. A final IURC order on such a request may not occur until 1995. IPL's last authorized increase in electric rates and charges occurred in August, 1986. Steam Rate Order The IURC authorized IPL to increase its steam system rates and charges over a six-year period beginning January 13, 1993. Accordingly, IPL implemented new steam tariffs effective on that date which were designed to produce estimated additional annual steam operating revenues as follows: Capital Requirements The capital requirements of IPL are primarily driven by the need for facilities to ensure customer service reliability and environmental compliance and by the impact of maturing long-term debt. Forecasted Demand & Energy From 1994 to 1998, annual peak demand is forecasted to experience a compound 1.5% increase, while retail kilowatthour (KWH) sales are anticipated to increase at a 2.0% compound growth rate. Both compound growth rates are computed assuming normal weather conditions and include the effects of DSM. IPL expects a reduction of about 120 megawatts (MW) of annual peak demand by the year 2000 as a result of DSM programs. Integrated Resource Plan Sales growth projections indicate a need for about 800 MW of additional capacity resources by the year 2000. These resource requirements can be met in a variety of ways including, but not limited to, a combination of the use of DSM, power purchases, peaking turbines and base-load generation. IPL continues to review its integrated resource plan to consider the appropriateness of all resource options to meet capacity requirements over the decade of the 1990's and beyond. IPL has a well-defined, near-term integrated resource plan and is considering all reasonable options to meet its long-term capacity requirements. The following discussion makes certain assumptions regarding IPL's plans to meet these requirements. In order to maintain adequate summer capacity reserve margins in the near-term, IPL entered into a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP), which expires March 31, 1997. Under this agreement, IPL is receiving 200 MW of capacity. The agreement provides for monthly capacity payments by IPL of $1.2 million through March 31, 1997. IPL can terminate the agreement, should the ability to recover future demand charges through rates be disallowed. IPL and IMP will also exchange 50 MW of seasonal power over the 1995-1998 period. IPL plans to add two 80 MW combustion turbines with in-service dates in 1994 and 1995. Under Indiana law, IPL must obtain from the IURC a certificate of "public convenience and necessity" (Certificate) prior to purchasing or commencing construction of any new electric generation facility. IPL received Certificates from the IURC for construction of these combustion turbines during 1992. IPL is considering a variety of options to meet its long-term capacity requirements through the year 2000 including DSM, utility and nonutility power purchases, additional peaking turbines and base- load generating units. Presently, IPL plans to add two additional 80 MW combustion turbines with in-service dates in 1998 and 1999. IPL also has options to extend the 200 MW firm power purchase agreement with IMP through December 31, 1997 and subsequently through November 30, 1999, with capacity payments of $1.2 million per month and $1.55 million per month, respectively. Under a recent agreement, IPL has an option to purchase up to 250 MW from PSI Energy over the 1996 to 2000 period. IPL is also evaluating the installation, on a joint ownership basis, of two 426 MW base-load generating units to be placed in service in 2000 and 2002, respectively, or beyond. Of the total 852 MW, IPL proposes to own 400 MW, with other partners owning the remaining 452 MW. There is no assurance that IPL will be able to ultimately reach a joint ownership agreement with any other party. IPL has not applied for Certificates for the additional combustion turbines or the base load unit. Environmental Compliance Construction Requests IPL estimates that the capital cost of complying with the Act through 1997 will be approximately $240 million, including Allowance for Funds Used During Construction (AFUDC), of which $33.0 million has been expended prior to 1994. IPL further estimates that, subsequent to December 31, 1997, no significant capital expenditures will be required to bring generating units into compliance with the Act until the year 2010 or beyond. Cost of Construction Program The cost of IPL's construction program during 1993, 1992 and 1991 was $149.3 million, $115.3 million and $96.3 million, including AFUDC of $3.6 million, $3.2 million and $1.6 million respectively. IPL estimates the cost of the construction program for the five years, 1994-1998, to be approximately $1.0 billion including AFUDC of $73.1 million. This program is subject to continuing review and is revised from time to time in light of changes in the actual customer demand for electric energy, IPL's financial condition and construction cost escalations. In addition to costs of environmental compliance, the five-year construction program includes $113.7 million for the four 80 MW combustion turbines and $217.2 million for the base-load capacity, mentioned above. Additional expenditures will be incurred beyond 1998 for the capacity with in- service dates subsequent to 1998. Transmission and substation facilities relating to the planned base-load capacity amount to $29.0 million in the five-year construction program. Expenditures for the new capacity are contingent upon the review of other long-term and near-term options previously discussed and subsequent receipt of the necessary Certificates. Retirement of Long-term Debt and Equity Securities During 1993, 1992 and 1991, IPL retired long-term debt, including sinking fund payments, of $96.9 million, $75.0 million and $96.4 million, respectively, which required replacement with other debt securities at a lower cost. IPL will retire $7.5 million, $15.0 million, $11.25 million and $18.75 million of maturing long-term debt during 1994, 1996, 1997 and 1998, respectively, which may require replacement in whole or in part with other debt or equity securities. In addition, other existing higher rate debt may be refinanced depending upon market conditions. Financing Financing Requirements During the three-year period ended December 31, 1993, IPL's permanent financing totaled $275.3 million in long-term debt. The net proceeds of these securities were used, along with internal funds, to retire existing long-term debt. All of IPL's construction expenditures during this three-year period were funded with internally generated cash and short-term debt. IPL's permanent financing requirements for the five-year period, 1994-1998, are forecasted to include additional sales of debt and equity securities totaling $447.7 million. This amount is highly contingent on the timing and cost of any new capacity. The timing, number and dollar amounts of such financings will depend on market conditions and other factors, including required regulatory approvals. In addition to the sale of new securities, IPL has authority from the IURC to redeem and replace certain of its existing securities, should favorable market conditions dictate. Internally generated funds supplemented by temporary short-term borrowings are forecasted to provide the remaining funds required for the five-year construction program. Uncertainties which could affect this forecast include the impact of inflation on operating expenses, the actual degree of growth in KWH sales, the level of interchange sales with other utilities and the receipt of Certificates required for new electric generation facilities. Mortgage Restrictions IPL is limited in its ability to issue certain securities by restrictions under its Mortgage and Deed of Trust (Mortgage) and its Amended Articles of Incorporation (Articles). The restriction under the Articles requires that the net income of IPL, as specified therein, shall be at least one and one-half times the total interest on the funded debt and the pro forma dividend requirements on the outstanding preferred stock and on any preferred stock proposed to be issued, before any additional preferred stock can be issued. The Mortgage restriction requires that net earnings as calculated thereunder be two and one-half times the annual interest requirements before additional bonds can be authenticated on the basis of property additions. Based on IPL's net earnings for the twelve months ended December 31, 1993, the ratios under the Articles and the Mortgage are 3.28 and 7.33, respectively. IPL believes these requirements will not restrict any anticipated future financings. MID-AMERICA Mid-America, the holding company for the unregulated activities of IPALCO, has as subsidiaries Indianapolis Campus Energy, Inc. (ICE), Store Heat And Produce Energy, Inc. (SHAPE) which is 70% owned and Mid-America Energy Resources, Inc. (Energy Resources). Energy Resources has as subsidiaries Cleveland Thermal Energy Corporation (Cleveland Thermal) and Cleveland District Cooling Corporation (Cleveland Cooling). Energy Resources has operated a district cooling system in downtown Indianapolis, Indiana since 1991 and Cleveland Cooling began operations of its district cooling system in downtown Cleveland, Ohio during 1993. During 1993, ICE entered into an agreement to provide chilled water to the Lilly Technical Center in near downtown Indianapolis. Operations of this campus facility are expected to begin in 1996. SHAPE became a majority owned subsidiary of Mid-America during 1993. Construction Program During 1993, 1992 and 1991, the construction expenditures of Mid- America and its subsidiaries totaled $8.8 million, $29.8 million and $14.0 million, respectively. These costs were financed with internal funds and a $9.5 million debt issue in 1991. Construction requirements during the next five years are estimated to be $18.8 million, $.4 million, $17.9 million, $9.3 million and $29.4 million, for ICE, SHAPE, Energy Resources, Cleveland Thermal and Cleveland Cooling, respectively. Such expenditures are highly contingent upon the development of markets for the products and services offered by the Mid-America family of companies. The cash requirements of Mid-America and its subsidiaries are expected to be funded by Mid-America from existing liquid assets, future cash flows from operations and $46.3 million of project specific debt financing. Projected Operations SHAPE is projected to provide operating profits in 1995 and ICE is projected to provide operating profits concurrent with commencement of operations in 1996. The existing projects of Energy Resources, Cleveland Thermal and Cleveland Cooling are currently projected to begin contributing to operating profits in 1996. This projection could be materially affected by the rate at which customers are added and other factors. During the next five years, 1994-1998, IPALCO may continue to become involved in unregulated businesses through the formation of one or more additional Mid- America subsidiaries. The sources of capital to finance these businesses will be determined at the time they are established. The cash assets of Mid-America are invested in a variety of short-term financial instruments and marketable securities, pending investment in any such unregulated business. IPALCO ENTERPRISES CONSOLIDATED Additional information regarding IPALCO's historical cash flows from operations, investing and financing for the past three years including the capital expenditures of IPL are disclosed in the Statements of Consolidated Cash Flows (See page II-15) and in the Notes to Consolidated Financial Statements (pages II-18 - II-29). RESULTS OF OPERATIONS 1993 vs. 1992 Earnings per share during 1993 were $2.00 or $.35 below the $2.35 attained in 1992. The following discussion highlights the factors contributing to this result. Operations Utility operating income increased $8.1 million in 1993 compared to 1992. Contributing to this increase was an increase in electric operating revenues of $30.1 million, due to increases in retail sales of $25.9 million, wholesale sales of $2.8 million and miscellaneous electric revenue of $1.4 million. Retail electric sales were higher due to increased retail KWH sales of $31.1 million and decreased fuel cost recoveries of $5.2 million. The increase in retail KWH sales this year resulted primarily from the return to normal weather conditions in 1993 as compared to the abnormally mild summer weather conditions in 1992. During 1992, cooling degree days were 26.5 percent below normal. Wholesale sales were higher as a result of increased energy requirements of other utilities, who were also affected by the mild summer during 1992. The continuing health of the Indianapolis economy also contributed to the growth in KWH sales, particularly in the large industrial class. Fuel costs increased $3.3 million due to increases in fuel consumption of $9.6 million, partially offset by decreased unit costs of coal and oil of $.5 million and deferred fuel costs of $5.8 million. Power purchased increased $11.6 million due to increased capacity payments of $7.2 million to IMP in accordance with a five-year power purchase agreement, and by increased purchases of energy as a result of the near normal weather conditions in 1993 as compared to 1992. Maintenance expenses increased $4.9 million. This increase reflects higher unit overhaul and outage expenses in 1993, partially offset by decreased distribution maintenance expenses as a result of a severe storm in 1992 that cost $3.9 million. Amortization of the deferred return--rate phase-in plan, decreased due to the completion in August 1992 of the five-year amortization period. Taxes other than income taxes decreased $1.7 million as a result of lower property assessments. Income taxes - net, increased $4.3 million as a result of the increase in pretax utility operating income and a one percentage point increase in the federal income tax rate. Other Income And Deductions During 1993, IPALCO incurred a one-time charge against earnings of $33.9 million before taxes ($21.1 million net of applicable income taxes), for legal, financial and administrative costs pertaining to IPALCO's effort to acquire PSI Resources, Inc. The charge resulted in a decrease in earnings per share of 56 cents. Other - net, which includes operations other than IPL, decreased $2.4 million due to lower pretax income from nonutility investments and operations of $4.0 million. The decreased investment income reflects lower interest rates and decreased cash balances available for investment as a result of the capital requirements of Mid- America's subsidiaries, primarily for construction of district cooling facilities. Operations other than IPL and excluding the one- time charge against earnings, in total, experienced a net loss of $3.1 million, or $.08 per share. This compares to a net loss of $1.5 million during 1992, or $.04 per share. Interest Charges Interest on long-term debt decreased $1.3 million as a result of refinancing six series of IPL's First Mortgage Bonds as follows: the 10 1/4% Series, First Mortgage Bonds in October 1993 (replaced with the 5.50% Series, First Mortgage Bonds); the 5.80% Series, First Mortgage Bonds in October, 1993 (replaced with the 5.40% Series, First Mortgage Bonds); the 6.90% and the 6.60% Series, First Mortgage Bonds (replaced with the 6.10% Series, First Mortgage Bonds); and the 9.30% and 9 1/2% Series, First Mortgage Bonds in September 1992 (replaced with the 7 3/8% Series, First Mortgage Bonds). The allowance for borrowed funds used during construction increased due primarily to an increased construction base. Other interest charges increased $1.1 million due to higher notes payable balances carried during 1993. 1992 vs. 1991 Earnings per share during 1992 were $2.35 or $.37 below the $2.72 attained in 1991. The following discussion highlights the factors contributing to this result. Operations Utility operating income decreased $15.6 million in 1992 compared to 1991. Contributing to this decrease were lower electric operating revenues of $16.7 million, due to lower retail electric sales of $13.9 million, lower wholesale sales of $1.8 million and lower miscellaneous electric revenue of $1.0 million. Retail electric sales were lower due to decreased retail KWH sales of $10.6 million and decreased fuel cost recoveries of $3.3 million. The decrease in retail KWH sales in 1992 resulted primarily from unusual weather conditions in both 1992 and 1991. Abnormally mild summer weather conditions in 1992 resulted in lower KWH sales, while the unusually hot weather during the summer of 1991 significantly increased KWH sales in that year. During 1992, cooling degree days were 48 percent lower than 1991 and 26.5 percent below normal. Wholesale sales were lower as a result of decreased energy requirements of other utilities, who were also affected by the mild summer. Fuel costs decreased $7.4 million due to decreases in fuel consumption of $4.3 million, decreased unit costs of coal and oil of $2.0 million and deferred fuel costs of $1.1 million. Other operating expenses increased $2.9 million due primarily to an increase in administrative and general expenses of $1.4 million (primarily as a result of increased salaries and group insurance costs), and a $2.0 million expense related to the FAC Agreement. Power purchased increased $3.9 million due to capacity payments of $5.4 million to IMP in accordance with a five-year power purchase agreement, partially offset by decreased purchases of energy as a result of the mild summer weather. Maintenance expenses increased $2.0 million, reflecting transmission and distribution system repair expenses as a result of a severe storm in June that cost a total of $3.9 million. These expenses were partially offset by decreased unit overhaul expenses in 1992, compared to 1991. Amortization of the deferred return--rate phase-in plan, decreased due to the completion in August 1992, of the five-year amortization period. Taxes other than income taxes increased $2.7 million as a result of increased property assessments and higher property tax rates. Income taxes-net, decreased $3.0 million primarily due to the decrease in pretax utility operating income. Other Income And Deductions Allowance for equity funds used during construction increased $1.3 million due to an increased construction base in 1992. Other - net, which includes operations other than IPL, decreased $6.8 million due to lower pretax income from nonutility investments and operations of $2.9 million, decreased interest and dividend income earned by IPL of $2.4 million, and as a result of a $1.5 million contribution to customer energy assistance programs expensed in 1992. The decreased investment income reflects lower interest rates and decreased cash balances available for investment as a result of the capital requirements of Mid-America's subsidiaries, primarily for construction of district cooling facilities. Operations other than IPL, in total, experienced a net loss of $1.5 million, or $.04 per share. This compares to net income of $1.3 million during 1991, or $.03 per share. Income taxes - net, decreased $1.1 million as a result of decreased pretax operating income of the unregulated subsidiaries, decreased IPL interest and dividend income and the increased contribution expense previously mentioned. Interest Charges Interest and other charges - net, decreased $6.4 million primarily due to decreased interest on long-term debt of $3.8 million. This decrease is the result of refinancing four series of IPL's First Mortgage Bonds as follows: the 12% Series, First Mortgage Bonds in August 1991 (replaced with the long-term note at a floating interest rate that approximates tax-exempt Commercial Paper Rates); the 9 7/8% Series, First Mortgage Bonds in November 1991 (replaced with the 8% Series, First Mortgage Bonds); and the 9.30% and 9 1/2% Series, First Mortgage Bonds in September 1992 (replaced with the 7 3/8% Series, First Mortgage Bonds). The allowance for borrowed funds used during construction increased due primarily to an increased construction base. Other interest charges decreased $1.4 million due to lower interest rates during 1992. Factors having a bearing on 1994 earnings compared to 1993 will include the one-time 1993 charge against earning for the costs of the withdrawn tender offer, the impact of economic conditions, weather conditions, an increased level of construction expenditures, an increase in monthly capacity payments and the implementation of new steam system tariff rates. Authorized electric operating income for 1994 as determined by the IURC is approximately $144.0 million. (IPL earned $141.2 million during 1993 and $133.4 million during 1992.) Affecting 1994 earnings will be the cost of the IMP purchases mentioned previously. Annual capacity payments will increase by $1.8 million. The overall effect these factors will have on 1994 earnings cannot be accurately determined at this time. Item 8. Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT IPALCO Enterprises, Inc. and Subsidiaries: We have audited the accompanying consolidated balance sheets and statements of preferred stock and long-term debt of IPALCO Enterprises, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated income, common 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 at Item 14(a). 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 IPALCO Enterprises, 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. 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 Notes 1 and 9 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. Deloitte & Touche Indianapolis, Indiana January 21, 1994 IPALCO ENTERPRISES, INC. and SUBSIDIARIES Notes to Consolidated Financial Statements For the Years Ended December 31, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation--IPALCO Enterprises, Inc. (IPALCO) owns all of the outstanding common stock of its subsidiaries (collectively referred to as Enterprises). The consolidated financial statements include the accounts of IPALCO, its utility subsidiary, Indianapolis Power & Light Company (IPL) and its unregulated subsidiary, Mid-America Capital Resources, Inc. (Mid-America). Mid-America conducts its businesses through various wholly owned subsidiaries, including Mid-America Energy Resources, Inc. (Energy Resources), and one 70 percent owned subsidiary. The operating components of all subsidiaries other than IPL are included under the captions OTHER INCOME AND (DEDUCTIONS), "Other-net" and "Income Taxes-net" in the Statements of Consolidated Income. Revenues from these operations were not significant. All significant intercompany items have been eliminated in consolidation. System of Accounts--The accounts of IPL are maintained in accordance with the system of accounts prescribed by the Indiana Utility Regulatory Commission (IURC), which system substantially conforms to that prescribed by the Federal Energy Regulatory Commission. Revenues--Utility operating revenues are recorded as billed to customers on a monthly cycle billing basis. Revenue is not accrued for energy delivered but unbilled at the end of the year. A fuel adjustment charge provision, which is established after public hearing, is applicable to substantially all the rate schedules of IPL, and permits the billing or crediting of fuel costs above or below the levels included in such rate schedules. Under current IURC practice, future fuel adjustment revenues may be temporarily reduced should actual operating expenses be less than or income levels be above amounts authorized by the IURC. Authorized Annual Operating Income--In an IURC order dated May 6, 1992, IPL's maximum authorized annual electric operating income, for purposes of quarterly earnings tests, was established at approximately $147 million through July 31, 1992, declining ratably to approximately $144 million at July 31, 1993. This level will be maintained until IPL's next general electric rate order. Additionally, through the date of IPL's next general electric rate order, IPL is required to file upward and downward adjustments in fuel cost credits and charges on a quarterly basis. As provided in an order dated December 21, 1992, IPL's authorized annual steam net operating income is $6.2 million, plus any cumulative annual underearnings occurring during the five-year period subsequent to the implementation of the new rate tariffs. Deferred Fuel Expense--Fuel costs recoverable in subsequent periods under the fuel adjustment charge provision are deferred. Allowance For Funds Used During Construction (AFUDC)--In accordance with the prescribed uniform system of accounts, IPL capitalizes an allowance for the net cost of funds (interest on borrowed and a reasonable rate on equity funds) used for construction purposes during the period of construction with a corresponding credit to income. IPL capitalized amounts using pre-tax composite rates of 8.0%, 9.5% and 9.6% during 1993, 1992 and 1991, respectively. Utility Plant and Depreciation--Utility plant is stated at original cost as defined for regulatory purposes. The cost of additions to utility plant and replacements of retirement units of property, as distinct from renewals of minor items which are charged to maintenance, are charged to plant accounts. Units of property replaced or abandoned in the ordinary course of business are retired from the plant accounts at cost; such amounts plus removal costs, less salvage, are charged to accumulated depreciation. AFUDC is capitalized and depreciated over the life of the related facility. Depreciation was computed by the straight-line method based on the functional rates and averaged 3.4% during each of the years 1993, 1992 and 1991. Statements of Cash Flows - Cash Equivalents--Enterprises considers all highly liquid investments purchased with original maturities of 90 days or less to be cash equivalents. Marketable Securities--Securities with original maturities of over 90 days are classified as marketable securities and are carried at the lower of aggregate cost or market, determined at the balance sheet date. Financial Investments--Financial investments represent investments in limited partnerships and managed asset funds which are actively managed stock and bond funds which value their investments at market. Enterprises accounts for these investments on the equity method. Unamortized Deferred Return - Rate Phase-in Plan--IPL deferred the pre- tax debt and equity costs relating to its investment in plant which did not earn a cash return during the first year of a two-year, two-step retail electric rate phase-in plan authorized August 6, 1986. This deferred return and the related income taxes were amortized to cost of service over a five-year period commencing with the August 8, 1987 implementation of the second step of the phase-in plan. The deferred return was fully amortized in August, 1992. Unamortized Petersburg Unit 4 Carrying Charges--IPL has deferred certain post in-service date carrying charges of its investment in Petersburg Unit 4 (Unit 4). These carrying charges include both AFUDC on and depreciation of Unit 4 costs from the April 28, 1986 in-service date through the August 6, 1986 IURC rate order date in which IPL's investment in Unit 4 was included in rate base. Subsequent to April 28, 1986, IPL has capitalized interest on these deferred carrying charges. In addition, IPL has capitalized $7.0 million of additional allowance for earnings on shareholders' investment for rate-making purposes but not for financial reporting purposes. As provided in the rate order, the total amount of deferred carrying charges will be included in IPL's next general electric rate case. Unamortized Redemption Premiums and Expenses on Debt and Preferred Stock--In accordance with regulatory treatment, IPL defers non-sinking fund debt redemption premiums and expenses, and amortizes such costs over the life of the original debt or, in the case of preferred stock redemption premiums, over twenty years. Other Regulatory Assets--At December 31, 1993 and 1992, IPL has deferred certain costs and expenses which are recoverable in future rates as follows: Income Taxes--Deferred taxes are provided for all significant timing differences between book and taxable income. Such differences include the use of accelerated depreciation methods for tax purposes, the use of different book and tax depreciable lives, rates and in-service dates, and the accelerated tax amortization of pollution control facilities. Investment tax credits which reduced Federal income taxes in the years they arose have been deferred and are being amortized to income over the useful lives of the properties in accordance with regulatory treatment. Effective January 1, 1993, Enterprises adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," on a prospective basis. This statement requires the current recognition of income tax expense for (a) the amount of income taxes payable or refundable for the current year, and (b) for deferred tax liabilities and assets for the future tax consequences of events that have been recognized in Enterprises' financial statements or income tax returns. The effects of income taxes are measured based on enacted laws and rates. Substantially all of the adjustments required by SFAS 109 were recorded to deferred tax balance sheet accounts, with the offsetting adjustments to regulatory assets and liabilities. The adoption of this standard did not have a material impact on Enterprises' cash flows or results of operations due to the effect of rate regulation. Employee Benefit Plans--Substantially all employees of IPALCO and IPL and certain management employees of Mid-America are covered by a non- contributory, defined benefit pension plan which is funded through two trusts. Additionally, a select group of management employees of IPALCO, IPL and Mid-America are covered under a funded supplemental retirement plan. Collectively, these two plans are referred to as Plans. Benefits are based on each individual employee's years of service and compensation. IPL's funding policy is to contribute annually not less than the minimum required by applicable law, nor more than the maximum amount which can be deducted for Federal income tax purposes. IPL also sponsors the Employees' Thrift Plan of Indianapolis Power & Light Company (Thrift Plan), a defined contribution plan covering substantially all employees of IPALCO and IPL and certain management employees of Mid-America. Employees elect to make contributions to the plan based on a percentage of their annual base compensation. IPL matches each employee's contributions in amounts up to, but not exceeding four percent of the employee's annual base compensation. Substantially all non-management employees of Energy Resources and its subsidiaries are covered by a contributory 401(k) plan. Reclassification--Certain amounts from prior years' financial statements have been reclassified to conform to the current year presentation. 2. UTILITY PLANT IN SERVICE The original cost of utility plant in service at December 31, segregated by functional classifications, follows: Substantially all of IPL's property is subject to the lien of the indentures securing IPL's First Mortgage Bonds. 3. DISCLOSURES 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 Enterprises, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that Enterprises could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have an effect on the estimated fair value amounts. Cash, cash equivalents, marketable securities and notes payable--The carrying amount approximates fair value due to the short maturity of these instruments. Other property - other long-term investments--Mid-America has an investment in the publicly traded common stock of a company which owns and operates radio stations. The fair value of this investment as determined by the market value of its common stock at December 31, 1993, approximates its carrying value of $7.5 million. At December 31, 1992, it was not practical to estimate the fair value of this investment because at that time the common stock of the company was not publicly traded. Long-term debt, including current maturities and sinking fund requirements--Interest rates that are currently available to IPL and Energy Resources for issuance of debt with similar terms and remaining maturities are used to estimate fair value. At December 31, 1993 and 1992 the consolidated carrying amount of Enterprises' long-term debt, including current maturities and sinking fund requirements, and the approximate fair value are as follows: 4. CAPITAL STOCK Common Stock: Enterprises has a Shareholder Rights Plan designed to protect Enterprises' shareholders against unsolicited attempts to acquire control of Enterprises that do not offer what the Board believes is a fair and adequate price to all shareholders. The Board declared a dividend of one Right for each share of common stock to shareholders of record on July 11, 1990. The Rights will expire July 11, 2000. At this time, no Rights have been distributed. The Rights are not taxable to shareholders or to Enterprises, and they do not affect reported earnings per share. Under the Shareholder Rights Plan, Enterprises has authorized 40,000,000 shares for issuance. Enterprises' Automatic Dividend Reinvestment and Stock Purchase Plan allows common shareholders to purchase shares of common stock by reinvestment of dividends and limited additional cash investments. The plan provides that such shares may be purchased on the open market or directly from Enterprises at the option of Enterprises. Enterprises is authorized to issue 643,038 additional shares as of December 31, 1993 pursuant to this plan. Under the Thrift Plan, shares may be purchased either on the open market or, if available, as original issue shares directly from Enterprises. Enterprises is authorized to issue 93,161 additional shares of common stock pursuant to the Energy Resources 401(k) plan. Enterprises has a stock option plan (1990 Plan) for key employees under which options to acquire shares of common stock and stock appreciation rights covering common shares may be granted. One million shares of common stock have been authorized for issuance under the 1990 Plan. The maximum period for exercising an option may not exceed ten years and one day after grant or ten years for incentive stock options. Upon the first anniversary date after the grant, and each anniversary date thereafter, these options are exercisable in proportion to the number of years expired in a three-year period. At December 31, 1993, there were 43,500 shares available for future grants. During 1991, the 1991 Directors' Stock Option Plan (1991 Plan) was established. This plan provides to the non-employee Directors of Enterprises options to acquire shares of common stock. These options are exercisable for the period beginning on the six month anniversary of and ending on the ten year anniversary of the grant date. Under the 1991 Plan, 250,000 shares of common stock have been authorized for issuance and 192,000 are available for future grants. A summary of options issued under both plans is as follows: The number of shares exercisable at December 31, 1993, 1992 and 1991 were 411,000, 227,000 and 148,000, respectively. Restrictions on the payment of cash dividends or other distributions on IPL common stock held by Enterprises and on the purchase or redemption of such shares by IPL are contained in the indentures securing IPL's First Mortgage Bonds. All of IPL's retained earnings at December 31, 1993, were free of such restrictions. There are no other restrictions on the retained earnings of Enterprises. Cumulative Preferred Stock: Preferred stock shareholders are entitled to two votes per share, and if four full quarterly dividends are in default, they are entitled to elect the smallest number of Directors to constitute a majority. 5. LONG-TERM DEBT The 9 5/8% Series due 2012, 10 5/8% Series due 2014, 6.10% Series due 2016, 5.40% Series due 2017, and 5.50% Series due 2023 were each issued to the City of Petersburg, Indiana (City) by IPL to secure the loan of proceeds received from a like amount of tax-exempt Pollution Control Revenue Bonds issued by the City for the purpose of financing pollution control facilities at IPL's Petersburg Generating Station. On August 6, 1992, IPL issued $80 million of First Mortgage Bonds, 7 3/8% Series, due 2007. The net proceeds from this issue were used to redeem on September 1, 1992, IPL's First Mortgage Bonds, 9.3% Series, due 2006 and 9 1/2% Series, due 2016, at the prices of $104.17 and $107.13, respectively, plus accrued interest. On April 13, 1993, IPL issued a First Mortgage Bond, 6.10% Series, due 2016, in the principal amount of $41.85 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds were used to redeem on June 1, 1993, IPL's $19.65 million First Mortgage Bonds, 6.90% Series, due 2006, and IPL's $22.2 million First Mortgage Bonds, 6.60% Series, due 2008, at the prices of $100 and $101, respectively, plus accrued interest. On October 14, 1993, IPL issued a First Mortgage Bond, 5.40% Series, due 2017, in the principal amount of $24.65 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds, were used to redeem on November 15, 1993, IPL's $24.65 million First Mortgage Bonds, 5.80% Series, due 2007, at the price of $100 plus accrued interest. Also, on October 14, 1993, IPL issued a First Mortgage Bond, 5.50% Series, due 2023, in the principal amount of $30.0 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds, were used to redeem on November 15, 1993, IPL's $30.0 million First Mortgage Bonds, 10 1/4% Series, due 2013, at the price of $103 plus accrued interest. IPL has a 30-year unsecured promissory note which was issued to the City of Petersburg, Indiana, in connection with the issuance of $40 million of Pollution Control Refunding Revenue Bonds, due 2021, by the City of Petersburg. This note and the related bonds provide for a floating interest rate that approximates tax-exempt Commercial Paper Rates. The average interest rate on this note was 2.40% for 1993 and 3.00% for 1992. At the option of IPL, the bonds can be converted to First Mortgage Bonds which would bear interest at a fixed rate. Energy Resources has a 20-year unsecured note which was issued to the City of Indianapolis, Indiana, in connection with the issuance of $9.5 million of 7.25% Exempt Facility Revenue Bonds, due 2011, by the City of Indianapolis. The net proceeds were used to finance costs incurred during the construction of the district cooling system in near downtown Indianapolis. Maturities and sinking fund requirements on long-term debt for the five years subsequent to December 31, 1993, are as follows: 6. LINES OF CREDIT IPL has lines of credit with banks of $100 million at December 31, 1993, to provide loans for interim financing. These lines of credit, based on separate formal and informal agreements, have expiration dates ranging from January 31, 1994 to November 30, 1994, and require the payment of commitment fees. At December 31, 1993, these credit lines were unused. Lines of credit supporting commercial paper were $90 million at December 31, 1993. Mid-America also has a line of credit of $2 million, which was unused at December 31, 1993. The line of credit requires the payment of a commitment fee and expires January 31, 1994. 7. INCOME TAXES Federal and State income taxes charged to income are as follows: The provision for Federal income taxes (including net investment tax credit adjustments) is less than the amount computed by applying the statutory tax rate to pre-tax income. The reasons for the difference, stated as a percentage of pre-tax income, are as follows: The significant items comprising Enterprises' net deferred tax liability recognized in the consolidated balance sheet as of December 31, 1993 are as follows: 8. RATE MATTERS Steam Rate Order By an order dated January 13, 1993, the IURC authorized IPL to increase its steam system rates and charges over a six-year period. Accordingly, IPL implemented new steam tariffs designed to produce estimated additional annual steam operating revenues as follows: Environmental Compliance Plan On August 18, 1993, IPL obtained an Order from the IURC approving its Environmental Compliance Plan, together with the costs and expenses associated therewith, which provides for the installation of sulfur dioxide and nitrogen oxide emissions abatement equipment and the installation of continuous emission monitoring systems to meet the requirements of both Phase I and Phase II of the Federal Clean Air Act Amendments of 1990. The order provides for the deferral of net gains and losses resulting from any sale of emission allowances for future amortization to cost of service on a basis to be determined in the next general electric rate proceeding. Demand Side Management Program IPL obtained an Order from the IURC approving a Stipulation of Settlement Agreement between IPL, the Office of Utility Consumer Counsel, Citizens Action Coalition of Indiana, Inc., an industrial group, the Trustees of Indiana University and the Indiana Alliance for Fair Competition relating to the Company's Demand Side Management Program (DSM). The order provides for the deferral and subsequent recovery in rates of certain approved DSM costs. The order also provides for the recording of a return on deferred costs until recognized in rates. 9. EMPLOYEE BENEFIT PLANS AND OTHER POSTRETIREMENT BENEFITS Enterprises' contributions to the Thrift Plan were $3.2 million, $3.1 million and $2.8 million in 1993, 1992 and 1991, respectively. Net pension cost including amounts charged to construction is comprised of the following components: A summary of the Plans' funding status, and the amount recognized in the consolidated balance sheets at December 31, 1993 and 1992, follows: As of the October 31, 1993 valuation date, approximately 10.5% of the Plans' assets were in equity securities, with the remainder in fixed income securities. Enterprises also provides certain postretirement health care and life insurance benefits for employees, other than Mid-America's subsidiaries' employees, who retire from active service on or after attaining age 55 and have rendered at least 10 years of service. On January 1, 1993, Enterprises adopted the provisions of SFAS No. 106 -- Employers' Accounting for Postretirement Benefits Other than Pensions (SFAS 106). Generally, SFAS 106 requires the use of an accrual basis accounting method for determining annual costs of postretirement benefits. The January 1, 1993 transition obligation of $122.8 million is being amortized over a 20 year period. Prior to 1993, the cost of such benefits was recognized when incurred and amounted to $3.5 million and $2.8 million in 1992 and 1991, respectively. Net postretirement benefit cost, including amounts charged to construction for 1993 is comprised of the following components: A summary of the retiree health care and life insurance plan's funding status, and the amount recognized in the consolidated balance sheet at December 31, 1993 follows: Enterprises is expensing its non-construction related SFAS 106 costs associated with its unregulated and steam businesses. The SFAS 106 costs, net of amounts paid and capitalized for construction, associated with IPL's electric business are being deferred as a regulatory asset on the consolidated balance sheet, as authorized by an order of the IURC on December 30, 1992, which provided for deferral of SFAS 106 costs in excess of such costs determined on a cash basis. A request for recovery in rates of these costs will be included in IPL's next general electric rate petition. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation is 12.6% for 1994, gradually declining to 5.0% in 2003. 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 $24.4 million and the combined service cost and interest cost for 1993 by approximately $3.4 million. Plan assets consist of the cash surrender value of life insurance policies on certain retired IPL employees. Assumptions used in determining the accumulated benefit obligation for the pension plans for 1993, 1992 and 1991 and for the accumulated postretirement benefit obligation for 1993 were: 10. COMMITMENTS AND CONTINGENCIES In 1994, Enterprises anticipates the cost of its subsidiaries' construction programs to be approximately $247 million. IPL will comply with the provisions of "The Clean Air Act Amendments of 1990" (the Act) through the installation of SO2 scrubbers and NOx facilities. The cost of complying with the Act from 1994 through 1997, including AFUDC, is estimated to be approximately $207 million, of which $80 million is anticipated in 1994. During 1993, expenditures for compliance with the Act were $13.7 million. IPL has a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP) for 100 megawatts (MW) of capacity effective April 1992, with the purchase of an additional 100 MW (for a total of 200 MW) beginning in April 1993. The agreement provides for monthly capacity payments by IPL of $.6 million from April 1992 through March 1993, increasing to a monthly amount of $1.2 million which began in April 1993 and continues through March 31, 1997. The agreement further provides that IPL can elect to extend purchases through December 31, 1997, and subsequently through November 30, 1999, with capacity payments of $1.2 million per month and $1.55 million per month, respectively. IPL can terminate the agreement, should the ability to recover future demand charges through rates be disallowed. Capacity payments in 1993 and 1992 under this agreement totaled $12.6 million and $5.4 million, respectively. In October 1993, IPL received a Findings of Violation regarding compliance with the thermal limits of the National Pollutant Discharge Elimination System permit for its Petersburg Generating Station. IPL expects to meet with the Environmental Protection Agency in early 1994 to resolve this matter. IPL believes it has met all the requirements of its permit, but if IPL's position is found erroneous, IPL could be subject to fines of up to $25,000 per day of violation. Enterprises is involved in litigation arising in the normal course of business. While the results of such litigation cannot be predicted with certainty, management, based upon advice of counsel, believes that the final outcome will not have a material adverse effect on the consolidated financial position and results of operations. 11. WITHDRAWN TENDER OFFER During 1993, IPALCO incurred a one-time charge against earnings of $33.9 million before taxes ($21.1 million net of applicable income taxes), for legal, financial and administrative costs pertaining to IPALCO's effort to acquire PSI Resources, Inc. The charge resulted in a decrease in earnings per share of 56 cents. 12. QUARTERLY RESULTS (UNAUDITED) Operating results for the years ended December 31, 1993 and 1992, by quarter, are as follows (in thousands except per share amounts): The quarterly figures reflect seasonal and weather-related fluctuations which are normal to IPL's operations. Weather conditions in 1993 reflected near normal conditions, while weather conditions in 1992 were considerably moderate. The quarter ended September 30, 1993, includes a $33.9 million expense pertaining to the withdrawn tender offer. The quarter ended June 30, 1992, includes a $3.9 million expense as a result of severe storm damage to IPL's transmission and distribution systems, and a $2.8 million expense in connection with the settlement of disputes regarding fuel adjustment issues. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Items 10, 11, 12 IPALCO Enterprises, Inc. will file with the Securities and and 13 Exchange Commission a definitive proxy statement pursuant to Regulation 14A. This document will incorporate by reference the information required by these items, except for the information regarding executive officers which is set forth in Part I, following Item 4 hereof under the heading "EXECUTIVE OFFICERS OF THE REGISTRANT." PART IV Item 14 Item 14 (a). DOCUMENT LIST The Consolidated Financial Statements and Supplemental Schedules under this Item 14(a). 1 and 2 filed in this Form 10-K are those of IPALCO Enterprises, Inc. and subsidiaries. 1. Consolidated Financial Statements Included in Part II of this report: Independent Auditors' Report Statements of Consolidated Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Statements of Consolidated Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Statements of Consolidated Preferred Stock and Long-Term Debt, December 31, 1993 and 1992 Statements of Consolidated Common Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Supplementary Data and Consolidated Financial Statement Schedules Included in Part IV of this report: For each of the years ended December 31, 1993, 1992 and 1991 Schedule V - Utility Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Utility Property, Plant and Equipment Schedule V - Nonutility Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Nonutility Property, Plant and Equipment Schedule IX - Short-Term Borrowings Schedule X - Supplemental Consolidated Income Statement Information The schedules, other than those listed above, are omitted because of the absence of the conditions under which they are required or because the information is furnished in the consolidated financial statements or notes thereto. 3. Exhibits Required by Securities and Exchange Commission Regulation S-K Copies of the documents listed below which are identified with an asterisk (*) are incorporated herein by reference and made a part hereof and have heretofore been classified as basic documents under Rule 24(b) of the SEC Rules of Practice. (3) Articles of Incorporation and By-Laws * --Copy of Amended Articles of Incorporation of Enterprises dated April 16, 1986 and Articles of Amendment dated April 18, 1990. (Form 10-K for year ended 12-31-90.) * --Copy of By-Laws of Enterprises as amended August 23, 1993. (Form 10-Q for quarter ended September 30, 1993.) (10) Material Contracts * --Certificate of the Resolution establishing the Unfunded Deferred Compensation Plan for Enterprises' Directors dated December 27, 1983. (Form 10-K for year ended 12-31-83.) * --Copy of the Resolution amending the Unfunded Deferred Compensation Plan for Enterprises' Directors effective January 1, 1992. (Form 10-K for year ended 12-31-92.) --Copy of the Resolution amending the Unfunded Deferred Compensation Plan for Enterprises' Directors effective January 1, 1994. --Copy of the Resolution adopting the Unfunded Deferred Compensation Plan for Enterprises' Officers effective January 1, 1994. --Directors' and Officers' Liability Insurance Policy No. DO392B1A93 effective June 30, 1993, to June 1, 1994. * --IPALCO Enterprises, Inc. Benefit Protection Fund and Trust Agreement effective November 1, 1988. (Form 10-K for year ended 12-31-88.) --Exhibit A to IPALCO Enterprises, Inc. Benefit Protection Fund and Trust Agreement dated February 23, 1993. * --IPALCO Enterprises, Inc. Annual Incentive Plan and Administrative Guidelines effective January 1, 1990. (Form 10-K for year ended 12-31-89.) * --IPALCO Enterprises, Inc. 1990 Long-Term Performance Incentive Plan and Administrative Guidelines effective January 1, 1990. (Form 10-K for year ended 12-31-89.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Copy of First Amendment to the IPALCO Enterprises, Inc. 1990 Long-Term Performance Incentive Plan and Revised Administrative Guidelines, effective January 1, 1992. (Form 10-K for year ended 12-31-92.) (21) Other Documents or Statements to Security Holders --Form 10-K of Indianapolis Power & Light Company for the year ended December 31, 1993, and all documents listed at Item 14 (a) 3 thereof. (23) Consents of Experts and Counsel --Independent Auditors' Consent (99) Additional Exhibits * --Agreement dated as of October 27, 1993, by and among IPALCO Enterprises, Inc., Indianapolis Power & Light Company, PSI Resources, Inc., PSI Energy, Inc., The Cincinnati Gas & Electric Company, CINergy Corp., James E. Rogers, John R. Hodowal and Ramon L. Humke. (Form 10-Q for quarter ended September 30, 1993.) Item 14 (b). REPORTS ON FORM 8-K A report on Form 8-K, dated October 26, 1993, reporting Item 5, "Other Events", and Item 7, "Exhibits", with respect to a settlement agreement with PSI Resources, Inc. and Cincinnati Gas & Electric Company, and the release of third quarter earnings. 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. IPALCO ENTERPRISES, INC. By John R. Hodowal ----------------------------------- (John R. Hodowal, Chairman of the Board and President) Date February 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 --------- ----- ---- (i) Principal Executive Officer: /s/ John R. Hodowal Chairman of the Board February 22, 1994 ------------------------ and President (John R. Hodowal) (ii) Principal Financial Officer: /s/ John R. Brehm Vice President February 22, 1994 ------------------------ and Treasurer (John R. Brehm) (iii) Principal Accounting Officer: /s/ Stephen J. Plunkett Controller February 22, 1994 ------------------------ (Stephen J. Plunkett) (iv) A majority of the Board of Directors of IPALCO Enterprises, Inc.: /s/ Joseph D. Barnette, Jr. Director February 22, 1994 ---------------------------- (Joseph D. Barnette, Jr.) /s/ Robert A. Borns Director February 22, 1994 ---------------------------- (Robert A. Borns) SIGNATURES (Continued) /s/ Mitchell E. Daniels, Jr. Director February 22, 1994 ---------------------------- (Mitchell E. Daniels, Jr.) /s/ Rexford C. Early Director February 22, 1994 ---------------------------- (Rexford C. Early) /s/ Otto N. Frenzel III Director February 22, 1994 ---------------------------- (Otto N. Frenzel III) /s/ Max L. Gibson Director February 22, 1994 ---------------------------- (Max L. Gibson) /s/ Edwin J. Goss Director February 22, 1994 ---------------------------- (Edwin J. Goss) /s/ Dr. Earl B. Herr, Jr. Director February 22, 1994 ---------------------------- (Dr. Earl B. Herr, Jr.) /s/ John R. Hodowal Director February 22, 1994 ---------------------------- (John R. Hodowal) /s/ Ramon L. Humke Director February 22, 1994 ---------------------------- (Ramon L. Humke) /s/ Sam H. Jones Director February 22, 1994 ---------------------------- (Sam H. Jones) /s/ Andre B. Lacy Director February 22, 1994 ---------------------------- (Andre B. Lacy) /s/ L. Ben Lytle Director February 22, 1994 ---------------------------- (L. Ben Lytle) /s/ Michael S. Maurer Director February 22, 1994 ---------------------------- (Michael S. Maurer) SIGNATURES (Continued) /s/ Thomas M. Miller Director February 22, 1994 ---------------------------- (Thomas M. Miller) /s/ Sallie W. Rowland Director February 22, 1994 ---------------------------- (Sallie W. Rowland) /s/ Thomas H. Sams Director February 22, 1994 ---------------------------- (Thomas H. Sams) /s/ Zane G. Todd Director February 22, 1994 ---------------------------- (Zane G. Todd)

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ITEM 1. BUSINESS GENERAL Mirage Resorts, Incorporated (the "Registrant" or the "Company") is a Nevada corporation incorporated in 1949. The Registrant, through wholly owned subsidiaries, owns and operates (i) The Mirage, a hotel-casino and destination resort on the Las Vegas Strip, (ii) Treasure Island at The Mirage ("Treasure Island"), a hotel-casino resort adjacent to The Mirage, (iii) the Golden Nugget, a hotel-casino in downtown Las Vegas and (iv) the Golden Nugget-Laughlin, a hotel-casino in Laughlin, Nevada. In January 1993, the Registrant, through a wholly owned subsidiary, purchased the assets of the former Dunes Hotel, Casino and Country Club (the "Dunes") on the Las Vegas Strip and is developing long-term plans for the site, which include construction of extensive new hotel, casino and resort facilities. THE MIRAGE The Registrant's wholly owned subsidiary, THE MIRAGE CASINO-HOTEL ("MCH"), owns and operates The Mirage, which opened on November 22, 1989. The Mirage is a luxurious, tropically themed destination resort containing approximately 2.7 million square feet in a 29-story Y-shaped hotel tower and an expansive low-rise complex. The Mirage features a 95,500-square foot casino, 3,030 hotel rooms (including 265 suites), 14 villa suites, approximately 82,000 square feet of meeting, convention and banquet space, a parking garage with space for approximately 2,200 vehicles, a valet parking garage with space for approximately 1,830 vehicles shared with Treasure Island, surface parking for approximately 1,650 vehicles, a 1,500-seat showroom featuring top-name entertainment (showcasing the world-famous illusionists Siegfried & Roy), five international restaurants, a California-style pizza restaurant, a coffee shop, a buffet, four bars (two of which feature live entertainment), two snack/ liquor bars, an ice cream parlor, a health spa and beauty salon, a swimming pool and cabana area, a white tiger display and extensive retail facilities. The exterior of the resort is landscaped with palm trees, abundant foliage and more than four acres of lagoons and other water features, centered around a 40-foot simulated volcano and waterfall. Each evening, the volcano erupts at 15-minute intervals, spectacularly illuminating the front of the resort. Inside the front entrance is an atrium with a tropical garden and additional water features capped by a 150-foot (in diameter) glass dome. The atrium has an advanced environmental control system and creative lighting and other special effects designed to replicate the sights, sounds and fragrances of the South Seas. Located at the rear of the hotel, adjacent to the swimming pool area, is a dolphin habitat with adjoining food, beverage and retail facilities. As of March 1, 1994, The Mirage's casino offered 119 table games (including blackjack, craps, roulette, baccarat, pai gow, pai gow poker, Caribbean stud poker, red dog and big six), keno, poker, a race and sports book and approximately 2,250 slot machines and other coin-operated devices. During the years ended December 31, 1993 and 1992, The Mirage's average occupancy rates for standard rooms were approximately 98% and 96%, respectively. These percentages include occupancy on a complimentary basis. TREASURE ISLAND The Registrant, through Treasure Island Corp. ("TI Corp."), a wholly owned subsidiary of MCH, owns and operates Treasure Island, a pirate-themed hotel-casino resort located on the same 116-acre site as The Mirage with approximately 550 feet of frontage on the Las Vegas Strip. Construction of Treasure Island commenced in March 1992, and the facility opened on October 26, 1993. Treasure Island features a 75,000-square foot casino, 2,900 hotel rooms (including 212 suites), a steak and seafood restaurant, a contemporary Continental restaurant, an Italian specialties grill, a coffee shop, a buffet, three snack bars, an ice cream parlor, four bars (three of which feature live entertainment), a 1,500-seat showroom featuring an all-new production, "Mystere," developed by the creators of the world-renowned Cirque du Soleil, and an 18,000-square foot amusement arcade. Treasure Island also offers extensive retail facilities, approximately 18,000 square feet of meeting and banquet space, two wedding chapels, a swimming pool with a 230-foot mountain water slide, a parking garage with space for approximately 2,400 vehicles and the valet parking garage shared with The Mirage. The facade of Treasure Island, fronting on the Las Vegas Strip, is an elaborate pirate village in which full-scale replicas of a pirate ship and a British frigate periodically engage in a pyrotechnic and special effects sea battle, culminating with the sinking of the frigate. Management believes that the pirate-themed features of Treasure Island and its proximity to The Mirage make it a "must see" attraction for Las Vegas visitors and local residents. As of March 1, 1994, Treasure Island's casino offered 79 table games (including blackjack, craps, roulette, baccarat, pai gow, pai gow poker, Caribbean stud poker and big six), keno, poker, a race and sports book and approximately 2,260 slot machines and other coin-operated devices. From its opening through December 31, 1993, Treasure Island's average occupancy rate for standard rooms was approximately 97%. This percentage includes occupancy on a complimentary basis. GOLDEN NUGGET The Registrant's wholly owned subsidiary, GNLV, CORP. ("GNLV"), owns and operates the Golden Nugget, a hotel-casino which, together with parking facilities, occupies approximately 2 1/2 square blocks in downtown Las Vegas. The Golden Nugget features a 38,000-square foot casino, 1,907 hotel rooms (including 102 suites), two international restaurants, a California-style pizza restaurant, a coffee shop, a buffet, a snack bar, three bars, an entertainment lounge, a ballroom/showroom, approximately 23,000 square feet of meeting and banquet space, two gift and retail shops, two hotel lobbies with guest registration facilities, a swimming pool and lounge area, a health spa, a beauty salon and two parking garages with space for approximately 1,050 vehicles. As of March 1, 1994, the Golden Nugget's casino offered 69 table games (including blackjack, craps, roulette, baccarat, pai gow, pai gow poker, Caribbean stud poker, red dog and big six), keno, a race and sports book and approximately 1,300 slot machines and other coin-operated devices. During the years ended December 31, 1993 and 1992, the Golden Nugget's average occupancy rates for standard rooms were approximately 97% and 94%, respectively. These percentages include occupancy on a complimentary basis. GOLDEN NUGGET-LAUGHLIN The Registrant's wholly owned subsidiary, GNL, CORP. ("GNL"), owns and operates the Golden Nugget-Laughlin, a hotel-casino in Laughlin, Nevada. The hotel-casino is located on approximately 13 acres with approximately 600 feet of Colorado River frontage near the center of Laughlin's existing hotel-casino facilities. The Golden Nugget-Laughlin includes a two-story low-rise featuring a 32,000-square foot casino, three restaurants, three bars, an entertainment lounge, a snack bar and a gift and retail shop. The hotel is a four-story structure located adjacent to the low-rise containing 296 standard rooms and four suites. Other facilities at the Golden Nugget-Laughlin include a swimming pool, a parking garage with space for approximately 1,585 vehicles adjacent to the low-rise and approximately four and one-half acres of surface parking for recreational vehicles. The hotel and a 50% expansion of the casino were completed in December 1992. GNL also owns and operates a 78-room motel in Bullhead City, Arizona, across the Colorado River from Laughlin. As of March 1, 1994, the Golden Nugget-Laughlin's casino offered 20 table games (including blackjack, craps, roulette, pai gow poker and Caribbean stud poker), approximately 1,300 slot machines and other coin-operated devices, keno and a race and sports book. IGUAZU FALLS, ARGENTINA CASINO VENTURE The Registrant, through a wholly owned subsidiary, owns a 50% equity interest in Mirage Universal de Misiones S.A., an Argentine corporation ("MUMSA"). In February 1994, MUMSA was awarded a 15-year concession by the Province of Misiones, Argentina to develop, own and operate a casino near Iguazu Falls, Argentina. The Registrant's total investment in the venture of $4 million was contributed in January 1994. The casino is initially expected to offer approximately 15 table games, 120 slot machines and food and beverage service. It is anticipated that the casino will be opened to the public in mid-1994 and will be managed principally by one of the other stockholders of MUMSA. FUTURE EXPANSION In January 1993, the Registrant, through a wholly owned subsidiary, completed the purchase for $70 million of the land, buildings and certain other assets comprising the Dunes. The Dunes site consists of approximately 164 acres situated on the Las Vegas Strip between Flamingo Road and Tropicana Avenue. Pursuant to the terms of the purchase agreement, the seller terminated all operations of the Dunes prior to the closing of the purchase. The Registrant reopened the Dunes golf course to the public in February 1993 as "The Mirage Golf Club" and intends to operate it at least until the commencement of major construction at the site. The Registrant is developing long-term plans for the Dunes property, which include construction of extensive new hotel, casino and resort facilities. The scope and timing of such a project are still uncertain, but management does not currently anticipate breaking ground on any major construction prior to late 1994 or completing such construction prior to late 1996. In October 1993, the Registrant imploded the north hotel tower of the Dunes as part of the opening ceremonies for Treasure Island. The implosion received worldwide news coverage and was featured in a one-hour fictional television special produced by the Registrant which aired on network television in January 1994. Assuming development of the Dunes property as presently contemplated, the cost of such development is expected to be in excess of, and may significantly exceed, $500 million. There can be no assurance that the Registrant will determine to proceed with such a project, that financing will be available on terms satisfactory to the Registrant or that the project, if constructed, will be profitable. In addition, there can be no assurance that the Registrant will obtain the requisite approvals, permits, allocations and licenses, including gaming licenses, or that such approvals, permits, allocations or licenses can be obtained on a timely basis. The Registrant regularly evaluates and pursues potential expansion and acquisition opportunities in both the domestic and international markets. Such opportunities may include the ownership, management and operation of gaming and other entertainment facilities in states other than Nevada or outside of the United States, either alone or with joint venture partners. The Registrant has presented a large number of formal and informal proposals to develop, own and operate gaming facilities in new and potential gaming jurisdictions, several of which proposals are currently outstanding. Development and operation of any gaming facility in a new jurisdiction is subject to numerous contingencies, several of which are outside of the Registrant's control and may include the enactment of appropriate gaming legislation, the issuance of requisite permits, licenses and approvals and the satisfaction of other conditions. In addition, some of the expansions being proposed require a substantial capital investment by the Registrant and may require significant financing. There can be no assurance that such financing can be obtained on terms acceptable to the Registrant, that the Registrant will elect or be able to consummate any such acquisition or expansion opportunity outside of Nevada or that the operations of any such venture will be profitable. MARKETING Operations at the Registrant's hotel-casinos are conducted 24 hours a day, every day of the year. The Registrant does not consider its Las Vegas business to be highly seasonal. The Registrant considers its Laughlin business to be seasonal, with the greatest level of activity occurring during the spring and fall months and the lowest during December, January and the summer months. The Registrant's revenues and operating income depend primarily upon the level of gaming activity at its casinos, although the Registrant also seeks to maximize revenues from food and beverage, lodging, entertainment and retail operations. Therefore, the primary goal of the Registrant's marketing efforts is to attract gaming customers to its casinos. The principal segments of the Nevada gaming market are tour and travel, leisure travel, high-level wagerers and conventions (including small meetings and corporate incentive programs). The Registrant believes that The Mirage's hotel occupancy and gaming revenues can be maximized through a balanced marketing approach addressing each market segment. The Registrant's marketing strategy for Treasure Island and the Golden Nugget is aimed at attracting middle-to upper-middle-income wagerers primarily from the tour and travel and leisure travel segments. The Registrant believes that the success of its hotel- casinos is also affected by the level of walk-in customers and, accordingly, has designed these facilities to maximize their attraction to these patrons. The tour and travel segment consists of gaming customers who take advantage of travel "packages" produced by wholesale operators. The Registrant has relationships with wholesalers selected on the basis of market penetration, reputation and commitment. Tour and travel trade emphasizes mid-week occupancy, as compared with the regionally based leisure travel segment, which is primarily weekend-oriented. The Registrant has developed specialized marketing programs for the tour and travel market. The Registrant has also developed important relationships with, and programs for, certain of the major air carriers which have their own wholesale tour and travel operations. The leisure travel segment is largely composed of individuals traveling to Las Vegas from the regional market, primarily Southern California and the Southwest, by automobile and, to a lesser extent, by airplane. This segment represents a significant portion of the customers for the Registrant's facilities. As with the tour and travel business, The Mirage aims to attract the upper-middle and higher-income strata of this segment, while the focus of Treasure Island and the Golden Nugget is on the middle-to upper-middle-income strata of the leisure travel segment. To this end, the Registrant has utilized substantial media advertising (particularly radio and television commercials and billboards) emphasizing the amenities, the atmosphere of excitement and the relative value offered by the facilities. The Registrant also participates in joint advertising and marketing programs with selected air carriers and benefits from personal referrals and its high public profile. The Registrant markets to the high-level-wagerer segment primarily through direct sales, using its 19 marketing offices located in a number of major domestic and foreign cities. Special entertainment and other events and programs, including golf privileges at Shadow Creek as discussed below and the presentation of major professional boxing matches, together with the provision of complimentary rooms, food and beverage and air transportation and the extension of gaming credit, are offered to attract high-level wagerers. The Registrant employs several marketing executives who have extensive customer relationships in certain areas of Asia, Latin America and Canada, as well as casino hosts from many of the countries to which international marketing efforts are directed. Convention business, like the tour and travel segment, is mid-week oriented, and is a major target for The Mirage, with its 82,000 square feet of meeting, convention and banquet space. The Mirage seeks those conventions whose participants have the best gaming profile. Treasure Island's and a portion of The Mirage's convention business is derived from small corporate meetings (those requiring less than 500 rooms per night) and corporate incentive programs (travel packages produced by independent "incentive houses" for corporations desiring to motivate their employees and reward them for superior performance). Since the Golden Nugget's facilities are inadequate to accommodate conventions requiring more than 200 rooms per night, its focus on this segment has been limited to smaller groups and "spill-over" business from larger conventions headquartered at other facilities, including The Mirage. As discussed under "Future Expansion," the Registrant recently opened The Mirage Golf Club at the Dunes site. The Registrant makes reduced green fees and preferential tee times at The Mirage Golf Club available to guests of its hotels. Management believes that The Mirage Golf Club has been beneficial to the Registrant's marketing efforts. Walk-in customers are those who patronize a facility's casino but are not guests of its hotel. The Mirage and Treasure Island, which are strategically located on the Las Vegas Strip, have been designed to attract walk-in casino business. The Golden Nugget-Laughlin appeals primarily to patrons from the middle-income strata of the gaming populace. Many of the Golden Nugget-Laughlin's customers, particularly those who arrive on bus tours, are older and retired individuals who are attracted by lodging, food and beverage and entertainment prices that are generally lower than those offered by the major Las Vegas hotel-casinos. Many are also attracted by lower minimum wagering limits and higher slot machine paybacks than those prevalent in Las Vegas, and by their perception that Laughlin offers a more "relaxed" gaming and recreational atmosphere. The predominant portion of the Golden Nugget-Laughlin's casino revenues is derived from slot machine play. During 1993, slot revenues accounted for approximately 87% of its total casino revenues. Convention and high-level-wagerer patrons do not comprise a significant segment of the Laughlin gaming market. The Registrant, through a wholly owned subsidiary of MCH, owns approximately 315 acres of real property located approximately 10 miles north of The Mirage and Treasure Island and five miles north of the Golden Nugget. The Registrant has developed a world-class 18-hole golf course and related facilities known as "Shadow Creek" on approximately 80% of such property. In connection with its marketing activities, the Registrant makes the course and related facilities available for use, by invitation only, by high-level-wagerer patrons. CREDIT Credit play represents a significant portion of the table games volume at The Mirage. The Registrant's other facilities do not emphasize credit play to the same extent as The Mirage, although credit is made available. The Registrant maintains strict controls over the issuance of credit and aggressively pursues collection of its customer receivables. Such collection efforts parallel those procedures commonly followed by most large corporations, including the mailing of statements and delinquency notices, personal and other contacts, the use of an outside collection agency, civil litigation and criminal prosecution, if warranted. Nevada gaming debts evidenced by credit instruments are enforceable under the laws of Nevada. All other states are required to enforce a judgment on a gaming debt entered in Nevada pursuant to the Full Faith and Credit Clause of the Unites States Constitution and, although foreign countries are not so bound, the United States assets of foreign debtors may be reached to satisfy a judgment entered in the United States. SUPERVISION OF GAMING ACTIVITIES In connection with the supervision of gaming activities at its casinos, the Registrant maintains stringent controls on the recording of all receipts and disbursements. These audit and cash controls include the following: locked cash boxes; personnel independent of casino operations to perform the daily cash and coin counts; floor observation of the gaming area; observation of gaming and certain other areas through the use of closed-circuit television; computer tabulation of receipts and disbursements for each of the slot machines and table games; and timely analysis of discrepancies or deviations from normal performance. INSURANCE AND FIRE SAFETY MEASURES The Registrant maintains extensive property damage, business interruption and general liability insurance. Safety and protection have been, and continue to be, of maximum concern in the construction and expansion of the Registrant's facilities. The Mirage, Treasure Island, the high-rise towers of the Golden Nugget and the Golden Nugget-Laughlin were constructed pursuant to modern stringent fire codes, and generally exceed such codes. The Mirage, Treasure Island and the Golden Nugget is each rated by insurance companies as a "highly protected risk." COMPETITION The Mirage, Treasure Island and the Golden Nugget each compete with a number of other hotel-casinos in Las Vegas. Currently, there are approximately 27 major hotel-casinos located on or near the Las Vegas Strip, nine major hotel-casinos located in the downtown area and several major facilities located elsewhere in the Las Vegas area. During 1993 (principally during the fourth quarter), Las Vegas hotel and motel room capacity increased by approximately 10,300 rooms, to a total of approximately 83,700 rooms. This increase includes the effect of the opening of Treasure Island and two other major Strip hotel-casinos in the fourth quarter. Management believes that the primary competition for The Mirage comes from other large hotel-casinos located on or near the Strip that offer amenities and marketing programs that appeal to the upper-middle and higher-income strata of the gaming populace. The Mirage competes on the basis of the elegance and excitement offered by the facility, the desirability of its location, the quality and relative value of its hotel rooms and restaurants, its top-name entertainment, customer service, its balanced marketing strategy and special marketing and promotional programs. Management believes that Treasure Island primarily competes with the other large hotel-casinos located on or near the Strip that offer amenities and marketing programs that appeal to the middle-to- upper-middle-income strata of the gaming populace. Treasure Island competes on the basis of the entertainment and excitement offered by the facility, the desirability of its location (including its proximity to The Mirage), the affordability of its hotel rooms, the variety, quality and attractive pricing of its food and beverage outlets, its unique showroom and innovative amusement area, customer service and its marketing and promotional programs. In management's opinion, the Golden Nugget primarily competes with the large hotel-casinos located on or near the Strip, particularly those offering amenities and marketing programs that appeal primarily to the middle-and upper-middle-income strata of the gaming populace. The Golden Nugget competes for gaming customers primarily on the basis of the elegance, intimacy and excitement offered by the facility, the quality and relative value of its hotel rooms and restaurants, customer service and its marketing and promotional programs. In order to compete more effectively with the Strip hotel-casinos, a coalition of several major downtown Las Vegas hotel-casino owners (including GNLV), in conjunction with the City of Las Vegas, is developing The Fremont Street Experience, a major tourist attraction in the downtown area. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in Item 7 of Part II of this Form 10-K. The Golden Nugget-Laughlin competes with eight nearby hotel-casinos. During 1993, the number of available hotel rooms in Laughlin increased by approximately 1,100 rooms, to a total of approximately 10,300 rooms. The Registrant's facilities also compete for gaming customers to a lesser extent with hotel-casino operations located in other areas of Nevada, Atlantic City, New Jersey and other parts of the world. They also compete with state-sponsored lotteries, off-track wagering, card parlors, riverboat and Indian gaming ventures and other forms of legalized gaming in the United States, as well as with gaming on cruise ships. Certain states have recently legalized, and several other states are currently considering legalizing, casino gaming. Management does not believe that such legalization of casino gaming in those jurisdictions will have a material adverse impact on the Registrant's operations. However, management believes that the legalization of large-scale land-based casino gaming in or near certain major metropolitan areas, particularly in California, could have a material adverse effect on the Las Vegas market. The competitive impact of Treasure Island on the Registrant's other hotel-casinos cannot yet be fully determined, but Treasure Island may attract customers who would otherwise patronize these facilities. EMPLOYEES AND LABOR RELATIONS As of March 1, 1994, the Registrant and its subsidiaries had approximately 14,600 full-time and 2,400 part-time employees. At that date, the Registrant had collective bargaining contracts with unions covering approximately 7,700 of its Las Vegas employees, which expire in May 1994. The Registrant is in the process of negotiating with respect to the renewal of such contracts. Although unions have been active in Las Vegas, management considers its employee relations to be excellent. REGULATION AND LICENSING The ownership and operation of casino gaming facilities in Nevada are subject to (i) the Nevada Gaming Control Act and the regulations promulgated thereunder (collectively, the "Nevada Act") and (ii) various local ordinances and regulations. The Registrant's gaming operations are subject to the licensing and regulatory control of the Nevada Gaming Commission (the "Nevada Commission"), the Nevada State Gaming Control Board (the "Nevada Board"), the City of Las Vegas and the Clark County Liquor and Gaming Licensing Board (the "Clark County Board"). The Nevada Commission, the Nevada Board, the City of Las Vegas and the Clark County Board are collectively referred to as the "Nevada Gaming Authorities." To the best knowledge of management, the Registrant and its subsidiaries are presently in material compliance with all applicable laws, regulations and supervisory procedures described herein. The laws, regulations and supervisory procedures of the Nevada Gaming Authorities are based upon declarations of public policy which are concerned with, among other things: (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity; (ii) the establishment and maintenance of responsible accounting practices and procedures; (iii) the maintenance of effective controls over the financial practices of licensees, including the establishment of minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada Gaming Authorities; (iv) the prevention of cheating and fraudulent practices; and (v) providing a source of state and local revenues through taxation and licensing fees. Change in such laws, regulations and procedures could have an adverse effect on the Registrant's gaming operations. The Registrant's direct and indirect subsidiaries that conduct gaming operations are required to be licensed by the Nevada Gaming Authorities. The gaming licenses require the periodic payment of fees and taxes and are not transferable. MCH is registered as an intermediary company and has been found suitable to own the stock of TI Corp. MCH has also been licensed to conduct nonrestricted gaming operations at The Mirage. TI Corp. has been licensed to conduct nonrestricted gaming operations at Treasure Island. GNLV has been registered as an intermediary company and has been found suitable to own the stock of Golden Nugget Manufacturing Corp. ("GNMC"), its inactive subsidiary which is licensed as a manufacturer and distributor of gaming devices. GNLV has also been licensed to conduct nonrestricted gaming operations at the Golden Nugget. GNL has been licensed to conduct nonrestricted gaming operations at the Golden Nugget-Laughlin. MR Realty, MRI's subsidiary which owns the Dunes site, has been licensed to conduct restricted gaming operations at The Mirage Golf Club. The Registrant is registered by the Nevada Commission as a publicly traded corporation (a "Registered Corporation") and has been found suitable to own the stock of MCH, GNLV and GNL, each of which, together with TI Corp., MR Realty and GNMC, is a corporate licensee (individually, a "Gaming Subsidiary" and collectively, the "Gaming Subsidiaries") under the Nevada Act. As a Registered Corporation, the Registrant is required periodically to submit detailed financial and operating reports to the Nevada Commission and furnish any other information which the Nevada Commission may require. No person may become a stockholder of, or receive any percentage of profits from, the Gaming Subsidiaries without first obtaining licenses and approvals from the Nevada Gaming Authorities. The Registrant and the Gaming Subsidiaries have obtained from the Nevada Gaming Authorities the various registrations, approvals, permits and licenses required in order to engage in gaming activities in Nevada. The Nevada Gaming Authorities may investigate any individual who has a material relationship to, or material involvement with, the Registrant or the Gaming Subsidiaries in order to determine whether such individual is suitable or should be licensed as a business associate of a gaming licensee. Officers, directors and certain key employees of the Gaming Subsidiaries must file applications with the Nevada Gaming Authorities and may be required to be licensed or found suitable by the Nevada Gaming Authorities. Officers, directors and key employees of the Registrant who are actively and directly involved in gaming activities of the Gaming Subsidiaries may be required to be licensed or found suitable by the Nevada Gaming Authorities. The Nevada Gaming Authorities may deny an application for licensing for any cause which they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal and financial information followed by a thorough investigation. The applicant for licensing or a finding of suitability must pay all the costs of the investigation. Changes in licensed positions must be reported to the Nevada Gaming Authorities, and in addition to their authority to deny an application for a finding of suitability or licensure, the Nevada Gaming Authorities have jurisdiction to disapprove a change in a corporate position. If the Nevada Gaming Authorities were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with the Registrant or the Gaming Subsidiaries, the companies involved would have to sever all relationships with such person. In addition, the Nevada Commission may require the Registrant or the Gaming Subsidiaries to terminate the employment of any person who refuses to file appropriate applications. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada. The Registrant, MCH, GNLV, GNL and TI Corp. are required to submit detailed financial and operating reports to the Nevada Commission. Substantially all material loans, leases, sales of securities and similar financing transactions entered into by MCH, GNLV, GNL or TI Corp. must be reported to or approved by the Nevada Commission. If it were determined that the Nevada Act was violated by a Gaming Subsidiary, the licenses it holds could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, the Registrant, the Gaming Subsidiaries and the persons involved could be subject to substantial fines for each separate violation of the Nevada Act at the discretion of the Nevada Commission. Further, a supervisor could be appointed by the Nevada Commission to operate The Mirage, Treasure Island, the Golden Nugget and the Golden Nugget-Laughlin and, under certain circumstances, earnings generated during the supervisor's appointment (except for the reasonable rental value of the casino) could be forfeited to the State of Nevada. Limitation, conditioning or suspension of the gaming license of a Gaming Subsidiary or the appointment of a supervisor could (and revocation of any gaming license would) materially adversely affect the Registrant's gaming operations. Any beneficial holder of the Registrant's voting securities, regardless of the number of shares owned, may be required to file an application, be investigated and have his suitability as a beneficial holder of the Registrant's voting securities determined if the Nevada Commission has reason to believe that such ownership would be inconsistent with the declared policies of the State of Nevada. The applicant must pay all costs of investigation incurred by the Nevada Gaming Authorities in conducting any such investigation. The Nevada Act requires any person who acquires more than 5% of a Registered Corporation's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires that beneficial owners of more than 10% of a Registered Corporation's voting securities apply to the Nevada Commission for a finding of suitability within 30 days after the Chairman of the Nevada Board mails a written notice requiring such filing. Under certain circumstances, an "institutional investor," as defined in the Nevada Act, which acquires more than 10%, but not more than 15%, of a Registered Corporation's voting securities may apply to the Nevada Commission for a waiver of such finding of suitability requirement if such institutional investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of the board of directors of the Registered Corporation, any change in the corporate charter, bylaws, management, policies or operations of the Registered Corporation or any of its gaming affiliates or any other action which the Nevada Commission finds to be inconsistent with holding the Registered Corporation's voting securities for investment purposes only. Activities which are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by stockholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in its management, policies or operations; and (iii) such other activities as the Nevada Commission may determine to be consistent with such investment intent. The City of Las Vegas requires 10% stockholders to be licensed. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership or trust, it must submit detailed business and financial information, including a list of beneficial owners. The applicant is required to pay all costs of investigation. Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Nevada Commission or the Chairman of the Nevada Board may be found unsuitable. The same restrictions apply to a record owner if the record owner, after request, fails to identify the beneficial owner. Any stockholder found unsuitable who holds, directly or indirectly, any beneficial ownership of the common stock beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a criminal offense. The Registrant is subject to disciplinary action if, after it receives notice that a person is unsuitable to be a stockholder or to have any other relationship with the Registrant or the Gaming Subsidiaries, the Registrant (i) pays such person any dividend or interest upon voting securities of the Registrant, (ii) allows such person to exercise, directly or indirectly, any voting right conferred through securities held by that person, (iii) pays remuneration in any form to such person for services rendered or otherwise or (iv) fails to pursue all lawful efforts to require such person to relinquish his voting securities including, if necessary, the immediate purchase of the voting securities for cash at fair market value. Additionally, the Clark County Board has taken the position that it has the authority to approve all persons owning or controlling the stock of any corporation controlling a gaming licensee. The Nevada Commission may, in its discretion, require the holder of any debt security of a Registered Corporation to file applications, be investigated and be found suitable to own the debt security. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the Nevada Act, the Registered Corporation can be sanctioned, including the loss of its approvals, if without the prior approval of the Nevada Commission, it: (i) pays to the unsuitable person any dividend, interest or any distribution whatsoever; (ii) recognizes any voting right by such unsuitable person in connection with such securities; (iii) pays the unsuitable person remuneration in any form; or (iv) makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation or similar transaction. The Registrant is required to maintain a current stock ledger in Nevada which may be examined by the Nevada Gaming Authorities at any time. If any securities are held in trust by an agent or nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Gaming Authorities. A failure to make such disclosure may be grounds for finding the record holder unsuitable. The Registrant is also required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power to require the Registrant's stock certificates to bear a legend indicating that the securities are subject to the Nevada Act. To date, the Nevada Commission has not imposed such a requirement on the Registrant. The Registrant may not make a public offering of its securities without the prior approval of the Nevada Commission if the securities or proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Nevada or to retire or extend obligations incurred for such purposes. On May 27, 1993, the Nevada Commission granted the Registrant prior approval to make public offerings for a period of one year, subject to certain conditions (the "Shelf Approval"). However, the Shelf Approval may be rescinded for good cause without prior notice upon the issuance of an interlocutory stop order by the Chairman of the Nevada Board. The Shelf Approval also applies to any affiliated company wholly owned by the Registrant (an "Affiliate") which is a publicly traded corporation or would thereby become a publicly traded corporation pursuant to a public offering. The Shelf Approval also includes approval for the Gaming Subsidiaries to guarantee any security issued by, or to hypothecate their assets to secure the payment or performance of any obligations issued by, the Registrant or an Affiliate in a public offering under the Shelf Approval. The Shelf Approval does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities offered. Any representation to the contrary is unlawful. The Registrant has filed an application for a renewal of the Shelf Approval, which it anticipates will be considered by the Nevada Board and the Nevada Commission in May 1994. Changes in control of the Registrant through merger, consolidation, stock or asset acquisitions, management or consulting agreements or any act or conduct by a person whereby he obtains control may not occur without the prior approval of the Nevada Commission. Entities seeking to acquire control of a Registered Corporation must satisfy the Nevada Board and Nevada Commission with respect to a variety of stringent standards prior to assuming control of such Registered Corporation. The Nevada Commission may also require controlling stockholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control to be investigated and licensed as part of the approval process relating to the transaction. The Nevada Legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defensive tactics affecting Nevada corporate gaming licensees, and Registered Corporations that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to: (i) assure the financial stability of corporate gaming licensees and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the Registered Corporation can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. The Nevada Act also requires prior approval of a plan of recapitalization proposed by the Registered Corporation's board of directors in response to a tender offer made directly to the Registered Corporation's stockholders for the purpose of acquiring control of the Registered Corporation. License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Nevada and to Clark County and the City of Las Vegas, in which the Gaming Subsidiaries' respective operations are conducted. Depending upon the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly or annually and are based upon either: (i) a percentage of the gross revenues received; (ii) the number of gaming devices operated; or (iii) the number of table games operated. A casino entertainment tax is also paid by casino operations where entertainment is furnished in connection with the selling of food or refreshments. Nevada licensees that hold a manufacturer's or distributor's license, such as GNMC, also pay certain fees to the State of Nevada. Any person who is licensed, required to be licensed, registered, required to be registered or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming venture outside of Nevada, is required to deposit with the Nevada Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation by the Nevada Board of its participation in such foreign gaming. The revolving fund is subject to increase or decrease at the discretion of the Nevada Commission. Thereafter, Licensees are required to comply with certain reporting requirements imposed by the Nevada Act. Licensees are also subject to disciplinary action by the Nevada Commission if they knowingly violate any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fail to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engage in activities that are harmful to the State of Nevada or its ability to collect gaming taxes and fees or employ a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability. The sale of alcoholic beverages at The Mirage, Treasure Island, the Golden Nugget-Laughlin and The Mirage Golf Club, and the sale of alcoholic beverages at the Golden Nugget, are subject to licensing, control and regulation by the Clark County Board and the City of Las Vegas, respectively. All licenses are revocable and are not transferable. The agencies involved have full power to limit, condition, suspend or revoke any such license, and any such disciplinary action could (and revocation would) have a material adverse effect on the operations of the Gaming Subsidiaries. ITEM 2. ITEM 2. PROPERTIES The Mirage and Treasure Island share an approximately 116-acre site owned by the Registrant on the Las Vegas Strip. At March 15, 1994, both The Mirage and Treasure Island were subject to aggregate encumbrances approximating $396.0 million, including amounts based upon the accreted value of zero coupon first mortgage notes. The Golden Nugget, including parking facilities, occupies approximately seven and one-half acres in downtown Las Vegas. The improvements and approximately 90% of the underlying land are owned by the Registrant, with the remaining land being held under three separate ground leases that expire (after giving effect to renewal options) on dates ranging from 2025 to 2046. The Golden Nugget-Laughlin, including adjacent parking facilities, and GNL's motel in Bullhead City, Arizona, occupy an aggregate of approximately 15 1/2 acres. All of the property is owned by the Registrant. The Golden Nugget-Laughlin is subject to a blanket encumbrance collateralizing the Registrant's bank credit facility, $20.0 million of which was drawn at March 15, 1994. The Dunes site comprises approximately 164 acres of improved property owned by the Registrant on the Las Vegas Strip. The Mirage Golf Club occupies approximately 125 acres of such property. The Registrant owns approximately 315 acres of land in North Las Vegas. Shadow Creek occupies approximately 80% of such property. Shadow Creek is subject to the blanket encumbrance collateralizing the Registrant's bank credit facility. The Registrant also owns or leases various improved and unimproved property, and options to purchase or lease property, in Las Vegas, Atlantic City, New Jersey and other locations in the United States and certain foreign countries. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Registrant (including its subsidiaries) is a defendant in various lawsuits, most of which relate to routine matters incidental to its business. Management does not believe that the outcome of such pending litigation, in the aggregate, will have a material adverse effect on the Registrant. 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. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant's common stock is traded on the New York and Pacific Stock Exchanges under the symbol MIR. The following table sets forth, for the calendar quarters indicated, the high and low sale prices of the common stock on the New York Stock Exchange, as adjusted to reflect a five-for-two split of the Registrant's common stock effective October 15, 1993. The Registrant paid no dividends in 1993 or 1992. There were approximately 12,300 record holders of the Registrant's common stock as of March 15, 1994. The Registrant's bank credit agreement contains a covenant restricting the ability of the Registrant to pay cash dividends on its common stock or make certain other restricted payments. At December 31, 1993, pursuant to such covenant, the Registrant was permitted to pay dividends and make restricted payments totaling approximately $280 million. In addition, certain subsidiaries of the Registrant are parties to the credit agreement and to indentures which contain covenants restricting the subsidiaries' ability to pay cash dividends on their capital stock to the Registrant. Refer to Exhibits 4(a), 4(e), 4(g) and 10(dd) to this Form 10-K, and Note 5 of Notes to Consolidated Financial Statements referred to in Item 14(a)(1) of this Form 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 There is incorporated by reference the information appearing under the caption "Directors and Executive Officers" in the Registrant's definitive Proxy Statement to be filed with the Securities and Exchange Commission. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION There is incorporated by reference the information appearing under the caption "Executive Compensation" in the Registrant's definitive Proxy Statement to be filed with the Securities and Exchange Commission. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is incorporated by reference the information appearing under the caption "Stock Ownership of Major Stockholders and Management" in the Registrant's definitive Proxy Statement to be filed with the Securities and Exchange Commission. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is incorporated by reference the information appearing under the captions "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions" in the Registrant's definitive Proxy Statement to be filed with the Securities and Exchange Commission. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(3). EXHIBITS. (b). REPORTS ON FORM 8-K. The Registrant filed no reports on Form 8-K during the three-month 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. MIRAGE RESORTS, INCORPORATED By: STEPHEN A. WYNN -------------------------------------- Stephen A. Wynn, PRESIDENT 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.

105006_1993.txt

105006_1993

1993

105006

ITEM 1. BUSINESS (a) General Development of Business The company has continued to conduct its business under the same corporate structure. There have been no material reclassifications, mergers, or consolidations of the company or its subsidiaries during the year. During 1990-1991, the company realigned and restructured its operations into three principal elements which were renamed in 1993; semiconductor equipment, electronics, and environmental services. There have been no acquisitions or dispositions of material amounts of assets other than in the ordinary course of business during 1993. (b) Financial Information about Industry Segments The company operates within three industry segments-semiconductor equipment, electronics, and environmental services. Financial information about industry segments is included in Note 10 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. (c) Narrative Description of Business Semiconductor Equipment The Semiconductor Equipment Group manufactures semiconductor processing equipment, primarily chemical-vapor deposition (CVD) equipment. The company's atmospheric-pressure CVD equipment is used by semiconductor manufacturers worldwide in the production of memory devices (DRAMs) and microprocessors. Historically, the company's CVD systems have been used primarily for the deposition of interlevel-dielectric films--the first dielectric layer on a semiconductor wafer. The company's current principal product, the TEOS999 System, deposits both interlevel and intermetal layers of film on sub-half-micron geometries. The addition of the intermetal capability increased the potential market size for W-J's CVD equipment. The company's next-generation product, the WJ-1000 System, is designed for high-throughput CVD onto the 200-mm (8-inch) wafers currently entering production in major fabrication facilities in the U.S. and overseas. A variant of Watkins-Johnson's semiconductor-production tool is used for manufacturing flat-panel displays for personal-communication, computing and entertainment products. Semiconductor equipment products are primarily marketed through manufacturers' representatives and global distributor networks. Sales by the segment were 28% of consolidated sales in 1993, 21% in 1992 and 24% in 1991. Semiconductor equipment product customers are numerous. The majority of the segment's sales are to manufacturers of semiconductor integrated circuits. There are several domestic and international competitors and competition is intense. In meeting the competition, emphasis is placed on selling quality products having excellent reliability and performance and a strong customer support network. Electronics The Electronics Group manufactures turnkey systems, integrated subsystems and signal-processing components for a broad range of communications and defense applications. The group is serving new customers who have wireless-communication and "dual-use" requirements in addition to supplying sophisticated electronic products for defense-intelligence, missile-guidance and space-communications missions. Recent commercial contracts include high-fidelity W-J cellular receivers to monitor ongoing telephone traffic to ensure authorized use of the system, transponder subsystems to enable ship traffic to navigate treacherous waterways during inclement weather and signal-processing components for a wide range of wireless-communications products. Watkins-Johnson receivers, antennas and signal-analysis equipment are used by both commercial and military governmental agencies to perform range-monitoring, frequency-measurement, signal-localization and interference-analysis functions, often in complex, high-signal-density environments. Key missile programs, such as the Advanced Medium-Range Air-to-Air Missile (AMRAAM) and the High-speed Anti Radiation Missile (HARM) continue to represent a substantial portion of the group's core defense-electronics business. Electronics products are marketed through direct sales efforts and distributor networks. Sales by the electronics segment were 70% of consolidated sales in 1993, 76% in 1992 and 72% in 1991. The majority of the segment sales is made to government agencies and to customers engaged in defense contracting. The principal customer for such sales is the U.S. Department of Defense. Sales contracts with the government are customarily subject to terms and conditions which provide for renegotiation of profits or termination of the contract at the election of the government. The right to terminate for convenience has not had any significant effect on the company's financial position or results of operations. The electronics segment has numerous competitors which include both large diversified corporations and smaller specialty firms. Due to the various industries in which the company and its competitors operate, a competitive ranking cannot be reasonably established. However, the electronics segment is a leading supplier in several of its product markets. In meeting its competition the company offers quality products featuring excellent reliability and performance at competitive prices. Environmental Services W-J Environmental (WJE) specializes in hydrogeology and offers services from the remedial investigation of contaminated-water sites through the remedial action necessary to eliminate the environmental problem. The recent addition of an environmental engineering capability enabled WJE to design and install an innovative wastewater-minimization system which eliminates the discharge of heavy metals and cyanide into the public sewer system. This system is being marketed to manufacturers and governmental agencies charged with finding ways to cope with increasingly restrictive environmental regulations. The unit also markets its capabilities in chemistry, microbiology, geophysics, toxicology, risk assessment and data management to customers who do not require a full range of environmental services, but have a serious requirement for one or two areas of expertise which our new group can satisfy. Other Business Items Raw materials for the production of semiconductor equipment and electronics products are obtained from numerous suppliers. Dependence on any particular supplier is minimal. Business operations are not believed to be seasonal. Except for negotiated advance or progress payments from customers on long-term contracts in the defense-electronics business, there are no special working capital practices in any of the three segments. The company has been increasingly active in securing patents and licensing agreements to protect certain proprietary technologies and know-how resulting from its on-going research and development efforts. Although the company holds and has filings pending on numerous domestic and foreign patents and technology licenses for the manufacture and sale of various products, patents have not significantly affected the company's operations or financial performance. Management believes the company's competitive position is derived primarily from its core competence of engineering, manufacturing and understanding of its customers and markets. Total company backlog at December 31, 1993 was $222,628,000 compared to $207,827,000 at December 31, 1992. The percentage of backlog attributable to the semiconductor equipment and electronics segments were 22% and 77% respectively in 1993, compared to 9% and 89% in 1992. Approximately 86% of all backlog at year-end 1993 is expected to be shippable within 12 months compared to 83% at year-end 1992. Company-sponsored research and development expense was $27,163,000 in 1993, $27,210,000 in 1992, and $27,180,000 in 1991. Customer-sponsored research and development was estimated to be approximately $18,000,000 in 1993, $25,000,000 in 1992, and $15,000,000 in 1991. The company's employment on December 31, 1993 was 2,390. None of the company's employees is covered by a collective bargaining agreement. The company's relationship with its employees is good. Environmental issues are discussed in Note 8 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. (d) Financial Information about Foreign and Domestic Operations and Export Sales. Company foreign operation assets and sales are less than ten percent of consolidated totals. Sales outside the United States accounted for 33% of the company's sales in 1993, 25% in 1992, and 30% in 1991. The inherent risks of foreign business are similar to those of domestic business but with the additional risks of foreign government instability and export license cancellation. A major portion of foreign product orders in the electronics segment requires export licensing by the Department of State prior to shipment. For international shipments of electronics and semiconductor equipment, the company purchases forward exchange contracts and/or obtains customer letters of credit to reduce foreign currency fluctuation and credit risks. For further information on foreign sales, see Note 7 and Note 10 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. ITEM 2. ITEM 2. PROPERTIES Watkins-Johnson Company and subsidiaries conduct their main operations at plants in Palo Alto, Scotts Valley and San Jose, California and Gaithersburg, Maryland. Additional operations are conducted in Columbia, Maryland, and Windsor, England. The company has nine field offices in the United States and five offices overseas. As part of the company's cost reduction efforts, the 56,000 square-foot facility located in North Carolina was closed in 1991. At December 31, 1993 there were approximately 732,000 square feet of plant space in California, 225,000 square feet in Maryland, and 15,000 square feet in England. Approximately 90% of the company's plant space is occupied for the company's operations. The company is pursuing opportunities to realize the market value of its properties while ensuring efficient use of available space. The electronics segment utilizes substantially all of the above named facilities except for the Scotts Valley plant, which houses the semiconductor equipment segment. In addition, the environmental services division maintains leased field offices located in Palo Alto, California and Denver, Colorado. The Palo Alto and Columbia facilities are leased. Sales offices are also leased. The San Jose plant is held subject to a long-term mortgage. Information on long-term obligations is in Note 3 to the consolidated financial statements contained in Part II, item 8 of this annual report on Form 10-K. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Information required under this item is contained in Note 6 and Note 8 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The company submitted no matters to a vote of the shareowners during the last quarter of the period covered by this report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The company's common stock is principally traded on the New York and Pacific stock exchanges. At December 31, 1993 there were approximately 4,600 shareowners, which included holders of record and beneficial owners. The company expects that comparable cash dividends will continue in the future. DIVIDENDS AND STOCK PRICES 1993 QUARTERS 1ST 2ND 3RD 4TH ---------- ---------------------------------------------- Dividends Declared Per Share (in cents)................... 12 12 12 12 Stock Price (NYSE--in dollars). High 15-1/2 18-1/2 24-1/2 26-1/4 Low 12 12-3/4 17-1/4 19-3/8 1992 QUARTERS 1ST 2ND 3RD 4TH ---------- -------------------------------------------------- Dividends Declared Per Share (in cents)......................... 12 12 12 12 Stock Price (NYSE--in dollars)... High 12-5/8 12-1/8 10-7/8 15 Low 10-1/4 9-3/4 8-3/4 8-5/8 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Financial Condition: The company's financial condition remains strong while operations continued to generate sufficient funds for growth. During 1993 cash and equivalents decreased slightly from $49 million to $45 million as a result of higher demands on working capital and increased business volume. The company continues to be in excellent position to pursue investment opportunities including additional product development, potential acquisitions and stock repurchase. The company had no significant commitments outstanding at the end of the year. Current Operations: Performance of the Semiconductor Equipment Group was excellent in 1993. Sales and profit rebounded strongly from the poor conditions of the last two years. Sales volume in the Asia/Pacific region and the U. S. increased substantially. During 1993 Semiconductor Equipment Group facilities were modified to improve production efficiency and capacity in keeping pace with delivery commitments. The Semiconductor Equipment Group's record backlog at year-end indicates that a similar level of business volume is likely to continue through the first half of 1994. Electronics Group sales were steady in 1993 while profits declined slightly. Lower margins were attributable to the disruption of operations resulting from the consolidation of a product line during the first half of 1993. Persistent pricing pressures from customers and competitors also contributed to the lower profitability. The Electronics Group is positioning itself to achieve a better balance between commercial and defense products. During 1993 the group was successful in capturing orders for high-end microwave components, RF receiver opportunities and other wireless communication products for commercial applications. It must be recognized that the semiconductor equipment business is cyclical and can change rapidly. Uncertainty increases significantly when projecting demand for semiconductor equipment products more than six months into the future. Over a longer horizon, uncertainty persists as to how changes in worldwide defense spending may affect sales of the company's Electronic Group products. Therefore, the performance and results of 1993 may not be indicative of future performance. Result of Operations: 1993 Compared to 1992 Semiconductor Equipment Group sales jumped 46% while Electronics Group sales remained flat. Margins improved significantly in the Semiconductor Equipment Group due to the higher volume and operational efficiencies. This more than offset the slight decline in profit margins experienced in the Electronics Group as explained above. As a result, the combined gross margin improved from 34% in 1992 to 35% in 1993. Selling and administrative expenses were higher as expected due to the increase in volume and expenses associated with the profitability of the company. In a percentage-of-sales comparison, selling and administrative expenses were favorable relative to 1992 but may increase in 1994 due to anticipated higher commissions and expenses associated with certain international sales. Research and development expenses decreased for the first three quarters of 1993 as activities eased from the intense levels experienced in 1992. In the fourth quarter 1993, Semiconductor Equipment Group began to reemphasize research and development activities to focus on the next generation of products to meet the time-to-market window. The higher level of research and development expenses incurred in the fourth quarter is expected to continue for at least the first half of 1994. All other nonoperating income and expenses were within expectations. Due to the combined effect of the above factors, 1993 net income of $11,596,000 more than doubled the 1992 income of $4,963,000 before the cumulative effect of an accounting change. A cumulative tax benefit of $5,438,000 was added to the 1992 year-end results due to the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". 1992 Compared to 1991 Company sales decreased 5%, mostly attributable to the continued softness in semiconductor-equipment business while electronics sales were flat. The company was able to achieve a 34% gross margin and an inventory turnover rate of more than four times a year by maintaining minimum levels of inventory during 1992. Although 1992 gross margins improved from the 32% in 1991, all elements of cost were under substantial pressure because of the extremely competitive business environment. The decline in selling and administrative expenses was primarily attributable to the company's continual cost reduction efforts. Research and development expenses were maintained at 10% of sales to improve our competitive position in both the electronics and semiconductor equipment markets. Intense R&D efforts resulted in several acceptances by key customers of our TEOS-Ozone process, indicating increased order opportunities for the Semiconductor Equipment Group. As discussed below, certain nonrecurring provisions related to restructuring, environmental remediation and government claims adversely affected 1991 results. The provisions made in 1991 continued to appear adequate to meet the company's obligations. Interest income was higher in 1992 resulting from additional funds for investment. All other nonoperating income and expenses were within expectations. The company adopted provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109) resulting in a cumulative tax benefit of $5,438,000. Income before the cumulative adjustment was $.66 per share in 1992 compared to a net loss of $2.98 per share in 1991. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) YEAR ENDED DECEMBER 31 ----------------------------------- 1993 1992 1991 ------- -------- -------- Sales .......................... $286,290 $264,400 $277,540 ---------- ---------- ---------- Costs and expenses: Cost of goods sold ........... 184,749 173,816 188,275 Selling and administrative ... 57,452 55,648 60,180 Research and development ..... 27,163 27,210 27,180 Restructuring ................ 12,251 ---------- ---------- ---------- 269,364 256,674 287,886 ---------- ---------- ---------- Income (loss) from operations .. 16,926 7,726 (10,346) Other income (expense): Interest income .............. 1,497 1,422 1,056 Interest expense ............. (1,293) (1,497) (1,519) Other income (expense)--net .. (284) (438) (2,915) Environmental remediation .... (15,000) ---------- ---------- ---------- Income (loss) before Federal and foreign income taxes and cumulative effect of accounting change............. 16,846 7,213 (28,724) Federal and foreign income taxes . (5,250) (2,250) 6,325 ---------- ---------- ---------- Income (loss) before cumulative effect of accounting change .... 11,596 4,963 (22,399) Cumulative effect of change in accounting for income taxes .. 5,438 ---------- ---------- ---------- Net income (loss) ............ $ 11,596 $ 10,401 $ (22,399) ========== ========== ========== Per share amounts: Income (loss) before cumulative effect of accounting change .. $1.45 $ .66 $(2.98) Cumulative effect of change in accounting for income taxes .72 ---------- ---------- ---------- Net income (loss) ............ $1.45 $1.38 $(2.98) ========== ========== ========== Average common and equivalent shares......................... 7,999,000 7,551,000 7,527,000 See notes to consolidated financial statements. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 31 ---------------------------------- 1993 1992 ---------- --------- ASSETS CURRENT ASSETS: Cash and equivalents ................ $ 45,040 $ 49,081 Receivables ......................... 73,971 55,562 Inventories:......................... Finished goods .................... 1,805 2,172 Work in process .................... 28,014 29,290 Raw materials and parts ............ 7,327 6,029 Deferred income taxes ............... 10,545 9,630 Other ............................... 2,072 1,479 ---------- --------- Total current assets .......... 168,774 153,243 ---------- --------- PROPERTY, PLANT AND EQUIPMENT: Land ................................ 4,130 4,130 Buildings and improvements .......... 31,250 28,881 Plant facilities, leased ............ 13,060 13,060 Machinery and equipment ............. 119,417 116,948 ---------- --------- 167,857 163,019 Accumulated depreciation and amortization ....................... (121,028) (115, 908) ---------- --------- Property, plant and equipment--net .. 46,829 47,111 ---------- --------- OTHER ASSETS: Deferred income taxes ............... 4,380 4,220 Other ............................... 645 1,516 ---------- --------- Total other assets ............. 5,025 5,736 ---------- --------- $ 220,628 $ 206,090 ========== ========== LIABILITIES AND SHAREOWNERS' EQUITY CURRENT LIABILITIES: Accounts payable .................... $ 13,243 $ 10,950 Accrued expenses .................... 10,619 10,605 Advances on contracts ............... 11,820 10,559 Provision for warranties and losses on contracts .......................... 5,984 6,964 Payroll and profit sharing .......... 13,217 11,693 Income taxes ........................ 5,394 1,620 ---------- --------- Total current liabilities ........... 60,277 52,391 ---------- --------- LONG-TERM OBLIGATIONS .......... 26,463 28,644 ---------- --------- SHAREOWNERS' EQUITY: Preferred stock, $1.00 par value-- authorized and unissued, 500,000 shares ............................. Common stock, no par value-- authorized, 45,000,000 shares; outstanding: 1993, 7,598,290 shares; 1992, 7,554,865 shares ..... 9,106 7,839 Retained earnings ................... 124,782 117,216 ---------- --------- Total shareowners' equity ..... 133,888 125,055 ---------- --------- $ 220,628 $ 206,090 ========== ========== See notes to consolidated financial statements. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) COMMON STOCK TOTAL ----------------- RETAINED SHAREHOLDERS' SHARES DOLLARS EARNINGS EQUITY ---------- ------ ---------- ---------- Balance, January 1, 1991 ...... 7,519,645 $ 7,521 $136,454 $ 143,975 Net loss for 1991 .......... (22,399) (22, 399) Dividends declared--$.48 per share ...................... (3,614) (3,614) Sales under stock option plans 18,850 164 164 --------- ------ ---------- ------- Balance, December 31, 1991 ..... 7,538,495 7,685 110,441 118,126 Net income for 1992 .......... 10,401 10,401 Dividends declared--$.48 per share .................. (3,626) (3,626) Sales under stock option plans 16,370 154 154 --------- ------ --------- ------- Balance, December 31, 1992....... 7,554,865 7,839 117,216 125,055 Net income for 1993 ........... 11,596 11,596 Repurchase of common stock .... (32,000) (27) (399) (426) Dividends declared--$.48 per share (3,631) (3,631) Sales under stock option plans .. 75,425 1,294 1,294 --------- ------- -------- -------- Balance, December 31, 1993.......... 7,598,290 $ 9,106 $124,782 $133,888 ========= ======= ======== ======== See notes to consolidated financial statememts. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) YEAR ENDED DECEMBER 31 ------------------------------------- 1993 1992 1991 --------- ---------- --------- OPERATING ACTIVITIES: Net income (loss) .................. $ 11,596 $ 10,401 $(22,399) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization ..... 9,961 11,305 11,945 Write-down of assets related to restructuring ................... 8,785 Deferred tax provisions including accounting change ............... (1,075) (6,450) (3,660) Changes net of restructuring:...... Receivables .................... (18,409) 13,527 21,708 Inventories .................... 345 (2,218) 8,880 Other assets .................... (556) 4,438 (4,347) Accruals and payables .......... 8,878 1,318 (5,788) Advances on contracts ........... 1,261 (12,037) 5,803 Provision for warranties and losses on contracts ........... (980) 198 2,508 Environmental remediation ....... (1,676) (1,581) 15,000 -------- --------- -------- Net cash provided by operating activities.......... 9,345 18,901 38,435 -------- --------- -------- INVESTING ACTIVITIES: Additions of property, plant and equipment ......................... (9,714) (5,206) (9,889) Other .............................. 869 32 49 -------- ------- -------- Net cash used in investing activities.................... (8,845) (5,174) (9,840) -------- ------- -------- FINANCING ACTIVITIES: Net borrowings (repayments) under lines of credit..................... 204 (343) (371) Payments on long-term obligations ... (1,982) (974) (918) Proceeds from issuance of common stock............................... 1,294 154 164 Repurchase of common stock .......... (426) Dividends paid ..................... (3,631) (3,626) (4,517) -------- -------- ------- Net cash used in financing activities..................... (4,541) (4,789) (5,642) -------- -------- ------- Net increase (decrease) in cash and equivalents ......................... (4,041) 8,938 22,953 Cash and equivalents at beginning of year................................. 49,081 40,143 17,190 --------- ------- ------- Cash and equivalents at end of year .......................... $ 45,040 $49,081 $40,143 ========= ======== ======= Other cash flow information: Income taxes paid (refunded) . $ 3,808 $(2,638) $ 4,242 Interest expense paid .......... 1,324 1,522 1,503 See notes to consolidated financial statements. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation--The consolidated financial statements include those of the company and its subsidiaries after elimination of intercompany balances and transactions. Cash Equivalents--Cash equivalents consist principally of U.S. Treasury bills and commercial paper acquired with remaining maturity periods of ninety days or less and are stated at cost plus accrued interest which approximates market value. The company's investment guidelines limit holdings in commercial paper to $1,000,000 per issuer. Inventories--Inventories are stated at the lower of cost, using first-in, first-out and average-cost basis, or market. Cost of inventory items is based on purchase and production cost. Long-term contract costs and selling and administrative expenses are excluded from inventory. Progress payments are not netted against inventory. Property, Plant and Equipment--Property, plant and equipment are stated at cost. Leases which at inception assure the lessor full recovery of the fair market value of the property over the lease term are capitalized. Provision for depreciation and amortization is primarily based on the sum-of-the-years'-digits and declining-balance methods. Revenue Recognition--Revenue on fixed-price contracts other than long-term contracts is recorded upon shipment or completion of tasks as specified in the contract. Sales and allowable fees under cost-reimbursement contracts are recorded as costs are incurred. Long-term contract sales and cost of goods sold are recognized using the percentage-of-completion method based on the actual physical completion of work performed and the ratio of costs incurred to total estimated costs to complete the contract. Any anticipated losses on contracts are charged to earnings when identified. Income Taxes--In 1992 the company adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes" (SFAS 109); previously the company had accounted for taxes under SFAS 96 (see Note 7). Under both SFAS 109 and 96, the consolidated statements of income include provisions (benefits) for deferred income taxes using the "liability" method for transactions that are reported in one period for financial accounting purposes and in another period for income tax purposes. State and local income taxes are included in selling and administrative expenses. Per Share Information--Beginning in 1993 net income per share is computed using the weighted average number of common and common equivalent shares (dilutive stock options) outstanding during the year. The difference between fully diluted earnings per share and primary earnings per share is not significant. Prior to 1993, the computation excluded outstanding stock options as their dilutive effect was not material. Reclassification--Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. 2. RECEIVABLES Receivables consist of the following (in thousands): 1993 1992 ---------- ---------- U.S. Government long-term contracts: Billed .............................. $ 2,936 $ 2,125 Unbilled ........................... 4,896 3,560 Commercial long-term contracts: Billed .............................. 3,818 2,416 Unbilled ........................... 11,917 10,367 ---------- ---------- Total long-term contract receivables .. 23,567 18,468 Other trade receivables ............... 50,404 37,094 ---------- ---------- Total receivables less allowance of $999 in 1993 and $982 in 1992 .... $73,971 $55,562 ========== ========== Unbilled receivables represent revenue recognized for long-term contracts not yet billable based on the terms of the contract. These amounts are billable upon shipment of the product, achievement of milestones, or completion of the contract. Unbilled receivables are expected to be billed and collected within one year. Receivables representing retainage not collectible within one year are not material. There are no significant billed or unbilled receivables subject to future negotiation. Government contracts have provisions for audit, price redetermination and other profit and cost limitations. Contracts may be terminated without prior notice at the Government's convenience. In the event of such termination, the company may be compensated for work performed, a reasonable allowance for profit, and commitments at the time of termination. The right to terminate for convenience has not had any significant effect on the company's financial position or results of operations. 3. LONG-TERM OBLIGATIONS AND LINES OF CREDIT Long-term obligations, excluding amounts due within one year, consist of (in thousands): 1993 1992 ---------- ---------- Mortgage ........................... $ 4,238 $ 5,508 Deferred compensation .............. 4,034 2,898 Environmental remediation .......... 10,257 11,933 Long-term leases ................... 7,934 8,305 ---------- ---------- Total ........................... $26,463 $28,644 ========== ========== The current portion of long-term obligations is included in current liabilities. The expected maturity amounts are as follows: 1994, $4,102,000; 1995, $1,873,000; 1996, $1,917,000; 1997, $1,964,000, 1998, $2,016,000. Mortgage--Primarily consists of a mortgage bearing 8-3/4% interest secured by the San Jose, California plant. The annual payments totaling $710,000 continue into the year 2003 and are payable in monthly installments. Based on the borrowing rates currently available to the company for loans with similar terms, the carrying value of the mortgage approximates fair value. Deferred Compensation--The company has deferred compensation plans covering selected members of management and key technical employees. The purpose is to reward and encourage talented employees to remain with the company. Environmental Remediation--As discussed in Note 8, the company is obligated to remediate groundwater contamination at the Scotts Valley and Palo Alto facilities. The portion expected to be paid within one year is included in current liabilities. Leases--Certain long-term leases for plant facilities are treated as capital leases for financial statement purposes. The leases expire during the years 1994 to 2014, however renewal options provide for lease extensions ranging from fifteen to thirty-five years at revised rental terms. The company also has noncancellable operating leases for plant facilities and equipment expiring through 1996. The leases may be renewed for various periods after the initial term. Payment obligations under these capitalized and operating leases as of December 31, 1993 are as follows (in thousands): CAPITAL OPERATING LEASES LEASES ---------- --------- Lease payments: 1994 .................... $ 1,156 $1,104 1995 .................... 848 839 1996 .................... 848 163 1997 .................... 848 36 1998 .................... 848 Remaining years ........ 16,568 ---------- --------- Total ...................... 21,116 $ 2,142 ========== Imputed interest ........... (12,811) --------- Present value of lease payments (current portion, $371) .. $ 8,305 ========= Rent expense for property and equipment relating to operating leases is as follows (in thousands): 1993 1992 1991 --------- --------- -------- Real property ................ $ 1,033 $ 1,188 $1,234 Equipment .................... 865 830 929 -------- -------- ------- Total ................. $ 1,898 $ 2,018 $2,163 ======== ======== ======= Lines of Credit--The company has arranged with certain banks to provide unsecured revolving lines of credit totaling $23,500,000. These agreements are generally renegotiated on an annual basis. No material compensating balances are required or maintained. Borrowings under these facilities generally bear interest at prime rate, which was 6 percent in 1993. The lines of credit were substantially unused during the year. The amount of outstanding letters of credit and other guarantees, which may reduce the company's available lines, totaled $4,230,000 at December 31, 1993. 4. SHAREOWNERS' EQUITY Stock Repurchase Program--The Board of Directors has authorized the company to repurchase a maximum of 1,500,000 shares of company stock. Approximately 936,000 shares have been repurchased through December 31, 1993. Common Share Purchase Rights--For each share of company common stock outstanding, one Common Share Purchase Right is attached. The Rights expire October 20, 1996, and may be redeemed by the company for $.01 per Right at any time prior to 15 days after an entity acquires 20% or more of the company's common stock. The Rights become exercisable if an entity acquires 20% or more of the company's outstanding common stock, or announces an offer which would result in such entity acquiring 30% or more of the company's common stock. When exercisable, the Rights trade separately from the common stock and entitle a holder to buy one share of the company's common stock for $160. If the company is subsequently involved in a merger or other business combination, each Right will entitle its holder to buy a number of shares of common stock of the surviving company having a market value of twice the $160 exercise price. The Rights also provide for protection against self-dealing transactions by a controlling shareowner. Stock Option Plans--The Employee Stock Option Plan provides for grants of nonqualifying and incentive stock options to certain key employees and officers. The options are granted at the market price on date of grant and expire at the tenth anniversary date. One-third of the options granted are exercisable in each of the third, fourth and fifth succeeding years. The Plan allows those employees who are subject to the insider trading restrictions certain limited rights to receive cash in the event of a change in control. Shares issued are net of retirement of shares used in payment for options exercised. In addition, the Plan permits the award of restricted stock rights subject to a fixed vesting schedule. The holder of vested restricted stock has certain dividend, voting, and other shareowner rights. No restricted stock awards have been made through December 31, 1993. The Nonemployee Directors Stock Option Plan provides for a fixed schedule of options to be granted through 1998. Options granted are exercisable similarly to the Employee Stock Option Plan. The total number of shares to be issued under this plan may not exceed 200,000 shares. Included in the tables below, 17,640 option shares were granted at $12.88 in 1993 and 19,080 option shares were granted at $10.00 in 1992. 1993 SHARES PRICE - ---------- ---------- ---------- Granted ...................... 449,640 $12.38 to $24.50 Exercised .................... 87,945 $13.00 to $21.00 Terminated .................. 154,167 At December 31: Outstanding ................ 1,869,412 $ 9.63 to $36.75 Exercisable ................ 1,058,700 Reserved for future grants . 1,657,230 1992 SHARES PRICE - ---------- ---------- ------------ Granted ...................... 556,080 $ 9.25 to $10.75 Exercised .................... 19,270 $ 8.88 to $10.17 Terminated .................. 161,524 At December 31: Outstanding ................ 1,661,884 $ 9.63 to $36.75 Exercisable ................ 711,046 Reserved for future grants . 1,952,703 5. RESTRUCTURING During 1991, the company took actions resulting in restructuring charges totaling $12,251,000 associated with the consolidation and closure of facilities. Such actions included reductions in work force and consolidation of product lines required to concentrate on core markets. Charges incurred were primarily related to severance pay and write-down of assets. 6. OTHER INCOME (EXPENSE)--NET In 1991 the company received and reviewed various audit reports and claims asserted by the Defense Contract Audit Agency (DCAA) for contracts completed in prior years. Although the company believes it has meritorious defenses, provisions totaling $2,500,000 were recorded for these claims in 1991. 7. INCOME TAXES In 1992 the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109) which permits recognition of tax benefits for certain temporary differences that could not be recognized under SFAS 96. Under SFAS 109, deferred tax assets are recognized when management believes realization of future tax benefits of temporary differences is more likely than not. In estimating future tax consequences, SFAS 109 generally considers all expected future events other than enactments of changes in the tax law or rates, whereas SFAS 96 gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. The cumulative effect of this accounting change increased deferred tax assets at January 1, 1992 and first quarter 1992 net income by $5,438,000 or 72 cents per share. As permitted by SFAS 109, the income tax provision for 1991 has not been restated. The provision (benefit) for Federal and foreign income taxes consists of the following (in thousands): 1993 1992 1991 ---------- ---------- ---------- Current .................. $ 6,325 $ 3,262 $ (2,665) Deferred ................. (1,075) (1,012) (3,660) ---------- ---------- ---------- Total ............. $ 5,250 $ 2,250 $ (6,325) ========== ========== ========== Deferred tax assets (liabilities) are comprised of the following at December 31 (in thousands): 1993 1992 1991 ---------- ---------- ---------- Capitalized leases ...................$ 675 $ 736 $ 786 Deferred compensation ................ 3,357 2,055 2,291 Loss accruals ....................... 5,423 5,919 4,762 Environmental remediation ............ 4,034 4,601 5,134 Uniform capitalization .............. 1,055 929 844 Vacation accrual ..................... 1,744 1,698 1,656 Unusable tax benefits under SFAS 96 .. (5,438) Other ................................ 454 211 20 ---------- ---------- --------- Gross deferred tax assets......... 16,742 16,149 10,055 ---------- ---------- --------- Depreciation ....................... (1,413) (1,910) (2,267) Other ............................... (404) (389) (388) ---------- ---------- --------- Gross deferred tax liabilities.... (1,817) (2,299) (2,655) ---------- ---------- --------- Net deferred tax asset .............. $14,925 $13,850 $ 7,400 ========== ========== ========== The differences between the effective income tax rate and the statutory Federal income tax rate are as follows: 1993 1992 1991 ---------- ---------- ---------- Statutory Federal tax rate ........... 35.0% 34.0% 34.0% FSC ............................... (7.4) (7.8) 3.5 Deferred tax changes ............. (14.7) Foreign subsidiary losses ........ 1.8 3.1 Other ............................. 1.8 1.9 (.8) ---------- ---------- ---------- Effective rate ..................... 31.2% 31.2% 22.0% ========== ========== ========== Deferred tax changes in 1991 resulted primarily from loss provisions for which no tax benefit was recognized under SFAS 96. Domestic state and local income taxes included in selling and administrative expenses totaled $1,257,000 in 1993, $640,000 in 1992, and $265,000 in 1991. Foreign operation amounts represent less than 5% of totals. The Omnibus Budget Reconciliation Act of 1993 (the Act) became effective on August 10, 1993. The provisions of the Act did not have a material effect on the company's deferred taxes or its results of operations. 8. ENVIRONMENTAL REMEDIATION AND OTHER CONTINGENCIES In 1991, the company completed negotiations with the Environmental Protection Agency (EPA) for a consent decree, which was subsequently lodged in U.S. District Court. The agreement requires the company to complete restoration and thereafter maintain the groundwater quality at the Scotts Valley Plant. In a separate action, the California Environmental Protection Agency issued a letter challenging the company's position that the source of subsurface contamination originated outside of company facilities in Palo Alto and directed the company to revise its remedial investigation/feasibility study. The state further directed the company to clean up certain contamination under the company facilities irrespective of the origin thereof; and to coordinate remedial efforts among the potential responsible parties cited in a 1988 regional remedial action order. The company recorded a provision totaling $15,000,000 for estimated costs to comply with the consent decree on the Scotts Valley Plant site and for estimated costs necessary to fully investigate, develop, and implement the remedial actions at the Palo Alto Plant site. The provision was not reduced by any potential recoveries from insurers or other responsible parties. The ultimate cost of restoring the sites cannot be predicted with certainty. Additional uncertainty exists with the Palo Alto site since the extent of the contamination and the respective share of each potential responsible party has not yet been conclusively determined. Technological advances and developments may also affect the future costs of the restoration efforts. Moreover, the company will continue to vigorously pursue recovery from its insurers and other responsible parties. The company believes adequate provisions have been taken to cover the expected expenditures associated with the known environmental actions at this time. In addition to the above environmental matters and pending government claims discussed in Note 6, the company is involved in various legal actions which arose in the ordinary course of its business activities. Except for the provisions noted above and in Note 6, the company believes the final resolution of these matters should not have a material impact on its results of operations and financial position. 9. EMPLOYEE BENEFIT PLANS Profit Sharing Investment Plan--The Watkins-Johnson Employees' Profit Sharing Investment Plan conforms to the requirements of ERISA and the Internal Revenue Code as a qualified defined contribution plan. The Plan covers substantially all employees and provides that the company's contribution equal 9% of the net pretax earnings and be funded each year. The amount charged to income was $1,945,000 in 1993, $906,000 in 1992, and $0 in 1991. Employee Stock Ownership Plan (ESOP)--To encourage employee participation and long-term ownership of company stock, an ESOP was implemented on January 1, 1991. The Board determines each year's contribution depending on the performance and financial condition of the company. The Board approved a contribution equal to 1% of eligible employee compensation for 1993, 1992, and 1991, which resulted in charges to income of $887,000, $900,000, and $910,000, respectively. The ESOP is a qualified defined contribution plan under the similar employment and regulatory requirements as the Profit Sharing Investment Plan. 10. BUSINESS SEGMENT REPORTING The company operates in three industry segments. Operations in the Electronics (formerly Defense) segment include the design, development, manufacture and sale of advanced electronic systems and devices for military, space, and commercial applications. Operations in the Semiconductor Equipment (formerly Commercial) segment involve the development, production, sales and service of chemical-vapor-deposition equipment for the manufacture of semiconductor products and flat-panel displays. The Environmental Services operations provide technical consulting services ranging from the exploration, development and utilization of groundwater resources to the detection and remediation of contaminated sites. The U.S. Government is a significant customer for the Electronics and Environmental Services segments. Hughes Aircraft Company is a significant customer for the Electronics segment. Sales to U.S. Government agencies and Hughes Aircraft Company totaled $63,000,000 and $41,000,000 in 1993; $70,000,000 and $28,000,000 in 1992; $71,000,000 and $25,000,000 in 1991, respectively. Corporate assets consist primarily of cash and equivalents. Intersegment sales were transferred based on negotiated prices. Sales by geographic area are as follows (in thousands): 1993 1992 1991 ---------- ---------- ---------- United States .................. $193,075 $199,611 $ 193,298 Export sales: Europe ....................... 20,830 12,266 14,704 Far East ..................... 44,970 26,548 42,143 Other ........................ 15,652 11,311 14,294 European foreign operations .. 11,763 14,664 13,101 ---------- ---------- ---------- Total ..................... $286,290 $264,400 $ 277,540 ========== ========== ========== Foreign operations' sales and identifiable assets are less than ten percent of consolidated totals. 11. QUARTERLY FINANCIAL DATA-UNAUDITED Unaudited quarterly financial data are as follows (in thousands, except per share amounts): YEAR ENDED DECEMBER 31 ------------------------------------------ 1993 QUARTERS 1ST 2ND 3RD 4TH - -------------- -------- ------- -------- -------- Sales ...........................$67,083 $68,216 $72,708 $78,283 Gross profit ................... 22,147 23,250 25,462 30,682 Net income ...................... 1,370 2,652 3,512 4,062 Net income per share ............ $.18 $.33 $.42 $.52 1992 QUARTERS 1ST 2ND 3RD 4TH - -------------- -------- ------- -------- -------- Sales .......................... $63,049 $66,984 $68,478 $65,889 Gross profit ................... 21,851 23,973 23,629 21,131 Net income ..................... 6,913(a) 754 1,368 1,366 Net income per share ........... $.92(a) $.10 $.18 $.18 - ---------- (a) The first quarter of 1992 includes a tax benefit of $5,438 or 72 cents per share due to the cumulative effect of an accounting change (see Note 7). REPORT OF MANAGEMENT The consolidated financial statements of Watkins-Johnson Company and subsidiaries were prepared by management, which is responsible for their integrity and objectivity. The statements were prepared in conformity with generally accepted accounting principles and, as such, include amounts that are based on the best judgments of management. The system of internal controls of the company is designed to provide reasonable assurance that assets are safeguarded and that transactions are executed in accordance with management's authorization and are reported properly. Perhaps the most important safeguard for shareowners is the company's emphasis in the selection, training and development of professional accounting managers to implement and oversee the proper application of its internal controls and the reporting of management's stewardship of corporate assets and maintenance of accounts in conformity with generally accepted accounting principles. Deloitte & Touche, independent auditors, are retained to provide an objective, independent review as to management's discharge of its responsibilities insofar as they relate to the fairness of reported operating results and financial position. They obtain and maintain an understanding of the company's accounting and financial controls, and conduct such tests and related procedures as they deem necessary to arrive at an opinion on the fairness of the financial statements. The Audit Committee of the Board of Directors, composed solely of Directors from outside the company, meets periodically, separately and jointly, with the independent auditors and representatives of management to review the work of each. The functions of the Audit Committee include recommending the engagement of the independent auditors, reviewing the scope and results of the audit and reviewing management's evaluation of the system of internal controls. W. Keith Kennedy Scott G. Buchanan President and Vice President and Chief Executive Officer Chief Financial Officer INDEPENDENT AUDITORS' REPORT The Shareowners and Board of Directors of Watkins-Johnson Company: We have audited the accompanying consolidated balance sheets of Watkins-Johnson Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareowners' 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 materials respects, the financial position of Watkins-Johnson Company 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. In 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," as described in Note 7 to the consolidated financial statements. February 4, 1994 Deloitte & Touche San Francisco, California 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 The information required by this item concerning the company's directors is shown under the caption "Election of Directors" in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A. The information relating to the company's executive officers is presented in Part I of this Form 10-K under the caption "Executive Officers of the Registrant". ITEM 11. ITEM 11. EXECUTIVE COMPENSATION See this caption in the definitive proxy statement which the company has filed with the Commission pursuant to Regulation 14A. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information is shown under the captions "Security Ownership of Certain Beneficial Owners & Management" in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain business relationships is shown under the caption "Executive Compensation" in the definitive proxy statement which the company has filed with the Commission pursuant to Regulation 14A. There were no transactions with management for which disclosure would be required by Item 404 of Regulation S-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K PAGE ---- (a)1. Consolidated Financial Statements Consolidated Statements of Operations For the Years Ended December 31, 1993, 1992 and 1991 7 Consolidated Balance Sheets December 31, 1993 and 1992 8 Consolidated Statements of Shareowners' Equity For the Years Ended December 31, 1993, 1992 and 1991 9 Consolidated Statements of Cash Flows For the Years Ended December 31, 1993, 1992 and 1991 10 Notes to Consolidated Financial Statements 11-18 Report of Management 19 Independent Auditors' Report 20 2. Financial Statement Schedules PAGE ---- Independent Auditors' Report........................................ 24 I Marketable Securities as of December 31, 1993................ 25 VIII Valuation and Qualifying Accounts and Reserves For the Years Ended December 31, 1993, 1992 and 1991......... 26 IX Short-Term Borrowings For the Years Ended December 31, 1993, 1992 and 1991.............................27 X Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991.................28 Schedules not listed above are omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or in the notes thereto. 3. Exhibits A list of the exhibits required to be filed as part of this report is set forth in the Exhibit Index, which immediately precedes such exhibits. The exhibits are numbered according to Item 601 of Regulation S-K. Exhibits incorporated by reference to a prior filing are designated by an asterisk. ---------- (b) No reports on Form 8-K were required to be filed during the last quarter of the period covered by this report. (c) The exhibits required to be filed by Item 601 of Regulation S-K are the same as Item 14(a)3 above. (d) Financial statement schedules not included herein have been omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or in the notes thereto. 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. WATKINS-JOHNSON COMPANY ----------------------------------------- (Registrant) Date: March 25, 1994 By /s/ DEAN A. WATKINS ------------------------------------- DEAN A. WATKINS CHAIRMAN OF THE BOARD INDEPENDENT AUDITORS' REPORT Watkins-Johnson Company: We have audited the consolidated financial statements of Watkins-Johnson 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 February 4, 1994, which report includes an explanatory paragraph as to an accounting change in 1992 to adopt Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," such consolidated financial statements and report are included in Item 8 of this annual report on Form 10-K. Our audits also included the consolidated financial statement schedules of Watkins-Johnson Company and subsidiaries, listed in Item 14. These consolidated 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 consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. February 4, 1994 Deloitte & Touche San Francisco, California Schedule VIII WATKINS-JOHNSON COMPANY AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 BALANCE AT CHARGED TO BALANCE AT BEGINNING COSTS AND END OF DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS(1) PERIOD(2) - ---------- ---------- ---------- ------------- ---------- Allowance for doubtful accounts ....$982,244 $ 21,420 $ 4,666 $ 998,998 ========== ========== ======== ========== Allowance for doubtful accounts ....$965,989 $ 24,550 $ 8,295 $ 982,244 ========== ========== ======= ========== Allowance for doubtful accounts ....$617,772 $351,817 $ 3,600 $ 965,989 ========== ========== ======= ========= - ---------- (1) Write-off of uncollectible accounts. (2) Reduction to accounts receivable. SCHEDULE X WATKINS-JOHNSON COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ------------------------------------- ITEM 1993 1992 1991 ---------- ---------- ---------- ---------- 1. Maintenance and repairs .............$3,788,406 $4,652,897 $6,553,973 2. Depreciation and amortization of intangible assets ..................... (1) (1) (1) 3. Taxes, other than payroll and income taxes .......................... (1) (1) (1) 4. Royalties ............................. (1) (1) (1) 5. Advertising costs ..................... (1) (1) (1) - ---------- (1) Expense did not exceed 1% of sales. EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION - ---------- ------------ 3-a ...... *Articles of Incorporation of Watkins-Johnson Company, as amended May 8, 1989. 3-b ...... *By-Laws of Watkins-Johnson Company, as amended April 27, 1989 (Exhibit 3-b to Form 10-K for 1980, Commission File No. 1-5631). 10........ Material Contracts: 10-a...... *Lease and Agreement between Lindco Properties Company and Watkins-Johnson Company commencing May 1, 1969 (Exhibit (b) I to Form 10-K for 1969, Commission File No. 2-22436). 10-b ..... *Lease and Agreement between Morrco Properties Company and Watkins-Johnson Company dated October 31, 1975 (Exhibit 2(c) to Form 10-K for 1976, Commission File No. 1-5631). 10-c...... *Lease and Agreement between Danac Real Estate Investment Corporation and Watkins-Johnson Company (Exhibit 6 to Form 10-K for 1972, Commission File No. 2-22436) and the amendments thereto (Exhibit 1(b) to Form 10-K for 1976, Commission File No. 1-5631). 10-d...... *Building and Loan Agreement and Deed of Trust Note between Danac Real Estate Investment Corporation and Watkins-Johnson Company (Exhibit 7 to Form 10-K for 1972, Commission File No. 2-22436). 10-e ..... *Promissory Note and Deed of Trust Agreement entered into between the New England Mutual Life Insurance Company and Watkins-Johnson Company dated May, 1978 (Exhibit 2 to Form 10-K for 1978, Commission File No. 1-5631). 10-f...... *Promissory Note and Deed of Trust entered into by the Wake County Industrial Facilities and Pollution Control Financing Authority, the NCNB National Bank of North Carolina and Watkins-Johnson Company dated December 28, 1984 (Exhibit 10-f to Form 10-K for 1984, Commission File No. 1-5631). 10-g .......*Deferred Compensation Plan effective November 29, 1979 (Exhibit 10-g to Form 10-K for 1984, Commission File No. 1-5631). 10-h .......*Key Top-Management Incentive Bonus Plan Summary (Exhibit 10-h to Form 10-K for 1985, Commission File No. 1-5631). 10-i .......*Employment Agreement Form, in effect for those employees listed in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A (Exhibit 10-i to Form 10-K for 1984, Commission File No. 1-5631). 10-j .......*Deferred Compensation Plan effective November 29, 1979 as amended March 31, 1986 (Exhibit 10-j to Form 10-K for 1986, Commission File No. 1-5631). 10-k .......*Lease and Agreement between Seagate Technology and Watkins-Johnson Company dated September 19, 1986 (Exhibit 10-k to Form 10-K for 1986, Commission File No. 1-5631). 10-k(1) ....*Termination of Lease and Agreement between Seagate Technology and Watkins-Johnson Company dated September 22, 1987 (Exhibit 10-k(1) to Form 10-K for 1987, Commission File No. 1-5631). 10-l .......*Severance Agreement Form, in effect for those employees listed in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A (Exhibit 10-l to Form 10-K for 1986, Commission File No. 1-5631). 10-m .......*Form of Rights Agreement between Watkins-Johnson Company and Bank of America National Trust and Savings Association (Exhibit 4 to the 1986 Third Quarter Form 10-Q, Commission File No. 1-5631). 10-n .......*Watkins-Johnson Company 1976 Stock Option Plan, as amended September 28, 1987 (Appendix A to the company's definitive proxy statement dated March 1, 1988 filed with the Commission pursuant to Regulation 14A). 10-o .......*Watkins-Johnson Company 1989 Stock Option Plan for nonemployee directors (Appendix A to the company's definitive proxy statement dated February 28, 1990 filed with the Commission pursuant to Regulation 14A). 10-p .......*Watkins-Johnson Company 1976 Stock Option Plan amended and renamed as the 1991 Stock Option and Incentive Plan (Appendix A to the company's definitive proxy statement dated February 28, 1991 filed with the Commission pursuant to Regulation 14A). 11 .........Statement re Computation of Per Share Earnings. 21 .........Subsidiaries of Watkins-Johnson Company. 23 .........Consent of Independent Auditors.